The Debt Bubble

The financial crisis started in one corner of the US mortgage market, but the fallout from the collapse of the subprime lending bubble has spread across the globe via the disintermediation of the originate-to-distribute banking model. What began as a crisis for individual markets and institutions has now undermined the foundations of the entire global financial system. Credit markets were the first to be engulfed, but the contagion subsequently reached all asset classes that were reliant on a combination of cheap money and high leverage, bringing the demise of the independent Wall Street investment banking model and sending countries from Iceland to Hungary ‘cap-in-hand’ to the International Monetary Fund (IMF).

In the period of the run up to the crisis, the US and the global economy displayed robust growth, which was expected to continue. Interest rates were low, liquidity was high and growing, financial innovations were proceeding at a rapid pace (especially in securitisation and structure finance), complacency in the face of growing risk was deepening, and regulation as well as supervision receding and weakening. All of this created an incentive structure that encouraged excessive risk-taking in search of higher yields. By March of 2007, the excesses “came home to roost” (Mirakhor and Krichene, 2009). Easy credit had already created an incentive for home purchases and refinancing of existing mortgages, while prices in the housing market were already increasing, indicating a boom. This provided the primary motivation for the emergence of the subprime market, for, as long as house prices were increasing, the underlying debt obligation would be continuously validated by an increase in value regardless of the size of the down payment, the credit record of the buyer, or the adequacy of documentation.

The liquidity crunch was fundamentally the result of the credit bubble bursting. Too much liquidity and overcapacity in the industry resulted in much lower underwriting standards. Consequently, consumers became overleveraged. With new entrants in both the mortgage lending and bank loan markets, competition led to loan terms that did not compensate for the risks. In this process, the risk management model followed by financial institutions is to be blamed for the crisis, as rising risk and falling returns became a dangerous mix.

It should be mentioned that the economy is always passing through cycles in the long term, or what economists call ‘Kondratief cycles’, within which there are other small cycles. The current cycle is not new, nor did it occur overnight (Economist Intelligence Unit, 2009). Many commentators recognised the potential consequences long before they became real. Yet the feeling seemed to be that ‘as long as the music was playing, lenders had to dance’. Indeed, a financial institution cannot afford to sit out the dance unless it can stomach a significant loss of market share. In a hypercompetitive market, however, banks sometimes have to take the long-term view and refrain from dancing. Some did, as they shunned option adjustable-rate mortgages and high loan-to-value products, and their better performance in the current environment is already beginning to differentiate itself.

Banks around the world have been put under significant pressure; most affected are those that were originally highly leveraged and heavily dependent on wholesale funding. A few years ago, it would have been unthinkable that iconic financial services groups would become so widely distrusted. Regaining this trust is, however, key to worldwide economic recovery. Figure 5.2 depicts how the market value of the world's largest banks had significantly shrunk between mid-2007 and January 2009. Banking giants saw their market value diminishing at an unprecedented pace. For example, Royal Bank of Scotland had its market value shrink from USD 120 billion in mid-2007 to USD 4.6 billion by January 2009; UBS from USD 116 billion to USD 35 billion; HSBC from USD 215 billion to USD 97 billion; and Citigroup from USD 255 billion to USD 19 billion.

Securitisation channels have shut down in the crisis process from 2008 onward, and banks that rely on the originate-to-distribute model have substantially reduced their volumes of new lending, thus leading to a sharp reduction in revenues. Some banks, in recent times, are attempting to shift back to a more traditional on balance sheet banking model. The growth of derivatives during the boom years decoupled from the growth of the real economy. There will now be a reduction in that decoupling effect. As a response, indeed, derivatives will not disappear, but their volumes may shrink and become more aligned with the size of real economies. However, as a result of the crisis, access to short-term funding channels has been severely compromised, and a number of banks became reliant on government support. This opened criticism in the financial industry of substantial malpractice in highly geared investments and questionable risk management practices. More importantly, it has raised questions on the integrity of the sophisticated conventional modern financial system in which regulators are trying desperately to catch up with market innovations, particularly in the space of derivatives, debt markets and speculation.

That period in the markets provoked thoughts on failures in conventional risk management techniques and the need for a better alternative. Therefore, “this crisis has been a wake-up call for reassessing the effectiveness of international financial architecture and in particular for mechanisms to head off systemic risk”, stated Reza Moghadam, director of the IMF's strategy, policy and review department (Wroughton, 2009).

