Islamic Financing: Malaysian Sukuk

April 9, 2019

By: Ayaan Shaikh

Saudi Aramco, the state-run oil company of Saudi Arabia recently issued USD12 billion of bonds. Surprisingly, for the deeply Islamic kingdom and the “home of Islam“, the bonds were conventional bonds and not Islamic bonds or sukuk.

Islamic finance, based on Sharia (Islamic Law), is the primary method of banking in Muslim majority countries such as Saudi Arabia, Pakistan, and Malaysia, and is a growing area of finance globally. Assets of Islamic banking and finance institutions make up approximately 1% of the world’s funds (Lichtfous). Sharia prohibits interest, referred to as riba, on any loans. Sharia also prohibits investment into businesses that promote products that are considered haram or forbidden. Such products include pork, alcohol, and gambling.

A banking system where loans are interest-free works similarly to the issuance of equity instruments. Sharia promotes a profit-sharing system. If the business borrowing the money makes a profit then the profit is shared with the lender, if there is no profit or the business defaults, then there is no profit payment made on loan.

Islamic finance is not restricted to consumer and loan markets. It plays a significant role in capital markets where a sukuk certificate acts as an alternative to debt financing. Sukuk works within the profit sharing system and rather than debt based, it is asset based where the investor shares the asset and the profits derived from it. Similar to a debt instrument, a sukuk certificate has an expiration date and will make payments till that date or until sold and will have a monthly yield as a percentage of profit instead of as a percentage of interest.

Sukuk Market

The sukuk market is advocated by the Gulf Cooperation Council (GCC), in which the issuance of sukuk reached USD80 billion in 2017, a 50% increase from 2016. Many of the Asian Muslim majority countries have booming Islamic finance markets and have pushed the issuance of sukuk bonds. Some of these countries include Indonesia, Malaysia, and Pakistan. Indonesia had prescribed its version of the sukuk in 2017 when it issued a 1.25 billion dollar green sukuk, a product that is used to fund green projects. This sukuk cannot use its funds to finance any businesses or operations that use the burning of fossil fuels or which create harm to the environment. The banks that underwrote this issuance were CIMB, Citigroup, Dubai Islamic Bank, HSBC, and Abu Dhabi Islamic Bank.

Another big user and issuer of sukuk financing is Pakistan. Pakistan has issued over USD8 billion worth of sukuk in the last decade. The government accounts for 80% of that issuance while the rest of the sukuk instruments were issued by public sector firms. (Geo TV)

The biggest sukuk market in the world and the largest issuer of sukuk by volume is Malaysia (The Star). Malaysia accounts for 45% of the sukuk issued and is one of the countries where the private sector is a majority issuer of sukuk (Navarro-Martin). Around 78% of the sukuk issued in Malaysia were issued by private corporations while the other 22% were sovereign Islamic securities (The Asset). The Islamic Development Bank is one of the major issuers of sukuk in Malaysia.

Wakala Sukuk

There are two main types of sukuk issued in Malaysia. These are the wakala sukuk and the murabaha sukuk. The wakala sukuk works like an agency agreement in a conventional business setting, in which the investor appoints an agent who places the investment into a pool of other investments and uses her expertise to manage that principal for the duration of the bond. After agreeing on the yield on profit, the investor gets monthly payments of profit as a percentage, and at the end of the duration, the investor gets her principal back. This structure of sukuk works best when the appointed agent has a portfolio of investments and can use her expertise to manage the investments to create a return for the investor. In this way, both the investor and the agent are better off as the payment of principal is on the returns of the investment in the profit sharing system, rather than a fixed coupon.

