Ed Sukuk EnglishVIP

7/29/2019 Ed Sukuk EnglishVIP

1/21

ISLAMIC FINANCIAL SERVICES BOARD

EXPOSURE DRAFT

CAPITAL ADEQUACY REQUIREMENTS FOR SUKKSECURITISATIONS AND REAL ESTATE INVESTMENT

Comments on this Exposure Draft should be sentto the IFSB Secretariat not later than 10 May 2008

at email [email protected] or facsimile +603 2698 4280

December 2007


2/21

ABOUT THE ISLAMIC FINANCIAL SERVICES BOARD (IFSB)

The IFSB is an international standard-setting organisation that promotes and enhancesthe soundness and stability of the Islamic financial services industry by issuing global

prudential standards and guiding principles for the industry, broadly defined to includebanking, capital markets and insurance sectors. The standards prepared by the IFSBfollow a lengthy due process as outlined in its Guidelines and Procedures for thePreparation of Standards/Guidelines, which involves, among others, the issuance ofexposure drafts, holding of workshops and, where necessary, public hearings. The IFSBalso conducts research and coordinates initiatives on industry-related issues, as well asorganises roundtables, seminars and conferences for regulators and industrystakeholders. Towards this end, the IFSB works closely with relevant international,regional and national organisations, research/educational institutions and marketplayers.

For more information about the IFSB, please visit www.ifsb.org


3/21

i

TECHNICAL COMMITTEE

ChairmanDrAbdulrahman Abdullah Al-Hamidy Saudi Arabian Monetary Agency

Deputy ChairmanDr Mulya E. Siregar Bank Indonesia

Members*Mr Khalid Hamad Abdulrahman Hamad Central Bank of Bahrain

Mr Hamid Tehranfar Central Bank of the Islamic Republic of IranDr Sami Ibrahim Al-Suwailem Islamic Development Bank

Mr Ibrahim Ali Al-Qadhi Central Bank of KuwaitMr Bakarudin Ishak Bank Negara Malaysia

Mr Azhar Kureshi State Bank of PakistanMr Mu'jib Turki Al Turki Qatar Central BankMr Chia Der Jiun Monetary Authority of Singapore

Mr Osman Hamad M. Khair Central Bank of SudanMr Saeed Abdulla Al-Hamiz Central Bank of the United Arab Emirates

* In alphabetical order of the country the member represents

SPECIAL ISSUES ON CAPITAL ADEQUACY WORKING GROUP

ChairmanMr Khalid Hamad Abdulrahman Hamad Central Bank of Bahrain

Deputy ChairmanMr Chia Der Jiun Monetary Authority of Singapore

Members*

Mr Abdulrahman Abdulla Al Sayed Moosa Central Bank of Bahrain

Dr Karl F. Cordewener Bank for International SettlementsPengiran Haji Ismail PLW Pengiran Haji Yusof Ministry of Finance BruneiMr Ahmad Soekro Tratmono Bank Indonesia

Mr Ahmad Fahad Al Manayes Central Bank of KuwaitMr Muhammad Said Abdul Wahab El-Saka Kuwait Finance House, Kuwait

Dr Hamim Syahrum Ahmad Mokhtar Bank Negara MalaysiaMr Alaa Eldin Mohamed Aly El Ghazaly Qatar Central Bank

Mr Khalid Abdullrahman Abahussain Saudi Arabian Monetary AgencyMr Elhadi Salih Mohamed Salih Central Bank of SudanMr Peter Casey Dubai Financial Services Authority, United Arab Emirates

* In alphabetical order of the country the member represents


4/21

ii

ISLAMIC DEVELOPMENT BANK SHARAHCOMMITTEE*

ChairmanSheikh Mohamed Mokhtar Sellami

Deputy ChairmanSheikh Saleh bin AbdulRahman bin Abdul Aziz Al Husayn

Sheikh Abdul Sattar Abu Ghodda Member

Sheikh Hussein Hamed Hassan MemberSheikh Mohamed Hashim Bin Yahaya Member

Sheikh Mohammad Ali Taskhiri Member

* In alphabetical order

SECRETARIAT, ISLAMIC FINANCIAL SERVICES BOARD

Professor Rifaat Ahmed Abdel Karim Secretary General

Mr Abdullah Haron Assistant Secretary GeneralProfessor Simon Archer Consultant


5/21

iii

TABLE OF CONTENTS

ACRONYMS ....................................................................................................................................iv

INTRODUCTION ............................................................................................................................. 1

1. SukkSecuritisation ........................................................................................................ 21.1 Definition ................................................................................................................. 21.2 Sukkstructures .................................................................................................... 21.2.1 Collateral security structure .................................................................................. 3

1.2.2 Sukk structure with a repurchase undertaking (binding promise)....... 31.2.3 Pass-through structure with no repurchase undertaking........................ 4

1.3 Parties in a securitisation structure ..................................................................... 41.4 IIFS exposure to risks from various perspectives ............................................. 51.5 Operational requirements pertaining to Sukkand securitisation ................... 6

1.5.1 The assets in Sukk securitisations.......................................................... 61.5.2 Recognition of risk transference (asset derecognition criteria).............. 6

1.6 Treatment for regulatory capital purposes of Sukkand securitisationexposures ............................................................................................................... 81.6.1

Risk weight of IIFS as originators, sponsors, issuers or servicers........ 9

1.6.2 Treatment of liquidity facilities................................................................. 10

1.7 Treatment of credit risk mitigation for securitisation exposures .................... 101.8 Treatment of credit enhancement provided by an originator .......................... 10

2. Real Estate Investment .................................................................................................. 112.1 Current regulatory environment of real estate investment .............................. 112.2 Definition ............................................................................................................... 112.3 Risk exposures in real estate investment .......................................................... 122.4 Treatment of investment exposures in real estate subsidiaries of IIFS ......... 122.5 Concentration limits of real estate investment.................................................. 122.6 The risk weighting of real estate investment exposures.................................. 132.7 Treatment of unrestricted investment accounts in a commingled fund for real

estate investment ................................................................................................. 142.8 Valuation of real estate investment .................................................................... 14

