Description
The report aims to explore basic background of Islamic banking, Islamic instruments of financing, the banking procedures and the care required for their execution and implications involved in such transactions
2012
REPORT ON ISLAMIC BANKING AND ISLAMIC INSTRUMENTS OF FINANCING
By: Umar Shuja Ud Din
The report aims to explore basic background of Islamic banking, Islamic instruments of financing, the banking procedures and the care required for their execution and implications involved in such transactions
CONTENTS
1. The Need for Islamic Banking 02 2. History of Modern Islamic Banking 02 3. The Market 4. Islamic Banking Scenario in Pakistan 04 5. Financial Instruments under Islamic Banking 05 a. Murabaha b. Mudarabah c. Musharakah d. Salam e. Istisna f. Ijarah g. Sukuk i. Types of Sukuk h. Takaful 23 6. Conclusion 24 05 07 08 10 11 12 13 14 03
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By: Umar Shuja Ud Din
About Author: Name: Umar Shuja Ud Din Student: BSc. Business (Hons.) Specialization – Accounting and finance Forman Christian College University, Lahore, Pakistan Email: [email protected] Contact No.: 0302-4890939
1. The Need for Islamic Banking:
After the 2007-2012 global recession, the need for a new banking system has become the latest debate amongst the financial circles around the world. Islamic banks performed better in this global crisis, proving to be more resilient. The reason for which includes that Islamic bank do not deal in complex derivative products. The collapse of leading Wall Street institutions, and the subsequent global financial crisis and economic recession, are encouraging economists world-wide to consider alternative financial solutions. Attention has been focused on Islamic banking and finance as an alternative model. Explained in a basic way, the religion Islam envisions for a fair and just society in which there are equal opportunities for growth and development of all. It provides guidance for a system which ensures equality and impartiality amongst the mankind. The Islamic rulings provide us with a solid path towards such a society of peace, harmony and contentment; a society where there should be no excuse for sinful and unjust way of obtaining the resource to fulfill ones need, a system which ensures basic rights for all. The current capitalistic economic system does not promote such a society in which there is enough for everybody. It makes the rich richer and the poor poorer, putting people in an unfair competitive position, which is exactly what Islam does not want to occur. Islam prohibits any such system which increases the sufferings and miseries of the poor. The prohibition of charging interest on loans or Riba in Islam is for the very same purpose.
2. History of Modern Islamic Banking:
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It had long been a perception earlier that in today‘s complex world an interest free economy is not possible and that Islamic principles are obsolete. However this view has been proven wrong, Islam provides complete directions for the achievement of such an economic system. This has been proven by the growth in Islamic banking in last few decades. Perhaps the first writings on Islamic economic system appeared in 1942 and 1945 by Mirza Basheer-Ud-Din. ?The next two decades interest-free banking attracted more attention, partly because of the political interest it created in Pakistan and partly because of the emergence of young Muslim economists. Works specifically devoted to this subject began to appear in this period.? ?The early 1970s saw institutional involvement. The Conference of the Finance Ministers of the Islamic Countries held in Karachi in 1970, the Egyptian study in 1972, the First International Conference on Islamic Economics in Mecca in 1976, and the International Economic Conference in London in 1977 were the result of such involvement. The involvement of institutions and governments led to the application of theory to practice and resulted in the establishment of the first interest-free banks. The Islamic Development Bank, an inter-governmental bank established in 1975, was born of this process. The first modern experiment with Islamic banking was undertaken in Egypt under cover without projecting an Islamic image for fear of being seen as a manifestation of Islamic fundamentalism that was anathema to the political regime. The pioneering effort, led by Ahmad Elnaggar, took the form of a savings bank based on profit-sharing in the Egyptian town of Mit Ghamrin 1963. This experiment lasted until 1967, by which time there were nine such banks in country.? [1]
3. The Market:
For years now, Islamic banking has seen double digit growth rates globally and has far surpassed their conventional counterparts. Though there are many challenges faced by this sector, the market has still enough room for growth and expansion. Several potential markets with large Muslim populations remain largely untapped, such as India. In addition the overall market penetration in many industry sectors is quite low. At the same time, several new markets have opened up for Islamic banking, with even more on the horizon.
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?Islamic banking-financial activity consistent with Shariah, or Islamic law-has become a material part of the global financial services industry, growing rapidly in both size and stature. Total Islamic assets are estimated around $1,200 billion in 2010. Islamic banking assets make up around 90 percent of this, while outstanding Islamic Sukuk and Islamic investment funds comprise the rest.? ?In terms of Islamic banking penetration (that is, Islamic banking assets as percent of total banking assets), markets can be broadly categorized into three clusters: established, emerging and untapped. The established cluster of Islamic banking activity is the Middle East and South East Asia, with some of the world's most active markets such as Kuwait, the Kingdom of Saudi Arabia, the United Arab Emirates and Malaysia. Emerging markets such as Pakistan and Indonesia have vast Muslim populations and offer significant growth prospects. Large yet untapped markets such as India offer great potential to daring investors. To date, there are no major initiatives undertaken to promote Islamic banking, and if tackled strategically, markets such as India present a vast opportunity for expansion. There are three main types of players in the Islamic banking industry: full-fledged Islamic banks, Islamic windows of conventional banks, and Islamic finance companies. Fullfledged Islamic banks are either fully independent entities or subsidiaries of conventional banks, holding banking licenses. Islamic windows are secluded Islamic banking departments within conventional banks. Islamic finance companies focus on supplying Shariah-compliant financing products such as auto and home finance, and are not allowed to take deposits.? [2] ?A new IMF study compares the performance of Islamic banks and conventional banks during the recent financial crisis, and finds that Islamic banks, on average, showed stronger resilience during the global financial crisis.? ?In ?The Effects of the Global Crisis on Islamic and Conventional Banks: A Comparative Study,‘ economists Jemma Dridi of the IMF‘s Middle East and Central Asia Department and Maher Hasan of the IMF‘s Monetary and Capital Market Department look at the effects of the crisis on bank profitability, credit, and asset growth in countries where both types of banks have a significant market share. The new working paper adds an empirical dimension to the debate on the relationship between Islamic banking and financial stability, a topic that has generated renewed interest since the global crisis.?
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?Islamic banks contributed to financial and economic stability during the crisis, given that their credit and asset growth was at least twice as high as that of conventional banks. The paper attributes this growth to their higher solvency and to the fact that many Islamic banks lent a larger part of their portfolio to the consumer sector, which was less affected by the crisis than other sectors in the countries studied. These findings were corroborated by external rating agency‘s reassessment of Islamic bank‘s risk, which was generally found to be more favorable than-or similar to-that of conventional banks. In view of their robust growth during the crisis, Islamic banks will likely take a growing market share in the future-but this implies greater supervisory responsibility.? [3] Credit risk is the main risk for both types of banks, however unlike conventional banks the Islamic banks are not permitted to have any direct exposure to financial derivatives or conventional financial institutions‘ securities-which were hit most during the global crisis.
4. Islamic Banking Scenario in Pakistan:
In 1947 Pakistan was constituted as the first Islamic republic created in the name of Islam. On the opening ceremony of State bank of Pakistan in 1948, Quaid-e-Azam the founder of Pakistan stated: "We must work our destiny in our own way and present to the works an economic system based on true Islamic concept of equality of manhood and social justice" In 1997, after the procedure of banking adopted by the banks was declared un-Islamic by federal shariat court, Al-Meezan Investment Bank was established with a mandate to pursue Islamic Banking. In the year 2003 Meezan Bank establishes itself as the pioneer of Islamic Banking in Pakistan and quickly establishes branches in all major cities of the country. In 2003 the State Bank established a dedicated Islamic Banking Department (IBD) by merging the Islamic Economics Division of the Research Department with the Islamic Banking Division of the Banking Policy Department. A Shariah Board was appointed to regulate and approve guidelines for the emerging Islamic Banking industry. The Government of Pakistan awarded the mandate for debut of international Sukuk (Bond) offering for USD 500 million. The offering was a success and established a benchmark for Pakistan.
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The Sate bank‘s website states under its Islamic banking department that: ?The progress of Islamic banking in Pakistan has been commendable during the last five years. Currently there are six licensed fully fledged Islamic banks and twelve conventional banks with standalone Islamic banking branches with a total branch network of over 336 branches operating in more than 50 cities of all the four provinces and Azad Kashmir in the country as of 17.07.2008 and applications for few more players are under consideration. Islamic banking is a high priority area for State bank of Pakistan. Steps are being taken to make Islamic banking industry in Pakistan is robust enough to offer a viable alternative to conventional banking, should the market decide that Pakistan should have an exclusively Islamic banking system in the country.?[4]
5. Instruments of Financing under Islamic Banking:
There are six main products under Islamic banking system, the names of which are as follows: ? ? ? ? ? ? ? ? Murabaha Mudarabah Musharakah Salam Istisna Ijarah Sukuk Takaful
Despite of efforts made to ensure that maximum care is taken to make these products compliant to shariah, critiques are still present and many are still not fully satisfied. A number of questions remain unanswered by the Muftis who worked on developing these products. The increasingly complex trade and business world, and ever increasing customer demands make it difficult for Islamic banks to be spot-on in shariah compliance, however, banks are learning and the market is also developing hence things improving. The details of these products are as follows: MURABAHA:
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In Islamic banks Murabaha is the most commonly used Islamic instrument, more than 60% investment transactions are through Murabaha. Murabaha is a credit sales transaction. In which the seller sells his goods for an added profit amount, over its cost price. The seller also mentions the cost he had incurred and the profit he has added. This is to be noted here that there is a difference in a simple sale where the seller does not disclose his cost price whereas in Murabaha it is important to disclose the cost. Under this arrangement, the client can fulfill his working capital needs such as the need for money to buy raw materials. Typically, banks use Murabahah in asset financing, property, microfinance and commodity import-export. When the client approaches the Islamic bank, the bank does not offer him a loan; since interest based loans are not permitted in Islam, instead the bank offers him to engage in a Murabaha. Under this agreement the bank promises to sell and the buyer promises to buy the commodity on an agreed ratio of profit added to the cost. Since the bank does not usually have the expertise, technical understanding and the knowledge to buy the particular product; for example: the particular raw material required by the client, the bank may appoint the client as his agent. Under this agency agreement, the client procures the required products from the market on the bank‘s behalf, takes the possession of goods and tries to negotiate for a fair price. The bank makes payment to the supplier. Now the bank is legally the owner of those goods and is entitled for risks and rewards associated with them. After this stage is complete, now the bank can further sell the goods as it has the ownership. The bank declares the cost and his profit and offers to sell whereby the client agrees to purchase and accepts those goods and the transaction is made. The payment of Murabaha transaction can be in lump sum, in installments or in lump sum after a particular time. In case of payment in installments or in lump sum after a certain time, the bank has to ensure it incorporate the time value of money since the agreed sale price cannot be changed. Now the issue arises what to do if the client defaults or fails to make payment on a particular agreed date? For that purpose the bank can ask to furnish a security, which includes mortgages. The bank can also ask the seller for a 3rd party guarantor, in case of default he will be liable to pay however it is important that guarantor cannot charge a fee to the original client for clearing his loan as it comes under riba or interest. However he can charge for any legal expenses incurred. Likewise incase of dishonest clients who
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delay the payments, a fine can be charged for late payment however the bank cannot use it as an added income, the bank must give that charge in charity. Similarly in the case of early payments, there still cannot be any rebate or discount for the client in the view of most scholars however even if the bank offers a rebate on its own this is not objectionable specially if the client is needy. The Commodity Murabaha has been criticised by Islamic Scholars who say it should only be used as a structure of last resort where no other structure is available this is because in most transactions the commodities never change hands and usually there are no commodities at all, merely cashflows between banks, brokers and borrowers. Commonly the mistake done while making Murabaha agreements include assuming that Murabaha can be used for all types of transactions and financing, whereas Murabaha can only be used where some commodity is to be purchased by the customer. In some cases various stages of Murabaha is not taken care of; especially the importance of occurrence of each stage and its time thus the whole Murabaha agreement becomes void. Likewise some financial institutions applied Murabaha to already purchased commodities which are not allowed in Islam. Murabahah can be used in following conditions: Short / Medium / Long Term Finance for: Raw material, Inventory, Equipment, Asset financing, Import financing, Export financing (Pre-shipment), Consumer goods financing, House financing, Vehicle financing, Land financing, Shop financing, PC financing, Tour package financing, Education package financing, All other services that can be sold in the form of package. MUDARABAH: Mudarabah is a type of partnership in which one partner provides investment and the other provides his expertise, skill and services by conducting business activities. The investor is called Rab-ul-maal whereas the other partner is called Mudarib. The profits generated through this partnership are shared at predetermined ratio and the loss is shared solely by the investor since Mudarib has no investment. Mudarabah can be restricted or not i.e. the Rab-ul-maal provides money for investing in a particular type of business or might not put any restrictions on the type at all. The Mudarib cannot keep another Mudarib or invest his own money in the business without the consent of the Rab-u-maal. Rab-ul-maal cannot interfere in the business affairs but
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has the authority to oversee Mudarib‘s activities and work with Mudarib with his consent. The amount of total capital invested should be known, if an asset is invested by Rab-ul-maal whose value cannot be determined then the Mudarabah is void. Mudarabah also involves some principles which are to be observed; these include technical points such as who bears the expenses of the Mudarib? All the personal expenses of Mudarib have to be borne by himself such as clothing, food and medical expenses etc. However in case of a business trip the guidelines we get from Islam regarding the point gives us a concept of Safar-e-sharai. Safar-e-sharai is when Mudarib is travelling for business purpose for more than 48 miles distance and stays there overnight, then all the expenses will be borne by Mudarabah as business expenses, however if distance is shorter or he does not stay overnight, he then himself is liable for all the expenses. All the expenses for the functioning of the business including cost of goods sold, salaries of workers and laborers, commissions etc are included in Mudarabah. If for any reason Mudarabah contract is void, the Mudarib is only entitled to get Ujrat-emisl i.e. the salary or wage of that work according to the market value of that work. Ujrat-e-misl should be less than his earnings in case of a valid Mudarabah according to his profit share. The profit sharing ratio is as per the mutual agreement between both of the parties, however it cannot be fixed to a given amount such as 100,000Rs for Rab-ul-maal and rest fot the Mudarib, but a particular ratio can be determined such as 60% of the total profit for Rab-ul-maal and 40% for the Mudarib. Rab-ul-maal can also share profits varying in the ratios for various scenarios such as: ?I will take 60% profit if u trade commodity A and will take 50% in case you trade commodity B.? Islam specifies some roles and duties for the Mudarib. These are that he acts as: ? ? ? ? Ameen or trustee for the Rab-ul-maal and looks after his investment/business carefully. Wakeel or agent who purchases and trades from the funds provided by the Rabul-maal. Shareek or partner the earned of profits. Zamin or liable for providing against any losses done due to his personal mistake or neglect.
