## _wp07117

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### Introduction: role of securitization and Islamic constraints
- Financial globalization and compressed spreads have driven investors to seek higher yields; securitization facilitates risk transfer and liquidity transformation.
- Shariah constraints: ban on interest (riba), speculation (maisir), excessive uncertainty (gharar), trading in haram activities, and certain sale/purchase forms (bay’ al inah).
- Islamic finance emulates conventional instruments (equity, mortgages, derivatives) via structural asset-transfer arrangements rather than guaranteed interest-bearing debt.
- Conventional securitization’s reliance on interest-bearing debt limits acceptance; legal uncertainty over enforceability of investor interests is a major barrier.
- Over the last five years the nascent Islamic securitization market has seen positive developments driven by enabling capital market regulations, favorable macroeconomic environment, and financial innovation aimed at shariah compliance.
- Most popular Islamic ABS structures are sukuk backed by synthetic loans, sale-leasebacks, or profit-sharing arrangements; sukuks operate similarly to mortgage pass-throughs except investors own a portion of the underlying assets.

### Definition of Islamic finance: main types and economic tenets
- Core prohibitions under shariah relevant to finance:
  - (i) interest earnings or usury (riba) and money lending;
  - (ii) haram activities (e.g., alcohol, pork, firearms, tobacco, adult entertainment);
  - (iii) speculation, betting, gambling (maisir);
  - (iv) trading the same object between buyer and seller (bay’ al inah);
  - (v) preventable uncertainty (gharar) such as financial derivatives, forwarding contracts, and futures.
- Primary religious/legal sources: the shariah (qur’an and sahih hadith) and fiqh (Islamic jurisprudence).
- Three fundamental Islamic financing methods:
  - (i) synthetic loans (debt-based) — sale-repurchase or back-to-back sale (e.g., murabaha, salam, bai bithaman ajil (BBA), istisna);
  - (ii) lease contracts (asset-based) — sale-leaseback or leasing third-party acquired assets (al-ijarah; ijarah wa iqtina);
  - (iii) profit-sharing contracts (equity-based) — mudharaba (mudarabah) and musharaka (musharakah/musyarakah).
- Contract features:
  - Murabaha: “cost-plus sale” where resale price = original cost + pre-specified profit markup; variants include salam, BBA, istisna, quard al-hasan, musawama.
  - Ijarah: leasing where lessor retains legal title during lease; financing leases may include call option-like features permitting borrower to acquire asset at maturity.
  - Mudharaba/musharaka: equity participation with profit-sharing; investors bear losses unless due to misconduct/neglect.

### Put-call parity and valuation of Islamic contracts
- The three Islamic finance forms can be represented by put-call parity: asset-based contracts modeled as combinations of written calls and long puts on the underlying asset with strike price E and asset value S.
- For asset-based leasing, lender’s position at maturity (present-value terms) = PV(E) + C(E) - P(E), equivalent to present value of principal + interest of a conventional loan.
- Discrete-time, periodic repayment structure: series of forward contracts; call option extendible with borrower renewals; lender’s put option provides recourse by selling the asset at rental due dates or enforcing repurchase at maturity.
- Debt-based Islamic finance (murabaha, salam, istisna) yields lender payoffs similar to asset-based finance but may imply limited recourse when deferred-delivery or future-asset contracts introduce market and counterparty risks.
- Equity-based contracts yield lender payoffs with no recourse (+P(E) absent) unless collateralization exists; rent-to-buy mortgage-like structures involve declining strike prices as borrower equity increases.

### Asset pricing approach and implied interest in Islamic debt
- Valuation within the Black-Scholes-Merton (BSM) framework under a lognormal asset process:
  - Asset price dynamics: dS = μS dt + σ S dW_t.
  - Default barrier defined as b = E/S.
  - Expected probability of default and “distance to default” derived as standard normal functionals.
  - Call option value determines fair market value of rental/lease payments; put-call parity identifies individual components.
- Annual continuously compounded interest rate of Islamic debt derived as r' = (1/T) ln(E/(S - C(E))) (equation 15).
- Numerical example reported:
  - E = 120;
  - T = 5 years;
  - risk-free interest rate f_r = 5.0% (continuously compounded in example) gives PV(E) = 93.46 and PV(F) = 77.88 for full and partial repayment respectively.
  - For asset value S = 100, fair market price of the Islamic lending contract = 83.59, which implies an (implicit) annual interest rate r' = 7.5% according to the OPT-based valuation model, assuming 0% r =.

### Islamic securitization: principles and permissible structures
- Islamic securitization transforms bilateral Islamic finance risk-sharing into market-based refinancing: originators sell existing or future revenues from lease receivables, “sale-back profit,” or private equity to an SPV, which issues securities to investors who become collective financiers.
- Key shariah compliance conditions for Islamic securitization:
  - (i) Real purpose behind raising funds; collateral assets must be identifiable and non-consumable.
  - (ii) Transaction participants should share both risk and return; investors receive pay-off only from profitable ventures.
  - (iii) Collateral assets must not be debt, cash, or haram; no association with speculation or gharar.
  - (iv) Structure should compensate investors for business risk and not equate to exchange of debt for interest-generating return.
  - (v) Investors should hold an unconditional and unsecured payment obligation, not a guaranteed promissory note.
  - (vi) Sufficient element of ownership must be conveyed to investors.
  - (vii) Investor proceeds and issuer returns cannot be reinvested in short-term cash instruments or interest-bearing debt; commodities could be acceptable for short-term investments.
  - (viii) Underlying assets/obligations must not be used for speculative purposes and turnover should be low.
  - (ix) Conventional insurance violates shariah; takaful (Islamic insurance) should be used instead.
  - (x) Credit enhancement and liquidity support must be in permissible forms.
- Pass-through securitization (equity participation) is closest to strict shariah interpretation because it transfers ownership and direct business risk to investors; true sale and irrevocable dedication of cash flows support shariah compliance.
- Credit enhancement can be permissible if optional and not changing the transaction’s character; tranche subordination can be replicated by ijara lease-buyback structures where investors receive partial ownership rights and the issuer leases back the portfolio.

