Merrill Lynch - Principles of Islamic Finance - Sep 2006

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European Structured Finance - ABS

Principles and Structures ofIslamic Finance

Islamic Finance is governed by ShariaIslamic Finance basic principles are clearly defined by Sharia (Islamic law) and

embrace the prohibition of riba (usury), gharar (preventable uncertainty), maysir

(gambling), bay’ al-inah (trading same object between buyer and seller), haram

(forbidden activities) and the promotion of halal (permitted activities) and maslaha

(public good). Modern finance requires interpretation and analogical reasoning of

these principles: five major madhahib (juristic schools) provide guidance in the

interpretation and application of Sharia.

Islamic finance can synthesise close equivalents to equity,mortgages, derivatives as known in Western finance

Applying the basic principles of Islamic Finance, practitioners following theguidance of the mufti (religious scholar) belonging to one of the five main schools

can develop financial products to provide equity financing through a managed

fund (mudaraba) or partnership (musharaka) , debt financing through cost-plus

financing (murabaha), leasing (ijara), futures contracts (salam), through Islamic

bond (sukuk) and related securitizations. Islamic auto finance and housing

finance is developing to address the needs of the retail market. Some types of

swaps and options can also be synthesized.

Islamic finance is growing fast and can be equally attractiveto Islamic and non-Islamic companiesIslamic finance sector has been estimated to grow by 15% per annum and the

expectations are for this growth to continue in the foreseeable future. Islamic

finance is gaining relevance to Muslim and non-Muslim alike. There is a

potentially large untapped market for Islamic home finance and sukuks.

Structured Finance | Europe | ABS

13 September 2006

Alexander Batchvarov, CFA +44 20 7995 8649Int'l Str. Fin. StrategistMLPF&S (UK)[email protected]

Nicolas Gakwaya +44 20 7995 7212Research AnalystMLPF&S (UK)[email protected]

James Holmes acted as a consultant

on the issues of Islamic Finance for the

purposes of this report.




13 September 2006

2

1. Introduction to Islamic Finance

What is Islamic finance?Islamic finance is governed by Shariah (Islamic law). Shariah is based primarily

on the teachings of the Quran, the sayings and doings of the Prophet Muhammad(the sunnah/hadith). In modern finance, however, these may not provide enough

clarity, and it is up to a mufti (religious scholar) to rule in favour of or against an

innovation through ijtihaad (interpretation) and qiyas (analogical reasoning).

Each Mufti’s verdict, however, may differ depending on which one of the five

juristic schools (madhab) he belongs to. Thus, some Islamic Financial Institution

(IFI) may offer products unacceptable to others. Similarly, some Muslim investors

may be more pragmatic than others.

HistoryIslamic finance (in the form of fiqh al-mu’amalat) has been around for 1,500

years, but its modern history begins in the 1950s and 1960s coinciding with the

post-war revivalism in Islam. Arab nationalism soared and GCC economies grew

massively thanks to oil revenues. However, the limited financial infrastructurewas ill-equipped to absorb much of this new wealth and developed banking

requires a system of ‘checks and balances’. New shariah finance structures were

experimented with in the 70s, attracting first-generation investors such as

Citibank and Barclays. The pace quickened in the 80s, when Islamic banks first

entered syndications and project finance, with longer tenors. The Kuwaiti Souq

al-Manakh crash in 1982 and later the Gold Market depression drew Muslims’

attention to the perils of speculation, resulting in such IFIs as Dar al-maal al-

Islami and the al-Barakah group.

It was only in the 90s’ era of globalization, however, that Islamic banks started

capital market activities such as sukuk-al-ijara securitisations and fund

management. Markets were liberalized, resulting in IFIs with global reach, e.g.

CitiIslamic. The financial centre shifted from Beirut to Bahrain and the Accounting

and Auding Organisation of Islamic Financial Institutions (AAOIFI) was

established to promote greater harmonisation of the 6000 or so fatwas (legal

verdicts). In the new millennium, Islamic Finance now has gained mainstream

relevance for Muslims and non-Muslims alike. Sovereign sukuk (bonds) have

been issued for the first time and complex Islamic derivatives/liquidity

management methods are being developed to facilitate the sector’s estimated

15% annual growth rate.

Principles of Islamic FinanceIslamic finance is often dubbed 'ethical capitalism'. Its basic principles are:

Prohibition of r i b a (usury)

This encompasses Riba al-nasa' – interest on any loan, and Riba al-nasi'ah –

interest resulting from a delayed loan payment, as well as Riba al-fadi – interest

of 'excess', i.e. pure return on the exchange of natural and monetary

commodities. This protects the commodity's 'true value', if there is asymmetric

information. Clearly, then, currency swaps are forbidden.

Prohibition of ghara r (preventable uncertainty)

The subject matter, terms and conditions of a contract must be completely clear

to all parties. Sometimes, however, this is not practicable, e.g. knowing all the




13 September 2006

3

aspects of a house's foundations. Therefore, shariah distinguishes between

'trivial' gharar and 'substantial' gharar .

Prohibition of maysi r (gambling)

There is a difference, however, between speculation, which is viewed as

unhealthy, even immoral, and business risk, which is necessary. Commercialinsurance is prohibited as it trades on personal misfortune, but mutual insurance

(takaful) is allowed.

