144240089 - Topic2 - Islamic Finance

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Topic 2:An Introduction To Islamic Finance

& BankingESC Rennes School of Business

2009/2010

Dr Khalid ELBADRAOUI



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Learning Objectives

This course is designed to:

Help students consider in some detail the principles ofIslamic Banking and the differences between Islamicand conventional banking.

Equip students with a practical and detailedunderstanding of Islamic products and their use in abusiness context.



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References

Books: Iqbal Z. and Mirakhor A., “An Introduction to Islamic Finance: Theory and

Practice”, Hardcover, 2006.

Ayub M., “Understanding Islamic Finance”, Hardcover, 2007.

Khan M. and Mirakhor A., “Theoretical Studies in Islamic Banking andFinance”, Islamic Publications International, 2005.

Websites: http://www.islamic-finance.com

http://www.islamicfinancenews.com

http://www.aaoifi.com: Accounting & Auditing Organisation for IslamicFinancial Institutions (AAOIFI)

http://www.ifsb.org: Islamic Financial Services Board (IFSB)

http://www.iifm.net: International Islamic Financial Market (IIFM)

http://www.iirating.com: Islamic International Rating Agency (IIRA)

http://www.ibisonline.net: Islamic Banks and Financial InstitutionsInformation

http://www.islamic-banking.com: Institute of Islamic Banking



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Road Book

What is Islamic Finance?

History & development of Islamic Finance

Islamic Contracts & use of funds

Islamic Bond (SUKUK)

Islamic Insurance (Takaful)

Asset Management/Fund Management

Subprime crisis and Islamic Finance

Challenges facing Islamic Finance

Conclusion



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•Islamic banking has the same purpose as conventional bankingexcept that it claims to operate in accordance with the rules ofShariah, known as Fiqh al-Muamalat (Islamic rules ontransactions).

•The basic principle of Islamic banking is the sharing of profitand loss and the prohibition of riba (interest).

•Amongst the common Islamic concepts used in Islamic bankingare profit sharing (Mudharaba), safekeeping (Wadiah), joint

venture (Musharaka), cost plus (Murabaha) and leasing (Ijarah).

•The key Islamic contracts are described in more detail in the3rd section.

What is Islamic Finance and Banking?



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Shariah terms

Halal – that which is permitted or compliant

Haram – that which is not permitted

Riba – charging of interest or unjustified increase

Gharar – the taking of unreasonable risk; uncertainty

Maisir – reliance on chance or speculation, rather than effort



7

Islam

Aqidah(Faith and Belief)

Shariah(Practices and Activities)

Akhlaq(Moralities and Ethics)



8

Basis of Shariah Approval (At a Glance)

Considerationof

PrimarySource

Considerationof

SecondarySource

Considerationof

Local Laws

Quaran &Sunnah

IjmaIjtehadQiyas

Law ofCountry

AcceptableTo

Market

But Shariah principlesshall not be compromise

HolyQuran Thesacred text

of Islam

SunnahPractices

and sayingsof ProphetMuhammad

Ijtehad Reasoningapplied by

Scholars

IjmaaConsensus

of Ummah Qiyas

Analytical

comparison



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Banking and finance needs

Islamic finance is the outcome of religion inbanking

Shariah filter

Islamic banking and finance solutions

• Prohibition of:

Interest

Speculation

Gambling

– Quran

– Sunnah

– Ijma‟ (jurist

consensus)

– Qiyas (analogy)

– Ijtihad (reasoning)

– Musharaka - Partnership

– Mudaraba - Partnership

– Murabaha - Purchase-resale

– Ijara - Lease

– Istisna - Manufacturingcontract

– Salam - Forward sale

• Asset-backedtransactionswithinvestments inreal, durableassets

Fiqh al-Muamalaat contractsShariah sources

• Prohibition of certain investments:

Sectors (e.g.: alcohol,armaments, financial services,gambling, pork, pornography,tobacco)

Instruments (e.g. no forwardtransactions, limited option use,

no derivatives, short-selling)

• Credit anddebt productsare notencouraged



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Islamic Finance

Principles and Foundations laid down by Shariah (Islamic law)

Quran – Revealed word of God

Sunnah – Sayings and practices of the Prophet Mohammed

Moral guidance or set of principles practiced by muslims

Shariah Supervisory Board (SSB)

