Islamic Finance: Standard & Poor’s General Views and Ratings Approach

1. Osservatorio Del MediterraneoMinistry of Foreign AffairsRoma, Nov. 4, 2009 Islamic Finance: Standard & Poor’s General Views and Ratings Approach Dr. Mohamed Damak Associate -- Co-Chair of Islamic Finance Workgroup Standard & Poor’s Financial Services

2. Agenda 1- Introduction 2- Impact of the crisis on Islamic Finance and Sukuk market 3- The European experience 4- Sukuk market at a glance 5- Standard & Poor’s approach to rating Islamic Financial Institutions and Sukuk

3. Introduction

4. Islamic Finance At A Glance

5. Islamic Finance At A Glance Geographic expansion of Islamic Finance Islamic Finance is rapidly emerging in new territories!

6. Islamic Finance At A Glance What makes Islamic finance different? The Five Pillars of Islamic Finance 1- Prohibition of interest 2- Prohibition of speculation 3- Prohibition of the financing of illicit sectors (pork, weapons, alcohol,…) 4- Profit & Loss sharing principle 5- Asset backing principle Islamic finance is not restricted to Muslims (the “natural” clients) as some of its principles may attract non-Muslim clients.

7. Impact of the crisis on Islamic Finance and Sukuk market

8. Impact of the crisis on Islamic Finance and Sukuk market • We note thatIslamic banks have no exposure to structured investment products (CDOs, SIVs and ABS…) and have not been directly affected by the decline of the value of these products. • We note thatIslamic banks are not risk free, however, as one of the principles of Islamic Finance requires that participants in each transaction share risks and rewards (profit & loss sharing principle). • In our view, one of the main sources of risk for Islamic banks in the Gulf stems from their high exposure to the real estate sector (Dubai, in particular). • Given the outlook for real estate sector in Dubai, for example, Standard & Poor’s took rating actions on Dubai-based banks, including the downgrade and the change of outlook to negative from stable on Dubai Islamic Bank (BBB+/Negative/A-2). • Some Islamic banks are also under pressure due to: • 1- Liquidity drying-up and their reliance on wholesale funding; and • 2- Their exposure to the U.S and Europe through private equity, real estate, and asset-based investments.

9. Standard &Poor’s Observations on how the crisis has affected Islamic Finance and the Sukuk market S&P’s expectations for rated Islamic banks (2009-2010) 1- Weaker financial performance as the economic environment has deteriorated (slowdown in business volumes, lower fees and commissions, higher price competition, higher provisioning needs…). 2- Weaker asset quality indicators. 3- More conservative approach toward growth, as liquidity is scarce and more expensive.

10. Standard &Poor’s Observations on how the crisis has affected Islamic Finance and the Sukuk market • The Sukuk market experienced a sharp slowdown in 2008 compared with 2007. However, recovery appears to have started in the second half of 2009. • Total issuance reached $15.3 billion during the first nine months of 2009 compared with $14.9 billion in 2008 and $34.3 billion in 2007. Main drivers for the slowdown • Liquidity dry-up on international markets; • Widening of spreads; • Investors “wait and see” attitude; and • Intrinsic challenges (comments on Sharia compliance, the low liquidity of sukuk, etc…). A more positive trend in the recent past Standard & Poor’s believes that the market is picking up again as market conditions begin to improve and stakeholders are deploying efforts to overcome the intrinsic challenges related to Sukuk market. Reported pipeline of more than $50 billion?

11. The European Experience

12. Islamic Finance At A Glance Initiatives in European countries • UK: Five Islamic banks, one Takaful company, more than 15 conventional financial institutions offering Islamic financial products. • France: Discussion at the highest level of the state on the strategy and the necessary steps to introduce Islamic finance. Talks about the licensing of an Islamic bank by the end of the year. • Italy: Conference organized by the Osservatorio Del Mediterraneo focusing on the opportunities for Italy. • Germany: €100 million Sukuk issued by the State of Saxony-Anhalt rated «AA-» and matured on Aug. 13, 2009. • Switzerland: several Swiss banks offering private banking and Sharia compliant wealth management (local banks and affiliates of Gulf banks). • A significant number of European banks are active in the structuring of Sharia compliant transactions In the Gulf Cooperation Council countries and Asia.

