Welcome for the new ‘paper chase’

MUSHTAK PARKER looks at a bid to help financial institutions manage short-term liquidity and ‘to park their capital reserves requirements on a Shariah-compliant basis’

The imminent issuance of a multi-million lira sovereign domestic Sukuk issuance by Turkey’s Under-Secretariat of the Treasury and the actual issuance of a QR1bn domestic Sukuk in March by the Central Bank of Qatar (CBQ) mark an encouraging albeit nascent trend amongst some MENA treasuries and central banks of issuing government commercial papers. The aim is to help financial institutions authorised in their jurisdictions to manage short-term liquidity and to park their capital reserves requirements on a Shariah-compliant basis.

Government papers such as Sukuk, medium-term notes (MTNs), government securities and certificates, especially those that are asset-backed, are increasingly preferred to other instruments such as Commodity Murabaha based products, including an Islamic equivalent to Repos, which are based on receivables.

In some respects, the issuance of short-term sovereign local currency papers for liquidity management is essential for the maturing of a financial market, especially if the local interbank money market is not well established and often more costly.

Some countries such as Sudan and Iran, through their ministries of finance and municipalities, in the past have even used the issuance of Musharakah (equity) participation certificates as a monetary policy management tool and to raise funds for infrastructure and development projects.

While the domestic bond market in most MENA countries is still developing or, in many cases, almost non-existent, in the Islamic finance space especially, the lack of sovereign domestic papers is a major impediment for Islamic financial institutions (IFIs) in managing their liquidity requirements.

“There has been much coverage of the increase in aggregate Sukuk issuance through 2012 and the first quarter of 2013,” explains Stella Cox, managing director of DDGI Limited, whose career in providing intermediation and commodity brokerage services to the MENA Islamic finance industry goes back almost 30 years. “But as far as government securities are concerned, few MENA sovereigns have established a yield curve to develop local bond markets when compared to more developed markets in Europe and even some emerging markets in Asia.

“Regulators will undoubtedly have an ongoing and central role to play, especially outside of the core Muslim markets, where it can still be difficult for Islamic banks to establish and operate effective liquidity management structures within the constraints of existing financial regulation.

“Certainly in a number of international jurisdictions, including the UK, work has been undertaken but, again, it is probably the issue of an Islamic bank having insufficient access to AAA-rated investment securities so as to maintain its core liquidity in High Quality Liquid Assets (HQLAs) that has posed one of the biggest concerns when the only eligible paper does not surpass $10bn in aggregate. Therefore, currently, regular recurrent issuance of domestic government Sukuk are of key importance to domestic Islamic banks.”

The importance of emerging new issuers such as Turkey and Qatar in the MENA region and Indonesia and Pakistan in south east Asia cannot be overstated.

However, as Stella Cox points out, in most of the core jurisdictions for Islamic financial services, government and central banks can issue Shariah-compliant paper if they wish and some, for example in Bahrain, Qatar, the UAE and Malaysia, have done so, but it has not always been recurrent or of sufficient volume.

Furthermore, the issuance of Shariah-compliant sovereign paper that is short-term and tradable, and equivalent in profile to a Treasury Bill, is even scarcer. To date, only the Central Bank of Bahrain has issued short-term paper regularly, but it has not always been in tradable form.

Although, historically, Islamic banks have maintained excess liquidity, this, observes DDGI’s Cox, is sometimes no longer the case and certainly can no longer be taken for granted.  Accordingly, relevant central banks have recently made concerted efforts to underpin Islamic banks’ recourse to market liquidity by evolving Shariah-compliant facilities comparable to those normally available to banks from a Lender of Last Resort (LOLR).

Given the historical absence of an efficient, Islamic capital market infrastructure, the role played by government and central banks in supporting the system, and assuring liquidity remains within it, she contends, has been and remains crucial.

Nevertheless, in those emerging Sukuk markets, once the first sovereign domestic Sukuk offering is realised through the regular auction, the logic of issuing subsequent Treasury papers becomes apparent, especially if the demand in the market is robust. The domestic Sukuk issuance mechanism, in fact, gains a momentum of its own, as in Bahrain and Malaysia, albeit even there the question of size, volume and frequency remain a problem.