DEFINITIONS ................................................................................................................................ 15


6/21

iv

ACRONYMS

ABS Asset-backed securityBasel II International Convergence of Capital Measurement and Capital

Standards: A Revised Framework, Updated November 2005

ECAI External credit assessment institutionIAH Investment account holders

IFSB Islamic Financial Services BoardIFSB-1 IFSB Capital Adequacy StandardIIFS Institutions offering Islamic financial services

IMB Ijrah Muntahia Bittamleek

SPE Special purpose entity

UIAH Unrestricted investment account holders


7/21

1

BismillahirrahmanirrahimAllahumma salli wasallim ala Sayyidina Muhammad waalalihi wasahbihi

INTRODUCTION

1. In December 2005, the Islamic Financial Services Board (IFSB) issued its CapitalAdequacy Standard for institutions offering only Islamic financial services (IIFS) hereinafter IFSB-1.Subsequently, and in the light of industry developments, the IFSB received inputs from the industryregarding issues of capital adequacy not addressed by the Standard IFSB-1, namely those relatingto types of Sukknot covered by IFSB-1, to Sukkorigination and issuance, and to investment inreal estate. The IFSB decided to develop a single supplementary Standard providing guidance onthese issues.

2. In the case of Sukk, this Standard deals with aspects of regulatory capital requirementsfor IIFS in respect of Sukkthat are not covered in the IFSB-1. These aspects are the following:

(a) Capital requirements for IIFS that are holdersof Sukkthat do not meet the criteriaset out in paragraph 193 of IFSB-1 that is, they do not represent the holdersproportional ownership in an undivided part of an underlying asset (or pool ofassets) where the holder assumes all rights and obligationsattaching to such anasset or pool of assets, so that the requirements of section C.7 of IFSB-1 do notapply.

(b) The capital treatment of the exposures of an IIFS where it is, or acts in a capacitysuch that it is considered to be, the originatorof a Sukk issue, or as an issuer orservicer of a Sukkissuance i.e. securitisation exposures. Essentially, this part ofthe Standard deals with the conditions that need to be met in order forsecuritisation exposures to be derecognised or minimised, and with the capitaltreatment of such exposures by IIFS when they occur.

3. This Standard applies to both originating and issuing IIFS (including originating IIFS that

invest in their own originated Sukk securitisation). For Sukk that are traded in the secondarymarket, the market risk capital requirement as mentioned in IFSB-1 is applicable.

4. For real estate investment, this Standard deals primarily with the following issues:

(a) capital requirements for an IIFS that invests its own funds in real estate investmentactivities; and

(b) the capital treatment of exposures in real estate investment activities where an IIFSeither commingles the funds of investment account holders (IAH) with those ofshareholders (and other non-profit-sharing investment account holders) orotherwise invests the funds of unrestricted investment account holders (UIAH).

5. The Standard also points out the need for the authorities supervising IIFS to set forththreshold limits for IIFS having real estate investment activities and financing activities involving realestate exposures.

6. The Standard adapts the practices of various institutions in terms of prudential regulationsand capital adequacy requirements regarding real estate exposures in both investment andfinancing activities that are set out by various countries, including IFSB member countries and theBasel Committee for Banking Supervision. It should be noted that conventional institutions have nodirect exposures to real estate assets as part of their financing activities.


8/21

2

1. SukkSecuritisation

1.1 Definition

7. Sukk(plural of Sakk), frequently referred to as Islamic bonds, are certificates with eachSakkrepresenting a proportional undivided ownership right in tangible assets, or a pool of assets,or in the assets of a specific project or investment activity. Sukkdiffer from conventional interest-based securities or bonds in a number of ways, including:

(a) The funds raised through the issuance of Sukkshould be applied to investment inspecified assets rather than for general unspecified purposes. This implies thatidentifiable assets should provide the basis for Islamic bonds (see paragraphs 23to 25).

(b) Since the Sukkare based on the real underlying assets, income from the Sukkmust be related to the purpose for which the funding is used.

(c) The Sukkcertificate represents a proportionate ownership right over the assets inwhich the funds are being invested. The ownership rights are transferred, for a

fixed period ending with the maturity date of the Sukk, from the original owner (theoriginator) to the Sukkholders.

8. Sukk securitisation is broadly referred to as a process of issuing Sukk involving thefollowing steps:

(a) origination of assets (in conventional finance, these are normally loans or otherreceivables, while in Islamic finance they are Sharah-compliant assets such asthe subject matter of Ijrah);

(b) transfer of the assets to a special purpose entity (SPE) which acts as the issuer bypackaging them into securities (Sukk); and

(c) issuing the securities to investors.

1.2 Sukkstructures

9. While it may initially appear that Sukk structures that are not based on partnership

interests (Mushrakah or Murabah) have real assets at their core, a detailed analysis of thecommercial terms and legal structure shows that, in fact, any one of the three following situationsmay exist:

(a) An asset-backed structure that meets the requirements for being an asset-backedstructure as assessed by a recognised external credit assessment institution (ECAI): thisstructure would leave the holders of Sukkto bear any losses in case of the impairment of

the assets. The applicable credit risk is that of the underlying exposures, and this will bereflected in any credit rating issued by a recognised ECAI. (This is the category explicitlycovered by IFSB-1.)

(b) A Sukk structure with a repurchase undertaking (binding promise) by theoriginator: the issuer purchases the assets, leases them on behalf of the investors andissues the Sukk. Normally the assets are leased back to the originator in a sale-and-leaseback type of transaction. The applicable credit risk is that of the originator, subject toany Sharah-compliant credit enhancement by the issuer. Such structures are sometimes


9/21

3

referred to as pay-through structures, since the income from the assets is paid to theinvestors through the issuer.

(c) A so-called pass-through Sukkstructure: a separate issuing entity purchases theunderlying assets from the originator, packages them into a pool and acts as the issuer ofthe Sukk. This issuing entity requires the originator to give the holders recourse, butprovides Sharah-compliant credit enhancement by guaranteeing repayment in case ofdefault by the originator.

