Malaysia may not appear at first glance to be the most logical hub for an Islamic financial centre, when you consider Indonesia and, of course, the Middle East but it boasts the world’s largest market in sukuk, or Islamic debt.
Furthermore, the Malaysian government has been determined for several years to demonstrate it can deliver fixed-income sophistication with religion.
At the behest of the regulators, Malaysia’s sukuk market has grown, particularly of late. Muhyiddin Yassin, deputy prime minister, said at the 10th Kuala Lumpur Islamic Finance Forum 2013 in September that the country’s Islamic debt surged from $1.5 billion in 2001 to more than $148 billion in June this year, accounting for 60.4% of outstanding global sukuk.
The form of financing is so popular that even Binariang GSM, a private telecom company backed by Malaysian tycoon Ananda Krishnan, is seeking to raise about M$6 billion ($1.9 billion) by issuing Islamic bonds in the coming months.
It’s an impressive performance for a relatively small country of just 30 million people, only 60% of whom are Muslim. And many experts believe the increasingly supportive regulatory framework will prompt more sophisticated sukuk.
Sukuks are specifically designed to act like bonds but work in a manner that is compliant with the restrictions of shariah, or Islamic law. Effectively, they are investment certificates that do not offer interest or the chance to speculate. Instead they pay a profit generated by an underlying asset, which is allowed under Islamic law.
Of late, a new prospect has emerged. The Islamic finance industry now has a chance to innovate a new breed of sukuk that can cater to the growing capital needs of Islamic banks as stipulated by the Basel III accords. Stricter regulation is forcing banks globally to shore up capital, reduce leverage and improve liquidity.
Malaysia is keen to be a pioneer in loss-absorbing bank notes. But in the Islamic space it is still lagging behind the Middle East in this category of debt.
Abu Dhabi Islamic Bank pioneered the world’s first $1 billion Tier 1 Basel III-compliant sukuk last November, which was oversubscribed 30 times by investors.
Given the positive response to such instruments, Malaysian Islamic banks are keen to follow in the Middle East’s footsteps and regulators have been more than happy to provide the necessary capital adequacy guidelines that comply with Basel III requirements in the Islamic finance space.
Malaysia’s local rating agency, RAM Rating Services, recently published its methodology for bank securities in November, while Bank Negara Malaysia (BNM) released its final guidelines on Basel III’s capital components at the end of 2012. All these factors, combined with the nation’s deep Islamic markets, provide a solid foundation for the country to excel in launching the region’s first ever Basel III-compliant sukuk.
“Malaysia is currently at the forefront in issuing sukuk that are compliant with existing shariah and prudential requirements,” a spokesperson from BNM told FinanceAsia. “Future issuance of Basel III-compliant sukuk by the Islamic banking institutions would diversify the volumes of sukuk as well as enhance the resilience of the Islamic banking system.”
In the conventional space, two local banks have already hit the ground running. CIMB Bank in September sold Malaysia’s first M$750 million ($234 million) 10-year Basel III-compliant Tier 2 subordinated debt, with a callable option at the end of year five offering semi-annual coupon payments thereafter. It was priced at a yield of 4.8% per annum, which is 15bp-20bp tighter than its Basel II note — also known as ‘old-style’ debt.
Public Bank followed shortly after, riding on CIMB’s success. RHB Investment Bank and AmInvestment Bank also have similar programmes in place.
“We believe other banks, including Islamic banks, will follow suit,” said Sophia Lee, RAM Ratings’ co-head of financial institution ratings. “We may see some issuance soon as issuers may take advantage of the current low yields to issue before the tapering of US’ quantitative easing kicks in, which is expected to push up yields.”
Although Malaysia has put in place guidelines, there are still likely to be teething issues.
In December 2010, the Basel Committee on Banking Supervision revised the set of guidelines that spells out reforms to raise the quality and quantity of banks’ regulatory capital bases. Unlike Basel II instruments, Basel III-compliant additional Tier 1 and 2 capital instruments will absorb losses at the point of non-viability — which is where investors could lose all their money if regulators decide the bank cannot survive — by being written off or converted into common stock.
Malaysia’s Basel III instruments require the inclusion of these loss absorption features but domestic Islamic banks are still trying to manage these clauses, suggesting the issuance timing of the first Basel III sukuk remains uncertain.
“The problem with some banks is that not all Islamic banks are publicly listed, which means that the share conversion option is not considered favourably,” said a head debt capital markets (DCM) at a local bank. “If I was an investor I would rather have a partial write-off provision as it still gives the investor some right to recover some money in the event the bank survives.”
However, investors in these Islamic instruments are at a disadvantage at the moment given that there are still no clear guidelines from Malaysian regulators on whether partial write-offs are allowed. This is an important step that regulators need to consider otherwise it could hamper the issuance of Basel III sukuk, added the head of DCM.
Moreover, the trigger points for Tier 2 non-viability are determined at the discretion of local regulators, which brings about another level of uncertainty. The combination of these issues then prompts one vital question — how do investors price these risks?
Bankers highlight that the price discovery process for Basel III-compliant sukuk is extremely difficult as there is no precedent and the price needs to take into account investors’ expectation of a premium. “The premium shall be demanded by the investors as they are to take higher risk due to the loss-absorption nature of these instruments,” said Yazit Yusuff, head of Islamic capital markets for RHB Investment Bank. “This may lead to many players taking the wait-and-see approach for other players to issue first for better price guidance.”
The acting head of Maybank Kim Eng, John Chong, notes that Basel III-compliant subordinated sukuk should be priced in line with the inherent risks of such instruments and the rating accorded by the local rating agency, which at the moment for an investment grade bank is only one notch below its senior rating.
“[Premiums offered should be] similar to how the investors are pricing corporate bonds [versus] corporate sukuk,” he said.
But for now at least, Malaysia’s Islamic banks do not urgently need to raise capital. This is because the nation’s financial institutions are so well capitalised that they could sustain a 300% rise in non-performing loans without Tier 1 common equity falling below 7%, according to rating agency Moody’s due to their prudent lending practices.
Moreover, most banks in Malaysia — both conventional and Islamic — issued a large volume of Tier 2 Basel II-compliant capital instruments last year before new Basel III requirements kicked-in in January 2013. In 2012, a total of about M$8.86 billion of subordinated debt was issued by Malaysian banks, which is 5.5 times larger than the previous year and the biggest volume ever in five years, estimate analysts.
Despite teething issues and the lack of need to raise Basel III capital for the time being, bankers believe that financial institutions will be required to replace maturing old-style paper over the next two years. AmInvestment Bank estimates that M$1.4 billion of Islamic Tier 2 notes will come due in 2016, followed by M$400 million the following year.
“We have the programme in place to tap Basel III capital because it is a more efficient use of capital and we are looking forward to this development,” said Seohan Soo, head debt capital markets at AmInvestment Bank. “Come 2014, 2015 when banks have maturing Tier 2 capital under the old Basel II, they would obviously need to replace them.”