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Introduction to Islamic

banking and finance


Prepared by
Wahyu Jatmiko, S.E., M.Sc.
Kuliah Intensif Ekonomi Islam (KIEI), FEB UI
Outline
• Background and History of Islamic Finance
• Islamic Banking Models
• Ideal Model
• 2nd Best Model
• 3rd Best Model
• Non-banking Islamic Financial Institutions
• Takaful
• Islamic Capital Market (stock and sukuk)
• Inclusive Islamic financial institutions
Background and history of
Islamic finance
Origins of Islamic Economics/Finance
• Many Muslim countries colonized in the 19th century
• After independence in the 20th century, most adopted Western
economic/legal systems
• There was an urge to introduce Islamic economic system
• Writings of scholars in the early 20th century
• Syed Abul ‘Ala Maududi (India/Pakistan)
• Muhammad Baqir As-Sadr (Iraq)
Origins of Islamic Economics/Finance
• Formal launching of Islamic economics – First International
Conference in Islamic Economics held in Makkah, 1976
• Introduce a moral filter in economics
• Value system of Islam (based on Islamic worldview would fulfill the maqasid
al Shari’ah) would provide a bettwe concept of economic development
• Provide a ‘just and humane’ alternative to the ideologies of capitalism and
socialsm
• Islamic banking and finance considered a component of the Islamic
economic system
Origins of Islamic Economics/Finance
• Egypt
• In 1963, Ahmed al Najjar established saving/investment houses in small
towns in Northern Egypt, starting in ‘Mit Ghamr’
• Provided financing on profit-loss sharing basis to small entrepreneurs and
poor farmers
• Savings/investment Houses closed an liquidated in 1967.
• In 1971, the government established Nasser Social Bank – used Islamic
principles (interest-free financing and distribution of zakah-obligatory alms)
• Malaysia
• Tabung Haji: In 1963, Pilgirms’ Management and Fund Board established
• To help people save money to go for hajj (pilgrimage)
• Funds used to invest in industrial and agricultural projects
Originis of Islamic Banking and Insurance
• Establishment of Organisation of Islamic Cooperation (OIC) in 1873
• 1975
• OIC established Islamic Development Bank in Jeddah, Saudi Arabia
• UEA, a businessman (Saeed Ahmed Lootah) established the first Islamic
commercial bank Dubai Islamic Bank
• 1979
• The Islamic Arab Insurance Co. (IAIC), UAE
• The Islamic Insurance Co. of Sudah
2000’s
• Islamic Banks
1990’s • Takaful/retakaful
• Islamic Banks • Mutual Funds
• Takaful/retakaful • Mudarabah Co.
• Mutual Funds • Leasing Co.
1980’s • Investment Banks
• Mudarabah Co.
• Islamic Banks • Leasing Co. • Islamic indices
• Takaful/Retakaful • Investment Banks • Sukuk
• Mutual Funds • Islamic indices • Private Equity &
• Mudarabah co. Venture Capital
1970’s • Hedge Funds
• Infrastructure
• Islamic Bnaks
• Islamic REITs
• Takaful
• Trust/Waqf
Management
Size of Islamic Financial Industry
• Islamic financial sector is significant and expanding at a fast rate
• More than 500 Islamic financial institutions in over 75 countries
• Over 706 Shari’ah compliant mutual funds
• 2014: Estimated total Islamic financial assets under management -
$1.87 trillion
• Banking - $1.1476 triillion
• Sukuk Outstanding - $294.7 billion
• Islamic Funds Assets - $75.8 billion
• Takaful contributions - $21.4 billion
• Annual growth rate of 17% during 2009-2013
Islamic Banking Models
Islamic Banking Concept
• Riba prohibition – Interest-free banking
• Gharar issues raised by Shari’ah scholars
• Maxim of risk sharing
• Entitlement to gain is linked to the responsibility of loss (risk) (recall: Al-
Ghurm bi al ghunm)
• Emphasis on using profit-loss sharing (PLS) modes of financing –
equity modes
• Islamic banking model – investment intermediary rather than just a
commerical bank
Responsibilities of an Enterprise
• Responsibilities of a firm includes
• Economic: firms produce/supply goods and services to earn profit;
• Shareholders vs. Stakeholders interests
• Legal: firms must comply with all the laws and regulations of the host country
• Ethical: society expects firms to follow certain ethical norms
• Social/philantropic: desirable for firms to be philanthropic
• Most firms would fulfill economic and legal responsibilities
Responsibilities of IFI
• Responsibilities of Islamic financial institutions
• Economic: Shareholders vs. Stakeholders
• Legal: Islamic Fis conform not only to the national laws and statutes, buu to
Shari’ah at the transactions level
• Ethical: Being ethical is required of an Islamic firm, not just expected.
• Social/philanthropic: desirable and expected?
Ideal Islamic Banking Model
• Two-tier mudarabah model
• Profit-loss sharing modes of financing on both the asset and liabilities side

