When the dinar and the dirham were first minted in the form of metal coins, Iblis the accursed held them happily. He then placed them over his eyes and said to them, ‘You are the fruit of my heart and the delight of my eyes; through you, I will drive people to become tyrants. I will cause them to become disbelievers and lead them to Hell. I accept from the son of Adam if he would only become attached to you, and worship you, and that’s even if he would become indifferent to the remainder of pleasures of this world.
Ibn Abbas
Shortly after the sun rises over the desert dunes in the barren east, Dubai’s neon-lined highways and space-age skyscrapers are bathed in colour – the gold, green and silver prisms splaying a spectrum into the Arabian Gulf beyond. All the way to the horizon the Sheikh Zayed Road, a gargantuan roaring river of multi-laned asphalt, begins feeding the city’s office towers with workers.
On a January morning in 2011, Bilal parks his car in the underground car park of the Dubai International Financial Centre, takes the lift up to the marble foyer and swipes his security card at the turnstile.1 Through the glass door of his investment bank’s trading floor is an open-plan office, laid out as a miniaturized version of its big brother in London. The room is dominated by two plasma screens: one permanently tuned to the digitized ticker tape of Bloomberg Television, the other directly facing the open-plan office and displaying a live webcam feed from their colleagues’ desks in London. This morning Bilal has arrived earlier than his Dubai co-workers – the salesmen and -women of the bank’s emerging markets team – and so the chaotic hubbub of simultaneous conversations on a bank of trader-phones is yet to begin.
In the quiet moments before they arrive, Bilal fills his coffee mug and collects his thoughts in preparation for the day ahead. The past few weeks have been difficult. The bank’s financial position remains precarious in the middle of the worst economic downturn in living memory. Rumours have been circulating of mass redundancies.
‘A rainmaker in the Islamic finance market’: that’s what they dubbed Bilal when his bosses hired him two years ago. But like the wider banking industry, tumbleweeds have been blowing through the Islamic finance industry for the past couple of years and capricious bosses in London have blown hot and cold on the need for the bank to invest in this frontier market. Can we afford this luxury? Should we devote resources to understanding it? Or should we retrench to what we know best?
Bilal logs in and, almost as if in answer to his concerns, an email pops up. It’s good news. An Islamic deal that the bank closed last year has just been awarded one of the industry’s leading accolades. It is the first time that an independent body has recognized the bank’s contribution to the Islamic finance industry and, as such, is a vindication of the effort of his team. If the Islamic finance market is about to turn the corner, then this bank will be at the forefront. Perhaps today is going to be a good day.
Bilal settles into the day’s work. His firm is in the process of setting up a vast platform, a factory of financial products that conform with Islamic law. The output from this factory will be sold to high net worth individuals and financial institutions in the Middle East, all looking for investments that conform to their religious beliefs. At the same time, Bilal’s team is working with banks throughout the Middle East and South-East Asia to establish itself as their preferred banking counterparty on large transactions: currency trades, commodity investments, and ‘swap’ contracts to lubricate the cogs of the fastest growing segment of the world’s finance industry. It is an enormous undertaking and one that he hopes will propel his firm up the industry league tables. But does the bank’s senior management team in London believe that?
Bilal’s BlackBerry rings from a number he doesn’t recognize. It is the head of HR asking him to step into the conference room. He sighs and silently shakes his head – this morning’s email arrived too late to make a difference. He knows what this call means and resigns himself to the conversation that is about to take place. Ironically his last act as an employee is to send an email to his colleagues congratulating them on the award. He collects a few personal items and picks up his briefcase.
As Bilal enters the conference room his London-based boss is displayed on a giant television screen on one wall, seated in a glass-fronted corner office at the edge of a vast trading floor in Canary Wharf. In the conference room itself are the head of HR and the bank’s chief executive officer for the Middle East. In front of all three are identical pieces of paper. Their manner is impeccably professional, though they manage to look both grim and kindly at the same time. Yep, this looks pretty final.
