Oman - A sukuk shortage and housing shortage

As Islamic banks and windows enter Oman's housing finance market, they have the opportunity to use the shortage of Omani sukuk to benefit the entire market without creating too much risk for the government.  For example, with a government guarantee, the risk should be covered by the originators through fees in exchange and limits on the eligible mortgages to ensure it can be targeted specifically at the segments of the market where supply is the most lagging of demand.

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Positive developments for Islamic banking in Oman

The development of Islamic finance in Oman will be aided by several developments recently: the announcement of plans for RO200 million in Central Bank of Oman sukuk, the reported pricing of the country’s first corporate sukuk, and the easing of restrictions for Bank Nizwa (but not for Islamic windows) for foreign placements. Together these developments auger well for the development of Islamic banking in the Sultanate.

There remain challenges, such as the continuing illiquidity in local bond markets that will be accentuated by the demand for yielding assets that will make sukuk a hold-to-maturity type of asset for the Islamic banks. In addition, the lack of tawarruq as a liquidity management tool could lead Islamic banks and windows to hold more cash on their balance sheet than they otherwise would. However, despite these challenges, the roll-out of Islamic banking in Oman has so far proceeded relatively smoothly.

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White Paper on Oman's Entry into Islamic Finance

From the Islamic Finance Gateway

Despite being more than 600 pages long, many industry experts suggest that the Central Bank of Oman's 'Islamic Banking Regulatory Framework' is much more advanced than others in the Gulf, at least from the perspective of remaining true to the core ethos of the sharia. However, for a nascent industry, market participants actually implementing the standards consider the prohibitions a challenge to implement without substantially impairing profitability, particularly those affecting the treasury and capital markets. That said, this might just be THE opportunity to innovate and find authentic sharia-based solutions to advance the development of the Islamic financial services industry.

These and many more issues were brought to the fore by the Islamic finance industry at the forum “OMAN’S ENTRY INTO ISLAMIC FINANCIAL MARKETS” held on the 24th of February. We are pleased to announce that the white paper incorporating the main discussion points and recommendations is now available for download.

You can download the white paper from - http://r.reuters.com/wuk66t

The forum was organized by the Islamic Finance Gateway (IFG) Community (an initiative of Thomson Reuters / Zawya) and was held in collaboration with the General Council for Islamic Banks and Financial Institutions (CIBAFI) and the Islamic Research and Training Institute (IRTI), a member of the Islamic Development Bank Group, with the support of the Capital Markets Authority (CMA).

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Oman’s Islamic banks request additional access to foreign Islamic money markets

Oman’s development of Islamic banking has been surprisingly smooth, so far but the first roadbump may lie just ahead once the country’s new Islamic banks start deciding where to invest the deposits they have been gathering since the beginning of 2013. Specifically, how are they going to manage to earn sufficient returns to satisfy both equity holders and depositors in order to remain competitive with conventional banks in attracting both.

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Oman's CMA releases draft sukuk rules

Last week, in a post I questioned whether there was scope for arbitrage between the restrictions on tawarruq for banks and the rules on sukuk, which were laid out in descriptive form in the Islamic Banking Regulatory Framework, subject to final rulemaking by the Capital Markets Authority (CMA).  In the letter to banks from the Central Bank of Oman (CBO) sent with the rules which I had not seen (and a reader of the blog helpfully sent me), the CBO highlighted that with respects to sukuk, "Licensees shall note that business, authorized under IBRF will be subjected to general/specific approvals and restrictions.  Licensees should, in particular, note that certain enabling provisions/reference to Sukuk, Securitization, subsidiary etc., in-built for possible roll-out, do not accrue to Licensees automatically and shall depend upon future policies/authorizations/enablers"

Now that the CMA released rules, there are a few additional safeguards to avoid murabaha sukuk to be used by non-banks as backdoor sources of tawarruq which are interesting not only for Oman, but for Islamic finance in general in providing sufficient transparency for both regulators and for sukuk holders, that will provide more benefit than just cutting off potential for regulatory arbitrage.  The CMA draft rules (PDF) state:

The Sukukholders' agent shall monitor the Obligor's and the Sukuk Issuer's performance in respect of their obligations as mentioned in the prospectus, and shall seek to protect Sukukholders' interests. In particular, it shall be responsible for the following:
[...]ascertaining that the funds raised through the issue of the Sukuk are utilised in accordance with the prospectus;

The rules from the CBO already restrict sukuk issuers from issuing sukuk for "general unspecified purposes".  Whether or not that limits the use of sukuk for 'general working capital', there will be some oversight from the CMA on each individual sukuk, since they must be reviewed and approved by the CMA, and the Sukukholders' agent has an obligation to ensure that the funds are used for the approved purpose. 

