my Say: Moratoriums for SMEs — an Islamic finance alternative

This article first appeared in Forum, The Edge Malaysia Weekly, on June 28, 2021 - July 04, 2021.
my Say: Moratoriums for SMEs — an Islamic finance alternative
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As repeated waves of the pandemic have led to new lockdowns and economic disruption, there have been renewed calls for moratoriums. Moratoriums, however, merely offer borrowers breathing space but do not solve anything, nor are they sustainable in the long term. The fact that the same entities offered the moratorium earlier are in need of it again says much about its efficacy as a solution.

Moratoriums are the proverbial “kicking the can down the road”. As a potential squeeze on bank profits is often mistaken as the only cost of a moratorium, such calls seem logical and even politically correct. There are, however, several problems with this.

First, a moratorium is based on the implicit hope that an impending recovery will be strong enough to sort out the cash flow problems of businesses. However, the years of monetary policy looseness has meant huge debt accumulation at all levels of the economy and so this self-sorting mechanism may not work as expected.

Second, the moratorium increases the vulnerability of the banking sector since the rescheduled loans are still on the banks’ books. The automatic lengthening of the loans increases the duration of the banks’ assets and their duration gap. Not only is there an overall deterioration in asset quality but banks also become more fragile as their duration gaps increase.

While there is no doubt that domestic businesses — particularly small and medium enterprises (SMEs) — faced with disrupted cash flow need help, the problem is closely intertwined with the banking sector. A holistic solution therefore would require two things: First, the SME loans need to be restructured in order to reduce the cash flow burden on SMEs; and second, the rescheduled loans need to be removed from banks’ balance sheets. This would ensure that asset quality and duration mismatches do not deteriorate and banks remain in a position to originate new loans.

A resolution to this multifaceted problem can be found by combining the risk-sharing principles of Islamic finance with the securitisation processes already in use within banking. Simply put, the process has two stages — the first, restructuring the SME loans at the level of the Islamic bank; and second, carving them out through securitisation and sukuk issuance.

Restructuring of SME financing is undertaken by lengthening the tenor while simultaneously reducing the periodic profit rate charged. This substantially reduces the debt-servicing burden of the SME.

For the bank, the change in tenor does not change the total principal outstanding, but the reduced profit rate impacts its earnings. This difference in the profit rate is to be paid by the SME dependent on its net profits as dividends. Any shortfall in the periodic payments due and/or dividends are to be accumulated to the outstanding principal.

In essence, the SMEs’ financial obligations and funding costs are relatively unchanged but they are being provided flexibility in repayment — à la equity. To minimise the potential agency problems and moral hazard, there are in-built equity kickers.

Note that at the revised maturity, one of two outcomes is possible. The first is where all due dividends and principal amounts are paid in full and so everything is settled. A second outcome is where there is still an outstanding amount.

Here, if the SME’s position as an ongoing concern is unimpaired, the equity kickers will be triggered. Else, foreclosure is initiated to recover underlying collateral. The equity kickers are intended to provide the bonding effect that debt has on SME owners.

Moral hazard is reduced since the equity kickers will mean not only dilution of earnings but also of ownership. It will, therefore, be painful for SME owners to try and take advantage of the flexibility provided.

It is obvious that this first step of restructuring requires prequalifying parameters like availability of collateral, good payment track record, the three Cs of credit assessment (capital, capacity and character) and acceptance of the SME of equity kickers.

The second stage of securitisation involves the pooling of the restructured loans into tranches, taking into consideration the need for diversification, standardisation of maturity and collateral coverage ratios.

The tranches are then monetised through the issuance of sukuk backed by the pooled assets. The sukuk are, in essence, pass through. (The proposed sukuk is a pass through since the bank that gave the original loan to an SME will continue to collect the periodic repayments from the SME, but as it has now securitised and “sold” the loan, it will simply pass on the payments it receives from the SME to the sukuk’s administrator and special purpose vehicle, which will then pass it on as dividends or principal payments to sukuk holders.)

A sukuk wakalah bi isthimar structure may be ideal. Listing and trading these sukuk on exchanges or existing electronic trading platforms enables secondary market trading and liquidity. Designing a portion of the issuance to be of small denomination makes it possible for retail participation.

The main advantage of this model is that it leverages processes and techniques already existing within the banking system. Thus, there is little need for new infrastructure. Banks already carve out and sell their assets through securitisation; the regulatory framework for origination, securitisation and trading are all currently in place.

As banks securitise and place out parts of their loan portfolio, there will be an automatic reduction in needed capital adequacy requirements. Besides the cost saving, this reduction enables new loan origination.

Investors in the sukuk will get much higher returns than from deposits. Since the underlying loans have previously passed the credit evaluation of banks and are collateralised, credit risk is minimal. Thus, from a risk-return viewpoint, such sukuk should offer superior trade-offs.

Governments, too, benefit since the proposal imposes no burden on their budgets. The key strength of the proposal, however, lies in the market-based solution being offered. Allocative efficiency is not compromised, nor will there be any dead-weight loss or economic distortions.


Dr Obiyathulla Ismath Bacha is professor of finance at the International Centre for Education in Islamic Finance (INCEIF)

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