13. The European Experience of Islamic Banking Three apparent strategies: 1- Retail and private banking: local Muslims, recycling of immigration funds, private banking (local and foreign Muslim customers). 2- Wholesale banking: corporate, project financing, private equity. 3- Access to Islamic capital markets (Sukuk market).

14. The European Experience 1- Retail and private banking • Islamic Bank of Britain • Launched in 2004 as the first retail Islamic bank in the U.K. • Main indicators as of Dec. 31, 2008 Total assets: £180.8 million Total financing: £23.4 million Total deposits: £153.3 million Net income: £(5.9) million

15. The European Experience Sharia compliant private banking, wealth management Sharia compliant retail banking products (home and auto financing)

16. The European Experience • More than 14 million potential customers in the selected countries sample. • Average GDP per capita of $42 K in 2009. • Islamic Finance is not restricted to Muslims!

17. The European Experience 2- Wholesale banking: corporate and project financing - SMEs financing, large corporate financing, foreign direct investment in Europe, private equity. Example: Viridian PLC acquired by Arcapita in the U.K. ($4.2 billion); CEPL acquisition in France by Arcapita ($450 million), etc. 3- Access to Islamic capital markets U.K. government plan to issue Sukuk, “rumors” on Sukuk issuance out of France, Switzerland… Investor base diversification and attraction of institutional investors (incl. Sovereign Wealth Funds).

18. Major hurdles/unanswered questions 1- Demand quantification: in the GCC, the offer created its own demand, is it replicable in Europe? 2- Regulatory environment: tax neutrality of Sharia compliant transactions, regulation of Islamic banks... 3- Political environment: launch of Sharia compliant operations in secular countries for example; necessity of political stakeholders’ support. 4- A common strategy for the E.U.? 5- Specific weaknesses of Islamic finance: standardization of products, Sharia interpretation, lack of qualified human resources, lack of liquidity instrument management, small size of the Sukuk market... Observations 1- IFOP : 47% of the sample are interested in Sharia compliant saving products; 55% in Sharia compliant financing. 2- Efforts deployed by U.K. and French regulators to render the environment more friendly. 3- France and U.K. communication from the top level of the state in favor of the development of Islamic Finance. 5- Efforts being deployed by stakeholders to overcome these hurdles. The European Experience

19. The European Experience • Our opinions 1- Islamic finance development is expected to be gradual starting with wholesale activities and possibly retail offering in a second step (including the recycling of immigrants deposits and funds transfers as Islamic finance begins to emerge in home countries, mainly in Africa). 2- More private equity and FDI transactions from the Gulf states and other Muslim countries to Europe (mature economies, strong legal environment, still untapped opportunities...). 3- European banks to continue playing an important role in complex financial transactions and Sukuk structuring.

20. Sukuk Market At A Glance

21. Sukuk Market At A Glance • A sukuk is a Sharia compliant debt instrument that allows an entity to raise funds. • Main reasons for Sukuk issuance: • Size: limited access to bank financing (regulation limiting concentration, loan to deposit ratio limits). • Cost of funding: desintermediated financing. • Maturity: longer than bank loans. • Sharia compliance: Sharia-compliant financing (if the structure is approved by Sharia board).

22. Sukuk Market At A Glance • Significant slowdown of Sukuk issuance in 2008 because of market conditions. • Apparent recovery in the recent past • Reportedly healthy pipeline

23. Sukuk Market At A Glance • Malaysia has taken the lead but GCC is still contributing significantly. • No Sukuk issued out of Europe in 2009*.

24. Sukuk Market At A Glance • The US$ is slowly recovering its position as the currency of choice for Sukuk. • More than 70% of issuance where done in local currencies in 2009*.

25. Sukuk Market At A Glance • Government and related entities are driving the growth of the market compared with FI and corporates in the past. • This trend should help the construction of a yield curve against which issuers can benchmark themselves.