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?
Ajeer or employee when Mudarabah gets fasid, he is then only a employee.
In case when Mudarabah is terminated by any of the involved parties by notice or the contract period is over, the capital of the business will be distributed amongst both parties as per agreed ratio after deducting and payables and other business liabilities. From the remaining amount, Rab-ul-maal‘s investment would be returned to him and if any money above that is left it is shared between the Mudarib and the Rab-ul-maal according to the agreed ratio. MUSHARAKAH: ?Musharakah is a type of Shirkat-ul-Amwal which literally means sharing. In the context of business, it refers to a joint enterprise in which partners (or parties) to the enterprise share the profit and loss of the enterprise. Musharakah has far reaching implications for Islamic banking and finance in the modern context and provides an excellent alternative to the interest-based economy.?
[5]
The concept is that the financer and the client go
into a joint ownership of an asset, enterprise or equipment. In a Musharakah, the party investing the capital shares equally in both the profit and loss, which is different from an interest-based system. Another form of Musharakah i.e. recently developed and is used specially in Islamic banking is the Diminishing Musharakah. In Diminishing Musharakah the asset is divided into equal units of shares, the client promises to periodically purchase more share-units from the bank which subsequently leads to complete ownership of the asset with the client and a profitable investment for the bank. It is to be noted that the bank gets signed a promise deed from the client that he would keep on purchasing next shareunits from the bank so that bank‘s capital is recovered and asset is transferred to the client. The buying of share-units cannot be combined in the actual Musharakah agreement as an obligation in a single document as in Islam conditional sale is not allowed. Thus the promise deed is signed in a separate document. If the client defaults and does not make payments to buy next shares as per the initial understanding, bank can challenge his promises deed in the court. Typically Musharakah is used for asset financing including home, car financing and trade or business financing. For instance let‘s take home financing, A home worth Rs10 Million is bought through a Musharakah agreement. This property is divided into 10 equal shares, the investment ratio was that the client bought 20% and the bank owns 80% of
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the shares. Since the asset – the home is fully in use of the client and not the bank, the bank charges rent from the client for using his share of the home. At the end of each year, the client as per his promise, purchases next share unit from the bank; changing the ownership ratio to 30 – 70%. As the share of the client increases the rent decreases as now client is using only 70% of the property he does not own. This would continue till the banks share is reduced to zero, now the bank cannot charge any rent from the client. As a rule the price of each unit of share can be pre fixed in this type of home financing contract or each next share-unit can be sold at market value of that share, although usually in practice the price is made fixed. This arrangement provides an opportunity for the client to purchase an asset which he cannot pay for in lump sum and bank gains profit in terms of rental from the client, along with return of its capital. In case the a client wants to starts a business and enters into a Musharakah contract with the bank, a profit sharing ratio is determined between both of the parties, whereas loss is shared exactly equal to their investment ratios. The client gradually purchases next share-units from the bank. In this case the price of the each next share unit cannot be pre-fixed as it will mean the financer remains with or without profit each time selling his share; meaning that either the capital gain is prefixed or there is no capital gain. Such arrangement would be against the Islamic rules. In this case for setting the price, the business is valued and a share price is determined on the basis of that, if the business value has increased the share price will increase and vice versa. For the assets such as machinery where asset depreciates over the time, the depreciation factor should also be kept in mind while deciding prices of the share-units. ?Uses of Musharakah / Mudarabah: These modes can be used in the following areas (or can replace them according to Shariah rules). Asset Side Financing: Short/medium/long - term financing, Project financing, Small & medium enterprises setup financing, Large enterprise financing, Import financing, Import bills drawn under import letters of credit, Inland bills drawn under inland letters of credit, Bridge financing, LC without margin (for Mudarba), LC with margin (for Musharakah). Export financing (Pre-shipment financing), Working capital financing, Running accounts financing / short term advances. Liability Side Financing: For current /saving/mahana amdani/investment accounts (deposit giving Profit based on Musharkah / Mudarabah – with predetermined ratio), Inter- Bank lending / borrowing, Term Finance Certificates & Certificate of Investment,
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T-Bill and Federal Investment Bonds / Debenture, Securitization for large projects (based on Musharkah), Certificate of Investment based on Murabahah, Islamic Musharakah bonds (based on projects requiring large amounts – profit based on the return from the project)?[6]
SALAM: When the interest or Riba was declared haram in Islam, farmers (specially small ones) could not take interest based loans. Therefore Holy Prophet Mohammed (Peace be upon him) allowed farmers to sell their agricultural products in advance. In Salam the seller agrees to supply specific goods on a particular future date the payment for which is received in full in advance. This allows the seller to fulfill his immediate need of money and the buyer gets advantage of purchasing goods on a lower price which he can sell later and the difference would be his profit. The permission of buying and selling of goods when they do not exist is an exception only in case of Salam, otherwise which is prohibited in Islam. There are some strict rules which encompass Salam that are as follows: ? ? The buyer has to pay the price in full to the seller otherwise the purpose of providing for the ?immediate need? of the seller remains unfulfilled. It is important that the goods sold can be specified properly, those goods which cannot be specified exactly cannot be sold under Salam agreement such as precious stones which vary in size, weight and other specifications. ? It is important to grab the concept that Salam takes place for a particular commodity and not to the produce of a particular farm of field. It means even if the farm or the field of Mr. A is destroyed, for which he had got payment under Salam from Mr. B, he is still liable to produce the specified goods to the buyer Mr. B. ? ? ? Quality and quantity must specified leaving no chance for any future conflict. In Salam it is also important to determine an exact date and place of delivery of the goods. A security can also be demanded in the form of mortgage or guarantee in order to ensure that the seller delivers.
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?
Further selling the produce is the responsibility of the buyer upon reception of goods.
The buyer can also further sell the undelivered goods to another buyer through a parallel Salam contract but these both contracts are totally independent from each other, which mean if Mr. A does not deliver on time to Mr. B, he is still responsible to produce the specified goods to the third party, say Mr. C. thus Mr. B‘s liability is not dependant on Mr. A. It is to be noted that Salam facility cannot be used as a buy back facility where thru parallel Salam the initial seller tries to buy back the goods if he has another company. Though if the company has other share holders involved too in the ownership, then it is a valid contract.
Salam finds its application in: ? ?The Salam sale has the flexibility to cover the needs of various sectors of people such as farmers, industrialists, contractors or traders. It can be used to meet the capital requirements as well as to meet cost of operations. ? Salam sale is suitable to finance agricultural operations, where the bank can transact with farmers who are expected to have commodity in plenty during harvest either from their own crops or crops of others, which they can buy and deliver in case their crops fail. Thus the bank renders great services to the farmers in their way to achieve their production targets. ? Salam sale is also used to finance the commercial and industrial activities, especially in phases prior to production and export of commodities and that is by purchasing it on Salam and marketing them for lucrative prices. ? Salam sale is also used to finance the commercial and industrial activities, especially in phases prior to production and export of commodities and that is by purchasing it on Salam and marketing them for lucrative prices.
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?
