Grey Matters

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Thorsten Beck, Asli Demirguc-Kunt & Ouarda Merrouche,
“Islamic vs. Conventional Banking: Business Model, Efficiency and Stability, World Bank Policy Research Working Paper No. 5446”,

(1 October 2010), available at

This paper discusses Islamic banking products and interprets them in the context of financial intermediation theory. Anecdotal evidence shows that many of the conventional products can be redrafted as Sharia-compliant products, so that the differences are smaller than expected. Comparing conventional and Islamic banks and controlling for other bank and country characteristics, the authors find few significant differences in business orientation, efficiency, asset quality or stability. While Islamic banks seem more cost-effective than conventional banks in a broad cross-country sample, this finding reverses in a sample of countries with both Islamic and conventional banks. However, conventional banks that operate in countries with a higher market share of Islamic banks are more cost-effective but less stable. There is also consistent evidence of higher capitalisation of Islamic banks and this capital cushion plus higher liquidity reserves explain the relatively better performance of Islamic banks during the recent crisis.

CFR comment
Islamic finance is often touted as a coming thing, not surprising given the amount of money piling up in some Islamic nations. Islamic banking practices are spreading, as financial institutions seek to tap into this pool of wealth. This World Bank paper gives the question of the impact of the spread of those practices a careful look and finds that there are fewer differences between Islamic and non-Islamic banking than might be expected based on the more extravagant claims about Islamic banking. This paper could be profitably read together with Timur Kuran’s excellent Islam and Mammon: The Economic Predicaments of Islamism (Princeton University Press 2004), a sceptical analysis of the differences and similarities between Islamic banking and the more traditional sort.

William A. Birdthistle,
“Breaking Bucks in Money Market Funds”,

2010(5) Wisconsin Law Review pp. 1155-1201, available as

This Article argues that the Securities and Exchange Commission’s first and most significant response to the economic crisis increases rather than decreases the likelihood of future failures in money market funds and the broader capital markets. In newly promulgated regulations addressing the “breaking of the buck” in the $3 trillion money market – a debacle at the fulcrum of the 2008 financial meltdown – the SEC endorses practices that obfuscate rather than illuminate the capital markets, including fixed pricing for money market funds, potentially riskier portfolio requirements, and the continued use of discredited ratings agencies. These policies, premised implicitly upon doubt in the ability of markets to process information effectively, obscure the true perils of money market funds.  Rather than swaddling investment risks in misleading regulatory padding, the SEC should illuminate the possible menace of these funds. This Article offers transparent solutions to alleviate moral hazard and systemic risk in the broader market and to end the regulatory subsidy of these specific investments.

CFR comment

Prof Birdthistle is one of the best academic writers on mutual funds and the law, a statement that understates his contributions because he doesn’t have much competition for the title. Even if there was more legal academic writing, he’d be at the top of the heap. (He’s also written on the FIFA World Cup, proving mutual fund junkies don’t have to be dull. See Football Most Foul, 10 Green Bag 2d 159 (2007) available at william_birdthistle/1/). Anyone interested in the future of regulation of this industry needs to keep an eye on his work.

Mohammad Omar Farooq & SAyd Zubair Farook,
“Incentive Based Regulation for Islamic Banks”

Journal of Islamic Accounting and Business Research, 2011, available at

Recent calls by prominent Islamic scholars to shift the focus of Islamic Finance away from bond-like sukuk have been met with great unease by bankers in the industry. Islamic Financial Institutions (IFIs), which hold the majority of all sukuk issued, face deposit side constraints on the types of returns they distribute, due to a need to match returns to market based deposit interest rates. Hence, it is in their interest to hold assets that provide stable benchmark based returns. The purpose of this paper is to provide an outline of an original incentive based regulatory mechanism to encourage Islamic banks to reconcile their intended normative structure (profit and loss sharing) with the operational and pragmatic realities within which Islamic banks exist.

CFR comment
Quite a few jurisdictions, including Cayman, have made considerable investments in developing Islamic finance business. This paper addresses a crucial issue for the future of these businesses, whether sukuk instruments will continue to be regarded by Islamic scholars as sharia compliant. Materials like this provide a valuable window into the debates that will influence the future of a sector about which many in the offshore world have had high hopes.

