an introduction to islamic finance i.pdf
TRANSCRIPT
1
ISLAMIC FINANCE AND BANKING: CHALLENGES AND
OPPORTUNITIES
Lecture Outline
2
1. Overview of Islamic Finance
2. Islamic Shariah and Contracts
3. Important Islamic Financial Contracts
4. Models of Islamic Banks
5. Global Financial Crisis and Islamic Financial
Solution
6. A Case Study of Financial Murabaha
7. A Case Study of Legal Stratagem: Tawarruq
8. A Case Study of Sukuk
9. Risk and Regulation of Islamic Financial
Industry
3
ISLAMIC SHARIAH AND CONTRACTS
Islamic Sharia’a: An overview
4
Islam as a ‘complete code of life’ encompasses every aspect of human life. It provides directives as to how economic and financial activities should operate based on moral and just economic system. The source of Islamic morality stems from Sharia’a. The following diagram shows the position of banking and financial activities within the framework of Islamic Sharia'a.
Islam
Aqidah
(Faith & Belief)
Sharia’a
(Practices & activities)
Ibadah
(Man-to-God worship)
Muamalat
(Man-to-man activities)
Political
Activities
Economic
Activities
Other Economic
Activities
Banking & Financial
Activities
Social
Activities
Akhlaq
(Moralities & Ethics
Islamic Worldview
The essence of Islam is tawhid—oneness and sovereignty of God
(Allah)
Has many implications
Allah is the only source of value
Humans are created equal
Resources are trust from Allah
Humans are vicegerents (khalifah)
Humans have free-will
Muslim—submission to the Will of God
Will of God—expressed in revelation 5
Sources of Islamic knowledge
Two sources of knowledge in Islam
Revealed knowledge (Shari’ah)
Quran
Hadith/Sunnah (Sayings/traditions of the Prophet)
Derived knowledge (Fiqh)—through ijtihad (exertion)
Al-Qiyas (analogy)
Ijma (consensus)
Etc.
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7
Sources of Law for Transactions
Two sources of law in Islam
Shariah—Revealed knowledge
Quran –Recited
Hadith/Sunnah—Un-recited
Fiqh– Derived knowledge through ijtihad (exertion)
Ijma (consensus)
Al-Qiyas (analogy)
8
Basic Approach to Islamic Law
Islamic laws can be broadly classified into two types
Ibadat (devotional acts) – Any worship which is not legalized by Shariah is void
Muamalat (dealings or transactions)—Transactions are permitted unless prohibited by Islamic law (principle of permissibility)
In muamalat, new transactions can be accommodated through ijtihad as long as they do not contain the prohibited (riba and gharar)
9
Documentation of contracts in Islam
Islamic perspective for transaction involving time: “O you who belief! When you contract a debt for a fixed period, write it down. Let a scribe write it down in justice between you. Let not the scribe refuse to write as Allah has taught him, so let him write. …You should not be weary to write it (your contract), whether it be small or big, for its fixed term, that is more just with Allah; more solid as evidence, and more convenient to prevent doubts among yourselves, save when it is present trade which you carry out on the spot amongst yourselves, then there is no sin on you if you do not write it down. But take witnesses whenever you make a commercial contract. …” (Quran 2:282)
10
Essential Features of Islamic Contracts Contract can be created by mutual agreement
Contract (aqd)—an engagement and agreement between two persons in a legally accepted, impactful, binding manner
Basic elements of a contract—offer (ijab) and acceptance (qabul) at free will
Contractual agreements outlines the rights and duties of various parties in a transaction
Difference between a promise and contract Moral obligation vs moral and legal obligation
Islamic Fiqh Academy Resolution on promise
11
Contracts-Islamic Nature Freedom of contracts—provide the prohibited
elements are avoided
Some aspects of the contractual relationship determined by Shari’ah/Fiqh to avoid Injustice
Conflicts
Exploitation
Among others the following must be avoided in financial contracts Riba
Gharar
RIBA
1. Riba
– Literally means extra
– Two types: Al-Nasiah & Al-Fadl
– Prohibition – in 4 stages. Final verse:
“Oh you who believe! Be afraid of Allah and give up
what remains from Riba if you are believers. And if
you do no do it, then take a notice of war form Allah
and His messenger…” (2: 278-279)
13
Types of Riba Riba al Fadl:
If there is exchange among the same specie of the ribawi goods, it has to be done on spot and should be of equal amounts.
If the amounts exchanged are different then it will be riba al fadl.
Riba al Nasiah Root word nasaa meaning to postpone—refers to the
delayed payment riba. When there is exchange of the same specie over a period of time, the amount exchanged has to be the same (qard hasan)
If an excess is paid over the amount this will lead to riba al nasiah.
Riba Al-Nasiah…
Riba in loan contracts:
– Give out loan (principal sum)
– Repayment include additional amount because of
delay in payment
This is the riba prohibited in Al-Qur’an
A.k.a. Riba al-Duyun, Riba Al-Jahiliyyah
Riba Al-Fadl
Riba in exchange contracts
Based on the saying of the Prophet:
“Gold for gold, silver for silver, wheat for wheat,
barley for barley, dates for dates and salt for
salt – like for like, equal for equal and hand to
hand. If the commodities differ, then you may
sell as you wish, provided that the exchange is
hand to hand” (Muslim, Kitab al-Musaqat)
Summary of Riba Al-Fadl
Type Function Rule Example
Same Same •Equal amount
•Spot
•Gold – gold
•Dates – dates
Quality does not play a role
Different Same •Spot •Gold – silver
•Barley – dates
•USD – RM
Different Different •Free to trade •Gold – wheat
•RM - goods
The six commodities could be divided into two categories:
1. Currency – gold and silver
2. Staple food – wheat, barley, dates, salt
Implication from prohibition of riba
Riba Al-Nasiah
– financing using loan contracts?
– No extra is allowed
Riba Al-Fadl
– Currency exchange – must be spot transaction
– No forward currency transactions
Usage of Money
To help
Guarantee, No extra
Loan
Guarantee
No extra
Saving
Extra
No guarantee
Invest
The Riba Equation
Extra Gua. Riba
20
What is Gharar?
