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Islamic bank managers often opt for the relatively risk-free products such as ijara (leasing) and murabaha, rather than the riskier PLS finance such as mudaraba and musharaka. In a mixed system, the capital on investment accounts may be effectively protected from downside risk. This creates another risk, fiduciary risk: banks face legal action if found in breach of their fiduciary responsibility towards depositors (with investment accounts) or for failing to comply with Shariah law. They also face institutional risk, arising from a divergence between product definition and practices (El-Hawary et al., 2004,

p.48).

Iqbal and Mirakhor (2002) estimated that these products make up 80% or more of

the assets side of most Islamic banks. The other 20% involve profit sharing (musharaka) projects. It is a conservative approach because some form of collateral implicitly backs most of the banks’ assets. However, these banks lose out on the benefits of diversification. Furthermore, the mark-up often involves a formula based on the return a project would get if market interest rates applied.75 Dar and Presley (2003) report exceptions to the dominance of murabaha and Ijara. In Iran and Switzerland, Islamic banks and financial institutions use PLS when arranging Islamic finance, and use very little in the way of mark-up type products. In Iran the wikala contract is used instead of the mudaraba contract – the agent receives a fixed fee rather than a share of the profits.

High reserve ratios, in the order of 30 – 40%, are maintained because of the short-term nature of the banks’ liabilities. The risky nature of the ventures causes banks to confine their loans to well-established, valued clients. Also, a bank will monitor closely the employment of capital it has financed.

Another issue relates to investment accounts. The idea is that both the bank and depositors share in the profits and losses of the investment. El-Hawary et al. (2004) argue that in practice, in mixed systems where Islamic and conventional banks are competing for the same customers, if asset values fall, the value of the deposit may not be written down, leaving other parties to subsidise this group of investors. El-Hawary et al. (2004) cite the example of Egypt’s International Islamic Bank for Investment and Development. The bank, during hard times, paid no dividends to its shareholders in the late 1980s, allocating them to investment account holders. In 1988, this amount exceeded profits – the difference was reported as a loss carried forward. Also, individuals tend to hold these accounts, even the high value ones, with little control over what is done with their funds, adding to potential moral hazard problems. The onus is on regulators and the Shariah Boards to ensure that their rights are protected.

An additional problem for these banks is the lack of standard contracts for Islamic bank services, together with an ineffective legal system to enforce contracts. Usually procedures for resolving disputes are inadequate. This has led to impromptu solutions to problems. For example, Shariah law forbids penalties being imposed if there is late or non-payment by the party concerned. The banks have responded by imposing penalties, but giving them away to charitable causes.

75 Dar and Presley (2003) identify other approaches to mark-up, including an arrangement for profit/loss sharing, a fixed rate determined and agreed upon by parties to the transactions, or a mark-up based on the average profit from a similar investment in a certain industry.

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Likewise, the 1993 Malaysia Islamic Banking Act treats investment accounts as liabilities. Clearly this is an issue requiring further clarification.76

El-Hawary et al. (2004) argue in favour of a segmented approach to Islamic regulation that centres on the degree of risk aversion. Segment A would be for highly risk averse depositors using the bank for transaction purposes and/or to ensure their capital is protected. This group’s funds would be invested in Shariah compliant low risk securities. The arrangement is similar to the ‘‘narrow bank’’ idea explained in Chapter 4. The second segment would be for less risk averse investors who are prepared to risk some capital in exchange for some expected return. The bank would use the funds for medium to long-term instruments, such as ijara or istina. Or a mudaraba fund could be set up with the investors holding shares. They would operate like mutual funds and could be traded if the market was sufficiently liquid and deep. This segment would be for investors prepared to take a significant degree of risk – their deposits would be used to fund musharaka or mudaraba, which are backing riskier projects, akin to private equity or venture capital. For musharaka funded projects, the bank itself has the right to participate directly in the way the venture is run, and would be expected to develop a long-term relationship with the musharaka enterprises, with a seat on a firm’s board – not unlike the German and Japanese approaches. For all three segments, the regulator would ensure the depositors’ and investors’ funds were being directed to the appropriate instruments. Regulators would also monitor a bank’s overall exposure to make certain it is well diversified.

There are other regulatory issues in the area of transparency and market discipline. The difference in standards across states with Islamic banking is widely acknowledged. The Accounting and Audit Organisation for Islamic Financial Institutions (AAOIFI) was established in 1991 and has 105 members in 24 countries.77 A self-regulatory organisation, to date it has issued 50 standards on accounting, auditing, governance, ethical and Shariah law related issues. It has also encouraged harmonising accounting and auditing standards. In 2002, an Islamic Financial Services Board was set up by the central banks of Islamic countries. Its objective is to agree on a set of international standards in corporate governance, transparency and disclosure for the Islamic financial services sector, covering banking, insurance and securities.78

The International Islamic Rating Agency (IIRA) was established in 2002. The Bahrain agency rates Shariah compatible banks and mutual funds. Assuming the IIRA is able to establish a credible reputation, it will help to persuade investors of the attractions of Islamic banks and funds.