As such, Turkey’s Under-Secretariat of the Treasury is merely following up on the issuance of its debut domestic sovereign Sukuk – a TL1.6bn Sukuk Al-Ijarah (leasing certificates) – in late 2012. That two-year offering was well over-subscribed and is paying a rental return of 3.7 per cent every six months.

Similarly, the Central Bank of Qatar (CBQ) has indicated that its local currency debt will be issued at regular intervals with varying maturities. The CBQ is actually following a dual system debt issuance, comprising both conventional bonds and Sukuk.

In March 2013, the CBQ auctioned QR4bn of Treasury papers comprising two tranches of conventional bonds (QR2bn and QR1bn tranches) and a QR1bn tranche of Sukuk. The conventional tranches have a maturity of three months (QR2bn tranche) and six months (QR1bn tranche) and will pay a yield of 0.98 per cent and 1.07 per cent respectively; while the QR1bn Sukuk tranche has a nine-month maturity and will pay a yield of 1.15 per cent. The tranches were well over-subscribed and all allocated to local Qatari banks.

The CBQ also believes that domestic Sukuk issuances may enhance options for domestic financing of Qatari banks and reduce reliance on more costly borrowing from foreign banks.

Ufuk Uyan, CEO of Kuveyt Turk Participation Bank, believes that the domestic sovereign Sukuk issuances by countries such as Turkey, Qatar and Indonesia will have a positive impact well beyond the borders of these countries and such instruments will eventually become standard in the MENA region, Asia and even in Europe

“For the MENA region, certainly yes, and for Europe if the governments there are serious about resolving the Eurozone’s ongoing economic and financial problems, they should seriously consider to resorting to the asset-based financing model of Islamic banking. Printing money through quantitative easing; consuming incessantly while producing and with hardly any savings, shall not save the Eurozone. The countries one day will be forced to confront the reality of Cyprus and Greece,” he claimed.

In the case of Turkey, participation (Islamic) banks have traditionally resorted to raising short-term funds from the syndicated Murabaha market, until Kuveyt Turk Participation bank (KTPB), a subsidiary of Kuwait Finance House, one of the largest Islamic banks in the world, issued its first international Sukuk – a $100m offering in 2010, followed by another $350m Sukuk in 2011.

The KTPB Sukuk was a game changer because suddenly the bank could raise finance on a much longer basis than previously. The first issuance had a maturity of three years and the second one of five years. Since then, Asya Bank, another participation bank, issued its debut $250m subordinated Sukuk in March 2013, which has an even longer maturity of 10 years.

From a liquidity and cash management point of view for banks, the issuance of sovereign Sukuk – both international and domestic – are crucial for several other reasons.

For participation banks in Turkey, says Ufuk Uyan, “all of our exposure up until the debut Turkish Treasury US dollar and Turkish lira Sukuk in 2012 was to the real sector. On the other hand, if you look at the conventional banking sector, government bonds and Treasury Bills (T-Bills) constituted 50 per cent to 60 per cent of their assets portfolio.

“In other words, conventional banks benefitted from the low credit risk of T-Bills and Zero Risk Weighting on Capital Adequacy, so they could grow efficiently with less capital requirement. Most of the income of conventional banks was from these ‘high-return-no-risk’ government securities in the past. This was a concession given to conventional banks, whereas it took 10 years, from 2002 to 2012, to convince the Turkish Treasury and government to issue a debut sovereign Sukuk.”

The T-Bills and government bonds are also traded on the Istanbul Stock Exchange in the secondary market, and are sold directly to clients who love to receive fixed returns. The challenge is to change the conventional banking mindset and expectations of investors in Shariah-compliant government domestic Sukuk on the secondary market. In this respect, competitive trading commissions and trading income will also be an important aspect of this new segment for participation banks.

Participation banks have also been quick to capitalise on the debut sovereign domestic Sukuk issuance. They dared to start issuing Turkish lira Sukuk in the local market. Bank Asya started the ball rolling with a debut TL125m domestic Sukuk with a one-year maturity in March 2013 and which pays a profit rate of 7.2 per cent per annum. KTPB itself is also in the process of issuing its first Turkish lira Sukuk. In 2012, in  contrast, Turkish banks raised TL37bn of conventional bonds in the domestic market.