3-5 Islamic Scholars

Decide what is compliant or not

Interpret Islamic Jurisprudence (Fiqh)



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The Foundations of Islamic Finance

Avoid Interest (Riba)

Riba al Naseeyah or Riba al-Quran – excess resulting from apre determined interest

Riba al-Fadl or Riba al Hadith – Excess compensation withoutconsideration

Avoid Uncertainty/Deceit (Gharar)

Final result is uncertain

Short Selling

Fraud

Options

Avoid Gambling (Maysir)

Involvement In speculative and gambling transactions

No Derivatives



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Transactions should be backed by Tangible assets. Obligation to share to a certain extent profits and losses and in the

forms of buyer – seller (murabaha), lessor – leasee (ijarah),partnership (musyaraka), and or debtor – creditor (qard hasan)relationship.

Promote honesty, transparency justice and fairness in commercialdealings.

Charitable distributions:

Zakat (Mandatory) (2.5% Lunar or 2.5775% Solar Calendar)

Sadakat (Voluntary)

Gambling (Casinos)

Insurance

Pork

Weapons & Armaments

Adult Entertainment

Alcohol

Banking



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Bank Client

Money

Money + money (interest)

Bank Client Goods &Services

Money

CONVENTIONAL

ISLAMIC

CONVENTIONAL BANKING

•Is based on interest.•Deals in money or papers

•Is based on fixed return on bothSides of the balance sheet.

•Does not involve itself in tradeand business directly

Islamic BANKING

. Is based on profit or rent

. Deals in assets.

. Is based on profit sharing on .deposits side, and on profit onassets side.

. Actively participates in trade,production and valid servicesthrough valid contracts.

Islamic vs. Conventional



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Conventional Bank

Bank acts as a financialIntermediary

Maturity Transformation – Takes in long term financeand lends short term

Main income consists of

Interest Margin

Islamic Bank

Return must take the form ofa tangible asset

Bank acts a a fund/assetmanager (Mudarib)

Depositors are seen asinvestors (Rab al Mal)

Islamic vs. Conventional



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Expectations

More ethical business and economy.

Better governance, due to participation of investors (debtholders) in risk sharing.

Less uncertainty and less transaction costs.

Less speculation.

Shariah businesses deal only on real sector (goods and services),

so that it will add economic value.



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History and Development of Islamic

Finance and banking



17Historical Background of IF&B



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1960‟s-1980New Concept,

Limited toCommercial

Banking

• New Concept, Limited to Commercial Banking

1980‟s-1990

• Expansion into Asian Markets

• Introduction of Islamic Insurance (Takaful) + Project Financing

1990‟s

• Oil shocks resulted in rapid growth• Birth of the Islamic bond (Sukuk)• Equities market• Leasing (Ijarah)

2000- Today

• Internationalization of Islamic Finance• Creation of Islamic Funds / Asset Management• Structured Products

Industry has developed a comprehensive productoffering over its young history



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Reach and richness

Niche presence

Mainstream relevance

Conceptual exploration

Engaging with regulators

Reach and richness

Source: HSBC

Amanah

Islamic finance industry is developing a globalreach…



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Singapore:

Active in

developing

Islamic

finance

Germany:

Saxony issues

E100m Sukuk (2004)

UK:

New legislation for

Islamic mortgages (2003)

UAE:

30% of retail banking

is Islamic (2005)

•Several institutions

have converted from

conventional to Islamic

Malaysia:

Islamic product and

industry, development

and sophistication lead

USA:

Harvard workshop

with six regulators

(1995)

China:

Active member

of Islamic

FinancialServices Board

(2004)

Bahrain:

Leading Islamicfinancial centre, and

housing regulatory

bodies

Saudi Arabia:

95%+ of new consumer

lending is Islamic (2006)

•Retail market rapidlyconverting to Islamic

(2006)

Source: HSBC Amanah, Press

Reviews

Japan:

JBIC explorin

Islamic

financingopportunities

(Dec. 2006)



21Islamic Banking

KualaLumpur

Dubai Manama Doha London Singapore

Population 1.5m 1.3m 718,306 928,635 7.5m 4.6m

Muslims 40% 96% 81.2% 77.5% 8% 14.9%

Fin Sector

(Assets)

