intro to shariah compliant structures mohammed haris

Introduction to Shariah Compliant Structures and Business Applications

Mohammad Haris

Deputy General Manager, Corporate Banking, Structured Finance & Product Development

April 28, 2009

1St East and Central Africa Conference on Islamic Banking

Presentation Outline Part I: Shariah compliant structures

Murabaha Ijarah Musharaka Mudarabah

Part II: Business solution Financing Requirements

• Working Capital

• Asset/Project /BMR Financing

Trade Requirements• Imports

• Exports

• Fx


Shariah Compliant Structures

Murabaha


Murabaha

• Murabaha is a particular kind of sale

• where the transaction is done on a “cost plus profit” basis i.e. the seller discloses the cost to the buyer and adds a certain profit to it to arrive at the final selling price

• The distinguishing feature of Murabaha from ordinary sale is

- The seller discloses the cost to the buyer

- And a known profit is added


Murabaha

• Since Murabaha is a sale transaction - rules of Shariah regarding sale should be understood to judge if a Murabaha transaction is valid


Basic Rule for Murabaha

1) Asset to be sold:

a) must exist.

b) should be in ownership of the seller at the time of sale.

c) should be in physical or constructive possession of the seller.

d) should not be used for un-Islamic purpose.

2) Sale price should be determined.

3) Forward sale is not allowed.


Bank Customer

Supplier

Agreement for Murabaha(1)

Payment(2)

Asset

(3)

Offer to Purchase(4)

Acceptance + Transfer of Title (5)

Payment of Sale Price(6)

Process Flow 1St East and Central Africa

Conference on Islamic Banking


Ijarah


Ijarah• Ijarah is a term which means “To give something on rent”

• The term “Ijarah” is used in two situations:

1. It means ‘To employ the services of a person on wages’ e.g. “A”

hires a porter at the airport to carry his luggage

2. Another type of Ijarah relates to paying rent for use of an asset or

property


Ijarah

• Ijarah is an Islamic alternative of Leasing.

• Leasing backed by an acceptable contract is an acceptable transaction under

Shariah.

• The question of whether or not the transaction of leasing is Shariah compliant

depends on the terms and conditions of the contract.

• Several characteristics of conventional agreements may not conform to Shariah

thus making the transaction un-Islamic and thereby invoking a prohibition.


Vendor Bank Customer

Undertaking to Lease

(1)Payment to Purchase

Assets(2)

Transfer of title(3)

Lease Agreement (4)

Rental Payment (5)

At the end of Contract period client purchase the assets

And Transfer of Title (6)

Process Flow


Rules of Ijarah

1. Ownership of the leased asset remains with the Lessor

2. All rights and liabilities relating to ownership are borne by the Lessor.

3. Subject matter of Lease should be Valuable, Identified and Quantified.

4. The period of Lease must be determined in clear terms.

5. The Lessor cannot increase the rent unilateral


Rules of Ijarah

6. The Lessee is responsible for damage to the asset caused by fraud or

negligence.

7. Normal maintenance is Lessee’s responsibility

8. If the leased asset is destroyed, the lease will terminate.

9. Lease rentals for the entire lease period must be fixed;



Musharaka


Definition

• “Musharakah ” means “Sharing”.

• The word Musharakah has been derived from “Shirkah” which means being a

partner

• Musharakah is basically a kind of partnership in which the partners join together

with different contributions, work or obligation for the common objective of

undertaking business and trade in accordance with the principles of Shariah.


Types of Musharakah

Shirkat-ul-Milk

It means joint ownership of two or more persons in a particular property.

Shirkat-ul-’Aqd

This is the second type of Shirkah which means:

A partnership effected by a mutual contract in which the partners join together with different contributions, work or obligation for the purpose of earning profit.


Rules of Musharaka

Management of Musharaka

• Each partner has a right to take part in Musharaka management.

• The partners may appoint a managing partner by mutual consent

• One or more of the partners may decide not to work for the Musharaka and work as a sleeping partner.


Rules Of Musharaka

Rules for Profit Distribution

• The ratio of profit distribution must be agreed at the time of execution of the contract

• The ratio must be determined as a proportion of the actual profit earned by the enterprise

• Not as percentage of partner’s investment

• Not in lump sum amount

• A sleeping partner cannot share the profit more than the percentage of his capital.


Rules Of Musharaka

Illustration for Profit Distribution

• If A and B enter into a partnership and it is agreed between them that A shall be given Rs. 10,000/- per month as his share in the profit, and the rest will go to B, the partnership is invalid.

• Similarly, if it is agreed between them that A will get 15% of his investment, the contract is not valid.