KTPB’s Ufuk Uyan emphasises that Turkish lira denominated Sukuk issued by the participation banks “will enable them to improve their asset-liability mismatch. Despite the fact that the Turkish government and the Central Bank of Turkey (CBT) have launched various incentives to extend the deposits maturities of banks, the average maturity of deposits in the banking system is still lower than three months. Therefore, issuing Turkish Lira Sukuk with six months or one year maturities is an improvement on the asset-liability mismatch.”

Another new development is that government-issued Turkish Lira Sukuk certificates are accepted as a security against and an instrument for borrowing from the TCB. In the absence of such instruments, participation banks were at a competitive disadvantage to conventional banks over the past few years because the TCB was effectively funding conventional banks on the Open Market Transactions Desk at lower rates than the real interest rates, through one week or maximum one month via Repo transactions.

The other drivers for banks issuing Sukuk apart from funding balance sheet requirements, is a need to improve capital adequacy ratios (CAR) under the new Basel III provisions, especially under the Basel III: The Liquidity Coverage Ratio (LCR) and Liquidity Risk Monitoring Tools’ Standard, which was introduced by the Group of Governors and Heads of Supervision (GGHS) of the world’s top banking regulators at their meeting in Basel in January 2013.

The LCR Standard aims to promote the short-term resilience of the liquidity risk profile of banks. It does this, according to the above Standard, “by ensuring that banks have an adequate stock of unencumbered high-quality liquid assets (HQLA) that can be converted easily and immediately in private markets into cash to meet their liquidity needs for a 30-calendar-day liquidity stress scenario”.

In a rare reference to alternative Shariah-compliant banks in a Basel document, the GGHS recognised that an insurmountable impediment is the ability of Shariah-compliant banks to meet the LCR requirement. In such cases, “national supervisors in jurisdictions in which Shariah-compliant banks operate have the discretion to define Shariah-compliant financial products (such as Sukuk) as alternative HQLA applicable to such banks only, subject to such conditions or haircuts that the supervisors may require”.

Sovereign domestic Sukuk issuances are, of course, not new. Bahrain and Malaysia have pioneered such Treasury instruments for the last two decades or so, although the Indonesian Treasury and Bank of Indonesia (the central bank) and the State Bank of Pakistan are also now active issuers of domestic Sukuk. In February, Indonesia, through its Debt Management Office of the Ministry of Finance, raised a total of 1.5 trillion rupiah in its first Sukuk auction in 2013. At the same time, the Bank of Indonesia held its first auction of its Bank of Indonesia Certificates Shariah (SBIS) in January, with an overall indicative target of raising 700bn rupiah.

The Central Bank of Bahrain (CBB) auctions three month Al Salam Sukuk and six month Sukuk Al-Ijarah (leasing certificates) on a regular monthly basis on behalf of the government of Bahrain.

The CBB, for instance, issued Al Salam Sukuk worth BD72m in the first four months of 2013 – BD18m each month. The auction in March of BD18m Sukuk Al-Salam Islamic securities carries a maturity of 91 days, and was oversubscribed by 246 per cent. The expected return on the issue, which matures on 26 June 2013, is 0.81 per cent.

The CBB, similarly, auctioned BD80m of Sukuk Al-Ijarah in the first four months of this year at a monthly BD20m issue amount. The offering in March, which carries a maturity of 182 days, was oversubscribed by 205 per cent. The expected return on the issue, which matures on 19 September 2013, is 0.95 per cent.

The CBB has already published the dates of the Sukuk auctions, as for the conventional Treasury bills, for the entire year of 2013.

With the proliferation of IFIs continuing all over the world, both in traditional markets and in new markets both in the Muslim world and outside, and assets under management in the Islamic finance industry estimated to increase to $3 trillion by 2015, the demand for short-term liquidity management instruments will inevitably increase. As such Sukuk and Commodity Murabaha may not suffice in terms of liquidity investment instruments.

