As the global Islamic finance industry enters its 40th year in 2015, and continues to assume an accepted niche in the world’s mainstream financial system, its prospects, too, continue to evolve especially regarding its role in contributing to the financial reform agenda, financial stability, GDP growth, intra-Islamic trade and investment, infrastructure development, financial inclusion and wealth management. MUSHTAK PARKER tells its story
Whilst the past year saw the entry of non-Muslim jurisdictions – especially the UK, Hong Kong, South Africa and Luxembourg – into the Islamic capital market through debut Sukuk issuances, and the market size now surpassing an estimated $2 trillion with the potential to reach about $5 trillion by the end of the decade, it is clear that outside the remarkable average year-on-year growth rate of the past decade of an estimated 17.7 per cent and the increasing impact of the Sukuk market, the industry has yet to breakthrough into the mainstream financial system.
All this has occurred at a time when that very system has been experiencing shocks that nearly brought it to collapse. This came about through investment and trading practices that are anathema under the core faith principles of Islamic financial intermediation.
The reality is that Islamic financial assets account for a mere two per cent of global financial assets. It remains the industry that dare not speak its name at the major fora of the world, including the G20, the International Monetary Fund (IMF)/World Bank annual meetings, Basel Committee meetings; and the UN Agenda and so on.
In fact, whenever there are side meetings or top occasional papers on the topic it is largely due to the initiatives of the World Bank and the Basel Committee with the engagement of a few proactive people and institutions in the sector, including the Islamic Financial Services Board (IFSB) and the Islamic Development Bank (IDB) Group.
In the immediate past, Iran and Malaysia have been raising the suitability of Islamic finance in development and economic growth at the World Bank/IMF meetings but even they have gone cold over the last three years.
Islamic bankers in Malaysia, for instance, are disillusioned by the inertia of the government of Prime Minister Mohd Najib Abdul Razak in general and by what they perceive as some of the provisions of the straightjacket of the Islamic Financial Services Act 2014 and subsequent restrictions on a number of proven products peculiar to the local market.
“We can hardly do any financing now in the Malaysian market,” emphasised the CEO of one major Islamic bank, who wishes to remain anonymous. “We are only left with Tawarruq (Commodity Murabaha), which dominates by far. We would like to see the introduction of genuine Shariah-compliant risk-sharing products,” he rued.
In its efforts to promote international linkages especially with the MENA region, Bank Negara Malaysia (BNM), with the help of government tax incentives, is encouraging the use of products that are acceptable to MENA Islamic banks and Shariah scholars. This immediately rules out products such as Bay al Dayn (commodities-backed debt trading) and Bay Al Inah, which are now confined to a small number of domestic operations.
Indeed, in its 2015 Budget, the Malaysian government is extending the deduction of expenses incurred in the issuance of Ijarah (leasing) and Wakalah (investment and agency) Sukuk for another three years until the new year of assessment in 2018. Similarly, in an effort to encourage SME and venture capital start-ups, it is also introducing a new Shariah-compliant investment product in 2015 called the Investment Account Platform (IAP). To promote investment in this, the government proposes that individual investors be given income tax exemption on profits earned from qualifying investment for three consecutive years.
The Sukuk structures are popular in the Gulf Cooperation Council (GCC) states and the new measures in addition are partly aimed also to attract more GCC investors, and issuers to raise funds in the domestic and liquid Malaysian market. Already, Mumtalakat (the Bahrain sovereign wealth fund); Gulf International Bank, Abu Dhabi Commercial Bank, Gulf Investment Corporation; Turkiye Finans (majority owned by National Commercial Bank of Saudi Arabia); TAQA of UAE and Al Bayan of Saudi Arabia have raised funds in the ringgit market over the past year or so.
Developments in the global Islamic finance market in 2015 will materialise in four key areas, namely: regulatory reforms as part of the global financial reform agenda being promoted by the G20/Financial Stability Board (FSB) of the IMF; the continued march of the global Sukuk market; liquidity management for Islamic banks, especially short-term platforms and products to deal with their reserve requirements and meet their money market needs; and the continued predominance of Tawarruq and Murabaha syndication in cash management and trade finance.