Assets Liabilities and Equity


- Mudarabah/Musharakah financing - Profit-sharing investment accounts
(PSIA – Mudarabah based)
- Demand Deposits (qard hasan)
- Capital
Features of Ideal IB Model
• PLS (risk-sharing) assets would imply rubust investmens lending to
economic growth
• Choosing projects that make good economic sense
• Monitoring of the investments closely
• Equity financing usually long-term
• Sharing risks of assets by the liability side makes the bank more stable
• Losses covered by PSIA and capital
Islamic Banking in Practice
• Islamic banks adopted the convetional banking format
• Profit-maximising entities
• Debt-based institutions
• Some Islamic banks started with PLS financing modes
• Risk of equity-financing different from that of debt-financing
• Banks lost money
• Resorted to modes that had lowe risks
• Started using fixed-income debt instruments
• Murabaha
• Ijarah
Islamic Banking Practice: 2nd Best (Pragmatic)
Model
• One-tier Mudarabah with Multiple Investment Tools (Murabaha
syndrome)
• Liability side – PSIA (Mudarabah based)
• Asset Side – multiple investment tools, dominated by fixed income
contracts (murabahah, ijarah, istisna, etc.)
Assets Liabilities and Equity
- Murabahah - PSIA – Mudarabah based
- Ijarah - Demand Deposits (qard hasan)
- Istisna - Capital
- Mudarabah/Musharakah - Reserves
- etc
Other Features of nd
2 Best Model
• Lack of PLS mode on asset side – growth argument weakened
• PSIA – profit-rate smoothing
• Profit Equalizing Reserves (PER) – amount deduxted from gross income to
smooth PSIA returns
• Investment Risk Reserves (IRR) – amount deducted from the income of PSIA
depositors (after deduction of bank’s shares) to meet losses on investments
financed by PSIA
• Penalties
• Penalties charged on late payments and defaults
• Most Shari’ah scholars do not approve this, but used to discipline
delinquencies
• Funds collected given to charities
Islamic Banking Practice: 3rd Best (Liberal)
Model
• Fixed Liabilities with Multiple Investment Tools (Tawarruq syndrome)
• Liabilities Side – Fixed-income investment accounts (using tawarruq)
• Asset side has multiple investment tools, dominated by fixed income
contracts (tawarruq, murabahah, ijarah, etc)

Assets Liabilities and Equity


- Tawarruq - Fixed income investment accountrs
- Murabahah (tawarruq)
- Ijarah - Demand deposits (qard hasan)
- Istisna - Capital Reserves
- Mudarabah/Musharakah, etc
Tawarruq

• Tawarruq – monetization
• 1. A buys a commodity on deferred payment from B
• 2. A sells the commodity to C spot to get cas
• Allowed by a minority of the Scholars (in the Hanbali and Hanafi schools)
Organised Tawarruq

