Mohammed Shodiq, Academic Head for Bank Rakyat Indonesia Syariah speaks exclusively to IQPC on sukuk and the Islamic finance industry. Shodiq also talks about the huge potential in Indonesia and trends that he is seeing in Asia with regards to Sukuk?
IQPC: What lies behind the attraction of sukuk?
Demand for diversification asset class and geography. Sukuk market provides investment opportunities to a broad range of investors including public pension fund managers, reserve managers, central banks and Auqaf managers.
Sukuk introduce a new asset class for investment diversification and fill the gap in Sharia compliant tradable instruments. Islamic orientation of investors increasing, even among high-end investors. Demand for significant infrastructure/project financing. Sukuk by nature of being asset backed are amenable to finance infrastructure development, and a number of emerging markets are looking to finance projects through issuance of sukuk.
Improving branding to a new global investor group. Companies in non-Islamic markets look to increase Islamic credibility to a growing investor class with strong Islamic affinity.
IQPC: What are the some lessons from sukuk defaults and what can be done to minimize or prevent occurrences of these defaults?
Mohammed Shodiq:
A default is triggered by the occurrence of one or more events, such as non-payment or insolvency, which are provided in the relevant transaction documents. Therefore, if a standstill or a restructuring occurs after an event of default is triggered, then technically the default has occurred.
The occurrence of sukuk defaults mostly driven by credit and market risk. These deals would have gone wrong even if they were conventionally financed. Risk is inherent in any transaction, whether Islamic or conventional.
The problems also associated with restructuring have something to do with sukuk’s inherent complexity. Several defaults on sukuk have tested their legal structures. The defaults have led to uncertainty about legal protection for investors. In some cases, the concern has been that investors may not have the right to own property assets posted as collateral for sukuk. In other cases, confusion has arisen over whether investors have recourse to the assets that back them.
Many sukuk are based on or backed by assets that may be located in different jurisdictions. Complications exist in many jurisdictions, especially to property law and transferable interests.
Sukuk behave like conventional bonds but avoid Islam’s prohibition on charging or receiving interests through a variety of complex lease agreements. The presence of land and other assets that allow sukuk to avoid interest have sometimes led investors to believe they can take ownership of those of assets in the event of default. That, however, simply is not for the vast majority of sukuk.
Any change in legal structures arising from recent sukuk defaults will probably be visible when sukuk explicitly backed by assets. Also need for more harmonization of sukuk structures which vary between jurisdictions.
The market for sukuk has reached critical mass, but is still relatively young and experiencing some growing pains. In order for the sukuk market to grow, some form of standardization is needed because there are variations in terms of structuring a sukuk in Asia, the Middle East and even in Europe. The emergence of an integrated global sukuk market would be facilitated by greater standardization, especially when it comes to
shariah interpretation and the regulatory framework.
IQPC: Indonesia is a potentially huge market for Islamic finance. In your view, what do you think are the factors affecting the slow growth?
Mohammed Shodiq:
Indonesia is a potentially huge market for Islamic finance. Factors affecting the slow growth are:
Lack of human talents
The scarcity of competent sharia bankers who are skillful and knowledgeable in both sharia banking operations and sharia mindset have been critical for improving the performance of sharia banking.
Lack of product innovation
Most of the products available in the market are debt based shariah compliant products.
One of the features that could potentially benefit to the economic system is the presences of equity and sharia based financing. However, equity and shariah based financing has not been dominating due to some possible reasons that prevent such financing from the applications such as:
Higher risk involved in the investment due to lack of transparency and inability to monitor the investment
Principal-agent problem, where the agent (mudharib) does not always act in the best interest of the principal (shahibul maal)
Lack of competency of the sharia banks’ human resources to conduct such investments
Unavailability of information about business performance of each targeted industrial sector.
Government support
To support the operational soundness, sharia banking should be equipped with a proper set of regulatory and supervisory instruments that fits its operational activities which are different from the conventional ones. At the early stage of development, sharia banking still applies conventional framework for regulatory and supervisory activities although a few set of regulations have been developed. These are for example, licensing regulation, inter-sharia bank financial instruments, sharia monetary instruments (SWBI) and minimum statutory reserve for sharia banking. The lack of a proper regulatory and supervisory framework can potentially reduce its operational capability.
