An introduction to Islamic finance and institutions

1. Badalotti Ilaria Eddal Adil Gracco Giovanni Manente Alberto Montanari Giulia Paolicelli Ivana Puccio Alessandro Università degli Studi di Parma International Business and Development An introduction to Islamic finance and institutions International Financial Markets and Institutions

2. Purposesof the presentation 1) Make a brief overview of the Islamic financial system 2) Describe the institutions dealing IF instruments in Europe 3) Display the most important financial (banking and non-banking) instruments

3. Islamic Finance • not a geographical denomination • financial system based upon the principles of Shari’ah Islamic law = framework for everyday life for Muslims

4. Brief evidence about IF 40s political, ideological and cultural genesis within British India = idea that Islamic religion should not be just private, but has to concern every aspect of everyday life, finance included early 60s conventional birth of IF with TabungHaiji Bank (1962, Malaysia) and MitGhamr Bank (1963, Egypt) early 70s extremely slow development of Shari’ah-based finance 1975 foundation of the Islamic Development Bank by OIC (Organization of Islamic Conference), with the aim of promoting economic and social development since then IF becomes more and more important and some countries (e.g. Pakistan, Iran, Sudan) “islamize” their whole banking system

5. Figures about IF Islamic Finance displays a turnover equal to nearly 1 trillion $, with average growth rates around 15-20% per year It is fair to say that Islamic Finance has gone global, with 300 institutions covering more than 65 countries

6. The sixbasicprinciples • Prohibition of usury (riba) • Ban on hazard and uncertainty (gharar) • Risk- and loss-sharing between lender and borrower • Promotions of ethical investments and prohibition of forbidden assets (haraam) • Real asset-backed finance • Disclosure of information as a sacred duty

7. The sixbasicprinciples • Prohibition of usury (riba) • fundamental and most widely known principle • any level of interest is considered to be usurious and is prohibited, in contrast with the conventional forms of finance • Ban on hazard and uncertainty (gharar) • uncertainty in contractual terms and conditions is not allowed • in a financial transaction, all the terms and conditions of risk must be clearly understood by all parties

8. The sixbasicprinciples • Risk- and loss-sharing between lender and borrower • prevent an uneven distribution of risks and losses • risks and profits of the business are proportionally shared between the two parties • Promotions of ethical investments and prohibition of forbidden assets (haraam) • principle of almsgiving (zakat) • prohibited activities reprehensible from an ethical or religious stand point: alcohol, pornography, gambling, leisure industry (music, cinema, etc), finance industry and pork-based products

9. The sixbasicprinciples • Real asset-backed finance • each financial transaction must be tied to a “tangible, identifiable underlying asset” • strict link between finance and real economy • Disclosure of information as a sacred duty • transparency intended as a form of sanctity of contracts • feature intended to reduce the risk of asymmetric information and moral hazard, common problem on the financial markets

10. Islamic banking – whatisit? • Islamic banking refers to a system of banking or banking activity that is consistent with the principles of the Shari'ah (Islamic rulings) and its practical application through the development of Islamic economics. • It has the same purpose as conventional banking except that it operates in accordance with the rules of Shari’ah, known as Fiqhal-Muamalat(Islamic rules on transactions). • The principle source of the Shari’ah is The Qur’an followed by the recorded sayings and actions of Prophet Muhammad (pbuh) – the Hadith. Where solutions to problems cannot be found in these two sources, rulings are made based on the consensus of a community leaned scholars, independent reasoning of an Islamic scholar and custom, so long as such rulings do not deviate from the fundamental teachings in The Qur’an.

11. Commercial banks in muslimlands • When the Muslim world came into contact with the West, Muslims had two choices: • To accept commercial banking, arguing that the interest charged by them did not contain the element of riba prohibited in the Qur'an; or, • To accept that interest charged was riba and try to develop an alternative system of banking. • But ancient Muslim institutions, such as the Shari'ah courts, had been made ineffective by the colonial powers. Muslims had no alternative but to work with the colonial institutions, including commercial banking.

