Islamic Banking – Products & Operations A practical introduction Duncan R. Smith Arab Banking Corporation March 2008 CONTENT OF PRESENTATION • Understanding the context • Looking at the products • Concluding Remarks UNDERSTANDING THE CONTEXT • What is Islamic Banking? • What prompted Islamic Banking? • Origins of Islamic Banking • Islamic Finance Perspectives WHAT IS ISLAMIC BANKING? • Interest free banking? • Profit and loss sharing? • Ethical banking? WHAT PROMPTED ISLAMIC BANKING? • Emergence of Arab nationalism and the search for identity • Oil shocks and petrodollars • Privatization and the individual’s right to choose ORIGINS OF ISLAMIC BANKING Quran Hadith & Sunna Interpretation by Shariaa Scholars Surah Al-BAQARRAH (#2) Verse(s) 275-279 AL-EMRAN (#3) 130 AN-NESSA (#4) 161 Sayings of the Prophet i) Sahih Al-Bokhari ii) Sahih Muslim AR-RUM (#30) 39 Teachings & Life style of the Prophet Two Sects of Islam Sunnah 1) Hanbaly 2) Shafei 3) Hanafi 4) Maliki Shia’h 5) Ithna-Ashriah Qiyas - Ijtehad – Ijma’a ISLAMIC FINANCE PERSPECTIVES • 1.5 billion Muslims (20% of population) • Fastest growing and one of most active religions • Modern Islamic Banking started in the mid-70s, although financing principles pre-date Islam • Financial assets now around US$ 700 billion • Liquid Funds in the Islamic Markets looking for quality assets are around US$ 100 – 200 billion • Market is growing at 15% pa LOOKING AT THE PRODUCTS • Islamic Finance Principles • Short Term Working Capital • Medium Term Sales Financing • Syndication • Islamic Securitization • Islamic ABS • Islamic Mortgages • Islamic Funds ISLAMIC FINANCE PRINCIPLES • Financiers are linked to the underlying transaction • Not permitted finance of activity related to: - alcohol, pork, drugs, gambling, etc - speculation or unjustified enrichment • Money is not a “Commodity” in itself, merely reflecting “Time Value” for a return • Hence, no receipt or payment of Interest (Riba) • Transactions must be transparent with all details agreed in advance and ownership undisputed (1) WORKING CAPITAL – COMMODITIES MURABAHA FOR SAUDI CORPORATE • Saudi Corporate (SC) requires US$ 20 million from Islamic Bank (IB) for 3 months under Master Agreement which sets out procedures and means of fixing pricing • SC contracts to buy via IB an amount of a commodity with a cash price of US$ 20 million on deferred term of 3 months • IB contracts to sell the commodity on behalf of SC for US$ 20 million cash and passes cash to SC • SC contracts to pay IB for the commodity after 3 months at the cash price plus an agreed mark up (1) WORKING CAPITAL – COMMODITIES MURABAHA FOR SAUDI CORPORATE Deferred obligation of $ 20 million + mark up (3 months) Buys commodity on deferred terms Commodity for cash Saudi Islamic Commodity Corporate Bank Broker Sells commodity for cash Cash price ($ 20 million) Commodity for cash (2) LIBYAN CONSTRUCTION EQUIPMENT FINANCE TRANSACTION • A $ 40 million facility to finance equipment for a project in Libya • LC’s issued initially to finance the purchase and import of construction equipment from Italy and elsewhere used on the project • LC’s converted into Murabaha leverage financing during 2007 • Was initially to be an Islamic lease/Ijara contract but there were tax and legal uncertainties surrounding this • Facility amortization over 5 years commenced July 2007 (2) LIBYAN CONSTRUCTION EQUIPMENT FINANCE TRANSACTION Suppliers Opens Letters of Credit Makes payments against documents ABCIB $ payments Equipment Contractor Client Contract payments Supply goods / equipment (3) SYNDICATED FINANCING – REVOLVING MURABAHA FOR KUWAITI CORPORATE • 3 year revolving facility • $ 100 million with ABC Islamic Bank as Investment Agent (underwriter and arranger) • Series of individual murabaha transactions with payment of profit only on individual transactions; conventionally a “bullet” payment of principal at maturity (4) SUKUK ISSUE – “ISLAMIC ABS”; SAUDI HOUSEBUILDER • Dar Al-Arkan is a major Saudi builder • Requirement for raising finance to develop houses to meet underserved Saudi market • In 2007 raised $ 1.6 billion in two sukuk issue • Complexity because of Saudi law on property ownership • Total market of approx $ 100 billion of sukuk in issue end 2007 (4) SUKUK SUMMARY Issuer Dar Al-Arkan International Sukuk Company (a limited liability company incorporated in the Cayman Islands) Guarantor Dar Al-Arkan Real Estate Development Company (Dar Al-Arkan) Issue Maturity Floating Rate Coupon 5 Year US$[*] Trust Certificates due 2012 5 years, bullet 3-month US$ LIBOR US$ LIBOR plus 225bps Application made to Dubai International Financial Exchange (DIFX) Public Listing and Labuan International Financial Exchange (LFX) Issue Type Sukuk Al-Ijara Saudi law for property-related documents Governing Law English law for Trust Deed and Certificates ABC Islamic Bank (E.C.); Arab National Bank; Deutsche Bank AG; Joint Lead Managers Dubai Islamic Bank PJSC; Gulf International Bank B.S.C.; Kuwait and Joint Bookruners Finance House (Malaysia) Berhad; Unicorn Investment Bank, B.S.C. (c) (4) TRANSACTION STRUCTURE (SUKUK AL IJARA) SUKUK HOLDERS Issue Proceeds (US$) Offshore On-shore Certificates Lease Payments ISSUER 5 Year Lease (Dar Al-Arkan International Sukuk Co.) (Use of Real Estate Assets) Dar Al-Arkan Guarantee Payment for Real Estate Rights (US$) Transfer of Real Estate Rights Sale Proceeds (US$) SAUDI SPV Sale of Real Estate Assets (Transfer of Title Deeds) (5) CONTAINER SUKUK ISSUE • Al Hamila is an ABC – established SPV which owns shipping containers • Al Hamila finances its purchases through the issue of floating rate and fixed rate sukuk. The sukuk “coupons” match the profit of underlying leases • Client (shipping company) gets lease finance with funds raised from Arab and International markets (6) ISLAMIC MORTGAGES – DIMINISHING MUSHARAKA • Requirement for British Muslims to buy their own houses without borrowing at interest • Approximately 2 million Muslims in UK with potential “mortgage” market size of £ 6 billion • Marketed under the “alburaq” brand • Bank and customer buy the property jointly and over period Bank sells its share to customer; Bank charges rent on the share that it owns • Rent re-fixed semi-annually vs. Libor benchmark (6) DIMINISHING MUSHARAKAH / IJARAH STRUCTURE Property / Asset Joint Purchase Based on Shirkatal-milk. Bank takes title Customer agrees to repay principal by the buying over time, the Bank’s share. Consequently the customer’s ownership interest in the property increases and the Bank’s decreases The Customer leases the Bank’s share, with periodic adjustments made to rental to reflect the fact that a reducing bank share is being leased Customer (20% share) Bank (80% share) (“Customer Share”) (“Bank’s Share”) Increasing ownership Customer Bank Acquisition cost instalments to purchase 80% share Rental Customer (as tenant) Lease of reducing Bank’s share Bank’s Share ISLAMIC INVESTMENT PRODUCTS – 320 Worldwide; top 93 Islamic Equity Funds 31 Islamic Income Funds 18 Islamic Real Estate Funds 10 Islamic Balanced Funds 7 Islamic Leasing Funds 5 Islamic Commodity Funds 4 Islamic Funds of Funds 3 Islamic Index Funds 3 Islamic Murabaha Funds 3 Islamic Growth Funds 3 Islamic Hedge Funds 2 Islamic Hybrid Funds 1 Islamic Infrastructure Funds 1 Islamic Mutual Funds 1 Non Investment Islamic Fund 1 CONCLUDING REMARKS • Matching needs of surplus with shortage • Oil price, available Sharia technology, volatility in home markets create supply • Credit crunch (possibly short tem), desire for diversification as a strategy, more familiarity with Sharia compliance create appetite • Potentially more benign regulatory treatment • Potential for investment products and serving local market needs (10 million-plus Muslims in Western Europe) Mille Grazie !