Islamic Securitisation and Conventional Securitisation
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According to the topic of discussing the differences between Islamic securitisation and conventional securitisation, the discussion will lead to the satisfactory aspects of comprehensive analysis of the information gathered during the research. Moreover, it continues with the Islamic securitisation structure on the qualitative as well as quantitative basis according to the difference from the conventional securitisation structure. Securitisation which openly deals with the trade have more emphasis on the aspects to provide lucidity that it is riba-free (non-Islamic interest free) and its mechanism is based on shariah compliant system. We will be discussing different aspects that provide a clearer picture to mechanism that how it works i.e. structure, elements of risk shifting (risk scattering) and risk sharing in the deemed process so far as the area requires a lot more research to acquire steadiness in financial world and to enrich more on the topic some distinctive facts and figure are discussed as well.
Background information of the topic:
From the beginning of the Islamic banking in early 1960s which reckons the acuity of Islamic Shariah according to Quran and Sunnah brought into account as legal maxims with many ideas to facilitates the use of finance in both debt based and equity based. Not only Muslims countries regarding Islamic securitisation is worried about many factors to find a way out to enrich financial systems many other countries however following the conventional financial and banking systems. In the start and yet it is quite infant situation of securitisation because of the collective concerns of lenders or financier and borrowers. Lately, it has to move on with incentive compatibility and attractiveness for investors. Financial intermediaries even nowadays face quite drastic situations despite their in-house financial management; debt handling being a global concern. There is a wider line drawn understanding the differences between Islamic ways and uses of securitisation and its conventional counterpart though it seems quite trembling discussing about when it is debt based securitisation. Refer to the figures shown below which signifies the basic mechanism of securitisation; providing a clearer picture to its importance.
According to Masum Billah M., in his article 'Shari'ah Frameworks of Securitisation in the Capital Market', he discusses about securitisation being a prevalent method of financing nowadays more precisely in corporate sector. Furthermore he illustrates securitisation that 'where the company pooled its illiquid assets together and issued a claim to a pool of assets' and 'when the assets are securitised, it made the assets tradable in the financial market'. Furthermore, he presented the simplest definition that the 'securitisation is a process where corporation converts its physical assets in to financial assets'. Masum aggregated in his words about 'the assets that have to be securitised have to be illiquid – cannot be traded in share market or secondary market- and should also have produce cash flows over its lifetime. Besides that, the assets should have financial value so that they can be used as a claimed against the securities'. From the above depiction, a securitisation engages the sale of a large pool of assets by an entity or the originator that creates or purchases the assets in the course of its business to 'bankruptcy remote', special purpose vehicle (SPV). The SPV acts as an issuer, issue and sale the securities through either in a private placement or public offering. When securitisation process is 'closed' funds flow from the purchasers of the securities to the issuers and from the Issuers to the Originator. All these transaction occur virtually simultaneously. (Masum) Hence, the above description is the basic structure of securitisation. The actual structures are more complex because it involves more elements and participants. Refer to the rainbow-pie chart which presents a practical implication of securitisation according to Commerz bank.
The above implementation can be an example of securitisation though many different approaches and products that provide seamless structure on Shariah compliant way which lie still under research yet required to be evolved.
Scope of the research:
The entire research is nourished on the basis of salient research techniques which consist of a vast study of reference books, written journals (inclusive of e-journals), research papers, seminar notes, open survey from public and some online resources. Furthermore, it helped a lot as a combination of theoretical and statistical comparison between conventional and Islamic securitisation in the literature review (which encompasses the knowledge as well as defined focus on the topic) with ground reality at an optimum level.
Before moving on with detailed analysis there is a need to proclaim types (structures) of securitisation in general depiction. According to Masum, there are three main structures commonly used in securitisation. The originator chooses between three types of structures: pass-throughs, asset backed bond and pay-through. Masum further defined those structures coming forth; pass-through structures likely represent the direct ownership by the originator in a portfolio of assets. The originator services the portfolio, makes collections, and passes them to the investors. In pass through, the securities is not debt obligations of the originator thus, do not appear on the originator's financial statement. Since the ownership of the assets lies with the originator, pass-through is designed to represent an assignment of a portion of ownership, rights and obligation but not a conveyance of title. (Masum)
Masum elaborates that 'the Asset-Backed bond is collaterised by a portfolio of assets. The Asset-Backed Bond is a debt obligation of the issuers. In the issuer's financial statement, the collateral remains as assets and the Asset-Backed Bond appears as a liability. The cash flows from the asset are not dedicated to the investors. The investors only receive a part of the cash flows and the residual remains with the issuers'.
