The Global Financial Crisis, Securitization and Islamic Finance: An Opportunity For Inward and Outward Reform

THE GLOBAL FINANCIAL CRISIS,
SECURITIZATION AND ISLAMIC

FINANCE: AN OPPORTUNITY FOR
INWARD AND OUTWARD REFORM
Sherif Ayoub*
Abstract
It is often contended by academics and practitioners in the Islamic

finance industry that the global financial crisis would not have
happened if the international financial markets had followed the
principles of SharÊÑah, especially in the asset securitization sphere.
This article attempts to respond to these assertions by examining
the factors that contributed to the global financial crisis alongside
an analysis of how Islamic finance could have been of value in its
aversion. Specifically, the article provides details on the origins of the
global financial crisis, its evolution and triggers. It then proceeds to
investigate the financial principles, both conceptually and practically,
in the Islamic securitization (ÎukËk) model. Ultimately, it is argued
that from a conceptual standpoint, Islamic financial principles
would have served to avert the crisis; however, contemporary ÎukËk
practices would have only been likely to reduce the probability of
its occurrence. This outcome is important insofar as it assists the
Islamic finance industry achieve its full potential, which includes the
capability of proposing effective reforms to the international financial
architecture.
Keywords: Global financial crisis; Islamic finance; Securitization;

ØukËk; Credit enhancements; Tranching.
* Sherif Ayoub is a PhD candidate at the Business School of the University of

Edinburgh, Edinburgh, UK. He can be contacted at S.E.Ayoub@sms.ed.ac.uk.
ISRA International Journal of Islamic Finance • Vol. 4 • Issue 2 • 2012 53
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The Global Financial Crisis, Securitization and Islamic Finance:
An Opportunity for Inward and Outward Reform
I. INTRODUCTION
The global financial crisis was not a haphazard occurrence. It

was a natural development from the structural deformities in the
international financial architecture, especially in asset securitization.
The ingredients that led to it, which were touted as ushering in a new
era of market efficiency, can only be described as something akin to
underlying features of a violent chemical reaction with far-reaching
consequences on international financial stability and the overall
health of the global economy.
In the aftermath of the global financial crisis, the Islamic finance
literature was full of commentary from academics and practitioners
alike regarding the relatively small impact that the crisis has had on
the Islamic finance industry because of its asset-backed nature as well
as its lack of superficially innovative, financially engineered products.
Essentially, the message was that the world should seriously consider
adopting SharÊÑah economic principles that underlie contemporary
Islamic finance in order to increase the prospects for sustainable
economic growth and wealth generation.
However, in the face of those assertions, it is interesting to note
that the roots of both Islamic finance capital market activity and the
global financial crisis are securitized assets. The difference lies in the
securitization framework in which the assets are meant to be packaged
and sold to investors. This similarity presents a unique opportunity
to pose the important question of whether the global financial crisis
could have indeed been averted if the world had operated within
the rules dictated by the contemporary Islamic finance paradigm.
The answer to this question is significant in that it may provide
some tangible indications regarding opportunities to reform the
international financial architecture with particular emphasis on the
asset securitization sphere.
To that end, this article is divided into two parts. The first part,
which concentrates on conventional finance, describes conventional
financial instruments as well as the credit structures related to
asset securitization, which took an increasingly important role
in international capital markets in the years preceding the global
financial crisis. It then analyzes the effect that the interplay between
these financial instruments and credit structures had on the various
types of risks, especially systemic risk. Finally, it outlines the
evolution of systemic stress and its triggers, which in turn instigated
the global financial crisis.
54 ISRA International Journal of Islamic Finance • Vol. 4 • Issue 2 • 2012

Sherif Ayoub
In the second part, the article focuses on the perspectives of the

contemporary Islamic finance paradigm on the global financial crisis.
It undertakes a conceptual examination of the derivative instruments
that deal with credit risk and the ÎukËk asset securitization model
within the context of the normative principles and modern directives
of the SharÊÑah in addition to their practical applications. Lastly, the
article concludes with a summarized comparative analysis between
the securitization framework within the conventional and Islamic
finance industries in order to ascertain the validity of the claims that
circulated in the aftermath of the global financial crisis.
Eventually, it is argued that the response to the question of whether
the contemporary Islamic finance paradigm could have contributed to
the aversion of the global financial crisis is likely to be the following:
Islamic securitization would have decreased the probability of its
occurrence but would not have eliminated it. Along the same lines,
it can be argued that in the event of a financial crisis due to some
structural flaws in the modern practices of Islamic securitization,
the relatively lower levels of excessive speculative (i.e., gambling)
activity in the Islamic finance industry will help to reduce the extent
and scope of its negative effects on other economic sectors.
The consequence of this realization should assist the Islamic
finance industry to undertake the appropriate internal reforms in
order to achieve its full potential of offering a better global financial
system (i.e., outward reform) that promotes financial stability and
sustainable economic growth.
II. THE GLOBAL FINANCIAL CRISIS:

INGREDIENTS AND EVOLUTION
The financial turmoil that unfolded in 2008 has its roots in US sub-
prime mortgages and the markets for structured products and related
financial instruments, namely Collateralized Debt Obligations
(CDOs) and Credit Default Swaps (CDSs). In effect, these financial
innovations, together with a strong supporting cast that included
insurance companies, investment and commercial banks, hedge
funds, and rating agencies, are widely believed to be responsible for
the worst financial crisis since the Great Depression.

The coming sections of this first part of the article attempt to outline the
configuration of conventional securitization and its credit structures
and the effect they have on systemic risk. Subsequently, the evolution
of systemic stress is explored with an overall objective of developing
a better understanding of the causes of the global financial crisis.
A. Conventional Securitization
The securitization of credit effectively commenced in the mortgage

lending sector after the creation of the US mortgage giant Fannie
Mae in the 1930s; however, it was not until the 1980s that it assumed
a prominent role in the asset pools in Western capital markets (FSA,
2009). By the late 1990s, the centerpiece of the asset securitization
sphere in conventional finance was the CDOs, which continued on a
tremendous growth trajectory until their collapse in the aftermath of
the global financial crisis.
CDOs are a form of securitization whereby a financial institution
pools together its identifiable future cash flows and transfers those
rights to another entity. The second entity (usually a Special Purpose
Vehicle or SPV) is specifically created to hold the rights as well as
sell portions of those rights as securities to investors.
Figure 1: Typical CDO Structure
Rating
Agencies
Asset
Manager
Manages portfolio assign ratings
management fee
Senior Notes
AAA
principal proceeds from
investment notes Mezzanine Notes
Collateral Issuer AAA
Pool collateral SPV
proceeds and
principal and interest Equity
interest Unrated
fiduciary underwriting hedge
duties
Trustee, Arranger,
Custodian, Underwriter & Hedge
Paying Agent Placement Agent Counterparty
Source: The Bond Market Association (2004: 2)

Sherif Ayoub
Specifically, the CDOs were formulated with three important

attributes: assets, liabilities, and credit structure (Lucas, Goodman and
Fabozzi, 2007: 1). The assets of the CDOs have traditionally included
corporate loans, consumer loans, auto loans as well as residential and
commercial real estate loans. The liabilities, on the other hand, were
structured as differentiated interests in the pool of the underlying
assets of the CDOs. As for the credit structure of the CDOs, it revolved
around the concept of internal and external credit enhancements in
order to achieve the desired credit rating. Tranching, as a form of
internal credit enhancement, provided investors with specific risk
and return preferences and ability to invest in the differentiated set of
liabilities by the SPV that included senior debt, mezzanine debt and
equity shares. In the pre-2008 period, the super-senior tranches were
rated AAA, the mezzanine tranches were usually rated below AAA
but were still considered investment grade (i.e., BBB and above) and
the equity classes were either rated below investment grade or not
rated at all. Naturally, the expected pay-off from these differentiated
liabilities was a function of their pre-determined risk profile.
The external credit enhancement, for its part, was typically
characterized by the financial backing of a third party to the transaction;
for example, monoline insurance companies (Monolines)1 and other
credit guarantee sellers who participated in the CDS derivatives
market.2 In the case of monolines, the promise by these companies
to repay security holders in case of default effectively endowed the
CDO securities with the rating enjoyed by the monoline insurance
companies themselves, which was invariably AAA. The extension of
this credit service, of course, was through an “insurance” premium
that mostly depended on the total size of the issuance. Therefore, the
higher the transaction size, the greater the incentive for the monolines
to participate in it by offering credit protection.
CDSs, in contrast, are credit derivative contracts where one party
(protection buyer) pays a periodic fee to another party (protection
1 Insurance regulations in the US prohibit property/casualty insurance companies,

life insurance companies and other multi-line insurance companies from providing
credit guarantees for financial products.
2 Hedge funds and other credit sellers, such as regular insurance and investment
companies, had become important players in the credit guarantee market through
CDSs in the period preceding the beginning of the financial crisis.

