1 Chapter 1 Introduction to Islamic Banking and Finance
Introduction to Islamic Banking and Finance: Principles and Practice M. Kabir Hassan, Rasem N. Kayed, and Umar A. Oseni Chapter 1 Introduction to Islamic Banking and Finance
2 Subject Aims: The key aim of this subject is to assist students in understanding the theory and practice of Islamic banking, based on the contemporary situations. At the end of the course, students will be able to: 1. Understand the theory of Islamic banking, 2. Understand the operation of Islamic banking, 3. Identify the products offered by Islamic banks, 4. Evaluate the performance of Islamic banks, and 5. Analyse current issues and problems faced by Islamic banks.
3 Introduction Islam is a way of life. A verse from the Quran states, “This day I have perfected your religion for you, completed My favour upon you, and have chosen Islam as your way of life” (Qur’an 5:3). The lexical meaning of the word Islam is ‘submission’ Actions in Islam can be categorized into two broad categories, namely ‘Ibadaat and Mu’amalaat. الْيَوْمَ أَكْمَلْتُ لَكُمْ دِينَكُمْ وَأَتْمَمْتُ عَلَيْكُمْ نِعْمَتِي وَرَضِيتُ لَكُمُ الإِسْلاَمَ دِينًا.
4 Introduction (cont) ‘Ibadaat – Acts of Worship
Ibadaat are based on the individual’s direct relationship with God. This entails that specific acts of worship must be directed solely for Allah (God) alone with sincerity. This includes one’s Prayers, Fasting, Pilgrimage etc. Mu’amalaat – Interactions with People This refers to the conduct one has with fellow human beings. This can refer to law, work, marriage, inheritance, business transactions, partnerships, buying, selling etc. Islamic finance and banking falls under this category. One must ensure their conduct is in conformity with Shari’ah principles. Objective of human life is to please GOD – Almighty Allah via Ibadaat and Mu`amalaat.
5 Introduction (cont) Shari’ah –Islamic Law
Shari’ah is the set of rules which includes and clarifies obligations, prohibitions, recommended duties, detested (yet not blameworthy) actions, what is lawful and unlawful etc. Therefore it includes ethics, manners, laws, public life, social life, economic life, politics etc. Sources of the Shari’ah The two Primary sources of the Shari’ah are the Qur’an and the Sunnah. Other sources include Ijma’ (consensus) and Ijtihad (juristic decision)
6 Basis of Islamic Banking and Finance
Figure 1.1: Shari’ah as the Basis of Islamic Banking and Finance
7 The Qur’an The Qur’an is believed by Muslims to be the word of God revealed to the Prophet Muhammad – peace be upon him (PBUH). It is the final revealed scripture and remains intact in the Arabic language. The Prophet Muhammad was instructed with the Message of Islam when he was at the age of forty in the year 610 CE. From then onwards, his Prophethood lasted twenty-three years until the Message was complete and the Prophet passed away. The Qur’an was therefore revealed over a period of twenty-three years in stages and intervals. The Qur’an can be studied closer by looking into the Sunnah, the teachings of the Companions (who learned directly from the Prophet and were preserved when verses were revealed concerning specific circumstances), studies from scholars and experts in the Arabic language.
8 Basis of Islamic Banking and Finance
Learning Objective 1.1 Describe the conceptual basis of the modern practice of Islamic banking and finance. Basis of Islamic Banking and Finance The Qur’an The first source of the Shari’ah General and specific rules on religious, commercial, political, economic, legal and social norms Emphasis on mutual consent and consensus among consenting parties Prohibits exploitative measures: Excessive risk or uncertaintly (gharar) Usary or interest (riba) Prohibits cheating and corrupt practices in the management of funds Does not allow dealings in prohibited products
9 The Sunnah The Sunnah refers to the authentic statements, actions and approvals of the Prophet Muhammad. Sunnah literally means way and therefore refers to the way of the Prophet. Another word sometimes interchangeably used with Sunnah is Hadith (speech, statement or saying). Therefore, books of Hadith are referred to as the Sunnah as they are collections of the statements, actions and approvals of the Prophet Muhammad - PBUH. The Sunnah is collected in many volumes of Hadith books. Hadith can be used to help explain and elaborate on the Qur’an. Likewise, the Sunnah contains rulings and guidance on all kinds of issues and circumstances. There are over forty verses in the Qur’an which command adherence to the way of the Prophet (his Sunnah).
10 Other sources for Shari’ah are Ijma’ (consensus) and Ijtihad (juristic decision).
Ijma’ (Consensus) – This refers to teachings in Islam that have been agreed upon by the early generations of Muslims or Muslim scholars. These are matters that are established and leave no room for disagreement in the Shari’ah. Ijtihad (Juristic decision) – Ijtihad is applied by the Mujtahid (Muslim Jurist/Scholar) who does not find the answer clear cut from the Qur’an or Sunnah. Therefore, they explore into the Primary sources to find the answer based on their skills of judgment -maintaining the aims of the Shari’ah- and trying their best to interpret the intent of the Law Maker. Sometimes the word Qiyas (analogy) is used to refer to ijtihad. Qiyas is used to figure out rulings based on similar existing rulings by way of analogy.
11 Origins and Historical Overview of Islamic Banking and Finance
Learning Objective 1.2 Explain the historical development and conceptual arguments of Islamic banking and finance Origins and Historical Overview of Islamic Banking and Finance Islamic finance is both a new and old phenomenon. The history of Islamic finance is divided into two general aspects: The early days transactions (The guiding principles of Islamic Finance originate from the early days of Islam). The modern-day experiments (Experiments in Islamic finance in Egypt, Malaysia, and Pakistan: the basis of modern Islamic banking and finance) .
12 Origins and Historical Overview of Islamic Banking and Finance
Learning Objective 1.2 Explain the historical development and conceptual arguments of Islamic banking and finance Origins and Historical Overview of Islamic Banking and Finance The early days transactions The Era of the Prophet The Period of Orthodox Caliphate (632 – 661 C.E.) Period of the Noble Companions and the Succeeding Generations The Umayyad and Abbasid Eras
13 Origins and Historical Overview of Islamic Banking and Finance
Learning Objective 1.2 Explain the historical development and conceptual arguments of Islamic banking and finance Origins and Historical Overview of Islamic Banking and Finance The Era of the Prophet The prevailing modes of transactions during this era include: Shirkah (partnership) based on profit-and-loss sharing (PLS) Al qard Al hasan (benevolent loan) Salam (Forward) contract Sarf (exchange of money), i.e. gold for gold and silver for silver at the same sitting Ijarah (leasing) Trans-regional trade involved trade caravans from Mecca to Syria and vice versa
14 Origins and Historical Overview of Islamic Banking and Finance
Learning Objective 1.2 Explain the historical development and conceptual arguments of Islamic banking and finance Origins and Historical Overview of Islamic Banking and Finance Timeline of Modern-day Experiments of Islamic Banking and Finance from 1962 to 1975 Initial Reforms in the Banking Industry in Pakistan in 1962 Mit Ghamr Local Savings Bank in Egypt of 1963 (“the first modern-day trial of Islamic baking”) The Malaysian Pilgrims Savings Board, Tabung Haji of (managing savings of prospective pilgrims by investing in Sharī’ah- compliant investments) The new birth of modern Islamic finance took place in Dubai in 1975 through Dubai Islamic Bank as the first Islamic commercial bank in the world. At the same time, IDB established and started Islamic Finance.
15 Origins and Historical Overview of Islamic Banking and Finance
Learning Objective 1.2 Explain the historical development and conceptual arguments of Islamic banking and finance Origins and Historical Overview of Islamic Banking and Finance The functions of the IDB are: To participate in equity capital and to grant loans To provide financial assistance to member countries To establish and operate special funds for specific purposes To accept deposits and to mobilize financial resources through Sharī’ah compatible modes To promote foreign trade, especially in capital goods, among member countries
16 Origins and Historical Overview of Islamic Banking and Finance
Learning Objective 1.2 Explain the historical development and conceptual arguments of Islamic banking and finance Origins and Historical Overview of Islamic Banking and Finance Dubai Islamic Bank (DIB) The first fully-fledged Islamic world commercial bank in Operates five main business groups: Retail banking Corporate banking Real estate Investment banking Proprietary trading investments
17 What is Islamic Banking?
Definition: “an Islamic bank is a financial institution whose statutes, rules and procedures expressly state its commitment to the principle of Shariah and to the banning of the receipt and payment of interest on any of its operation…” (OIC) Moreover, the Malaysian Islamic Banking Act 1983, defines an Islamic bank as “… a company which carries on Islamic business. Islamic business means banking business whose aims and operations do not involve any element which is not approved by the religion of Islam…” Thus, Islamic banking is banking that complies with Shari’ah or Islamic law.
18 The Banking Business Bank is an authorized deposit-taking institution (ADI) Facilitates intermediation between savers and investors. Transfer funds from surplus units to deficit units. It manages payments and clearing systems (EFTPOS, Cards, BPAY, Cheques,…) Islamic and conventional banking (1 to 4 above + …) The prohibition of riba (interest, usury), gharar (excessive uncertainty) and haram (impermissible) activities. The implementation of profit and loss sharing (PLS) principle. The emphasis on productivity and real economic activity (rather than credit worthiness).
19 The Banking Business: Flow of money
20 The Banking Business: Flow of profits
21 Key 6 principles of Islamic banking
Prohibition of predetermined loan repayments as interest (riba) Profit and loss sharing, which is at the heart of the Islamic finance system Making money out of money as being unacceptable, with all financial transactions needing to be asset-backed Prohibition of speculative behavior Only Shariah approved contracts being acceptable The sanctity of contracts In the News: The Vatican says Islamic Finance May Help Western Banks in Crisis “The ethical principles on which Islamic finance is based may bring banks closer to their clients and to the true spirit which should mark every financial service,” (the Vatican’s official newspaper Osservatore Romano)* *A Lorenzo Totaro 2009 'Vatican Says Islamic Finance May Help Western Banks in Crisis, Bloomberg.com, viewed on 17 February
22 Islamic Banking and Finance around the world
And many more.
23 Islamic Banking and Finance in Australia
"The LM Australian Alif Fund has been awarded 'Best New Product 2009' at the world's leading Islamic Banking and Finance awards in Dubai for its innovative approach to Shariah-compliant investment, beating a shortlist of prominent international Islamic institutions'‘
24 What is Islamic Banking?
Definition: “an Islamic bank is a financial institution whose statutes, rules and procedures expressly state its commitment to the principle of Shariah and to the banning of the receipt and payment of interest on any of its operation…” (OIC) Moreover, the Malaysian Islamic Banking Act 1983, defines an Islamic bank as “… a company which carries on Islamic business. Islamic business means banking business whose aims and operations do not involve any element which is not approved by the religion of Islam…” Thus, Islamic banking is banking that complies with Shari’ah or Islamic law.
