Hedging Current Islamic Bank Managers - Case Study Example

Primary Research: How do Islamic Bank Managers Hedge against Risk in Sukuk? Copyright Sukuk, or Islamic bonds have witnessed an unprecedented growth within the past several years and a number of variants of Sukuk have been identified. Thus, Sukuk is the most popular and widely used financial instrument that is available to the Islamic bankers and financial managers. However, Islam prohibits derivatives and derivative related transactions and this means that the ability to deal with the risks associated with Sukuk becomes hampered. Imaginative, innovative and creative solutions are therefore needed to better manage risks that are associated with Islamic finance and the Sukuk. The primary research that has been presented here attempts to discover how Islamic financial managers hedge against risk in Sukuk. Declaration I certify that, except where cited in the text, this work is the result of research carried out by the author of this study. The main content of the study which has been presented contains work that has not previously been reported anywhere. _____________________________________________ Name and Signature of Author August 2008 This write - up is presented in fulfilment for the requirements related to primary research on Risk Management for Sukuk. Biographical Sketch Acknowledgements Contents Introduction 1 Primary Research and Interviews with Islamic Financial Managers about Practical Risk Management for Sukuk 4 Conclusion 10 Appendix A – Interview Questionnaire 12 Bibliography/ References 15 List of Figures Figure 1: The Securitisation Process for Sukuk 2 (This page intentionally blank) Introduction Sukuk has gained popularity in Islamic finance as an alternative source of funding for corporations and sovereigns (Ayub, 2007, Pp. 390). Sukuk can be considered as being certificates that are of equal value which represent undivided shares in the ownership of tangible assets, the right to use property that belongs to someone else without injuring it, service renderings and projects or any other investment activity that does not violate the Shariah laws of Islam. Unlike shares which are issued for an unspecified period of time, Sukuk are issued for specified periods that range from several months to ten years and they carry returns based on the cash flows that originate from the underlying assets on the basis of which they are issued. A Special Purpose Vehicle, or SPV, is set up to manage assets that have been sold to it by parties that then use the funds from such sale and the SPV issues investment certificates to those who have contributed funds. The SPV also allocates monthly cash flows to the investors depending on the performance of the underlying assets, as shown in the figure below. Figure 1: The Securitisation Process for Sukuk (Ayub, 2007, Pp. 394) Generally speaking, Sukuk certificates can be freely traded in the market and are convertible into cash, but only after the certificate has been transferred to an owner. Thus, Sukuk is similar to the bond, except that its value is not determined by fixed interest rate considerations and the Sukuk value should be determined by the cash flow that is generated by the underlying assets and their value. However, risks are inherent in Sukuk because the underlying assets on the basis of which Sukuk is issued may have foreign exchange components or other market risks which include general or systematic risks and idiosyncratic or firm specific risks may influence the Sukuk (Tariq, 2004, Pp. 43 – 53). Systematic risks can have an impact because shifts in broad government policy or shifts in economic policy can influence Sukuk and idiosyncratic risks are the result of competing prices of various available financial instruments in which investors may have an interest. Thus, it is desirable from an investor’s perspective to try to manage risks associated with Sukuk. Although derivative instruments, including futures, swaps and options are not permitted in Islam, it has been asserted that Islamic finance does provide the basic building blocks that are necessary to provide financial instruments and that risks can be creatively managed (Iqbal, 1999, Pp. 546 – 557). However, other researchers have lamented that contract based jurisprudence in Islam has been rendered incoherent as a result of prohibitions, contract conditions and contract – based juristic rulings (El – Gamal, 2007, Pp. 1 – 15). Also, it has to be understood that the prohibitions against interest in the Jewish law Halakhah are even stricter than they are in Islamic law, but the world has yet to see an entirely satisfactory system of finance in which a business cannot charge a lower cash price and a higher credit price to eliminate interest (El – Gamal, 2007, Pp. 2). This write up is a report about a series of interviews that were carried with several Islamic financial managers about how they actually managed risks that are associated with Sukuk. Primary Research and Interviews with Islamic Financial Managers about Practical Risk Management for Sukuk Because of the fact that Islamic Sharia does not permit the use of derivative instruments and put or call options, it is necessary to try to find out how financial managers manage risks associated with Sukuk in practice. In order to discover the practical methods for risk management for Sukuk, it was necessary to put together a questionnaire and to conduct interviews with several managers of Islamic bank and finance companies. For this study, a total of five separate interviews were conducted using the questionnaire that has been presented in Appendix A of this report. The responses that were recorded were then analysed using the grounded theory approach and the common strategies and methods that were pointed out were extracted and recorded. It should be noted that the interview questionnaire that has been presented in Appendix A presents a set of the most prominent questions that were asked and that it was necessary to encourage a respondent to open up and to express themselves freely and clearly. A detailed transcript of the responses has not been presented because this is likely to be a lengthy document for every respondent and only the salient points that were presented as a result of the analysis of the interview transcript are presented in this primary research report. All Islamic bank and