It will be interesting to see the first few sukuk issued from Omani companies to see how specific they are on the use of the proceeds, and whether it could be applied in other countries to make sukuk offering documents more transparent. 

Oman's prohibition of tawarruq and murabaha sukuk

The Omani banking law is notable in many ways, but the most discussed way is that it prohibits--with very few exceptions--the use of commodity murabaha (tawarruq) (CMT).  The exceptions are narrow: an Islamic bank is permitted to use CMT if its "survival is genuinely threatened, or in case of a conventional bank's conversion into Islamic where no other alternative mechanism exists to convert part or all of its portfolio, as determined by the bank's SSB".  Any use of the CMT requires Central Bank approval, which should be effective in limiting the times it is used.  In any case, it cannot be rolled over and so it can only be used for three months. 

However, the concept of murabaha is usable, in particular, through sukuk.  The Islamic banking law describes: "Murabaha Sukuk are certificates of equal value issued for the purpose of financing the purchase of goods through Murabaha, in which the certificate holders are granted ownership of the Murabaha commodity".  The transaction has four steps:

1) The SPV set up by the company looking to finance the acquisition of a particular asset and issues sukuk certificates, selling them at par;
2) The SPV buys the asset needed by the company (the originator), using the proceeds of the sukuk issuance;
3) The SPV sells the asset to the originator in exchange for the commitment of the originator to pay their value, plus a fixed profit margin, with set payment terms;
4) The originator makes payments and when the final payment is made (either of the par value if it pays profit during the term of the sukuk or of the full cost plus profit amount) the proceeds are passed along to investors and the sukuk certificates are redeemed.  

Nothing in the above description above varies from the typical structure used in murabaha sukuk (nor would it be expected since the rules require compliance with AAOIFI standards).  However, what is not mentioned, and I cannot find in the rules, is whether there is approval of the purpose of the sukuk issuance. 

What I mean here is that there is not a stipulated requirement that I can find for the murabaha sukuk to be approved by the central bank to determine whether it is a straight murabaha, or if the murabaha sukuk (or presumably any other murabaha financing) could be turned into a tawarruq.  The law is pretty clear that CMT is prohibited for Islamic banks, so it would rule out this situation for Islamic banks (the Central Bank of Oman, in its capacity as regulator, would presumably review any murabaha undertaken by a bank to ensure it was not in violation of the prohibition of CMT).

However, it is unclear whether there would be oversight from the Capital Markets Authority (CMA), which would likely fill the role of regulator of any sukuk issuance by non-financial companies.  I don't think the rules for sukuk are available yet from the Omani CMA (please tell me if they are) and they may cover this, but from the searching through the Islamic banking law, the closest I can find is:

The funds raised through the issuance of Sukuk should be applied to investment in specified assets rather than for general unspecified purposes.  This implies that identifiable assets should provide the basis for Sukuk.

Otherwise, what would be stopping a company in need of capital from issuing a sukuk to acquire 600 MT of nickel for $10 million and then in a separate transaction selling the nickel to realize $9.8 million in proceeds.  Perhaps there would be a way for the CMA to target the issuer for failing to disclose accurately the reason for the sukuk (since it could not just be issued for 'general corporate purposes').  I would hope that there is some clarity when the CMA releases its guidelines for sukuk issuers that include some ex post review of the use of the assets to ensure that they are used for the stated purposes, but regardless it introduces some uncertainty. 

Oman gov't to consider sovereign sukuk

According to Reuters, Oman's government may be planning to issue sukuk to function as liquidity management instruments, which is especially needed for the new Islamic banks because the banking laws (PDF) specifically--and quite forcefully--prohibit any use of tawarruq by Islamic banks.  

Commodity Murabaha or Tawarruq, by whatever name called, is not allowed for the Licensees in the Sultanate as a general rule.  

It is not entirely unexpected to me that the government appears to be relenting and realizing that it needs to offer an alternative.  A government sukuk (issued either by the Central Bank or the Ministry of Finance) would give Islamic banks a place to park a share of their assets that would be viewed under capital rules as safe, and potentially serve as a liquidity buffer that still generates a return for the bank. 

While the development of a government sukuk is definitely a positive, it is up to the Central Bank to designate alternatives to interbank financing (wakala is permitted and is used elsewhere alongside tawarruq).  One key need is a way to provide lender of last resort financing, and a system of Shari'ah-compliant deposit insurance. 

