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Credit ratings are opinions of relative credit risk and default probability. Accordingly, the rating symbols assigned to each credit denote relative ranking, with the higher ratings indicating lower credit risk and lower probability of default. Bondholders and lenders can rely on credit ratings as a tool to facilitate the pricing of credit risk.
It is, however, acknowledged that a large cross section of bondholders are primarily concerned with the “will default” or “not default” aspect of an entity’s credit risk. More than “pass” or “fail” indicators, credit ratings are actually designed to assist in benchmarking a rated entity’s credit risk relative to its peers.
Sound credit risk assessment requires all the risk factors associated with a particular credit to be identified, evaluated and quantified in order to arrive at the best credit decision. Reference is often made to the five “C’s” to consider during a credit risk assessment: character, capacity, capital, condition and collateral.
There may be more “C’s” to consider when the borrower has meaningful international operations: country, currency and cultural risk.
A credit rating agency goes through a similar process of identifying the key risk drivers for a rated entity or issue. This is reflected in the rating methodologies used to rate a particular entity or debt.
The analytical framework used to rate Islamic debt and Sukuk does not differ markedly from that used to rate conventional debt as the prevalent forms of Islamic financial instruments, predominantly fixed income Islamic instruments, behave no differently from fixed income conventional debt instruments. The central focus of a rating is the same, which is the likelihood of timely payment or probability of default (PD).
In some other agencies, the recovery value which translates to the expected loss (EL) of the issue or issuer in the event of non-timely payment is taken into consideration in deriving the rating. This EL element, when taken into rating consideration, may give benefits to structure with high value of asset pledged as security.
Malaysian Rating Corporation Berhad (MARC) does not give benefit to the degree of EL as we are primarily focused only on timeliness of payments by employing the PD method in our rating approach.
Islamic debt instruments:
Evolution to current structure
Islamic finance is based on the fundamental set of Shariah rules. The basic tenets of Shariah compliant financing include the prohibition of interest-based (riba) transactions, the avoidance of economic activities involving speculation (gharar), the elimination of exploitation of either party, and the prohibition of financing the production of goods and services which contradict the Islamic ways (haram). The early forms of Islamic private debt securities or bonds in Malaysia were simple “cost-plus” and “sell and buyback” Islamic structures based on the Bai’ Bithaman Ajil and Murabahah concepts.
While these instruments served their purpose well in promoting Islamic finance in the Malaysian market, they could not win the approval of the GCC Shariah scholars. Nevertheless, on hindsight, they provided the impetus for the explosive growth in the demand for Islamic debt instruments in the late 1990s.
Since 1997, when Islamic bonds made their debut in the Malaysian bond market, MARC has rated RM57.2 billion (US$17.14 billion) of all issued Islamic bonds and Sukuk (excluding government Sukuk). This represents about 36% of the total issued amount in the vibrant Malaysian Islamic bond market of RM160 billion (US$48 billion) to date in terms of value as shown on table.
MARC had rated the first US dollar-denominated Serial Islamic Lease Sukuk listed on the Labuan International Financial Exchange in Malaysia, issued by First Global Sukuk Inc, a special purpose vehicle of Kumpulan Guthrie (now merged with Sime Darby Group).
In the new millennium, market players were seen to offer more innovative products that bore reduced resemblance to conventional financial instruments. Products using the Musharakah and Ijarah concepts proliferated the market with resounding acceptance and success.
More recently, continuing momentum towards a purer breed of “risk reward” sharing instruments has been provided by a recent pronouncement issued by the Shariah Board of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI).
AAOIFI has issued a formal pronouncement on Sukuk that identifies the use of purchase undertakings in Musharakah structures, and the full recourse nature of such financing as being incompatible with the principles of the Shariah. Although such a ruling will likely create Shariah non-compliance issues for investors of earlier Sukuk issuances, it will encourage innovation in the structuring of non-recourse financing within the Sukuk framework.
Following the AAOIFI statement last year, new Sukuk Musharakah structures based on non-recourse project finance principles have emerged, and should lead the way in the structuring of Sukuk in the real estate, infrastructure and energy sectors.
Shariah jurisprudence:
Element of credit risk?
It has been a long-standing stance of most credit rating agencies to disregard Shariah jurisprudence in the credit ratings of Islamic financial instruments. There are differences in interpretation between the various Islamic schools of thought that further complicate the assessment of Shariah compliance.
Credit rating agencies are generally not equipped to validate the degree of Shariah compliance and conformity to the Shariah requirements of a particular jurisdiction. The growing awareness among many quarters of the Islamic finance community for greater convergence in such matters is particularly encouraging. However, at the same time, mutual respect among the various Shariah scholars with regard to the divergence in interpretations must also be maintained.
Bahrain-based Islamic International Rating Agency (IIRA), in which MARC is a shareholder, has been quick to fill the void for Shariah compliance assessments for the astute Islamic investor and fund manager.
Its rating solution, a product called Shariah Quality Ratings, aims to provide an evaluation of the extent to which the organization’s overall internal operations and risk management philosophy support adherence to applicable Shariah requirements of its jurisdiction.
It is not an evaluation of Shariah compliance based on a single global rating scale to be used across all jurisdictions. This opinion, which may be likened to a Shariah compliance audit, could prove useful for certain institutions like Takaful operators and Islamic fund managers. The widespread use of such ratings will add depth to our Islamic capital market.
Moving away from credit risk
to investment quality
The issuance of a new breed of Islamic financial instruments which embodies the true sharing of risk and reward between principals in a transaction has gained traction with AAOIFI’s pronouncement on the use of Sukuk Musharakah. The introduction of variable income and outcome dependent instruments based on Musharakah structures will create the need for a new rating product.
At MARC, we believe that rating such instruments on the basis of investment quality is more appropriate because total return on investment has a greater relevance here than timely payment. MARC has conceptualized a new rating scale that provides a rank ordering of investment quality to meet the challenge for rating this new breed of instruments.
Notwithstanding the progressive evolution of Islamic finance, credit ratings continue to play an important role in providing an independent, informed and objective assessment of credit risk pertaining to securities and entities.
The challenge to rating agencies such as MARC is to fill the void in present-day and foreseeable near-to-intermediate term requirements of the growing Islamic finance investor community, be it in the form of Shariah compliance assessments and investment quality opinions or rating products yet to be created.
Since its inception in 1996, MARC has been committed to playing an integral role in the development of Islamic finance in the domestic Malaysian and regional markets.
Milly Leong
Chief rating officer
milly@marc.com.my
Malaysian Rating Corporation (MARC)
5th Floor, Bangunan Malaysian Re
No 17 Lorong Dungun
Damansara Heights
50490 Kuala Lumpur
www.marc.com.my
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