It should be noted that the conventional systems have pretty much forgotten about ethics; this is an important cause of the financial crisis. The fragility of the conventional system operating on the basis of speculation, manipulation and interest rates was underlined by the infamous 2001 Nobel Prize-winning economist Joseph Stiglitz (2008) who argued that: “The present financial crisis springs from a catastrophic collapse in confidence. The banks were laying huge bets with each other over loans and assets. Complex transactions were designed to move risk and disguise the sliding value of assets … Financial markets hinge on trust, and that trust has eroded. It was all done in the name of innovation, and any regulatory initiative was fought away with claims that it would suppress that innovation.”

In addition, the crisis has highlighted shortcomings in banks' pricing, monitoring and managing of risk. Too much reliance has been placed on quantitative models, based on historical data, to make assessments of current and future risks. The inappropriate use of financially innovative structured products has led to tremendous wealth destruction.

The crisis cannot be explained by the argument that it occurred because of liquidity, which was being there one day and gone the next. When trust and confidence disappeared and investors asked for their money back, it became apparent that real liquidity had not been created in the first place, a situation that should not occur under an aspirational Islamic financial system where there is a partner, rather than a debtor, relationship with depositors.

Derivatives and the Crisis: A Source of the Financial Crisis

Following the outbreak of the crisis, it became fashionable to malign derivatives for doing much damage to the global economy. Politicians and the media held derivatives responsible for massive corporate losses and the downfall of companies like insurer AIG and Lehman Brothers. Some have gone so far as to suggest that derivatives were the main contributing factor to the credit crisis and to the wider global recession.

Bartram (2009) disagrees with this approach, as he argues that blaming derivatives is like blaming a car for causing a crash, rather than the reckless driver who was behind the wheel. The cause of the global recession in reality is manifold and the reason for many corporate failures is varied too, he adds. However, derivatives are complex securities that transfer one kind of risk but create newer risks which are difficult to assess. They break down the relationships between lender and borrower and encourage risk-taking at the originator level (Ahmed, 2009). One of the interviewees for this research, Engel (2010), argues that derivatives should not be blamed for the mess that happened in the financial sector.

As financial products, derivatives are great risk transfer tools: they help stop systemic collapse in the financial sector. For example, when Enron collapsed, many feared that several top banks would go under because of their huge exposure to Enron. It was derivatives that spread the risk among several banks and saved the system from a total meltdown. While it is true that bankers make derivatives look very complicated, once they are broken down into little boxes and pieces, their structure can be understood with greater ease.

Searching for the Causes of the Crisis

A number of economists have tried to determine the causes of the crisis. Some consider financial liberalisation and deregulation to be the cause in an environment where the financial systems of many countries are not sound as a result of improper regulation and supervision. Others feel that the ultimate cause is the bursting of the speculative bubble in asset prices driven initially by excessive risk-taking and the use of innovative complex structures. It has also been argued that the root cause of the crisis was the maturity mismatch and liquidity mismanagement where long-term assets were far greater than short-term liabilities.

The available literature on the financial crisis thus indicates as many opinions as there are researchers. However, even though all these factors may have had some role to play in the crisis, no consensus seems to have developed so far in pinpointing the ultimate cause or the cause of all causes. In the absence of a proper understanding on the ultimate cause, conflicting remedies have been proposed. Consequently, the proposals for government bailouts, stricter regulations and supervision have been unable to step beyond the basic principles of the conventional banking mechanism.

In pre-crisis times, most conventional banks employed intense financial-leveraging techniques to magnify their gains in expansionary economic times. The use of leverage amplifies returns during a boom cycle, but it can also have a reverse effect during a recessionary phase when managements not only have to write down losses on their declining asset portfolios, but also have to pay interest on their outstanding loans – the exact situation that most conventional banks were faced with.

Banks created complex opaque financial instruments that produced new risks, which were not well understood (Ahmed, 2009). This decomposing of risk through financial engineering and product development made risk management a serious scientific process, as risk management became often dependent on sophisticated mathematical models.

It had become apparent that, during the process of financial crisis, at many banks, multiple lines of defence failed – business managers, risk managers, audit and control. Coupled with these failures was weakness in board risk oversight. The crisis revealed that very few firms have a true ‘culture’ of risk management that will not be compromised when competition heats up, regulatory pressure abates or management changes.

The weaknesses of the system have to be studied in a comprehensive manner, and as a result of such an approach, the key factors causing the crisis can be identified at three levels: instrumental (the use of innovative complex products), organisational (financial institutions engaged in excessive risk-taking) and regulatory (a deregulated environment and lax regulations) (Ahmed, 2009). However, the industry debate has focused on pure risk management failures, particularly the shortcomings of risk models in measuring risks accurately, without addressing the broader issue of how risk is managed at the highest macroeconomic levels and how the whole financial system is based on greed and lack of morality.