26. Main developments/Hurdles 1- Sukuk default (The Investment Dar, East Cameron Gas, Golden Belt…). 2- Comments made by AAOIFI regarding the Sharia compliance of sukuk issued so far and lack of standardization. 3- Low liquidity of the sukuk market (mostly OTC instruments) Efforts deployed/Conclusions 1- Default is providing the market with interesting information on Sukuk resolution (access to the underlying assets; guarantee enforcement, etc.) 2- AAOIFI will screen products for Sharia compliance and the National Sharia Advisory Council of Bank Negara Malaysia have the status of final arbiter for Sharia compliance. 3- Creation of Saudi Sukuk and bond market (might help improving the liquidity of sukuk listed there). S&P’s Views of the Sukuk Market

27. S&P’s Views of the Sukuk Market • Our expectations for 2009-2010 • The Sukuk market is slowly reviving but issuance volume will continue to depend on market conditions (market are reopening at least for good names). • Sovereign issuers are expected to continue driving the market upward. From 2010, more corporate issuers and FI to re-enter the market. The construction of a yield curve will be helpful. • Our expectations in the longer-term • Prospects remain positive in our view (more than $50 billion of Sukuk were either announced or talked about in the market) • Investors are increasingly seeking to invest in products that are compliant with their beliefs. • Infrastructure projects in the GCC require a huge amount of financing. • Asset and liability mismatch management for financial institutions. • Non-Muslim countries/issuers looking to diversify their investors base.

28. Standard & Poor’s approach to rating Islamic Financial Institutions and Sukuk

29. Standard & Poor’s approach to rating Islamic Financial Institutions and Sukuk Standard & Poor’s has covered Islamic Finance for more than a decade and has developed a recognized expertise in this field. Standard & Poor’s is active in: 1- Rating Islamic banks, Takaful companies, Sukuk issued by corporates and sovereigns; and 2- Launching Sharia compliant indices. Standard & Poor’s does not: 1- Comment on the Sharia compliance of a specific issue or issuer; or 2- Provide consultancy or advisory services (ex. structuring sukuk.) • The need for independent research is high in Islamic Finance! Standard & Poor’s has published numerous articles on Islamic Finance and frequently participates in seminars to communicate its views. • Standard & Poor’s is in regular contact with different market participants (issuers, investors, regulators, press...)

30. Standard & Poor’s approach to rating Islamic Financial Institutions and Sukuk Islamic Bank Balance Sheet 1 2 1 Classic Rating Methodology Specific Rating Methodology 2

31. Standard & Poor’s approach to rating Islamic Financial Institutions and Sukuk • In rating Sharia compliant issuers, Standard & Poor’s applies the same methodology as for conventional issuers but takes into consideration the specificities related to operating in compliance with Sharia. • Standard & Poor’s has developed a specific methodology for rating Sukuk. • For some instruments, Standard & Poor’s has developed a specific methodology (Stability ratings for Islamic Financial Institutions offering Profit Sharing Investment Accounts) that takes into account the differences between these instruments and their equivalent in conventional finance.

32. Selected publications 1- The Sukuk market has continued to progress in 2009 despite some roadblocks - Sept. 2009. 2- Rated Gulf Islamic financial institutions and takaful companies have shown resilience to global market dislocations but they are not immune – Feb 2009 3- Sukuk Market Declined Sharply In 2008, But Long-Term Prospects Remain Strong – Jan 2009. 4- The Sukuk market continues to grow despite global gloomy market conditions - Sept. 2008. 5- The Sukuk market continues to soar and diversify, held aloft by huge financing needs - March 2008 6- Risk management for Islamic Financial institutions: A rating perspective – Jan. 2008 7- S&P’s Approach to Rating Sukuk - Sept. 2007 8- S&P Launches Stability Ratings For Islamic Banks Offering Profit-Sharing Investment Accounts - Sept. 2007 9- Islamic finance in France: Paris tries to reduce the gap with London - July 2007 10- Key Business Drivers Of Global Islamic Finance - April 2007 11- Islamic Finance Expands Slowly But Surely In The Maghreb, April 2007 12- Takaful: A New And Viable Insurance Business Model Or Just A Marketing Opportunity? April 2007

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