ARE WE HAMPERING THE GROWTH OF ISLAMIC FINANCIAL INSTITUTIONS BY CALLING THEM BANKS?
It is necessary for Islamic institutions to address the issues of creating investment vehicles that will allow them access to the international markets. It is, therefore, important to focus on some of the factors that seem to be hampering the growth of the Islamic market and to identify some practical solutions to these problems.
For this it is necessary first to examine whether ‘Islamic banks’ are banks according to the conventional concept of a bank.
The next step is to consider what affects the capital at risk in, and the liquidity demands on. Islamic banks; to review a typical Islamic bank portfolio; and to draw practical conclusions for portfolio building and liquidity management.
What’s in a Name?
Is an Islamic bank truly a bank in the terms of the existing debt-driven, commercial banking market? This is relevant to portfolio building and liquidity management because if an ‘Islamic bank’ is not a bank in Western terms, then why should it saddle itself with Western banking restrictions such as the BIS (Bank for International Settlements, Basle) regulations on liquidity and capital adequacy?
Using the term “bank”, on which there are specific restrictions, regulations and licensing requirements in most OECD countries, certainly seems to give banking supervisors some cause for consideration. Michael Ainley of the Bank of England, in a presentation at the IIBI entitled “A Central Bank’s View of Islamic Banking”, asked “What is Islamic banking?”. He then provided the following answer:
“There seems to be no single definition of what constitutes Islamic banking’ the basic principle is, however, clear, namely, that making money out of money is contrary to Islamic law. Rather wealth should accumulate from participation in trade and the ownership of real assets.”
In the commercial banking market, the taking of deposits is generally considered the defining activity of a banking institution. In the UK, the central legal statute concerning banking is the Banking Act 1987, which defines deposits as:
1. Subject to the provisions of this section, in this Act, “deposit” means a sum of money paid on terms –
a) under which it will be repaid, with or without interest or premium, and either on demand or at a time or in circumstances agreed by or on behalf of the person making the payment and the person receiving it; and
b) which are not referable to the provision of property or services or the giving of security; and references in this Act to money deposited and to the making of a deposit shall be construed accordingly.
So here is the first hurdle. Generally, Islamic investment relates to the acquisition of “property”, as it states in the Act, in the form of goods or assets, so Islamic investments are unlikely to satisfy this definition of a deposit.
Further, the Act, in Part One, Section 6, defines the nature of a deposit taking business, i.e., one that requires approval to operate as a bank, as:
(1) Subject to the provisions of this section, a business is a deposit-taking business for the purposes of this Act if:
a) in the course of the business money received by way of deposit is lent to others; or
b) any other activity of the business is financed, wholly or to any material extent, out of the capital of, or the interest on, money received by way of deposit.
(2) Notwithstanding that paragraph (a) or (b) of sub-section (1) above applies to a business, it is not a deposit-taking business for the purposes of this Act if the person carrying it on does not hold himself out as accepting deposits on a day-to-day basis.
Again, the nature of Islamic investments is not encompassed by this definition of a deposit taking business.
Alternatively, non-bank financial institutions are defined in the Financial Services Act, Schedule One, Part II, under the heading ‘Activities Constituting Investment Business” as: buying, selling, subscribing for, or underwriting investments, or offering or agreeing to do so, either as principal or as an agent.
So here the overriding concern to an Islamic bank should be, do the goods or services in which an Islamic institution invests, fall within the terms of the Financial Services Act definition of “investments”?
Investments are defined in Schedule One, Part I, of the Financial Services Act, as:
1. Shares and stock in the share capital of a company…
So, this type of investment, in equities, will be subject to the terms of the Financial Services Act for Islamic investors. The rest of the investments defined would appear to fall outside of the parameters acceptable under Sharia law, and are not, therefor, of interest to the Islamic market.
