Islamic Syndication vs Conventional

Are Islamic syndicated financings different from conventional syndicated loans?

University of Maastricht Faculty of Economics and Business Administration Maastricht, 03.08.2009 Farbood, Hutan (I229830) Master of Science in International Business Concentration: Finance Supervisor: Professor Dr. S. Kleimeier Final Master Thesis

Table of Contents

Page 1. Introduction…………………………………………………………………… 2 2. Islamic Financing …………………………………………………………….. 2.1. The Principles of Islamic Financing ………………………………….……... 2.2. Islamic Financing Methods ……………………………. …………………… 2.2.1. The Profit-and Loss-sharing Modes …………………………………. …… 2.2.2. The Mark-up Modes……………………………………… ……………….. 2.2.3. Sukuk……………………………………………………………………….. 2.3. Islamic Syndicated Finance………...…………………………………………

5 5 7 9 10 11 12

3. Descriptive Research Questions …………………………..…………………. 15 4. Analysis on Loan Spreads of Malaysian Syndications ………….………... 21 4.1. The Banking System in Malaysia…………………………………………...... 25 5. Data Selection………………………………………………………………...... 5.1. Data Selection for the Descriptive Research Questions………………...…..... 5.2. Sample Characteristics for the Descriptive Research Questions...………...…. 5.3. Data Selection & Sample Characteristics for the Loan Spread Analysis of Malaysian Syndications ……………………………………………......…......

27 27 28 29

6. Empirical Results…………………………………………………………..….. 31 6.1. The source of funds for Islamic Syndicated financings...……………...……... 31 6.2. The receivers of Islamic syndicated financings………………………..……… 34 6.3. Industries towards which Islamic syndicated financing are directed to …...…. 37 6.3.1. Changes of Islamic syndicated deals for different industries over time…..… 44 6.4. Shares of lead banks: Islamic syndications vs. conventional syndications….... 46 6.5. Maturities of Islamic syndicated financings versus conventional syndications. 47 6.6. Financial debt covenants: Islamic syndications vs. conventional syndications. 49 6.7. Participating banks: Islamic syndications vs. conventional syndications…….. 49 6.8. Deal Size: Islamic syndications vs. conventional syndications……………..... 50 6.9. Differences in the Spread……………………………………………………... 51 7. Conclusion and Limitations………………………………………………....... 56 References……………………………………………………………………....… 60 Appendix……………………………………………………………………...…... 65

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1. Introduction:

Islamic finance has become a widespread hot topic, and even more heard since the storm of financial and economic crisis erupted in the end of 2007. Financial Institutions in the oil rich states at the Persian Gulf, thriving emerging nations in South-East Asia and African nations, with their large Muslim populations, but also financial centers in the Western World rush to take part at the phenomenal 15-20% growth of Islamic financial products even in the wake of the recent financial crash. Even banks which are laying off their workforce on a large scale are still looking to increase their workforce in the Islamic financing business as they hope to tap into this promising niche market. The Islamic financial assets size is expected to be between $700bn and $1tn in spring 2009 (Reuters, 2009). Indeed Islamic finance has seen fast growth since 1975, when the first Shariah-compliant bank in the world was set up.1 Islamic financial institutions in the last three decades grew faster than their conventional counterparts in Muslim nations. The number of Shariahcompliant financial institutions has risen to more than 300 institutions operating in 75 countries till 2008 (Hasan, 2008). A determinant factor for the growth of the Islamic finance industry is because it complies with the religious beliefs and also the cultural characteristics of societies in Muslim nations (Hamwi & Aylward, 1999). Furthermore, the rise in Islamic finance can also be attributed to the rise of the petrodollar income in the Middle East (The Boston Consulting Group, 2008). But next to the growth of Islamic financial institutions in Islamic countries, Islamic finance has gained ground in predominantly non-Muslim nations as well. The United Kingdom and Singapore for example opened their doors to become centers for Islamic finance (Akhtar, 2007). There it has been noticed that mostly conventional banks have opened Islamic windows, in contrast to the Middle-East where there is the tendency to establish stand-alone Islamic institutions. The growth of Islamic finance also in non-Muslim countries is due to the rising demand of the Muslim population in Western countries and the desire of Islamic 1

Islamic financing, lead to sustained economic development throughout the Islamic world already during the Middle Ages (Grais & Pellegrini, 2006).And in 1963, a small Islamic savings fund started operations in Malaysia. This Islamic institution managed funds for pilgrimages to Mecca (Solé, 2007). Also in 1963 a savings bank, working in line with Islamic principles, in Mit Ghamr in Egypt was founded. But this bank did not include any reference to Islam or the Shariah in its charter (Chong & Liu, 2007).

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investors, especially Investors from the Persian Gulf, to diversify their investment portfolio geographically while complying with Islamic jurisprudence (Solé, 2007). But also more and more non-Muslims find the philosophy of Islamic banking desirable (The Boston Consulting Group, 2008). Another argument accrues as well, namely the uneven performance of the conventional financial markets, especially in the West (Grais & Pellegrini, 2006). Therefore non-Muslim European investors use Islamic financial products to diversify their investment portfolio (Oakley, 2009). On the one hand it is expected that Islamic finance is going to continue its growth path, as Islamic financial institutions will attract 40 to 50% of the total savings of the population in the Muslim World already in some years (Dahlia El, Wafik, Zamir, 2004). The European Islamic Investment Bank even believes that about 60% of Muslim investors will turn to Islamic financial products in the future, compared with 20% in 2009 (Financial Times, 2009). But on the other hand, further growth may be hindered by uncertainty on scholarly views2 on the compliance of Islamic financial products and a lack of standardization, which is believed to make Islamic financial products more timeconsuming to construct and therefore also more expensive (Reuters, 2009). Furthermore, agency problems at Islamic financial institutions do deserve separate and special attention to enable further growth in the future. Reasons for this special attention arise due to the fact that the bankers in Islamic financial institutions are entrusted to maximize shareholder value in a Shariah conform way. Islamic financial institutions have different operations dynamics and the relationships between the parties involved are different. Another reason why agency problems at Islamic financial institutions deserve separate and special attention is because of the incredible growth of Islamic financial institutions. Also the fact that little empirical research has been done on this subject can be seen as a reason why agency problems deserve special attention at Islamic financial institutions (Safieddine, 2008). This paper takes into account these considerations, particularly of the special agency challenges at Islamic financial institutions. Empirical research is conducted on Islamic 2

Supervisory boards of Islamic financial institutions rely on their own Shariah experts. This may lead to contradictions of the permissibility of financial instruments in different countries. And this in turn can hamper the cross-border use of Islamic financial products and the growth potential of this industry (Solé, 2007).

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syndicated financings and compared with conventional financings. Differences in the structure of Islamic and conventional syndicated loans are researched to find out what influences agency effects have. This enables to make conclusions on the dimension of the agency problematic. Furthermore a model is built to find out whether Islamic syndicated financings are more expensive than their conventional counterparts, by taking into account the special structural differences between Islamic syndicated financings and conventional syndicated loans. As there is no paper, to the knowledge of the author, which conducts empirical research on Islamic syndications, this paper will contribute to new insights into Islamic syndicated financings. The aim is to show differences which exist between Islamic syndicated financings and conventional syndicated loans. This paper will also add value, by finding out how far Islamic syndications are affected by the agency problematic, as the empirical findings will hint the truth of the agency conflict at Islamic syndicated financings. This paper starts by introducing the concepts of Islamic financing and how the different Islamic financing modes are structured. Then, the concept of Islamic syndications is elaborated. Next, the descriptive research questions on Islamic syndications and the hypothesis for the analysis of Malaysian loan spreads are formulated. These include research questions about which countries are the source of Islamic syndications and which countries are the benefiters. Afterwards the industries which receive financings via Islamic syndications are researched. Differences over time in the financings of the benefiting industries are researched as well. In regard to the agency problematic, the size and maturity of the Islamic syndicated financings, the existence of debt covenants at Islamic syndications, the number of participating banks at Islamic syndications and the share of the lead banks at the Islamic syndication are researched and compared to empirical data on conventional syndications. Finally a hypothesis test for the analysis of Malaysian loan spreads is conducted, to find out whether there are differences in the spread of Islamic syndicated financings and conventional syndications in Malaysia. The hypothesis test further investigates the influence of borrower characteristics, contract characteristics and the syndicate structure on the spread. The following paragraph starts with an introduction to the concepts of Islamic financing.

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2. Islamic Financing: “Shariah compliant” finance is a system of prudent lending to reduce risks, to share profits and to ban speculations such as the short selling of stocks (Hasan, 2008). The Shariah is based on rules by the Quran and the Sunnah, which entails explanations and practices rendered by the Prophet Muhammad (Iqbal, 1997). The Islamic financial systems are complemented by the explanations of scholars in Islamic jurisprudence within the laws and rules set by the Quran and the Sunnah.

2.1 The Principles of Islamic Financing

The Islamic financial systems are different in regard to conventional financial systems by the means that they entail special principals (Iqbal, 1997). The most widely known principal is the “prohibition of interest”, which rules out the use of debt-based financial instruments. Any positive, predetermined and fixed rate that is fixed to the maturity and the principal is believed to be “riba”, which means excess and is therefore prohibited. As interest is seen as a cost that is not tied to the achievements in the business it is not seen as social, as social justice would mean that rewards and losses would be divided in an equitable fashion. This leads to the next principal, the “risk sharing”. This principal is a result of the first principal, the prohibition of interest. As the lenders become investors, because they cannot charge interest, they join the productive business. Therefore they share risks of the business for the share at the profits. The next principal describes money as “potential capital” as long as it is not invested in productive businesses and therefore it is not entitled to the time value of money. The Islamic financial systems recognize the time value of money only when money acts as capital at productive activities. “Materiality” is another principle in the Islamic financial system and means that financial transactions have to lead to a real economic transaction (Dahlia El, Wafik, Zamir, 2004). In addition, Islamic financial systems prohibit “gharar”3, or speculative behavior, which

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“Gharar” means, not knowing the value of the good purchased. Terms of a contract shall be well defined and leave no ambiguity to avoid gharar (Chong & Liu, 2007).

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incorporates transactions that involve extreme uncertainties and risks. Consequently gambling, “maysir”, for example is forbidden. Another principle is the “sanctity of contracts”. This means that it is a religious duty to stick to contractual obligations and to disclose information. This principle has the mean to reduce asymmetric information and the moral hazard problem. The next principle is the “prevention of exploitation” of any of the parties involved in a transaction. And as a last principle, the financing deals shall not finance “sinful activities” such as the production of alcoholic beverages. Finally, only those investment activities can qualify to be “Shariah compliant” which comply with the above mentioned laws and rules of the Shariah and the Sunnah. The difference of an Islamic financial system to a conventional financial system is that equal emphasis is placed on ethics, moral, social and religious dimensions contrary to the sole focus on economic and financial aspects (Iqbal, 1997). So the Islamic financial system has the noble goal to foster fairness and equality in the society. And this Islamic system acts for risk sharing, entrepreneurship, individuals’ rights and duties, property rights and the importance of contracts while discouraging speculative behavior (Iqbal, 1997). But it has to be mentioned that there is no uniform Islamic financial system. The explanations of scholars in Islamic jurisprudence within the laws and rules set by the Quran and the Sunnah differ enormously. The al-Azhar University, the well respected theological centre for Sunni-Islam in Egypt, for example has issued a fatwa which states that interest is not always “riba” or usury (Tripolipost, 2008). Returns which are not excessive but prespecified by lenders are permissible if there is a mutual agreement and if it brings in the advantage to reduce uncertainty. But this argument is of course very disputed, as a fixed return for the financier is much disputed under Islamic law. And nor do common Islamic financial instruments conform to the principle of profit-and loss-sharing (Rajesh, Amos, Tarik, 2000). Islamic financial products are mostly very debt like in essence and based on the markup principle. This is seen as rational responses of the Islamic financial institutions to the environments in which they operate, which are financial markets that are characterized by high degrees of imperfect information and rent-seeking behavior. Financings according to the profit-and-loss-sharing principle would entitle the financing provider to be compensated at the profits but also the losses of

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the project. Some scholars don’t interpret it too squeezed, and advice just to avoid Islamic financial instruments based on the markup principle, while they see these financial products as permissible under Islamic law. In the next paragraph, the most common Islamic financing methods are introduced.

