AAOIFI to investigate breaches of Shari'ah-compliance, S&P predicts $20bn in sukuk pipeline in 2010

Arabian Business is reporting that AAOIFI will begin to investigate breaches of Shari'ah-compliance by Islamic financial institutions. They will work with companies with violations and only will approach authorities if the institutions refuse to comply. The secretary general of AAOIFI, Dr. Mohamad Nedal Alchaar, says that "It will be amicable, as we are the gatekeepers of this industry and we want to work through negotiation" adding that "Only if that does not work, will we go through the authorities". One important thing that is not clear from this article is what specifically will be reviewed. Will AAOIFI review the transaction documents of any institution that claims to be Shari'ah-compliance and pass judgement on the compliance of each product or will it instead focus on ensuring that Islamic financial institutions have the necessary safeguards in place (e.g. a Shari'ah board that reviews the products and audits the activities of the bank on a regular basis)? The AAOIFI guidelines are not universally required and there could be disagreement about whether they apply to Islamic financial institutions in jurisdictions where they are not mandatory.

In general, this is useful to prevent institutions from offering products that are described as Shari'ah-compliant without actually ensuring that they are approved as Shari'ah-compliant. However, if it is done poorly, it could hamper the growth of Islamic finance by restricting Islamic financial institutions from offering new products which may receive approval by the institution's Shari'ah board, but not be approved yet by AAOIFI. I will provide more comments when the scope of the AAOIFI committee is released with more specifics.

Standard & Poor's says that the pipeline for sukuk in 2010 is $20 billion, which would be roughly equal to the total issuance in 2009 ($23.3 billion). This estimate is calculated using those sukuk "publicly announced that is likely to come to market if conditions permit", according to analyst Mohamed Damak. In January 2010, $1.1 billion of sukuk have been issued according to Dealogic, which is up significantly from one year ago when only $77 million were issued as the global financial crisis was still limiting access to capital.

An article describe the CMHC report on Islamic home finance in Canada which I wrote about earlier this week. The public/private initiative Toronto Financial Services Alliance welcomed the CMHC report and said it had established a working group to look at the challenges and opportunities for Toronto in the Islamic finance industry.

The UK-based International Financial Services London released their latest annual report on the Islamic finance industry. The UK remains the largest Western center for Islamic finance with 22 Islamic financial institutions. The U.S. has 9 and this includes the two largest Islamic mutual funds in the world, the Amana Income and Growth funds.

Without going into too much detail, I agree with the Chief Executive of Qatar Financial Centre Regulatory Authority who said it was a "myth" that Islamic financial products are safer than conventional products. Islamic finance can alter the relationship between parties in a financial contract and can encourage equitable dealing and transparency, but it cannot remove risk from investments when they are structured to mirror conventional debt products. The close look that Nakheel's sukuk received when it was at risk of defaulting highlighted some of the areas where the idea that it was asset-based (and thus more secure than conventional debt) were exposed as false because the structure meant that in case of default, it would be treated as an unsecured obligation of Nakheel.

Other News

• The lord mayor of London said that oil companies could turn to the U.K. for Shari'ah-compliant loans.
  
• India is planning to change its regulations to allow non-banking Islamic financial institutions to attract investments from the Gulf and encourage the underbanked Muslim majoirty to participate in the financial system.
  
• Tamweel's chairman said it may still be merged with Amlak in the first quarter of 2010.
  
• DSAM Kauthar commodity funds released its performance results for 2009.
  
• The Central Bank of Bahrain's short-term Sukuk Al-Salam securities were oversubscribed and provide a return of 1.05%.
  
• The Islamic Corporation for the Development of the Private Sector, a part of the Islamic Development Bank said it would work with the government of the Maldives to establish an Islamic bank in the island country.
  
• Bank Islam, a Malaysian Islamic bank, is looking to acquire Islamic banks in Southeast Asia, including in Indonesia.
  
• The Malta regulators are close to being able to publish guidelines on an Islamic securities market, which could be released during the first half of 2010. There are still some legal and technical problems according to the Finance Minister.
  
• Dar Al-Arkan, the Saudi real estate developer is on an international roadshow for a sukuk that could be up to $1 billion.
  

CMHC report on Islamic home finance

The Canadian Mortgage & Housing Corporation (CMHC), the Canadian national housing agency commissioned a study a couple of years ago, which has recently been completed by law firm Gowlings Lafleur Henderson LLP. The CMHC reiterates at the beginning of the report that "CMHC Insurance business has no plans to insure Shari'a mortgages, nor is CMHC making changes to legislation or administrative practices". The prominence of this disclosure is probably, at least in part, a reaction to the small but loud reaction from critics of Islamic finance when the study was announced.

