IFSB considering changes to capital adequacy requirements, ADIB may issue a sukuk which qualifies

The IFSB is considering which sukuk will qualify as capital under the more stringent Basel III requirements, and "'For issuing sukuk as part of bank capital we have proposed different types of sukuk,' [IFSB Spokeswoman Rose] Halim said, adding that sharia advisors where still discussing details."  Meanwhile the article mentions a proposed sukuk issuance from Abu Dhabi Islamic Bank which would be a hybrid Tier 1 perpetual USD mudaraba sukuk.  

Comments from Arqaam Capital available here suggest that the sukuk will likely be a mudaraba structure, with non-cumulative divedends that are fully discretionary and "We think it probably will qualify as Tier-1 under Basel 3 provided it is classified under equity."  This will be a relatively complicated structure to fit within the Basel capital rules, but from a cash flow perspective, it may be relatively more simple with the mudaraba funds combined with the bank's funds, and applied towards the Islamic banking business, with a share of the profits from the mudaraba used to pay the coupons ("Non-cumulative dividends, fully discretionary = Fixed 6 year rate (MS + initial margin), afterwards MS will be reset, not the margin (no step-ups) = No principal loss absorption or non viability absorption (no conversion into shares or write-down of principal).").

This would be different from some of the recent mudaraba sukuk because it would not subject the investor to principal loss based on the bank's capital level, but would probably have excess returns paid into a reserve account that could be used to make up for shortfall in profits below the anticipated coupon.  However, in contrast with other mudaraba sukuk, it would not reduce the principal amount if there were a shortfall in profits; the holders of the sukuk would just see a reduced coupon payment.  

The exact structure is of course unknown until it is released, but it sounds, from the description by Arqaam Capital, that it will be an innovative mudaraba structure that maintains some simplicity in the relationship between risk and reward, without relying (apart from any call features) on a fixed price purchase undertaking, which featured prominently in some of the pre-AAOIFI ruling sukuk that were deemed to have crossed a line.  

Drop your comments here, or over at the new Sharing Risk Facebook page. 

Arcapita's district cooling investment in jeopardy

Arcapita, the Bahrain-based Islamic investment bank currently in Chapter 11 bankrupcty, filed a motion (pdf) that would allow a $1.9 million murabaha financing, with a profit rate of 15%, into District Cooling.  District Cooling is a joint venture with Dalkia Utilities Company that provides district cooling and other services to three developments in Bahrain and Abu Dhabi. 

The financing would be bridge financing while Arcapita and District Cooling renegotiate a concession agreement with Abu Dhabi’s Tourism Development & Investment Company (TDIC) to reduce capital needs by lowering the number of cooling plants at Saadiyat Island from three to two, as well as to pay for diesel fuel and rent for the temporary plants currently in operation on Saadiyat Island, as well as to continue construction required under the concession agreement. 

Arcapita stated in a filing with the Bankruptcy Court that it believes it is in the “ordinary course of business” to fund District Cooling and that it can do so without Court approval, but in response to objections from creditors it is asking for court approval to “support candor” in its disclosure of the transfer of capital to entities not included in the bankruptcy process.

Without the additional bridge financing, Arcapita believes it could lose its entire investment in District Cooling, a minority interest they estimate is valued at $20 million, which includes a guarantee made by Arcapita of a $10 million performance bond from Standard Chartered Bank, Arcapita’s secured creditor. 

Arcapita foresees a “public relations nightmare” that could inhibit its ability to conclude a reorganization plan if it is not allowed to support District Cooling.  It estimates that absent additional funding, Paragon ABD Cooling, the entity providing cooling and other services to Saadiyat Island, will run out of money in late September. 

District Cooling is currently negotiating with Dalkia and TDIC to modify the concession agreement, as well as negotiating with third-party and present investors and Dalkia to provide an exit for ABD that would preserve the value other two subsidiaries of District Cooling, one of which is currently operating at the Bahrain Bay development and another at Al Areen, both in Bahrain.  Arcapita has requested a court hearing on the motion to allow for the murabaha, but the date has not yet been scheduled.

Shari'ah risks are not the only risks to Islamic repo

Repurchase agreements, also called repos, are a common way for conventional banks to manage liquidity needs or to lend out surplus liquidity.  By doing so, the banking industry is able to manage its liquidity in a way that, at least in theory, does not create systemic risks.  This is because a repo transaction is a form of secured lending so that even if the counterparty in the repo transaction goes out of business, the lender can recover the amount lent by liquidating the securities provided as collateral.

The International Islamic Financial Market released a paper exploring the different options for a Shari'ah-compliant version of the repo transaction used by conventional banks.  The paper, which I discussed in a newsletter and in a blog post, had several possible methods for an Islamic repo, but the most likely to be used in practice is likely the collateralized murabaha structure.  A few using the collateralized murabaha have been executed in the market, but there is still not nearly enough agreement on the structure for it to become as commonplace as repos are in the conventional banking industry. 

The National Bank of Abu Dhabi seems to be leading the charge into using the collateralized murabaha structure, since it first executed a one-week $20 million Islamic repo with Abu Dhabi Islamic Bank.  However, moving forward in $20 million or even $100 million increments will not put the Islamic repo into common usage anywhere close to the levels of conventional repos (even when viewed in terms of relative size compared with total assets  in the Islamic banking system). 

Part of that is that it is new, and any new product will start out being used by one institution and other banks will only adopt it gradually.  However, based on the Reuters article describing the discussions at the AAOIFI conference, the entire structure is still facing an uphill climb to gain industry-wide approval from various Shari'ah boards regarding some of the issues associated with the transactions (for example, margin interest and netting exposures by setting off positions against other transactions in similar amounts in the opposite directions).

These are thorny issues, but as the idea of an Islamic repo gains market acceptance, there will be other weightier issues around the systemic risks from repos that will arise outside of the current discussion over Shari'ah issues with repos.  Specifically, if you return to remembering why a collateralized murabaha repo would be an improvement for the industry, it is because the collateralization protects the lenders in the transactions from default by the counterparty since in the case of default they can always sell off the collateral to recover the amount lent. 