25 The Banking Business Bank is an authorized deposit-taking institution (ADI) Facilitates intermediation between savers and investors. Transfer funds from surplus units to deficit units. It manages payments and clearing systems (EFTPOS, Cards, BPAY, Cheques,…) Islamic and conventional banking (1 to 4 above + …) The prohibition of riba (interest, usury), gharar (excessive uncertainty) and haram (impermissible) activities. The implementation of profit and loss sharing (PLS) principle. The emphasis on productivity and real economic activity (rather than credit worthiness).
26 The Banking Business: Flow of money
Fund providers Funds users Mobilization of funds Bank (Financial Intermediary) Allocation of funds Surplus Units (savers) Deficit Units (borrowers) Deposits mechanism: Mobilizes funds from savers according to return and liquidity (withdrawal) requirements. Efficiency in mobilization of funds is improved with increase in the range of financial assets and instruments. Allocation of funds is facilitated through various financing products based on personal loans, joint venture, morgages but in IF like Mudaraba, Musharaka and so on. Real Economic activity (assets, projects, service…)
27 The Banking Business: Flow of profits
Fund providers Funds users Bank (Financial Intermediary) Surplus Units (savers) Distribution of profits Allocation of profits Deficit Units (borrowers) Unique risk/return needs and expectations by savers and investors are matched through the creation of a range of financial products and services. Use of the funds is of primary concern in IBF. Making money out of money (by lending it on interest) is prohibited in Islam. Profits are a result of economic activity that links money with real assets, projects, services and so on. Real Economic activity (assets, projects, service…)
28 Why so much interest in “No Interest” banking?
29 Key 6 principles of Islamic banking
Prohibition of predetermined loan repayments as interest (riba) Profit and loss sharing, which is at the heart of the Islamic finance system Making money out of money as being unacceptable, with all financial transactions needing to be asset-backed Prohibition of speculative behavior Only Shariah approved contracts being acceptable The sanctity of contracts In the News: The Vatican says Islamic Finance May Help Western Banks in Crisis “The ethical principles on which Islamic finance is based may bring banks closer to their clients and to the true spirit which should mark every financial service,” (the Vatican’s official newspaper Osservatore Romano)* *A Lorenzo Totaro 2009 'Vatican Says Islamic Finance May Help Western Banks in Crisis, Bloomberg.com, viewed on 17 February
30 Islamic Banking and Finance around the world
And many more.
31 Islamic Banking and Finance in Australia
"The LM Australian Alif Fund has been awarded 'Best New Product 2009' at the world's leading Islamic Banking and Finance awards in Dubai for its innovative approach to Shariah-compliant investment, beating a shortlist of prominent international Islamic institutions'‘
32 Video: Why Islamic Finance?
Play Any other questions?
33 ISLAMIC BANKING - FIN5BNK
Topic 2: Ethics & Prohibitions in Mu’amalat Ethics in Islamic Finance and Banking - Main prohibitions in Mu’amalat: Riba - Gharar - Impermissible (Haram) activities Sanctity of Contracts FACULTY OF LAW AND MANAGEMENT SCHOOL OF ECONOMICS AND FINANCE
34 Ethics in Islamic Finance and Banking
"Assist one another in righteousness and piety. And do not assist one another in sin and transgression…" (Qur’an 5:2) One objective of Islamic finance and banking is to assist in the spread of economic prosperity. The other objective is to do this in accordance with Shari’ah principles. Among the norms concerning Islamic finance are a free market, where prices are determined by demand and supply, freedom from manipulation, prevention of hoarding, profit and loss sharing in partnerships, information efficiency etc.
35 Among the norms in Islamic finance that we want to elaborate on here are the following three topics:
1. The Prohibition of Riba (Interest or Usury) – Money is not to be exchanged for money with profit. As a result of this prohibition, alternative solutions are given which encourage trade and equity participation. 2. The Prohibition of Gharar (Uncertainty) – This demands transparency in contracts as well as in buying and selling. Prices should be specified, there should be clarity of the delivery details, quality of goods, quantity of goods etc. The information should be available to all parties involved and the outcomes of a contract should be free from ambiguity etc. 3. Sanctity of Contract – Contracts should be fair and agreed upon by both parties. Therefore, the contract should be free from the elements of Gharar and reach Shari’ah approval in their content.
36 1. The Prohibition of Riba (Interest or Usury)
Definition of Riba: الربا Riba in the Arabic language literally means increase. However, according to the specific Shari’ah definition, it means unlawful increase الزيادة المحرمة. Under today’s literature and terminologies, riba commonly refers to interest and usury. The Islamic Fiqh Academy which was initiated through the OIC (Organization of the Islamic Conference), was established to bring scholars from around the world in order to address current issues and concerns. During the 2000 meeting, the OIC reaffirmed the consensus of the historical prohibition of interest. Riba is one of the core concerns in Islamic finance. In order to avoid riba, many financial alternatives have been adopted over the centuries. Although scholars describe rationales as to why riba may be prohibited, the sole reason for sincere Muslims to refrain from riba is to conform to what the Law Maker has legislated.
37 Interest in Judaism and Christianity
The prohibition of interest is not something exclusive to Islam. Jews and Christians were likewise given instructions in their scriptures which forbade them to deal with interest or usury. Although other faiths may have had aversion to interest or usury, only Judaism and Christianity are singled out here due to the common historical link between the three faiths. Below are some passages from the present day Bible. Old Testament If you lend money to one of my people among you who is needy, do not be like a money lender; charge him no interest (Exodus 22:25). Do not take interest of any kind from him, but fear your God, so that your countryman may continue to live among you (Leviticus 25:36). Do not charge your brother interest, whether on money or food or anything else that may earn interest (Deuteronomy 23:19). Hath given forth upon interest, and hath taken increase: shall he then live? He shall not live: he hath done all these abominations; he shall surely die; his blood shall be upon him (Ezekiel 18:13).
38 New Testament But love ye your enemies, and do well, and lend, hoping for nothing again; and your reward shall be great, and ye shall be the children of the Highest: for he is kind unto the unthankful and to the evil (Luke, 6:35). In Judaism and Christianity, lending money in order to receive a profit was strongly condemned. In the Talmud, Ezekiel condemned interest as an abomination. He also likened usurers to people who shed blood. In Judaism, the distinction was made between Jews and gentiles. They tolerated charging interest to gentiles, yet, were forbidden to practice it with their own fellow brethren (Deuteronomy 23:20). Pope Alexander III (12th Century) excommunicated usurers, which in that period was seen as an extremely harsh punishment. In 1317 the Council of Vienna took a strong stance and issued a law that usurers were to be excommunicated. However, by the fifteenth century in Europe, usury practices gradually gained ground and acceptance.
39 Riba الربا (Interest or Usury)
Riba is strongly prohibited in Islam. The many verses of the Qur’an leave no question in this regard: “Allah has permitted trade and forbidden riba.” (Qur’an: Surah Al-Baqarah 2:275). The verses prohibiting riba are located in four Surahs of the Qur’an; Surah Al-Baqarah 2: , ; Surah Aal Imran 3:130; Surah An-Nisaa 4:161 and; Surah Ar-Room 30:39. Riba is further elaborated on in the Prophet’s Sunnah. Numerous hadiths explain the details surrounding riba. In a hadith narrated by the Prophet’s companion Jaabir: “Allah’s Messenger cursed the one who accepts riba, the one who gives it, the one who records it and the two witnesses to it, saying, ‘They are all the same.’” (Collected By Muslim).
40 Types of Riba: There are two major categories of riba.
The first category is known as Riba An-Nasee’ah which relates to riba in debt. It increases with time (e.g. interest on borrowed money). This is the most common type of riba today and it relates to return of money on money at any rate (fixed or floating, compounded or simple interest). The other category is Riba Al-Fadl which refers to riba in exchange. This type of riba refers to the six commodities (e.g. Gold) mentioned in the hadith. It increases with the transaction.
41 Riba An-Nasee’ah - Riba in Debt
This form of riba was well known in jahiliyah (pre-Islamic era of ignorance). When the date of maturity neared for one’s debt, it would be said to him, “pay up, or pay riba (increase)”. Due to deferment in repaying the debt, the debt would increase. It would continue to accumulate as compounded interest until it doubles and so on. Another practice from the jahiliyah period included the loaning of money with a fixed increase in the return. For example, one would borrow, 10 gold coins (Dinars) with the condition of returning 12 gold coins at a future date. From the above description, we see how riba an-nasee’ah is equivalent to interest. For example, it includes the use of credit cards and “interest free” periods, as the date of maturity passes, interest is incurred. Likewise it is typical of bonds, or loans from conventional banks today which lend money with the condition to be paid back with an increase of a certain percentage in the future, at a variable or fixed interest rate.
42 Riba Al-Fadl - Riba in Exchange
Although gold and silver were the real currency at the time, the Prophet described certain commodities that relate to riba. These commodities are prohibited to exchange, same for same, unless they are of equal amount, without increase. One hadith states, “Gold with gold, silver with silver, wheat with wheat, barley with barley, dates with dates, and salt with salt; same quantity for same quantity, equal for equal; transaction being made hand to hand (i.e. on the spot payment)” (Muslim). Some scholars have stated that these commodities are only limited to the six mentioned. Other scholars, by making Qiyas (analogy), have stated that it can also include other commodities that can be weighed, or other food, or specific food which can be stored similar in nature to the six.
43 Riba Al-Fadl - Riba in Exchange (cont)
However, gold and silver are the universal tenders like cash money today. The remaining four commodities may have been used in a similar fashion to currency. Another hadith mentions, “Do not sell gold for gold unless it is the same amount for the same amount, and do not make one amount greater than the other. Do not sell silver for silver unless it is the same amount and do not make one greater than the other.” (Bukhari and Muslim).
44 Riba Al-Fadl - Riba in Exchange (cont)
The following narration sheds light on this form of riba with the exchange of these types of commodities. A hadith mentions, “Once Bilal brought Barni (a kind of dates) to the Prophet and the Prophet asked him, ‘From where have you brought these?’ Bilal replied, ‘I had some inferior type of dates and exchanged two Sa’s (approximately 6 kilograms) of it for one Sa’ (approximately 3 kilograms) of Barni dates in order to give it to the Prophet to eat.’ Thereupon the Prophet said, Beware! Beware! This is definitely Riba! Don’t do so, but if you want to buy (a superior kind of dates), sell the inferior dates for money and then buy the superior kind of dates with the money” (Bukhari). This hadith shows the prohibition of exchanging the same commodity of a different measurement, yet it also displays the alternative solution. That is to sell the dates, and buy the other dates with the money.
