Introduction to Islamic Finance

Its Concepts, Models, Growth and

Opportunities
Rachid Ouaich
November 2012
November 2012

Contents

The Islamic Finance overview and related core principles

The Islamic Financial instruments
Legal and Tax structures
Accounting, auditing, reporting and compliance principles
Our services
Questions

Introduction to Islamic Finance

Slide 2

The Islamic Finance overview and related core principles

Islamic Finance Markets highlights

Chronology of modern Islamic Finance
Sharia Structure
Sources of guidance of Islamic Financial Operations
Concept behind Islamic Finance : principles
Supranational authorities governing Islamic Finance
Special feature: Sharia board

Introduction to Islamic Finance

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The Islamic Finance Markets - highlights

Estimated growth rate of 15-20% per annum.

Sharia compliant assets have reached US$ 1.3 trillion by end of 2011.

Islamic assets close to reach 2% of global financial assets

Industrys total assets and overseas portfolios estimated to reach US$ 4

trillion by 2020.

Global sukuk volume is estimated to reach US$ 140 bn at year-end 2012

Malaysia remains the biggest Sukuk Market

Introduction to Islamic Finance

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The Islamic Finance Markets - highlights

56 Islamic countries member of Islamic Development Bank (IDB)

Leading Islamic Finance centres : Bahrain, Dubai/UAE, Kuala Lumpur,

Riyadh, Qatar, Singapore, London, Luxembourg

More than 500 Islamic financial institutions operate worldwide in some 75

countries

Top management of Islamic banks not confined to Muslims countries but

spread over Europe, the United States, the Far East and the Middle East

In the aftermath of September 11, 2001, there has been a flight of Islamic
Capital from the USA to Europe, Asia and also back to the Middle East

Introduction to Islamic Finance

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Chronology of modern Islamic Finance

1963 : Egypt interest free saving banks, not overtly islamic invested in
trade and industry on the basis of share in profits
1971 : Egypt Nasr social bank
1973 : conference of Islamic countries finance ministers
1975 : Islamic Development Bank, Jeddah, fee based and PLS, revolving
capital
Dubia Islamic Bank, UAE, first Islamic commercial bank in the world
1970 : Development in the Gulf (Bahrain, Kuwait), Asia (Malaysia,
Philippines and Africa (Nigeria, South Africa) :

Faisal Bank of sudan and Egypt

Bahrain Islamic Bank
Indonesia Islamic Finance House
Al Rahji London
HSBC Amanah

Introduction to Islamic Finance

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Sharia structure

Introduction to Islamic Finance

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Sources of Guidance of Islamic Financial Operations

Compliance with Sharia that is derived from three sources :

QURAN (Primary source of Sharia)

SUNNAH (Practices of the Prophet)

IJMA (Consensus)

QIYAS (Analogy)

IJTIHAD (reasoning of a group of qualified scholars, which is aimed at

adapting Islamic rules to the contemporary world)

Introduction to Islamic Finance

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Quran

- Primary source for discerning the laws of God

- Binding to Jurists to have the first recourse to the QURAN for answers

- Evidence found in other sources are subject to the QURAN

- Example : GodhaspermittedtradeandprohibitedRiba

Reference : Surat Al Baqara verse 275

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Sunnah

- Literally means : Well-known path

- Words or Acts of the Prophet
- Sayings of the Prophet (SAW) used to lay down and give moral guidance
- Acts of the Prophet (SAW) which have a legal content (ex: method of praying)
- Tacit approval (silence) of the Prophet (SAW) on the action of one of his
companions in his presence or in his knowledge
Introduction to Islamic Finance
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Ijma

- Literally means agreement on a matter

- In its technical sense, it means the consensus of the independant jurists
from the Ummah of the Prophet Muhammad (SAW) after his death
- Example : Jurists have reached a consensus (Ijma) that the selling of goods
by an party who doesnt own the goods and without the approval of the goods
owner is void

Introduction to Islamic Finance

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Qiyas

- Literally means measuring or estimating one thing in terms of another

- Technically, it is the assignement of the legal rule of an existing case found in
the texts of the QURAN, the SUNNAH, or IJMA to a new case whose legal
rule is not found in these sources.
- Example : Jurist looked into details of the prohibition of alcohol. After
analysis, it was decided that the underlying reason is intoxication . Once this
has been defined, the scholars would look at other liquids that intoxicate and
extend the legal rule

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Ijtihad

- Number of meaning of Ijtihad

- Islamic scholars take into account the customs of a place that adress a
problem but are not offensive to Sharia
- In some cases, Islamic Scholars develop their own preference from a
solution to an apparently unique problem
- Fundamentaly, it is a personal exercise until other scholars are able to agree
with the solution proposed by the innovator.