Of course there will limited progress in other areas in public policy: Shariah and corporate governance; further market proliferation; financial inclusion and in leveraging social finance structures such as Waqf (perpetual trusts) and Zakat (obligatory tithes), whose combined potential assets exceeds an estimated $1.5 trillion globally.
The global financial crisis exposed the weaknesses in regulatory architecture and the failure to reign in excessive private sector risk-taking, which in turn incurred substantial costs to the system. So this led to an overhaul. And, not surprisingly, the G-20 Agenda mandated the IMF and its Financial Stability Forum (FSB) the vital task of restoring global financial stability, thus making the system more resilient.
This covers all the sectors of the financial services industry and has focused equally on enhancing the supervisory and enforcement elements of regulation as much as strengthening rules and standards.
The core goals of the IMF comprise strong micro-prudential regulation that is globally coordinated; effective supervision; a robust cross-border resolution framework; a macro-prudential dimension; and a larger regulatory perimeter that includes, for instance, addressing shadow banking issues, and strengthening accounting standards, data gaps and credit ratings.
The G20/FSB Regulatory Reform Agenda G-20 encompasses efforts:
i) to enhance the resilience of financial institutions
ii) to end too-big-to-fail institutions
iii) to transform shadow banking into transparent and resilient market-based financing
iv) to make the derivatives market safer.
Needless to say, these apply equally to Islamic financial institutions as they, too, are part of the global financial system.
The consensus is that the progress of the regulatory reform agenda is mixed – some initiatives are nearing implementation while others remain work-in-progress.
The Basel III framework, which is a cornerstone of resilience through its new capital and liquidity frameworks, is well in place with a defined timeline for implementation. The liquidity framework has refined the concept of High Quality Liquid Assets (HQLA) and introduced two standards, the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR), amongst others, to bolster this framework. The LCR came into effect in 2014 but is to be phased in by 2019.
The good news is that for the first time Islamic finance, thanks to the work done by the IFSB, has featured in a Basel Standard in that a certain type of Sukuk can qualify to be included as HQLA.
BNM governor Dr Zeti Akhtar Aziz has confirmed that Malaysia will start phasing in eligible Sukuk as part of the HQLA stance of Islamic banks authorised in the country from 2015.
One other important development in 2015 will be the adoption of the Standard on Core Principles for Islamic Finance Regulation (CPIFR) (Banking Segment), IFSB-17. The IFSB, the multilateral prudential and supervisory standard body for the global Islamic finance industry, issued a draft of the standard for public consultation in December 2014.
This standard has been developed with input from the IMF/World Bank and comes under the latter’s Financial Sector Action Plan (FSAP) – for the banking, insurance and capital markets sectors to see how far a particular jurisdiction and market complies with sets of core principles of the regulation of the three sectors.
The main objective of CPIFR, according to the IFSB, is to provide a set of Core Principles – along with associated assessment methodology – for the regulation and supervision of the Islamic financial services industry (IFSI), taking into consideration the specificities of Islamic finance.
“It is envisaged that these Core Principles will be used by jurisdictions as a benchmark for assessing the quality of their regulatory and supervisory systems and for identifying future work to achieve a baseline level of sound regulations and practices for Islamic finance. The CPIFR will promote further integration of Islamic finance with the international architecture for financial stability,” explained Jaseem Ahmed, Secretary general of the IFSB.
The IMF/World Bank have instigated more than 84 FSAPs, including several in MENA countries, but in only one jurisdiction, namely Malaysia, carried out an assessment of the Islamic banking, capital market and insurance sectors at the specific request of BNM. This occurred even though there were no such Core Principles developed for the three sectors from an Islamic financial system point of view.
After the final issuance of IFSB-17 in 2015, the IFSB envisages preparing the Core Principles for the Islamic insurance (Takaful) and Islamic capital market sectors.
These initiatives would indeed be a major development and indicate the further integration of the Islamic finance system into the global financial system.
Sustaining the Sukuk market
The Sukuk market is expected to maintain its momentum in 2015, surpassing the issuance figures for the past two years. The market will be buoyed by further consolidation of traditional repeat issuers especially sovereigns, quasi-sovereigns and corporates especially in Malaysia, Saudi Arabia, the UAE and Qatar, the four largest Sukuk markets by volume in the world.