The study describes how Islamic finance works and in particular how Islamic mortgages work. The report provides one of the most comprehensive and detailed overviews of the Islamic mortgage markets in a number of countries including Western secular democracies, secular republics with Muslim majorities and Islamic republics.

The most interesting section of the report, of course, is the focus on Canada. This section, however, begins with an interesting observations:

"Little empirical evidence based on a sound methodology assumptions exists to accurately project what portion of the Canadian population would be interested in [using] Shari'a-compliant financing"

This point is relevant beyond just the narrow focus of the Canadian report because there is little evidence about what factors--either within Muslim populations or within the Islamic finance industry--lead to demand for Shari'ah-compliant financial products. This is clearly a much larger issue than I can cover in this short blog post, but it suggests a promising area for research about what issues in Islamic finance matter for Muslim consumers of financial products.

Returning to the Canadian market, the market structure of the market has limited the ability to provide Shari'ah-compliant home financing to those Muslims who demand them. The market has for most of the past 25 years, been dominated by small cooperatives reliant upon member's investments to finance new home purchases. UM Financial entered the market in 2005 and used mudaraba financing from Credit Union Central of Ontario for $120 million, which has been used to finance home purchases and refinancing. Until UM receives addition financing, which it has reportedly been working on, it is limited in the financing it can provide. As the CMHC report notes, of the Canadian banks and other mainstream financing institutions, which represent 60% of the mortgage market, "none of them have actually offered Shari'a-compliant housing finance, not even on a pilot-project basis".

Whether these banks enter the market on their own or through specialized Islamic home finance companies, there will continue to be a limit on the availability of Islamic home finance in Canada. This problem is accentuated by the lack of certain numbers on the size of the market in Canada. While there are expected to be between 0.98 million to 1.30 million Muslims in Canada by 2011 and between 1.23 million and 1.78 million Muslims by 2017 according to Statistics Canada, there is no clear estimate about how many of these will be homebuyers and of those buyers how many will opt for Shari'ah-compliant mortgages over conventional alternatives.

The study does cite one statistic that probably impacts the rate of Muslims who choose Islamic mortgages rather than conventional alternatives. They cite a story in the Financial Post from May 2007 which said that Shari'ah-compliant mortgages are between 100 and 300 basis points more expensive than conventional mortgages (versus a similar spread of 40 to 100 basis points in the United States). Whatever a study of Muslims in Canada would say if one were conducted, the cost of the mortgage will make the difference between whether the indifferent consumer will choose one over the other. Muslims are often subdivided into three groups (not necessarily of equal size): those that only use Islamic finance, those that would prefer Islamic finance if the cost is equivalent (or close) and those who will not use Islamic finance. The middle group will be the group that determines the size of the market in Canada for Islamic finance.

The reason I raise this issue is that the market structure in Canada is not necessarily conducive to significant growth in Islamic finance without something different that opens up capital for new Islamic mortgages. In the U.S., this roles is played by Freddie Mac (and to a limited extent Fannie Mae). There are legitimate criticisms of how Freddie Mac operates to provide capital to Islamic mortgage companies, however, the cost premium in Canada is likely due mostly to the lack of a similar provider of capital.

In Canada this is likely to be assumed by one or more of the big five banks. This study could provide the foundation for Islamic finance products to be placed on equal footing in tax and regulatory treatment to conventional mortgages through changes in laws. It has also been reported that there are several Islamic bank applications that have been held up pending the completion of this report. Their approval would add to the pressure for the Canadian government to reform tax and regulatory laws (probably in line with changes made in the past decade in the UK).

The broader points that this report raises is that Islamic finance (particularly retail Islamic finance) is limited if: 1) it is not competitive in price with conventional alternatives; 2) regulatory uncertainty; and, 3) significant uncertainty over the size and characteristics of demand for Islamic finance.

These limitations can be reduced if: 1) Islamic financial institutions have greater access to capital; 2) regulatory and tax restrictions that add cost are removed to put Islamic finance on equal footing with conventional finance; and 3) the factors that determine whether the marginal Muslim financial consumer will opt for Islamic or conventional finance is better understood.

Should Islamic finance move towards asset-backed securitization?

Two lawyers with experience in Islamic finance, Debashis Dey and Stuart Ure, wrote an article in The National about the future of sukuk and in particular, they highlight one of the important features of sukuk which is often misunderstood:

"In the majority of unsecured sukuk transactions the investors ultimately have no direct recourse to the assets themselves. The repayment of their investment is dependent on the exercise of a purchase undertaking by the seller of the assets at maturity or upon default. Thus, as with a conventional bond, the investors take credit risk on the seller who has granted the purchase undertaking.