Prohibition of bay ’ a l - i nah

Trading the same object between the same buyer and seller, as this might

effectively replicate an interest-bearing loan. This is disputed by the Malaysians

on the strength of an obscure hadith: "If people are left alone, Allah will give them

provision from one another".

Prohibition of the combination of two separate contracts into one

Islamic law requires a contract to stand on its own and be independent of all other

contracts.

Good outweighs bad

Public benefit (maslaha) is the most important factor.

Prohibition of ha ram (forbidden) activities

Such activities include the provision of pork, alcohol, pornography, etc. Activities

with negative externalities such as arms dealing and pollution are included here,

too.

As is widely known, the prohibition of riba plays a central part in Islamic finance.

Without riba, Islamic banks theoretically have no conflict of interest with their

clients. They are also viewed as having lower transaction costs as real and

financial markets are integrated more closely. Furthermore, they theoretically

have no fixed liabilities, allowing them to absorb real shocks better, and may

contribute to social equity better, because there are no net transfers of wealth

(based on one's past accumulation of capital). They are obliged to work

according to a profit/loss paradigm rather than riba (fixed positive return that one

doesn't have to work for), resulting in more selective investment decisions with

allegedly better performance and transparency.

Juristic schools (madhahib)There are 5 major juristic schools (madhahib) in Shariah and a mufti's verdicts

might differ depending on which he belongs to:

Hanafi is considered to be the most flexible school as the emphasis is on

progressive qiyas rather than hadith. Significantly, it allows the Muslim in a non-

Muslim country to take un-Islamic transactions (eg. a conventional mortgage) if

there is no other practical alternative and no intention of fraud. Therefore, it

works well in countries with non-Arab populations in Europe and Central Asia.

Hanbali, in stark juxtaposition to the above, may be considered the most rigid

and literalist school. For example, physical warehouse space must be provided

for the commodities used in international murabaha transactions to prove the

bank's ownership. This school mostly applies to the GCC states.

Maliki is the earliest school, whose emphasis is on the behaviour of early




13 September 2006

4

Medinans (Muhammad's community) as they are the 'living sunnah.' This school

covers all of North Africa except Egypt and Sudan.

Shafi'i accepts any sound hadith over analogy (qiyas)/'living sunnah', so long as

it does not contradict the Quran. This school marries pragmatism with

conservatism. However, towards the end of his life Imam al-Shafi'i seeminglyretracted some of his earlier edicts, leading to controversies such as the

Malaysian practice of bay al-inah. This school mainly applies to South East Asia

(Malaysia, Indonesia) and Egypt.

Jafari, also known as 'twelver' Shia Islam, is an uniquely flexible school. There

is a tradition of taqleed, where imitation of a scholar is encouraged. It is followed

mainly in Iran, Bahrain and South Lebanon.

Jafari followers must pay khums, a 20% religious tax on annual savings and

commercial profit. The four other Sunni schools (above) only stipulate zakat tax

(2.5% of annual salary).

Main differences by region As highlighted in the dominant schools above, there are differences in the

development and dominance of Islamic Finance by region.

South East Asia and Malaysia have a more liberal Shafi’i approach to Islamic

Finance and, hence, they have the most fully integrated capital markets. More

significantly, growth is retail-led. They account for just under one third of total

Islamic funds. The GCC nations have a harder line Hanbali approach and are not

the first to accept innovation. Growth has traditionally been wholesale-led and

restricted to the High Net Worth strata. Arabia accounts for two-thirds of Islamic

funds. North Africa is not a particularly significant Islamic Finance market. Often

the most exciting advances have taken place in London and Western capital

cities. International Islamic transactions are usually governed by English law

and there are large Muslim minorities (mostly flexible Hanafis) in Europe and

North America. There is a phenomenal growth in retail banking (e.g. Shariah

mortgages). Certain western regulators seem more amenable to Islamic Finance

than Muslim governments themselves. For example, the UK was the first to

remove double stamp duty on both residential and commercial property.

Compatibility At first glance Shariah seems rigid. In practice, however, most Shariah scholars

are sophisticated realists, already familiar with Western finance methods. Whilst

there may be major philosophical differences between Islamic and conventional

finance (e.g. regarding the house rather than money as the underlying asset),they are often of little financial consequence. It should be noted that Islamic

finance can synthesise close equivalents to mortgages, equity funds, derivatives,

as known in Western finance, and does not need to replace them wholesale.

Many non-Muslims are, thus, becoming interested in shariah-compliant products.

On the subsequent pages of this report we look at the key Islamic financing

structures, their applications, strengths and weaknesses, and real world potential.

We follow up with a discussion of consumer finance, risk management and

liquidity issues, as well as future opportunities and challenges.




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2. Equity financing

Mudaraba (managed fund)Similar to a mutual fund, the rabb al-maal (investor) provides the financial

intermediary (mudarib) with working capital. Although the investor has rights tobe informed, only the mudarib is allowed to actually manage the fund. The

mudarib is compensated by taking an agreed share of the profit and may impose

a set-up fee. Any losses, however, are borne solely by the investor, and are

limited to his principal. The Mudarib is allowed to set up reserve funds to smooth-

out profitability.

