Issue Twenty

Time to clarify opaque systems

The underlying problem of the credit crunch is that conventional financial institutions are holding a large volume of securities of falling and doubtful value, which implies large losses. Further losses are in store from having insured asset values through credit default swaps and other derivatives. Contributing to the market malaise is the lack of transparency in over-the-counter markets and the constant speculation. Even if a conventional bank knows its own balance sheet is intact, it cannot be sure its counterparty is in the clear, or in some way exposed to a third party with problems. In this environment of distrust and capital shortage, standard macroeconomic policy instruments are blunted and a strategy that relies mainly on liquidity provision by central banks—while essential—will not suffice. By contrast, Islamic banking contracts are generally more transparent. Fundamentally, Islamic banking is based on a few basic contracts that can be used to create products as desired. They are structured with the objective of equitable distribution, avoiding exploitation of the poor and not recognising interest. Several factors have contributed to the phenomenal growth of Islamic banking, but there are concerns. Islamic banking is based on sharing profit and loss as partners, so the funding and return of a project tie in not only with the amount and duration of the borrowing but also with the purpose and performance. Equity financing is stressed, not debt financing. In conventional finance, the canvas of the risk is narrower and carries only a financial dimension. In Islamic finance, the canvas of the risk is bigger and covers many extra elements due to participation, purpose, and other restrictions attached to capability of payment. Moreover, in Islamic finance additional factors such as a deficient legal framework and fewer standards, procedures and less-qualified manpower and qualified government support increase risk exposures. Thus, risks in Islamic banking are more complex because they are more dynamic and intermingled, necessitating special treatment.

Challenges for new growth

The financial issues of American International Group Inc have not affected our insurance companies’ ability to pay claims andunderwrite new policies. Regulations ensure that our assets back up each policy. AIG Middle East, Mediterranean & South Asia (MEMSA) continues to serve the conventional general insurance market. AIG Takaful Enaya, was set up in 2006 as a regional entity with a vision of global expansion. Our direction has not changed. AIG Takaful Enaya continues to pursue its growth strategy and business objectives. Global takaful has been growing at an impressive rate over the last few years. New takaful companies are being established across the globe. Existing takaful operators are starting operations outside their home countries and conventional operators are developing takaful businesses as well. The entry of international players should contribute to accelerate growth as they bring their conventional expertise and knowledge to the development of the takaful industry. There are in excess of 130 takaful operators worldwide and this will rise. With this in mind it is hardly surprising that takaful is estimated to grow by 20% per annum and potentially reach US$10 billion by 2015 (Morgan Stanley research, 2008). Putting things into perspective, the takaful industry is small compared with the world’s insurance sector as a whole. However, takaful’s influence and importance extend well beyond its current size. There is substantial potential for growth in the Middle East, Asia, Europe and North America. The world Muslim population represents around 1.6 billion people, approximately 25% of the world population, of which 70% are under the age of 35. More than half of the takaful operators have established their base in the Middle East, with a large majority headquartered in the GCC, where the economy has grown by 74—twice that of 2000. The takaful market remains a major growth opportunity and the success of the nascent industry will depend on the underwriting and investment returns within the guidelines of Shariah law. AIG Takaful Enaya is a regional company headquartered in Bahrain and regulated by the Central Bank of Bahrain (CBB), providing accident and health, and property and casualty insurance for commercial and consumer clients in compliance with Islamic Shariah tenets and principles as well as local legislation/regulation. AIG Takaful Enaya is building its strength on AIG’s 85 years of experience in insurance.

Social responsibility

There has been no shortage of articles that have posited the importance and potential for Islamic micro-finance as the real conduit toprove to the world what Islamic finance is really supposed to achieve. Behind the legal form characteristic of contemporary Islamic finance is an overarching social development goal that provides the impetus for millions of Muslims to believe in an “Islamic” sort of finance. Yet there is much that Islamic finance can do to change the world in a manner profitable to its shareholders. Many practitioners and a few academics will argue that social development is not necessarily an immediate objective of Islamic finance. These responsibilities should lie with the state as a matter of public policy and shifting such responsibilities to private institutions places an intolerable burden on their shoulders. So long as Islamic financial institutions (IFIs) abide by the cardinal rules prohibiting usury (riba), intolerable uncertainty (gharar) and gambling (maysir), IFIs owe no definite obligation to greater society. This sort of rationalisation is strangely similar to the Friedman-style analysis of the role of corporations: to make profit for its shareholders. Perhaps it became convenient for Islamic financiers to adopt such an ideology to rationalise their existence. Then there are some who will claim that, just by abiding by this set of cardinal rules, they are better than conventional banks and somehow more ethical. After all, Islamic finance does not only make profits; but also makes profits in a manner compliant with Islamic law. Islam has a well developed contract law that, fundamentally, parallels the development of common law. Parties to an agreement are required to have capacity (understand the implications of the transactions) to undertake bilateral contracts of value. There should be no ambiguity in the contractual clauses or in the outcome of the contract, let alone any element of extreme probability. This is to ensure that one party does not go out of the deal losing everything and the other party gaining everything. Most importantly, one cannot lend another an asset and expect something greater in return without actually conducting a trade or an investment. Some would say these are ethical rules. While this is true, others would argue these sorts of rules were developed in parallel in the common law system and there is nothing unique about the system.