Of the above three categories, this Standard focuses on the last two, which are not explicitlycovered in IFSB-1.

1

10. In conventional securitisations, the structure is normally such that the originator transfersthe beneficial rights in or title to the assets to the issuer on behalf of the investors, who do not holdsuch rights directly but have beneficial ownership through their legal relationship to the issuer. Theissuer is a SPE, which should be bankruptcy remote from the originator in order to protect therights of the investors in case of the insolvency of the originator.

11. In many jurisdictions, however, including some in which Sukk issues may take place,there may be legal obstacles to setting up an appropriate type of SPE which can meet the

conditions for the fiduciary responsibilities mentioned above. In such legal environments it may notbe possible to transfer beneficial title in the assets to the investors, or to ensure that the investorsare able to exercise these rights (for example, to repossess Ijrah assets) in case of default. Insuch cases, it is not feasible to create a structure for issuing non-recourse asset-backed securities(ABS).

2

1.2.1 Collateral security structure

12. Consideration of the collateral security structure is a critical factor; it needs to be thesubject of legal opinions and is subject to Sharahpermissibility (in the case of perfectibility). Thosesecurity interests must be first priority (there can be no prior or subsequent claims) and perfected(or perfectible).

13. The legal opinions must address the nature of the security interest, the enforceability of thesecurity interest against third parties, and perfection requirements (such as notices, registration andrecordation). The effects of bankruptcy on perfection must also be considered and opined upon.Issues arising include:

(a) Rahn (mortgage or other pledge of assets) concepts in certain jurisdictions arepossessory in nature. This makes perfection a particularly difficult opinion issue inthese jurisdictions.

(b) In many jurisdictions, and without regard to Rahnconcepts, perfection and priorityregimes are not well developed.

(c) Bankruptcy laws and regimes may also not be well developed in some jurisdictions.

1.2.2 Sukkstructure with a repurchase undertaking (binding promise)

14. In this structure, the originator enters into a repurchase undertaking (binding promise to buythe assets), according to which the assets are repurchased by the originator at maturity or uponearly termination. Such structures are often used in the case of Ijrah(sale and leaseback) Sukk

1IFSB-1 deals in detail with risk weights on Sukk exposures when the Sukk are ABS involving full transfer of legal

ownership of the underlying assets.2

In this case, if the law permits, IIFS may retain the ownership title of the assets.


10/21

4

issues. Where a repurchase undertaking exists, investors have a credit exposure to the corporateor sovereign entity providing the undertaking, and an analysis of the exposure of the underlyingassets becomes secondary. This gives rise to the risks of (a) the enforceability or strength of therepurchase undertaking in the jurisdiction, and (b) the ranking or priority of the Sukkin the capitalstructure of the originator. The term pay through is used for this type of structure when the incomefrom the securitised assets is paid to the issuer, who passes it on to the investors (less anycommission due to the issuer).

15. A commonly used Sukkstructure with a repurchase undertaking is the sovereign Sukkissued by certain national monetary authorities. Both Ijrah-based (tradable) and Salam-based(non-tradable) Sukkhave been issued using such a structure, with a repurchase undertaking fromthe national monetary authority. In such a structure, the credit risk of the Sukk is that of theoriginator. When the latter is a highly rated sovereign, the Sukkbenefit from an investment-gradecredit rating; however, achieving such a rating may be problematic for a private-sector originator.

16. A Mushrakahstructure may be used that aims at replicating asset ownership by setting upa venture (Mushrakah) jointly owned by the Sukk issuer (usually incorporated as a SPE) andthe originator. The issuer and originators shareholdings in the Mushrakah represent theirrespective capital contributions based on a parity agreed at the outset, usually comprised of: (a)capital from the issuer (e.g. investors Sukkproceeds); and (b) specific assets and management

skills from the originator. Should the cash flows generated by the assets under the business planof the Mushrakahnot be sufficient to fund these payments, subject to Sharahpermissibility, theissuer may have the option to call the repurchase undertaking.

1.2.3 Pass-through structure with no repurchase undertaking

17. This is a structure involving asset-based Sukkwhere a separate entity may act as sponsorand issuer, by purchasing the underlying assets from the originator (i.e. a financial institution),packaging them into a pool and securitising the pool by issuing the Sukk. This sponsoring entityrequires the originator to give the holders recourse, but provides Sharah-compliant creditenhancement by guaranteeing repayment in case of default by the originator. This creditenhancement provides the Sukk issuance with the credit rating of the (highly rated) issuer andthus enables it to achieve an investment-grade credit rating.

1.3 Parties in a securitisation structure

18. The parties in a securitisation structure include the originator, the issuer and the investors,in addition to which the following may be involved: one or more credit rating agencies to rate thesecurities (Sukk), an investment banker to act as an adviser or to place the securities withinvestors, and (in conventional securitisations) an institution that acts as a provider of creditenhancement.

3

19. An IIFS may act as originatorof Sukkissues in any of the following cases:

(a) The ownership of assets held by the IIFS is transferred to holders of Sukk bymeans of a securitisation. Such a securitisation may offer the IIFS one or more of

the following benefits:

(i) increased liquidity, since a relatively illiquid asset (such as an asset held aslessor in an Ijrah or Ijrah Muntahia Bittamleek (IMB)) is converted intocash paid by the investors in the Sukk; and

3A credit enhancement in a securitisation is a contractual arrangement whereby an IIFS retains or assumes some part of a

securitisation exposure and thereby provides some degree of added protection to the other parties. Particular care must betaken to ensure that any credit enhancement is Sharahcompliant.


11/21

5

(ii) reduced capital requirements, insofar as the securitisation may permit theIIFS to exclude the assets from the calculation of its risk-weighted assetssince they are derecognised.

The achievement of the second of these benefits will depend on the way in whichthe securitisation is structured. For this, the IIFS must be able to derecognise all ormost of the exposures relating to the assets from its balance sheet, according tothe criteria for derecognition set out in paragraphs 27 to 29.