$387.5 B $340.0 B $251.1 B $81.3 B $19.1 Tr $276.5 B

Islamic $50.0 B $46.3 B $16.4 B $14.8 B $10.0 B $1.8 B

% 12.9% 13.5% 6.5% 18.2% 0.05% 6.5%

MajorPlayers

HSBC,Bank IslamMalayasia,Prudential

NoorIslamicBank,DIB,

EmiratesIslamicBank,

AcrapitaBank, Gulf

FinanceHouse,BahrainIslamicBank

AcrapitaBank, Gulf

FinanceHouse,BahrainIslamicBank

IslamicBank ofBritain,HSBC,

EuropeanFinanceHouse

StandardChartered,

Islamic Bankof Asia,

Malayan Bank

22N t d F t f th IF&B



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•1.6 Billion Muslims worldwide (24% of total world‟s population)

•10-20% annual growth rate

•Market of Shariah compliant assets approximately $800bn

•Islamic indexes on Dow Jones/FTSE//MSCI

0

500

1000

Islamic

Funds 2008

Islamic

Funds 2010

650950

Number of Islamic Funds

0

2

4

MuslimAUM 2008

MuslimAUM 2010

1.62.7

Assets held by musliminvestors in $trillions

Natures and Facts of the IF&B

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Conventional banks, including multinationals get into the

business, offering islamic financial products.

Grais & Pellegrini (2006) reported that the global Islamicfinancial services industry consisted of 284 institutions offeringIslamic financial services (IIFS) operating in 38 countries, bothMuslim and non-Muslim.

Solé (2007) identified that there were more than 300 Islamicfinancial institutions spread over 51 countries, plus well over 250mutual funds that comply with Islamic principles.

Assets held by fully Shariah-compliant banks or Islamic bankingwindows of conventional banks rose by 28.6% to $822bn from$639bn in 2008, compared to just 6.8% for that of conventionalbank (The Banker‟s Top 500 Islamic Financial Institutions Survey).


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The major contributors to asset growth for Islamic funds:

Gulf Cooperation Council (GCC) countries (US$262.7bil);

Asia (US$67.1bil);

Australia/Europe/the United States (US$35.3bil); and non-GCC Middle East countries, Middle East and North Africa(US$248.3bil).

The IF & B has involved in all of industries: energy, consumerdiscretionary, staples, financials, materials, informationtechnology, health care, telecommunication, utilities,education, etc.

IF & B also provides financing for large scale projects such asthose in energy and infrastructure through sukuk (asset based)financing.


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Global Islamic Banking Assets

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29Infrastructure Regulatory Framework and



Infrastructure, Regulatory Framework andGovernance for If & B

Islamic law and regulatory framework exist, including those deal

with modern business. However, there are limitations in terms ofthe capacity of the jurists to deal with large scale economictransactions, and that there is no court of final appeal that resultin controversies (Monger and Rawashdeh 2008).

The most notable initiative is the establishment of Accounting andAuditing Organization of Islamic Financial Institutions (AAOIFI) =>to develop standards for accounting, auditing, governance, andethics to ensure Shariah compliance.

The Islamic Financial Services Board (IFSB) was created to set

standards for the industry, in which twenty-two agencies, includingseveral national central banks, International Monetary Fund andWorld Bank are members. The board intially focussed on riskmanagement and capital adequacy for islamic financial industry.

30Infrastructure Regulatory Framework and



The IDB initiatives are also important to support the infrastructure

for operation and development of Islamic financial industry.

Other supporting structures, such as ratings, indexes, studies,

predictions and analysis for IF & B institutions are available andprovided by conventional and international institutions (such as

S&P, Dow Jones, etc.).