Gharar–Excessive risk, hazard, or ambiguity
Rulings from hadith
Four conditions should exist in a transaction for gharar to have legal consequences
Uncertainty has to be excessive
Has to occur in exchange contracts
Has to concern the subject matter of the contract itself (not something attached to it)
Should not fall in the public need category
21
Types of Gharar Gharar can exist in the essence or terms of
the contract
Uncertainty of whether something will take place or not and the consequences of a transaction are not clear
Two Sales in One
The Toss Sale
Suspended/conditional Sale
The Future Sale
22
Types of Gharar
Gharar can exist in the object of the contract
Subject matter of sale
Ignorance of the Attributes/Properties of the Object
Ignorance of the Quantity sold
Existence of the Object and the Ability to Deliver
Price of the Good
Ignorance of delivery time
23
Implications of Islamic Principles
1. Selling debt (at discount)—riba
2. Futures/Options—gharar
24
IMPORTANT ISLAMIC FINANCIAL CONTRACTS
25
Major Islamic Contracts used in Financing
1. Partnerships – musharakah or mudarabah
2. Sale (Exchange) Contracts 1. Deferred trading contracts
1. Price deferred sale (murabahah)
2. Object deferred sale (salam, istisna)
2. Leasing-sale of usufructs (ijarah)
3. Grants—interest free loans (qard hassan) or loans at service charges
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Murabahah
1. The financial institution buys and then sells the good to the client at a mark-up
2. Price paid at a later date
3. The bank must own and posses the good
4. The profit rate and other terms should be clearly specified in the contract
5. The bank can ask for guarantees or collateral
6. Murabahah bills of trade cannot be traded (at discount)
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Salam 1. A pre-production sale of goods—selling
goods in advance
2. Can be used for homogenous goods
3. Used to finance the agricultural sector
4. The price has to be fixed and paid when the contract is concluded
5. Goods delivered at a later date
6. The delivery time should be fixed
7. Parallel salam
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Istisna
1. A pre-production sale used when an item/asset needs to be manufactured/constructed
2. The price of the good should be known and time of payment can be negotiated among the parties
3. The seller of the good (bank) can either manufacture it or sub-contract it—parallel istisna
4. The bank, however, liable for the goods delivered
29
Ijarah
1. A leasing contract involving sale of usufructs of durable assets/goods
2. Ownership of the asset is not transferred to the lessee
3. The asset can be transferred to a third party
4. The maintenance costs can be paid by the lessee if included in the contract, but costs of total damage of asset is borne by owner
5. The lessee can sub-lease the asset to third party unless explicitly prohibited in the contract
(Similar to operating lease)
30
Ijarah wa Iqtina
1. A hire-purchase leasing contract—ownership is transferred to lessee at the end of the contract period
2. Fiqhi objections—two contracts in one; purchase contract cannot be binding
3. Banks give away the asset at nominal value or as a gift at the end of the lease period
(Similar to financial lease)
31
Mudarabah
1. A form of partnership—one party supplies the capital (rab-ul mal) other manages (mudarib)
2. Profit shared among parties at an agreed upon ratio
3. Loss borne by financier only
4. Financier cannot ask for a guarantee of capital or return
5. Mudarabah can be restricted or unrestricted
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Musharakah
1. A partnership contract in which all partners contribute capital and labor
2. Like a mudarahah, but all partners manage the project
3. The profit share among the partners at an agreed upon ratio
4. Loss shared according to share of capital
Murabahah
Financing Mode in Islamic Banks—Debt
The financial institution buys and then sells a good to the client at a mark-up
Price paid at a later date
The bank must own and posses the good
The profit rate and other terms should be clearly specified in the contract
The bank can ask for guarantees or collateral
Productspot
Pricefuture
Traditional Murabahah/Bai al-Muajjal
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Salam
Financing Mode in Islamic Banks—Debt
Used to finance the agricultural sector
The price has to be fixed and paid when the contract is concluded
Commodities delivered at a later date
The delivery time should be fixed
Pricespot
Commoditiesfuture
Traditional Salam
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Istisna
Financing Mode in Islamic Banks—Debt
A pre-production sale used when an item/asset needs to be
manufactured/constructed
The price of the asset should be known and time of payment can
be negotiated among the parties
The seller of the asset (bank) can either manufacture it or sub-
contract it
Paymentinstallments
Assetfuture
Traditional Istisna
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Ijarah
Financing Mode in Islamic Banks—Leasing
A hire-purchase leasing contract
Ownership is transferred to lessee at the end of the contract period
Banks give away the asset at nominal value or as a gift at the end of the lease period
Asset (for rent)fixed period
Rental Payments
Traditional Ijarah
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Mudarabah
Financing Mode in Islamic Banks—Equity
Partnership between bank and clients
Used on the liability and asset sides
Profit shared among parties at an agreed upon ratio
Loss borne by financier only
Financier cannot ask for a guarantee of capital or return
Mudarabah can be restricted or unrestricted
Fundsspot Service/labour
Profit sharefuture Profit sharefuture
Traditional Mudarabah
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Musharakah
Financing Mode in Islamic Banks—Equity
A partnership contract in which bank contributes capital and managerial services
Like a mudarahah, but all partners manage the project
The profit share among the partners at an agreed upon ratio
Loss shared according to share of capital
Funds & labour Funds & labour
Profit sharefuture Profit sharefuture
Traditional Musharakah
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39
ISLAMIC BANKING MODELS
Operational Models of Islamic Banks
40
The global development of Islamic financial institutions has taken various organizational forms and types according to the needs of the Islamic financial communities in each country.
Some countries have adopted a dual-banking system, where conventional financial institutions operate alongside fully-fledged Islamic financial institutions. Example, Bangladesh and Malaysia.
Other countries have introduced a totally Islamic financial system, where only Islamic financial institutions are allowed to operate. Example, Iran.
A further group of countries has decided that Islamic financial activities can be carried out only by fully-fledged Islamic financial institutions which have to be established alongside the conventional ones not allowed to offer islamic services (in the case of Kuwait and Lebanon).
The evolution of the global Islamic banking and finance industry is being continually refined in each country.
