Different Types of Risks Affect Sukuk Essay (Critical Writing)

Introduction and Literature Review

Shariah-compliant investments emerged in the 1990s and prohibited taking of interest, speculation, and making investments in sectors considered immoral such as alcohol, pornography, or cigarettes under the Shariah law. In addition, Shariah’s banking law requires the customer and the bank to share gains and losses. This sector still represents less than one percent of the investments in the world. According to the KFH-Research study, the activity of Islamic banks account for 80.3% of the assets, which is valued at 1.3 trillion dollars at the end of 2012 (an amount close to funds invested in private equity) (Zawya, 2013). Sukuks accounted for slightly less than 15% of the total. It is obligations to circumvent the payment of interest (forbidden by Shariah) by backing such products with assets that pay upon performance. In the case of the British debt, London could exchange for funds received to provide an asset. Islamic funds represent four percent of the masses managed, while insurance (takaful) is still in its infancy, but it is estimated to represent one percent of the market.

Risk of Sukuk

Different types of risks affect Sukuk, just like other financial instruments. The first distinction of risk is notable between market risk and other kinds of risk. Market risk is a risk of an instrument, in this case, Sukuk, traded in a specific market (Heffernan, 1996). It can be subdivided into systemic risk that relates to governmental and economic guidelines or idiosyncratic risk that relates to different firm particular instruments that can be priced out of a relationship with other organizations’ instruments (Tariq, 2004). Market risk is compounded by equity price risk, forex risk, equity price and commodities risk, and interest rate risk.

For instance, sukuk fixed rates and traditional fixed rate bonds experience the same interest rates in a similar manner. On the other hand, Sukuk certificates are indirectly linked to fluctuations of the benchmark interest rate, in this case LIBOR. Sukuks are also exposed to Foreign Exchange Rate Risk. This is the account unit of IDB in Islamic Dinar, and it is equivalent to one Special Drawing Right (SDR) of the IMF with a weight that consists of 45% in US$, 29% in Euro, 15% in Japanese Yen and 11% in Great Britain Pounds (Tariq, 2004). Since Sukuk are denominated in US dollar, there is a mismatch of currencies with IDB and every movement of the US currency affect profit and loss of IDB.

Moreover, sukuks also have operational risks. Credit risk represents the probability that an asset becomes irrecoverable due to default or delay in settlement (Tariq, 2004). There are different kinds of credit risks, which may be relevant in Islamic finance. For instance, Salam contracts may suffer risks that relate to failure to supply on time or supply the required amount. Coupon payment risk may also affect Sukuk. This happens in case the payee does not pay the approved vouchers as stated in the contract. The asset redemption risk may take place if the original assets fail to achieve full redemption, and the source has to purchase them again from an individual who has the certificate. Risks also relate to Special Purpose Vehicle (SPV). These risks could take the form of settlement risk engaged to the SPV in which the owner must pay back certificate holders via a clearinghouse (Heffernan, 1996). In addition, Sukuk structures may also experience liquidity risks because of a lack of a properly developed structure and adequate liquid secondary market. In some cases, several holders of certificates would retain their certificates until maturity.

Another risk that may affect the Sukuk is Shari’ah compliance risk. Shariah compliant risk relates to the decline in the value of asset because of the issuers’ disregarding trust requirements under the Shari’ah principle. Shari’ah jurists have a fundamental role in the realisation of the Sukuk prospectuses. The dissolution clauses of these prospectuses creates situations that will get the Sukuk deed null and void due to Shari’ah non-compliance” (Tariq, 2004).

Managing Risks of Sukuks

Islamic Bonds or Sukuk has become the most preferred Islamic banking instruments among non-Muslim countries. In addition, Multinational banks have also focused on offering Islamic derivatives to consumers. This practice is mainly common in the Asian region. The Islamic derivatives on offer in these financial institutions include “forward-rate agreements, cross-currency swaps, and equity-linked structured products” (ATKEARNEY, 2012). London, one of the world’s largest financial centres, expects to become the first non-Muslim country that is willing to open its doors to this specific type of bonds (Sleiman and French, 2013). Gordon Brown had advocated for the introduction of Islamic banking system in the UK (Christofi, 2007). The former premier wanted to make the UK a financial hub for Islamic baking in Europe. Although the progress is slow in most these countries, there are positive indicators that they would eventually embrace the system because many of them have expressed their desires to sell sukuks. Today, David Cameron also intends to promote Sukuks since they will work as an avenue of funds from Muslim investors, who are allowed by their religious practices to invest in these products.