Murabaha Sukuk

The other type of sukuk issued in Malaysia is the murabaha sukuk. According to Islamic finance, in a murabaha, the financier sells assets to the customer with spot delivery of the assets while the payment for these assets is deferred. The price paid to the financier is adjusted to cover the initial price of the asset and the markup profit derived from that asset. In the sukuk market, the issuer of the sukuk uses the proceeds of the sale of the certificate to buy the underlying asset and sells it to the customer with a profit. The monthly purchase payments for the asset turn into a profit stream for both the issuer and the investor, as the issuer can pay the investor with the profit. Therefore, the profit can be used to provide in percentage terms, the yield on a principal. This type of sukuk is less popular because it cannot be traded on the secondary markets as Sharia does not allow debt or debt style finance to be bought at prices that are lower than par. As the certificate is held closer to the expiration date, the price of the certificate and value of sukuk will decrease, as with a conventional bond.

The Differences

A fundamental difference between Sharia and conventional debt financing is the concept of profit sharing. This concept is reiterated in the social objectives of Islam, which is to elevate the poor from poverty and not force anyone into poverty. One of the ways this objective is achieved is through the system of profit sharing rather than charging interest. On the other hand, the conventional system of interest banking charges a fixed percentage interest on principal, regardless of the profit or loss made on the investment. The same goes for the sukuk certificate market as opposed to conventional debt financing. The sukuk is treated as equity. As an equity issuer gains from the business, so does the investor.

Petronas 2020 Case

As Malaysia is one of the biggest issuers of sukuk, it issues a variety of sukuk certificates in the market. One of these issuances was the Petronas 2020 global sukuk issuance. This was an issuance by Petronas, Malaysia’s biggest oil and gas company owned and operated by the government, of USD 1.25 billion in sukuk certificates. The sukuk was issued in March 2015, to be redeemed in 2020. The Petronas sukuk had an agreed on profit rating of 2.707% distribution to be paid annually, with Moody’s evaluation of the sukuk to be A1.

Petronas issued this sukuk to increase its operating capabilities. The proceeds from the sukuk bought part interest in a local refinery based in Malaysia and were owned by the Malaysian subsidiary of Petronas. The issuance of this sukuk was split into two pars. First, 33% of the sukuk was to be used as a leasing asset, in which Petronas would lease the assets bought from the Malaysian subsidiary and pay rent as a semi-annual payment of profit to the certificate holders. This is the tangible portion of the issuance, in which Petronas Global Sukuk (the issuer) entered into a wakalah agreement with Petronas Limited.

The intangible portion used the rest of funding (67%) towards a murabaha product of sukuk, in which Petronas Global Sukuk buys the commodities such as natural gas from a commodity broker and then on-sells these commodities with a deferred payment to Petronas Limited. Petronas Limited then sells these commodities to another commodity broker and pays out the profit as a coupon payment. Upon redemption of the sukuk, the deferred sale price of the commodity is settled by the obligor of the sukuk, Petronas Limited.

The banks that undertook this issuance by Petronas were primarily Merrill Lynch (Singapore), CIMB Investment Bank Berhad, Citigroup Global Markets Limited, J.P. Morgan Securities plc, and Morgan Stanley & Co. International Plc. The principal facilitating agent that undertook this issuance was CIMB Investment Bank Berhad, an asset management and a financial product underwriting bank based in Malaysia, and which specialized in Islamic financing.

The risk factors involved in the Issuance of this sukuk were disclosed in the prospectus document outlining the procedure and the underwriting. Some of the risk factors included the ownership of the government and its ability to interfere in the profit-seeking and maximizing function of Petronas. Another risk factor was exchange risk, as the sukuk was denominated in USD, the exchange rate was not hedged and therefore prone to volatility in the forex markets. Profit payments are not adjusted to the forex risk. Also, as a majority of the sukuk is based on murabaha principles, to be Sharia compliant, it is not to be traded on the secondary market.

Regulations

As Malaysia is a Muslim majority country, its banking system incorporates both conventional and Islamic banking. Principles and regulations that govern Islamic banking are specific. The lead regulators in regulating Islamic financing are Bank Negara Malaysia (BNM) and the Ministry of Finance. BNM is the central bank of Malaysia and regulates financial institutions on their level of risk management and risk minimization, a concept that is central to the Islamic financing idea of gharar, which is to only engage in trades where there is no deception, and the risks of the trade are minimized. The Sharia Council of the BNM is tasked solely with the handling of Islamic banks in Malaysia. Any ruling made by the council is binding in court.

