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Why a Madoff scandal couldn't happen in Islamic finance

The Madoff scandal reveals a majorweakness in the hedge fund business, resulting in the fraudulent activity that is the fuel behind speculative bubbles and the “magic” behind all financial scams. No-one in recent times has exploited this as blatantly as Wall Street major player Bernard Madoff, a former NASDAQ chairman arrested for allegedly running the biggest dollar Ponzi scheme of all time.
His victims include wealthy friends and family as well as banks and numerous financial institutions such as HSBC Bank, BNP Paribas Bank, Fortis Bank, Bank Medici, Fairfield Greenwich, Nicola “Supermum” Horlick’s Bramdean Alternatives and many more, valued in total at more than $50bn.
     This figure raises questions. How could such a large shortfall have arisen, given that Bernard Madoff Investment Securities had assets of only $17bn under management at the start of the year? The funds run by Madoff were not advertised as being leveraged, although derivatives were supposedly used to reduce volatility. But who now knows? Nothing about his “black box” investment process can now be believed.
     The supposition is that it was a giant Ponzi scheme, with returns funded by new investors. But if that is the case, Mr Madoff must have been raising hundreds of millions of dollars a month to achieve his alleged returns of about 10% a year. In these markets, however, raising that kind of money is tricky and his downfall came when some investors actually asked for their money back, as investors will now do from a host of other funds.

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Beyond straightforward screens

Fund management is all about generating alpha. So does it really matter whether a Shariah-compliant or a conventional fund is managed? Ideally, there should be no difference, except that a smaller asset universe is available for Shariah-compliant investment. So what makes Shariah-compliant fund management special or different? Quite simply, a number of aspects that should not bother fund managers at all. Their time should be utilised in doing the job for which they are hired—making money.
     Ensuring that a fund is managed in a Shariah-compliant manner goes far beyond automated sector filtering/screening and simple ratio calculations such as those done by some fund managers on their spreadsheets. The validation of Shariah-compliance is about providing fund managers with credible Shariah screening, purification calculation and compliance monitoring.
     Screening is about the exact translation of the verbal requirements defined by the respective Shariah board and putting them into practice. This is only possible if companies are researched in-depth. Automated sector screening based on industry classification codes can be performed easily using spreadsheet filters but would result in less credibility because compliant companies might be classified as being non-compliant and vice-versa. Banks normally generate revenue from riba and are therefore non-compliant. But this cannot be a generalised rule because a lot of banks in the Middle East are Islamic banks and should be considered compliant.

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Are we resilient or are we at risk?

In advertising the first Asia Sukuk Summit 2009, the Hong Kong Monetary Authority offered this quote from the International Monetary Fund: “The Islamic financial system may be in a better position to withstand shocks in the global financial system than its conventional counterpart.”
     It goes on to say: “Promoting dialogue and exchanges among financial markets and industry professionals is important in addressing some of the key challenges the [Islamic financial] industry faces, such as consensus on international standards and global awareness. Greater transparency and harnessing of standards are therefore demanded to push the industry to the next level of development, and it would not have been possible without the collective efforts of regulators and market players in respective regions.”
     The above quotes provide rather conflicting views of Islamic finance. On the one hand, the Islamic financial system may be more resilient yet it needs to be pushed to the next level of development for the sake of “greater transparency and harnessing of standards”. One may wonder whether the resilience of the Islamic financial system rests on its lack of development, transparency or standards and if this is true, whether the conventional wisdom must apply: “If it ain’t broke, don’t fix it.”
     Since the flare-up of the international financial crisis, it has become fashionable to cite the immunity of Islamic finance to financial crises as a testament of its resilience. This is obviously a self serving argument and an exercise in delusion. Islamic finance, as practised today, places the industry in a more vulnerable situation than conventional finance. IThe real issue is not the intrinsic resilience of Islamic finance, but that the industry has not yet faced the same conditions as conventional finance, à l’Américaine, has faced. Islamic finance will likely traverse a far more dangerous terrain if it continues on its present path.

