April 18, 2008
Growth of Private Equity in the Gulf region
The rise of Islamic Banking, sharp rise in oil income, increased private sector financing of industrial and service sector development, real estate boom has led to the model of private equity investment in the gulf region, a model that seems well poised for a big leap. The private equity model diverges from conventional debt financing model, but has the same result of leveraging the business. Thus, it is the convenient route for islamic finance , that cannot adopt interest baring securities to ensure compliance to the Shariah. By being imperfectly correlated with other asset classes such as equity, this enables diversification of overall portfolio risks in the Banks.
Private Equity, thus , not only provides diversification benefits in the asset portfolio of Banks, they also demonstrate the similar trait
of focus on partnership rather than guaranteed return. Such investments provide huge returns or may lead to huge losses depending ion the performance of the particular venture. The rewards have gone in thes for taking the plunge into the uncertain world of private equity forgoing opportunities of guaranteed returns.Risks are certainly much higher in private equity as exemplified by the spreads in returns across the globe.
The problem is while billions of dollars have gone into Private Equity funding, valuations and risk management practices are at a nascent stage. Fair valuation of private equity investments are not easy as tons of assumptions go into the valuation processes based on diverse methods including earnings multiple, discounted cash flows from earnings, industry valuation benchmarks or using net assets.
The lack of consensus on valuation practices heightens the risks from investment in priovate equity, where Islamic Banks in the Gulf are making huge investments. Islamic investment banks , in addition, face concentration risks and often cover such risks by greater equity contributions. While risks are yet to be fully comprehended, this fast growing market provides huge opportunities and significant risks to banks of the region.
Posted by sunandoroy at 10:58 AM
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April 05, 2008
The Power of Central Bank Communications
In Chris Whalen's interesting blog ( April 4,2008) on the Subprime crisishttp://www.prmia.org/Weblogs/Regulation/ChristopherWhalen2/)
, a few lines are particularly interesting :
"As BSC was being shut out of the interdealer market, LEH was also being shunned by other dealers and attacked by the hedge fund hordes in the same fashion as BSC. Several veteran traders in the CDS market say that LEH was essentially in danger of failing as well.
One hedge fund veteran, who was and is short LEH, complains to The IRA that LEH was essentially dead in the water on Monday, March 17, but the Fed intervened. When the markets opened after the Easter holiday, clients and other dealers were backing away from LEH and the shorts were swarming in for the kill, he claims. This apparently explains the unusually long conference call with investors by LEH CFO Erin Callan, who has only held that position since September.
Indeed, the only reason that LEH did not fail as well, claims this well-connected trader, was a conference call on that Monday with the top ten dealers organized by the Fed of New York. During that call, the Fed of New York reportedly told the other dealers that it would lend LEH "whatever is necessary" to keep that leading mortgage-backed security underwriter and CDS house afloat. That open-ended promise, not the Fed's new lending facility, reportedly saved LEH from collapse - for now."
This open ended promise, is nothing but an increasingly powerful instrument in the hands of Central Banks, its signaling policy. A credible central bank, through the use of the media, can effectively and quickly transmit signals in the market.This obvious and very promising tool , which can be used (and abused), is not adequately researched in the context of financial regulation. The academic research, however, dates back a few decades. Jurgen Habermas' critical theory of law is essentially based on the argument that communication channels can be used to reform law and it need not always be driven by official dictat, as Max Weber had earlier suggested. In one of his later accounts of this power of communication, Habermas wrote about the "liberating power of symbols", where communication creates symbols that travels through media, changes public mind and as a result , transforms policy.
In the framework of financial regulation, the framework of central bank's communication policy is less clear, but is getting increasing academic attention as central banks transcend their traditional focus of monetary policy and focus more on financial stability.
