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Topic 12

ECON 3430 - Islamic Banking and Finance
Capital market involves long-term investment; maturity of
greater than a year
Issued by large corporations and governments
2 major instruments: Debt-based vs Equity-based instruments
1. Role of investors: capital provider vs owner
2. Payment: fixed payment vs profits
3. Default: priority claimant vs residual claimant
Shariah principles on equity investment
1. Prohibition of riba (no guaranteed fixed return), gharar
(excessive uncertainty) and maysir (gambling/game of chance)
2. Primary business activity must be halal
3. Majority of assets must be illiquid
4. Non-permissible income must be below a specified benchmark
The market offers a deep pool of Shariah approved equity securities
with accompanying benchmark indices, Islamic bonds and Islamic
unit trusts
Other conventional products such as warrants, call warrants,
crude palm oil, future contracts and asset back securities are also
deemed to be Shariah approved.
The growing popularity of such securities has led to the
introduction of the KLSI (Shariah index) in 1999
Shari'ah Compliant Stocks in Bursa Malaysia
(As of November 2011)
Screening Methodology for
Shari'ah-Compliant Stocks
Currently there is no international Shari'ah standard for stock
Different funds or fund managers utilise different standards based
on their respective Shari'ah councils
In Malaysia: list issued by Shariah Advisory Council of Securities
Commission, Dow Jones-RHB Islamic Malaysia Index and FTSE Bursa
Malaysia, namely FBM Hijrah Shariah Index and FBM EMAS Shariah
At global level: there are Dow Jones Islamic Market Indexes, FTSE
Global Islamic Index Series, S&P Islamic Index Series, MSCI Islamic
Index Series
Screening Methodology for Shari'ah-
Compliant Stocks
Various types of screening criteria depending on SAC decisions
1) Securities Commission of Malaysia: central level; screening based on core
activities and benchmark of tolerance for mixed activities
2) Pakistan uses Meezan Bank Islamic Fund criteria: screening based on
permissibility of underlying businesses and balance sheet composition
3) Dow Jones Islamic Index and FTSE: screening based on primary business activities
and acceptable financial ratios
(and more)
Shari'ah stock screening
Rules to ensure that ordinary shares are Shari'ah compliant
In general, the stock screening process are divided into two
1. Evaluation in terms of company activities, products and industry
2. Computation of a set of financial ratios & compare them against
specified benchmarks
Shariah benchmark for listed shares
1a. Primary Activities Criteria
1. Conventional finance (riba)
2. Gambling/gaming (maysir)
3. Prohibited goods & services
Pork, alcohol, prostitution
4. Conventional insurance (gharar)
5. Entertainment deemed non-permissible
6. Tobacco manufacturing or sale
7. Stock-broking or share trading in non-Shariah
approved securities
Shariah benchmark for listed shares
1b. Mixed Company Criteria [applied to revenue & profit before tax ]
5% Benchmark
Clearly prohibited activities conventional banking, gambling, liquor,
10% Benchmark
umum balwa (prohibited element affecting most people & difficult to
e.g. interest income from fixed deposits in conventional banks,
tobacco-related activities
25% Benchmark
maslahah to the public
e.g. hotel and resort operations, stock-broking
2. Financial filters is also used to refine the selection
Use of selected financial ratios and compare them against their respective
benchmarks to weed out non-Shariah compliant stocks
In general these ratios can be categorized as liquid assets, interest income and
Ratio benchmark ranges from:
Liquid asset: 17% to 49%
Interest income: 5% to 15%
Leverage: 30% to 33%
Data are taken from:
Balance Sheet
Income Statement
Macroeconomic date (in the case of DJI)
Securities Commission of Malaysia applies additional criteria to
companies which are involved in multiple industries, i.e., companies whose
business activities comprise both Shari'ah permissible and non-permissible
Analysis is done at the holding company, subsidiary company and associate
company levels. Criteria include:
1. Core activities of the company are activities not against the Shari'ah principles as
mentioned earlier
2. Haram element is small compared to core activities, i.e., compared against
3. Public image/perception of company is good
4. Core activities of the company are important and of public interest (maslahah) to the
Muslim ummah and the country
5. Proportion of haram element is small and in matters such as umum balwa (common
plight), uruf (customs) and rights of non-Muslim community which are accepted by
It maybe possible that a company is in industries which are Shariah
compliant but the revenue from the subsidiary whose activities are not
Shariah compliant may lead the company to be considered as non-Shariah
Consequences of non-standardization
1. Slow development due to lack of confidence in shariah-
