Governance and Risk Management Issues for Sukuk Dr

Governance and Risk Management Issues for Sukuk Dr Salman Khan

Governance and Risk Management • • • Governance Risk management Definitions Relevance with Sukuk Overlap/connection – Emerge in discussion

Governance and Risk Management • Governance: – Types • Relevant: – Corporate – Sharia • • • • Public Private Global Non-profit Corporate Sharia Project Environmental Internet Information technology Regulatory Participatory Multilevel Meta Collaborative

Governance and Risk Management • • Risk management: Again: Discussion Specifically: types of risk – Systematic – Idiosyncratic

Governance • Governance – Corporate – Sharia • Corporate governance ==>

Governance • Corporate governance (CG): (simple def? ) • “Behaving well and fairly” – Good governance corporates • CG: (def*) – The system of rules, practices and processes by which a company is directed and controlled. Corporate governance essentially involves balancing the interests of the many stakeholders in a company - these include its shareholders, management, customers, suppliers, financiers, government and the community. – Encompasses practically every sphere of management, from action plans and internal controls to performance measurement and corporate disclosure. * Investopedia

Corporate Governance and Sukuk • International corporate markets: – – (examples? ) Accountability Transparency Arms-length Lack of disclosure • Consequence: – – Bankruptcies Compromised audit Fraud Risk to financial system • Key objective: learn and avoid by improved regulation

Corporate Governance and Sukuk • => Regulators responsibility (primary) • Also: market leaders (good CG - why? ) – – – Capital formation Cost of capital lowered Value-maximisation and optimisation Encourages strong and stable markets overall Benefit to all • Regulators & market leaders synergy

Corporate Governance and Sukuk • Key purpose of CG – – To protect rights of ‘residual claimants’ (RCs) Entrusted capital to third party to obtain return Essentially: “welfare of investors depends on agents/trustees” CG principles specifically designed for this : • “Principal-Agent Problem” (or “Agency Problem”) • All of : direct relevance to Sukuk

Sharia governance • Same fundamental purpose as ‘good’ CG • Basic thrust: best practice • Aim: – Instituting best practices vis-à-vis requirements of a Shariah compliant system – To ensure smooth, efficient, professional and consistent operation 10

Sharia governance • Definition? (*) • “Set of institutional and organisational arrangements through which an IIFS ensures that there is effective independent oversight of Shariah compliance over a number of key structures and processes” • Structures and processes? 11

Sharia governance • Key elements of a sound Shariah governance system: (IFSB) – – Competence Independence Confidentiality Consistency • And: relevance to sukuk 12

Sharia governance • Competence – Scholars – Qualifications • Independence/confidentiality – Conflicts • Consistency – Market stability – Development – Accountability 13

Sukuk: Basic structure Participants/ Investors Declaration of trust over Sukuk assets Investment funds/ sukuk purchase price Issuer (SPV) Returns (rent/profit, etc) paid to sukukholders deriving from Shariacompliant business activity of underlying project Returns (rent/profit, etc) Investment of funds in profit generating business project/activity, e. g. : • Purchase of asset/RE and lease of same to earn rental return (sukukholders source of return) Investment funds • Purchase of (share in) productive enterprise, profits paid to sukukholders as return (with ultimate liquidation and possible further return on capital)

Corporate Governance and Sukuk • Principal-Agent issue: many considerations => Key: – Conflicts of interest – Conflicts of duty – Related-party transactions

Corporate Governance and Sukuk Principal-Agent • Conflicts of interest: “A situation in which the interest/concerns/benefits of two parties are incompatible” (typically because one party is able to derive unfair benefit at expense of other) • Conflict of duty: “…. where a party represents the interests of two (or more) separate principals, such that its roles may clash with each other” • Related parties transaction: “Transaction b/w parties having a prior business relationship” (RPs) “Transfer of resources/services/obligations b/w RPs ($ or $X)” (RPTs) (IAS 24)

Corporate Governance and Sukuk Principal-Agent • Role of SPV: • Ownership: – – Should be independent agent (but is it? ) Obligor subsidiary True orphan? Transfer of ownership? • Saad Group • Investment Dar discuss • Nakheel

