Understanding Shariah Markets:
the key to profitable new product innovation
- Ascertaining client needs
- The growing demand for Islamic finance
- Discovering transparency across the Islamic client base
- Gathering momentum for product creation
- Researching liquidity, market making, volumes and pricing
Ranjeet Guptara
Chief Operating Officer, Public Sector & Infrastructure Finance
DEPFA BANK plc
Geneva, 28th May 2008
1. DEPFA’s experience of product innovation
2. Background to Islamic Finance
3. Possible avenues in Islamic Finance
2
DEPFA BANK plc is the only Bank focused on Public Sector & Infrastructure Finance
DEPFA
DEPFA has a portfolio of over €250bn in Government Related Investments, an
increasing portion of which is from the Middle East and in Shariah Compatible
Sukuk / Murabaha format.
3
Ascertaining client needs may be serendipitous but a strategy helps
Customer
Deposits
23%
CB Repo
14%
USCP
2% CAD CP
2%
FCP
5%
$50bn+
Yankee
11%
Interbank
22%
ECP
21%
Islamic
5%
Constantly
Innovating
New
Products
Customer
Deposits
22%
$1bn+
CB Repo
13% USCP
2%
CAD CP
2%
Yankee
10%
Interbank
21%
Constant diversification in response to client demand, e.g.:
Programmes Deposits, Commercial Paper, Certificates of Deposit, Repo
Currencies EUR, USD, CAD, GBP, CHF, JPY
Durations
overnight to 30 years
Ratings
A+ Unsecured Deposits to AAA Covered Bonds
Jurisdictions Germany, Ireland, USA…
4
FCP
5%
ECP
20%
Ascertaining client needs may be serendipitous but a strategy helps
New Clients
New Product
New Product Need Identified
Old Clients
Old Product
Client needs change due to variety of factors, for example:
-Same Investor Base but new realisations
- growing demand for Shariah Compliancy, e.g. Bahrain
- legal constraints, e.g. issuing out of New York branch vs. Dublin
- Changing Investor Base
- External shifts in wealth, e.g. Middle East, BRIC, Emerging Markets
- Internal shifts in policy, e.g. Credit allowing Corporate deposits
- Market changes e.g. better Repo rates, CAD market closing
5
What DEPFA can add to Islamic Banking
 DEPFA serve government clients and have strong existing relationships with Central Banks
 Islamic investors are willing to pay a premium for such a credit quality and for a product in line
with their religious beliefs
 DEPFA’s AA- credit rating is in line with Islamic Banking's desire to avoid gharar, or excessive
risk
 DEPFA will provide diversification in the market, as there are not enough providers of Islamic
products
 Diversity within Islamic depositary institutions is necessary to fulfil their regulatory requirements
as they cannot have more than 20% in holding with any one bank
 DEPFA’s willingness to become involved in the Islamic Market adds further liquidity and
transparency to the world of Islamic Finance
 DEPFA has already invested around $500m in Islamic Assets (Sukuk / Murabaha) where we see
attractive pricing opportunities (all investments in Sovereigns / Infrastructure)
Hypo Real Estate, our parent company, has successfully structured >$500m in Shariah compliant
Real Estate deals for Islamic investors since 2003.
6
Obstacles encountered
 Perception versus Reality
 DEPFA still feels like a European bank, with predominantly Irish / German roots
 Islamic Finance can be perceived as something very Alien, but “reprogramming”
is possible
 Lobbying at Board level before even asking for approval can create
opportunities: e.g. Sarbanes-Oxley / USA example
Reality
 Expectations management: not possible to launch overnight – relationship driven
 Often strategically interesting but questions raised about financial viability
(e.g. UK Treasury)
 Specific problems: much of DEPFA’s assets deemed “usurious” as a Bank
 General problems: Costs of legal, tax advice, Shariah board: $1m?
 Benefit vs. same costs involve in a US Registered 144A issuance?
 Internal operational barriers to overcome / departments to bring alongside
(New Product Process):





