Islamic Banking: A Charade

This is going to be slightly long post.

I have always been a proponent of Islamic finance and have been promoting it at all forums since my undergrad. I worked in conventional banking for 5 years yet I kept promoting Islamic Banking. Then I did my masters in finance from one of the top business school of the world. Subsequently I have worked in Islamic investments as well as Islamic banking for almost 8 years and got a chance to see the transactions and structures used in Islamic financing up close and personal. After working on a few landmark transactions recently in structured finance, Sukuk and syndicate financing, I have come to the definite conclusion that Islamic banking as practiced today is total charade.

No need to repeat the Quranic verses here but the essence of Quranic injunctions is that debt should be interest free or a non-profit transaction. If you want to engage in profitable transactions, do trade which entails taking equity stake. That was the argument at the Prophet’s time that both trade and lending for profit are the same i.e. if you treat money as commodity, there is no difference between trading and interest based lending in letter of the law. However, Quran forbade lending and approved trading. I like to think of it as difference of spirit of the law and letter of law.

Anyway, my smell test is the duck test. If it looks like a duck, walks like a duck, and quacks like a duck, then it is a duck. Similarly in Islamic finance transaction, if the transaction is a debt based transaction, and then it is Riba, no matter how many commodities we trade to show it as a trading transaction.

Initially it used to stated that global system is interest based system and we can’t just remove it and establish an Islamic system overnight. We need a mid way approach. Hence, a Murabaja structure was devised as mid-way structure wherein by carrying out certain steps, a debt transaction would be Islamized i.e. made into a trading transaction. Probably the Islamic scholars thought they were innovating but they were following in the footsteps of the Christian clergy who gave their blessing to Contractum Trinius allowing Christian merchants/bankers to bypass Christian rulings against Usury.

What is worse that today Murabaha instead of being considered the mid way faulty stop gap arrangement that it is, it is now considered a standard uncontroversial instrument of Islamic finance beyond reproach. A more disservice to Islamic finance hasn’t been done.

The size of global Islamic finance is touted anywhere from US$1.5 trillion to US$ 4 trillion. This amount has everyone salivating and trying to come up with products to get a piece of this pie. The international bankers have been very active in this segment and sharia scholars have been very happy to guide them (for a fee of course) on how to Islamize the products available in the conventional financing sphere.

To take a small digression. Regulations are there to safeguard market participants. But there is a low of money to be made in regulatory arbitrage products. Before the credit crisis, such products allowed sophisticated investors including banks and other institutions to bypass the limits set up by regulators for investors’ protection. Lawyers and investment bankers would come with most convoluted structures to bypass legislation/regulations. Lawyers, investment bankers and accountants earned handsome fee for this business. Investors eventually were at the losing end. Similarly there are significant tax arbitrage opportunities wherein foreign investors’ to US can invest through Cayman Island structures to take benefit of the loopholes in tax codes. US treasury loses out on taxes, investor loses out on expenses of capital structures/ multiple SPVs. Only people who make money are lawyers and accountants for coming up with this structure. Similarly, we have sharia arbitrage wherein a product or service may not be sharia compliant, but enough lawyers and sharia scholars bang their heads together on it for a while (and the incentive of hefty fee of course) they will make it a sharia compliant product.

Some of the recent most used products that I have seen that are down right riba with just a lip service (read sharia fatwa) to sharia compliance are:

1. Tawarruq or reverse murabaha
2. Wa’ad
3. Sukuk
4. Sharia compliant derivates (oxymoron if ever there was one)
5. Profit rate swaps

There will always be people who will continue to justify one product or other and have detailed fatwas and explanations that how a certain transaction is sharia compliant but if it doesn’t pass the smell test, it is Riba.

