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 Sources Quran Primary source of Sharia Sunnah Practices of the Prophet Shariah Ijma (Consensus) Interpretation Ijtihad (Reasoning of a group of qualified scholars) Operations (Techniques) Organisation (Shariah Boards) Applications Mindset 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 Prohibition of payment or receipt of interest Assets to back the transaction should not belong to prohibited activities (e.g. alcohol) Speculative trading in financial instruments is prohibited The Bank acts as an agent/partner with the depositor who is entitled to share the gains/loss of the investment Asset Backed Prohibition of Interest interest Prohibited Activities Speculative trading 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
Depositors Islamic vs Conventional Banks Overview of Islamic finance Sources and Application of Funds Lend @ 15% Conventional Banks Spread 5% Lend @ 20% Loans Depositors Depositors share of profit after deducting the management fee (Mudaraba fee) of 15% Islamic Banks Fund management agreement Mudarib fee @15% Trading & Investments 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 Islamic Bank 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. Pure Islamic banks which offers only Islamic Financial services. 9
2. Islamic contracts 10
Mudaraba Murabaha Equity Type Sukuk Istisna Debt Type Salam Musharaka Ijara 11
2. Islamic contracts 2.1 Mudaraba 12
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
Mudaraba (continued) Customer (Rab al mal) 1) Customer deposits funds with the bank under Mudaraba contract 3) Bank invests funds in a Shariacompliant investment Bank (Mudarib) 2) Bank provides Mudaraba deposit certificate 4) Make profit / loss from investment 5) Distributes profit from investment Sharia compliant investment 14
2. Islamic contracts 2.2 Musharaka 15
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
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 participations, Partners share in capital remain constant and unchanged. 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
Musharaka (continued) Permanent/Constant Musharaka Bank Customer Profit 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 18
Musharaka (continued) Diminishing Musharaka Customer 2) Customer s contribution to the purchase of property (x) 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 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) 19
2. Islamic contracts 2.3 Sukuk Al Ijarah 20
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
Sukuk Al Ijarah (continued) Supplier Supplier of the Asset is identified and negotiations is finalized by Saudi LLC Saudi LLC 22
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
Sukuk Al Ijarah (continued) Supplier Payment made to Supplier Title is transferred to SPV Issuer SPV Sukuks Investors Saudi LLC Proceeds SPV issues certificates and receives proceeds which are used to purchase asset from the supplier 24
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 Investors Saudi LLC SPV leases Plant to Saudi LLC under Ijarah 25
Sukuk Al Ijarah (continued) Saudi LLC (Lessee) Issuer SPV Investors Periodic Lease Rentals Semi-annual coupon distribution amounts Saudi LLC (Lessee) pays periodic rentals to SPV for tenors & amounts matching the coupon & tenor of the Sukuks 26
Sukuk Al Ijarah (continued) Exercises the purchase undertaking. Asset transferred to Saudi LLC Saudi LLC (Lessee) Issuer SPV Investors Pays the exercise price at dissolution 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. 27
2. Islamic contracts 2.4 Murabaha 28
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
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. 30
Murabaha (continued) Product Structure 1. Client and bank sign an agreement to enter into Murabaha. Bank Murabaha Agreement Client 31
Murabaha (continued) Product Structure 2. Client is appointed as agent to purchase goods on bank s behalf. Bank Murabaha Agreement Client Agency Agreement 32
Murabaha (continued) 3. Bank gives money to client for purchase of goods. Bank Islamic Bank Murabaha Client Agreement Agency Agreement Disbursement to the client 33
Murabaha (continued) 4. Client purchases goods on bank s behalf and takes their possession. Transfer of Risk Vendor Client purchases goods and takes possession Bank Client 34
Murabaha (continued) 5. Client makes an offer to purchase the goods from bank. Bank Bank Client Offer to purchase 35
Murabaha (continued) 6. Bank accepts the offer and sale is concluded. Murabaha Agreement + Transfer of Title Bank Client 36
Murabaha (continued) 7. Client pays agreed price to bank according to an agreed schedule. Usually on a deferred payment basis (Bai Muajjal). Bank Payment of Price Client 37
Tawaruq (Reverse Murabaha) Trader A Islamic Bank Trader B Customer (i) (ii) (iii) (iv) (v) Islamic Bank buys the goods from Trader A on cash payment basis (spot); Islamic Bank sells the goods to Customer on deferred payment basis (cost price plus profit); 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; Islamic Bank then sells the goods, as agent of Customer, to Trader B on cash payment basis in the commodity market; 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. 38
2. Islamic contracts 2.5 Ijara 39
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
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
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
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
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) The lessor remains the owner till the very end bearing all the risks and responsibilities. Full cost of the asset is amortized during the lease period. 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. 3. Ijara Mawsoofa Bil Thimma (Forward lease) Lease of specified items which are to be delivered after manufacturing or construction. 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. 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. 44
2. Islamic contracts 2.6 Salam 45
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
Salam (continued) Salam with parallel Salam 6) Payment to IB for future delivery 3) IB pays for goods at market price Customer Bank 3rd Party 1) Salam contract and promise to deliver goods in the future 2) IB promises to buy goods in the future 5) Delivery of goods from Bank to Customer on future date 4) Delivery of goods from 3 rd Party to the Bank on future date 47
2. Islamic contracts 2.7 Istisna 48
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
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
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
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
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. 53
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. Displaced Commercial Risk Commercial pressure to pay returns that exceed the rate that has been earned on its assets financed by investment account holders. Shariah Noncompliance Risk 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. General risks Islamic Bank Credit Risk Market Risk Liquidity Risk Operational Risk 56
Please note that this presentation do not contain or convey any accounting advice/opinion/views by PricewaterhouseCoopers 57