The collateralized murabaha repo would presumably give the lender the same right, which would improve on the current commodity murabaha inter-bank lending (which is unsecured).  In the current state, lenders are likely to be more attuned to the risks that their counterparties default since their loans are backed only by the full faith and credit of the counterparty to repay the principal plus profit.  There is no asset they could take ownership of and liquidate so Islamic banks would or should be more hesitant to engage in inter-bank lending with institutions at risk of failing. 

They will be much faster at denying interbank credit to the very banks that need the funding the most to stay solvent and avoid a liquidation of their assets in a fire sale, which could turn a liquidity crunch into insolvency for the bank (which is where the systemic issues begin if the panic spreads to the banks who had been lending to the troubled one).  A secured inter-bank financing market based on collateralized murabaha repos will make Islamic banks more likely to continue to lending to one another even if one becomes troubled since the lender will have the collateral to protect its financing interest in the counterparty. 

The point where a risk remains is "what is the collateral?".  Most conventional repos are backed by government or quasi-government debt and so in most times banks can be assured that there will be a stable market with a ready bid if it ever needed to seize and liquidate the collateral.  The same cannot be said for most sukuk.  There is, in the best of times, a thin market for sukuk and any troubles for the issuers of sukuk lead to sharp sell-offs. 

When sukuk are used as collateral, the lending bank will require a haircut based on the strength of the sukuk issuer and the liquidity of the market for that sukuk, which introduces an inefficiency that, by requiring a higher degree of overcollateralization, will limit the potential for Islamic repos to replace unsecured commodity murabaha inter-bank lending.  Or else, participants in the Islamic repo market will ignore the risks that the collateral itself can play in the repo transaction as a whole, which is perhaps a worse outcome.

The Shari'ah issues probably will be resolved to provide an Islamic repo structure that is accepted widely, mostly out of the need for such a product.  However, the systemic issues underlying the growth in Islamic repo that uses risky collateral will not be addressed as easily.  However, it is incumbent on the industry to recognize these risks, and while the adoption of international financial and accounting standards like the Basel standards should force this issue to the forefront for each institution, it should be another reminder of the importance of ensuring a large supply of high-grade sukuk with a liquid secondary market behind it.

Green sukuk and oil exports

Bloomberg has an article about the prospects for a green sukuk coming out of the GCC (with suppport from Australia's National Australia Bank and Abu Dhabi-based Clean Energy Business Council).  One thing I noticed in the article that, while it makes sense if you step back, seems odd at first glance was the statement that: "Building a renewables industry allows more crude to be exported, said Indraj Mangat, a partner at Eversheds LLP". 

The idea that renewable energy development would be promoted in order to export more crude oil sounds contradictory, but it is not necessarily so.  In 2008, 4 of the top 10 countries in terms of carbon emissions per capita were located in the GCC (Qatar [1], UAE [3], Bahrain [5], Kuwait[7]) with Saudi Arabia [13] and Oman [14] not far behind.  Although some destinations for the oil and gas that would otherwise be exported (e.g. US and Canada) are not much better in terms of carbon emissions per capita, many destinations are (e.g. European nations, South Korea, Japan and China). 

The per capita carbon emission might not be the ideal measure (carbon emissions per unit of GDP is probably better, and comes up with slightly different results): Qatar [18], Bahrain [20], Kuwait [25], Saudi Arabia [26], UAE [36], Oman [39].  The real change here is whether the export markets are less carbon intensive than the GCC (which would make the shift away from domestic consumption of oil and gas towards renewable): USA [54], UK[115], Germany [92], France [144], Japan [96], South Korea [58], China [10].  Substituting oil that is sent to China will not reduce the overall carbon footprint because it will be used relatively inefficiently for creating GDP, and there will be marginal savings for oil sent to the US.  However, South Korea, Japan and European countries will convert the carbon emissions from the barrel of oil more effectively in creating GDP and there will be a net carbon savings relative to the GDP that is created. 

TAQA goes east with a sukuk

Abu Dhabi National Energy Company (TAQA) has issued a 10-year ringgit-denominated sukuk, which was met with strong demand, continuing a trend for GCC issuers to look east to Malaysia for capital to diversify funding sources.  In the past, I have suggested that some issuance in ringgit may be an effort to speculate on the direction of the Ringgit versus the US dollar (to which GCC currencies are pegged).  This has been speculation on my part (with the ringgit-dollar exchange rate at the highest point in at least 6 years, a fall in the value of the ringgit would reduce their obligations in principal and profit).  However, it appears that TAQA does not have this objective in mind since they swapped the exposure into US dollars at a rate of 5.3% (the ringgit rate on the sukuk was 4.65%).  The 10-year tenor of the sukuk is longer than most of the issuance out of the GCC (where 5 years is favored) so perhaps it was the ability to find demand for longer-dated sukuk (perhaps based on a more liquid secondary market) was the reason for looking to KL. 

Kazakhstan Islamic finance hits speed bump

Kazakhstan's Islamic finance ambitions appear to hit a speedbump according to an article by Alastair Marsh in FT Tilt.  The article reports that Al Hilal Bank, the country's only Islamic bank (owned by the government of Abu Dhabi) had its license suspended for having too little equity capital, which the Abu Dhabi government says has been fixed and was due to large losses in its first year.  In addition, progress on a sovereign sukuk is slow, partly because of concerns that a sukuk would be significantly more expensive than a conventional bond.

Where will sukuk markets gravitate?

The markets for Dubai's sukuk are giving the "all clear" with yields falling and the spread between Dubai's sukuk and Malaysia's sovereign sukuk falling to their lowest levels (the Malaysian sovereign sukuk was issued last summer). There are other articles giving warnings of the effect of the protests in many countries, with Bahrain causing the greatest effect on the Islamic finance industry.

