Apr 15th 2010 | From The Economist print edition


THERE was a time when proponents of Islamic finance sniffed opportunity in the crisis. The problems of speculative, casino-like Western banks contrasted nicely with the emphasis that sharia-compliant finance places on an ethical, risk-sharing approach. But risk-sharing looks much less appealing when issuers are defaulting.


Dubai’s debt problems badly shook investors in sukuk, a type of Islamic bond, issued by Nakheel, a troubled property developer. Although a restructuring deal announced last month should ensure that Nakheel’s bondholders will now be paid back on schedule, the saga is bound to have damaged confidence. Three other sukuk issuers have defaulted in recent months: East Cameron Partners, an American oil and gas producer; Investment Dar, a Kuwaiti investment firm; and Saad Group, a Saudi conglomerate.

Islamic finance’s fans insist that this does not represent a crisis. They say that the individual issuers are at fault, not the products. Dubai’s state-backed firms ran up too much debt. East Cameron was a poor credit risk from the start, with a CCC+ rating at the time the bond was issued. Investment Dar was too reliant on short-term debt, they argue, and the Saad Group is at the centre of fraud allegations.

Even so, the prospect of losses has forced creditors to think about some of the uncertainties surrounding Islamic default. One issue is enforceability: many sukuk contracts are governed by English law but refer to assets located in the Gulf. Another is the spectre of “sharia risk”. Investment Dar is wrangling over the repayment of a separate type of debt to Blom Bank, a Lebanese bank, on the grounds that the transaction was not sharia-compliant; an English court surprised many by ruling that the firm had an “arguable case”.
Lawyers point out that these problems are, again, not unique to Islamic finance. Enforceability is an issue in any cross-border transaction. The objection that a counterparty lacks the legal capacity to do a deal is not unknown in conventional finance (though defining what is sharia-compliant is a tricky task).


Much more damaging is widespread confusion among sukuk investors about the sorts of risks they were really taking on. A sukuk is structured to avoid the Islamic prohibition on interest payments. It manages this by paying bondholders with the cashflows generated by specific assets, which are put into a special-purpose vehicle (SPV) as part of the deal. Many seem to have thought that the bonds were “asset-backed” , giving them a claim on the assets in the event of a default. Most sukuk, however, are “asset-based”, handing investors ownership of the cashflows but not of the assets themselves. “Many sukuk holders have a perception that they hold a security that is collateralised,” says Anouar Hassoune of Moody’s, a rating agency. “In 90% of cases, that is incorrect.”

A bit more scrutiny could have helped investors work this out for themselves. If assets are not really being sold to the SPV, they do not move off the issuer’s balance-sheet. But lenders will demand greater clarity in future, which points to a bigger problem for Islamic finance than any source of legal uncertainty: it is likely to get more expensive.

The bulk of the sukuk issued so far have not been rated. International investors, at least, are unlikely to stand for that in future, which will make life dearer for issuers that are below investment grade. The illiquidity of the sukuk market will probably incur a greater premium in future. Investors in occasional asset-backed deals will be more focused on where the assets are physically located. Holders of more common, asset-based sukuk are likely to demand a bigger excess spread between the cash flowing into the SPV and the cash flowing out of it to them: the bigger this “reserve account”, the greater the buffer protecting investors. Risk is central to Islamic finance. Now it is going to get properly priced.