Already complements to domestic Sukuk issuance are emerging. The Central Bank of Turkey, for instance, is working on the possibility of issuing real estate certificates that would be tradable.

But by far the most interesting initiative is coming from the Bahrain-based International Islamic Financial Market (IIFM), whose mandate inter alia is to develop and launch standardised documentation for the Islamic finance and capital market products, including liquidity management instruments.

“Historically, the Islamic financial industry has faced challenges that the Islamic finance sector has faced in evolving a complete suite of liquidity management instruments. Amongst those is the final development by IIFM of a widely accepted Shariah-compliant repurchase (Repo) type product, I’aadat Al Shira, that the market has long since indicated it perceives as being a priority for addressing the short-term liquidity management requirements of IFIs,” explains DDGI’s Stella Cox.

As part of the ongoing research process, extensive consultation has taken place with banks and wholesale financial institutions, as their knowledge and practical experience is important in ensuring that the proposed structure and guidelines will gain wide international acceptance.

The IIFM has also been promoting the concept of collateralised liquidity arrangements, where Shariah-compliant securities, such as Sukuk, might be utilised as feasible, alternative collateral for liquidity management purposes.

Following positive feedback, IIFM widened its working group to include additional stakeholders (including custodians, administrators and accountants) to deliberate the issues and seek basic consensus of approach in addressing them. A market consultative meeting was held in 2012, where it was established that a Collateralised Murabaha structure, based on conventional Triparty collateral arrangements, was the direction for the industry to take. The intention is that Collateralised Murabaha arrangements will ultimately enable financial institutions to make more efficient use of holdings or portfolios of liquid, Shariah-compliant securities.

“The Murabaha structure,” explained Cox, “was considered best suited to the purpose because of its aforementioned international acceptance as an evolved, credit based financial instrument with wide, cross-border application. IIFM noted that these factors have previously caused a number of its development initiatives to focus on Murabaha, as it best supports the primary objective of transactional and operational standardisation.”

However, further review of the potential application of alternative contracts to support the collateralised product is being undertaken. Drafting of documentation is currently in process with the input of banks and also established Triparty Agents, custodians and industry regulators. IIFM targets publication of the product standard in 2013.

From the perspective of the securities that will underpin collateralised transactions, Sukuk are now very familiar as an asset class and many banks hold Sukuk in their portfolios, with prime issues often being held to maturity because of perceived commercial, yield and risk benefits.

However, as DDGI’s Stella Cox explains, “Sukuk are potentially eligible as collateral but currently the majority of Sukuk in issue are domestic, illiquid or with price disclosure that is somewhat opaque. Additionally, the cross-border market infrastructure for issuance, listing and trading of Sukuk is still working towards completion. Greater standardisation is being sought at both regulatory and legal levels and there is still much work in progress, to similar effect, throughout many of the Islamic financial industry’s core territories and, increasingly, across the global marketplace.”

Shariah-compliant equities that are held in longer-term portfolios might present an additional possibility of underpinning collateralised transactions. Currently, suggests Cox, equities are usually underweighted in the Islamic bank portfolio.  This could be due to regulatory impact or asset class and risk aversion.  “However, many of the regional equity capital markets most relevant to our industry have expanded and deepened within recent years with market order, stability and regulation coming to the fore.  Financial crisis not withstanding, the global equity markets are even deeper. Shariah engagement and oversight has resulted in a diversity of highly rated, liquid and market tradable equities, indices and equity based Exchange Traded Funds (ETFs) that have been screened for Shariah compatibility and deemed eligible for investment.”

Also, in this asset class there is no significant additional requirement for creation of new infrastructure, be it in relation to financial regulation, tax or law, outside of that already established by the relevant securities market authority, she adds.

However, the ultimate mechanism for sovereign local currency Sukuk issuance to gain much-needed traction, suggests KTPB‘s Ufuk Uyan, is for the Islamic Financial Services Board (IFSB) to introduce a Special Standard or Guidance Note regarding such instruments. He strongly believes that the introduction of “such a Special Standard which should be made compulsory by Capital Market Authorities and Boards, will save the future of the domestic Sukuk market”.