Trade Finance in Islamic Banks

Trade Finance in Islamic Banks

Muhammad Faisal ShaikhBankIslami Pakistan Ltd

Shaban 03 , 1426September 08, 2005

� Famous quote in Conventional Banking

¨BANKS DEAL IN DOCUMENTS NOT GOODS¨


�The quote needs to be modified as follows:

¨ISLAMIC BANKS DEALS IN GOODS AND DOCUMENTS¨


� Trade Finance Operations of Banks play an important role in overall economic development of the country through facilitating Imports and Exports.

�Since they usually involve assets, conversion of trade finance operation is relatively easier.

�We will now look at different options to finance imports and exports in Islamic Banking.


�Following modes can be applied in financing trade

�Musharakah/Mudarabah�Murabahah


�Musharakah/Mudarabah can be applied in Trade Finance

without complexities generally faced in such financing

arrangements.

�Since the chances of fraud, negligence and others problems

are relatively lower.

�Islamic Banks can use Musharakah/Mudarabah in trade

finance to build a profitable and secure portfolio.

Export Finance through

Musharakah/Mudarabah

Banks can use Musharakah and Mudarabah in trade finance in the following manner.

�The exporter receives an order from abroad to export a

specific commodity/good at a known price.

�Exporter can estimate its expected profit.

�Exporter needs financing for manufacturing/procurement of

the goods.

�The Bank can provide financing on the basis of Musharakah

or Mudarabah.



�Profit would be shared on a pre-agreed percentage.

�The Bank can secure itself from any negligence on the part of

the exporter

�However, being a partner of the exporter, the bank will be

liable to bear any loss which may be caused due to any reason

other than the negligence of the exporter.



�However, in order to undertake such operation Banks need to

understand the nature of exporter´s business and other

requirements.

�A practical application of a similar transaction of import

finance is discussed next.



A government department awarded a contract to a local supplier (ABC & Co) for supply of an Imported Equipment.

ABC & Co was interested in financing the transaction through a Musharakah arrangement.

Import Finance through


The structure of the product was developed on a special kind of Musharakah i.e. Shirkat-ul-Wujooh.

In a Shirkat-ul-Wujooh arrangement the partners have no investment at all. They purchase goods on deferred price, and sell them at spot. The profit so earned is distributed between them at an agreed ratio.



The process of the transaction consisted of following steps

� ABC & Co opened a Usance LC of Rs. 10 million which was issued by Islamic Bank (Islamic Bank participation) in favor of M/s XYZ Machines Italy.



1. XYZ Machines agreed to give credit period of 180 days.

2. Equipments were shipped to Karachi through Air Cargo due to sensitiveness of the equipment.

3. ABC & Co inspected the goods and confirmed their satisfaction to the bank upon which Islamic Bank conveyed its acceptance of documents to the negotiating bank.



4. Pakistan Custom’s took 30 days for the clearing of equipment.

5. ABC & Co took around 50 days to install the equipment.

6. After the installation, government inspected and tested the equipment for its performance.

7. As soon as the satisfaction certificate was issued system, bill was lodged for payment.



8. Payment was received within 150 days of shipment.9. Profit was distributed among the partners as per the agreed

ratio.

10. Islamic Bank settled the LC on the due date.



On the same lines other transaction may also be undertaken.However, a detailed study should be undertaken before the execution of transaction. Close relationship with the customer during the currency of the transaction is necessary.



Trade Finance through Murabahas

� Murabahah is widely used as mode of finance in trade finance.

� As explained before since assets are involved in trade finance structured Murabahah facility can be used.

Trade Finance through Murabahah

�Murabaha is simply a sale transaction

�Which is being used by Islamic Financial institutions as a mode of financing by routing the transaction through Bai Mujjal.

�The mode can be used to provide financing to exporter for purchase of raw materials.

�A step by step process is explained next.

Murabahah Financing for Exports

Step by step Murabahah financing

1. Exporter and bank sign an agreement to enter into Murabahah.

Agreement to Murabaha

Bank Exporter


2. Exporter appointed as agent to purchase goods on bank’s behalf


Bank Exporter

Agency

Agreement



3. Bank gives money to exporter for purchase of goods.

Supplier

Disbursement to the supplier or agent


Bank Exporter

Agency

Agreement



4. Exporter purchases goods on bank’s behalf and takes their possession.

Transfer of RiskDelivery of goods Vendor

Bank Agent



5. Exporter makes an offer to purchase the goods from bank.

Bank Exporter

Offer to purchase



6. Bank accepts the offer and sale is concluded.

Bank Exporter

Murabaha Agreement



7. Exporter pays agreed price to bank according to an agreed schedule.

Bank ExporterPayment of Price



�Exporters some times needs financing for processing of raw material.

