As promised in the last article, today I will explain how a genuine hybrid structure can be adopted to mitigate various risks for investors of Sukuk.

When I say ‘genuine’, my reference is toward the synthetic Murabahah–Mudarabah structure I discussed in article 174 where Mudarabah is calculatingly made inert and full reliance is made on Murabahah for providing a periodic distribution amount (profit) to Sukukholders as well as to redeem them at the end of the Sukuk term.

Why do some industry practitioners opt for such a superficial structure? The answer is to ward off criticism of excessively relying on a single commodity Murabahah transaction. By combining Mudarabah with Murabahah, they believe the structure becomes tolerable by the scholars and the critics of the commodity Murabahah approach.

Another motive to overemphasize the Murabahah role in the hybrid structure is to make the Sukuk fast sellable to the institutional investors and the fund managers from the conventional world who are accustomed to accepting the credit risk similar to conventional bonds, and may not appreciate the equity, performance and the rate of return risks in a Sukuk offering. Let me explain how the practitioners can achieve similar results from the genuine mix of Musharakah with Ijarah that they aim to get from the Murabahah–Mudarabah hybrid structure.

Assume an Islamic bank customer would like to purchase a 10-storey tower for investment purposes and requests for 80% finance from the bank. Pursuant to approval, the bank agrees to invest 80% and the asset is jointly purchased by the bank and the customer through entering into a Musharakah agreement.

The Musharakah agreement stipulates that the bank and the customer together hold an undivided pro-rata ownership of 80:20 respectively and that the profit generated by the Musharakah asset shall be distributed as per an agreed ratio. However, the bank would like to mitigate (and not eliminate) the operation, performance or market and the rate of return risks, and to a certain degree the ownership risk as well. What should the Islamic bank do to secure itself from these risks?

The Islamic bank shall enter into the Ijarah Muntahiya Bil Tamleek (IMBT) or the financial lease agreement with the customer whereby it will lease its part of the ownership in the Musharakah asset to the customer for an agreed period of time — usually the entire tenure of the Musharakah agreement.

During the lease tenure, the customer shall pay to the bank the lease rent on a periodic basis, which shall be comprised of the two elements viz. the profit to the bank on its investment and the recovery of the bank’s investment in acquiring the Musharakah asset. By leasing its part in the ownership of the Musharakah asset on the IMBT basis, the Islamic bank will successfully be able to mitigate the following risks:

Operational risk: Having leased its part of the joint ownership in the asset to the customer, the Islamic bank will not be responsible for day-to-day operation and management of the asset. By default, the customer shall be liable to manage the entire asset, ie its own share of the asset besides the Islamic bank’s share, which it has taken on lease.

Performance or market risk: By obtaining the bank’s part of the ownership in the Musharakah asset on lease, the customer shall be responsible for renting the entire asset out to third parties. Hence, the Islamic bank shall stand spared from assuming the performance or market risk. The asset can be leased by the customer either at higher than the lease rent agreed with the Islamic bank or lower than that, based on fluctuating market conditions.

In my opinion, the customer shall certainly be in a position to lease the asset at the rent, which is higher than the amount it shall pay to the Islamic bank. This is because the Islamic bank’s rent shall be in parallel to the pricing charged by the conventional banks on the term loan for a similar amount and tenure.

Rate of return risk: Since the Islamic bank would enter into a financial lease agreement with the customer for the entire Musharakah term at an agreed lease rent, it would ensure a regular and known rate of return for itself. In other words, the Islamic bank shall be able to shield itself from the ups and downs in the return on investment which it would have been exposed to had it been leasing the asset jointly with the customer.

Ownership risk: By entering into the IMBT agreement with its partner (ie the customer), each time the customer shall pay the lease rent, a part of the equity invested by the bank in acquiring the asset shall stand recovered by the bank. On the other hand, the bank’s share in the title or ownership of the asset shall remain static until the end of the lease term when the bank would have fully recovered its equity in the asset. This way, the Islamic bank’s security position shall continue to get strengthened since on one hand, it will be getting the equity redeemed and on the other it will continue to enjoy the original share in the ownership/title of the jointly owned asset.

Credit risk: By adopting the aforesaid model, the Islamic bank would be able to convert the operational, performance and market risks into credit risk for so long as the lease agreement is not defaulted by the customer.

In view of the foregoing, it is apparent that by adopting the hybrid Musharakah–Ijarah structure for Sukuk, the Islamic capital market stakeholders shall be able to achieve the same result that they get by going through the synthetic Murabahah–Mudarabah approach. What happens if the customer is unable to comply with the financial lease terms and there is default? I will hold my horses until the next week.

The purpose of this educative series and the article is not to hurt any religious or commercial sentiments either consciously or even unwittingly.

Sohail Zubairi is an Islamic finance specialist and AAOIFI-certified Shariah advisor and auditor. He can be contacted at [email protected].

Next week: Discussion on Sukuk transactions shall continue.