### Sukuk: characteristics, types, and market concerns
- Sukuk definition: shariah-compliant, tradable asset-backed, medium-term notes representing undivided shares in ownership of tangible assets, usufructs and services, or assets of projects or investment activities (AAOIFI Standard No. 17).
- Two broad sukuk structures:
  - (i) Originators issue notes backed by existing Islamic assets.
  - (ii) Originator sells assets (and/or proceeds) to an unaffiliated SPV, which issues notes; notes entitle investors to pro rata ownership in the SPV and proceeds generated by the assets.
- Sukuk convey equity interest via call-option-like rights on ownership and a calculable profit share; amount of debt issued limited to value of assets held by SPV.
- Common sukuk types: ijarah (asset/lease-backed) sukuks — sale-leaseback (“sale model”) and headlease-sublease models.
- Concerns: structures or pricing that resemble guaranteed discounted returns or implicit interest have raised shariah compliance questions.
- Examples of sovereign/quasi-sovereign issues cited:
  - Malaysia US$600 million in 2002;
  - Qatar US$700 million in September 2003;
  - Bahrain US$250 million in February 2004;
  - Pakistan US$600 million in February 2005;
  - Bahrain Monetary Agency International Sukuk Co., June 2004: US$250 million structured as an unconditional, unsubordinated, unsecured general-payment obligation backed by the Kingdom of Bahrain.

### Current state of Islamic securitization and market development
- Market scale and growth figures:
  - Roughly 200 Islamic financial institutions operating in 48 countries hold more than US$300 billion in assets under management (GCIBFI, El-Hawary and others, 2004).
  - Islamic finance sector estimated to grow by more than 15 percent per year.
  - Gross sukuk issuance volume surged from US$6.7 billion to about US$15.0 billion by end-2006.
  - Islamic securitized issuance still shy of 10 percent of conventional securitized issuance in emerging markets during the same period.
- Market characteristics and constraints:
  - Early growth dominated by sovereign-sponsored issuance; investors often bought on sovereign credit rather than evaluating underlying asset performance.
  - Constraints: deficient legal frameworks and accounting standards for structured finance; regulatory rigidities; poor market practice; under-developed local institutional investor base.
  - Securitization is modest in most Islamic countries except for self-contained projects with government guarantees (e.g., Turkey, Pakistan, Malaysia, Egypt).
  - As market matures and liquidity increases, sukuks expected to expand beyond low-yielding sovereign credits to cover full risk-return spectrum.

### Box — Malaysia as pacemaker: market composition, milestones, and transactions
- Malaysia hosts the world’s largest Islamic bond market, estimated at US$300 billion, which has grown at an average rate of 20 percent per year over the last three years.
- Market composition:
  - Private debt securities constitute 70 percent of Malaysia’s Islamic bond market.
  - Most common sukuk types are based on bai bithaman ajil (BBA) and murabahah (ca. 90 percent).
  - Government entities tend to issue istina sukuks, used as pricing benchmarks.
- Key transactions and milestones:
  - Mid-2001: Securities Commission introduced guidelines for ABS.
  - October 2004: Cagamas Berhad issued RM1.6 billion (US$432 million) mortgage-backed offering to create a yield curve for MBS.
  - July 2005: Cagamas issued first Islamic mortgage-backed issue of mudharabah bonds of RM2.05 billion (US$532 million).
  - Cagamas plans to securitize RM25 billion (US$5.5billion) of staff housing loan receivables in the near future.
  - February 2005: First Islamic sovereign securitization in Malaysia issued by Pasir Gudang Local Authority as a mudharabah sukuk on RM80 million (US$18 million) of future property tax revenues.
  - February 2005: Malaysia staged the first Islamic commercial mortgage-backed securitization (CMBS) issued by Talam Corp. for RM150 billion (US$ 33 million).
  - 2006: Khazanah Nasional Berhad placed US$750 million worth of local-currency-denominated Islamic bonds.
  - Khazanah planned a U.S. dollar-denominated Islamic bond issue in 2007.
- Institutional role of Cagamas Berhad:
  - National Mortgage Corporation; purchases mortgage loans with full recourse for three to seven years.
  - Referred to as a secured financing arrangement; refinances through unsecured conventional debt securities or Islamic bonds without pre-specified investment return.
- Investor behavior:
  - Non-Islamic institutional investors drove much of the demand in heavily oversubscribed issues.
  - Khazanah’s planned U.S. dollar-denominated issue aimed to attract Middle East investors who had avoided similar sales due to divergent shariah interpretations.

