Islamic Financial Instruments
-A vision for the future-
Dr. Orhan Erdem
Borsa İstanbul
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Outline
1. Why Islamic Finance has become popular ?
2. Main Islamic Financial Instruments: Banking
3. Main Islamic Financial Instruments:Capital Markets
4. The future vision
Don’t Forget
We are trying to play football in a basketball field.
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Why Islamic Finance has become popular ?
Global Financial Crisis lessons
1. Global Economic and Financial System has
several vital problems.
2. People do not always behave rationally.
Global Economic and Financial System
Problems
i. Loans Without Advance Payment
• Infinite Leverage
• No Stake in the Game
• Household Debt – 1980: 48% of GDP
– 2008: 99% of GDP
USA Household Debt/GDP
5 1. Why Islamic Finance Has Become So Popular?
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Global Economic and Financial System
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• USA House Prices Index
1. Why Islamic Finance Has Become So Popular?
Global Economic and Financial System
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ii. Deregulation and Financial Innovation – N.I.N.J.A. Mortgages: No income, no job or assets.
Chuck Prince: «As long as the music is playing, you’ve got to get up and dance. We’re still dancing»
iii. Injustice and Inequality
1. Why Islamic Finance Has Become So Popular?
Global Economic and Financial System
Result
• The total value of homes in USA
– 2006: 22.7 trilyon $,
– 2011: 16 trilyon $ (-% 29.7)
• Extreme decline in values of bonds and bankruptcy of those real estates.
• L. Brothers, B. Stearns and Merrill Lynch Fannie Mae, Freddie Mac, AIG.
Commercial Mortgage-Backed Securities
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0
50
100
150
200
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2001 2002 2003 2004 2005 2006 2007 2008 2009
Mily
ar $
CMBS
1. Why Islamic Finance Has Become So Popular?
Economic Center of Gravity Moves to Asia
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Questioning
“The Great Credit Crisis has cast into doubt
much of what we thought we knew about
economics” B.Eichengreen, UC Berkeley
“Most work in macroeconomics in the past 30
years has been useless at best and harmful at
worst.” 2008 Nobel Economy Prize Winner Paul Krugman
1. Why Islamic Finance Has Become So Popular?
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2. Are People Rational? Example-1
• Which one do you prefer?
$50,000 at where people win $25,000?
or
$100,000 at where people win $200,000?
1. Why Islamic Finance Has Become So Popular?
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2. Are People Irrational? Example 2
• People do not always behave rationally.
• Risk is more than an intellectual activity.
• It is a profoundly physical experience
• Example-2: Greed
– «If the human has two valleys of full of goods, he would be willing to have the third.”
[Prophet Muhammad]
Are People Irrational?
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• Monetary gains activate mesial prefrontal cortex in brain. (Breiter,Kahneman 2001)
• Which is the area of brain that is activated by narcotics. (Addiction and Capitalism)
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Searching for Alternatives
• Islamic Finance/Economy suggests very
relevant arguments on these two issues.
Behavioral Finance
• Peoplecan make mistakes which can affect their financial decisions.
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Key Features of Islamic Finance
• Main Principal: Funding of real economy
• Being asset backed (secured debt)
• Precluding leverage
• Sharing of profit and loss
• Prohibition of gambling and alcohol etc.
• Ethic and fair transactions
• Preservation of social justice etc…
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Interest and Profit Share
•Interest is banned by many verses of the Quran: Bakara, 2/ 275 •Interest is banned by both the old and the new Testiment. •E.g. (Luke,6/34). But interest was officially legalized in Geneva, 1574. • Question: What is interest?
•Can interest be at the same level with inflation? • Islam offers partnership instead of interest. •What is profit share?