Infrastructure, Regulatory Framework andGovernance for If & B

31Self-regulatory organizations bring credibility



GCIBFI

(2001)Bahrain

Promoting industry in theory and practice

− Disseminating Shariah concepts & multilateral understanding between IFIs and public− Improving IFI practices, cooperation, professionalism and transparency

IIFM (2001)

Bahrain

Development of global Islamic capital and money market

− Promoting active and regulated trading and capital flows

− Catalyzing trading infrastructure, product innovation and information flows

through standardization of practices

AAO-IFI (1991)

Bahrain

Benchmark of Islamic accounting standards

− 56 accounting, auditing, governance and Shariah standards− Enhancing clarity, transparency and harmonisation

IIRA (2005)

Bahrain

Reference point for IFI ratings

− Issuing sovereign, credit, Shariah quality and corporate governance ratings

− Providing effective tool for informed investment decision-making

IFSB (2002)

Malaysia

Standard-setting body of regulatory and supervisory agencies

− Complementing Basel II Capital Accord

− Key standards: risk management, capital adequacy & corporate governance

LMC (2002)Bahrain

Creation of active Islamic inter-bank market

− Creating secondary market for short-term Shariah-compliant treasury products

− Enabling IFI management of liquidity mismatch

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Islamic Banking Operating Structures

Islamic Windows

Branches

Subsidiaries

Fully fledged Islamic Banks

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Islamic Contracts & Use of Funds

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Sources & Uses of Client Funds

Sources

Deposit Accounts

Current account

Savings account

Investment account

Shareholders funds

Share Capital

Reserves

Other

Off balance sheet (specificaccounts)

Uses

Murabaha

Musharaka

Mudaraba

Ijara

Salam

Istisna

Off Balance sheet

Funds

Sukuk (Islamic Bond)

Reserves (general & statuary)

Type of Contracts

35

l f C



Elements of a Contract

Contracting parties Mature

Sane

Subject Matter

Valuable according to Shariah law Existence (material effect)

Must be owned

Ability to deliver

Specific Conditions & offer and acceptance

Acceptance must match offer

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Murabaha (Set Profit Sale)

Definition of Murabaha:

It is a sale contract, with a set increment on the original price,agreed upon by the two parties.

It is a particular kind of sale where the seller expressly mentionsthe cost of the sold commodity he has incurred, and sells it toanother person by adding some profit.

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Murabaha Financing



Murabaha FinancingInstallment Credit Sale

Differed 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, registeredor not, constructive or physical

Bank Client

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Mechanics of Murabaha



Mechanics of Murabaha

A typical Murabaha transaction as practiced today takes placebetween 3 players:

The financier or the Islamic bank

The vendor or the original seller of the product

The user of the product requiring the bank to purchase andfinance the product

The transaction is explained in detail in the following steps:

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Step 1

The bank‟s client seeking financing describes to the vendor the

goods they intend to obtain, and ask the vendor to quote theprice.

Client Trader/Vendor

Pricequote

PriceInquiry

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Step 2

The bank‟s client contacts the bank promising to buy the goods

from the bank if the bank buys the same from the vendor andresells them to the client at price inclusive of the original cost +profit to be agreed mutually.

Client Islamic Bank

Promise to buyat cost-plus-

profit

Price quote byTrader/Vendor

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Step 3

Client Islamic Bank

saleItem/Commodity

Trader/Vendor

saleItem/Commodity

PaymentCost-pluscontract

•The bank purchases the product from the vendor by making payment.•The Murabaha contract is drawn between the client and the bankindicating the profit or mark-up to be charged.

•The contract is finalized by agreeing on the mode of payment (lumpsum, installments).

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Step 4

Client Islamic Bank

Payments (Lumpsum/Installments)

•At the time of payments, the client makes the payment to thebank.

•This payment includes the cost of the product + profit margin tothe bank.

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44

Commodity Murabaha (Liquidity Management)



Commodity Murabaha (Liquidity Management)

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F t d C diti f M b h



Futures and Conditions of Murabaha

Murabaha must be based on a sale and should not be used forfinancing purposes.

In the case of default by the end used, the financier only hasrecourse to the items financed and no further mark-up or penalty

may be applied to the outstanding liability.

The mark-up rate charged is influenced by: the type of productfinanced, the credit worthiness of the client, the length of timefor which the financing takes place.

The financier is allowed to ask for security to protect itselfagainst any non-payment in the future (often an other asset istaken as security).

46

Mudaraba (Partnership Contract)



Definition

This is a kind of partnership where one partner gives money toanother for investing in a commercial enterprise.

The investment comes from the first partner who is called “Rab alMal” (Investor) while the management and work is an exclusive

responsibility of the other, who is called “Mudarib” ( WorkingPartner) and the profits generated are shared in a predeterminedratio.