seller) in return for compensation in the case of default by the

reference entity. In essence, a CDS is similar to an insurance contract
with respect to the compensation that the protection buyer receives
from the protection seller when an underlying security defaults or
loses value. This trait endowed the CDSs with a “real” purpose in
the conventional finance realm, which is to hedge a particular credit
exposure to a collateralized debt obligation.
However, it is unlike an insurance contract in that the protection
buyer does not have to own the underlying security; have any
insurable interest in that security; or even suffer any loss in order to
recover on the CDS. Furthermore, normal insurance contracts are not
traded in the over-the-counter market as is done with CDS contracts
(Stulz, 2010). This feature within the CDS framework makes it fall
within the realm of excessive speculation, as investors gamble on
changes in a security’s credit quality in terms of CDS spreads.
In addition, CDSs have also served as securities in CDOs. These
so called Synthetic CDOs do not own cash assets (e.g., Residential
Mortgage Backed Securities (RMBS), other Asset Backed Securities
(ABS), loans) but gain credit exposure through the use of CDSs in
order to meet the ever increasing investor appetite for CDOs (Gibson,
2004). Basically, CDO managers and underwriters were able to use
CDSs to fill a CDO portfolio when cash assets, especially mezzanine
CDO tranches, were difficult to obtain. In fact, the mezzanine CDOs
issued between 2005 and 2007 used CDSs to take a much greater
exposure to the 2005 and 2006 yearly intake of sub-prime BBB-rated
RMBS that were actually issued (160% in 2005 and 193% in 2006)
(BIS, 2008: 5).
As a result of the demand factors for the CDSs, whether for
hedging or speculation purposes, their market increased tremendously.
To illustrate, the total notional amount of CDSs outstanding increased
from US$ 631 billion in early 2001 to US$ 62 trillion by the end of
2007,3 which was in itself much larger than the outstanding notional
value of debt obligations that were used as reference (BIS, 2008: 22).4
3 International Swaps and Derivatives Association (ISDA) Market Survey (2008).

Available at http://www.isda.org/press/press092508.html.
4 While it may be true that notional amounts do not provide a complete picture of
risk exposure; however, the illustration is meant to demonstrate the growth of this
segment of the financial markets.

Sherif Ayoub
B. Credit Structures and Risk
The internal and external credit enhancements warrant some

clarification since it has been argued repeatedly in academic papers
and the financial media that their presence in the securitization
framework not only inappropriately affected their valuations, but also
distorted how the risks of the CDOs were perceived and analyzed.
From a valuation standpoint, the complexity of the structures of
the CDOs, which imposed an add-on separation between the investors
and the underlying assets of their securities, made their valuation a
difficult endeavor. More specifically, the lack of transparency in the
CDO’s tranching configuration, along with inferior and incomplete
valuation models (FSA, 2009; Zamora-Mesinas, Galindo and Lopez,
2011), contributed to the ostensible failure by some of the most
sophisticated financial institutions and investors to properly analyze
and price the risks (individually and their inter-relationships) inherent
in these securities.
The risk assessment of CDOs (and CDSs) requires a more detailed
analysis due to the effects that the features of these securities have had
on the distortion and augmentation of systemic risk by virtue of the
structure of the CDOs as well as the speculative behavior associated
with these instruments. This, in turn, has had profound implications
on the stability of global financial markets.
While the CDOs were able to reduce the idiosyncratic risk
factors, the tranching structures resulted in a much greater exposure to
systematic risk (BIS, 2008: 49).5 That is, the risks that are associated
with individual assets (idiosyncratic risks) were greatly diversified
away due to asset pooling while the system-wide risks (systematic
risk) were amplified.6 Along those same lines, the inter-relationships
between the various risks were also intensified in a way that further
increased the systemic risk as a whole.
The reason behind the increased exposure of the CDOs to
systematic risk has to do with their two-layer structure, where a
typical CDO note’s payout and risk depend, in a non-linear way, on
5 Also, the elimination of idiosyncratic risk is present in the pooling of assets in

general; the difference is related to the effects of the overall structure of CDOs on
systematic risk.
6 Notably, the systematic risks are unlike idiosyncratic risks in that they cannot be
diversified.

a diversified asset pool (BIS, 2008: 47; Krahnen and Wilde, 2006:
6). This trait endows the CDOs, especially the senior tranches, with
a low expected loss but a high variance of loss or a high vulnerability
to the business cycle (BIS, 2008: 14). Put differently, CDO tranches
have been shown to exhibit an all-or-nothing risk profile whereby
they are expected to perform well in most circumstances but have a
“Cliff Effect,” as they experience significant losses during times of
stress (BIS, 2008: 37; 54).
For its part, speculation within the CDO framework had an
instrumental role in the destabilization of the global financial markets
through its effect on augmenting and intensifying counterparty risk,
concentration risk and liquidity risk as it took advantage of the efforts
to manage credit risk. The destabilization was, in effect, driven by
counterparty risks since the settlement of the CDS contracts posed
unique challenges due to the modality of settlement if a credit
event occurs, especially with the ambiguous valuation mechanisms
involved. Essentially, CDSs can either be settled physically or
through cash payment. In effect, in a credit event, the protection
seller pays the protection buyer the par value of the security and in
return takes possession of the debt obligation of the reference entity
(physical settlement), or the protection seller pays the protection
buyer the difference between par value and the market price of the
debt obligation (cash settlement). The latter option was more realistic
in the majority of transactions in the market.
Thus, as the ratio of CDS notional value to reference debt largely
exceeded 1:1, due to speculation and the presence of synthetic
CDOs, the CDS market moved from the hedging domain into that of
excessive speculation with its accompanying need for cash settlement
(of a much larger amount) at the time of a credit event. Also, the lack
of transparency in the CDS market, because all contracts are privately
negotiated, and the complicated nature of the CDOs made the pricing
of these instruments for cash settlement an extremely difficult task
(Stulz, 2010). Therefore, for all intents and purposes, the CDS
system: (i) was designed for a greater reliance on cash settlement; (ii)
was based on unattainable pricing capacity; and (iii) evolved into a
much larger outstanding notional amount.
The end result is that the global financial system became entangled
in a complex inter-linked chain of privately negotiated and opaque
CDS transactions (and liabilities) between financial institutions,

Sherif Ayoub
many of whom were active players from the unregulated hedge fund
industry. The implications of this chain on systemic risk stem from
the inability of the poorly capitalized and unregulated links within
the CDS chain (i.e., hedge funds) to meet their debt obligations. This
led the system to concentrate on the strongest links―such as AIG,
Lehman Brothers and Bear Stearns―which can cause the complete
framework to unravel in times of systemic stress.
C. Evolution of the Systemic Stress
Having described the influence that the structure of the CDOs

and their credit enhancements had in diminishing the ability for
appropriate valuation and risk assessment of these instruments in the
capital markets as well as their effect on augmenting systemic risk,
we can now turn to the actual evolution of systemic stress and the
triggers that turned it into the global financial crisis.
For starters, the perceived benefits of the CDOs―that of offering
a large number of investors, with varying investment objectives and
constraints, a means to invest in relatively higher-yielding and rated
securities with seemingly defined risk profiles― served to increase
the supply of funds to these financial instruments. Moreover, with the
increase in the supply of funds to CDOs came an aggressive campaign
to increase the demand for funds in an effort to make assets available
for their securitization. Commercial lenders, on their part, played an
important role in this new structural shift in asset financing toward
irresponsible credit extension. Effectively, they were able to profit
from originating, structuring and underwriting fees while not having
to hold the associated credit risks of these assets (BIS, 2008: 7).
This so called “originate to distribute” business model led to
the reduction in the prudent lending standards for these assets, as
mortgage originators were driven mostly by loan volume and fees as
well as investor preferences rather than the quality of the underlying
assets (BIS, 2008; Purnanadam, 2011). In effect, at the most basic
level, this new structural shift in financing served to accentuate
the classical moral hazard and adverse selection problems, as the
commercial lenders were not only able to extend financing to riskier
segments of the markets (i.e., sub-prime) without having to maintain
credit exposure, but also to be selective in which assets to securitize
(Bomfim, 2004; Purnanadam, 2011).

