The Pakistan Credit Rating Agency PACRA Credit Ratings For Islamic Instruments May 07’12 ADNAN AFAQ MD PACRA 1

About PACRA 1. PACRA, Pakistan’s first rating agency – 1994 Banks AMC Insurance Refineries IPPs Corporate Sukuks 2. JV : IFC + Fitch Ratings + Lahore Stock Exchange 3. To date + 1,500 rating opinions Rated 85% of debt instruments in Pakistan 4. Recognized by Apex Regulators – Pakistan & Bangladesh 5. Development work for World Bank: Bond Market - NBFI sector 6. We do: Risk Advisory, Specialized Training on Risk Management Corporate Governance Assessment (IFC model)

Development of Credit Ratings Coverage of rating agencies (~ 90% of World GDP) World GDP: Current Prices: USD 63trn (June-11) PPP: USD 76trn (June-11) In Africa: Nigeria, Kenya, Zimbabwe and South Africa Recently started in Zambia and Cameroon

Why Credit Rating? Public Money Risk & Return Bank Deposits Tax Payers’ money Listed Companies Insurance Real Estate Projects Mutual Funds Whenever Public Money is invested Disclosure of Risk & Return is imperative Risk & Return Correlation Transparency: Independent view of risk

Why Credit Rating Regulators Management Investor Matching of Greater Access to Capital Timely Action Transparency Relative Position Management Investor Regulators Identify Risk Factors Enterprise Risk level Systemic Risk Not possible to capture without quantification Market condition Market action/inaction Matching of Risk & return

Crux of Islamic Finance Transaction must have real economic purpose No undue speculation allowed [Gharar] No exploitation or sinful activities permitted Underlying concept: Sharing of risks & rewards Riba: Interest & other Unlawful gain are prohibited

World Sukuk Markets Total Sukuk Size: $215 b outstanding

World Sukuk Markets Main Players: Latest happenings Azerbaijan Malaysia (60-70% of new issuances globally) Saudi Arabia UAE Pakistan Latest happenings Malaysia- Largest Islamic bond Plus highway $10bbn Saudi Arabia- rise in activity: Civil Aviation, Saudi bin Ladin SATORP South Africa- Treasury Sukuk proposition Thailand- Tax Incentive Oman- Infrastructure Sukuk proportion Japan- Changes in tax & stamp duties Ireland- Finance Bill 2010 facilitate Islamic Finances Preparing Launch Azerbaijan Kazakhstan Australia India Japan Singapore Nigeria Ireland

Introduction to Sukuks Plural of Sak – meaning ‘certificates’ in Arabic Beneficial ownership interest in a tangible asset &/or resulting cash flows Ijara Istisna’a Murabaha Mudaraba Musharaka Resembles a conventional lease agreement Late payment charges paid to charity Financier commissions the construction/manufacture of asset Simultaneous forward Ijara agreement Sale of agreed asset at cost plus agreed profit margin Provides liquidity to the customer Funds entrusted with a corporate for use in pre-agreed business Profit & loss sharing Similar to Mudaraba but this is an equity stake Risks associated with structure type

Sukuk Ratings Rating looks through the structure of the Sukuk at the originator of the transaction. Step 1; Base rating = originator’s Rating Step 2; Notching [Up –Down ] dependent on: Type of claim or underlying contract Ijara ensures predictable returns due to fixed rentals while Musharaka is equity-based and hence less predictable Quality of assets underlying the transaction Mechanisms like reserves can further enhance credit Sukuk rating will be IDR plus one or multiple notches depending on strength of afore-mentioned factors

Credit Risk Assessment Pyramid Ownership 1 Governance 2 Management 3 Business Risk 4 Financial Risk 5 Long-term Sustainability Relative Positioning Macro-Economic Environment Business Life-cycle Short-term Sustainability 11

Credit Ratings – An Introduction Rating Scale – To measure relative credit risk Credit Quality Rating Category Exceptionally Strong AAA Very Strong AA Strong A Adequate BBB Speculative BB Highly Speculative B High Default Risk C Default D Investment Grade Speculative

Creates Credit History Default… Failure to perform an obligations laid down in the agreement Failure to pay amounts due; Very strict adherence to covenants (promise) Brings Market Discipline Creates Credit History

Limitations of Sukuk Enforcement not ensured (lack of legal precedent) Interpretation may differences between Shariah and local courts 2. Register able asset not always transferred to SPV: Due to Foreign ownership Cumbersome Expensive

Iranian Sukuk Market

Any Q & A ??? Thank You!