Industry Status

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Global Overview

CAMELS RATINGS

• Examiners continue to emphasize the asset/liability management process. Banks must manage their financial position and CAMEL rating.

• C - Capital adequacyA - Asset qualityM - Management qualityE - EarningsL - LiquidityS - Sensitivity to Market Risk

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Prohibition of Riba

Those who take riba (usury or interest) will not stand but as stands the one whom the demon has driven crazy by his touch. That is because they have said: Trading is but like riba. So, whoever

receives an advice from his Lord and stops, he is allowed what has passed, and his matter is up to Allah. And the ones who revert back, those are the people of Fire. There they remain forever.

Allah destroys riba and nourishes charities. And Allah does not like any sinful disbeliever.

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Islamic Banking Growth

• First formal Institution: Mit Ghamar Saving Banks, Egypt (1963-67)

• Today: Over 300 institutions worldwide in over 75 countries• Islamization at National levels: Sudan, Iran and Pakistan• Comprehensive levels as a system: Malaysia and Bahrain• Parallel Banking Mega Groups: e.g., Arab Banking

Corporation, Citibank, HSBC, Kleinworth Benson, The Australia and New Zealand Banking Group, United Bank of Kuwait

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Accounting and Auditing Organisation for Islamic Financial

Institutions(AAOIFI)

Liquidity Management Center

(LMC)

International Islamic Financial Market

(IIFM)

Islamic Financial Services Board

(IFSB)

International Islamic Rating Agency

(IIRA)

Infrastructure Institutions

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Some Common Myths and Mis-Conceptions-1

• Any return on deposit is Riba• If return is pre-fixed, it becomes Riba• Repayment of loans in Not a serious issue. It should

be waived off (Qard e Hassan)• Trade Profit is similar to Interest on Loans / Debts• Sale Price of Cash and Credit sale Must be same• Profit margin on credit sales by banks resembles Riba• Money can be rented like other assets• Products of Islamic banking look the same as those of

conventional banking

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Myths-2

• Hazrat Muhammad (PBUH) himself carried out trading. Trading profits are allowed because they involve the Efforts and Risk of the trader

• Islam recognizes the concept of Time Value of Money so it allows traders to charge a different pre determined and mutually agreed price for cash and credit sales

• Therefore, when banks extend some goods to customers (and not money), they have a right to earn some profit when the customer will not pay right away

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Conventional banking prices money

Islamic banking prices goods and services (assets)

Conventional Banking Islamic Banking

Depositors get a fixed rate regardless of the bank’s profitability, thus insulating them from the bank’s true performance

Profit is shared with the depositor, higher the bank’s profit, higher the depositors’ income

Distinguishing Features

Deals in money or papers Deals in assets

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Definition of Riba• Any stipulated profit on any debt is Riba

• Any increase over and above the principal amount payable in a contractual agreement / obligation is Riba if it is not covered by a corresponding increase in the – Commodity– Labor– Risk or– Expertise

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Types of Riba• Riba Al-Fadl - Sale TransactionsSale Transactions

– Quality premium in exchange of low quality with better quality goods of same kind; prohibited e.g. dates for dates, wheat for wheat etc.

• Riba Al-Nasia - Loan TransactionsLoan Transactions– Riba Al-Nasia (Riba Al-Ouran) involved in credit/delay;

modern banking transactions falls under Riba Al-Nasia,

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Islamic Sale

• Definition of Sale (Bai)

– Exchange of a thing of value with another

thing of value with mutual consent

– The sale of a commodity in exchange of

cash

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Islamic Sale Valid Sale (Bai Sahih)

• A sale is valid if all elements together with their conditions are present

• Elements of valid sale are– Contract– Subject Matter– Price– Possession or Delivery

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Islamic Modes of Financing

Debt Creating ModesMurabaha

Salam

Istesna

Ijara

Partnership Based ModesMusharakah

Mudarbah

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Islamic Modes of Financing• The basic conditions for a validity of a sale in Shriah are:

– The purchased commodity must be existing– The seller should have acquired the ownership of that

commodity– The commodity must be in the physical or constructive

possession of the seller

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MurabahaMurabaha• Murabaha is a particular kind of sale where the

seller discloses its cost and profit charged thereon

• The price in this sale can be both on spot and deferred

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Banking MurabahaBanking Murabaha• It is a contract wherein the institution, upon request by the

customer, purchases a asset from the third party usually a supplier /vendor and resells the same to the customer either against immediate payment or on a deferred payment basis

• It is a bunch of contracts completed in steps and ultimately suffices the financial needs of the client

• The sequence of their execution is extremely important to make the transaction Shariah compliant

• The Bank / Institution is the seller and the client is buyer

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Banking MurabahaBanking Murabaha