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Authorities on interpretation
- Four different schools of jurisprudence make up the SUNNI world of Islam :
- Maliki : North Africa
- Hanbali : Saudi Arabia and Gulf region
- Hanafi : Eastern Europe and Turkey
- Shaafi : Malaysia and South east Asia
- While the Shia world follow their own seperate schools (Mainly Irak and Iran)
- The Islamic Fiqh academy (created in 1981 by the Organisation of Islamic
Countries) is a body which meets periodically to discuss issues originated
from Islamic thinking
- Sharia scholars or Sharia Board
Introduction to Islamic Finance
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Islamic Finance Principles - Concept

No intrinsic value in money :

-

Money as a way of exchange and a store of value not subject to trade

Fundamental principle :
-

Risk sharing partnership => Profit and Loss Sharing (PLS)

basically, no pain no gain

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Islamic Finance Principles - Rationales

Requirements

Rationale

Asset backed

Transactions must be backed by tangible

assets
Prohibition of interest as incremental of debt

Prohibition of payment/receipt of Riba

Prohibition of activities
Prohibition of Gharar (uncertainty) and Maysir
(gambling)
Profit/Loss Sharing

Considered harmful to the society (e.g. alcohol,

pork, weapons, drugs, pornography business,
etc)
Subject of contract must exist, must be
specifiable and measurable. Speculative
trading in financial instruments is prohibited
The bank act as an agent/partner with the
depositor who is entitled to share the gains/loss
of the investment

Sharia Compliant Transaction

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Islamic Finance Principles Riba

- Literally means excess
- Prohibition of payment/receipt of Riba interest as incremental of debt
- 2 types of Riba :
- Primary form : Riba al Naseeyah
=> Excess resulted from predetermined interest which a lender receives
over and above the principal amount
- Second form : Riba al Fadl
=> Excess compensation without any conisderation resulting from an
exchange or sale of goods (exchange of commodities contracts)

Introduction to Islamic Finance

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Islamic Finance Principles Ethical dimension

- Undesirable sectors :
Tobacco
Alcohol
Arms or munitions
Gambling
Pornography
Conventional financial services
- Charitable aspects :
Interests donated to charity (cleansing / purification)
Zakat charitable tax paid by muslims according to Quranic guidance

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Islamic Finance Principles Gharar and Maysir

- Gharar literally means overall uncertainty

- Maysir means gambling
- May be defined as preventable ambiguities or omissions in contracts
=> ex : Buying a house , the price of which need to be specified in the
future or price is fixed but specification is to be defined in the future
- Consequence of this principle : Buying and selling in most types of
derivatives products for any purpose including speculation is strictly forbidden

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Islamic Finance Principles - Contracting

- Aqd litterally means contract
- Majority of scholars defined the following requirements :
-

Contracting parties (Mature and sane)

Subject Matter (Valuable, Existence, Ownership, Ability to deliver, Specific)
=> consequence : speculation like short selling is forbidden
Offer and acceptance : consent of the parties is fundamental element in concluding a contract
Price : should not be uncertain or depending on future events

- Classification of contracts :
-

Sahih litterally means valid which could be either :

- Nafiz : enforceable
- Mawqoof : unforceable until authorized
Fasid : voidable
Batil : invalid

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Islamic Finance Principles - Implications

Implications => All products need to be approved by the Sharia scholars

This may have sevral implications :
-Costs
-Timing
-Latitude of flexibility

Introduction to Islamic Finance

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Basic Difference between Islamic and Conventional

Modes of Finance

Islamic finance

Supplier

Goods

Sale : 100

Bank

Goods
Goods

Client

Sale 2 : 110

Goods
Goods

Buyer

Sale 3 : 100

Credit sale or Murabaha

Introduction to Islamic Finance
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Special feature : Shariaboard