Chart 1: Mudaraba

Mudaraba

Rabb al-maal(Investors)

Mudarib

Investments Investments Investments

Investments Profitdistribution

Mudaraba



MudaribMudarib

Investments Investments Investments

Investments Profitdistribution

Source: Structuring Islamic Transactions, Euromoney Institutional Investor, London (2005)and is edited by Abdulkader S. Thomas,Stella Cox, and

Bryan Kraty.

The mudaraba structure can be applied to:

syndicate loans. How that works is demonstrated by the example of US

Global Telecoms. When the company suffered a credit-downgrade, it didn't

want to risk overleveraging itself on corporate bonds. Instead, it asked

United Qatar Bank to set up a mudaraba fund to develop and acquire

products from one of its suppliers, eventually achieving tax benefits and

creating $1billion of sales.

aggregate retail funds. Islamic Gulf Bank acquired and subsequently

merged three US sports companies, selling the resulting company on to retail

investors in a mudaraba it had set up in the Cayman Islands.

aggregate funds for non-bank financial institutions . Many Pakistanibusinesses create mudarabas as a way of raising capital and to enhance

their funding.

The strength of a mudaraba structure is that it permits income smoothing and an

effective asset management synthesis. On the other hand, though, a Mudaraba,

like Musharaka, is more illiquid and less flexible than listed equity. Being a fixed-

term partnership, the consent of all parties is needed if any capital is to be

withdrawn or added. Also, all profits must be distributed as dividends; hence,

there are no capital gains.




13 September 2006

6

There are two kinds of Mudaraba: mudaraba al-muqayyada is restricted to a

specific trade, time and place, while mudaraba al-mutlaqa is unrestricted.

As with every other structure there are some variations among countries. For

example, Iran has formally codified partnerships; there is greater flexibility as to

which costs are deducted before sharing profit. On the other hand, Malaysianunit trusts are based on an unwritten 'amana' (trust) contract between the investor

and the trust.

Musharaka (partnership)Musharakah (participatory) financing is akin to venture capital, where both parties

(IFI and the Client) provide working capital. Profit distribution may be done in

accordance with a set formula, while losses and expenses may be distributed in

proportion to capital contribution. Both parties have contractual management

rights. The Client may buy out the IFI over time – this is known as a declining

Musharakah. However, the partnership can only be dissolved by notice of

bankruptcy or mutual consent.

In the Islamic law there are two types of partnerships. One is related to

inheritance and involves property, Shirkat al-milk - partnership in property, and

has no commercial application. The other is the shirkat al-'aqd, mutual

partnership by contract and has commercial application.

Chart 2: Musharaka

Investor/IslamicBank

Partner (client)MusharakaE.g. 70%ownership

E.g. 30%ownership

Investor/IslamicBank

Partner (client)MusharakaE.g. 70%ownership

E.g. 30%ownership

Source: Lovells

Musharaka can be applied to:

Real estate/inventory financing, where a declining musharakah is commonly

used to buy out the bank’s initial share. The bank's profit is in the rental stream.

Note that although the Client promises to acquire the property, the Joint Purchase

Agreement means that this cannot be legally binding. Banks may, therefore,

insist upon extra security, such as letters of credit. An example of musharakah

can be financing by Sudan Islamic bank, which buys fixed assets for a farmer

(tractor, plough, etc.) and then shares 70% of any profits at an agreed rate – the

residual 30% compensates the farmer's management efforts.

Build Operate Transfer (BOT) as used in financing infrastructure projects, such

as the Bosphorus bridge and toll roads. Some possible variations in musharaka

include the view taken by Hanafis (one of the five schools) that BOTs can be

traded regardless of liquidity ratios.

Given the proportionate sharing of losses in a musharaka partnership, the

structure encourages better performance of joint venture. The parties share in

profits according to a pre-agreed formula, which allows for compensation of each

parties efforts. Many observers and practitioners regard musharaka as the purest

form of Shariah finance.




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7

Naturally, musharaka has its own strengths and weaknesses. It can be viewed as

inflexible and illiquid, and, hence, riskier than listed stocks. Its performance is

sensitive to business cycles.

Musharaka financing has not been that successful in the past (eg the Islamic

Development Bank in the 70s) and certainly involves more due diligence for thebank than certain debt forms (murabaha). However, this position is changing, as

many banks such as the Islamic Bank of Britain begin to offer musharaka-based

mortgages instead of murabaha-based mortgages.

Direct Investment A bank might build a shopping mall or set up a managing subsidiary company,

etc. In Iran, this investment must not conflict with the public interest (maslaha)

and initial capital provided must represent over 40% of the total cost of the project




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3. Debt financing

Murabaha (cost-plus financing)Murabaha is an unconditional sales contract, where the buyer pays the seller a

lump sum deferred to a later date or by installment with an agreed profit mark-upbuilt in. The sale must involve a tangible object, must have a clearly stipulated

term, and the title must ultimately transfer from seller to buyer.

Chart 3: Murabaha

Seller

3. Pays cost-plus anagreed markup on date

1. Agrees paymentterms & spec

2. Delivers goods Buyer

Seller

3. Pays cost-plus anagreed markup on date

1. Agrees paymentterms & spec

2. Delivers goods Buyer

Source:Structuring Islamic Transactions, Euromoney Institutional Investor, London (2005)and is edited by

Abdulkader S. Thomas,Stella Cox, and Bryan Kraty.

