Limited Purpose Banking: An Alternative That Suits Islamic Finance?

This article was published in Arab Times on July 26th 2011. click Here to read

Following their earlier article on Islamic Finance, Usman Hayat CFA, Director of Islamic finance & Environmental, Social, and Governance (ESG) factors in investing at CFA Institute and Raghu Madagolathur, President of CFA Kuwait, discuss limited purpose banking in the region as an alternative financial system that suits Islamic banking.

The global financial crisis has stirred a search for an alternative financial system. Whilst the Middle East has not been affected as much as some of the Western economies, it has by no means completely recovered. A number of high profile failures as well as continuous provisioning have prevented many banks from a robust recovery and global debate on alternative financial system is also relevant for the Middle East.

Islamic banks in the Middle East are also not immune from problems facing the global banking sector. For instance, they are exposed to speculative financing of real estate. It is worthwhile reviewing some of the issues that follow from our previous article on Islamic finance in the context of alternative financial systems.

The ongoing debate suggests that there are two major expectations from any alternative financial system. First, it should be free of bailouts of private institutions from public money, and second, it should focus on serving the real economy.

One potential alternative that might meet these expectations is limited purpose banking. It is proposed by Laurence Kotlikoff, a prominent economist and a professor at Boston University, who explains it at length in his book “Jimmy Stewart Is Dead” (2011).

As implied by its name, limited purpose banking limits the role of banks. In an audio podcast (2011) that we recorded with him, Kotlikoff explains that “limited purpose banking moves us from trust-me banking to show-me banking”. Simply put, banks will not extend credit themselves but operate like asset management companies offering mutual funds.

These mutual funds that do not borrow to invest will only buy the assets specified in their charters, be they mortgages or corporate bonds. The payment system would function through cash-only mutual funds. Banks will not be able to expand the money supply and the government would have full control of the money supply (M1).

There will be no opaque leveraged speculation through banking and no reason for a contagious run on the bank. Therefore, there will be no need for any bailout, deposit insurance, lender of last resort, and so on.

Unlimited liability will apply to those financial institutions, such as hedge funds, that cannot work as mutual funds. That is, the personal wealth of those who want to speculate on borrowed money will no longer be safe from their actions, cutting the appetite for speculation.

A single financial regulator will take the lead in ensuring safe custody of mutual fund securities and transparency in underlying transactions. This should help prevent fraud as exemplified by Bernie Madoff, “liar loans” and “toxic assets”.

This, in short, is how limited purpose banking seeks to eliminate bailouts and give finance compelling reasons to focus on the real economy.

Does it sound radical? “It’s not radical. What is radical is maintaining the current financial system”, argues Kotlikoff in his video on YouTube (2010).

Limited purpose banking is not without its supporters. Those who have praised “Jimmy Stewart Is Dead” include five Nobel laureates in economics and some known policymakers like George Shultz, former U.S. secretary of the Treasury. Mervyn King, the Governor of the Bank of England, has also talked about Kotlikoff’s “much wider vision of how the financial system can ultimately end”.

Kotlikoff’s alternative may not appeal to high street bankers, but it may find appreciation in some unexpected quarters: Islamic finance.

Islam, it is widely held, prohibits lending money on interest. Literature on Islamic finance tends to discourage the sale of risk and debt financing. Similarly, it encourages profit and risk sharing, it sees as suitable for economic justice. However, observers often note that the Islamic finance industry, usually estimated at around $1 trillion in assets, does not always match this description.

Take, for instance, “Islamic Law and Finance: Religion, Risk, and Return” (1998) by Frank E. Vogel and Samuel L. Hayes III, two professors from Harvard University. In the concluding chapter of this book, they termed it a “legal and financial embarrassment” that Islamic banks “mimic conventional banks” instead of being the profit-and-loss investment intermediaries that Islamic economic theory demands. They went on to suggest that genuine profit sharing through pooled funds could be the solution.

