Fundamentals of Islamic
Finance
Presented by:
Irshad Mahmood
Director Assurance
2 January 2014
Contents
1. Overview of Islamic finance
2. Islamic contracts
3. Risks faced by Islamic Banks
2
1.
Overview of Islamic finance
3
Overview of Islamic finance
Quran
Primary source of Sharia
Sunnah
Practices of the Prophet
Sources
Shariah
Ijma (Consensus)
Interpretation
Ijtihad
(Reasoning of a group of qualified scholars)
Operations
(Techniques)
Organisation
(Shariah Boards)
Mindset
Applications
4
Overview of Islamic finance
What makes Islamic Finance Different?
Investment avenues in conventional finance focus on risk adjusted optimal returns;
however in Islamic finance financial transactions have to meet the following additional
criteria…
Transactions must be backed by an asset
Asset Backed
Prohibition of payment or receipt of interest
Prohibition of Interest
interest
Assets to back the transaction should not belong to
prohibited activities (e.g. alcohol)
Prohibited Activities
Speculative trading in financial instruments is prohibited
Speculative trading
The Bank acts as an agent/partner with the depositor who is entitled
to share the gains/loss of the investment
Profit/loss Sharing
Shari’a Compliant Transaction
5
Overview of Islamic finance
 Use of funds: Financing (ASSETS)
•
•
•
•
•
•
Murabaha
Ijarah (leasing)
Salam (with parallel Salam)
Istisna (with-parallel Istisna)
Mudaraba
Musharakah
 Sources of funds: Deposits (LIABILITIES)
• Un-restricted Investment Account (URIA)
• Restricted Investment Account (RIA)
• Current (demand) deposits
There is not necessarily a difference in the functions of
conventional and Islamic banks
6
Islamic vs Conventional Banks
Overview of Islamic finance
Sources and Application of Funds
Depositors
Lend @ 15%
Conventional Banks
Spread 5%
Lend @ 20%
Loans
Islamic Banks
Mudarib fee @15%
Trading &
Investments
Depositors
Depositors share of profit after
deducting the management fee
(Mudaraba fee) of 15%
Fund management
agreement
Mandated to invest based on the predetermined % of deposits
Profit or loss
7
Overview of Islamic finance
Why are there issues on adaptation in Islamic finance
products?
Islamic practitioners with conventional knowledge
Expect Shariah scholars to align Islamic financial products to suit
conventional operating environment
Relegate Shariah as product shaper as compared to environment shaper
Need to develop conducive and robust Shariah environment
•Genuine Islamic financial instruments
•Islamic banking practices and disciplines
•Regulatory and legal regime
Shariah scholars are key stakeholders to facilitate this development
8
Overview of Islamic finance
Operating structures of Islamic Banks
Islamic financial services offered by the
Conventional Financial Institutions
Window model
Branch Model
Subsidiary
• Operating structure
where a
conventional bank
simultaneously
carries out Islamic
Financial activities
but also assures
clients of
segregated
accounting and
operations for
conventional and
islamic activities.
• Similar to window
model but services
are offered through
dedicated channels.
• Seperate legal
entity (subsidiary)
set up specifically
to undertake
Islamic Financial
services activities –
Formulate and
manages its own
policies.
Islamic Bank
• Pure Islamic banks
which offers only
Islamic Financial
services.
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2.
Islamic contracts
10
Islamic Contracts
Murabaha
Mudaraba
Equity
Type
Musharaka
Sukuk
Istisna
Debt
Type
Salam
Ijara
11
2.
Islamic contracts
2.1 Mudaraba
12
Islamic Contracts
Mudaraba
Key principles
 The Bank, in substance, acts as a “manager” of the funds provided by the
customer.
 Profit sharing contract.
 Returns depend on a profit being earned.
 Conditions could apply to what the investment can be used for.
 Requires a commitment to participate in the risk associated venture.
 The Mudarib (managers) only loses the time and effort expended on the
project, where the Rab Al Mal (financier) assumes the financial losses.
 Does not entitle the financier any say in the running of the venture.
13
Islamic Contracts
Mudaraba (continued)
Customer
(Rab al mal)
1) Customer deposits
funds with the bank
under Mudaraba
contract
2) Bank provides
5) Distributes
Mudaraba deposit profit from
certificate
investment
Bank
(Mudarib)
3) Bank invests
funds in a Shariacompliant
investment
4) Make profit /
loss from
investment
Sharia
compliant
investment
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2.
Islamic contracts
2.2 Musharaka
15
Islamic Contracts
Musharaka
Key principles
 Profit and loss sharing contract.
 Musharaka literally means “sharing”.
 There are two main forms of Musharaka:
1. (1) Permanent Musharaka
2. (2) Diminishing Musharaka
 The financier invests into the venture.
