Islamic Banking - a compelling mix of religion and finance
June 6, 2008 8:40 AM   Subscribe

While western banking institutions continue to reel from the credit crunch, Islamic banking, with assets approaching one trillion dollars, is growing at roughly 20% pa by offering Sharia compliant - and only Sharia compliant - financial products. But compliance to Sharia law in matters financial is not easy (previously).

Sharia law, derived from The Koran, is central to all aspects of Islamic life including, of course, financial affairs. Devout Muslims are forbidden from investing in businesses dealing in alcohol, tobacco, pornography, weapons or pork. Further constraining Islamic Bankers, financial products offering interest (making money from money, "riba") or allowing the holder to profit from speculation (uncertainty or gambling, "gharar") are expressly forbidden by The Koran.

Considering such restrictions one might think cash is the only Sharia compliant investment. But such thinking is deeply rooted in the mindset of Anglo American capitalism. Indeed, Islamic Banking - ethical investment by definition - offers devout Muslims a wide range of Sharia compliant, financial products.

Murabaha is a transaction where all profit earned by the seller must be revealed to the purchaser. Sharia compliant Ijara mortgages are structured in this manner, where a property, acquired and owned by a bank, is paid off by the purchaser via fixed monthly payments broken down as rent plus equity. And lest one think Islamic banking incapable of recognising business realities, Tawliyah or Wadiah - selling at cost or at loss respectively - are Sharia compliant transactions.

Sukuk is a Sharia compliant bond. It works by, for example, purchasing then leasing out land with capital paid in. Profits are returned to the Sukuk holder instead of interest. Such vehicles allows investors to realise regular return on their capital, but not by the receipt of interest. Sukuk is superior to many Western fixed income products, as there are always physical assets underlying the structure.

Takaful - Sharia compliant insurance - pools the financial resources of a group of Muslims, and allowing them to claim benefit when needed. The five principles of Takaful encourage mutual cooperation, personal responsibility and foster community.

With these basic structures almost any retail financial product can be offered in a Sharia compliant manner. And Islamic banking is big business; HSBC, Barclays and many other western insitutions now offer Islamic financial products.

Finally, western governments have caught on as well - England and Hong Kong both have plans to issue Islamic bonds, hoping to tap into offshore oil wealth.
posted by Mutant (40 comments total) 26 users marked this as a favorite
 
Interesting. Would one have to be Muslim to take advantage?
posted by chugg at 8:48 AM on June 6, 2008


While I'm not disputing that some of the principles underlying these sharia compliant transactions might lead to better investment outcomes, isn't this just form over substance? Take the mortgages---you can call it rent, you can call it interest, you can call it magical fairy dust--I call it profit.
posted by gagglezoomer at 8:48 AM on June 6, 2008


Stuff like this reminds me of the sorts of tricks some Jewish people will play to get around rules about doing nothing on the Sabbath. It's interesting how people get creative with the constraints of their religion.
posted by chunking express at 8:53 AM on June 6, 2008


Yes, it is interesting, and so is this post. Good stuff.
posted by caddis at 9:03 AM on June 6, 2008


gagglezoomer: You're correct. A lot of it is just a polite fiction to pay out profits while maintaining technical compliance with the Sharia laws. But it seems to pass muster. I guess god isn't much of an accountant.
posted by Justinian at 9:03 AM on June 6, 2008


Justinian:

God is, apparently, a lawyer. Adhere to the letter, and don't worry about the spirit.
posted by Tomorrowful at 9:10 AM on June 6, 2008 [3 favorites]


Like many strict religious principles, it's the letter of the law that matters, not the spirit.

God is irrelevant, except insofar as one might interpret the text to be God. That whole "and the word was God" thing? Yeah, not an accident. The written letters are what's important, not why it was written.
posted by aramaic at 9:12 AM on June 6, 2008


...the sorts of tricks some Jewish people will play to get around rules about doing nothing on the Sabbath.

What, by having a Shabbos goy light the stove for them?

Very interesting post, btw.
posted by jsavimbi at 9:14 AM on June 6, 2008


Ah murabaha, what a loophole.

