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Fundamentals of Islamic (Shariah Compliant) Finance
Basic requirements and philosophy Types of Islamic Finance Products Basic Assumptions Additional Matters
Overview of Islamic Finance Market
Use of Islamic Finance in Different Market Sectors Governance
Background Products and processes Regulator/operator issues Specific issues International Guidance Basel IFSB Standards Non executive functions
Historical Background of the Islamic Banking
1950 – Islamic Banking in Theory 1970 – Islamic Banking in Practice 180 – Islamic Financial Institutions (major)
The Purpose of Islamic Banking
Forbidden of Interest
Exodus Leviticus Deuteronomy Psalms Proverb
Nehemiah Ezakhiel 7 Verses of the Quran More than 40 sayings of the Prophet Muhammad
Fundamental Difference Between Conventional and Islamic banking
Procedur es Interest Uncertai nty
4. Speculation 5. Unlawful Products 6. Unlawful Services
Basic Banking Activities Deposit Collection Financing Other Services .
Deposit (Frame work) •Wadi`a (Trust) •Qardhan hassana ( Loan) •Mudaraba (Passive Partnership) .
Working of Mudaraba .
Various Forms of Financing .
The Structure of Murabaha Contract .
•The title to the asset is transferred to the customer at the time of purchase but usually the customer provides the same or other assets as collateral to the bank for the period of financing. which is payable on a deferred payment basis.Modalities of Murabaha •The Bank Buys the asset from the Vendor •The customer then buys the asset from the bank at a mark-up price (P+X) . . •The period covering the deferred payment is effectively the period of financing.
The Structure of Contract Under Ijarah wa Iqtina .
at the end. .Modalities of Ijaarah •The bank buys the asset from the vendor •The bank then leases the asset to the customer •Periodic rentals are collected by the bank •The title of the asset remains with the bank under as operating ijaarah •Title passes to the customer under a Lease ending with transfer of ownership. either gradually over the period of the contract.
e. e. development of a Tourist Resort.Ijara (Leasing) Sukuk • Can be used for long term infrastructure projects by the mobilisation of short term deposits i.g. . securitisation of Government tangible assets • Possible use in project financings.
•The customer and the bank share in the profits according to the agreed proportions. Any losses of the enterprise will be borne by the customer and the bank according to their capital contributions. the customer buys out the bank`s share over a period of time. which may be different from the proportions of capital contributed.Modalities of Musharaka •Both the Bank and the customer contributes towards the capital of the enterprise •Under a “diminishing” Musharaka. .
Mudaraba (Passive Partnership) .
the bank (as the fund provider or Rabbul Mal) has to bear all the losses unless the loss has resulted from negligence on the part of the mudarib. A classical mudarib fee is based on a percentage of the profits only. . •The balance of the profit of the enterprise is payable to the bank •If the enterprise makes a loss. •The customer is responsible for the day to day management of the enterprise and is entitled to deduct its management fee( mudarib fee) from the enterprise`s profits. •The mudarib fee could be a fixed fee (to cover management expenses) and a percentage of the profits or a combination of the two.Modus Operandi of Mudarabah •The bank provides to the customer (mudarib) all the capital to fund a specified enterprise •The customer contributes only entrepreneurship.
The Structure of a Salam Contract .
•A Salam is primarily a deferred delivery sale contract usually used for commodity finance. To mitigate the asset risk a financier can enter into parallel Salam. .Modus operandi under Salam Contract •A Salam (sometimes referred to as Salaf) is a short term agreement in which a financial institution makes full pre-payments for future delivery of a specified quantity of goods on a specified date. It is similar to a forward contract where delivery is in the future in exchange for spot payment.
The Structure Under a Istisna Contract .
It is similar to conventional work in progress financing for a capital project. . similar to salam. In practice it is usually used for construction and trade finance such as pre shipment export finance.Modalities of Istisna` Istisna` is primarily a deffered delivery sale contract.
