Islamic Finance: Asset securitisation under Sharia

Last week's article on Sukuk has raised a few questions in the minds of some readers. They would like to know if the asset securitisation, prevalent in the West, is allowed under Sharia.

Definition
What does securitisation mean? Well, in conventional terms, it is a process whereby loans, interest receivables and other illiquid assets with similar characteristics in the balance sheet of a financial institution are packaged into interest-bearing securities at a rate regarded comparatively attractive by the investors.

Asset securitisation can also be defined as the structured process whereby loans, interests and other receivables are packaged, underwritten, and sold to the investors in the form of asset-backed securities.

Why securitise?
Necessity to securitise stems from four core factors. They are: Imposition of capital adequacy ratios and reserve requirements.

Stricter regulations have made financial institutions safer places to invest in. But these restrictions also have apparent and hidden costs as they either add to the direct expenses or restrict the ability of financial institutions to increase their volume of business beyond a certain threshold.

In a well-refined manner, securitisation allows an institution to cash in certain assets appearing on its balance sheet. In other words, the institution is able to monetise illiquid assets and recycle cash so obtained for further investments. Thus, securitisation helps financial institutions to serve more and more customers without contemplating to raise additional funds in the form of new equity or fresh deposits.

Increase in the cost of funds
In the rising interest rate scenario, securitisation helps financial institutions to raise cash at manageable costs to feed new business.

Peer pressure for sophistication
Present day investor is always looking for sophisticated investment instruments. With growing convergence of various capital markets due to removal of barriers and globalisation, many financial institutions are forced to come up with innovative investment schemes in order to excite the high demanding investor of the present age. Securitisation is one of them.

Improved rating and share value
A post-securitisation financial institution is in a much better position to improve returns on capital and the overall rating in view of its ability to entertain the new business without increasing costs.

Benefits
In a conventional financial environment, the asset securitisation is perceived to be beneficial to all parties concerned, viz lenders, investors and borrowers.

For lenders, it is the conversion of their on-balance sheet assets into off-balance sheet fee-income item. For investors, benefits include better yields, increased secondary market liquidity (easy exit) and collateral.

Borrowers benefit from the enhanced availability of credit on terms that lenders may not have been able to offer had they continued to keep the loans on their balance sheets.

Islamic way
We know that the concept of asset backing is prevalent in all Islamic financing transactions. For example, in trade finance the Islamic banks use murabaha contract, which enables them to purchase certain goods and sell them to a client at a pre-agreed profit amount, rather than giving an interest-bearing loan to the client, who then purchases the goods.

Similarly, in project financing, the banks prefer to buy equipment and lease it to a project promoter, instead of providing him with liquid cash in the form of loan at an interest rate.

In view of the Sharia principles being in favour of asset-backed financing, the question, therefore, is not whether Islamic banks should play a role in this dynamic market; it is how which intrigues Islamic investors.

Challenges
An Islamic financial institution may face certain challenges while attempting to do a securitisation transaction. Some of them are listed below:

Sharia supremacy
The securitisation is broadly comprised of pooling the assets, packaging them into securities and distributing the securities to investors.

As Islamic institutions remain concerned with the Sharia acceptability of whatever business they conduct, their focus in a securitisation transaction should remain on the content of the package rather than the process of packaging.

Therefore, they must ensure that the assets in the package, and not the package alone, are Sharia compliant and will be acceptable to the Islamic investors.

In this connection, Islamic banks should take extreme care to verify that riba (interest) is not admitted unwittingly through the back door in the name of financial innovation or in the process of Sharia interpretation.

Regulatory framework
Securitisation is prevalent in the countries with advanced regulatory framework whereby Islamic financial institutions conduct major part of their business in the Muslim world, which is not so developed from the regulatory point of view.

Therefore, while Islamic institutions can comfortably securitise whatever little assets they may own in the developed economies, they may not be able to easily do the same in their respective areas of operation in the Muslim world due to lack of effective regulatory framework needed for securitisation.

Asset information
A vital ingredient for any successful securitisation transaction is the availability of complete credit and financial information on underlying assets verified by reputable auditors, and their independent valuation by the high-ranking surveyors/agencies.

It has been observed that he majority of asset portfolio held by Islamic banks operating in the Gulf is comprised of large family-owned corporates. These corporates do not divulge enough financial information and many of them never provide banks with their audited accounts.

Perhaps, the conversion of large family-controlled businesses into public joint stock companies will pave the way for obtaining complete financial information on them, thereby providing a shot in the arm for securitisation in the region.

Rating
In developed countries, large corporate borrowers do invariably have individual ratings. As such, the rating of any proposed securitisation portfolio is determined based on the overall quality of its assets.

However, the Gulf is not familiar with the rating system and for the purpose of promoting the securitisation market, it will be important to instill the rating discipline in the regional corporate scene.

Since most of the reputed rating agencies work on conventional lines, it may be required to set up separate Islamic rating agencies due to the fundamental differences in ascertaining the risk profile in Sharia with compared to conventional system.

It may be suggested that to start with, the existing known rating agencies should establish Islamic wings to understand and apply Sharia principles in assessing an entity's risk profile. As the concept grows familiar and is widely adopted, independent Islamic rating agencies can also be established along the line.

Secondary market
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