(b) An IIFS may act as sponsor of an asset-backed Sukk issuance or similarprogramme involving assets of a customer in which the IIFS manages or acts asadviser to the programme, places the Sukk into the market, or provides liquidityand/or credit enhancements. In this case, the benefit to the IIFS would be theearning of fees from the services provided.

20. In a securitisation structure, the role of servicer consists of collecting payments on behalf ofthe investors and passing them onto the latter, when this function is not carried out by the issuer. Inthe case of Ijrahor Ijrah Muntahia Bittamleek (IMB) assets, the lessor is legally responsible formaintaining the assets in such condition that the lessee is not deprived of the full usufruct of the

assets, which involves responsibility for basic maintenance, insurance, and so forth. This function isperformed on behalf of the Sukkholders by the servicer, but the originator may act as servicer.

1.4 IIFS exposure to risks from various perspectives

21. As described earlier, an IIFS may act in various capacities in a Sukk securitisation. Itsexposure to risks may be similar to that of the conventional securitisation; however, Sharahrulesand principles may add an extra dimension to the existing risk exposures and may have a materialeffect on the risk profile of Sukkholders.

22. These considerations are summarised in Table 1.

Table 1: Risk Exposures from the Various PerspectivesOriginator Servicer Issuer SPE Holder

Risks related torepurchaseundertaking(binding promise)

The originator isobligated to makepayments inrespect of theSukkor theassets in certaincircumstancesresulting from abreach of certain

representationsand warranties.The originator mayneed tocompensate theissuer in theequivalent amountor replace the

Service defaultWhere theunderlying assetsare consumerlinked, there is stilla dependence onthe originatordespite the factthat they havebeen sold to theSukkSPE. Theoriginator usuallymaintains thebusiness

relationship withthe underlyingconsumers andcontinues to collectpayments onbehalf of the Sukkholders.

DefaultIf the obligor failsto pay the couponpayments, theSukkholders (orthe SPE on theirbehalf) can declarean event of defaultand accelerate theprincipal paymentobligation of theobligor bycompelling theobligor to

repurchase theasset.

If the obligor failsto pay the principalamount equal tothe Sukkissueamount at the

BankruptcySPE is generallyincorporated as abankruptcy remotevehicle to mitigatebankruptcy risk.

SettlementTo avoid anysettlement risk inrelation to the SPE,all payments duefrom the obligor willbe paid by the

obligor directly tothe clearinghouse,if any, which willthen settle thepayments directlyto the Sukkholders.

LiquidityThe Sukkholderwill be subject toliquidity riskassociated with themarket, whether inthe primary orsecondary market.

Rate of returnIf the underlyingrentals are fixed,then IIFS holdingthe Sukkwill be

exposed to rate ofreturn risk sincetheir IAH areexpecting returnsreflecting a floatingrate benchmark.

The issuer may


12/21

6

Originator Servicer Issuer SPE Holder

relevant assets. In this capacity, theoriginator isreferred to as aservicer anddespite satisfactionof all the regular

securitisationconditions, adefault of aservicer would stillhave an adverseeffect on the Sukkperformance.

maturity of thelease term, theSukkholders (orthe SPE on theirbehalf) will have aright to take legal

action against theobligor. The Sukkholders (or theSPE on theirbehalf) may alsohave the right tosell or foreclose onthe underlyingassets.

exercise a clean-up call,

4and the

holders of theSukkbeingcancelled may notmake the return

they are expecting.

1.5 Operational requirements pertaining to Sukkand securitisation

1.5.1 The assets in Suk

ksecuritisations

23. The assets in the Sukksecuritisation have to be in compliance with the Sharahrules andprinciples. Islamic finance typically relates finance to assets, and the concept of payments ofincome and principal being derived from Sharah-compliant assets is prevalent in Islamicstructured transactions.

24. For an IIFS, the underlying assets to be securitised may include Ijrah leased assets,

Murbahahor Salamreceivables, Istisn`assets or equity ownership (Mushrakahor Murabah)according to Sharahrules and principles. The Sukkcan also have a portfolio of underlying assetscomprising different categories. Use of such a portfolio allows for a greater mobilisation of funds, asMurbahah or Salam assets that do not meet Sharah criteria for tradability (being classed asreceivables) can be combined in a portfolio with Ijrahassets which are classed as non-financial.

25. Thus, while Sukkbased on financial assets are not tradable, the latter may be combinedin a pool with non-financial assets that can act as a basis for tradable Sukk, provided theproportion of non-financial assets (neither debt nor cash) in the pool is not less than a certainacceptable minimum ratio, in accordance with Sharahrules and principles.

26. Business ventures organised as Mushrakah or Murabah partnerships may also besecuritised, and the resultant Sukk are tradable. Where such Sukk are held by an IIFS untilmaturity and are unrated, the provisions of IFSB-1 for equity position risk in the banking book areapplicable.

1.5.2 Recognition of risk transference (asset derecognition criteria)

27. An originating IIFS may exclude securitised exposures from the calculation of its risk-

weighted assets only if all of the following conditions have been met. IIFS meeting these conditionsmust still hold regulatory capital against any exposures that they retain in respect of thesecuritisation (such as credit enhancements). It should be noted that for the reason given in (c)below, assets securitised in non-ABS securitisations would not qualify for derecognition.

4A clean-up call is a call option that permits asset-backed Sukkto be called before all of the capital payments due to the

holders have been made. For example, this would apply when the underlying assets are IMB assets, the lease paymentsmade by the lessee contain a purchase or capital element, and a number of lease payments remain to be made. It wouldgenerally be accomplished by the originator repurchasing the Sukkonce the number of lease payments remaining to bemade had fallen below some specified level.


13/21

7

(a) Substantially all credit risks (and price risk, where applicable) associated with thesecuritised assets have been transferred to third parties. (Please refer toparagraphs 28 to 31 on Sharahrequirements pertaining to the transfers.)