Islamic finance, however, continues to be largely commercial banking within conventional fractional reserve banking. According to the IFSL research report (2010) on Islamic finance, 74 percent of the assets of the industry are in commercial banking and only 5 percent are in funds. Fractional reserve banking is often criticized in Islamic finance.

One of its foremost critics is Tarek El Diwani, a London-based Islamic finance adviser. In his book, “The Problem with Interest” (1997), Diwani makes a detailed economic case against the proliferation of debt and resulting injustice that he sees inherent in fractional reserve banking.

It will soon be four decades since the establishment of the first Islamic commercial bank in 1975. There are many challenges facing the industry but there is a growing realization among reformists that the current financial system is one of the biggest. At the very least, it favors interest-bearing loans and leveraged speculation, making Islamic finance swim against the current.

But does limited purpose banking suit Islamic finance better?

Dr. Volker Nienhaus, an economist from Germany, thinks it does. In a video podcast (2011) that we recorded with him, he suggests that ending financing via banking and routing financing through mutual funds will lead to genuine and transparent risk sharing between contracting parties. According to Nienhaus, this structure will make finance serve the real economy and it “puts into practice what is promised” in Islamic finance. Nienhaus is of the view that Islamic financial sector should adopt this structure even if global banking reform does not mandate it.

In the past, a similar proposal, but with a limited scope, was narrow banking. This was part of the Chicago Plan of 1930s. Interestingly, the Chicago Plan predates modern Islamic finance but some see it as a fit. In a research paper (2004), Valeriano García, Vicente Fretes Cibils, and Rodolfo Maino suggested that narrow banking and equity financing are “what Chicago and Islam have in common”.

Some practitioners in Islamic finance—such as Iqbal Khan, the founding CEO of HSBC Amanah—have also spoken in favor of a mix of narrow banking and asset management for Islamic finance.

The Chicago Plan was never implemented despite the support of leading economists. Time will tell if limited purpose banking enjoys better luck. But it would probably enjoy support among reformists in both conventional and Islamic finance by meeting their expectations from an alternative financial system.

Room to grow-GCC Asset Management

This article Published on The Gulf. You can read here

Reform of the Gulf’s capital markets will spur development in the asset management industry

The Gulf Co-operation Council (GCC) enjoys an active retail investment culture aided by the performance of regional stock markets. In spite of their high volatility, GCC stock markets have delivered superior risk-adjusted returns over the past few years helped by their low correlation to emerging and developed markets - though that advantage is slowly disappearing.

However, GCC stock markets lack both depth and breadth; they have low institutional participation and are dominated by retail investors (although Kuwait is an exception). Sovereign wealth funds and other investment institutions have evinced little interest in local markets due to the perception of high risk, as well as a fear of stoking liquidity in an already speculative market.

Even though stock markets have been in existence since the 1980s (in Saudi Arabia and Kuwait), mutual funds came into being only recently. Hence, there are very few funds that can claim a track record of say five or 10 years. Mutual funds continue to offer a narrow range of products with very little innovation; most are direct country funds.

From a modest $120 billion in 2000, GCC market capitalisation reached $1.1 trillion by the end of 2007, an annual growth of 37 per cent, before dropping to $734 billion at the end of 2010.

Dubai is now home to all the major names in the asset management and investment banking businesses, as is Saudi Arabia. Some have wound up in response to the financial crisis but many of them continue to hold up. And, even though GCC stock markets are yet to find their rightful place within the global family of indices, they are not far from it.

The GCC asset management industry is estimated to be about $28.9 billion in size. There are currently more than 100 asset management companies which manage money under 325 funds.

At $13 billion, equity funds make up almost half of assets managed under funds spread over 208 funds, yielding a per fund value of $63 million. The Islamic segment of this constitutes 39 per cent. Saudi Arabia leads the pack in the equity segment with $5.2 billion in assets under management (AUM), a market share of 40 per cent, followed by Kuwait with a market share of 32 per cent. Saudi Arabia and Kuwait’s high share can be traced to their early adoption of mutual funds as an investment vehicle along with older stock exchanges. The market is very much concentrated among the top asset management companies, with the top 10 controlling a share of 72 per cent of the total.