In banking murabaha is often used by banks to structure term deposits or to

finance businesses and real estate in place of a conventional loan. The bank

buys the property on behalf of the client, takes legal title, and sells it to the client

in monthly installments at a mark-up (often based on LIBOR+spread). The titletransfers to the client at the end of the tenor. Many countries, including Islamic

ones, impose a stamp duty upon the transfer of the title effectively twice. That

may or may not include commercial property. The UK abolished the double

stamp duty as of 2003.

In contrast with a conventional loan the bank has an actual possession of the

property, cannot impose delinquency penalties and cannot increase the profit

margin in return for an extension or prepayment.

Thus, murabaha involves greater risks, but these may be hedged in different

ways. One of them is to make the client the bank's agent, responsible for

sourcing and invoicing the goods. Moreover, the bank can draft such tight

delivery terms as to make it impossible for the customer to refuse the object.

Another way is to elicit a unilateral promise of purchase. Alternatively, additional

security, e.g. letter of credit, can be demanded. Yet another way is to speed up

the remaining payments.

Murabaha can also be applied as a short-term cash management

instrument. An investor uses an agent to buy and sell non-monetary

commodities, say aluminium, on deferred basis and contingent upon purchaser's

letter of credit.




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9

Murabaha has large application in consumer credit. The Islamic Bank of Britain

offers personal finance from £1,000-£20,000 at an equivalent rate of 7.9% APR,

where the customer buys commodity from the bank and then appoints an agent

(also the bank) to sell the commodity back to the market. The required amount of

cash is generated and credited to the customer’s account and the customer

makes monthly repayments over an agreed period. SMEs may also be funded inthis way.

Murabaha trade is more often renewable than revolving as used in trade

finance (typically 6 months term). The buyer pays supplier's bank, while principal

and profit margin are syndicated by investors.

The multiple applications of murabaha as described above are a consequence of

its simplicity and operational familiarity, and similarity to conventional loans.

Although murabaha is widely used, it is not regarded as the most Islamically

sound. Its convenience and preponderance may have actually stifled research

into longer-term Shariah instruments. It is inflexible as an instrument as it does

not allow compensation for delinquencies and cannot be generally securitized as

this would be viewed as selling debt. The financing entity assumes additionalsale/purchase/inventory risks by stepping into the sales process, which may be

reflected into a higher risk premium. The bank, as seller, must often provide

warehouse space and take physical possession of the product subject to

financing. The bank must also become the warrantor of quality instead of the

manufacturer. All these additional burdens increase the amount of paperwork

associated with each transaction.

Variations As with every other product variations exist among countries: Malaysia allows

the sale of murabaha debts (bai' al-dayn) as long as they are true trade

transactions, and offers murabaha (munif) notes that are paid by the issuer upon

maturity. Their justification is the weak hadith (as mentioned in the beginning)and the presence of a 'transparent regulatory system' in Malaysia to protect the

maslaha (the public good). GCC/South Asian countries, however, disagree and

point out that Imam al-Shafai (a classical scholar) later reversed his earlier

permission. Bai' al-'inah is combining two sales contracts in the same contract

between the same parties. Again, this is only acceptable in Malaysia as others

feel that this is a backdoor entrance to riba.

A variation of murabaha is the musawama: a negotiable sale, where the profit

margin is hidden from buyer. This is only permitted for merchant banks, as in the

case of Kuwait Finance House's in-house car dealership.

Murabaha transactions have been and continue to be the lynchpin of virtually all

Islamic banks in recent years. Its simplicity and workability have ensured asteady, if somewhat uninspiring, source of income. There are still some growth

opportunities as banks move into microcredit and agricultural finance, though with

the developments of new products and concepts murabaha will decline in

importance. Moreover, there is little potential for integration between Malaysia

and the other Muslim countries as far as murabaha is concerned.




13 September 2006

10

Ijara (Leasing)Ijara is similar to an operating lease, but may be structured as a finance lease

(ijarah-wa-iqtina'a) with a put option or a promise to buy. Rents are fixed or

variable, recalculated as often as every 3 months based on LIBOR. There is no

late payment penalty, though a specified service fee may be charged, either

directly or built into the next installment. The policy of awarding liquidationdamages in case of non-performance of obligations under the contract differs

from one Shariah board to another. Ijara financing can be securitised and the

SPV assumes ownership rights (but not always title).

Chart 4: Ijara

Bank owner ofassets

3. Assets purchased

2. Payment

Manufacturer

1.Lease terms agreed

4. Lease

Lesse

Bank owner ofassets

3. Assets purchased

2. Payment

Manufacturer

1.Lease terms agreed

4. Lease

Lesse


Bryan Kraty.

Ijara has multiple applications. It is used in commercial and residential real estatefinancing (either vanilla ijara or ijara wa-iqtina’a). It can also be applied in long

term project finance: ijara appeals to many US businesses - Muslim and non-

Muslim – as there is often a discrepancy between US credit market cycles and

US business cycles, i.e. it relies on the underlying assets rather than on the

financial market conditions for the extension of the financing. It is mainly provided

by the Gulf banks, which may be shielded from US credit cycles. It can help in

(re)financing structures, as was the case with Malaysia Telekom selling some of

its assets and leasing them back, thus raising sufficient capital for an expansion

project. Ijara mawsufah bil thimma is a lease derivative similar to Western time-

share securities. Such notes were issued before constructing the ZamZam

towers in Saudi Arabia, entitling each holder to a particular room on particular

dates (known as intifa'a or occupancy benefits). They are freely tradable.

