Current Trends in Islamic Structured Finance and Capital Markets
Since last summer, structured finance has come into sharp focus on account of its role in propagating the economic fallout from the US sub-prime crisis, causing a major re-assessment of risk, and the price it should command across all asset classes, a widespread retrenchment of mortgage exposures, and substantial liquidity injections by central banks to support inter-bank money markets.1 The consequent implosion of the banks’ balance sheets has further exacerbated the morphing of credit crisis into profound economic slowdown. So far, the recent episode of financial turmoil that ensued from the dislocation of the structured finance market seems to vindicate the longstanding policy concerns that unfettered financial innovation – together with poor credit origination and valuation standards, lack of adequate regulatory foresight, and excessive risk-taking without sufficient capital provisioning – can perpetuate market disruptions, with potentially adverse consequences for financial stability and economic growth. Write-downs at financial institutions following the slide in house prices and the surge in foreclosures have already reached close to US$500bn. At the same time, assessing the exposures of financial institutions and devising means of crisis resolution due to differing and incomplete disclosure of activities outside the remit of banking regulators and capital market supervisors have become more difficult.
After having nearly ground to a halt last year, securitisation is now staging a modest comeback, but current efforts fall short of restoring investor confidence. Focused on getting the nation’s credit gears smoothly working again, the Federal Reserve has recently announced that it would extend emergency loans into next year in a move that marks the latest effort to help banks overcome credit problems. Yet, an elevated premium for uncollateralised lending as manifested in the rise of the LIBOR-OIS spread indicates that liquidity pressures as well as concerns about counterparty risk persist. While the market ruptures caused by the headlong flight to safety during the initial phase of the credit crisis seem to have been contained, the market for securitised mortgages remains tense and pricing depressed as banks dispose of non-core assets and raise capital to de-lever and bolster their balance sheets. Future securitisation transactions may require issuer participation across the capital structure and thereby sharing in the performance of the overall structure. Despite the continued viability of certain kinds of securitisation, structures are likely to become simpler, while demand for complex instruments, such as CDOs, could be dormant in the foreseeable future.
After the credit crisis has eroded market confidence and sapped risk appetite of investors in the conventional markets, unsettled investors have been flocking to Islamic finance. The Islamic finance industry is in the midst of a phenomenal expansionary phase, exhibiting average annual grown rates of about 15% in recent years. There is currently more than US$800bn worth of deposits and investments lodged in Islamic banks, mutual funds, insurance schemes (known as takaful), and Islamic branches of conventional banks. The current growth has been fueled not only by surging demand for Shariah-compliant products from financiers from the Middle East and other Muslim countries, but also by investors around the world seeking Islamic investment as a means of diversification, thus rendering the expansion of Islamic finance a global phenomenon.
Although the rapid expansion of Islamic finance is taking place across the whole spectrum of financial activities, perhaps the most striking element has been the fast growth of sukuk, the most popular form of securitised credit finance within Islamic finance. Sukuk issuance has soared over the last three years in response to growing demand for alternative investments.2 At the end of 2007, outstanding sukuk globally exceeded US$90bn.3, 4 Gross issuance of sukuk has quadrupled over the past two years, rising from US$7.2bn in 2004 to close to US$39bn by the end of 2007, owing in large part to enabling capital market regulations, a favorable macroeconomic environment, large infrastructure development plans in some Middle Eastern economies and financial innovation aimed at establishing Shariah compliance.
Sukuk have largely escaped the credit crisis that erupted last year hobbling financial markets, with investment banks and finance houses worldwide still reeling from the collapse of the US sub-prime mortgage market. Although the issuance of sukuk in the first half of 2008 still remains somewhat below the 2007 record, volumes have held up (in contrast to asset-backed securitisation (ABS) markets), while the number of deals brought to market has steadily increased, chipping away at a significant backlog of shelved sukuk issues in 2007. On the assumption of a stable rate of growth, the volume of sukuk issued by governments and corporates will surpass the US$150bn mark by 2010, spurred by buoyant demand especially from banks, insurance companies and pension funds in both Islamic and non-Islamic countries.
