An Introduction to Islamic Finance I.pdf

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1 ISLAMIC FINANCE AND BANKING: CHALLENGES AND OPPORTUNITIES Lecture Outline 2 1. Overview of Islamic Finance 2. Islamic Shariah and Contracts 3. Important Islamic Financial Contracts 4. Models of Islamic Banks 5. Global Financial Crisis and Islamic Financial Solution 6. A Case Study of Financial Murabaha 7. A Case Study of Legal Stratagem: Tawarruq 8. A Case Study of Sukuk 9. Risk and Regulation of Islamic Financial Industry

Transcript of An Introduction to Islamic Finance I.pdf

Page 1: An Introduction to Islamic Finance I.pdf

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ISLAMIC FINANCE AND BANKING: CHALLENGES AND

OPPORTUNITIES

Lecture Outline

2

1. Overview of Islamic Finance

2. Islamic Shariah and Contracts

3. Important Islamic Financial Contracts

4. Models of Islamic Banks

5. Global Financial Crisis and Islamic Financial

Solution

6. A Case Study of Financial Murabaha

7. A Case Study of Legal Stratagem: Tawarruq

8. A Case Study of Sukuk

9. Risk and Regulation of Islamic Financial

Industry

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ISLAMIC SHARIAH AND CONTRACTS

Islamic Sharia’a: An overview

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Islam as a ‘complete code of life’ encompasses every aspect of human life. It provides directives as to how economic and financial activities should operate based on moral and just economic system. The source of Islamic morality stems from Sharia’a. The following diagram shows the position of banking and financial activities within the framework of Islamic Sharia'a.

Islam

Aqidah

(Faith & Belief)

Sharia’a

(Practices & activities)

Ibadah

(Man-to-God worship)

Muamalat

(Man-to-man activities)

Political

Activities

Economic

Activities

Other Economic

Activities

Banking & Financial

Activities

Social

Activities

Akhlaq

(Moralities & Ethics

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Islamic Worldview

The essence of Islam is tawhid—oneness and sovereignty of God

(Allah)

Has many implications

Allah is the only source of value

Humans are created equal

Resources are trust from Allah

Humans are vicegerents (khalifah)

Humans have free-will

Muslim—submission to the Will of God

Will of God—expressed in revelation 5

Sources of Islamic knowledge

Two sources of knowledge in Islam

Revealed knowledge (Shari’ah)

Quran

Hadith/Sunnah (Sayings/traditions of the Prophet)

Derived knowledge (Fiqh)—through ijtihad (exertion)

Al-Qiyas (analogy)

Ijma (consensus)

Etc.

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Sources of Law for Transactions

Two sources of law in Islam

Shariah—Revealed knowledge

Quran –Recited

Hadith/Sunnah—Un-recited

Fiqh– Derived knowledge through ijtihad (exertion)

Ijma (consensus)

Al-Qiyas (analogy)

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Basic Approach to Islamic Law

Islamic laws can be broadly classified into two types

Ibadat (devotional acts) – Any worship which is not legalized by Shariah is void

Muamalat (dealings or transactions)—Transactions are permitted unless prohibited by Islamic law (principle of permissibility)

In muamalat, new transactions can be accommodated through ijtihad as long as they do not contain the prohibited (riba and gharar)

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Documentation of contracts in Islam

Islamic perspective for transaction involving time: “O you who belief! When you contract a debt for a fixed period, write it down. Let a scribe write it down in justice between you. Let not the scribe refuse to write as Allah has taught him, so let him write. …You should not be weary to write it (your contract), whether it be small or big, for its fixed term, that is more just with Allah; more solid as evidence, and more convenient to prevent doubts among yourselves, save when it is present trade which you carry out on the spot amongst yourselves, then there is no sin on you if you do not write it down. But take witnesses whenever you make a commercial contract. …” (Quran 2:282)

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Essential Features of Islamic Contracts Contract can be created by mutual agreement

Contract (aqd)—an engagement and agreement between two persons in a legally accepted, impactful, binding manner

Basic elements of a contract—offer (ijab) and acceptance (qabul) at free will

Contractual agreements outlines the rights and duties of various parties in a transaction

Difference between a promise and contract Moral obligation vs moral and legal obligation

Islamic Fiqh Academy Resolution on promise

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Contracts-Islamic Nature Freedom of contracts—provide the prohibited

elements are avoided

Some aspects of the contractual relationship determined by Shari’ah/Fiqh to avoid Injustice

Conflicts

Exploitation

Among others the following must be avoided in financial contracts Riba

Gharar

RIBA

1. Riba

– Literally means extra

– Two types: Al-Nasiah & Al-Fadl

– Prohibition – in 4 stages. Final verse:

“Oh you who believe! Be afraid of Allah and give up

what remains from Riba if you are believers. And if

you do no do it, then take a notice of war form Allah

and His messenger…” (2: 278-279)

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Types of Riba Riba al Fadl:

If there is exchange among the same specie of the ribawi goods, it has to be done on spot and should be of equal amounts.

If the amounts exchanged are different then it will be riba al fadl.

Riba al Nasiah Root word nasaa meaning to postpone—refers to the

delayed payment riba. When there is exchange of the same specie over a period of time, the amount exchanged has to be the same (qard hasan)

If an excess is paid over the amount this will lead to riba al nasiah.

Riba Al-Nasiah…

Riba in loan contracts:

– Give out loan (principal sum)

– Repayment include additional amount because of

delay in payment

This is the riba prohibited in Al-Qur’an

A.k.a. Riba al-Duyun, Riba Al-Jahiliyyah

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Riba Al-Fadl

Riba in exchange contracts

Based on the saying of the Prophet:

“Gold for gold, silver for silver, wheat for wheat,

barley for barley, dates for dates and salt for

salt – like for like, equal for equal and hand to

hand. If the commodities differ, then you may

sell as you wish, provided that the exchange is

hand to hand” (Muslim, Kitab al-Musaqat)

Summary of Riba Al-Fadl

Type Function Rule Example

Same Same •Equal amount

•Spot

•Gold – gold

•Dates – dates

Quality does not play a role

Different Same •Spot •Gold – silver

•Barley – dates

•USD – RM

Different Different •Free to trade •Gold – wheat

•RM - goods

The six commodities could be divided into two categories:

1. Currency – gold and silver

2. Staple food – wheat, barley, dates, salt

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Implication from prohibition of riba

Riba Al-Nasiah

– financing using loan contracts?

