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Advanced Diploma in Islamic Finance

A global product for a diverse world

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CIMA Advanced Diploma in Islamic Finance A global product for a diverse world

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Chartered Institute of Management Accountants (CIMA) 26 Chapter Street, London SW1P 4NP, UK T. +44 (0)20 8849 2287 F. +44 (0)20 8849 2450 E. if@cimaglobal.com www.cimaglobal.com Second edition 2011 Published by Global Trade Media, a division of SPG Media Ltd

CIMA Advanced Diploma in Islamic Finance: ISBN 978-1-85971-634-2 Copyright Š2011 CIMA All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, photocopying or otherwise, without prior permission of the copyright owner. No responsibility is assumed by the copyright holder for any injury and / or damage to persons or property as a result of products liability, negligence or otherwise, or from any use or operation of any methods, products, instructions or ideas contained in the material herein. Whilst every effort has been made to ensure the accuracy of the information in this publication, neither CIMA nor SPG Media Limited accept responsibility for errors or omissions. Printed by Williams Press

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Contents

Contents CIMA Advanced Diploma in Islamic Finance How to use this guide

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What is finance?

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Introduction

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Authors

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Chapter one Application of contracts in the structuring processes of Islamic financial products

22

Chapter two Structuring process and related challenges in the Islamic financial services industry

48

Chapter three Regulatory and prudential requirements and the supervisory review process for Islamic banking and financial products

74

Chapter four Structuring deposits, investment accounts and money market instruments

100

Chapter five Structuring financing facilities for working capital and consumer financing

126

Chapter six Project financing: structures and strategic considerations

160

Chapter seven Equity market regulations and issues of screening methodology for public-listed companies

188

Chapter eight Structuring and strategic issues for Islamic funds

220

Chapter nine Sukuk structuring and rating methodology

250

Chapter ten Takaful models and issues of legal and rating requirements

284

Chapter eleven Retakaful and retro-Takaful operations and industry in the global Retakaful market

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Chapter twelve Islamic derivatives as risk management tools for the Islamic financial services industry

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Conclusion

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Bibliography

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Sample examination

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Glossary of terms and contracts

390

Index

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How to use this guide

How to use this guide

Realising your potential with this study guide as a learning companion We at CIMA want you to succeed in your studies and to use this success to your own advantage and to that of your current or future employers. Regardless of how interested you are in the subject, distance-learning materials are challenging at the best of times. These words will be familiar from the introduction to the CIMA Diploma in Islamic Finance (CDIF), and having completed the CDIF you will know that self-study can also be rewarding. For those who join the Advanced Diploma in Islamic Finance (CADIF) by direct entry, the subject may not be new, but the method of study may be outside your usual comfort zone. The following pages include useful information and tips that will act as a reminder to CDIF holders, and assist direct entrants in using the guide as a learning companion on the journey to expanding your learning horizon. CIMA, along with a group of respected authors and industry experts in the field, have pioneered the development of a tiered approach to studying Islamic finance. The four study guides that comprise the CDIF cover the major areas of Islamic finance in depth and provide you with a strong foundation in this field of study. Building on that foundation, the CADIF will help you develop and assemble the building blocks necessary to create Islamic finance products and services. To enable you to succeed we have provided you with the material needed to pass the required assessment. We wish you every success in your learning experience and subsequent career in this exciting and fast-growing field of the finance industry.

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The advanced diploma We developed the CADIF as an extension of the CDIF. All candidates are encouraged to be familiar with the contents of the CIMA Diploma in Islamic Finance, which underpins much of the material included in this study guide. You will regularly see references such as this, CDIF/2/5/108-109, which means that key information you need is included in a Diploma study guide. The symbols relate first to the Diploma (CDIF), then the specific guide (2), then the chapter (5) and finally the relevant pages (108-109). So in this case you will find relevant information in Study Guide Two, Islamic Banking and Takaful, on pages 108-109 of chapter five. We would expect you to refer to this material before you proceed further in the relevant section. For those of you who joined the CADIF by direct entry, we recommend that you acquire copies of the CDIF study guides. These can be obtained by contacting: if@cimaglobal.com This study guide includes a glossary of the key terms and contracts used throughout CIMA’s Islamic finance learning materials. For easy reference, these sections can also be found on the CIMA website www.cimaglobal.com/islamicfinance It is vital that you read these sections and that you refer to them regularly as you work through the guide. It is also important that you appreciate the relevance of several key aspects of the study guides. Each of these aspects is explained below and tips are offered, where appropriate, as to how you can get the most from your studies.

Language The guide is written in English; however, Islamic finance relies to a great extent on a large number of Arabic terms and phrases, as well as a few in Latin. Islamic finance is built on a foundation of historic contracts, which have been used for centuries in Islamic commerce. These contracts, while straightforward in terms of content, are introduced by their Arabic names. These names, many of which are challenging to pronounce, will probably be new to you. The subtle differences between the meanings of some of them need to be understood, as that will be key to you pursuing a successful career in Islamic finance. In addition to the contract names there are many other Arabic terms used in the industry. You need to be comfortable with these terms and phrases as they are integral to the construction and delivery of the various contract types that underpin Islamic finance. By referring to the glossary you will soon be comfortable with such terms as Qard, Wakalah, Musharakah and Murabahah, to name but a few. The most challenging aspect of the study of Islamic finance will be your understanding of these terms and phrases, but, as with any new language, the sense of achievement you will feel once you become fluent in their use will make it worthwhile. You will also be able to impress your family, friends and business associates with your new-found language skills; after-dinner conversations and meeting presentations will never be the same again.

Self-study Working on your own, particularly when the subject matter is new, is never an easy task. In writing this study guide, the authors have constantly put themselves in your position and attempted to create materials that will hold your interest. They have also tried to ensure that they are easy to follow and act as a complete learning experience. We believe that the guide you are about to read, and the additional reading we refer you to, will give you a thorough underpinning in the subject area. It will provide you with all you need to pass the final examination and to follow a successful and rewarding career in Islamic finance. The text regularly requires you to stop and attempt exercises or Islamic challenges to get you to interact with what you are reading. It is crucial to your understanding of the subject that you attempt these exercises or challenges honestly. The answers for the exercises are given at the end of the respective chapter to confirm your understanding. In addition, at the end of each chapter are a series of questions with which to test your new-found knowledge. Each set of questions relates to a case study that is assessed through a series of multiple choice questions and short essay questions. The final assessment you will be required to pass to achieve the award of CADIF will be assessed using a combination of multiple choice questions and essay questions. In this way we can ensure both breadth and depth of coverage in the assessments. We recommend that you attempt to answer the

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multiple choice questions and practise essay writing as you progress through each chapter of the guide. Solutions are at the end of each chapter. The guide concludes with a series of mock examinations based around case studies. These have been devised to develop and test your knowledge beyond the written text in the module. The answers to these challenges can be found through a critical understanding and analysis of the written text. Islamic finance challenges form part of the text and should transmit critical knowledge to you. The guide concludes with a mock examination comprising general multiple choice and short answer questions and case-based multiple choice and short answer questions. Completing the mock examination is a good way of assessing whether you are ready or not to sit the final live assessment.

Learning outcomes At the start of each chapter we list the learning outcomes that you should have achieved by the time you have worked through the chapter. These learning outcomes relate to the questions you will be required to answer in the assessment that you must pass to be awarded the CADIF. It is therefore vital to your success that you feel confident at the end of each chapter that you have achieved these outcomes. A useful tip would be to return to the learning outcomes once you have come to the end of each chapter and make sure that you are familiar with each of them. The questions and answers in each chapter have been created to test you in your achievement of these learning outcomes. Getting the right answer to these questions at the first attempt is a good sign that you are achieving the learning outcomes. An inability to answer them is a sure sign that you need to return to the detailed content of the chapter. The final examination will include questions relating to the chapters and respective learning outcomes (see below for more details).

Key points The authors have highlighted key points that they feel you should remember. While the rest of the text is important to your understanding of the subject in question, these key points indicate the crucial element of the text.

Examples from real life Throughout the study guide you will see examples taken from, or adapted from, real-life situations. These examples are included to reflect both best practice and practice that may, in some quarters, be questionable. Islamic finance is an innovative and dynamic subject that is a thriving financial activity around the world today. We have included, where possible, examples of Islamic financial products to complement descriptions in the text. Many such examples are given in the form of extracts from advertising materials used by real financial institutions to market their products. It should be emphasised that these real-life examples are given as exemplars only. As stated above, Islamic finance is a dynamic and fast-changing industry, and some of the products illustrated in the text may already have been superseded by new or altered versions. To ensure that you have access to up-todate versions of each product, we recommend that you search the internet for similar products being offered at the time you are reading the text.

Exercises and answers Included throughout the guide are exercises that require you to respond to the material you have just been reading. The answer to each exercise is given at the end of the relevant chapter, but to get the most from your studies you should refrain from simply reading the question and then going to the answer. You will learn little from this practice and remember even less. Read the question and give an answer, if you can. If the answer is not on the tip of your tongue, then go back through the preceding text and see if you can find it.

Islamic finance challenges Each chapter includes a series of Islamic finance challenges. These have been devised to develop and test your knowledge beyond that which is required for the final examination. These have been devised to develop and test your knowledge beyond the written text in the module. The answer to these challenges could however be extracted or inspired through a critical understanding and

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analysis of the written text. Islamic finance challenges form part of the text and should transmit critical knowledge to you. The final examination will test you on both the text and Islamic finance challenges as they collectively form the body of the knowledge in the module Unlike the exercise questions, the answers to these Islamic financial challenges are given immediately after the challenge.

Chapter summaries At the end of each chapter we have included a summary listing the important points that you should have understood from your studies. These summaries help you to track the important sub-topics and the key points discussed in the guide.

Revision questions with answers Each chapter ends with a series of questions and answers comprising a series of multiple choice questions and short essay-style questions related to a given case study. It is very important that you attempt each of these as they are indicative of those that will be used in your final examination.

Mock examination For a comprehensive pre-assessment of your learning experience, you will find a mock examination at the end of the study guide. While the live questions will be different to those tested here, the areas and weightings of the topics covered will be the same. If you can answer these questions correctly you can be fairly confident that that you will be able to answer the ‘live’ questions correctly and thus pass the test. You need to score 60% in the examination to pass. The questions asked have been created to test each of the learning outcomes listed at the start of each chapter. As mentioned above, the revision questions at the end of each chapter represent the type of questions you will be asked in the ‘live’ examination. You should use both sets of questions to test your understanding of this challenging subject.

CIMA Islamic finance website While CIMA believes that this guide is all you need to successfully complete your studies, we also know that you will feel more comfortable knowing there is somewhere out there you can go to for additional support. The CIMA Islamic finance website has been created to provide the assistance you need and includes important information about the Diploma and Advanced Diploma. The website also has an area where we list frequently asked questions on the programmes and the answers that were given. It also includes an area where we will post updates that we feel are relevant to your studies. We would hope that you will be a regular visitor to the website and thus feel that you are not alone in your studies. www.cimaglobal.com/islamicfinance

Assessment of materials found on the website Islamic finance is constantly changing and CIMA will regularly update the study guides to reflect these changes. As changes to the hard copy guides can only take place during a reprint, we will keep you up to date by posting details on the website of changes that have occurred between print runs. Where necessary, we will also supply references to additional support material, including suggested further reading. Most changes to the material that we will highlight on the website will be for information purposes only and will not affect the assessments you sit. Where changes are deemed sufficiently important, CIMA may change the assessments to reflect this. Students will be emailed alerts about any new examinable material that appears only on the website. Where applicable, new material will be assessable three months from the date of the first alert and when it appears on the website.

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The future You are embarking on a new journey, which for many will be a gateway to new knowledge and experience. Like all journeys, you need to be properly prepared to meet all eventualities. This guide is, we believe, a vital part of a successful career in this exciting new development in global finance.

The final examination To achieve the CIMA Advanced Diploma in Islamic Finance you will need to take a final examination comprising case studies and related questions. The cost of each examination is normally included in the price of the study guide. The examinations are electronic based and can be taken at the assessment centres identified on the CIMA IF website. Each examination will be made up of three sections. Section A comprises 20 multiple choice questions (MCQs) and are general in nature i.e. they test material from throughout the guide. Section B comprises a case study with ten related MCQs and five related short answer questions. Section C comprises five general short answer questions i.e. they test material from throughout the guide. The means by which you answer all the questions in the final examination are contained within the study guide and reflect the learning outcomes shown at the beginning of each chapter. You will have had the opportunity to do numerous practice examples by the time you come to the end of this study guide. You have three hours to complete the examination and you need to achieve a 60% pass mark. We wish you every success in your studies.

For further information and advice please contact if@cimaglobal.com

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What is finance?

What is finance?

Islamic finance in the context of conventional finance What is finance? The finance industry has evolved over hundreds of years and covers a wide range of areas, including banking, credit, investment, and insurance. Primarily, it relates to the allocation of resources between those who have a surplus and wish to invest, and those who need to borrow in order to finance a project or purchase transaction. Simply put, it is a mechanism for reallocating funds between those who have and those who have not. Finance can be viewed as an opportunity to arbitrage when there is a disparity between price and value arising from a state of disequilibrium of value expectations. Every level of risk assumed by the investor or financier is met with an expected or required return. The finance industry also includes the insurance sector where individuals or those in business safeguard themselves or their assets against injury or loss by the transfer or pooling of risks. Conventional or Western finance has become a multi-billion dollar industry, where individuals or businesses can invest or borrow funds through specialist markets around the world. With the exception of funds generated for illegal activities, the finance industry does not concern itself with the use to which funds are put or from which funds arise. There is almost no limit to the variety of financial products available for those with a need to invest or borrow. As an individual, you will no doubt have interacted in some way with the finance industry, most likely as a depositor, borrower or insurance customer. Two factors underpin conventional finance: the use of interest as a form of return or benchmark for those investing funds and the cost to those borrowing them; and risk, an element of which covers almost all areas of finance. Conventional finance has evolved sophisticated products to meet the financing requirements of individuals and businesses with funds to invest, funding requirements to be met and insurance cover to be provided. Each of these products to some extent will involve an element of risk, and banking products will incorporate interest charged as a form of remuneration or as a cost of borrowing or defaulting on an agreement. Traditionally in finance, interest rates rise to compensate for the increase in risk assumed by the lender. Alternatively, measures to mitigate or reduce risk can anticipate a lower rate of interest. CIMA Advanced Diploma in Islamic Finance

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What is Islamic finance? Islamic finance involves the revival of trade and investment principles and practices established centuries ago in the context of a modern finance and financial system. As a relative newcomer to the finance industry, it has arisen because conventional finance does not meet the requirements of Shari’ah principles and rules, and does not conform to the beliefs and precepts of the religion of Islam. Key to the evolution of Islamic finance is the belief held by Muslims that absolute ownership belongs to God, and man as the servant and vicegerent acts in trust in administering wealth in a just and equitable manner. Oppressive behaviour, such as usury, is prohibited and the charging and receiving of interest is unacceptable. Hence, a moral code and social order is prescribed based on the Islamic belief system. The Qur’an is the absolute source of divine guidance and Shari’ah law according to Islamic belief. It instructs mankind to engage in activities that are lawful and good, and prohibits those that cause harm and dispute in the society. Among its prohibitions are trading in pork or pork products, and trading in intoxicants and games of chance. The teachings of Islam based on the Qur’an and Sunnah state that the entire value chain of activities relating to these prohibited activities is equally prohibited. This includes all aspects of the production, storage, transportation, marketing and advertising of such products and activities. In prescribing the form of economic activities under Islam, trade is encouraged, usury is prohibited and the acquisition of wealth is to be achieved through lawful means that promote mutual consent and goodwill. In this respect, interest as usury is replaced with profit from trade. Muslims believe that profit should involve decisions on risk preferences and choices, and that finance should be mobilised for acceptable personal and business purposes as prescribed by Shari’ah principles and rules. You will now realise that the conventional finance industry, as described at the start of this section, does not meet the requirements of Shari’ah principles and rules as it is priced and motivated by interest rates, takes risk in favour of lenders and is not generally concerned about the use or application of funds. In the last 40 years various financial institutions have attempted to develop financial products that are consistent with Shari’ah principles and rules. The cash surpluses generated from the extraction of oil in the Middle East and throughout South East Asia, both of which have substantial Muslim populations, focused attention on the need to develop a financial system that met the requirements of Muslims. Similarly, from the perspective of insurance, individuals who follow the teachings of Islam also wanted to insure themselves or their property against loss or injury, through risk-sharing and pooling arrangements that promote mutual goodwill and assistance in case of peril or hazard. Simple economic theory explains what happened next. With an estimated 1.8 billion Muslims worldwide, increasing cash balances from oil extraction and the demand for acceptable investment and insurance products, an industry developed to meet these requirements. Twenty-five per cent of all Muslims live in countries with a Muslim majority, which means that the demand for acceptable products in these countries is backed by the political will to underpin the industry with relevant legislation and legal systems. To date, probably as a result of substantial oil revenues, development in this sector has focused on two key regions of the world: the Middle East and South East Asia. However, an ever-increasing number of Muslims and non-Muslims worldwide are seeking out Islamic financial products. As a result of this increasing demand, financial institutions around the world have taken up the call for new products and almost all areas of the conventional financial industry have now been replicated or adapted in a way that is acceptable to Islamic beliefs and practices.

Shari’ah compliance A vital part of Islamic financial activities is the requirement to achieve Shari’ah-compliant status, that is to ensure that the financial activities of the institution meet the requirements of the Shari’ah principles and rules prescribed in the Qur’an and the Traditions of the Prophet Muhammad. To achieve this, there is a need to establish adequate systems and controls in the form of an internal Shari’ah control system (ISCS). The ISCS provides assurance that all financial activities are conducted in accordance with Shari’ah principles. An internal Shari’ah review is a prudent if not a regulatory requirement to self-assess the degree of compliance that the financial institution adheres to in terms of all Shari’ah principles prescribed in the form of standards, guidelines and best practices by relevant governing bodies, such as the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) and Islamic Financial Services Board (IFSB).

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Shari’ah compliance is critical to an Islamic financial institution’s (IFI) operations, and compliance must permeate throughout the organisation, its products and activities. The implications of Shari’ah noncompliance and risks associated with the IFI’s fiduciary responsibilities towards different fund providers expose it to withdrawals, loss of income or the voiding of contracts. This, in turn, leads to a diminished reputation and/or the limitation of business opportunities.

Shari’ah advisory boards Shari’ah advisory boards are independent advisory panels, comprising scholars and jurists in Islamic commercial law and Islamic finance. The board explains and interprets the teachings of Islam, as well as formulating policies and expressing opinions to guide Islamic financial practices based on Shari’ah principles and rules. These opinions, policies and guidelines have been developed to provide assurance and integrity to the systems of financial institutions by ensuring that products, processes and instruments do not run contra to principles set under the Shari’ah. They are perceived as the most essential organ of governance in the structure of Islamic banking and finance. The Shari’ah board or Shari’ah committee of an IFI should be able to express opinions on the financial institution and be able to endorse the products or services of that institution. Although all Shari’ah boards share the common goal of ensuring compliance, variations arise in terms of the establishment and conduct of the board such as methods of appointment, composition of members and internal supervision. International Shari’ah standard-setting bodies, such as the AAOIFI, have issued standards on such matters, as well as on aspects of governance of Shari’ah compliance. The recommended practices of many governing bodies such as the AAOIFI and IFSB, as well as adopted practices by individual IFIs, are based on the decisions of the Shari’ah board that are binding on IFIs and those institutions that adopt Islamic financing transactions.

The importance of contracts In Islam, fulfilment of contractual rights and obligations is an integral element of social conduct within Islamic society. These contracts should be lawful and proper and adhere to Shari’ah principles and rules. A variety of commercial contracts plays a vital part in underpinning the products and services offered by IFIs as well as Islamic financial instruments. Such contracts ensure that those interacting within the Islamic financial system are seen to benefit from trading and real investment activities and not simply from the transferring and holding of cash balances and receivables in the form of loans and advances. Those practising Islamic belief do not accept that profits are earned simply from the use of money, that is interest earned from loans and advances. Muslims believe that profit should be earned by the recipient from productive investment or trading activity. As such, surplus funds held by an individual should only be invested in projects in which the investor has an active role in assuming trade or investment risk, or both, and if they are to benefit from the investment, that is if they wish to see the surplus funds increase. Consequently, individuals or businesses can obtain financing instead of loans by involving the financial institution in financing purchase, trade or investment transactions. The financial institution then profits from a true sale, real trade or investment transaction. Under conventional finance, X borrows from Y to obtain funds. Y charges X interest based on the amount of the loan, the perceived risk and duration of the loan. In the context of Islamic finance, X and Y need to become trading parties or investment partners. The necessity for both the provider and user of funds to interact in a trading enterprise requires that agreements or contracts play an important role in the trading or investment process. The nature of these contracts is at the very heart of every aspect of Islamic finance. To date, the Islamic finance industry has replicated conventional interest-bearing and risk-bearing products by using a set of key trade and investment contract types. An understanding of these contract types is crucial to understanding most of what follows in the area of Islamic finance. The glossary of contracts, which forms part of each guide, explains each of the major contract types. You need to understand each if you are to be articulate and involved in Islamic finance.

Islamic financial institutions: products and services The nature of IFIs has evolved since the 1960s to meet the various needs of Muslim communities, society and industry. From specialised financial institutions that promoted the welfare of Muslims during the earlier phase, these institutions have become innovative and enterprising financial institutions within the global financial industry. The financial intermediation of lending-based institutions is replaced with partnership and profit-sharing institutions that are directly involved in the financing of transactions, as well as engaging in equity partnerships.

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Loans and advances have been replaced by new financing vehicles that are based around sales, lease and equity contracts. The financing of sales and purchases, as well as leasing, involves trade contracts. Equity-based financing involves Mudarabah and Musharakah financing or investments. These contracts vary in their application to suit the purpose of financing, such as term or working capital financing, as well as matching customer requirements, such as retail or corporate, along with the financial institution’s funding objectives. Fixed deposits are replaced with investment accounts where fixed determinable interest paid to depositors is replaced with profit-sharing dividends. The latter involves a predetermined profit-sharing ratio mutually agreed by both the financial institution and the investment account holder (IAH). For certain types of investments, the IAH can specify the area in which the funds are to be invested. In this respect IAHs can share in the profits with the financial institution for a given level of risk exposure. Other savings and current accounts are based on safe custody contracts or loan contracts that do not involve dividend payments. However, the financial institution may, at its discretion, declare dividends in the form of a gift (Hibah) to the account holders.

The Islamic capital market (ICM) Capital markets, along with financial institutions, perform the function of effectively mobilising funds in society. The capital markets help to mobilise surpluses from economic units with excess capital, transferring them to agents who have managerial and entrepreneurial talents and investment opportunities. This method of fund mobilisation is known as direct financing because the funds are transferred from the public to companies directly, without the financial intermediation of financial institutions. The Islamic capital market (ICM) refers to a system where capital market activities are carried out in ways that comply with Shari’ah principles and rules. Over the years, the ICM has evolved to provide a wide array of services to meet the needs of companies and investors seeking products and instruments that are not only commercially feasible and attractive but also, more importantly, Shari’ah-compliant. Generally speaking, the ICM provides three markets similar to the conventional capital markets described above. They are: • the Islamic equity market • the Islamic fixed-income instruments or Sukuk market • the Islamic derivatives or Islamic structured products market.

The Islamic equity market The Islamic equity market refers to the marketplace where Shari’ah-permissible stocks or shares are transacted. A share is known in Arabic as ‘Sahm’ or ‘Ashum’ (plural). There is no distinction with regards to the features of a share in Islamic finance vis-à-vis a conventional share. As described above, they are capital-raising instruments, a means of sharing risk, a means of securing ownership and are transferable, negotiable and liquid. The main concern of Islamic equity does not relate to the structure of an ordinary share, but to the activities of the company that issues the share to the public. In other words, investors, particularly Muslim investors who are sensitive to Islamic investment guidelines, must examine whether the company undertakes its activities according to Shari’ah principles and rules. As shares represent an ownership right in the company, Muslim shareholders ought not to invest their capital to support activities that are non-compliant. As a result they should not invest in companies that offer interest-based financial products, conventional insurance, gambling activities, pornography and entertainment activities. It should be noted that the Islamic equity component of the ICM also includes other sub-divisions such as Islamic unit trusts or mutual funds, Islamic private equity funds, Islamic real-estate investment trusts, Islamic exchange-traded funds, as well as specialised funds such as money market and gold funds.

The Islamic fixed-income instruments or Sukuk market A Sukuk refers to the process of aggregating tangible assets, usufruct or an interest in a project or venture into divisible units or securities that reflect the proportionate ownership of that asset or usufruct or project. A Sukuk does not deal with receivables or financial assets. Sukuk holders each hold an undivided beneficial ownership interest in the underlying assets. Consequently, Sukuk holders are entitled to share in the revenues generated by the Sukuk assets. In short, Sukuks are monetary denominated participation certificates of an equal unit value to be issued

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to investors. These Sukuks represent their proportionate share in the ownership of the underlying assets and a pro-rated share in the income generated by those assets. Sukuks do not represent any indebtedness by the issuer to the investor. The return to the investors in a Sukuk is not fixed or guaranteed but is subject to the performance of this underlying asset. A Sukuk, which is performance-based, does not promise any fixed income.

The Islamic derivatives or Islamic structured products market Islamic structured products or Islamic derivatives are meant to hedge the financial risk associated with an underlying asset. The asset could be commodity, share, bond or Sukuk. Traditionally, Shari’ah contracts, such as the Salam contract, can immediately be utilised as a hedging investment tool where the buyer and seller lock in the future price to be paid by one to the other. Similarly, the unilateral Wa’d contract can be used by the promisor to undertake a currency exchange at a preagreed future date. Newer Islamic derivative instruments have increased in sophistication to achieve desired hedging benefits. For instance, the Murabahah-tawarruq structure has often been used to achieve Shari’ah compliant currency swaps which are more robust for the parties involved. To achieve this, the parties generate a set of liabilities denominated in foreign currencies via the Murabahahtawarruq transaction. Similar Murabahah-tawarruq structures also underlie Islamic profit-rate swaps where fixed profit rates are swapped for floating rates. In essence, Islamic derivative products provide the opportunity for Islamic market players to hedge their financial risk, while removing the opportunity for them to only profit from undertaking these transactions.

Accounting and analysis of Islamic financial transactions Within Islamic finance, the purpose of financial reporting is re-examined in the light of ensuring that user information needs are addressed and that all financial activities of IFIs are not only commercially viable but also Shari’ah-compliant. The accounting, reporting, auditing and governance of IFIs’ financial operations significantly evolved with the establishment of AAOIFI financial standards in these areas. The contractual rights and obligations of Islamic financial activities needs to be disclosed as does the fact that neither unlawful income nor unlawful expenditure has been earned or incurred. In addition, the profit-sharing mechanism between shareholders and IAHs needs to demonstrate equitable distribution policies and practices. Hence the financial reality presented in the financial statements reflects both financial and religious accountability in terms of meeting international financial reporting standards as well as Shari’ah principles and rules.

Advanced Diploma in Islamic Finance: Content Introduction The growth in the Islamic finance industry has outpaced the development of education in this area. This study system has been devised to meet the shortage in teaching materials and will introduce you to key areas of the Islamic finance industry as identified above. The core of the CADIF, which follows the CIMA Diploma in Islamic Finance (CDIF), is the theme of structuring, taking a broad view of the concepts of structuring within Islamic finance and progressing into the specific product structuring process that has been undertaken in the Islamic banking, capital market and Takaful sectors. You will be introduced to specific issues, including any limitations, of individual Shari’ah contracts that have been applied in developing existing Islamic banking and finance instruments in the global markets. You will also be shown that the product strategy ensures that each product is competitive in the individual markets within the respective legal and juridical boundaries that surround each market.

Terminology Many of the technical terms used in Islamic finance are derived from Arabic. You will already have noticed the use of such words as Takaful, Shari’ah, Mudarabah, Musharakah, Hibah, Sukuk and Salam, which are all Arabic terms. For those of you with no experience in Arabic, these words and terms may prove challenging, but it is essential if you are to succeed in understanding much that underpins Islamic products and services that you master these concepts and terms. We have expanded the original glossary of terms that appeared in the CDIF for you to refer to and we have included a detailed explanation of the nature of the contracts, the key to all of the Islamic financial products and services. It is left to you to make the most of the glossary and contract explanations to maximise the benefit you gain from the guide.

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Introduction

Introduction The CIMA Advanced Diploma in Islamic Finance (CADIF) has been designed as a professional diploma for the Islamic financial services industry. The CADIF will enable you, as financial professionals and practitioners, to apply Islamic finance principles to the analysis of Islamic financial products and services, as well as to the development of innovative products or solutions for the Islamic financial services industry. The core of the CADIF is with the theme of structuring. It begins with a bird’s eye view of the broad concepts of structuring within Islamic finance and progresses into the specific product structuring process that has been undertaken in the Islamic banking, Islamic capital market and Takaful sectors. Each chapter of the CADIF introduces you to specific issues, including any limitations, concerning the individual Shari’ah contracts that have been applied in developing existing Islamic banking and finance instruments in global markets. You will be shown that the product strategy ensures that each product is competitive in the individual markets and within the respective legal and juridical boundaries that surround each market. The CADIF follows the CIMA Diploma in Islamic Finance (CDIF) with its core foundation modules of Islamic Commercial Law, Islamic Banking and Takaful, Islamic Capital Markets and Accounting for Islamic Financial Institutions. As the Advanced Diploma assessment will be based on your ability to grasp essential principles in Islamic finance and relate them to practical situations, the CDIF self-learning modules are essential learning materials. For those who have progressed from the CDIF, this will not be a problem, but we still recommend that you constantly refer to relevant sections in the CDIF guides as you progress through the Advanced Diploma. For those who have joined by direct entry, we recommend that you use the CDIF guides as essential reading before you commence your Advanced Diploma studies.

The CIMA Diploma in Islamic Finance The CIMA Diploma in Islamic Finance (CDIF) provides foundation knowledge in the four distinctive areas of Islamic finance. This is presented in four separate study guides.

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Study guide one: Islamic Commercial Law Study guide one focuses on Islamic commercial law and its application to transactions within Islamic finance. The guide explains the importance of the Qur’an and the Traditions of the Prophet Muhammad as sources of Shari’ah, and highlights how Islamic jurisprudence has been adopted by modern scholars to explain and interpret the Shari’ah in an attempt to solve modern problems in Islamic finance. The guide also introduces students to the historic contracts involved in Islamic commercial law and explains what is meant by Shari’ah compliance.

Study guide two: Islamic Banking and Takaful – Products and Services Study guide two focuses on two key areas of Islamic finance: banking and insurance (Takaful). Here, students are introduced to developments that have taken place with regard to these Islamic financial industries and their related systems. The guide explores the sources of funds available to banks and how they are rewarded. It explains the various Shari’ah-compliant products developed by Islamic banks for their customers. The second section of the guide introduces students to the insurance (Takaful) industry, with a focus on the products and services developed in this area.

Study guide three: Islamic Capital Markets and Instruments Study guide three introduces students to the overall Islamic capital market (ICM), showing that it has the same structures as those found in the conventional market. The guide explores the two key capital markets: the primary market in which products are created to raise funds for businesses and governments; and the secondary market where the products created can be traded. It explains that within these two markets the ICM provides three product markets similar to the conventional capital markets: the Islamic equity market; the Islamic fixed-income instruments or Sukuk market; and the Islamic derivatives or Islamic structured-products market. The guide goes on to explain that the ICM has the same regulatory considerations as the conventional capital markets, but in addition it must ensure that each aspect of the market and its products are Shari’ah-compliant.

Study guide four: Accounting for Islamic Financial Institutions This study guide introduces students to the process of how to account for and analyse the results of businesses operating within the Islamic finance industry, a key component of Islamic finance often overlooked. The relationships an Islamic financial institution has with those it receives finance from and those it finances are completely different to those of conventional banks. This can result in a bank becoming a partner, customer, supplier, landlord or shareholder as opposed to simply a borrower or lender. The guide also explains that the position of the Takaful operator is different to that of conventional insurance companies. The Takaful operator has no personal liability in relation to those taking out insurance but is merely entrusted to manage the Takaful funds on behalf of the participants/policyholders. Depending on the agreement, the operator may act simply as an agent for those covered by the fund, in return for an agency fee, or the agreement may allow the Takaful operator to partake in a share of the profits earned from the Takaful fund. The relationship between the various parties to Islamic finance is not the same as those between participants in conventional finance. The reports compiled for those operating in the Islamic finance industry need to reflect the differences.

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The CIMA Advanced Diploma in Islamic Finance (CADIF) Introduction The Advanced Diploma programme has been developed as an integrated self-learning module for professionals. It focuses on structuring and strategy within Islamic finance, explaining both the technical issues as well as the product strategies applied in the field of Islamic finance. On completion of the guide you will be able to develop and apply the specific technical skills required to analyse and structure Islamic financial products and services in light of Shari’ah, legal, accounting and risk considerations. You will also be able to analyse the impact of structuring on a financial institution and recommend a product strategy for given economic conditions and industry requirements. Throughout the guide, specific financial products or instruments from the banking, capital market and Takaful sectors are explained, often with examples of current practice, along with analysis, process-flow and reporting tools. The financial environment and relevant models of each financial sub-sector are explained to ensure that you understand the relevant policies and standards and regulatory considerations.

Assessment You will be assessed in terms of your ability to analyse Islamic financial products and related contracts, and evaluate them based on relevant standards and best practices. The Advanced Diploma adopts a case-based, product-centred learning strategy that requires you to recommend, solve or construct solutions in developing Islamic financial products and related strategies. Hence it is important to note that the assessment is not segmented into individual chapters but will be based on multiple chapters throughout the module. This will help you achieve a systematic and coherent understanding of all the principles, issues and standards affecting Islamic financial products’ structuring and strategies. The learning process enables you to understand the structuring processes as well as the relevant product strategies for each financial sector. On completion, you will have an in-depth and coherent understanding of the structuring and strategic issues arising from the technical specification, Shari’ah requirements, regulatory requirements and related reporting considerations and risk implications for each product. The case-based assessment allows CIMA to evaluate your ability to formulate, construct, appraise and recommend appropriate product structures and relevant strategies.

Content The Advanced Diploma comprises five main sections: • Shari’ah contracts, structuring process and financial environment • Islamic banking system and products • Equity, Sukuk and fixed-income instruments • Takaful and Retakaful models and policies • Islamic risk-management tools and strategies.

Shari’ah contracts, structuring process and financial environment Chapter one reviews the nature and importance of Shari’ah compliance in Islamic finance transactions, and explains the purpose and benefits of contracts adopted in structuring Islamic financial products. It outlines the sources of Shari’ah and methodologies of reasoning and interpretation, with special reference to financial product structuring. The chapter also explains how the object, elements and conditions of the contract are taken into consideration when structuring an Islamic financial product. Chapter two introduces you to the structuring process that is integral to the product development strategy of institutions offering Islamic financial products and services. It identifies the critical components of the process and explains them with reference to specific Shari’ah requirements. The chapter also considers the effect of varying financial environments and industry requirements in the adoption of a structuring process. Finally, the chapter highlights factors that may impair the structuring quality for Islamic financial products, as well as considering the possible consequences of a poor product structuring strategy. The importance of the purpose of Islamic financing contracts, and the relevant application of those contracts in designing Islamic financial products, as outlined in chapter one, is fundamental in ensuring the proper and effective adoption of appropriate contracts. Also, the behaviour of Islamic financial contracts will have an effect on the development of Shari’ah compliance to achieve

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financially viable and sustainable financial products and services. The chapter highlights the product requirements for an effective structuring strategy as well as the potential pitfalls in structuring. Finally, you will be shown how the structuring process and strategic considerations enable the Islamic finance industry to design, develop and implement a comprehensive strategy for the creation of Islamic financial products and services. Chapter three explains the banking environment in relation to the principal monitoring or governing agencies, in addition to regulatory or industry requirements. It also highlights the importance of regulatory requirements and supervisory issues that must be considered when structuring Islamic financial products. The chapter considers the specific Islamic banking risk framework and other relevant guidelines to illustrate their impact on the structure of Islamic financial products, as well as on the development of a growth strategy for different models of institutions and products within the industry.

Islamic banking system and products Chapter four examines deposit structures using a variety of contracts and explains the importance of applying a structuring process within a framework that takes into account regulatory requirements. It identifies suitable contracts by analysing deposit and investment account behaviour from both the corporate and individual perspective. Where appropriate, the chapter considers cost implications in relation to the Islamic deposit structuring process. In addition, it highlights the impact of structuring on deposit behaviour as well as its implications in relation to the deposit framework. Finally, the chapter examines the requirement for Islamic money market instruments and treasury products that are being offered in the Islamic finance industry. Chapter five introduces you to a number of financing products using different Islamic financial techniques that cater for both corporate and retail banking customers. The chapter focuses on working capital financing, asset financing and personal financing, as well as debit, charge and credit cards. It describes the various product structures and the relevant mechanisms, contract flows and requirements, and explains regulatory requirements. This will assist you in analysing the relevant features and issues in structuring financing products for an Islamic banking institution, particularly for commercial purposes. From a structuring perspective, this chapter deals with the challenge of choosing appropriate contracts to meet the commercial requirements for both corporate and retail customers. It explores issues relating to the adoption of relevant financing contracts, with ancillary contract conditions, to mitigate relevant credit and market risks. Finally, the chapter highlights aspects of prudent strategies and policies, such as avoidance of non-regulated consumers and highly-leveraged financing, to emphasise the importance of a prudent credit policy in providing Islamic financing, particularly for Islamic retail customers. Chapter six introduces you to the nature and importance of Islamic project financing, undertaken in line with Islamic financial precepts. It explores the various structures of project financing using equity, debt and Sukuk. The chapter also considers the different approaches that can be undertaken to finance projects, including the private finance initiative (PFI), public–private partnership (PPP), buildlease-operate-transfer (BLOT) and build-operate-transfer (BOT), all of which must be compliant to Shari’ah principles. It highlights other issues relating to financial structuring and its inherent risks, including the most appropriate contract or contracts that can be used to mitigate the risks that arise in project financing.

Equity, Sukuk and fixed-income instruments Chapter seven explains the regulation of the Islamic capital market, with regards to the equity market. Specific focus is given to the importance and acceptability of stock-screening criteria for asCDIFaining Shari’ah-approved stocks. The chapter looks at comparative stock-screening criteria, explaining the basis and applicability of such criteria in different financial conditions. It highlights the impact of specific criteria on stock-screening to explain the inclusion or non-inclusion of a particular stock in the approved lists. Finally the chapter considers relevant strategies to achieve Shari’ah compliance status for stock based on established stock-screening criteria. Chapter eight provides you with an analysis of the different types of Islamic funds in terms of structure, features and economic behaviour. The discussion is limited to funds involved in commodities, gold, real estate, money markets and private equity investment. Specific focus is directed towards issues of structuring open-ended and close-ended funds, as well as exchanged traded funds (ETF) in relation to various underlying investment assets in the form of real estate funds,

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commodity and gold funds, money market funds and private equity funds. This chapter considers the general performance of Islamic investments compared with conventional investments, particularly in the equity market. Finally, it introduces strategic considerations that could enhance the industry of Islamic asset management in the global market. Chapter nine introduces you to the structuring techniques of various Sukuk instruments, as well as the key issues relating to Sukuk as fixed-income instruments that are structured around different types of contracts with ancillary terms and conditions. The discussion covers the variety of product features that result from the possible different structures. A special discussion examines the structuring features of Sukuk post the AAOIFI pronouncement 2008, as the pronouncement has significantly affected previous structures and led to a decreasing number of Sukuk issuances. The chapter considers all Sukuk instruments issued before and after the AAOIFI pronouncement. The chapter examines the Sukuk rating methodologies adopted by relevant rating agencies, explaining and analysing them in terms of their usefulness and limitations. Finally, the discussion focuses on the impact of investor preferences and the effect that the changes in Shari’ah rulings have had on the structures and rating methodologies of Sukuk.

Takaful and Retakaful models and policies Chapter ten outlines the key differences between Takaful and conventional insurance, looking at purpose, structure and perceived benefits. It introduces you to the various Takaful models that distinguish the different roles played by Takaful operators, as well as their level of engagement in managing Takaful funds. The chapter analyses the treatment of deficits or underwriting surpluses that can occur in a Takaful fund and the impact of this treatment on the performance of that Takaful fund. It also outlines relevant legal and rating issues to allow you to understand the regulatory framework in which the Takaful industry operates. Finally, the chapter considers how further support can be given to promote the growth of this nascent industry. Chapter eleven expands the discussion of Takaful operations focusing on Retakaful and retro-Takaful, analysing the challenges faced by Retakaful operators in an emerging industry across different sovereign states. In particular, this chapter elaborates on the various forms of reinsurance and re-Takaful arrangements in the form of facultative and treaty types on a proportionate or non-proportionate basis. It considers the reasons for allowing the reinsurance of Takaful contributions by conventional reinsurance companies, offering a critical examination of the Shari’ah concession of such reinsurance arrangements under the principle of necessity. The chapter also illustrates the arrangement of a Retakaful company to retrocede some of the risks to another Retakaful or reinsurance company (retrocedent company).

Islamic risk-management tools and strategies Chapter twelve examines financial risk mitigation in the Islamic finance industry as exhibited by the product features of derivatives. It analyses the introduction of these structures and the challenges caused by variations in Shari’ah opinions, as well as changes in market conditions. The chapter also considers the application of financial arrangements using derivatives and their impact on market confidence in line with Shari’ah and regulatory requirements. Finally, it introduces you to the distinction between approved hedging mechanisms and non-approved speculative activities.

Learning outcomes On completing this study guide you should have achieved the following learning outcomes:

Shari’ah contracts, structuring process and financial environment Chapter one: Application of contracts in the structuring processes of Islamic financial products By the end of this chapter you should be able to: • suggest types of contracts, as a result of suitable analysis, deemed appropriate to particular products, based on intended or designed product features • distinguish between Shari’ah-complaint products and Shari’ah-based products • analyse the validity of contract conditions based on Shari’ah requirements • assess the validity of product features based on contract conditions.

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Chapter two: Structuring process and related challenges in the Islamic financial services industry By the end of this chapter you should be able to: • describe the structuring process in the development of Islamic financial products and services • evaluate and analyse the impact of weaknesses in structuring financial products and services • assess potential changes in industry requirements that have an impact on the structuring process.

Chapter three: Regulatory and prudential requirements and the supervisory review process for Islamic banking and financial products By the end of this chapter you should be able to: • • • •

explain the impact of the prevailing regulations and guidelines on Islamic finance distinguish and evaluate the impact of legislation in the dual banking system analyse the regulatory factors affecting the growth of Islamic financial services discuss the implications of a risk management framework and bank supervision for IFS.

Islamic banking system and products Chapter four: Structuring deposits, investment accounts and money market instruments By the end of this chapter you should be able to: • analyse and evaluate the validity of underlying contracts in raising deposits and funds • appraise prudential treatment in structuring Islamic deposits • assess the implications of contract structures in meeting liquidity requirements

Chapter five: Structuring financing facilities for working capital and consumer financing By the end of this chapter you should be able to: • analyse and evaluate the validity and suitability of various underlying contracts in providing financing for different purposes • discuss the risk features inherent in structuring financing products for both corporate and retail customers • appraise the importance of a proper credit policy for Islamic consumer financing.

Chapter six: Project financing: structures and strategic considerations By the end of this chapter you should be able to: • analyse and evaluate the validity and compatibility of various underlying contracts to support project financing purposes • recommend the relevant structure for different infrastructure project financing • assess the risk features of project financing and propose appropriate instruments to mitigate relevant risk exposures.

Equity, Sukuk and fixed-income instruments Chapter seven: Equity market regulations and issues of screening methodology for public-listed companies By the end of this chapter you should be able to: • assess the implications of various stock-screening criteria for Islamic-approved equities • analyse the impact of specific stock-screening criteria on the acceptability of a particular stock • recommend strategies for the inclusion of stock in Shari’ah-approved stocks and Islamic indices.

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Chapter eight: Structuring and strategic issues for Islamic funds By the end of this chapter you should be able to: • evaluate structuring features and issues of various Islamic funds • assess relevant criteria and recommend policies for Shari’ah-compliant funds • analyse the suitability of structures involving commodities and gold funds, real estate funds, money market funds and private equity funds • evaluate strategic issues for the further development of Islamic funds.

Chapter nine: Sukuk structuring and rating methodology By the end of this chapter you should be able to: • analyse contracts as well as appreciate the issuer and investor expectations involved in structuring different forms of Sukuk • analyse the impact of product features on the validity and tradability of Sukuk • evaluate rating methodologies for Sukuk instruments.

Takaful and Retakaful models and policies Chapter ten: Takaful models and issues of legal and rating requirements By the end of this chapter you should be able to: • evaluate the various underlying contracts of Takaful • analyse the impact of various Takaful management models on its participants and the Takaful operator • analyse the impact of a Takaful fund deficit and underwriting surplus on the performance of Takaful funds • explain relevant legal and rating requirements • suggest appropriate Takaful policies and strategies for the sustainable growth of Takaful institutions and the Takaful industry.

Chapter eleven: Retakaful and retro-Takaful operations and industry in the global Retakaful market By the end of this chapter you should be able to: • evaluate the importance of the reinsurance business, its various structures and its application to Retakaful • assess current global trends and issues affecting the re-pooling of Takaful funds to either Retakaful or reinsurance • examine the validity and challenges of the reinsurance of Takaful contributions by conventional reinsurance companies • recommend strategies for Retakaful and retro-Takaful in the development of the global Takaful and Retakaful industry • examine governance issues affecting the Takaful and Retakaful industry.

Islamic risk management tools and strategies Chapter twelve: Islamic derivatives as risk management tools for the Islamic financial services industry By the end of this chapter you should be able to: • • • •

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Authors

Authors

Dr Mohd Daud Bakar Dr Mohd Daud Bakar is the President/CEO of the International Institute of Islamic Finance (IIIF) Inc. (BVI), Amanie Business Solutions Sdn. Bhd (Kuala Lumpur) and Amanie Islamic Finance Consultancy and Education LLC (DIFC, Dubai). His first degree was in Shari’ah from the University of Kuwait and he obtained his PhD from the University of St. Andrews, United Kingdom. He also holds a Bachelor of Jurisprudence from the University of Malaya. He was the Deputy Vice-Chancellor of the International Islamic University of Malaysia. Dr Mohd Daud is a leading global scholar in Islamic finance. As well as chairing the National Shari’ah Advisory Council of the Central Bank of Malaysia, he is a member of various Shari’ah supervisory boards for other standard-setting bodies and financial institutions, including the Securities Commission of Malaysia, the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) (Bahrain), the International Islamic Financial Market (IIFM) (Bahrain), the Dow Jones Islamic Market Index (New York), the Bank of London and Middle East (London), the Noor Islamic Bank (Dubai), Morgan Stanley (Dubai), the Dubai Financial Market (Dubai) the Islamic Bank of Asia (Singapore), and the Japan Bank of International Cooperation (Tokyo).

Dr Syed Musa Alhabshi Dr Syed Musa Alhabshi is currently an Associate Professor with the Graduate School of Business, Universiti Tun Abdul Razak, Malaysia, and a fellow consultant with the International Institute of Islamic Finance and Amanie Business Solutions. He obtained a first class honours degree in business administration from the International Islamic University (IIUM), Malaysia, and was later awarded Doctor of Business Administration (Accounting and Finance) from Strathclyde University, UK. As a consultant with Centennial Group International, Dr Syed was involved in developing the Islamic Financial Services Board (IFSB) Prudential Standards. He has also served as a member of the Accounting, Auditing and Governance Standards Board of the Accounting Auditing Organization for Islamic Financial Institutions (AAOIFI). In Malaysia he has been involved in the development of MASB standards as well as conducting Islamic finance research and product development for regulators and industry.

Effendy Rahaman Effendy Rahaman is a consultant with the International Institute of Islamic Finance (IIIF) and Amanie Business Solutions. He holds a degree in Business Management from the University of London, an MSc in International Economics (with Distinction) from Cardiff University, UK, and is currently pursuing his PhD in Economics from the University of Malaya in Malaysia, specialising in Monetary and Islamic Economics. Working with a team of industry specialists, Effendy primarily contributes to developmental work at both IIIF and Amanie. His expertise lies in the field of economic research and he has previously held several research assignments from the Malaysian Institute of Economic Research (MIER) and the International Centre for Education in Islamic Finance (INCEIF), an international Islamic finance university in Kuala Lumpur.

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Chapter one Application of contracts in the structuring processes of Islamic financial products Learning outcomes By the end of this chapter you should be able to: • suggest types of contracts, as a result of suitable analysis, deemed appropriate to particular products, based on intended or designed product features • distinguish between Shari’ah-complaint products and Shari’ah-based products • analyse the validity of contract conditions based on Shari’ah requirements • assess the validity of product features based on contract conditions.

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Indicative list of content • What is a Shari’ah-compliant financial product? • Structuring for Shari’ah-compliant financial products • Juristic rulings and financial product structuring • Financial product features and purpose of Islamic contracts • Application of essential contract conditions to recognised contracts for financial products • Case study: structuring products and choice of contracts

1.0 Introduction This chapter reviews the nature and importance of Shari’ah compliance in Islamic finance transactions, and explains the purpose and benefits of contracts adopted in structuring Islamic financial products. It outlines the sources of Shari’ah and the methodologies of reasoning and interpretation, with special reference to financial product structuring. The chapter also explains how the object, elements and conditions of the contract are taken into consideration when structuring an Islamic financial product. 1.1 Shari’ah-compliant financial products 1.1.1 Financial products and financial intermediation In conventional banking, interest-bearing deposits are placed with banks by customers with excess cash or liquidity. Subsequently, interest-based loans and advances are provided to bank customers who borrow to meet their consumer or business financial needs. Similarly, in financial markets, the issuance of shares and bonds or other financial instruments by corporations is used to source funds from the investing public. The issuing corporation can either invite equity participation by issuing shares or borrow by issuing bonds with an interest denomination. The Islamic financial services industry (IFSI) has evolved rapidly to meet the needs of a sub-group with specific needs. There has been a proliferation of financial products in the form of banking, capital markets and Takaful products and services. In essence these products represent the expectations of financiers and customers in the banking industry as well as issuers and investors in the capital market sectors. Primarily, the financial intermediation role of financial institutions and securities exchanges enables the mobilisation of funds from surplus to deficit units. This process is carried out through the creation of financial products that efficiently allocate funds to productive activities and do not compromise the beliefs of this sub-group.

1.1.2 Features of Islamic finance Islamic finance refers to financial business that complies with Shari’ah principles (CDIF/1/1/20). Islamic finance, like other financial systems, recognises the need for financial intermediation to achieve efficiency in the allocation of funds for productive activities. In this respect, financial institutions and financial markets are both essential components of a financial system to enable efficient mobilisation of funds. The salient features of Islamic finance, which are outlined in CDIF/1/1/23-25, include: • the prohibition of interest • the need for real transactional contracts involving underlying assets instead of lending money for interest • the avoidance of uncertainty • the avoidance of gambling • the provision of deposits or financing based on profit and loss sharing • the importance of adhering to the rights and liabilities arising from various transactional contracts

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• the avoidance of dealing in non-halal goods or services • the need for transactions to be consistent with the overriding principles of Islamic law in all terms, conditions and practices. These features provide the frame of reference for recognising Islamic financial activities, thus meeting Shari’ah compliance requirements.

1.1.3 What is Shari’ah compliance? Essentially, Islamic finance is about avoiding prohibitive transactions and practices to achieve compliant status from a religious point of view. Of the features listed above, four are deemed to be fundamental to render a financial product compliant with Shari’ah principles. These are: • • • •

avoidance of interest-based activities avoidance of uncertainty in transaction conditions avoidance of gambling activities avoidance of activities relating to non-halal goods and services.

As and when a financial product is free from these features, it may be considered compliant and acceptable.

1.1.4 Prohibited items or practices The first presumption of Islamic law is that a contract, term or condition, or practice, can be viewed as acceptable to Islam provided no evidence to the contrary is established. This is in line with the established Islamic legal maxim that dictates that all matters are deemed to be approved unless proven otherwise. This is similar to the legal maxim where one is presumed to be innocent unless proven otherwise. This methodology of prescribing the law in matters of commerce and trade, at least from the initial impression of the law, is based on the established interpretation of the Qur’an and the Traditions of the Prophet Muhammad. For example, the Qur’an did not elaborate on what is permissible for the believers as much as what is not permissible. As the list of prohibited items or practices is limited and exhaustive, the Qur’an expounds what is not permissible in the form of revelation to guide human interaction and activities. At the same time the Qur’an provides general guidance on what is lawful and good as permissible. With such general guidance, mankind is encouraged to explore all forms of halal and good products and activities that are beneficial.

Key point • The principle of ‘presumption of permissibility’ in Islamic law is the Islamic legal maxim that dictates that all matters in commerce and trade are deemed to be approved unless proven otherwise.

1.1.5 Prohibitions within financial and commercial transactions In respect of financial and commercial transactions, the Qur’an commands the prohibition of interest, uncertainty in terms and conditions of the contract, gambling activities, and misappropriation of others’ property in an unjust manner, such as deceit, misrepresentation or fraud. The Qur’an also prohibits the consumption of intoxicants and non-halal food and drink. Islamic law has therefore been based on the principle, or maxim, of presumption of permissibility of any commercial matter or conduct until, and unless, evidence to the contrary is found or established. Applying this maxim in Islamic finance means that a proposed new product, or a new feature added to an existing approved product, can be advocated as compliant, unless or until an argument to the contrary is put forward. Arguments leading to prohibition are normally confined to the four identified practices or eventualities mentioned above.

Exercise 1.1 By reference to CDIF/1, identify where the prohibition of interest and the misappropriation of the property of others was founded in Islamic law.

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1.1.6 Shari’ah compliance In Islam, social interactions in the form of commercial, financial, matrimonial or other forms of socially beneficial activities are not only permissible but encouraged. Divine guidance on acceptable conduct and moral action are revealed in the Qur’an and exemplified in the Traditions of the Prophet Muhammad. These two primary sources of Shari’ah are meant to preserve and promote the wellbeing of society, which is harmonious towards the common good, an important goal of Shari’ah. The general rule here is that all human activities are permissible unless prohibited under Shari’ah principles. For example, consumption should be directed to halal products and services that are beneficial to mankind. Essentially, the norms and values specified in the sources of Shari’ah and prescribed in the form of Shari’ah principles and rules are the basis for Shari’ah compliance. These have been documented as legal verdicts (Fatwas), Shari’ah rulings and resolutions of various supervisory boards, and Shari’ah standards set by relevant agencies. The salient features of Shari’ah compliance, that is the avoidance of prohibited activities and the fulfilment of mandatory requirements with regard to the terms and conditions of a particular contract, must be represented in both the process (means) and outcome (end) (CDIF/1/2/40-41).

Key point • A Shari’ah-compliant product requires the avoidance of all prohibitions and the fulfilment of all contract requirements.

Exercise 1.2 An exporter receives a Letter of Credit worth US$1 million issued by an importer’s bank to export printing equipment. The Letter of Credit will mature 90 days after the issuance date. The exporter seeks to liquidate the Letter of Credit by assigning it to an Islamic financial institution (IFI) for a cash payment of US$1 million. Would this practice be acceptable in Islamic finance? If you think it is, what could happen that would cause this practice to be non-compliant? In order to test your knowledge, the answer to this question may not be evident from the discussion so far. We recommend that you refer to CDIF/1/6/116 and CDIF/3/6/99-100 before attempting to answer this question.

1.1.7 Islamic financial products When creating an Islamic financial product, its purpose, design and structure, legal documentation, operational process flow, accounting treatment, monitoring, recovery and restructuring (if any), IT support and risk management must all comply to Shari’ah principles and rules.

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Figure 1.1 Stages of product development

Recovery & restructuring

* These processes are supported by IT Support & Risk Management

Monitoring

Accounting treatment

Operational process flow

Legal documentation

Product design and structure

1.1.8 Shari’ah compliance governance To ensure that financial products and services are Shari’ah-compliant, various organs of Shari’ah governance have been established to guide and monitor institutions offering Islamic financial products and services. The Shari’ah Supervisory Board (SSB) provides direction in formulating legal verdicts (Fatwas) as well as Shari’ah endorsements on Islamic financial products (CDIF/1/2/42-43). Standard setting bodies such as the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) and the Islamic Financial Services Board (IFSB) promulgate Shari’ah governance, audit and prudential standards to guide the industry in adopting the prescribed or recommended practices (CDIF/1/11/184).

Exercise 1.3 Based on your knowledge of Islamic contract principles and giving reasons for your answer, which of the following does and does not describe a Shari’ah-compliant financial product?

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Product

Description

A

A deposit that promises a fixed return based on a Murabahah-tawarruq transaction.1

B

Mutual fund issuing two classes of shares/units whereby class A takes precedence over class B in profit distribution and loss distribution (in the case of liquidation).

C

The disbursement of profits in Musharakah not in accordance to capital contribution ratio.

D

The rescheduling of a Murabahah facility for an extra profit due to the revised tenor of payment.

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1.2 Structuring of Shari’ah-compliant financial products 1.2.1 Design and structure of the product For any financial product to be deemed Shari’ah-compliant, various parties must carry out a systematic analysis and evaluation concerning its design, structure and development, particularly at the origination phase. Islamic financial product initiatives arise by either adapting existing conventional products to meet Shari’ah requirements or by developing new products based on Shari’ah requirements without any link or reference to conventional financial product design and its economic benefit. The former are generally known as Shari’ah-compliant products, the latter are generally described as Shari’ahbased products.

Key points • Shari’ah-compliant financial products relate to an existing comparable conventional financial product, having the same economic benefit but excluding any prohibited elements. • Shari’ah-based financial products are new products with features that are fundamentally derived from Shari’ah principles, with no comparison to any existing conventional financial product features.

1.2.2 Shari’ah-compliant products Shari’ah-compliant products are based on existing conventional financial products, particularly with regard to their economic benefit and risk behaviour. These products, in general, do not differ from their conventional counterparts except that they are free from interest and other prohibited features. Examples include Islamic debit cards, Islamic credit cards, Islamic personal financing, call options and profit rate swaps.

Figure 1.2 Examples of Shari’ah-compliant products

Islamic credit cards

Islamic debit cards

Islamic personal financing Shari’ah compliant products

Islamic profit rate swaps

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Islamic call options

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‘Urbun is essentially a down payment made by a buyer to a seller after both parties have entered into a valid contract. The down payment represents the commitment to purchase the goods.

A call option would give the right, not an obligation, to the holder to purchase an underlying asset at a certain agreed price in the future (strike price). If the holder of the call option decides not to exercise the option, the premium paid will be forfeited. This practice can be replicated in Islamic finance on the basis of the ‘Urbun contract (CDIF/3/13/214).

1.2.3 Shari’ah-based products Shari’ah-based products comprise financial products that are not only compliant to Shari’ah principles but are also based on features that are unprecedented in conventional financial products. These products are not found in a conventional financial system and thus may require, for example, a different treatment of risk management, accounting, corporate governance, security and collateral and legal requirements. Examples of such products include Mudarabah for an investment account, Sukuk, which reflects asset-based securitisation, house financing based on Ijarah with an option to purchase, or Musharakah mutanaqisah, which is based on Musharakah and a Letter of Credit.

Figure 1.3 Examples of Shari’ah-based products

Mudarabah investment account

Ijarah house financing

Sukuk Shari’ah based products

Musharakah letter of credit

Musharakah mutanaqisah house financing

Sukuk Ijarah, for example, gives Sukuk investors the right to benefit from the rental lease payment payable by the originator/lessee. However, it is different from conventional bonds as it allows Sukuk investors recourse to the originator/lessee to repurchase the leased asset from Sukuk investors in the case of default. This is made possible because Sukuk investors in the case of Sukuk Ijarah, unlike conventional bond holders, are owners of the leased asset (CDIF/3/7/106-107).

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Islamic finance challenge 1.1 (a) Compare and contrast the features of a conventional fixed deposit and an Islamic investment account based on a Mudarabah contract. (b) Explain whether an Islamic investment account is a Shari’ah-compliant or a Shari’ahbased product, outlining the features of an Islamic investment account contract that lead to your conclusion.

Solution Your answer should be based on your general knowledge and the general features of this product as discussed in CDIF/2/4/76-78. (a) Unlike an interest-based fixed deposit, which is a form of loan to the bank by the depositors, an Islamic investment account is an equity-based profit-sharing account whereby the depositors provide the investment capital to the bank in return for a share in any profits earned by the bank. However, they also bear any loss of capital. In a conventional fixed deposit, predetermined interest is specified and accrued for the period, whereas for an Islamic investment account, Islamic bank profit is shared, based on a pre-agreed profit-sharing ratio (PSR) with the account holders of the investment account at the beginning of the period. The fixed deposit is guaranteed for both the deposit amount and the interest income. (b) Based on the Mudarabah contract, capital is recovered before profit is recognised. Hence the bank minimises loss exposure while generating a return to the account holder. As a result, this product is Shari’ah-based as it does not relate to any interest-based feature or economic benefit found in a conventional fixed deposit. An Islamic investment account poses a number of issues that fundamentally differ from a conventional fixeddeposit scheme, including, but not limited to, capital guarantee, displaced commercial risk, capital risk and ex-post returns.

1.2.4 Shari’ah-compliant v Shari’ah-based The dichotomy between Shari’ah-compliant and Shari’ah-based products is more prevalent in dual banking systems when Islamic financial products retain most of the conventional product features to gain acceptance and be competitive. In the dual banking system, where both conventional and Islamic financial institutions operate within a similar financial environment and provide financial services to a common pool of customers, depositors, investors or issuers, the opportunity to expand the spectrum of financial products and services will always be explored by the relevant institutions. For example, a conventional bank that has established an Islamic window or Islamic subsidiary would be inclined to design similar product features for both Islamic and conventional products that can be supported by common shared bank services, such as legal, accounting, risk management and IT systems. Hence the motivation would be to benefit from economies of scale while engaging in a new market segment of Islamic finance.

Exercise 1.4 To benefit from its existing IT and risk systems, and support shared services that will be costeffective, the Islamic window of a conventional bank seeks to offer its clients an overdraft facility which is compliant to Shari’ah principles but has the same financial or economic benefit as its conventional overdraft. (a) Explain how the Islamic overdraft could be structured. (b) State whether the new overdraft would be deemed as Shari’ah-compliant or Shari’ah-based.

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Islamic finance challenge 1.2 An Islamic financial institution wants to offer a new product, similar to a conventional overdraft that would allow clients to benefit from the financing facility as and when required. The management of the institution decides not to use Tawarruq as the basis of this new product. They ask you to advise them as to the potential contracts that could be used for this purpose. They mention a few contracts such as Qard, Salam, Mudarabah and Musharakah for your consideration. Your response should briefly describe how these contracts may be constructed to have the same economic benefit as an overdraft facility.

Solution An overdraft facility is meant to provide flexibility to clients to meet short-term obligations and is usually packaged as part of project financing or cash financing. Islamic finance recognises this short-term liquidity need and can support it with a range of contracts depending on the ancillary purpose to which the facility is attached. Where the customer requires minimal overdraft payments to support current account transactions, a few institutions may offer Qard, an interest-free loan. This would most likely be offered only to their privileged customers. In the case of project financing where identifiable assets are purchased as part of working capital financing, the revolving facility could be based on the Murabahah contract where every drawdown is accompanied by a sale contract. If such a facility represents a continuous commitment by the bank to provide cash or capital, then it may take the form of either Mudarabah or Musharakah capital, designated as a float to meet the short-term obligations. Generally, the economic benefit to the customer is that it allows flexibility in cash flow management, while the economic benefit to the bank is that it allows for an effective yield when providing financing to the client. Alternatively, an Islamic overdraft may be structured based on a Salam contract where the seller of Salam will get the cash in advance for his own use. This contract can provide cash financing that can replicate the conventional overdraft.

The flexibility provided by financial authorities to Islamic financial institutions to extend beyond the traditional lending and borrowing activities of the core banking system facilitates the development of either enhanced products or new financial products.

1.2.5 Shari’ah requirements for structuring financial products Generally the structuring for Shari’ah-compliant financial products involves two stages: (a) developing the product concept; and (b) a review of the product concept by a Shari’ah board or committee. (a) Developing the product concept The client who intends to raise funds or provide financing to a particular customer will prepare and present a product concept of the intended financial product. The product concept should state: • • • • • • •

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the purpose of the funding or financing the activity being funded the asset or project meant for fund utilisation the financing amount and the manner of disbursement the payment schedule the expected yield or return to the financier any form of security or collateral required to mitigate the risk exposure of the product.

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In addition, where relevant in specific jurisdictions, it is also necessary to consider the validity and enforceability of the product in the given legal framework. For instance, the application of bankruptcy remote Special Purpose Companies (SPCs) in Sukuk structures is made easier in countries that practise a common law legal system that accepts the concept of beneficial ownership, vis-à-vis legal ownership under the equity principle of common law. Companies can use SPCs to legally isolate high-risk projects/assets from the parent company and allow other investors to take a share of the risk. Some civil law countries such as Bahrain have had to introduce a special law on trust in their civil law jurisdiction to facilitate the incorporation of an SPC as the trustee holding Sukuk assets on behalf of, and in the interest of, the Sukuk holders. This legal structure has the benefit of protecting the interests of Sukuk holders during the tenor of the Sukuk. Creditors to the originator/legal owner of the asset/lessee will not be entitled to make any claim from the asset as the trust is held exclusively for the benefit of the beneficiaries/Sukuk investors. Tax implications arising from the product features may also have to be considered. Countries such as the UK and Singapore, that have amended their Stamp Duty Acts to avoid double stamp duty, are facilitating the development of Islamic financial products and services that have to use more than one transaction to achieve the economic benefit intended of a Shari’ah-compliant product such as Murabahah asset financing and Murabahah cash financing.

Table 1.1 Islamic financial product features and Shari’ah requirements Product features

Shari’ah requirements

Purpose of fund/financing

Specified and legitimate

Activity, asset or project for fund utilisation

Legitimate and traceable

Financing amount

Specified with no interest income or obligation

Disbursement schedule

Specified and must observe contract requirements

Payment schedule

Specified and must observe contract requirements

Profit or yield determination or estimation and recognition

Irrespective of whether it is fixed (sale contract) or floating (Ijarah) or estimated (equity), the amount or the benchmark or the ratio must be fixed

Security or guarantee

Legitimate assets and mechanisms, and must observe contract requirements

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(b) Reviewing the product concept by a Shari’ah board or committee. The second stage of the process involves a Shari’ah board or committee reviewing the product design and features to determine whether the product design and its features are permissible. The decision on permissibility is based on Shari’ah requirements that include, but are not limited to, whether: (a) the purpose of financing or fund raising is lawful and legitimate according to Shari’ah requirements (b) an identifiable asset, activity or scope of the project has been determined to ensure that the funds are utilised according to the designated purpose (c) the financing amount generated relates to a valid underlying Shari’ah-approved transaction, meaning it is sale or leased-based, or involves an equity claim (d) the choice of contract for the transaction is suitable for the funding or financing arrangement in that it fulfills the elements and conditions of the contract, as well as any ancillary conditions of other supporting contracts (e) where more than a single contract is executed, the process is permissible according to Shari’ah (f) the manner of disbursement is consistent with the conditions of the underlying contract (g) the determination and recognition of the yield or return is consistent with the conditions of the underlying contract (h) the payment schedule and re-schedule (if any) is consistent with the conditions of the underlying contract (i) the security arrangements, such as collateral or guarantee, which are meant to safeguard the interest of the financier, issuer or investor, are compatible with the purpose of financing, and are consistent with Shari’ah requirements.

Exercise 1.5 Given the excessive volatile market conditions, an asset management company launches an Islamic product known as an Islamic Capital Guaranteed Fund. This fund will be invested only in Shari’ah-compliant stocks. However, there is an undertaking by the fund manager to purchase back the units of shares in the fund at a price equivalent to its initial purchase cost if the index of the fund has depreciated less than the initial Net Asset Value (NAV) of the fund. (a) Would this product offering be complaint to Shari’ah principles? (b) Explain your reasoning for the answer given in (a) above. (c) Suppose the same asset management company has changed the strategy from a Capital Guaranteed Fund to a Capital Protected Fund, would the Shari’ah perspective be different from the previous product design and strategy?

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1.2.6 Purpose of funding and suitability of contracts At this stage the product development manager would need to provide substantive information on product features and structure, taking into account implementation issues as well as the monitoring and redemption or restructuring of the product, where relevant. The most critical issues for the Shari’ah board or committee to assess are the purpose of funding or financing, as well as the validity and suitability of contracts used to support a particular financial product. For example, if the purpose of funding or financing is not permissible in Shari’ah, or is ambiguous and may involve elements of prohibited activities, a financial product will not be considered as compliant. Similarly, in the case where the sale contract is adopted but the subject matter of sale is unknown, uncertainty or Gharar will result in the financial product not being approved.

Table 1.2 Financial product structuring: Shari’ah considerations Critical considerations in financial product structuring ✓

Is the purpose of the financial product lawful and proper?

Do the elements of the contract form a valid and enforceable contract?

Do the payment and yield avoid any prohibitive financial elements of the financial transaction?

Exercise 1.6 In a Murabahah commodity structure to facilitate cash financing as well as fixed-income financing products, one of the parties to the transaction must purchase a commodity from the original owner prior to selling the same commodity to the other counterparty, which is then paid via a deferred payment scheme. The following specifications of an underlying asset for this facility are described in the schedule of the Murabahah Financing Agreement as follows: a. b. c. d. e.

Type of asset: Aluminium Quantity: 10 tons Quality: Grade A Location: Not available Identification: Not available

(a) Would this transaction based on the above specifications be a valid sale? (b) State the reason for the validity or invalidity of this sale.

Follow-up question: (c) If the object of the sale was gold and not aluminium, and the location and identification were fully designated and identified, give reasons as to whether the Shari’ah ruling would be different.

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1.3 Juristic rulings and financial product structuring 1.3.1 The juristic rule formulation processes The juristic rule formulation processes in reviewing financial products take into consideration both the sources and methodology of interpretation of Islamic commercial law. The sources of law, which refer to the Qur’an and the Traditions of the Prophet Muhammad, contains general principles of law and, where a rule or legal argument is used, substantive law (CDIF/1/3/55-56). The methodology of Islamic law is based on Ijtihad or legal reasoning, which adopts various tools and techniques, namely: • • • • • • •

Ijma’, or consensus Qiyas, or analogical reasoning based on ‘Illah, or ratio decidendi Istihsan, or juristic preference Maslahah, or public interest Sadd al-dharai’, or blocking the means ‘Urf, or customary practice Istishab, or ‘presumption of permissibility’.

The outcome of the legal interpretation is Fiqh, which is a set of practical rulings and laws governing a specific case law or issue that requires a specific solution (CDIF/1/3/60-64). Islamic legal theory, as a discipline, helps jurists interpret and deduce the law using guided and systematic reasoning. Reasoning cannot be void of Shari’ah guidance as the sources of law are absolute and immutable. The application of various juristic techniques in interpreting and deducing Islamic law has resulted in the development of various schools of Islamic legal thought. The four prominent schools of law are the Hanafi, Maliki, Shafi’i and Hanbali schools. (CDIF/1/3/66-68) The structuring of Islamic financial products may vary in acceptability based on the application of different juristic techniques by the various schools of law. It is important to be aware of such variations if this is exhibited in different Shari’ah rulings on Islamic financial products. For example, scholars are divided in their interpretation of a Tradition of the Prophet that a person must not sell something (to a third party) until, and unless, he has taken possession of the asset. While the majority of scholars have applied this prohibition to all types of asset, the Maliki school of law has qualified this prohibition to mean only food items. Therefore, a person may sell non-food items to a third party, even though he has not actually taken possession of the asset that has been sold.

1.3.2 Forms of juristic rulings Jurists use a process to arrive at a legal ruling under the guidance of broad Shari’ah principles known as Ijtihad. The ruling could either be textual-based or human-based reasoning. The latter may, among others, be based on equity and consideration of custom. The process of determining a juristic ruling involves a systematic process based on the hierarchy of the sources of Shari’ah, as well as the appropriate application of juristic techniques in deducing the appropriate ruling for a Shari’ah-compliant activity or contract.

Table 1.3 Impact of juristic rulings on financial product structuring Forms of juristic ruling

Impact on financial product structuring

Text-based reasoning

Consistent and firm legal view based on revealed Qur’anic text and relevant Prophetic traditions – Permanence. Example: prohibition of usury/interest.

Human-based reasoning

Varies in accordance with the juristic techniques used in understanding the technicalities of the contract and their requirements – Transient. Example: permissibility of a conditional sale with an option to re-purchase the same asset at the same face value in the future.

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1.3.3 Structuring and contract requirements In Islamic finance the adoption of a valid and enforceable contract is the primary consideration in structuring an Islamic financial product. Generally the elements of contract comprise: (a) (b) (c)

contracting parties (offeror and offeree) with legal capacity offer and acceptance the object and consideration.

The legal capacity of the contracting parties applies to both natural and legal persons. The nature and purpose of the object of the transaction are to be Shari’ah-compliant, known, determined and deliverable. The consideration must be lawful, precise and of a determinable value as well as deliverable. If any of these elements are found wanting, the contract is invalid and not enforceable, and hence will render the financial product non-Shari’ah compliant.

Table 1.4 Purpose and consideration of unilateral contracts Elements

Requirements

Offeror and offeree

Legal capacity to enter into contract for both natural and legal persons

Offer

Effective communication by offeror to transfer or receive benefit from offeree

Acceptance

Effective communication by offeree to transfer or receive benefit from offeror

Object

Lawful, determinable, measurable & deliverable

Consideration

Lawful, determinable, measurable & deliverable

1.4 Financial product features and purpose of Islamic contracts 1.4.1 Bilateral or unilateral contracts Either bilateral or unilateral contracts can be adopted for structuring a financial product. A bilateral contract arises from a counterparty exchange of considerations while a unilateral contract is where a consideration is transferred from one party to another for no reciprocal consideration. Bilateral contracts are categorised according to various commercial purposes for the benefit of both parties to the contract. Unilateral contracts have only one purpose, which is to provide a financial favour to one party for no consideration in return. Thus, bilateral contracts, unlike unilateral contracts, have many different financial motivations which each contract under the purview of a bilateral contract is designed to achieve. These are contracts for works or services, safe custody, security, partnership, leasing, sale and loan. Further sub-classification is based on the form of consideration, the subject matter of contract, the pricing, the payment modes or the delivery type. All of the above applies only to bilateral contracts and hence their classification.

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This can be illustrated in the following table:

Table 1.5 Purpose and consideration of bilateral contracts Purpose

Consideration

Sub-features

Provision of services for the benefit of the principal (services)

Commission fee

Ju’alah

Agency fee

Wakalah

Provision of safe custody for the depositor (safe custody)

Safe custody fee

Wadiah

Security in favour of the party in whose interest the contract is concluded (security)

Transfer of debt

Hiwalah

Guarantee

Kafalah

Pledge

Rahn

Partnership to share the profit or profit and loss (partnership)

Capital only

Musharakah

Capital & work

Mudarabah

Enabling the non-owner to benefit from the usufruct of another’s assets (lease)

Usufruct only

Ijarah

Usufruct with ownership transfer option

Ijarah muntahia bi tamleek

Transfer of ownership from the original owner to another (sale)

Subject matter

Currency

Contract type

Bay’

Financial assets Tangible assets Intangible assets/ rights Pricing

Payment

Delivery

Provision of the right to use for no consideration (loan)

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Non-monetary

Discount

Wadiah

Cost plus mark-up

Murabahah

Negotiated Sale

Musawamah

Cost price

Tawliyah

Advance

Salam

Progressive

Istisna’

Deferred

Mu’ajjal

Piecemeal or one-off delivery

Istisna’

One-off delivery in the future

Salam

Qard ‘Ariyah

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Based on the respective purpose of the contract, one can identify appropriate exchange considerations that must be used as the basis of the financial transaction and hence the type of contract.

Exercise 1.7 In an Islamic financing scheme, the client may wish to acquire the asset on a deferred payment basis or may just wish to have the right to use the usufruct of the asset without having an ownership right over the asset. On the other hand, the client may have ultimately the option to either use the asset or acquire the asset as he wishes, without having any pre-agreed obligation for either. Also, the client may wish to purchase an asset, but have it delivered in the future for either a flexible scheme of payment or a lump sum payment. Alternatively, the client may invest in the asset with the view of benefiting from the income generated by the asset, but having the flexibility to liquidate the investment in the asset in an effective and low-cost manner. Given each of the possible requirements outlined above, state the respective contract that could be considered by an Islamic financial institution to meet the requirements of the above client.

1.5 Application of essential contract conditions to recognised contracts for financial products The following is the brief summary of the contract classifications that match the financial product purpose and the purpose of the contracts in Islamic commercial law.

1.5.1 Work services Here the financial services performed include collection or payment services. The contract would initially be considered work or serviced-based. The contract could be Wakalah or Ju’alah, depending on the nature of the reward payable to the worker or person who performs such a work. A Ju’alah contract is based on a fee that is only payable upon the successful performance of the required work. Wakalah could either be for a fee payment, which is paid irrespective of the successful performance of the required work, or it could include a no-fee payment feature.

Recognition criteria • Wakalah – services rendered could be compensated with a fee or could be free of any fee. • Ju’alah – services rendered and where the required work expectation has been achieved should be compensated with a performance fee.

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1.5.2 Safe custody services Depending on the specific circumstances, two contracts could be used in relation to the offer of safe custody services. Where financial institutions, acting in trust, hold funds or assets in safe custody for a third party, a Wadiah yad amanah contract would be adopted with a fee paid for the safekeeping services. Alternatively if the institution, as the custodian, wishes to utilise the funds with the permission of the depositor and, at the same time, guarantees the nominal value of the funds (in the case of monetary assets), a Wadiah yad dhamanah contract should be adopted.

Recognition criteria • Wadiah yad amanah – safe custody of monetary and non-monetary assets. • Wadiah yad dhamanah – safe custody of monetary and non-monetary assets with permission to use those assets but to guarantee those assets in all circumstances.

1.5.3 Security The appropriate contract to be used when a debt due to or from one party is transferred to another with the permission of the original creditor or debtor as a consideration for the purpose of settlement is known as Hiwalah. For example, a customer with a deposit amount placed in Bank A may request a third party to collect his debt from Bank A. Effectively, the customer has transferred his obligation to another party so that Bank A will have to affect the payment to this party, the creditor. The bank of an importer, which guarantees payment to an exporter according to the terms specified in a Letter of Credit, could provide this service using the contract of Kafalah. For example, when the goods specified in a Bill of Lading match those specified in the Letter of Credit the importer financial institution, being the guarantor, will undertake to disburse payments to the exporter. In addition, any pledge made by the customer to secure a line or facility can be made based on the Rahn contract. For example, a trader may pledge specified assets in favour of the financier to secure the payment obligation by the trader to the financier.

Recognition criteria • Hiwalah – debt settlement via assignment of debt in favour of the principal creditor. • Kafalah – guarantee executed to guarantee the payment or delivery of asset to secure the interest of creditor or purchaser. • Rahn – pledge of asset to secure interest of creditor.

1.5.4 Partnership Both the Musharakah and Mudarabah contracts can be used in cases of partnership. When two or more parties provide funds for a common commercial purpose, where the PSR is specified and agreed between them and the loss sharing ratio corresponds to their capital contribution, the appropriate contract would be Musharakah. Alternatively, if one party provides funds and the other provides the entrepreneurship, where the profit is shared between them (agreed PSR), but losses are borne by the capital provider, then a Mudarabah contract would be adopted.

Recognition criteria • Musharakah – funds provided by two or more parties who mutually agree on a PSR and share losses based on their capital contribution. • Mudarabah – funds provided by one party and entrepreneurship by another, with both sharing profits and the provider of capital bearing the loss.

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1.5.5 Leasing In cases where the customer prefers to benefit from the use of the asset while not owning it, financing through a lease based on the Ijarah contract could be considered. In this case the financial institution finances the customer by acquiring the asset and leasing it to the customer. Alternatively, if the customer prefers the right to own the asset to be embedded in the lease agreement, a contract of Ijarah muntahia bi tamleek (lease with purchase option) could be adopted.

Recognition criteria • Ijarah – transfer of beneficial use of asset (usufruct) to the party who uses the asset for a consideration. • Ijarah muntahia bi tamleek – transfer of beneficial use of asset (usufruct) to the party who uses the asset for a consideration, plus an option to acquire the asset.

1.5.6 Sale Financing through the sale of an asset is the most prevalent form of financing. The goods, which must be Shari’ah-compliant, could be tangible, financial, currency, receivables or intangible assets. When the financial institution assumes the position of a seller, it will purchase an asset at cost price and subsequently sell it at cost plus mark-up. This transaction makes use of the Murabahah contract. Alternatively, where deferred payment is required, the customer will request the financial institution to finance the purchase of an available standardised good or commodity, which the financial institution then sells to the customer on a deferred payment (Muajjal) basis for a negotiated price (Musawamah) without need to disclose the cost. Both structures enable the financing of the purchase of identifiable assets. Where an IFI completes the sale at cost to facilitate the delivery of goods, the appropriate contract is Bay’ al-tawliyah. Finally, an IFI may sell the asset it purchases at a price below the cost price to liquidate the commodities in a relatively shorter time to avoid storage problem. This sale is known as Bay’ al-wadiah. The common legal requirement of all Murabahah, Tawliyah and Wadiah sales is that the seller shall disclose the actual cost price in their quotation made to the purchaser. When payment is made in advance and the commodity is to be delivered in the future, a Salam contract is adopted. Alternatively, if the goods specified have to be manufactured or constructed and subsequently delivered, the sale contract used would be Istisna’.

Recognition criteria • Murabahah sale – sale of goods at cost plus mark up. • Musawamah sale – sale of commodities at negotiated price. • Wadhi’ah sale – sale of goods at a discounted price. • Tawliyah sale – sale of goods at cost. • Muajjal sale – sale with deferred payment feature. • Salam sale – sale with advance payment and deferred delivery of commodity. • Istisna’ sale – sale of goods yet to be manufactured or constructed with option of a flexible payment scheme.

1.5.7 Loan When cash is extended as a loan for a specified period of time, the contract adopted is Qard. No return is allowed on the loan, although the borrower is legally required to return the loan capital to the lender. The loan capital is the liability of the borrower to repay in all circumstances. The lender can only demand for actual expenses incurred in providing this loan, such as paper work, telecommunication charges and lawyer fees.

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Table 1.6 Purpose and consideration of unilateral contracts Purpose

Consideration

Counterparty

Contract type

Will to bequest to posterity

Asset

Beneficiary

Wasiyyah

Waiver to set aside right

Right to benefit or claim

Donation to discharge social obligation

Asset

Recipient

Sadaqah

Gift to transfer asset with no reciprocal benefit

Asset

Recipient

Hadiah/Hibah

Promise to undertake obligation to perform

Undertaking to perform

Promisee

Wa’d

I’fa’

1.5.8 Will Unilateral contracts are either adopted independent of other contracts or as enablers for other contracts. Bequests in the form of a will are made by the owner of wealth when such wealth is transferred to beneficiaries specified in the will. The application of the will is executed to enable continuity of the rights of ownership or claims on the wealth that is transferred to the beneficiary. This allows for business continuity as well as the relevant inherent financial rights, claims or liabilities.

1.5.9 Waiver A waiver is a contractual right to relinquish the right to make a claim. For example, a lessor has a right to claim lease payments but may waive such payments for a specified period.

1.5.10 Donation A donation is a benevolent act of charity where wealth, or the right to benefit from such wealth, is transferred to another party for no exchange consideration in aid of a charitable or social cause.

1.5.11 Gift A gift is effected in financial transactions to enable the complete transfer of ownership of wealth or the right of claim. Similar to other unilateral contracts, there is no expected consideration payable by the recipient to effect the contract.

1.5.12 Promise A promise is made to provide assurance to the party that benefits from such a promise that any benefit expected to accrue to such party will be fulfilled, or any disadvantage that may affect such party is avoided.

Recognition criteria • Wasiyyah – A bequest in the form of a will to designated beneficiaries. • Donation – A charitable act of wealth transfer to a beneficiary. • Gift – A transfer of wealth in the form of an asset or return for the benefit of one party. • Promise – An undertaking to safeguard the interest of one party by securing a benefit or avoiding a disadvantage to that party.

Key point • While a bilateral contract aims to satisfy both parties to the contract financially, a unilateral contract seeks to financially reward only one party to the contract, that is, the recipient.

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Exercise 1.8 From a list of transactions described below, identify the type of contract(s) adopted for the transaction, explaining the criterion for your choice. A

Financing arranged for the purchase of a property by a customer which is agreed at cost plus mark-up, with the property secured as collateral.

B

A fund manager agrees to manage the equity fund on a fee basis where the profit and loss is shared exclusively among the investors.

C

A leased asset is securitised for investors to benefit from the lease payments generated for the specified period.

D

A deposit received will entitle the customer to share the profits earned from the bank’s financing and investment activities.

Islamic finance challenge 1.3 A proposal is developed by an IFI to launch Islamic Ijarah financing for vehicle and consumer goods for the retail market. The proposed tenor for this financing is five to seven years. Given the fact that the cost of the fund is volatile, the IFI proposes to make the rental rate floating, based on the discretion of the IFI taking into account the profit rate to be paid to its depositors with Profit Sharing Investment Accounts (PSIA), displaced commercial risk, as well the competitive rate in the market to achieve a degree of equilibrium between the IFI’s depositors and the retail financing customers. The IFI also proposes to grant a rebate for early payment based on its sole discretion. Identify the type of contract involved and the potential Shari’ah issues involved in structuring this product based on the above features.