Corporate Governance and Sukuk Principal-Agent • MLA/Sukukholders’ Agent: – MLA >>> Agent ($) – Hence, often “bundled” service – Conflict? • Strong incentive $ • Potentail to u/p deal-stopper risks • MLA-Obligor : – Typically long-standing – Not deal-specific (potential bias ) • Inadequate internal controls: - E. g. obligor subsidiary ‘internal Chinese walls’ - Corporate Trust departments ‘captive’ ‘dependence’ for revenue - (N. B. : not always there)

Corporate Governance and Sukuk Principal-Agent • Sharia control function: • Sharia Supervisory Board: – Appointed by shareholders of bank – Financial compensation/bonuses decided by management, approved by board – Potential COI • • Approval of transactions $ management Direct/indirect opportunity to profit must be excluded Independence paramount

Corporate Governance and Sukuk Principal-Agent • Key step forward: => Functions performed by independent agents – – Managing assets/cash Making payments Control/report breaches Compliance/audit • Indp trustee/custodian/designated Sukukholder • Investor rights protection • Incentives ü

Corporate Governance and Sukuk Principal-Agent • Impact? - Market stability Sharia credentials Overall ethics, CG, & SG Good ratings Overall performance

Corporate Governance and Sukuk • Islamic Finance market: fast growth • Sukuk: huge increase – 110, 125*, 250* (USD bns) • Coming years: – Infrastructure – Sovereign – Corporate • Fast expanding market matching regulation • Sukuk regulation?

Corporate Governance and Sukuk • Two aspects of regulation: – Effective vs ‘Guide’ • Effective regulation: – – Bespoke X (Sharia-ethical reqts) BASEL, central banks (conv) Dependence on conv Shapes within conv model • Sharia-related (“Guide”): – Some work (IFSB) – Enforced X

Corporate Governance and Sukuk • Effective regulatory development: – Crucial link to Asset-Based Sukuk (ABS) versus Asset. Backed Sukuk (ABK) – Widely known: ABK – Used: ABS (almost x) • Crucial link: “Credit Risk” • Move on to “Risks” – Systematic (market) – Idiosyncratic (asset-specific)

Corporate Governance and Sukuk Risk management • Equity/asset/commodity price risk: – – “P asset” Reality? ( Credit) PU / X tr/f of assets Obligor • Uncertainty: – Ratings? – Misleading: sukukholders? – Bankruptcy scenario & underdeveloped legal fr/ws – uncertain outcomes (affects market stability and durability)

Corporate Governance and Sukuk Risk management • ROR risk: – – – Theory Reality? LIBOR-link (“ 50%”) PUs Liquidity facility ‘SC’ hedging Sharia implication? • Foreign exchange risk: – Theory: Sukuk asset pool currency different to income of assets – Guarantee (originator) – Lower risk for ST sukuk

Corporate Governance and Sukuk Risk management • Credit/counterparty risk: – – PU 3 P Gr Good quality KYC Important aspect: “real transfer” • SC risk: – In reality? – Scope for variation/flexibility in rulings

Corporate Governance and Sukuk Risk management • Operational risk: – SPV risks – Investment manager risk (for mud/mush, in theory) – Institutional risk (due to weak regulatory infrastructure/legal ‘grey’ areas)

AAOIFI’s position on Sukuk • Tradeability and PG • Investment sukuk – Mudaraba, musharaka, wakalatul istithmar – Nominal (fv) X ü • Ijara sukuk: – May redeem at market price “or at a rate agreed upon” (i. e. fv) – Does not apply to partnership/agency • Comment (’ 08) • Big debate – Focus: partnership sukuk – “ 85% non-SC”

AAOIFI’s position on Sukuk • Opinion? • Key issue here? – – – PLR Guarantee Other’s expense Risk Credit versus project activity (risk) • What about Ijara sukuk?

AAOIFI’s position on Sukuk • Ijara sukuk – – – – – Lessee Agent guarantee X Rewind: guarantee (fundamental) Lessee ü : Agent X Why (basic principle) ? Both guarantees confirm return Equal playing turf? Consequence: ijara sukuk ‘favoured’ Opinion?