2016 – Islamic Finance Opportunities and Challenges

We anticipate that 2016 will be a year of both opportunity and challenge for the Islamic finance industry. New banking regulations across the EU bring to the fore issues that will need careful consideration when structuring and implementing Shari’ah compliant financing transactions. The lifting of EU and US secondary sanctions against Iran holds potential for the global Islamic finance industry. Geo-political and geo-economic circumstances are likely to see the continuing trend towards Islamic compliant wealth preservation transactions by investors.

Bank Recovery and Resolution Directive – “Bail-in”

January 1, 2016 saw the deadline for implementation by EU Member States of the provisions of the Bank Recovery and Resolution Directive (Directive 2014/59/EU) (“BRRD”) relating to “bail-in” powers set out in Articles 43 to 55 of BRRD. The aim of the bail-in regime is to remove the risk of tax payer-funded bailouts of EU banks and certain qualifying investment firms. The regime provides the relevant resolution authorities in member states with the power to bail-in the claims of unsecured creditors of financial institutions which are failing or likely to fail in order to enable failing financial institutions to be resolved and recapitalized without recourse to public funds. The regime provides the relevant resolution authorities with wide-ranging powers which include the ability to impose losses on an institution’s direct stakeholders through a bail-in whereby the claims of unsecured creditors can be written down or converted into equity.

In order to ensure cross-border effectiveness of bail-in powers, Article 55(1) of BRRD requires in-scope institutions to include a contractual term in contracts governed by the law of a non-EEA country whereby the creditor or party to the agreement creating the relevant liability recognises that the liability may be written down or converted under the BRRD bail-in tool and agrees to be bound by any reduction of the principal or outstanding amount due, conversion or cancellation that is effected by the exercise of those powers by a resolution authority.

BRRD – Islamic Finance considerations

The bail-in powers have a range of potential implications for the Islamic finance industry and present a number of challenges which will need careful consideration. The new powers may have implications for:

• Islamic banks and qualifying investment firms in the EU which are subject to BRRD; and
• Conventional banks which have become engaged in Islamic finance transactions and Islamic participants in such transactions.

Contractual recognition of bail-in

The bail-in regime provides resolution authorities with the power to write down debt or convert debt to equity. The bail-in powers also extend to other forms of unsecured liabilities of in-scope entities. The exercise of the bail-in powers under BRRD by a resolution authority will be recognised automatically within the EU. Article 55 of BRRD is designed to ensure bail-in measures are given effect outside the EU by requiring in-scope entities to include contractual terms in contracts creating relevant liabilities which are governed by non-EEA law whereby the counterparty acknowledges and accepts that the liability of the inscope entity may be subject to the BRRD bail-in powers. The application of the provisions is broad, applying to all liabilities which are not expressly excluded. BRRD expressly excludes only a limited range of liabilities such as deposits of individuals and small and medium sized companies, secured liabilities up to the value of the security, certain liabilities to employees and short terms liabilities of under 7 days to unaffiliated banks. Post January 1, 2016, in drafting Islamic contracts with in-scope entities which are governed by the law of an non-EEA country, consideration will need to be given as to whether the nature of the liability created falls within the scope of the bail-in provisions and if so, including contractual terms required by Article 55 of BRRD.

Conversion of Debt to Equity

The bail-in regime provides resolution authorities with the power to convert debt to equity. This may have wide-ranging implications across a range of Islamic finance structures. Recent trends in Islamic finance have seen conventional banks entering the Islamic finance market in a range of ways including raising Shari’ah compliant funding from Islamic investors through the issuance of Sukuk and facilities. In the case of Shari’ah compliant funding provided to a conventional institution, a debt-to-equity conversion may have the unintended consequence of the Islamic institution or investor becoming the holder of equity in a non-shari’ah compliant institution. Although Shrai’ah does recognise a concept of necessity where Islamic investors would be at a disadvantage, potential Islamic investors should consider the potential Shari’ah compliance implications of a debt to equity conversion under the bail-in regime and the actions to be taken in the event of such a resolution.

Bail-in and the Sukuk

The bail-in regime creates a number of potential issues in relation to Sukuk. The potential difficulties surrounding Sukuk may be augmented by the structure which is used and the issuing or originating entity. Applying the bail-in regime to Sukuk which are issued directly by an Islamic bank is less problematic as the Sukuk usually constitute liabilities of the bank, but the application of the regime to such liabilities may still present a number of challenges which will need to be considered in structuring the Sukuk.

Sukuk structures have become increasingly complex and may include a range of underlying Islamic compliant contracts. For example, a combined Murabaha/Wakala structure where proceeds are utilized by an SPV to make funding available to a conventional originating bank by way of Murabaha and Wakala may be impacted by a bail-in through the write-down or conversion of the Murabaha component. This, in turn, may result in the collapse of the structure.

Going forward, when structuring Sukuk, banks and investors should consider the extent to which Sukuk or underlying assets or contracts may be subject to bail-in.

Iran – the Islamic Finance opportunity

In January 2016, United Nations sanctions on Iran were lifted together with the majority of European sanctions which included an embargo on oil imports. In addition, the United States lifted its nuclear sanctions on Iran which included the imposition of penalties on banks and corporates from other jurisdictions conducting business with Iran. Iranian companies have been restricted from raising capital from western lenders and the lifting of sanctions may restore Iran’s access to global financial markets. The lifting of sanctions may provide a significant boost to the global Islamic finance market. Iranian banks make up the world’s largest Islamic financial system with assets estimated by the IMF to be around USD 482 billion or 40% (based on some estimates) of the industry total. Iran’s banking system is unique in that it operates fully in accordance with Islamic principles.

The impact of sanctions on Iran have seen a marked decline in investment in key economic sectors and it is anticipated that following easing of sanctions, significant investment projects requiring foreign investment will arise. Iran has indicated that in the oil sector alone, it will present investors with projects worth more than USD 100 billion. While the Iranian banking system combined with foreign direct investment may be utilized in respect of some of the planned investments, other forms of financing such as Sukuk are likely to be utilized to fund projects.

Iran has instigated a number of regulatory changes in recent years which will aid investment including changes clarifying the framework for Ijara Sukuk, allowing fiscal neutrality for SPV’s in Sukuk issuances and the introduction of regulatory requirements for Sukuk. It is however likely that further regulatory changes will be required to allow Iranian companies to utilize other accepted structures and to clarify if instruments may be issued under foreign law.

The lifting of sanctions in Iran provides an opportunity for Shari’ah compliant investment while also providing Islamic investors with diversification opportunities through investment in a growing economy which is diversified beyond dependence on oil.

Wealth Preservation – the new trend

Over the past year, the Middle East has experienced geo-political and geo-economic challenges. These challenges have led to a trend towards wealth preservation transactions with Middle Eastern investors investing an increasing amount of funds in stable Shari’ah compliant investments. In particular, we have noted increased interest from Middle Eastern investors to invest in and/or set up property funds across the UK and Europe. We anticipate an increasing demand for Islamic compliant investment opportunities across Europe in 2016.