The GCC asset management industry is composed of two parts: mutual funds and managed accounts. Due to the high net worth nature of the market, more assets tend to be managed through portfolios rather than mutual funds. A recent McKinsey survey estimated that AUM for managed accounts could be twice as much as that managed under funds.

It must be noted that Kuwait is the only market that discloses statistics pertaining to managed accounts. As of December 2010, Kuwait managed nearly $66 billion in managed accounts compared to $5.4 billion in funds, a factor of 12 times. Such a high ratio can be attributed to the presence of a large number of investment companies (over 100) as well as an active sovereign wealth fund, the Kuwait Investment Authority (KIA). If we assume a factor of 2x for other markets, then total assets managed, including managed funds, stand at an estimated $113 billion, with Kuwait leading the list with 58 per cent followed by Saudi Arabia with 32 per cent.

Capital markets are relatively nascent in most of the Gulf countries, providing immense scope for future growth. Due to their short history, markets exhibit inefficiencies that can be successfully exploited by fund managers through superior fund performance relative to benchmarks.

The GCC has undergone tremendous economic expansion and is expected to remain strong in the coming years. High economic growth will directly result in very strong liquidity – a situation that is highly conducive for stock markets.

Regulatory reforms in the area of capital markets will spur development in the asset management industry. The high net worth nature of the market demands product sophistication along with superior risk management propositions. As the economy expands in size, foreign investment interest is bound to develop rapidly in what is viewed as one of the most prosperous regions in the world.

Impact investing: evolution of socially responsible investing

Impact investing usually refers to investments made by the private sector to generate measurable social and environmental impact alongside a financial return. Usman Hayat, a Director of Islamic Finance and ESG at CFA Institute, explores this fast growing investment theme.

 

What is impact investing?

Impact investments are made to create jobs or affordable housing in low income urban areas or to provide clean drinking water or accelerate agricultural growth in rural areas. Similarly, they may seek to improve access to education, or health services, and financial services. Some investors may expect a competitive return while making a positive impact. Other investors may be willing to accept lower expected return or higher risk compared to a comparable investment not seeking to make a social impact. So impact investing lies somewhere between giving money away in charity and investing solely for one’s own economic interest. Estimates of market size vary significantly with one estimate suggesting that impact investing can attract up to US $1 trillion in 10 years.

 

How does impact investing differ from socially responsible investing?

Traditional socially responsible investing is about avoiding investments that are inconsistent with the values of the investors, whether it is products, such as tobacco, or norms, such as labour standards. Some investment opportunities may be preferred over others because of positive attributes, such as efficiencies in managing energy and waste, and investors may also try to influence corporate behaviour by voting and entering into a dialogue with the companies. But these investments tend not to actively pursue a positive impact.  The more recent shades of responsible investment tend to focus on long term risks and opportunities arising out of environmental, social, and governance issues but also without directly seeking a positive impact. Impact investing can be viewed as an evolution of socially responsible investing and it is the declared intention at the outset and the relative emphasis on making an impact that differentiates it.

 

What type of investors, asset classes, and regions are associated with impact investing?

Impact investments are diverse. Investors include philanthropic entities, commercial financial institutions, and high net worth individuals. Impact Base, a database of impact investments, which is an initiative of the not-for-profit Global Impact Investing Network (GIIN), lists about 200 impact investing funds. According to Impact Base, these funds invest across regions and about half of these funds are in North America and Africa. Access to finance, access to basic services, employment generation, and green technologies are the major impact themes. More than half the funds are classified as private equity or venture capital. Many impact funds are relatively small, with less than $100 million in terms of assets under management.

 

What are some of the examples of impact investing and investors in Middle East and North African (MENA) region?

