Saudi Arabia: the new horizon

A new law in Saudi Arabia will be a game changer for the housing finance and real estate development market and will propel Islamic finance to the next level in the Kingdom. MUSHTAK PARKER explains

Judging by the burgeoning number of transactions successfully closed and the utterings of senior officials and bankers in Saudi Arabia this year, it is easy to get the impression that the Kingdom is a natural fit with and a developed market for Islamic finance.

In sheer statistical terms, it may well be the single largest Islamic finance market in terms of the total size of deals concluded or investments made. But statistics can very often be beguiling and be a veil for the true anomalies of a particular market.

In Saudi Arabia, the anomalies are indeed considerable, albeit there is recent evidence of some movement in the right direction. For instance, it is not very often that Islamic finance is involved in the privatisation process in a given market or in a strategic sector where the operations of the asset are outsourced to the private sector.

Earlier this year, for instance, Malaysia’s PLUS Berhad closed a record landmark RM30.6 billion Sukuk Al Musharaka issuance programme comprising both government guaranteed and private AAA-rated issuances of varying tenors, sizes and expected returns and yields to maturity. The issuance was set up to acquire the Malaysian business and undertakings including the assets and liabilities of PLUS Expressways Berhad, the major provider of expressway operation services in Malaysia, under a privatisation exercise.

In August this year, at the same time, Saudi Arabia’s General Authority of Civil Aviation (GACA) awarded a contract to Tibah Airport Development Company, a consortium of TAV Airports of Turkey, Al Rajhi Holding Group and Saudi Oger, to build the new US$1.2bn Prince Muhammad bin Abdulaziz International Airport in Madinah. The project is being built under a public-private partnership agreement involving a build-operate-transfer (BOT) structure, and the financing comprises Shariah-compliant equity participation, bridge and Istisna (construction forward financing) facilities provided by National Commercial Bank of Saudi Arabia and a US$750m syndicated Istisna facility arranged by Japan’s Sumitomo Mitsui Banking Corporation.

The important policy departure in this contract is that for the first time GACA, under the contract terms, is handing over the operations of a Saudi airport to a private airport operating consortium, something that would have been unheard of until recently. In fact, this is the second time that a new Saudi airport is being funded through Islamic finance facilities. Earlier this year, GACA itself issued a SR15bn Sukuk, which was fully guaranteed by the Saudi Ministry of Finance and whose proceeds are being used to part finance the construction of the SR27.1bn ($7.23bn) new King Abdul Aziz International Airport in Jeddah.

GACA director general Prince Fahd bin Abdullah bin Mohammed al-Saud is a proactive supporter of accessing Islamic finance in infrastructure and projects. At the time, he hinted of things to come in 2012 and beyond. “This will be the first batch of Sukuk, which will be followed by other issues. By issuing these Sukuk, the government intends to open new channels of investment and saving and provide economically viable projects to the private sector,” he emphasised.

The two major anomalies are in regulation and legislation on the one hand; and in the court process and procedure, where defaults and non-performance cases especially involving international banks or institutions remain largely untried and untested.

Anomalies in regulation and legislation largely stem from a lack of a clear government policy on Islamic finance, which in turn is enmeshed in political sensitivities over the “unseen” or the lack of a religious basis of the banking system in the Kingdom, and a curious interpretation of the maxim that “anything that is not prohibited by the Shariah, is allowed”.

In terms of regulation and legislation, the Kingdom does not have a dedicated Islamic banking law such as in neighbouring Kuwait, Qatar, Bahrain and the UAE. In fact, Saudi Arabia and Oman are the only two GCC countries in this position.

As such, all banks are regulated and supervised under the general banking law. This despite the fact that the guidelines of the Islamic Financial Services Board (IFSB), the prudential and supervisory standard setting board for the global Islamic finance industry and of which Saudi Arabia is a founder member, clearly states the need for a stand-alone Islamic banking law to recognise and accommodate the specificities of Islamic banking and finance. These include a range of issues, including the nature of deposits; the relationship between depositors and the bank; the guaranteeing of deposits which is not allowed under Islamic financial principles; issues dealing with the nature of bank capital, including adequacy ratios under Basel II and III; and, of course, liquidity management especially the reserves of Islamic banks some of which such as Alrajhi Bank are the largest in the world in terms of size of balance sheet.