The woman from HR begins reading a script, ‘We regret to inform you that your position is being made redundant as of today.’ As she reads on, Bilal cannot help the flicker of a smile curling from his lips. Somewhat perversely he finds his mind detaching itself from the situation and begins to enjoy the faux sympathy of his co-workers, as if he were watching this practised ritual in a television drama. Even as she reads on, Bilal is reminded of the contempt he has for the corporate world, for the way in which it dehumanizes every protocol, every interaction between employer and employee, between boss and subordinate, rationalizing its behaviour in the pursuit of short-term profit over long-term stability.
Bilal’s last interaction with his colleagues reinforces his natural cynicism of Big Corporate. He has long held the view that large corporations are incapable of feeling or of acting in their employees’ and their customers’ long-term interests. Modern corporations create social arrangements that force employees to reduce the world to a collection of potential threats, opportunities and the accumulation of wealth. This enforced morality renders all other considerations inconsequential. Corporate social responsibility, ethics, integrity: they are just words used by the press office. Perhaps it is this outlook that steered Bilal towards Islamic finance in the first place.
Bilal snaps back to the conference room. Who will take up the Islamic mantle after he leaves? His boss doesn’t feel it is necessary to be in the market. ‘You’re a good guy and it’s nothing personal. We just don’t need someone of your ability or experience – the products aren’t complex enough.’ The regional CEO squirms uncomfortably in the seat next to Bilal. He has spent the past year telling his clients and colleagues in the Middle East how strategically important it was to offer Islamic finance in this market and now he will be forced to backtrack. But he plays the party line and nods his head as his London colleague explains why the bank will not continue to pursue Islamic finance.
‘I’m afraid I have to ask you to hand in your BlackBerry and security card,’ says the woman from HR apologetically. Phlegmatically, Bilal blinks slowly, reaches into his pocket and hands them over, still with a half-smile on his face. ‘Is there anything we can get from your desk? A personal mobile? Your wallet?’ Bilal shakes his head.
‘In order for you to receive your redundancy payment, there is an agreement we will require you to sign.’ She hands over the compromise agreement, a catch-all designed to ensure that the terminated employee does not rat on the firm, defame it in public, or solicit any of its employees or clients. Bilal takes the paper, shakes hands with his colleagues and is escorted out of the building.
And that’s it. In an economic downturn precipitated by unethical practices the bank has decided that a system of finance based on ethics and morality was an unnecessary luxury, and Bilal’s two years of work are wiped clean. And although the bank’s senior management do not yet realize it, their number is up: the bank will shortly be indicted by authorities around the globe in a massive financial scandal.
A short walk away, over at Goldman Sachs’s Dubai offices, the Islamic finance specialist is also having a bad day. His firm has just tried to raise $2 billion of finance from Islamic investors and is struggling. For some reason, Islamic investors are staying away from Goldman Sachs, and ethics and morality may be the reason.
And in eighteen months’ time, the world’s largest provider of Islamic banking products to retail customers, HSBC, will be investigated by the US authorities for alleged links to drug money and terrorist financing. Despite the healthy commercial returns from HSBC’s subsidiary, Amanah, HSBC will shut down Amanah’s Islamic retail banking operations in key markets. Officially, its excuse for the withdrawal is that ‘[HSBC] allocate[s] capital to markets and businesses with clear growth potential…we [therefore] no longer offer Shari’ah compliant products in some markets.’2 Only a few months earlier, HSBC Amanah’s own chief executive claimed that these markets were growing at an incredible rate of 23.5 per cent year on year.3 But something has changed internally and, according to bitter insiders, Amanah finds itself an unwilling political football.
* * *
Every Friday, in the first three or four rows of the congregation at the Masjid Al-Samad – an avant-garde cubically proportioned mosque serving the Emirates Hills area of Dubai – one will find the epicentre of today’s Islamic finance revolution. As the imam begins his weekly sermon, in those front rows will be silently sitting two CEOs of Islamic financial institutions, and five of the world’s leading Islamic finance bankers and lawyers, all of them global heads of Islamic finance at gigantic investment banks and English law firms. Many of their staff will also be at this gathering.