From banks’ perspective ijara is more flexible than murabaha as pricing is can be

adjusted and underlying assets are sellable. Its nature of lease financing is

understandable and attractive to non-Muslim investors, as is its ability to be

securitised. However, in an ijara structure the lessor can only get insurance

proceeds in the case of total loss. Furthermore, banks might be stuck with a

depreciated asset if client walks away. It is also difficult to impose penalties for

delinquencies and termination.




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11

Salam (futures contract)Similar to a futures contract, a full payment is made for future delivery of goods

immediately after the agreement is sealed. Clearly the contract price might be

lower than the spot price. Typically, it is restricted to transactions for less than 30

days and to primary commodities in the agriculture and construction sectors.

a) salam financing

Chart 5: Salam fi nancing

Buyer Bank

2. Salam term agreed 3. Orders & pre-pays

Trader Agent

1. Purchase order +promise to pay (or)

+parallel salam

Buyer Bank

2. Salam term agreed 3. Orders & pre-pays

Trader Agent

1. Purchase order +promise to pay (or)

+parallel salam


Bryan Kraty.

b) salam commodity financing

Chart 6: Salam commodity financing

2. Pre-payment Bank 1. Notification

Manfacturer 5. PaymentCommodity broker

agent for purchase

Comm broker agent

For sale comm

processing

4. Sale3. Purchase

2. Pre-payment Bank 1. Notification

Manfacturer 5. PaymentCommodity broker

agent for purchase

Comm broker agent

For sale comm

processing

4. Sale3. Purchase


Bryan Kraty.

Salam financing can be used for liquidity management through a parallel salam

process between the bank and the trader, and the trader and the market.

However, this is may not be acceptable in jurisdictions other than Malaysia, as

Shariah prohibits ina inah, which can also be interpreted as parallel contracts,

which rely on each other. Under parallel salam there is a dual obligation to




13 September 2006

12

deliver (except in Malaysia), which increases the risk of the financing.

Salam is used for commodity financing and helps increase supplier's turnover,

reduce their capital needs, and collect immediate profits. It can be viewed as an

effective way of hedging against market volatility. Arabian bottling used such a

structure to flatten out the market volatility of aluminium that faced its suppliers.Bahrain Monetary Authority issues non-tradable salam-sukuks (salam-securities)

to banks, tying up cash till maturity, thus achieving monetary policy goals. Salam

financing can be used to extend working capital loans.

A variation of salam is istisna'a, which is a complex derivative based on more

highly manufactured goods than commodities or on more complex projects. It is

suitable for big long term projects, e.g. oil refineries. This financing may allow for

penalties in case of late delivery or late installment payments, etc.

Overall, we understand that there is great potential for salams and, especially, in

the large agricultural societies, for which it was originally envisaged, e.g. Egypt

and Pakistan. However, these countries must further improve the legal-

framework for salam transactions.

Qard al-Hasan (beneficial loan)Islamic banks play an important social role and may choose to provide interest-

free loans for worthy causes. In most countries this is completely discretionary,

e.g. Faisal Bank of Egypt. In Iran, however, all banks must put aside an amount

each year to provide such loans to poor farmers or for other charitable

undertakings.




13 September 2006

13

4. Securitisation

Sukuk (Islamic bond) According to the AAOIFI definition Investment Sukuk are “certificates of equal

value representing undivided shares in ownership of tangible assets, usufructsand services".

Sometimes known as an 'Islamic' bond, sukuk must be backed by underlying

assets, e.g. a house or a car, and may be based on salam, ijara, istina'a or

musharakah/mudaraba transactions (murabaha is only used in Malaysia). Clearly

credit cards and conventional mortgages do not qualify. Ownership is undivided

and passes to the SPV (also known as Islamic Global Sukuk Structure) at the

start of the contract, which issues sukuk in turn. However, these are often

referred to as 'rights akin to ownership' rather than simply 'ownership', in order to

circumvent the restrictions on foreign ownership present in many Middle Eastern

countries. The nature of these rights and the extent to which they are conveyed

to the SPV differ from jurisdiction to jurisdiction, but must be sufficient to avoid the

transaction being characterised as a secured loan. The coupon rate is oftenbenchmarked to LIBOR. Sukuks can be used as a longer term alternative to

commodity murabaha liquidity management.

Chart 7: Sukuk

FinancialInstitution/ Borrower

Special purposevehicle (IslamicGlobal Sukuk

company

Investors (financialinstitution)

Sale/Transfer of assets

Lease

Rental paymentunder lease

Purchase price ofassets

Sukuk certificateproceeds

Periodic andamortisingpayments

Sukuk Certificates

FinancialInstitution/ Borrower

Special purposevehicle (IslamicGlobal Sukuk

company

Investors (financialinstitution)

Sale/Transfer of assets

Lease

Rental paymentunder lease

Purchase price ofassets

Sukuk certificateproceeds

Periodic andamortisingpayments

Sukuk Certificates

Source: Lovells

Sukuk is one of the most exciting aspects of Islamic finance, with issuance

volume and take-up growing at 15% annually. Non-Muslim investors are also

becoming interested – about half of the recent Qatari sovereign issuance went to

conventional investors. More notably, the German state of Saxony-Anhalt issued

$120 million of sukuk, citing massive investor demand and international respect

for other investment cultures as reasons for making it Shariah compliant. Ijara

based securitisations such as the BMA’s $1billion issuance (2004) currently lead

the pack, but there is also potential for equity based securitizations, e.g. Emirates

Airline's musharaka sukuk, which, unlike other structures, may be freely traded on

the secondary markets. However, a coherent legal-framework for sukuk must be

developed in many Islamic countries, and particularly in Saudi Arabia. Only then,

will sukuks realize their full potential.