�In Pakistan textile composite units purchase cotton to manufacture finished cloth, these unit cannot rely on Murabahah Finance, since their main raw material also include labor and overhead expenses.

�Murabahah alone cannot fulfill their requirements.

Murabahah-Istisna Financing for Exports

�These exporters can be financed using the following Islamic Financing instruments:

� Istisna� Murabahah� Wakalah

�A step by step process in discussed next


Having the LC in hand, the exporter primarily needs funds to

�Purchase raw material

�To manufacture the finished product

The Bank fulfills the need of the exporter by providing

funding


� This funding is provided under the following two agreements:

�Murabahah

�Istisna

� Murabahah is provided for purchase of Raw Material

� Istisna is provided to manufacture the required goods


� Istisna is an exception where a sale is allowed without delivery of the goods sold

� It relates to goods that require manufacturing

� If the manufacturer undertakes to manufacture goods

with material available with the manufacturer, the

Istisna transaction is effected.

� It is necessary for the Istisna transaction that price is

fixed and necessary specifications of the product

are clearly defined


The process will consist of the following steps

1. The bank will finance the purchase of Raw Material

through a Murabahah transaction.

2. It will also give funds to the customer under a separate

Istisna agreement to manufacture and deliver the

goods to the bank as per the LC.

3. Once the goods are manufactured they will become

the property of the bank.


4. The bank will appoint the exporter as its agent to export the goods on its behalf under a Wakalah agreement.

5. The Wakalah agreement is required because under Istisna the customer is liable to deliver goods to the bank.

6. The exporter will now export the goods, acting as the

bank’s agent.


7. The export proceeds will be remitted to the bank

8. Which will deduct from the proceeds

The cost of goods ( Istisna price)

And profit

9. Client will pay Murabahah price to the Bank.

Graphical flow of the new process is explained next.


Exporter Request for financing Islamic Bank

Exporter Islamic BankMurabahah Facility for purchase of Raw Material

Exporter Islamic BankIstisna Facility to manufacture goods

Exporter Islamic Bank Agreement to Wakalah

Exporter Islamic BankDelivery of Goods

manufactured under Istisna

Exporter Islamic BankWakalah Agreement

Exporter Islamic Bank

ImporterGoods Exported

Exporter Islamic Bank

Importer

Remittance of Export Price

Islamic Bank

Islamic Bank will deduct the cost of goods from the export proceeds and will pay the

balance as bonus to the exporter

Exporter Islamic BankPayment of Murabahah Price

� Exporters some time needs Post-Shipment financing in the form of Bill Purchas/Discounting.

� Islamic Banks cannot provide the facility of Bill Purchase/Discounting.

� However, Murabahah can be used to partially help the exporters in this regard.

Post-Shipment Financing to Exporters

1. It is understood that MMFA is executed between the client and the Islamic Bank.

2. On January 1, 2005 Client would approach Islamic Bank with a bill of US $ 200,000/- to be realized after 55days (February 25, 2005) for discounting. Spot rate of dollar is Rs. 57.75/US$

3. Islamic Bank agrees to quote rate of Rs. 57.50/US$. However, the transaction would be executed in the following manner.


4. The Under the arrangement, Islamic Bank would disburse funds of Rs. 5,750,000/- to the client under the Agency Agreement for the purchase of agreed commodities.

5. Client will make the purchasing of the equivalent amount andwould sent Declaration to the Bank to purchase the stocks held by it as agent, at US$ 200,000/- to be paid on February 25, 2005.


6. Islamic Bank would accept the offer and sale would be concluded.

7. On February 20, 2005, Foreign Bank would remit US$ 200,000/- in the client’s account maintained with Islamic Bank.

8. As per the authority given by the client, the Islamic Bank would deduct US$200,000/- from the client account and transaction would be completed.


� Islamic Banks are using Murabahah in import financing very effectively all over the world.

� Details of the procedure being followed is discussed next.

Import Finance through Murabahah

Step 1:

� Islamic Bank and the customer will sign a Master Murabahah Finance Agreement and an Agency Agreement to finance Lcs of the Customer.

� As per the Agency Arrangement the customer would purchase goods from foreign suppliers on Bank’s behalf by opening LCs with the Bank.