• It is a fixed price sale and normally is done for short term

• The transaction can be used in order to meet the working capital requirements however it cannot be used to meet cash / liquidity requirements of the customer

Banking Murabaha - Banking Murabaha - General Mechanics

CUSTOMERISLAMICBANK AgreementVENDOR

• The customer approaches the Bank with the request for financing

• The Bank purchases and receives title of ownership from the vendor

• The Bank makes payment to the vendor

• The Bank transfers the title over to the customer upon payment

• The customer makes payment up-front or on a deferred basis

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Basic Rules For Murabaha• Subject of sale must exist

• It should be in ownership of the seller at the time of sale

• Subject of sale should be in physical or constructive possession of the seller

• The sale should be instant and absolute

• Subject matter should be something having value

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Basic Rules For Murabaha

• Subject of sale should not be used for un-Islamic purpose

• It should be specific and identifiable

• Buy Back arrangement is not allowed

• Delivery date should be certain

• Price certainty

• Sale must be unconditional

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Salam• Seller undertakes to supply specific goods to the

buyer at a future date in exchange of an advanced price fully paid at spot

• Price is in cash at spot but the supply of goods is deferred

• Background of Salam– Before prohibition of interest farmers used to get interest based

loans for growing crops and harvesting. After prohibition of interest, they were allowed to do Salam transactions. This helped them to get money in advance for their needs

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Salam

• Purpose of Salam– To meet the needs of small farmers who need money to grow

their crops and to feed their family up to the time of harvest– To meet the need of traders for import and export business

• Benefits– Salam is beneficial to the seller, because he receives the price

in advance, – It is beneficial to the buyer, because normally, the price in

Salam is lower then the price in spot sales

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Istesna

• Istesna is sale transaction where commodity is transacted before it comes into existence

• It is an order to producer to manufacture a specific commodity for the purchaser

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Conditions of Istesna

• The subject of Istesna is always a thing which needs manufacturing

• Manufacturer use his own materials

• Quality and Quantity should be agreed in absolute terms

• Purchase price should be fixed with mutual consent

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Ijara• Transferring of usufruct and not ownership to another person at an agreed

price, at an agreed consideration• Subject of lease should be

– Valuable, – Identified & – Quantified

• Consumable things cannot be leased out.– Anything which cannot be used without consuming cannot be leased out;

e.g., money, wheat etc.• All Liabilities of ownership are borne by lessor

– Corpus of leased property remains in the ownership of the seller

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Ijara• Period of lease

– Must be determined in clear terms at the time of contract

• Lease for specific purpose only– If no specific purpose is identified in the agreement, then it can

be used for any purpose for which it is used in normal course

• The lessee is liable to compensate the lessor for every harm to the leased asset caused by any misuse or negligence

• The leased asset shall remain in the risk of the lessor throughout the lease period

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Ijara• Lease of jointly owned property

– Is permitted and rentals shall be distributed between all the joint owners according to the proportion of their respective shares in the property.

• Expenses consequent to ownership to the lessor– As the lessor is the owner of the asset, he is liable to pay all the expenses

incurred in the process of its purchase and its import to the country of the lessor for example expenses of freight and customs duty etc.

• If the lessee contravenes any term of the agreement, the lessor has a right to terminate the lease contract unilaterally. If not then it can be terminated through mutual consent only

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Determination of Rentals• The rental must be determined at the time of contract for

the whole period of lease

• It is permissible that different amounts of rentals are fixed for different phases during the lease period, provided that the amount of rent for each phase or formula for calculation of rentals is specifically agreed upon and specified at the time of effecting the lease

• The lease period shall commence from the date on which the leased asset has been delivered to the lessee.

• Rental will be charged when the Leased asset is handed over to the lessee

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Ijara

• Expenses under Ijara are as follows– Lessor - expenses relating to the corpus of the

asset i.e. insurance, accidental repairs etc. will be borne by the lessor

– Lessee - actual operating/overhead expenses related to running the asset will be borne by the lessee

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Car Ijara At An Islamic Bank• How it is

different from conventional Car Financing

? Portion of Principal as Down Payment

Portion of Principal as Down Payment

Processing ChargesProcessing Charges

1st Years' Insurance in Advance

Registration Charges

1st Months' Installment in Advance

Islamic BankConventional Bank

At Down Payment

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Car Ijara At An Islamic Bank

Portion of Principal as Repayment

Portion of Principal as Repayment

Banks' ProfitBanks' Profit

1st Years' Insurance Recovered

2nd Years' Insurance in Advance

Registration Charges

Islamic BankConventional Bank

Monthly Installment / RentalHow it is different from conventional Car Financing

?

