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An Islamic covered bond?The post-financial crisis sukuk innovation is to move into more boring areas, as shown by acovered sukuk issued by Gatehouse Bank in the UK, and that is not problematic for an area offinance that is young by the standards of conventional finance. You have to learn to walk beforeyou 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 assetswhich remain on the issuer’s balance sheet set aside specifically for the bond investors shouldthe 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 yieldon covered bonds—and sukuk—tends to be low. In the case of Gatehouse Bank, the coupon onthe five year sukuk is 3%. In addition to the features mentioned above, the covered sukuk isputtable back to Gatehouse every three months, provide an early redemption feature forinvestors. The ‘cover’ is provided by a building owned by Gatehouse in Basingstoke, southwestof London.The financial crisis showed that complicated structures do not necessarily protect investors anymore than simple structures, but there has been a relatively good track record for coveredbonds, 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 asmuch or more than the structure is that the quality of the collateral covering the bonds hasremained high. Large participants in the market have pushed back against broadening theassets allowable for covered bonds (most recently to include SME loans). London-based fundmanager at BlackRock warned: “We should be very protective of the covered bond marketbecause it’s had certain features for so many years, including the resilience of the collateral, andit’s a very safe asset class”.There are other questions that the prospects for covered sukuk need to answer in order to makethem accepted within the sukuk industry. The first is whether the same tax treatment of acovered 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 forsukuk with relatively low yield, something which is impossible to judge based on the Gatehousecovered sukuk alone, which carried a 3% coupon, because at £6.9 million ($10.4 million) it is avery 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 asovereign guarantee.One interesting aspect of the article on the Gatehouse covered sukuk is the premise that it couldprovide a money market alternative to the Islamic banking industry. The article includes a quotefrom Shahid Feroz, an Associate VP at Gatehouse Bank, who said: “The sukuk is a liquid andtradable note, and can be used as a short-term, three-month deposit instrument”. According toZawya, the sukuk is listed on the Cayman Islands Stock Exchange, where institutional investorsare able to trade the sukuk (as an ijara sukuk there would not be any Shari’ah-compliancereason why the sukuk would not be tradable).The questions arise, however, when looking at how an investor would approach the sukuk andhow it would affect the overall stability of Islamic financial markets through the put option thatis embedded in the early redemption feature (making it a short-term, three-month depositinstrument). The context here is that this sukuk has a stated maturity of 5 years, and mostinvestors 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 thestructure independent of the issuer. A bank issues a 5-year ijara sukuk to investors with theoption 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 perspectivemanaging liquidity, the benefit of a five-year (non-redeemable) sukuk is that the bank can takethe issuance proceeds and use it to acquire long-term assets with less liquidity transformationrisk than if it had used deposits to fund. With deposits, there is always the risk that some of thedepositors each week will come in and withdraw their funds, so the bank will reserve someportion of those funds to meet its liquidity needs. With the 5-year non-redeemable sukuk, aslong as the bank believes it will have significant enough liquidity five years from today toredeem the sukuk (or that the markets will remain healthy enough that they can roll over thesukuk five years from now).But, introduce the redemption feature and there will be some proportion of the investors whowill redeem the sukuk at any given time and the bank will need to hold cash that couldotherwise be invested in longer-term assets to meet the expected redemptions. This will makethe sukuk more like a 3 month certificate of deposit that it expects to be able to roll over every 3months (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 bigdifference 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 attheir first opportunity (commercial paper is defined as any debt with a tenor of 270 days orunder, 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 investorsare less willing to have exposure to other financial institutions, or where there exist questionsabout the solvency of the issuer. Instead of selling the security into the secondary market (at aprice below par), investors will redeem the sukuk instead, which has the potential to influenceothers to do the same, which in situations where the decision-making is guided more by theshifts in perceptions rather than the actual solvency. However, the effect is the same becausethe redemptions amount to a ‘run’ on the bank by creating an outflow of liquidity that maybecome greater than the institution has prepared for.Returning to the issue of a covered bond as a liquidity instrument, there are further systemicissues 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 tomake up a larger part of the market in the GCC, they could hinder the market for unsecuredinter-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 inbankruptcy. Depositors are at the top, secured creditors and covered bond holders are at thetop (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 unsecuredcreditors (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) secureddebt; and, 3) covered bonds, a bank decreases the amount of assets available to all the othercreditors if it were to enter bankruptcy. As there are fewer assets that are not already pledgedto the creditors higher up the ladder, the unsecured creditors will expect (all else being equal) toreceive a lower recovery rate on the unsecured inter-bank financing they provide which willraise the cost of unsecured inter-bank financing and likely diminish both the supply of anddemand 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 managementbenefits 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 inexisting 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 sukukprovides a greater link between the financing and an underlying asset, which may make it usefulin some situations (for example, by providing a more investor-friendly version of sukuksecuritizations). Another possibility is that a covered bond could be used in an istithmaar sukukto provide additional ‘secured’ features to a sukuk structure that bears similarities to a coveredbond.