The former could be addressed through Islamic repurchase agreements; however, the structure in use currently is essentially a secured commodity murabaha financing agreement.  In cases where the bank's survival is threatened, there are exceptions that allow for its use for no more than three months:

The only exception may be a real emergency situation defined as follows: If a Licensee's survival is genuinely threatened, or in case of a conventional bank's conversion into Islamic where no alternative mechanism exists to convert part or all of its portfolio, as determined by the bank's SSB.  In such situations and on a case to case basis the Central Bank may allow the use of CMT after the approval of the respective Shari'a Supervisory Board on a one-off basis for a specified time period no longer than three months.  Roll over in such CMTs or changing the price is not allowed under any circumstances.  

On the second issue of deposit insurance, I was not able to find specific reference in the banking rules, but presumably there is only conventional deposit insurance available, though it is not clear whether Islamic banks would be required to participate in the deposit insurance fund (this is generally allowed where the laws mandate participation in the deposit insurance funds).  However, this is not likely to be an immediate concern, though it should remain as a future issue to be dealt with. 

Islamic banking in Oman to start in 2013

The new rules for Islamic banks in Oman will be released in the first quarter of 2013 and the first standalone Islamic bank, Bank Nizwa will launch early in 2013 with Bank Al Izz to follow in 3-6 months. The draft regulations were distributed to banks, and there were reports were that tawarruq, a common structure used for inter-bank financing, will not be permitted.  The draft regulations are said to be the same as the draft guidelines issued earlier. 

As a result most of the Islamic banks in Oman will have surplus cash uninvested, and they will be likely to not have the option of placing these funds outside of Oman with Islamic banks using tawarruq through limits on foreign investments, but if they do place the funds with Islamic banks elsewhere, they will have the option to use wakala.  This will actually benefit the Islamic banks in Oman right out of the gate so long as they are lending into inter-bank markets since rates on wakala, according to data from ThomsonReuters, are higher than for tawarruq.

From the start, the shortage of options in the inter-bank money market will not be problematic as deposits are likely to flow much more quickly to Islamic banks with Islamic financing from the banks to follow more slowly (due to the time it takes to assess the quality of the creditor and approve the financing).  There will also be a question about how many Islamic banks the market can support, in part because loan growth dropped in the third quarter of 2012, although with just two Islamic banks this might not be as much of a problem as if the market were larger.

The area where Islamic banks might face a challenge is with competition from Islamic windows of domestic conventional banks, which will also be able to start up in 2013.  Foreign banks would be allowed to enter the market depending on how the Islamic banks in Oman perform once they are allowed to begin operations.  At last count, there were five that were planning to open Islamic windows, which would put the total market for Islamic finance at 7 institutions. 

The area of real concern for the standalone Islamic banks is, therefore, whether the conventional banks' Islamic windows are able to leverage their existing branch network to attract more of the market share for Islamic banking from the standalone banks.  On the other hand, they will likely face challenges adapting their conventionally-focused systems to ensure segregation of the funds between the Islamic banking business and the rest of their conventional business.  Once they do this, they will also have to convince customers that this segregation is airtight, a problem that the Islamic banks will not have to face. 

So for now, it is time to look forward to the opening of a new market for Islamic banking, one that was largely driven by domestic demand for Islamic banking products.  Once the operations begin, the discussion about these issues can commence again. 

Sukuk plans from Oman company a savvy move

The first sukuk announcement from a company in Oman is on the table with Al Madina Real Estate formally announcing it will issue a 5-year, $130 million in the first quarter of 2013.  I offer no opinion about the quality of the sukuk, but the timing of the announcement seems quiet savvy.  As I wrote about earlier this week, the new Islamic banks and Islamic windows of conventional banks will likely see an inflow of deposits once they are able to launch.

While loan growth has slowed recently at conventional banks, there will likely still be demand for loans from Islamic banks, as people convert their conventional loans into financing from Islamic banks (not everyone, but some percentage of the population).  Yet even this shift will be slower to develop than the shift of deposits from conventional to Islamic banks (it's easier to move a checking or savings account than it is to refinance a loan).

Meanwhile, Islamic banks will have inflows of funds which will sit idle, earning nothing (since there are no plans currently for the government to issue sukuk), while the new depositors will expect to receive a similar return on their savings (not to mention the banks' equity investors).  There is also no sign yet that the government will waive the limitation on the foreign assets, thus requiring banks to keep most of their funds within the country, where there are few investment opportunities in the short-term.

