Found this on the internet. A good overview of the Sukuk market.
OVERVIEW OF THE SUKUK MARKET, FORECAST STUDY IN 2015 Redha Al Ansari Senior Islamic Capital Markets Specialist Thomson Reuters.
2015 promises to be an interesting year as the IFSA 2013 comes into effect for Malaysian Banks. We will finally see that shift in the industry as the 30 June 2015 deadline approaches where Banks will draw the line in the sand, separating their Current Account / Savings Account portfolio into the following:
The push by Bank Negara Malaysia (BNM) is really quite clear; Mudharaba as the flagship product that introduces the customers to the world of risk-taking and therefore, potentially higher returns. And if the Mudharaba is to be classified as an Investment Account, then it should behave as one.
But in all honesty, Mudharaba has always been an “investment or entrepreneurial” contract. Worldwide, the concept of Mudharaba means; take customers funds and enter into an investment and share the profits (if any) and should there be a loss, the customer will take that capital losses. This definition does not change, post-June 2015 when the IFSA for deposit comes into effect.
What has changed is that Mudharaba will now be classified as Investments, instead of investments that behaves like a Deposit. There is no fundamental difference between the “now” Mudharaba and “future” Mudharaba. The clause where the capital investment of the Mudharaba is open to potential losses has always been there. The terms and condition contains this. But due to the classification of Mudharaba as Investments post-June 2015, the treatment on how a Mudharaba Investment is processes, managed and executed now changes.
Under a Mudharaba Deposits, the following happens:
But what happens if the Mudharaba must now behave as an Investment? The process looks very similar to how you onboard a customer as an Investor in a more sophisticated product, such as Unit Trusts or Structured Investment products, or even equity shares on the stock exchange. Notice the types of product that the Mudharaba is now being aligned to; higher risks, specific investments, strategy allocation as well as potentially higher returns, depending on the prevailing market conditions,
So if Mudharaba Current Account or Savings Account is to be deemed as Investments, the following must happen:
So you see, the Mudharaba now is defined closely into what a real investment is; capital not guaranteed, returns based on risks, and real valuation. Some will even carry redemption risks i.e. loss of capital if redeemed before maturity.
As a start, the Mudharaba Investment Account, migrated from a Mudharaba Current Account or Savings Account, will now carry their own risk profile, depending on the portfolio of the Investment Assets. It can now be categorised into:
Therefore, even for a basic Current Account or Savings Account, once it is converted into an Investment Account, carries some degree of risks post-June 2015. For one, the PIDM cover will no longer include Investment-type of accounts, and while there are questions of its applicability in its current state, the comfort of such cover is now lost to the daily consumers. Having said that, ideally the Banks should reinforce the idea that with higher risk there should be higher returns. Living in the old thinking that Investment Accounts are the same as Deposits Account (Savings or Current Account) will only result in a disconnect to what BNM is trying to do.
The idea of Investment Account is not only limited to Mudharaba-type of contracts. Any contracts that carries an element of risks to the customer’s capital will be classified as Investments. The on-boarding treatment of customers into these contracts will be the same; The risks of the investment must be made known to the customer, customers must be assessed to identify the risk profile, customers must make their own decision on the risks that they are willing to take, and enter as a real investor taking real market risks. Such contracts will include Wakala Fi Isthihmar (Investment Agent) or Musyaraka (Partnership).
As a summary, what will happen in 2015 once your Mudharaba-type of account (Savings or Current Account) be converted into an Investment Account?
Yes some change will happen, and Banks will be looking to seek customers consent whether to allow the conversion into an Investment-type of account, with the additional disclosures and risk warning statements, or to convert the account into a deposit type of account. As I see it from the Bank’s perspective, the management of the funds in the account remains largely the same, with greater level of transparency needed in terms of where the customers funds are invested into (the Investment Assets), the management of returns and valuation of the assets on maturity or early redemption. Sounds complicated, but really it is not. It is business as usual for the Banks, with some additional reporting, management and compliance requirement to adhere to.
Personally, when the Mudharaba account migrates, I do not foresee a significant increase in risks to the customer capital (as it will still be managed similarly as before) and no significant increase (or decrease) in returns on their “investments”. If the Bank keeps the Investment Assets as “low risk”, there should not be any concerns to the average customers.
