Muscat – Moody’s Ratings has said that a proposed new Sharia’a standard may slow down the vibrant sukuk issuance market. A new draft standard, Shariah Standard 62, proposed by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), mandates that Islamic sukuk be effectively backed by underlying assets rather than merely referencing such assets in their structure, as has been the case until now.

This change would constitute an asset transfer to sukuk holders rather than the assets remaining owned by the issuer. Such a fundamental shift would likely cool sukuk issuance, according to Moody’s.

‘Sukuk holders of AAOIFI Shariah Standard 62-compliant instruments would be exposed to the performance risk of the underlying sukuk assets, although they may benefit in the event of an issuer insolvency in terms of recovery prospects relative to unsecured creditors. The proposed standard would also increase the legal complexity of the sukuk structure and might raise transaction costs, probably prompting some issuers to seek alternative funding options,’ Moody’s said in a report.

The proposed new standard, according to Moody’s, would fundamentally alter the credit risk of a typical sukuk. ‘Under the proposed Sharia’a standard, newly issued AAOIFI-compliant instruments would be asset-backed, and holders would essentially be exposed to the performance risk of the underlying assets. However, the new standard could potentially improve holders’ recovery prospects compared to unsecured creditors in the event of issuer insolvency.’

If approved in its current form and adopted by banking regulators, Shariah Standard 62 would increase the legal complexity of the sukuk structure and raise transaction costs, according to Moody’s.

Moody’s further stated that, in a distressed scenario, the issuing company would no longer be able to sell the sukuk’s underlying assets to raise cash. ‘This reduces the buffer the issuer has available to absorb unexpected shocks. The proposed standard will also limit the ability of issuers that already have considerable secured debt in their capital structure to raise new sukuk.’

Moody’s noted that, due to the proposed new standard, cross-border sukuk issuance would be more disrupted than domestic issuance.

It said, ‘AAOIFI Sharia’a standards are only fully adopted in 12 countries, and we expect local currency issuance in those countries will be disrupted by the new standard if implemented as proposed. Issuers based in those 12 countries accounted for only 13% of total local-currency sukuk issuance in 2023, so the new standard will have minimal global impact.’

However, the rating agency added that issuers domiciled in countries that fully adopt AAOIFI standards make up 24% of 2023 cross-border sukuk issuance, indicating a greater risk of disruption.