2.2 Islamic Financing Methods

Under the teamwork of scholars, bankers and lawyers, modern Islamic banking has invented a multitude of Islamic financing products, which shall conform to the Shariah and the Sunnah (Wigglesworth, 2009). All basic Islamic financial instruments can be used for Islamic syndicated financings as well. These Islamic financial instruments can be based on the profit-and-loss-sharing principle or the markup principle and comprise amongst others the following financing modes:

Profit-and-losssharing principle:

Markup principle:

“Mudarabah”

“Murabaha”

(Venture capital

(Cost-plus

financing, limited

financing, trade

partnership)

financing)

“Musharaka”

“Ijara” (Leasing),

(Partnership with right of control), “Sukuk“ (Bond) Table 2.1: Examples of Islamic financing instruments

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The examples of Islamic financial instruments in table 2.1 are not full fledged. Islamic financings entail the freedom of contracts, which enables almost infinite forms of financial instruments and transactions (Khan & Mirakhor, 1990).

2.2.1. The Profit-and-Loss-sharing Modes

Mudarabah and Musharaka financing can be seen as equity investments and therefore represent the profit-and-loss-sharing principle. The financiers are entitled to share profits (or losses) of the borrowers business, settled on a ratio based on the contractual agreement. The rate of profit is determined as a percentage and not as a lump-sum payment. Financings based on the profit-and-loss-sharing mode cannot claim collateral or other guarantees that would reduce the credit risk for the lender (Sundararajan, V. & Errico, L., 2002). But banks, even though they have no legal means, have direct and indirect control over the borrower. Further credits could be declined in the future and the credibility and reputation of the borrower is at stake, which is a strong point in Islamic ethics (Khan & Mirakhor, 1993). The main problem for profit-and-loss-sharing instruments is how to hold the borrowers accountable to the Islamic lender, while maintaining the borrower’s freedom, incentives and the control over the business project (Dar & Presley, 2000). On the other side, profit-and-loss-sharing instruments are generally seen as stable. This is due to the reason that the term and structure of the liabilities and the assets are systematically matched through profit sharing arrangements and since no fixed interest rates mount up and as no refinancing via debt is possible (Iqbal, 1997). Furthermore, allocations are supposed to be efficient as the investment possibilities are scrutinized on their productivity and the rate of return. Under the Mudarabah financing mode, the sole capital provider to finance a project is the bank. So in case of a financial loss the financial institution bears all losses. The borrowing company on the other side offers its labor and expertise. So the managing

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company has complete freedom to manage the business.4 Only in case of negligence or mismanagement, the borrowing company can be made responsible for the resulting financial losses. However the capital provider is permitted to supervise the businessproject (Sundararajan, V. & Errico, L., 2002). The borrowing company is compensated by a stake in the profits of the project (Hamwi & Aylward, 1999). Usually Mudarabah modes are utilized to finance projects with a short duration in trade and commerce. The Musharaka mode of financing resembles venture capital. The financial institution is not the sole provider of the investment. Other partners, such as the borrowing company for example who form the partnership, provide capital to finance the project as well. The profits are shared in the relation to the capital contribution. Lenders can participate in the management of the borrowing company. Voting rights can also be exercised according to the share at the borrowing company’s equity capital. The Musharaka mode of financing is more utilized to finance projects with a long duration (Sundararajan, V. & Errico, L., 2002). Profit-and-loss-sharing contracts in general need special risk considerations from the investor side, as the credit risk is shifted from the Islamic financial institution to the investment depositor. The profit-and-loss-sharing contracts are more complex and need to determine the profit-and-loss-sharing ratio. Mudarabah contracts for example give the financiers no possibility to control the borrower-agent who manages the business. The borrowing company has free hands to run the business to their best judgment. Musharaka contracts enable the financiers better monitoring opportunities of the borrowing entity, as they have more influence on the management and may exercise voting rights. In addition it should be noted that in case of losses, part of the loss is absorbed by the borrower. Also the interest rate risk does not apply for profit-and-loss-sharing financing modes. But the question is whether this can absorb the special risks of this mode of financing. Another risk is the operational risk which becomes crucial for investments based on the profitand-loss mode. This is due to the special activities that the Islamic financial institution has to perform internally to ensure the monitoring of the investment process and the compliance to the institutions Islamic investment policy. Operational risk may also arise 4

Mudarabah financings are structured usually as unit trusts, limited partnerships or as limited liability companies (Hamwi & Aylward, 1999). Venture capital financing represents a modern example of Mudarabah in the Western world (Dar & Presley, 2000).

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due to the non-standardization of Islamic financial products and due to the lack of a reliable and efficient Shariah litigation system that enforces financial contracts. Dar and Presley (2000) mention that laws in most Muslim nations hinder the adaption of profitand-loss sharing modes by prohibiting Islamic banks to take controlling rights in borrowing firms in two ways: First, by making controlling very costly, second, the controlling blocks in the borrowing firms in Muslim nations are structured so that the managers of the borrowing company control the decision making. In addition, Mudarabah contracts are in general hostile towards investors. Therefore reforms in the banking regulations would be required to balance the control between financiers and managers.

2.2.2. The Mark-up Modes

Financing modes under the markup principle allow in contrast to financings according to the profit-and-loss-sharing modes to calculate the return as a fixed percentage of the total investment. But legally even the markup mode contracts do not exhibit a fixed negotiated rate of return, as guaranteed returns are un-Islamic. Markup financing modes even give the possibility to request a pledge for collateral from the borrower. Generally, markup instruments of Islamic financial institutions resemble instruments of conventional financial institutions most of all (Dhumale, R., & Sapcanin, A., 1998). Murabaha and Ijara are based on the markup principle and are historically based on commercial trade activities. In the Murabaha mode of financing a markup is negotiated between a buyer and a seller, whereby the seller informs the buyer about the true cost for acquiring or producing the specified product. The agreed sum is usually paid in installments. The Ijara mode of financing can be translated as Leasing. So a product is leased for a specified time and a specified sum. Also a lease purchase mode exists which is called “Ijara wa Iqtina”. Here the installments include a portion toward the final purchase of the product and consequently the transfer of ownership of the product (Sundararajan, V. & Errico, L., 2002). Payments to the investors generally depend on the rent or profits of the leaseholder (Oakley, 2009). This is an important point, which gives

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Ijara financings its Islamic credibility. Advantages of Ijara financings are the access to finance with low credit requirements. Furthermore, no collateral is required, as the ownership of the leased assets is initially not transferred to the borrower. In addition the transaction costs are low. So Ijara provides a source for long-term financings (Hamwi & Aylward, 1999). Another advantage of Ijara financing is that the client doesn’t need an initial large capital, and can pay for the services of the asset by its operating income (Ebrahim, 1999). Islamic Investment modes based on the markup principle are more similar to conventional financing modes, but entail also special risks. But generally financings based on the markup principle carry less risk than financings which are based on the profit-and loss-sharing principle. The interest rate risk affects only indirectly through the mark-up. Ijara contracts for example do not allow the Islamic financial institution to transfer substantial risks and rewards of the ownership to the leaseholder, because the Islamic financial institution has to hold the leased assets on its balance sheet for the time of the lease (Sundararajan, V. & Errico, L., 2002).

2.2.3. Sukuk

The Sukuk is an Islamic bond which is asset based. This means that the investor owns an undivided interest on a real tangible asset and receives a proportionate investment return on that asset. The Sukuk can be designed as a profit-and-loss-sharing instrument or a markup instrument (Iqbal, 2007). But Sukuks have turned to be mainly an Ijara structure. Scholars from the Bahrain-based Accounting and Auditing Organisation for Islamic Financial Institutions have banned Musharaka and Mudarabah modes as structures for Islamic bonds. In February 2008, these two structures were declared to break Islamic law, as investors were offered the possibility of a repurchase undertaking under these structures. This means that the issuer had to guarantee to pay back the face value of the bond when it matured or in case of default (Oakley, 2009).

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2.3. Islamic Syndicated Finance

In this paragraph, first a general introduction on syndicated loans is provided, and then the concept of Islamic syndicated financings and differences to conventional syndicated loans are explained. Finally the structure, how the parties involved in an Islamic syndication deal with each other is elaborated. The basic idea of syndicated loans is to pool resources to finance large transactions, while reducing the risks for the finance providers. Therefore a group of banks jointly arrange a loan. The risk reduction is due to the ability of the financiers to invest in more projects as the investment size is reduced, whereby they can diversify their investments more effectively. A syndicate typically includes one or a few lead banks, which assess the borrower quality and which negotiate the terms and conditions of the contract. Furthermore the lead banks prepare the information memorandum for the participating banks, which have to decide then how much of the syndicate loan to invest in. After the deal is signed, the deal agent, which is often one of the lead banks, has the responsibility to monitor the borrower, whether the borrower complies with the loan covenants and to negotiate with the borrower and the lenders in case of default. To retain the incentives of the lead banks to properly monitor post-signing the contract, the lead banks usually retain a share of the loan in order to signal the quality of the specific syndicated loan. (Giannetti & Yafeh, 2009). Islamic syndicated financings are based on Islamic rules and laws which are referred to as “Shariah compliant”. The syndicated Islamic finance market has seen noticeable growth in the last years. In 2007 there were about 28 syndicated Islamic finance deals which summed up to a total value of $15.2 billion (Iqbal, 2007). It is also often the case that Islamic financing is pooled in alongside conventional finance and is pari passu with other senior debt (Akhtar, 2007). The main distinguishing features of Islamic syndications are that the returns are not structured as interest income and that generally returns to the investors are not guaranteed as it is required by the Shariah. The conformity of syndicated financing deals to the Shariah is ensured by using eligible Islamic financing modes, as described in the paragraphs above. Most Islamic financial instruments are qualified for syndications, but Murabaha and Sukuk are the most widely used ones.

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Another distinguishing point between Islamic syndications and conventional syndications is that in the opinion of many Islamic scholars the lead arranger has to sell the “debt” down at par and not at discount or at a premium. In conventional syndicated loans, the lead bank sells the debt further to other banks and this might also be at a discount or at a premium. But the lead arranger for an Islamic syndication is allowed to take an administration or management fee for the arrangement of the syndication process. Except for the distinguishing points explained above, syndicated Islamic financings are very similar to their conventional counterparts. A detailed description of how the different stakeholders of Islamic syndications are involved with each other follows next.