SecuritisationIslamic securitization is very similar to conventional asset-backed securitization.

However, ownership must actually be transferred to the issuer. There exist one-

tier, two-tier and sovereign structures:




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14

In the case of one-tier structure, the single SPV owns the assets and

issues the sukuk.

In the case of two-tier structure, the seller transfers the assets to an

intermediary SPV which passes-through ijara (or other) payments to a

second, issuing-SPV. Proceeds from sukuk issuance enable theintermediary SPV to pay off the seller. This structure allows businesses to

circumvent foreign ownership restrictions and take advantage of more stable

tax and legal environments – e.g. Saudi Hanco's issuing SPV was based in

the Cayman Islands.

Chart 8: A typical two ti er system

Vendor/Servicer Special Purpose

Vehicle (1)

Client / LeasesBack –up servicer

Payment ofpurchase price

Transfer of leasedassets and contracts

Back up servicingagreement

Rental payments+purchase price

Special PurposeVehicle (2)

Price

Assignment of rental

payments + purchaseprice

Ijaracontract

Units (Ijarasukuk)

Cashproceeds

Issuance of nonIslamic bonds

Cashproceeds

LOCAL JURISDICTION (e.g. Saudi) FOREIGN JURISDICTION(e.g. Cayman Islands)

Vendor/Servicer Special Purpose

Vehicle (1)

Client / LeasesBack –up servicer

Payment ofpurchase price

Transfer of leasedassets and contracts

Back up servicingagreement

Rental payments+purchase price

Special PurposeVehicle (2)

Price

Assignment of rental

payments + purchaseprice

Ijaracontract

Units (Ijarasukuk)

Cashproceeds

Issuance of nonIslamic bonds

Cashproceeds

LOCAL JURISDICTION (e.g. Saudi) FOREIGN JURISDICTION(e.g. Cayman Islands)

Source: Gide, Loyrette, Nouel

Similar to a traditional securitization an Islamic SPV in one- and two-tierstructures must be a bankruptcy remote vehicle, with a limited recourse toavailable funds and with the requisite non-petition covenants. There should be norisk of consolidation with a parent company, and decision making is restricted tothose necessary for the securitization transaction. There must be a true sale ofassets to the SPV (not just cash-flow pass-through) that is enforceable againstthird parties. Credit risk rating relates to the SPV and performance of underlyingassets rather than the originator of the assets.

Sovereign structures - Sovereign issuance is an exception and does not

aim for true securitization, but rather a shariah-compliant bond issuance.

Thus, the originator may guarantee its sovereign sukuk, with credit-risk

ratings based on the originator's ability to pay and not the underlying assets.

Such guarantees are contentious, however, as they are tantamount to paying

money for money – riba. Other forms of credit enhancement are more

acceptable, such as tranching.

Securitisations face some challenges in the Islamic countries. One is the limited

acceptability of currency derivatives to hedge currency mismatches in the case of

two-tier cross border issuances. Another is the weak trust laws in most GCC

countries. Yet another one is the unstable tax environment in most Arab

countries.




13 September 2006

15

There is a healthy demand for sukuk. However, legal-frameworks remain weak

or non existent in many Islamic countries. In fact, any kind of domestic, one-tier

securitization in Saudi Arabia is prohibited. Securitisation structures in the West,

however, will continue to grow. In the US, there is even a possibility about theapplication of mortgage agency wrap for certain Shariah MBS. And if Islamic

scholars can find an acceptable way of securitizing future flows of income, from

airline tickets, toll roads etc., Shariah securitization can further expand.




13 September 2006

16

5. Equity fundsMuslims are allowed to invest in listed stocks, shares and funds – concepts not

dissimilar to musharakah and mudaraba. They can invest in both non Muslim

and Muslim companies, subject to the following conditions:

Screening - companies are scrutinized to ensure that they meet Shariah

standards in a process known as screening, and must meet certain criteria in

order to be deemed suitable for investments, namely:

Debt-to-Equity ratio must not exceed 33% (Shariah definition of minority)

cash and interest bearing securities must not exceed 33% of market

capitalization; note that some interest is tolerated, otherwise start-ups and

low-interest payers would be excluded

account receivables must be less than 45% of total assets - this ratio

accommodates halal (permitted) deferred payment receivables (e.g. from

murabaha), but any larger amount would considered a 'sale of debt', which is

forbidden (haram).

Purification - the portion of return on an Islamic investment that is derived from

un-Islamic (haram) activities is estimated and then 'purified' – deducted and given

to charity. Different Shariah boards have different interpretations on exactly what

should be purified: just the dividends, or capital gains of the underlying shares in

a portfolio (the portfolio is treated as a company), or share price index.