Sukuk transactions already contain many features that are now being considered instrumental to a timely resurgence of conventional markets for securitised debt. As one measure to revitalise the secondary mortgage market, policy-makers in the US have drawn up plans to encourage the issuance of covered mortgage bonds (or ‘on-balance sheet’ securitisation in general), popular in some other countries such as Germany, to redress the misaligned incentives of asset managers that undermined ex ante market discipline and led to the demise of the structured finance market. Covered bonds are secured debt obligations collateralised by a dedicated reference portfolio of assets retained by the issuer. The interest payments are guaranteed by the issuer and do not dependent on the performance of the underlying cover assets. Sukuk are in fact akin to such mortgage pass-throughs, except that investors receive no institutional guarantee. Instead, they have direct recourse to the underlying assets, which fund unsecured repayment from profitable investment in religiously sanctioned, real economic activity only. Since asset-backing, entrepreneurial investment and specific credit participation in identified business risk are fundamental to any Islamic transaction, mortgage securitisation represents a straightforward capital market-based form of Islamic finance.
Sukuk might be a viable source of funds that could help stabilise the securitisation market. While sukuk are structured in a similar way to conventional ABS, risk-sharing and full participation of both issuers and investors in the capital structure of the transaction point to possible improvements in conventional securitisation. Sukuk transform bilateral risk sharing between borrowers and lenders into the market-based refinancing of Shariah-compliant lending or trust-based investment in existing or future assets. They commoditise the capital gains from asset transfer in either one of the three basic forms of Islamic finance (i.e. debt-based contracts, for example, synthetic loans/purchase orders [murabahah]; asset-based contracts, e.g. sale-leasebacks [ijara]; or equity-based contracts, e.g., profit-sharing/’sweat capital’ arrangements or trusts [musharakah or mudarabah]). To this end, the religious prohibition of maisir and gharar restricts speculative activity and contractual uncertainty in sukuk, while preventing issuer leverage on the underlying asset portfolio. Thus, direct investor interest in sukuk fosters adequate disclosures underpinned by a solid foundation of religious standards (supervised by a designated Shariah board), which not only inform incentive compatibility between issuers and investors but also curb excessive risk taking and valuation problems that had infested the conventional securitisation market.
Despite considerable, and growing, demand for Shariah-compliant assets, the further development of sukuk depends on essential economic, regulatory and infrastructural conditions.
Amid weak reliance on capital market financing in many Islamic countries, issuers of sukuk are first and foremost faced with several critical economic impediments that pertain to their ability to (i) identify reference assets that meet Shariah requirements and offer attractive returns, and (ii) substitute standard structural features in conventional securitisation structures, such as credit enhancement and liquidity support, which are not permissible in an Islamic context. Given the limited sourcing and structuring of eligible asset portfolios, Islamic issuers have begun to originate their own Islamically acceptable assets (rather than buy asset pools in the market).
In addition, the absence of uniform and definitive guidance on Shariah compliance affects the legal integrity of restitution interest of investors in sukuk. Islamic investors are not only concerned with the compliance of both cover assets and the transaction structure with the Shariah, but also with legal enforceability of asset claims under contract law. In this context, the question of whether Islamic law governs sukuk by substance or form arises. While the conclusion of financial transactions under different legal regimes can lead to the same outcome (i.e. substance), the legal process (i.e. form), and possibly the associated rights and obligations of the contractual parties, might vary considerably. If Shariah compliance is treated (only) as a matter of substance and upholds in spirit what was created in form, such as perfected security interest defined by commercial law, the violation of the Shariah would temper investor interest but not preclude legal enforceability of investor claims. However, if the transaction were governed solely by Shariah law as a matter of form, the opinion of Shariah courts could override commercial legal concepts and re-qualify the legal nature of a securitisation transaction. For instance, insolvency officials in Islamic jurisdictions could invalidate the substantive non-consolidation and ‘re-characterise’ a true sale securitisation as an unsecured loan.
Recent efforts to achieve regulatory consolidation and standard setting have addressed economic constraints and the legal uncertainty imposed by Islamic jurisprudence and poorly developed uniformity of market practices. Therefore, market inefficiencies caused by divergent prudential norms and diverse interpretations of Shariah compliance are expected to wane in the near future. Leading regulatory organisations in Islamic finance, such as the Accounting and Auditing Organization of Islamic Finance Institutions (AAOIFI), the General Council for Islamic Banking and Finance Institutions (GCIBFI), the Islamic International Rating Agency (IIRA), the Islamic Financial Services Board (IFSB) and the Fiqh Academy in Jeddah, have been working on aligning Shariah principles on a consistent basis. In this regard, a fine balance is required between collective initiatives and regulatory revisions, so as to ensure that standardisation is achieved without staving off financial innovation. This year, an IFSB task force is due to publish recommendations for standard sukuk structures in response to efforts by professional organisations towards greater uniformity.