7
Legal / Tax / Compliance
Shariah Advisory Board
Risk Management
Accounting, Operations & IT
Products & Sales
contracts? jurisdiction? new customer forms (non-Irish resident)?
Necessary? Obligation on purchaser, not issuer (except retail)?
Commodities Risk? Reputational Risk? Counterparty Risk?
Transaction process through to settlement?
Fit with product palette? Marketing material? Potential clients?
Example Corporate Structure / Organisation
Relationship / sales
DEPFA BANK plc
Central Banks
+
ACS
PFB
Banks / Institutions
Places assets
If necessary
Autonomous SPV
sets up
Public Shariah
Funding Trust
services
monitors
appoints
when
necessary
Shariah
Board
Murabaha
Product
monitors
8
Shariah Funding Programme: Overview
DEPFA could profit from this rapidly growing market
“Total Sukkuk issuance in 2007 reached $40bn.
In 2006, $26.8bn was issued.
Seven years ago, issuance was just $336m.“ *(Gulf Times / Financial Times)
 DEPFA could take a “three step” approach to this market:



A. $1bn+ Money Market 90 day “Murabaha” (deferred sale) program – mid 2008?
B. Securitisation of $400m+ existing Islamic assets on the Balance Sheet – late 2008?
C. Eventual Sukuk issue (backed by IFU assets) by 2009?
 Clients



9
visited to ascertain interest for Shariah products since ‘07
HRE already has a track record with several smaller Shariah-compliant Real Estate products
The suitability of IFU Assets are being considered to collateralise potential DEPFA Sukuk
issuance, perhaps dedicated “water sukuk”.
Depend on client feedback to show where demand is greatest, for what amount, at what price
* Financial Times, quoting Islamic Finance Information Service, 3rd September 2007
Infrastructure
Finance
Asset quality: portfolio analysis
Parking
1.5%
Ports
4.2%
Waste Mgmt
0.4%
UK
55%
Sovereign
0.2%
BB1
9%
Telecommunications
4.2%
Accommodation
4.3%
D
0%
BBB3
13%
Water
22.9%
Rail / Metro
4.6%
B
0%
BB2
0%
Schools
6.6%
BBB2
6%
AAA
56%
Bridges /
Tunnels
7.7%
Roads
14.5%
Airports
8.3%
Healthcare
9.5%
Power
11.0%
Total Commitments:
€ 16.4 bn
10
BBB1
7%
Other
10%
USA
12%
France
4%
Canada
4%
Italy
6%
Australia
9%
90%+ in OECD countries
A3
3%
A2
2%
A1
2%
AA3
1%
AA2
1%
Average rating: A1
Investment Grade: 95%+
Treasury:
Capital Markets: DEPFA ACS Secondary Market Levels
DEPFA ACS current levels vs peers - USD market
Asset Swap Spread (bp)
20
10
0
DEPFA ACS
-10
BNG
-20
KfW
EIB
-30
-40
2009
FNMA
DEPFA ACS
2011
2013
2015
2017
2019
FNMA
2021
2023
EIB
2025
KfW
2027
2029
BNG
2031
2033
2035
Source: Dresdner 25th October, 2007
DEPFA ACS current levels vs peers - EUR market
Asset Swap Spread (bp)
0
-5
-10
DEPFA ACS
EIB
Eurohypo
-15
-20
Dexma
FHLMC
KfW
-25
-30
-35
-40
-45
-50
2009
DEPFA ACS
2011
Source: Morgan Stanley 25th October, 2007
| 11 |
2013
EIB
FHLMC
2015
2017
Dexma
2019
Eurohypo
2021
KFW
2023
2025
2037
Treasury: Capital Markets
DEPFA ACS USD 1.25bn 5.125% due 16 March 2037
Transaction Details
Issuer:
Rating:
Bookrunners:
Size:
Coupon:
Settlement:
Maturity:
Pricing:
Format:
Listing:
DEPFA ACS BANK
Aaa/AAA/AAA
Goldman Sachs,
Merrill Lynch,
Morgan Stanley
USD 1.25 billion
5.125%, annual
15 March 2007
16 March 2037
US Treasury +57.25 bps,
Mid Swaps +2 bps
Euro/144A
Dublin
Transaction Highlights
I This landmark transaction is DEPFA’s first ultra-long ACS issue and the first ever 30yr USD
covered bond
I US accounts bought 88% of the deal, the rest being sold in Europe
I 79% of bonds were allocated to accounts that had not participated in any of the last 3 DEPFA USD
transactions
I The largest amount went to Funds (73%), followed by Insurance (16%), Pension Funds (7%) and
Central Banks (4%)
I The total order book reached USD1.8 bn, the largest order book that DEPFA has had on a USD
deal, and included 30 orders ranging from USD 0.5mn to USD290mn
I This transaction priced at UST +57.25 bps which corresponds to m/s +2 bps
I The decision to price at +2 was based on two factors: DEPFA's standard approach in terms of fair
pricing to recognize in the Treasury spread if there has been a material move in swap spreads
during the process and to bring in brand new accounts to the Covered Bond market who felt more
comfortable at +2
Investor Allocation by geography
Investor Allocation by geography
Investor Allocation by type
Investor Allocation by type
Insurance
16%
US
88%
US
88%
Funds
73%
Europe
12%
| 12 |
Insurance
16%
Europe
12%
Funds
73%
Pension
Funds
7%
Pension
Funds
7%
Central
Banks, 4%
Central
Banks, 4%
Meeting with Lawyers regarding Shariah Funding
Clifford Chance Dubai
1. Introduction
„DEPFA BANK is responding to client demand from Asset Managers and Middle
Eastern Central Banks in investigating a Shariah compliant funding programme.
DEPFA will only issue to institutional clients.“
2. Funding Volume
Initial client demand estimates are in the €1–2bn area. No single client will be >€200m.
3. Duration
Flexible, up to 2 years maximum at present.
4. Structure
Murabaha; perhaps forex or metals based, although other commodities might be
possible.
5. Shariah Board
Willing to consider London or middle-east based advisors
6. Commercial Structure
We have been informed it may be best if a separate company is set up eventually, and
a rolling funding programme established. Compare with DEPFA ACS Bank specially set
up to issue Irish Covered Bonds.
7. Timing
We intend to have a product ready before or shortly after a planned Gulf Roadshow in
late Q3 / early Q4.
8. Costs
Do you have examples of legal advice / documentation / shariah compliance costs
incurred by similar banks? If so, for what programmes over what period of advice?
| 13 |
Project Organisation
Sharia Products Steering Committee
| 14 |
Brian Farrell (Chair)
Kieran Walsh
Des Moran (Legal)
Ranjeet Guptara
(Project Leader)
Money Markets
Sales
Legal Counsel
Sarah Lea
(Project Office)
| 15 |
1. DEPFA’s experience of Product Innovation
2. Background to Islamic Finance
3. Possible Avenues in Islamic Finance
16
Introduction to Islam

