Islamic Banking and Risk Management

Islamic Banking and Risk

Management

Presented by: Tayeb Dajani,

November 2020

Presenter Background

• Tayeb Dajani received a master’s degree in 1989 in Applied Economics from the AmericanUniversity in Washington, D.C. and a bachelor’s degree in Economic Theory andInternational Development in 1986, Maryland University, College Park, USA.

• A Visiting Scholar to the Comparative Legal Studies Program at Harvard Law School,Harvard University in 1997 where he researched and lectured on the building blocks ofIslamic banking and finance.

• Lectured on the Islamic macro-economic model at the Nobel’s Colloquia in Venice at theend of 2010. Participated in the study and discussion group of the global financial crisis of2007-2010 with two Nobel laureates in economics during the said conference.

• Lectured on Islamic banking and finance since 1994 in London, Dubai, Istanbul, Beirut andat Kuwait’s Economics Society and the Institute of Banking Studies, Kuwait City.

• Joined the Islamic Development Bank as an economist in 1991. The National Bank ofKuwait as senior manager in 1996. Established Atlas International Advisory in 2001.

• A member of the board and CEO of Taiba Kuwaiti Holding since 2006, a listed KuwaitiCompany with USD 75 million in net shareholders equity.

• A consultant to the United Nations-ESCWA in conflict resolution and the UN-Islamic socialfinance initiative since 2019 up to the present.

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Presentation Outline• The Atlas of Islamic banking and finance.

• Geopolitical-economy and essential statistics of the growth of Islamic banking and finance.

• Governments Influences and the impact of global regulations on Islamic finance risk.

• Islamic nominate medieval financial instruments and their respective risk elements.

• Murabaha

• Mudaraba

• Credit Sale

• Ijara, leasing

• Istisna

• Salam

• The three methodologies of innovation in Islamic structured products and Sukuk.

o The adoption of Islamic medieval financial contracts/instruments.

o The adaptation of conventional financial instruments not through artifice.

o The origination of new financial instruments without subterfuge and/or stratagems.

• The Islamic macro-economic perspective of the risks inherent in the global financial system.

• A case study on the default of Nakheel Sukuk, Dubai. Lessons learnt in Islamic risk analysis.

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Islamic Banking Industry

A fairly new industry, still evolving and growing fast.

Unlike conventional banking which evidenced many major

failures over the past 200 years that shaped the industry

as it is today, Islamic Banking impregnated ethical and

social positive spillover effects with conventional banking

and finance.

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Growth of Islamic Finance • Wealth in Middle East is estimated at U.S$ 2.5 Trillion, the bulk of which

comes from G.C.C countries, with Saudi Arabia representing 63% of it, as per Atlas Advisory estimate.

• Total Islamic Banking financial assets ranges between U.S$ 1.2 to 1.47 Trillion as of the end of 2014. Islamic Banking is demand driven and loyalty based.

• Total Islamic Sukuk/bonds issuance was US$119 in 2013. It is estimated to reach U.S$ 133 Billion by the end of 2014.

• As per KFH research unit, Islamic banking average growth rate as a sector was 17.5% from 2008 up to end of 2014.

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• The actual size and rate of growth of Islamic banks worldwide is difficult tomeasure. Size estimates range from $1.2 trillion to more than 1.47 trillion,including the banks assets of the three Islamic economies, Pakistan, Iran andthe Sudan and excluding the Islamic financial assets deposited withinternational conventional banks that exceed $1.380 billion as per Atlasresearch.

• The approach to measuring the size of the Islamic savings pool would be toaggregate the balance sheets of all Islamic banks and financial institutions.

• Despite a number of complications which make this route unpromising, acomparison of the balance sheet footings for the leading Islamic banks forwhich numbers can be obtained shows a growth rate of more than 17% p.a.over the past thirty years throughout the Muslim World.

• It would not be unusual for a bank in London (a major market center forIslamic finance) to place $900 million or more on behalf of a single Islamicinstitution, family or even individual (a ruling family member or politician inthe most likely situation).

Growth of Islamic Finance

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• There is general agreement that the funds currently handled by Islamic banksrepresent the ready money- i.e., the funds of individual investors with strongpersonal commitments to Islamic religious principles.

• Thirty years earlier, many such rich Muslims kept their funds idle in non-interestbearing accounts in Western banks. Others circumvented the conventional bankingsystem altogether, keeping money in their homes.

• With this easily attracted money now accounted for, some experts believe that thecurrent pace of growth will be sustained should oil prices and production continueto increase in the medium term.

• In other expert opinion, future growth will also depend on the Islamic financeindustry's ability to attract the funds of savers and investors who currently opt forthe superior returns and risk characteristics of conventional bankers.

• Islamic banking represents an opportunity of significant growth for global, regionaland local financial institutions. This industry can not be ignored, as it opens theopportunity to generate higher levels of profitability compared to same sizeconventional banking.


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• The Islamic capital and money markets have not gone unnoticed by financialinstitutions - either indigenous or foreign-owned operating in countries withIslamic populations.

• By the end of 2013, more than four hundred firms categorized themselves asIslamic financial institutions globally.

• In addition, hundreds of other financial institutions either had Islamic windows orsubsidiary organizations dedicated to accepting and investing funds according toIslamic principles.

• A handful of large Gulf-owned Islamic banks dominate the current regionalmarket. These include al-Rajhi Banking Group, Qatar Islamic Bank, DMI (for Daral-Mal, or "treasury" in Arabic), al-Baraka, Kuwait Finance House. Bank IslamMalaysia dominates in South East Asia among others.


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• Some indigenous and Western conventional commercial banks havesubstantial Islamic operations including Citibank, Deutsche Bank, NationalCommercial Bank, Saudi American Bank, and many others.

• A number of these were initially reluctant to initiate Islamic deposit programswith profit-sharing structures for fear of cannibalizing their conventionalaccount base in which some Islamic depositors were accepting no interest.This fear later proved to be unjustified.

• While Western operators enjoy an aura of deep pockets, geographicdiversification, and reputations for sophisticated, reliable and innovativebanking, regional and national Islamic banks still possess higher levels ofcustomer loyalty as per Atlas market research.