finance managers agreed that although Sukuk has an inherently lower level of risk associated with it as compared to the Western bond, because of the detailed financial analysis, checks and balances that are involved with the setting up of a SPV which is constantly monitoring the performance of the funds that are extended to the originator and in other ways managing the payments to investors, risks do exist with Sukuk. It is possible for things to go wrong with the management of the financial activity that is being undertaken by the originator, investors may prefer other similar financial instruments and government policies with regard to the activities of an originator and broad economic policy can all have an impact on the Sukuk. Also, a Sukuk is issued after proper valuation of its underlying assets and the currency in which this valuation is made is important. Thus, any fluctuation in the exchange rate of the base currency can have an adverse impact on the market value of the Sukuk. The previously mentioned uncertainties and risks make it difficult for exacting financial analysis and engineering to be carried out with certainty. It was unanimously agreed by all Islamic bankers and finance managers that the most widely accepted technique for the management of risks associated with Sukuk, especially the exchange rate risks is the Salam method in which a contract or an agreement is made at an earlier time for execution or delivery in the future. This is the most frequently mentioned method for managing Sukuk risk in literature related to Islamic finance. However, more practical methods for the management of Sukuk risk involves due diligence when studying a Sukuk in detail for a decision regarding purchase and an ongoing constant monitoring for any change in the nature of the underlying activity associated with the Sukuk and policy that may have an impact. It is also necessary to monitor the market for alternatives in order to remain appraised about how well an investment in a Sukuk may be regarded. It is also important to maintain a portfolio of investments that can provide a lower overall level of risk that is far more acceptable as compared to investing in a single Sukuk offering. Thus, it is necessary for an Islamic bank or a Islamic finance company to have effective internal risk management and control systems that can respond effectively to any risk scenarios. It was pointed out by the bankers and finance managers that investors in the Sukuk had a right to be presented with the maximum possible information related to a Sukuk at all times and also investors had a right to approach the SPV with their concerns. Thus, if a risk scenario was evident then it was appropriate to weigh if any improvement was possible and if it was considered that unacceptable risks existed, the Sukuk could be sold to those who were better able to carry the risk in the market. It was pointed out that if derivative instruments were permitted in Islam then it is likely that more exacting risk management and financial engineering could have been possible. However, Islam frowns on the notion that business arrangements produce total winners and losers. Thus, a need exists for bankers to try to improve on the risk management methods that have already been described while maintaining all action within the limits imposed by Islamic law. However, if new methods for managing risks associated with Sukuk are to be effective then such methods should be widely accepted and understood as being market practices that had common, if not unanimous acceptance. Thus, a need exists to design, discuss and to gain acceptance for any new techniques for risk management. The managers who were interviewed also indicated that well developed markets offered better risk management prospects. As an example, in Malaysia and other well developed Islamic markets, Sukuk is traded on the Scripless Securities Trading System and this means that it is possible to rapidly trade in Sukuk issues and also to be aware of the latest market information associated with a Sukuk issue. Thus, it must be said that in poorly developed Islamic markets, it was less likely that the most sound risk management strategies could be followed in practice. Thus, although the risks associated with the Sukuk do hinder exacting risk analysis and financial engineering, it is only possible to improve if efforts are made to improve and to develop efficient and transparent Islamic financial markets. Risk management can be better accomplished if Sukuk issues were to be issued in at least two major global currencies as being the basis for the valuation of the underlying assets. Thus if a proportion of a Sukuk issue is presented with an underlying valuation of assets in United States Dollar and the remaining proportion is presented in Euro, then it is likely that the investors will be better able to hedge against foreign exchange currency risks by investing in both currency issues of the Sukuk. Fluctuations in exchange rate are than more likely to sustain the value of the Sukuk in times of market turbulence. The two currency issue concept can also be extended to a basket of currencies if needed. It is also possible to implement a more suited SPV organisational structure and to device better agreements for the Sukuk issue. However, these are fundamental change concepts and they require that supervisory bodies associated with the supervision of a Sukuk issue encourage such change. It is unlikely that a single investor can force change to go through and it is only likely that well debated and judicious reforms are likely to be widely acceptable. A broad consensus was indicated by the Islamic financial managers that a diversified portfolio was the proper approach towards risk management in Islamic finance. Thus, it was considered that a portfolio with about 50 % varied Sukuk holding and the remaining in cash, shares or stocks and real estate is likely to be optimal for risk management. Islamic bankers and financial managers agreed that it was important that Islamic financial institutions try to encourage and sustain research into new ways of better managing Sukuk risks while staying within the boundaries that had been prescribed by the Sharia. However, they also noted that bringing about positive change and carrying on with research was not something that Islamic financial institutions or the Islamic Ummah