Will Saudi Hollandi return with another mudaraba sukuk

The news that Saudi Hollandi Bank is planning a SAR1.4 billion ($373 million) sukuk to raise the bank's capital levels could serve as a 'tell' on the future for sukuk markets, depending on the structure.  If SHB returns with another mudaraba sukuk (it issued one of the first using that structure after AAOIFI issued a ruling significantly limiting some of the features used in mudaraba sukuk that made it more 'fixed income'-like). it could indicate that the structure may see a resurgence in the future.

If, however, SHB abandons the mudaraba structure in favor of, for example, an istithmar sukuk backed by receivables (ijara, salam, istisna'a and murabaha), it will be more support for that structure.  Istithmar has become more common with issuance by the Islamic Development Bank and the ability of financial institutions--which tend to have few physical assets to base sukuk on--to raise money through sukuk issuance (istithmar can include up to 67% in debt-based receivables like murabaha, although most istithmar sukuk limit this percentage to 50%). 

Only time will tell. 

Gov. Zeti tells it (mostly) like it is

An article in Arab News describes the prospects for Islamic finance as seen by Zeti Akhtar Aziz, the governor of the central bank of Malaysia, Bank Negara.  Included in the article is a quote from Gov. Zeti which I think does an admirable job at describing the ways in which Islamic finance is affected by the global financial crisis and the recession which followed.  She said:

"The Islamic finance industry was insulated from the first round of the crisis (the global financial crisis). Islamic financial institutions (IFIs) are more resilient because they are closely linked to the real economy, with in-built checks and balances such as profit-sharing and risk-sharing. As such, there are greater elements of responsible lending. As economies slow down and financial markets experience a correction, these will impact financial institutions including IFIs. That is why it is important to have capital buffers, risk management and governance practices that are sound. We are continuing to develop mechanisms, institutional arrangements and financial infrastructures such as greater liquidity management and more so that the Islamic finance industry would continue to be resilient."

There are some things I think are not necessarily true.  IFIs do have some elements of responsible lending because they cannot move risk off balance sheet quite as easily (and in opaque ways) as conventional banks through credit default swaps (which the FT Alphaville blog described in two posts earlier today).  But, I am not sure that IFIs are any more linked to the real economy than conventional banks (with the exception of situations like before the credit crisis when some banks were loaded up with CDOs created (synthetically in many cases) from subprime MBS.  Most (smaller) banks didn't participate in these instruments, but were still hurt because of tightening credit, falling real estate prices and a slowing economy.

However, she is absolutely correct that IFIs are susceptible to a slowdown in the economy, which necessitates a similar level of regulation as other financial institutions.  Gov. Zeti is usually a good source for clear statements on the Islamic finance industry and this quote is a good example.

A couple other things in the article caught my eye.  First, the 3 applications for Islamic mega banks are not from Western institutions, and are reportedly backed by GCC-based investors, which continues the trend of convergence between the GCC and Malaysia.  Second, Governor Zeti is quoted saying: ""The IILM [International Islamic Liquidity Management Corporation] is currently obtaining the required rating, as well as fulfillment of all other parameters for the issuance including high quality underlying assets".  This to me suggests that the sukuk will be more likely an istithmaar sukuk, backed by Shari'ah-compliant financial assets from the central banks that are the members of the IILM.  Under standard practice, fewer than 50% of these assets will be murabaha and istisna'a if the sukuk are going to be tradable (though I think AAOIFI rules stipulate a cutoff of 33%). 

IILM delays first sukuk issue

The International Islamic Liquidity Management Corporation (IILM) has delayed its first sukuk issuance according to Zeti Akhtar Aziz, the chairwoman of the IILM and head of Malaysia's central bank.  She said that the first issuance would come in the next six months, while previous statements had said issuance would occur before the end of 2011.  However, progress is being made with a rating forthcoming.  The first issuance would be small, with follow-on issuance in the range of $2-$3 billion per issue in several currencies to meet demand, although in the past the IILM has stated that issuance would begin in US dollars and be followed by Euro issues with other currencies added as they were demanded by Islamic financial institutions. 