 Requires the participants to work in partnership.
 The financial institution or lender has a say in the running of the project.
16
Islamic Contracts
Musharaka (continued)
This is a form of partnership between the Islamic Bank and its client whereby
each party contributes capital in equal or varying degrees, to establish a project
or share in an existing one.
Permanent/Constant Musharaka: similar to equity
Partners’ share in capital remain constant and unchanged.
participations,
Diminishing Musharaka: method of long term financing via a Musharaka.
The IB transfers gradually its share to other partner until the partner becomes
sole owner.
17
Islamic Contracts
Musharaka (continued)
Permanent/Constant Musharaka
Bank
Profit
Customer
Contributions
(cash or in kind)
Contributions
(cash or in kind)
Profit
Joint Venture
•
•
•
•
The customer approaches the Bank with the request for financing
The Bank enters into a Musharaka agreement with the customer
Specific role of the two parties in the management of the venture
Profit from the venture is distributed between the Bank and the customer
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Islamic Contracts
Musharaka (continued)
Diminishing Musharaka
Customer
4) Periodic
payment
over the agreed
period of time
plus
purchase share
of ownership
1) Customer
signs the
Musharaka
agreement for
the purchase of
a property
2) Customer’s contribution
to the purchase of property (x)
5) At the end of
agreed period,
ownership is
transferred to the
Customer
Property
Bank
3) Bank’s contribution to
the purchase of property (100-x)
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2. Islamic contracts
2.3 Sukuk Al Ijarah
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Islamic Contracts
Sukuk Al Ijarah
Saudi LLC
(Corporate)
Saudi LLC wishes to purchase a new asset and plan to raise finance
through issuance of Islamic Sukuk.
21
Islamic Contracts
Sukuk Al Ijarah (continued)
Supplier
Supplier of the Asset is
identified and negotiations is
finalized by
Saudi LLC
Saudi LLC
22
Islamic Contracts
Sukuk Al Ijarah (continued)
Supplier
Issuer
SPV
(LLC 100% owned by the
Saudi LLC)
Saudi LLC
SPV is created by Saudi LLC as a separate Limited Liability Company.
23
Islamic Contracts
Sukuk Al Ijarah (continued)
Supplier
Sukuks
Payment made to
Supplier
Title is transferred
to SPV
Issuer
Investors
SPV
Saudi
LLC
Proceeds
SPV issues certificates and receives proceeds which are used to purchase asset
from the supplier
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Islamic Contracts
Sukuk Al Ijarah (continued)
SPV holds Asset as Trustee and
leases the plant to Saudi LLC
under Ijarah
SPV holds
Plant/ Asset
as Trustee
Issuer
SPV
Saudi LLC
Investors
SPV leases
Plant to
Saudi LLC
under Ijarah
25
Islamic Contracts
Sukuk Al Ijarah (continued)
Saudi LLC
Issuer
(Lessee)
SPV
Periodic Lease Rentals
Investors
Semi-annual coupon
distribution amounts
Saudi LLC (Lessee) pays periodic rentals to SPV for tenors & amounts matching
the coupon & tenor of the Sukuks
26
Islamic Contracts
Sukuk Al Ijarah (continued)
Exercises the purchase
undertaking. Asset transferred to
Saudi LLC
Saudi LLC
Issuer
(Lessee)
SPV
Pays the exercise
price at dissolution
Investors
Redeems the Trust
Certificates at
dissolution
 Saudi LLC (Lessee) give the SPV an irrevocable purchase undertaking to purchase the
Asset at maturity.
 Exercise Price = Initial Purchase Price of Asset + service costs.
 Asset is transferred back on maturity, upon payment of the Exercise Price to the SPV /
Sukuk Holders.
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2.
Islamic contracts
2.4 Murabaha
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Islamic Contracts
Murabaha
Key principles
 Islam prohibits charging fixed interest on money, but permits charging fixed
profit on sale of goods. This clears a common misconception that charging
fixed profit is haram.
 Murabaha is a particular kind of sale where the transaction is done on a “cost
plus profit” basis i.e. the seller discloses the cost to the buyer and adds a
certain profit to it to arrive at the final selling price.
 The distinguishing feature of Murabaha from ordinary sale is
•
The seller discloses the cost to the buyer
•
And a known profit is added
29
Islamic Contracts
Murabaha (continued)
Key principles (continued)
 Murabaha is a sale transaction - rules of Shariah regarding sale should be
understood to judge if a Murabaha transaction is valid.
 Asset to be sold:
• must exist.
• should be in ownership of the seller at the time of sale.
• should be in physical or constructive possession of the seller.
• should not be used for un-Islamic purpose.
 Sale price should be determined and profit should be declined.
 Forward sale is not allowed.