6.4.3. Islamic Banking in Malaysia, Iran and Pakistan

Malaysia operates both a conventional and an Islamic banking system. The first Islamic bank was established in 1983, and dual banking, where a bank can offer both conventional and Islamic banking services, was introduced in 1993. Banks offering both types must have

76Archer and Ahmed (2003) identify the areas of Islamic banking which require explicit attention with regard to prudential regulation, accounting and corporate governance.

77Accounting and Audit Organisation for Islamic Financial Institutions (AAOIFI), www.aaofi.com, 2004.

78See Karim (2004) for more detail on the activities of the IFSB.

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a firewall between their Shariah compliant Islamic bank and their conventional bank. Also, a standard system is required for computing the rate of return to determine the distribution of profit on the relevant products and ensure a satisfactory capital adequacy framework for the Islamic bank portfolio. The latter point is part of the drive by the Bank Negara Malaysia (the central bank) initiated to ensure that all Malaysian banks, including Islamic ones, comply with international prudential and supervisory standards. Transparency in accounts is considered to be even more important because investment accounts carry a downside risk, unlike conventional deposits. By the end of 2002, Islamic banking assets reached 9% of total assets, deposits stood at 10% of total deposits and the market share for Islamic financing was 8%. Based on these figures the system is on course to meet the market share targets of 20% in assets, deposits and financing by 2010.79

By contrast, Iran nationalised its banks after the 1979 revolution. In 1983, the UsuryFree Banking Act limited the activities domestic banks could undertake. Savings and current accounts must be interest-free, though prizes and bonuses are allowed. There are short and long-term investment accounts, operated on a PLS basis, unlike most other systems, such as Pakistan, which rely heavily on mark-up. Banks charge fees for loans. Iran’s overseas banking operations are exempt from the Act. Iran’s Supreme Council of Banks determines rates of return and loan fees. Until 1990, the Supreme Council insisted all banks have the same rate of return on investments, but has since relaxed this rule to promote competition.

Pakistan introduced Islamic banking in 1984. Over the period, the banks introduced new products to conform to Shariah law. Until the Shariah court intervened, the interest-free banking system that evolved in Pakistan was fairly typical of systems found in other countries operating an Islamic system. It included loans where no interest is charged (Quard-e-Hasan), trade related modes of financing such as Isira or a buy back agreement, and investment type financing such as musharaka – profit and loss sharing. However, the Federal Shariat Court judged a number of key products offered by Islamic banks to be inconsistent with Islam, i.e. riba was, indirectly, being paid. There were 55 appeals against the judgement but in 1999 the Supreme Court dismissed them. The government decided not to appeal against this dismissal and began a wholesale transformation of the economy which would be necessary if the Supreme Court’s vision of true Islamic banking was to be implemented. One of the affected banks did appeal the judgement, which the government eventually supported because it was proving very difficult to implement the large-scale changes that were necessary. In June 2002, the Supreme Court quashed the 1999 ‘‘riba’’ judgement. It meant Pakistan would revert to its original system of interest-free banking until the courts had sorted out the question of what constitutes riba.

6.4.4. Expansion into Global Markets

Some Islamic banks have attempted to expand into the global markets since the early 1980s, to capture a Muslim market overseas and diversify their portfolio, but have faced a number of challenges. There are difficulties with being recognised as banks, because they

79 Source: ‘‘Malaysia IBS deposits Hit 10% Market Share’’, Islamic Banker, 90, July 2003, pp. 8–11.

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cannot hold interest-earning government securities, such as bonds.80 The profit/loss-sharing nature of their deposit and lending business is at odds with a western system, which protects depositors and emphasises the importance of a transparent portfolio, where all assets can be valued. Furthermore, in cases where a bank lends money and shares in the profits, the borrower repays the bank out of profits after tax. Those banks that do establish themselves in the west usually have to adapt their deposit-taking and lending rules to gain recognition. A few western institutions have also entered the Islamic banking market, including HSBC and Citicorp – both have Shariah advisors. To date a large proportion of the resulting assets are short-term, and the banks are focusing on the development of long-term instruments that are compatible with Islamic banking.

6.5. Sovereign and Political Risk Analysis

6.5.1. A Review of Terminology

The final section of this chapter undertakes a brief review of sovereign and country risk. Again, whole books have been written on the subject. The purpose here is to explore the key ideas and findings in this area. The section provides the definitions of standard terms, reviews why emerging market economies tend to be net importers of external finance, and investigates models designed to identify the factors which increase the risk of sovereign defaults, The impact of political risk is also reviewed.