### Challenges: legal uncertainties, economic and structural impediments
- Legal uncertainties:
  - Shariah compliance requires assessment under commercial law and Islamic law; shariah boards (at least three scholars) supervise/substantive-review products.
  - Jurisprudential variability: divergent shariah board opinions and lack of uniform precedent create legal uncertainty and can temper investor interest and liquidity.
  - Governing law and bankruptcy remoteness: whether Islamic law governs a securitization by substance or form affects re-characterization risk (true sale vs. loan); failure to establish true sale may void transfers.
  - Synthetic securitization could sidestep transfer/perfection issues but is not widely accepted in Islamic jurisdictions.
  - Rating agencies often limit ratings to issues supported by government guarantees; many shariah-compliant securitizations remain unrated.
- Economic and structural impediments:
  - Difficulty identifying suitable shariah-compliant reference assets and permissible substitutes for standard credit enhancements and liquidity supports.
  - Limited sourcing of securitizable assets; issuers often must originate assets themselves.
  - Paucity of historical default data hinders reliable recovery estimates; rating agencies adopt conservative assumptions.
  - Banks flush with liquidity and capital reduce incentive to securitize.
  - Prevalence of sovereign guarantees makes asset risk incidental to counterparty risk and hampers market sophistication.
  - Conventional credit enhancements (over-collateralization, reserve/spread accounts) are difficult to implement within shariah limits.
  - Market illiquidity and restricted distribution channels (often single buy-and-hold investor) impede price discovery.

### Advantages and opportunities of Islamic securitization
- Economic benefits mirror conventional securitization:
  - improved access to funds and lower capacity constraints;
  - market-based valuation of securitized assets and potential for enhanced credit ratings;
  - better asset-liability management and active portfolio management;
  - disaggregation, customization, repackaging and distribution of asset risk when hedging instruments are absent;
  - facilitation of market entry for finance companies specializing in securitizable assets;
  - completion of domestic fixed income markets by enabling securitized debt issuance beyond originator credit rating.
- Market opportunity:
  - Islamic home finance and sukuks provide an untapped market for structured finance where conventional securitization is virtually absent.
  - Shariah compliance can entail tax exemptions when investors hold direct ownership interest in securitized assets.
  - Greater liquidity and a broader investor base could allow sukuks to cover the full risk-return spectrum.

### Policy and market development implications (conclusions and recommendations)
- Key prerequisites for scaling Islamic securitization:
  - legal certainty and bankable governing law (retention of conventional finance documentation standards and supremacy of bankable governing law as form);
  - efficient and transparent capital markets and depth of eligible asset supply;
  - consistent regulatory standards and harmonized shariah interpretations.
- Institutional and standard-setting roles:
  - Importance of IFSB, AAOIFI, GCIBFI, and IIRA in adding consistency in shariah interpretations and market practice.
  - IFSB developments: inaugurated November 3, 2002; comprises 88 members; issued exposure drafts of prudential standards on March 15, 2005, and preparing standards on corporate governance, supervisory review, transparency and market discipline.
- Near- and medium-term outlook:
  - Islamic securitization has been largely government-driven but private entities expected to consider shariah-compliant securitization in response to investor demand.
  - Structural innovation and refinement of sukuks anticipated to make offerings competitive with conventional investments, conditional on resolving legal, regulatory and market-friction constraints.
  - Example of product innovation: February 2006 introduction by Abu Dhabi Commercial Bank (ADCB) of a shariah-compliant takaful and savings scheme, called meethaq.
- Persistent barriers:
  - lack of efficient and transparent capital markets, bankable legal frameworks, and recognition of foreign regulatory judgments will limit meaningful near-term growth.
  - reliance on sovereign guarantees and limited investor sophistication must be addressed to develop a sustainable private securitization market.

*Source: _wp07117 (3. Securitization and Capital Market Development in Emerging Markets; Box 1. Malaysia as Pacemaker; Box 3. Securitization and Capital Market Development in Emerging Markets).*

### References..............................................................................................................

### _wp07117 - References

### Figures
- 1. The Pay-Off Profile under Put-Call Parity of the Three Basic Forms of Islamic Finance ..10
- 2. The Pay-Off Profile of Asset-Backed Securities under the Three Basic Forms of Islamic  
  Finance .........................................................................................................................15
- 3 The Concept of an Ijarah Sukik Transaction ........................................................................20

### Text Boxes
- 1. Malaysia as Pacemaker of Islamic Securitization................................................................23
- 2. Two-Tier SPV Ijarah Securitization—CARAVAN I Limited.............................................24

*Source: _wp07117 - References*

### 3. Securitization and Capital Market Development in Emerging Markets ..............................26

### 3. Securitization and Capital Market Development in Emerging Markets

### Introduction: role of securitization and Islamic constraints
- Financial globalization and compressed spreads have driven investors to seek higher yields in alternative investments; securitization facilitates risk transfer and liquidity transformation.
- Islamic finance is governed by the shariah, which bans interest and speculation and requires income to be derived as profits from shared business risk rather than guaranteed return.
- Islamic finance can synthesize equivalents to equity, mortgages, and derivatives via structural arrangements of asset transfer between borrowers and lenders to emulate conventional interest-bearing contracts.
- Conventional securitization, developed in non-Islamic economies, invariably involves interest-bearing debt; this limits acceptance in Islamic finance due to religious restrictions on sale/purchase of interest-bearing debt and legal uncertainty over enforceability of investor interests.
- Over the last five years the nascent Islamic securitization market has seen positive developments driven by enabling capital market regulations, a favorable macroeconomic environment, and financial innovation aimed at shariah compliance.
- The most popular ABS structures in Islamic finance are sukuk bonds backed by: synthetic loans, sale-leasebacks, or profit-sharing arrangements. Sukuks operate similarly to mortgage pass-throughs except investors own a portion of the underlying assets.