• Western global banks are becoming leaders the issuance of Islamic structured products.


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• Islamic scholars have a profound influence on the day-to-day practice of financeand banking.

• Islamic financial institutions generally maintain boards of scholarly advisors,called shari'a boards, to review all proposed transactions for conformity withreligious law. The judgment of religious scholars is neither absolute nor uniform.

• In Sunni Islam, four schools of Islamic jurisprudence apply Islamic teachings tobusiness and finance in different ways. Disagreements on specific points ofreligious law occur both between these four schools and within themselves.

• This also applies to Shi’a three schools of jurisprudence. Furthermore, shari'aboards sometimes change their minds, reversing earlier decisions.

• The sophistication of shari'a boards has visibly increased as they have gainedexperience with modern financial concepts and their applications incontemporary commerce.

• In the early years, religious scholars were less familiar with the dynamics offinancial markets.

Sharia Scholars

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• Not surprisingly, their pronouncements were cautious and often lookedmore to the form of financing arrangements than to their intent oroutcomes (Form over Substance).

• All parties to these contracts, in fact were feeling their way along anunfamiliar road, and the terms of the finance typically spelled out inelaborate detail, often with frequent referrals back to the shari'a board forclarification and approval on particular points of religious law.

• Today, shari'a boards are more knowledgeable about modern finance andthe practical requirements of investors and businesses, and they increasinglyconsider the intent as well as the letter of situations brought before them.

• The length and degree of detail included in many of these contractdocuments has shrunk undoubtedly reflecting, at least in part, an enhancedunderstanding of the working of the financial markets, and their increasedcomfort level with frequently-used Islamic contracts.

Sharia Scholars

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• Although the raison d'etre for the practice of Islamic finance is undeniablyreligious, politics and national government policy also play important roles indetermining how it manifests itself in the Islamic World. Government stances canbe divided into several categories:• those that have transformed their entire internal financial systems to an

Islamic form (Iran, Pakistan and Sudan);• those that embrace Islamic banking as a national policy while supporting dual

banking tracks (Saudi Arabia, Bahrain, Brunei, Kuwait, Malaysia, Turkey,United Arab Emirates, Oman and Yemen);

• those that neither support nor oppose Islamic banking within theirjurisdictions (Egypt, Yemen, Singapore and possibly Indonesia); and

• those that have actively discouraged a separate Islamic banking presence(Morocco until recently with the Bin Kiran government coming to power).

• Following the revolution in 1978-79, the Iranian government called for animmediate transformation of the country's economy to one run according toIslamic principles, including a switch to a wholly Islamic banking and financestructure.

Government Influence

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• In Malaysia, civil disturbances in the late 1960s by ethnic Malays protesting theethnic Chinese dominance in the commercial sector prompted a governmentprogram to redistribute wealth and balance political power.

• The government initiated Islamic banking in parallel with conventional bankingon a trial basis.

• Ten years later, it made Islamic banking a permanent part of the financialstructure, and increasingly takes pride in its Islamic banking sector.

• The Sultanate of Brunei followed Malaysia's example in 1985 when the Sultandecreed an Islamic banking option.

• Although the Brunei government did not actually put an Islamic bank intooperation until 1992, it has actively supported that bank and has providedsubsidies that permit it to pay competitively attractive dividends to depositors.

• A profitable Islamic insurance sector has also been established in variousMuslim states.


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• In Turkey, Late President Ozal initiated Islamic banking in 1982, both as a wayof attracting deposits from the Gulf States and, through subsidies, to createprofits to finance his political party.

• The ascendency of current Prime Minister Recep Tayip Erdogan to power from2002 up to the present had a clear and positive impact on the growth ofIslamic finance in Turkey.

• A particular strength of the Islamic finance sector in Turkey is in its ability toattract numerous syndicate Murabaha and Ijara finance deals.

• Islamic funds channeled towards direct investment in Turkey is a classical caseof success in the modern experience as well.

• Turks have shown average level of enthusiasm for this Islamic alternative - lessthan fifteen percent of total deposits are channeled to Islamic finance in linewith the Average across many Arab and Muslim states.

• Reserve requirements in Turkey, for instance, used to be set at 1 percent forIslamic investment deposits in contrast to the 12 percent reserve required forconventional bank deposits.


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• Egypt is usually credited with being the cradle of Islamic banking, since much of theearliest financing activity was centered there, but insufficient governmentregulation helped create conditions that led to massive fraud by certain "Islamicinvestment companies" in the 1980s, resulting in huge depositor losses.

• Since then, both government and savers tread a cautious path regarding Islamicbanks. This is the case recently after the overthrow of President’s Morsi IslamicBrotherhood government.

• In the last category of Islamic countries, Saudi Arabia provides an instructiveexample. Saudi has actively discouraged a distinct Islamic banking sector in thepast, despite the fact that Saudi Arabia is a highly traditionalist Islamic religiousstate and fountainhead of much of the private sector savings that fuel Islamicbanking elsewhere in the Gulf, Europe, Asia and North America.

• Its official position has been that since it is an Islamic state, all of its banks are asIslamic as is feasible.


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• To single out certain of banks in Saudi as Islamic would imply that the othersare not Islamic.

• In reality, few of the Kingdom's principal banks follow the principles ofcontemporary Islamic banking and finance, except where the otherconventional banks have been permitted to open Islamic windows toaccommodate religious depositors.

• Some observers suggest that, in contrast to Malaysia, which encouragesIslamic banking as a constructive outlet for Islamic religious fervor, the Saudileadership may fear that Islamic extremists would turn an Islamic bankingbase into a political weapon to disrupt the country.

• The rise of fundamentalist political Islam in Saudi Arabia is a reality. This willlead to higher rates of growth in Islamic finance, as expected by thegeopolitical experts.

• The risk of oil prices declining or the deterioration of the ability of SaudiArabia to export oil in excess of nine million barrels a day poses a risk to thegrowth of Islamic finance sector as a whole.


