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The rapid development of the Islamic capital market in respect of the issuance of its products, particularly Sukuk or Islamic bonds, has placed Malaysia as a capital market hub recognized throughout the world. Kuala Lumpur has emerged as an Islamic financial center similar to Dubai and Bahrain, mirroring the significance of the Malaysian market.
The recent subprime mortgage, however, has affected the global market as investors are being too suspicious of the ratings assigned to the papers and the masses opt for direct financing instead, the results of which are hardly impressive. Conventionally, banks have financed their mortgage lending through the deposits received from their customers, which eventually limits the amount of mortgage lending they can do.
What went wrong is that the banks now are specialized in a new type of mortgage, which is subprime lending to borrowers with poor credit histories and weak documentation of income which has proven to be extremely profitable for the banks.
The lack of refined regulations in the mortgage system in the US has wounded not just those who have lost or are about to lose their homes, it has also badly affected the conventional financial markets in terms of losses incurred. As the impact of subprime is overwhelmingly faced by the industry, the Islamic financial markets are also to be placed on watch.
The crisis that happened is testament to how sensitive Sukuk issues have become to movements in international markets; this can be seen, as an example, in how Dana Gas and Ithmaar Bank had delayed their Sukuk issuance in 2007 due to the unfavorable interest rate environment.
Although Islamic finance may have been affected by the crisis, with the current growth in the Islamic market, it comes as no surprise that Sukuk has grown ever more rapidly; to the point that global Sukuk, according to Goldman Sachs, totaled US$14 billion in 2006 and US$80 billion in 2007.
One point that needs further scrutiny is how subprime mortgage pools, which are fundamentally based on poor credit and high-risk loans, can be graded into “AAA” investment as 70% of the subprime mortgages are rated “AAA”?
The paramount value of rating agencies to bond investors is to help distinguish securities that are good credit risks from those that are not. Moreover, “AAA” bonds are thought to have virtually no risk of default. When this happens, investors are drawn to invest and, subsequently, leads to the emergence of more problems for the investor, bank and of course the customer as he would be facing the possibility of losing his home.
Previously, ratings were never an issue as they were meant only for domestic investors who are more familiar with the products and the project they are involved in. However, under the present scenario, concern is now on both the ratings and Shariah compliance as it is important for Sukuk to be rated in order to attract foreign investors.
The rating agencies usually require a true sale legal opinion from relevant counsel. This can be an issue in jurisdictions where the laws are subject to the Shariah. Counsel from these jurisdictions will understandably qualify their legal opinion as they are usually not Shariah scholars themselves, and this qualification is an issue for the rating agencies. In Malaysia, for example, it is a requirement under the asset backed guidelines that the sale is the true sale and this needs to be confirmed by legal counsel.
The global credit market has not upset the drive of corporate bond and Sukuk issuance in the Gulf Cooperation Council (GCC), even if the Shariah scholars have recently challenged the Islamic credentials of Sukuk deals traded in the region. Some GCC banks, particularly international investment banks based in Bahrain, have significant exposure to AAA-rated CDO (collateralized debt obligation) issues, which have lost more than a third of their value in the secondary market.
The exceptional growth of the Saudi economy as one of the GCC countries has created a favorable foundation for change, and the Capital Market Law and the Capital Market Authority have made a positive contribution to the development of the Saudi capital markets.
Hong Kong
Islamic finance in Hong Kong has grown tremendously since the 1980s and has gone through a series of rapid transformation in less than two decades. It has gained pervasive recognition not only among Muslim investors, but also among other investors who see Islamic finance as a new investment alternative.
Hong Kong’s Securities and Futures Commission (SFC) has entered into an “Islamic finance” pact with the Dubai Financial Services Authority.
Under the memorandum of understanding, both parties will scrutinize the possibility of establishing a framework for the mutual recognition of their regulatory regimes on Islamic funds to facilitate cross-border marketing and distribution of such funds.
In November 2007, SFC authorized Hong Kong’s first Islamic fund for sale to retail investors, the Hang Seng Islamic China Index Fund. The index-tracking fund tracks the performance of the Dow Jones Islamic Market China/Hong Kong Titans Index.
In June 2008, the Hong Kong Airport Authority had expressed interest in pioneering the sale of the first Islamic bond up to US$1 billion, which is scheduled by the third quarter of this year. In addition, the Hong Kong Mortgage Corporation (HKMC) and railway operator MTR Corporation plan to issue Sukuk within the same time frame.
In December 2007, HKMC signed a joint venture agreement with Malaysia’s national mortgage corporation Cagamas to set up a company to develop the mortgage guarantee business in Malaysia and elsewhere; and May 2008 saw the introduction of a new Dow Jones Islamic Market Index to track China-related equities listed on the Hong Kong stock exchange, further enriching the Islamic index infrastructure in Hong Kong.
Greater efforts are being made to establish a level playing field in the conduct of Islamic finance business with reference to conventional activities.
The government is conducting a review of tax laws to ensure that Islamic financial transactions will not be deprived simply because of their special structure to supply for conformity with the Shariah law.
Japan
Its government bonds hiked tremendously within four weeks after banking shares slid on concerns US financial companies would be forced to raise more capital.
An Arab News report in July 2008 hailed the launch of the Daiwa Exchange-Traded Fund (ETF) by Daiwa Asset Management as a further boost for the global Islamic capital markets and the increasing involvement of Japanese financial services companies in the sector. Daiwa Asset Management is Japan’s second-largest asset manager.
