Dec 05 2012
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Perpetual Participation Sukuk - A proposed additional tier-1 capital under Basel III
On the funding side of an Islamic bank's balance sheet, we are expected to find three types of equities - equity of musharakah, equity of mudharabah and equity of sukuk. Our approach to these equity types needs to be changed to respond effectively to Basel III reforms and benefit from and contribute to genuine Islamic finance. With this spirit we suggest the perpetual participation sukuk within the framework of Basel III as additional tier-1 capital.
Mudharabah is an important Islamic partnership and asset price risk driven contract. In a nutshell, the principal amount of funds and profit rates cannot be guaranteed and the contract is fundamentally a profit sharing arrangement between the two parties.
A perpetual participation sukuk (PPS) is a mudharabah equity share in an Islamic bank to be traded on the stock markets. The PPS will fully conform to the fundamental Shariah requirements of the mudharabah partnership contract. In addition, the PPS will be perpetual, non-redeemable, and junior to all forms of deposits of the Islamic bank but will be treated as senior to musharakah equity shares whether held privately or publically. Furthermore, the PPS will meet all the conditions of Basel III for fulfilling the additional tier-1 capital criteria.
Basel III has introduced important capital reforms for strengthening tier-1 capital, especially by introducing a new category of capital with the name of 'additional tier 1 capital'. Additional tier 1 capital is a perpetual financial instrument. It is not guaranteed, it has no redemption features, and it is junior to depositors and other creditors of the bank.
The equity of mudharabah and the equity of sukuk do not qualify to be a form of capital under Basel III.
All existing sukuk are facing what can be called "structural risks" - a risk showing a condition in the design of the contract when asset price risk, rate of return risk and credit risk are not separated properly. The rating agencies, sukuk arrangers and law firms have tried to remove the asset price risk from sukuk through various undertakings, particularly the re-purchase undertaking at the initial price. In the existence of this undertaking, sukuk replicates the credit risks and interest rate risks of conventional bonds.
But most Shariah scholars reject the undertaking, considering it Bai' Al I'nna. If the re-purchase undertaking at initial price is removed, the sukuk will move into the category of equity driven by asset price risk.
This tussle between the asset price risk driven sukuk which is preferred by the Shariah scholars on one hand and credit risk driven sukuk as preferred by rating agencies, arrangers and law firms on the other hand compound the sukuk structure risks. Therefore, sukuk with structure risks cannot be a stable source of funding for Islamic banks.
The central focus of Basel III is on strengthening the stable sources of funding and liquidity in banking institutions. The PPS is based on a pure mudharabah contract, it is driven by asset price risk, it is perpetual and non-redeeming, it is junior to deposits and hence it will be fully compliant with the Basel III additional tier-1 capital criteria.
The Modaraba Certificates of Pakistan
The market is already familiar with the PPS. Modaraba Certificates are already being issued on the Pakistani stock markets since 1984, by Modaraba Companies registered with the Securities Exchange Commission (SEC) of Pakistan. The business is governed under the federal Modaraba Companies and Modaraba Floatation and Control Ordinance 1980, and rules, regulations and guidelines issued for follow-up by the SEC and State Bank of Pakistan.
The activities are regulated by the Registrar of Modarabas of SEC and also by the State Bank of Pakistan. The Religious Board of the Registrar of Modarabas ensures Shariah compliance. Most recently, Registrar of Modarabas issued Circular No 8 2012 to strengthen the Shariah supervision and audit process.
The proceeds of Modaraba Certificates are used for financing businesses by utilizing the contracts of murabahah, ijarah and istisna, for trade, construction and project financing. The Modaraba Certificate holders are entitled to cash dividends, stock dividends and rights issues.
The Association of NBFIs and Modarabas of Pakistan issues a consolidated yearbook. The statistics from Yearbook 2012 shows that despite general slowdown in the domestic economy of Pakistan as well as in the global economy, the Modaraba segment of the stock exchanges performed satisfactorily during 2009-2011.
All the critical indicators for the Modarabas show significantly positive trends. The earnings per share for the Modaraba Certificates also significantly improved during 2010-2011. This shows that the market performance of the Modaraba Certificates (the proposed PPS) has already been significantly positive.
Dr. Tariqullah Khan is a professor of Islamic Finance at Hamad bin Khalifa University, Qatar Foundation.
This article is excerpted from the author's paper on the same theme.
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