Solution The above retail finance scheme is based on an Ijarah contract that is part of the bilateral contract. Although the illustration did not specify the actual classification of the Ijarah contract, it seems that the proposed Ijarah for this scheme is Ijarah muntahia bi tamleek whereby the vehicle or consumer good is intended to be transferred to the customer ultimately. The contract for the rebate for early payment is based on a gift contract which is unilateral in character. Under Shari’ah principles, the discretion of the IFI in fixing the floating rate of rental payment in an Ijarah contract is not permissible simply because Ijarah is a bilateral contract that requires the pricing formula to be agreed or fixed upfront to avoid uncertainty (Gharar). A certain established benchmark must be agreed upon to decide the future floating rate of rental. However, uncertainty in a unilateral contract such as a rebatebased transaction is permissible as the ultimate aim of the unilateral contract is not financial but rather a kind of reward or favour to the recipient.

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1.6 Conclusion This chapter has introduced you to, and demonstrated the importance of, Shari’ah compliance in structuring Islamic financial products. By reviewing the sources and methodology of interpretation of Shari’ah principles governing Islamic commercial law, we have explained how Shari’ah rulings affect the structuring of Islamic financial products. Discussion on the formation and classification of contracts explained the importance of recognising the appropriate contract when matching the purpose of the contract with the intended or selected product features. Finally the overall structuring process that addresses Shari’ah requirements within the framework of Shari’ah governance and review was mapped out to enable you to determine Shari’ah compliance for different types of Islamic financial products in the banking, capital markets and Takaful sectors of the Islamic financial services industry

1.7 Summary Having read this chapter the main points that you should understand are as follows: • the products of the Islamic financial services industry evolve with respect to the expectations of both financiers and customers in each respective market • Islamic finance recognises the need for financial intermediation to achieve efficiency in allocation of funds for productive activities • the principle of ‘presumption of permissibility’ in Islamic law is the Islamic legal maxim that dictates that all matters are deemed to be approved unless proven otherwise • various organs of Shari’ah governance have been established to guide and monitor institutions offering Islamic financial products and services in terms of their compliance and performance • Shari’ah-compliant financial products relate to existing comparable conventional financial products, having the same economic benefit but excluding any prohibited elements • Shari’ah-based financial products are those with features that are fundamentally derived from Shari’ah principles, with no comparison to any existing conventional financial product features • Shari’ah-compliant financial products are structured through the development of the product concept and a review of the product concept by a Shari’ah board or committee • the validity and enforceability of the developed product in the given legal environment is an important consideration • the structuring of Islamic financial products may vary in acceptability, based on the application of different juristic techniques that stem from the variety of methodologies of interpretation adopted by the various schools of law • a valid and enforceable Islamic contract must comprise of contracting parties who possess legal capacity, an offer and acceptance, and the object matter and consideration • the type of contract used as the basis of the financial transaction must reflect the appropriate exchange considerations identified.

1.8 Islamic finance case study Structuring products and choice of contracts First Time bank, a conventional bank, is at the initial stage in offering Islamic financial products. In a recent board meeting, the chairman raised the issue of the soundness and stability of Islamic financial products due to the controversy arising from new rulings on permissible products and nonenforceable contracts. The chief executive officer (CEO) updated the board by explaining that the Islamic Financial Authority is re-visiting the status of the financial services industry, particularly with reference to the legitimacy and acceptance of certain Islamic financial products. The CEO agreed to direct the Product Development Department to review the contract types adopted in the Islamic financial products offered by the bank and present a report at the next board meeting.

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Deposits

Loans and Advances

Conventional

Islamic alternative offered

Current Account

Islamic Current Account - Qard

Savings Account

Islamic Savings Account - Qard

Fixed Deposit

Islamic Investment Account - Mudarabah

Term loans

Murabahah term financing

Motor vehicle finance lease

Ijarah motor vehicle finance

Personal loan

Tawarruq

Notes: When designing its Islamic deposit products, the bank promised dividend returns equivalent to conventional interest paid to customers. • For its Murabahah term financing, the profit due to the bank accrues as long as the financing amount is outstanding without any additional mark-up. • Its Ijarah vehicle financing calculates a profit rate similar to motor vehicle finance lease. • Its Islamic personal financing provides cash financing and computes profit rates on a drawdown basis similar to that of an overdraft. As the product development manager of the bank, you are asked to review and analyse the contract types of the core banking products adopted by your bank.

Upon reviewing the Islamic financial products and consultation with a Shari’ah scholar, the product manager prepares the following report:

Review of First Time Islamic financial products Islamic deposits All outstanding deposits of the bank are guaranteed by the bank. When determining the profit attributable to Qard and Mudarabah depositors, profit payments adopt a declared computed rate. Profit is computed as follows: Profit = inter-bank offered rate X amount of deposit X (No. of days outstanding/365)

Murabahah term financing Murabahah term financing is administered in a similar way to loans and advances. There is neither any evidence of the sale of an asset nor the determination of cost and mark-up to the customer. The profit rate is, however, a floating rate mechanism based on LIBOR (London Inter-Bank Offer Rate) plus 50 basis points that is paid every six months throughout the tenor of the facility.

Ijarah vehicle financing Vehicles identified and purchased by customers are financed by the bank on the basis of Ijarah. The bank has the right to repossess the vehicles in all circumstances.

Islamic personal financing Financing originates from cash disbursements with no indication of sale of goods or services to the customer. The customers indicated that the financing was needed to meet temporary shortfalls in household expenses. The bank has stipulated in the contract that the proceeds of this facility shall only be used for Shari’ah-compliant purposes.

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Case study multiple choice questions 1. Which of the following features of the rate payable in the above-mentioned Islamic deposit is not consistent with Shari’ah principles? (A) Rate payable based on predetermined rate on outstanding deposit period (B) Rate payable to Murabahah fixed income depositors based on predetermined profit (C) Rate payable based on profit distributable to Mudarabah account holders (D) Rate payable based on floating rate of return on outstanding deposit

2. In the case of Murabahah term financing it is necessary to execute: (A) disbursement of cash payment to the customer for the approved amount (B) sale of goods to the customer at cost plus mark-up subsequent to cash purchase from the supplier (C) sale of goods to the customer at cost plus mark-up prior to cash purchase from the supplier (D) disbursement of cash to the customer to purchase the goods from the supplier.

3. In Ijarah financing of the First Time bank, which of the following features is not consistent with the Ijarah contract: (A) bank purchases and leases the assets to the customer (B) customer purchases and the bank leases the asset to the customer (C) customer sells the asset to the bank and leases the asset back from the bank (D) customer purchases and leases the asset to the bank

4. Which of the following products for providing cash financing is compliant with Shari’ah principles? (A) Cash financing based on Qard with a predetermined return (B) Cash financing based on Murabahah with a mark-up (C) Cash financing based on Wadiah with a predetermined return (D) Cash financing based on Musharakah with a predetermined return

5. Based on the information provided and using the structuring process described in this chapter, which of the following product features should be analysed and evaluated first? (A) Contract requirements (B) Customer expectations (C) Current banking practices (D) Customer cash flow requirements

Case study short essay questions 1. How appropriate are contracts identified for the Islamic financial products offered by the First Time bank? 2. Do the product features portray the underlying contracts adopted by the products? 3. State the essential purpose of the contracts relating to each product feature. 4. Recommend the structuring process that would take into consideration the relevant Shari’ah requirements.

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Chapter one answers Exercise 1.1 The prohibition of usury (Riba) and the misappropriation of the property of others was specifically mentioned in the Qur’an in Chapter 2:275 and Chapter 4:29 respectively (CDIF/1/1/24).

Exercise 1.2 This practice could essentially be envisaged as permissible in principle as it has no element of interest, uncertainty, gambling or any dealing with non-halal goods and services. Without looking for specific evidence for its permissibility (CDIF/1/6/116) one can safely conclude, although on a preliminary basis, that this practice is, and should be, permissible because it is free from the prohibitive practices and transactions as outlined in Shari’ah. This practice could, however, be rendered non-compliant if the IFI exchanges the Letter of Credit for a cash value of below US$1 million. The transaction would then generate interest. This is against Shari’ah principles, as the monetary asset in terms of Islamic receivables worth US$1 million is not being exchanged for money on a par value.

Exercise 1.3 Product

Description

A

The promised fixed return on deposit via a Murabahah-tawarruq contract is compliant as this contract is not equity-based.

B

This is not compliant as the investors in the same fund must be treated equally in terms of profit sharing and loss distribution.

C

The profit-sharing ratio in a Musharakah contract can be pre-agreed or be based on a capital-contribution ratio.

D

The rescheduling of the Murabahah tenor of payment for extra profit due to a longer tenor is not compliant as the Murabahah selling price must be fixed at all time.

Exercise 1.4 (a) The structure of an Islamic overdraft could be based on the Tawarruq principle. A conventional overdraft facility provides a cash line that enables the customer to utilise the loan for any purpose. Similarly, Tawarruq enables a cash line for the customer to utilise the funds for any lawful purpose in a flexible manner. However, an overdraft has predetermined interest charged on any amount outstanding. Under Islamic finance this is prohibited as usury. Tawarruq involves a mark-up sale that generates profit for the specified credit period (CDIF/2/5/108). (b) This is simply a Shari’ah-compliant product because it is based on the same behaviour as the conventional overdraft in terms of its accounting and risk management scheme.

Exercise 1.5 (a) The product outlined would not be Shari’ah-compliant. (b) One reason for this is that the par value of the fund capital is guaranteed, which is inconsistent with Shari’ah principles. An equity contract should not guarantee either the capital or the profit. A guarantee in any form in equity-based funds, either by the partner or the manager of the fund as Wakil, would not be compliant.

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(c) If the fund adopted investment strategies, such as investment in Islamic fixed-income instruments, for example, Murabahah and Sukuk Ijarah, the fund could be described as an Islamic Protected Fund. Such funds never guarantee the capital, but it will seek, on a best efforts basis, to preserve the capital by investing in underlying assets that provide a fixed and secured income generated within a prescribed period.

Exercise 1.6 (a) The sale, as originally described, would not be valid. (b) The asset is uncertain as it cannot be identified with special reference to its location and identification. This invokes the prohibition of uncertainty or Gharar.

Follow-up answer (c) If the object of sale was changed to gold, the sale would still be invalid as the payment of the purchase of gold, being a Ribawi (usurious) item must be paid on the spot. Although the new sale is free from uncertainty, it now invokes the interest prohibition, as gold, being a usurious item, is sold to another party on a deferred payment scheme instead of a spot transaction.

Exercise 1.7 While the Islamic financial institution (IFI) may use either Murabahah or Musawamah to affect a credit sale for the client, the IFI may offer an Ijarah contract for the transfer of the usufruct of the asset to the client. As for a client looking for the option of either the purchase or lease of the asset, Ijarah muntahia bi tamleek may be used to facilitate this commercial purpose. In the case of the purchase of an asset to be delivered in the future, either the contracts of Istisna’ or Salam may be used. While Istisna’ accepts flexible payment from the client, Salam requires a full payment paid in advance at the time of contract. As for the purpose of investment and easy liquidation, the IFI may also offer an investment fund based on a Musharakah contract. This will allow the client to invest in certain assets such as shares, properties and commodities through a mutual fund and other collective investment schemes such as real estate investment trusts (REITs) and exchange traded funds (ETFs) without the need to physically hold those assets to benefit from their income. Investments in assets using a Musharakah contract are relatively liquid for easy disposal.

Exercise 1.8 A

A Murabahah financing contract could be used here to meet the need for the cost plus mark-up sale along with a pledge (Rahn) as an ancillary contract of security.

B

The fund manager is being appointed on a Wakalah contract and the investors are pooling their funds based on a Musharakah contract.

C

Securitisation of leased asset involves an Ijarah’ contract whereby the investors may benefit from the lease rental payments.

D

Deposits received from customers on a profit-sharing basis are based on a Mudarabah contract.

Case study multiple choice answers 1 (A) Payment of predetermined or ex-ante rates on loans or Qard-based deposits are not Shari’ahcompliant as they are interest-based payments. Even on the Mudarabah investment deposits, only the PSR is pre-agreed and not the actual profit payment. 2 (B) Murabahah is a mark-up sale whereby both the contracting parties are made aware of the cost of the asset and agree upon the mark-up rate. The seller, which is the bank, must own the Shari’ah-compliant asset prior to selling it off to the customer. 3 (B) Under the Ijarah contract, only the party who owns the asset, or at least owns the beneficial use of the asset, can subsequently lease out the asset. In this case, the bank must own the asset or own the master lease to the asset to subsequently be able to lease the vehicle to the customer.

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4 (B) Predetermined returns are never allowed for Qard and Wadiah-based products. With regards to Musharakah, the only predetermined item is the PSR and not the actual returns. 5 (A) Islamic banking and finance is always underlined by Shari’ah contracts. The process of making the product features suitable to the contract requirements is always easier than vice versa as the product features can always be changed but the contract requirements must always be fulfilled.

Suggested solutions to case study short essay questions 1. First Time bank is offering depositories as well as financing products. For its Islamic deposits, the bank is offering its current and savings account based on the Qard contract. As a benevolent loan, the bank is not allowed to offer any return upfront to the customers. Ex-ante returns are not Shari’ahcompliant here, and this also corresponds to the returns of its Mudarabah investment accounts. The only difference between the returns of its Qard-based account and the Mudarabah-based investment accounts is that the former is given at the discretion of First Time bank and the latter is contracted based on a pre-agreed PSR. For the Murabahah term financing, the financing that is given to the customer is based on the mark-up sale of a Shari’ah-compliant asset conducted prior to the generation of the debt. The Ijarah financing is based on the identified usufruct that is leased to the customer, with the bank initially owning the leased asset and the cash-financing facility generated through the mark-up sale between the customer and the bank, with the bank paying the customer immediately with cash. 2. There are several non-compliant features described in the product features. With regards to Islamic deposits, the first issue of non-compliance arises from the guarantee provided by the bank. An Islamic investment account based on a Mudarabah contract cannot operate with the bank, as the Mudarib, guaranteeing the investment account holders outstanding deposits. The next issue lies with profit attributable to Qard depositors. Under Shari’ah, Qard depositors cannot be promised any returns as this would be tantamount to interest. Should the bank wish to reward its Qard depositors, it should instead grant them Hibah or gift, which cannot be contracted or promised. Murabahah term financing must be underlined by a mark-up sale of a Shari’ah compliant asset or commodity. The cost price of the asset must be made known and both the bank and the customer must agree upon the mark up made on the asset as well as the credit/financing tenor. The adoption on a floating profit rate based on LIBOR is not Shari’ah compliant as this will render the price uncertain and variable. Under the Ijarah vehicle financing, the bank will have the right to repossess the vehicle if the account becomes delinquent. The issue for this product is the fact that the bank never purchased the vehicle from the vendor. It was the customer who purchased the vehicle and the bank simply leased the vehicle to him. This transaction may lead to a loan contract. Under Islamic personal financing, as in the term financing above, it must be evidenced by a sale of a Shari’ah compliant underlying asset. Only then would the financial obligation of the customer to the bank be adequately established. The facts given seem to suggest that there was no transaction between the bank and the customer, thus making this Murabahah contract for personal financing questionable. 3. The Qard-based deposit accounts of First Time bank are designed for safekeeping, while the Mudarabahbased account allows the customer the opportunity for investment gains based on the expertise of the bank in managing their funds. The Murabahah term financing allows the bank to provide an opportunity for the customer to purchase an asset and the personal financing product disburses cash directly to the customer through cash financing. First Time’s Ijarah vehicle financing provides the customer with a leasing opportunity. 4. Regardless of whether it is the depository or financing products, First Time bank must institute a structuring process that can identify whether the purpose of the financing is indeed lawful and if the features of the instruments correspond directly to the requirements of the contracts. The financing products will only be Shari’ah-compliant if the requirements and the features of the individual contracts they are based upon are sufficiently complied with. There can be no divergence from the features and requirements of each contract used. In addition, First Time bank must abide by the regulatory requirements set in the jurisdiction it operates in. Notes: 1. Under Resolution 179 (19/5) the International Council of Fiqh Academy, which is an initiative of the Organisation of Islamic Conferences (OIC), prohibited the use of organised Tawarruq. Currently this decision is in conflict with AAOIFI standards. Murabahah-tawarruq can also still be found practised in the Middle East. The issue of what is acceptable practice will only be resolved by market forces or the intervention of the regulator.

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Chapter two Structuring process and related challenges in the Islamic financial services industry Learning outcomes By the end of this chapter you should be able to: • describe the structuring process in the development of Islamic financial products • evaluate and analyse the impact of weaknesses in structuring financial products • assess potential changes in industry requirements that have an impact on the structuring process.

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Indicative list of content • Essential elements of the structuring process • Essential Shari’ah principles in structuring Islamic financial products • Essential strategic considerations in product structuring and development strategy • Possible impact of weak structuring methodology in Islamic financial product development • Case study: Shari’ah considerations in structuring products

2.0 Introduction Chapter two introduces you to the structuring process that is integral to the product development strategy of institutions offering Islamic financial products. The critical components of the process are identified and explained with reference to specific Shari’ah requirements. The chapter also considers the effect of varying financial environments and industry requirements in the adoption of a structuring process. Finally, the chapter highlights factors that may impair structuring quality for Islamic financial products, as well as considering the possible consequences of poor product structuring strategy. As outlined in chapter one, the importance of the purpose of Islamic financing contracts, and the relevant application of those contracts in designing Islamic financial products, is fundamental in ensuring the proper and effective adoption of appropriate contracts. The behaviour of Islamic financial contracts, as outlined in chapter one, affects strategic considerations in the development of Shari’ah-compliant, financially viable and sustainable financial products and services. Both the product requirements for an effective structuring strategy, as well as the potential pitfalls in structuring, will be highlighted. Finally, you will see how the structuring process and strategic considerations enable the Islamic financial services industry to design, develop and implement a comprehensive strategy for Islamic financial products and services. This allows them to meet customer requirements and comply with Shari’ah principles and the legal framework in a cost-effective manner. 2.1 Essential elements of the structuring process 2.1.1 What is an Islamic financial product structure? In general terms, a product, in the form of goods or services, represents the rights or obligations in ownership and use of the product, as well as the perceived economic benefits generated from the product. In the case of a sale of goods, the title of the goods is transferred from the seller to the buyer and the buyer benefits from the merchantable quality of the goods. Similarly, an owner may lease his vehicle to the lessee where the right of use is transferred to the latter. In the case of a financial product, the seller or the financier is able to provide financial services to the buyer allowing the buyer to benefit from the financial facilities. These financial facilities include loans, financing or investments services. Conventional financial products are recognised by features such as the loan or investment amount, interest rates or investment yields, payment schedules and investment periods. Islamic financial products with similar features must exclude interest and uncertainty in the contract conditions. The prohibition of interest has been well documented in the Qur’an and the Traditions

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Gharar relates to risk, uncertainty or hazard which may be to the disadvantage of one of the parties to an agreement.

of the Prophet Muhammad. Gharar in contracts can lead to unsavoury situations whereby one party may take advantage over another and act deceitfully, or it can create disputes between the counterparties. An Islamic financial product must also be based on valid Islamic financial transactions that potentially facilitate direct lawful production, trade and consumption activities. This is because Islamic finance is either asset-based or service-based financing that relates to real-economy activities. Conventional finance does not sell or lease any asset or service and therefore is not related to real production of wealth in the lending transaction between the lender and the borrower. An understanding of the elements of Islamic financial product structuring, which ensures that the product complies with Shari’ah principles and rules, is therefore essential.

Key point • Islamic financial products are based on valid Islamic financial transactions that facilitate lawful production, trade and consumption activities.

2.2 Islamic financial product structuring 2.2.1 An overview In general, financial product structuring involves formalising the expectations of relevant parties based on the expressed contractual rights and obligations of counterparties. It also takes into account anticipated market behaviour in valuing the perceived benefits of the product. In the case of Islamic financial products and services, structuring involves formalising the expectations based on expressed Islamic finance contractual rights and obligations of counterparties, as well as considering the anticipated market behaviour in valuing the perceived lawful benefits of the product. The process deals with permissible valid transactions that meet the legitimate purpose of the financial product, where both the purpose and the means must be equally compliant. The act to mitigate risk is always praiseworthy in Islam and can be achieved through either risk transfer or risk distribution. Risk transfer for a payment or premium, as practised in conventional insurance, is prohibited under Islamic commercial law as it is seen to be similar to making a wager, which is akin to gambling. However, risk distribution among policyholders is acceptable under Islamic commercial law, based on the principle of mutual assistance and goodwill through contributions in the form of a mutual donation in the case of need and claim (CDIF/2/7/133). For example, Islamic finance uses the contract of Tabarru’ (donation), which is unilateral in character, to insure against pure risk in life such as death, accident and natural calamity, among others, which are always uncertain. This practice is acceptable in Islamic finance because unilateral contracts, unlike bilateral contracts, tolerate uncertainty as the financial advantage of one party does not arise at the expense of the other party. This product structure not only achieves its lawful purpose of distributing risk by applying a valid donation contract but also has competitive features, unlike conventional insurance products, such as giving an opportunity to the policyholders to benefit from the underwriting surplus, as well as investment profit, where relevant and applicable.

2.2.2 Product structuring phases Product structuring involves three phases: the design, development and implementation of the product. In the design phase, the product concept, purpose and features are identified and analysed to ensure that the product is coherent and is able to meet the expectations of the counterparties to the transaction. The development phase comprises activities, including legal documentation, operational and process flows documentation, marketing and promotion, accounting records and reporting systems, risk assessment and monitoring, IT systems and support, customer care and quality improvement. The implementation phase deals with the monitoring, control and review of the product with regards to the approved product design and its supporting documents. Each of these phases of Islamic financial product structuring must be considered to ensure that they each ultimately comply with both Shari’ah and industry requirements.

Key point • Islamic financial product structuring is a process that formalises counterparty financial expectations in the form of Islamic finance contractual rights and obligations that result in perceived lawful economic benefits to the parties and society.

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Exercise 2.1 An investor expects a guaranteed return of 5% per annum on capital invested and would like the financial institution to structure a financial product accordingly. Explain whether a product can be structured to meet the customer’s expectations and remain compliant to Shari’ah principles. What feature, if any, can be included in the structure to enhance the likelihood of receiving this expected profit and how can this structuring be put forward?

2.3 Critical elements of the Islamic financial product structuring process 2.3.1 Current trends Current trends in the development of Islamic financial products have been instigated by both private and government initiatives. In response to market competition or economic conditions, individual financial institutions have explored and developed alternative Islamic financial products for the Islamic finance market segment. Government policies and regulations in certain jurisdictions have initiated infrastructure support for the development of Islamic financial products. These initiatives provide the motivation to structure Islamic financial products. Institutional and macro factors influencing Islamic financial product structuring will be covered in Section 2.4. Figure 2.1 illustrates the elements of Islamic financial product structuring throughout all stages of the process.

Figure 2.1 Structuring an Islamic financial product Sources, methodology & contract guidelines Yes Appropriateness of product concept & purpose?

No

Yes

Structural product No

Choice of valid and enforceable contract?

review required to ensure product design is Shari’ah compliant

Yes Relevance of product features & contract requirements

No

Yes No

Completeness of product manual & process flow

Legal & operational

Yes

product review

Appropriateness of product legal & supporting documentation

No

ensure product development is

Yes Adequacy of process flow & system support

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Shari’ah compliant No

Yes

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Product implementation is Shari’ah compliant

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The diagram illustrates the many stages of the process involved in structuring a financial product that is not only compliant to Shari’ah principles but also to other banking, legal and IT requirements. In the first stage of product structuring, the product development team of an Islamic financial institution (IFI), either for retail or corporate financing, will work on fulfilling all the requirements to make the proposed product acceptable from a basic Shari’ah and financial requirement. For IFIs that have an in-house Shari’ah compliance officer, the product development team will consult with this officer to vet the basic Shari’ah requirements. Otherwise, the IFIs may consult the Shari’ah supervisory board or any other external experts. Based on the different policies of the IFIs, the product features at this stage may have to be endorsed by its Shari’ah supervisory board before it can move to the next stage. Some IFIs may, however, complete the next stage before submitting the product features and its supporting documentation to their Shari’ah supervisory board for deliberation and endorsement. The next stage involves a bigger IFI team such as IT, legal and system development. Also, the involvement of an external legal firm to look at the documentation of this proposed new product may be crucial. The legal documentation should be not only compliant to Shari’ah principles but also, more importantly, to the laws of the country to make it admissible in the courts of law and enforceable. Equally important are the comprehensive and coherent IT and product manuals that must also be compliant to Shari’ah requirements. Implementation is the next stage where it is the responsibility of senior management of the IFIs to ensure that all practices and business conduct, from the level of marketing to recovery, if relevant, are in line with the approved Fatwa and manual of the products.

2.3.2 Elements of the structuring process The elements of the structuring process identified in figure 2.1 above demonstrate the sequence required to facilitate an orderly and effective structuring of Islamic financial products. These elements are the established sources, methodologies and contract guidelines, product concepts and purposes, choice of valid and enforceable contracts, product features and contract requirements, product manual and process flow, product legal and supporting documentation and finally the process flow and system support. When these elements of the structuring process have obtained Shari’ah approval or endorsement, the Islamic financial product shall be deemed to be Shari’ahcompliant or Shari’ah-based as the case may be. The product structuring cycle completes with timely and effective monitoring, and a review that is undertaken after the product development process. Any fundamental breach of Shari’ah requirements in the product structure that is found postimplementation will need to be re-addressed and re-examined. In other words, a product may have satisfied all the theoretical requirements but may have some difficulties, for example, in following the required flow of contract in practice. Similarly, the product may be found not to have been implemented according to the prescribed guide or manual.

Exercise 2.2 In Islamic finance, discuss whether product structuring is limited to product design and product development only?

2.4 Product design/origination phase The design phase determines the recognition, as well as legitimacy, of an Islamic financial product. Any failure on the part of a financial institution to meet Shari’ah requirements at this stage will affect the subsequent stages and will probably render the product non-Shari’ah compliant.

2.4.1 Compliance with Shari’ah principles and rules based on the sources and methodology of interpretation of Shari’ah principles The Qur’an and Traditions of the Prophet Muhammad are the primary sources of Shari’ah principles and the ultimate references on the legitimacy of the adoption of any Islamic financial product or service. Applying the maxim of presumption of permissibility, any financial product must be free from any elements that are categorically prohibited by Shari’ah principles. Also, any form of legal reasoning (Ijtihad) exercised in interpreting or evaluating a financial product must be consistent with prescribed principles. In addition to sources of law, financial products and services must be in tandem with many established legal maxims that are well documented and articulated in Islamic law literature. The principle of the presumption of permissibility is one such maxim.

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For example, the Traditions of the Prophet Muhammad clearly mentioned that any hybrid contract between loan and sale executed between the same parties should be avoided as it may lead to interest, although in an indirect way. The lender of the money, although on an interestfree loan basis, shall not sell any asset to the borrower as the lender-cum-seller may take advantage of this to compute the interest on his loan in the sale price, thus leading to prohibited interest. This product, the provision of an interest-free loan, combined with a sale contract, may be commercially appealing, but it will not pass the test as it contradicts the prescribed prohibition as reported in the Traditions of the Prophet Muhammad.

2.4.2 Satisfaction of product concept, purpose and features that are consistent with Shari’ah principles, as well as structured for lawful and legitimate activities Based on the broad guidelines for permissibility of Islamic financial products, the product concept is analysed in terms of its coherent and consistent structure and mechanism as well as its purpose and features, which must be Shari’ah-compliant at all times and in all circumstances.

2.4.2.1 Product purpose As explained in chapter one, the purpose of a financial product must be lawful and for the common good and benefit of mankind. If any element is identified at this stage that is either prohibited or can cause harm, the product needs to have its purpose re-defined or be replaced with another product. In Islam, the purpose of the product must not only benefit the individual parties but also benefit the broader segment of society. The purpose of the contract must be compliant with Shari’ah principles, otherwise it will not obtain the necessary approval, even though the contract may be compliant, in terms of structure and feature, on its own merit.

For example, if the purpose of a financial product such as Murabahah or Ijarah financing is to finance the promotion and consumption of intoxicants that impair the human faculty of reasoning, then this product, with this ultimate purpose, must be rejected. There could be, however, some products that may be doubtful in terms of their ultimate purpose. An example is using Istisna’ financing for the construction of a building where the ultimate purpose is to sell the building after its completion to a conventional financial institution. Such a case must be discussed thoroughly with the Shari’ah scholars or advisers to ascertain the Shari’ah perspective on the proposed purpose.

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Islamic finance challenge 2.1 Syndicated Islamic financiers have agreed to finance the construction of a new building, designated to be the financial centre of a country, using both Istisna’ and a forward lease. However, upon completion of the building, the Islamic financiers will immediately have to sell the whole building to the project owner who will then lease the building to the respective financial institutions that are granted the right to occupy that building. Required Explain how the Istisna’ and forward lease operate in this structure, and explain whether this structure or mode of financing is compliant with Shari’ah principles, taking into account the ultimate purpose of the construction. Would the Shari’ah position be different if the Islamic financiers were to lease directly this building to different tenants in that financial centre building?

Solution Financing the construction of a building using a combination of both Istisna’ and forward lease is a unique scheme of project financing. Essentially, the project owner or contractor will enter into an Istisna’ contract with the financier. The financier would request the contractor/project owner to build and deliver to the financier a complete asset in the future at an agreed price. The financier as the buyer shall disburse the Istisna’ financing amount to the project owner as per the progress payment schedule. Thereafter, the financier will enter into a forward lease contract with the project owner whereby the project owner as a lessee will pay the rental in advance under the forward lease contract to the financier. The rental payment, which will be fixed, is payable within the period of construction. Upon completion and delivery of the asset, the project owner-cum-lessee shall have the option to purchase the building. By purchasing the building from the financier, the project owner would become the ultimate owner of the building and may lease any part of the building to any tenant, irrespective of the activities of the tenants as the project owner is not an Islamic financier. The Islamic financiers are not involved in this leasing business and, therefore, their financing, using both Istisna’ and forward lease, is compliant as the financing ends up with the sale of the building to the project owner. Some scholars may object to this financing structure as this could be deemed as financing the construction of a building to be used by conventional financial institutions. If the Islamic financiers were to own and lease the building to respective tenants that include mainly conventional financial institutions then this would be seen as not compliant by all of the scholars as the ultimate purpose in that scheme is leasing the building to non-compliant tenants.

2.4.2.2 Product structure The financial product structure comprises the essential product components that enable the product to be recognised as either a funding, financing or investment financial product. The product components include elements such as the financier/investor or customer/issuer, terms of financing or investments, authority or limits, scope of specified purpose, security arrangements and any other element essential to a product. The structure is determined by the validity of the elements representing contractual rights and obligations of the contracting parties as well as the permissible conditions of the contract. The product structure and related contract requirements for funding can be in the form of deposits, Sukuk or funds. Financing can be categorised based on types of assets and purpose of financing, as well as underlying sale or lease activity. Investments are represented in the form of rights of claim through direct equity participation or securitisation of assets.

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For example, if the product structure describes the cash contribution as a capital investment for profit and loss sharing, but the features of the product entail capital guarantee or profit guarantee or both, then this is not consistent with the prescribed financial product structure, which is claimed to be of profit and loss sharing in nature. The rights and obligations arising from this financial product structure obviously do not represent the inherent rights and obligations of any equity contract such as Mudarabah and Musharakah. However, if the product structure specifies that the project manager will be liable for capital redemption in the case of negligence or misconduct, or breach of his terms and conditions, then this would be in line with Shari’ah principles relating to damages that could lead to capital guarantee to safeguard the interests of investors. Hence capital guarantee on equity is possible only in the case of negligence, misconduct or breach of a project manager’s terms and conditions.

2.4.2.3 Product mechanism The financial product mechanism represents the process adopted within a defined product structure. The mechanism can be described as the practical means to achieve what the product has been designed for. The mechanism includes measures such as the pricing of the product, the mode of mobilising surplus funds from economic agents and institutions and allocating them among deficit units, the manner of securing settlement or the means of promoting mutual goodwill between the counterparties. This represents the means to achieve the desired outcome where both the means and desired outcomes should be permissible according to Shari’ah requirements.

For example, if financing is provided to enable the services of the leased asset to be transferred to the lessee but the leased asset was impaired, then the lease contract is suspended until the lessor finds a replacement asset or the lessee has the right to terminate the lease contract. In this case, any financing income shall not be recognised, although the financing amount or the lease facility remains outstanding. This financial product, which is based on lease contract, would cease to operate whenever the leased asset is impaired, preventing the lessee from benefiting from the usufruct of the leased asset.

Key point • Product purpose, structure and mechanism are expected to be coherent and consistent with Shari’ah requirements in all aspects.

Exercise 2.3 A financial institution provides financing for the lease of machinery to a customer with a promise that the customer will purchase the machinery at the end of the lease period. During the period of financing the equipment becomes faulty and non-operational. The financial institution claims that lease payments should be made for the financing period. Evaluate the validity of this claim.

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2.4.3 Satisfaction of contractual elements to ensure a valid and enforceable contract Any contract adopted for a particular Islamic financial product structure should reflect the essential elements of that contract. As explained in chapter one, essential elements of bilateral contracts, such as offer and acceptance, certainty of subject matter of contract and exchange consideration, must exist and be appropriate for the choice of contract. If any of the elements of the contract are not effectively executed, the contract will be void or voidable and hence not enforceable. Financing for the sale of an asset must reflect the effective exchange of considerations between payment and delivery of the goods. In an asset financing structure using a Murabahah transaction, the financier may appoint the customer to purchase the goods from the supplier on behalf of the financier. The financier may also disburse the payment of the purchase price to the customer to pay on behalf of the financier to the supplier. This would be followed by the sale of the goods from the financier to the customer at a cost plus mark-up profit. In the event where the customer did not purchase the goods from the supplier on behalf of the financier as instructed, the sale of Murabahah to the customer will be null and void since the ownership of the asset by the financier was never established.

2.4.4 Satisfaction of contract conditions of the underlying contract(s) that are represented in the Islamic financial product structure Once the eligible elements of the contract have been ascertained, the specific contract conditions governing the effective execution of the elements of the contract need to be examined. Omission or non-observance of expressed or implied conditions of the contract will render the contract void or voidable and hence the Islamic financial product will not be approved. The following example using a Salam contract illustrates the above point. It is an essential condition in a Salam sale that full payment is made at the time of entering the contract. Where it is stipulated that a financial institution may defer such payment in view of receiving the goods in the future, the use of this contract would be void.

Islamic finance challenge 2.2 Due to customer demand for working capital facilities, a financial institution proposes a fixed-rate annual revolving credit facility to its business customers with specified drawdown limits based on customer credit standing. The facility applies the Commodity Murabahah structure contract in offering this facility to the customer. The customer is not obliged to notify the nature of utilisation of the financing amount for each drawdown. If the above revolving working capital facility is based on a Salam contract, explain what the required distinctive operating requirements for this financial product would be to be compliant with Shari’ah principles which are different from the Murabahah commodity structure. Analyse the product purpose, structure and process in relation to Shari’ah requirements.

Solution A revolving credit facility is a ready line of cash financing that enables customers the flexibility to utilise funds for operational activities. Although the implied purpose of this facility is for business financing, the actual nature of business is not specified. This requires disclosure of the ultimate usage of the proceeds of the Murabahah to avoid using Murabahah proceeds for non-halal business activities. As a revolving credit facility, it is envisaged that there shall be a series of Murabahah structures as and when financing is required. A proper product design, process flow and execution according to the process flow are required to ensure the compliance. Salam is a forward sale contract with purchase price paid in advance to the Salam seller. From the point of view of working capital requirements, Salam could assist in providing working capital to the customer. However, under this structure, the financier who advances the money must be willing to take the market risk of the commodity bought under Salam. For all intents and purposes, this Salam contract must result in the delivery of the asset to the buyer in the future either actually or constructively.

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2.5 Product development phase 2.5.1 The challenge of implementation At the origination phase of the product design, all relevant Shari’ah principles and requirements, as well as contract elements and conditions, must be thoroughly considered in light of the product purpose, structure and mechanism. This is followed by their translation into appropriate documentation and process flows, as well as technical specifications of relevant supporting processes and procedures. The Shari’ah requirements of the product design and the legal, operational risk reporting, and IT solution requirements are challenging at this phase. Each of these functional requirements evolved with different terminologies, varying best practices and varying standards from their respective discipline. Examining them from a Shari’ah perspective requires an in-depth understanding of the semantic differences of the terms used as well as the common purpose of these requirements which are peculiar to the product to be developed.

2.5.2 The perspective taken In the product design and process phase, the interface of product structure and the different processes presents different functional representations and behaviour depending on the perspective taken. A case in point is an Islamic financial product that is structured to attract funds in the form of term deposits with a return based on profit sharing. The key terms for this deposit product can be understood from a variety of different perspectives as shown in Table 2.1:

Table 2.1 An analysis of deposit behaviour from various perspectives Perspectives

Focus of functional representations/behaviour

Legal

Legal obligation

Statutory

Sight (Time) deposits

Operational

Outstanding amount owed by bank to customers for a defined period

Risk management

Liquidity and return exposures

Financial reporting

Obligation as liability

Marketing

Deposit motives, such as transaction, precautionary or investment motives

IT solutions and support

Deposit as part of core banking process and online information management

The above table highlights the various perspectives on the nature of a deposit that need to be effectively communicated and implemented by different departments within the financial institution. Any lack of congruence in product design and purpose will impede the product development process at the origination phase. Product documentation, known as the product manual, as well as product terms of reference or the Standard Operating Procedure, need to be developed in a comprehensive manner that articulates all the product concepts, structures, mechanisms and flows, as well as all the Shari’ah and functional requirements. Such documentation will provide coherence in documenting, communicating, reporting, implementing and controlling Islamic financial products.

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2.5.3 Approval of the operational process flow that is consistent with Shari’ah principles and rules The product mechanism specified in the design stage is documented as a process flow. It describes how the product is originated, offered to the customer or issued, traded (where relevant), redeemed or restructured (where relevant), monitored and controlled. The principal process flow may interface with process flows from different functional and supporting processes. Such forms of interface ensure that the functional and supporting process objectives will be congruent to the product purpose and objectives. During this stage a matrix of objectives is identified for different functional requirements that are consistent with Shari’ah requirements specified for the product purpose. Any form of inconsistency with the requirements may affect the product development that could lead to product misrepresentation to the customer. The following illustration explains the above position.

Illustration: Predetermined rate for investment account holder An investment account holder places US$10,000 with an Islamic bank for a period of three months. The return is based on a 50:50 agreed PSR of income attributable to investment account holders (IAH). The bank imputes a predetermined 3.6% profit rate per annum in its IT system that accrues US$90 as the profit payout for the three months. Based on performance of the investment account funds it is found that the effective return on investment account holders (ROIAH) at the end of the three month period is 4%. The bank should therefore compensate the IAH for the difference and adopt an appropriate profit distribution engine to determine the profit rate distributable to the IAH.

For example, in Murabahah financing it is part of the requirements that the financier shall own and possess the asset prior to its sale to the customer at mark-up sale. However, if this is not specified in the process flow, the IFI may disburse the financing amount to the customer to purchase the asset at a predetermined mark-up rate. In this scenario, the IFI neither purchases the commodity from the supplier nor sells the commodity to the customer on Murabahah. The effect would be a money-for-money transaction for a premium that is prohibited. Therefore, the proper documentation of the process flow and procedure is important to determine that the right contract and product feature of a financial product is operationalised.

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2.5.4 Approval of the legal and supporting documentation that reflect Shari’ah principles and requirements, as well as product design, features and mechanism Legal documentation is essential to ensure enforceability of the resulting financial contracts in a court of law within a particular jurisdiction. The approved product structure and mechanism must be reviewed in relation to the statutory legislation and financial law in practice to ascertain adequate and consistent legal representation of Shari’ah requirements as specified in the contracts. In particular, rights and obligations specified in the Islamic financing contracts are translated as legal rights and obligations with reference to the statutory definitions, as well as the legal definition and court interpretation of the financial law. Both the substantive and procedural aspects of the law are taken into consideration in drafting legal documentation to render the contract and its agreements valid and enforceable, as per law requirements within the particular jurisdiction in which Islamic finance operates.

The case of a deposit product is a good illustration in this context. The document relating to the deposit products of an IFI refers to the statutory definitions and relevant financial authority guidelines, such as central bank guidelines. The rights of depositors and obligations of the financial institution are established based on relevant case law as interpreted by the courts. These rights relate to procedures on acceptance of deposits, refunding of deposits, security, guarantee on deposit, consolidation and set-off using the deposit, redeeming depositors, as well as payment of returns due to depositors. Also, in the case of sales-based financing, the delivery of goods purchased by the customer from the IFI must be expressed and executed in the proper sequence as per the documentation. Goods should be purchased by the IFI from the supplier upon receipt of the purchase order from the customer. Subsequently the IFI sells the goods to the customer at the disclosed purchase price (cost) plus an agreed mark-up. Failure to execute the sequence accordingly implies non-effective transfer of legal title from the supplier to the IFI and subsequently to the customer as the ultimate purchaser.

Supporting documentation stems from the process flow and other related functional processes. These include records, bills, receipts and other supporting documents that relate to the process flows. The document flows should facilitate the tracking of documents that are concurrent with the respective process flows. Information captured, processed, communicated and reported must be consistent with the data requirements of the relevant processes that reflect Shari’ah requirements.

Key point • In conventional finance, most of the rights and liabilities are the result of one contract only; that is, the loan contract. In Islamic finance, rights and liabilities of the parties at any point of time are the result of various contracts such as trade or investment.

2.5.5 Approval of reports and disclosures that represent Shari’ah requirements pertaining to a financial product When the legal documentation and supporting process flow documents are verified for Shari’ah requirements, the financial and risk-reporting functions need to be identified and specified in the overall product process flow. These include the accounting treatment of the product and the related contracts based on international reporting standards, product and contract guidelines, as well as risk management considerations based on relevant liquidity and solvency frameworks or guidelines from the financial authorities. At this stage both the accounting and risk issues are dealt with to determine the commercial viability of the product, as well as the associated financial risks to the financial institution in terms of solvency, liquidity and profitability. In addition, the product document needs to make specific reference to Shari’ah requirements when formulating accounting policies and treatment, as well as risk-mitigation techniques and tools for the product. Relevant international standard setting bodies such as the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) and the Islamic Financial Services Board (IFSB), which promulgate standards and best practices on financial reporting and governance, must be referred to accordingly.

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For example, an Islamic financial product concept, which adopts a lease arrangement ending with a sale contract (Ijarah thumma al-bay) has been endorsed by a financial institution’s Shari’ah board. The financial institution reports the transaction as a finance lease as it only considers the amount outstanding for the leased asset to be reported as receivable with relevant credit risk exposures. In all material respects the reporting of accounting treatment and risk exposures does not address the lease (Ijarah) contract that requires a leased asset to be reported on the balance sheet. Both market and credit risks of the asset, based on the product structure and features, need to be considered in risk assessment.

Islamic finance challenge 2.3 The head of operations of an established IFI is particularly concerned when an Islamic financial product is approved by the board of directors (BOD) to be implemented by the institution. Of particular interest is the profit sharing feature of the Profit Sharing Investment Account (PSIA). According to the operations manager, the existing operational process flow of deposits accrues profit on outstanding deposits and reports interest expense on a monthly basis. Since the operational system does not cater for the profit sharing arrangement, the existing system computes distributed profit rate on the same basis. To what extent is the existing operational process flow suitable to cater for the PSIA?

Solution The existing operational flow computes and accrues profit payouts to depositors on the contracted fixed profit rate based on an outstanding amount on a periodic basis. In the case of PSIA, the account holders have a right of claim on the income attributable to mobilisation of PSIA funds that is shared with the financial institution. Hence the process flow needs to take into consideration the amount of PSIA funds mobilised to generate the income and apply the profit-sharing ratio (PSR) to distribute such income to the PSIA. By applying the fixed profit-based computation, the operational flow is not effectively according the rights of the PSIA holders on the distributable profits but rather applying the imputed rate. Hence the financial institution is not effectively discharging its obligations to the PSIA holders.

2.6 Implementation and monitoring phase With the completion of the product design and development, the product implementation process will then be executed. The operational aspects of product implementation involve promotion and marketing of the product, execution and administering of the product operations and procedures, timely and effective review and reporting of the operations, and customer feedback. A significant focus and emphasis will be on the internal control systems that integrate activities ranging from marketing to customer feedback for continuous improvement. The internal control system is embedded with Shari’ah-compliant objectives that represent Shari’ah requirements of the product specified in the design and development phases.

2.6.1 Product conformance, acceptance and quality Among the criteria to be considered at this stage are product conformance, product acceptance and product quality. Product conformance indicates the degree of compliance to criteria and requirements established at the design and development stages when the product is implemented. Product acceptance applies to both ‘internal customers’ who are departments of the institution as well as ‘external customers’ represented by regulators, customers, competitors and Shari’ah scholars. Internal customers’ acceptance refers to the degree of support or resistance in the adoption of Islamic financial products. The resistance could be because of additional investment required to deal with a lack of expertise, a lack of system integration and support, as well as the fear of displacement or the cannibalisation effect on existing conventional products by the new or innovative Islamic financial product. External customers’ acceptance refers to the reliability of the product in terms of conformance with the regulatory framework and system, and being benchmarked to international standards and best practices. Not meeting such requirements or expectations may result in resistance by external parties.

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Finally, product quality refers to meeting customer value expectations and timely as well as effective delivery. All these contribute to the implementation of a sustainable Islamic financial product and service.

2.6.2 Product implementation The implementation stage will be guided by the internal control system that governs the process flow and related processes and procedures, as well as the relevant documents, records and reports generated from the process flow. The review of the internal control objectives will facilitate effective implementation of the product, as well as the reports and opinions expressed by the Shari’ah board on Shari’ah quality assurance in terms of corrective action and continuous improvement of the process flow.

2.6.3 Shari’ah review on the implementation, monitoring, redemption or restructuring of the products Islamic financial products are deemed to commence the implementation stage when marketing and promotional documents are released after the product launch. The first interface with external customers is critical in terms of product image, acceptance and perceived value. In cases where Shari’ah approval is not properly sought, reputational risk and sometimes regulatory intervention could arise.

Illustration: Product misrepresentation A brochure printed by an IFI specifies a guarantee on capital invested with returns up to 10%, which will be redeemed and distributed to investment account holders only upon withdrawal after one year of the investment tenor. This is highlighted by the Shari’ah board to be non-Shari’ah compliant. A fundamental flaw is that the product structure is based on a Mudarabah contract. The capital should not be guaranteed and the return should be shared, based on a PSR according to expost performance. The brochure, however, reports otherwise and would have to be amended to adequately represent the product’s structure and features.

2.6.4 Shari’ah review Shari’ah review, as explained in CDIF/1/12/213 is conducted by the Shari’ah board on a periodic basis. Information and reports generated in the product design, development and implementation phases relating to Shari’ah requirements should be presented for the board’s review and where relevant for approval and endorsement. Prior to implementation, the product manual and related documents pertaining to Shari’ah matters should have been reviewed and endorsed accordingly. This will minimise possible misstatements or errors as the approved documents will provide guidance for the product implementation phase. During the product implementation phase, an internal Shari’ah review, as explained in CDIF/1/12/214, will be conducted by the internal audit department or designated unit on a more regular and sometimes ad hoc basis to determine product conformance, product acceptance and product quality as described earlier. Product conformance to internal Shari’ah control objectives includes conformance to the specified product features as well as the operational flow. For example, a revolving facility, based on a Murabahah contract, requires timely execution of the credit sale of assets at mark-up, which are identified by the customer and purchased by the IFI. Due to direct delivery of the goods to the customer from the supplier, no documentary evidence of the purchase of goods from the supplier by the IFI prior to the Murabahah sale to the customer is found. This omission affects the validity and enforceability of the Murabahah financing. As a result, the invalid profit arising from this particular transaction should be set aside for charity as per the Shari’ah board’s decision.

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A Murabahah contract refers to a cost plus mark-up transaction between parties. It is the prevalent mode of asset financing undertaken by a large number of Islamic banks.

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In the case of product acceptance, the approval of both Shari’ah board and regulators is sought. Based on this consideration customers and investors would then decide on the perceived lawful economic benefits of the product. The influence of external factors on product implementation will be discussed in the next section of this chapter in order to analyse their impact on Islamic financial product structuring in different jurisdictions. Finally, a product quality criterion during the implementation stage is part of the internal monitoring process. It provides corrective measures and actions, and continuous improvement of the operational process flow. Islamic financial product quality relates to the purpose of the product and application of contract requirements. In the event that a non-compliant feature or practice is discovered, the structure and product mechanism, as well as the related processes and document flows, will need to be reviewed. A corrective action may involve a change to both product structure and the entire mechanism.

Illustration: Product misrepresentation For example, in the case where an Ijarah vehicle financing is approved by a bank and disbursed to the customer, it is agreed that the motor vehicle insurance is to be borne by the customer similar to conventional finance leases. A review of the product structure finds that the insurance costs should be borne by the bank and deducted as an expense from the lease income accrued, or received, from the customer.

2.6.5 Preparation of a report that expresses the opinion on the status of the Islamic financial products A report is prepared on a periodic basis to provide findings of the Shari’ah review, as well as any certification or opinion expressed by the Shari’ah board on the Shari’ah status of the products. The report, where relevant, will rely on the internal Shari’ah review findings conducted on an on-going basis by the internal audit. The report is then tabled as the Shari’ah supervisory board’s findings and later deliberated by the board of directors, or, where relevant, the regulatory or governing agencies.

Islamic finance challenge 2.4 A Shari’ah review report finds that a significant percentage of reported income for the year was accrued from overdue financing arrangements that were re-scheduled from the previous period. On further investigation, it is discovered that this arose from sales-based financing contracts in the form of penalties, as well as profits accrued in excess of the agreed mark-up profit. Suggest how this phenomenon could have occurred and explain the necessary corrective action.

Solution When the Islamic financing products were approved and implemented, there may have been a lack of monitoring on the behaviour and performance of the products. An example is the automatic extension of the tenor of sales-based financing, in the case of the defaulted payment by the customer, for an extra profit on top of the agreed mark-up. In sales-based financing both the price and the profit are to be determined in advance. Unlike loans and advances where interest accrues when the loan is rescheduled or restructured, debt from sales-based financing does not accrue in the same manner. Hence any additional profit or penalty imposed from such delinquent behaviour is not regarded as income. However, a new contract to restructure the relationship is required to enable both parties to continue the financial arrangement in accordance with Shari’ah requirements. A restructuring mechanism using relevant compliant Shari’ah techniques and contracts is needed to address this issue. This may require cancelling the existing sales-based financing scheme and replacing it with one based on a different contract that would be able to accommodate the feature of extension of tenor. A mere rescheduling of the facility for an extra profit is not compliant as this goes against the very basic structure of a valid sale contract.

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2.6.6 The importance of Shari’ah governance The importance of Shari’ah governance through the establishment of a Shari’ah board or committee is essential to provide assurance on the origination, implementation, monitoring and reporting of the Islamic financial products which should be consistent with Shari’ah requirements. The Shari’ah governance framework and the Shari’ah board as the organ of governance are essential to ensure the integrity of the structuring process. This would involve the following stages: • Formation of a Shariah board/committee. • The Shari’ah board should approve contracts and contract requirements to be adopted by the IFI. • Endorsement of product concept, structure, manual and supporting systems that enable implementation and monitoring of product compliance and performance. • Periodic Shari’ah review on product behaviour, performance and compliance.

2.7 Essential strategic considerations in product structuring and development strategy Similar to any type of financial product, the interaction of the product and its resulting behaviour in an Islamic financial system is influenced by various exogenous factors that determine the effective implementation of the product as well as its acceptance. Taking into account the development of regulatory requirements and industry best practice, the following section will explain the importance and impact of these factors as strategic considerations in Islamic financial product development and strategy.

2.7.1 Islamic financial product strategy A product strategy is required to chart the direction of the product design, development and implementation in a manner that ensures it achieves the intended objectives and outcomes. The strategy may vary with the stage of the product life cycle in the industry, as well as industry and market factors that influence the product behaviour in a given environment. The following diagram depicts the essential strategic considerations affecting an IFI’s policy as well as its implications. The strategic considerations are customer expectations or market behaviour, Shari’ah requirements, legal requirements, regulatory requirements and industry standards and best practice.

Figure 2.2 Structuring of Islamic financial products: Strategic considerations; business policy and impact analysis Strategic considerations Customer expectations/market behaviour Shariah requirements Legal requirements Regulatory requirements Industry standards & best practices

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Business policy

Business impact

Product design and development + customer relationship management

Market acceptance

Product design and development + customer relationship management

Risk assessment & analysis

Product design and development + customer relationship management

Reporting & disclosure requirements

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A product represented by customer expectations essentially requires a structure that takes into account how these expectations are to be met. These expectations may vary according to the different types of financial systems that have adopted Islamic financial activities and practices. Shari’ah principles and rules are derived from the established revealed sources of Islamic law and hence are universally applicable. However, the application of legal reasoning and interpretation may take into consideration customary practices of particular locality or jurisdiction supported by various forms of Shari’ah governance. The legal requirements relate to the application of Islamic law principles within each jurisdiction. Hence the laws may influence the enforceability and dispute resolution involving Islamic financial transactions. Regulatory requirements generally set the pace and direction of the industry requirements and reporting environment. Different jurisdictions adopt different approaches based on the respective regulatory framework in governing Islamic financial activities. A convergence towards Islamic financial practices through harmonisation and standardisation has been helped by international standards, guidelines and best practices that provide relevant benchmarks for industry practices. With these strategic considerations, the structuring of Islamic financial products will take a broader approach to product structure and acceptance, and to the business model and assurance which are integral parts of product policy. The policy implications can then be examined and analysed from the point of view of market response, acceptance and risk analysis, as well as reporting and disclosure issues.

2.7.2 Islamic financial systems and their impact on Islamic financial product strategy The early developments of Islamic finance attracted varying socio-economic and political responses from the ruling authorities of various jurisdictions. The types of response that supported Islamic finance depended on the perceived need of the financial community to adopt either an alternative financial system or a financial intermediation mechanism, which either co-existed with or replaced the interest-based banking system. This led to the adoption of either the dual banking system or the single/sole banking system from 1979 onwards. From 1979 to 1994, most of the Islamic banks were established, operating in an environment that was denominated by conventional financial institutions. From 1994, particularly in Malaysia, all conventional financial institutions were allowed to set up Islamic windows operating in the same premises of conventional financial institutions.

2.7.3 The case for a dual banking system The dual banking system enables interest-based financial products, as well as Islamic financial products, to be offered to the common pool of customers within a similar financial environment. In a single banking system, such as Iran, Islamic finance replaces the interest-based banking system. Because of the complexity of the financial system and the varying needs of depositors, investors, issuers and financial institutions, a move to a single Islamic banking system would be met with significant challenges and resistance. Significant developments, however, have taken place in the dual system where comparative industry trends, market behaviour and institutional response have systematically influenced the development of Islamic financial products.

2.7.4 Seeking a separate identity As explained in CDIF/2/1/24, a financial system comprises several components, including both banking and non-banking institutions, regulatory bodies and agencies, and payment and settlement systems. The key component of any system is the financial services authority that ensures the soundness and stability of the system. Currently the financial industry is regulated either by a central financial authority or two separate financial authorities. Separate financial authorities for banking and capital market regulation and supervision are found in certain jurisdictions such as Malaysia, Saudi Arabia and Indonesia. Islamic financial activities operating within existing dual financial systems are generally governed by similar financial authorities. In this respect, similar regulatory policies in the form of Islamic financial instruments and guidelines are instituted to govern the IFIs, products and activities. The challenge faced by the Islamic finance community is to demonstrate to existing financial authorities the unique features of Islamic financial products and services that require a different regulatory response.

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The need to distinguish the identity of Islamic financial products from comparative conventional products as well as a need for Islamic financial products to be benchmarked, with the latter based on expectations of a common pool of depositors, investors, issuers and customers, poses a continuous challenge in developing Islamic financial products within the dual banking system. To a significant extent the transaction, safety and investment motives are similar for both conventional and Islamic products. However, the manner in which the contracts are structured reflects the importance of trading and real investments, as well as profit and loss sharing compared with pure conventional borrowing and lending activities.

2.7.5 Impact of separate legislation In certain jurisdictions, such as Malaysia, separate legislation has been introduced to license and regulate IFIs in addition to licensed conventional institutions. The recognition of these institutions, such as Islamic banks and Takaful companies, emphasises the importance of shareholder commitment to Islamic finance. In addition, the need to safeguard and protect the interests of investors and depositors has been met by the promulgation of relevant banking and securities guidelines. Some jurisdictions have issued specific guidelines and requirements for IFIs to observe in addition to general financial laws and regulations. For example, the Central Bank of Bahrain and the Dubai International Financial Centre have issued special guidelines to the effect that all IFIs operating in their respective jurisdictions shall adhere to both the Accounting and Auditing Organisation for Islamic Financial Institutions’ (AAOIFI) Shari’ah Standards and AAOIFI Accounting Standards. The development of Islamic financial products must take into consideration these statutes and guidelines. Generally these guidelines provide the overall assurances that protect depositors’ interests, ensure the integrity of the financial institutions and systems, and promote the soundness and stability of the overall financial system.

2.8 Possible impact of weak structuring methodology in Islamic financial product development In any design and development process, specifying the right purpose and objectives, followed by a proper application of the relevant methods or tools, is critical to the successful implementation of the product. Hence any misspecification of product purpose or misapplication of the Islamic financing contract will result in the product’s failure.

2.8.1 Getting the structure right During the early stages of the development, Islamic financial products and services, introduced under extenuating circumstances, had to be subsequently reviewed. Significant changes in industry requirements, as well as market demands, have brought about the need for Islamic financial products that either complement or substitute for conventional financial products. Various approaches were tried, including maintaining existing product structures and allowing for contract variations within similar economic conditions and financial consequences, as well as their possible permutations. In some cases this led to a significant replication of faulty product structures either due to fundamental errors in misspecification of product purpose or misapplication of contracts, or omissions of pertinent Shari’ah considerations.

For example, an Islamic deposit pays a promised or contracted return to depositors based on Wadiah, Qard or Mudarabah contract equivalent to the conventional fixed deposit. The promised or contracted return based on these contracts is not Shari’ah-compliant. However, an IFI may achieve the same economic benefit of a conventional fixed deposit by using a Murabahah commodity structure. This will be further explained in chapter four.

When a financing structure needs to consider flexibility in price, delivery or payment, an existing sales-based financing contract may not be appropriate. Some of the contracts are relevant when goods involve spot delivery with an established price upon conclusion of the contract. Hence such contracts will be restrictive and not appropriate for other forms of arrangement.

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For example, in some jurisdictions, such as Malaysia, a Murabahah contract has been used to finance construction projects. Obviously, Murabahah is not a suitable contract for this transaction as the project is still under construction. Furthermore, in the case of project delay, the purchaser will bear the risk of non-delivery as well as the liability to fully settle the Murabahah sale price to the vendor. There is a need to depart from this contract to a more suitable contract such as Istisna’ or a combination of both Istisna’ and a forward lease. Both of these contracts recognise the asset needs to be constructed, as well as the risks associated in the price and payment structure. This will be explained in the following chapter.

From the above example, it can be concluded that misspecification of product purpose and misapplication of Islamic finance contracts will result in two major consequences. First, the product may not be compliant and hence result in the contracts being void or voidable at the option of the parties to the contract. Second, market confidence in product structure viability in meeting the product purpose will be affected. In other words, product acceptance may be impaired.

2.9 Islamic financial product structuring process: the case for Profit Sharing Investment Accounts (PSIA) The following grid provides a step-by-step approach toward designing, developing and implementing a specific Islamic financial product. It is based on the structuring process and the relevant Shari’ah and other requirements.

Table 2.2 Product design: Profit Sharing Investment Account Description

Shari’ah requirements

Product concept

A profit sharing investment account that shares profit with the bank and is exposed to business risk

Based on Mudarabah contract requirement on the nature and type of capital. No guarantee of capital except for fiduciary performance of the IIFS

Product purpose

Provide investment opportunity to depositors

Shari’ah-compliant or legitimate investment opportunities. Source of fund to be segregated, subject to qualification by the investors as to whether their investment is being made under a restricted or unrestricted investment mandate

Source of funds for IIFS

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Product structure

Capital provided by the investor is known and specified for a defined period. It may be restricted or qualified for specified purpose and may not commingle with other IFI funds

Contribution value to be ascertained ab initio and conditions on fund utilisation to be specified

Product mechanism

Amount received will be mobilised on or off balance sheet for financing or investment. Capital is recovered before profits are distributed. Profit is derived after deducting direct cost of financing. Profits generated from utilisation of funds are shared according to mutually agreed PSR

Subject to expressed qualifying conditions, funds outstanding shall be the determinant for loss exposure. Ex post-profit is derived from gross income and shared based on mutually agreed PSR

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Table 2.3 Product Development: Profit Sharing Investment Account Description

Shari’ah requirements

Operational process flow

Product manual of investment account that describes the deposit, deposit utilisation, profit and loss determination, profit distribution and withdrawal processes

Segregation of Shari’ah-compliant funds as well as specific conditions apply in the case of restricted Mudarabah contract requirements

Legal documentation

Investment certificate that specifies contractual terms and requirements

Contractual terms and requirements are subject to Mudarabah contract requirements and are legally enforceable

Document process flow

Product manual specifies the relevant supporting documents that ensure the efficacy and traceability of the process flow, as well as its timely and effective execution of processes

Supporting documents that ensure the efficacy and traceability of the contract flows, as well as its timely and effective execution of contracts

IT System & Support

Relevant IT customer information file, processes and engines to enable proper information processing and management that facilitates achievement of Shari’ah-compliant objectives

Information parameters take into consideration Shari’ah contract requirements. IT processes and engines observe the relevant contract conditions pertaining to profit computation

Reports and communication

Timely and accurate update of investment account balances and performance of investment accounts, as well as proper utilisation of funds

Provide assurance to investors that funds are Shari’ah-compliant and that profit sharing nature is properly communicated

Product conformance

Investment account holder funds are used according to specified purpose, and fund performance is measured according to profit sharing arrangements

Mudarabah contract conditions and requirements are observed during implementation

Product acceptance

Investment yield matches the risk preference or appetite of investment account holders for different investment horizon and other specified conditions

Investment account products are accepted based on Shari’ah standards and industry best practice

Shari’ah review

Review of process flow of the investment account with reference to product structure and mechanism

Investment account process flow is reviewed according to the Shari’ah governance framework and standards

Shari’ah opinion

Opinion expressed in the Shari’ah board report that all aspects of the investment account are Shari’ah compliant

Shari’ah opinion on investment account is expressed by Shari’ah board as prescribed by the Shari’ah governance framework and standards

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2.10 Conclusion This chapter has demonstrated the importance of observing Shari’ah requirements in each part of the Islamic financial structuring process, that is the design, development and implementation phases. A detailed discussion of the elements of the structuring process emphasises that the process is not confined to product design, but instead involves or interfaces with other processes relating to legal documentation, operational process flow, reporting and risk management processes. Product failure to comply with Shari’ah requirements, as specified in the product structure, will result in legal, operational and risk-related issues that would be dealt with in the subsequent chapters.

2.11 Summary Having read this chapter you should understand the following points: • Islamic financial products must be based on valid Islamic financial transactions that facilitate lawful production, trade and consumption activities • financial product structuring involves formalising the expectations of relevant parties based on the expressed contractual rights and obligations of counterparties • the development of Islamic financial products can be instigated by either private or government initiatives • product documentation needs to be developed in a comprehensive manner that articulates all the product concepts, structures, mechanisms and flows, as well as all the Shari’ah and functional requirements • product documents need to make specific reference to Shari’ah requirements when formulating accounting policies and treatment, as well as risk-mitigation techniques and tools for the product • customers’ expectations may vary according to the different types of financial systems that have adopted Islamic financial activities and practices; but Shari’ah principles and rules are derived from established revealed sources of Islamic law and hence are universally applicable • Islamic financial products must be developed according to the regulatory requirements and guidelines of the jurisdictions where they are being offered.

2.12 Islamic finance case study Shari’ah considerations in structuring products and services In a Shari’ah board meeting of an established financial institution, the chairman raises concerns on the Shari’ah-compliant status and market acceptance of Islamic financial products and services offered by its wholly owned Islamic bank subsidiary. As the CEO of the Islamic bank subsidiary you explain that a recent court decision, which was in favour of a customer of another IFI, was partly attributed to its inadequate structuring process and reliance on group-shared services when offering Islamic financial products. The BOD directs you to convene a product development meeting and prepare a report to recommend an appropriate strategy for the product development of Islamic financial products and services for your bank. The group product development manager furnishes you with the following list of financial products offered by your Islamic bank subsidiary.

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Deposits

Financing

Islamic current account

Murabahah property financing

Islamic savings account

Ijarah vehicle financing

Islamic fixed income account

Murabahah working capital financing

Islamic investment account

Murabahah-tawarruq personal financing

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Case study multiple choice questions 1. The primary objective of structuring Islamic financial products is to ensure that the financial product is: (A) Shari’ah-compliant only (B)

Shari’ah-compliant and accepted by the Islamic financial services industry

(C) competitive and accepted by the Islamic financial services industry (D) a competitive alternative to interest-based financial products. 2. Depositors who expect a fixed return from deposits are offered deposits based on: (A) Mudarabah contract (B)

Qard contract

(C) Commodity Murabahah contract (D) Wakalah contract 3. In the structuring process, the product operational process flow is documented in a product manual to facilitate the timely and effective: (A) execution of the contract requirements of the Islamic financial product (B)

drafting of the legal documentation of the Islamic financial product

(C) development and promotion of the Islamic financial product (D) management and control of the non-performing Islamic financial product 4. At which phase of the Islamic financial product structuring process is Shari’ah endorsement sought? (A) At the design and development phase (B)

At the implementation phase

(C) At the monitoring and control phase (D) At the reporting phase 5. In order to ensure proper monitoring of product compliance to Shari’ah principles and requirements throughout the lifecycle of a product, timely and effective Shari’ah review should be conducted: (A) On a specified periodic basis (B)

At the implementation phase

(C) At the design and development phase (D) At any time during the life cycle of the product 6. Under what circumstances would product enhancement be required for Islamic financial products? (A) To achieve better market acceptance for a common pool of customers in a dual banking system (B)

To rectify deficiencies in the existing product structure for a common pool of customers in a dual banking system

(C) To achieve better market acceptance for a differentiated pool of customers in a single banking system (D) To rectify deficiencies in the existing product structure for a common pool of customers in a single banking system

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Case study short essay questions 1. Identify the key matters to be raised in the agenda for the special meeting on structuring of Islamic financial products. 2. From the list of Islamic financing products, it is observed that 80% of the financing comprises property and vehicle financing. Briefly state the essential Shari’ah considerations in the design and development stages of these products. 3. Due to unfavourable economic conditions and the tightening of monetary policy, a gradual increase of non-performing financing is observed. Identify relevant structuring issues in the implementation and monitoring stages that need to be addressed to avoid this happening in the future. 4. In your report to the board, highlight the essential considerations, structuring issues and recommendations necessary to ensure that the structuring process is effective for the Islamic bank subsidiary.

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Chapter two answers Exercise 2.1 As a matter of principle, the customer will be advised that a return on capital in any investmentbased contract cannot be guaranteed in Islamic finance as the investor must share the possibility of loss with the investment manager or among the partners (CDIF/2/5/92-97). However, the customer could be introduced to direct investment in assets which can potentially provide a fixed income to the investors such as a specified investment return in a Murabahah commodity structure or Sukuk Ijarah. These two instruments represent an investor’s direct investment and participation in real assets with an obligation feature where the obligor in these Murabahah and Sukuk Ijarah instruments has to pay the investors the principal of the investment and the profit based on the obligation to pay any sum due to the investors. For example, investors who, say, invest US$100 million in a Sukuk Ijarah fund effectively invest their monies in Sukuk Ijarah. Based on an Ijarah contract, the originator/lessee may undertake to pay to the fund the principal and profit every six months at 2.5% (CDIF/3/7/106-107). In addition, the Islamic finance industry has also introduced a product that combines both Wakalah and Kafalah to enhance the probability of expected profit to investors. Although the originator/lessee under Sukuk Ijarah, for example, gives an undertaking to pay the lease rental payments on time, the issuer (who issues and manages the Sukuk Ijarah issuance as an agent under the principle of Wakalah), may give a guarantee (under the contract of Kafalah, to the Sukuk Ijarah investors or Sukuk Ijarah fund investors) to make good any shortage of lease rentals that may be due from the originator/lessee. This will further enhance the structure and render it a real fixedincome instrument for the investors, particularly those who are seeking Islamic fixed-income instruments with a guaranteed profit.

Exercise 2.2 In Islamic finance, as the fundamental objective of product structuring is to ensure compliance to Shari’ah principles, the process includes product design, product development and product implementation. This can only be fully achieved if a particular product is actually implemented in accordance with that process. Non-compliance may result from inappropriate implementation and not necessarily from product design or documentation. This is also why Shari’ah reviews and continuous monitoring of the product are vital.

Exercise 2.3 According to the Ijarah contract, lease payments are due, provided the beneficial use of the asset (usufruct) is transferred to the lessee. Although full disbursement is made by the financial institution to make the asset available for lease to the customer, the financial institution as the lessor has the right to claim only on the actual or possible utilisation of the asset. Since the asset is impaired, the lease payment should be suspended and will only recommence when the leased asset has been restored to use. The financial product structure only represents financial claims that directly relate to the operating lease contract.

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Case study multiple choice answers: 1. (B) 2. (C) 3. (A) 4. (A) 5. (A) 6. (A)

Suggested solutions to case study short essay questions: 1. The agenda for the special meeting on structuring of Islamic financial products should include the following: a.

current status and performance of Islamic financial products and services offered to the Islamic financial services industry

b.

review of product concepts and features, as well as their purpose, structure and mechanism

c.

examination of product manuals and legal documents

d.

review of products, as well as document process flows and supporting documents

e.

evaluation of product quality in terms of conformance and acceptance based on Shari’ah review and relevant reports

2. The primary considerations in the design and development stages are that: a.

the product purpose is Shari’ah-compliant and meets customers’ expectations;

b.

contracts are appropriate, their relevant requirements and conditions are effectively adopted and applied, and that they are adequately documented and communicated in the product manual.

3. In the case of asset-based financing, such as Murabahah and Ijarah, non-performing financing during unfavourable economic conditions will affect the payment period. In the case of Ijarah financing this will also affect the valuation of the leased assets because the asset may be situated in an area that is not favourable or the asset may belong to a particular sector which is more affected by the market’s unfavourable conditions. All of this will affect the credit and market risk of this product based on Ijarah, which is now in default. Any form of rescheduling or restructuring should observe the relevant contract requirements and should not violate the conditions of the contracts. 4. A pertinent issue to be raised is the need for an internal Shari’ah control system that facilitates a Shari’ah review of the control objectives, which will be the basis for Shari’ah opinion expressed in the annual Shari’ah report. This empowers the internal Shari’ah review to effectively monitor the activities of the bank on a daily basis. An issue can also be raised in terms of heavy reliance on conventional support services, such as treasury and risk management departments, as well as IT core banking solutions. Moving forward, these critical services must be developed exclusively for the Islamic bank subsidiary.

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Chapter three Regulatory and prudential requirements and the supervisory review process for Islamic banking and financial products Learning outcomes By the end of this chapter you should be able to: • explain the impact of the prevailing regulations and guidelines on Islamic finance • distinguish and evaluate the impact of legislation in the dual banking system • analyse the regulatory factors affecting the growth of Islamic financial services (IFS) • discuss the implications of risk management framework and bank supervision for IFS.

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Indicative list of content • Financial laws and regulations governing Islamic financial products • Comparative analysis of Islamic banking business models and related products • Prudential requirements, supervision and Shari’ah review of Islamic financial products • Illustrations of banking models and their Islamic financial product structuring process • Case study: comparitive analysis of banking models in a dual banking system

3.0 Introduction This chapter explains the banking environment in relation to the principal monitoring of governing agencies, in addition to regulatory or industry requirements. It highlights the importance of regulatory requirements and supervisory issues that must be considered when structuring Islamic financial products. The chapter also considers the specific Islamic banking risk framework and other relevant guidelines to illustrate the impact of such guidelines when structuring an Islamic financial product, as well as developing a strategy for growth for the different models of institutions, products and the industry. 3.1 Financial laws and regulations governing Islamic financial products 3.1.1 The need for financial laws and regulations Regulation and governance of Islamic Financial Institutions (IFIs) is generally meant to ensure a sound and stable system through effective supervision, disclosure, transparency and market discipline. This was discussed in CDIF/2/3/51. In general, laws and regulations exist in the banking and financial markets to ensure truthful disclosure to consumers, assure the financial solvency of the institutions and, to a lesser extent, make financial services accessible to all segments of the population with the proper regulatory supervision. An over-riding and yet understated concern of all laws and regulations is the need to protect the economy. Without confidence in financial products and financial service providers, the pool of investment capital that keeps the world economy moving would dry up. If one cannot trust a bank with one’s savings, why would anyone maintain bank deposits? Individuals might as well store their money under a mattress. Such action would lead to a lack of investment funds in the banking and capital markets, where companies and households alike would find it hard to source financing. Companies might not be able to expand their business ventures and households could find it difficult to finance personal requirements, such as the purchase of a home or a vehicle. Financial institutions are organs of investments in any capitalist economy and financial laws and regulations are required to maintain confidence in the financial systems.

Key point • Adequate regulation and governance of the IFSI is required to maintain confidence in the financial systems.

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3.1.2 The legal and regulatory bodies In any market-driven economy, there are basically two identifiable markets that are heavily regulated by the financial authorities. One is the banking market, which usually includes the insurance market; the other is the capital market. The banking segment is usually regulated by a central bank or monetary authority, while the securities commission or capital markets authority usually covers the regulation of the capital market. However, in some jurisdictions, such as Bahrain, Singapore and the UK, there is only one regulator to oversee all financial markets, be it banking, insurance or capital market. What matters is that the conduct of all licensed financial institutions in any country is effectively supervised. This requirement also includes the supervision of IFIs. Financial legislation and the licensing requirements relating to various institutions determine the structure of each financial system. For instance, banking licences issued by central banks would essentially determine the number of commercial banks the local banking market can support, as well as the types of banking business each bank can participate in. These regulatory requirements and supervisory processes, and reporting and disclosure requirements, aim to safeguard the financial interest and confidence of the financial community.

3.1.3 The authority of central banks and security commissions To ensure that central banks or security commissions have the authority to meet their regulatory objectives, they are usually vested with comprehensive legal powers via legislation (royal decree in monarchies) to regulate and supervise the financial system. An example would be the Central Bank Act (or Monetary Authority Act as the case may be) in countries such as Kuwait and the Kingdom of Saudi Arabia, which provides for the administration and objectives of the central bank (or monetary authority). Such acts usually enumerate the powers and the duties of the relevant central bank in relation to the issuance of currency, maintenance of external reserves, authorised business of the bank, the specific powers given to them to deal with ailing institutions and its relationship with the government and other financial institutions. Similarly, capital market regulators, such as the Securities Commission of Malaysia, would also be vested with an equivalent act, which among other things, would: • • • • • • •

supervise exchanges, clearing houses and central depositories act as a registering authority for corporation prospectuses have the authority to approve corporate bond issues regulate all matters relating to securities and futures contracts regulate the takeover and merger of companies issue licences and supervise those holding licences ensure the proper conduct of market institutions and licensed persons.

While the functions above underpin the responsibility of the regulatory authorities in protecting the investor, these same regulatory bodies are also obliged by statute to encourage and promote the development of the banking and financial markets as deemed fit by central governments.

3.2 Centralised or decentralised Shari’ah supervisory systems As outlined in CDIF/2/3/59-61, Shari’ah advisory boards are key organs in the process and governance structure of Islamic banking and finance. The boards provide assurance as to the integrity of the system by ensuring that resulting policies and instruments do not breach Shari’ah principles.

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3.2.1 Centralised supervisory systems A centralised Shari’ah supervisory system is represented by the financial regulatory authority assuming the responsibility to act as the sole authority in deciding on Shari’ah matters on Islamic banking and financial business. In this form, it is able to rationalise and streamline the functions and duties of the various Shari’ah committees of financial institutions in the country, and issue guidelines on the governance of these Shari’ah committees. Their guidelines outline the roles and responsibilities of the independent bodies of specialised scholars in Islamic commercial jurisprudence, as well as set the basic criteria and qualifications for individual Shari’ah advisers. In Malaysia the ultimate authority is the Central Bank (Bank Negara); the system is similar for Pakistan and Sudan where respectively the State Bank of Pakistan and the Bank of Sudan take the lead. On the other hand, in Indonesia, the ultimate authority on Shari’ah issues is vested with the National Council of Scholars, an independent organisation separate from the Central Bank of Indonesia. This is a unique framework. The Council decides on the appointment of Shari’ah board members in all IFIs in Indonesia and determines the Shari’ah standards to be applied in that jurisdiction.

3.2.2 Decentralised supervisory systems The alternative to the above is a decentralised Shari’ah supervisory system whereby the individual IFIs fully decide on the composition of the Shari’ah supervisory board. This would be market-driven as investors play a part in deciding who they are most comfortable working with to ensure that the Islamic financial instruments they invest in adhere to Shari’ah principles. Decentralised systems often function in collaboration with the policies, standards and guidelines set by international Islamic agencies, such as the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) and the Islamic Financial Services Board (IFSB) as covered in CDIF/2/3/61-63. Examples of countries that generally abide by this system are Bahrain, Singapore, the Dubai Financial Centre of Dubai and the UK.

3.2.3 Centralisation v decentralisation The applicability of either centralisation or decentralisation within a Shari’ah supervisory system depends on the country that hosts the Islamic banking system. In countries where the Islamic banking and finance initiative is largely government-driven, centralisation would be more applicable. The same holds true vice versa. However, there are comparative advantages linked to both systems that could affect the choice. The centralised system creates a more structured banking and financial environment, with market players being guided in their conduct within the Islamic banking and finance system. A centralised system, with more guidelines and best practices set in place, should reduce the need for conflict resolution. In addition, the design of new Shari’ah-approved instruments will be centrally managed with information being disseminated from the central authorities. Centralised systems can also set other limits, such as how many financial institutions each Shari’ah scholar can represent domestically. A decentralised system on the other hand may provide a more open environment for Islamic product development and innovation. With decentralisation, IFIs do not have to wait for approval from central authorities on the design of their Shari’ah-compliant structures. Decentralisation usually results in a more competitive environment whereby the most efficient and cost-effective Shari’ah-compliant instruments gain an advantage over the rest. It also accommodates crossregional Islamic instruments where foreign investors are more likely to be inclined to accept market-driven Shari’ah instruments.

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Exercise 3.1 Imagine you are structuring a new Islamic deposit scheme in a system that is governed by a centralised Shari’ah supervisory system. Describe the peculiarities of that system that you are likely to encounter.

3.3 Islamic finance policies In an attempt to promote the development of the Islamic finance industry some countries have amended their fiscal rules. An example is the Malaysia International Islamic Financial Centre (MIFC) initiative jointly undertaken by Bank Negara Malaysia (BNM), the Securities Commission of Malaysia, Labuan Offshore Financial Services Authority (LOFSA) and Bursa Malaysia. Under this initiative Islamic banks and banking units licensed under the Islamic Banking Act 1983, Takaful companies, units licensed under the Takaful Act 1984, and Foreign Islamic Fund Companies are given full tax exemption for 10 years (effective 2007 to 2016). In addition, local and foreign firms managing funds for foreign investors, established under Shari’ah principles and approved by the Securities Commission, are given full income tax exemption on management fees received. This exemption, which is also valid for 10 years until 2016, means that such firms avoid the concessionary 10% income tax charged on management fees received from foreign investors. Malaysia has also targeted Islamic stockbroking in this initiative. The pre-commencement expenses of Islamic stockbroking businesses are now allowed as deductions for tax purposes, if the business commenced within two years from the Securities Commission approval date (that is, until the end of 2009). A similar tax break for Islamic securities, where a deduction was allowed on expenses incurred on issuance of Islamic securities based on leasing (Ijarah), progressive sales (Istisna’), profit sharing (Mudarabah) and profit and loss sharing (Musharakah) has been extended to 2010. To promote Malaysia as a hub for the Islamic capital market, Special Purpose Companies (SPCs) created will not be subject to tax and the company that establishes the SPC will be able to deduct, for tax purposes, the cost of issuing Islamic bonds or Sukuks. However, any income received by the SPC is deemed as income received by the company that establishes the SPC and is subject to tax. Currently, stamp duty exemption is given to instruments that are executed in accordance with Islamic principles. To encourage further development in this area, stamp duty exemption was increased by 20% to instruments used in Islamic financing for a period of three years until 2009. Historically, interest income received by non-residents, from banks and financial institutions established under the Banking and Financial Institutions Act 1989, was exempted from tax. However, profits and interest income received from other financial institutions, including those established under the Islamic Banking Act 1983, was subject to tax. To align the tax treatment, profits and interest income received from all financial institutions is now exempt from tax. The Securities Commission of Malaysia and the BNM issued a Joint Information Note on the Issuance of Foreign Currency-Denominated Bonds and Sukuk in Malaysia on 27 March 2007. One of the issues covered in this note was the income and withholding tax charged on investors of foreign currency-denominated Sukuk. Resident investors are exempt from payment of income tax on the profits received from foreign currency-denominated Sukuk issued in Malaysia. In addition, profits or income on non-residents’ investments in foreign currency-denominated Sukuks issued in Malaysia are fully exempt from withholding tax. Bahrain has a slightly different approach in developing its Islamic finance industry. Instead of incentivising investors to participate in its domestic industry, the Kingdom associates itself with international Islamic agencies by playing host to a number of organisations central to the development of Islamic finance, including the AAOIFI, the Liquidity Management Centre (LMC), the International Islamic Financial Market (IIFM), and the Islamic International Rating Agency (IIRA). By doing so, Bahrain has positioned itself at the centre of the Islamic finance industry. As these Islamic agencies gain popularity and acceptance in the market, other financial centres will follow the Kingdom’s lead. In another development, the Dubai Financial Services Authority (DFSA) and the Securities Commission of Malaysia have signed a mutual recognition agreement, the first of its kind between two Islamic markets. This reciprocal liberalisation between two Islamic financial centres will enable cross-border marketing and distribution of Islamic funds with minimal regulatory intervention. The agreement facilitates the entry of Malaysian-approved Islamic funds into the DFSA’s recognised jurisdiction notice. Likewise, Islamic funds that have been registered or notified with the DFSA will be accessible by Malaysian investors. Malaysian capital market intermediaries will benefit from a

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gateway to distribute their Islamic products to a fast-growing market while Malaysian investors will have access to a range of Islamic products from DFSA-approved Islamic funds.

Exercise 3.2 Mutual recognition policies between two jurisdictions are deemed to provide many benefits for both the regulators and investors. State some of the benefits of adopting this policy and highlight the options available in cases where this policy is not in place.

3.4 Tax laws and neutrality policies Tax laws in each state are designed to find the best compromise between generating sufficient revenue for the state from income-generating activities and sustaining investments within the state. The introduction and development of Islamic finance alongside conventional finance across the different jurisdictions poses a challenge to regulators who have to ensure that the tax burden is not biased to either system. A key issue is that the conventional financial system is centred on the issue of loans and is interest-based, with tax laws developed to take this into account. The Islamic financial system on the other hand is, among other things, trade-based and is moving towards an equity-based system. As a result, financial activities in this system have to live with issues such as double-stamp duties. In an attempt to address such issues, several countries have begun amending their tax laws so as to level the playing field.

An example of where one country has attempted to redress existing tax bias would be Tax Neutrality Laws enacted in countries such as Malaysia. In Malaysia, it states under Section 2 (8) of the Income Tax Act that the disposal of an asset or a lease pursuant to an Islamic financing scheme approved by either the Central Bank or the Securities Commission shall be accorded the same tax treatment as that in conventional schemes so as to avoid unnecessary tax on the Islamic instruments. Prior to this tax neutrality policy, which was enacted in 2005, amendments were made to the Stamp Duty Act and Real Property Gains Tax in 1983 to avoid double stamp duty and tax on capital gains respectively.

3.4.1 Pure sale v financing One of the ways Tax Neutrality Laws work is in recognising that the trade or sale activities between Islamic banks and their customers are not ‘pure sales’ but are part of a financing process. The resulting transfer of assets between the customer and the developer will incur stamp duty as would, say, a mortgage loan in a conventional bank. In this way, the tax bias against the Islamic system of trading would be removed and the Islamic financial system would be able to develop and compete in the market on a level footing.

In Singapore, the policy has been to align tax treatment of Islamic contracts with the treatment of conventional financing contracts to which they are economically equivalent. In 2005, Singapore waived the imposition of double stamp duties in Islamic transactions involving real estate and accorded the same concessionary tax treatment on income from Islamic bonds as applied to conventional bonds. Three Shari’ah-compliant products were identified by the Singapore regulatory authorities in 2006 to ensure that they did not suffer excessive taxes due to the nature of their structuring. To further level the tax playing field for Sukuk, remission will be granted on stamp duty on immovable property in a Sukuk structure, that is in excess of its equivalent conventional bond issue.

Key point • Tax neutrality policies and the removal of double stamp duties have improved the competitiveness of Islamic financing instruments.