### Definition of Islamic finance: main types and economic tenets
- Core prohibitions under shariah relevant to finance:
  - (i) interest earnings or usury (riba) and money lending;
  - (ii) haram activities (e.g., alcohol, pork, firearms, tobacco, adult entertainment);
  - (iii) speculation, betting, gambling (maisir);
  - (iv) trading the same object between buyer and seller (bay’ al inah);
  - (v) preventable uncertainty (gharar) such as financial derivatives, forwarding contracts, and futures.
- Primary religious/legal sources: the shariah (qur’an and sahih hadith) and fiqh (Islamic jurisprudence).
- Islamic finance substitutes shared business risk (and returns) for guaranteed, fixed interest-based returns; profits must not be guaranteed and accrue only from investment performance.
- Three fundamental Islamic financing methods:
  - (i) synthetic loans (debt-based) — sale-repurchase or back-to-back sale (e.g., murabaha, salam, bai bithaman ajil (BBA), istisna);
  - (ii) lease contracts (asset-based) — sale-leaseback or leasing third-party acquired assets (al-ijarah; ijarah wa iqtina);
  - (iii) profit-sharing contracts (equity-based) — mudharaba (mudarabah) and musharaka (musharakah/musyarakah).
- Features of these contracts:
  - Murabaha: “cost-plus sale” where resale price = original cost + pre-specified profit markup; variants include salam, BBA, istisna, quard al-hasan, musawama.
  - Ijarah: leasing where lessor retains legal title during lease; financing leases may include call option-like features permitting borrower to acquire asset at maturity.
  - Mudharaba/musharaka: equity participation with profit-sharing; investors bear losses unless due to misconduct/neglect.

### Put-call parity and valuation of Islamic contracts
- The three Islamic finance forms can be represented by put-call parity: asset-based contracts can be modeled as combinations of written calls and long puts on the underlying asset with strike price E and asset value S.
- For asset-based leasing, lender’s position at maturity (present-value terms) is represented as PV(E) + C(E) - P(E), equivalent to present value of principal + interest of a conventional loan.
- Discrete-time, periodic repayment structure involves a series of forward contracts; the call option is extendible as borrower renews the option to acquire the asset, while the lender’s put option provides recourse by selling the asset at rental due dates or enforcing repurchase at maturity.
- Debt-based Islamic finance (e.g., murabaha, salam, istisna) yields lender payoffs similar to asset-based finance but may imply limited recourse when deferred-delivery or future-asset contracts (salams/istinas) introduce market and counterparty risks.
- Equity-based contracts yield lender payoffs with no recourse (+P(E) absent) unless collateralization exists; rent-to-buy mortgage-like structures involve declining strike prices as borrower equity increases.

### Asset pricing approach and implied interest in Islamic debt
- Islamic lending transactions and their constituent option components can be valued using capital-structure-based option pricing theory (OPT) within the Black-Scholes-Merton (BSM) framework under a lognormal asset process:
  - Asset price dynamics: dS = μS dt + σ S dW_t (equation 7).
  - Lognormal formulation of end-of-period asset value (equations 8–10).
- Default barrier defined as b = E/S (ratio of face value E to asset value S).
- Expected probability of default and “distance to default” derived as standard normal functionals (equations 11–12).
- Call option value determines fair market value of rental/lease payments (equation 13); put-call parity identifies individual components (equation 14).
- Annual continuously compounded interest rate of Islamic debt derived as r' = (1/T) ln(E/(S - C(E))) or equivalent representation (equation 15).
- Numerical example from text:
  - E = 120; T = 5 years; risk-free interest rate f_r = 5.0% (continuously compounded in example) gives PV(E) = 93.46 and PV(F) = 77.88 for full and partial repayment respectively.
  - For asset value S = 100, fair market price of the Islamic lending contract = 83.59, which implies an (implicit) annual interest rate r' = 7.5% according to the OPT-based valuation model, assuming 0% r =.

### Islamic securitization: principles and structures
- Islamic securitization transforms bilateral Islamic finance risk-sharing into market-based refinancing: originators sell existing or future revenues from lease receivables, “sale-back profit,” or private equity to an SPV, which issues securities to investors who become collective financiers.
- Key procedural and substantive shariah compliance conditions for Islamic securitization:
  - (i) Real purpose behind raising funds; collateral assets must be identifiable and non-consumable.
  - (ii) Transaction participants should share both risk and return; investors receive pay-off only from profitable ventures.
  - (iii) Collateral assets must not be debt, cash, or haram; no association with speculation or gharar.
  - (iv) Structure should compensate investors for business risk and not equate to exchange of debt for interest-generating return.
  - (v) Investors should hold an unconditional and unsecured payment obligation, not a guaranteed promissory note.
  - (vi) Sufficient element of ownership must be conveyed to investors.
  - (vii) Investor proceeds and issuer returns cannot be reinvested in short-term cash instruments or interest-bearing debt; commodities could be acceptable for short-term investments.
  - (viii) Underlying assets/obligations must not be used for speculative purposes and turnover should be low.
  - (ix) Conventional insurance violates shariah; takaful (Islamic insurance) should be used instead.
  - (x) Credit enhancement and liquidity support must be in permissible forms.
- Pass-through securitization (equity participation) is closest to strict shariah interpretation because it transfers ownership and direct business risk to investors; true sale and irrevocable dedication of cash flows support shariah compliance.
- Credit enhancement can be permissible if optional and not changing the transaction’s character; tranche subordination can be replicated by ijara lease-buyback structures where investors receive partial ownership rights and the issuer leases back the portfolio to support returns.

