Islamic Finance & Sukuk ( April 2014)

Islamic Finance & Sukuk

Dr. Aly Khorshid

Course detais• Islamic Finance (2 day’s course)• Introduction to Islamic Finance• Shariah requirements• Prohibitions in Islamic Finance trading • Islamic bank and the difference with conventional banks• • Shari’ah compliant products • Musharakh (Joint Venture)• Mudarabah (Profit sharing)• Murabaha (Cost Plus)• Ijarah (Rental)• • Shari’ah compliant products (Cont.)• Istisna’a (Manufacturing)• Salam (Future payment)• Bay Bithaman ajil (Delayed payment)• Qard Hassan (Interest free loan)• • Sukuk (Islamic Bonds) Type, structure, Index, trading• Sukuk types• Sukuk structure and application• Securitizing Sukuk• Sukuk Index• Sukuk trading and secondary market•

Course Structure• Structure Islamic fund for investment and Project Finance• Principals of Islamic investment • Structured finance: An overview• Structured product within Shari’ah compliant• Sukuk structure an idea project finance investment• Securitisation (asset-backed Securitisation)• • Product innovation Private equity, Wealth management in Islamic finance• Islamic Private equity fund• Wealth Management • Islamic derivatives and hedge funds• • Islamic asset Management • Shariah-compliant Portfolio Management• Islamic asset management• Shariah-compliant Asset Classes• Sukuk, fixed income asset class • • Corporate Governance and Risk Management in Islamic Finance• Governance frame work in Islamic finance institutions• Shariah Board responsibilities and accountability • Disclosures and Transparency• Risk Management in Islamic Finance

Introduction to Islamic Finance Shari’ah Compliant Products

Sukuk, Type, Structure, Index, and TradingStructure Islamic Funds for Investment and

Project FinanceProduct Innovation

Islamic Asset Management, Private equityCorporate Governance and Risk Management in

Islamic Finance

A Rapidly Growing Industry

Islamic Finance globally

There are 1.7 billion Muslims in the world(23% of total world population) with annual growth of 15% (in 2020 Muslim population expected 25% of the world population) , making it 2nd largest religion after Christianity. Only 20% of those live in Arab Countries.

• Market of Sharia compliant assets approximately $1.2 Trillion

Islamic Finance

• Shari’ah requirements• Prohibitions in Islamic Finance trading

• Islamic banks and the difference with conventional banks

Shari’ah requirements

Shari’ah LawJustice, equity, fairness and morality

• Values which underpin both the entire Islamic way of life.• Shariah gives guidance as to what is, and what is not, acceptable

behaviour in all areas of a Muslim’s life (including economic and commercial life).

• Shariah is based on the Qur’an and Sunnah of the Prophet • Shari'ah is developed by Shari'ah scholars (Known as Schools of

thoughts) some 1000 years ago• The recent Scholars known as Shari'ah advisors or Shari’ah board

has studied Fiqh Al-Mu'amalat able to explain Shari'ah law for recent dealings.

• The principal of the Shari’ah Law is:

the permissibility, the prohibition is exceptional

Shari’ah Law• Recent Islamic scholars who from time to

time re-examine the Shari'ah principals and structure new financial instruments must comply with principals of

• The of Shari'ah law ethics originate from: – The Qur'an – The Sunnah, – Ijmaa' - consensus among the jurists, – Qiyyas' - analogy and – Ijtihad' - reasoning.

Prohibitions in Islamic Finance trading

ProhibitionsIn Islamic financial system

• Prohibition of Unfairness & Unjust• Prohibition of Riba (usury)• Prohibition of Gharar (Deception &

Speculation) • Prohibition of Gambling • Prohibition of Monopolies• Prohibition of Short Sales• Prohibition in money trading(Money is a

medium not a commodity)• Prohibition of Dealing in Unlawful or

Unethical Goods or Services

Prohibition In Islamic financial system

Short Sale

Monopoly

Unfair & Unjust

ContractsUnlawful &

unethical trade

Money Trading

Gambling

Gharar

What is Riba?

• One of the main prohibitions is Riba (usury)

• Riba is prohibited in Judaism, Christianity before Islam and even in man-made religions such as Hinduism and Buddhism

• Unearned increase in an exchange contract without offering anything in return

• Interest on money-lending is the most common kind of Riba

• Examples of Riba • interest on bank loans and credit cards• gains from trading in debts• interest earned on savings and deposits accounts.

What is Gharar?

• Gharar is an ambiguity in transactions• Selling anything without owning it first • Fraud and deception • Absence of knowledge or uncertainty of delivery• One party's risk higher than the other's• Examples:

– Short-selling of stock where the cost of acquiring stock to meet future obligations is unknown

– Any transaction without defining the subject accurately

Islam Perception of Money

• Because of the importance of money to all human being, regardless of his or her beliefs

• Islam has addressed this issue in general terms, and gave societies the choice to develop their own financial systems, as long as the system is

Fair & Just

To everyone

Islamic banks and the difference with conventional banks

Difference between Conventional and Islamic Banks

Conventional Bank• Banking activities not

consistent with Christianity or Judaism religion, based on secular

• Riba (Usury) is not an issue• Conventional banks invest

in any business generate profits regardless of its activities

Islamic Banks• Islamic banks activity is

consistent with the principles of Islamic law (Shariah)

• Shariah prohibits renting of money (Riba, usury)

• Islamic banks do not do businesses contrary to its ethics and prohibitions (Haram, forbidden)

Conventional Bank• Money is a commodity

and a medium of exchange and store of value

• Money can be sold at a price higher than its face value and it can also be rented out

Islamic Banks• Money is not a

commodity though it is used as a medium of exchange and store value

• Money cannot be sold at a price higher than its face value nor it can't ne rented out

• Time value is the basis for charging interest on capital

• Interest is charged even in case the organisation suffer losses

• Profit on trade of goods or charging on providing service is the basis for earning profit

• Islamic Bank operates on the basis of profit and loss sharing

• No lending based profit or loss sharing

• When money used as commodities that leads to high inflation

• Musharakh & Mudarabah a tools for Islamic bank business

• When using trade related activities and money linked to real assets that leads to economic development

• While disbursing cash finance, running finance or working capital finance, no agreement for exchange of goods & services is made

• The exchange of agreements for the exchange of goods & services is a must, while distributing funds under Murabaha, Salam & Istisna'a contracts

• Conventional banking has focus on financial efficiency without linking to the purpose of lending

• Conventional banking usually rests on interest rates

• Islamic banking prefers to link to the cause of lending and not just the financial efficiency

• whereas Islamic banking does not.

• Conventional banking has more formal and legalized structures

• The main aim of conventional banking is to facilitate financial activities

• Islamic banking is still in its formative stage, is practiced informally and does not have strong legal support in all jurisdictions

• Islamic banking is based on equitable distribution of wealth and income and justifiable social finance.

• Conventional banks offer deposit insurance,.

• Return on investment is fixed since lending is offered on fixed interest rate

• No deposit insurance offered in Islamic banking

• Return on investment is variable since Islamic banks offer profit& loss sharing

• Conventional banking does not have a moral or ethical dimension

• Conventional banking is supported by highly active money markets and overnight borrowing facilities

• Islamic banking rests on moral and ethical dimensions

• Islamic banking is not yet fully supported by money markets

• Risk management tools developed by trial and errors and common practice, but lacking additional filters to avoid financial crises

• Other banking practices tools such as hedging and derivative are highly developed, formalized, and widespread

• Risk management based on conventional banks tools plus additional Shari’ah filters

• Other banking practices

tools hedging derivative are not fully developed, Those tools needs to be developed

• There are several formal educational and research programmes available in the domain of conventional banking all over the world

• This results into conventional banking having a steady flow of qualified manpower

• Islamic banking still lacking education and research programmes

• Islamic banking faces a severe shortage of skilled staff

• Conventional banking system has 100’s years experience and function deep in the global banking system

• Islamic banking system is still in the awareness stage, although the growth by 20% annually but still less than 2% of the global banking system

• Conventional banking is well supported by governments

• Whereas Islamic banking is still slowly moving towards being an accepted form governments, The differences are a fundamental source of uniqueness and identity of Islamic banking

Shari’ah Compliant Products

• Musharakh (Joint Venture)• Mudarabah (Profit sharing)