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3.4.2 Tax in GCC countries Tax bias with regard to Islamic finance seldom arises in ‘tax-haven’ countries such as in the Gulf Cooperation Council (GCC) whereby tax laws are generally focused on oil and gas companies. In Bahrain, income is only taxed on oil and gas companies. Generally, Islamic finance instruments issued in such countries will not be subject to tax. However, if an oil or gas company issues an Islamic financial instrument, income from the instrument will be subject to tax, but there are no specific regulations dealing with taxation of income. In some GCC countries, such as Saudi Arabia, tax is only levied on foreign or non-GCC nationality residents.

Exercise 3.3 The UK Financial Services Authority (FSA) removed the double payment of stamp duty land tax in 2003. Explain what this means and how it helps financial institutions structuring Islamic house-financing schemes.

3.5 Comparative analysis of Islamic banking business models and related products 3.5.1 Islamic finance regulations The task of regulating the Islamic finance industry falls within the purview of the same regulatory organs identified above. Banking and capital market regulators have both adopted specific legislation, at varying levels, in the different regions that practise the business of Islamic banking and finance. As explained in CDIF/2/3/52-61, different countries have adopted either single or dual banking systems with either single or separate legislation to suit their local business environment. For instance, the Central Bank of Bahrain has adopted single legislation to manage its dual banking system. BNM on the other hand manages its dual banking system with separate legislation, by granting separate licences to conventional and Islamic banks. The regulatory authority’s stance in adopting either a centralised Shari’ah supervisory system or one that is more decentralised and more market-driven will also have an impact of the development of its Islamic finance industry, which will be discussed in the following sections.

3.5.2 Single or dual banking system Islamic banking can operate in either a single or dual banking system. The most extreme would be a single banking system that only allows Islamic banks to operate, as was formerly tested in Pakistan and Iran. Those examples failed simply because of international demand and acceptance. The most common single banking systems exist within conventional banking systems, such as Singapore, Japan and the UK, which allow the operation of either Islamic banks or Islamic banking subsidiaries/windows. Rapid development of Islamic banking business can culminate in the relevant regulatory authority adopting a dual banking system, after fostering growth of Islamic banking via the Islamic windows model. A good example would be the case of the BNM, which is now in the latter stages of converting former Islamic banking windows into fully-fledged subsidiaries. The original conventional banking parent or bank holding group may still retain full ownership of the Islamic subsidiary, but the subsidiary must maintain a separate capital structure from the parent. In addition, BNM restricts further growth via Islamic windows by allowing banks, foreign or local, to undertake Islamic banking business by establishing fully-fledged Islamic banks or subsidiaries. The Japanese Financial Services Agency amended its financial regulations in December 2008 to allow Japanese bank subsidiaries and sister companies of banks and insurance companies to engage in the Islamic finance business. In Japan, Islamic finance business is effectively deemed to be equivalent to the provision of credit. The consequent impact of moving from a single banking system to a dual banking one ranges from the effect on micro-economic bank-specific operations that usually involve cost considerations, to macro-economic systemic concerns that involve the intervention of the banking authorities. Tables 3.1 and 3.2 below provide a summary of the related issues.

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Table 3.1 Micro-economic considerations Issues

Single banking system

Dual banking system

Capital

Existing capital structure – cost-effective as it only requires segregated capital accounting

Requires fresh capital – may be costly

Human capital

Cost sharing between Islamic windows and parent bank

New organisational structure with a separate cost centre

Physical location

Can exist within the current branch banking set-up – costeffective

Requires its own branching network

Branding and marketing

Islamic windows and its products can be branded and marketed within the ambit of the parent bank – cost-effective

While it may retain some features of the parent bank’s branding, the marketing cost is borne on its own

Banking funds

Funds generated from the Islamic windows must be segregated from conventional funds

No segregation required as the business is fully Shari’ahcompliant

Regulatory reporting

Segregated set of accounts

Single set of accounts

Table 3.2 Macro-economic considerations Issues

Single banking system

Dual banking system

Payment system

Shares one payment system with conventional banking; segregation of Islamic funds can be promoted according to segregated accounts but will be limited to number of windows operating in the banking system

Dedicated payment system for Islamic banking; full segregation of Islamic funds is possible

Liquidity instruments

Utilises conventional banking liquidity instruments as the Islamic windows may be too small to warrant viable and competitive Islamic liquidity instruments

Developed market for Islamic liquidity instruments that can exist on its own; such instruments are usually initiated by the central banks; the Islamic money market provides an avenue for Islamic banks to expand their banking portfolios

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3.6 The role of central banks /monetary authorities Apart from regulating the banking system, the central banks/monetary authorities are also mandated to govern the monetary conditions of the economy to ensure that conditions are suitable to promote growth of the economy. Some of the banking regulations set by the authorities, such as the statutory reserve requirements that all banks must adhere to, are in fact either direct or indirect monetary policy instruments that the central bank/monetary authority uses to manage the monetary conditions in the economy. For instance, when the economy is in recession, the central bank/monetary authority may loosen its monetary policy stance by reducing the statutory reserve requirement, thus flooding the system with money to promote short-term economic growth. The banks in the economy are thus the conduit of the central bank’s/monetary authority’s monetary policy actions.

3.6.1 The challenge of Islamic banking on regulatory authorities For any economy, the existence of a dual banking system to accommodate Islamic banking poses a new set of challenges for the regulatory authorities in their conduct of monetary policy. The central banks/monetary authorities need to know whether their monetary policy changes would result in identical reactions from the two banking systems. The price elasticity of deposits, for example, may not be the same for Islamic banking deposits compared with conventional deposits. An initiative to remove excess money from the system via an increase of the short-term policy rate could bring contradictory reactions from the two banking systems if their individual price elasticity on deposits was vastly different. As such, the regulatory authorities need to know which monetary policy instruments operate in an unbiased fashion towards each banking system to ensure a level field.

3.6.2 Single v dual banking systems The adoption of either a single or a dual banking system will have an effect on the types of banking instruments made available to the end user. For instance, Islamic banking windows would tend to offer an Islamic alternative to their conventional parent’s products, perhaps because of their requirement to share backroom systems and operations. Fully-fledged Islamic subsidiaries are not constrained to this requirement and are at liberty to offer more innovative banking products.

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Islamic finance challenge 3.1 (a) Explain how a central bank can improve its monetary policies in a banking system that houses both Islamic and conventional banks. (b) What are the impediments that Islamic financial institutions normally encounter operating in a dual banking system? (c) What strategic approaches can be undertaken by regulatory authorities to render Islamic financial institutions more competitive?

Solution (a) As the sole regulator of the banking sector, a central bank’s monetary policies must always remain unbiased to either banking system. The monetary policies of the central bank are designed to generate an environment conducive to developing the economy. As such, the central bank must be able to forecast the impact of each monetary policy instrument, be they direct or indirect instruments, on each banking system. These forecasts can be developed through a system of rigorous statistical back testing of banking and policy data. To promote this, the central bank must be efficient in collecting data from both banking systems. The central bank should also make such data available to research agencies that can assist in this statistical research (b) Most central banks’ monetary policy instruments are usually attuned to the larger and more established conventional banking system and the nascent Islamic banking system is still too new to generate enough statistical data. This may be an impediment as the subsequent monetary policies of the central bank may affect the competitiveness of the Islamic banking instruments, without the central bank being able to forecast this anomaly. Should a central bank find any of its monetary policy instruments to be biased towards one banking system, and if the overall effect is critically large enough over time, it should refrain from using such an instrument until it can redress the bias. Another impediment to the Islamic banking system is usually the lack of an Islamic money market or liquidity instruments. Islamic banks usually have a higher cash position compared with conventional banks that have an established money market in their system. This could affect the profitability of the Islamic banks and they may be unable to reward their depositors as competitively as conventional banks can. This in turn can drastically affect deposit mobilisation in Islamic banks which can end up having to pay for higher cost of funds at the discount windows. (c) To render IFIs more competitive in such a legal environment, a proper and dedicated dispute resolution centre within the domestic jurisdictions needs to be established where disputes can be resolved more efficiently. The judges presiding over such disputes must be familiar with Islamic law. On top of that, standardised legal documentation, such as an equivalent to International Swaps and Derivatives Association (ISDA) documentation, must be developed to enhance cross-border transactions between IFIs. Without such documents, the IFIs would have to resort to in-house legal documents that might be costly and might not have been tested in the courts.

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3.7 Single or separate legislation Islamic banks, as well as conventional banks, operate not only in an oligopolistic environment characterised by few players in the market, but also help manage a country’s financial wealth. The act of deposit taking is a privilege bestowed upon a select group of institutions and requires the highest level of regulation and monitoring by the regulatory authorities. A banking or deposit-taking licence is a prerequisite for both Islamic and conventional banks to participate in this deposit-taking oligarchy. Central banks or monetary authorities are often vested with legal powers under legislation to provide for the licensing and regulation of institutions carrying on banking businesses. In countries such as Bahrain, Singapore and the UAE, single legislation provides for the licensing for both conventional and Islamic banks. In other countries, for example in Malaysia, legislative powers have provided separate legislation for the licensing of Islamic banks. The Islamic Banking Act (IBA) provides for the licensing and regulation of Islamic banking business. The Act includes provisions on the financial requirements and duties of an Islamic bank, including its ownership, control and management, restrictions on its business, powers of supervision and control, and other general provisions.

3.7.1 Substance over form While distinctions between single and separate banking legislation may, on the surface, appear to have only an administrative effect, there are several important implications. Most significant is the scope of banking business that an Islamic bank can undertake if it is licensed separately from a conventional bank. Unlike conventional banks, whose businesses are wholly based on debt with the ‘lender-borrower’ paradigm at the top of the agenda, Islamic banking business may not necessarily be confined to that with the plethora of equity and equity-based contracts on offer. Western banks, with the noted exception of Germany, have since the Great Depression subscribed to a regulatory firewall between commercial and investment banking activities, also known as the Glass-Steagall Act . This stopped commercial banks from holding equity positions in companies and prevented them from issuing unsound loans to such companies. This was replaced by the Gramm-Leach-Bliley Act 1999 that allowed banking institutions to provide a broader range of services including underwriting and other dealing activities.

3.7.2 Islamic banks as universal banking entities With separate Islamic banking legislation, an Islamic bank, with its different depository structure (restricted and unrestricted investment accounts, compared with conventional fixed-deposit accounts), can take advantage of a wider scope of banking that it may not have access to if it is licensed under the same legislation as commercial banks. Far from being less prudent, an Islamic bank can function as a universal banking entity, aligning them closer to German banks. Universal banking is an alternative mechanism to a stock market for risk-sharing, for providing information to guide investment and for contesting corporate governance. In Germany, where the stock market has historically been small, banks hold equity stakes in firms and have proxy voting rights over other agents’ shares. In addition, banks lend to firms and have representatives on corporate boards. If a banking relationship is a substitute for the stock market then cross-ownership with a bank should improve the performance of firms. German banks typically hold voting shares in commercial firms as part of their long-term portfolio and also serve as proxies for small shareholders, enhancing their corporate voting powers. German banks also take a more formal role in a firm’s affairs through their membership on supervisory boards. Historical empirical evidence shows that equity block holdings by German banks led to improved firm performance, while block holdings by ‘non-bank’ firms did not lead to improved performance. This advantage has since been negated by the improved efficiency and liquidity of the German capital markets. The ability of banks to exercise due diligence on companies in which they have equity positions strengthens the argument in favour of universal banks. As a part equity owner, universal banks have better access to the financial information of the companies they have invested in. Universal banks in such jurisdictions will be in a better position to extend, for example, financing facilities to the companies they part-own. Universal banks’ involvement in the capital market is more crucial in jurisdictions where capital markets are less developed. Companies operating in such jurisdictions may face difficulties in raising capital cost efficiently on their own.

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Whether Islamic banks should be governed under a single or separate banking legislation naturally depends on the precedence that the newly established Islamic banks would enjoy upon incorporation. If existing banks in the economy already engage in equity or lease-based business as well as debt-based instruments, such as banks in the GCC, then a separate Islamic banking legislation would seem unnecessary. However, if the existing banks in the country only offer loans and debtbased business, as in Malaysia, the enactment of separate Islamic banking legislation could promote the development of Islamic banking in that jurisdiction.

3.8 Prudential requirements, supervision and Shari’ah review of Islamic financial products Islamic banks appear to observe similar prudential requirements as those set for conventional banks. This is because much Islamic banking business corresponds directly to contemporary financial intermediation. Islamic banks source deposits from households, corporate and government sectors, and utilise such deposits to fund their asset portfolio. While the contractual relationships used differ between conventional and Islamic banks (debt arising from interest-bearing loans versus interestfree loans or safe custody, or debt arising from trading activities), the economic benefits are usually identical across the two banking sectors. As such, Islamic banks usually observe similar Capital to Asset Ratios (CAR) statutory reserve as well as liquidity requirements, as do conventional banks. There are, however, situations whereby the underlying relationships between Islamic banks and their customers are fundamentally different from that of conventional banks. In such instances the regulatory authorities, with the advice of International Islamic agencies, such as the IFSB, may implement an additional set of prudential requirements to better protect the customers.

3.8.1 The changing nature of deposit Islamic investment accounts have been described in CDIF/2/4/77 as innovative products. They transform the banking lender-borrower relationship into a partnership banking relationship whereby the depositor is converted into an investor. To date, the Mudarabah contract underpins these investment accounts and two variant products are currently on offer: the Mudarabah unrestricted investment account and the Mudarabah restricted investment account. Under the former the deposited funds are pooled with other deposits in the Islamic bank and under the latter the funds are segregated from the rest of the Islamic bank’s deposits and invested separately. The funds associated with such accounts do not have costs in the form of an interest expense paid out of interest-bearing liabilities, but share in the distributable profit of the IFI via dividends. These dividends are paid to investment account holders (IAHs) on an active profit-allocation basis, thus changing the nature of the fund.

3.8.2 Profit Equalisation Reserve (PER) The regulatory authorities have instituted several mechanisms to protect the interest of the IAH. Several are designed to safeguard the dividend payouts to the investment account depositors. For instance, the Profit Equalisation Reserve (PER) acts as a mechanism to mitigate the fluctuation of rates of return arising from the flux in income, provisioning and total deposits. This ensures that the rates of return paid out by Islamic banks remain competitive and stable at all times. Allocated during profitable years, the PER is the amount appropriated by the Islamic bank out of the Mudarabah income (or the total gross income) before allocating the profit-sharing portion or share to the managing partner or Mudarib in order to maintain a level of return on investment for IAHs. The main objective of introducing a PER is to provide Islamic banks with an opportunity to mitigate the undesirable fluctuations of income and remain competitive, particularly in terms of the increased deposit interest rates in the conventional banking system with which they are in competition. In several jurisdictions, Islamic banks are allowed to make a monthly provision of up to 15% of the gross income plus net trading income, other income and irregular income, such as recovery of nonperforming financing (NPF) and write-back of provisions. To provide for further amounts, Islamic banks would have to obtain permission from the regulatory authorities. Islamic banks may be allowed to build up and maintain a maximum accumulated PER of 30% of the shareholders’ funds. They may write back the amount of PER into the total gross income in the event that prevailing rates have become less competitive. However, Islamic banks must at all time exercise prudence in building up and writing back the PER.

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3.8.3 Investment Risk Reserve (IRR) Regulatory authorities operate another mechanism to safeguard the capital invested by IAHs. Known as the Investment Risk Reserve (IRR), it is the amount appropriated by the Islamic bank out of the IAHs’ share of profits, after allocating the Mudarib share, to mitigate future losses for IAHs. From a depositor’s point of view, the IRR acts as a comfort buffer for the depositors. Investment accounts are still classified under deposits and as such this pool of depositors would require some form of risk mitigation for money deposited. From the banks’ point of view, they rest assured knowing that the IRR utilised to placate the depositors is generated from funds due to the depositors. It is a cost-effective way of promoting confidence in the depository instruments.

3.8.4 Authorisation required to operate PERs and IRRs The introduction of the PER and IRR are good examples of the improving prudential requirements that have been set specifically for Islamic banks. However, there are several Shari’ah as well as operational issues that must be addressed in managing such reserves. Managers of Islamic banks, for instance, must obtain the consent of the IAHs prior to allocating such reserves or in making distributions from them. The ceilings and floors of such reserves must also be approved by both the regulatory authorities and the account holders. Other issues would include whether an Islamic bank was required to set up one overall PER and IRR for all its relevant business, or separate reserves for each category. In addition, the Islamic bank would need to decide if there should there be different ceilings and floors for the different types of investment, that is one for the real estate investment portfolio and another for the car leasing portfolio. These bona fide issues would have to be resolved individually by each Islamic bank so the interest of their IAHs was best protected at all times.

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Islamic finance challenge 3.2 (a) Analyse the financial statements of the two international banks as given in table 3.3 below. (b) Describe the issues that are involved, both Shari’ah as well as operational, with regards to the allocation of PER within each bank. (c) Explain whether a higher PER allocation necessarily means a more profitable banking operation.

Solution (a) The PER provides a cover over the future profit potential for IAH while the IRR provides a cover over the capital invested. The Malaysian bank is seen to be allocating higher percentages of PER as a percentage of income compared with the Bahraini bank during the profitable years 2003 and 2004. To do this, the managers of the Malaysian bank must operate within the maximum PER allocation guidelines of the regulatory authority (given at 15%). (b) In order to fulfil Shari’ah requirements, both banks must obtain consent from the IAH prior to allocating both PER and IRR. This is because the allocated amount accounts for actual profits that can be distributed to the IAH. This consent is obtained during the initial opening of the investment accounts. Once mandated, Islamic bank managers must decide what percentage of income can be allocated to the PER and IRR. This is a balancing act as the managers must keep in mind that the composition of the IAH would change over the years. A percentage too high would tax the IAH unfairly and one too low would result in insufficient reserves. (c) One possible explanation is that Malaysia has already instituted a deposit Takaful scheme that protects the capital of the IAH. Another explanation could be that the Malaysian banking system is well regulated and the Malaysian bank is already well capitalised. The PER fund for the Malaysian bank was reduced to zero at the end of 2005. This suggests that the Malaysian bank experienced a very bad year in 2005 and obtained permission from the IAH (a Shari’ah requirement) to disburse the full amount to the IAH in that year. It also appears that the bank paid out USD155,000 from the PER Fund to smoothen profits for IAH holders in 2004. The above permission is a requirement as different groups of IAH have placed funds at different timescales, some since 2003 and others at the start of 2005. As such, different groups of IAH have contributed different amounts to the PER and as such the managers must be operationally efficient in distributing the PER equitably.

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Table 3.3 Excerpts of financial statements of a Malaysian bank versus a Bahraini bank for the years 2003 to 2005 2003

Malaysian bank (US ‘000)

Bahrain bank (US ‘000)

Shareholders’ fund (SHF)

309,202

281,980

Income derived from investment of depositors’ funds

158,809

32,671

PER allocation for year

2,065

0

PER fund

2,065

0

0

0

PER as a % SHF

0.67%

0.00%

PER allocated as a % income

1.30%

0.00%

Shareholders’ fund

323,108

294,047

Income derived from investment of depositors’ funds

169,904

44,241

PER allocation for year

7,176

1,200

PER fund

9,241

1,200

0

3,350

PER as a % SHF

2.81%

0.41%

PER allocated as a % income

4.22%

2.71%

Shareholders’ fund

202,828

337,911

Income derived from investment of depositors’ funds

206,089

54,199

PER allocation for year

1,986

4,795

PER fund

11,227

5,995

0

0

PER as a % SHF

0.00%

1.77%

PER allocated as a % income

0.96%

8.85%

IRR allocation for year

2004

IRR allocation for year

2005

IRR allocation for year

3.9 Deposit insurance/Takaful Deposit insurance schemes are not a new phenomenon. Given the importance of ensuring the stability of a nation’s financial system, such schemes have been adopted by more than 80 countries including the US, Canada, Taiwan, Japan, Germany, Indonesia and Hong Kong. The scheme offers an explicit guarantee that depositors will get their money back should a bank fail in its operations, replacing the implicit guarantee from the government. This represents part of the authorities’ concerted efforts to strengthen protection for depositors and is a clear signal to the banking community, as well as the general public, that financial institutions should no longer expect to be bailed out in the event of mismanagement and/or sheer lack of financial discipline on their part. Malaysia’s 2005 initiative to introduce a deposit insurance scheme represents the world’s first scheme that covers Islamic deposits. Operating via a third-party guarantee, the Islamic Deposit Insurance Scheme initially provided a maximum coverage of RM60,000 per depositor, per member institution for Islamic deposits. This effectively provides 95% coverage for the system’s depositors, and 35% of the total deposited amount.

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Exercise 3.4 Explain the impact of the Islamic Deposit Insurance Scheme on the Islamic banking industry in Malaysia.

Islamic finance challenge 3.3 Explain whether the Islamic Deposit Insurance Scheme in Malaysia can guarantee the Mudarabah capital of the IAH, which cannot be guaranteed by the Mudarib.

Solution Mudarabah is a form of Islamic equity-based partnership contract, commonly known as a profit-sharing contract. It is a partnership contract where the capital provider, Rabb alMal, contributes the capital while the manager or Mudarib provides entrepreneurial skills to manage the Mudarabah capital accordingly. Taken within the context of the Mudarabah investment account, the IAHs are the Rabb al-Mal and the Islamic bank is the Mudarib. A feature of the Mudarabah contract is that the Mudarib cannot guarantee the Mudarabah capital or capital redemption. The capital has presumably been invested in the identified venture and hence must absorb the associated market risk involved. The Mudarib can, however, provide a guarantee against fiduciary risk; that is a capital guarantee or an undertaking on capital redemption in the case of loss in the event of the Mudarib’s misconduct, negligence or breach of the terms of the contract. An independent third party, not related to either Mudarabah partners, can also guarantee the capital for misconduct, negligence or breach of the terms by the partners based on the separate Tabarru’ contract. Taking the cue from conventional deposit insurance, premiums for the scheme must be borne by the banks and cannot be transferred to the depositors. With the Mudarib responsible for the costs, the question that must now be answered is whether the Islamic deposit insurance scheme guarantees the performance of the investment accounts or does it actually only cover fiduciary risks. The former is non-compliant while the latter appears to be within the boundaries of the Shari’ah. The regulatory authorities are aware of this contradiction, but the immediate need to further protect small depositors in the Islamic banking system may justify the use of the concept ‘for the betterment of the society at large’ or Maslahah. While this may be the basis of approving the current application of Islamic deposit insurance schemes, one should continue to develop better alternatives in the near future. Interestingly, the Islamic deposit insurance scheme in Malaysia has been developed using the contract of Kafalah for a fee. The fee is paid by all participating financial institutions in the country. The imposition of a fee by the guarantor is questionable among the scholars, but it seems that the Malaysian Shari’ah authority has opted for the view, allowing a Kafalah contract for a certain agreed fee.

3.10 Shari’ah compliance review Regardless of whether an IFI is operating in the banking or the capital market industry, the institution must undergo a periodic Shari’ah compliance review. This also applies to companies that issue Islamic instruments, such as a Sukuk, whereby the subject of review would be the operations of the Islamic instrument. Strong corporate governance is essential to ensure that Islamic banking and finance institutions are managed in an effective and prudent manner. In the Islamic banking and finance industry, Shari’ah compliance is one of the important dimensions of the governance.

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3.10.1 An independent appraisal A Shari’ah compliance review is defined as an independent appraisal of the IFI’s activities and operations in adherence to Shari’ah principles and rules as prescribed by the relevant Shari’ah authority. In particular, the review is carried out to ensure that specified Shari’ah control objectives have been achieved. The review is governed by a Shari’ah compliance framework set for IFIs or the instruments, which evaluates all compliance aspects of the financial instruments and practices. This entails both the pre and post-Shari’ah review processes on the financial institutions or the Islamic instrument’s product concept, structure and operations.

3.10.2 Scope of the independent appraisal While the purpose of the Shari’ah compliance review is to provide comfort to the investors as well as the regulatory authorities that Shari’ah requirements have been met, the scope of the review is based on established Shari’ah principles, standards and guidelines. These benchmarks have been set by the Shari’ah advisory committees of the regulatory authorities, as well as those established inhouse by the financial institutions. The scope would also include adherence to the relevant acts that the financial institution has to comply with, as well as the best practices and standards promoted by international bodies such as the AAOIFI and the IFSB. The following table depicts the individual areas that the Shari’ah compliance review would address:

Table 3.4 Scope of Shari’ah compliance review Technology

i. Review of the application system to ensure it can support the Islamic product specifications and transactions ii. Review of the Islamic application access and control to ensure compliance to Shari’ah rules

Operations

i. Assessment of adequacy and effectiveness of policies and procedures of business activities ii. Review the contracts, products and services in accordance to Shari’ah rules iii. Review the product development, product branding and market development iv. Report new research and latest findings in Islamic banking

People

i. Review the staff roles and responsibilities in executing Islamic finance activities ii. Review adequacy of training and development of human capital

Governance

i. Review the key governance functions ii. Review the capital adequacy framework iii. Review the Islamic accounting standard and treatment iv. Review the liquidity framework of Islamic banking v. Assessment on risk management vi. Legal issues in Islamic finance industry vii. Profit distribution policy to IAHs and other depositors

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3.10.3 Benefits of a Shari’ah review process A good example of the benefits of a Shari’ah review process comes from the Islamic capital market. Shari’ah equity mutual funds invest in common shares of companies and utilise a variety of Islamic stock-screening methodologies to ascertain their investable Shari’ah-compliant universe. As stated in CDIF/3/9/137, the Islamic equity screening methodology generally employs three screens: corebusiness activities, financial ratio and non-halal income. Shari’ah authorities have predetermined, through Fatwas, the permission levels of tainted income that can be tolerated for a stock to be labelled Shari’ah-compliant. It is through this process of periodic Shari’ah review that mutual fund managers can ascertain what the current levels of tainted income generated are and what must be cleansed. The cleansing process can take place through donating the tainted income to pre-identified charities. The Islamic mutual fund’s internal Shari’ah advisory committee is usually consulted prior to this cleansing process.

Exercise 3.5 A Shari’ah review examines whether the operations of the product are in line with the approved Fatwa. If the operations are found to be against the Shari’ah parameter prescribed in the Fatwa of the Shari’ah board, the board has to recommend correctional measures to comply with Shari’ah principles including, but not limited to, revocation of contract, disposal of any profit to charity and suspension of the whole facility at bank level. In the case of Sukuk issuance, a financial institution declares in an information memorandum that its Sukuk Musharakah proceeds will be utilised in financing the construction of a power plant in country ‘A’. The Shari’ah review is never undertaken throughout the tenor of the Sukuk. It is discovered after the maturity of the Sukuk that proceeds were actually used to invest in money market products, some of them not compliant to Shari’ah principles. Identify the causes of this non-compliance and the measures that must be taken to ratify and avoid this happening in the future.

3.11 Zakat treatment of Islamic finance investors Zakat is a form of religious levy on the wealth of Muslims and has been discussed in CDIF/2/1/25. Based on wealth that exceeds the specified quantum for a defined period, it is meant for the poor and needy, as well as other specified beneficiaries mentioned in the Qur’an. As it is the third pillar of Islam, Zakat is obligatory for all Muslims who have the financial means to discharge such obligations. Zakat can therefore be viewed as an Islamic equivalent of a direct tax on property and income. It is levied on the total of the taxpayer’s capital resources and income that is not invested in fixed assets. Where an individual owns shares in a company, such resources include the company’s capital, net profits, retained earnings and reserves not created for specific liabilities. Zakat payments by IFIs vary as each financial institution is supervised by their individual Shari’ah advisory boards. For instance, in Malaysia, the Kuwait Finance House pays a rate of 2.5775% on its opening reserve balances. Other institutions reportedly pay Zakat only on their business proceeds and not for their shareholders. Islamic banking industry practice is such that no Islamic banks pay Zakat for their depositors. The depositors settle their own Zakat obligations.

Zakat is a religious obligation for Muslims, payable on all wealth able to give a financial return. There is no specific date set for the payment of Zakat, but it should be paid on all wealth held for more than 12 lunar months. Zakat is not payable on the value of the individual’s home, furniture, transport or ‘tools of trade’, nor is it paid on personal jewellery.

Even in Muslim countries there may be no law or regulation imposing the payment of Zakat by IFIs. The Islamic Banking Act 1983 of Malaysia made the payment of Zakat by the shareholders of IFIs licensed under this Act compulsory. Thus, the Shari’ah board of these institutions is required, by virtue of the Act, to ensure the payment of Zakat by the IFIs on behalf of the shareholders. There was, however, no law imposing Zakat on individual Muslims be it depositor, investor or Sukuk holder.

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Islamic finance challenge 3.4 As explained in the discussion on Takaful (CDIF2/8/149), the obligation to pay all the claims to the claimant is vested with the Takaful or risk fund. The Takaful company, or the operator, is merely a fund manager and not an insurer. There is, however, no law or written regulation to legally oblige the Takaful operator to undertake to provide this interest-free loan when the need arises. In practice, a Takaful fund can run into a deficit if the claims of a given period exceed the contributions and the reserves. Should the law prescribe on all Takaful operators to provide this interest-free loan fund from the very beginning of the operation, explain what the implication would be on a Takaful company from a commercial and Shari’ah perspective?

Solution It would appear to be a good policy to ensure that the licensed Takaful company is solvent when the need arises to pay the outstanding claims that are beyond the limit of the Takaful fund. From a capitalisation perspective, if this fund could be considered as part of the capital of the Takaful company, then it will improve its capital adequacy while maintaining a solvency to pay claims if the Takaful fund is in deficit. However, if the law or regulation were to insist that this provision of an interest-free loan could not be deemed as part of the capital of the Takaful company, then the company may have to provide a larger capital base to create a better capital adequacy ratio. While some companies may be in the position to provide a larger capital base for both capitalisation and solvency requirements, some of the prospective Takaful companies may not be able to do that, thus affecting the growth of Takaful business. The provision of interest-free loans by the Takaful company in advance may pose a Shari’ah compliance issue as the Takaful company, being the lender, is also the agent or Wakil to manage the Takaful business and the Takaful fund investment for an agreed fee. As stipulated in Shari’ah principles, a loan contract shall not be combined with any other contracts that may give indirect benefit to the lender. The Takaful company, after lending out the money for this fund for solvency purposes, may charge higher Wakalah fees for managing the Takaful fund. This could be construed as indirect charging of interest, which is prohibited. The argument against this practice will be irrelevant if the management contract between the Takaful fund/policyholders and the Takaful company is based on Mudarabah simply because Mudarabah, unlike Wakalah, does not have a fixed-fee feature into which a possibility of an interest charge may be included.

3.12 Conclusion This chapter looked into the various financial laws and regulations that govern IFIs and the Islamic instruments that they generate. The various financial regulatory organs and their functions were discussed, as well as the regulatory systems that they adopt. The chapter elaborated on the monetary, tax and legal policies adopted by these regulatory authorities that affect the development of the Islamic finance industry in its domestic market. Various Islamic banking models were analysed to provide justification as to how the business and legal environment determines which model would be most suitable in the jurisdiction. Issues on prudential requirements, supervision and Shari’ah review were also discussed to give you a holistic overview on the issues you would have to keep in mind as you undergo the Islamic product structuring process.

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3.13 Summary Having read this chapter the main points that you should understand are as follows: • adequate regulation and governance of the IFSI is required to maintain confidence in the financial systems • financial legislation and licensing requirements determine the structure of each financial system • the regulator’s policy to promote its Islamic finance industry through tax breaks or tax subsidies will have a major impact on the development of that industry • tax neutrality policies and the removal of double stamp duties have improved the competitiveness of Islamic financing instruments • Islamic finance instruments may require a unique set of prudential requirements different from conventional instruments because of different contracting relationships • a Shari’ah review is an important process in ensuring that Islamic instruments maintain Shari’ah compliance at all times • Islamic deposit insurance improves confidence in the Islamic banking industry.

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3.14 Islamic finance case study Comparative analysis of banking models in a dual banking system Greenwich Bank is a traditional conventional commercial bank that has been operating in the UK since 1923. Its main banking focus is in the retail banking business and Greenwich has always maintained an average market share of 23% of the total deposits mobilised in the UK. Since 2004, Greenwich has had an Islamic banking window in the UK to cater for the growing interest in Islamic-compliant instruments. Greenwich is keen to export its Islamic banking expertise overseas, particularly to Malaysia and Bahrain, to tap into Islamic deposits there.

Case study multiple choice questions 1.

2.

3.

4.

5.

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How can the Financial Services Authority promote and develop the Islamic banking and finance industry in the UK? (A)

By issuing more Islamic liquid instruments in UK currency

(B)

By providing tax subsidies to Islamic financial institutions and products

(C)

By allowing multi-currency-based Shari’ah-compliant products

(D)

By introducing special laws and regulation on Islamic finance

Which legislative system will best enable Islamic financial institutions to develop better in the UK? (A)

A separate legislative system

(B)

A single legislative system

(C)

A centralised banking legislative system

(D)

A decentralised banking legislative system

Why would an Islamic bank be more successful if it were a universal bank? (A)

Universal banks are given tax subsidies by most governments

(B)

Universal banks are more cost-effective

(C)

Islamic deposits and financing instruments are not necessarily debt-based

(D)

Islamic depositors are more risk-tolerant

Which of the following statements about PER is correct? (A)

PER is appropriated out of Mudarabah income before allocating a profit-sharing portion to the Mudarib

(B)

PER is appropriated out of Murabahah income before allocating a profit-sharing portion to the Mudarib

(C)

PER is appropriated out of Mudarabah income after allocating a profit-sharing portion to Mudarib

(D)

Approval from the IAH is not required for the appropriation of PER

A Shari’ah compliance review is an important process to: (A)

Ascertain that the Islamic finance instruments remain Shari’ah-compliant at all times

(B)

Ascertain that the financial institution that issues Islamic finance instruments remain Shari’ah-compliant at periodic times

(C)

Ensure that the Islamic finance instruments are tax-efficient

(D)

Ensure that the Islamic finance instruments are profitable

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Case study short essay questions 1. Continuing with the case study: (a) Explain the strategies that Greenwich Bank should have in its plan to work in Malaysia and Bahrain, as mentioned in the case study. (b) Explain the Islamic banking models that Greenwich Bank could potentially apply in these two jurisdictions, utilising the information contained in this chapter. (c) Outline the Islamic banking instruments Greenwich Bank can potentially offer in Malaysia and Bahrain. Give reasons for selecting these instruments. 2. Explain to Greenwich Bank how it could increase its Islamic banking operations in the UK, taking into account all regulatory requirements and limitations. 3. Operating in a dual banking system, one of the problems that Greenwich Bank could face is a displaced commercial risk (DCR), thus affecting the shareholders’ dividend. Recommend Shari’ah-compliant measures that would overcome this risk.

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Chapter three answers Exercise 3.1 Operating in a centralised Shari’ah supervisory system, one would be expected to be well versed in the Shari’ah guidelines of the contracts and Islamic instruments that have already been approved by the central Shari’ah authorities. The structuring team may wish to adapt contracts that have been utilised in other IFIs to suit the features of their new products. This would appear to simplify the task as the principles of the chosen contracts would already have been specified in the guidelines of earlier instruments. The structuring team can then concentrate on any new features to ensure that they would appeal to the target consumers. However, when introducing a new Shari’ah contract to the domestic market, the structuring team would be best advised to seek guidance or best practice established by international Islamic agencies such as the AAOIFI and the IFSB in relation to the specific contract. This would help in gaining approval from both their internal Shari’ah advisory board and the centralised Shari’ah authorities. The team would, of course, have to ensure that the guidelines adopted from such international agencies did not conflict with the interpretation of Shari’ah principles in their own country. Consequently, a product that has not been approved in that jurisdiction cannot be introduced there although the product may have obtained Shari’ah approval from other Shari’ah boards in other jurisdictions. The structuring team should endeavour to find a solution that would achieve the same economic benefit, but using a different contract or product structuring. For example, an Islamic credit card based on the Murabahah commodity structure may not be accepted by the central Shari’ah board as the Murabahah commodity structure has not been approved for this purpose. However, an Islamic credit card may be introduced in that jurisdiction using a different contract such as Wakalah or Kafalah.

Exercise 3.2 The benefits of this policy include: a. Cost-effectiveness as there is no need to get clearance for the licensing and distribution of Islamic products once licensed and approved by the respective party to the agreement. b. Mutual recognition of different Shari’ah interpretations, if any. c. Cross-border investment opportunities for the investors in participating countries. However, in cases where this policy is not available, the Islamic asset management companies will have to set up a feeder fund in their respective country to raise funds to be channelled entirely to another fund manager overseas. The management of the fund will be undertaken by the overseas party.

Exercise 3.3 The UK FSA recognised that the ‘trade’ or ‘sale’ between the financial institution and the customer that takes place in an Islamic financing scheme is not a ‘pure sale’ but is part of a financing process. Before this recognition was made, parties to an Islamic house finance scheme were required to pay stamp duty land tax on the sale between the original house owner and the financial institution and on the ‘sale’ between the financial institution and the ultimate buyer. The removal of the double payment of stamp duty land tax, which would have occurred if the trade was taken as a ‘pure sale’, ensures that Shari’ah-compliant financial products are taxed in a way that is neither more nor less advantageous to equivalent conventional banking products. The amendment allows providers of an Islamic house-financing scheme to offer such instruments without facing any commercial disadvantage through unequal tax treatment. If the change had not been introduced, the Islamic instrument would be tax-inefficient compared with conventional mortgages. IFIs can therefore tap into otherwise conventional-only customer pools where they can attach innovative Islamic product features that are not offered in conventional mortgages. It also enables customers to take up these Shari’ah-compliant products without encountering uncertainty or disadvantage over tax treatment.

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Exercise 3.4 The Islamic Deposit Insurance Scheme provides assurance to Islamic depositors that their funds should be safe in Islamic banks. A large portion of Islamic deposited funds in Malaysia are based on the Wadiah yad dhamanah contract and as such would be utilised by the Islamic bank for its financing portfolio. The Islamic Deposit Insurance Scheme improves Islamic banks’ safe-guaranteed obligations. The scheme would also relieve the central bank from the burden of implicitly guaranteeing deposits. This system should further enhance the Malaysian financial industry, increasing the system’s stability in the process. The migration from a flat-rate premium system to a risk-based premium system, which will be implemented at a later stage, would also encourage sound risk-management practices in the banking sector. With the newly introduced deposit insurance scheme, the credit ratings of financial institutions would play an even more crucial role, for depositors and banks alike.

Exercise 3.5 It seems that the issuer has breached the representation which they made in the information memorandum. The issuer may be subject to legal action as they have breached the disclosure statement made in the official document. The trustee who has been assigned to look after the Sukuk proceeds seemed to be negligent in not monitoring how the Sukuk proceeds were utilised. To some extent, it also reflects poor Shari’ah internal monitoring as the Shari’ah review has not been done either by the scholars who approved the Sukuk or by the internal Shari’ah officer of the arranger bank. This Sukuk product may be argued as null and void as the profit being distributed during the tenor was not derived from the project specified but from another project. Furthermore, the proceeds have been invested in non-approved instruments, the income of which must be disposed to charity. The causes for this non-compliant activity are due to a breach of terms and conditions by the issuer, negligence by the trustee, and poor Shari’ah review procedures. Given the above, it seems that the product is not compliant. The Shari’ah way of managing the issue is to examine how to describe this breach of contract. This could invoke many juristic discussions. One possibility is to deem this transaction as an extra action performed by the agent who is the managing partner/ issuer. Put simply, he has acted beyond his authority and therefore is liable for the capital of the Sukuk investors. Another possibility is that he is liable for both capital and reasonable profit according to the average market conditions as the managing partner has breached a clear-cut term and condition. Prudent measures to ensure compliance with regards to utilisation of Sukuk proceeds include periodical Shari’ah review of the operations of the issuer with regards to Sukuk proceeds, access to the formula of determination of profit and loss for every distribution of dividend and, if necessary, a site visit to ascertain the real undertaking of the project financing.

Case study multiple choice answers 1

(B) Tax subsidies will allow Islamic instruments to be more tax-efficient and hence investors would be more willing to use them for investments.

2

(A) UK banks have a historical bias towards a debt-based system with the traditional lenderborrower relationship firmly in place. To suit the equity-based contracts that Islamic finance are associated with, it may be more suitable that Islamic banks are separately licensed so they can take equity positions in companies or assets.

3

(C) The universal banking concept allows an Islamic bank to match its equity-based deposits to equity-based financing instruments. The universal banking concepts still allows the Islamic financial institution to generate debt-based business but it simply gives an option for an equity-based business.

4

(A) This is a fundamental feature of the PER.

5

(A) Islamic instruments must at all times be Shari’ah-compliant.

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Suggested solutions to case study short essay questions 1

(a) The Malaysian financial industry operates a dual banking system with separate licensing. The Malaysian Central Bank has ceased allowing conventional banks to operate Islamic windows thus restricting all banking business in Malaysia strictly to Islamic. All existing Islamic windows are being converted to Islamic banking subsidiaries. As such, Greenwich Bank would have to apply for a new Islamic banking licence if it wishes to conduct Islamic banking business in Malaysia. The bank will not be allowed to export its Islamic window model to Malaysia. The Bahraini financial industry also operates a dual banking system, but via a single licence system. As with the Malaysian counterparts, the Islamic window model no longer exists in Bahrain. Greenwich Bank would need to incorporate a fully fledged Islamic bank in Bahrain in order to participate in the industry, and would also be restricted to solely undertaking Islamic banking business. (b) Separate licensing would mean that the Greenwich Bank Islamic operation in Malaysia will have the option of offering equity-based or leasing Islamic financing instruments to its potential customers, on top of the usual debt-based instruments. This may be a necessary pre-condition for the Islamic subsidiary in order to be competitive in the Malaysian market. Even though Bahrain operates a dual banking system based on a single legislation, the difference that the Islamic subsidiary would face there may not be as vast as previously expected. GCC banks have a history of originating as traders (either commodity or foreign exchange) prior to their banking history and, as such, are more capable of handling equitybased and leasing instruments compared with western banks. Bahraini banks also have an extensive history of managing operating leases and owning the leased assets in their books. As such, the single legislative nature of their banking licence does not impede Islamic banks in conducting their banking business. One major difference would lie in the Shari’ah authority in Bahrain, which is decentralised, compared with the centralised Shari’ah authority system in Malaysia. Greenwich Bank’s Islamic subsidiary would therefore enjoy autonomy in issues such as the selection of Shari’ah advisers to the bank, compared with the subsidiary operating in Malaysia. (c) Greenwich Bank would have to look beyond its history of debt-based instruments and quickly attain expertise on Islamic equity-based and leasing instruments. For instance, the Islamic subsidiary would have to offer operational leases and incorporate the leased assets in its balance sheet instead of only providing mortgages or vehicle loans. With regard to depository products, the Islamic subsidiary would have to be in a position to offer Islamic investment accounts. This equity-based instrument is also a point of departure for Greenwich Bank which would be used to mobilise deposits via debt or through the ‘lender-borrower’ relationship.

2. Greenwich Bank would need to establish a fully-fledged Islamic bank or at least an Islamic subsidiary in the UK to pursue Islamic banking business earnestly. To date, there are already five fully-fledged Islamic banks in the UK and the first movers usually maintain the advantage. Although the issues over double stamp duty have been resolved by the FSA, Greenwich Bank would need to move away from solely utilising debt-based financing for its asset portfolio. It should take advantage of minimising the duration gap between its future Islamic asset and liability portfolios by utilising more equity-based Islamic contracts for both its depository as well as financing portfolios. This transition is made easier through a fully-fledged Islamic bank or subsidiary, especially for a bank that has an entrenched foundation in a credit-based traditional banking model. Prolonged utilisation of the Islamic window model would limit Greenwich Bank’s opportunity of entrenching itself in the Islamic banking industry. 3. The issue of DCR will always exist as long as the Greenwich Bank Islamic subsidiary sees the need to mitigate the risks assumed by the IAH by transferring them to the shareholders. Instead of doing that, Greenwich Bank may utilise a portion of the profits due to the IAH by setting up a PER and an IRR. The IAH should be reminded that the opportunity of being remunerated with superior returns over traditional depository returns would come with the price of extra risk assumption.

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Chapter four Structuring deposits, investment accounts and money market instruments Learning outcomes By the end of this chapter you should be able to: • analyse and evaluate the validity of underlying contracts in raising deposits and funds • appraise prudential treatment in structuring Islamic deposits • assess the implications of contract structures in meeting liquidity requirements.

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Indicative list of content • Wadiah and Qard deposits for safe custody, payment and security • Mudarabah investment deposits or accounts • Murabahah ‘fixed-income’ deposit • Prudential considerations in structuring Islamic deposits • Essential considerations for structuring Shari’ah-compliant money market and treasury instruments • Case study formulating deposit strategies and meeting depositors’ expectations

4.0 Introduction Deposits are a class of financial asset placed or deposited at licensed commercial banks. For both conventional and Islamic commercial banks, deposits are the primary source of funds. They are essentially liability instruments for deposit-taking institutions such as commercial banks, which absorb cash from their depository clients in various forms of deposit. The depository funds allow banks to extend various financing schemes that make up the banks’ asset portfolios. Technically speaking, banks mobilise deposits to undertake financing in real and financial assets or to provide financing to customers for the purchase of assets such as houses, vehicles, equipment, land and buildings. This chapter examines deposit structures using a variety of contracts and explains the importance of applying a structuring process in a framework that takes into account regulatory requirements. Suitable contracts will be identified by analysing deposit and investment account behaviour from both the corporate and individual perspective. Throughout the chapter, where appropriate, cost implications will be considered in relation to the Islamic deposit structuring process. In addition, the chapter highlights the impact of structuring on deposit behaviour as well as its implications in relation to the deposit framework. Finally, the chapter examines the requirement for Islamic money market instruments and treasury products and the various products offered in the Islamic finance services industry. 4.1 Pertinent features of Islamic deposits There is a variety of Islamic deposits, ranging from sight or demand deposits to investment or time deposits. They share features with conventional deposits while retaining distinctive features of their own. We will start by considering the similarities, which include the need for liquidity, interest/profit sharing, customer relationships and guarantees.

4.1.1 Liquidity One of the most important features that deposits share is that they are very liquid assets, regardless of whether they are structured under a conventional or Islamic finance scheme. In terms of liquidity, deposits are ranked second only after cash. Time deposits are obviously less liquid than, say, sight deposits, with the former requiring a pre-agreed committed tenure before withdrawal. The drawback from providing this liquidity is that deposit products are the lowest return-generating class of assets for banking clients, ranked only higher than cash, which essentially generates zero returns.

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4.1.2 Interest/profit sharing

Hibah - gift.

Islamic banks offer depository products similar to their conventional counterparts. Demand or sight deposits are available in the form of Islamic checking and Islamic savings accounts, with Islamic investment accounts showing a close correlation to time deposits. The distinct difference between an Islamic and conventional deposit is how the depository clients are remunerated. Islamic deposits, unlike their conventional counterparts, are non-interest based and do not pay out pre-agreed exante returns. Depending on the contracts used, Islamic banks usually generate ex-post returns for their depository clients via profit sharing arrangements or even discretionary Hibah as deemed fit (CDIF/2/4/76-82).

4.1.3 Relationships with customers Although deposit mobilisation between Islamic and conventional banks may appear similar, the underlying concepts and principles of the deposits are different. In conventional finance, deposits are structured strictly under a loan contract where the depositors are the lenders and the bank the borrower. This ‘lender-borrower’ depositor-bank relationship need not necessarily manifest itself in Islamic deposits. The relationship can be ‘lender-borrower’ if the Qard contract is utilised, but the relationship could be ‘owner-trustee’ if the Wadiah contract is used, or even ‘investor-manager’ if the Mudarabah contract is applied.

4.1.4 Guarantees Another feature is that deposits in conventional banking are explicitly guaranteed by the bank that issues them and the regulator in their capacity as lenders of last resort. Recently, deposit insurance schemes have supplanted the regulator’s role of lenders of last resort. This issue will be discussed in more detail later in this chapter. In the case of demand or sight deposits, depositors fully expect banks to make good their deposits as and when they want to withdraw them. For time deposits, they would have to wait for the tenure to expire to recover the full amount. The inability of a bank to meet any withdrawal request from its depositors could trigger a run on the bank as was seen in 2008/09 during the credit crisis when many banks around the world were subject to concerns about their ability to repay depositors. Certain Islamic deposits, such as those under the concept of Mudarabah, cannot technically be guaranteed by the issuing bank and it remains to be seen whether the lenders of last resort facility will be made available to them.

Exercise 4.1 A customer has opened an Islamic investment account for the period of one year with an Islamic financial institution (IFI) using a Mudarabah contract. However, after six months the customer needs to withdraw his investment to meet pressing financial needs. The terms and conditions of the account have stipulated inter alia that the investment shall be for the agreed period. Advise the IFI on how to deal with this customer and how to improve the terms and conditions of the account moving forward.

4.2 Why people hold deposits People hold money for many reasons and this affects the type of product they choose to invest in. Some people look for liquidity to meet their transactionary motives, while others hold money for precautionary reasons, that is, to meet unexpected demands. Table 4.1 below outlines the various definitions of money in the banking system. Deposits fall within the definition of money, that is M1 for demand/sight deposits or M3 which includes time deposits. The liquidity features of the various deposit products determine its classification. Demand deposits, for example, are very liquid and can be used by the deposit holder to pay for example via debit card, for goods or services, whereas time deposits are less liquid and can’t be used for day-to-day transactions. As such, deposits fulfil the transactionary motive of holding money. On the other hand, the guarantee feature of deposits also fulfils the precautionary motive of holding money.

Key points • The transactionary motive of holding money refers to its use for purposes of business transactions and personal consumption. • The precautionary motive of holding money refers to the demand for security or in cases of emergency.

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Table 4.1 Economic measures of money M0

Currency (notes and coins) in circulation and in bank vaults, plus reserves that commercial banks hold in their accounts with the central bank (minimum reserves and excess reserves). M0 is usually called the monetary base - the base from which other forms of money (such as checking deposits, listed below) are created - and is traditionally the most liquid measure of the money supply.

M1

Currency in circulation, plus checkable deposits (checking deposits, officially called demand deposits, and other deposits that work like checking deposits), plus traveller’s cheques. M1 represents the assets that strictly conform to the definition of money: assets that can be used to pay for goods or services or to repay debts. Although cheques linked to checking deposits are gradually becoming less popular, debit cards linked to these deposits are becoming more popular. Like cheques, debit cards as a means to complete a transaction through their links to checkable deposits can also be considered as a form of money. Even in the case of traveller’s cheques, most users hold pre-paid cards rather than paper cheques. These will usually be foreign-currency denominated, and are not, therefore, part of the home country’s money supply.

M2

M1, plus savings deposits, time deposits less than US$100,000 and money market deposit accounts for individuals. M2 represents money and ‘close substitutes’ for money. M2 is a key economic indicator used to forecast inflation.

M3

M2, plus large time deposits, institutional money market funds, short-term repurchase agreements, along with other larger liquid assets.

The table above defines the different financial measures of money and ranks according to the level of liquidity, with M0 being the most liquid form of money. According to conventional wisdom, the more liquid the ‘form of money’ is, the less it should be remunerated with returns or interest. For instance, cash or currency (M0) pays zero returns to the person holding it. Checkable deposits (M1) also generate lower returns to the depositors compared with time deposits (M2). While it is perhaps not applicable to the Islamic banking and finance industry where interest is prohibited, it is nevertheless useful for Islamic banking and finance managers to be aware of this as they are in competition for funds with conventional banks. This is, to a large extent, manifested in the types of contracts being offered to Islamic depositors. Both Wadiah and Qard contracts are liability contracts, which therefore constitute demand deposits. The Mudarabah is not a liability contract but rather represents a longterm investment and therefore has a different risk-reward profile. This will be discussed later in this chapter.

4.3 Costs considerations in structuring Islamic deposits In addition to maintaining the features mentioned above, one has to consider the costs that are incurred as a result of structuring Islamic deposits.

4.3.1 Cost of funds Theoretically, money can be converted to productive capital when it is appropriately invested. In Islamic finance, only when money is transformed into production capital can it be remunerated with the appropriate share of profits. Remuneration by interest is categorically prohibited in Islam. From the point of view of the deposit-issuing party, the cost of funds to the Islamic bank relates to the returns on capital that any endeavour generates and is shared with the depositors. For instance, returns payable to the Mudarabah investment deposit holders must be benchmarked to the returns on the portfolio of assets the deposits are invested in, less the direct costs incurred by the Mudarib/Islamic bank. The cost incurred by the Islamic bank performing the Mudarib role may include items such as identification of potential financing clients, managing the financing portfolios (if the portfolio, for instance, includes house financing) or even the maintenance of the leasing assets (if, for example, the investment funds are utilised for asset leasing). The cost of funds is the single most important cost function for all banks as they search for an efficient methodology to price their products.

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4.3.2 The cost of household and corporate deposits Deposits are considered the cheapest source of funds as they command a discount over other money market rates. Within the depository funds available to IFIs, households are usually considered the cheapest source of funds, despite the number of such accounts, because of the typically small quantum held in each. This ‘small but numerous’ feature of household deposits does not usually afford households with any bargaining power and they are usually labelled as ‘cheaper’ to the banks. Corporate deposits on the other hand are considered costlier as the corporates would expect a higher rate of return on the larger balances involved.

4.4 Cost and the relevant structure chosen The cost of funds for conventional banks is simply the ratio of their interest expense over the interest liabilities. The actual interest paid is determined by the different sources from which such funds are mobilised. Within Islamic finance, the different contracts that oversee the ‘Islamic bankdepositor’ create a variety of other factors related to product differentiation that have an effect on the cost.

4.4.1 Deposit structure The pertinent issue here is whether the funds mobilised by Islamic banks are guaranteed (by both the bank and regulatory authorities) or not. Conventional deposits are guaranteed by the two parties and hence, by virtue of the guarantee, the deposits attract returns that are at a discount over market-interest rates. Certain Islamic deposits, such as those under the concept of Mudarabah, are not guaranteed and should theoretically cost more to the Islamic bank as the funds are expected to generate more returns from the point of view of a higher level of risk assumed by the depositor.

4.4.2 Contract nature This is pertinent only for Islamic banks as conventional banks only operate on a loan contract. Islamic banks make use of a variety of deposit contracts, several of which may remunerate depositors through Hibah which is a discretionary gift such as in Qard or Wadiah-based deposit taking. Islamic banks can therefore manage the cost of remunerating their depositors through the choice of contract applied. Islamic banks do not have to promise ex-ante returns to their depositors and may reward their depositors with returns only if and when they are able to. This also applies to the equity-based contract of Mudarabah when profits are paid out by the banks only when there are actual profits being made, even though the profit sharing ratio has been pre-agreed. The only situation when Islamic banks have to make good promised returns is when they use ‘trade-based’ contracts such as Murabahah, where the profits due to the depositors are pre-agreed from the mark-up sale transaction that underlines the contract.

4.4.3 Pooling Islamic deposits can either be invested together as a pool through unrestricted investments, or can be identified with a specific type of investment through restricted investments (CDIF/2/4/70). Under unrestricted investments the resulting profit sharing ratio is based on profits earned through bank-wide operations, whereas the profit sharing ratio for restricted investments is limited to profits earned from specific investments.

4.4.4 Depositors’ expectations Banks are responsible for developing and maintaining their depositors’ expectations on the returns paid on deposit funds. For instance, a conventional bank’s current account depositors will receive lower returns in comparison to, say, savings accounts. The same holds true for Islamic banks where Hibah is regularly paid on Wadiah savings or current accounts. Depositors would expect this practice to continue over the medium to long term. Non payment of Hibah (which is within the Islamic bank’s rights) would result in a fall in investor confidence in the Islamic bank which could affect its fund mobilisation process. As such, depositors’ expectations must be built into the bank’s pricing strategy.

4.4.5 Displaced Commercial Risk Displaced Commercial Risk (DCR) is an issue that arises for Islamic banks when managing depositors’ expectations over risk and return. Islamic banks have a responsibility to protect depositors’ funds,

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including the investment account deposits that are based on profit and loss sharing agreements. DCR occurs where the profit sharing-based investment account holders (IAHs) are protected against return volatility by the Islamic bank and its shareholders assuming some or all of the risks through a profit equalisation reserve. If the IAHs bear all the risks associated with the portfolio, then the DCR will be equal to zero. In practice, this is not likely to be the case for unrestricted and restricted investment accounts. Islamic banks and their shareholders would, in all likelihood, assume some of the DCR to provide comfort to its IAHs. The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) recommends that 50% of the risk-weighted assets of the profitsharing investment accounts should be included in the denominator of the capital adequacy ratio. The Central Bank of Bahrain has applied this since 2002.

Islamic finance challenge 4.1 The table below depicts the annual fixed deposit rates of AON Bank and the expected return for its Islamic window’s Islamic investment account for durations from three months to five years. Given this scenario, what is likely to happen to the development of Islamic banking and finance?

Comparison between AON Bank’s FD rates and AON’s Islamic window’s Islamic investment account’s expected returns 1 mth

3 mth

6 mth

9 mth

1 yr

3 yr

5 yr

Fixed deposit rates/ per annum

1.75%

1.80%

1.90%

1.93%

2.00%

2.25%

2.80%

Expected investment account returns/ per annum

1.50%

1.65%

1.70%

1.80%

1.85%

1.95%

2.40%

Solution The Islamic investment accounts will be in direct competition with conventional fixeddeposit accounts for the pool of deposit funds. The Islamic alternative may have its own pool of customers who are motivated by religious convictions, but this doesn’t mean that this pool should settle for less competitive returns compared with fixed-deposit customers. The rates tabled above show that returns are uncompetitive for all durations. This would not motivate Islamic depositors to place their funds in such accounts. On top of that, Islamic IAHs are expected to be burdened with higher risks, compared with conventional fixed-deposit customers. The Islamic investment account does not operate with guaranteed funds and, as such, potential account holders would expect a far higher return compared with conventional fixed deposit account holders. This scenario would certainly not augur well for the development of Islamic banking and finance. Islamic deposit instruments need to be more competitive than their conventional counterparts in order to woo new customers to this nascent segment. With this scenario, the Islamic window would find difficulties in mobilising deposit funds. The window would need to source more costly funds, such as issuing a Sukuk to fund its operations, and to build up a more profitable asset portfolio using the funds supplied by Sukuk.

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4.5 Operating cost The operating costs involved in managing Islamic deposits can be divided into two major categories: overheads and regulatory costs.

4.5.1 Overhead costs Overhead costs for financial institutions consist of all the indirect costs and other costs necessary to provide the financial products and services. A large portion of the financial institution’s overhead costs relate to personnel expenses, in the form of salaries and wages, as well as administrative, marketing and information technology expenses. Many current Islamic banking institutions are established either as subsidiaries of larger banking conglomerates or operate as Islamic window facilities, or are fully fledged Islamic banks. Such institutions, in cases like the former scenario, often operate via a model known as ‘shared services’ that seek to reap the benefit of economies of scale and also external economies that large banking conglomerates have in place. Services that are often shared between Islamic subsidiaries or windows and their conglomerate parent banking institutions are information technology services, marketing and distribution channels and personnel. The Islamic subsidiary or window is then allocated a percentage of the overhead cost from the parent conglomerate. This ‘shared services’ scenario will not be applicable in the case of a fully-fledged bank as it would have its own internal resources, including human resource and information technology, as well as distribution channels at its disposal.

Key point • The shared services model can be used for Islamic windows or Islamic subsidiaries as these services are permissible in Islam to support the core banking operations.

Exercise 4.2 Outline the guidelines to which an Islamic bank can subscribe in order to achieve both operational efficiency and Shari’ah compliance.

4.5.2 Regulatory costs Financial institutions are key players in ensuring the viability and stability of an economy’s financial system. Deposit-taking financial institutions are closely regulated by the monetary authorities as their business activities revolve around guaranteed deposits.

4.5.2.1 Capital adequacy ratio One prudent regulatory requirement covering these institutions is the requirement to hold a portion of the institution’s capital, as a percentage of the institution’s financing assets, in the form of liquid assets. The opportunity cost forgone for being unable to invest these liquid assets forms a holding cost for these financial institutions, and can also be considered a regulatory tax. This cost has to be factored into the pricing mechanism of the institutions.

4.5.2.2 Statutory reserve requirement Another regulatory tax that is specific to deposits is the statutory reserve requirement that sets the minimum reserves that each bank must hold in relation to customer deposits and notes. These reserves are normally in the form of cash stored in a bank vault or with a central bank, or placements in treasury bills. On top of that, banks usually hold excess reserves to meet the day-today operational withdrawals made by their depository clients. As these reserves are usually held in cash, banks forgo the opportunity of generating returns on these reserves, thereby justifying its classification as a regulatory tax. Some of the above issues are relevant to the importance of Islamic treasury and money market products in Islamic finance industry which will be discussed at the end of the chapter.

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4.5.2.3 Deposit insurance scheme Most advanced economies have instituted a deposit insurance scheme to further protect depositors and prevent the occurrence of a bank run. While deposit insurance systems are one component of a financial system safety net that contributes to the promotion of financial stability, they are nevertheless costs for the deposit issuing bank. Islamic deposit insurance schemes are available in some jurisdictions and are either run by the government or are private-entity backed or licensed by the government. The Malaysian Islamic Deposit Insurance Scheme is mandatory and has been in place since 2005. The premiums for the scheme must be borne by the Islamic banks and cannot be transferred to the depositors. This practice is similar to that of the conventional deposit insurance scheme. This means that banks in such jurisdictions would have to allocate an additional expense entry to their books, unlike banks operating in jurisdictions where the scheme has not been brought into effect. As such schemes gradually become more sophisticated there will be an inevitable migration from a flat-rate premium system to a risk-based premium system. This would encourage sound risk management practices in the banking sector and better reflect the risk proposition of each Islamic bank as their Islamic deposit insurance premium would depend on how sound their banking practices are. Countries that have instituted such regulatory taxes make the process transparent to both Islamic and conventional banks, regardless of whether they operate single or dual banking systems. Islamic banks are encumbered with similar regulations with regards to deposit mobilisation and their depository instruments must reflect this if they want to be competitive in the long run. Having considered the costs and regulatory implications surrounding deposits, we will now look at how Islamic deposits are structured.

4.6 Structuring Islamic deposits: Islamic current accounts Islamic current accounts provide the account holder with a guarantee on the principal amount deposited while entitling the account holder to receive funds on demand. The account holder can also issue cheques on the account to transfer legal ownership of funds to others. Also known as demand deposit accounts, they fulfil the precautionary and transactionary motives of depositors in holding money. There are two popular forms of current accounts in Islamic banking as shown in Figure 4.1 below:

Figure 4.1 Contract forms of current Account

Islamic current account

Wadiah/Qard current account

Mudarabah current account

Principle of safe custody/liability

Principle of profit sharing

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Table 4.2 Shari’ah structuring issues for Islamic current accounts Account

Wadiah current account

Qard current account

Mudarabah current account

Depositors’ precautionary requirements

Trustee safe custody under Wadiah yad amanah or guaranteed safe custody under Wadiah yad dhamanah

Guarantee is implicit as it is a liability of the bank

No explicit or implicit guarantee for depositors; bank may need to establish a reserve to guard against fiduciary risk

CDIF/2/4/74-75

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Depositors’ transactionary requirements

Non-issue under Shari’ah purview

Non-issue under Shari’ah purview

Non-issue under Shari’ah purview

Charging of service fees for transactionary services provided

Non-issue under Shari’ah purview; the fees are usually based on the type of services rendered, for example cheques and ATMs for withdrawals

Non-issue under Shari’ah purview; the fees are usually based on the type of services rendered

Non-issue under Shari’ah purview; the fees are usually based on the type of services rendered

Utilisation of deposited funds by the bank

Funds deposited under Wadiah yad amanah must be kept in custody and not reinvested; non-issue for Wadiah yad dhamanah

Non-issue under Shari’ah purview

Non-issue under Shari’ah purview

Commingling of deposited funds

Non-issue under Wadiah contract

Non-issue under Qard

Non-issue under Mudarabah mutlaqah; if the underlying contract is Mudarabah muqayyadah, pooling of funds from other sources is not allowed; note that pooling can only occur with Islamic accounts, such as savings and current accounts; no pooling is allowed with conventional deposit accounts

Returns for depositors

No ex-ante returns to be promised to depositors; the bank may award Hibah on its sole discretion; gifts upon account opening are construed as a promised return and are therefore prohibited

No ex-ante returns to be promised to depositors; the bank may award Hibah on its sole discretion; gifts upon account opening are construed as a promised return and are therefore prohibited

Pre-agreed profit sharing returns; if unrestricted investments are used then returns will be based on the bank’s overall returns

Application of Islamic deposit insurance

Non-issue under Shari’ah purview as it is a guarantee on a liability contract

Non-issue under Shari’ah purview as it is a guarantee on a liability contract

May trigger a Shari’ah compliance issue as Mudarabah is a profit and loss sharing PLS contract and a guarantee by the IFI through this scheme may be objectionable

Target depositors

General households and corporates

General households and corporates

Sophisticated households and corporates

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The primary aim of Islamic current accounts is to provide depositors with instruments to cover their transactionary and precautionary needs. As with table 4.2 above, the former is fully addressed in all three accounts while the latter appears to be lacking for the Mudarabah current account. It is true that the Mudarabah contract does not provide an implicit guarantee facility, but it can be utilised in well-regulated countries where the depositors are sophisticated and are confident in the established banks and the banking systems that operate there. The pull of a Mudarabah current account lies in the profit sharing feature whereby the depositors have a stake in the profits of a bank that they are already confident in. On top of that, the institution of Islamic deposit insurance will provide such depositors with an added safety net. For Islamic banks, issuing Mudarabah current accounts gives them an advantage in providing depositors with a profit sharing account, something they would not be able to do under a Wadiah or Qard arrangement. An important operational question that crops up in structuring Islamic current accounts is the level of service fees that an Islamic bank can charge. Banks are often in favour of charging fees in relation to the amount of funds deposited. This is acceptable under Shari’ah principles as the fees are imposed by the borrower or the custodian in the context of Qard and Wadiah current accounts, thus there is no possibility of any interest payment. However, an Islamic bank can rank the services it provides to different segments of clientele. For instance, premier depositors who maintain large deposits would be entitled to premium services such as dedicated banking branches or queues, or access to customer relationship managers, services that would not be rendered to depositors with lower account balances. The bank can in turn charge a higher service fee on these premier banking clients, rather than charging fees based on a fixed formula based on the amount deposited.

Exercise 4.3 A customer opens an Islamic current account using a Wadiah/Qard contract with a deposit of €50,000. One week later, the depositor issues a cheque to a third party amounting to €55,000. The cheque issued needs bank clearance. What are the options that the bank has in this scenario?

4.7 Structuring Islamic deposits: Islamic savings accounts The Islamic savings account is offered to depositors primarily to fulfil their precautionary motives of holding money, as well as to meet some of their transactionary and investment needs where relevant. Figure 4.2 below illustrates the popular contracts used for Islamic savings accounts.

Figure 4.2 Forms of Islamic contracts in savings accounts

Islamic savings account

Wadiah/Qard savings account

Mudarabah savings account

Principle of safe custody/ liability

Principle of profit sharing

It is the contract underlying Islamic deposits that distinguishes the nature of relationships between the bank and the depositor. Table 4.3 below reflects on the matrix of Shari’ah issues to be considered when structuring Islamic savings account. Note that the deposit features relating to the account, depositors’ precautionary requirements and depositors’ transactionary requirements are very similar to those seen for Islamic current accounts.

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Table 4.3 Shari’ah structuring issues for Islamic savings accounts

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Account

Wadiah savings account

Qard savings account

Mudarabah savings account

Depositors’ precautionary requirements

Trustee safe custody under Wadiah yad amanah or guaranteed safe custody under Wadiah yad dhamanah

Guarantee is implicit as it is a liability to the bank

No explicit or implicit guarantee for depositors; bank may need to establish a reserve to guard against fiduciary risk

Depositors’ transactionary requirements

Non-issue under Shari’ah purview

Non-issue under Shari’ah purview

Non-issue under Shari’ah purview

Charging of service fees for transactionary services provided

Non-issue under Shari’ah purview; the fees are usually based on the level of services rendered, for example ATMs and internetbased services for withdrawals

Non-issue under Shari’ah purview; the fees are usually based on the level of services rendered, for example ATMs and the internet

Non-issue under Shari’ah purview; the fees are usually based on the level of services rendered, for example ATMs and the internet

Utilisation of deposited funds by the bank

Funds deposited under Wadiah yad amanah must be kept in custody and not reinvested; nonissue for Wadiah yad dhamanah

Non-issue under Shari’ah purview

Non-issue under Shari’ah purview; under the Mudarabah muqayyadah contract, the funds would have a specific use

Commingling of deposited funds

Non-issue under Wadiah contract

Non-issue under Qard

Non-issue under Mudarabah mutlaqah; if the underlying contract is Mudarabah muqayyadah, pooling of funds from other sources is not allowed; note as mentioned above in relation to the Islamic current accounts, pooling can only occur with Islamic accounts, such as savings and current accounts; no pooling is allowed with conventional deposit accounts

Returns for depositors

No ex-ante returns to be promised to depositors; bank can issue Hibah at its discretion; gifts upon account opening are construed as a promised return and are therefore prohibited

No ex-ante returns to be promised to depositors; bank can issue Hibah at its discretion; gifts upon account opening are construed as a promised return and are therefore prohibited

Pre-agreed profit sharing returns; if unrestricted investments are used then the returns will be based on the bank’s overall returns

Application of Islamic deposit insurance

Non-issue under Shari’ah purview as it is a third-party guarantee

Non-issue under Shari’ah purview as it is a third-party guarantee

May trigger Shari’ah-compliance issue as Mudarabah is a PLS contract and a guarantee by the IFI through this scheme may be objectionable

Target depositors

General households

General households

Sophisticated households

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The aim of Islamic savings accounts is primarily to provide depositors with instruments to cover their precautionary needs. However, savings accounts can also provide depositors with some returns as well as being flexible enough to accommodate some payment facilities, further fulfilling some degree of investment and transactionary motives of holding the deposits. As with the Islamic current account, the Mudarabah contract does not provide an implicit guarantee facility. However, it can be utilised in well-regulated countries where the depositors are sophisticated and confident in the established banks and the banking systems that operate there. The issue of returns on Islamic savings accounts, while not explicitly guaranteed by Islamic banks, can be provided for as long as the banks are not contracted to giving it. Savings accounts, however, do not offer as good returns compared with longer-term deposits, even in conventional banking. Similar to the Islamic current accounts, the important operational question of the level of service fees an Islamic bank can charge applies here as well. As the level of transactionary services here would presumably be less compared with the Islamic current account (current accounts are still the only accounts that provide cheque facilities), it is likely that Islamic banks would charge lower service fees for their Islamic savings accounts.

Key point • Islamic depository accounts are structured to meet the different motives of holding money. Islamic current and savings accounts are designed to meet depositors’ transactionary and precautionary motives.

4.8 Structuring Islamic deposits: Islamic investment accounts Islamic investment accounts can be construed as a substitute for conventional fixed or time deposits. Both have similar features: the accounts provide precautionary and investment motives to hold money for depositors, and both operate on a pre-agreed deposit tenure or duration. However, the Islamic substitute essentially changes the traditional lender-borrower relationship to a partnership venture whereby the bank is the manager or administrator and the investor is the fund owner. From a depository account perspective, the Islamic investment account can be described as ‘risk capital’ compared with traditional depository accounts, as it does not carry an implicit guarantee by either the bank or the financial regulatory authority, nor do the equity-based contracts used allow for capital guarantee. The funds mobilised can also be separately invested in higher-return, and thus riskier-asset, portfolios. As previously elaborated in CDIF/2/4/77-79 there are two popular forms of Islamic investment accounts.

4.8.1 Unrestricted investment accounts (Mudarabah mutlaqah) Under this scheme, the IAH fully authorises the bank to invest the funds without restrictions as to where, how and for what purpose the funds should be invested as long as it is deemed appropriate by the bank, within the ordinary course of Islamic banking business. Some banks will invest in leasing assets while others may concentrate on house financing. The funds are pooled with shareholder funds and other deposits for the various financing and investments made by the bank. The returns are shared and distributed across the varying classes of IAH based on different investment horizons.

4.8.2 Restricted investment accounts (Mudarabah muqayyadah) Based on the contract of Mudarabah muqayyadah (restricted investment principle) the funds generated in this partnership agreement are restricted with regard to the manner as to where, how and for what purpose the funds are to be invested. Commingling of these funds with shareholders’ and other deposit funds is usually restricted. Such a restriction will limit the risk exposure of financing and investments to unrestricted investment funds only. As a profit-sharing remuneration scheme, the returns to restricted IAHs are confined to returns on a designated specific investment portfolio agreed on by the restricted IAHs.

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Table 4.4 Shari’ah structuring issues for Islamic investment accounts

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Account

Unrestricted investment account (Mudarabah mutlaqah)

Restricted investment account (Mudarabah muqayyadah)

Depositors’ precautionary requirements

No explicit or implicit guarantee for depositors; the bank may need to establish a reserve to guard against fiduciary risk

No explicit or implicit guarantee for depositors; the bank may need to establish a reserve to guard against fiduciary risk

Depositors’ transactionary requirements

Nil

Nil

Charging of service fees for transactionary services provided

Non-issue under Shari’ah purview; the fees are usually based on the level of services rendered

Non-issue under Shari’ah purview; the fees are usually based on the level of services rendered

Utilisation of deposited funds by the bank

Non-issue under Shari’ah purview

Non-issue under Shari’ah purview, but the funds would have a specific use

Commingling of deposited funds

Non-issue under the Mudarabah mutlaqah contract

Pooling of funds from other sources is not allowed as the underlying contract is Mudarabah muqayyadah

Returns for depositors

Pre-agreed profit sharing returns based on the bank’s overall returns

Pre-agreed profit sharing returns based on the returns of the specific portfolio

Application of Islamic deposit insurance

May trigger Shari’ah-compliance issues as Mudarabah is a PLS contract and a guarantee by an IFI through this scheme may be objectionable

May trigger Shari’ah-compliance issues as Mudarabah is a PLS contract and a guarantee by an IFI through this scheme may be objectionable

Target depositors

General and sophisticated households, corporates

General and sophisticated households, corporates

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4.8.3 AAOIFI definitions AAOIFI standard 13 defines restricted Mudarabah as: ‘A contract in which the capital provider restricts the actions of the Mudarib to a particular location or to a particular type of investment as the capital provider considers appropriate, but not in a manner that would unduly constrain the Mudarib in his operations.’ The restriction that the Mudarib can only work with the capital in certain places, such as certain cities, is valid according to all jurists. This restriction qualifies as a useful condition in the contract, since prices vary across locations and travel increases the risk associated with transported capital. This restriction is applied, not only to the Mudarib, but also to the capital. Therefore, he cannot give the capital to someone else to enable that person to trade in other places.

4.8.4 Unique attributes relating to restricted investment accounts Offering restricted investment accounts results in a series of unique attributes, which do not affect other accounts.

4.8.4.1 Separate disclosure of restricted investments accounts AAOIFI (FAS No. 6) requires that an IFI maintains separate disclosure of restricted investment accounts in the form of a statement of restricted investments. This implies that such financing or investment is off-balance sheet (contrasted with all other deposits which are on-balance sheet items) as the control on such funds depends on the restricted IAHs’ preference for assets with a particular risk profile. Since the funds are restricted to certain financing or investments specified by the restricted IAH, the financial institution must manage these funds and assets separately from its own assets. Performance of the assets is then reflected in the net value of the fund only.

4.8.4.2 Neither equity nor liability The investment account is neither equity nor a liability to the IFI as the depositor does not assume the rights of the equity holders nor is the deposit guaranteed as a liability. As a result, the risk exposure of the bank is reduced with the involvement of IAHs in Islamic bank financing and investments. The benefit of this non-guarantee feature should mean that Islamic banks are less susceptible to the onset of bank runs. However, the banking business is largely based on reputation and no Islamic bank would take the risk of not honouring deposit withdrawals when depositors demand them.

4.8.4.3 Smoothing income fluctuations With the consent of Islamic account holders, Islamic banks in some jurisdictions are now able to mitigate the undesirable fluctuations of income and remain competitive, particularly in terms of the deposit rates by utilising two forms of reserves: the profit equalisation reserve (PER) and the investment risk reserve (IRR). PER is the amount appropriated by the Islamic bank out of the Mudarabah income, before allocating the Mudarib share, to maintain a certain level of return on investment for IAHs and increase owners’ equity. IRR, on the other hand, is the amount appropriated by the Islamic bank out of the IAHs’ share of profit, after allocating the Mudarib share, to compensate against future losses for IAHs. In Malaysia, Islamic banks are allowed to make a monthly provision (for PER) up to 15% of the gross income plus net trading income, other income and irregular income, such as recovery of nonperforming financing (NPF) and write-back of provisions. The banks may write back the amount of PER into the total gross income in the event that prevailing rates have become less competitive. However, Islamic banks must at all times exercise prudence in building up and writing back the PER. PER has been adopted in other jurisdictions apart from Malaysia, but elsewhere it is done on an individual institutional basis and not in accordance with regulator regulation. For instance, Bahrain’s Shamil Bank began allocating PER in 2004, but the Central Bank of Bahrain has not stated how much can be allocated.

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Exercise 4.4 Between either unrestricted or restricted IAHs, which should be treated like an Islamic bank’s shareholders, if at all?

Islamic finance challenge 4.2 Explain why a Murabahah fixed-income deposit account is offered by reference to the features of the various Islamic deposit accounts against those of conventional deposit accounts. What issues do these accounts generate for Islamic banking operations?

Solution The first feature that Islamic accounts do not offer is pre-agreed or ex-ante returns. All conventional deposit accounts offer the depositor some form of return prior to opening the account, but Islamic deposits structured under the contracts of Qard, Wadiah or Mudarabah cannot accede to this. This is important as any pre-agreed or ex-ante return would be construed as interest or Riba. However, ex-ante or pre-agreed returns can be offered under a Murabahah contract as it is a sale contract with the buyer and seller pre-agreeing to the mark-up over the underlying Shari’ah-compliant goods that will be sold. This may make the account more appealing to Islamic depositors.

Murabahah-tawarruq is a contract to realise cash.

The next feature that the Murabahah account intends to replicate is a guarantee over the capital deposited. As you should be aware, Islamic investment accounts based on Mudarabah cannot be guaranteed by the Mudarib. Utilising the Murabahah-tawarruq structure, the capital deposited in this account can be guaranteed as the bank must make good the purchased amount under the sale contract. Coupled with the ex-ante or pre-agreed returns feature, this may rival the features of the fixed-deposit account in conventional banks. However, the Murabahah-tawarruq deposit account does come with issues for the Islamic banks. Operationally, this structure involves the utilisation of underlying Shari’ah-compliant assets and perhaps two sets of prime brokers. This signals the fact that it may be costly for the Islamic bank (or the Islamic depositors) to use this structure because of the cost of preparing the legal documentations involved. This may result in cost-inefficient depository products, and the case against it is multiplied if we are talking about numerous small deposit accounts. As such, the minimum balance requirements for the account are often large, in excess of GBP50,000 for some Islamic banks. On top of that, the Islamic bank may also be exposed to the market risk of owning the commodity, something that they probably would not want to be involved in. As before, the risks here are also escalated with the number of such deposit accounts on offer. This Murabahah-tawarruq facility may be an operationally tedious account to manage, especially if it is offered to the retail banking sector.

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4.9 Structuring Islamic deposits: Islamic fixed-income deposits Another close substitute for the conventional banking time or fixed deposit is the Murabahahtawarruq fixed-income deposit. Based on a tri-party Murabahah structure, it utilises an asset or commodity to underline the transaction and allows the depositor to earn a pre-agreed ex-ante return. As the transaction generates a debt or liability to the issuing bank, the Islamic fixed-income deposit covers the depositor’s precautionary motive of holding deposits as it is implicitly guaranteed to be paid up by the issuing bank. Table 4.5 below depicts the matrix of Shari’ah issues to be considered when structuring Islamic fixedincome deposits. The structure of the Murabahah-tawarruq fixed-income deposits can be found in CDIF/2/4/79.

Table 4.5 Shari’ah structuring issues for Islamic fixed-income deposits Account

Murabahah-tawarruq fixed-income deposits

Depositors’ precautionary requirements

Guarantee is implicit as it is a liability for bank

Depositors’ transactionary requirements

Nil

Charging of service fees for services provided

Non-issue under Shari’ah purview; the fees are usually based on the level of services rendered, for example ATMs and internet banking facilities

Utilisation of deposited funds by the bank

Non-issue under Shari’ah purview

Commingling of deposited funds

Non-issue

Returns for depositors

Pre-agreed ex-ante returns for depositors

Application of Islamic deposit insurance

Non-issue under Shari’ah purview as it is not an equity-based contract

Target depositors

Corporate

These fixed-income deposits can also be utilised as money market instruments when Islamic banks face a shortfall of liquidity in the short-term and require a liquidity injection from the monetary authority at the discount window or from other surplus banks. One of the drawbacks of utilising liability generating contracts is that the banks would have to enter a new agreement when the current one lapses. An extension is possible, but the financing/surplus bank may not be able to charge additional fees for the extension as the profit rate has been agreed and cannot be altered. However, entering a new agreement is costly because of the additional legal and stamp duty incurred.

4.10 Islamic money market instruments and liquidity management 4.10.1 Overview of the money market and its instrument in conventional banking The money market is fundamentally a financial market instrument for short-term borrowing and lending among financial institutions. Essentially, it provides short-term liquidity funding for the financial system. It is where short-term obligations, such as Treasury bills, commercial paper and bankers’ acceptances, are traded. Apart from its instruments, the money market is made up of financial institutions and dealers in money or credit who wish to either borrow or lend. Participants borrow and lend for short periods of time, typically up to 13 months. The money market trades in short-term financial instruments commonly called ‘papers’. Inter-bank borrowing and lending form the core of the money market, often utilising short-term commercial papers, repurchase agreements and other similar instruments. These instruments are usually referenced to interest-rate benchmarks prevailing in a given jurisdiction for the appropriate term and currency.

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4.10.2 Islamic bank’s treasury and its product range In essence, an Islamic bank’s main treasury objective is to ensure that the bank has sufficient liquidity to meet all current and future obligations. It has to perform this role while maximising returns on the overall investment portfolio that it manages. As such, the treasury must ensure that the Islamic bank is funded in the most appropriate and cost-efficient manner, and has to identify and mitigate financial risk that could erode the bank’s financial standing. The Islamic bank has at its disposal an array of Islamic treasury products ranging from Islamic foreign exchange instruments, Islamic structured products, such as currency and profit rate swaps, and Islamic money market products.

4.10.3 The Islamic money market and its related products As with the conventional money market, the Islamic money market is an integral feature of the Islamic banking system. It provides IFIs with a facility for funding and adjusting portfolios over the short-term while serving as a channel for the transmission of monetary policy. Trading of Islamic money market instruments allows Islamic banks to channel surplus funds to deficit banks, thereby maintaining the funding and liquidity mechanism necessary to promote stability in the Islamic financial system. The establishment of a well-functioning Islamic money market allows Islamic banks the ability to match funding requirements effectively and efficiently. Islamic money market instruments exist to help IFIs manage their assets and liabilities in a relatively short time period. There are at least six Islamic financial products that could serve the above purpose, namely the Islamic inter-bank money market based on the Mudarabah contract, the Qard contract, an Islamic Sukuk, a Wakalah investment, the Murabahah commodity (Tawarruq), and Sukuk Salam.

4.10.3.1 Islamic inter-bank money market facility based on Mudarabah This is a Malaysian-based facility which is managed by the Central Bank of Malaysia through the interbank money market. Utilising the Shari’ah principle of Mudarabah, the surplus Islamic bank will invest as a capital provider in the deficit bank, who will perform the role of manager. With an investment period ranging from overnight to 12 months, the investment will be based on the agreed profit-sharing ratio (PSR) between the two banks with the anticipated gross annual profit rate of investment for the specified period. Upon maturity of the investment period, an effective profit rate is declared as dividend based on PSR as a percentage of the annual rate, proportionate to the actual investment period.

4.10.3.2 Qard facility This is a simple treasury product whereby the Islamic bank lends its surplus funds to the central bank on a Qard contract or interest-free loan. Upon maturity or redemption, the central bank repays the capital to the Islamic bank. The central bank may award some gift (Hibah) to the bank, with no contractually agreed return or premium. This is a useful Islamic money market instrument that is used to mop up excess liquidity in the market.

4.10.3.3 Islamic Sukuk The central bank may issue Sukuk, for example Sukuk Ijarah, to be subscribed only by IFIs to help them manage their liquidity. Any surplus bank may invest in this Sukuk, which has a fixed return, or coupon, on the investment. If the need for liquidity arises, the bank can easily liquidate and redeem this Sukuk from the central bank/issuer.

4.10.3.4 Wakalah in investment (Wakalah fi al-istithmar) A relatively new Islamic money market instrument in the industry, particularly in the Middle East, Wakalah replicates some features of the Mudarabah inter-bank investment. It is, however, not organised through a market, but rather offered over the counter. Either a surplus or a deficit bank may initiate this transaction. For example, a surplus bank that is seeking to have a return of investment of ‘x %’ may approach a deficit bank for a short period of investment. Technically, the surplus bank (the principal) will appoint and authorise the deficit bank (the agent) to invest the monies of the surplus bank, provided the investment return shall not be less than ‘x%’.

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In practice, the deficit bank will not accept this offer if it thinks it cannot generate the rate of return the surplus bank/principal seeks. However, if the realised profit is more than the expected ‘x%’, the surplus bank/principal will normally waive this amount to the agent as an incentive fee. This over-the-counter money market instrument is made possible because the investment amount is invested in the balance sheet or asset portfolio of the deficit bank/agent. Therefore, the investment portfolio and its expected return can be estimated, if not secured. Following this structure, the deficit bank/agent in this case cannot be a conventional entity as the investment by Islamic banks in the asset portfolio of a conventional bank would not be compliant. The opposite structure is compliant, however, as the conventional bank, here the surplus bank/principal, may invest in the asset portfolio of an Islamic bank which is a deficit bank/agent in this structure.