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Mudaraba (Partnership Contract)



Client (Rab al Mal) „deposits‟ (Invests) his money.

Bank (Mudarib) offers its skill/effort/knowledge.

Contracts between client & bank is a partnership contract.

Banks profit: share of investment profit instead of spread. (eventhough a profit margin is structured into the deal)

Mudarib could hold reserves so as to smooth out income/make itmore consistent.

Risk of loss lies with the client. (unless bank broke rules)

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FundManager/AssetManager (BANK)

(Mudarib)

$10,000 Profit

49



50



51



Client C(Rab Al Mal)

Client A(Rab Al Mal)

Client B(Rab Al Mal)

52



Client C(Rab Al Mal)

Client A(Rab Al Mal)

Client B(Rab Al Mal)

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54Types of Mudaraba



Al-Mudaraba Al-muqayyadah (restricted Mudaraba):

Where Rab al Mal specifies aparticular business for themudarib, in which case heshall invest the money in thatparticular business only .

Al Mudaraba Al Mutlaqah (unrestricted Mudaraba):

Where Rab al Mal leaves thedoor open for the mudarib toundertake whatever businesshe whishes, the mudarib shallbe authorized to invest themoney in any business hedeems fit.

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Musharaka Contract (Sharing contract)



Definition

Musharaka or Shirka can be defined as a form of partnershipwhere 2 or more people combine either their capital or labor,to share the profits and losses, and where they have similar

rights and liabilities.

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Musharaka Contract (Sharing contract)



Client Enters Agreement with bank to Invest in a Project. Bankissues notes of participation.

Client invests $80,000, Bank Invests $20,000

Profit Share is Based on a 70%:30%

Client invests $80,000 Bank invests $20,000

$100,000Project

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Musharaka Project makes $30 000 profit



Musharaka Project makes $30,000 profit.

Client receives 70% of profit $21,000

Bank Receives 30% of profit $9,000

Client receives$21,000

Bank receives $9,000

$30,000Profit

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Musharaka 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 lossof $50,000

50,000 remaining.

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Difference between Musharaka and Mudaraba



1. The investment in Musharaka comes form all the partners, while inMudaraba the investments comes from Rab Al Mal only. This meansthat the Musharaka is a partnership in profit and capital, whileMudaraba is a partnership in profit not in capital.

2. In Mushararka all the partners can participate in the managementof the business, and can work for it. While in Mudaraba the Rab AlMal has no right to participate in the management, which is carriedout by the Mudarib only.

3. In Musharaka all the partners share the loss. While in theMudaraba, only Rab Al Mal suffers the loss, while the Mudaribsuffers the loss of his labor.

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Bai Al Salam or Salam



•Bai Al Salam or as some call it 'Salam' means a contract in which anadvance payment is made for goods to be delivered later on.

•The seller undertakes to supply some specific goods to the buyer at a'future date' in exchange of an advance price fully paid at the time of

contract.

•The objects of this sale are goods and cannot be gold, silver orcurrencies, because these are regarded as 'monetary values exchange' ofwhich is covered under rules of Bai al Sarf (exchange of money for

money).

(Purchase with deferred delivery)

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Bai Al Salam or Salam



Purchase price(discounted)

CUSTOMER FINANCIER SUPPLIER

Purchase price(plus premium)

Sale of asset(delivery deferred)

Sale of asset(delivery deferred)

(Purchase with deferred delivery)

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Istisna(Partnership in Manufacturing)



• Seller agrees to manufacture a particular product with predetermined specifications and commits to deliver it to the buyer at apre determined price.

• Price can be paid in installments, or can even be deferred until theproduct is delivered

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Features of Istisna



Istitsna‟a is a pure sale contract and not a hire contract.

Commodity is non existing and is to be manufactured to bring it toexistence.

Does not include natural goods like fruits, cereals etc.

Quantity, Quality & Price are fixed at the time of signing thecontract.

Price need not be paid in advance. It can be either be paid ininstallments or can be partially deferred until delivery.

No fixed delivery date and no payment in full at outset required.