It is also likely that new entrants to the market in the UK, Hong Kong, South Africa and Luxembourg will see further offerings especially by corporates now that a benchmark issuance is prevailing in those jurisdictions. Bankers emphasise that there has been interest for Sukuk origination from corporates and government-linked companies (GLCs) in all four markets.
However, the added value will further come from unusual heavy-weight sovereign and multilateral issuers, which would set the market alight especially in the diversification of the asset pools and applications of Sukuk.
Further innovation will come at the other end of the Sukuk spectrum – that of socially-responsible investment (SRI) Sukuk and financial inclusion Sukuk based on Waqf assets and even involving Zakat funds.
According to the Thomson Reuters Sukuk Perceptions & Forecast for 2015 study released in December 2014, there are currently about $312.3bn worth of Sukuk outstanding globally.
Global Sukuk issuances totalled $119.71bn in 2013, a decrease of 8.77 per cent on the record $137.2bn of issuances in 2012. In the first nine months of 2014, according to the Thomson Reuters study, Sukuk issuances have reached $99.26bn, which is 85 per cent of 2013’s full-year value, and the market is optimistic that the Sukuk growth trajectory is widely expected to continue for the foreseeable future and is expected to surpass the 2013 figure in 2014 and 2015.
According to a Sukuk Survey carried out by Thomson Reuters for the study, the figure for 2014 is expected to be up to $149.9bn, and the forecast for Sukuk issuance in 2015 to be within the range of $150bn to $174.9bn, reflecting strong market confidence in the future of Sukuk. However, these figures may be underestimates, given the rapid opening of new frontiers for Islamic finance in Central Asia, Europe and Africa, with Mexico also reportedly exploring the possibility of issuing a sovereign Sukuk.
There certainly was a scramble in the last few weeks of 2014 to close a number of Sukuk deals as if the sector got a second wind to close the year on a high. These comprised both sovereign and corporate issuances, some of which were debutantes.
On the sovereign side, Turkey issued a $1bn Reg S/Rule 144A Sukuk Ijarah in late November 2014, its third offering in the international market to date. The 10-year certificates were priced at a profit rate 4.489 per cent per annum.
Sovereign Pakistan similarly raised $1bn through a 5-year 144A/RegS Sukuk offering issued through The Second Pakistan International Sukuk Company and priced at a profit rate of 6.75 per cent per annum.
Bahrain sovereign wealth fund (SWF) Mumtalakat Holding Company B.S.C., in a rare foray by a GCC SWF into the Sukuk market, successfully priced a $600m 7-year Sukuk with a four per cent profit rate per annum and a spread of 205 basis points over USD Mid-Swaps.
The transaction represents Mumtalakat’s first US dollar Sukuk issuance. The SWF issued its debut Sukuk in the ringgit market in Malaysia last August.
According to the SWF, the innovative Sukuk structure (a hybrid structure comprised of a commodity Murabaha and a Wakala based on Mumtalakat’s holding in its portfolio companies) allowed the company to capitalise on the strong Islamic pool of liquidity.
Corporate Sukuk issuances during the period included the debut SR1bn Sukuk issued by Saudi Arabia-based Advanced Petrochemical Company; the 5-year $120m Murabaha Sukuk issued by the UAE-based Drake & Scull International PJSC, a regional market leader in the integrated design, engineering and construction industry, and the first Sukuk based on Murabaha trades of Shariah-compliant certificates on the NASDAQ Dubai Murabaha Platform; and the $500m 5-year Wakala Sukuk issued by Dubai Aviation Corporation, the operators of flydubai at a profit rate of 3.776 per cent, equivalent to 200 basis points over the 5-year USD Mid-swaps.