Ultimately, sub-prime mortgages, marked by high loan-to-value

ratios and less credit-worthy borrowers with virtually no income
verification, have made up an increasing proportion of originations
and CDO collateral since 2002 (S&P’s, 2007). To illustrate, sub-
prime mortgages increased from 8 percent of all originations in 2003
to 20 percent in 2005 and 2006 (Harvard, 2008: 2). As for the CDO
collateral, it is estimated that the typical high grade and mezzanine
ABS CDOs in 2007 contained about 50 percent and 70 percent of
sub-prime RMBS respectively (BIS, 2008: 5). The ability of these
ABS CDOs to maintain relatively high ratings with what are clearly
low-grade assets is a direct contribution of credit enhancements.
The irresponsible credit extension also resulted in and was fed by
the unsustainable increase in housing prices that became a housing
bubble. For example, single family housing prices (adjusted for
inflation), which increased 11 percent in the 1974 to 1997 period,
increased 57 percent in the 1997 to 2007 period. Similarly, the ratio of
housing prices to annual income (also adjusted for inflation), which
was in the 2.3 to 2.5 range in the 1974 to 1997 period, increased to
3.55 in 2007 (Harvard, 2008: 33).
These pricing figures, coupled with the rise in sub-prime
mortgages, demonstrate rather well the solid belief among commercial
lenders and investment bankers that mortgages, and eventually
CDOs, were safe investments because the collateral (asset values,
especially real estate) were increasing quickly and were not prone to
value losses (Shiller, 2005). In essence, it was thought that sub-prime
borrowers would be caretakers of these well-performing assets until
the loan was paid-off.
Eventually, the housing market began to lose steam in 2005 due
to higher borrowing costs and the effect of skyrocketing home prices
on slowing homebuyer demand and eventually started a down-turn
in the latter part of 2006 (Harvard, 2008: 20). The actual trigger for
the bursting of the housing bubble can be attributed to the various
“mortgage innovations” that were promoted by mortgage lenders in
order to facilitate the borrowing process. The innovations, which for
the most part revolved around adjustable rate mortgages as well as
interest only and payment-option plans, while resulting in an increase
of home ownership to levels not previously experienced in the United
States, also exposed the sub-prime borrowers to payment shocks

Sherif Ayoub
when their low introductory interest rates expired and were reset to
higher market rates (Harvard, 2008: 20).
In effect, just as much of the sub-prime loans were hitting their
reset dates, the underlying indexes on adjustable-rate loans increased
by about three-percentage points (due to monetary tightening by the
Federal Reserve) thereby exposing the sub-prime borrowers to much
higher monthly mortgage payments. This exposure, when coupled
with very low equity in the homes7 (due to excess leverage) and a
reduction in house prices, served to increase the default rates and
subsequently the foreclosure rates in the housing market, as many
borrowers owed more on their mortgage than the value of their
property (Harvard, 2008). As can be expected, foreclosure filings
(default notices, auction sales notices and bank repossessions) in
2007 were up about 148 percent from their 2005 levels (RealtyTrac,
2008).
Consequently, the market for structured products based on
mortgages began its cycle of collapse with institutional investors, such
as commercial and investment banks as well as insurance companies
and hedge funds, being hit the hardest. This was due to steep losses
in their CDO portfolios in addition to vulnerable positions in the
increasingly cascading CDSs market.
The unraveling of the CDS chain combined with the settlement
structure of the CDS transactions also had a significant impact on
liquidity in the global financial system. In effect, the ensuing freeze
of the global credit markets seemed only natural as virtually no one
was able to decipher the exposure their counterparty had to different
events of default (Stiglitz, 2009). In addition to the global credit
freeze, the liquidity in the financial markets was exacerbated due
to the winding-down of positions by hedge funds (and other CDS
players) in a disorderly manner (Cole, Feldberg and Lynch, 2007:
15).
Essentially, margin calls and unplanned asset sales due to
investor redemption resulted in downward pressures on asset prices,
necessitating further sales and deeper declines in prices (BIS, 2008:
26). This accelerating and self-sustaining downward spiral developed
7 Higher home equity increases the ability and the incentive of the borrowers to make
on-time payments.

into a liquidity crisis as prices cascaded in the CDS market and market
participants were unable to raise the needed liquidity to meet their
obligations (MFA, 2005: 55).
It is also important to highlight the repercussions of the ensuing
liquidity crisis on the investors of CDOs, especially for the senior
tranches. In essence, the dual facts that an increasing portion of the
CDO issuances were securitized by CDSs (Synthetic CDOs) and that
the credit protection of AAA-rated cash CDOs was highly doubtful
(due to the CDS market crash and the clear inability of the insurers
to meet their obligations) both led to massive write-downs by some
of the largest institutional investors8 in the world, bringing many of
them to the brink of collapse, as they had difficulty in acquiring the
necessary funds to re-capitalize and survive.
Interestingly, the rating agencies, as legitimizers of the overall
structure of CDOs (especially with their credit enhancements), were
faced with a dilemma throughout these unfolding events. On the
one hand, the credit quality of the CDOs was clearly deteriorating,
warranting rating downgrades; on the other hand, it also became
apparent that any such moves would push the global financial crisis
further into the abyss.9 The same logic was espoused in the rating
of monolines and other major participants in the CDS market. This
provides a good example of how effects (objective credit ratings)
can evolve into causes (systemic collapse) in an improper and
irresponsible global financial architecture.
In the end, it suddenly became clear that the house of cards that
was intricately built by the international financial markets and made
up of seemingly sophisticated financial innovations had housing
prices as its foundation. When housing prices crashed in a single
country, the whole global system crumbled, heralding the systemic
shock that was neither anticipated nor accounted for.
8 The financial institutions were implicated due to investments in the CDOs and the
inability to sell down the inventory after the sub-prime crisis unfolded in 2007.
9 They would also affect the fee-generating capacity of one of the most lucrative
markets for credit ratings.

Sherif Ayoub
III. THE GLOBAL FINANCIAL CRISIS:

ISLAMIC FINANCE PERSPECTIVES
After the unfolding of the global financial crisis, there was widespread
commentary in the Islamic finance industry regarding the relatively
small impact that the crisis has had on it due to its asset-backed
nature (as opposed to being debt-based) and its lack of superficially
innovative, financially engineered products that included internal and
external credit enhancement. The discourse was largely directed at
the partisans of the conventional finance industry with the invariable
recommendation to adopt the SharÊÑah economic principles that
underlie contemporary Islamic finance in order to increase the
prospects for sustainable economic growth and wealth generation.
Specifically, from a normative standpoint, the three economic
pillars of the SharÊÑah―namely the prohibitions on ribÉ (usury),
gharar (excessive uncertainty) and maysir (gambling)―would have
surely limited the scope and magnitude of the financial crisis.10 In
particular, the prohibition of ribÉ seeks to eliminate the injustices
linked to the financial slavery of individuals by opportunistic money
lenders who strive to benefit from the sanctity of debt repayment
obligations in Islam without any of the commensurate risks that exist
in the world of commerce. In the context of gharar, the SharÊÑah
attempts to increase the certainty of commercial transactions by
reducing the information asymmetry as well as prohibiting the
malicious devouring of the property of others by dishonesty,
deception, or taking advantage of informational ignorance. As for
maysir, the objective of Islamic jurisprudence is the promotion of a
productive work ethic that increases social welfare (individually and
as a society) as opposed to concentrating on the unearned gains of
gambling with all its associated anti-social behavior.
However, as one moves from the normative to the practical
sphere (with the participation of SharÊÑah scholars, legal counsels and
bankers), one can observe that the Islamic religious directives begin
to diverge in practice in response to the incentives and constraints that
exist both implicitly and explicitly to the various participants in the
10 The reason for mentioning “limited” as opposed to “eliminated” is not due to the
religion but rather in how humans choose to adhere to it.