The disruption caused by the protests is unfortunate for Bahrain which saw its financial industry grow to around one-quarter of the economy before the protests after capturing share from Beirut in the 1980s after the beginning of the Lebanese civil war. Now the protests in Bahrain could shift the center of finance--and Islamic finance in particular--elsewhere in the GCC if the disruption continues. The old saying about finance reminds that markets and financial firms, while taking risk, will avoid uncertainty. However, despite the disruption to business activity in Bahrain the Central Bank has continued its sukuk issuance with one sukuk al-salam recently that was heavily oversubscribed. However, the yield of 1.15% was sharply up from six months ago when the CBB issued a sukuk al-salam paying just 0.67%.

Even before the protests, the center of sukuk issuance was seen as shifting away from the GCC with Malaysia being the destination of choice for issuers with its much more liquid secondary markets. Although I still belive (as I predicted at the end of 2010) that this would slow and begin to shift back towards the GCC, it will probably take longer than I expected with the disruption in one of the financial capitals in the region. However, given that there has been limited spread in protests to Saudi Arabia, the UAE and Qatar, there should still be issuers looking to issue sukuk domestically (like, for example, Bank Al-Jazira, which just issued a SR1 billion ($267 million) sukuk).

One factor that could be slowing the return of issuers to the GCC besides the events in the region is the currency: the ringgit is the strongest it has been in 13 years against the dollar, to which the GCC currencies are pegged. Given the tendency of financial prices to revert to the mean in the longer term, this would benefit issuers from the GCC who issue sukuk at current levels because their repayment obligations is in ringgit and if the currency returns to the average level over the past five years, it would effectively reduce their local currency obligations. As the ringgit appreciates, it would be expected that this affect would be diminished and coupled with a return to calm in the GCC would encourage issuers to look more to the local GCC markets.

Within the GCC, the impact of the instability in Bahrain will probably lead to a shift of Islamic finance activities--particularly if the protests continue--to another country. While the resolution of some of the Dubai World troubles with cash payments being made to creditors will remove some uncertainty around the Dubai situation, it is unclear whether it will be the preferred destination for any financial institutions fleeing Bahrain. Perhaps Qatar, with its 2022 World Cup, or Abu Dhabi will become the destination. Or perhaps, Saudi Arabia, with its mortgage law expected to come into effect in 2012 will have its bid as a hub for Islamic finance become as significant as its economy's size within the GCC.

An Islamic repo coming to market

The National Bank of Abu Dhabi announced that it will launch a murabaha-based Islamic repo (repurchase agreement) product in March. I believe this would be the first Islamic repo. The few details in the article suggest that it is similar to the structure proposed as most likely by the International Islamic Financial Market (IIFM) . That structure (and likely the NBAD structure) essentially create a secured commodity murabaha contract. The two parties engage in a commodity murabaha transaction (sale of a commodity with deferred repayment), but unlike a normal murabaha transaction, the borrower pledges a pool of sukuk to secure the repayment.

This transaction is not terribly innovative on its face. The main difference between this transaction and a commodity murabaha is the pledge of sukuk as collateral. There are other add-ons that could be part of the transaction. For example, the transaction could be structured so that the buyer (lender) can re-hypothecate the sukuk (i.e. use it for its own purposes, including by using it to engage in repos with other counterparties). This would differentiate the repo from commodity murabaha transactions because it ties up assets of the bank for the length of the transaction.

The downside of the repo transaction is that it further limits the potential for secondary market liquidity in sukuk because holders of sukuk will use the repo market as an alternative way to make their holdings liquid. Thus, they will be less likely to offer their sukuk holdings in the secondary markets that are already limited in the supply of sukuk being offered. The flip side of this is that it could benefit the primary markets for sukuk because investors (depending on the quality of the issuer) would be able to generate liquidity from longer-term sukuk than they can today. It could also reduce any illiquidity premium that is priced into current sukuk offerings, which would make sukuk more competitive with conventional bond offerings.

The one area of caution that the article raises is that repo transactions were used by Lehman Brothers to clean up (manipulate) its balance sheet at the end of each quarter (window dressing). By "selling" assets around the date when financial information is reported and using the proceeds of the loan (which was classified as a sale and thus not debt) to pay down debt, it was used by Lehman Brothers to reduce the level of indebtedness reported in its financial statements. This is certainly a possibility within Islamic finance, but the lending contracts are more cumbersome, raising the cost of repaying and reborrowing debt. However, the real lesson is that the practice (called Repo 105 and Repo 108 by Lehman Brothers) should be discouraged by regulatory bodies.

The details of the specific NBAD Islamic repo are not yet known, but can be guesstimated based on the IIFM paper on possible structures. Islamic repos--particularly if the pledged sukuk cannot be re-hypothecated--will not do much to reduce the reliance on commodity murabaha, but it can increase the liquidity management options available for Islamic banks, which should (given enough controls to prevent abuse) make Islamic banks more stable. One of the secondary effects could be a reduction in the spread between conventional bonds and sukuk, which could increase the appetite by issuers to choose sukuk. This on its own could help the secondary markets because investors might shed their hold-to-maturity outlook, at least those investors who maintain that attitude because of a shortage of replacement sukuk in either the primary or secondary markets.

Wednesday bullets

• The Islamic Development Bank plans to sell $1 billion in sukuk to fund development projects. It also listed its RM1 billion sukuk medium-term note program on Bursa Malaysia under the exempt regime, which means it will not trade or be quoted on the exchange.
  
• Returns on sovereign sukuk are beating returns on corporate sukuk for the first time since May.
  
• CIMB Islamic expects $25 billion in sukuk issuance in 2010 compared with $20 billion in 2009. Bloomberg updated its list of sukuk sales.
  
• Abu Dhabi Islamic Bank signed a $300 million loan facility with Al-Jaber Energy Services.
  
• Dubai says it has no plans to request a rating from a rating agency or issue bonds. It currently has open a $2.5 billion Islamic medium-term note program and a $4 billion plan for conventional bonds.
  

Islamic foreign exchange forward contracts; halal participation banking?