The 2011 report, Impact Investing in Emerging Market, by Responsible Research lists Souk Tel in Palestine and Souk el Tayeb in Lebanon as two examples of impact investments in the region. The former develops mobile phone services to improve access of communities to relief services while the latter helps improve market the produce of small scale farmers. Examples of impact investors that have a presence in the MENA region include Synergos and Willow Tree Impact Investors. Because youth unemployment is a huge challenge in MENA, job creations through small and medium sized enterprises (SMEs) is an area of interest. Industry reports suggest that in terms of volume and value of impact investments, MENA region ranks low compared to other regions.

 

How does Islamic finance relate to impact investing?

Like traditional socially responsible investing, Islamic finance has tended to focus on excluding ‘sin’ businesses rather than making a positive impact. Because lending money on interest and sale of risk are widely considered to be prohibited in Islamic finance, it is concerned with the structure and not just the purpose of financing. Academic literature and news reports suggest growing interest in Islamic finance in making and measuring positive impact, such as through micro finance and this rapidly growing sector is also a possible source of growth for impact investing.

 

How do social impact bonds relate to impact investing?

Social impact bonds are a relatively new innovation within impact investing. They are a contract between a private and public entity in which the public entity commits to pay for improved social outcomes. Although they are called bonds, they are in fact public-private partnerships, with risk-return profiles that are likely to be closer to private equity than fixed income. The public sector is motivated to pay the private sector for the positive social benefits and corresponding savings. The first-ever social impact bond was issued in the UK to reduce recidivism among offenders through counseling services for prisoners serving a short sentence at Peterborough Prison.

 

What are some of the challenges and opportunities facing impact investing?

Impact investing faces the same risks that would be found in commercial investments. One risk that is likely to be found to a greater degree in impact investments is reputational risk. They may face criticism for over-promising or even profiting by exploiting the poor. Microfinance, a prominent shade of impact investing, has faced just such a criticism.

According to a 2011 report by J.P. Morgan, lack of track record of successful investments is seen as the most important challenge for growth of impact investing. Because it is a relatively new field, a nascent institutional framework is emerging, such as the Impact Reporting and Investment Standards (IRIS) which seeks to facilitate comparisons and performance benchmarking. Overall reports suggest we can expect strong growth in impact investing in the future.  

Islamic Finance and socially responsible investing (SRI): The Expectations Gap

This article was originally published in Arab Times

 

Usman Hayat, CFA, Director of Islamic finance & ESG at CFA Institute and Raghu Mandagolathur, President of CFA Kuwait discuss Islamic finance and socially responsible investing (SRI).

With the increased profile of Islamic banking globally, the GCC Islamic banking community is well positioned to build on a leadership role versus other potential competing centers such as Malaysia, Iran or even the UK. GCC countries collectively now account for more Shariah-compliant financial assets globally than any other region or country.  GCC Islamic banks have also demonstrated their ability to be more innovative in terms of product development and provision of services as they compete for business with conventional banks. However competition in the GCC has also resulted in a fragmented Islamic finance industry with most local institutions remaining relatively minor players on a global scale. With their relatively lower asset bases they have also seen stiff competition in their own backyard from some of the largest international banks looking to tap the market.

When labels like “Islamic,” “responsible,” and “sustainable” are associated with finance, they trigger expectations of ethical differences from the mainstream. Meeting expectations of customers is a tough task for any business, but when it comes to Islamic finance and socially responsible investing (SRI), the gap between expectations and practice presents a significant challenge.