encouraged and it was possibly as a result of this that the nation of Islam had appeared to lose its glory. The managers noted with regret that any attempts to formulate new risk management strategies were required to be well debated, well accepted on their merit and ably supported by the judicial system. It was noted with regret that the pursuit of pure profit and a desire to make money at all cost had resulted in divergence from the intention based standards of Islam which could once depend on the purity of intentions and that Munafiqat had eroded the Islamic societies at all levels from the rulers to the judiciary and the trading classes to present a hell in which nothing certain could ever be dreamed of. In fact it appeared that unlike the rest of humanity, Muslims preferred uncertainty in everything, ranging from providing for the old, conquest of disease to the building of structures and the management of risks, preferring instead to dump their obligations on Allah who was now regarded as being a servant of a depraved humanity and not a judge of acts. Despite the previous observation, it was also agreed that a lot of creativity was required to come up with new techniques and strategies for the management of Sukuk risks because it was difficult to ignore the legal risks in Islamic societies in which neither the individual, nor the judiciary or the rulers took any interest in justice and their duty to impose it. Although a quasi derivative action based on an agreement to repurchase a certain proportion of Sukuk in the event of a substantial fluctuation comes to mind, because such an agreement will be both well intentioned and legal, it was difficult to determine if the such an agreement based on Wada, W‘adah (Promise) and Bai’ al-tawrid with khiyar al-shart could be relied on to be honoured because the Ummah considered everything in which their profit was not involved as something that was not worth anything. Conclusion In conclusion it can be stated that the most basic means that are available to Islamic bankers to manage Sukuk risks at present include Salam, diversification of portfolio, incorporation of risk management and control strategies and purchase of Sukuk which have been issued with underlying assets denominated in a portfolio of currencies. As the market for Sukuk continues to develop and becomes more informed, it is likely that risk management for Sukuk will become easier. Islamic bankers are thinking about new risk management techniques that fall within the permissible in Islam, but they have to be creative, imaginative and innovative. Islam does not permit derivative instruments, but perhaps approaches that are similar to Bai’ al-tawrid with khiyar al-shart which is an acceptable form of Salam variation in Islamic finance in which certain clauses of an agreement come into operation if the market price of a commodity that is the subject of the Salam agreement fluctuates beyond an agreed on limit may form the basis of acceptable solutions that are quasi derivative, but that are based on good and pure intentions. However, a need exists for Islamic business people to improve compliance with agreements because unfortunately it has been noticed that legal risks associated with non-compliance are high in many countries. Appendix A – Interview Questionnaire 1. In your opinion are the risks associated with the issue of Sukuk, such as the market risk and the foreign exchange risk substantial and do these risks need a management strategy? 2. How do the risks associated with Sukuk, which are after all also known as Islamic bonds, compare with similar risks for bonds in the Western financial system? 3. Is there a standard or accepted procedure that is well accepted in the Islamic finance industry that can be relied upon to manage Sukuk risks? 4. How adequate or effective are the better accepted methods for the management of Sukuk risks in practice? 5. Is it possible to adequately manage Sukuk risks in every Islamic financial market? 6. The Sukuk has assumed an unprecedented level of importance as an instrument in Islamic finance. In your opinion do the risks associated with Sukuk hinder financial engineering? 7. Does a need exist to bring about improvements related to the issue and operation of the Sukuk issue in order to better manage Sukuk risks? 8. Although the Sukuk is amongst the most important financial instrument in Islamic finance, approximately what proportion of the total portfolio of a bank or Islamic finance company should be made up of Sukuk? 9. In your opinion, is there a need to bring about improvements in the effectiveness of methods for managing risk associated with Sukuk and what efforts are Islamic bankers and finance managers making to accomplish this goal? 10. In your opinion, what methods or techniques are the more promising for an improved risk management for the Sukuk? (This page intentionally blank) Bibliography/ References 1. Ayub, Mohammad. 2007. Understanding Islamic Finance. John Wiley and Sons Limited. 2. El-Gamal, Mahmud A. 2007. Incoherence of Contract-Based Islamic Financial Jurisprudence in the Age of Financial Engineering. Rice University. Retrieved: August 21, 2008. From: http://cas.uchicago.edu/workshops/islammod/Finance.pdf 3. Hassan, Kabir M and Lewis, Mervin K. 2007. Handbook of Islamic Banking. Edward Elgar Publishing. 4. Iqbal, Zamir. 1999. Financial Engineering in Islamic Finance. Thunderbird International Business Review, Vol. 41(4/5)5 41-560 (July-October 1999). Retrieved: August 21, 2008. From: http://www3.interscience.wiley.com/cgi-bin/fulltext/114112387/PDFSTART 5. Jobst, Andreas A. 2007. Derivatives in Islamic Finance. Islamic Economic Studies, Vol. 15, No. 1. Retrieved: August 20, 2008. From: http://poseidon01.ssrn.com/delivery.php?ID=066097067102104081094000003102019124061045066084038066109099000011092119104123072093002050032125061099054064110115026119117066053081007021045117089105067087030030035002052114074027123106117074074006085&EXT=pdf 6. Khan, Mansoor M and Bhatti, Ishaq M. 2008. Development in Islamic banking: a financial risk-allocation approach. The Journal of Risk Finance Vol. 9 No. 1, 2008 pp. 40-51. Retrieved: August 21, 2008. From: www.emeraldinsight.com/1526-5943.htm 7. Khan, Tariqullah and Ahmed, Habib. 2001. 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Retrieved: August 20, 2008. From: http://www.islamicfinance.de/sukukrisks.pdf Read More