Rules for Investment •Primary business activity must be Shariah •Majority of assets are illiquid •Involuntary non permissible income must be less than 10 % and purified •At the AGM interest based transactions must be apposed .
The Structure of a Sukuk .
Historical Background .Sukuks Need for liquidity and good liquidity management Different periods between maturities of assets and deposits – resulting in either surplus of non performing cash or a shortage of cash to fund investments Lack of: active interbank and secondary market (mostly primary market trading) – acceptable Shariah compliant instruments – acceptable regulatory conditions – limited available agency credit ratings – unsophisticated market – limited information flow The need for a more sophisticated capital. financial and insurance market. – .
representing an undivided beneficial ownership in the underlying assets” .Sukuks – Legal Meaning All this changed with the development of the Sukuks. Definitions: a) “Participation Securities. investment certificates” b) “Certificates of equal value. coupons.
Like turnkey projects. . MUSHRAKA SUKUK Musharaka is a form of partnership whereby each party contributes assets or capital with a view to establishing a project or to share in an existing one. Mudarib/Rabbul-Mal IJARA SUKUK An ijara is essentially an Islamic leasing transaction which can be used as a financing tool. DEVELOPMENT SUKUK (ISTISNA) Istisna is defined as a contract of sale of specified goods to be manufactured with an obligation on the manufacturer to deliver them upon completion.Types of Sukuks MUDARABA SUKUK A mudaraba is a partnership for profit between capital employed on one hand and work on the other.
The characteristics of a sukuk are similar to a conventional bond with the difference being that they are asset backed. for a defined period the risk and returns associated with the cash flows generated from the assets belong to the sukuk holder.Modus operandi Under Sukuk Sukuks represent proportionate beneficial ownership. .
Typical Project Financing Structure .
Ijara (Leasing) Sukuk – Case Study for a Project Financing of a Tourist Resort. Works as follows:Sale of tangible assets to a special purpose restricted Mudaraba (SPV) assets are then leased to the interested parties through a Ijara lease the MUDARABA participation SUKUK will be issued and sold to public/investors with a guarantee of payments (usually from Government or international bank) required security will be given to SUKUK holders MUDARABA managed (on behalf of SUKUK holders) by MUDARIB MUDARIB signs and executes all relevant contracts ensures Shariah compliance transparency and efficient operation .
Tourist Resort SUKUK Holders Periodic rentals and capital amount payments Periodic rentals and capital amount payments Assets/Hotel (Beds) Sold Sukuk proceeds Sukuk proceeds Seller MUDARIB MUDARABA (SPV) Project Assets Lessee (Project Operator) IJARA Lease For a fixed period of time and service agency .Leasing Sukuk .
Contract law must recognize debt obligations and repayment obligations. Insolvency laws must give priority to security holders in the event of the insolvency of Issuers. Property laws must recognize the concept of security interests. .Legal Requirements for Bonds and Sukuks Laws must allow the concept of trust. Important for Sukuks and Bonds.
Listing rules similar to your stock exchange listing rules. Investment professionals and other professional advisers available to advise on structures. e. lawyers and accountants.Market Requirements for Corporate Bonds and Sukuks. Adequate investor protection . A sufficient number of investors. A sufficient number of issuers. Transparent dealings. Effective legal documentation. Credit rating. The need for a secondary trading market to provide liquidity.g.
. Consider sovereign guarantee for sukuk issues. Protection of creditors’ rights.Enforcement The need for a suitable enforcement regime. Enforcement of judgments in a timely and efficient manner. Possibility of foreign arbitration.
Qard Hasan – (“good loan”). Halal (“religiously permissible”). Riba (“interest/unjustified rewards/unlawful gain”). . Haram (“not religiously permissible”).Fundamentals Islamic (Shariah) Finance Quranic (Shariah Law) principles. Gharrar (“uncertainty. speculation”). Al-Wadia – (“safekeeping”). risk.
