YBhg Dato Dr Nik Ramlah Mahmood
Deputy Chief Executive, Securities Commission Malaysia
6th IFSB Legal Seminar on
Innovation in Sukuk Securitisation and Islamic Hedging Instruments: Development and Challenges
25th March 2014, Bandar Seri Begawan, Brunei
I would like to thank IFSB for inviting me to deliver a keynote address at the 6th Legal Seminar on Sukuk Securitisation and Islamic Hedging Instruments: Development and Challenges. It is truly an honour and a privilege to be at this Seminar here in Bandar Seri Begawan.
Securitisation continues to be a subject of much deliberation and debate among policymakers, regulators and market practitioners after the global financial crisis. And this is not unexpected as securitisation in fact has a key role within the financial system.
Securitisation injects much needed funding into the economy by enabling businesses and financial institutions to realise the value of cash producing assets. Lenders can get their loans off their books, transforming illiquid assets into liquid and tradeable capital market instruments. It also allows lenders to manage the risks arising from such loans by slicing the loans into different tranches based on credit quality and transferring the risk to different investors with different risk appetite. Additionally the ring fenced and segregated assets once decoupled from the risks of the originator can attract higher rating thus reducing the originator’s cost funding. Thus securitisation allows businesses and financial institutions to realise the value of their assets, allowing them to support other economic activities. Investors on the other hand have access to another asset class that meets their risk-reward profile. This securitisation bridges the gap between financial and capital markets by converting financial assets into tradeable capital market products.
Given the pervasive benefits of securitisation to the financial system, to the capital market and to the economy as a whole, it is indeed unfortunate that the securitisation market has had to bear the blame for the global financial crisis due to among others to
Despite the stigma of the global financial crisis, there is now increasing realisation that it will be a mistake to throw the securitisation baby out with the bath water as this will affect the long term financing of the economy. And thankfully this is being realised by regulators and policymakers worldwide. Just last week, Reuters reported the call by IOSCO Secretary General David Wright for global regulators to intensify their efforts to revive a securitisation market tarnished by the financial crisis as banks who are the traditional suppliers of loan to be packaged into interest bearing bonds have become more cautious as they focus on rebuilding their capital buffer.
On the capital market front, the International Organisation of Securities Commission (IOSCO) issued a report on “Securitisation and Securitised Debt Instruments in Emerging Markets” in October 2010. The report highlights the challenges in the securitisation business model and regulatory framework which include wrong incentives in the value chain, inadequate risk management practices of investors; and inadequate regulation and oversight. The report also highlights that improved disclosure and transparency is required, as are improved risk management practices, elimination of arbitrage opportunities in capital regulation and alignment of incentives in remuneration arrangements. The perimeter of regulation should also be expanded to include key entities in the process such as CRAs.
The IOSCO report further identifies key recommendations to deepen securitisation markets in emerging market jurisdictions; in particular the report encourages regulators to:
In addition, IOSCO has issued a guide on “Disclosure Principles for Public Offerings and Listings of Asset-Backed Securities 2010 (ABS Disclosure Principles)” aimed at enhancing investors protection by providing guidance to regulators who are developing or reviewing their disclosure regimes for offerings and listings of asset-backed securities. Additionally, it has also issued a report on Principles for On-going Disclosure for Asset-Backed Securities 2012 to complement the ABS Disclosure Principles, emphasizing on the requirement of on-going disclosure and requirements to disclose material developments.
So far, I have talked about the securitisation market in general. Arguably Islamic asset securitisation has not suffered the stigma of the sub-prime crisis. But that is probably because the size of this asset class is small, even within the sphere of Islamic finance. This is so despite the concept of Islamic securitisation being recognised through various guidelines. In Malaysia the SC had introduced the Guidelines on the Offering of Asset-Backed Debt Securities in 2001, which was revised in 2004 (ABS Guidelines) to further strengthen the asset securitisation framework. The ABS Guidelines provide for the issuance of both conventional bonds and sukuk via securitisation process.
“Securitisation transaction” in the ABS Guidelines is defined as an arrangement which involves the transfer of assets or risks to a third party where such transfer is funded by the issuance of debt securities or sukuk to investors. Payments to investors are principally derived, directly or indirectly, from the cash flows of the assets.