– No extra is allowed

Riba Al-Fadl

– Currency exchange – must be spot transaction

– No forward currency transactions

Usage of Money

To help

Guarantee, No extra

Loan

Guarantee

No extra

Saving

Extra

No guarantee

Invest

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The Riba Equation

Extra Gua. Riba

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What is Gharar?

Gharar–Excessive risk, hazard, or ambiguity

Rulings from hadith

Four conditions should exist in a transaction for gharar to have legal consequences

Uncertainty has to be excessive

Has to occur in exchange contracts

Has to concern the subject matter of the contract itself (not something attached to it)

Should not fall in the public need category

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Types of Gharar Gharar can exist in the essence or terms of

the contract

Uncertainty of whether something will take place or not and the consequences of a transaction are not clear

Two Sales in One

The Toss Sale

Suspended/conditional Sale

The Future Sale

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Types of Gharar

Gharar can exist in the object of the contract

Subject matter of sale

Ignorance of the Attributes/Properties of the Object

Ignorance of the Quantity sold

Existence of the Object and the Ability to Deliver

Price of the Good

Ignorance of delivery time

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Implications of Islamic Principles

1. Selling debt (at discount)—riba

2. Futures/Options—gharar

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IMPORTANT ISLAMIC FINANCIAL CONTRACTS

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Major Islamic Contracts used in Financing

1. Partnerships – musharakah or mudarabah

2. Sale (Exchange) Contracts 1. Deferred trading contracts

1. Price deferred sale (murabahah)

2. Object deferred sale (salam, istisna)

2. Leasing-sale of usufructs (ijarah)

3. Grants—interest free loans (qard hassan) or loans at service charges

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Murabahah

1. The financial institution buys and then sells the good to the client at a mark-up

2. Price paid at a later date

3. The bank must own and posses the good

4. The profit rate and other terms should be clearly specified in the contract

5. The bank can ask for guarantees or collateral

6. Murabahah bills of trade cannot be traded (at discount)

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Salam 1. A pre-production sale of goods—selling

goods in advance

2. Can be used for homogenous goods

3. Used to finance the agricultural sector

4. The price has to be fixed and paid when the contract is concluded

5. Goods delivered at a later date

6. The delivery time should be fixed

7. Parallel salam

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Istisna

1. A pre-production sale used when an item/asset needs to be manufactured/constructed

2. The price of the good should be known and time of payment can be negotiated among the parties

3. The seller of the good (bank) can either manufacture it or sub-contract it—parallel istisna

4. The bank, however, liable for the goods delivered

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Ijarah

1. A leasing contract involving sale of usufructs of durable assets/goods

2. Ownership of the asset is not transferred to the lessee

3. The asset can be transferred to a third party

4. The maintenance costs can be paid by the lessee if included in the contract, but costs of total damage of asset is borne by owner

5. The lessee can sub-lease the asset to third party unless explicitly prohibited in the contract

(Similar to operating lease)

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Ijarah wa Iqtina

1. A hire-purchase leasing contract—ownership is transferred to lessee at the end of the contract period

2. Fiqhi objections—two contracts in one; purchase contract cannot be binding

3. Banks give away the asset at nominal value or as a gift at the end of the lease period

(Similar to financial lease)

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Mudarabah

1. A form of partnership—one party supplies the capital (rab-ul mal) other manages (mudarib)

2. Profit shared among parties at an agreed upon ratio

3. Loss borne by financier only

4. Financier cannot ask for a guarantee of capital or return

5. Mudarabah can be restricted or unrestricted

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Musharakah

1. A partnership contract in which all partners contribute capital and labor

2. Like a mudarahah, but all partners manage the project

3. The profit share among the partners at an agreed upon ratio

4. Loss shared according to share of capital

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Murabahah

Financing Mode in Islamic Banks—Debt

The financial institution buys and then sells a good to the client at a mark-up

Price paid at a later date

The bank must own and posses the good

The profit rate and other terms should be clearly specified in the contract

The bank can ask for guarantees or collateral

Productspot

Pricefuture

Traditional Murabahah/Bai al-Muajjal

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Salam

Financing Mode in Islamic Banks—Debt

Used to finance the agricultural sector

The price has to be fixed and paid when the contract is concluded

Commodities delivered at a later date

The delivery time should be fixed

Pricespot

Commoditiesfuture

Traditional Salam

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Istisna

Financing Mode in Islamic Banks—Debt

A pre-production sale used when an item/asset needs to be

manufactured/constructed

The price of the asset should be known and time of payment can

be negotiated among the parties

The seller of the asset (bank) can either manufacture it or sub-

contract it

Paymentinstallments

Assetfuture

Traditional Istisna

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Ijarah

Financing Mode in Islamic Banks—Leasing

A hire-purchase leasing contract

Ownership is transferred to lessee at the end of the contract period

Banks give away the asset at nominal value or as a gift at the end of the lease period

Asset (for rent)fixed period

Rental Payments

Traditional Ijarah

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Mudarabah

Financing Mode in Islamic Banks—Equity

Partnership between bank and clients

Used on the liability and asset sides

Profit shared among parties at an agreed upon ratio

Loss borne by financier only

Financier cannot ask for a guarantee of capital or return

Mudarabah can be restricted or unrestricted

Fundsspot Service/labour

Profit sharefuture Profit sharefuture

Traditional Mudarabah

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Musharakah

Financing Mode in Islamic Banks—Equity

A partnership contract in which bank contributes capital and managerial services

Like a mudarahah, but all partners manage the project

The profit share among the partners at an agreed upon ratio

Loss shared according to share of capital

Funds & labour Funds & labour

Profit sharefuture Profit sharefuture

Traditional Musharakah

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ISLAMIC BANKING MODELS

Operational Models of Islamic Banks

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The global development of Islamic financial institutions has taken various organizational forms and types according to the needs of the Islamic financial communities in each country.

Some countries have adopted a dual-banking system, where conventional financial institutions operate alongside fully-fledged Islamic financial institutions. Example, Bangladesh and Malaysia.

Other countries have introduced a totally Islamic financial system, where only Islamic financial institutions are allowed to operate. Example, Iran.

A further group of countries has decided that Islamic financial activities can be carried out only by fully-fledged Islamic financial institutions which have to be established alongside the conventional ones not allowed to offer islamic services (in the case of Kuwait and Lebanon).

The evolution of the global Islamic banking and finance industry is being continually refined in each country.

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Operational Models of Islamic Banks

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The Windows Model

This refers to the operating structure where a conventional bank simultaneously

carries out Islamic financial activities. Under this structure, the bank assure clients

of segregated accounting and operations for conventional and Islamic activities.