Basic Requirements and Philosophy true risk sharing. no exploitation of a weaker position. . promotes economic and social development. not socially unproductive. and charitable (“zakat”). not economically wasteful.
g.g. HSBC Islamic Windows in major Global Banks Islamic Bank of Britain Primary Market: initially basic finance products Compatibility with conventional products .Overview of Islamic Finance Market Islamic and Dual Banking Systems Retail Islamic finance products offered for a number of years. Middle Eastern banks. some low key e. others high profile e.
Arab nations Follow the same Islamic Banking Rules .
Arab culture is diverse There are 22 Arab nations .
forex. . Wholesale & Retail Products: • • • • • • • loans. fund transfers. Asset Financing Lending. securities safe keeping. letters of credit. Types of Islamic Finance Products: Equity. investment management and device. partnership investments. Trade Financing.
Funds Work. Islamic Finance (Cont’d): Al-Wadia (safekeeping): usually not remunerated. SUKUK/Securitisation (Capital & Secondary Markets). Takaful (Insurance). and Derivatives/Funds Management. .
Basic Assumptions Underlying asset must be acceptable Different interpretations on what proportion of asset must not be “haraam” Proposed structure of transaction has to be acceptable No prohibited activities (proportionate approach) Need to account for regulatory requirements and comply with two sets of law (Shariah and law of country) .
Shariah Boards – competition. Maslaha (general interest to justify). Urf (custom). Additional Matters Zakat (specified amounts to be allocated from disposable income). pragmatic approaches. Hiyal (ruse) . Darura (overriding necessity).
Use of Islamic Finance in Different Market Sectors Real Estate Project Financing Co-financings (Power. Oil & Gas) Retail Banking Depositors Investment Account Holders General Leasing Ijara Asset Finance Bond (SUKUK) Issuance Private Equity Funds Insurance (Takaful) Capital Markets (Sukuk/Arboun/Salaam) . LNG.
structuring and marketing Shariah compliant financial products can be cumbersome and complex IIFS needs to account for regulatory requirements and comply with two sets of jurisprudence/law (Shariah and the law and regulations of relevant jurisdiction) .Governance Background Developing.
Products and Processes Products and Processes need to be effective from the following viewpoints: Understandable Competitively priced Tax effective Available and transparent Not administratively burdensome Not “alien” to regulatory requirements Governance of institution offering Islamic financial services needs to be the same .
Regulator/Operator Issues Scope for the continuing development of good corporate governance in the field of Islamic finance No inconsistency with Shariah .
in particular.Specific Issues Islamic finance industry needs to. focus on issues regulators will be concerned with Remember that Shariah-compliance will not normally be an issue for non-Islamic countries or where Shariah is not part of a general legal framework Shariah Supervisory Board presence and scrutiny therefore essential .
terminology and treatment Dissemination of codes of best practice Practical Adaptability .Specific Issues (cont…) Islamic finance industry regulators need to consider regulation of Shariah Supervisory Board Islamic financing industry need for a unified front to regulators Standardisation of models used.
Guidance Many forms of International and National Guidance available OECD principles UK Stock Exchange Combined Code Cadbury Report Hempel Report Higgs Report .
Guidance (cont…) France/Germany: different forms of governance models US: Sarbannes-Oxley Other/Corporate Governance Standards Country Specific Accounting and Industry Specific IFSB guidance Principles outlined “Comply or Explain” .
Basel Basel Committee on Banking Supervision 1999 paper 2006 paper .
IAHs .e.) shareholders.General Principles Establish Good Governance Policy as a principle of Shariah Monitoring and work of Board Committees Executive Management Shariah Supervisory Board Internal and external auditors Different Stakeholders Mechanisms of balancing the roles of different stakeholders i. management.
Non Executive Functions Role of non-executive directors/managers Guidance Oversight Compliance issues Future compliance policy .
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