Although typically there is a physical asset in the structure, it is present primarily to generate periodic profit payments, not to enhance the credit quality of the deal or provide investors with recourse to the assets upon a default."

This is one of the aspects of sukuk which I have criticized because it isolates the actual asset from the transaction and thus creates an unsecured debt that appears to be based on an asset. While this is clear in the offering documents, the amount of different articles that talk about Islamic finance as being more stable because it is based on real assets suggest that they have not read offering circulars of sukuk.

The solution, if the industry wants to make the rhetoric match the reality, in the eyes of these two lawyers (which I agree with) is:

"While Sharia principles seem harmonious with the nature of asset-backed securitisation, for securitisation to become more mainstream in the GCC, three prerequisites will be required: firstly, investors will need to demonstrate a commercial desire to take the risk (and reward) associated with the true sale of assets in an asset-backed structure, including the management of those assets in a default scenario; secondly, those companies seeking finance will need to demonstrate a desire to sell their assets (which will have accounting and shareholder equity implications); and thirdly, a robust legal framework will need to evolve as bankruptcy and asset-selling laws in many jurisdictions in the GCC remain opaque and militate against securitisation structures."

These three points are important and have not been the focus of the future of sukuk as much as they should be.

The prime example for a sukuk which does use an asset-backed securitization structure that has run into trouble (and therefore is instructive when compared with recent defaults of unsecured asset-based sukuk) is the East Cameron sukuk. This sukuk was a musharaka between the issuer SPV and an oil-and-gas exploration & production company. The asset was an overriding royalty interest (ORRI) and the two parties split the production from the musharaka assets (natural gas), which was then sold to make periodic payments and redeem the sukuk.

The transfer of the ORRI to the musharaka SPV was a true sale and this has been upheld in the bankruptcy court overseeing the reorganization of East Cameron Partners. According to documents filed in the bankruptcy court, the sukuk investors have provided debtor-in-possession financing to the company and a reorganization plan is expected to be submitted sometime in January 2010. However, for the discussion of ABS structures for sukuk, the idea of using a true sale rather than a sale of beneficial interest that is common in unsecured sukuk has shown to protect sukuk investors by giving them rights to the underlying asset that is insulated from the claims of other creditors.

Of course, this case occurred in the U.S. where the legal system is more developed in terms of understanding and resolving claims regarding asset-backed securitizations than in other jurisdictions where sukuk are issued. The ability to take this example and generalize to sukuk issued elsewhere is, therefore, limited. However, lack of generality does not make it a useless exercise.

Other News

• The UK has proposed changes that would put corporate sukuk issuance on equal footing with conventional bond issuance by removing them from regulation as collective investment schemes. A Reuters blogger, Cecilia Valente, says that there continue to be discussions about a sovereign sukuk from the UK government, although she ascribes the renewed focus as a reaction to moves by the French to promote their own ambitions of being a Western hub for Islamic finance.
  
• The Accounting and Auditing Organization for Islamic Financial Institutions released updated standards for the Islamic financial institutions.
  
• Thomson Retuers launched a risk management system for Islamic banks.
  
• The Islamic Development Bank is increasing the size of its medium-term note program, which will allow it to issue more sukuk to fund its activities.
  
• Bahrain-based Al Baraka is considering acquiring a large minority stake in Bank Muamalat, an Islamic bank in Malaysia.
  
• A report on microfinance in Afghanistan includes a suggestion that microfinance institutions offer Islamic microfinance based on client demand, although they note that it will be unclear if it will be demanded if it is more expensive than conventional microfinancial products.
  
• The Secretary General of the Franco-Arab Chamber of Commerce believes France will become a large part of the Islamic finance industry.
  
• Reliance Capital is entering Islamic finance through a Malaysian subsidiary, Reliance Asset Management.
  
• Forbes magazine provides a profile of Nicholas Kaiser, the head of the Amana Funds' parent company Saturna Capital.
  
• Indonesia priced its retail sukuk offering at 8.7%.
  

Dubai bailout, BNM Shariah parameters

The bailout that Dubai received from Abu Dhabi to resolve the immediate problem of the maturing Nakheel sukuk is still only slightly clearer than it was at the time. Initially, the bailout was reported to be $10 billion, which led to criticism about the lack of transparency about where the rest of the money went. This has been somewhat cleared up. Only $5 billion was provided directly from Abu Dhabi ($4.1 billion to pay sukuk certificateholders with the remainder used for other payables). The other $5 billion of the total was the line of credit provided by two government-owned banks in Abu Dhabi, of which about $1 billion has been drawn.