The Salam sale is applied by the bank in financing craftsmen and small producers by supplying them with the inputs of production as a Salam capital in exchange of some for their commodities to remarkets.? [7]
ISTISNA: It is a sale transaction where a commodity is transacted before it comes into existence it can be an order to the manufacturer to manufacture something. A price is agrees upon with mutual agreement of the parties involved and the specifications of the product are also set. The Istisna seems similar to the Salam but there are differences between both and are stated below: ? In Salam the advance payment is made in full whereas in Istisna it is not necessary that the payment is made in advance, it is not even necessary to pay the full price at delivery. It can defer to any time as per agreement in the contract; including payment in installments. ? ? ? In Istisna it is always something which needs manufacturing, but in Salam it can be anything which needs manufacturing or not. The time of delivery is also not necessary to be fixed in Istisna A unilateral cancellation right of cancelation of the agreement is possible before manufacturing starts, whereas in Salam it can only be cancelled bilaterally. As mentioned above, in Istisna it is not necessary to fix a time of delivery but the purchaser may fix a maximum time limit, after which he has the right to accept or reject the goods. In order to ensure that the goods are delivered within the specified time period a penal charge may be deducted, from the price payable, calculated on daily basis if the manufacturer delays. Classical jurists seem to be silent about this issue however they have allowed penalizing in the similar case of Ijarah (Which is discussed next) thus on the same analogy, the price of Istisna may be tied up with time of delivery after agreement between both the parties. Istisna can be used for: House financing, financing of plant / factory / building, BOT arrangements, construction of buildings and plants, booking of apartments. IJARAH: Ijarah is the Islamic type of lease. The concept is similar to of a normal lease but with some important differences that make it halal. It is also important to understand that
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lease is originally not a mode of financing but in banking it finds its application as a financing mode. This is because the client‘s interest usually is to purchase the asset and not to continue using it on rent. In Ijarah the asset to be leased must exist and should be in the ownership of the lessor, for example in conventional banking when a car is leased the bank starts to charge rent for it in advance – no matter if the asset (car) has been delivered to the lessee or not, or it has been just booked by the bank for future delivery. Rules laid by Islam guide us that you cannot charge rent for an asset that does not exist and specially is not in the use of the lessee. Since ownership is with the lessor; the bank, liabilities also remain with the bank. It is also to be noted that consumable things cannot be leased and the period of lease must be determined clearly. Jointly owned properties can also be leased but the rental would then be divided according to their share proportion. Likewise there are some responsibilities on the lessee too and these are that he shall compensate for any damage to the asset caused by his misuse or negligence, any loss by factors beyond his control would be borne by the lessor. The rental must be determined at the time of contract for the whole period of lease. The lessor cannot increase the rent unilaterally or the lease would be void. A penalty can be imposed on the lessee in case he delays the payment of the rental amount, this penalty is an added profit for the conventional banks but in Islamic banks this money must go for charity and should not become part of its income. For this purposes Islamic banks maintain a charity fund where such amounts are credited and advanced for charity purposes. In Islamic lease or Ijarah, the lessor cannot terminate the lease unilaterally, in case the lease contravenes with terms of agreement only then he has the right of unilateral termination. Likewise in some financial lease there is a term in the contract that incase lessee wants to terminate the lease he shall pay all the remaining installments of the lease period, this is also not in accordance with the Shariah. As mentioned earlier, most financial leases end up with transfer of ownership to the lessee since the lessor has earned his capital back along with and profit through the rental amounts. Thus the asset at the end of the lease period is transferred to the lessee, however in Ijarah this condition cannot be made a part of the original contract, as lease is not a mode of financing and making a transaction with a pre-condition attached to it is not allowed in Islam. Thus a separate promise may be signed by the lessor to sell the asset upon the end of the lease period; the promise though is only binding on the lessor. The lessee
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might purchase or not purchase; the asset at the end. In case he wants to purchase, lessor can sell it for a nominal token price. In Ijarah-Wa-Iqtina the lessor promises to gift the asset at the end of the lease period however that is not in practice under Islamic banking. SUKUK: ?Sukuk in general may be understood as a shariah compliant ?Bond‘. In its simplest form Sukuk represents ownership of an asset or its usufruct. The claim embodied in Sukuk is not simply a claim to cash flow but an ownership claim. This also differentiates Sukuk from conventional bonds as the latter proceed over interest bearing securities, whereas Sukuk are basically investment certificates consisting of ownership claims in a pool of assets. Sukuk were extensively used by Muslims in the middle ages as papers representing financial obligations originating from trade and other commercial activities. However, the present structure of Sukuk is different from the Sukuk originally used and is akin to the conventional concept of securitization, a process in which ownership of the underlying assets is transferred to a large number of investors through certificates representing proportionate value of the relevant assets.? [8] ?Most commonly used Sukuk structures replicate the cash flows of conventional bonds. Such structures are listed on exchanges, commonly Luxembourg stock exchange and London stock exchange in Europe, and made tradable through conventional organizations like Euroclear or Clearstream. A key technique to achieve capital protection without amounting to a loan is a binding promise to repurchase certain assets, e.g. in the case of Sukuk Al Ijara, by the issuer. In the meantime a rent is being paid, which is often benchmarked to an interest rate like Libor, which is disliked by shariah scholars. From a shariah perspective, certificates of debt are not tradable, although a different view is held by many in Malaysia. The most accepted structure, which is tradable, is thereafter the Sukuk Al Ijara. Debt certificates can be only bought before the finance occurs and then held to maturity from an Islamic perspective, which is critical on debt trading at market value regarding any difference to be like the prohibited Riba. As shariah considers money to be a measuring tool for value and not an asset in itself, it requires that one should not receive income from money alone. This generation of
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money from money is Riba, and is forbidden. The implication for Islamic financial institutions is that the trading and selling of debts, receivables, conventional loan lending and credit cards are not permissible. This principle is widely understood to mean uncertainty in the contractual terms and/or the uncertainty in the existence of an underlying asset in a contract, which causes issues for Islamic scholars when considering the application of derivatives. Shariah also incorporates the concept of maslahah or "public benefit", denoting that if something is overwhelmingly in the public good, it may yet be transacted – and so hedging or mitigation of avoidable business risks may fall into this category, but there is still much discussion yet to come on this issue.? [9] TYPES OF SUKUK: ?Sukuk can be of many types depending upon the type of Islamic modes of financing and trades used in its structuring. However, the most important and common among those are Ijarah, Shirkah, Salam and Istisna. Among the fourteen eligible Sukuks identified by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), following are more common: 1. Mudaraba Sukuk: These are investment Sukuk that represent ownership of units of equal value in the Mudaraba equity and are registered in the names of holders on the basis of undivided ownership of shares in the Mudaraba equity and its returns according to the percentage of ownership of share. The owners of such Sukuk are the rab-ul-mal. Mudaraba Sukuk is used for enhancing public participation in big investment projects. Steps involved in the structure:
?
Mudarib
enters
into
an
agreement
with
project
owner
for
construction/commissioning of project.
? ?
Special purpose vehicle (SPV) issues Sukuk to raise funds. Mudarib collects regular profit payments and final capital proceeds from project activity for onward distribution to investors.
?
Upon completion, Mudarib hands over the finished project to the owner.
Mudaraba Sukuk in practice:
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Shamil Bank of Bahrain raised 360 million Saudi Riyal investment capital through the Al Ehsa Special Realty Mudaraba, representing an investment participation in a land development transaction with a real estate development company in the Kingdom of Saudi Arabia. The investment objective of the Mudaraba is to provide investors with annual returns arising from participation in the funding of a land financing transaction, profits due to investors will be accrued on the basis of returns attained from investing the subscriptions.
2. Musharaka Sukuk These are investment Sukuk that represent ownership of Musharaka equity. It does not differ from the Mudaraba Sukuk except in the organization of the relationship between the party issuing such Sukuk and holders of these Sukuk, whereby the party issuing Sukuk forms a committee from the holders of the Sukuk who can be referred to in investment decisions. Musharaka Sukuk is used for mobilizing the funds for establishing a new project or developing an existing one or financing a business activity on the basis of partnership contracts. The certificate holders become the owners of the project or the assets of the activity as per their respective shares. These Musharaka certificates can be treated as negotiable instruments and can be bought and sold in the secondary market. AAOIFI define these as: ?These are certificates of equal value issued with the aim of using the mobilized funds for establishing a new project, developing an existing project or financing a business activity on the basis of any partnership contracts so that the certificate holders become the owners of the project or assets of the activity as per their respective shares, with the Musharaka certificates being managed on the basis of participation or Mudaraba or an investment agency.‘ (AAOIFI Standard 17, 3/6) Steps involved in the structure:
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Corporate and the Special Purpose Vehicle (SPV) enter into a Musharaka Arrangement for a fixed period and an agreed profit-sharing ratio. Also the corporate undertakes to buy Musharaka shares of the SPV on a periodic basis.
?
Corporate (as Musharik) contributes land or other physical assets to the Musharaka
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SPV (as Musharik) contributes cash i.e. the issue proceeds received from the investors to the Musharaka
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The Musharaka appoints the Corporate as an agent to develop the land (or other physical assets) with the cash injected into the Musharaka and sell/lease the developed assets on behalf of the Musharaka.
?
In return, the agent (i.e. the Corporate) will get a fixed agency fee plus a variable incentive fee payable.
? ?
The profits are distributed to the Sukuk holders. The Corporate irrevocably undertakes to buy at a pre-agreed price the Musharaka shares of the SPV on say semi-annual basis and at the end of the fixed period the SPV would no longer have any shares in the Musharaka.
Musharaka Sukuk in Practice: US$550 million Sukuk transaction for Emirates airline, the seven-year deal was a structured on a Musharaka contract. The Musharaka or joint venture was set up to develop a new engineering centre and a new headquarters building on land situated near Dubai‘s airport which will ultimately be leased to Emirates. Profit, in the form of lease rentals, generated from the Musharaka venture will be used to pay the periodic distribution on the trust certificates. Sitara Chemical Industries Ltd, a public limited company, made a public issue of profitand-loss sharing based term finance certificates (TFC‘s) worth Rs 360 million which were subscribed in June 2002. The TFC‘s had a fixed life tenor of five years and profit and loss sharing was linked to the operating profit or loss of the Chemical Division of the company.
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Kuwait Finance House (KFH), Liquidity Management Center (LMC) and Al Muthanna Investment Company (MIC), the mandated lead arrangers launched US$ 125 million Lagoon City Musharaka Sukuk to support the Lagoon City residential and commercial real estate development as part of Kheiran Pearl City project. 3. Ijara Sukuk These are Sukuk that represent ownership of equal shares in a rented real estate or the usufruct of the real estate. These Sukuk give their owners the right to own the real estate, receive the rent and dispose of their Sukuk in a manner that does not affect the right of the lessee, i.e. they are tradable. The holders of such Sukuk bear all cost of maintenance of and damage to the real estate. Ijarah Sukuk is the securities representing ownership of well defined existing and known assets tied up to a lease contract, rental of which is the return payable to Sukuk holders. Payment of Ijarah rentals can be unrelated to the period of taking usufruct by the lessee. It can be made before beginning of the lease period, during the period or after the period as the parties may mutually decide. This flexibility can be used to evolve different forms of contract and Sukuk that may serve different purposes of issuers and the holders. Steps involved in the structure:
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The obligator sells certain assets to the SPV at an agreed pre-determined purchase price.
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The SPV raises financing by issuing Sukuk certificates in an amount equal to the purchase price.
? ?
This is passed on to the obligator (as seller). A lease agreement is signed between SPV and the obligator for a fixed period of time, where the obligator leases back the assets as lessee.
? ?
SPV receives periodic rentals from the obligator; These are distributed among the investors i.e. the Sukuk holders.
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?
At maturity, or on a dissolution event, the SPV sells the assets back to the seller at a predetermined value. That value should be equal to any amounts still owed under the terms of the Ijara Sukuk.
Ijara Sukuk in Practice: In December 2000, Kumpulan Guthrie Berhad was granted a RM1.5 billion (US$400 million) Al-Ijara Al-Muntahiyah Bit-Tamik by a consortium of banks. The original facility was raised to re-finance Guthrie‘s acquisition of a palm oil plantation in the Republic of Indonesia. The consortium was then invited to participate as the underwriter/primary subscriber of the Sukuk Transaction. US$350 million Sukuk Trust Certificates by Sarawak Corporate Sukuk Inc. (SCSI) Sarawak Economic Development Corporation (SEDC) rose financing amounting to US$350 million by way of issuance of series of trust certificates issued on the principle of Ijara Sukuk. The certificates were issued with a maturity of 5 years and under the proposed structure, the proceeds will be used by the issuer to purchase certain assets from 1st Silicon (Malaysia) Sdn Bhd.* Thereafter, the issuer will lease assets procured from 1st Silicon to SEDC for an agreed rental price for an agreed lease period of 5 years.
*(Malaysia uses Sdn. Bhd. [Sendirian Berhad], meaning "private limited", which is the equivalent of an incorporated entity in the U.S.)
4. Murabaha Sukuk: In this case the issuer of the certificate is the seller of the Murabaha commodity, the subscribers are the buyers of that commodity, and the realized funds are the purchasing cost of the commodity. The certificate holders own the Murabaha commodity and are entitled to its final sale price upon the re-sale of the commodity. The possibility of having legally acceptable Murabaha-based Sukuk is only feasible in the primary market. The negotiability of these Sukuk or their trading at the secondary market is not permitted by shariah, as the certificates represent a debt owing from the subsequent buyer of the Commodity to the certificate-holders and such trading amounts to trading in debt on a deferred basis, which will result in riba. Despite being debt instruments, the Murabaha Sukuk could be negotiable if they are the smaller part of a package or a portfolio, the larger part of which is constituted of negotiable instruments such as Mudaraba, Musharaka, or Ijara Sukuk. Murabaha Sukuk
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are popular in Malaysian market due to a more liberal interpretation of fiqh by Malaysian jurists permitting sale of debt (bai-al-dayn) at a negotiated price.
Steps involved in the structure:
? ? ? ?
A master agreement is signed between the SPV and the borrower SPV issues Sukuk to the investors and receive Sukuk proceeds. SPV buys commodity on spot basis from the commodity supplier. SPV sells the commodity to the borrower at the spot price plus a profit margin, payable on installments over an agreed period of time
? ?
The borrower sells the commodity to the Commodity buyer on spot basis. The investors receive the final sale price and profits.
Murabaha Sukuk in Practice: Arcapita Bank, a Bahrain-based investment firm has mandated Bayerische Hypo-und Vereinsbank AG (?HVB?), Standard Bank Plc (?SB?) and West LB AG, London Branch (?WestLB?) (together the ?Mandated Lead Arrangers?), to arrange a Five Year Multicurrency (US$, € and £) Murabaha-backed Sukuk. Sukuk will have a five-year bullet maturity and proposed pricing three month LIBOR +175bps. 5. Salam Sukuk Salam Sukuk are certificates of equal value issued for the purpose of mobilizing Salam capital so that the goods to be delivered on the basis of Salam come to the ownership of the certificate holders. The issuer of the certificates is a seller of the goods of Salam, the subscribers are the buyers of the goods, while the funds realized from subscription are the purchase price (Salam capital) of the goods. The holders of Salam certificates are the owners of the Salam goods and are entitled to the sale price of the certificates or the sale price of the Salam goods sold through a parallel Salam, if any. Salam-based securities may be created and sold by an SPV under which the funds mobilized from investors are paid as an advance to the company SPV in return for a promise to deliver a commodity at a future date. SPV can also appoint an agent to market the promised quantity at the time of delivery perhaps at a higher price. The
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difference between the purchase price and the sale price is the profit to the SPV and hence to the holders of the Sukuk. All standard shariah requirements that apply to Salam also apply to Salam Sukuk, such as, full payment by the buyer at the time of affecting the sale, standardized nature of underlying asset, clear enumeration of quantity, quality, date and place of delivery of the asset and the like. One of the shariah conditions relating to Salam, as well as for creation of Salam Sukuk, is the requirement that the purchased goods are not re-sold before actual possession at maturity. Such transactions amount to selling of debt. This constraint renders the Salam instrument illiquid and hence somewhat less attractive to investors. Thus, an investor will buy a Salam certificate if he expects prices of the underlying commodity to be higher on the maturity date. Steps involved in the transaction:
?
