In this issue…
- Making Islamic banking ‘bail-in-able’
- Islamic development bank sukuk prices tightly with sizeable joint arranger investment
As the Islamic finance industry across emerging markets expands, it will struggle to find a way to integrate into the broader ethical, responsible finance marketplace without specific, conscious intent. The Responsible Finance Summit, being hosted by Bank Negara Malaysia, organized by RFI Foundation and co-organized by Middle East Global Advisors, is focused on the specific growth opportunity within emerging markets. You, the Finance Forward audience is made up of some of the leaders in the financial sector in the MENASEA region, the nexus for the convergence of socially responsible and Islamic finance. If you register before 15 March 2016 using the exclusive Finance Forward discount code (FF@RFS) at www.rf-summit.com, you will receive a 25% discount for the Summit registration fee. We look forward to seeing you in Kuala Lumpur!
“Depositors’ confidence is affected [but] at the end of the day, people need to put their money somewhere.” – Nicos Anastasiades, President of Cyprus
The quote above was from an interview one year after the Cyprus bailout which saw uninsured depositors at the country’s second-largest bank converted into shares of the bank as it was being restructured with funding from the European Central Bank. It shares both the promise for depositor risk-sharing but also a warning for Islamic banking regulatos to be cautious and plan ahead, if they decide to formalize the potential for unrestricted profit sharing investment accounts (UPSIA) to be ‘bail-in-able’.
A recent Standard & Poor’s report highlights the impact on Islamic bank risk-sharing practices that could result from an increased likelihood that regulators in key Islamic finance markets follow the trend in developing markets to “introduce[e] resolution regimes and the requirements that some banks set aside a certain amount of loss-absorbing instruments”.
The argument from S&P’s Mohamed Damak is that the UPSIA are already legally structured to be loss-absorbing instruments but, he warns, “applying profit and loss sharing without properly explaining the principle to depositors in advance could result in significant deposit outflows for banks and even jeopardize their financially stability”.
Cyprus’ growth experience following the 2013 bail-in suggests that the hit to depositor confidence has an effect on growth. Countries whose regulators are designing regulations that increase the likelihood of imposing losses on depositors face an unpalatable situation if they use this power, whether or not the legal support exists. In Cyprus, uninsured depositors were always subject to loss even though most thought it would be unlikely because of the secondary effects it would cause to the economy.
Today, most Islamic banks are in a similar situation of having UPSIA holders who have formally signed up to bear risk in exchange for potentially higher returns but few Islamic banks (or their regulators) are willing to foresee the possibility of using the loss-sharing. If they saw the loss sharing option as usable, the regulators would have given more credit in the capital computation for Islamic banks for assets funded by UPSIA than they do now.
The regulatory systems within which Islamic banks operate are designed to make Islamic banks compete on a level playing field with conventional banks. This level playing field may conceptually and formally allow for risk-sharing deposits at Islamic banks but it is more than overshadowed by the competitive pressure to protect depositors.
The most comprehensive approach to bringing loss-sharing into the Islamic banking market is Malaysia where there is now a split between insured deposits and uninsured investment under Malaysia’s Islamic Financial Services Act 2013. The Act creates a sliding scale of products from fully insured deposits to restricted accounts with much more limited liquidity and the ability to specify specific investments for the deposits. It also gives credit in the capital computations of banks depending on the risk-sharing nature of their products, which better allows the competitive process to price the risk that is being shared.
The unrestricted investment accounts that provide higher returns, deliver some risk-sharing and more flexible liquidity are the most relevant for the current discussion. In order to protect depositors from chasing higher returns without understanding the risk sharing nature are required to have additional requirements, particularly their disclosure requirements about the possibility of loss. These accounts also have more stringent requirements that the bank manages these accounts using sound investment principles. It also, significantly, requires that the assets will be ring-fenced should there be a winding up procedure on the bank.
The early stages of expanded risk sharing are beginning to take place in Islamic banks, but the challenge going forward is that expanding risk sharing has to follow good regulation. In Malaysia, the regulatory system has been clearly and thoughtfully developed to protect investment account holders and ensure they are fully aware of what they are signing up for. The experience in Malaysia over the next couple years will be instrumental in demonstrating that risk-sharing deposits work, and if successful, how Islamic banks can show a path useful for all banks (Islamic or conventional) to be contributors to a more stable financial system.
The Islamic Development Bank issued a $1.5 billion sukuk with a 5-year tenor (the most common tenor across the sukuk markets). The pricing came in to 50 basis points over mid-swaps (from initial guidance of mid-to-high 50 basis points over mid-swaps) resulting in a 1.775% coupon for the sukuk. Issuance in the sukuk has been in higher demand with regulatory concessions that allow it to be held by Islamic banks to meet their High Quality Liquid Asset (HQLA) level, even though secondary markets remain underdeveloped and the tenor is longer than allowed for most HQLA under the Basel III rules.
There are some interesting features of the pricing of the sukuk that reveal a little about the current state of Islamic banks. With lower oil prices has come a drop in the liquidity flowing into banks; deposits growth is slowed or reversing while asset growth continues nearly unabated. This will, all else equal, reduce the demand for sukuk. It will also probably affect the preference between forms of sukuk towards the more liquid and higher quality sukuk like the AAA-rated IDB sukuk.
For comparison, a USD denominated sukuk issued by the IDB that matures in March 2020 currently yields 1.758%, which means the new sukuk from the IDB combines an extra year maturity rise and the new issue premium of just 1.8 basis points in total. The yield pickup from the extra year in the comparison (based on US Treasuries) is 17.3 basis points meaning that there was actually a new issue discount of 15.5 basis points.
It is not disclosed what the actual oversubscription amount was for the sukuk which is intriguing because it would be imagined such a tight pricing would be accompanied by strong subscriptions. Reuters reported “orders worth more than $1.5 billion” but $243.9 million of those orders (one-sixth of the total amount sold) came from lead arrangers “and related parties”. Reuters reported earlier in the day that there were $1.4 billion in orders and just $190 million from the joint lead arrangers.
Based on the participation by the lead arrangers in the sukuk, one explanation is that the lead arrangers saw strong demand for a benchmark sukuk (typically over $500 million) and wanted to fill it to the maximum amount. The purpose of an IDB sukuk is just to finance the expansion of the IDB but also to develop Islamic capital markets. With higher demand driven by HQLA needs, the additional participation by lead arrangers to up-size the offering to $1.5 billion (rather than $1.0 billion) could have been seen as something of benefit to the lead arrangers themselves, the IDB (for its capital needs) and the investors and future secondary market purchasers of the sukuk, even though it was priced aggressively.
It is hard to judge from one sukuk from a development bank to the rest of the market but it is possible that this demonstrates tighter liquidity on the one hand (the order book was in the neighborhood of $1.25 billion ex-lead arrangers, compared to multiple times subscribed offerings when liquidity was more abundant. However, it does indicate that, for high quality issuance at least, the issuer can still price aggressively and compress the new issue premium and still complete the issuance which should be supportive for other sukuk issuers.