The definition of investments continues:
2. Debentures, including debenture stock, loan stock, bonds, certificates of deposit and other instruments creating or acknowledging indebtedness…
3. Government and public securities: loan stock, bonds and other instruments creating or acknowledging indebtedness issued by or on behalf of a government, local authority or public authority…
4. Warrants or other instruments entitling the holder to subscribe for investments falling within paragraphs 1, 2 or 3 above…
5. Certificates representing securities…
6. Units in a collective investment scheme…and I will refer to this again,
7. Options…
8. Futures…
9. Contracts for differences…
10. Long-term insurance contracts…
11. Rights to and interests in anything which is an investment falling within any other paragraph of that Part of this Schedule.
Returning to “Collective Investment Schemes” these only relate to items defined in paragraphs 1-5 and 10 above, so would only affect an Islamic investor where the collective investment scheme traded in equities.
Generally, the terms on which Islamic banks do business would not fall under any of the above definitions. Why then should Islamic banks accept the same types of controls as commercial banks either at home, or when their overseas branches or subsidiaries are subjected to surveillance and/or control by foreign central banks?
Returning to Michael Ainley’s comments again, he identified the fundamental question as, “to what extent, and in what precise forms, are funds placed with an Islamic institution capital-certain, thus falling within the definition of a banking deposit? And to what extent are they participating in a collective investment scheme, thus falling under the Financial Services Act?”
Many Islamic products and structures are not covered by the definitions contained in either Act and require a definition of their own. They are neither capital certain, i.e., the retail investor does not have the full faith and commitment of the Islamic bank regarding the return of the sum invested, and they are not, equities accepted, investments in property as defined by the Financial Services Act. Islamic banks should be pressing their own Central Banks, and those Central Banks that control them abroad, to arrive at a uniform definition for Islamic banks.
Until we can define what an Islamic bank is, or is not; until we can identify and measure the risks inherent in the way the capital of an Islamic bank is utilised; until we can identify the liquidity demands placed on the cash flows under management, and; until we can show all of this to the satisfaction of investors, banking supervisors at home and abroad, and correspondent banks in both the Islamic and commercial markets, Islamic banks will be forced to carry a risk premium factor which will be reflected in the capital adequacy and liquidity levels which Islamic banks will be required to maintain. This in turn will cause portfolio constraints as banking supervisors struggle to understand the exact nature of new products in this Islamic banking market.
Having the word ebanki in the title is not essential. Some organisations in Kuwait manage substantial financial operations under Sharia law without using the word ebanki in their title, for example, the Kuwait Finance House, and the Kuwait Foreign Trading Contracting and Investment Company.
In short, referring to institutions as “Islamic banks” may be a misnomer that is causing excess pressure to be brought upon these institutions in their development. This pressure is amplified by a lack of clarity in financial presentation and the failure to present a rational, industry-wide approach to the classification of the various risks and demands of these new financial products.
Liquidity Issues
What affects the Capital at Risk in, and Liquidity Demands on. Islamic banks?
From the above discussion, it seems clear that an Islamic bank’s primary function, being guided by the principles of:
1). wealth accumulation from participation in trade and the ownership of real assets, and
2). a prohibition against making money out of money, does not fit with the definition of either a deposit-taker or an investment business.
It follows that Islamic banks are special vehicles which deserve their own definition, and that this should be driven by an analysis of the risks, liquidity and capital requirements of their portfolios and instruments.
The demands on capital for any institution are a function of the risks undertaken by that bank or company. If a conventional bank borrows funds, i.e., it takes deposits, from one client and then lends that money to another client, it is putting its own capital at risk to honour the repayment of the deposit, which it is obliged to do irrespective of the performance of the borrower.
A similar type of operation could be performed by an Islamic bank, i.e., investing funds for a client in a Murabaha transaction. In this case as the capital repayment is not an obligation of the bank, the Islamic investor has a transactional risk on the funds taken No capital allocation is required on the part of the Islamic bank as none of its capital is at risk.