Bank Negara, the Malaysian central bank, has issued three 'Shari'ah parameters' so far that provide guidance on the important areas for different contract types. This type of standardization is useful for the Islamic finance industry because they provide a starting point for discussions about the applicability of different contracts as well as the characteristics of each without creating a fixed contract that could stifle innovation. As I have argued in the past, the move towards some standardization is welcome, as long as it does not limit the potential for future change, either new innovations or a refinement of the existing products. The DIFC Sukuk Guide, released in December 2009, also provides a basic overview of the typical structures used specifically in sukuk, and also provides a reference point for further discussion about the contract structures used in Islamic finance.

The initial reports of the new microfinance institution, Family Bank of Bahrain, said that it provided Shari'ah-compliant financial services. The Grameen Bank's Grameen Dialogue describes the goals of the Family Bank (from 2007 when the Memorandum of Understanding was signed). The Family Bank is listed (as of November 30, pdf) as a conventional retail bank.

Other News

• In an interview with Gulf News, Malaysian Prime Minister Mohammad Najeeb Bin Abdul Razzaq indicated that Kuala Lumpur plans to establish an "iconic" centre to house all its Islamic financial institutions.
  
• An article provides a nice description of Devon Bank, a community bank in Chicago that offers Shari'ah-compliant financing.
  
• Pakistani BankIslami will acquire Emirates Global Islamic Bank, in part to meet the minimum capital requirements of the State Bank of Pakistan.
  
• Bank Negara, the Malaysian central bank, is expected to give an Islamic banking license to the National Bank of Abu Dhabi.
  
• An article in Indian newspaper The Economic Times describes the Islamic fund management business in India.
  

Islamic financial institutions should become UNEPFI signatories

Michael Gassner, an expert on Islamic finance based in Europe, recently called on Islamic financial institutions to become members of the United Nations Environment Programme’s (UNEP) Financial Initiative. His call was seconded by Dr. Mahmoud El-Gamal, who added that “This is consistent with my earlier call in my book on Islamic Finance that those engaged in Islamic finance should support the earlier UN initiative for financial markets knows as ‘who cares wins’.”

I would like to add my support for this because of the similarities—in theory more so than practice—Islamic finance provides an ethically-based financial model. The gap between rhetoric and reality was described by Dr. El-Gamal: “I have long been a critic of the Islamic finance industry focusing mainly on avoiding prohibitions, but not recognizing that prohibitions are secondary to positive injunctions”. My hope is that Islamic financial institutions become signatories to the UNEPFI as the first step in broadening their focus from avoiding Shari'ah non-compliant activities and adding a focus on promoting sustainable business practices.

The UNEP Financial Initiative is a voluntary initiative that requires signatory financial institutions to incorporate sustainability (the environmental, social and governance impacts of their business) into their business practices. Institutions joining must sign one of two statements (one for financial institutions, one for insurance companies).

Ijara, mudaraba and musharaka sukuk: a critical perspective

I have been having some interesting discussions with a few people about my recent posts about the Saudi Hollandi Bank mudaraba sukuk and ijara sukuk in general and it has led me to think more about the overall direction for the sukuk market now that the prospects for new issuance seems to be improving.

Should sukuk mirror conventional bonds?

One of the overarching themes is whether sukuk should mirror conventional bonds or whether there can be a different risk-return profile while retaining investor interest. Until now the sukuk market is primarily focused on producing Shari’ah-compliant bond-equivalent financial products. This trend of product development was criticized for creating products which used Islamic financial contracts in theory while creating an identical economic outcome with protections for investors that mirror conventional bonds. This criticism was partially resolved with the AAOIFI ruling on sukuk which limited, among other things, the ability of mudaraba and musharaka sukuk to have repurchase agreements where the issuer would repurchase the sukuk at par upon maturity or in cases of default.

This ruling, coming in the midst of the early stages of the Great Recession, was a contributing factor in the steep decline in new sukuk issuance. This was due to the heavy use of mudaraba and musharaka sukuk by Islamic banks who represent a significant share of sukuk issuance. The AAOIFI resolution occurred several months after Sheikh Taqi Usmani made comments that 85% of all GCC-based sukuk were not structured in a Shari’ah-compliant manner. Until the Saudi Hollandi Bank sukuk, few issuers brought new mudaraba and musharaka sukuk to the market. Instead, most new issuers used the ijara structure, which was not subject to the limitations on purchase undertakings at par to redeem sukuk.