SPV signs an undertaking with an obligator to source both commodities and buyers. The obligator contracts to buy, on behalf of the end-Sukuk holders, the commodity and then to sell it for the profit of the Sukuk holders.
? ?
Salam certificates are issued to investors and SPV receives Sukuk proceeds. The Salam proceeds are passed onto the obligator who sells commodity on forward basis
? ? ?
SPV receives the commodities from the obligator Obligator, on behalf of Sukuk holders, sells the commodities for a profit. Sukuk holders receive the commodity sale proceeds.
Salam Sukuk in Practice: Aluminum has been designated as the underlying asset of the Bahrain Government al Salam contract, whereby it promises to sell aluminum to the buyer at a specified future date in return of a full price payment in advance. The Bahrain Islamic Bank (BIB) has been nominated to represent the other banks wishing to participate in the Al Salam contract. BIB has been delegated to sign the contracts and all other necessary documents on behalf of the other banks in the syndicate. At the same time, the buyer
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appoints the Government of Bahrain as an agent to market the appropriate quantity at the time of delivery through its channels of distribution. The Government of Bahrain provides an additional undertaking to the representative (BIB) to market the aluminum at a price, which will provide a return to al Salam security holders equivalent to those available through other conventional short-term money market instruments. 6. Istisna Sukuk Istisna Sukuk are certificates that carry equal value and are issued with the aim of mobilizing the funds required for producing products that are owned by the certificate holders. The issuer of these certificates is the manufacturer (supplier/seller), the subscribers are the buyers of the intended product, while the funds realized from subscription are the cost of the product. The certificate holders own the product and are entitled to the sale price of the certificates or the sale price of the product sold on the basis of a parallel Istisna, if any. Istisna Sukuk are quite useful for financing large infrastructure projects. The suitability of Istisna for financial intermediation is based on the permissibility for the contractor in Istisna to enter into a parallel Istisna contract with a subcontractor. Thus, a financial institution may undertake the construction of a facility for a deferred price, and sub contract the actual construction to a specialized firm. Shariah prohibits the sale of these debt certificates to a third party at any price other than their face value. Clearly such certificates cannot be traded in the secondary market. Steps involved in the structure:
? ?
SPV issues Sukuk certificates to raise funds for the project. Sukuk issue proceeds are used to pay the contractor/builder to build and deliver the future project.
? ?
Title to assets is transferred to the SPV Property/project is leased or sold to the end buyer. The end buyer pays monthly installments to the SPV.
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The returns are distributed among the Sukuk holders.
Istisna Sukuk in Practice:
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Tabreed‘s five-year global corporate Sukuk (on behalf of the National Central Cooling Company, UAE) provided a fixed coupon of 5.50%. It is a combination of Ijara Istisna and Ijara Mawsufah fi al dhimmah (or forward leasing contracts). The issue was launched to raise funds to retire some existing debt, which totals around US$136 million, as well as to finance expansion. The Durrat Sukuk will finance the reclamation and infrastructure for the initial stage of a broader US$ 1 billion world class residential and leisure destination known as ?Durrat Al Bahrain‘, currently the Kingdom of Bahrain‘s largest residential development project. The return on the Sukuk is 125 basis points over 3 months Libor payable quarterly, with the Sukuk having an overall tenor of 5 years and an option for early redemption. The proceeds of the issue (cash) will be used by the Issuer to finance the reclamation of the land and the development of Base Infrastructure through multiple project finance (Istisna) agreements. As the works carried out under each Istisna are completed by the Contractor and delivered to the Issuer, the Issuer will give notice to the Project Company under the Master Ijara Agreement and will lease such Base Infrastructure on the basis of a lease to own transaction..
7. Hybrid Sukuk: Considering the fact that Sukuk issuance and trading are important means of investment and taking into account the various demands of investors, a more diversified Sukuk – hybrid or mixed asset Sukuk – emerged in the market. In a hybrid Sukuk, the underlying pool of assets can comprise of Istisna, Murabaha receivables as well as Ijara. Having a portfolio of assets comprising of different classes allows for a greater mobilization of funds. However, as Murabaha and Istisna contracts cannot be traded on secondary markets as securitized instruments at least 51 percent of the pool in a hybrid Sukuk must comprise of Sukuk tradable in the market such as an Ijara Sukuk. Due to the fact the Murabaha and Istisna receivables are part of the pool, the return on these certificates can only be a pre-determined fixed rate of return. Steps involved in the structure:
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?
Islamic finance originator transfers tangible assets as well as Murabaha deals to the SPV.
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SPV issues certificates of participation to the Sukuk holders and receive funds. The funds are used by the Islamic finance originator.
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Islamic finance originator purchases these assets from the SPV over an agreed period of time.
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Investors receive fixed payment of return on the assets.
Hybrid Sukuk in practice: Islamic Development Bank issued the first hybrid Sukuk of assets comprising 65.8% Sukuk al-Ijara, 30.73% of Murabaha receivables and 3.4% Sukuk al-Istisna. This issuance required the IDB‘s guarantee in order to secure a rating and international marketability. The $ 400 million Islamic Sukuk was issued by Solidarity Trust Services Limited (STSL), a special purpose company incorporated in Jersey Channel Islands. The Islamic Corporation for the Development of Private Sector (ICD) played an intermediary role by purchasing the asset from IDB and selling it to The Solidarity Trust Services Limited (STSL) at the consolidated net asset value.? [8] Controversy: ?Sukuk are widely regarded as controversial due to their perceived purpose of evading the restrictions on Riba. Conservative scholars do not believe that this is effective, citing the fact that a Sakk (Islamic bond) effectively requires payment for the time-value of money. This can be regarded as the fundamental test of interest. Sukuk offer investors fixed return on their investments which is also similar in appearance to interest in that the investor's return is not necessarily dependent on the risks of that particular venture. However, banks that issue Sukuk are investing in assets—not currency. The return on such assets takes the form of rent, and is evenly spread over the rental period. The productivity of the asset forms the basis of the fixed income stream and the return on investment. Given that there is an asset underlying the value of the certificate, there may be, depending on the value of the asset, more security for the investors involved, accounting for the additional appeal of Sukuk as a method of financing for investors. Certain common structuring elements for Sukuk were criticized by Sheik Muhammad Taqi Usmani President of the Shariah Council of the Accounting and Auditing
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Organization for Islamic Financial Institutions (AAOIFI) in a paper entitled "Sukuk and their Contemporary Applications" released in November 2007. Sheik Usmani identified the following three key structuring elements that differentiate Sukuk from conventional bonds:
?
Sukuk must represent ownership shares in assets or commercial or industrial enterprises that bring profits or revenues
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Payments to Sukuk-holders should be the share of profits (after costs) of the assets or enterprise
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The value payable to the Sukuk-holder on maturity should be the current market value of the assets or enterprise and not the principal originally invested.
Sheik Usmani stated that by complex mechanisms Sukuk had taken on the same characteristics as conventional interest-bearing bonds, as they do not return to investors more than a fixed percentage of the principal, based on interest rates, while guaranteeing the return of investors' principal at maturity. Sheik Usmani estimated that 85% of all Sukuk in issuance were not Shariah-compliant due to the existence of guaranteed returns and/or repurchase obligations from the issuer.
Following Sheik Usmani's criticisms the global Sukuk market shrunk from US$50bn in 2007 to approximately $14.9bn in 2008, although how much of this was due to his criticisms or the Global Financial Crisis is a matter of debate.? [9] TAKAFUL: Takaful is an Islamic insurance which is based on the principle of mutual assistance or ?Ta‘awun‘, and donation/gift etc which is called ?Tabaru‘ whereby the risk is shared collectively by a group with their discretion. This is a pact between the members who agree to jointly provide compensation among themselves in the event of loss or damage etc i.e. defined in the pact. There are three models of how Takaful can be implemented:
? ? ?
Mudarabah model (profit-sharing) Wakala model A combination of both
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In Mudarabah model, the participants enter in a Mudarabah contract and
for
indemnification and share of the underwriting results. The surplus is shared between the participants (Rab- ul-maal) and the Takaful operator (Mudarib) in an agreed ratio. This model allows the Takaful operator to share in the underwriting results from operations as well as the favorable performance returns on invested premiums. However shariah concerns are that profits from a normal Murabaha are not same as the Takaful ?Surplus‘ which is equal to Profit – net claims hence the status of this issue is confusing, the relationship of the participants here is of Tabaru and not Murabaha thus technically profit cannot be shared here. The requirement to provide Qarz-e-Hasanah (in case of a deficit) in a Mudarabah contract by definition is against the concept of Mudarabah which is a profit sharing contract and a Mudarib cannot be a guarantor. In Wakala model a cooperative risk sharing ensures that the participants are safe guarded against their losses. Here the Wakeel or the agent charges a fee for his services. The operator also gets an upfront deductible fee and shares the profit of investments but it does not share the results of underwriting. The money accumulated from the contributions made by the members will be invested by the Takaful Company or the wakeel, based on Islamic principle of trade. Likewise a ceding amount by the contributors will remained invested and the rest would be used for compensations of losses. The waqf fund will also lay down rules for how and how much to compensate to a party in case of a loss, here the waqf acts as a separate entity and has decision making powers regarding investments, compensations and surplus amounts. Surplus may be distributed on the basis of these points: ? ? ? A portion may be reserved for future losses A portion of surplus should be distributed amongst the participants specially to differentiate it from conventional insurance. A portion may be given for charity purposes each year.
As a Mudarib, the Takaful Company will invest the funds of the waqf in shariah compliant investments and is entitled to receive profit for that at a fixed ratio. 6. Conclusion:
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Islamic banking though holds its importance and future growth potential; hence it will attract more investment in the coming years but still more consideration is required to ensure its shariah compliance. Especially Sukuk bonds are controversial, the need is felt that independent bodies such as AAOIFI provide solid framework for Islamic products and investments to be followed by all Islamic banks and funds. With conventional banks in the international markets opening their Islamic windows to tap this market, it is a primary concern that does these banks has enough expertise and knowledge on the subject matter or not? Since it is a very complex issue and there is a large probability that people might lose their trust in these banks if they invest in products which are un-Islamic. In practice Islamic banks have Muftis on their pay role to get advice regarding compliance of their products and other financial issues, though we know that manipulation is possible since these Muftis are on the Bank‘s pay role. Thus the need for an international independent regulatory body is strong felt. In Pakistan State Bank of Pakistan is doing a good job by regulating Islamic banks through its Islamic banking department and is playing a great role.
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REFERENCES Secondary Sources: 1.http://en.wikipedia.org/wiki/Islamic_banking 2.http://www.atkearney.com/index.php/Publications/the-future-of-islamicbanking.html 3.http://www.imf.org/external/pubs/ft/survey/so/2010/RES100410A.htm 4.http://www.sbp.org.pk/departments/ibd.htm 5.http://cief.wordpress.com/2006/03/12/musharakah/ 6. From the book – Meezan Bank‘s Guide to Islamic Banking.* 7.http://www.barakaonline.com/default.asp?action=article&id=48 8.http://ifresource.com/2010/04/27/ho...on-structuringand-application-of-sukuk-bonds/ 9.http://en.wikipedia.org/wiki/Sukuk ?http://en.wikipedia.org/wiki/United_states_housing_bubble
Books: *
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?
Meezan Bank’s Guide to Islamic Banking, Author: Dr. Muhammad Imran Ashraf Usmani (Ph.D.IslamicFinance), Publisher: Darul-Ishaat Karachi, Edition: First.
