Islamic Securitization - The Right Way Forward?: RGE

Heiko Hesse, Andreas Jobst and Juan A. Sole | Feb 13, 2009

1 Introduction

The collapse of the securitization market and the ensuing market turbulence have cast serious doubts on this economic proposition of unbundling, transforming, and re-distributing credit risk via structured finance instruments. In view of sweeping fiscal intervention in the financial sector, a widespread retrenchment of mortgage exposures, and substantial liquidity injections by central banks to support inter-bank money markets, both the scale and persistence of the current credit crisis seem to suggest that pervasive securitization — together with improvident credit origination, inadequate valuation methods, and insufficient regulatory oversight — can perpetuate market disruptions, with potentially adverse consequences for financial stability and economic growth.

After having nearly ground to a halt last year, the market for securitized debt remains moribund and pricing depressed as banks dispose of non-core assets and raise capital to de-lever and bolster their imploding balance sheets. The complexity of securitization structures, which once obscured actual loss exposures, perpetuated benign asset valuations, and incubated fallacious investor complacency, is now debilitating effective banking sector resolution in a time of systemic distress.

As the global credit crisis continues to deepen, the soul-searching in conventional finance has directed attention to alternative modes of structured finance to fill the void of unmet credit demand. In this context, some investors – unsettled by excessive risk-taking and asset price volatility – turned to Islamic finance as market ruptures caused by the headlong flight to safety during the initial phase of the credit crisis seem to recede only slowly. Islamic finance is driven by the general precept of extending religious doctrine in the shari’ah to financial agreements and transactions. Islamic finance is distinct from conventional finance insofar as it substitutes the (temporary) use of assets (or services) by the borrower for a permanent transfer of funds from the lender as a source of indebtedness (Jobst [2007]). Predatory lending, deteriorating underwriting standards, and a series of incentive problems between originators, arrangers, and sponsors, of which all have infested the conventional securitization process, belie fundamental Islamic principles.

In this regard, Islamic securitization, via shari’ah-compliant investment certificates or sukuk, invites a comparison of conventional and Islamic finance principles as to their capacity to sustain efficient capital allocation and financial stability. Sukuk have been affected by the global financial crisis only recently in response to inflationary pressures in the Gulf countries, uncertainty about commodity prices, and the widespread economic downturn. These Islamic investment certificates encompass a broad range of shari’ah-compliant financial instruments and can be best described as participation certificates that grant investors return from actual asset ownership in one or more Islamic contracts that are commonly accepted in the legal tradition. While sukuk are structured in a similar way to conventional asset-backed securities (ABS) or covered bonds, they can have significantly different underlying structures and provisions (Jobst et al. [2008]). Most importantly, sukuk — like Islamic financial instruments in general — need to comply with shari’ah, which prohibits the receipt and payment of interest and stipulates that income must be derived from an underlying real business risk rather than as a guaranteed return from interest.

The following article relates the characteristics of this form of securitization to calls for enhanced disclosure and standardization, ratings agency reforms, and better transparency of origination and underwriting practices in conventional structured finance. In particular, it assesses the potential of conflicts of interest (which became apparent in the U.S. subprime mortgage crisis) to contaminate the integrity of the securitization process if it were conducted in compliance with shari’ah principles.

2 Incentive problems of conventional securitization

The main cause of the crisis can be traced to market failure stemming from conflicts of interests in the securitization process and ill-designed mechanisms to mitigate the impact of asymmetric information. By substituting intermediated lending with capital market finance, securitization creates considerable agency cost (which are ultimately borne by investors) if agents are tempted to pursue their own economic incentives. The U.S. sub-prime mortgage crisis exposed the severity of fundamental incentive problems in conventional securitization and the lack of ex ante market discipline. The attendant market fallout demonstrated that remaining conflicts of interests between stakeholders entail significant agency costs, which — if left unchecked — escalate the adverse effects of deteriorating credit conditions, valuation difficulties, and higher leverage on financial stability. In particular, securitization facilitated excessive risk-taking to a point where the inability of issuers to gauge actual credit risk and the flexibility of asset managers to subvert investment mandates intensified the potential of systemic vulnerabilities to credit shocks.

For more on this article, please click on the following link: Islamic Securitization - The Right Way Forward?: RGE