One distinct feature of the modern Islamic banking movement is the role of the
Shariaboards

boards made up of Islamic jurists and scholars available to an Islamic

financial institution for guidance and supervision in the development of
Sharia compliant products, which have to approve all transactions :
Sharia board ensures that investments structures are in line with Islamic law
Sharia board has the responsibility of laying down the underpinning Sharia
principles and rules that the institution should adhere to
Sharia board Publish annually, a report concerning the level of Sharia'a
compliance of the entity
The Sharia Board is not responsible for:
- Shareholders money
- Funds operation management
- Funds portfolio management

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Supranational authorities governing Islamic Finance

- AAOIFI (1991) : Accounting and Auditing Organisation for Islamic Financial institutions
=> Benchmark of islamic accounting and auditing standards (56 standards)
- IFSB (2002) : Islamic financial Services Board
=> Standard setting body of regulatory and supervisory agencies (complementing BASEL II Capital
Accord)
- IIFM (2001) : International Islamic Financial Market
=> Development of Global Islamic capital and money market
- GCIBFI (2001) : General Council for Islamic Banks and Financial Institutions
=> Promoting industry in theory and practice
- LMC (2002) : Liquidity Market Council
=> Creation of active Islamic inter-bank market
- IIRA (2005) : International Islamic Rating Agency
=> Rating of Islamic Financial institutions
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The components of the Islamic Banking and Finance industry

1) Banks
- Investment & Investment management
=> ex : BLME, Bank Al Khair, NBAD
- Generic Banking services (current accounts, transfers, credit cards, home
finance, etc.)
=> ex : HSBC Amanah, Islamic Bank of Britain
2) Equity and Capital Markets
3) Insurance companies : Takaful
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Operating structures of Islamic Banks

1) Window model
=> Operating structure where a conventional bank simultaneously carries out
Islamic Financial activities but assure clients of segregated accounting and
operations for conventional and islamic activities (ex : BNP Paribas Bahrain)

2) Branches
=> Similar to window model but services are offered through dedicated channels

3) Subsidiaries
=> Seperate legal entity (subsidiary) set up specifically to undertake Islamic
Financial services activities Formulate and manages its own policies

4) Fully-fledged islamic banks

=> Pure Islamic banks which offers only Islamic Financial services
Introduction to Islamic Finance
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Balance Sheet of an Islamic Bank

Assets

Liabilities

Cash & equivalents

Murabaha financing
Mudarabah financing
Musharakah Financing
Sukuk
Assets for trading (securities,
inventory,other assets)
Invetsments (not for trading)
Other assets
Fixed asets

Customer current accounts

(not remunerated)
Due to banks and financial
institutions
Payables
Other liabilities
Sukuk issued
Profit sharing Invetsment
Account (restricted vs
unrestricted)
Equalization reserve
Share Capital & Reserves

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The Islamic Financial instruments

Islamic monetary instruments

Islamic debt-like instruments
Islamic asset-like instruments
Hybrid Islamic Finance instruments
Takaful (Insurance)

Introduction to Islamic Finance

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The Islamic Financial instruments

Monetary instruments :
- Current account
-Term deposits & PSIA
- Tawarruq
- Arbun

Debt like instruments :

- Murabaha
- Ijara
- Salam
- Istisnaa

Islamic Financial
instruments
Takaful (insurance)

Equity like instruments :

- Equity
- Mudaraba
-Musharaka
-Invetsment funds

Hybrid instruments :
Securitization - Sukuk
Structured products

Introduction to Islamic Finance

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Islamic Monetary instruments

- Current accounts
- Term deposits or PSIA (Profit Sharing Investment Account)
- Tawarruq
- Arbun

Introduction to Islamic Finance

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Islamic Monetary instruments Current accounts

- Used for day to day cash management. No return is paid to depositors
- Used for higher return savings account
- Banks may sometimes pay a return, depending on their own profitability.
- Losses are not in practice passed on to depositors and are absorbed trough the banks
reserves
- 3 forms :
- Amanah form (applied globally)
=> entrusted to the bank for safekeeping and should e returned in whole
- Wadia form (applied in Malaysia)
=> Wadia is a promise to return the money to the depositor
- Qard hassan
=> loan without interest or yield between the client and the bank
- Complete segrergation of funds and no overdrat facility on these acounts
Introduction to Islamic Finance
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Islamic Monetary instruments Term deposits or PSIA

- PSIA = Profit Sharing Invetsment Account
=> These are specific to Islamic Finance industry