The key function that the IILM provides is short-term sukuk, issued by a body with a high credit rating to meet the liquidity needs of Islamic banks.  Banks generally take in short-term deposits and use those funds to lend long-term.  To remain in business, they need to have sufficient liquidity (i.e. cash) on hand to meet withdrawals by depositors.  The rating on the short-term assets they hold is important for meeting their minimum capital requirements under Basel and local regulations.  The short-term sukuk provide an investment option that will generate some yield without exposing the banks to the counterparty risk that would emerge from inter-bank murabaha, for example. 

There is also the potential, particularly if the IILM extends the maturities of sukuk it sells, for these sukuk to form the backbone for repurchase agreements (repos).  A repo is a secured short-term (often overnight) loan between banks and in the conventional world operates using high quality bonds as collateral like US Treasuries.  In the Islamic form of repos in use today in the UAE, the collateral is commodity murabaha-based certificates of deposit issued to banks by the UAE central bank, of which I have been critical.  The International Islamic Financial Market (IIFM) has laid out other alternatives, none of which are optimal, for Islamic repos, which I described in an earlier post.

The next piece of information that will be interesting will be the assets that are used to back the issuance, and Zeti said they are working to "get the allocation of high-quality underlying assets".  The most likely structure will be istithmaar or ijara, both of which would probably be done using an asset-based structure.  The assets would likely be contributed by IILM members, most of which are central banks from OIC countries, although the Central Bank of Luxembourg is a member.  The central banks are not likely to risk that their assets could be taken by sukuk holders should the IILM default or otherwise fall apart. 

It is good to see the IILM move towards beginning operations, however late its development is.  The biggest need it can fill is to provide a source of short-term assets for Islamic banks that do not have the risks associated with lending their surplus funds to other Islamic banks.  When an Islamic bank lends its funds to another bank--even for a short period--it subjects itself to the risk that the funds would be lost or tied up if that bank failed.  For the Islamic banking system as a whole, this provides a powerful mechanism for contagion, where the fears about an Islamic bank's solvency could be transmitted to other institutions which have lent money to it. 

The rise of istithmar sukuk

From my newsletter:

On June 20, 2011, the Malaysian central bank, Bank Negara, unveiled its newest liquidity management product, although few details were offered. In the first auction on the following day, Bank Negara sold RM500 million.($165 million) of the 1- to 3-year sukuk. The product itself is based on the istithmar structure, which combines other receivables from murabaha as well as ijara transactions. In general, under AAOIFI rules, the portfolio must have at least 33% ijara sukuk in order to be tradable, although in many cases, a more conservative interpretation is used where 51% of the portfolio must be ijara.

It is always interesting to see new Shari'ah-compliant liquidity management products come out with different structures (istithmar, commodity murabaha, salam and ijara are the ones I have run across). However, beyond the liquidity management space, the istithmar structure is becoming more widely used with institutions like the Islamic Development Bank. The International Finance Corporation used a similar wakala (agency structure) which securitized a portfolio of other contracts.

The thing that I find about this interest in istithmar sukuk is that it (and/or wakala) have potential to replace mudaraba and musharaka sukuk, which were used (and misused) extensively before the financial crisis and the AAOIFI ruling clarifying the rules around the buyback clauses used at maturity of those sukuk. There may be less concern about misusing structures (or misapplying their rules) in an istithmar sukuk (compared with a mudaraba or musharaka) because the former type is designed to be specifically an investment portfolio, where latter is commonly associated with venture financing (either providing financing from one party in mudaraba or through a joint-venture financing in a musharaka).

It will remain to be seen how much uptake their is in the istithmar sukuk structure but they are likely holding many ijara and murabaha assets on their balance sheets that could be securitized. It will likely depend on whether they have sufficient ijara assets to match up with murabaha to get to the threshold to make their sukuk tradable.