Obligor

Wakeel (Lead Bank)

Muwakkil

Muwakkil

………

Muwakkil

Graph 2.3: Syndicated Islamic Finance (Source: Iqbal, 2007)

The Islamic financial instrument for an Islamic syndicated financing is provided by the lead bank to the obligor (Graph 2.3). The lead bank will set up an investment agency agreement (IAA) with the participating banks in the syndicate. Usually the lead bank is

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part of the syndicate as well. The lead bank acts as a “Wakeel” or agent, the participating banks in the syndicate are called the “Muwakkils” or principals. While the Muwakkils provide the funds, the Wakeel is the managing agent of the funds. The Wakeel has the obligation to monitor and manage the transaction and to keep the direct contact with the obligor, as the Muwakkils only have a direct relationship with the Wakeel and not the obligor. The IAA specifies the conditions for the participation in the syndication, but stipulates also the purpose for which the capital provided by the Muwakkils can be used. So the IAA determines the rights and obligations of the parties involved in the syndication (Iqbal, 2007).

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3. Descriptive Research Questions:

This paper has the objective to fill the empirical gap on Islamic syndicated financings, as Islamic financings in larger dimensions are relatively young. Therefore, first a descriptive research on the characteristics of the Islamic financings, based on the data of all syndicated loans from the time period between January 1995 and October 2006 will be conducted.5 These characteristics will then be compared with conventional syndicated loans. Also differences in between this time period will be researched. The results on the structural characteristics of Islamic syndicated financings provide answers on the true dimension of the agency conflict and the structural tools used to reduce agency costs. The following part will discuss research results of different authors on general Islamic financial instruments or general syndicated loans. These discussions might hint what research results to expect for Islamic syndicated financings and help to formulate the research questions on Islamic syndicated financings. First, this article will conduct a descriptive research on multiple features of Islamic syndicated financings. The first characteristics which will be evaluated for the descriptive research are based on the lenders and the borrowers of Islamic syndicated financings. Where are the funds of Islamic syndicated financings coming from? Are the oil rich Persian Gulf states the source of Islamic syndicated financings? The Boston Consulting Group (2008) argues that the growth of Islamic finance can be attributed to the accelerating wealth of the petrodollar-rich Persian-Gulf states. And which countries are receiving these funds? It seems most probable that countries with Muslim populations are the main target for Islamic syndicated financings. The article “Turning towards Mecca” (Economist, 2008) argues for example that Islamic finance with funds from the Persian Gulf states is also flowing towards Islamic countries in Africa. But funds might also flow towards Western countries, to enable Persian Gulf investors to diversify their investment portfolio geographically while complying with Islamic jurisprudence (Solé, 2007). These thoughts lead to the following research questions:

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This time period starts with the emergence of the first Islamic syndicated financings and ends before any effect of the financial crisis, which emerged in 2007, to affect the research.

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1) Research Question: Where are funds of Islamic syndicated loans coming from?

2) Research Question: Which countries are receiving the funds of Islamic syndicated financings?

The next characteristic which is to be explored is the industrial distribution of the Islamic syndicated financings. Generally, the majority of Islamic financial transactions are directed away from agriculture and industry towards retail and trade finance (Rajesh, Amos, Tarik, 2000). This is because these involve fewer risks for the lending institutions. Islamic financings have the characteristic to be concentrated on short-term trade, retail, finance and service sector financings than on the capital intensive industrial sector (Hamwi & Aylward, 1999). But as Islamic financings are expected to profit emerging nations in Muslim nations, the financing of infrastructure projects should see a rising trend as the paper “Infrastructure project finance and capital flows: A new perspective” (Dailami and Leipziger, 1998) would suggest. There are opportunities for Islamic infrastructure financings, especially in power and telecommunications projects. But also projects in transportation and utilities are becoming more important. The growth in demand for investments in these sectors has increased due to the privatization drive of many governments and the difficulties these large projects face to mobilize funds for these large-scale projects. Traditionally governments had been the source of funds for infrastructure projects, but governments have to adapt to tighter budget constraints. Furthermore the limited recourse project financing structures fit well in the Islamic financing modes as they are in line with Islamic law at a general level because they are asset based and socially valuable (Hamwi & Aylward, 1999). This paper will research the business areas where Islamic syndicated financings have been provided for in the time between January 1995 till October 2006 and whether there are changes during time.

3) Research Question: Towards which industries are Islamic syndicated financings directed to? And are there changes over time?

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Next, the structure of Islamic syndicated financings shall be researched. For the structure of syndications, the agency problem and information asymmetries play an important factor. In general, Islamic financing is different than conventional financing as the lenders face different risks, even though Islamic financing resembles conventional lending (Chong & Liu, 2007). Grais & Pellegrini (2006) argue that the agency problem for Islamic financial institutions is not only due to the separation of ownership and control, which is the common agency problem that conventional syndicated loans face, but agency problems hit Islamic financial institutions also due to the separation of depositor’s and investor’s cash flows and control rights (Grais & Pellegrini, 2006). Agency problems for Islamic financial instruments, resulting from non-compliance to Shariah regulations and resulting from poor transparency, can affect Islamic banks credibility and its ability to attract investors (Chapra and Ahmed, 2002). Safieddine (2008) states that most Islamic banks understand the importance of incorporating corporate governance mechanisms. But deficiencies in the actual corporate governance system are observed.6 Especially profit-and-loss-sharing instruments are exposed to agency problems. Compared to a self-financed manager, borrowers of profit-and-loss-sharing instruments have less incentive to bring in effort and have more incentive to report less profit. In addition, the lenders’ role in the management is restricted and doesn’t facilitate participation in the management (Dar & Presley, 2000).7 To mitigate agency problems for syndicated loans, there are specificities in the structure of these loans. Sufi (2007) finds out that the lead banks hold a larger share of the syndicated loans and that the syndicate is more concentrated, when information asymmetry requires more intensive monitoring and due diligence of the borrower. Sufi (2007) also finds out that in case that the information asymmetries are very large, if the 6

It is for example not common yet for Islamic banks to have a governance committee, an audit committee or clear internal audit functions. As this leads to a financial reporting process which is not sufficiently monitored, this leads to agency problems (Safieddine, 2008). 7 There are also other reasons, which are not related to the agency problem, why Islamic markup modes are preferred to profit-and-loss sharing modes of Islamic financings: Financings which are more debt-like enjoy tax advantages. Profits are taxed, but interest (regarded as a cost) is exempted. Furthermore, property rights are often not well defined and protected in many Muslim nations. But well-defined property rights are an inalienable requirement for profit-and-loss-sharing contracts. Another reason is that financial products which are based on the profit-and-loss-sharing mode have the disadvantage that there is no secondary market to enable financial institutions to trade those (Dar & Presley, 2000).

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borrower is informationally opaque, participant banks are closer to the borrower, by geographical means and by the means of previous lending relationships. Giannetti & Yafeh (2009) have evaluated how cultural differences affect syndicated loans. They find out that the share of participant banks are smaller as the cultural distance is higher. In addition, the larger the cultural distance between the lead bank and the borrower, the larger the share of the lead bank, as cultural differences reduce risk sharing within the syndicate.8 There are several reasons for these results. The first one is information asymmetry. The closer the culture is, the lower the cost of information gathering, as lenders consider borrowers from a distant culture more risky. Another reason might be the higher transaction costs for culturally distant lenders.9 And finally another argument might be a taste-based discrimination which arises due to a negative perception because of the cultural differences between borrowers and lenders (Giannetti & Yafeh, 2009). These considerations on the one hand mean that Islamic syndicated financings should exhibit larger shares of the lead banks, as their agency conflicts seem especially great. On the other hand the gap of cultural differences between Islamic borrowers and lenders is not very clear until now. Cultural closeness between lenders and borrower could mean that a larger share of the lead banks is not required anymore. Cultural distance between lenders and borrower could lead to even increased shares of the lead banks. These considerations lead to the following research question, which might hint about the urgency of the agency problem and the gap of cultural differences between borrowers and lenders at Islamic syndicated financings.

4) Research Question: Are the shares of lead banks at Islamic syndicated financings larger than in conventional syndicated loans?

In the context of Islamic syndicated financings, the loan maturity is an important measure of the agency problem and the perceived asymmetric information. A shorter maturity can 8

Regarding the quality of the borrower there is an information asymmetry between the lead banks and the participating banks. The more severe the information asymmetries and the agency problems the larger the share of the loan, the lead banks have to retain. This in turn limits the lead banks ability to diversify their investments (Giannetti & Yafeh, 2009). 9 The higher transaction costs may arise due to difficult communication, from difficult co-ordination between individuals of different cultural backgrounds and from conflicts that arise due to the differences in national cultures (Giannetti & Yafeh, 2009).

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be interpreted as a contracting tool, in case the borrower is perceived to have high default probability (Giannetti & Yafeh, 2009). Moreover, Islamic financial institutions do have a preference to finance short-term investments due to the regulations of Islamic financial systems or the practice of Islamic financial institutions (Rajesh, Amos, Tarik, 2000). Islamic financial institutions haven’t had the abilities to develop well-functioning secondary markets for long-term Islamic financial products and the missing of qualified market makers are also reasons why Islamic financial institutions have been limited to invest in long-term projects (Dahlia El, Wafik, Zamir, 2004). Therefore, the next research question is concerning the maturity of Islamic syndications in comparison to conventional syndication. All arguments hint that the Islamic syndications should exhibit shorter maturities than their conventional counterparts.

5) Research Question: Do Islamic syndicated financings exhibit shorter maturities than conventional syndicated loans?

And also loan covenants are important measures of the agency problem and the perceived asymmetric information. As Islamic financing involves risk sharing, there are tighter controls from the side of the Islamic financial institutions. And because Islamic syndicated financings are mostly structured as markup-modes and less as profit-and-losssharing modes, there is no right of control, which might strengthen the requirement for debt covenants, especially for financial debt covenants. This leads to the next research question, which explores whether more Islamic syndications exhibit financial debt covenants than conventional syndications.

6) Research Question: Do more Islamic syndicated financings exhibit financial debt covenants than conventional syndicated loans?

Information asymmetry can also mean that the syndicate is more concentrated to be better able to monitor the borrower. As the Islamic financial system is not as developed as the conventional banking system and as the number and size of Islamic financial institutions is limited, it seems also probable that there are fewer banks engaged in Islamic syndicates

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than in conventional ones. Therefore the next research question is concerning the number of participating banks in an Islamic syndication in comparison to a conventional syndication.

7) Research Question: Are there fewer participating banks in Islamic syndications than in syndicated loans?

Another tool to limit effects of agency problems and information asymmetry is the limitation of the size of the loan. Giannetti & Yafeh (2009) for example, find out that culturally distant borrowers are offered smaller loans, as they exhibit larger agency problems and information asymmetries compared to culturally closer borrowers. Therefore the next research question examines the size of the Islamic syndicated financings in comparison to the conventional syndicated loans.

8) Research Question: Are Islamic syndicated finances smaller than conventional syndicated loans?