In the latest World Bank/International Monetary Fund (IMF) Financial Sector Assessment Report (FSAP) on the Kingdom entitled Saudi Arabia: Financial System Stability Assessment—Update, which was published in April this year, even the Fund urged the adoption of a legal definition as to the objectives and improved disclosure of its expectations for new banks; and recommended that SAMA should publish its detailed criteria for licensing new banks (including Islamic banks), fully align them with objectives focused on safety and soundness, and withdraw the requirement that new licensees should “add value.”

Another stark example is the lack of reference to the role and potential of Islamic finance in the Kingdom’s National Budget, 5-year Development Plan and the Small and Medium-sized Enterprises (SME) Plan or in any government economic and financial policy documents.

In the 2012 Saudi national budget there is no direct mention of the role of Islamic banking and finance in the Kingdom’s economy. In contrast, Malaysia’s 2012 National Budget has seven specific new provisions relating to the Islamic finance industry, including a tax deduction on expenses incurred for Sukuk Wakala for a 3-year period; further tax exemptions for ringgit-based Sukuk; seed funding for Islamic exchange traded funds (ETFs); tax concessions for Islamic REITs (real estate investment trusts); the establishment of a RM2 billion Shariah-compliant SME Financing Fund and a RM500 million Shariah-compliant Commercialisation Innovation Fund for SMEs.

Even South Africa had provisions regarding legal amendments to facilitate Sukuk in its 2012 National Budget, which paved the way for the national treasury to issue a mandate to a consortium of six banks, including the Saudi-owned Albaraka Banking Group and Kuwait’s Liquidity Management House, in July to advise and structure the country’s debut sovereign international Sukuk.

It seems that there is a dichotomy in the official policy of the Saudi government relating to Islamic finance and its role in the economy. On the one hand, the government appears to be reluctant to institutionalise Islamic finance in its banking, finance and economic policy from a regulatory and legal point of view, and even to contemplate discussing it in international forums such as the G20 summit, of which the Kingdom, together with Turkey and Indonesia, are the only Muslim member countries.

But, on the other hand, Saudi Arabia as a market – and this includes government-linked companies, utilities, quasi-sovereigns and, of course, the private sector – has been pushing Islamic finance aggressively albeit in an unassuming way.

But even here there is some movement in the right direction. The Saudi Arabian Monetary Agency (SAMA), the central bank, for instance, now has an active Islamic finance advisory committee, which includes one or two prominent Shariah advisories. The market, however, is still awaiting the new governor of SAMA, Fahad Al-Mubarak, who replaced Dr Muhammed Al-Jasser last December, to make that definitive statement on the Islamic finance industry. It was noteworthy that Governor Al-Mubarak did not attend this year’s 10th Annual Summit of the IFSB, which was held in Istanbul in May.

Similarly, the Capital Market Authority (CMA) goes out of its way when announcing the approval of a Sukuk issuance in the Kingdom to say that it is part of the government’s policy to promote the Islamic capital market in the Kingdom and to add depth to the local capital market by diversifying the sources of fund raising for local utilities and corporates, and “in continuance with its efforts to develop and diversify investment channels in the capital markets via offers of securities.”

Another area the Kingdom can improve on is the law-drafting process. The way the Cooperative Insurance Law, for instance, was introduced a few years ago was shambolic given that it was not clear whether the law was Shariah-compliant or not; or whether it met the governance standards for being Shariah-compliant. The National Cooperative Insurance Company (NCCI) only appointed a Shariah Board much later. The law is also different to the general Takaful Model used in most other markets.

Similarly, in July this year the government finally introduced a new Mortgage Law, which has been on the cards since 2008, when the Shoura Council (Consultative Assembly) actually approved the original draft Mortgage Law in 2008, only for it to be returned for further deliberations after objections from the Council of Ministers because of serious differences relating to several articles of the draft law.