Branches

Under this structure, the Islamic financial services are offered through dedicated

service delivery channels. For example, a conventional bank sets up a number of

branches that offer only Islamic financial services.

Subsidiaries

This refers to the operating structure where a separate legal entity (a subsidiary),

owned by a conventional bank or other financial institution (a parent), is set up

specifically to undertake Islamic financial services activities.

Fully-fledged Banks

Fully-fledged Islamic banks are set up to participate solely with Islamic financial

services, offered through their own service delivery channels.

Support Institutions for Islamic Banking Industry

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• Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI)

• The International Islamic Financial Market (IIFM)

• The International Islamic Rating Agency (IIRA)

• The Islamic Financial Services Board (IFSB)

• The Islamic Research and Training Institute (IRTI),

• The General Council for Islamic Banks and Financial Institutions (GCIBFI)

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Ideal Islamic Banking Model

Two-tier mudarabah model

–Profit-loss sharing modes of financing on both the asset and liability

side

Liabilities and Equity Assets

Profit-sharing investment accounts (PSIA-Mudarabah based)

Demand Deposits (qard hasan)

Capital

Mudarabah/musharakah financing

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Features of Ideal IB Model

PLS (risk-sharing) assets would imply robust investments leading to economic growth

–Choosing projects that make good economic sense

–Monitoring of the investments closely

–Equity financing usually long-term

Sharing risks of assets by the liability side makes the bank more stable

–Losses covered by PSIA and capital

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Islamic Banking in Practice

Some Islamic banks started with PLS financing modes

Risks of equity-financing different from that of debt-

financing

Banks lost money

Resorted to modes that had lower risks

Started using fixed-income debt instruments

–Murabahah

–Ijarah

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Islamic Banking Practice: 2nd Best Model

One-tier Mudarabah with Multiple Investment Tools Liability Side—PSIA (Mudarabah based)

Asset Side—multiple investment tools, dominated by fixed-income contracts (murabahah, ijarah, istisna, etc.)

Liabilities and Equity Assets

PSIA-Mudarabah based

Demand Deposits (Qard hasan)

Capital

Reserves

Murabahah

Ijarah

Istisna

Mudarabah/Musharakah, etc.

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Other Features of 2nd Best Model

PSIA—profit-rate smoothing

–Profit Equalizing Reserves (PER)-amount deducted from gross income

to smooth PSIA returns

–Investment Risk Reserves (IRR)-amount deducted from the income of

PSIA depositors (after deduction of bank’s share) to meet losses on

investments financed by PSIA

Penalties

–Penalties charged on late payments and defaults

–Most Shari’ah scholars do not approve this, but used to discipline

delinquencies

–Funds collected given to charities

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Tawarruq

Tawarruq—monetization

1. A buys a commodity on deferred payment from B

2. A then sells the commodity to C spot to get cash

Allowed by a minority of the Scholars (in the Hanbali and

Hanafi schools)

1

2

3 B

A C

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Organized Tawarruq

The client wants a personal loan and approaches the bank

1. Bank buys commodity from a broker paying spot (for £100)

2. Bank sells the commodity to client payable at a future date (for £110)

3. The client sells commodity to broker spot (for £100)

[The client appoints the bank as agent to sell the commodity. The bank sells the commodity spot to the broker for £100 on behalf of the client and deposits the money in his account.]

At the end of the transaction, the client walks away with £100 and owes the bank £110 payable in the future

[Bai al’Inah: No third party involved—bank and client do the selling and buy-back]

1

2

3 Bank Client

Broker

THE CHRONOLOGY OF THE DEBATE OVER TAWARRUQ

OIC FIQH ACADEMY

*Permissible: *Condition: -The customer not sell the commodity to its original seller

*Two types of Tawarruq:

* Banned the application of organized tawarruq: Explicitly?

Implicitly? Common practice?

Financier

Mustawriq

Transaction

Three rulings on the matter:

Tawarruq Fiqhi/ Haqiqi

(Real Tawarruq)

Tawarruq Munazzam/ Masrafi

(Organized Tawarruq)

15th (1998)

17th (2003)

19th (2009)

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OIC Fiqh Academy: 17th Session

TAWARRUQ

Tawarruq Fiqhi/ Haqiqi (Real Tawarruq)

Tawarruq Munazzam/ Masrafi (Organized Tawarruq)

Violations of Shariah Principles: 1) Issues pertaining to commodities

(السلع) 2) Issues pertaining to possession &

delivery ( القبض والتسليم) 3) Issues pertaining to Bay’ al-’Inah 4) Issues pertaining to agency

(التوكيل) 5) Issues pertaining toTawaatu’ (تواطؤ)

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AL-ZUHAYLI: The subject matter must meet all the specifications & conditions of

good commodities

VALID

AL-QURADAGHI: Spoiled commodities are used in modern

organized tawarruq

Issues Pertaining to Commodities ( السلع)

Broker Bank

‘Junk’ (10 years stored)

ABU GHUDDAH: Lack of proper monitoring

Redundancy of commodities

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Page 27: An Introduction to Islamic Finance I.pdf

Issues Pertaining to Possession & Delivery

( القبض والتسليم)

Seller Buyer

INVALID SALE (Bay’ fasid)

Seller 1 Buyer 1

Customer (constructive possession)

US $10,000

US $ 8,000 Netting

arrangement

Nett off

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Issues Pertaining to Bay’ al-’Inah

AAOIFI, 2008: Shariah Standard No.30, Article 4/5: “ The commodity (object of tawarruq) must be sold to a party other than the one from whom it was purchased on a deferred-payment basis ( a third party) so as to avoid ‘inah, which is strictly prohibited. More over, the commodity should not return back to the seller by virtue of prior agreement or collusion between the two parties, or according to custom

Seller Buyer

3rd party

Sell

Bu

y Sell

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Page 28: An Introduction to Islamic Finance I.pdf

Issues Pertaining to Agency

(التوكيل)

Market Bank/Agent Client

3rd Party

Buy

Buy (delayed price)

Sell

Sell

Organized tawarruq AAOIFI, Article 4/7-4/10

Requirement: 1) The bank or its agent

should not sell the commodity on the customer’s behalf if the customer initially bought that commodity from the bank; neither should the bank arrange a proxy third party to sell this commodity

2) Instead, the client should sell the commodity either himself or through his own agent. At the most, the bank should provide the client the information needed to sell the commodity.

