Apr 15 2013
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The booming sukuk industry: a source of worry?
15 April 2013
Global sukuk issuance is in constant acceleration, especially since the fourth quarter of 2011. More players are entering the market, especially from the GCC, which now claims a bigger slice of the pie at the expense of Malaysia (although the latter still dominates the sukuk market). The amounts raised through sukuk issuance are also becoming more substantial.
This trend is not necessarily a sign of healthy development for the Islamic finance industry, for three reasons.
A sign of liquidity shortage
At first sight, it appears that sukuk issuers have the necessary internal fund resources to finance their investment projects but may be trying, by issuing sukuk, to diversify their funding schemes to benefit from the relatively competitive current market conditions with respect to fund raising. However, we recently experienced sukuk defaults from reputable UAE institutions that no one would have expected, such as Nakheel and Dana Gas.
Governments too started to borrow massively through debt-based sukuk structures like commodity murabahah to finance budget deficits. This further supports the idea that massive sukuk issuance is not necessarily a sign of real economic growth but rather a symptom of financial difficulties, including from major economic players.
Enhanced credit risk
In conventional bonds, there are usually no underlying assets guaranteeing repayment. As a consequence, such products are regarded as unsecured investments.
Asset-based sukuk (as opposed to asset-backed sukuk) are similar to conventional bonds in their economic effects. In the event of default, investors may end up losing possibly the entire amount of their nominal investment and will not have any recourse to an underlying asset. They will thus rank pari passu with the other creditors in case of default of the issuer.
Unfortunately, 95% of the sukuk issued recently are asset-based sukuk and thus regarded as unsecured debt. As such, they are identical to conventional bonds in terms of credit risk.
Defaults on such sukuk would have severe adverse economic effects on the Islamic finance market as sukuk holders would simply lose their investments without any specific recourse. In addition, this would also most probably entail a confidence crisis affecting the reputation and consequently the attractiveness of this market, thus further reducing the available liquidity.
Those accessing the sukuk market would do well to prioritize issuance of asset-backed sukuk, which can in any case be considered far more Shariah-compliant than asset-based ones.
Shariah compliance at stake
AAOIFI Shariah standards concerning sukuk make it clear that the following conditions have to be abided by when issuing sukuk:
1. Sukuk, to be tradable, must be owned by sukuk holders, with all rights and obligations of ownership.
This condition is not respected by the majority of the sukuk issued so far since, as mentioned in the second section above, nearly all of them are asset-based and not asset-backed.
2. Sukuk, to be tradable, must not represent receivables or debts, save in exceptional cases, as mentioned in the AAOIFI Shariah Standard No. 21 on Financial Papers.
However, sukuk issued on the Malaysian market hardly comply with such a requirement as they allow the use of debt (the so-called bay aldayn) as an underlying asset for sukuk which results in debt being traded at discount in the secondary market. As Malaysia is the prime issuer of sukuk, it is absolutely imperative to actively discourage bay aldayn in sukuk structures. Failure to do so may result in a debt crisis, whose effect would be similar to those of the sub-prime crisis, and could thus affect negatively all the Islamic finance industry.
3. Shariah Supervisory Boards (SSB) shall play an active role in reviewing all relevant contracts and documents related to the actual transaction at structuring stage, and monitor the actual means of implementation before delivering a fatwa, and thereafter make sure that the operation complies, at every stage, with Shariah guidelines.
It seems however that this rule is unlikely to be complied with since the role of the SSBs is still limited, in practice, to the issuance of fatwa on the admissibility of a contemplated sukuk structure from a Shariah perspective, and will thus issue their fatwa by relying exclusively on the information provided by the Islamic financial institutions.
The absence of close monitoring probably explains why we can see some Shariah scholars sitting in more than 100 SSBs.
There is a need to rethink the entire sukuk industry if we want to tend towards more Shariah compliance and, most importantly, mitigate the adverse economic risks associated with the current trend.
Sufian Bataineh is the managing director of Dananeer, an Islamic finance consulting and training firm based in Luxembourg. He is also a founding member of Islamic Finance Professionals Association.
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