- Considered as investment accounts under the mudaraba format

=> Islamic banks receive funds from the PSIA holders who place their
funds on the basis of the mudaraba profit and loss sharing bearing account

- Deposits are fixed term and cannot be cashed in before maturity (some
exceptions)
- The profit-sharing ratio varies between institutions and could be a function of
the banks profitability or that of the portfolio of end borrowers
- Can be Restricted or Unrestricted
- Application of equalization reserves

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Islamic Monetary instruments Term deposits or PSIA

- Restricted :
- Like collective investment scheme
- The asset allocation is restricted as set out in the contract
- No secondary market butinvetsors may be able to to withdraw their
funds (including unredistributed profits but less any losses) before
maturity with the agreement of the bank
- The scheme is not a seperate legal entity but operates as a mudaraba
agreement (bank = mudarib and client = rab al mal)
- The bank is entitled to a percentage of the invetsment income for a
financial period as its fee for investment management but does not
share in any periodic losses

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Islamic Monetary instruments Term deposits or PSIA

- Unrestricted :
- The asset allocation is not restricted by contract. The bank as a
mudarib will place the funds in any Sharia compliant investment at its
discretion.

sole

- Less risky than the restricted PSIA as the bank tries to mitigate the
risk by placing money in a basket of Sharia compliant investments
- Lack of transparency
- Corporate governance issue as the funds from the holders are
co- mingled with other funds at the baks disposal => possible conflict
interests with regard to the choice and riskiness of investments and the
allocation of the income from those investments
- Different applications in different countries
Introduction to Islamic Finance
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Islamic Monetary instruments Tawaruq

- Contract whereby the bank sells to

its client a commodity with a forward
payment (also called reversed
murabaha)
- The client sells it immediately to a
third party on spot generating
therewith some cash availabilty
- Usually no exposure on market to
the price risk fluctuation of the
commodity as actions (i) to (iv) are
undertaken simultaneously
Introduction to Islamic Finance
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Islamic Monetary instruments Arbun

- Pre-purchase of right to acquire asset :

- Deposit/down payment for the purchase of an asset at a later date which will be kept
by the seller in case the sale does not happen. This down payment constitues a part of
the purchase price and thus is not refundable.
- Because of its similarity to an option, it has met with varying levels of approval from
the school of islamic jurisprudence
- Usually combined with a murabaha product
- Most acceptable to Hanbali scholars
Introduction to Islamic Finance
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Islamic Debt like instruments

- Murabaha
- Ijara
- Salam
- Istisna

Introduction to Islamic Finance

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Islamic Debt like instruments - Murabaha

- Literally means profit

- Contract where the bank upon request by the customer purchases the asset
from a third party and resells it to the customer on a deferred payment basis
- Sale of goods at cost plus an agreed profit mark up
- Difference between a murabaha and a loan :
-

The bank must have some form of actual ownership constructive or physical
The maturity can be extended but may not result in an increase in the mark-up
or a penelaty fee. Any of these would violate the basic principle riba
If the payment is late, no form of penalty may be charged for the profit of the
creditor (even though a tird party colection agent can recover costs of collection

Introduction to Islamic Finance

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Islamic Debt like instruments - Murabaha

1. Definition of needs and goods

specifications
2. Binding promise to buy which can be

structured using Arbun

3. IB buys the goods at spot from the

seller
4. Spot Delivery of goods to the Bank
5. Spot Delivery of goods to the Client
6. Payment of instalments or deferred

payment at P + margin
=> Profit declared as a mark-up
=> Buyer knows sellers cost

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Islamic Debt like instruments Commodity Murabaha

Introduction to Islamic Finance

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Islamic Debt like instruments Commodity Murabaha

1. Islamic bank instructs the conventional bank as agent to invest say US 10 million for
one month.
2. The conventional bank buys a commodity from a broker A, value spot on behalf of
the Islamic bank.
3. The conventional bank sells the commodity at cost plus mark-up on a deferred
payment basis (one month) to Broker B. Buying and selling is very fast (less market
fluctuation exposure)
4. On maturity (in one month) the conventional bank pays to the Islamic bank profit
(mark up) plus the original investment of US 10 million.
5. Commission will be payable to the conventional bank as agent (approximately 25
basis points) and to the commodity brokers (approximately $50 per 1 million of the
commodity) on buying and selling the commodities. These commissions will be built
into the price quoted to the Islamic bank are not accounted for separately.
6. The mark-up is typically based on the LIBOR as a benchmark which makes these
transactions comparable to traditional interbank deposits.