• The client wants a personal loan and approaches the bank


• 1. Bank buys commodity from a broker paying spot (for $100)
• 2. Bank sells the commodity to client payment at a future date (for $110)
• 3. The client sells commodity to broker spot (for $100)
[the client appoints the bank as agent to sell the commodity. The bank sells the commodity
spot to the broker for $100 on behalf of the client and deposits the money in his account.]
At the end of the transaction, the client walks away with $100 and owes the bank $110
payable in the futures
[Bai al’inah: No third party involved – bank and client do the selling and buy back]
Other Features of 3 rd Best Model
• Assets side
• Initially different modes used for differnet purposes
• Durables – murabahah, ijarah
• Agriculture – salam
• Real estate construction - istisna
• Tawarruq can replace all the above (similar to a loan)
• Liability side
• Fixed-income investment accounts replaced PSIA
• No link between return on assets and liabilities
• Stability argument weakened
Non-banking Islamic
Financial Institutions: Takaful
Insurance - Introduction
• One of the functions of the financial sector
• Facilitating ‘trading, hedging, diversification and pooling of risks’
• Insurance is a key financial service after banking
• Forward looking—protection of assets/life against risks
• Penetration of insurance is low in Muslim countries (IFSB 2014)
Insurance Models
• Commercial/Propriety Insurance
• Owned by shareholders
• Policy holders pay premium to get protection from risks
• Surplus arising from the operations distributed to shareholders
• Mutual/Cooperative Insurance
• Owned by policy holders/members
• Surplus arising from operations distributed to policy holders
• In both models, there is one balance sheet which intermingles capital
and pool of risk funds
Insurance – Shari’ah Perspectives
• OIC Fiqh Academy Resolution 9 (9/2) 1985 forbids conventional
insurance
• Gharar (uncertainty about the object of sale and outcome)
• Islamic viewpoint—risks can be mitigated but approach has to be
different
• Takaful based on
• Tabarru’ (gift or donation)—Gharar does not exist in gratuitous contracts
• Ta’awun (mutual assistance)
• Avoid riba in transactions (applies to assets)
Takaful - Introduction
• Key features
• Takaful Operator (TO)—shareholders establish a takaful company
with their own fund (Shareholders’ Fund-SF)
• Takaful participants contribute (tabarru) to Participants’ Risk Fund
(PRF)
• SF and PRF are separate—shareholders do not take any
underwriting risks
• Hybrid of commercial (SF) and mutual insurance (PRF) models
Takaful Milestones
• Takaful started in 1979 with the launching of two companies:
• The Islamic Arab Insurance Co. (IAIC),UAE
• The Islamic Insurance Co. of Sudan
• In 1984, the first legal framework specific to Takaful in Malaysia
(Takaful Act Malaysia)
• Current estimates (IFSB 2014)
• $18.3 bl. Takaful contributions (1H 2013)
• 200 Takaful companies (2012)
• Annual Growth Rates 2007-2012—18.06% (1.1% of the total Islamic finance
assets)
Takaful Types and Models
• Types of takaful
• General (casualty)
• Contracts of guarantee for limited period of time (e.g. 1 year)
• Takaful contributions go to Participants Risk Fund (PRF)
• Family (life)
• Long term investment opportunities
• Financial relief in case of risk event (e.g. death, accident)
• Contributions distributed to two funds
• Participants Investment Funds (PIF)
• Participants Risk Fund (PRF)
• Different Models of Takaful
• Mudarabah (Partnership)
• Wakalah (Agency)
Wakala General Takaful

[Source: IFSB (2009)]


Mudarabah GeneralTakaful

[Source: IFSB (2009)]


Wakala Family Takaful

[Source: IFSB (2009)]


Mudarabah Family Takaful

[Source: IFSB (2009)]


Mudarabah-Wakala Family Takaful

[Source: IFSB (2009)]


Issues Related to Takaful Models
• If there is a loss due to excessive claims, the company gives a interest-
free loan to the participants, which is recovered later
• Some scholars object to this as guaranteeing a certain profit share
• Combining conditional gift (tabarru’) and mudarabah dilutes the non-
profit features—gharar may exist
• Donation or gift (tabarru’) is still owned by the contributors
• Surplus goes back to tabarru’ contributors
• Contract of compensation, not gift
• Introduce a waqf—Islamic endowment
• legally the contributors do not have ownership of waqf
Non-banking Islamic Financial
Institutions: Islamic Capital
Market
Stock Market
• Equities represent ownership rights in corporations
• Usually perpetual
• Corporation—a musharakah type arrangement in which every
shareholder is a sharik (partner)
• AAOIFI ruled that the contracts of corporation to be generally valid
• From Islamic perspective, permissibility to invest depends on the type
of corporation
• Two main criteria used for screening
• Sector-based
• Accounting-based
Stock Market: Sector Based Screening
• Main business of the firm should be halal
• Forbidden goods and services cannot be included in the acceptable business
activities.
• Unacceptable business activities include:
• Alcohol, tobacco, pork-related goods, pornography, conventional finance
(banking and insurance), trading in gold and silver on a deferred basis, and
entertainment (hotels, casinos/gambling, cinema, etc.).
Financial Markets: Fiqh Principle
• Financial ratios in identifying stocks
• No basis in Shari’ah (Quran & Sunnah)
• Two principles
• Juristic maxim: “The majority deserves to be treated as the whole of a thing”
• Simple majority —more than half (51%)
• Super majority —more than two-thirds (67%)
• Hadith of minority (1/3rd of will)
• “one-third, yet even one third is too much." (Narrated by Ibn 'Abbas)
Stock Market: Accounting-Based Screening
• Acceptable financial ratios related to level of leverage, cash, and
interest income
Criterion DJIM S&P
1. Total debt/24-mont Moving Average Less than 33% Less than 33%
Market Capitalisation
2. Cash and interest-bearing securities/24- Less than 33% Less than 33%
month Moving Average Market Capitalisation
3. Account receivables/24-month Moving Less than 33% Less than 49%
Average Market Capitalization
4. Non-permissible inome and other interest - Less than 5%
income/Total revenue
Sukuk - definition
• Accounting and Auditing Organization for Islamic Financial Institutions
(AAOIFI) defines sukuk as:
• “Certificates of equal value representing after closing subscription,
receipt of the values of certificates and putting it to is as planned,
common title to shares and rights in tangible assets, usufructs and
services, or equity of a given project or equity of special investment
activity”
Sukuk—Types
• AAOIFI identifies 14 types—can be broadly classified as asset-, debt-,
equity, and agency- based