When the financial crisis erupted, most people referred to ‘greed’ as the source behind the crisis – the ultimate cause; the worship of markets in general and financial markets in particular is considered the source of ‘greed’. However, the main causes stem from the creation of (excessive) debt, de-linkage of wealth creation from debt creation, and the making of money (debt) by banks, which may be linked to the ‘greed’ of those involved in such processes. These factors have led to debts growing faster than wealth, which must eventually be equalised by a crash resulting in business failures, unemployment and ultimately gross inequalities of income and wealth. An economy with a heavy reliance on debt can lead to nothing but high risk and volatility.

After the crisis, the global economy was not expected to rebound quickly, but rather to return to trend growth rates, with persistent unemployment and budget deficits. Figure 5.3 offers a stylised illustration of global macroeconomic and credit conditions over recent years. The financial crisis may be behind us but the sovereign risk challenges, with huge public debts, definitely represent a rocky road ahead. World economies went from low risk aversion during the boom in 2006 to high risk aversion during the peak of the panic in 2009. A decade later, the worldwide economic recovery remains fragile. Trade and currency wars between the US and China, the global recession, the budget deficit in the US and sovereign debt issues in the Eurozone are still sources of high concern to investors. ‘Slowbalisation’ seems to be the name of the game for years to come across the globe.

Islamic Finance: No Subprime Exposures But Not Fully Immune

The foundational principles and operational mechanisms of IBF were discussed in Chapter 2, which made reference to the ethical sources of IBF. Despite such foundational ethical claims, on the surface the story of Islamic banking as more resilient than conventional banking, which has been repeated in a world torn by a financial tsunami, is attractive. Unfortunately, at least in the form in which it is currently practised, such expectations of IBF are not entirely true.

Since the main liquidity for Islamic banks comes from the GCC region, it should be mentioned that many Islamic banks, especially in the GCC, have not been immune to the financial crisis. The liquidity squeeze in the region has put pressure on these banks just as much as on their conventional peers.

In examining the propensity of IBF for crisis, it can be seen that Islamic banks mainly carry four main asset classes within their investment portfolios: property, equity, sukuk and managed funds (which include underlying assets mainly comprising infrastructure, private equity, real estate and stocks). In the financial crisis process, it is observed that such assets have all lost value (Moody's, 2009a). In addition, the volume of sukuk issuance dramatically declined between September 2008 and summer 2009, although it started to take off later in 2009 (Standard & Poor's, 2010a). However, Islamic banks, due to the immaturity of the industry coupled with constraints imposed by the Shari'ah, have been relatively protected because they had no exposure to subprime assets and their derivatives, such as dubiously rated collateralised debt obligations (CDOs) and special investment vehicles (SIVs) securitised debt-based assets.

Table 5.1 describes the impact of the financial crisis on Islamic banking.

It can be argued that IFIs around the world have generally displayed strong resilience amid the global financial debacle. One obvious reason for their proven ability to weather the storm is embedded within the core principles of Islamic banking: both speculation and interest are prohibited. In addition, the subprime crisis was driven by a number of factors that in combination led to the accumulation of risks, which were again magnified through the use of complex, often highly structured financial products – all of which were explicitly riba-based. However, it may be that the Islamic finance industry was not as badly affected as its conventional counterpart because of its comparative lack of sophistication and Shari'ah restrictions rather than anything different in its current activities. It is a fact that re-packaging of debt obligations into several layers without a substantial trace to the underlying asset is difficult to achieve through Shari'ah engineering. Islamic securities should be asset-based. Furthermore, a direct link to the asset is the substantial basis of asset-generating returns. Moreover, Shari'ah disallows the trading of future obligations until the asset is actually delivered.

Based on the observed progress, it can be argued that IFIs are not risk-immune, but their capacity to resist the crisis was bolstered by the natural conservatism inherent in the principles of Islamic finance, which is based on ethical norms of Islamic moral economy.

Islamic Banks Affected by the Financial Crisis: No Man is an Island

Similar to other institutions, Islamic banks do not operate in isolation. They are part of local, regional and increasingly global interdependent financial markets. In this respect, although they are less sensitive to the monetary fluctuations of the West, they remain dependent on the real economic cycle. The Islamic financial market will always need to interact and engage with the conventional one – it does not exist in some isolated bubble; therefore some level of ‘contamination’ may be difficult to avoid.

