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An Islamic covered bond?
The post-financial crisis sukuk innovation is to move into more boring areas, as shown by a
covered sukuk issued by Gatehouse Bank in the UK, and that is not problematic for an area of
finance that is young by the standards of conventional finance. You have to learn to walk before
you run. For those of you not familiar with covered bonds, which are most prevalent in Europe,
they are bonds carrying the repayment obligation of the issuer, as well as having specific assets
which remain on the issuer’s balance sheet set aside specifically for the bond investors should
the issuer fail to repay the bond (with the possibility for over-collateralization).
As a result of the extra security provided by the issuer’s guarantee and the collateral, the yield
on covered bonds—and sukuk—tends to be low. In the case of Gatehouse Bank, the coupon on
the five year sukuk is 3%. In addition to the features mentioned above, the covered sukuk is
puttable back to Gatehouse every three months, provide an early redemption feature for
investors. The ‘cover’ is provided by a building owned by Gatehouse in Basingstoke, southwest
The financial crisis showed that complicated structures do not necessarily protect investors any
more than simple structures, but there has been a relatively good track record for covered
bonds, as none have ever defaulted, according to an article in the Financial Times. However,
one of the qualities of the European covered bond market that may account for this success as
much or more than the structure is that the quality of the collateral covering the bonds has
remained high. Large participants in the market have pushed back against broadening the
assets allowable for covered bonds (most recently to include SME loans). London-based fund
manager at BlackRock warned: “We should be very protective of the covered bond market
because it’s had certain features for so many years, including the resilience of the collateral, and
it’s a very safe asset class”.
There are other questions that the prospects for covered sukuk need to answer in order to make
them accepted within the sukuk industry. The first is whether the same tax treatment of a
covered bond or sukuk that is granted in Europe is possible in countries outside of Europe (e.g.
the GCC) where taxation is not yet fully developed even for the plain vanilla forms of sukuk.
Beyond this, there are questions about whether investors will express sufficient demand for
sukuk with relatively low yield, something which is impossible to judge based on the Gatehouse
covered sukuk alone, which carried a 3% coupon, because at £6.9 million ($10.4 million) it is a
very small sukuk. For comparison, that yield is comparable to the current yield on Dubai’s
sovereign sukuk maturing in 2017 (3.05%) and the Gatehouse sukuk does not come with a
One interesting aspect of the article on the Gatehouse covered sukuk is the premise that it could
provide a money market alternative to the Islamic banking industry. The article includes a quote
from Shahid Feroz, an Associate VP at Gatehouse Bank, who said: “The sukuk is a liquid and
tradable note, and can be used as a short-term, three-month deposit instrument”. According to
Zawya, the sukuk is listed on the Cayman Islands Stock Exchange, where institutional investors
are able to trade the sukuk (as an ijara sukuk there would not be any Shari’ah-compliance
reason why the sukuk would not be tradable).
The questions arise, however, when looking at how an investor would approach the sukuk and
how it would affect the overall stability of Islamic financial markets through the put option that
is embedded in the early redemption feature (making it a short-term, three-month deposit
instrument). The context here is that this sukuk has a stated maturity of 5 years, and most
investors would treat it as a 5-year sukuk because there is, by and large, a preference for buy-
and-hold within the sukuk markets (outside of Malaysia where there is greater liquidity).
Step back for a moment from the current example of the Gatehouse sukuk and look at the
structure independent of the issuer. A bank issues a 5-year ijara sukuk to investors with the
option for investors, at their choosing, to return to the bank and exchange the sukuk for cash,
and this is allowed every three months until the sukuk matures. From the bank’s perspective
managing liquidity, the benefit of a five-year (non-redeemable) sukuk is that the bank can take
the issuance proceeds and use it to acquire long-term assets with less liquidity transformation
risk than if it had used deposits to fund. With deposits, there is always the risk that some of the
depositors each week will come in and withdraw their funds, so the bank will reserve some
portion of those funds to meet its liquidity needs. With the 5-year non-redeemable sukuk, as
long as the bank believes it will have significant enough liquidity five years from today to
redeem the sukuk (or that the markets will remain healthy enough that they can roll over the
sukuk five years from now).