Malaysian scholar Shamsiah Mohamad, who is a member of the Securities Commission Shariah Advisory Council, said that muwa'adah is a valid contract for foreign exchange contracts. Muwa'adah is a mutual promise in forward foreign exchange contracts and has been ruled impremissible by AAOIFI. The trading of currencies in forward markets is viewed as prohibited because currencies (taking the analogy from trading of gold and silver, which were used as dinar and dirham coins) must be traded only in the spot market. The distinction made with muwa'adah by the scholar is that the forward trade is a promise, not a contract because "it is not a sale and purchase contract because specific words must be used to enter into a contract in Islam". The controversy emerges because AAOIFI has ruled that the transaction (the binding mutual promises) does represent a contract and therefore cannot be used for foreign exchange futures contracts. It is one more example that the fiqh surrounding financial matters is still evolving in many areas and--whether it leads to positive or negative outcomes for the industry--it does represent an area of uncertainty in Islamic finance.

Rushdi Siddiqui's latest article in Gulf News deals with whether Islamic banking needs a rebranding. I have heard him speak a number of times and he has articulated the need to move beyond the 'Islamic' brand and the use of Arabic names for contracts to become more 'familiar' or 'accessible'. In his article, he ends with a combination of two ideas for Islamic banking: 'Halal Participation Banking', which combines the idea of that which is halal (which has been successful in the food industry) with participation banking, the name for Islamic banking in Turkey. I think it will be difficult to change the description of Islamic banking as 'Islamic', but that should not deter anyone from trying. In particular, the use of "participation" as a descriptor of the Islamic banking system is a good one in my opinion because it represents a reminder that Islamic banking differentiates itself as one where 'risk sharing' is an important idea. It may be used in practice less often as many Islamic financial products have replicated conventional financial products, but it provides a more clear explanation of how Islamic finance is designed to differ from conventional finance. It is also a phrase which can more easily convey the difference (in theory) with conventional finance and can be more easily be grasped by non-Muslims who may agree with the ideas of Islamic finance without even realizing it because of the use of Arabic terms and the 'Islamic' or 'Shari'ah-compliant' label.

Other News

• South Africa has a proposal to modify its tax laws to place Islamic finance on equal footing with conventional footing by treating the profits in Islamic finance in a way equivalent with its treatment of interest in conventional transactions.
  
• The latest Central Bank of Bahrain Sukuk al-Ijara was oversubscribed 630% with BD63 million in subscriptions received for the BD10 million ($26.5 million) issue.
  
• Abu Dhabi Commercial Bank issued the first sukuk in its RM3.5 billion ($1.1 billion) sukuk program for RM500 million at 4.75%.
  
• Bloomberg has an article about the IIFM report on Islamic repos, which I discussed after it was released.
  
• An article describes the potential of Islamic finance in Russia and adds that state-controlled VTB Bank, which has had a sukuk in the pipeline for several years, will issue its sukuk for $200 million in the second half of the year, citing a Reuters report from April.
  
• Dubai's oldest Islamic bank, Dubai Islamic Bank, reported lower income in its second quarter financial report. It did not reveal its exposure to Dubai World. DIB owns 20% of Tamweel, the troubled Islamic mortgage company, and Deyaar, a Dubai-based property developer. Tamweel, which is in merger talks with Amlak Finance, another Islamic mortgage company in Dubai, reported positive income for the most recent quarter.
  
• A takaful provider, Dar Altakaful, launched a takaful policy for horse owners if their animal dies or becomes injured.
  
• An article in Bloomberg discusses the growth of Islamic investing in Malaysia with the entrant recently of international companies like Saturna Capital, the parent company of the Amana Funds in the U.S.
  
• Gulf Finance House is planning to raise additional capital--the second time in less than a year--and has delayed reporting its results.
  
• Ithmaar Bank reported its first results as an Islamic retail bank since its reorganization with its former subsidiary Shamil Bank.
  
• Bahrain Financial Harbour Holding Company repaid a $134 million sukuk.
  

Thursday bullets

• The head of Shari'ah and CEO of IIMF believe that greater transaction document standardization, like the Master Agreement on Treasury Placement released by IIFM, will benefit the industry.
  
• There are a number of articles on Khazanah's S$1.5 billion ($1.1 billion) sukuk, including from Bloomberg, AsiaOne News and and Reuters.
  
• The Deputy Governor of the Central Bank of Malaysia gave a speech at the 21st Conference of Presidents of Law Associations of Asia on Islamic finance. The full text is available as a pdf.
  
• Al Rajhi Investment and Banking Corporation Malaysia Bhd, a subsidiary of the Saudi Islamic bank Al Rajhi Bank joined the Bursa Suq Al-Sila', the commodity murabaha/tawarruq platform in Malaysia.
  
• An article offers a few details about the Family Bank Bahrain, an Islamic microfinance institution that is working with the Grameen Trust.
  
• An article published by Zawya, written by three lawyers at King & Spalding, covers the different trends in how Islamic financial products are taxed.
  
• BMB Islamic released its Global Islamic Finance Report 2010, which in addition to describing the industry's growth also acknowledges that there is a shortage of authentic data on the size, growth and performance of the institutions making up the industry.
  
• The Maldive's Monetary Authority issued the first Islamic banking license to Maldives Islamic Bank Pvt. Ltd.
  
• Bloomberg has another article about the potential for growth in sukuk issuance from Asia while the GCC primary markets are at their slowest pace since 2005.
  
• A commenter for the Guardian Michael Tomasky takes a look at Islamic finance and realizes that the hyperbolic charges leveled against it are ridiculous on further examination.
  
• An Islamic brokerage, Makaseb Islamic Financial Services, in Abu Dhabi is closing.
  
• Malaysian companies Axiata Group Bhd and Malaysia Airports Holding Bhd are planning RM4.2 billion ($1.3 billion) in 7-10 year sukuk and RM3.1 billion ($981 million) in sukuk of unspecified tenor, respectively. The bulk of the Axiata sukuk will be sold to the Employees Provident Fund.
  

Islamic retail banking in the West: Can the US provide an example?