"Let’s say that you, a small businessman, wish to go into business selling cars. A conventional bank would examine your credit history and, if all was acceptable, grant you a cash loan. You would incur an obligation to return the funds on a specific maturity date, paying interest each month along the way. When you signed the note and made the promise, you would use the proceeds to buy the cars—and meet your other expenses—yourself. But in a murabaha transaction, instead of just cutting you the check, the bank itself would buy the cars. You promise to buy them from the bank at a higher price on a future date—like a futures contract in the commodities market. The markup is justified by the fact that, for a period, the bank owns the property, thus assuming liability. At no point in the transaction is money treated as a commodity, as it is in a normal loan.

But here’s the catch: most Muslim scholars agree that there is no minimum time interval for the bank to own the property before selling it to you at the markup. According to Timur Kuran, the typical interval is “under a millisecond.” The bank transfers ownership of the asset to its client right away. The client still pays a fixed markup at a later date, a payment that is usually secured by some sort of collateral or by other forms of contractual coercion. Thus, in practice, murabaha is a normal loan."

posted by anthill at 9:27 AM on June 6, 2008


".....There are some benefits to using Islamic lenders that only make sense to practicing Muslims, such as knowing that the Zakat will be paid on earnings, but the bottom line is that is is far too Jewish for my tastes." (emphasis added).


WTF? Is the botom line dressed up with a kippah and tefillin? Or is this something else entirely?
posted by lalochezia at 9:28 AM on June 6, 2008


I remember reading Medici Money by Tim Parks and it detailed all the ways the 15th Century church played linguistic and logical games to heavily pretend no interest or interest like things were happening in a growing banking market. It was fascinating and amusing. To operate a financial system that denies its own nature is an intellectual cesspit of hypocrisy of course, but then again so is any kind of worldview based on literal readings of Dark Ages holy books.
posted by The Salaryman at 9:34 AM on June 6, 2008


Yeah, that's a rather, uh, disturbing comment Burhanistan.
posted by Justinian at 9:35 AM on June 6, 2008


If Sharia forbids earning interest, are Muslims forbidden from having savings accounts? What do they do with their cash?
posted by ghost of a past number at 9:41 AM on June 6, 2008


Interesting post, thanks!
posted by languagehat at 9:53 AM on June 6, 2008 [1 favorite]


Are you actually surprised that a Muslim would be anti-Jewish?
posted by sonic meat machine at 9:59 AM on June 6, 2008


Ahh, I missed the apology.

Burhanistan, the Jewish Sabbath is just an interesting outlier in a universal human tendency to bend the rules. You should see Southern fundamentalists try to explain why they can eat pork but homosexuals are going to burn in Hell.
posted by sonic meat machine at 10:00 AM on June 6, 2008 [2 favorites]


So if I'm reading it correctly, in a murabaha I instantly owe the bank principle+interest, and they are simply allowing me to pay it back over time? I guess that means that if I were to come into the money tomorrow, I wouldn't be able to pay it back right away and escape the cost of the loan? I suppose that unless it's forbidden, they could write a forgiveness clause into the contract which would be equivalent.

In an ijaria mortgage, since the bank owns the property is it the equivalent of a no-recourse loan? If it burns down uninsured on day 2 that's the bank's problem?
posted by a robot made out of meat at 10:01 AM on June 6, 2008


ghost: the deposits are essentially pooled into a sharia compliant money market fund which invests in sharia-compliant investments like low risk sukkuk. The interest is variable and call fall to zero, though your principal is not at risk.
posted by patricio at 10:02 AM on June 6, 2008


Bill Maurer has some interesting things to say about riba and zakat and the mathematics and epistemology of equivalence in his 2003 Society and Space article, "Uncanny exchanges: the possibilities and failures of 'making change' with alternative monetary forms." Unfortunately, I can't find a live version to link to: if you've got access to an academic library, it's worth checking out.
posted by vitia at 10:06 AM on June 6, 2008


and robot: you're required to have insurance (Takaful) - see HSBC's explanation of their Ijara and Takaful range (as per Mutant's link above)
posted by patricio at 10:08 AM on June 6, 2008


(Basically, Maurer's claim, supported by compelling evidence, is the same as that of this post, although from the comments, most people seem inclined to disagree with said point, which being: there's more than one way to think about money.)
posted by vitia at 10:10 AM on June 6, 2008


The current mortgage meltdown makes me wonder how one could change the ethics of finance in the US. Whether by religion or education, I don't know. But I do see unconstrained greed in operation. Have there been any huge financial meltdowns in countries whose financial business is regulated by Islamic law?
posted by mdoar at 11:20 AM on June 6, 2008


It might be worthwhile to point out that the Christian tradiition tends to favour the notion that charging interest is a sin and for some reason this belief largely fell by the side.