This is New Dubai. Twenty kilometres south of the old creek dredged by the first ruler of Dubai, this previously virgin desert stretches south towards the emirate of Abu Dhabi, the area redeveloped so that expatriates can buy their own freehold properties and establish themselves in the United Arab Emirates as more than merely transient economic migrants. Not many in this Friday congregation of some thousand worshippers are aware that a quiet revolution – one that may have a far-reaching impact on the global banking system – is being orchestrated by a handful of men (for the instigators of this revolution are almost exclusively men), many of whom sit among them at this moment.
A neatly turbaned Australian-Egyptian with a trim beard stands at the pulpit. His speech is thumpingly cadenced and impassioned, his audience rapt. Today’s sermon is about knowledge.
Allah tells us in the Quran:
Behold what is in the heavens and the earth!
He says ‘behold’. What does this mean? It means we are instructed to seek knowledge, to contemplate the secrets behind creation, and our status is raised if we seek knowledge and education. And this is what we were doing while Europe was in its Dark Ages. Between twelve hundred and seven hundred years ago, Baghdad was the world’s intellectual capital, and Bayt al-Hikma, the House of Wisdom, was its heart. How many of us know this? How many of our kids are taught this at school?
He looks around at his congregation. It’s pretty clear that their Western-centric education has taught them that Galileo was the father of astronomy; that Thales, Socrates and Descartes gave birth to modern notions of philosophy; and that almost nothing happened in the medical world between Hippocrates and the development of vaccines in the nineteenth century.
Little is taught in the Western world of Islamic history, but it is difficult to fathom why, given the geopolitical importance of the Islamic world today. So influential is Western learning in all its facets that, even in the Arab world, few today know much about the House of Wisdom, an institute of learning from the heyday of Baghdad, which collected the cream of intellectuals and culture into one powerhouse of arts, science and letters.
The Australian preacher’s eyes twinkle as he peppers his speech with glorification of his Lord. He tells his congregation that Muslim scholars translated works from every scientific and philosophical discipline across the world into Arabic, an undertaking so productive that, without it, today’s Europe would not be reconnected with its own ancient scholarly history. A spiritual quest to derive the secrets of the heavens and the earth – as their Lord had instructed them in the Quran – would lead the Islamic scholars of the Middle Ages to reinvent the sciences, to rationalize the seemingly magical world around them. No matter what the source of the knowledge they absorbed, if it were of benefit it would be incorporated into their own works. From the ninth century of the Christian era onwards, with a population of over one million and second in size to Constantinople, Baghdad boasted a reputation for intellectual prowess and riches second to none. Under the reigns of the caliphs Al-Rashid, Al-Mamun, Al-Mutadhid and Al-Muktafi, its denizens existed on the cutting edge of science and technology, arts and literature, of civilization itself. The Caliph Al-Mamun is reported to have had a dream in which Aristotle appeared to him saying: ‘Knowledge has no borders, wisdom has no race or nationality. To block out ideas is to block out the kingdom of God.’ Al-Mamun is then reported to have instructed men to travel to Byzantium and Persia, to bring back the greatest books from their libraries, and establish a centre for scholarship and learning in Baghdad, the House of Wisdom.
Four generations of caliphs took a personal interest in the development of this centre of learning: the collation of manuscripts, the building of a library and its wings for each branch of science, the procurement of works from all over the world, sometimes brought in by 100 laden camels, all instigated and overseen by the rulers.4
As the sermon and congregational prayer are concluded, the preacher reminds his audience of a traditional saying of the Prophet Muhammad (peace be upon him):5 Who took a path asking in it for knowledge, Allah enhances a path for him to Heaven. Then the congregation rises. They greet each other and plan the weekend’s football matches and family picnics. Their families are part of one community, sharing dinner parties, births and deaths, an old-fashioned connectedness that they didn’t find in their home countries – for most of them the United Kingdom – where each has typically spent the first thirty years of his life before migrating in search of fortune. That fortune lies in Islamic finance.
