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Hedge Fund Monthly
 
Surpassing the Crisis
Camille Klass
Islamic Finance Asia
Oct 2010
 

Keeping to Shariah tenets is an obligation for Islamic financial institutions (IFIs) and it has certainly been a blessing in the wake of the recent financial crisis. Many of the world's banks were brought to their knees on account of indiscriminate lending, excessive speculation and risk, all of which the Shariah prohibits.

"IFIs have 'hard wired' Shariah restrictions which prevented them from investing in riskier instruments such as derivatives and subprime debt," said Mohammad Faiz Azmi, Global Islamic Finance Leader at PricewaterhouseCoopers (PwC) in Kuala Lumpur.

Although IFIs were fortunate enough to be precluded from those activities, they were not immune, as some had initially thought, to the slowdown in economies across the globe which saw international trade shrink, capital flows dwindle and consumer confidence fall.

"You can't say Islamic financial institutions are operating in the real economy and then say they weren't affected – there has to be a one to one correlation to the two things," said Afaq Khan, CEO of Standard Chartered Saadiq. "Of course, Islamic financial institutions had some local problems when the economy slowed, but that's a normal economic problem, not a systemic problem."

The crisis was a wakeup call for IFIs to re-examine their businesses and business practices, having taken some knocks, as asset, commodity and oil prices fell, hurting their balance sheets and liquidity position.

It has also highlighted the need for regulators and supervisory authorities to be more vigilant in overseeing the industry and implementing risk management procedures to anticipate any future crisis that may unfold, as well as strengthen the existing regulatory structure to keep in step with the global financial system as it evolves.

Islamic financial transactions, as a matter of principle, must be backed by or based on real assets, as it relates to one of the key requirements of Islamic finance being tied to real Shariah-compliant economic activity. Due to Shariah restrictions on investments, the investment portfolios of IFIs had the tendency to be over-reliant on real estate assets and equities.

Even though IFIs have "limited their exposure to many of the toxic assets associated with the global financial crisis", Neale Downes, a partner at Trowers & Hamlins, an international law firm in Bahrain, pointed out that IFIs' over-exposure to real estate and stocks made the value of their balance sheets vulnerable to the "horrendous downturn" in the real estate sector that was global but accentuated locally.

While this may have limited their exposure to many of the assets associated with the global financial crisis, the value of the balance sheets of IFIs were extremely vulnerable to falling market values in two particular asset classes, namely, equity portfolios and real estate, he added.

The losses were exacerbated by the large number of IFIs involved in real estate--related activities and who were all looking to exit their investments when the market slid. The smaller capital base of IFIs, compared to their conventional counterparts, also made them more susceptible to any financial shocks.

IFIs with construction projects still on their hands are having difficulty now in either raising leverage to implement or complete those projects, or in generating stable revenues to service that leverage, said Trowers & Hamlins' Downes.

Given their tight liquidity positions, IFIs have had to rethink their business strategies, acknowledging the need to adapt and diversify their businesses in order to generate stable income streams to rebuild their balance sheets.

"There's a need for a change of strategy from when capital was easy to come by," said Afaq of Standard Chartered Saadiq. "We're in a different operating environment now where the economy is growing by 1–2% and we have to look at the economy in terms of decades, not weeks or months."

To that end, some IFIs have already moved away from investment banking and heavy reliance on real estate assets and construction projects to focus more on retail or small to medium enterprise business, said industry insiders. While this move brings lower margins, it also means a bigger and more stable customer base which will allow IFIs to raise fresh capital and focus on retail deposits.

Aside from the need to generate new business streams and strengthen balance sheets, IFIs have also had to re-examine the ways in which they conduct business.

A lack of adequate corporate governance, due diligence and risk management were some of the areas in which IFIs had come up short, industry insiders said.

"In times of growth, corners are cut and diligence is sometimes lacking," said PwC's Faiz, referring to the "go-go years" when IFIs created sophisticated sukuk structures which the industry's accounting and auditing standards body, AAOIFI, ruled in 2008 as being non-compliant with the Shariah.

The near-default of the Nakheel Sukuk highlighted the lack of due diligence on the part of Islamic bankers as many had presumed that it was a quasi-sovereign issuance, and as a result, the sukuk was guaranteed by the Dubai Government. Although Dubai World, Nakheel's parent, is a government linked entity, Nakheel is considered a private entity.

Trowers & Hamlins' Downes said due diligence "needs to be regarded as an essential deal function, not an unnecessary evil which Islamic banks don't want to pay for".

In addressing the inadequate disclosure and lack of transparency that have typically surrounded their deals, IFIs are now starting to place greater emphasis on compliance and risk management, as well as corporate governance by appointing non-executive and independent directors, audit committees and lawyers, noted industry insiders.

Change, it appears, is underway.

"We have seen some tightening up of processes and post-mortems to learn from these mistakes, and a move towards retail banking to diversify risk," said PwC's Faiz. "Globally, the issues are still being addressed, given the scale of the potential losses still being negotiated, and there have been some high-level changes of management reflecting accountability."

Industry insiders said there is recognition of the need for greater standardisation across the industry in terms of accounting, Shariah or laws in order to keep industry-specific risk in check.

Faiz even suggested that "more of these issues may have surfaced earlier if there was standardisation."

Consolidation is another area that industry insiders believe would help industry players compete with conventional banks globally on a more solid footing. Mergers or takeovers would mean the creation of bigger banks with assets sizable enough to do that and to serve customers' large funding needs. With the exception of Saudi Arabia's Al Rajhi and National Commercial Bank, IFIs tend to hold fewer assets than conventional banks.

With the need for more instruments to hedge, as well as risk and balance sheets to manage, the development of more innovative products such as longer tenor sukuk or true variable rate products for hedging, risk and balance sheet management purposes would be welcome, industry insiders said.

The implementation by IFIs of Basel II and Basel III standards in line would also go a long way towards ensuring greater compliance, risk management and capital adequacy.
 
"The new requirements on minimum bank capital – 7% tier one capital – will help address particular weaknesses in their balance sheets and exposure to particular market shocks," said Downes.

Industry insiders note the ongoing work being done by industry bodies, such as the Islamic Financial Services Board (IFSB), the Auditing and Accounting Organization for Islamic Financial Institutions (AAOIFI), the International Swaps and Derivatives Association (ISDA) and the International Islamic Financial Market (IIFM), is beneficial in creating new industry standards.

While the industry has yet to return to the stage it was at prior to the crisis, the measures being undertaken at both the corporate and institutional levels spell a promising future.

 

 

This article first appeared on www.IslamicFinanceAsia.com in October 2010.

 

 
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