### Sukuk: Islamic investment certificates
- Sukuk are shariah-compliant, tradable asset-backed, medium-term notes representing undivided shares in ownership of tangible assets, usufructs and services, or assets of projects or investment activities (AAOIFI Standard No. 17).
- Two broad sukuk structures:
  - (i) Originators issue notes backed by existing Islamic assets.
  - (ii) Originator sells assets (and/or proceeds) to an unaffiliated SPV, which issues notes to fund acquisition; notes entitle investors to pro rata ownership in the SPV and proceeds generated by the assets.
- Sukuk convey equity interest to investors via call-option-like rights on ownership and a calculable profit share; the amount of debt issued is limited to the value of assets held by the SPV.
- Common sukuk types: ijarah (asset/lease-backed) sukuks—sale-leaseback (“sale model”) and headlease-sublease models; in sale-leaseback SPV holds legal title and leases assets back to the originator, often with repurchase obligation.
- Concerns about shariah compliance have arisen when issues were structured or priced in ways that may resemble guaranteed discounted returns or implicit interest.
- Examples cited: sovereign/quasi-sovereign sponsored issues (Malaysia US$600 million in 2002 kick-start; Qatar US$700 million in September 2003; Bahrain US$250 million in February 2004; Pakistan US$600 million in February 2005). One cited transaction: US$250 million sukuk by Bahrain Monetary Agency International Sukuk Co. in June 2004 was structured as an unconditional, unsubordinated, unsecured general-payment obligation backed by the Kingdom of Bahrain.

### Current state of Islamic securitization and market development
- Market scale and growth:
  - Roughly 200 Islamic financial institutions operating in 48 countries hold more than US$300 billion in assets under management (GCIBFI, El-Hawary and others, 2004).
  - Islamic finance sector estimated to grow by more than 15 percent per year.
  - Gross sukuk issuance volume surged from US$6.7 billion to about US$15.0 billion by end-2006.
  - Islamic securitized issuance still shy of 10 percent of conventional securitized issuance in emerging markets during the same period.
- Market characteristics and constraints:
  - Early market growth dominated by sovereign-sponsored issuance; investors often bought on sovereign credit rather than evaluating underlying asset performance.
  - Constraints on wider development: deficient legal frameworks and accounting standards for structured finance; regulatory rigidities; poor market practice, standards of origination, trading, and investor protection; under-developed local institutional investor base.
  - Securitization is modest in most Islamic countries except for self-contained projects with government guarantees (e.g., Turkey, Pakistan, Malaysia, Egypt).
  - As market matures and liquidity increases, expectations are for sukuks to expand beyond low-yielding sovereign credits to cover the full risk-return spectrum.

*Source: _wp07117 - 3. Securitization and Capital Market Development in Emerging Markets (https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2007/_wp07117.pdf)*

### Box 1. Malaysia as Pacemaker of Islamic Securitization

### Box 1. Malaysia as Pacemaker of Islamic Securitization

### Overview
- Malaysia is described as the pacemaker and champion for the development of capital-market-based, fixed-income instruments under Islamic law in the form of sukuks.
- It hosts the world’s largest Islamic bond market, estimated at US$300 billion, which has grown at an average rate of 20 percent per year over the last three years.

### Market composition and common structures
- Private debt securities constitute the largest segment: 70 percent of Malaysia’s Islamic bond market.
- The most common types of sukuks are based on bai bithaman ajil (BBA) and murabahah (ca. 90 percent).
- Government entities tend to issue istina sukuks, which are also considered pricing benchmarks.

### Key transactions and milestones
- Mid-2001: Malaysia’s Securities Commission introduced guidelines for ABS.
- October 2004: Cagamas Berhad issued a RM1.6 billion (US$432 million) mortgage-backed offering to create a (liquid) yield curve for mortgage-backed securities (MBS) with longer maturities to promote a viable and active secondary securitization market.
  - Although non-Islamic, this transaction established a pricing benchmark for subsequent offerings in Malaysia; subsequent offerings up to that time had been sukuk offerings.
- July 2005: Cagamas raised funding with its first Islamic mortgage-backed issue of mudharabah bonds in the amount of RM2.05 billion (US$532 million), issued to regional investors and adding a new asset class to the local debt market.
- Cagamas plans to further securitize some RM25 billion (US$5.5billion) worth of staff housing loan receivables in the near future.
- February 2005: First Islamic sovereign securitization in Malaysia was issued by Pasir Gudang Local Authority as a mudharabah sukuk on RM80 million (US$18 million) of future property tax revenues (Jobst, 2006c).
- February 2005 (related): Malaysia staged the first Islamic commercial mortgage-backed securitization (CMBS), issued by property developer Talam Corp. for an amount of RM150 billion (US$ 33 million).
- 2006: Khazanah Nasional Berhad successfully placed US$750 million worth of local-currency-denominated Islamic bonds, described as the largest convertible bond issues in Asia in 2006.
- Khazanah Nasional Berhad planned to debut the first U.S. dollar-denominated Islamic bond issue in the course of 2007 to attract Middle East investors.

### Regulatory and market-development efforts
- Over the two years preceding the report, Malaysia stepped up efforts to broaden the investor base and foster greater asset diversity in the securitization market:
  - Announced an overhaul of the exchange market (Capital Market Plan).
  - Released revised Guidelines on Asset Backed Securities in March 2005.
- In 2005, Malaysia’s central bank launched the first regular issue of ijarah leasing securities.

