Introduction to Islamic Finance Its Concepts, Models, Growth and Opportunities Rachid Ouaich

1. Introduction to Islamic Finance Its Concepts, Models, Growth and Opportunities Rachid Ouaich November 2012

2. Contents • The Islamic Finance overview and related core principles • The Islamic Financial instruments • Legal and Tax structures • Accounting, auditing, reporting and compliance principles • Our services • Questions Introduction to Islamic Finance

3. The Islamic Finance overview and related core principles • Islamic Finance Markets highlights • Chronology of modern Islamic Finance • Sharia Structure • Sources of guidance of Islamic Financial Operations • Concept behind Islamic Finance : principles • Supranational authorities governing Islamic Finance • Special feature: Sharia board Introduction to Islamic Finance

4. The Islamic Finance Markets - highlights • Estimated growth rate of 15-20% per annum. • Sharia compliant assets have reached US$ 1.3 trillion by end of 2011. • Islamic assets close to reach 2% of global financial assets • Industry’s total assets and overseas portfolios estimated to reach US$ 4 trillion by 2020. • Global sukuk volume is estimated to reach US$ 140 bn at year-end 2012 • Malaysia remains the biggest Sukuk Market Introduction to Islamic Finance

5. The Islamic Finance Markets - highlights • 56 Islamic countries member of Islamic Development Bank (IDB) • Leading Islamic Finance centres : Bahrain, Dubai/UAE, Kuala Lumpur, Riyadh, Qatar, Singapore, London, Luxembourg • More than 500 Islamic financial institutions operate worldwide in some 75 countries • Top management of Islamic banks not confined to Muslims countries but spread over Europe, the United States, the Far East and the Middle East • In the aftermath of September 11, 2001, there has been a flight of Islamic Capital from the USA to Europe, Asia and also back to the Middle East Introduction to Islamic Finance

6. Chronology of modern Islamic Finance • 1963 : Egypt interest free saving banks, not overtly islamic – invested in trade and industry on the basis of share in profits • 1971 : Egypt Nasr social bank • 1973 : conference of Islamic countries finance ministers • 1975 : Islamic Development Bank, Jeddah, fee based and PLS, revolving capital • Dubia Islamic Bank, UAE, first Islamic commercial bank in the world • 1970 : Development in the Gulf (Bahrain, Kuwait), Asia (Malaysia, Philippines and Africa (Nigeria, South Africa) : • Faisal Bank of sudan and Egypt • Bahrain Islamic Bank • Indonesia Islamic Finance House • Al Rahji London • HSBC Amanah Introduction to Islamic Finance

7. Sharia structure Introduction to Islamic Finance

8. Sources of Guidance of Islamic Financial Operations • Compliance with Sharia that is derived from three sources : • QURAN (Primary source of Sharia) • SUNNAH (Practices of the Prophet) • IJMA’ (Consensus) • QIYAS (Analogy) • IJTIHAD (reasoning of a group of qualified scholars, which is aimed at adapting Islamic rules to the contemporary world) Introduction to Islamic Finance

9. Quran • Primary source for discerning the laws of God • Binding to Jurists to have the first recourse to the QURAN for answers • Evidence found in other sources are subject to the QURAN • Example : « God has permitted trade and prohibited Riba » Reference : Surat Al Baqara verse 275 Introduction to Islamic Finance

10. Sunnah - Literally means : « Well-known path »  - Words or Acts of the Prophet - Sayings of the Prophet (SAW) used to lay down and give moral guidance - Acts of the Prophet (SAW) which have a legal content (ex: method of praying) - Tacit approval (silence) of the Prophet (SAW) on the action of one of his companions in his presence or in his knowledge Introduction to Islamic Finance

11. Ijma’ - Literally means agreement on a matter - In its technical sense, it means « the consensus of the independant jurists from the Ummah of the Prophet Muhammad (SAW) after his death - Example : Jurists have reached a consensus (Ijma) that the selling of goods by an party who doesn’t own the goods and without the approval of the goods’ owner is void Introduction to Islamic Finance

12. Qiyas - Literally means measuring or estimating one thing in terms of another - Technically, it is the assignement of the legal rule of an existing case found in the texts of the QURAN, the SUNNAH, or IJMA’ to a new case whose legal rule is not found in these sources. - Example : « Jurist looked into details of the prohibition of alcohol. After analysis, it was decided that the underlying reason is intoxication . Once this has been defined, the scholars would look at other liquids that intoxicate and extend the legal rule » Introduction to Islamic Finance