Operational Models of Islamic Banks
41
The Windows Model
This refers to the operating structure where a conventional bank simultaneously
carries out Islamic financial activities. Under this structure, the bank assure clients
of segregated accounting and operations for conventional and Islamic activities.
Branches
Under this structure, the Islamic financial services are offered through dedicated
service delivery channels. For example, a conventional bank sets up a number of
branches that offer only Islamic financial services.
Subsidiaries
This refers to the operating structure where a separate legal entity (a subsidiary),
owned by a conventional bank or other financial institution (a parent), is set up
specifically to undertake Islamic financial services activities.
Fully-fledged Banks
Fully-fledged Islamic banks are set up to participate solely with Islamic financial
services, offered through their own service delivery channels.
Support Institutions for Islamic Banking Industry
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• Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI)
• The International Islamic Financial Market (IIFM)
• The International Islamic Rating Agency (IIRA)
• The Islamic Financial Services Board (IFSB)
• The Islamic Research and Training Institute (IRTI),
• The General Council for Islamic Banks and Financial Institutions (GCIBFI)
43
Ideal Islamic Banking Model
Two-tier mudarabah model
–Profit-loss sharing modes of financing on both the asset and liability
side
Liabilities and Equity Assets
Profit-sharing investment accounts (PSIA-Mudarabah based)
Demand Deposits (qard hasan)
Capital
Mudarabah/musharakah financing
44
Features of Ideal IB Model
PLS (risk-sharing) assets would imply robust investments leading to economic growth
–Choosing projects that make good economic sense
–Monitoring of the investments closely
–Equity financing usually long-term
Sharing risks of assets by the liability side makes the bank more stable
–Losses covered by PSIA and capital
45
Islamic Banking in Practice
Some Islamic banks started with PLS financing modes
Risks of equity-financing different from that of debt-
financing
Banks lost money
Resorted to modes that had lower risks
Started using fixed-income debt instruments
–Murabahah
–Ijarah
46
Islamic Banking Practice: 2nd Best Model
One-tier Mudarabah with Multiple Investment Tools Liability Side—PSIA (Mudarabah based)
Asset Side—multiple investment tools, dominated by fixed-income contracts (murabahah, ijarah, istisna, etc.)
Liabilities and Equity Assets
PSIA-Mudarabah based
Demand Deposits (Qard hasan)
Capital
Reserves
Murabahah
Ijarah
Istisna
Mudarabah/Musharakah, etc.
47
Other Features of 2nd Best Model
PSIA—profit-rate smoothing
–Profit Equalizing Reserves (PER)-amount deducted from gross income
to smooth PSIA returns
–Investment Risk Reserves (IRR)-amount deducted from the income of
PSIA depositors (after deduction of bank’s share) to meet losses on
investments financed by PSIA
Penalties
–Penalties charged on late payments and defaults
–Most Shari’ah scholars do not approve this, but used to discipline
delinquencies
–Funds collected given to charities
48
Tawarruq
Tawarruq—monetization
1. A buys a commodity on deferred payment from B
2. A then sells the commodity to C spot to get cash
Allowed by a minority of the Scholars (in the Hanbali and
Hanafi schools)
1
2
3 B
A C
49
Organized Tawarruq
The client wants a personal loan and approaches the bank
1. Bank buys commodity from a broker paying spot (for £100)
2. Bank sells the commodity to client payable at a future date (for £110)
3. The client sells commodity to broker spot (for £100)
[The client appoints the bank as agent to sell the commodity. The bank sells the commodity spot to the broker for £100 on behalf of the client and deposits the money in his account.]
At the end of the transaction, the client walks away with £100 and owes the bank £110 payable in the future
[Bai al’Inah: No third party involved—bank and client do the selling and buy-back]
1
2
3 Bank Client
Broker
THE CHRONOLOGY OF THE DEBATE OVER TAWARRUQ
OIC FIQH ACADEMY
*Permissible: *Condition: -The customer not sell the commodity to its original seller
*Two types of Tawarruq:
* Banned the application of organized tawarruq: Explicitly?
Implicitly? Common practice?
Financier
Mustawriq
Transaction
Three rulings on the matter:
Tawarruq Fiqhi/ Haqiqi
(Real Tawarruq)
Tawarruq Munazzam/ Masrafi
(Organized Tawarruq)
15th (1998)
17th (2003)
19th (2009)
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OIC Fiqh Academy: 17th Session
TAWARRUQ
Tawarruq Fiqhi/ Haqiqi (Real Tawarruq)
Tawarruq Munazzam/ Masrafi (Organized Tawarruq)
Violations of Shariah Principles: 1) Issues pertaining to commodities
(السلع) 2) Issues pertaining to possession &
delivery ( القبض والتسليم) 3) Issues pertaining to Bay’ al-’Inah 4) Issues pertaining to agency
(التوكيل) 5) Issues pertaining toTawaatu’ (تواطؤ)
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AL-ZUHAYLI: The subject matter must meet all the specifications & conditions of
good commodities
VALID
AL-QURADAGHI: Spoiled commodities are used in modern
organized tawarruq
Issues Pertaining to Commodities ( السلع)
Broker Bank
‘Junk’ (10 years stored)
ABU GHUDDAH: Lack of proper monitoring
Redundancy of commodities
52
Issues Pertaining to Possession & Delivery
( القبض والتسليم)
Seller Buyer
INVALID SALE (Bay’ fasid)
Seller 1 Buyer 1
Customer (constructive possession)
US $10,000
US $ 8,000 Netting
arrangement
Nett off
53
Issues Pertaining to Bay’ al-’Inah
AAOIFI, 2008: Shariah Standard No.30, Article 4/5: “ The commodity (object of tawarruq) must be sold to a party other than the one from whom it was purchased on a deferred-payment basis ( a third party) so as to avoid ‘inah, which is strictly prohibited. More over, the commodity should not return back to the seller by virtue of prior agreement or collusion between the two parties, or according to custom
Seller Buyer
3rd party
Sell
Bu
y Sell
54
Issues Pertaining to Agency
(التوكيل)
Market Bank/Agent Client
3rd Party
Buy
Buy (delayed price)
Sell
Sell
Organized tawarruq AAOIFI, Article 4/7-4/10
Requirement: 1) The bank or its agent
should not sell the commodity on the customer’s behalf if the customer initially bought that commodity from the bank; neither should the bank arrange a proxy third party to sell this commodity
2) Instead, the client should sell the commodity either himself or through his own agent. At the most, the bank should provide the client the information needed to sell the commodity.
