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.

Posted at 11:19 am IST on Fri, 27 Nov 2009         permanent link

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