There will be other options available to the average investor, but the purpose of this post is to highlight to the existing “investors” that there is no panic button to be pressed. There will be a period of awareness building (reinforcement, more likely) on what “future” Mudharaba is all about, in the stricter understanding of its investment nature. But all this while, the Mudharaba structure is already being managed as an “Investment” via the General Investment pool.
The investment risks have always been there, but because the pool has been managed properly and successfully by Banks, it has become Urf’ (customary) to the customer to believe that capital is protected (when actually it should not). It really is not, as Mudharaba is always an Investment arrangement, and is reflected even in existing documentation and product terms & conditions. Now it may look like it is going to be a different animal in June 2015, however if you take a step back, it is actually an increase in disclosures to the customer on the product features; nothing more. Internal banking processes will be adjusted and enhanced to meet the additional disclosure requirements.
Investment Accounts may seems like a huge change, but it is actually a refinement of the contract requirements. It provides greater transparency to customers, and enhance their involvement in the product by understanding the risks undertaken. The definition of Investment Account has already been captured in organisations such as AAOIFI, where Investment Account and its treatment are defined. BNM is now taking steps in the same direction.
Investment Accounts may change the way you bank at the moment, but it really is a similar proposition to the Mudharaba Deposit account with eventually greater transparency and disclosure. We look forward to welcoming Investment Accounts into our midst of products available.
Fresh off the press, the Concept Paper on Liquidity Coverage Ratio is issued by BNM today.
Off-hand, there has been a lot of concerns with the issue of treatment of deposits, especially in the light of the treatment of Mudharaba Deposits as Investment Accounts, and the Wadiah with limitations on Hibah and perhaps the reclassification as Qardh. Each Bank had decided on a course of action with regards to how deposits are being treated and managed. There is expected to be shifts in the deposit structure of each Bank and worries that with the new changes, there will be deposit flight from the Islamic banking financing system.
The Liquidity Coverage Ratio (LCR) Concept Paper
talks about the Bank having enough liquidity to withstand liquidity stress scenarios by maintaining sufficient High Quality Liquid Asset (HQLA).
The LCR is part of BNM’s effort to meet Basel III initiative to ensure high quality capital and liquidity strength of Banks. This is part of the framework that includes Net Stable Funding Ratio (NSFR) and Liquidity Risk Management Standards.
The areas covered under the CP includes:
Bankers will really need to digest this document to fully appreciate the intention of the paper. We have until end of November to come back with feedback on the issues on implementation of the LCR.
The effective date of this CP is 1 June 2015.
Reading the Ijarah Concept Paper issued by BNM leaves me with one very strong impression; Is BNM seriously asking Islamic Banks in Malaysia to start offering Operating Lease to the customers?
In general, Malaysian Banks (as well as many Middle-Eastern Banks) employ the Financial Lease structures for the purpose of financing the purchase of Assets, Equipment or Property. Financial Lease usually refers to a financing arrangement where the Assets are “rented” to the Customer (Lessee) and at the end of the rental period, the Asset ownership is transferred to the Lessee via a Gift transaction, or a nominal amount Sale Transaction. This means Financial Lease is very similar to a Hire Purchase i.e. you hire, then at the end of the tenure, a purchase is executed. The risks and ownership expenses are borne by the Lessee and in the Bank’s books (Lessor), the obligation is recorded as a receivable.
But reading the questions posed in the CP, one can’t help but escape the notion that BNM is toying with the idea that eventually, “pure” lease, or Operating Lease will become one of the products that is made available by Islamic Banks. Pure Ijara means that the Bank now takes on the ownership risks associated with the Assets. All ownership-related expenses will now be borne by the Asset owner, namely the Bank. Many Ijara structures nowadays delegates such responsibilities to the Customers by appointing the Customer as an Agent to upkeep the Asset, and it is in the best interest of the Customer to ensure the Asset is in good working condition. Under a pure Ijara structure, ownership will always be with the Bank, and therefore the Bank will incur these cost and shouldering the responsibilities.
So what happens under Operating Lease?
Why has no Banks seriously exploring and offering pure Ijara? The answer is simple; The high cost of setting up and maintaining the business, coupled with the operational requirements of offering a pure Ijara product, and the risks that the Islamic Bank faces, makes it a difficult product to offer.