The irony of it all is that Islamic finance doesn’t ask you to change the world or come up with paradigm shifting products. The best product that fulfills the criteria of Islamic finance and has been in existence for ages is operating lease or Ijara. The bank owns the equipment (there is no lending of money at all, no need to rotate commodities just to islamize the transaction). The bank leases/rents the equipment for its use. At the end of lease term, the bank gets the equipment back. The bank takes the risk in any increase in demand for the equipment or excess depreciation in the value of the equipment. Whereas Islamic banks and central banks in Islamic countries may look down on such transactions, banks in the west have their operating lease arms as well as operating lease portfolios in their books. As such, it is not like Islamic banks are being asked to do reinvent the wheel.

The other transaction is where the bank acts a developer. For example, you bring a real estate project to a bank. Rather than giving you debt for construction financing, bank has two choices: one) if it believes in the economics of the project (it was willing to give you finance, wasn’t it) it should invest as equity holder sharing both on the upside and downside of the project when it is completed. Two) it can act as a developer i.e., sign an agreement with you to develop the project against some agreed upon costs to be paid to the bank upon delivery of the complete project or as per agreed terms. This is similar to Istisna. For banks in Islamic countries this sounds radical but western banks are already doing the similar transactions under the aegis of banking.

From a depositor perspective how will this work. Depositor has two main options. To place money with the bank in current account. Or deposit money with the bank in an investment account. There can be multiple types of investment accounts to cater to the need of depositor in terms of liquidity, risk and return parameters. The lowest risk product could be in the form of a REIT fund with weekly/monthly etc liquidity. Bank on behalf of investors/depositors buys rented real estate. Depositors will get rental income from the property as return on their deposits (after bank deducts the necessary fees etc). The depositor is allowed to withdraw his investment at the NAV of the fund which can go up and down based on the real estate market performance. Similarly, investors seeking higher returns can invest in higher risk products such as equipment leases, istisna transactions etc.

This is risky and requires due diligence on part of customer. Believe it or not, depositing in any conventional bank is risky. There is this illusion among depositors that conventional deposits are safe. They don’t realize that conventional bank are highly regulated organizations and carry implicit or explicit guarantees from government. In US, federal government under FDIC insures your deposit up to a certain amount. In other countries, central bank steps in or is their is implicit guarantee. Islamic banking is no more riskier provided they have similar appropriate regulations, controls and compliance mechanisms in place.

The aforementioned idea of the bank taking a loss when property value goes down is not that radical either. Amir Sufi and Atif Mian in their award winning and critically acclaimed book House of Debt also propose a similar solution for mortgage financing. Their justification which they argue through data and statistics is that this is more fair for everyone (for the bank and mortgagee) as well as leads to less frequent or severe bubbles. 

Obviously all transactions cannot be done on Ijara or Istisna basis. The banks may actually have to engage in real commodity transactions_ buy commodities, have warehouses to store them, act as market maker and occasionally sell them at losses. Again not a radical concept. Goldman Sachs and JP Morgan do it. In the words of Goldman Sachs’ chairman, “we are doing God’s work”. Ironically conventional banks are doing the transactions and leading the market which the Islamic banks should have been doing. But the latter and their central bankers do not even consider such transactions which are by design sharia compliant. (No fees for the sharia scholar I presume.)

Does this mean that Islamic finance banks will not fail, they will not have frauds, there will not be bubbles? No, we may have all of those things because any system is only as good as the people running it and checks and balances built in to it. Why is it that when conventional banks fail and are bailed out, it is the fault of management or regulator but if an Islamic bank fails it is the fault of underlying Islamic economics.

Anyway, Islamic finance is not a radical concept. All the products already exist rather conventional banks carry out such transactions all the time. It is a concept which avoids debt and debt like structures. The only disadvantage it has is the tax code. Tax code treats interest (or profit on financing) payments as tax deductible compared to returns on equity. From capital structure perspective, Modgiliani and Miller proved decades ago that capital structure doesn’t make a difference on before tax basis. Now only if the tax code is modified that it doesn’t penalize equity investors and benefit debt providers.

Two posts I wrote earlier on the same topic earlier are:

1. Whither Islamic Finance
2. Whither Islamic Finance – II

Decision Journal : Job Switch

Earlier I had talked about my career going nowhere in a few posts here, here and here. Now I have finally been presented with an opportunity and I have resigned from my current job. I am optimistic about the new job (otherwise why would I have chosen it) but I am also careful not to have too high hopes as I have seen that greener grass on the other side can turn yellow few years down the road or sometimes even as soon as you step on it.

