Dr. Hussain Hamed Hassan, a prominent Shari’ah scholar provided some interesting comments in an interview with Emirates Business 24/7 about the relationship between the Islamic finance industry and the financial crisis. There are several interesting comments and some of them are open to some debate and I disagree with one of them in particular. Before I discuss them, however, I want to add a caveat to my analysis.
Dr. Hassan is a well regarded Shari’ah scholar with far more qualifications than I or many other people in Islamic finance and in particular the application of Shari’ah standards in modern financial products. My comments are largely limited to how the Islamic finance industry works in practice compared to his description. Every so often an article is published with the criticism of Shari’ah scholars (usually accompanied by charges of ‘fatwa shopping’ by banks offering Islamic financial products). I am not going to go down this route because I—and I believe most people in the Islamic finance industry—believe that the differences of opinion between Shari’ah scholars is one based on legitimate disagreements and does not indicate any opportunism on their part.
Dr. Hassan describes that “the Islamic financial system does not allow trading in debt, which has been the root cause for the present crisis. […] Sukuk clearly represent equity ownership and has no linkage to debt. The issuer of the sukuk is selling an asset to the holder of the sukuk. The sukuk holders [in an ijara sukuk] are owners […] and they are entitled to the rentals generated by the asset.”
This may be the case in theory for Islamic financial instruments (insofar as how the legal reality is constructed), but it is often not the case in practice. The ijara sukuk with a repurchase agreement at par creates a stream of rental income from the underlying asset, which is in line with what Dr. Hassan describes. However, the insertion of the repurchase clause where the issuer repurchases the asset at par or in cases of default makes the instrument a debt. The sukuk holders have no recourse to take possession of the asset; their claims are transformed into unsecured debt obligations against the issuer.
The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) Shari’ah board (of which Dr. Hassan is a member) removed the possibility of repurchase at par for mudaraba and musharaka sukuk. In terms of ensuring that sukuk retain some features of equity (repayments are not guaranteed and depend on the performance of the underlying assets or business), this was an entirely appropriate move. However, the exemption provided under some circumstances to ijara sukuk leaves that as one of the forms of tradable debt open to issuers. The sukuk certificateholders retain ownership of the asset and therefore are selling a claim to that asset when they trade ijara sukuk in the secondary markets, but the claim on the assets when a repurchase agreement (at par) is present remains unsecured debt.
Were the Islamic finance industry to move away from this type of ijara sukuk (which in my opinion would be disruptive, but not cataclysmic) and include the requirement that repurchase agreements of ijara sukuk were done at market value or even at a value agreed upon between issuers and investors at the time of redemption or default, it would leave the ownership intact until the sukuk certificates are redeemed. The price of this redemption would be determined on the redemption date, it would remove some of the debt-like qualities of the sukuk. In addition, this would provide sukuk certificate holders with actual ownership of the assets upon default and they could either negotiate a sale to the issuer or, if that is not possible, be able to lease the assets to the company or a third party, or alternatively, sell the assets at the current market price.
This idea is a relatively simplistic assessment on my part of the issues facing the Islamic finance industry over the tradability of sukuk and the role of repurchase agreements. However, when describing the Islamic financial industry, I believe there remain disagreements about whether the products like ijara sukuk do or do not constitute a debt. In the strict legal sense they don’t. The sukuk is a stream of rental payments with two sale transactions as bookends. However, in the actual outcome—fund the purchase with the sukuk proceeds, make rental payments and redeem the certificates at par through a purchase undertaking—they are debt. The asset (and more importantly the change in its market value) is removed from the final transaction in order to mimic a bond with par redemption.
Despite my criticism presented above, I believe that it is incredibly useful when Shari’ah scholars provide more clarity about their thinking about the industry and the products used by the industry. I would recommend reading Dr. Hassan’s interview in full from the link above.