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4. Analysis on Loan Spreads of Malaysian Syndications:

In this section, an OLS regression model with determinants of loan pricing for Islamic and non-Islamic loans in Malaysia is built to find out whether Islamic syndicated financings are more expensive than conventional syndications and whether specific attributes of Islamic and non-Islamic syndicated loans influence credit spreads. This analysis is based on the model used by Ivashina (2009) in her article “Asymmetric information effects on loan spreads”. The time period evaluated is again, as it is the case for the descriptive research, between 1995 and October 2006. The research will focus on Malaysia, one of the most developed markets for Islamic banking products, which exhibits an Islamic banking system next to the existence of the conventional banking system. The choice for one single country allows for a more accurate comparison between Islamic syndicated financings and conventional syndicated loans. Empirically, to the knowledge of the author, there is no literature on the research question, whether the spreads on Islamic syndicated financing are priced differently than conventional syndicated loans. But there is literature on the pricing of Islamic financial instruments in general. This question entails the important issue of corporate governance. In the discussion of corporate governance, the fundamental problem is concerning the agency problem, which results from the separation of ownership and finance or control (Shleifer & Vishny, 1997). Therefore the main objective of shareholders’ value based corporate governance is to develop incentives for managers to pursue the incentives of the shareholders (Grais & Pellegrini, 2006). When there is a shift from shareholder value maximization to aggregate welfare maximization of stakeholders, as is the case for Islamic financings, the managerial incentives are difficult to design (Tirole, 1999). Reputational risk evolves for the whole Islamic financial industry if individual Islamic institutions do not comply with the Islamic jurisprudence. Therefore, Islamic financial institutions incorporate corporate governance structures and processes which shall ensure the Shariah compliance to reassure all the stakeholders (Grais & Pellegrini, 2006).10 10

The most applied method for Shariah compliance reassurance are certifications by independent bodies. Furthermore a Shariah Supervisory Board is part of the internal corporate governance structure of the Islamic financial institutions to give advice on Shariah conformity. Shariah Supervisory Boards deal with five corporate governance issues, namely the independence, confidentiality, competence, consistency and

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Islamic financial institutions are exposed to cash-flow risk that might erode the capital base of Islamic banks. Negative deviations from promised liability at a conventional bank are absorbed by its equity. In Islamic banks depositors are not guaranteed their deposits or any profit (Ebrahim, 1999). This might lead depositors to take away their money when markets are not promising. Therefore Islamic financial institutions and Islamic financial instruments have a different risk pattern than conventional financial institutions and instruments (Ariss, 2009). Syndicated loan lenders, as described by Giannetti & Yafeh (2009), are associated with asymmetric information and moral hazard problems. All these research results therefore hint that Islamic syndicated loans are priced differently than conventional syndicated loans. Better corporate governance enables corporations to extend financing to a business and enables a lower cost of capital. Islamic scholars might argue that Islamic financial instruments enable better corporate governance, as Islam obliges stakeholders to engage ethically. But the sticking of stakeholders to Islamic ethically correct principles cannot be taken for granted. Islamic financial institutions suffer from breaches of fiduciary responsibilities and from effects of asymmetric information as much as conventional banks do. Scandals in Islamic banking look very much the same as for conventional banking scandals, such as audit failure, collusion of the board with the management, excessive risk taking or imprudent lending. Furthermore the Islamic financial industry does raise specific challenges for the corporate governance, which do not hold for the conventional financial industry. One example is the confidence keeping of the stakeholders of the compliance of the institutions activities with the Islamic rules and ethics (Grais & Pellegrini, 2006). But the more perceived agency problems are, the larger their effects on the Islamic syndicated financing contract, entailing the cost of the financing. Differences in perceived risk can also be attributed to cultural differences between borrowers and lenders, which lead to differences in the spread of Islamic and conventional syndicated loans. The loan spread is in general lower if borrowers and lenders share the same

disclosure. Except for Iran, where the Shariah compliance is monitored and guaranteed by the central bank, Shariah Supervisory Boards exist in all Islamic countries. Further, centralized Shariah Supervisory Boards are used in many Islamic countries for ex-ante monitoring, which develops further the standardization of Shariah operations, and ex-post monitoring of the Shariah conformity (Grais & Pellegrini, 2006).

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religion and are culturally closer (Giannetti & Yafeh, 2009). So this would mean that syndicated Islamic financings should be more expensive for a borrower in the Middle East, if the lead lender of the syndicate is a Western bank than compared to an Islamic financial institution from the Middle East as a lead lender. Safieddine (2008) points out that there are also conflicts between some agency mitigating mechanisms and the Shariah law. This could lead to higher costs for Islamic financial instruments. Others argue that the margins for Islamic banks would be larger, due to the “piety premium” which also other ethical investment products possess (Hasan, 2008). Also the Tripolipost (2008) mentions, that Islamic product are regarded as more expensive, as clients have to pay a premium on Islamic financings. But Akhtar (2007) mentions that tranches of Islamic financings, which are incorporated within a multi-sourced financing offering, are priced competitively. This paper will research whether Islamic syndicated financings are more expensive, based on the credit spreads founded on data of syndicated loans for Malaysian borrowers. Since there is a huge difference in the risk pattern, which can enhance information asymmetries and the agency problems and because there might be a cultural distance between borrowers and lenders and since Islamic syndicated financings might include a “piety premium”, it is hypothesized that the spreads for Islamic syndicated financings are higher than for conventional syndicated loans.

Hypothesis:

Islamic syndicated financing spreads are higher than spreads for

conventional syndicated loans.

The method to test this hypothesis will be based on the model used by Ivashina (2009) in her article “Asymmetric information effects on loan spreads”. As in the article of Ivashina (2009), the determinants of the loan pricing in this statistical test are based on borrower characteristics, contract characteristics and the relevant characteristics of the syndicate structure. The borrower characteristics are determined by the respective credit ratings.11 Contract characteristics might include the maturity, the deal size and the existence or not-existence of financial covenants. Characteristics of the syndicate 11

Borrowers which do not exhibit a published rating will be classified as “Not-Rated”.

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structure might be the size of the lead-banks share or the number of participating banks. Furthermore the source of the funds may play a relevant role, as cultural distance might have a negative effect. Relevant contract characteristics and characteristics of the syndicate structure for the statistical test are determined in the descriptive research. Since financings according to the profit-and-loss sharing principle do not exhibit fixed spreads, the research can only take into account data given from deals based on the markup-pricing principle. But it is important to note again that Islamic financial instruments exhibit skewness towards markup pricing instruments. According to the article “Islamic Banks and Investment Financing” (Rajesh, Amos, Tarik, 2000), the markup-principle is the most widely used financing structure in Malaysia and other Muslim countries with a dual banking system, such as Egypt or Jordan. And also in Iran, where the banking system is entirely Islamic the majority of Islamic financial instruments are based on the mark-up principle. Furthermore, this trend has even increased for all these countries over time. Markup-pricing in this research is determined for syndicated financings where the base rate & markup is either fixed or based on the LIBOR plus a markup. The pricing difference will be based on the difference of the markup on the base rate or the LIBOR. Of course there are also other factors than the spread which will determine the total cost of the financing. The comprehensiveness of the regulatory framework and the provision of the necessary legal framework could be reasons why Islamic financing becomes more or less expensive than conventional financing. The provision of tax exemptions and the provision of complete value chains of Islamic financial products in the markets can have an important effect on the total Islamic financing costs (islamicfinanceasia.com, 2008). But it is assumed that there are no disadvantages for Islamic syndicated financings compared to their conventional counterparts in Malaysia, as the Islamic banking industry tends to appear and grow there, where legal and tax hurdles are paved, as it happened in Malaysia. Furthermore, the considerations about differences of the regulatory and legal framework are less important in this paper, as this research is conducted on a single country, namely Malaysia and as all Islamic syndicated financings have to cope with the same regulatory and legal framework.

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The consideration to conduct this research only on Islamic syndicated financings and conventional syndicated loans from Malaysia has several reasons. The first reason is that Malaysia exhibits the conventional and the Islamic banking system, which makes an accurate comparison between the two systems possible. The article of Ainley, M. & Mashayekhi, A. & Hicks, R. & Rahman A. & Ravalia, A. (2007) points out, that there is variation in Islamic banking practices among countries and jurisdictions. And these differences are not only due to differences of interpretation of Islamic scholars but also the level of industry development and the regulatory framework. This means that comparable differences in Islamic banking are better done between very similar countries, which would increase the difficulties to compare the results among different Islamic nations. Furthermore,

Malaysia exhibits one of the most developed banking systems in the Islamic World and also in the database used for this research, Malaysia is found to be by far the largest market for Islamic syndicated financings. As this research is done on Malaysian Islamic syndicated financings, the next paragraph shortly introduces the banking system in Malaysia.

4.1 The Banking System in Malaysia

Malaysia with its dual banking system, which facilitates the co-existence of Islamic and conventional banking systems, provides a unique opportunity to compare Islamic financing with conventional financing. Malaysia is reportedly one of the largest Islamic financing hubs in the world (Solé, 2007). To achieve this position, regulatory premises were set with the establishment of the Islamic Banking Act in 1983 (Chong & Liu, 2007). So for example, the central bank of Malaysia gives tax breaks for Islamic products. Furthermore rules were relaxed to allow commercial and investment banks to carry out Islamic business transactions in foreign currencies. Malaysia, like several other countries has introduced a central Shariah board in its regulatory systems (Hamwi & Aylward, 1999). Today there are 17 Islamic banks in Malaysia, including the Islamic windows of large conventional banks, such as HSBC Holdings Plc, Oversea-Chinese Banking Corp. and

25

Standard Chartered Plc (Bloomberg, 2009). Islamic banking modes have often been criticized to resemble debt, especially in countries with a dual banking system. Chong & Liu (2007) argue, especially in the case of Malaysia, that next to the severe agency problems which Islamic financing modes create, competition from conventional banking might be a reason why Islamic financing modes resemble debt instruments.12 The ability to maximize the risk-adjusted returns on investment and the ability to sustain stable and competitive returns, ensure that Islamic financial institutions stay competitive against their conventional peers (Chong & Liu, 2007).

12

Islamic banks, sticking to the profit-and-loss sharing principle, would face „withdrawal risk“ as a result of a lower rate of return for depositors than the rate of return competitors pay (Chong & Liu, 2007).

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5. Data Selection:

The data source for this Master thesis stems from the LoanAnalytics (former Loanware) database, which contains detailed information on the whole population of loan facilities. The data population from 1995 up to October 2006 was kindly placed at the disposal of mine by Dr. Stefanie Kleimeier, Associate Professor of Finance at Maastricht University, as the research source for this Master thesis.

5.1 Data Selection for the Descriptive Research Questions

For the descriptive research questions all worldwide Islamic syndicated financings from 1995 till October 2006 were selected. Islamic financings were separated from the other financing facilities by two ways. First all facilities which were described as Islamic financings by the information contained in the LoanAnalytics database on the loan facilities. Second, facilities which have no remarks to be Islamic financings were treated as Islamic financing facilities if the facility contained at least one participating financial institution which conducts its business exclusively in an Islamic compliant manner.13And also if the borrower is a solely Islamic financial institution, the facility is treated as an Islamic financing facility. The reason is that Islamic financial Institutions are only allowed to lend and borrow in an Islam compliant way (Chong & Liu, 2007). Furthermore the question arises whether loans to Iranian companies in Iran, the only country in the database which exhibits a solely Islamic banking system14, by foreign financial institutions are automatically Shariah compliant. But even though the borrowing companies are mostly state owned enterprises, the loans from abroad are not

13

Especial attention has to be paid to Iranian banks, as they are often seen as Islamic financial institutions, as the Islamic banking regime in Iran may induce. But the LoanAnalytics dataware shows that often Iranian banks, which lend money from branches abroad to international borrowers, do mostly not follow Islamic financing modes. 14 Only Sudan had introduced a wholly Islamic banking system as well. Sudan promulgated the full Islamization of its financial system in 1992. But since January 2005, the time when the Sudanese government and the former Christian opposition group Sudan People’s Liberation Movement (SPLM) have signed a peace agreement, conventional banks are allowed to work in Sudan again (Solé, 2007).