The credit crisis highlighted the globalised nature of the world we live in: imagining that a subprime crisis could never happen in Islamic finance would be to encourage complacency. As the financial crisis gradually turned into a real economic downturn, asset quality ultimately deteriorated and Islamic banks' high exposures to the real estate sector turned out to be a curse rather than a blessing. For example, the Gulf countries now contemplate the effects of property and stock market declines coupled with lower economic growth prospects in the short term, and Islamic and conventional institutions alike are feeling the pain of reduced liquidity and credit losses. This is due to the fact that the global financial and economic crisis did not spare the once-booming economies of the Middle East, and the Gulf Arab states in particular. However, in general, the macroeconomic repercussions were milder in the region, where recovering oil prices and large amounts of liquidity in numerous Sovereign Wealth Funds allowed governments to take interventionist counter-cyclical measures to stimulate their domestic economies and support flagship government-owned banks and companies.

As such, Islamic banks have been facing three series of cyclical challenges, which again reflect their current structural strengths and weaknesses (Moody's, 2009c):

1. Managing short-term liquidity has been made more difficult.
2. Investment portfolios, concentrated on illiquid and cyclical asset classes, have been impaired.
3. Access to long-term funding has been postponed, forcing banks to reduce the maturity profile of their assets.

With the financial crisis, market disruptions made it difficult for Islamic banks to continue fuelling their aggressive pre-crisis growth as key funding sources dried up. Customer deposits shrank as money that had entered in 2008 left the market leaving governments to prop up deposits single-handedly, and IFIs, particularly in the GCC, started to raise deposit rates to ensure retention. Governments stepped in to ease short-term liquidity positions; however, this did not alleviate the overall long-term position gap. To help manage their liquidity, Islamic banks will have to develop creative funding strategies and improve their internal capabilities to understand and forecast their liquidity needs.

However, despite such constraints, which are expected to be temporary, Islamic banks have had the capacity to resist due to a number of buffers in the following format:

1. Their credit portfolios have been essentially domestic, with limited pressure on asset quality so far.
2. Their entrenchment in the retail banking arena, with high customer loyalty and deposit stability, limits the probability of massive bank runs.
3. High capitalisation and ample core liquidity often provide a relatively higher amount of confidence to counterparts.

In the economic downturn, falling asset prices, credit seizures and liquidity crunches created a difficult situation where retail-funded commercial Islamic banks are better placed than their rivals. They enjoy low leverage and abundant liquidity. Islamic investment banks, meanwhile, are wholesale-funded with a concentrated deposit base and are also highly exposed to cyclical and illiquid asset classes such as real estate, private equity and venture capital. Consequently, they have suffered far more, with two of them defaulting: Global Investment House and The Investment Dar, both within the GCC. Another Islamic finance company whose survival has come under pressure for the same reasons is Tamweel, which is merging with its rival Amlak in the United Arab Emirates.

In general, Islamic banking had shown stronger performance than conventional banking. In 2009, amid the peak of the global crisis, more Shari'ah banks were launched and more markets opened up to Islamic products. While most conventional banks suffered substantial losses and severe asset reductions, assets in Islamic finance grew to USD 822 billion in 2009, an increase of 29% compared with 2008, with the opening of 20 Islamic banks, according to Maris Strategies and the Banker (Oakley, 2009).

Traditionally, IFIs have not been heavily leveraged. The primary reasons for conservative financial leverage maintenance are:

1. IFIs have limited incentives to grow debt-like liabilities because their assets tend to be highly profitable;
2. They needed to set aside extra capital buffers to prepare for expansion;
3. Funding is usually cheap, thanks to easy access to non-remunerated qardh hasan current account deposits; and
4. The necessity to set aside capital charges for specific risks like displaced commercial risk (DCR), reputational risk and concentration risks as per Basel II's Pillar 2 (Moody's, 2009d).

These capital and liquidity buffers, previously criticised by opponents of Islamic finance as a burden on profitability, have perhaps been one of the most important strengths of the IFIs amid the crisis because they provided a financial institution with surplus cash to use as a shock absorber. As a result, under the difficult economic conditions of the crisis, most IFIs were able to seek out opportunities by using their surplus liquidity to aggressively boost deposit volumes and thus to increase their market shares by growing lending volumes, while maintaining their focus on the retail and corporate sectors. For example, this is a strategy employed by GCC banks to de-couple their retail lending business from global markets by focusing on extending credit locally. According to Thun (2010), one of the interviewees for this research, with few exceptions (especially in Dubai), funding has been less of a constraint for IFIs because of the market's perception that these players will be more resilient than their conventional peers to global credit turmoil. Thus, the market has acknowledged that Islamic banks cannot carry assets such as highly leveraged structured instruments or global investment banks' shares on their balance sheets because these are considered haram and therefore are not eligible for investment according to the Shari'ah boards' fatawa.

