The collapse of the securitization market and the ensuing market turbulence have cast serious doubts on this economic proposition of unbundling, transforming, and re-distributing credit risk via structured finance instruments. In view of sweeping fiscal intervention in the financial sector, a widespread retrenchment of mortgage exposures, and substantial liquidity injections by central banks to support inter-bank money markets, both the scale and persistence of the current credit crisis seem to suggest that pervasive securitization — together with improvident credit origination, inadequate valuation methods, and insufficient regulatory oversight — can perpetuate market disruptions, with potentially adverse consequences for financial stability and economic growth.
After having nearly ground to a halt last year, the market for securitized debt remains moribund and pricing depressed as banks dispose of non-core assets and raise capital to de-lever and bolster their imploding balance sheets. The complexity of securitization structures, which once obscured actual loss exposures, perpetuated benign asset valuations, and incubated fallacious investor complacency, is now debilitating effective banking sector resolution in a time of systemic distress.
As the global credit crisis continues to deepen, the soul-searching in conventional finance has directed attention to alternative modes of structured finance to fill the void of unmet credit demand. In this context, some investors – unsettled by excessive risk-taking and asset price volatility – turned to Islamic finance as market ruptures caused by the headlong flight to safety during the initial phase of the credit crisis seem to recede only slowly. Islamic finance is driven by the general precept of extending religious doctrine in the shari’ah to financial agreements and transactions. Islamic finance is distinct from conventional finance insofar as it substitutes the (temporary) use of assets (or services) by the borrower for a permanent transfer of funds from the lender as a source of indebtedness (Jobst ). Predatory lending, deteriorating underwriting standards, and a series of incentive problems between originators, arrangers, and sponsors, of which all have infested the conventional securitization process, belie fundamental Islamic principles.
In this regard, Islamic securitization, via shari’ah-compliant investment certificates or sukuk, invites a comparison of conventional and Islamic finance principles as to their capacity to sustain efficient capital allocation and financial stability. Sukuk have been affected by the global financial crisis only recently in response to inflationary pressures in the Gulf countries, uncertainty about commodity prices, and the widespread economic downturn. These Islamic investment certificates encompass a broad range of shari’ah-compliant financial instruments and can be best described as participation certificates that grant investors return from actual asset ownership in one or more Islamic contracts that are commonly accepted in the legal tradition. While sukuk are structured in a similar way to conventional asset-backed securities (ABS) or covered bonds, they can have significantly different underlying structures and provisions (Jobst et al. ). Most importantly, sukuk — like Islamic financial instruments in general — need to comply with shari’ah, which prohibits the receipt and payment of interest and stipulates that income must be derived from an underlying real business risk rather than as a guaranteed return from interest.
The following article relates the characteristics of this form of securitization to calls for enhanced disclosure and standardization, ratings agency reforms, and better transparency of origination and underwriting practices in conventional structured finance. In particular, it assesses the potential of conflicts of interest (which became apparent in the U.S. subprime mortgage crisis) to contaminate the integrity of the securitization process if it were conducted in compliance with shari’ah principles.
2 Incentive problems of conventional securitization
The main cause of the crisis can be traced to market failure stemming from conflicts of interests in the securitization process and ill-designed mechanisms to mitigate the impact of asymmetric information. By substituting intermediated lending with capital market finance, securitization creates considerable agency cost (which are ultimately borne by investors) if agents are tempted to pursue their own economic incentives. The U.S. sub-prime mortgage crisis exposed the severity of fundamental incentive problems in conventional securitization and the lack of ex ante market discipline. The attendant market fallout demonstrated that remaining conflicts of interests between stakeholders entail significant agency costs, which — if left unchecked — escalate the adverse effects of deteriorating credit conditions, valuation difficulties, and higher leverage on financial stability. In particular, securitization facilitated excessive risk-taking to a point where the inability of issuers to gauge actual credit risk and the flexibility of asset managers to subvert investment mandates intensified the potential of systemic vulnerabilities to credit shocks.