55
56
Implications of Tawarruq
Tawarruq and Gresham’s Law (bad money drives away good money)
Tawarruq is driving all other modes away
Tawarruq replicates a loan transaction
The result—third best model of Islamic banking
57
Islamic Banking Practice: 3rd Best Model
Fixed Liability with Multiple Investment Tools Liability Side—Fixed-income investment accounts (using tawarruq)
Asset Side has multiple investment tools, dominated by fixed-income contracts (tawarruq, murabahah, ijarah, istisna, etc.)
Liabilities and Equity Assets
Fixed income investment accounts (tawarruq)
Demand Deposits (Qard hasan)
Capital
Reserves
Cash Tawarruq Murabahah Ijarah Istisna Mudarabah/Musharakah, etc.
58
Other Features of 3rd Best Model
Assets side
–Initially different modes used for different purposes
–Durables—murabahah, ijarah
–Agriculture—salam
–Real estate construction-istisna
–Tawarruq can replace all of the above (similar to a loan)
Liability side
–Fixed-income investment accounts replaced PSIA
No link between return on assets and liabilities
–Stability argument weakened
59
Islamic Modes of Financing
UAE Bahrain Pakistan Sudan Modes
49.29 51.73 50.96 42.45 Murabahah
2.59 0.89 2.52 17.77 Musharakah
4.36 1.96 - 3.10 Mudarabah
18.90 5.56 20.41 0.87 Ijarah
3.22 0.63 - 0.95 Istisna
- - 0.23 0.55 Salam
21.65 39.23 25.88 34.31 Others (RE, bai-
muajjal, Invest., etc,)
Source: 2007 Islamic Finance Directory, Gen. Council for Islamic Banks & Fin. Institutions
60
Islamic Modes of Financing
Saudi Arabia
Jordan Malaysia Iran Modes
15.81 15.41 41.04 21.02 Murabahah
0.65 2.99 0.24 0.97 Musharakah
0.05 11.36 0.27 1.51 Mudarabah
0.04 13.80 9.40 2.18 Ijarah
3.74 1.20 1.72 0.07 Istisna
- - - 0.03 Salam
79.71 55.25 47.33 74.22 Others (RE, bai-
muajjal, Invest., etc,)
Source: 2007 Islamic Finance Directory, Gen. Council for Islamic Banks & Fin. Institutions
61
GLOBAL FINANCIAL CRISIS AND ISLAMIC FINANCE SOLUTION
Interesting Facts
62
The Median house price increased 4 times during 1980-2007
Stock Index increased from 803 in 1982 to 14,115 in 2007
US Savings declined from 11% in 1980 to less than 1% in 2007
Debt servicing increased to 35% in 2007
An average American gained about 20 Ibs in the last 20 years
The US obesity was 15% in the 70s and it is 33% now
Interesting Fact
63
In the 1980s, only two states (Nevada and New Jersey) had casinos,
now 12 states has casinos and 48 states legalized betting
In 1980, the US credit market debt was equal to US GDP
In 2007, it had risen to 350 times of US GDP
In 2007, CDS-45.5 trillion; US stock market 21.9 trillion; mortgage security market-7.1 trillion; US treasury market-4.4 trillion
In contrast, the US GDP in 2007 was 13.4 trillion.
Causes of the US Subprime Mortgage Crisis
64
CAUSES FOR FINANCIAL CRISIS
The causes of the current crisis can be traced to
three levels:
–Regulatory
–Organizational
–Products
65
Regulatory Environment
Financial Institutions operated in a deregulated environment
–Fed—Emphasis on self-regulation
–1999—Gramm-Leach-Bliley Act (repeal of Glass-Steagall Act)
–2004—SEC loosened capital requirements for 5 large investment banks
(MerL, LehB, GolS, MorS, BeaS) – Increased leverage (BeaS had debt/equity ratio of 33:1)
–Resistance to control OTC derivatives market
–Basel II—Market based risk assessment and capital requirements
66
Organizational Failures
Lax Risk Management Practices
–High Leverage (low capitalization)
–Transferring risk—Excessive risk taking
–Creating newer risks (not well understood)
–Under-pricing of risks
67
Product Level
Innovations:
–Securitization and sale of debt
–Creation of complex and opaque financial instruments (derivatives)
–Hedging (risk transfer)
–Speculation
Changed financial structure
–Sources of funds of banks moved from depositors to capital markets
(securitization)
–A complex network of inter-relationships
–Created systemic risks not well-understood
68
Making of the Crisis
1. Driven by excessive profit-motives, banks/financial institutions engaged in sub-prime lending (with adjustable interest rates)
2. Loans packaged as Mortgage Backed Securities (MBS)/Collateralized Debt Obligations (CDO)
• 55% of the $10.2 trillion loans securitized (end 2006)
• 12-15% of securitized loans were sub-prime
3. Rating Agencies gave positive ratings to these securities (to get more business and collect fees)
69
Making of the Crisis
4. Investors (banks, hedge and pension funds, municipalities, schools, etc.) acquired these securities
5. Investors/speculators bought Credit Default Swaps (CDS) to hedge credit risks on MBS/CDO
• Notional amounts of OTC Derivatives in 2007 $596 trillion, CDS $58 trillion (US GDP $13.8 trillion)
6. Issuers of CDS (Investment banks & Insurance companies) took on the risk of default
70
From Defaults to Economic Meltdown
Interest rates began to rise (1% to 5.25% between 2004-2006)
Adjustable rate subprime loans started to default
Holders of MBS/CDO incurred losses
Prices of CDOs fell
Issuers of CDS had to pay-off the losses caused by default
Losses caused depletion of capital of FIs
Scramble to get funds Money market froze (as lenders did not know the risks involved)
Lack of financing caused housing market to crumple—further decreasing housing (CDO) prices and increasing market risks
Credit risks, market risks, and liquidity risks produced systemic risks
Vicious cycle of deleveraging and economic downturn
71
Locating Finance in Islam
Ethics related to financial activities
Prohibitions (fraud, hoarding, exploitation of need, gambling, etc.)
