UK Continues to Play Active Role in Promotion and Development of Islamic Financial Services

DDCAP Limited Managing Director and CEO, Stella Cox, gave an exclusive interview to Islamic Banker magazine. Excerpts of the interview are published below.

As the Islamic finance industry enters the new decade, its recovery in the aftermath of the global financial crisis, which impacted the conventional sector much more, is tempered with cautious optimism. There are already signs that the global Sukuk market is on track to match its pre-crisis issuance volume and the industry is consolidating on tried and tested core business lines such as commodity Murabaha.

Here Stella Cox discusses with Islamic Banker the prospects and main challenges for the Islamic finance industry in 2011 and beyond.

Islamic Banker: What are the main regulatory and market challenges for the industry in 2011?

Stella Cox: In 2010, the global financial marketplace started its recovery from the worst financial crisis in decades. Extraordinary measures have been called for to restore equilibrium in mature markets and government support has, and continues to be, central to sustained global recovery. The financial crisis was swift and unprecedented, emphasising the importance of the relationship between liquidity and solvency.

It exposed the structural flaws of the conventional financial system and rapid decisions had to be made to introduce new levels of financial regulation, governance and supervision. Indeed some consider it is time now to distinguish between “greater” and “better” regulation. Amongst the challenges that we face in 2011, our industry has to ensure that appropriate lessons are learned. Conventional finance is largely based upon debt and risk transfer, Islamic finance is, or should be, asset-based and focused on risk sharing. The very essence of Islamic financial principles should help to mitigate certain risks, through avoidance of financing or investing in the sectors and instruments that adversely impacted the conventional space.

Accordingly, many reports suggest that Islamic banks have weathered the global crisis better than conventional banks. Selectively, this may be true, but some reports have been based upon over-simplified assumptions about Islamic finance without analytical evaluation or statistical data. It is inappropriate and dangerous to make conclusions about the sector as a whole on such a basis and without consideration of the varying regulations, controls and conditions that prevail across the numerous jurisdictions in which Islamic banks operate.

We know that the Islamic financial system was not immune from the impact of the crisis and areas of concern frequently highlighted for consideration even prior to it have included: a) the lack of sufficiently diversified asset classes which has caused excessive investment concentration in some sectors (i.e. real estate); b) the absence of a cross border liquid market infrastructure and instruments for management of liquidity risk (which introduced additional stress during the height of the crisis); c) an incomplete or untested legal framework.

It is important, too, that we are not complacent and are transparent about perceived weaknesses in our financial infrastructure. Many believe that the pre-crisis approach to regulation of Islamic financial activity in some jurisdictions did not consider its unique characteristics. However, fortunately, the desire to aid swift recovery has been equally apparent in our industry and has prompted focus on the delivery of strategies and initiatives, at both commercial and regulatory level, that are intended to enhance its stable foundation and core financial stability.

Indeed, effort and input in that area is being made on an ongoing basis. For example the Financial Stability Task Force, the task force on global financial stability established by the Islamic Development Bank recommended in April of last year the establishment of an Islamic Financial Stability Forum (IFSF) to be based at IFSB. Its objectives are to interface with the conventional system via the Financial Stability Board and to thereby jointly promote global financial stability. Separately endeavours have been made to address liquidity risk within the Islamic financial space and, although challenges remain, it is clear that those authorities central to our industry’s ongoing success and development are collectively engaging to resolve them.

Emergence of robust solutions is being emphasised and the efforts of the IFSB’s Islamic Liquidity Task Force have even more recently supported the announcement and formation of the International Islamic Liquidity Management Corp, an entity to be hosted in Malaysia with shareholders drawn from the governments of a number of core Islamic market and international jurisdictions with a mandate to enhance industry access to short dated, liquid and highly rated Islamic securities.

Banks are concentrating on core business lines – do you think 2011 will be a year for increased Commodity Murabaha, structured trade finance offerings?

