Professional Documents
Culture Documents
Learning Objectives
References
Books:
Iqbal Z. and Mirakhor A., An Introduction to Islamic Finance: Theory and Practice, Hardcover, 2006. Ayub M., Understanding Islamic Finance, Hardcover, 2007. Khan M. and Mirakhor A., Theoretical Studies in Islamic Banking and Finance, Islamic Publications International, 2005.
Websites:
http://www.islamic-finance.com http://www.islamicfinancenews.com http://www.aaoifi.com: Accounting & Auditing Organisation for Islamic Financial Institutions (AAOIFI) http://www.ifsb.org: Islamic Financial Services Board (IFSB) http://www.iifm.net: International Islamic Financial Market (IIFM) http://www.iirating.com: Islamic International Rating Agency (IIRA) http://www.ibisonline.net: Islamic Banks and Financial Institutions Information http://www.islamic-banking.com: Institute of Islamic Banking
Road Book
What is Islamic Finance? History & development of Islamic Finance Islamic Contracts & use of funds Islamic Bond (SUKUK) Islamic Insurance (Takaful) Asset Management/Fund Management Subprime crisis and Islamic Finance Challenges facing Islamic Finance Conclusion
Shariah terms
Halal that which is permitted or compliant Haram that which is not permitted Riba charging of interest or unjustified increase Gharar the taking of unreasonable risk; uncertainty Maisir reliance on chance or speculation, rather than effort
Islam
Aqidah
(Faith and Belief)
Shariah
(Practices and Activities)
Akhlaq
(Moralities and Ethics)
Law of Country
Sunnah
Practices and sayings of Prophet Muhammad
Ijmaa
Consensus of Ummah
Ijtehad
Reasoning applied by Scholars
10
Islamic Finance
Principles and Foundations laid down by Shariah (Islamic law) Quran Revealed word of God Sunnah Sayings and practices of the Prophet Mohammed Moral guidance or set of principles practiced by muslims Shariah Supervisory Board (SSB) 3-5 Islamic Scholars Decide what is compliant or not Interpret Islamic Jurisprudence (Fiqh)
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Riba al Naseeyah or Riba al-Quran excess resulting from a pre determined interest Riba al-Fadl or Riba al Hadith Excess compensation without consideration
Avoid Uncertainty/Deceit (Gharar)
12
Obligation to share to a certain extent profits and losses and in the forms of buyer seller (murabaha), lessor leasee (ijarah), partnership (musyaraka), and or debtor creditor (qard hasan) relationship. Promote honesty, transparency justice and fairness in commercial dealings.
Charitable distributions: Zakat (Mandatory) (2.5% Lunar or 2.5775% Solar Calendar) Sadakat (Voluntary)
13
Money
Bank
Money + money (interest)
ISLAMIC
Client
Is based on interest. Deals in money or papers Is based on fixed return on both Sides of the balance sheet. Does not involve itself in trade and business directly
Islamic BANKING
. Is based on profit or rent . Deals in assets. . Is based on profit sharing on . deposits side, and on profit on assets side. . Actively participates in trade, production and valid services through valid contracts.
Bank
Client
Money
14
Conventional Bank Bank acts as a financial Intermediary Maturity Transformation Takes in long term finance and lends short term Main income consists of Interest Margin
Islamic Bank Return must take the form of a tangible asset Bank acts a a fund/asset manager (Mudarib) Depositors are seen as investors (Rab al Mal)
Expectations
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More ethical business and economy. Better governance, due to participation of investors (debt holders) in risk sharing.
