Governance and Risk Management Issues for Sukuk by Dr. Salman Khan

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 Public Private Global Non-profit Corporate Sharia Project Environmental Internet Information technology Regulatory Participatory Multilevel Meta Collaborative Relevant: Corporate Sharia

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

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 Nakheel discuss

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 (N.B.: not always there) - Corporate Trust departments - captive - dependence for revenue

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

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: Passet 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 3P 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)

AAOIFIs position on Sukuk Tradeability and PG Investment sukuk Mudaraba, musharaka, wakalatul istithmar Nominal (fv) X 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

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

AAOIFIs position on Sukuk Ijara sukuk Lessee Agent Agent guarantee X Rewind: guarantee (fundamental) Lessee : Agent X Why (basic principle) ? Both guarantees confirm return Equal playing turf? Consequence: ijara sukuk favoured Opinion?