Islamic finance can give early warning of debt woes

By Umesh Desai

HONG KONG (Reuters) - The transparency and structure demanded of Islamic finance that is attracting investors burnt by the subprime crisis could well have provided warning signals of the impending debt turmoil.

The subprime crisis has seen an exodus from riskier asset classes, partly as investors veer away from sophisticated products such as collateralized debt obligations that are difficult to fathom.

Investors say Islamic finance products demand greater transparency and accountability from company management, so it would be more obvious when companies are getting into debt problems.

Under Islamic finance, because the lender is also an investor, he remains an active participant through the life of the transaction and is in a position to rectify mistakes before the situation worsens, bankers say.

This appeal has added to the growth in Islamic finance.

Global bond and loan offerings issued according to Islamic guidelines have jumped 64 percent to $5.5 billion so far this year, data from Thomson Financial shows.

Islamic finance assets are growing at an annual pace of 20 percent and are set to hit $2 trillion in 2010 from the current $900 billion, fuelled in part by a flood of petrodollars generated by the rise in energy prices.

Islamic finance principles stipulate that deals must be based on tangible assets and require tight controls on debt levels, features analysts say offer some protection to investors and ensure corporate accountability.

"At the core of the current subprime crisis is the securitization of subprime mortgages or debts, a concept that would generally not be acceptable from a shariah perspective," said Arshad Ismail, Dubai-based head of sukuk at HSBC Amanah.

He said shariah-compliant financing also avoided transactions which had an element of speculation and those that are not asset-based, thus providing investors with in-built safeguards.

EARLY WARNINGS

These features provided early warnings to investors ahead of such corporate debacles as the collapse of Enron and WorldCom.

Both companies were part of the Dow Jones Islamic Market index .DJIMI, which has a screening process under which constituents with unacceptable financial ratios are removed from the benchmark. That happened to Enron and Worldcom.

"They were excluded from the DJ Islamic market index months before the crash -- the high level of debt indicated ineffectiveness of control," said Aznan Hasan, sharia adviser to investment bank Aseambankers Malaysia Berhad.

Kuala Lumpur-based Hasan said that securitization was not permissible under Islamic finance like in conventional debt and that the screening process demanded that a lender could see tangible assets and business activity from a borrower.