Introduction to Islamic Finance

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Islamic Debt like instruments Ijara

- literally means to give something on rent.
- Ijara contract is an agreement wherein a lessor (muajjir) leases physical asset or property to a
lessee (mustajir) who receives the benefits associated with ownership of the asset against
payment of predetermined rentals (ujrah). Ijara is for a known time period called ijara period.
- utilized by banks as a mode of financing to provide the customers with short to medium-term
financing to lease
- Ijara is comparable (but not identical) to conventional leasing contract.
- Ijara is less risky as compared to other financing structures
- Liability is known from day one No surprises or uncertain exposure.
- Strict compliance with Sharia and the applicable law is required for enforceability.
Introduction to Islamic Finance
Slide 42

Islamic Debt like instruments Ijara

Customer

Step 5
Lease of the Property
to the customer through
Lease Agreement

Usufruct of the Property

Owner / Developer
Step 1
Promise to
lease

Step 3
Acquisition of the Property
through purchase agreement

Step 4
Purchase Price

Step 6
Lease
Rental
Step 2
Purchase Offer

Title & Possession to

the Property

Islamic Bank

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Islamic Debt like instruments Ijara

Ijara: 3 types
- Simple Ijara (Operating lease)
- Ijara Muntahia Bittamleek (Finance lease)
- Ijara Mawsoofa Bil Thimma (Forward lease)

Simple Ijara :
- Commonly known as operating lease. Also called a service lease, or a true lease.
- It is a short-term arrangement.
- Full cost of the equipment or property is not amortized during the primary lease period.
- Lessee may cancel the lease any time he wishes to do so, with a prior notice according to
the contract.
- In an Ijara, the title of the equipment or property always remains with the lessor
irrespective of how much the lessee has paid out as lease installments. Consequently, the
risks and responsibilities of ownership are always borne by the lessor.
- Ownership of the asset remains with the lessor (bank), the asset reverts to the bank at the
end of the lease period. The bank may then lease it out to another customer if the asset is
in good shape.

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Islamic Debt like instruments Ijara

Ijara Muntahia Bittamleek

- commonly known as financial lease
- Also called Ijara-thumma-al-Bay (lease-sale) or "Ijara-wa-Iktina'a"
- The lessee is offered the option of ultimately purchasing the asset or property at the end
of Ijara period at a predetermined price.
- Full cost of the asset or property is amortized during the lease period.
- Can not be cancelled except if the lessor is compensated for any losses.
- The bank remains the owner till the very end bearing all the risks and responsibilities
- The customer is responsible for only the rentals as long as he uses the equipment or
property. He becomes the owner only if, and when, he exercises his option
- This Ijara involves two different contracts to be executed at two different stages :
First a leasing contract (ijara) with a unilateral promise (waad) to sell the asset to the
customer at a predetermined price.
Once the lease expires and lessee has made all payments, the lessor is obliged to
fulfill his promise to sell by executing the contract of sale (bay)
the sale contract is independent of the ijaracontract.

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Islamic Debt like instruments Ijara

Ijara Mawsoofa Bil Thimma

- Commonly known as 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 lessees obligation to pay rental triggers with the commencement
of the lease.
- An 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 through 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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Islamic Debt like instruments Ijara vs Murabaha

- Ijara, like murabaha is a debt-based financing. In both cases, the bank is not a natural owner of
the asset (sold under murabaha or given in lease under ijara.) It acquires ownership upon
receiving a request from its customer.
- Similar to murabaha, the ijararentals are also paid in installments over time to cover the cost of
the asset or value of investment for the bank plus a fair return on investment.
- In ijara, ownership of property is not transferred throughout the ijaraperiod while the customer
receives the benefits of using the asset.
- In murabaha on the other hand, the benefits and risks of ownership of the asset are transferred
to the customer along with ownership.
- Both products involve cash outflows for customer or cash inflows for the bank over a definite
future time period. Those flows are cover the cost of the asset and provide for a fair return on the
asset to the bank.
- However, these cash flows are predetermined in case of murabaha and no subsequent increase
or decrease is allowed. In case of ijara, however, the rentals could be flexible and be made to
reflect the changing economic and business conditions

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Islamic Debt like instruments Ijara vs Murabaha

