Islamic Banking

BK 6503, BK5503January Semester 2011Prof. Saiful Azhar Rosly, Ph.DDepartment of Banking, INCEIF

Islamic Banking 1

Islamic banking and finance Islamic finance has grown tremendously since it

first emerged in the 1970's. Current global Islamic banking assets and assets under management have reached USD750 billion and is expected to hit USD1 trillion by 2010.

There are over 300 Islamic financial institutions worldwide across 75 countries According to the Asian Banker Research Group, The World's 100 largest Islamic banks have set an annual asset growth rate of 26.7% and the global Islamic Finance industry is experiencing average growth of 15-20% annually.

3

Contents4

Islamic Finance Islamic Banking Business Shariah Framework Regulatory Framework Legal Framework Deposits Financing Operations Risk faced by Islamic banks

Islamic Finance

• EQUITY,JUSTICE and FAIRNESS• Deterministic ie Rule set by God• Shariah Rules• Philosophy – Maqasid Al-Shariah

Doing the

Right Thing

• EFFICIENCY – efficient use of scarce resources (ie funds)

• Using Reason and Facts in decision making

• Strategies, Planning, Process/procedures.

• Back, Middle, Front Office.

Doing Things Right

Peter Drucker

Islamic Finance6

Shari’ ComponentsProduct development and

screenning activitiesValue: Quran and Hadiths

(Shariah)JUSTICE AND EQUITY

Tabi’ ComponentsBusiness models,

strategies and policiesValue: Reason and

ExperienceEFFICIENCY

The Emergence of Islamic Finance

7

1960s and 1970sIslamic Economics

1980s/1990sIslamic Banking

2000 onwardsIslamic Finance

Components of Islamic Finance

8

Islamic

Finance

Shariah

Islamic Economics

Islamic Banking

Islamic Capital Market

Takaful

Islamic Wealth Plannin

g

Three Facets of Islamic Finance

9

As a Field of Study

Shariah (Quran,Hadiths

and Fiqh)as Primary or

Core Knowledge

Secondary Knowledge from Reason and Facts

As a Financial System : Set of

Rules and Regulation that

govern the flow of funds from the

Surplus Unit to the Deficit Unit

Rule 1: Al-Ghorm bil Ghonm“no reward

without risk”

Rule 2: Al-Kharaj bil Daman“with profit

comes responsibility”

As a Business

Equity ObjectiveAchievable by

adhering to the Shariah Rules and

Values

Efficiency Objective

Achievable by observing the law

in nature.

TOPIC 1ISLAMIC BANKING BUSINESS

Nature of the Banking Business11

The Banking Business: Banks as Financial Intermediaries

12

Holds Capit

al

Takes Depos

itsMakes Loans

Intermediation function of Conventional banking: Bank as a borrower and lender and carry financial risks

13

Deficit Sector Surplus SectorBank as financial Intermedi

ary

A Bank as a Financial Intermediary Make loans to

customers Borrows from

depositors

Holds capital

14

Conventional Banks: Market for deposits and loans based on interest rates.

15 Market for

DepositsDemand

for DepositsSupply

of Deposits

Market for

LoansDemand for Loans

Supply of Loans

r

D

r

Loans eposit

Sd

Dd

SL

DL

id

iL

D1L1

Market for DepositMarket for Financing

LiabilityAsset

Deposits $200m@ 5%

Loans $200m@10%The Banking Business

profit = (iL x L) – (iD x D) = (0.1 x 200m) – (0.05 x $200m) = $20m - $10m = $10 million

10%5%

$200m$200m

Capital

16

Profit versus Financial Stability

17 More bank profits: Bank take risky and aggressive and “irresponsible” positions to maximize profits

Credit defaults and bank closures: FinancialInstability

Bank - Corporate Score Card (Actual versus Budget) Operating Profit before Allowances for Loss Profit before Tax and Zakat Profit after Tax and Zakat Return on Equity Return on Asset Fee based income to Total income Productivity ratio 1. Overhead to total income2. Staff cost per employee Gross Financing to total deposit Financing growth Non-performing financing Financing loss coverage Risk-weighted Capital Ratio (RXCR)

18

19

Bank Regulation: The 3 Pillars of Basel II

The new Basel Accord is comprised of ‘three pillars’…

Pillar IMinimum Capital

Requirements

Establishes minimum standards for management of capital on a more risk sensitive basis:

• Credit Risk• Operational Risk• Market Risk

Pillar IISupervisory Review

Process

Increases the responsibilities and levels of discretion for supervisory reviews and controls covering:

• Evaluate Bank’s Capital Adequacy Strategies

• Certify Internal Models• Level of capital charge• Proactive monitoring of

capital levels and ensuring remedial action

Pillar IIIMarket Discipline

Bank will be required to increase their information disclosure, especially on the measurement of credit and operational risks.

Expands the content and improves the transparency of financial disclosures to the market.

The Banking Business20

Bank Capit

al

Capital Adequacy ratio = 8%

Risk-Weight Assets - to reflect risk-profile of business

unitsTo absorb potential

losses

Business of Leveraging CAR = 8%. CAR = Capital/ RWA; 0.08 = $100m/RWARWA = $1250m

$1250m

(for every $1 financing, it is supported with 8 cents of bank’s capital)

$1250m

Capital = $100m

(Bank can raise up to $1.25billion of deposits from its $100m capital)

Financing Deposits

21

Risk-taking and Capital Allocation

$100m 50%

CAR = K/RWA0.08 = K/ ($100

x .5)K = $4m(to make $100m loan at

50% RW, the bank needs to hold $4m)

Financing Risk weights Capital

22

Risk-taking and Capital Allocation

$100m 150%

CAR = K/RWA0.08 = K/ ($100 x

1.5)K = $12m(to make $100m loan

without collateral at 150% RW, the bank needs to hold $12m)

Financing Risk weights Capital

23

Risky Financing and Capital Stress

24

Risky positio

ns

Higher Risk-

weights

Higher capital

Conventional risk-weights

Loans with collateral

Personal loan Government

bonds Corporate bonds Equities

50% 100% 50% 80% 150%

Financing Risk-weights

25

Risk-weights: Islamic products

Murabaha with collateral

AITAB (financial lease with collateral)

Government Sukuk Corporate sukuks Equities Istisna Bona fide Murabaha

50% 50% 50% 80% 150% 150% 150% 150%

Financing Risk-weights

26

Conventional Banking Balance Sheet

27Asset Liability

Cash Current AccountHome Loans Savings AccountHP Car loans Fixed depositsPersonal Loans NICDGovernment SecuritiesCorporate BondsFixed Assets Shareholders’ Capital

Conventional banking P & L28

Profit and LossRevenuesCost of Funds

$500m$200m

Gross Profit $300mOverheadsProvisions for NPL

$80m$10m$5m

Profit Before Tax $200mTax $60mNet Profit $140m

29

1. High NPL

2. Low revenues3. High cost of

deposits

Negative Earnings

Capital Erosion

Bank Insolvent

30

1. Low NPL

2. High revenues

3. Low cost of

deposits

Positive Earnings

Capital Accumula

tion

Healthy & Stable

Banking

31

Bank Business

Model?

SafeLow yielding loans with

control repayment

AggressiveHigh yielding

Loans without

collateralIrressponsi

bleLoans to non-

viable customer“subprime

loans”

Islamic Banking within conventional financial system32

Holds Capital

Take Deposi

ts

Extend Financi

ng

Islamic banking: Bank as mudarib/agent and depositors as investors: as a mudarib, the bank manages deposit funds.

33

Deficit Sector Surplus SectorBank as financial Intermedi

ary

Islamic banks as financial intermediaries

34

• Based on Trading contracts

• Not based on lending and borrowing contracts

Deposit

Market• Based on Trading

contracts• Not based on

lending and borrowing contracts

Financing

Market

“Allah has allowed Al-Bay (trading) but prohibits Riba” (Al-Baqarah 275)

35

AL-BAY RIBA

36

Al-Bay

Money exchanged for

goods and services

Business riskCapital loss due to adverse price

movement

RibaMoney

exchanged for more money

Financial risksCapital loss due to credit default and interest rate

volatilities

Trading Models37

• Buy • Sell

Trading

Model I

• Buy• Sell• Financing

Trading

Model II

FinancingTradin

g Model

II

Trading (Al-Bay) Models38

Trading Model 1

• Buys at $10• Sells at $15

cash• Profit = $5

• Business risk

Trading Model II


cash• Sells at $20

credit• Profit = $5

+ $5 = $10

• Business risk

• Credit risk• Interest rate

risk

Trading Model III


credit• Profit = $5

• Credit risk• Interest rate

risk

39

• Capital = $50 million• Asset = $50 millionTradin

g• Capital = $50 million

• Asset = $625 million (CAR = 8%)

Islamic

banking

Business risk in Trading > Business risk in Islamic Banking

40

• Business riskTrading

• Business risk• Financial risk

Islamic banking

with credit system

• Business risk• Financial risk

Conventional

banking with credit

system

Islamic Banking Under Basel II

41

Using Trading Model in Banking

Taxes on asset

purchases

Capital charges on

asset purchases and equity investment Bank faces

high business risk with

expectation to earn

higher profits

Types of Islamic banks42

Islamic Bank A

Buy and Hold and sell

on credit

Business risk + financial

risks

Islamic Bank B

Sale and buyback

without title transfers

Financial Risks

Islamic Financial Market43

Islamic Financial Market

Direct Financial Market

(Capital Market)

Sukuk65%

SC Screening

Equity85%

SC Screening

Indirect Financial market

Bank20%

Takaful18%

Unit TrustMutual Funds

Venture Capital

Dual-Banking System44

Asset LiabilityMortgage SavingHire-Purchase

Fixed Deposit

PersonalBonds Capital

Asset LiabilitiesFinancingMortgageHPPersonal

Wadiah Dhamanah Savings

Operational Leasing

Investment Accounts

JVStocksSukuks Capital

IBA 1983: Trading ContractsBAFIA 1989 : Lending and Borrowing Contracts

US Banking Glass-Stegall Act

1932

Wall separating Commercial and Investment Banking and Insurance companies

The Gramm–Leach–Bailey Act 1999

Allowed commercial banks, investment banks, securities firms, and insurance companies to consolidate

45

Universal Banking Retail Banking + Investment Banking +

Insurance Retail Banking:1. Take deposits2. Make loans Investment Banking1. Underwriting2. Lead-Arrange Insurance1. Underwrite pure risk

46

Islamic Banking Under IBA 1983

47 Financing

FinancingMortgage

Hire-PurchasePersonal, enterprise

,

Leasing

Venture capital

Property

Deposit

Saving

PSIA

Private Equity

Asset LiabilitiesFinancing Wadiah

Dhamanah Savings

Operational Leasing

PSIA

JV

Stocks

Sukuks Capital

MORE OUTPUT AND REAPING ECONOMIES OF SCALE

BENEFITS

Simple Bank Organization48

Board of Directors

Corporate Retail Investment

Risk Managem

entICBU

CEO

Shariah Advisory Committee Audit

Islamic Bank’s Average Balance Sheet

49Asset Liability

Cash Wadiah Dhamanah Current Account

BBA Home Financing Wadiah Dhamanah Savings Account

AITAB Car Financing Restricted Mudarabah Account

Bay al-Inah Personal FinancingEnterprise Financing

Unrestricted Mudarabah Account

Government Islamic Securities

Commodity MurabahahNegotiable Islamic Certificate of Deposits

SukukFixed Assets Shareholders’ Capital

Income Statement‘Reward comes with Risk”

50Islamic Banking


$500m$200m

Gross Profit $300mOverheadsProvisions for NPFProfit Equalization Reserve

$80m$10m$5m

Profit Before Tax and Zakat

$200m

Tax and Zakat $60mNet Profit $140m

r

D

r

Financing eposit

Sd

Dd

SL

DL

rd1

rL1

D1F1

Market for DepositMarket for Financing

LiabilityAsset

Deposits $200mFinancing $200mThe Banking Business

Profit = (rF1 x F1) – (rd1 x D1) = (0.1 x 200m) – (0.05 x $200m) = $20m - $10m = $10 million