As I re-read the newsletter, it occurs to me that the entire area of securitization has largely passed Islamic finance by, although it would be a natural source of new sukuk were Islamic banks to pass on their risk and return to investors. However, the likely reasons for the absence of securitization (with a few exceptions) is the absence of standardization of the contracts for securitization, as well as the collapse in the securitization market that occurred just as the sukuk market was reminded of the rules around mudaraba and musharaka sukuk, which had been widely used (and as I mentioned, misused).

Now that the securitization market is coming back to life in the conventional market, it would be a good time to look towards pure securitization. It has the "ideal" structure (in the eyes of many) of making investors participate in both the risk and reward, would allow for the relatively quick creation of a lot of new sukuk in a market that has been coming back strongly from the credit crisis and the istithmar and wakala structures are much better vehicles, at least on a high-level view view, than mudaraba and musharaka, which were somewhat co-opted for creating sukuk based on a pool of financial assets.

There are, of course, some caveats. The first would be to find and address the reason why Islamic banks are reluctant to securitize their assets. Perhaps they believe that they will be more highly rewarded by holding the assets themselves, although that creates additional risk within the system as a whole. Or, perhaps, the infrastructure for creating cheap securitizations does not exist. Compared to the first possibility, this would be the best case. The International Islamic Financial Market (IIFM) is already reported to be working with Hawkamah on a standardized contract for ijara sukuk.

There is also the ever-present risk to investors that Islamic banks will securitize their bad assets and keep the ones they believe will perform the best. Given the ability of some Islamic banks (Gulf Finance House is the best known name) to use questionably ethical business models, the potential for Islamic banks to dump risky assets into securitized sukuk risks creating Subprime (v.Islamic). Perhaps the Western Islamic banks could take the lead in developing the infrastructure for Islamic securitizations.

Sukuk ALIM - RAM Ratings report

RAM Ratings in Malaysia has a fantastic overview (registration required) of the Sukuk al-Amanah Li al-Istithmar (ALIM) that was issued recently by Cagamas (the national mortgage corporation) working with Al Rajhi Bank. The sukuk structure is unique in Malaysia in that it was specifically created to be acceptable under Shari'ah standards in both Malaysia and the GCC. It is also the first I have seen that uses an auction to redeem the sukuk certificates rather than a wa'ad (purchase undertaking), which is used in most other cases. The AAOIFI rules that prohibited purchase undertakings at par for mudaraba and musharaka sukuk limited the issuance of those types of sukuk in the intervening two years.

The Sukuk ALIM structure is very similar to the sukuk al-istithmar structure used by the Islamic Development Bank. The sukuk certificates are issued and are used to purchase a basket of contracts. In the case of the sukuk ALIM, the SPV purchases home finance contracts (ijara and 'debt-based' like murabaha). The portfolio of contracts are set up so that there are more than 50% in the ijara contracts where ownership of the underlying asset is transferred to sukuk investors. AAOIFI rules require that at least 33% of contracts transfer real ownership of an asset (rather than just ownership of a receivable) in order for the contracts to be tradable. The Islamic Development Bank's first istithmar sukuk used this threshold, but subsequent sukuk raised the level to 50%.

Any cash remaining that is not used to purchase assets (either ijara or debt-based) is invested in commodity murabaha transactions with Cagamas through the Bursa Suq al-Sila' platform (with Al Rajhi as the commodity agent). This essentially provides income on surplus cash for the sukuk investors.

The redemption of the sukuk is also unique. Instead of a wa'ad (purchase undertaking), the assets held by investors are auctioned to third parties or Cagamas with a minimum acceptable bid of the principal and final profit payment. This has the benefit for investors that if the auction is conducted at a time when the assets value is higher than par, the investors could receive a higher redemption value than if it were a bond. They are not likely to face a loss. If there are no outside bids for the assets, Cagamas can also bid on the assets and would likely make a bid of at least the minimum amount (Cagamas' largest shareholder, with 20%, is the Malaysian Central Bank, Bank Negara). This is reflected in the credit rating on the sukuk, which is the same as Cagamas' other unsecured debt.