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Implications of Tawarruq

Tawarruq and Gresham’s Law (bad money drives away good money)

Tawarruq is driving all other modes away

Tawarruq replicates a loan transaction

The result—third best model of Islamic banking

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Islamic Banking Practice: 3rd Best Model

Fixed Liability with Multiple Investment Tools Liability Side—Fixed-income investment accounts (using tawarruq)

Asset Side has multiple investment tools, dominated by fixed-income contracts (tawarruq, murabahah, ijarah, istisna, etc.)

Liabilities and Equity Assets

Fixed income investment accounts (tawarruq)

Demand Deposits (Qard hasan)

Capital

Reserves

Cash Tawarruq Murabahah Ijarah Istisna Mudarabah/Musharakah, etc.

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Other Features of 3rd Best Model

Assets side

–Initially different modes used for different purposes

–Durables—murabahah, ijarah

–Agriculture—salam

–Real estate construction-istisna

–Tawarruq can replace all of the above (similar to a loan)

Liability side

–Fixed-income investment accounts replaced PSIA

No link between return on assets and liabilities

–Stability argument weakened

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Islamic Modes of Financing

UAE Bahrain Pakistan Sudan Modes

49.29 51.73 50.96 42.45 Murabahah

2.59 0.89 2.52 17.77 Musharakah

4.36 1.96 - 3.10 Mudarabah

18.90 5.56 20.41 0.87 Ijarah

3.22 0.63 - 0.95 Istisna

- - 0.23 0.55 Salam

21.65 39.23 25.88 34.31 Others (RE, bai-

muajjal, Invest., etc,)

Source: 2007 Islamic Finance Directory, Gen. Council for Islamic Banks & Fin. Institutions

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Islamic Modes of Financing

Saudi Arabia

Jordan Malaysia Iran Modes

15.81 15.41 41.04 21.02 Murabahah

0.65 2.99 0.24 0.97 Musharakah

0.05 11.36 0.27 1.51 Mudarabah

0.04 13.80 9.40 2.18 Ijarah

3.74 1.20 1.72 0.07 Istisna

- - - 0.03 Salam

79.71 55.25 47.33 74.22 Others (RE, bai-

muajjal, Invest., etc,)

Source: 2007 Islamic Finance Directory, Gen. Council for Islamic Banks & Fin. Institutions

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GLOBAL FINANCIAL CRISIS AND ISLAMIC FINANCE SOLUTION

Interesting Facts

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The Median house price increased 4 times during 1980-2007

Stock Index increased from 803 in 1982 to 14,115 in 2007

US Savings declined from 11% in 1980 to less than 1% in 2007

Debt servicing increased to 35% in 2007

An average American gained about 20 Ibs in the last 20 years

The US obesity was 15% in the 70s and it is 33% now

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Interesting Fact

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In the 1980s, only two states (Nevada and New Jersey) had casinos,

now 12 states has casinos and 48 states legalized betting

In 1980, the US credit market debt was equal to US GDP

In 2007, it had risen to 350 times of US GDP

In 2007, CDS-45.5 trillion; US stock market 21.9 trillion; mortgage security market-7.1 trillion; US treasury market-4.4 trillion

In contrast, the US GDP in 2007 was 13.4 trillion.

Causes of the US Subprime Mortgage Crisis

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CAUSES FOR FINANCIAL CRISIS

The causes of the current crisis can be traced to

three levels:

–Regulatory

–Organizational

–Products

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Regulatory Environment

Financial Institutions operated in a deregulated environment

–Fed—Emphasis on self-regulation

–1999—Gramm-Leach-Bliley Act (repeal of Glass-Steagall Act)

–2004—SEC loosened capital requirements for 5 large investment banks

(MerL, LehB, GolS, MorS, BeaS) – Increased leverage (BeaS had debt/equity ratio of 33:1)

–Resistance to control OTC derivatives market

–Basel II—Market based risk assessment and capital requirements

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Organizational Failures

Lax Risk Management Practices

–High Leverage (low capitalization)

–Transferring risk—Excessive risk taking

–Creating newer risks (not well understood)

–Under-pricing of risks

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Product Level

Innovations:

–Securitization and sale of debt

–Creation of complex and opaque financial instruments (derivatives)

–Hedging (risk transfer)

–Speculation

Changed financial structure

–Sources of funds of banks moved from depositors to capital markets

(securitization)

–A complex network of inter-relationships

–Created systemic risks not well-understood

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Making of the Crisis

1. Driven by excessive profit-motives, banks/financial institutions engaged in sub-prime lending (with adjustable interest rates)

2. Loans packaged as Mortgage Backed Securities (MBS)/Collateralized Debt Obligations (CDO)

• 55% of the $10.2 trillion loans securitized (end 2006)

• 12-15% of securitized loans were sub-prime

3. Rating Agencies gave positive ratings to these securities (to get more business and collect fees)

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Making of the Crisis

4. Investors (banks, hedge and pension funds, municipalities, schools, etc.) acquired these securities

5. Investors/speculators bought Credit Default Swaps (CDS) to hedge credit risks on MBS/CDO

• Notional amounts of OTC Derivatives in 2007 $596 trillion, CDS $58 trillion (US GDP $13.8 trillion)

6. Issuers of CDS (Investment banks & Insurance companies) took on the risk of default

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From Defaults to Economic Meltdown

Interest rates began to rise (1% to 5.25% between 2004-2006)

Adjustable rate subprime loans started to default

Holders of MBS/CDO incurred losses

Prices of CDOs fell

Issuers of CDS had to pay-off the losses caused by default

Losses caused depletion of capital of FIs

Scramble to get funds Money market froze (as lenders did not know the risks involved)

Lack of financing caused housing market to crumple—further decreasing housing (CDO) prices and increasing market risks

Credit risks, market risks, and liquidity risks produced systemic risks

Vicious cycle of deleveraging and economic downturn

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Locating Finance in Islam

Ethics related to financial activities

Prohibitions (fraud, hoarding, exploitation of need, gambling, etc.)

Obligations & Recommended (charity, honesty, interest-free loans, risk sharing, etc.)

