Or maturing his felonious little plans
His capacity for innocent enjoyment
Is just as great as any honest man's.
-- Gilbert & Sullivan, “Pirates of Penzance”
When I wrote recently of the likely recurrence of old-fashioned accounting scams – here – based on non-existent assets and fictitious transactions, I promised to put up my own candidate as the sector ripe for eruption.
It’s this: the already huge and rapidly growing market for financial products and services based on Islamic law – Sharia – which is closing in on $1 trillion in size, targeted at Muslim customers comprising one-fifth of the world’s population, and predicted to expand at ten to twenty percent a year (here, here).
It can be safely predicted that market pressures, competitive greed and misaligned incentives will breed scandals in Sharia-based finance – going well beyond the large if simple issues of non-performance already seen in the suspension of debt payments by Kuwait’s Investment Dar as majority holder in carmaker Aston Martin, and the missed debt payments and cross-defaults of Global Investment House (here and here).
Why? And how, if they can be predicted, can they be prevented?
There are two drivers: the prospect that the bursting of the “shadow banking” bubble will bring a general global return to more traditional asset-based financing structures, and the certain cycles of re-emergent white-collar rascality.
Koranic principles prevent the charging of interest or the assumption of undue risk. Sharia-based financiers are therefore inhibited in using derivatives or other hedging contracts, short selling, insurance in the Western sense or other risk-mitigating techniques.
Instead their financings involve the sharing of risks and rewards – exemplified by “sukuks” -- structured offerings of asset-based securities, with the “buyer” entitled to a “rent” based on a participation in underlying tangible property, and “murabahas” – financing commitments involving a “profit rate” rather than an interest payment.
Well enough, so far: boards of Islamic scholars vet and approve each transaction for compliance with Sharia principles as applicable, country-by-county. But what the resulting imprimatur – the “fatwa” -- does not do is extend to either up-front due diligence or on-going audit work to assure the fundamental bona fides of the transaction.
And right there lies the hazard. Islamic finance is a fermenting laboratory experiment for the cultivation of schemes and irregularities: a sector big enough to attract new and eager players, out-sized growth potential, modest size and limited talent and experience among the current participants, and cultural incentives to grow in competition against foreign non-believers.
History should teach that the incentives to gain or hold market share, or to stretch the level of transaction risk for the sake of enhanced volume and returns, open the door to irregular behavior on the part of individuals acting under stress -- no less for a Sharia-based sukuk than for a real estate investment trust or a field of oil wells.
One certainty is that the recurrence of financial frauds is no respecter of either piety or theology. The ecumenical scope of exploitive scandals ranges from the 1982 discovery of Roberto Calvi – “God’s Banker” – hanging dead under Blackfriars Bridge in London even as his Banco Ambrosiano suffered multi-billion lire holes in its balance sheet – to the disgraced fall of Christian evangelists Jim and Tammy Bakker – to Bernard Madoff’s looting the community of his Jewish friends and golf partners.
And the pressures are only amplified where a sector is going through dramatic and rapid growth, with a stretching of experience and resources, increased transaction costs in lieu of interest-based revenue, and the ever-present temptation to minimize the red flags of risk in favor of the satisfaction of aggressive targets.
And so – Sharia transactions involving profit participations based on shared interests in presumably real assets raise exposures of the old-fashioned variety, namely the “sales” of assets that are inflated or fictitious – with variations on the shell-game devices used throughout history to evade due diligence and to fool the auditors.
Among the incisive comments on my last piece on likely audit threats were these:
• One reader had the anxiety-raising concern that a gremlin may yet emerge in the securitized residential mortgage market, beyond the issues of bad credit and poor collateral – a portfolio of entirely fictitious houses or borrowers. The accuracy of his concern was promptly confirmed not only by the SEC’s broad charges of mortgage-related fraud against the Countrywide team led by CEO Angelo Mozilo (here), but by criminal charges over a New York scheme based on unbuilt buildings, fictional addresses and bogus appraisals (here).
• And another, a regulator, had the reminder that beyond all the weaknesses in audit sampling, lies the ever-present threat of “shadow” control structures, designed and run for the pure purpose of evasion and manipulation.
Regulators, gate-keepers and systems of justice in Western traditions have been caught unprepared and flat-footed, all too often. Whether their counterparts in the emerging Sharia environment can somehow do better – despite an absence of history, tradition or experience – remains to be proved.
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