10%5%

$200m$200m

Capital

51

Conventional bank

Profit = (iL x L) – (iD x D)iL = 10%, iD = 5%L = D = $100 million

Profit = (0.1 x 100) – (0.05 x 100) = 10m – 5 m = $5m

Islamic BankProfit = (rF x F) – (rD x D)rF = 10%, rD = 5%F = D = $100m

Profit = (0.1 x 100) – (0.05 x 100) = 10m –.5 m = $5

52

Islamic Bank as a Financial Intermediary1. CAR 8%1a. Bank Capital1b. RW = 50%0.08 = [$20b/F x 0.5] F = $500b

$20b

2. Investment Deposit (Partnership) Transaction Deposit

$500m@ 5% ex post

3. Financing (Trade) $500m@10%

4.Revenue $500m x 0.1 = $50b5. Cost of deposits $500m x 0.05 = $25b6. Overhead $3b7. Provisions $1b8. Profit $50b – ($25b + 3B + $1b) =

$21

9. ROE ($21b/$20b) x 100%= 105%10. ROD 5%

53

EXERCISE 1: FINANCING DEPOSIT

• BBA $300@8%• AITAB $600@7%• Personal F $250@10%• Sukuk$80m@5%• Mudarabah

$20m@15% Total = $1250

Calculate:Total revenues =

• CASA $300@1%• PSIA $950@3%

Total = $1250

Calculate:Total cost of deposits =

54

Calculate PROFIT =

Income Statement‘Reward comes with Risk”

55Islamic Banking


$20m ($9.80m)$10m ($6.85)

Gross Profit $10m ($2.95m)OverheadsProvisions for NPFProfit Equalization Reserve

$3m$2m$1m


$4m


Islamic Banking Performance

56

Market share in terms of asset: 17.3% Average annual growth: 20% 65% of market is concentrated on 6

players Majority are still small in size in capital

terms

Islamic Financin

g31/12/08

Al-Bai-bithaman ajil (BBA)

32.99%

Ijara Thumma Al-Bay (AITAB)30.44

Ijarah2.65%

Murabaha15.5%

57

Islamic Financin

g by purpose

Landed property22.2%

Construction2.4%

Purchase of securities

2.4%

Credit Card0.7%

Purchase of transport vehicle30.5%

Working Capital

26%

Personal Use9.4%

58

Malaysian Islamic Financial System

59

Tabung Haji

I st Islamic Bank1983

Islamic window1992

Islamic money market

Financial Sector

Master Plan2001

Islamic capital market2001

Islamic banking

Subsidiary2005

Foreign Islamic Bank

2005

MIFC2006

Bank Negara

Bill 2010

TOPIC 2SHARIAH FRAMEWORK

Alam Arwah(Primordial

Life)

Alam Rahim(Life in

Mother’s Womb)

Alam Dunya(Life in this

World)

Alam Barzakh

(Life in the Grave)

Life in the Hereafter

KNOW YOUR CUSTOMER!THE WORLDVIEW Of A THE MUSLIM CUSTOMER

AL-MITHAQ (THE PRIMODIAL COVENANT)

“When thy Lord drew forth from the Children of Adam, from their loins their descendants, and made them testify concerning themselves, (saying), “Am I not your Lord (Who cherishes and sustains you)? They said: Yea! We do testify! (This), lest ye should say on the Day of Judgement: Of this we were never mindful.” (Al-Araf: 172)

63

Man is indebted

(dyn) to God for giving

him life and sustenance

Man settle his debt with

God by submitting his desires

to the Will of God

The Will of God is the Shariah

Shariah

Aqidah(Belief)

5 Pillars of Iman (Faith)

Akhlak(Moral

conduct)Muamalat

(Transaction)

Man with Allah swt

5 Pillars of Islam

Man among Man

The Shariah

64

Objective of Shariah (Maqasid Shariah)

Protecting Public Interest

Removing the Harm

“Iba’a”

Securing the Benefit“Tahsil”

65

66

Public Interest (Maslah

a Ammah)

1. Protectio

n of Religion

(Din)

2. Protection of Life (Nafs)

3. Protectio

n of Intellect

(‘Aql)

4. Protectio

n of Family (Nasl)

5. Protectio

n of Property

(Mal)

67

Protection of Religion

(Din)

Performance of 5 daily prayers

(solat)

Protection of Life (Nafs)

Capital punishment on murder (Hadd)

Protection of the

Intellect (‘Aql)

Prohibition of consuming Intoxicants

(qimar)

Protection of Family

(Nasl)Prohibition of adultry (zina)

Protection of Wealth

(Mal)

Prohibition of riba, gamblingPermissibility

of trading (bay)

68

The Shariah serves to

protect Public Interest

(maslaha al ammah)

Shariah = Shariah rules

Some Shariah rules:

1. Prohibition of riba

2. Elimination of Gharar

3. Prohibition of Gambling

These rules are meant to:1. Prevent the

Harm2. Preserve the

benefits

Shariah Framework for Islamic Banking

69

5 Shariah Principles

1 Prohibition

of Riba“riba is profit

derived from

loans”

2.Application of Al-

Bay“work,

effort and responsibil

ity’

3.Avoidance of

Gharar in Contracts‘ambiguiti

es in prices, subject matter,

counterparties.

4.Prohibition of

Gambling (maisir)

‘outcome due to pure

chance”

5. Prohibition to engage in the

trading of impure

commodities

Maqasid of Shariah (Objective of Shariah)

70

Islamic financial products as defined by AQAD methodology, should contain more benefits (masalih) and less or no harm (madarah).

“ in gambling (maisir) and liqour (qimar), there are some sins and some profits. But the sins are greater than the profits” (Al-Baqarah: 216).

MudaratSins

ManfaatProfits

“ in Gambling (maisir) and Liqour (qimar), there are some sins and some profits. But the sins are greater than the profits” (Al-Baqarah: 216).

Gambling & Liqour

71

Mudarat

Manfaat

#1 NO Riba!72

Aqidah Viewpoint: Trade and Riba

73

“Allah has allowed trade but prohibits riba”. Explain the verse in the light of risk magement.

Main lesson: Rejecting love for money, which is one form of Hubbul Dunya. The believer must only love Allah swt since He is the Creator and Sustainer of life.

In riba, money will always appreciate. Principle + interest = appreciation.

In trade (al-bay’), money is converted into capital. Capital is used to buy merchandize or underlying assets

Business capital can increase, decrease or remains the same over time due to risk-taking. Risk is potential loss. Capital is subject to market volatility.

Because there is no love for money but only God, money must be allowed to appreciate and depreciate, leading to gain or loss.

Fiqh Viewpoint Contract of Qard with upfront/contractual

increase is invalid.1. Agent of contract: Lender and borrower2. Objective of contract: Exchange of

equivalents3. Subject matter: i. currency/moneyii. Price = 04. Ijab and Qabul

74

‘IWAD(Equivalent countervalue)

RISK(Ghurmi)

WORK & EFFORT

(Kasb)

LIABILITY(Daman)

PROFIT =

RIBA: ECONOMIC VIEWPOINT

1.Al-Bay’2.Al-Ijarah

3.Salam4.Istisna’

5.Mudarabah6. Musyarakah

75

#2 TRADING!

Profit from Trading76

Profit from

Trading(al-Bay)

Capital at Risk

Value-addition

Responsibility

3 basic reasons77

Prohibition of Riba

(Usulfiqh)

Fiqh Viewpoi

nt

(Usulludin)

Aqidah Viewpoi

nt

Economic

viewpoint

Riba in Loan78

$Riba1.An upfront and fixed

increase on a loan2. Fixed by the lender.

3. Contractual in nature

Islamic loan79

$Increase on Islamic

loan

1.An increase on a loan known only at maturity2. Fixed by the debtor3. Voluntary in nature

Mudarat

Manfaat

Al-Bay

80

Mudarat > Manfaat

HARAM

81

Mudarat < Manfaat

HALAL

82

#3 NO GHARAR!1.Gharar (ambiguities) must be avoided in contracts2. Gharar will invite legal disputes leading to injury and loss of well-being83

Pillars of

Contract

(‘AQD)

1. Buyer and Seller(Rational and well-informed)

Subject matter

(posesion and

ownership)

Offer and Acceptanc

e(negotiatio

n)

Price(must be

set upfront)

#4 No Gambling!84

Profit in Islam is derived from risk, work and responsibility.

Profit from gambling (maisir) is

derived from game of chance

TOPIC 3REGULATORY FRAMEWORK

Basel 2, IFSB, AAOIFI, Central Banking

Bank regulations are a form of government regulation which subject banks to certain requirements, restrictions and guidelines.

Financial instability hypothesis - Regulation/Government intervention is inevitable as the financial sector is “inherently unstable”. Instability arising from “internal factors”.

Efficient market hypothesis – market is inherently stable, thus the market does not need government interference. Instability arises from “external factors”.

86

87

Banking Regulati

on

Prudential –

protection of

depositors

Systemic risk

reduction

Avoid misuse of

banks

Credit allocation

Objectives of Regulation

Islamic Banking Regulations88 Shariah

Framework

Fiqh Academy Mekah

AAOIFI, Bahrain

Bank Negara Shariah

Supervisory Board,

Malaysia

Regulatory

FrameworkBasel II

Islamic Financial

Service Board (IFSB)

Bank Negara Malaysia


Framework

Fiqh Academy Mekah

AAOIFI, Bahrain

Bank Negara Shariah

Supervisory Board,

Malaysia

Regulatory

FrameworkBasel II

Islamic Financial



Islamic Banking Law91

Islamic

Banking

Act (IBA)1

983“Islamic bank” means any

company which carries on Islamic banking business and holds a valid

license; and all the offices and branches of such a bank shall be

deemed to be a bank”

“Islamic banking business” means banking business who aims and operations do not

involve any element which is not allowed by the Religion of Islam”

Islamic Banking Act 198392

4. Restriction on Business

2. Financial requirement and duties of Islamic

banks

3. Ownership, control and management of

Islamic banks

5. Powers of supervision and control

over Islamic banks

1. Licensing of Islamic

banks

Islamic Banking Under IBA 1983

93 Financing

FinancingMortgage

Hire-PurchasePersonal, enterprise

,

Leasing

Venture capital

Property

Deposit

Saving

PSIA

Private Equity

Asset LiabilitiesFinancing Wadiah

Dhamanah Savings

Operational Leasing

PSIA

JV

Stocks

Sukuks Capital

MORE OUTPUT IN THE BANKING BOOK

Conventional to Islamic94

Asset Liability

Mortgage Saving

Hire-Purchase PSIA

Personal

Sukuks

Asset LiabilitiesFinancingMortgageHPPersonal

Wadiah Dhamanah Savings

Operational Leasing

PSIA

JV

Stocks

Sukuks

IBA 1983: No Wall between Commercial andInvestment bankingIslamic Banking and BAFIA 1989

Universal Banking: Economies of Scale and Scope

95

More Outputs

Less Cost per Unit

Higher Profits

Shariah Advisory Board96

Islamic Banking Act 1983 on Shariahadvisory body

“that there is in the article of association of the bank concerned, provision for the establishment of a Syariah advisory body to advise the bank in the operation of its banking business in order to ensure that they do not involve any element which is not approved by the Religion of Islam”

Commercial banking

Investment banking

Fund managem

entJoint -

ventureIslamic banking

Islamic Banking Act 1983Bank Negara Bill 2010

97

Role of Shariah Supervisory Board

98

To study fatwas previously

issued by SSB of member banks and how these fatwas conform

to Shariah rulings

Supervise activities of

member banks to ensure they

are in conformity with Shariah

rulings

To issue fatwas (religious legal opinions) on

financial products and

banking operations

Shariah Product Auditing

Role of Shariah Supervisory Board

99

Accounting policy adopted by banks

Determination of profit-sharing ratio between

banks and clients

Determining the calculation and

payments of zakat

Determining the income distributed and expenses to be borne by depositors

Others Duties

IFSB Guiding Principles on Shariah GovernanceIndependence of Shariah Board

100

No individual or group of individuals shall be allowed to dominate the Shariah board’s

decision-making

The Shariah Board should play a strong role and independent oversight role, with

adequate capability to exercise objective

judgement on Shariah related matters.

BNM Guidelines on Shariah Supervisory 2010

Shariah Compliance

Shariah Framework

101

IMPACT OF BASEL II ON ISLAMIC BANKING CAPITAL REQUIREMENT

103

Bank is required to back-up loans with some capital.

If CAR = 8%, it means for every $100 loan given out, it must be supported by $8 of bank’s capital.