Islamic finance industry. Thus, after developing an understanding of

the financial ingredients that contributed to the global financial crisis
as well as its evolution in the first part of the article, it is appropriate
to evaluate if Islamic finance, as it is currently practiced, would have
averted the global financial crisis.
Thus, in essence, the question is not so much whether the three
pillars of the SharÊÑah on economic matters would have contributed
to reducing the probability of economic stress,11 but rather how the
interpretation of the pillars and the actual industry practice, especially
in the securitization sphere, would have led to different results. The
answer to this question will determine how seriously to take the
claims of the partisans of the contemporary Islamic finance industry
that it should be looked into as a means to improve the stability of
the international financial architecture by way of reforms built on the
industry’s practices.
To this end, this section begins with a review on the topic of
credit derivatives in Islamic finance followed by an in-depth look
into the securitization process of the industry from conceptual and
practical standpoints since the OIC Islamic Fiqh Academy legitimized
the issuance of ÎukËk, as a form of asset securitization, in its fourth
session in February 1988.12
A. Credit Derivatives
The issue of derivatives was first explored by the OIC Islamic Fiqh
Academy in Jeddah in their Seventh Session in May 1992. The view
was that derivative contracts are modern forms of contracts with
no equivalence in Islamic jurisprudence and due to their perceived
negative effects on the financial markets they were deemed
impermissible for usage in the Islamic finance industry.
Since the Islamic Fiqh Academy’s ruling, there have been some
initiatives in recent years to help the Islamic finance industry cope
with exposures in the market risk domain with a focus on volatility
in the currency markets and mark-up rates (i.e., benchmark rates or
11 There is a plethora of literature demonstrating that excessive credit, excessive

uncertainty and excessive speculation are the roots of financial crises.
12 Islamic Fiqh Academy Resolution Number 30 (5/4).

Sherif Ayoub
profit rates). These initiatives were mostly based on the in-house

formulation of derivative instruments by various Islamic banks and
their subsequent utilization upon the approval by their own internal
SharÊÑah boards. Subsequently, some efforts towards standardization
resulted in the elaboration of the TaÍawwuÏ (Hedging) Master
Agreement, which was a product of the partnership between the
International Islamic Financial Market (IIFM) in Bahrain and the
International Swaps and Derivatives Association (ISDA) in New
York.13 It should, however, be noted that these efforts have yet to
result in a wide consensus among SharÊÑah scholars regarding the
utilization of derivatives in the market risk domain.
More specifically, thus far the discourse on the permissibility
of utilization of derivatives in the Islamic finance industry has
centered on market risk management with some work alluding to
the investment sphere, albeit mostly outside of the credit markets
(Al-Amine, 2008; Al-Suwailem, 2006; Bacha, 1999; El-Gari, 1993;
Kamali, 2000; Vogel and Hayes, 1998). There has been very little
debate on the permissibility of CDSs, which was not due to a simple
oversight by the industry but rather to the realization that invoking
maÎlaÍah (public interest) for acceptance of CDSs would be
tantamount to circumventing the spirit of the economic doctrine in the
SharÊÑah. This is because CDSs have yet to produce any semblance
of a real economic purpose other than the questionable rationales of:
(i) the attempted transfer of credit risk by lending institutions from
their portfolio, and/or (ii) excessive speculative behavior by market
participants in the credit markets.
For credit risk transfer, it was contended in the conventional
banking industry that the providers of capital in funding transactions
need not assume the credit risk of the borrower of funds (corporations,
home-owners, etc.). Rather, the allocation of capital and the financial
markets can be more efficient if the credit risks associated with
the financing transactions can be passed on to those who are more
able and willing to bear them (Stulz, 2010). Needless to say, and as
demonstrated previously, this assumption ignores the issues of moral
hazard and adverse selection in the extension of credit in addition to
13 See http://www.iifm.net/default.asp?action=category&id=54. Accessed February

11, 2012.

the distorted incentives for the negotiation of a settlement in the event

of financial distress on the part of the borrower.
More specifically, the extension of financing entails the
generation of profits from the assumption of credit risks by the
financial institutions as a core function that cannot be transferred to
a third party on a fee-for-risk basis without resulting in economic
distortions that are built on the accumulation of sub-optimal assets
and its effects on a multitude of risks, not least among them being
systemic risk. Moreover, the holders of a CDS (or even a monoline
insurance contract) as a form of credit backing on a particular debt
have little incentive to cooperate with the distressed borrower if
in fact they can gain the full amount of the default from the swap
counterparty thereby increasing the probabilities of default in the
credit markets.
The economic argumentation favoring the existence of the CDSs
become even more untenable as one departs from the realm of risk
management of insurable interest to excessive speculation over
fluctuations in the credit markets. In essence, it was advanced by
the promoters of the CDSs that they increase market liquidity and
transparency in the establishment of the market price for default
risk. However, what has become increasingly apparent in the years
preceding the global financial crisis is that there is little economic
benefit from developing a price of credit risk for a particular security.14
This is especially relevant since the mispricing of the credit risks
(due to misinformation, accounting manipulation, etc.) can oscillate
between offering incentives for the over-extension of credit or the
over-curtailment of financing, both of which eventually increase the
chances of financial distress.
Thus, it appears that the demonstrated importance of the assumption
of the credit risks of the borrower within the Islamic finance industry,
as a core function for financiers in order to legitimately generate
returns, along with the prohibition in the utilization of derivatives in
the credit sphere, have served to align the practices of the industry
with both the pillars of economic doctrine in the SharÊÑah as well as
14 The growing importance, in terms of size, of the markets for Index CDS and the
Basket CDS (both of which have multiple reference securities) as opposed to the
CDS on particular reference entities weaken the pricing benefit arguments of credit
markets.

Sherif Ayoub
the analysis of the deficiencies in the structured finance markets in

the period preceding the global financial crisis.
With the foregoing examination and its reasonable inference that
credit derivatives, which had served as a key factor in the distortions
of the incentives and constraints that existed in the conventional
securitization sphere, would not have been permitted (and were
indeed not used) in the realm of Islamic finance, we can now turn
to the conceptual and practical elements of asset securitization in
Islamic finance.
B. The ØukËk Securitization Model
The concept of ÎukËk could be distinguished from CDOs, which

were the prevalent form of asset securitization in the conventional
finance realm in the period preceding the global financial crisis, by
four main features. First, ÎukËk are meant to encourage the expansion
of financing to productive activities and therefore may not wholly
securitize debt owed as a liability, such as unsecured consumer and
corporate debt (AAOIFI, Shari’a Standard No. 17, Para. 5/1/2, 2010).
In fact, growth in consumption and corporate expenditure is generally
beneficial to any economy, as they constitute the largest components
of GDP. However, it can be argued that the unsustainable levels of
their growth, which can be fueled by unsecured debt,15 increase the
chances of severe economic shocks because of the short-term liquidity
constraints (Antzoulatos, 1996; Ludvigson, 1999).
In the period prior to the global financial crisis there was ample
evidence of a substantial enlargement of household and corporate
debt. To illustrate, in the United States, household debt expanded
from 77 percent of disposable income in 1990 to 127 percent in 2008
(Economist, 2008). The situation in the corporate sector, especially
Wall Street, was much worse as companies found it financially
advantageous to finance their speculative investments through
the cheaper short-term unsecured debt markets, which eventually
resulted in a huge increase in their debt-to-capital ratios (Labaton,
2008; Stiglitz, 2009).
15 Part of the structural deficiency in the conventional finance realm is the deductibility
of interest cost in the Western taxation system, which provides a misguided subsidy
for amassing debt. This is in contrast to full dividend taxation.