Different reasons why a customer will choose ijara(leasing) rather than murabaha
(borrowing) from the bank to purchase the needed asset.
1. It is easier to lease than borrow for short-term needs.
2. To avoid different types of risk
3. Ijara mostly do not require credit evaluation.
4. Gives more freedom of changing equipment as technology advances
5. Easier to get finance through leasing for companies with credit standing; these kinds
of companies may not be able to borrow from banks or the public and if they do, have
to pay high rate of interest.
6. In many cases, leases can be advantageous from taxing point of view. Since
equipment leased remains the ownership of the lessor and hence the lessor pay the
taxes.
7. In many countries, leasing is an off-balance-sheet financing. The asset itself is kept
on the lessor's balance sheet, and the lessee reports only the required rental expense
for use of the asset.
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Islamic Debt like instruments Salam

Purchase or sale of a commodity for deferred delivery in exchange for
immediate payment

Introduction to Islamic Finance

Slide 49

Islamic Debt like instruments Istisna

Customer

Step 5
Sale of the described
Property on Parallel
Istisna basis

Delivery
to the Customer after
at completion

Owner / Developer
Step 1
Promise to
Purchase on
Parallel Istisna
basis

Step 3
Purchase of the described Property
through Istisna Agreement

Step 4
Istisna Purchase Price

Step 6
Parallel Istisna

Purchase
Price

Step 2
Purchase Offer
Delivery of the described
Property after completion

Islamic Bank

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Islamic Debt like instruments Istisna

Agreement for manufacturing goods and commodities, allowing cash payment in

advance and future delivery of the goods and commodities or a future payment and
future delivery

In Istisna sale, the seller sells a described property to be delivered to the purchaser
once the same is completed.

Istisna requires combination of either lease of the purchased assets back to the
seller or sale of the purchased assets to the customer, provided that the purchase is
not from the same customer.

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Islamic Debt like instruments 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 Istisna, the proce may be paid in advance, according to progress or in

instalments post delivery

Under Salam, the price must be paid in advance

Under Salam, the contract may be cancelled

Under Istisna, the contract may be cancelled unilaterally before work starts

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Islamic Equity like instruments

Equity

Mudaraba

Musharaka

Investment in equities is
acceptable if the fund does not
invest in prohibited activities
(industrial screening) and
underlying respect the financial
ratios (financial screening)

Partnership in profit between

Capital and Work

Form of partnership between

the Islamic Bank and its client

Agreement in which the

investor (the rab- al-mal)
provides the necessary finance
while the recipient (mudarib or
manager) provides
professional, managerial and
technical know-how towards
carrying out the venture, trade
or service with an aim of
earning profit

Each party contributes capital

in equal or varying degrees, to
establish a project or share in
an existing one

Purification : For interest on

cash and underlying not 100%
sharia compliant

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Sharia compliant equities

Islamic stocks selection

Islamic stocks selection

(Industry sin screen)

(Financial screen)

Conventional Banking and Insurance

Total Debt / market capitalization < 33%

Alcohol (including distribution)

Interest income / Total revenue < 5%

Pork (complete supply chain)

Account receivables / Total assets < 45%

Weaponry (complete supply chain)

Ratios used by DJIM (Dow Jones

Gambling (Hotels, casinos, )

Adult entertainment (complete supply
chain)

Islamic Market)
FTSE Global Islamic Index use the

following :
Total Debt / Total Asset < 33%

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Mudaraba
Investor (Rab el Mal) :
- invests the capital
- has an absolute right to information
- risks loosing the capital

Expert-Manager (Moudarib) :
- invests expertise
- empowered alone to make business
decisions
- doesnt share financial losses (Looses
time and efforts)
=> Similar to discretionary asset
management
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Slide 55

Two-tiers mudaraba

Introduction to Islamic Finance

Slide 56

Musharaka

Profit sharing and loss sharing contracts

- Capital quantified and specific
- Profit distribution as per contract
- Losses repartition as per share of capital

Musharaka Contract between X and Y:

- X Investment: 80.000 USD
- Y Investment: 20.000 USD
- Profit repartition: X 70%, Y 30%

Project generates 10.000 USD profit :

- X receives: 7.000 USD
- Y receives: 3.000 USD

Project looses 10.000 USD :

- X looses: 8.000 USD
- Y looses: 2.000 USD
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Hybrid Islamic Financial instruments

