* Huge demand for ADIB's perpetual sukuk may start trend
* Sukuk appear to fit in well with Basel III principles
* Qatari, Saudi lenders might use them to support lending
* But banks without clear state support could find issues
* Tier 2 sukuk may be problematic for regulatory reasons
By Bernardo Vizcaino
DUBAI, Nov 22 A $1 billion sukuk issue by Abu
Dhabi Islamic Bank this month may start a trend that
was probably not contemplated by the founders of modern Islamic
finance: Islamic bonds may become a key tool for banks to meet
tightening capital rules.
The trend could add further momentum to a global boom in
sukuk issuance. It could also ease pressure on banks which find
it hard to raise capital from equity issues as global financial
instability depresses stock markets.
ADIB attracted a spectacular order book of over $15 billion
for this month's $1 billion perpetual sukuk, which has no
maturity date; ADIB can choose to repay the bond on certain
dates from 2018 if it wishes.
The hybrid sukuk was the first to be publicly issued by a
bank to meet the Tier 1 capital requirement in Basel III global
banking standards that will be phased in around the world over
the next several years - although ADIB privately placed a $2
billion Tier 1 note in 2009.
Features such as the subordination of sukuk holders and the
conditionality of payments - ADIB can halt periodic
distributions to investors if it wishes - mean sukuk behave more
like equity than debt, which is favoured by the new Basel
standards, said Alex Roussos, counsel at Norton Rose in Dubai.
"We are likely to see more of it in this market in the near
future," he said.
Even before ADIB's issue, sukuk issuance was rising sharply;
globally, $109 billion worth of sukuk were issued in the first
nine months of 2012, up 69 percent from a year ago, according to
research by Zawya, a Thomson Reuters company.
But supply still appears to be far from satisfying demand
among cash-rich Islamic institutions in the Gulf and southeast
Asia; outstanding global demand for sukuk totals about $300
billion, according to an estimate by Ernst & Young.
Furthermore, ADIB's hybrid sukuk helped to open up a new
investor base for Islamic bonds; private banks catering to
wealthy individual clients were allocated 60 percent of ADIB's
issue, in contrast to most regional bond issues which are
snapped up by other bank investors.
So ADIB's success may over the next one or two years prompt
a wave of hybrid sukuk issues by banks raising capital.
"The prospects are good and ADIB's success is a positive
precedent for other banks. The ADIB issue provides a good
benchmark for other GCC (Gulf Cooperation Council) issuers who
are thinking of accessing this market," said Ahsan Ali, head of
Islamic origination at Standard Chartered Saadiq.
"We expect to see the issuance of hybrid instruments over
the next 12 to 18 months as implementation of new regulatory
guidelines takes effect in various countries."
Some bankers said that in addition to meeting Basel III
standards, Gulf banks might use hybrid sukuk to bridge the gap
between rapid loan growth and slower deposit growth.
Qatari and Saudi lenders are likely candidates. Deposits in
Qatari commercial banks grew 16.1 percent year-on-year in
September while total credit jumped 32.2 percent, according to
central bank data; Saudi bank deposits grew 11.8 percent while
bank loans to the private sector climbed 14.8 percent.
Despite the euphoria over ADIB's sukuk, there are several
obstacles to its success being repeated on a large scale.
Because perpetual sukuk are so similar to equity, they are
seen as relatively risky; one banker said he believed that in
the Gulf, only banks from Abu Dhabi or Qatar could feasibly get
such a deal done, because governments there have directly
supported local banks. Perpetual sukuk will be less welcome in
markets where state support is less firm, he said.
ADIB, rated A+ by Fitch and A2 by Moody's, was able to price
its sukuk very cheaply compared to conventional hybrid bonds
issued by Western banks over the past year. Its perpetual
carried a 6.375 percent profit rate.
By contrast, Dutch lender Rabobank, rated two
notches higher by Fitch and three notches higher by Moody's,
priced a Tier 1 conventional perpetual at 8.4 percent in
November last year. Earlier this year, Banco do Brasil
raised $1.75 billion of Tier 1 perpetual bonds at a
yield of 9.25 percent.
ADIB's sukuk has performed strongly in the
secondary market, another sign of demand for such paper. It was
bid at 103.6 cents on the dollar on Thursday, yielding 5.7
percent, according to Thomson Reuters data.
It is not clear, however, whether banks outside the
supportive environment of Abu Dhabi could price their hybrid
sukuk so cheaply. And because of their newness, hybrid sukuk
could face regulatory risk for issuers - the danger that
authorities might decline to accept them as high-grade capital.
"In questions of eligibility, it will be up to national
supervisors to determine if a specific issuance qualifies," said
a spokeswoman at the Bank for International Settlements, which
provides the Basel Committee with its 17-member secretariat.
This month, the Kuala Lumpur-based Islamic Financial
Services Board released draft guidelines on capital adequacy for
Islamic banks, shedding light on the types of sukuk that could
be classifed as bank capital. The IFSB aims to introduce the
final standard in December next year. But its guidelines are not
binding on national regulators.
While Tier 1 instruments essentially carry only market
risks, issuing sukuk to raise Tier 2 capital under Basel III
could prove more problematic for scholars and rating agencies
because it combines market and credit risks, said Tariqullah
Khan, professor of Islamic finance at the Qatar Foundation.
"This issue of market risk and credit risk is tricky...often
leading to increased structure risk of a sukuk," he said.
Under Basel III, Tier 2 sukuk could be difficult to accept
because of concerns relating to the subordination of debt,
according to Simon Archer, visiting professor at the University
of Reading and consultant to the IFSB's capital adequacy working
group. "There are some grey areas," he said.
Gulf lenders such as Commercial Bank of Qatar,
Burgan Bank, Saudi Hollandi Bank and Bank Al
Jazira have all sold Tier 2 instruments in recent
years to comply with the previous Basel II rules.
Saudi Arabia's regulator has said it will allow Tier 1 and
Tier 2 instruments that no longer qualify under Basel III to be
phased out over a 10-year period beginning in 2013.
Despite the obstacles, the use of hybrid sukuk to raise bank
capital seems to have strong ideological support in the Islamic
finance industry, so institutions will find ways to issue Tier 1
and Tier 2 hybrids, analysts said.
Their equity features make them appealing from the point of
view of Islamic finance, said Madzlan Hussain, Malaysia-based
partner and head of Islamic financial services at law firm Zaid
Ibrahim & Co.
"Sharia scholars in particular have been calling for more
equity-like and equity-based products in the domain of the
Islamic finance market, and a departure from debt-like and
debt-based products," he noted.
Ali at Standard Chartered Saadiq said the market might
favour ADIB's mudaraba format, which is based on an investment
management partnership, because it is relatively simple and easy
for investors to understand.
"There are other possible structures but the mudaraba
concept is simple and straightforward, as it is more equity-like
and fits better into use as a hybrid," he said.
(Additional reporting by Rachna Uppal; Editing by Andrew