CAR = Capital / Risk-Weight Assets

Conventional Bank Under Basel 2104 Assets Amount Riskweights

RWassetsLoans $600m 50% $300Hire-Purchase $300m 50% $150Personal Loans $200m 100% $200Bond $100m 50% $ 50TOTAL $1200 $700

Capital ratio = (Regulated Capital / RWA)8% = RC / $700RWA = [($600m x 0.5) + ($300m x 0.5) + ($200m x 1.00) + ($100 x 0.5)] = $300m + $150m +$200m + $50m = $700

RC = $700 x 0.08 = $56mNote Risk weight also known as conversion factor.

Islamic Bank Under Basel 2: Higher Capital Requirement

105 Assets Amount Riskweights RWassetsMurabaha $600m 50% $300AITAB $300m 50% $150Personal F $200m 100% $200Sukuk $100m 50% $ 50 TOTAL $1200 $700

Capital ratio = (Regulated Capital / RWA)8% = RC / $700RWA = [($600m x 0.5) + ($300m x 0.5) + ($200m x 1.00) + ($100 x 0.5)] = $300m + $150m +$200m + $50m = $700

RC = $700 x 0.08 = $56mNote Risk weight also known as conversion factor.

106

Bank intends to give a $200,000 BBA facility to Ali.

How much capital it require to hold given that RW on the facility is 50%.

0.08 = x / RWA 0.08 = x / $200,000 x 0.5 = x /$100,000 X = $8,000.

Islamic Bank with Musharakah financing under Basel 2: Higher Capital Requirement

107 Assets Amount Riskweights RWassetsMurabaha $500m 50% $250AITAB $300m 50% $150Personal F $200m 100% $200Sukuk $100m 50% $ 50Musharakah $100m 250% $250TOTAL $1200 $900

Capital ratio = (Regulated Capital / RWA)8% = RC / $900RWA = [($500m x 0.5) + ($300m x 0.5) + ($200m x 1.00) + ($100 x 0.5) + ($100 x 2.5)] = $250m + $150m +$200m + $70m + $250 = $900

RC = $900 x 0.08 = $72.00mNote Risk weight also known as conversion factor.

Stress on Islamic bank capital

108

Since the risk-weight for Musharakah is 250%, the bank is charged higher capital from $56m to $78m. The bank has to come up with $22m more capital to meet regulator’s requirement in order to undertake the Musharakah project.

In this sense, the Musharakah project places stress of Islamic bank capital.

Basel II assumes that Islamic deposits are similar with conventional deposits.

In conventional deposits, the deposits and interest income are guaranteed.

This is not the case for Islamic deposits since they are based on profit-sharing system. In this manner, the bank need not provide capital guarantees.

Islamic Banking under Basel II/IFSB

Murabaha without title

Murabaha with title Ijara Financing lease Ijara Operating lease Musharakah Salam Istisna Tawaruq

50% 150% 50% 100% 150% 100% - 150% 100%- 150% 100%

Islamic Products Risk-weights

109

TOPIC 4LEGAL FRAMEWORK

Legal Framework111

TaxTax

Neutrality

Tax on leasing,

murabahah, assets

LawContract

Documentation

Litigation

Tax implication: Shariah and Civil Law

A true sale will trigger a tax claim by the government. Murabaha – stamp duties Ijara – stamp duties Tax neutrality 1. PPA2. PSA Since PPA and PSA is not a true sale it is easy to exempt it from

tax, thus a case of tax neutrality on Islamic financing. But the S & P agreement is still subject to tax since the sale is

a true one. When an Islamic bank purchases an asset (say, property) from

a developer, it will have to pay tax or stamp duties to the government.

Stamp duty: Tax implication Stamp duty tax is one of the important

property taxes applicable within the country. For comparison, the stamp duties in Malaysia within the year 2007 and 2008 are given below.

Price Stamp Stamp Duty in 2007 Stamp Duty in 2008RM250, 000 RM4, 500 RM2, 250 (-50%)RM150, 000 RM2, 000 RM1, 000 (-50%)RM350, 000 RM6, 000 RM6, 000 (unchanged)

Based on the current rate of 1% for first RM100,000 and 2% for RM100,001 to RM1,000,000)This situation is prompting property developers to provide more properties at below the price of RM250,000 in order to entice buyers. However, new home buyers face two main Stamp Duties: for title transfer and the bank loan facility agreement.

• Financial Distress• Default

Credit risk

• Litigation• Civil Court

hearingForeclos

ure• Invalid contract• Improper

documentationShariah

risk

114

Legal Framework: The Judiciary and Court of Law

• Bank carries higher capital charge

• Bank carries higher tax burden• Bank to carry new risk ie.

business risk due to the holding of inventories + credit risk + market risk + operational risk

True Sale

• No extra capital charge

• No new tax implication

• Bank only faces credit risk + market risk + operational risk

Fictitious sale

FICTITIOUS SALE : Sale without title transfer.Bay’ al-enah

Bank Customer

1) Sells asset X to customer for RM15,000

2) InstallmentPayments@ RM250

((4) Cash payments RM10,000

COF = RM10,000Profit rate per al

(1) Bank Sells asset $10,000 + profit margin = $12,000

(2) Customer pays byEqual instalment over 5Years = $12,000/60 = $200

(3) Customer sells asset To Bank for $10,000

(4) Bank pays cash $10,000To Customer

Fictitious Sale Loan

Convergence

True Sale

Fictitious Sale

Divergence!

Promotion and Defence of Fictitious

Sale

Helps avoid capital charges + new tax

burden + risk-taking business

Islamic bank can run a business based on

the lending –borrowing model

Less need to change risk-appetite

behaviour of bank’s stakeholders.

Protection of Deposits and

Financial Stability are Guaranteed

1st Arguement

Promotion and Defence of Fictitious

Sale

Helps avoid capital charges + new tax

burden + risk-taking business

Islamic bank can run a business based on

the lending –borrowing model

Less need to change risk-appetite

behaviour of bank’s stakeholders.

Intent of the Law (Maqasid Shariah) in

riba prohibition is not met

2nd Arguement

True Sale

1. Higher Capital Charges

2. New tax burden

3. Carries new risk –

business risk

Impact on:1. Pricing of

Islamic instruments2. Return on

Equity

Banking Infrastruc

ture

Shariah Framewrok

Regulatory Framework I

Regulatory Framework II

Legal Framework I

Legal Framework II

Legal Framework III

True Sale

Bank purchases Asset from Vendor as cash price (lower

price)Bank sells asset to

Customer at credit price (higher price)

Higher Risk-Weights

Islamic bank to hold additional capital

Pay Stamp-Duties

No tax neutrality

Civil Court determines sale character based on legal documentation drawn by solicitor – Title transfer

Non-bona fide sale

Bank purchases asset from Customer at lower price and sells it back at higher price.

Risk-weight equal to risk-weight of loans

Islamic bank holds same amount of capital

No Stamp-duties

Tax neutrality

Civil Court determines sale character based on legal documentation drawn by solicitor - no title transfer

PRODUCTS AND SERVICES

Islamic Banking

125

FinancingPRODUCT

Home-financingAuto-financing

Personal financingTrade financing

Credit card

CONTRACTBai-bithaman Ajil

Al-Ijarah Thumma Al-bayBay’ al-’inahWakalah LC

Murabahah LCKafalah LG

Islamic accepted bills.

Bay’ al-’inah

Islamic Banking = Equity + Efficiency 126

ISLAMIC BANKINGFINANCING OPERATIONS

ASSET-BASED FEE-BASED

Murabaha(deferred sale)

Ijara(leasing)

Istisna’(sale by order)

Kafalah(guarantee)

PROFIT-SHARING

Qirad/Musharaka(partnership)

Wakalah(Agency)

TOPIC 5DEPOSITS

Transaction and Investment Deposits

Basel III – Back to Basics

Take Deposi

tOrigina

te Hold

Funding needs – Back to Basics

CORE FUNDINGDeposits

(Financing/Deposit) Ratio

NON-CORE FUNDINGInterbank

Market

Funding

Subprime Crises, Northern Rock etc

CORE FUNDINGDeposits

(Financing/Deposit)

Ratio

NON-CORE FUNDINGInterbank Market

Funding

131

Islamic DepositsProfit-Sharing/Mudarabah Investment

Account (PSIA)

General Specific

Transaction Deposits

(Safe-Custody with Guarantee)Wadiah Dhaman

ah Current Account

Wadiah Dhaman

ahSavings Account

Money Market Deposits

Commodity

Murabaha

Negotiable

Islamic Certifica

tes of Deposits

Transactional Deposits132

Current Accoun

t

Wadiah Yad

Dhamanah

SavingsAccoun

t

Wadiah Yad

Dhamanah

Product Contract

Investment Deposits133

General Investm

ent Account

Mudarabah

Specific Investm

ent Account

Mudarabah

Product Contract

Money Market Deposits134

Negotiable

Islamic certificat

e of Deposit

Bay al-Dayn

(Sale of Debt)

Commodity

Murabaha

Tawaruq

Product Contract

Wadiah Dhamanah Deposits135

Deposits

$5,0001/8/09

0Deposit

s$5,00015/8/09

1. Islamic bank acts a custodian and guarantees full withdrawal/capital protection with acondition that depositors allow the bank to use the fund in its financingoperations. No fee charges on the safe-custodial service.

2. Bank does not give any fixed return on the deposits.3. Bank may give an extra over the deposits based on the principle of gift (hibah/hadiah).

Hibah is not contractual but voluntary136

$5,0001/8/09

$5(Hibah)

$500515/8/09

Hibah is not fixed upfront137

Hibah

10%

0%5%

Tagging deposits financing138

BBA

Transaction Deposits(Current

and Savings Account)

Joint Venture

FinancingMudarabah

Deposits

139

Mudarabah

RabulMal(Depositors)

Contributes

Capital

Mudarib(Bank)

Contributes

Skill and Expertise

Project

Al-Mudarabah Investment 1. No guarantee on deposits2. No guarantee on returns3. Flexible rate liability

Placement of deposits using the principle of Al-Mudarabah (trustee partnership)

140

Bank - Mudarib(value added)

DepositorsRabulmal(Capital)

Al-MudarabahProject

Profits (iLossf any)- distributed accordingto PLS ratio

Loss (if any)- capital depreciation Total liability on depositorsValue added not compensated

Profit Loss

Bank Negara Malaysia (BNM) Guidelines on Profit-Sharing Investment Account (PSIA) with risk absorbent

141

In order to highlight the more accurate nature of mudarabah deposits (PSIA) and its impact on bank capital, BNM has provided a new formulation for determining regulated for Islamic banks.

PSIA will be used to finance a relatively more risky projects based on mudarabah, istisna and musharakah contracts.

The formulation capital adequacy ratio (CAR) = Capital/ (RWA less (1-α)RWA funded by PSIA less (α)RWA in the form of PER)

When α = 1, the bank holds all risks in the balance sheet. When α is say 30%, the bank carry risks only from wadiah

dhamanah deposits and general mudarabah deposits. Then 70% of the risks (1-α) = (1-0.3), is carried by PSIA deposits. Then CAR will be less than CAR without α as a risk-absorbent

factor. This will reduce stress on Islamic banking capital. Hence, the smaller the α i.e. the more risks carried by PSIA, the

lower is the CAR.

Modified Formula Incorporating the Risk nature of Mudarabah Deposits

142

RWCAR Islamic = [Capital Base] /[(TRWAIslamic) Less (1-) (Credit and Market Risk

Weighted Asset funded by PSIA) Less ()(proportional of Credit

and Market Risk Weighted Assets funded by PSIA in the form of PER)]

Islamic Bank with Musharakah financing under Basel 2: Higher Capital Requirement

143

Assets Amount Riskweights RWassetsMurabaha $500m 50% $250AITAB $300m 50% $150Personal F $200m 100% $200Sukuk $100m 50% $ 50Musharakah $100m 250% $250TOTAL $1200 $900

Capital ratio = (Regulated Capital /( RWA – [1-α]RWA funded by PSIA –[α] RWA funded by PSIA as PER)

1.α= 30%2.(1-α) = 70%3.RWA funded by PSIA = $250m (musharaka)4.RWA as PER = $2m (by assumption)

RWA = [($500m x 0.5) + ($300m x 0.5) + ($200m x 1.00) + ($100 x 0.5) + ($100 x 2.5)] = [$250m + $150m +$200m + $70m + $250] - (0.7)($250) – (0.3)($2) = $900m - $175m - $0.6m = $724.4m

RC = $724.4 x 0.08 = $57.95m

Note Risk weight also known as conversion factor.PER = Profit Equalization Reserve.