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Risks in Banking Regulatory defined, with a focus on:

o Credit risk

o Operational risk

o Market risk

Other noteworthy risks include:

o Fiduciary/Reputational risk

o Legal risk

o Systemic risk

o Other risks

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• The relationship between bank liquidity needs, profitability, and the appropriatecomposition of the capital structure is an important issue.

• Liquidity concerns have caused Islamic banks to be particularly cautious in theirinvestment policies, to the detriment of bank profitability.

• The Bank for International Settlements has established minimum capital levels forconventional commercial banks around the world, and recently these standardshave been established for Islamic banks as well.

• Most Islamic banks of the Arab Gulf Co-operation Council States completed theimplementation of the Islamic version/equivalent of Basel II.

• Basel I inherent weaknesses included emphasis on credit analysis and capitaladequacy ratios of tier I and tier II capital. Guidelines were targeting top globalbanks in the G-10 advanced economies.

• Basel II weaknesses included dependence on credit rating agencies that failed inthe recent global financial crisis and its inability to stress test extreme systemicrisk, contagion effects and cross-credit defaults.

Risk & International Regulations

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• Basel I Accord divides itself into four “pillars.” The first, known as The Constituents ofCapital, defines both, what types of on‐hand capital are counted as a bank’s reservesand how much of each type of reserve capital a bank can hold.

• Under the Accord, banks were required to hold a backing for weighted assets of noless than 8% total capital and at least 4% of tier 1, or core capital.

• Core capital was defined as issued and fully paid ordinary shares/common stock plusnon‐cumulative perpetual preferred stock and disclosed reserves.

• Since promulgating Basel I rules, the banking industry has become exceedingly morecomplex. Increasing use has been made of sophisticated funding tools, such assecuritizations, and complex derivatives to reduce capital requirements and to hedgeand manage risks.

• The use of the state of the art of risk measurement, VaR and modeling has advancedvery significantly. Within that context, the lack of internationally agreed rulesconcerning securitization exposures was thus considered by banking regulators to be amajor gap in Basel I, and its remedy was a major objective of Basel II.

• The other vein of criticism of Basel I is its narrow scope. Because it only covers creditrisk and targets G‐10 countries, Basel I is seen as too narrow in its scope to ensureadequate financial stability in the international financial system due to the omission ofmarket discipline.


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• Basel II, known formally as a Revised Framework on International Convergence ofCapital Measurement and Capital Standards and informally as “Basel II” greatlyexpands the scope, technicality, and depth of the Basel I.

• Basel II has fundamentally altered the conventional rule‐based and reactiveapproaches to designing a regulatory framework, to a superior and relevantregulatory and supervisory mechanism.

• It takes into account the bank’s situation in the market, expressed by the rating andthe probability of default, describing the risk level.

• In comparison to Basel I, a unique feature has been introduced by Basel II in thedynamism and the potential it accords to banks in enabling them to manage highlevels of credit –through a transformation of their funds from loans to bonds.

• Basel II relies on three pillars (minimum capital requirements, supervisory review, andmarket discipline) to attain the safety and soundness of the financial system.

• The first, a set of formulas for determining regulatory capital requirements; thesecond, a set of principles for the exercise of supervisory oversight; and the third, aset of disclosure requirements intended to enhance market discipline.


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The extents of the Basel II impact on the financial crisis of 2007 – 2010:

• It is argued that Basel II rules were not actually applied in major countries when thecrisis erupted.

• In Europe most banks have started to apply the new rules in 2008 and in the US regulatory agencies have decided to postpone its implementation to 2010.

• Some of the 'regulatory failures' like inadequate growth of banks' capital,proliferation of off‐balance‐sheet exposures, which cannot be denied are failures ofBasel I, rather than of the new framework.

• But, in other cases like the pro-cyclicality and the role of rating agencies, failures are indeed related to Basel II. However, there are some issues which are still significant like the fair‐value assessment, have nothing to do with prudential regulation.

• Although, Basel II proposed more comprehensive framework, it couldn't overcomesome of Basel I shortcomings. That resulted in that, in many cases, the drawbacks ofboth accords are remarkably similar, and not avoided. The followings serve asevidences for that:

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• Basel II largely examines risk as faced by individual financial institutions. It isnot well equipped to respond to extreme events.

• Basel II does not ask – at least not explicitly – whether there is adequate capitalacross the entire banking system in case of systemic risk (contagion), liquidity crisis,or cross-failure of institutions with a peculiar magnification effect. The currentfinancial crisis may be an instance where this failed to hold.

• The proposed statistical models to be used for forecasting risk have beenproven to give inconsistent and biased forecasts, notably underestimating the jointdownside risk of different assets. In particular, the Value‐at‐Risk technique thatadopted by Basel II as market risk management tool can destabilize an economyand induce crashes when they would not otherwise occur.

• Heavy reliance on credit rating agencies for the standard approach to credit risk ismisguided as they sometimes provide incorrect customer’s creditworthiness.

• They are unregulated and the quality of their risk estimates is largely unobservableoperational risk modeling is not possible, given current databases and technology.


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Risk & International Regulations • Whilst it is contended that under Basel I, based on research evidence, capital buffers

increase during economic downturns and decrease during economic booms, andthat increased risk sensitivity of Basel II would amplify the degree of pro-cyclicalitymay still exist even if banks were not restricted by capital.

• Both the risk sensitivity of the capital rule (Pillar I) and the principles underlyingPillars II and III (tighter examination, control and exposure to the market to lowerrated banks) will reduce banks’ risk taking incentives.

• It was approved that Basel II would have had adverse effects on the preventing thetransmission from a currency crisis to a banking crisis in the case of the SouthKorean crisis of 1997/1998.

• For emerging economies, though each states that its positions are notrecommended for application in emerging market economies, the emerging marketsin an awkward position—they can either adopt Basel I and II, receive internationalcapital flows, and face excessive risk‐taking and an overwhelmed central bank, orthey can be cut off from most international capital.

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• Basel II may induce the systemic misperception of risk, due to the fact that theadvanced approaches of Basel II are more calibrated to the environment ofthe G10 countries.

