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Opalesque Islamic Finance Intelligence

Editor's Note: Disclosure, Due Diligence & Death Spirals By Bernardo Vizcaino, CAIA

Wednesday, April 28, 2010

Much has been said about what is right and what is wrong within Islamic finance, but every so often one must admit that while we scrutinize the current events and immediate developments (mostly in the short term) we tend to lose sight of the long term objectives of the industry (i.e. where it is heading). At times however, it seems that in discussing the more immediate aspects of the industry one forgets about its long term viability and sustainability.

Not long ago I was attending a particular event where various practitioners took to the stage to talk about Islamic finance (or to be more precise to sell us their services). The whole episode left me with much to think about in terms of who is representing Islamic finance (since the 'pitch' was aimed squarely at the local government and regulator). This wouldn't surprise the seasoned industry veteran (advertorials are an almost daily occurrence), but this takes on greater importance when we place this in the context of the new markets where Islamic finance is nascent and gradually opening up.

It begs the question - what are the priorities of these individuals/institutions? While I run the risk of being accused of naivet© (after all we all have to look after our business interests), it appears that their short-term financial/business gain takes priority at the expense of the long-term health of the industry. A few things to consider:


Most of the presentations during this event had nothing new: sukuk, tawarruq, riba, Shariah boards, etc, etc. What was conspicuously missing was any mention of some rather significant issues that should be discussed openly (if not candidly): but not a word about Nakheel, Blom Bank, OIC rulings, or the huge magnifying glass that is currently set on top of asset-based sukuk. Everyone has the right (and professional duty) to market their products and services, but we should encourage the disclosure of the various industry issues (at the very least to illustrate that we have learned from these bumps in the road). One thing that has remained constant in our discourse is the need to be open, frank, and practical in our comments and suggestions. Some will argue it is transparency and eventually this leads to something equally important: credibility.

Another aspect of disclosure pertains to which Islamic finance model (if any) does a particular country follow (again this is much more important for frontier markets where Islamic finance is just taking hold). Nonetheless, very little was shared in this regard but it comes down to whether a country follows one of these:

  1. An umbrella SSB model - be that at the country level or at the industry level. The umbrella SSB has proven successful in Malaysia, Pakistan and Indonesia to name a few. Some of the key benefits are market recognition, volume of transactions and low-cost product development. Overall, the umbrella SSB is tasked with providing substantial direction (for instance in the shape of product standards and/or guidelines). This requires strong government - as well as political - support so it is not as easy to implement (but not impossible either).
  2. An individual SSB model - whereby each market participant can chose their own path to compliance. This is usually illustrated when regulators take a hands-free approach and signal market participants to respond to 'market forces' when selecting the Shariah advisors or scholars whom they employ (in other words, no signal or direction is given except in the broadest sense). The individual SSB model can work well in offshore jurisdictions (say Luxembourg, Ireland, jersey), where financial transactions are often not high in volume or are structured as pass-through vehicles (think special purpose vehicles and the like), or where Islamic finance remains a niche segment.

There is absolutely nothing wrong with either one of these, but they cater to very different markets and situations. One might work for Brazil while the other might work for Bermuda. Similarly, there are various exceptions such as the vibrant London and UAE markets (for the individual SSB model) which exhibit volume and visibility (although at the expense of higher costs). Again, it should be left to the policy makers to make these decisions, although what is necessary is for them to hear from all viewpoints (this is often not the case).

For the record, my preference is for the umbrella model mentioned above. It might be more elegant and cost-effective but what is far more enticing is how it engages the entire community of capital market participants. Hence Islamic finance is not privy to a few specialized funds houses, instead it is open to any financial institution that wishes to explore this 'alternative' finance. It simply makes more sense, especially when one deals with markets that contain significant capital market activity. Regardless, the point here is that one needs to assess and explore all options - and this is especially true with new markets (as they can start from a clean slate).

Due Diligence

There will always be a learning curve and we are not advocating placing an undue burden on service providers for them to educate governments, regulators or new entrants at large. These new market participants need to do their homework as well. Even a superficial analysis of the industry would yield many of the issues that have been highlighted earlier but unfortunately this is lost when hearing from industry experts that are advocating one point of view and this can have an undue influence on policy makers. Some might not the most industry-savvy individuals out there or they might be driven by political motives rather than strategic reasoning. A balanced presentation of the industry would be most refreshing, alongside an objective digest from the audience. Hence due diligence is vital and it is a two way street - it is not just about asking questions (even if they are simple ones) it is about asking them to the right sources (and on the overall quality of these answers).

To illustrate, the following points (or rather incomplete arguments) were made during the event:

  • "Lack of Scholars": This bottleneck was argued both in terms of quantity and quality (and this might well be the case). This could support the use of an umbrella SSB; Nevertheless, the lack of Scholars argument is used to suggest that some Scholars are not up to standard and that preference should be given to the more 'progressive' ones. However this could make the bottleneck even worse. What needs to be addressed is the nurturing of new Scholars and/or ensuring proper training is given to the younger generation of Scholars.
  • "Priority to issue sovereign sukuk": Again this is partly true, having a government issuance is a widely accepted positive (as it provides a pricing benchmark for the market), but this requires the private sector to follow suit (i.e. sovereign sukuk is followed by private issuances). This would also suggest that most would issue the same type of sukuk (cue product convergence), hence this would benefit tremendously from having an industry guideline and/or standard for such a product. Once again, these points were missed altogether.
  • "More bang for your buck": The argument was made by another presenter that a sovereign sukuk or an educational program would provide maximum market visibility (not surprisingly he represents an educational service provider). Nevertheless, there are other equally noticeable initiatives: a country level SSB, publishing an industry roadmap, issuing a product guideline/directive. Any of these could be equally powerful signals.
  • "Musharaka is a beautiful but impractical concept": This particular gem came from an actual AAOIFI board member, and I really don't have much to say except that if we are dissing musharaka while marketing organized tawarruq we have really lost sight of things. The truth is that one is not better than the other, but what we should advocate is a balanced approach.
  • "Industry immunity to the global financial crisis": This point has been covered extensively by many but it was curious to see presenters quoting Singapore and South Korea as examples of markets where Islamic finance has flourished. The fact is that Islamic finance has stagnated in the former and is barely taking off in the latter. They are both prime examples of the struggles faced by new markets (in terms of high costs, lengthy timelines, etc) and at the same time they can prove to be excellent examples of what actually is needed by market participants (Singapore's recent product guideline on Istisna financing is an acknowledgment that leaving things to 'market forces' does not always work).
  • "Lack of objective journalism": Not in disagreement, but interesting how that the person making this point (representing a media service provider) was simultaneously selling their advertorial-rich reports.

Death Spirals

It is very clear, and overtly encouraging, that in the next few years we will have Islamic finance springing in various new markets. In some cases this will be at great expense to the first movers in those markets. Nevertheless various other service providers and market participants will follow suit. The risk is that the upfront costs will be overtly high, the obstacles numerous and the benefits limited. Hence we might not see Islamic finance endure after this short honeymoon period.

Certainly not advocating spoon-feeding and/or baby-sitting these new entrants, yet we want to see the industry expand in a sustainable fashion not degenerate into a downward spiral. At the moment it seems that certain service providers are engaged in short term tactics at the expense of long term viability. In fact some seem to have a love affair with complexity (the more moving parts the better), giving priority to SPV-rich instruments and promoting commission-laden structured products, while simple and perhaps more 'natural' products are sidelined. A more pragmatic approach should be expected (if not demanded) from those individuals who we deem as guardians and representatives of the industry.

Your feedback and comments are very important to us, please feel free to contact the author via email.

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