Sukuk

Structured Product

Sukuk are certificates of equal value

representing common title to shares and rights
in tangible assets, usufructs and services, or
equity of a given project or equity of a special
investment activity

Combination of two or more plain vanilla

products

14 types of sukuk foreseen by AAOIFI

Asset based (90% of issues) vs Asset backed
Asset backed refers to securities/Sukuk backed
by income generating assets sold/transferred
by an originator to a buyer/issuer (usually an
SPV);
The main source of repayment => revenue
from underlying Sukuk assets;

Securitization

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Sukuk (Islamic Bonds)

Saudi Electricity Company (SEC) Sukuk

Sukuk Assets comprise : - the right to undertake the following services for 20 years:
Reading electricity consumption and maintaining meters
Preparing, issuing & distributing electricity bills and the corresponding entitlement to
levy charges according to the applicable regulation (CMR 169).
- and the right to levy and receive the charges relating to them
The instrument is tradable during its life
SEC appointed to continue to manage the services
For certain Specified Customers only (exclude industrial, agricultural and
governmental customers)

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Sukuk (Islamic Bonds)

Introduction to Islamic Finance

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Takaful (Islamic insurance)

Takaful literally means guaranteeing each other
Sharia compliant alternative to conventional insurance
Can be thought of as a mutual insurer within a shareholder wrapper i.e. the shareholders
operate the company on behalf of the policyholder and any insurance surplus is distributed
back to the policyholders
Based on solidarity, co-operation & mutuality
Products are broadly similar to conventional insurance
Free of uncertainty (gharar), gambling (maisir) and interest (riba)
Investments must be Sharia compliant (Sukuk bonds, collective investment schemes etc)
In theory and in practice in the more mature Islamic Finance economies, it is price
competitive with equivalent conventional products
Insurance deficit will be financed with Qard Hassan (interest free loan)
The interest free loan will be paid as soon as surpluses arise
Introduction to Islamic Finance
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Takaful (Islamic insurance)

Takaful Company

Conventional Insurance

Contributions

Premiums

Investment
Income

Capital & Reserves

Investment
Income

Fees & Loan

S/H Fund
Capital

Claims

Expenses Reinsurance

Expenses

P/H (or Takaful)

Fund
Reserves

Claims

ReTakaful

Introduction to Islamic Finance

PricewaterhouseCoopers
Slide 62

Legal & Tax structures

Overview of Islamic Funds industry

Introduction to Islamic Finance

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Accounting, auditing, reporting and compliance principles

AAOIFI Introduction
AAOIFI & IFRS - Comparison on structural objectives
AAOIFI & IFRS - Categories of accounting standards for IFIs
AAOIFI & IFRS - Examples of main differences
Adoption of AAOIFI Standards
How AAOIFI Standards support Islamic Finance Industry
Compliance and reporting requirements

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AAOIFI - Introduction
- Responsible for formulation and issuance of international Islamic finance standards.
- Has issued 68 standards :

25 accounting standards;
5 auditing standards;
6 governance standards (incl. on Sharia supervision);
2 codes of ethics;
30 Sharia standards (rules for application of Sharia).

- Also developing new standards and reviewing existing standards.

- Supported by over 170 institutional members from over 35 countries.
- Members include central banks and regulatory authorities; Islamic and conventional financial
institutions; accounting and auditing professions; and Islamic financial support services providers.

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AAOIFI & IFRS - Comparison on structural objectives

Introduction to Islamic Finance

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AAOIFI & IFRS Categories of standards for IFIs

1. AAOIFI standards issued because IFRS / IASB standards cannot be
adopted in whole by Islamic financial institutions (IFIs)
=> Cases where application of IFRS / IASB standards leads to Sharia compliance issuesdo not
fully cover characteristics of Islamic banking and finance.
=> AAOIFIs FAS 1 (General Presentation and Disclosure in Financial Statements of IFIs) covers
IAS 1 (Presentation), 7 (Cash Flow), 18 (Revenue), etc.

2. AAOIFI standards issued for specific Islamic banking and finance practices
that are not covered by IFRS / IASB standards
=> Financial transactions and practices are unique to Islamic banking and finance
=> AAOIFIs FAS 2 (Murabaha & Murabaha to the Purchase Orderer), FAS 7 (Salam & Parallel
Salam).