Quite how Dubai, and this area of Dubai in particular, has managed to attract so many singularly qualified individuals is difficult to fathom. Perhaps there was a design at work, man-made or otherwise. Perhaps it is the serendipitous confluence of many factors: the creation of an international financial centre; the repatriation of Gulf money from overseas following 9/11; the increasing perception of Islamophobia in Britain, prompting an exodus of the best and brightest minds; the ‘East meets West’ tolerance of this emirate, the creation of its freehold property zones and subsequent real estate boom.
Traditionally the Islamic finance industry was once populated by bookish experts in Sharia law, often graduates of Indo-Pakistani universities, typically sincere and ideologically led, but more often than not lacking a commercial background, or the hard-nosed business sense to rise to the top of a commercial organization. Their specialism was understanding canonical law derived from the word of God, recorded in the Quran, and the actions of their Prophet – the Sunnah – that provide them with a precedent. They know what God wants from us: to be good to our fellow man. They know that God wants us to be fair and just in our dealings with one another. That we should be transparent and equitable. That social harmony is an over-riding objective in any of our day-to-day human interactions. But can they help us to translate these simple principles into a system that ensures profit may be pursued, and men may become wealthy as a result, but that wealth is also equitably distributed, and the vulnerable are protected? In other words, a just or caring form of capitalism.
Before Masjid Al-Samad, the industry attracted conventional bankers alongside the bookish Sharia experts. Sometimes these bankers were the ones who couldn’t quite make it in conventional institutions and saw Islamic banks as a soft alternative, and sometimes they were the opportunists who saw it as a chance to make a quick buck.
But that is changing, and Masjid Al-Samad may find itself a precursor to a modern-day House of Wisdom and a reclamation of past glory, emerging from the confluence of individuals within Masjid Al-Samad and their part in the global banking system. The bankers and lawyers of Masjid Al-Samad are forging their own path, ‘asking in it for knowledge’. Their idealism has the backing of technical competence, and they look to apply the techniques they’ve picked up from the conventional (Western) banking industry to expand Islamic finance far beyond its ancient principles of justness and transparency in commercial dealings.
Perhaps it may be a fantasy too far to suggest that this is what is happening today in Dubai – a cosmopolitan melting pot and a forum for discourse in Islamic finance. Perhaps, with the patronage of Dubai’s ruler, the Islamic finance industry may find its own Muhammad Al-Khwarizmi, the father of algebra, or its own Al-Kindi, the most accomplished of Arab philosophers.
Or perhaps in the mad scrambling race to accumulate wealth and celebrate growth, this is but a fanciful romanticism. Time will tell. Regardless, in the fight for the spoils in a trillion-dollar industry, Dubai remains a key protagonist, and its access (within a short flight) to a large share of the global Muslim population may hold the key to its dominance of the industry.
According to a number of analysts, the total dollar value of assets of Islamic financial institutions is over one trillion dollars,6 dwarfed of course by its equivalent in the conventional banking industry, but nevertheless a gigantic leap from its near zero value in the early 1970s. Although Islamic banking growth has declined in recent years in line with the wider economy, it has continued to outpace overall banking assets and gross domestic product (GDP) growth. In the depths of the global financial crisis in 2009, for example, Islamic assets grew at 15 per cent whilst total banking assets remained static and GDP growth was negative.7
The Islamic banking market has consequently increased its share across the Islamic world, with particularly notable gains in the markets of the Gulf Cooperation Council (the GCC, comprising Saudi Arabia, the UAE, Bahrain, Kuwait, Qatar and Oman), South-East Asia (mainly Malaysia and Indonesia) and Turkey. Not surprisingly, conventional banks have been desperate to tap into this lucrative customer base, though their so-called ‘Islamic windows’ have met with variable success, as we shall discover throughout this book.