Bankers however, emphasise that the core drivers of this growth going forward into 2015 include:
i) the strong economic prospects (GDP growth, young demographics) in MENA, Asia and Africa. According to S&P, the real GDP growth forecast for 2014 for four of the top Sukuk markets is encouraging – 5.2 per cent for Malaysia, 4.6 per cent for Saudi Arabia, 3.76 per cent for the UAE, and 5.6 per cent for Indonesia
ii) demand for infrastructure investment, which in Asia, MENA and Africa alone adds in excess of $3 trillion over the next decade according to the World Bank. The base is low, so there is much room for improvement in the role Sukuk can play in project and infrastructure financing. S&P data suggests that in 2012, for instance, only $17.6bn through 95 Sukuk issuances were related to infrastructure
iii) The increasing use by airlines and aviation authorities of Sukuk to raise funds to finance fleet acquisitions and airport infrastructure
iv) refinancing activities that will increase as a big stock of both Islamic and conventional financings near maturing. S&P, for instance, projects that Sukuk refinancing alone needs $50bn in 2014 going through to 2015
v) the IFSB has reiterated the critical importance of government issuances of Sharīah compliant securities, of which Sukūk is a prime example, in sufficient volumes and range of maturities that would serve to help address the constraints and lead to the development of liquid markets and instruments for liquidity management purposes and other purposes
vi) the greater migration of asset management funds into Sukuk portfolios and specialised funds
vii) the increased pressure on the 22 or so Muslim sovereign wealth funds to diversify into the Sukuk and Islamic finance market
viii) the anticipated uptake of the credit enhancement Sukuk Insurance Policy of the Islamic Corporation for the Insurance of Investment and Export Credit, the export credit agency of the IDB Group, by investment grade and below sovereign issuers.
Further market and psychological traction will come from three sources – one tried and tested and the other two novel issuers.
The tried-and-tested issuer in the global Sukuk market is the Islamic Development Bank (IDB), which is very committed to the continued development of the market. The IDB closed its latest issuance last September – a 5-year $1.5bn Sukuk Al Wakalah, under its $10bn Islamic Trust Certificate Issuance Programme, which was launched in December 2013.
The issuance is the second international Sukuk issued by the multilateral development bank (MDB) in 2014. In March last year the IDB issued a 5-year $1.5bn, Sukuk Al Wakalah. In addition, the IDB has issued two Sukuk through private placement in 2014 – a $1bn Sukuk with a tenor of 5 Years in July, and a $100m Sukuk in April. As such, in total the IDB has raised $4.1bn from the markets in 2014 alone under its programme, which means that the programme is almost half depleted in a mere nine months.
A senior IDB source confirmed that the MDB is taking measures to increase its Sukuk issuance programme substantially. The final considerations are being currently ironed out. It is almost certain that the new IDB Islamic Trust Certificate Issuance Programme will exceed $20bn, which will be a major boost for the Sukuk growth dynamics.
The IDB is also under pressure from the UK government to issue a debut sterling Sukuk as part of the MDB’s local currency Sukuk issuance programme. Already the IDB has issued Sukuk in ringgit and Singapore dollars.
The IDB is also being asked to increase its programme to much higher levels to enable it to issue Sukuk much more frequently and in larger volumes as peer multilaterals are doing, so as to build a strong issuance history with which a wider base of investors can become familiar. This would also drive down the cost of finance, which is still comparatively higher than peer multilaterals, including the World Bank, Asian Development Bank and the African Development Bank.
The two novel issuers could not be more blue chip – the World Bank and UK Export Finance (UKEF), Britain’s export credit agency.
The World Bank under its International Finance Facility for Immunisation Co. (IFFI) launched a debut $500m Sukuk – a 3-year floating rate note in November 2014, which was priced at 3-Months LIBOR plus 15 basis points. The proceeds from the Sukuk, which was jointly lead arranged by Qatar’s Barwa Bank, Malaysia’s CIMB, NBAD Capital of Abu Dhabi, NCB Capital of Saudi Arabia and Standard Chartered Bank, will be used to provide free vaccines and related health system strengthening support to many of the world’s poorest nations.
The World Bank acts as treasury manager for IFFI, which is rated AA by Standard and Poor’s, Aa1 by Moody’s and AA+ by Fitch, whilst the immunisation programmes are funded by IFFI through GAVI, the Vaccine Alliance. To date, the World Bank under IFFI has raised $4.5bn through conventional bonds in the retail markets in Australia and Japan through the issuance of so-called “kangaroo” and “uridahsi” bonds.
The issuance attracted orders of more than $700m and was a major arranging coup especially for the GCC banks involved. Not surprisingly, Khalid Al-Subeai, acting CEO of Barwa Bank, expressed his delight to be appointed “associated with a transaction that marries true Islamic finance values with the basic needs of the world’s population. Our appointment reflects our expertise in the rapidly expanding international Islamic capital markets and securing a mandate like this is the clearest testament to our credibility, track record, and delivery.”