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Islamic Contracts
Murabaha (continued)
Product Structure
1. Client and bank sign an agreement to enter into Murabaha.
Bank
Client
Murabaha
Agreement
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Islamic Contracts
Murabaha (continued)
Product Structure
2. Client is appointed as agent to purchase goods on bank’s behalf.
Bank
Client
Murabaha
Agreement
Agency Agreement
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Islamic Contracts
Murabaha (continued)
3. Bank gives money to client for purchase of goods.
Bank
Islamic
Bank
Client
Murabaha
Agreement
Agency Agreement
Disbursement to the client
33
Islamic Contracts
Murabaha (continued)
4. Client purchases goods on bank’s behalf and takes their possession.
Vendor
Transfer of Risk
Bank
Client purchases
goods and takes
possession
Client
34
Islamic Contracts
Murabaha (continued)
5. Client makes an offer to purchase the goods from bank.
Bank Bank
Client
Offer to purchase
35
Islamic Contracts
Murabaha (continued)
6. Bank accepts the offer and sale is concluded.
Murabaha Agreement
+
Transfer of Title
Bank
Client
36
Islamic Contracts
Murabaha (continued)
7. Client pays agreed price to bank according to an agreed schedule. Usually on a
deferred payment basis (Bai Muajjal).
Bank
Client
Payment of Price
37
Islamic Contracts
Tawaruq (Reverse Murabaha)
Trader A
Islamic
Bank
Trader B
Customer
(i)
Islamic Bank buys the goods from Trader A on cash payment basis (spot);
(ii)
Islamic Bank sells the goods to Customer on deferred payment basis (cost
price plus profit);
(iii) The Customer can appoint the Islamic Bank as his agent to sell the goods to
Trader B on cash payment basis in the commodity market;
(iv)
Islamic Bank then sells the goods, as agent of Customer, to Trader B on cash
payment basis in the commodity market;
(v)
Islamic Bank credits Customer’s Account with proceeds of sale received from
the Trader B; and
(vi)
Customer settles the amount due to Islamic Bank in instalment.
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2.
Islamic contracts
2.5 Ijara
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Islamic Contracts
Ijara
 Ijarah is the transfer of ownership of a service for an agreed upon consideration.
 Operating Ijarah do not end up with the transfer of ownership of leased assets to
the lessee.
 Ijarah Muntahia Bittamleek ends up with the transfer of ownership of leased
assets to the lessee.
There are several types of Ijarah Muntahia Bittamleek. These are characterized based
on the method by which the ownership transfers to the user:
•
For no consideration (through a gift)
•
For token consideration
•
For price specified in the lease
•
For remaining amount (if lease is terminated before period)
•
Gradual transfer
40
Islamic Contracts
Ijara (continued)
.
Vendor
.
Islamic Bank
Agreement 1
Customer
 The customer approaches the Bank with the request for financing and enters into a
promise to lease agreement.
 The Bank purchases the item required for leasing and receives title of ownership from
the vendor.
 The Bank makes payment to the vendor.
41
Islamic Contracts
Ijara (continued)
.
Vendor
Islamic Bank
Agreement 2
.
Customer
 The Bank leases the asset to the customer after execution of lease agreement.
 The customer makes periodic rental payments as per the contract.
 At the end of the tenure customer can purchase the asset from the bank with the help
of separate Sale agreement.
42
Islamic Contracts
Ijara (continued)
Difference b/w Conventional Lease & Ijarah
1. In conventional lease the Lessor has the unilateral right to rescind the lease contract
at his sole discretion, which is against the laws of Shariah.
2. Expenses under Ijarah 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
3. Two contracts into one contract is not permissible in Shariah therefore, we cannot
have the agreement of hire and purchase into one agreement, only we can
undertake/promise to purchase the leased asset.
4. In conventional lease the lease starts even before the existence of assets, which is also
not permissible in Shariah.
5. Penalty income is charged for late payments in Conventional lease.
43
Islamic Contracts
Types of Ijara
Ijara
1. Simple Ijara
(Operating Lease)
Title of the asset remains with
the lessor; the risks and
responsibilities of ownership are
always borne by the lessor.
Full cost of the asset is not
amortized during the primary
lease period.
Lessee may cancel the lease at
any time, with a prior notice
according to the contract.
The asset reverts to the lessor
at the end of the lease period.
The lessor may then lease it out
to another customer if the asset
.
is in good shape
2. Ijara Muntahia
Bittamleek (Finance lease)
3. Ijara Mawsoofa Bil Thimma
(Forward lease)
The lessor remains the owner
till the very end bearing all the
risks and responsibilities.
Lease of specified items which are to be
delivered after manufacturing or
construction.
Full cost of the asset is
amortized during the lease
period.
Lease of the underlying assets starts on the
date of delivery of the asset to the lessee and
the lessee’s obligation to pay rental triggers
with the commencement of the lease.