The second distinguishing feature of ÎukËk is that they are tradable

certificates of equal value representing undivided shares of common
ownership of tangible assets, usufructs, and services (AAOIFI Shari’a
Standard No. 17, Para. 2, 2010; IFSB, 2009, Section 1.1).16 Therefore,
they are differentiated from CDOs in that they are considered common
interests in the assets of the SPV rather than tranches of liabilities
with pre-determined risk and reward configurations. In fact, the
idea of different rights and obligations for different securities of the
same asset pool is not acceptable within the framework of Islamic
securitization (AAOIFI Shari’a Standard No. 21, Para. 2/6, 2010).
The benefits of this feature in the ÎukËk structures include a
reduced ability to augment systemic risks due to the distortions in
the incentive arrangements implicit in CDO securitization. More
specifically, the superficial alterations of the asset pool payoffs have
been shown to increase the potential for the accumulation of lower
grade assets that underlie the securitization structure. Indeed, it has
become apparent in the period preceding the global financial crisis
that the high ratings granted to the superior tranches in the CDO
structure depended less on the overall quality of the assets being
securitized and more on the crucial presence of a sufficient critical
mass of lower-rated tranches, including the-so-called “toxic waste”
or equity tranches.
Apart from the absence of tranching, the superiority of ÎukËk,
as a concept of true asset securitization, rests on its simplicity. From
the investors’ viewpoint, assuming the absence of moral hazard,
adverse selection and asymmetry of information, they are benefiting
from Markowitz’s (1952, 1959) pioneering work on portfolio theory
in that they enjoy an average of the returns of the assets underlying
the ÎukËk along with the lower overall risk due to less than perfect
correlation of returns.17 The recourse to the assets also provides an
added advantage lowering the overall risks of the transaction.
Fund seekers (corporations and financial institutions), on the other
hand, despite relinquishing the returns of these assets, gain from this
16 The ownership is thought to be a factor of the corporeal traits of an asset (along with
legitimate legal title) rather than the rights of its cash flows (also with a legitimate
legal title).
17 The risk reduction is also one of the rationales for the CDO structures in that the
idiosyncratic risks are diversified in a diverse pool of assets. But the returns are not
averaged in the CDO structure due to tranching.

Sherif Ayoub
transaction the ability to achieve lower capital adequacy requirements

(for banking institutions) as well as the prospect of proceeding with
investments offering higher net present value and/or of lowering their
operating or financing costs.18 Moreover, securitization can also be
used to lessen the asset-liability mismatches (e.g., concentration risk,
maturity mismatches, etc.) thereby reducing overall enterprise risk
exposures.
Needless to say, for the aforementioned benefits to actually be
realized, the transaction taken as a whole needs to adhere to the
principles of true asset securitization, whereby the asset is legally
transferred to the investors (or an SPV owned by them) and the
fund seeker is not liable for the asset performance with any form of
guarantees. Put differently, the benefits demonstrated by Markowitz―
that of average returns and lower portfolio risk to investors―can only
be attained if in fact the returns to the investors are actually derived
from the asset, not the concentration of the risk on the credit of the
fund seeker as an unsecured debt.
Similarly, the advantages of debt-free financing to fund seekers
evaporate with the presence of a contractual obligation to guarantee the
payments to the security holders. That is, if the decision to securitize
the assets was taken as a means to―(i) have funding available to
undertake higher net present value investments than those offered by
the current underlying assets in the securitization process, (ii) take
advantage of the higher prospective rating of the group of assets
(vis-a-vis the rating of the institution itself), and/or (iii) benefit from
lower capital adequacy requirements (for banking institutions)―then
the guarantee given to the security holders essentially makes it an
expensive form of issuing an unsecured debt that places mostly the
same credit constraints on the originator.
This leads to the third feature of ÎukËk, which is related to
guarantees. Explicitly, ÎukËk cannot be guaranteed by the originator19
(except for torts and negligence), nor can they be insured by a third
18 For operating costs, the potential for investments increasing economies of scale
can have positive economic effects. For financing costs, the originator can benefit
from low financing costs if the assets transferred have a higher credit rating than the
originator itself.
19 If the assets are actually transferred and which include the repurchase of the asset at
a predetermined nominal value.

party apart from cases where the guarantee is not linked in any manner
to the actual securitization contract and the fees involved do not
exceed the actual administrative expenses (AAOIFI, Shari’a Standard
No. 17, Para. 5/1/8/7, 2010). However, the use of a profit equalization
reserve is encouraged as a form of communal risk management.
This feature is to ensure that the guarantees do not distract the
investors from the fundamentals of the assets underlying the ÎukËk
and do not place a burden of debt on the fund seeker in its efforts to
proceed with value-added investments. In addition, the lack of focus
on external credit enhancements serves to undermine the incentive
distortions due to the fee-based insurance arrangements and the
associated concentration on what can be called the “supremacy of the
strongest link” in the credit management chain.
The fourth feature of ÎukËk can be linked to speculation. In effect,
trading ÎukËk in assets that are yet to be determined (or non-existent)
is not permitted, nor in ÎukËk that are linked to assets that have
already been sold (AAOIFI, Shari’a Standard No. 17, Para. 5/2/8 and
5/2/15, 2010). The objective here can be conjectured to center on the
reduction of gharar (excessive uncertainty) and focus the financing
on productive activities that provide real economic substance to their
owners and to society, rather than speculative bets with very little, if
any, value-added qualities.
C. ØukËk Structures: Substance vs. Form
The discussion in the previous section presented a conceptually

superior Islamic securitization framework to the one existing in
the conventional debt markets in the period preceding the global
financial crisis. However, as one moves beyond the conceptual
sphere to the examination of some of the specific SharÊÑah directives
related to asset securitization as well as actual ÎukËk practices, it can
be discerned that real underlying substance vs. form issues exist in
Islamic securitization.
The importance of the discourse into the substance and form
of contemporary ÎukËk practices stems from the fact that the inter-
temporal SharÊÑah directives in the economic realm should depend
primarily on the benefits and injustices that present themselves in
the way humans interact with one another with economic resources
rather than a simple and exclusive focus in how the commercial

Sherif Ayoub
agreements are legally structured. This, of course, does not mean that
the ends justify the means; rather, it simply espouses the position that
has been articulated by Ayoub (2012: 24) that there needs to be “a
more scientific approach in properly defining the means and ends
of Islamic finance in a manner that accounts for their continuously
evolving manifestations in light of contemporary challenges and
opportunities in the real economy.”
In essence, building on the arguments elaborated by Saeed and
Salah (2012) with regard to ÎukËk structures, it could be contended
that the discourse in the securitization debate can benefit from a
reduced focus on variables such as which contractual form of assets
can be securitized and in what percentage (which are quite arbitrary)
and a greater concentration on the actual nature of the underlying
assets. This proposition takes special importance especially after the
AAOIFI’s Shari’a Board statement in February 2008 that stipulated
the importance of having the majority of assets in the ÎukËk structure
being characterized with transfer of ownership rights over tangible
assets (e.g., real estate) or usufructs and services (e.g., leasehold
rights, toll road concessions, etc.).20
Effectively, AAOIFI’s stance espoused the position that trading
in ÎukËk was reserved for those structures with ijÉrah contracts as the
underlying assets since only they can endow the investors with legal
ownership rights of the transferred assets. It may be discerned that
AAOIFI’s position is likely derived from the professed position by
some SharÊÑah scholars such as Justice Usmani (also the Chairman
of the AAOIFI SharÊÑah Board) who have linked the securitization of
murÉbaÍah (installment sale) transactions to the prohibition of bayÑ
al-dayn (sale of debt) as well as other proscribed practices (Ariff, Iqbal
and Mohamad, 2012; Usmani, 1998: 149-150). Consequently, the
murÉbaÍah structures and similar “debt” contracts, even those secured
by real and productive assets formalized by religiously legitimate
contracts, were deemed not suitable for securitization. This is despite
the fact that the arbitrary nature of contractual classifications21 and
20 Available at http://www.aaoifi.com/aaoifi_sb_ÎukËk_Feb2008_Eng.pdf.
21 An ijÉrah contract with a promise to give the property as a gift at maturity (or for a
very small amount) and a secured murÉbaÍah contract are essentially the same from
the economic and legal standpoints.

