The outlook for Islamic finance remains positive: recent efforts to develop common standards for Islamic financial institutions should help to provide a sound basis for the expansion of the industry.
Guest Post by Oxford Analytica
Islamic finance is one of the fastest growing segments of international financial markets. Currently, total sharia-compliant assets amount to an estimated 1.125-1.275 trillion dollars, with an annual growth rate of 15-20%. The global credit crunch has not left it unscathed, and recent capital market growth has been hampered by conflicting interpretations of the sharia compliance of specific wholesale product structures (sukuk). Nevertheless, the outlook for the sector is positive.
Efforts to standardize Islamic financial products should enhance the sector’s prospects. The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) plays an important role in this regard:
- Originally subscribed by an alliance of domestic and international Islamic banks as well as the Islamic Development Bank, industry-sponsored AAOIFI has since extended its membership categories to include authorities that regulate and supervise Islamic financial institutions.
- It also offers observer member status to conventional financial institutions that operate Islamic ‘windows’ (special facilities offered by conventional banks to provide services to Muslims who wish to engage in Islamic banking).
AAPOIFI’s Sharia Standards 2010 contains 41 standards, including eleven new stipulations pertaining to gharar (uncertainty) in financial transactions, arbitration, zakat (alms giving) and online financial transactions among others. Additionally, its Accounting, Auditing and Governance Standards 2010 contains 40 standards covering the areas of accounting, auditing, ethics and the governance of Islamic financial institutions. These standards are primarily targeted at individual Islamic financial institutions, but they have also been adopted at a national level:
- The AAOIFI’s standards have been made mandatory for Islamic financial institutions in Bahrain, Dubai International Financial Centre, Jordan, Sudan, Syria and Qatar.
- Last month, the State Bank of Pakistan announced that it had begun selectively to implement AAOIFI Sharia Standards and has advised Islamic banks to prepare for the phasing in of further standards in the near future.
- In other countries, including Indonesia, Lebanon, Malaysia, Saudi Arabia and the United Arab Emirates, AAOIFI standards have been incorporated into national guidelines and are adhered to by AAOIFI member institutions.
The lack of standardization of Islamic financial products has been a major barrier to the cross-border sale of Islamic financial products.
The AAOIFI and its sister standard-setting organisation, the Kuala Lumpur-based Islamic Financial Services Board (IFSB) — primarily tasked with developing capital adequacy rules for Islamic financial institutions — have become key players in the construction of the emerging international framework that governs Islamic finance. The AAOIFI has over 200 members from 45 countries while the IFSB has 193 members operating in 39 jurisdictions.
So far, the compliance of member institutions with the standards can neither be enforced nor fully monitored, unless they are mandated at country level and then enforced by domestic regulators. Last month, the AAOIFI announced a timetable for taking a more intrusive approach to regulating Islamic financial products, including plans to create a watchdog committee – composed of sharia scholars and market practitioners — by the second half of 2010. However, increasingly different trajectories of Islamic banking and Islamic capital market development could in turn affect the further standardization of Islamic financial products.
There are two major challenges to the further growth prospects and pace of development of the industry. Both could benefit from enhanced standardization and the AAOIFI’s work more generally.
- Interpretation of Islamic law. Given the absence of a highest religious authority in majority Sunni Islam, assessing the Sharia quality of Islamic financial products depends on a number of representatives from different legal schools with sometimes widely varying interpretations.
- Scarcity of qualified sharia scholars. To address the shortage of scholars well versed in both sharia and finance, a number of programs have sprung up that offer degrees in Islamic finance.
Technorati Tags: credit-markets, islamic-finance, sukuk
Japan urgently needs to publish a credible fiscal consolidation plan, and to back this with early revenue increases, if the integrity and credibility of fiscal management are to be guaranteed.
Guest Post by Oxford Analytica
Periodic reminders of the seriousness of Japan’s debt position tend to be brushed off by the government and in the Japanese Government Bond (JGB) market. According to the Ministry of Finance, only 5.8% of JGBs in issue are held outside of Japan and the bulk of holdings are in strong, domestic institutional hands that are willing and able to absorb the high levels of debt involved.