45 Riba rules - summary The commentator of Sahih Muslim, Imam Nawavi has summarized these rules in the following way: When the underlying ‘Illah of the two goods being exchanged is different, shortfall/excess and delay both are permissible, e.g. the exchange of gold for wheat or dollars for a car. • When the commodities of exchange are similar, excess and delay both are prohibited, e.g. gold for gold or wheat for wheat, dollars for dollars, etc. • When the commodities of exchange are heterogeneous but the ‘Illah is the same, as in the case of exchanging gold for silver or US Dollars for Japanese Yen (medium of exchange) or wheat for rice (the ‘Illah being edibility), then xcess/deficiency is allowed, but delay in exchange is not allowed. (Ayub 2007, p.52)
46 Wisdom behind the prohibition of riba as put forward by some scholars.
It goes against mutual cooperation, generosity, and spirit of partnership. Acquisition of property by wrongful means and harm to the needy. Removal of the possibility for injustice and exploitation. Drives the capital-owner away from enterprise and real economic activities that contribute to the welfare of society (e.g. commerce, manufacturing, construction and so on) Money is meant to be a medium of exchange and standard of value for other goods. Riba violates the entire rationale behind money and diverts money from doing what it is meant to do.
47 2. The Prohibition of Gharar (Uncertainty)
Gharar has a broad scope and is not limited to one simple definition. For our purposes here, it relates to excessive uncertainty or ignorance by way of a contract, or the goods involved in a sale, the price, ownership, possession of goods, deliverability, dates of exchange etc. A hadith collected by Muslim narrated by Abu Hurairah states, “The Prophet forbade selling by way of tossing stones to settle a sale (Al-Haasah), and the sale of Gharar.”
48 Minor and major Gharar Minor Gharar
Gharar has been categorized into two categories, namely major and minor. It is expected that minor (or trivial) accounts of gharar will exist and for that reason it is tolerated and not given concern. Such is the case of catching a taxi, there is an element of uncertainty in the price as it rises with the mileage, yet this is a minor form of uncertainty and is permissible. Another example is buying fruit without peeling the skin to see inside. Major Gharar Causes for alarm are the major or substantial forms of gharar which are clearly condemned from a Shari’ah perspective. Major Gharar will be simply referred to as gharar in the rest of the lecture notes.
49 Gharar can generally refer to the following:
Lack of Transparency -The Shari’ah stipulates that transparency must exist in order for contracts to be legitimate. For example, the terms of the contract must be clear to both parties involved in order to be just and fair. Under such measures, individuals are protected from fraud, deceit and exploitation. Deception - Gharar can also imply deceit. Once Prophet Mohammad came upon a heap of grain in the market of Madinah and thrust his hand onto it. His fingers felt dampness. On being asked, the trader replied that rain had fallen upon it. The Prophet observed, "Why did you not then keep (the wet portion of) it above the dry grain, so that people may see it? He who deceives, has nothing to do with me” (Muslim). Therefore, relevant information cannot be withheld.
50 Selling what you do not have
Part of Gharar is selling what is not in one’s possession. The common example of this is the selling of the fish in the ocean which has not been caught yet, or selling vegetables that the seller is yet to purchase (i.e. they are not in possession or ownership). This can lead to settlement risk and is therefore a form of gharar. One should therefore catch the fish and then sell it, or buy the vegetables from a wholesaler, and then sell them to avoid the risk of uncertainty. An exception to this rule is a salam contract (Bai’ As-Salam) which relates to farm produce which has not been harvested yet. Such a contract is paid up-front and an agreed upon amount of goods (e.g. one ton) must be delivered at a later date when the produce is harvested.
51 Ignorance - The buyer should have relevant information about the goods they intend to buy or the contract they intend to sign. This is why it is important to inspect the goods one is about to buy. With regards to what the buyer is buying, the buyer should know (for example) the quantity, the attributes, species etc. Or in the case of a contract, both parties should have a sufficient understanding of the details and outcome of the contract in order to remove any doubt. Unspecified Price - The price of the sale should be stipulated. This is important if the goods are purchased on credit, in order to avoid disagreement at a later date. Unspecified dates - As for the delivery of goods, the price can be delayed or the goods can be delayed in delivery, yet this should be by mutual consent of the buyer and seller.
52 Akin to gambling Maisir (game of chance) is regarded as gambling because the outcome is unknown and clearly involves gharar. The practice of Maisir is declared forbidden in Qur’an (2: 219). Therefore, according to the Shari’ah, such games of chance are to be avoided. An example of this is speculation in short selling, conventional methods of forwards, futures, options and other derivative transactions where future delivery of underlying assets is uncertain (and usually settled in cash) as being forms of maisir. Although excessive gharar is condemned by the Shari’ah, this does not rule out levels of risk by way of entrepreneurial risk and risk associated with calamities (such as natural disasters). Systematic risk and unsystematic risk will be covered in more detail in the following weeks. Complexity in Contracts Undue complexity in contracts or interdependent contracts where two sales are combined in one are not permitted. (e.g. I will sell you A as such a price, if you sell me B at such a price.)
53 3. Sanctity of Contract Sanctity of Contract
As excessive gharar is impermissible in Islam, the Shari’ah emphasizes that contracts must include transparency and honesty. Prices should be specified, there should be clarity of the delivery details, quality of goods, quantity of goods etc. The information should be available to all parties involved and the outcomes of a contract should be free of ambiguity. When full disclosure is present, both parties eliminate or reduce financial speculation and undue complexity in contracts (due to gharar). This will include discloser of the risk involved by providing as much information as possible for buyers or investors.
54 3. Sanctity of Contract (cont)
If two or more parties come together for a partnership (e.g. musharakah), all parties should be aware of their profit-sharing ratio, underlying assets involved, and other conditions of the contract. The parties involved must mutually agree on the sale or contract, albeit orally or preferably in written form, without coercion. Contracts must be in accordance with Shari’ah principles. Therefore, investments considered unethical, unlawful (haram), unjust etc, would not be considered. Although riba and gharar may not be involved, one must make sure that other unlawful practices are not present. For example, it is prohibited to finance a casino or deal with alcohol etc.
55 Case study: Riba & Gharar today
Identify role of Riba & Gharar in: Global Financial Crisis (GFC) European debt crisis (EDC) Other examples?
57 ISLAMIC BANKING - FIN5BNK
Topic 3: Equity Based Financing (PLS mode) Equity Based Financing: Musharaka (Sharing, Equity/Business partnership, Joint Venture) Mudaraba (Trustee/Limited/Investment Partnership) FACULTY OF LAW AND MANAGEMENT SCHOOL OF ECONOMICS AND FINANCE
58 Introduction The bank generally acts as a financial intermediary between lenders and borrowers. By connecting savers to borrowers via various financial products, banks mobilise funds that impact on economic activities. However, Islamic financial Institutions are less straightforward because the Shariah prohibits certain transactions. Islam prohibits making money by money and thus all transactions must not involve any interest (riba). The Qur'anic verse "Allah has permitted trade and has forbidden interest (usury)" [2:275] is the main reason why Islamic banking derives its profit from real economic activities by means of trading or investment. Given that the Shari’ah equally prohibits charging and paying interest, opportunities for the Australian financial sector lie in establishing Shari’ah compliant financing instruments.
59 Equity based financing
Under Islamic Banking there are two main fields of financing. One is Equity Based Financing and the second is Debt Based Financing. These modes of financing primarily differ from conventional financing due to their voidance of interest. Equity Based Financing - profit-and-loss sharing (PLS) Musharaka (Sharing, Equity/Business partnership, Joint Venture) Mudaraba (Trustee/Limited/Investment Partnership)
60 Musharaka (Sharing, Equity/Business partnership, Joint Venture)
Two or more parties come together and contribute funds in a partnership. Partners share in the profit or loss of a joint venture. The profit-ratio is determined according to the agreement of the partners and not necessarily according to their capital contribution. This could depend on how much each partner contributes to the partnership beyond their capital share. However, the losses must be determined according to the percentage of one’s share in the investment. Scholars agree (Ijma’) on the equal division of loss in accordance with the ratio of each investor. The profit returned to each partner should reflect the actual profits made by the enterprise as opposed to a set income. Partners may contribute cash or assets towards the partnership. Their contribution ratio should be determined according to the value of the assets.
61 Musharaka (Equity partnership, Joint Venture)
$2.5mil Profit Investor A 25% $10mil (25%) Business Venture Profit 10mil Investor B $30mil (75%) 75% $7.5mil Profit
62 Musharaka - example Investor Contribution Outcome 1 Profit 200 2 Loss 100 A 100 (10%) 20 (10%) -10 (10%) B 300 (30%) 60 (30%) - 30 (30%) C 600 (60%) 120 (60%) - 60 (60%) Profit arrangement ratio is pre-agreed at the start (10/30/60 or it could be eg. 15/30/55) based on investors involvement in the business management and other relevant factors (eg. experience, skills and so on). However, loss must be shared in proportion to contributed capital (in this case 10/30/60) and can not be changed.
63 Home purchase Diminishing Musharaka – This method can be used in purchasing property or assets such as machinery for a factory. For example, under a diminishing Musharakah contract, the bank (or financier) and the client become partners. The client must provide a significant amount of funds e.g. 20% to purchase the house with the bank. The bank in this case owns the other 80% which the client will pay over time in installments. Since the client will be living in the house, they will pay (on top of the installments) a certain percentage (e.g. 8%) in rent (ijarah) to the bank for the share the bank owns. Over time, the client will own more equity in the house until it is completely bought, while the rent will decrease as the bank’s share diminishes.
64 Diminishing Musharaka (Musharaka Mutanaqisa)
Home Purchase Ownership % Bank Customer 80%↓ 20%↑ 70%↓ 30%↑ 60%↓ 40%↑ 50%↓ 50%↑ 40%↓ 60%↑ 30%↓ 70%↑ 20%↓ 80%↑ 10%↓ 90%↑ 0%↓ 100%↑ Bank Customer Transfer of ownership Payment for piece of property (eg. 10%) Rent % Rent % Price 80% Price 20% Bank’s participation diminishes over time until customer becomes sole owner of the property.
65 Mudaraba (Trustee or Investment Partnership)
Such a contract requires one partner with the funds, known as Rabb-ul-Mal (Owner of Wealth), and one partner is the Mudarib (Entrepreneur, Fund Manager). There can be more than one Mudarib to work together as partners with the Rabb-ul-Mal. If the business or project is a success, the profit is shared according to a pre-agreed ratio. Typically, the Rabb-ul-Mal bears the risk of losing money, while the Mudarib loses time and effort if the project does not bear fruit. The Rabb-ul-Mal may specify where they want the Mudarib to invest their money (Al-Mudaraba Al-Muqayyada – specific or restricted Mudaraba, eg. Specific type of business of place). Otherwise, the Mudarib is free to invest where they best see fit (Al-Mudaraba Al-Mutlaqa – unrestricted or general investment (Mudaraba), unrestricted by time, place, activity and so on).