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automatically Shariah compliant (Shafizadeh, 2008).15 Therefore in this research, borrowings by Iranian companies from foreign financial institutions (if the deal is arranged at least by one foreign financial institution) are only assumed to be Shariah compliant if this information is contained in the LoanAnalytics database. But for Iranian banks, not borrowing via a branch abroad, any borrowing is assumed to be Shariah compliant, as these institutions have to comply with the Islamic banking system inside the country.

5.2 Sample Characteristics for the Descriptive Research Questions

The sample includes all worldwide syndicated Islamic financings. The final sample size consists of 175 Islamic syndicated financing deals from 1995 till October 2006. For some of the descriptive research results the sample size is lower, as specific information required is missing on the dataset. But the exact number of deals is given for every descriptive research result. The time span ends in October 2006, not to include any effect of the credit crisis which followed the following year. The total facility amount of these deals in this time span totals about $28.55bn. There is generally an increasing trend visible, but there are also several drawbacks visible in the generally positive trend for Islamic syndicated financings (Chart 4.2). These drawbacks coincide with the periods of the Asian Crisis in 1997, the bust of the economic bubble in the end of 2000 and the start of the Iraq War in 2003. The year 2006 exhibits the highest amount ever, invested in syndicated Islamic financings, with a record of more than $9.38bn in investments till October 2000.

15

After many years of discussion, foreign lenders, who lend money to borrowers in Iran, have to pay taxes on their interest income. But most financial facilities of foreign lenders entail provisions which require any payments by the borrower back to the lender to be grossed up of any tax payments attributable to it (Shafizadeh, 2008).

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Chart 4.2: Investments in Islamic Syndicated Loans from 1995 till October 2006

5.3 Data Selection & Sample Characteristics for the Loan Spread Analysis of Malaysian Syndications

In order to select the data for the hypothesis test, first all Malaysian borrowers of Syndicated loans, Islamic and conventional ones, were selected. As for the descriptive research, the LoanAnalytics database is used as the data source. The sample includes all Malaysian borrowers from the time period between 1995 and October 2006, where the all-in spread was given in the database. In a few cases other important information in regard to the determinants of loan pricing, such as the name of the lenders or the maturity date of the deal are missing in the database as well. These few cases were excluded too. Furthermore the borrower characteristics, which are determinants of the loan pricing, are measured by the respective credit ratings of the borrowers. The credit ratings for the Malaysian borrowers were found on the websites of the two credit rating agencies in Malaysia, Ram Ratings Services Berhard (RAM) and Malaysian Rating Corporation Berhard (MARC). If the borrowing company doesn’t have a credit rating, it was researched whether this company has a mother company which was rated, to eventually include this rating as a proxy. Furthermore, it is not always possible to find credit ratings for the borrower for the specific year, when the syndicated loan deal was signed. In case

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there is no credit rating for the time of the deal signing, the credit rating which is closest in time is chosen. If there is no credit rating found, the deal is classified as “Not Rated” in the analysis. Data on the syndicate structure and the contract characteristics were found on the LoanAnalytics database. The sample finally includes a total of 420 Islamic and non-Islamic syndicated loan deals. Of these, 32 syndications are Islamic financings. As there are 57 Malaysian Islamic syndications for this time period in total, this means that the final sample includes 56% of them. Not all of the syndications could be included, as data on the spread was missing in these cases. It is important to mention that the 57 Malaysian Islamic syndicated financings count for about a third of all 175 Islamic syndications worldwide in the researched time period.

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6. Empirical Results:

This paragraph presents the results for the descriptive research questions and the outcome of the loan spread analysis for the Malaysian syndicate borrowers. First the results of the descriptive research questions are presented, and then the results of the regression model for the loan spread analysis are provided. For the descriptive research results, countries except for Malaysia, which has a very dominant share, are also added up to regions to emphasize the dominance of specific regions for Islamic syndications. Furthermore the exceptional role for Malaysia continues as Malaysian syndications are taken for the loan spread analysis.

6.1 The receivers of Islamic syndicated financings:

The first research question investigates the receivers of Islamic syndicated financings. In table 6.1.1 the benefiters are categorized in countries. The total tranche amounts for all Islamic syndicated financings worldwide, for the time period between 1995 and October 2006, add up to $28.55bn. The deal count totals 175 Islamic syndicated financings. In respect to the tranche amounts, Saudi Arabian borrowers have the lead with $6.67bn of Islamic syndicated financings, which means that more than 23% of all the financings have been received by Saudi Arabian borrowers. The United Arab Emirates follows with $5.90bn of Islamic syndicated financings, which shows that borrowers in the United Arab Emirates have gained almost 21% of all the Islamic syndicated financings. Malaysia is next with $5.02bn of Islamic syndicated financings which is equal to a share of almost 18% for Malaysia. Borrowers from Kuwait and Iran are also important benefiters of Islamic syndicated financings, and their share of all the Islamic syndicated financings is about 12% and 9% respectively. Companies from predominantly non-Islamic nations, such as the Netherlands, Kazakhstan, Brazil, the United Kingdom, South-Korea, Italy, France, Singapore and the United States have benefited from Islamic syndicated financings as well.

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Tranche amount Tranche Amount in Percent of ($) Total Bahrain 1.065.167.800 3,73% Brazil 85000000 0,30% France 54.300.400 0,19% Indonesia 370.000.000 1,30% Iran 2.630.812.904 9,21% Italy 100.000.000 0,35% Jordan 15.000.000 0,05% Kazakhstan 250.000.000 0,88% Korea (South) 130.000.000 0,46% Kuwait 3.475.000.000 12,17% Malaysia 5.016.268.305 17,57% Netherlands 750.000.000 2,63% Oman 260.000.000 0,91% Pakistan 450.005.580 1,58% Qatar 139.590.000 0,49% Saudi Arabia 6.667.200.000 23,35% Singapore 85.000.000 0,30% Turkey 834.500.000 2,92% United Arab Emirates 5.902.000.000 20,67% United Kingdom 228000000 0,80% USA 45.000.000 0,16% Total 28.552.844.989 100,00% Table 6.1.1: Receivers of Islamic syndicated financings Country

Deal Count 8 2 5 3 22 1 1 3 3 8 57 1 1 9 3 11 1 15 17 3 1 175

Chart 6.1.1 shows the borrowers of Islamic syndicated financings added up in regions, to emphasize the most important benefiting regions. Malaysia as explained already above is exceptionally left as a single country. The regions consist of the West 16, the Middle East17, Malaysia and Others18. The chart (6.1.1) shows that 75% of the borrowers of more than $28.55bn of investments in syndicated Islamic financings are located in the Middle East. Malaysia, as the largest hub for Islamic financings in South-East Asia comprises about 18% of all the Islamic syndicated financings in the world. The absorption of capital by the West is very limited, but still not neglectable at about 4%. Other borrowers comprise 3 % of all Islamic syndicated financings. 16

The West is defined to entail France, Italy, the Netherlands, the United Kingdom and the United States. In this paper, the Middle East is defined as the Greater Middle East which includes Bahrain, Iran, Jordan, Kuwait, Oman, Pakistan, Qatar, Saudi Arabia, Turkey, and the United Arab Emirates. 18 The Others entail Brazil, Indonesia, Kazakhstan, South Korea and Singapore. 17

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Chart 6.1.1: Receivers of Islamic syndicated financings in % of the total Islamic syndicated financings

In regard to the deal counts, Malaysia has the lead with 57 out of 175 Islamic syndicated financing deals (Table 6.1.1). Iran and the United Arab Emirates follow with 22 and 17 deals respectively. Saudi Arabian borrowers exhibit only 11 deals, even though they have the largest share in Islamic syndications in total amounts. The number of deals therefore does not reflect the same outcome as the respective percentages of the investments. Table 6.1.2 shows well, that comparably loans to Malaysian borrowers are smaller than to borrowers in the Middle East. While the average deal size for Malaysian Islamic syndicated financings is about $88.0 million, the average deal size for Middle Eastern borrowers is about $225.7 million. The average deal size for all Islamic syndicated financings is $163.2 million. Western and Other borrowers have average deal sizes of $107.0 million and $76.7 million respectively. The reason for these significant differences might be the industries that profit from Islamic syndications in the respective countries. Malaysian deals for example, overhelmingly invest in the construction industry, while Islamic syndications in the Middle East are mostly on very capital intensive industries, such as the oil and gas sector, or the utilities sector. A more detailed description of the industrial distribution can be found in paragraph 6.3.

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Number of Deals Total Deal Sum ($) Average Deal Size ($) 11 1.177.300.400 107.027.309 West 95 21.439.276.284 225.676.592 Middle East 57 5.016.268.305 88.004.707 Malaysia 12 920.000.000 76.666.667 Others 175 28.552.844.989 163.159.114 All Table 6.1.2: Receivers of Islamic syndicated financings in total numbers for regions

6.2 The source of funds for Islamic Syndicated financings:

The second research question investigates where funds of Islamic syndicated financings come from. In order to do this, the lending institutions are explored. The place of the headquarters of the lending institutions is taken as the source for the countries, from where the funds of Islamic syndicated financings are coming from. Again these countries are added up to regions as in the paragraph before. And as before, the regions consist of the West19, the Middle East20, Malaysia and Others21. As expected, the Middle East contributes a large share of the investments in Islamic syndicated financings (Chart 6.2). But surprisingly, Western lenders exhibit an even larger share of investments in Islamic syndicated financings then Middle Eastern lenders. While Western lenders have contributed about 50% of the funds for Islamic syndicated financings, Middle Eastern lenders have provided 34%. Malaysia as a financial hub for Islamic financings alone provided 11% of the funds of all Islamic syndications. 5% of the funds are from other lenders, such as from Japan or Singapore.

19

The West is defined to entail France, Italy, the Netherlands, the United Kingdom and the United States. In this paper, the Middle East is defined as the Greater Middle East which includes Bahrain, Iran, Jordan, Kuwait, Oman, Pakistan, Qatar, Saudi Arabia, Turkey, and the United Arab Emirates. 21 The Others entail Brazil, Indonesia, Kazakhstan, South Korea and Singapore. 20

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Chart 6.2: Source of funds of Islamic syndicated financings

Next, it seems also very interesting to find out which fund providers are the most important for which Islamic syndicated financing receiver. As can be seen in table 6.2.3, Western Lenders are focused on the Middle East, as 79% of all investments in Islamic syndications by Western financial institutions are absorbed by borrowers in the Middle East. Malaysian borrowers are also paid attention to, as 14% of all investments in Islamic syndications by Western financial institutions are absorbed by borrowers in Malaysia.