12. Commercial banks in muslimlands • Nevertheless, during the 19th century, several religious scholars argued that the term riba referred to loans for consumption, which people found it difficult to repay, and not to commercial banking loans, where the debtor can repay from the profits. • But the Qur'an makes no distinction between loans for consumption and loans for productive purposes. So their views were rejected. As a consequence, modern commercial banking did not make much headway in Muslim countries and to this day the presents of the conventional framework still dominates the national financial system.

13. How the monetary and banking system would function if interest were abolished by law? • In 1963, in MitGhamr, in Egypt, the first Islamic interest-free bank came into being. • The tasks were: • To respect Islamic values concerning interest. • To educate the people about the use of banking. • Types of accounts accepted: • Savings accounts; • Investment accounts; • Zakataccounts; • The MitGhamr project was successful (deposits increased, default ratio equal to “0”,) • But project was eventually abandoned for political reasons. Nevertheless, it had shown that commercial banking could be organised on a non-interest basis.

14. Islamic Finance in Europe • The development of Islamic financial services in Western Europe . • The Netherlands: • a limited number of Islamic finance transactions have been undertaken in the Netherlands; • limited number of retail asset management products; • the majority of transactions are associated with real estate and private equity investments. • France: • introduction of Islamic Finance instruments was due to historic ties with northwest Africa and the size of the Muslim population in France; • IF products that are offered in France are undertaken from French banks operating in the Middle East.

15. Islamic Finance in Europe • Germany: • The introductionof IF instrumentsis due to the sizeofMuslimpopulation in Germany; • Theseproducts are offeredbybranches in the UK or in ME ofGermanBanks. • The UK: • the UK isby far the mostadvancedcountry in developing IF; • had recognized the importance of IF as part of the overall financial industry; • there are fully Shari’ah compliant banks and banks opening a “operating window” to offer IF instruments.

16. Financial bank InstrumentsGeneral INVESTMENT PRODUCTS Non-profit accounts “quard”(housing function): Small amounts withdrawable ( no notice needed) No interest payouts The borrower owns the funds The bank acts on behalf of the borrower The capital is refunded

17. Financial bank instruments Non-profit accounts Current accounts “al-hisab al-gari”: The bank can invest the funds on behalf of the investor The refund of the capital is guaranteed At the end of the financial year, possibility for the investor to get gifts in kind or privileged credit conditions Saving deposits “hisab al-tawfir”: Operations are registered on a bank book [daftar]

18. Financial bank instruments Profit sharing accounts & Mixed accounts Profit sharing accounts“hisabat al-mustaraka”(investment function): Minimum amount as entry requirement Periodic withdraws (notice is compulsory) The bank owns the funds and the borrower shares with it profits and losses Investment accounts “hisabat al-istihamar” Payouts are proportionally computed according to the profits of the investment Mixed accounts

19. Financial bank instrumentsProfit-loss sharing FINANCE PRODUCTS Bank’s Liabilities Profit-loss sharing (PLS) Risk sharing Collaterals not used as guarantees Most common types:

20. Trust financial contract “mudaraba”: The bank finances the investor’s project Risk sharing (on a fixed percentage base) The investor contributes with his managerial skills and work and he will be paid only with the investment’s profits Clausula “rebus sic stantibus” Equity partecipation contract “musharaka”: Partnership (bank – entrepreneur) Risk sharing Decreasing contract “musharaka mutanaqisa” : for craftsman and small enterprises The bank’s share of profits decreases year by year until zero The entrepreneur’s share of profits increases until the total amount of capital Financial bank instrumentsProfit-loss sharing

21. Agriculture trust financial contract “muzar’ah”: Like mudaraba for agricultural activities Profits divided between the two parties Losses taken by the lender Agriculture equity partecipation contract “musaquat”: Like musharaka for agricultural activities Profits divided between the two parties according to the share owned Bond investment “mugarada” The bank buys mugarada bond to finance a specific project (becomes a shareholder with no right to vote) Financial bank instrumentsProfit-loss sharing

22. Financial bank instruments Non profit-loss sharing Non profit-loss sharing (non PLS) + Mark-up Mark-up application on exchanges Is used only when PLS instruments can’t be applied Determined return and collaterals Most common types:

23. Financial bank instrumentsNon profit-loss sharing Commercial credit contract “murabaha” mark-up financing: The bank buys a good at a given price and sells it to the borrower at a major price (immediate or delayed payment) The borrower acts on behalf of the bank and proceeds to purchase the good, providing a collateral to the future repayment The bank owns the good until the borrower’s payment covers the majored price of the good Periodic commercial credit contract “bay’mu’aggal”: The same as murabaha but with a defined periodic payment

24. Financial bank instrumentsNon profit-loss sharing Purchase differed delivery contract “salam”: The bank anticipates goods’ payment to the manufacturer and the goods are delivered within a certain deadline The bank makes its perfomance immediately while the customer at the end

25. Financial bank instruments Non profit-loss sharing Leasing contract “ijara” Operating leasing “ijara”: the transfer of the usufruct with fixed periodic payments Financial leasing “ijara-iqtina” gives the possibility to the borrower to take title of the good after the payment’s period Trilateral relationship: producer-seller, lender-lessor [mu’aggir], user-lessee [musta’gir] The lender shall give to the future landlord the mandate to choose, in behalf of the lender, the property covered by the contract, defining features and price

26. Sukuk market Sukuk: Islamic Bond compliant with Shariah law,which pays a return based on tangible assets instead of an interest rate (asset-backed). Each sukuk-holder owns a fraction of the entire ownership of the good and he gains a periodic rent, that are the profits derived from the project.

27. Sukuk market 14 Eligible Asset Classes according to AAOIFI are: SUKUK AL-IJARAH SUKUK AL-ISTISNA’A SUKUK AL-MURABAHA SUKUK AL-MUSHARAKA SUKUK IJARAH MOWSUFA BITHIMA SUKUK MANFAA IJARAH SUKUK MANFAA IJARAH MOWSUFA BITHIMA SUKUK MILKIYAT AL-KHADAMAT SUKUK AL-SALAM SUKUK AL-MUDARABA SUKUK AL-WAKALA SUKUK AL-MUZRA’A SUKUK AL-MUSAQA SUKUK AL-MUQARASA Actual Size of the Market ~ USD 53 Billion

28. Sukuk market –Types Most common types of Sukuk are: Ijarasukuk: ownership of equal share in a rented real estate the sukuk-holder owns the real estate and receives the rent holder bears all costs (mantainance + damage) Fixed or floating rent Tradable on the secondary mkt

29. Sukuk market –Types Musharaka sukuk: ownership of musharaka equity Used for new or existing projects (businesses on partnership basis) Holder owns the project Tradable on the secondary mkt Istisna’ sukuk: Mobilizing funds required for producing products that are owned by the certificate holder (financing large infrastructure projects) Holder owns the product and is entitled to the sale price of the certificates Non tradable in the secondary mkt

30. Sukuk market –Types Murabaha sukuk: Issuer is the seller of the murabaha commodity Subscribers are the buyers of the commodity Holder owns the commodity and receives the final sale price upon re-sale of the commodity Non tradable on the secondary mkt (represents a debt)

31. INSURANCE The insurance has developed in Islamic countries since 1985, when the Islamic Fiqh Academy has determined that insurance is acceptable from a religious point of view. Islamic insurance, known as takaful ( التكافل), is based on the principle of mutuality: partecipants choose to collectively protect themselves from some risks by giving its resources in a collective fund.

32. Principles of Takaful • Policyholders cooperate among themselves for their common good • Every policyholder pays his subscription to help those that need assistance • Losses are divided and liabilities spread according to the community pooling system • Uncertainty is eliminated in respect of subscription and compensation • It does not derive advantage at the cost of others • Takaful fund can be used both to manage the damage insurance (takaful general) and the life insurance (takaful family).

33. Family Takaful This type is characterized by the coexistence of two separate funds: • The first part, which takes the form of a donation (tabarru), converges in a risk fund, used to carry on the insurance activities • The second part, which is insured property, gives rise to a financial investment that will be paid to the insured upon the occurrence of some terms of the contract (such as death, retirement..)