4.10.3.5 Commodity Murabahah A trading-based instrument, Commodity Murabahah functions with the surplus bank initially purchasing an asset from a metal exchange (possibly at the London Metal Exchange) at, say, US$10 million (equivalent to the amount that the deficit bank is in need of). The surplus bank will sell the asset to the deficit bank at US$10.5 million, which is payable in one week (equivalent to the period of investment). Upon the acquisition of the asset by the deficit bank, the deficit bank may sell the asset to the market or back to the exchange for US$10 million cash.

4.10.3.6 Sukuk Salam This is a facility equivalent to a ‘government treasury bill’ but is compliant with Shari’ah principles. It is managed by a central bank, for instance, the Central Bank of Bahrain, through the utilisation of a Special Purpose Company (SPC). The SPC will initially issue Sukuk Salam to the IFIs that are looking for short-term investment. Sukuk are subscribed on a cash basis to form the capital/purchase price for the Salam commodity, for example aluminium. Sukuk Salam represents the right of investors/Salam purchasers/IFIs to receive the underlying Salam commodity in, say, two months, pursuant to the Salam contract. To facilitate a legitimate return to the Sukuk Salam investors, which are the surplus banks, as well as to mitigate the market risk of the underlying Salam asset, a promise by a third party to purchase the Salam asset at an agreed price in the future, at cost plus profit, will be effected. This allows IFIs to invest in this short-term paper issued by the central bank, although it is not tradable in the market because of the debt feature of the Salam contract.

4.11 Liquidity of an Islamic money market instrument The availability of money market instruments for liquidity management is an essential feature of a banking system. This is especially so for a banking system that is based on a lending or credit model as it deals primarily with guaranteed deposits or funds. Such systems must be sufficiently liquid to meet depositors’ cash withdrawal needs on demand, and yet have a healthy portfolio to yield attractive returns required to remunerate the guaranteed funds in the first place. This requires the presence of sufficient and suitable liquidity instruments (usually issued by regulatory authorities) in the market. Tradability of such liquidity instruments is an important criterion so the instruments can be disposed of quickly through a sale process without causing a significant movement in the price and with minimum loss of value. This preserves the profitability of the bank that is disposing of the asset. An active and efficient secondary market is needed for such transactions to take place.

4.11.1 Tenure mismatch and duration gap Whether it is an Islamic or conventional bank, a credit-based system translates to one similar feature: a liability portfolio that has a shorter tenure than its asset portfolio. There is also a duration gap between the liability and asset portfolios, with duration defined as a measure of the portfolio’s sensitivity to interest-rate movements. Islamic banks’ liabilities, made up of depository accounts, have shorter maturity and are thus less sensitive to the movement of the rates. On the other hand, their asset portfolios, made up of long-term (sometimes 30 years) financing, are longer in tenure and hence are more susceptible to rate movements. With this duration gap and a mismatch between the tenures, Islamic banks must be sufficiently liquid so they can somehow meet unexpected withdrawals from their depositors. Bank runs are the single largest worry for all banks as they can cause profitable, albeit illiquid, banks to collapse.

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Theoretically, for an Islamic bank based on a trading model that relies more on restricted investment accounts, there is less need to have liquidity instruments. Islamic investment funds are nonguaranteed deposits and Islamic banks can design their liability portfolios to have a tenure and duration closer to their asset portfolios. Islamic banks are also not obliged to be responsible in meeting account holders’ withdrawals in full as account holders are aware that their deposited funds have been invested in specific portfolios. However, operating in the current financial framework, IFIs must be able to achieve liquidity in all circumstances because of either early withdrawal of Islamic deposits or mismatch of assets and liabilities.

4.11.2 Planning for the tradability of Islamic liquidity instruments The development of Islamic liquidity instruments has followed different paths across the various jurisdictions. It was explained in CDIF/2/6/122-125 that in south east Asian countries such as Malaysia, where the banking system was developed alongside the lending/credit-based model, the issue of tradability of Islamic liquidity instruments has always been in the forefront.

4.11.2.1 Malaysian GIC and GII In Malaysia, the original Government Investment Certificates (GIC), introduced in July 1983 under the concept of Qard, were subsequently replaced by the Government of Malaysia GII (Government Investment Issue) on 15 June 2001. The replacement facilitated trading in the secondary market via the concept of Bay’ al-dayn (debt trading). It was further improved by the five-year tenure ProfitBased GII, a coupon-bearing paper upon which the government pays half-yearly profits to investors. While secondary trading of the GII is acceptable in the Malaysian domestic market, the product is not globally tradable as it contains some contracts such as Bay’ al-Inah (sell and buy-back) and Bay’ al-dayn (sale of debt), which are not globally approved.

4.11.2.2 Sukuk Bank Negara Malaysia Ijarah (SBNMI) In an attempt to bring its banks into the global Islamic market and yet preserve its need for tradable Islamic liquidity instruments, the Malaysian government, via the Central Bank of Malaysia, introduced the Sukuk Bank Negara Malaysia Ijarah (SBNMI) on 16 February 2006. The Sukuk is structured in line with international Shari’ah standards with the securitisation of this product being asset-based, that is property, and not merely receivables. Compliance with international Shari’ah standards and the fact that securitisation is asset-based means that the SBNMI can be traded in the secondary market and should, therefore, be more liquid.

4.11.2.3 Money market instruments in the Middle East The development of Islamic money market instruments in the Middle East has not been as systematic and organised as in Malaysia. One possible reason for this could be that, with the excess liquidity from its oil-producing activities, Middle Eastern banks may be awash with liquidity and do not require liquidity instruments. However, the Central Bank of Bahrain’s issuance of the Sukuk Salam perhaps shows that there is a need to provide short-term papers such as Treasury Bills, although this Sukuk is not tradable. Sukuk Salam never addressed the issue of a liquidity requirement from the point of view of a deficit bank. Middle Eastern and British-based Islamic banks have subsequently developed Wakalah fi alistithmar to act as an ‘Islamic money market’ instrument to facilitate both surplus and deficit banks to manage their liquidity positions. These inter-bank investment activities are offered over the counter and are not subject to any regulation. Recently, given the crisis of liquidity faced by some IFIs in the United Arab Emirates following the global financial crisis, the Central Bank of UAE provided funding to a few Islamic banks through a Wakalah fi al-istithmar instrument. Given the significance and importance of the Wakalah fi al-istithmar instrument (CDIF/2/6/125), there is a legitimate need for its usage to be regulated among IFIs on the one hand, and the financial institutions and the Central Bank, on the other.

Key point • The existence of a liquid Islamic money market is an important consideration to promote the efficiency and profitability of the Islamic banking system.

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Exercise 4.5 Outline the main considerations that a central bank needs to take into account if it decides to issue a Sukuk Salam as an Islamic treasury instrument. Explain the risks it would have to consider and outline the limitations of the Sukuk as an Islamic treasury instrument.

4.11.2.4 Money market instruments – the way forward The tradability of Islamic liquidity instruments will become a growing concern as Islamic banking grows. The development of new tradable instruments under new or different globally accepted structures will be the key to ensuring the viability of Islamic banks. Such developments can only take place if Islamic banking practices across jurisdictions are harmonised. There is also the need to develop a viable and robust Islamic secondary money market, in the various jurisdictions, to facilitate tradability of such liquidity instruments and promote efficient liquidity management of IFIs. The introduction of the Mudarabah inter-bank money market facility, as well as Sukuk Ijarah for treasury purposes, are welcome innovative steps in short-term liquidity management.

Islamic finance challenge 4.3 Outline the pertinent issues that a regulatory authority needs to consider when it structures Islamic money market instruments and Islamic treasury products for its credit-based Islamic banks.

Solution The tradability of an instrument will define how liquid the instrument can be. Under Shari’ah purview, the tradability of an instrument will depend on the kind of Islamic contracts the instrument is based upon. In line with international Shari’ah practice, debt-based instruments generated out of contracts such as Murabahah, Istisna’ or Salam would not be tradable. Given the scenario in the challenge, the regulatory authority must consider other non-debt based contracts such as Mudarabah, Musharakah or Ijarah. The regulators must also consider what types of Shari’ah-compliant asset it has to generate the Islamic money market instruments. Most regulators would own physical assets such as office buildings that they can rent out to other companies, and this could be the basis of a money market or treasury product using Sukuk Ijarah. Failing this, the regulators as issuers would have to identify an appropriate business venture that they can utilise as a basis for a Sukuk musharakah. As a general rule, the tradability of any asset would also depend on the number of players in the market. The regulators would, therefore, be required to build up the critical mass of banks in its system. Failing this, the regulators themselves or other related governmental agencies must be prepared to participate as potential players in the Islamic money market and treasury products.

4.12 Critical issue for the Islamic lender of last resort This section explores a problem faced by IFIs around the globe. In situations where liquidity is tight, IFIs will either rely on the Islamic inter-bank money market or the respective central bank for liquidity injections. While the present Islamic inter-bank money market is not that organised and regulated (except in the case of Malaysia and Bahrain), the injection by respective central banks may or may not take place depending on the availability of the funds and market conditions. Given the market conditions of 2008/2009, it is critical that a new independent institution is created to perform the role of ‘lender of last resort’ for IFIs. The lack of liquidity seen in 2008/2009 may have caused IFIs to collapse. This could have been avoided through a systematic institutional approach. The role that the International Monetary Fund plays for conventional financial institutions can be given as an example. This lender of last resort function for IFIs can be assigned to an existing international Islamic bank, such as the Islamic Development Bank. An alternative is to create a new institution. The shareholders of this new institution can comprise all IFIs operating in the world. Islamic finance has, for all intents and purposes, developed most of the institutional and prudential requirements, except the lender of last resort or at least a global liquidity management house for IFIs.

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4.13 Conclusion Structuring Islamic depository instruments requires the same level of skill as the structuring of interest-based deposit instruments. In addition, these accounts would require specific Shari’ah expertise as Islamic depository products are based on commercial Islamic contracts. The depository client’s motives for demanding different forms of Islamic deposits must be properly addressed, that is the precautionary, transactionary and investment motives. Islamic banks involved in the structuring process then need to match the clients’ expectations of the features available with each Islamic commercial contract. Only then can Islamic deposit products become desirable to the pool of depositors. Islamic banks will manage their liability portfolios profitably and efficiently only when there is a sufficient pool of Islamic treasury and money-market products that provide liquidity for the Islamic banking industry. The establishment of a lender of the last resort for IFIs is seen as critical to ensure that IFIs remain sustainable during difficult liquidity conditions.

4.14 Summary Having read this chapter the main points that you should understand are as follows: • • • • • •

• • • •

deposits are very liquid assets, ranked second only after cash Islamic deposits need not necessarily be structured using loan/debt Islamic deposits can be invested together as a pool or be restricted for specific investments a shared services model can be operated in an Islamic window or subsidiary, but not in a fullyfledged Islamic bank an Islamic investment account transforms the lender-borrower relationship to a partnership venture liquidity is an important consideration for Islamic banks that are based on the credit model and which operate on a guaranteed-deposit structure, as their liabilities are always more liquid and are of shorter tenure than their assets the Islamic money market provides IFIs with the facility for funding and adjusting portfolios over the short-term tradability of Islamic treasury and Islamic money market products will depend on the contracts that underline the product and will affect the liquidity in the market the development of new tradable instruments under new or different globally-accepted structures can only take place if Islamic banking practices across jurisdictions are harmonised the development of a lender of the last resort for IFIs is critical to ensure the sustainability of IFIs.

4.15 Islamic finance case study Formulating deposit strategies and meeting depositors’ expectations. Gateway Commercial Bank (GCB) has recently obtained ‘in-principle approval’ from the financial regulators with regards to its proposal to establish an Islamic banking subsidiary, Al-Iman Islamic Bank (AIIB). AIIB will be an Islamic commercial banking entity. The focus of the AIIB management is to establish their short to medium-term deposit or liability strategy. Upon incorporation, AIIB will operate out of three branches in the City of Frankfurt for the first three years. Expansion of AIIB’s operations will depend on market conditions and its profitability. AIIB personnel may utilise some of GCB’s established infrastructure, although future deposit customers would only be able to access AIIB’s three branches for their banking transactions. Traditionally, GCB’s liability portfolio is dominated by deposits sourced from the retail or household sector. This is because GCB has a well-known brand name and an extensive network of branches in Frankfurt. The GCB asset portfolio is also aligned substantially with floating rate mortgages, which has been the preferred mode of practice in Frankfurt. Taking its cue from its parent company and the banking conditions in Frankfurt, AIIB needs to establish sound banking strategies for its Islamic deposit campaign. AIIB needs to ensure that Islamic deposit products contain features that are sought after by its chosen market segment. AIIB also needs to consider its infrastructure limitations and the fact that it is still a newly established organisation. It may choose to benefit from the brand name of its parent company, but needs to ensure that it is also seen as a distinct entity, solely focused on Islamic banking activities. The Islamic banking licence that AIIB will receive will include similar regulatory and reporting requirements as those of conventional banks. This means that AIIB will need to meet the liquidity requirements set by the regulators. In addition, the regulator established a deposit insurance scheme for the banking system in 2008. The Islamic banking system also has a similar scheme, which AIIB would need to qualify for to participate in the market.

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Case study multiple choice questionsns 1.

2.

3.

4.

5.

AIIB intends to place its surplus fund with the GCB on a short-time basis. Which of the following is NOT a suitable product for AIIB? (A)

Sukuk Salam

(B)

Wakalah fi al-istithmar

(C)

Sukuk Ijarah

(D)

Murabahah commodity structure

What would be the best deposit account for AIIB to offer to replicate the behaviour of a conventional fixed deposit? (A)

Islamic saving account based on Qard

(B)

Islamic deposit based on the Murabahah commodity structure

(C)

Restricted Mudarabah investment account

(D)

Unrestricted Mudarabah investment account

What are the suitable Islamic money market and treasury products that an AIIB subsidiary in Malaysia can participate in, as compared with a subsidiary in Bahrain? (A)

Sukuk Salam and Wakalah fi al-istithmar

(B)

Sukuk Salam and Mudarabah inter-bank money market

(C)

Mudarabah inter-bank money market and central bank Sukuk Ijarah

(D)

Central bank Sukuk Ijarah and Sukuk Salam

What are the intended purposes of structuring an Islamic saving account based on a Mudarabah contract? (A)

Transactionary, precautionary and investment

(B)

Investment and precautionary

(C)

Leveraging, investment and precautionary

(D)

PER and IRR

How should AIIB address the issue of the smooth and stable payment of profits to its Islamic investment account holders? (A)

Apply for Islamic deposit insurance

(B)

Allow shareholders to absorb DCR

(C)

Utilise a PER and IRR

(D)

Not offer Islamic investment accounts based on Wakalah fi al-Istithmar

Case study short essay questions 1.

Identify the segments of the market that AIIB should focus on.

2.

Explain the pertinent features of Islamic deposits that AIIB must address with regard to its market segment.

3.

Identify the required contracts with the respective accounts that AIIB should utilise to deliver the features it needs to address.

4.

Explain the liquidity implications that the Islamic deposits generate for AIIB and state whether their Islamic deposits qualify for the Islamic deposit insurance scheme.

5.

Explain how AIIB can synergise with GCB’s resources.

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Chapter four answers Exercise 4.1 The customer is the owner of the deposited funds, the Rabb al-mal, under the Mudarabah contract used in this Islamic investment account. As such he can normally withdraw his funds or liquidate his position any time he chooses. Under Islamic finance, where the IFI does not allow premature withdrawal, the depositor has to be mindful that the funds may have been invested in an identified venture or ventures, and that he may not be able to recoup the original capital invested in the account. He may have to wait until the maturity of the agreed period of investment. Where IFIs allow premature withdrawal, they need to have addressed the issue of early withdrawals or early liquidation in their terms and conditions. Some IFIs allow the depositor to withdraw part or all of the funds during the term of the deposit but restrict the prospective profit distributed to him. For this to happen, the depositor must sign a waiver clause when the account is opened. Other IFIs are prepared to return the capital plus all the profits that have been earned up to the date of the withdrawal. The profit figure paid is based on the rate of profit of the previous accounting period and calculated on a daily, weekly, monthly or yearly basis, provided the investment venture is profitable, which is supported by evidence of the current accounting record.

Exercise 4.2 There are generally two sets of guidelines or best practices that a bank can subscribe to, one with operational efficiencies in mind, and the other involving Shari’ah compliance. The former affects the bottom line and includes appropriate cost allocations that can be assigned to, say, the parent bank and the Islamic window. Shared services include marketing events whereby the parent bank is keen to market its full range of services, including that offered by its Islamic window, in one single campaign. How the bank allocates the proportionate marketing costs to its Islamic window affects the profitability of the window. Another example is the utilisation of its backroom staff. The parent bank must be able to allocate the appropriate costs to the Islamic window in order to paint an accurate picture of the window’s performance. The guidelines affecting Shari’ah compliance usually involve money and its reporting. Using the same analogy of a parent bank and its Islamic window, the bank must be able to segregate the funds of its windows. This means that the window has a separate set of accounts from the bank. Islamic funds cannot be commingled with funds generated from the conventional parent bank. For the Islamic subsidiary, the capital utilised to set it up must be distinguished from the banking conglomerate or parent bank’s capital. Usually, the IT system utilised in an Islamic subsidiary or Islamic window must be customised to better reflect the banking transactions that have taken place. For instance, the IT systems must be able to generate reports that do not contain entries such as interest-earned or interest expense, all of which are familiar entries from the reports of the parent conventional bank.

Exercise 4.3 The bank has the right not to honour this cheque as the amount exceeds the amount the customer deposited. If this was to occur the depositor would have to face the consequence of issuing a cheque without sufficient deposits in the account. Conversely, the bank may decide to grant an interest-free loan to the customer as a stop-gap measure, especially if the customer is of high net worth. This facility should have been set up in advance. Alternatively, the bank may provide a standby Islamic overdraft facility, based on Murabahah-tawarruq, to cover the higher amount of the cheque over the deposited amount. More likely, the bank would ask the customer to top up the account immediately so they can honour the cheque. The bank may facilitate this by granting an intra-day interest-free loan.

Exercise 4.4 The main difference between restricted and unrestricted IAHs lies in the investment scope of the funds mobilised. Funds mobilised from the former can only be invested in specific ventures or portfolios that have been pre-agreed. For the latter, its funds can be invested as and how the Islamic bank deems fit.

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From that analogy, the unrestricted IAHs should be treated more like shareholders, but in reality, they are not. One possible reason would be that funds mobilised are still depository funds and, as such, Islamic banks must follow regulatory guidelines on how such funds can be invested. International Islamic agencies have also developed means by which to manage the volatility of the returns of the invested funds, such as the PER. Shareholders in the IFIs, on the other hand, are not afforded such measures and may be exposed to displaced commercial risk as Islamic banks try their best to mitigate risks assumed by the IAHs. Islamic banks’ shareholders have the opportunity to realise capital gains if they liquidate their shareholdings. Investment account depositors are not afforded this opportunity and can only realise returns via a share in profits. Mudarabah investment account depositors also do not have voting rights in the Islamic bank.

Exercise 4.5 Salam refers to the contract for the purchase of a commodity on a deferred delivery in exchange for immediate payment. This means that the commodity buyer pays in full for the commodity at the execution of the Salam contract and the delivery of the commodity takes place at a pre-agreed future date. Applying this to an Islamic money market instrument, the central bank, through the use of its Special Purpose Vehicle (SPV), becomes the agent or Wakil that manages the operation of the Sukuk Salam. For more details of the structure of the Sukuk Salam refer to CDIF/2/6/124. Assuming that the tenure of the Sukuk is three months, the IFI would immediately receive upon its investment an undertaking by a third-party ultimate-commodity purchaser that he would execute this purchase at a pre-agreed purchase price, at a pre-agreed premium over the original amount that the IFI invested. Naturally, the central bank would have to consider the price volatility of the commodity in question. The bank wouldn’t want to utilise a commodity that could present substantial market risk when the IFI funds are invested in the Salam commodity. The central bank must also consider the financial strength and legitimacy of the third-party ultimate commodity purchaser. The bank would want to limit the counterparty risk of the commodity purchaser. To militate against this, the central bank may request a performance guarantee from the purchaser to protect the interest of the investee IFI. The application of Sukuk Salam as an Islamic treasury instrument is limited because of the inability to effectively trade it in the market. Essentially, this structure creates a trade debt and is represented by the Sukuk Salam certificates held by the investee bank. According to AAOIFI’s Shari’ah Standard 7, debt can only be traded or transferred at par and not at a premium or a discount. This will effectively limit the tradability option of the Sukuk and means it will usually be held by the investee IFI to maturity. Nevertheless, as an Islamic money market instrument, it is still viable in jurisdictions that are awash with liquidity.

Case study multiple choice answers 1

(B) A newly established over-the-counter product, it looks ideal for short-term placements. However, GCB is a non-IFI and the funds placed on Wakalah cannot be invested in GCB, even in the short term. The other options are all suitable with compliant assets.

2

(B) Murabahah deposits can actually generate a pre-agreed return and can guarantee the capital deposited. AIIB must, however, consider the operational costs of offering such accounts.

3

(C) The Malaysian Central Bank has on offer both products, which no other central bank does. Sukuk Salam are only available in Bahrain.

4

(A) It fulfils all the stated motives of holding money.

5

(C) PER and the IRR are recommended by the Islamic Financial Services Board to manage the returns and the capital of the investment accounts.

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Suggested solutions to case study short essay questions

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1.

With the current three branches in Frankfurt, AIIB should focus on high-net-worth individual depositors as well as corporate depositors. It would have to forgo pursuing the general retail or household segments because small depositors would prefer to visit branches that are conveniently located in their respective area. With only three branches, AIIB would not appeal to most retail depositors. AIIB would have to leverage technology and its human resource pool to reach out to the high-net-worth and corporate depository clients.

2.

Considering that AIIB would be targeting sophisticated depositors from high-net-worth individuals and corporate customers, AIIB must bank on meeting the target depositors’ transaction requirements. This can be achieved through investments in information technology. AIIB must have an extensive network of ATMs as well as an established internet banking system, or at least the facility for its clients to use the ATMs of other banks. Customers must be able to transfer funds or make payments at any location through the ATMs or internet-based systems. AIIB’s depository accounts must also be innovative and provide competitive returns.

3.

Riding on the brand name of its established parent company GCB, AIIB should focus upon the innovative Mudarabah contract for its current and savings accounts, rather than the run-ofthe-mill Qard or Wadiah contracts that are more suited to retail customers. The Mudarabah contract will allow for features such as account sweeping, that is automatically transferring amounts that exceed a certain level into a higher profit-earning account that will allow its sophisticated depositors the opportunity to generate more returns. For instance, AIIB can sweep amounts that exceed a pre-set US$10,000 limit from a customer’s Mudarabah current account into a higher return generating Mudarabah savings account.

4.

The focus on a Mudarabah contract would not impair AIIB’s liquidity position. In fact, under the pure Mudarabah contract, AIIB cannot explicitly offer a guarantee on its deposit portfolio as Mudarabah is a profit-sharing arrangement. This would also mean that AIIB’s deposits technically do not qualify for the Islamic deposit insurance scheme. Nevertheless, the brand name and the established value of its parent company GCB would militate against this lack of an explicit guarantee.

5.

AIIB can tap into the resources of GCB through being associated into GCB’s marketing campaigns. This would not only be a very cost-effective exercise, but the association with GCB would also grant AIIB the credibility it would require to penetrate into the Islamic banking market. AIIB personnel can also utilise GCB extensive branch network to latch on to their prospective clients. AIIB brochures, for instance, can be placed within the GCB branch network to create brand awareness. GCB personnel will also be able to cross-sell AIIB products to its established clientele pool.

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Chapter five Structuring financing facilities for working capital and consumer financing Learning outcomes By the end of this chapter you should be able to: • analyse and evaluate the validity and suitability of various underlying contracts in providing financing for different purposes • discuss the risk features inherent in structuring financing products for both corporate and retail customers • appraise the importance of proper credit policy for Islamic consumer financing.

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Indicative list of content • Essential strategic considerations in structuring a financing product • Working capital financing: structure and issues • Personal financing: structure and issues • Property financing: structure and issues • Vehicle financing: structure and issues • Case study: Structuring Islamic consumer financing

5.0 Introduction Banking financial products can generally be split into two categories: corporate and retail. This chapter introduces you to a number of financing products using different Islamic financial techniques that cater for both corporate and retail banking customers. The chapter focuses on working capital financing, asset financing, personal financing, as well as debit, charge and credit cards. The various product structures are described and the relevant mechanisms, contract flows and requirements, as well as the relevant regulatory requirements, are explained. This should assist you in analysing the relevant features and issues in structuring financing products for an Islamic banking institution, particularly for commercial purposes. From a structuring perspective, this chapter deals with the challenges caused by related conditions when choosing appropriate contracts to meet the commercial requirements for both corporate and retail customers. Pertinent issues relating to the adoption of relevant financing contracts with ancillary contract conditions are explored to mitigate relevant credit and market risks. Finally, aspects of prudent strategies and policies, such as avoidance of non-regulated consumers and highly leveraged financing, are also highlighted to emphasise the importance of prudent credit policies in providing Islamic financing, particularly for Islamic retail customers. The discussion surrounding the products in this chapter is not meant to be exhaustive but rather to help you develop a systematic approach in developing financing products for various legitimate commercial purposes in the interest of a bank’s customers. 5.1 Conventional structure As you should be aware by now, Islamic finance and conventional finance differ for many reasons. The following sections will act as a brief reminder of the key areas of difference.

5.1.1 Conventional corporate and retail finance In conventional banking, loans and advances are provided to corporate and retail customers to help them meet their respective financing requirements. For corporate clients these products range from short-term working capital loans, mezzanine (bridging) loans, equipment loans and special purpose loans to long-term property loans. In retail banking, types of financial products range from overdrafts, debit, charge and credit cards, vehicle loans and long-term residential mortgages. Essentially, each loan arrangement, whether in corporate or retail banking products, involves the determination of an interest rate payable on the amount of the loan provided for a specified period.

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While repayment capacity is important in both corporate and retail financing, the ability of the corporation as well as the retail customers to service the loan depends on the business cash flow and ability to make monthly payments. The cash flow pattern or cycle of the business activity, as presented by the applicant to the bank in the form of a cash flow statement, provides a basis upon which to recommend an appropriate type of loan for a corporate customer. In the case of retail loans, the income capacity of the borrower provides the basis for determining the amount and period of any loan to be granted to the applicant. In either case a primary concern of the banks as lenders is the recovery of the loan and interest and the establishment of relevant security arrangements to achieve this objective in the case of default by the customer. The need for security specifically relates to the creditworthiness of the borrower. In particular, various forms of security, such as pledge, guarantee and assignment, are structured into the product to secure the payment of the loan with interest.

Key point • Cash flow analysis, financial ability for repayment and creditworthiness of the borrower are important in conventional corporate and retail financing.

5.1.2 Conventional corporate and retail finance: interest spread From a conventional bank’s perspective the interest income earned should be sufficient to achieve a required level of interest spread, that is the difference between interest income and interest expense which is the cost of funds. The determination of the interest rate charged to the customer also takes into account various components of credit risk exposures. These include default risk, liquidity risk and marketability risk, all of which help determine the term structure of the interest rate. In addition, other factors, such as exchange rate volatility and inflation are imputed where relevant when providing such loans. The bank also needs to be cognisant of the regulatory requirements relating to loan concentration in certain customer and asset categories, as well as the impact of credit risk exposures on the computation of capital adequacy requirements. For example, a secured loan will attract a lower risk weight compared with an unsecured loan in determining the total risk weighted assets for the computation of capital adequacy ratio. The amount of loan disbursed to the customer also takes into consideration the mortgaged asset value referred to as the loan to asset value (LTA).

Exercise 5.1 A conventional commercial bank launches a special product aimed at its privileged customers. The bank intends to offer a special house loan facility at a competitive rate of interest, as well as a special discount interest rate for credit card customers. In order to qualify for this offer, the customer must agree to mortgage their house with the bank as security to repay the house loan facility and credit card facility. Explain the basis and justification for this conventional product structuring from a credit and risk perspective.

5.2 Islamic banking products for corporate and retail finance An Islamic bank, similar to a conventional bank, accepts deposits and provides finance. The previous chapter discussed various contracts used for deposit-taking by Islamic banks in addition to Islamic money market and treasury products. In general, Islamic financing relates to the provision of finance in a Shari’ah-compliant manner for lawful and legitimate activities.

5.2.1 The choice of contract Islamic banking offers both business and retail banking products that adopt appropriate contracts suitable for the different types of products. Islamic banks address the needs of the customer by reference to similar terms of finance with respect to the amount, period and income generated from the financing activity, as well as the importance of appropriate security arrangements. However, the terms of financing are related to the product structure, which is based on a selected contract suitable for the product. The selection of the relevant contract, as will be illustrated later, must meet both the commercial requirements of financing including security requirements, as well as Shari’ah compliance requirements. Based on the cash flow pattern arising from the business needs and qualitative creditworthiness for retail needs, Islamic financial products are designed to match the cash flow expectations, as

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well as the risk preference and risk exposures of the counterparty. In this respect the choice of contract adopted for the Islamic financial product, which represents the rights and obligations of the counterparties, must also include the financier’s right to benefit from the form of return or yield, as well as the related obligation or liability to risk. Contracts in the form of equity transactions implemented in Islamic financial products will have different risk-return implications for the bank, as well as economic benefits to the customer, compared with debt-based financing.

An example is a customer who requests 90-day financing for the import of goods with a letter of credit application to an Islamic bank. The bank can provide both Murabahah and Musharakah letters of credit. Since this request is to finance the purchase of imported goods, the customer requests Murabahah financing at a mark-up rate specified by the bank. The bank is exposed to credit risk that may be secured by a guarantee or collateral upon disbursement of the financing amount and subsequent delivery of the goods to the customer. Alternatively, the bank can issue a letter of credit based on the Musharakah contract to enable it to share in the profit earned on the sale of the imported goods. Under this contract the bank would expect a higher yield than the Murabahah rate to account for the business risk imputed in the market price risk of the goods, as well as the credit risk for possible non-payment by the customer.

5.2.2 Ancillary contracts to secure the interest of the creditor The contracting parties may consider adding ancillary contracts to secure the interest of the creditor such as guarantee (Kafalah), promise (Wa’d) or pledge (Rahn) to provide assurance to the bank on performance or recoverability of the financing amount. These ancillary contracts would be executed as part of the Islamic financial product to ensure that relevant risks such as market and credit risks are mitigated.

Key point • Aspects of security and risk management also apply to Islamic banking financial products in addition to cash flow and creditworthiness analysis of the customer seeking Islamic finance.

5.2.3 Agreed return Unlike the interest rate determination of conventional financing, the rate of return determined for Islamic financing is based on a mutually agreed selling price or rental amount in the case of sale or lease-based transactions respectively. Alternatively, an estimated profit rate based on a mutually agreed profit-sharing ratio is determined when the parties engage in an equity-based transaction. The ex-post profit is realised subject to the performance of the activity. In this manner, the financing rate is directly related to real economic business activities from which the profit element of the financing activity is derived. The traceability of the profit to lawful business activities is an important consideration in Islamic financing.

Key point • Profit rate determination is based on a mutually agreed selling price or lease payment in sale or lease financing contracts. Traceability of legitimacy of profit is based on the validity of the contract, as well as the sale or lease of lawful object, or lease for a legitimate purpose.

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Islamic finance challenge 5.1 Critics argue that Islamic finance is just another form of conventional finance that does not fundamentally differ in its financial intermediary functions of money-for-money transactions. Although it is claimed to be based on sale or lease, or partnership contracts, Islamic finance is no different from conventional finance that simply advances loans in return for interest. Instead of calling the premium ‘interest’, Islamic banks consider this as ‘profit’. Therefore, according to some critics and analysts, Islamic house financing, Islamic letters of credit and Islamic working capital financing, among others, are essentially loan contracts with disguised interest. How would you respond to such an opinion and contention?

Solution Although Islamic finance shares many common financial and regulatory features with conventional finance, such as the credit analysis of customers, the requirement of security (where relevant) and capital adequacy requirements, it fundamentally differs from the conventional finance structure. Generally the rights and obligations of the Islamic financier and customer relate to real economic benefits and loss exposures identified in trading and investment transactions. In the case of Murabahah house finance, for example, it is incumbent on the Islamic bank to purchase the house from the vendor before selling it to the customer at the mark-up price. This structure of finance involves two sets of transactions that invoke stamp duty in some jurisdictions such as Malaysia, Singapore, and the UK. Amendments to the regulations in those jurisdictions had to be made to avoid double stamp duty. Obviously, this would not be necessary if Murabahah financing was simply a loan contract. In the case of lease-based financing, the cost of Takaful is borne by the lessor. If the lessor is just a lender, such a requirement from the Shari’ah perspective is not relevant. In the case of profit sharing-based financing, the difference is more obvious. In a venture being financed using an equity contract, the capital provider cannot impose on the manager the requirement to repay the capital and any agreed profit where the venture suffers a loss. In a conventional loan contract, the borrower must repay the principal and interest irrespective of the profitability of the venture. In Sukuk-based transactions such as Sukuk ijarah, the investors may have recourse to the leased asset in the case of default as Sukuk is an assetbased securitisation, not simply an IOU instrument as is the case with conventional bonds.

5.2.4 Regulatory requirements and risk exposure Regulatory requirements placed on banks within each jurisdiction apply equally to Islamic financing. These include customer limits and credit risk exposures computed in to satisfying capital adequacy requirements, which safeguard the interest of depositors and investment account holders. However, specific contract variations and resulting risk exposures may result in different risk weights as identified by standards imposed by the Islamic Financial Services Board (IFSB).

For example, unrestricted investment account funds mobilised by an Islamic bank in the form of financing are identified to segregate the risk exposures of the financing assets. In the computation of the capital adequacy ratio, risk-weighted assets will exclude assets funded by investment account funds.

In this chapter, while Islamic financial products for business customers are discussed with specific reference to working capital, Islamic financial products for retail customers are discussed with reference to asset and cash financing, as well as various cards facilities such as debit, charge and credit cards respectively.

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5.3 Working capital financing 5.3.1 Importance and need for working capital Most businesses have to address short-term financing needs in the form of working or operating capital. Working capital can be described as current assets that relate to short-term or immediate cash flow needs. Current assets are categorised as assets that will be liquidated within one year. These assets vary in composition depending on the type of business involved, but are generally composed of current assets such as inventory, receivables and cash. Business prudence requires that current assets are matched with current liabilities or short-term obligations. The net difference between them is referred to as net current assets or net working capital. In the management of working capital, businesses need to decide on optimal levels, such as the level of stock to avoid stockouts, as well as the timely payment of operating expenses, such as transport and utilities, which accrue during the business activity.

Key point • Working capital refers to current assets that relate to short-term or immediate cash flow needs that are matched with short-term obligations to determine the level of net working capital.

5.3.2 Conventional direct credit facilities from the supplier Direct credit facilities obtained from suppliers, for example, the 30-day credit period, are key to the working capital of many businesses. Trade credit granted in business operations can take many forms, such as 2/10 net 30. This refers to a customer who will obtain 2% discount payable if the outstanding amount is cleared in 10 days or if they can pay the full amount in 30 days. In the ordinary course of business the profit from such credit sales is recognised as trading profit. However, such credit terms may not be adequate as sources of working capital funds. As a result a business may request a one-year facility or a credit line from a bank either on a draw down or term basis. The former enables the customer to utilise the funds on a needs basis and the financing amount will fluctuate during the period. In most cases the bank requires collateral or some form of guarantee to ensure that the financing amount will be recovered. The financing rate may be variable or fixed and sometimes a commitment charge is imposed for not utilising or under-utilising the amount set aside for financing by the bank. Any profit earned from the financing rate is reported as financing income by the financing institution and as an expense to the customer. Working capital financing is also provided as part of a more comprehensive package such as project financing. The facility is reviewed periodically either to terminate the line or expand it to other activities, or increase the limit to a higher amount. Islamic project financing will be discussed in chapter six of this guide – Project financing: structures and strategic considerations.

5.3.3 Conventional revolving credit and overdraft Conventional working capital financing usually takes the form of revolving credit and overdrafts. Revolving credit is a type of credit that does not have a fixed number of payments, in contrast to instalment credit. Corporate revolving credit facilities are typically used to provide liquidity for a company’s day-to-day operations. The borrower may use or withdraw funds up to a pre-approved credit limit. The amount of credit decreases and increases as funds are borrowed and then repaid. Revolving credit may be used repeatedly. The borrower makes payments based on the amount utilised or withdrawn, plus any related interest. The borrower may repay over time (subject to any minimum payment requirement), or in full at any time. In some cases, the borrower is required to pay a commitment fee to the lender for any money that is not drawn on the revolving facility; this is especially true of corporate bank loan revolving credit facilities. An overdraft occurs when withdrawals from a bank account exceed the available balance which gives the account a negative balance. A person can be said to be overdrawn if the amount of any cheque written, standing orders or Direct Debit instructions or any other form of uncleared payment exceeds the current account balance. Where there is a prior agreement with the account provider for an overdraft protection plan, and the amount overdrawn is within this authorised overdraft, then interest is normally charged at a specified rate. If the balance exceeds the agreed terms, then fees may be charged and higher interest rates might be applied. Both revolving credit and overdraft facilities charge interest and provide flexible drawdown and payment schedules within the financing period.

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Key point • Conventional revolving credit is a credit line facility to the customer that enables flexible withdrawal for a specified approved amount in a specified period. Any outstanding balance is to be settled by the end of the credit period. Conventional overdrafts allow a customer to utilise a credit line facility when payments exceed the cash balance in their current account.

5.4 Islamic working capital financing In designing Islamic financial products for working capital financing, it is important to consider the essential product features and short-term business cash flow needs of the customer. The facility should provide ease of flexible drawdown of the financing amount, as well as flexible payment within the agreed period at a competitive rate. Based on prevalent financial practices in the Islamic financial services industry (IFSI), three forms of product structures can be identified based on different contract types to enable working capital financing: revolving Murabahah working capital financing; Murabahah-tawarruq term capital financing; and Mudarabah/Musharakah working capital financing. Each of these structures will now be analysed based on their contract flows and requirements, legal documentation, operational issues in terms of implementation and control, and related issues on risk and reporting.

5.4.1 Revolving Murabahah working capital financing The revolving credit facility allows the customer to effectively draw down specified amounts of funds for a defined period. For example, a ÂŁ50,000 facility could be approved for a customer to purchase goods or equipment within a year from the date of approval. The Murabahah contract can be adopted for such a facility to provide short-term finance for the purchase of operating assets. The assets in question must be identifiable and can be sold at cost plus mark-up. Essentially, Islamic banks will agree to provide this facility as a line of credit up to a fixed financing amount within an agreed period of time. During this period, the customer may request the bank to purchase assets that the bank will subsequently sell to them at cost, plus an agreed mark-up profit. Such assets are typically tangible assets for the immediate use of the customer in their business activities either as a producer, exporter or developer. In developing a revolving Murabahah working capital agreement, the profit rate will either be fixed or based on the prevailing cost of funds according to an agreed benchmark such as LIBOR. During this period, the customer may utilise this facility up to the limit at any time. If the customer has made some payment to earlier transactions under the Murabahah agreement, the existing limit will revert back to the maximum originally agreed. For example, where a financier agreed to make available US$1 million and the business has asked the bank to buy assets to the value of US$200,000, which it subsequently paid, the facility would revert to US$1 million. At the end of the tenor, both parties may agree to renew the facility agreement or the facility will lapse.

5.4.1.1 Safeguarding the interests of the bank in Murabahah working capital financing To safeguard the interest of the bank, some conditions may be imposed on the customer. For example, the customer must maintain a certain level of debt to equity ratio or be restricted from entering into other borrowings/financings. Islamic finance does not allow banks to impose commitment fees for the lost opportunity cost where a customer does not fully utilise the facility, as there is no basis to justify the loss under Islamic commercial law. An illustration of the terms of revolving working capital financing based on a Murabahah contract is presented in table 5.1.

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Table 5.1 Basis for terms of revolving Murabahah working capital financing Terms of financing

Basis

Approved financing amount

Total amount of inventory purchase required per annum

Financing amount

Amount of inventory per order quantity

Financing period

Inventory turnover

Financing rate

Mark-up rate derived from selling price for each order quantity

Mark-up profit

Selling price, less cost of financing for each order quantity

Disbursement

Upon purchase for each order quantity

Payment

During the financing period based on sales receipts

Security

Floating charge on inventory purchased Third-party guarantee on timely payment

5.4.1.2 Prescribed flow of Murabahah working capital financing When structuring revolving Murabahah working capital financing, it is necessary to determine its purpose, its anticipated operating cash flows, as well as any security arrangement (where relevant). The creditworthiness of the customer is then assessed and evaluated to decide on the credit financing amount, the profit rate, the limit of credit exposure and the payment schedule or period. An agreement is then made to specify the financing terms of the revolving credit facility using the Murabahah contract. Figure 5.1 outlines the contract process that is executed for Murabahah financing to take effect.

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Figure 5.1 Revolving working capital financing - Murabahah contract

(5) Sale of goods (6) Deferred payment for goods

(1) Purchase order to purchase the goods on behalf of the bank

Customer

(2) Purchase goods on behalf of bank

(3) Notification to the bank of goods delivery

Supplier

Islamic financial institution

(4) Cash payment to the supplier

Step

Description

1

Based on the facility being approved, the customer initiates a purchase order with the Islamic bank to purchase specified goods from the supplier as agent of the bank.

2

Upon obtaining approval, the customer purchases the asset from the supplier on behalf of the bank.

3

Goods purchased are delivered to the supplier as the purchasing agent who then notifies the bank.

4

Cash payment by the bank is made to the supplier, as per the purchase price.

5

The bank subsequently sells the goods on credit at cost plus mark-up for the credit period specified, as per the terms of the revolving credit.

6

The customer makes payment including the mark-up to the bank, either in instalments or by full payment at the end of the credit period.

The above steps constitute a single purchase request transaction by the customer that is concluded with the sale by the bank and payment from the customer. Several similar transactions could be executed according to the needs of the customer, provided the total purchase price at any point in time does not exceed the approved credit limit specified for the facility.

Key point • An important criterion when adopting the Murabahah contract for revolving working capital financing is that the current asset is identifiable and the mark-up on pre-determined costs can be specified. The total purchase price at any point in time shall not exceed the approved credit limit.

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Exercise 5.2 A bank approved a £500,000 revolving Murabahah facility for a customer at a mark-up rate of 12% per annum on 1 January for a period of two years. The following transactions are identified: •

The customer submitted purchase request for goods valued at £200,000 and obtained financing in January.

In February the customer made another request for goods valued at £250,000 for which the bank has agreed to enter into the second Murabahah transaction. No payment had been received as yet by the bank as far as the first Murabahah sale is concerned.

In March, the customer paid half of the total Murabahah selling price for the January transaction and made a request for the purchase of additional goods valued at £200,000.

1. Based on the information above, what is the Murabahah selling price charged to the customer for purchases made in January and February respectively? 2. Should the bank accept part payment for the January purchase? 3. What would be the status of the outstanding debt? 4. Should the bank approve the purchase request in March? Explain the basis for your answer. 5. Based on this product structure, what are the possible limitations? In implementing Murabahah working capital financing, several product features warrant special attention. Non-observance of these features would render the contract either void or voidable, as well as expose the bank to credit and operational risk.

5.4.1.3 Effective delivery, security and timely payment Upon determining the product’s concept and purpose, as well as identifying the Murabahah contract for its financing, it is important to examine the certainty of delivery of goods and assurance of payment by the debtor. In legal documentation, ancillary contracts are considered to ensure effective delivery and timely payment of the outstanding debt. Based on Figure 5.1, the requisition made by the customer may be accompanied by a deposit or advance in the form of Hamish Jiddiyah (security deposit) or ‘Urbun payment (earnest money). This represents the commitment of the customer to purchase the goods ordered that have met goods specifications and conditions. Failure to take delivery of the goods will result in the deposit or advance being forfeited, or compensation being charged by the bank for any loss on disposal of the goods. In order to ensure the purchase, the customer may be required to promise to undertake the purchase of the goods upon acquisition of the requested goods by the bank. From the risk management perspective, without this purchase undertaking the bank is exposed to possible adverse changes in the value of the goods represented by market risk. Alternatively, a purchase undertaking based on Wa’d (unilateral promise) by the customer can be documented to mitigate the market risk exposure of the bank if the customer did not proceed with the purchase of the asset as promised. Upon disbursement made to the supplier of the goods at cash price, the Islamic financial institution (IFI) will then execute the Murabahah sale to the customer. Security for the financing amount may be in the form of a pledge (Rahn) or guarantee (Kafalah) to ensure the financier will get payment either from the sale proceeds of the pledged asset or from a third party.

Key point • Effective and timely delivery and payment of goods in a Murabahah contract requires proper documentation and recording of the purchase and sale of goods by the bank to the customer.

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During the period of financing, the customer may be faced with seasonal or, sometimes, cyclical demands for their goods and hence the approval limit of the facility may need to be increased or the period extended. Based on the facility agreement concluded between the customer and the bank, the total amount of the facility and the financing rate can be reviewed on a periodic basis. This ensures flexibility in facilitating the customer’s response to their business cycle. The Murabahah contracts that are executed within the facility agreement for each purchase transaction will then make specific reference to this agreement and hence observe the approval limit, as well as the agreed financing rate and financing period.

5.4.1.4 Delinquent customers In cases where the customer is not able to meet scheduled payments for the financing facility, the account may be classified as delinquent or even non-performing if the delay extends beyond a certain period from the payment due date. Based on the Murabahah contract, both the principal and the profit accrued during the period is recognised as the debt due by the customer. A penalty may be imposed for the delay. As such charges are meant to deter delinquent customers, proceeds must be distributed as charity after allocating the actual expenses to the bank as a result of the default. Similar to loans, Murabahah financing with instalment payments adopts an amortisation table to recognise profits from the outstanding principal balance. The effective rate applied on a periodic basis is computed from the quoted financing rate to the customer. For example, 12% per annum is recognised as 1% effective yield on the outstanding balance of Murabahah receivable on a monthly basis. Hence the mark-up price is computed based on the monthly effective yield and not the annual rate.

For example, a customer obtains £100,000 financing for two years to purchase equipment. At 12% per annum and an effective yield of 1% on a monthly basis the monthly instalment is £4,707 for 24 months. The Murabahah selling price is £112,976. The mark-up is £12,976 as deferred profit. The first instalment paid or due will recognise a profit of £1,000, and subsequent profit will proportionately reduce with the outstanding balance. With no payment made in the case of delinquency, the effective yield for the month will accrue and thus the total mark-up will exceed the selling price. Since the mark-up does not change with a similar selling price any delay will reduce the effective yield to the bank.

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Islamic finance challenge 5.2 A two-year master agreement for a revolving Murabahah facility is concluded between an IFI and one of its customers for an approved limit of £500,000 at a mark-up rate of 6% per annum. During the period the customer purchases equipment for £300,000 payable in one year. At the end of the year, the customer has difficulty in settling the amount and requests an extension of one year at the same rate. Identify the consequences of non-payment as well as the application for extension of the period.

Solution Although the facility approval is £500,000, the purchase value is only £300,000, therefore not all of the financing amount is utilised. The total period of financing is two years but the payment is scheduled for one year. The issue arising from the primary feature of Murabahah contract is the disclosure of cost plus mark-up. Based on the facility agreement, the maximum mark-up that can be earned from Murabahah sales is (0.06 X 500,000 X 2) £60,000 for the two years. If the Murabahah financing for the £300,000 purchase is structured for the two-year period the total mark-up would be £36,000. Hence if the Murabahah contract is concluded for a two-year credit period, any accelerated payment in one year can benefit from a potential rebate, therefore an extension period is not required because outstanding payments can be re-scheduled for the whole two-year period. In this case the customer may continue to make payment for the financing amount, as well as the profit agreed for the two-year period. However, if Murabahah financing for the £300,000 purchase is structured for one year, with a mark-up of £18,000, the payment will then be in arrears and the payment cannot be re-scheduled with an additional mark-up beyond the contracted period. Alternatively, the financing of £318,000 which is due in one year, must be restructured according to compliant restructuring processes. An increase in the profit rate due to the extension of the period is not compliant as the mark-up has already been pre-agreed. Any extension can only take place at no additional cost to the customer.

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5.4.2 Murabahah-tawarruq term working capital financing Unlike Murabahah working capital financing, the Murabahah-tawarruq contract is adopted to enable working capital financing to be made available to the customer in the form of cash. Information relating to Murabahah-tawarruq is available in CDIF/2/5/108-109. By executing a series of sale-andpurchase contracts between several parties, the customer can obtain cash financing in the form of working capital. The same structure can be used to provide an Islamic overdraft that provides a credit facility for the customer to utilise as and when cash is needed. The basic structure is presented in the following diagram.

Figure 5.2 Murabahah-tawarruq working capital financing

Commodity exchange

Broker A

(1) Delivery of commodity

Broker B (2) Payment of commodity

(6) Payment of commodity

(5) Delivery of commodity

(4) Deferred payment

Islamic financial institution

Customer (3) Delivery of commodity

The customer applies for working capital financing in the form of cash financing and provides information about the purpose of the financing and his anticipated operating cash flow. The bank assesses and evaluates the creditworthiness of the customer and decides on the credit financing amount, its credit limit, as well as the tenor of financing or line of credit.

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Step

Description

1

Upon granting the facility, the bank purchases the commodity based on the full amount of the facility from Broker A.

2

Cash payment (disbursement) is made to Broker A.

3

The bank sells the commodity to the customer at cost plus mark-up on credit sale.

4

The customer pays deferred instalments on the financing amount.

5

The customer sells the commodity to Broker B for cash to effectively obtain the financing amount.

6

The customer sells the commodity to Broker B for an amount that equals his working capital requirements.

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Islamic finance challenge 5.3 Given that a conventional overdraft is an open line of credit to enable a customer to draw down from the current account on a needs basis, subject to an approved limit and interest charged on the outstanding balance, as well as a fee imposed for early settlement, is an ‘Islamic overdraft’ concept or term acceptable to Shari’ah principles?

Solution Looking at the meaning and application of a conventional overdraft, this cannot be replicated in Islamic finance as a customer cannot use the facility beyond that which was already allocated. For example, if a customer is provided with Murabahah working capital financing to purchase assets up to US$500,000, more money cannot be obtained when the limit is utilised. However, in business practice, there could be circumstances where the customer may need extra money to support urgent or unexpected expenses or opportunities. Here Islamic finance ought to provide this cash line facility in addition to Murabahah working capital financing for asset financing. In this case, the bank may enter into a Murabahah-tawarruq transaction to create a credit line facility for the customer. The agreed amount, which is due to the customer, will be deemed as a credit line facility that may be used as and when the need arises. Unlike a conventional overdraft, the fee for early settlement is not compliant to Shari’ah principles as the money created in the account is actually the customer’s and there should not be any penalty for not using it. The bank may, however, decline to award the rebate for any early settlement unless the financial situation warrants such a rebate. All in all, this product should not be called an ‘Islamic overdraft’ as there is no ‘overdraft’ action in a Murabahah-tawarruq transaction.

5.4.2.1 Additional flexibility of Murabahah-tawarruq The Murabahah-tawarruq working capital facility is structured as short-term financing and for cash financing purposes. Unlike Murabahah working capital, which involves the transfer of an asset to the customer by virtue of a Murabahah sale, Murabahah-tawarruq does not involve the transfer of an asset to the customer, but rather provides cash financing to the customer. The financing amount, as per the approved limit of the facility, is available for disbursement at the point of origination. The only outstanding obligation is the debt due from the customer to the bank, Step 4, in which the customer is expected to redeem the financing amount, including profit according to an agreed payment schedule. In certain respects, Murabahah-tawarruq provides more flexibility than Murabahah working capital in terms of financing as the underlying asset is not necessarily related to the business of the customer, and the purpose of the financing could be very flexible as long as it is used in a Shari’ah-compliant manner. Hence the customer does not need to identify the asset to draw down the facility amount, nor are they restricted in terms of its use to identifiable ticket items. The customer also has the option to use the financing amount for any purpose, including the payment of operational expenses such as utilities. Such flexibility is an important feature of this product structure in gaining product acceptance from the business community. The customer may at any time draw down for payment without having to support the application with specified purchase transactions. Flexibility in drawdown at any time is an added feature.

5.4.2.2 Cost plus mark-up principle Based on the Murabahah contract, the cost plus mark-up pricing principle is adopted and the selling price is agreed at the point of disbursement. Effectively, the profit from Murabahah-tawarruq financing is earned for the financing period and imputed in the payment due from the customer. Thus the customer is expected to fully utilise the financing amount during the financing period. Hence the customer may not be able to reduce the overall cost of financing if the utilisation amount is below the approved financing amount.

Key point • A distinction between Murabahah working capital and Murabahah-tawarruq cash financing is the effective transfer of goods to the customer. An ultimate transfer of ownership of asset occurs in the former but not in the latter, where cash is the sole purpose of financing.

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Exercise 5.3 A customer obtains Murabahah-tawarruq financing for an amount of £500,000 at a markup profit rate of 6% per annum (0.5% per month) for a period of two years (24 months). The customer is expected to pay a monthly instalment of £22,160. During the first year, the customer withdraws £100,000 each quarter and makes regular instalment payments. In the second year, no drawdown is made and the customer requests that the payments be rescheduled for an additional six months. Any request for the deferment of the payment period will lower the effective yield on the financing amount as income to the bank. Hence the bank will be reluctant to accede to such request unless it is compensated for by additional returns over the extension period. However, the customer argues that since the remaining £100,000 has not been withdrawn, the bank should consider adjusting the effective yield to provide flexibility to the customer. Based on the above arguments, discuss the Shari’ah implications of extending the payment period and the resulting status of the financing contract.

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Islamic finance challenge 5.4 A conventional bank launches a new financing product for small and medium enterprises (SMEs) in the form of a combination of a term loan and an overdraft facility against residential or commercial property. This product is useful for professional service firms, sole proprietors, proprietorship firms, partnership firms or private limited companies with a steady annual turnover exceeding an agreed benchmark. The benefits of this new product include, inter alia: 1. loan up to 80% of the market value of the property 2. flexibility to opt for a pure term loan or a combination of a term loan and overdraft 3. loan up to a maximum of US$500,000 4. tenure up to 12 years 5. overdraft facility up to a maximum of 50% of the total sanctioned limit 6. attractive interest rate. This product has been marketed as a flexible product to fulfil short-term and long-term business requirements, be it working capital requirements or for business expansion by unlocking the potential value of the customer’s property. Based on the above features of the financial product, convert this product to a Shari’ahcompliant product while maintaining the main terms and features of the above conventional product.

Solution The example above is a form of secured financing as the liability of the customer is secured against the property of the customer, be it residential or commercial property. However, the total combined loan to value (LTA) for both term loan and overdraft (80% plus 50% of the value of property) is 130%. Therefore, the excess of 30% of the value of the property remains unsecured. This is a commercial risk that is applicable to both conventional and Islamic finance. As for the term loan, Islamic finance may offer Murabahah term financing for 12 years or revolving Murabahah working capital financing with a periodic review limited to US$500,000. However, term financing is less flexible than the revolving credit with specified mark-up and single drawdown. As for the overdraft, Islamic finance may offer a Murabahahtawarruq facility to allow the customer to have the credit line of up to 50% of US$500,000, that is US$250,000 at any time. Alternatively, an Islamic bank may offer working capital financing (for asset purchases) as well as working capital financing (cash) using equity-based working capital financing. In this case, the Islamic bank will provide US$500,000 as equity financing to this business customer, plus US$250,000 as standby equity financing as and when required. However, the rate of profit cannot be specified with a fixed return, unlike the above structure using Murabahah and Murabahah-tawarruq contracts.

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5.4.3 Mudarabah/Musharakah working capital financing In certain situations when the bank provides equity-based financing to the customer, Mudarabah or Musharakah contracts can be considered for this type of product. The Mudarabah contract is adopted when the bank is the sole provider of working capital and profit is shared between the bank and customer, based on the gross profit generated from the utilisation of the capital. Losses will be borne by the capital provider, which is the bank.

5.4.3.1 Mudarabah working capital financing The process entails determining the business risk exposure from the valuation of outstanding nonmonetary assets, either as inventory or receivables, as well as recoverability in terms of collection of the principal payment and accrued profits. A preferred choice by the bank for working capital financing based on Mudarabah is when the expected yield is known from the customer’s business track record or financing a company that exclusively provides house financing to, say, government employees. Under such exclusive situations, payments will be debited directly from employees’ salaries, therefore avoiding the probability of non-performing financing. In either case, business risks can be mitigated and expected returns can be estimated with reasonable certainty. Unlike Murabahah, financing in Mudarabah is based on capital contribution and not a sale-and-purchase agreement. Hence, capital is only specified for business purposes and not in relation to the acquisition of goods. Capital redemption may be specified in the form of a payment schedule for the period of financing. Any form of profit guarantee is prohibited, but a performance bond or guarantee by a third party for capital recovery, if any, is permissible.

5.4.3.2 Musharakah working capital financing Musharakah, or diminishing Musharakah working capital, is a facility that involves capital contribution by both the bank and the customer. In practice the product can be structured on either a constant or diminishing capital contribution. In a constant Musharakah structure, capital is redeemed at the end of the period thus enabling the customer to utilise the total outstanding capital balance throughout the financing period. In the case of diminishing Musharakah, the customer will follow a payment schedule to pay the bank’s capital throughout the period. The loss exposure of the bank is limited to the capital outstanding at any time during the financing period. A constant Musharakah financing structure provides flexibility in terms of utilisation of the outstanding balance for a wide variety of expenditures as per the specified-approved business purpose, with maximum commitment of capital provided by the bank. Diminishing Musharakah working capital on the other hand limits the bank’s capital to the outstanding balance at a time subject to the payment schedule.

A customer has secured a tender to supply and service computers to a government agency. The value of the tender at £1 million includes 30% of potential service income for maintenance in the next three years. The total cost of computer parts is estimated at £350,000. The customer anticipates a gross income of £650,000. Operational expenses are estimated at £400,000. Hence, net income is derived as £250,000 for the next three years. If the bank provides Musharakah working capital financing, the expected net income is shared between the bank and the customer based on a mutually agreed profit-sharing ratio for a disbursed financing facility of £750,000, that is 75% of the total value of the tender. The bank’s loss exposure is limited to the financing amount. With an effective annual rate of 5% per annum, the bank is expected to earn (0.05 X 750,000 X 3) = £112,500 based on a profit-sharing ratio of 45:55 between the bank and the customer. The bank can secure payment by ensuring that payment proceeds are assigned to the bank trust account prior to payments to the customer or profit distribution.

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5.5 Comparative analysis of working capital financing From the above descriptions of different contract types adopted for working capital financing it is possible to analyse and evaluate its purpose and features (see table 5.2 below).

Table 5.2 Comparative features of working capital financing by contract types Murabahah

Murabahah-tawarruq

Mudarabah/ Musharakah

Purpose of financing

Specified by type of purchase transaction

Specified by type of purchase transaction

Specified by type of purchase transaction or business purpose

Approve limit

Based on estimated total purchase value of transactions for a specified period

Based on estimated total purchase value of transactions for a specified period

Based on total operating expenditure required during the period

Determination of cost of funds

Mark-up price is specified upon granting the facility and applied to each transaction

Mark-up price is specified upon granting the facility and applied to the main/ principal transaction

Based on estimated returns shared according to a mutually agreed profit-sharing ratio

Availability of funds

Amount of financing is made available for each purchase transaction not exceeding the overall limit

Total amount of financing is made available upon execution of the primary/ principal transaction

Total funds are made available upon approval for any expenditure, including utilities, for business purpose

Effective cost of funds

Subject to each purchase transaction credit period for the specified rate

Total cost is imputed based on the single primary/principal purchase transaction

Effective cost of funds is imputed against the risk preference and expected return shared by the bank

Flexibility of withdrawal

Each withdrawal is subject to approval of the purchase transaction

A single withdrawal is approved based on the primary/principal transaction

A single withdrawal of the full amount is possible based on capital available

Flexibility of payment

All payments are to be made within the specified credit period for each transaction not to exceed in the total financing period of the approved facility

All payments are to be made within the financing period of the approved facility

The payment schedule in the case of diminishing Musharakah is agreed in advance and recovered prior to the end of financing period

Security

A collateral and guarantee of financing amount, as well as profits, can be secured accordingly

A collateral and guarantee of financing amount, as well as profits, can be secured accordingly

A third-party performance guarantee on customer’s performance, as well as a priority claim on capital over profits, can be exercised

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Exercise 5.4 If the purpose of financing is to obtain cash without the customer taking delivery of the goods at a predetermined rate, what would be the appropriate financing structure?

5.6 Islamic retail financing This section outlines financing products used to facilitate retail customers. Retail banking is geared primarily towards individual consumers rather than corporations or other banks. Retail banking products include a wide range of personal banking services, including savings and checking accounts, bill paying services, as well as debit and credit cards. Through retail banking products, consumers may also obtain mortgages, vehicle loans and personal loans.

5.6.1 Personal financing via debit, charge and credit cards In retail banking, personal financing is an important component of customer-end financing to meet the needs of the customer. With the increased sophistication of electronic forms of payments by both financial institutions and super stores, the availability of customer credit is considered essential to either support or induce customer purchases. Generally customer credit facilities are identified by the three broad categories of debit card, charge card and credit card. Each helps to shape customer behaviour.

5.6.1.1 Debit cards Debit cards are a form of electronic cheque allowing funds to be withdrawn from demand accounts (current and savings accounts) for payment transactions. Such withdrawals are made through bank automated teller machines (ATMs) as well as store payment outlets. The amount withdrawn is limited to the outstanding customer deposit balance. No credit is granted to the customer. The debt card mechanism is Shari’ah-compliant as an efficient payment system as there is no credit feature. Although the purchase of prohibited goods from specified stores is restricted, it cannot be enforced where such purchases are from general stores. The merchants simply deduct the payment of goods or services from the account which the cardholder has in one of the financial institutions. Also, the debit to the customer’s account will be immediate. The only possible Shari’ah issue in structuring an Islamic debit card is the feature allowing the debit cardholder to draw down more than the balance available in the account as an overdraft. The issue of overdraft has been discussed in 5.3.3 and the same principles apply in regard to Islamic debt cards.

5.6.1.2 Credit and charge cards A credit card authorises the holder to buy goods or services on credit without having to use cash. The issuer of the card grants a line of credit to the consumer (or the user) from which the user can borrow money for payment to a merchant or for cash advances. Normally, the holder will enjoy an interestfree period from the posting date of the transactions to the point where they settle the full account with one payment. Where they only make a partial or minimum payment toward the amount, they will be charged interest, called financial charges, for all purchases paid through the card from the date of the transactions. A credit card transaction is different to that occurring with a charge card. A charge card requires the outstanding balance to be paid in full each month. Thus, a charge card could be deemed to be compliant if full payment is made on time as it will be free from interest. In contrast, credit cards allow the consumers to ‘revolve’ their balance, at the cost of having interest charged. Credit cards generally provide a higher risk adjusted return than other types of financing. Card issuers earn income from three sources: charging cardholders’ fees; charging financing cost on outstanding balances; and discounting on the charges that merchants accept on the purchases. The fees charged at specified amounts per annum are based on the issuance and maintenance of the card. Sometimes because of market competition the card issuers waive such charges. Finance charges are based on a specified annual rate with a higher effective rate due to monthly or daily compounding. On average, discount on merchants is earned at between 2% to 5% per purchase.

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The basic model of credit card issuing process is shown as per the figure below:

Figure 5.3 Credit card transaction process

1

Individual

Retail outlet 2

4

Card issuing bank

Clearing network

Local merchant bank 3

3

2 Steps

Fees

1. Individual uses a credit card to purchase merchandise from a retail outlet

None

2. Retail outlet deposits the sales slip or electronically transmits the purchase data at its local bank

The merchant bank discounts the sales receipt; at 3% discount, the bank gives the retailer ÂŁ97 in credit for each ÂŁ100 receipt

3. Local merchant bank forwards the transaction information to a clearing network, which routes the data to the bank that issued the credit card

The bank that issued the card charges the merchant bank an interchange fee equal to 1% to 1.5% of the transaction amount for each item handled

4. The bank that issued the card sends the individual an itemised bill for all purchases

The bank that issued the card charges the customer interest and an annual fee for the privilege of issuing the card; a card issuing bank also serves as a merchant bank

The above credit card transaction process applies to Islamic credit cards except when the bank charges interest to the customer for the outstanding credit. Therefore, Islamic credit cards need to be restructured to avoid interest. Most credit cards require a minimum payment by the customer to the credit card issuing bank to ensure the card remains active.

5.6.1.3 Avoiding interest In response to this prohibitive element, Islamic banks have adopted Islamic finance contracts such as Murabahah-tawarruq to avoid charging interest payments for outstanding credit. Essentially, a credit card is a form of cash financing to the customer for personal expenses. It also enables the customer to avoid carrying or holding cash by managing credit purchases with timely payments to the credit card issuing banks. In certain cases consumerism may influence the customer to spend more than they need to or are able to pay out of future income. Such behaviour is not consistent with Islamic teachings that encourage prudent spending and saving for the future. However, the need to possess credit cards to meet immediate payments is necessary with proper expense monitoring, as well as adequate planning for cash disbursements. A similar structure of Murabahah-tawarruq, which is applied in the case of term working capital financing, is adapted to facilitate customer credit card financing. The basic credit card process model is shown in the following diagram.

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Figure 5.4 Islamic credit card process models Stage 1: Agreement between customer and credit card issuing bank Applies for credit facility to the issuing bank

Customer

Islamic bank

Approval of facility based on credit standing. Customer will enter into a Murabahah commodity transaction with the issuing bank to create a credit facility which represents the monetary value of the Islamic credit card

At this stage, the card issuer/Islamic bank will purchase a certain commodity from the vendor/ commodity broker A. The value of this commodity relates to the value of credit granted to the cardholder later. Subsequently, the card issuer/Islamic bank will sell the same commodity to the cardholder/customer at the Murabahah selling price that comprises both the cost and agreed markup. The card issuer/Islamic bank will facilitate the cardholder/customer to sell the commodity to the market/commodity broker B at a price that is the value of the credit card to be issued by the Islamic bank. Pursuant to this contract, the cardholder has a credit line to be utilised to pay for the goods or services using the card instead of cash.

Stage 2: Credit card transaction process

Customer

E. Payment for outstanding purchase

B. Purchase goods and services from retail outlets

A. Murabahah sale of goods to customer at specified mark-up rate

Card issuing bank

Retail outlet

D. Cash payment after discount is remitted to retailer

Clearing network

C. Submits request for cash payment

Local merchant bank

F. Outstanding payments between the banks shall be set-off

Stage 2 of the credit card process illustrates the parties involved in the transaction. Step A shows the origination of the credit facility through a Murabahah sale by the card issuing bank. Step B describes the purchase by the cardholder of goods or services from the retail outlets. Steps C and D describe the internal transactions between the retail outlet and the local merchant bank in relation to submitting the request for cash payment by the retail outlet and the cash payment remittance to the retailer by the local merchant bank. Finally, steps E and F show that payment by the customer to the card issuing bank and settlement between the banks based on set-off arrangement. As highlighted by the circle, the outstanding credit is created and monitored by the card-issuing bank for customer credit purchases.

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Exercise 5.5 A credit card issued by an Islamic bank adopted an Islamic contract that specified a 12% per annum mark-up rate on a monthly basis for every customer purchase not exceeding a credit limit of £5,000. For each purchase transaction, the mark-up price is applied on a monthly basis if the payment period exceeds two weeks from the credit billing date. The customer presents the card to a retail outlet and purchases goods valued at £4,000 in the month of January. Upon receipt of the credit card billing amount at the end of January, the customer pays £2,000 and defers payment of the balance. In February the customer purchases £3,000 worth of goods and pays £1,500 at the end of the month. a. Explain the relevant contracts that enable the transaction to be executed when the card is presented to purchase goods from the retailer. b. State the basis for fees collected by the credit card issuing bank to facilitate payment transactions. c. Compute the Murabahah-tawarruq profit and amount earned for each credit purchase transaction.

5.6.1.4 The Kafalah contract In Bahrain in particular, Islamic credit cards are based on the Kafalah contract as the bank guarantees payment to the merchant. Essentially, credit card transactions involve an advance of money or Qard from the card issuer to the cardholder, which is paid direct to the merchants. Upon purchasing goods or services from the merchants by the cardholder, the card issuer will transfer the payment amount to the merchants and will later have recourse to the cardholder for the loan being advanced. This is an interest-free loan. However, the card issuer will also act as the guarantor under the Kafalah contract for which the guarantor will charge a fee for providing this service. This fee is the income to the issuing bank. This structure has been endorsed by some IFIs although the practice of Kafalah for a fee has not been endorsed by the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) Shari’ah Standard No.5.

5.6.1.5 Covered and uncovered credit cards This Islamic credit card is known as an ‘uncovered’ credit card as the basis of the repayment is not supported by any account owned by the customer. However, Islamic credit cards that are structured on the Murabahah-tawarruq structure will be supported by a pool of money in the account of the customer, thus known as a ‘covered’ Islamic credit card.

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Islamic finance challenge 5.5 A covered Islamic credit card is based on the Murabahah-tawarruq structure. It offers some advantages to the cardholders in comparison to non-covered Islamic credit cards based on Kafalah. However, it has been argued by some practitioners that covered Islamic cards are simply debit cards. Discuss.

Solution The Murabahah-tawarruq structure allows an Islamic credit card to operate in a similar way to that of a conventional credit card in terms of the revolving feature and the profit or interest to be paid by the cardholder. Little adjustment is required to be made to the existing operating procedures of this facility. Both credit cards may look similar, but they are fundamentally different; while one provides a loan for interest; the other provides credit within the approved Shari’ah principles. Also, this structure allows the cardholder to invest his account created from Murabahah-tawarruq in a Mudarabah investment account at the card issuing bank, the profit of which can be used to set-off any payment outstanding arising from the usage of the credit cards. It therefore seems that the above claim is valid and justified as the outstanding payment created by the utilisation of the credit card is directly debited to the Murabahahtawarruq account, which was created prior to the issuance of this credit card. However, from another perspective, the totality of this structuring has created a credit line for the cardholder that can now be used through this card. This is an innovative structure that offers a compliant product to replicate the functions of a conventional credit card. Although it may not replicate fully the conventional credit card, Islamic credit cards based on the Murabahah-tawarruq structure make the payment of goods or services possible without resource to cash.

5.6.2 Islamic personal financing using the Murabahah-tawarruq structure In addition to the credit facility offered via charge and credit cards, Islamic banks may offer Islamic personal financing or rather cash financing using the Murabahah-tawarruq structure.

For example, an annual credit card limit of ÂŁ5,000 can originate from a series of sale and purchase transactions of the Murabahah-tawarruq structure at an annual profit of ÂŁ500. The customer may utilise the line for any purchase of goods and services during the year not exceeding the limit, and pay the profit accordingly.

5.7 Islamic personal financing: Ijarah In addition to the above, Islamic finance has developed a scheme of personal financing using the concept of Ijarah or service of a person or a hire contract. In this case, two hire contracts exist between the service provider and the financier, and subsequently between the financier and the ultimate user. The second contract is known as a sub-hire that effectively transfers the services from the ultimate provider to the ultimate user. This scheme of financing has been used in a few sectors such as tourism, medication and education.

For example, a customer seeks financing for a two-week holiday package in Bali, Indonesia, which costs US$20,000. This includes air tickets for four people, land transportation and hotel arrangements. The bank may finance this customer with a full lease payment of US$20,000 to the holiday package provider as the rightful lessee to benefit from the package, and subsequently sub-lease it to the customer at US$22,000 which can be paid within one year. The first contract is essentially a lease contract over the services of the whole package. The bank will have beneficial use (services) of the package by paying the fee for this package. The bank will subsequently lease this service to the customer at a higher service fee.

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5.8 Residential property financing: conventional Residential property financing refers to financing the construction, acquisition or leasing of residential properties. In conventional banking, term loan facilities are offered to the customer. No other forms of financing are available in conventional banking, particularly for retail banking customers.

Key point • Property financing may vary with various stages of property construction and development such as bridging, project and term financing. In the case of retail banking, term financing is the form of financing provided to customers.

5.8.1 Conventional property financing for retail customers Financing for residential property is focused on meeting the needs of buyers who intend to occupy or lease such properties. The profile of residential property buyers can be identified by their age group and lifestyle, as well as their income capacity to acquire such property. Hence, financing structures are designed to accommodate their specific profile to enable them to achieve their purpose of property financing. For example, in the early stage of their career, property buyers are inclined to lease rather than purchase a property. This behaviour is most apparent in conventional lending when interest rates increase more significantly than property rental. Alternatively, when property prices decline significantly, property buyers are inclined to purchase property in lieu of market rebound to realise a capital gain. In certain jurisdictions, loans are made available to homebuyers to purchase residential property under construction; upon sale of the completed property, the anticipated increase in property price will record a capital gain to the homebuyers.

Key point • In the case of residential property financing, motivations to acquire property may vary with the desire to occupy, lease or invest in the property. Although property financing may vary at different stages of property construction, development and sale, this section deals with term financing or end financing. In other words financing is directed to the customer who will purchase the property. In conventional banking, property loans to homebuyers are essentially classified as mortgages, where the lending is secured by the property’s value. In the credit appraisal, the buyer’s willingness and ability to pay the loan and interest, and the property value as collateral to the loan, are primary determinants in the loan approval process. In addition, the property would be covered by relevant insurance policies to safeguard the financial interest in the property. Mortgage reducing term assurance is another form of insurance used to secure repayment to the bank or building society in case of the death or disability of the homebuyer. The status of the property, whether completed or under construction, has resulted in different loan schemes that enable the customer to acquire the property. In the case of completed property, the loan granted will be at a specified margin of the property value.

For example, 90% margin of the property value of £150,000 implies the loan amount of £135,000 and the customer pays the seller or developer the balance of £15,000.

Alternatively a property under construction involves a gradual loan disbursement by the bank at each stage of the development based on the percentage of completion. The customer will service the interest during the construction period and subsequently make instalment payments of both principal and interest for the remaining loan period. Similarly the initial payment by the customer to the developer takes into consideration the margin of finance provided by the bank.

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Key point • In property financing, security of recovery of the loan amount, plus any interest, is addressed by the value of the property as well as other guarantees and insurances, including mortgage reducing term assurance (MRTA).

5.9 Islamic property financing: residential property Islamic financing recognises the financial needs of homebuyers as discussed earlier in relation to property financing. However, the contracts identified in structuring property financing also take into consideration the status of the property, whether it be completed or under construction. The primary role of Islamic property financing is to enable homebuyers to acquire or construct to occupy, lease or invest in a property in a manner that avoids usury and ensures proper, legitimate and effective transfer of the title or ownership, as well as the usufruct or beneficial use of the property. Unlike conventional loans and advances the financing amount will always be used for the property transaction and it will not be left to the customer to decide on the use of the loan.

Key point • Islamic property financing to enable the property buyer to occupy, lease or invest in a property can be structured based on suitable contracts for such purposes.

5.9.1 Completed or under construction In the case of a completed property, the customer may purchase the property at cost plus markup (Murabahah financing) or lease followed by transfer of title of the property (Ijarah muntahia bi tamleek) from the bank. Where the property is under construction, a construction contract (Istisna’), particularly Parallel Istisna’, and an Istisna’ contract followed by a forward lease, can be adopted to finance the developer accompanied by the customer’s promise (Wa’d) to acquire the asset upon completion. The property can then be sold to the customer based on Murabahah or lease using Ijarah muntahia bi tamleek. In structuring property financing, it is important that contract elements are present, its requirements are observed and provisions are properly executed. This will be illustrated for each property financing structure. In addition, the terms of financing, namely the financing rate, payment schedule, financing period and security arrangements must be valid and representative of both the underlying asset and the resulting economic event involving both completed property and property under construction.

Key point • In practice, Islamic property financing applies different Islamic financing contracts suited for completed property and property under construction.

5.9.2 Completed property: Murabahah contract A Murabahah property financing arrangement can be executed when the property identified by the customer is purchased at cost for cash and sold to the customer at cost plus mark-up for deferred payment. Upon receipt of the customer request, the bank may require a security deposit as well as an undertaking to purchase the property to effect the promise. In cases where the customer breaches such promise, the bank has the right to reduce losses by disposal of the property, as well as claiming any residual outstanding loss from the customer. Upon acquisition of the property, the bank pledges the property as collateral for the Murabahah sale to the customer. In addition, the bank may obtain a guarantee from third parties to ensure the customer’s timely payment of the financing amount and mark-up. Other forms of assurance, including Takaful protection for fire and payment upon death of the customer, are also considered in most property financing arrangements. The payment schedule may include regular payments or instalments comprising the principal and profit portion. The profit, based on the mark-up, is predetermined and is contracted upon the sale of property by the bank to the customer. The basis of profit recognition is made known to the customer and can be

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computed from the outstanding balance as per the date of payment, also referred to as the constant rate of return. In most cases, the instalment amount is skewed towards earlier profit payment. Any early settlement on the part of the customer provides an option for the bank to consider waiving the unearned profit portion of the mark-up. In some cases, the bank uses this option to sustain existing customers. This occurs when the market profit rates decline to a level not attractive for customers to pay the mark-up specified in the selling price. Any delay or delinquency on the part of the customer exceeding three months in certain jurisdictions of non-payment would classify the financing amount as non-performing. Hence, profit is suspended until payment continues. Failure to settle the outstanding financing amount and profit gives the bank the right to dispose of the property and recover all principal and profit due to the bank.

5.9.3 Completed property: Ijarah muntahia bi tamleek (lease) Where the customer chooses to lease the property from the bank with the option to purchase at the end or during the financing period, an Ijarah muntahia bi tamleek financing product is structured. Under this product structure the bank will purchase the property identified by the customer (in some cases the customer pays a deposit that will subsequently represent part of the lease payment). Upon purchase of the property, the bank will lease the property to the customer for a specified period. The bank may segment the financing period into several lease periods to enable payment and the rental rate to be revised on a periodic basis so as to reflect the market cost of the fund. The total lease payments would enable the bank to recover the full amount of financing, including the rental income. This structure provides flexibility to the customer to lease the property and upon execution of the option to purchase (Wa’d) the property is effectively sold to the customer at a mutually agreed price. As with Murabahah financing, the bank can institute security arrangements to recover the financing amount and rental income in the form of lease payments. The property owned by the bank provides comfort to the bank to recover the financing amount upon disposal of the property. A third-party guarantee to secure lease payments, as well as the undertaking to purchase the property (Wa’d), will also assure timely lease payments and reduce the bank’s market risk exposure to changes in property value. Upon termination of a lease arrangement due to a default in the lease payments, the bank has the right to require the customer to purchase the said leased asset in line with the undertaking to purchase under the Wa’d principle. The formula used to determine the purchase price, under this security arrangement, will take into account the outstanding principal amount due to the bank and the outstanding rental payments.

Key point • Murabahah property financing is structured to enable the customer to purchase the property, while Ijarah muntahia bi tamleek property financing enables the customer to occupy and subsequently own the property.

5.9.4 Completed property – Musharakah mutanaqisah From an equity financing perspective, the bank can jointly own the property and subsequently lease it to the customer for a defined period. During the financing period the equity share is transferred to the customer based on the contract of diminishing Musharakah (Musharakah mutanaqisah). The rental income due to the bank is proportionate to the bank’s capital contribution. In other words, the lease payment is apportioned according to the bank’s outstanding capital contribution for the period.

For example, in year five of a 20-year financing period, the bank’s outstanding capital is 75% of the property purchase price. Hence, the lease payment payable to the bank for the year will be 75% of the specified lease payment amount.

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Exercise 5.6 An Islamic bank offers the following three financing packages for the customer to purchase a completed property: Home financing Package I

Bank’s selling price at cost plus mark-up of 5% with monthly regular instalments for a maximum period of 20 years

Package II

Lease payment payable, with an option to purchase the property at a price based on a fixed formula during the lease period; market rental rate is contracted and reviewed on a periodic basis

Package III

Initial part payment to co-own property and subsequently lease to own the property at the end of the financing period for a maximum of 20 years

Based on the above description, identify and analyse the appropriate contracts for each home financing package, and suggest any customer preferences that could arise for each type of package.

5.9.5 Property under construction When a customer is considering purchasing a property under construction, the financing arrangement will need to consider the uncertainty of the deliverability of the property with respect to the timeliness and quality of delivery. Neither Murabahah nor Ijarah contracts cited for completed properties are appropriate as they apply only to properties in existence. A more appropriate contract known as Istisna’ recognises the progressive payment at different stages of property construction at a mutually agreed price. The customer upon identifying a property under construction requests the bank to purchase the property based on the contract of Istisna’. The customer at the same time undertakes to purchase from the bank upon its acquisition of the completed property (Wa’d). The bank makes progressive payments to the developer or contractor for an agreed price X1 and will subsequently sell the property to the customer at an agreed price X2. The bank records a profit margin of the price difference between X1 and X2. In a Parallel Istisna’ arrangement, the customer makes part payment to the bank during the construction period and subsequently pays the balance upon acquisition of the property. Effectively, payments received for the property construction based on Istisna’ contract are recognised proportionate to the value of the constructed property at each stage. Recent developments in financing property under construction apply forward leases with a specified description of the property to be constructed and delivered (Ijarah mausufah fi al-dhimmah). However, advance lease payments are only recognised when the property is completed and delivered to the buyer.

5.10 Islamic vehicle financing Vehicle financing represents a significant amount of financing extended to consumers by most retail banks and finance companies. Transportation is an essential economic activity and has brought about a preference for privately owned vehicles that provide flexibility in personal and family travelling. Similar to property financing, the choice of sale-based or lease-based contracts can be considered for motor vehicle financing. Among the challenges faced in motor-vehicle financing is that the moveable asset can be stolen or fully depreciated at scrap value within seven years, depending on road and traffic legislations of different jurisdictions. Hence the financing amount recovered is medium-term financing between three to five years at a higher financing rate. Furthermore, the hazards of fire or road accidents affect the net claims value of the vehicle, as well as the recoverability of the financing amount.

Key point • A unique feature of vehicle financing is the moveable nature of the property which can be exposed to peculiar risks and perils that require specified contracts to safeguard the interest of the bank.

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5.10.1 Payment or recovery of the outstanding financing When financing of a motor vehicle is based on outright sale of the vehicle, such as Murabahah financing, the bank can recover the outstanding financing amount in the form of a receivable, as well as the mark-up profit realised during the period of financing. The product structure does not facilitate re-possession of the vehicle but acts as security to recover proceeds from the disposal value of the vehicle. In most cases the disposal value is lower than the recoverability of the financing amount and profits, and outstanding claims need to be brought to a court of law. In certain jurisdictions, legislation in the form of statutes, such as a hire-purchase act, specify the mode of financing and charges, as well as the financier’s right to repossess the vehicle given the risky nature of the type of asset financed. A more appropriate contract is leasing or Ijarah with the option for the customer to purchase the vehicle. The bank as lessor owns the asset and hence, at any time, would be able to repossess the asset because of termination of the lease by expiry of the lease period, default or negligence on the part of the customer. Total lease payments amount to the total financing amount, plus the rental income.

Exercise 5.7 A customer obtains financing to lease a motor vehicle from a bank and is required to make regular instalment payments for a period of three years. At the end of the second year, the vehicle is involved in an accident and the total loss is confirmed by the Takaful loss adjuster. Explain the status of the lease financing in these circumstances and suggest who is liable for the loss.

5.11 Consumerism from an Islamic perspective Consumerism can be defined as the equation of personal happiness with consumption and the purchase of material possessions. In economics, consumerism refers to economic policies placing emphasis on consumption. In an abstract sense, it is the belief that the free choice of consumers should dictate the economic structure of a society. Although the consumer is important, it should not imply that their unlimited desires should be met by wasteful consumption or that they should become indebted for a significant part of their life to fulfil indiscriminate consumption behaviour. Islam provides specific guidelines to avoid wastage, which is held to be prone to evil, and help prevent an individual consuming more than they need or can afford. Although debt is permissible under Islam, it should be settled as soon as possible and not prolonged indefinitely. The proliferation of credit cards has induced excessive spending hedged against future income. This behaviour is frowned upon under Islam as it can destabilise the economy as well as the financial system. With the approval of cash financing structures such as Murabahah-tawarruq, customers are given liberty to utilise credit for personal consumption. From the prudential perspective, any credit limit must match the customer’s capacity to earn and pay. However, because of a lack of controls, including the absence of central credit agencies, in some cases credit card financing has significantly increased customer indebtedness to the point of bankruptcy. Although credit cards are Shari’ahcompliant instruments, customer credit limits need to be regulated or governed by an effective regulatory or governance framework for the IFSI.

5.11.1 Consumerism: the role of the banks Generally, banks are required to observe customer credit limits to avoid the overconcentration of financing to a particular individual or market segment, including credit cards. Hence, when such limits are exceeded, the bank’s exposure can destabilise its solvency. If this phenomenon is prevalent in the industry, systemic risk is anticipated which can effectively destabilise the financial system. In such a situation the primary contracts become poor-quality receivables, affecting any effort towards securitisation of the debt or towards credit enhancement to improve the rating of the issuer’s instruments. The subprime crisis of 2008/9 was related to poor credit customer financing that subsequently defaulted and escalated into a crisis of confidence in financial instruments related to consumer loans. This phenomenon is not confined to conventional loans and may affect Islamic customer financing if prudential policy and regulatory mechanisms are not in place to check excessive customer credit.