Islamic banking is not specific to one country, and there are products like the Petronas Global sukuk invested in and traded around the world. There are distinct international regulatory bodies that ensure Sharia is adhered to. Some of the significant regulators are the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) and the Malaysian Islamic Financial Services Board (IFSB). These bodies work together with the US-based World Bank and IMF to promote the regulation of Islamic banking and to make sure controls are being followed by international financial institutions. The AAOIFI sets and recommends the commercial standards and principles for financial institutions while the IFSB is tasked with risk regulation and recommendations based on an assessment of the relevant risk factors. In a majority of multinational businesses that operate within the Islamic banking sector, there is a specific board of scholars similar to the Sharia council in Malaysia, who work on a business level, making sure the regulations of Sharia are closely followed.

Ethics Considerations

There some ethical considerations when understanding any financial instrument and the systems in which it operates. Some of the ethical considerations specifically regarding Islamic finance lies in the Sharia system of profit sharing. The utilitarian nature of Sharia is seen in its primary goal of lifting people out of poverty and not creating more poor people by forcing them to pay more than they can afford. For example, a business that takes out a 100 dollar loan and invests it into assets pays back a percentage of the profit made on the asset under Islamic financing. If the asset makes a loss then the bank that issued the loan shares part of the loss, but the principal would be paid back in full. In conventional banking, the 100 dollar loan amasses interest payments regardless of what happens to the investment. In this way, Islamic financing allows the loan to be a non-zero-sum game and both parties gain.

According to business ethics, as finance is used to help people with their money (Tan Bhala) Islamic financing takes the ethical standpoint which helps people not to lose more money than they can afford to lose. In that aspect, ethical socialism is the theory that Islamic finance relates most to because of the profit/loss sharing scheme. The approach to money is one of social justice and less to individualism, a trait of conventional financing and the basis of capitalist economics.

One of the critiques of this form of ethics is that there is asymmetric information in a profit-sharing system wherein the borrower has little to no loss of her own and does not have to prove the financier worthy while it is different the for the financier. The banks/lenders have to understand how creditworthy the borrower is. This information asymmetry increases costs for the lender, therefore, making it less feasible for the lender to use such a product. Another ethical consideration for a profit-sharing system is it incentivizes borrowers to misrepresent profits as the lender would be taking a part of the reported profits.

Critiques and Challenges

Islamic financing faces some challenges, a few of which stem from the profit sharing system. There is no guaranteed return on investment, making lending riskier than it would be under conventional financing. Also, as Islamic banking does not allow conventional derivatives and other financial instruments, Islamic banks are unable to hedge against risk, thereby further increasing the risk of business for these banks. This risk comes to play when Islamic financial instruments are underwritten in a different currency from the issuer’s local currency and the company is unable to hedge against this forex risk, an issue relevant to the Petronas 2020 sukuk. Islamic financing also faces problems with illiquidity. As many of the instruments cannot be traded on the secondary market, it is difficult for certificate holders to get their principal back especially on five and ten-year maturity sukuk.

Another challenge faced by investors trying to get into the Islamic financing market is the lack of guidelines and rules that govern this type of financing. An investor must make sure that not only do the financing methods obey Sharia, but also common law and the laws of the state. This can get difficult as the laws of the country may not clearly outline the property rights, this is common in Muslim countries where there is a discourse on property rights for Muslims to Non-Muslims and if there can be a transfer of rights in that situation.

Nevertheless, sukuk is an alternative source of funding in Malaysia, a country forecast to lead the issuance of this funding method in the coming years. The introduction of the green sukuk is also revolutionizing the sukuk market, emphasizing the need for climate and environmentally conscious investment. This alternative debt instrument, along with Islamic financing will have to overcome some obstacles in regards to regulation to become as common as conventional financing, but for now, Islamic financing is an ethical alternative to the traditional way of banking.