Several issues have come to the fore in the context of signaling by the central banks with focus on four key aspects of policy, namely,
efficiency, time-consistency, optimality of communications, and institutional decision making processes. Efficiency issues centre around quality, formation of expectations, and implementation lags. The time-consistency issues relate to the conditions for substitutability between communications and policy actions, and choices between effectiveness of unanticipated policies relative to elimination of uncertainty in private decision making. The optimality
issues address the aspects of dangers of disseminating information which could result in crowding out of the formulation of independent beliefs by the privatesector – which is critical to well-functioning markets.
While dealing with this sensitive areas of regulatory intervention through communications, several questions come to the fore.
First, what should be the optimal content of such communications?
Second, will such communication have the same impact on all segments of society, including financial markets, media and general public?
Third, at what stage of internal debate the communication should take place?
Fourth, how to ensure that communication is timely enough to prevent panic or disasters in the market?
Fifth, should there be a clear line of agreed course of action, with clearly demarkated lines of responsibilities ensuring transperancy and removing conflicts of interests, if any?
Quite clearly, central bank communications in today's world have gone far beyond annual reports and periodic monetary policy assertions. Assurances over Conference Calls can produce the desired impact on the financial markets. While more research in this area is clearly desirable, one can be reasonably confident that such issues are likely to gain prominence in future as Central Banks all over the world try to deal with volatile , interlinked global financial markets.
Posted by sunandoroy at 05:24 AM
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April 04, 2008
The rise of Sukuks
The global market for Sukuk has exploded since 2006, generating a huge international interest in the product and its risk and return profiles. The Islamic financial market is over USD 500 billion and growing at a rapid pace of about 15 per cent globally. From a small base in 2005, Sukuks have recordrd triple digit growth in many countries, with Malaysia, UAE and Bahrain emerging as key players in the Sukuk market.
As a background, it may be mentioned for the uninitiated in the concepts, Islamic financial products need to comply with Shariah laws that prohibits accepting or paying interest. Interest payment , known as Riba or "extra" is forbidded in Islam. Accordingly, Islamic products are based on participAtion in financial ventures. Financial debt is thus avoided. the market for Islamic products, though growing through rapid expansion, are less structured and formalised that conventional financial markets. The market has less legal support and lacks money markets and secondary markets , thereby differentiating its risk profile from conventional markets.
Sukuk is the counterpart of conventional asset backed securities , a type of bond backed by assets.It is a certificate used by the beneficiary to collect funds and entitling, in the process, rights in certain assets. The risk and return in Sukuks thus are linked ton the assets generated from such liabilities. Thus, Sukuks can be Musharakah Sukuks, Ijara Sukuks, Istisna Sukuks and so on. Maturity profile may vary just like bonds, though most Sukuks till date are below 5 year horizon.
While the Sukuk market is growing at a rapid pace reaching total issuance of over USD 30 bn in 2007, there are several challanges faced in the market today.
1. Legal clarity is still an issue , particularly in early termination and default
2. Regulation in the capital market is evolving in many countries making cross border operations difficult.
3. The secondary market is almost non-existent, and coupled with lack of money markets, this heightens liquidity risk.
4. Repo regulations are in formative stages
5.There is absense of central counterparty and multilateral netting
6.Risk management is evolving in Islamic Banks and consequently Sukuks have not been subjected to stress scenarios.
7. Lack of maturity in the market leads to higher costs and difficulty in pricing products in a meaningful manner.
8. The demand for human resources with appropriate skillset far outnumbers supplies.
9. The interface between conventional and Islamic markets are still not well developed
10. Several taxation and valuation issues are yet to be sorted out.
Despite these constraints, the growth prospects of the middle east, the elevated level of oil prices and heighted global interest in Islamic finance is likely to result in strong expansion in the Sukuk markets in the near future. Products and Regulations will get standardised, growth in secondary market will provide more liquidity, risk management practices ( particularly modeling of risks) will improve and regulatory clarity and convergence will see greater cross border growth in this type of asset backed securities in the global financial marketplace.
Posted by sunandoroy at 07:45 AM