I had a long discussion with my closest friend about taking leaps of faiths, regrets and future not turning out how one hoped it would (I will right the next post on the discussion), and then I came across this article How to Improve Decision Making in Your Organization which suggests making a decision journal:

Whenever you’re making a decision of consequence, take a moment to think; Write down the relevant variables that will govern the outcome, what you expect to happen, and why you expect it to happen. (Optionally you can add how you feel about the decision and your confidence level in the outcome you expect.)

A journal of this nature will reduce hindsight bias and give you accurate and honest feedback.

It’ll also help you distinguish between when you’re right for the wrong reasons and when you’re wrong for the right reasons.

If you’re anything like me, one thing that you’ll discover is that, on the few occasions when you’re right, it’s often for the wrong reasons.

I have already resigned a week ago but I think the variables that nudged me in this direction as still fresh in my mind. It will also help me to make an improved decision when next time I am presented with similar opportunity.

The opportunity

Title:                  One step down

Salary:               Slightly above

Organization:      Reputed, well established financial institution

The Positives

  • Small department reporting directly to CEO
    • Not a huge hierarchy at the moment. It means unless someone is sandwiched in between, the communication channel with the CEO will be direct and I will get due credit if I do good work
  • Learning new stuff
    • Potential of learning lots of challenging new work in international investments, syndications and debt capital markets something I wanted to do for a long time but wasn’t able to do
    • Whereas my current job promises my lot of relaxation, the greatest fear I have is that my mind is rusting. If god forbid I get fired from this position (which seems not improbable due to recent warning made by my superior explained further in glass ceiling point below) I will have a hard time landing a new job because I have not added much to my skillset in past 5 years
    • Secondly, my work in past few years has been in restructuring and any good opportunities that present themselves nowadays are asking for people with new investment experience. If I accept this position, I will get the requisite exposure of new investment which is so sought out during boom times.
  • New financial institution does not have a heavy baggage like my present employer
    • The new employer that I am joining is a proper bank whereas currently I work for an investment company_a sector which has received lot of flak in the crisis years. On the other hand the bank was established after the crisis and hence does not have a stigma of huge losses, restructuring or bail out attached with it thus giving me the opportunity to make a clean break.
  • The institutions has funds as well as willingness to deploy those funds
    • Though we talk about some funds coming available in my current job (I was responsible for managing those assets and generating those funds) however those are not huge funds and will be utilized in maximum two real estate investments. After that it will be back to monitoring existing investments. Whereas the new organization not only has available liquidity to invest but is also investing in multiple sectors (not just real estate) thus allowing me to add to diversify my skillset and add to my CV.
  • Istikhara
    • Unlike other people I don’t see signs in Istikhara. I just pray while deciding to make the decision or during the interview phase for example and if everything pans out in the end and my mind is inclined in that direction I take the decision. Even if the consequences doesn’t play out as I hoped they would, but since I did the Istikhara I believe that I am better off. Who knows something worse might have happened if I had not taken the decision. Life has ups and downs and nobody knows the future. Having done the istikhara makes me feel better (not always but most of the times) when I am going through a rough patch down the path in the decision I have taken.