Process Flow:


Step 1:

� The difference between a general Murabahah agreement and LC Murabahah agreement lies in the fact that it is possible in LC Murabahah that a good may be sold at cost price in case of a spot Murabahah.

� In order to accommodate such transaction agreement need to mention that such transactions would be regarded as Muswamah.


Process Flow:

Step 2:

�The customer will negotiate a deal with some foreign supplier (exporter) for the purchase of assets as agent of the bank.

�It should be ensured that such deal should be finalized only after execution of Agency Agreement.

Process Flow:


Step 3:

� Importer will request the Bank to open LC by submitting all relevant documents.

� Insurance to be arranged by the importer on behalf of the bank and relevant policy to be forwarded along with the LC application form.

Process Flow:


Step 4:

The Bank will record LC opening and other charges due from the customer and issue an LC in the favor of the beneficiary(exporter).

Process Flow:


Step 5:

� On receipt of LC exporter will ship the goods and deliver the related shipping documents to the negotiating bank for the payment of bill amount.

� If the documents are found in order the negotiating bank will send documents to Islamic Bank.

Process Flow:


Step 6:

� On receipt of documents Islamic Bank will contact the customer and inform him of the availability of the documents.

� The customer will negotiate the FX rate for the required foreigncurrency amount.

� Islamic Bank will discuss the payment terms with the customer and settle the bill

Process Flow:


Settlement:

Normal Payment:

� Islamic Bank will discuss the payment date with customer and if the customer wishes to settle the transaction, it will issue a Musawamah Declaration to the Customer.

� Through Musawamah Declaration Bank would sell the assets at the following price of the customer:

LC Cost+All Charges+Insurance� After receiving payment Bank will release the shipping documents

to the customer. � However, Bank's risk on the goods will end only after the assets

delivery to the customer.

Process Flow:


Settlement:

Normal Payment:

� Islamic Bank will discuss the payment date with customer and if the customer require financing it will issue a Sub-Murabahah.

� Issuance of Sub-Murabahah means signing of declaration by the customer and the acceptance of its offer to purchase by the Islamic Bank. Profit will be charged from the day bank’s nostro was debited to the Murabahah settlement date according to the agreed profit rate.

� The Bank will release the shipping documents to the customer andrecord a Murabahah receivable.

Process Flow:


Settlement:

Payment Against Documents(PAD):

� Sub-Murabaha will be booked on the day the customer can arrange funds and shipping documents will be released on the same day.

� The price will included profit from the day Bank’s Nostro account was debited till the Sub-Murabahah settlement date.

Process Flow:


Settlement:

Trust Receipt (TR) Murabahas

� TR Murabahas are the same as the case normal payment.

� The only difference is that the financing by the Bank is done for a longer period such as 60, 90 or 120 days.

Process Flow:


Shipping Guarantees or Delivery Order(DO):

� If the goods have arrived prior to the shipping documents the customer may request Islamic Bank to issue a shipping guarantee or delivery order.

� In such cases the Bank will take 110% margin from the customer and execute a Sub-Murabahah based on the FX rate prevailing on that date. The selling price will be fixed at that stage.

Process Flow:


Shipping Guarantees or Delivery Order(DO):

� If however, upon arrival of the documents the cost of the goods comes out to be higher or lower than the cost price of the Sub-Murabahah, the Bank will settle the difference with the customerby paying or receiving the differential amount.

� This adjustment in price after the execution of Murabahah is possible because Murabahah is a cost plus profit transaction and if after the execution of the Murabahah the seller discovers that the cost was higher or lower he can settle the difference with the buyer.

� However, only cost portion may be adjusted, profit portion wouldnot be adjusted.

Process Flow:


� Conventional Forward Rate hedging is not allowed in Shariah.

� Alternate to the need of forward cover has been

developed by Shariah Scholars on the basis of promise.

� A unilateral request from customer can be entertained

for obtaining cover on behalf of the customer.

Import Finance Forward

Cover

� No forward contract shall be signed for booking of forward cover.

� On the basis of Unilateral promise, the customer is

bound to purchase the foreign exchange at the booking

rate.

� In case of default of purchase of foreign exchange,

customer would be liable to compensate for actual loss

to the bank.

Import Finance Forward

Cover

Conclusion

Conclusion

� Several other options may also developed.

� There is a need to further research on the topic.

� Trade Finance Experts and Shariah Scholars needs to

collaborate more to develop mutual understanding.

Trade Finance in Islamic Banks

Documents

Transcript of Trade Finance in Islamic Banks