Obligations & Recommended (charity, honesty, interest-free loans, risk sharing, etc.)
Laws governing economic/financial activities
Principle of permissibility: All transactions are permitted expect what is explicitly prohibited by Islamic law
Prohibitions are riba and gharar
72
Key Intrinsic Principles of the Islamic Financial System
73
Islamic Financial Principles and Crisis
Islamic principles:
Using risk-sharing instruments—more monitoring
Prohibition of selling of debt (CDOs)
Prohibition on derivatives (CDSs)
Prohibition on short-selling—limiting betting on downside risks
If Islamic principles were followed, the crisis would not
have taken place the way it did
74
Crisis and Islamic Finance:
Ethical and Legal Dimensions Conventional
1. Banks/financial institutions engaged in sub-prime lending
2. Loans packaged as MBS/CDO
3. Rating Agencies gave positive ratings to these securities
4. Investors/speculators bought securities
5. Credit Default Swaps (CDS) to hedge/speculate on credit risks
Islamic
1. [Risk–sharing modes preferred] [Excessive greed discouraged]
2. Selling of debt prohibited
3. [Dishonesty discouraged]
4. -
5. Derivatives prohibited [Speculation discouraged]
75
Financial Crisis: Lessons for Islamic Finance
Key elements of the crisis from risk perspectives are
–De-regulated environment
–FIs seeking higher rates of profit (excessive risk taking
and leverage)
–Using innovative complex instruments
If Islamic finance follows the same path, can it end up in
the same situation?
76
Status and Practice of Islamic Finance
Regulatory: IF regulatory environment in elementary stages and still evolving
Organizational: Excessive profit/risk-taking—difficult to impose moral order
–Episodes of speculation observed in the Gulf states
Products: Innovations mimicking conventional products
–Fixed income assets—No risk-sharing
–Sukuk – Risk transfer through securitization
– Do investors have control over assets?
–Return-swap – Returns on assets can be swapped with return on any class of assets (including sub-prime
CDOs)
– Capital efficient solutions?
77
Crisis: Lessons for Islamic Finance
Markets/banks cannot be left to regulate themselves
Regulators have to address risks arising at systemic,
organizational and product levels
IF has principles at product level that could have prevented
the crisis
Shari’ah principles do not have anything specific to say
about systemic and organizational aspects of the crisis
78
Crisis: Lessons for Islamic Finance
Products developed are diluting the principles
Regulations must include three features
–Minimizing Systemic Risks
–Strengthening Organizational RM Regimes
–Products Regulation
79
Regulations and Support Systems to Minimize Systemic Risks
Until now, the focus has been on regulating individual
institutions
Need to minimize systemic risks—oversee the system as a
whole
–Regulate all FIs—understand the inter-linkages
–Separation of commercial and investment banking
–Reformation and accountability of Rating Agencies
–Sound Liquidity Framework to minimize liquidity risks—
Takaful Fund to be used in case of crisis
80
Regulations: Strengthening Organizational
RM Regimes
Capital Requirements—understand the risks of Islamic financial products
Introduce prudent risk management culture and practices in IFIs
– Prevent excessive risk-taking by setting investment criteria
– Impose restrictions on excessive leveraging
– Require more transparency and accountability
– Enhance transparency and information disclosure
– Ensure maintenance of credit standards at all times
81
Product Regulation
Products determine the nature and direction of industry
Shari’ah Boards play a key role in approving the appropriate products
–Products approved at organizational level taking the industry closer to conventional
Shari’ah Board at the national level
–Approve and monitor Islamic products
–Provide Shari’ah governance guidelines
–Reduce Shari’ah compliance and reputational risks
82
83
A CASE STUDY: HOW FINANCIAL MURABAHA EVOLVED
A Case Study: How Financial Murabaha evolved
84
Murabaha: Islamic Classical Standard
Murabaha: Modern Standard
Murabaha: Islamic Banking Practice
Risk Mitagation in Financial Murabaha
MURABAHA:
Islamic Classical Standard
85
BANK
Client/customer
3rd party
1. order
2. purchase
deliver
4. pay 3. sell
MURABAHA:
Modern standard
86
BANK
Client/customer
3rd party
1. order
2. purchase
deliver
4. pay 3. sell
MURABAHA:
Islamic Banking practice
87
1a. authorize
5. Pay installment 4. sell
Client/customer
BANK 3rd party
1. Order
2. purchase
3. delivery
Financial Murabahah
88
The financial institution buys and then sells the
good to the client at a mark-up
The bank must own and posses the good
The profit rate and other terms should be clearly
specified in the contract
The bank can ask for guarantees or collateral
Murabahah-basic features
89
1. Murabahah is a sale contract
2. The seller reveals the actual price of the asset/good
being sold and indicates the profit in lump-sum or as a
percentage
3. Delivery of the asset/good is spot, payment can be spot
or deferred
4. Bai-muajjal is a sale with spot delivery and deferred
payment
Murabahah as Financing Mode
90
As financial intermediaries, banks use
murabahah as financing mode (Purchase order
murabahah or financial murabahah)
Financial murabahah is a combination of
contracts
Financial Murabahah
91
Financial murabahah has the following elements:
1. Promise Agreement: The bank and the client signs and overall
agreement of the promise to buy/sell
2. Agency Agreement: The bank appoints the client as an agent to
purchase the good/asset
3. Purchase of the Good from the Supplier: The client buys the good and takes possession as a agent
4. Offer of Purchase: The client offers to buy the good from the bank
5. Acceptance of the Offer: The ownership of the good transferred from the bank to the client
6. Debt created: Payment due at future date(s)
Points to note
92
The commodity cannot be bought from the client
If the bank purchases, the agency contract not needed
• In such cases, two separate contracts (for supplier and buyer) and the purchase has to be before sale
Bills of trade resulting from transaction can be transferred at face-value only
Risks in Financial Murabahah
93
Pre-Sale Risks
Loss/damage of the good before delivery
Refusal of the buyer to take delivery
Market (price) risk
Post Sale Risks
Latent defects in goods
Settlement (credit) risk
Market (benchmark) risk
Pre-Sale Risks Mitigation
94
1. Loss/Damage of good before delivery:
Before delivery, the good is bank’s responsibility
Risks mitigated by:
Minimize the period of holding (time between
purchase and sale)
If time is long—insurance can be bought
Pre-Sale Risks Mitigation
95
2. Refusal of the Buyer to take Delivery: The bank
is left with the good
Risks minimized by:
The bank purchases the good with a right to
return it within a specified time
The bank sells the good and client pays the
difference between cost and sale price
Pre-Sale Risks Mitigation
96
3. Market (price) risk: Risk of changes in price prior
to delivery of good to client
Risks mitigated by:
Minimizing the holding time by selling
immediately after buying
Post-Sale Risks Mitigation
97
1. Latent Defects in Goods: It is possible that the
good supplied by the supplier is defective.