3 The case of Islamic securitization
Sukuk contain many contractual features that are now being considered instrumental to a resolution of inherent conflicts of interest between agents in the conventional securitization model. Any financial transaction under shari’ah law implies direct participation in underlying asset performance and assigns to financiers clearly identifiable rights and obligations for which they are entitled to receive commensurate return in the form of state-contingent payments subject to contractual certainty. There are several Islamic principles of sukuk, which could potentially redress many conflicts of interest and valuation problems that infested the conventional securitization process:
• between asset manager and investor (“principal-agent dilemma”):
– The religious prohibition of both gambling (maisir) and speculation (gharar) prevents restricts trading to bona fide merchant transactions on real assets, limits excessive risk-taking (in the form of asset substitution), and commands clear object characteristics and/or delivery results as part of contractual certainty.
– Asset managers cannot create leverage on the underlying asset portfolio (and benefit from moral hazard in response to redistribution of risk) as exposure is limited to the nominal value of the reference portfolio in asset-based contracts or the scope of profit-sharing in equity-based contracts respectively.
• between issuer and investor:
– Investor return is derived from effective (or intended) ownership of real asset(s) underlying the securitization structure (after actual and direct transfer as object of an unconditional sale), which allows direct recourse tantamount to on-balance sheet securitization.
– The prohibition of an exchange of debt (and cash settlement) ensures commercial value to investor(s), wealth creation, and diversity of trade from underlying asset transfer.
• between borrower and originator:
– The Islamic principle of social benefit as public interest (maslaha) and the precept of supporting a system of distributive justice (via a mutually beneficial balance between borrowers and lenders) would preclude any moral hazard of originators (“predatory lending” or borrowers (“walking away”). Moreover, the shari’ah prohibits debt modification and unilateral gains (which are considered exploitation). Nonetheless, many pitfalls of financial innovation that contributed to the U.S. sub-prime crisis also apply to finance based on such principles , such as sound risk assessment, adequate rating processes, and the use of integrated risk mitigants. For instance, inflated asset prices of difficult-to-value collateral could obfuscate lower-than-expected asset performance, increase residual equity, and help maintain artificial arbitrage gains of asset managers.
4. Current market situation
Although the current level of issuance remains a fraction of the global volumes of conventional bonds and ABS, the sukuk market had soared in response to surging demand for shari’ah-compliant products from financiers in the Middle East and other Muslim countries as alternative investments before the first round of severe market disruptions in 2007 showed first effects in capital markets. Gross issuance rose from US$7.2 billion in 2004 to close to US$39 billion by the end of 2007,[i] owing largely to enabling capital market regulations, a favorable macroeconomic environment, large infrastructure development plans in some Middle Eastern economies and financial innovation aimed at establishing shari’ah compliance (IOSCO ). At the end of 2007, the outstanding volume of sukuk globally exceeded US$90 billion (Moody’s [2007 and 2008]).
Exhibit 1. Global sukuk issuance (2005-08, in USD billion).
However, the sukuk market has not escaped the throes of the credit crisis that erupted last year, with investment banks and finance houses worldwide still reeling from the collapse of the U.S. sub-prime mortgage market and the breakdown of the wholesale money markets amid persistent counterparty risk concerns and deep-seated investor distrust in credit-sensitive assets. In 2008, sukuk volumes sharply declined to US$17.2 billion (about 50 percent) as the structured finance market contracted to just US$387 billion of annual issuance (down by about 80 percent) during the same time (see graph below) [Hesse et al. [2008a and 2008b]). Factors contributing to this decline include the presentation of new rules on sukuk, the global economic slowdown and GCC currency risk. Even countries that have been driving forces in the sukuk market in recent years have witnessed sizable declines (Burton , Hijazi ). The slowdown in issuance was most pronounced in Malaysia, where fewer domestic transactions at smaller volume have balanced the market shares of GCC and Southeast Asian countries. There has been a trend in 2008 away from U.S. dollar-denominated sukuk deals to issues in local currency, a trend that is likely going to continue.