The auction method is interesting because it provides a way to make the final redemption price based on the market value of the assets at maturity. However, it is not really a risk-sharing arrangement because there is limited potential for loss if the asset value falls because Cagamas will be unlikely (at least as unlikely as for the sovereign) to withhold a minimum offer on the assets at maturity. However, that is generally the current state of sukuk; they will incorporate limited profit-sharing, but not to the point at which the sukuk has risks that differ from an unsecured bond.

The sukuk ALIM does add a new dimension into the sukuk market because of the incorporation of an auction and there may be additional potential for this to become more widely used--particularly in securitizations. However, it is unlikely to become universally used because many sukuk are issued using an asset that the issuer would not want to part with if its value rose during the term of the sukuk issued. A business that used its headquarter building is unlikely to want to risk having to pay more than the face value of the sukuk in order to maintain owenership of its headquarters. In those cases it is likely that the purchase undertaking (which is permitted in an ijara sukuk) is likely to remain common in many situations. However, it will be interesting to see how the sukuk ALIM is received in the market and how it performs when the first redemption occurs.

Islamic finance lagging in private equity; sukuk for the Saudi mortgage market

An article cites Hussein Hassan, the head of Middle east structuring at Deutsche Bank pointing out that Islamic banks avoid private equity despite its similarity with the partnership approach in Islamic finance contracts like mudaraba. This is attributed to the use of high levels of debt in private equity, the financing of haram industries and the asset-liability mismatch in Islamic banks which limits their ability to invest in longer-term projects. Lahem Al-Nasser covers a similar topic when he chides Islamic banks for financing more "traditional" projects over projects which are new and untested. He says this bias is based on the management having experience in conventional banking who believe that "Islamic banking is nothing more than a marketing instrument to make profit" and they "lack the incentive to push for creativity and innovation".

The VP and MENA business manager for corporate trust at BNY Mellon Corporate Trust in Dubai suggests that "sukuk would be the best way to mortgage homes in a Shari'ah-compliant fashion" using an asset-backed structure. I would tend to agree because so long as most of the mortgages are tradable (i.e. not based on murabaha), they could be securitized in a way similar to the Islamic Development Bank's sukuk al-istithmar. In the istithmar sukuk, the underlying assets are other financing contracts (in the case of the IDB sukuk, they are murabaha, istisna'a and ijara). The sukuk is tradable so long as the proportion of ijara contracts (by value) is more than one-half of the total assets. The reason for this is that murabaha and istisna'a contracts create a debt obligation (the financier holds a receivable for future payment), whereas an ijara contract provides the financier with ownership of an asset.

Kazakhstan is planning to issue $500 million in sovereign sukuk, in part to try and make the country the "Islamic finance hub" for the former Soviet Union. The government of Abu Dhabi-owned Al Hilal Bank opened the first Islamic bank in the country earlier this year. The CEO of the Kazakhstan branch of Al Hilal Bank, Prasad Abraham, tempers the expectation saying that issuance could start at just $200 million this year but rising to as much as $3 billion per year by 2015. The sukuk is replacing a cancelled $750 million Eurobond, which Bruce Gaston, the CEO of Skybridge Finance, says will cost the government up to 150 basis points m more compared to the Eurobond.

Other News

• Kuwait Finance House Research estimates that global sukuk issuance in 2010 will reach $30 billion. The first half issuance was $16.5 billion.
  
• Al Baraka Banking Group plans to raise $200 million through its first sukuk issuance by the end of 2010. Al Baraka also signed a non-exclusive memorandum of understanding with the Islamic Corporation for the Development of the Private Sector (ICD). ICD is part of the Islamic Development Bank group.
  
• Gulf Finance House is planning to increase its capital by $300 million but did not specify how it plans to raise that capital.
  
• Dubai may issue debt in 2010, but it is "not under pressure to do anything".
  
• Bahrain Financial Harbour raised $240 million through a 7-year ijara facility to repay debt.
  
