Sharia Compliance and Fiduciary Ratings Dr. Mohamed Damak Senior Director Global Head of Islamic Finance Copyright 2017 by S&P Global. All rights reserved.
Agenda 1- S&P Credit Ratings 2- Fiduciary Ratings: Would they add value? 3- Standardize and the industry will reach its full potential 2
1. S&P Credit Ratings 3
What Is A Credit Rating? S&P Global Ratings opinion on the ability and willingness of an obligor to meet its financial obligations as they fall due. What It Is A forward-looking opinion about the ability of an issuer to pay back investors in full and on time Strives to be globally comparable across sectors Incorporates views on relative likelihood of default that are applied to entities (issuers) and securities (issues) One of many inputs available to investors as part of their decisionmaking process And What It Is Not A guarantee of credit quality or default probability Investment advice or recommendation (buy, sell or hold) A measure of liquidity or price A way of defining good or bad companies An audit of the company An opinion Sharia compliance or governance framework related to Sharia. 4
Rating Scale General Summary of The Opinions Reflected by S&P Global Ratings Investment Grade Speculative Grade AAA AA A BBB BBB- BB+ BB B CCC CC C D Extremely strong capacity to meet financial commitments. Highest rating Very strong capacity to meet financial commitments Strong capacity to meet financial commitments, but somewhat susceptible to adverse economic conditions and changes in circumstances Adequate capacity to meet financial commitments, but more subject to adverse economic conditions Considered lowest investment grade by market participants Considered highest speculative grade by market participants Less vulnerable in the near term, but faces major ongoing uncertainties to adverse business, financial and economic conditions More vulnerable to adverse business, financial and economic conditions, but currently has the capacity to meet financial commitments Currently vulnerable and dependent on favorable business, financial and economic conditions to meet financial commitments Currently highly vulnerable A bankruptcy petition has been filed or similar action taken, but payments of financial commitments are continued Payments default on financial commitments 5
Our Rating Process 1. Contract The issuer requests a rating and signs an engagement letter. 2. Pre-evaluation We assemble a team of analysts to review pertinent information. 3. Management Meeting Analysts meet with management team to review and discuss information. 6. Notification We generally provide the issuer with a pre-publication rationale for its credit rating for fact-checking and accuracy purposes. 5. Rating Committee The committee reviews the lead analyst s rating recommendation then votes on the credit rating. 4. Analysis Analysts evaluate information and propose the rating to a rating committee. 7. Publication We typically publish a press release announcing the public rating and post the rating on www.spglobal.com. 8. Surveillance of Rated Issuers and Issues 6
What do we rate in Islamic finance? In Islamic finance, we rate: 1- Islamic financial institutions and Takaful companies (using the same methodology we apply to conventional issuers but factoring the specificities related to their Islamic nature in our analysis). 2- Sukuk: based on a specific methodology that was published initially in 2007 and updated in 2015. Sharia compliance is not part of the factors that we incorporate in our analysis. 7
Bank Rating Methodology ALAC Support introduced in 2015 8
Specificities for Islamic banks BUSINESS POSITION Business stability Concentration and diversity Common view Islamic banks are more stable than conventional banks. They have been immune to the Global Financial Crisis for example. Islamic banks are more retail focused and therefore more resilient. Our view Incorrect. IB were immune because the principle of Islamic finance prohibited them from investing in structured products. They were equally, sometime more, impacted when the GFC transformed into an economic crisis. Partially correct: it is true that IB have the religious argument which is more appealing to retail clients but IB can also be active in very risky business such as private equity investments for example (GFH, Arcapita, etc.) 9
Specificities for Islamic banks BUSINESS POSITION Management and corporate strategy Common view Governance is stronger for Islamic banks because besides regular audit, they are also subject to Sharia audit and ruling. In addition, the principle of Islamic finance prohibits excessive risk taking which result in a more risk averse strategy of Islamic banks. Our view Partially correct: with regards to strategy, it is true that Islamic finance prohibits speculative behavior but it is also equally true that some of the activities conducted by IB can be very risky. Governance: Sharia governance is still subject to further development. Ex. currently, ex-post Sharia compliance is conducted by internal auditors without external disclosure. 10
Specificities for Islamic banks CAPITAL & EARNINGS Regulatory requirements Quality of capital and earnings Earnings capacity Islamic Banks Specificities Regulatory requirements can be based on AAOIFI standards which give the local regulators the discretion to deduct a portion of the activity financed by PSIAs. This might result in situation where the IB capitalization would be much lower than similar conventional bank. The risk transfer from shareholders to PSIAs holders is rarely effective (for on BS PSIAs). Very limited use of hybrid instruments in Islamic finance but this is developing. Hybrid sukuk were structured based on Mudaraba structure with real risk transfer (i.e. deduction from the principal in case of misperformance of the underlying asset (ex. NCB sukuk). IFSB recognizes only Musharaka sukuk as eligible for capital content. However, Musharaka sukuk was not used because it would likely result in a significant cost of funding for the bank. Sometime can be higher for Islamic banks that are purely retail players (Al Rajhi Bank) but this is the exception rather than the norm. 11
