An Introduction to Islamic Banking and Finance The history, role and future of Islamic Banking

Warren Edwardes

Introduction to Islamic Banking & Finance

Institute of Islamic Banking & Insurance London, 19 April 2004

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An Introduction to Islamic Banking and Finance The history, role and future of Islamic Banking

Warren Edwardes, ceo, Delphi Risk Management Ltd• Presentation to The Financial Services and Banking

Department of the Dubai Men's College • at The Institute of Islamic Banking & Insurance• London, 19th April 2004• Full article on: http://dc3.co.uk/islamicbanking.htm• Islamic banking news: http:// dc3.co.uk/ibnews

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QuotesHappy the man who far from schemes of

business, like the early generations of mankind, ploughs and ploughs again his ancestral land with oxen of his own breeding, with no yoke of usury on his neck.

Roman philosopher, Horace

Julius Caesar limited interest to 8 1/3 %

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QuotesNeither a borrower nor a lender be; For loan oft

loses both itself and friend and borrowing dulls the edge of husbandry.

Shakespeare’s «hamlet», a Danish father advising his son

UK usury laws on excessive interest abolished in 1854

South Africa and US (except Virginia and Delaware) have usury laws

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QuotesThose who devour usury will not stand except

as stands one whom the evil one by his touch hath driven to madness. That is because they say: "trade is like usury but Allah hath permitted trade and forbidden usury.”

The Koran: Surah 2, verse 275

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Latin Jargon used by lawyers

• In haec verba

– Verbatim

• nunc pro tunc

– Retroactive

• Caveat emptor

– Let the buyer beware

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Greek Jargon used by derivatives dealers

• Delta

– Sensitivity of an option price to changes in the price of the underlying equity

• Theta

– Sensitivity of an option price to changes in time

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Arabic Jargon used by Islamic bankers

• Alwadiah

– Safe keeping

• Baimuajjal

– Deferred-payment sale

• Baisalam

– Pre-paid purchase

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Jargon Arabic - used by Islamic bankers

• Ijara

– Leasing

• Muqarada

– Mudaraba

• Mudaraba

– Profit-sharing

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Jargon Arabic - used by Islamic bankers

• Murabaha or Shirka

– Cost-plus or mark-up

• Musharaka

– Equity participation

• Qard Hasan

– Benevolent loan (interest free)

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Overview

• Hallal vs. Haram

– Not just about Hallal mutton curry but also about a way of life

– This is including finance

• Interest, usury, riba used interchangeably

• Essentially three dimensions of Islamic products1. Riba free - Profits and loss sharing PLS

2. Riba free - Mark up

3. Ethical dimension

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Overview – Profit & Loss Sharing• Profit & Loss Sharing

– basically, no pain no gain

• Venture capital, non-recourse project finance, equity investment vs lending

• US / UK banking vs German, Japanese, Spanish banking

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Overview - Markup

• Mark up - predetermined profit.– Predominates 87% Pakistan, 63% Iran– Investors’ risk aversion– Borrowers’ protection of equity interests

• Tax similarities - interest versus capital gains tax• Interpretations change

– Treasury bills, foreign exchange, zero coupons, circular transactions.

• Various jurisdictions / opinions– Gulf, Malaysia, London

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Overview - Ethics

• Ethical dimension - undesirable investments sectors

– Tobacco

– Alcohol

– Armaments

– Gambling

• Charitable aspects

– Interest donated to charity

– Can the borrower afford to repay?

– Faith does not mean soft option.

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Brief History• 1963 Egypt interest free savings banks

– Not overtly Islamic - invested in trade and industry

– Share of profits

• 1971 Egypt Nasr social bank

– Still no overt reference to Islam

• 1975 Islamic development bank

– Jeddah. Conference of Islamic finance ministers1973

– Fee based and PLS

– Revolving capital

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Brief History

• 1970’s Dubai Islamic bank, Faisal Islamic bank of Sudan / Egypt, Bahrain Islamic bank

• Malaysia, Philippines, Nigeria, Indonesia

• Islamic finance house, Luxembourg, DMI Geneva, Al Rajhi London

• Denmark, Australia, south Africa

• HSBC Amanah fund, ANZ first ANZ International Murabaha ltd., IBU of United Bank of Kuwait.