their superficial implementation can result in distorting the economic

incentives whereby the benefits of securitization are endowed with
the institutions that are forced to assume greater risks and burdens
as part of their role as lessor in the ijÉrah financing transactions that
SharÊÑah scholars prefer.22
The cost of this reality for institutions operating in the Islamic
finance industry is that they will either choose to limit their own ability
to securitize their assets or else proceed by cleverly structuring the
transaction in order to adhere to the form of the SharÊÑah injunctions
that favor ijÉrah-type ÎukËk securitization (El-Gamal, 2006: 106-
107). As could have been expected, the competitive pressures in the
industry resulted in the latter option being the preferred route taken
by Islamic financial institutions.
To illustrate, given the contemporary SharÊÑah prohibition of
trading ÎukËk backed by non-ijÉrah assets,23 it should be of no surprise
that ÎukËk issuances have been mainly ijÉrah-type structures (IIFM,
2011). This is despite the fact that most of the banking assets are in
murÉbaÍah contracts (BMB, 2010). In effect, since Islamic banking
assets serve as a fair characterization of the nature of the contracts
in the industry (inside and outside of banking), it is perplexing that
ÎukËk capital market activity is nonetheless dominated by ijÉrah-
type structures. Essentially, either: (i) the ijÉrah asset requirement
is precluding the industry from effectively securitizing its assets,
which means that the industry can never truly achieve its capital
market potential in the context of the current AAOIFI ruling, or (ii)
originators are structuring their ÎukËk issuances to recycle murÉbaÍah
assets into the ijÉrah structures to comply with the form of SharÊÑah
requirement.
Eventually, it can be conjectured that the preceding illustration
is an example of how a focus on the form (i.e., name of the contract
or the means) of some SharÊÑah directives in setting the regulation
can be quite ineffective in promoting the desired outcome (i.e., the
substance or the ends). This is especially ironic when it is apparent
22 Under ijÉrah, the burdens include asset ownership risks and the responsibility for the
maintenance and upkeep of the assets. Of course, these risks and burdens tend to be
shifted in practice to the lessee, but this comes at a cost of circumventing the spirit
of the SharÊÑah.
23 Trading in mushÉrakah ÎukËk is also allowed, but it amounts more to a mutual fund.

Sherif Ayoub
that the higher-level SharÊÑah directives in the securitization sphere,

as outlined in the previous section, provide a solid basis for matching
the economic doctrine of the SharÊÑah with contemporary financial
best practices.
With that, it should be stated that if the wider message is that
murÉbaÍah financing is so undesirable that it should not figure in
ÎukËk issuances, then not only should Islamic banking institutions
be guided to reduce (or refrain) from this type of financing, but also
investors should be precluded from investing in banking institutions
whose asset base consists mainly of murÉbaÍah contracts, which
are the majority of large banking corporations (BMB, 2010). This
is because, from an accounting and financial sense, the value of
an Islamic bank’s tradable common stock is dependent on the
shareholders’ residual claim on the net assets (and their current and
prospective cash flows) of the institution. In other words, trading
the equity securities of Islamic banking institutions whose portfolio
consists mainly of murÉbaÍah assets should not be considered
fundamentally different from trading in ÎukËk backed by those assets
(if they are indeed fully transferred to an SPV).
A viable alternative, and one that more directly relates to the
economic pillars of the SharÊÑah, is to focus less on the name of
the transaction and more on the actual economics of the assets that
underlie a particular ÎukËk issuance, which include their permissibility,
productivity and accessibility as well as their ability to provide the
necessary cash flows that can service the payments to ÎukËk investors
until maturity.24 These, along with the actual transfer of the rights and
obligations of the assets to the SPV, should be considered the key
differentiating characteristics.
Notably, the transferred assets in this case will be legitimate
financing contracts with a positive stream of cash flows rather than
legal title of the underlying. In effect, a valid case could be made
that murÉbaÍah financing schemes backed by real assets, which
are currently ambiguously allowed to take a minority role in the
mix of the underlying assets in a tradable ÎukËk issuance, should be
allowed to play a more prominent role in the securitized asset pool
24 The consideration of the cash flows is important for the ÎukËk to exist in a stand-
alone fashion without any form of guarantees, which are effectively prohibited.

that is commensurate with their importance in the financing schemes

existing thus far in the Islamic finance industry.25
D. Contemporary ØukËk Practices
After outlining the concept of securitization in Islamic finance and

discussing the issues of substance and form that exist in some of the
contemporary SharÊÑah directives, it is perhaps appropriate at this
stage to examine some current ÎukËk practices in order to attest to
their perceived superiority vis-a-vis conventional securitization. For
this, the forthcoming analysis shall focus on the ijÉrah-type ÎukËk
structures since, as mentioned earlier, they have been the most
favored by SharÊÑah scholars.
We begin with the distinction between the two main types of
ijÉrah ÎukËk structures that exist in the Islamic finance industry,
namely the asset-based ÎukËk and the asset-backed ÎukËk. For this, the
views from the rating agencies should provide valuable insights on
the nature of these financial instruments (BMB, 2010; S&P’s, 2009,
2010). This is because the scrutiny of these institutions surpasses
the complex structuring and multiple contracts that are involved and
focuses instead on the actual commercial terms of the transaction as
well as the associated credit and legal risks.
For Moody’s, asset-based ÎukËk are ones whose principal and
payments are effectively guaranteed by the originator by way of
a purchase undertaking at nominal value (i.e., a commitment to
buy back the assets at maturity for a fixed price) and a liquidity
provision pledge or reserve (i.e., a commitment by the originator to
ensure sufficient liquidity to meet coupon payments). These same
characteristics for asset-based ÎukËk are acknowledged by Standard
and Poor’s as “full credit enhancements”. Consequently, the rating
of this type of ÎukËk issuance by these two agencies is equalized
25 To be sure, there are murÉbaÍah ÎukËk; however, they are prohibited from being
traded in the secondary markets because the process is viewed as a form of trading
in debt. The financial institution can, however, try to convince the customer to take
an ijÉrah financing with binding promises for lease payments as well as the purchase
and sale undertaking, which can facilitate securitization. The second option is only a
form of the first with the same economic payoffs. Interestingly, Standard and Poor’s
stated: “[T]ypically, we consider that lending policies are not materially different
between Islamic and Conventional Banks” (S&P, 2010: 27).

Sherif Ayoub
with the rating for unsecured debt securities by the originator. Along
the same lines, it should be stated here that within the asset-based
framework, there is usually little disclosure (if any) of the physical
assets underlying the ÎukËk issuance since the focus is on the obligor
(Dey and Ure, 2011: 147-148).
Asset-backed ÎukËk, on the other hand, are wholly dependent
on the cash flows of the underlying assets, which are transferred to
the SPV, and entail no formal guarantees for the principal or coupon
payments from the originator. Thus, the financial and economic
attributes of the issuance alongside the legal structure for the asset
recourse in the event of originator insolvency become of prime
importance in valuing the expected payoffs of the ÎukËk until maturity.
Naturally, since the focus is on a predetermined underlying, the full
disclosure of the asset specifics in addition to their risk and return
characteristics (historical and implied) is an indispensable necessity
to investors.
Thus, it can be construed that the main features differentiating
asset-based ÎukËk from asset-backed ÎukËk are the external credit
enhancements in the form of guarantees as well as the nature of the
relationship between the assets underlying securitization and their
originator. Once more, as observed by many commentators and
Islamic finance experts, a guarantee by a third party (i.e., insurance
company or government agency) has the exact same effect as the one
offered by the originator in that the rating will depend on the entity
with the stronger credit standing (Ali, 2011). With that, it should be
stated at this juncture that the arguments for the permissibility of
sovereign-backed ÎukËk (or even multi-lateral ones as in the case
of the Islamic Development Bank) can be understood within the
context of a public good that promotes maÎlaÍah (public interest);
this rationale, however, disappears within the realm of finance for
profit-oriented private sector entities.
Subsequent to the earlier elaboration of the concept of
securitization in Islamic finance, and in light of the aforementioned
distinction between asset-based and asset-backed ÎukËk, it should be
quite surprising to learn that the rating agencies acknowledge that
most of the ÎukËk that they rate are actually asset-based in nature.
In fact, in a relatively recent study by the International SharÊÑah
Research Academy for Islamic Finance (ISRA) it was found that 549