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Therefore, although Shari’ah requirements are specified for financing structures to enable customer financing, including cash financing, ethical as well as moral conduct is strongly encouraged in consumption behaviour to realise the overall purpose of meaningful life and the goals of Shari’ah.

5.12 Conclusion In this chapter you were shown that structuring for working capital and consumer financing exhibit common features. We explained that working capital financing, meant for short-term business cycles, requires certainty in relation to the corporate cost of financing. Therefore it would require the adoption of Murabahah or Murabahah-tawarruq contracts to facilitate either assetpurchase transactions or cash financing respectively. We showed that this also applies to consumer financing. We introduced the idea that challenges faced with regard to early payment are mainly due to the lack of flexibility in pricing structure since rates are predetermined. We explained that attempts to build in a discretionary rebate system may not be sufficient to make the products competitive. Finally, other service-based contracts, such as Ijarah and Musharakah, were explored where services are identified or assets are not determinable. These are more useful for medium to long-term financing.

5.13 Summary Having read this chapter the main points that you should understand are as follows: • the important considerations for borrowings are financial capacity for repayment and the creditworthiness of the borrower • appropriate Shari’ah contracts that address the needs of the customer must be suitably applied for different types of financing products in Islamic banking • contracting parties may consider adding ancillary contracts to secure the interest of the creditor, such as guarantee (Kafalah), promise (Wa’d) or pledge (Rahn) to provide assurance to the bank on the performance or recoverability of the financing amount • the rate of return determined for a financing amount is based on a mutually agreed selling price or rental amount in the case of sale or lease-based transactions respectively • working capital refers to current assets that relate to short-term or immediate cash flow needs and these are matched with short-term obligations to determine the level of net working capital • effective and timely delivery of goods in a contract requires proper documentation and recording of the transaction by the bank to the customer • a distinction between Murabahah working capital and Murabahah-tawarruq cash financing is that the effective transfer of goods to the customer, as ultimate purchaser, occurs in the former but not in the latter, where cash is the sole purpose of financing • Islamic credit cards can be generated under Murabahah-tawarruq or Kafalah structures • Islamic personal financing can be structured under Murabahah-tawarruq or Ijarah structures • Islamic property financing, which enables the property buyer to occupy, lease or invest in a property, can be structured around suitable contracts such as Murabahah or Ijarah muntahia bi tamleek • a unique feature of vehicle financing is the moveable nature of the property which is exposed to peculiar risks and perils that specified contracts can safeguard in the interest of the bank • Islam provides specific guidelines to avoid wastage, which is held to be prone to evil, and help the individual avoid consuming more than they need or can afford.

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5.14 Islamic Finance case study Structuring Islamic consumer financing A government officer, who has been offered the opportunity to study for a four-year full-time PhD in law at Harvard University, applies to an Islamic commercial bank for personal financing. According to the offer letter, the fees for the course are US$200,000 and living expenses will amount to US$200,000. As a government officer, he is granted study leave with half pay amounting to US$50,000 per year. Harvard University also offers him a teaching fellowship with an annual allowance of US$50,000 per year. The Islamic commercial bank rates the applicant as a good customer with a secure highranking government officer post. He has made a timely payment for his outstanding Islamic house financing of US$180,000, which includes US$100,000 deferred profit that will mature in 15 years. The applicant subscribed to mortgage reducing term assurance (MRTA) Takaful for the house, the market value of which is US$100,000. In order for him to pursue the course he requests additional personal cash financing for up to US$200,000 for a period of five years for payment of the tuition fees. Alternatively, he applies for an Islamic scheme to finance his tuition fees of US$200,000, if the bank has any such financing product, and an Islamic credit card facility with a limit of US$20,000.

Case study multiple choice questions 1.

2.

3.

4.

Cash flow statement analysis as the pertinent consideration for customer credit evaluation is particularly relevant in: (A)

retail banking and wholesale banking

(B)

investment banking and retail banking

(C)

corporate banking and investment banking

(D)

personal financing and working capital financing

Based on the case outlined above why would a personal financing structure based on Murabahah be suitable for tuition fees? (A)

Because it is an identifiable

(B)

Because of the flexibility of cash availability on draw down basis

(C)

Because of the fixed payment schedule during the financing period

(D)

Because of quantifiable services in monetary terms

In terms of the customer’s ability to pay, which of the following should be considered in order to approve the personal financing structure? (A)

Net customer earnings for payment of financing amount

(B)

Post-doctoral earning capacity to pay the financing amount

(C)

Mortgage Takaful for his house financing

(D)

Credit facility via Islamic credit cards

Based on the annual tuition fee payment schedule, when would the payment for personal financing be affected? (A)

During the study period

(B)

During and post financing period

(C)

During financing period

(D)

Post financing period only

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5.

6.

Which of the following structures would be suitable for the credit card financing of US$20,000? (A)

Murabahah structure

(B)

Murabahah-tawarruq structure

(C)

Ijarah structure

(D)

Musharakah structure

Which of the following would mitigate the bank’s risk exposures in relation to the personal financing and credit card facility? (A)

Salary assignment, house mortgage and mortgage Takaful

(B)

House mortgage and Islamic credit card

(C)

Allowance deduction from university appointment

(D)

Government guarantee on his employment

Case study short essay questions

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1.

Suggest a financing scheme suitable for the applicant to use to pay his course tuition fees.

2.

Identify the distinguishing features of the personal and cash financing schemes suitable for tuition fees and cash financing.

3.

State the IFI’s risk implications of these two structures and the security arrangements required to mitigate the risk exposures.

4.

An employee has been given the task of preparing a comprehensive proposal for the bank to consider the applicant’s request. What should be the essential considerations of the proposal?

5.

If the applicant had no mortgage or had the mortgage but not the mortgage Takaful, how would this affect the consideration of the customer’s financing request?

6.

If the applicant was applying for financing for his family holiday to Disneyland Paris, (rather than tuition fees) what should be considered in order to approve or disapprove his request?

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Chapter five answers Exercise 5.1 Providing a secured house loan facility is a normal conventional banking practice in the market. The value of the mortgage will, among other considerations, significantly influence the LTV to the customer. The interest rate charged for the secured loan is normally lower than on unsecured loans such as credit cards. In the case of default, the secured loan will benefit from the proceeds of the sale of the mortgaged asset pursuant to the order of sale by the court, unlike the unsecured credit card facility. With a lower credit risk, a relatively low interest rate can be charged for the secured borrowing. With a credit card facility, where no collateral or guarantee is available, the card issuer is exposed to a higher degree of credit risk and hence charges a higher interest rate to the customer. The above proposal is exceptional as the customer may enjoy a relatively low interest rate for both the house loan and credit card facility compared with normal banking practice. While this product benefits the bank and the customer, it may also lead to excessive consumer financing as it may encourage the customer to use their credit card excessively because of the relatively low interest rate charged compared with a normal credit card.

Exercise 5.2 1. The bank’s selling price for each customer purchase is based on the amount disbursed at cost plus mark-up for the two-year or remaining period at the time of sale. Usually the maximum period of two years is applied and the mark-up will then be (£200,000 X 0.12 X 2) £48,000 for the first Murabahah financing and (£250,000 X 0.12 X 2) £60,000 for the second Murabahah financing. However, if the second purchase is limited to financing for 23 months then the markup is lower than £60,000. Based on a monthly rate of 1%, the mark-up is less (£250,000 X 0.01 X 1) £2,500, which is £57,500. 2. The payment schedule is specified by the terms of Murabahah revolving credit financing. These may vary in frequency and affect the effective Murabahah rate charged to the customer. For example, 12% per annum is translated as a monthly effective rate of 1% compounded monthly, a quarterly effective rate of 3% compounded quarterly and semi-annual rate of 6% compounded semi-annually. In the case of a monthly basis, the customer has delayed payment in February. Alternatively, if a quarterly or semi-annual payment is required, the customer has made an early payment and part settlement. In either case the total amount of profit earned should not exceed the agreed mark-up. 3. The bank may accept the part payment, but the bank is not obliged to waive the deferred profit and may decide accordingly when full settlement for each transaction is made or upon termination, or expiration of the revolving facility. 4. In March the outstanding financing amount is (£250,000 + £100,000) £350,000. With the purchase request for £200,000 the total outstanding amount would exceed the limit by £50,000. Operationally the bank has to consider increasing the credit limit for additional financing to be provided. With the approval of the new limit, the third Murabahah sale can be concluded, but the new profit rate must be mutually agreed between the two parties as this rate is not expressed in the earlier master agreement. 5. Subject to the amount of revolving financing credit made available to the customer, the maximum mark-up profit will be (£500,000 X 0.12 X 2) £120,000 on a straight line annual basis. Any early settlements may reduce the profit accordingly. Furthermore, only selective purchases of big ticket items can be effectively monitored by the bank. If financing involves numerous purchases of nominal items, it becomes an onus on the bank to provide and monitor such financing. In this case a Murabahah-tawarruq structure is applicable as the utilisation of the financing amount need not be asset-specific. In addition, a Musharakah structure does not require identification of the asset purchased using the financing amount.

Exercise 5.3 Extending the payment period longer than the two-year credit term is not an issue under the Shari’ah. An issue arises when the bank seeks to charge additional fees or penalties to consider the extension request of the customer. While this feature of charging additional fees is common in conventional overdrafts when extensions are being considered, it cannot be CIMA Advanced Diploma in Islamic Finance

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undertaken under Islamic finance particularly when the underlying contract is Murabahah and the mark-up or profit has already been pre-agreed at 6% per annum of the financing amount drawn down. In this exercise, the maximum profit the bank can charge is 6% per annum of the US$400,000 drawn down.

Exercise 5.4 From the customer perspective, cash financing is meant for customer consumption not known to the bank. A Murabahah sale requires identification of goods purchased and sold that meet Shari’ah requirements. In the case of Murabahah-tawarruq, a series of sale-and-purchase transactions are made to facilitate the cash disbursement to the customer based on agreed terms of financing. The customer does not take delivery of goods and does not need to disclose the utilisation of cash financing. Hence, Murabahah-tawarruq is a suitable contract for such financing.

Exercise 5.5 a. The execution of the purchase of goods or services by the cardholders can be explained in terms of the very structure of Islamic credit cards. If the cards were to be issued on the basis of Murabahah-tawarruq, the cardholder simply assigns the merchants to get payment from his account at the issuing bank. To some extent, it looks similar to the debit card as the payment of the credit card is automatically debited from the account created for the cardholder under the Murabahah-tawarruq structure between the card holder and the card issuer. As for Islamic credit cards issued based on Kalafah, the cardholder simply requests the merchant to seek recourse from the issuing bank as the guarantor for the payment of the purchases made by the cardholder. b. Upon issuing the credit card to the customer, the issuing bank has to maintain the payment services as well as monitor the credit purchase behaviour and credit standing of the customer. Fees paid to the issuing bank are recognised as Ujrah for services rendered by the issuing bank. c. Based on the transactions, the customer’s purchase in January amounted to (£4,000 £2,000) £2,000 in credit for a period of one month. The customer’s purchase in February amounted to (£2,000 + £3,000 - £1,500) £3,500 in credit for a period of one month. Hence, profit earned by the bank is as follows: Based on the Murabahah-tawarruq contract, the £5,000 purchase can be paid over one year at a mark-up profit of (£5,000 X 0.01 X 12) = £600 for the year or £50 for each month. Although payments are made in each month the profit chargeable is fixed at £50 per month for the credit line.

Exercise 5.6 Package I should adopt the Murabahah financing package where the customer purchases the house from the bank at cost plus mark-up. The customer should be able to commit to regular instalments during the financing period which is subject to a fixed rate specified in the agreement. Any changes in the rate will affect the bank and customer inversely. Any decrease in market profit rate will influence the customer to re-finance at a lower cost while an increase in the market profit rate will affect the bank’s ability to match with a higher cost of funds. Package II adopts the Ijarah contract with flexible lease payments payable by the customer. Although the customer has an option to purchase the house during the lease period, at lease period renewal the rental rate may be revised to reflect the market rental rate. As an investor, the customer may choose to purchase the house at a price that is certain according to the fixed formula (which is not subject to the market value) or continue to lease if the payments in aggregate are lower than the purchase price. Package III adopts the Musharakah contract where the customer jointly owns the property upon acquisition. During this period, share of ownership is transferred to the customer and rental income is paid to the bank as a lessor. The customer may be granted the flexibility to re-schedule the capital transfer while continuously paying a lease to the bank as per the outstanding capital contribution.

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Exercise 5.7 Due to the total loss scenario, the bank/lessor will not be entitled to claim the rental payment since the customer/lessee will not be able to benefit from the usufruct of the leased vehicle. The bank may claim the value of the vehicle from the Takaful company. If the accident is proven to have resulted from the negligence of the customer, the customer may be requested to compensate the bank for losses not covered by the Takaful policy.

Case study multiple choice answers 1. (C) Corporate and business customers of the bank present cash flow statements and projections in addition to balance sheets and income statements to enable the bank to determine the payment capacity and performance of the company or business entity. Cash flow statement analysis is not relevant to retail financing. 2. (A) The Murabahah contract facilitates personal financing without having a direct or indirect linkage to the education services. The customer will obtain a certain amount of money to settle the fees. There is no contract on education services, which could be difficult to qualify as an asset for any sale. 3. (A) Customer credit evaluation is based on the customer’s capacity and willingness to make payments. Net customer earnings are a useful measure of customer payment capacity. 4. (B) Flexibility to schedule tuition fee payments is essential in personal financing and applies to both the actual and post-financing period. 5. (B) The Murabahah-tawarruq structure provides a definitive financing amount and related charges to the customer without requiring the customer to identify specific credit card purchase transactions. 6. (A) Salary assignment assures timely payment, the house mortgage secures the financing amount and mortgage Takaful facilitates payment of any outstanding balance upon the untimely death of the customer.

Suggested solutions to case study short essay questions 1. Ijarah personal financing would be the most flexible as it allows the customer to schedule payments during and post the financing period. 2. Personal financing may adopt the Ijarah structure while cash financing may adopt the Murabahah-tawarruq structure. The former involves effective services rendered to the customer while the latter allows only a credit line to the customer. 3. Both Ijarah and Murabahah-tawarruq structures can be secured in the form of pledged assets, the assignment of salaries (Hiwalah), and a guarantee by a third party (Kafalah). 4. The prime concerns in this question are creditworthiness, including capacity and willingness to make payment, the forms of security for the financing amounts, as well as the payment schedule. Also to be considered are the quality of financing in terms of the promotion of the social well-being of the applicant, as well as a suitable financial product structure to facilitate timely disbursement and payment, and effective yield to the bank. 5. If the customer applies with no mortgage or related security arrangements, a higher risk premium is applied to the financing rate. Hence, other risk mitigation arrangements, such as an assignment or guarantee, should be considered. 6. The family holiday is considered a service package similar to the education package. The considerations for financing depend on the customer’s creditworthiness and economic standing, as well as payment behaviour. From a longer-term perspective the enhanced potential capacity of the customer as per the education package is, however, absent as the consumption behaviour does not relate to personal development but only a form of social benefits.

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Chapter six Project financing: structures and strategic considerations Learning outcomes By the end of this chapter you should be able to: • analyse and evaluate the validity and compatibility of various underlying contracts to support project financing purposes • recommend the relevant structure for different infrastructure project financing • assess the risk features of project financing and propose appropriate instruments to mitigate relevant risk exposures.

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Indicative list of content • Overview of project financing features and requirements • Structuring financial instruments for various project financing scenarios • Risk exposures of project financing and mechanisms to mitigate risk exposure • An illustration of a project financing model highlighting the features, risks and relevant structuring issues • Case study: Islamic project financing structures using multiple contracts

6.0 Introduction This chapter introduces you to the nature and importance of project financing using Islamic financial instruments, undertaken in line with Islamic financial precepts. The various structures of project financing using equity, debt and Sukuk are explored. The chapter also considers different approaches that can be undertaken to finance projects, including the private finance initiative (PFI), the public-private partnership (PPP), the buildlease-operate-transfer (BLOT) and the build-operate-transfer (BOT), all of which must be compliant to Shari’ah principles. Other issues relating to financial structuring and its inherent risk are highlighted, including the most appropriate contract or contracts that can be used to mitigate the various risks arising only in project financing. 6.1 Project financing In the context of this guide, project financing refers to the development of infrastructure, energy, telecommunications, health, education and other public amenities that require large amounts of capital to support the cost of construction. By and large, private sector project financing assists governments with the development of the required infrastructure to ensure growth in the economy by increasing supply capacity while transferring project risk costs to the private sector. Project financing normally involves a number of risks that are not present in other forms of financing. They include construction phase risk, operation phase risk, market or off-take risk, currency risk, technical risk, regulatory or approval risk and political as well as force majeure risk. Each of these aspects will be considered in this chapter.

6.1.1 Project financing participants Project financing normally involves many participants or stakeholders in the finance transaction. The main participants in any project financing are: the government; equity funders, also known as the sponsors, who set up a special purpose company (SPC) or project management company; nonrecourse debt funders; construction/engineering consultants; environmental impact assessment consultants; and any affected communities. • The government is responsible for creating an enabling environment for project finance transactions to take place through its legal system and other associated legislation, such as agreements, permits, property rights and concession rights. • Equity funders are the owners of the project management company or the SPC. They contribute equity to this new entity that is independent from the legal entities of the equity providers. They are technically known as sponsors. It is important to limit the liability of the SPC to this company and not to the entities of the equity providers. The SPC is created to borrow the necessary monies and to manage the design and construction of the project. The same company may be the operator post-construction or it may appoint another party as the operator that is in control of the construction and operations, as well as the management of the project.

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• Non-recourse debt funders are lenders and financiers who provide the financing scheme for this project to be undertaken without recourse to the equity provider from the independent company, in addition to equity provided by the sponsors. • The construction or engineering consultant is the company responsible for the engineering, procurement and construction (EPC). • The environmental impact assessment consultant assesses whether the project meets the minimum standard of both national and international environmental-related legislation and agreements. • Affected communities include those who are directly or indirectly affected by the project.

6.1.2 Project financing: large scale Traditionally, project financing relates to large-scale, capital-intensive projects where the repayment of the financing obligation is normally sought or expected from the project’s subsequent cash flows. Project financing is a form of financing in which lenders look solely or primarily to the subsequent cash flows of a project to repay the debt and, as this financing is likely to be long-term, it relies on long-term funding.

6.1.3 Project financing: collateral Another peculiar feature of project financing is that project assets usually serve as collateral against the repayment of the loan. In the case of default, the financing could be either of nonrecourse or limited recourse. In a non-recourse loan, lenders only have recourse to the underlying project assets as collateral and not the personal assets of the borrower. In the case of limited recourse financing, the lenders may have recourse to the sponsors/equity holders. Any other financial arrangements that depart from these two important features are inappropriate for project financing in its technical sense. The following hypothetical case is an example of conventional project financing.

The Electric-Power Co. is an established contractor and operator of a commercial power plant. It has been granted a concession by the government to design, construct, operate and maintain an independent power station. The electricity authority of the country has signed the power purchase agreement (PPA) under which the Electric-Power Co. undertakes to supply a certain capacity of electricity to the electricity authority for a certain period of time at an agreed price. The ‘project’ to be undertaken, according to specifications in the concession agreement, entails the design, construction, commissioning and operation of two steam-electric coal-fired units, each with a nominal 700MW net capacity; common coal unloading, storage and handling facilities; and a 500KV switchyard. The project also includes the construction of transmission lines connecting the plant to the National Grid. The whole project is expected to be completed within two years from the date of the PPA. The estimated cost for the whole project is United Arab Emirates Dirham (AED) 1 billion. Under a project finance scheme, the Electric-Power Co. will have to set up an SPC (project management company) called Electric-Power Holdings Inc. Electric-Power Co. (and other stakeholders, if any) will have to invest equity into this company, say, 10% of the estimated cost, that is AED 100 million. Electric-Power Holdings Inc. will later sign a construction contract with Electric-Power Co. to build this power plant based on the specifications in the PPA. In order to support the construction cost, Electric-Power Holdings Inc. will need to secure financing through either a loan or a bond. A government or bank guarantee may be useful to facilitate or enhance the financing by other commercial banks. Also, the off-take by the country’s electricity authority will address the issue of the market risk, in case there is no buyer for the electricity at an agreed price. After the completion of the project, the electricity will be supplied to the country’s electricity authority pursuant to the PPA and all proceeds payable to Electric-Power Co. will be used to repay the loans or bonds. In the case of a default in the non-recourse loan, the only collateral available to the lenders is confined to all project assets including the revenue-producing contracts, that is the PPA.

Key point

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Key point • Project financing is a financing scheme for long-term infrastructure and development projects through loans that are secured by the project assets and paid entirely from project cash flow. The following diagram illustrates the various components of the conventional financing structure from the initial sponsor to the repayment from the proceeds that flow after production begins.

Figure 6.1 Simplified conventional project finance structure Financier

Financier

Financier arranger

Sponsor $ Equity

Financier

$ Debt

Repayment

Project company Company set-up

Construction

Operation & production

Feedstock supply contract

Advisory Services Financial arranger Technical consultant

Operation & maintenance contract

EPC contractor Subcontractors Equipment supplier Operator

Feedstock suppliers The spot market Off-takers

}

Sales of goods and payment proceeds

Equipment supply contract

The above is a simplified example of a possible project financing in the energy and power sector that has been modelled on a conventional financing scheme. We will now look at how Islamic finance may contribute to such financing while maintaining the salient features of project financing, as well as addressing various types of risks common in project financing.

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Exercise 6.1 Given the above description of project financing in a conventional finance scheme, which of the following may prove challenging from a Shari’ah perspective? (A) The off-take agreement (B) The fact that collateral is limited to project assets only (C) Funding supplied by syndicated financiers (D) The establishment of the project management company as the SPC

Islamic finance challenge 6.1 Why might infrastructure project financing lend itself more towards Islamic finance compared with other forms of financing such as a credit facility or overdraft?

Solution There are a number of reasons why infrastructure project financing, unlike other forms of financing, is more inclined to Islamic financing. Any list you have produced should include some or all of the following: •

They are asset-based.

They are non-speculative projects.

They may require some equity.

They often result in some socio-economic benefits.

6.1.4 Project financing: products and instruments available As explained above, Islamic project financing is different from other financing initiatives. The source of repayment of the financial obligation is derived from the subsequent cash flows of the project, while the collateral in non-recourse loan/financing, in the case of default, is generally limited to the project’s assets. In order to qualify as Islamic project financing instruments, Islamic financing products and instruments and their credit enhancement have no option but to meet these two conditions. We now need to take a look at the various products and instruments that are available to facilitate Islamic project financing. We will start by focusing on Islamic financial products and instruments that not only finance the cost of construction according to Shari’ah requirements, but also meet the technical features of project financing as adopted by the industry. We will then focus on some of the other Islamic financial products that could support the financing purpose of a project under construction, but do not necessarily meet the technical definition of a project financing scheme.

6.2 Acceptable Islamic project financing instruments Not all Islamic contracts can be adopted to suit the technical definition of project finance as accepted in conventional finance. To a certain extent, it is difficult for Islamic finance to match many of the technical features of conventional project financing. In conventional project finance, an interestbased loan is the only contract that underlies the financing granted to the project management company. Irrespective of the financial structuring involved in such loan contracts, the central theme is for the lenders to provide a loan where the source of repayment of the loan capital and interest will be in the form of subsequent cash flows of the project. The collateral for these lenders comprises the assets of the project. It is therefore relatively easy to structure conventional project financing while meeting the technical description. The following sections will show that this may not be the case for Islamic financial contracts.

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6.2.1 Istisna’ and Parallel Istisna’ In Islamic finance the most appropriate contract that matches the conventional project financing scheme in terms of the repayment of the financing amount and collateral is the contract of Istisna’ (CDIF/1/6/113). An Istisna’ contract relates to the sale of assets to be constructed by the seller according to the descriptions and specifications of the buyer. In the context of Islamic financing, the Islamic financial institution (IFI) could be the buyer as financier, or seller as the intermediary to the ultimate buyer. The government or any government-linked companies may place an order for an IFI or syndicated Islamic financiers to build and deliver, say, a new hospital for the government at an agreed price payable within a defined period. Such an order, placed by the government, would constitute the first Istisna’ contract in the process. Islamic financiers are not construction companies or hospital operators and hence enter into another Istisna’ contract with a contractor or developer to purchase the complete hospital as specified in the first contract. Islamic financiers will act as the Istisna’ buyer to purchase the hospital from the construction company, thus forming the second Istisna’ contract. To render this Parallel Istisna’ arrangement compatible with the technical description of project financing, two conditions have to be met (CDIF/1/7/131). It has to be a condition that the source of payment by the government to the Islamic financiers is derived solely from the cash flows of the hospital’s activities for the next 10 years. It also has to be incorporated into the Istisna’ contract that the collateral was assigned in favour of the Islamic financiers. Should the government default, the Istisna’ payment is limited only to the proceeds generated by the hospital’s assets, including its future revenue.

Exercise 6.2 Given the scenario above, explain whether the Parallel Istisna’ structure suggested would meet modern project financing requirements in terms of financing either the contractor or the concessionaire who has won the contract to build the hospital. The Istisna’ contract described above may not be relevant and practical to the practice of project financing in the industry. This is because the government or body that needs the new hospital, bridge or telecommunications server will not award the contract to an IFI as it is neither a contractor nor developer. IFIs, similar to conventional financial institutions, are merely the financial intermediaries. Usually, a government that engages the private sector will seek to transfer project risks and costs to this party, and will only therefore approach reputable contractors or builders to construct and deliver what is needed. Only subsequent to this would the contractor approach the financier for the required cost of the construction. Thus, despite the fact that this proposed Parallel Istisna’ appears in many textbooks and Shari’ah standards, it is only useful for consumer financing where an individual, say, asks a bank to build a house for him. Such Parallel Istisna’ would not be useful in the real project financing market.

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Islamic finance challenge 6.2 A gas-producing country sign a contract to produce, process and transport natural gas to its neighbouring countries, which have signed a contract to purchase the natural gas for the next 10 years. The project involves: a. the development of gas wells and installation of two platforms in the producing country b. two multiphase sea lines from the wellheads to the processing plant c. a gas processing and compression plant at a specific location in the producing country d. an offshore pipeline from that identified location to a gas station in one of the neighbouring countries e. gas receiving facilities in the identified location. The gas-producing country is seeking a Shari’ah-compliant instrument to finance the construction of the offshore pipeline (item d above) to transport the refined natural gas to the identified gas station. The estimated construction cost of the offshore pipeline is US$1 billion. On behalf of the gas-producing country, the facility arrangers approach several IFIs to obtain Islamic project financing using an Istisna’ contract. Required Prepare an outline of the required Istisna’ structure needed to finance the project.

Solution The above request would not suit a Parallel Istisna’ structure that requires a pair or ‘backto-back’ Istisna’ involving three independent parties. In this scenario, there will only be two parties: the gas producing country and the financiers. Parallel Istisna’ between two parties is not compliant according to the Accounting and Auditing Organisation for Islamic Financial Institutions (Shari’ah Standard No 11: Clause 2/2/4). A new Islamic financial product must be structured to facilitate this financial requirement that is unique in terms of product requirements and features. In the scenario, it is envisaged that the Islamic financier(s) may finance this project using a combination of two contracts to give the effect of real project financing and at the same time provide some risk management tools for the financiers. A widely used structure in financing green field or new projects, such as constructing a new pipeline, is the combination of an Istisna’ contract and a forward-lease contract. Under this structure, Islamic financiers enter into an Istisna’ contract with the gas-producing country to purchase the complete pipeline at a fixed price with payment based on the progress of the project. This payment will be used by the seller/gas-producing country to support the construction costs of the gas pipeline therefore meeting the financing requirements. Upon completion, the seller of the Istisna’ is under an obligation to deliver the complete pipeline to the Islamic financiers, who are the purchasers of the Istisna’ asset. To allow the Islamic financiers to earn a profit from the provision of this Istisna’ financing to the client, they will enter into a forward-lease agreement with the gas-producing country, normally on the same day that the Istisna’ contract between the two parties is concluded. Under this forward-lease contract, the gas-producing country will enter into a forward-lease for the pipeline from the Islamic financiers/lessors for a fixed rental. Under a forward-lease contract, the financier/lessor can collect the rental in advance even though the leased asset is still under construction. The total amount is essentially the payment for the Istisna’ financing facility plus some profit to the Istisna’ financiers. This is a good example of Islamic project financing as it easily meets the two conditions of typical project financing. At the same time it relates to market practice where the contractor or project owner approaches the financier directly to seek financing. The Istisna’ financing that requires a pair or ‘back-to-back’ Istisna’ contracts, known as Parallel Istisna’, may be difficult to apply in the real market.

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6.2.2 Istisna’ and forward-lease arrangement The Istisna’ and forward-lease arrangement outlined in the solution to Islamic finance challenge 6.2 above has been widely accepted by the Islamic finance industry. Unlike Parallel Istisna’, it suits the practice of project financing. In practice, it is the construction company or concessionaire that is awarded the contract of construction or concession by the awarding parties. Also, it is this company that needs financing to undertake all construction work. A Parallel Istisna’ structure would require a modified flow of transactions that is not common in market practice. As a result, Istisna’, followed by a forward-lease contract, can be used to finance such projects and, at the same time, reward the financier for providing this financing. Another example is where a project management company is given the contract to develop a new water treatment plant. In order to raise the necessary funding, the company can approach syndicated Islamic financiers for, say, US$500 million financing. Using this arrangement, Islamic financiers will first purchase the water treatment plant from the project management company under an Istisna’ contract for the agreed cost of US$500 million, payment of which can be based on the progress of its construction. The period of Istisna’ financing can be for two years, within which the project is expected to be completed and delivered to Islamic financiers. The financing amount granted under an Istisna’ contract will be channelled to support the construction cost of the project. Subsequently, the project management company can enter into a forward-lease contract with the Islamic financiers to lease the water treatment plant for a period of 10 years. The rental payment can be a fixed amount or it can be a floating rental linked to an agreed benchmark to avoid any dispute. The Islamic financiers will reclaim their financing amount and their profit based on this agreed rental payment, be it fixed or floating. This financing arrangement is useful for any construction project. Under this arrangement, the financiers get the advantage of variable costs of funds and it helps them hedge the volatility risk of that cost.

Key point • Istisna’ combined with a forward-lease contract provides the best Islamic scheme for debtbased financial structuring for project financing.

6.2.3 Istisna’ using the concept of build-operate-transfer (BOT) Under the private finance initiative (PFI) or public-private partnership (PPP), build-operate-transfer (BOT) is a relatively popular product. It is a form of project financing where a government awards a concession to the private sector to design, construct and operate a project using its own financial resources to finance the costs. Although the concessionaire is expected to finance the construction cost, the government will allow them to operate the project for an extended period to cover the cost of construction and earn an expected return.

For example, in a highway project, a government may award the right to fix and collect a toll to a concessionaire company over a long period of time. In some cases, there will be a clause in the concession agreement requiring the government to compensate the concessionaire for any shortfall in expected revenue. This form of project financing is popular in India, China, Japan, Malaysia, Croatia and the Philippines and a version known as BOOT (Build-Own-OperateTransfer) is popular in Canada, Australia and New Zealand. Again, the whole intention of both BOT and BOOT is for the government to transfer the cost of funding to the private sector, together with the project’s risks.

Key point • PFI and PPP allow governments to transfer project risks, as well as project costs to the private sector. BOT/BOOT have the same characteristics as other typical project financing: • the lenders/financiers will look primarily at the potential cash flow of the project instead of the credit assessment of the concessionaire • the collateral is largely confined to project assets, its rights and future income.

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6.2.3.1 Shari’ah acceptance of BOT/BOOT Some Fatwas and Shari’ah standards have argued that BOT/BOOT can be structured under the principle of Istisna’, particularly with regard to the concession agreement awarded by the government to the concessionaire. Under an Istisna’ contract, the payment of the Istisna’ sale price can be effected in cash, commodity or service. For example, a contractor may build a house for his client for a consideration of US$100,000 or for another house owned by the Istisna’ purchaser (irrespective of the value of that house), or for a service to be provided by the Istisna’ purchaser to the contractor, such as allowing him to stay in the purchaser’s house for one year. In the case of BOT/BOOT, the buyer of the future asset is the government/awarding party, but the payment to be paid by the buyer to the seller will not be in the form of cash. Instead, the payment of the Istisna’ sale price is based on the right to use the project, for example, a highway, for a certain period of time, that is a service with the right of income through charging tolls. The right to use, with its resulting income-generating potential, is the consideration given for the Istisna’ sale price. The concessionaire will effectively build the highway for the government and, in consideration for this asset, the government will award the right to the concessionaire to operate the highway for a period of certain years. The toll collected over the agreed period will go to the concessionaire. When the agreed period expires the highway will be delivered to the government.

Key point • The consideration for an Istisna’ purchase could be in the form of cash, tangible goods or the Usufruct of an asset for a fixed period. The Usufruct could be derived from any asset or from the same asset that is under construction.

6.2.3.2 Financing BOT/BOOT The example outlined above is a valid structuring of BOT/BOOT from a Shari’ah perspective. However, the question needs to be asked how the concessionaire would raise the financing needed to support the costs of construction prior to using the asset commercially, that is to the point where they can earn income from, say, toll collections or the sale of electricity. A Parallel Istisna’ will not be workable in this context for the reason explained in Section 6.2.1 above. The only option available for a funding structure is to raise the funds through either equity financing or debt financing, which is the topic of the next section.

6.2.4 Sale and lease-back arrangements Originally developed as a refinancing scheme for companies to raise cash by selling unencumbered assets with the purpose of taking it back on lease, this arrangement has been widely adopted in Sukuk Ijarah, which has been popular among both sovereign and corporate issuers. Given the structure of Sukuk Ijarah (CDIF/3/7/106-107), the project management company or sponsors must have an identified asset that can be sold to investors for an agreed price. The proceeds of this sale will be used by the originator/owner of the asset to support the construction cost of a particular project that the originator wishes to undertake. Sukuk Ijarah will not be relevant in the case where the project management company does not already own an unencumbered asset. The investors will lease the same asset back to the originator/project management company for a fixed or floating rental payment as the case may be. The rental payment is structured in this manner to compensate the investors for their financing cost. In this structure, the originator may give an undertaking to repurchase the leased asset at any price in the case of default. This feature of Sukuk Ijarah is not only compliant to AAOIFI Shari’ah Standards, but also provides a better rating for the structure as the obligation of the originator to redeem the principal and pay the profit is backed by the purchase undertaking and leased asset. The issue of the Sukuk structure and its rating will be discussed in chapter eight.

Exercise 6.3 A plot of land is designated for the development of a medical city. The land is awarded to a project management company to develop for the government of Qatar. The company wishes to issue Sukuk to cover the cost of the construction. What would be the best Sukuk structure to finance this project?

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Islamic finance challenge 6.3 A piece of land is awarded to a project management company for a period of 30 years. This land is not valid for any sale or transfer of ownership. Also, the property in the form of apartments and hotel rooms built on this land cannot be sold to anyone other than citizens of the country. Non-citizens are not qualified to purchase any of the properties. However, it is the intention of the project management company to have global Muslim ‘ownership’ without breaching the laws of the land. The land is designated for five-star Islamic serviced apartments and hotels catering to Muslim pilgrims going to the Holy Land of Mecca. The project management company is contemplating issuing Sukuk to raise the required funds of about Saudi riyals (SR) 1 billion. Outline the salient features of Sukuk that would suit the above scenario.

Solution The above scenario is a relatively viable project as the volume of visitors to the Holy Land is growing steadily. However, the fact that the land is not valid for any transfer will render the structure of Sukuk Ijarah impossible. This is because Sukuk Ijarah would require the originator or party that requires the funding to sell his asset to the investors who are the Sukuk Ijarah investors. The fact that this land could not be sold to other foreign investors would make Sukuk Ijarah, which is based on sale followed by lease, not legally valid. In the event that Sukuk Ijarah was used, investors may lose their beneficial interest on the land and the property on it as the sale may be deemed invalid. Other possible Sukuk structures include Sukuk Mudarabah and Sukuk Musharakah. In this case, the investors will be exposed to all the risks related to project financing. Upon completion, the properties may be sold to nationals or leased. Neither scenario will satisfy the project management company’s intention of global representation and ownership. It is against this background that Sukuk Intifa’ (certificates of investment in the Usufruct) may be proposed not only to finance this project but also to meet the developer’s visionary outlook of a property owned and subscribed to by a global Muslim population. AAOIFI Shari’ah Standard No 17 allows the securitisation of both existing and future Usufruct. The above scenario relates to the securitisation of future Usufruct. Under this structure, the issuer will issue certificates of investment, or Sukuk, to interested investors to purchase the right to stay in the apartments and hotels when they are ready. The proceeds of this subscription, SR 1 billion, will be used by the project company to develop this project. Upon completion, the Sukuk Intifa’ holders will have the right to stay a few nights a year in that property as prescribed in the Sukuk Investment Prospectus. Sukuk holders will also appoint the project management company as the operator to maintain and manage the property for a fee under a Wakalah agreement. Should the Sukuk holders wish to sub-lease their right to the Usufruct, they may do so to another visitor for a rental that is normally based on market value. If the Sukuk holders need to liquidate their investment certificate, they may dispose of this investment certificate in the market. This Sukuk structure is able to meet the financing requirements of this project and is also able to meet the legal framework and constraints of the project. Alternatively, this could also be called the Islamic securitisation of ‘time sharing’.

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6.3 Supporting contracts for Islamic project financing There are a few contracts and arrangements supporting project financing from the Shari’ah perspective that may not necessarily satisfy the textbook description of project finance. These include the contracts and arrangements below.

6.3.1 Equity-based financing: Mudarabah and Musharakah In addition to a combination of Istisna’ and forward-lease contracts, Islamic project financing may be offered on the basis of a Mudarabah or Musharakah contract. The Islamic financier will finance the cost of construction of the client by providing the capital as equity financing. This capital will be invested in an identified project. It is different from the equity contribution made by the sponsors in the project management company or SPC. Mudarabah or Musharakah capital providers are not the shareholders in the company. A Mudarabah or Musharakah contract allows investors/financiers to share in the profit generated when the project is complete and begins to generate income. However, unlike the first structure, which is a debt-based structure, a Mudarabah or Musharakah contract generally yields a variable return and does not guarantee the capital invested. The salient features of equity-based contracts are: • no guarantee for principal repayment or return • the return is based on actual performance of the financed project • in the case of Musharakah financing, both the financier and the financing client share any realised losses in proportion to their capital contribution; in the case of Mudarabah, only the investors bear the capital loss.

6.3.2 Participation term certificates The Mudarabah contract structure was used for participation term certificates (PTCs) in Pakistan in the early 1980s. PTCs were introduced to replace interest-based ventures. They are transferable corporate instruments based on the principle of profit sharing where PTC holders have a share in the profit of the company or the project as the case may be. The same logic and behaviour will also apply to Musharakah investment certificates, except that the managing partner in the Musharakah venture must also contribute some capital to the project to entitle him to a share of the profit and to bear losses in proportion to his investment. PTCs may be used as a vehicle to finance the construction of, for example, a hospital to be subsequently leased to the government. This could take the form of a build-lease-operate-transfer where the managing partner of the Mudarabah or Musharakah investors, as the case may be, will use the investment capital to build the hospital and, after completion, lease it to the government for a certain period of time with an option given to the government to purchase it in the future under a put option scheme. Holders of PTCs would benefit from the rental paid by the government and, perhaps, from the capital gains if the property were sold at a higher price. This Mudarabah or Musharakah structure can effectively provide Islamic project financing to the client seeking an Islamic project financing scheme based on equity structure.

Exercise 6.4 Using the case scenario in Islamic finance challenge 6.2, could the Mudarabah or Musharakah contract be used to finance the construction of a gas pipeline? Explain whether the same contract can be used to finance items a, b and d of that scenario?

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Islamic finance challenge 6.4 Given the above discussion regarding the possibility of using both Mudarabah and Musharakah contracts in Islamic project financing, explain whether Mudarabah or Musharakah are suitable for project financing as dictated by its typical features of cash flow orientation and project asset-based collateral.

Solution Technically, both contracts dictate that the project management company as the managing partner shares the profit that is generated solely from the cash flow of the project. This is very similar to any typical equity investment by investors in a project management company. However, in the case of default, investors providing capital under either Mudarabah or Musharakah contract will rank second to other creditors who provide financing based on Islamic debt-based financing such as Istisna’, Ijarah or Murabahah. In this respect, investors assume not only the typical project risks but also the investment rate of return risk. From a financial structuring perspective, the agreed profit-sharing ratio needs to be higher than the margin of profit given to financing providers using debt-based transactions. Another relevant issue is related to the enforcement of collateral in such an equity-based structure. As established earlier, equity-based contracts do not have the feature of either principal guarantee or profit guarantee. There is no concept of indebtedness in equity-based contracts and, therefore, the use of collateral may not be relevant to protect the interest of the equity financiers. Shortfall of any expected profit will not trigger the default clause. The investors in this structure are vulnerable to capital loss if the project was to suffer a great loss. To mitigate the risk of moral hazards to the project management company, the document pertaining to these contracts should have a relevant clause on the negligence, misconduct or breach of the terms and conditions by the project management company. Such a clause would mean that the collateral may be used to redeem the investment capital only. This is a permissible clause and practice since it is a guard against the negligence or misconduct of the project management company.

6.3.3 Convertible Mudarabah and Musharakah Islamic project financing may also consider raising funds through Mudarabah and Musharakah contracts with an option given to equity financiers to convert their investment capital into shares of the project management company or the parent company. This convertibility feature gives some flexibility to the equity financier to either opt for the profit sharing generated from the project itself or convert their investment into shares of the project management company, or the parent company if the prospect of the profitability at the company level is higher than the expected profit at the project level. The formula of the conversion should be agreed in advance to avoid any dispute. This allows the investors flexibility as they may choose between a profit-sharing ratio and a stake in the sponsor’s company. Financing using both Mudarabah and Musharakah may be structured as a banking product provided by Islamic banks or a capital market product using the vehicle of Sukuk.

6.3.4 Quasi-equity financing Risk involves exposure to loss due to an uncertain outcome and is fundamentally a non-prohibitive outcome under the purview of the Shari’ah. In the Islamic financial industry, risk is inevitable in all Islamic financial transactions. The wholesale adoption of risk within the Islamic finance sphere is further evidenced by the maxim that ‘there can be no return from a position of zero risk’. A total equity structure may not be appealing to some Islamic investors as exposure to loss is a central feature of normal equity financing. Quasi-equity financing (QEF) addresses the need for a financing vehicle that provides for flexibility, capital protection and, at the same time, addresses various economic cycles. QEF relies on the security of cash flows and requires a detailed awareness, identification, assessment and qualification of all business and financial risks. QEF can be traded in the capital market at a capital gain as it is linked to the issuer’s profitability performance. QEF represents a different class of equity as compared with preference shares as it excludes any cumulative right to receive return or any preferential treatment over and above ordinary shareholders. Preference shares are not compliant to Shari’ah principles as they hold a priority to

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returns or dividends pay-out over ordinary shareholders. During the financing stage, QEF investors have a profit-sharing claim over the returns of the venture that ends after the invested capital is redeemed or when the QEF is converted into equity. QEF allows investors to accumulate losses until the venture is able to fully redeem the capital. The accumulation of loss means that the financing is not deemed to be in default, although the issuer is not financially able to generate the expected return or redeem the investment capital. The financing period will be further extended should the investors feel that they are not able to absorb the loss within the original financing tenure. It equates the position of QEF holders to equity holders given the same business risk absorbed by both parties, primarily profit and loss sharing. This suits the nature of long-term project financing as the investors may redeem their capital plus profit at a certain time or they may defer the redemption of the capital in the case of loss until the venture is able to provide profit. It has the element of debt-based financing with regards to the agreed time of capital redemption in the case of profit, as well as an element of equity in the case of loss. QEF addresses the need for a financing vehicle that provides flexibility and, at the same time, the various economic cycles. QEF can be traded in the capital market at a capital gain as it is linked to the issuer’s profitability performance. This can fuel and enhance the size of the capital markets where 100% of companies (equity and debt) could be traded at attractive returns. QEF allows an investor to gauge first hand the operations and capabilities of the investee company prior to investing in the investee’s equity. This is a very important factor in today’s volatile markets as it is linked to the issuer’s profitability performance with cash returns and redemption features. As a financing option, QEF does not cause concern to an otherwise sound and profitable company during volatile times. It provides financial stability that enhances the continuity of companies in bad times. QEF is a financing mode that can potentially enhance a bank’s profitability in good times with stronger debt recovery prospects in bad times. QEF may offer Shari’ah-compliant financing relative to conventional preference shares as well as senior debt. Although in the case of liquidation it will rank pari passu (on equal footing) to other equity holders, it will rank alongside debt due to its specified payment or redemption schedule. Thus, QEF investors will be paid their share of profit prior to the profit distribution to shareholders of the project management company.

Key point • Project financing via equity-based contracts can be based on Mudarabah or Musharakah, with or without the convertibility option, as well as on quasi-equity financing with both a convertibility option and a loss accumulation feature.

6.3.5 Murabahah working capital financing Islamic financiers may finance part of the project using either a Murabahah structure for asset financing or a Murabahah commodity structure for cash financing. While the first structure purchases raw materials and equipment at cost and subsequently sells them to the project company at cost plus profit, the second structure facilitates cash financing. Both of these structures assist the developer in getting either the necessary raw materials on credit or in providing a cash facility to cover any liquid expenses such as salaries or fees. More information about the generic Murabahah financing structure can be found in CDIF/2/5/100.

6.4 Risk exposures for varying contracts using different financing project arrangements and entities Risk identification and allocation is central to any project finance. Risk management lies at the heart of project financing. Unlike other asset financing, a project being developed is vulnerable to a number of technical, environmental, economic and political risks. The risk associated with project finance, the method of controlling it and the party accepting the risk are shown in the following table:

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Table 6.1 Matrix of project finance risk Risk category

Risk to be controlled

Method of controlling

Party normally accepting the risk in financing

Construction

• Cost overruns

• Fixed-price contract

• Contractor/equipment supplier

• Completion guarantee/standby funding

• Sponsors

• Completion delay • Technology • Force Majeure

• Proven technology

• Financiers • Insurance company

• Insurance Operation

Targeted plant performance

• Performance guarantee

Financiers

• Engineers review • Turnkey contract* Supply

• Resource costs increase

• Supply contract

• Availability of raw material input

• Contingency reserves

• Price fluctuation of raw material supply

• Commodity hedging

Financiers

• Analyse future availability of raw materials, reserves, future demand etc. Market offtake

• Demand/price falls for project output

• Market control

Financiers

• Fixed price contract

• Competition International

• Currency and financing rate volatility • Political risk

• Currency hedging

Financiers

• Political risk insurance • Composition of project consortium

* Turnkey contacts involve a project being constructed by a developer and sold or turned over to a buyer in a ready to use condition. There are three basic tenets in dealing with risk in project finance: • risk identification and analysis • risk allocation • risk management.

6.4.1 Risk identification and analysis Normally the project sponsors will prepare a feasibility study that will be reviewed by the financiers who may engage independent expert consultants to verify and vet all the potential risks. Issues that are relevant at this stage are whether the costs of the project have been properly assessed and whether the cash flow streams for the project have been properly calculated. Some risks are analysed using financial models to determine the project’s cash flow and the ability of the project to meet the repayment schedules. Different scenarios are examined by adjusting economic variables such as inflation, interest rate or cost of funds, exchange rates when foreign currency transactions are involved and prices for the inputs and outputs of the project. Such issues will be discussed in more detail in chapter twelve.

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6.4.2 Risk allocation After ascertaining the various risks and impact of these risks on the project and relevant stakeholders, the risks are allocated by the parties through the negotiation of the contractual framework. Risk allocation is the process of identifying, delineating and apportioning risks among various project participants with conflicting interest. Ideally, a risk should be allocated to the party that is the most appropriate to bear it, that is the party in the best position to manage, control and insure against it, and with the financial capacity to bear it.

6.4.3 Risk management All the risks identified and allocated must be managed to minimise the possibility of the risk occurring and to minimise its impact if it does. Since financiers take relatively greater risks in any project, they need to get more disclosure and control over the project. This may involve the financiers monitoring the project closely if they are not directly involved. They may also impose strict reporting obligations on the project company and have control over the project’s accounts. Various mitigating measures for relevant risks will be discussed in the next section.

Key point • Risk in project financing involves risk identification, risk allocation to the appropriate parties and participants and risk management using acceptable risk management tools. The following table summarises the key risk elements in project financing, their likely impact, the party most likely to assume the risk and the tools to mitigate this risk either in pre-completion or post-completion risk.

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Table 6.2 Pre-completion risk Issue

Impact

Party to assume risk

Mitigation

Project is not completed on time

• Incremental project cost due to increased capitalised financing fees and fixed costs

EPC contractors on a turnkey basis

• Sufficient budgeted contingencies for increased cost • Adequate ‘construction all risks’ and ‘delay start-up’ insurance cover

• Loss of revenue

• Sufficient ‘delay liquidated damages’ payable by EPC contractors

• Damages payable to off-taker Project is not completed within budget

Higher project cost leading to potential cash flow shortfall to complete the project

EPC contractors on turnkey basis

• World reputable EPC contractors. • Adequate cost contingencies and cost overrun facilities • EPC are on fixed price, lump sum and date certain basis

Project fails to meet operational specifications

Higher operating expenses

EPC contractors

• Sufficient performance liquidated damages payable by the EPC contractors • Parent technology • World-reputable EPC contractors • Sufficient warranties from equipment suppliers

Interconnecting or auxiliary facilities fail to be completed on schedule

• Loss of revenue • The project cannot be tested to ascertain project completion

• Party responsible for the construction of the interconnecting or auxiliary facilities

In the event that the party responsible for these facilities is the off-taker, it will be deemed complete and revenue payment will commence

Failure to obtain necessary permits on time for the implementation of the project

• Project fails to complete on time and within budget

• Before financial closing –sponsor

• Higher project cost

• Post-financial closing – EPC contractors/ shareholders/ project financiers

• In most cases, project financiers would require that all material permits and licenses are obtained prior to initial disbursement • The sponsor’s extensive network and legal counsel are critical in securing all the permits required • Budgeted project contingencies and cost overruns

Force majeure affecting the project

• Project fails to complete on time and within budget

Project insurers

Comprehensive project insurable package

• Higher project costs • Physical damage to the project

Political force majeure affecting the project

Loss/delay of revenues

Sponsor risk

• Sponsor does not have the resources to perform their obligations that could cause construction delays, project abandonment or cost overruns

Political risk insurer

Sponsor

• Financing rate volatility may lead to cost overruns

• Upfront equity injection prior to initial disbursement

Shareholders/ financiers

• Lack of financing to complete the project

Foreign exchange risk

Currency movement could increase the total project cost for EPC

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• Reputable sponsors with proven track record • Credit enhancement of the sponsor’s equity contribution

• Sponsor may not have adequate resources to satisfy its financial obligations Financing risk

• Secure political risk insurance • Credible track record of host government

• Adequate financial hedging programme • Committed equity and senior debt • Adequate project contingency and excess cost overruns by sponsors

EPC contractor

• Matching of currency between EPC contract(s) and financing • Financial hedging instruments

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Table 6.3 Post-completion risk Issue

Impact

Party to bear

Mitigation

Feedstock supply risk

• Project will be restricted from normal operation due to lack of feedstock supply.

Financiers

• Primary feedstock readily available and tradable

• Incremental cost in sourcing alternate feedstock

• Back-up supply of feedstock

• Incremental cost in adjusting project to take in different feedstock supply • Reduced project cash flow. Technology/ operation risk

• Non-fulfilment of obligations under off-take agreement • Revenue loss • Higher operation and maintenance expenses • Inability to secure parts from third-party supplier due to propriety technology

Market risk

Lack of demand that could lead to reduced revenues

Equipment/ technology supplier while warranty is valid; thereafter shareholders/ financiers

• Market recognised proven technology

Shareholders/ financiers

• Tradable commodities

• Extended supplier warranty • Adequate insurance programme

• Detailed market studies by independent market consultants • Secure long-term offtake contract

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Off-taker/ counterparty risks

Off-taker unable to meet its financial obligations causing cash flow impact

Shareholders/ financiers

Extensive due diligence on the financial position of the off-taker

Regulatory risk arising from change in law

• Higher operation and maintenance cost

Shared between shareholders/ financiers and offtaker (if off-taker is a governmentowned equity)

Risk-sharing agreement

Natural force majeure affecting the project

• Physical loss or reduction of revenues

Insurers

Comprehensive insurance programme to cover all physical loss from the project and loss of revenues

Natural force majeure affecting offtaker (usually state entity)

Off-taker unable to uplift product from the project

Off-taker

Off-taker remains liable for payment of products not taken

Foreign exchange risk

Increase in plant operation expenses

Hedging counterparty

Financial hedging programme

Political force majeure affecting the project offtaker

Loss or reduction of revenues

Political risk insurers

Adequate political risk insurance

• Lower project returns

• Higher cost

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The above summary is not meant to be exhaustive. An example of a specific situation is in airport project financing. The typical risks associated with building a new airport are related to traffic issues such as landing fees, airline commitments and conflict between main and secondary airports. They are also related to political issues such as competition between airports and national and provincial class, or environmental and operating issues such as an inexperienced operator.

Islamic finance challenge 6.5 Your employers, an Islamic financing company, are required to finance the construction of a new highway. This new highway is to link a country’s main port to the capital city to ease traffic on existing government roads. The new operators will be allowed to charge vehicles a toll for using the highway and this concession is valid for 10 years. Before deciding the most suitable contract to finance the construction, as a risk manager you have been requested to outline the various risks that may affect its viability. Outline these risks and explain how they may affect the cash flow of the project.

Solution Of critical consideration is the quality of future traffic flow. This requires appropriate and independent traffic studies from reputable consultants. It should be noted that the existing free highway next to the tolled road may reduce future traffic using the new highway. This also relates to a possible tariff escalation in the future that will depend on whether the government will be willing to compensate the project company should the collected toll fall short of the expected volume. Indirectly, this leads to a political risk as the intervention of the government to help the project company may be seen as a ‘bail out’. Equally critical is the infrastructure risk of whether the rights to interchanges and rights of ways can be easily awarded by the relevant agencies. A lack of interconnection or interchanges will render the new highway unviable. The challenges in operating a project are always relevant in project financing that involves technical and maintenance costs. The global economic situation may also affect the level of traffic as the new highway will be largely dedicated to the transport of imported and exported goods. Fundamentally, the viability of any project financing scheme will always be based on accurate cash flow projections. The above discussion should impress upon you that Islamic project financing schemes must be equally concerned with the risks involved as well as Shari’ah compliance concerns.

6. 5 An illustration of a project financing model using multiple Shari’ah contracts and their relevant project risks The following example has been created to illustrate the various options open to those seeking finance for large projects. Many of the issues outlined will be further expanded in subsequent chapters. The government of a developing country awards a concession to a power plant company, Global Light, which is based overseas. The company has been operating for the past 20 years in the design, building and maintenance of power plants in its home country as well as overseas. The company has a few complete power plants in its home country that are generating power for the power purchaser and ultimately for the public at large. The market value of these power plants is only US$300 million. The government, which is the concession awarder, agrees to assign land for the company to build the power plant on, thus reducing the cost of land purchase. However, the government stipulates in the concession agreement that, after 30 years of operation, the power plants and land must return to the government for no consideration. The government signs an offtake agreement as well, which means that it will undertake to purchase the output of this power plant at a certain agreed price upon its production. To facilitate fund raising for this project, the company (concessionaire) establishes a limited liability company known as Global Power to own and operate the project. The equity holders of this project company are both the concessionaire (80% equity) and several other electricity companies in the host country (20% equity). There are several Islamic and conventional financial institutions that are willing to provide Islamic financing and conventional loans respectively through syndicated financing, combining both Islamic and conventional facilities. The lead

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arranger of this syndicated financing is the Infra Bank, which is a conventional international bank. The IFIs agree among themselves to finance this project using Islamic financing concepts. The funds allocated to the Islamic finance tranche are US$1 billion, while the remaining US$1 billion will be made through loans by a syndicated group of conventional banks. All financing by both Islamic and conventional banks will be secured by a combination of the cash flows from the operation of the project and the assets comprising the project and other assets owned or held by the project company pursuant to assignment agreements. The primary categories of assets of the project company include various contracts (including feedstock or raw materials for industrial process and other input and off-take agreements), other real property rights and interests, approvals and licences, intellectual property rights (including technology rights and licences), cash, bank accounts, accounts receivable, immovable, the assets comprising the project itself, computers, office equipment, and other personal property. One of the options for Islamic financing is Murabahah working capital financing to finance the acquisition of the raw material and equipment on credit sale or to facilitate cash financing to the project company. Islamic financiers may agree to finance an amount of US$100 million to be pro-rated or otherwise among all the financiers using this structure. Also, given the fact that this project company has a few complete power plants, the project company decides, based on the advice of the finance adviser, to issue Sukuk Ijarah worth US$300 million using the structure of sale and lease back. Under this structure, the project company as the originator may give an undertaking to repurchase the leased assets at a price equivalent to the outstanding amount of the Sukuk at the point of default by the originator, thus proving a good rating for this Sukuk. This is also compliant with the recent pronouncement of AAOIFI on Sukuk (refer to section 9.2 of chapter nine). Following this Sukuk structure, the project company is not being financed directly by the Islamic banks but from capital market investors. Islamic banks and other investors may subscribe to this Sukuk to finance the cost of construction of this power plant. Alternatively, the project company may enter into an Istisna’ contract with the syndicated Islamic financiers, followed by a forward-lease contract to facilitate the project financing using the Shari’ah-based construction contract. The use of the Istisna’ and forward-lease structure may complete the total funding required to undertake an Islamic finance tranche for this project. In other words, these three contracts can be collectively structured into a US$1 billion Islamic project financing. The project company or the syndicated Islamic financiers, as the case may be, may instead opt for just one financing structure for the US$1 billion facility. This is a commercial decision of both the project company and the financiers. In addition, the project company may raise funds from Islamic investors through either a Mudarabah or Musharakah contract. This could be a total investment by only Islamic investors or a combination of both Islamic investors and non-Islamic funds, or a conventional loan as the case may be. The investors may invest directly in the project managed by the project company or in the SPC, whereby the Islamic investors delegate the investment and management of the SPC’s fund/assets to the project company. The issue of a combination of Islamic funds and a conventional loan in the SPC will be discussed in chapter eight. The project company will use the funds to purchase the land and undertake the development of the project. The project company may construct the project itself or may enter into an Istisna’ contract with another construction company. The project company will sell the developed land to the ultimate purchasers. The proceeds from the sale of the land will be shared among the various investors proportionately. At the level of the project company, Islamic financiers may invest as equity providers under either a Mudarabah contract, a Musharakah contract or through quasi-equity financing. Alternatively, an asset management company may set up an Islamic infrastructure fund to raise the funds by issuing shares or units to corporate and public investors in the form of mutual funds. All these structures are possible from the Shari’ah perspective. The challenges arising from this equitybased structure are related to the fact that the project company may have to arrange loans amounting to US$1 billion with interest via conventional banks. Islamic investors in the project company, either as direct investors or through Islamic funds, are not supposed to deal with an interest-based loan. The situation would be different if the total financing provided to the project company was made up entirely of Shari’ah-compliant financing instruments.

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The above scenario has illustrated how many Shari’ah-compliant financing modes could be used either to finance the project company or to invest in the project company itself as the equity investor. Also, in providing this financing in various forms, Islamic financiers must take into consideration relevant project risks that are associated at every phase of the project, pre- and post-completion. Some of these risk management tools, such as currency hedging, will be discussed in forthcoming chapters. Islamic insurance or Takaful will also be considered to provide the indemnity where relevant.

Islamic finance challenge 6.6 During the global economic crisis of 2008/2009, many public infrastructure projects were delayed or cancelled because of either the lack of liquidity of financial institutions or a lack of confidence among the investors, both institutional and public. However, new projects such as schools, universities, hospitals, bridges, highways and power plants are always central to the growth of a country, as well as to the needs of the public at large. At the time, many governments announced stimulus packages to revive their economies through public spending on infrastructure projects. The support of the private sector, such as banks, insurance companies and other mutual funds, was equally important to complement the governments’ efforts to stimulate their economies through the development of the infrastructure sector of their countries. Having put these initiatives in place, infrastructure project financing may remain insignificant because of the greater risks that the financiers have to assume. Risks may include project risks, as well as the risk of mismatching the assets and liabilities of the financiers as the deposit is short-term while project financing is medium to long-term. Given the benefit of hindsight, suggest what the major problem was behind the economic crisis of 2009 and outline a possible solution that could be useful to both financiers and government.

Solution While there may be many answers to this question, you should cover many of the key issues in the following solution. One of the lessons learnt from the global crisis of 2008/2009 was the over-reliance on leveraged or excessive borrowing. Although Islamic debt financing instruments, such as Murabahah, Istisna’ and Ijarah, are compliant, their excessive use may render the project being financed in default if there is any delay of the completion to affect the cash flow of the project. Given this background, more exposure to equity financing or investment would be appreciated. Therefore, the sponsors of the project should be able to provide a higher amount of equity to the project management company. Also, funding for the project management company may be a combination of both debt and equity-based instruments. However, Islamic financiers and investors tend to be reluctant to commit to higher equity financing as the risks are too great. To resolve this issue, a new financing structure may be needed to give some comfort to all stakeholders in this project financing. One of the proposals may be to invite all potential financiers to be shareholders in the project management company for a certain project. Obviously, an off-take agreement by the government or any government-linked company will further enhance the future marketability of the product, thus significantly reducing market risk. Following that, all potential financiers and investors, including the government, would provide proportional financing to the project. The project management company, which is owned by all the shareholders/sponsors, would be responsible for managing the construction according to agreed specifications and milestones. Irrespective of the mode of financing, this mutual shareholding and financing would create a sense of collective responsibility and monitoring for the benefit of all. Any form of government guarantee is also a credit enhancement to the financiers. This would effectively instil confidence among investors and financiers in a very commercial manner without burdening the government and its public expenditure. Normally, the government would prefer to transfer project risks and costs to the private sector from the very beginning. However, in this instance, the government would be expected to take some of the cost and risk to stimulate private-sector financing. In short, project financing may take the form of private equity, instead of being a pure banking and capital market product, as all investors are general as well as limited partners, as widely applied in any private equity fund structure.

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Key point • Islamic project financing can offer a variety of schemes of financing to meet the needs of relevant scenarios and their inherent risks.

6.6 Sharing of collateral in syndicated financing One issue that needs to be highlighted is the position of the charge over project assets, as the charge is being shared between Islamic and conventional financiers. In practice, all the project assets, as described above, are essentially held for the interest of all the conventional lenders and Islamic financiers. We need to consider whether the sharing of the charge among Islamic financiers and conventional lenders would be compliant. Islamic finance allows for a syndication of financiers of both conventional and IFIs in providing the funding for a project. Modes of financing by IFIs will be compliant even though the financing amount is applied to the same project or parts of the project where conventional financing is also applied. The obligation of the project management company to pay all the financial obligations is normally secured by the project assets. The concept of collateral is known as Rahn in Islamic commercial law. Rahn implies that a debtor/pledgor will pledge his assets in favour of his creditor/ pledgee to secure the payment of all the debtors’ obligations. In the case of default, the creditor/ pledgee is entitled to sell the pledged asset to the market upon obtaining the necessary approval from the court or related agencies. In Islamic commercial law, a pledge will give priority to the pledgee with respect to sale proceeds over other creditors. Assuming that all the conventional lenders and Islamic financiers have the same charge over the project assets, then there is no preference of one group of financiers over the other based on the principle of pari passu whereby each and every creditor/lender in providing the financing will rank equal to each other and have a pro rata share in the proceeds of the sale of these assets. However, if Islamic financiers have agreed to take the second charge/pledge, they will only be entitled to claim from any outstanding proceeds of the sale of the pledged asset after satisfying all the financial obligations of the first-party chargees, who would be the conventional lenders. In brief, Islamic commercial law allows both pari passu as well as different rankings of charge.

Key point • Collateral in syndicated financing can be shared between Islamic financiers and conventional lenders either on a pari passu basis or on a different ranking.

6.7 Conclusion You should realise from having read this chapter that project financing is an important asset class in Islamic finance. Within Islamic project financing, financers become directly integrated into real-life, business-generating economic activities. Project financing also sits well with the objective of the Shari’ah which is to promulgate business development and risk taking. Individual project financing arrangements allow for the use of various sources of funding ranging from syndicated Islamic financing to Sukuk. Key to this is the requirement that the business-generating assets that are financed in this way must be Shari’ah compliant and will generate Shari’ah compliant cash flow streams. The chapter also showed that Islamic project financing deals must be large enough to be successful in attracting additional capital participation. However, the inclusion of multiple financing sources adds structural complexity to an already complex financing structure. As such, transparency of the financing structure and proper legal documentation, in addition to adequate regulatory oversight, are key considerations in structuring any project financing deal. We explained that at the launch of the project financing deal, the income generating asset does not exist and as such the financiers are potentially exposed to additional risk during the development phase. This, and the quality of the financed asset, are issues that have historically plagued Islamic

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project financing. This may be why Islamic project financing deals are often limited to sovereign backed infrastructure projects or those backed by established corporations. We suggest that the industry needs to identify different and innovative Shari’ah-compliant ways to manage the risks undertaken by financiers or investors if they wish to improve the uptake of Islamic project financing.

6.8 Summary Having read this chapter the main points you should understand are as follows: • project financing funds long-term infrastructure and development projects through loans secured on project assets which are repaid entirely from the project cash flows • the source of payments in Islamic project financing is the financial revenue derived from the subsequent project cash flows, while the collateral in non-recourse loan/financing, in the case of default, is generally limited to the project’s assets • unlike Parallel Istisna’, Istisna’ combined with forward-lease arrangements suits the practice of project financing and has been widely accepted by the Islamic finance industry • the consideration for an Istisna’ purchase could be in the form of cash, tangible goods or the usufruct of an asset for a fixed future period; the usufruct could be derived from any asset or from the asset under construction • project financing via equity-based contracts could be based on Mudarabah or Musharakah, with or without a convertibility option, or by quasi-equity financing with both a convertibility option and a loss accumulation feature • risk in project financing involves risk identification, risk allocation to the appropriate parties and participant and risk management using acceptable risk management tools • Islamic project financing allows for the participation of various sources of funding ranging from bank financing, syndicated financing or Sukuk.

6.9 Islamic Finance case study Islamic project financing Solid Engineering Co. (SECO) is a real estate developer. It wishes to develop and construct multilevel residential apartments on a piece of land that they have on lease for 100 years. This project is known as Residential AAA. Prior to the construction, SECO signs a sale and purchase agreement with 1,000 purchasers for 1,000 apartment units. Under the agreement, these units are to be delivered to the end purchasers after 24 months from the date of the agreement. To facilitate the cost of construction, a financial adviser arranges a number of Islamic financial facilities comprising both equity and debt-based financing. A number of Islamic infrastructure funds commit to placing the equity investment in the project under Musharakah financing. This facility entitles the investors to convert their certificates of investment to shares of SECO if they so wish. SECO also forms a limited liability SPC, known as Solid Construction Inc (SCI), to get the financing from a few Islamic financiers. SECO is still in the process of getting approval from the Environmental Department as the land is part of a hill where construction may result in some environmental damage. Approval by other relevant agencies to construct these residential apartments is pending the approval of the Environmental Department. The Islamic financiers decide to finance the construction cost using an Istisna’ contract and a forward-lease arrangement. To secure the interest of Islamic financiers, all the project assets, including the sale and purchase agreement, will be treated as collateral with the Islamic financier having priority over equity financiers. With regards to the forward lease, the rental payment will be floating based on an agreed benchmark. There will be a put option agreement allowing Islamic financiers/owners to force SCI to purchase units of the apartments at a price equivalent to any outstanding financing amount. This agreement is useful in the case of a default by SCI in the payment of rent. Also, there will be a call option agreement allowing SCI to purchase the apartments from the Islamic financiers at a certain agreed price. Islamic financiers will appoint SCI to manage these residential apartments for a pre-arranged management fee. To mitigate the environmental risk, Islamic and equity financiers require that SCI invest in an insurance scheme to cover all possible penalties that may be caused by not adhering to some aspects of the environmental regulations.

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Case study multiple choice questions 1.

2.

3.

4.

5.

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When financing a project, which of the following is not compliant with Shari’ah principles? (A)

Parallel Istisna’ between the contractor and the financier

(B)

Sale and lease-back arrangement

(C)

Quasi-equity financing with a loss accumulation feature

(D)

Murabahah working capital requirement financing

What are the most relevant risks involved in the above project financing? (A)

Construction and market risks

(B)

Political and technology risks

(C)

Environmental and construction risks

(D)

Supply and market risks

A ‘back-to-back’ Istisna’ arrangement, although compliant with Shari’ah principles, is deemed impractical and not useful in modern project financing. How could this arrangement be used to facilitate smooth project financing from the financier’s perspective? (A)

By using Built-operate-transfer (BOT)

(B)

By awarding the construction contract to a consortium of Islamic financiers

(C)

By including project financing with the off-take agreement

(D)

By ensuring that the contractor is also the operator when the asset is complete

Identify the differences between an Istisna’ forward-lease arrangement and a sale and lease-back arrangement in Islamic project financing. (A)

While an Istisna’ forward-lease arrangement applies to assets under construction, a sale and lease-back arrangement applies only to the refinancing of the asset.

(B)

While an Istisna’ forward-lease allows fixed and floating rental payments, sale and leaseback only allows a fixed rental payment.

(C)

While an Istisna’ forward-lease arrangement appeals more to short-term financiers, sale and lease-back appeals more to medium and long-term financiers.

(D)

While an Istisna’ forward-lease arrangement is universally acceptable, sale and leaseback is only acceptable by some Shari’ah boards.

Given the scenario that the financing amount was sourced in US$, but that the payment of capital/principal and profits would either be under equity financing or that debt-based financing was to be in United Arab Emirates Dirham (AED), risk could be hedged by: (A)

comprehensive insurance policy and the quality of the sponsors

(B)

currency hedging and the fixed price of EPC

(C)

fixing the cost of financing and comprehensive insurance policy

(D)

guarantee from the sponsors and currency swap.

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Case study short essay questions 1.

Given the schematic flow of the above transactions, outline any major Shari’ah issue that would need to be addressed and explain how these issues could be ratified to make it compatible to Shari’ah principles?

2.

Propose other potential financial structures that could facilitate the financing of the cost of the construction of the project outlined.

3.

Instead of obtaining only Shari’ah-compliant financing instruments to finance the construction of these residential apartments, SCI could decide to operate a syndicated financing scheme combining both conventional lenders and Islamic financiers. If it goes ahead with this, what would be the immediate impact on the above transactions and how could this be addressed from a Shari’ah structuring point of view?

4.

In the case where there is no sale and purchase agreement signed between SEO and the ultimate purchasers, what tools could be proposed to mitigate this market risk as far as the financiers are concerned?

5.

Assuming that the project to be constructed is a new power plant using solar energy and that the financiers to this project insist on providing capital market products only, how would you propose to structure the financing scheme for SCI?

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Chapter six answers Exercise 6.1 (C) The issue that may be questionable from the Shari’ah perspective is the supply of funding from syndicated financiers. The issue here is that the form of financing could be through either an interest-based loan from a commercial bank or a bond with the obligation of the issuer to pay back the principal and interest. The other features, such as the off-take agreement, the nature of collateral and the SPC are neutral to Shari’ah considerations.

Exercise 6.2 Although the above structure meets all the technical features of a modern project financing scheme, it does not effectively serve the financial requirements of the contractor. The relationship between the awarding party, the building contractor and the financiers, however, is not as per the scheme. Conventionally, the awarding party finds a building contractor who then seeks finance to complete the project. Under Parallel Istisna’, the awarding party approaches the financier who then seeks out a building contractor to develop and deliver the required hospital to the financier prior to its ultimate delivery to the awarding party. Using the above illustration of Parallel Istisna’, it is clear that the Islamic financier will not finance the contractor or concessionaire on the construction cost of this hospital, except in the case where the government or any other awarding party has initially requested the Islamic financier to construct and deliver the same hospital to the awarding party; that is a ‘back-to-back’ Istisna’ arrangement. In practice, this seldom happens as the awarding parties, such as government agencies, always award the construction contract to a developer which will then seek financing from a financier, be it a conventional or Islamic financier. The awarding party will not approach the financier for this project financing.

Exercise 6.3 Relatively speaking, Sukuk Ijarah seems most attractive as the originator would be awarded a piece of land that can be used as the underlying asset for the sale-and-lease-back arrangement. The land may be sold to Sukuk investors at a price that is required by the originator to develop the medical city. Suppose that the required cost of construction is US$700 million, then the land can be sold to the investors at US$700 million. The same piece of land may then be leased to the originator at the floating rental, based on the rate of a certain agreed benchmark that is pegged to the US$700 million financing amount. Depending on the Shari’ah arguments of the issuer’s and investors’ Shari’ah board, the land, which is essentially bare but earmarked for the future project, may be sold at any price based on the ‘willing seller/willing buyer’ principle. Also, the same bare land may be leased out for a certain rental payment. Some scholars may find this objectionable as the price of the land should reflect its market value. Also, some scholars may argue that bare land does not have any usufruct to be leased out, thus rendering this land an invalidly leased asset. However, this kind of Sukuk has been issued by the Qatar government. The government has given the undertaking to repurchase the lease asset at a price that is equivalent to the outstanding amount of Sukuk in the case of default. This structure is also compliant with the 2008 AAOIFI pronouncement on Sukuk.

Exercise 6.4 Unlike an Istisna’ or Ijarah contract, Mudarabah or Musharakah are more flexible as they can be used to finance the construction of an asset, as well as finance working capital requirements. As explained, project finance requires the involvement of many participants, such as construction or engineering consultants, as well as environmental impact assessment consultants. The fees payable to these consultants may be financed using Mudarabah or Musharakah investment capital. The Mudarabah and Musharakah contracts are, therefore, useful in financing all aspects of project financing, including items a-d of the above scenario.

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Case study multiple choice answers 1

(A) For a Parallel Istisna’ to be Shari’ah-compliant, it has to consist of two Istisna’ contracts undertaken by three different parties. The first Istisna’ is contracted between the purchaser and the financier, while the second is contracted between the financier and the contractor. Parallel Istisna’ between two parties (that is financier and contractor only) is noncompliant.

2

(C) The project involves construction on land that is part of a hill. The construction may result in some environmental damage to society.

3

(B)

4

(A) By definition, Istisna’ is applied when the asset needs to be constructed, while a sale requires the asset to be in existence at the time of the sale. Pricing through fixed or floating benchmarked rates does not define the contracts and the contracts can be applied for either short or long-term financing.

5

(B)

To facilitate the Istisna’ scheme, Islamic financiers must be awarded the Istisna’ contract first from the purchasers. These financiers can then award the subsequent Istisna’ contract to the contractor for construction purposes.

Shari’ah-compliant currency hedging mechanisms have been established and the processes would have to strictly comply with guidelines such as spot currency transactions. Fixing the EPC cost through currency hedging is important to ensure that EPC costs do not carry the volatility of the currency markets.

Suggested solutions to case study short essay questions 1. One potential major Shari’ah issue is that the residential apartments were sold to the ultimate purchasers before the project financing based on Istisna’ and forward-lease was signed. This will create an anomaly in a Shari’ah juristic discussion because under the Istisna’ contract concluded between SCI and the Islamic financiers, the owner of these units, after their completion, will be the Islamic financiers/purchasers of the Istisna’ asset. Subsequent to that contract, the Islamic financier will lease the assets under construction to SCI and will expect SCI to pay the rental for this forward lease. For all intents and purposes, prior to selling the units to the ultimate purchasers after 24 months of the sale and purchase agreement, SCI shall ensure that it has actually purchased the units from Islamic financiers under the call option agreement. The ownership of Islamic financiers will cease and subsequently the lease contract will be terminated. This is to allow SCI to become the legal owner of the units prior to passing the title to the ultimate purchasers. One practical commercial issue is whether SCI is able to make the full lease payment for it to exercise the call option agreement within two years. Obviously, if all the ultimate purchasers have made the full payment to SEO, then it would be easy for SCI to settle the outstanding payment under a lease agreement and invoke a call option agreement. The issue of land that is on lease to SEO/SCI is not relevant from the Shari’ah perspective as an Istisna’ asset could be built on the land of the contractor or the purchaser, or on a piece of land belonging to a third party. 2. In addition to equity investment via Islamic funds and the Istisna’ and forward-lease arrangement, the above project may be financed using the concept of sale and lease-back. Depending on the Shari’ah view on long-term leases, such as 100 years, the land may be sold to the Islamic financiers with a view to leasing it back to SCI thus providing a financing amount to SCI. The sale and lease-back arrangement has been used in many Islamic finance facilities even on the basis of a long-term lease. Another potential structure would be the Murabahah commodity structure to facilitate cash financing to SCI. Obviously, financing through equity such as Mudarabah and Musharakah is also possible where the market risk is being reduced because of the sale and purchase agreement signed between SCI and the ultimate purchasers. 3. Where financing will be syndicated to both Islamic and conventional financiers, the position of Islamic equity investors may be affected. If Islamic infrastructure fund investors have invested in SCI as the project management company, then SCI is not in a position to borrow conventionally as this goes against Shari’ah principles because Islamic investors are the owners of the company. However, if Islamic infrastructure fund investors were to invest at the project level with no ownership in SCI, then the Islamic equity investment may co-exist with conventional financing,

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although Islamic investors rank lower than conventional and Islamic debt-based financiers in terms of the right to profit and liquidation. 4. The market risk of this project may be mitigated through options such as a guarantee by a third party or an off-take agreement by the sponsors. Alternatively, financiers may prepare the proposal for securitisation of these properties using an asset-backed transaction to be offered to the country’s mortgage corporation or to an Islamic real estate investment trust (REIT) fund. 5. Constructing a power plant using alternative energy such as solar is more risky than constructing residential units as it involves many risks such as technology and feedstock risk. The margin of profitability will likely be higher in this financing. A potential structure that can be used is Sukuk Ijarah, which is based on sale and lease-back with the underlying asset being the land on a longterm lease. Also, equity-based financing, as well as quasi-equity financing may be useful for this long-term financing. The development of this power plant could be financed using either a private equity fund to invest in SCI or an infrastructure fund. Interestingly, under an Islamic private equity fund, investors may finance SCI through Murabahah, but the right to receivables arising from the Murabahah facility could be ‘converted’ into the shares of SCI through the principle of Wa’d or unilateral undertaking by SCI to sell its shares to these investors. This structure will eventually be a capital market instrument as well.

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Chapter seven Equity market regulations and issues of screening methodology for public-listed companies Learning outcomes By the end of this chapter you should be able to: • assess the implications of various stock-screening criteria for Islamic-approved equities • analyse the impact of specific stock-screening criteria on the acceptability of a particular stock • recommend strategies for the inclusion of stock in Shari’ah-approved stocks and Islamic indices.

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Indicative list of content • Regulatory requirements pertaining to Islamic equity capital markets • Factors affecting the inclusion or non-inclusion of stock in Islamic-approved stocks and Islamic indices • Comparative stock-screening methodologies and criteria • Strategies for making a public-listed stock compliant • Case study: Screening of a public-listed company in various market conditions and commercial realities

7.0 Introduction A natural progression in the growth of the Islamic financial services industry is the emergence of a distinct Islamic equity capital market, where investment activities and products are structured in accordance with Shari’ah principles. As with the Islamic banking industry, an effective legal, regulatory and supervisory framework is required to provide the essential foundation for the functioning of a modern equity capital market and to ensure that it is adequately regulated. Equity capital market regulation seeks to oversee the interests of listed companies, the provision of investor protection and the maintenance of investor confidence, as well as the need to protect the reputation and integrity of the market as a whole. As stated in CDIF/3/1/21, capital markets perform the function of effectively mobilising funds in any society through a direct financing process. To protect investors, the markets therefore require a high degree of effective governance through monitoring and the production of relevant and material information to all stakeholders. This chapter focuses on equity screening for both public-listed and private limited companies, as well as strategies to convert a public-listed company into a compliant company so that a wider group of investors can become involved. The discussion of mutual funds, private equity funds, various other funds, Sukuk and derivative products, which form part of Islamic capital markets, is included in chapters eight, nine and twelve respectively. In this chapter we explain the regulation of the Islamic capital market with regards to the equity market. Specific focus is given to the importance and acceptability of stock-screening criteria for ascertaining Shari’ah-approved stocks. We also look at comparative stock-screening criteria, explaining the basis and applicability of such criteria in different financial conditions. The impact of specific criteria on stock-screening is highlighted to explain the inclusion or non-inclusion of a particular stock in the approved lists of stock. Finally, we consider relevant strategies to achieve Shari’ah-compliance status for stock based on established stock-screening criteria.

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7.1 Islamic capital markets and regulatory requirements We mentioned in chapter three that capital markets in various jurisdictions are regulated by either their respective central banks or separate regulatory authorities that focus exclusively on capital market regulation. Supervision in Bahrain is undertaken by the Capital Markets Supervision Directorate of the Central Bank of Bahrain and in Singapore by the Capital Markets Department of the Monetary Authority of Singapore. In Malaysia, supervision is achieved through the Malaysian Securities Commission (SC), in the United Arab Emirates via the Securities and Commodities Authority (SCA) of the United Arab Emirates, and in Saudi Arabia via the Capital Market Authority (CMA) of the Kingdom of Saudi Arabia. Often backed by law, a regulatory act or royal decree, the main objective of capital market regulators is to maintain a transparent, fair and efficient capital market to ensure investor protection and market stability. The Islamic capital market is usually a subset of the jurisdiction’s capital market as a whole and, as such, regulators have to be mindful that the regulations relating to the Islamic sector are as fair and unbiased as possible, while maintaining the objectives that have been set for that country’s capital market.

7.1.1 The structure of a capital market Typically, a capital market is an amalgam of three distinct individual markets, each of which carries its own lines of products and services, as shown in the diagram below.

Figure 7.1 Typical capital market structure

Capital market

Equities market

Fixed income market

Derivatives market

Supporting the individual markets is a settlement system that ensures the secure handling of transactions in predominantly dematerialised securities (securities that only exist in the form of an entry on an account). This system enables the processing of transactions on both the primary market (on which new securities are issued) and the secondary market (on which financial instruments already in circulation are exchanged). The system ensures the settlement of transactions based on instructions sent by the two counterparties to the transaction (dual-notification principle). It also ensures that delivery of, and payment for, the securities occurs simultaneously and irreversibly (delivery against payment principle). The system settles transactions on a gross basis (transaction by transaction).

7.1.2 Using the existing infrastructure The Islamic capital market in most jurisdictions takes the structure of and utilises existing infrastructure that has already been established for conventional capital markets. Regulators in Bahrain and Malaysia, for example, only prescribe guidelines for the establishment of Islamic funds to invest in Shari’ah-compliant shares already listed on the country’s stock exchange. From the Shari’ah perspective, there is no requirement to make the stock exchange compliant as the various Islamic funds screen the stocks listed on the exchange according to their own selected or accepted Shari’ahapproved screening methodologies.

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The development of various stock-screening methodologies, Islamic indices and various forms of Islamic funds are not in conflict with the existing structure of contemporary stock exchanges in many jurisdictions. The structure of the stock exchanges and their rules of listing and trading, as well as other administrative issues, will not affect the compliance of the investment made by various Islamic funds investing in some of the stocks listed in those exchanges. An issue may only arise if the entire stock exchange itself seeks to obtain Shari’ah-compliance status. This is particularly relevant where the stock exchange has become a public-listed company and has sought to be classified as Shari’ahapproved where Islamic investors could invest in any of its shares.

Key point • Islamic stock screening, Islamic indices and Islamic equity-based funds may co-exist within existing stock exchange structures as the Shari’ah screening standard can be applied to the equities listed on the exchange without affecting the very structure of the exchange.

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Islamic finance challenge 7.1 After a few years of operation, a stock exchange in a given jurisdiction announces that it will be transformed into a full Islamic stock exchange in two years’ time. At the time of the announcement, almost 70% of its listed companies are not regarded as compliant to Shari’ah principles, based on an international Shari’ah standard of stock screening as per AAOIFI Shari’ah Standard (No 21). Outline the challenges that face the stock exchange in achieving its goal and explain the necessary measures that need to be undertaken to render this exchange fully Shari’ah-compliant in two years’ time.

Solution An exchange is merely a platform to facilitate the issuance and trading of shares in one common place. It is here that companies can float their shares for public participation and where investors can trade their shares systematically in a cost-effective manner. Being a platform, the exchange may list companies that are both compliant and non-compliant with Shari’ah principles. Many exchanges around the world have adopted this approach, for example the Bahrain Stock Exchange, the Bursa Malaysia, the Singapore Exchange and the Saudi Stock Exchange. As suggested in the challenge, the shareholders of a specific exchange may decide to launch a dedicated Islamic stock exchange or convert an existing exchange into a fully dedicated Islamic exchange. In order to convert the exchange in question, several measures must be put in place. •

The stock exchange must first establish a Shari’ah supervisory board to begin work on the prescribed screening guidelines so companies can meet a standard agreeable to the Shari’ah board of the stock exchange. The Shari’ah board may adopt any of the established internationally recognised Shari’ah stock-screening criteria or may devise its own stock-screening criteria. This is to facilitate the acceptance of new companies in future listings so they would be compliant from the date of inception and to guide the conversion of existing listed companies into Shari’ah compliance. The exchange must decide how to deal with the income generated from non-compliant companies, including any relevant fees payable to the exchange during the two-year conversion period.

