Risks underlying Sukuk
Risks adverse effect the competitiveness of an asset’s pricing. The novelty of Sukuks inherently entails a higher exposure to certain market and financial risks (Managing financial risks of Sukuk Structures by Ali Arsalan Tariq; 2004). Sukuk are exposed to different types of risks. The most important are the market risk, operations risk and Shari’ah compliance risk. And the challenge for Sukuk issuing entities becomes to devise an effective risk management strategy congruent to Shari’ah principles.
Market risk is the risk on instruments traded in well-defined markets (Modern Banking in Theory and Practice by Shelagh Heffernan, 2003); it includes a systematic risk that arises due to governmental and economic policy shifts and idiosyncratic risk that arises due to different firm specific instruments that may be priced out of correlation with other firms’ instruments. Market risk is mainly composed of interest rate risks and foreign exchange risks. As far as Sukuk are concerned, interest rate risks can be considered as rate of return risks. Maturity plays a very important role in intensifying the impact of this risk; the longer is the maturity, the higher is the risk for the investor. Sukuk based on fixed rates are exposed to this risk in the same manner as fixed rate bonds because the rise in market interest rates leads to the fall in the fixed-income Sukuk values. In fact, Sukuk certificates are exposed indirectly to interest rate fluctuations through the widespread benchmarking with LIBOR in their financing operations (Managing financial risks of Sukuk Structures by Ali Arsalan Tariq; 2004). Adverse changes in market rates will also unfavorably affect the credit worthiness of the issues and will lead to the increase in the credit risk of the issue. Moreover, Sukuk are exposed to foreign exchange rate risks as any unfavorable exchange rate fluctuations will undeniably have an effect on the assets in the Sukuk pool and in the currency of denomination in which the Sukuk funds are accumulated.
Furthermore, there are many other risks specific to the operation of the Sukuk, which are mainly inherent to the structure of the issuances. Default risk refers to credit risk that involves the probability that an asset or loan becomes irrecoverable due to a default or delay in settlements. Ijarah Salam and Istisna’a’ are particularly exposed to that risk. The credit and counterparty risks inherent in Islamic finance are unique owing to the nature of Islamic financial instruments that become the foundation of the Sukuk asset pools (Corporate Governance in Islamic Financial Institutions by Chapra Umer and Habib Ahmed; 2002). Salam contracts are exposed to the risk that commodities will not be supplied on time or to the agreed quantity and Istisna’a contracts involve performance risk. There is also a coupon payment risk linked to Sukuk, in case the obligor fails to pay the required coupons on time. The asset redemption risk may occur as the underlying assets may not be fully redeemed when the originator has to buy them back from the certificate holder. There are also specific risks related to the SPV, such as the notion of settlement risk involved with the SPV where the originator will have to reimburse the certificate holders through a clearinghouse. Besides, the Sukuk structures are exposed to a liquidity risk because there is currently no well structured and sufficiently liquid secondary market and most of the certificates tend to be held until maturity. The underlying assets of the Sukuk certificates are also subject to a risk of loss, which is an important risk in the case of equipment and large scale construction. Yet, there is a possibility to mitigate the risks of asset losses by using provisions for insurance claims in the form of Takaful.
Shari’ah compliance risk refers to the loss of asset value as a result of the issuers’ breach of its fiduciary responsibilities with respect to compliance with Shari’ah (Managing financial risks of Sukuk Structures by Ali Arsalan Tariq; 2004). Shari’ah jurists play an essential role in the formulation of the Sukuk prospectuses; the dissolution clauses of these prospectuses define events that will make the Sukuk deed null and void due to Shari’ah non-compliance. For example, in the case of incidence of a Wakeel, the guarantor and the agent have to be separate entities to negate any conflicts of interest and moral hazards.
Market risk is the risk on instruments traded in well-defined markets (Modern Banking in Theory and Practice by Shelagh Heffernan, 2003); it includes a systematic risk that arises due to governmental and economic policy shifts and idiosyncratic risk that arises due to different firm specific instruments that may be priced out of correlation with other firms’ instruments. Market risk is mainly composed of interest rate risks and foreign exchange risks. As far as Sukuk are concerned, interest rate risks can be considered as rate of return risks. Maturity plays a very important role in intensifying the impact of this risk; the longer is the maturity, the higher is the risk for the investor. Sukuk based on fixed rates are exposed to this risk in the same manner as fixed rate bonds because the rise in market interest rates leads to the fall in the fixed-income Sukuk values. In fact, Sukuk certificates are exposed indirectly to interest rate fluctuations through the widespread benchmarking with LIBOR in their financing operations (Managing financial risks of Sukuk Structures by Ali Arsalan Tariq; 2004). Adverse changes in market rates will also unfavorably affect the credit worthiness of the issues and will lead to the increase in the credit risk of the issue. Moreover, Sukuk are exposed to foreign exchange rate risks as any unfavorable exchange rate fluctuations will undeniably have an effect on the assets in the Sukuk pool and in the currency of denomination in which the Sukuk funds are accumulated.
Furthermore, there are many other risks specific to the operation of the Sukuk, which are mainly inherent to the structure of the issuances. Default risk refers to credit risk that involves the probability that an asset or loan becomes irrecoverable due to a default or delay in settlements. Ijarah Salam and Istisna’a’ are particularly exposed to that risk. The credit and counterparty risks inherent in Islamic finance are unique owing to the nature of Islamic financial instruments that become the foundation of the Sukuk asset pools (Corporate Governance in Islamic Financial Institutions by Chapra Umer and Habib Ahmed; 2002). Salam contracts are exposed to the risk that commodities will not be supplied on time or to the agreed quantity and Istisna’a contracts involve performance risk. There is also a coupon payment risk linked to Sukuk, in case the obligor fails to pay the required coupons on time. The asset redemption risk may occur as the underlying assets may not be fully redeemed when the originator has to buy them back from the certificate holder. There are also specific risks related to the SPV, such as the notion of settlement risk involved with the SPV where the originator will have to reimburse the certificate holders through a clearinghouse. Besides, the Sukuk structures are exposed to a liquidity risk because there is currently no well structured and sufficiently liquid secondary market and most of the certificates tend to be held until maturity. The underlying assets of the Sukuk certificates are also subject to a risk of loss, which is an important risk in the case of equipment and large scale construction. Yet, there is a possibility to mitigate the risks of asset losses by using provisions for insurance claims in the form of Takaful.
Shari’ah compliance risk refers to the loss of asset value as a result of the issuers’ breach of its fiduciary responsibilities with respect to compliance with Shari’ah (Managing financial risks of Sukuk Structures by Ali Arsalan Tariq; 2004). Shari’ah jurists play an essential role in the formulation of the Sukuk prospectuses; the dissolution clauses of these prospectuses define events that will make the Sukuk deed null and void due to Shari’ah non-compliance. For example, in the case of incidence of a Wakeel, the guarantor and the agent have to be separate entities to negate any conflicts of interest and moral hazards.
