Andreas A. Jobst Monetary and Capital Markets Dept. International Monetary Fund (IMF) Sukuk – Quo Vadis? Islamic Securit

1. Andreas A. Jobst • Monetary and Capital Markets Dept. • International Monetary Fund (IMF) • Sukuk – Quo Vadis? • Islamic Securitization After the Subprime Crisis 700 19th Street, NW, Washington, DC 20431, USA E-mail: ajobst@imf.org

2. Overview • Macroeconomic Situation and Effect on Islamic capital market instruments • Developments of the Sukuk Market • Islamic Securitization as the “Third Way” • Challenges and Outlook

3. Monetary and Capital Markets Department

4. Financial Sector Write-downs and Capital Infusions (billions of U.S. dollars) Infusions by Region Write-downs by Region Write-downs by Type Capital Shortfall  new funding, dividend cutback Mortgages Loans/Leveraged loans Other SIVs Trading Monolines

5. General Impact of the Current Market Situation • … but there are several factors driving up spreads • series of measures announced by central banks (liquidity injections, e.g. collateral framework, FX swaps, standing facilities) and governments (asset purchases, capital support and debt guarantees) • only supply-side effect on secured money markets • failed to restore inter-bank lending and investment in credit-sensitive assets • externalities of Fed/ECB/BoE actions: currency premium, trading bias towards “guaranteed banks” • Keynesian deficit-spending: crowding out by govt debt LT govt re-financing via debt issuance or higher taxes • financial sector de-leveraging: large ST and MT asset supply  further price depression and tight credit • higher Sharpe ratio, currency option skew, etc.

6. The Credit Crisis and its Effect on Islamic Finance • Islamic finance industry in expansionary phase: average annual rates of about 15% • >US$800 billion of deposits and investments in Islamic banks, mutual funds, insurance schemes and Islamic branches of conventional banks • … but some factors exacerbate the impact of global credit environment: • “imported inflation”/de-pegging in GCC, and increased local currency issuance/local investment in sukuk (Islamic “bonds”) • asset-based concept of Islamic finance: sectoral concentration and little asset diversity  slump in real estate • “compliance risk” after recommendations by AAOIFI on sukuk structures (Feb. 2008)

7. Sukuk and Islamic Finance Principles • sukuktransform bilateral risk-reward sharing between borrowers and lenders into market-based refinancing of shari’ah-compliant lending or trust-based investment in existing or future assets. • sukukdo not pay interest, but generate returns through commoditization of capital gains from actual transactions (i.e., asset transfer), such as: • leasing (sale-leaseback): ijara (thumma al-bay)] • cost-plus sale (sale-buyback): murabahah (bay al-inah) • profit-sharing/”sweat capital”/trust: musharakah or mudarabah •  shari’ah-compliant assets, usufructs or services • investors own the underlying asset(s) via SPV that funds unsecured payments to investors from direct investment in real, religiously-sanctioned economic activity

8. Basic Sukuk Structure (w/ Third Party Assets)

9. Past Development of Sukuk Market • increasing appeal in non-core markets (UK, Turkey, Maghreb) • sukuk issuance soared over the last three years in response to growing demand for alternative investments • outstanding sukuk globally exceeded US$90 bn. at end-2007 • gross issuance of sukuk has quadrupled over the past two years, rising from US$7.2 bn. in 2004 to close to US$39 bn. by end-2007, and growth predicated at 15-25% p.a. owing in large part to large infrastructure development plans in Middle East and financial innovation • total issuance in 2007 equivalent to roughly a quarter of conventional securitization in EM but only two percent of conventional (local and foreign) bond issuance

10. Current Development of Sukuk Market • moderate issuance in 2008, but number of deals brought to market has steadily increased (139 in 2008 vs. 161 in 2007 over same time) • sukuk volume dropped to US$15.2bn(50% from US$36.3bn.) in 2008 so far, while structured finance volume dried up with just US$387bn. issued (80%) amid stable EM issuance (US$310bn.) • ijara structure now dominates (>50%), followed by musharaka and mudaraba sukuk • issuance still concentrated in parts of Asia and countries of the GCC • other currencies (but USD, SAR and MYR) hold largest share (approx. US$7 bn.)