Relatively speaking, it is more challenging and demanding to convert an existing exchange into Shari’ah compliance than to convert a banking or insurance entity. There is always the risk that many companies will not be willing to be listed on this exchange because of this restriction of compliant core activities and financial management, unless they specifically seek Islamic-based investors. If they are of the latter category, they may decide to be listed on this exchange for a better profile and subscription by investors. The latter scenario will also help the exchange to significantly achieve its vision at the same time as it enhances public-listed companies seeking the right branding and profiling among Islamic equity investors. The exchange should assist existing non-compliant companies to make their balance sheet compliant by facilitating or advising them on securing facilities of Islamic leverage, as well as Islamic investment product opportunities. Having said this, the issue of how to convert companies that were essentially set up to undertake commercial activities that are not compliant remains outstanding. The fees earned from non-compliant companies should be channelled to a charity. This can only be done with the agreement of the shareholders of the stock exchange as this policy will render these fees as non-recognised income. Given the objective of the challenge, shareholders would agree to this policy as they have already announced their intention to make the exchange Shari’ah-complaint.

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7.2 Shari’ah governance structure in Islamic capital markets Shari’ah compliance is the key distinguishing feature of the Islamic equity capital market. In order to be deemed Shari’ah-compliant, Islamic equity capital market products and services need to undergo a pre-defined vetting and approval process by Shari’ah advisers. While some jurisdictions have established regulatory requirements for the appointment of Shari’ah advisory bodies in Islamic banking, there is presently no standardised requirement across jurisdictions governing Islamic capital market activities with respect to the qualifications and appointment of the Shari’ah advisers.

7.2.1 Self-regulation As with the Islamic banking regulatory system outlined in chapter three, the Shari’ah certification process in the Islamic equity capital market is carried out through two different methods. The first is through a market-centred approach whereby the exchange, issuing entities, or the fund management companies have their own in-house independent Shari’ah advisory bodies that screen and endorse their Islamic equity capital market products and services. This process is driven by private sector-led initiatives and is not mandated by any specific regulatory or policy requirement. This approach can be seen in jurisdictions such as Bahrain, Saudi Arabia, Kuwait, Qatar and the UK. This is also true for internationally recognised Islamic indices such as the Dow Jones Islamic Market (DJIM), the London Stock Exchange (FTSE) Islamic Index, the Morgan Stanley Islamic Index and Standard and Poor’s (S&P) Islamic Index. These organisations have developed their own respective Islamic indices with the collaboration of their Shari’ah supervisory boards without any direct control from any agency or regulator.

7.2.2 Centralised regulation The second regulatory method takes a centralised approach whereby the centralised regulatory authority assesses Shari’ah compliance and issues the appropriate Shari’ah certification for Islamic equity capital market products and services under its purview. Authorities for the Dubai Financial Market and the Malaysian Securities Commission have used this approach. The Shari’ah certification process is undertaken at the exchange or regulator’s level, wherein the exchange and regulatory authorities have established their own Shari’ah advisory bodies to formally advise on issues pertaining to Islamic equity capital market products and services. In the case of Malaysia (effective May 2007) the Securities Commission of Malaysia has allowed Bursa Malaysia (in partnership with the FTSE Index) to screen stocks using only the FTSE Islamic Index screening criteria, which are different from the Securities Commission’s. The new Islamic index is called the Bursa FTSE Hijrah Index. However, to ensure that there is no direct conflict between these two criteria, the FTSE Islamic Index can only further screen stocks that have been approved by the Securities Commission’s screening filter. This is to ensure that stocks approved by the FTSE Islamic Index screening will not contain any stock that is not initially approved by the Securities Commission’s screening methodology. Islamic funds, such as those in Malaysia and Bahrain, would also be legally required by regulators to form individual Shari’ah advisory boards to ensure that their Islamic equity capital market instruments comply with the Shari’ah standards that have been set by these exchanges and regulators. While the appointment of the Shari’ah board at the fund level is a standard practice in Islamic asset management, the appointment of a Shari’ah board at the regulator or the stock exchange level is peculiar to a few regulators and exchanges, for example in the Malaysian and Dubai financial markets.

Exercise 7.1 ABS is a public-listed company listed in Bursa Malaysia. According to its last audited financial report, this company has total assets of RM750 million and a 12-month trailing average of market capitalisation of RM978 million. The report shows that it has conventional leverage of RM195 million and interest income of RM18 million. The company also has RM274 million in cash and interest-bearing instruments. While the total revenue of the company is RM590 million, the profit before tax is RM200 million. Based on CDIF/3/9/145-146, would this company pass the screening filter of the Securities Commission of Malaysia and would the company be approved according to the FTSE Islamic Index screening? State the reasons for either the inclusion or non-inclusion of this company by the respective screening methodologies.

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7.3 Shari’ah compliance issues in the Islamic capital market Shari’ah compliance issues, as taken into consideration in the above Shari’ah governance model, include product approval and eligibility criteria for issuing parties, reporting requirements and disclosure.

7.3.1 Product approval and eligibility criteria for issuing parties All equity capital market instruments, ranging from equities to managed funds, must undergo a product-approval process overseen by regulatory authorities and by the respective Shari’ah board. Islamic equity capital market instruments are treated in the same way and are subject to an additional layer of product approval known as Shari’ah certification. This is overseen by either the Shari’ah authorities set up by the regulators or by individual Shari’ah boards, or by both, depending on which Shari’ah governance structure the jurisdiction follows.

Taking an example of the listing of an Islamic equity, the issuer must fulfil the listing requirements of: • paid-up capital, whereby the floor amount will be taken into consideration when considering main board or second board listings • percentage of paid-up capital in public hands, of which the authorities may put a floor figure of 25% • minimum profit track records for three or five uninterrupted years • minimum forecast after-tax profits • minimum period of business operations, perhaps five years.

The requirements set out in the example above are no different from those that are observed by nonIslamic equity issuers. However, an Islamic equity issuer, such as in Malaysia, may have to undergo what is known as a pre-IPO (initial public offer), or its equivalent Shari’ah compliance review, whereby the issuer would have to furnish relevant information that may not be available in the financial accounts to determine compliance of its securities with the principles of Shari’ah. As such, subject to certain conditions, companies whose activities are not contrary to Shari’ah principles will be classified as Shari’ah-compliant securities. This process can be undertaken by the regulators’ Shari’ah authorities or the relevant exchange. Financial information, such as the level of contribution of interest income received by the company from conventional fixed deposits or other interest-bearing financial instruments, is taken into account, in addition to dividends received from investments in Shari’ah non-compliant securities. As stated, the pre-IPO screening exercise described above is peculiar to Malaysia and is also noncompulsory. The practice is adopted by companies that may require the pre-IPO screening exercise as a marketing tool to attract Islamic investors who are yet to be convinced of the company’s Shari’ah compliance. To date, regulators in various jurisdictions rarely screen the equities listed in their domiciled exchanges pre- or post-IPO. In some cases, additional regulatory requirements are imposed on Islamic financial intermediaries, such as requiring professionals to have adequate knowledge in Shari’ah law as well as requirements related to the internal controls of the intermediary. For instance, the guidelines on Islamic fund management from Malaysia’s Security Commission states that an Islamic fund manager must appoint a Shari’ah compliance officer who is well-versed in Islamic fund management and has adequate Shari’ah knowledge on Islamic finance and capital markets. Whatever the approach taken by the regulator, it is critical that regulators are well apprised of developments within this market segment, particularly where there is a significant level of activity occurring in the market.

7.3.2 Reporting requirements and disclosure The main issues that must be addressed in relation to accounting and auditing standards are: • comparability and reliability of information • internationally acceptable standards • quality of accounting and auditing standards.

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7.3.2.1 Adopting international standards The application of accounting standards and practices for Islamic equity capital market transactions is not uniform across jurisdictions, but there is a common approach among Islamic financial institutions (IFIs) to apply International Accounting Standards (IASs) for financial reporting. In Bahrain, the financial statements comprise consolidated financial statements of the company and its subsidiaries in accordance with International Accounting Standard 27. However, there are also separate initiatives by several jurisdictions to formulate and adopt accounting standards that are tailored specifically for their local Islamic equity capital market transactions. In the UAE, financial statements are prepared in accordance with International Financial Reporting Standards and Shari’ah rules and principles as determined by the companies’ Shari’ah supervisory boards and applicable requirements of UAE laws. As a result, Musharakah income is accounted for on the reducing balance method on a time-apportioned basis that reflects the effective yield on the asset, while Ijarah income is recognised on a time-apportioned basis over the lease term.

7.3.2.2 Developing international standards The challenge of formulating a robust financial reporting framework for the Islamic financial services industry arises from the fact that Islamic finance is still undergoing substantial development and innovation. The current approach to developing financial standards for Islamic transactions is to benchmark against international standards such as IASs to ensure consistency with globally accepted standards and modify them, where necessary, to ensure financial statements fairly present the financial position, financial performance and cash flows of the IFI.

7.3.2.3 The requirement of additional information In the case of an Islamic product offering, issuers are generally required to provide additional statements in the offer document relating to Shari’ah aspects. For instance, statements in the prospectus of an Islamic fund should cover matters such as the role and responsibilities of the fund’s Shari’ah adviser. This can be achieved by inserting the following statement: “The role of the Shari’ah adviser to the Fund is to ensure that the operations and investments of the Fund are Shari’ah-compliant. The responsibility for ensuring proper compliance of the Fund with Shari’ah principles in all relevant aspects rests solely with the Manager.” In most situations, the product issuer must undergo an accreditation process whereby the business activities and the method of financing it adopts must be scrutinised to ascertain whether it meets with Shari’ah principles. It should be noted that these Shari’ah screening procedures are implemented differently in different jurisdictions. While some jurisdictions have incorporated the Shari’ah approval process into the regulatory framework, others have opted for an informal process that is not subject to any level of regulation by the authorities. This issue shall be explained further in Section 7.5 of this chapter.

Islamic finance challenge 7.2 Explain whether it is better to develop best practices or specific regulatory guidelines with regards to disclosure, or whether it is preferable to allow issuing parties to decide how best to disclose information to their potential investors.

Solution The question has often been raised of whether it is desirable to develop best practices or specific regulatory guidelines to ensure that the disclosures made accord the investor with full information on Shari’ah compliance. Central to this is the integrity and reliability of the Shari’ah approval process and the credibility of such approval processes. The issue is whether ‘material information’ is being disclosed and is ‘relevant to an investment decision’. If interpreted as such, general disclosure requirements can be applied to the offer documents or similar documents in relation to Shari’ah compliance. This would imply a need to ensure that the duties and liabilities of advisers and officers of the issuer, with regards to their exercise of due diligence in the provision of this additional information, are appropriately regulated.

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7.3.2.4 Voluntary disclosure Generally, non-financial statement disclosures are still voluntary. However, there is a trend towards increasing the extent of non-financial statement disclosures to ensure that the investor receives adequate information. With respect to this, regulators may want to consider encouraging disclosures in relation to meeting the specific investment needs of investor groups. One must note that the requirement for Shari’ah compliance is a continuous process. It is possible that the business activities of the issuer may change over time, for example, arising out of mergers and acquisitions, and may result in a company or investment product no longer being Shari’ah-compliant. For this purpose, Shari’ah compliance assessments need to be conducted continuously, perhaps on a periodic basis. It should be noted that if the nature of a company, an activity or asset changes in nature to the point of being non-Shari’ah compliant at any point in time, the impact of non-Shari’ah compliance will extend to all other related products of the company, such as debt, collective investment schemes and structured products. Shari’ah funds that have invested in these assets must be aware of the risks that arise from a change in the Shari’ah status of the assets. Subsequently, it should be noted that requirements for disclosures outlining the process to manage such risks should be routinely provided to investors.

7.4 Additional functions of capital markets regulatory authorities To ensure better regulation of markets, on the domestic as well as international level, and to maintain just, efficient and sound markets, regulatory authorities must: • exchange information on their respective experiences in order to promote the development of domestic markets • unite their efforts to establish standards and effective surveillance of securities transactions • provide mutual assistance to ensure the integrity of the markets by a vigorous application of the standards and by effective enforcement against offences. In relation to Islamic equity capital market products and activities, regulators should also consider issues related to the clarity and consistency of regulation and its application. Furthermore, regulators should consider and/or review capital market laws to ensure that they adequately deal with the risks associated with the new product’s structures based on Shari’ah principles. In this regard, regulators, such as the Central Bank of Bahrain, have sought to mitigate these risks through enhanced disclosure requirements for specific Islamic products. Because of the unique aspects of Islamic capital market products and services, it could be held that specialised regulation for the Islamic capital market may be more appropriate. While most jurisdictions apply exactly the same set of regulations in terms of product approval, as well as standards for intermediaries and other regulated entities (such as collective investment schemes), some jurisdictions have developed additional regulations, rules and guidelines catering to Islamic capital market activities. For example, Bahrain has issued Guidelines for Issuing, Offering and Listing of Debt Securities, which lay down clear requirements and conditions for issuers as well as for each class of debt securities, such as Islamic bonds. Malaysia has in place additional requirements for Islamic Sukuk within its Guidelines on the Offering of Private Debt Securities. Pakistan has developed specific legislation (Mudarabah Companies and Mudarabah (Flotation and Control) Ordinance 1980) to regulate Mudarabah companies, which are the main issuers of Islamic equities. In many cases, these regulatory requirements relate to additional disclosures as a result of the structure of the product.

Exercise 7.2 Outline whether you believe it is necessary for regulatory authorities to employ dedicated staff to govern Islamic capital market regulations or whether this function should be delegated to existing capital market staff.

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7.5 Factors affecting inclusion and non-inclusion of a stock in Islamicapproved stocks An equity investor in a company participates in the share capital of the company, therefore, technically, becoming a part-owner, particularly from a Shari’ah perspective. The investor is, therefore, ultimately responsible for the company’s primary business activities as well as its financial activities in the sense of its borrowing and investment. The Islamic investor needs to consider whether the potential investable companies are involved in Shari’ah non-compliant core activities. This is referred to as sector screening, which is the most fundamental and critical aspect of screening. Prior to the mid-1990s, Shari’ah scholars tended to rule out investment in the equity/stock market because of a high prevalence of non-compliant practices. It was beyond the ability of ordinary Muslim investors as individuals or funds to make these activities compliant to the teachings of Islam. Equity markets operating in various stock exchanges, even in Muslim-dominated countries, were viewed as conflicting with Shari’ah principles and therefore not eligible for investment by Muslims. This deprived Muslims from investing in stocks and equities that could have been listed and traded in an organised market.

7.5.1 Developing screening methodologies Realising the importance of investment in this market and the complications surrounding the Shari’ah compliance of companies and their shares, there were attempts in the mid-1990s to develop a methodology for screening that would be acceptable to the teachings of Islam, at least in the current financial landscape. Early efforts by the RHB Islamic Index in Malaysia, followed by the Dow Jones Islamic Market Index, opened up new opportunities for screening stocks deemed compliant to Shari’ah principles. This reflects the interface between Islamic teaching principles and modern institutions to offer opportunities to Islamic communities to be part of the modern global financial market, albeit subject to certain limitations and restrictions as per Shari’ah requirements.

7.5.2 Core activity screening At present, a few screening methodologies have been advocated and developed to screen stocks listed in various stock exchanges. These methodologies agree on the importance of screening the core activities of the company. Thus, any company that undertakes a core activity which is non-compliant would not be approved for Islamic investors. The list of sectors or core business activities that are commonly viewed as non-compliant (CDIF/3/9/138-140) includes the following: a. conventional financial institutions that are interest-based, including banks, finance houses and leasing companies b. insurance and reinsurance companies c. entertainment-related industries d. manufacturing, packing, distribution or sale of tobacco products e. manufacturing and sale of weapons or military equipment f. manufacturing, packing, distribution or sale of non-Halal food and beverages, particularly pork and alcoholic products g. pornography or the production or distribution of such h. gambling or casinos i. other immoral and unethical activities.

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The following table lists the sectors excluded by many stock exchanges as a consequence of the above prohibited list of activities. The list includes, but is not limited to, the following sectors:

Table 7.1 List of prohibited sectors Defence

Distillers & vintners

Food products

Recreational products

Tobacco

Food retailers & wholesalers

Hotels

Media agencies

Gambling

Banks

Recreational services

Restaurants and bars

Property and casualty insurance

Full line insurance

Life insurance

Investment services

Mortgage finance

Consumer finance

Insurance brokers

Specialty finance

7.5.3 Balance sheet screening In addition to screening the sector or core activities of the companies, most established Islamic indices also screen the balance sheets of these companies to examine relevant information that may affect its Shari’ah compliance. Basically, the financial screening will examine the following items: a. the debt or leverage of the company compared with either the market capitalisation or total assets b. the cash and interest-bearing assets of the company as a proportion of market capitalisation or total assets c. the cash and account receivables compared with either the market capitalisation or total assets of the company d. interest income and other non-compliant income compared against the total revenue of the company The details relating to this financial screening were outlined in CDIF/3/9/141-142.

Key point • The core activities and the relevant financial ratios of a company are both subject to Shari’ah screening to obtain Shari’ah approval status.

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Islamic finance challenge 7.3 Islamic stock indices are useful for investors to find out the performance of a certain basket of shares that constitute the index. Also, a given index is based on certain prescribed index methodologies with regards to, for example, market capitalisation, sector and geographical area. They are also useful for investors to determine compliant stocks as all the stocks that constitute the index are considered compliant to Shari’ah principles. This may appeal to institutional investors such as Islamic mutual funds. Given your understanding of how an index is developed and how an index should behave, explain, with reasons, whether existing Islamic indices, such as the DJIM and FTSE Islamic Index, can be useful for retail investors who seek to invest in approved shares across the global market.

Solution The existing Islamic indices provided by Dow Jones, FTSE, S&P and others have been instrumental in the development of Islamic equity capital markets. Fund managers as well as institutional investors have been subscribing to them on an ongoing basis. However, such indices are usually out of the reach of the average retail investor. One of the main reasons is the cost of subscribing to these indices, as the substantial fees would only make it costefficient for institutional investors. Another reason why such indices may not be applicable to retail investors is that the constituents are largely made up of highly capitalised companies, some of which may be too expensive for the average investors to get involved with. Furthermore, the constituents of these indices are non-exhaustive as the index providers do not screen all the companies that are available in all jurisdictions. Retail investors as such would not have a full idea of the actual universe of investable equities, even if they did manage to subscribe to these premium services. The challenge is thus to generate a screening engine that is able to screen all stocks available across the world while making them available in a cost-effective manner to the average retail Islamic investor. The generation of an exhaustive, worldwide Islamic equity universe is quite a challenge considering the different screening methodologies that have been adopted in different parts of the world. On top of that, the volatility of the various stock markets and the adoption of new business activities by current Shari’ah-compliant companies, such as mergers and acquisitions, would result in the frequent exit and re-entry of companies into the Shari’ah-compliant universe. The service provider must be able to reconcile the differences between the screening methodologies, as well as effectively trace developments within each constituent equity, to be able to generate a robust worldwide screening engine for the use of both institutional and individual investors.

7.6 Analysis of sector-based screening: scope and challenges Shari’ah principles categorise certain commercial activities as non-permissible for Muslims to invest in. Investment in the shares of any company engaged in such activities as its main business is clearly not permissible under Shari’ah principles because of the doctrine of ownership and ownership liability. An IFI may provide financing based on Murabahah to these non-compliant companies as the relationship is purely commercial and debt-based financing. Through this debt-based financing, IFIs cannot be deemed to be involved in the business activities of this company. However, a Muslim or Islamic-based investor, upon investing in shares in this company, may be said to be involved in the prohibited activities of the company as investment via shares would make them proportionate owners and hence be liable for the conduct of the company.

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7.6.1 Companies that are mainly compliant Sector-based screening is equally important as there would be instances of business firms that are primarily engaged in permissible activities but have a part of their operations involved in activities that are not permissible. For instance, companies involved in the hotel or airline industry may serve alcoholic drinks as part of their operations, although their main activity is to provide accommodation and transportation to travellers. It is for this reason that some screening methodologies have also provided another income-screening method that tolerates prohibited income up to 5% of the total revenue of the company. Therefore, a company whose core activity is compliant but engages in a secondary activity which is not compliant may be subject to this income screening. However, to all intents and purposes, all companies are subject to this non-Halal income screening irrespective of whether they do or do not have a core prohibited activity because any company may have received some income that is not compliant to Shari’ah principles in the course of their core business activity. This non-Halal income includes all income arising from interest payments (interest income), income from selling a prohibited item and service, such as non-Halal food and drink, tobacco-related products and pornographic materials. The aggregate of this income will be deemed as one total income to comply with the 5% ratio.

For example, ABC is an IT-based company that produces anti-virus software for individual and company users. The total revenue of this company last year was US$100 million. In addition to developing and selling this software, the company has also deposited their non-invested cash in a conventional bank which generates US$2 million in interest income. The company also operates a few IT-based centres for public users wherein it sells liquor, non-Halal food and adult movies. The total income from these products is reported to amount to US$6 million. On the aggregate basis, this company has effectively received an income from interest, liquor, non-Halal food and pornography amounting to US$8 million, which represents 8% of the total revenue. Under the income-screening criterion, this company, although essentially an IT-based company, will not be compliant for Islamic investors.

7.6.2 Screening for indirectly linked prohibited items Another challenge is screening companies offering services that are indirectly linked to one or more prohibited core activities; for example, a security company that offers security services in the form of security personnel or security alarms for clients including banks, casinos, universities, factories or commercial properties. Applying a general sector screening methodology as prescribed would result in this company being held to be compliant. However, if the Shari’ah board of the Islamic index provider or screening company were to request a detailed breakdown of this security company’s clients, the company may be deemed non-compliant if the majority of the clients are of non-compliant industries. Such additional screenings are designed to avoid approving a security company that is dedicated to, or specialises in, providing protection to either casinos or conventional banks. Otherwise, any company that provides security services for all types of clients may be deemed compliant. Similarly, a company that produces bottles for ‘various purposes’ may be deemed compliant from the core-activity perspective. However, if the company specialises in producing bottles exclusively for the liquor industry, then it should be disapproved.

7.6.3 Determining the percentage of non-compliant activity It can sometimes be difficult to ascertain the exact percentage of non-Halal income from audited financial reports alone. Liquor income, for example, is more often than not included under food and beverage that may be both Halal and non-Halal. Similarly, interest income may be mixed with profit paid by IFIs. This is often recorded under the item ‘interest income’ in the financial reports of the company, even though some of the company’s cash is deposited with IFIs, thus yielding non interestbased returns. The stock-screening company will have to undertake more thorough research in order to have a more accurate assessment of the company. This may include either field trips to the relevant companies to ascertain the nature and degree of their non-Halal income, or following up any announcement or corporate findings through direct discussion with the company’s management to gain a breakdown of some of the income.

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Key point • Sector-based screening is the most critical screening to exclude prohibited core activities as well as to ascertain the ratio of non-Halal income to total revenue of the company. While some sectors are easily screened, others require more thorough investigation to obtain an accurate picture of the activities involved.

Exercise 7.3 World-Wide Ads is an advertising company that helps companies market their products and services more efficiently and effectively. Its total income is recorded as US$40 million and clients include conventional financial institutions, gambling companies, universities and hotels. Per the previous year’s audited financial report, it has interest income of US$250,000. Outline the issues to be considered in screening this company from the commercial activity perspective in order to ascertain its Shari’ah compliance status.

7.6.4 The defence industry Out of all the prohibited activities, the defence industry is the one that scholars differ over most. The defence industry is not clearly prohibited by Shari’ah principles. However, due to the perception that weapons are developed to cause war, the industry has a negative image. Islamic investors should not invest in weapon-based companies as this would support the development of the industry and, consequently, support wars where people die, including children, women and the elderly. As this is a matter of perception and preference, some screening companies or authorities, such as the Dubai Financial Market, have excluded the defence industry from the list of prohibited industries or sectors, provided these companies are licensed by the respective jurisdictions. The argument is that the industry is important to defend a country from unlawful aggression and oppression.

7.6.5 Screening for ethical and social acceptability Recent developments have led to stocks being screened beyond what is prohibited by Shari’ah principles. This has led to attempts by some index providers to screen companies beyond their core activities and examine their ethical make-up before they can be included in the Shari’ahapproved list. Socially responsible investment (SRI) combines the social, ethical and environmental considerations of the investor with their financial objectives. In short, SRI seeks to invest in companies that contribute positively to the world and avoids or excludes those that harm society or the environment. Conventional SRI and Islamic core activity screening criteria has a common investment perspective on sectors such as gambling, alcohol, tobacco and weaponry. For Islamic screening to be closer to SRI, methodologies must take into account a few additional aspects such as avoiding companies that use child labour or contribute to pollution or global warming.

7.6.6 Screening sustainability The Dow Jones Sustainability Indices, launched in 1999, are the first global indices tracking the financial performance of the leading sustainability-driven companies worldwide. The indices provide asset managers with reliable and objective benchmarks to manage sustainability portfolios. Corporate sustainability is a business approach that creates long-term shareholder value by embracing opportunities and managing risks deriving from economic, environmental and social developments. A growing number of investors perceive sustainability as a catalyst for enlightened and disciplined management, and, thus, a crucial success factor. As a result, investors are increasingly diversifying their portfolios by investing in companies that set industry-wide best practices with regards to sustainability.

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Companies listed on the index undergo a review process where they are continuously monitored for their corporate sustainability performance. The objective is to verify a company’s involvement and management of critical environmental, economic and social crisis situations that can have a highly damaging effect on its reputation and core business. This can be ascertained through corporate reports on companies’ involvement in, for example, excessive logging activities, or water pollution by disposing toxic materials into rivers, lakes and sea, or in not adhering to carbon credit policy as agreed in the Kyoto Protocol. In addition, the consistency of a company’s behaviour is reviewed in line with its stated principles and policies. The Islamic screening methodology may be applied to shares that are included under this index, thus ensuring a combination of both positive and negative screening.

Key point • Islamic screening is complimentary to SRI screening by combining both negative and positive screening of companies to ascertain Shari’ah compliance as well as SRI-compliance.

Islamic finance challenge 7.4 Explain whether you support the consideration of SRI in screening stocks from the Shari’ah perspective, in addition to the existing Shari’ah screening methodology.

Solution Shari’ah screening is largely a negative screening exercise that involves avoiding investments that do not meet the prescribed standards set. SRI employs both negative and positive screening methodologies, an added process that eventually ranks the investments that can be made. From one angle, the inclusion of positive screening would make Shari’ah screening a more sophisticated tool as investors would be able to generate a preferred list of companies to invest in, in accordance to Shari’ah perspectives. However, it may be difficult to set the criteria or benchmarks for the positive screening as it is rather abstract and may not be well articulated.

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Table 7.2 Financial ratio screening – comparative overview Dow Jones Islamic Market Index

Standard & Poor’s Islamic

FTSE Islamic Market Index

Morgan Stanley Islamic Index

Accounting and Auditing Organisation for Islamic Financial Institutions (“AAOIFI”)

Average market capitalisation

Average market capitalisation

Total assets

Total assets

Average market capitalisation

Conventional leverage

33%

33%

33%

33.33%

30%

Cash and interest income-bearing instruments

33%

33%

33%

33.33%

30%

Cash and accounts receivable

33%

49%

50%

70%

70%

Denominator or basis used

Thresholds

7.7 Analysis of financial behaviour of the company for screening purposes Three aspects are generally considered while studying the financial structure of a business from a Shari’ah viewpoint. These are: • debt or leverage taken by the company that results in interest expense • cash and interest-bearing instruments that result in interest earnings or income to the company • cash and receivables of the company that reflect the liquidity position of the company. Table 7.2 above illustrates various benchmarks for the financial ratio screening adopted by various Islamic index providers and Shari’ah standard-setting agencies (such as AAOIFI). Each of these ratios will be critically discussed below. The first two thresholds are crucial for Shari’ah-based screening as they relate to either interest expenses or interest income. The third aspect, as explained in CDIF/3/9/143-144, relates to issues of tradability of shares in the market. Each of these aspects has some practical issues and challenges. These will be considered in the following sections.

7.7.1 Indebtedness of the company Currently, most organised businesses rely on banks to part finance their activities. This is partly due to the need for fluctuating working capital and the ready availability of bank capital for financing and maintaining ongoing trade, and its expansion in the face of unforeseen exigencies of business. Apart from working capital needs, banks also finance the acquisition of fixed assets in the case of major expansion or diversification of business activities. Because of fluctuating conditions, it becomes almost inevitable for even a moderately-sized company to access bank capital, at least for working capital purposes. This is accentuated by the fact that many public-listed companies, which are listed on international exchanges, are based in countries where Islamic banking products are not readily available. This results in the need to borrow from conventional banks for interest that is non-permissible. While investing in these equities and becoming part-owner of such a company may be, strictly speaking, against Islamic norms, tolerance may be needed as this is the reality of the modern commercial world. However, a limit must be put in place to avoid excessive

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conventional borrowing by the companies. The most acceptable standard (DJIM, Standard & Poor’s, FTSE and Morgan Stanley) is 33% of the market capitalisation or total assets, as the case may be. The measure used to assess the level of indebtedness of a company is the debt to market capitalisation of a 12-month trailing average or total assets of the company. Although acceptable screening methodologies do not qualify this debt with conventional debts, the implied meaning of this requirement is to restrict borrowing to conventional borrowing or leverage only. Therefore, if a company were to obtain financing through Shari’ah-compliant instruments, this requirement is no longer relevant. Indeed, a company may get financing of up to 100%, provided it is Shari’ahcompliant financing.

7.7.2 Conventional debt Conventional debt could be classed as normal banking facilities, bonds or preference shares. However, in the context of the current practice of stock screening, it is not clear whether the term ‘conventional debt’ includes all of the above or if it is limited to only conventional banking facilities, such as working capital loans, overdrafts and term loans. At the present time, it seems that this requirement does not include bonds and preference shares. In other words, conventional bonds and preference shares are excluded from the calculation of total conventional debt. Also, from a Shari’ah perspective, inter-company borrowing, although it generates interest, does not lead to prohibited lending. Interest is only relevant and prohibited when it takes place between two independent parties and not between the parent company and its subsidiaries. Therefore, in the screening exercise, any interest generated from inter-company loans must also be excluded.

7.7.2.1 The effect of the global financial crisis of 2008/9 With the advent of the global financial crisis in 2008, many public-listed companies experienced the decline of market capitalisation. This may lead to the exclusion of those companies from the list of Shari’ah-approved shares as the denominator against which debt is measured will be smaller than before the financial crisis. Suppose the total conventional debt of a company in 2007 was US$100 million and the market capitalisation of the company in the same year was US$1 billion, then the ratio of debt to market capitalisation in 2007 was only 10%, which is below the 30% limit. However, suppose, in 2008, given the fact that the stock market was affected by the global financial crisis, the market capitalisation of the same company declined to US$200 million, while the total debt is US$100 million, then the ratio of debt to market capitalisation will be more than the 30% cap.

Many public-listed companies that are Shari’ah-compliant may now become non-compliant as their ratio of debt to market capitalisation exceeds 30%. The exclusion of these companies, relatively speaking, is due to a technical reason or a commercial reality beyond anyone’s control.

7.7.2.2 Interest-based earnings Banks play a major role in facilitating transactions. The cash flows of all companies are routed through banks. As a result, businesses have to maintain accounts with banks. These accounts attract some nominal interest. In addition, at times, companies have to keep security deposits with banks and others to cover performance guarantees and assurances. These accounts also earn the company interest. When it has excess funds, a company may also deploy the excess short-term liquidity in bank deposits and securities as a measure of treasury management. For an outsider investing in the equity of a company, it is difficult to judge whether and to what extent interest accruing to a company is inadvertent and involuntary or planned and deliberate. It is not feasible to expect the investor to investigate this aspect.

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7.7.2.3 Acceptable levels of interest To ensure that the interest earnings of a company do not substantially contribute to its revenue, it is essential to set limits to the proportion of cash and interest-bearing instruments to either the market capitalisation or total assets of the company. Similar to the issue of debt to market capitalisation or total assets, the ratio of 30% or 33% will be applied, pending the relevant screening criteria as discussed above. This is to ensure that the company does not earn a large amount of income from interest income instead of operating income from its approved core activities. As explained earlier, the actual interest income generated from these deposits will be further screened under non-Halal income screening, which is subject to a 5% ratio to the total revenue of the company.

7.7.2.4 Achieving Shari’ah compliance Some public-listed companies are keen to be included in one of the established Islamic indices because management believes this will render their shares more liquid as the indices have a wider pool of investors, both Islamic and conventional. However, upon checking their balance sheets, they may discover that their inclusion in one of the Islamic indices would require them to reduce their conventional leverage, reduce their cash and interest-bearing instruments, reduce their non-Halal income, or reduce their liquid asset proportion to illiquid assets to meet the ratios prescribed by the respective Islamic index providers. The common obstacle for these companies is mainly leverage and interest-bearing instruments. Among the strategies that these companies may adopt is to obtain Islamic financing either through Sukuk, which is a capital market product, or a Murabahah-tawarruq structure, which is a banking product, or a combination of both.

Key point • Public-listed companies may endeavour to make their financial ratios compliant by the redemption of conventional debt through Islamic finance and by managing its cash through Shari’ah-compliant deposits and liquid instruments.

Suppose company XRS is a manufacturing company and has a liability of a conventional loan of US$300 million, which exceeds the ratio of 33% of the ratio of debt to market capitalisation or total assets. XRS may secure any Islamic financing in whatever form, the proceeds of which can be used to redeem the outstanding conventional debt. By so doing, the ratio of debt to either market capitalisation or total asset may be reduced as leverage through Islamic financing will not be counted in the total debt or leverage of the company. To engage in this redemption process, the financial adviser must consider the cost of the funds involved to attain new financing to redeem the old financing. The company may not want to proceed if the cost of new funding is too expensive. Irrespective of this financial consideration, this is the most effective way of reducing conventional debt to qualify the company for Shari’ah-approved stocks. Also, the company may need to transfer the cash management of the company to Islamic shortterm deposits and liquid instruments so as to address the requirement of having less than 33% in conventional deposit and investment products. At the same time, this will also address the screening of non-Halal income.

7.7.3 Cash and receivables/payables of the company Under Shari’ah law, cash and debts cannot be traded except at par value. In applying this ruling to the valuation put on a company’s shares, Shari’ah scholars have considered a company as the bundle of assets and liabilities (reported on its balance sheet), including fixed assets, investments, cash, inventory, receivables, payables and debts. The traded price of its equity can hence be considered as representing value paid for the underlying assets and liabilities. If the fixed assets and investments of a company are negligible (as happens for trading companies), then the remaining assets and liabilities will mainly comprise of debts, deposits and stocks. In equity trading, the price of equities traded is driven by future expectations of prices and not by the book value of the company. Hence, if stocks (inventories) are valued at market prices, one can end up with a residual value for the cash and debts of the company, which can be out of line with their par values.

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Islamic finance challenge 7.5 Set out below is an excerpt from the financials of Malaysia’s Bank Muamalat for 2008. Based on the financial report, explain whether the shares of this Islamic bank can be subscribed to and traded in the market freely. BANK MUAMALAT MALAySIA BERHAD (Incorporated in Maylaysia) BALANCE SHEETS AS AT 30 SEPTEMBER 2008 (30 RAMADHAN 1429) Group 30 September 31 December 2008 2007 Note RM’000 RM’000

Bank 30 September 31 December 2008 2007 RM’000 RM’000

ASSETS Cash and short-term funds Securities: Held-to-maturity (d)i Available-for-sale (d) ii Financing of customers (e) Statutory deposits with Bank Negara Malaysia Other assets Investment in subsidiaries Deferred tax assets (net) Goodwill Property, plant and equipment Prepaid land and lease payment Total Assets

3,433,693

4,466,215

3,432,591

4,465,895

30,891 2,903,681 6,239,252

30,891 3,302,350 5,585,247

30,891 2,903,681 6,239,252

30,891 3,302,350 5,585,247

308,871 80,554 46,917 1,218 44,608

288,471 63,152 23,013 1,219 44,530 269

308,871 81,32 10,722 46,917 44,530

288,471 63,406 10,723 23,013 44,427 269

13,089,685

13,805,357

13,098,757

13,814,692

Notes: i.

Securities ‘held-to-maturity’ and ‘available-for-sale’ (items (d)i & (d)ii respectively) are made up of Islamic capital market instruments such as Islamic commercial paper, Sukuk, Islamic bonds, Islamic notes etc.(refer to CDIF 3/6/89-100)

ii. Financing of customers (item (e)) refers to Islamic banks’ home and vehicle financing activities utilising financing instruments structured under various contracts, such as Ijarah, Ijarah thumma al-bay’ or Musharakah.

Solution The financial report shows that the cash and account receivables of this Islamic bank amount to more than the 50% (DJIM/FTSE/S&P) and 70% (AAOIFI) of the total assets benchmarks set. Following the above stock selection, the shares of this Islamic bank can only be bought and cannot be sold as the shares of the bank represents more liquid assets than illiquid assets, thus becoming a monetary asset. A monetary asset is always subject to rules of interest in the exchange; in other words it can only be traded at par value and any premium or discounts to the par value would be regarded as interest. The restriction to par value would thus limit the tradability of this bank’s equity in the market.

The measure or parameter most commonly used to judge compliance on this score is the percentage of current assets or receivables or net current assets to total assets (or total market capitalisation) of the company. Alternatively, the numerator can be net receivables instead of net current assets. The cut-off value of the parameter is usually set in the range of 45% to 49% as explained in CDIF/3/9/143-144. However, the stock-screening criteria of AAOIFI Shari’ah Standard (No 21) have increased the ratio of liquid assets to illiquid assets to 70%. Thus, a company whose total asset is US$100 million and has a total cash and account receivable of US$60 million is a compliant company under AAOIFI stockscreening criteria, but not under all other international Islamic stock-screening criteria. Subsequently, the shares of the company may be traded in the market freely without any restriction of par-value transaction. Following other stock-screening criteria, the shares of this company may be bought but cannot be sold except on a par value basis to avoid an interest element in buying one monetary asset (a liquid asset) for another monetary asset (another liquid asset) at a different price.

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7.8 Comparative stock-screening methodologies and criteria Currently, equity market players, ranging from portfolio managers, institutional investors and regulators use various screening methodologies to generate their universe of Shari’ah-compliant equities, each with their own specific objectives. In the case of index providers, their selection criteria and weightings are likely to be biased to the more intensely traded and higher market capitalisation stocks, primarily derived with the intention of providing investors with a measure to judge the current state of the market against that prevailing on an earlier day or likely to prevail in future. These Islamic indices also enable investors to assess how a particular stock is doing in relation to the overall market. In defining the screening methodologies to identify Shari’ah-compliant equities, the aim is to select those stocks from the market universe that function within the minimum realistically acceptable deviations from Shari’ah stipulations, keeping in mind the nature of the environment. In judging the Shari’ah compliance of any equity, one has to consider not only the nature of the business it is engaged in but also the way the business is structured. Table 7.2 above shows a comparison of Shari’ah equity screening criteria that has been applied in the various markets.

7.8.1 Screening for acceptable business activities Activities of Shari’ah-compliant companies cannot be inconsistent with Shari’ah. Therefore, based on revenue allocation, if any company has business activities in the Shari’ah inconsistent group or sub-group of industries it is excluded from the Islamic index universe. The established categories of industries that are inconsistent with Shari’ah (see table 7.1) are alcohol, pork-related products, conventional financial services (banking, insurance, etc.), hotels, entertainment (casinos/gambling, cinema, pornography, music, etc.), tobacco, and weapons and defence industries. The non-permitted areas documented in the Dow Jones, FTSE, S&P and FTSE-Bursa Hijrah Shari’ah indices are exhaustive. It appears they have resorted to being extra cautious, resulting in the exclusion of even Shari’ah-compliant units in an industry if most units in that industry are not compliant. Hotels, media and broadcasting for instance (under the entertainment category), do not have anything intrinsically objectionable about their activities. However, as a practice, hotels do serve non-Halal foods and alcoholic beverages. Similarly, media coverage and broadcasting may include material with nudity or obscene images. However, for a provider of market information it may not be easy or feasible to obtain and keep abreast of such details about operations of specific units in industries where most units tend to be Shari’ah non-compliant.

7.8.2 Screening for acceptable financial ratios After removing companies with unacceptable primary business activities, the next step is to identify and remove companies with unacceptable levels of debt/leverage, liquid assets and receivables by applying the following screens. The Shari’ah basis of these financial screens has been discussed in CDIF/3/9/142-143.

7.8.2.1 Debt/leverage The acceptable level of indebtedness is set at less than 33% across Dow Jones, FTSE and S&P screening criteria. Dow Jones uses market capitalisation as a denominator, whereas FTSE and S&P use total assets and a trailing 12-month average market value of equity (similar to market capitalisation). The ratio of debt to total assets that Dow Jones formerly used would have been a more rational approach. It gives a measure of how much of a company’s operations are being financed by the Shari’ah non-compliant debt component. Such a ratio, therefore, clearly follows from the objective sought. However, the debt to total asset ratio is the most static ratio among the three as companies’ assets are not frequently marked-to-market. The change to the trailing market capitalisation (and its equivalent) denominator produces a more dynamic, hence more accurate, ratio. Nevertheless, this dynamic ratio has generated criticism in times of market volatility. For instance, in the short run, the debt numerator will not change but the denominator may plunge with a market crash. This was a consequence of the 2008 financial crisis, which resulted in a number of equities falling out of the Shari’ah-compliance listings as their market capitalisation fell rapidly in the short term.

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The question with regards to the tolerance levels of debt is unavoidable, with the ideal perhaps being 0%. Because of conventional financial wisdom that requires companies to rely consciously on moderate debt levels to leverage profitability, Shari’ah scholars tend to settle for a debt ratio of 30% or 33% to equity on the argument outlined in CDIF/3/9/143.

7.8.2.2 Receivables to market capitalisation Screening criteria stipulate certain maximum ratios of receivables or liquid assets as one of the screens for checking Shari’ah compliance. Its rationale, as explained in CDIF/3/9/144, is to preserve the idea that a company’s equity reflects its business assets and not its monetary assets. If the company has a higher ratio than that prescribed, there would be a question of whether its equities can be traded at any value other than par. However, it is equally wrong to treat a company whose equity is publicly traded in the modern world as simply a bundle of accounting assets and liabilities, defined on its balance sheet. Some very vital and valuable assets of the company may not figure on its balance sheet at all. Marketing assets such as brands, distribution networks and logistical arrangements, as well as licences, quotas, permits and access to lucrative but protected markets do not normally appear on balance sheets. There are also other intangibles such as the company’s public image, the value of key individuals in the company’s top management, marketing, production and research teams that don’t appear on the balance sheet. The question is how to ascertain the value of the intangibles with regards to the market value of the physical assets that the company holds. Until such a methodology is developed, it is best to be prudent in accounting for the receivables to asset ratio.

7.8.2.3 Cash As with the debt/leverage ratio above, the difference between the Dow Jones/ S&P criteria and the FTSE lies in the denominator where the former utilises a dynamic 12-month trailing average market capitalisation/market equity value and the latter uses total assets as the denominator.

7.9 Share price fluctuations There is often no rationale behind the way share prices fluctuate. The only definite statement that can be made about price movements on the equities market is that they are largely driven by sentiments about future earnings and movements. What creates those sentiments on a particular day is an unpredictable matter. It can be past performance, news of current performance, expectations of future results, market manipulations, demand-supply imbalances, government policies, political developments or international price movements. Often in the span of a few weeks or a couple of months, the share price of an equity share can skyrocket or nosedive. It is not unusual to find over a year share prices rising to more than double or sinking to less than half their original values, when there is no apparent change in their underlying business activities.

7.9.1 Sudden price fluctuations A practical problem of using market capitalisation is that with sudden market movements a company that was considered Shari’ah-compliant one day has to be considered Shari’ah non-compliant the next day if there is a downward price fluctuation. As a result, Islamic investors would have to compulsorily exit, leading to further downward pressure and even further destabilising the company’s price. Similarly an opposite movement could lead to a corresponding (although more muted) upward move. All this occurs with no change in the company’s operations. Such market destabilisation would also be an unhealthy and wholly avoidable consequence of involving market capitalisation in the screening norms.

7.9.2 Unlisted companies Another practical problem in using market capitalisation as the denominator in the screening norms for selecting companies for investment is that such screening ratios cannot be used to screen unlisted companies. A similar argument would apply (to a lesser extent) to infrequently traded companies or companies with low floating stocks. Often, due to the low liquidity associated with such scripts, even fundamentally strong companies of this group quote very low book values.

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Exercise 7.4 Based on table 7.2 above, assess the compliance status of the company whose financials are given below. Where applicable, apply the stock screening criteria that best suit this company. Aquaflo is a water treatment company in Qatar that processes sea water into drinkable water. It then sells the processed water to Qatar. The following are extracts of the financials of the company: a.

Average market capitalisation (2008)

: Qatari Rial 441, 529,000

b.

Total asset (2008)

: Qatari Rial 682, 281,000

c.

Conventional leverage (2008)

: Qatari Rial 51,343,000

d.

Cash and interest bearing instruments (2008)

: Qatari Rial 151,224

e.

Cash and accounts receivable

: Qatari Rial 440,000,000

7.10 New developments in screening methodology due to global financial crisis 7.10.1 Adapting the screening process to account for changing market capitalisation The financial crisis of 2008/9 posed a new challenge, especially for Islamic indices and Islamic equity funds that adopt market capitalisation as the denominator in the screening process. Therefore, some Shari’ah boards exercised their Ijtihad, resulting in at least three approaches, especially for stockscreening criteria using market capitalisation as the denominator. 1. The first approach is to use the previous year’s market capitalisation that is based on the financial report of 2007, until market conditions recover. The current and prevailing market capitalisation of the company will be suspended for screening purposes until the market is seen to recover to its normal position. 2. The second approach is to use a 36-month instead of a 12-month trailing average of market capitalisation to show a more stable market capitalisation for the company under review. This period will cover the years 2006, 2007 and 2008 on an average basis for the purpose of screening, based on its financial report ended 31 December 2008. 3. The third approach is to change the denominator from market capitalisation to total assets, if this is possible, particularly for Islamic funds following Islamic indices that adopt the market capitalisation principle. However, certain Islamic index providers that use market capitalisation in their screening methodologies may not necessarily be able to switch to total assets if this has always been their standard screening methodology. They may then adopt the first two approaches if they wish to maintain the denominator of the market capitalisation to avoid the exclusion of many constituents because of this abnormal market condition.

Key point • The debt to market capitalisation or total asset ratio refers to total conventional debt, excluding Islamic finance debt, in proportion to market capital capitalisation or total assets.

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Table 7.3 Illustration of the decline of market capitalisation of a public-listed company (real scenario)

XX AIRWAYS GROUP, INC. 2004 (US$ ‘000s)

12,118

11,700

11,557

5,077

2,339

Operating income

(606)

445

664

(171)

(55)

83

172

153

30

8

253

273

295

147

80

Earnings before interest and taxes (EBIT)

(1,957)

707

699

(188)

(9)

EBIT & depreciation (EBITDA)

(1,717)

896

898

(93)

45

1,240

2,176

2,366

1,585

3,563

20

226

1,249

452

127

Cash

1,220

1,950

1,117

1,133

3,436

Total assets

7,214

8,040

7,576

6,964

4,721

Total assets - as reported

7,214

8,040

7,576

6,964

1,475

Receivables (Net)

293

374

388

353

109

Other investments

778

877

753

792

102

Total debt

3,996

3,148

3,002

2,960

3,461

Total shareholders’ equity

(505)

1,439

970

420

616

Working capital

(580)

844

691

(100)

3,361

Total capital

3,129

4,470

3,877

3,169

4,077

Funds from operations

(609)

472

599

(111)

110

929

523

232

44

219

3,638

2,323

5,552

4,392

-

882

1,351

4,916

3,017

-

Preferred stock

-

-

-

-

-

Minority interest

-

-

-

-

-

Net debt

2,756

972

636

1,375

102

Z Score

0.309

1.978

2.289

0.733

1.187

Interest expense on debt

Cash & short-term investments Short-term investments

Capital expenditures (additions to fixed assets) Enterprise value Market capitalisation

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2005 (US$ ‘000s)

Net sales or revenues

Non-operating interest income

210

2006 (US$ ‘000s)

2007 (US$ ‘000s)

P2008 (US$ ‘000s)

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Exercise 7.5 Based on the above illustration of a company, apply the screening methodology of both the DJIM and FTSE Islamic Index. What are your observations regarding this company when comparing the financials of 2007 and 2008? Also, if the Islamic fund was to follow the proposal of adopting a trailing 36-month average market capitalisation for this company instead of the previous year’s trailing 12-month average, what would be the result of the screening process?

7.11 Conclusion Shari’ah compliance is the key distinguishing feature of the Islamic capital market. Islamic capital markets need to be efficiently regulated, not only to ensure adequacy and transparency of information provided to investors, but also to build confidence that the Islamic capital market instruments comply with Shari’ah principles at all times. Shari’ah regulatory structures can take the form of either a centralised model or one that is led by private initiatives or market forces. The applicability of either model will depend on the jurisdictions within which the instruments are on offer. Subsequently, the Shari’ah screening criteria adopted by a fund manager will once again depend on the jurisdictions within which the Islamic fund is on offer. The fund manager can apply any of the established Shari’ah screening methodologies from DJIM, FTSE or AAOIFI, to name a few. It is important for the manager to understand the different limits that have been set between each screening methodology and the different denominators applied for each financial ratio as they can affect the results of Shari’ah financial screening.

7.12 Summary Having read this chapter the main points that you should understand are as follows: • an effective legal, regulatory and supervisory framework is required to provide the essential foundation for the functioning of a modern equity capital market • the Islamic capital market takes the structure of and utilises infrastructure that has already been established for conventional capital markets • the development of various Shari’ah stock-screening methodologies, Islamic indices and various forms of Islamic funds are not in conflict with the existing structure of contemporary stock exchanges • Islamic equity capital market products and services need to undergo a pre-defined vetting and approval process by Shari’ah advisers • the challenge to formulating a robust financial reporting framework for the Islamic financial services industry arises from the fact that Islamic finance is still undergoing substantial development and innovation • voluntary disclosures of non-financial statements are a good step in increasing transparency and ensuring that the investor receives adequate information • both the core activity and the relevant financial ratios of the company shall be subject to Shari’ah screening to obtain Shari’ah approval status • sector-based screening is the most critical screening step to exclude prohibited core activities, as well as to ascertain the ratio of non-Halal income to total revenue of the company • in judging the Shari’ah compliance of an equity one has to consider not only the nature of the business it is engaged in but also the way the business is structured.

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7.13 Islamic Finance case study Screening of public-listed company in various market conditions and commercial realities QPP is a public-listed company in the property sector, which is listed on the Tadawul Stock Exchange in the Kingdom of Saudi Arabia. Its core activities are buying land that has the potential for the construction of both commercial and residential properties, as well as developing the properties for either outright sale or long-term lease. Considering the economic boom that the country is experiencing and the large inflow of expatriates, the supply of properties, particularly residential properties, is extremely scarce. The company has also developed and owns properties outside the Kingdom, in the UK, the US, Malaysia, India and China. The properties owned outside the Kingdom are both residential and commercial properties, such as shopping complexes, offices and warehouses. In addition, the company has ventured into the hospitality and leisure sector of hotels and resorts inside and outside the Kingdom of Saudi Arabia. At present, the company owns and operates luxury hotels in China, Malaysia and India. It also owns and operates a few serviced apartments in the UK, the US and Germany, in addition to a few serviced apartments in the Kingdom itself. Apart from this core activity, the company has a subsidiary company investing in an engineering company in a European country to produce military equipment. The following are the extracts of last year’s audited financials for the company.

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Table 7.4 QPP INC (US$ million) 2008

2007

2006

1,063

1,199

1,234

146

181

246

Interest income

12

14

17

Interest expense on debt

79

81

144

134

240

338

EBIT & depreciation (EBITDA)

(255)

292

379

Cash & interest-bearing securities

1890

1998

1766

10,544

11,566

17,066

4978

3789

1456

47

227

530

300

334

700

Total shareholders’ equity

1,884

1,746

1,886

Working capital

2,798

2,712

3,395

271

246

259

34

35

36

4,690

4,321

5,035

Enterprise value

729

1,678

2,747

Preferred stock

626

10

10

-

-

-

3,336

2,634

2,278

0

0

0

Net sales or revenues Operating income

Earnings before interest and taxes (EBIT)

Total assets Receivables (Net) Other investments Total debt

Total capital Funds from operations Capital expenditures (additions to fixed assets)

Minority interest Net debt Z Score

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Case study multiple choice questions 1. RTS is an electricity company that has a conventional debt of US$200 million against its market capitalisation of US$500 million and total assets of US$ 700 million. It seeks to make its shares compliant according to the DJIM standard. Given the above financials, what is the most important action RTS must undertake to achieve compliance with the DJIM standard? (A)

Reduce its conventional debt to lower than US$165 million

(B)

Reduce its total assets to US$500 million

(C)

Reduce its conventional assets through Islamic private equity funds

(D)

Reduce its conventional loan to lower than US$225 million

2. The weaponry industry is deemed non-compliant by most Islamic index providers and stockscreening companies and authorities except in the: (A)

Morgan Stanley Islamic Index

(B)

Dubai Financial Market

(C)

FTSE Islamic Index

(D)

Bursa-FTSE Hijrah Index

3. In a bear market, the level of trading of shares may not be active thus affecting the volume of trading that later affects the market capitalisation of some companies. Which of the following is not a temporary solution to address the issue of a high decline of market capitalisation to avoid the exclusion of companies? (A)

Suspending the market capitalisation consideration until the market stabilises

(B)

Extending the 12-month trailing market average to a longer period

(C)

Changing the ratio of debt and cash and interest-bearing instruments against market capitalisation to 70%

(D)

Converting the market capitalisation screening methodology to a total asset screening methodology

4. Which of the following activities may affect the inclusion of QPP into the approved stocks as per established Shari’ah stock-screening criteria, according to sector-based screening? (A)

Service apartments outside the Kingdom of Saudi Arabia

(B)

Sale of land on credit sale

(C)

Hotel operations outside the Kingdom of Saudi Arabia

(D)

Hotel and resort operations in Kingdom of Saudi Arabia

5. If QPP was to reduce its conventional leverage through either Sukuk or Murabahah-tawarruq, how much new funding would be required to redeem the conventional debt to make the company eligible in 2008 to be considered compliant under DJIM?

214

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(A)

US$60 million

(B)

US$50 million

(C)

US$40 million

(D)

US$30 million

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6. An Islamic property fund was established in Bahrain in 2008 to invest in various Shari’ah compliant companies that are related to the property sector. The prospectus for the fund mentions that it will subscribe to DJIM when selecting a particular company for investment. Applying the DJIM criteria strictly will exclude some potential companies from the approved stocks as the market capitalisation of these companies will have significantly fluctuated downwards given the global financial crisis in 2008. What is the immediate option available to this fund if it was to invest in these companies whose market capitalisation has dropped due to market conditions? (A)

Choice of using either market capitalisation or total asset

(B)

Suspension of the calculation of total assets

(C)

Converting all the leverage and investment to Shari’ah-compliant leverage and investment

(D)

Using a trailing 36-month average market capitalisation

Case study short essay questions 1.

Using the FTSE Islamic index and Morgan Stanley Islamic Index stock-screening criteria respectively, convert the financials as given above to the relevant financial ratios to ascertain the compliance of this company.

2.

If the above company were to be reviewed and screened according to DJIM, AAOIFI, Standard & Poor’s Islamic Index, and Securities Commission of Malaysia’s stock screening respectively, with regard to financial ratio screening, what measures would need to be taken to achieve the compliance objective?

3.

Suppose the income from liquor and non-Halal food sold in its four hotels is quite substantial compared with the total revenue of the company, what measures could be taken to achieve compliance status?

4.

If QPP was later acquired by another property company that primarily owns and operates fivestar hotels in Europe and North America, would this affect the screening criteria and, if so, why?

5.

SRI Islamic Index is a hypothetical new Islamic Index. Do you think that the QPP company will be included in the constituents of this new index (irrespective of the financial ratio screening) and, if so, why?

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Chapter seven answers Exercise 7.1 One of the Securities Commission (SC) of Malaysia’s screening criteria is the 10% benchmark that looks into issues such as interest income as a percentage of profit before tax. ABS’ interest income percentage works out to be: RM18 million/RM 200 million x 100% = 9% This figure does not exceed the SC’s 10% benchmark and hence ABS will pass the SC’s screening criteria. FTSE on the other hand applies additional financial screens and ABS’ FTSE financial screening results are as follows: Leverage: Total debt/Total assets

= RM195 million/RM750 million x 100% = 26%

Cash:

(Cash + interest-bearing securities)/Total asset x 100% = RM274 million/RM750 million x 100% = 36.5%

Non-Halal Income

= RM18 million/ RM590 million x 100% = 3%

ABS would not be included in the FTSE Islamic Index/Islamic-approved stocks as per the FTSE Islamic Index criteria it fails the cash and interest-bearing instrument screening, which is currently set at 33%, even though it passes the non-Halal income screen, which is currently set at 5%. Although ABS passes the Securities Commission Shari’ah Advisory Screening, it will not pass the Bursa FTSE Hijrah Index. However, its screening by the FTSE Islamic Index will only be done after the first screening by the Securities Commission of Malaysia.

Exercise 7.2 Several regulatory authorities have dedicated staff who look into product origination, innovation and expansion opportunities available within this market segment, with a view to creating regulatory incentives to promote the growth of this market segment. Labuan (Malaysia’s offshore financial centre), for instance, has established an Islamic Financial Development Division, while the Malaysian Securities Commission has an Islamic Capital Market Department. In addition to developmental work, these dedicated units, together with other relevant supervisory departments, work together with respect to regulatory functions such as licensing, supervision, inspection, investigation and enforcement, with specific reference to Islamic capital market activities. On the other hand, Muslim countries where the capital markets are comparatively small in the number of companies listed and that are already geared towards business activities that are generally Shari’ah-compliant may not separate regulatory oversight. Gulf Cooperation Council (GCC) nations, such as Saudi Arabia and Kuwait, may not necessarily require dedicated Islamic capital market oversight, as perhaps the only non-Shari’ah compliant business activities that they need to apply additional oversight to applies to interest-based financial institutions. Prohibited industries, such as the manufacture of alcoholic beverages, do not exist in those homogenously Muslim-dominated countries and thus the markets would require less supervision.

Exercise 7.3 Advertising is Shari’ah-neutral. The act of providing such a service does not contradict any Shari’ah principles. Advertising is a competitive industry whereby market leaders often lead the way with innovative advertising campaigns, delivered in cost-effective ways. Advertising campaigns are often delivered via various media ranging from print, radio, television and the internet. None of these media on their own contravene Shari’ah principles in any way.

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The question of whether World-Wide Ads can pass the Shari’ah screening exercise rests on financial ratios applied. Interest income is definitely a consideration for most screening methodologies: Dow Jones, FTSE and S&P limits it to i) 5% of non-Halal income and ii) less than 33% (including cash) of a company’s total assets or market capitalisation. World-Wide Ads’ non-Halal income forms only 0.6% of its total income of US$40 million, which makes it Shari’ah-compliant, on the basis that it does not have any other source of non-Halal income. From the non-Halal income screening perspective, World-Wide Ads would likely pass the Shari’ah screening exercise. The question that has to be considered concerns World-Wide Ads’ clientele. If it is wholly made up of companies within the prohibited industries’ list, then World-Wide Ads should be excluded from the Shari’ah-approved stocks, even though its core business activity does not fall within one of the prohibited sectors or activities. If the clientele is mixed, the question is whether income from noncompliant companies can be accurately ascertained. If so, then the Shari’ah board of the screening party may be able to ascertain the amount of income generated from non-compliant clients through the revenue earned from advertising conventional banking products and services, as well as gambling activities. If the total income from these clients, plus any interest income, exceeds 5% of the total revenue, then this company should be disqualified from the list of approved Shari’ah stocks. Given the fact that this company is an advertising company, it will pass the first sector screening but fail the non-Halal income screening if the total impure income was to exceed 5% of the total revenue of the company.

Exercise 7.4 It seems that Aquaflo will only be compliant under the Morgan Stanley Islamic Index screening criteria of financial ratios. The use of total assets instead of market capitalisation and a 70% ratio for liquid and illiquid asset proportions instead of 49%, as adopted by Morgan Stanley, will render this company compliant. The company will not be compliant under other stock-screening criteria. The summary of the financial results of this company under the Morgan Stanley Islamic Index screening criteria is as follows: Denominator/basis used: Total assets

Qatari Rial 682,281,000

Numerator/aspects

Qatari Rial,000

Ratio

Threshold

Compliance

Conventional leverage

51,343

8%

33.33%

Complied

Cash and interest incomebearing instruments

151,224

22%

33.33%

Complied

Cash and accounts receivable

440,000

65%

70%

Complied

Exercise 7.5 The major difference between the screening methodologies of DJIM and FTSE is the denominator that they each utilise to generate their leverage and cash percentages. DJIM employs a dynamic 12month moving market capitalisation as the denominator whereas FTSE uses a more static total asset figure. To reflect the differences, the table below shows the leverage and cash percentages for the company from 2005 to 2008.

DJIM

FTSE

2008

2007

2006

2005

Leverage %

453%

233%

61%

98%

Cash %

141%

161%

48%

53%

Leverage %

55%

39%

40%

43%

Cash %

17%

27%

31%

23%

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The exercise above is not generated to test whether XX Airways is a Shari’ah-compliant company via the financial screen. Its result shows that there is a wide difference between the leverage and cash percentages for the same company utilising the two different denominators. For instance, the FTSE leverage screen shows a 39% figure in 2007, but under DJIM the figure is 233%. In the same year, the FTSE cash screen gave a figure of 27% (permissible as it is below 33%), but the DJIM screen shows a non-permissible figure of 161%. The major difference shown above is due to market volatility where the XX Airways value went down steeply, but its asset value is yet to be adjusted. The real question is which of the screening methodologies should be applied as there would be instances (not here) whereby one company would be included in the FTSE Shari’ah-compliant list and not in the one generated by DJIM. That question must, however, be deliberated by the Shari’ah board and the management of the entity that is looking to invest in the company. The utilisation of a 36-month trailing average market capitalisation would indeed improve the results to the DJIM financial ratio screen. This is especially so for companies that have seen a downward spiral to their value of market capitalisation over the past few years. The result for XX Airways using this denominator is as follows:

2008 DJIM

Leverage %

168%

Cash %

52%

Notice that the company still fails the DJIM screening criteria, but its results are much closer to the FTSE results as shown above. A possible explanation is that the company’s market capitalisation fell too rapidly and by too much in 2007 and 2008.

Case study multiple choice answers

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1

(A) According to DJIM, conventional debt or leverage ratio cannot exceed 33% of the company’s market capitalisation.

2

(B) It is a fact that the weaponry industry is regarded by most Shari’ah screening bodies as noncompliant. The exception to this is found with the screening body at Dubai Financial Market which argues that weaponry is critical to defend one’s country from unlawful aggression, a legitimate cause.

3

(C) Changing the debt as well as cash and interest-bearing ratios as suggested here will not improve the market capitalisation denominator used for screening purposes. Unlike the rest of the answers this will affect the calculation of the financing ratio screening.

4

(C) The hotel industry is one of those industries that is usually flagged during screening, due to alcohol being served within the premises. However, hotels in Saudi Arabia cannot and do not serve alcohol, and as such can be categorically included as a Shari’ah-compliant business activity. What would affect QPP inclusion as an approved Shari’ah stock is the participation in the hotel business outside Saudi Arabia. Hotel businesses elsewhere therefore require screening.

5

(A) DJIM uses market capitalisation as a denominator in calculating the leverage ratio. The 2008 figure states that the company has a leverage ratio of 41%, with the conventional debt of US$300 million. To reduce it to an acceptable 33% or at about US$240 million, the company must issue a Sukuk or Murabahah-tawarruq financing amounting to US$60 million.

6

(D) Trailing market capitalisation as a denominator in calculation of financial ratios is a feature of DJIM screening methodology.

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Suggested solutions to case study short essay questions 1.

The financial screening results using FTSE and Morgan Stanley screening methodologies are given in the table below. One should note that both methodologies employ total assets as the common denominator. The main difference lies within the receivables criterion; receivables ratio – FTSE less than 50% while Morgan Stanley is less than 70%.

year 2008

QPP Ratio

FTSE Islamic Index

Morgan Stanley Islamic Index

Leverage ratio

2.85%

Pass

Pass

Receivables ratio

47.21%

Pass

Pass

Cash and interest-bearing instrument ratio

17.92%

Pass

Pass

Non-Halal income ratio

8.22%

Fail

Fail

2.

To achieve Shari’ah compliance under the indexes prescribed, QPP must first reduce the receivables ratio to one that is below the prescribed threshold. Dow Jones has set a threshold of 33% of market capitalisation; S&P accepts a figure of 49%, while AAOIFI allows a receivables ratio of up to 70%. The issue here is that the methodologies use market capitalisation as the denominator instead of total assets, which can be a problem in times of falling market values. The ratio is not relevant for the Securities Commission’s screening as it does not feature in its criteria. The next issue for QPP is to reduce its non-Halal income. One source may be the interest the company receives from placing its cash deposits in conventional banks. If possible, QPP should place those deposits in Islamic banking institutions, if available, so it does not lose out on potential returns.

3.

The most commendable option for QPP to achieve Shari’ah compliance in this regard is to refrain from conducting business that involves liquor and non-Halal food. However, this option may not be feasible in most countries as the needs of other communities must be dealt with. One possible option for QPP is to outsource the liquor and non-Halal food to a third party. The third party must be located outside the hotel premises to avoid a lease contract between the hotel and the operator.

4.

In all likelihood, the acquiring company will not be compliant as the western-based hotel operator would most likely generate a large portion of its business revenue from the sale of liquor and non-Halal food in its premises, especially in Europe and North America. Therefore, it may be likely that QPP would fall out of the Shari’ah compliance list if the acquiring company intends to run QPP like the rest of its operations. However, it could be that the acquiring company intends to keep QPP as a niche market and preserve its compliance status. There is no issue of ownership by the parent company on QPP’s compliance status if it can be determined that QPP’s operations and financials remain Shari’ah-compliant. However, if the two companies are merged, there will be consequences for the financial ratios as the seemingly conventional investor company’s leverage and other ratios would impede the Shari’ah compliance of the newly merged companies.

5.

The idea behind socially responsible investing is to provide investors with an investable universe made up of socially responsible companies with good corporate values. The provision of liquor and military equipment may go against the benchmarks of SRI screening, which would affect QPP’s entry into the SRI list. While the case of the provision of liquor is clearly unacceptable with the SRI, the weaponry industry is still arguable, as some military equipment, such as military satellites to forecast weather and climate change and military equipment to deal with catastrophic events, are not necessarily destructive. Above all, some may argue that military equipment, even in the form of weapons, is useful and needed to defend one’s country from illegitimate and unlawful aggression and invasion. This is the argument put forward by Dubai Financial Market Shari’ah stock screening, which excluded weaponry from the prohibited list of activities.

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Chapter eight Structuring and strategic issues for Islamic funds

Learning outcomes By the end of this chapter you should be able to: • evaluate structuring features and issues of various Islamic funds • assess relevant criteria and recommend policies for Shari’ah-compliant funds • analyse the suitability of structures involving commodities and gold funds, real estate funds, money market funds and private equity funds • evaluate strategic issues for the further development of Islamic funds

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Indicative list of content • Structuring features and issues of Shari’ah-compliant funds • Structuring requirements for Shari’ah-compliant commodity and gold funds • Structuring requirements for Shari’ah-compliant money market funds • Structuring requirements for Shari’ah-compliant private equity funds • Strategic issues for the development of Islamic funds • Case study: structuring and strategic issues of Islamic private equity funds

8.0 Introduction Investments may be made directly by individual investors into respective assets such as bonds or Sukuk, shares, property and commodities. Alternatively, investors may pool together their investment into a collective scheme or fund where their investment activities are managed by a professional fund manager. The management of collective investments gains prominence with the development of capital markets where financial securities are traded in established stock exchanges. This model clearly provides investors with the opportunity to invest in many more assets in terms of value and diversification than would otherwise be possible if they were to invest individually. Since the introduction of such collective funds as investment vehicles, the opportunity for smaller investors to participate in investments that enable risk diversification has been an important factor in their establishment. In general, Islamic funds portray similar expectations of investors’ preference towards risk diversification in equity investments and other asset classes as occurs in conventional funds. The funds operate around an agreed trust deed that caters for Shari’ah-compliant requirements in all permissible investments. Collective investment schemes may be formed under company law or by legal trust or statute. The nature of the scheme and its limitations are often linked to its legal structure and associated tax rules within a given jurisdiction. Central to this legal requirement is the establishment of a Shari’ah supervisory board to assist the fund management in compliance with Shari’ah principles in terms of the legal structure of the fund, investment activities, redemption, as well as the trading of units and shares of the fund. This chapter analyses the structure, features and economic behaviour of different types of Islamic funds. The discussion is limited to funds involved in commodities, gold, real estate, money markets and private equity investment. Focus is directed towards the issue of structuring open-ended and close-ended funds, as well as exchanged traded funds (ETF) in relation to various underlying investment assets in the form of real estate funds, commodity and gold funds, money market funds and private equity funds. This chapter also highlights the general performance of Islamic investment compared with conventional investments, particularly in the equity market. Finally, you will be introduced to strategic considerations that could enhance the industry of Islamic asset management in the global market. CIMA Advanced Diploma in Islamic Finance

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8.1 Islamic funds As stated in the introduction, investments may be made directly by individual investors or investors may pool together their investment into a collective scheme whereby their investment activities are managed by a professional fund manager. Management costs will be reduced as they are borne proportionately by each and every investor in this scheme. Collective investment schemes may be formed under company law or by legal trust or statute. The nature of the scheme and its limitations are often linked to its legal structure and associated tax rules within a given jurisdiction. The focus of this chapter is on collective investment schemes conducted in accordance with Shari’ah principles. A collective investment scheme pools investments from a group of investors, allowing them to participate in a wider range of investments than would otherwise be feasible and to share in its costs and benefits. Such schemes are referred to as mutual funds, investment funds or simply ‘funds’. Although investments may be restricted to geographic regions, specific industries, currency denominations or investment styles, such as growth-based funds or value-based funds, it remains collective in nature as it needs to have investment from more than one source in a number of diversified assets. By investing in such schemes, investors are issued with shares, units or certificates of investment to reflect their ownership claim on the underlying assets of the investment. Investors will either be subscribing to the investment fund or exiting or disposing of their interest in the fund. The disposal or the tradability of the shares and units, where relevant, is peculiar to collective investment schemes as physical possession of the underlying assets of the investment rarely takes place. All investment and divestment activities are done through these shares or units of investment issued by the fund manager. A collective investment scheme will pool all investors into one type of fund, which is a separate legal entity. The fund will represent the undivided ownership of the investors in the underlying investment assets. In this case, an individual investor has given his rights and liabilities to the fund to act on his and other investors’ behalf. The fund, being a separate legal entity acting on behalf of the investors, must undertake its operation according to the wishes of the investors. Therefore, if the investors were to seek Shari’ah-compliant investment activities, then the fund must behave accordingly. The scheme may also pose relevant Shari’ah issues that otherwise would not be a problem if investment was to be exercised by an individual Muslim investor. An individual Muslim investor may purchase gold or currency on spot and subsequently sell the same gold or currency to another third party on spot basis for a capital gain. This is allowable under Shari’ah principles as long as the transaction is spot. However, if an investor was to invest in a collective investment scheme of gold fund, and was subsequently issued with a share or unit, he could not sell this share or unit in the secondary market based on the net asset value (NAV) of the fund. This action may be deemed as selling gold not at par value, therefore breaching the principle of selling gold for money at par value to avoid Riba.

Key point • Collective investments may result in a number of Shari’ah issues that would not otherwise be so with individual investment activities by a Muslim investor.

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Islamic finance challenge 8.1 Scenario one A Muslim investor pays €1 million to purchase gold bullion from a gold supplier or to purchase an apartment in the City of London. In addition to his cash investment of €500,000, the investor borrows €500,000 from a conventional bank to complete the transaction. He then decides to sell his gold or property to another party either at spot or on a credit basis. Explain whether this is an issue from a Shari’ah perspective. Scenario two An Islamic fund of €100 million has a mandate to invest in gold or real estate assets. The fund manager issues units to the investors as evidence of their ownership interest in the fund and its underlying investment assets. The fund allows the unit holders to sell these units in the secondary market in order to exit the investment. The fund also borrows €50 million from a conventional bank to purchase gold or properties in excess of the equity contribution of the fund investors. Explain whether this would be an issue from a Shari’ah perspective and contrast and compare to the first scenario.

Solution Both scenarios would result in a number of relevant Shari’ah issues. There are no Shari’ah issues with an individual investor purchasing or selling his investment assets except with regard to the sale of gold, which must be done on a spot basis (as gold is a Ribawi item). He may also take out a conventional loan as this has to do with his personal conduct (although it is not actually compliant with Shari’ah principles given that he is a Muslim). However, the fund needs to be compliant in all respects if the institution has a mandate to be Shari’ahcompliant. In this case, Shari’ah issues will be insignificant as the transactions are physical and directly linked to specifically identified commodities or property. In the case of the Islamic fund, all potential Shari’ah issues originate from the fact that units and shares are issued to investors as evidence of their proportionate and undivided ownership of the underlying investment assets. This opens the door for these shares and units to be traded in the secondary market, which may not be compliant if the underlying assets are gold, cash or receivables. This, however, does not apply to investment in real estate. Borrowing using a conventional loan is also objectionable as the fund is acting as an agent for the investors. Therefore, structuring Islamic funds according to Shari’ah principles is critical in contrast to individual investments, irrespective of the investment assets.

8.2 Structuring issues of Shari’ah-compliant funds Structuring any compliant fund would require a thorough examination of at least five issues: • • • • •

the underlying investment assets the financial activities of the fund the contractual terms and conditions the clauses and terms of the investment contracts the cleansing or purification of non-Halal income.

8.2.1 The underlying investment assets The underlying investment assets, which are the central focus of any Shari’ah-compliant fund, must be compliant. While some investment assets are obviously permissible, such as grain, oil and metals, others may need Shari’ah screening, such as bonds, Sukuk, properties, shares, money market and treasury products. For example, if a fund has invested in the equity of public-listed companies then shares or stocks must be compliant according to established Shari’ah screening criteria as discussed in chapter seven. Failure to meet these criteria would affect the integrity as well as the credibility of the fund. The necessary screening methodology for other asset classes, such as properties and Sukuk, will also need to be carried out if the fund is structured as a property or Sukuk fund.

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8.2.2 The financial activities of the fund The financial activities of the fund must be equally compliant to Shari’ah principles. Thus, an Islamic fund is not allowed to raise funds through conventional borrowing. Furthermore, all investments by the fund must be conducted in a manner compliant to Shari’ah principles be it for short-term or longterm investments using the cash available in the fund (either from the initial investment proceeds or capital gains and dividend payments). The cash management of the fund must be channelled towards Islamic-approved deposit or investment schemes. In addition to the fund’s leverage and investment, all risk management techniques, such as currency hedging, investment via call options (if relevant), must be compliant to Shari’ah principles.

8.2.3 The contractual terms and conditions The terms and conditions of the contractual arrangement between the investors and other parties, such as the fund manager, the fund administrator and the trustee should also be Shari’ah-compliant. A fund could be based on either the Mudarabah or Musharakah contract. In practice, most Islamic funds are based on a Musharakah contract where investors are co-partners who share profits and losses as specified in the deed of agreement of the fund. The relationship between the pool of investors and the fund manager is also an important element of the structure of a fund. In most cases, the fund manager is appointed as an agent based on a Wakalah contract.

8.2.4 The clauses and terms of the investment contracts In addition to the important contractual issues that govern the relationship among investors and between the pool of investors and the fund manager, all clauses and terms of the investment contracts must be Shari’ah-compliant. For example, an Islamic mutual fund investing in compliant equities may propose to issue two classes of shares, namely class A and class B for two classes of investors. Shari’ah principles may allow the distinction of relevant rights and liabilities of these two classes of shareholders, such as the right of voting or different fees structures. However, Shari’ah principles will not allow any preferential treatment between the two classes with regards to profit distribution and loss bearing in the case of liquidation of the fund if all the investors are Musharakah investors.

8.2.5 The cleansing or purification of non-Halal income The term sheet or information memorandum of an Islamic investment fund must address the issue of cleansing or purifying non-Halal income generated by the fund. Some of this income may be due to the screening criteria that allowed the fund to invest in relevant underlying assets that generated a portion of non-Halal income. This can occur in investments in items such as shares and properties. It can also occur by accident where the Shari’ah compliance status of the underlying asset has changed as a result of corporate re-structuring, as in the case of mergers and acquisition or market movements. Generally, non-Halal income is measured against the total revenue of the underlying assets. This amount must be purified from either the dividend received (in the case of shares) or rental income (in the case of properties).

Key point • The structuring of Islamic funds looks at five main issues: the underlying investment assets, the financial activities of the fund, the contractual terms and conditions, the clauses and terms of the investment contracts and the cleansing or purification of non-Halal income. Table 8.1 shows a summary of the features of a typical property fund that can be found in its information memorandum.

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Table 8.1 Summary of LM Australian Alif Fund (based on Information Memorandum issued 17 April 2009) (LM Investment Management Ltd, www.LMaustralia.com) Investment objective

• To provide profit to the unit holders relevant to the risk return of the Fund, whilst adhering to Shari’ah principles; and • To provide an investment with a stable unit price.

Assets

The Fund’s investment remit covers investment in existing property direct property, property development, other managed funds, joint ventures and compliant business investment. All investments are into asset classes are in accordance with Shari’ah principles.

Investment term

Thirty-six months. Arrangements may be able to be made with the manager for different investment terms, for example, five years.

Currencies

Investment may be arranged for most currencies. USD JPY SGD CHF THB GBP CAD EUR HKD AUD Investments in the Fund can be hedged in the relevant currency against Australian dollar currency movements, while an AUD investment is not hedged.

Investment strategy

• • • •

Shari’ah investment guidelines

The fund precludes investment in certain businesses, such as alcohol, pornography, gambling and conventional financial institutions.

Reinvestment of distributions/profit

Distributions are automatically reinvested upon the 12-month anniversary of the investment.

Payment of distributions/profit

When the manager has been instructed by the investor to pay annual distributions, distributions are paid within 30 business days of the annual anniversary of the investment.

Automatic rollover

At the end of the initial 36-month term of the investor’s original investment (unless the investor elects to have the distribution paid direct to the account nominated on the Application Form), the capital and the profit is automatically reinvested in the originally nominated currency for further 36-month investment terms unless either the investor notifies the manager to reinvest the investment for different investment terms, or a withdrawal notice is received by the manager.

Investment term

Investments are made for a fixed term of 36 months.

Minimum investment

AUD$5,000

Withdrawal notice

At least 90 days prior to the expiration of the fixed 36-month term.

Minimum withdrawal

Multiples of AUD$5,000.

Minimum balance

AUD$5,000.

Unit pricing

Units are issued on application. The unit price is variable and as at the date of this Information Memorandum is AUD$1.00 per unit.

Fees

No entry or exit fees are payable provided the investment is held for the full investment term.

Direct investment in properties Investment in property development and on-sale Other Shari’ah-compliant property funds Joint ventures with other property developers

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Exercise 8.1 Based on the above summary, outline any other areas that should be incorporated in this summary to ensure its complete compliance with Shari’ah principles.

8.3 Fund structures and the Shari’ah perspective Funds can be structured in a variety of ways and some may have Shari’ah implications. The following section briefly discusses the various forms that a fund structure can take and when and how some of these structures may affect Shari’ah-compliance issues either at the issuance/origination or at the trading stage.

8.3.1 Open-ended funds As discussed in CDIF/3/10/157-158, an open-ended fund is essentially a fund that allows the fund manager to issue new shares or units on a demand basis. It also gives investors the right to redeem the shares or units from the fund based on the prevailing net asset value (NAV) of the fund that can only be made available at the end of each trading day. The issuance of new shares and redemption of existing shares will affect the NAV of the fund. The NAV is the basis of the price of new shares or units to be issued or redeemed for existing shares or units. This feature of the open-ended fund does not pose any Shari’ah issues as the NAV is an acceptable benchmark for all investors and the fund manager.

8.3.2 Close-ended funds Unlike an open-ended fund, a close-ended fund is a fund listed and traded on an exchange. The number of shares or units in this fund must be limited to the volume of the issue at the inception of the fund, that is to say no more shares or units will be issued to the market. These shares or units, unlike in the case of an open-ended fund, may be traded on a secondary market subject to market forces. If demand for the shares or units is high, investors may trade at a premium to NAV. However, if demand is low then they may trade at a discount to NAV. Like open-ended funds, close-ended funds should not pose any problems relating to Shari’ah compliance. The exception occurs when the underlying investment asset is gold, silver, currency or receivables. The trading of these underlying assets in the secondary market, at a price different from their face value, must be avoided so as not to lead to a Riba transaction.

8.3.3 Exchange traded fund (ETF) An exchange traded fund (ETF) is an open-ended fund that can be traded on a daily basis (CDIF/3/10/158). ETF offers public investors undivided interest in a pool of securities and other assets, and therefore are similar to traditional mutual funds, except that shares or units in an ETF can be bought and sold throughout the day like stocks on a securities exchange. ETF allows the trading of its shares or units at any time of the day instead of at the end of each trading day and are not redeemed by the fund (as in the case of an open-ended fund). The main difference between an ETF and a close-ended fund is that one of its shares or units represents a basket of underlying assets as contained in a particular index to which the ETF is linked, whereas a close-ended fund is not linked to an index. An ETF is normally described as an index tracking fund or, to be more precise, a listed index-tracked fund as it is listed on an exchange and it tracks a particular index that is used as a benchmark for the fund’s performance. Unlike other funds, irrespective of whether they are open-ended or close-ended, the investment portfolio in an ETF is already linked to a specified index so the fund manager does not need to re-balance it. An ETF is the logical progression of an equity market environment. The equity market began with stock trading. As retail investors did not have the time and expertise to pick and trade stocks this gave rise to mutual funds in both open-ended and close-ended forms. As mutual funds were usually unable to beat the market return (as measured by certain indices), the index fund was created. As mutual funds and index funds are not listed and traded, the market invented ETF, which is a listed index fund. From a structuring point of view, ETFs do not pose a Shari’ah challenge except when the underlying asset is gold, silver or receivables. This is relevant to the issue of trading rather than the issuance and origination of such funds. If the trading of ETF on these assets can be prevented, then an ETF can be structured around Shari’ah sensitive-based assets such as gold, silver and monetary assets.

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Key point • Islamic funds may be structured as open-ended, close-ended or exchange traded funds.

Exercise 8.2 An Islamic asset management company is considering the launch of two Islamic ETFs, one for shares and the other for gold bullion. Outline any specific structuring issues that many relate to either ETF.

8.4 Structuring requirements for compliant commodity and gold funds The following sections look at the structuring requirements for commodity and gold funds.

8.4.1 Commodity funds A commodity is an investment asset that investors may be interested in. This investment is perceived either as an alternative to traditional investment assets, such as shares and bonds, or as a diversification of the investment. A commodity includes a wide range of assets, such as oil, gold, corn, soya and metal, which offer an alternative investment for investors in addition to shares and bonds. The fund is normally structured to facilitate a collective investment in commodities that are important to global market needs, such as oil, precious stones, metals and grains. The vehicle of investment may take the form of open-ended, close-ended or ETF. A commodity fund is any fund that has a direct holding in real commodities. For example, aluminium or grain funds are true commodity funds. From a Shari’ah perspective, a Shari’ah-compliant commodity fund must exclude any fund that has a holding in commodity-linked derivative instruments such as futures and forwards. In the conventional market this is a common mutual fund strategy for investing in the commodities market in a situation where investors have no desire to take delivery of the commodities but simply want to profit from price changes in the market. An Islamic commodity fund must actually own and possess the underlying commodities. During the ownership period, investors must bear all the risks associated with these commodities as the market can be volatile. Central to this risk is the liquidity and market risk of the commodities in question. An Islamic fund investing in commodities-related assets ought to provide relevant Shari’ah-compliant hedging instruments to mitigate the liquidity as well as the market risks. Commodity funds do not pose any specific challenges to Shari’ah structuring except in relation to risk management as Islamic funds cannot participate in forwards or futures markets as practised in the conventional commodities market. The Shari’ah issue will be more relevant when underlying commodities involve precious metals, such as gold and silver, as these assets are usurious items. The next section considers gold funds as a sub-section of commodity funds.

Key point • A commodity fund, with the exception of gold and silver, is a compliant fund provided it is free from futures, forwards and options contracts in its business transactions.

Exercise 8.3 Based on your understanding of conventional futures and forwards contracts as outlined in CDIF/3/13/211-213, which of the following contracts would be a suitable Shari’ah-compliant alternative to mitigate market risk in the commodities market and why? (A) Wa’d and Musharakah (B) Wa’d and Salam (C) Murabahah and Salam (D) ‘Urbun and Murabahah

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Islamic finance challenge 8.2 A few financial institutions have seen the potential of investing in grain-based commodities. They have issued an investment paper under which all participating financial institutions will invest up to US$10 million to achieve the target minimum investment of US$100 million. The syndicated investors have appointed Green Investments Ltd to manage the investment portfolio for a fee of 5% per annum. Green Investments Ltd has been in the commodities market for the past 20 years and has been buying grain from farmers on a forward contract. Occasionally, Green Investments Ltd purchased the grain on a credit sale for a two-month period. Green Investments Ltd would also normally sell the grain to the ultimate purchasers or producers on credit terms. The average profit from such transactions has been 10% of the investment amount per annum for the past five years. Based on these facts, propose how the product could be restructured into a Shari’ah-compliant investment scheme.

