Monday, November 05, 2012

Equity-based sukuk (IFSB proposed rules on capital adequacy)

The last post I wrote on the new IFSB capital adequacy rules was flying a little blind (working just off of an article describing the changes).  Now I have had a little time to go through a small part of the proposed rules, and it does in fact look like some forms of sukuk will be treated as capital.  Here's a few sections from the rules (see pages 8-9 of this PDF version):
Subject to Sharī`ah approval, an IIFS may issue equity-based Sukūk against the assets owned by the IIFS that are able to absorb the related losses so as to qualify for inclusion in Additional Capital.
Repayment of principal through repurchase or buyback is allowed subject to supervisory approval without any expectation of repayment being created by the IIFS.
minimum maturity of the instrument shall be at least five years...must not have step-up features (i.e. periodic increases in the rate of return) and is without any other incentive to the issuer to redeem it...the issuer is permitted to exercise a call option only after five years and subject to certain requirements such as: (i) prior supervisory approval; (ii) no call expectation is created by the IIFS; and (iii) ability to replace the called instruments with the same or better quality of capital, either before or concurrently with the call.
The contract should provide that non-distribution of profits would not constitute a default event. Distributions should not be linked to the credit rating of the IIFS, either wholly or in part.
The amount paid at issuance is neither secured nor  guaranteed by the IIFS or any related entity. In addition, there should not be any arrangement that legally or economically increases the seniority of the instrument’s claim in the case of liquidation.
The types of sukuk this would include are mudaraba and musharaka, where the sukuk investors are taking a quasi-equity investment in the financial institution, albeit at a higher level of priority than common equity.  However, the types of sukuk that would qualify under these rules would probably share features with the hybrid Tier 1 sukuk being sold now by ADIB: a perpetual, callable (after >5 years) sukuk where the distributions are dependent upon the underlying performance of the bank, and with the ability to see distribution fall if profits come in below the amount required to fund the anticipated coupon.

In general, however, I would expect this type of instrument to function similarly to how some of the mudaraba sukuk have been designed post-AAOIFI clarification, with features included that will lead to a greater probability that the anticipated dividends will be paid on schedule.  This is typically set up so that the profits generated are allocated between the bank (mudarib) and sukuk holders (rabb ul-mal) in a preagreed split.  The dividend amount is based on a benchmark interest rate plus a spread, and is paid out of the investors' share of profits.  Any excess is placed in a reserve account to 'top up' future distributions if there is a shortfall in profits below the benchmark plus spread.

It is not clear exactly how the loss-sharing aspect will work within a mudaraba sukuk, except that in general the rabb ul-mal is supposed to bear all losses, and will, with the exception of funds remaining in the reserve account.  The key point is that most mudaraba sukuk allow the bank to use the funds alongside its own funds, so there will have to be some breakdown of any losses between the bank's invested capital and the mudaraba between the bank and sukuk holders.

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