Here comes the sun

In 1976, in a world much less open, Lafico the Libyan government’s bank and precursor of the Libyan SWF, became a shareholder of Fiat, at that time in dire straits. Regeb Misellati and Abdullah Saudi were given two seats on the executive board and proved friendly and competent administrators. Ten years after, Fiat was again flourishing—the strategic vision of Giovanni Agnelli was vindicated and Libya cashed in an extraordinary gain SWFs are not a new phenomenon in the financial world, nor a new category of investment, as many of the established funds have been around for several decades, some since the 1950s. The new phenomenon is the SWFs’ growing prominence fuelled by their sheer size, by some high-profile attempts to purchase large stakes in Western companies and by their providential help to recapitalise some of the world’s leading financial institutions, thus shifting the burden to keep them off the taxpayers’ shoulders. Almost overnight SWFs have become all the rage, to the point that Italy is proposing to turn the mammoth European Investment Bank (EIB) into a sovereign investment fund for the 27-nation bloc, whereas France, with the usual touch of Gallic chauvinism, wants its own. Brazil, Japan, India, Taiwan and Thailand plan to launch their SWFs, whereas Saudi Arabia is considering plans to merge its various funds into one super fund. Officials, on the other hand, seem to have lost any sense of direction. While Gordon Brown welcomes the positive role that SWFs play in the UK and the US, deputy treasury secretary Robert Kimmitt flies to the Middle East and calls on GCC countries to continue investing in the US. American regulators keep launching investigations into SWF investments while memories of the P&O saga are still hurting the feelings of many Emiratis. Italy’s centre-right government opposes SWFs buying more than 5% of individual Italian companies. SWFs are caught in the middle: they get an unfavourable media coverage but are the favoured topic of economic and geo-strategic forums worldwide while financial institutions are courting them as they play the white knight role. This over exposure has created a great deal of apprehension about SWFs’ purposes, structures and investment strategies and has raised issues about their potential impact on financial markets, corporate governance and national security. The unease about their ultimate intentions has spread through governments and Western public opinions alike.

Which firm do you call on when the going gets tough?

These are troubled times for many in the banking industry. The melt-down on Wall Street, the bankruptcy of Lehman Brothers, the acquisition of venerated bank Merrill Lynch by Bank of America and the emergency rescue of AIG highlight the turmoil afflicting global finance. Given such difficult conditions, consultancy companies are often turned to by executives for help in navigating their own firms through choppy economic waters. Islamic Banking & Finance contacted major consulting companies such as Deloitte & Touche, McKinsey & Company, Accenture, Solving Efeso, the Boston Consulting Group and KPMG to enquire about their Islamic banking practice. The latter two declined to participate. Deloitte, McKinsey, Accenture and Solving Efeso shared their views on the Islamic banking sector as well as key facts and figures about their consulting practice. Each consultancy firm possesses its own unique strengths. Deloitte’s team includes a Shariah scholar and has Islamic banking practices in the key Islamic banking capitals of Dubai, London and Kuala Lumpur. Accenture has a strong capital markets consultancy practice. Solving Efeso is strong on strategy in the Middle East. McKinsey stamps its authority by helping produce the annual World Islamic Banking Competitiveness Report, a key resource for many decision-makers. Deloitte operates in 140 countries, employs 165,000 people and maintains Islamic banking consultancy practices in the UK, Middle East and Malaysia. Director Dawood Ahmedji says that, as complex debt instruments are not Shariah-compliant, the Islamic banking system has been relatively sheltered from the immediate fall-out in the global economy. On the other hand, the challenging conditions could present an opportunity for the Islamic financial sector. I“The turmoil will, however, present opportunities for Islamic financial institutions able to think creatively to develop products and markets,” he says. Mr Ahmedji cautions, however, that it would be naive to ignore the indirect macro consequences, such as the loss of confidence in global markets and resulting slowdown in economic activity. “The knock-on effects of other factors, such as currency and interest-rate changes, which Islamic banks use as benchmarks for pricing profit rates, will indirectly impact on operations, although this is unlikely to have a catastrophic effect. The key issues for Islamic banks operating in the Gulf Cooperation Council (GCC) are the prospects for the underlying economic sectors they are exposed to, particularly the real estate market,” Mr Ahmedji says.