The use of repurchase agreements in ijara sukuk

The reliance on ijara sukuk with repurchase agreements after similar structures were prohibited for mudaraba and musharaka sukuk highlighted a discrepancy in the Shari’ah standards between different types of sukuk. There are differences between the two structures and there are fewer restrictions on how profits and losses are shared between the two parties in the ijara structure. However, the ijara sukuk structure includes a purchase and sale transaction at issue and maturity, which is not part of the actual leasing transaction.

The ijara transaction is relatively uncontroversial. The SPV, as beneficial owner of the assets, leases those assets to the issuer company for a set period with the rents benchmarked to an interest rate and sometimes a variable rental rate that resets periodically to incorporate changes to the benchmark interest rate. The other part of the transaction involves a sale of the asset by the issuer company to the SPV using the proceeds from the issue of sukuk certificates and a sale back to the issuer company at maturity in default or at maturity to redeem the sukuk.

The sale and repurchase (at par) transactions do seem to be more controversial because they essentially strip the asset out of the transaction for the purpose of investors looking at the transaction. From the view of the economic outcome, an ijara sukuk with an repurchase clause and where the sale of the assets to the SPV are not a ‘true sale’ but instead transfer beneficial ownership to the SPV is an unsecured obligation of the issuer company. As a comment to an earlier post pointed out, there may be fewer legal rights for sukuk holders (although I do not have enough legal expertise to say this with certainty) than for a conventional unsecured bond. The purchase undertaking may create only damages that the investors can claim, rather than a debt that may rank higher in order of priority in a liquidation. In a ‘true sale’, the legal ownership of the asset would be transferred to the SPV and in a default, the SPV will be able to take possession of the assets if the issuer is not able to produce the funds needed to fulfill the purchase undertaking (again, I do not have legal expertise enough to make this statement conclusively).

The impact for the Islamic finance industry of the sale-lease-repurchase structure of the ijara sukuk is important. Frequent claims are made that Islamic finance is more resilient, provides a superior outcome, and is more stable than conventional finance based on its connection with real assets. However, if the transaction creates unsecured obligations that may or may not be equal in a liquidation to the claims of unsecured bondholders, then it would be wholly reasonable to dispute this claim and point to secured financing as a more stable form of financing. In a secured financing (and I think this would be true if the assets were sold in a ‘true sale’ to the SPV), the investors have recourse to the underlying assets if there is a default. Both parties share the risk of failure: the issuer loses the use of the assets unless the investors decide to continue leasing the assets to the issuer and the investors lose the difference between par value and the market value of the assets in the sukuk.

This idea leads to whether sukuk should be equivalent to bonds in the investor protection and the model of an ijara with a ‘true sale’ may provide this (it could potentially be overcollateralized to provide additional protections). At the same time, it would provide a path by which investors could receive protection while perhaps setting up a more satisfactory resolution of a default for both investors and the issuer. The SPV would retain ownership in the default (rather than giving it up for an unsecured claim through the purchase undertaking) and the issuer would lose the use of the asset. The asset could continue to be leased to the issuer while a price was negotiated for the purchase of the asset at a value above market value and below the par value, which would lead to a sharing of risk between issuer and investors.

Mudaraba versus musharaka: Are there incentive problems that could hurt investors?

For mudaraba and musharaka sukuk, there seems to be a different trend emerging following the Saudi Hollandi Bank sukuk. Instead of having the issuer advance interest-free loans to make regular payments, the mudaraba would pay out regular coupons (fixed-rate or floating-rate) during the term of the sukuk, while also tracking profits (and profit-sharing) from the mudaraba. At the redemption, the redemption value would be equal to the value of the mudaraba assets plus any amount in the reserve account (which accumulated profits in excess of the periodic payment amounts) until the par value is reached. If the assets plus reserve account was insufficient to make repayment at par, the investors would receive less than par.

This structure includes more risk for investors than an ijara sukuk because the value of the sukuk assets falling below the par value would likely lead to a reduced payout at maturity. This could limit the appeal of these types of sukuk, although this was not evident in the Saudi Hollandi Bank sukuk which was four times oversubscribed. This demand may not be present if a mudaraba sukuk structured in a similar way were to default with investors paid less than the par value. However, if Islamic finance wants sukuk to become an alternative asset class for investors, this is not a bad thing.

This structure seems particularly advantageous for Islamic banks, which often lack the physical assets to structure other forms of sukuk. Their business model, which relies upon making a spread between cost of financing and the returns they receive from extending financing (offset by losses in financing), which should be sufficient to redeem the sukuk at par in most times. However, as we have seen, not all times are “most times” and the loan losses may be accentuated if the banks are incentivized to take more risk than is prudent for the investors.