Islam is the religion founded by Muhammad (Peace be upon him).

Muslims are the followers of the religion of Islam

“Islam” means “Surrender”(to the will of Allah)

Muslims believe Muhammed (PBUH) was the final prophet of Islam



17
Muslims claim Adam, Abraham, and Moses as previous prophets of Islam. While Muslims recognise
Jesus as a virgin-born prophet, who will judge the earth, they do not revere him as God. Muhammad
takes the title “paraclete” which is reserved for the Holy Spirit in the Bible.
Muhammad’s life is documented in the Qur’an, Sunna and Hadith, but some question
historicity

Muhammad was born in c.570 AD in the city of Mecca in Arabia and died in 632 AD in Medina

He was a merchant by trade, and started preaching around the age of 43

Following persecution he became a warrior, leaving Mecca in 622 AD
There are “5 pillars of Islam”:

Shahadah ~ Profession of faith

Salah ~ Prayer

Zakah ~ Almsgiving (2%)

Sawm ~ Fasting during Ramadan

Hajj ~ Pilgrimage to Mecca
Islamic Geography




Islam spreads across around 20%1 of the worlds population, or 1.2bn people2
Muslims are also increasingly prevalent in the west: USA: 3m, Germany: 3m, UK: 2m, Ireland: 30k
The majority of estimated $400bn+ of Muslim institutional wealth is in the Gulf, where Islamic Finance is
requested by around 75%3 of the population, but has only c.20% penetration in banking products
There are three axes of strictness – Malaysia and the Far East (lax), Gulf/Subcontinent (strict), Cairo (sidelined)
Kuwait
Riyadh Bahrain
Dubai
1: Todd Johnson, "Religious Projections for the Next 200 Years," World Network of Religious Futurists, at: http://www.wnrf.org/articles/next200.htm
18 2: Samuel Huntington, "The Clash of Civilizations and the remaking of world order," Touchstone Books, (1998), Pages 65 to 66.
3: Abdulkader Thomas: “Structuring Islamic Finance Transactions”, Euromoney (1995)
4: Map Source: University of Texas
Moses’ Finance
•
•
•
•
19
The Old Testament has several reminders not to lend money with usury.
“If you lend money to any of my people, even to the poor with you, you shall
not be to him as a creditor; neither should you lay upon him interest. (Exodus,
22:24)”
“And if your brother become poor…; then you should uphold him: as a
stranger and a settler he should live with you. Take no interest from him, but
fear God. You shall not give him money for interest, nor give him food at your
profit.” (Leviticus, 25:35-37)
“You shall not lend on interest to your brother: interest of money, interest of
food, interest of any thing that is lent upon interest. To a foreigner you may
lend on interest; but to thy brother you shall not lend upon interest; that the
LORD your God may bless you in all that you put your hand to, in the land
where you go in to possess it.” (Deuteronomy, 23:20-21)
Jesus’ Finance
•
•
•
20
Jesus gave us two parables in the New Testament that refer to concepts of
"usury" or "interest" both approving of the concept in principle.
In the parable of the gifts or talents, Jesus gives the story of a rich owner
(representing God the Father) who says to the lazy servant “Why didn’t you
put my money into the bank, that I would have been able to get usury on my
money?” (Gospel of Luke, 19:23).
Many people have thought that this meant Jesus didn’t mind usury. However,
this was an amusing absurdity to a Jewish audience; and shows that even
the great sin of usury was considered less than wasting the opportunities and
talents God has given.
Christian Finance
•
Already from the earliest church councils (Council of Nicea, AD 325) Usury was
considered a crime. The poet Dante ranked usury as a crime for the 7th circle, the
lowest pit of hell!
•
Previously, even the Greek philosopher Aristotle said that "to live by usury is
exceedingly unnatural".
•
St. Thomas Aquinas, the leading 12th Century theologian of the Catholic Church,
argued charging of interest is wrong because it amounts to "double charging",
charging for both the thing and the use of the thing.
•
Aquinas said this would be morally wrong in the same way as if one sold a bottle of
wine, charged for the bottle of wine, and then charged for the person using the wine to
actually drink it.
•
In the 13th Century, Cardinal Hostiensis argued that the principle of lucrum cessans
(profits given up) allowed for the lender to charge interest "to compensate him for
profit foregone in investing the money himself."
•
In the Fifth Lateran Council, (AD 1512 – 1517) Pope Leo X made the first concessions
to usury in the Catholic Church (the Medici Family as the foremost bankers in Europe
had already made Usury widespread).
21
Islamic Finance
•
•
•
22
Those who charge usury are in the same position as those controlled by the
devil's influence. This is because they claim that usury is the same as
commerce. However, God permits commerce, and prohibits usury. Thus,
whoever heeds this commandment from his Lord, and refrains from usury, he
may keep his past earnings, and his judgment rests with God. As for those
who persist in usury, they incur Hell, wherein they abide forever (Al-Baqarah
2:275)
God condemns usury, and blesses charities… O you who believe, you shall
observe God and refrain from all kinds of usury, if you are believers. If you do
not, then expect a war from God and His messenger. But if you repent, you
may keep your capitals, without inflicting injustice, or incurring injustice. If the
debtor is unable to pay, wait for a better time. If you give up the loan as a
charity, it would be better for you, if you only knew. (Al-Baqarah 2:276-280)
O you who believe, you shall not take usury, compounded over and over.
Observe God, that you may succeed. (Al-'Imran 3:130)
Islamic Economics

Islamic Finance is based upon two principles:
 No “riba” (“usury”, or interest from money)
 No “gharar” (excessive risk) / equitable approach to risk sharing

Islamic Finance was overtaken by colonialism around the 17th century

The resurgence of Shariah-compliant finance began in Egypt in the 1960s as
a micro-finance experiment in the Nile Delta town of Mit Ghamr by Dr. Ahmad
Elnaggar.