(b) The transferor (i.e. originator) does not maintain effective or indirect control overthe transferred assets. The assets are legally isolated from the transferor in such away that the exposures are put beyond the reach of the transferor and its creditors,even in bankruptcy or receivership. These conditions must be supported by anopinion provided by qualified legal counsel. The securitised assets held by theissuer will not be consolidated with the assets of the originator or the issuersparent in a bankruptcy or insolvency of any of those entities.

(c) Holders of the Sukk(investors) have a claim only to the underlying pool of assets,and have no claim against the transferor. Hence, assets in non-ABS structures(pay-through and pass-through structures, as described in subsection 1.2 above),would not qualify for derecognition.

(d) The immediate transferee is a SPE, and the holders of the beneficial interests in

that entity have the right to pledge or exchange such interests without restriction.

(e) Clean-up calls must be at the discretion of the originating IIFS. They must not bestructured to provide credit enhancement and must be exercisable only when 10%or less of the purchase consideration for the underlying assets (e.g. in an IMB)remains to be paid. If a clean-up call does not meet these conditions, it will betreated as a credit enhancement by the originator and give rise to a capital chargeaccordingly.

28. In order to comply with Sharah rules and principles, the structure must transfer allownership rights in the assets from the originator via the issuer to the investors. Depending on theapplicable legal system, these ownership rights do not necessarily include registered title. Thetransfer could be a simple collection of ownership attributes that allow the investor (a) to step intothe shoes of the originator and (b) to perform (perhaps via a servicer) duties related to ownership.The transfer could also include rights granting access to the assets, subject to notice, and, in caseof default, rights of collateral over the assets.

29. The transfer raises questions of whether one transfers (a) the control of assets, and (b) allof the risks and rewards of ownership of the assets. For the purpose of tax, accounting and/orregulation, the derecognition of the assets from the originators balance sheet relies on a truesale.

5True sale means that one has transferred the economic value of assets from one party to

another in a way that prevents the creditors or liquidator of the seller to claim the assets from thebuyer: thus, creating bankruptcy remoteness for the assets.

30. From the Sharahperspective, there are four key criteria for a transaction to be consideredas a true sale that transfers beneficial title:

(a) The transfer must be such that it cannot be recharacterised by a court or otherbody as a secured loan, or otherwise be avoided in a bankruptcy or insolvencyproceeding involving the originator of the assets (such as pursuant to a fraudulenttransfer in anticipation of bankruptcy or a preference payment).

(b) The bankruptcy or insolvency of the originator should not affect the assets thathave been transferred to the issuer SPE. This, in turn, means that the issuer will be

5A true sale at law is necessary in order to remove the assets from those of the originator in the event of insolvency of the

originator. This is necessary to isolate the risk of the transferred assets from the credit risk of the originator of those assets.


14/21

8

able to enforce collection and other rights against the source of the income (thepayer) without hindrances resulting from the bankruptcy or insolvency of theoriginator.

(c) The transfer must then be perfectible at the election of the issuer.6

(d) The sale must be free and clear of all prior overriding liens.

31. In the case of bankruptcy remoteness, the conditions that must be met are as follows:

(a) If there were a bankruptcy of the issuer, the assets of the issuer would bedistributed in accordance with law or a court order, rather than in accordance withthe contractual arrangements involving the issuer.

(b) Separateness covenants will be required to ensure bankruptcy remoteness (as wellas non-consolidation).

(c) Another provision to ensure bankruptcy remoteness relates to non-competition andbankruptcy declarations. The originator, investors, credit enhancers and othersagree in the transaction documents not to initiate involuntary bankruptcy

proceedings against the issuer. The issuer also provides, in both its constitutivedocuments and the transaction documents, not to initiate voluntary bankruptcyproceedings.

1.6 Treatment for regulatory capital purposes of Sukkand securitisation exposures

32. In conventional securitisations, it is common to have a structure in which the cash flowsfrom an underlying pool of assets are used to service at least two different stratified risk positions ortranchesreflecting different degrees of credit risk. Junior securitisation tranches can absorb losseswithout interrupting contractual payments to more senior tranches. A key objective of suchstructures is credit enhancement for the senior tranche, such that it achieves at least aninvestment-grade credit rating.

7

33. This Standard is concerned with the capital treatment of exposures of an IIFS where theIIFS is the originator (or sponsor, issuer or servicer) of a Sukk issuance involving oneclass ofSukk the income of which is derived from the income of underlying assets. In general, the riskweights as set out in paragraph 21 to 27 of IFSB-1 are applicable to IIFS. One key issue for IIFS isthe extent to which the exposures or obligations attaching to the underlying assets have beeneffectively transferred to the Sukkholders. A related issue is whether any types of risk other thancredit risk need to be considered, such as price risk in the context of a securitisation where theunderlying asset is a Salamor Istisn`asset.

34. When referring to securitisations, it is customary to use the term exposures when referringeither to (the credit risk of) assets involved in the securitisation, or to other exposures such as thoseresulting from credit enhancements or from acting as sponsor, issuer or servicer. In Islamic finance,

6 Sharah scholars differ on the permissibility of separation of legal and equitable title to assets, and these raiseimpediments to effectuation of securitisations in certain unperfected transfer structures. If separation of legal and equitabletitle is not permissible, legal title would have to be transferred in a manner that satisfies all of the applicable perfectionrequirements (including notification of the payer).7

Conventional securitisations are categorised as either traditionalor synthetic. In a traditional securitisation, payments to theinvestors depend on the performance of the specified underlying exposures, as opposed to being derived from an obligationof the entity originating those exposures. In a synthetic securitisation, the credit risk of an underlying pool of exposures istransferred, in whole or in part, through the use of credit derivatives or guarantees that serve to hedge the credit risk of theexposures by transferring significant credit risk to investors as holders of the securities.


15/21

9

in addition to credit risk there may be other exposures attaching to certain asset categories, asnoted above.

35. While it is clear that the tradability of Sukk is often a key issue, and is of fundamentalimportance if an IIFS is acting as a sponsor of an asset-backed securitisation programme involvingassets of a customer, this section of the Standard does not deal with the issue of whether theSukksatisfy the Sharahcriteria for being tradable, as this is unrelated to the capital treatment ofthe underlying exposures by the originator.