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Riba is more than Usury

• US, South Africa, UK

– Excessive interest

– Early repayment penalty

• Active vs passive lending

• Pawn broking / money lending vs modern banking.

• No distinction between fair and unfair interest

• Trade is allowed

• Repayment only if borrower is able to?

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Why?

• Pork etc.

• Property rental - Hallal

• Real benefit, wear and tear

• Capital rental - Haram

– Gold for gold, barley for barley; Inflation indexed?

– Equity/debt hybrid profit sharing? Undated preference shares? Section 233 loans?

• “Unearned” income taxed at 97% in the UK

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Key Islamic Financial Instruments PLS

• Mudaraba / Modaraba

– PLS no pain no gain

– Rabbulmal - capital provider / investor

– Mudarib - entrepreneur / borrower

– Profits split between Rabbulmal and Mudarib as agreed

– Losses only to financier.

• Looks like non-recourse project finance

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• Shirka

– Generalised Mudaraba

– More than 2 parties

– Non contractual - Al Milk,

– Contractual Ul Uqud

• Looks like syndicated non-recourse project finance

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• Musharaka / Mosharaka

– Equity investing

– Limited partnership

– Profits distributed according to pre-agreed formula

– Fair share of profits? 95% to investor?

• Looks like normal equity investments or fund management

• Sounds like “shares”

• Loss sharing? Limited liability to investment.

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Key Islamic Financial Instruments PLS• Al- Wadiah

– Retail savings account

– Cheque books bill payments, credit cards etc.

– Dividend paid subject to profits through the year

– Only profits no loss of capital

– Short term accounts

• Looks like with profits bonds

• Other retail

– Prizes, gifting of interest to charity, no transaction fees

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Key Islamic Financial Instruments – Mark-up

• Murabaha / Morabaha

– Mudaraba / Musharaka on bank liability side

– Murabaha / Morabaha on asset side.

– Locked-in return

– Bank buys asset on behalf of client / borrower and then sells it for deferred payment

– Title transfers at outset or on payment at maturity

– Interest into capital gains? Use of Libor

• Sounds like “Repo” a sale and repurchase agreement

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Key Islamic Financial Instruments - mark-up

• Baimuajjal

– Property financing on a deferred basis

– Payment in instalments or lump sum with mark-up

– Predetermined profit.

• Ijara

– Leasing type transaction

– Title stays with lessor

– Option to buy goods on maturity of contract

– Ijara wa iqtina is renting then purchase

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Key Islamic Financial Instruments - Mark-up

• Baisalam

– Manufacturers financing of production

– Bank buys and pays for goods at a discount before manufacture

– Commodity futures contract? A derivative?

– Similar to Bankers Acceptance – BAs

• Al Bay Bithaman Ajil

– BBAs popular in Malaysia

– Financing sales by deferred instalments

– Trade not debt

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Key Features of Islamic Banking

• Interest free

• Trade related and perceived need for funds

• Pure form of Islamic Banking? - equity related

• Avoids exploitation - no usury

• Ethical investments

– Alcohol, tobacco, gambling, armaments, pornography etc

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European Retail Islamic Banking

• mainly high net worth

• 7 million Muslims in Europe

– 1.2 Mio UK, 3 Mio France, 2.9 Mio Germany

• so why minimal penetration?

– Poor image, Mystery, Risk aversion, tax issues.

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Conclusion

• Growth market for strongly capitalised banks

– Islamic investors are risk averse

– Aware of rating agencies

– Top banking brand names such as HSBC, ANZ, UBK have an advantage - I believe

• But local banks need to try harder with relationship and innovation

• Speech not about economics or social science

– Idea is to encourage growth and achieve reasonable profit for capital invested

An Introduction to Islamic Banking and Finance The history, role and future of Islamic Banking

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