### Institutional roles and features
- Cagamas Berhad:
  - Described as the National Mortgage Corporation of Malaysia and a government-controlled secondary mortgage facility providing short- and medium-term finance and capital market access to mortgage lenders.
  - Purchases mortgage loans from mortgage originators, with full recourse, at a fixed or floating rate for three to seven years.
  - Referred to as a secured financing arrangement where Cagamas looks first to the credit of the financial institutions when mortgage loans default; indirect government sponsorship implies direct participation of Cagamas in the performance of the acquired mortgage pool.
  - Refinances itself through the issuance of unsecured conventional debt securities (fixed or floating rate bonds or short-term notes) or, more recently, through Islamic bonds without pre-specified investment return.

### Investor behavior and cross-border considerations
- Although it was widely assumed that Muslim investors had bought most of the sukuk bonds, non-Islamic institutional investors drove most of the demand of the heavily oversubscribed issues (Khala et al., 2007).
- Khazanah’s planned U.S. dollar-denominated issue in 2007 aimed to attract Middle East investors who previously avoided similar sales due to different interpretations of Islamic law.

*Source: _wp07117 - Box 1. Malaysia as Pacemaker of Islamic Securitization*

### Box 3. Securitization and Capital Market Development in Emerging Markets

### Box 3. Securitization and Capital Market Development in Emerging Markets

### Economic benefits and market functions of securitization
- Issuers and originators benefit from:
  - improved access to funds and lower capacity constraints.
  - market-based valuation of securitized assets and the prospect of an enhanced credit rating.
  - better asset-liability management: cash flows from securitized assets can be perfectly matched to the repayment of investors until redemption.
  - active management of designated asset portfolios.
  - increased competition of financial institutions in traditional credit markets.
  - the capacity to create new end products for the consumer.
- Securitization mitigates disparities in availability and cost of credit by linking single credit facilities to aggregate pricing and valuation discipline of capital markets (Jobst, 2006c).
- Securitization allows financial institutions to disaggregate, customize, repackage and distribute asset risk when suitable hedging instruments are absent.
- Securitization alleviates credit constraints stemming from capital adequacy rules and risk concentration limits by placing exposures with entities more willing and able to hold them (insurance companies, mutual funds, other institutional investors) via off-balance sheet asset sale or synthetic risk transfer.
- Securitization can facilitate market entry of new finance companies that specialize in easily securitizable assets, breaking oligopolistic control in traditional money markets.
- Securitization “completes” domestic fixed income markets where issuers cannot issue straight bonds due to insufficient credit standing; securitized debt can be raised at a cost of capital once beyond an originator’s own credit rating by detaching asset risk from the originator.
- Amid regulatory, tax and legal reforms, securitization helps accommodate a growing investor base (particularly pension and insurance fund investors) needing long-term, highly-rated local currency bond investments to match liabilities, improving risk diversification and contributing to a more liquid yield curve.

### Preconditions and viability criteria for securitization markets
- General criteria for viable securitization use (supply and demand perspective):
  - structural market imperfection due to fiscal constraints and high borrowing costs;
  - an adequate and bankable legal and regulatory framework for bankruptcy, tax, and corporate governance issues;
  - transparent transaction structures that ensure demonstrable and unimpeded control over securitized assets subject to persistent monitoring by rating agencies, trustees and guarantors.

### Constraints and impediments in emerging markets
- Market frictions hampering securitized issuance and investment activity:
  - limited and narrow asset supply.
  - light prudential standards regarding disclosure and transparency requirements.
  - absence of enabling regulation.
  - prevented emergence of a mature investor base, sound credit culture, market practice, established standards of investor protection, and equitable tax treatment between structured finance and conventional investment products.
  - lack of data on corporate defaults, hindering reliable estimates for default probabilities and recovery rates for transaction structuring.
  - high execution costs, structural complexity, potential principal-agency problems between issuers and investors, administration, collection and fraud risks.

