my Say: Moratoriums for SMEs – an alternative to Islamic finance
As the repeated waves of the pandemic have brought new lockdowns and economic disruption, new calls for moratoria have been made. Moratoriums, however, only give borrowers a break but do not solve anything, nor are they sustainable in the long run. The fact that the same entities to which the moratorium was proposed earlier need it again speaks volumes about its effectiveness as a solution.
Moratoriums are the proverbial “kick the box”. As a potential squeeze in bank profits is often mistakenly seen as the only cost of a moratorium, such calls seem logical and even politically correct. There are, however, several issues with this.
First, a moratorium rests on the implicit hope that an imminent recovery will be strong enough to address corporate cash flow problems. However, the years of loosening monetary policy have resulted in a huge build-up of debt at all levels of the economy and this self-triage mechanism may therefore not work as expected.
Second, the moratorium increases the vulnerability of the banking sector since rescheduled loans are still on the books of banks. Automatic loan extension increases the duration of banks’ assets and their duration spread. Not only is there an overall deterioration in asset quality, but banks are also becoming more fragile as their duration spreads increase.
While there is no doubt that domestic businesses – especially small and medium-sized enterprises (SMEs) – facing disrupted cash flows need help, the problem is closely linked to the banking sector. A comprehensive solution would therefore require two things: first, loans to SMEs must be restructured in order to reduce the cash burden on SMEs; and second, rescheduled loans must be removed from banks’ balance sheets. This would ensure that asymmetries in asset quality and duration do not deteriorate and that banks remain able to issue new loans.
A solution to this multifaceted problem can be found by combining the risk sharing principles of Islamic finance with the securitization processes already used in the banking sector. Simply put, the process has two stages: the first, the restructuring of loans to SMEs at the level of the Islamic bank; and second, to slice them up through securitization and the issuance of sukuk.
The restructuring of SME financing is undertaken by lengthening the duration while simultaneously reducing the periodic rate of profit charged. This greatly reduces the debt service burden on SMEs.
For the bank, the change in content does not change the total principal amount outstanding, but the drop in the profit rate affects its results. This difference in the rate of profit must be paid by the SME according to its net profits in the form of dividends. Any shortfall in periodic payments due and / or dividends must be accrued on the principal outstanding.
Essentially, the financial obligations and financing costs of SMEs are relatively unchanged, but they enjoy repayment flexibility – much like equity. To minimize potential agency problems and moral hazard, there are built-in equity levers.
Note that at the revised deadline, one of the two outcomes is possible. The first is where all dividends and amounts due are paid in full and therefore everything is settled. A second result is one where there is an outstanding amount.
Here, if the position of the SME as a permanent concern is not altered, the equity kickers will be triggered. Otherwise, foreclosure is initiated to reclaim the underlying collateral. Equity is intended to provide the bonding effect that debt has on SME owners.
Moral hazard is reduced since equity kickers will mean not only a dilution of profits but also of ownership. It will therefore be painful for SME owners to try to take advantage of the flexibility offered.
It is evident that this first stage of restructuring requires prequalification parameters such as the availability of collateral, a good payment history, the three Cs of credit assessment (capital, capacity and character) and acceptance of the loan. SME equity.
The second step of securitization consists of grouping the restructured loans into tranches, taking into account the need for diversification, standardization of maturities and collateral coverage ratios.
The tranches are then monetized by the issuance of sukuk backed by the pooled assets. The sukuk are, in essence, passing through. (The proposed sukuk is a transfer since the bank that made the initial loan to an SME will continue to collect periodic repayments from the SME, but since it has now securitized and “sold” the loan, it will simply pass on the payments it receives from the SME to the ad hoc administrator and vehicle of the sukuk, who will then pass it on in the form of dividends or principal payments to the sukuk holders.)
A sukuk wakalah bi isthimar structure may be ideal. Listing and trading of these sukuk on existing exchanges or electronic trading platforms allows trading and liquidity in the secondary market. Designing part of the issue to be of low face value allows for retail participation.
The main advantage of this model is that it builds on processes and techniques already existing within the banking system. Thus, new infrastructure is little needed. Banks are already splitting and selling their assets through securitization; the regulatory framework for origination, securitization and trading are all currently in place.
As banks securitize and place portions of their loan portfolios, there will be an automatic reduction in the necessary capital requirements. In addition to the cost savings, this reduction allows the creation of new loans.
Investors in sukuk will get much higher returns than deposits. Since the underlying loans have already passed the banks credit rating and are secured, the credit risk is minimal. So, from a risk-return perspective, such a sukuk should offer superior tradeoffs.
Governments also benefit since the proposal does not impose any burden on their budgets. The key strength of the proposition, however, lies in the market-based solution that is offered. The efficiency of the allocation is not compromised, nor will there be deadweight losses or economic distortions.
Dr Obiyathulla Ismath Bacha is Professor of Finance at the International Center for Islamic Finance Education (INCEIF)