The second novel issuer that could potentially start a trend both in the East and West is the planned Sukuk by UKEF in the First Quarter of 2015, which will become one of the very few ECA-backed Sukuk issuances to date.
UKEF, in fact, has recently issued a Shariah-compliant guarantee in supporting customers of Airbus aircraft and Rolls-Royce engines.
“A UKEF-guaranteed Sukuk product is a natural step to extend the scope and appeal of this guarantee,” explained Andrea Leadsom, Economic Secretary to Treasury, at the 10th World Islamic Economic Forum (WIEF) in Dubai last October.
“UKEF expects to bring its first guaranteed Sukuk to market in the New Year in support of an Airbus customer – the first Sukuk for an ECA-backed aviation transaction, and a significant step forward in UKEF’s existing work with a wide range of airlines from the Islamic world.
“Like conventional capital markets guarantees, it will be available for use in a range of currencies to suit all customers. And our indications are that, given the confidence the market has in both the strength of the UKEF guarantee and the principles of Shariah financing, its pricing would be consistent with the conventional capital markets product.”
The UKEF ambition is that this Sukuk product will be rolled out to a range of other customers and sectors, including airlines from Muslim countries and sectors such as oil and gas, power generation, healthcare and infrastructure.
The liquidity management challenge
The dearth of short-term Shariah-compliant liquidity management tools for money market transactions and to park the reserves of Islamic financial institutions (IFIs) is the bane of the Islamic finance industry.
Only Bahrain and Malaysia have an adequate Islamic money market to facilitate short-term liquidity management through the regular issuances of Bai Salam Sukuk, Ijarah Sukuk, and government issuances of various sorts. Qatar, Turkey, Indonesia and Pakistan have also started issuing regular local currency Sukuk to facilitate the requirement. Other markets such as the UAE, Saudi Arabia and Oman have resorted to Murabaha-based repos (repurchase contracts) and other Murabaha-based contracts.
There is huge demand for short-term commercial papers by Islamic banks the world over. While there is some traction in local currency tools, the dearth in international currency (including the US dollar, sterling and the euro) short-term liquidity management solutions is even greater.
The International Islamic Liquidity Management Corporation (IILM) was specifically established in 2011 as a multilateral institution to facilitate the above through short-term Sukuk issuance. Thus far IILM Sukuk outstanding is $1.85bn, which is way below the demand in the market.
The IILM issued its latest offering only five weeks ago – a $590m Sukuk with a 3-month tenor, comprising a $390 million reissuance and a $200m new tranche. The A-1 rated Sukuk by Standard & Poor’s Rating Services were priced with an average yield of 0.53285 per cent.
The Sukuk, according to the IILM, were fully subscribed by 10 primary dealers: Abu Dhabi Islamic Bank, Al Baraka Turk, Barwa Bank (Qatar), CIMB Islamic Bank Berhad (Malaysia), KBL Private Bankers (Luxembourg), Kuwait Finance House, Maybank Islamic Berhad (Malaysia), National Bank of Abu Dhabi, Qatar National Bank and Standard Chartered.
Needless to say, one institution could have subscribed to the entire amount signifying its modest size. Unless, the IILM can dramatically upsize both the volume and the frequency of its issuances, its impact on the liquidity management challenge will remain muted.
However, there are snippets of potentially exciting developments on the horizon in 2015. The inadequate supply of short-term liquidity management tools for IFIs is prompting unlikely regulatory authorities to join the fray.
The Bank of England, for instance, has confirmed that it “will commence work in the second half of 2015 to assess the feasibility of establishing a Shariah compliant facility as part of its strategy to broaden liquidity provision to the market”. Assuming such a facility – in the wake of HM Treasury’s debut £200m sovereign Sukuk offering in 2014 – is launched the impact on the market would be game-changing in that it will be the cue for hitherto other reluctant regulatory authorities, especially in Muslim countries, to follow suit.
The bank emphasised in a statement, that it “recognises the challenges Islamic banks face in meeting their liquidity requirements with the currently limited range of options, and notes that its existing facilities are not Shariah-compliant because they involve interest bearing activity. The Sterling Monetary Framework in particular is used as a mechanism by which to set interest rates. The arrangement of any Shariah-compliant facility will be a significant undertaking: it will involve careful analysis, on, for example, pricing, terms, and access, and should therefore be seen as a medium-term project”.