The early church's attitude towards banking explains why most of the early European bankers were Jews, and some of anti-Jewish sentiments in that period were stirred up when Christian heads of state didn't feel like paying back loans.
posted by Deep Dish at 12:25 PM on June 6, 2008


>>universal human tendency to bend the rules. You should see Southern fundamentalists try to explain why they can eat pork but homosexuals are going to burn in Hell.

I can only speak personally, but when I see this, it looks very much like the individual in question thinks they can fool their God, which if that God actually exists, is ridiculous. I don't have any personal stake in what the Judeo-Christian God thinks, as I'm a Taoist, but I really don't get a picture of God high-fiving people in heaven for exploiting loopholes.
posted by SaintCynr at 12:26 PM on June 6, 2008 [3 favorites]


Yeah; I've said before that this sort of thing strikes me as nothing more than D&D rules lawyering. Except the GM is GOD. Like, literally, and not just in his own head like most GMs.
posted by Justinian at 1:09 PM on June 6, 2008 [1 favorite]


vitia
I don't have access to an academic library anymore (sadly), but I'm curious if you would mind elaborating a bit about the point Maurer is making. I don't think anyone here is disagreeing with the sentiment that there is more than one way to think about money. I think what's bothering people is that these Sharia forms seem like the same way of thinking about money, just contorted to give the appearance of complying with religious rules against gambling and interest. What exactly is different here other than the imposiiton of these religious rules?
posted by Sangermaine at 1:38 PM on June 6, 2008


Cool post as usual Mutant (BTW, you might want to say per annum or per year instead of abbreviating as pa to be more accessible). I'll read it after work.

To derail further; among my other favorite religious rule-bending cognitive dissonance examples: engaging in oral/anal sex to save oneself for marriage and getting around prohibitions against drinking alcohol by using it as an ingredient in food recipes like rum balls and fruitcake.
posted by BrotherCaine at 2:05 PM on June 6, 2008


The justification for following the letter of the law, and not the spirit, is that a perfect God does not create imperfect laws. Therefore any loopholes are intentional, left for humans to find.
posted by rottytooth at 3:22 PM on June 6, 2008


I can just imagine the reaction of the MeFites if this was an article about Christian banking. Pray tell, how do gay & lesbian owned businesses fare in the Muslim world?
posted by mattholomew at 4:47 PM on June 6, 2008


...and I just loved these 2 sentences:

Islamic Banking - ethical investment by definition - offers devout Muslims a wide range of Sharia compliant, financial products.

Finally, western governments have caught on as well - England and Hong Kong both have plans to issue Islamic bonds, hoping to tap into offshore oil wealth.

posted by mattholomew at 5:00 PM on June 6, 2008


mattholomew
Yes, I noticed that about the post as well. I hope mutant is around to answer because his characterization in the post was very strange. He describes Islamic Banking as "ethical investment by definition", yet I fail to see how he arrived at that conclusion. Sure, they can't invest in "alcohol, tobacco, pornography, weapons or pork". But does that mean it inherently meets the definition he provided?

"Investment philosophy which attempts to balance the regard for morality of a firm's activities and regard for return on investment. Ethical investors seek to invest (usually through mutual funds or unit trusts) in firms which make a positive contribution to the quality of environment and quality of life."

They claim not to charge interest or engage in speculation, yet as even the post says, "With these basic structures almost any retail financial product can be offered in a Sharia compliant manner. " They find clever ways to get interest and speculate anyway, as many have noted above. There is no reason why Islamic Banking is inherently any more ethical than Western banking, which has its own set of ethical rules as well.

Western banking, being unconstrained (at least in modern times) but such rules offers a much wider variety of financial products, some great, some terrible. "Sukuk is superior to many Western fixed income products, as there are always physical assets underlying the structure." This statement says nothing, really, other than that sukuk is just another form of financial product among many.

