This document discusses SPV structures in sukuk and their capital adequacy requirements under Basel II. It examines how sukuk representing equity, debt, and asset-backed securities would be treated. For equity-style sukuk holding over 20% of assets, capital deductions or pro rata consolidation is required. For debt-style sukuk, risk weights from 20-150% apply depending on the obligor's credit rating. For asset-backed sukuk, crucial factors are the rating and whether the assets are truly sold. Ratings determine capital charges or risk weights from 20-350%. Many issues can affect the rating if not guaranteed by an obligor.

1. SPV Structures in
Sukuk
Capital Adequacy
Requirements
Ahmed Adil
Partner, Business Risk Services (BRS) &
Islamic Financial Services Group (IFSG)
16th May 2005

2. 2
SPV Structures in Sukuk
Ownership of
Assets
Bankruptcy
Remoteness
Sukuk
Issuance
SPV

3. 3
What Does SPV Sukuk Structure
Represent ?
Equity ?
Redeemable through sale of
investment or liquidation
Not an obligation on the issuer
Residual interest on assets and
income of the issuer
Debt (Finance) ?
Guaranteed principal and profit
Obligation of issuer
No residual interest on assets and
income of the issuer
Asset Backed
Security (ABS) ?
Tranched structure in substance
True sale of assets
Uninterrupted rights to cash flow of
the assets

4. 4
Sukuk - Equity
Basel II Capital Adequacy Requirements
> 50% Consolidate or carve out
>20% <50% Deduct from capital or pro rata consolidation
<20% Requirements under Standardised Approach
RW of 150 % or higher reflecting higher risks associated
with equity
<20% Requirements under IRB Approaches
Choices
PD / LGD ApproachMarket Based Approach
Simple Risk
Weight Method
Internal
Models Method
RW = 300% for
publicly traded
equity
RW = 400%
for all other
equity
VaR calculated by
Internal measurement
models
- Calculation of PD
- LGD assumed at 90%
- Minimum RW of 100%
- Maximum RW of 1250 %

5. 5
Sukuk – Debt (Finance)
Basel II Requirements
Obligor can be a sovereign, bank or corporate
Requirements under Standardised Approach
UnratedBelow
B-
BB+ to
B-
BBB+ to
BBB-
A+
to A-
AAA
to AA-
Banks
50 %150 %100 %50 %50 %20 %Bank
100 %150 %100 %100 %50 %20 %Sovereign
UnratedBelow
BB-
BBB+
to BB-
A+ to
A-
AAA to
AA-
Corporates
100 %150 %100 %50 %20 %
Requirements under IRB Approaches
RWA = (f (PD, LGD, M)) * 12.5 * EAD
UnratedBelow
B-
BB+ to
B-
BBB+ to
BBB-
A+
to A-
AAA
to AA-
Sovereign
100 %150 %100 %50 %20 %0 %

6. 6
Sukuk – Asset Backed Securities
Basel II Capital Adequacy Requirements
Originating banks and investing banks
Crucial question is rating
Requirements under Standardised Approach
DeductionDeduction100 %50 %20 %Risk Weight (for
originators)
Deduction (50 %
from Tier 1 and
50 % from Tier
2)
350 %100 %50 %20 %Risk Weight (for
investors)
B + and below /
unrated
BB + to
BB -
BBB + to
BBB -
A + to
A -
AAA to
AA -
ECA (Long-term
rating category)
Deduction100 %50 %20 %Risk Weight
All other ratings
or unrated
A-3/P-3A-2/P-2A-1/P-1ECA (Short -term rating
category)

7. 7
Sukuk – Asset Backed Securities
Basel II Capital Adequacy Requirements
Requirements under IRB Approaches
Choices
Supervisory
Formula Approach
Ratings Based
Approach
RW given by
supervisor based
on ratings
(Deduction for
unrated)
Internal Assessment
Approach
RWA calculated
through internal
assessment
methods
Capital charge
calculation through
a complex formula
External or Inferred
Rating
Unrated Liquidity or
Credit Support ABCP
Unrated Other
Exposure

8. 8
Sukuk – Asset Backed Securities
Basel II Capital Adequacy Requirements
Rating is crucial
Many issues in rating if not guaranteed by obligor (Fitch
Ratings report dated 24th March 2005)
True sale
Non consolidation
Bankruptcy remoteness
Security structures
Enforceability
Choice of law and enforcement of judgment

9. 9
Contact Information
Ahmed Adil, Partner
Business Risk Services (BRS) &
Islamic Financial Services Group (IFSG)
Ernst & Young, Bahrain
PO Box 140
14th Floor, The Tower
Sheraton Commercial Complex
Manama, Bahrain
Phone: + 973 17 535 455
Fax: + 973 17 535 405
Email: ahmed.adil@bh.ey.com