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Industry has developed a comprehensive product offering over its young history
1960s-1980 New Concept, Limited to Commercial Banking
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1980s-1990
Expansion into Asian Markets Introduction of Islamic Insurance (Takaful) + Project Financing Oil shocks resulted in rapid growth Birth of the Islamic bond (Sukuk) Equities market Leasing (Ijarah)
1990s
2000- Today
Internationalization of Islamic Finance Creation of Islamic Funds / Asset Management Structured Products
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UK: New legislation for Islamic mortgages (2003) USA: Harvard workshop with six regulators (1995)
Saudi Arabia: 95%+ of new consumer lending is Islamic (2006) Retail market rapidly converting to Islamic (2006)
UAE: 30% of retail banking is Islamic (2005) Several institutions have converted from conventional to Islamic
Singapore: Active in developing Islamic finance Malaysia: Islamic product and industry, development and sophistication lead
Islamic Banking
Kuala Lumpur Dubai Manama Doha London
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Singapore
Population
Muslims Fin Sector (Assets) Islamic % Major Players
1.5m
40% $387.5 B
1.3m
96% $340.0 B
718,306
81.2% $251.1 B
928,635
77.5% $81.3 B
7.5m
8% $19.1 Tr
4.6m
14.9% $276.5 B
$16.4 B 6.5% Acrapita Bank, Gulf Finance House, Bahrain Islamic Bank
$14.8 B 18.2% Acrapita Bank, Gulf Finance House, Bahrain Islamic Bank
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1000 500 0 Islamic Islamic Funds 2008 Funds 2010 650 950
1.6
23
24
25
26
27
28
29
Islamic law and regulatory framework exist, including those deal with modern business. However, there are limitations in terms of the capacity of the jurists to deal with large scale economic transactions, and that there is no court of final appeal that result in controversies (Monger and Rawashdeh 2008). The most notable initiative is the establishment of Accounting and Auditing Organization of Islamic Financial Institutions (AAOIFI) => to develop standards for accounting, auditing, governance, and ethics to ensure Shariah compliance. The Islamic Financial Services Board (IFSB) was created to set standards for the industry, in which twenty-two agencies, including several national central banks, International Monetary Fund and World Bank are members. The board intially focussed on risk management and capital adequacy for islamic financial industry.
30
The IDB initiatives are also important to support the infrastructure for operation and development of Islamic financial industry. Other supporting structures, such as ratings, indexes, studies, predictions and analysis for IF & B institutions are available and provided by conventional and international institutions (such as S&P, Dow Jones, etc.).
31
Disseminating Shariah concepts & multilateral understanding between IFIs and public Improving IFI practices, cooperation, professionalism and transparency
Standard-setting body of regulatory and supervisory agencies Complementing Basel II Capital Accord Key standards: risk management, capital adequacy & corporate governance Creation of active Islamic inter-bank market Creating secondary market for short-term Shariah-compliant treasury products Enabling IFI management of liquidity mismatch Reference point for IFI ratings Issuing sovereign, credit, Shariah quality and corporate governance ratings Providing effective tool for informed investment decision-making
32
Islamic Windows
Branches
Subsidiaries
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34
Uses
Murabaha Musharaka
Mudaraba
Ijara Salam Istisna Off Balance sheet Funds Sukuk (Islamic Bond) Reserves (general & statuary)
Type of Contracts
Shareholders funds
Share Capital Reserves
Other
Off balance sheet (specific accounts)
35
Elements of a Contract
Contracting parties Mature Sane Subject Matter Valuable according to Shariah law Existence (material effect) Must be owned Ability to deliver Specific Conditions & offer and acceptance Acceptance must match offer
36
Definition of Murabaha: It is a sale contract, with a set increment on the original price, agreed upon by the two parties. It is a particular kind of sale where the seller expressly mentions the cost of the sold commodity he has incurred, and sells it to another person by adding some profit.
37
Bank
Client
Mechanics of Murabaha
38
A typical Murabaha transaction as practiced today takes place between 3 players: The financier or the Islamic bank The vendor or the original seller of the product The user of the product requiring the bank to purchase and finance the product
39
Step 1
The banks client seeking financing describes to the vendor the goods they intend to obtain, and ask the vendor to quote the price.
Price Inquiry
Client
Price quote
Trader/Vendor
40
Step 2
The banks client contacts the bank promising to buy the goods from the bank if the bank buys the same from the vendor and resells them to the client at price inclusive of the original cost + profit to be agreed mutually.
Client
Promise to buy at cost-plusprofit
Islamic Bank
41
Step 3
The bank purchases the product from the vendor by making payment. The Murabaha contract is drawn between the client and the bank indicating the profit or mark-up to be charged. The contract is finalized by agreeing on the mode of payment (lump sum, installments).
Cost-plus contract
Payment
Client
Islamic Bank
sale Item/Commodity
Trader/Vendor
sale Item/Commodity
42
Step 4 At the time of payments, the client makes the payment to the bank. This payment includes the cost of the product + profit margin to the bank.
Client
Islamic Bank
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44
45
46
Definition This is a kind of partnership where one partner gives money to another for investing in a commercial enterprise.
The investment comes from the first partner who is called Rab al Mal (Investor) while the management and work is an exclusive responsibility of the other, who is called Mudarib (Working Partner) and the profits generated are shared in a predetermined ratio.