The Negatives

  • May be a glass ceiling for expats
    • The way my superior at the current position told me couple of months ago, he was hinting that I have already surpassed a glass ceiling as he can’t deliver what he promised me 2 years ago for sticking with him and lot of locals in the office have their eyes on my office room
  • Politics
    • This is really a disadvantage. If there is politics in my current organization, I am really immune to it for now. Whereas in the new place not only there is “Egyptian mafia” in the Accounts department but also lot of pressure from Government as well as locals on the CEO to hire locals and push out expats.
  • No increase in salary and missing out on Bonus
    • The elusive bonus that was supposed to be given to us in March 2013 and its December 2013 and it still hasn’t been announced due to some issues with Board of Director’s compensation and reluctance of parent company.
    • And its my belief that any Rizq that Allah has written for me, I will get it either Halal way or Haram way or while I am doing challenging assignment or while I am miserable in my job browsing the internet the whole day.
  • CEO dependent
    • I have a track record in my current position, however, in my new organization my growth, development and even if I get to stay depends on CEO as he is involved in nitty-gritty of the bank. Moreover, if he leaves and in his place a new CEO comes, he may not be interested in taking the same path to growth as earlier CEO has taken and might bring in his blue eyed boys to run the show and sidelining me.
  • One step down in job title
    • When I joined my current organization, I had taken a step down in my career as well as salary. I was getting into the most vibrant sector before the crisis and I also wanted to get out of corporate back office finance to the front office world of investment. Unfortunately, days after my joining the new company, Lehman Brothers collapsed and it has been an uphill struggle since then to recover my title as well as my earlier salary (during this time I have grown, my family size has increased etc). Now after 5 years, I am moving to another job with stars in my eyes (not really, after the last 5 years, I am what you call in financial BS “cautiously optimistic”) with another step down. I had a long discussion with the CEO of my prospective employer over the titles but he just wouldn’t budge saying that if he moves to Citibank, he will not be made CEO as he is coming from a smaller financial institution and he might join them as VP or SVP etc. I impressed upon him that the title he is offering me is entry level (it wasn’t but it makes my case stronger) and anywhere you go no one will come at this title. I am happy to say that after 45 minutes of discussion and to and fro, though I still didn’t get what I sought but he agreed to nudge me one position upwards. I like to think of this step down as “investment in my career” as I mentioned in my earlier post Karma is a bitch.

The Conclusion

The idea of a journal is to help one decide what decision to take and be a useful reference for future when hindsight is 20-20. Since I resigned a week ago, I am highlighting here the variables I considered in making a decision. If one looks at it lengthwise, the negatives are larger than positive implying that I have allotted higher weight to positive factors.

I assigned weights to all the listed points initially: +100 divided equally amount positives and -100 divided equally amongst negatives. Then I changed the weights relative to each other based on how I subjectively felt about them when I took the decision.

  • Small department                    +20
  • Learning new stuff                   +50
  • New financial institution           +30
  • Have funds                             +40
  • Istikhara                                +50
  • Glass ceiling                          -20
  • Politics                                  -20
  • Missing out on bonus              -10
  • CEO dependent                      -40
  • One step down                       -40
  • NET                                      +60

Weight allocations are bit arbitrary and not normalized but this is my first attempt and it is as much subjective (or may be more) as it is objective. The reason I have allocated higher weight to “one step down” is as it hurt me the most and this is the most I negotiated when I accepted the job offer.

Only Allah knows the future. All that man can do is to strive with hard work and dedication, analyze his options if and when they become available as best as he can and take decisions that he believes are best under the circumstances. Finally, he must pray that Allah accepts his struggles and make the future full of prosperity for him.

Karma is a bitch – Career edition

I tweeted this yesterday.

May be despised was the wrong word. The correct phrase would should have been “looked down upon”. When started my first job, I was brimming with youthful enthusiasm. I am still brimming but its not youthful anymore. I had ambitions of making it big in the “corporate world” or “banking world” as I was working in a bank at the time. Since it was a family owned bank, they told  me I can’t be the CEO unless I belonged to their family (and no, marrying into the owner’s family wasn’t an option due to various reasons) I had toned down my answer to the job interview stupid question “Where do you see myself in ten years” from being a CEO to being a COO.

Working at the entry level analyst job I could see that there were people who were in their 40s and 50s and were two rungs ahead of me in corporate ladder. Country was in a recessionary phase and many foreign banks had closed down as well as local banks had gone through downsizing. Some of the people made redundant accepted such offers and small banks like ours were too glad to hire them as they brought with them experience and skills at the cheap.