Since conventional securitisation is virtually absent in Islamic countries, considerable demand for Shariah-compliant investment assets provides an untapped market for structured finance as a means to advance both capital market development and promote alternatives modes of intermediation. Islamic securitisation also complements the conventional ABS universe as an alternative and more diversified funding option that broadens the pricing spectrum and asset supply, as high demand for alternative investment products causes greater lending width.
However, the sukuk market is still plagued by illiquidity in the secondary market, with the combination of high originator concentration and regional fragmentation clouding the overall positive outlook. Although the concept of asset backing is inherent to Islamic finance, structured credit transactions are few and far between where financial transactions have to follow the precepts of the Shariah. The current level of sukuk issuance by corporates and public sector entities still remains a fraction of the global fixed income markets. Since only a handful of large banks and managers are behind the bulk of transactions completed by a small number repeat issuers, origination and servicer risk from narrow asset supply poses challenges to investor diversification. At the same time, a large part of Islamic capital markets remains a collection of disseminated and weakly co-ordinated local operations.
An even bigger diversification issue arises from poor asset diversity given narrow range of deal types and maturity tenors in the existing market. Sukuk are available at maturities of three, five and 10 years, but not for short-term maturities, which significantly limits their application for money markets. Although Islamic banks are currently one of the largest buyers of Shariah-compliant products (at long maturities), they would benefit most from issues at shorter tenors. There is some hope that the launch of different sukuk funds in the near future might potentially unlock liquidity constraints, but this might only create new demand without sufficiently alleviating supply constraints. It is currently also difficult to set up sukuk funds with sufficient diversification.
Despite the phenomenal growth of sukuk over the last three years, future development of sukuk could be arrested by insufficient supervisory harmonisation across national boundaries and the ongoing controversy about the financial innovation in Islamic finance. Governance issues, especially the Shariah compliance of products and activities, constitute a major challenge for the Islamic finance industry. Although Shariah rulings (fatwas) by legal scholars are disclosed, there are currently no unified principles on which Shariah scholars decide on the Shariah compliance of new products. Fatwas are not consolidated, which inhibits the dissemination, adoption and cross-fertilisation of jurisprudence across different countries and schools of thought. Moreover, there is still considerable heterogeneity of scholastic opinion about Shariah compliance, which undermines the creation of a consistent regulatory framework and corporate governance principles. The fragmented opinions of Shariah boards, which act as quasi-regulatory bodies, remain a source of continued divergence of legal opinion.
Despite a number of challenges, the future looks bright for Islamic finance. Financial institutions in countries such as Bahrain, the UAE and Malaysia have been gearing up for more Shariah-compliant financial instruments and structured finance, both on the asset and liability sides. Various Islamic countries have teamed up in a bid to create more liquidity and enhance market transparency with a view to becoming centres of Islamic finance, while more specific regional initiatives provide a valuable platform for drawing further attention to structured finance as an important element of local capital market development. The leading financial centres, e.g., Hong Kong, London, New York and Singapore, are making significant progress in establishing the legal and prudential foundations to accommodate Islamic finance side by side with the conventional financial system. Countries such as Indonesia are planning to issue international sukuk to fund large infrastructure projects. Many of the largest western banks, through their Islamic windows, have become active and sometimes leading players in financial innovation and new Shariah-compliant financial instruments that attempt to alleviate many of the current constraints such as a weak systemic liquidity infrastructure. More conventional banks are expected to offer Islamic products, enticed by enormous profit opportunities and ample liquidity, especially across the Middle East.
The views expressed in this article are those of the authors and should not be attributed to the IMF, its Executive Board, or its management. Any errors and omissions are the sole responsibility of the authors. Parts of this article have been previously published as “Trends and Challenges in Islamic Finance” in World Economics (2008), Vol. 9, No. 2.
1International Monetary Fund (IMF), 2008, Global Financial Stability Report, World Economic and Financial Surveys (Washington, April).
2Jobst, Andreas A., Kunzel, Peter, Mills, Paul and Amadou Sy, 2008, “Islamic Bond Issuance – What Sovereign Debt Managers Need to Know,” International Journal of Islamic & Middle East Finance and Management 1(4). Published also in IMF Survey Magazine, International Monetary Fund (September 19, 2007).
3Moody’s, 2008, “Focus on the Middle East,” Inside Moody’s (Spring), p. 4.
4Moody’s, 2007, “Focus on the Middle East,” Inside Moody’s (Winter), p. 4.