But, introduce the redemption feature and there will be some proportion of the investors who
will redeem the sukuk at any given time and the bank will need to hold cash that could
otherwise be invested in longer-term assets to meet the expected redemptions. This will make
the sukuk more like a 3 month certificate of deposit that it expects to be able to roll over every 3
months (with a relatively low yield as a result). However, from a financial stability perspective,
the 5-year sukuk with quarterly redemptions will not work the same way because it is a bond—
albeit a covered bond—and is not covered by deposit insurance. And that makes a big
difference because, like was the case in the commercial paper market during the financial crisis,
there was a wholesale ‘run on the bank’ where investors fled most any financial institution at
their first opportunity (commercial paper is defined as any debt with a tenor of 270 days or
under, roughly 9 months).
A longer-term sukuk with short-term redemption options will not on its own lead to problems.
However, it will be more susceptible in times of general financial market stress when investors
are less willing to have exposure to other financial institutions, or where there exist questions
about the solvency of the issuer. Instead of selling the security into the secondary market (at a
price below par), investors will redeem the sukuk instead, which has the potential to influence
others to do the same, which in situations where the decision-making is guided more by the
shifts in perceptions rather than the actual solvency. However, the effect is the same because
the redemptions amount to a ‘run’ on the bank by creating an outflow of liquidity that may
become greater than the institution has prepared for.
Returning to the issue of a covered bond as a liquidity instrument, there are further systemic
issues that are presented when examining the hypothetical case described in the Reuters article:
But covered sukuk have one major, potential advantage for the Gulf; because of their
security, it is possible - if they are issued in much larger volumes - that they could be
used as tradable Islamic money market instruments, of which there is currently a
shortage in the region.
Start with the assumption of “they are issued in much larger volumes”. If covered sukuk were to
make up a larger part of the market in the GCC, they could hinder the market for unsecured
inter-bank borrowings. An FT article included the following indirect quote of the HSBC CEO:
Stuart Gulliver, HSBC’s chief executive, says one reason why he is loath to lend to other
banks now is because that kind of unsecured lending is far riskier than it used to be
since such a large portion of banks’ assets are now “encumbered”, or pledged as
collateral on other financing, such as covered bonds.
To understand the implications of this, you have to consider the prospects for creditors in
bankruptcy. Depositors are at the top, secured creditors and covered bond holders are at the
top (and the assets securing their loans are pulled out from the assets available to creditors).
The remaining creditors have the remaining assets left to fulfill first the claims of the unsecured
creditors (including inter-bank loans), and then any remaining goes to subordinated creditors
and equity. So, by increasing the amount of assets that are funded by 1) deposits; 2) secured
debt; and, 3) covered bonds, a bank decreases the amount of assets available to all the other
creditors if it were to enter bankruptcy. As there are fewer assets that are not already pledged
to the creditors higher up the ladder, the unsecured creditors will expect (all else being equal) to
receive a lower recovery rate on the unsecured inter-bank financing they provide which will
raise the cost of unsecured inter-bank financing and likely diminish both the supply of and
demand for it.
At the end of the day, the idea of a covered sukuk is promising, despite all of the caveats and
‘what ifs’ I have provided in this post, although I am still skeptical of the liquidity management
benefits of issuing puttable sukuk. It is still a useful exercise to find the ‘what could go wrong’
scenario, even if it may be just a remote possibility. There are still limitations (e.g. covenants in
existing bonds restricting the encumbrance of assets or issuance of debt senior to existing debt)
that will make covered bonds not accessible to some issuers. However, a covered sukuk
provides a greater link between the financing and an underlying asset, which may make it useful
in some situations (for example, by providing a more investor-friendly version of sukuk
securitizations). Another possibility is that a covered bond could be used in an istithmaar sukuk
to provide additional ‘secured’ features to a sukuk structure that bears similarities to a covered
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