Islamic economics is economics in accordance with Islamic law. There are
two paradigms:
 one assuming the political framework is Islamic (i.e., Khilafah)
 the other assuming the political framework is non-Islamic, resulting in a
paradigm that seeks to integrate some prominent Islamic tenets into a
secular economic framework
23
Debt Arrangement

Most Islamic economic institutions advise participatory arrangements between capital and labor.

The latter rule reflects the Islamic norm that the borrower must not bear all the cost of a failure, as
"it is God who determines that failure, and intends that it fall on all those involved.“

Conventional debt arrangements are thus usually unacceptable - but conventional venture
investment structures are applied even on very small scales.

However, not every debt arrangement can be seen in terms of venture investment structures.

For example, when a family buys a home it is not investing in a business venture - a person's
shelter is not a business venture.

Similarly, purchasing other commodities for personal use, such as cars, furniture, and so on,
cannot realistically be considered as a venture investment in which the Islamic bank shares risks
and profits for the profits of the venture.
24
Problems with Islamic Finance

There is a lack of census on Shariah compatibility

Shariah scholars opine on what is allowed (negative constraints: do not invest in pork,
gambling, pornography, idolotrous industries)

This is different from Ethical Investing as promolgated by e.g. Sustainable Asset
Management (www.sam-group.com) or the FTSE 4 Good index.

Venture Philanthropy / Social Entrepreneurship may be a way to combine these issues
of conscientious investing
25
1. DEPFA’s experience of Product Innovation
2. Background to Islamic Finance
3. Possible Avenues in Islamic Finance
26
Dow Jones Citigroup Sukuk Index (since March 2006)
Increasing
Volatility
But still
somewhat
of a hedge to
mainstream
bond classes
27
Proponents of Shariah Products
Many Investment and Corporate Banks appreciate the liquidity in the Middle East and South-East Asia
Sukuk underwriting League table 2008 ytd: Total $6bn, 93 Issues, 28 underwriters, fees ~0.5%
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
28
Calyon
HSBC
Aseambankers Malysia Berhad
Morgan Stanley
Dubai Islamic Bank
Emirates NBD
JP Morgan
Standard Chartered
CIMB
Affin Investment Bank Bhd
Deutsche Bank
UBS
AM Investment Bank Bhd
Gulf International Bank
OSK Investment Bank
Bank Islam Malaysia Berhad
Kuwait Finance House
Commercial Bank of Qatar
Qatar Islamic Bank
Qatar National Bank
Source: Bloomberg, May 2008
New Issues Monitor: Signs of increasing activity and recovery
Many Investment and Corporate Banks
May 2008: Islamic Bond Market
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
29
Malaysia
3.4%
Bahrain Leasing
2.4%
Bank Negara
0%
SABIC
FRN
RAK Capital
FRN
SBI Syariah
8.24%
Horizon Hills
4.1%
Jimah Energy
9.85%
Almana
FRN
HBFC
FRN
Aras Sejagat
4.85%
Hong Leong Industry 4.8%
Nakheel Development FRN
Tabreed
7.5%
Total Mobile
6.5%
Austrian Volksbank
FRN
Source: Bloomberg, May 2008
100m MYR
5m BHD
600m MYR
5,000m SAR ($~1.3bn)
1,000m AED
544bn IDR
30m MYR
240m MYR
(12 to 16 year maturity)
600m AED
1.5bn PKR
420 MYR
50m MYR
3.6bn AED ($1bn)
1.7bn AED
10m MYR
10m EUR
Market Size

Islamic finance has been gaining momentum on a global scale for the last 30 years, and
offers profitable opportunities for institutions and individual investors of all sizes.