• Murabaha (Cost Plus)• Ijarah (Rental)

• Istisna’a (Manufacturing)

Islamic finance

contracts (Tools)

MusharakhMuda

rabahMurabaha

Ijara Contract

s, etc.Ijara Wa Iqtina

SalamIstisna'a

Bai be Thaman

AjilSukuk

Qard Hassan

Tawarruq

Home Financing

Musaqaa

Muzara

Musharakh (Joint Venture)

• It’s a Partnership arrangement• Musharakh involves a mutual contract to

participate in a commercial enterprise• Management

– All partners may be involved in the management of the enterprise

– Transparent management and accounts is essential– Remuneration for the management is part of expanses– Parties may agree in advance that one party, is a sleeping

partner, and the remaining management is compensated for sole management role ( normally when banks or finance institutions are involved)

• distribution of profit must be agreed at the time of entering into the Musharakh contract

• the ratio of profit of each partner is determined as the profit accrued on the capital invested

• Profit & loss shared according to the ratio of each party's investment

• Capital can be monetary, commodities or in kind• liability of each partner is recognized• Termination of Musharakh by agreement

Musharakh versus equity investment

Musharakh• Venture of limited duration• Partnership with joint

ownership• No exit without agreement

of partners• Investors obtain profit

share• Little probability of asset

gains when venture terminates

Equity investment• Company exists in

perpetuity(no time limit)• Exclusive ownership by

shareholders• Exit at any time if

company listed• Investors get dividends• Focus on capital gains and

market value of equity

Musharakh investment fund(equity financing)

• The Islamic financial institution and the customer provide financing for a specified project in agreed proportions.

• All parties have the right to participate in the project but the parties also have the right to waive such rights

• In the event of loss, both parties will bear the losses in proportion to their participation

• Profits and losses are shared in proportion to the contributions

• The Islamic financial institution may receive an agreed management fee.

Possible Musharakh structure

Investorsor banks

NewMusharakh partnership

Initial investment

Regular profit share payments

Musharakahaccounts

Financial reporting

Existingbusiness

Finance Pay-outs

Proprietor(s)Ownership

Possible Musharakh structure

Investorsor banks

NewMusharakh partnership

Initial investment

Regular profit share payments

Musharakahaccounts

Financial reporting

Existingbusiness

Finance Pay-outs

Proprietor(s)Ownership

Musharakh Contract (Sharing contract)

• Client Enters Agreement with bank to Invest in a Project• Client invests $80,000, Bank Invests $20,000• Profit Share is Based on a 80%:20% (they may agree on different percentage subject to negotiation)

Client invests $80,000

Bank invests $20,000

$100,000Project

Scenario 1• Musharakh Project makes $30,000 profit.

• Client receives 80% of profit $24,000• Bank Receives 20% of profit $6,000

Alexandros Severis 09/06/2009 44

Client receives $24,000

Bank receives $6,000

$30,000Profit

20%80%

Scenario 2• Musharakh Project $50,000 loss, Project value=$50,000• Losses are borne according to their initial capital

contribution• Client receives proportion of investment (80% of $50,000)

= $40,000• Bank receives proportion of investment (20% of $50,000) =

$10,000

Client receives $40,000

Bank receives $10,000

Project makes loss of $50,000

50,000 remaining.

80% 20%

Mudarabah (Profit sharing)

A special kind of partnership – where one partner invests money with another

entrepreneur in a commercial enterprise. – The investment comes from the first partner who is called

the “rabb-al-mal”, while the management and work is the exclusive responsibility of the entrepreneur, who is called the “Mudarib”.

Mudarabah may be contracted in two forms: Restricted Mudarabah

Rabb-al-mal may specify that his money is invested in specific business.

Unrestricted MudarabahThe Mudarib is given the discretion to invest the money

in business as he deems fit (most common in Islamic funds).

• The rabb-al-mal (investor) has no right to participate in the management which is managed only by the Mudarib

• The loss, if any, is on the rabb-al-mal (unless the Mudarib is proven negligent or dishonest)

• All goods purchased by the Mudarib are solely owned by rabb-al-mal

• Distribution of the profit(at a pre-agreed percentage, and it may be agreed on a case- by-case basis)

• Termination by mutually agreed terms

• This arrangement involves two parties, the managing trustee (Mudarib) and the beneficial owner (Rub al Maal).

• The Islamic financial institution may either put up all the funds itself and undertake responsibility for investing them, Or alternatively it can provide funds to the customer who then acts as Mudarib.

• The funds provided will be usually of those of its investors rather than the Islamic financial institution

• The Islamic financial institution acting as trustee for those investors Thereby assuming fiduciary responsibilities.

• reward is a fixed share in the balance of the revenue generated by the investments , the remainder goes to the investors.

• No guarantee that the Islamic financial institution’s investment will be returned or that a profit will be generated

Murabaha (Cost Plus)

• A buyer wishes to purchase commodity, he is in need of finance:

• A financer will purchase the commodity for the buyer, The financer specifically stipulating, that the cost of acquiring the commodity as well as the amount or percentage of profit or mark-up price for the commodity is agreed between the buyer and the financer.

• The financer purchase the commodity and sale it to the buyer

• The subject matter (the commodity) must be: • In the ownership of the seller at the time of sale• property of value• is in existence at the time of sale.• The subject matter must be:• Permissible product with the Shari’ah • specifically known and identified by the buyer• in the physical or constructive possession of the seller at the

time of sale.

• The sale must be instant and absolute.• The delivery to the purchaser must be certain,

not dependent on a contingency or chance.

• Payment may be on the spot or at a later agreed date.• The profit may be determined by mutual consent,

either in the form of a lump sum or a ratio of profit to be charged over the cost.

• All expenses incurred by the seller are included in acquiring the commodity (such as freight, custom duty, etc.)

• The actual cost of the commodity is known to buyer• The sale must be unconditional, unless the condition

is part of the transaction.

Case study of Murabaha management through inter-bank deposits

• Bank purchases goods on behalf of a client and re-sells at a mark-up, Ownership risk justify return to the bank.

• Uses of Murabaha contract in this transaction make an Investment funds for the bank a profitable commodities purchasing transaction, where the bank entering a simultaneous contract to re-sell the commodity in one, two or three months at a mark-up.

• Normally Islamic bank places funds for commodity trading in the markets such as the London Metal Exchange.

Murabaha Financing (Installment Credit Sale)

• Deferred payment Sale/Installment Credit Sale + Profit Mark-Up

• Closing & payment date must be clear• Bank can appoint client as agent (if bank is

inexperienced)• Technical ownership of good remains with

bank• Bank may request

Collateral/Security/Guarantee• Buyer knows the original seller price• The banker in a Murabaha must have some

form of actual ownership, registered or not, constructive or physical

Bank Client$10,000

$10,000+1000Differed payment date

Car Dealership

HummerChina

Islamic Bank

Request for 3 Hummer Cars

Buys 3 Hummers 3 x $60,000 ($180,000)

Transfer ownership of 3 Hummers

Transfers 3 Hummers

Pays $150,000 + $30,000 mark up(on deferred date)

Murabaha Financing (Deferred Payment Sale Example)

Commodity Murabaha (Liquidity Management)

Islamic Bank

Reliable & Good

Rating Bank Acting as

Commodity Broker A

Commodity Broker B

Request Bank to buy commodities

Transfer Commodities

Buy Commodities @ Spot (as agent)

Sell Commodities Deferred (Murabaha Agreement)

Sell Commodities @ Spot

Transfer Cash SpotPrice + Mark up Deferred

* 2 Brokers so as to avoid twin sale!

•Mark up based on LIBOR•3months-1year•Deferred payment with letter of Credit

Ijarah (Rental)

• Ijara is a contract which involves the transfer of usufruct of a property or asset to another person in return for an agreed consideration

• Ijara means selling the benefit or the use of a property own by other party for a fixed rental price.

• Under this concept, the Bank makes available to the customer the use of service of assets/ equipment such as plant, office automation or motor vehicles for a fixed period and price.

• The subject matter must of a value and use• The ownership remains with the lessor of the property or

asset. • All liabilities emerging from the property or asset is to be

borne by the lessor• liabilities arising from the use of the property shall be

borne by the lessee. • The period of lease must be determined in a clear term.

