Reality check for Islamic finance

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Reality check for Islamic finance

Reality check for Islamic finance

By Rushdi Siddiqui, Special to Gulf News, Available at:

Liquidations, defaults and downgrades call for some serious soul-searching

Dubai: For Islamic finance, 2009 and 2010 may be categorised as the years of ‘R-Cubed’ — reflection, reassessment, and reality check. Since the beginning of 2009, there have been 42 liquidations of Islamic funds, defaults by 34 sukuks, rating downgrades of Takaful operators, and increase in layoffs in the sector.

A recent Deloitte study, the ME Islamic Finance (IF) Leaders Survey, arrived at some interesting conclusions: 64 per cent of respondents agreed that IF is lagging in risk management; 65 per cent believe IF institutions are not properly capitalised; 66 per cent expect change in existing business models in the foreseeable future.

Market volatility, liquidity crisis, confidence crisis, market sell-off, and so on, are horizon indicators for Islamic finance.

The financial crisis did not pose a systemic risk to the industry, and a recent IMF paper asserted, with caveats, that Islamic finance fared better due to Sharia prohibitions against ‘toxic’ assets, enhanced by leverage and magnified by derivatives.

But, the embryonic nature of Islamic finance also prevented the disaster. To some, ‘innovation’ in the sector seemed to imply the wrapping of existing products in an ‘Islamic veil’ and the addition of high-margin fees.

The industry needs to take a step back and look at the ‘tea leaves’ associated with defaults, liquidations and rating downgrades as this a reality check on which pathway to take to the watering hole.

However, a percentage-wise break-up puts things in perspective: 7 per cent of total funds liquidated accounting for 4 per cent of total assets under management.

Many funds, it turned out, had small assets under management.

Some theories on Islamic fund liquidation are underpinned by postulations like:

* Capital-protected funds have limited life span
* Crisis resulted in redemptions by investors and smaller amounts of assets under management could not support the costs of running the fund
* Fund under-performance relative to peers and Islamic benchmarks resulted in redemptions

The industry needs to reflect on not only the true size of the target market, but also their demand and distribution channels. For example, a recent release for the ‘JETS DJIM ETF,’ the first Islamic ETF in the US, said it “… will cease trading on October 19, 2010. … failed to attract the level of investor interest that had been anticipated. … with over seven million Muslims in the United States … but we found it difficult to reach target investors…”

Sukuk defaults

According to Thomson Reuters data, there were 34 sukuk defaults since the beginning of 2009. Some of the interesting observations:

* Malaysia had 25 defaults in the corporate sector, led by oil/gas and auto-parts manufacturing, with three major modes of contract of Murabaha (14 defaults), BBA (6) and Ijara (3), and all were private placed.
* Pakistan had three defaults in the cement and electric products manufacturing sector. Yet the news focused on high-profile defaults: Golden Belt, East Cameron Gas, IIG and Investment Dar.

The total amount of defaults is about 1 per cent of $130 billion sukuk outstanding, and about 2 per cent of the 1,546 sukuk outstanding (Thomson Reuters, second quarter, 2010).

Sukuk defaults are just as important as new issue coverage, as it not only tells on overall geographic market sentiment, issuer’s credit health (of debt-based Sukuk like Murabaha/BBA), but also shows the influence on the mode of Sukuk contract for geography.

An interesting observation: sukuk ‘fallout’ seems more attributed to the Dubai standstill agreement of last year than the financial crisis, but it was the latter that had an impact on the former.

The link between Takaful operators and Islamic investing is close, as premiums must be deployed in a Sharia-compliant manner. Although there have been no bankruptcies announced in the Takaful industry since beginning of 2009, there have been challenges.

Over-exposed to equities

President and CEO of Tokyo Marine ME Ajmal Bhatty stated … “the global economic downturn did affect investment portfolios of several takaful companies, but these were the ones that were over-exposed to equities and real estate. The ensuing issues and problems with certain sukuk also impacted few takaful companies. All of this resulted in the rating downgrade of some of the takaful companies.”

The reality check is that Islamic finance needs to move toward its authenticity paradigm. We need to take a deep-dive analysis of liquidations, defaults and downgrades and ask: are these the growing pains of a young industry, do they call for a business model upgrade, or is the link to conventional finance much stronger?

Best Regards

  • Srebrenica, Bosnia Herzegovina, a place where more than 8,000 Muslims were killed in July 1995.

    By seeking to eliminate a part of the Bosnian Muslims, the Bosnian Serb forces committed genocide. They targeted for extinction the 40,000 Bosnian Muslims living in Srebrenica, a group which was emblematic of the Bosnian Muslims in general. They stripped all the male Muslim prisoners, military and civilian, elderly and young, of their personal belongings and identification, and deliberately and methodically killed them solely on the basis of their identity. By Theodor Meron

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