In practice, customers are switching their savings from conventional banks (perceived as riskier) to Islamic banks (perceived as less directly exposed to subprime). This activity has been recorded in a number of countries, especially the UAE, Kuwait and Bahrain. The latest figures on these banks show an increase of 34.4% in their Q3 2008 deposit base over the previous year (Moody's, 2009a). This retail entrenchment is a good strategic shift – one suitable for the current environment with wholesale funding restricted and liquidity ratios lower (albeit not severely so).

Moreover, wholesale-funded IFIs were affected by their inability to access the retail deposit segment for funding, as retail deposits are more granular, more stable and cheaper, while wholesale depositors are savvy and constantly arbitrage institutions in need of funding. It is no coincidence that Islamic intermediaries like Global Investment House (GIH) in the field of merchant banking and Amlak and Tamweel in specialised mortgage finance found it extremely difficult to fund their businesses (Alvi, 2009a).

Islamic investment banks that operate largely as private equity firms have been feeling the impact of global market conditions because they have invested in real estate markets and companies outside the Gulf region, through private equity transactions. Falling real estate prices, the credit crunch, and the economic recession in Europe and the US lessened the value of these investments and pushed these Islamic investment banks to either enlist their generally sophisticated clients' support to share any losses or to write down losses to preserve their reputations. Effectively illustrating this is Arcapita Bank, which reported significantly deteriorated liquidity; its 2008 financial performance declined versus historical levels, and between January and June 2009 its credit rating was downgraded by Standard & Poor's from BBB to BB-; this is a four-notch downgrade in less than six months. In June 2009, Arcapita requested to withdraw its rating.

Although GCC countries, home to most IFIs, announced that they stand ready to support their financial systems if needed, providing support to IFIs is more complicated than for conventional banks, because governments are limited to using the same mechanisms as those for conventional institutions. For instance, interest-based repo facilities or traditional deposits are not Shari'ah-compliant, which by definition implies limitations on the instruments that governments have to intervene with the liquidity of Islamic banks. The UAE has based its support for IFIs on wakala, which has required some time to implement (Standard & Poor's, 2010a).

Failures in Islamic Finance: Sukuk Defaults

Sukuk issuers such as the Kuwait-based Investment Dar Company defaulted on their sukuk as part of a general debt restructuring program. Another noticeable example is the Saudi Arabia-based Saad Group, which defaulted on its debt in the recent past, including the Golden Belt sukuk that it issued in 2007. This was followed by the Dubai debt bombshell, which put sukuk in the spotlight for all the wrong reasons. Nakheel, the property arm of Dubai World, responsible for key developments in the region such as the Jumeira Palm and The World, issued three sukuk to finance its investments. Three years after issuing the world's biggest sukuk, Dubai's Nakheel grabbed the headlines once again, this time through default. On 25 November 2009, the Government of Dubai announced that it intended to restructure part of the debt (approximately USD 26 billion) of Dubai World, the Emirate's largest state-owned conglomerate. Nakheel asked for trading to be suspended on all three of its listed sukuk until it was in a position to provide clarification to investors and the market. On 14 December 2009, Abu Dhabi provided USD 10 billion to help Dubai to meet its obligations, including USD 4.1 billion needed to repay Nakheel, with the rest of the money to be used to pay trade creditors and contractors as well as meeting interest expenses and company's working capital (Oakley, 2009). Indeed, Dubai's woe did hit the reputation of IBF. As a response, Dubai first had announced that it would restructure the debt, then two weeks later it announced that it would repay, possibly on the back of market reaction. Dubai realised that it could not afford the damage of not repaying. But the damage may have already been done.

The market conditions during the 2008/2009 crisis had resulted in other defaults in the Islamic finance sector, such as the Saad Group, Investment Dar and the East Cameron Gas Company. These failures have brought several key risk management issues like enforcement of judgments in the GCC, transparency, corporate governance and asset-based sukuk into the limelight.

These episodes reminded investors that default can and does happen in the sukuk market, as in any other part of the financial sector. However, sukuk default is a new phenomenon, as the market is still in its infancy. This represents an interesting development, and it should help investors to understand what could happen in the case of default and what the legal and financial repercussions could be. According to Professor Habib Ahmed of Durham University (cited in Newby, 2009), “Islamic economists have been saying that Islamic finance was not affected directly by the subprime problems. The Nakheel problem shows that Islamic finance can have similar problems if wrong investments are made … This case is a wake-up call for Islamic finance to focus more on ethical and moral issues that it has been ignoring for so long.”