compliancy of products
2. Lack of generally accepted operational standards : criteria for
determining shariah-compliancy of the stocks need to be improved and
unified across jurisdictions
3. Weak regulatory environment
4. Fund managers cannot benefit from economies of scale: Islamic
capital markets are segmented across countries and regions, thus reducing
the effective available size and riskreturn spanning possibilities to
Islamic Investment: Sukuk
Definition of Sukuk
Literally means written document: A document or certificate which
represents the value of an asset
investment Sukuk are certificates of equal value representing
undivided shares in ownership of tangible assets, usufruct and
services or in the ownership of the assets of particular projects or
special investment activity[] (AAOIFI Standard 17)
Technically defined, sukuk are financial securities of equal
denominations representing undivided ownership interests in a
portfolio of eligible existing and/or future assets, usufruct, services,
and business activities (Ali, 2008, p. 4)
It is an ownership claim to an asset or a pool of assets, but not a
financial claimto a cash flow or receivables as in conventional bond
Sukuk holders receive returns from the underlying assets
AAOFI defines 14 types of Sukuk, the main ones are:
i. Ijara Sukuk (leasing)
ii. Certificates of ownership of usufructs (e.g. Sukuk Manfaat Al-Ijara)
iii. Salam Sukuk (deferred commodity delivery)
iv. Istisnaa Sukuk (manufacturing or project finance)
v. Mudarabah Sukuk (partnership/finance trusteeship)
vi. Murabaha Sukuk (purchase order)
vii. Musharaka certificates (Joint Venture)
Salient Features of Sukuk
Asset-backed, stable income, tradeable, shariah-compliant
trust certificates
Not simply a claim to cash flow but an ownership claim
Return derives from yield generated by clients lease of the asset
Shariah legitimacy of sukuk lies in the fact that they do not
take advantage of interest rate movements
Sukuk are directly linked to real sector activities: will not create short-term
speculative movement of funds and potential financial crises
Investing in sukuk involve funding of trade or production of tangible assets
Represent ownership stakes in existing
and/or well defined assets
Represent pure debt obligations due from
Underlying contract for sukuk issuance is a
permissible contract such as a lease or any
of the other categories defined by AAOIFI
Core relationship is a loan of money, which
implies a contract whose subject is purely
earning money on money
Underlying assets monetised in a sukuk
issuance must be Islamically permissible in
both their nature and use
Bonds can be used to finance almost any
purpose which is legal in its jurisdiction
Asset-related expenses may attach to
sukuk holders
Bond holders are not concerned with asset-
related expenses
Sukuk prices depend on market value of
underlying asset, apart from obligors
Price depends solely on issuer
Sale of sukuk represents a sale of a share
of an asset
Sale of bond is basically the sale of a debt
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Sukuk Conventional
Types/RM Billion 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Sukuk 38.46 54.71 71.06 88.37 88.37 120.12 146.44 199.45 211.37 248.47 294.19
Conventional Bond 224.91 245.94 236.01 276.28 284.20 297.83 306.10 358.04 374.59 395.36 469.18
263.37 300.64 307.07 364.65 372.57 417.95 452.54 557.48 585.96 643.83 763.37
Malaysia: Amount of sukuk and conventional corporate bonds outstanding, 2000 to 2010
Issue-Secondary Marketing (Bay Ad-dayn)
Tradability of bonds in secondary market is a key feature of
-To provide liquidity options to the investor
-Without a liquid secondary market, bonds are not attractive to
With this debt-based bond, object of trade is debt (dayn)
-The debt is the right to future cash payments or the financial claims
-Controversy on permissibility of bay-ad-dayn
IOU paper
Break up payments
into periodic
Can sell to C,D,E
IOU- financial liquidity
-securitizing the debt
Issue-Secondary Marketing (Bay Ad-dayn)
Tradability of bonds in secondary market is a key feature of
-To provide liquidity options to the investor
-Without a liquid secondary market, bonds are not attractive to
If the sukuk is asset-based (debt), object of trade is debt
-Controversies regarding the permissibility of bay ad-dayn
Asset Based (Debt)
Murabahah, salam
Asset Backed (Equity)
Mudharaba, musharakah
Classification of Sukuk
Key difference is the concept of true sale
Asset-based sukuk allows inclusion of the actual asset which may
NOT be legally recognized to be owned outright by the sukuk
Asset-backed sukuk:
grants sukuk holder a share of the asset or business venture, and a share of
risk commensurate with the true sale ownership of the asset
There is a true sale between the originator and the special purpose vehicle
(SPV) that issues the sukuk and sukuk holders do not have recourse to the