To consider this question one must first separate the activities of merchants in early Islamic history whose business was conducted according to the tenets of Sharia, and the activities of modern financial institutions who purport to conduct financial transactions according to Sharia. It is the latter that I focus on throughout this book, though in examining the extent to which such institutions have met both the letter and spirit of Sharia, we will benchmark against the fundamental precepts that have applied to Muslims throughout the ages.
The birth of modern Islamic finance occurred sometime in the 1950s or perhaps the 1960s, depending on what we choose to be the catalyst for the growth of the industry as we know it today. European mutual banking institutions and cooperatives may have been the inspiration for social banking experiments in the early 1950s in Pakistan, as well as for the formation of the Malaysian Tabung Haji (a fund set up by the Malaysian government to assist pilgrims travelling to Makkah) in the 1960s. However, typically many observers tend to credit the Mit Ghamr experiment in Egypt in 1963 as the forerunner of today’s Islamic banks.
Eighty kilometres north of Cairo, Mit Ghamr is a town on a branch of the Nile, today producing around 70 per cent of Egypt’s total aluminium output. In 1963, the economist Dr Ahmed Elnaggar devised and implemented a remarkable experiment in this otherwise unremarkable town. He founded the Mit Ghamr Savings Bank, a profit-sharing institution that neither charged nor paid interest, and engaged in what today would be referred to as ‘real economy’ transactions. Thus, it engaged in trade and industry, sharing its profits with depositors, functioning less as a commercial bank and more as a vehicle for savings and investments.
The experiment lasted four years, during which time eight other similar institutions sprang up in Egypt. In time, the Mit Ghamr Savings Bank would become part of Nasser Social Bank, which would be declared an interest-free commercial bank. Interestingly, to avoid the impression that the experiment and its consequential creation of a commercial institution were driven by an overtly Islamist agenda, the charter of Nasser Social Bank made no reference to Islam or the Sharia, a dilemma that some apparently Sharia-compliant institutions are facing today.
The baton of the Islamic finance industry quickly passed to pioneers in Saudi Arabia, Kuwait and Dubai. The first Islamic banks in the GCC were capitalized in the mid-1970s, including the largest bank in the UAE, Dubai Islamic Bank. At first, the experimental phase of the modern Islamic finance industry produced institutions that were true to the principles of risk sharing, building on concepts of investor/manager relationships in which a provider of capital entrusts that capital to a specialist for the purpose of investment, and both parties share in the ensuing profits or losses: the essence of Islamic finance, rather than the borrower/lender relationship typical of conventional banks.
The experiment continued in Pakistan following General Muhammad Zia ul-Haq’s military coup in 1977, after which he installed himself as the country’s president and merged Sharia laws into Pakistan’s existing penal code. In 1979, Zia introduced a programme intended to Islamize the economy and, on 1 January 1980, around 7,000 interest-free counters were opened at the nationalized commercial banks. Pakistan had become the first nation to establish a fully fledged Islamic banking system.
But Pakistan’s courting of Islamic economics was overly simplistic, focusing on basic issues related to interest-free banking, the abolition of riba (interest), the laws of inheritance and zakat (the annual wealth tax that all Muslims are obliged to pay). Some questioned why Islamic imperatives of equality and social justice had not been addressed by the imposition of an Islamic economy, and surmised that it was another attempt to assert an Islamic identity based more on a political agenda in parallel with Zia’s support for the resistance against the Soviet invasion of Afghanistan, and the development of a nuclear capability.
The programme was crudely implemented. A cousin of mine recalls being ordered by family elders in the port city of Karachi to (literally) get on his bike and collect the family savings from the bank (in this case Habib Bank and United Bank Limited). The hapless youngster cycled furiously from branch to branch, one of many who were sent out that week by families desperate to withdraw their savings before the deadline for a compulsory tax payable on each bank account. This, the 2.5 per cent compulsory zakat stipulated in Islam to be payable by all on one’s wealth, had become the reason for a run on the banks.