• The lessee uses the leased property only as specified in the Ijara agreement.

• The lessee is liable to compensate the lessor for any damage caused by his negligence or misuse on the property.

• Risk on the property in terms of damage or loss caused by factors beyond the control of the lessee rest on the lessor.

• Property jointly owned by more than one person can be leased out, and the rentals shall be distributed amongst the joint owners

• A joint owner of a property can lease his proportionate share to his co-sharer only, and not to any third party.

• The leased asset is fully identified by the parties.• The rental for the whole lease period must be

determined at the time of the contract. • It is permissible to fix a different amount of rent for

different phases of the lease.• The lessor cannot increase the rent unilaterally.

• The rent can be payable in advance and remain as “on account or in trust” towards the rent when due.

• The lease period commences from the date the asset has been delivered to the lessee.

• If the leased property has lost its purpose or function of lease, the lease shall be terminated.

• The lessee may be charged a late penalty for late rental payment; however, this payment is disbursed for charitable purposes only.

• If the lessee contravenes any term of the lease agreement, the lessor is entitled to terminate the lease unilaterally.

• If the leased property is insured under Takaful, its expenses should be borne by the lessor and not the lessee.

• At the end of the lease period, the lessor may agree to transfer the leased property to the lessee at a mutually agreed price.

• The lessee may only sub-lease the property if the lessor expressly agrees to such sub-lease.

• The lessor may sell the whole or a part of the leased property to a third party whereby the relation of the lessor and the lessee will thereafter be between the new owner and the existing lessee.

Ijara Investment Fund•This encompasses the leasing of machinery, equipment, buildings and other capital assets.

•The Islamic financial institution will purchase the asset in question and lease it to the ultimate customer for an agreed rental

•The rental may be fixed in advance or subject to occasional review by a mutually agreed

•The attitudes of Islamic financial institutions towards insurance of the asset vary

•some Shariah committees imposing an obligation on the lessee to insure the asset

•Premiums are likely to be paid by the Islamic financial institution, even if they are recovered through rentals or otherwise.

Ijara Thumma Al Bai’ (Hire purchase)

• Parties enter into contracts forming a complete lease/buyback transaction.

• The first contract is an Ijara that outlines the terms for leasing or renting over a fixed period,

• Second contract is a Bai (Sale) that triggers a sale or purchase once the term of the Ijara is complete.

Ijara-Wa-Iqtina (Rental ends with purchase)

• The Islamic bank provides equipment, buildings or other assets to the client against an agreed rental together with a unilateral undertaking that the client's ownership in the asset will be transferred to the lessee.

• The undertaking or the promise does not become an integral part of the lease contract.

• The rentals as well as the purchase price are fixed in such manner that the bank gets back its principal sum along with profit over the period of lease.

Other forms of Ijara

• Ijara Wa Iqtina/Ijara Montahia Bittamleek– Lease with acquisition/ Lease ending in Ownership– At the end of rental period Lessee buys asset.

• Ijara Mawsoofa Bil Thimma– Combination of construction finance followed by a redeemable lease – which buys the project (Forward priced lease)

• If there is a history of late payments or evidence of poor treatment of• the asset, the lease can be re-priced.

Customer =Lessee

Bank =Lessor Supplier

lease title

rentalpayments

end of contract:return of asset

purchaseprice

todaydelivery

future

paymentsreturn

Ijarah Structure (Operating Lease)

Customer =Lessee

Bank =Lessor Supplier

lease title

rentalpayments

lessee as service agent

purchaseprice

purchase of asset

purchase price

end oflease

period5

bank’s perspective: purchase undertaking ≈ put optionlessee’s perspective: sale undertaking ≈ call option

purchase

todaydelivery

future

paymentspurchase

Ijarah Wa Iktina Structure (Financial Lease)

House Purchaser

Islamic Bank

House is leased by Islamic Bank to the house purchaser

*Bank could appoint Purchaser to buy House from seller

•Bank has some form of ownership until end•Purchaser pays ‘rent’ to the bank•Rent could be fixed for length of lease or readjusted periodically

Istisna’a (Manufacturing)

• Istisna'a contracts normally for high value products such as Airplane's military equipment's

• Is an order to a manufacturer to manufacturer a specific commodity by the purchaser.

• Istisna'a shares similarity with Salam in terms of selling a particular commodity which is yet to exist at the point of sale transaction.

• The price is fixed mutually by the parties• The specification of the manufactured commodity is agreed in

advance and determined by the parties• Istisna'a creates moral obligation on the manufacturer to

manufacture• Cancellation before the start of manufacture by giving notice to the

other party (venality may be charged ). • After manufacturing started, the contract cannot be cancelled

unilaterally. • The buyer has the option to reject the manufactured goods if they

do not comply with the specification agreed in the contract.

Istisna'a from of Financing • Istisna’a used to provide financing especially in the housing finance

sector. • The financier constructs the house then enters into a parallel

Istisna'a contract with a third party or he may hire the service of a contractor (other than the client).

• Istisna'a allows the parties to fix the time of payment. • The payment may also be on an installment basis• In order to secure the payment of installments; the financier keeps

the deed as security• If the government wants to construct a highway, it may enter into a

contract of Istisna'a with a builder. The price of Istisna'a may be the right of the builder to operate the highway and collect toll fees for a specified period.

Project Financing with Istisna’a • Contract to acquire goods on behalf of a third party• Price paid to a manufacturer in advance of goods being purchased• Payments received cover wages and costs of input supplies• Applied to production of specific items• Delivery at an agreed date• The modern BOT (buy, operate and transfer) agreement may also be

formalized on the basis of Istisna'a.

Istisna'a structure

ProjectIslamic

Client

Payment forsupplies

Completion of project

Deferred payment

Istisna’a Structure

Customer Bank Manufacturer

title to asseton completion

sale or lease contract (Ijara Wa Istisna’)

advance payment

of purchaseprice

(instalments)

purchase contract(Istisna’)

title to asseton completion

e.g. advance

rental payments

duringconstruction

payment delivery

future

Istisna'a’ Structure

Shari’ah Compliant Products

• Salam (Future payment)• Bay Bithaman ajil (Delayed payment)

• Tawaroq• Qard Hassan (Interest free loan)

• Case study, Comparison between Islamic Finance tools vs. conventional investment

Salam (Future payment)

Salam(Advance payment for later delivery)

Salam is a sale contract, whereby the seller undertakes to supply specific goods to the buyer at a future date in exchange for an advanced price fully paid on the spot.

Payment in advance with deferred delivery is Salam contract is not a forward sale;

Therefore it’s subjected to some strict conditions: • The objects of this sale are goods and cannot be

commodity such as gold, silver or currencies.• Salam covers almost everything that is capable of being

definitely described as quality and workmanship.

Salam Standard elements of the contract cont.

• The price of Salam may be fixed at a lower rate than the price of such commodity paid on the spot. The difference between these 2 prices may be a valid profit for the buyer.

• In order to ensure that the seller delivers the commodity at the agreed date, the buyer may ask the seller to offer security in the form of guarantee or mortgage.

• The buyer pays the full price to the seller at the time of sale. • This is necessary to avoid being similar to sale of a debt against a debt,

which is prohibited.

Salam Standard elements of the contract

• It can only be effected on commodities whose quantities and quality can easily be determined.

• Salam is a mechanism that ensures the seller has the property required for the transaction.

• Salam cannot be effected on a product from a particular field or farm, The quality of the commodity must comprehensively specified in the contract, leaving no ambiguity which may lead to dispute.

• The quantity of the commodity is agreed upon in unequivocal terms.• The exact date and place of delivery must be specified in the contract.• Salam commodities must be paid for by money not an exchange of other

commodity

Parallel Salam contract• After purchasing the commodity, the bank may sell it through

a parallel contract of Salam for the same date of delivery. The period of Salam in this parallel contract is shorter and the price is higher, thus the difference between the price of the first Salam transaction and the second, which is the profit to the bank.

• If the parallel Salam is not feasible, unless the bank can obtain a unilateral promise from a third party buyer to purchase the commodity.

• the bank enters into two different contracts. In the first contract, the bank is the buyer and in the second, the bank is the seller.