• Such impact could exacerbate a credit crunch during periods of weakeconomic performance, with amplified impact because of the high reliance ofthe emerging economies on the banking systems to finance the economicactivities.

• Further, capability gaps in the adoption of the more onerous approachesunder Basel II may place domestic banks at a competitive disadvantage in suchcountries with the international counterparts.

• Basel II can raise the costs of and reduce the access to external financing.• Islamic banks are preparing for the implementation of Basel III by 2018 in

many Arab and Muslim states.


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• A thorough study leads to the conclusion that- no irreducible obstacles existto the continued development of Islamic finance. This is not to suggest anabsence of challenges.

• An important deterrent to continued growth in the Islamic banking sector isa shortage of investment outlets with acceptable risk/reward tradeoffs.

• Unlike conventional investors who can choose from a broad menu of debtand equity investments, Islamic investors have relatively fewer choices.

• I therefore give much attention to existing Islamic contracts and ways toexpand their uses in either their original or modified forms.

• Governance and risk management requirements both at the local and internationallevels necessitate the merger of many small and medium size Islamic banks.

• Mergers and acquisitions trends in Islamic banking should be an important method forgrowth in addition to organic expansion of the industry.

The Potential of Islamic Banking

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• One almost indispensable resource for accomplishing healthy growth in theindustry is a secondary market capable of providing acceptable liquidity forinvestors.

• There is much debate about what kinds of investments can be traded in anorganized Sharia compatible secondary market. Islamic law forbids the saleor trade of financial contracts, which explains why financing of accountsreceivables is difficult.

• On the other hand, if a contract or security represents a direct share in a realasset, it may be sold or traded as per Sharia rules currently implemented inthe Arab Gulf region.

• Thus, if a common share is understood as a stake in the ownership of acompany's assets, it may be eligible to be traded under Islamic law. A leasecan also be traded because it represents a direct claim on an asset. However,Murabaha debt may not be securitized as will be explained in a later section.


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• Given such interpretations, there appear to be a number of Islamic securitiesthat could be traded.

• So why is there now no viable secondary market for any instruments in anypart of the Islamic World? For one thing, there is no generally accepted set oflegal and Islamic religious principles, which can assure that such tradedsecurities will meet the religious standards for all groups of Muslim investors.

• Additionally, a variety of accounting issues need to be clarified to establish justwhat an investor is paying for when he buys a publicly traded instrument.

• Then, too, Islamic vendors appear reluctant to commit the capital and theoverhead required to create such a market in the aftermath of many Islamicsukuk/bonds defaults as a result of the recent Global Financial Crisis.


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• Thus, among the most obvious impediments to the future growth ofIslamic banking and finance are lack of liquidity, a limited set of approvedinstruments, cumbersome transactional arrangements, and no readyprovisions for risk management.

• But none of these impediments is insurmountable. Innovation, driven bygrowing demand for Islamically-approved capital outlets, has the potentialto create new forms that will satisfy the need of capital users, investors,and religious requirements.


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The Islamic Financial Institutions and

Instruments

This section pursues four main topics:

The basic model and theory for an Islamic financial institution and risk.

The Islamic contracts used in Islamic finance and risk related each.

The prospects for Sukuk being an Islamically structured products.

The risks associated with Sukuk

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Islamic Banking Products

Islamic Rules and Precepts فقه المعاملات

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Standardized Nominate Contracts

• Asset-based financing (no Ribā):

• Murābaha = cost-plus sale

• Bayc bi-thaman ‘ājil = credit sale

• ‘Ijāra (wa -qtinā’) = Lease (to purchase)

• Risk-sharing mechanisms (no Gharar):

• Mudāraba = silent partnership (commenda)

• Mushāraka = simple partnership

• Exceptions (Istihsān, cUrf or Maslaha!):

• Salam = forward with pre-paid price

• ‘Istisnāc = Commission to manufacture

• Named contracts are mostly pre-Islamic

• Through futyā, new contracts were legitimized ex post by jurists

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Mudaraba

• Mudaraba, although conceptually a partnership, does not require that acompany (incorporated or not) be formally created; a bank can make amudaraba investment in any existing enterprise, as long as the profits arisingfrom that investment can be determined separately.

• For example, a customer could use bank funds on a mudaraba basis topurchase automobiles wholesale, agreeing to share the net proceeds of retailsales, or a mudaraba could be used to add additional capacity to an existingfactory, as long as resulting increase in profits could be known.

• The "diminishing mudaraba," is a newly developed contract by which theinvestor's share in a mudaraba is progressively retired or liquidated. Underthis contract, the mudarib, in his periodic profit distributions to the bank, paysnot only the bank's profit share but also a predetermined portion of his ownprofits, which go to reducing the bank's capital share.

• Either the funds are held in an account to purchase the bank's share in a lumpsum at the end of the mudaraba, or the funds progressively reduce the bank'scapital share (thereby also reducing the bank's claim on profits).

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Three theoretical problems are raised by this contract:• it purports to be a binding future sale of mudaraba ownership, which is

not valid.• in its second form (progressive purchase), it incorporates the concept of

transfer from one party to another of a mudaraba capital investment, at aprice of par, arousing difficult issues of how profits are fairly accounted tothe parties;

• viewing the second form of the contract in another way, it is a bindingagreement to enter into a diminishing series of mudarabas, eachliquidated by a conjectural final accounting, distributing final profits, andeach followed obligatorily by a new partnership with a reduced capitalcontribution from the bank; but an agreement to enter into a mudarabain the future may not be valid.

• All three issues are serious ones from Islamic jurisprudence perspective.After extensive discussion, OIC Academy has upheld this contract as havea number of banks' shari'a boards. It is in not so frequent use.

Mudaraba

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Risks related to Mudaraba

The usual credit risks

Ways OutUnknown

rate of return

Loss of principal

CharacterCapacityCapitalConditionsCollateral

Ability to selloff the bank’s equity share if needed

Inability to plan revenues

If the client loses, so does the bank. There is no fallback

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The Model for an Islamic Financial Institution

• How is a modem system of banking and investment to be built, given the rules of Sharia?