66 Mudaraba (Investment Partnership)
Example title for notes and handouts Mudaraba (Investment Partnership) 10/10/2017 Share of profits Investor capital Business Venture Profit Mudarib (entrepreneur) management Share of profits Profit can not be a fixed amount (for PLS financing) but must be determined by a pre-agreed ratio. In case of loss, the investor loses capital and the mudarib loses time and effort. In the case of proven negligence by the mudarib, the mudarib may be liable for capital as well. Example footer for notes and handouts
67 ISLAMIC BANKING - FIN5BNK
Topic 4: Debt-Based Financing (non-PLS Modes) Murabaha (Cost Plus Sale) - Bai’ bithaman ajil (BBA, deferred payment) - Ijarah (Leasing) - Bai’ As-Salam (Deferred Delivery Sale) - Bai’ Al-Istisna’ (Manufacturing Sale) - Bai’ Al-Istijrar (Suply Sale) - Qard Hasan Contentious Instruments: Bai’ Al-Einah (Back to back repurchase) - At-Tawarruq (Tripartate Sale) - Bai’ Al-Dayn (Sale of Debt, Bill discounting) FACULTY OF LAW AND MANAGEMENT SCHOOL OF ECONOMICS AND FINANCE
68 Debt-Based Financing or non-PLS Modes.
The following instruments are the most commonly used within IBF. They are the Shari’ah compliant alternatives to interest based modes of financing. Murabaha (Cost Plus Sale) Implies a mark-up in price. The merchandise is purchased, the buyer marks up the price and sells it to the customer and thus benefits from the profit. Bai’ bithaman ajil (BBA)- Murabaha (deferred payment) In the case of financing, Murabaha is the useful alternative to conventional loans when it is combined with Bai’ bithaman ajil (BBA). Bai’ bithaman ajil (BBA) means sale with deferred payment and can also be known as Bai’ Al-Mu’ajjal, which carries the same meaning.
69 BBA and Murabaha are similar concepts and are often used interchangeably, where Murabaha is used for short term and BBA represents long term credit sale. When a customer seeks to purchase a product and is unable to pay up-front, the customer may require the bank (or financier) to purchase the product. Thereafter, the bank (or financier) sells the product to the customer who will pay at a later date, in full or by installments (BBA), with a mark-up in price. The profit is a fixed amount agreed upon at the commencement of the contract. Under a Murabaha contract, both parties are aware of the original price as well as the mark up price. This is different from a typical everyday sale (Musawama) where costs and profit are not disclosed (like buying from the shop).
70 Financing asset purchase
Murabaha Financing asset purchase Goods (immediate delivery) Goods (immediate delivery) Bank Goods Supplier Customer $100,000 (spot payment) $130,000 (deferred payment, including profit mark up) Bank must own the asset before selling it. Debt Based Financing: Why it is called debt based? Why is it Shariah complaint?
71 Upon the close of an ijarah contract:
Ijarah (Leasing) Leasing entails that ownership remains that of the lessor and is to be transferred to the lessee by way of usufruct (i.e. the right to use it). The lessee pays the lessor for the duration of the contract at an agreed amount. Upon the close of an ijarah contract: The lessee may return the assets to the owner. The lessee may sign another contract to continue leasing. The lessor may offer to sell the assets to the lessee under another contract. This is known as Al-Ijarah Thumma Al-Bai’ (AITAB). The lessor may give the asset as a gift to the lessee. This is referred to as Al-Ijarah Muntahia Bittamleek (a contract of leasing ending with ownership). Ijarah cannot be applied to money, or perishables (food), or other things that can be consumed (such as fuel). Ijarah can also be used in reference to the services given by a person (such as a lawyer) who is paid by the hour for their services.
72 Bai’ As-Salam (Deferred Delivery Sale, pre-paid sale)
When the Prophet came to Madina, the inhabitants use to pay in advance for dates to be delivered a year or two later. The Prophet told the people, “Whoever pays in advance for dates (to be delivered later) should pay it for a known specified weight and measure (of the dates).” Another hadith mentions, “…for a specific period”(Collected by Bukhari). The other items that were sold in the lifetime of the Prophet under a Salam sale included wheat, barley and raisons. Selling agricultural produce in advance is permissible providing certain conditions are fulfilled. Some may refer to a Salam contract as a forward contract, however, a forward contract involves a deferred payment as well as deferred delivery. Among the conditions of a Salam contract is the up-front spot payment. This may help the farmer with the means of sustenance or for the finance needed to harvest the crops. As the hadiths above mention, the Salam contract must stipulate a specified measure for a specific time period.
73 Bai’ Al-Istisna’ (Manufacturing Sale) – This sale requires the manufacture, assembly, construction etc of a specified item or items. This could be used for the production of electrical goods, machinery, a construction of a house, plane etc. Unlike a Salam sale, an Istisna’ sale may consist of a deferred payment, lump sum or installments, depending on the agreement. Bai’ Al-Istijrar (Suply Sale) – This involves the delivery of certain goods periodically over time. Likewise the price can be paid periodically according to the agreement of both parties. Qard Hasan (Benevolent Loan) – This is a loan that involves no interest. The principle is paid at a later date without any increase. If one borrows $1000, they will repay $1000 at a later date.
74 Contentious Instruments.
The following products are used in some countries, yet, have received the most criticism from various scholars. Bai’ Al-Einah (Back to back repurchase) One contract that comes under scrutiny is Bai’ Al-Einah. When someone requires money, they sell a product to the bank in receipt of cash. The seller then agrees to buy back the product from the bank at a higher price to be paid in the future, commonly through installments (BBA). Therefore, it includes a spot sale and a credit sale. Most scholars criticize this sale as a form of ‘riba through the back door’. The sale is artificial in order to receive cash. Likewise the bank buys the goods momentarily for which it has no use. Likewise, Al-Einah involves two sales in one contract. The Prophet forbade “two sales in one” (Ahmad, An-Nasaa’i, Al-Tirmithi).
75 Bai-al-Einah (Repurchase)
In Bai-al-Einah, identity of the customer & supplier is the same. Customer ends up with $100 (cash) and deferred debt of $110 is created. Profit in this case is not result of a genuine sale and is therefore indistinguishable from riba. This mechanism is used in some countries for credit card arrangements. Goods Bank Customer $100 (spot payment) Repurchase of goods $110 (deferred payment)
76 At-Tawarruq (Tripartate Sale)
Tawarruq has been criticized as being related to Al-Eenah in the sense that it is seen as a means to by-pass Riba. Others may see it as a legitimate sale, some scholars do not. Those who tolerate this sale may do so based on the individual’s need for instant cash, providing certain conditions are met. Unlike Al-Eenah which involves only two parties, three parties are involved in Tawarruq. For example, the customer seeking cash approaches the bank. The bank buys a product from a vendor, then sells it to the customer BBA-Murabaha (Mark-up sale with deferred payments). The customer agrees and then requires the bank (now as an agent) to sell it to a vendor on their behalf in order to receive cash. The customer gains liquidity, yet now they have a higher debt to pay at a later date.
77 Tawarruq (Tripartate Sale)
Goods (immediate delivery) Goods (immediate delivery) Bank Goods Supplier Customer A $100,000 (spot payment) $130,000 (deferred payment) In Bai-al-Einah identity of the customer A & supplier is the same, while in Tawarruq it is not. Customer A ends up with cash that is result of a genuine sale to customer B. This mechanism is used in some countries for credit card arrangements. However, organised tawarruk where goods supplier and customer B have same identity may resemble Bai-al-Einah transaction. Spot sale for $100,000 Customer B
78 Bai’ Al-Dayn (Sale of Debt, Bill discounting)
The Shariah promotes investment in tangible assets as opposed to investment in debts. The only exception put forward (by the Shafi’ee School) for the sale of debt is when the debt is sold off (or passed on) at par value without any discount. This condition is necessary in order to prevent any form of riba (interest). In the following weeks we will look at how some of these mechanisms have been applied in the Islamic banking industry.
79 Bai’ Ad-Dayn (Sale of Debt, Bill discounting)
Transfer of debt $115 B C $110 Bill of exchange *Representing deferred payment of money. Eg $115. Note: Selling more money (later) for less money (now). Transfer of debt only allowed at par value in order to prevent creation of riba (interest).
81 ISLAMIC BANKING - FIN5BNK
Topic 5: Deposit products Main Deposit accounts: Current (Wadiah/Qard) account - Savings (Wadiah/Mudaraba) account - Investment (Mudaraba) account - Debit and Charge cards FACULTY OF LAW AND MANAGEMENT SCHOOL OF ECONOMICS AND FINANCE
82 Bank (Financial Intermediary) Deposit products
In order to facilitate intermediation between savers and investor, the bank mobilizes funds via a range of deposit products with different risk/return characteristics. Main Deposit accounts: Current (Wadiah/Qard) account Savings (Wadiah/Mudaraba) account Investment (Mudaraba) account Bank (Financial Intermediary) Deposit accounts: 1. Current account 2. Savings account 3. Investment account Financing Products Deposits Equity-Based (PLS) Debt-Based (Non-PLS)
84 Deposit products (cont)
Deposit accounts play a key role, not just for banks, but for the economy in general. Much of the wealth kept within the trust of a bank is utilized in investments, financing businesses etc. This in turn helps the workforce and stimulates productivity via a number of PLS and debt-based modes of financing. Islamic banks therefore, with deposits from customers, utilize these modes of financing to provide a sustainable service to the community. While mobilizing in a Shari’ah compliant manner, other issues such as risk, return, liquidity, maturity, safety, and stability are considered before offering the right deposit account that would satisfy customers’ needs.
85 Current accounts It is attractive for customers to leave their deposits in banks for safe-keeping and to have easy access to liquidity. These accounts allow money to be withdrawn by card access to automated teller machines (ATM). The deposits are held with the bank as an Amanah (Trust). Current account deposit may be structured on various mechanisms. Two of the most common are: Wadiah-wad-Dhamanah (Guaranteed deposits) Qard (benevolent loan)
86 Current accounts (cont)
Wadi’ah (Safekeeping) – Customers deposit money in Islamic banks under the principle of Wadi’ah wad Damanah. وديعة Wadi’ah means Deposit or Trust. ضمانة Damanah means Guarantee. Wadi’ah is like an Amanah (trust), yet under a trust there is no total guarantee (due to theft, catastrophe etc). Therefore the word Damanah is added. Under such an account the customer is able to safely deposit their money on the basis of trust, knowing that they can withdraw all or part of their funds when they desire. Since there are no conditions for deposits and withdrawals, funds kept by the bank as a trust may be utilized at the banks own risk. Depositors do not share any risk, so, any profit or loss is passed only to the bank.