Operating Lease is not an easy proposition as a lot of infrastructure needs to be built. More importantly, an Islamic Bank is not set-up to take on such high risks on their portfolio. In general, the Banks wants stability in its business model and not take unnecessary risks on its books. Personally, I have seen the operation of the Operating Lease in the first Bank I worked in (actually its a finance company), and it took a lot of effort to build the infrastructure to fully support the Leasing (financing) structure. Ijara Financing provides an easier alternatives but that does not mean Islamic Banks should not start exploring Operational Lease. This might one day meet the lofty aspirations of the BNM; to offer products that meets the international understanding of how an Islamic Banking product should work.
At the moment, we are staying off the Operating Lease structures to ensure continued sanity.
A few days ago, several Banks in Malaysia officially made available Deposit products based on Commodity Murabaha transactions.
Looks like Commodity Murabaha (CM), or in another variation is called “Tawarruq” has now expanded its domain from Financing-based to Deposit-based products. More and more banks will have to rely on this structure on both sides of the balance sheet. Bai-Inah based portfolio used to consist of nearly 80% of the overall financing portfolio of some banks; now with the push for Commodity Murabaha structures in financing to avoid interconditionality issues in Bai-Inah, it is expected that Commodity Murabaha financing to eventually replace the Bai-Inah portfolio.
Now with the introduction of CM for Deposits, the popularity of commodities will take a sharp rise! Bursa Malaysia will have their hands busy supplying the industry with commodities to support the underlying transactions. Islamic bankers will also have their hands full buying and selling commodities between the bourse and the customers, either as buying agents or principal purchasers!
I am not sure whether this is necessarily a good thing.
The industry will now shift from having a Bai-Inah-heavy portfolio into a Commodity-Murabaha-heavy portfolio. Concentration risks towards one Islamic contract will grow, and the question is that whether Banks will take the time to develop other contracts into viable propositions instead of just building the CM infrastructure. Do bear in mind that a lot of infrastructural work needs to be done to ensure CM remains the flagship contract for years to come.
The specific risks that Banks faced when offering CM products are manifold; shortage of commodities, delays in transactions, wrong sequencing of purchase and sale of commodity, errors in commodity prices and description, delivery of commodities issues, ownership issues and ownership evidencing. All these requirements needs to be watertight to ensure income from these CM transactions don’t just go to charity. Whenever there is an Asset involved in the transaction, all the factors need to come together to ensure Sharia compliance.
And the way we are going, it seems that CM will probably have 80% of the financing pie and 70% of the deposits pie in a typical Islamic Bank’s balance sheet in 3-5 years time. With IFSA deadlines on June 2015, this ratio could come sooner rather than later.
Will the development of other contracts be further left behind since the shift now is on CM? Maybe, historically Malaysian Banks follows the “Urf Tijari” route of following what the other bank is doing. We have seen this when Bai Bithaman Ajil (BBA) was introduced; nothing else was developed in the market but BBA. It was the same with Bai Inah.
But there is other opportunities for development of other Islamic contracts, although I don’t imagine this is the case for Malaysia while we busy ourself becoming commodity traders. Oman, on the other hand, has rejected tawarruq totally, focusing on other contracts such as Ijara and Musyaraka. This is a good development, as no countries has seriously looked at developing complex, high-risk structures. Maybe once the thinking to shift to understand the transactional and Sharia risks of the new products is made, perhaps the market can warm up to the idea that Sharia compliant banking can be a different way of banking.
Goods Services Tax (GST) will be one of the hot topics for the years to come in Malaysia, when the GST finally comes into place in 2015 to replace the Services Tax. Many arguments have been made on both side of the political divide but the reality is that GST will be implemented and have a huge impact on how services and goods are being priced.
A quick look at the GST finds that Sharia compliant banking, while having all its contracts requiring underlying transactions, asset ownership and movement of actual goods, the impact that the GST may have on Islamic contract will remain similar to what impacts a conventional banking product. There is not expected to have a “worse-off” effect on Sharia compliant banking.
It is heartening to see that Customs has made an effort to understand the various Islamic banking contracts and how it works, and identify potential transactional points where a GST may be imposed. I find the attached document (GST Industry Guide – Islamic Banking (As at 1 November 2013)) extremely useful summary of the intended GST implementation on Sharia banking contracts.
10 particular contracts have been identified and the GST points are outlined accordingly.