However, such a big move involves several risks. There are some investments, which directly relate to Islamic bonds, and they need to be managed. The Financial Services Authority (FSA) in the UK identifies five main risks that these bonds will bring along with their wide pool of funds.

The first risk relates to the approval of “Shariah” scholars. There is a possibility of complication when it comes to offering Sukuks in different jurisdictions or to different institutions. The second risk refers to the fact that a Sukuks may be sold according to Shariah requirements, but it needs to be monitored throughout its life cycle, which could result into several complications and costs. Mitigating these risks would mean bringing scholars to the UK and to specific sectors where they would approve and monitor bonds.

The third important risk factor to consider is that Shariah scholars are not adequate. Not many Shariah scholars are available to monitor and approve all environments in which every sukuk business will take place. One specific case in which this would be a problem is in the required yearly audit for “sharia compliance” on firms’ dealings with Islamic bonds. This requires effective management by the FSA (Ainley, Mashayekhi, Hicks, Rahman & Ravalia, 2007).

The FSA identifies human resources as risks to sukuks. It refers to the fact that there is a shortage not only of Shariah scholars, but also of professionals in Islamic finance. On this regard, Islamic financial institutions would have to offer further training on their products in order to mitigate these risks. Finally, the last risk listed relates to contract and documentation. Contracts for these Islamic transactions will face complications if ever presented in the UK court given that the terms and conditions for the product are written based on Shariah principles. The FSA has to make sure that this does not become a big problem when introducing the product and services. Hence, words and phrases on product documents and terms would have to bear their ordinary, common meanings. Contracts will require careful wording in order to eliminate risks of associated with misinterpretation.

Evaluation and Challenges

This part of the paper will mainly deal with the challenges of Sukuk, inter alia lack of standardization and liquidity, legal and regulatory issues, as well as evaluation issues.

The first challenge is the lack of standardization. Sukuk needs to be a Sharia compliant product. The absence of widely recognized standards causes volatility and risk, especially in the fast growing market. The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) is engaged to manage this problem. At the same time, the AAOIFI must not put a statement that the public can misinterpret because the impact could be devastating. It had standardized fourteen types of Sukuk, inter alia Ijara, Murabaha, Mudaraba-wakala. Nevertheless, the guidelines are not mandatory. The market requires a uniform procedure for internal control and a guiding set of principles, which is acceptable by at least the majority of Shariah advisors. The major player Malaysia can serve as an example. Malaysian government ensures that every Sukuk is Shariah compliant by establishing a Shariah supervisory board at the national level. However, the motivation should be driven a step further to establish an international uniform standard (like IFRS) for consistency and international comparability (Khan and Porzio, 2010).

Sukuk relies on Shariah law. However, it has to conform with the commercial law as well. However, these requirements may lead to inconsistencies because of different laws with different financial principles, which Islamic institutions must manage. This might be a challenge because Sukuk is an Islamic Financial instrument while English laws are conventional laws. In addition, Sukuk is issued through special purpose vehicles. The IFRS may reject some steps in this process. Another challenge may emanate from supervisory and regulatory bodies because asset management and commercial banking in Islamic finance are involved to mobilize funds. Khan and Porzio note, “Regulators will be rightly worried about how to define firewalls to keep asset management and commercial banking separate, legally, administratively and operationally, in order to ensure proper monitoring and supervision of the bank’s activities” (Khan and Porzio, 2010).