Finally, the post seems to imply that Islamic Banking is growing because of Islamic law: "Islamic banking, with assets approaching one trillion dollars, is growing at roughly 20% pa by offering Sharia compliant - and only Sharia compliant - financial products." But it's not cause and effect, or at least there's no reason to assume so. They are growing at 20% per annum while offering Sharia-compliant products. Perhaps Sharia compliant financial products are superior and are causing the huge growth, but perhaps it is largely due to booming economies and oil profits in the region and a huge burst of investment in the last decade or so.

This post is interesting, I just wish it had come off as more descriptive and less supportive.
posted by Sangermaine at 6:39 PM on June 6, 2008


Thanks for the excellent set of links, Mutant. Lots of stuff here that even I wasn't privy to. As a muslim who doesn't really follow the financial markets--the only thing that I'm aware of as far as monetary matters are concerned from an Islamic perspective--is not to accept Interest, which is a widely known fact. (Anything which constitutes a fixed amount of return would fall under that category, and would thus be Haram under Islamic law, as far as I know, but whatever falls under the precepts of Profit and Loss is Jayiz.)

To complicate things even further, there are different standards in different countries which allow a certain amount of wiggle room in these matters. The Quran and Hadith, again--as far as my limited knowledge in these matters is concerned--paint a very broad stroke and leave quite a lot of room to be interpreted. Therefore, you have people like the Grand Mufti of India (or whatever he's called) declaring that Interest is acceptable in India for muslims because it is a secular state, and not an Islamic one run on the basis of Sharia law... ?

Now, I don't know much about the ins and outs of Islam, but that kind of logic seems a bit screwy to me. I mean--alcohol is considered Haram for muslims to consume, but just because you're living in a Secular State does not make it Halal. (It's like that story of a bunch of pigeons that were caught in a trap set up by a group of Muftis. Along with the captured pigeons was a lone crow who started cawing loudly, to which the pigeons responded: what have you got to worry about, it's not you who they're going to eat, you're not Jayiz. The crow looked at the pigeons and said--with these guys--who knows... .)

So, to answer your question about what my thoughts are on this topic, I'd say it's best to use your own judgement in these kinds of cases and do what you feel is right according to you (and pray that you're making the right choice--Alahu Alam!).
posted by hadjiboy at 4:06 AM on June 7, 2008 [1 favorite]


I'll try to focus on the most recent question, hoping that it captures all open issues.

Sangermaine -- "Yes, I noticed that about the post as well. I hope mutant is around to answer because his characterization in the post was very strange. He describes Islamic Banking as "ethical investment by definition", yet I fail to see how he arrived at that conclusion. Sure, they can't invest in "alcohol, tobacco, pornography, weapons or pork". But does that mean it inherently meets the definition he provided?

"Investment philosophy which attempts to balance the regard for morality of a firm's activities and regard for return on investment. Ethical investors seek to invest (usually through mutual funds or unit trusts) in firms which make a positive contribution to the quality of environment and quality of life."



Ah good question. I'm trying to actively trim the length of my FPPs (and longer versions are going somewhere else) so I unfortunately left out some detail that would have addressed this - my apologies. Ok, so ethical investing from the Muslim viewpoint (disclaimer: I'm not Muslim, just interested in this topic and, as vitia caught on, other monetary systems in general).

All Sharia compliant products must be approved by what's known as a Shariah Advisory Council (SAC), a group structured to provide expertise in religious, capital markets, Islamic economics and legal matters. In Malaysia, for example, the SAC has ten members with deep domain expertise. Clearly, in an Islamic State, the SAC operates at a national level.

The SAC advises which businesses are suitable for Sharia investment by evaluating business activities, then maintaining an approved list. In an Islamic State they have regulatory power to obtain this data from both listed and non listed companies. By undertaking this activity they boost investor confidence by insuring companies on the approved list operate only in industries not forbidden (e.g., alcohol, tobacco, etc as previously noted) and, further, operate according to Islamic principles (e.g., not making money from money, etc)

Each bank operating in the Islamic State and offering Sharia compliant products will work with their own experts ("Sharia Consultants") before submitting their offerings to the SAC for approval.