To cope with the challenges, Bank Indonesia as the banking regulatory authority has put foundations for regulatory instruments that cover:
Establishment of financial instruments that is expected to improve efficiency
Formulation of an early warning system for sharia banking (CAMEL rating system) which is capable of describing its operational risks and maintaining sustainability and also transparency in the reporting
Formulation of the rules of conduct for players to improve the quality of corporate governance
Developing the concept of regulation that concerns about systemic stability
Developing the concept of regulation that ensures compliance with sharia principles
Financial institution sophistication.
Limited operational coverage could potentially reduce customer comfort. There are several challenges that should be faced in the effort to expand the operational coverage, such as:
Creating a conducive environment to attract new comers especially conventional banks that already have wide operating network or promoting strategic alliance with other financial institutions to improve efficiency
Simplification of licensing procedures for new comers without reducing prudentiality
Providing information about sharia financial services
Improving the professionalism and quantity of manpower for the industry.
Lack of knowledge and understanding by the public.
Based on surveys conducted in collaboration with universities within six provinces in Indonesia between 2000 to 2001, it is concluded that there is still a gap between needs and knowledge of sharia financial products and services.
The gap could delay the success to mobilise potential public funds to investment because of low switching rate from potential demand to real demand. Furthermore, the gap will also make marketing and selling effort for sharia banking products and services more difficult. There are several challenges to face in order to improve the awareness and knowledge among the potential target customers, such as:
Large numbers of people dispersing in a wide diversified background Efforts to educate the public requires considerable budget and other resources Limited promotion budget for stakeholders due to the small size of the industry
One potential solution to overcome these challenges is to have a concerted and coordinated effort of public education
Lack of efficient institutional structure supporting efficient sharia banking operations
A comprehensive, effective and efficient institutional structure is essential to ensure a stable and sustainable development of sharia banking. Currently, there have been supporting institutions founded as parts of sharia banking in Indonesia. However, it still requires substantial effort to make them more effective in order to sustain an efficient sharia banking operations.
There are several institutions and functions that need to be developed to improve the institutional environment such as:
Sharia auditor, to ensure the compliance of sharia banks with the sharia principles Communication Board (FKPPS), to enable an effective coordination of the effort to improve public awareness and education for sharia banking.
Institution for Sharia Financing Insurance, to provide financial protection to sharia banks against fraudulent practices by recommended customers.
Sharia finance information center, serving as a linkage between real sector and sharia finance sector by providing a Special Purpose Company to facilitate asset securitization for Islamic banks that want to enhance its liquidity management. It also provides sharia investment opportunities for other domestic banks and investors as well as international investors.
Operational inefficiency
In spite of its performance that is systematically better than conventional ones, sharia banking still gives a lower rate of return to investors compared to the rate of return paid by conventional banks. Improvement in operational efficiency leading to a higher rate of return to customers could motivate investors of sharia banking to stay loyal with Islamic banks since they expect both the sharia compliance and also the rate of return. This
should be noted carefully particularly when facing an era of free competition in which competitors come not only from the banking industry but also from other companies in different industries that are capable of delivering similar financial services.
Besides improving internal efficiency, sharia banking may also apply different strategies for expansion: ‘economies of scale’ and or ‘economies of scope’. The first strategy could be conducted through expanding operational coverage such as conducting strategic alliances with either domestic or international companies. The second strategy could be conducted by providing a wider variety of banking products (including the use of technology advantages) so that the public could enjoy the sharia financial services in a more flexible way.
IQPC: How can the Islamic finance market grow over-relying on the repackaging of conventional products?
Mohammed Shodiq:
Islamic finance should move from shariah compliant products to shariah based products.
Shariah compliant products were based on mirroring concept to conventional products with the elimination of prohibited items. The compliance criterias were based on aqad assessment. Shariah based products should be based on both of aqad assessment and objectives of shariah (maqasid shariah) assesment.
IQPC: Where are some of the trends that you are seeing in the sukuk market in Asia?
Mohammed Shodiq:
A developing Country like Indonesia needs to elaborate more on corporate and municipal sukuk. Indonesia is an archipelagic country with more than 17 thousand islands, 34 provinces and 400 municipalities nationwide needs to develop the region. The municipal administration have the authority to issue a bond/sukuk to solve their deficit budget.
There are also untapped market like East Asia Countries (i.e China, Japan,Korea) which is no single sukuk has been issued so far.
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