'One of the important aspect of the Asset-Backed Bond is that the securities is over-collateralized i.e. the value of the underlying assets is significantly in excess of the total obligation. For example, Company A issued RM1, 000,000.00 of bond using the Asset-Backed Bond structures. The value of the underlying assets that 'backed' the bond is RM2, 500,000.00. The issuer chooses to over-collateralised its bond in order to provide some level of comfort to the investors'. (Discussed by M.M. Billah in his paper)
Lastly, he concluded with the final structure of securitisation is the pay-through structures. This structure has combination of pass-through and Asset-Backed Bond. The bond is collateralized by a pool of assets and appears on the issuer's balance sheet as a debt. However, the cash flows arise from the assets is passed to the investors. The issuer only earns the service fees from the investors. From the above description of the mentioned, we can see that pass-through is the structure closest to satisfy the Islamic principle. Under pass-through, the cash flows collected are dedicated to the investors and the issuer only earns the service charge. Besides that, the security does not classify as a debt by the originator. Henceforth, conventional securitisation must be secluded according to research in different products and approaches and thus a large part of the conventional securitisation market – for example, mortgage backed securities, would be prohibited because the income (though not the principal) element of the cash flow would be characterised as riba. Similarly, CDOs and other such instruments could not be allowed as an asset class as these represent 'Debt' rather than an allowable commodity or activity. However, these restrictions do not mean that an Islamic securitisation market cannot develop. There are many classes of assets with a long history of securitisation that are halal (allowable), in particular any physical asset such as plant and machinery, and many of the techniques used in a conventional securitisation transaction are equally valid in an Islamic transaction. The remainder of this article will try to show just how similar those requirements are, and point out some further underlying differences in structuring a Shari'a compliant securitisation.
Mervyn and Kabir (2007) conversed Islamic point of view of investments in different aspects according to ethics and moral besides regulatory framework and it is quite well defined perception that an investor needs a brighter depiction of profit generation to allow him to think about different financial intermediaries in this modern world though it is going through analysis time to time since many years following their psyche on the other hand banks being financial intermediary have to put through making most of it avoiding concept that money should not be loan according to legal maxims. According to Ayub M. (2007), Islamic principles can make the difference and that Islamic finance is passing significant milestones; which lead entrepreneurs not to stop putting their research on and on. Islamic researchers are more concerned meeting shariah compliant regulatory requirements. Sohail (2006) overstated that Islamic retail banking and finance is not only designated for Muslim community only; which means Islamic retail banking products are adopted to some extent because of their competency and efficiency, and are being used under the umbrella of conventional (non-Islamic) banks; they often call it as window for Islamic banking products.
Detailed analysis of differences between Islamic securitisation and its conventional counterpart:
Islamic lending transactions are governed by the precepts of the shariah, which bans interest and stipulates that income must be derived as return from entrepreneurial investment. Since Islamic finance is predicated on asset backing and specific credit participation in identified business risk, structuring shariah-compliant securitisation seems straightforward.
As mentioned in by Kabir and Mervyn (2007) according to Humayoun A. Dar; fixed-return modes deals with the control and management of funds as clients have the possession which was made available by the investors, financial frameworks are often used with different areas of Islamic banking products like investment accounts based on mudharabah and saving account based on wadi'a, inclusive of Islamic retail banking products like Islamic mortgages, Islamic auto finance, sukuk (Islamic bonds) and many other products dealt with the concept of asset-backing and riba-free i.e. Islamised frameworks. Nonetheless, financial institutions have been able to develop various forms of Islamic finance instruments that are virtually identical to their conventional counterparts in substance. Since most Islamic financial products are based on the concept of asset backing, the economic concept of asset securitisation is particularly amenable to the basic tenets of Islamic finance. Securitisation under Islamic law bars interest income and must be structured in a way that rewards investors for their direct exposure to business risk, i.e., investors receive a share of profits commensurate to the risk they take on in lieu of pre-determined interest. All three asset types of Islamic finance are principally eligible for Islamic securitisation; however, unresolved issues, including restrictions on debt trading or the management of prepayment risk could limit their indiscriminate use as collateral.
Characteristics of conventional securitisation only apply if they convey a sufficient element of ownership to investors as entrepreneurial investment in real economic activity within an interest-free structural arrangement. In addition, also administrative issues, such as underwriting standards, issue placement and the procurement of ratings, are subject to religious scrutiny. Any capital generated from securitised issuance under Islamic law is to be used exclusively used for the repayment of initial funding. Conventional securitisation, which originated in non-Islamic economies, invariably involves interest bearing debt.