Presentation Slides: ? Takaful, By Dr. Muhammad Imran Usmani, SECP Takaful Conference
Papers: ? Do Islamic Banks Perform Better than Conventional Banks? Evidence from Gulf Cooperation Council countries. By: Hadeel Abu Loghod ? The importance of Islamic banking for Muslim minorities By: Ahmed Fazel Abrahim ? Why Islamic Banking Is Successful? Islamic Banks Are Unscathed Despite of Financial Crisis. By: Prof. Rodney Wilson - Professor-Durham University
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doc_365823146.docx
The report aims to explore basic background of Islamic banking, Islamic instruments of financing, the banking procedures and the care required for their execution and implications involved in such transactions
2012
REPORT ON ISLAMIC BANKING AND ISLAMIC INSTRUMENTS OF FINANCING
By: Umar Shuja Ud Din
The report aims to explore basic background of Islamic banking, Islamic instruments of financing, the banking procedures and the care required for their execution and implications involved in such transactions
CONTENTS
1. The Need for Islamic Banking 02 2. History of Modern Islamic Banking 02 3. The Market 4. Islamic Banking Scenario in Pakistan 04 5. Financial Instruments under Islamic Banking 05 a. Murabaha b. Mudarabah c. Musharakah d. Salam e. Istisna f. Ijarah g. Sukuk i. Types of Sukuk h. Takaful 23 6. Conclusion 24 05 07 08 10 11 12 13 14 03
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About Author: Name: Umar Shuja Ud Din Student: BSc. Business (Hons.) Specialization – Accounting and finance Forman Christian College University, Lahore, Pakistan Email: [email protected] Contact No.: 0302-4890939
1. The Need for Islamic Banking:
After the 2007-2012 global recession, the need for a new banking system has become the latest debate amongst the financial circles around the world. Islamic banks performed better in this global crisis, proving to be more resilient. The reason for which includes that Islamic bank do not deal in complex derivative products. The collapse of leading Wall Street institutions, and the subsequent global financial crisis and economic recession, are encouraging economists world-wide to consider alternative financial solutions. Attention has been focused on Islamic banking and finance as an alternative model. Explained in a basic way, the religion Islam envisions for a fair and just society in which there are equal opportunities for growth and development of all. It provides guidance for a system which ensures equality and impartiality amongst the mankind. The Islamic rulings provide us with a solid path towards such a society of peace, harmony and contentment; a society where there should be no excuse for sinful and unjust way of obtaining the resource to fulfill ones need, a system which ensures basic rights for all. The current capitalistic economic system does not promote such a society in which there is enough for everybody. It makes the rich richer and the poor poorer, putting people in an unfair competitive position, which is exactly what Islam does not want to occur. Islam prohibits any such system which increases the sufferings and miseries of the poor. The prohibition of charging interest on loans or Riba in Islam is for the very same purpose.
2. History of Modern Islamic Banking:
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It had long been a perception earlier that in today‘s complex world an interest free economy is not possible and that Islamic principles are obsolete. However this view has been proven wrong, Islam provides complete directions for the achievement of such an economic system. This has been proven by the growth in Islamic banking in last few decades. Perhaps the first writings on Islamic economic system appeared in 1942 and 1945 by Mirza Basheer-Ud-Din. ?The next two decades interest-free banking attracted more attention, partly because of the political interest it created in Pakistan and partly because of the emergence of young Muslim economists. Works specifically devoted to this subject began to appear in this period.? ?The early 1970s saw institutional involvement. The Conference of the Finance Ministers of the Islamic Countries held in Karachi in 1970, the Egyptian study in 1972, the First International Conference on Islamic Economics in Mecca in 1976, and the International Economic Conference in London in 1977 were the result of such involvement. The involvement of institutions and governments led to the application of theory to practice and resulted in the establishment of the first interest-free banks. The Islamic Development Bank, an inter-governmental bank established in 1975, was born of this process. The first modern experiment with Islamic banking was undertaken in Egypt under cover without projecting an Islamic image for fear of being seen as a manifestation of Islamic fundamentalism that was anathema to the political regime. The pioneering effort, led by Ahmad Elnaggar, took the form of a savings bank based on profit-sharing in the Egyptian town of Mit Ghamrin 1963. This experiment lasted until 1967, by which time there were nine such banks in country.? [1]
3. The Market:
For years now, Islamic banking has seen double digit growth rates globally and has far surpassed their conventional counterparts. Though there are many challenges faced by this sector, the market has still enough room for growth and expansion. Several potential markets with large Muslim populations remain largely untapped, such as India. In addition the overall market penetration in many industry sectors is quite low. At the same time, several new markets have opened up for Islamic banking, with even more on the horizon.
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?Islamic banking-financial activity consistent with Shariah, or Islamic law-has become a material part of the global financial services industry, growing rapidly in both size and stature. Total Islamic assets are estimated around $1,200 billion in 2010. Islamic banking assets make up around 90 percent of this, while outstanding Islamic Sukuk and Islamic investment funds comprise the rest.? ?In terms of Islamic banking penetration (that is, Islamic banking assets as percent of total banking assets), markets can be broadly categorized into three clusters: established, emerging and untapped. The established cluster of Islamic banking activity is the Middle East and South East Asia, with some of the world's most active markets such as Kuwait, the Kingdom of Saudi Arabia, the United Arab Emirates and Malaysia. Emerging markets such as Pakistan and Indonesia have vast Muslim populations and offer significant growth prospects. Large yet untapped markets such as India offer great potential to daring investors. To date, there are no major initiatives undertaken to promote Islamic banking, and if tackled strategically, markets such as India present a vast opportunity for expansion. There are three main types of players in the Islamic banking industry: full-fledged Islamic banks, Islamic windows of conventional banks, and Islamic finance companies. Fullfledged Islamic banks are either fully independent entities or subsidiaries of conventional banks, holding banking licenses. Islamic windows are secluded Islamic banking departments within conventional banks. Islamic finance companies focus on supplying Shariah-compliant financing products such as auto and home finance, and are not allowed to take deposits.? [2] ?A new IMF study compares the performance of Islamic banks and conventional banks during the recent financial crisis, and finds that Islamic banks, on average, showed stronger resilience during the global financial crisis.? ?In ?The Effects of the Global Crisis on Islamic and Conventional Banks: A Comparative Study,‘ economists Jemma Dridi of the IMF‘s Middle East and Central Asia Department and Maher Hasan of the IMF‘s Monetary and Capital Market Department look at the effects of the crisis on bank profitability, credit, and asset growth in countries where both types of banks have a significant market share. The new working paper adds an empirical dimension to the debate on the relationship between Islamic banking and financial stability, a topic that has generated renewed interest since the global crisis.?
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?Islamic banks contributed to financial and economic stability during the crisis, given that their credit and asset growth was at least twice as high as that of conventional banks. The paper attributes this growth to their higher solvency and to the fact that many Islamic banks lent a larger part of their portfolio to the consumer sector, which was less affected by the crisis than other sectors in the countries studied. These findings were corroborated by external rating agency‘s reassessment of Islamic bank‘s risk, which was generally found to be more favorable than-or similar to-that of conventional banks. In view of their robust growth during the crisis, Islamic banks will likely take a growing market share in the future-but this implies greater supervisory responsibility.? [3] Credit risk is the main risk for both types of banks, however unlike conventional banks the Islamic banks are not permitted to have any direct exposure to financial derivatives or conventional financial institutions‘ securities-which were hit most during the global crisis.
4. Islamic Banking Scenario in Pakistan:
In 1947 Pakistan was constituted as the first Islamic republic created in the name of Islam. On the opening ceremony of State bank of Pakistan in 1948, Quaid-e-Azam the founder of Pakistan stated: "We must work our destiny in our own way and present to the works an economic system based on true Islamic concept of equality of manhood and social justice" In 1997, after the procedure of banking adopted by the banks was declared un-Islamic by federal shariat court, Al-Meezan Investment Bank was established with a mandate to pursue Islamic Banking. In the year 2003 Meezan Bank establishes itself as the pioneer of Islamic Banking in Pakistan and quickly establishes branches in all major cities of the country. In 2003 the State Bank established a dedicated Islamic Banking Department (IBD) by merging the Islamic Economics Division of the Research Department with the Islamic Banking Division of the Banking Policy Department. A Shariah Board was appointed to regulate and approve guidelines for the emerging Islamic Banking industry. The Government of Pakistan awarded the mandate for debut of international Sukuk (Bond) offering for USD 500 million. The offering was a success and established a benchmark for Pakistan.
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The Sate bank‘s website states under its Islamic banking department that: ?The progress of Islamic banking in Pakistan has been commendable during the last five years. Currently there are six licensed fully fledged Islamic banks and twelve conventional banks with standalone Islamic banking branches with a total branch network of over 336 branches operating in more than 50 cities of all the four provinces and Azad Kashmir in the country as of 17.07.2008 and applications for few more players are under consideration. Islamic banking is a high priority area for State bank of Pakistan. Steps are being taken to make Islamic banking industry in Pakistan is robust enough to offer a viable alternative to conventional banking, should the market decide that Pakistan should have an exclusively Islamic banking system in the country.?[4]
5. Instruments of Financing under Islamic Banking:
There are six main products under Islamic banking system, the names of which are as follows: ? ? ? ? ? ? ? ? Murabaha Mudarabah Musharakah Salam Istisna Ijarah Sukuk Takaful
Despite of efforts made to ensure that maximum care is taken to make these products compliant to shariah, critiques are still present and many are still not fully satisfied. A number of questions remain unanswered by the Muftis who worked on developing these products. The increasingly complex trade and business world, and ever increasing customer demands make it difficult for Islamic banks to be spot-on in shariah compliance, however, banks are learning and the market is also developing hence things improving. The details of these products are as follows: MURABAHA:
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In Islamic banks Murabaha is the most commonly used Islamic instrument, more than 60% investment transactions are through Murabaha. Murabaha is a credit sales transaction. In which the seller sells his goods for an added profit amount, over its cost price. The seller also mentions the cost he had incurred and the profit he has added. This is to be noted here that there is a difference in a simple sale where the seller does not disclose his cost price whereas in Murabaha it is important to disclose the cost. Under this arrangement, the client can fulfill his working capital needs such as the need for money to buy raw materials. Typically, banks use Murabahah in asset financing, property, microfinance and commodity import-export. When the client approaches the Islamic bank, the bank does not offer him a loan; since interest based loans are not permitted in Islam, instead the bank offers him to engage in a Murabaha. Under this agreement the bank promises to sell and the buyer promises to buy the commodity on an agreed ratio of profit added to the cost. Since the bank does not usually have the expertise, technical understanding and the knowledge to buy the particular product; for example: the particular raw material required by the client, the bank may appoint the client as his agent. Under this agency agreement, the client procures the required products from the market on the bank‘s behalf, takes the possession of goods and tries to negotiate for a fair price. The bank makes payment to the supplier. Now the bank is legally the owner of those goods and is entitled for risks and rewards associated with them. After this stage is complete, now the bank can further sell the goods as it has the ownership. The bank declares the cost and his profit and offers to sell whereby the client agrees to purchase and accepts those goods and the transaction is made. The payment of Murabaha transaction can be in lump sum, in installments or in lump sum after a particular time. In case of payment in installments or in lump sum after a certain time, the bank has to ensure it incorporate the time value of money since the agreed sale price cannot be changed. Now the issue arises what to do if the client defaults or fails to make payment on a particular agreed date? For that purpose the bank can ask to furnish a security, which includes mortgages. The bank can also ask the seller for a 3rd party guarantor, in case of default he will be liable to pay however it is important that guarantor cannot charge a fee to the original client for clearing his loan as it comes under riba or interest. However he can charge for any legal expenses incurred. Likewise incase of dishonest clients who
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delay the payments, a fine can be charged for late payment however the bank cannot use it as an added income, the bank must give that charge in charity. Similarly in the case of early payments, there still cannot be any rebate or discount for the client in the view of most scholars however even if the bank offers a rebate on its own this is not objectionable specially if the client is needy. The Commodity Murabaha has been criticised by Islamic Scholars who say it should only be used as a structure of last resort where no other structure is available this is because in most transactions the commodities never change hands and usually there are no commodities at all, merely cashflows between banks, brokers and borrowers. Commonly the mistake done while making Murabaha agreements include assuming that Murabaha can be used for all types of transactions and financing, whereas Murabaha can only be used where some commodity is to be purchased by the customer. In some cases various stages of Murabaha is not taken care of; especially the importance of occurrence of each stage and its time thus the whole Murabaha agreement becomes void. Likewise some financial institutions applied Murabaha to already purchased commodities which are not allowed in Islam. Murabahah can be used in following conditions: Short / Medium / Long Term Finance for: Raw material, Inventory, Equipment, Asset financing, Import financing, Export financing (Pre-shipment), Consumer goods financing, House financing, Vehicle financing, Land financing, Shop financing, PC financing, Tour package financing, Education package financing, All other services that can be sold in the form of package. MUDARABAH: Mudarabah is a type of partnership in which one partner provides investment and the other provides his expertise, skill and services by conducting business activities. The investor is called Rab-ul-maal whereas the other partner is called Mudarib. The profits generated through this partnership are shared at predetermined ratio and the loss is shared solely by the investor since Mudarib has no investment. Mudarabah can be restricted or not i.e. the Rab-ul-maal provides money for investing in a particular type of business or might not put any restrictions on the type at all. The Mudarib cannot keep another Mudarib or invest his own money in the business without the consent of the Rab-u-maal. Rab-ul-maal cannot interfere in the business affairs but
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has the authority to oversee Mudarib‘s activities and work with Mudarib with his consent. The amount of total capital invested should be known, if an asset is invested by Rab-ul-maal whose value cannot be determined then the Mudarabah is void. Mudarabah also involves some principles which are to be observed; these include technical points such as who bears the expenses of the Mudarib? All the personal expenses of Mudarib have to be borne by himself such as clothing, food and medical expenses etc. However in case of a business trip the guidelines we get from Islam regarding the point gives us a concept of Safar-e-sharai. Safar-e-sharai is when Mudarib is travelling for business purpose for more than 48 miles distance and stays there overnight, then all the expenses will be borne by Mudarabah as business expenses, however if distance is shorter or he does not stay overnight, he then himself is liable for all the expenses. All the expenses for the functioning of the business including cost of goods sold, salaries of workers and laborers, commissions etc are included in Mudarabah. If for any reason Mudarabah contract is void, the Mudarib is only entitled to get Ujrat-emisl i.e. the salary or wage of that work according to the market value of that work. Ujrat-e-misl should be less than his earnings in case of a valid Mudarabah according to his profit share. The profit sharing ratio is as per the mutual agreement between both of the parties, however it cannot be fixed to a given amount such as 100,000Rs for Rab-ul-maal and rest fot the Mudarib, but a particular ratio can be determined such as 60% of the total profit for Rab-ul-maal and 40% for the Mudarib. Rab-ul-maal can also share profits varying in the ratios for various scenarios such as: ?I will take 60% profit if u trade commodity A and will take 50% in case you trade commodity B.? Islam specifies some roles and duties for the Mudarib. These are that he acts as: ? ? ? ? Ameen or trustee for the Rab-ul-maal and looks after his investment/business carefully. Wakeel or agent who purchases and trades from the funds provided by the Rabul-maal. Shareek or partner the earned of profits. Zamin or liable for providing against any losses done due to his personal mistake or neglect.