The above principles must be applied continuously and consistently, which may

fail to take care of variations in companies’ activities and balance sheets due to:

the business cycles: the 2001-03 bear market reduced most companies'

market capitalisation value whilst increasing their debt, screening out

fundamentally sound investments (especially in the technology sector).

cash holdings vary with market volatility and the business cycles. Shariah

fixed ceilings may affect an investor's capital gains and exit strategy.

changing nature of business: cut-throat competition has now forced all the

major car manufacturers (Ford, GM etc) to offer interest-based credit. This

further reduces the pool of businesses of Shariah compliant investments.

Notwithstanding the 2001 slowdown, there has been massive growth in Islamic

equity fund investing – from $800million in 1996 to over $5billion in 2004 (68%

per annum). That underscores the potential for further growth, especially given

the record GCC liquidity after investors pulled out from western funds in the wake

of 9/11, coupled with nascent interest in Gulf real estate funds.

This potential, however, will not be fully exploited unless a number of issues are

addressed. Funds and products must be introduced with a broader appeal than

just for the High Net Worth market (1-2%), which is reaching a higher degree of

saturation. In addition, the distributional/marketing capabilities of Islamic finds are

currently limited and must be improved. The absence of dedicated monitoring

and ratings agency practice is not helpful at present, either.




13 September 2006

17

6. Consumer finance

Islamic consumer finance is developed in the area of auto financing and home

purchase.

Islamic Auto finance (IAF)Ijara wa-iqtina’a is the most common structure, with a built-in put option allowing

the client to purchase the vehicle at a competitive market rate. Ownership only

transfers at the end of the lease. This kind of financing is riskier for the bank than

a conventional loan, but this risk is offset to some extent by the lower credit-risk

profile of IAF customers.

Demand for IAF products has grown strongly, with rates now as competitive as

those offered by conventional banks. This is due to high replacement rates for

cars in the GCC desert environments, changing demographics, flexible regulation

(unlike with home finance products) and the fact that in many Middle Eastern

societies, the car-ownership is a more important and visible status symbol than

home-ownership. Superior marketing and AAOIFI efforts to standardise practiceswill ensure continued growth. Securitisation of auto loans is expected to become

even more important under BIS2.

Housing financeTraditionally IFIs offered Murabaha mortgages and to a lesser extent, Ijara, but

these are increasingly being replaced with the more ‘Islamically pure’ diminishing

musharaka (DM) products. The discussion of Islamic mortgage finance goes

beyond this report, but we thought it appropriate to show the present status of

Islamic finance for housing in the UK – leading lenders and main type of Shariah

compliant product they are offering.

Table 1: UK leading Islamic finance lenders

UK Lenders Product Ahli United Bank Murabaha

HSBC Amanah Ijara/ DM

Al-Buraq DM (distributes through Lloyds TSB, Bristol&West)

United National Bank Ijara

Ansar Finance Ijara

Natwest/ RBS Marabaha (commercial)

Arab Banking Corporation Istisna’a (development)

Bank of Ireland Murabaha (commercial)

Source: Merrill Lynch




13 September 2006

18

7. Shar iah banking

With the possible exceptions of Malaysia and Bahrain, Islamic countries lack

secondary capital markets in any real measure – debts cannot be transferred

except at par-value. Moreover, the financial systems are incomplete as there areno inter-bank money markets. Thus, most banks simply cannot absorb their

excess liquidity, with ratios of 40% not uncommon. BIS2 will force Islamic banks

to allocate 100% capital for each Shariah mortgage they originate. Murabaha

and salam are too short-term to help significantly and things will not improve

unless more longer term-ijara/mudaraba sukuks are issued, such as those piloted

by the Bahrain Monetary Agency and the Islamic Development Bank.

The needs for liquidity management techniques and long-term financing for banks

are obvious. From short-term perspective banks can use:

Murabaha - as discussed earlier, it relies on the bank having surplus cash, so

it cannot be used to fund deficits. Moreover, such transactions cannot be

unwound, save with a 'parallel murabaha', but the Islamic bank' partners areoften risk sensitive international banks e.g. many pulled out of deals with

GCC banks in the first Gulf War.

Overnight investment programmes (pioneered by Arab Banking Corporation)

Lease funds (which may be difficult to securitise due to existing regulatory

framework)

Commodity salams.

Long-term financing instruments in use are:

Demand deposits - akin to conventional current accounts, these receive no

return. Most banks, including Jordan Islamic Bank, may only use thesefunds after seeking depositor’s agreement through so-called ‘amanah’ trust

accounts. In Iran, however, these deposits are regarded as Qard al-Hasan

loans made to the bank, and no permission is required. All deposits are fully

guaranteed, however.

Savings deposits - the bank may use these funds without asking the

permission of the depositor and it is under no obligation to share resultant

profits. However, many banks choose to reward their customers on a

discretionary basis (al-wadia), maybe by way of promotional benefits (Iran) or

by waiving normal banking fees. Again, these deposits are fully guaranteed.

Investment accounts - the bank invests these and shares any profit with

the customer at a pre-agreed ratio - perhaps 1:10 in favour of the bank.They are subject to a minimum amount and, like time deposits, the account

holder cannot withdraw before maturity. They may have a specific or general

investment purpose.