Under IFSB 15: Revised Capital Adequacy Standard for Islamic Financial Institutions Offering Islamic Financial Services [excluding Islamic Insurance (Takaful) Institutions and Islamic Collective Investment Schemes], sukuk is described as a securitisation process whereby the investors are protected against the financial problems of the originator and due to the ownership of the underlying assets, expose them to losses in case of the impairment of the securitised asset. The financial engineering in sukuk securitisation involves payment of face value and income derived from the cashflows generated by the securitised asset and legal or beneficial ownership of the underlying asset is transferred to the investors in the form of sukuk.
In 2013 Malaysia continues to dominate the global sukuk market with 69% share of total. Malaysian Ringgit-denominated sukuk represented 67% of total sukuk issuances in 2013, totalling USD80.38 billion, followed by US Dollars with a 15% share worth USD17.98 billion. The growth of the Malaysian ABS market however has not caught up with the growth of the bond market. The SC had, between the period of 2004 and 2013, approved a total of 44 ABS proposals, of which 9 were Islamic ABS. By way of comparison, during that period a total of 940 proposals for conventional private debt securities and sukuk were received. ABS thus represented 4.7% out of the total proposals approved by the SC. These ABS proposals involved various asset classes such as residential mortgages, plantation assets, commercial properties, credit card receivables and auto loan receivables.
One area where securitisation has contributed significantly to national economic development is in the securitisation of housing loans. In Malaysia, Cagamas, the national mortgage corporation plays a pivotal role in the development of ABS market – both conventional and Islamic ABS. Cagamas has to-date, issued five ABS, of which two were Islamic ABS. The first issuance of ABS by Cagamas involved the securitisation of government servant housing loan (GSHL), in 2005, pursuant to the Housing Loan Fund Act 1971. The said issuance represented a landmark for the Malaysian ABS market as it was the first residential mortgage-backed securities transaction backed by the Government assets. Subsequently, two Islamic ABS were issued – in 2005 and 2007 – under the principle of Musharakah involving investment in a specifically identified pool of mortgage asset by the originator.
The securitisation exercise by Cagamas resulted in increased liquidity for the financial institutions, enabling them to grant more housing loans thus, making loans more accessible and affordable to potential house buyers. This enables the key social objective of increasing home ownership which is the basic necessity for the society, to be met. The Cagamas model has been a success and recognised by other countries as well as the World Bank.
Apart from Cagamas, Telekom Malaysia Berhad (TM), a government-linked corporation had also issued sukuk Ijarah known as Menara ABS in 2008. This Islamic ABS allowed TM, amongst others, to monetize its non-core assets in order to strengthen its core telecommunication business. As TM’s sukuk Ijarah was structured based on ABS, it was important for TM to effect true legal sale of the underlying asset so that all rights and obligations attached to the assets would be transferred to the new owner. Menara ABS was a trust-owned SPV, set up for the securitisation of four office buildings owned by TM. With a value of just over RM1 billion, it represented Malaysia’s largest Islamic securitisation exercise to date, as well as the largest sales on non-core assets of TM. This ABS exercise had improved TM’s balance sheet by allowing the company to offload some of its fixed assets.
Similar trend in Islamic ABS has been seen globally with the issuance of USD100 million sukuk Wakalah by FWU Group subsidiary in 2013 which securitised takaful policies as its underlying assets. The issuance represents an important step for FWU group to expand its funding sources into Shariah compliant capital markets. This Islamic securitisation exercise provides an opportunity for the investors to participate and invest in a true ring-fencing of assets.
Another recent innovation worth mentioning is the issuance of the first structured covered sukuk in the region by Malaysia Building Society Berhad (MBSB) in 2013 (MBSB Covered Sukuk). This MBSB Covered Sukuk has similar characteristics with covered bonds which are debt obligations that are secured by portfolio of assets. It provides dual recourse to the investors i.e. the issuer in covered bonds is fully liable for all payments to the investors (while solvent) and in the event of insolvency of the issuer, the pool of assets serve to satisfy the covered bond debt and is separate and distinct from the issuer’s other assets.
MBSB Covered Sukuk was structured under the Shariah principle of Murabahah, backed by a pool of Shariah compliant personal financing receivables, which was sold via “true sale” from originator to the SPV. In this structure, the SPV was created for the purpose of isolating the pool of assets from the insolvency of MBSB which allows the investors to have dual recourse: firstly, to MBSB and secondly, to the pool of personal financing receivables as the financing receivable are separate and distinct from the MBSB’s other assets. The credit risks of the MBSB Covered Sukuk were linked to MBSB. However, the MBSB Covered Sukuk is intended to be isolated from any default and bankruptcy proceedings against MBSB as the covered asset is able to service the obligations. In the event of MBSB’s default, investors have preferred claim to the covered asset.