144

(1-) represents the quantum of PSIA recognized as a risk absorbent for RWCR computation purposes and approved by Bank Negara Malaysia.

= 1 means all risks carried by bank = 0 means all risks carried by PSIA.The smaller the , the lower is RWCR.

Money market placement: Commodity Murabaha

Islamic Liquidity Center (ILC)

Surplus Bank (SB)Broker A

Broker B

Sells X $10.5mmurabaha

Pays $10.5m at maturity

Pays cash $10m

Buys X

Sells X

Pays Cash $10m

Commodity Murabaha SB to place excess funds with ILH in return for fixed income

and protected deposit. How? SB purchases commodity (eg palm oil) from Supplier A via

broker A at $10m. SB sells the commodity to ILH. ILH will pay on credit in 6

months at $11m. This is a 6-month facility placement. ILH sells the commodity to Supplier B via Broker B and

obtain cash. Cash will be invested in ILH financing operations.

ROI of the $10m varies. Assume that the ROI = 20%. Thus ILH secures $10m x 0.2 = $2m profit.

At maturity ILH pays SB $11 million with net margin for SB and ILH respectively = $1m.

Brokers’ charges: Commodity Murabaha Deposit

147

Deposit = $20 million Agent’s Fee (AF) = 25 basis points $20,000,000 x 0.025 = $500,000 Broker’s fees (BF) = $50 per $1 million

transaction$50 x 20 = $1000 Depositor will received net of AF and BF.

TOPIC 6FINANCING OPERATIONSProducts and Contracts

Retail Products149

Home Financin

g

Al-Bai-bithama

n Ajil(BBA)

Car Financin

g

Ijarah Thuma Al-bay (AITAB)

Product Contract

Retail Products150

Personal

Financing

Bay al-enah

Credit card

Bay al-enah

PRODUCT CONTRACT

Enterprise Financing151

Letter of CreditTrust

Receipt

WakalahMurabah

a

Overdraft

Bay al-enah

PRODUCT CONTRACT

Enterprise Financing152

Joint venture

Musharakah

Sale by Order

IstisnaSalam

PRODUCT CONTRACT

HOME BBA FINANCING :

Plain BBA154

Developer

Customer

Bank

Bank buys directly from Developer on cash basis

Customer pays Bank on deferredpayment basis.

$

Transferownership

Bank Sells assetTo Customer

1

2

BBA as applied in Banks155

Developer Customer

Bank

S & P

PPAPSA

Customer Pays down payment

11

2

3BankSellsAsset to Customer

Customerpaysby installment

CustomerSells assetTo bank

Bank paysCustomercash

BBA Property Financing156

Price of Property = $400,000 Down-Payment = $80,000 (20%) Bank Financing = $320,000 Profit rate = r =6% Tenure = n = 20 years Profit margin = BF x r x n = $320,000 x 0.06 x

20 Selling price = BF + (BF x r x n) = $320,000 +

$384,000 = $704,000. Monthly payment = {BF + (BF x r x n)} /120 =

$5,866.

Al-Bai-bithaman Ajil Financing

157

Structure1. Risk2. Pricing – Fixed and floating rate asset3. Amortization – allocation of profit and capital Documentation1. Sale and Buyback

PPA : Property Purchase AgreementPSA: Property sale Agreement

2. Charge agreement Governing Laws1. Litigation

BBA Based on Novation Agreement

Developer

Customer

Bank

Bank buys Asset on Behalf of CustomerDeveloper to deliver asset to Bank as if theBank = Customer

Downside:

1. Developer will find it risky dealingwith Bank as Buyer. Failure to deliver onprescribed time has severe legal implicationssince the developer is dealing now with a bankand not an individual customer.

2. Bank feels uneasy since there is no bindingcomittement of Customer to purchase the property.A promise (wa’ad) may not be enough to guaranteea sale.

Customer promisesto buy property fromBank.

CAR FINANCING

Leasing

Operational Leasing

Leasing without

intention to own

Not a loan

Financing Leasing

Leasing with

intention to own

Term LoanHP Act 1967

161

Ijarah Thumma Al-Bay (AITAB)

Leasing

Bank holds beneficial ownership

Customer holds legal ownership

SaleAt maturity

Price 1. Last installment

payment2. Nominal value $1

AITAB162

Cost of Car = $40,000 Term charges = 7% per annum (flat) Tenure = 5 years Total charges = 0.07 x $40,000 x 5 = $14,000 Total rental to be collected over tenure = $40,000

+ $14,000 = $54,000 Monthly rental = $54,000/60 =$900Documentation:1. Master Ijarah agreement2. Charge agreement

PERSONAL FINANCING PRODUCTS

Islamic Personal Financing164

Bay’ al-’inah Personal Financing (Malaysia)

Al-Rahn Personal Financing At-Tawarruq Personal financing (Middle-

East)

Al-Rahn Personal FinancingIn the Hedaya, rahn literally signifies the detention of a thing (the pledge or security) on account of a claim that may be answered by means of that thing

165

Contract of Qard (loan) Contract of Al-Rahn (Mortgage) Contract of Wadiah Amanah - Safe keeping

Qardhu Hasan$4,000

Rahn$5,000

Al-Wadiah Amanah

Custodial Fee

Borrower

Islamic Pawn-

Broking(Lender)

Pledge$4,000

($4,000/$100) = 2% x 5 = $40166

Al-Rahn – Bank Rakyat167

According to Bank Rakyat, a pledge valued at less than $1,000 will cost the rahin (1,000/100) x 40 sen or $4 a month. Normally, only about half of the pledge value is given to the rahin as an interest-free loan. Thus, a $500 loan payable in 6 months will incur a storage cost of $4 x 6 = $24.

At the end of the term, the rahin will pay the murtahin $524. The rahin can ask for periodic loan extension provided he pays an additional storage fee.

On failure to pay the loan after a prolonged reminder, the operator holds the right to put the collateral on auction.. The rahn company will claim loan plus storage fees due to them. The surplus therein will be returned back to the rahin.

Custodial Fee168

Amount of Loan (Qard): $20,000 Rahn : $30,000 Service fee = 40 cents @$100 per

month Tenure = 6 months Ujrah (fee) = ($20,000 /$100) x 0.04 x 6

ISLAMIC PERSONAL FINANCINGBay’ al-enah

169

Bank Customer

COF = RM10,000Profit rate per al

(1) Bank Sells asset $10,000 + profit margin = $12,000

(2) Customer pays byEqual instalment over 5

Years = $12,000/60 = $200

(3) Customer sells asset To Bank for $10,000

(4) Bank pays cash $10,000To Customer

Tawaruq170

Bank Client

Buyer

1) Sells X

2) deferredpayments Sells

cashPays cash

FEE-BASED PRODUCTS

Trade Finan

ce

KafalahLG

MurabahaLC

WakalahLC

172

COMPONENTS OF PROFIT IN ISLAM

1. Risking his Capital 2. Putting work and effort

3. Warranty 4. Delayed Payments

Trader deserves to earn profit

174

‘IWAD(Equivalent countervalue)

RISK(Ghurmi)

WORK & EFFORT

(Kasb)

LIABILITY(Daman)

PROFIT =

ISLAMIC NORMATIVETHEORY OFPROFIT

1.Al-Bay’2.Al-Ijarah

3.Salam4.Istisna’

5.Mudarabah6. Musyarakah

175

Cash Sale and Sale by deferred payments176

1/6/09Wholesale Price = $20

5/6/09Retail Price = $25

Profit = $5 = risk + effort + liability

5/6/10Deferred price$30

CASH SALE DEFERRED SALE

Profit = $5

Profits from delayed payments

177

Profits from

Delayed Payment

s

Opportunity costs?

Inflation risk?

Others?

Default risk?

178

Profit from

Deferred Sale$10

Profit from cash price

Cost price = $10

Retail price = $15

Profit from delayed payment

Retail price = $15

Credit price = $20

Price of Sale with Deferred Payment179

• “ Price will possibly rise due to its deferred payment”(Badai’ as-Sona’i, Al-Kasani, 5/187)• “The deferment for some period of time has a value in the

price” (Bidayatul Mujtahid, Ibn Rush Al-Hafid, 2/108)

• “Five which is paid in cash is equal to six which is paid on deferred” (Al-Wajiz, (Abu Hamid Al-Ghazali, 1/85).

• “The period is part of the price” (Fatawa Ibn Taimiya, 29/499)

• “This is the evidence that the period of time in sale and purchase has its portion in the price; and it is permissible for sale and purchase contracts” (Al-Mughni, Ibn-Qudamah, 6/385)

Profit from delayed payments

180

MurabahaProfit

derived from

delayed paymentMoney

exchange for Asset

Interest-bearing

LoanProfit

derived from

delayed paymentMoney

exchange for money

Conditions on the permissibility of profits from delayed payments

181

Profit from

delayed paymen

ts

Bank must hold

ownership of asset

Price determination based consent

(negotiation) Bank

exposure to inventory

risk

Cash Price

Credit Price

Business risk

Liquidity risk?

Default risk?

Business risk

182

Murabaha/BBA Financing183

Murabaha/BBA Selling Price

$150,000

Cost Price$100,000

Profit MarginProfit rate x $Facility

x tenor10% x $100,000 x 5

years = $50,000

Murabaha Financing184

Profit Rate

Cost of Deposit Overhead

Statutory profit

margin

Risk/Default

Premium

185

Interest Rate

Risk Free rate

True Time Value of Money

Risk PremiumCredit + Liquidity

risk

TOPIC 7 RISK EXPOSURE IN FINANCING ACTIVITIES

Profitability vs Stability

Risks faced by Islamic banks

Bank takes position

Bank faces: 1. Credit risk2. Market risk3.Liquidity risk4. Operational and Shariah risks

Risk management1.Credit risk management2.Market risk management3.Liquidity risk management4.Operational risk management

Trade and Risk188

Allah has allowed al-bay but prohibits riba (Al-Baqarah:275)

How is risk management related to the above verse?

Risk Management189

When a bank takes a position (ie. decided to lend/to extend financing), it has an exposure.

Exposure is a loose word to describe a transaction which generates some risk. Sometimes it also refers to the amount of risk or amount subject to loss of value or the size of the commitment.

Risk Management190

• Risk is the potential loss arising from uncertainty of events, which can have a potential adverse effect, which is a possibility of loss. Uncertainty refer to the randomness of outcomes.

• Risk management is the process of identifying, measuring, controlling and pricing of the risks taken abroad.

Risk is potential loss191

Risk itself is not an evil thing Avoiding risk with zero profit is allowed –

Wadiah Yad Dhamanah deposit Avoiding risk with positive profit is not

allowed – interest from loans. Avoiding risk is an evil action if it injures

the counterparty –interest from loans

Risk Management in Islamic Banking

192

• Fundamental principle in Islamic business :

a. no reward without risk – al-ghorm bil ghonm

b. With profit comes liability – al-kharaj bil daman.

• Risk taking behaviour – as the above – risk > 0, profit > 0 permissible

• Risk avoiding behaviour – risk =0, profit >0 - not permissible

Islamic Financing193

Business Risk

Credit and Market risk,Rate of Return risk, Displaced commercial risk

Credit Financing based on True Sale (bona fide

sale) Credit risk, Market risk

Rate of return risk, Displaced commercial risk, Rate of return risk, Shariah risk.

Credit Financing based onNon-bona fide Sale

True Sale Financing System194

• Tax burden: tax on sale and purchase. Who to absorb the new transaction cost?

• Capital charge: higher capital allocation to a more risky business unit.

• Exposure to business risk (ie. asset holding/ownership prior to sale).

• Exposure to credit,market,RoR,DCR.

Business risk195

• Potential loss in the world of business due to uncertainty about:

1. Demand for products2. The price that can be charged for those

products3. The cost of producing and delivery the

products

Islamic Financing without True Sale

196

No new tax burden No additional capital charge No exposure to business risk Exposure to credit and market risk. Exposure to RoR,DCR. Exposure to Shariah risk

Risks in BBA Financing

Credit RiskLow credit scoring for

Islamic customers,

higher probability of default

(PD)

Market Risk Negative Gap

can mean losses as

Interest rate increases

Shariah Risk

Recent Court Judgement

on murabaha/BBA as

non bona fide sale

Operational Risk

Conventionalsolution/system not able to accomodate Islamic accounting principles

leading toovercharging and

undercharging customers.

