Bank Negara’s prudence

Reuter's last week reported "... Malaysia's central bank has rejected BIMB's proposal to secure the sukuk with shares of the company, which will need to identify an alternative asset for the exercise... BIMB last month proposed a 10-year Islamic bond or sukuk of RM1.5 billion as part of a plan to acquire the 49% stake it does not own in Bank Islam held by Dubai Group and Tabung Haji."

Sukuk have been issued where the underlying asset has been toll road revenue, aircraft leases, offshore oil drilling leases, mobile phone air-time, etc. Furthermore, a variety of Sukuk include convertible sukuk (to compliant company shares), exchangeable sukuk (another compliant company controlled by sukuk issuing company), perpetual sukuk (capital ratio), etc.

The regulator has to walk the fine line between encouraging Islamic capital market development with supporting compliant instruments, and prudence, especially after credit crisis l (US subprime) and credit crisis ll (Euro zone sovereign debt), that protects and promotes the integrity of the market place (where asymmetric inform is a common-place).

Michael Enzi, US Senator, said, "The American people need to know that money is being used effectively because frankly, the nation can't afford careless spending, no matter how well-intentioned."

It must be recalled that the derivatives market reached the size of $700 trillion, whilst the world economy was at $60 trillion, hence, regulators conscious of maintaining the connection between offering instrument (abuse) and underlying (local) economy in an inter-connected capital markets. The lesson learned from the US subprime is investors actually had more risk in their portfolio than they thought, and many have attributed this to rating agency "failure".

Shares are Asset?

"A shareholder or stockholder is an individual or company (including a corporation) that legally owns one or more shares of stock in a joint stock company .... Shareholders are granted special privileges depending on the class of stock, including the right to vote on matters such as elections to the board of directors, the right to share in distributions of the company's income, the right to purchase new shares issued by the company, and the right to a company's assets during a liquidation of the company. However, shareholder's rights to a company's assets are subordinate to the rights of the company's creditors." Source: Wikipedia.

Thus, does the issue come down to, "shareholders rights subordinated to creditors" for company shares secured to issue Sukuk?

The responsible regulator must think through the question, "what happens when things go wrong or the (optimistic) assumptions do not materialise?"

Prudence of Bank Negara Malaysia

Bank Negara Malaysia, led by a central banker's banker, governor Zeti Akthar Aziz, was correct, on prudence, in rejecting BIMB's proposal to secure sukuk issuance with the bank's shares. As the original Reuter' story was lacking details, the rejection may be due to some of the following reasons:

1. Shares of an Islamic bank are generally illiquid (and smaller free float) compared to conventional counter-part publicly listed bank, hence, an illiquid 'holding' to an already illiquid instrument (attested by minimal secondary market trading volume for non-Murabaha Sukuk)

2. What happens if the bank is acquired, taken private, stock-splits, issuance of additional shares, market sell-off, earnings declining due to non-performing loans and corresponding provisioning, or if it goes bankrupt? If company goes bankrupt, the common stock holders would have the "residual assets of the company after discharge of all senior claims such as secured and unsecured debt."

3. Now, assuming it was approved, it sends a "misleading" message to Shariah compliant companies that must be screened. What if the Shariah compliant company, not Shariah based like an Islamic bank, Takaful operator, Islamic REIT, violates one of the financial ratios (of Securities Commission) at the review, and must removed from an Islamic index, what happens to the Sukuk? Does it convert into a conventional bond, as the company is no longer Shariah compliant? Will the "Islamic" holders of the paper need to sell immediately to continue being Islamic?

Would clever lawyers be able to build in fail-safe mechanisms, but, will it make the sukuk (1) difficult to price/understand and (2) require a 'fail-safe' premium?

4. Assuming it was approved, the 49% would be in a trust, with corresponding responsibilities, would there be a conflict between Sukuk holder and non-Sukuk stock holders at AGMs, voting for directors, etc.? Would the Sukuk holders have some extra fiduciary duty, care and loyalty, to the company?

Martin Whitman, US based fund manager, stated, "...it can safely be stated that there does not exist any publicly traded company where management works exclusively in the best interests of OPMI [Outside Passive Minority Investor] stockholders. Instead, there are both 'communities of interest' and 'conflicts of interest' between stockholders (principal) and management (agent). This conflict is referred to as the principal/agent problem. It would be naive to think that any management would forego management compensation, and management entrenchment, just because some of these management privileges might be perceived as giving rise to a conflict of interest with OPMIs…"

5. Finally, it would interesting to understand how a rating agency like RAM or S&P, would undertake analysis of BIMB and the Sukuk if the Sukuk was issued.

Conclusion

Islamic finance, as it matures and evolves and becomes cross border, will encounter both diminishing tailwinds and increasing headwinds. To address the headwinds, prudence may demand erring on side of caution to protect and preserve confidence and trust in this niche market, hence, with the responsible regulators saying, 'no, not yet as more research is required.'

Only through foundational and stress tested research, across time and (possibly) geographies, white papers, public comments, etc., can the negative turned into an affirmative. It has taken 40 plus years to get to $1.3 trillion, it may take 40 seconds to undo, hence, not worth the systemic risk!

"A ship in harbor is safe - but that is not what ships are for."  - John A. Shedd, Salt from My Attic - September 10, 2013.

* This is the personal opinion of the writer or publication and does not necessarily represent the views of The Malaysian Insider.