The delay at the same time prompted most Saudi banks and authorised specialist mortgage finance companies to delay the introduction of their products and services even though they had been preparing for this in anticipation of a reasonably efficient turnaround of the mortgage law package.

The Mortgage Law, which is Shariah-compliant, comprises a package of five laws – mortgage registration law; execution law, including foreclosure processes and proceedings; a financial leasing law; real estate finance law, and a finance company law.

The five draft laws in the mortgage package would improve the housing finance framework in the Kingdom. Besides laying the foundation for an efficient mortgage system, the new laws will create a consumer protection framework, empower SAMA to regulate and supervise non-depository lenders, and establish a framework for the development of funding instruments (mortgage refinance facility, securitisation, covered bonds).

But once again, the lack of public consultation means that there remain many unanswered questions relating to the Islamic mortgage finance structure – whether Ijara (leasing); diminishing Musharaka (diminishing shared equity with a rental component) or even Murabaha (cost-plus financing). Other issues that remain unclear are whether the mortgages would require a Shariah-compliant mortgage insurance or contents insurance warp; the implications of transfer of title to deeds; and the inheritance process should a mortgagee pass away unexpectedly.

In the World Bank/International Monetary Fund (IMF) Financial Sector Assessment Report (FSAP) on the Kingdom, the IMF indeed urges SAMA to pay far more attention to individual large exposures of Saudi banks to major corporates especially during on-site inspections in a system that the Fund says is characterised by high single-name concentration.

“The possibility for SAMA to allow large exposures of as much as 50 per cent of capital, which was recently used (one large exposure stands at 38 per cent of capital), should also be removed,” said the IMF. It recommended capping large exposures of Saudi banks at 25 per cent of capital; strengthening the definition of related parties needs to ensure that close family relationships are taken into account; the issuing by SAMA of a framework circular aimed at bringing all aspects of risk management into one document; and updating requirements on market risk and internal controls to reflect developments in the last decade.

The recommendations effectively have arisen from an IMF study conducted in 2011 and are based largely on the issues relating to the widespread bank losses caused by the 2009 failure of two large well-established family groups in the Kingdom – SAAD Group and Al-Gosaibi. Indeed the parties also defaulted on the periodic payments on their Sukuk, leaving several major institutions – both local and international – with huge losses.

SAMA at the time emphasised that this was not a regulatory but a market failure, and as such it was up to the parties involved to resolve the issue. The Kingdom, despite SAMA’s denial, did suffer a reputational risk. One major international bank, for instance, confirmed that it had sizeable exposure to the Sukuk, and, as a result of the attitude of the regulators and the institutions, it was indefinitely putting on hold all future investments or involvement in the Saudi market. In fact, the bank rued the fact that it had virtually no recourse to the Saudi courts and was completely subject to the vagaries of developments in the case, which included internecine disputes between the two affected family businesses in the courts in New York.

Indeed, the IMF FSAP Report suggested that there may have been weaknesses in the credit risk management of the banks and hence SAMA’s supervisory regime.

Whereas the FSAP Report on the Kingdom did not consider the Islamic finance market in Saudi Arabia per se, given that it is purportedly the largest single one in the world, Malaysia’s Bank Negara, the central bank, insisted that the World Bank/IMF FSAP on the country’s financial sector includes a parallel assessment of the country’s Islamic banking and finance sector. The FSAP was conducted in May this year and the findings will be published shortly.

Similarly, in a parallel FSAP Report entitled Saudi Arabia: The IOSCO Objectives and Principles of Securities Regulation – Report on Standards and Codes (ROSC) published in April, the World Bank/IMF urged Saudi Arabia’s CMA to clarify its role especially where there are regulatory overlap with the Ministry of Commerce and Industry (MOCI); to improve information sharing with SAMA and to boost the transparency and disclosure of its enforcement function, which is limited due to the publications policy of its board whereby not all enforcement actions (and agreed settlements of action) are published.

“The regulatory framework for the securities market in Saudi Arabia has significantly developed since the enactment of legislation to regulate the capital markets. The CMA has made significant progress in establishing its supervision credentials, including issuing implementing regulations. Regulation is of a high standard but the market requires further development,” observed the report.