There are a number of articles about the challenges facing the Islamic finance industry that caught my eye in the last couple days but none challenge the conventional wisdom as much as an article from Bloomberg that Islamic banks or conventional banks Islamic windows in the UK have been set back substantially by the recession. Further, there may be too many banks (22) chasing too small a market ($19 billion versus $93 billion in Malaysia). Another article in the Independent focuses on the withdrawal or shrinkage of retail Islamic finance at large banks in the UK. One of the areas where the Bloomberg article flies in the face of conventional wisdom is that the UK government has not supported the Islamic financial industry sufficiently. This contradicts the widely held view that the UK is preeminent among non-Muslim-majority regions in both its level of development and the scope of government support. As much as this challenges these ideas, there is a caveat that is not mentioned in the article: it is mostly focused on the domestic market, not the participation of UK-based banks in the global Islamic finance industry. However, it does set back the idea that Islamic banking can become a widely accepted subset of the domestic financial industry in non-Muslim-majority countries with sizeable Muslim minorities.

On the scale that Bloomberg is looking, there probably is not a large enough market that can easily be penetrated by large institutions and the one solely retail focused and Shari'ah-compliant institution, the Islamic Bank of Britain represents too small a sample to generalize about the prospects for smaller institutions. In this regard, the United States may provide an example of how Islamic banking can be feasible without participation from large conventional banks. The US market--for reasons of regulation and geographical concentration of the Muslim population--has no product availability among the large banks, but under the radar exist community banks, credit unions and non-bank financial companies that provide Islamic financial services. This may be the maximum size that is profitable currently in countries without sizable Muslim populations and that should be recognized as a success. Although the headlines are drawn by the largest and the newest products and institutions, having financial institutions that recognize the value of remaining small enough to serve their customers and avoid overexpansion is a virtue in itself. Not all areas in the U.S. have remained under the radar. For example, the Amana mutual funds have grown over the past decade and two of the funds are the largest Islamic equity funds in the world, in large part because they have transcended their natural market and attracted non-Muslims based on their performance.

Areas of the Islamic financial industry that are not yet able to attract significant non-Muslim participation but are able to avoid growth-at-any cost may not make the headlines, but the experience of the Amana Funds shows that this is not necessarily a failure. The Amana Funds remained small for many years before starting their rapid growth at the beginning of the last decade. Their growth was "supply-driven"; it was "demand-driven" based on their ability to provide a service demanded by consumers both Muslim and non-Muslim based on its performance. There cannot be a direct analogy that could work elsewhere in non-Muslim majority countries, but the contrast could provide lessons for other non-Muslim-majority countries with aspirations to develop a domestic Islamic finance market. Maybe the next decade will be the decade for retail banking.

Other News

• Rushdi Siddiqui has two great articles in Gulf News. In one article he suggests: "For Islamic finance, a lack of Muslim inclusion should be a greater concern than lack of standardisation. When we speak of convergence, it may well entail technology (mobile phone) and banking for the non-bankable Muslims. Hello, is Islamic finance listening at the other end?". In the other, he interviews Dr. Mohammad Nedal Al Chaar, the Secretary-General of AAOIFI.
  
• As the Islamic finance industry grows in Canada, the Rotman School of Management at the University of Toronto is the first to offer a course on the subject for MBA students.
  
• Saudi Binladin Group sold a short-term sukuk with a maturity of 9 months for $187 million (SAR700 million). Most sukuk have a tenor between 3 and 7 years.
  
• Sukuk sales in 2010 are expected to be $23-$25 billion according to a poll by Reuters. This was close to the $23.3 billion issued last year and lower than a poll conducted in April which forecasted $28 billion in sukuk sales. Asa Fitch wrote a good article in The National about the growth of the sukuk market and the rapid decline during and after the financial crisis.
  
• Even after a four-month rally, the yields on Nakheel's sukuk are twice as high as 2007. A credit analyst at S&P in Paris, Mohamed Damak who also is co-chair of the Islamic finance working group for S&P points to this as evidence that the market is still hard to access for real-estate-based companies.
  
• Kazakhstan has resumed planning for its first sukuk, which is not expected soon and will likely be an ijara sukuk of roughly $300 million. There are a number of regulatory issues that need to be dealt with.
  
• Russian bank Vneshtorgbank (VTB) has also resumed work on a sukuk issuance and "a range of other Islamic financial products". The Association of Regional Banks of Russia established a task force on Islamic financial institutions.
  
• An article in Arab News describes the backlash facing Islamic banks in South Africa over high fees. However, the criticism of the high fees are not limited to Islamic banks.
  
• A report about Islamic banking in Indonesia was released recently.
  
• The Saudi Electric Company is planning a fourth sukuk. The timing, size and pricing are yet to be determined.
  
• Abu Dhabi Ports Company is considering a bond or sukuk of up to $1 billion in early 2011.
  
• Bermuda is trying to attract the Islamic finance industry following a trip by the CEO of the Bermuda Stock Exchange to Bahrain.
  
• An opinion piece in China Daily by the program director of the University of Hong Kong SPACE on the development of Islamic finance in Hong Kong, including the areas where it is being held back, particularly in human capital.
  

Thursday bullets

• The Director of Treasury and International Banking at Bank Muamalat in Indonesia says that the country's Islamic banks may be undercapitalized because none has equity exceeding $200 million. In the last three years, the number of Islamic banks has increased from 3 to 10. The Indonesian government may cancel its global sukuk because domestic conventional bond sales may be sufficient to cover the budget deficit.
  
• Nakheel outlined a restructuring plan covering $10.5 billion in bank debt. Creditors have until August 31 to respond. The debt plans are being linked with lowering yield spreads on GCC sukuk.
  
• Nomura raised $70 million from a commodity murabaha facility in the Middle East following its $100 million sukuk issued in Malaysia. The sukuk will be listed on Bursa Malaysia.
  
• Although Abu Dhabi Islamic Bank updated its sukuk program prospectus, it has "no immediate plan" for a sukuk sale.
  
• Paul McNamara, the co-founder of Yasaar Media, wrote a book on marketing for Islamic banks available as an e-book.
  
• Kuwait Finance House may announce a $266 million first half profit according to unidentified sources.
  

