The maiden sukuk to have claimed to be in compliance with Basel III requirements, which was issued in November 2012 by Abu Dhabi Islamic Bank (ADIB), worth $1billion and classified as AT1 capital requirements, according to a report published by Bank Negara Malaysia.
The reported titled “Innovation for Growth: Basel III creates a golden opportunity” said the ADIM sukuk generated an overwhelming response with an order book of $15.5billion (more than 30 times over-subscribed on the initial benchmark size), and carries a profit rate of 6.375%, the lowest ever coupon for an instrument of this type.
These statistics reinforce the proposition that sukuk issuers have an opportunity to tap into the Basel III-compliant sukuk market.
Similarly, Basel III compliant sukuk can be an alternative funding source for institutions that face difficulties in raising capital through equity issuances as global financial instability depresses stock markets. Basel III compliant sukuk are an eligible instrument for both conventional and Islamic institutions on the condition that funds are utilised for Shariah-compliant activities. Hence, market expectations are that the ADIB issuance will steer interest among other banks, particularly in the Middle East where regulators generally require higher levels of capital, to explore issuances of such sukuk. The momentum is expected to pick up pace as Basel III accords are phased-in through the coming years.
The Islamic Financial Services Board (IFSB) released draft guidelines on capital adequacy for
Islamic banks in November 2012 which clarifies the use of sukuk as additional capital. As per the IFSB Exposure Draft 15, sukuk issued against assets owned by an Islamic bank may be used by that bank as additional capital to meet regulatory minimum requirements. The minimum maturity of the sukuk is five years and it should not have step-up features, such as periodic increases in the rate of return, giving an incentive for the issuer to redeem it.
The ADIB USD1bln sukuk was based on the contract of Mudharabah and is classified as equity, which therefore does not include principal loss absorption or equity conversion features. Periodic
distributions are fully discretionary and non-cumulative. The sukuk is unrated, but will be included in Fitch-eligible capital with a 50% equity credit. It has no maturity date while ADIB can choose to repay the sukuk on certain dates from 2018 if it wishes.
Below is an illustrated example of a Basel III compliant sukuk Mudharabah structure. The notable difference is that unlike some of the previous sukuk issuances, payments of Mudharabah profit by Islamic banks (as Mudarib) is at the sole discretion of the bank and may only be made if it meets certain conditions. The certificates are perpetual securities in respect of which there is no fixed redemption date and accordingly, the Mudharabah is a perpetual arrangement with no fixed end date. Subject to certain conditions set out in the Mudharabah agreement, the Islamic bank may at its option liquidate the Mudharabah in whole, but not in part, on the basis of an actual liquidation of the Mudharabah. For example, in the ADIB sukuk, it was agreed ADIB will only liquidate the Mudharabah to the extent that, on a dissolution, the Mudharabah capital would be equal to the nominal amount of the sukuk to be repaid. To the extent that ADIB (as Mudarib) breaches this obligation, it is required to indemnify the issuer (SPV) in respect of this shortfall.
Basel III has now introduced new considerations for managing tier 1 capital adequacy ratios of Islamic banks. Nonetheless, Basel III has created a market gap for the supply of Basel III compliant sukuk which can be filled by issuers. Such issuances would help in boosting the growth rates of the sukuk industry while further reinforcing the role of Islamic Finance in the global economy.