out of 560 ÎukËk issues (about 98 percent of the total) were asset-
based ÎukËk (Dusuki and Mokhtar, 2010).
Notwithstanding the nature of the underlying in the ÎukËk
structure, it should be equally startling to observe that there have
been some attempts to introduce the tranching “technology” to
Islamic securitization in an effort to improve the credit ratings of
some ÎukËk issuances. These include the Tamweel US$ 210 million
ÎukËk issuance in 2007 and the Sorouh Real Estate US$ 1.1 billion
muÌÉrabah structure in 2008, which achieved tranching through a
musÉwamah (negotiation) agreement. Both of these structures seem
to feature different profit-rates and risk characteristics based on the
tenor of the ÎukËk shares. In the absence of details of the transaction,
one can discern that what is effectively being created is higher-rated
tranches as the shorter-tenors while the longer-term tenors are granted
lower ratings. For the Sorouh ØukËk, the tranches achieved a rating of
A, BBB+ and BBB-.
As for external credit enhancements, there was the interesting
belief by some Islamic finance commentators that the obstacle to
effective securitization was the dearth of religiously-sanctioned
institutional arrangements, such as takÉful monoline insurance
companies; the recommendation put forth to alleviate that constraint
being the less optimal usage (in a religious sense) of conventional
insurance (Manjoo, 2005: 64-66).
With that, it should be stated that the nature of the ÎukËk market―
as one dominated by asset-based securities with an attempted creep of
tranching and external credit enhancements―does present a paradox.
This is because it was clearly stated by the SharÊÑah regulatory
bodies that ÎukËk are tradable certificates of equal value representing
undivided shares of common ownership of assets.26 In addition, it
was also argued earlier that both investors and fund-seekers in the
capital markets jointly benefit from the asset-backed structures in
securitization. Finally, it has been distinctly shown in the previous
sections that internal and external credit enhancements (tranching
and guarantees) served a vital role in grossly distorting the incentives
of securitization in the conventional realm, which, in turn, led to
26 Again, it may be argued that ownership can also entail rights over a cash flow stream
from a legitimate, and religiously sanctioned real-economy transaction.

Sherif Ayoub
high debt creation along with excessive speculative behavior that

culminated in the global financial crisis.
Essentially, the current ÎukËk structures not only disregard the
SharÊÑah directives established by the regulatory bodies, but also
choose not to adhere to the economic rationale behind the true asset
securitization model in a seemingly blind inclination to tap the
unsecured debt markets. There must be some logic that can explain
such seemingly irrational behavior.
For this, one should look at the various constraints and incentives
that exist in both the global debt markets and the particular regions
where ÎukËk are issued. To start with, there is a contention that a true
sale cannot be effected by the originator in ÎukËk structures due to
the constraints on title transfer in some jurisdictions (e.g., the Gulf
countries) and prohibitive taxes for the sale and repurchase of assets
in others. While this is true, there should be little difficulty in the
seller retaining legal title but entering into an agreement with the
SPV to transfer all rights and responsibilities of ownership of the
underlying assets until maturity. This is above and beyond the fact
that Malaysia, the world’s biggest ÎukËk market, does not have these
constraints yet continues to issue predominately asset-based ÎukËk.
Thus, the aforementioned title and property tax assertion does not
seem to offer a credible explanation for the asset-based inclinations
of the ÎukËk markets.
A more plausible argument could be that the Islamic finance
industry still responds to the incentives that exist in the conventional
securitization sphere, even if these incentives are unrelated to its
conceptual essence or practical usage.27 These incentives are shaped
by the deductibility of interest by the originator on its debt obligations
(which does not apply in Islamic finance settings) as well as the little
inducement by originators for providing full disclosure regarding the
underlying assets since the credit rating, which is the predominant
focus of investors, is that of the originator and/or external credit
enhancement provider.
27 Most ÎukËk buyers are in Muslim countries by virtue of the size of the domestic
ÎukËk issuances as well as the regional uptake in the international ÎukËk issuances
(IIFM, 2011).

The latter incentive, despite the specific SharÊÑah directives for

the avoidance of gharar, can be considered of high importance in
explicating this irrational preference for unsecured financing in the
ÎukËk markets. It is apparent from the statistics on the number of
asset-based ÎukËk vis-a-vis asset-backed ÎukËk that not only can
originators get away with less than optimal disclosures, but also
that Islamic investors (e.g., treasurers, funds, etc.) still prefer the
easier and more familiar route of investing in these instruments as
unsecured creditors rather than owners of the risk and return of the
underlying assets directly. If this were not the case, the fund supply in
the ÎukËk markets would have adjusted accordingly to accommodate
the investor preferences for the exposure and relative safety offered
by asset-backed ÎukËk.
E. The Global Financial Crisis and Islamic Finance:

An Ex-Post Assessment
After examining the Islamic finance industry’s securitization

principles and practices, it is now appropriate to return to the question
posed earlier regarding whether the global financial crisis, which was
instigated by structural flaws in conventional securitization, would
have been averted if the financial world had adopted the contemporary
Islamic finance paradigm. As it turns out, the information presented
thus far demonstrates that the answer to this important query is not
so straightforward and actually depends on how it is contextualized.
If the context is in the normative realm where the three pillars of
SharÊÑah―notably the prohibition of usurious debt creation, lack of
transparency and gambling behavior―are considered, the answer
would be in the affirmative. In contrast, if the question was framed
within the context of modern ÎukËk practices in the Islamic finance
industry, the answer would likely not be endowed with the same level
of certainty.
This is because it has been shown that the current modus operandi
in Islamic asset securitization does not fully follow the economic
doctrines of the SharÊÑah and has paradoxically chosen to adopt some
of the same features in conventional finance that instigated the global
financial crisis. The end result of this decision is similar financial
performance between those two industries thereby stripping the
Islamic finance industry of its oft-contended economic crisis-proof
status.

Sherif Ayoub
To illustrate, global ÎukËk issuance decreased by over 50 percent

from its pre-crisis levels and the HSBC/DIFX ØukËk Index, which
represented the weighted average credit spread over LIBOR of the
individual constituents underlying the index, increased by over three
times to a little over 400 basis points (it later increased to about 900
basis points in October 2008) (BMB, 2010). These figures existed
despite the repeated assertions that ÎukËk are different financial
products than the credit-based CDOs or even the unsecured debt
market.28 The Islamic equity markets did not fare much better, with
steep losses (sometimes up to a fifth of their value) in the aftermath
of the global financial markets downturn (DJIMI, 2008).
With these figures outlining at least some similarities in the
performance of Islamic and conventional finance, it is perhaps
necessary at this point to provide a summary comparative analysis
between the two industries in the field of securitization since any
similarities between their securitization structures may have also
been an underlying factor for the comparable performance in the
capital markets.
To that end, it can be discerned from the analysis in the previous
sections that there are two main features in any securitization
framework that add to the prospect of systemic instability in the
financial markets, namely credit enhancements and the nature of the
underlying. In terms of credit enhancements, one can observe that
external credit enhancements in the form of originator guarantees
and/or external backing were endemic in both the conventional and
Islamic securitization spheres. However, it should be noted that
CDSs, premium-based credit insurance, and any format of synthetic
securities were markedly absent from the Islamic finance industry.
For internal credit enhancement, the ÎukËk structures appear to have
largely, but not completely, avoided the tranching technology.
28 It is no secret that the monetary authorities in the Gulf region were instrumental in
assisting the banking sector in overcoming the challenges of the global financial
crisis. In the absence of more complete public information, it would be difficult
to appropriately analyze the effect of the crisis on the Islamic finance industry.
However, it is apparent that the decline in the industry was the minimum type of
damage that could have been sustained and could have been much worse without
state monetary intervention.

As for the underlying assets, despite the repeated assertions of

the asset-centric nature of the Islamic finance industry, it is rather
clear that the ÎukËk issuances were largely similar to unsecured
debt instruments in that they mostly did not include a true sale or
even the possibility of recourse. This, combined with the fact that
the cash flows for these securities came directly from the balance
sheet of the originator as opposed to being derived directly from
the securitized assets, makes the economic substance of these two
instruments largely identical. Interestingly, the CDO structures, apart
from the structural flaws associated with their credit enhancements,
actually provide more of an asset-centric securitization model than
that offered by ÎukËk.
Having said that, within the framework of asset securitization,
it should also be noted that the predatory lending practices and
ambiguous interest rate innovations were largely absent in the Islamic
finance industry thereby reducing the problems of moral hazard and
adverse selection, which played a major role in the securitization
of sub-standard quality assets in the conventional finance industry.
Notwithstanding the above, there is ample evidence that the ÎukËk
structures, especially from GCC originators, had large concentration
risks in the real estate sector in what could only be described as
excessive speculative behavior on the part of real estate developers,
promoters, financiers and investors.
Specifically, the claims by some commentators that the sub-
prime mortgage debacle, as a source of global financial crisis,
could not have happened in the Islamic finance industry because
of SharÊÑah proscriptions should merit some reconsideration. In
essence, one should be aware that SharÊÑah directives do not prohibit
mortgage finance (sub-prime or otherwise). In fact, as evidenced by
the involvement of Islamic banks in the real estate boom in the Gulf
region, it appears that such financing was deemed preferable in the
industry since it was firmly believed that it was for a real asset (i.e.,
not debt).
However, it should also be acknowledged that what the SharÊÑah
does stipulate is that Muslims should strive to seek moderation and
avoid excesses in their actions. Effectively, the claims that the sub-
prime mortgage issues could not have emerged in an Islamic setting
depend less on particular SharÊÑah injunctions (since asset financing