Western Middle Eastern Malaysian Borrowers Borrowers Borrowers Western Lenders 2,3% 79,0% 14,0% Middle Eastern Lenders 7,7% 89,6% 0,3% Malaysian Lenders 0,0% 5,4% 94,6% Other Lenders 6,9% 89,3% 3,8% Table 6.2.3: Lenders and borrowers of Islamic syndicated financings in % terms in % of Lenders

Other Borrowers 4,7% 2,5% 0,0% 0,0%

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Western Middle Eastern Malaysian Other Total Borrowers Borrowers Borrowers Borrowers 337 11.355 2.006 680 14.379 Western Lenders 750 8.753 28 240 9.770 Middle Eastern Lenders 0 167 2.932 0 3.099 Malaysian Lenders 90 1.164 50 0 1.304 Other Lenders 1.177 21.439 5.016 920 28.553 Total Table 6.2.4: Lenders and borrowers of Islamic syndicated financings in absolute numbers in million-$

In absolute numbers, $11,355 million and $2,006 million of investments in Islamic syndications by Western financial institutions were absorbed by borrowers in the Middle East and Malaysia respectively (Table 6.2.4). Middle Eastern lenders focus almost purely on their region, as 89.6% of their investments in Islamic syndications stay in the region. But 7.7% of the funds flow to Western borrowers (Table 6.2.3). Again in absolute numbers this means that $8,753 million of Islamic syndications from Middle Eastern lenders have been absorbed by Middle Eastern borrowers, while also $750 million have reached borrowers in the West (Table.6.2.4). Malaysian lenders are also very focused on their home market, as 94.6% of the Malaysian funds flow to Malaysian borrowers (Table 6.2.3). But there are also investments done in the Middle East. 5.4% of the Malaysian investments in Islamic syndications are absorbed in the Middle East. In absolute numbers these investments total $2,932 million and $167 million for Malaysian and Middle Eastern borrowers respectively (Table.6.2.4).Lenders, other than Western, Middle Eastern and Malaysian focus their investments on the Middle East. The Middle East absorbs 89.3%, of the total investments in Islamic syndications. And also Western countries absorb 6.9% of the funds of the other lenders (Table 6.2.3). In absolute numbers these investments have a size of $1,164 million and $90 million for Middle Eastern and Western borrowers respectively (Table 6.2.4). To sum up these results, the Middle East absorbs most Islamic syndicated financings from Western lenders and Middle Eastern lenders. Malaysian borrowers receive most of the Islamic syndicated financings from Malaysian lenders. But Malaysian borrowers also obtain a respectable share from Western lenders. Western borrowers receive a respectable share of Islamic syndicated financings from Middle Eastern lenders. Other lenders focus on Middle Eastern borrowers.

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6.3 Industries towards which Islamic syndicated financings are directed to:

The next descriptive research question investigates the industries which profit from Islamic Syndicated financings the most. Then, a more detailed look is done on each of the most important borrowing industries and the distribution among countries. But first the industries which profit from Islamic Syndicated financings the most are researched.22 As can be seen in chart 6.3.1, the oil and gas sector, financial services and telecommunications received the bulk part of about 59% of all the financings in Islamic syndications.

Chart 6.3.1: Industrial distribution of Islamic syndicated financings

The oil and gas sector alone has received about 27% of all the Islamic syndicated funds, the financial services follow with 18% and then telecommunications with 14%. Utilities and construction follow with each 9% of the total investments. Government borrowings constitute another 7%. These results are in line with the results of the borrowers of Islamic syndicated financings, which are to the largest part situated in the Middle East. 22

A detailed list of the industrial distribution of the investments by syndicated Islamic financings can be found in Appendix 6.3.0

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Borrowers in the Middle East have used these financings for typical industries for this region, which require large investments, such as oil and gas. But also financings which are required to cope with the economic boom and population growth, such as the financial sector, telecommunications, the utility and construction sector, were taken in form of Islamic syndication. In the following part, the borrowers of the above elaborated main sectors, which profit most from Islamic syndicated financings, are examined. These sectors include the oil and gas industry, financial services, telecommunications, utilities, construction and government. The borrowers are sub-divided into countries where they are based in. The research results of the share of the countries, in which the borrowers are based in, are listed detailed in tables. Pie charts are used to give emphasis to the most important borrowers. The oil and gas industry is the biggest profiteer of Islamic syndicated financings with about $7.7bn of total investments. Especially the energy rich Persian Gulf nations, Saudi Arabia, United Arab Emirates and Kuwait use Islamic syndications to finance their oil and gas industries (Chart 6.3.2).

Islamic Syndicated Financings in Oil and Gas

0% 1% 7%

4%

4% Saudi Arabia 38%

United Arab Emirates Kuwait Malaysia Bahrain Indonesia

20%

Pakistan Iran 26%

Chart 6.3.2: Distribution of Islamic syndicated financings in the oil and gas sector by borrowing country

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Their share constitutes already about 84% of all the Islamic syndicated investments in the oil and gas sector. Other important borrowers in the oil and gas sector come from Malaysia (7%), Bahrain (4%) and Indonesia (4%).

Oil and Gas Amount of Investments ($) Percentage of Total Saudi Arabia 2.913.200.000 37,89% United Arab Emirates 2.000.000.000 26,01% Kuwait 1.500.000.000 19,51% Malaysia 524.500.000 6,82% Bahrain 330.000.000 4,29% Indonesia 322.000.000 4,19% Pakistan 75.000.000 0,98% Iran 23.730.252 0,31% Total 7.688.430.252 100,00% Table 6.3.2: Borrowers of Islamic syndicated financings for the oil and gas sector

The second biggest profiteer of Islamic syndicated financings with more than $5.2bn of the total investments is the financial services sector. The most important borrowers of Islamic syndicates, working in the financial sector, are all placed in the Middle East (Chart 6.3.3).

Chart 6.3.3: Distribution of Islamic syndications in the financial services sector by borrowing country

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The borrowers are placed in Iran (34%), Kuwait (23%), Bahrain (14%) and Saudi Arabia (11%) according to the share of the syndicate investments in relation to the total investment in this industry sector.

Financial Services Amount of Investments ($) Percentage of Total 1.777.082.652 33,98% Iran 1.225.000.000 23,42% Kuwait 735.167.800 14,06% Bahrain 584.000.000 11,17% Saudi Arabia 250.000.000 4,78% Kazakhstan 210.526.319 4,03% Malaysia 180.500.000 3,45% Turkey 100.000.000 1,91% Italy 85.000.000 1,63% Singapore 63.000.000 1,20% United Kingdom 20.000.000 0,38% United Arab Emirates 5.230.276.771 100,00% Total Table 6.3.3: Borrowers of Islamic syndicated financings for financial services

The third biggest borrower of Islamic syndicated financings with more than $4.1bn of total investments is the telecommunications sector. Here the borrowers in the kingdom of Saudi Arabia are the most important borrowers and absorb 57% of all Islamic syndicated investments in the telecommunications sector (Chart 6.3.4). The Netherlands is the second biggest profiteer of Islamic syndicated financing in the telecommunications sector. With $750 million in investments or a share of about 18%, the telecommunication sector shows how Islamic financings can be used in predominantly non-Muslim Western states as well. Kuwait receives the same size of Islamic syndicated financings of 18% for the telecommunications sector, like the Netherlands.

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Chart 6.3.4: Distribution of Islamic syndications in the telecommunications sector by borrowing country

Other benefiters of Islamic syndicated financings in the telecommunications sector are Malaysia and Turkey, with a share of 4% and 2% respectively. In total numbers, these amounts to $171 million and $100 million of investments for Malaysia and Turkey (Table 6.3.4).

Telecommunications Amount of Investments ($) Percentage of Total 2.350.000.000 57,02% Saudi Arabia 750.000.000 18,20% Netherlands 750.000.000 18,20% Kuwait 171.052.632 4,15% Malaysia 100.000.000 2,43% Turkey 4.121.052.632 100,00% Total Table 6.3.4: Borrowers of Islamic syndicated financings for the telecommunications sector

Another important borrower of Islamic syndicated financings with about $2.6bn of total investments is the utilities sector. The borrowers in the United Arab Emirates are the biggest receivers of Islamic syndicated financings in the utilities sector with the absorption of about 80% of all the investments of this sector (Chart 6.3.5). Malaysia is the second biggest borrower, with a share of 10%. Saudi Arabia and Pakistan follow with 8% and 2% respectively. 41

Islamic Syndicated Financings in Utilities

8%

2%

10% United Arab Emirates Malaysia Saudi Arabia Pakistan

80%

Chart 6.3.5: Distribution of Islamic syndicated financings in the utilities sector by borrowing country

In absolute numbers, borrowers from the United Arab Emirates exhibit $2.04bn of Islamic syndicated financings in the utilities sector (Table 6.3.5). Malaysia and Saudi Arabia follow with $245 million and $210 million. Borrowers from Pakistan have received more than $61 million of Islamic syndicated financings for the utilities sector.

Utilities United Arab Emirates Malaysia Saudi Arabia Pakistan Total

Amount of Investments ($) 2.040.000.000 244.769.049 210.000.000 61.319.766 2.556.088.815

Percentage of Total 79,81% 9,58% 8,22% 2,40% 100,00%

Table 6.3.5: Borrowers of Islamic syndicated financings for the utilities sector

The next important borrower of Islamic syndicated financings with about $2.5bn of the total investments is the construction sector. In this sector, Malaysian borrowers are the stunning majority, with a share of close to 96% (Chart 6.3.6). Turkey and France follow with a share of 2% each.

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Chart 6.3.6: Distribution of Islamic syndicated financings in the construction sector by borrowing country

The absolute total amount of Islamic syndicated financings for the construction sector totals $2.38bn for Malaysia. The financing amount totals $62 million and $54 million for Turkey and France respectively (Table 6.3.6).

Construction Amount of Investments ($) Percentage of Total 2.379.522.670 95,34% Malaysia 62.000.000 2,48% Turkey 54.300.400 2,18% France 2.495.823.070 100,00% Total Table 6.3.6: Borrowers of Islamic syndicated financings for the construction sector

Other important borrowers of Islamic syndicated financings with more than $2bn of the total investments are governments. The United Arab Emirates enjoys the largest chunk of these financings, with a share of 49% (Chart 6.3.7). Iran follows with a share of 25% and then Turkey and Pakistan with 16% and 10% respectively.

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Islam ic Syndicated Financings in Governm ent

10% 16% 49%

United Arab Emirates Iran Turkey Pakistan

25%

Chart 6.3.7: Distribution of Islamic syndicated financings received by governments by borrowing country

In total absolute amounts, the United Arab Emirates has received $1bn of Islamic syndicated financings. Iran follows with $500 million. And the governments of Turkey and Pakistan have received $332.5 million and $200 million in Islamic syndicated financings respectively.

Government Amount of Investments ($) Percentage of Total 1.000.000.000 49,20% United Arab Emirates 500.000.000 24,60% Iran 332.500.000 16,36% Turkey 200.000.000 9,84% Pakistan 2.032.500.000 100,00% Total Table 6.3.7: Governments as borrowers of Islamic syndicated financings

6.3.1 Changes of Islamic syndicated deals for different industries over time:

In the following paragraph, the research results for changes in the Islamic syndicated financing deals for major industry groups are depicted (Graph 6.3.1).23 Generally, the number of syndication deals that include Islamic tranches is very volatile. It is also very noticeable that the Islamic syndicated financings have begun in the middle of the 90s and 23

A detailed list of the changes of the industrial distribution over time, of the investments by syndicated Islamic financings can be found in Appendix 6.3.1

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that there is a general increase in the deal counts over the years, except for the year 2003. Remarkable is the surge in the Islamic syndicated financing deals in the construction sector in the time period between 2003 and 2005. The financial services sector has especially profited from Islamic syndication deals in the time period between 1999 and 2002. And compared to 2005, the financial services sector has seen high growth in Islamic syndication deals for this sector again in 2006. The utilities sector has seen the highest number of deals in 2001. The transportation sector was most successful between 2000 and 2002 to attract Islamic syndicated financings. The oil and gas sector has seen growth in the absorption of Islamic syndication deals since 2004.

Graph 6.3.1: Industrial distribution of Islamic syndications over time

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6.4 Shares of lead banks: Islamic syndications vs. conventional syndications:

In case of more intense information asymmetries and to mitigate agency problems for Islamic syndicated financings, lead banks are expected to hold a larger share of the syndicated financing. This enforces more intensive monitoring and due diligence of the borrower. Furthermore, do lead banks hold larger shares if there is a cultural gap between lenders and borrowers. But do lead banks hold larger shares of Islamic syndicated financings than for conventional syndicated loans, to confront the expected larger agency problems and information asymmetries?