Parallel Salam contract• Being merely a promise and not the actual sale, the buyer need not have

to pay the price in advance. Thus a higher price may be fixed and as soon as the commodity is received by the bank it will be sold to the third party at a pre-agreed price, according to the terms of the promise.

• The conditions and obligations of each contract are independent of each other (enforcement and performance are not contingent on each other).

• Parallel Salam is allowed with a third party only. The seller in the first contract cannot be made buyer in the second contract because it will be a buy-back contract and prohibited by Shariah.

• Even if the purchaser in the second contract is a separate legal entity, but it is fully owned by the seller in the first contract, the arrangement is not allowed.

Bay’ al Salam Structure

Customer Bank Supplier

sale of assetdelivery deferred

advance payment

in full(discounted)

purchaseprice in full

(plus premium)

payment delivery

future

sale of assetdelivery deferred

Bay’ Salam Structure

Salam V Forward Transactions

• Forward transactions– Only deposit is paid, and delivery is uncertain– Permissible even if traded prior to execution, as are futures

and options • Salam

– Financier pays price of commodity in advance in full– Quantity and delivery date and place specified– Financier may enter parallel Salam to sell commodity at a

slightly higher price if period is shorter to delivery– Price differential represents financier’s profit– Risk involved to justify profit as time period of contracts may

not coincide and financier could be exposed

Istisna'a V Salaam

Istisna'a•The subject is to be manufactured•Payment accepted by installment •Can be cancelled before manufacturing commences •Delivery time can be renegotiated

Salaam•The subject does not have to be manufactured•Payment in full in advance•Can’t be cancelled once contracted•Delivery is fixed

Arbun (Deposit)• The Arbun is contract provides for the purchaser to make a deposit

(which forms part of the purchase price) for the purchase of particular assets at a later date

• The sale of the assets not proceed if the purchaser elects not to proceed and the Arbun forfeited

• Arbun in modern day financing has met with varying levels of approval amongst the schools of Islamic jurisprudence.

• Arbun contract has been likened to an option. • A clear understanding of the Islamic requirements for this mode of

financing are required in order to ensure that it satisfies the principles of Shari’ah and is not held to be speculative or uncertain.

Tawaroq

Tawaroq(Opposite of Murabaha)

Murabaha Bank buys and owns the commodity Commodity sold to the client at a mark-up

Parallel or reverse MurabahaA client is in need of liquid cash, he has

commodity stock. He authorizes the bank or an institution nominated by

the bank to sell the commodity for a service commission

The client may purchase his own commodity stock at a price plus mark-up at deferred payment

Sale value (less mark-up) deposited into client's account

Bay Bithaman ajil (Delayed payment)

Qard Hassan (Interest free loan)

Islamic Finance

• Sukuk types• Difference between Sukuk and Bonds

• Sukuk structure and application• Securitising Sukuk

• Sukuk issuance and index• Sukuk trading and secondary markets

• Case Study

What Sukuk look like

• Essential difference between Bonds & Sukuk• Kinds of Sukuk• Types of Sukuk

• Ijara Sukuk • Mudarabah Sukuk • Istisna'a Sukuk • Musharakh Sukuk • Salaam Sukuk

• Corporate governance for Islamic finance

What is a Sukuk?• AAOIFI:

– ‘certificates of equal value representing undivided shares in the ownership of tangible assets, usufructs and services or (in the ownership of) the assets of particular projects or special investment activity’

– Arabic Sakk – plural Sukuk• “check” derived from Sakk

• AAOIFI does not refer to application or uses of Sukuk• Only to classification• Governs use of funds received from Sukuk holders• E.g. Istisna Sukuk, Murabaha Sukuk, Ijara Sukuk etc.• No mention of Project Finance, Convertible, Working Capital etc

Is Sukuk equity or debt?

• AAOIFI definition can fit quite well

to the definition of a company that

issues equity/shares

• A model for investment, sharing

risk and rewards

• However in practice, it is a debt

instrument

Types of Sukuk

• Musharakh and Mudarabah Sukuk – Partnership transaction– Often used to manage the relationship between different parties– Often in combination with Salam or Istisna'a Sukuk

• Murabaha Sukuk• Mudarabah Sukuk• Istisna’a Sukuk• Ijara Sukuk

– Sale and Lease Back– Use of existing asset to raise funds for a new project or development

• Salam and Istisna'a Sukuk– Short term and long term production finance

Party to Sukuk structure• Issuer

• Corporate or government raising funds (originator)

• Special Purpose Vehicle (SPV)– Asset Acquisition– Bankruptcy remote– Tax efficient jurisdiction– Trustee

• Investor• Manager (representing Sukuk investors)• Servicer (to collect cash from assets, maintenance of assets.

Sometimes performed by the originator)

• Bank• Holding bank to receive fund from Sukuk

holders and transfer fund to issuer 101

Basic Sukuk structure

IssueMaturity

Legal Documents in issuing Sukuk

• Purchase agreement• Master Ijarah agreement• Sellers Declaration of trust• Service agency agreement• Insurance (Takaful) agreement• Purchases Undertaking Deed• Sale Undertaking agreement

Sukuk Structure• Sukuk obviously cannot bear interest. • For Sukuk to be Shari’ah compliant, the

Sukuk holder must have part in the assets being financed.

• The Sukuk holder’s return is income generated(Ijara) by the issuer

• He own proportional ownership of the project.

• Typically, a bankruptcy remote issuer (SPV) would acquire property, which will be held on trust for the Sukuk holders.

• The property will generally be leased, in order to generate income.

Sukuk structure

• The issuer issues the Sukuk certificates, to the Sukuk holders who acquire proprietary interest in the assets of the issuer.

• The nature of this proprietary interest will depend on the view taken by the Scholars

• The minimum ownership requirement for the Sukuk holder is an entitlement to income generated by the assets.

• The issuer, acting as trustee, collects such income and distributes it to the Sukuk holders

Bond Structure

• A conventional, plain vanilla bond is a simple debt

• The note holder’s return for providing capital to the note issuer takes the form of interest.

• The Bond holder’s return on his subscription proceeds is an income generated by the debit generated from the cash flow, he own debit and promises to pay

Bonds Sukuk• A bond is an obligation to

pay to bond holders, on certain specified dates, interest and principal.

• Primary level – loan contract to create indebtedness

• Return to investors is the extra amount charged on the loan amount minus interest charges

• A Sukuk holder is an owner in the underlying assets

• Sukuk holders are entitled to share in the revenues

• Primary Level – not a loan contract, because of prohibition from Riba in a loan transaction

• Return to investors come from the in-built profit elements in the sale, lease, or partnership contract

Bonds Sukuk• The loan indebtedness is

securitized with zero coupon

• Bonds are sold to investors which are backed by the underlying cash flows

• Bonds (if specified by the issuer) can be converted into a fixed number of ordinary shares of the issuing company

• The financial rights under the contract are securitized

• Sukuk sold to investors which are backed by underlying assets

• Sukuk cannot be converted once they are issued

Bonds Sukuk

• Bonds depend solely on the creditworthiness of issuer; in the case of issue failure, bond holders join the pool of general creditors seeking the assets of a bankrupt company

• Sukuk holders are secured creditors as they own part of the underlying asset; even if failure occurred, Sukuk holders are paid before any secured or unsecured creditors, and Sukuk prices depend on the value of the underlying assets

Bonds Sukuk• Bond holders are not

concerned with asset-related expenses

• The underlying contract for bonds only depends on the issuer

• Rights of bond holders are not linked to assets

• Term does not correspond to term of underlying project

• No Sharia’a constraint

• Asset-related expenses is attach to Sukuk holders

• The underlying contract for Sukuk issuance is a permissible contract such as lease or any of the 14 categories defined by AAOIFI

• Proportional ownership• Shares in profits, may incur losses

(Risk sharing)• Maturity typically links to end

date of underlying project• Subject to Sharia’a

Special Purpose Vehicle(SPV)• An SPV must have independent and professional directors

or Trustee• The SPV must be sufficiently “bankruptcy remote”;• The SPV is ultimately responsible to ensure that its assets

are managed with due care and in the best interests of the Sukuk holders

• The SPV and the securities issued must not carry the same name as the Originator or be similarly identified

• The SPV must keep proper accurate accounts its assets, liabilities, income and expenditure to be transparent