87 Current accounts (cont)
Qard Hasan (Benevolent Loan) – Another way current accounts may be described is with the use of Qard Hasan. The deposit by the customer is seen as an interest free loan given to the bank. The account bears no profit for the customer. As was the case with a Wadiah account, the bank may utilize the funds at its own risk. Any benefit to the lender under this mechanism is seen as riba and against the spirit of the qard account. The main motive for a customer to have a current account is to keep excess liquidity available in demand. The objective to earn profit is not the priority. These accounts are operated for the safe custody of deposits, and for the convenience of customers.
89 Example:* Islamic Bank of Britain: Features and Benefits
Interest-free bank account: receive no interest, pay no interest Deposits may be made by cash, cheque or direct account transfer Withdraw funds at our branches through an ATM, or by direct account transfer to another bank account Funds deposited will be administered in accordance with Sharia Principles. Standing order and Direct Debit facilities International payments Access to our foreign currency and travellers cheque services Automatic access to your account via our automated telephone banking service 24/7 or online *
90 Saving accounts Deposit products that are modeled on Wadiah/Mudaraba mechanisms, are known as savings deposits. Their function is to safeguard deposits whilst providing a modest return on the capital. In that sense it is similar to the savings account with a conventional bank. This form of deposits is very popular in South East Asian countries, as customers have a degree of convenience in using and accessing their funds. Banks must request the permission of depositors before utilizing the funds for investment. The bank however claims ownership over the profits and at times rewards the customers. Withdrawal facilities are provided by the banks to the customer, such as passbook, ATM cards and so on.
91 Saving accounts (cont)
The bank has no obligation to give beyond what is deposited, however, the bank may give a gift (for wadiah) or profit (for mudaraba based deposits) to the customers who meet the minimum required deposit under this account. For Mudaraba it is mainly related to a minimum balance maintained for investment during the time period. For Wadi’ah accounts, Hibah (gift) varies and is not a condition of the contract. Jaabir ibn Abdullah said, “The Prophet owed me something and he paid me back and gave me something extra” (Abu Dawud). Regarding this hadith, one commentator (Al-‘Azimabadi) on the hadith collection of Abu Dawud stated, “If, while paying off his debt, a person gives something extra of his own accord, it is not riba but just an act of generosity on his part”. Although the Prophet gave extra in this case, it definitely was not a condition prior to taking the loan.
94 Investment Accounts Investment accounts follow the principle of Mudaraba (investment partnership). The investor is the Rabb-ul-Mal who deposits money in the bank under an investment account. The bank in this case acts as the Mudarib who will manage the funds. The bank will find Shari’ah compliant investments such as projects, sukuk (certificates), financing transactions, property etc. The profit will be according to a pre-determined ratio agreed upon by both parties. As it is based on the success of investments, the rate of return cannot be fixed.
95 Investment Accounts (cont)
The investor will receive weightages which are profit ratios according to each investment. Inevitably, the depositor (Rabb-ul-Mal) risks the loss of funds if the investments fail. Although bearing loss is not common, this is how a Mudaraba contract works. However, some banks may guarantee the principle of the deposit if investments fail.
96 Types of Investment accounts
Mudaraba Muthalaqa (General Investment Account) – Under this account, the depositor does not stipulate where they want their funds invested. They leave the bank with the flexibility to manage the funds how it deems fit. The funds may be placed in a pool of funds from other investors for a fixed period. Likewise, the funds may be used for a combination of investments with different maturities. Mudaraba Mudayyaqa (Special Investment Account) - This account allows the depositor to specify what type of investments they prefer. This may require a certain level of funds to qualify for this account. The bank therefore only utilizes the funds to invest in a company, project, venture etc, where both parties mutually agree.
97 Example:* Al Rajhi Fixed Term Investment Account
The Al Rajhi Fixed Term Investment Account-i is a flexible, easy and ethical way to get your money to work harder for you. And the peace of mind that comes with knowing that all Al Rajhi Bank's products protect you under the principles enshrined in the Shariah. Enjoy a minimum investment from as low as RM500 High profit-sharing ratio up to 80% Flexible tenure up to 60 months The investment period and the profit-sharing ratio are agreed upfront. The performance of your investment funds are calculated on a monthly basis. And of course you can be assured that we only invest in Shariah-approved financing and investment activities. *
98 Debit and Credit Facilities
Debit Cards As offered by conventional banks, the debit card is a useful alternative to credit cards. The card is merely a prepaid card and therefore does not assist users by falling into debt and most importantly, paying interest. Debit cards fulfill the same purposes of credit cards like online purchases (such as airline tickets). The major difference is that customers must upload their own money to use the debit card. Likewise, debit cards also allow cash withdrawals from ATMs worldwide. Some banks charge a monthly or annual access fee, while some banks charge no fees.
99 In 2010 a ‘Halal-approved MasterCard’ was officially launched in Canada. It is known as the iFreedom Plus MasterCard. Although it is only a prepaid card, it was endorsed by a number of Muslim scholars and likewise it offers a range of discounts when used (such as 10% discount with Etihad Airways). Other Shari’ah Compliant Cards Other cards function for the purpose of providing the customer with the means to purchase, however they incur a debt that must be repaid. Islamic Charge cards for example, function according to Al-Eenah or Tawarruq where the bank makes a profit through the transactions. It is an attempt to replace the credit card by means of supplying credit for customers. Yet it bears the hallmarks of a real credit card and for that reason it finds much criticism.
100 Some banks promote Shari’ah compliant credit cards
Some banks promote Shari’ah compliant credit cards. These are advertised as bearing no interest and no hidden costs. The customer pays an annual fixed fee which can be paid monthly. This fee is seen as ijarah for the services provided (or Ujrah). There is a grace period like a conventional credit card contract, thereafter penalties apply for late payments. Late Fees According to Taqi Usmani, to incur a fee for the late payment resembles Riba An-Nasee’ah (Riba of Debt) where the lender would say, “pay up or pay riba (increase)”. However, some scholars may tolerate a fee for overdue payments providing the fee does not go to the bank, lessor, lender etc. It should be stipulated that the fee will be given to a charity. This may act as a deterrent for the debtor to delay payments.
101 ISLAMIC BANKING - FIN5BNK
Topic 6: Financial management Risk and Liquidity management Systematic risk (Macroeconomic factors) Unsystematic risk (Unique to a firm or an industry) Risk Management Liquidity management The differences in managing risk: IB and CB
102 Financial management The objective of financial management is to maximize the value of the firm. The value of the firm can be measured through its profitability and risk level. In reality one of the key aspects of financial management is risk management because every decision or process will have a risk. Risk arises when there is a possibility of more than one outcome and the ultimate outcome is unknown.
103 The Elements of risk and Liquidity in Islamic banks
Risk is the variability or volatility of unexpected outcome. Risk can be divided into two types: systematic risk and unsystematic risk. Systematic risk is a risk that arises from the macroeconomic factors such as changes in economy, political and social issues, business environment, interest rates, inflation, war and international incidents. As such it can be hedged, but cannot be diversified completely away. Systematic risk includes: interest rates risk, foreign exchanges risk, commodity prices risk and industry concentration risk.
104 Unsystematic risk is a risk that is unique to a firm or an industry.
It is associated with random causes that can be eliminated through diversification and it can be controlled through good governance. The examples of unsystematic risk are regulatory action, mismanagement of a firm, labour difficulties, consumer preferences, loss of key accounts and labour strikes.
105 Risk Management The nature of financial institution operations exposes them to different types of risks. Both depositary and non-depositary financial institutions are a risky business. According to Saunders and Cornett (2006), there are five common risks faced by financial institutions: credit or default risk, interest rates risk, liquidity risk, underwriting risk and operating risk.
106 Risk Management (cont)
Largest source of serious banking problems is credit risk, the risk of counter party default. Credit Risk is defined as a risk that the value of portfolio may change due to the unexpected changes in the credit quality of issuer or trading partner (McNeil, Frey, & Embrechts, 2005). Note:Islamic finance is also vulnerable if care is not taken - not in terms of its product structuring, but in relation to non-performing financing due to its credit policies.
107 Risk Management (cont)
Islamic banking is involved in risk taking by its very nature, with the risk minimized by way of valid risk management tools, but never totally avoided or eliminated. In Islamic banking there has to be real business conducted as a result of which profit or loss can be incurred and hence Islamic Banks take on risk. The additional risk that IFI have to face, compared to conventional finance, is asset risk, market risk, Shariah non-compliance risk, greater rate of return risk, greater fiduciary risk, and greater legal risk.
108 Risk Management (cont)
Asset risk is involved in all modes, particularly in Murabaha (onward sale to the client with mark-up price), Salam (after taking delivery from the seller) and Ijarah as all the ownership-related risk belongs to the bank as long as the asset is in its ownership. If the asset is damaged without any fault on the part of the lessee and it is not deliverable, the bank’s right to receive rent will cease. Shirkah-based risk (PLS) is borne as per the share in the ownership market risk.
109 Risk Management (cont)
The bank might not be able to market the goods purchased on the basis of salam, Istisna etc at a profitable price. Rate of return risk is involved as the price (once fixed) in Murabaha /Salam cannot be increased. Remaining within Shariah principles, Islamic banks are allowed to take risk mitigation/management measures, but transfer of risk to anyone else without transferring related rewards is not permissible.
110 Risk Management (cont)
In addition to effective management and supervision, other factors necessary to ensure the safety of the banking institution and the stability of the financial system and the market include; sound and sustainable macroeconomics policies; well developed and consistent legal framework; adequate financial sector infrastructure; effective market discipline; and a sufficient banking sector safety net.
111 Risk Management (cont)
Credit risk is simply defined as the potential that a borrower or counterparty will fail to meet their obligation in accordance with the agreed term. It is the risk of failure of the counter party to honour their commitment and also refer to default risk. This arises from the inability of the counterparty to service the debt on the agreed term. It can also arise when the solvency or the credit rating of the counterparty changes adversely. In Islamic banking there is limited availability of credit rating defined from external agencies.
112 Risk Management (cont)
The risk of non-compliance with Shariah rules is referred to as Shariah risk. This can be included in operational risk as non-compliance can lead to reputational damages which can trigger an exodus of findings from the Islamic investor, causing failure and system risk. If Islamic financing found a product that does not fully comply with Shariah rules, then it would be subject to Shariah scrutiny and thus be considered to be an adaptation based on current market needs. These products pose special risks in terms of being rejected under the scrutiny of Shariah rules. As interpretation can differ, the utmost precaution is needed before entering into any contract, with approval from the Shariah council .