Taking the same example, a little further and analysing the liquidity impact on the two differing banking institutions, the conventional bank has a contingent liquidity risk either directly dependent on the performance of the borrower, if it has matched the maturities of the asset and liability in its books, or as a general portfolio risk if it has mismatched the maturities. For the Islamic bank, however, there are no capital or liquidity issues because its role is simply that of a broker or investment manager.
In turn these factors will be affected by the way each bank manages their portfolio.
A pro-active approach to investment policy, where the Islamic bank takes a portfolio approach to treasury management and mismatches its investments, based on probable versus contractual liquidity requirements to its clients, is riskier but should provide higher returns. The pro-active player should also seek a wider spread of geographic and industry risk to generate better returns than minimal-yielding OECD bank guaranteed transactions – a tool commonly employed by reactive institutions.
Asset Portfolio Review
Assets are not homogenous. They have different risk factors such as credit, performance, political, climactic, etc. They have different maturities and each must therefore be considered and allocated to a group of similar investments; each group having a common standard across the Islamic banking industry.
So, what does the average Islamic bank hold in its portfolio of assets or investments?
Typically, the largest single category will be Murabaha or similar instruments such as Mutajara. These investments are usually placed by a brokerage type operation with third parties for short terms, against a pre-agreed profit margin. The risk is to the retail investor is not the Islamic bank, it is the payment risk of the fund’s taker, often supported by a letter of credit or guarantee from an acceptable bank.
The Islamic bank is under no obligation to its client for the payment of either the capital invested or the profit margin agreed. The Islamic bank has invested the money for a fixed term and has no obligation to its client in the event that the client wishes to terminate the investment at an earlier date than originally agreed. The demands on an Islamic bank for this type of investment, in terms of capital allocation and liquidity are, zero.
Mudaraba transactions, assuming the modern structure of the triple Mudaraba (with an investor, a bank acting as Mudarib and an entrepreneur) usually avoid capital allocation and liquidity demands. The Islamic bank operates in the classic investment banker’s disintermediated role of an arranger and introducer for which the bank takes a fee in the form of a proportion of the profits generated by the enterprise. In the event of a loss, the investor takes the financial loss and the entrepreneur and the Mudarib receive nothing for their time and endeavour.
In the case of a Musharaka, however, the bank must allocate some capital to the transaction and will have liquidity demands as it is both an investor in, and an arranger of, the venture. Suitable risk parameters need to be decided for such investments and the allocation of capital thereto.
Ijara is a market with a growing demand but the longer, fixed term periods involved, form a limiting factor for many investors. There are some substantial advantages though for both capital allocation – because ownership of the underlying assets is usually held outside the bank’s balance sheet in a closed fund and liquidity – subject to some further considerations which I will refer to later.
Istisna and Bai Salam, in conjunction with Ijara, offer major opportunities for risk diversification, portfolio building and liquidity management for the future. Properly managed their capital impact can be mitigated and they can provide the major impetus to the development of more tradable portfolios in the future. Greater tradability means greater liquidity.
In short, Bei Salam, Istisna and Ijara transactions are the key growth areas for Islamic banks.
Other Considerations
Other considerations include looking at more general issues concerning the management of Islamic banks.
First, as bankers, we rely very heavily on reported financial information. Yet Islamic banks themselves have not been able to agree a standard on which their financial statements are based. For the creation of the right kind of environment to allow Islamic banks to move beyond reactive treasury management to pro-active treasury management they will have to provide the key information, i.e., their financial statements, in a form that other bankers, both Islamic and conventional, can readily comprehend.
Trying to base improved liquidity, as some have suggested, around a central bank or the IDB (Islamic Development Bank) is likely to prove slow, cumbersome, bureaucratic and limiting. If you look at the conventional banking market you will see that the real liquidity is provided between the commercial banks, with the central bank operating as a “lender of last resort”. This inter-bank market is based on strong, consistent and timely financial reporting within an established framework. That is one of the key criteria that all Islamic banks should be aiming for today.
