Jeff Black | Berlin

Some Islamic debt instruments have been falling foul of Muslim scholars–widening a new debate in finance known as Shari’a risk.  Coming up in the next issue of The Middle East…

Consider the following scenario: The international market for a class of new Islamic financial instruments, sukuk, is booming, having reached US$100bn from scratch in just five years. Sukuk, akin to a conventional bond, are the star performer of the trillion-dollar global Islamic financial services industry. In the Muslim world they meet an increasing requirement by companies and governments for Shari’a-compliant borrowing in a credit-tightening world. Elsewhere, sukuk are becoming a regular part of the conventional financier’s arsenal, as bankers use anything they can lay their hands on to get the best spreads possible. Ergo, everybody wins. Until, that is, a leading scholar of Islamic law throws an industrial-sized spanner into the works by saying that most of the sukuk on the world market aren’t properly Islamic. This is Shari’a Risk.

The scholar in question is Sheikh Muhammad Taqi Usmani, Chairman of the Shari’a Board of the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), a Bahrain based outfit that has fast become the world’s leading standards-setting body for the heterogeneous global Islamic finance industry. He was speaking at a conference of the organisation in November 2007. The following six months were perhaps the worst that the sukuk industry has faced since its inception.

Sukuk are, like their industry itself, a mixed bunch. An issuance by a bank in Malaysia can take a very different form from one by a real-estate firm in Dubai. But in general they are equated with bonds because they pay a fixed income to the holder and are redeemed at a specific date by the issuer. Sukuk generally differ from bonds in that their fixed coupon rate is supposed to be fulfilled by profits from an underlying asset which the holder of the sukuk actually owns a portion of–for example, a real-estate development–and not merely interest payments accruing from debt. 

As a result of their asset-backed nature, sukuk in theory comply with two cardinal rules of Islamic finance–that interest is forbidden and that risk must be shared equally around the community. This, however, is where Sheikh Taqi Usmani took issue.

The first problem concerns prohibition of interest, the sine qua non of Islamic finance. Remarkably, it is common to find sukuk marketed to investors, whether Muslim or not, on the basis of interest rates. For example, early in 2008 Saudi Arabian property developer Dar al-Arkan listed its US$1bn sukuk on the Bahrain Stock Exchange, Dubai’s DIFX and Malaysia’s LFX, with a stated “profit rate” of 3-Month US$ LIBOR + 225 basis points per annum. LIBOR is the interest rate at which banks lend to each other on the London wholesale money market. The practice of marketing those asset-based returns on the basis of a popular interest-rate benchmark is, according to Usmani, a “corruption.” “The time has come to revisit this matter, and rid sukuk of these blemishes,” he wrote in a policy paper.

The second issue concerns the allocation of risk. According to Shaikh Usmani, it is also common for the mudarib, or manager of a sukuk issuance, to agree to re-purchase the shares in the original asset upon maturity of the sukuk for a set price. This allows sukuk to behave much like conventional bonds, inasmuch as it significantly lowers the risk profile for the investor. It does not, however, share risk in a way fully congruent with the principles of Islam: “That such a commitment to investors on the part of a mudarib is void should be obvious because it is a capital guarantee by the mudarib to the investors, and no jurist has ever averred that such an arrangement is lawful,” wrote Usmani.

Obviously, the credibility of one of Islamic finance’s most athletic innovations in recent years is under significant threat. It is this kind of controversy in Islamic finance which has given rise to the very notion of Shari’a risk. It is essentially the possibility that investors or lenders can lose money through disputes about a given product’s Shari’a compliance.

On the face of it, Shari’a risk is a significant and urgent problem. Kilian Bälz, a fellow of the Islamic Legal Studies Program at Harvard Law School and perhaps the leading researcher on the issue of Shari’a risk, argues that it is an inevitable by-product of the rapid growth and globalisation of Islamic finance. As Islamic banks and investment houses primarily operate in and across jurisdictions which have secular civil or common-law commercial legal systems, (the United Kingdom, Malaysia, United Arab Emirates, Bahrain), the legal basis of any financial contract is not in fact the Quran or Sunna. As a result, the market-driven demand for financial contracts based on an entirely different set of legal concepts can, according to Bälz, seriously endanger the enforceability of a transaction.

