applications of contracts in banking and finance · diminishing musharakah contracts used: 1....

Applications of Contracts in Banking and Finance

Prof. Habib Ahmed

Durham University Business School

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Presentation Plan

• Approaches to Innovation

• Islamic Financial Products

– Banking

– Takaful

– Sukuk

– Derivatives

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Traditional Contracts

• Key contracts

– Asset based—Ijarah (existing owned, existing leased, and future assets), Manfah (existing and futures assets)

– Sale based-- Murabahah, Istisna, Salam

– Equity based-- Mudarabah, Musharakah

– Agency based- Wakala

• Supporting contracts

– Gift (hiba), guarantee (kafala), mortgage (rahn), etc.

4

Approaches to Innovation

Approaches to financial engineering:

•‘Reverse engineering’—an Islamic replication of a conventional product is engineered

– Contractual stipulations (mode) are fulfilled in a legalistic manner

•‘Innovative engineering’—come up with Shari’ah based products

– Start with the market segment and needs and then come up with new products satisfying the need and the form/spirit of Islamic law

5

Approaches to Product Development

The specific methods used to develop products are:

1.Adapt traditional contracts to contemporary products

2.Adapt conventional financial products

3.Combine existing nominate contracts—financial/legal engineering

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Adapting Traditional Contracts

• Arboon as call option• Call option—pay a fee for the right to

purchase an object at a specific price in the future

• Arboon—a down-payment paid by buyer to secure an object for a period of time. If the buyer does not purchase the object, seller keeps the advance

• Used in capital-protected funds– Invest 97% in fixed income assets, 3% to buys

options on stocks. If the market price is greater than strike price, option is exercised

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Adapt Conventional Products• Eliminate undesirable components from

conventional financial products • Stocks and mutual funds

• Eliminate according to industries (gambling, alcohol, financial sector, arms, etc.).

• Financial ratios

Criterion DJIM S&PS

1. Total debt/Market Capitalization Less than

33%

Less than

33%

2. Cash and interest-bearing

securities/Market capitalization

Less than

33%

Less than

33%

3. Account receivables/Market

capitalization

Less than

33%

Less than

49%

4. Non-permissible income and other

interest income/Total revenue

- Less than 5%

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Combination of Contracts:Financial Murabahah

Contracts used:1. A promise (wad) to purchase by client2. Security deposit (hamish jiddiyah)—to be used in

case of non-fulfilment of promise3. Sale contract 1 (bay’): between vendor and bank 4. Sale contract 2: between bank and client

(murabahah/bay muajjal)5. Agency contract (wakala): between bank and client

(to purchase on behalf of bank)6. Pledge/guarantee (rahn/kafala)—collateral to secure

the debt.7. Clause in the contract—in case on non-repayment

on time, a penalty will be charged

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Combination of Contracts:Diminishing Musharakah

Contracts used:1. Promise (wad) to rent for the term of the contract.2. Promise (wad) to purchase units at different

stages.3. Create a joint ownership (musharakah) (of the

asset)4. Lease (ijarah) agreement (bank leases to client)5. Actual purchase of units of asset.6. Legal mortgage (rahn)7. Trust deed

Presentation Plan



– Banking

– Takaful

– Sukuk

– Derivatives

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Use of Islamic Contracts in Products

• Unlike in conventional sector, in Islamic finance different modes of financing can be used for a product

• Various modes have different risk-return features

• Product development team decides what contract to use in a specific product

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Financing Durables (1)

• Murabahah based financing

– Client promises to buy good/asset from bank

– The bank buys the good/asset and sells it at a markup to the client

– The price is paid back to the bank in installments

• Used by: Dubai Is Bank, Meezan Bank, Bahrain Is. Bank

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• Ijarah wa iqtina based financing

– A promise to lease by the client

– The bank buys the assets and rents it to the client for a specific period of time.

– At the conclusion of the term, the asset is given to the client at gift or sold at a token price.

• Used by: Meezan Bank

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• Diminishing musharakah based financing– Bank and client jointly own an asset that is divided

into a number of units.

– Client uses the asset, pays rent on the bank's share and periodically buys units/shares of the asset from the bank.

– Over time the client becomes the owner of the asset by purchasing all units owned by the bank.