And that is the savvy timing from Al Madina with the announced sukuk for its Tilal Development Company.  It will sell the sukuk into a market with a vast surplus of investable funds (that can only be invested in Shari'ah-compliant assets) chasing after very limited investment opportunities, desperate for a Shari'ah-compliant asset that generates yield. 

On eve of Islamic banks' launch, Oman loan growth slows

With Islamic banking set for takeoff in Oman, it was perhaps disheartening for many to read "Credit growth in the retail segment inclusive of housing loans of the six listed Omani banks together dropped considerably to 1.9 per cent in third quarter ending September 2012 compared to its average quarterly growth rate of 8 per cent during the previous three quarters." but it probably will not be as much of a headwind for new Islamic banks in Oman, and may be an indication of why the conventional banks in the country are rushing to set up Islamic windows. 

The slowing in loan growth was due largely to restrictions from the Central Bank of Oman limiting the amount of a borrower's monthly salary that can be debited for installment payments to 50% for personal loans and 60% for mortgage loans.  However, it might not have much of an impact on Islamic banks, and with their entry into the market, it will pressure further conventional banks who will face both increased competition and slower loan growth if the current growth rate continues.  

For the new Islamic banks and windows, the first move will be to attract depositors, followed by finding consumers to whom they can provide financing.  The deposit growth will likely be more rapid initially than the growth in Islamic financing, since the former does not require the bank to undertake a screening of potential borrowers.  Indeed, the rapid deposit growth for Islamic banks could put pressure on the institutions to quickly provide financing since they will have depositors looking for a yield and few other investment opportunities if the government isn't interested in issuing a sukuk.  

But, to the question of why Islamic banks can be more sanguine about slowing loan growth than conventional banks.  Their natural customer base is Omanis who currently bank with conventional banks but would prefer Islamic banks (which have not been available in the past).  These consumers have experience working with banks already and will be easier to convince to switch to Islamic banks (and some may need no prodding at all).  Combined with slowing loan growth, the potential outflow of customers from conventional banks has them worried enough that at least 5 are considering opening Islamic windows in a bid to retain their existing customer base. 

Over time, the Islamic banks will have to shift their focus to attracting currently unbanked consumers (the current bank penetration rate is 70%, compared to a GCC average of 114%) , but right out of the gate, they will certainly focus their efforts on consumers who already have a relationship with an existing conventional bank.  And the enthusiasm for Islamic banking in Oman has been strong, which, in an environment of slower loan growth, should (and it seems, is) scaring conventional banks. 

Islamic finance enters Oman

After many years of not allowing Islamic banks, Oman recently changed course and licensed two Islamic banks, Nizwa Bank and Al Izz.  Nizwa Bank already went through its IPO with strong demand, and Al Izz expects to complete its IPO by September and is seeking to raise 40 million rials ($104 million), including an investment from Aabar Investments, which is owned by the Abu Dhabi government.

With the two new launches, existing banks are planning entrance into the Islamic finance market, with a successful rights offering from Bank Muscat, which will fund the development of an Islamic window at the bank.  The rationale for the country's about-face on Islamic finance is that it wants to stop the flow of deposits out of the country to Islamic banks elsewhere in the GCC. 

An article in The National describes the challenges for the Muscat exchange as being primarily falling volumes, and it is unclear whether the development of Islamic banks will address this challenge. The new Islamic financial institutions will have to attract funds from elsewhere in the GCC and one way it can do this would be to attract issuers of sukuk from within the Sultanate. 

However, it is unclear about how even new listings from within the Sultanate can attract significant investments from the rest of the GCC.  Even now, there are just 9 conventional bonds listed on the Muscat Securities Market and adding a few sukuk to that will not create a liquid market for these sukuk. 

The initial push for Oman will probably come from attracting deposits now stashed in Islamic banks elsewhere in the GCC held by people who are unwilling to place their deposits with conventional banks.  There is no telling how significant these deposits are or whether there will be sufficient demand locally from individuals and companies for financing from the new Islamic banks.  It will be likely that initial demand will come from people and companies who have avoided conventional banks so far, which should provide good quality assets for the banks (since the first clients will have built their businesses with no debt). 

Whether the Islamic banks will be able to grow both deposits and loans (as well as issue sukuk to increase their capacity to provide financing) to become large enough to support their fixed expenses remains unclear.  But, the new Omani Islamic banks will at least have a long track-record of Islamic banking in the GCC to learn from.