Anecdotal evidence suggests that, rightly or wrongly, some of the expectations triggered by “Islamic” finance are no lending money on interest, no financing of “sin” industries (e.g., gambling), profit and loss sharing, asset and enterprise, microfinance, small and medium sized enterprise (SME) finance, poverty alleviation, and environmental sustainability. Perhaps the underlying theme is profit sharing, doing good, and avoiding harm to society and the environment.
In practice, other than refusing to finance “sin” industries, these expectations are hard to meet. Despite the expectation of profit sharing, most of the financing in the Islamic financial sector is debt based, where the form of financing is changed to that of a sale or a lease without necessarily changing its economic substance. For example, payment schedule and terms and conditions in home financing in the Islamic financial sector may look very similar to, if not the same as, those in a conventional mortgage.
Customers are usually told that the difference between Islamic finance and conventional finance lies in fulfilling certain technical conditions of classic Islamic commercial jurisprudence, which give financing the contractual form of a trade or a lease. Some customers scale down their expectations and take what is available; others turn away in disappointment.
This gap between expectations and practice produces sarcastic media coverage—for example, “Don’t Call It Interest” (Richard C. Morais, Forbes, 2007) and “How Sharia-Compliant Is Islamic Banking?” (John Foster, BBC News, 2009). Such academic research papers as “Incoherence of Contract-Based Islamic Financial Jurisprudence in the Age of Financial Engineering” (Mahmoud A. El-Gamal, 2007) also raise similar issues. Unfortunately, form versus substance is a persistent debate in Islamic finance, with no closure in sight.

Regarding doing good and avoiding harm to society and environment, some argue that the job of financial institutions is to maximise profit for their shareholders and that profitable business leads to prosperous society. If shareholders want to do something charitable, they can do so in their private lives.

A counterargument is that to use the “Islamic” label, financial institutions need to go beyond changing the form of financing and earn their profits while actively doing something positive. For example, Islamic banking should focus on SMEs rather than high–net-worth individuals; Islamic financing for cars should finance fuel-efficient vehicles, such as hybrids, instead of fancy gas guzzlers; and Islamic project financing should push for fair treatment of construction workers and efficiencies in energy, waste, water, and carbon emissions.
The catch here is that for such positive pursuits to work, customers also have to do their part. That is, for the financier to lease a hybrid vehicle, the customer also has to want one. To avoid interest-bearing debt in financing, customers have to be ready to share profits with the financier, and to make investments rather than extend interest-bearing loans, customers should probably seek equity funds and not bank accounts.
Similarly, if customers want institutions that offer Islamic financial services to pursue socioeconomic goals, they should be willing to share any additional risks and costs. If customers are unwilling to put their money where their heart is, finance, pragmatic as it is, may also be unwilling to go very far in nonfinancial pursuits. This gap between expectations and practice is not unique to Islamic finance. Other shades of ethical finance, such as SRI, face it too. One would think that because lending money on interest is not an issue in SRI, meeting expectations would be easy - not exactly.

In 2004, in a research paper titled “Socially Responsible Investing,” Paul Hawken found that “the cumulative investment portfolio of the combined SRI mutual funds is virtually no different than the combined portfolio of conventional mutual funds.” In other words, the expected ethical difference was blurred.

In its 2007 “Guide to Climate Change Investment,” Holden & Partners provided a similar finding: “SRI and ethical funds perform just as well (if not slightly better) than their mainstream counterparts because in most cases they are in fact mainstream.”

Perhaps the titles of these two biting articles published in 2010 summarize their content: “100 Best Corporate Citizens? What a CROck!” (Marc Gunther) and “When Pigs Fly: Halliburton Makes the Dow Jones Sustainability Index” (R.P. Siegel). Paul Hawken also noted in 2004 that “Muslim investors may be puzzled to find Halliburton on the Dow Jones Islamic Index fund.”

How to deal with this gap between expectations and practice? Do financial institutions mislead customers with labels like “Islamic,” “responsible,” and “sustainable”? Or do customers have unrealistic expectations? Is it possible to bring the practice and expectations closer?

There is no easy answer to these questions. Having said that, one thing that could help in narrowing the gap between expectations and practice is honest communication of what exactly is the ethical proposition so that when someone takes “a small step” toward ethical ideals, it is not criticised for not being “a giant leap” but appreciated for what it is.