The Fund also makes several recommendations as to how Saudi Arabia through the CMA can improve its implementation of the IOSCO  (International Organisation of Securities Commissions) Principles on Securities Regulation.

In sheer market development terms, however, Saudi financial institutions, corporates and investors have been pushing ahead regardless accessing Islamic finance opportunities, thus indicating both a huge latent appetite and resourcefulness. This augurs well in terms of Islamic finance market dynamism ahead. Islamic finance now dominates retail banking and consumer finance as the preferred choice especially of young Saudis. This received a major boost a few years ago, when NCB effectively “Islamised” its entire retail banking offering. Similarly, Islamic corporate finance, syndicated Murabaha and Sukuk issuance have flourished over the past few years to the point that they, too, are fast becoming the preferred choice for Saudi utilities, banks and companies.

It is also clear that the Islamic finance industry is expected to contribute its fair share in crucial areas such as the financing of small-and-medium-sized enterprises (SMEs) primarily to generate employment especially for the youth; the provision of mortgage or housing finance and housing development finance; funding infrastructure and projects including through PFI (Public Private Financing); and helping Saudi corporates to diversify sources of funding away from bank finance to raising finance through the capital markets, predominantly through Sukuk origination.

The Saudi market over the last two months has been leading the global Islamic finance sector in many respects. The National Commercial Bank (NCB) was the lead Islamic finance adviser and structurer of an Islamic airport construction finance facility for the new Prince Muhammad bin Abdulaziz International Airport in Madinah, which is being built on a BOT basis by Tibah Airport Development Company. From a Shariah-compliant financing perspective, the BOT is an interesting development. Islamic finance has not been involved in many BOT projects although the potential is huge especially relating to infrastructure and development.

The fact that Japan’s Sumitomo Mitsui Banking Corp arranged the US$750m  syndicated Istisna facility for the project is revealing. Not only is the syndication the largest Islamic finance facility arranged by a Japanese bank, but Sumitomo is also keen to enhance its presence in the GCC especially through the Islamic finance market. The syndication involved three Saudi banks, including NCB, Saudi British Bank and Arab National Bank.

According to NCB, the Madinah Airport project structure could become a model for financing other infrastructure projects in the Kingdom especially in sectors such as roads and railways. The new airport will have a capacity to accommodate eight million passengers in the first phase, which will be ready in three years. The capacity will be increased by 12 million in the second phase, which will be completed in 2020.

TAV Airports president and CEO M Sani Sener is confident that “our partnership with two major companies of Saudi Arabia gave rise to a collaboration whereby we can succeed in further airport tenders in Saudi Arabia”.

The Kingdom has also set the pace in Syndicated Murabaha facilitiers, which has been a regular feature of the Islamic financial landscape for the last three decades but over the past few years has been overshadowed by the emergence of Sukuk. Nevertheless, some bankers have likened the vanilla commodity Murabaha to “oxygen” that fuels the day-to-day business of Islamic financial institutions all over the world.

In Saudi Arabia, Jarir Marketing Co. (JMC), the Kingdom’s largest stationery and electronic products retailer, successfully closed in August a SR225m Murabaha facility arranged by Saudi Investment Bank. The facility is part of a SR233m Islamic finance facility. According to a statement lodged with the Tadawul Stock Exchange, the medium-term facility is to be settled in four semi-annual instalments after two years of grace period.

The proceeds of the facility will be used to finance the acquisition of land in good locations for the construction of new showrooms for Jarir Bookstore in Saudi Arabia in line with the company’s expansion plan to cover all the cities in the Kingdom. Jarir’s estimated net profit reached SR106.8m in Q2 2012 compared to SR98.5m for the same period in 2011. The estimated net profit for the first half of 2012, according to the company, was up by SR15.2m to reach SR271m.

Similarly, the National Shipping Company of Saudi Arabia (Bahri) signed a US$120m equivalent Murabaha financing agreement with the Public Investment Fund (PIF) in July to part finance part of the construction of two general cargo vessels at Hyundai Mipo Dockyard in South Korea. The two vessels are part of an order for six vessels signed in March 2011 for delivery from early 2013.