Global Islamic Finance Asset Size
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Global Islamic Finance Asset Distribution
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Conventional Banks
Assets
Loans (Consumer, Corporate)
Securities Investments
Fees
Liabilities
Deposits
Capital
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Key Highlights • Deposits are loans to the Bank as debt • Assets are invested in fixed-income securities and loans • Bank has fixed obligations on deposits but uncertainty on assets returns • Bank is exposed to assets and liabilities mismatch risk
Islamic Banking
Assets
Trade Financing, Leases,
Mudarabah financing
Securities Investments
Fees
Liabilities
Investments by Depositors
Capital
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Key Highlights
Depositors are investors rather
than lenders
Risk Sharing through Profit and
loss sharing.
Assets and Liabilities are
matched.
Ethical and socially responsible
assets
Market Size in Various Countries
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The Profit Margins and Interest Rates in Turkey
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5
10
15
20
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2005 2006 2007 2008 2009 2010 2011 2012 2013
%
Deposit Rates
IF Banks Conventional Banks
Average Deposit Rates Difference: IF Banks-Conventional
-6
-5
-4
-3
-2
-1
0
1
2
3
4
Jan
-05
Ap
r-0
5
Jul-
05
Oct
-05
Jan
-06
Ap
r-0
6
Jul-
06
Oct
-06
Jan
-07
Ap
r-0
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Jul-
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Oct
-07
Jan
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Ap
r-0
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Jul-
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Oct
-08
Jan
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Ap
r-0
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Jul-
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Oct
-09
Jan
-10
Ap
r-1
0
Jul-
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Oct
-10
Jan
-11
Ap
r-1
1
Jul-
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Oct
-11
Jan
-12
Ap
r-1
2
Jul-
12
Oct
-12
Jan
-13
Ap
r-1
3
Jul-
13
Oct
-13
%
1m 3m 6m 1y
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Murabahah
Seller Bank Client
•Most Common Instrument: Murabaha •Murabaha: Sale on profit.
•The difference from the Credit is •The money is not lent to the customer.
•New Trend: Buying with waqalat
Example: Murabahah
• The Bank buys a car for 20.000 TL for her customer.
• It sells it to her for 21.324 to be pa id in 12 installments. (%1 monthly for 12 months)
• Excel: PMT(...)
Months Balance Payment Profit Amortisement Remaining
loan Balance
Jan. 20,000 1,777 200 1,577 18,423
Feb. 18,423 1,777 184 1,593 16,830
March 16,830 1,777 168 1,609 15,222
Apr 15,222 1,777 152 1,625 13,597
May 13,597 1,777 136 1,641 11,956
June 11,956 1,777 120 1,657 10,298
July 10,298 1,777 103 1,674 8,624
Aug 8,624 1,777 86 1,691 6,934
Sept 6,934 1,777 69 1,708 5,226
Oct 5,226 1,777 52 1,725 3,501
Nov. 3,501 1,777 35 1,742 1,759
Dec. 1,759 1,777 18 1,759 0
Total 21,324
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Musharakah
Joint venture partnership. Two or more parties contribute capital to a business and participate with the related profits and losses. The capital need not be money only.
Bank Client
Project
Capital
Shared Profit Shared Profit
Capital
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Musharakah
Joint venture partnership. Two or more parties contribute capital to a business and participate with the related profits and losses. The capital need not be money only. 1. Consecutive musharaka: Each partner can keep its share
in the partnership until the very end of the joint venture, project, or business.
2. Diminishing musharaka: One partner is allowed to buy the other partner’s share of equity step by step until the whole equity of the other partner is transferred.
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Example: Musharakah
• Erdem ltd is willing to make a business.
– The business is worth 5m TL
– The company has 2 m TL
– The company does not have an expertise on the field.
• The Bank provides Erdem ltd. with 3 m TL and an expertise.
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Mudarabah
An economic agent with capital develops a partnership with an entrepreneur with an agreement to share the profits
Investor Entrepreneur/Mudarib
Project
Management
Shared Profit Shared Profit
Capital
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Ijara (Leasing)
Ijara is a sale of the usufruct (the right to use the object) for a specific preiod of time.
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Bay’al-salam
• The buyer pays the seller the full negotiated price of a specific product which the seller promises to deliver at a specified future date.