Advance funding of:

- Major industrial, construction and real estate development

- Large equipment e.g. ships, aircraft

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Mechanism of Istisna



CUSTOMER FINANCIER DEVELOPER/CONTRACTOR/

MANUFACTURER

Purchase price plus premium (deferred)

Sale of developed equipment/construction

Sale of developed equipment/construction

Purchase price

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Ijara Contract (leasing)



Similar to the a conventional lease contracts

A bilateral contract allowing the transfer of the usufruct

Rental could be fixed for the life of repayment or adjustedperiodically

Sub-leases are acceptable so long as lessor agrees Bank (lessor) & client (lessee) agree to the terms of lease.

(object/lease date/rent)

Additional security is acceptable (guarantees, collateral)

Title remains with bank until full repayment

Used for aircraft financing, ship financing and project financing

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67



68



69




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• Bonds are important part of overall financial system.

• Well developed bond markets ensures stable financial system asit minimize over-reliance on financing from the banking sector.

• The development of the bond market allows for access tofunding with the appropriate maturities, thus avoiding thefunding mismatches. It also allows for the diversification of risksby issuers and investors.

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Dealing in Bonds is not permissible according to Shariah

because of two aspects:

1. Firstly, they represent a portion of Debt payable by theissuer. Earning any kind of profit falls under the category ofRIBA as defined in the Hadith.

1. Second aspect pertain to the trading of Bonds. Shariahprohibits trading of debts (Bai Dayn) as it involves Gharar.

Trade of such Sukuks is permissible, because it will beequivalent to the sale/ purchase of holder‟s proportionate

share in the assets.However, trading of Murabaha and Salam Sukuks is notpermissible.

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How is an Islamic Bond Different?



Sukuk Sukuk are always linked to

underlying assets.

Sukuk are proof of ownershipor beneficial ownership of

the asset Sukuk holders have a right to

profits but also losses

Sukuk holders may dismisssukuk manager/issuer

Maturity is based onunderlying project/activity

Sukuk prospectus includes allshariah related rules

Conventional Bond

Bond holder does not incurdamages/loses suffered bythe company.

The security rights are notlinked to the company‟sassets

Represents a share in thefinancing process, it is not

directly linked to the project

No Shariah Constraints

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74



75

50000

Global (Listed) Sukuk Issuance



0

5000

10000

15000

20000

25000

30000

35000

40000

45000

U S $

M i l l i o n

Rest of World Middle East

76



Islamic Sukuk-Types

Sukuk

Al Ijarah

Sukuk

Al Salam

Sukuk

Al Murabaha

Sukuk

Al Musharaka

77



ABC Ltd. wishes to purchase a new asset and plan to raise finance throughissuance of Islamic Sukuk.

ABCLtd.

(Corporate)

78



Supplier

ABC

Ltd.

Supplier of the Asset is identifiedand negotiations is finalized by

ABC Ltd.

79

S li



Supplier

ABC

Ltd.

SPV is created by ABC Ltd. as a limited liability Company.

IssuerSPV

(LLC

100%

owned

ABC Ltd.)

80

Supplier



SPV issues certificates and receives proceeds which are used topurchase asset from the supplier

Sukuks

Proceeds

Payment made to

SupplierTitle istransferred to

SPV

Supplier

IssuerSPV

(LLC

100%

owned

ABC Ltd.)

ABC

Ltd.

Investors

81



ABC

Ltd.

SPV holds Asset as Trustee andleases the plant to ABC Ltd. as perrules of Ijarah

Issuer

SPV Investor

SPV holds

Plant/ Asset asTrustee

SPV leasesPlant to ABC

Ltd. on Ijarah

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ABC Ltd.

(Lessee)

Periodic Lease

RentalsSemi-annual coupondistribution amounts

Issuer

SPV

Investors

ABC Ltd. (Lessee) pays periodic rentals to SPV for tenors & amounts

matching the coupon & tenor of the Sukuks

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Exercises the purchase undertaking. Asset transferred to ABC Ltd.



Redeems

the TrustCertificatesatdissolution

Exercises the purchase undertaking. Asset transferred to ABC Ltd.

Pays theexercise priceat dissolution

•ABC Ltd (Lessee) give the SPV an irrevocable purchase undertaking topurchase the Asset at maturity.

•Exercise Price = Initial Purchase Price of Asset + service costs.

•Asset is transferred back on maturity, upon payment of the Exercise Priceto the SPV / Sukuk Holders.