13. Ijtihad - Number of meaning of Ijtihad - Islamic scholars take into account the customs of a place that adress a problem but are not offensive to Sharia - In some cases, Islamic Scholars develop their own preference from a solution to an apparently unique problem - Fundamentaly, it is a personal exercise until other scholars are able to agree with the solution proposed by the innovator. Introduction to Islamic Finance

14. Authorities on interpretation - Four different schools of jurisprudence make up the SUNNI world of Islam : - Maliki : North Africa - Hanbali : Saudi Arabia and Gulf region - Hanafi : Eastern Europe and Turkey - Shaafi’ : Malaysia and South east Asia - While the Shia world follow their own seperate schools (Mainly Irak and Iran) - The Islamic Fiqh academy (created in 1981 by the Organisation of Islamic Countries) is a body which meets periodically to discuss issues originated from Islamic thinking - Sharia scholars or Sharia Board Introduction to Islamic Finance

15. Islamic Finance Principles - Concept • No intrinsic value in money : • Money as a way of exchange and a store of value not subject to trade • Fundamental principle : • Risk sharing partnership => Profit and Loss Sharing (PLS) • basically, no pain no gain Introduction to Islamic Finance

16. Islamic Finance Principles - Rationales • Sharia Compliant Transaction Introduction to Islamic Finance

17. Islamic Finance Principles – Riba • - Literally means « excess » • - Prohibition of payment/receipt of Riba interest as incremental of debt - 2  types of Riba : - Primary form : Riba al Naseeyah => Excess resulted from predetermined interest which a lender receives over and above the principal amount - Second form : Riba al Fadl => Excess compensation without any conisderation resulting from an exchange or sale of goods (exchange of commodities contracts) Introduction to Islamic Finance

18. Islamic Finance Principles – Ethical dimension • - Undesirable sectors : • Tobacco • Alcohol • Arms or munitions • Gambling • Pornography • Conventional financial services - Charitable aspects : • Interests donated to charity (cleansing / purification) • Zakat – charitable tax paid by muslims according to Quranic guidance Introduction to Islamic Finance

19. Islamic Finance Principles – Gharar and Maysir - Gharar literally means « overall uncertainty » - Maysir means « gambling » - May be defined as preventable ambiguities or omissions in contracts => ex : Buying a house , the price of which need to be specified in the future or price is fixed but specification is to be defined in the future - Consequence of this principle : Buying and selling in most types of derivatives products for any purpose including speculation is strictly forbidden Introduction to Islamic Finance

20. Islamic Finance Principles - Contracting - Aqd litterally means contract - Majority of scholars defined the following requirements : • Contracting parties (Mature and sane) • Subject Matter (Valuable, Existence, Ownership, Ability to deliver, Specific) => consequence : speculation like short selling is forbidden • Offer and acceptance : consent of the parties is fundamental element in concluding a contract • Price : should not be uncertain or depending on future events - Classification of contracts : • Sahih litterally means « valid » which could be either : • Nafiz : enforceable • Mawqoof : unforceable until authorized • Fasid : voidable • Batil : invalid Introduction to Islamic Finance

21. Implications => All products need to be approved by the Sharia scholars This may have sevral implications : Costs Timing Latitude of flexibility Islamic Finance Principles - Implications Introduction to Islamic Finance

22. Basic Difference between Islamic and Conventional Modes of Finance Islamic finance Goods Goods Goods Goods Goods Buyer Client Bank Supplier Sale : 100 Sale 2 : 110 Sale 3 : 100 Credit sale or Murabaha Introduction to Islamic Finance

23. Special feature : Shariaboard • One distinct feature of the modern Islamic banking movement is the role of the Shariaboards • boards made up of Islamic jurists and scholars available to an Islamic financial institution for guidance and supervision in the development of Sharia compliant products, which have to approve all transactions : • Sharia board ensures that investments structures are in line with Islamic law • Sharia board has the responsibility of laying down the underpinning Sharia principles and rules that the institution should adhere to • Sharia board Publish annually, a report concerning the level of Sharia'a compliance of the entity • The Sharia Board is not responsible for: • Shareholders’ money • Funds operation management • Funds portfolio management Introduction to Islamic Finance