Then the economy started picking up. With hard work and some luck, within three years I jumped those rungs and still in my mid 20s was at the same level of responsibility and pay-scale as people twice my age. This was the time for young people. These oldies tried to bring their A-game to the table but they seemed out of place amongst the youthful crowd on both sides of the table. Then there were those who had resigned themselves to saving their jobs by keeping a low-profile dead-end desk-job avoiding slightly risky jobs of business development etc. They would retire from the same positions.

I came across many such people in the ten years of my career. We used to downplay their experience of 20-30 years saying it was one year of experience multiplied by 20 or 30 as they have been doing the same job for last many years without any increase in skills.

Then shit hits the fan. Lehman Brother collapses. At the time, I was working as an investment analyst at a Middle Eastern private equity firm which had invested in real estate, banking, transport sectors in developed economies as well as emerging markets. Nothing was safe anymore (except may be US treasuries but then we had all our funds tied in now dead investments). People around me started losing jobs or getting their salaries reduced.

To keep my job, even I acquiesced to reduction in my perks. However, I started looking around for a new job and the people I knew strongly advised me against it saying at least I know the inside situation of my company and I wouldn’t know what is the true financial strength of the company I would be entering. Since the whole financial sector growth owed a lot to creative accounting practices of last decades, one could not trust the financials of the prospective company. It turned out to be a good advice. Some of the financial companies did hire a few people I know at good salaries but then they fired them later or the company shut down.

One of the few people whose job was secure for the time being, I received so many CVs from friends, counterparts in different firms, even people I barely knew but using some reference to find them a job in my company. Though I couldn’t get them a job as we weren’t hiring but I tried my best to find them a job or referred them to a friend who was in a better position to find them work. It made me glad to be lucky enough to have a job or not having a sword hanging over my head.

I had joined the present company to do investments, engage in transactions, develop new assets but since the crisis had struck and all our investable cash was already invested in assets that were in serious need of restructuring, for next many years I focused on restructuring these assets, trying to monetize them, increase their cashflows if possible, reduce their expenses and sell them at minimal losses to bring in much needed cash to pay our salaries.

I used to joke that it will be hard for me to find a job when the economy booms as all my experience is of bust cycle. When the boom comes around, companies will be looking for people who have made new investments, closed deals, etc whereas all my experience is of managing existing investments or to restructuring them. I know one can try to sell oneself to prospective employer by saying that what I will bring to the job will be knowledge of what NOT to do as I have seen how investments can go sour in unexpected ways due to wrongly structured transactions, agreements that did not take all circumstances into account etc. but we all know its a hard sell when the employer is looking for a particular skill.

People often tell me to lie on my CV or make it comply with the job description. I do reasonably embellish my CV or put key words of job description as mentioned in the job ad but it goes against my principles to twist the facts or to put experience on the CV that even I don’t recognize myself.

Its not that I haven’t tried a bit of risk-taking. I even tried for positions that were one or two rungs below my current position to quote a phrase that was taught to my friend by JPMorgan banker when my friend was applying for an undergrad job despite having a graduate degree. The banker told my friend that whenever anyone asks him why is he applying for low level job, he should say that I consider this sacrifice as investment in my career as I will be building up my profile for working with JP Morgan. Needless to mention that my friend didn’t get the JPM job nor I was successful in my attempts to “invest in my career”.

Last night, a headhunter after going through my LinkedIn profile asked me if I am interested in a Senior Vice President position in Investment Banking/Private Equity in a leading investment firm. My reply was affirmative and I sent him my CV which clearly lays out that I have done asset management and restructuring. Now he comes back to me asking if I could send him a

comprehensive deal sheet that includes all of the deals you have worked on throughout your investment experience from CIB till date, including transaction, size of the deal, type of the deal, your role in the execution etc

It was so frustrating. Finally someone asks me for a CV for a position that I always wanted to work for and unfortunately I don’t have the relevant experience. Not exactly, but with no new investments happening in last 5 years nor new assets added to the portfolio and no promotion, I could describe my experience as one year of restructuring experience multiplied by 5 years. It is with this frustration that I rather write this blogpost than to prepare a comprehensive deal sheet to forward to that headhunter.