Recent sukuk defaults highlight the issues Sheikh Taqi Usmani battled with, as he rejected the ‘opaque’ musharakah/mudarabah type whereby investors did not really know what ‘assets’ as sukuk holders they were getting but did not care as they relied on the creditworthiness of obligor. Ijara, although not perfect, at least gives sukuk holders the ability to assess the value of what they are getting for their money (inflated or otherwise). In addition, the rating agencies were concerned only with the credit rating of the obligor (because of the purchase undertaking), whereas a proper musharakah/mudarabah sukuk would have forced them to look at the merits of the underlying business – and perhaps to reject them on that basis.

During the financial crisis, the default of a couple of sukuk was thus possibly partly responsible for the recent slowdown in issuance. The silver lining was that these defaults should provide the market with useful information on how sukuk will behave following default.

According to Standard & Poor's (2010a), despite its relative recovery in 2009, major hurdles remain on the path to sukuk market development, including:

1. Difficult market conditions, which are slowing the planned issuance of numerous sukuk;
2. Uncertainty about the legal recourse to the underlying asset as demonstrated by the recent defaults;
3. The lack of standardisation, notably when it comes to Shari'ah interpretation; and
4. The low liquidity of the sukuk market, which constrains investors trying to exit the market in times of turbulence or access the market looking for distressed sellers.

The need to address those issues in a well-regulated Islamic finance market is even more crucial due to its nascent stage of development. Any failure in the Islamic financial sector now will hurt its reputation and could threaten its survival. “If there is a failure of the bond market in California, nobody will question whether there is a systemic risk to the global bond market. But if a sukuk fails, it will raise questions on the entire Islamic finance” said the economist Mirakhor, a former IMF executive director (Oana, 2009).

Islamic Banking Emerging Stronger from the Crisis

It should be considered that lower volumes, shrinking margins and deteriorating asset quality will all weigh on IFIs' profitability and ultimately their capitalisation. However, once again, the impact will be more manageable than for their conventional peers. Fortunately, Islamic banks have been very profitable in the past and have therefore accumulated large amounts of capital, making them capable of absorbing these sorts of shocks. Conventional banks have had greater appetite for exotic asset classes, like bank bonds, hedge funds and direct exposures to global financial institutions and insurers, than have Islamic banks. In that sense, asset-quality deterioration at conventional banks may be more pronounced. In addition, conventional peer banks used to be less well capitalised and less liquid, and hence will find it more difficult to book new business in the current market conditions. To grow today, a bank must have accumulated excess liquidity and capital in the past: most commercial Islamic banks have, some conventional banks have not.

Wilson (2009) points out that Islamic banks have been less adversely affected by the crisis than major international banks. He argues that, as the latter have been weakened by the recent financial crisis, this undoubtedly presents an opportunity for Islamic banks, especially in the GCC, which have been less adversely affected. GCC-based investors in conventional banks, such as Prince Waleed's Kingdom Holdings, which holds 5% of Citibank, and the Abu Dhabi and Qatar Investment Authorities, which hold significant stakes in Barclays, have seen the value of their investments plummet. In contrast, the value of Al Rajhi Bank and KFH investments in retail Islamic banking affiliates in Asia has been much more resilient.

The Islamic financial industry is therefore expected to emerge stronger from the crisis, provided some conditions are met: more innovation bound with the ethical norms of the Islamic moral economy, enhanced transparency, more robust risk management architecture and culture, and, most importantly, less deviation from the core Shari'ah principles. These are the lessons to be learnt from the financial crisis, as it has forced Islamic banks to do a complete reassessment of their policies and attitudes not only to whether they are merely Islamising conventional products but also to whether the financing is beneficial to the real economy. In an interview with Arab News (2009), Sheikh Esam M. Ishaq stated, “I think in a way the financial crisis is a blessing in disguise for Islamic banking because Islamic banks unfortunately were far down the road in trying to mimic and replicate anything and everything that was there in the conventional banking sector.” Hence, the call exists for a return to the foundational basics of Islamic finance to overcome or at least moderate the consequences of potential financial crises.

Paradoxically, the reputation of Islamic banks has benefited from the recent crisis (albeit with some exceptions), reflecting their conservative approach to business, a close proximity to their domestic and regional deposit franchises, their balanced and ordered appetite for growth, and their focus on the basics of banking as opposed to over-innovation, with an emphasis on their domestic market first. All these factors, which used to be perceived as weaknesses before the credit crisis began, are now being used as shields against the potential damage of imported stress. Investors may therefore view IFIs as safer havens less prone to excessive financial shocks. Several Islamic banks therefore are in a position to gain market share at the expense of conventional peers, which have been weakened by toxic subprime assets. Furthermore, a global economic recovery is likely to benefit the GCC as oil and gas prices rebound, resulting in fresh liquidity being pumped into Islamic banks to fuel further expansion (Wilson, 2009).