Repayments. The overall level of interest paid by the government on its debt has remained more or less constant at 1.4 % over the past five years — one quarter of the level prevailing at the time when Japan’s bubble economy collapsed in 1991, despite a near quadrupling of the nominal amount of government debt since then. At an estimated 9.8 trillion yen (108.7 billion dollars) for fiscal 2010 (beginning April), debt repayments are lower than they were from 1985 to 1998 despite the huge increase in government debt that came after this. This is because of the low interest rate regime in Japan of the past decade, a weak economy requiring huge fiscal stimulus, adding to government indebtedness.
Policy position. All this suggests that the JGB market is willing and able to absorb public debt, even at very low nominal interest rates. However, the OECD and IMF argue that Japan needs to put its public finances on a more sustainable track and publish a plan for fiscal consolidation. The Democratic Party of Japan (DPJ)-led administration has pledged to produce such a map by May or June this year, partly in response to market concerns over the DPJ’s plans to boost social spending. However, with a key election looming in July, the DPJ will want to avoid specifying targets.
Critical factors in determining the sustainability of Japan’s debt levels are the ability to service the debt and ability of the market (in its broadest sense) to absorb it.
Beyond that, questions of debt reduction depend critically in turn on revenue and expenditure projections:
- Interest. At a projected 20.6 trillion yen for fiscal 2010, interest payments will be equal to 22% of total budget spending of 92.3 trillion yen. The amount of debt service continues to rise in absolute terms, requiring more new debt issues each year simply for servicing existing debt. Servicing of high debt levels is affordable while rates are very low, but becomes less so when rates rise.
- Absorbing debt. That two-thirds of outstanding JGBs are held by domestic financial institutions — notably the state-owned Postal Savings and Insurance entities and the Bank of Japan — is seen as a source of stability. However, while the ability to absorb JGBs appears not be in question for now, the OECD takes the view that this will no longer be the case if primary budget deficits continue and borrowing continues to rise. Even a doubling of the national consumption tax from 5% to 10%, along with cuts in public investment and in the public wage bill, are unlikely to stabilise Japan’s debt-to-GDP ratio by 2015 and see it start dropping away by the early 2020s, the OECD thinks. Moreover, the government had pledged not to raise the sales tax for four years.
- Revenues. Apart from increasing the sales tax, the government needs to broaden the tax base. It claims to have abolished already some eight of the 300 or so preferential tax measures that limit government revenues, but an estimated 60% of all registered companies in Japan pay no tax. The personal income tax threshold is high.
Technorati Tags: credit-markets, japan, Oxford-Analytica, sovereign-debt
A new report from Aite Group finds that credit ratings agencies are too integral to the financial system to disappear. However, they are likely to lose their hegemony over time as a result of proposed regulatory actions and changes in the marketplace.
The report examines the role that Nationally Recognized Statistical Ratings Organizations (NRSROs) play in the debt issuance and investment process, and looks at pending regulations and possible credit rating agency (CRA) responses to these regulations.
Historically, CRAs have measured the financial strength (i.e., provided gradations of creditworthiness) of corporations that have tapped publicly traded debt markets to finance their operations. Because of recent write-downs and expected losses – primarily related to mortgage-related securitized debt – credit rating agencies have taken a hit to their reputation for providing credible credit analysis.
These SEC-sanctioned credit rating agencies (known as NRSROs), comprise 10 firms, including Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings, which have for years held onto their constituent firms with a near-monopoly grip. Nothing lasts forever. Investor dissatisfaction with NRSROs, and drafted regulation, such as the Restoring American Financial Stability Act have primed the playing field for major changes.
“While NRSRO ratings will remain a part of the global debt markets, NRSRO hegemony may wane in the face of proposed legislation and investor displeasure,” says John Jay, senior analyst with Aite Group and author of this report. “Consequently, NRSROs will need to share their sandbox with other credit ratings agencies, and even investors themselves. More than any other party, investors have some ability to look out for their own interests by taking credit analysis onto their own shoulders.”
