Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Dubai World brings Islamic finance down to earth

Back in 2007 and 2008, people were fond of arguing that the crisis
was due to highly complex financial instruments and that if finance
became boring, it would be a good thing. People even argued that
Islamic finance would be a good idea.

This week Dubai put an end to this talk by making it clear
that Dubai World would default on debt issued by its subsidiary Nakheel
Development Limited. The debt falls due in the middle of December, but
Dubai wants creditors to agree on a standstill till May while a
restructuring is worked out.

The interesting thing is that the instrument in question is an
Islamic bond – a Sukuk. The prospectus (available in the FT
Alphaville Long
Room
) proudly refers to the “pronouncement dated 11 December
2006 issued on behalf of the Sharia Supervision Board of Dubai Islamic
Bank PJSC confirming that, in their view, the proposed issue of the
Certificates and the related structure and mechanism described in the
Transaction Documents are in compliance with Sharia principles.”
(page 34)

Of course, one can argue that there is really nothing Islamic about
modern Islamic bonds other than an opportunity for some religious
scholars to earn a living by issuing pronouncements on Sharia
compliance. But that itself is a warning that trying to legislate
simplicity in finance is often futile.

Modern corporate finance teaches us that money is made and lost on
the asset side of the balance sheet. To adapt a favourite statement of
the Austrian economists, losses occur when wrong investment decisions
are made. The defaults on the liabilities side of the balance sheet
only serve to announce and crystallize this loss. Last month, I blogged
about how bank losses from loans in the current crisis exceed losses
on securities. The default on the Sukuk reinforces this idea that
mis-allocation of capital produces losses regardless of the composition
of the liability structure.

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