This structure enables MBSB to obtain better credit rating and lower its financing costs. The rating in this structure was notched up from MBSB’s issuer credit rating reflecting the available credit enhancement from the covered asset and the transaction’s structural features. With its dual recourse, the structured covered sukuk would appear to be more attractive to investors.
For the securitisation market to develop further numerous issues need to be addressed and I am sure many of these will be discussed in this seminar by the many experts present. An appropriate and facilitative legal environment must be in place. One of the issues is with regard to the bankruptcy remoteness of the SPV. Some jurisdictions permit the creation of bankruptcy remote entity under trust law while in some others, the creation of those entities may be made under corporate law. Whatever the means of achieving it, legal clarity with regard to the status of the SPV is critical. The manner the asset is transferred from the originator to the third party, is also important, be it by way of true sale, equitable assignment, novation etc. From a securitisation point of view, the objective of the transfer is to achieve cost effective and clean sale and provide necessary legal protection to all parties.
Furthermore, if the asset being securitised is a fixed asset (e.g. property), then the transfer of the asset from originator to the third party must comply with other relevant laws (e.g. land law) and subject to the requirements as stated under those laws (e.g. in Malaysia, additional requirements under the National Land Code must be adhered to). In the event of default, the securitised asset is subject to the conditions attached to the assets which may result in investors having difficulties in enforcing them. The additional requirements under the respective laws may also incur additional costs on the part of the issuer or the originator.
Another challenge relating to securitisation is with regard to taxation especially if it involves cross border securitisation as the taxation issues can become complicated because the tax regime of more than one country must be considered. Issues to be considered include (i) whether a SPV is subject to taxation as an entity or is only a pass through conduit that would qualify it as a non-taxable entity; (ii) whether stamp duty and taxes may be imposed on the transfer of the securitised asset. In Malaysia for example, the real property gain tax on the disposal of the securitised asset has been exempted since year 2003.
Investors must be made aware of the technicalities and the risks associated with securitisation given the complexity of the process. For Islamic securitisation, it is important to ensure that the products are shariah compliant in all respects. Easy access to information on the products and the assets backing the products is crucial to ensure that investors obtain relevant and accurate information prior to investing in such products. Another challenge faced by originators of Islamic securitisation is the limited availability of Shariah compliant suitable assets.
Given the constraints and challenges surrounding securitisation transaction, be it from legal, taxation, accounting aspects, the responsibility for policy and regulatory formation in these areas rest with separate institutions in the respective country. Therefore, continuous dialogue and co-ordination between these institutions and relevant government agencies is vital to ensure consistencies in rules and regulations formulated within securitisation framework.
Streamlining and tightening the corporate governance regime at every level of transaction could minimise the risk typically link to securitisation. Exercising thorough due diligence without overly relying on CRAs would certainly benefit the investors in making informed investment decision.
The infrastructure for securitisation which includes monitoring and supervision on the securitised asset and making available relevant and accurate information to the public may need to be further developed and strengthened. This can be achieved through strict observant of market discipline by market participants.
As global policymakers and regulators continue to pursue efforts to revive the conventional securitisation market that is still struggling to regain its credibility after the global financial crisis, in my view there is a golden window of opportunity for Islamic securitisation to lead the way. By its very nature Islamic securitisation offers all the benefits of securitisation without some, if not all the weaknesses that led to the sub-prime crisis. While still at a stage of relative infancy, the inherent features of Islamic securitisation can potentially position this product as the catalyst for the revival of the securitisation market. The exclusion of complex structures such as CDOs for instance, acts as a natural risk mitigant that offers an enhance value proposition for investors.
On its part, IFSB as a standard setting body for the Islamic financial services industry, can provide leadership by introducing standards that will address key aspects of Islamic securitisation and support the orderly development of the market. I am sure the experts who are present in this room, will offer invaluable solutions and proposals to further promote Islamic asset securitization.
With the reform to the global financial market landscape, we hope to see more innovation in Islamic securitization with diverse asset classes to further boost the Islamic finance market globally.