So the SAC, operating in tandem with the Sharia Consultant(s) insure the investments offered are ethical from an Islamic viewpoint, as they make positive contributions to the larger Muslim community and way of life.


"They claim not to charge interest or engage in speculation, yet as even the post says, "With these basic structures almost any retail financial product can be offered in a Sharia compliant manner. " They find clever ways to get interest and speculate anyway, as many have noted above. There is no reason why Islamic Banking is inherently any more ethical than Western banking, which has its own set of ethical rules as well.

Western banking, being unconstrained (at least in modern times) but such rules offers a much wider variety of financial products, some great, some terrible. "Sukuk is superior to many Western fixed income products, as there are always physical assets underlying the structure." This statement says nothing, really, other than that sukuk is just another form of financial product among many."



A couple of points; first of all, Western banking is by no means "unconstrained", although that perception is rife on MeFi. Banking is very heavily regulated and I wouldn't be surprised if it were one of the more heavily regulated industries.

In fact, the regulatory umbrella on banking is actually tightening in recent times, in contrast to lay opinion I see expressed on MeFi (and other blogs) time and time again. And I've said many times since last August - the fallout from the credit crunch will be very severe in terms of regulatory actions. We're already seeing nascent actions by the regulators, the battle lines are beginning to be drawn, but the real tightening is yet to come.

But ok, why do I believe Sukuk to be superior to many Western fixed income products? Well, I'm personally (and used to be professionally) very active in fixed income (high yield currently, but I know the entire asset class fairly well, bonds, derivatives and structured products) and all bonds (aka "fixed income products") are not created equal.

For example, there is a corporate pecking order. Senior, Senior Subordinate, Subordinate, the list goes on and on (and the Wikipedia falls short of the reality). The point is, it is possible to purchase a fixed income product that IS NOT backed by physical assets of any kind, or that doesn't have definitive claim on an asset.

This isn't possible with a Sukuk, there will always be an underlying, cash flow generating, physical asset associated with the Islamic product. Not so with Western fixed income offerings, as many investors have found out to their woe.


"Finally, the post seems to imply that Islamic Banking is growing because of Islamic law: "Islamic banking, with assets approaching one trillion dollars, is growing at roughly 20% pa by offering Sharia compliant - and only Sharia compliant - financial products." But it's not cause and effect, or at least there's no reason to assume so. They are growing at 20% per annum while offering Sharia-compliant products. Perhaps Sharia compliant financial products are superior and are causing the huge growth, but perhaps it is largely due to booming economies and oil profits in the region and a huge burst of investment in the last decade or so."

You're absolutely correct, the Gulf States have been acquiring huge amounts of capital but that is hardly a new phenomenon. In many oil nations extraction costs are roughly $20 / barrel so this cash has been piling up for some time now, both at the national and personal levels.

As many of these nations and people living in these countries already had large amounts of money, but tied up in cash a key driver of the growth of Islamic Banking is because it offers Muslims an opportunity to invest in accordance with their religion. An alternative that didn't exist in its present form a decade ago. Effectively funds that either are dormant (in cash) or even invested in non Shaira compliant offerings (hey it happens) are now entering the Islamic banking system, driving growth.

And while the system grows it is also maturing. One recent development is Sharia complaint benchmark indices, a critical tool needed for both institutional as well as retail investors (if an investment vehicle can't be benchmarked it struggles to attract capital). And recently we've seen the emergence of an active secondary market for Sukuk.

Now when folks acquire Sukuk they're not burdened with it until maturity; if they need their capital back immediately, they can sell the Sukuk on, again much like a Western fixed income product. So the emergence of trading in Sukuk - another sign of the development and maturing of Islamic banking - is another reason for the growth overall of this market.
posted by Mutant at 5:55 AM on June 7, 2008 [3 favorites]


where all profit earned by the seller must be revealed to the purchaser.

That, in and of itself, would solve a lot of problems in the Western world's finance industry and government. A right to conceal amounts to a right to deceive.
posted by aeschenkarnos at 9:57 AM on June 7, 2008


mutant,
Thank you for your response. It was very informative, as always.
posted by Sangermaine at 3:37 PM on June 7, 2008


aeschenkarnos,

Are you serious? Really!