The report notes that potentially $2.8 trillion of cumulative credit market losses remain on the books of financial institutions for the period 2007-2010.
Holders of existing debt and regulators that oversee segments of these holders may wish to consider either outsourcing or building their own infrastructure to analyze credit risk.
Technorati Tags: credit-markets, financial-regulation, Fitch, Moodys, ratings agencies, Standard & Poor's
Fitch Ratings expects default rates for European leveraged buyouts are expected to show some stabilisation in H2 2010. However, many credits still have unsustainable capital structures and, given the high level of low rated transactions, a second medium- to longer-term wave of defaults in the sector by 2013, when widespread maturities come due, cannot be ruled out.
“LBO business plans remain susceptible to the effects of a weak economic recovery, which could lead to stalled de-leveraging and heightened refinancing risks from 2012 onwards when many bullet repayment tranches will start to fall due,” said Pablo Mazzini, Senior Director at Fitch’s European Leveraged Finance group.
Given that the primary leveraged bank loan and securitisation markets are constrained to provide funding for leveraged borrowers, medium-term refinancing risk for existing borrowers remains high as they are unlikely to generate sufficient free cash flow to repay debt when maturities come due.
Debt amortisation for Fitch’s portfolio of 293 privately shadow-rated leveraged credits will increase to a yearly aggregate average of EUR48bn between 2013 and 2016, from a more manageable EUR6.5bn in 2010. Fitch also estimates that average leverage multiples will remain high by end-2012 at 4.6x (senior)/6.1x (total). For the 157 credits rated ‘B-*’ and ‘CCC*’ leverage is expected to be even higher at 5.2x (senior)/7.2x (total).
Fore details, see European LBOs Still Face Medium-term Default Risk, Despite Signs of Stabilisation (Premium)
Technorati Tags: credit-markets, Europe, LBO, leveraged finance
Morgan Stanley expects single-digit gains in global developed equity markets in 2010, as well as a bounce in the dollar and uneven credit markets.
Highlights from Morgan Stanley’s Global Macro Preview 2010:
- Global GDP growth of 4% with 2% in G-20 countries and 6.5% in emerging economies.
- Credit markets to outperform risk-free interest rates as risk diminishes
- US and Canadian Dollars to rally as Pound and yen weaken.
- Single-digit gains for developed country equities.
- Overweight Japan and Asia, neutral North America and underweight UK and Europe.
- Crude oil may rise, gold well supported, corn has 15% potential upside.
The full 76-page report is available here.
Technorati Tags: commodities, corn, credit-markets, currency, dollar, equities, gold, oil prices
Robust trading activity in OTC derivatives products likely to continue as reform momentum dissipates.
Guest Post by Oxford Analytica
Over-the-counter (OTC) derivatives, particularly credit default swaps (CDSs), were faulted as a cause of the credit crunch, most prominently in a June 17 speech by US President Barack Obama announcing his administration’s plan for financial reform. This led to calls in the United States and elsewhere to regulate the CDS market.
Regulatory outlook. Some of this pressure has been addressed indirectly by proposals such as the G20’s commitment to require all standardised OTC derivative contracts to be traded on exchanges or electronic trading platforms, where appropriate, at the latest by the end of 2012 — non-centrally cleared contracts would be subject to higher capital requirements.
The Obama administration has made a strong case for pushing to move ’standardised’ OTC derivatives transactions to organised exchanges, so as to benefit both from standardisation (and the expected price decreases that will follow), and centralised clearing mechanisms (which would replace the exchange as the nominal counterparty to the transaction, thus eliminating the lion’s share of counterparty risk). Unsurprisingly, the exchanges themselves support such moves and have positioned themselves to offer a broader product mix, and cross-border services
Yet different sources of opposition have arisen, even to such modest proposals. It remains uncertain whether the 2012 G20 deadline will be achieved, despite calls from such prominent officials as EU Internal Market Commissioner Charlie McCreevy for more rapid and meaningful standardisation of such markets.