1.6.1 Risk weight of IIFS as originators, sponsors, issuers or servicers

36. IIFS as originators are required to hold regulatory capital against all of their retainedsecuritisation exposures, including those arising from the provision of credit risk mitigants to asecuritisation transaction, investments in ABS originated by them, and extension of a liquidityfacility or credit enhancement. Repurchased securitisation exposures must be treated as retainedsecuritisation exposures.

37. The risk-weighted asset amount of a securitisation exposure is computed by multiplying theamount of the exposure by the appropriate risk weight. For off-balance sheet exposures, IIFS mustapply a credit conversion factor and then risk weight the resultant credit equivalent amount. Please

refer to paragraph 25 to 27 of IFSB-1.

38. When an IIFS is required to deduct a securitisation exposure from its capital, the deductionmust be taken 50% from Tier 1 and 50% from Tier 2. Deductions from capital may be calculated netof any specific provisions taken against the relevant securitisation exposures.

39. When an originator provides implicit support to a securitisation, it must, at a minimum, holdcapital against all of the exposures associated with the securitisation transaction as if they had notbeen securitised. This refers to a situation where an IIFS is meeting the implicit guarantee out of itsown funds. Without IAH consent, this could constitute misconduct and negligence, which could giverise to other issues. This would also be true of any other implicit support that is not Sharahcompliant. In this context, the IIFS is required to disclose publicly (a) that it has provided non-contractual support and (b) the capital impact of doing so.

8

40. The credit rating of Sukk must be from an eligible ECAI as recognised by the IIFSssupervisory authority, and must take into account the entire amount of the credit exposure that theIIFS has with regard to all payments owed to it. Where Sharahrequirements can materially affectthe credit risk, these will be considered. Where an IIFS holds Sukkof which it is the originator, itmay not apply a risk weight to such Sukkthat is lower than its own risk weight, even if the Sukkhave an ECAI rating that maps into a lower risk weight. If for any reason a Sukk issuance has aless favourable ECAI rating than that of its originator, the latter must apply to the Sukkexposure arisk weight that reflects the less favourable ECAI rating.

41. For a Sukk issuance that is likely to be exclusively supported by that of the originatorthrough a repurchase undertaking, the credit risk weight of the originator will be applied, subject toany Sharah-compliant credit enhancement by the issuer. The capital treatment of securitisation

exposures is that of the originator.

42. In the case of Sukk rated below BB- held by the originator, in line with the Basel IIFramework on International Convergence of Capital Measurement and Capital Standards: ARevised Framework (Basel II) framework, this Standard requires originators to deduct any holdingof Sukkthat they have themselves originated from their capital.

9

8The provision of any such implicit support would be matter for supervisory concern and possible action to restrain such

behaviour.9

Basel II, paragraph 574 states some exceptions to the above requirement that would not apply to an Islamic securitisation.


16/21

10

1.6.2 Treatment of liquidity facilities

43. The liquidity facilities in certain types of Sukkstructures are commitments from the facilityprovider to lend to or purchase assets from third parties if funds are needed to repay maturingSukk. The need for such facilities may result from a timing mismatch between cash collections ofthe underlying Sukk assets and the scheduled payments (such as Ijrah rental) under theprogramme to its holders. In this context, it is deemed the liquidity facilities comply with theSharah rules and principles and meet operational requirements for the eligibility of a Sukkliquidity facility set out by the national supervisory authority. The proposed risk weight for facilitieshaving a maturity of less than one year is set at 20%, while that for facilities with maturitiesexceeding one year is set at 50%.

44. The national supervisory authority has discretion to assign a risk weight of 0% to servicer

cash advance facilities. A servicer cash advance, based on Qar (interest free), is an advancegranted by the servicer to the SPE to ensure timely payment to the investors for instance, in casesof timing differences between collection and payments. However, it is a Sharah requirement thatsuch facilities remain essentially separate from the Sukkundertaking.

1.7 Treatment of credit risk mitigation for securitisation exposures

45. The treatment below applies to an IIFS that has provided a credit risk mitigant to asecuritisation exposure. Credit risk mitigants include guarantees, collateral and on-balance sheetnetting. Collateral refers to that used to mitigate the credit risk of a securitisation exposure, ratherthan the underlying exposures of the securitisation transaction, subject to fulfilling criteria inparagraphs 12 to 13 above.

46. Eligible collateral is limited to that recognised under the standardised approach for CreditRisk Mitigation (IFSB-1, paragraph 36). Collateral pledged by SPEs may be recognised.

1.8 Treatment of credit enhancement provided by an originator

47. For Sukkwith credit enhancement provided by the issuer or the originator, the risk weight

is based on the credit rating of the credit enhancer.

48. Subject to Sharahapproval of the structure, an originator may retain a small equity sharein a pool of securitised assets in order to provide over-collateralisation. For example, the originatorof a securitisation of a pool of Ijrahlease assets might securitise 90% of the pool and retain 10%as an equity position (first loss position),

10 that is, a residual claim. The Sukkholders would be

entitled to income based on 90%, and the originator based on the remaining 10%, of the rentalincome from the pool. However, if the rental income falls below the expected level,

11the shortfall

would be made good to the extent of the originators first loss position based on hibahagreement.Assuming that the originator derecognised the percentage of the asset that was securitised, thecapital treatment of the originators residual equity share would be either a deduction from its capitalor a risk weighting of 1250%.

10The term first loss position does not imply in this context that the originator would make good an actual loss suffered by

the investors, which would not be Sharahcompliant. Rather, if the income from the assets fell below a specified level, theholder of the first loss position would waive its right to some or its entire percentage share (e.g. 10%) of the income infavour of the investors.11

The expected level of rentals would be calculated taking account of the expected level of non-payment, void periods, etc.