The "right to conceal" is called the private market, something I am sure you benefit from very much. I am not trying to get personal, but your position really is ridiculous. (I didn't read the other comments -- maybe you were being sarcastic).

...having fun coming back to this thread...
posted by gagglezoomer at 7:18 PM on June 7, 2008


Hello mutant (and all reading this thread),

Long time lurker here. Am totally not a fixed income expert, but I was wondering about your reply to Sangermaine, explaining that Sukuk bonds are "better" than many Western bonds because the former are backed by real assets. Do you mean "better" in terms of your own subjective perception (i.e., your own experiences in fixed income lead you to distrust bonds that don't have the sort of backing that a Sukuk would)? Or is there a theoretical backing for your view?

It's just that I'd've thought that any bonds that had poorer backing than a Sukuk would offer higher returns to compensate investors for their additional risk. If Sukuk are theoretically better, I think they'd be offering a higher risk-adjusted return than bonds without the Sukuk's high level of protection - is that the case? (Or is my understanding off?)
posted by laumry at 1:40 AM on June 8, 2008


laumry -- "Long time lurker here. Am totally not a fixed income expert, but I was wondering about your reply to Sangermaine, explaining that Sukuk bonds are "better" than many Western bonds because the former are backed by real assets. Do you mean "better" in terms of your own subjective perception (i.e., your own experiences in fixed income lead you to distrust bonds that don't have the sort of backing that a Sukuk would)? Or is there a theoretical backing for your view?

It's just that I'd've thought that any bonds that had poorer backing than a Sukuk would offer higher returns to compensate investors for their additional risk. If Sukuk are theoretically better, I think they'd be offering a higher risk-adjusted return than bonds without the Sukuk's high level of protection - is that the case? (Or is my understanding off?)"


I've gotten a very similar query by email, so my apologies to all for perhaps a poor choise of words; yes, it is subjective to some extent and you're absolutely spot on in terms of risk / reward (excellent understanding).

You know the thing that I appreciate most about Sukuk is clarity; because there is a direct linkage between a cash flow generating asset and the Islamic bond, short of issues with the underlying land/commodity/etc securing the debt, default risk or the risk of missing a coupon payment is fairly low.

Western bondholders, by comparison, do have to concern themselves with these risks (and more). The perception is that of the two assets classes (debt and equity), bonds are safer. Well, safety is relative, worst case is in a liquidation debt gets paid BEFORE equity (textbook example), but all bonds are not created equal.

And even if you've accepted lower yield for the security that Senior Debt offers, guess what? There have been instances where somehow, due to some (almost always obscure) provisions, Senior gets wiped out. Sometimes you'll see this happen with convertibles, for example - debt is sitting there fat, dumb, happy, nice coupon stream, no worries and there is some funky ass conversion clause on convertibles (equity side) that either wipes out debt totally, or forces sharp reductions in coupon, changes the liquidation hierarchy (and thus market value of debt), etc. So that's always a concern if you're holding debt. Where precisely are we in the liquidation hierarchy? And what's securing my principal?

Just to show the other side, I've got a buddy that runs a lot of money in strategies like this - he finds some interesting convertibles, determines how these instruments could benefit him best, and if things look good / he can manipulate matters in his favour, he then acquires and executes. And he's made good money at it.

So the thing that appeals to me - and yes, you're correct, this is subjective and I do hope this came through in my comments (I always try to clearly separate my opinion from the facts) - about Sukuk is the clarity. They aren't entertaining complex corporate structures so you get a refreshing one to one in terms of many Sukuk and the asset(s) it is secured by.

I mentioned before I'm currently very active in high yield and our kitchen table is littered with prospectus', annual reports and other research (in fact we're living off this asset class now as I'm taking a year off from banking and that cash flow is how Mrs Mutant and I support ourselves) and its very intriguing when you start to drill in just how shakey your position might be in the corporate structure with some issues. And often trying to figure out precisely the level of cover (e.g., cash flow from assets in excess of the coupon payment a bond pays out) a specific issue has is very troublesome to determine - even under GAAP accounting this isn't always clear. I'm on email/phone a lot with some of the issuers of the assets I'd like to acquire. Or have acquired, 'cause after you've bought something then you've really gotta watch it. I personally haven't had a bad experience with fixed income (knock on my wooden head), tend to make money consistently but then again I'm a suspicious (read that as risk adverse please) bastard.