• Searching deeply in Islamic law for fundamental economic and legal norms, Muslims have seized on the principles of partnership, particularly mudaraba, as the model for a non-interest based banking system.

• They have given special emphasis to two of these principles:• return on capital cannot be fixed in advance but must be a

proportion of profits;• capital not labor, is liable to the risks of the venture.

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• Muslim economists argue that mudaraba offers the opportunity of pure finance, enabling the owner of capital to invest his/her capital without himself becoming involved in managing that capital and without exposing himself to liabilities in excess of that capital.

• Unlike interest lending, however, the two basic partnership principles maintain a fair balance between the owner of capital and the entrepreneur who uses it.

• Most importantly, the capital provider cannot claim both a fixed profit and the assured return of his capital, whatever the fate of the investment.

• He profits only in proportion as the investment profits, and his capital is diminished by any loss, although he will not be liable beyond that capital. ("Profit" is understood to be the increase in the total value of the enterprise over the initial capital investment –i.e., the total return -- rather than just the cash income of the venture)

• The entrepreneur, the mudarib, receives a percentage of profit. In the event of a loss, he loses only his labor.

The Model for an Islamic Financial Institution

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The Two-Tier Mudaraba

• After adopting these principles, founding Islamic banker’s next task was todevise institutions for practicing them. The concept or mudaraba again provedthe appropriate tool.

• The notion of two-tier mudaraba serves as the model for the Islamic financialinstitution. According to this concept, a first-tier mudaraba is created wheninvestors (we shall call them "depositors") place their capital with an Islamicbank, fund or other financial institution, which here acts as the mudarib orworking partner.

• The financial institution or mudarib in turn invests these funds withentrepreneurs (the equivalent of a conventional bank's borrowers) by means ofsecond-tier mudarabas, in which the Islamic financial institution now has therole of capital investor.

• Such a practice is possible since classical law permits a mudarib to choose not toperform the productive work himself but to invest the partnership capital withother mudaribs.

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• The institution's profits then come not from interest income but from apercentage of the profits from the second-tier mudarabas.

• The bank or fund in this arrangement faces fewer liquidity problems than aconventional bank since it does not guarantee the capital of its depositors. (Ifdepositors want total security for their capital, they may have it, but at thecost of foregoing any profit on their accounts.)

• The risk assumed by depositors enables the institution to tolerate greater riskon its "assets" side, as it must if it is to make equity investments in mudarabaventures instead of lending on interest.

• An Islamic bank can earn additional income by charging fees for bankingservices (letters of credit, guarantees, credit investigations, and so forth) onthe basis of various contracts including (ijara).

• It may make interest-free loans (qard hasan) either as a charitable activity oras a favor to customers and banking counterparts (the point system ininterbank money market), lawfully charging for the actual costs of its servicesin providing such loans. but not for the opportunity costs of the money.

The Two-Tier Mudaraba

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Islamic Legal Challenges Facing this Islamic Banking Model

While these adaptations of mudaraba are both inspired and simple, many issues in classical law had to be addressed before they could be widely applied. Many of these concern are still not fully solved. We shall consider three major groups of issues:

Problems in managing deposit interests, arising because these deposits are understood as partnership interests under Islamic law.

Problems in organizing the Islamic bank or financial institution using conventional legal forms and practices, particularly those of the corporation.

Problems arising from pressure on Islamic financial institutions to frame deposits and investments to have risk and liquidity characteristics similar to those of conventional commercial banks, in order to compete.

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• This mudaraba continues unaffected by changes of membership.

• Its returns are determined not by actual liquidation but by using accounting techniques (and various assumptions like pro-rating) to provide a constructive or conjectural equivalent to a liquidation.

• Another innovation is that of the reserve against loss: depositors agree in advance to "donate" a portion of their gains to a charitable fund to be used to meet losses of later investors or, if unused, to be given to charity.

Islamic Legal Challenges Facing This Islamic Banking Model

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Adapting the Islamic Bank to Modern Legal Forms and Practice.

• Classical Islamic law knows partnerships and modern companies with artificialpersonality from the mudaraba/carata or muqarada system of the early age ofenlightenment in Venice, Italy.

• Since it would be extremely cumbersome to use classical partnership law tostructure present-day banks or funds, most modem Islamic financial institutionstake the form of modem corporations or stock companies.

• By permitting banks to be organized in this fashion, scholars have committedthemselves to resolving a number of problems under Islamic law.

• Mudaraba is the closest classical analogy to the modem relationship betweenstockholders and bank management. The analogy is not perfect, however.

• For example if management corresponds to the mudarib and stockholders tocapital investors, then mudaraba rules would dictate that both be compensatedby a share of profits.

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Liabilities Structure of an Islamic Bank

Profit and Loss Sharing Principle with Depositors

If Bank loses, depositors share

in the loss

Liquidity and Market Risks are thus mitigated

Theoretical Situation

Actual Situation

Any bank that attempts to apply this formula in the case of losses will face a much higher risk of a Rush, leading to loss of liquidity,

reputation, and business, rendering its continuity questionable

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Risks related to Liabilities

Deposits in their nature are short term

Deposits are susceptible to economic risks, market vagaries, historical rate of return, future expectations, and reputation

In the case of Islamic banks, reputation also means how pure the public perceives the Islamic practices of the bank

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Islamic Banking Products

Murabaha, in its various forms and other structured

products based on Murabaha still constitutes the bulk of

Islamic Banking activities on the Assets side

Credit Sale, Leasing, Istisna, Wakala and Salam are gaining

more traction in the Islamic finance.

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Bay' Mu'ajjal, or Credit Sale

• Bay' Mu'ajjal, or sale with delayed payment, is the closest Islamic analogue tointerest finance, and accordingly has been extensively employed as a vehicleof finance throughout Islamic history.

• Nothing in Islamic law dictates how the price for such a sale is determined; itis simply whatever the parties agree upon.

