Islamic Finance Set To Tackle Long-Standing Repo Challenge

Separate but converging efforts are underway in Islamic finance to help develop globally accepted alternatives to conventional repurchase agreements, as the industry tries to crack one of its greatest structural limitations.

In the last several years Islamic banks have grown faster than conventional ones, partly because of economic booms in the core regions for Islamic finance, the Gulf and southeast Asia.

But the banks have largely lacked the collateralised money market tools which many bankers believe are essential for the industry’s long-term health and viability.

Developing sharia-compliant substitutes for repos would help Islamic banks manage their liquidity more cheaply and flexibly, allowing them to cope better during times of market stress.

Islamic banks are now considered systemically important in countries including Kuwait, Saudi Arabia, Qatar, Malaysia and the United Arab Emirates, according to the Kuala Lumpur-based Islamic Financial Services Board (IFSB).

Until now, progress in developing “Islamic repos” has been slow because of a lack of consensus among bankers, regulators and scholars on what structures would be both religiously permissible and financially effective.

But this is now changing. Pressure on regulators to agree on Islamic repo structures has increased; Basel III banking standards, now being phased in around the world, make banks’ need to manage short-term funding more acute, the IFSB said last month as it released draft guidance on liquidity risk management.

Early this month another Islamic standard-setting body, the Bahrain-based Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), said it was developing a sharia standard for repurchase agreements.

And on Sunday, the Bahrain-based International Islamic Financial Market (IIFM) released a contract template for collateralised murabaha transactions, a cost-plus-profit structure which might serve as an alternative to conventional repos.

So far, Bahrain and Malaysia have been at the forefront of creating such tools but more efforts are needed, Jeddah-based Mohamed Ali Elgari, an industry expert who sits on over 80 sharia boards around the world, told Reuters.

“Any successful structure has to satisfy the requirements of sharia, and the requirements of regulators, and the requirements of risk managers. To combine all these three factors, it’s very difficult.”

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Conventional repos allow institutions to lend out assets for short periods to generate liquidity. This is problematic in Islamic finance because it entails charging interest.

“Repurchase is not permitted in a purchase contract. This is combining two types of contracts,” Elgari said.

Also, Islamic finance specifies that actual ownership of collateral be transferred, a requirement which has limited the international approval of some solutions.

For example, Malaysia’s approach uses a sale and buy-back contract known as inah, but the practice has been shunned by Gulf-based Islamic banks which argue that transfer of ownership of assets is not clearly executed.

The IIFM’s collateralised murabaha format tries to avoid controversy by having the financier buy the asset at market value and immediately sell the asset to the customer for a mark-up on a deferred payment basis.

But in practice, such transactions need more clarity to gain wider acceptance, said IIFM chief executive Ijlal Ahmed Alvi.

“There is still a lot of work and deliberation needed such as fixing of forward leg between two counterparties, the legal entity which can act as the third party and take risk, etc.”

For its own standard on repurchase agreements, AAOIFI will conduct extensive consultations with scholars on all aspects of the transactions, said secretary general Hamed Hassan Merah on the sidelines of AAOIFI’s annual conference in Manama last week. Merah did not specify when the standard might be ready.

Meanwhile, some regulators see short-term, U.S. dollar-denominated Islamic bonds (sukuk) issued by the Malaysia-based International Islamic Liquidity Management Corp (IILM) as collateral that might be used for sharia-compliant repos.

Nigeria’s central bank has issued guidelines for asset-backed securities that can employ IILM sukuk as collateral, while regulators in Indonesia are discussing ways to allow IILM sukuk to be used as guarantees in money market transactions.

“We are studying whether we can accept IILM to be traded as short-term sukuk securities within Indonesia’s Islamic money market,” said Halim Alamsyah, deputy governor of Bank Indonesia.

Islamic banks are largely buy-and-hold investors of sukuk; collateralised transactions could energise sukuk secondary markets by encouraging banks to make better use of those assets.

“Institutions of all sizes will be equally comfortable to transact and better utilise their Islamic securities portfolios, particularly sukuk,” said Khalid Hamad, executive director of banking supervision at Bahrain’s central bank and IIFM chairman.