113 Risk Management (cont)
There are four elements that should be well defined and considered in financial risk analysis for Islamic products, which are: 1. The construction of the financial contract 2. Identification of the markets 3. Identification of the behavior of counterparties 4. Interaction of the above two within a time period mapped into the financial contract.
114 Risk Management (cont)
The role of information in the risk management of the Islamic financial institution can be more critically compared to conventional finance, with the nature of contracts in Islamic banking more integrated with the activities of the entrepreneur. The PLS contract is heavily biased towards the availability of information for managing risks. In the case of musharakah and mudarabah contracts, there is a heavy bias towards the availability of information for risk management.
115 Risk Management (cont)
There is special emphasis on transparency in the conduct of activities, calculation of profit and loss, as well as the nature of activities. This includes a focus on social responsibilities, with efficient information management requiring special dimensions in Islamic finance institutions which are more than merely statutory . Profit has to be earned by sharing risk and reward of ownership through the pricing of good services. Investment both by bank depositors and the financial institution will be considered only if it is part of real activity, or is itself a real activity. This is because money has the potential for growth when joined with entrepreneurship, as in itself, it is recognized as capital and therefore it cannot earn a return.
116 Risk Management (cont)
The business risk involved in shirkah (PLS) based modes where loss has to be borne by the capital provider, whilst the manager or entrepreneur loses the labour in the case of joint business venture. For the depositor in Islamic banking, risk stems from the failure of business and uncertainty in the level of profit to be shared. Depositor should not be burdened on the account of negligence. Mitigation of that risk would require special expertise and sound knowledge of Shariah rules, lest it may lead to non-Shariah compliance.
117 Risk Management (cont)
Risk of default by clients can be mitigated, in some cases, by putting a penalty clause in the contract to serve as a deterrent, the amount of penalty would go to a Charity account. This is in all modes except Istisna, when the bank can insert a clause for decrease in the price if asset in case of delay in delivery. The logic behind the provision in the case of Istisna is that manufacturing/construction of any asset depends, to a large extent, on personal effort, commitment and hard work by the Manufacturer who may start work on the contract with other people. While in the case of Murabahah and Salam one has to pay the deferred liability that has been defined and stipulated in the contract.
118 Liquidity Management Liquidity management means ensuring that the bank has sufficient liquid funds available for a smooth running of its operation in order to meet short term financial obligations as and when due.
119 Liquidity Management (cont)
Liquidity can be managed by dealing in the Islamic interbank fund market. The most useful instrument for the transaction is the mudaraba ratio that could be negotiated according to market conditions. Liquidity management in Islamic banks can also be done through securitization of the pool of income generating assets. If the bank requires liquidity it may sell sukuk in the secondary market to another bank to generate cash. If it is in surplus, it can purchase sukuk from the market.
120 Liquidity Management (cont)
In the case of Mudahrabah ,the following process can be adopted: A mudarabah relationship will be created Funds received will be allocated to pools Weightages will be assigned periodically, based on different tier/categories Profit earned will be allocated accordingly to weightages assigned at the beginning of the period. The bank will charge a pre-agreed Mudarib fee as a percentage of the realized profit, the bank can pay additionally from its share The investor will be at a loss unless it arises from misconduct or negligence of the Mudarib.
121 The differences in managing risk: IB & CB
Risk management is a process that protects assets and profit of an organization by; reducing the potential for loss before it occurs; mitigating the impact of the loss if it occurs; and executing a swift recovery after the loss occurs (Coffin, 2009). Financial institutions are a business entity owned by their shareholders and the objective of the business entity is to maximize the shareholders’ wealth. One way to achieve this objective is that the management should efficiently diversify the unsystematic risk and reduce or transfer the systematic risk. In the financial sector, risk management is an area of high interest due to the financial crises of the last two decades (Galindo & Tamayo, 2000).
122 Basic Concept of Risk Management Process and System
Establishing Appropriate Risk Management Environment and Sound Policies and Procedures Maintaining an Appropriate Risk Measurement, Mitigating and Monitoring Process Adequate Internal Control
123 The differences in managing risk: IB & CB (cont)
Islamic financial institutions can be riskier than conventional financial institutions due to several reasons including the specific nature of risk and the unlimited number of ways to finance a project using either profit loss sharing or non-profit loss sharing contracts. Scarcity of hedging instruments, undeveloped inter-bank money markets and a market for government securities which are Shariah compliant. Therefore, Islamic financial institutions may be more vulnerable to unfavourable events than conventional financial institutions.
124 The differences in managing risk: IB & CB (cont)
Inability to utilize money markets makes Islamic financial institutions more susceptible to liquidity risk. For Islamic financial institutions, liquidity risk can be considered as one of the most critical risks due to certain factor such as: (1)limited liability of Shariah compatible money market and inter-bank market, (2) shallow depth of secondary market for Islamic financial instruments and (3) the problem of the lender as a last resort from central bank.
125 The differences in managing risk: IB & CB (cont)
The last group of risks faced by Islamic financial institutions are governance risks. Governance risk refers to the risk arising from: a failure in governing the institutions; negligence in conducting a business and meeting contractual obligations; and from a weak internal and external institutional environment, including legal risk, whereby financial institutions are unable to enforce their contracts.
128 ISLAMIC BANKING - FIN5BNK
Topic 7: Introduction to Islamic Capital Markets Conventional capital markets Islamic Capital Market (ICM) Portfolio choices: Investment in Shares Conditions for investing and trading with shares Commodity Murabaha - Islamic Investment Fund Derivatives in Islamic Finance Sukuk (Islamic equivalent of bonds) FACULTY OF LAW AND MANAGEMENT SCHOOL OF ECONOMICS AND FINANCE
129 Capital Markets In the conventional sense, a capital market is a place where debt (e.g. bonds) and equity (shares) securities are traded. It is generally divided into: Primary market (issuing and trading new securities, raising new capital) Secondary market (facilitates trading of previously issued securities). Why is it called ‘capital’ market? Why do we need them? How would conventional be different from Islamic capital markets?
130 Islamic Capital Market (ICM)
In the Islamic capital market, all financial intermediation activities must be Shariah compliant (i.e. free from unethical, immoral, speculative or prohibited activities such as usury (riba), gambling (maisir), excessive uncertainty (gharar) and so on). Two main components of an Islamic capital market (ICM) include:* Debt securities market (Instruments created through deferred contracts of exchange) Equity securities market (Instruments created through profit sharing contracts) *(Kettell, Islamic Capital Markets, 2009, p. 76)
131 Islamic capital market (ICM)
Main objectives include: Efficiency in allocation of financial resources including transparency in pricing of securities with regards to risk/return/time preference. Transfer of funds from surplus saving to deficit spending units and equitable distribution of benefits. Companies: Raise funds that are used to finance buying buildings, aeroplanes, factories and other assets and/or business activities. Investor: Yield profitable returns from investment. Enhancing liquidity, risk management and portfolio diversification.
132 Portfolio choices: Investment in Shares
Shares represent units of ownership interest or a specific part of the total capital of a company. By purchasing shares in a company a person becomes a shareholder or partner in a business. As such, a shareholder is entitled to receive proportional profits that result from the company’s economic activities. (Similar to a musharaka arrangement) In general there is nothing wrong with buying or selling shares as part of an investment strategy, as long as Shariah conditions relative to the main business of the company are followed.
133 Conditions for investing and trading with shares
Qualitative Screens Industry screening Business practices Quantitative Screens Debt/Asset Ratio Interest-related Income Monetary Assets Prohibited Trading Practices Day trading, margin trading, derivatives & short selling. *Slides on investing and trading with shares adapted from: Investing in stock market: the Shariah way by The Milli Gazette Online, 2006, <
134 A Qualitative Screens Industry screening:
There are two types of qualitative screens: Industry screening and business practices. Industry screening: The main concern relates to the type of industry the company is involved in. The general rule is that most business activities are permitted (halal) unless specifically prohibited by the Shariah. For that reason, if the main business of the company is halal (permissible) and Shariah prohibitions are avoided (e.g. Riba), then shares of such a company are also permissible. It is not acceptable to buy/sell shares of a company that is involved with un-Islamic/unlawful (haram) products or services, such as, gambling, alcohol, pork, tobacco products, interest based financial institutions like banks and Insurance companies, adult products and so on.
135 Business practices Islamic principles relating to investing and trading stipulate that the acquisition of shares, from an investor’s point of view, must also be done in a Shariah compliant way. The following two principles must be observed while investing: 1. Investible funds must be free from interest based debt: Financing investment can not be done by borrowing on interest (e.g. Margin trading (borrowing and leveraging investment) as it is commonly done by hedge funds). 2. Prohibition of speculation Entering market as a speculator and thus making short-term speculative investment decisions is not allowed (This is fundamental difference between a true investor which is allowed and a speculator).
136 Quantitative Screens There are three types of quantitative screens: 1. Debt/Asset Ratio Question of debt to asset ratio and how much has the company borrowed? Usually it should not exceed 33%. What if it is interest based? What if it is not? Is a ratio of 33% acceptable? 2. Interest-related Income Does the company generate any interest or interest-related income? (For instance, where earning interest is not their business, but their surplus funds are placed in investments that yield interest income). What if it is less than 5%? What if this 5% of the dividend earnings is given in charity? Difference of opinions- Why?
137 Quantitative Screens (cont)
3. Monetary Assets To invest in Shariah compliant companies, one has to be very careful that non-liquid assets be over 51% (note that this ratio is the matter of ijtihad). The reason is that money cannot be traded except at par value. Why Quantitative screens? Why the difference of opinions?
138 Prohibited Trading Practices
i. Day Trading Buying and selling on short-term price fluctuations (normally within one day) is closer to gambling and speculation than actual investing. Should it be prohibited? ii. Margin Trading: Margin trading involves interest based borrowing from the broker in order to buy stocks. It is prohibited because it involves riba and involves excessive risk.
139 Prohibited Trading Practices (cont)
iii. Derivatives – Options, Futures & Swaps The opinion that Futures trading is not permitted due to the presence of gharar and maisir. iv. Short Selling: Short selling (borrowing a stock from the brokerage firm and selling it in anticipation that the stock price will further go down) involves huge risk and maisir (gambling) in addition to selling what one does not possess (borrowed stock). What are some examples?