Late payment penalties, liquidity management, creating secondary markets in sukuk

An article in Arab News discusses the issue of a fee charged by an Islamic financial institution for late payments. In May, Bank Negara Malaysia's Shari'ah Advisory Council said that charging a fee in case of late payment is allowable and separated out the cases where the bank can and cannot keep it and recognize it as income. In the case where the fee is charged as a fine or penalty (gharamah), it must be donated to charity and not recognized as income. Where the fee is for compensation (ta'widh) for actual loss by the Islamic bank, it can be kept and recognized as income. While the distinction is clear between the two concepts, it seems likely to be difficult to distinguish in practice. Perhaps it might be a better practice for Islamic banks that use this to treat everything as ta'widh until the actual costs of collections are met and only then be able to treat any fees as allowable income. However, it is unlikely that such a solution could be approved because it would not be possible to provide ex ante certainty in the contracts between the bank and its customers. Whether this is used or not, it could allow Islamic banks to increase the total fees to Islamic banking customers, which would make the products less competitive and probably result in a slower growth rate for Islamic banking. It would also complicate the Shari'ah audits because it would require that the fees be reviewed to determine whether the bank has basis for compensation if it used the principle of ta'widh.

A fantasstic article from Islamic Business & Finance discusses the challenges facing Islamic finance in developing short-term liquidity management products, despite their importance. The article specifically looks at the UAE commodity murbaha Islamic CDs, the idea of Shari'ah-compliant repo transactions and an electronic wakala/murabaha platform.

Rushdi Siddiqui has another interesting article in Gulf News, this one covering the issue of where is the hub of Shari'ah transactions, which quickly morphs into the discussion of the lack of a hub. One point that he makes, which I agree with and have made before on this blog, is the lack of secondary markets for sukuk. He takes it one step further adding that even where there are secondary markets for sukuk, they are not deep enough or liquid enough to provide much information. He suggests that the Islamic finance industry needs to 'institutionalize' and 'internationalize' itself, primarily by moving from bilateral price discovery through over the counter (OTC) trading to "multiple price discovery". As much as the effort towards creating secondary market platforms for sukuk will help lay the groundwork for this in the future, it is impossible until there is enough supply to sate the demands of hold-to-maturity investors and leave enough exchange-listed sukuk that can be traded in secondary markets to develop meaningful liquidity that provides more information than bilateral trades in illiquid markets can.

Other News

• Sorouh raised $640 million in conventional and Islamic debt, of which $400 million (AED1.47 billion) will be used to redeem the remainder of the sukuk issued in 2008 which I described about a month ago in a blog post. At the time, there was AED1.5 billion remaining of the AED4 billion securitization sukuk.
  
• Malaysia's central bank, Bank Negara, issued its fourth Shari'ah Parameter Reference which covers musharaka. The previous SPRs covered ijara, murabaha, and mudaraba. The bank also issued a concept paper on takaful.
  
• Bloomberg compares the performance of Shari'ah-compliant equity indices with sukuk indices. Equities have lagged sukuk in the past 2 quarters due to an agreement to restructure $23.5 billion of debt by Dubai World and its creditors.
  
• Japanese firm Nomura Holdings plans to issue a $100 million sukuk in Malaysia, the first Japanese company to do so.
  
• The proposed Islamic Bank of Thailand THB5 billion ($154.5 million) is likely to be issued in the second half of 2010 depending on market conditions. The sukuk will have a 5 to 7 year maturity.
  
• Deutsche Bank's Shari'ah-compliant platform is investing in a foreign exchange strategy, based on "investor demand" according to the managing partner of the advisory firm which will create the strategy using a structured note. Deutsche Bank previously created the controversial Total Return Swap structure that allowed investors to receive a return benchmarked to a group of conventional hedge funds.
  
• Singaporean REIT company Mapletree Investments is launching an Islamic REIT whose IPO may be up to $713 million (S$1 billion). The REIT will be marketed in the GCC by Arcapita.
  

Islamic pricing benchmark, Khazanah sukuk

The International Shariah Research Academy for Islamic Finance (ISRA) in Malaysia is planning to release a study on a proposed Islamic benchmark pricing rate in 2011. The proposal received criticism about the practicality of having two different pricing benchmarks within Malaysia. The criticism has merits and the development of a separate Islamic yield curve would provide limited benefit compared to other areas that the effort required could be directed towards like strengthening Islamic financial institutions' liquidity management. However, if Islamic financial products move beyond replication of conventional financial products and take on different risk characteristics than conventional products, a separate pricing benchmark could be useful for new issuers because the pricing would reflect the balance between supply and demand for Islamic financial products in the secondary markets.

Malaysian state-owned Khazanah Holdings may issue S$500 million ($354 million) in sukuk to finance its purchase of Parkway Holdings, a hospital operator. The sukuk would be the largest issued in Singaporean dollars passing a S$200 million issue from the Islamic Development Bank.

Other News

• The final decision on Tamweel and Amlak, two troubled Dubai-based Islamic mortgage companies could come this month. It is reported that Dubai Islamic Bank is seeking to increase its share of Tamweel to over 50%. Tamweel's statement on its restructuring did not confirm or deny Dubai Islamic Bank's reported plans.
  
• Saturna Capital, the fund manager of the Amana Funds received a fund license in Malaysia.
  
• A credit union in the US is offering Islamic financial services.
  
• Gulf African Bank, one of the first Islamic banks in Kenya, reported a profit in the first quarter of 2010 and expects its first full-year profit this year.
  
• Pakistan hopes to double the share of Islamic banks in the country over the next 3 years, to 12% of total assets. For comparison, Malaysia is set to reach the 20% mark this year.
  
• An article discusses the idea that Dubai World attracted more attention than its overall impact in the financial markets and points out that the reason for the near-default was the financial and economic conditions as well as company-specific factors that were not related to Nakheel using a sukuk rather than a conventional bond to raise financing.
  
• Nakheel has begun paying contractors and may resume construction on some projects "within weeks".
  
• A Malaysian bai bithaman ajil (BBA) sukuk was placed on negative ratings watch. The BBA structure is used extensively in Malaysia, but not accepted in most other countries.
  