Risks minimized by transferring the liability to
the vendor/supplier (through warranty)
Post-Sale Risks Mitigation
98
2. Settlement (credit) Risk: The risk that the client will not pay his/her dues on time or default
Risk minimized by:
The bank can ask for a guarantee (sign a guarantee agreement)
Ask for a security or collateral—can sell the collateral if debtor defaults
Impose penalty for delinquency problem
Post-Sale Risks Mitigation
99
3. Market (benchmark rate) risk: The risk that the
returns of the bank will be affected if the
benchmark rate changes
Risks minimized by:
The contracts are usually of short-run duration
100
A CASE STUDY: LEGAL STRATAGEM OF TAWARRUQ
Case Study: Legal Stratagem of Tawarruq
101
Islamic Banking is mimicking conventional banking
From Inah to Tawarruq
Degrees of Separation to veil Riba
Bai al-inah
Tawarruq
Has ownership really changed?
The Unintended results
Imam Taymiyah on Sale/Riba
102
Would “Islamic” Banking take the Same Route?
What is the current model of
“Islamic” banking?
Is RIBA still not present?
“Islamic” banking products mimic
conventional via legal startegems
Selected judgments may provide the
indication
103
From Inah to Tawarruq to Sukuk
The idea of making an impermissible transaction permissible through degrees of separation is not new
In fact, it underlies many of the juristic stratagems (hiyal) for circumventing prohibitions
By adhering strictly to the letter but not the spirit of the law
Inah Tawarruq Sukuk
Degrees of Separation to Veil Riba
104
A
RM100 Cash
B
RM105 (deferred payment)
RIBA
105
A B
RM100 Cash
RM105 (deferred payment)
sell brick for cash
resell brick on credit
Bai’ul Innah
106
A
RM100
Cash
B
RM105
(deferred
payment)
Riba (HARAM)
A B
Bai’ul Innah (SYARIAH COMPLIANT?)
sell brick for cash
resell brick on credit
RM100
Cash
RM105
(deferred
payment)
Degrees of Separation to Veil Riba
107
A B
C Metal
Trader
Resells metal on credit
105 Cash (deferred payment)
Tawarruq
108
Issues What is the function of C?
No change of ownership of metal
Legal subterfuge?
Individually: syariah-compliant
Read together: syariah-compliant?
Effect of 2 degrees of separation circumvent riba
Structure obeys the letter of the law but subverts the spirit
Form over Substance, Compliance over Essence
109
It is easy to see how we can keep adding degrees of separation until eventually it would become impossible for any jurists, however strict, to prohibit the practice as merely a trick to subvert the substance of Islamic Law (avoidance of interest-bearing loans) while adhering to its medieval juristic forms.
Degrees of Separation
110
The Danger
An impending subversion of Islamic Law
By approving and eventually codifying (through AAOIFI, IFSB, OIC Fiqh Academy, etc.) legal stratagems to replicate conventional financial practices, jurists, bankers & regulators will eventually drown the substance of Islamic Law, if not already!
111
The (Unintended?) Result
An illegal act will be made legal eventually, through the act of codification!
With advances in structured finance, can easily disguise riba in any contract, and it would be the ultimate of disingenuousness to say "but this is bay` (sale), and Allah has permitted bay` and forbidden riba"
112
IBN TAIMIYYAH
Like other major scholars, Ibn Taimiyyah considers bay
al-inah a legal device in order to overcome the
prohibition of riba, and is not deemed to be an act of
sale, as there is clear evidence that such act amounts,
in effect, to a contract of loan.
The use of legal device is evidence that the niyyah
factor is undermined or made secondary.
113
IBN TAIMIYYAH
Ibn Taimiyyah divides sales into three groups according to the buyer’s
intentions, namely:
that he purchases the goods in order to use or consume them such as food,
drink and the like, in which case this is sale, which God has permitted
that he purchases the goods in order to trade with them; then this is trade,
which God has permitted
that the reason for purchasing the goods is neither the first nor the second,
then the reason must be dirhams (money) which he needs, and it was
difficult for them to borrow, so he purchases the goods on credit (with an
increased dirhams) in order to sell it and takes its price. This, then, is ‘inah
which is Haram according to the most eminent of the jurists.