Challenging a financial contract on the basis of compliance with Islamic law is known as a “Shari’a Defence”. A few such cases have already entered the courtroom, the most well-known being the Shamil Bank of Bahrain v. Beximco case in 2004. In that instance, the borrower (Beximco) disputed its obligation to repay Shamil Bank on the basis that the Shamil’s Islamic Mudaraba loan was in fact a standard interest-bearing loan dressed up as being Shari’a compliant. Beximco lost on account of Shari’a law’s irrelevance in the jurisdiction of the contract, the United Kingdom.

However, Bälz argues that the Shari’a defence could in theory be potent with regard to controversial sukuk structures. The guaranteed-buyback agreement mentioned above, is a particular area of concern, especially if asset values fall significantly during the term of the bond. “In finance a limited legal risk can be a big, big issue, especially if it is based on something that is difficult to follow for the normal international banker, such as exotic Shari’a defences,” he told The Middle East.

There is obviously a question of jurisdiction here. If Islamic finance in fact operates in mostly secular legal environments, what is the real danger posed by diverging interpretations of Islamic law? Perhaps a greater question is how much the perception of Shari’a compliance affects the market value of the instruments in question. The furore surrounding Shaikh Usmani’s 2007 comments, which reverberated around the world’s financial press, ought to have been a test-case for this very question, had it not happened in the midst of a much larger problem–the global credit crunch.

In an atmosphere of rising credit prices around the world, GCC firms that would have been prospective sukuk issuers held back from the market, wary of the general rising cost of borrowing. New issuances dried up. Investors balked also at uncertainty about GCC dollar-peg arrangements, as most sukuk were denominated in the falling American currency. Worse still, in March 2008 spreads on HSBC’s GCC Corporate Sukuk index widened dramatically as western institutions (which frequently hold between 40-60 percent of a large issuance) dumped their Gulf sukuk holdings in search of easy and safe liquidity. Sukuk, argues Ahmed Abbas, a leading Gulf bond arranger, “paid the price for being part of the global financial village.”

Abbas, who is CEO of the Liquidity Management Centre, a Bahrain-based organisation that arranges short-term Islamic instruments for Shari’a compliant banks, downplays the seriousness of the Shari’a compliance issue in the midst of worries about the credit crisis.

“[The controversy] had no effect on the primary or secondary sukuk markets–there were bigger issues at stake,” he told The Middle East. He also espouses the widely-held view that both Usmani’s criticisms, and the reporting of them, were exaggerated.

“The Shari’a compliance issues are based on subjective views. For example, I don’t see the Malaysia model, which differs from the UAE model, dying. If the market demands greater harmonisation, then it will get it. The investor will decide,” he said.

For now, it is difficult to predict how Muslim investors would react if a similar controversy over Shari’a compliance occurred in a bull market. There are, in theory, two possibilities. First, if Shari’a risk has actual economic effects, such as a sudden drop in the market value of any given instrument because of the pronouncements of a Shari’a scholar, then Islamic finance has a job to do to solve the problem and standardise the area of Shari’a compliance. They ought to be in a hurry, because oil at $125 a barrel creates a huge wall of petrodollars increasingly looking for somewhere suitably Islamic to invest. Organisations like AAOIFI are earnestly beginning to narrow the margin for error, through tougher sukuk guidelines and contract standardisation.

However, if Shari’a risk turns out to be a negligible problem in the real world, because Islamic law does not in fact really govern the conduct of Islamic finance, and investors are willing to elide the distinction between interest rates and profit rates, then perhaps a debate about the real role of Islamic finance is in order. In the meantime, according to Ahmed Abbas, the market will keep turning: “Money rules, and still rules. That saying didn’t come out of nowhere.”