Anna Gelpern & Gaurang Mitu Gulati, “Sovereign Snake Oil” ,

Law and Contemporary Problems, Forthcoming, available at

Collective Action Clauses (CACs) are back at the forefront of financial crisis response, this time in Europe. In the absence of a sovereign bankruptcy regime, CACs help solve coordination problems in sovereign bonds by binding all bondholders to the terms of a debt restructuring approved by the majority. But unlike the last two campaigns to include CACs in foreign sovereign bonds in the 1990s and early 2000s, today’s initiative does not point to coordination problems. Most of the sovereign bonds at issue either already have CACs or include other features that make restructuring relatively straightforward. Much of the European debt problem stems from private sector debts, which can be restructured in bankruptcy. Moreover, standardised CACs on the model referenced in EU statements fit awkwardly in domestic law bonds, which account for the bulk of the EU sovereign debt problem. Why revive such an ill-fitting remedy? In this essay, we review the recent history of CAC initiatives to suggest that they serve as a convenient political diversion from the hard problems and painful solutions at the heart of a financial crisis. [This is a modified version of the editors’ introduction to the LCP volume on the modern history of sovereign debt.]

CFR comment
Profs Gelpern and Gulati are among a very small set of academic analysts of sovereign debt. This paper, the latest in their work on the topic, continues the high standards of their earlier work. A must read for anyone concerned with sovereign debt.

John Waters,”The Effect of the Sarbanes-Oxley Act on Innovation”,
U. of Westminster School of Law Research

Paper No. 11-04, available at

This paper adds to the literature on the Sarbanes-Oxley Act’s net effects by looking at whether its passage was associated with a change in innovation and patenting. Its effects are separated into temporary uncertainty and changes in long term investment incentives in a dynamic programming problem faced by innovators who learn over time about SOX’s effect. Innovation is found to fall under uncertainty for potential losses that are low relative to the potential profits. As companies learn, innovation rates readjust to SOX’s long term persistent effect. We examine US patenting in stem cell technologies from 2001 to 2009 for SOX related changes. To reduce the dependence of our estimates on timing assumptions, we look for changes over the whole period. We firstly use a rolling break test with a single break point with Monte Carlo correction to p-values for search process endogeneity and MLE bias. Secondly, we run a hidden Markov model allowing for multiple states in the patent process and transitions between the states.  We find a large and statistically significant change at a date consistent with a SOX effect under both testing methods. A three state hidden Markov model finds subsequent correction consistent with the theoretical model. Four competing explanations are found to account incompletely for the observed data.

CFR comment
CFR (and many others) have often noted the problems caused by the Sarbanes-Oxley Act in the US, where it raises costs for firms and confers no discernable benefit on anyone besides lawyers and accountants. This paper uses a sophisticated set of econometric techniques to reveal how the uncertainty SOX created affected patent activity, a useful insight for those investing in companies that depend on innovation.

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Andrew P. Morriss

Andrew P. Morriss, Chairman, is the D. Paul Jones, Jr. & Charlene Angelich Jones – Compass Bank Endowed Chair of Law at the University of Alabama School of Law. He was formerly the H. Ross & Helen Workman Professor of Law and Business at the University of Illinois,Urbana-Champaign. He received his A.B. from Princeton University, his J.D. and M.Pub.Aff. from the University of Texas at Austin, and his Ph.D. (Economics) from the Massachusetts Institute of Technology. He is a Research Fellow of the N.Y.U. Center for Labor and Employment Law,and a Senior Fellow of the Institute for Energy Research, Washington,D.C., as well as a regular visiting faculty memberat the Universidad Francisco Marroquín,Guatemala. He is the author or coauthor of more than 50 scholarly articles, books, and bookchapters, including Regulation by Litigation (Yale Univ. Press 2008) (with Bruce Yandle and Andrew Dorchak), and is the editor of Offshore Financial Centers and Regulatory Competition (American Enterprise Institute Press 2010).

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