17/21

11

2. Real Estate Investment

2.1 Current regulatory environment of real estate investment

49. The IFSB has observed that regulatory and/or supervisory authorities in a number ofjurisdictions permit IIFS to invest in real estate directly on their balance sheets, or as part of off-balance sheet asset management activities, or indirectly through a wholly or majority-ownedsubsidiary. Real estate lends itself as a permissible asset class, as the Sharah rules andprinciples allow investment. However, there is a general concern that such investments mayexpose the IIFS to the effects of cyclical real estate markets.

50. Conventional institutions in general cannot engage in real estate investments unless theyobtain consent from the regulatory authority. These institutions are required to comply withapplicable capital standards, and the authority determines that the activity poses no significant riskto the depositors. They also need to have an adequate risk management process in place, and theoverall financial conditions (including capital requirements) should be able to withstand potentialrisk associated with the holding of investment property. In most instances, the authorities requireconventional institutions to establish a subsidiary to conduct the real estate investment activities, soas to place these activities in a separate corporate entity.

51. In the case of the IIFS, the IFSB has conducted its own survey, which indicated thatsupervisory authorities in some jurisdictions do not place any restrictions on the types of real estateinvestment activities in which they engage. In some cases, these activities are treated as financingand not investment. The regulatory authorities treat them as a type of mortgage, and they requirethem to be treated with the same regulatory credit risk treatment. Some IIFS act as propertydevelopers and/or then owners, which is normally undertaken by real estate specialists. Suchinvestments raise supervisory issues, particularly with respect to risk management and capitaladequacy.

12In certain jurisdictions, the supervisory authorities provide more detailed guidance on

the definition and classification of permitted activities.

2.2 Definition

52. Real estate covers residential housing, commercial offices, trading spaces, hotels andrestaurants, retail outlets, and industrial and government buildings. Real estate activity involves thepurchase, sale and development of land, and residential and non-residential buildings. Theactivities of the real estate sector encompass the completed properties and construction sectors.

53. Investment in real estate refers to the IIFS investing its own and/or customers funds in realestate assets (or in partnerships in real estate) for commercial purposes to achieve profits fromproperty development, or to benefit from asset price appreciation. However, the investment doesnot include assets held by a lessor under an Ijrah or IMB contract that is, Islamic financing.Therefore, the key criterion in distinguishing between real estate investment and financing is theexistence of a regular cash flow due or receivable from a customer in respect of the asset. Theexistence of such a cash flow signifies that the IIFS is providing financing to the customer for theasset, while the absence of such a cash flow indicates that the IIFS has invested in the asset on its

own account (or in its own and its unrestricted IAH accounts).

54. In the context of this document, the investment is classified in three broad categories:

(a) The activity of holding real estate at any stage of the development process, or evencompleted properties, where such holding is not part of a financing transaction for athird party (e.g. MurbahahPurchase Orderer, IMB or Istisn`).

12IFSB Guidance on Key Elements in the Supervisory Review Process for IIFS, December 2007, paragraph 63.


18/21

12

(b) If there is no binding promise from a third party to acquire (by Murbahah) or tolease the asset, holding would also be treated as investment (not financing) if theholding period exceeds a relatively short period such as six months (at supervisorydiscretion) and based on evidence of management intention.

(c) In the case of operating Ijrah, where a property that has previously been leasedremains without a new lessee for a period that exceeds a relatively short periodsuch as six months (at supervisory discretion), the property must be reclassified asan investment.

55. In considering the source of funding for real estate investment, this document focuses onthe issues raised by funding from the unrestricted investment accounts (where permitted), but notrestricted investment account funds. This focus takes into account the degree of sophistication ofthe investors regarding the risk exposures of their funds.

2.3 Risk exposures in real estate investment

56. Investments in real estate that is, holding the assets at any stage of the developmentprocess, or even completed properties, can be generally characterised as risky in that there is ahigh degree of variability or uncertainty of returns on invested funds, as well as a risk of a significant

loss of capital. The risk is likely to be higher for properties under development compared tocompleted ones.

57. In the case of a non-binding promise to purchase an asset in Murbahah, or to lease anasset under a contract of IMB, the circumstance that gives rise to the risks is the possibility of losson disposal of such an asset, or from having a property vacant over a certain period, or from asignificant drop in prices during the holding period.

58. The real estate investment exposes the unrestricted investment account holders to thesame risks as those borne by the IIFS when the funds are commingled. The UIAH trust the IIFS toattain the target of maximised, safe and sustainable returns to them, and they generally have asmall risk appetite. Moreover, they have no representation on the IIFSs board of directors or otherrepresentation in the management of their funds.

59. Owing to the risks outlined above, real estate investment activities are suitable for an IIFSonly on a very limited scale and under restrictive conditions designed to control the various risksposed to the IIFS and its UIAH.

2.4 Treatment of investment exposures in real estate subsidiaries of IIFS

60. As mentioned earlier, conventional institutions are not permitted, in most jurisdictions, toinvest commercially and directly in real estate. They may have subsidiaries that carry out suchcommercial activities, subject to restrictions. From a capital adequacy perspective, investment insuch subsidiaries should be treated the same as investment in commercial entities that is, bydeduction from capital if the IIFSs shareholding interest is greater than 15% of its capital base.

2.5 Concentration limits of real estate investment

61. In jurisdictions where real estate investment is permissible, some supervisory authoritiesadopt a combined approach in limiting the risks to which the IIFS or its IAH are exposed throughrestricting the total amount of exposures in the sector, restricting the usage of unrestrictedinvestment accounts or applying specific risk weights for this investment.

13

13For conventional institutions, the normal treatment is for a banks investment as a parent in a real estate subsidiary or

affiliate to be deducted from its capital (equivalent to a 1250% risk weight). IIFS in some countries currently follow a similardeduction approach, but other countries surveyed apply risk weights of 100% or less (i.e. treatment as credit risk) or risk


19/21

13

62. Primarily, the supervisory authority needs to satisfy itself that the IIFS meets prudentialrequirements that allow the IIFS to engage in real estate investment activities on its own balancesheet or indirectly through a wholly or majority-owned subsidiary. The authority may, among otherthings, set the type of activity, level of real estate investment suitable for the IIFS and theconcentration level of risks. It may also set the financial conditions and managerial resources of theIIFS in order to ensure the IIFSs ability to support real estate investment activities, determine thatthe IIFS is adequately protected from litigation risk, and set robust risk management, stress testingand valuation processes, and appropriate practices with regard to the IIFS commingling its fundswith those of the UIAH.

