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Default woes may spell Islamic finance turning point

Fears of more sukuk defaults likely to weigh on the global sukuk market this year.

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August 6, 2010 8:50 by



Recent sukuk defaults and Investment Dar’s legal battles are set to reshape Islamic finance as investors demand more transparency on asset structures and proof of borrowers’ creditworthiness.

Several high-profile Islamic bond defaults and the near failure of Dubai property firm Nakheel’s sukuk have soured investor sentiment toward the sector, casting doubt on claims that the sharia’s safeguards offer added protection.

But as Islamic firms struggle to restructure their debts and holders of defaulted sukuk wait to be repaid, industry experts say these issues will alter an industry which has thrived on cheap oil money and fragmented regulatory standards.

Mandatory sukuk ratings, improved clarity on Islamic bond structures and an increased focus on the financial health of borrowers are some of the changes expected.

“As the restructurings take course and are settled and creditors’ claims are dealt with, it will provide a clear path as to how defaults are dealt with within the sukuk context because it’s a relatively recent instrument,” said Dubai-based Morgan Stanley senior adviser Yavar Moini.

Restructuring difficulties and fears of more sukuk defaults are likely to weigh on the global sukuk market this year, with sales forecast to be little changed from 2009′s $23.3 billion, respondents to a recent Reuters poll said.

Kuwait-based Islamic firm Investment Dar was the first company in the region to default on a major sukuk in May 2009. Other sukuk defaults have included Kuwait’s International Investment Group and U.S. energy firm East Cameron.

Bankers say the industry’s reputation also suffered a blow from a recent dispute between Investment Dar and Blom Bank, and predict that the case could raise the cost of Islamic transactions as investors demand increased due diligence.

Lebanon’s Blom Bank sued Dar in a British court last year to recover $10.7 million it invested in the company in 2007, as well as a 5 percent return promised in the terms of the Islamic contract.

Dar refused to pay, arguing the wakala, or agency, deal was not sharia-compliant. It said the fixed profit could be seen as interest, which is forbidden under Islam, and Dar’s charter prohibits it from entering into non-Islamic transactions. Dar’s sharia advisers have said the contract was a valid Islamic transaction. It failed to meet a May 25 deadline to pay over $10 million for an appeal to challenge the contract and an out-of-court settlement may be sought, according to a media report.

Moody’s said the case raises the sharia risks in Islamic finance, adding that it might need clear documentation demonstrating that such has been addressed before it rates sukuk and Islamic institutions in the future.

“After these court cases, investors are now looking at the documentation with a fine-tooth comb,” said Khalid Yousaf, asset management head at Gulf Global Group.

“These are positive changes which would help further the promotion and development of the Islamic finance industry.”

MORE TRANSPARENCY SOUGHT

Sharia scholar Mohd Daud Bakar, who advises influential industry body AAOIFI, said the case could indicate a need for greater use of restricted wakala where investors have more control on how their funds are invested.

“What is important is not to consider who is the borrower and who is the customer taking the money but also the underlying asset and the projects,” Daud said.

“This is a good lesson because people realise that you cannot simply leverage on the good name of the issuer, the borrower, the customer.”

In the Middle East, where details on financial deals are often shrouded in secrecy, sukuk investors are expected to push for mandatory ratings to ascertain an issuer’s creditworthiness.

Such debt ratings are compulsory in Malaysia which has the world’s largest Islamic bond market.

Many bankers say credit issues are at the root of sukuk defaults, but investors are expected to scrutinise the structure of these instruments more carefully.

“The structures of sukuk are important now in the sense of how transparently they are organised,” said Bank Muamalat Malaysia CEO Mohd Redza Shah Abdul Wahid.

(Editing by Kim Coghill)



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