In the Sukuk market, Saudi Binladin Group, one of the largest construction companies in the Kingdom, closed its latest Sukuk offering in August 2012 with a 1-Year SR1bn (US$267m) issuance. The Sukuk, which was solely arranged by HSBC Saudi Arabia Limited, which was also the sole book-runner for the transaction, was issued through a special purpose vehicle (SPV), SBG Sukuk Ltd, and will pay a profit rate of 2.5 per cent.

The issuance is guaranteed by the obligor, the Saudi Binladin Group Limited. HSBC Saudi Arabia Limited also acted as payments administrator and Sukukholders’ agent. HSBC Amanah acted as the Shariah advisor. The company has been a pioneer of Sukuk issuance in the Kingdom. It issued its debut Sukuk in 2008 – a US$266.6m  issuance – through a private placement to Saudi-only investors. Since then, it has gone to the market to raise funds through Sukuk issuances on an annual basis for the past three years. In July 2010, it issued a 9-months SR700m (US$187m) Sukuk Al-Murabaha which matured in April 2011, the first in the current series.

This was followed by a one-year SR1bn Sukuk issuance in July 2011, which was over-subscribed 300 per cent and which paid a profit rate of 2.5 per cent; and the latest 1-Year SR1bn Sukuk issuance offered in August 2012. According to international law firm Clifford Chance LLP, working in partnership with the local Al-Jadaan & Partners, the issuance once again attracted strong demand from Saudi investors, which comprised mutual funds, private investors, government-linked entities, financial institutes, and corporates.

Apart from the massive infrastructure spend and the continuing demand from the oil, gas, petrochemicals and electricity industries in the Kingdom, all of which have been proactive and regular users of Islamic finance over the last few years, the biggest stimulus will come from the Islamic mortgage finance and insurance market, following the adoption in July by Saudi Arabia’s Council of Ministers of the new Saudi Mortgage Law. Local bankers emphasise that the new law will be a game changer for the housing finance and real estate development market and will propel Islamic finance to the next level in the Kingdom.

According to a recent NCB Report, “the Mortgage Law will allow for greater use of Islamic mortgage financing schemes such as Murabaha, which would allow the buyer to retain ownership of an asset. The passing of the mortgage law is expected to help convince individuals and entities to enter the housing market in the country. However, the law clearly addresses solutions to the pent-up demand for housing by the middle- to-high income segment, but does not address the inherent supply shortage of affordable housing. Additionally, until precedence has been set, the enforcement and full applicability of the law will be unknown”.

Islamic mortgage finance could have the same impact in consumer finance as Sukuk is having on the Saudi corporate sector as a fund-raising instrument. In addition, according to Ajmal Bhatty, president and CEO, Tokio Marine Middle East Limited, which is in the process of establishing a Takaful (Islamic insurance) joint venture in Saudi Arabia with Alinma Bank, the Alinma Tokio Marine KSA, the adoption of a mortgage law could also boost the mortgage Takaful industry in a major way, which could lead to further developments in mortgage securitisation as the market matures and as originators of the financing seek to diversify their risk by enabling them to secure immediate liquidity for assets.

“I think the introduction of the Saudi mortgage law is a major development for the housing market. I understand that more than 60 per cent of the households may need new units because of the young demography of the Kingdom. So there is a huge housing market for mortgage finance. And, of course, that opens up opportunities on the Mortgage Takaful side as well. But it has to be handled properly with the right products and processes,” he explained.

International credit rating agency, Moody’s Investors Service, in a statement also emphasised that “the implementation of the mortgage laws is credit positive for Saudi banks because we expect it to enhance their asset growth potential, strengthen the profitability of retail franchises and increase loan book diversification”.

According to Deutsche Bank Research, the total outstanding home finance provided by the private sector in Saudi Arabia is less than one per cent of GDP compared with well over 50 per cent in most developed countries, and approximately six per cent in Kuwait and seven per cent in the UAE. Saudi Arabia, according to Deutsche Bank, will need 1.2 million additional housing units by 2015. This is projected to increase on a yearly basis by 150,000 units.