63. In this context, it is recommended that the supervisory authority include, inter alia, thefollowing restrictions or prudential limits:

(a) Limitation of total real estate exposures (financing plus investment) to 60% of itscapital base, with a 15% limit on individual real estate investment exposures. If theIIFS exceed the aggregate limit of 60%, the IIFS shall inform their supervisory authority and

submit a corrective action to restore the aggregate exposures within the limit.(b) Limitation on placing UIAH funds in real estate investment (not financing) to a

maximum of 15% of such funds.

64. Notwithstanding the above recommendation on prudential limits, since different jurisdictionsmay have different macroeconomic, socioeconomic and prudential objectives, the supervisoryauthority may at its discretion determine appropriate punitive capital requirements for over-concentration in real estate investment and financing.

2.6 The risk weighting of real estate investment exposures

65. IIFS are required to hold regulatory capital against all of their real estate investmentexposures. The risk weights being applied in Table 2 assume the exposures are in the balancesheet of the IIFS. When an IIFS is required to deduct a real estate investment exposure from itscapital base, the deduction must be taken 50% from Tier 1 and 50% from Tier 2. Deductions fromcapital may be calculated net of any specific provisions taken against the relevant real estateinvestment exposures.

66. The risk-weighted asset amount of a single real estate investment exposure is computed bymultiplying the amount of the carrying value

14by the appropriate risk weight. An alternative to

applying a 1250% risk weight is deduction of the carrying amount from capital.

weights of other assets. Basel II guidelines for other assets appear to refer to other financial assets (see paragraphs 27 to30 and 80 to 81).14

See section 2.8 of this document on valuation of real estate investment.


20/21

14

Table 2: Risk Weights

No. Item Restriction* RW Note

15% 187.5The exposure is considered as amarket risk exposure; thus a marketrisk capital charge is applied.

1 Single exposure on real estateinvestment

>15%1250 or

deduction

* As a percentage of capital.

67. In the case of restricted investment accounts, which are clearly for the purpose of realestate investment, there is no limit on the percentage of such funds that may be invested in realestate. For this reason, supervisors should apply a limit to single exposures at their discretion.

2.7 Treatment of unrestricted investment accounts in a commingled fund for real estateinvestment

68. In order to protect the interests of UIAH, when employing their funds, IIFS are expected to

limit the investment of such funds in real estate assets to a maximum of 15% of such funds. In somejurisdictions where an IIFS uses a substantial proportion of the funds of unrestricted investment accounts forthe purpose of real estate investment, supervisory authorities may provide a timeline for the respective IIFS tocomply with this restriction. If the IIFS exceed the maximum limit of 15%, the IIFS shall inform their supervisoryauthority and submit a corrective action plan to restore the exposure of such funds within the limit.

69. The above limit on investment of UIAH funds applies only to investment in real estate, andnot to real estate held in connection with financing for example, Ijrahor Murbahahwith bindingpromise.

2.8 Valuation of real estate investment

70. The measurement of risk exposures in real estate investment is dependent on sound and

proper valuations from third parties. The risks inherent in the real estate investment depend on anumber of factors, including the type of property and independent parties that will assess theseinvestments. Therefore, it is vital that the supervisory authorities have adequate valuation rules andproper valuation methodologies.

71. It is essential that the supervisory authority ensure that active IIFS within its jurisdictionvalue their property investment on a consistent basis. Otherwise, there can be no level playing fieldfor capital adequacy treatment. In the case of assets under MurbahahPurchase Orderer or Ijrahtransactions, the supervisory authority should satisfy itself on appropriate valuation to estimate theamount for which a property switches from investment to financing, or vice versa.


21/21

DEFINITIONS

The following definitions are intended to give a general understanding of the Arabic terms used inthis document. The list is by no means exhaustive.

Ijrah An Ijrahcontract refers to an agreement made by IIFS to lease to a customer

an asset specified by the customer for an agreed period against specifiedinstalments of lease rental. An Ijrah contract commences with a promise tolease that is binding on the part of the potential lessee prior to entering theIjrahcontract.

IjrahMuntahiaBittamleek

An Ijrah Muntahia Bittamleek(or Ijrah wa Iqtina) is a form of lease contractthat offers the lessee an option to own the asset at the end of the lease periodeither by purchase of the asset through a token consideration or payment ofthe market value, or by means of a gift of contract.

Istisn` An Istisn`contract refers to an agreement to sell to a customer a non-existentasset, which is to be manufactured or built according to the buyersspecifications and is to be delivered on a specified future date at apredetermined selling price.

Murabah A Murabah is a contract between the capital provider and a skilledentrepreneur, whereby the capital provider would contribute capital to an

enterprise or activity that is to be managed by the entrepreneur as the Murib(or labour provider). Profits generated by that enterprise or activity are shared

in accordance with the terms of the Murabahagreement, while losses are tobe borne solely by the capital provider unless the losses are due to the

Muribs misconduct, negligence or breach of contracted terms.

Murbahah A Murbahah contract refers to a sale contract whereby the IIFS sell to acustomer at an agreed profit margin plus cost (selling price), a specified kind ofasset that is already in their possession.

Mushrakah A Mushrakah is a contract between the IIFS and a customer to contribute

capital to an enterprise, whether existing or new, or to ownership of a realestate or moveable asset, either on a temporary or permanent basis. Profitsgenerated by that enterprise or real estate/asset are shared in accordance withthe terms of the Mushrakah agreement, while losses are shared in proportionto each partners share of capital.

Qar A non-interest bearing loan intended to allow the borrower to use the loanedfunds for a period with the understanding that the same amount of loanedfunds would be repaid at the end of the period.

Documents

Ed Sukuk EnglishVIP