It is helpful to begin by reviewing the terminology used.

Sovereign Risk: definitions vary but generally it is the risk that the government of a country will default on its external debt, which may be in the form of loans or bonds. It is known as sovereign debt because it is either owed or guaranteed by a sovereign government. For example, in 1998 the Russian government declared a moratorium on the repayment of their foreign debt and defaulted on its domestic debt. Sovereign risk is a special type of credit risk, but unlike a conventional loan, lenders cannot seize a country’s assets if they default on external debt.

Country Risk: this term is more general, and usually means sovereign risk plus the political risk foreign investors are exposed to. To understand the term country risk, it is important to recognise the three types of foreign investment.

(1)Foreign Loans: these include loans to businesses headquartered in another country, which may or may not be guaranteed by the state. They also include loans to any foreign government, at any level, e.g. national or local.

(2)Foreign Direct Investment: when a foreign national sets up business operations in another country. These firms will face all the normal business risks plus the political risk that arises because the operation is based in another country. In stable countries that do not discriminate against foreign operations, the risk is trivial. In other countries,

80 Nor can Islamic governments issue bonds. Public funds are raised through profit sharing loans made by banks to state owned enterprises. Tax exempt loan certificates are used to meet any government requirements for short-term funds.

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it may be very high, for a variety of reasons. The government may be unstable, the country may have a reputation for nationalising foreign firms, or there may be the threat of a government coup d’etat, high crime rates, red tape, and so on.

(3)Foreign Equity or Portfolio Investment: when an investor buys shares in foreign firms. Again, there are the standard risks associated with any equity investment but with foreign shares, the degree of political risk may vary from nil to quite substantial. If the portfolio includes shares in countries such as Canada or Australia, there is virtually no political risk. On the other hand, foreign shareholders with a stake in a large profitable mine in Siberia face more substantial risk, as a group recently discovered. They tried to attend a shareholders meeting but were unable to after being confronted by armed bouncers at the door. This group soon found the other shareholders had agreed to an increase in capital, which diluted the value of the foreign shareholding, leaving the foreigners with a minority stake.81

Thus, country risk is a measure of the perceived probability that a country will be unable or unwilling to meet its obligations, with respect to foreign debt, equity or foreign direct investment. The responsibility to meet these obligations does not always rest with the state but with private borrowers, firms and even employees engaged to work there. The political situation may enhance or detract from a country meeting its obligations, and therefore its country risk profile. Sovereign risk, as defined above, is a type of country risk. Political risk can raise a country’s risk profile. Given the focus of this book, the rest of this section is concerned with sovereign risk, including the effect of politics on sovereign risk.

6.5.2. Why do Developing Nations Demand External Finance?

Capital-importing developing nations demand capital in excess of their own domestic capital base. The demand for external finance is explained by the ‘‘development cycle’’ hypothesis. Countries demand capital based on expectations of higher future income streams. By borrowing capital, the country can finance a more rapid rate of economic growth and smooth consumption paths over time. Provided the country’s domestic capital base is insufficient to meet its growth rate targets and the expected marginal productivity of the domestic endowment of capital exceeds the rate of interest charged for the borrowed capital, it will borrow capital from the international capital markets, that is, it will import capital. Financial repression is likely to increase the need for foreign finance because the absence of a well-developed money capital market will exacerbate the shortage of domestic finance, on the part of both government and domestic firms. Financial repression can involve restrictions on private international capital flows, and usually means that governments have to try to borrow more from abroad.

External finance comes in a number of different forms: short and long-term private and official loans made by foreign banks/governments, foreign direct investment and portfolio investments, consisting of debt securities (private or state backed bonds and other securities issued by the LDC) and equity, acquired when non-residents purchase shares on the LDC’s

81 Source: Gros and Steinherr (2004), pp. 239–240.

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stock markets and/or private shares. Emerging market countries also receive official finance from other governments, the IMF and the World Bank, which may be concessionary or non-concessionary. As net importers of finance, these countries are leveraged (or geared), just like firms. A country’s foreign leverage (or gearing) ratio is defined as the ratio of foreign debt or equity of the capital-importing nation. Foreign debt consists of loans made plus bonds purchased by non-residents, and foreign equity includes direct and portfolio investment by non-residents.

