Risk-free investments are generally not found in the Islamic business environment. The reward system under Islamic philosophy is based upon taking risks; there is no room for profit without exposure to some degree of risk. As outlined by Islamic teachings, all business and financial institutions should run their business in a way that complies with Shariah principles.
The major aspects of this are:
the prohibition of interest-based transactions adhering to Halal (lawful activities) and Haram (sinful activities) rules carrying some degree of risk
Therefore, Islamic financial and business institutions should structure their businesses according to prescribed principles, especially regarding the sources and uses of finance. Islamic institutions' participation in the securitization line of business is growing over time due to the achievements that they have made during last three decades, as well as the hope of reaping huge benefits when they embark on a global financial market.
Securitization Situation
The global securitization market has been driven by several factors. One of the major ones is that the cost of funding is increasing tremendously, especially in those countries with a low credit rating class, as well as capital regulatory requirements imposed by monetary and supervisory bodies. It is inevitable that institutions there will resort to more innovative, cheaper sources of capital; risk-mitigating techniques and securitization can help in this situation. Also, along with the growing convergence of capital markets through global financial dynamism and ongoing technological advancement, the barriers between such markets have been gradually removed. The resulting strong competition for efficient capital has been intensified and has made reliance upon new sources inevitable for business survival.
Another important dimension that has made securitization an important resource for Islamic institutions is that it can be viewed as a viable bridge for those institutions to a money market environment. This allows Muslim investors to deal successfully in money market instruments and permits corporate institutions to actively manage their assets/liabilities. Considering the fact that bond issuance and trading are important means of investment in the modern economic system, Muslim scholars are striving to find alternatives. As Islamic jurisdiction prohibits dealings through interest-based transactions, all financial and credit dealings under Islamic philosophy tend to relate finance to specific types of assets, and it is possible to structure asset backed securities (ABS) Islamically as long as they follow Islamic principles. The use of securitization techniques would, then, bring in much-needed liquidity to Islamic institutions by enabling them to free part of their capital that is tied up with illiquid assets into short, partnership-based instruments without a predetermined rate of return. We can't ignore the huge benefits that would be realized to the macro economy from the evolution and development of the securitization market for Arab and Muslim societies
According to the guidelines on the operation of Islamic entities, there are several regulatory issues that related to securitization processes. As securitization is highly evolved in the non-Islamic world, the asset backed securities (ABS) developed there do not necessarily conform to Islamic principles (due to interest-bearing credit and receivables, area of business, etc.) According to Islamic rules, the assets to be securitized might include leasing contracts that can be used in different business lines, equity ownership, Murabaha and Salam transactions (with some conditions) and other sales and finance contracts, in addition to current tangible assets that generate systematic and predictable cash flows that are acceptable for trading by Islamic investors.
A Different Role
The structure of securitization under Islamic philosophy does not differ greatly from that of the conventional type. The major players are the originator, trustees, servicers, special purpose vehicles (SPV), investment bankers, credit enhancers and rating agencies.
The differences in their roles under Islamic philosophy are as follows:
The securities issued by the SPV are claims on assets held by the issuer SPV and are such that the claims are closely attached to the ownership of such assets.
The ABS does not guarantee a predetermined rate of return, but a variable one according to the performance of the assets under securitization (However, it can be predicted).
The credit enhancer provides the required credit (if needed) that could be either part of the fund generated from asset cash flows, collateral pledged to support assets or a guarantee in order to obtain a sound credit rating.
The pass-through securitization structure can be visualized as the closest arrangement that would satisfy Islamic principles.
The transfer of assets from an originator to an SPV should be on a true-sale basis; in some securitization cases that relate to a productive investment project, the originator has a right to compete in the repurchasing of the underlying assets after selling it to an SPV, once the securitization deal is finalized. This is always done in securitizing government productive assets where the public interest dictates the retention of government ownership to a specific strategic venture.
RoadblocksThe majority of securitization experiences in Arab and Muslim countries involve financing specific projects through issuing securities (with a variable return according to project performance, for a short to medium duration, backed by the expected flows of the project). This is always done through Mudaraba contracts. As most Arab and Muslim countries are banking-based economies rather than financial-based economies, securitization and financial instrument transactions are very rarely used.
At first glance at Arab and Muslim financial statistics, we can say that the ratio of market capitalization to GDP is generally not more than 10 percent, whereas in an emerging market, it tends to approach more that 50 percent. Securitization in the Arab regions would probably be considered low as compared with that of advanced economies. There are several factors to account for this:
Islamic entities conduct most of their business in the Muslim world. Being a regulation-driven process, however, securitization would evolve only in countries with a developed regulatory framework and adequate institutional settings, as in most advanced countries, in addition to few emerging countries such as Malaysia and Taiwan. While Islamic institutions can easily securitize the assets they own in most developed economies, they may not easily do the same with the bulk of their assets in the Muslim world due to insufficient financial and regulation infrastructure.
In addition, the securitization process requires the availability of sophisticated credit and financial information on the underlying assets as well as the existence of proper accounting standards, which might not be adequate in the Arab regions.
Most Arab and Muslim countries are unrated credit-wise, and this might jeopardize their chances in promoting securitization products, especially abroad.
One of the main factors that hinders the spread of securitization know-how practices in Arab economies is the poor financial structure and knowledge among individuals and institutional bodies.
Making Progress
Securitization and structured finance are necessary financial processes that any institution should adopt for survival. This can also be generalized to Islamic financial and business institutions that are always working in a risky environment. In spite of this, major Arab and Muslim countries are striking progressively toward establishing the institutional and regulatory structures for this new, dynamic process.
Dr. Fathelrahman A.M. Salih holds a Ph.D in economics from Sudan University for Sciences and Technology, 2004, and a master's degree in economics from Omdurman Islamic University, 1998. He has worked for the Financial Investment Bank - Khartoum in Sudan since 2000, currently focusing on mutual funds and portfolio administration. He has published many articles in different Islamic financial areas inside and outside Sudan.
By Dr. Fathelrahman A.M. Salih
Business Islamica 2007