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?
Ajeer or employee when Mudarabah gets fasid, he is then only a employee.
In case when Mudarabah is terminated by any of the involved parties by notice or the contract period is over, the capital of the business will be distributed amongst both parties as per agreed ratio after deducting and payables and other business liabilities. From the remaining amount, Rab-ul-maal‘s investment would be returned to him and if any money above that is left it is shared between the Mudarib and the Rab-ul-maal according to the agreed ratio. MUSHARAKAH: ?Musharakah is a type of Shirkat-ul-Amwal which literally means sharing. In the context of business, it refers to a joint enterprise in which partners (or parties) to the enterprise share the profit and loss of the enterprise. Musharakah has far reaching implications for Islamic banking and finance in the modern context and provides an excellent alternative to the interest-based economy.?
[5]
The concept is that the financer and the client go
into a joint ownership of an asset, enterprise or equipment. In a Musharakah, the party investing the capital shares equally in both the profit and loss, which is different from an interest-based system. Another form of Musharakah i.e. recently developed and is used specially in Islamic banking is the Diminishing Musharakah. In Diminishing Musharakah the asset is divided into equal units of shares, the client promises to periodically purchase more share-units from the bank which subsequently leads to complete ownership of the asset with the client and a profitable investment for the bank. It is to be noted that the bank gets signed a promise deed from the client that he would keep on purchasing next shareunits from the bank so that bank‘s capital is recovered and asset is transferred to the client. The buying of share-units cannot be combined in the actual Musharakah agreement as an obligation in a single document as in Islam conditional sale is not allowed. Thus the promise deed is signed in a separate document. If the client defaults and does not make payments to buy next shares as per the initial understanding, bank can challenge his promises deed in the court. Typically Musharakah is used for asset financing including home, car financing and trade or business financing. For instance let‘s take home financing, A home worth Rs10 Million is bought through a Musharakah agreement. This property is divided into 10 equal shares, the investment ratio was that the client bought 20% and the bank owns 80% of
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the shares. Since the asset – the home is fully in use of the client and not the bank, the bank charges rent from the client for using his share of the home. At the end of each year, the client as per his promise, purchases next share unit from the bank; changing the ownership ratio to 30 – 70%. As the share of the client increases the rent decreases as now client is using only 70% of the property he does not own. This would continue till the banks share is reduced to zero, now the bank cannot charge any rent from the client. As a rule the price of each unit of share can be pre fixed in this type of home financing contract or each next share-unit can be sold at market value of that share, although usually in practice the price is made fixed. This arrangement provides an opportunity for the client to purchase an asset which he cannot pay for in lump sum and bank gains profit in terms of rental from the client, along with return of its capital. In case the a client wants to starts a business and enters into a Musharakah contract with the bank, a profit sharing ratio is determined between both of the parties, whereas loss is shared exactly equal to their investment ratios. The client gradually purchases next share-units from the bank. In this case the price of the each next share unit cannot be pre-fixed as it will mean the financer remains with or without profit each time selling his share; meaning that either the capital gain is prefixed or there is no capital gain. Such arrangement would be against the Islamic rules. In this case for setting the price, the business is valued and a share price is determined on the basis of that, if the business value has increased the share price will increase and vice versa. For the assets such as machinery where asset depreciates over the time, the depreciation factor should also be kept in mind while deciding prices of the share-units. ?Uses of Musharakah / Mudarabah: These modes can be used in the following areas (or can replace them according to Shariah rules). Asset Side Financing: Short/medium/long - term financing, Project financing, Small & medium enterprises setup financing, Large enterprise financing, Import financing, Import bills drawn under import letters of credit, Inland bills drawn under inland letters of credit, Bridge financing, LC without margin (for Mudarba), LC with margin (for Musharakah). Export financing (Pre-shipment financing), Working capital financing, Running accounts financing / short term advances. Liability Side Financing: For current /saving/mahana amdani/investment accounts (deposit giving Profit based on Musharkah / Mudarabah – with predetermined ratio), Inter- Bank lending / borrowing, Term Finance Certificates & Certificate of Investment,
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T-Bill and Federal Investment Bonds / Debenture, Securitization for large projects (based on Musharkah), Certificate of Investment based on Murabahah, Islamic Musharakah bonds (based on projects requiring large amounts – profit based on the return from the project)?[6]
SALAM: When the interest or Riba was declared haram in Islam, farmers (specially small ones) could not take interest based loans. Therefore Holy Prophet Mohammed (Peace be upon him) allowed farmers to sell their agricultural products in advance. In Salam the seller agrees to supply specific goods on a particular future date the payment for which is received in full in advance. This allows the seller to fulfill his immediate need of money and the buyer gets advantage of purchasing goods on a lower price which he can sell later and the difference would be his profit. The permission of buying and selling of goods when they do not exist is an exception only in case of Salam, otherwise which is prohibited in Islam. There are some strict rules which encompass Salam that are as follows: ? ? The buyer has to pay the price in full to the seller otherwise the purpose of providing for the ?immediate need? of the seller remains unfulfilled. It is important that the goods sold can be specified properly, those goods which cannot be specified exactly cannot be sold under Salam agreement such as precious stones which vary in size, weight and other specifications. ? It is important to grab the concept that Salam takes place for a particular commodity and not to the produce of a particular farm of field. It means even if the farm or the field of Mr. A is destroyed, for which he had got payment under Salam from Mr. B, he is still liable to produce the specified goods to the buyer Mr. B. ? ? ? Quality and quantity must specified leaving no chance for any future conflict. In Salam it is also important to determine an exact date and place of delivery of the goods. A security can also be demanded in the form of mortgage or guarantee in order to ensure that the seller delivers.
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?
Further selling the produce is the responsibility of the buyer upon reception of goods.
The buyer can also further sell the undelivered goods to another buyer through a parallel Salam contract but these both contracts are totally independent from each other, which mean if Mr. A does not deliver on time to Mr. B, he is still responsible to produce the specified goods to the third party, say Mr. C. thus Mr. B‘s liability is not dependant on Mr. A. It is to be noted that Salam facility cannot be used as a buy back facility where thru parallel Salam the initial seller tries to buy back the goods if he has another company. Though if the company has other share holders involved too in the ownership, then it is a valid contract.
Salam finds its application in: ? ?The Salam sale has the flexibility to cover the needs of various sectors of people such as farmers, industrialists, contractors or traders. It can be used to meet the capital requirements as well as to meet cost of operations. ? Salam sale is suitable to finance agricultural operations, where the bank can transact with farmers who are expected to have commodity in plenty during harvest either from their own crops or crops of others, which they can buy and deliver in case their crops fail. Thus the bank renders great services to the farmers in their way to achieve their production targets. ? Salam sale is also used to finance the commercial and industrial activities, especially in phases prior to production and export of commodities and that is by purchasing it on Salam and marketing them for lucrative prices. ? Salam sale is also used to finance the commercial and industrial activities, especially in phases prior to production and export of commodities and that is by purchasing it on Salam and marketing them for lucrative prices.
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?