Industrial companies. Within the EU, large industrial companies have emerged as an unanticipated source of opposition. The consequence of mooted changes would be to increase their costs, as they would be required to post margin to make such trades, which is currently not necessary:
- Ironically, proposals are designed to reduce the systemic risk posed by financial institutions engaging in such trading (especially given its concentration in a handful of firms), but would have a strong cost impact on the industrial firms who use OTC derivatives for valid non-speculative hedging purposes.
- Some industrial players have called for exempting industrial firms from margining and clearing requirements, but such a suggestion is impractical, if not conceptually impossible.
- Yet if reforms proceed, industrial firms may attempt to move their trading offshore to reduce such costs, and away from stringent regulation, thus reducing another major motivation for reforms.
Financial institutions. While some firms, such as JP Morgan Chase, have opposed changes upfront and outright, more serious debate will centre on what constitutes a ’standardised’ contract, with the industry pushing for narrow interpretations so as to continue to gain high spread from structuring and offering bespoke products; and under what conditions and to what extent higher disclosure standards must be met.
Exchange default risk? Some regulators have echoed parallel concerns, for example that expanding the definition of ’standardised’ transactions would put exchanges in the position of clearing illiquid products; and unexpected future systemic shocks might reveal unexpected consequences of such a policy:
- Centralised clearing is held to reduce counterparty risk, because the exchange is a counterparty to each trade.
- However, it does not eliminate such risk, because the exchange itself could default on commitments.
This seems unlikely given past history of exchange performance, but is not impossible. Some have suggested that exchanges thus far largely have not defaulted on their commitments because they have limited themselves generally to clearing liquid products.
Congressional priorities The United States has taken the lead in pushing for exchange trading of OTC products, and the US Treasury Department has produced draft legislation. Timely US implementation of meaningful legislation could advance this issue significantly, but any such action is unlikely this year, in part because Congress first will focus on proposals to create a Consumer Financial Protection Agency, and improve regulation of credit ratings agencies.
Outlook. Robust trading activity in OTC derivatives products, including credit derivatives, is likely to continue, and signifies the broader return to ‘normal’ trading conditions. Yet despite the G20 commitment to move more such trading onto organised exchanges, the lack of a strong US lead to move forward quickly to this goal means major changes are unlikely before 2010 — afterward further momentum may dissipate.
Technorati Tags: credit-markets, derivatives, financial-regulation
Moody’s says global speculative-grade default rate will rise to a peak of 12.5% in the fourth quarter of this year and then decline sharply to 4.5% a year from now.
Excerpts from Moody’s “September Default Report”
The trailing 12-month global speculative-grade default rate finished at 12.0% in the third quarter of 2009, up from a level of 10.6% in the previous quarter and only 2.8% a year ago.
The U.S. speculative-grade default rate ended the third quarter at 12.9%, up from 11.5% in the second quarter, while in Europe the default rate rose to 9.3% from 6.4%. At this time last year, the U.S. and European default rates stood at 3.2% and 0.7%, respectively.
In all, a total of 50 Moody’s-rated corporate debt issuers defaulted in the third quarter, down from 89 in the first quarter and 83 in the second quarter. Last year, only 62 defaults were recorded in the first three quarters of the year.
For U.S. speculative-grade issuers, Moody’s forecasting model predicts that the default rate will peak at 13.5% in the fourth quarter before declining sharply to 4.4% by the third quarter of 2010.
Overall, the Automotive industry was the worst performer in the third quarter as seven companies in that sector defaulted. The Advertising/Publishing/Printing Media industry followed closely behind with six defaults. Across regions, 39 of the Q3 defaulters were based in North America while eight were from Europe. The remaining defaulters were domiciled in South America and Asia.
Across industries over the coming year, Moody’s default rate forecasting model indicates that the Consumer Transportation sector will be the most troubled in the U.S. and the Durable Consumer Goods sector will have the highest default rate in Europe.