• Therefore, nothing prevents the seller from linking the sale price to the periodof time for which credit is extended, and Islamic financial institutions in factdo so, employing formulae using LIBOR, Mid Swap and other benchmarks andeconomic indicators in their actual documentation.

• Note that a late payor cannot be forced to pay penalties due to delay (notonly for sale but for all obligations). Delay by one who is solvent is, however, asin, and therefore a crime from an Islamic legal point of view.

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• Classically such a solvent/rich person refusing to pay his debt was subject tolashing and imprisonment to force him to pay, but since such measures are nolonger in use (except imprisonment in Saudi Arabia), and since available courtprocesses are slow, late payment does create serious problems for Islamicbanks.

• Debtors know that they can pay Islamic banks last. Since doing so involves nocost.

• To remedy the situation, Scholars have proposed expediting court processes orimposing criminal fines on solvent debtors (these paid to the government andnot to the banks).

• Pending such solutions some banks include terms in their documentationrequiring debtors to pay late penalties that are measured by the profitpercentages earned by the bank's own depositors, since the bank presumablycould have invested the unpaid sums and earned at least that amount.

• Some scholars have issued fatwas supporting this approach, overcoming anumber of serious objections to it. A spirited journal debate on this procedurehas ensued.

Bay' Mu'ajjal, or Credit Sale

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Risks related to Credit Sale


Product/ commodity related risks

Fixed rate of return

Loss of revenue in

case of protracted repayment


Market price fluctuationsAbility to

Resell

Over a medium-to-long term

Additional penalties must be contributed to charity

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Murabaha, or Sale with a Markup

• As classically defined, murabaha is simply a sale contract which fixes the price interms of the seller's cost plus a specified percentage markup.

• The seller must disclose all items of expense, which are included in the cost ifthese are not known through custom.

• Murabaha is now commonly in use only in a composite form known as al-murahaha lil-amir bi-al-shira'. or "the murabaha of the one who commissionsanother to purchase," which was also known classically from the era of thesecond prudent or Rashed caliph/ruler Umar bin Al-Khattab.

• In this transaction, A requests B (nowadays usually a bank) to purchase goodsaccording to certain specifications and then, after B has obtained the goods, tore-sell them to A by murabaha. Either of these two sales can be on credit (bay'mu 'ajjal), and in modem practice the second of them always is.

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• This transaction has many advantages. First, ordinarily no bank engages intrading in goods, finding this enterprise too risky and distracting. But thiscommissioned murabaha enables the bank to avoid these drawbacks; it neverpurchases unless it already has an assured buyer, who moreover informs thebank how to obtain the goods it wants.

• Second, while the bank's profit (the markup) conceivably derives in part fromits services in securing the goods through the first sale, it is far more likely --especially in the present-day -- to derive from the extension of credit in thesecond sale.

• To the extent that the bank's services in carrying out the two sales and thecosts and risks of its interim' ownership can be minimized, the transactionbecomes economically very similar to a conventional commercial loan.


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• The validity of "murabaha with order to purchase" is questioned because, ifconducted cleverly enough, can asymptotically approach interest lending.

• How does it differ from a simple loan on interest to a customer who thenbuys the goods himself? In law, if not in economics, there are substantialdifferences.

• The most important of these arise from the fact that, for the intervalbetween the two sales, the bank possesses and owns the goods.

• During that time the bank bears the risk that the goods will be destroyed,harmed or develop a defect, and that the seller may default.

• At the time of the second sale the bank faces the risk that the buyer willreject the goods as unsatisfactory or defective.

• None of these situations impinge on a loan. On the basis of such differencesthe OIC Academy has approved the contract


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• While the distinction from a mere loan is compelling in theory, in practiceIslamic banks often employ various stratagems to reduce their risks inmurabaha almost to zero, particularly in international trade. Practitioners callmurabahas using such stratagems "synthetic," meaning "artificial.“

• In actual deals we have seen, the bank and its customer agree in advance thatthe second sale (bank sells to customer) occurs the same instant as the bankgains title under the first sale (supplier sells to bank).

• Thereby the bank's risk of casualty to the goods becomes infinitesimal. Thecustomer also agrees to waive all claims on the bank as seller, such as forbreach of warranty or defects in the goods.


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• The bank assigns to the customer its warranty or other rights against thesupplier of the goods. Usually the bank appoints the customer as its agent topurchase and obtain the goods, reducing any possibility of error as to thegoods to be bought or of a change of mind by the customer, and eliminatingany burden or costs associated with buying or taking delivery of the goods.

• Sometimes the agreement is made without even specific delivery date for thegoods, leaving that entirely to the customer to determine.

• In one case the customer had already contracted to purchase the goods fromthe supplier before the murabaha was signed. All in all, the bank's connectionwith the goods becomes merely theoretical.


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• Such arrangements eliminate the risks of ownership, but the bank still faces therisk that the customer will break his promise to purchase, forcing the bank to tryto avoid the first sale or, if it has occurred, to dispose of the goods.

• Under strict interpretation of classical Islamic law, in fact, the customer cannotbindingly agree to purchase the goods until the bank already has possession ofthe goods.

• Scholars have proposed a solution for this last problem, which has won theapproval of the prestigious OIC Academy.

• The solution is to construe the customer's undertaking to buy not as a contractbut as a promise.

• Ordinarily, classical law did not enforce promises as such. But several opinions inthe Maliki school hold promises (at least to do a gratuitous act like a gift or loan)binding if the promise has a motive or cause [sabab] and the promisee relies onit.


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Risks related to Murabaha


Product/ commodity related risks


Loss of revenue in

case of protracted repayment


Market price fluctuationsAbility to

Resell


Additional penalties must be contributed to charity

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Ijara, or Lease

• Since lease is understood as the sale of usufruct [manfa'a], its rules follow closely the rules for ordinary sale.

• Leasing, a rapidly growing segment of the Islamic financial marketplace, is used chiefly as an alternative to installment sale for financing purchases of equipment. Unlike installment sale, the lessor retains legal title to the property being financed, assuring an effective security interest.

• In some jurisdictions leasing offers tax savings compared with sale. Other major advantages of leases include flexibility in payment terms and negotiability or transferability aspects.

