In this issue…
- GCC governments hold the keys to the green sukuk opportunity
- Malaysia’s Investment Account Platform can be the catalyst for changes needed in Islamic banking
Lower oil prices were cited as the reason behind Standard & Poor’s ratings cut of Saudi Arabia, Oman, Bahrain, Kazakhstan and Brazil. At the moment, the dramatic cuts (the three GCC countries were cut by two notches) puts Standard & Poor’s in a position of being more pessimistic than either of the other two ratings agencies. There are two ways for this to be resolved—either fiscal tightening or oil prices rebounding forces a reversal by S&P—or the other ratings agencies are eventually forced to cut their ratings as well. In either case, it is cause for greater attention to issues of sovereign risks because the denouement will almost certainly occur before the announcement of a change in the ratings.
The concept of a ‘green sukuk’ has been floated widely for several years but the recent rating cuts to several GCC markets will make it more difficult for a debut green sukuk from a non-multilateral issuer. The reasons for the ratings action by Standard & Poor’s was the effect of low oil prices which has made the fiscal. Hit by the ratings cuts were saw Saudi Arabia (cut two notches to A-), Oman (cut two notches to BBB-) and Bahrain (lost its investment-grade rating with a cut to BB).
The ratings cuts on their own do not make a green sukuk out of the question and five of the six GCC countries retain their investment-grade ratings. An analysis of the labeled and unlabeled green bonds from HSBC and the Climate Bonds Initiative shows that, although the vast majority of green bonds are highly-rated investment grade, there are many issued even with lower-investment grade ratings, particularly those funding energy-related projects. About four in ten of all green bonds are rated BBB or A, but for energy projects, this rises to eight of ten.
There is an opportunity that lies in renewable energy financing in the GCC where a green sukuk could emerge, but it needs a champion to demonstrate that it is possible. Within green bond markets, champions have traditionally come from multilateral institutions and the Islamic Development Bank seems particularly well positioned to support a green sukuk market developing within the GCC.
At the International Conference on Financing for Development, the IDB Chairman, Dr. Ahmad Mohamed Ali, pledged that the IDB Group would “double its development assistance activities from around US$80 billion recorded during the [Millennium Development Goals]-period to more than $150 billion in the next 15 years (2016-2030)”. The IDB also financed $1 billion in clean energy projects between 2010 and 2012 and is working with the UN Environment Program (UNEP) to continue its growth on renewable energy and towards the Sustainable Development Goals.
In addition to the Islamic Development Bank, the UAE appears the closest to issue a green sukuk and the Dubai Environment & Water Authority (DEWA) announced plans in March 2015 to issue a green sukuk and reiterated their intentions in November 2015. However, the market turmoil created a tough pricing market and there are other factors that limit the interest by investors in renewable energy projects. The capital markets issues are compounded by regulatory factors put in focus in a recent energy market newsletter from APICORP:
“For net [oil-]exporting countries—with the exception of the UAE—renewables will take a back seat as they continue to rely primarily on conventional sources for additional capacity in the coming years and will use demand-side efficiency and price reform as measures to tackle rising consumption [despite the region having] the lowest renewable-energy prices […] for both PV and wind. [It] needs governments to rise to the challenge and improve the regulatory and investment environment to attract investment”.
Efforts in the green sukuk space from the IDB and government-owned entities like DEWA would mirror developments in the green bond markets where multilaterals and municipalities have taken the lead to be followed by companies. In order to spur as many companies to issue green sukuk despite the downgrades of regional sovereign credits (which cap many corporate ratings), the IDB and regional government-linked issuers will have to carefully time the issuance to ensure the pricing is done in line with other sukuk.
A common complaint about Islamic banking is the degree to which the banks are not able to demonstrate clearly how their intermediation role differs from conventional banks. As a result, many see approaches rooted in FinTech that disintermediate the banks as solutions to better connect depositors with the real economy businesses their deposits are funding. These investment platforms work for a time but run into issues of scale as they grow larger and are forced to decide whether to compete or cooperate with the banks they were designed to ‘disrupt’.
Malaysia’s new Investment Account Platform, run by six of Malaysia’s Islamic banks supported with RM 150 million ($35.6 million) in seed capital from Bank Negara attempts to disrupt this model by bringing banks in on the ground floor. Broadly speaking, the IAP is a platform which expands the financing capability of Malaysia’s Islamic banks to offer direct funding opportunities to their high net worth depositors. The eligible individual depositors who are able to invest through the IAP are those who have selected an investment account instead of a current account. It will also be open to institutional investors.
The IAP development emerged with the mandatory split the Islamic Financial Services Act 2013 between capital protected deposit accounts (still guaranteed under the deposit insurance scheme) and investment accounts (not insured accounts for investors willing to bear additional risk to potentially earn higher returns. In a keynote address delivered at the launch of the IAP by Dr. Zeti Akhtar Aziz, Governor of Bank Negara, she highlighted the rising uptake of investment account products. Since the split occurred in mid-2015, the share of investment accounts has reached 10% of total funding for the banks as of December 2015 (up from 7% in August 2015).
The Platform, which allows online access to depositors to choose from ventures evaluated by the sponsoring banks, is similar to many crowdfunding websites but adds diligence performed by the banks and a rating by RAM Ratings. This distinguishes it from traditional crowdfunding sites where the diligence is a requirement of the investors.
Although quasi-equity and equity investments are possible through the portal, it is likely that the initial investment universe will center around debt-based products. This will likely be the case because the banks are doing the screening are most comfortable in evaluating the risks associated with debt financing and the ratings agencies are also most familiar with debt-based products. That does not diminish the significance of the platform compared to non-bank FinTech alternatives. It is also likely to increase the financing available to SMEs relative to the status quo of banks providing on-balance sheet financing to SMEs.
In the traditional Islamic deposit account, funds are collected as unrestricted investment account balances available for the bank’s use to fund any of its assets. Depositors expect a certain return of their funds shared from what the bank earns from the assets, and so, in practice, the deposits are treated identically to a conventional bank deposit. Despite formally passing of the asset risk from the bank to the depositors, in substance and for capital calculation purposes, the risk sharing is excluded or (at best) only given partial credit (an ‘alpha’ that is less than one but greater than zero). SME financing, which is more highly risk weighted, requires higher capital levels which is costly for bank shareholders.
In contrast, an investment account platform investment is provided full risk-sharing benefit to the bank as long as the funds are provided fully by investment account holders and they are not given liquidity of their investment by the bank. The relevant rules from Bank Negara provide that “Credit and market risk weighted assets funded by investment accounts that fulfil the requirements in this policy document shall be excluded from the calculation of capital adequacy ratio of the IFI”.
That means, rather than treating the deposits as a liability, they are taken off-balance sheet for capital calculation purposes because the risk of the assets they finance are fully transferred to the investment account holders (providing full risk absorption for the bank). Free from being heavily risk-weighted by the bank (and viewed as more costly), there may be an increase in SME financing if the investment accounts deliver solid performance, and do not create significant losses for investment account holders.
This is the mechanism by which the investment account platform can be most effective. By providing a demonstration effect that SME financing can be better done with the support of banks and their depositors but financed directly from depositors, there can be further experimentation with alternative ‘banking’ structures. This has to begin with a product that offers relatively similar risks for investors compared with the deposit products they are replacing, but if it builds a track record of success can be the mechanism through with quasi- and full-equity investments can be brought into Islamic banking.