To read the New Reference Rate Framework Concept Paper, click here
One of the papers currently being floated around for discussion is the new Reference Rate paper. While no date is indicated for the paper to be effective, [Update : today it was announced that effective date by 2 January 2015] its implication will be significant to both the banking system in Malaysia, Islamic and non-Islamic. The main purpose of the paper is the way Banks price their financing product must now be different. Gone will be the Base Lending Rates (BLR) and Base Financing Rates (BFR), and welcome the new defined term; Prime Financing Rate (PFR).
The intention is this; a lot of the things that go into the BLR/BFR are pricing related to risks, and these premiums are loaded into the base borne by customers. This leaves the margin (or customer spread) that is charged becomes somewhat “clean” as a return to the bank, with the exception of impairments (loan/financing defaults). In addition, banks earn “additional” returns from the “savings” built into the BLR/BFR itself. As a lot of risk premiums are built into the base rate, if these risks do not materialise, the bank technically “earns” this savings. You charge the customer in the base rate some premium for the expected risks, but you get the benefit for it. Ideal scenario.
It is therefore no surprise that some good banks, that are able to manage their risks effectively, are pricing their financing at a base-minus rate. It is now common to see home financing packages being priced at BFR minus 2.0% p.a., and the BFR being 6.60% p.a., the pricing is therefore 4.40% p.a. In theory, taking into account the actual cost of funds, adding only the “necessary” premium to cater for risks that is beyond the bank’s control, the base-minus rate still makes decent money for the Banks.
Therefore, even at 4.40% p.a., there is still room for the Bank to earn a margin, after deducting actual cost of funds. I believe the new Reference Rate framework aims to address this issue somewhat.
The concept paper was issued in January 2014 and this will change the way we price the financing portfolio. Under the concept paper, the base pricing shall only consist of the following:
As you can see, these components of the new Prime Financing Rate (PFR) leaves very little room for Banks to manoeuvre the rates. COF is market driven, based on interbank lending rates, while SRR is a regulatory requirement based on specific percentage. BNM know that these are the most rigid components to pricing, therefore this may be a deliberate composition selection by BNM aimed at institutions to re-think the pricing formula.
And under the new regime of PFR, the following should no longer be built into the base rate. These costs, if the Banks want it, should be a part of the margin to the Banks loaded into the customers.
These cost, if to be taken by the Bank, must therefore be part of the margin charged onto the customer. Customer will now know what components go into their financing i.e. The margin is now reflective of the risk the Bank perceive onto the customer. The higher the customer’s risk profile, the higher the margin can be.
As such, the 2.50% p.a. maximum margin chargeable onto the base rate should no longer be applicable. As at January 2014, the BLR / BFR is 6.60% and at a margin of +2.50%, the maximum rate chargeable is 9.10% p.a. Under the new regime, the dynamics may now be different for example the PFR could be 3.90% and the margin +5.00% which adds up to 8.90%. In absolute terms it’s cheaper but the customer might balk at the +5.00% margin when they are used to +1.00% or even -1.00% margins.
This is actually a good framework as Banks will have to be more competitive in pricing as the lower the margin, the more risks you are taking on your customers as the risk pricing is built into the margin. Additionally, the concept paper restricts the bank from quoting a price lower than the PFR, and this will make sense because it won’t eat into the Bank’s Cost of Funds. While you can have a BFR-2.00% (i.e. 4.60%), a PFR-2.00% won’t make sense as the PFR component, for example priced at 3.90% will give a net financing rate of 1.90%, and eats into the cost of funds.
In short, the pricing for financing moving forward will be based on the creditworthiness of the customer. Any changes in pricing will be reflecting the changes in operating costs, portfolio defaults or funding strategies. It gives the Bank more flexibility to determine pricing based on agreed scenarios or specific events.
This is a positive development. Banks now have the ability to decide on how to price a product based on real strategies and existing capabilities. Customers will have more transparencies in terms of what they are being charged. This will also spur competition among Banks, and provide better products and services to consumers, especially if the Bank gets its risk profiling right and able to effectively manage its default. All this will require a critical re-think on how a product profitability is determined, and a re-think of how the right management can provide a sustainable financing portfolio.