Laws governing economic/financial activities

Principle of permissibility: All transactions are permitted expect what is explicitly prohibited by Islamic law

Prohibitions are riba and gharar

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Key Intrinsic Principles of the Islamic Financial System

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Islamic Financial Principles and Crisis

Islamic principles:

Using risk-sharing instruments—more monitoring

Prohibition of selling of debt (CDOs)

Prohibition on derivatives (CDSs)

Prohibition on short-selling—limiting betting on downside risks

If Islamic principles were followed, the crisis would not

have taken place the way it did

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Page 38: An Introduction to Islamic Finance I.pdf

Crisis and Islamic Finance:

Ethical and Legal Dimensions Conventional

1. Banks/financial institutions engaged in sub-prime lending

2. Loans packaged as MBS/CDO

3. Rating Agencies gave positive ratings to these securities

4. Investors/speculators bought securities

5. Credit Default Swaps (CDS) to hedge/speculate on credit risks

Islamic

1. [Risk–sharing modes preferred] [Excessive greed discouraged]

2. Selling of debt prohibited

3. [Dishonesty discouraged]

4. -

5. Derivatives prohibited [Speculation discouraged]

75

Financial Crisis: Lessons for Islamic Finance

Key elements of the crisis from risk perspectives are

–De-regulated environment

–FIs seeking higher rates of profit (excessive risk taking

and leverage)

–Using innovative complex instruments

If Islamic finance follows the same path, can it end up in

the same situation?

76

Page 39: An Introduction to Islamic Finance I.pdf

Status and Practice of Islamic Finance

Regulatory: IF regulatory environment in elementary stages and still evolving

Organizational: Excessive profit/risk-taking—difficult to impose moral order

–Episodes of speculation observed in the Gulf states

Products: Innovations mimicking conventional products

–Fixed income assets—No risk-sharing

–Sukuk – Risk transfer through securitization

– Do investors have control over assets?

–Return-swap – Returns on assets can be swapped with return on any class of assets (including sub-prime

CDOs)

– Capital efficient solutions?

77

Crisis: Lessons for Islamic Finance

Markets/banks cannot be left to regulate themselves

Regulators have to address risks arising at systemic,

organizational and product levels

IF has principles at product level that could have prevented

the crisis

Shari’ah principles do not have anything specific to say

about systemic and organizational aspects of the crisis

78

Page 40: An Introduction to Islamic Finance I.pdf

Crisis: Lessons for Islamic Finance

Products developed are diluting the principles

Regulations must include three features

–Minimizing Systemic Risks

–Strengthening Organizational RM Regimes

–Products Regulation

79

Regulations and Support Systems to Minimize Systemic Risks

Until now, the focus has been on regulating individual

institutions

Need to minimize systemic risks—oversee the system as a

whole

–Regulate all FIs—understand the inter-linkages

–Separation of commercial and investment banking

–Reformation and accountability of Rating Agencies

–Sound Liquidity Framework to minimize liquidity risks—

Takaful Fund to be used in case of crisis

80

Page 41: An Introduction to Islamic Finance I.pdf

Regulations: Strengthening Organizational

RM Regimes

Capital Requirements—understand the risks of Islamic financial products

Introduce prudent risk management culture and practices in IFIs

– Prevent excessive risk-taking by setting investment criteria

– Impose restrictions on excessive leveraging

– Require more transparency and accountability

– Enhance transparency and information disclosure

– Ensure maintenance of credit standards at all times

81

Product Regulation

Products determine the nature and direction of industry

Shari’ah Boards play a key role in approving the appropriate products

–Products approved at organizational level taking the industry closer to conventional

Shari’ah Board at the national level

–Approve and monitor Islamic products

–Provide Shari’ah governance guidelines

–Reduce Shari’ah compliance and reputational risks

82

Page 42: An Introduction to Islamic Finance I.pdf

83

A CASE STUDY: HOW FINANCIAL MURABAHA EVOLVED

A Case Study: How Financial Murabaha evolved

84

Murabaha: Islamic Classical Standard

Murabaha: Modern Standard

Murabaha: Islamic Banking Practice

Risk Mitagation in Financial Murabaha

Page 43: An Introduction to Islamic Finance I.pdf

MURABAHA:

Islamic Classical Standard

85

BANK

Client/customer

3rd party

1. order

2. purchase

deliver

4. pay 3. sell

MURABAHA:

Modern standard

86

BANK

Client/customer

3rd party

1. order

2. purchase

deliver

4. pay 3. sell

Page 44: An Introduction to Islamic Finance I.pdf

MURABAHA:

Islamic Banking practice

87

1a. authorize

5. Pay installment 4. sell

Client/customer

BANK 3rd party

1. Order

2. purchase

3. delivery

Financial Murabahah

88

The financial institution buys and then sells the

good to the client at a mark-up

The bank must own and posses the good

The profit rate and other terms should be clearly

specified in the contract

The bank can ask for guarantees or collateral

Page 45: An Introduction to Islamic Finance I.pdf

Murabahah-basic features

89

1. Murabahah is a sale contract

2. The seller reveals the actual price of the asset/good

being sold and indicates the profit in lump-sum or as a

percentage

3. Delivery of the asset/good is spot, payment can be spot

or deferred

4. Bai-muajjal is a sale with spot delivery and deferred

payment

Murabahah as Financing Mode

90

As financial intermediaries, banks use

murabahah as financing mode (Purchase order

murabahah or financial murabahah)

Financial murabahah is a combination of

contracts

Page 46: An Introduction to Islamic Finance I.pdf

Financial Murabahah

91

Financial murabahah has the following elements:

1. Promise Agreement: The bank and the client signs and overall

agreement of the promise to buy/sell

2. Agency Agreement: The bank appoints the client as an agent to

purchase the good/asset

3. Purchase of the Good from the Supplier: The client buys the good and takes possession as a agent

4. Offer of Purchase: The client offers to buy the good from the bank

5. Acceptance of the Offer: The ownership of the good transferred from the bank to the client

6. Debt created: Payment due at future date(s)

Points to note

92

The commodity cannot be bought from the client

If the bank purchases, the agency contract not needed

• In such cases, two separate contracts (for supplier and buyer) and the purchase has to be before sale

Bills of trade resulting from transaction can be transferred at face-value only

Page 47: An Introduction to Islamic Finance I.pdf

Risks in Financial Murabahah

93

Pre-Sale Risks

Loss/damage of the good before delivery

Refusal of the buyer to take delivery

Market (price) risk

Post Sale Risks

Latent defects in goods

Settlement (credit) risk

Market (benchmark) risk

Pre-Sale Risks Mitigation

94

1. Loss/Damage of good before delivery:

Before delivery, the good is bank’s responsibility

Risks mitigated by:

Minimize the period of holding (time between

purchase and sale)

If time is long—insurance can be bought

Page 48: An Introduction to Islamic Finance I.pdf

Pre-Sale Risks Mitigation

95

2. Refusal of the Buyer to take Delivery: The bank

is left with the good

Risks minimized by:

The bank purchases the good with a right to

return it within a specified time

The bank sells the good and client pays the

difference between cost and sale price

Pre-Sale Risks Mitigation

96

3. Market (price) risk: Risk of changes in price prior

to delivery of good to client

Risks mitigated by:

Minimizing the holding time by selling

immediately after buying

Page 49: An Introduction to Islamic Finance I.pdf

Post-Sale Risks Mitigation

97

1. Latent Defects in Goods: It is possible that the

good supplied by the supplier is defective.