High NPF and Write-Offs

Capital Depletion

Earning at risk (EAR)

Capital at risk (EAR)

Litigation CostsErosion of earnings

IncreaseOverheads

Litigation costs

197

Islamic

Banking

Risk

Credit Risk

Market Risk

Liquidity Risk

Operational Risk

Rate of Return Risk

ShariahRisk

DisplaceCommercial Risk

198

199Islamic Banking


$500m$200m

Gross Profit $300mOverheadsProvisions for NPFProfit Equalization Reserve

$80m$10m$5m


$200m


MARKET RISK

Income Gap Analysis201

Impact on income from changes in profit-rate

GAP = Rate sensitive assets (RSA) – Rate sensitive liabilities (RSL)

Change in income = GAP x (change in profit rate)

Deposits202

Wadiah DhamanahMudarabah PSIA

Variable Rate Deposits

Commodity MurabahaNICD Fixed rate Deposits

Capital

Financing203

MusharakahMudarabah

Variabale Rate Assets

BBAAITAB Fixed Rate Assets

Capital

Islamic Banking Realities:Negative Gap Asset-LiabilityRSA < RSL

204

Fixed Rate Assets

Fixed Rate Deposits

Variable Rate Assets(RSA)

Variable Rate Deposits

(RSL)

Income Gap Analysis Fixed rate asset

(FRA)1. BBA(F)2. AITAB3. Tawaruq PF Flexible rate

asset (VRA or RSA)

1. Mudarabah2. Musharakah3. BBA(V)

Fixed rate liabilities (FRL)

1. CMD (Commodity Murabaha)

2. NICD Variable rate

liabilities (VRL or RSL)

1. WAD2. PSIA3. INI

205

Salam Bank Balance SheetAssetBBA

$700mAITAB

$400mTawaruq PF $100mMudarabah $ 50mFixed Asset $

100m

LiabilityWadiah Dhamanah

$200mPSIA $800mCMD $250m

Capital $100m

206

GAP = $50m - $1000m = -$950m

FRA1. BBA $700m2.AITAB $400m3. Tawaruq $100m Total $1200mRSA1. Mudarabah $50mGAP = -$950If profit rate decreases

by 1%, then net income will increase by (-$950m x 0.01) = $9.5m

RSL1. WAD $200m2. PSIA $800m

Total $1000mRSL 3. WAD & PSIA $1000GAP = -$950If profit rate increases

by 1%, then net income will fall by (-$950m x 0.01) = $9.5m.

207

Risks peculiar to Islamic banks

208

• Potential loss arising from loss of deposits• Gap/Asset-Liability Mismatches• Rate of Islamic deposits < deposit interest rate• Rd < id• Actual rate of return < indicated/expected rate of return

Rate of Return Risk

• Potential loss that occurs when Shareholders’ Funds are utilized to “smoothen” rate of return on Islamic deposits.

Displacement

Commercial Risk

• Amount appropriated out of total income to main an acceptable level of return on Islamic deposits.

• Serve to smoothen return on Islamic deposits (RoID).• Increase PER provisions when RoID not competitive.

Profit Equalization

Reserve

Implication of Negative Gap: Example:209

Profit = ($100m x 0.07) – ($100 x 0.03)= $7m - $3m = $4m

When market interest rates go up, what can happen to the bank?

The bank cannot raise then profit rate to accommodate prevailing cost of fund. If it does, the murabaha contract turns invalid.

The bank will lose deposits when Islamic deposit rate (IDR)< conventional interest rates (CII).

When it losses deposits and forced to acquire money market funds at a higher cost, the bank earning drops. This is known as the Displaced Commercial Risk (DCR).

To mitigate DCR, the Profit Equalization Reserve (PER) was instituted.

PER serves to fill the gap between IDR and CII. Or the expcted rate of return and the realized rate of return.

Increase in interest rates

Loss of income to Islamic banks

1996-1997 Asian Financial Crises2010 onwards….rising interest rates

210

Fall in interest rates

Increase in income for Islamic Banks

Low interest-rate environment 2004-2009

211

Lack of LiquidityHIGH

INTENSITY OF FIXED-RATE PRODUCT

RSA<RSL -Income Gap Fall in bank earnings

rd < idMigration of

deposits from IB to CB

Deposit shortfall

Acquire funds from money

market

Further drop in bank’s earning

Bank subsidizes

Islamic depositors

such that rd = id

Displaced commercial

risk

Mitigating Market risk: Floating rate Murabaha/BBA

213

Set AQAD profit rate based on future/projected/forecasted rate, say =12%

Current rate of profit = 8% Monthly installment based on future rate = $2,000 Monthly installment based on current/mark-to

market rate = $1,200. Rebate = $800. If rate rises to 9%, monthly installment = $1,300.

Rebate is less = $700 (ie. $2,000 - $1,300) As profit rate increases due to higher cost of

funds, rebate decreases.

CREDIT RISK

Banks as Risk-Takers Banks take money from depositors and extent financing to

clients. In conventional system, a bank takes deposits and make

loans. A bank can charge a very high rate to a very risky borrower

but it may suffer high losses when the borrower defaulted. Credit risk is higher when the bank becomes an

aggressive risk-taker. It charges high credit risk premiums and hopes that the customer will not default.

Deposit fund will be in danger when bank gives loan or extends financing to clients with low creditworthiness.

But to play safe, by giving loans to clients with high creditworthiness will mean small margins and if a default occurs, it will wipe out bank’s entire profit.

Hence banks must seek strategies to minimize their risk exposures through diversification.

Credit risk and DefaultProducts

Murabaha Ijara Salam/Istisna

Failure

To repay the installments

To pay rentals To deliver goods

at the delivery date

Credit risk

• Credit risk is the risk that a change in the credit quality of a counterparty will affect the value of a security or portfolio.

• When counterparty defaults, the bank loses either all of the market value of the position or, the part of the value that it cannot recover.

a. Expected loss (EL)– covered by provisions

b. Unexpected loss(UL) – covered by capital

Credit Risk Loss

Expected Loss

(Covered by bank’s provisions)

Unexpected Loss

(Covered by capital)

Total Loss

Loss due

Credit Risk

Rising Non-

Performing

Financing

Reduce Earning

s

Capital Depletio

nBank

Failure

Financial

Instability

• Very good• Good• Satisfactory• Sufficient• Insufficient

Ratings

• Low• Below average• Average• Above average• High

Risk Value

s

• 1• 2• 3• 4• 5

Grades

Qualitative Method: Credit Risk Assessment

Qualitative Characters

Assessment

Default Age Education level Years with current employer Household income Debt to income Credit card debt Other debt

Microeconomic Analysis of default Default = f (Age, education level, years with current employer, years

at current address, household income, debt to income, credit card debt, other debt)

Y = b0 + b1X1 + b2X2 + b3X3 + b4X4 + b5X5 + b6X5 + b7X7 + b8x8Relationship between dependent and independent variablesb1:b2:b3:b4:b5:b6:b7:b8:

Macroeconomic Analysis of Default NPL = f(level of interest rates, GDP,

inflation rate, exchange rate, export, import)

NPL = b0 + b1I + b2Y + b3IFL + b4FOREX + b5X + b6M

Total Loss

Expected Loss

Largely due to

unsystematic risk

Unexpected Loss

Largely due to

systematic risk

Credit Risk in BBA• The risk of the facility is characterized

by:1. The external and /or internal rating

attributed to each obligor, usually mapped to probability of default (PD).

2. The loss rate given default (LGD) and EAGD of the facilities. LGD is the loss rate when the borrower defaults.

Credit Risk1. Exposure at given default (EAGD) :

notional value of a loan, or exposure for loan commitment. Amount of credit outstanding at the time of default.

The expected loss (EL) for each credit facility:

EL = PD x EAGD x LGD

Credit risk inn BBA• Expected loss (EL) is the basis for the calculation of the

bank’s allowance for BBA losses, which should be sufficient to absorb both specific and general credit related losses.

• EL can be viewed as cost of doing business. That is, on average, the bank will incur a credit loss amounting to EL.

• However ACTUAL credit losses may be higher or lower than EL.

• The variation for credit losses beyond EL is called unexpected loss (UL).

• UL is the basis for the calculation of economic and regulatory capital.

Example: Expected Loss Zahidi Bank hold a $500 million BBA

portfolio with 15 years tenor. PD of the portfolio = 10% BBA defaulted after 5 years Exposure at given default (EAGD) =

$400 Collateral $300m

Credit Risk Loss rate given default = (EAGD –

collateral)/EAGD = ($400m - $300m)/$400m =

($100/$400) x 100% = 25% EL= PD x EAGD x LGD EL = 0.1 x $400m x 0.25 = $10 million Bank will put aside $10 million for NPF

provisioning.

Origination PD = 10%

Default Maturity

EAGD = $400m

BBA PORTFOLIO = $500m

EXPECTED LOSS = PD x EAGD x LGD

Expected Loss is covered by Bank’s Provisioning

General and

Specific Provisions

Expected Loss (EL)

Probability of Default

(PD)

Loss Rate Given

Default (LRGD)

Exposure at Given Default (EAGD)

Assessing credit exposure Compute EL Compute UL Determine the volatility of expected loss

of a BBA to the whole portfolio. Calculate the probability distribution of

credit loss for the portfolio and asses the capital required to absorb the unexpected losses.

Credit Risk Valuation When a customer defaulted on his debt obligation,

the bank will incur a loss. The first type of loss is known as expected loss (EL)

which is a loss that bank expect to make as part of doing the credit business and are covered by reserves and income.

The second type of loss is called Unexpected loss (UL) which is a loss to the bank as a result of unexpected events except the catastrophic ones and are covered by the economic capital.

Actual level of credit loss in any one period could be significantly higher than the expected level.

Credit Risk Valuation How to estimate Expected Loss (EL) and

Unexpected Loss (UL).EL = PD x EAGD x LGDPD = probability of default (in %)EAGD = Exposure at given default (in

$values)LGD = Loss rate given default (in %)

Probability of default (PD) The PD is the likelihood that the

counterparty will be unable to comply with his/her debt obligation.

Estimating PD PD is the percentage of the contracts that were

defaulted in relation to the total portfolio of contracts during the period of one year.

PD = (DCt/TC) x 100DCt = the number of default contracts during the

period t under examinationTC = total number of contracts of the examined class.Default is the inability of the debtors to pay a

substantial portion of the lend capital for a predefined set of period such as three months or 90 days.

Exposure at Default (EAGD) EAGD is the estimation of the

institution’s exposure in the event of, and at the time of, counterparty defaults

Loss Rate Given Default (LGD) LRGD is the weighting of the loss when a

default occurs. LRGD is the ratio of losses to exposure at

default (EAGD). An important parameter to estimate LGD is the

estimation of recovery rate (RR). RR = [(recovery from cash payment + recovery

from collateral – administrative cost)/(1-variation in market value) divided by EAGD] x 100.

LGD = 1 - RR LGD = Charge Offs (Net of Recovery)

/Outstanding Balance at Default (ie EAD)

Loss Rate Given Default (LGD) LGD parameter increases in value in

relation to the collateral asset. If asset is not backed by a collateral

asset, the LGD will be high If asset is backed by a collateral asset,

the LGD will be lower

Credit Risk: EL & ULSuppose Salam Bank has portfolio of 5 murabaha customers with given EAD (Exposure at default), LGD (Loss Given Default) and (PD) Probability of Default. Suppose the said figures for the first customer is are as given below -EAD = 100,000, LGD = 0.45 and PD = 0.10. Then the loss is 100,000 * 0.45 = 45,000. ie EAD x LGD Expected loss for this customer is EL = 45,000*0.10 = 4,500 ie Loss x 0.1 Or EL = PD x EAD x LGD = 0.1 x 45,000 x 0.01 = 4,500Calculate the unexpected loss (UL) for each murabaha facility? Suppose bank data is as given below :Customer EAD LGD PD

1 100,000 0.45 0.10 2 150,000 0.45 0.10 3 300,000 0.45 0.05 4 500,000 0.45 0.01

5 400,000 0.45 0.1

Unexpected Loss Unexpected loss = Loss that is not budgeted for

(expected) and is absorbed by an attributed amount of economic capital.