Although the religious prohibition of the exchange of debt and the required conferral of ownership interest to participate in business risk still poses challenges to further development of Islamic securitisation, the gradual acceptance of Islamic investment certificates, so-called sukuk bonds, represents a successful attempt to overcome these impediments based on the adequate interpretation and analogical reasoning of shariah principles applied in Islamic finance. Sukuks are shariah-compliant and tradable asset-backed, medium-term notes, which have been issued internationally by governments, quasi sovereign agencies, and corporations after their legitimization by the ruling of the Fiqh Academy of the Organization of the Islamic Conference in February of 1988. Sukuk notes convey equity interest to (capital market) investors in the form of a call option on partial or complete ownership of underlying reference assets, including the right to some calculable rate of return as a share of profit (secondary notes) and the repayment of the principal amount (primary notes). All three broad types of Islamic finance transactions (asset-, debt- and equity-based) can be reference assets of such Islamic securities.
Following exhibits (3 and 4) provide the sukuk implementations.
Detailed analysis of elements of risk shifting and risk sharing in securitisation process:
Over the last five years, the sukuk has evolved as a viable form of capital-market-based Islamic structured finance, which reconciles the concept of securitisation and principles of the shariah law on the provision and use of financial products and services in a risk-mitigation structure subject to competitive pricing (El-Qorchi, 2005). Notwithstanding these religious constraints, Islamic finance can synthesize close equivalents to equity, mortgages, and derivatives known in conventional finance. To this end, it relies on structural arrangements of asset transfer between borrowers and lenders to emulate traditional interest-bearing financial contracts. Since lending transactions under Islamic law are based on the concept of asset backing and specific credit participation in identified business risk, it also appears relatively straightforward to structure a shariah-compliant asset-backed securitisation (ABS) that delivers a risk-return profile similar to a conventional structure. However, conventional securitisation was developed in non- Islamic economies and invariably involves interest-bearing debt. Essentially, asset securitisation represents a cost-efficient and flexible structured finance1 technique of liquidity transformation and risk transfer, which converts present or future asset claims of varying maturity and quality into tradable debt securities. The various methods of securitisation have much to offer, but so far they have found only limited acceptance in Islamic finance due to religious restrictions on the sale and purchase of interest-bearing debt and legal uncertainty surrounding the enforceability of investor interest under Islamic jurisprudence. Over the last five years, the nascent Islamic securitisation market has seen many positive developments owing to the adoption of enabling capital market regulations, a favorable macroeconomic environment, and financial innovation aimed at establishing shariah compliance. The most popular ABS structures within Islamic finance are commonly referred to as sukuk bonds backed by either one of the three basic forms of Islamic finance (synthetic loans, sale- leasebacks, or profit-sharing arrangements). Asset securitisation describes the process and the result of issuing certificates of ownership as pledge against existing or future cash flows from a diversified pool of assets ('reference portfolio') to investors. (Jobst, 2006b).
Foreign Investment Insurance Policy-'FIIP' by The Islamic Corporation For The Insurance of Investment And Export Credit 'ICIEC'
Islamic securitisation transforms bilateral risk sharing between borrowers and lenders in Islamic finance into the market-based refinancing of one or more underlying Islamic finance transactions. Protection against basic risk; can be unless returns for investors are linked to the rate of interest on the underlying assets, there is a risk that the relationship between the rate paid on the underlying assets and that paid on the securities will differ over time. Normally a swap will be arranged to protect against this risk. In addition, conventional securitisation is virtually absent in Islamic countries, where Islamic home finance and sukuks provide a potentially untapped market for structured finance. Islamic securitisation complements the conventional ABS universe as an alternative and more diversified funding option that broadens the pricing spectrum and asset supply as high demand for alternative investment products causes greater lending width amid a low-yield market environment. In some circumstances, the shariah compliance also entails tax exemptions when investors hold direct ownership interest in the securitised assets.
Islamic securitisation is a helpful and important tool, which must be carried out prior to the issuance of Islamic bonds or Islamic Debt Securities. By securitising assets, the Islamic way, Muslim investors can now participate in the bond market without worrying that the process of securitising the assets and issuing of the bonds are contradictory to the Islamic teachings. Islamic finance is being more attractive for not only the Muslim community but for non-muslim world. Its products are being progressive even though there been some hurdles and late development of Islamic banking and finance industry and moreover it is has been so securitised for customer satisfaction and avoided almost the pity of riba-based banking structure. In this regard, it has a more focus on the revision and research on the proposed and as well as on financial structures that are being practiced nowadays. It has been proven that many big names like HSBC, Lloyds and Standard Chartered are putting there focus on Islamic products and especially on retail banking products and securitisation products.
Suggestions and Recommendations:
Islamic Finance Expanding Rapidly (2007) by IMF(M&CM Dept.)
Many Islamic products have the thirst to be researched on and provided quite attractive picture for entrepreneur to spot focus on Islamic finance industry. Besides many Islamic retail banking products, Sukuk (i.e. Islamic Bonds – despite of the type), Takaful (Insurance) and Tawarruq (AAOIFI standardised loan) are called out as the future for Islamic banking and might have a better attraction to conventional banking world as well.
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