The risk of this excessive risk incentive is present in the sukuk structure used in the Saudi Hollandi Bank sukuk, which could have been mitigated if it were a musharaka sukuk, as I’ll describe in a second. The way it was structured, the bank commingles its own investments with the investments accounted for in the mudaraba sukuk to develop its Islamic banking business. The mudaraba assets are then used to extend financing to produce a return greater than the floating-rate payments to the sukuk certificateholders. Any losses are borne by the investors. The excess amount remaining in the reserve account beyond that required to redeem the sukuk at par are paid to the bank as an ‘incentive payment’.

This structure creates a perverse incentive for the bank. If they are able to generate sufficient returns to cover the periodic payments plus redemption at par, they receive the excess profits. If their investments fail to produce sufficient returns to make periodic payments and redeem the sukuk at par, the investors bear that loss. If the returns are insufficient to cover the periodic payments and redeem the sukuk at par, but the sukuk assets are valued at par, then the bank pays out the difference between the actual returns and the variable-rate profits, which are then an additional cost to the bank.

The incentive created is for the bank to take excessive risks with investors’ capital to generate a return greater than the cost of capital because every dollar generated above the profit rate will flow to the bank, while any losses from adopting the riskier approach will be borne by the investors (although the bank will likely be hurt as well through the impact on its capital and ability to raise money in the future). This seems disturbingly close to the ‘heads I win, tails you lose’ incentive created in the banks that failed during the financial crisis.

Conclusions

One possible solution would be for the bank to adopt a musharaka structure instead, especially since the bank commingled assets with the mudaraba assets. In the musharaka, in contrast with the mudaraba, the losses are shared between both parties based on the assets contributed to the joint venture. This would align the incentives of each party better and make it less likely that the risk taken on by the bank was closer to optimal from the perspective of the sukuk investors.

This post is far from complete in the discussion of the issues of ijara, mudaraba and musharaka sukuk, but it is my hope that it will be a starting point for further discussion about the future of sukuk structures. The sooner this discussion occurs within the industry, and most importantly with the Shari’ah scholars who can provide the Shari’ah-compliance perspective that I cannot, the better suited the Islamic finance industry will be for the recovery in financial markets and the flood of new issuance sure to come when the recession ends. If this introspection makes its way into new issuance, there should be greater certainty about the rights of sukuk investors should another crisis occur (which it most certainly will at some point).

Islamic finance should focus on poverty; Dubai World fallout, updates

The Senegalese president Abdoulaye Wade says that Islamic banks should fight poverty, including in Africa. In related news, Bahrain became the home of a new Shari'ah-compliant microfinance bank, Family Bank of Bahrain. The bank is based on the Grameen Bank model and is majority (63%) owned by the Royal Charity Organization and the Social Development Ministry, with the remainder owned by Kuwait Finance House, Ahli United Bank, Bank of Bahrain and Kuwait and Ithmaar Bank.

These two stories illustrate something important that has been somewhat sidelined in the attention paid to sukuk and other institutional forms of Islamic finance. There is a strong social mandate in Islamic finance and microfinance, both within the Gulf and in other countries, can play a part in fulfilling this mandate. It is also clear that there are many things that microfinance cannot accomplish in terms of poverty reduction, but the Islamic financial industry has largely overlooked the role that microfinance can play in fighting poverty and promoting greater economic equality, which is often cited as one of the fundamental reasons for Islamic finance to exist. I will be interested to see how the microfinance bank develops and if any readers of this blog have information about the products it uses, please email them to me at blake@sharingrisk.org.

An article overviews the impact of Dubai World and Nakheel debt problems on the Islamic finance industries. One of the important conclusions to the article is the claim that "One thing remains certain: Islamic institutions were no different than conventional bankers in ignoring the speculative frenzy that took Dubai by storm and incurred massive losses for many sukuk holders." This is an important point because Islamic banks in the GCC have relatively large exposure to the real estate markets. Regardless of the structure used in the financing, whether conventional or Islamic, a steep decline in real estate values had an impact on the ability of debtors to repay their obligations. There may have been aspects of conventional financing markets that accentuated the decline in these investments, but that does not mean that the crisis avoided having an impact on Islamic financial institutions with large real estate exposures.

The Dubai World debt problems may move into a new phase if reports that a standstill agreement is imminent are accurate. The standstill agreement would protect Dubai World from creditor's claims for six months while a restructuring plan is created and agreed upon. The Nakheel 2 sukuk is scheduled to pay a periodic distribution of $10.3 million on January 19, 2010. Meanwhile, Barclay's Capital recommended that sukukholders sell their sukuk because the current trading value exceeds their projection for recovery values of 40 to 50 percent of par.

Other News

• The National newspaper has a long article about the pending merger between Islamic mortgage firms Amlak and Tamweel.
  