24. Supranational authorities governing Islamic Finance • - AAOIFI (1991) : Accounting and Auditing Organisation for Islamic Financial institutions => Benchmark of islamic accounting and auditing standards (56 standards) • - IFSB (2002) : Islamic financial Services Board => Standard setting body of regulatory and supervisory agencies (complementing BASEL II Capital Accord) • - IIFM (2001) : International Islamic Financial Market => Development of Global Islamic capital and money market • - GCIBFI (2001) : General Council for Islamic Banks and Financial Institutions => Promoting industry in theory and practice • - LMC (2002) : Liquidity Market Council => Creation of active Islamic inter-bank market • - IIRA (2005) : International Islamic Rating Agency => Rating of Islamic Financial institutions Introduction to Islamic Finance

25. The components of the Islamic Banking and Finance industry • 1) Banks - Investment & Investment management => ex : BLME, Bank Al Khair, NBAD - Generic Banking services (current accounts, transfers, credit cards, home finance, etc.) => ex : HSBC Amanah, Islamic Bank of Britain • 2) Equity and Capital Markets • 3) Insurance companies : Takaful Introduction to Islamic Finance

26. Operating structures of Islamic Banks • 1) Window model • => Operating structure where a conventional bank simultaneously carries out Islamic Financial activities but assure clients of segregated accounting and operations for conventional and islamic activities (ex : BNP Paribas Bahrain) • 2) Branches • => Similar to window model but services are offered through dedicated channels • 3) Subsidiaries • => Seperate legal entity (subsidiary) set up specifically to undertake Islamic Financial services activities – Formulate and manages its own policies • 4) Fully-fledged islamic banks • => Pure Islamic banks which offers only Islamic Financial services Introduction to Islamic Finance

27. Assets Cash & equivalents Murabaha financing Mudarabah financing Musharakah Financing Sukuk Assets for trading (securities, inventory,other assets) Invetsments (not for trading) Other assets Fixed asets Balance Sheet of an Islamic Bank Liabilities • Customer current accounts (not remunerated) • Due to banks and financial institutions • Payables • Other liabilities • Sukuk issued • Profit sharing Invetsment Account (restricted vs unrestricted) • Equalization reserve • Share Capital & Reserves Introduction to Islamic Finance

28. The Islamic Financial instruments • Islamic monetary instruments • Islamic debt-like instruments • Islamic asset-like instruments • Hybrid Islamic Finance instruments • Takaful (Insurance) Introduction to Islamic Finance

29. The Islamic Financial instruments Introduction to Islamic Finance

30. Islamic Monetary instruments - Current accounts - Term deposits or PSIA (Profit Sharing Investment Account) - Tawarruq - Arbun Introduction to Islamic Finance

31. Islamic Monetary instruments – Current accounts • - Used for day to day cash management. No return is paid to depositors - Used for higher return savings account - Banks may sometimes pay a return, depending on their own profitability. - Losses are not in practice passed on to depositors and are absorbed trough the banks’ reserves - 3 forms : - Amanah form (applied globally) => entrusted to the bank for safekeeping and should e returned in whole - Wadia form (applied in Malaysia) => Wadia is a promise to return the money to the depositor - Qard hassan => loan without interest or yield between the client and the bank - Complete segrergation of funds and no overdrat facility on these acounts Introduction to Islamic Finance

32. Islamic Monetary instruments – Term deposits or PSIA • - PSIA = Profit Sharing Invetsment Account • => These are specific to Islamic Finance industry - Considered as investment accounts under the mudaraba format => Islamic banks receive funds from the PSIA holders who place their funds on the basis of the mudaraba profit and loss sharing bearing account - Deposits are fixed term and cannot be cashed in before maturity (some exceptions) - The profit-sharing ratio varies between institutions and could be a function of the banks profitability or that of the portfolio of end borrowers - Can be Restricted or Unrestricted - Application of equalization reserves Introduction to Islamic Finance

33. Islamic Monetary instruments – Term deposits or PSIA - Restricted : - Like collective investment scheme - The asset allocation is restricted as set out in the contract - No secondary market butinvetsors may be able to to withdraw their funds (including unredistributed profits but less any losses) before maturity with the agreement of the bank - The scheme is not a seperate legal entity but operates as a mudaraba agreement (bank = mudarib and client = rab al mal) - The bank is entitled to a percentage of the invetsment income for a financial period as its fee for investment management but does not share in any periodic losses Introduction to Islamic Finance

34. Islamic Monetary instruments – Term deposits or PSIA - Unrestricted : - The asset allocation is not restricted by contract. The bank as a mudarib will place the funds in any Sharia compliant investment at its sole discretion. - Less risky than the restricted PSIA as the bank tries to mitigate the risk by placing money in a basket of Sharia compliant investments - Lack of transparency - Corporate governance issue as the funds from the holders are co- mingled with other funds at the baks disposal => possible conflict interests with regard to the choice and riskiness of investments and the allocation of the income from those investments - Different applications in different countries Introduction to Islamic Finance