Assets are owned by the SPV, returns are derived from assets, and asset prices
may vary over time
The majority of sukuk issues, however, are not asset backed
Asset-based versus Asset-backed Sukuk
Issue-Secondary Marketing (Bay Ad-dayn)
Fiqh views in relation to trading of debt (bay al-dayn)
1. Bay al-dayn at par value
Unanimously agreed as permissible
Represents the contract of hiwalah (transfer of debt)
2. Bay al-dayn at discount to issuer
Unanimously agreed as permissible
Principle of dha wa taajjal (incentive to expedite payment of debt) between
original buyer and seller
Issue-Secondary Marketing (Bay Ad-dayn)
3. Bay al-dayn at discount to third party (securitization)
Disagreement among fiqh scholars
Middle Eastern view unlawful tantamount to riba
Malaysian view lawful extend application of dha wa taajjal to third party
Most common case of secondary trade
Types of Sukuk
Different sukuk structures:
Ijarah sukuk
Ijarah Sukuk
According to AAOIFI, this specific sukuk are certificates that carry
equal value and are issued by either owner of a leased asset or an asset
to be leased by promise, or by his agent, the aim is to sell the asset and
to recover its value from subscription, in which case the owners become
owners of the asset
In essence, lessor chooses to sell leased asset to a number of
individuals, then the ijarah certificate should be issued to represent the
individuals proportionate ownership in the assets
Holder of this certificate will assume rights and obligations of owner or
lessor to the extent of the number of certificates he holds
Secondary market
Figure 1: Ijarah Sukuk Structure 1 Sale and Leaseback
Trading of Sukuk
1. Company sells leased assets to SPV for an amount
required in the financing exercise
2. SPV does not hold any cash, thus issue sukuk to raise the
required funds. The sukuk- represents investors
proportionate ownership of the leased asset
4. The company will pay the rentals periodically with a
payment of maturity or to incorporate the principal with
rentals periodically, hence leasing to own
SPV(Rab-al-mal representing
Figure 2: Mudaraba Sukuk
1. Company and
Investors enter into
a Mudaraba
2. SPV (managed by
Trustee) issues
Sukuk evidencing
participation in
Mudaraba venture
3. Investors make
payments to
account of
Mudaraba capital
1. SPV issues sukuk to investors
while using the gathered
proceeds to make payment to
account for mudharaba
2. Any profits arising from the
mudharaba project should be
divided according to
predetermined ratio or the
originator simply take the
mudharib fee.
3. Losses will be borne by
(representing Investors)
Figure 3: Musharaka Sukuk
1. Company and
Investors enter into a
Musharaka Agreement.
2. SPV (managed by
Trustees) issues Sukuk
participation in
Musharaka venture
3. Financier makes
payments to
Like Ijarah,and Mudhrabah
Sukuk, Musharaka Sukuk
represents participation
certificate where the
investor becomes a
proportionate owner in the
business activity.
1. Company invites
investor to a
partnership in a specific
2. Share profits and
Primary Subscriber
Need fund/ cash
/ Sukuk Issuer
2. Fund
1. Asset sale
4. Sukuk BBA
5. Proceed
3. Sell back
Secondary Market
6. Sell BBA Sukuk
( Bai ad-Dayn)
Figure 4. ABBA Sukuk
ABBA Sukuk
1. SPV sells the asset to the investors with the price of RM300 million in cash after
having beneficial ownership over the asset.
2. Such fund of RM 300 million is given to the company for a particular project to
which this Sukuk is issued.
3. The investors sell back the asset with RM 300 million and expected return in
deferred within the period of 5 years BBA Murabahah
4. SPV issues sukuk BBA on behalf of investors in receiving payment made in part by
the SPV and the company.
5. Payment will be made in deferred, thus investors will receive their capital and profit
expected within those 5 years.
6. Along that 5 years period, the investors are free to keep and accept the payment in
deferment on behalf of SPV or sell it in the secondary market to get the immediate
cash. If it is sold, it will use debt selling concept (bai ad-dayn)
(1) Identify
assets to be
acquired by the financier
(2) Financier purchased the
asset under the BBA principle
at a cost of RM100 mil
(3) Sells assets at
a price higher than (2)
say at RM124 mil
ABBA bonds
(4) Issue ABBA bonds as evidenced
of indebtedness
Al-Bai Bithaman Ajil Bond (ABBA)
Eg. PLUS RM5.1 billion Sukuk in 2002
SPV Sukuk Investors
Figure 4: Istisnaa Sukuk
1. Istisnaa purchase agreement between 3
party and SPV. 3rd
party is responsible for delivering the goods.
2. SPV issues Sukuk to investors. These sukuk are not negotiable
and cannot be traded until the asssets are manufactured or
3. Proceeds of Sukuk to purchase the Istinaa assets.
4. SPV enters another istisnaa agreement with company where the
SPV is responsible of delivering the specified asset to the company
at a profit (parallel istisnaa).
5. The company does not pay lump sum. Pays profit portion on
periodic basis and pays principal at maturity.