The Salam sale is applied by the bank in financing craftsmen and small producers by supplying them with the inputs of production as a Salam capital in exchange of some for their commodities to remarkets.? [7]
ISTISNA: It is a sale transaction where a commodity is transacted before it comes into existence it can be an order to the manufacturer to manufacture something. A price is agrees upon with mutual agreement of the parties involved and the specifications of the product are also set. The Istisna seems similar to the Salam but there are differences between both and are stated below: ? In Salam the advance payment is made in full whereas in Istisna it is not necessary that the payment is made in advance, it is not even necessary to pay the full price at delivery. It can defer to any time as per agreement in the contract; including payment in installments. ? ? ? In Istisna it is always something which needs manufacturing, but in Salam it can be anything which needs manufacturing or not. The time of delivery is also not necessary to be fixed in Istisna A unilateral cancellation right of cancelation of the agreement is possible before manufacturing starts, whereas in Salam it can only be cancelled bilaterally. As mentioned above, in Istisna it is not necessary to fix a time of delivery but the purchaser may fix a maximum time limit, after which he has the right to accept or reject the goods. In order to ensure that the goods are delivered within the specified time period a penal charge may be deducted, from the price payable, calculated on daily basis if the manufacturer delays. Classical jurists seem to be silent about this issue however they have allowed penalizing in the similar case of Ijarah (Which is discussed next) thus on the same analogy, the price of Istisna may be tied up with time of delivery after agreement between both the parties. Istisna can be used for: House financing, financing of plant / factory / building, BOT arrangements, construction of buildings and plants, booking of apartments. IJARAH: Ijarah is the Islamic type of lease. The concept is similar to of a normal lease but with some important differences that make it halal. It is also important to understand that
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lease is originally not a mode of financing but in banking it finds its application as a financing mode. This is because the client‘s interest usually is to purchase the asset and not to continue using it on rent. In Ijarah the asset to be leased must exist and should be in the ownership of the lessor, for example in conventional banking when a car is leased the bank starts to charge rent for it in advance – no matter if the asset (car) has been delivered to the lessee or not, or it has been just booked by the bank for future delivery. Rules laid by Islam guide us that you cannot charge rent for an asset that does not exist and specially is not in the use of the lessee. Since ownership is with the lessor; the bank, liabilities also remain with the bank. It is also to be noted that consumable things cannot be leased and the period of lease must be determined clearly. Jointly owned properties can also be leased but the rental would then be divided according to their share proportion. Likewise there are some responsibilities on the lessee too and these are that he shall compensate for any damage to the asset caused by his misuse or negligence, any loss by factors beyond his control would be borne by the lessor. The rental must be determined at the time of contract for the whole period of lease. The lessor cannot increase the rent unilaterally or the lease would be void. A penalty can be imposed on the lessee in case he delays the payment of the rental amount, this penalty is an added profit for the conventional banks but in Islamic banks this money must go for charity and should not become part of its income. For this purposes Islamic banks maintain a charity fund where such amounts are credited and advanced for charity purposes. In Islamic lease or Ijarah, the lessor cannot terminate the lease unilaterally, in case the lease contravenes with terms of agreement only then he has the right of unilateral termination. Likewise in some financial lease there is a term in the contract that incase lessee wants to terminate the lease he shall pay all the remaining installments of the lease period, this is also not in accordance with the Shariah. As mentioned earlier, most financial leases end up with transfer of ownership to the lessee since the lessor has earned his capital back along with and profit through the rental amounts. Thus the asset at the end of the lease period is transferred to the lessee, however in Ijarah this condition cannot be made a part of the original contract, as lease is not a mode of financing and making a transaction with a pre-condition attached to it is not allowed in Islam. Thus a separate promise may be signed by the lessor to sell the asset upon the end of the lease period; the promise though is only binding on the lessor. The lessee
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might purchase or not purchase; the asset at the end. In case he wants to purchase, lessor can sell it for a nominal token price. In Ijarah-Wa-Iqtina the lessor promises to gift the asset at the end of the lease period however that is not in practice under Islamic banking. SUKUK: ?Sukuk in general may be understood as a shariah compliant ?Bond‘. In its simplest form Sukuk represents ownership of an asset or its usufruct. The claim embodied in Sukuk is not simply a claim to cash flow but an ownership claim. This also differentiates Sukuk from conventional bonds as the latter proceed over interest bearing securities, whereas Sukuk are basically investment certificates consisting of ownership claims in a pool of assets. Sukuk were extensively used by Muslims in the middle ages as papers representing financial obligations originating from trade and other commercial activities. However, the present structure of Sukuk is different from the Sukuk originally used and is akin to the conventional concept of securitization, a process in which ownership of the underlying assets is transferred to a large number of investors through certificates representing proportionate value of the relevant assets.? [8] ?Most commonly used Sukuk structures replicate the cash flows of conventional bonds. Such structures are listed on exchanges, commonly Luxembourg stock exchange and London stock exchange in Europe, and made tradable through conventional organizations like Euroclear or Clearstream. A key technique to achieve capital protection without amounting to a loan is a binding promise to repurchase certain assets, e.g. in the case of Sukuk Al Ijara, by the issuer. In the meantime a rent is being paid, which is often benchmarked to an interest rate like Libor, which is disliked by shariah scholars. From a shariah perspective, certificates of debt are not tradable, although a different view is held by many in Malaysia. The most accepted structure, which is tradable, is thereafter the Sukuk Al Ijara. Debt certificates can be only bought before the finance occurs and then held to maturity from an Islamic perspective, which is critical on debt trading at market value regarding any difference to be like the prohibited Riba. As shariah considers money to be a measuring tool for value and not an asset in itself, it requires that one should not receive income from money alone. This generation of
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money from money is Riba, and is forbidden. The implication for Islamic financial institutions is that the trading and selling of debts, receivables, conventional loan lending and credit cards are not permissible. This principle is widely understood to mean uncertainty in the contractual terms and/or the uncertainty in the existence of an underlying asset in a contract, which causes issues for Islamic scholars when considering the application of derivatives. Shariah also incorporates the concept of maslahah or "public benefit", denoting that if something is overwhelmingly in the public good, it may yet be transacted – and so hedging or mitigation of avoidable business risks may fall into this category, but there is still much discussion yet to come on this issue.? [9] TYPES OF SUKUK: ?Sukuk can be of many types depending upon the type of Islamic modes of financing and trades used in its structuring. However, the most important and common among those are Ijarah, Shirkah, Salam and Istisna. Among the fourteen eligible Sukuks identified by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), following are more common: 1. Mudaraba Sukuk: These are investment Sukuk that represent ownership of units of equal value in the Mudaraba equity and are registered in the names of holders on the basis of undivided ownership of shares in the Mudaraba equity and its returns according to the percentage of ownership of share. The owners of such Sukuk are the rab-ul-mal. Mudaraba Sukuk is used for enhancing public participation in big investment projects. Steps involved in the structure:
?
Mudarib
enters
into
an
agreement
with
project
owner
for
construction/commissioning of project.
? ?
Special purpose vehicle (SPV) issues Sukuk to raise funds. Mudarib collects regular profit payments and final capital proceeds from project activity for onward distribution to investors.
?
Upon completion, Mudarib hands over the finished project to the owner.
Mudaraba Sukuk in practice:
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Shamil Bank of Bahrain raised 360 million Saudi Riyal investment capital through the Al Ehsa Special Realty Mudaraba, representing an investment participation in a land development transaction with a real estate development company in the Kingdom of Saudi Arabia. The investment objective of the Mudaraba is to provide investors with annual returns arising from participation in the funding of a land financing transaction, profits due to investors will be accrued on the basis of returns attained from investing the subscriptions.
2. Musharaka Sukuk These are investment Sukuk that represent ownership of Musharaka equity. It does not differ from the Mudaraba Sukuk except in the organization of the relationship between the party issuing such Sukuk and holders of these Sukuk, whereby the party issuing Sukuk forms a committee from the holders of the Sukuk who can be referred to in investment decisions. Musharaka Sukuk is used for mobilizing the funds for establishing a new project or developing an existing one or financing a business activity on the basis of partnership contracts. The certificate holders become the owners of the project or the assets of the activity as per their respective shares. These Musharaka certificates can be treated as negotiable instruments and can be bought and sold in the secondary market. AAOIFI define these as: ?These are certificates of equal value issued with the aim of using the mobilized funds for establishing a new project, developing an existing project or financing a business activity on the basis of any partnership contracts so that the certificate holders become the owners of the project or assets of the activity as per their respective shares, with the Musharaka certificates being managed on the basis of participation or Mudaraba or an investment agency.‘ (AAOIFI Standard 17, 3/6) Steps involved in the structure:
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Corporate and the Special Purpose Vehicle (SPV) enter into a Musharaka Arrangement for a fixed period and an agreed profit-sharing ratio. Also the corporate undertakes to buy Musharaka shares of the SPV on a periodic basis.
?
Corporate (as Musharik) contributes land or other physical assets to the Musharaka
?
SPV (as Musharik) contributes cash i.e. the issue proceeds received from the investors to the Musharaka
?
The Musharaka appoints the Corporate as an agent to develop the land (or other physical assets) with the cash injected into the Musharaka and sell/lease the developed assets on behalf of the Musharaka.
?
In return, the agent (i.e. the Corporate) will get a fixed agency fee plus a variable incentive fee payable.
? ?
The profits are distributed to the Sukuk holders. The Corporate irrevocably undertakes to buy at a pre-agreed price the Musharaka shares of the SPV on say semi-annual basis and at the end of the fixed period the SPV would no longer have any shares in the Musharaka.
Musharaka Sukuk in Practice: US$550 million Sukuk transaction for Emirates airline, the seven-year deal was a structured on a Musharaka contract. The Musharaka or joint venture was set up to develop a new engineering centre and a new headquarters building on land situated near Dubai‘s airport which will ultimately be leased to Emirates. Profit, in the form of lease rentals, generated from the Musharaka venture will be used to pay the periodic distribution on the trust certificates. Sitara Chemical Industries Ltd, a public limited company, made a public issue of profitand-loss sharing based term finance certificates (TFC‘s) worth Rs 360 million which were subscribed in June 2002. The TFC‘s had a fixed life tenor of five years and profit and loss sharing was linked to the operating profit or loss of the Chemical Division of the company.
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Kuwait Finance House (KFH), Liquidity Management Center (LMC) and Al Muthanna Investment Company (MIC), the mandated lead arrangers launched US$ 125 million Lagoon City Musharaka Sukuk to support the Lagoon City residential and commercial real estate development as part of Kheiran Pearl City project. 3. Ijara Sukuk These are Sukuk that represent ownership of equal shares in a rented real estate or the usufruct of the real estate. These Sukuk give their owners the right to own the real estate, receive the rent and dispose of their Sukuk in a manner that does not affect the right of the lessee, i.e. they are tradable. The holders of such Sukuk bear all cost of maintenance of and damage to the real estate. Ijarah Sukuk is the securities representing ownership of well defined existing and known assets tied up to a lease contract, rental of which is the return payable to Sukuk holders. Payment of Ijarah rentals can be unrelated to the period of taking usufruct by the lessee. It can be made before beginning of the lease period, during the period or after the period as the parties may mutually decide. This flexibility can be used to evolve different forms of contract and Sukuk that may serve different purposes of issuers and the holders. Steps involved in the structure:
?
The obligator sells certain assets to the SPV at an agreed pre-determined purchase price.
?
The SPV raises financing by issuing Sukuk certificates in an amount equal to the purchase price.
? ?
This is passed on to the obligator (as seller). A lease agreement is signed between SPV and the obligator for a fixed period of time, where the obligator leases back the assets as lessee.
? ?
SPV receives periodic rentals from the obligator; These are distributed among the investors i.e. the Sukuk holders.
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?
At maturity, or on a dissolution event, the SPV sells the assets back to the seller at a predetermined value. That value should be equal to any amounts still owed under the terms of the Ijara Sukuk.
Ijara Sukuk in Practice: In December 2000, Kumpulan Guthrie Berhad was granted a RM1.5 billion (US$400 million) Al-Ijara Al-Muntahiyah Bit-Tamik by a consortium of banks. The original facility was raised to re-finance Guthrie‘s acquisition of a palm oil plantation in the Republic of Indonesia. The consortium was then invited to participate as the underwriter/primary subscriber of the Sukuk Transaction. US$350 million Sukuk Trust Certificates by Sarawak Corporate Sukuk Inc. (SCSI) Sarawak Economic Development Corporation (SEDC) rose financing amounting to US$350 million by way of issuance of series of trust certificates issued on the principle of Ijara Sukuk. The certificates were issued with a maturity of 5 years and under the proposed structure, the proceeds will be used by the issuer to purchase certain assets from 1st Silicon (Malaysia) Sdn Bhd.* Thereafter, the issuer will lease assets procured from 1st Silicon to SEDC for an agreed rental price for an agreed lease period of 5 years.
*(Malaysia uses Sdn. Bhd. [Sendirian Berhad], meaning "private limited", which is the equivalent of an incorporated entity in the U.S.)
4. Murabaha Sukuk: In this case the issuer of the certificate is the seller of the Murabaha commodity, the subscribers are the buyers of that commodity, and the realized funds are the purchasing cost of the commodity. The certificate holders own the Murabaha commodity and are entitled to its final sale price upon the re-sale of the commodity. The possibility of having legally acceptable Murabaha-based Sukuk is only feasible in the primary market. The negotiability of these Sukuk or their trading at the secondary market is not permitted by shariah, as the certificates represent a debt owing from the subsequent buyer of the Commodity to the certificate-holders and such trading amounts to trading in debt on a deferred basis, which will result in riba. Despite being debt instruments, the Murabaha Sukuk could be negotiable if they are the smaller part of a package or a portfolio, the larger part of which is constituted of negotiable instruments such as Mudaraba, Musharaka, or Ijara Sukuk. Murabaha Sukuk
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are popular in Malaysian market due to a more liberal interpretation of fiqh by Malaysian jurists permitting sale of debt (bai-al-dayn) at a negotiated price.
Steps involved in the structure:
? ? ? ?
A master agreement is signed between the SPV and the borrower SPV issues Sukuk to the investors and receive Sukuk proceeds. SPV buys commodity on spot basis from the commodity supplier. SPV sells the commodity to the borrower at the spot price plus a profit margin, payable on installments over an agreed period of time
? ?
The borrower sells the commodity to the Commodity buyer on spot basis. The investors receive the final sale price and profits.
Murabaha Sukuk in Practice: Arcapita Bank, a Bahrain-based investment firm has mandated Bayerische Hypo-und Vereinsbank AG (?HVB?), Standard Bank Plc (?SB?) and West LB AG, London Branch (?WestLB?) (together the ?Mandated Lead Arrangers?), to arrange a Five Year Multicurrency (US$, € and £) Murabaha-backed Sukuk. Sukuk will have a five-year bullet maturity and proposed pricing three month LIBOR +175bps. 5. Salam Sukuk Salam Sukuk are certificates of equal value issued for the purpose of mobilizing Salam capital so that the goods to be delivered on the basis of Salam come to the ownership of the certificate holders. The issuer of the certificates is a seller of the goods of Salam, the subscribers are the buyers of the goods, while the funds realized from subscription are the purchase price (Salam capital) of the goods. The holders of Salam certificates are the owners of the Salam goods and are entitled to the sale price of the certificates or the sale price of the Salam goods sold through a parallel Salam, if any. Salam-based securities may be created and sold by an SPV under which the funds mobilized from investors are paid as an advance to the company SPV in return for a promise to deliver a commodity at a future date. SPV can also appoint an agent to market the promised quantity at the time of delivery perhaps at a higher price. The
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difference between the purchase price and the sale price is the profit to the SPV and hence to the holders of the Sukuk. All standard shariah requirements that apply to Salam also apply to Salam Sukuk, such as, full payment by the buyer at the time of affecting the sale, standardized nature of underlying asset, clear enumeration of quantity, quality, date and place of delivery of the asset and the like. One of the shariah conditions relating to Salam, as well as for creation of Salam Sukuk, is the requirement that the purchased goods are not re-sold before actual possession at maturity. Such transactions amount to selling of debt. This constraint renders the Salam instrument illiquid and hence somewhat less attractive to investors. Thus, an investor will buy a Salam certificate if he expects prices of the underlying commodity to be higher on the maturity date. Steps involved in the transaction:
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SPV signs an undertaking with an obligator to source both commodities and buyers. The obligator contracts to buy, on behalf of the end-Sukuk holders, the commodity and then to sell it for the profit of the Sukuk holders.