• To comply with all regulatory reporting requirements in the jurisdiction

Sovereign Sukuk vs. Corporate Sukuk

• Sovereign • Issued by Government• Sets benchmark• Ijara structure –

preferred• Sukuk Holders are

Domestic owners or/ and international owners (Unless Sovereign Law passed by the parliament)

• Corporate• Issued by Corporate

company (no guarantee)• Ijara more difficult• Variety of structures

• Musharakh,• Mudarabah,• Wakala• Istisna'a

• Sukuk Holders domestic or/and International owners

Who buys Sukuk

• Islamic banks– Liquidity management– Balance sheet usage

• Islamic Funds– Asset diversification

• Islamic Pension funds, Takaful– Fixed income, annuity type income

• Large investors• Non-Islamic investors – all of above

Project Finance Sukuk• Financing of large projects infrastructure and

industrial projects (Sovereign Sukuk manly)• Equity – based on projected cash flows rather than

balance sheet of project sponsors• Typically non recourse loans, secured by project

assets, including revenue-producing contracts • Debt and Equity• Musharakh Sukuk used more often• Istisna'a combined with Ijara Sukuk• Shariah view, during construction “the Sukuk is

not tradable as not backed by assets at that stage”

Project Finance Sukuk

Source – DIFC Guide Book

Types of Sukuk

• Mudarabah Sukuk ( Financing)• Musharakh Sukuk (partnership company)• Murabaha Sukuk (Financing, and

Investment)• Intifaa Sukuk ( Operate and use)• Istisna'a Sukuk (Manufacturing)• Salaam Sukuk ( Future delivery)• Ijarah Sukuk (Rental)• Hybrid Sukuk (Mix basket )• Muzara 'a Sukuk ( Sharecropping)• Musaqaa Sukuk ( Irrigation)

Principals of Sukuk

• A debt ( Murabaha Sukuk)• An asset (Ijarah Sukuk)• A project (Istisna'a Sukuk)• A business ( Musharakh Sukuk)• An Investment (Istithmar Sukuk

Musharakh SukukKey Contract types

• It’s a Partnership arrangement• Musharakh involves a mutual contract

between Issuer & SPV (for Sukuk Holders) to participate in a commercial enterprise for a specific period( from 5-20 Years)

• Management– All partners (SPV is one partner) may be involved in the

management of the project– Transparent management and accounts is essential– Remuneration for the management is part of expanses

Musharakh Sukuk

• Musharakh is a relationship established under a contract by the mutual consent of the parties for sharing of profits and losses in the joint business.

• It is a partnership arrangement between two or more parties to finance a business venture whereby all parties contribute capital for the purpose of financing the project.

• Any profit derived from the venture will be distributed based on a pre-agreed profit sharing ratio,

• loss will be shared on the basis of equity participation

Musharakh Sukuk

• The Musharakh Sukuk can also be structured with all investors putting capital in a Musharakh and appointing the issuer as their agent to manage the project.

• The issuer will issue certificates evidencing the capital contribution of the investors and the ‘indicative rate of profit’.

• Profits, if any, will be shared between the Musharakh participants at an agreed sharing ratio.

Mudarabah Sukuk

• Similar to Musharakh Sukuk • It’s a Partnership arrangement• Mudarabah involves a mutual contract between Issuer

& SPV (for Sukuk Holders) to participate in a commercial enterprise for a specific period( from 5-20 Years)

• Management– Issuers are the sole management of the project– SPV is not involved in the management of the project– Transparent management and accounts is essential– Remuneration for the management is part of expanses

Mudarabah Sukuk

• The profit is to be shared in according to a pre-agreed ratio.

• A contract is made between Issuers and SPV to finance a business venture and issue Sukuk.

• The profit will be distributed based on a pre-agreed ratio.

• The loss shall be borne solely by the issuers of the Sukuk (Obligator) in the event of any loss.

• Mudarabah Sukuk give their owner (issuer) the right to redeem the Sukuk for the original value plus the profit agreed.

Murabaha Sukuk

• Murabah is the sale of goods at a price comprising the purchase price plus a margin of profit by parties concerned.

• Sukuk al-Mudarabah are certificates of equal value issued for the purpose of financing the purchase of goods through Murabah contract, so that the certificate holders become owners of the Murabah commodity.

• The issuer of the Sukuk certificate is the seller of the Murabah commodity

Murabaha Sukuk

• The subscribers are the buyers of that commodity• The realized funds are the purchasing cost of the

commodity. • The certificate holders own the Murabah commodity

and are entitled to proportion of the final sale price.• It is short term Sukuk• Manly used to supply commodities such as Grains,

Oil, Coal

Murabaha Sukuk structure

IssuerObligator S P V

Sukuk owners

Payment

Initial transfer of title Final transfer of title

Part Income generated

Ijarah Sukuk• Sukuk al-Ijarah will offer a high degree of

flexibility

• They are issued as sovereign Sukuk by government, municipalities, awqaf or any other asset users,

• private or public companies, financial intermediaries or directly by users of the leased assets Sukuk al-Ijarah is completely negotiable and can be traded in the secondary markets.

• Sukuk al-Ijarah holders, bear full responsibility for their property.

• They are to maintain the internal of the properties

Ijarah Sukuk

• Ijarah Sukuk is a contract which involves the transfer of usufruct of a property or asset to another (SPV) in return for an agreed regular consideration

• Sukuk al-Ijarah are subject to risks related to pay the rental installments.

• Market risks arising from potential changes in asset pricing and in maintenance and insurance costs.

• The net return on Sukuk al-Ijarah is fixed and determined in advance,

• All maintenance and insurance expenses are determined in advance.

Istisna'a Sukuk

• Istisna'a is a contractual agreement for manufacturing goods and commodities

• Cash payment in advance and future delivery or a future payment and future delivery.

• A manufacturer or builder agrees to produce or build a well described good or building at a given price on a given date in the future.

• Price can be paid in installments, step by step as agreed between the parties.

Istisna'a Sukuk

• Istisna'a can be used for providing the facility of financing the manufacture or construction of houses, plant projects and building of bridges, roads and highways.

• Sukuk al-Istisna'a are certificates that carry equal value and are issued with the aim of mobilizing the funds required for producing products that are owned by the certificate holders.

Istisna'a Sukuk

• The issuer of these certificates is the manufacturer (supplier/seller);

• The subscribers are the buyers of the intended product

• the funds realized from subscription are the cost of the product.

• The certificate holders own the product and are entitled to the sale price of the certificates or the sale price of the product sold on the basis of a parallel Istisna'a, if any.

Salam Sukuk• Salam is the sale of a specific commodity,

• Well defined in its quality and quantity,

• Delivered to the purchaser on a fixed date in the future against an advanced full payment of price at spot.

• Sukuk al-salaam are certificates of equal value issued for the purpose of mobilizing salaam capital so that the goods to be delivered on the basis of salaam come to the ownership of the certificate holders.

Salaam Sukuk

• The certificates or the sale price of the salaam goods sold through a parallel salaam

• Salam-based securities may be created and sold by an SPV • The funds mobilized from investors are paid as an advance

to the SPV for deliver at future date. • SPV can also appoint an agent to market the promised

quantity at the time of delivery, perhaps at a higher price. • The difference between the purchase price and the sale

price is the profit to the SPV and hence to the holders of the Sukuk.

Salaam Sukuk

• The issuer of the certificates is a seller of the goods of salaam

• Subscribers are the buyers of the goods

• The funds realized from subscription are the purchase price (salaam capital) of the goods.

• The holders of salaam certificates are the owners of the salaam goods and are entitled to the sale price

Obligators

(Undertaking future sale of commodities for the investors)

Obligator(Sells commodity on salaam basis)SPV

(Special purpose Vehicle)

Salam SukukHolders

(Investors)

Secondary Sukuk Trading

• The market for Sukuk is maturing and there is an increasing demand for secondary Sukuk market

• Sukuk have confirmed their viability as an alternative means to mobilize medium- to long-term savings and investments from a huge investor base.

• Investors are able to focus on the underlying asset and viability of a project and not just on the credit of the issuer.

Secondary Sukuk trading

• Different Sukuk structures have been emerging over the years but most of the Sukuk issuances to date have been Sukuk al-Ijarah.