47
Client (Rab al Mal) deposits (Invests) his money. Bank (Mudarib) offers its skill/effort/knowledge. Contracts between client & bank is a partnership contract. Banks profit: share of investment profit instead of spread. (even though a profit margin is structured into the deal) Mudarib could hold reserves so as to smooth out income/make it more consistent. Risk of loss lies with the client. (unless bank broke rules)
48
$10,000 Profit
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50
51
52
53
Types of Mudaraba
54
Al-Mudaraba Al-muqayyadah (restricted Mudaraba): Where Rab al Mal specifies a particular business for the mudarib, in which case he shall invest the money in that particular business only.
Al Mudaraba Al Mutlaqah (unrestricted Mudaraba): Where Rab al Mal leaves the door open for the mudarib to undertake whatever business he whishes, the mudarib shall be authorized to invest the money in any business he deems fit.
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56
$100,000 Project
57
Musharaka Project makes $30,000 profit. Client receives 70% of profit $21,000 Bank Receives 30% of profit $9,000
$30,000 Profit
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Musharaka Project $50,000 loss, Project value=$50,000 Losses are borne according to their initial capital contribution Client receives proportion of investment (80% of $50,000) = $40,000 Bank receives proportion of investment (20% of $50,000) = $10,000
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60
The objects of this sale are goods and cannot be gold, silver or currencies, because these are regarded as 'monetary values exchange' of which is covered under rules of Bai al Sarf (exchange of money for money).
61
SUPPLIER
FINANCIER
CUSTOMER
Istisna
(Partnership in Manufacturing)
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Seller agrees to manufacture a particular product with pre determined specifications and commits to deliver it to the buyer at a pre determined price. Price can be paid in installments, or can even be deferred until the product is delivered
Features of Istisna
Istitsnaa is a pure sale contract and not a hire contract.
63
Commodity is non existing and is to be manufactured to bring it to existence. Does not include natural goods like fruits, cereals etc. Quantity, Quality & Price are fixed at the time of signing the contract. Price need not be paid in advance. It can be either be paid in installments or can be partially deferred until delivery. No fixed delivery date and no payment in full at outset required.
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Mechanism of Istisna
Purchase price
DEVELOPER/CONTRACTOR/ MANUFACTURER
FINANCIER
CUSTOMER
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68
69
70
Bonds are important part of overall financial system. Well developed bond markets ensures stable financial system as it minimize over-reliance on financing from the banking sector.
The development of the bond market allows for access to funding with the appropriate maturities, thus avoiding the funding mismatches. It also allows for the diversification of risks by issuers and investors.
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Islamic Sukuk-Types
Sukuk Al Ijarah
Sukuk Al Salam
Sukuk Al Murabaha
Sukuk Al Musharaka
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ABC Ltd. wishes to purchase a new asset and plan to raise finance through issuance of Islamic Sukuk.
78
Supplier
Supplier of the Asset is identified and negotiations is finalized by ABC Ltd.
ABC Ltd.
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Supplier
Issuer SPV (LLC 100% owned ABC Ltd.) ABC Ltd.
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Supplier
100%
owned ABC Ltd.) ABC Ltd. Proceeds
Investors
SPV issues certificates and receives proceeds which are used to purchase asset from the supplier
81
SPV holds Plant/ Asset as Trustee SPV holds Asset as Trustee and leases the plant to ABC Ltd. as per rules of Ijarah Issuer SPV
Investor
ABC
Ltd.
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Investors
ABC Ltd. (Lessee) pays periodic rentals to SPV for tenors & amounts matching the coupon & tenor of the Sukuks
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ABC Ltd.
(Lessee) Pays the exercise price at dissolution
Issuer
SPV Redeems the Trust Certificates at dissolution
Investors
ABC Ltd (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.
84
Essential Condition
Its essential that the Ijarah Sukuks are designed to represent real ownership of the leased assets, and not only a right to receive rent.
Sukuk Al Salam
so named because securities are based on the concept of Bai Salam.
85
Government of Bahrain first issued Salam Sukuks as an alternate to short term government treasury bill.
Under the transaction Government took an advance payment from the investors for a future delivery of Aluminum ingots. A paper was issued as an acknowledgment of receipt which is known as Salam Sukuk. Upon delivery of Aluminum ingots to the investors at the time of completion of Salam contract, Government sold ingots to third parties as agent of the investors. The difference between Sale and Purchase price was the profit of the investors.