114
A CASE STUDY: SUKUK
115
Sukuk—Economics of Growth
Several driving forces for Shari’ah compatible securities market
Demand side
Muslims/Islamic financial institutions—Shari’ah compatible securities
Non-Muslims--Alternative investment opportunities
Supply Side
Provides a cheaper source of financing
Provides an alternative source of financing
Provides financing without diluting shareholder equity
Provides a source of off-balance sheet financing (can hold less capital)
Regulatory
Basel II—marketable securities need less capital than direct credit exposures
116
Obligor
(undertakes
future sale
of commodity
for the investors)
SPV
Investors 1
2a
Salam Proceeds
Undertaking Sukuk Certificates
Commodity Commodity Sale Proceeds
Sukuk Certificates
Proceeds 2b
6 4
3
Sukuk al-Salam
• Sale of well-defined quality and quantity of commodity
• Fixed rates of return
• Sukuk al-salam are not negotiable
5 Commodity Sale
Commodity
Buyer
117
Sukuk al-Salam: Example
Sukuk name/date Sukuk al-Salam/Aug. 1, 2007 (Issue no. 75)
Sukuk base Aluminium
Obligor Government of Bahrain
Issuer Central Bank of Bahrain
Purpose of Offering Short-term liquidity
Tenor 91 days
Issue size BD 6 million
Expected rate of
return
5.06%
Credit enhancers Guaranteed by Bahrain Government
Governing Law Bahraini Law
Redemption/
Principal repayment
With price at maturity
Rating None
118
Sponsor/
Originator/
Obligor
SPV
Investors
1
• Transfer of assets back to Issuer can take place is 2 ways:
a. Periodic payments include rent and amortization (capital)
b. Bullet payment at maturity (the Issuer buys back the assets)
• Sukuk al ijarah are negotiable
• Can have fixed/flexible rates
• Risks of assets transferred to certificate holders (though issuer can guarantee the capital)
2a
Purchase Price of Assets
Sale/Transfer of Assets
Lease of Assets
Sukuk Certificates
Rental Payment
Periodic Rental
Payments
Sukuk Certificates
Proceeds 2b
4b
5
4a
3
Sukuk al-Ijarah
119
Sukuk al-Ijarah: Example
Sukuk name/date Qatar Global Sukuk/Oct. 8, 2003
Sukuk base Certain Land Parcel in Qatar
Obligor State of Qatar (lessee of leased assets)
Issuer Qatar Global Sukuk QSC
Purpose of Offering Construction of Hamad Medical City
Tenor 7 Years
Issue size USD 700 million
Expected rate of
return
Semi-annual lease rentals (Libor+ credit spread+
amortization payment)
Credit enhancers Guaranteed by Qatari Government
Governing Law English and Qatari Law
Redemption/
Principal repayment
With rental payments (amortization with rental
payments)
Rating A+ (S&P)
120
Balance Sheet Based Sukuk—IDB
IDB is a multilateral development bank (MDB) operating on Islamic principles
Before issuing sukuk, 100 percent equity based institution (paid-up capital $4.3 billion)
Other MDBs raise funds from market World Bank raised funds worth 918% its capital (total borrowing $ 96
billion)
ADB raised 777% of its capital (capital $3.6 billion)
Development impact of IDB small compared to other MDBs
Plans to raise up to USD 4 billion in the next 10 years
121
SPV
Investors
1
1. IDB bundled ijarah assets (65.8%), along with murabahah (30.7%) and istisna (3.5%) receivables
3a
Sells
assets
bundle worth
$400 m.
Appoints as agent to collect income from assets
Sukuk Certificates
Sells assets $400m.
Periodic Income from
Assets
Sukuk Certificates
Proceeds 3b
2
7 4
IDB-Hybrid Asset Sukuk
Delegates
agency
role
5
Provides guarantee about assets
6
122
IDB-Hybrid Asset Sukuk Sukuk name/date IDB Global Trust Certificates/Aug.12, 2003
Sukuk base Balance sheet assets of IDB (Ijarah, istisna,
murabahah)
Obligor Islamic Development Bank
Issuer Solidarity Trust Services Limited (through ICD)
Purpose of Offering Financing other assets
Tenor 5 Years
Issue size USD 400 million
Expected rate of
return
Semi-annual lease rentals (Fixed 3.625%)
Credit enhancers Guaranteed by IDB
Governing Law English Law
Redemption/ Principal
repayment
Purchase of assets at maturity at sale price
Rating AAA (S&P)
123
Corporate/
Borrower
Issuer
SPV
Investors 1 2a
Commodity
Master Agreement
Sukuk Certificates
Sale Price + profits
Sukuk Proceeds 2b
7
4
Sukuk al-Murabahah
Commodity
Buyer
Commodity
Supplier
Commodities 3a
3b Commodity
Price
Commodity
Price 6
Commodity 5b 5a
Commodity
Price
124
Sukuk al-Murabahah-Example
Sukuk name/date Arcapita Multicurrency sukuk/June 2005
Sukuk base Commodity (purchase/sale)
Obligor Arcapita Bank BSC
Purpose of Offering Investment in assets
Tenor 5 Years
Issue size USD 210 million
Expected rate of
return
0.175% above LIBOR rates
Credit enhancers Full recourse to Arcapita
Redemption/ Principal
repayment
Bullet payment at maturity
Rating Arcapita rating (BBB)
125
Corporate
SPV
Investors
1
Transfer of Assets Back to Issuer can take place is 2 ways:
1. Payments Include profit and purchase of shares (diminishing musharakah)
2. At maturity, the corporate buys back the shares.
2a
Periodic profit and Incentive fee
Physical Asset Contribution
Sukuk Certificates
Periodic profit
Sukuk Proceeds 2b
6
4
Sukuk al-Musharakah
Musharakah
Sukuk proceeds 3 Periodic profit 5
Corporate undertakes to
buy musharakah shares
of the SPV 7
126
Sukuk al-Musharakah: Example
Sukuk name/date Wings-FZCO Sukuk/June, 2005
Sukuk base Issuer provides assets in kind ($100 million)
Obligor Emirates Airlines
Issuer Wings FZCO
Purpose of Offering Construction of Group Headquarters and
Engineering Centre
Tenor 7 Years
Issue size USD 550 million
Expected rate of
return
1st coupon after year, thereafter semi-annually
(0.75% above USD LIBOR rates)
Credit enhancers Strength of Emirates and UAE
Governing Law English Law and Dubai Law
Redemption/ Principal
repayment
Bullet payment at redemption
Rating/Listing Listed with Luxemburg SE
127
Shariah-related issues
Asset type—most of the sukuk issued are backed by real estate or other tangible assets
Tangible assets may be limited (as services constitute larger percentage of output)
May limit the growth of sukuk industry
Way forward
Use other structures (e.g., musharakah)
Add newer asset classes (services, usufructs, intellectual properties)
128
Shariah-related issues
Guarantee in Sukuk issues--3rd party guarantees allowed
without any charges
Originator provides guarantees against a shortfall in capital
Critics: Originator/guarantor and SPV same entity– guarantee of
capital/return can open doors for riba
Supporters: SPV independent from originator, guarantee by
originator is by 3rd party
129
Shariah-related issues
Ijarah and lease back structure a form of bai-al-wafa or bai al-inah
Objections to redemption/purchase of asset/shares at pre-determined price
Ijarah sukuk, Obligor buys back assets at maturity at sale price (face value)
In musharakah sukuk, one musharakah partner buying shares of another at face value
Redemption/purchase of asset/shares at market price allowed
130
Economic Issues—Liquidity
Liquidity/marketability of Debt Sukuk
While equity-based and asset-backed sukuk are tradable, debt-based
sukuk are not.