Sherif Ayoub
for a home is recommended) and more on how Muslim choose to

follow the spirit of the SharÊÑah in their affairs. The excesses in the
real estate boom in the Gulf region, especially in Dubai, and the
associated ÎukËk markets (e.g., Nakheel), should serve as a reminder
of the importance of focusing on the economic substance of the
SharÊÑah (with its view of moderation) rather than its contractual
forms.
Eventually, based on the foregoing analysis, the response to the
question posed earlier as to whether Islamic finance, as is currently
practiced in the securitization realm, could have helped avert the
global financial crisis, the possible answer is likely to be the following:
Islamic securitization would have decreased the probability of its
occurrence but would not have eliminated it. Along the same lines,
it could also be argued that in the event of a financial crisis, due
to some structural flaws in the contemporary practices of Islamic
securitization, the relatively lower incidence of excessive speculative
activity (especially with unsecured debt, credit derivatives, etc.) in
the Islamic finance industry would have served to reduce the extent
and scope of its negative effects on other economic sectors.
IV. CONCLUSION
The global financial crisis that began in 2007 is a culmination of a

myriad of factors that led to a perfect storm of sorts. However, as
opposed to storms which come into being from purely natural causes
and weather patterns, the collapse of the international financial
markets was mainly due to deliberate choices by a relatively small
number of decision makers, which included regulators, bankers and
policy-makers. In essence, the financial system was designed to self-
destruct, with inexplicable and far-reaching consequences to most of
the world’s population.
This paper traced the complex origins of the global financial
crisis as they relate to securitization and credit derivatives and
how the various financial instruments, institutional arrangements
and market players, as well as the overall international financial
architecture, all contributed, individually and in an inter-related
fashion, to the instigation of systemic stress that led to the collapse of

the international financial system. Furthermore, it described some of

the principles of Islamic finance, from a conceptual standpoint, that
relate to the issues raised concerning conventional securitization and
how those principles could have gone a long way in inhibiting the
factors that led to the global financial crisis. The analysis provided
is important insofar as it assists world leaders to look for innovative
reforms that can contribute to the future stability of the international
financial markets and sustainable increase in global economic growth.
However, despite its conceptual superiority as a model for
global financial reform, the Islamic finance industry has to undergo
its own internal reforms to ensure that the economic doctrine of the
SharÊÑah, with its three pillars, is truly appreciated and practiced in
the industry as opposed to: (i) the forcing of an economic model that
focuses exclusively on the permissibility (and the arrangements of
that permissibility) of individual contracts, and (ii) the oft-witnessed
irrational desire to replicate the instruments in the conventional
unsecured debt markets.
For this, it has been argued that the SharÊÑah scholars in the
Islamic finance industry should grant a greater focus to substantive
compliance with the economic doctrine of the SharÊÑah rather than the
simple concentration on contractual forms, especially in the definition
of the accepted forms of assets that can underlie a particular ÎukËk
issuance. Essentially, in adhering to the SharÊÑah, it should be realized
that some modern economic and financial practices are quite different
from those that were practiced in the early Muslim community in
the 7th century. In fact, the challenges faced by the financial sector
today in its attempt to meet the economic needs of individuals (and
institutions) are unlike ever experienced before.
Thus, it would be quite difficult to continue to regulate a growing
and complex form of financial intermediation within the narrow
confines of qiyÉs (analogical reasoning), the result of which is
the contemporary usage of Arabic-named complex derivations of
financial products that bear very little resemblance to their 7th century
predecessors or even the institutional arrangements that surrounded
their existence. In effect, a greater internalization of the Islamic theory
of maÎlaÍah (public interest) should arguably take a more prominent
role in contemporary SharÊÑah directives regarding commercial
matters (i.e., not acts of worship) in a manner that accounts for
positive and negative externalities.

Sherif Ayoub
The consequence of this substantive reformulation of the SharÊÑah

directives should assist in their actual implementation by the Islamic
finance industry as a means to achieve sustainable long-term growth
even if it comes at a short-term financial disadvantage. Essentially,
from the foregoing analysis it was evident that when a SharÊÑah
directive (i.e., only ijÉrah assets can be securitized in tradable ÎukËk)
was deemed unrealistic by the murÉbaÍah-driven Islamic finance
industry, a tendency developed to bypass it through clever financial
engineering.
The danger in this behavior is that once the circumvention barrier
is breached, the rationale for adherence to other religious regulations
diminishes. This was obvious in the circumvention of the economically
rational SharÊÑah directives of asset-backed securitization (to the
tune of 98 percent) and the proscription of security tranching, which
together serve to align the constraints and incentives in the capital
markets to promote sustainable economic growth and wealth creation.
In conclusion, the Islamic finance industry does hold a lot of promise
for appropriate outward reforms to the international financial
architecture in the aftermath of the global financial crisis. However,
in order for that promise to be fulfilled there should be some
consideration for inward reforms that assist the industry to achieve
its full potential.

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The Global Financial Crisis, Securitization and Islamic Finance: An Opportunity For Inward and Outward Reform

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THE GLOBAL FINANCIAL CRISIS,

SECURITIZATION AND ISLAMIC

It is often contended by academics and practitioners in the Islamic

Keywords: Global financial crisis; Islamic finance; Securitization;

* Sherif Ayoub is a PhD candidate at the Business School of the University of

ISRA International Journal of Islamic Finance • Vol. 4 • Issue 2 • 2012 53

fanewISRA VOL4 IS 2.indd z53 12/20/12 5:27 PM

The global financial crisis was not a haphazard occurrence. It

fanewISRA VOL4 IS 2.indd z54 12/20/12 5:27 PM

In the second part, the article focuses on the perspectives of the

II. THE GLOBAL FINANCIAL CRISIS:

ISRA International Journal of Islamic Finance • Vol. 4 • Issue 2 • 2012 55

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The securitization of credit effectively commenced in the mortgage

Figure 1: Typical CDO Structure

Source: The Bond Market Association (2004: 2)

56 ISRA International Journal of Islamic Finance • Vol. 4 • Issue 2 • 2012

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Specifically, the CDOs were formulated with three important

1 Insurance regulations in the US prohibit property/casualty insurance companies,

ISRA International Journal of Islamic Finance • Vol. 4 • Issue 2 • 2012 57

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seller) in return for compensation in the case of default by the

3 International Swaps and Derivatives Association (ISDA) Market Survey (2008).

58 ISRA International Journal of Islamic Finance • Vol. 4 • Issue 2 • 2012

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B. Credit Structures and Risk

The internal and external credit enhancements warrant some

5 Also, the elimination of idiosyncratic risk is present in the pooling of assets in

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60 ISRA International Journal of Islamic Finance • Vol. 4 • Issue 2 • 2012

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C. Evolution of the Systemic Stress

Having described the influence that the structure of the CDOs

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Ultimately, sub-prime mortgages, marked by high loan-to-value

62 ISRA International Journal of Islamic Finance • Vol. 4 • Issue 2 • 2012

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64 ISRA International Journal of Islamic Finance • Vol. 4 • Issue 2 • 2012

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III. THE GLOBAL FINANCIAL CRISIS:

ISRA International Journal of Islamic Finance • Vol. 4 • Issue 2 • 2012 65

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Islamic finance industry. Thus, after developing an understanding of

11 There is a plethora of literature demonstrating that excessive credit, excessive

66 ISRA International Journal of Islamic Finance • Vol. 4 • Issue 2 • 2012

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profit rates). These initiatives were mostly based on the in-house

13 See http://www.iifm.net/default.asp?action=category&id=54. Accessed February

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the distorted incentives for the negotiation of a settlement in the event

68 ISRA International Journal of Islamic Finance • Vol. 4 • Issue 2 • 2012

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the analysis of the deficiencies in the structured finance markets in

B. The ØukËk Securitization Model

The concept of ÎukËk could be distinguished from CDOs, which

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