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Musharakah• Musharakah literally means Sharing• The word Musharakah has been derived from “Shirkah”

which means being a partner• Musharakah means a joint enterprises formed for

conducting some business in which all partners share the profit according to an agreed ratio while the loss is shared as per the ratio of investment

• Musharakah is Commingling by two or more persons either their money or work or obligations to earn a profit or a yield or appreciation in value and to share the loss if any according to their proportionate ownership

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Basic Rules of Musharakah• Management of Musharakah

– Each partner has a right to take part in Musharakah management– The partners may appoint a managing partner by mutual consent– One or more of the partners may decide not to work for the

Musharakah and work as a sleeping partner• Capital

– Share capital in a Musharakah can be contributed either in cash or in the form of commodities. In the latter case, the market value of the commodities shall determine the share of the partner in the capital.

– However, the commodities to be contributed must be evaluated at the time of execution of Musharakah

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Basic Rules of Musharakah• Distribution of Profit

– The ratio of profit distribution must be agreed at the time of execution of the contract

– The ratio must be determined as a proportion of the actual profit earned by the enterprise and

• Not as percentage of partner’s investment• Not in lump sum amount

– The partners may agree on any ratio of profit distribution provided the ratio of profit of sleeping partner does not exceed his ratio of investment

• Sharing of Loss– In case the business incurs a loss, all partners will have to share the

loss in exact proportion to their investment– This rule is based on a saying of Hazrat Ali: “Profit is based on

agreement of the parties, but loss is always subject to the ratio of investment”

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Basic Rules of Musharakah• Termination / Redemption of Musharakah

– Musharakah will be deemed to have terminated in the following events

• Each partner has the right to terminate the Musharakah at any time after giving prior notice to other partners

• If any of the partners die during the currency of the Musharakah his heirs will have the option to

– Either liquidate their share or– Continue with the business

• If any one of the partners becomes insane or otherwise incapable of conducting commercial transactions

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Structure of Musharaka• Permanent Musharaka

– Permanent Musharaka is the partnership of permanent nature, which is not bound with a time period

• Temporary (Redeemable) Musharaka– Musharakah can be for a limited time period, after that it will be

redeemed. Redemption of Musharakah will take place through sale of shares from one partner to another

• Diminishing Musharaka – It is a form of partnership in which one of the partner promises

to buy the equity share of the other partner gradually until the title to the equity is completely transferred to him

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CUSTOMER

The Bank enters into a Musharakah (Joint Ownership) agreement with the customer and both of them pay their respective shares to the seller of the asset.

Customer pays rent for the use of banks share in the property

The customer approaches the Bank with the request for Project/Machinery/House financing

BANK

Joint Ownershi

pMusharak

a

Rent

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CUSTOMER

The Bank enters into a Musharakah (Joint Ownership) agreement with the customer and both of them pay their respective shares to the seller of the asset.

Ownership of the asset is gradually transferred to the customer upon payment of asset price.

Customer pays rent for the use of banks share in the property

BANK

Joint Ownershi

pMusharak

a

Gradual Transfer of Ownership

The customer approaches the Bank with the request for Project/Machinery financing

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Mudarbah

• Mudarbah is a special kind of partnership where one partner gives money to another for investing it in a commercial enterprises.

• The investment comes from the first partner who is called “Rabb-ul-Mal”

• The management and work is an exclusive responsibility of the other, who is called “Mudarib”

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Mudarbah• Capital

– In principle, the capital of Mudarbah must be provided in the form of cash. However, it may be presented in the form of tangible assets, in which case the value of the assets is the contribution to the Mudarbah capital.

– The Capital of Mudarbah should be clearly known to the contracting parties and defined in terms of quality and quantity in a manner that eliminates any possibility of uncertainty or ambiguity

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Mudarbah• Profit / Loss Distribution

– The profit sharing ratio should be specific because it is the subject of the contract and being unknown abrogates the contract

– It is impermissible to stipulate a lump sum as profit to either party

– Losses accruing in the Mudarbah shall be only sustained by the Rabb-ul-Mal and not the Mudarib. The Mudarib shall only to responsible for the recovery of loss in the case of negligence and willful misconduct

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Mudarbah• Termination of Mudarbah

– The contract of Mudarbah can be terminated at any time by either of the two parties. The only condition is to give a notice to the other party

Liquidity Management in Islamic Banks

The Liability SideThe Liability Side

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Nature of Deposit in Conventional Banking according to Shariah

• Deposits made in the conventional banks are Qard according to Shariah not Amanah (derived from Amanat) as generally believed

• According to Shariah– Amanah cannot be used by the holder and has to be returned– He cannot be held responsible for any loss or damage suffered

by Amanah without his negligence– Both of these characteristics are missing in conventional Both of these characteristics are missing in conventional

depositsdeposits– Therefore any benefit drawn from such deposit / investments /

Qard by conventional banks is not permissible according to Shariah