The issuance of Sukuk requires the creation of a special purpose vehicle, which causes additional costs in terms of transaction costs, taxes, and stamp duties. Many scholars agree that rating Sukuk is different from rating conventional bonds in terms of complexity (Skully, 2012; Ariff, Safari & Mohamad, 2012). Skully notes that sukuks have made significant progress in some European countries. However, most governments have failed to formalise suitable taxation laws. Skully notes that governments should base such laws on “the outcome rather than the technical legal specifics of an Islamic financial transaction” (Skully, 2012). He also claims that it would not be too hard for a government to follow an existing principle. The UK and other countries, which are mainly sukuk receiving countries, have moved to tax neutrality approaches as a facilitative regulatory condition for sukuk and development of cross-border investments (Parker, n.d).

Therefore, Islamic institutions should evaluate conventional methodologies before applying them in their sukuk models. Sukuk requires tangible assets as securities, which are adversely few and eligible for ownership under Islamic financial institutions. Moreover, underlying assets determine the productivity of Sukuk. This makes Sukuk to face extreme competition from conventional bonds in terms of liquidity, since tangible assets such as mortgages are not easy to liquidate (Hanefah, Noguchi and Muda, 2013).

Liquidity is essential to sustain a market. Sukuks have another disadvantage compared to bonds in terms of liquidity. It is difficult to trade sukuks on the secondary market because they are not liquid and transparent. The higher risk due to the lack of liquidity can be one major reason “why yields in the Sukuk markets are significantly higher than in the bond markets for an identical term and quality rating” (Ariff, Safari & Mohamad, 2012). Liquidity comes from the market. Therefore, market makers have a corresponding responsibility to maintain liquid to acceptable standards (Ariff, Safari & Mohamad, 2012).

Conclusion

Overall, sukuks are facing several challenges. In order to manage the liquidity issue, sukuk should function more widely and efficiently. Several issuers and many types of issuances could make the market viable and deeper. Lower transaction costs, better tax treatment (like in the UK), as well as a better financial infrastructure could make the market more attractive. In order to manage the lack of standardization and legal issues, regulators should develop uniform international accepted and binding regulatory framework. The difference between Islamic Banking and conventional requires explicit legal terms and conditions, skilled human resources and rating methods. There is still a poor public awareness of Sukuk and, therefore, a lack of familiarity, which additionally increases the level of competition between conventional bonds. Investors must also understand that sukuk does not attract any interests. However, they must claim a part of profit that the company generates from sukuk. This also applies to losses, but it depends on the type of contract between the parties. Overall, financial institutions and regulators must note that banking principles evolve with time.

References

Ainley, M, Mashayekhi, A, Hicks, R, Rahman, A, &Ravalia, A 2007, Islamic Finance in the UK: Regulation and Challenges, Financial Services Authority, United Kingdom, Financial Services Authority, United Kingdom.

Ariff, M, Safari, M & Mohamad., S 2012, Sukuk securities, their definitions, classification and pricing issues. In M. Ariff, M. Iqbal & S. Mohamad (eds.), The Islamic Debt Market for Sukuk Securities: The Theory and Practice of Profit Sharing Investment (pp. 11-41), Edward Elgar Piublishingm Cheltenham, UK.

ATKEARNEY. (2012). The Future of Islamic Banking, Web.

Christofi, H. (2007). Islamic Banking in Britain. Web.

Hanefah, MM, Noguchi, A and Muda, M 2013, ‘Sukuk: Global Issues and Challenges’, Journal of Legal, Ethical and Regulatory Issues, vol. 16, no. 1.

Heffernan, S 1996, Modern banking in theory and practice, John Wiley & Sons, New York.

Khan, F and Porzio, M 2010, Islamic Banking and Finance in the European Union: A Challenge, Edward Elgar, United Kingdom.

Parker, M. (n.d). Sukuk market challenges must be addressed to maximize potential. Web.

Skully, M 2012, Australia: The wait continues, Web.

Sleiman, M and French, D 2013, Western banks eye growth in Islamic trade finance, Web.

Tariq, AA 2004, Managing Financial Risks of Sukuk Structures, Web.

Zawya. (2013). KFH-Research: USD 1.3 trillion assets of Islamic banks by end of 2012, Web.