Islamic finance not immune to global crisis

Its ban on interest and its lack of structured products prevented it from investing in toxic products initially protected it.

Islamic banking can no longer claim immunity from the global financial crisis with now that it is hitting the industry's main source of funding and property values in the Gulf. The industry escaped the immediate fallout from the crisis as its ban on interest and its lack of structured products prevented it from investing in the assets that turned toxic for conventional banks. In a report issued last week, debt rating agency Moody's said Islamic financial institutions in the Gulf showed strong resilience during the global financial turmoil, but that they are not risk-immune due to a shortage of liquid instruments and the lack of an Islamic interbank market.

The ratings agency expects growth in Islamic banking assets to slow sharply in 2009, to around 10 to 15 per cent from a range of 20 to 30 per cent this year. Islamic banks now stand in the same firing line as their non-Islamic counterparts, facing a slump in equities valuations and a slump in Gulf property, to which they are heavily exposed. Even though Islamic banks avoided the speculative investments and complex financial instruments that derailed Western banks, their balance sheets still show a mismatch between assets and liabilities, and they depend more on short-term maturity liabilities than conventional banks.

At the end of 2007, only 10 per cent of Gulf Islamic banks' liabilities were bonds and other long-term liabilities, compared with 23 per cent at conventional banks, according to McKinsey & Company. "There is a need to diversify our funding sources, we still typically depend on retail deposits," said David Pace, chief financial officer at Bahrain-based Unicorn Investment Bank. As liquidity has dried up in a region spoiled by high oil revenues, Islamic banks need to diversify their products and better manage the cash they have on their balance sheets.

Islamic hedging products, derivatives, liquidity- and risk-management tools are all in early stages of development. "If derivatives are used to mitigate risks, they are viewed positively," said Muneer Khan, partner and head of Islamic banking at law firm Simmons & Simmons. He said practitioners and scholars are increasingly open to more aggressive hedging structures. South-east Asian sharia banks are particularly vulnerable to a similar crisis that hit conventional lenders as a push for market share creates acceptance of risky products forbidden by Islam, a religious adviser said yesterday.

Strict lending rules and rigorous demands for transparency have shut out opaque structures and shielded Islamic banks from the worst of the financial crisis. But this austerity has also kept the $1 trillion Islamic finance sector relatively small despite a boom in Gulf petrodollars which propelled the sector into the limelight. South-east Asian Islamic banks are especially susceptible to a crisis due to their use of derivatives and options although any difficulty would not be on the same scale as that which hit Western banks, said sharia adviser Said Bouheraoua.

"Most of the problems in the Western countries is based on speculation, on derivatives and options," said Mr Bouheraoua, an Algerian scholar who advises Malaysian sharia lender Affin Islamic Bank, which is part of banking group Affin Holdings. "Most of it is debt, transfer of debt or making profit from debt." These aggressive hedging structures would be of particular importance for project finance, a key banking business in the Gulf that still has a large number of infrastructure projects in the pipeline.

But developing new products is an arduous process, as Islamic scholars need to approve their compliance with Islamic Sharia law, which is open for interpretation. Just as the biggest financial crisis since the 1930s has hit banks worldwide, the industry is soul-searching in a key segment, Islamic bonds, or sukuk. Sukuk issuance this year has dropped 60 per cent from 2007, as a debate over whether some types of sukuks are compliant with Sharia law has added to the liquidity drain.

"It's not only looking up at new products, but looking back down at the roots of Islamic banking, at what is it that actually makes it different from conventional banking," said Richard Thomas, chairman of UK-based Islamic Gatehouse Bank. Although the industry has been viewed as more crisis-proof due to the asset-backed nature of its transactions, that theory is increasingly being tested by economic and legal realities.

For example, the UAE last week bailed out Islamic mortgage lenders Amlak and Tamweel. There are also structural impediments. Islamic property lenders under the ijara and diminishing mudaraba deal structures acquire formal ownership of the property serving as loan collateral and then lease it to the customer. While the ijara deal is a simple leasing structure, property ownership under the diminishing mudaraba deal is gradually transferred to the bank customer over a fixed period.

"Do you have a legal protection from the authorities (in an ijara deal) that in case of a default you simply go there and say, Mr. So and So, get out!', or do you still have to go through lengthy procedures to enforce the right (as with a conventional mortgage)?," said Jamal Abbas Zaidi, chief executive officer of the Islamic International Rating Agency. "I have not seen this tested at any of my customers as yet. It has to be tested in the courts to see how it functions," he said.

Unicorn's Pace said that very few sukuks have actually reached maturity yet. "It worries me that there's billions of dollars worth of sukuk, which are due to mature in the next 12 to 18 months. I have doubts about the ability of all borrowers to either repay those or to refinance them," he added. *Reuters