So Sukuk (although I'm not active in this asset class) is something very appealing to me personally (I'd almost take lower returns just to get a lot of that crap off the table).

Ah but now I see you've brought up Risk Adjusted Return which is a very good point and not mentioned in the email I earlier referred to.

I have seen prospectus' for various Islamic offerings citing a higher Sharpe ratio (return to the investor above and beyond the risk free rate of return) but I'm hesitant to say Sukuk is "better" because of this as most (if not all) of these products were based by commodities or real estate. So the underlying assets have been performing very well, no surprise the vehicle is tossing off prodigious amounts of alpha.

In terms of academic papers, Cakir & Raei (2007) wrote an interesting paper (that I haven't read yet but its on my list). They were looking at pricing behaviour of Sukuk and bonds offered by the same issuer, and more specifically trying to see if Sukuk alone would introduce diversification benefit. Not exactly what you're asking about, but this is one of the few papers I'm aware of looking at Sukuk and applying Risk Management tools.

In any case, their paper Sukuk vs. Eurobonds: Is There a Difference in Value-at-Risk? [.pdf] looks very promising.

An excerpt from their conclusion: "This paper shows evidence that Sukuk—contrary to our priors—are different types of instruments than conventional bonds, as evidenced by their different price behavior. If an investor is ready to allocate certain amount of funds in the bonds of a certain issuer, diversification by including Sukuk in the investment portfolio could significantly reduce the portfolio’s VaR compared to a strategy of investing only in conventional bonds of that issuer. The results were broadly the same in both methods that were used in this analysis, namely the delta-normal approach and the Monte-Carlo simulation."

Full citation: Cakir, S., Raei, F., 2007, Sukuk vs. Eurobonds: Is There a Difference in Value-at-Risk?", IMF Working Paper, WP/07/237


In terms of other tools, I certainly haven't done a RAROC calculation myself on Sukuk and a quick google only provided one reference, regarding the Second International Conference on Islamic Banking:Risk Management, Regulation and Supervision organised by Bank Negara Malaysia, the Islamic Development Bank, Islamic Research and Training Institute, Jeddah and IFSB.

And that conference took place in November 2005, so it seems they are slowly adopting Western Quantitative tools. Curious.

But that's a very good point you raised. Thanks for bringing it up.


On another note, earlier Maurer's name got brought up regarding a paper he'd written. I haven't been able to find a free source for this paper, but an anonymous benefactor (yes, specifically asked not to be mentioned in thread) mailed a link to another of Maurer's papers that is indeed freely avaialble, and thought it might add some insight to folks curious about his work. Entitled The Anthropology of Money [.pdf]. I haven't read it but I have downloaded it.

I've reproduced the abstract here so folks can decide if they'd like to dl: "This review surveys anthropological and other social research on money and finance. It emphasizes money’s social roles and meanings as well as its pragmatics in different modalities of exchange and circulation. It reviews scholarly emphasis on modern money’s distinctive qualities of commensuration, abstraction, quantification, and reification. It also addresses recent work that seeks to understand the social, semiotic, and performative dimensions of finance. Although anthropology has contributed finely grained, historicized accounts of the impact of modern money, it too often repeats the same story of the “great transformation” from socially embedded to disembedded and abstracted economic forms. This review speculates about why money’s fictions continue to surprise."

This paper has itself been cited several times, so it seems as though it may be a good read.
posted by Mutant at 4:18 AM on June 8, 2008 [1 favorite]


Thanks, Mutant!
posted by laumry at 4:22 AM on June 10, 2008


Mutant - Thanks for an interesting post and a fascinating follow-up. I defer to your expertise in fixed income space but I do think you're maybe being a bit bullish on Sukuk compared to bonds.

You know the thing that I appreciate most about Sukuk is clarity; because there is a direct linkage between a cash flow generating asset and the Islamic bond, short of issues with the underlying land/commodity/etc securing the debt, default risk or the risk of missing a coupon payment is fairly low.

