Adapting conventional structures to Islamic needs

Although traditional sukuk (or Islamic bonds) are still the fastest-growing segment of the Islamic finance market, new structures are rapidly gaining acceptance. Based on conventional riba-(interest) based instruments, these structures are evolving to meet the financing needs of banks and companies. They are also meeting the demands of both religious and secular investors for assets with a variety of risk-return profiles, and at the same time, countering objections from some Islamic scholars that many plain vanilla sukuk do not conform to SharÆiah principles.

Global sukuk volume at the end of 2007 reached $97.3 billion after six years of growth, with the majority coming from Malaysia and the Gulf. Islamic finance in general makes up only a small part of the world finance industry, and is estimated by MoodyÆs Investor Services to be worth around $700 billion globally. However, it has grown by around 15% in each of the past three years, partly as a result of the increased wealth in Islamic countries driven by high oil prices. The Gulf Cooperation Council (GCC) states issued 50 sukuk last year, worth more than $9 billion, with the United Arab Emirates (UAE) and Saudi Arabia accounting for about 87% of the total. The other four GCC member states are Bahrain, Kuwait, Oman and Qatar.

As Islamic finance becomes more mainstream, so it looks towards conventional finance to adapt structures in order to satisfy the increasing demand for more sophisticated instruments.

Securitisation, for example, removes property- and project-based loans from banksÆ balance sheets, and subordinated sukuk issues could better satisfy Islamic banksÆ capital requirements ahead of implementation of the Basel II rules on capital adequacy ratios, while also offering higher yields to investors.

Issuing asset-backed rather than asset-based instruments also side-steps the repurchase controversy, whereby a borrower guarantees repayment of securities at face value on maturity or in the event of default. Some interpretations within fiqh (Islamic jurisprudence) say this contravenes the risk- and profit-sharing criteria required for SharÆiah compliance. With asset-backed instruments, the assets are legally isolated by the borrower into a special purpose vehicle, the cash flows and risk profile of which depend on the performance solely of the assets rather than of the borrower, and there is no repurchase undertaking.

Real estate investment trusts in the GCC are expected to reach new record issuance due to the tremendous property boom in Middle East markets, and should be supported by the concentration of high-net-worth individuals and family businesses whose collective wealth is estimated at over $1.3 trillion.

Tamweel Residential ABS CI (1)Æs $220 million issue last year was the first GCC residential Islamic securitisation that was rated investment grade. The assets are ijarah lease receivables on residential properties located in Dubai and marks the first securitisation originated by Tamweel, one of the biggest ShariÆah-compliant home financing lenders in the UAE.

More convertible sukuk, such as the multi-billion-dollar issues launched by DubaiÆs DP World and Nakheel are also likely, as long as regional stock markets are buoyant. Expect issuance in local currencies, given investorsÆ appetite for equity exposure and amid currency revaluation concerns, says MoodyÆs.

Infrastructure project finance sukuk are also likely this year. For instance, the Qatari minister of finance has said $70 billion will be needed to finance projects in the energy and telecoms sectors during the next few years, of which $15 billion will be financed through long-term fixed-income securities, including both conventional and Islamic bonds.

Islamic funds have expanded significantly in the past five years, growing at a compound annual rate of 22%, and are expected to show new features, especially in private equity, which saw the launch of the first Islamic mezzanine fund by Corecap in 2007.

In Saudi Arabia, the private sector is expected to have a big role in home financing after the introduction of a new mortgage law this year. Institutions such as National Commercial Bank and Al-Rajhi Bank are trying to gain first-mover advantage in providing housing finance products with mainly Islamic mortgage structures.

This story first appeared in a Middle East Report that was published together with the July issue of FinanceAsia magazine.

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