The “Sukuk” Risks
Dr. Nimrod Raphaeli
February 8, 2008 Memri
Hat Tip-Margo I.
Sukuk [Islamic bonds] are distinct from traditional bonds by some risks that each issuer and investor must take into account. These sukuk should not be treated simply as debt instruments that do not differ from bonds and whose underlying assets as well as their contractual structures are kind like bridge for transferring funds from investors to the sukuk issuers. This perception leads to the inability to [properly] assess the sukuk and, as a result, these risks will not be covered by the appropriate means.
The risks that the sukuk encounter vary according to the structure of the sak (singular for sukuk); so the risks of “Sukuk al-Murabaha” (Fixed Return Notes) differ from those of “Sukuk al-Musharaka” (Partnership Sukuk); the risks of “Sukuk al-Istisna’” (project finance using a contract where a commodity is transacted before it is manufactured) differs from those of “Sukuk al-Ijara” (Variable Return Notes based on Leasing); the same is true for the risks of “Sukuk al-Murakaba” (Fixed Return Notes) combined of many contracts which they differ from those of “Sukuk al-Basita” (Regular Sukuk) formed from one contract. These risks also vary depending on the underlying assets of these sukuk, were they fixed or movable assets, utilities or services. They can be outlined as follows:

First: Violation of the Islamic Shari’a Provisions

Since the sukuk are financial tools based on the Islamic Shari’a provisions, the violations of these provisions would lead to damages that vary according to the type of violation and the degree of its seriousness. It ranges from voiding the sak in its entirety to the cancellation of certain conditions. For example, when the underlying components of the sak are “Deyoun Murabahat” (debts to be paid back through fixed return notes) and “Usul Mouajara” (leased-assets based on variable return notes) the percentage of the debt should not exceed 33% of (the assets) underlying the sak throughout the lifetime of the sak so that its circulation would be permitted. If the debts were higher than this percentage, then the sak may not be circulated and thus becomes a weak liquidity (tool), or the ownership of the assets of “Sukuk Al-Ijara” becomes artificial.

For example, many of the Islamic institutions transfer the ownership of some of their customers’ assets to a mortgage status and not for an actual sale. If these institutions bond these assets to a form of “Sukuk al-Ijara” or “Musharaka” or other kinds of available sukuk, these sukuk will become null and void because the institution had sold to the sukuk holders something that they do not own, which is among the prohibited sales in the Islamic shari’a. There are many ways of violating Islamic law, and each of the sukuk structures has its Islamic religious controls whose violations are considered among the risks for which the possibility of their occurrence, the ways to reduce them and the methods to address them must be studied.

Second: Operational Risks

Since the structures of the tradable Islamic sukuk must be based on assets and the return on these sukuk originates from these assets, then the operational risks of these assets must be carefully studied. For example, it is known that the return in the “Sukuk al-Ijara” is the revenue of the sak; so if the benefits to the leasing tenants as underlined in the “Sak al-Ijara” were late to materialize, the lessee must not pay for the lease and therefore the sak would have no revenue. Hence, the property-based “Sukuk al-Ijara” are less prone to the risks of revenue loss, due to the delay in getting their benefits compared to those sukuk that are based on vehicles, factories, aircrafts or ships. Furthermore, the potential risks arising from ownership of these assets will be carried out by the sukuk holders such as the environmental damages caused by factories or ships and other risks that are separately related to each asset.

Third: Legal Risks

Since many of the regulations and legislations in many countries are emplacement regulations [man-made], that cause many of their clauses to violate the provisions of Islamic shari’a, a conflict between these regulations and the provisions of Islamic shari’a might occur, and the application of the Islamic shari’a provisions will be ignored in litigations.

Conclusion

The importance of taking into account the difference between sukuk and traditional debt bonds is clear. This difference would result in risks that must be studied and measured in an accurate scientific method to be followed by efforts to cover these risks by appropriate means that are compatible with Islamic shari’a.

The author is an adviser in Islamic banking.

al-Sharq al-Awsat, London, February 5, 2008. The article originally appeared in Arabic, and excerpts from the article were translated by the staff of www.memrieconomicblog.org  

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