The Daiwa ETF is a Shariah compliant fund based on the FTSE Shariah Japan 100 Index, which was launched in April 2008. Its purpose is to closely track the performance of the FTSE Shariah Japan 100 Index, which consists of the largest and most liquid Islamic companies in Japan, based on the FTSE Global Equity Index Series.
AEON Credit Service and Toyota were the first two Japanese companies to raise funds via Sukuk, both issued in Malaysia. At the end of 2006, Japan’s largest bank, Mitsubishi UFJ, forged an alliance with Malaysia’s CIMB Group to provide Islamic financial investment banking services such as issuing Islamic bonds to Japanese companies operating in Malaysia.
In September 2007, the Bank of Japan joined the Islamic Financial Services Board, an international standard setting body, as an observer to enhance its knowledge of Islamic finance.
Singapore
The Singapore Investment Banking Association (SIBA) has contributed to the remarkable success of the republic’s capital markets. SIBA has not only managed to represent the interest of the investment banking community well, its initiatives have also facilitated the robust development of investment banking activities in Singapore, making it one of the most vibrant financial centres in the region.
The Monetary Authority of Singapore (MAS), together with other relevant agencies like the Accounting and Corporate Regulatory Authority and the Singapore Exchange (SGX), has actively worked on various initiatives to enhance disclosure, strengthen market discipline and improve the corporate governance of listed companies.
These efforts included the Code of Corporate Governance, revisions to SGX listing rules and the introduction of a civil penalty regime under the Securities and Futures Act that provides an alternative enforcement mechanism.
Recently, in May 2008, MAS announced directives on the issuing of Islamic products (including Sukuk) to create benchmarks for the marketplace, as well as satisfying local market demand for Shariah compliant products.
Sukuk bonds and Shariah compliant fund-raising structures are now widely considered to be effective investment alternatives to conventional financing activities. The Islamic capital markets include assets in banking, insurance, investment funds and capital market products, and are estimated to be worth S$1.5 trillion (US$1.05 trillion).
Indonesia
One of the factors holding back Takaful in Indonesia is a lack of Islamic investment instruments like Sukuk due to the difficulties in finding the best returns that are Shariah compliant. There is no such problem for conventional insurance, as it has offered more choices and investment opportunities.
Another challenge on the regulatory aspect, even though the first Takaful company has been around for 14 years in Indonesia, is that there is no law on Islamic insurance yet.
However, recent notable improvements in its regulatory and legal provision is a strong indication of the administration’s increased attention toward the development of Islamic finance. Among which is the Islamic banking law aimed at accelerating the growth of the Shariah banking industry. The law stipulates that conventional banks hosting Shariah units must separate the business if the Shariah unit’s capital reaches half of the bank’s total capital.
Malaysia
Further to the emergence of the above markets, the GCC is building up its base in Malaysia. To cater to the products introduced by these markets, Bank Negara Malaysia (BNM) and the Securities Commission Malaysia have come up with regulations that govern the establishment of new products in the country.
Under section 2.1, it is stipulated that BNM’s “Guidelines on Permitted Capital Market Activities for Islamic Banks” shall apply to:
(i) Domestic and foreign Islamic banks licensed under subsection 3(4) of the IBA (Islamic Banking Act 1983) to carry on Islamic banking business; and
(ii) International Islamic banks licensed under subsection 30B(3) of the IBA to carry on Islamic banking business in currencies other than ringgit. In this regard, the activities permitted to be conducted shall be confined to those transacted or denominated in currencies other than ringgit.
Under Practice Note 1A issued pursuant to the Guidelines, it seeks to dis-apply, unless otherwise stated, the application of the Guidelines on the Offering of Islamic Securities and to set out specific provisions governing the issue of, offer for subscription or purchase of, or invitation to subscribe for or purchase, foreign currency-denominated Islamic securities or Sukuk originated in Malaysia by qualified issuers.
As to the mode of issuance, the foreign currency-denominated Sukuk issued pursuant to this practice note shall be issued on a scripless basis via the Fully Automated System for Issuing/Tendering (FAST). The qualified issuer and principal adviser shall ensure that the issue complies with all the rules and requirements of FAST.
Foreign currency-denominated Sukuk issued pursuant to this Note shall be deposited with the Real-time Electronic Transfer of Funds and Securities (RENTAS) system with BNM as the central depository agent for the Sukuk and authorized depository institutions in Malaysia as sub-depositories. The qualified issuer and principal adviser shall ensure that the issue complies with the rules of the RENTAS system in relation to this depository requirement.
The role that the Malaysia International Islamic Financial Center is playing is to uphold Malaysian laws in respect of any transaction or dealing pursuant to the issuance of Sukuk. The laws of Malaysia, the UK or the US may be used in the legal documentation of an issue, offer or invitation under this Note.
However, the relevant provisions of the Securities Commission Act 1993 and the Securities Industry Act 1983 in relation to the issuance, subscription and trading of Sukuk in Malaysia shall apply, and are to be complied with at all times.
The issuance of Islamic products may have been disrupted by the ongoing credit crunch in the conventional market due to the effects of subprime, yet Sukuk are expanding even to non-Islamic nations such as Hong Kong and Japan. It is the result of an integrated regulatory approach to developing capital markets, particularly an Islamic one, and also a relentless effort in the innovation of the products.
Mohamed Ridza Abdullah
Managing partner
ridza@ridzalaw.com.my
Mohamed Ridza & Co
50-10-9, Wisma UOA Damansara
Jalan Dungun
Damansara Heights
54090 Kuala Lumpur
Tel: +603 2092 4822
www.ridzalaw.com.my
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