As policy makers in mature markets enter unchartered territory of dealing with troubled banks, restoring illiquid securities markets and restarting economic growth, heightened risk aversion and depressed commodity prices are likely to exacerbate rising credit constraints and delay the timely recovery of the sukuk market. Besides the continuing slowdown in sukuk issuance, in some cases, governments have taken a greater role in shaping the growth prospects of the fledgling Islamic capital market (which is largely sponsored by banks). For instance, Qatar Investment Authority bought a stake in Qatar Islamic Bank, and also Sovereign Wealth Funds in some countries have been instructed to support domestic equity markets, which would also have been beneficial to the financial sector overall. Although many GCC governments seemed to be prepared to spend their way through the crisis, recent IMF estimates have halved GDP growth from 6.8 per cent in 2008 to 3.5 per cent this year, which might entail a significant scaling back of planned infrastructure projects.
In particular, issuers are likely to face additional funding pressure as the public market for capital market instruments (other than those issued with government guarantees) remains largely shut. The absence of government guarantees for corporate sukuk (which would violate the basic tenets of shar’ah law), the prospect of higher leverage ratios of banks (together with the general market focus on equity/assets and similar ratios), and lack of demand by institutional investors due to general de-leveraging limit the scope of attractive funding sources. The increase of term markets by an avalanche of government debt will also raise the prospect of more sovereign involvement in sukuk markets (after Japan, Kuwait and Thailand postponed their sukuk issuances last year). That being said, there is a silver lining on the horizon as the structural demand for sukuk persists. Since conventional securitization is virtually absent in Islamic countries, considerable demand for shari’ah-compliant investment assets, such as sukuk, provides an untapped market for structured finance as a means to advance capital market development. Islamic securitization also complements the battered ABS market as an alternative and more diversified funding option that broadens the pricing spectrum and asset supply. With more than US$2 trillion of credit demand projected to be unmet in the next three years as the conventional securitization market remains dysfunctional, the current market situation provides a window of opportunity for sukuk. Just last week, Emirates Islamic Bank (EIB) launched a US$100 million four-year close-ended callable shari’ah-compliant sukuk fund, which will hold a portfolio of sukuk issued by companies, based predominantly in the Middle East and North Africa. In spite of having been hemmed in by the credit crisis, the widespread economic downturn, and the recent slump in the real estate sector of the GCC, the sukuk market is expected to soon gain momentum again.
Burton, John, 2009, “Islamic Bond Issues Seen Dropping Further,” Financial Times, Capital Markets, January 22.
Hesse, Heiko, Jobst, Andreas A., and Juan Solé, 2008a, “Trends and Challenges in Islamic Finance,” World Economics 9(2), 175-193.
Hesse, Heiko, Jobst, Andreas A., and Juan Solé, 2008b, “Quo Vadis Islamic Finance?,” RGE Monitor (November 27), 28-33 (available at: http://www.rgemonitor.com/us-monitor/254573/quo_vadis_islamic_finance).
Hijazi, Faisal, 2009, “Global Sukuk Issuance: 2008 Slowdown Mainly Due to Credit Crisis, But Some Impact from Shari’ah Compliance Issues,” Moody’s Investors Services, International Structured Finance (Europe, Middle East, Africa & Asia-Pacific), January 21.
IOSCO, 2008, “Analysis of the Application of IOSCO’s Objectives and Principles of Securities Regulation for Islamic Securities Products,” International Organization of Securities Commissions (IOSCO), September, Paris.
Jobst, Andreas A., 2007, “The Economics of Islamic Finance and Securitization,” Journal of Structured Finance, Vol. 13, No. 1 (Spring), 1-22. Also published as IMF Working Paper 07/117 (Washington, D.C.: International Monetary Fund (IMF)).
Jobst, Andreas A., Kunzel, Peter, Mills, Paul, and Amadou Sy, 2008, “Islamic Bond Issuance – What Sovereign Debt Managers Need to Know,” International Journal of Islamic & Middle East Finance and Management 1(4). Published also in IMF Survey Magazine, International Monetary Fund (MF), Washington, D.C. (September 19, 2007).
Moody’s, 2008, “Focus on the Middle East,” Inside Moody’s (Spring), 4.
Moody’s, 2007, “Focus on the Middle East,” Inside Moody’s (Winter), 4.