34. Qard Hasan If the risk fund is not sufficient to make the payments Qard Hasan It is a free loan, granted by a management company , which will be repaid (without interest) with the surplus in the future.

35. Models of Takaful The funds described above are managed by a professional, paid according to different contractual models: • Mudarabah model the takaful operator conducts all the activities , bearing the costs, in exchange for a portion of the profits investment.

36. Models of Takaful • Wakalah model is the most common form of takaful: the operator conducts all the activities with a commission which covers the costs, so his profit is fixed • Mixed model Mudarabah is used for the management of the investment fund while Wakalah is used for the management of the risk fund

37. Shari’ah board The uniqueness of Islamic insurance is also characterized by the presence of Shari’ah board a council of teachers of Koranic law that ensures, with veto power on all the activities of the takaful company, ensuring and certifying that the activities are in accordance with Qur'anic law

38. SHARES The Islamic world has accepted the organization company of big business, based on the collection of large amount of capital on the stock markets. There are currently around 150 Islamic funds. Most of them follow the Dow Jones Islamic Market Index of the New York Stock Exchange, which is under the supervision of a Shari’ah board of scholars.

39. SHARESListed companies defined as "halal" Companies which have to do with alcohol, tobacco, pork products, gambling, pornography, night-clubs or armaments are out, as well as banks and insurance companies which are based on interest. Even airlines or hotels may be avoided, since they offer alcohol to their guests. In addition, it is forbidden to invest in companies with more than 33 percent outside capital.

40. SHARESStrict rules.. A potentialobstacleto the properfunctioning of stock markets is the right, under Shari’ah law, of shufaah (pre-emptive right), including the right of preference of the membersnotonly in the case of capital increase, butalsowhen a memberdecidestowithdraw from society. However, observers note that the rigour with which these rules are applied has meant that Islamic Funds have avoided the major bankruptcies of recent years, such as Worldcom or Parmalat. That has saved them from substantial losses.

41. INVESTMENT FUNDS Islamic banks, according to the principles of Sharia law, can manage the funds collected from customers for investment purposes. The collection of funds to be used in individual projects, is carried out through investment accounts (hisabat) or funds (amwal), or through the issuance of securities (sanadat),with participation in annual net profit realized.

42. INVESTMENT FUNDS Certificates are most often issued by the bank itself, which thus has the dual purpose of providing means of investment to investors and raise capital with which to finance the projects. The issuance of certificates is often related to a transaction type "insurance" which addresses the need to pursue a goal of solidarity between the parties (takaful).

43. INVESTMENT FUNDS The contract is concluded on the one hand by the participants and on the other by the manager, the company that manages the money raised through the issue of certificates. Objectives of this kind of operations are to increase private savings, to invest it in accordance with the rules of sharia, and to promote solidarity among participants.

44. Islamic investmentFunds • Equity Fund the amounts are invested in the shares of joint stock companies. The profits are mainly derived through the capital gains by purchasing the shares and selling them when their prices are increased. Profits are also earned through dividends distributed by the relevant companies. • Ijarah Fund In this fund the subscription amounts are used to purchase assets like real estate for the purpose of leasing them out to their ultimate users. These certificates may preferably be called ‘sukuk’

45. Islamic investmentFunds • Commodity Fund In the fund of this type the subscription amounts are used in purchasing different commodities for the purpose of their resale. The profits generated by the sales are the income of the fund which is distributed pro rata among the subscribers. • Murabahah Fund ‘Murabahah’ is a specific kind of sale where the commodities are sold on a cost-plus basis. Islamic banks purchase the commodity for the benefit of their clients, then sell it to them on the basis of deferred payment at an agreed margin of profit added to the cost.

46. Islamic investmentFunds • Mixed Fund Another type of Islamic Fund may be of a nature where the subscription amounts are employed in different types of investments, like equities, leasing, commodities, etc. This may be called a Mixed Islamic Fund

47. An introduction to Islamic finance and institutions Università degli Studi di Parma International Business and Development Thankyouforyour kindattention Badalotti Ilaria Eddal Adil Gracco Giovanni Manente Alberto Montanari Giulia Paolicelli Ivana Puccio Alessandro