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Survival of the fittest

As activity slowed to a crawl last year, one joke making the rounds among Islamic finance professionals was that the only groups still making money from the industry were conference organisers. And no wonder. The rapid rise in the profile of Islamic finance and the ever-increasing amounts of money flowing into the sector have spurred equally impressive growth in dedicated conferences. Sukuk, private equity, real estate, project finance, hedge funds: as each and everything that could possibly be made Shariah-compliant became hotter, organisers have matched them with every forum, symposium, seminar or summit possible. “The conferences focusing on Islamic finance, like the industry itself, has witnessed extraordinary growth, especially over the past three or four years, which has seen many generalist conference companies dabble in the market,” says David McLean, managing director of Mega Events, Dubai.
     In the quarter to December last year alone, there were no fewer than 30 Islamic finance-themed conferences held in Asia, Europe and the Middle East. In London, last summer it was possible for a banker to network at least once a week through an Islamic finance event, which are as much about discourse as they are about the informal mingling of suits and ties.
But quantity does not always mirror quality. While attendees are reluctant to criticise any conferences publicly, the consensus is that the huge increase in the events has meant a decrease in the number genuinely productive and worth attending. Only a handful of conferences stand out when executives are asked what they won’t miss, come rain, shine or snow.

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Growth and development

Amidst the global financial turmoil and harsh critiques that conventional banking is facing, Islamic banking system has emerged as a vibrant alternative in Malaysia. In this nation of 25 million people, few financial sectors have grown as quickly as the Islamic banking industry, whose religious precepts have struck a nerve not only with the older generations but with younger investors as well. An interesting point to note is that, Islamic finance in Malaysia is generally well accepted among all Malaysians—non-Muslims lead in subscribing to Islamic finance products and services.
     It is widely known that Islamic financial services are among the fastest growing fields in the banking and finance industry. In its annual intelligence report, McKinsey & Co stated that Islamic banking assets and assets under management reached US$750 billion in 2006 and are expected to reach US$1 trillion by 2010.The financial authorities in the central bank, Bank Negara, as well as the Malaysian government and Kuala Lumpur’s banking community, understood the potential of this trend and sought to create the right conditions in which the nascent industry could thrive.
     Capitalising on the existing infrastructure and comprehensive local Islamic financial system, which has been developed for almost 30 years, the Malaysia International Islamic Financial Centre (MIFC), a strategic body that spearheads the development of Malaysia as an international Islamic financial hub, was set up in 2006 to promote Malaysia’s expertise in Islamic banking. Also in 2006, Malaysia, again led by its central bank, founded the International Centre for Education in Islamic Finance (INCEIF) as a global university for Islamic finance.

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Treasury management systems

Some of the key trends in treasury management for Islamic banking are ensuring that investments with companies conform to the Halal index and the need to develop a secondary market for treasury—hedging in its true form is not permissible under Shariah law. There are two bonds available to cater to this need—the sukuk (Malaysia) and the musharakah mutanaqisah, both of which are being discussed and reviewed by Shariah scholars.
      In Malaysia, there has been a strong surge in demand for Shariah-compliant treasury products, and there are no indications that demand will wane. As treasury products within Islamic banking are leaned on more heavily as tools to invest and to provide a hedge, the need for systems that can automate and support these processes while maintaining Shariah compliance will continue to grow. Cash management, debt, investment and currency management are common threads, as is the need for strong audits and controls. An Islamic treasury system should help manage and control operational risk within defined parameters. Efficiency is maximised through straight-through processing at each stage in the transaction lifecycle.
     The ability to quantify and report the impact of market volatility through a comprehensive risk management framework and real-time integration with core systems is key. So is the ability to adapt as the clients’ business and the competitive landscape changes, particularly as new instruments come to market.

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Women in Islamic finance

The first wife of the Prophet Muhammad, Khadijah bint Khuwaylid, is considered to be one of the greatest women in Islamic history. A widely respected and successful businesswoman who inherited her father’s business, Khadijah is known as the first female entrepreneur in Islam. Her title of al-Tahira (“the pure one”) was earned through her purity, generosity and service to others.
     Khadijah employed Muhammad as an agent to trade her merchandise to Syria and, impressed by his sense of responsibility and business skills, she proposed to him. She was also the first to declare faith in Islam.Khadijah’s example sets a standard for aspiring businesswomen across the Islamic world—her success in a male-dominated society provides inspiration for women to pursue their own careers. But how easy is it, in modern times, for a woman to gain acceptance from her male peers and become successful in an environment such as Islamic finance? And what does the future hold for women in the sector?
     The Western view of a successful woman generally relates to an accomplished career and financial independence. But in Islam, although a Muslim woman can pursue a career, her primary role as wife and mother are considered more important. The status attached to the role of mother is equal to, or more than, that associated with the father as provider:

A man came to the Prophet and said: “O Messenger of God! Who among the people is the most worthy of my good companionship?” The Prophet said: “Your mother.” The man said: “Then who?” The Prophet said: “Then your mother.” The man further asked: “Then who?” The Prophet said: “Then your mother.” The man asked again: “Then who?” The Prophet said: “Then your father.”
Bukhari and Muslim hadith