Asset Based Ijarah (existing owned, existing leased, and future assets),
manfah-usufructs (existing and future assets)

Debt Based Istisna, salam, murabahah


Equity Based Murabahah, musharakah, Muzara’a (sharecropping), Musaqa
(irrigation), Mugharasa (agricultural/plantation)

Agency Based Wakala


Shari’ah Concerns Asset-based Structures
• Asset-Backed vs Asset-Based 1.Guaranteeing initial
capital
2.Sale of assets and
transfer of ownership.
3.Undertaking to buy
back assets
4.Sale and lease-back
5.Smoothing
rental/profit payments
to the expected rate
6.Sale of asset back to
originator
Shari’ah Issues and Controversies
1. Guaranteeing initial capital to investors
• Guarantee in Sukuk issues—3rd party guarantees allowed without any
charges
• Critics: Originator/guarantor and SPV same entity– guarantee of capital/return can open
doors for riba
• Supporters: SPV independent from originator, guarantee by originator is by 3rd party
2. Sale of assets and transfer of ownership.
• Sale of assets must result in actual transfer of ownership (actual vs. beneficial
ownership)
• In only 2% of sukuk (out of 560) actual sale (legal and accounting terms) takes
place
3. Undertaking of buying back assets at the selling price at
maturity/bankruptcy
• Bankruptcy—the investors sell the assets to the obligor
• The payment for assets become a debt and the investors rank pari passu with other
unsecured debtors
• The credit exposure transferred from assets to the obligor
4. Sale and lease-back structure
• If existing asset is sold—Bay' al-istighlal (a form of bai al ‘inah)
5. Smoothing rental payments to the expected rate
• If the actual return is higher than expected, the manager of sukuk keeps it as
incentive
• If the actual return is less than expected, loan is given to the investors that is
recovered later.
6. Objections to redemption/purchase of asset/shares at pre-
determined (selling) price
• Redemption/purchase of asset/shares at market price allowed
Non-banking Islamic Financial
Institutions: Inclusive IFI
IB and Microfinancing
• Islami Bank Bangladesh Ltd (IBBL) has a Rural Development Program
(RDS) to finance MSEs
• Started in 1996 and funded from IBBLs general investment fund
• As of Dec 2014, RDS operated from 244 branches, covering 18,086
villages providing financing to 911,470 clients
• Recovery rate is 99.5 percent.
• Employees involved with RDS have better benefit packages than other
MFIs
• Employees get in-house training at IBBL Training Academy
Alternative Models: Qard Hassan Funds
• Qard Hassan (QH) Funds—Iran
• First contemporary QH Fund established in 1969 at a mosque in
Tehran
• Created by philanthropic contributions
• The poor and needy can borrow funds with no-interests
• QH Funds evolved into informal NBFIs—accepts savings
Alternative Models: Akhuwat Model
• Interest free loans to groups (social collateral) and individuals with
guarantee
• Groups being phased out
• Individuals must have two guarantors
• Branches associated with mosques/church
• Loans advanced in mosques
• Charges—membership fee of 5% of loan and 1% for insurance
• Branches—302; Amount disbursed—Rs. 12. 251 billion;
• Recovery rate—99.87%
Alternative Models: Islamic Pawnshop
• Islamic pawn-broking—Ar Rahnu Scheme
• Client deposits an asset (gold) to Al Rahnu broker
• Broker charges safe-keeping fees (depends on value of the asset)
• Gives the depositor an interest free loan—uses the asset as collateral
• If the loan is repaid back along with the safe-keeping dues, the asset
is returned
• If the loan/safe-keeping dues are not paid, the asset is sold and Al
Rahnu keeps its dues, and returns the balance to the depositor
Alternative Models: Zakat, Waqf and Inclusive
Finance
• Suggestions to integrate zakat and waqf in financing to serve the poor
• 1. Cash waqf—waqf established in the form of cash
• Can be used for microfinancing

• 2. Qard hassan bank—nonprofit financial intermediary


• Capital would be cash waqf
• Will receive current accounts
• Provide qard hassan (interest free loans) for microfinancing

• 3. MFI based on awqaf and zakat


• Returns from waqf given for investment purposes and zakat funds for consumption
purposes
Alternative Models: Waqf-based MFI
• Sources of Funds (liability)
• Waqf—the corpus (endowment) has to be intact
• Obtain funds from waqf and other sources (waqf certificates, qard hasan
deposits, etc.)
• Savings deposits — mudarabah contracts
• Use of funds (assets)
• Allocation of assets into fixed income and microfinancing activities
• Qard (loan at service charges)
• Sale based and hiring modes (murabahah, salam, ijarah)
• Profit-sharing modes (Musharakah and mudarabah)
Discussion