Unexpected loss=

0.1 (1-0.1) x 45,000 x 0.1 = 0.3 x 45,000 x 0.1 = $1,350

P (1-P) x EAD x LGD

242

Loss Distribution due to Credit Risk - Expected and Unexpected Loss

Expected Loss: the mean loss due to a specific event or combination of events over a specified period

Unexpected Loss: loss that is not budgeted for (expected) and is absorbed by an attributed amount of economic capital

Losses so remote that capital is not provided

to cover them.

1,000Expected Loss,

Reserves

Economic Capital =Difference 3,000

0Total Loss

incurred at x% confidence

level

Determined by confidence level associated with targeted rating

Prob

abili

ty

Cost

4,000

EL UL

This is done by Screening Monitoring & enforcing restrictive covenants

Establishment of long term customer relationships

Loan commitmentSpecialized lendingCollateral and compensating balance requirements

Credit rationing

Credit Risk Management

Islamic securitization

Asset-Backed Securitization(True Sale via

SPV)

Securitization of Financial

Assets

Securitization of Physical

Asset

Asset-Based Securitization

Bay Al-Enah Securitization(No true sale,

no SPV)

Securitization of Debt

LIQUIDITY RISK

Excess Liquidity - Liquid Assets financed by High-Cost Deposits

Liquid Assets

Inter-bank Short-term

placements

Short-term

government

securities

Cash

Underutilization of scarce resources: Excess Liquidity in Islamic Banks. Why?

Shariah Compliant

Issues

• DISPLACEMENT EFFECT

• enah and tawaruq products displacing risk-taking and equity-based products

IB risk-adverse appetite towards

risk-taking

• GREENFIELDS• True-sale

murabaha• Salam & Istisna

IB adverse risk-

appetite towards

risk-sharing

• GREENFIELDS• Musharakah• Mudarabah

EXCESS LIQUIDITY – Lack of products

Excess Liquidity

Islamic bank with less

diversified portfolio

Less instrument to do business –

highly dependence on

credit based financing

Excess liquidity

Sukuk/IPDS market to

mopped up excess cash balances in

Islamic banks

Reduces excess liquidity in

Islamic banks

Lack of LiquidityHIGH

INTENSITY OF FIXED-RATE PRODUCT

RSA<RSL -Income Gap Fall in bank earnings

rd < idMigration of

deposits from IB to CB

Deposit

shortfall

Acquire funds from money

market

Further drop in bank’s earning

Bank subsidizes

Islamic depositors

such that rd = id

Displaced commercial

risk

Lack of Liquidity Islamic banks with high dependence on fixed rate assets

(FRA) will face –income gap. When interest rate increases, bank’s earning will fall and bank can’t keep up with conventional deposits rates. Rate of return on Islamic deposits (rd) is now lower than interest rate on deposits (id). When rd < id, outflow of Islamic deposits triggers asset-liability mismatches with Financing/Deposits ratio > 1. To match the balance sheet, Islamic bank is forced to use money market funds at a higher cost which further depresses bank’s earning. To deter further outflow of Islamic deposits, Islamic bank must ensure that rd = id, which means giving Islamic depositors more that they deserved. This is done by using bank’s own reserves. By doing so, the bank faces displaced commercial risk (DCR). The reserves or capital that the bank uses can support financing operation bearing potential income.

US Subprime Crises Credit CrunchLack of Liquidity

Money Market Funds

Originate

Distribute

Asset Liquidity

RiskUnable to execute transactions at the

prevailing market price because there is no

market appetite for the product.

Inability to dispose of the asset due to Shariah

issues such as prohibitions of bay al-dayn (sale of debt) at

discount.

Deposit Liquidity

RiskOverdependence on Corporate Deposits .

Overall cost of deposits increases since corporate

deposits usually command higher rate of

deposits on GIA.

When an Islamic bank is overly dependent on corporate deposits,

withdrawals at maturities will create adverse asset-liability mismatches. Cost overrun when the bank acquires funds

from more costly money market sources such as Negotiable Islamic instruments

(NII).

LIQUIDITY RISK

Asset Liquidity

RiskUnable to execute transactions at the

prevailing market price because there is no

market appetite for the product.

Inability to dispose of the asset due to Shariah

issues such as prohibitions of bay al-dayn (sale of debt) at

discount.

Deposit Liquidity

RiskOverdependence on Corporate Deposits .

Overall cost of deposits increases since corporate

deposits usually command higher rate of

deposits on GIA.

When an Islamic bank is overly dependent on corporate deposits,

withdrawals at maturities will create adverse asset-liability mismatches. Cost overrun when the bank acquires funds

from more costly money market sources such as Negotiable Islamic instruments

(NII).

Dependence on money market funds to finance

operation.Eg Northern Rock

LIQUIDITY RISK

Lack of Liquidity – Funding Problem #1Short-Term

DepositsCurrent and

Savings Accounts

Low cost deposits

Long-term

DepositsProfit-

Sharing Investment

Account (GIA)

High Cost Deposit

Lack of Liquidity : Problem #2

Assets

BBA

Sukuk

Deposits

CASA

PSIA

MutualFunds/Unit TrustStock Market

Concentration RiskLow-Cost Deposit

High-Cost

Deposit

GIA

GIA

GIA

GIA

CA & SA

Asset Liability Long-term

Financing1-20 years

Short-term Funds1-12

months

Concentration RiskReliance on money-market funds to replace withdrawals

Withdrawals of Corporate Deposits (PSIA)

Liquidity RiskFall in

Earnings

Increase in

Cost of Funds

Liquidity Risk Funding liquidity risk – a bank’s inability

to mobilize deposits to satisfy withdrawals. Also referring to deposit concentration risk.

Mitigating liquidity risk through Salam contracts

Islamic Liquidity Hub

Surplus BankBroker A

Broker B

Buy X $9.5m Deliver X at specified date (maturity)

Sells X $10m

Cash $10m

Buy X at $10m

Deliver X

Salam financing SB places $10m with ILH with fixed

income. How? SB buys commodity (ie palm oil) from ILH

for $9m (ie below market price) and waits for delivery in 6 months time.

ILH uses the cash for investment. ROI varies, not known upfront. (eg, 10%, 7%, 20%)

At maturity, ILH purchases commodity from Supplier B via Broker B at $10m and make delivery to SB.

SB sells the commodity to Supplier A via broker A for $10m. Thus, SB gains $0.5 million.

SHARIAH RISK AND OPERATIONAL RISK

Shariah risk is the potential loss to the Islamic bank arising from cost of civil actions carried or absorbed by the bank from lawsuits by customers. The cost of the civil actions may include:

264

Compensations and damages paid to

customers

Returning profit

collected from the Islamic facility

Cost of court

proceedings

Reputation risk.

•Financial Distress•Default

Credit risk

•Litigation•Civil Court hearing

Foreclosure

•Invalid contract•Improper documemntation

Shariah risk

265

Legality Issue

Court judgement issued by

Malaysian High Court Judge Datuk Abdul Wahab Patail pertaining to

the invalidity of murabaha/al-bai-bithaman

ajil

Shariah Risk

266

BBA LEGAL DOCUMENTATION

1. Sale and Purchase Agreement (SPA)2. Property Purchase Agreement (PPA)3. Property Sale Agreement (PSA)4. Deeds of assignment/Charge

2. Bank do not have legal + beneficial ownership of property to make a valid sale

‘Do not Sell what you do not Own” Hadith (Sahih Bukhari)

High Court Judge Datuk Abdul Wahab Patail says that the sale element in BBA sale is not a bona fide sale (Mayban Finance vs Taman Jaya)

1. No transfer of title from Customer to Bank

Latest Court Case on Islamic Banking268

Abdul Khalid Ibrahim(Defaulted on his debt obligation, contract not

valid when BIMB violated collateral agreement)

BIMB(Dispose of collateral)

Shariah risk can be avoided by attending to:

269

Financial reporting requireme

nt

Legal documenta

tion requireme

nt

Maqasid-Shariah

requirement.

Shariah Board

Governance

270

Shariah Risk in BBA Financing

Financial reporting: prior to PSA, bank

must hold ownership of asset. Recorded as

fixed asset.Legal documentation: transfer of ownership

from bank to customer. Warranties.

Maqasid approach: benefits outweigh the

disbenefits.

There are two aspects of financial transaction involving Islamic banking business, namely:

The concept of the transaction: This concerns whether the contract is based on sale, ijarah,

wakalah, musharakah and other common contracts in Islamic banking, where the pillars

of ‘aqd are central.The legal documentation of the transaction that spelt out the

rights, responsibilities and obligations of the contracting parties. In essence, it defines the relationship between the bank and the

customer. Usually the documentation is based on civil law.

271

Shariah RiskLosses arising from money

paid by Islamic bank to customers when contracts

were found invalid in favour of customers.

Contracts and legal

documentation are not

consistent.

Sale with no transfer of ownership

title.

Form over substance.

Purchase undertakings

in Musharakah

sukuk.

272

Operational risk An operational risk is, as the name

suggests, a risk arising from execution of a company's business functions. It is a very broad concept which focuses on the risks arising from the people, systems and processes through which a company operates. It also includes other categories such as fraud risks, legal risks, physical or environmental risks.

Shariah risk Basel II: Operational risk is the risk of loss resulting from

inadequate or failed internal processes, people and systems, or from external events.

People – outright fraud – eg poor loan origination due to kickbacks.

Shariah risk and People – negligence and deliberate action leading to improper conduct of contract causing injuries to counterparties.

Murabaha/BBA: Sale contract but rights and obligation of counterparties are equivalent to that of loan agreement.

Shariah Risk There are two aspects of financial transaction

involving Islamic banking business, namely: The concept of the transaction: This concerns

whether the contract is based on sale, ijarah, wakalah, musharakah and other common contracts in Islamic banking, where the pillars of ‘aqd are central.

The legal documentation of the transaction that spelt out the rights, responsibilities and obligations of the contracting parties. In essence, it defines the relationship between the bank and the customer. Usually the documentation is based on civil law.

Approved Islamic Finance Products• BBA Home Financing• Bay Inah Home Financing• Bay Inah Personal Financing/Overdraft/credit card• Tawaruk munazam personal financing• Commodity murabaha• Ijarah thumma al-bay• Bai-bithaman Ajil Islamic Debt Securities (BAIDS)• Discounted Bay al-dayn MuNif• Sukuk Ijarah• Sukuk Musharakah

Challenging issues in AQAD-based Islamic Finance Products • Benchmaking profit rate against interest rate (LIBOR,KLIBOR).• Profit Equalization Reserve (PER) – displaced commercial risk• Sale with condition to buyback at predetermined price between two and three parties.• Profit generated over installment payments – time value of money• Penalties on delayed payments• Benchmaking sukuk rates against LIBOR• Musharakah with Purchase undertakings – fixed profit to one party only.• Ijarah Sukuk - Sale with repurchase agreement at par value and not mark-

to market• Ijarah Sukuk – Ownership of asset by SPV• Profit-rate swaps – speculation or gambling?

Shariah Risk Foreclosure Foreclosure is the legal process by which a mortgagee or other

lien holder, usually a lender, obtains a court ordered termination of a mortgagor's equitable right of redemption. Usually a lender obtains a security interest from a borrower who mortgages or pledges an asset like a house to secure the loan. If the borrower defaults and the lender tries to repossess the property, courts of equity can grant the borrower the equitable right of redemption if the borrower repays the debt. While this equitable right exists, the lender cannot be sure that it can successfully repossess the property, thus the lender seeks to foreclose the equitable right of redemption.

Court Declaration A declaration is a written statement submitted to a court

in which the writer swears 'under penalty of perjury' that the contents are true. That is, the writer acknowledges that if he is lying, he may be prosecuted for perjury. Declarations are normally used in place of live testimony when the court is asked to rule on a motion.

Effect on Profit and Loss Client to return only the Principle Facility Principle + Profit Profit = earned and unearned profit. Paid amount and earned profit Bank to write-off earned profit –

Clawback effect Opportunity cost of Principle Facility.

