Islamic finance body backs divisive sukuk ruling

KUALA LUMPUR, Nov 19 (Reuters) - A ruling forbidding repurchase agreements in some Islamic bonds will help develop Islamic finance, an industry body said on Wednesday, offering support for a controversial view that has roiled the sukuk market.

The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) said late last year about 85 percent of sukuk, or Islamic bonds, did not comply with Islamic law because of repurchase agreements.

Experts say the ruling -- combined with difficult global credit markets -- has virtually crippled the market, which has been the industry's fastest growing segment.

Sukuk issues have fallen to around $14 billion this year from last year's $50 billion, BNP Paribas (BNPP.PA) said this month.

But a top official of the Bahrain-based International Islamic Financial Market (IIFM), an Islamic financial standards body, threw his weight behind the AAOIFI ruling.

"I think it is basically to further improve Islamic finance," IIFM Chief Executive Ijlal Ahmed Alvi told reporters on the sidelines of an industry forum.

"There are certain things which, when we go along, we have to adjust. The immediate impact (is you) may sort of find it confusing but in the medium run or long run it's very beneficial."

Islamic law argues that business partners must share the risk and reward of a venture and not guarantee returns regardless of venture success for any party.

Islam bans interest on loans as usury. Instead, returns derived from underlying physical assets are paid to bondholders. These physical assets may be financed through profit-sharing ventures, such as musharaka and mudaraba deals.

Most Islamic bonds, or sukuk, have been sold with a repurchase undertaking -- a promise that the borrower would pay back their face value at maturity, or in the event of default, mirroring the structure of a conventional bond.

AAOIFI is of the view that this promise contravenes the obligation to share risk in the case of mudaraba and musharaka sukuk. The bonds should be bought at market value at maturity.

Sukuk based on an ijara, or leasing structure, do allow a repurchase guarantee, as bond returns are derived from rental payments, and not from a joint business venture.

Under mudaraba, a bank will provide capital for a project while the entrepreneur will manage the deal. Profits are split according to a pre-determined ratio and the bank will bear any monetary losses that arise.

With the musharaka principle, parties contribute capital to a project with profits to be distributed according to an agreed ratio while losses are generally divided as per the capital contribution ratio.

Alvi said the sukuk market was expected to recover from its dry spell caused by the storm in global financial markets.

"It's isolated in some way but it can't be totally isolated," he said referring to the impact of the crisis on the Islamic bond market." (To read more Reuters stories on Islamic finance, click on [ID:nISLAMIC]) (Reporting by Liau Y-Sing; Editing by Jan Dahinten)