Other non-Muslim jurisdictions, including South Africa, Kenya and Luxembourg, which at the time of writing was in the process of authorising its first Islamic bank, are also looking at introducing Shariah-compliant liquidity management tools over the next year or so.
The need is for Central Bank money market transactions to meet the possibility to create a repo market that can be used by Islamic banks. The Bahrain-based International Islamic Financial market (IIFM) is working on a l’aadat Shira’a (Islamic Repo Alternative) and Collateralisation Master Agreement that can be used universally.
Similarly, Turkey is exploring the possibility of establishing a domestic trading platform for Commodity Murabaha transactions. But bankers in Istanbul maintain that the priority should be for the Turkish Treasury to develop and diversify dramatically its Sukuk issuance programme. The need is also for a robust secondary market for Sukuk trading globally, but led by credible market makers.
The lack of Shariah-compliant liquidity instruments place Islamic banks at a huge disadvantage vis-à-vis conventional banks, thus severely constraining the access of Islamic banks to interbank lending. This has forced the banks to resort to Tawarruq placements with a very limited number of banks in the market.
IFIs like their conventional counterparts also have to comply with capital adequacy and liquidity management rules under the new Basel III Concordat. Bankers believe that Islamic banks are not likely to find it overly difficult to comply with the enhanced capital requirements coming out of Basel III, though they might find meeting the enhanced liquidity requirements relatively more challenging.
On the latter the IFSB is in the process of undertaking a thorough review of the proposed parameters of the new liquidity standards so that these specificities of Islamic finance are fully taken into account in the calculation of these ratios.
In December 2014, the IFSB published a draft Guidance Note (GN-6) for public consultation, which aims to complement the global liquidity standards (such as LCR and NSFR) of Basel III and other developments on liquidity risk management for the Islamic financial services industry (IFSI).
“It will help the regulatory and supervisory authorities to provide a level-playing field to the IIFS in the application of liquidity standards vis-a-vis their conventional counterparts, and thus will promote the sound management of liquidity risk in IIFS,” said the board in a statement. Once again, GN-6 will be issued during 2015.
Another potentially important development whose impact will be felt in 2015 is the launch by IIFM in Manama at the end of last November of the Master Collateralized Murabahah Agreement.
“This global master agreement,” explained Ijlal Ahmed Alvi, CEO, IIFM, “has been developed as an additional tool to be used for liquidity management by institutions active in Islamic finance. It is the best possible alternative to conventional repo arrangements and will enable the institutions to utilise their idle Sukuk or Shariah-compliant portfolio for generating liquidity. The master agreement also provides for credit enhancement resulting in better risk management in an environment where the global finance market is generally moving away from clean lending.”
The key features of this Master Agreement, according to Alvi, is that the fund placing institution will have a comfort of having the collateral in case of any eventuality, segregated safe keeping and margin maintenance mechanism to support risk management. The collateral is taken through a pledge mechanism and envisages that the collateral will be held by a third party custodian to facilitate getting hold of the collateral in case of default or severe impairment of the collateral giving institution’s credit worthiness.
The document has been welcomed by both regulators and market players. Khalid Hamad Abdul-Rahman Hamad, executive director, banking supervision at the Central bank of Bahrain (CBB), who is also the chairman of IIFM, explained at the launch of the Master Agreement that the structure “is based on ‘rahn’ or collateral and will provide an alternative avenue to institutions for low-risk financing arrangements locally as well as cross-border. With the publication of this global standard document, institutions of all sizes will be equally comfortable to transact and better utilise their Islamic securities portfolio, particularly Sukuk. Another feature of this agreement is the potential to make use of a tri-party agent for safe keeping as well as marking to market and such services.”
To Naveed Khan, deputy chairman of IIFM and managing director, ABC Islamic Bank, on the other hand “this Master Agreement fills the acute gap and removes a disadvantage for the Islamic finance industry compared to its conventional counterpart. In as much as re-use is not a feature, it retains its full Shariah-compliant flavour. I am hopeful that both existing and new users will find the standard useful in bridging their liquidity needs.” n