ABC Ltd.

(Lessee)

Issuer

SPVInvestors

84



Essential Condition

“It’s essential that the Ijarah Sukuks are designed to represent real ownership of the leased assets, and not only a right to receive rent.”

85Sukuk Al Salam

• so named because securities are based on the concept of Bai



pSalam.

• Government of Bahrain first issued Salam Sukuks as an alternateto short term government treasury bill.

• Under the transaction Government took an advance payment

from the investors for a future delivery of Aluminum ingots. Apaper was issued as an acknowledgment of receipt which isknown as Salam Sukuk.

• Upon delivery of Aluminum ingots to the investors at the time of

completion of Salam contract, Government sold ingots to thirdparties as agent of the investors.

• The difference between Sale and Purchase price was the profit ofthe investors.

86

I C di i



• Salam Sukuk represent investors shares in the Advance Pricepaid to the seller.

• Since its a dayn, it cannot be traded in the secondary market.

Important Conditions

87Sukuk Al Musharaka

• Musharaka is a mode of financing against which Sukuks can beissued.



• If a comapany required financing for any of its project throughMusharaka it can issue Sukuks against which investors wouldprovide funding as per the rules of Musharaka.

• Every Sukuk would represent holder's proportionate ownership in

the assets of the Musharaka.

• Once the majority of the cash amount is converted into fixedassets, these Musharaka Sukuk can be treated as negotiableinstruments in the secondary market.

• Musharaka Sukuks can be used for number of purposes including:

Construction of Projects and factories

Expansion Projects

Working Capital Finance

88

P fit d b th M h k i h d di t




Profit earned by the Musharaka is shared according to anagreed ratio between the Issuer and Investors at an agreedratio.

Loss is shared on pro rata basis.

To ensure tradability of the Sukuks following condition

should be adhered to:

All the assets of the Musharaka should not be in liquidform.

At least 20% of the value of Portfolio should be investedin non-liquid assets.

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Sukuk Al Murabaha



Sukuks can also be issued against a Murabaha transaction. Underthe transaction investors would provide funding to purchase someassets for the issuer. Acknowledgment of their investment wouldbe regarded as Murabaha Sukuk.

The asset would be purchased from its supplier and would beimmediately sold to the issuer against deferred price.

Profit earned from the transaction would be distributed among theinvestor proportionately.

90




Murabaha Sukuk represent investors shares in receivable from thepurchaser.

Since its dayn, it cannot be traded in the secondary market.

91



Islamic Insurance(Takaful)

92Islamic Insurance(Takaful)

Conventional Insurance means a way to provide security / and



compensation of what is valuable in the event of its loss, damage or

destruction based on the principle of risk taking and speculation.

Islamic Fiqh (science of Shariah) Academy, meeting in its SecondSession in Jeddah, KSA, (Dec 1985) issued a Resolution which insummary stated the following:

• The commercial Insurance contract… is prohibited (Haraam) according to the Shariah.

• The alternative Takaful contract which conforms to the principles of

Islamic dealings is Halaal, being the contract of cooperativeinsurance, which is founded on the basis of charitable donation andShariah compliant dealings.

93Why conventional insurance is prohibited?

Scholars view the insurance contract as an exchange contract – moneyis being exchanged for money over time.



Riba:

In the case of life insurance, policyholders get back the premiumsalong with interest in the case of survival and the insured amount inthe case of death before maturity of the policy.

Insurance funds are invested in financial instruments which containthe element of Riba.

Gharar (uncertainty): in the case of general insurance, thepolicyholders have to pay the premiums against unknown risks:

Whether the insured will get the compensation promised?

How much the insured will get?

When will the compensation be paid? Gambling: The insured loses the money paid for the premium when

the insured event does not occur.

The company will be in deficit if claims are higher than premium.

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Definition for Takaful



Takaful is an Arabic word that means "guaranteeing each other".

It is a system of Islamic insurance based on the principle of TA-AWUN (mutual assistance) and Tabarru (Voluntarily) where the riskis shared collectively by the group Voluntarily.

This is a pact among a group of members or participants who agreeto jointly guarantee among themselves against loss or damage toany of them as defined in the pact.