### IV. Challenges and Opportunities of Islamic Securitization — A. Legal Uncertainties
- Core legal uncertainties and procedural/substantive difficulties:
  - structured finance in Islamic jurisdictions faces stringent restrictions and uncertainties due to legal frameworks that are not always securitization-friendly.
  - shariah-compliant securitization requires assessment under two legal regimes: applicable commercial law and Islamic law (shariah).
  - Islamic investors require both legal enforceability under contract/commercial law and compliance of underlying assets and transaction structure with the shariah.
- Shariah boards:
  - Islamic finance and instruments under Islamic law are subject to approval by a shariah board that evaluates religious compliance of substance and structure.
  - religious boards are comprised of at least three acclaimed experts or scholars of Islamic law.
  - religious boards have supervisory and consultative functions; they review day-to-day operations and examine proposals for new transaction types and financial products.
- Jurisprudential variability and implications:
  - Islamic jurisprudence lacks homogeneous interpretation and uniform recognition; not bound by precedent and legal opinions may deviate.
  - shariah law is open to interpretation and boards frequently hold divergent views; no consistent ruling of Islamic courts on eligibility of certain assets and structures for securitization.
  - consequence: legal uncertainty can affect legal integrity and temper investor interest and liquidity.
- International standard-setting efforts and institutional responses:
  - the Islamic Financial Services Board (IFSB) was inaugurated in Malaysia on November 3, 2002 after a two-year consultative process initiated by central banks and national monetary authorities with support from the Islamic Development Bank (IDB), the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and the International Monetary Fund (IMF).
  - the IFSB serves as an international standard-setting body of regulatory and supervisory agencies with the aim to ensure stability and soundness of the Islamic financial services industry by developing or adapting international finance standards consistent with shariah principles and harmonization of practices.
  - the IFSB comprises of 88 members, including 21 regulatory bodies, 62 financial institutions from 16 countries and international organizations, such as the World Bank and the International Monetary Fund (Coomber, 2006).
  - on March 15, 2005, the IFSB issued exposure drafts of prudential standards on risk management and capital adequacy for the Islamic financial service industry; preparations are underway to issue an exposure draft of standards on corporate governance by the end of 2005. In April 2005 the IFSB also started preparing standards on the supervisory review process as well as transparency and market discipline.
- Governing law and bankruptcy remoteness:
  - whether Islamic law governs a securitization transaction by substance or form determines legal/structural risks associated with bankruptcy remoteness of certain security arrangements.
  - if shariah compliance is treated as governing law as a matter of form, Islamic courts could re-qualify legal nature of securitization transactions (e.g., recognition of true sale from originator via bankruptcy-remote SPV).
  - true sale and substantive non-consolidation require factual and document-based conformity (see factors listed in source for true sale and consolidation analyses).
  - requirement under Islamic law for a direct linkage between identifiable assets and investors conflicts with commercial interest in legal separation of assets from originator bankruptcy estate; ex post re-characterization risk exists (bankruptcy courts could “re-characterize” asset sale as unsecured loan).
  - failure of asset transfer to be defined as true sale may void the sale and transfer assets back to original owner, undermining securitization’s economic purpose.
  - synthetic securitization (patterned after German PROMISE) could sidestep legal transfer/perfection issues, but market participants and regulators in Islamic countries are not ready to adopt that approach.
  - bankruptcy and dispute resolution processes of Islamic securities are largely untested due to rare default cases.
- Rating agencies and shariah compliance:
  - legal uncertainties often limit official ratings to Islamic securities sufficiently supported by government guarantees.
  - most shariah-compliant securitizations have been unrated; major rating agencies reluctant to rate local structures.
  - ratings focus solely on credit aspects under applicable commercial law; shariah compliance per se is not the subject of rating unless Islamic jurisprudence impedes credit quality as a matter of form.
  - certain shariah-compliant transactions have disavowed shariah governing law while satisfying shariah as a matter of substance.
  - ijara sukuks tend to be rated similarly to the lessee creating the lease receivables; higher ratings are rare without additional risk-mitigating features such as sovereign guarantees or secured repayment obligations conforming to shariah law.

### IV. Challenges and Opportunities of Islamic Securitization — B. Economic and Structural Impediments
- Key economic difficulties for Islamic securitization:
  - identification of reference assets that meet shariah requirements (no impediment in form of haram) and offer attractive returns.
  - substitutes for standard structural features in conventional securitization (credit enhancement, liquidity support) that are not permissible under shariah.
- Specific impediments:
  - limited sourcing and structuring of securitizable asset portfolios due to shariah compliance requirements; issuers often must originate own Islamically acceptable assets rather than buy asset pools.
  - paucity of historical default data hinders reliable recovery rate estimates and pricing; leads rating agencies to use very conservative assumptions.
  - banks in the region often flush with liquidity and capital, reducing balance sheet rationale for securitizing.
  - use of sovereign guarantees has been common to redress prohibition of credit enhancement; prevalence of sovereign guarantees makes asset risk incidental to counterparty risk, hampering market maturity and investor sophistication.
  - replication of tranche subordination possible via sale-leaseback conforming to Islamic law, but other conventional credit enhancements (over-collateralization, reserve and spread accounts, retention of equity claims) are more difficult to implement within shariah limits.
  - if issuer retains undistributed cash flows as excess spread, transaction may not qualify as complete pass-through with full ownership by investors and might be deemed incompatible with shariah principles.
  - under direct participation principles, Islamic investors would need to contribute own income to fund reserve accounts to cover possible losses.
  - market illiquidity persists due to limited depth and breadth, impairing efficient price discovery and information dissemination.
  - distribution for smaller corporate deals often restricted to one “buy-and-hold” investor; prevalence of sovereign guarantees has restricted market development.

### IV. Challenges and Opportunities of Islamic Securitization — C. Advantages of Islamic Securitization
- Islamic securitization offers many of the same economic benefits as conventional structured finance:
  - active management of designated asset portfolios and isolation of certain assets to make them self-financing at fair market rates.
- Market opportunity:
  - conventional securitization is virtually absent in Islamic countries, while Islamic home finance and sukuks provide a potentially untapped market for structured finance.
  - Islamic securitization complements conventional ABS as an alternative and more diversified funding option that broadens the pricing spectrum and asset supply amid high demand for alternative investment products and a low-yield environment.
  - shariah compliance can entail tax exemptions when investors hold direct ownership interest in securitized assets.

### V. Conclusion — policy and market development implications
- Islamic finance has expanded geographically and in product richness; structured credit finance receives substantial attention.
- Islamic securitization has been largely the domain of government issuers as a stepping stone in evolving a market for shariah-compliant fixed income instruments.
- with recent oil rally, fiscal funding through debt issuance is less important in some Islamic countries, but governments recognize the externalities of public debt for creating pricing benchmarks for corporate market development.
- Malaysian issuers have led innovation; more private entities are expected to consider shariah-compliant securitization to accommodate high demand from investment funds in Islamic and non-Islamic countries.
- constraints to meaningful near-term growth:
  - lack of efficient and transparent capital markets and bankable legal frameworks will limit growth.
  - universal conditions for evolving a sustainable securitization market apply irrespective of shariah compliance.
  - a longstanding barrier: legal uncertainty due to regulatory disparity among national supervisors and lack of recognition of foreign regulatory judgments; efforts in Bahrain and Malaysia are addressing this.
  - greater importance of IFSB, AAOIFI, GCIBFI, and IIRA expected to add consistency of shariah interpretations and enhanced market practice.
  - retention of conventional finance documentation standards and supremacy of bankable governing law as a matter of form remain essential to further growth.
- outlook:
  - greater interest in Islamic securitization will spur structural innovation and refinement of sukuks and similar products that may be offered at competitive levels with conventional investments.
  - Islamic financial institutions in Bahrain, Kuwait, Malaysia and Sudan are gearing up for shariah-compliant financial innovation across assets and liabilities.
  - example: in February 2006, Abu Dhabi Commercial Bank (ADCB) introduced a shariah-compliant takaful and savings scheme, called meethaq, in a joint arrangement with the Dubai Islamic Insurance and Reinsurance Company and Germany-based FWU AG.
- overall: legal certainty, transparent markets, depth of eligible asset supply, and consistent regulatory standards are critical to scale Islamic securitization beyond predominantly sovereign-guaranteed transactions.