• The government of Kazakhstan is supporting Islamic finance in the country with the assistance of Abu Dhabi, whose government owned bank Al Hilal opened an Islamic bank in Kazakhstan.
  

Sun Finance sukuk and Islamic securitizations

I took a good look at the Sun Finance (Sorouh) sukuk documents which were issued at the beginning of the intensification of the financial crisis (late 2008). The sukkuk was a sukuk-al-mudaraba and was issued after the AAOIFI guidance on sukuk, meaning it could not stipulate repurchase at par, which was included through the purchase undertaking not specifically referencing the repurchase price for the portion of sukuk repurchased under the amortization schedule. The sukuk, despite the challenging environment for the global economy and the securitization market, has been successful so far and none of the three rated tranches have been downgraded despite a collapse in the securitization markets.

In the transaction, Sorouh Real Estate ('Sorouh') was seeking to securitize receivables from plot sales to sub-developers in two of its developments, Shams-Reem Island and Saraya. The proceeds of the sukuk were used to fund the mudaraba and those were used by the mudarib, Sorough Abu Dhabi Real Estate LLC ('SPV'), an SPV set up as a distinct entity from Sorouh, to purchase the full title to the underlying plots from Sorouh. The SPV provides the sukuk certificate holders with a beneficial ownership of the plots, while the SPV executed a 'true sale' of the assets from Sorouh. A portion of the sukuk proceeds were placed in various reserve accounts to make up any shortfall in profit payments (Liquidity Reserve), to fund expenses of the SPV (Senior Expense Fund) and to finance the construction of infrastructure on the plots (Infrastructure Fund). The profit sharing ratio between the mudarib (SPV) and rabb ul-mal (sukuk certificateholders) was 1% and 99%, respectively.

The receivables from the sub-developers (all 109 plots were sold by Sorouh to sub-developers before the sukuk was issued) will be paid to the SPV and used make periodic payments on the sukuk. The remainder will be paid to the mudarib (the SPV) as an incentive payment. This amount will then be used to repurchase a portion of the beneficial interest held by the sukuk holders (described in the offering documents as a 'constructive dissolution'). This leads to payment of both the profit on the sukuk assets as well as a principal redemption. The interest rate risk (the payments to sukuk holders of all tranches is based on EIBOR plus a spread) from changes in the benchmark is hedged by the SPV in a separate transaction where it acts in its own capacity and not as the mudarib. At some point, if the sub-developers continue to make payments or the plots are resold in case of sub-developer bankruptcy, the entire beneficial interest held by the sukuk holders will have been extinguished and the SPV will retain the right to the remaining payments.

The unique feature of this sukuk is that it offered three different rated tranches, each with different priority rights and coupon amounts. The three tranches (A, B and C) had successively higher return (spread over 1 month EIBOR) of 200, 250 and 350 basis points, respectively. The three tranches were also accorded different priority for periodic payments with the A tranche senior to the B tranche which was senior to the C tranche. The way the seniority over periodic and principal payments was structured was using a musawama (cost-plus sale where only the final amount is agreed between the parties). At each periodic payment date, each class is paid 2.5 percent of the rabb ul-mal's profit allocaiton and the remainder of both profit and amortization payments are made according to seniority with a musawama between the tranches used to create a non-pari passu payment outcome.

The sukuk has performed well with payments passed on from sub-developers to the SPV and used to redeem the sukuk (see table below which reflects the amounts included on Sorouh's balance sheet, which does not break down the results for each tranche of the sukuk, nor does it provide a way to measure the performance of the sukuk as a whole). However, it does show that the carrying value of the debt on Sorouh's balance sheet has declined throughout the life so far of the sukuk as the cumulative payments made rises.

When the sukuk is viewed in more detail, the structure was clearly made to mirror a multi-tranche securitization deal and the fact that it is Shari'ah-compliant had limited impact on its performance. The use of a non-recourse securitization removes the issuer's financial strength from the picture so long as it is able to continue servicing the receivables (there was a back up servicer specified in the offering documents). The performance of the sukuk reflects the ability of the underlying plot sub-developers to continue paying installment payments on the plots (where the total value of the securitized assets provided overcollateralization for sukuk investors).

This type of sukuk, while in limited use so far, does not provide any additional security compared to a conventional securitization. The quality of the assets used in creating the securitization will ultimately determine its success or failure. However, the general conservative nature of (most) Islamic financial institutions' lending will make it less likely that future securitizations using this model would include questionable assets. Despite this caveat, securitizations could present an opportunity to create debt instruments for investors while also providing Islamic financial institutions with additional capital to expand their lending. Of course, as the subprime meltdown reiterated, if the quality of the securitized assets is poor, then the performance of the securitization is also likely to be poor. There is always the possibility for a securitization crash in Islamic finance if the standards used to evaluate recipients of future financing that is then securitized.

In a rapidly growing industry like Islamic finance, the ability to free up capital on bank balance sheets through securitization could provide a way for additional capital to be lent out while also broadening the number of sukuk for investors looking to Islamic finance. There is an additional potential: conventional investors looking for private-label securitizations will be hard pressed to find conventionally securitized mortgage-backed securities and they could provide additional capitla for Islamic mortgage companies that can demonstrate high lending standards. That would benefit those investors as well as the Islamic finance industry that, for example in the US has relied upon conventional securitization through Freddie Mac and Fannie Mae. Creating an Islamic securitization market for home finance could further expand Islamic finance in Western countries where it is currently limited.

The potential for Islamic securitization is nothing new. Back in 2007, Standard & Poor's released its approach to rating sukuk [1] and stated that:

"We expect that this type of sukuk [sukuk with no credit enhancement from the issuer] will become more popular in the foreseeable future in response to the huge number of projects in the planning stage, particularly in Gulf countries. Changes to regulation in the Gulf could give a boost to this type of sukuk. Banks and regulators in the Gulf are currently considering enhancing the legal framework surrounding mortgage financing for both commercial and residential properties. In the longer run, once sufficient mortgage loan volumes are booked on banks' balance sheets, Islamic securitization will become more attractive."

