Should sukuks seek to equitably share the risk and return between the issuer and the holder?
It may be only two to three decades since Islamic finance took off in the region. The initial initiatives were confined to Islamic banking and takaful (Islamic insurance) operations.
It was in the 1990s that a new range of structured products made its way into the market and sukuks slowly evolved into a market-friendly product which has witnessed a growth in the region of 30 to 40 per cent over the last few years. Though Malaysia saw the initial action in sukuks, the GCC, especially the UAE, is fast becoming the modern hub of suluk activities.
Expectations are that the sukuk issuance in the current year could nearly double that of the value raised through this sharia'a-compliant debt paper in 2007 and even cross the $75 billion mark. The general criticism the Islamic finance industry faced all along was that it almost stayed within the framework of conventional finance but for sharia'a compliance certified by a scholars' body called the Sharia'a Committee.
Credibility in question
Having said that, however, the very credibility of the the popular sukuk was rendered the first blow by a recent statement made by the chairman of the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), Sheikh Muhammad Taqi Usmani, that 85 per cent of the GCC sukuks do not comply with the sharia'a principles and thereby, don't qualify to be called Islamic at all. The statement has been strong enough to rattle the very foundation of Islamic finance participation or risk-sharing. "It is a fact that there exists a confusion as to whether Islamic banking needs to be introduced in the purest form or practical form as this industry is still in the formative stage," says Mohammad Shaheed Khan, senior manager, Islamic Finance Division, Saudi Hollandi Bank, Saudi Arabia and secretary, ABN AMRO Global Sharia'a Advisory.
Real issue
Taqi Usmani's statement essentially refers to the equity-based sukuks - mudarabah and musharakah - which are structured on the basis of risk-sharing or partnership between the issuer and the bondholder.
Under the agreement, the partners agree to share the profit on a pre-determined ratio whereas the loss, if any, would be shared depending on each partner's capital contribution. Moreover, under this structure, the sukuk holders are paid the face value on maturity, irrespective of whether the underlying asset made a profit or loss. The new controversy hinges on the question of whether the structure of these sukuks should seek to equitably share the risk and return between the issuer and the sukuk holder, which is not only the basis of the sukuks but more prominently of Islamic finance itself.
"Structuring of these instruments should move more towards risk-sharing than guaranteed returns," says an Islamic banking scholar based in Dubai.
The controversy is ill-timed for the industry as this has happened at a time when the global market has come under the grip of a prolonged credit crisis. A study says that due to the global credit crisis, the sale of sukuks has dropped to $856 million this year against $4.7 billion last year.
Sukuks must represent ownership for sukuk holders with all of the rights and obligations that accompany ownership. The manager of a sukuk issuance must establish the transfer of ownership of such assets in its books and must not retain them as its own assets. It is not permissible for the manager of sukuks to undertake to offer loans to sukuk holders when actual earnings fall short of expected earnings. However, it is permissible to establish a reserve to cover shortfalls.
It is also argued that mudarib (investment manager), sharik (partner), or wakil (investment agent) are not supposed to promise to buy back assets at face value at maturity. However, it is allowed to agree to purchase the assets at their net value, or market value, or fair market value, or for a price agreed to at the time of their purchase.
More expensive
"Instead of being more expensive, the new structure may yield more revenue if it is based on real sharing of profits and losses. The difficulty is not inherent in the proposed structure itself, rather is only in the conventional approach that wishes the Islamic sukuks to be reflecting all the characteristics of conventional banks," said Taqi Usman.
The new development coupled with the fact that the industry doesn't have a sufficient number of sharia'a scholars is posing the biggest challenge of all times to the relatively new Islamic finance industry.
The scarcity phenomenon doesn't end at the sharia'a scholar level; the industry finds it hard to get enough Islamic finance professionals, forcing the financial institutions to look outside to meet the growing demand from the industry. Taking the market realities along with the sharia'a principles is not an easy job and even a genuine attempt in this direction is viewed with much skepticism by the financial services industry at large. "The lack of knowledge and understanding of Islamic finance has led many a person to criticise this newest branch of finance without any basis or logic," said a sharia'a scholar interviewed by The Business Weekly.
There are experts who believe that sharia'a scholars can change the terms of Islamic finance, if based on reality. "Scholars have the clear view about what is possible Islamically and what is not possible." Brian Kettell, director of Islamic Banking Training, United Kingdom, said. "There is confusion with question marks being raised now. Taqi Usman's comments have opened the floor for discussions."
Shaheed Khan fears that the regulatory framework or the legal framework may not be geared for the purest form of Islamic banking.
"Structuring Islamic products has started off along the lines of conventional model and during the course, all elements that are not sharia'a-compliant were being taken out until they reached a critical mass." he said.
Critical mass
Now, many believe the critical mass has been reached and scholars view that Islamic finance can be refined further and kept away from the 'conventional'. This is the new challenge.
However, Moinuddin Malim, head of corporate and investment banking, Badr Al Islami, holds a different view on the evolution of Islamic finance and the subsequent changes the basic rules have undergone in the process. "The regulators should have set the rules at the initial stage itself. There has to be uniformity for the issuance of regulations. The key question now is whether Islamic banking needs the conventional platform or should it create something new altogether," says Malim.
This points to the new controversy in sukuks or Islamic bonds. The new turn in sukuks is happening at a time when more and more corporates are resorting to sukuks for their funding purposes.
Central banks are shying away from these issues leaving it to the market to organise itself. At the same time, AAOIFI which claims to have 11 jurisdictions under it, says it does not represent the Central Bank but the industry. New structures are coming from different new jurisdictions and the Central Bank cannot certify them until uniformity is attained in products and contracts and this will take time as it is still a formative phase for Islamic banking products.
By CL Jose
© The Business Weekly 2008