13 September 2006

19

8. Risk management/ derivatives/hedging

Islamic banks are generally risk averse, concentrating on short-term murabaha

contracts. In the absence of an inter-bank money market, lender of last resort

and deposit insurance, they fear liquidity crunch and are reluctant to tie up capital

in longer-term musharaka contracts. Moreover, credit risk assessment

procedures in Islamic banks are not discerning enough, meaning that otherwise

credit-worthy customers must choose between a high one-size-fits-all risk

premium or overcollaterilisation. Often neither proves acceptable, and they end

up going to conventional banks where their higher credit standing is taken into

account. Islamic banks must, therefore, understand and price their risks better, if

they are to manage them effectively.

Given the nature of the products these banks use, they face some risks similar to

the conventional banks, as well as somewhat different set of risks. All those risks

must be managed.

How do Islamic banks manage risk?The use of derivatives in Islamic banking is a grey area. Shariah scholars are

mainly concerned about derivatives speculation and trying to make a profit out of

them. Few scholars, however, would have any problem with the ISDA's definition

'a derivative is a risk-shifting agreement.' They may be viewed, therefore,

generally as halal. Their Islamic syntheses should rely on a number of

guidelines, practices and instruments.

First, of course, comes the view that Shariah's investment criteria and prohibition

on gharar /maysir automatically reduces risk. Moreover, the emphasis on

participatory finance improves investment decisions and reduces complacency.

Furthermore, takaful - commercial insurance is not permitted, but mutual

insurance is.

• Synthesizing an option

Then comes the Khiyar al-shart, which similar to a conventional option where the

seller/buyer has the right to confirm/rescind a contract before a specified date, so

as to hedge against changing market prices. For example, Party A agrees to sell

to Party B, but has the right to confirm or rescind this contract before a certain

date. If market prices are higher, A will clearly confirm, and vice versa. Unlike an

option, however, there is no separate fee at the start of the contract for granting

the option privilege. Instead, the economic value of this option is built into the

delivery price.

• Synthesizing a swap

Profit rate swap (analogous to interest rate swap in a securitisation): as only ijara

contracts allow periodic re-pricing, banks must synthesise interest rate swaps if

they are to manage market risk on longer term facilities. Party A sells a

commodity to Party B on a murabaha basis. B pays A the fixed profit mark-up

installments at 6 month intervals for 2 years, and then pays the original cost of the

commodity as a balloon payment with the last installment upon contract maturity.

Simultaneously, A enters into a separate contact of identical tenor with B, where

A buys from B on a ‘revolving reverse murabaha’ basis. The ‘master promise to




13 September 2006

20

purchase’ makes binding the purchase of a commodity at four separate points of

time. The four respective profit mark-ups reflect prevailing market rates. This is

analogous to the floating leg of an interest rate swap. Each contract is only

cancellable by mutual consent. By swapping a fixed profit rate for a floating rate

(or vice versa) the bank reduces its exposure to rate volatility at both micro and

macro levels.

We note that credit default swaps cannot be synthesised as there are no tangible

underlying asset.

Other ways to manage risk include:

Urboun (down payment): protects capital funds by granting the investor the

right to buy equity shares at a predetermined price

Commodity murabaha transactions to offset re-pricing risks

Salams: credit risk is less significant as there is immediate payment (unlike in

a forward contract)

Securitisation: the bank may reduce risk by securitizing many of its interest

rate sensitive illiquid assets

As Islamic banks seek to move into secondary markets, there is a pressing need

to manage risk more effectively. Islamic bankers, however, need to further

develop their familiarity with the conventional derivatives in order to be able to

engineer a more sophisticated breed of Islamic derivatives.

Whilst there is clearly long-term potential for such products, some additional

issues must be addressed, some of them psychological and perceptional such as

the concerns about the possibility of gharar /maysir in derivatives trading and the

absence of Islamic hedge funds (buyers of residual risk) due to widely-held belief

that they are risk creators.




13 September 2006

21

9. Challenges/future

The growth of Islamic finance is facing a number of challenges both from within

and from without:

Shariah's strict riba and contract laws will require fresh innovation and a massive

research effort. Obviously, it will not be enough to simply convert existing

western hedging/liquidity management techniques.

Integration between local Islamic regulators and global regulatory frameworks

(e.g. Basel) is difficult. Neither Basel I nor Basel II recognize Shariah finance and

applies 100% risk weighting (capital allocation) on murabaha/ijara mortgages, for

example, thus making them less competitive products. WTO reforms in GCC

countries have brought big conventional bulge-bracket banks to the regions,

providing tough competition for many of the smaller IFIs.

There is a need for stricter compliance regimes to overcome certain negative

perceptions about Islamic finance. Overall, there is a need for a better corporate

governance of IFIs. There are, as already discussed, different schools and

interpretations of Sharia, which brings difficulties of harmonising sharia standards

and corporate cultures and integrating Malaysia with the GCC. Regional stock

markets need greater informational efficiency and trading volumes: merging is

one way of achieving this.

Despite these significant challenges, we must not forget that Islamic finance is

forging ahead, and that by 2020, it is predicted that the GCC will have a 100%

Shariah compliant banking/financing system. There is a potentially huge

untapped market for Islamic home finance and sukuks, including large Muslim

minorities in the west, and even non-Muslims. The FSA recognizes this and is

currently working to better integrate Shariah finance in the UK.

This report has not been reviewed or approved by the Sharia Board thatadvises Merrill Lynch.




13 September 2006

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Merrill Lynch - Principles of Islamic Finance - Sep 2006

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