February 2013

February 3, 2013

In the wake of the Arab Spring, the Libyan banking system faced a crisis of confidence amidst a shortage of currency, despite the government monetizing its deficit by issuing bonds to the Central Bank and withdrawing the proceeds to finance the budget deficit.  To stem the flow of cash out of the country’s banks, the central bank placed caps on the amount of currency depositors could withdraw.  In June 2012, the central bank lifted these limitations.

Prior to the lifting of the limitations on withdrawals, the government approved an Islamic banking law, which was expected to go into effect by the end of 2012 (it is not clear whether it has yet).  Even with the Islamic banking law still being implemented, Qatari Islamic bank Masraf al-Rayan said it is seeking approval from its shareholders to acquire an unnamed Libyan commercial bank.

Since there are currently no Islamic banks to speak of in Libya, any acquisition by Masraf al-Rayan, which is a wholly Islamic bank, would have to be converted from conventional to Shari’ah-compliant following an acquisition.  In most cases, the process is difficult because banks hold most of their assets in conventional loans that have to either mature or be converted from interest-based to Shari’ah-compliant.  As a result, most Islamic bank conversions are done over a multi-year period.

Within Libya, the process of converting the bank’s assets might be easier due to the high levels of liquid assets held in the banking system.  A 2012 IMF report (PDF), Libyan banks held 74.3% of their total assets in the form of liquid assets (mostly deposits with the country’s central bank) as of 2010.  The remaining assets that were loans had a high level of non-performing loans, 17.2% in 2010, but the banks were well capitalized with regulatory capital as a share of risk-weighted assets of 17.3% and the ratio of provisions to non-performing loans was 85%.

Of course, these figures were from 2010 before the revolution toppled Muammar Qaddafi.  As a result, the NPL has likely risen substantially, particularly since many loans were likely made to those connected with the former regime.  In addition, the assets put up as collateral for these loans is likely to be confiscated by the government, so the recovery rate on the regime-connected NPLs will be high.

An Islamic bank entering the market through an acquisition (perhaps of one of the central bank-owned commercial banks) will have to likely write-off many of the existing assets, while also stemming the tide of withdrawals by depositors.  The links to the reports on the Central Bank website on more recent statistics on the banking sector are broken, so it is hard to tell whether there are publicly available data on the deposits held today by Libya’s banks.

That being said, however, there will be an easier process of shifting borrowers and depositors into Shari’ah-compliant products since many of the few loans made are likely to be in default and need to be written off.  On the liability side, the bank can provide depositors with confidence in their deposits through the bank’s link with its new parent bank, as well as holding up its status as one of the country’s few Islamic banks (assuming other Islamic banks open once the Islamic banking law takes effect).  Even if depositors do withdraw their deposits, the banks’ high levels of liquid assets should make a bank run that threatens the bank’s solvency a relatively remote risk.

Once the bank’s balance sheet is stabilized and the loans written off that need to be written off, what can a foreign-owned Islamic bank offer to the country?  One of the main things that a foreign owned bank of any kind—conventional or Islamic—can offer is management expertise.

With a mostly state-owned banking system formerly directed by the former regime, there are likely to be few skilled people working in the top levels of these banks with the necessary experience to run a private sector bank particularly for an Islamic bank, since they have been absent from the market.  There will—and should—be an effort by a new Islamic bank to attract Libyans who have been living outside Libya with experience in Islamic banking to return while training programs are established to provide the necessary training of Libyans to work in the bank.

There should be a focus also within the bank on providing financing for the non-oil sector which was growing prior to the Arab Spring which represents a small part of the economy (less than 30% according to the IMF) and a negligible part of the country’s exports.  These are areas that would benefit the country the most, although that is not necessarily the grounds by which an Islamic bank will prioritize its activities.  But, this type of business would likely provide the greatest return to the country in terms of employment increases.  With a small private sector there should be opportunities that other commercial banks have not yet targeted that can be profitable for the bank while also facilitating the development of the ‘real economy’.

It is not likely to be an easy path for a bank like Masraf al Rayan to acquire a Libyan commercial bank and convert its operations to become Shari’ah-compliant, let alone then go and make it profitable.  However, there is likely to be a source of stable depositors in the country for a bank that can offer Islamic banking and also leverage its management’s experience to project a level of security that the bank will remain solvent and its depositors’ money will be protected.  That will provide it with the resources it needs to make a contribution to the economic growth of the country’s ‘real economy’, hopefully including the non-oil private sector.

February 17, 2013

Arcapita is setting a lot of ‘firsts’ in 2012 and 2013, not all of them good for Arcapita’s shareholders and creditors, but all of which should be good for the Islamic finance industry, since they provide some certainty about how the bankruptcy of an Islamic private equity company can proceed.  The latest ‘first’ was Arcapita becoming the first Islamic financial institution to file a reorganization plan in a Chapter 11 bankruptcy proceeding in the United States.  Before moving into a description of what the reorganization plan means for the industry as a whole, I’ll cover the basics of the plan itself.

