Islamic Financial Instruments

-A vision for the future-

Dr. Orhan Erdem

Borsa İstanbul

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Outline

1. Why Islamic Finance has become popular ?

2. Main Islamic Financial Instruments: Banking

3. Main Islamic Financial Instruments:Capital Markets

4. The future vision

Don’t Forget

We are trying to play football in a basketball field.

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Why Islamic Finance has become popular ?

Global Financial Crisis lessons

1. Global Economic and Financial System has

several vital problems.

2. People do not always behave rationally.

Global Economic and Financial System

Problems

i. Loans Without Advance Payment

• Infinite Leverage

• No Stake in the Game

• Household Debt – 1980: 48% of GDP

– 2008: 99% of GDP

USA Household Debt/GDP

5 1. Why Islamic Finance Has Become So Popular?

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• USA House Prices Index

1. Why Islamic Finance Has Become So Popular?

Global Economic and Financial System

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ii. Deregulation and Financial Innovation – N.I.N.J.A. Mortgages: No income, no job or assets.

Chuck Prince: «As long as the music is playing, you’ve got to get up and dance. We’re still dancing»

iii. Injustice and Inequality

1. Why Islamic Finance Has Become So Popular?

Global Economic and Financial System

Result

• The total value of homes in USA

– 2006: 22.7 trilyon $,

– 2011: 16 trilyon $ (-% 29.7)

• Extreme decline in values of bonds and bankruptcy of those real estates.

• L. Brothers, B. Stearns and Merrill Lynch Fannie Mae, Freddie Mac, AIG.

Commercial Mortgage-Backed Securities

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CMBS

1. Why Islamic Finance Has Become So Popular?

Economic Center of Gravity Moves to Asia

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Questioning

“The Great Credit Crisis has cast into doubt

much of what we thought we knew about

economics” B.Eichengreen, UC Berkeley

“Most work in macroeconomics in the past 30

years has been useless at best and harmful at

worst.” 2008 Nobel Economy Prize Winner Paul Krugman

1. Why Islamic Finance Has Become So Popular?

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2. Are People Rational? Example-1

• Which one do you prefer?

$50,000 at where people win $25,000?

or

$100,000 at where people win $200,000?

1. Why Islamic Finance Has Become So Popular?

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2. Are People Irrational? Example 2

• People do not always behave rationally.

• Risk is more than an intellectual activity.

• It is a profoundly physical experience

• Example-2: Greed

– «If the human has two valleys of full of goods, he would be willing to have the third.”

[Prophet Muhammad]

Are People Irrational?

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• Monetary gains activate mesial prefrontal cortex in brain. (Breiter,Kahneman 2001)

• Which is the area of brain that is activated by narcotics. (Addiction and Capitalism)

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Searching for Alternatives

• Islamic Finance/Economy suggests very

relevant arguments on these two issues.

Behavioral Finance

• Peoplecan make mistakes which can affect their financial decisions.

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Key Features of Islamic Finance

• Main Principal: Funding of real economy

• Being asset backed (secured debt)

• Precluding leverage

• Sharing of profit and loss

• Prohibition of gambling and alcohol etc.

• Ethic and fair transactions

• Preservation of social justice etc…

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Interest and Profit Share

•Interest is banned by many verses of the Quran: Bakara, 2/ 275 •Interest is banned by both the old and the new Testiment. •E.g. (Luke,6/34). But interest was officially legalized in Geneva, 1574. • Question: What is interest?

•Can interest be at the same level with inflation? • Islam offers partnership instead of interest. •What is profit share?

Global Islamic Finance Asset Size

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Global Islamic Finance Asset Distribution

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Conventional Banks

Assets

Loans (Consumer, Corporate)

Securities Investments

Fees

Liabilities

Deposits

Capital

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Key Highlights • Deposits are loans to the Bank as debt • Assets are invested in fixed-income securities and loans • Bank has fixed obligations on deposits but uncertainty on assets returns • Bank is exposed to assets and liabilities mismatch risk

Islamic Banking

Assets

Trade Financing, Leases,

Mudarabah financing

Securities Investments

Fees

Liabilities

Investments by Depositors

Capital

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Key Highlights

Depositors are investors rather

than lenders

Risk Sharing through Profit and

loss sharing.

Assets and Liabilities are

matched.

Ethical and socially responsible

assets

Market Size in Various Countries

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The Profit Margins and Interest Rates in Turkey

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Deposit Rates

IF Banks Conventional Banks

Average Deposit Rates Difference: IF Banks-Conventional

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Murabahah

Seller Bank Client

•Most Common Instrument: Murabaha •Murabaha: Sale on profit.

•The difference from the Credit is •The money is not lent to the customer.

•New Trend: Buying with waqalat

Example: Murabahah

• The Bank buys a car for 20.000 TL for her customer.

• It sells it to her for 21.324 to be pa id in 12 installments. (%1 monthly for 12 months)

• Excel: PMT(...)

Months Balance Payment Profit Amortisement Remaining

loan Balance

Jan. 20,000 1,777 200 1,577 18,423

Feb. 18,423 1,777 184 1,593 16,830

March 16,830 1,777 168 1,609 15,222

Apr 15,222 1,777 152 1,625 13,597

May 13,597 1,777 136 1,641 11,956

June 11,956 1,777 120 1,657 10,298

July 10,298 1,777 103 1,674 8,624

Aug 8,624 1,777 86 1,691 6,934

Sept 6,934 1,777 69 1,708 5,226

Oct 5,226 1,777 52 1,725 3,501

Nov. 3,501 1,777 35 1,742 1,759

Dec. 1,759 1,777 18 1,759 0

Total 21,324

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Musharakah

Joint venture partnership. Two or more parties contribute capital to a business and participate with the related profits and losses. The capital need not be money only.