• Bursa Malaysia was the largest location for new listed sukuk with 12 issues totaling $17.6 billion. The first listing occurred in August 2009.
  
• Australia's government said in a report that Islamic finance should be placed on an equal tax footing with conventional financial services.
  
• Morocco, which has lagged in Islamic finance, reduced the value-added tax applicable to Islamic financial products.
  
• Bangladeshi finance company Bank Asia Limited began offering a musharaka financing product. Musharaka is largely underused by many Islamic banks compared to murabaha and ijara.
  
• A report from Alpen Capital, an investment banking firm, says that takaful will grow by 16.1% in the Gulf during 2010, faster than conventional insurance. The growth in takaful has lagged the overall Islamic finance industry and is far smaller. Alpen Capital estimates that it will be $3.5 billion in the Gulf at the end of 2010. One of the interesting differences between takaful companies and conventional insurers highlighted in the report is that takaful providers are reliant upon a smaller investment universe including real estate and equities in addition to mudaraba and wakala placements with Islamic financial institutions. The lack of sukuk products could limit the growth of takaful if there is another decline in equities or real estate values.
  

Are ijara sukuk debt or equity?

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.

Friday bullets

• An executive of Kuwait Finance House told Al Arabiya that the bank will launch a $250 million investment fund focusing on Canada.
  
• An article, not focused on Islamic finance, describes the pitfalls facing Dubai in the coming months after the recent debt crisis.
  
• Islamic banks in Yemen are mismanaged, according to an economist. The economist, Ali Al-Wafi, described, "Unfortunately, in spite of attracting capital, the Islamic banks in Yemen could not manage the capital collected efficiently [...] the main problem of capital management, restricting the performance of Islamic banks in Yemen, is that administrations of these banks monopolize the use of the capital and divert it for investing only in the businesses of certain privileged segments of the society."
  

Tuesday bullets

• DP World made a periodic payment on its sukuk yesterday, signifying that it may escape much of the crisis in Dubai that centers around real estate.
  
• Thailand may see the first sukuk issued in the first quarter of 2010.
  
• Islamic finance may find opportunities in financing shipping and the deterioration in the global economy may present opportunities for the industry to acquire assets at a discount.
  
• Gatehouse Bank is launching its trade finance fund, which it will offer with DDCAP Limited.
  
• Cyprus may try to attract Islamic finance with regulatory changes and the 'establishment of a framework to attract Islamic finance'.
  
• Gulf Finance House wrote down its exposure to Dubai through the Legends Project, which it said accounted for all of its material exposure to Dubai.
  
• The high court in the Indian state of Kerala blocked the formation of an Islamic venture capital bank partially financed by a state-owned company.
  

A new structure for mudaraba sukuk

One of the big unknowns for the sukuk market over the past two years is what would be done to incorporate the new rules laid out by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) relating to the structure of mudaraba sukuk. The ruling, which came in February 2008 (pdf), restricted the repurchase of mudaraba sukuk. Prior to that ruling, it was common for issuers (primarily Islamic banks) to issue mudaraba sukuk with repurchase agreements that stipulated a repurchase upon maturity of the entire par value. The AAOIFI rules were clarified with regards to loans to cover shortfalls:

"It is not permissible for the Manager of Sukuk, whether the manager acts as Mudarib (investment manager), or Sharik (partner), or Wakil (agent) for investment, to undertake to offer loans to Sukuk holders, when actual earnings fall short of expected earnings. It is permissible, however, to establish a reserve account for the purpose of covering such shortfalls to the extent possible, provided the same is mentioned in the prospectus."

And to the redemption amount:

"It is not permissible for the Mudarib (investment manager), sharik (partner), or wakil (agent) to undertake {now} to re-purchase the assets from Sukuk holders or from one who holds them, for its nominal value, when the Sukuk are extinguished, at the end of its maturity. It is, however, permissible to undertake the purchase on the basis of the net value of assets, its market value, fair value or a price to be agreed, at the time of their actual purchase".

The example of a post-AAOIFI sukuk is the recently-issued SAR775 million ($193 million) Saudi Hollandi Bank subordinated, callable sukuk. The mudaraba sukuk, priced at 190 basis points over the Saudi Interbank Rate (SAIBOR) and is callable annually in and after 2014 until the year prior to its maturity in 2019. If the sukuk is not called in 2014, the expected profit payments are increased by a step-up margin for the final five years. The sukuk was issued to finance the expansion of the bank's Islamic finance business and is Tier II capital.