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Important Conditions
Salam Sukuk represent investors shares in the Advance Price paid to the seller. Since its a dayn, it cannot be traded in the secondary market.
Sukuk Al Musharaka
Musharaka is a mode of financing against which Sukuks can be issued.
87
If a comapany required financing for any of its project through Musharaka it can issue Sukuks against which investors would provide funding as per the rules of Musharaka. Every Sukuk would represent holder's proportionate ownership in the assets of the Musharaka. Once the majority of the cash amount is converted into fixed assets, these Musharaka Sukuk can be treated as negotiable instruments in the secondary market. Musharaka Sukuks can be used for number of purposes including: Construction of Projects and factories Expansion Projects Working Capital Finance
Important Conditions
Profit earned by the Musharaka is shared according to an agreed ratio between the Issuer and Investors at an agreed ratio. Loss is shared on pro rata basis. To ensure tradability of the Sukuks following condition should be adhered to:
88
All the assets of the Musharaka should not be in liquid form. At least 20% of the value of Portfolio should be invested in non-liquid assets.
89
Sukuk Al Murabaha
Sukuks can also be issued against a Murabaha transaction. Under the transaction investors would provide funding to purchase some assets for the issuer. Acknowledgment of their investment would be regarded as Murabaha Sukuk.
The asset would be purchased from its supplier and would be immediately sold to the issuer against deferred price. Profit earned from the transaction would be distributed among the investor proportionately.
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Important Conditions
Murabaha Sukuk represent investors shares in receivable from the purchaser. Since its dayn, it cannot be traded in the secondary market.
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Scholars view the insurance contract as an exchange contract money is being exchanged for money over time. Riba: In the case of life insurance, policyholders get back the premiums along with interest in the case of survival and the insured amount in the case of death before maturity of the policy. Insurance funds are invested in financial instruments which contain the element of Riba. Gharar (uncertainty): in the case of general insurance, the policyholders have to pay the premiums against unknown risks: Whether the insured will get the compensation promised? How much the insured will get? When will the compensation be paid? Gambling: The insured loses the money paid for the premium when the insured event does not occur. The company will be in deficit if claims are higher than premium.
94
95
96
10
6
11.0
2
1.4
1.7
2.0
2.5
3.0
3.6
4.3
97
Takaful contract pertains to Tabarruat as against muawadat in case of conventional insurance. Payments made with the intention of Tabarru (contribution) Eliminates the elements of Gharrar, Maisir and Riba. Wakalah/Modaraba basis of operations. Joint Guarantee / Indemnity amongst participants shared responsibility. Constitution of separate Participants Takaful Fund. Constitution of Shariah Supervisory Board.
98
Piety (individual purification) Brotherhood (mutual assistance) Charity (Tabarru or contribution) Mutual Guarantee
99
Organization Principle
Basis Value Proposition
Laws
Ownership Management status Form of Contract
Secular/Regulations
Shareholders Company Management Contract of Sale
Investments
Interest based
Surplus
Shareholders account
Participants account
100
ASSET/FUND MANAGEMENT
101
29
100
0 2003 2004 2005 2006 2007 2008 of Islamic Funds AUM Number
1Q 2009
102
103
104
105
106
From the Mortgage Crisis to the Global Economic & Financial Crisis
107
108
Major Impacts
109
3.0
-1.4
0.5 6.1
-3.8 1.5
110
111
111
112
113
113
114
115
Forbid
Stipulate
115
116
117
117
118
119
In governance, independence of SSBs is being questioned, because they are part of management (paid by the banks).
Differences in practice and application of Shariah laws, that may result in confusion in market. As an example, a practice of guaranteeing profit in some institutions is against islamic laws since it is similar to interest rate.
Studies (using Indonesian Islamic Index) indicate that speculation plays an influencial role in islamic market (Kurniawan 2008), and there is moral hazard in Shariah based financing practices (Nasution and Wiliasih 2007). Regulatory & tax issues Shariah scholars & Shariah compliant products Trained & Skilled Islamic Bankers
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Conclusions
IF & B has been a choice of financial and banking services for Muslim and non-Muslim communities.
The size of their businesses and the asset managed grow significantly.
To improve their role in global economy, IF & B need to improve their infrastructure and governance, so that the islamic laws and values are consistently and essentially actually applied. Islamic financial institutions are affected by the financial crisis. They are not risk immune, however, during the economic crisis their growth is remained strong, and they have shown resilience to global market dislocation.