It is quite clear that the policies implemented and practised by Islamic banks have luckily worked to their advantage so far. From a risk management perspective, however, (and in light of the financial crisis) IFIs are using unstable policies without growing their liquid asset supply and monitoring their risk levels. As the market matures and the crisis deepens, the negative impact of these policies could lead to bankruptcies due to inaccurate liquidity management and defective asset qualities. That said, the chances of an IFI becoming insolvent are low due to the availability of government support – especially in the GCC – and support from other financial institutions.

From a conceptual perspective, Islamic banks will probably be the big winners when the crisis ends, provided that the abovementioned conditions are fulfilled. As a sub-set of ethical finance, Islamic banking is now considered not so much a niche business standing at the margins, but rather as representative of a credible, viable and sustainable alternative business model for sound, ethical and socially responsible banking (Oakley, 2009). Many now believe that mainstream finance has moved too far into excess leverage, meaningless innovation and value-destroying investments. As a rule, Islamic bankers tend to view a monetary, banking and financial system as existing to serve the real economy and not being served by it. In a sense, the Islamic banking model inherently calls for social and economic responsibility from those who create money with credit, encouraging balance, care, honesty and transparency in doing business. What Islamic banking also promotes is that debt is a responsibility and should not be overly traded; that money is a measure of value, not a commodity; and finally that human factors, rather than simply profits, are the cornerstone of any economic and financial system. In that sense, by endogenising such features into its operations, IFIs will undoubtedly find their reputations strengthened, and Islamic finance as a whole will come out stronger from this crisis. At this stage, supervisory authorities and IFIs have a golden opportunity to achieve the true goals of the Islamic moral economy and to create a stable Islamic financial system that can resist economic shocks and that truly operate on the basis of profit and loss sharing (PLS) (Awan, 2008). The credit crunch has shaken confidence in the existing Western regulations and created the need for a better, more transparent system; this has opened the door for Islamic bankers to take up the opportunity. Indeed at the 5th World Islamic Economic Forum (WIFE) in Jakarta on 2 March 2009, Muslim leaders, including Indonesian President Susilo Bambang Yudhoyono and Malaysian Prime Minister Abdullah Badawi, called on the Muslim world to leverage the global financial crisis by turning “adversity into opportunity” (Parker, 2009).

In short, Islamic banking has suffered from the liquidity drought, to the point where a few of the sector's investment banks have defaulted; but as an industry it now has a track record of resilience, which had not been tested before. It is true that Islamic finance has been more conservative because of Shari'ah rules, which has resulted in Islamic financiers steering clear of toxic repackaged credit instruments. By partially following the core principles of Shari'ah IFIs were more financially stable than their conventional peers. Therefore, a true Shari'ah-compliant financial model can be a panacea if it is followed purely, without deviation.

Tawarruq: A Contentious Islamic Finance Instrument

One major example of the apparent divergence between theory and practice is the excessive use of murabahah, which gives a fixed return. This has been dubbed ‘murabahah syndrome’, with an ironic feeling about operations of IFIs. This practice, referred to as tawarruq in Arabic (meaning ‘cash generation’), has been under criticism from many Shari'ah scholars, such as Sheikh Muhammad Taqi Usmani, Dr Abdul Latif Al Mahmood and others. It was initially approved as an interim solution until IFIs move to genuine commodity murabahah, but it seems that several banks took advantage of this interim approval and prefer to stick to tawarruq as it bears minimal commodity risks for the bank and replicates a conventional loan. Figure 5.4 shows that IFIs have a long-standing bias toward simple products that use mostly murabahah and ijarah structures, both of which offer more predictable returns, and have similar profiles to conventional products. Furthermore, they do not bear the challenges in terms of governance, profit calculation and allocation of more complex structures, like musharakah and mudarabah, which allow for more advanced financing offerings such as private equity.

Sheikh Muhammad Taqi Usmani, as cited by Ayub (2007:446), states about tawarruq and fixed-income instruments: “Shari'ah scholars have allowed their use for financing purposes only in those spheres where musharakah cannot work and that, too, with certain conditions. This allowance should not be taken as a permanent rule for all sorts of transactions and the entire operations of Islamic banks should not revolve around it.”

The problem is that for many banks tawarruq has become an essential tool for conducting day-to-day business (Davies, 2009).

Practically, however, fixed-income murabahah is being used to a very large extent and the use of the PLS mode is negligible, even in institutions in which the honourable Sheikh Usmani used to serve as Shari'ah supervisor or member of the Shari'ah board.