Specificities for Islamic banks RISK POSITION Common view Our view Growth and change in exposure Complexity IB tend to benefit from higher collateralization compared with conventional banks. In case of default, they are in a better position. IB are less complex than conventional banks. They cannot be involved in derivatives and structured products. Partially correct: In most of the cases, IB do not have access to the underlying asset subject of the transaction or sometime it is difficult, from a reputation perspective to size the asset (ex. mortgage). Partially correct: IB do not have access to derivatives, in general and therefore are not exposed to risks related to these products. However, Islamic products themselves are structured products and can result in unexpected risks (legal, Sharia, etc.) 12
Specificities for Islamic banks RISK POSITION Common view Our view Risks that the RACF does not cover. IB have no exposure to interest rate risks (prohibited). Their exposure to FX risk is limited as they don t have access to hedging mechanisms. Incorrect: Islamic banks are exposed to margin risk but in theory they can transfer misperformance of assets to their PSIAs clients. In practice, this is not done to avoid liquidity related risks. IB are also exposed to FX risks and have no tools to cover it apart from trying to balance the structures of their assets and liabilities. Islamic banks are also exposed to other risks such as being perceived as non Sharia compliant. 13
Specificities for Islamic banks FUNDING & LIQUIDITY Funding Liquidity Common view Presence of PSIAs exposes the IB to displaced commercial risk. Islamic banks lack liquidity management tools Our view Correct: PSIAs can be very volatile if the IB decides to serve negative returns or lower returns to its PSIAs holders. The industry has developed few techniques such as PER and IRR to cover for this risk. Correct: they tend to keep a higher level of cash and interbank deposits vs. conventional banks due to the lack of instruments to manage their liquidity. Several central banks created some instruments specific for IB to manage their liquidity. 14
Sukuk Rating Criteria We equalize with sponsor senior unsecured credit rating if: Sufficient contractual obligations No conditionality Sukuk rating Senior Obligations Coverage of SPV Costs Irrevocable obligations 15
Sukuk Rating Criteria Total Loss Event Contractual obligations to indemnify or remote risk Rate at the same level TLE Not covered or coverage is conditional and TLE is not remote Cap the rating or do not rate. If issuers/scholars want the risk not to be covered or profit and loss sharing to be effective, then they should accept higher pricing as the risk will be higher. 16
2. Fiduciary Ratings 17
Fiduciary Rating Vs. Credit Rating S&P does not do Fiduciary Ratings for Islamic Financial Institutions Credit rating and fiduciary ratings are totally different and serve different perspectives. We focus on the relative credit quality and fiduciary score focus on governance. Governance is part of the issues that we analyse when we do credit ratings. Example of fiduciary ratings/scores Morningstar Rating for a fund that measures risk adjusted returns and is derived from a weighted average of the performance figures associated with its 3-,5- and 10- year (if applicable) rating metrics Fi360: peer percentile ranking of an investment against a set of quantitative due diligence criteria selected to reflect prudent fiduciary management. IIRA Fiduciary score: based on corporate governance, Sharia governance and asset manager quality. 18
Sharia Compliance Rating Vs. Credit Rating S&P does not do Sharia Compliance Ratings for Islamic Financial Institutions Credit rating and Sharia compliance ratings are totally different and serve different perspectives. We focus on the relative credit quality and Sharia compliance rating focus on Sharia governance/compliance? What does it mean if an issuer has a low Sharia compliance rating? Does it mean that it is not compliant? Could it destabilize the issuer? Against which criteria would that be determined knowing that there are no widely adopted standards for Sharia and interpretation can be different? 19
3. Standardize and the industry will reach its full potential 20
The industry is at a crossroads # The easy way: accept 5% growth rate and let the industry continue to evolve as it is. # The hard way: believe that Islamic finance can do more; create new growth opportunities while solidifying the foundations of the existing industry through standardization. 21
Solidifying the foundations of the industry Regulation - Adopt international regulations Islamic economy - Integrate the different components Standards - Adopt international Standards - Implement Central Sharia Boards - Move toward external Sharia audit - Standardize legal documentation ISLAMIC FINANCE ECOSYSTEM Education - Educate and create a new generation of IF experts 22
Solidifying the foundations of the industry Standardize legal documentation and Sharia interpretation Decision to issue Identify the asset and structure Finalization of the documents Adjustment of legal environment Negotiation (Sharia, Lawyers) Market Condensation of these steps through standardization Benefits: Reduces risks (recent case type, legal interpretation risks, Sharia noncompliance risks); creates avenues for future growth through innovation (hybrid Sukuk and Sukuk with partial loss absorbency; Green Sukuk; SRI Sukuk); increases the appeal of the industry to new players. 23
Create new opportunities for growth Islamic Finance Principles Sustainable Development Goals - No Riba - No speculation - No illicit sectors - Profit and loss sharing - Asset backing Seize new opportunities created by SDGs, responsible finance and impact investments to which IF is a natural partner. Use existing products (Waqf, Zakat, etc.) and innovate! Islamic finance can be a natural contributor to shared prosperity. 24
Thank you Dr. Mohamed Damak Senior Director, Global Head of Islamic Finance T: +971 437 271 53 Mohamed.damak@spglobal.com 25
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