This may pose problems in the growth and development of the
Islamic money/capital markets
Possible solutions
Hybrid sukuk (with minority debt component)
Embedded options in sukuk
Conversion of debt into goods/assets/shares
131
Economic Issues—Risks
Risks of Islamic financial instruments in general and sukuk in particular are
complex and not well understood
As Islamic financing is asset-backed or equity-based, market risks play an
important role along with credit risk
Credit/Counter-party risks
Risks related to obligor (default, coupon payment, and asset redemption risks)
Market risks
Interest rate risk (in fixed income sukuk)
Risks related to commodity/asset (loss, damage, etc.) and its price
Liquidity risks
Lack of secondary markets for sukuk
Debt based sukuk cannot be traded
132
Legal and Regulatory Issues
Securities and sukuk laws to protect investors
Most SPVs are trusts Created for bankruptcy remoteness
Lack of trust laws in many countries
Legal risks
Legal transfer and ownership to SPV
Conflict in laws—common law, civil law, and Shari’ah
A Shari’ah contract originating in civil law countries using English law as the governing law
Different components of the transaction has different applicable laws (ijarah and musharakah vs. trust)
Rating agencies—use the criteria of conventional securities to rate sukuk
133
Future Market Prospects
Demand for sukuk much greater than supply
Over-subscription of all sukuk issues
Huge liquidity in the region—lack of investment opportunities
Islamic financial industry growing at a fast pace—more demand for
Islamic products for treasury operations
Strong demand for Islamic products from non-Muslim countries
134
Future Market Prospects
Most sukuk are short-term—great potential for sukuk of long-
term maturities
Infrastructure financing
Estimated +$300 billion for MENA for next 10 years
New emphasis on private-public participation
135
Sukuk and Saudi Market
Sukuk market in Saudi Arabia–sleeping giant
Being the largest economy in the region—a great potential exists
After the Capital Market Law, two large sukuk issued SABIC—20 year SR 3 bill. sukuk (2006)
Saudi Electric Company— 20 year SR 5 bill sukuk (15/7/07)
The initiatives of developing the infrastructure and economic cities opens up opportunities for the sukuk market Capital investment planned for next few years-$283 billion
Saudi Aramco capital expenditure plan-$190 billion
136
RISK AND REGULATION OF ISLAMIC
FINANCE
137
Critics of Islamic Finance
Practice of Islamic finance far from ideal
–Bankers
–A $300 billion deception
–Islamic economists
–Fulfilling the form, not the substance or spirit of Islamic finance
–Similar to conventional, but more inefficient
–Shari’ah scholars
–Shari’ah scholars questioning the acceptability of some products
138
CHALLENGES IN ISLAMIC FINANCE
Challenges
Strategy and Plan to develop the
right business model
Willingness to invest in Human
Capital Development
Information system to cater to
Islamic Finance transactions
Replication v. Authenticity
Comprehensive Shariah
Governance & Audit *
Meeting evolving consumers’
demand
Risk Management*
Legal, Regulatory & Accounting
Framework*
Wealth Management
139
Credit Risk
Market Risk
Insurance Risk
Sustainability Risk
Liquidity Risk
Pension Fund Risk
Residual Value Risk
Reputation Risk
Operational Risk
RISK MANAGEMENT IS
Accounting
Business Continuity
Fiduciary
Fraud
Information
Legal
Compliance
Operations
People
Tax
Technology
Shariah Risk Management
Embedded within the conventional
business risk management framework
Non-compliance with Shariah rules and
regulations
New product due diligence including
simplification of product complexities
Application of Late Payment / Penalty for
default in a Shariah compliance manner
Advise on debt restructuring
Changes in fatwa resulting in existing
product being non-compliance
Advising / guiding with ongoing Shariah
requirements
140
MAJOR SHARIAH
RISKS Concentrated reliance on a single
broker for transacting commodity
murabaha (substantial Global
Business is based on this structure)
Untested legal infrastructure (case
laws or court proceedings)
supporting products
Major Risks
Credibility of “Commodity Murabaha”
/ “Tawarruq” structure questionable
Manual Processes increase
operational risks
Lack of inter-bank market creates
challenges in matching assets and
liabilities
Identification of new brokers required
and find alternative to existing
commodity (eg. Bursa Al Sila’)
Using experienced legal counsel for
preparing documentation and
structures
Looking to diversify to other
structures.
To address concerns raised.
Rationalisation of product range.
Long term, automation and
standardisation required
This has to be addressed and
financial linkages required
RISKS ACTIONS
141
Functional Segmentation During Transition
1) Given the lagging institutional infrastructure, segmentation of
payments / transaction functions and investments may present
advantages.
2) Investment activities can be modulated to the degree of
investors’ risk appetite.
3) Segmentation would facilitate regulation of IFI
142
Outline of Segmented Activity: Depositors Risk Appetite ASSETS LIABILITIES
Asset–Backed / Trade
Financing Segment A
Minimal Risk Depositors
Ijara, Istisna, Mudaraba Segment B
Low–Med Risk Depositors
Musharaka–Mudaraba Segment C
Vc-Private Equity Depositors
143
A Market Vision for the Industry Growth
In designing the regulatory framework for IFIs, regulators should recognize the current difference between the theory and practice of Islamic Finance.
- First, they should accommodate current practices to promote stability and soundness of the Islamic financial operations.
- Second, they should provide right incentives so that different players are encouraged to follow the paradigm of Islamic banking in the future.
- How ? By improving information facilities to reduce asymmetric information problems between IFI and investors and by improving the legal system supporting bank activities.