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Salam certificates are issued to investors and SPV receives Sukuk proceeds. The Salam proceeds are passed onto the obligator who sells commodity on forward basis
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SPV receives the commodities from the obligator Obligator, on behalf of Sukuk holders, sells the commodities for a profit. Sukuk holders receive the commodity sale proceeds.
Salam Sukuk in Practice: Aluminum has been designated as the underlying asset of the Bahrain Government al Salam contract, whereby it promises to sell aluminum to the buyer at a specified future date in return of a full price payment in advance. The Bahrain Islamic Bank (BIB) has been nominated to represent the other banks wishing to participate in the Al Salam contract. BIB has been delegated to sign the contracts and all other necessary documents on behalf of the other banks in the syndicate. At the same time, the buyer
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appoints the Government of Bahrain as an agent to market the appropriate quantity at the time of delivery through its channels of distribution. The Government of Bahrain provides an additional undertaking to the representative (BIB) to market the aluminum at a price, which will provide a return to al Salam security holders equivalent to those available through other conventional short-term money market instruments. 6. Istisna Sukuk Istisna Sukuk are certificates that carry equal value and are issued with the aim of mobilizing the funds required for producing products that are owned by the certificate holders. The issuer of these certificates is the manufacturer (supplier/seller), the subscribers are the buyers of the intended product, while the funds realized from subscription are the cost of the product. The certificate holders own the product and are entitled to the sale price of the certificates or the sale price of the product sold on the basis of a parallel Istisna, if any. Istisna Sukuk are quite useful for financing large infrastructure projects. The suitability of Istisna for financial intermediation is based on the permissibility for the contractor in Istisna to enter into a parallel Istisna contract with a subcontractor. Thus, a financial institution may undertake the construction of a facility for a deferred price, and sub contract the actual construction to a specialized firm. Shariah prohibits the sale of these debt certificates to a third party at any price other than their face value. Clearly such certificates cannot be traded in the secondary market. Steps involved in the structure:
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SPV issues Sukuk certificates to raise funds for the project. Sukuk issue proceeds are used to pay the contractor/builder to build and deliver the future project.
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Title to assets is transferred to the SPV Property/project is leased or sold to the end buyer. The end buyer pays monthly installments to the SPV.
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The returns are distributed among the Sukuk holders.
Istisna Sukuk in Practice:
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Tabreed‘s five-year global corporate Sukuk (on behalf of the National Central Cooling Company, UAE) provided a fixed coupon of 5.50%. It is a combination of Ijara Istisna and Ijara Mawsufah fi al dhimmah (or forward leasing contracts). The issue was launched to raise funds to retire some existing debt, which totals around US$136 million, as well as to finance expansion. The Durrat Sukuk will finance the reclamation and infrastructure for the initial stage of a broader US$ 1 billion world class residential and leisure destination known as ?Durrat Al Bahrain‘, currently the Kingdom of Bahrain‘s largest residential development project. The return on the Sukuk is 125 basis points over 3 months Libor payable quarterly, with the Sukuk having an overall tenor of 5 years and an option for early redemption. The proceeds of the issue (cash) will be used by the Issuer to finance the reclamation of the land and the development of Base Infrastructure through multiple project finance (Istisna) agreements. As the works carried out under each Istisna are completed by the Contractor and delivered to the Issuer, the Issuer will give notice to the Project Company under the Master Ijara Agreement and will lease such Base Infrastructure on the basis of a lease to own transaction..
7. Hybrid Sukuk: Considering the fact that Sukuk issuance and trading are important means of investment and taking into account the various demands of investors, a more diversified Sukuk – hybrid or mixed asset Sukuk – emerged in the market. In a hybrid Sukuk, the underlying pool of assets can comprise of Istisna, Murabaha receivables as well as Ijara. Having a portfolio of assets comprising of different classes allows for a greater mobilization of funds. However, as Murabaha and Istisna contracts cannot be traded on secondary markets as securitized instruments at least 51 percent of the pool in a hybrid Sukuk must comprise of Sukuk tradable in the market such as an Ijara Sukuk. Due to the fact the Murabaha and Istisna receivables are part of the pool, the return on these certificates can only be a pre-determined fixed rate of return. Steps involved in the structure:
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Islamic finance originator transfers tangible assets as well as Murabaha deals to the SPV.
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SPV issues certificates of participation to the Sukuk holders and receive funds. The funds are used by the Islamic finance originator.
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Islamic finance originator purchases these assets from the SPV over an agreed period of time.
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Investors receive fixed payment of return on the assets.
Hybrid Sukuk in practice: Islamic Development Bank issued the first hybrid Sukuk of assets comprising 65.8% Sukuk al-Ijara, 30.73% of Murabaha receivables and 3.4% Sukuk al-Istisna. This issuance required the IDB‘s guarantee in order to secure a rating and international marketability. The $ 400 million Islamic Sukuk was issued by Solidarity Trust Services Limited (STSL), a special purpose company incorporated in Jersey Channel Islands. The Islamic Corporation for the Development of Private Sector (ICD) played an intermediary role by purchasing the asset from IDB and selling it to The Solidarity Trust Services Limited (STSL) at the consolidated net asset value.? [8] Controversy: ?Sukuk are widely regarded as controversial due to their perceived purpose of evading the restrictions on Riba. Conservative scholars do not believe that this is effective, citing the fact that a Sakk (Islamic bond) effectively requires payment for the time-value of money. This can be regarded as the fundamental test of interest. Sukuk offer investors fixed return on their investments which is also similar in appearance to interest in that the investor's return is not necessarily dependent on the risks of that particular venture. However, banks that issue Sukuk are investing in assets—not currency. The return on such assets takes the form of rent, and is evenly spread over the rental period. The productivity of the asset forms the basis of the fixed income stream and the return on investment. Given that there is an asset underlying the value of the certificate, there may be, depending on the value of the asset, more security for the investors involved, accounting for the additional appeal of Sukuk as a method of financing for investors. Certain common structuring elements for Sukuk were criticized by Sheik Muhammad Taqi Usmani President of the Shariah Council of the Accounting and Auditing
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Organization for Islamic Financial Institutions (AAOIFI) in a paper entitled "Sukuk and their Contemporary Applications" released in November 2007. Sheik Usmani identified the following three key structuring elements that differentiate Sukuk from conventional bonds:
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Sukuk must represent ownership shares in assets or commercial or industrial enterprises that bring profits or revenues
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Payments to Sukuk-holders should be the share of profits (after costs) of the assets or enterprise
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The value payable to the Sukuk-holder on maturity should be the current market value of the assets or enterprise and not the principal originally invested.
Sheik Usmani stated that by complex mechanisms Sukuk had taken on the same characteristics as conventional interest-bearing bonds, as they do not return to investors more than a fixed percentage of the principal, based on interest rates, while guaranteeing the return of investors' principal at maturity. Sheik Usmani estimated that 85% of all Sukuk in issuance were not Shariah-compliant due to the existence of guaranteed returns and/or repurchase obligations from the issuer.
Following Sheik Usmani's criticisms the global Sukuk market shrunk from US$50bn in 2007 to approximately $14.9bn in 2008, although how much of this was due to his criticisms or the Global Financial Crisis is a matter of debate.? [9] TAKAFUL: Takaful is an Islamic insurance which is based on the principle of mutual assistance or ?Ta‘awun‘, and donation/gift etc which is called ?Tabaru‘ whereby the risk is shared collectively by a group with their discretion. This is a pact between the members who agree to jointly provide compensation among themselves in the event of loss or damage etc i.e. defined in the pact. There are three models of how Takaful can be implemented:
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Mudarabah model (profit-sharing) Wakala model A combination of both
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In Mudarabah model, the participants enter in a Mudarabah contract and
for
indemnification and share of the underwriting results. The surplus is shared between the participants (Rab- ul-maal) and the Takaful operator (Mudarib) in an agreed ratio. This model allows the Takaful operator to share in the underwriting results from operations as well as the favorable performance returns on invested premiums. However shariah concerns are that profits from a normal Murabaha are not same as the Takaful ?Surplus‘ which is equal to Profit – net claims hence the status of this issue is confusing, the relationship of the participants here is of Tabaru and not Murabaha thus technically profit cannot be shared here. The requirement to provide Qarz-e-Hasanah (in case of a deficit) in a Mudarabah contract by definition is against the concept of Mudarabah which is a profit sharing contract and a Mudarib cannot be a guarantor. In Wakala model a cooperative risk sharing ensures that the participants are safe guarded against their losses. Here the Wakeel or the agent charges a fee for his services. The operator also gets an upfront deductible fee and shares the profit of investments but it does not share the results of underwriting. The money accumulated from the contributions made by the members will be invested by the Takaful Company or the wakeel, based on Islamic principle of trade. Likewise a ceding amount by the contributors will remained invested and the rest would be used for compensations of losses. The waqf fund will also lay down rules for how and how much to compensate to a party in case of a loss, here the waqf acts as a separate entity and has decision making powers regarding investments, compensations and surplus amounts. Surplus may be distributed on the basis of these points: ? ? ? A portion may be reserved for future losses A portion of surplus should be distributed amongst the participants specially to differentiate it from conventional insurance. A portion may be given for charity purposes each year.
As a Mudarib, the Takaful Company will invest the funds of the waqf in shariah compliant investments and is entitled to receive profit for that at a fixed ratio. 6. Conclusion:
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Islamic banking though holds its importance and future growth potential; hence it will attract more investment in the coming years but still more consideration is required to ensure its shariah compliance. Especially Sukuk bonds are controversial, the need is felt that independent bodies such as AAOIFI provide solid framework for Islamic products and investments to be followed by all Islamic banks and funds. With conventional banks in the international markets opening their Islamic windows to tap this market, it is a primary concern that does these banks has enough expertise and knowledge on the subject matter or not? Since it is a very complex issue and there is a large probability that people might lose their trust in these banks if they invest in products which are un-Islamic. In practice Islamic banks have Muftis on their pay role to get advice regarding compliance of their products and other financial issues, though we know that manipulation is possible since these Muftis are on the Bank‘s pay role. Thus the need for an international independent regulatory body is strong felt. In Pakistan State Bank of Pakistan is doing a good job by regulating Islamic banks through its Islamic banking department and is playing a great role.
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REFERENCES Secondary Sources: 1.http://en.wikipedia.org/wiki/Islamic_banking 2.http://www.atkearney.com/index.php/Publications/the-future-of-islamicbanking.html 3.http://www.imf.org/external/pubs/ft/survey/so/2010/RES100410A.htm 4.http://www.sbp.org.pk/departments/ibd.htm 5.http://cief.wordpress.com/2006/03/12/musharakah/ 6. From the book – Meezan Bank‘s Guide to Islamic Banking.* 7.http://www.barakaonline.com/default.asp?action=article&id=48 8.http://ifresource.com/2010/04/27/ho...on-structuringand-application-of-sukuk-bonds/ 9.http://en.wikipedia.org/wiki/Sukuk ?http://en.wikipedia.org/wiki/United_states_housing_bubble
Books: *
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Meezan Bank’s Guide to Islamic Banking, Author: Dr. Muhammad Imran Ashraf Usmani (Ph.D.IslamicFinance), Publisher: Darul-Ishaat Karachi, Edition: First.
Presentation Slides: ? Takaful, By Dr. Muhammad Imran Usmani, SECP Takaful Conference
Papers: ? Do Islamic Banks Perform Better than Conventional Banks? Evidence from Gulf Cooperation Council countries. By: Hadeel Abu Loghod ? The importance of Islamic banking for Muslim minorities By: Ahmed Fazel Abrahim ? Why Islamic Banking Is Successful? Islamic Banks Are Unscathed Despite of Financial Crisis. By: Prof. Rodney Wilson - Professor-Durham University
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