Moody’s speculative-grade corporate distress index — which measures the percentage of rated issuers that have debt trading at distressed levels — stood at 28.1% at the end of the third quarter, down from 36.3% in the previous quarter. A year ago, the index stood at 26.8%.
Technorati Tags: corporate-default, credit-markets, junk-bonds, speculative-grade-bonds
IMF Staff Position Note says government interventions have helped, but a deterioration in the economic environment could impair the fragile recovery by big banks.
Excerpts from Policies to Address Banking Sector Weakness: Evolution of Financial Markets and Institutional Indicators
Since the measures by governments at end-March (including the G-20 meetings), the business environment in which some banks operate has improved, but a deterioration in the economic environment could impair the fragile recovery by banks. For instance, earnings in many U.S. banks were higher than expected in 2009:Q1 and 2009:Q2 and many banks passed the stress test unscathed. This is reflected in a reversal of the downward trend in the one-year forward consensus earnings per share for Swiss and U.S. banks.
…the economic forecast for the remainder of 2009 and 2010 is still gloomy and banks are not immune to a deterioration in the economic environment.
Through end-March 2009, the effects of the support measures on large complex financial institutions (LCFIs), financial markets, and stakeholders addressed immediate confidence issues in the banking system, but financial markets remained under stress. While liquidity and regulatory capital ratios were boosted significantly, profitability and earnings outlook of LCFIs deteriorated, their tangible common equity (TCE) remained at a critical level, and asset quality weakened. As a result, market confidence remained weak. While government guarantees for senior bank debt relieved some of the funding pressures, these actions did not avert the collapse in bank stock prices.
In credit markets, the situation remained highly dependent on official support, with highly rated issuers having access to central bank facilities while lower-rated issuers were credit- constrained. Moreover, structured credit product markets remained largely frozen except for agency-guaranteed issues.
Technorati Tags: bank bailout, big banks, credit-markets
Ratings agency expects default rate to decline after November.
Moody’s Liquidity-Stress Index continued to fall in September and at 14.0%, was down more than three percentage points for the quarter. This is the lowest that the Liquidity- Stress Index has been since October 2008’s level of 13.9%, said Moody’s in its latest “SGL Monitor Flash” report.
The sharp drop in the LSI highlights a trend of meaningful improvement in liquidity among speculative-grade corporate issuers, and offers more evidence that the default rate is likely to decline after November 2009.
The number of lowest-rated SGL-4 issuers fell last month to 72 from 78, down 32% from a peak of 106 at the end of March. SGL upgrades outnumbered downgrades by 5 to 1 in September, as refinancing, cash conservation and new debt continued to give issuers more breathing room.Overall, there have been 48 SGL upgrades and 22 downgrades since May 2009.
[Standard & Poor's said the junk bond default rate in the U.S. fell for the first time this year, coming in at an estimated 9.36% in September.]
Technorati Tags: corporate-default, credit-markets, junk-bonds, speculative-grade-bonds
But Standard & Poor’s sees continued deterioration of credit quality and restricted lending conditions.
Excerpts from Default, Transition, and Recovery: U.S. Credit Metrics Monthly: Default Rate Recedes In September
The speculative-grade default rate in the U.S. has fallen for the first time this year, coming in at an estimated 9.36% in September. However, credit metrics in the U.S. show continued deterioration of credit quality and restricted lending conditions, contrasted with signs of life among new issuance.
- The number of corporate defaults in 2009 slowed markedly in the U.S. in September, totaling eight during the month. This brings the year-to-date total to 155. The defaults in September are attributable to five nonfinancial sectors.
- The preliminary estimate for the U.S. 12-month-trailing speculative-grade default rate in September is 9.36% (subject to revision), down from the 10.4% in August and the first decline in the default rate this year.
We expect the speculative-grade default rate to escalate to a mean forecast of 13.9% by August 2010, but it could reach as high as 18% if economic conditions are worse than expected.
Technorati Tags: corporate-default, credit-markets, junk-bonds, speculative-grade-bonds