. The topic of Islamic securitizations was also raised by Andreas Jobst of the International Monetary Fund [2]. He wrote that:

"Since most Islamic financial products are based on the concept of asset backing, the economic concept of asset securitization is particularly amenable to the basic tenets of Islamic finance. [...] Islamic securitization transforms bilateral risk sharing between borrowers and lenders in Islamic finance into the market-based refinancing of one or more underlying Islamic finance transactions. In its basic concept, originators would sell existing or future revenues from lease receivables (asset-based), 'sale-back profit' (debt-based) or private equity from a portfolio of Islamically acceptable assets to a special purpose vehicle (SPV),31 which refinances itself by issuing unsecured securities to market investors, who are the 'capital market corollary' to a singular lender in Islamic finance."

However, those articles were written before the onset of the financial crisis that saw conventional markets for securitization nearly completely shut down. Investors may be more wary of securitizations than they were when interest rates were low and economies strong and anything providing higher yields was sought after. However, the Islamic finance industry may provide an opportunity for securitization to re-emerge with more secure backing and without the additional re-securitizations that were the main impetus for the collapse in the securitization markets. There still remain several obstacles to Islamic securitizations although the relatively successful outcome of sukuk like the Sun Finance (Sorouh) sukuk can provide an example for future securitizations that comply with the new AAOIFI rules on mudaraba sukuk.

[1] Standard & Poor's. 2007. "Standard & Poor's Approach To Rating Sukuk," September 17, 2007.
[2] Jobst, Andreas A. 2007. "The Economics of Islamic Finance and Securitization," Journal of Structured Finance, Volume 13, Number 1. (Working paper)

Sun Finance Sukuk Payments & Remaining Balance, 2008Q4 - 2010Q1

Quarter	Cumulative Payments	Balance	Accrued Profit
2010Q1	AED 2,494,500	1,497,213	98,967
2009Q4	2,041,666	1,940,643	89,563
2009Q3	1,691,923	2,279,300	78,477
2009Q2	n/a	2,843,853	n/a
2009Q1	820,546	3,123,973	51,773
2008Q4	320,873	3,609,919	38,030
At Issue		4,016,000

All figures in AED '000.
Source: Company financial statements.

Dubai World, Saad Group

The Dubai World debt negotiations hit another potential snag with the repayment of the Nakheel sukuk maturing in May becoming more likely even without a restructuring deal. This compounds the issues caused by the offer of a 1% interest rate for banks who are owed money by Dubai World at the same time that trade creditors are offered 40% cash payment with the remaining 60% paid through a sukuk yielding 10%. A top official at Al Ghurair, which is described as a 'key trade creditor' by Emirates Business 24/7, said the 10% profit was "very generous".

I have previously questioned whether the restructuring would incorporate Shari'ah-complaince and there still has not been a complete reporting of this aspect of the restructuring. However, the use of a sukuk to repay trade creditors indicates that Dubai World remains interested in Islamic finance. The big potential problem is the differential treatment of different creditors, most of which are unsecured creditors. Banks are offered 1%, trade creditors offered 10% on a portion with the remaining being repaid while sukuk holders of the sukuk maturing next month receive full repayment. This differential treatment does no favors to Islamic finance because it reinforces the uncertainty about the rights of creditors in one of the largest geographical concentrations of sukuk issuers. This will make it more difficult for issuers to bring new sukuk to market because although the problems are largely Dubai-related, the uncertainty is generalized to the UAE, if not the GCC. Although the debt holders would suffer delays and would probably come out worse for it, for the Islamic finance industry, it may have been preferable for the whole Dubai World mess to end up in the tribunal in front of internationally recognized judges under DIFC law, which closely resembles English law.

Sukuk holders of the Saad Group have agreed to dissolve the sukuk trust. According to a Reuters factbox, the Saad Group sukuk was an asset-based sukuk, which would mean that the dissolution of the sukuk trust does not provide investors with an avenue to recover their money except through a bankruptcy proceeding as unsecured creditors of Saad Group, where they would be treated equally (pari passu) with other unsecured debt holders and subordinated to any secured creditors.

Khalil Jarrar has an interesting column in the latest Opalesque Islamic Finance Intelligence.

My latest article on the East Cameron sukuk was published by Islamic Business & Finance in the latest issue.

Other News

• The World Bank and the International Finance Corporation will be in Malaysia to discuss a Shari'ah-compliant fund for green technology investments.
  
• The relative strengths and weaknesses of using equity vs. debt in Islamic finance acording to an executive at Elaf Bank in Bahrain.
  
• Arcapita is planning to build a fund management business to reduce the cyclicality of revenues in the private equity business. I believe this is something that more Islamic investment banks and private equity houses will undertake to smooth their revenues and reduce the prospects of being severely harmed in future downturns and this is good for the industry as a whole.
  
• The Abu Dhabi Stock Exchange may begin to indicate which investments are Shari'ah-compliant and which are not.
  
• The CEO of a Malaysian invesmtent bank, Alliance Investment Bank, says that sukuk have a promising future.
  
• Kencana Petroleum Bhd, a Malaysian oil and gas services company, is planning to issue $78 million (MYR250 million) in sukuk sales. Cagamas issued $156 million (MYR500 million) in 5 year sukuk that were rated AAA by MARC because Cagamas is state-owned.
  
• Indonesia issued $22 million in sukuk, about 20% of its planned offering. Demand was limited, according to reports, because of limited liquidity in the sukuk.
  
• KPMG in India has expressed support for the development of guidance from the central bank for Islamic financial institutions in the country which have been slow to develop.
  
• The latest monthly commentary abou the performance of the Dow Jones Islamic Market Indexes for April is now available.
  
• Dundee University in Scotland will offer a postgraduate degree in Islamic finance.
  
• AsiaOne has a summary of Islamic finance structures that are commonly used.
  
• The company offering Salaam Halal, Principle Insurance Holdings, has been sold to a Kuwaiti buyer who was one of the largest shareholders.
  
• AAOIFI will hold its annual meeting at the end of May.
  
• The new Christian ETFs will not be a competition to Islamic financial products, but will encourage greater uptake of ethical products, according to an article in the Malaysian Insider.