Lack of Appetite for Risk-Sharing Assets

One of the major criticisms of Islamic banks is their reluctance to hold risk-sharing assets. By design, because of the prohibition of interest and pure debt, and the sharing of risks, Islamic banks should engage in partnerships and equity-sharing financial assets, but in practice the portion of such assets on the balance sheets of Islamic banks is minimal. For example, Table 5.2 shows the asset composition of selected banks from 1999 to 2002. It is evident that Islamic banks' first preference is for financial instruments that are generated through debt creation, sale contracts and leasing instruments. Informal observation of more recent balance sheets shows a similar picture.

Islamic banks' reluctance with regard to risk-sharing instruments such as musharakah and mudarabah is problematic for achieving the true potential and promise of the system. The reason for shying away from such instruments is a lack of appetite for risky assets, which in turn is due to Islamic banks' attempts to emulate conventional commercial banks where preservation of depositors' principal is their foremost objective. By investing in financing and trade-related instruments, Islamic banks are able to provide low-risk and good fee investment opportunities; they want the best of both worlds. There are also pressures on Islamic banks to make their investment accounts behave like conventional deposits in terms of return profile. These pressures are twofold – namely, from the marketplace and from the banking supervisor in some countries (IFSB, 2007).

The real issue in Islamic banking, as mentioned above, is the excessive reliance on form at the expense of substance. By promoting risk-sharing through asset-based equity-type facilities on the assets side and profit-sharing investment accounts on the funding side, Islamic finance could in principle contribute to a better balance between debt and equity, thereby fostering stability. However, in practice, the use of equity-type financing facilities is limited due to risks linked to considerations of asymmetric information and adverse selection (IFSB, 2007).

IFIs should change this business model and expand their portfolio to include risk-sharing instruments. Islamic banks often claim that their reluctance is a direct reflection of depositors' low appetite for risk-sharing products. However, it is possible that depositors' low appetite for such instruments is due to a lack of transparency and confidence in the ability of the financial intermediary. Therefore, Islamic banks should consider doing a better job of selecting and monitoring risk-sharing assets, and enhance the transparency of the investment process by informing depositors through good estimates of exposures to risks taken by the bank on investing in risk-sharing instruments (Askari et al., 2009). The long-term sustainable growth of Islamic banking will depend largely on the development of risk-sharing products.

Sukuk

While there are many sukuk structures (14 described by Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI)), the majority of those applied (be they ijarah, musharakah or mudarabah) effectively ‘reduce’ to a form that is an Islamic equivalent of a conventional unsecured bond. Much complexity is generated by asset-based aspects of the structure, but the ultimate objective is to replicate the risk-and-return characteristics of a fixed-income bond. Moreover, most originators in these structures do not intend to sell the contributed assets, and the transfer of assets is often not legally perfected or registered (Dey and Holder, 2008). Most sukuk transactions are therefore ‘asset-based’ rather than ‘asset-backed’.

This disparity between the ‘ideal’ and the ‘reality’ of sukuk was highlighted by AAOIFI in February 2008 following a well-publicised criticism of the mudarabah sukuk structure by the prominent Shari'ah scholar and Chairman of the AAOIFI Shari'ah Board, Sheikh Taqi Usmani. AAOIFI then published a statement containing six principles regarding sukuk structures. Subsequently, many sources attributed the market decline to this statement. In reality, the decline in sukuk market volume in 2008 was probably due more to prevailing global credit market conditions (it was a very difficult time to raise funds, whether conventional or Islamic) rather than to any direct reaction to the AAOIFI statement. In the midst of this global turmoil and the market pause, the AAOIFI comment has provided for some self-reflection in the industry.

While there was some debate regarding the method of its release, the AAOIFI's comments constituted a positive effort toward improving transparency and bringing the ‘substance’ of sukuk products closer to the basic tangible and risk-sharing principles on which there is an almost universal consensus; it is in the implementation of these principles that matters become complex for investors.

To date, many of the current sukuk types adhere to AAOIFI in form, but not in substance. The highly successful Indonesian sovereign sukuk (USD 650 million) issued in April 2009 shows there is still heavy demand for these unsecured, asset-‘based’ structures (Moody's, 2009d).

The term ‘based’ is often used to reference a ‘looser’ asset security structure that has little or no legal relevance in the event of a corporate default or distress. There is no scope in the courts for such vagaries – either the investors have a legally enforceable claim on assets or they do not. So when crunch time comes, those investors in asset-based structures are left with nothing: no assets, no security, just an unsecured claim in substance like a debt of the company. The majority of investors happily accept these structures. Many investors – Islamic and non-Islamic alike – simply want a fixed-income bond: rough estimates put the market size at USD 45–50 trillion and it is this powerful investor demand that primarily drives the shape of the market (Moody's, 2010b).