• The correct basis for distribution would be an agreed percentages of the actual profit accrued to the business.


Rules Of Musharaka

Rules for Loss

In the case of a loss, each partner shall suffer the loss exactly according to the ratio of investment.

Profit is based on the agreement of the parties, but loss is always subject to the ratio of investment.

20


Processflow

Partner A

Partner B

Funds Shariah

Compliant Business

Profit



Mudarabah


Mudarabah

• This is a kind of partnership where one partner gives money to another for investing in a

commercial enterprise.

• The investment comes from the first partner who is called “Rabb-ul-Maal” (Investor)

• The management and work is an exclusive responsibility of the other, who is called

“Mudarib” (Manager)

• Profit is shared as per agreed ratio

• All losses are borne by Investor


Types of Mudarabah

1. Un-restricted Mudarabah

No restriction from the Rabb-ul-Mal (Investor) regarding the

business.

2. Restricted Mudarabah

Some restrictions implemented from the Rabb-ul-Mal (Investor)


Processflow

Depositors

Asset Manager

Funds Shariah Compliant

Assets, Financing

Profit

Expertise


Diff b/w Musharaka & Mudarabah

Musharakah

• In Musharaka all partners invest

• Both parties can work

• Loss is shared according to contribution

Mudarabah

• In Mudarabah one party invests (Investor) and other party works (Manager)

• Profit is shared as per agreed ratio

• All losses are borne by Investor


Business Solution - Financing Requirement

Working Capital Financing

Using Murabaha (Sale) Mode of Financing


Murabaha

Murabaha is a particular kind of sale where the transaction is

done on a “cost plus profit” basis


Murabaha – Illustration

1. The Customer and the bank sign Master Financing

Agreement along with Agency Agreement.

2. Customer identifies and finalizes a purchase deal for

cotton with a supplier.

3. Customer makes a written request to the bank for the

purchase of Raw Cotton.

4. The bank disburses funds amounting to KES. 100 million

to the supplier.


5. Agent/Bank purchases and takes possession of the Cotton.

6. The Customer then makes an offer to purchase it at KES 106

million to be paid after six months by signing the Offer.

7. The bank accepts the offer and the sale is concluded

whereby ownership as well as risk is transferred to the

Customer.

Murabaha – Illustration


Bank Customer

Cotton Supplier

Agreement for Murabaha(1)

Agency Agreement to source cotton supplier

(2)

Payment of Kes 100 Mio (3)

Delivery of Cotton (4)

Offer to Purchase cotton at Kes 106 Mio in 6 months (5)

Acceptance of Sale + Transfer of Title (6)

Differed payment of Kes 106 Mio (7)

Process Flow 1St East and Central Africa

Conference on Islamic Banking

Issues in Murabaha

Rollover in Murabaha

Rebate on early payments

Penalty for late payments


Business Solution - Financing Requirement

Asset/Project Financing

Using Ijarah (Leasing) Mode of Financing


Ijarah

• Ijarah is a term which means “To give something on rent”

• Ijarah is an Islamic alternative of Leasing.


Illustration1. Customer request financing for a truck costing Kes. 10 million.

2. Islamic Bank agrees to finance the cost.

3. Undertaking to lease is signed.

4. Bank makes payment to truck supplier and take possession.

5. Bank and customer sign the lease agreement for 3 years.

6. The customer uses the truck and pays regular rent for 3 years.

7. At the end of 3rd year, the customer buys the truck from the bank at nominal value and ownership is transferred.


Process Flow

Vendor Bank Customer

Undertaking to Lease

(1)ksh10m

(2)

Truck Title(3)

Lease Agreement (4)

Rental Payment (5)

(At the end of Lease period) Truck Title

(6)


1. Risk and rewards of ownership lies with the owner

2. Once and if the asset is destroyed, the lease agreement is terminated

3. Late payment penalty cannot be booked as income by the Lessor.

4. Lease and Sale agreement should be separate and non contingent.

Difference b/w Conventional Lease & Ijarah


5. The Lessor cannot increase the rent unilaterally

6. Expenses to be borne by the parties:

• Lessor-- expenses relating to the corpus of the asset

• Lessee- - actual operating/overhead expenses related to running the asset

7. Rent is charged after delivery of the asset to the Lessee.

Difference b/w Conventional Lease & Ijarah


Business Solution- Financing Requirement

Asset/Project Financing

Using Diminishing Musharaka (Partnership)Mode of Financing


Diminishing Musharaka

• It involves taking share in the ownership of a specific asset and then gradually

transferring complete ownership to the other partner.

