The idealistic solution
22 May 2006
The driver for the huge growth in Islamic finance is due to demand - a demand resting on the desire to obtain financing compliant with religious beliefs. For some, that is too simplistic a rationale. There is an appreciation that borrowers have the option to rent money and get a 'riba' (loosely translated from Arabic as 'interest') paying debt. Payment of interest will be anathema for some, but for others this will only be a hindrance if the commercial benefits outweigh the religious prohibition. The judgement rests on the adherence to sharia rules and the tangible benefits provided.
Parallels with the ethical finance movement are easy to see. The qualitative difference is that Islamic finance rests on a religious belief system, which has equity and fairness and the need to avoid exploitation in commercial dealings at its heart. Renting money is out. But that does not mean that financiers cannot make a return, or for that matter get collateral for that return.
What is key is the adherence to the principles of sharia. Easy principles to understand are the prohibition of financing or investing in activities that are 'haram' (casinos, pork, alcohol, gharar speculation). Contracts need to be certain, which should be music to lawyers' ears - no maisir gambling or speculation. For those lawyers familiar with these basic principles, it is a starting point, nothing more. Definitive pronouncements on sharia compliance are not the domain of lawyers - that is the preserve of sharia advisers, whose knowledge is acquired through study, experience and respect.
Supply and demand
Increased demand for Islamic finance has to be matched by supply. In the capital markets sphere, consumers want the espoused benefit of more relaxed covenants, longer tenors and cheaper pricing attendant to a diverse investor base and huge liquidity that provides at a time of record oil prices. But what happens if the more discerning investors have a more varied palate, such as a convertible or exchangeable bond? Can Islamic finance deliver?
A sukuk is not an IOU or debt instrument - debt trading is prohibited. A sukuk is a certificate representing the holder's pro rata interest in an asset or enterprise, with the return on that asset or enterprise 'servicing' the sukuk. The burgeoning sukuk market has seen the most pronounced innovation in the wholesale Islamic finance sector. To reiterate, this has been brought about by demand. That demand has been greatly assisted by the perennial difficulty for Islamic financial institutions to transform their short-term liabilities - ie deposits - into long-term assets.
The difficulty arises because Islamic banks are unable to leverage their balance sheets through trading in debt. Accordingly, one of the significant drivers for the development of the sukuk market is the creation of an Islamic 'money' market, rather than temporarily housing excess liquidity in short-term commodity murabaha (cost plus mark-up financings), treasury liquidity management products and programmes.
Growing investor base
Interposing asset ownership into any financing requires detailed due diligence. Sukuks are also noteworthy for their highly structured nature. All this adds to expense. So why is an ever-increasing number of corporates and governments alike entering the sukuk market, or at least exploring it. Commercially, there can be real benefits from a wider investor base of Islamic and non-Islamic banks and financial institutions not available in the conventional bond market. A good example is the pricing on Emirates' 2005 $550m (£290.4m) sukuk. The spread on that sukuk was 75 basis points, compared with 80 basis points on its 2004 $500m (£264m) eurobond.
But pricing advantage only materialises when a sukuk is priced and, critically, closes. What, then, happens when there is a huge acquisition, a buoyant Gulf IPO market and the need for Sukuk financing on an unprecedented scale? Can the sukuk market deliver? The closing of the Ports Customs & Free Zone Corporation (PCFC) sukuk suggests a resounding yes. The PCFC sukuk al-Musharaka was the world's largest sukuk to date, the first convertible sukuk of this kind, coupled with a number of innovations that have received less attention than the jumbo issue amount - understandably, the issue amount of $3.5bn (£1.85bn), linked to DP World's acquisition of P&O, was attention-grabbing.
The PCFC sukuk should not detract from the fact that the huge growth of Islamic finance is a consumer-led phenomenon. Consumers in the Middle East and in other Islamic countries are voting with their wallets and electing for financing compatible with their beliefs.
The huge growth in deposits has led to a number of banks in the region switching to being Islamic banks and the provision of a range of sharia-compliant consumer products, ranging from car financing, credit cards and mortgage products. The rise in consumer demand for Islamic financing is readily seen in the UK's burgeoning sharia-compliant mortgage sector, assisted by recent tax changes.
Consumer demand will lead to more products. More products will lead to more work for lawyers. Islamic finance is not a fashion. It will grow. The innovations seen thus far are not a fad. Economics may drive some banks in this fast-growing sector, but be assured that consumers are at the wheel.
Rahail Ali is global head of Islamic finance at Denton Wilde Sapte