Monday, 23 October 2017

Tranching of risk and Shariah

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One of the hottest topics in Islamic finance is the tranching issue and its acceptability by the different Shariah schools and scholars. By Iad Boustany, general manager, and Kamal Assi, associate – capital markets group, BSEC.

Why is tranching viewed by some as being non-Shariah compliant when other credit enhancement techniques (similar or identical to tranching) are so widespread and accepted? What is the philosophical rationale behind such prohibition? The purpose of this article is to bring forward the debate on tranching and to highlight the need of transparent and coherent thinking to grow and develop Islamic finance.

Scholars have provided mixed views on the ability to give different investors differentiated rights over the same underlying asset. The theological rational underpinning such a potential prohibition is unclear. But in any case, should the above be unlawful it would de facto stretch to all types of credit enhancement, as we will see below.

Tranching is (only) a credit enhancement mechanism (like many others). Tranching, subordination, reserves, over-collateralisation, buy-back guarantees, discounted sale and recourse are all financial techniques designed to meet the same goal in enhancing/ameliorating the credit quality of an underlying asset or an issuer. Usage of any of the different credit enhancement tools depends on the suitability of such tool to the structure or nature of the financing, especially when it comes to asset-based or asset-backed financing. In this context, it is the nature of the asset that dictates the right tool to be used

Tranching and other credit enhancement techniques

Subordination (under covenant format or tranching format, or any other legal financial device used for that purpose) is in essence a technique that is meant to rank the rights of different creditors over one single collateral. Certain creditors (whether holders of marketable securities or not) are entitled in priority to the proceeds of the collateral. Only when the senior creditors are made whole will the excess be allocated to the other creditors. This again indicates that different creditors are holding different rights over the same assets.

Take over-collateralisation. In case of given default, such default will first be allocated to the junior creditor (again tranching) until such portion of collateral in excess of the senior is exhausted, and only then will the senior start incurring write-offs. Conversely, in case of no defaults, all the collateral redeems the sukuk in full and the excess is allocated to the payment of the residual (or junior or equity or subordinated) portion. Hence, the same collateral is used to pay two different creditors with different rights and remuneration. This is yet again identical to tranching.

Let us analyse cash reserves. In all instances cash reserves are credit enhancement to the extent that they ensure that a portion of the sukuk are protected from default even if the ultimate collateral defaults entirely. From that perspective, sukuk holders and other creditors have differentiated rights over the same collateral. Conversely, if the collateral does not default, the cash reserve goes back to the holder of a subordinated right to the sukuk holder. The cash reserve is hence a collateral over which at least two creditors have rights with one creditor being subordinated in his rights to the other – exactly as tranching.

Discount selling is yet another technique to achieve the same goal. This mechanism is based on selling assets for less of their market value, which is in substance similar to risk tranching since it simply makes the seller of assets bear a part of their risk instead of the investor. An accounting reading of such an operation clarifies the tranching element in this practice. Absent any default and after all the collateral has paid the sukuk in full, the excess is allocated to the payment of the "residual" (or junior or equity or subordinated) portion.

Where the credit enhancement comes in the form of recourse to the company (asset-based sukuk), a default in the underlying assets triggers a senior right for the investors to the company collateral, which results in different creditors having differentiated rights over the same collateral. This is clearly creating different risk profiles from the same pool of assets.

All of the credit enhancement techniques create differentiated rights to different investors over the same (or a same) collateral and as such are identical to tranching.

Credit enhancement and Islamic finance (1)

A review of most existing Islamic finance deals, including capital market transactions and sukuk, highlights the widespread implicit or explicit existence of tranching. Certain Sukuk structures such as Salam Bounian Development Company Sukuk Ltd, Villamar Sukuk Company Ltd, Tabreed, Sabic, Caravan I, East Cameron and others benefit from credit enhancement in the form, inter alia, of cash reserve, over-collateralisation, discounted sale, etc, resulting in differentiated rights to different investors over the same collateral. The below table illustrates the implicit tranching of risk:


The same mechanism in structured finance, more specifically securitisation, makes the investors subject to different risk profiles from the same ring-fenced assets of the same corporation and is being viewed by Shariah scholars as being non-compliant to Shariah principles, given that no clear principal or precept forbids this practice.

The key concern is the non-existence of a unified norm to evaluate the lawfulness to Shariah, although efforts are being deployed to reach a common understanding of the base Shariah precepts but this is more difficult and tricky than it appears given that the debate on the Shariah issues goes even beyond the finance arena.

The above illustrates how almost every Islamic financing scheme, especially when it comes to structured finance, has an embedded credit enhancement achieved through one of the various tools. This shows the value added of the financial engineering to the Islamic finance sector, without which this sector will be limited to bilateral financing schemes that obviously limit the scope and coverage of an industry that has a huge growth potential mainly driven by the high levels of liquidity and the growing number of Islamic players.

This joins the debates that were lately initiated by certain Shariah boards (especially the conservative ones) saying that a big part of the sukuk currently outstanding are not fully compliant with Shariah precepts. It is not intended to question the structures of these transactions, but the intention is to highlight the desperate need for a regulation that governs the Shariah aspect of all Islamic finance transactions.

Many other Islamic finance transactions involve buy-back guarantees making a party (practically the seller) bear the risk of the underlying asset along with the investors, given that the strict Shariah approach requires that the owner of the asset bears its risk, such owner being the investor. The question is, under which qualification is another party bearing such risk?

This practice finds its origin in the simple philosophy of tranching the risk of a given asset that ultimately is the key value added in capital markets transactions. In these transactions the buy-back (or whatever other nomination) is a promise to buy back in the future the asset at a price determined at the time of issuance (or financing), which is obviously deferring (between different parties) a portion of the risk.

The question remains as to why the principle of tranching being implicitly embedded in almost all Islamic financing schemes is not being viewed as Shariah-compliant when implemented explicitly.

The objective of tranching is to issue different classes of shares/sukuk from the same pool of assets having different risk profiles but always referring to the same real assets and bearing their risk.

Whereas all credit enhancement mechanisms are identical in substance, the debate on the compliance to Shariah principles of one single technique hinders the development of Islamic structured finance by creating a grey area on this subject.

This debate over one credit enhancement technique (and not the others!) comes at a time when small and medium corporations in Islamic countries are in dire need for financing. More so, they are in need of efficient financing, which only structured finance (and all its credit enhancement techniques and mainly tranching) can provide. Absent that, the development of these entities and their ability to compete globally and to provide employment, welfare and increased living standards remains hampered and burdened by the financial charges of traditional financing schemes.


We owe ourselves and the Islamic finance industry a clear and logical explanation of the theological or philosophical precepts that prohibit or allow certain credit enhancement mechanisms. This is crucial to grow Islamic structured finance and enable companies in Islamic countries to access the cheapest possible financing, and create wealth, employment and better living standards for people.

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