140 Dow Jones Islamic Market
142 Wholesale Markets Commodity Murabaha
Commodity Murabaha is equal to Tawarruk but the commodity typically represent metals (excluding gold and silver), that is listed on, for instance, the London Metal Exchange. It is used for short term financing. Under a basic Murabaha, the customer (who wants to own the commodity) buys goods from the bank with deferred payment option. Commodity Murabaha is a sub category of Murabaha, but the client does not want to own commodity. Rather, the objective is to sell it to another broker for cash (e.g. To be used as a working capital for business). Transaction may or may not contain elements of interest, hence, like in Tawarruq*, it is subject to the same controversy, conditions and possible misuse. *Tawarruq (or reverse Murabaha) is when a party in need of cash purchases a commodity on deferred basis, then sells it on the spot for cash. (seeking cash/liquidity, selling a specific commodity)
143 Commodity Murabaha (cont)
Current practices and reasons for it? The transaction does not represent a genuine sale (as practiced on London Metal Exchange) Why? What happens with the goods? Do they ever leave the warehouse or are they only used to generate debt? What if it was a genuine sale/trading transaction? How would it work? Would it be possible to trade gold and silver? Which type of riba is this? How to prevent faulty structuring of murabaha?
144 Islamic Investment Fund (List 5 investment funds)
Islamic Investment fund works on a partnership basis, where investors jointly pool surplus money for investment purposes. The subscribers of the Fund receive certificates or shares. Modes of Investing: Equity fund (investment in the shares of a joint stock company) Ijarah Fund (investment used to purchase assets for the purpose of leasing) Commodity Fund (used for purchasing of different commodities for the purpose of the resale) Murabaha Fund (sale on a cost plus basis, deferred payment basis) Mixed Fund (Tangible assets must be over 51%. If liquidity and debt exceed 50%, it can not be traded [it must be a closed- end Fund])
145 Modes of Investing: Equity fund (investment in the shares of a joint stock company) Ijarah Fund (investment used to purchase assets for the purpose of leasing) Commodity Fund (used for purchasing different commodities for the purpose of the resale) Murabaha Fund (sale on a cost plus basis, deferred payment basis) Mixed Fund (Tangible assets must be over 51%. If liquidity and debt exceed 50%, it can not be traded [it must be a closed- end Fund])
146 Derivatives in Islamic finance
A derivative - financial instrument (security) - is a contract between two or more parties, whose value is derived from expected future price movement of the underlying asset (e.g. shares, currency, commodities, bonds, interest rates and market indexes). An example of a typical derivative that involves the purchase of debt and liabilities between two parties (subject of a future outcome of the underlying asset) are options, swaps and futures. Main Use: hedging risk and speculative purposes. Example of hedging in a forward contract: Farmer - Exposure to price fluctuation of the grain. Contract Involves parties facing risk in opposite directions (win/lose situation). By agreeing on a future (deferred) price and delivery, both parties eliminate price movement risk (like insurance). Is this a Shariah compliant contract?
147 Why are derivatives forbidden (haram)?
“They ask thee (O Prophet) about Khamr (intoxicants) and games of chance (gambling). Say: In both of them there is great harm although there is some advantage as well in them for men, but their harm is much greater than their advantages.” Qur’an 2:219 While there are some benefits in financial instruments such as derivatives, the general Islamic principle is that harm which results from gambling and speculative nature of conventional derivatives is much greater.
148 Sukuk (Islamic equivalent of bonds)
Sukuk – plural of Sakk (legal instrument, deed, check). Sukuk are Islamic Investment Certificates (Islamic equivalent/alternative of bonds) Sukuk are defined by the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) as: ‘certificates of equal value representing undivided shares in the ownership of tangible assets, usufructs and services or (in the ownership of) the assets of particular projects or special investment activity.’
149 Sukuk Structure: Typical Sukuk Structure:
Partial ownership in a debt (Sukuk Murabaha) Asset (Sukuk Ijarah) Project (Sukuk Istisna) Business (Sukuk Musharaka) Other mixed structures Note: Typical Sukuk structure is a combination of several financial mechanisms such as Murabaha, Ijara, Istisna and so on.
150 Differences between Sukuk and conventional bonds
Prohibition on charging or paying of interest and other Shariah constraints. Some Sukuk (e.g. debt) are not tradable in the secondary market. Sukuk – securitisation & issuance of sukuk (taskeek) – Transforming an asset’s future cash flow into present cash flow.
151 *SPV – Special Purpose Vehicle (Issuer)
Eg: Sukuk Ijara Name of Sukuk is derived from underlying principle that underpins Sukuk structure – in this case ijarah! Lease (Ijarah) SPV* Pay Issue price ABC Ltd Investor Rental Payment Issue Sukuk & pay profits *SPV – Special Purpose Vehicle (Issuer) How would Murabaha or Mudaraba Sukuk look like?
152 Sukuk (cont) Ijarah vs Murabaha Sukuk, example: Q: Who owns asset/debt in each structure and why is that important? Who should maintain property and how? Can certificate be traded in secondary markets? Other issues? Difference between ijarah and, for instance Murabaha based Sukuk, is the simple issue of ownership and valuation of share in the asset. While in Murabaha cash flow simply represents debt (dayn) resulting certificate can not be traded on secondary market. This is resolved in ijarah Sukuk where price of certificate reflect proportional price of underlying asset. Therefore, since trading with debt at a discount or a premium is prohibited, ijarah Sukuk represents actual asset and not cash flow or debt .
153 Example: GE Sukuk GE Capital, the finance arm of General Electric, has listed a recently completed US$500 million Sukuk (Islamic bond) on NASDAQ Dubai, the Middle East's international exchange.
155 Sukuk (cont) Structuring Sukuk and Shariah risk A recent controversy paralysed Sukuk markets when Sheikh Taqi Usmani, chair of the AAOIFI Shariah board, announced in 2007 that majority of equity-based Sukuk such as Mudaraba and Musharaka were not structured in an Islamic acceptable way. For instance, when structuring the question of ownership must be clearly identified. It is not simply enough that Sukuk are asset ‘based’ but they must be asset ‘backed’ and therefore represent real ownership which will provide sureness for investor in case of the default. It is only in this situation that performance of the assets will be linked with profitability of investment and not arbitrary interest rate.
156 Sukuk (cont) Contemporary Issues* 1. Sukuk should be issued for new commercial and industrial ventures. If they are issued for established businesses, then the Sukuk must ensure that Sukuk holders have complete ownership in real assets. 2. The returns of enterprises should be returned to Sukuk holders regardless of what amounts they reach after costs, including the manager's fees, or the share of the mudarib in profits. If there is to be an incentive for a manager, then let it be based on the profits expected from the enterprise and not on the basis of an interest rate. *Read full text: Mufti Taqi Usmani, 2007, Sukuk and their Contemporary Applications,
157 Sukuk (cont) 3. It is unlawful for a manager to lend money when actual profits are less than expected. 4. It is unlawful for a manager, whether a mudarib or a partner or an agent, to commit to repurchase of assets at face value. Instead, their resale must be undertaken on the basis of the net value of the assets, or at a price that is agreed upon at the time of purchase. 5. Shariah supervisory boards must abide by the Shariah Standards issued by the Shariah Council.
159 ISLAMIC BANKING - FIN5BNK
Topic 8: Legal and regulatory issues in Australia Introduction: Islam and Muslims in Australia Islamic banking and finance in Australia - Legal and regulatory issues Awareness & Future opportunities FACULTY OF LAW AND MANAGEMENT SCHOOL OF ECONOMICS AND FINANCE
160 Islam in Australia Muslims came to Australia as early as the 1600s. Fishermen from Indonesia’s Sulawesi Island began Australia’s first industry. It involved the gathering of trepang (sea slug) which were shipped to Indonesian waters to sell to various trade ships. With the introduction of camels, the Muslim cameleers brought new found hope for Australia in the 1860s. Camels were able to handle the harsh interior of Australia’s outback. This facilitated inland exploration, the delivery of supplies, food provisions and other necessities to remote areas. The cameleers mostly came from what is known today as Pakistan, Afghanistan and India. Due to their help, many train lines were made as well as the overland telegraph line. The overland telegraph line stretched three thousand kilometers across the interior and thus connected Australia to the outside world through telecommunication.
162 Today’s Muslim population in Australia is estimated at 400,000
Today’s Muslim population in Australia is estimated at 400,000. Muslims have migrated to Australia from over 120 countries and are ethnically and linguistically diverse. Islamic finance is yet to make significant impact on Australian soil. However there are signs of facilitation for growth from the Australian government. During the launch of the booklet by the Australian Trade Commission (Austrade) titled Islamic Finance, former Trade Minister Simon Crean said that “Islamic financing is a crucial plank in the Government's strategy to make Australia a financial hub in the Asia Pacific region”. In May 2010 Senator Nick Sherry inaugurated the book launch in Sydney of Demystifying Islamic Finance: Correcting Misconceptions, Advancing Value Propositions. He mentioned, “We are taking a keen interest in ensuring there are no impediments to the development of Islamic finance in this country, to allow market forces to operate freely.”
163 Further Readings in PDF Format Islamic Finance (Austrade Publication)
Senator Nick Sherry also said, “On 26 April, I announced that the Board of Taxation would undertake a comprehensive review of Australia's tax laws to ensure that, wherever possible, they do not inhibit the expansion of Islamic finance, banking and insurance products.” Further Readings in PDF Format Islamic Finance (Austrade Publication) Demystifying Islamic Finance: Correcting Misconceptions, Advancing Value Propositions (Zaid Ibrahim and Co. Publication)
165 Awareness of Islamic banking products among Muslims: The case of Australia
Query* Yes (%) No (%) N/A* (%) Awareness of halal banking products 55.7 44.1 0.3 Ever having held a halal stylised bank account 19.3 80.1 0.7 Willingness to switch to a halal product given some quality of conventional banking service (ATM, online access, phone banking) 92.5 7.4 1.5 Willingness to switch without credit facilities 79.0 20.9 Willing to switch to a profit-and-loss agreement where you might incur losses 60.8 37.9 3.3 Willingness to switch dependant on brand recognition 60.1 39.7 *Responses are quoted in percentage terms with N/A representing the proportion of missing responses for a particular question. Source: Rammal & Zurbruegg (2007).
166 Awareness of Islamic banking products among Muslims: The case of Australia
Table indicates that, over 90% of Muslims would prefer a Shariah compliant (halal) account and would consider switching to another bank if opportunity was presented. What is even more interesting is that the overwhelming majority of Muslim customers would switch to halal banking even without facilities (ATM, online access, phone banking) and despite possible losses. While this study was concentrated mainly on the profit and loss arrangements, it shows a demand and willingness of the Muslims to engage proactively in Shariah compliant banking products.
167 Islamic Banking and Finance in Australia
168 Introduction Islamic banking and finance globally represents one of the fastest growing financial industries. With its strategic position and well regulated financial system, Australia is attempting to create conditions that would facilitate and replicate global success in the Australian context. Australia is, and almost always has been, a capital importing country. On the road to attract capital, every investment ultimately needs to pass the test of profitability. Since Shariah compliant investors have increased the number of global choices, just offering Shariah compliant products is not enough to attract key industry players.