In the 1960s, foreign direct investment as a percentage of external finance was, on average, 39%. Official finance and commercial loans each contributed about 30% to external finance in developing countries. From the late 1960s onwards, the growth rate in the real value of foreign direct investment was very slow. Commercial medium and long-term lending increased at an annual average real rate of just under 10% per annum, most of it in the form of sovereign loans. By the late 1970s, foreign direct investment had fallen to less than 15% of the total external finance component; sovereign loans peaked at 75%, falling after 1982, the year Mexico announced it could no longer service its external debt. This triggered defaults by a large number of developing countries. The phenomenon tends to come in waves: the early 1980s, the early 1990s (e.g. Mexico, 1994), with new problems in Russia in 1998 and Argentina in 1995, and again in 2001. External finance from official sources also fell steadily until 1982, and then from 1982 – 88 it increased to over 50% of the total. Issues of foreign bonds and foreign equity were negligible until the late 1980s.

On the supply side, the increased sovereign lending accompanied a rise in syndicated lending (where a lead bank arranges the loan, but involves a syndicate of other banks). The syndicated loan market peaked in 1982, with the majority of the loans arranged for sovereign borrowers. After a decline of several years, 1987 saw a rapid increase in the volume of syndicated loans arranged, but these were largely confined to the private sector. Normally, the loans are in US dollars and subject to a variable rate of interest.

Thus, throughout the 1970s, there was a dramatic rise in developing country foreign gearing/leverage ratios (FGRs/FLRs). At the same time sovereign debt became the predominant form of lending. Three parameters play a crucial part in the determination of a country’s optimal foreign gearing (leverage) ratio. These are risk attitudes, moral hazard and interference costs.82

Risk Attitudes

Suppose borrower and lender are risk neutral, that is, the agents are indifferent to a fair bet with even odds. In this case, foreign debt and equity are perfect substitutes, and neither party has preference for one instrument over another. If one of the parties is risk averse, the agent will refuse a fair bet with even odds. To isolate the importance of risk attitudes in international debt, assume there are no costs associated with moral hazard or interference, borrower and lender treat foreign equity as a risky asset (the returns on foreign equity are proportional to domestic output) and foreign debt is considered a safe asset (the returns to debt are guaranteed, payable at a fixed rate and independent of what happens to domestic

82 For a more technical treatment of these ideas, see Heffernan (1986).

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the loans, and bankers did not monitor their use very closely. However, developing nations failed to impute the hidden costs arising from IMF macroeconomic stabilisation conditions imposed when debt was rescheduled (see below).

The attraction of sovereign lending over other forms of investment is exacerbated if there is a bank-related moral hazard problem. The argument here is that banks will engage in riskier investments if they think they are going to be bailed out by a lender of last resort, or assisted by the state. However, in the 1970s banks were attracted to sovereign loans because they genuinely thought they were low-risk assets. How, after all, could a government default on its debt? Subsequent intervention by the IMF did not give bankers an easy time of it. Hence, the moral hazard problems generated after the 1982 sovereign debt crisis were probably kept to a minimum.

To summarise, the three factors discussed above help to explain why developing countries allowed themselves to become highly geared by sovereign borrowing in the 1970s and early 1980s. First, western banks were willing to make sovereign loans because they thought they were low-risk; risk premia and monitoring were kept to a minimum. Developing countries were willing to borrow from private banks to finance development and because interference costs were thought to be comparatively small. Both parties ignored the impact of random economic shocks on their borrowing and lending decisions. For example, many countries borrowed on the strength of wildly optimistic forecasts about future commodity prices. In the cases where commodity prices did rise as forecast (e.g. oil), they were far more volatile than had been anticipated. Subsequent oil price declines prompted serious debt servicing problems for some countries. By definition, it is not possible to forecast random shocks, but in this situation scenario analysis might have helped the banks better assess the impact of possible changes in the global macroeconomic situation.

After Mexico defaulted on its debt in 1982, Brazil and other countries soon followed. Between 1980 and 1993, 64 developing nations experienced problems repaying their sovereign external debt and negotiated multilateral debt relief agreements totalling $6.2 billion. In the late 1980s and early 1990s, global banks began to increase their exposure in emerging markets, though sovereign loans were largely replaced by the use of debt securities and equities. Thus, the early 1990s (as in many previous years) saw a net financial transfer towards emerging market economies, peaking at $66 billion in 1993. However, in December 1994, Mexico was forced to devalue its currency because of rising trade deficits and falling reserves. Fears of another default escalated, with drastic effects for emerging capital markets around the world. Investors began dumping emerging market debt and equity. The Clinton government and IMF calmed the markets by intervening to sort out the Mexican problems. Mexican debt was restructured with the help of $20 billion in loan guarantees by the US government, IMF loans totalling just under $18 billion and BIS loans of $10 billion. Mexico worked with the IMF and international bankers to restructure the country’s debt. Rising oil revenues meant that by 1997, Mexico was able to repay the US government loans in full.

Though the intervention calmed the markets, the provision of external finance to the developing world began to fall off. After 1996 these economies made, in aggregate, a net financial transfer to the ‘‘Rest of the World’’, so financial flows out of developing countries