Many banks focused on core business strategies and the re-instatement of profitable and appropriately risk profiled activity in 2010. Amongst them, a good percentage of our clients report that they are keen to emphasise key, traditional areas of expertise and historically the application of classical, Murabaha based solutions to structured trade finance has been a cornerstone of the market.

Of course in recent years we have become all too accustomed to seeing Murabaha criticised for its excessive utilisation, lack of tangible asset backing and even its role in introducing unacceptable amounts of leverage into the Islamic financial system. As in the conventional system, Islamic financial contracts can, as recent experience shows, be adapted to support their application to situations outside of their classical or intended purpose and it is important, therefore, that the products and services that include and promote such structures are transparent, open and available to rigorous and regular scrutiny as they traditionally have been. To that effect it is important that all entities involved are willing to engage with the relevant authorities, including Shariah Advisors and financial regulators, at the earliest stage so that structures can be built upon from a solid foundation to the comfort and satisfaction of all.

DDCAP is delighted to have been positioned to participate both as a principal, as well as an intermediary, in a series of structured Murabaha trade financings during 2010 involving a diverse range of commodity assets for both institutional customers and funds. Although our firm is often, and not entirely accurately, principally identified with the facilitation of physical commodity assets for purposes of liquidity management, we prioritise a disciplined approach to all of our commitments involving supply of allocated (i.e. identifiable) and authenticated physical assets incorporating a diverse range of commodity classes. To ensure ongoing compliance, we focus on our continual adherence to the Murabaha contract stipulations advised to us by our clients’ Shariah Advisors which readily transfer to structured Murabaha trade financing opportunities and we encourage regular inspection and audit of our business activities and processes by those Advisors, too.

In the wider market and especially noteworthy is the value of Murabaha to key emerging Islamic markets with the IDB’s International Islamic Trade Finance Corporation continuing to deliver classical structured models to support the development of commodity and agricultural supply chain transactions.

Do you think Tawarruq is here to stay and its use will proliferate especially for liquidity management if not cash management?

Despite efforts to establish clearer parameters, criticism of the contract persists amongst certain scholars and practitioners so it is not really for me to say whether or not it is here to stay. I do appreciate, however, that Tawarruq has long been a sensitive issue and its merits have been debated at length so it is absolutely essential that market participants, whether principal or intermediary, have full awareness of, and commit to, the very precise guidelines and standards that are issued by Shariah bodies such as AAOIFI and the OIC Fiqh Academy, as well as individual bank Shariah Committees.

These standards are issued in respect not only of products and structures, but also in respect of related trade execution. If asset backed processes are to be followed strictly in accordance with Shariah stipulation there is usually a commercial impact. After all, this is not a conventional financial market practice. However, in the midst of the pressures faced by financial institutions in recent years, the desire to reduce or remove such cost implications seems often to have become a priority. Endeavours to cut costs can result, intentionally or otherwise, in subtle revisions to approved structures and thereby adherence to the prescribed standards and stipulations for the arrangement.

If they are not identified and immediately resolved, situations such as this will ultimately tarnish the integrity of any structure. There is no excuse for this as the Shariah authorities have made their concerns very clear. Their requirement is that Tawarruq should be utilised selectively in wholesale activity and with the utmost caution at consumer level where, again, there is particular concern about the introduction of leverage as well as the segregation of contractual responsibilities. We all have a role to play in ensuring that the principles and standards are upheld to the finest detail and respected by all; be we sponsors, originators or even market intermediaries. Nothwithstanding this, it is interesting to see the increasing number of Financial Exchanges seeking to offer liquidity management services that incorporate Tawarruq or a Murabaha component.

These have already been launched by Bursa Malaysia through Bursa Suq Al Sila and are due to be launched by the Bahrain Financial Exchange through Bait Al Bursa. This week there has also been an announcement of similar intent by the Jakarta Futures Exchange. Financial market regulatory authorities such as the Central Bank of the UAE are choosing to base their new Sharia’a compliant notes issuance programmes on the Murabaha contract. I think we can therefore take some comfort that such structures have been exposed to both regulatory and Sharia’a scrutiny and have been endorsed by those also empowered to oversee best market practice as being suitably transparent and fit for purpose.