• This concept is based on Declining ownership of the financier

• Three components

1. Joint ownership of the Bank and customer

2. Customer as a lessee uses the share of the bank

3. Redemption of the share of the Bank by the customer


Illustration

1. Customer request financing for a property costing Kes. 10 million.

2. Islamic Bank agrees to provide financing up to 60% of the cost.

3. Joint Ownership Agreement is executed between the bank and the Customer.

4. Bank will purchase 60% share in the property by paying Kes. 6 million to supplier.

5. Customers pays its share of Kes. 4million.


Illustration

6. Bank’s share is divided into sixty units.

7. Customer agrees to buyout Bank’s share (units) on monthly basis and the Undertaking

is executed by the customer.

8. Customer pays the rent for the usage of the Bank’s units.

9. Rental reduces after purchase of each unit by the customer.

10. After five years ownership of the asset is completely transferred to the customer.


Bank Customer Joint Partnership

Musharaka

Payment of Rental and Purchase of Unit

Gradual Transfer of Ownership

Process Flow

Supplier

Kes 6m Kes 4m


Business Solution - Trade Requirement

Trade Finance Products


Trade Finance Products

• Sight & Usance LCs

• Import Financing through “Import Murabaha” & “Musharaka”

• Export Financing through “Musawamah & Agency” & “Musharaka”

• Forex transactions: Spot and forward

• Collaterally Managed Assets financing through “Murabaha”


Letter of Credit

• Shariah allows that the bank may charge service charges for providing various

services in the course of issuing LCs.

• However, these service charges should be developed keeping in view the reasonable cost estimates.

• For example if the importer extends the LC, less service charges should be collected as less services would be required for extension in the period of the LC.


Business Solution - Trade Finance Requirement

Import Financing

Using Murabaha (Sale), Ijarah (Leasing) and Musharaka (Partnership) Mode of Financing


Import Murabaha

• The customer opens the LC from the Bank as an agent of the Bank.

• The bank assumes ownership of the goods until they arrive at the port and are sold to the customer.

• Upon receipt of documents Bank makes payment to the foreign supplier.

• The Bank sells the goods to the customer on Murabaha (i.e. cost plus profit basis. )


Import Ijarah

• The Importer places order with the foreign supplier on behalf of Islamic Bank.

• The importer signs undertaking to lease.

• The Importer opens the LC from Islamic Bank as an agent of the Bank.

• Upon receipt of documents Islamic Bank makes payment to the foreign supplier.

• The bank will enter into an Ijarah agreement with the customer.

• After the term of Ijarah agreement is completed, the bank may sell the asset to

the importer at an agreed price.


Import Musharaka

• The bank and the importer will sign Musharaka Agreement.

• The bank and the importer may agree on any profit sharing ratio.

• The bank will make payment to the exporter after receiving the

documents.

• Importer will sell the commodity in local market.

• The bank and the importer will share the profit as per the agreed ratio.


CM Murabaha• Bank and the customer sign master murabaha agreement and agency

agreement

• Customer finalizes terms with CM company.

• Customer opens the LC thru the bank as its agent to import commodity.

• Bank makes payment upon arrival of documents

• Upon arrival of shipment, bank will release import documents to CM.

• Customer will request bank to release commodity in tranches

• Bank will release the commodity in tranches after signing offer and acceptance.

• Bank will calculate murabaha price after adding all costs incurred to date and applying profit rate.

• The transaction will complete once the customer has paid for the entire consignment for its release.


Business Solution - Trade Finance Requirement

Export Financing

Using Musharaka (Partnership) and Wakala (Agency) Mode of Financing


Export Musharaka

• The exporter has a confirmed order to export commodity backed by LC

• The bank and the exporter will sign Musharaka Agreement.

• The bank and the importer may agree on any profit sharing ratio.

• The bank and the exporter will contribute their share of funds.

• The exporter will ship the commodity through the bank in accordance with LC terms. The

documents will be couriered to the importer

• The bank will receive export proceeds and will share it with the exporter as per agreed ratio.


Purchase and Agency • The exporter has a confirmed export order backed by LC

• The exporter has already procured the commodity and is ready for shipment.

• The bank will buy the commodity prior to shipment.

• The bank will arrange to ship the commodity.

• The documents will be couriered to the importer.

• The bank will receive export proceeds and will settle the o/s exposure along with

booking profit.


Business Solution - Trade Requirement

FX Deals


Spot Fx Deals

• Trading of currency with another currency is allowed so far

as the delivery of one or both is not deferred.

• The counter values of the same currency must be of equal

amount.


Forward Cover

• A bilateral promise to buy or sell currency on a future date is

not allowed

• However, a promise from one party is permissible.


Thank you


Q & A


intro to shariah compliant structures mohammed haris

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