Risks minimized by transferring the liability to

the vendor/supplier (through warranty)

Post-Sale Risks Mitigation

98

2. Settlement (credit) Risk: The risk that the client will not pay his/her dues on time or default

Risk minimized by:

The bank can ask for a guarantee (sign a guarantee agreement)

Ask for a security or collateral—can sell the collateral if debtor defaults

Impose penalty for delinquency problem

Page 50: An Introduction to Islamic Finance I.pdf

Post-Sale Risks Mitigation

99

3. Market (benchmark rate) risk: The risk that the

returns of the bank will be affected if the

benchmark rate changes

Risks minimized by:

The contracts are usually of short-run duration

100

A CASE STUDY: LEGAL STRATAGEM OF TAWARRUQ

Page 51: An Introduction to Islamic Finance I.pdf

Case Study: Legal Stratagem of Tawarruq

101

Islamic Banking is mimicking conventional banking

From Inah to Tawarruq

Degrees of Separation to veil Riba

Bai al-inah

Tawarruq

Has ownership really changed?

The Unintended results

Imam Taymiyah on Sale/Riba

102

Would “Islamic” Banking take the Same Route?

What is the current model of

“Islamic” banking?

Is RIBA still not present?

“Islamic” banking products mimic

conventional via legal startegems

Selected judgments may provide the

indication

Page 52: An Introduction to Islamic Finance I.pdf

103

From Inah to Tawarruq to Sukuk

The idea of making an impermissible transaction permissible through degrees of separation is not new

In fact, it underlies many of the juristic stratagems (hiyal) for circumventing prohibitions

By adhering strictly to the letter but not the spirit of the law

Inah Tawarruq Sukuk

Degrees of Separation to Veil Riba

104

A

RM100 Cash

B

RM105 (deferred payment)

RIBA

Page 53: An Introduction to Islamic Finance I.pdf

105

A B

RM100 Cash

RM105 (deferred payment)

sell brick for cash

resell brick on credit

Bai’ul Innah

106

A

RM100

Cash

B

RM105

(deferred

payment)

Riba (HARAM)

A B

Bai’ul Innah (SYARIAH COMPLIANT?)

sell brick for cash

resell brick on credit

RM100

Cash

RM105

(deferred

payment)

Degrees of Separation to Veil Riba

Page 54: An Introduction to Islamic Finance I.pdf

107

A B

C Metal

Trader

Resells metal on credit

105 Cash (deferred payment)

Tawarruq

108

Issues What is the function of C?

No change of ownership of metal

Legal subterfuge?

Individually: syariah-compliant

Read together: syariah-compliant?

Effect of 2 degrees of separation circumvent riba

Structure obeys the letter of the law but subverts the spirit

Form over Substance, Compliance over Essence

Page 55: An Introduction to Islamic Finance I.pdf

109

It is easy to see how we can keep adding degrees of separation until eventually it would become impossible for any jurists, however strict, to prohibit the practice as merely a trick to subvert the substance of Islamic Law (avoidance of interest-bearing loans) while adhering to its medieval juristic forms.

Degrees of Separation

110

The Danger

An impending subversion of Islamic Law

By approving and eventually codifying (through AAOIFI, IFSB, OIC Fiqh Academy, etc.) legal stratagems to replicate conventional financial practices, jurists, bankers & regulators will eventually drown the substance of Islamic Law, if not already!

Page 56: An Introduction to Islamic Finance I.pdf

111

The (Unintended?) Result

An illegal act will be made legal eventually, through the act of codification!

With advances in structured finance, can easily disguise riba in any contract, and it would be the ultimate of disingenuousness to say "but this is bay` (sale), and Allah has permitted bay` and forbidden riba"

112

IBN TAIMIYYAH

Like other major scholars, Ibn Taimiyyah considers bay

al-inah a legal device in order to overcome the

prohibition of riba, and is not deemed to be an act of

sale, as there is clear evidence that such act amounts,

in effect, to a contract of loan.

The use of legal device is evidence that the niyyah

factor is undermined or made secondary.

Page 57: An Introduction to Islamic Finance I.pdf

113

IBN TAIMIYYAH

Ibn Taimiyyah divides sales into three groups according to the buyer’s

intentions, namely:

that he purchases the goods in order to use or consume them such as food,

drink and the like, in which case this is sale, which God has permitted

that he purchases the goods in order to trade with them; then this is trade,

which God has permitted

that the reason for purchasing the goods is neither the first nor the second,

then the reason must be dirhams (money) which he needs, and it was

difficult for them to borrow, so he purchases the goods on credit (with an

increased dirhams) in order to sell it and takes its price. This, then, is ‘inah

which is Haram according to the most eminent of the jurists.

114

A CASE STUDY: SUKUK

Page 58: An Introduction to Islamic Finance I.pdf

115

Sukuk—Economics of Growth

Several driving forces for Shari’ah compatible securities market

Demand side

Muslims/Islamic financial institutions—Shari’ah compatible securities

Non-Muslims--Alternative investment opportunities

Supply Side

Provides a cheaper source of financing

Provides an alternative source of financing

Provides financing without diluting shareholder equity

Provides a source of off-balance sheet financing (can hold less capital)

Regulatory

Basel II—marketable securities need less capital than direct credit exposures

116

Obligor

(undertakes

future sale

of commodity

for the investors)

SPV

Investors 1

2a

Salam Proceeds

Undertaking Sukuk Certificates

Commodity Commodity Sale Proceeds

Sukuk Certificates

Proceeds 2b

6 4

3

Sukuk al-Salam

• Sale of well-defined quality and quantity of commodity

• Fixed rates of return

• Sukuk al-salam are not negotiable

5 Commodity Sale

Commodity

Buyer

Page 59: An Introduction to Islamic Finance I.pdf

117

Sukuk al-Salam: Example

Sukuk name/date Sukuk al-Salam/Aug. 1, 2007 (Issue no. 75)