That's only true at the moment because the assets backing the sukuks are super-safe middle east infrastructure projects implicitly or explicitly backed by wealthy governments or are sovereign issues. As I understand it, there's no appetite for tranching the capital structures because (a) it's difficult to achieve in a Sharia-compliant way and (b) there's no need given the huge demand for single class deals.

I think the clarity in the economics is misleading though - the risk in these products is legal and political. The legal side is the most concerning for me (no surprise there, I'm a lawyer). There are two levels - at the sukuk level you have the problem that the instrument itself is "governed" by Sharia principals but has an actual governing law which is English or NY. The extent to which those courts will interpret the Sharia element is uncertain. The second problem is that the underlying assets are all Sharia contracts, which means that creditors rights are limited if the become non-performing. For example, musharaka mortagages or Ijara leases are non-recourse so foreclosure and liquidation are extremely difficult. My worry is that the value of the underlying assets behaves very differently under a sukuk than from an ABS.

The political risk is probably more of a positive compared to bonds, but there's still a lot of political prestige riding on the success of sukuks so the relevant governments like Dubai and Qatar may well intervene rather than see a default. It's likely to be subtle though and unpredictable (the version I heard for example was that if a real-estate sukuk looked in trouble the government would just shift some of its Ijara leases at an infated rent into the asset pool).

Western bondholders, by comparison, do have to concern themselves with these risks (and more). The perception is that of the two assets classes (debt and equity), bonds are safer. Well, safety is relative, worst case is in a liquidation debt gets paid BEFORE equity (textbook example), but all bonds are not created equal.


And even if you've accepted lower yield for the security that Senior Debt offers, guess what? There have been instances where somehow, due to some (almost always obscure) provisions, Senior gets wiped out. Sometimes you'll see this happen with convertibles, for example - debt is sitting there fat, dumb, happy, nice coupon stream, no worries and there is some funky ass conversion clause on convertibles (equity side) that either wipes out debt totally, or forces sharp reductions in coupon, changes the liquidation hierarchy (and thus market value of debt), etc. So that's always a concern if you're holding debt. Where precisely are we in the liquidation hierarchy? And what's securing my principal?

This is totally true, but not really a fair comparison because sukuks are all specific asset backed or are sovereigns. I'm not aware of any general corporate issuance at all - I think it could be done, but it's hard to see what the underlying contracts would be.


I mentioned before I'm currently very active in high yield and our kitchen table is littered with prospectus', annual reports and other research (in fact we're living off this asset class now as I'm taking a year off from banking and that cash flow is how Mrs Mutant and I support ourselves) and its very intriguing when you start to drill in just how shakey your position might be in the corporate structure with some issues. And often trying to figure out precisely the level of cover (e.g., cash flow from assets in excess of the coupon payment a bond pays out) a specific issue has is very troublesome to determine - even under GAAP accounting this isn't always clear. I'm on email/phone a lot with some of the issuers of the assets I'd like to acquire. Or have acquired, 'cause after you've bought something then you've really gotta watch it. I personally haven't had a bad experience with fixed income (knock on my wooden head), tend to make money consistently but then again I'm a suspicious (read that as risk adverse please) bastard.


I would think this goes double for sukuks. Interest rate swaps are not permitted so there has to be an exact match between the asset cash-flows and the sukuk payments. That's quite limiting compared to a normal ABS. If the SPV is not a pure-pass it will need to prepare accounts and depending on its jurisdiction GAAP may well not apply at all.


Essentially, given the structural limitations, the complexity in drafting and the fees that get taken out at the underlying level I'm surprised that they would have an equivalent yield to a straight bond. The other big issue at the moment (though this will hopefully improve) is the total illiquidity of the secondary market. The figures I saw were that in the region of 80% of total issuance is buy to hold (which is a point raised in that excellent paper you linked to). An interesting point that I learned recently about the market for Islamic instruments is the requirement for the buyer of an asset to get its own independent fatwah from a Sharia board irrespective of the fact that the arranging institution would have got one at the issue date. That's got to hurt liquidity, especially in distressed situations.

Ultimately, all these things can and will be ironed out in time, but at the moment my personal take is that a bit of caution is required. Thanks again - this is a really interesting topic and I'm keen to see where it ends up.
posted by patricio at 6:12 PM on June 21, 2008


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