Demystifying Islamic Banking British Bankers Association Executive Lunch 7 March 2002 1/27 Warren...

Warren Edwardes

Demystifying Islamic BankingBritish Bankers Association Executive Lunch 7 March 2002

1/27

Demystification of Islamic Banking

Warren Edwardes, ceo, Delphi Risk ManagementBritish Bankers Association Executive Lunch 7th March 2002

text on: dc3.co.uk/islamicbanking.htm

Islamic banking news: dc3.co.uk/ibnews

Warren Edwardes


2/27

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, HoraceJulius Caesar limited interest to 8 1/3 %

Warren Edwardes


3/27

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

US federal law allows penalty rates / insurance premiums

Warren Edwardes


4/27

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

Warren Edwardes


5/27

Latin Jargon used by lawyers

• In haec verba

– "Verbatim

• nunc pro tunc

– Retroactive

• Caveat emptor

– Let the buyer beware

Warren Edwardes


6/27

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

Warren Edwardes


7/27

Arabic Jargon used by Islamic bankers

• Alwadiah

– Safe keeping

• Baimuajjal

– Deferred-payment sale

• Baisalam

– Pre-paid purchase

Warren Edwardes


8/27

Jargon Arabic - used by Islamic bankers

• Ijara

– Leasing

• Muqarada

– Mudaraba

• Mudaraba

– Profit-sharing

Warren Edwardes


9/27

Jargon Arabic - used by Islamic bankers

• Murabaha or Shirka

– Cost-plus or mark-up

• Musharaka

– Equity participation

• Qard Hasan

– Benevolent loan (interest free)

Warren Edwardes


10/27

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

Warren Edwardes


11/27

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

Warren Edwardes


12/27

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– Malaysia, Gulf, London

Warren Edwardes


13/27

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.

Warren Edwardes


14/27

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

Warren Edwardes


15/27

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 Murabah ltd., IBU of united bank of Kuwait.

Warren Edwardes


16/27

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?

Warren Edwardes


17/27

Why?

• Pork, fish

• 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

Warren Edwardes


18/27

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

Warren Edwardes


19/27


• Shirka

– Generalised Mudaraba

– More than 2 parties

– Non contractual al milk,

– Contractual Ul Uqud

• Looks like syndicated non-recourse project finance

Warren Edwardes


20/27


• 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.

Warren Edwardes


21/27


• Alwadiah– 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

Warren Edwardes


22/27

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

Warren Edwardes


23/27

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

Warren Edwardes


24/27

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

Warren Edwardes


25/27

Key Features of Islamic Banking

• Interest free

• Trade related and perceived need for funds

• Pure form - equity related

• Avoids exploitation - no usury

• Ethical investments

– Alcohol, tobacco, gambling, armaments, pornography etc

Warren Edwardes


26/27

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.

Warren Edwardes


27/27

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

• Speech not about economics or social science

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

Demystifying Islamic Banking British Bankers Association Executive Lunch 7 March 2002 1/27 Warren...

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