Solution This is essentially the typical flow of transactions in the commodities market involving grain trading. The above description of the transaction may result in Shari’ah compliancy issues as Green Investments Ltd may have used a forward contract that is not compliant to Shari’ah principles (CDIF/3/13/211-212). However, if Green Investments Ltd was to use a credit sale arrangement when buying grain from farmers, then this will be acceptable. To mitigate the market risk, Green Investments may want to use either the Wa’d, Salam or ‘Urbun contracts, depending on what would be more relevant to the risk profile of the parties. These alternative contracts cannot replicate the full features and benefits of conventional forward and futures contracts, but may offer some aspects of risk management for the Islamic investors. For example, in the case of Wa’d, Green Investments Ltd may request the farmers to undertake to promise to sell a certain quantity of a specific grain to the fund in two months’ time at a specific price. This will protect both parties from market volatility during the intervening period. With regards to the investment vehicle, a Mudarabah investment certificate may be issued by Green Investments Ltd to pool investments from all participating Islamic-based investors. While the loss is to be borne by the investors, the profit is to be shared between the investors and Green Investments Ltd. Alternatively, a Shari’ah-compliant commodity fund may be formed to invite the investors to invest in this pool under a Musharakah contract. The Musharakah investors will later appoint Green Investments Ltd to manage the investment for a fee of 5% per annum. In both structures, the fund cannot borrow conventionally if it is in need of more funds.

8.4.2 Structuring compliant gold funds Gold is also seen as a commodity and gold funds, like other commodity funds, must have actual direct holdings in the commodity. For example, a gold fund holds gold bullion. Investors will own the bullion in proportion to their investment interest in the fund. However, from a Shari’ah perspective, gold should be treated differently from other commodities. In Shari’ah, gold and silver take the position of currencies and, therefore, cannot be sold except on par value and spot basis as per Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) Shari’ah Standard (No: 8). This will be discussed later. The following diagram illustrates the general structure of a typical Shari’ah-compliant gold fund.

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Figure 8.1 Gold fund structure Investors 1 Fund manager

5 Gold fund

4

Fund management vehicle 2 Physical gold bullion

3

Returns (capital gains)

Step 1

Investors place their investment money in the gold fund.

Step 2

A fund manager purchases the physical gold bullion in an allocated form that is identifiable.

Step 3

The fund manager manages the asset through its management vehicle for a period of time, usually a long-term strategy.

Step 4

The fund gets its returns by calculating the net asset value (NAV) at the end of the holding period. The NAV per share is calculated by dividing the fund assets, minus liabilities, to the number of shares issued or outstanding.

Step 5

The fund then distributes the profit, if any, to the shareholders in the form of a capital gains distribution.

The Shari’ah-compliant gold fund is structured with the intention of gaining long-term capital appreciation as investors take the view that the value of gold will appreciate over time. The fund primarily invests in physical gold bullion in certain specific gold commodity markets throughout the world such as Dubai Gold and Commodity Exchange. In this arrangement the physical gold bullion is purchased in an allocated form which will be identified and tagged, and kept in a secure place. The prime reasons for investing in gold are: • • • •

Gold is one of the most effective value-preserving commodities. Demand for gold is ever-increasing due to its reduced supply. Gold itself possesses excellent durability as the metal never degrades. It is tradable at any time in every location.

8.4.2.1 Restrictions relating to gold funds At this stage it is appropriate to highlight a few issues that relate to a gold fund vis-à-vis other underlying assets in a commodity fund. These issues include, but are not limited to, the following: • As previously explained, the structure of any fund could be open-ended, close-ended or ETF. An openended fund structure would seem more suitable for a gold fund to ensure that shares or units are not traded in the secondary market. Any secondary trading of these shares or units may be questionable as gold can only be sold or exchanged for money at face value instead of at a value based on the NAV of the gold fund or at the market value based on market forces. The structure of an ETF gold fund may result in Shari’ah compliancy issues as an ETF may be traded in the secondary market unless the exchange, while approving the ETF gold fund, for example, prevents its trade until it matures.

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• In order to satisfy the Shari’ah requirement of real ownership of the gold bullion by investors, the units or shares of the respective investors must be traceable to an identified piece of gold bullion. Also, the fund must make it possible for investors to take physical delivery of the gold bullion if they wish. However, all the expenses pertaining to the delivery and transportation and insurance must be borne by the respective investor. • In the case of early redemption of the unit or share of the fund, the fund may have a policy that no investor can redeem an investment until the fund matures. However, the fund may allow investors, under strict circumstances, to liquidate their position by buying the units or shares at the prevailing market price, based on the NAV of the fund. This is only allowed for redemption and not for trading purposes. The investor normally cannot exit the investment until it matures to be compliant to Shari’ah principles. However, in some exceptional cases, such as when the investor is in dire need of cash and subject to the scrutiny of the fund manager, the fund manager may redeem this share or units based on NAV to allow early redemption. This is the only mechanism to allow early redemption since the fund disallows secondary trading of the units. • It is also relevant to pose the question of whether an Islamic investor may invest in gold-related investment structures, such as the equities of worldwide companies engaged in the exploration, mining, production or processing of this precious metal. The view of scholars is divided on this matter as the shares of these public-listed companies in the exchange are liquid and tradable. There is a concern that investment in these companies may lead to the trading of cash for ‘gold’ as the company’s assets comprise gold, even though it is still involved in the mining process.

Key point • Shares and units in a gold fund, unlike a normal commodity fund, must not be tradable in the secondary market to avoid a Riba transaction. While trading is not permissible, redemption of the shares and units in the gold may be permissible subject to certain requirements.

Exercise 8.4 An Islamic fund proposes to launch an Islamic money market fund comprising 30% Sukuk Ijarah and 70% investment in gold bullion. The fund intends to use an exchange traded fund as its investment vehicle. Would this structure be compliant to Shari’ah principles as per AAOIFI Shari’ah standards and if it is not compliant, what would you propose to make it compliant?

8.5 Shari’ah real estate funds / Shari’ah real estate investment trust (REIT) Investment in real estate or landed property may take the form of a normal mutual fund or real estate investment trust (REIT). A discussion of Islamic REITs was made in CDIF/3/12/189-201. The following is a typical structure of a real estate fund which takes the form of a mutual fund.

Figure 8.2 Islamic real estate funds Investors

Fund manager

Fund management vehicle

Direct property (existing property)

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Joint venture

Property development (new property construction)

House financing

Property companies

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8.5.1 Islamic mutual funds and Islamic REITs investing in real estate The relevant issues of both Islamic mutual funds and Islamic REITs investing in real estate are as follows: • The screening methodology must be established to screen the mixed use of real estate, compliant use and non-compliant use. Unlike in the equity sector, the global Islamic finance industry has not provided a universal Shari’ah standard for screening real estate properties. Therefore, the development of this sector may be affected. Some guidelines, for example, have prescribed a maximum of 20% for non-Halal lease income as the benchmark (as in the case of the Securities Commission of Malaysia), while other Islamic real estate funds may adopt a zero tolerance for nonHalal rental income. By reference to the screening used for stocks, one may infer that a maximum 5% benchmark could be advocated to screen non-Halal rental income. • The non-Halal income generated from non-compliant tenants must be given to charity to purify the tainted income to the fund. • Any financing by the fund to enhance its investment capabilities must be undertaken according to Shari’ah principles. In other words, although the fund may leverage, it should only do that in a manner that is Shari’ah-compliant.

8.5.2 Real estate funds versus REITs Although both real estate funds and REITs operate in a similar way, that is, to acquire property and lease it to tenants for a rental income, REITs may have a different investment strategy. Among other possibilities, the property owner may leverage it using the scheme of REITs. In this case, the owner may pool the assets, which are compliant, such as hospitals, universities and residential apartments, with a view to selling them to Islamic REITs at a certain price. The proceeds of this sale may be used by the owner for other property development or activities deemed fit that are not related to Islamic REITs and its investors. The owner of the properties, and Islamic REITs investors are two different and independent parties. Islamic REITs as a fund will issue units to investors to evidence undivided interest of the investors in those assets that the Islamic REITs fund is buying from the owner. These assets could be subsequently leased back to the owners as the operator, given their expertise in managing those assets before the acquisition by the Islamic REITs. The lease rental paid is the income to be distributed proportionately among the Islamic REIT investors.

8.5.3 Financing or leveraging Islamic REITs Pertinent to both real estate fund and Islamic REITs is the issue of financing or leverage to enhance their financial capabilities to acquire more properties, exceeding the equity portion of the fund. In an Islamic fund or Islamic REITs all financing activities should be compliant. These can be facilitated either through Islamic banking products or capital market products such as Sukuk. The challenges arise if the fund was to increase its profitability by undertaking a relevant joint venture with other property developers to secure a higher degree of profit since they will be involved from the very beginning of the project. The joint venture between Islamic real estate funds or REITs with other property developer companies must be structured according to Islamic principles. For example, the new joint venture company, which is formed by both an Islamic fund and another developer company, should not borrow a conventional loan to finance the cost of the project. It has to obtain Shari’ah-compliant project finance, even though the entity which seeks this financing is not an Islamic fund. The Islamic fund as co-owner is liable for its financial conduct.

Key point • Islamic real estate funds and Islamic REITs may only invest in compliant properties, although these properties may generate some non-Halal rental income from their tenants. The tolerance level must be decided by the fund’s Shari’ah supervisory board in the absence of globally accepted property screening criteria.

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Islamic finance challenge 8.3 An Islamic property fund in India is considering investing in the real estate sector using several investment strategies. The following strategies have been shortlisted by the fund management company: •

Purchase of new residential apartments in the city of Mumbai to lease them out to expatriates working in the city with the minimum rental payment of Indian Rupee (INR) 200 million per year.

Purchase and manage serviced apartments in the same city.

Purchase and manage three-star hotels in the city of Bangalore.

Joint venture (JV) with local developers to build new houses in various main cities in India of up to 500 units. While the Islamic property fund will provide the equity of up to INR10 billion to the JV company, the other venture partners will provide a small amount of equity of INR1 billion. However, the JV company will later borrow up to INR10 billion from a conventional bank to finance the cost of the construction.

Based on the above information, advise whether these proposed investment strategies are compliant with Shari’ah principles and, in the case of any that are not compliant, propose the investment structure required to make them compliant with Shari’ah investment guidelines.

Solution The Islamic property fund may invest in (a) and (b) without generating any Shari’ah issues as the main purpose of residential apartments and serviced apartments is essentially accommodation and lodging. Serviced apartments, as widely observed around the world, do not provide any food and beverage to its guests or visitors and, therefore, the issue of income from non-Halal food and drink is avoided. However, the proposed investment in the hotels may pose a Shari’ah investment issue as the hotels may offer non-Halal food and drink. Subject to a non-Halal income tolerance ratio subscribed to by this Islamic fund, the fund may continue with this investment if the income from non-Halal food and drink is below the prescribed ratio. This non-Halal income is, however, always subject to a cleansing or purification requirement. Alternatively, the fund may outsource the food and beverage services to a third party of which the fund has no relationship in terms of ownership of the premise or the management of this third party servicer. If either of these options is not possible, then the fund must drop this investment target. As for the investment via joint venture, the proposed structure of establishing the JV company, the leverage to be undertaken by the JV company using a conventional loan appears to be non-compliant as the company is jointly owned by both an Islamic fund (via equity contribution of INR10 billion) and the local partners (via equity contribution). An Islamic fund, being the owner of this new JV, should not borrow through a conventional loan as this will generate interest payments that are an expense to the fund. A possible solution is for the JV company to seek Islamic financing, such as Murabahahtawarruq, if available. If it is not available, which is quite likely in this case, another structure may be proposed. The act of conventional borrowing must be done by the local partners and the proceeds of this loan will be contributed as equity in the new JV company, which is also contributed by the Islamic fund. In this case, the company will be getting a total equity of INR21 billion contributed by the Islamic fund (INR10 billion) and local partners (INR11 billion, whereby INR10 billion is raised through a conventional loan). In this structure, the company will not be involved in conventional borrowing, and will be compliant with Shari’ah principles.

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8.6 Islamic money market funds Money market funds are mutual funds that invest in liquid, short-term instruments. These funds seek to limit exposure to losses due to credit, market and liquidity risks. Liquidity and capital preservation are the two pertinent features of money market funds that investors look for. These features are also required by Islamic investors who, in addition, require that the instruments invested by their money market funds are Shari’ah-compliant. Unlike conventional fund managers, who have at their disposal a plethora of debt and interest-based instruments to suit their money market portfolios, Shari’ah-compliant money market instruments are still comparatively in the infancy stage. To date, Islamic fund managers allocate their Islamic money market funds to investments in either Commodity Murabahah, Wakalah fi al-istithmar or short-term Sukuk such as Sukuk Ijarah.

An example of this is the Boubyan Financial Fund. The fund aims to maintain stability on returns through its investment in Shari’ah-compliant financial instruments, including asset-backed Sukuk, Sukuk Ijarah, Sukuk Musharakah, Sukuk Murabahah and other Shari’ah-compliant Sukuk and regular Murabahah deals that are typically based on the Murabahah-tawarruq structure. The fund invests the available surplus funds in Shari’ah-compliant short-term Murabahah deposits and aims to realise competitive or higher returns than traditional money market Kuwaiti Dinar returns over the short and medium term. It seems that this fund will only invest in those assets that are liquid, fixed-income and short-term in nature. This is the very basic feature of any money market fund, be it Islamic or conventional. The extract of the term sheet for Boubyan Financial Fund is below:

Table 8.2 Term sheet for Boubyan Financial Fund Maximum subscription

50% of Total Issued Units

Fund type

Open-ended

Fund tenor

Ten years, renewable subject to majority approval

Net asset value

Calculated on weekly basis

Subscriptions and redemptions

Weekly (one month after launch of fund)

Fund’s custodian

Gulf Clearing Company (Bahrain)

Selling agents

Boubyan Bank and any other financial institutions appointed by the fund manager

Auditor

Deloitte & Touche, Bahrain

Management fees

0.625% p.a. of net asset value (NAV)

Fund registration/governing law

Central Bank of Bahrain (CBB)/Laws of the Kingdom of Bahrain and State of Kuwait

Abstract of term sheet sourced from Boubyan Bank, www.bankboubyan.com

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As per the comparative performance of this fund vis-Ă -vis other money market funds, the table below explains that the performance of the Boubyan Islamic money market is comparatively better.

Table 8.3 Comparative performance of Islamic money market fund Cumulative by %

Annualized by %

4 Wks

1 Yr

YTD

3Yr

5Yr

10Yr

Boubyan Financial (KWD)

0.71

7.46

2.65

7.39

--

--

LGC – Money Market (Other Currencies)

4.64

-12.64

6.09

1.3

2.61

3.79

Figure 8.3 Comparative performance of Boubyan Financial and LGC money market funds 13000 12000 11000 10000 2006

2007

Boubyan Financial (KWD)

2008

2009

9000

LGC - Money Market Other

Historical performance sourced from Lipper Fund Screener

The Boubyan Financial Fund was originally launched at US$10,000 per unit. The orange-labeled graph in figure 8.3 above represents the net asset value (NAV) per unit throughout the duration of the fund. The fund grew steadily from 2006 until the first quarter of 2009, with the fund recording a NAV of US$11,242 when this report was generated.

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8.6.1 The performance of a sample of Islamic money market funds Table 8.4 below shows the performance of a sample of Islamic money market funds that have more than a year’s track record (sourced from Coast Investment Islamic Funds Analysis 2008).

Table 8.4 Performance of Islamic money market funds N Periods

Geometric mean %

Arithmetic mean %

Standard deviation %

KSE Weighted Index

88

37.44

39.59

24.75

First Investment Al-Muthana Fund

88

5.17

5.18

Al Dar - AlDar M. Mkt Fund

51

6.71

Boubyan Boubyan Financial Fund

33

KMEFIC - Amwal Islamic M. Mkt Fund

24

Beta

Alpha

Sharpe ratio

Highest return %

Lowest return %

Median %

0.309

0.027

0.446

20.25

-14.26

45.78

0.4

-0.004

0.004

-0.597

0.68

0.26

4.94

6.72

0.53

0.002

0.005

0.392

0.91

0.28

6.98

2.65

2.78

5.15

0.002

0.003

-0.178

0.71

-5.84

7.22

7.64

7.64

0.17

-0.001

0.006

2.882

0.7

0.53

7.7

Source: Coast Research

The table depicts the performance of the funds through various statistical measures. It is evident that the Boubyan Financial Fund is the most volatile, while the Amwal Islamic money market is the least volatile. Al Dar money market fund posted the highest returns followed by Boubyan financial funds. However, when looking at Sharpe ratio values, which are calculated on an annual basis, it is clear that Amwal Islamic money market funds managed to post the highest risk-adjusted return as represented by the highest Sharpe ratio value. Meanwhile, Al-Dar came in second for posting the highest Sharpe ratio. In terms of Alpha, another statistical measure that shows the excess returns of the fund, Amwal Islamic money market fund has the highest Alpha while Boubyan financial has the lowest. Additionally, the Al Muthanna fund and the Amwal Islamic money market fund both have a negative Beta while the rest of the funds have a positive Beta. Table 8.5 below shows another example of an Islamic money market fund from Saudi Arabia:

Table 8.5 below shows another example of an Islamic money market fund Al-Badr Murabahah fund SAR

Al-Badr Murabahah fund US$

Base currency of the fund

Saudi Riyals

US Dollar

Currency exposure

SAR &USD

USD &SAR

Fund objective

To achieve returns at low risk, to strictly adhere to Shari’ah compatible commodity trading and interest free financing models, as well as to enable investors to access their investment, if required, at short notice.

Investment policy

To invest in non interest bearing International Trade finance transactions with reputed local international counterparties, to invest in Islamic Sukuks, Murabahah funds and any other Islamic instruments that fulfill the fund objectives in the view of the manager.

Risk/return profile

Low

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8.6.2 Shari’ah-compliant money market funds Shari’ah-compliant money market funds are needed to allow investors with excess capital to invest in short-term, but safe or low-risk investment instruments that are basically fixed-income instruments. This kind of fund may be appealing to Islamic financial institutions and other Islamic funds that need to manage their cash according to Shari’ah principles, as well as other retail investors through a dedicated Islamic mutual fund investing only in money market instruments or in a combination of equity and money market instruments. However, as the underlying investment asset of this fund may contain monetary assets, such as receivables arising from a Murabahah-tawarruq structure, the shares or units of this fund are not meant for trading in the secondary market. If the fund intends to make the shares and units of the fund tradable, then the fund should contain some other asset classes, such as Sukuk Ijarah, to make it a hybrid fund instead of a fully fledged money market fund. A ratio of 30% (for Sukuk Ijarah) and 70% (for monetary assets) is an acceptable benchmark as per AAOIFI Shari’ah Standard (No: 21).

Key point • The Islamic money market is crucial not only for Islamic investors who seek to benefit from the performance of this fund and its underlying assets, but also for many other Islamic funds that need to manage their cash in the short term and via liquid Islamic investment instruments.

Exercise 8.5 Asset allocation is central to any fund management. An Islamic equity or real estate fund may have 80% invested in stocks or properties respectively and 20% in cash or Islamic money market instruments. The fund needs to maintain some investment in cash or money market instruments in the expectation of redemption by the unit holders (particularly in the case of an open-ended fund). However, if the stock market or real estate sector is expected to face a decline, the fund may decide to invest 60% of the investment amount in Islamic money market instruments either through direct investment or through another Islamic money market fund. Would this switch of investment decision affect the tradability of the shares and units of either equity or real estate funds?

Islamic finance challenge 8.4 A leading scholar of Islamic finance, in an address at a major Islamic conference, commented on the term ‘Islamic money market’ as part of Islamic fund schemes. He was reported to have said: “Money in Islam is a medium of exchange and has never been a commodity. The term ‘Islamic money market fund’, which some Islamic funds have used, from my perspective, may be misleading, if not an actual deviation from Islamic finance teachings. This should be addressed by all stakeholders to avoid continuous confusion in the market.” Explain whether you agree with his remarks and state why.

Solution From a technical perspective, the term ‘Islamic money market fund’ will be very confusing not only for Islamic investment communities but also for general investment communities. Ideally a new term should be created to replace the above term to reflect the actual nature of the fund. Among other proposals is ‘Islamic fixed-income fund’ or ‘Islamic liquid fund’. This is to avoid giving the impression that money has a market in which it can be traded. Some of the components of this fund may have their own nomenclature if they are solely based on that underlying asset, such as a Sukuk fund or Wakalah fund or Murabahah fund, where relevant and applicable. However, the problem arises when a single fund tends to invest in all of these investment assets that combine many different features. They tend to share common features such as ‘fixed income’ and ‘liquid instruments’. Moving forward, a new term that reflects the true nature of this fund should be adopted.

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8.7 Shari’ah requirements of structuring private equity funds As stated in CDIF/3/11/180, private equity essentially refers to investments in shares of companies that are not freely tradable in the open market. The funds used for private equity investments are raised privately. The fund is normally a closed-end fund as investors may have to invest for a fixed period of time before they can liquidate their investment; that is upon the maturity of the fund. Unlike mutual funds or unit trusts that are invested in public-listed companies’ shares, private equities are seen as more focused in their investment strategies in that they typically do not invest in a wide portfolio of companies. Also, private equity funds tend to take control of the management of the investee companies.

Islamic finance challenge 8.5 Explain whether the same stock screening methodologies described in chapter seven (section 7.5) should be applicable to screening the private companies that Islamic private equity funds intend to invest in. Give reasons why there may be a need to devise another screening methodology, given that the primary purpose of investing in private companies is to have management control over the investee companies.

Solution The above hypothesis is a valid and relevant issue. Essentially, Islamic private equity funds may need to have a different screening methodology as the ultimate purpose of the fund is to have control over the management of investee companies. Management control is not present in the investment process in the shares of public-listed companies. Thus, investee companies in Islamic private equity investments must be totally compliant to Shari’ah principles from the very beginning of the investment mandate. As investment via private equity funds results in management control, the tolerance given in the context of screening public-listed companies, such as cash and interest-bearing instruments, as well as conventional leverages, are no longer relevant in Islamic private equity screening. However, to all intents and purposes, this methodology is still relevant if the Islamic private equity funds were to invest as minority investors with other conventional private equity investors as majority investors in any investee company simply because management control ceases to exist if Islamic private equity funders are the minority shareholders. This is a viable alternative to allow an Islamic private equity fund to participate in private equity investment activities, that is to participate as minority shareholders. Although the participation is merely a minority shareholding that gives Islamic private equity fund no control, the purpose of management control can still be achieved. Both Islamic private equity and conventional private equity, as its majority co-investor, will be managed by the same management company, that is a general partner or SPV, to effectively manage the companies as desired by both the funds, Islamic and conventional.

8.7.1 Shari’ah screening requirements for private companies Shari’ah screening requirements for private companies are relatively strict compared with publiclisted equities. The key issue relates to the management control that private equity investors hold over investee companies. Under Shari’ah principles, such control would necessitate that the private equity fund ensures that the company invested in must be totally Shari’ah-compliant if the Islamic private equity fund were to invest as majority or ultimate investors. The reason for this requirement is that investors do not have management control over these public-listed companies to ensure that all their financial activities are compliant. In the case of a private equity investment strategy, the objective is always to take management control of the company. Therefore, Islamic private equity funds, as the ultimate investor and manager of the company, are not supposed to take any conventional leverage, even for a small amount or percentage, because paying interest is categorically prohibited for an entity that is either owned or controlled by Islamic investors seeking a totally Shari’ah-compliant investment.

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Key point • Islamic private equity funds may entail ownership and management control over investee companies. Any company owned and controlled by Islamic private equity funds must not conduct activities that are non-compliant to Shari’ah principles.

8.7.2 Options available to allow Islamic private equity investors to participate in this asset class There are at least three possible solutions for Islamic private equity investors to participate in this asset class. 1. Shari’ah scholars would allow Islamic private equity funds to invest as minority investors in the investee company, together with other conventional private equity investors. This is referred to as co-investment or parallel investment. 2. Islamic private equity funds may be allowed to invest in the investee companies as majority investors on the provision that a certain grace period is given to the management of the investee company to convert all their activities to meet Shari’ah requirements in the fullest sense, such as zero exposure to either interest-based financing or interest-based income. 3. The third solution is for Islamic private equities to provide financing via Murabahah-tawarruq, instead of equity, which can be technically ‘converted’ into the shares of the investee company, subject to those shares being compliant at the time of conversion.

8.7.3 Options in practice With regards to the first solution, several Islamic private equity funds have devised a mechanism to invest in permissible companies that may have conventional gearing in their portfolios by taking a minority stake in such ventures. This means that the Islamic private equity funds will acquire the investee company alongside a conventional private equity fund that is the majority shareholder. Under this mechanism, the Islamic private equity fund does not have a controlling share in the investee company (the conventional private equity fund does) and hence the same financial tolerance limit made available to mutual funds or unit trusts investing in public-listed companies will also be at their disposal, albeit requiring several adjustments in calculation, such as total assets being used as the denominator. This is because the shares of the private companies are not actively traded in the market; hence market capitalisation is not relevant or applicable.

8.7.4 Co-investment From a structuring point of view, take the example of private equity firm Horizon Capital, which plans to establish two partnership entities. The first entity is a conventional limited partnership (LP One) and the second is the Islamic limited partnership (LP Two). Horizon Capital will be the general partner (GP) for both LP One and LP Two, acting as the manager for both LP investors. The GP will invite Islamic investors to subscribe to an Islamic private equity fund in the vehicle of LP Two for, say, US$500 million, while investors for a conventional private equity fund will raise say US$1 billion. Both LPs will be managed by the same GP. The GP, aware of the specific requirements of the Islamic investors of LP Two, will screen potential companies to identify those that are compliant according to established stock screening as prescribed for public-listed companies. Upon ascertaining these companies from both commercial and Shari’ah considerations, the GP will make an investment in these companies with the aim of acquiring and managing these companies, which is a usual practice in private equity investment. However, the GP will allocate a majority shareholding to LP One investors, such as 70%, and the remaining investment will be allocated to LP Two investors. In this respect, Islamic investors are not deemed the majority investors and are therefore allowed to invest in companies that pass the Shari’ah screening test but may have some non-compliant financial activities. In the final analysis, Islamic private equity funds, following this alternative, will only be possible if the private equity firm or GP is committed to having two partnership entities investing in the same target company.

8.7.5 Achieving complete compliance via dedicated investment Another permissible alternative is to allow Islamic private equity funds, in the form of a limited liability company (LLC), to invest as majority shareholders in investee companies, even though they are not fully compliant at the time of investment. Normally, this fund is given a two to three-year

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period by its Shari’ah supervisory board to convert the financial activities of these companies in line with Shari’ah principles with regards to leverage and investment activities. It should be mentioned that these companies must have permissible core activities at the time of investment; otherwise the approval for this investment strategy may not be possible. An equally important consideration is that the conversion programme, in terms of period and feasibility, must be probable and achievable. Therefore, this special approval or concession may not be given to companies that are located in jurisdictions that do not provide any Islamic financial products and services to convert existing leverage and interest-based investment to Shari’ah-complaint financing and investment. With regards to interest-based investment, approval may be given for the company to invest in noninterest bearing accounts, such as a current account that pays no interest. In conclusion, approval may be limited to companies that are likely to get access to Islamic financial products, particularly Islamic financing instruments for leveraging purposes.

Key point • Islamic private equities may co-invest with conventional private equities in the same investee company or invest as the majority shareholder in that company on the provision that the investee company shall be converted into a fully compliant company within a prescribed period.

Exercise 8.6 Care Services LLC is a company specialising in providing home care services for elderly citizens who need accommodation and the necessary support to live in a reasonable lifestyle without the support of family members. The company provides this service for a certain payment to cover operational costs as well as to earn an operating profit. The scheme of payment consists of contributions from both the government and the individual participants. The government’s total grant for this scheme is US$100 million per annum and the total contribution by the participants is US$30 million per annum. While the total assets of the company in the last audited account was US$300 million, profit before tax was US$30 million. The company did not take out a loan from the bank as the funds contributed by both the government and participants were sufficient to cover both the expansion and operating expenses of the centre. However, the company has invested its cash in conventional banks that generated an interest payment of US$5 million. The total cash in interest-based instruments is US$50 million. Medina Equity is a private equity fund that seeks to invest in this company. This company has assigned you to outline the possible issues and strategies involved in setting up an Islamic private equity fund to invest specifically in Care Services LLC. Prepare the outline of your professional advice and perspective.

8.7.6 Investing through both equities and loan – an example In conventional private equity business, it has been observed that a private equity fund may not necessarily invest in investee companies through equities. It may invest through both equities and loans that would then be convertible to the equities of the companies. This is a prudent way of investing, particularly when the fund is not certain of the performance and value of the investee company. Suppose a conventional potential investee company needs US$20 million to expand its new line of business to generate more future profit. The private equity fund has some reservations about the potential of this new line of business, even though the investee company has been generally successful in creating new value in the past. In this context, the private equity fund may decide to contribute US$10 million as equities in the investee company and another US$10 million as a loan to the investee company. The manner of conversion of this loan to equities will have to be agreed upon upfront. Suppose the agreement has fixed that where the net tangible asset (NTA) of the investee company reaches a certain level, the lender of the loan may convert it into equities of the company at the ratio of 1:2, that is, for every dollar of loan, the lender will get two shares in the company. If the NTA does not increase as per the expectation of the lender, the investee company will have to repay the loan plus interest.

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8.7.7 Acceptability of converting loans to equity within Islamic private equity funds Islamic private equity funds may also be interested in having a similar investment scheme when deciding on an appropriate investment strategy to bring better value to investors. This is relevant in a case where the investee company is not yet fully compliant but has the potential to become fully compliant in the future. In some cases, Islamic private equity funds will need to finance the investee company through both equity and financing or through financing exclusively. However, we need to ask if devising a financing scheme that is ‘convertible’ to the shares of an investee company would be permissible under Shari’ah principles. Under Shari’ah principles, a loan or a debt cannot be simply converted into equities as per the AAOIFI Shari’ah Standard (No: 13). Thus, Islamic private equity funds would have to provide financing through a Murabahah-tawarruq structure (CDIF/2/5/108-109), but the fund is not allowed to simply convert the account receivable to a number of shares based on an agreed formula. This, then, will not fit into the intended scheme of both financing and conversion of debt into equities.

8.7.8 Achieving acceptability The Islamic private equity fund market has devised a scheme of financing that can effectively achieve the purpose of converting Islamic debts into equities. The following is an illustration of this innovative scheme.

Suppose the investee company needs US$20 million for its business expansion and the Islamic private equity fund, due to its business risk analysis, can only agree to provide US$10 million in the form of equities and the remaining amount in the form of Murabahah-tawarruq. Prior to Murabahah-tawarruq financing, the investee company can give an undertaking under the principle of Wa’d or a unilateral promise to sell a number of its shares to an Islamic private equity fund in the future. This is subject to the performance of the company as per the agreed net tangible asset at a price that equals the amount payable under the Murabahah-tawarruq financing. This undertaking will give the Islamic private equity fund an option, not an obligation, to either ‘convert’ this account receivable arising from Murabahah-tawarruq financing to shares of the investee company or to demand this amount at the time of the maturity as a debt payable.

Under the above example, there is no direct conversion of Islamic debt into equities in the structure. Instead, the investee company will undertake to sell a number of its shares to the financier at an agreed price in the future and the price of this sale is set-off against the outstanding payment under a Murabahah-tawarruq structure.

Key point • Loans convertible into equities may be replicated in Islamic finance through a Murabahahtawarruq structure. Here the investee company undertakes to sell its shares to an Islamic private equity fund by setting-off the payment due under a Murabahah-tawarruq structure for the consideration of the shares.

8.8 Comparison of performance between Islamic and conventional-based investments Islamic finance has developed a set of prudential and ethical criteria for investing, especially through the stock markets or exchanges. By means of these criteria, unacceptable companies are identified and ‘screened out’. Criteria include tests at the level of a company’s primary business and at the level of its financials or capital structure. Shari’ah screening criteria have been used by major international index providers to establish specialised Islamic market indexes.

8.8.1 Performance in good or bad times During the stock market turmoil witnessed in 2008/09, Islamic indexes, although they fell, fared somewhat better in relative terms because of the exclusion of bank and insurance stocks, which failed to pass through the screens owing to the nature of their business (dealing in interest). Since Islamic indices do not have any exposure to these interest-based financial institutions, the impact of the financial crisis affecting this financial sector has not adversely affected Islamic indices.

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Figure 8.4 Comparative performances of Islamic index and conventional index 1,200 1,100 1,000 900 800 700 600 500 1/30/09

1/2/09

1/16/09

12/19/08

11/2/08

12/5/08

11/7/08

11/21/08

10/24/08

9/12/08

10/10/08

8/29/08

8/1/08

8/15/08

7/4/08

7/18/08

6/6/08

S&P Global BMI

6/20/08

5/9/08

5/23/08

4/11/08

4/25/08

3/14/08

3/28/08

2/29/08

2/1/08

2/15/08

400

S&P Global BMI Shariah

Source: O’Brien, O’Brien, Christopher, “Applying Globally Accepted Shari’ah Standards across Markets,” Standard & Poor’s, March 2009.

Figure 8.4 above compares Standard & Poor’s (S&P) global Shari’ah index with its global conventional index. In 2008, the S&P global index lost 42.5%, while its Islamic counterpart lost 36.8%. The S&P 500 lost 38.6%, while its Islamic counterpart lost 28.9%. However, it should be mentioned that the real performance of Islamic investments depends not only on the sector and financial ratio screening but also global market conditions. It goes without saying that during the time when the shares of financial institutions are buoyant, the performance of any conventional index with significant exposure to the financial industry will outperform an Islamic index. Therefore, Islamic investors and fund analysts must examine the performance of a fund or an index against one another.

8.9 Strategic issues for further development of Islamic funds By and large, Islamic funds have appealed to a wide spectrum of Islamic investors in various asset classes. The development of these funds has given opportunities to many investors seeking an Islamic-based investment. However, there are some issues that need to be addressed to enhance the growth and development of this sector.

8.9.1 Retail investors’ participation Most of the current Sukuk funds and Islamic money market funds are not designed for retail investors. Therefore, the need for retail investors’ participation could be promoted to enhance the wider investors’ participation by the creation of Islamic fixed-income funds that are based on a Sukuk and Murabahah commodity for retail investors. Otherwise, the individual retail investors may not be financially able to invest in either Sukuk or Murabahah commodity instruments as direct investment would require a minimum investment amount that is relatively large for individual investors.

8.9.2 Analysis of performance An update and thorough analysis of the performance of various Islamic funds around the globe is required. As fund performance is the acid test of any fund management, the need for analysis is crucial to provide proper and relevant information to the Islamic investment community. At present, there is no leading performance measurement firm that specialises in Islamic funds worldwide. Rating agencies should perhaps also rate Islamic asset management companies for better disclosure to the investing public.

8.9.3 Innovation and product development Continuous innovation is required to spearhead product development in the area of Islamic investment. Product development, if not product innovation in the case of Islamic ETF and REITs, is an interesting example of how Islamic investment products can be structured along the lines of conventional sophisticated products, subject to necessary modifications, to render Islamic funds

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more cost-effective and, in some jurisdictions, tax effective. Islamic private equity is always close to Islamic investment principles in terms of choice of business activities and business development, as well as control and management. Many compliant projects and business developments may be financed through private equity using both the equity and debt structure, where relevant.

8.9.4 Proper financial planning schemes Islamic investment is an integral part of financial planning for individuals, corporate entities or institutions. The Islamic community, as a whole, needs a proper financial planning scheme and modules to suit not only the commercial terms of the financial planning but also, more importantly, the Shari’ah requirements of each and every investment strategy and instrument. Only with an effective scheme will Islamic-based investment activities flourish to a level that is fulfilling and meaningful.

8.9.5 Better integration between financial markets around the world Integration can be improved with additional investment in infrastructure, such as the development of standardised Shari’ah-compliant documentation. Cross-jurisdiction transactions have often been conducted using bilateral documentation that may yet withstand the test of legal scrutiny and proceedings. Standardised International Swaps and Derivative Association (ISDA)-like documentation, for Shari’ah-compliant money market or treasury transactions, using Murabahahtawarruq or Wakalah fi al-istithmar contracts, would immensely improve the effectiveness of the Islamic fund manager. The same may be emulated in the field of Islamic REITs, Islamic ETF and other investment vehicles and structures where relevant and applicable. Also, mutual recognition of Islamic investment products between two or various jurisdictions, such as the Securities Commission of Malaysia and the Dubai Financial Services Authority, makes the whole Islamic investment market more cost-effective, coherent and global.

8.10 Conclusion The advent of Shari’ah-compliant funds gives rise to Islamic investment opportunities not only for institutional or high-net-worth investors but also to average Islamic retail investors who are now able to diversify their investment risks. In general, Islamic funds portray similar expectations of investors’ preference towards risk diversification in equity investments and other asset classes, based on an agreed trust deed that caters to Shari’ah-compliant requirements in all permissible investments. Structuring any compliant fund would require a thorough examination of the underlying asset under management, the financial activity of the fund, the contractual agreement between the contracting parties and the terms and conditions of the investment. Whether it is a Shari’ah commodity, gold, real estate or money market fund, the fund can usually exist as an open-ended, close-ended or exchange traded format. Each of these forms of Shari’ahcompliant funds must correspond to the different Shari’ah standards that have been established by AAOIFI and other Shari’ah authorities that govern the jurisdictions of the funds’ domicile. For Islamic private equities, the Shari’ah requirements placed upon them are stricter only because private equity investors are usually the majority stakeholders of the companies they invest in and, hence, are able to influence business operations. The issue of whether the Islamic funds must be 100% Shari’ah-compliant or can be allowed to display the usual tolerance levels prescribed by Shari’ah screening agencies thus depends on questions of ownership and control over business processes and activities.

8.11 Summary Having read this chapter the main points that you should understand are as follows: • Shari’ah-compliant investments may be made directly by individual investors into respective assets such as bonds or Sukuk, shares, property and commodities, or through collective investment schemes • Islamic funds provide similar expectations of investors’ preference towards risk diversification in equity investments and other asset classes based on an agreed trust deed that caters for Shari’ahcompliant requirements in all permissible investments • collective investments may pose some Shari’ah issues that are not otherwise relevant to investment activities by an individual Muslim investor, such as financing schemes that the funds participate in • most Islamic funds are based on a Musharakah contract among the investors of the fund • Shari’ah does not allow preferential treatment between shareholders with regards to profit distribution and loss bearing as all investors are Musharakah investors

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• Islamic funds can undertake leverage but they have to do this in a Shari’ah-compliant manner • to ensure tradability, Islamic money market funds usually subscribe to the acceptable AAOIFI Shari’ah Standard ratio of 30% (for Sukuk Ijarah) and 70% (for monetary assets) • Shari’ah screening requirements for private companies are relatively strict compared with publiclisted equities because of the issue of management control over investee companies that private equity investors hold • Islamic private equities may co-invest with conventional private equities in the same investee company or may invest as the majority shareholder in that company on the provision that the investee company shall be converted into a fully compliant company within a prescribed period.

8.12 Islamic finance case study Structuring Shari’ah-compliant private equity funds for healthcare services TRA BioCapital (the ‘Fund’) is a growth capital fund dedicated to investments in the life-science and healthcare service industries, primarily across the Middle East and North Africa (MENA) and South Asia region. The Fund is comprised of two limited partnerships (LP), one of which, TRA Islamic Limited, is Shari’ah-compliant, the other a conventional outfit named TRA Equity Limited. Investments generally focus on the pharmaceutical industry, by far the largest segment of the life sciences industry, including manufacturing, licensing, regulatory approval, development, marketing and distribution of patent-protected novel biologies and classical chemical drugs, specialty pharmaceutical products, vaccines, generics, bio-generics and ‘over-the-counter’ (OTC) drugs. Other life sciences target markets include medical devices, diagnostics, molecular diagnostics, imaging, laboratory services and clinical development services. A second focus of the Fund is the fast-growing healthcare services sector, where the focus is on specialised clinics. The Fund is managed and advised by an international investment team with strong operating credentials working out of offices in Frankfurt. The originator of this fund project, the TRA Capital Life Sciences Practice, has a long track record of 75 investments in the sector over a 30-year period. The team of professionals at TRA Capital have established themselves as the leading providers of equity capital in pharmaceutical and biotech markets in Europe and the north eastern region of the US. The fund has identified two potential biotechnology companies that it is very keen to invest in. One is Hilal-Smith Chemicals, a pharmaceutical start-up located in Bahrain, the other is Star-Biotechnicals, a market leader in laboratory devices located in India. TRA Capital Life Sciences is looking to reach Islamic investors for these investments to showcase its capabilities as a player in Islamic private equity investments. To date, the fund has accumulated US$350 million, of which US$150 million comes from TRA Islamic Limited and US$200 million from TRA Equity Limited. The relevant financials of these two investee companies are given over. Year 2008

Current market value

Hilal-Smith Chemicals (US$ million)

Star-Biotechnicals (US$ million)

115

175

Revenue

27

43

Cash & interest-bearing securities

12

18

Total assets

100

170

Receivables

33

45

Total debt

25

48

Interest income

1.1

3

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Case study multiple choice questions 1.

2.

3.

4.

5.

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Which of the following is NOT common to both public equity funds and private equity funds from a Shari’ah perspective? (A)

Screening of non-Halal income and core activities of the investee company

(B)

Management control for private equity and permissibility of the tolerance ratio of prohibited financial activities

(C)

Management control from private equity funds and non-tolerance ratio of prohibited financial activities

(D)

Cleansing of impure income generated from non-Halal income

Screening requirements for private companies are stricter than the public companies due to: (A)

the issue of management control

(B)

the issue of market capitalisation where public companies are usually larger

(C)

the concern over corporate governance of smaller private companies

(D)

the fact that private companies are more vulnerable to excessive leverage

Co-investment is a strategy that is often utilised in Islamic private equity investment, whereby: (A)

the Islamic LP will usually assume the role of the majority investor, leading the conventional LP

(B)

the Islamic LP will usually assume the role of the minority investor, behind the conventional LP

(C)

both the conventional and Islamic LP must place investments of equal amount

(D)

neither the conventional nor the Islamic LP can assume a position of less than 33% in the private equity investments

Which of the following is the definitive feature of an Islamic Commodity fund? (A)

An Islamic commodity fund must engage in Shari’ah-compliant financial activities in both the financing and investment activities

(B)

An Islamic commodity fund must undertake cleansing or purification of any non-halal income generated during its operations

(C)

An Islamic commodity fund must own and possess the underlying commodities, whereby the investors must bear all the risks associated with these commodities.

(D)

An Islamic commodity fund must utilise Shari’ah-compliant contracts and documentation at the time of origination as well as at the time of the liquidation

Based on the above case of TRA BioCapital, which of the potential investee companies may pose a problem for TRA Islamic Limited? (A)

Hilal-Smith Chemicals

(B)

Star-Biotechnicals

(C)

Both Hilal-Smith and Star-Biotechnicals

(D)

None of them

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Case study short essay questions 1.

Using the FTSE Islamic index stock-screening criteria, convert the financials as given above into the relevant financial ratios required to ascertain the compliance of both the investee companies.

2.

Can TRA Islamic Limited invest in Hilal-Smith Chemicals as the majority shareholder? Give the reasons for your answer.

3.

Suppose TRA Bio-Capital decided to establish only Islamic private equity funds to invest in these two companies; what are the relevant issues to be highlighted?

4.

Assume that instead of raising funds through private equity funds, Hilal-Smith Chemicals decides to float its shares for the initial public offering (IPO) in both the Dubai NASDAQ Exchange under the governance of the Dubai Financial Services Authority and in the Bursa Malaysia under the Securities Commission of Malaysia, but is seeking an Islamic IPO. Advise the company on this exercise.

5.

Star-Biotechnicals is reported to have acquired new technology for its business after the investment from TRA Bio-Capital was made. However, this new technology is not yet proven and there is always a technology risk. TRA Bio-Capital prefers to invest as the creditor instead of as equity investors unless the technology has been proven. This debt will later be converted into shares of Star-Biotechnicals in the future according to an agreed milestone. TRA Bio-Capital has decided that both TRA Islamic Limited and TRA Equity Limited should contribute US$50 million each for this financing exercise. Propose an outline under Shari’ah-compliant financing for TRA Islamic Limited to participate in this financing exercise.

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Chapter eight answers Exercise 8.1 Although the above summary has addressed most of the potential Shari’ah issues, the fund manager and its Shari’ah supervisory board must address the issue of cash management, currency hedging and the modus operandi of joint ventures as one of the fund’s potential strategies to create more value. While cash management and currency hedging may be easily addressed, the involvement of the fund in joint ventures with other property developers either through equity or debt or both may pose Shari’ah-compliance issues. This is because the Islamic fund must only use Shari’ah-compliant instruments to finance joint-venture partners. Also, the purification or cleansing policy must be incorporated to alert the investors about this requirement as this will also affect the net income of the fund.

Exercise 8.2 The underlying shares of an Islamic ETF must be compliant to Shari’ah principles. There are no specific requirements for the tradability of the shares and units of this ETF. However, for an Islamic ETF investing in gold, structuring needs to take into consideration the ownership of the gold bullion by the fund, the ability to deliver the physical gold bullion to those investors who may need to redeem their investment through the physical redemption of the gold and the non-tradability of the shares or units of the ETF during the life of the fund. However, the investors may liquidate their investment by selling their shares or units to the fund manager based on the NAV of the fund.

Exercise 8.3 The alternative to conventional hedging contracts is a Shari’ah-compliant contract that either uses the principle of Wa‘d, which is a unilateral promise to buy or sell a commodity in the future at a fixed price, or the Salam contract where both the buyer and seller have locked in the price in the future, although the payment must be fully made in advance. The correct answer is therefore (B) Wa’d and Salam.

Exercise 8.4 It appears that the above proposed structure is compliant as the breakdown of assets, both physical assets (represented by the Sukuk Ijarah asset) and financial or monetary assets (represented by gold), is within the permissible ratio under AAOIFI Shari’ah Standard (No 21). According to that standard, a combination of tangible or physical assets and financial assets (such as debt or currency and gold through analogy) must not exceed a ratio of 70/30 to allow this asset as a hybrid fund to be traded, even if not at face value. There is no reason, therefore, to make any amendment to the proposed structure. However, if the fund were to follow other Shari’ah standards, such as the Dow Jones Islamic Market (DJIM) or FTSE, or any other Shari’ah view that accepts a lower ratio of these two assets of the fund, then the composition of Sukuk Ijarah must be increased to dilute the prevailing nature of the gold assets.

Exercise 8.5 The switch of the balance of the investment of either equity or real estate funds may affect the tradability of the shares or units, particularly for Islamic funds that subscribe to the Fatwa that the financial asset of the funds, such as money market instruments, must not exceed the tangible asset of the fund comprising either equity or real estate. However, this is acceptable under the AAOIFI Shari’ah standard as previously explained. Even for those who subscribe to the 50% benchmark, it is always advisable to ascertain the nature of each and every money market instrument as some are not financial or receivable-based, such as Wakalah fi al-istithmar, Sukuk Ijarah and Sukuk Musharakah. Therefore, generally speaking, a fund that combines either equity or commodity, or property with Islamic money market instruments, either for cash management or investment purposes or both, is generally considered compliant with regards to its origination and trading since it has a mixture of underlying investment assets, tangible and financial.

Exercise 8.6 The provision for care services for the elderly is essentially a Shari’ah-neutral business activity. There is, therefore, potential for Care Services LLC to be invested in by an Islamic private equity fund. With the business activity acceptable, the next avenue in ensuring Shari’ah compliance will be the financials of the company. Having zero debt, it is easier for Care Services LLC to achieve Shari’ah compliance as it does not have to convert any existing loans. The question now would be to determine whether the company is too liquid and to outline the action plans available to handle its interest income.

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In assuming that Medina Equity will be the majority shareholder of Care Services LLC, it has to effectively manage the interest income collected. The first option is to see whether there are any Islamic banking and finance facilities available in the domiciled jurisdiction. If available, Care Services would then have to divert its cash from conventional banks and reinvest it into Islamic banking instruments. This would immediately remove the potential of any further interest income and Medina Equity’s Shari’ah board would likely grant it a specified duration to achieve this. On the other hand, if Islamic banking and finance facilities are not available, a co-investment with another conventional equity fund would be an option. While Islamic private equity investors would invest less than 50% to Care Services, the remaining equity would be contributed by conventional private equity investors. This is because the current financials of Care Services have some noncompliant activities and income. The third solution is for Islamic private equity funds to provide an Islamic financing scheme to an investee with a view to ‘converting’ this financing amount to the shares of the investee company if applicable.

Case study multiple choice answers 1 (C) All the mentioned activities (other than C) are common to investment in both public equity and private equity funds. However, as private equity funds result in management control of the investee private company, the tolerance ratio of prohibited financial activities would not be given to the private equity investment scheme. 2 (A) Shari’ah screening requirements for private companies are stricter compared to public-listed equities, with the key issue relating to the management control that private equity investors hold over investee companies. Tolerance given to the investment in publiclisted companies is due to the fact that investors do not have management control over these public-listed companies to ensure that all of their financial activities are compliant 3 (B) As the minority shareholder in the private equity deal, the Islamic LP or investors are not deemed the majority investors and are therefore allowed to invest in companies which pass the Shari’ah screening test but may have some non-compliant financial activities within the tolerance level. 4 (C) The Islamic commodity fund must indeed be invested in commodities with real ownership and possession. The other choices are common features of any Islamic fund. 5 (B) Star Biotechnicals have a non-Halal income percentage of about 7% of its revenue. This is in excess of the normal tolerable limit of 5%.

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Suggested solutions to case study short essay questions 1.

The life sciences and healthcare service industries are fundamentally Shari’ah-compliant industries. As such, the business activities undertaken in these industries are Shari’ah-compliant. Before pursuing investment strategies, it may be useful to look into the screening ratios that can be generated for both companies. Utilising FTSE screening methodology, the results are displayed in the table below: Year 2008

Hilal-Smith Chemicals

Star-Biotechnicals

Leverage ratio

25.0%

28.2%

Receivables ratio

33.0%

26.5%

Cash ratio

12.0%

10.6%

4.1%

7.0%

Non-Halal income ratio 2.

Based on the above ratio, or at least based on the FTSE Islamic Index, it appears that TRA Islamic Limited may not be able to invest as the majority shareholder because the investee company of Hilal-Smith Chemicals is not fully Shari’ah-compliant as it has some financial activities that are not compliant. Therefore, the proposal to co-invest with TRA Equity Limited will be accepted, provided the majority equity investment is provided by TRA Equity Limited. However, TRA Islamic Limited may invest as the majority investor on the condition that the fund manager is able to convert all financial activities of Hilal-Smith Chemicals into fully compliant activities within two years of the date of the investment.

3.

It appears that both the Bahraini and Indian companies pass most of the screening ratios that have been set, apart from the non-Halal income ratio for Star-Biotechnicals, which is higher than the 5% allowed. However, one has to remember that Shari’ah screening is usually applied under the context that one is not the majority holder/owner of the company and thus would not be able to participate in the management of the companies. This screening methodology will, therefore, only be applicable if the fund invests in either or both Hilal-Smith Chemicals or Star-Biotechnicals with the Islamic LP, TRA Islamic Limited, taking a minority share of the private equity deal. If this happens, the fund would only need to reduce the non-Halal income from Star-Biotechnicals to a value below 5% of its revenue. As soon as the minority-stake strategy is not being considered and TRA Islamic Limited is the majority shareholder of the private equity deal, the Shari’ah-screening methodology will cease to apply and the fund will have to fully convert either or both the companies it invests in into 100% Shari’ah compliancy. This means that there can be no conventional leverage, interest or non-Halal income in either Hilal-Smith Chemicals or Star-Biotechnicals, while the cash and receivable ratios can be maintained. This may not be an issue for Hilal-Smith Chemicals as Shari’ah-compliant banking and financing instruments are available in Bahrain, but it may be a challenge in India. Complications will arise if there are insufficient Islamic banking and finance facilities in India for Star-Biotechnicals to effectively place, for example, its cash deposits to avoid an interest income. It is extremely likely that the Shari’ah advisers of the fund would allow some lead time (perhaps a year) for the company to redirect its cash placements. If the Islamic banking and finance facilities are not available, the company may be given the option to either place its cash in non-interest bearing conventional accounts or be given leeway to cleanse their interest income by donating them to suitable charities. As mentioned, the fund will be given some lead time for this conversion to take place and by the end of that time its Shari’ah board and Islamic investors would fully expect that the companies are fully Shari’ah-compliant.

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One should note that the US$150 million (accumulated in TRA Islamic LP) would not be sufficient to invest fully in both companies targeted or even in the US$175 million-valued StarBiotechnicals. The fund may be in a position to take up Shari’ah-compliant financing facilities to make up the balance required. For instance, at the fund level, the fund may take up a US$140 million (US$115 + US$175 – US$150) Murabahah-term financing for a period of perhaps five years to finance the purchase of Star-Biotechnicals. There is no issue on how much Shari’ahcompliant leverage the fund can undertake and there are instances where such leverage can reach up to 100% of the value of its equity. This may be a viable option, especially if there are non-Islamic banking and financing facilities in India and if Star-Biotechnicals is an extremely valuable investment proposition. 4.

IPO Hilal-Smith Chemicals must be aware of the Shari’ah regulatory scenarios prevalent in the two markets that it seeks to list in. For instance, Nasdaq Dubai is bound by AAOFI Shari’ah standards and as such Hilal-Smith Chemicals must follow the stock screening of AAOIFI. One of the pertinent features of the AAOIFI screening methodology is that the company can extend its receivable ratio by up to 70% of its total asset. With regards to an IPO in Bursa-Malaysia, the stock-screening methodology in Malaysia does not take into account financial ratios, apart from interest income. Hilal-Smith Chemicals may also take up the pre-IPO screening process in order to improve marketability.

5.

TRA Islamic Limited may have to resort to the Murabahah-tawarruq option to finance the investment. Murabahah-tawarruq financing can be technically ‘converted’ into the shares of Star-Biotechnicals, subject to those shares being compliant at the time of conversion. Prior to Murabahah-tawarruq financing, Star-Biotechnicals should give an undertaking under the principle of Wa’d or unilateral promise to sell a number of its shares to TRA BioCapital in the future. This is subject to the performance of the company as per the agreed NTA, at a price which equals the amount payable under the Murabahah-tawarruq financing. This undertaking will give the Islamic private equity fund an option, not an obligation, to either ‘convert’ this account receivable arising from Murabahah-tawarruq financing to shares of Star-Biotechnicals or to demand this amount at the time of the maturity as a debt payable. Obviously, there is no direct conversion of Islamic debt into equities in this structure. Instead, Star-Biotechnicals will undertake to sell a number of its shares to TRA BioCapital at an agreed price in the future and the price of this sale is set-off against the outstanding payment under a Murabahah-tawarruq structure.

Notes: 1. The discussions in this chapter exclude issues related to public equity investments that are limited to the screening process and purification of any tainted dividends/income. Both of these issues were addressed in chapter seven of this study guide and chapters ten and eleven of study guide three (Islamic Capital Markets and Instruments) of the Diploma in Islamic Finance. 2. A ratio developed to measure risk-adjusted performance. The Sharpe ratio is calculated by subtracting the risk-free rate from the rate of return for a portfolio and dividing the result by the standard deviation of the portfolio returns. The Sharpe ratio tells us whether a portfolio’s returns are due to smart investment decisions or a result of excess risk. 3. Alpha is a measure of performance on a risk-adjusted basis. Alpha takes the volatility (price risk) of a mutual fund and compares its risk-adjusted performance with a benchmark index. The excess return of the fund relative to the return of the benchmark index is a fund’s Alpha. A positive Alpha of 1.0 means the fund has outperformed its benchmark index by 1%. Correspondingly, a similar negative Alpha would indicate an underperformance of 1%.

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Chapter nine Sukuk structuring and rating methodology

Learning outcomes By the end of this chapter you should be able to: • analyse contracts as well as appreciate the issuer and investor expectations involved in structuring different forms of Sukuk • analyse the impact of product features on the validity and tradability of Sukuk • evaluate rating methodologies for Sukuk instruments.

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Indicative list of content • Structuring various forms of Sukuk: debt-based, asset-based, project based and asset-backed • Comparative Sukuk structures and related issues • An illustration of Sukuk structures for different types of financing arrangements • Rating methodologies for various Sukuk structures • Case study: structuring of Sukuk and Sukuk rating exercise post-AAOIFI pronouncement

9.0 Introduction A Sukuk is an innovative product for raising Islamic funds to support financing requirements through the use of capital market instruments. Sukuk have generally been seen as an alternative to conventional bond instruments that are organised in a capital market instead of a banking market. Conceptually, a Sukuk is an investment instrument that is intended to reward investors. A Sukuk provides a new form of funding structure for all categories of issuers: governments, corporations and banks. Since its introduction in 1990 through the Sukuk Musharakah for Shell MDS in Malaysia, it has developed into various forms in different jurisdictions, applying sophisticated structures. Today, investors not only have a choice between local currency and non-local currency-denominated Sukuk, they can also have their pick in terms of types of Sukuk, tenures, underlying assets, structures, issuers and risk profiles. In this chapter, we consider the structuring techniques of various Sukuk instruments. We also consider the key issues relating to Sukuk as fixedincome instruments structured around different types of contracts with ancillary terms and conditions. The discussion highlights the variety of product features that result from the different structures. A special discussion will examine the structuring features of Sukuk post the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) pronouncement of 2008, as this significantly affected previous structures and led to a decreasing number of Sukuk issuances. The chapter considers all Sukuk instruments issued prior to and after the AAOIFI pronouncement. Particular reference will be given in the chapter to the Sukuk rating methodologies adopted by relevant rating agencies. These will be explained and analysed in terms of their usefulness and limitations. Finally, the discussion will focus on the impact of investor preferences and how changes in Shari’ah rulings have affected the structures and rating methodologies of Sukuk.

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9.1 General introduction to Sukuk Securitisation is a process for raising finance based on predictable cash flows relying on either the creditworthiness of the issuer/borrower or a particular set of assets which have a steady income stream. Securitisation has become the preferred practice by governments and corporations to raise funds using instruments such as bonds and notes. In Islamic finance, the securitisation process was facilitated by the introduction of Sukuk. The Sukuk market has, until recently, represented a significant part of the Islamic financial system and played a key role in facilitating the funding requirements for some key economic developments, and corporate project financing. A Sukuk refers to the process of aggregating the receivable or tangible assets or usufruct, or an interest in a project, as the case may be, into pieces or securities that reflect proportionate ownership of these underlying assets. A Sukuk does not deal with receivables or financial assets except in the case of some Malaysian Sukuk. Sukuk holders each have an undivided beneficial-ownership interest in the underlying assets. Consequently, Sukuk holders are entitled to share in the revenues generated by the relevant assets in the case of Sukuk Mudarabah and Sukuk Musharakah. As for Sukuk Ijarah, the revenues are generated by the lease rental payments paid by the obligor/lessee to the issuer/ special purpose vehicle (SPV), which then proportionately distributes the revenue to the Sukuk Ijarah investors. It is important to understand that Sukuks, unlike bonds, are not debt certificates or ‘IOU’ instruments, with the exception of some Malaysian Islamic bonds and Sukuk that are based on receivable securitisation. Sukuks, by and large, are certificates that provide evidence of an investment in either an asset or a project, which is typically an income-generating asset or a project. The return to investors is not fixed or guaranteed but is subject to the performance of this underlying asset. The issuing of Islamic bonds or notes, particularly by the Malaysian market prior to the development of Sukuk Ijarah, was contentious mainly because the trading of these securities was based on the sale of debt concept. This is because these Malaysian Islamic bonds were essentially based on the securitisation of receivables and to be Shari’ah-compliant any trading of these securities must be based on the par value to avoid Riba in the transaction. Receivables have been perceived by the majority of scholars as representing monetary assets. Therefore, the trading of those securities must be based on face value to avoid the element of Riba, which requires an equal amount in the exchange of money. For more information on Sukuk, prior to 2008, refer to CDIF/3/7/104-115. Generally, prior to 2008, no Shari’ah issues arose other than the Sukuk structure that is based on the securitisation of receivables as manifest in some Malaysian Sukuk. Towards the end of 2007, market practitioners and scholars began questioning the validity of some practices in this area, mainly with regard to Sukuk based on the Mudarabah, Musharakah or Wakalah contracts. The key issue related to the inclusion of a purchase-undertaking clause in the relevant information memorandum. The inclusion of this clause was deemed to ultimately lead to a capital guarantee to the Sukuk investors, which is not compliant under Shari’ah principles. In equity-based contracts, investors are exposed to the risk of the loss of their capital. Any arrangement by the issuer (either as partner or managing partner, or agent of investment) to effectively provide such a capital guarantee renders the contracts null and void.

9.2 AAOIFI pronouncement 2008 In February 2008, the AAOIFI produced an announcement to go with its existing Shari’ah Standard 17 relating to investment Sukuk. The AAOIFI pronouncement in 2008 can be summarised as follows: • Sukuk issuances have to be backed by real assets, the ownership of which has to be legally transferred to the Sukuk holders in order to be tradable. • Sukuk must not represent receivables or debts except in the case of a trading or financial entity selling all its assets, or a portfolio with a standing financial obligation in which some debts owing by third parties, incidental to physical assets or usufruct, are unintentionally included. • The manager of the Sukuk is prohibited from extending ‘loans’ to make up for any shortfall in the return on the assets, whether acting as a Mudarib (investment manager) or Sharik (partner) or Wakil (agent for investment). • Guarantees to repurchase the assets at nominal value upon maturity, with the exception of Sukuk Ijarah structures, are also prohibited. • The Shari’ah supervisory board is required to give closer scrutiny to the documentation and subsequent execution of the transaction.

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9.2.1 Reasons for the announcement The AAOIFI felt this addendum to the existing Shari’ah Standard 17 was necessary for the two main reasons set out below.

9.2.1.1 Inclusion of purchase undertakings As stated above, most of the equity-based Sukuk, such as Sukuk Musharakah, Sukuk Mudarabah and Sukuk Istithmar incorporated a clause of purchase undertaking to be used in the event of the issuer/ partner failing to pay the expected periodical profit payments. This clause, when used, rendered the capital of Sukuk guaranteed, as the issuer/partner was undertaking to purchase the outstanding Sukuk at a price that was equivalent to the outstanding principal and profit matured up to the point of default. This effectively guaranteed the payment of principal to the Sukuk investors. Any principal guarantee in an equity-based contract is not in accordance with Shari’ah principles. As highlighted in AAOIFI Shari’ah Standard 17, it is permissible for the issuer to undertake, through the prospectus of issue, to purchase the Sukuk at market value. However, it is not permissible for the issuer to undertake to purchase the Sukuk at their par or nominal value.

9.2.1.2 Profit smoothing It had also been observed that the issuers of some of these Sukuk smoothed profit payments by estimated periodic profit payment using the issuer’s funds instead of the real income generated by the underlying asset or project. This practice was employed to avoid triggering a possible default as documented in the prospectus or information memorandum of the Sukuk. It also had the effect of providing a guarantee on the profit, which is not in line with equity-based contracts that dictate profit sharing as well as loss sharing.

9.2.2 Effect of the pronouncement on Sukuk issuance The above two practices, which were common in the Sukuk market up to the time of the pronouncement, prompted the AAOFI Shari’ah Board to take action so as to correct the practice. In this chapter we introduce you to various types of Sukuk and explain how these Sukuk must align themselves to the AAOIFI pronouncement of 2008 to make them acceptable. The new structuring of Sukuk post this pronouncement has affected the process of rating Sukuk as the previous rating system was based on the merit of purchase undertaking, which proved no longer to be valid and justified. The comparative percentage of the respective Sukuk issuance before and after the 2008 AAOIFI pronouncement is illustrated in the following diagram. The decline in issuance is a direct market response to the AAOIFI pronouncement of February 2008.

Figure 9.1 The growth of the global Sukuk market 2000-2008* 80000

75,238.70

70000

US$ million

60000 48,114.82

50000 40000

32,172.89

30000 20000 12,033.76 7,209.53

10000 0

5,717.06 336.3

780

985.83

2000 2001 2002 2003 2004 2005 2006 2007 2008 Tabulated by IIIF Data source from IFIS

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Year

*to May 2008

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The predictable result of this pronouncement was the increase of Sukuk Ijarah and the decline of all Sukuk based on equity contracts. This can be seen in the following diagram.

Figure 9.2 Comparison of the same period in 2007 with the same period post-AAOIFI pronouncement in 2008 6000 Post AAOIFI pronouncement

5000 4000

Sukuk Ijarah Sukuk Musharakah Sukuk Mudarabah

3000 2000 1000 0 2007 March-June

2008 March-June

Tabulated by IIIF, data sourced from IFIS

When comparing the same four-month period (March-June) for 2007 and 2008 (post AAOIFI pronouncement), one can see a trend in Sukuk issuance, which affects not only the structure and the design but also the growth of the Sukuk in general. There is a clear increase in the issue of Sukuk Ijarah as a means of raising capital as the Sukuk Ijarah structure and practice was excluded from the pronouncement. On the other hand, there is a clear decrease in the issuance of Sukuk Mudarabah and Musharakah. Prior to the pronouncement, these latter Sukuk were structured to provide recourse to the originator/issuer through an undertaking by them to repurchase the underlying assets at a price representing the face value of the Sukuk at maturity, or following the event of a default in the terms of the Sukuk. Shortfalls in periodic distribution amounts were similarly covered by the originator/ issuer in the event that insufficient returns were generated by the Sukuk assets. Sukuk Musharakah, which was by far the most popular Sukuk vehicle in 2007, experienced the largest fall as a result of the pronouncements made by AAOIFI in 2008.

Exercise 9.1 Which of the following issues prompted the AAOIFI Shari’ah Board to issue its official pronouncement on Sukuk in February 2008? Give reasons for your answer.

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(A)

The existence of Sukuk structures that were devoid of underlying tangible assets

(B)

The undertaking by the issuer to purchase the equity-based Sukuk at par value in the event of default by the issuer to pay the expected profit

(C)

The undertaking by the issuer to provide liquidity facilities to ensure a profit payment in the event of a lower-than-expected profit, but subject to that facility making good at maturity

(D)

The undertaking by the issuer to purchase the equity-based Sukuk at market value in the event of a default

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9.2.3 Effect of the AAOIFI pronouncement on Sukuk rating As a result of the AAOIFI pronouncement, the rating of Sukuk has become more challenging as equity-based Sukuk are no longer in a position to provide any guarantee for the redemption of investment capital. This is because the clause on purchase undertaking by the issuer is no longer valid and acceptable. This also affects the rating exercise as the performance of Sukuk, post the AAOIFI pronouncement, will depend less on the creditworthiness of the originator/issuer and more on the performance of the assets or projects, as in the case of conventional asset-backed securities or non-recourse project financing. This pronouncement has essentially transformed Sukuk into an equity instrument instead of a fixed-income instrument. This has resulted in many fixed-income investors, such as Takaful operators, pension funds and other institutional investors, whose mandate is confined to fixed-income instruments, now having no access to Sukuk instruments. Consequently, the rating methodology as applied to bond instruments will no longer be relevant to equity-based Sukuk instruments as equity and bonds, from the contractual rights and liabilities perspective, have different financial behaviours. The issue of rating will be more challenging in jurisdictions where rating is mandatory before Sukuk can be issued and traded in the financial market. This would be the case in the Malaysian and Indonesian exchanges and in a number of western jurisdictions such as the Luxembourg Financial Centre. The challenges of Sukuk rating since the AAOIFI pronouncement will be discussed more fully later in this chapter. The AAOIFI pronouncement may also, in some jurisdictions, bring about the issue of Shari’ah risks. Shari’ah risk centres on the issue of Shari’ah compliance, with the risk often borne out of the operations of the Islamic Financial Institution (IFI) or the Islamic financial instruments. It can be generated through cross-boundary transactions whereby a Fatwa issued in one jurisdiction is not accepted in another. Shari’ah risk issues emerge where the adoption of AAOIFI standards and pronouncements are not accepted in all jurisdictions. This may deter cross-boundary transactions. This situation is not without precedence. Different views on the application of Islamic contracts, for instance, have existed throughout the history of Islamic finance industry. These Shari’ah risks can be minimised if there is a move towards the adoption of globally accepted Fatwas or Shari’ah standards.

Islamic finance challenge 9.1 Many believe that the decline of the Sukuk issuance in 2008 and 2009 was largely due to Sukuk becoming less attractive instruments as a result of the AAOIFI pronouncement. To what extent is this contention technically accurate?

Solution The AAOIFI pronouncement affected the issuance of Sukuk, particularly Sukuk based on equity contracts such as Mudarabah and Musharakah. However, the pronouncement did not affect the issuance of Sukuk Ijarah, even though Sukuk Ijarah also has a provision for a purchase undertaking by the originator/lessee to repurchase the leased asset in the event of default by the originator/lessee. Sukuk Ijarah essentially requires the originator to have an asset for the purpose of sale and lease back. This therefore restricts the issuance of this kind of Sukuk as it requires the issuer to own an asset that can be sold to Sukuk investors for a certain period of time, as the originator/owner will repurchase this asset at either event of default or maturity of the Sukuk. As shown in figure 9.1, most of the Sukuk, in terms of number and size of issuance prior to the 2008 AAOIFI pronouncement, comprised Mudarabah, Musharakah and Sukuk Istithmar instead of Sukuk Ijarah as there was no requirement for the issuer to own an asset when issuing this kind of Sukuk.

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9.2.4 The global financial crisis of 2008/09 The global financial crisis of 2008/09 also contributed to the decline of Sukuk issuances with fund raising decreasing significantly in a distressed economy. There was no need to issue new bonds or Sukuk where projects being financed were either cancelled or suspended because of the financial crisis. This also affected the yield of the Sukuk as the rating of Sukuk in this financial environment would be low. Therefore, a higher yield for investors reflects higher costs to the issuer. Both the AAOIFI pronouncement and the global financial crisis can be seen to have contributed to the decline in Sukuk issuance, especially in jurisdictions badly affected by the global financial crisis.

Key point • The decline of Sukuk in 2008, compared with 2007, was mainly due to the AAOIFI pronouncement on Sukuk in February 2008 and the global financial crisis in 2008/09.

9.3 Broad categories of Sukuk structuring Conventional bonds can either be classified as straightforward IOUs, which offer a fixed income, or as asset-backed securities, which offer a variable income based on the performance of the underlying asset. There are two key ways to classify Islamic Sukuk. From the point of view of the underlying asset against which the Sukuk are issued they can be classified into four broad categories: • • • •

debt-based Sukuk asset-based Sukuk project-based Sukuk asset-backed Sukuk.

From the contractual perspective governing the relationship between the issuer and the investors, Sukuk may be classified into two broad categories: • debt-based Sukuk • equity-based Sukuk. The following discussion results in a slight overlap between these different bases of Sukuk classification, but the overlap and correlation between them is highlighted, where relevant, in each category of Sukuk. The following tables show the basis for classifying Sukuk and are a guide for Sukuk structuring as well as for the application of the respective rating methodology to various Sukuk structures.

Table 9.1 Classification of Sukuk based on the underlying asset

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Underlying asset

Sukuk type

Pertinent features

Debt-based Sukuk

Sukuk Murabahah and Sukuk Istisna’

The pay-off to the investors is dependent on the credit risk of the issuer.

Asset-based Sukuk

Sukuk Ijarah

The pay-off to the investors is not linked to the underlying asset, although the asset could be used as collateral. The payment is linked to the credit risk of the originator.

Project-based Sukuk

Sukuk Musharakah, Sukuk Mudarabah and Sukuk Istithmar

The pay-off to the investors is based on cash flows and the quality of the project asset

Asset-backed Sukuk

Sukuk Ijarah, Sukuk Musharakah, Sukuk Mudarabah and Sukuk Istithmar

The pay-off to the investors is based on the performance of the assets

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Table 9.2 Classification of Sukuk based on the contractual relationship between the issuer and investor Underlying asset

Sukuk type

Pertinent features

Debt-based

Sukuk Murabahah, Sukuk Istisna’ and Sukuk Ijarah

The pay-off to the investors is dependent on the credit risk of the issuer.

Equity-based Sukuk

Sukuk Murabahah, Sukuk Musharakah and Sukuk Istithmar

Investors participate in providing equity to invest in Sukuk assets

Although all of the above Sukuk must relate to an asset or project in some way, they have many different legal and economic implications, and different rating approaches, as the underlying assets may have different economic and legal functions. The classifications in table 9.1 not only distinguish one Sukuk from another but also demonstrate the chronological development of the Sukuk instruments. As the Sukuk market begins maturing, each new issuance represents a step-up on the ladder of sophistication. Sukuk issuances have begun moving away from the ‘bricks-and-mortar’ debt-based issuances to project-based issuances that pay specific attention to the underlying assets being constructed. These sophisticated Sukuk issuances are commensurate with the demands of Islamic investors who are always looking for more innovative products to fulfil their investment appetite. The next sections will look at these four broad categories of Sukuk, based on their chronological development in the market. The salient features of each Sukuk will be underpinned to allow you to appreciate their economic and financial behaviour, and understand how these features relate to respective rating methodology.

Key point • The basis of securitisation of the underlying asset in Sukuk can be debt-based or asset-based, or project-based or asset-backed. The contractual basis between the issuer and investor could be either debt or equity.

9.4 Debt-based Sukuk As explained in CDIF/3/6/89-91, Islamic receivables, such as those arising from Murabahah, Istisna’ and Ijarah, may be securitised into papers known either as Islamic bonds or Sukuk. As mentioned in CDIF/3/6/95-100, this instrument is only available in Malaysia where this structure has been deemed compliant by the Malaysian Shari’ah authorities in contrast to other jurisdictions. These papers evidence the right of the holder of the Sukuk or the Sukuk investor to receive the payment as stated in the primary and secondary notes of the Sukuk. This structure resembles the structure of conventional bonds that are simply IOUs, except that the receivables in an Islamic Sukuk structure must originate from Islamic-approved contracts that create these future receivables. Receivables must not originate from interest-based loans as is the case with conventional bonds. Under this structure, the issuer may obtain the required funding from the investors through an approved Islamic debt instrument, such as Murabahah, Tawarruq, Ijarah or Istisna’. The Sukuk will be issued by the issuer as evidence that the investors have a legal claim on the amount of financing plus the mark-up or profit which is embedded in all these contracts. In conclusion, this is a form of debtbased financing as the issuer is essentially indebted to the investor as a result of getting financing using debt-based financing contracts.

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9.4.1 Rating of debt-based Sukuk The most suitable corporate rating methodology to be applied to debt-based Sukuk is linked to the credit quality of the obligor/issuer, be it a government or corporate bodies. This is known as the corporate rating methodology. The quality of assets or projects used in Murabahah, Tawarruq, Ijarah or Istisna’ contracts is not relevant to the financial ability of the obligor/issuer to pay the primary and secondary notes. Such assets or projects are used merely to facilitate the creation of Islamic receivables that can be securitised in the form of an IOU. Although the issuance of these Sukuk based on Islamic receivables is not objectionable to international Shari’ah standards as per the AAOIFI Shari’ah Standard (No 17), the trading of these Sukuk on the secondary market at market value is unacceptable to some contemporary scholars. While Shari’ah authorities in Malaysia have allowed the trading of this Sukuk at market value based on market forces, other Shari’ah authorities have objections on the tradability of this Sukuk as receivables arising from these contracts are seen as monetary assets that need to be exchanged only at par value.

9.4.2 Solution to trade Islamic bonds at market value To enable this debt-based Sukuk to be traded on the secondary market, even at a discounted price, it has been proposed that secondary market investors would need to purchase the Sukuk from primary investors, that is Sukuk holders, in exchange for another commodity instead of money. For example, suppose a company has entered into a Murabahah-tawarruq contract with financial investors who ultimately invest cash of Malaysian ringgit (RM) 500 million. However, the company will be indebted to these financial investors for an amount of RM600 million. Let’s further assume that the debt is to be paid over a period of five years at six monthly intervals. The debt owed to the financial investors can be securitised in the form of Sukuk Murabahah that gives the right to Sukuk Murabahah holders to claim the payment as documented in the Sukuk Murabahah notes from the issuer/debtor. These investors/creditors may normally only sell this Sukuk to other investors at the secondary market, according to AAOIFI Shari’ah standards, at the face value of the Sukuk, which may not, however, be commercially appealing to secondary market investors. It has been proposed that secondary market investors could purchase the Sukuk or the receivables of Murabahah-tawarruq worth RM600 million (collectively for the purpose of the illustration) for a commodity worth RM580 million at the spot market. The issuer of the Sukuk/debtor will then sell this commodity to the spot market for the price of RM580 million, effectively realising the disposal of the Sukuk. The secondary market investors will, however, have the right to claim RM600 million from the issuer if they hold the Sukuk for the full five years. They could themselves sell the Sukuk on the basis of an exchange of the Sukuk for a commodity to avoid the sale of receivables for money not at face value. Although this proposal has not yet been put into practice, it has been approved by the Shari’ah boards of many IFIs. The issuance of Sukuk based on this concept is universally accepted even under AAOIFI Shari’ah Standards. It may require some institutional restructuring of the existing secondary market to facilitate the sale of debt-based Sukuk for a commodity. If that is not workable, then an over-thecounter transaction may be proposed to allow this transaction to take place. This Sukuk is classified as debt-based because the Sukuk investors, immediately after its issuance, would have no claim on the underlying assets that were initially used for the sole purpose of creating the Islamic receivables. The ownership relationship, as well as any other legal relationship between Sukuk investors and the underlying assets, ceases to exist immediately after the conclusion of a sale-and-purchase contract. Furthermore, Sukuk investors would not have a right of recourse to those assets unless they were made collateral to secure the payment of Islamic obligations arising from the debt-based contract. In this case, it is obvious that this kind of Sukuk is not an asset-based Sukuk as investors lose the link with the underlying assets immediately after the Sukuk issuance.

Key point • Debt-based Sukuk, which is only common in Malaysia, is evidence that the Sukuk holder has a right to claim a certain amount of money from the issuer of the Sukuk. This claim arises from a debt-based contract between the issuer and the investor. Although this Sukuk may be issued as per international Shari’ah standard, its tradability, based on market value, may not be universally Shari’ah-compliant except following special arrangements of trading such as being traded at par or exchanged for a commodity at any agreed price.

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Exercise 9.2 Explain why the sale of a receivable for a commodity, even at a discounted price, is permissible, while the sale of a receivable for money at a market value different from its face value is not permissible according to AAOIFI Shari’ah Standards. The following diagram illustrates how Sukuk Murabahah could be structured. Murabahah Liquidity Company (MLC) Inc. has issued Sukuk Murabahah based on the Murabahah-tawarruq contract. The structure and key terms and conditions of that structure are given in the diagram.

Figure 9.3 MLC Sukuk Murabahah structure

Vendor A

Buy commodity via Broker A Cash

Sukuk investors

2

1

Issue MLC Sukuk Murabahah

Cash

Cash

4

Sell commodity via Broker B

3 MLC Inc

Sell commodity on deferral

Corporate XYZ

Cash

Cash

5

5

Occurs on the same day

Vendor B

Trustee

Occurs upon maturity day

The process flow is as follows: 1. Investors appoint MLC Inc. as its agent to buy, for example, aluminium as the commodity asset. Subsequently, MLC Inc. appoints Broker A as its agent to carry out the said role. On the issue date, MLC Inc. issues a trust certificate (Sukuk Murabahah, for example RM$100 million for one year) as evidence of the investors’ undivided beneficial interest in the aluminium. A trustee is appointed to protect the interest of the Sukuk holders by way of a declaration of trust. 2. On the purchase date, MLC Inc., through Broker A, purchases aluminium from Commodity Vendor A on a cash basis. The asset purchase price payment to Vendor A is paid to a settlement account that Broker A (acting as the payment agent for the purchase and sale of a commodity transaction) holds in trust, as satisfaction of the asset purchase price from MLC Inc. 3. On the same day, MLC Inc. sells the commodity to corporate XYZ (which essentially requires the funding) on a deferred contract basis at the asset sale price (for example RM120 million) for an agreed tenure (for example one year). 4. Subsequently, Corporate XYZ sells the aluminium to Commodity Vendor B through MLC Inc. (acting as the payment agent for Corporate XYZ in the sale of the commodity) at a price that is equal to its asset purchase price (for example RM100 million) on a cash basis. The asset purchase price payment to Corporate XYZ is paid from the settlement account (as in step 2 above) as satisfaction of the asset purchase price from Vendor B. 5. Upon maturity, Corporate XYZ pays the whole asset sale price (RM120 million, assuming the profit distribution payable of RM20 million is paid upon maturity) to MLC Inc., which subsequently returns the money to investors and redeems the Sukuk. Note: Profit distribution payable, if any, to the Sukuk investors is equivalent to the instalment payment payable by Corporate XYZ to MLC Inc. and is determined at the point of tender of MLC Sukuk Murabahah to the investors. The frequency of the profit distribution to the investor is either on a semi-annual basis or at any agreed stipulated period.

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Exercise 9.3 Based on the structure and the objective of the Sukuk mentioned in the example above, and assuming that this structure is being developed in Malaysia, discuss the following issues: •

Would all IFIs in Malaysia be able to participate as investors in this Sukuk?

What would be the impact of this structure on IFIs in Malaysia that subscribe to AAOIFI Shari’ah Standards?

What would be the most suitable Sukuk instrument for creating Islamic liquidity instruments that would appeal to all Islamic investors worldwide?

9.4.3 Sukuk Istisna’ as an example of debt-based Sukuk and debt-based financing As stated above, Shari’ah authorities in Malaysia have allowed the trading of Sukuk at market value based on market forces. Other Shari’ah authorities, meanwhile, have raised objections on the tradability of this Sukuk as receivables arising from these contracts are seen as monetary assets that require to be exchanged at par value. The following example is an illustration of a debt-based Sukuk, as practised in Malaysia using an Istisna’ contract. Turbo Company (the Company) is an independent power producer that has been awarded a concession to construct, operate and own a 3,000 MV coal-fired power plant in Malaysia. The cost of the construction is expected to be about RM1 billion. A local electricity company has signed a power purchase agreement as an off-take agreement to purchase electricity in the future at an agreed price. The Company is new, with no fixed assets on its balance sheet and has decided to issue Sukuk Istisna’ following the Shari’ah concept approved by Malaysian regulators. Following a Sukuk programme, the obligor/issuer will only issue Sukuk, up to a maximum of RM1 billion, as and when the funds are required instead of one-off issuance. This is normal practice in project finance. The Sukuk investors, through the issuer, may enter into an Istisna’ contract to purchase specifically described assets from the Company, which it has to construct and deliver in the future to the investors for an agreed price, for example RM200 million, as the first series of the issuance. Under this leg of the contract of Istisna’, the investors will pay the Istisna’ purchase price of RM200 million to the Company. This amount of money is the amount required by the Company to start the first phase of the project, for example building the foundations of the power plant. Subsequently, the Company will enter into a second leg of the Istisna’ contract to purchase the same described asset from the Sukuk investors. This will also need to be constructed and delivered in the future for a price higher than the first Istisna’ purchase price of, for example RM220 million. By entering into the second leg of the Istisna’ contract, the Company has created a financial obligation that is payable to the Sukuk investors. The Company, as the obligor, will issue the primary notes worth RM200 million and the secondary notes that are attached to the primary notes amounting to RM20 million, which will mature at, say, six months intervals for a three-year period. In reality, the financial ability of the Company/issuer/obligor to pay this obligation, namely the primary notes and secondary notes, is not linked to the performance of this power plant to generate its future cash flow. What has been securitised is merely the requirement of the issuer to pay this financial obligation to the Sukuk investors. Therefore, the debt-based Sukuk investors take on the credit risk of the obligor rather than the risk of the underlying asset, which is the asset under construction. Investors have no claim on the assets immediately after the issuance of Sukuk Istisna’ except where the asset was made collateral for the payment of the Sukuk Istisna’. This is different from project-based Sukuk (to be discussed later) whereby the pay-off to the investors is linked, or will be linked, to the performance of the project in terms of cash flows and quality of the project asset.

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Exercise 9.4 In the above example, the structure of the Sukuk Istisna’ has used two legs of an Istisna’ contract, namely a sale-and-buy-back arrangement between two parties. By reference to CDIF/3/6/98-99, compare this structure to Parallel Istisna’. Explain why this structure is not well accepted outside Malaysia and outline the proposals, if any, that have been made to make it compliant to investors who are adhering to international Shari’ah standards in their investment decision.

9.5 Asset-based Sukuk In contrast to the debt-based Sukuk described above, asset-based Sukuk investors have some relationship with, or claim on, assets that are used to facilitate the issuance of Sukuk. However, from the financial obligation perspective, asset-based Sukuk are similar to debt-based Sukuk as the performance of the underlying asset has no significant impact on the credit quality of the obligor/ issuer, particularly from a rating methodology perspective and, therefore, on the quality of timely payment to Sukuk investors. The rating of the asset-based Sukuk relies primarily on the quality of the credit risk of the obligor/issuer and the position of the Sukuk investors vis-à-vis other secured or nonsecured creditors. The asset is present in this structure only for the purpose of Shari’ah-fulfilment, rather than to serve as a source of profit or capital redemption or payment. The risk that investors take is still largely related to the credit-risk assessment of the issuer/obligor in timely redemption of the Sukuk. Although the analysis of the asset in this structure may be significant from a Shari’ah contractual perspective, it is not significant from the financial one.