The important aspects of the Saudi Hollandi Bank sukuk from the perspective of the AAOIFI ruling is how the periodic payments and redemption value are determined. Under normal situations (i.e. outside of a default or winding up of the bank), the capital provided will be used in the Islamic banking business of Saudi Hollandi Bank and can be commingled with assets provided by the bank in this business. The net income is defined as the income minus direct costs of the Islamic finance business and any allocated costs and minus the current year provisions of Islamic finance business. This income is divided according to a profit-sharing ratio between the bank (10%) and sukukholders (90%).

If the net income exceeds the periodic distribution amount (the SAIBOR+190 basis points times the par value times the days in the period divided by 360 days), then the periodic payment amount is made and the excess is placed in a reserve account. If there is a shortfall, the difference is paid from the reserve account. If there is not sufficient funds in the reserve account, the shortfall is subtracted from the final redemption value (Condition 7(g): "If the monies (if any) standing to the credit of the Reserve are insufficient to cover such shortfall, the Issuer shall have the right to set off any such amounts due from the Sukukholders against the Redemption Amount to be paid to them by the Issuer pursuant to the Mudaraba Agreement."). At the redemption of the sukuk, if there is then a positive amount remaining in the reserve account, it is first used to cover any shortfalls in the redemption amount, with any remaining amounts paid to Saudi Hollandi Bank as an incentive payment.

This is a significant difference from how mudaraba sukuk worked before the AAOIFI clarification where the issuer would make an interest-free loan to cover any shortfalls in the periodic payments. There is also a difference in the redemption amount calculation. The redemption value at the maturity in 2019 will be "the aggregate face value of the Mudaraba Sukuk payable upon the redemption of the Mudaraba Sukuk by the Issuer upon the occurrence of the Expiry Date, the Optional Expiry Date, Regulatory Dissolution Date or the Event of Default Date, less any loss relating to the Mudaraba Assets not covered by the monies (if any) standing to the credit of the Reserve". There are some restrictions on redemption under the call provisions that protect the sukukholders relating to the value of the mudaraba assets. The bank can call the sukuk in the 5th, 6th, 7th, 8th and 9th years, but only if the redemption amount is not below the face value of the sukuk.

Things get difficult for investors, however, in the case of a default. Because the sukuk was issued as Tier II capital and is subordinated debt, the investors are not provided sole recourse against the assets of the mudaraba. The prospectus describes: "The obligations of the Issuer are not secured by any assets or security and are subordinated." The subordination is further described: "All payments by the Issuer to the Sukukholders of the Redemption Amount pursuant to the Mudaraba Agreement and all other amounts payable under each Transaction Document [...] will be subordinate in right of payment upon the occurrence of any Winding Up Proceeding of the Issuer to the prior payment in full of all deposit liabilities and all other liabilities of the Issuer, except in each case to those liabilities which by their terms rank equally in right of payment with or subordinate to the Subordinated Payment Obligations."

The Saudi Hollandi Bank sukuk is a new look for the mudaraba sukuk from what was common prior to the AAOIFI clarification and includes several changes that make it behave differently from conventional subordinated debt. There are changes that shift some of the risk that the mudaraba does not generate income sufficient to cover what are otherwise fixed payments and uses a reserve account to smooth payments over the term of the sukuk. One area of concern is that the sukuk creates greater risk for the investors without any corresponding potential return.

The aspect of the structure which confers greater risk without corresponding return is the structure of the reserve account. If the bank makes significant profits, the amount it must pay out to the sukukholders is limited to the specified return on the sukuk and further limited because in such a case, it may be advantageous for the bank to redeem the sukuk (assuming it is permitted by the Saudi Arabian Monetary Authority). Any excess return remaining in the reserve account is paid to the bank as an incentive payment. On the flip side, if there is a loss, the investors bear it in full.

This structure, while creating an incentive for the bank to maximize profits so as to generate earnings, it may also create an incentive to take on additional risks because the downside is borne by the sukukholders while the bank retains the upside. This incentive risk is somewhat minimized because equity shareholders should recognize that the regulatory requirements would force the bank to raise additional capital if it began making significant losses which could be dilutive to shareholders. However, this relies upon strong corporate governance, which may not be present (for example, see Lehman Brothers and Bear Stearns).

That caveat aside, the mudaraba structure used by Saudi Hollandi Bank is probably preferable from an 'authenticity' perspective to the 'old' mudaraba structure which used a repurchase agreement at par to redeem the sukuk regardless how the assets that supposedly were backing it performed. The development of sukuk and other Islamic financial products that substantively differ from conventional products (as opposed to mimicking them) will not happen overnight. It is likely to be a slow evolutionary process and the Saudi Hollandi Bank sukuk represents one step in that evolution.