Note: On the Deposit Rates requirements, there are not much in the Concept Paper itself. Most of the requirements on Deposits are captured under the various EDs such as Wadiah, Hibah, Wakalah and the Investment Account Concept Paper. The only notable mention on the Deposit Rates section is that for Basic Savings Account, returns should be paid irrespective of the account balance and shall not be lower than 0.25% per annum. Also, there is a clause that mentions for Islamic Current Accounts, any hibah/dividend payments should not exceed 2.00% per annum. This, in my opinion, runs counter to the ED on Wadiah (which allows the Bank pure discretionary payment of Hibah, and therefore should not be governed by a capped rate) and the Investment Account Concept Paper (which states that the Bank must reward the customer dividends due to them, based on actual portfolio performances, therefore should not be limited to only 2.00% per annum). These point are against the spirit of Wadiah and Mudharabah, as well as against the Competition Act. We understand BNM is discussing this point internally after receiving industry feedback, and may consider removing this from the framework. We wait with bated breath for this framework to be properly issued.
UPDATE : The 2.0% per annum maximum cap on the Islamic Current Account has been removed via BNM circular dated 20 March 2014. Indeed this puts us back on the right playing field with conventional banking.
For some news on the above topic, please find the following newspaper articles:
There are days I wish I was a multi-millionaire with vast resources, cool regulatory connections, tech-savvy and excellent people motivator. Someone who sees the new regulations for the opportunity it is and the potential in it.
If I was, I’d quit my cosy banking job and set-up my own company that provide services to all Malaysian Banks to support the compliance of the new guidelines. Instead of all the banks scrambling to meet the requirements, they can just outsource all their problems to my set-up to run it. One stop solution to all your headaches.
Perhaps I am writing this out of frustration because I do not have the resources for it. Or perhaps I am writing this for my own interest, hoping someone like Bruce Wayne takes up the challenge and make all our jobs easier. Maybe some of us can get an offer to join this company. That’s wishful thinking I bet.
What would this company / set-up offer to banks? Hmmm where do we start.
Compliance with the Investment Account Guidelines.
All Banks do not generally set up their operations to work like fund houses where you have fund managers running their investment desks. Neither are there an infrastructure to manage and monitor the fund or portfolio performance, nor having mechanisms to create mark-to-market valuations of the portfolio. Reading the Investment Account guidelines makes one think that the banking model itself has to change to a pure Mudharaba trading house. A dedicated fund house with ready systems supporting the investment requirements and offering their services to Islamic Banks will ease the burden at Banks to develop their own infrastructure.
Tawarruq Guidelines.
This can be a huge component of businesses in the near future. As BNM place more and more emphasis on the big 3 of Musyaraka, Mudharaba and Murabaha, more and more focus will be placed on building the long term infrastructure to support this. Warehousing infrastructure, including managing physical assets and commodities belonging to the Banks, will support the Murabaha envisioned by BNM. A re-vamp of the credit policies and a different approach to risks assessment will support Musyaraka. Mudharaba will encourage the Bank’s “entrepreneurial appetite” as Banks take a more hands-on approach to investments. Ensuring a compliant structure and supporting the requirements of Sharia on sequencing, documentation, management of commodities, ownership transfers, usufruct and beneficial ownerships and valuation must be developed for the long run. A company which offers these services, or provides an IT platform for this, are something that can reduce the stress placed on the industry.
Special Purpose Vehicles (SPVs).
There a easy lot of opportunities for SPVs to flourish in the Islamic banking market. To support the ownership issues, an SPV can be a useful conduit for the movement of assets which will then create the underlying transactions. Huge deals are done on SPVs. Complicated structures need them. This is a viable legal solution for across border deals. The only question is; what do we do with the SPVs once the transaction is done? Rent it out to another entity, I presume. Either way, SPVs are created for win-win situations for everybody.
The IFSA 2013 is like a large pool of compliance that needed development. There are many opportunities out there and with the coming of even more complicated regulations, Banks are always finding ways to meet the requirements set in the regulations. Some will be creative solutions, while others will address the fundamental requirements of the transaction. Whatever they may be, it will only provide possibilities where fortune smiles on the brave. Take that chance. Hopefully, you will succeed to make all our lives easier.
And to close off the year, BNM gave us a further 3 reading gifts for us to enjoy our holidays:
The Murabahah Standards looks interesting, and so is the Mudarabah Concept Paper. Do have a read and tell us what you think.
Looking forward to the coming holidays.
Islamic Bankers Resource Centre 