• Since they are based on the undivided pro-rata ownership of the underlying leased asset, it is freely tradable in the secondary Sukuk market at par, premium or discount.

• Tradable Sukuk represent tangible assets or proportionate ownership of a business

• Non-tradable Sukuk represent receivables of cash or goods that are non-tradable. e.g. Salam or Murabaha

Liquidity management in Sukuk

• It provides adequate protection for the separate interests with the emphasis on equity and the concept of trusteeship.

• Mudarabah, or participation financing, is also commonly used in partnerships for the acquisition or development of real property.

• Istisna’a can also be used to provide property development financing for the development of property on a post-acquisition basis.

Islamic Finance

What Structure using Islamic Finance tools do you think suitable for

Investment fund and Project Finance

major market playersin Islamic finance

ratingagencies

informationservices,media,associations

consultancy(legal, com-mercial,Shari’ah)

training,education,research

standardsetters, regulators,

stockexchanges,financial centres, …

Shari’ah compliantfinancial instruments

infrastructure of the Islamic finance industry

• mudarabah• musharakah• …

capital market instruments• Shari'ah compliant stocks• Islamic securities (sukuk)• Islamic derivatives …

• murabahah• ijarah• …

interest-free finance contracts

Islamicbanks

specializedIslamic finan-cial service providers:investmentcompanies, house financecompanies, …

conventional market players

IslamicsubsidiariesIslamic

windows

Takaful (Re-Takaful)

prohibition of riba (interest),gharar (uncertainty), maysir (gambling), problem: form vs. substance

investment & commercial banks 81%

Islamicfunds

estimated total volume of Shari'ah compliant assets 2012F: 1,6 trillion US dollars

AAOIFI, IFSB,BIS, BNM, CBB, SBP, DFSA, FSA, …

Bursa Suk Al-Sila’ (Malaysia), DIFC (Dubai),IIFM, IILM, …

Moody’s, S&P, Fitch,RAM Ratings, IIRA, …

BIBF, IRTI, World Bank,IBFIM, INCEIF, universities, …

Source of data: GIFF 2012.KPMG, E&Y, PwC, Deloitte,Yasaar, Amanie, …

Dow Jones, FTSE, MSCI, Thomson Reuters, RedMoney, …

Proposed Structure Islamic Funds for Investment and Project Finance

Islamic Finance

• Islamic private equity fund• Wealth management

• Islamic derivatives and hedge funds(Shari’ah restrictions & application)• Islamic Forward currency exchange, Currency options, profit rate swaps, and

Islamic Finance

• Structure Shari’ah-compliant Portfolio Management

• Islamic asset management, Equity market, private equity, venture capital and unit

trust• Equity and stock screening for Shari’ah

compliant• Shari’ah-compliant Asset Classes, Sukuk,

fixed income

Islamic Finance

• Governance framework in Islamic finance institutions

• Shari'ah Board responsibilities and accountability

• Disclosures and transparency• Risk Management in Islamic Finance

• Case Study• Q & A

Who is in Charge

Overview of Corporate Governance

• Corporate governance aims at providing institutions with a body of rules and principles

• to ensuring that good practices guide overall management

• It has now come to mean the whole process of managing a company

• Set of incentive structure to address principal-agent 148

Overview of Corporate Governance

• Issues and ensure that executive management serves the long-term best interests of the shareholders

• The company in conformity with the laws and ethics of the country.

• Balancing the power between the Chief Executive Officer (CEO), the board, and the shareholders

• Auditing, balance sheet and off-balance disclosure, • Insure transparency of the inistituton.

Islamic financial institutions present potential Corporate Governance

issues?• Since the inception of modern Islamic banking, the

number and reach of Islamic financial institutions worldwide has risen from one institution in one country in 1975, to more than 300 institutions operating in more than 75 countries.

• Product and service innovation through the development of Shari’ah compliant mortgages, leasing, securitization, Sukuk and Takaful have also contributed to growth in Islamic finance.

• The other major factor is that Shari’ah products have yielded higher returns compared to conventional assets in countries pegged to the US$.

Corporate Governance Aims to provide

• Institutions with a body of rules and principals to ensure good practice of management

• Ensure that the executive management service long term best interest of the shareholders and public

• Ensure that the institution sustainable value in conformity with the law and ethics of the country

• Ensure Transparency in the institution activities• Ensure that adequate disclosure of balance sheet and off

balance sheet• Ensure balancing the power between CEO & the Board & the

shareholders

The corporate governance framework should promote transparent and efficient markets, be consistent with the rule of law and clearly articulate the division of responsibilities among different supervisory, regulatory and enforcement authorities.

• A. The corporate governance framework should be developed with a view to its impact on overall economic performance, market integrity and the incentives it creates for market participants and the promotion of transparent and efficient markets.

• B. The legal and regulatory requirements that affect corporate governance practices in a jurisdiction should be consistent with the rule of law, transparent and enforceable.

• C. The division of responsibilities among different authorities in a jurisdiction should be clearly articulated and ensure that the public interest is served.

• D. Supervisory, regulatory and enforcement authorities should have the authority, integrity and resources to fulfill their duties in a professional and objective manner.

• E their rulings should be timely, transparent and fully explained.

Shari’ah Supervisory BoardRoll, responsibility & accountability

Dr. Aly Khorshid 155

Why Shari'ah Board Members’ Accountability Is Vital

A •It gives worldwide credibility for the Islamic finance system.

B •It creates confidence among investors and the public in the Islamic finance system.

C •It demonstrates that conventional finance institutions can adopt Islamic financial transparency.

D •It presents personal credibility to individual Shari’ah board members.•It demonstrates that the Islamic finance system is compatible with the

E •It demonstrates that the Islamic finance system is compatible with the conventional finance system.

F •It introduces Islamic risk management tools into global finance.

G •It reflects Islamic principles in the terms of transparency, ethics, fairness, justness, and honesty.

H •It allows management and shareholders to seek advice on Shari’ah matters•It demonstrates that the Islamic finance system is compatible with the

I •It allows the creation and structuring of new Shari’ah-compliant products within the global internationally developed market

J •It strengthens the global respect of fatwa issued for product development that is Shari’ah-compliant.

K •It introduces Shari’ah auditing standards to the global financial market

L •It strengthens the corporate governance of Islamic financial institutions

M •It embeds the values of Islamic finance into the business operations and governance of financial institutions.

N •It ensures Islamic ethical principles are preserved within the global market

O •It ensures Islamic ethical principles are preserved within the global market

P •It ensures the adoption of Basel II and Pillar II, particularly in regard to money laundering and capital adequacy issues, within Islamic finance institutions

Basic duties of Shari’ah scholars

• Advising management and shareholders on Shari’ah matters; • Structuring new Shari’ah-compliant products within the global

internationally-developed standard;• Issuing fatawa for Shari’ah-compliant product development • Proposing Islamic risk management tools to management; • Enforcing Shari’ah auditing standards in the procedures of their

institution; • Strengthening the corporate governance of Islamic financial

institutions;• Instilling Islamic finance values into financial institutions’

business operations and governance

• Instilling Islamic finance values into financial institutions’ business operations and governance;

• Conducting and/or supervising Shari’ah audits to ensure compliance;

• Ensuring Islamic ethical principles are preserved within the institution;

• Protecting consumers’ rights from abuse and fraud.• Ensuring the adoption of Basel II and Pillar II, particularly in

regard to the prevention of money laundering and capital adequacy issues within their institution

• Ensuring management accountability to the shareholders and customers

Education• there is no program in place for educating

and training the new generation of Shari’ah board members.

• Shareholders and clients of IFIs expect their investment to be protected by professionals adhering to strict standards of corporate governance.