Participation Numer of Average Median Minimum Maximum of Lead Banks observations 52% 0% 100% Islamic 55% 68 50% 0% 100% Non-Islamic 56% 22.944 Table.6.4: Average and Median share of lead banks at Islamic and Non-Islamic Syndicated loans

As can be seen in table 6.4, the average shares of lead banks at Islamic and Non-Islamic syndications are almost the same. The share of lead banks at Islamic syndications is on average about 55% of the syndicated financings, while the share of lead banks at nonIslamic syndications is about 56%. And there is also not a large difference between the median numbers. Islamic as well as non-Islamic deals have very different deal structures in regard to the participation of lead banks, as the minimum and maximum numbers show. This hints that the share of lead banks might be increased in case the borrower is perceived as more risky. But the results show that the share of the lead banks is not increased to lessen information asymmetries and agency problems specifically for Islamic syndicated financings. But there are other contracting tools, which might be used in order to lessen agency problems perceived with Islamic financial instruments. Such an instrument is the maturity of the Islamic syndicated financings, which is explored in the following paragraph.

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6.5 Maturities of Islamic syndicated financings versus conventional syndications:

Comparing the maturities of Islamic and conventional syndicated loans, the maturities, as can be seen in table 6.5.1 show certainly differences. On average Islamic syndicated financings do have a maturity of 5.35 years compared to 4.44 years for conventional syndications. Thus on the first sight, this would mean that the maturity is not used as a contracting tool against probable agency problems and information asymmetries of Islamic syndicated financings.

Average Median Number of Observations Maturity (Years) 5,35 5,00 143 Islamic 4,44 4,50 94.318 Conventional Table 6.5.1: Maturity of Islamic and conventional syndications

But the maturity needs a more differentiated analysis. In graph 6.5.1, the maturities of all Islamic and conventional syndication deals are depicted in the percentage of all respective deals per year. And indeed, more Islamic syndicated loans have a shorter maturity than their conventional counterparts in the first three years. This is especially true for the part of the loans with a maturity of 1 – 2 years. While 14% of the Islamic syndications have a maturity of 1-2 years, only 7% of the conventional syndications exhibit a maturity of 1-2 years (Table 6.5.2).

% of All Islamic or Conventional Syndications

Maturity: Islamic vs Conventional Syndications 35% 30% 25% 20%

Non-Islamic Syndications Islamic Syndications

15% 10% 5% 0% = 15

Years

Graph 6.5.1: Maturity of Islamic and conventional syndication deals in % of all deals per year

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But more conventional syndications exhibit maturities higher than three years than Islamic syndications. This gap holds for the syndicated loans with maturities up to nine years (Graph 6.5.1). Accordingly more Islamic syndicated financing deals have maturities lower than three years or higher than nine years, compared to conventional syndications. A lower loan maturity is an important tool against agency problems. This means that the maturity might be used to lessen the agency conflicts of Islamic syndicated financings, as there are more Islamic syndication deals which have a lower maturity in the first three years. Other reasons might be the preference to finance shortterm investments due to the regulations of Islamic financial systems or the practice of Islamic financial institutions (Rajesh, Amos, Tarik, 2000). Another explanation could be the differences between the industries which receive the financings, which might enforce different maturities between Islamic and non-Islamic syndicated financings. So the industries which receive the Islamic syndications might explain the larger amount of deals with lower maturities in the first three years compared to conventional syndications in the same time period. But as it is researched in paragraph 6.3, Islamic syndications are mostly invested in industries which exhibit larger investment needs and have usually more long-term financing requirements, such as the oil and gas industry, telecommunications or the utilities sector. This explains also why there are also more Islamic syndicated financing deals which exhibit maturities higher than nine years (Table 6.5.2). While about 5% of all conventional syndications have maturities longer than nine years, about 18% of all Islamic syndications have a maturity of more than nine years.

Non-Islamic Syndications Islamic Syndications 19% Maturity = 15 Years Table 6.5.2: Maturities of Islamic and Conventional Syndications in %

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And as the Islamic syndicated financings for these large projects are mostly for stateowned enterprises, the higher perceived agency conflict for Islamic syndicated financings diminishes, as the state acts as a kind of guarantor.

6.6 Financial debt covenants: Islamic syndications vs. conventional syndications:

Loan covenants are important measures of the agency problem and the perceived asymmetric information.

Interestingly, the results show that only 7% of Islamic

syndicated financings exhibit financial debt covenants, compared to 31% of conventional syndicated loans (Table 6.6).

Number of Observations Debt Covenants Yes No 175 Islamic 7% 93% 111.768 Conventional 31% 69% Table 6.6: Percentage of deals with or without financial debt covenants

This is the opposite of the result expected, as Islamic financing involves risk sharing. Therefore it is clear that financial debt covenants are not used as a tool against information asymmetries and agency problems.

6.7 Participating banks: Islamic syndications vs. conventional syndications:

Another mean to reduce information asymmetry, is to concentrate the number of the lenders in the syndicate, to be better able to monitor the borrower.

Number of Lenders Average Median Number of Observations 175 Islamic 6,78 5,00 110.588 Conventional 6,81 4,00 Table 6.7: Number of lenders in Islamic and conventional syndications

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As can be seen in table 6.7, this tool is also not used more predominantly for Islamic syndicated financings. The average number of lenders in Islamic and conventional syndications is just marginally different. The average number of lenders in an Islamic syndicate is 6.78, while it is 6.81 for conventional syndicated loans. The median number of lenders is even higher for Islamic syndications, with an average of 5 lenders, while conventional syndicated loans exhibit a median number of 4 lenders.

6.8 Deal Size: Islamic syndications vs. conventional syndications:

The effects of agency problems and information asymmetries can also be limited, by limiting the size of the Islamic syndicated financing. And indeed, the size of conventional syndicated loans is on average 36.6% larger than the average Islamic syndicated financing deal size. And also the median deal size is significantly lower for Islamic financings than for their conventional counterparts. Therefore, these results might hint, that the limitation of the deal size is a tool to limit information asymmetries and agency problems. And this result might not be due to the industries in which the financings flow in. As seen in paragraph 6.3, Islamic syndicated financings are to the largest part invested in capital-intensive industries, such as oil and gas industries, telecommunication and utilities. Furthermore, the reason cannot be due to Islamic financial institutions which do not have the capabilities for larger financings. As seen in paragraph 6.2, Western lenders and cash-rich Middle Eastern lenders constitute the overwhelming majority of Islamic syndicated financings.

Average Median Number of Observations Deal Size (in $) 168 Islamic 169.957.411 61.659.883 111.069 Conventional 232.189.860 77.848.549 Table 6.8: The average and median deal size of Islamic and conventional syndications

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6.9 Differences in the Spread

Agency problems have a larger effect on the syndicated loan contract, the more these problems are perceived. The difference in the risk pattern of Islamic syndications could yield different agency problems. Islamic syndicated financings could face agency problems because some agency mitigating techniques might have conflicts with the Shariah law. Cultural differences between borrowers and lenders can increase the perceived risk. And the higher the actual or perceived risk of the agency problems, the higher the loan spread. Also a piety premium could lead to a higher loan spread. The OLS regression model, with determinants of loan pricing for Islamic and non-Islamic loans in Malaysia, is built to find out whether Islamic syndicated financings are more expensive than conventional syndications, as explained in paragraph 4. Furthermore it is researched whether specific attributes of Islamic and non-Islamic syndicated loans influence credit spreads. At first, one dummy variable states whether a syndicated deal is Islamic or conventional. Then determinants of the loan pricing are added as dummy variables as well. As stated in paragraph 5.3, determinants of the loan pricing in the statistical model are based on borrower characteristics, contract characteristics and the characteristics of the syndicate structure. It is decided to include only those variables as determinants of the loan pricing, which have shown differences for Islamic and conventional syndications in the descriptive statistics, as these variables which show up differences are probably active tools to lessen agency conflicts. The credit ratings of the Malaysian borrowers are taken as the determinant for borrower characteristics. In order to accomplish this, dummy variables are created, indicating the credit ratings, namely “AAA”, “AA”, “A”, “BBB”, or “BB and below”. As many borrowers do not have a rating, a dummy variable would indicate that the specific borrower is not rated. For the contract characteristics, the maturity, the deal size and the existence or not-existence of financial covenants are included, as these were found out to be different for Islamic syndicated financings. In case of the maturity and the deal size, the dummy variables hint whether a syndicated deal is bigger or equal to the median size of Islamic or conventional syndications, depending whether the deal is Islamic or conventional. For the characteristics of the syndicate structure, the size of the lead banks share and the number

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of participating were found out to be not different for Islamic syndications than for conventional syndications. But the differences of the origin of the lending banks are taken as dummy variables for the syndicate structure. The dummy variables include whether a lending bank is Western, Middle Eastern, Malaysian or East Asian. As dependent variable for this model, the all-in spread for the deals is taken. The all-in spread is given for most of the syndications in the LoanAnalytics database. Those deals which had no spread given were excluded from the model. The sample for the regression model finally includes a total of 420 Islamic and non-Islamic syndicated loan deals with Malaysian borrowers. Of these, 32 syndications are Islamic financings, which constitute 56% of all Islamic syndicated financings for Malaysian borrowers. Obviously it is impossible to include all the variables in the OLS regression equation, as this would create a nearsingular matrix. In the regression, one of the variables is left out. At random, the dummy variable “BB and below” is left out. The first regression results can be seen in table 6.9.1. There is a trend visible for the borrower characteristics, as the rating coefficients have a decreasing trend, the higher the credit rating. However, the t-statistics indicate that the variables selected so far are not all very significant on their own. For the contract characteristics, the “Deal Size” is significant, which means that if the syndicated deal has a larger deal amount than the median deal size of all Malaysian syndications, the spread would decrease by 0,38%. For the syndicate structure, the variable “Conventional” is highly significant. This means that the model predicts that conventional syndicated loans have a 1.46% lower spread than Islamic syndicated financings. Furthermore, in case the lending bank is Malaysian, the spread significantly increases by 0.5%. But if the lending bank is East Asian, the spread significantly decreases by 0.33%.

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Coeff. t-stat Borrower Characteristics: Rating: AAA Rating: AA Rating: A Rating: BBB Not Rated

-0,65 -0,33 -0,47 -0,36 -0,19

-2,51 -1,30 -1,92 -1,39 -0,83

Contract Characteristics: Maturity Deal Size Financial Covenants

0,03 -0,38 -0,03

0,24 -3,16 -0,22

Syndicate Structure: Conventional Lending bank Western Lending bank Middle Eastern Lending bank Malaysian Lending bank East Asian

-1,46 0,02 -0,44 0,50 -0,33

-6,68 0,17 -0,54 3,68 -2,62

Observations R-squared

** *

**

***

*** ***

420 0,25

*** Indicates p value of 1% ** Indicates p value of 5% * Indicates p value of 10%

Table 6.9.1: First regression results

But there are also many variables in table 6.9.1, which seem not to be significant. To improve the model, those variables are iteratively removed from the model. Thus in order to improve the model, the variable with the highest p-value is deleted as the chance of this variable to be not significant is very high. Then the regression is run again and then the variable with the highest p-value is removed again. This procedure is done till all remaining variables are significant. This leads to the removal of “Lending bank Western”, “Maturity”, “Financial Covenant”, “Lending bank Middle Eastern”, “Not rated”, “Rating: AA”, “Rating: BBB”, “Rating A”. Table 6.9.2 shows the regression results after the removal of the last insignificant variable.