Shariah risk in Islamic Financial Instruments Financial reporting: prior to PSA, bank must hold ownership

of asset. Recorded as fixed asset. Legal documentation: transfer of ownership from bank to

customer. Warranties.

Shariah risk Maqasid approach: benefits outweigh the disbenefits. • Losses arising from money paid by Islamic bank to

customers when contracts were found invalid in favour of customers.

• Form over substance.• Contracts and legal documentation are not consistent.• Eg. Sale with no transfer of ownership title. • Sale without warranties• Purchase undertakings in Musharakah sukuk.

Shariah risk Shariah risk is the potential loss to the

Islamic bank arising from cost of civil actions carried or absorbed by the bank from lawsuits by customers. The cost of the civil actions may include:

Compensations and damages paid to customers

Returning profit collected from the Islamic facility

Cost of court proceedings Reputation risk.

INVESTMENT DAR (KUWAIT) IN ISLAMIC WRANGLE WITH BLOM BANK (LEBANON)Investment Dar defaulted on a $100 million sukuk last year and is restructuring its debts.

Investment Dar’s Sukuk Default Kuwait's troubled shareholding company Investment

Dar is refusing to pay Lebanon's Blom Bank $10.7 million, saying that their original deal did not comply with Islamic law, in a move that could pressure the Islamic finance industry.

According to a legal brief circulated this week and obtained by Reuters, Blom sued the company in a British court last year, asking for the principal it invested plus a 5 percent return, as structured in a deal it conducted with Daar in 2007.

Investment Dar vs Blom Bank The issue revolves around the

concept of interest and risk-sharing. Under the deal, known as a wakala, Dar served as an agent and accepted funds from Blom that it would invest in a sharia-compliant manner.But the contract called for the company to return the principal investment plus a fixed profit -- a deal Dar's attorneys now say constitutes interest, which is prohibited under sharia law.

Investment Dar This is a very dangerous defence," said

Sheikh Muddassir Siddiqui, sharia scholar and partner at law firm Denton Wilde Sapte. "For people dealing with Islamic financial organizations, it adds sharia risk to all the other common risks out there.”

286

TS ABDUL KHALID IBRAHIM VS BIMBClient defaulted on his RM66.60million BBA debt obligation obtained in 2001

High Court ordered TS Khalid Ibrahim to pay US$18.52m (RM66.67m) facilities that he obtained from BIMB to purchase Guthrie in 2001.

Court order without full court hearing since this is a common case of default.

TS Khalid made an appeal. Appeal court allows full court hearing if

the dispute involves violations of Islamic law.

The Client claimed that the BBA contract becomes invalid when BIMB disposes off the collateral (Guthrie shares) upon default.

BIMB sells the collateral to recover the amount the Client owes the bank.

BBA agreement Asset Purchase Agreement : Client sells

shares to Bank for $60m on cash basis. Asset Sale Agreement : Bank sells shares

Client for $70m (ie. $60m principle + $10m profit) on deferred payment basis

Charge Agreement: Client places the shares as collateral.

Rahn and Charge Agreement Civil law : Charge agreement - does not

need court order to sell of the collateral. Islamic law: shares charged to bank as

Rahn Islamic law requirse full court hearing

before it can make a court judgement to sell of the shares.

Shariah Risk• Potential loss to the bank arising from

cost of litigations against the bank as result of contract invalidation through the court of law.

• Shariah risk can be avoided by attending to:

1. Financial reporting requirement2. Legal documentation requirement3. Maqasid-Shariah requirement.

MEASUREMENT OF SHARIAH RISK AND BANK LOSS.

Shariah risk Highly exposed Islamic banking portfolio to credit financing

instruments such as BBA is not spared from losses due to default. Other unique risks faced by Islamic banks that can severely reduce its earning are risk of return risk (RoR) and displaced commercial risk (DCR). The former is potential loss arising from loss of deposits to conventional banks when rate of Islamic deposits are less competitive than interest rates on conventional deposits. The latter is the potential loss when the bank uses it own reserves to smoothen rates on Islamic deposits. Recently, a new type of risk called Shariah risk, surfaces into actual drama in both the legal and banking fraternity as it challenged the legality of BBA financing. It calls for immediate remedies to save Islamic banking from serious reputational risk as well as severe financial loss.

IFSB - Shariah risk The Islamic Financial Service Board (IFSB) defines Shariah

risk as one arising when an Islamic financial institution (IFI) offering Islamic financial services fails to comply with Shariah rules and principles determined by Shariah Board of the IFI or the relevant bodies in the jurisdiction in which the IFI operates. It asserts that IFIs should ensure that their contract documentation complies with Shariah rules and principles with regards to the formation, termination and elements possibly affecting contract performance such as fraud, misrepresentation, duress or any other rights and obligations (IFSB 2005).

Shariah risk When an Islamic financing facility is ruled invalid in the

court of law due to say, fraud and misrepresentation, Shariah risk can then be defined as the potential loss to the Islamic bank arising from the nullification of contracts with adverse impact on bank’s earnings. In general, Shariah risk originates from credit risk. It is triggered by default on BBA debt obligations leading to court hearing for foreclosure wherein the plaintiff and defendant will put their cases before the judge. The cost of the lawsuit may include the compensations and damages paid to customers, returning profit collected from the Islamic BBA facilities to the customers, cost of court proceedings and reputation risk.

Shariah risk can emerge many ways such as:

Foreclosure case against the customer upon default

Customer seeking a court declaration that BBA is invalid:

Foreclosure case against the customer: The bank filing lawsuit against a customer who has

defaulted on his murabaha/BBA obligation. But the judgement may turned in favour of the defendant (ie. customer) such as in the case of Arab-Malaysia Finance v Taman Jaya when the Judge Dato’ Wahab Patail ruled the contracted BBA as a non bona fide sale as it (ie BBA) constitutes a financing facility with a charge agreement rather than a sale. As the contract is void, the customer should only gives back the principle amount advanced to him by the bank. This also means that the bank must return the profit it has acquired from the customer, if total payments at default exceeded the original amount. This shall be discussed in more detail in Section 10.

Validity of BBA The court ruling by High Court Judge Dato’ Wahab Patail

concerning the validity of BBA (Abdul Wahad Patail 2008, Arab-Malaysian Finance vs Taman Ihsan Jaya). It is a civil court case that revolves around a default by Taman Ihsan Jaya that had received a BBA facility from Arab Malaysian Finance Berhad. Since the legal right of the property remained with the client, the bank was seeking to foreclose the property in court. Evidence concerning the contract validity was first sought in the legal documentation of the facility rather than what the counterparties perceived the contract to be. The court ruling on July 18th 2008 was in favour of the defendant as the judge held that the application of the BBA contract ran contrary to the Islamic Banking Act 1983, noting that the BBA sale is “not a bona fide sale”. As the BBA contract was seen to be faulty, the defendant was required to return only the original amount of the BBA facility to the bank, thus affecting the profit already realized by the bank.

299

Customer seeking a court declaration that BBA is invalid:

This action may take place when the customer is facing difficulties to fulfill his BBA obligations as the housing developer has abandoned the project. The customer is paying both rental on the house his family is currently staying and the BBA monthly payments which is too hard to carry out. According to BBA contract, the bank who acts as the selling party must made delivery of the subject matter upon completion. But the seller/bank has failed to deliver the property although the customer has made payments based on the agreed contract. Another case concerns incorrect use of contract.

High Court Ruling on BBA “[69] This court holds that where the bank purchased

directly from its customer (ie PPA) and sold back to the customer with deferred payment (ie PSA) at a higher price in total, the sale is not a bona fide sale, but a financing transaction, and the profit portion of such Al-Bai’ Bithaman Ajil facility rendered the facility contrary to the Islamic Banking Act 1983 or the Banking and Financial Institutions Act 1989 as the case may be”.

“[70] Acting upon the basis that the bank’s action resulted more likely from a misapprehension rather than of intent aforethought, the court holds the plaintiffs are entitled under section 66 of the Contracts Act 1950 to return of the original facility amount they had extended”.

301

For example, a BBA contract is only suitable for completed property but many Islamic banks have been using BBA instead of istisna’ for housing under construction. There is a Shariah compliance issue here at stake. In either case, the customer will file a lawsuit against the Islamic bank for not fulfilling its obligation. A lawsuit is a civil action brought before a court in which a party (plaintiff) has claimed to have received damages (ie. BBA payments without delivery, rental paid on current premise), the plaintiff, seeks a legal or equitable remedy.The defendants are required to respond to the complaint of the plaintiff. If the plaintiff is successful, judgment will be given in the plaintiff's favor, and a range of court orders may be issued to enforce a right, award damages, or impose an injunction to prevent an act or compel an act. A declaratory judgment may be issued to prevent future legal disputes.

Loan and BBA financing Based on the rules of BBA, an illustration is given in the

following. Hamid is keen to purchase a $200,000 apartment in Kuala Lumpur, which he has seen in person. He will meet the developer/vendor and sign a Sale and Purchase agreement (S&P) after placing a 10% down payment, i.e. $20,000. In conventional practice, Hamid will look for a bank that can lend him the remaining sum of $180,000. Assume that Fastbank approves the loan and disburses a sum of $180,000 to the developer on behalf of Hamid. Thus, Hamid gets a loan from Fastbank and settled the remaining balance with the developer on cash basis. Hamid will pledge the property as collateral via the charge agreement on the $180,000 loan. Assuming interest rate at 4% flat over 20 years, Hamid will pay the bank $144,000 more in interest. His monthly installment = ($180,000 + $144,000) / 240 = $1350.

BBA financing Once the Fastbank holds ownership via PPA, it then sells the property to

Hamid via the Property Sale Agreement (PSA). The terms are as follows: Seller (Fastbank) and Buyer (Hamid) Object of sale : Apartment Price of object: Cost price $180,000) + profit margin ($144,000) =

$86,000 = $324,000. Installment payments = $324,000/240 = $1350 per month. To sum up, conventional financing consists of the following contracts,

namely: Contract of loan between the Fastbank and Hamid. Deeds of Assignment/Charge.

BBA financing The same procedure applies for Islamic banks. But the transaction

becomes complicated when Fastbank is not involved in the sale and purchase agreement (S & P) with Hamid. Instead similar to conventional arrangement, Hamid purchases the property from the developer. He puts up RM20,000 as down payment to secure the Sales and Purchase (S&P) agreement on his favour. In this manner, Hamid becomes the beneficiary owner of the property.

But how could Fastbank observe the rules of BBA (to sell the property to Hamid) when in the first place it does not own the asset? The Holy Prophet pbuh says “do not sell what you do not own”. Here FastBank must be careful not to violate this critical Shariah injunction. To observe this Shariah rule, Fastbank is expected to purchase the property from Hamid via the Property Purchase Agreement (PPA for $180,000). Current practice indicates that the bank makes the $180,000 disbursement to Hamid, which it (ie. Fastbank) passes on to the developer.

BBA sale Once the Fastbank holds ownership via PPA, it then sells

the property to Hamid via the Property Sale Agreement (PSA). The terms are as follows:

Seller (Fastbank) and Buyer (Hamid) Object of sale : Apartment Price of object: Cost price $180,000) + profit margin

($144,000) = $86,000 = $324,000. Installment payments = $324,000/240 = $1350 per month.

BBA financing Similar with conventional practice, the house will be placed

as a collateral via the Deeds of Assignment or Charge. It says that the bank holds the right of beneficial ownership of the property in the manner that it holds the right to sell if when Hamid defaults on the BBA facility.

To summarize, BBA sale consists of three contracts, namely:

Property Purchase Agreement (PPA): Bank buys property from customer.

Property Sale Agreement (PSA): Bank sells property to customer at BBA price.

Statement of Appeal Court on IBA 1983 The trial judge had misinterpreted the meaning of 'Islamic

banking business' under s 2 of the Islamic Banking Act 1983 ('the Act'). 'Islamic banking business' as defined in s 2 of the Act does not mean banking business whose aims and operations are approved by all the four mazhabs. Further, the judges in civil courts should not take it upon themselves to declare whether a matter is in accordance to the religion of Islam or otherwise as it needs consideration by eminent jurists who are properly qualified in the field of Islamic jurisprudence. Moreover, as we had the legal infrastructure to ensure that Islamic banking business as undertaken by the banks in this country did not involve any element not approved by Islam, the court had to assume that the Syariah Advisory Council under the aegis of Bank Negara Malaysia had discharged its statutory duty to ensure that the operation of the Islamic banks was within the ambit of Islam (see paras 29-32 & 35).