*Source: Box 3. Securitization and Capital Market Development in Emerging Markets (extracted from the supplied content).*

### Chapter IV, Development of Corporate Bond Markets in Emerging Market Countries.

### Chapter IV, Development of Corporate Bond Markets in Emerging Market Countries.

### Key references on Islamic finance and sukuk
- International Organization of Securities Commissions, 2004, “The Islamic Capital Market: Fact Finding Report, and Report of the Islamic Capital Market Task Force of the International Organization of Securities Commissions, Madrid.
- Iqbal, Zamir, and Hiroshi Tsubota, 2006, “Emerging Islamic Capital Markets,” Islamic Finance Review, Euromoney Handbook, and Euromoney Institutional Investor PLC, London, pp. 5–11.
- Iqbal, Zamir, and Abbas Mirakhor, 2006, “An Introduction to Islamic Finance—Theory and Practice,” Wiley Finance Editions, John Wiley & Sons, Inc., Hoboken, New Jersey.
- Iqbal, Munawar, and David T. Llewellyn (eds.), 2000, “Islamic Banking and Finance: New Perspective on Profit Sharing and Risk”, Edward Elgar Publishing, Ltd., Cheltenham, United Kingdom, 4th edition.
- Mirakhor, Abbas and Zaidi Iqbal (1988), “Stabilization and Growth in an Open Islamic Economy,” IMF Working Paper No. 88/22, International Monetary Fund (IMF), Washington, DC.
- Richard, Kristel, 2006, “Two Aspects of Rating Sukuk: Shariah Compliance and Transaction Security,” Standard and Poor’s, Research.
- Richard, Kristel, 2005, “A Closer Look at Ijara Sukuk,” Standard and Poor’s, Research.
- Wilson, Rodney, 2004, “Overview of the Sukuk Market,” in: Adam, N. J. and A. Thomas (eds.) Islamic Bonds: Your Guide to Issuing, Structuring and Investing in Sukuk. Euromoney Books, London.
- The Accounting and Auditing Organization of Islamic Finance Institutions (AAOIFI), 2005, “Accounting, Auditing & Governance Standards for Islamic Financial Institutions, 2004 –5th Edition (Financial Accounting Statements),” Bahrain.

### Key references on securitization, structured finance, and derivatives
- Jobst, Andreas A., 2006a, “Correlation, Price Discovery, and Co-movement of ABS and Equity,” Derivatives Use, Trading & Regulation, Vol. 12, No. 1, pp. 60–101.
- Jobst, Andreas A., 2006b, “Asset Securitisation: A Refinancing Tool for Firms and Banks,” Managerial Finance, Vol. 32, No. 9, pp. 731–60.
- Jobst, Andreas A., 2006c, “Sovereign Securitization in Emerging Markets,” Journal of Structured Finance, Vol. 12, No. 3, (Winter), pp. 2–13.
- Jobst, Andreas A., 2006d, “What is Structured Finance? An Analysis of Derivatives, Securitization and Islamic Finance,” The Securitization Conduit, Vol. 8, No. 1. Reprinted in ICFAI Journal of Risk Management (2007) (forthcoming).
- Kendall, Leon T., 1996, “A Primer on Securitisation,” MIT Press, Cambridge, Massachusetts.
- Telpner, Joel S., 2003, “A Securitisation Primer for First Time Issuers,” Global Securitisation and Structured Finance 2003, Greenberg Traurig (http://www.gtlaw.com/pub/articles/2003/telpner03a.pdf).

### Key references on pricing, credit products, and market commentary
- Merton, Robert, 1973, “Theory of Rational Option Pricing,” Bell Journal of Economics and Management Science, Vol. 4, pp. 141–83.
- Merton, Robert, 1974, “On the Pricing of Corporate Debt; the Risk Structure of Interest Rates,” Journal of Finance, Vol. 29, pp. 449-70.
- Wighton, David, 2005, “Credit Protection: Lightyear Set to Exploit the CDO Market,” Financial Times, (January 3), pp. 10.
- Khalaf, Roula, Tett Gillian, and David Oakley, 2007, “Eastern Promise Turns to Western Delight,” Financial Times, (17 January).

### Other relevant works on Islamic finance and financial intermediation
- Karsten, Ingo,1982, “Islam and Financial Intermediation,” IMF Staff Papers, (March, 29), (1), pp. 108–42.
- Jobst, Andreas A., various works cited 2006a–2006d (see securitization and structured finance entries above).
- Additional practitioner-oriented and legal primers cited (titles and sources preserved above).

*Source: Chapter IV, Development of Corporate Bond Markets in Emerging Market Countries. (September 2005), pp. 126–28.*

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