The minority Shia community had argued that it should be exempt from the compulsory deduction, since it operated its own community zakat system. Indeed, my cousin heard heated debates amongst uncles arguing that perhaps it was time to use the family Shia connection. After Zia’s death in 1988, the programme was terminated and the economy reverted to a conventionally Western basis.
As the business model of GCC-based Islamic financial institutions matured, early pioneers such as Dr Elnaggar and Sheikh Saleh Kamel, the founder of the Dallah Al-Baraka Group, began to observe that such institutions operated by mimicking the practices, operations and customer products of conventional banks, and were failing to deliver economic and social development to the Muslim demographic. It is certainly the case that conventional international banks did not fail to recognize the potentially enormous demographic they had hitherto failed to tap. It was clear that their recognizable brands, economies of scale, access to talented product designers – known in the industry as structurers – and pushy international sales staff had the capability of ousting established Islamic institutions as the bank of choice for the Muslim customer. In time, their ‘Islamic windows’ would be regarded as the engine rooms of growth for the Islamic finance industry.
At first, international banks merely oiled the wheels of motion in the industry by providing money-market lines to Islamic banks desperate for liquidity. As they cottoned on to the potential for growth, their bankers approached Sharia scholars directly to learn more about the structuring of products on a Sharia-compliant basis, and established their own departments to do just that. The scholars were flattered by the attention – the world’s largest financial institutions were willing to lavish unimaginable remuneration on these clerics for their knowledge of Islamic commercial law.
By the early 2000s, the Islamic windows of conventional banks were employing conventional experts in the various disciplines of international finance – specialists in mergers and acquisitions, infrastructure finance, real estate finance, derivatives, equity share markets and corporate loans – all of whom had studied the basics of Sharia contracts, and all of whom had started to establish direct relationships with key departments in Islamic institutions. These key departments included treasury operations that manage exposure to market rates, currencies and other volatile macroeconomic variables; proprietary trading desks who invest the bank’s own money; private wealth management teams who sell funds and sophisticated personal investment products to high net worth customers. Now the conventional banker was deeply connected to an entirely new customer base.
Most significantly, the biggest international institutions, known as the ‘bulge bracket’, were able to call upon their abundant global resources to sell Sharia-compliant bonds, or sukuk, to investors around the world, just as they would for corporates and sovereigns raising conventional bonds in the international capital markets. Just as companies could raise money on international exchanges by issuing bonds – a loan divided into tiny pieces to be traded like a stock – so, too, could they raise an Islamic bond to be sold to Islamic investors. Sukuk would change the face of the Islamic finance industry: a publicly traded debt of a corporation or a sovereign nation, owned by and traded amongst thousands of investors, looking and feeling like its conventional equivalent: the bond. Until recently, those Islamic investors looking to own ‘fixed income’ instruments – that is, those which pay out a fixed running yield for the maturity of the debt – had few alternatives to the conventional, interest-bearing bond. Perhaps they could buy a property and rent it out to earn a fixed income yield. They could do the same with other large assets, like ships and aircraft, but these were not ‘liquid’ instruments – ones that could be converted into cash quickly and easily with a relatively stable price on an open market. Now the bond had become Sharia-compliant and Islamic investors were able to step into a more sophisticated trading arena.
The infrastructure for these tradeable debt instruments was already there: technology from the world of conventional bonds to price and trade sukuk on exchanges, offices around the world populated by hungry young salesmen and -women with clients desperate to diversify their investment holdings away from the stodgy world of conventional corporate bonds.
The bulge bracket firms, aptly described as ‘flow monsters’, immediately sensed that the key to raising money for their clients in the form of sukuk was their superior firepower, their industrial ability to create giant ‘financial factories’ to make product ‘flow’ out of the door. Local and regional Islamic institutions in the Middle East, and to a lesser extent in Malaysia, simply could not compete with the likes of Deutsche Bank, HSBC, Citibank and Goldman Sachs. And as governments and large corporations looked to fuel their aggressive infrastructure and expansion programmes in the post 9/11 boom, diversifying their traditional investor base was foremost on their mind. Who better to target than the under-served Islamic investor – and how better than to harness the financial muscle of the biggest global players?