• The Al Rajhi Bank-Cagamas cooperation may only be the first effort to bridge the divide--particularly in Shari'ah standards--between the GCC and Malaysia. While much of the news concerns the Shari'ah standards, there are other areas where harmonization of standards becomes difficult. Megat Hizaini Hassan, the head of Islamic banking & finance at Zaid Ibrahim, is quoted saying: "In the Middle East, in certain jurisdictions [Islamic finance] is not even regulated so how can you harmonise?".
  

Gulf sukuk market recovering, Asia leads; asset-based vs. asset-backed sukuk

The Gulf sukuk market may begin to open up as yield spreads fall with the issuance of sukuk from highly-rated issuers. This is one step in the process of recovering following the effect of the financial crisis which was most noticeably manifested by the Dubai debt crisis. Since the Dubai debt standstill, most of the few GCC-based issuers have been investment grade with the exception of Dar Al Arkan. GCC-based sukuk represented 30% of the Q2 and previous four quarters total global sukuk issuance value according to data from Zawya's Sukuk Quarterly Bulletin. HSBC expects to see a recovery in sukuk led by Asia as it has during the past year. [UPDATE: Bloomberg released an article about the shrinking yield spreads on Asian sukuk]

As the GCC market opens up and high-grade corporate and multilateral institutions like the Islamic Development Bank issue sukuk, it will provide somewhat of a benchmark for pricing other sukuk, particularly those from lower rated issuers. However, the benchmark from new issues will only become meaningful for encouraging new sukuk if there is liquidity in the secondary markets. In contrast to Malaysia, secondary market liquidity in sukuk is low. However, the new issuance is a start. Bloomberg provides a list of forthcoming or planned sukuk. One of those issuers is Abu Dhabi Islamic Bank, which filed a base prospectus for up to $5 billion in sukuk with the London Stock Exchange on July 8th.

Sheikh Yusuf DeLorenzo is quoted in an article in Bloomberg that suggests investors are more likely to demand asset-backed rather than asset-based sukuk based on the recent defaults. The difference is similar to the difference between a secured and unsecured debt and would also tackle the criticism that using an asset-based structure is fitting the round peg of Islamic finance into the square hole of conventional debt structures.

The European travel firm Thomas Cook failed to place $50 million in sukuk in the GCC because of its small size and investor's belief that the coupon of 7% was too low. It would have been the first European corporate sukuk. Based on its small size, I would tend to minimize the impact of the failure on future European corporate sukuk. If a larger European issuer fails to issue a sukuk, particularly if it is of benchmark size, then it may dissuade other European companies from issuing sukuk.

Indonesia auctioned only Rp246 billion ($27 million) in 15 year (Rp7 billion) and 20 year (Rp 239 billion) sukuk compared to the target of Rp1 trillion. As in previous failed acutions, investors submitted enough bids to cover (Rp 1.18 trillion) but the yields were higher than the Finance Ministry was willing to accept. The higher yields have been attributed to the lack of liquidity in secondary markets.

Other News

• Cagamas, the national mortgage company in Malaysia is expected to issue the first tranche of its sukuk which it developed with Al Rajhi Bank to be in compliance with AAOIFI standards. Many Malaysian sukuk are not accepted in the GCC. The sukuk is an al-Amanah Li al-Istithmar (ALIm). It will be backed by a mixed asset pool, but contain enough ijara assets to be tradable. The remainder of the assets will be based on bai, wakala and bai' bithaman ajil (BBA).
  
• A blog post notices the growth of Islamic banking and wonders if it could take a bigger role than it has. I think it can if Islamic banks decide that supporting and financing Islamic microfinance is a good way for Islamic banks to engage in corporate social responsibility.
  
• Malaysian bank Agrobank announced it plans to go fully Islamic by 2015. It has offered Islamic banking products since 2008. The bank reported that 60% of its non-Muslim clients choose Islamic banking products.
  
• Barwa Bank is close to completing its acquisition of First Finance Company.
  
• Gatehouse Bank acquired One Sovereign Street, a building in Leeds, for GBP40.175 ($60.9 million).
  
• Malaysian property developer LBS Bina is issuing a RM135 million ($42.1 million) sukuk to finance a housing project.