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Measurement of Shariah risk Exposure to BBA financing means that Islamic banks are

equally concerned with credit risk. In managing credit risk, they are required to measure the expected loss (EL) as well as unexpected loss (UL) from their credit financing portfolios.

Expected loss is covered by bank’s provisioning for bad debts while unexpected loss (UL) is to be absorbed by bank’s capital.

However, loss from Shariah risk is unique because it originates from BBA defaults, thus tieing it to credit risk rather than operational risk. At the moment Islamic banks in Malaysia are more concerned with the court ruling by High Court Judge Dato’ Wahab Patail in Malaysia concerning the invalidity of BBA (Abdul Wahad Patail 2008, Arab-Malaysian Finance vs Taman Ihsan Jaya).

Measurement of Shariah risk It is a civil court case that revolves around a default by Taman

Ihsan Jaya who had received a BBA facility from Arab Malaysian Finance Berhad. Since the legal right of the property still remains with the client, the bank seeks to foreclose the property in court. Evidences concerning contract validity are first sought in the legal documentation of the facility rather than what the counterparties perceived the contract to be.

The court ruling dated July 18th 2008 ran in favour of the defendant as the judge that the application of the BBA contract before the court ran contrary to the Islamic Banking Act 1983 with a note that the BBA sale is “not a bona fide sale”. As the BBA contract was seen faulty, the defendant is required to return only the original amount of the BBA facility to the bank, thus affecting the profit already realized by the bank.

Some except of the judge’s opinion are given below (MLJ 2008):

“[69] This court holds that where the bank purchased directly from its customer (ie PPA) and sold back to the customer with deferred payment (ie PSA) at a higher price in total, the sale is not a bona fide sale, but a financing transaction, and the profit portion of such Al-Bai’ Bithaman Ajil facility rendered the facility contrary to the Islamic Banking Act 1983 or the Banking and Financial Institutions Act 1989 as the case may be”.

“[70] Acting upon the basis that the bank’s action resulted more likely from a misapprehension rather than of intent aforethought, the court holds the plaintiffs are entitled under section 66 of the Contracts Act 1950 to return of the original facility amount they had extended”.

Continue.. Although Abdul Wahab Patail’s ruling was later overturned by the

Court of Appeal, it is imperative that the loss incurred by the bank is estimated if the customer had instead seek a court declaration for BBA invalidation or if the Court of Appeal agrees with the judge’s ruling. We will consider three situations involving a BBA default and the ruling based on section 66 of the Contract Act 1950 that is, to “return the original facility amount to the bank”. The three situations are given below:

Case A: Paid amount is less than original facility, which is equivalent to 75 monthly payments before defaulting.

Case B: Paid amount is equal to original facility which is equivalent to 134 monthly payments before defaulting.

Case C: Paid amount is more than original facility which is equivalent to 185 monthly payments before defaulting.

Based on the contract between Fastbank and Mr. Hamid, the total murabaha obligation is $324,000 with the original facility at $180,000.

The financing is for 20 years (240 moths) at 4% flat profit rate per annum.

Price of object: Cost price $180,000 + profit margin $144,000 = $324,000.

Installment payment: $324,000/240 = $1,350 per month ($750 principal portion + $600 profit portion).

Example: Case A Case A1: Mr. Hamid has paid $101,250 (75 months monthly

installment) before defaulting. The outstanding balance is $222,750. However, the court has ruled the nullification of BBA and the profits elements of the 75 installments paid are to be clawed back and returned back to the customer. The court requires him to pay extra $123,750 representing the unpaid capital portion.

Basically, the total of amount of the unpaid financing will be $222,750. The amount represents the 165 months of unpaid monthly installments ($1,350 x 165 months = $222,750). However, the court settlement requires Mr. Hamid to pay another $123,750 ($180,000 - $56,250 = $123,750) being the capital portion of original financing. In other words, any profit portions from the 75 monthly installments paid are to be returned back to the customer.

Continue..Case A Impliedly, the court judgment states that the financing that was

based on trading of asset was not a bona fide sale and therefore, there shall be no profits recognized from the transaction. Therefore, the bank has to claw back any profits that have been recognized so far. This means, there will be adjustments to be taken up to the current year’s profits and the retained earnings brought forward.

From the 75 monthly installments paid by the customers, the bank has recognized $45,000 profit paid. Therefore, $45,000 must be reversed out or clawed back from the bank current year’s profits plus retained earnings brought forward and to be returned back to the customer. The result of the clawed back resulting the bank to loss $45,000. Here, the customer is appearing to gain $45,000 as a result from the court injunction notwithstanding that his liability is now $123,750.

Net payment to Bank = $123,750 - $45,000 =$78,750.

SHARIAH RISK MITIGATION

Shariah Compliance: Consistency is Critical to avoid Shariah risk

‘AQADPrinciples

LEGAL/CONTRACT DOCUMENTATION

Protection of RightsMAQASID

Benefits vs disbenefits

FINANCIALREPORTING

AAOIFI/IFSB/IFRS

Shariah Compliant Parameters• Aqad-based – Contract-based• Maqasid al-Shariah (purpose of the

Law) – impact on society• Financial Reporting – actual strength

and performance of companies• Legal documentation – identification

and recognition of rights and obligations of contracting parties.

Aqad

Agents of

Contract

Objective of

ContractSubject Matter

Offer & Accepta

nce

#1 AQAD Method

Sale (Al-Bay’)

Buyer & Seller

Transfer of Ownership from Buyer

to SellerProperty Price set on

the spot

Contract of Sale• Example: Murabaha/BBA Sale1. Buyer and Sellereg. Seller owns asset/subject matter

before making sale2. Subject mattereg. Mal mutaqawim – property with

usurfruct3. Priceeg. Set on the spot4. Offer & Acceptance eg. Verbal or in writing

Method #2: Maqasid al-Shariah/Objective of Shariah

To protect the interest of the public (society)- maslahah al-ammah by:

1. removing the harm ( ibqa)2. securing of benefits (tahsil)

Maqasid

Shariah

Removing the Harm

Securing of

Benefit

#2 Maqasid Method

MudaratSins

ManfaatProfits

“ in Gambling (maisir) and Liqour (qimar), there are some sins and some profits. But the sins are greater than the profits” (Al-Baqarah: 168).

Gambling

& Liqour

Mudarat > Manfaat

HARAM

Mudarat < Manfaat

HALAL

Downside (Madarrah) of Credit-Financing

MACRO MICRO

Economic Bubbles Bankruptcy

Subprime Loans Foreclosure

Financial Turmoil Unemployment

The upside (Manfaat) of Credit-Financing

MACRO MICRO

Allocation of Capital Wealth creation

Economic Growth Rich becoming richer

Leisure, luxury and lifestyle

Maqasid To analyse(theoretical) and

measure( empirical) impacts of financial intermediation based on aqad-based Shariah compliant products.

1. Efficiency studies2. Profitability studies3. Studies on Consumer welfare and

protection4. Studies on Financial stability

Maqasid – protecting public interest. Aqad-based products (ABP) SHOULD contain more

benefits and less harm. What if, it was proven than they (ABP) contain more

harm than good?eg. Abandon projects – customer cannot make recourse against bank as selling party?Defaulted BBA customer are required to make settlement based on the selling price.Sale with no transfer of ownership.Giving away clean inah personal financing at high profit rates– a way towards subprime inah?

Conflict between Aqad and Maqasid?

Method #3: Financial Reporting Proper recording of transactions to evident TRUE SALE. BBA – bank must put BBA asset on balance sheet prior to

sale. I week, 1 month it depends. Once sold, it is recorded as BBA receivables. AITAB assets should be on banking book as leasing assets

but now treated as “financing and advances”. External auditors (PWC, KPMG etc.) are not required by the

authority to conduct Shariah audit. And they may not be not capable to do so.

Conflict between AQAD and financial reporting?

Islamic Bank Average Balance Sheet

Assets Liabilities

Murabaha/BBA Wadiah Dhamanah deposits

AITAB Profit Sharing Investment Acct

Islamic Securities/Sukuk Capital

Assets Liabilities

FIXED ASSET1. BBA asset

1. 1/9/2008 Bank purchases Property from Vendor for $200,000

2. 15/9/2008 Bank Sells Property to Customer for $280,000

Assets Liabilities

CURRENT ASSET

2. BBA Receivables

1st October 2008

15 October 2008

BBA LEGAL DOCUMENTATION1. Sale and Purchase Agreement

(SPA)2. Property Purchase Agreement

(PPA)3. Property Sale Agreement (PSA)4. Deeds of assignment/Charge

2. Bank do not have legal + beneficial ownership of property to make a valid sale

‘Do not Sell what you don not Own” Hadith (Sahih Bukhari)

High Court Judge Datuk Abdul Wahab Patail says that the sale element in BBA sale is not a bona fide sale (Mayban Finance vs Taman Jaya)

1. No transfer of title from Customer to Bank

Method #4: Legal Documentation BBA should be documented as a true sale and

not as a loan. (Dato’ Nik vs. BIMB)

Ijarah should be documented as operating lease and not a loan (Tinta Press vs. BIMB)

Islamic bank has not practice fairness compared with conventional bank (Affin bank vs Zulkifli).

Conflict between AQAD and documentation of AQAD?

Islamic Banking Performance336

Islamic Banking Doing the right

thing1. Role of Shariah2. Achieving

Equity, Justice & Fairness

Doing things right1. Role of reason

(‘aql) and experience.

2. Efficiency

Measuring Economic Efficiency Economic efficiency occurs when the

cost of producing a given output is as low as possible.

Production of a unit of good or services is termed economically efficient when that unit of good or service is produced at the lowest possible cost.

Economic efficiency occurs when the cost of producing a given output is as low as possible.

Malaysian bank : efficiency studies

1. Katib, 1999: bank did not effectively combine their inputs

2. Amrizal & Nursofiza 2002 : BIMB performed below its optimum level where input element were not fully utilized

3. Majid et, 2003 : the efficiency of Islamic bank is not statistically different from conventional bank”

Global- Islamic banks1. Yudistira 2003 – DEA –Islamic banks suffered inefficiencies during the financial crisis2. Hassan 2005 –SFA –Islamic banking industry is relatively less efficient compared to their conventional counterparts3. Al-Jarrah & Molyneux 2003 – Larger Islamic banks are more profit efficient than smaller Islamic banks4. Brown & Skully 2005 – DEA – Islamic banks in the Middle-east are the most efficient, followed by Asia and Africa.5. Saaid et al 2003 – Islamic banks in Sudan have low efficiency

Islamic Banking Strategies To increase revenues:

Retain and expand client baseImprove cross-selling opportunitiesIncrease customer profitability through a better understanding of behavior, needs, and preferences

Detect and deter fraudulent activity such as money laundering and identity theft

Address globalization issues, cross-border Islamic banking performances, capitalization

Better manage the risk associated with investments, credit and financing and consumer bankruptcies

Increase efficiency of core business (eg. retail) processes such as call center management, processing of financing applications, etc.

Comply with industry regulations .

Religiosity = Ethics and Law MAQASID Religiosity = Niche products Niche products larger revenues – blue ocean BUT Religiosity AQAD alone credit culture cannot compete with large conventional banks that run on credit too! Islamic banks running on credit are expected to plan and strategize smartly to remain competitive in the global environment. To do so, they must have access to information that help them make faster decisions.

Credit based Banking: Bank Failure - Bank of Hiawassee

High CRE and ADC loan concentrations Weak loan underwriting and credit administration

process contributed to the asset quality problem. Capital levels did not support the risks associated with

its high CRE and ADC concentrations. Bank loan losses and increases in NPL eroded capital. The increasingly relied upon non-core funding sources

to support its loan growth. Bank of Hiawassee closed down on March 19, 2010

because the institution was unable to raise sufficient capital to support its operations.

Bank Failure Concentration risk – property sector Weak credit administration Weak loan origination/underwriting

practices Reliance on potentially volatile funding

sources. Weak Board oversight

What’s Next? Shariah-based products1. Musharakah2. Salam & Istisna Issues:1. Bank risk-appetite2. Capital requirement3. Funding4. Taxation

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Thank You Imam Shafi`i: Knowledge is what

benefits, knowledge is not what one has memorized.

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Islamic Banking

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