• Used by: Meezan Bank

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• Tawarruq based financing

– Bank buys commodity and sells it to the client at a mark-up

– The client appoints the bank as an agent to sell the commodity to a vendor

– Money deposited in client's account

– Amount due to bank paid back in installments

• Used by: HSBC Amanah

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Presentation Plan



– Banking

– Takaful

– Sukuk

– Derivatives

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Insurance—Shari’ah Perspectives

• OIC Fiqh Academy Resolution 9 (9/2) 1985 forbids conventional insurance– Gharar (uncertainty about the object of sale and

outcome)

• Islamic viewpoint—risks can be mitigated but approach has to be different

• Takaful based on • Tabarru’ (gift or donation)—Gharar does not exist

in gratuitous contracts• Ta’awun (mutual assistance) • Avoid riba in transactions (applies to assets)

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Takaful—Introduction• Key features

– Takaful Operator (TO)—shareholders establish a takaful company with their own fund (Shareholders’ Fund-SF)

– Takaful participants contribute (tabarru) to Participants’ Risk Fund (PRF)

– SF and PRF are separate—shareholders do not take any underwriting risks

– Hybrid of commercial (SF) and mutual insurance (PRF) models

• Types of takaful– General (casualty)

– Family (life)

TakafulParticipants

Takaful Fund

PRF

Investment Profit/ Underwriting Surplus

Distributable Surplus/Profit

Shareholders’ Fund

Operating Expenses

Profit

Dividend

Taka

fulO

per

ato

r

Wakala General Takaful

Wakala fee

(% of contribution)

Retained

[Source: IFSB (2009)]19

TakafulParticipants

Takaful Fund

PRF

Investment Profit/ Underwriting Surplus

Distributable Surplus/Profit

Shareholders’ Fund

Operating Expenses

Profit

Dividend

Taka

fulO

per

ato

r

Mudarabah GeneralTakaful

Mudarabah Share

(% of Profit )

Retained

[Source: IFSB (2009)]20

Presentation Plan



– Banking

– Takaful

– Sukuk

– Derivatives

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Sukuk-definition

• Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) defines sukuk as:

“Certificates of equal value representing after closing subscription, receipt of the values of certificates and putting it to is as planned, common title to shares and rights in tangible assets, usufructs and services, or equity of a given project or equity of special investment activity”

2323

Obligor(undertakes future sale

of commodity for the investors)

SPV

Investors1 2a

Salam Proceeds

Undertaking Sukuk Certificates

Commodity Commodity Sale Proceeds

Sukuk CertificatesProceeds

2b

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Sukuk al-Salam

• Sale of well-defined quality and quantity of commodity

• Fixed rates of return

• Sukuk al-salam not negotiable

5 Commodity Sale

CommodityBuyer

24242424

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

2525

Sponsor/

Originator/

Obligor

SPV

Investors

1

• Sukuk al ijarah are negotiable

• Can have fixed/flexible rates

• Risks of assets transferred to certificate holders (though issuer can

guarantee the capital)

• 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)

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

Sale/Transfer of Assets

6

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Sukuk al-Ijarah: ExampleSukuk 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)

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Presentation Plan



– Banking

– Takaful

– Sukuk

– Derivatives

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Forwards: Shari’ah Perspectives

• Conventional derivatives are prohibited under Islamic commercial law

• AAOIFI Standard No. 20 ‘Commodities in Organised Markets’:

– “5/1/2 It is not permitted according to the Shari’ato undertake futures contract either through their formation or trading”

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Foreign Exchange Forward• Current Ex. Rate (ER): 1£=$1.5

– A needs $1500 after 3 months (price £1000 today)

– B will need £1000 after 3 months (price $1500 today)

• If after 3 months, ER: 1£=$1.4– A has to pay $1500/1.4=£1071.4

– B has to pay £1000x1.4=$1400

• If after 3 months, ER: 1£=$1.6– A has to pay $1500/1.6=£937.5

– B has to pay £1000x1.6=$1600

• Hedging foreign exchange risk can be considered essential need for businesses

• Forward: – A pays forward price to buy $1500 at ER: £1=$1.5 (long position)– B pays forward price to buy £1000 at ER: £1=$1.5

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Reverse Engineering:Islamic Synthetic Forward

• Client wants to buy $1500 in 3 months and hedge against risk at ER: £1=$1.5

• Tawarruq-based Forward – Bank buys copper (C) at price £1000 and sells at price

£1050 to the client payable in 3 months– Client sells C to broker and gets £1000– The client buys aluminium (A) at price £1000 and sells to

the bank at price $1500 payable in 3 months– The bank sells A to broker and gets bank £1000

• After 3 months:– Bank pays the client $1500 – Bank gets £1050 from client

[Note £50 is the fees for the transaction]

[email protected]

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