3. IFRS / IASB standards that can be adopted by IFIs

=>IAS 10 (Events after Balance Sheet Dates), IAS 24 (Related Party Disclosures).
Introduction to Islamic Finance
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AAOIFI & IFRS Example of main differences

PSIA (Profit Sharing Investment Account) :
- IFIs major source of funds generally managed by IFI based on Mudarabainvestment management profitsharing agreement.
- Under Mudarabainvestment management, IFI is not liable for loss arising from investments (except due to
IFIs misconduct, negligence, etc) based on AAOIFI Sharia standard.
- AAOIFI accounting standards require unrestricted investment account funds to be presented in statement of
financial position as a separate item between liabilities and owners equity.
- In contrast, based on IFRS, these would be presented as liabilities (along with other deposits).

IJARA (Leasing) :
- IFIs major financing mechanisms : Operating Ijarahand IjarahMuntahiaBittamleek(leasing that ends with
transfer of asset ownership to lessee).
- For both, asset ownership rests with IFI throughout the lease term.
- In IjarahMuntahiaBittamleek, there must be independent contract for transfer of asset ownership.
- As per AAOIFI accounting standards both Operations needs to be treated similar to Operating Lease.
- In contrast, based on IFRS, both operations (especially if lease term is for major part of economic life of lease
asset) would normally be classified and treated as Finance Lease.

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Adoption of AAOIFI standards

AAOIFI standards are mandatory in 9 jurisdictions (and supranational entity) :

Bahrain,DubaiInternationalFinancialCentre,Jordan,Qatar,QatarFinancialCentre,
Sudan,SouthAfrica(forinvestmentmanagement),Syria,andIslamicDevelopment
BankGroup.

AAOIFI standards are also adopted as guidelines or basis for national

standards in jurisdictions including :
Brunei,Indonesia,Kuwait,Lebanon,Malaysia,Pakistan,SaudiArabia,andUnitedArab
Emirates.

Overall, AAOIFI standards are used by all IFIs across the world.

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How AAOIFI standards support Islamic Finance industry

Introduction to Islamic Finance

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AAOIFI standards challenges and issues

- Global adoption of AAOIFI standards
In some countries, the standards are adopted in entirety and made mandatory by relevant national
authorities.
In others, they are adopted as basis of local standards issued by national authorities.
Adopted in all major Islamic finance centres.
Challenges in achieving global adoption include prohibitive local framework and differing Islamic
finance practices.

- Application of Sharia standards

Some jurisdictions do not have national framework for Sharia application on Islamic finance practices.
AAOIFI Sharia standards are for Islamic finance practices that have been accepted internationally.
Diversity in Islamic finance practices means there are practices that have not been covered by AAOIFI
Sharia standards.

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AAOIFI standards challenges and issues (continued)

- Adequacy of AAOIFI standards
AAOIFI has to keep up with new products and services introduced in the markets.
Development of standards depends on Sharia pronouncement for such products and services.
Meanwhile, existing standards must be constantly reviewed to reflect market development.

- Scope of AAOIFI standards

AAOIFI standards are only for Islamic financial institutions.
AAOIFI standards are not designed for adoption by customers of Islamic financial institutions.
Development of general Islamic accounting standard requires broadening of role and mandate of
AAOIFI.

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Compliance and reporting requirements

- Interest bearing cash or investments are not authorized

- In case of interests earned, this will be purified in the cleansing process
- No overdraft on cash. In case of Interests, these will be compensated to the fund by originator.
- Islamic stocks selection :

- Industrial screening (sectors prohibited)

- Financial screening (debt leverage ratios)

-Non compliant stocks :

- Fluctuation of financial data

- Evolution of the global financial market
- Mergers and acquisitions
- Temporary non-compliance => Stocks remain within the stocks universe
- Short-term non-compliance => The dividends for the period are not distributed
- Permanent non-compliance => Disinvestment occurs

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Compliance and reporting requirements (continued)

- Signed Sharia Board report needs to be included in the financial statemens to be compliant with
AAOIFI standards
- Cleasing to be performed :
- Purification of interest received (on overdrafts)
- Purification non-compliant portion of dividend income received (calculated using financial
ratios data
- Can be linked to partial non compliant activities of underlying companies
- Information obtained from third party or already included in sharia compliant indexes
- Calculation process should be reviewed by Sharia Board

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Slide 74

Thank you
Rachid Ouaich
e-mail: r.ouaich@eurx.lu
phone: +352 691 27 62 42

November 2012