9.6 Sukuk Ijarah: an illustration of an asset-backed Sukuk The structure that typically applies to an asset-backed Sukuk is that of the Sukuk Ijarah, which is based on the sale-and-lease-back concept (CDIF/3/7/106-107). In this structure, the obligor is normally the party that has an unencumbered asset and who is willing to transfer the beneficial ownership of this asset by selling it to the Sukuk investors in exchange for an amount of money. Subsequent to the sale of the asset, based on a beneficial ownership transfer, the Sukuk investors will lease the asset back to the obligor for an agreed rental payment, which includes the principal amount of financing, plus profit. This description of the Sukuk Ijarah highlights several technical and operational issues that need to be taken into consideration while structuring this type of Sukuk.

9.6.1 Ownership of the asset by the obligor/originator Sukuk Ijarah will not be possible without the ownership of the asset by the obligor/originator. Here the term ‘ownership’ requires the obligor to own an asset free from any claims or encumbrances. Where there is any claim, lien or encumbrance over the asset, consent for the sale from the relevant party who holds the lien or encumbrance must be sought prior to the sale of the asset to affect a valid and enforceable sale contract.

9.6.2 Eligibility of asset to be sold The asset must be eligible for sale under both Shari’ah principles and the law of the country. Obviously, assets that are impure from the Shari’ah perspective, such as conventional bank buildings or casinos or factories producing liquor and non-Halal food, are not valid assets for a sale from the Shari’ah perspective. Legal restrictions on the assets may also apply, such as lands designated exclusively for certain prescribed individuals, for example natives or government-owned buildings that are not eligible for transfer. In such cases, these assets may not be sold unless special permission is granted, where relevant and applicable.

9.6.3 Assets must be leasable The asset must not only be sold legally, according to Shari’ah requirements, but must also be of a type that can be leased out. This is because the Sukuk Ijarah structure requires two contracts, namely a sale followed by a lease contract. Many assets can be owned that are not necessarily ‘leasable’, such as shares, Sukuk, gold, silver, currency and petrol. Such assets cannot be used to facilitate the issuance of Sukuk Ijarah.

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9.6.4 Transfer of beneficial ownership The sale of an asset may be made on the basis of the transfer of beneficial ownership, instead of the transfer of legal ownership. This concept of beneficial ownership transfer is only valid and recognised in jurisdictions that apply English law principles. Beneficial ownership transfer derives its validity from the Trust concept that recognises legal ownership vis-à-vis beneficial ownership under the equity principles of law instead of common law. Following this concept, an owner may sell his asset to another party while maintaining the legal title of the asset. The purchaser, although not having a legal title, will be deemed by the law as the beneficial owner until a legal transfer is complete. Countries that apply civil law principles may not accept this concept of beneficial ownership transfer unless these countries decided to pass a special law on Trust, as in the case of the Trust Law in Bahrain enacted in 2006 and the Sukuk Law enacted in Indonesia in April 2007. Otherwise, a transfer of beneficial ownership to facilitate Sukuk Ijarah may not be acceptable in a court of law in the case of a dispute. For example, in the United Arab Emirates the law only recognises the legal transfer of ownership with a title.

9.6.5 Legal transfer of ownership There is technically no issue in applying a legal transfer of ownership. However, this may complicate operational issues, such as the recording of the asset, the valuation of the asset and its impact on the balance sheet of the owner. Also, in the case of government-based Sukuk Ijarah, the assets of the government may not be allowed to be disposed of to foreigners under local laws. The reason why a beneficial ownership transfer has been used in the past is to protect the interest of the issuing party so the underlying assets will not be transferred from the books of the obligor/originator, especially when the obligor/originator is the government.

9.7 Advantages and disadvantages of Sukuk Ijarah 9.7.1 Disadvantages and limitations of Sukuk Ijarah Having explained the features and requirements of asset-based Sukuk in the form of Sukuk Ijarah, mention should be made of the limitations of Sukuk Ijarah from the obligor/originator perspective, which include, but are not limited to, the following: • As it is based on assets, Sukuk Ijarah will restrict the obligor/originator from selling the asset, even where the obligor/originator may need to liquidate this asset for cash requirements or where they have an opportunity to generate a better income from its sale. As a result, the terms of the Sukuk Ijarah will often include a clause giving the issuer the right to replace the leased asset with another asset as and when needed, but subject to the consent of the investors. • Also, to facilitate the issuance of Sukuk Ijarah, the issuer must have an asset that can be leased out under either a commercial requirement or the laws of the country. The issuer may have many assets; however, these may be restricted from being sold and/or leased out under relevant laws, therefore restricting the use of these assets for this issuance.

9.7.2 Advantages of Sukuk Ijarah Despite the disadvantages mentioned, Sukuk Ijarah has many advantages to offer to both the issuer/ obligor and the investors: • Sukuk Ijarah provides flexibility in fixing the rental payment. Rental, unlike profit payments in a sale contract, may be fixed or variable according to an agreed benchmark. Also, both the obligor and investors may mutually vary the rental amount and lease period without the need to enter into a new contract. • The leased asset may be declared a Trust asset for the benefit of the Sukuk investors. Therefore, this asset will not be accessible to other creditors of the obligor should the obligor be declared insolvent and bankrupt. The nature of the leased asset as a Trust asset under the Sukuk Ijarah has made the structure distinct from conventional bonds. In this instance investors may have recourse to this Trust asset in the case of default and solvency of the obligor, with a priority over other creditors, whether secured or non-secured. • Although Sukuk Ijarah has a purchase undertaking for the obligor to purchase the leased asset in the case of default, it is not affected by the 2008 AAOIFI pronouncement. This is because Sukuk Ijarah is not based on an equity contract. Also, the obligor who gives the purchase undertaking is not a partner to Sukuk Ijarah investors and therefore the undertaking does not lead to a capital guarantee.

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Key point • Asset-based Sukuk, normally manifested in Sukuk Ijarah, reflects the sale of the asset followed by the lease contract, whereby the Sukuk holders will have the claim on ownership over the underlying asset throughout the tenor of the Sukuk while benefiting from income in the form of rental payment.

Exercise 9.5 Compare and contrast Sukuk Istisna’ and Sukuk Ijarah in terms of the principal parties involved, its structure, tradability, security, pricing mechanism, limitations and their acceptability in the global Islamic investment community.

9.8 Sukuk Ijarah of the Qatar Government The Qatar Government issued one of the earliest Sukuk Ijarah following the Government of Malaysia. Unlike the Sukuk Ijarah of Malaysia, Qatar’s used a piece of land earmarked for the development of a medical city. At the time of issuance, there was no development on the land. The land was sold to the issuer that the Government of Qatar then incorporated at US$700 million. Subsequently, on behalf of the investors, the issuer leased the same land back to the obligor at a rental payment with a formula based on the floating rate of LIBOR. The process is set out in the diagram below.

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Figure 9.4 Qatar Sovereign Sukuk Ijarah

Qatar government 1

4 2

3

Land for the development of a medical city

3

Qatar global Sukuk QSC (SPV)

1 5 7 Sukuk investors Sukuk certificates

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6

Step 1

The Government of Qatar sells land parcels valued at US$700 million to Qatar Global Sukuk QSC, an SPV. The plot of land is to be used for the development of the Hamad Medical City located in Doha, Qatar.

Step 2

The Qatar Global Sukuk pays a purchase price of US$700 million to the Qatar Government for the land.

Step 3

The Qatar Global Sukuk leases out land parcels under a master Ijarah agreement to the Government of Qatar. Under the terms of this lease, the Government of Qatar agrees that the Qatar Global Sukuk shall not, under any circumstances, be liable to the Government or to any third party for any cost, claim, demand, loss, damage or expense of any kind or nature caused directly or indirectly by, or out of, the use of any part or the whole of the land parcel.

Step 4

The Government of Qatar pays semi-annual lease rentals under the master Ijarah agreement, plus the margin.

Step 5

The Qatar Global Sukuk securitises the asset and issues Sukuk certificates to investors.

Step 6

Investors purchase the Sukuk certificates. The proceeds received from the investor as the result of the Sukuk issuance are then paid to the Government to complete the arrangement for the purchase of land.

Step 7

The investors are reimbursed periodically by distributions from the Qatar Global Sukuk, which originated from Government rental payments on the land parcels.

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Islamic finance challenge 9.2 Many Shari’ah-based organisations and boards, such as the International Islamic Academy of Fiqh and Dallah Barakah, have issued Fatwas on the position of intangible assets, such as trade name, copyright, design, brand name, patent, as valid and eligible assets that can be sold and leased. The relevant Fatwas also impose damages on any person who infringes these rights to compensate the loss to the owner of these assets because of the infringement. Intel Soft Inc. is a software company that has invented new smart and intelligent software that can transcribe a recorded message from a mobile phone into an email format, which can then be automatically sent out to the concerned party. The software is known as Smart Transformer. The company sells this software to the business community for a fee. The company is now developing new software to perfect the previous software. To finance the project, the company seeks to issue Sukuk Ijarah and has asked your professional opinion on its structuring. Advise Intel Soft Inc. on the possibility of using this structure and the relevant points to be considered if it is deemed possible. Suppose this structure is not possible; what alternative would you suggest for this company to leverage Sukuk on this important asset?

Solution Software is an intangible asset that can generate income for its owner. It is also deemed a valid brand name or trademark if it is registered and patented under the relevant laws of intellectual property. Based on the above Fatwa, the Company may issue Sukuk Ijarah to raise new funding to cover the cost of enhancing the existing software. This is because the Fatwa has alluded to the fact that this kind of asset is valid and can be sold as well as leased out. It is, therefore, treated no differently from any tangible assets. Following this argument, it is clear that the Company may sell this asset, subject to the proper valuation by experts, to Sukuk Ijarah investors for the investors to lease back the rights to the Company. In doing so, a few important points must be considered. This right must be able to be sold under the law, otherwise the whole structure may not proceed. Also, the lease contract period between the investors and the Company must not exceed the permitted right of this trademark or brand name under the law. In addition to this structure, we could propose a project-based Sukuk. Following this structure, investors will be invited by the issuer to pool their investments together to purchase this right at X price, for example, â‚Ź600 million. This amount will be used by the Company to cover the cost of developing enhancements to the existing software, which is the purpose of issuing this Sukuk. The investors will later appoint the Company to manage the business of this software for a management fee. However, any income generated from this software business will be divided among the investors proportionately and transparently. This structure has transformed the Sukuk structure from an asset-based to a project-based Sukuk, which will be discussed in the next section of this chapter.

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9. 9 Project-based Sukuk Similar to asset-based Sukuk, project-based Sukuk are a relatively new innovation of Islamic finance in the fixed-income market as they depart completely from the notion of IOU to profit and risk sharing. However, this Sukuk structure is fundamentally different from asset-based Sukuk. • It is based on profit and loss sharing in which Sukuk investors will have to consider the risk of the venture more than the credit risk of the issuer. This is because the pay-off to Sukuk investors is based on actual income generated by the underlying project upon which the Sukuk are issued. • The proceeds of the Sukuk will be used to finance the project. The income generated from the project, be it manufacturing or construction or plantation or services, will be distributed among the investors proportionate to their investment capital. • There is no guaranteed payment by either the obligor or the issuer as in the case of debt-based and asset-based Sukuk. As a result of these factors the rating exercise will be different. The rating of a bond, as applied in a conventional bond market, has been confined to the credit risk of the issuer/borrower. The rating agency never rated the project risk more than the credit worthiness of the issuer/borrower. This was one of the issues that led to the practice of purchase undertaking in most project-based Sukuk prior to the AAOIFI pronouncement in 2008 to enhance the credit rating and be rated according to corporate-rating instead of project finance-rating methodology.

Key point • Project-based Sukuk, which is ideal for project financing, is structured on the basis that Sukuk investors will receive payment from the subsequent performance of the underlying project being constructed or developed.

9.9.1 The SABIC Sukuk Istithmar The typical structure of a project-based Sukuk is represented by the SABIC Sukuk Istithmar. This Sukuk has managed to attract several accolades. For example, it was the first Sukuk to be launched in Saudi Arabia under the new Capital Market Law (date of issuance: 29 July 2006). It is also the first fully tradable Sukuk to be issued in Saudi Arabia and the first Sukuk to be settled/cleared through Tadawul (Saudi Stock Exchange). The issuer, Saudi Basic Industries Corporation ‘SABIC’, is a holding company for a group of companies that constitute the Middle East’s largest non-oil industry company and the 10th largest international petrochemical company in the world (as measured by revenues). The underlying Sukuk assets are based on marketing rights, that is the right given to SABIC as a holding company to market all products produced by all its affiliates and subsidiaries for a marketing fee. The structure of SABIC’s Sukuk Istithmar is as follows:

Figure 9.5 SABIC Sukuk Al-Istithmar Reserve 7 Sabic undertakes to buy Sukuk at years 5,10 &15 based on an agreement

SABIC (Issuer)

6. Extra income are placed in Reserve

2

Sukuk holders

3 4,5

1. Sukuk assets under custody during the Sukuk life

SABIC Sukuk LLC (custodian)

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2. Sabic issues Sukuk (representing ownership in Sukuk assets) 3. Sukuk holders pay Issue proceeds 4. SABIC manages Sukuk assets for the Sukuk holders 5. Distributions are paid from income of the Sukuk assets (income from Sukuk assets is expected to comfortably exceed coupon and extra amount)

Secondary market

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An issue raised during the Shari’ah structuring phase was that of the 20 years of marketing rights that form the basis of the Sukuk assets. These marketing rights have been defined as ‘the limited rights and obligations of SABIC in certain marketing contracts that underpin the marketing services that SABIC provides to its manufacturing affiliate and subsidiaries’. Essentially, all of the subsidiaries of SABIC signed this marketing agreement with SABIC as the holding company to market the products of all the subsidiaries for a fee. The sole income would be the marketing fees to be paid by all subsidiaries if the holding company was to market and sell the products produced by its subsidiaries. This issue was deliberated further and the outcome is below. • It was suitable for SABIC to be the holding company. • In addition to being a holding company, managing and coordinating its investments, SABIC has a research and technology unit (holding over 200 registered patents) and a marketing business unit. • This marketing unit incurs certain costs (the cost of marketing and selling products to thousands of global customers) and receives fees in return for this marketing effort. The fee is a percentage of the quantity of products sold. Therefore, the marketing rights were a valid venture that could generate income to the investor, providing investment capital to SABIC marketing works and services. The Sukuk entitles Sukuk holders with a 20-year right in the defined net income from these marketing services, subject to certain terms and conditions. The track record of the marketing fee income was reported as:

Marketing fee income Year

Total marketing fee income (SAR ‘000s)

2003

1,121,493

2004

1,670,648

2005

2,140,600

Against the illustrated cost and expenses Year

Total costs and expenses (SAR ‘000s)

2003

47,813

2004

84,528

2005

93.182

The net income derived from this investment is paid quarterly to Sukuk holders, up to a specific amount (based on a benchmark linked to LIBOR). Any surplus income is kept as a reserve and buffer to allow for profit distribution if future net income declines. The reserve also functions to pay every five years throughout the 20-year life of Sukuk an extra amount equal to 10% of the face value of Sukuk. Therefore, by the end of 20 years, the Sukuk holders will get 40% of the face value of Sukuk as well as the quarterly profit distribution. If there is any surplus in revenue at the end of 20 years or earlier (if the Sukuk are to be purchased by SABIC under purchase undertaking), the remaining balance is to be paid to SABIC as an incentive. In addition to the 10% extra amount paid to Sukuk holders every five years, SABIC provides Sukuk holders with a purchase undertaking under which it is to purchase the Sukuk for a specific amount at each pre-arranged date. This purchase undertaking is both irrevocable and individual. However, the purchase price will decrease over time, representing the remaining life of the Sukuk. The price decreases from 90% of the face value at the end of year five to 60% in year 10 and 30% in year 15. At the end of year 20, the Sukuk has no value as its life has expired. This is an investment by the Sukuk investors to enhance the marketing capabilities of SABIC, which entitles the Sukuk investors to the profit generated from the marketing fees.

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9.9.2 The Emirates Airlines Sukuk Another good example is the Sukuk Musharakah for Emirates Airlines (2005). The Emirates Airlines Sukuk is the largest corporate issuance to date. This deal was structured under the Musharakah concept and was the second Sukuk Musharakah listed on the Luxembourg Stock Exchange. The US$550 million Sukuk issue has a seven-year maturity period with a semi-annual coupon, except for the first coupon which was payable in 12 months. The Sukuk was priced at 0.75% above the relevant US% LIBOR rates. Emirates and the issuer of the Sukuk certificates, Wings FZCO (a special purpose issuer), entered into a Musharakah agreement whereby both Emirates and Wings had undivided ownership of the Musharakah assets made up (on the closing day) of capital contributions raised from the issue of Sukuk and the land contributed by Emirates, as evidenced by the usufruct letter. Subsequently, the Musharakah assets constituted all revenues and assets acquired from the application of the Musharakah capital, that is to say rental income generated from the development of the land. The structure of the Emirates Airline Sukuk is shown in the diagram below:

Figure 9.6 Emirates Airlines Sukuk Musharakah

Emirates as obligor

Exercise price

Emirates as lessee

Sale of units

Lease of new Emirates Group headquarters

Musharakah Wings FZCO as partner

Emirates as partner Usufruct letter

Wings FZCO (the issuer) Periodic distribution amounts

Dissolution distribution amount

Proceeds

Emirates Certificates

Investors

Pursuant to the terms of the issue, Wings FZCO issued US$-denominated floating rate trust certificates. Wings FZCO used the proceeds of the Sukuk issue to contribute to the venture between Wings FZCO and Emirates. The venture was to develop and lease to Emirates a new engineering centre and headquarters on land situated near Dubai’s airport. Profit, in the form of lease returns generated from the joint venture, will be used to pay the periodic coupon on the trust certificates. The trust certificates have been listed on the Luxembourg Stock Exchange.

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Emirates and Wings FZCO’s participation in the venture is represented by a specified number of units of the trust certificates generated. During the lifespan of the transaction, Emirates is scheduled to purchase units from the issuer. This reflects the amortisation schedule of the Sukuk certificates. The issue, oversubscribed by almost 50%, was closed at US$550 million as originally targeted. The deal was a joint effort of a prestigious consortium of local, regional and international banks, led by Dubai Islamic Bank (DIB). The issue was managed by a six-member group of banks acting as joint lead managers including DIB, National Bank of Abu Dhabi, Gulf International Bank B.S.C., Standard Chartered Bank, HSBC and UBS.

9.10 Asset-backed Sukuk Asset-backed securities are the real form of securitisation as they expose the investors to real value and risk of the underlying asset. Asset-backed Sukuk, as explained in CDIF/3/8/121-128, involve securitisation of an asset whereas the investors can only expect the returns from the cash flows of the underlying assets that are not linked to the credit risk of the originator/owner of the asset. These assets could be financial assets or physical assets. Under this type of Sukuk, investors generally do not have access to the asset owner, likewise they are safeguarded from the latter’s financial plights. This is because asset-backed Sukuk would require the owner of the asset to sell his asset on a ‘true sale’ concept without having any purchase undertaking to repurchase the asset at its outstanding face-value. In some cases, the owner/originator may undertake to repurchase the asset by giving a put option to the Sukuk investors. However, the purchase price must not be based on the face value of the outstanding Sukuk. Ideally, it should be based on market value to reflect a valid sense of a true sale concept. In short, asset-backed Sukuk are characteristically non-recourse Sukuk with the underlying assets forming the sole source of profit and capital payments. The following is a hypothetical illustration of an asset-backed Sukuk, which could also be linked to an Ijarah contract. Ship It Right (SIR) is a logistic company that owns a series of warehouses. As the company is looking for new funding to expand its business overseas, it may decide to sell the warehouses to the SPV/issuer on behalf of the investors. This sale shall be a true sale and there is no purchase undertaking by the company. The warehouses may be leased back to the same company, say for a period of five years, for it to continue operations with the existing clients. The lease rental income is the sole source of payment for the Sukuk investors. The investors have no right of recourse to the company if the lease rental income does not meet the minimum periodic distribution of profit/coupon. The company may, however, undertake to purchase back the asset at market value on the maturity date.

Figure 9.7 Asset-backed Sukuk

Asset-backed Sukuk investors 1

SIR company (owner)

2

Sukuk proceed

SPV/Issuer

Sale of asset

3

SIR Company (lessee)

Lease of asset

4 Call options to purchase the asset at market evaluation

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Key point • Asset-backed Sukuk entitles the Sukuk investors to the real value and risk of the underlying asset that is transferred to the Sukuk investors under a ‘true sale’ concept, which allows no recourse to the original owner under any circumstances. The original owner may have the call option over the asset but it should be based on the market value of the asset at the time of the exercise of the call option.

9.11 Possible new structures for Sukuk Possible new Sukuk may use other innovative structures. One of these structures could be to securitise the right to use future services such as the use of an apartment. This is in line with AAOIFI Shari’ah Standard (No. 17) that allows the securitisation of both existing and future services of an asset. The following illustration describes how a future service can be used as the underlying asset to raise necessary funding.

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A five-star apartment complex is being developed in the Holy Land of Mecca. As part of the master plan for the ongoing improvements of the Holy Cities of Mecca and Medina, the Waqf (endowment), owning significant properties, has entered into strategic plans to modernise and expand facilities for pilgrims and visitors. In Mecca, King Abdul Aziz Waqf is developing a multiplex of high-rise towers. Zam Zam Towers is a-sub-project secured by an affiliate of the Kuwait-based International Lease Investment Company (an Islamic Development Bank-sponsored entity) called Munshaat Real Estate.

Figure 9.8 Project structure King Abdul Aziz Waqf 28 yr BOT contract

Transfer Zam Zam Towers back to Waqf after 28 years

Bin Laden group of companies Sukuk proceeeds

24 yr lease

Issue USD390 mil Sukuk Al-Intifa

Munshaat real estate

Sukuk investors Sukuk proceeeds

Realising that the long-term ownership of the buildings would ultimately go to the Waqf, and there are limitations on non-Saudi Arabian ownership of real property, Munshaat re-characterised the property into multiple estates: the ground belonged to the Waqf; the building could belong to Munshaat as a Gulf Cooperation Council company, ultimately controlled by the Jeddah-based Islamic Development Bank; and the Manfa’at, or benefit of the space, could be sold for up to 24 years. Munshaat, then entered into a BOT contract with the Waqf, governed by the reversionary lease, and sub-contracted construction of a 31-storey, 1,240-unit building to a prominent Saudi Arabian builder. The US$390 million contract was funded by an issuance of Islamic securities or Sukuk known as Sukuk al Intifa’a or Sukuk for use or services. These securities or Sukuk represent a fractional ownership of the right to use a specific part of the building during a specific period. The shares were priced according to season, unit location and view. The shares were made fully exchangeable and represent a 24-year guaranteed right to utilise, for a specific time each year, a pre-specified space. The securities or Sukuk were sold prior to construction, thereby funding the construction. The Sukuk or securities represent a forward lease for the property, meaning that Munshaat bears a refund risk if the project is not completed. Among the novel features of this project is that the holder of Sukuk may elect to benefit from a number of options: he or she may simply show up at the reserved time; exchange times through a specialised affiliate of Munshaat; contract for Munshaat to sub-lease the contracted time to a willing tenant who wishes to visit Mecca at that time; or sell the Sukuk to a willing buyer for a profit or loss, with that buyer then acquiring all of the attendant rights and benefits of the Sukuk. The underlying property rights represented in the Sukuk, however, are limited in time and nature. Since the Sukuk represent a specific form of property, the certificates may be sold on an instalment basis. This facilitates one of the goals of the sponsor Munshaat: to make it easy for a large number of people to acquire the certificates and access and use the property that they represent. The Sukuk al Intifa’a issuance has established a model that is easily replicable in global markets. Based on an adaptation of a classical series of concepts, all of which centre on the flexible approach to the sale and utilisation of property facilities, this is the first modern lease in Islamic finance that is based on securitisation of (future) services.

Key point • Current or future services may be securitised in the form of Sukuk through which the Sukuk holders will financially benefit by the sub-leasing of these services to a third party for a rental payment.

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9.12 Rating methodology for Sukuk Rating, as understood in conventional terms, is the expression of an opinion about the ability and willingness of an issuer to meet financial obligations in a timely manner. The same meaning of rating is applicable in the context of Islamic finance with specific reference to Sukuk. The current rating of Sukuk by many international or local rating agencies, while ascertaining the ability and willingness of the issuer to make relevant payments to the investors, does not examine the quality of the Shari’ah approval for the Sukuk. This is because the Shari’ah quality rating is currently beyond the scope of many international and local rating agencies. The rating agencies will, however, consider whether the Sukuk instrument is enforceable according to the law of the relevant country as part of its due diligence and in this regard they may take cognisance of the Shari’ah approval as part of the enforceability issue, where relevant. The exception to this are the recent efforts of Bahrain’s International Islamic Rating Agency (IIRA). IIRA has developed a Shari’ah Quality Rating that is designed to provide information and independent assessment regarding the level of Shari’ah compliance by an IFI. IIRA uses a scale of AAA to B to rate Shari’ah Quality Compliance, with AAA being the highest possible rating and B being the lowest. This rating methodology places institutions on a single comparable scale in an independent, impartial framework prepared by IIRA’s Shari’ah scholars. This rating methodology is specifically applied to institutions offering Islamic financing instruments, rather than rating the actual financial instruments or Sukuks. Conceptually, a Sukuk is an investment instrument that is intended to reward the investors for their investment. However, the investors may need an independent rating to ascertain the ability of the issuer to make payments and other obligations arising from the Sukuk instrument. Ratings for Sukuk may take a different form from ratings for conventional bonds. One fact to be considered is that Sukuk are essentially based on many different contracts that give rise to many different legal and economic implications. The focus of the rating for Sukuk must therefore take into consideration the contractual dimension of the Sukuk, in addition to what is crucial in a general rating exercise, where relevant and applicable. Conventional bonds are all about the obligation of the issuer to pay a certain amount of principal and interest, based on a loan contract. The credit worthiness of the issuer is the main, if not the only, consideration in rating for a conventional bond. The only exception lies in conventional asset-backed securities that behave as an equity instrument instead of a loan obligation or simply an IOU.

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Islamic finance challenge 9.3 Why is the rating of a Sukuk as an investment instrument important compared with investments in other asset classes such as property or equity funds?

Solution Creditworthiness is a requirement for any party looking to borrow. A party will be allocated borrowings or financing if it can display to the financier that it has the ability, as well as the commitment, to fulfil the repayment obligations. Within the banking systems, the financing bank conducts credit analysis on all its borrowers, according to the bank’s credit criteria, to select the suitable financing pool. On the other hand, the capital markets investors rely on the analysis of rating agencies to signal to them the quality of credit that the potential issuing parties possess. Sukuk, like conventional bonds, are issued in the capital markets, to the same pool of investors who are comfortable with the credit rating processes that are requirements of any bond issuance. Therefore, Islamic investors worldwide also expect these Sukuk to be rated, even though, unlike conventional bonds, some Sukuk structures are not entirely dependent on the usual credit-rating mechanisms (because, for example, of returns dependent on projects). Sukuk ratings, which were primarily based on credit ratings, are now moving towards the ratings of specific features pertinent in every Sukuk. For instance, project-based Sukuk are now being rated based on a combination of credit as well as project financing ratings. The challenge now is not to rate all Sukuk issuance but to establish the correct rating methodologies for the different Sukuk structures. The answer as to why Sukuk needs to be rated while Islamic property or equity funds do not lies with the categories of investments that each asset class belongs to. The latter is purely an investment tool whereby the investors are exposed to all risks and profit potentials that the fund invests in. Sukuk, on the other hand, has an in-built capital redemption scheme whereby investors expect that their capital layout will eventually be redeemed by the issuers. The investors expect managed risk and they look forward to the ratings results to see whether the Sukuk investments are commensurate with their risk appetite.

Key point • Sukuk, unlike other capital market products, need to be rated as they involve capital redemption by the issuer, which is, technically speaking, a contingent liability on the issuer.

9.12.1 Issues to be considered in Sukuk rating Several issues need to be considered in Sukuk rating. The following are general considerations applicable to all types of Sukuk. However, each Sukuk structure may have additional considerations for the rating, which will be discussed in the next section.

9.12.1.1 Source of payment to the Sukuk holder/investor Any investor in Sukuk will expect some return on their investment in addition to capital redemption. Therefore, the first task is to ascertain how the issuer would seek to pay all the expected payments. Obviously, a debt and asset-based Sukuk will be different from a project-based or asset-backed Sukuk in terms of the source of payment to the Sukuk holders. This will be highlighted in discussion of various types of Sukuk and their rating methodologies.

9.12.1.2 Credit enhancement structures Credit enhancement structures enhance the ability of the issuer to pay all the expected payments in all relevant circumstances. This includes, among others: the charge of an asset as the collateral and the assignment of the proceeds of any sale or investment income to Sukuk investors; the creation of a trust on the leased asset or investment asset for the benefit of Sukuk investors; and purchase undertaking in equity-based Sukuk.

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9.12.1.3 Legal and judicial aspects Investors need to consider the legal and jurisdictional aspects of the Sukuk transaction, such as its enforceability, recognition of choice of law, insolvency and security-related matters. For example, some jurisdictions in the Middle East, such as Saudi Arabia, may raise questions about which parties’ obligations would be enforceable in local courts and whether they would recognise English law in that jurisdiction, and whether the security offered would be enforceable. Uncertainties pertaining to the legal environment surrounding Sukuk issuances affect the rating grade of the Sukuk.

9.12.1.4 Assessment of key parties to the transaction An assessment of key parties to the transaction would need to be carried out, including their roles in the transaction, such as originator (borrower), lessee or obligor, guarantor, contract servicer and financial adviser.

Exercise 9.6 Suggest why established rating methodologies for Sukuk do not include Shari’ah ratings.

9.12.2 Rating debt-based Sukuk As debt-based Sukuk is similar to conventional bonds in terms of risk and reward, a corporate rating methodology will usually be applied to grade the rating for Sukuk based on debt securitisation. Under this methodology, the rating of the Sukuk will be largely based on the underlying business and operations of the issuer. In other words, the credit quality of the corporate obligor will be the key driver affecting the credit risk of the Sukuk, with the final assigned rating dependent upon the ranking of Sukuk vis-à-vis other existing senior unsecured obligations of the issuer. Applying this methodology, a rating agency will examine relevant factors that may affect the credit risk of the issuer. The quality of rating will, however, not be linked to the underlying asset, which was used to facilitate the issuance of this Sukuk, as this asset and its performance has no impact on the future ability of payment. Those factors that are relevant to the issuer’s credit risk are summarised in the following diagram.

Figure 9.9 Corporate rating methodology: analytical framework

Industry analysis

Business analysis

Financial analysis

Management analysis

• Growth potential

• Market position

• Earning

• Track record

• Industry vulnerability

• Business diversity

• Cashflow analysis

• Operating efficiency

• Capital structure

• Capacity to overcome adversity

• Barriers to entry/ exit

• Cost structure

• Liquid position

• Risk appetite

• Financial flexibility

• Succession plan

• Financial policy

• Goals, philosophy and strategies

• Threats of substitutes • Level of competition

Source: Malaysian Sukuk Market Handbook, RAM Ratings Services Berhad (2008)

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Each of the above factors will be analysed to gain a comprehensive view of the business of the issuer. An industry analysis is important because it provides the setting for the appraisal of company-specific risk factors and establishes the relative importance of these factors in the overall credit evaluation. Pertinent aspects across all industries include the rated entity’s size; supply-and-demand dynamics, growth prospects, competitiveness, vulnerability to technological changes, capital requirements and other entry provisions or barriers, and government policies. The same detailed examination will be applied to business analysis, financial analysis and management analysis. This methodology does not differ from any rating exercise for any conventional bond, which is a straightforward IOU instrument.

9.12.4 Rating project-based Sukuk Project-based Sukuk needs a different methodology of rating from both debt-based and asset-based Sukuk. The focus is no longer on the credit risk of the issuer. The examination will focus on the ability of the underlying project asset to generate sufficient cash flows to make all the relevant payments under the Sukuk. The methodology of rating used for this Sukuk is known as a project finance rating methodology. The two key elements in the rating are the quality of the cash flows and the asset of the project. While the periodic cash flow stream is relied on as the sole source for profit (that to be distributed to, or shared with, the Sukuk investors), the project assets are usually secured as collateral for the Sukuk investors in the event of default or dissolution of the Sukuk. In this context, principles of rating for conventional project-finance transactions are largely used to ascertain the relevant rating grades for Sukuk that are linked to projects.

9.12.3 Rating asset-based Sukuk Although the structure of asset-based Sukuk, such as Sukuk Ijarah, is different from Murabahah or Sukuk Istisna’, it shares largely the same methodology of rating, based on the corporate rating methodology already described. The ability of the issuer to make a timely payment of the lease rental obligations and to purchase the leased asset does not depend on the performance of the underlying leased asset. Also, the proceeds arising from Sukuk Ijarah may not necessarily be used to finance the underlying asset that facilitated the issuance of Sukuk Ijarah. Therefore, the source of payment may be linked to other business activities of the originator/obligor in the case of Sukuk Ijarah. Having said this, Sukuk Ijarah have a distinctive feature in the structure that debt-based Sukuk may not have. In most Sukuk Ijarah, the seller/originator/lessee will issue a purchase undertaking to repurchase the leased asset on maturity or any interim date at a pre-determined price. At maturity, or dissolution event, the seller/lessor will have to repurchase the leased asset from the investors. This risk is linked to the financial strength of the credit risk of the seller/lessee. What makes Sukuk Ijarah different from debt-based Sukuk is that the leased asset, in some Sukuk Ijarah, is declared as a trust for the benefit of Sukuk investors. The creation of a trust over this asset has given preference to Sukuk Ijarah investors over other creditors of the seller/lessee in the case of liquidation. This will add positively to the rating, although, in the final analysis, it will boil down to the financial ability of the seller/lessee to repurchase this asset from the investors at a predetermined price.

Key point • Sukuk structured as an asset-based securitisation is subject to corporate rating methodology that focuses more on the creditworthiness of the issuer instead of any other elements, including the underlying asset.

9.12.4 Rating project-based Sukuk Project-based Sukuk needs a different methodology of rating from both debt-based and asset-based Sukuk. The focus is no longer on the credit risk of the issuer. The examination will focus on the ability of the underlying project asset to generate sufficient cash flows to make all the relevant payments under the Sukuk. The methodology of rating used for this Sukuk is known as a project finance rating methodology. The two key elements in the rating are the quality of the cash flows and the asset of the project. While the periodic cash flow stream is relied on as the sole source for profit (that to be distributed to, or shared with, the Sukuk investors), the project assets are usually secured as collateral for the Sukuk investors in the event of default or dissolution of the Sukuk. In this context, principles of rating for conventional project-finance transactions are largely used to ascertain the relevant rating grades for Sukuk that are linked to projects. CIMA Advanced Diploma in Islamic Finance

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Figure 9.10 Project finance rating methodology: analytical framework

Project funding

Project foundation

DSCR Analysis

Source: Malaysian Sukuk Market Handbook, RAM Ratings Services Berhad (2008)

9.12.4.1 Key business risk areas The rating exercise begins with an evaluation of the project foundation or key business risk areas, involving contractual requirements, regulatory environment, operational challenges, technology complexity of the project assets, demand risk, credit strength of the off-taker and construction risk (if the underlying asset has yet to be physically completed). In addition, specific areas of risk that can either reduce or defer the expected amount of cash that the project can generate must be identified.

9.12.4.2 Review of project funding The next step involves a review of the project funding or its capital structure, in line with the proposed financing terms. As most projects comprise a combination of senior debt, equity and/or junior/subordinated hybrid instruments, emphasis is thus placed on the project company’s ability to generate and conserve adequate cash reserves to prioritise the debt-servicing requirements of the most senior Sukuk instruments, followed by the more junior securities, before any equity distributions can be made. A well-structured debt redemption profile that matches the project’s cash flow generation pattern is crucial in project finance ratings assessment.

9.12.4.3 Debt service coverage ratios The first two steps generate the debt service coverage ratios (DSCRs) utilised to measure the availability of cash flows in relation to the annual debt servicing requirements of the Sukuk. Generally, the stronger the DSCRs, the higher the rating assigned to the Sukuk. The level of debt coverage will also play a part in determining the amount that can eventually be distributed to the shareholders of the project.

9.12.4.4 Construction risk Notwithstanding the DSCRs, a project’s Sukuk rating can also be capped by construction risk. Construction risk is a function of the contractor’s expertise and experience, where the complexity of works, the construction programme and the contract type are duly considered. Upon completion of the construction, the ratings for the project-based Sukuk should revert to the ratings that are commensurate with its DSCR level. Where applicable, a Sukuk rating can also be constrained by the rating of the project’s off-taker. This is because the quality of project cash flows typically hinges on the ability of one or a few off-takers to make timely payments for the services rendered by the project. The failure of these entities will severely affect the project company’s ability to meet its Sukuk obligations.

Key point • Rating project-based Sukuk adopts a project finance rating methodology that examines key business risk areas, project funding, debt service coverage ratio and construction risk.

9.12.5 Rating asset-backed Sukuk Asset-backed Sukuk are essentially non-recourse to the issuer and the source of payment (both profits and capital) is derived directly from the underlying assets of the Sukuk. Subsequently, the credit risk of the Sukuk is determined by the performance and the credit quality of these underlying assets. With no recourse on the issuer’s assets, Sukuk investors are also safeguarded from any of the issuer’s financial liabilities. While the underlying asset class will play a part in how asset-backed Sukuk is being rated, the generic rating approach is given as:

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Figure 9.11 Asset-backed/structured finance methodology: analytical framework

Asset risk assessment

Payment structure assessment

Legal and tax assessment

Servicer and trustee review

Source: Malaysian Sukuk Market Handbook, RAM Ratings Services Berhad (2008)

The ratings will focus on the robustness of the underlying assets in generating sufficient funds to meet the issuer’s periodic financial obligations, and an assessment of the expected realisable values of the assets upon maturity. It is vital to identify the intrinsic risks in the underlying assets with respect to their historical operational and performance data. Any potential impairment of cash flow must be ascertained as a result of possible delinquency or default on the Sukuk assets. The analysis is done while considering existing regulations governing business practices of the sponsor and the nature of the assets and consequent cash flow profile under various stress scenarios. The aim here is to examine the adequacy and timing of the cash flow vis-à -vis the financial obligations on the Sukuk, in accordance with the stated priority of payments under the transaction. Should a cash flow mismatch occur, it is important to see that this can be addressed. Besides emulating the defined payment flow other material factors that could affect the cash flow in the transaction, such as profit rates, prepayments on the asset and reinvestment rate, will also be built into the cash flow model. The adequacy and forms of credit enhancements will be evaluated by way of stress-testing the cash flow model. The level of stress applied will correspond to the assigned ratings. Generally, more rigorous stress tests are applied to higher-rated Sukuk. Structural features and the adequacy of each structural feature in addressing its intended purposes will be taken into consideration. Examples of structural features include credit enhancement, earlywarning mechanisms, such as trigger events, early-amortisation events and profit rates, as well as hedging arrangements for currency-exchange risk. While the usual tax and legal review may be undertaken, one particular issue that needs to be specifically addressed is the regulation that supports the separation of the underlying assets from the bankruptcy of the asset originator. Other legal issues that will be examined include the means by which the assets are transferred to the issuer, enforceability and the perfection of security interest. The rating exercise may also include a review of all transaction documents, such as the trust deed, sale and purchase agreement, servicing agreement, swap agreement, guarantee investment contract, credit-support agreement and liquidity-support agreement.

Key point • Rating asset-backed securities examines the quality of the underlying asset with regard to its cash flow and expected future income.

Exercise 9.7 Identify the similarities and differences between rating methodologies of project-based and asset-backed Sukuk.

9.12.6 Implications of a potential Sukuk default The possibility that the Sukuk issuer will default by failing to make good either coupon payments or the payment of the principal amount in a timely manner is inherent in all Sukuk issuances. To mitigate such instances of default the Sukuk will normally undergo a rating process, which also takes into consideration the existence of contingencies including credit enhancement tools such as guarantees, sinking funds and letters of credit, created to supplement the main instrument and reduce the default risk on specific issues. Unlike a conventional bond issuance, it is still not mandatory for a Sukuk issuance to undergo the rating process in some jurisdictions. This lack of regulatory requirement may act to prohibit development within the Sukuk industry. The potential default of any Sukuk would have negative implications for the industry, affecting the popularity of Sukuk as viable capital funding instruments within the Islamic finance industry. Unlike conventional bonds, which are typically debt-based, some Sukuks are issued under equity or

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participatory contracts that leave the Sukuk investors with little recourse to the issuer. The default of any type of Sukuk may therefore have a bigger effect on investors’ confidence compared with the effect of a similar situation within the traditional bond industry.

9.13 Conclusion This chapter has shown you that Sukuk are an important funding vehicle for the Islamic capital market. The Sukuk market has been growing at a remarkable pace since its establishment in 1990. The market has seen a variety of new and innovative structures applying a variety of different Islamic contracts to suit the features required. The development of this nascent yet important industry is overseen by Shari’ah authorities such as AAOIFI. It is the role of such international standard-setting agencies to address peculiarities in the industry, as demonstrated when the Shari’ah Board of AAOIFI issued the 2008 Sukuk pronouncement to amend practices arising with the issuance of some Sukuk. The chapter explained how Sukuk can be classified; either based on the underlying assets or based on the contractual relationship between the issuer and the investor. You were introduced to the different structuring issues that have arisen from structuring debt-based Sukuk and project-based Sukuk, along with the different types of financing arrangements available. This chapter also introduced you to the concept of ratings for Sukuk and elaborated on the methodologies used to rate different types of Sukuk. Developing robust and consistent rating methodologies for the different types of Sukuk is an important consideration, especially if one wants to see further integration between the Islamic capital markets around the world.

9.14 Summary Having read this chapter the main points that you should understand are as follows: • equity-based Sukuk should not have any clause that effectively guarantees the capital of the Sukuk • the AAOIFI pronouncement on Sukuk of 2008 made equity-based Sukuk with the clause of purchase undertaking by the issuer non-compliant • post the AAOIFI pronouncement, Sukuk, particularly those of an equity nature, must be free from any purchase undertaking or liquidity facility and must essentially reflect the ownership of the underlying asset or project • Sukuk can be classified into four broad categories based on the underlying asset against which the Sukuk is issued: debt-based Sukuk, asset-based Sukuk, project-based Sukuk and asset-backed Sukuk • Sukuk may also be classified based on the contractual perspective governing the relationship between the issuer and the investors, that is to say either debt-based or equity-based Sukuk • from the financial obligation perspective, asset-based Sukuk is similar to debt-based Sukuk as the performance of the underlying asset has no significant impact on the credit quality of the obligor/issuer • project-based Sukuk is a relatively new innovation of Islamic finance in the fixed-income market as it departs completely from the notion of IOU to profit and risk sharing • the 2008 Sukuk pronouncement by AAOIFI has readdressed the features of equity-based Sukuk and affected the rating processes of Sukuk • the current rating of Sukuk by many international or local rating agencies, while ascertaining the ability and willingness of the issuer to make relevant payments to the investors, does not examine the quality of the Shari’ah approval for the Sukuk • the rating methodologies applied on debt-based and asset-based Sukuk is largely based on credit ratings, although the creation of a trust for some asset-based Sukuk will add positively to its rating • project-based Sukuk requires a different rating methodology as the focus is no longer on the credit risk of the issuer but on the ability of the underlying project asset to generate sufficient cash flows to make all the relevant payments under the Sukuk • asset-backed Sukuk will be rated on the robustness of their underlying assets in generating sufficient funds to meet the issuer’s periodic financial obligations, and an assessment of the expected realisable values of the assets upon maturity • the development of acceptable rating systems is important to ensure that the investors understand the nature of the Sukuk issued and the risks involved, and to minimise the possibility of Sukuk defaults in the future.

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9.15 Islamic finance case study Sukuk structuring and Sukuk rating post the AAOIFI pronouncement The International Islamic Bank (IIB), a multi-national bank, has many project development projects located in various member countries, covering the infrastructure and energy capacity building sector for the benefit of member countries. The rating of IIB is AAA, as awarded by a few international rating agencies. Any paper or bond issued by IIB, based on that rating grade, will enjoy a relatively low rate of interest in the range of 3% to 3.25% per annum. Given current market conditions, any other commercial paper or bond issued by another corporation, even for the same identified projects, will only be granted an A grade, which will attract at least 5% interest per annum. The board of the directors of IIB decides to issue Sukuk to attract Islamic investment funds from member countries to invest in a few identified projects involving a new highway construction of 800km connecting all member countries, as well as an alternative power plant to supply power to all member countries in a more cost-effective manner. However, IIB decides not to utilise the existing fixed assets that it has to facilitate the issuance of Sukuk Ijarah, as IIB seeks to avoid ‘negative carry’ to its assets. IIB also seeks to have a good rating grade for this Sukuk not less than an AA grade, if not an AAA grade. In other words, IIB is not willing to raise funds from capital market investors to which they would have to pay a higher profit rate as IIB was enjoying a good investible grade, thus lowering the cost of borrowing. The outlines of the Sukuk features have been prescribed by IIB and include the following terms. • Sukuk proceeds are to be invested in the above two identified projects as well as the general business of IIB. • The Sukuk tenor will only be for five years as the investors may not prefer a long-term investment. • The Sukuk issuance must be globally accepted and approved to appeal to a wide group of investors, particularly IFIs and investment houses. • The rating grade of the Sukuk must not be less than AA. • The Sukuk may have the option of convertibility to shares of a subsidiary of the issuer, which is a telecommunication company providing services throughout the member countries. • IIB is willing to provide a guarantee for capital redemption, if relevant and applicable. • IIB will not be the issuer. The issuer of the Sukuk will be a project finance company that is a subsidiary of IIB.

Case study multiple choice questions 1.

2.

3.

Sukuk Ijarah has not been subjected to a review by the AAOIFI Shari’ah board although it has a purchase undertaking by the issuer to purchase the asset underlying Sukuk at a price equivalent to the par value of the outstanding Sukuk. Which of the following has rendered this purchase undertaking by the obligor irrelevant from the Shari’ah perspective? (A)

The purchase undertaking is by the originator and not the issuer

(B)

The purchase undertaking is on the obligation to purchase a leased asset

(C)

The purchase undertaking in Sukuk Ijarah is based on an agreed price

(D)

The purchase undertaking relates to equity redemption

The guarantee for capital redemption in equity-based Sukuk is only permissible in the case of: (A)

default by the issuer in paying all the expected periodical profits

(B)

the downgrading of the Sukuk rating to a lower rating grade

(C)

negligence and misconduct of the issuer

(D)

liquidation of the issuer

Based on the case study scenario, which of the following Sukuk may not be relevant for IIB to consider? (A)

Sukuk Ijarah

(B)

Sukuk Istithmar

(C)

Sukuk Musharakah

(D)

Sukuk Mudarabah

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4.

5.

What are the requirements to make convertibility of Sukuk to shares of a given company compliant? (A)

The rating of both Sukuk and shares must be equal, and there must be approval from ordinary shareholders

(B)

The certainty of the conversion formula and compliance status of the company shares

(C)

The redemption of Sukuk by the issuer prior to conversion of Sukuk into shares

(D)

The conversion is only possible in the case of profitability of the issuing company

Which of the following does the term ‘hybrid Sukuk’ refer to? (A)

A Sukuk that combines both tangible and intangible assets as the underlying asset

(B)

A Sukuk that combines both financial and fixed assets

(C)

A Sukuk that combines both assets under construction and assets already completed

(D)

A Sukuk that combines both debt financing and equity financing

Case study short essay questions

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1.

What are the possible structures of Sukuk that IIB may consider issuing? Which is your preferred structure and what is the basis of your preference?

2.

Being the subsidiary to a multi-national bank, the issuer as the project company may not attain the rating grade of AAA. What measures can be proposed to achieve the highest possible investable rating grade?

3.

Assuming that the project financing of the two projects in the case study needs at least 10 years to generate sufficient cash flows to redeem capital and pay off all expected profits, is the proposal to make a five-year Sukuk viable from an investor’s perspective?

4.

Can Islamic-backed securities be structured to apply to the above case study scenario and what is the justification for your opinion?

5.

Applying what you have learned in chapter six on Islamic project financing, what would you suggest to make the above Sukuk more viable and appealing to investors?

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Chapter nine answers Exercise 9.1 (B). The undertaking of the issuer to purchase the outstanding Sukuk, in the case of a default by the issuer at par value, leads to a capital guarantee in the contracts of equity that is not compliant with Shari’ah principles. This term in the contract will make equity-based Sukuk non-compliant as there is an implicit guarantee in relation to the capital in all circumstances. The other terms and practices are compliant and acceptable to Shari’ah principles.

Exercise 9.2 Even if receivables originate from Islamic-approved contracts, they are deemed by many scholars to be money or monetary assets. Therefore, the sale of receivables for money can only be at face value to avoid interest by excess (Riba al-fadl) because of an inequality of the counter values. However, if money or monetary assets were to be exchanged for a commodity, this strict requirement is no longer relevant as the amount of money or monetary asset in the form of a receivable does not need to match the actual amount or value of the commodity. A commodity, as a matter of principle, may be sold at either X or Y price as per the ‘willing buyer, willing seller’ concept. Thus, the proposal to sell Islamic receivables arising from Islamic contracts in exchange for a certain commodity is permissible, although it technically leads to the discounting effect of receivables disposed before their maturity date.

Exercise 9.3 • IFIs in Malaysia that subscribe to the Shari’ah Standards as prescribed by the AAOIFI, may participate in this Sukuk as the primary investors in the primary market instead of the secondary market, either as the seller or the purchaser. Other IFIs that do not necessarily subscribe to AAOIFI Shari’ah Standards may, however, participate in both the primary and secondary markets. • Malaysian IFIs may participate in this Sukuk if the product is seen as an investment product and not a liquidity product, which could only be sold on the secondary market at face value. The sale of this Sukuk at face value may not be attractive to secondary market investors. In this context, the sale of this Sukuk for a commodity on an ‘over-the-counter’ basis may be possible if this is allowed under the laws of Malaysia. • The best suited instrument for liquidity purposes is the Sukuk that is either asset-based such as the Ijarah contract or equity-based such as Mudarabah and Musharakah. These Sukuk may be traded freely in the secondary market, thus achieving the purpose of liquidity management. The Sukuk holder may sell down his portfolio as and when he needs the liquidity to meet his current liabilities.

Exercise 9.4 The ‘sale-and-buy-back’ arrangement in an Istisna’ contract has been deemed to be a form of ‘Inah contract, which is not approved under AAOIFI Shari’ah Standard No. 11. It is different from a Parallel Istisna’ arrangement as there must be three independent parties involved in a Parallel Istisna’ and the two Istisna’ contracts must be independent from each other. The ultimate purchaser in a Parallel Istisna’ is neither the financier nor the ultimate contractor. If the ultimate contractor failed to deliver the asset to the financier (as the purchaser of Istisna’), the financier (as the seller) shall not be exempted from the liability to deliver the required asset to the ultimate purchaser. While ‘sale and buy back’ of Istisna’ is not approved, the Parallel Istisna’ is approved by AAOIFI Shari’ah Standard (No 7). The Sukuk Istisna’ is not accepted by the AAOIFI Shari’ah Standard on two accounts. The first is that the underlying contract of ‘sale and buy back’ is an ‘Inah arrangement; the second is the nature of securitisation, which is purely debt-based. The Sukuk issued by the issuer/obligor simply represents the obligation of the issuer to pay a certain amount of money created by the second leg of the Istisna’ contract. Although the mere issuance of this Sukuk is acceptable, the tradability of this Sukuk at the secondary market, based on market value, is not acceptable to avoid the sale of monetary debt for cash. The sale of pure debt or receivables, except at face value, is not approved by AAOIFI Shari’ah Standards. Alternatives to raising required funding using Sukuk without creating Sukuk Istisna’ are available through Sukuk Musharakah, Sukuk Mudarabah or Sukuk Istithmar respectively, all of which are project-based Sukuk and use equity-based contracts. Unlike Sukuk Istisna’, investors in this alternative Sukuk structure must take on the risk of the project under construction instead of the credit risk of the issuer/obligor. The rating of this Sukuk will be primarily based on the viability of the project and its inherent risks. These alternative Sukuk have transformed from simple IOUs

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to certificates of equity investment whereby the Sukuk holders will only benefit from the profit generated by these projects and, therefore, must bear the losses of the project.

Exercise 9.5 Sukuk Istisna’ is a debt-based Sukuk that is based on receivables arising from the Istisna’ sale that the issuer (buyer) owes the investors (seller). The Sukuk principally involves two parties and the security for the issuance lies in the project assets that are to be developed. As it is a debt-based Sukuk, it is non-tradable and its pricing mechanism is based on a fixed principal and fixed coupons. Sukuk Istisna’ is, however, not globally acceptable. On the other hand, Sukuk Ijarah is a globally accepted asset-based Sukuk. To structure this Sukuk requires an asset to be sold to the investors for the investors to subsequently lease the asset back to the owner/originator. Like the above Sukuk, it involves two principal parties and the security of the Sukuk is based on a put option or purchase undertaking placed on the leased assets placed by the originator/lessee. The Sukuk can either be based on a fixed or floating lease/rental pricing mechanism. Sukuk Ijarah is tradable under international Shari’ah standards.

Exercise 9.6 Rating methodologies are limited towards analysing whether the Sukuk issuers are able to meet their payment obligation towards their investors, based on the legal environment where the issuance has taken place. Rating agencies are unable to conduct Shari’ah ratings because they do not have the expertise to carry out the exercise as well as to establish the Shari’ah rating methodologies. The expertise housed within rating agencies is usually limited to legal, tax and financial expertise.

Exercise 9.7 The main similarity between ratings of project-based and asset-backed Sukuk lies in the fact that the focus of the ratings on both types of Sukuk will be the cash flow generated from the underlying asset. The credit standing of the issuers in both Sukuk should have a minimal impact on their ratings. However, for the asset-backed Sukuk, the underlying asset must be in a condition to generate those returns with immediate effect, whereas in a project-based Sukuk the assets that are to generate those returns have yet to be built or constructed before the Sukuk is launched.

Case study multiple choice answers 1. (B) The purchase undertaking in Sukuk Ijarah does not lead to a capital guarantee. The purchase undertaking relates exclusively to the undertaking by the originator/lessee to purchase the leased asset at a price that could be equivalent to the Sukuk outstanding amount. 2. (C) Equity-based contracts would object to any capital guarantee by the managing partner in all circumstances except in the case of negligence and misconduct, as well as a breach of the terms and conditions. 3. (A) Sukuk Ijarah is obviously not relevant as IIB has excluded the possibility of using the existing assets of IIB to avoid the ‘negative carry’ and avoid restriction on the usage or disposal of those assets in future. 4. (B) Conversion of Sukuk to shares requires a certainty of the conversion formula and the fact that the shares of the company are compliant to Shari’ah principles. 5. (B) Hybrid Sukuk refers to an underlying asset of Sukuk that combines both financial assets, such as Islamic account receivables, and fixed assets, such as land, building and equipment.

Suggested solutions to case study short essay questions 1.

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Given the nature of IIB and the pre-set mandate for the issuance of Sukuk, the subsidiary of IIB may issue Sukuk Musharakah, Sukuk Mudarabah or Sukuk Istithmar as they are all applicable for project financing. Sukuk Ijarah will be disregarded as IIB seeks to avoid the ‘negative carry’. Relatively speaking, Sukuk Musharakah will be more preferable as both the issuer, that is the subsidiary of IIB, and the investors will contribute capital to the venture. This gives more comfort to Sukuk investors as the issuer is also contributing capital, as compared to Sukuk Mudarabah and Sukuk Istithmar. From the issuer’s perspective, capital contribution can be in the form of cash or kind (such as in the case of Sukuk Musharakah for Emirates Airlines).

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2.

The rating will be based on the performance of the underlying asset, which is a new power plant and highway. The rating methodology will be based on project-financing methodology. Among the measures to improve the rating of the Sukuk is an off-take agreement, a guarantee by IIB on the performance of the issuer of all expected works whereas the loss caused by the negligence or misconduct of the issuer/subsidiary will be borne by IIB, and all the risk management techniques in project-financing (as discussed in chapter six).

3.

If the full realisation of cash flow will only take place in Year 10 of the project, the issuer may issue a new Sukuk Musharakah to redeem the existing Sukuk Musharakah after five years. Alternatively, the Sukuk Musharakah can be structured on the basis of quasi-equity (as discussed in chapter six).

4.

Since the assets are still under construction, the application of asset-backed securities may not be relevant. Normally, asset-backed securities will apply to an asset that is in the position to generate steady income stream for the investors. However, upon the completion of the project financed by Sukuk Musharakah, which is project-based Sukuk, the Islamic asset-backed securities may be issued to redeem this Sukuk and allow the new investors to benefit from this asset’s cash flows.

5.

Among the proposed suggestions are the following: a) The off-take agreement b) The Sukuk investors are also the equity owners of the project company c) To convert Sukuk Musharakah to Sukuk Ijarah, if it is relevant and applicable to have a fixed-income Sukuk instead of variable income based on the performance of the asset d) Quasi-equity of Sukuk Musharakah

Notes: 1 From a chronological point of view, the chairman of the Shari’ah Board of AAOIFI issued a personal comment on the practice of ‘purchase undertaking’ of Sukuk towards the end of 2007, which was the first of the negative signals appearing in relation to Sukuk issuance. However, Sukuk issuance remained high to the end of 2007. Sukuk were still issued based on purchase undertaking until the official pronouncement in February 2008. 2

See Moody’s Structured Finance Updates: Global Sukuk Issuance: “2008 Slowdown Mainly Due to Credit Crisis But Some Impact from Shari’ah Compliance Issues” – www.moodys.com

3

There is now an International Islamic Rating Agency based in Bahrain that cites Shari’ah risk. However, the agency is not issuing ratings for Shari’ah compliance. It currently only issues ratings for Shari’ah compliance procedures based on requests from Islamic financial institutions. To date, it has not issued ratings for any product. The global acceptance by investment communities and their regulators of any product rating, which may come out of this agency in future if it decides to embark on rating product such as Sukuk from a Shari’ah perspective, will only be tested as and when such an event takes place.

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Chapter ten Takaful models and issues of legal and rating requirements Learning outcomes By the end of this chapter you should be able to: • evaluate the various underlying contracts of Takaful • analyse the impact of various Takaful management models on its participants and the Takaful operator • analyse the impact of a Takaful fund deficit and underwriting surplus on the performance of Takaful funds • explain relevant legal and rating requirements • suggest appropriate Takaful policies and strategies for the sustainable growth of Takaful institutions and the Takaful industry.

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Indicative list of content • Comparative underlying contracts of Takaful • Takaful management models and its impact on participants and shareholders • The treatment of a Takaful fund deficit or surplus • Legal and rating requirement issues • Strategies to enhance the Takaful industry vis-à-vis the conventional insurance industry • Case study: Legal ownership of the Takaful fund and the distribution of an underwriting surplus

10.0 Introduction The protection and preservation of life and property, as well as religion, intellect and family, are among the fundamental goals of Shari’ah to ensure a peaceful and harmonious society. In the light of uncertainty, such as death or the loss or destruction of property, there is a need for the financial consequence of peril or hazard to be mitigated. Generally the approach to dealing with risk is either to transfer it or pool it among respective members or participants. Conventional insurance became popular because risk was eliminated through the transfer of its financial consequence to a third party that guaranteed indemnity. Various insurance schemes that cater to a wide spectrum of insurable risks have since been introduced to absorb the risk of the participant for a price known as a premium. The fact that modern insurance transfers risk from the insured to the insurer for a financial consideration known as a premium implies a wager on the uncertain event that has yet to occur or may not occur. This fundamentally breaches the nature of an approved contract in Islamic law where the subject matter shall be certain and not tantamount to a game of chance (Maisir) or a lack of knowledge that could be detrimental to one of the parties (Gharar). The concept of Takaful, or the mutual obligation to contribute as well as provide financial assistance to a member of the fund who may be financially affected by a future event, was adopted as a suitable alternative to conventional insurance. This chapter outlines the key differences between Takaful and conventional insurance, looking at its purpose, structure and perceived benefits. It introduces various Takaful models that distinguish the different roles played by Takaful operators, as well as their level of engagement in managing Takaful funds. It explains the treatment of deficits or underwriting surpluses that can occur in a Takaful fund and analyses the impact this may have on the performance of the fund. The chapter outlines relevant legal and rating issues to allow you to understand the regulatory framework for the Takaful industry. Finally, the chapter considers the ways and means by which further support can be given to promote the growth of this nascent industry. CIMA Advanced Diploma in Islamic Finance

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10.1 The need for Takaful operations As stated in the introduction, the importance of the protection and the preservation of life and property, as well as religion, intellect and family, are among the fundamental goals of Shari’ah to ensure a peaceful and harmonious society. Conventional insurance transfers the financial consequence of risk to a third party which guarantees indemnity for such risk. The fact that modern insurance transfers the risk from the insured to the insurer for a financial consideration, known as a premium, implies a wager on the uncertain event that has yet to occur or may not occur. This fundamentally breaches the nature of an approved contract in Islamic law. However, if the subject matter is uncertain by nature, such as risk in the insurance industry, an appropriate contract can be identified and selected to suit that subject matter while remaining compliant with Shari’ah principles.

Key point • The modern insurance structure amounts to the imposition of a ‘wager’ on an uncertain event. This raises the issue of Gharar, which is prohibited under Shari’ah law. The table below, adapted from Takaful Islamic Insurance: Concepts and Regulatory Issues, 1 shows a comparison between conventional insurance and Takaful.

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Table 10.1 Comparison between conventional insurance and Takaful Conventional insurance (proprietary)

Conventional insurance (mutual)

Takaful

Contractual relationship

A policy in the form of an exchange contract (sale and purchase) between the insured (policyholder) and the insurance company

A policy in the form of a risk-sharing contract between the individual insured and the pool of insured as represented by the cooperative insurance company

A combination of Tabarru’ contract (donation) and contractual relationship between (a) the individual participants and the pool of participants, and (b) participants and the Takaful operator (TO)

Responsibility of policyholders/ participants

Policyholders pay a premium to the insurer

Policyholders pay contributions to the pool in the form of premiums paid to the cooperative insurance company; any underwriting surplus belongs to the policyholders, who are also liable for any deficit; annual surpluses are normally retained in underwriting reserves out of which any annual deficits are normally met

Participants make donations (Tabarru’) to the scheme, as well as an element of savings in life Takaful where a plan includes such a component; any underwriting surplus belongs to the policyholders who may (based on various Shari’ah interpretations) share the surplus with the TO as an incentive or performance fee; although the participants under the concept of mutual indemnity may be required to contribute more contributions in the case of the deficit of the Takaful fund, the TO may undertake to provide an interest-free loan to pay outstanding claims

Liability of the insurer/ operator

Insurer is liable to pay claims according to the policy using the underwriting fund and, if necessary, shareholders’ funds

Pool is liable to pay claims according to the policy using the underwriting fund

The TO acts as the administrator of the scheme and pays the Takaful benefits from the Takaful (underwriting) fund; in the event of the impending insolvency of a Takaful underwriting fund, the TO may be expected to provide an interest-free loan to the Takaful fund to enable it to meet its obligations

Access to capital

Access to share capital and debt with possible use of subordinated debt

No access to share capital, but access to debt with possible use of subordinated debt

Access to share capital by the TO but not to debt, except for any interestfree loans from the operator to the underwriting fund

Investment of fund

There are no restrictions apart from those imposed for prudential reasons

There are no restrictions apart from those imposed for prudential reasons

Assets of the Takaful funds are invested in Shari ‘ah-compliant instruments

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10.1.1 Mutuality in Takaful Islam promotes the spirit of mutual goodwill and assistance among mankind, both in normal as well as adverse conditions. Since life is plagued with uncertainty, the importance of mutual cooperation towards the common good of mankind is always encouraged if not enjoined. Uncertainty poses economic and financial consequences and challenges. With the anticipation of potential challenges in the form of peril or hazard, the need for mutual financial assistance is recognised in Islam as one of the approved forms of risk distribution; hence the concept of Takaful or the mutual obligation to contribute as well as provide financial assistance as a result of the financial consequence of peril potentially affecting a member of the group who has contributed to that common fund. Takaful is a Shari’ah-compliant system of insurance based on the principle of mutual support. Takaful participants mutually contribute compensation to the aggrieved party contingent upon the occurrence of a defined peril. These are designated contingencies, risks or hazards against which participants seek to protect themselves when subscribing to a Takaful policy. The various types of peril for which Takaful provides indemnity include the financial wealth of the family, loss of income and medical costs due to illness or death, loss in value of property due to fire or theft, as well as other potential losses due to a recognisable and financially quantifiable event.

10.1.2 General (or non-life) Takaful General or non-life Takaful includes home Takaful, motor Takaful and personal accident Takaful. 10.1.2.1 Home Takaful Home Takaful comprises house owner and householder policies. • A house owner Takaful policy covers the policyholder’s home against loss or damage caused by floods, fires and other such perils. It not only protects the policyholder’s house, but also the garage, outbuildings, walls, gates and fences around the property as well as permanent fixtures and fittings. • A householder Takaful policy covers the loss or damage to the contents of the policyholder’s residential property. A policyholder may participate in a house owner Takaful or a householder Takaful, or both for complete coverage. 10.1.2.2 Motor Takaful Motor Takaful covers against loss or damage to the policyholder’s vehicle due to accidental fire, theft or accident. It also covers bodily injury or death of a third party as well as loss or damage of a third party’s property. There are two types of cover for a motor Takaful plan: • Third party cover protects against a third party’s death, bodily injury and/or property damage. • Comprehensive cover protects against a third party’s death, injury and/or property damage as well as loss and/or damage to the policyholder’s vehicle due to accidental fire, theft or an accident. 10.1.2.3 Personal accident Takaful Personal accident (PA) Takaful is an annual plan that provides policyholders or their beneficiaries with compensation in the event of death, disablement or injuries arising from an accident. A policyholder can either participate in a PA Takaful for him/herself or a group plan for his/her family. PA Takaful is also available for short durations, for example when travelling abroad, to cover the policyholder should any accident occur during the travel period. 10.1.2.4 Medical Takaful Medical and health Takaful gives the policyholder cover for the cost of private medical treatment, like hospitalisation, surgery and treatment, if the policyholder is diagnosed with certain illnesses or is involved in an accident. The cover acts as a stand-alone policy or can be added to a basic family Takaful plan, providing better coverage and benefits from both policies. Health Takaful is a rapidly growing sector as it is increasingly being made compulsory in Gulf Cooperation Council (GCC) countries.

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10.1.2.5 Family (or Life) Takaful Family Takaful provides the policyholder with a protection policy and long-term savings. The policyholder or beneficiary is provided with financial benefits in case of a tragedy. At the same time, the policyholder enjoys an investment return because part of his/her contribution is deposited in an account for the purpose of savings. The policyholder has a choice of maturity periods and there is no forfeiture in the event of cancellation. The policyholder is also entitled to personal tax relief when participating in family Takaful, where relevant and applicable. 10.1.2.6 Investment linked Takaful An investment-linked Takaful is a family Takaful plan that combines investment and Takaful cover. The policyholder’s contribution gives him/her Takaful cover, which includes death and disability benefits, and also an investment in a variety of Shari’ah-approved investment funds of his/her choice. Family Takaful penetration, at present, lags far behind general and health Takaful, as Muslims tend to have greater inhibitions when it comes to life insurance. However, with the development of innovative family Takaful products and the increasing education of Muslims as to why family Takaful is Shari’ah-compliant, it is reasonable to assume that family Takaful will grow substantially.

Exercise 10.1 Compare and contrast Takaful and Kafalah contracts in terms of parties to the contract, rights and obligations, payment and special requirements from a Shari’ah perspective (refer to CDIF/1/6/117 and CDIF/1/7/128 to refresh your understanding of a Kafalah contract).

10.1.3 Takaful regulation As there is no supra-national regulatory body, the regulation for the Takaful industry is quite fragmented, posing a risk due to a lack of consistency across the regions. This is part of the issue the Takaful industry is facing (see section 10.7.1). The Shari’ah compliance of a product is in most cases vetted by the Shari’ah board of the provider. Despite this, Takaful operators are starting to emerge in secular countries. The UK, for example, has one company operating as a fully-fledged Takaful provider: Principal Insurance, under the brand name Salam Halal. It offers general Takaful policies and has been in operation since 2008. It is possible for international institutions in EC jurisdictions to establish what is called an Islamic window of Takaful. The main distributors in the UK include HSBC, RBS, Standard Chartered and Lloyds TSB. In the UK for example, there are no regulatory restrictions to a conventional insurer operating a Takaful window, as long as the window, like the remainder of the business, operates in accordance with UK financial services laws contained in the Financial Services and Markets Act 2000 and secondary legislation. The window will also need to meet governance standards and rules in the FSA Handbook as well as operate in accordance with company law. Ensuring the Shari’ah compliance of the Takaful window is the remit of a Shari’ah board which will need to be put in place. The Shari’ah board will examine the products offered through the Takaful window as well as the other aspects of the Takaful operation (for example, ensuring that donations are segregated from conventional premiums and ensuring that, on the investment side, the donations are invested in Shari’ah compliant investments). In the GCC and Asia also, international institutions have established Takaful operations, tapping into the rich potential of the industry, among them Allianz, Aviva, Fortis, Zurich and Axa.

10.1.4 Social or business model? The motivation towards the protection of life and property in the form of the preservation of financial wealth in Islamic tradition has been made possible through contracts such as gift, donation, Sadaqah, Zakat and loan. These are essentially social contracts that have promoted mutual as well as social benefits since the early days of Islam. Equally, the establishments of cooperatives that promote the common interest and welfare of members has been the foundation of mutual aid and financial assistance throughout the history of Islam. Although this cooperative model has been effective in the past, the model is faced with challenges when applied to a much broader range and a larger scale of contingent events such as occur in the modern world.

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The validity and relevancy of the Tabarru’ contract in the form of a donation poses the question of whether, in its simplest form, it is an effective instrument in making the Takaful practice commercially and legally feasible in the contemporary world. The question arises as to whether the industry of Takaful can be based on a contract that is ‘social’ in nature and whether, in practical terms, the donation by the participants could be a real and outright act of giving away one’s money to help the other participants in the same group. AAOIFI Shari’ah Standard (No 26) defines Takaful as:

‘An agreement between persons who are exposed to risk to protect themselves against harms arising from those risks by making contributions on the basis of a commitment to donate. Thereafter, the insurance fund is established and treated as a separate legal entity which has an independent financial liability. The fund will cover compensation against harms that befall any of the participants due to the occurrence of the insured risks (perils) in accordance with the terms of the policy.’

Exercise 10.2 Briefly identify the key words or terms used in the AAOIFI definition of Takaful above and explain them from both the Shari’ah and modern finance perspectives. The approach by the AAOIFI in looking at the definition of Takaful has changed the social contract of donation to a more legalistic and structured concept in that there is a commitment by the prospective participant to donate. With this more structured and legalistic form of contract of donation, it has been argued that there is no harm for any member in the society to donate to the pool with the intention of benefiting from this pool if they were to be inflicted with a prescribed risk. This is commonly known in Islamic commercial law discourse as a ‘conditional gift or donation’. The Shari’ah and practical issues arising from this concept will be discussed in the next section.

Key point • Takaful in its modern form involves a commitment by participants to donate to a fund that is a separate legal entity in order for this fund to compensate the participants in the case of loss, thus achieving mutual indemnity.

10.2 The underlying principles of a Takaful contract Juristic discourses on the status of Tabarru’ in the context of donation in Takaful have expanded the application of the principle of Tabarru’. A number of juristic texts available in Islamic jurisprudence have indicated that a gift with a condition of consideration is compliant with Shari’ah principles. In other words, there is no harm in someone donating something with a view to benefiting from his donation in the future. The benefit that he expects to receive may depend on a few contingent events; therefore it becomes a conditional donation. Although a gift with an expectation of future consideration is lawful, classical scholars have different views in ascertaining the character of this action. While some scholars view it as a sale, others regard it as a gift. The following is a quote from a leading juristic text contained in a comparative juristic book of Islamic law: ‘As for the gift for a consideration, the scholars have different views. While both Imam Malik and Abu Hanifah have approved, Imam Shafi’i, Abu Dawud and Abu Thur have not approved such a transaction. The reason for the disagreement is whether it (a gift for a consideration) is a sale for non-specified price or is it not a sale with an uncertain price? Those who perceive it as a sale for an uncertain price argue that this is a sale with uncertainty (Gharar), which should be prohibited. Those who do not perceive it as a sale for an uncertain price hold this transaction as permissible. It appears that Imam Malik recognised the similarity between the societal customary practice at that point in time and the condition in the case of gift for a consideration, i.e. permissibility of gift for similar consideration.’

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The above citation, particularly from the point of view of the Maliki school of law, implies that a gift, even for a consideration, does not render the gift contract a sale contract. The substance of a gift contract remains and all the relevant principles of a gift are to be applied, in particular so that no consideration is required in a gift contract. Subsequently, should there be any form of consideration proposed in return by the recipient of the original gift, this consideration could be uncertain or could be of a different value to the original gift without rendering the contract void. Applying this basic argument to Takaful means that a participant may donate a total sum of US$100,000, but he may only receive compensation upon the occurrence of certain prescribed peril of an amount of US$1 million or some other amount. There is no need to ascertain how much he will benefit from the scheme, although he has already donated US$100,000 as this is essentially a gift contract.

10.2.1 The ‘commitment to donate’ concept – outright donation or contingent donation? There are at least four approaches to formulating the Takaful contract that provides mutual indemnity among the participants. As previously stated, AAOIFI recognises that Takaful is based on the undertaking or commitment by participants to donate to a Takaful fund. However, AAOIFI did not discuss the contractual implications of this act. One may argue that this donation is an outright donation that is now vested with the Takaful fund. Put simply, after the participants have paid their contribution or donation to the Takaful fund, the ownership of this donation is transferred from that moment to the Takaful fund, which is a separate legal entity. The participants or their beneficiaries have no claim on this donation subsequent to that donation action. However, the Takaful fund, which is a separate legal entity, may prescribe in the donation fund deeds or its terms and conditions that the fund may give away part or all of the donation fund to anyone who deserves the indemnity, including the participants who have donated to the fund initially, and this may also include the underwriting surplus. Others may argue that, although it is a donation, ownership of the donation is still vested with the participants/donors until and unless there is a claim. Thus, the transfer of ownership of this donation is contingent upon the claim. Put simply, if there is no claim or if the claim is less than the committed amount of donation, the ownership of the amount committed for the donation will still be vested with the participants. Consequently, any underwriting surplus will have to revert to the participants if their ‘donations’ are not used, as the claims are less than the committed amount of the donation. The first approach involves an outright donation contract, the second approach is a placement followed by a donation. However, both are essentially based on a conditional donation.

10.2.2 Conditional gift concept Another approach is based on the Maliki school of law that a gift can be conditional on the intention of getting the reward from the recipient. This is known as Hadiah al-thawab where one gives a donation in the hope that the recipient will reward him in the future as and when he needs it. This has been the norm in society when one gives gifts and financial assistance, either in cash or in kind, to a relative or friend during certain social occasions such as a marriage, death or calamity. Under this social scheme, which is not contractually binding, if the donor was to experience, for example, the marriage of his children or the death of his close relative, the original recipients will reciprocally provide gifts and assistance to reward what the donor has done earlier. The Maliki school of law argues that this practice is similar to a sale contract, except that the uncertainty of the object of sale is tolerable. The distinction between this concept and the conditional donation lies in the fact that the conditional gift concept perceives the whole scheme as a sale contract, but the requirement to have the consideration to be certain is waived. Applying this concept to a modern Takaful scheme means that each and every participant would, for example, provide donations to the Takaful fund, such as US$1,000 each, to help a participant whose house has caught fire. The recipient of this gift will also provide a gift for this fund to reward those who have contributed to the restoration of his house.

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Waqf - permanent endowment

10.2.3 Takaful based on a Waqf structure Another approach is where a separate Waqf fund is created using a Takaful operator’s shareholders’ fund. For example, the Takaful operator using its shareholders’ fund will create this Waqf fund at €5,000 (a nominal amount) to legally establish the Waqf fund for the benefit of the participants of the Takaful. The proponents of this approach have strongly argued against the conditional donation or conditional gift as elaborated above. The conditional donation or gift is viewed as unacceptable because of the conditionality element. The donation or gift, from a Shari’ah perspective, must be exclusive and outright without any conditionality. Following the Waqf fund approach, participants will donate their contribution to a fund placed under Waqf administration as a separate legal entity. Ultimately, the donation by the participants will be deemed as part of the Waqf fund or as Waqf assets. Also, the Waqf fund, as a separate legal entity, may decide how to use this fund either for the benefit of the participants or non-participants, thus there is no conditionality in the donation or gift contributed by the participants. If the Waqf fund decides to pay the claim from this fund, then it is a decision of this Waqf entity that has no relationship with the participants who had donated earlier. Applying this concept to the modern Takaful scheme means that the Takaful operator must create a Waqf fund by contributing a nominal amount of money. All the contributions by the participants on the basis of donation, for example a total of €1 billion, will be given to this Waqf fund, thus converting the whole fund into a Waqf fund that will have no legal relationship with the participants/ donors. In the case of a claim, the payments will be made from this Waqf fund, using all the proceeds from the donation contribution up to €1 billion. As part of Waqf principles, the initial Waqf contribution by the Takaful operator, that is €5,000, will not be used to pay the claims. Any deficit will be covered through an interest-free loan to be advanced by the Takaful operator.

Exercise 10.3 From your assessment of the Waqf fund model for the modern Takaful scheme, would the structure be sufficient to neutralise the arguments against conditionality of the donation or gift as practised in other Takaful contracts using a conditional donation or gift?

Key point • From a contractual point of view, the contract among the participants in a Takaful scheme can be based on conditional donation, be it outright or contingent, or conditional gift or donation ultimately placed under a Waqf fund.

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Islamic finance challenge 10.1 A pure risk transfer is neither recognised nor permissible in Islam because of features that are not Shari’ah-compliant. The application of the Tabarru’ principle is meant to address this anomaly. What are the risk implications of not transferring but pooling risk in the case of a Takaful scheme?

Solution Any form of financial exchange of pure risk is uncertain and considered Gharar, and hence prohibited. A risk transfer is based on a financial exchange contract between pure risk and insurance premium. Effectively the insurer is liable to compensate claims from the premium earned as revenue as well as from a shareholder’s fund. In the case of a Takaful contribution, the risk is pooled among participants through a donation and the Takaful operator as the managing agent earns a Wakalah fee for services rendered. In the event of an underwriting surplus, the insurance company will benefit exclusively from such a consequence and alternatively, in the case of a deficit, it will bear all the losses. A Takaful underwriting surplus, on the other hand, will be owned collectively by the participants. However, if a deficit arises, the participants may need to top up their contributions and the Takaful operator is under no obligation to provide an interest-free loan (Qard). However, it would be impractical for the Takaful operator to demand this extra contribution. More often than not, Takaful operators have to provide this interest-free loan to pay for any outstanding claims. This is the only anomaly in the risk distribution model in Takaful. This requires the Takaful company to explore a mechanism to determine the contribution by the policyholders and to adequately manage the risk fund in the interest of the policyholders, particularly in the case of total claims exceeding the risk fund.

10.3 Impact of Wakalah vis-à-vis Mudarabah models The features of both Mudarabah and Wakalah-based Takaful management were explained in detail in CDIF/2/8/152. The models used may have an impact on the surplus distribution to the participants as well as the return on equity to the shareholders of the Takaful company.

10.3.1 Mudarabah model of Takaful management The Mudarabah model, as the name suggests, is a profit-sharing model whereby Takaful participants provide the capital in terms of contributions and the Takaful operator provides management. The contract should specify how the profit generated is to be shared, as some practices may include the sharing of underwriting surplus between the participants and the operator. Generally, such sharing arrangements may allow the operator to share in the underwriting surpluses resulting from the operations, as well as any favourable investment performance on the invested contributions. From a practice point of view, Mudarabah works on the following basis: the Takaful operator (shareholders) incurs all the expenses of running the business and in return is entitled to a share of the underwriting excess and investment profit. As a business model, this is a difficult model to manage, as expenses are fixed or known, but income (including surplus and investment profit) is not and can be volatile. However, from a participant’s perspective, this is a good model as the participant does not contribute directly to the operator’s costs. All contributions are effectively available to meet claims. Only when there is an excess of contributions over claims will the operator be compensated for expenses incurred, and even then only to the extent of shares of the surplus as a kind of profit sharing with the Takaful participants. To date, there has been a convergence in the application of the Mudarabah model of Takaful management. The Mudarabah profit-sharing arrangements are now more limited to the sharing of investment profits generated by invested contributions as well as investment returns arising from the invested underwriting surpluses.

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10.3.2 Wakalah model of Takaful management The Wakalah model operates somewhat differently. Takaful participants pay contributions to the Takaful fund. Out of this gross contribution the Takaful operator will deduct a certain percentage as the Wakalah management fee. The Takaful operator will share neither in the risk of the Takaful fund investment nor in the profit of the fund’s investment return. It should be noted that the Takaful operator’s remuneration may, depending on the terms of the contract, include a performance or incentive fee, charged against any surplus, as an incentive to manage the Takaful fund effectively. From a practice point of view, the Wakalah model is easy to explain and manage. Generally the Takaful operator runs the Takaful operation and charges a fee. In other words, under this management model, the Takaful operator can only make a profit by ensuring that the expense of managing the operations is less than the fee, inclusive of an incentive fee where relevant. Under the Wakalah management model, the Takaful operator may also seek to share in the underwriting surplus under the purview of the incentive fee as described above. This will put them in a better position than a Mudarabah-based model as the Takaful operator under the Wakalah-based model may have a fixed fee paid upfront and a floating income based on the quantity of the underwriting surplus. The question of the sharing of the surplus will be discussed in the next section of this chapter.

The following is a hypothetical scenario of the three possible models of managing a Takaful business, namely the Mudarabah model (without sharing in the underwriting surplus), the Wakalah model (without sharing in the underwriting surplus) and the Wakalah model (with a share of the underwriting surplus). In the first model (model A), we will assume that the investments profit-sharing ratio between the participants and the Takaful operator is 50:50. In the Wakalah model (model B), the Wakalah fee is fixed upfront at 50% of the gross contribution, but the Takaful operator gets no share of the surplus. In the third scenario (model C), the Wakalah fee is fixed at 30% and the Takaful operator’s share in the underwriting and investment surplus is 50:50. Suppose the following are the financials for this hypothetical scenario. Gross contribution : Kuwait Dinar (KD)100 million Investment profit : KD10 million Underwriting surplus : KD20 million Management expenses : KD30 million Applying the above financials to the three scenarios, the following results emerge: Model A

Mudarabah income generated from a 50% share in investment profits

Takaful operator (KD5 million, which ultimately means the Takaful operator loses KD25 million); participants (KD25 million)

Model B

Wakalah fee generated from only 50% gross contribution

Takaful operator (KD50 million as gross income and KD20 million as net profit before tax); participants (KD30 million)

Model C

Wakalah fee generated from only 30% gross contribution and 50% share in underwriting surplus and investment profits

Takaful operator (KD45 million gross income and KD15 million as net profit before tax); participants (KD15 million)

Whether model A is better for the participant or the Takaful company than model B will depend on the actual underwriting surplus plus the investment profit. The ultimate results for both the Takaful operator and the participants will change if the financials change. Therefore, whichever model the Takaful company adopts, the calculation of fees or profit sharing is critical in order to appropriately reward the shareholders in terms of return on equity.

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Key point • Each of the Mudarabah and Wakalah models of Takaful management will influence the degree of profitability of the Takaful operator given the various management expenses, claims, investment returns and underwriting surplus.

10.3.3 Determining the Wakalah fee The following discussion examines the parameters for determining the Wakalah fee for the Takaful operator. The Wakalah fee is usually determined as the sum of: • management expense • distribution cost, including commission • profit to the operator. A key issue to consider is what determines a fair profit to the operator. The standard benchmark of profitability for an enterprise is return on equity (ROE). Given a certain ROE requirement, the greater the capital required to underwrite the business, the higher the profit required for a set volume of business. Thus, if the statutory solvency requirement for Takaful is high, the profit margin to the operator would need to be correspondingly high. The question of ROE is an issue for the Takaful industry, which is licensed and regulated in a similar way to that governing ‘deposit-taking institutions’. Takaful companies are regulated much like conventional insurance companies, and as such would be required to put up high amounts of shareholders’ capital, similar to that required from commercial banks. However, the difference here is that the Takaful companies do not own the Takaful fund; they are simply managers as these funds are owned by the participants. Takaful companies here operate much like investment banks or unit trusts and yet are required to proffer a much larger capital outlay. This would severely affect the ROE due to the Takaful companies as the capital outlay might not accurately represent the type of business they are conducting in the industry.

Exercise 10.4 A new Takaful operator is commencing business operations and has yet to decide whether it should undertake the pure Wakalah model or the hybrid Wakalah-Mudarabah model, which allows it to have a share in the surpluses generated. The pure Wakalah model will earn the operator a fixed 32% of the gross contribution, whereas the hybrid model will pay the operator a fixed 18% fee plus a 30% profit-sharing return based on the surpluses generated. Devise a formula for how the operator would behave given these facts and explain what is the minimum projected surplus required to entice the operator to choose the hybrid model if the gross contribution is US$120 million.

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Islamic finance challenge 1