35. - Contract whereby the bank sells to its client a commodity with a forward payment (also called reversed murabaha) - The client sells it immediately to a third party on spot generating therewith some cash availabilty - Usually no exposure on market to the price risk fluctuation of the commodity as actions (i) to (iv) are undertaken simultaneously Islamic Monetary instruments – Tawaruq Introduction to Islamic Finance

36. Islamic Monetary instruments – Arbun • - Pre-purchase of right to acquire asset : • - Deposit/down payment for the purchase of an asset at a later date which will be kept by the seller in case the sale does not happen. This down payment constitues a part of the purchase price and thus is not refundable. - Because of its similarity to an option, it has met with varying levels of approval from the school of islamic jurisprudence - Usually combined with a murabaha product - Most acceptable to Hanbali scholars Introduction to Islamic Finance

37. Islamic Debt like instruments - Murabaha - Ijara - Salam - Istisna Introduction to Islamic Finance

38. Islamic Debt like instruments - Murabaha • - Literally means « profit » • - Contract where the bank upon request by the customer purchases the asset from a third party and resells it to the customer on a deferred payment basis - Sale of goods at cost plus an agreed profit mark up - Difference between a murabaha and a loan : • The bank must have some form of actual ownership constructive or physical • The maturity can be extended but may not result in an increase in the mark-up or a penelaty fee. Any of these would violate the basic principle riba • If the payment is late, no form of penalty may be charged for the profit of the creditor (even though a tird party colection agent can recover costs of collection Introduction to Islamic Finance

39. Islamic Debt like instruments - Murabaha Introduction to Islamic Finance

40. Islamic Debt like instruments – Commodity Murabaha Introduction to Islamic Finance

41. Islamic Debt like instruments – Commodity Murabaha • 1. Islamic bank instructs the conventional bank as agent to invest say US 10 million for one month. • 2. The conventional bank buys a commodity from a broker A, value spot on behalf of the Islamic bank. • 3. The conventional bank sells the commodity at cost plus mark-up on a deferred payment basis (one month) to Broker B. Buying and selling is very fast (less market fluctuation exposure) • 4. On maturity (in one month) the conventional bank pays to the Islamic bank profit (mark up) plus the original investment of US 10 million. • 5. Commission will be payable to the conventional bank as agent (approximately 25 basis points) and to the commodity brokers (approximately $50 per 1 million of the commodity) on buying and selling the commodities. These commissions will be built into the price quoted to the Islamic bank are not accounted for separately. • 6. The mark-up is typically based on the LIBOR as a benchmark which makes these transactions comparable to traditional interbank deposits. Introduction to Islamic Finance

42. Islamic Debt like instruments – Ijara • - literally means to give something on rent. • - Ijara contract is an agreement wherein a lessor (mu’ajjir) leases physical asset or property to a lessee (musta’jir) who receives the benefits associated with ownership of the asset against payment of predetermined rentals (ujrah). Ijara is for a known time period called ijara period. • - utilized by banks as a mode of financing to provide the customers with short to medium-term financing to lease • - Ijara is comparable (but not identical) to conventional leasing contract. - Ijara is less risky as compared to other financing structures - Liability is known from day one – No surprises or uncertain exposure. • - Strict compliance with Sharia and the applicable law is required for enforceability. Introduction to Islamic Finance

43. Customer Step 5 Lease of the Property to the customer through Lease Agreement Usufruct of the Property Owner / Developer Step 1 Promise to lease Step 3 Acquisition of the Property through purchase agreement Step 6 Lease Rental Step 4 Purchase Price Step 2 Purchase Offer Title & Possession to the Property Islamic Bank Islamic Debt like instruments – Ijara Introduction to Islamic Finance

44. Islamic Debt like instruments – Ijara • Ijara: 3 types • Simple Ijara (Operating lease) • Ijara Muntahia Bittamleek (Finance lease) • Ijara Mawsoofa Bil Thimma (Forward lease) • Simple Ijara : • Commonly known as operating lease. Also called a service lease, or a true lease. • It is a short-term arrangement. • Full cost of the equipment or property is not amortized during the primary lease period. • Lessee may cancel the lease any time he wishes to do so, with a prior notice according to the contract. • In an Ijara, the title of the equipment or property always remains with the lessor irrespective of how much the lessee has paid out as lease installments. Consequently, the risks and responsibilities of ownership are always borne by the lessor. • Ownership of the asset remains with the lessor (bank), the asset reverts to the bank at the end of the lease period. The bank may then lease it out to another customer if the asset is in good shape. Introduction to Islamic Finance