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Coeff. t-stat Borrower Characteristics: Rating: AAA

-0,35

-1,96

*

Contract Characteristics: Deal Size

-0,41

-3,60

***

Syndicate Structure: Conventional Lending bank Malaysian Lending bank East Asian

-1,41 0,51 -0,35

-6,68 4,36 -3,08

*** *** ***

Observations R-squared

420 0,24

*** Indicates p value of 1% ** Indicates p value of 5% * Indicates p value of 10%

Table 6.9.2: Final regression results

In table 6.9.2, all variables, except for “Rating: AAA” are significant at a 1% significance level. The variable of the borrower characteristic “Rating: AAA” predicts that a Malaysian syndicated borrower with AAA-rating is expected to pay 0.35% less spread than if it would not have the AAA-rating. This is in line with common sense, as less risky borrowers have to pay lower risk compensation. The remaining variable “Deal Size” means that if the Islamic or conventional syndicated deal has a larger deal amount than the median deal size of all Islamic or conventional Malaysian syndications respectively, the spread would decrease by 0.41%. The reason might be that larger syndicated financings are assured by more credible companies, which might be even state owned. Large industries, such as oil and gas, telecommunications or utilities are not very unlikely to be government owned or very large and therefore more credible for the lenders. For the syndicate structure, there are three significant variables in the regression results. Based on the coefficients of the variable “Conventional”, the model predicts that conventional syndicated loans have a 1.41% lower spread than Islamic syndicated financings. This might confirm that Islamic syndicated financings face a piety premium. Especially, as not all tools to lessen information asymmetries and agency problems are used, such as to increase the share of lead banks, to include financial debt covenants or to reduce the number of lending institutions, this indicates that the piety premium might be the reason

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for the higher spread. Another reason might be a higher perceived agency problem for Islamic syndicated financings, which would even not be reduced by introducing further tools to limit its effect, and which yields therefore a higher spread. Another interesting finding is that the variable “Lending bank East Asian” has a negative effect on the spread. As soon as the lending bank is East Asian, the model predicts that the spread is 0.35% lower than if the lending bank is not East Asian. Furthermore, the last variable, namely the variable “Lending bank Malaysian” is positive at 0.51%. Thus when the lending bank is Malaysian, the interest rate is expected to be 0.51% higher, than in the case when the lending bank is not Malaysian. These findings are in opposite of the arguments of Giannetti and Yafeh (2009), who find that loan spreads are lower, if borrowers and lenders are culturally closer.

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7 Conclusion and Limitations:

Islamic syndicated financings have seen a surge since their appearance in the mid 90s and constituted more than $28.55bn of financings worldwide in the time period of 2005 till October 2006. The aim of this paper is to find out differences between Islamic syndicated financings and conventional syndicated loans. Furthermore, the research results hint by how far Islamic syndications are affected by the agency problem. The research was conducted in two parts. First, descriptive research was carried out to find differences in the contract characteristics and syndicate structure of Islamic syndicated financings and conventional syndicated loans. Then a regression analysis on the loan spreads of Malaysian syndicated borrowers was conducted to find out whether Islamic syndicated financings have a higher spread, or in other words, if they are more expensive than conventional syndications. Furthermore, determinants of the loan pricing were added to the regression model to research their effects on the credit spread. The determinants of the loan pricing in the regression model are based on borrower characteristics, contract characteristics and the characteristics of the syndicate structure. Only those variables are included as determinants of the loan pricing, which have shown differences for Islamic and conventional syndications in the descriptive statistics researched before, because these variables which show up differences are most likely active tools to lessen agency conflicts For the descriptive research, first borrowers and lenders were researched. It is confirmed in this research that Muslim borrowers are the main benefiters of Islamic syndicated financings. But also Western borrowers received Islamic syndicated financings, a tool to attract investments from Islamic investors. 75 % of all Islamic syndicated financings were received by borrowers that are located in the Middle East. Malaysian borrowers follow with 18%. Western borrowers have a share of 4%. On the lenders side, the West uses its banking experience and the attractive markets, especially in the Middle East, and contributes 50% of all Islamic syndicated financings. Middle Eastern lenders have provided 34% of the funds. But these funds are to the largest part lent to Middle Eastern borrowers. The share of Malaysian lenders is at 11%. And also Malaysian lenders lent almost all of their funds to Malaysian borrowers of Islamic syndicated financings.

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Furthermore the industries which receive these financings are researched. Islamic syndications are mostly invested in industries, which are typical high-growth or cash-rich industries of its lenders, such as the oil and gas industry, telecommunications, financial services, or the utilities sector. To continue with the descriptive research, differences in the syndicate structure were researched. First differences of the share size of Islamic and conventional syndications are investigated. The results show that the share of lead banks at Islamic syndications is on average about 55% of the syndicated financings, while the share of lead banks at nonIslamic syndications is about 56%. As the minimum and maximum numbers show that Islamic and conventional syndications can have very different deal structures in regard to the participation of lead banks, this hints that the share of lead banks might be increased in case the borrower is perceived as more risky. But the results show that the share of the lead banks is not increased to lessen information asymmetries and agency problems specifically for Islamic syndicated financings. Another factor for the syndicate structure is the concentration of the number of lenders in the syndicate. And also this tool to better monitor the borrower to lessen agency problems is not used more predominantly by Islamic syndicated financings. Next the differences in the contract characteristics were researched as well. One factor of contract characteristics is the maturity. The research results show that more Islamic syndicated financing deals have maturities lower than three years or higher than nine years, compared to conventional syndications. A lower loan maturity is an important tool against agency problems. Therefore the results suggest that the maturity might be used to lessen the agency conflicts more often for Islamic syndicated financings than for conventional syndicated loans. But also other reasons such as regulatory factors for Islamic syndicated loans might explain the higher percentage of Islamic syndicated financings that have a maturity of up to three years. The higher percentage of Islamic syndicated financings with maturities above nine years can be explained by the industries in which Islamic syndicated financings are sourced to. Large industries in the gas and oil industry or the utilities sector require longer maturities. Agency problems, due to the higher maturity for these financings, are lessened by the fact that the borrowing companies are often large, therefore more credible and many times even state owned.

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Another factor for contract characteristics is the limitation of the size of the syndication deals. The effects of agency problems and information asymmetries can be reduced, by limiting the size of the Islamic syndicated financing. The research results show that the size of conventional syndicated loans is on average 36.6% larger than the average Islamic syndicated financing deal size. While the size of an average Islamic syndicated financing is about $170 million, it is about $232 million for conventional syndicated loans. The research results of the regression analysis on the loan spreads of Malaysian syndicated borrowers significantly show that conventional syndicated loans have a 1.41% lower spread than Islamic syndicated financings. This might confirm that Islamic syndicated financings face a piety premium. Especially, as not all tools to lessen information asymmetries and agency problems are used, such as to increase the share of lead banks, to include financial debt covenants or to reduce the number of lending institutions, this indicates that the piety premium might be the reason for the higher spread. Furthermore the variable “Credit rating: AAA” for the borrower characteristics predicts that a Malaysian syndicated borrower with AAA-rating is expected to pay 0.35% less spread than if it would not have the AAA-rating. Another significant variable is the variable “Deal Size” which shows that in case the Islamic or conventional syndicated deal has a larger deal amount than the median deal size of all Islamic or conventional Malaysian syndications respectively, the spread would decrease by 0.41%. The reason for this result might be again that larger deals are predominantly done with larger and therefore more credible borrowing companies. Another interesting finding is that the variable “Lending bank East Asian” has a negative effect on the spread. As soon as the lending bank is East Asian, the model predicts that the spread is 0.35% lower than if the lending bank is not East Asian. In addition, the variable “Lending bank Malaysian” is positive at 0.51%. Thus when the lending bank is Malaysian, the interest rate is expected to be 0.51% higher, than in the case when the lending bank is not Malaysian. These findings oppose the findings of Giannetti and Yafeh (2009), that loan spreads are lower, if borrowers and lenders are culturally closer. It has to be cautioned that the data on Islamic financing, and more precisely Islamic syndicated financings, are still scarce. The research results of the regression analysis should be cautioned to be true for all Islamic syndicated financings worldwide, as it

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contained only 32 Islamic syndicated financing deals with Malaysian borrowers. But for Malaysia, the regression results are significant and entail 56% of all Islamic syndicated financings. But taking all these results together, one can say that Islamic syndicated financings are only slightly different than conventional syndicated loans. For sure the ethical and religious specificities of Islamic syndicated financings play an important role and may attract specific investors or lead to new opportunities for Western banks to conduct business in the Islamic world. But in regard to the structure and contract specificities of Islamic syndicated financings, one can say that there are only minor differences. Some agency mitigating tools might be used for Islamic syndicated financings, but many tools are not used. Therefore one can say that Islamic syndicated loans do not suffer immensely more from the agency problem than conventional syndicated loans. The higher spread costs for Islamic syndicated financings in Malaysia can be therefore regarded more as a piety premium. As a research suggestion, it would be interesting to find out what the effects of the credit crisis were on Islamic syndicated financings and specifically on its spread. This might give new insights by how far Islamic borrowers are indirectly affected by the credit crisis, as Islamic financial institutions did not suffer from the international crisis directly (Wigglesworth, 2009).

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Appendix:

Industry Agriculture Automotive Beverage, Food, and Tobacco Processing Business Services Chemicals, Plastics & Rubber Manufacturing Construction Financial Services General Manufacturing Government Hotel & Gaming N/A Oil and Gas Real Estate Retail & Supermarkets Technology Telecommunications Transportation Utilities Wholesale Total Appendix 6.3.0

Industry Tranche Amounts / Total Tranche Amount 2,50% 0,28% 0,35% 0,54% 1,95% 8,67% 18,18% 2,53% 7,06% 0,22% 2,00% 26,72% 1,50% 0,27% 0,16% 14,32% 2,84% 8,88% 1,02% 100,00%

65

Changes of Islamic syndicated financings in different industries over time Agriculture Automotive Beverage, Food, and Tobacco Processing Business Services Chemicals, Plastics & Rubber Manufacturing Construction Financial Services General Manufacturing Government Hotel & Gaming N/A Oil and Gas Real Estate Retail & Supermarkets Technology Telecommunications Transportation Utilities Wholesale Total Appendix 6.3.1

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 0 0

0 0

1 0

0 0

2 2

2 0

2 0

0 0

0 0

0 0

1 0

0 0

0

0

0

0

0

0

0

1

0

0

0

1

0

0

0

0

0

0

0

0

1

0

0

1

0

0

0

0

0

0

0

0

0

0

0

2

0 0 0 2 0 0 0 0 0 0 0 0 0 0

3 0 2 0 0 2 2 0 0 0 0 0 0 0

0 0 0 2 0 3 0 0 0 0 0 0 0 2

0 0 0 0 0 4 2 0 0 0 0 0 1 0

6 6 0 0 0 3 2 2 0 0 0 0 0 2

4 4 0 0 0 0 0 0 0 0 0 3 0 1

3 3 0 0 0 0 0 0 0 1 0 2 4 1

1 7 0 1 0 1 2 1 0 0 1 2 3 2

0 0 0 0 0 0 0 0 2 0 0 1 1 0

5 3 1 0 0 0 3 1 0 0 3 1 1 1

16 0 2 0 1 2 3 0 0 0 0 0 0 0

0 7 2 1 0 0 6 0 0 0 2 0 1 0

2

9

8

7

25

14

16

22

5

19

25

23

66