• Similar to forward contracts
• But the payment is made at the deal date
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Islamic Finance: Capital Markets
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The Difference btw Banking and Capital Markets
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• Banking is for short term partnerships
• Capital Markets is for long term partnerships
Capital Markets: Equities
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Indicies
KATLM Index BIST100 Index
• Adana Çimento
• Akçansa
• Aksa
• Albaraka Türk
• Alkım Alkali Kimya
• Aygaz
• Bankasya
• Bim Mağazalar
• Bursa Çimento
• Çimsa
• Enka İnşaat
• Ford Otosan
• Good-Year
•Indeks Bilgisayar •Kartonsan •Konya Çimento •Mardin Çimento •Nuh Çimento •Park Elektrik •Pegasus •Petkim •Pınar Entegre •Pınar Süt •Soda Sanayii •Teknosa İç ve •Tümosan •Türk Hava Yolları •Türk Traktör •Turkcell •Ülker
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Capital Markets: Sukuk
• Sakk (Arabic):certificate
• Instead of only debt based instruments – Asset-based Long-term partnership
• The investor shares the asset.
• Even there numerous sukuk types two are of common – Mudarabah
– ijarah
• Sukuk can be issued basedhe future income flow.
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Sukuk
Funds Mobilizing Entity
Credit Enhancement
Special purpose Mudarabah “SPM”/”SPV”
Pool of Assets (Ijarah/Lease)
Servicing
Invesors
Assets Liabilities
Ijara Assets (Leases)
Sukuk
SPM Balance Sheet
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Sukuk Example
• The Turkish Treasury wants to buy a building worth 1million TL to work. An SPM collects money from its 50.000 investors each of which invests 20TL.
• The SPM buys the building and rents it to Treasury for 10 years for 12500TL. So each investor will receive 0.25 TL (coupon) each month.
• At the end of 120 month the investors will receive the principal 20 TL.
• The rate is 2.5% monthly. RATE(....) in Excel
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The Sukuk Payments
-20
1 2 120
20 0.25 0.25 …..
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Secondary Sukuk Market
• With the exception of Murabahah certifiate, all sukuk types are Shariah compatible for trading in the secondary market.
• Sukuk issued against a pool consisting of cash or debt like instruments cannot be traded in the secondary market
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Sukuk Markets
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0 2000 4000 6000 8000 10000 12000
London SE
Irish SE
Indonesia SE
Dubai FM
Singapore SE
Nasdaq Dubai
Bursa Malaysia
Bahrain SE
Hong Kong SE
LFX (Labuan)
Kazakhstan SE
Saudi SE
Global Sukuk Issuances (2012 – US Dollars)
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Challenges
•Murabahah and wakala issue
•Are credit cards ok in IF?
•20 prominent scholars holds %55 of all memberships of shariah boards.
•Two most popular scholar has 85 memberships in boards.
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Future Vision
• IF has not encountered a global crisis yet. • IF needs more research • Education and financial awareness in
necessary
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World Bank Global Islamic Finance Development Center
Mai
n F
un
ctio
ns
of
the
Ce
nte
r
Research & Knowledge
Standard Setting & Regulation
Innovation
Main Areas of Interest
Global Islamic Finance Report
Global Islamic Finance
Database
Islamic Capital
Markets
Islamic Banking
Islamic Finance and
Economic Development
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IF investors and Other Investors in Turkey (Çörtük and Erdem 2014)
All individual
Investors
Real IF
Investors
Real Conventional
Investors
n 855,303 28,413 826,890
Holdings(%) 100% 4.55% 95.45%
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Risk Appetite of IF investors and Other Investors in Turkey
(Çörtük and Erdem 2014)
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10
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Domestic Investors Exclding IF Investors IF investors
EUROZONE DEBT CRISIS
OMT
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Further Readings
• An Introduction to Islamic Finance, Theory and Practice by Zamir Iqbal and Abbas Mirakhor, Wiley
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