• Modern Islamic finance often combines leasing with purchase in a single contract called hire purchase, or ijara wa-iqtina'.

• Under such a contract the tenant pays, in addition to lease, a sum, which goes toward buying the leased property. Properly the tenant is given credit for his payments by becoming in ever-increasing degree the owner of the property, with the result that the proportion of his payments that goes for rent also continually reduces. The result is not dissimilar to a mortgage.

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• The Islamic law of leasing poses three sets of issues for modem Islamic finance that result from the right of the parties to fix riba and gharar principles.

• The first set of problems concerns restrictions on the right of the parties to fix the nature of the right sold, the usufruct, by their agreement, Islamic law understands the usufruct largely as a creature of contract, since only by the ijara contract does the usufruct become fixed and known (e.g., for how many years does the usufruct continue?) Still, the law does not give the parties total freedom in this respect.

• It views some benefits and burdens of the property as belonging naturally and unchangeably to the lessee, and others as belonging to the lessor. For example, the classical Islamic law provides that the duties to repair the goods fall always and solely on the lessor since the repairs benefit him as the owner.

• A clause purporting to shift repair costs to the lessee may be construed by Shari'a scholars as invalid because it unjustly enriches the lessor.

• Also, if repair costs were imposed on the lessee, they would increase the rent in an amount undeterminable in advance, which is gharar (a form of a gamble). Even a lessee’s duty to do every day upkeep and maintenance is thrown into doubt by this ruling.

Ijara, or Lease

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• The second set of issues arises from the fact that the usufruct of property is not something existent and tangible, but a stream of use extending into the future, and is therefore risky and unstable.

• What if future events reduce the value of the usufruct to the lessee? Concerned over this, Islamic law gives broad scope to the lessee to cancel the lease if events cause the usufruct to be less valuable to him than expected.

• For example, as noted previously, even the Hanbali School of jurisprudence, which has a narrow view of this right to cancel, allows reduction or elimination of rent in a lease for farm land if rainfall is less than usual and crops are harmed.

• A third set of issues concerns the various types of future sale and option terms that conventional financial leases use to dispose of the residual value of the leased goods at the end of the lease term.

• Under strict interpretation of Islamic law, such terms are invalid as unenforceable future or conditional agreements.

Ijara, or Lease

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• Islamic financial practice seems to have sidestepped all three groups ofproblems. As to problems of repair or destruction of the leased property,many Islamic leases simply adopt the conventional financial lease provisionthat the lessee remains liable even in the event of the property's totaldestruction.

• Other leases, such as that of the Islamic Development Bank, pay heed toIslamic law, acknowledging the lessee's right-to cancel in such an event. Butoften even the latter leases impose on the lessee the obligation to buycasualty insurance naming the lessor as beneficiary.

• On the second issue, a lessee's right to rescind due to diminished benefitfrom the usufruct, the present practice seems simply to ignore the problem,allowing lessees to avoid the lease only for conventional legal reasons suchas force majeure or a breach of contract or warranty.

• On the third issue, the unenforceability of terms in leases disposing of thefuture residual value by options or sales, the solution in practice seems tobe to include such terms in the leases, even if unenforceable Islamically, inthe expectation that incentives other than the Islamic law will cause thepromisor to uphold them.

Ijara, or Lease

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Risks related to Ijara


Technology Fixed rate of

return

Value in case of early

Liquidation


Obsolescence Over a medium-to-long term

Condition of assetMarket forces

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Salam

• The contract of salam -- the forward purchase of generically described goods forfull advance payment -- has important potential as an Islamic financing device,particularly for production of agricultural goods and working capital finance forother generic goods. It is not yet used extensively.

• Three major issues impact the salam contract's value as a financing vehicle.

• The first is the risk of default by the seller, made more severe by thefact of prepayment.

• A partial solution is to take security from the seller, whether pledge orguarantee.

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The second issue is the bank's need to liquidate the goods after delivery, an inconvenience made more serious by the Islamic legal rule that a salambuyer cannot sell the expected goods before actually taking possession of them.

To address this problem the idea has surfaced of a "parallel" or "back-to-back" salam.

After buying goods of a certain description from a seller and paying the full purchase price (salam sale I), but before the seller is due to deliver on that contract, the bank, in a separate and formally unconnected salam contract (salam sale 2), sells goods of exactly the same description and with the same due date to a third party, receiving full advance payment from that buyer.

The net result is that the bank has reversed its position, fixed the profits it will earn from the two trades, and assured a purchaser for its goods. Classical authors have mentioned this transaction without disapproval.

Salam

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The third issue is that Islamic law requires that, according to most scholars of the four schools, if at the time of delivery the seller can neither produce the goods nor obtain them elsewhere, the buyer has a choice: either take back his price, without increase, or await the goods becoming available later, with no compensation permitted for the delay.

In either case, the buyer loses all or much of the profit from the use of his money.

Salam

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• Classical Islamic law allows the manufacturing party in an istisna' to do themanufacturing, not by itself, but by contracting a second istisna' with a thirdparty, Islamic banks have used this structure, called a "back -to-back istisna'" tofinance purchases of major manufactured goods such as ships or airplanes.

• Under the first istisna' the bank as seller accepts a long-term schedule ofpayments from its customer, while under the second istisna' the bank as buyerpays the manufacturer over a shorter period with progress payments.

• The difference between the present value of payments under the two contractsis the bank's compensation for the finance. The mechanism is analogous to amurabaha with order to purchase.

Salam

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Risks related to Salam


of the Seller

Commodity/Product

Finance Risks


Ways out


PerformancePrice/InflationProject owner/

consultantDesignSubcontractorsDelayed

payments


Only one way out, which represents the value at risk

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Istisna

• In istisna', or "commissioned manufacture," one party buys goods that theother party undertakes to manufacture according to specifications given in thecontract. While the majority view among scholars allows the contract oncondition that it is not binding until the goods are made and accepted by thebuyer, a minority view, now followed in Islamic finance holds that it is bindingon both parties from the start - even though (exceptionally in Islamic law)neither party has to perform immediately.