45. Islamic Debt like instruments – Ijara • Ijara Muntahia Bittamleek • commonly known as financial lease • Also called “Ijara-thumma-al-Bay‘” (lease-sale) or "Ijara-wa-Iktina'a" • The lessee is offered the option of ultimately purchasing the asset or property at the end of Ijara period at a predetermined price. • Full cost of the asset or property is amortized during the lease period. • Can not be cancelled except if the lessor is compensated for any losses. • The bank remains the owner till the very end bearing all the risks and responsibilities • The customer is responsible for only the rentals as long as he uses the equipment or property. He becomes the owner only if, and when, he exercises his option • This Ijara involves two different contracts to be executed at two different stages : • First a leasing contract (ijara) with a unilateral promise (wa’ad) to sell the asset to the customer at a predetermined price. • Once the lease expires and lessee has made all payments, the lessor is obliged to fulfill his promise to sell by executing the contract of sale (bay’) • the sale contract is independent of the ijara contract. Introduction to Islamic Finance

46. Islamic Debt like instruments – Ijara • Ijara Mawsoofa Bil Thimma • Commonly known as forward lease • Lease of specified items which are to be delivered after manufacturing or construction • Lease of the underlying assets starts on the date of delivery of the asset to the lessee and the lessee’s obligation to pay rental triggers with the commencement of the lease. • An investor receives return on its investment out of the amount received from the lessee on account of rental which is adjusted against the actual rental. • Although investment in assets under construction through may not be free from certain downsides, it still has potential to serve both the parties, i.e. customer and financier – addressing the Project Financing requirements. • Appropriate structure for project financing Introduction to Islamic Finance

47. Islamic Debt like instruments – Ijara vs Murabaha - Ijara, like murabaha is a debt-based financing. In both cases, the bank is not a natural owner of the asset (sold under murabaha or given in lease under ijara.) It acquires ownership upon receiving a request from its customer. • - Similar to murabaha, the ijara rentals are also paid in installments over time to cover the cost of the asset or value of investment for the bank plus a fair return on investment. • - In ijara, ownership of property is not transferred throughout the ijaraperiod while the customer receives the benefits of using the asset. • - In murabaha on the other hand, the benefits and risks of ownership of the asset are transferred to the customer along with ownership. - Both products involve cash outflows for customer or cash inflows for the bank over a definite future time period. Those flows are cover the cost of the asset and provide for a fair return on the asset to the bank. • - However, these cash flows are predetermined in case of murabaha and no subsequent increase or decrease is allowed. In case of ijara, however, the rentals could be flexible and be made to reflect the changing economic and business conditions Introduction to Islamic Finance

48. Islamic Debt like instruments – Ijara vs Murabaha • Different reasons why a customer will choose ijara (leasing) rather than murabaha (borrowing) from the bank to purchase the needed asset. • 1. It is easier to lease than borrow for short-term needs. • 2. To avoid different types of risk • 3. Ijara mostly do not require credit evaluation. • 4. Gives more freedom of changing equipment as technology advances • 5. Easier to get finance through leasing for companies with credit standing; these kinds of companies may not be able to borrow from banks or the public and if they do, have to pay high rate of interest. • 6. In many cases, leases can be advantageous from taxing point of view. Since equipment leased remains the ownership of the lessor and hence the lessor pay the taxes. • 7. In many countries, leasing is an off-balance-sheet financing. The asset itself is kept on the lessor's balance sheet, and the lessee reports only the required rental expense for use of the asset. Introduction to Islamic Finance

49. Islamic Debt like instruments – Salam • Purchase or sale of a commodity for deferred delivery in exchange for immediate payment Introduction to Islamic Finance

50. Customer Step 5 Sale of the described Property on Parallel Istisna basis Delivery to the Customer after at completion Owner / Developer Step 1 Promise to Purchase on Parallel Istisna basis Step 3 Purchase of the described Property through Istisna Agreement Step 4 Istisna Purchase Price Step 6 Parallel Istisna Purchase Price Step 2 Purchase Offer Delivery of the described Property after completion Islamic Bank Islamic Debt like instruments – Istisna Introduction to Islamic Finance