Sukuk base Aluminium

Obligor Government of Bahrain

Issuer Central Bank of Bahrain

Purpose of Offering Short-term liquidity

Tenor 91 days

Issue size BD 6 million

Expected rate of

return

5.06%

Credit enhancers Guaranteed by Bahrain Government

Governing Law Bahraini Law

Redemption/

Principal repayment

With price at maturity

Rating None

118

Sponsor/

Originator/

Obligor

SPV

Investors

1

• Transfer of assets back to Issuer can take place is 2 ways:

a. Periodic payments include rent and amortization (capital)

b. Bullet payment at maturity (the Issuer buys back the assets)

• Sukuk al ijarah are negotiable

• Can have fixed/flexible rates

• Risks of assets transferred to certificate holders (though issuer can guarantee the capital)

2a

Purchase Price of Assets

Sale/Transfer of Assets

Lease of Assets

Sukuk Certificates

Rental Payment

Periodic Rental

Payments

Sukuk Certificates

Proceeds 2b

4b

5

4a

3

Sukuk al-Ijarah

Page 60: An Introduction to Islamic Finance I.pdf

119

Sukuk al-Ijarah: Example

Sukuk name/date Qatar Global Sukuk/Oct. 8, 2003

Sukuk base Certain Land Parcel in Qatar

Obligor State of Qatar (lessee of leased assets)

Issuer Qatar Global Sukuk QSC

Purpose of Offering Construction of Hamad Medical City

Tenor 7 Years

Issue size USD 700 million

Expected rate of

return

Semi-annual lease rentals (Libor+ credit spread+

amortization payment)

Credit enhancers Guaranteed by Qatari Government

Governing Law English and Qatari Law

Redemption/

Principal repayment

With rental payments (amortization with rental

payments)

Rating A+ (S&P)

120

Balance Sheet Based Sukuk—IDB

IDB is a multilateral development bank (MDB) operating on Islamic principles

Before issuing sukuk, 100 percent equity based institution (paid-up capital $4.3 billion)

Other MDBs raise funds from market World Bank raised funds worth 918% its capital (total borrowing $ 96

billion)

ADB raised 777% of its capital (capital $3.6 billion)

Development impact of IDB small compared to other MDBs

Plans to raise up to USD 4 billion in the next 10 years

Page 61: An Introduction to Islamic Finance I.pdf

121

SPV

Investors

1

1. IDB bundled ijarah assets (65.8%), along with murabahah (30.7%) and istisna (3.5%) receivables

3a

Sells

assets

bundle worth

$400 m.

Appoints as agent to collect income from assets

Sukuk Certificates

Sells assets $400m.

Periodic Income from

Assets

Sukuk Certificates

Proceeds 3b

2

7 4

IDB-Hybrid Asset Sukuk

Delegates

agency

role

5

Provides guarantee about assets

6

122

IDB-Hybrid Asset Sukuk Sukuk name/date IDB Global Trust Certificates/Aug.12, 2003

Sukuk base Balance sheet assets of IDB (Ijarah, istisna,

murabahah)

Obligor Islamic Development Bank

Issuer Solidarity Trust Services Limited (through ICD)

Purpose of Offering Financing other assets

Tenor 5 Years

Issue size USD 400 million

Expected rate of

return

Semi-annual lease rentals (Fixed 3.625%)

Credit enhancers Guaranteed by IDB

Governing Law English Law

Redemption/ Principal

repayment

Purchase of assets at maturity at sale price

Rating AAA (S&P)

Page 62: An Introduction to Islamic Finance I.pdf

123

Corporate/

Borrower

Issuer

SPV

Investors 1 2a

Commodity

Master Agreement

Sukuk Certificates

Sale Price + profits

Sukuk Proceeds 2b

7

4

Sukuk al-Murabahah

Commodity

Buyer

Commodity

Supplier

Commodities 3a

3b Commodity

Price

Commodity

Price 6

Commodity 5b 5a

Commodity

Price

124

Sukuk al-Murabahah-Example

Sukuk name/date Arcapita Multicurrency sukuk/June 2005

Sukuk base Commodity (purchase/sale)

Obligor Arcapita Bank BSC

Purpose of Offering Investment in assets

Tenor 5 Years

Issue size USD 210 million

Expected rate of

return

0.175% above LIBOR rates

Credit enhancers Full recourse to Arcapita

Redemption/ Principal

repayment

Bullet payment at maturity

Rating Arcapita rating (BBB)

Page 63: An Introduction to Islamic Finance I.pdf

125

Corporate

SPV

Investors

1

Transfer of Assets Back to Issuer can take place is 2 ways:

1. Payments Include profit and purchase of shares (diminishing musharakah)

2. At maturity, the corporate buys back the shares.

2a

Periodic profit and Incentive fee

Physical Asset Contribution

Sukuk Certificates

Periodic profit

Sukuk Proceeds 2b

6

4

Sukuk al-Musharakah

Musharakah

Sukuk proceeds 3 Periodic profit 5

Corporate undertakes to

buy musharakah shares

of the SPV 7

126

Sukuk al-Musharakah: Example

Sukuk name/date Wings-FZCO Sukuk/June, 2005

Sukuk base Issuer provides assets in kind ($100 million)

Obligor Emirates Airlines

Issuer Wings FZCO

Purpose of Offering Construction of Group Headquarters and

Engineering Centre

Tenor 7 Years

Issue size USD 550 million

Expected rate of

return

1st coupon after year, thereafter semi-annually

(0.75% above USD LIBOR rates)

Credit enhancers Strength of Emirates and UAE

Governing Law English Law and Dubai Law

Redemption/ Principal

repayment

Bullet payment at redemption

Rating/Listing Listed with Luxemburg SE

Page 64: An Introduction to Islamic Finance I.pdf

127

Shariah-related issues

Asset type—most of the sukuk issued are backed by real estate or other tangible assets

Tangible assets may be limited (as services constitute larger percentage of output)

May limit the growth of sukuk industry

Way forward

Use other structures (e.g., musharakah)

Add newer asset classes (services, usufructs, intellectual properties)

128

Shariah-related issues

Guarantee in Sukuk issues--3rd party guarantees allowed

without any charges

Originator provides guarantees against a shortfall in capital

Critics: Originator/guarantor and SPV same entity– guarantee of

capital/return can open doors for riba

Supporters: SPV independent from originator, guarantee by

originator is by 3rd party

Page 65: An Introduction to Islamic Finance I.pdf

129

Shariah-related issues

Ijarah and lease back structure a form of bai-al-wafa or bai al-inah

Objections to redemption/purchase of asset/shares at pre-determined price

Ijarah sukuk, Obligor buys back assets at maturity at sale price (face value)

In musharakah sukuk, one musharakah partner buying shares of another at face value

Redemption/purchase of asset/shares at market price allowed

130

Economic Issues—Liquidity

Liquidity/marketability of Debt Sukuk

While equity-based and asset-backed sukuk are tradable, debt-based

sukuk are not.