• To protect the system from abuse and fraud there must be corporate governance

Shari'ah Approval Process

Phase 1Identify Shari’a Options

Activities Determine our clients’

needs and business objectives

Identify potential high level Shari'a product structures

Discuss available options with our clients

Work through the commercial and practical considerations with our clients

Deliverables Preliminary Shari'a Report

Phase 2Finalise Shari'a Structure

Activities Review selected product

structure Liaison with Shari'a

Scholars on the structure design

Identify required legal documentation

Prepare draft Fatwa Review of structure by

Shari'a Board and issue of Fatwa on structure

Deliverables Fatwa on Shari'a Structure

Phase 3Review Legal Documentation

Activities Review legal documents for

compliance with Shari'a laws and the structure Fatwa granted

Liaise with Shari'a Scholars and the clients’ legal team during the documentation drafting

Legal documentation reviewed by Shari'a Board and issue of Fatwa on documentation

Deliverables Fatwa on Legal

Documentation

Throughout the process, Dar Al Istithmar adheres to relevant Shari'a industry standards, including the AAOIFI Shari’a Standards All processes are monitored through an internal quality assurance process and frequent consultation with the Chairman of the Shari'a Supervisory Board.

Client selects methodology

& builds detailed structure

Client produces

legal documents

Operating ModelsModel options Characteristics Shari’a Aspects

Shari’a Compliant Islamic Banks

Due to rapid development of Islamic Finance, new banks are being set-up which are fully Shari’a Compliant and offer retail as well as whole sale banking facilities.Since 2004, five fully Islamic banks have been set up in the UK, out of which one is a retail bank where as other four are whole sale banks.

From Shari’a perspective, these are at the lowest risk due to:• No dealing in conventional / interest based products• No risk of mixing of Islamic Funds with conventional.• More involvement of Shari’a Scholars in day to day activities of the bank.

Conventional bank with an Islamic subsidiary / Finance Vehicle

This model is used by conventional banks which want to extend their services into retail and whole sale Islamic Banking as well as retaining the conventional customer portfolio. This model is used by HSBC, Standard Chartered, Citi etc.

From Shari’a perspective, Islamic subsidiaries / finance vehicles are considered at a lower risk due to:• Bespoke IT system and infra-structure for Islamic Products.• Segregation of Islamic Funds, cash flows, assets and liabilities from conventional.• Involvement of Shari’a Scholars in day to day activities of the Islamic Finance Vehicle.

Conventional bank with an Islamic Window

This set-up is primarily used by conventional investment banks which want to provide its high net worth individuals and institutional customers access to Shari’a Compliant investments and Structured products.This model is followed by Deutsche Bank, Barclays Capital etc.

From Shari’a perspective, Islamic windows are considered to be high risk primarily due to:• IT Systems and infra-structure of conventional banks may not be not be flexible enough to cater requirements of Islamic Products. • Funds generated from Shari’a Compliant sources are not segregated from funds generated from conventional activities.

Contrast of Shari'ah Governance with Existing Governance Structure

FUNCTIONS TYPICAL FINANCIAL INSTITUTION

ADDITIONS IN IFIS

Governance Board of Directors Shari’ah Board

Control Internal Auditor

External Auditor

Internal Shariah Review UnitExternal Shariah Review

Compliance Regulatory and Financial Compliance

Internal Shariah Compliance Unit

Voluntary Standards on Shari’ah Governance

AAOIFI Governance Standards1. Shari’ah Supervisory

Board: Appointment Composition and Report

•At least 3 members (no directors or shareholders)•Requirements for report suggest Shari’ah board must play a deep role in review of bank’s operations.•Recommendation to publish fatwas, rulings and guidelines

2. Shari’ah Review

•SSB forms opinion, but Shari’ah compliance rests with management•Examination includes contracts, agreements, policies, products, transactions, memorandum and articles of association, financial statements, reports (especially internal audit and central bank inspection), circulars, etc. •complete and unhindered access to all records, transactions, and information from all sources including professional advisers and the IFI employees.

3. Internal Shari’ah Review•Internal division or part of internal audit•Examination and evaluation of the adequacy and effectiveness of the IFI’s system of internal Shari’ah control and the quality of performance in carrying out assigned responsibilities.

The SSB review procedures shall normally include: • obtaining an understanding of the management’s awareness, commitment and compliance control procedures for

adherence to the Shari'ah; • reviewing of contracts, agreements, etc.; • ascertaining whether transactions entered into during the year were for products authorised by the SSB; • reviewing other information and reports such as circulars, minutes, operating and financial reports, policies and

procedures, etc.; • consultation/co-ordination with advisors such as external auditors; and • discussing findings with an IFI’s management.

Risk Management in Islamic Finance

• Risk is exposing to danger and/or hazard• A possibility that the outcome of an action or event

could bring adverse impact resulting in loss• Banks are exposed to greater risk and loss because they

are stack holders of other people money• Risk is defined in ISO 3100, is intended to be a family of standards

relating to risk management codified by the International Organization for Standardization

• Is a structured discipline approach to manage strategy, processes, people, technology and knowledge for changing uncertainties

• Risk management can therefore be considered the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events.

• Risks can come from uncertainty in financial markets, project failures, legal liabilities, credit risk, accidents, natural causes and disasters as well as deliberate attacks from an adversary.

• The strategies to manage risk include transferring the risk to another party, avoiding the risk, reducing the negative effect of the risk, and accepting some or all of the consequences of a particular risk, ideal risk management minimizes spending while maximizing the reduction of the negative effects of risks.

Potential Risk treatment

• Once risks have been identified and assessed, all techniques to manage the risk fall into one or more of these four major categories:

• Avoidance (eliminate)• Reduction (mitigate)• Sharing (outsource or insure)• Retention (accept and budget)

Corporate Risk

Management

Credit Risk

Operational Risk

Strategic RiskReputation RiskLiquidity Risk

Price Risk

Rate of Return Risk

Funding (A/L) Risk;Prepayment Risk;Spread Risk;Option Risk.

Market Risk;Volatility Risk;Option Risk;Basis Risk

Funding Mismatch Risk;Debts Risk;Risk of Loss on Inv. sales

Compliance Risk;Regulatory Risk;Public Relations Risk;Shareholder Relations Risk

Competitive Risk;Political Risk;Legal Risk;Product Risk

Internal Control Risk;Systems (IS/IT) Risk;Accounting Risk;Settlement Risk

Default Risk;Counterparty Risk;Concentration Risk

SOURCES OF RISK

Shari’ahNon-compliance Risk

TYPES OF RISKS FACED BY IFIS

Market

Equity Investment

Rate of Return

Displaced Commercia

l Operational

Sharia’h Non

Compliance

Transparency Fiduciary

Credit

Risk Avoidance• Not performing an activity that could carry risk”for example

would be not buying a property or business in order to not take on the liability that comes with it”.

• Not flying in order to not take the risk that the airplane was to be hijacked.

• Avoidance may seem the answer to all risks, • But avoiding risks also means losing out on the potential

gain that accepting (retaining) the risk may have allowed. • Not entering a business to avoid the risk of loss also avoids

the possibility of earning profits

Hazard Prevention

• Hazard prevention refers to the prevention of risks in an emergency.

• The first and most effective stage of hazard prevention is the elimination of hazards.

• If this takes too long, is too costly, or is otherwise impractical, the second stage is mitigation.

• Prevents hazardous events occurring

Risk Reduction

• Involves methods that reduce the severity of the loss or the likelihood of the loss from occurring” for example, sprinklers are designed to put out a fire to reduce the risk of loss by fire” This method may cause a greater loss by water damage and therefore may not be suitable.

• But what choice can have? Complete loss, or partial loss

Risk Retention

• Involves accepting the loss when it occurs. • True self insurance falls in this category. • Risk retention is a viable strategy for small risks where

the cost of insuring against the risk would be greater over time than the total losses sustained.

• All risks that are not avoided or transferred are retained by default.

• Includes risks that are so large or catastrophic that they either cannot be insured against or the premiums would be infeasible.

Risk Sharing

• The term of 'risk transfer' is often used in place of risk sharing in the mistaken belief that you can transfer a risk to a third party through insurance or outsourcing.

• In practice if the insurance company or contractor go bankrupt or end up in court, the original risk is likely to still revert to the first party.