11. Prospects: Islamic Securitization as a “Third Way”? • Sukuk and Covered Mortgage Bonds • revitalize the secondary mortgage market • covered bonds: • unsecured debt obligations, collateralized by a dedicated (“ring fenced”) assets that are fully retained by the issuer • interest payments guaranteed and independent of cover assets • on-balance sheet treatment redress misaligned incentives that undermined ex ante market discipline and led to demise of the structured finance • ijara sukuk: • investors receive no institutional guarantee (and off-balance sheet) • but have direct recourse to real assets that fund secured repayment from profitable investment

12. Incentive Problems in Conventional Securitization

13. Islamic Securitization as a “Third Way”? (2) • Sukuk and conventional securitization – incentive problems • between asset manager and investor (principal-agent dilemma): • religious prohibition of gambling (maisir) and speculation (gharar) commands clear object characteristics/delivery results and restricts trading activity to bone fide merchant transactions on real debt based on contractual certainty • no issuer leverage on the underlying asset portfolio and excessive risk taking (asset substitution) • between originator and issuer: • adequate disclosures underpinned by a solid foundation of religious standards (supervised by a designated shari’ah board), which also curb and valuation problems that had infested the conventional securitization market. • between originator/servicer and issuer/asset manager: • contract certainty rules out potential of inflated, back-loaded (and variable) servicer expenses (and cannot be prioritized) • fixed, ex ante premium for transfer of “asset obligations” to servicer • between borrower and originator: • no predatory lending due to sanctioned exploitation (and unilateral gains); no moral hazard of “walking away” or debt modification (prohibited under shari’ah); social benefit as public interest and system of distributive justice (maslaha) 7 2 4-6 1

14. Incentive Problems in Conventional Securitization

15. AAOIFI Recommendations (Feb. ’08) (1) • Key recommendations relate to the role of asset ownership, investment guarantees, and the shari’ah advisory and approval process in sukuk origination and trading •  maintain tenet of risk-reward sharing (otherwise interest- bearing loan) •  Entrepreneurial investment: investors become legal owners (with all of the rights and obligations) rather than nominal holders of the securities •  transforms pari passu asset-based sukuk into tranched asset- backed securities (ABS).  Credit support: must not offer loansto investors in case of profit shortfall  Compliance of collateral: norevenue streams or debt •  Shari’ah certification: review of all contracts/documentation

16. AAOIFI Recommendations (Feb. ’08) (2) •  Purchase price guarantee: issuer/agent (wakil), partner (musharik) or manager (mudarib) cannot guarantee principal through re-purchase of underlying assets or guarantee except: • repurchase at net value or fair market value, or a price agreed at the time of purchase • ijara sukuk (remaining lease payments or nominal value) • trust guarantees to cover cases of negligence, misconduct or breach of contract (representations and warranties) • alternatives: • amortizing clause for underlying assets (cf. Villamar sukuk) or • (separate) voluntary guarantee agreement by agent in mudarabah/musharaka sukuk

17. Current Economic and Regulatory Challenges • origination and servicer risk from narrow asset supply poses challenges to investor diversification • poor asset diversity given narrow range of deal types and maturities • future development could be arrested by insufficient supervisory harmonization and the ongoing controversy about financial innovation • Islamic jurisprudence neither definite nor bound by precedent and no universal recognition and enforceability of rulings • cross-referencing of fatwas • regional diversity of secondary sources: ijtihad (independent analytical reasoning), ijma (consensus) and qiyas (deduction by analogy)

18. References • Čihák, Martin and Heiko Hesse, 2008, “Islamic Banks and Financial Stability: An Empirical Analysis,” IMF Working Paper 08/16 (Washington: International Monetary Fund). • Hesse, Heiko, Andreas A. Jobst and Juan Solé, 2008, “Trends and Challenges in Islamic Finance,” World Economics (April-June). • Jobst, Andreas A., Peter Kunzel, Paul Mills and Amadou Sy, 2008, “Islamic Bond Issuance – What Sovereign Debt Managers Need to Know,” International Journal of Islamic & Middle East Finance and Management, Vol. 1, No. 4. • Jobst, Andreas A., 2007, “The Economics of Islamic Finance and Securitization,” Journal of Structured Finance, Vol. 13, No. 1 (Spring), 1-22. • Solé, Juan, 2007, “Introducing Islamic Banks into Conventional Banking Systems”, IMF Working Paper 07/175 (Washington: International Monetary Fund).