The Industry size is currently estimated at more than $400 billion

The projected growth is at least 15% per annum.
30
The Market is growing: Grow with it!
Morgan Stanley said the $40bn sukuk issued by the GCC companies in 2007 could have
exceeded $50bn, had it not been for the liquidity crunch in the second half of 2007. Despite
current constrained liquidity, we expect growth in new sukuk issues to remain high in double-digit in
2008 and 2009? though the cost of debt was not likely to retract significantly? from the current levels,
it said. It said the GCC companies cannot afford to postpone their expansion for much longer and
added we expect Gulf-based banks, particularly the Islamic banks, to emerge as sukuk issuers.? The
reasons for the Gulf banks to emerge as sukuk issuers were due to the fact that growth in customer
deposits has been lagging growth in assets, particularly at the UAE banks, and also competition for
deposits had intensified in a negative real interest rate environment.
Moreover, we forecast a high teens CAGR (compounded annual growth rate) in assets in the next few
years, which should push banks to raise more sizeable medium-to-long-term funding, it said.
Highlighting that sukuk was one of the fastest growing financial instruments globally; Morgan Stanley
said it expected them to be largest contributor to sustained double-digit growth in Islamic finance.
It said total outstanding issued sukuk were more than $90bn, of which 40% were international
issues. Between 2003 and 2007, sukuk registered a CAGR of 60%. Islamic bonds have been issued
in 14 countries and in more than 10 currencies, it said, adding, Malaysia has issued 55% of
sukuk to data and the UAE 20%. Sukuk has also been issued by corporate houses and
sovereigns/quasi sovereigns including Malaysia, Pakistan, Qatar, Bahrain, Brunei and the UAE, it
said.
31
UK Government considers issuing Sukuk before 2009

London, April, 23, IRNA


Britain is seeking to become the first country in west to issue Islamic bonds, it was reported Monday.
Shariah-compliant bonds have previously been issued by the governments of Pakistan and Malaysia and also
by corporate issuers around the world but never by a western nation.
But according to the Financial Times, Treasury Secretary Ed Balls was set to announce Monday that Britain
was paving the way for the launch of such bonds no later than next year in a bid to bolster London's claim as a
centre for Islamic finance.
Britain will conduct a feasibility study into issuing Islamic bonds in a bid to bolster London's standing as a
centre for Islamic finance, Balls will say in a speech on Monday.
"Balls also believes that today's move will send a powerful message to the Muslim community both in Britain
and around the world that the UK authorities are intent on engaging with them in innovative ways," the daily
said.
The UK's aim was said to be not only to issue the new bonds on wholesale financial markets but also to use
them as vehicles to allow Muslims in Britain to invest in National Savings products through banks and post
offices.
Britain's Treasury, which hosted a summit last week with leading members of the Muslim community, has
estimated that total Islamic finance assets worldwide, including private equity and bonds exceed dlrs 250
billion.
The Financial Times said that although it has not yet worked out what the underlying structure of UK-issued
Islamic bonds will be, Balls was "confident that the technical details can be worked out by the Debt
Management Office and Treasury officials."
The move comes after Chancellor of the Exchequer Gordon Brown announced in his annual budget last month
that new measures will be introduced for sukuk, a Shariah-compliant trust certificate, so they can be issued,
held and traded in the same way as corporate bonds.
Issuing sukuk, or Islamic bonds that make regular payments to investors, is usually considered to be
slightly more expensive than raising funds with western-style bonds, because they require extensive,
costly legal and religious advice.
But Balls last week reiterated the British government's determination to create a level playing field for Islamic
finance products, with UK banks already declaring a range of Shariah- compliant services.








32 http://www2.irna.ir/en/news/view/menu-237/0704233373152608.htm
33
Sarah Lea
Project Management
DEPFA BANK plc
Ranjeet Guptara
Public Sector Finance
DEPFA BANK plc
1 Commons Street
Dublin 1, Ireland
105 Wigmore Street
London W1U 1QY, UK
Tel.: +353 1 792 2222
Fax: +353 1 792 2211
www.depfa.com
Tel.: +44 2072908482
Fax: +353 1 792 2211
www.depfa.com
Thank You!
34
Thank You!
35