• As in all sales, the parties are free to fix the price as they wish, using forexample a cost-plus or markup approach, or even an explicit reference to theopportunity costs of money (for example LIBOR rates).

• Since payments can be delayed until delivery, or even beyond, it is alsopermissible to arrange a schedule of progress payments, In practice, Islamicbanks frequently employ istisna' to finance manufacture and construction.

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Risks related to Istisna


Project Finance Risks


Ways out


PerformancePrice/InflationProject owner/

consultantDesignSubcontractorsDelayed

payments


Only one way out, which represents the value at risk

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What is the distinction between istisna' and salam

• In view of the more favorable payment rules available for istisna, classically thedistinction has to do with the nature of the goods being bought and sold, i.e.,unique, manufactured goods versus generic, fungible goods.

• Ordinarily, also in istisna' the purpose of a buyer is to obtain the manufacture ofgoods that otherwise would not exist (e.g., a pair of shoes to fit the customer'sfeet), while by salam a buyer seeks to fix the price for future goods that willlikely exist anyway (e.g. $X for so many bushels of a specific grade of wheat).

• A last distinction is that the rules of salam forbid tying the contract to anyparticular production process (e.g., the crop of a particular farm); in istisna', onthe other hand, a unique manufacturing process is involved. In istisna' there is adeliberate encounter with the risks of a particular source and process, and, onemay argue, the rules of the Hanafi school are that school's attempt to modulatethe legal relationships accordingly.

• In current Islamic legal circles little attention is paid to the issue of distinguishingistisna' and salam, meaning that Islamic finance likely now follows a rule ofthumb that if a transaction involves manufacture it may employ the favorablerule structure of istisna'.

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Risks in Islamic Banking

Same risks as in their conventional counterparts , but

these risks differ radically in nature

Differences stem from the very essence of Islamic Banking

and related products

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Additional Credit Risks of Islamic Banks

Inflexibility in restructuring debt in the case of default

Inability to refinance or selloff the debt

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The Mismatch Between Assets and Liabilities

2

4

6

8

10

Murabaha Mudaraba/ Musharaka

Other Deposits

Assets Liabilities

Year

s

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Operations Risks in Islamic Banks

Operations risks in Islamic banks are significantly higher than in conventional banks:

o A simple mistake in the sequence of events in a transaction could necessitate surrendering the revenues to charity

o Products are more complex and structured

o Very often, third parties are involved in a transaction, sometimes more than one third party

o Islamic banking automation systems are not always supportive, often a lot of manual processing/ intervention is required

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Risks related to structured products: Sukuk

Structured products are many, however the

most important instrument is Sukuk/Islamic

bonds that in essence carry all the risks

associated with each of their components, with

an augmented operations risk associated with

their complexity and additional third parties

involvement.

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Sukuk Structure: Form above function?

Consider contracts A and B, one forbidden and the other permissible based on juristic analogy (فقهي .(قياس

If contracts A and B are shown to be economically identical (in the Arrow-Debreu sense; A≡B), do we:

Forbid B, through the apparent analogy (الشبه ?(قياس

Permit B, while forbidding A allows for the fallacy of composition; avoids iterative analogy = قياس على ?(قياس

Or, revoke the earlier false juristic analogy based on the economic analysis of its proof ?(عله) and reasoning (دليل)

The fallacy of composition and new hiyal (a.k.a. “Islamic Financial Artifices”):

If A≡B+C, and the jurists forbid A, see if they accept B and C(e.g. sukūk al-salam, Murābaha lil’āmir bishshriā’)

If B is forbidden, but A is permissible, and A≡B+C, try to get jurists to accept C (e.g. synthetic embedded options)

Search the historical books of jurisprudence for A, B or C

In all cases, charge the customer a premium for the relatively inefficient “Islamic” (or “Islamized”) alternative

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The Case of Nakheel Sukuk Failure

• The lessons learnt from the US$ 4 billion Nakheel Sukuk failure are of significant importance to all investors in Islamic fixed income asset class. These are:-• Significant dead-weight loss emanating from a rather very complicated

legal structure that includes many unneeded SPV’s. A structuring failure. • Failure to legally implement the corporate guarantee offered to the

Sukuk holders at the holding level.• Inadequate judiciary system that fails at the implementation level of

court judgments.• Failure at the asset backed and asset based securities extended to the

Sukuk holders.• Failure at the sovereign level of the Dubai Sheikhdom with debt

exceeding US$ 120 billion.• Global financial crisis that left highly leveraged corporations in a dire

situation.

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• The World’s nominal GDP is estimated at U.S$ 75 Trillion by the end of the year2014.

• Global equity market capitalization is hovering around U.S$ 100 Trillion.Representing 133.33% of the World’s GDP.

• Global Bond market size is U.S$ 90 Trillion. Representing 120% of the World’sGDP.

• Total Money market size is U.S$ 130 Trillion. Representing 173% of the World’sGDP.

• Total Derivatives & Futures market size may reach U.S$ 600 Trillion.Representing 800% of the World’s GDP.

• Total Global FOREX market size is about U.S$ 1500 Trillion. Representing 20times the World’s GDP.

The Risk Inherent in the Capital & Financial Markets.

Given the sheer total size of financial and capital markets globally, one can deduce that we are living in a highly leveraged and unstable financial

environment. As such, sharp movements occur as a result of exogenous shocks and/or from within the system not only on yearly and quarterly basis but also on

daily basis huge shifts may occur as well.

The Islamic Economic Model Precepts Revisited

• Islamic commercial law prohibits:

• The securitization and the sale of debt for debt. Only assets can be securitized and sold or bought.

• The sale of items not owned by the seller. This limits the short selling in general.

• Many derivatives and currency speculation contracts are also prohibited.

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How to mitigate Market and Liquidity Risks in Islamic Banks?

Need to develop special deposit products linked to asset programs

Need to develop Islamic banking vehicles that provide long term funding for the balance sheet

Need to avail an Islamic lender of last resort that Islamic Banks can revert to if needed

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Islamic Banking and Risk Management

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