95



96

Global Takaful premiums ($bn)



1.41.7

2.02.5

3.0

3.6

4.3

11.0

0

2

4

6

8

10

12

20 04 2 00 5 200 6 20 07 2 00 8 20 09(f)2 010 (f) 2 015 (f)

97Basic Elements of Takaful

Mutuality and cooperation.

Takaful contract pertains to Tabarru’at as against mu’awadat in case



Takaful contract pertains to Tabarru at as against mu awadat in case

of conventional insurance.

Payments made with the intention of Tabarru (contribution)

Eliminates the elements of Gharrar, Maisir and Riba.

Wakalah/Modaraba basis of operations.

Joint Guarantee / Indemnity amongst participants – sharedresponsibility.

Constitution of separate “Participants‟ Takaful Fund”.

Constitution of “Shariah Supervisory Board.”

Investments as per Shariah.

98

Main drivers of Takaful



Piety (individual purification)

Brotherhood (mutual assistance)

Charity (Tabarru or contribution)

Mutual Guarantee

Community well-being as opposed to profit maximization.

99Comparing Takaful to ConventionalInsurance

Issue Conventional Insurance Takaful

O i ti P fit f h h ld M t l f ti i t



Organization

Principle

Profit for shareholders Mutual for participants

Basis Risk Transfer Co-operative risk sharing

Value Proposition Profits maximization Affordability and spiritualsatisfaction

Laws Secular/Regulations Shariah plus regulations

Ownership Shareholders Participants

Management status Company Management Operator

Form of Contract Contract of Sale Cooperative,

Islamic contracts of Wakala or

Mudarba with Tabar’ru

(contributions)

Investments Interest based Shariah compliant, Riba-free

Surplus Shareholders’ account Participants’ account

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ASSET/FUND MANAGEMENT



101

4143 44

700

800

40

45

50

U S $ B n )



20

23

29

34

0

100

200

300

400

500

600

0

5

10

15

20

25

30

35

2003 2004 2005 2006 2007 2008

N u m

b e r o f F u n d s

A s s e t s U n

d e r M a n a g e m e n t ( U

AUM Number of Islamic Funds

1Q 2009

102



103

Type of Islamic Funds



104

Stock Selection Process



105

Subprime Crisis and IslamicFinance



106

Making of the Crisis



107From the Mortgage Crisisto the Global Economic & Financial Crisis



108

Major Impacts



109

Revisions by IMF for 2009 Growth Projections

Slowdown in Economic Growth



3.0 -1.40.5 -3.86.1 1.5

110

Islamic Finance as aSolution



111The Global Economic & Financial Crisis:The Real Causes



111

112Implications for Islamic Banking



113Islamic Finance as a Solution



113

114

Islamic Theory of Finance

Islamic Theory of Finance andthe Global Financial Crisis




115

Rules and Regulations




115

Forbid

Stipulate

116





117

Principles of Islamic Finance against the Crisis




117

118

Principles of Islamic Finance against the Crisis




119Challenges Facing Islamic Banking

In governance, independence of SSBs is being questioned, becausethey are part of management (paid by the banks).

Differences in practice and application of Shariah laws, that may



e e ces p act ce a d appl cat o o S a a laws, t at ayresult in confusion in market. As an example, a practice ofguaranteeing profit in some institutions is against islamic lawssince it is similar to interest rate.

Studies (using Indonesian Islamic Index) indicate that speculationplays an influencial role in islamic market (Kurniawan 2008), and

there is moral hazard in Shariah based financing practices(Nasution and Wiliasih 2007).

Regulatory & tax issues

Shariah scholars & Shariah compliant products

Trained & Skilled Islamic Bankers

Understanding by its clients

Arabic Terminology

120

Conclusions

IF & B has been a choice of financial and banking services



for Muslim and non-Muslim communities.

The size of their businesses and the asset managed growsignificantly.

To improve their role in global economy, IF & B need toimprove their infrastructure and governance, so that theislamic laws and values are consistently and essentiallyactually applied.

Islamic financial institutions are affected by the financialcrisis. They are not risk immune, however, during theeconomic crisis their growth is remained strong, and theyhave shown resilience to global market dislocation.

144240089 - Topic2 - Islamic Finance

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Transcript of 144240089 - Topic2 - Islamic Finance