Will the Sukuk market rebound in 2011 perhaps beyond sovereign issuances to more corporate Sukuk?

Like everybody else, I read much research with conflicting view points but most of it seems to be optimistic about the prospects for Sukuk issuance in 2011, without necessarily anticipating that the aggregate volume for the year will surpass previous annual highs. In core markets including Malaysia and the GCC, we can certainly expect to see increased levels of issuance by corporates, although ongoing issuance by sovereigns is still important on a regular or recurrent basis to establish renewed confidence in the market and also to create that all important yield curve that will attract the attention of new classes of investor. Structure will be essential.

I have focused quite extensively on Murabaha in regard to market criticism of application and transparency but, actually, there has been at least equal concern about Sukuk in the wake of more recent market events. Prior to the AAOIFI led Shariah debate, the structuring process had become incredibly fragmented given aggregate volume in issuance and subsequent difficulties reinforced concern. Rebuilding the Islamic capital market is a more gradual process this time, but that is not necessarily a bad thing if it brings a depth of investors, as well as issuers, so it is important that the market adapts itself more effectively to support origination and development of structures and asset classes to meet the requirements of long-term investors.

Outside of core markets it is good to see the increasing number of announcements of inaugural sovereign issues, again from the perspective of establishing benchmarks and injecting confidence. However, clear intention and long-term commitment are essential and in the current environment government risk requires careful evaluation too. Another positive is the committed approach being taken by a growing number of international jurisdictions to create a level playing field through an ongoing process of revision to domestic legislation and, where appropriate, regulatory stipulation that will enable local engagement with Islamic financial services too.

Which asset classes will flourish in 2011 and why?

The asset management industry is also recovering from the global crisis and during 2010 rebuilding trust and re-establishing a relationship with investors was a priority concern for most managers. Obviously in the midst of portfolio redemptions there was a defensive return to cash, although in key Islamic financial markets within the Middle East, our clients reported that commercial banks were liquid in local currency with their customers preferring cash deposits rather than investment in comparable fund products.

In 2011, and as markets recover, investors will reduce their bias to cash in an endeavour to find better returns and they will ultimately gravitate towards performance and the asset classes that best suit their individual risk/yield preferences. In Islamic asset management, there has often been criticism of the lack of asset diversification in products available, whether due to Shariah screening, market access or regulatory implication.

As confidence returns, there is a renewed focus on performance monitoring rather than on the asset gathering of the pre-meltdown boom. Some of the traditional geographical and asset class preferences of our industry may be slow to recover as a result of negative investor experience so we might expect a gradual return to new product innovations, again with the aim of attracting the additional layer of term investors that are now seeking opportunity within the Islamic financial sector.

What are the prospects for the industry in the UK and Europe over the next year or so?

In pre-crisis markets, an overwhelming and probably inappropriate amount of attention was given to who in the West might issue the first and biggest sovereign sukuk. Presently it doesn’t appear that this is the UK’s territory, but I vigorously reject suggestions that the UK has not, and does not, continue to play its part in the active promotion and development of Islamic financial services, both domestically and in the international space.

For over a decade, we have been working to revise legislation so as to ensure that UK regulatory stipulation and our own laws provide a level playing field for institutions and individuals wishing to embrace, or engage with, Islamic financial services. In the UK, we have five fully Sharia’a compliant banks, one operating in the retail environment. Each of the wholesale banks are defining their individual spaces which encompass treasury, trade finance, real estate, capital markets, fund management and private banking.

The STG 6million Musharaka sukuk structured by Millenium Private Equity for International Innovative Technologies was modest in size, but significant in its ability to utilise the infrastructure available within the UK and establish new precedents. Elsewhere in Europe we have additional positive examples with the development of similar market infrastructure being pursued in France and a branch banking licence being granted to an Islamic financial institution in Germany. I also see huge opportunity coming from all of the positive indicators in Turkey, both within and outside of its domestic Islamic financial sector.

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