This may pose problems in the growth and development of the

Islamic money/capital markets

Possible solutions

Hybrid sukuk (with minority debt component)

Embedded options in sukuk

Conversion of debt into goods/assets/shares

Page 66: An Introduction to Islamic Finance I.pdf

131

Economic Issues—Risks

Risks of Islamic financial instruments in general and sukuk in particular are

complex and not well understood

As Islamic financing is asset-backed or equity-based, market risks play an

important role along with credit risk

Credit/Counter-party risks

Risks related to obligor (default, coupon payment, and asset redemption risks)

Market risks

Interest rate risk (in fixed income sukuk)

Risks related to commodity/asset (loss, damage, etc.) and its price

Liquidity risks

Lack of secondary markets for sukuk

Debt based sukuk cannot be traded

132

Legal and Regulatory Issues

Securities and sukuk laws to protect investors

Most SPVs are trusts Created for bankruptcy remoteness

Lack of trust laws in many countries

Legal risks

Legal transfer and ownership to SPV

Conflict in laws—common law, civil law, and Shari’ah

A Shari’ah contract originating in civil law countries using English law as the governing law

Different components of the transaction has different applicable laws (ijarah and musharakah vs. trust)

Rating agencies—use the criteria of conventional securities to rate sukuk

Page 67: An Introduction to Islamic Finance I.pdf

133

Future Market Prospects

Demand for sukuk much greater than supply

Over-subscription of all sukuk issues

Huge liquidity in the region—lack of investment opportunities

Islamic financial industry growing at a fast pace—more demand for

Islamic products for treasury operations

Strong demand for Islamic products from non-Muslim countries

134

Future Market Prospects

Most sukuk are short-term—great potential for sukuk of long-

term maturities

Infrastructure financing

Estimated +$300 billion for MENA for next 10 years

New emphasis on private-public participation

Page 68: An Introduction to Islamic Finance I.pdf

135

Sukuk and Saudi Market

Sukuk market in Saudi Arabia–sleeping giant

Being the largest economy in the region—a great potential exists

After the Capital Market Law, two large sukuk issued SABIC—20 year SR 3 bill. sukuk (2006)

Saudi Electric Company— 20 year SR 5 bill sukuk (15/7/07)

The initiatives of developing the infrastructure and economic cities opens up opportunities for the sukuk market Capital investment planned for next few years-$283 billion

Saudi Aramco capital expenditure plan-$190 billion

136

RISK AND REGULATION OF ISLAMIC

FINANCE

Page 69: An Introduction to Islamic Finance I.pdf

137

Critics of Islamic Finance

Practice of Islamic finance far from ideal

–Bankers

–A $300 billion deception

–Islamic economists

–Fulfilling the form, not the substance or spirit of Islamic finance

–Similar to conventional, but more inefficient

–Shari’ah scholars

–Shari’ah scholars questioning the acceptability of some products

138

CHALLENGES IN ISLAMIC FINANCE

Challenges

Strategy and Plan to develop the

right business model

Willingness to invest in Human

Capital Development

Information system to cater to

Islamic Finance transactions

Replication v. Authenticity

Comprehensive Shariah

Governance & Audit *

Meeting evolving consumers’

demand

Risk Management*

Legal, Regulatory & Accounting

Framework*

Wealth Management

Page 70: An Introduction to Islamic Finance I.pdf

139

Credit Risk

Market Risk

Insurance Risk

Sustainability Risk

Liquidity Risk

Pension Fund Risk

Residual Value Risk

Reputation Risk

Operational Risk

RISK MANAGEMENT IS

Accounting

Business Continuity

Fiduciary

Fraud

Information

Legal

Compliance

Operations

People

Tax

Technology

Shariah Risk Management

Embedded within the conventional

business risk management framework

Non-compliance with Shariah rules and

regulations

New product due diligence including

simplification of product complexities

Application of Late Payment / Penalty for

default in a Shariah compliance manner

Advise on debt restructuring

Changes in fatwa resulting in existing

product being non-compliance

Advising / guiding with ongoing Shariah

requirements

140

MAJOR SHARIAH

RISKS Concentrated reliance on a single

broker for transacting commodity

murabaha (substantial Global

Business is based on this structure)

Untested legal infrastructure (case

laws or court proceedings)

supporting products

Major Risks

Credibility of “Commodity Murabaha”

/ “Tawarruq” structure questionable

Manual Processes increase

operational risks

Lack of inter-bank market creates

challenges in matching assets and

liabilities

Identification of new brokers required

and find alternative to existing

commodity (eg. Bursa Al Sila’)

Using experienced legal counsel for

preparing documentation and

structures

Looking to diversify to other

structures.

To address concerns raised.

Rationalisation of product range.

Long term, automation and

standardisation required

This has to be addressed and

financial linkages required

RISKS ACTIONS

Page 71: An Introduction to Islamic Finance I.pdf

141

Functional Segmentation During Transition

1) Given the lagging institutional infrastructure, segmentation of

payments / transaction functions and investments may present

advantages.

2) Investment activities can be modulated to the degree of

investors’ risk appetite.

3) Segmentation would facilitate regulation of IFI

142

Outline of Segmented Activity: Depositors Risk Appetite ASSETS LIABILITIES

Asset–Backed / Trade

Financing Segment A

Minimal Risk Depositors

Ijara, Istisna, Mudaraba Segment B

Low–Med Risk Depositors

Musharaka–Mudaraba Segment C

Vc-Private Equity Depositors

Page 72: An Introduction to Islamic Finance I.pdf

143

A Market Vision for the Industry Growth

In designing the regulatory framework for IFIs, regulators should recognize the current difference between the theory and practice of Islamic Finance.

- First, they should accommodate current practices to promote stability and soundness of the Islamic financial operations.

- Second, they should provide right incentives so that different players are encouraged to follow the paradigm of Islamic banking in the future.

- How ? By improving information facilities to reduce asymmetric information problems between IFI and investors and by improving the legal system supporting bank activities.