First off, the plan would allow Arcapita to leave bankruptcy, but would then be involved only in exiting existing investments, not making new ones.  The plan refinances the $100 million in secured debt held by Standard Chartered Bank into a 3-year murabaha facility with 8.75% coupon and places it at the top of the capital structure (behind the administrative expense claims).  Additionally, Arcapita will receive $185 million in an Exit Facility, also a senior secured murabaha, with an unspecified lender, with profit of LIBOR plus 8% (and a LIBOR floor of 2%) due in 3 years.  The exit facility will be used to repay the debtor-in-possession (DIP) financing, as well as to provide working capital.

Behind these secured murabaha are the company’s remaining creditors who will see the bulk of their recovery come through coupon payments and redemption of a $550 million perpetual mudaraba with 12% coupon and a call date 6 years after the plan is approved.  KPMG estimated that Arcapita’s investments upon expected exit will return $1.3 billion to creditors (including administrative expenses from the bankruptcy and the secured creditors).  With $3.2 billion in liabilities, most unsecured creditors will realize a loss, but different creditors will fare substantially differently.

After the secured murabaha are repaid, the first payments will be to the sukuk holders who include the $1.1 billion syndicated murabaha (which Arcapita failed to refinance and which forced the bankruptcy) and the unsecured creditors of Arcapita’s Cayman-domiciled investment holding company AIHL.  These creditors are expected—based on a KPMG estimate of the exit proceeds and allowable claims—to recover roughly 60% of their claims.  Creditors of Arcapita Bank, on the other hand, face near total loss according to the KPMG estimates that show a recovery rate of just 6%.

The unsecured creditors of Arcapita Bank—including the Central Bank of Bahrain which provided a $250 million murabaha to Arcapita in 2009—end up with some of the new Class A preference shares (with liquidation preference of $790 million, but which are subordinated to the sukuk and secured murabaha) and most of the new ordinary shares of Arcapita, which will require significantly higher exit proceeds to have value.

The sukuk structure is relatively new because of the special situation that led to its issuance.  It has no fixed maturity (since there is no definitive timeline for when sufficient exits to cover administrative expenses, secured creditors and the sukuk principal) but has a call date in 6 years (and will be callable on that date and every quarterly periodic distribution date after that point.  The periodic distributions will accrue from the issue date, but will not be paid until the secured murabaha are fully repaid.  If there is not excess cash (i.e. cash not needed for operations) the sukuk coupon is not paid, although in the future, excess cash is used to pay accrued but unpaid periodic distributions.  Arcapita will “will explore reasonable options to facilitate off-market trading of the Certificates including enhanced financial reporting or, if practicable, listing the securities on a public exchange.”

While the structure of the sukuk is known, and is included in the plan, the Class A preference share structure is not.  The terms were decided upon: the Class A shares will be subordinated to the sukuk but senior to the new ordinary shares, and will be redeemed for $790 million (a number estimated based on full redemption of the sukuk within 3 years, which is odd since the sukuk is not callable until 6 years after the issue date).  Preference shares are not commonly used in Islamic finance and the structure was, as a result, not determined within the plan documents.  Instead, Arcapita and its creditors will work out the details to ensure Shari’ah-compliance so long as “no such modifications shall materially impair the economic rights conferred by such New Arcapita Class A Shares”.

One note in the plan, which refers to concepts which I am not familiar with, states that “the New Arcapita Class A Shares [will] be analyzed using the ‘self-lending’ or ‘preferred return’ exception to the prohibition on the payment of interest.”

If the Preference Shares are redeemed, any remaining funds are available to the new ordinary shareholders (mostly the Arcapita Bank creditors) and holders of various warrants.  However, based on the recovery rates for the different creditors, it is unlikely that there will be much value for the Class A shares after the sukuk is repaid, let alone for the ordinary shareholders.  They represent possible upside above the exit valuation estimates prepared by KPMG.

There are still aspects of the Arcapita bankruptcy yet to unfold.  It is not clear that—despite developing the plan in concert with the creditors committee—that it will be approved by creditors, although Arcapita has left the option of a cram down to force approval.  There may also be questions raised about $31 million in “value transfers” from Arcapita to relatives of the firm’s insiders two days before the bankruptcy filing.  This piece of data was announced in an amendment to the financial documents that was filed two days before Arcapita filed its reorganization plan.  The transfers were originally listed as being (undated) transfers to employees, and include several transfers for more than $1 million (the largest was $14 million).

As for the implications for the Islamic finance industry, the bankruptcy process should be seen as a positive development because the terms of the DIP financing, the exit financing and the securities given to creditors (with the possible exception of the preference shares) are all designed to be Shari’ah-compliant.  In the future, there should be greater certainty for creditors of companies that issued sukuk that the resolution can be accomplished in a Shari’ah-compliant way within a secular legal system.  The caveat for this optimism is that the resolution of Arcapita was done through the US Chapter 11 bankruptcy process, which is not available to most Islamic financial institutions (Arcapita held many of its assets within the US and had an office in Atlanta, Georgia, and was able to use the Chapter 11 process).