 Lessee cannot cancel except if
the lessor is compensated for any
losses.
The customer is responsible for
only the rentals as long as he
uses the asset. He becomes the
owner only if, and when, he
exercises his option.
The lessee is offered the option
of ultimately purchasing the
asset at the end of Ijara period at
a predetermined price.
Investor receives return on its investment
out of the amount received from the lessee on
account of rental which is adjusted against
the actual rental.
Although investment in assets under
construction may not be free from certain
downsides, it still has potential to serve both
the parties, i.e. customer and financier –
addressing the Project Financing
requirements.
Appropriate structure for project financing.
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2.
Islamic contracts
2.6 Salam
45
Islamic Contracts
Salam
Key principles
 Salam is similar to a forward sales contract wherein the price is paid in
advance at the time of executing the contract for goods that are to be
delivered in future.
 Involves a forward purchase of a commodity; full payment is made at the
beginning of the contract period; goods are received at the end of the
contract period.
 The goods must be clearly identifiable; remedies are available for failure to
complete the contract as specified.
46
Islamic Contracts
Salam (continued)
•Salam with parallel Salam
Customer
1) Salam contract
and promise to
deliver goods in
the future
6) Payment to
IB for
future delivery
5) Delivery of
goods from Bank
to Customer on
future date
Bank
3) IB pays for goods
at market price
2) IB promises to
buy goods
in the future
4) Delivery of
goods from 3rd
Party to the Bank
on future date
3rd Party
47
2.
Islamic contracts
2.7 Istisna
48
Islamic Contracts
Istisna
 Istisna’a is a sale agreement between the Bank as the seller (Al-sani) and the
Customer as the ultimate purchaser (Al-mustasni).
 The Bank based on the order from the customer undertakes to have
manufactured or otherwise acquire the subject matter (Al-masnoo) of the
contract according to the specifications stipulated by the customer.
 The Bank sells it to the customer for an agreed upon price and method of
settlement whether that may be in advance, by installments or deferred to a
specific future date.
Parallel Istisna’a
This is the second sales agreement between the Bank and the Subcontractor to
fulfill its contractual obligations in the first contract (Istisna’a) to the customer.
49
Islamic Contracts
Istisna (continued)
Customer
Al-mustani
Istisna’a
Agreement
Islamic Bank
Al-sani
Parallel
Istisna’a
Islamic Bank
Al-mustani
Par. Istisna’a
Agreement
Contractor
Al-sani
50
Islamic Contracts
Istisna (continued)
Customer
Al-mustani
Istisna’a
Agreement
Islamic Bank
Al-sani
Parallel
Istisna’a
Islamic Bank
Al-mustani
Par. Istisna’a
Agreement
Contractor
Al-sani
51
Islamic Contracts
Istisna (continued)
Customer
Al-mustani
Istisna’a
Agreement
Islamic Bank
Al-sani
Parallel
Istisna’a
Islamic Bank
Al-mustani
Par. Istisna’a
Agreement
Contractor
Al-sani
52
Islamic Contracts
Salam vs. Istisna
There are number of differences:
 Under Salam, deliverables have commodity-like characteristics and must
be fungible like base metals or grain.
 Under Istisna, deliverables are manufactured goods or constructed
property.
 Under Salam, the price must be paid in advance.
 Under Istisna, the price may be paid in advance, according to progress or
in instalments post delivery.
 Under Salam, the contract may be cancelled.
 Under Istisna, the contract may be cancelled unilaterally before work
starts.
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3.
Risks faced by Islamic Banks
54
Risks faced by Islamic Banks
 Islamic banks are not risk free; participants in each transaction share
risks and rewards (profit & loss sharing principle).
 High exposure to the real estate sector (Dubai, in particular).
 “No” exposure to structured investment products such as CDO’s,
SIVs and ABS….
 Exposure to the US and Europe through private equity, real estate and
asset-based investments.
 Some Islamic banks are also under pressure due to Liquidity drying-up
and their reliance on wholesale funding.
55
Risks faced by Islamic Banks
Specific risks
Rate of
Return
Risk
The potential impact
on the returns caused
by unexpected change
in the rate of returns.
General risks
Credit Risk
Displaced
Commercial
Risk
Shariah
Noncompliance
Risk
Commercial pressure to pay
returns that exceed the rate
that has been earned on its
assets financed by
investment account holders.
Risk arises from failure
to comply with the
Shariah rules and
principles.
Equity
Investment
Risk
The risk arising from
entering into partnership
for the purpose of
undertaking or
participating in a
particular financing or
general business activity.
Islamic Bank
Market Risk
Liquidity
Risk
Operational
Risk
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Please note that this presentation do not
contain or convey any accounting
advice/opinion/views by
PricewaterhouseCoopers
57