MANAMA – Regulators need to consider whether the use of off-balance sheet special purpose vehicles in Islamic finance gives rise to the same lack of transparency that occurred with off-balance sheet structured investment vehicles (SIVs) in conventional finance, a leading Middle East central banker said in mid-December.

Al Maraj was speaking as Abu Dhabi provided a $10 billion life-line for its fellow Persian Gulf emirate Dubai, which forestalled a threatened default on a $3.52 billion sukuk, or Islamic bond. The sukuk had been issued by the Nakheel property development offshoot of the quasi-government owned Dubai World investment company.

Analysts say the Dubai debt crisis shows that Islamic finance is far from immune to the problems seen in conventional finance. Some critics argue the reason is that many Islamic financial products are in fact structured in a way very similar to conventional products rather than reflecting the spirit and substance of Islamic law (see GRR, December 2009).

“There are many who might say that the events in the global financial system have little relevance to Islamic finance,” Al Maraj said.

“Many in the Islamic finance industry point out that it has been sheltered from the impact of the crisis in part because Sharia prohibits the excess leverage and speculative financial activities that were at its root.

“They also take comfort from the fact that many participants in conventional finance, as well as regulators, and policymakers have begun to ask whether there are lessons to be learned from the principles of Islamic finance which might help avoid future crises.”

But while acknowledging that recent events have created “a great opportunity” for Islamic finance, Al Maraj warned against complacency and said the industry must ensure the lessons of the crisis are fully learned.

He said the global financial crisis involved multiple failures of disclosure and transparency, noting for example that conventional banks moved assets to SIVs or “conduits” which did not form part of their normal financial reporting.

The risk disclosures of various financial instruments did not enable the purchasers of the instruments to perform a proper assessment of the risk/reward trade-off, he added.

There are parallels with Islamic finance, Al Maraj said. “The use of off-balance sheet special purpose vehicles has been a feature of the financing model of many Islamic banks. We need to consider whether this gives rise to the same problem of a lack of transparency that arose with off-balance sheet SIVs. Similarly accounting standards for Islamic finance need to keep pace with financial innovation. There is a lesson in the failure of the accounting of conventional instruments to keep pace with industry developments.”

Al Maraj said AAOFI will have important work to do to ensure that the transparency and disclosure of Islamic financial products matches the enhanced standards that are likely to be forthcoming for conventional finance.

He noted a risk common both conventional and Islamic finance is the assumption that all banks can exit their speculative positions at the same time.

Al Maraj said some people might believe that because Islamic financial firms cannot invest in CDOs (collateralised debt obligations) and CLOs (collateralised loan obligations), they must be immune to the problems faced in the crisis by conventional banks that couldn’t sell their CDOs and CLOs at any price.

“But think about the exposure of many Islamic banks to the real estate market,” he urged. “It might be a reasonable assumption for an individual institution that it could exit profitably a property development that it is funding. But when many other institutions are making similar assumptions about the projects they are funding, the industry as a whole may find it difficult to exit its investments without substantial losses or within a reasonable time-frame.”