Nothing seems quite so bleak as the digital job seeker’s all-but-obligatory LinkedIn account – Ann Friedman, All LinkedIn with Nowhere to Go

Whither Islamic Finance?

Since the credit crisis hit Middle East, people are constantly bashing Islamic Finance as a failure. I just intend to expose the ridiculousness of one of their arguments over here.

One can easily Google info about Islamic Finance over the internet, so I will not expend large amount of words on explaining it.

If you have taken Econ101, it defines three roles of money:

1. Money is a medium of exchange
2. Money is a measure of value
3. Money is a commodity (trade-able)

In Islamic Economics, the third one does not stand or is not allowed. You can not trade money, you cannot make a profit on it. As such, interest (or profit) on monetary loans is forbidden. This is the essence of Islamic Finance, the implication being that one can only trade hard assets. Hence Islamic finance is also known as asset backed finance.

People claim that money is also an asset like other assets and should be tradeable. Islam does not deny this, it just forbids you to treat it like one. It is clearly mentioned in Quran that they will claim that Riba (profit on money – interest) is like trading but Allah has allowed you to trade (assets) and forbidden you from Riba.

It is very clear that anything above principal in a money lending transaction is Riba, however, the naysayers are at pains to point out that translation of Riba is Usury and not Interest ( I have no idea where did they come up with this arbitrary differentiation). Thankfully Quran remains in its original language of Arabic otherwise I shudder to think that what else people would have claimed as lost in translation.

Now we come to the question of failed investments in Islamic Finance _ falling investment values, defaults on sokouk etc. Like any other investment, islamic (shariah compliant) investment vehicles also face risk and rewards.

Just because a company has raised money through shariah compliant means does not mean that it will definitely be profitable. If that money is used to make speculative deals in real estate (like Dubai companies have done) Shariah compliant or no shariah compliant, the investment has to go kaput.

Investing through Shariah compliant products may require you to maintain similar or even harsher level of due diligence than conventional finance because it not only restricts you from certain forms of raising money but also forbids you in making certain type of investments. If you do not do your homework, you are bound to fail.

People have used a default of a few sokouks and failed performance of few institutions to decry Islamic Finance.

If we want to use the same logic, I think the conventional banking in US, UK and Europe should be shut down as this credit crisis has shown them to be the most failed institutions/systems in the world requiring massive amounts of government funds to stand up. Similarly, such well regarded investment banks as Bear Stearns, Lehman Brothers, Merill Lynch have blown up within a year. Does this mean that investment banking and conventional commercial banking is a failure?

An argument that seems totally reasonable to decry conventional finance, people find it reasonable to bash Islamic Finance.

Islamic Finance is viable and workable economic model and is working fine wherever it is implemented. However, it has failed to gain traction not because it is flawed but the way it is practiced today. A few examples:

1. Replicating conventional methods
Most of the IF institution deal with borrowers that also borrow from conventional institutions. In order to make the borrower comfortable and  avoid teaching him intricacies of IF, IF institutions try to make their instruments look as similar to conventional instruments as possible that the only thing that is different is the word “profit” instead of “interest” in the loan agreements.

2. Offering similar investment products
By definition, derivatives are haraam in IF. Now if you go and create instruments and structures that offer you the same risk/return profile as derivatives but with a label “islamic”, then you are just trying to fool God. Might as well slaughter pigs and sell them as “halaal” pork.

3. Manpower
Conventional banks with their promises of bonus and high payscales attract top graduates. In order to not be left with low class talent, IF institions try to attract employees from conventional banks. These employees  have been trained to offer conventional instruments and are only interested in their bonuses and neither care about Islamic Finance nor educate themselves about its products. Rather than learn about the product and make a concerted pitch to the customer, they take the easy way out saying that this is a conventional product with the Islamic label.

These are some of the factors that bring a bad name to Islamic Finance and are the reason behind the infamous Urdu quote  “kaan ko, sar kay uper say haath ghuma kar, pakarna” (To grab the ear, with the hand coming around the head).

UPDATE: You can read the subsequent post in the series Whither Islamic Finance – Part II.