In the public mind, sukuk became the Islamic finance industry. Often touted in the press as ‘bonds which circumvent Islam’s ban on interest’, by the mid 2000s they had become the tool of choice in the GCC and Malaysia to raise capital on an enormous scale. Global investment banks built their Islamic finance practices on the back of selling billions of dollars of sukuk for their multinational clients. Ironically, more than half of the notional value of sukuk was sold to conventional investors looking for alternative places to park their money or looking for exposure to new geographies or asset classes. In the language of finance, these conventional investors were seeking ‘alternative risk/reward relationships’.
This was understandable. At first, yields – that is the rate of profit on the bond, typically paid to the bond investor in the form of a periodic coupon – were particularly attractive for investors as the risks inherent in the Sharia-compliant contracts that governed the bond and the bond’s underlying assets were not clearly understood. When investors cannot clearly quantify the risk inherent in a given financial instrument, they attach a risk premium to its price – they expect to be paid more because they perceive it to be more risky. Although the contracts governing a sukuk transaction are typically drafted under English law, they are also drafted in adherence to the principles of Sharia, and this creates a potential for dislocation between a court’s view of English law and Sharia. Not surprisingly, many perceive this as an additional risk.
In theory, the coupon on a sukuk instrument (economically the equivalent of interest on a bond) is supposed to be generated as a result of the income or profit resulting from the financing of an underlying asset. So, for example, a company may issue a $200 million sukuk to finance its ongoing activities, typically by selling real estate assets that it owns to the sukuk holders. These sukuk holders are often represented by a ‘ring-fenced’ shell company known as a special purpose vehicle or SPV, specifically set up for the purpose. Having paid the $200 million purchase price to own the real estate, the sukuk holders (represented by the SPV) then lease those assets back to the company, and the ensuing periodic rental income becomes the equivalent of a periodic coupon on a bond. Once the sukuk mature – in other words when the ‘loan’ terminates – the real estate assets owned by the SPV are sold back to the company typically for a consideration equal to the original issuance value of the sukuk.
The net economic effect is that the company has ‘borrowed’ $200 million and paid a rate of return to the creditor for the duration of the borrowing, then repaid the $200 million on maturity. During this time, a real asset passed from the borrower to the lender and back again.
When a real asset passes between the parties, the sukuk is described as ‘asset-backed’. In other words, the lender has recourse to that specific asset in the event the borrower can’t repay. And that’s good, because there is a tangible link between the financial paper trade and the real commercial one.
In practice, most sukuk end up being ‘asset-based’ rather than truly ‘asset-backed’. In such a case, although there is some contractual link between the financing and the underlying asset, the originator of the sukuk – in other words the company raising the financing – is the ultimate guarantor of the bond. The company guarantees the repayment of this bond through a ‘buy-back’ mechanism at maturity, a commitment to repay. As a result, the credit rating of the sukuk is in fact the credit of the originator (the company raising money), and not that of the specific assets that underpin the sukuk (such as real estate owned by the company).
No wonder conventional investors were so keen to add these exotic new instruments to their portfolios, and no wonder so many asked the question ‘what is Islamic about Islamic finance?’ Sukuk looked and acted like conventional bonds, and conventional investors could now diversify their exposure to new geographies and assets, earning significantly more than they would for conventional issuers of equivalent credit quality.
In time, as investors became more familiar with Islamic issuers and Islamic finance in general, sukuk yields began converging towards their conventional equivalents and for a while all seemed well in the world.
And then came the global financial crisis, precipitated by the bursting of the US housing bubble in 2007 and the subsequent institutional failures of September 2008. Within a year, a number of high-profile sukuk had defaulted. Suddenly, Sharia risk loomed large on the radar of financial institutions, both Islamic and conventional. The Islamic finance industry began experiencing an existential crisis and the ‘Samadiites’, the young bankers and lawyers of Masjid Al-Samad in Dubai, found themselves at the centre of it.