Risks in Islamic Banks

• Shari’ah Non-Compliant Risk• Commodities and Investment Risk: arising from holding inventory

under Murabaha(commodities) or assets lease under Ijara • Rate of return Risk: Similar to interest rate risk• Equity position Risk: arising from equity exposure in Musharakh &

Mudarabah financing contract• Pricing Risk: Uncompetitive products due to higher administrations

costs particular on new establishment• Ownership Risk : Assets owned as part of financing• Reputation Risk: Fiduciary duties towards depositors (withdrawal

of funds)

RISK’s FOR conventional BANKS

OPERATIONAL

FOREIGN EXCHANGE

REPUTATION RISK

RATE OF RETURN

EQUITY INVESTMEN

T RISK

SOLVENCY&

LIQUIDITY

Interest Rate Risk

MARKET

CREDIT

Risk’s For Islamic Banks

OPERATIONAL

FOREIGN EXCHANGE

REPUTATION RISK

RATE OF RETURN

EQUITY INVESTMEN

T RISK

SOLVENCY&

LIQUIDITY

SHARIAH COMPLIANC

MARKET

CREDIT

Shariah Compliance Inspection

(By the Central Bank)

Internal Shariah

Review / Audit (Internal Function)

Shariah Compliance

Consideration by External

Auditor / External

Shariah Audit

Shariah Review

(Performed by the Shariah

Board / Advisor)

Shariah Supervisory

Board / Shariah Advisor

Shariah Compliance Risk

The lack of consensus on Shari'ah interpretation adds aconsiderable risk element

TYPES OF RISKSCredit Risk

•Risks related to failure by IFIs’ customers or counterparties to meet their obligations to the IFIs.•For example, default in financing payment by customers can result in loss of income and capital.

Equity Investment Risk

•Risks in holding equity instruments for investment purposes. For example, shares or profit-sharing instruments in Mudaraba and Musharaka transactions.•Equity instruments expose IFIs to risks that value of investment capital may be impaired or that the companies (in which IFIs have invested) may fail to generate profit.

Market Risk

•Risks related to movement of profit benchmark rates, foreign exchange rates, equity prices and commodity prices.•Fluctuations on these rates or prices can impact IFIs’ earnings.

Liquidity Risk

•IFIs use their customers’ deposits and investment funds to finance IFIs’ financing/investment activities.•IFIs are exposed to risks that they may be unable to match any increase in financing/investment activities with corresponding increase in deposits/investment funds.

Rate of Return Risk

•IFIs have to manage expectation of their investment account holders and IFIs’ own ability to generate returns from IFIs’ assets.

Displaced Commercial Risk

•IFIs may be under market pressure to pay returns to its investment account holders that are higher than what has been earned from the IFIs’ assets (therefore, IFIs may waive their rights on their Mudarib share of profits).

Operational Risk

•Risks from inadequacy or failure of internal processes and controls; from non-compliance to Shari’a; or from external events.•These risks may lead to withdrawal of deposits, loss of income, or cancellation of contracts.

Consequential Business Risk

•Consequential Business Risks•Related to development in external market place.•Adverse changes to markets, counterparties, economic and political environment.•Reputational Risks•Related to failures in governance, business strategy and process.•Negative publicity will impact their market position, profitability and liquidity.

RISKS INHERENT IN IFIsSource of Funds (Liabilities Side)

Features Implications

External FundsInterest Free Deposits (Current Account Equivalent) - Qard Hasan

Profit Sharing Investment Accounts (Interest Bearing Deposit Equivalents)

Restricted PSIA (Off Balance sheet)

Liquidity RiskOperational Risk

Shariah Non-compliance RiskRate of Return Risk Transparency RiskFiduciary Risk

Internal Funds Equities

Operational Risk Rate of Return RiskReputational Risk Displaced Commercial Risk

RISKS INHERENT IN IFIsUses of Funds (Assets Side)

Features Implications

Asset BasedMurabaha in place of short term loans: where non-binding order is recognised; Murabaha; MPO may expose the IFI to unwanted assets:- Lower Price at the point of disposing the assets - Operational Issues such as storage

Ijarah and Ijarah Muntahia Bittamleek (IMB) assets in place of longer term conventional loans

Salam and Istisna give rise to non-financial assets Salam – hedge with parallel salam and/or promise Parallel Istisna – WIP inventories

Risk TransferCredit Risk or Market Risk Operational Risk Consequential Risk (RRR, DCR and Systemic)

Risk CombinedCredit Risk / Market RiskOperational Risk

Profit and Loss Sharing-Musharaka

Profit Sharing and Loss Bearing-Mudaraba

Investment in Real Estate

Capital Impairment RiskCredit RiskMarket RiskOperational RiskEquity Investment Risk

Market Risk, Liquidity Risk, Rate of Return Risk

Management of Credit Risk• Policy on credit selection criteria.• Processes on credit approval, review and monitoring.• Credit exposure portfolio based on borrower type (retail / commercial /

corporate), financing type, economic sector, country/region.• Policy for determining and allocating provisions for doubtful debt and

estimated impairment of financing assets.

Management of Equity Investment Risk

• Policy on investment selection criteria.• Processes on investment approval, review and monitoring.• Investment exposure portfolio based on types of investment,

expected returns, holding periods, risk tolerance.• Policy for methods of valuation for the investments.• Exit strategy from the investments.• Restricted Mudharaba / Musharaka Mutanakasah

Management of Market Risk

• Identification of underlying market risks in IFIs’ financing or investment activities. For example, commodity-based investment carries risks on movement of commodity prices.

• Quantification of market risk exposure (through valuation and pricing methodology) and monitoring of that exposure.

• Policy on provisions to support probable losses of impairment of assets.

Mitigated by:• Deal structure Murabaha.• Regulatory restrictions.• Hedging techniques through structured commodities.

Management of Liquidity Risk

• Framework to measure, monitor and report liquidity exposures.• Adequate funding capacity (access to IFIs’ own financing

arrangement or to additional capital).• Portfolio of customers’ funds (current account deposits, restricted /

unrestricted investment account funds).• Holding of other assets (eg., tradable securities) that can be

liquidated to cover any shortages.

Primer on Rate of Return Risk (1/3)Conventional banks, through the asset transformation function, mismatch the maturities of their assets and liabilities.• This mismatching expose banks to refinancing risk

Liabilities $10M

Assets $10M

Period 1 Period 2

Deposits rate 1% 2.5%

Loan rate 2% 2%

Profits $100,000 ($50,000)

• The dual banking system exposes Islamic banks to interest rate risk

• Ability of depositors to switch between the two banking systems forces Islamic banks to pay a rate of return equivalent to the market interest rate

• Co-movement in rates – Changes in conventional bank interest rates Granger Cause changes in Islamic bank rates of returns

Conventional IslamicIslamic if equal or higher rate of return

10% 20%70%

Primer on Rate of Return Risk (2/3)

• Under the pressure from the markets, some Islamic banks are smoothing returns

• When the bank return on its investments is lower than the market interest rate, it draws on its PER

• In this case, banks are exposed to certain types of risks in a similar way to that of conventional banks

Liabilities

• Debt-like instruments

• Investments

• Current accounts

• Investment Accounts

Profit Equalization Reserve

AssetsAssets

Primer on Rate of Return Risk (3/3)

Management of Rate of Return Risk / DCR

• Profit Equalisation Reserves: amount appropriated out of IFIs’ income (before allocating Mudarib share) in order to maintain a certain level of return to their investment account holders.

• Investment Risks Reserves: amount appropriated out of investment account holders’ income (after allocating Mudarib share) in order to cushion effects of risks of future investment losses on investment account holders.

• Cash flow forecasting on IFIs’ future earnings and expected payments to investment account holders.

Difference between the rate of return risk and the interest rate risk:

Greater uncertainty in the case of Islamic banks given the nature of the assets (it includes Musharaka and Mudaraba)

Although IAHs expect a rate of return comparable to the market interest rate, the return on such accounts is not predetermined

Management of Operational Risk

• Framework for internal processes and controls, incorporating documentation of operational procedures, review of compliance to those procedures, and internal audit programme.

• Shari’ah advisory and compliance structure including Shari'ah Supervisory Board and management structure for Shari'ah compliance.

• Compliance to auditing standards.• Segregation of duties.

Case Studies

Musharaka Contract (Sharing contract)

• Client Enters Agreement with bank to Invest in a Project• Client invests $80,000, Bank Invests $20,000• Profit Share is Based on a 80%:20% (they may agree on different percentage subject to negotiation)

Client invests $80,000

Bank invests $20,000

$100,000Project

THANK YOU

THE END

Islamic Finance & Sukuk ( April 2014)

Documents

Transcript of Islamic Finance & Sukuk ( April 2014)

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