Bank Client

Project

Capital

Shared Profit Shared Profit

Capital

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Musharakah

Joint venture partnership. Two or more parties contribute capital to a business and participate with the related profits and losses. The capital need not be money only. 1. Consecutive musharaka: Each partner can keep its share

in the partnership until the very end of the joint venture, project, or business.

2. Diminishing musharaka: One partner is allowed to buy the other partner’s share of equity step by step until the whole equity of the other partner is transferred.

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Example: Musharakah

• Erdem ltd is willing to make a business.

– The business is worth 5m TL

– The company has 2 m TL

– The company does not have an expertise on the field.

• The Bank provides Erdem ltd. with 3 m TL and an expertise.

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Mudarabah

An economic agent with capital develops a partnership with an entrepreneur with an agreement to share the profits

Investor Entrepreneur/Mudarib

Project

Management

Shared Profit Shared Profit

Capital

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Ijara (Leasing)

Ijara is a sale of the usufruct (the right to use the object) for a specific preiod of time.

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Bay’al-salam

• The buyer pays the seller the full negotiated price of a specific product which the seller promises to deliver at a specified future date.

• Similar to forward contracts

• But the payment is made at the deal date

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Islamic Finance: Capital Markets

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The Difference btw Banking and Capital Markets

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• Banking is for short term partnerships

• Capital Markets is for long term partnerships

Capital Markets: Equities

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Indicies

KATLM Index BIST100 Index

• Adana Çimento

• Akçansa

• Aksa

• Albaraka Türk

• Alkım Alkali Kimya

• Aygaz

• Bankasya

• Bim Mağazalar

• Bursa Çimento

• Çimsa

• Enka İnşaat

• Ford Otosan

• Good-Year

•Indeks Bilgisayar •Kartonsan •Konya Çimento •Mardin Çimento •Nuh Çimento •Park Elektrik •Pegasus •Petkim •Pınar Entegre •Pınar Süt •Soda Sanayii •Teknosa İç ve •Tümosan •Türk Hava Yolları •Türk Traktör •Turkcell •Ülker

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Capital Markets: Sukuk

• Sakk (Arabic):certificate

• Instead of only debt based instruments – Asset-based Long-term partnership

• The investor shares the asset.

• Even there numerous sukuk types two are of common – Mudarabah

– ijarah

• Sukuk can be issued basedhe future income flow.

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Sukuk

Funds Mobilizing Entity

Credit Enhancement

Special purpose Mudarabah “SPM”/”SPV”

Pool of Assets (Ijarah/Lease)

Servicing

Invesors

Assets Liabilities

Ijara Assets (Leases)

Sukuk

SPM Balance Sheet

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Sukuk Example

• The Turkish Treasury wants to buy a building worth 1million TL to work. An SPM collects money from its 50.000 investors each of which invests 20TL.

• The SPM buys the building and rents it to Treasury for 10 years for 12500TL. So each investor will receive 0.25 TL (coupon) each month.

• At the end of 120 month the investors will receive the principal 20 TL.

• The rate is 2.5% monthly. RATE(....) in Excel

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The Sukuk Payments

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20 0.25 0.25 …..

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Secondary Sukuk Market

• With the exception of Murabahah certifiate, all sukuk types are Shariah compatible for trading in the secondary market.

• Sukuk issued against a pool consisting of cash or debt like instruments cannot be traded in the secondary market

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Sukuk Markets

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London SE

Irish SE

Indonesia SE

Dubai FM

Singapore SE

Nasdaq Dubai

Bursa Malaysia

Bahrain SE

Hong Kong SE

LFX (Labuan)

Kazakhstan SE

Saudi SE

Global Sukuk Issuances (2012 – US Dollars)

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Challenges

•Murabahah and wakala issue

•Are credit cards ok in IF?

•20 prominent scholars holds %55 of all memberships of shariah boards.

•Two most popular scholar has 85 memberships in boards.

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Future Vision

• IF has not encountered a global crisis yet. • IF needs more research • Education and financial awareness in

necessary

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World Bank Global Islamic Finance Development Center

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Research & Knowledge

Standard Setting & Regulation

Innovation

Main Areas of Interest

Global Islamic Finance Report

Global Islamic Finance

Database

Islamic Capital

Markets

Islamic Banking

Islamic Finance and

Economic Development

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IF investors and Other Investors in Turkey (Çörtük and Erdem 2014)

All individual

Investors

Real IF

Investors

Real Conventional

Investors

n 855,303 28,413 826,890

Holdings(%) 100% 4.55% 95.45%

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Risk Appetite of IF investors and Other Investors in Turkey

(Çörtük and Erdem 2014)

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Domestic Investors Exclding IF Investors IF investors

EUROZONE DEBT CRISIS

OMT

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Further Readings

• An Introduction to Islamic Finance, Theory and Practice by Zamir Iqbal and Abbas Mirakhor, Wiley

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orhan_erdem

orhan.erdem@borsaistanbul.com

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