As a second consideration, standardised documentation is very important. Profitability can be raised by reducing low yielding cash or near cash investments and re-allocating them to higher yielding assets, but this has to be achieved without losing liquidity or “tradability”, within the asset portfolio. One major key to the efficient tradability of such assets lies in the standardisation of documentation in the Islamic market.
As a third consideration, rating of countries, enterprises and transactions by major rating agencies such as Moodies and Standard & Poors, will further develop a more liquid and tradable portfolio of assets.
The keyword in all these considerations is “transparency”. If contemporaries at other banks can quickly and clearly both see and understand the nature and risks in an asset they can more quickly arrive at a value of that asset, should they wish to bid for it. Complicated documentation, unclear accounting and/or auditing standards and a general lack of reference points for valuation will all conspire against the movement towards greater portfolio tradability and thus liquidity.
Liquidity Tools
Once Islamic banks turn to the concept of considering their business as based on trade and the creation and use of the tradability of assets within their portfolio, the next logical step is for them to trade assets as an aid to liquidity management.
Just as an international trading business can create cash liquidity by selling inventory so the Islamic banks should develop those same skills and market connections to create liquidity in the same way.
We need to create more, original. Islamic financing tools rather than modifying existing commercial bank structures.
Conclusion
Islamic banks must change the “status quo”. They are in the minority, globally, and minorities have, in the history of mankind, always had to stand up for their own rights in order that they should be treated on their own merits by the majority. It must be to ensured that the financial markets recognise that Islamic banks cannot simply be included together with all the other banks – unless, of course, they prefer to compete at a disadvantage!
The starting point for all of this change is within the Islamic banks themselves. Notwithstanding their desire to form a new banking industry at one with the Muslim unitary approach to life, their banking structures conform today – Sharia committees excepted – to the conventional Western form.
If the mantra of Islamic financial thinking is that wealth should be created through legitimate trade and the holding of real assets, then Islamic banks must make this their focus, and concentrate on the tradability of their portfolios of assets that will better place them to service the aspirations of their communities and brotherhood.
In conclusion, it can be seen that by creating greater clarity in the portfolio and in the Islamic bank’s presentation of their true financial position several major thrusts to portfolio development and liquidity management can be identified:
1. Islamic banks must show themselves clearly as different operations from conventional, commercial banks. They operate in a market where investors use their skills primarily as investment managers, not as their risk counter-parties. One of the major problems in developing as a recognised separate market is that the majority of Islamic financial institutions use the word “bank” in their title, a word which has very specific, legally defined and protected status in the West; a word which does not accurately reflect the function that Islamic banks fulfill. I suggest that a new term be created, say, “Islamic Financial Institution” and ensure that it becomes generally accepted, and legally defined.
2. Islamic banks need to ensure that their central bank approach to control and surveillance is structured in a way that reflects the Islamic bank’s assets, liabilities and liquidity demands. They can achieve this through the creation of an identifiable and definable market in which there is a Generally Accepted Accounting Practice, uniformly employed.
3. Islamic banks should recognise that their true vocation is as trading organisations and they should look to build what I call “greater tradability” into their portfolios. One of the major steps towards greater tradability is having common documentation on which to work that provides a standard framework in which players operate.
4. Islamic banks should make greater use of Murabaha – not less! It is an exceptional tool that allows Islamic banks to finance the short-term trading requirements of their clients in an off-balance sheet, capital free way.
5. Similarly, Islamic banks should make greater use of the Reverse Murabaha to create liquidity in their portfolios, when necessary.
6. Islamic banks have to build a system, perhaps through greater- use of the rating agencies, which will provide third parties with a benchmark or reference point for valuing assets.
7. Finally, Islamic banks must look to create new tradable assets to improve liquidity. If the creation of wealth is supposed to be based, at least in part on trade, why do Islamic banks appear to be so reluctant to join in?
The need for further change is obvious. The urgent need is for Islamic banking to create a positive, acceptable definition of its place in the global financial market.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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