169 Review of the present situation in Australia
With an estimated size of $1 trillion, Islamic banking is predicted to grow at 10% per annum (Austrade, 2010). Major financial institutions such as Citibank, JP Morgan/Chase, Goldman Sache, USB, HSBC, ABN Amro, BNP Paribas, Societe Generale, Deutsche Bank, Nomura Securities and many more are capitalising on this growth opportunity. Since Islamic financial products must be linked with tangible assets and real economic activities, Australia’s resource related services and infrastructure creates a superb opportunity. Moreover, its geographic position and close proximity to the million Muslims in Asia Pacific region are amongst primary drivers behind the move to position Australia as a financial centre in the Asia Pacific region (Austrade 2010).
170 Review of the present situation in Australia
The Australian Financial Centre Forum’s report entitled “Australia as a Financial Centre - Building on our Strengths” or as commonly referred as - The Johnson Report - identified the Middle East as the major global source of offshore capital due to its booming oil exports. The capital intensive nature of Australia’s’ resources related services and infrastructure (Agribusiness, Mineral resources, property, Oil and Gas) in addition to Islamic finance which works mainly with assets, services and projects, creates prospects for future partnership (Austrade 2010, The Johnson Report 2009).
171 The Johnson Report Recommendations 3.6 & 4.8
Issue: Lack of Islamic finance products in Australia is limiting our access to offshore savings pools. Recommendation 3.6: Islamic finance products The Forum recommends that the Treasurer refer to the Board of Taxation the question of whether any amendments to existing Commonwealth taxation provisions are necessary in order to ensure that Islamic finance products have parity of treatment with conventional products, having regard to their economic substance. Recommendation 4.8: Removal of regulatory barriers to Islamic finance The Forum recommends the removal of any regulatory barriers to the development of Islamic financial products in Australia, guided by the principle that there should be a ‘level playing field’ for such products.
172 Review of the present situation in Australia
However, despite this progress, when compared with other western nations, Australia is far behind and to see how far, we only have to look at the IBF situation in the UK with 22 banks in London (including five that are fully Shariah compliant), twenty Sukuk issues raising US$11 billion listed on London Stock Exchange, 20 law firms supplying services in Islamic finance and a number of institutions offering educational and training products supporting the IBF industry. In the environment that is dominated by the few conventional banks, ensuring a level playing field will require long overdue action to remove impediments that relate to taxation, legal and regulatory obstacles as outlined in the Johnson Report.
173 Legal and regulatory issues in Australia
Creating Islamic financial products is a vehicle that allows Australian assets to be sold to a third party. To make financial products attractive, beside Shariah compliant issues, it must be profitable. The key components that determine profitability typically is the tax treatment and the other regulations. For GCC investors - who do not pay taxes and do not have double tax agreements with Australia - this represents a particularly important issue. The Johnson report recognises wholesale investment opportunity and recommends changes that will attract Islamic investors and make IBF products more competitive.
174 Nature of the transaction
Shariah principle stipulates that in order to sell something one must take possession and assume all relevant risk associated with the ownership of the goods. In the murabaha transaction (below) it is required that the bank must own goods before it can sell it to the third party.
175 As apparent from figure A, the bank first obtains the goods with immediate payment and the delivery. Once the bank acquires ownership, it is then able to engage with the end customer and sell with deferred payment and immediate delivery. The bank in the murabaha transaction makes profit by charging mark-up that is added to the principle, while on the other side, the customer benefits from the deferred payment arrangement. From the outset, this transaction is classified as buying and selling and since the goods change hands twice, it attracts double Goods and Services Tax (GST). Furthermore, in addition to double GST, if the product arrangement involves housing loan that may pose additional burden of double stamp duty. While this problem was resolved in Victoria, it remains an impediment on the other jurisdictions, due to the fact that, property transfer occurs once to the bank and after that to the customer.
176 As a result of a higher cost, Islamic financing translates to less competitive products that are less attractive to both customers and investors. Finally, since commodities and the other Australian assets can be packaged with the Islamic financial products, treatment of the bank’s profit from the customer’s perspective must be addressed. In general, the tax discount that is applied to interest payments in conventional banking and profit or mark up treatment in shariah compliant products, should not disadvantage customers involved in Islamic financing. In addition to being taxed twice, which adds to the overall price of the transaction, profit and mark-up is not tax deductible as it is the case with interest paid on the conventional loan. In order to make Islamic finance competitive and a viable alternative for a wider customer base, it is necessary to provide tax neutrality that will accommodate shariah compliant transactions.
177 Discussion Paper: The Board of Taxation (Board) review of the taxation treatment of Islamic finance products The purpose of this discussion paper is to: • Examines the current approach to finance taxation in Australia; • Identifies issues associated with Australia’s current approach to the taxation of Islamic finance products; and • Examines the tax policy response to the development of Islamic finance products in other jurisdictions.
178 Example: Discussion paper 2010, Case study 1
Step 1: A Client agrees to purchase a house from a vendor. The Client approaches a resident Financier to finance the purchase. A purchase instruction with promise to purchase is completed by the Client which is a request that the Financier purchase the asset specified and an undertaking to purchase that asset from the Financier. Step 2: If the Financier approves the financing, an Asset Purchase Agreement will be executed where the Financier purchases the asset (house) from the vendor on a cash basis for a purchase price of $360,000. The Financier appoints the Client as its agent to purchase the asset. The asset is transferred to the Financier at this time. Step 3: Asset Sale Offer and Acceptance notices will be executed, in which the Financier will offer to sell the asset to the Client on deferred terms at the purchase price ($360,000) plus a profit component ($384,341). The Client will complete the Acceptance notice. The sale is executed and title is transferred to the Client with security granted to the Financier. Step 4: The Client will pay the sale price of $744,341 on an amortizing monthly installments basis over 20 years at $3, per month. What are the issues that should be considered when leveling playing filed?
180 "The Road Less Traveled“ (now I know why)
Ha-ha! Nice and easy! No uncertainty… "The Road Less Traveled“ (now I know why) Conventional road Oh! No! Stamp duty – AGAIN. What! Double GST. After all this NO deductions on profit ? IBF Road
181 Economic future Islamic banking and finance is well positioned to play a major role in the Australian economic future. While most of the world suffers from a lack of liquidity, the Johnsons report identified the Middle East as the major exporter of the capital. However, despite its natural advantage and favourable predisposition, Australia is not utilising opportunities to connect its capital intensive industry with offshore liquidity. BOT discussion paper 2010 is designed to highlight changes that which would ensure level playing filed and the uncertainty of tax treatment. Banks and institutions that embrace introductory steps and develop shariah compliant products at the retail & wholesale level will anticipate future opportunities with much more state of attentiveness. They will have a strong customer base, knowledge and brand recognition locally and internationally.
182 In conclusion Resource-Related services and infrastructure are ideal for Islamic financing (Agribusiness, Mineral resources, Oil and Gas, property, education etc.) Proximity to Muslim populations of the Asia Pacific (62% or million of the world total Muslim Population) Islamic banks are expected to account for 40 to 50 percent of total savings of the world’s Muslim population within 8 to 10 years* (KPMG Report) Billions of dollars needed to finance Australian infrastructure in the next decade.
184 ISLAMIC BANKING - FIN5BNK
Topic 9: Islamic Corporate Governance Islamic Corporate Governance (ICG) - Shari’ah Supervisory Board (SSB) Shari’ah Advisor - Institution of Hisbah Qualifications of a Shari’ah board scholar - Shari’ah Standards Bodies FACULTY OF LAW AND MANAGEMENT SCHOOL OF ECONOMICS AND FINANCE
185 Islamic Corporate Governance (ICG)
Corporate Governance (CG) is applied at varying degrees to all industries around the world. Principles of CG relate to the responsibilities of the board members, monitoring of management, allocation of duties and responsibilities, practices in accordance with the law, transparency, interests of the corporation, serving public interest, effective regulatory responsibilities, rights of shareholders, rights of stakeholders, co-operation and teamwork, discloser of accounting and auditing, high ethical standards, reviewing of strategies and structure, risk policy and so on.
186 Islamic Corporate Governance (ICG)
Corporate Governance based on an Islamic Framework is known as ICG (Islamic Corporate Governance). The principles of ICG laid out by the Islamic Financial Services Board (IFSB) reflect those of international standard-setting bodies such as the Organisation for Economic Co-operation and Development (OECD) (2004) and the Basel Committee on Banking Supervision (BCBS) (1999). ICG however, has the underlying principle of conformity to Shari’ah principles. Therefore the IFSB recommends alterations and additions where needed in order to compensate where other CG models fall short. This is done in order to avoid “re-inventing the wheel”. Likewise CG models merely serve as guidelines and may not necessarily be applied unconditionally in each country.
187 Islamic Corporate Governance (ICG)
Principles of ICG as proposed by the IFSB cover the following: General governance approach of IIFS (Institutions offering only Islamic financial services); Rights of investment account holders (IAH); Compliance with Islamic Sharī`ah rules and principles; and Transparency of financial reporting in respect of investment accounts. (Source: IFSB, GUIDING PRINCIPLES ON CORPORATE GOVERNANCE FOR INSTITUTIONS OFFERING ONLY ISLAMIC FINANCIAL SERVICES (EXCLUDING ISLAMIC INSURANCE (TAKAFUL) INSTITUTIONS AND ISLAMIC MUTUAL FUNDS) December )
188 Islamic Corporate Governance (ICG)
Points i, ii and iv share a number of principles with the major CG models. Nevertheless, all points are valued in light of the Shari’ah and adjustments are made accordingly to cater for corporate governance of Islamic Industries. However, point iii is the truly unique factor of the ICG model. Such governance requires a Shari’ah Supervisory Board (SSB). Industries that are Islamic, or provide Islamic windows, rely heavily on the endorsement, assistance and advice of SSBs.
189 Islamic corporate governance (ICG) seeks to devise ways in which economic agents, the legal system and corporate governance can be directed by moral and social values based on Shariah laws (M Bhatti & I Bhatti, 2009). Model is also analogous to the proposed OECD principles emphasizing the mechanisms of business ethics, decision-making, bookkeeping and final accounts, and also of adequate disclosure and transparency (M Bhatti & I Bhatti, 2009).
190 Framework is consistent with the six OECD principles:*
1. Ensuring the basis for an effective corporate governance framework. 2. The corporate governance framework should protect and facilitate the exercise of shareholders’ rights. 3. The corporate governance framework should ensure the equitable treatment of all shareholders, including minority and foreign shareholders. All shareholders should have the opportunity to obtain effective redress for violation of their rights. 4. The role of stakeholders in corporate governance is to be recognized by creating wealth, jobs and sustainability of financially sound enterprises. 5. Disclosure and transparency 6. The corporate governance framework should ensure the strategic guidance of the company, the effective monitoring of management by the board, and the board’s accountability to the company and the shareholders. * (M. Bhatti & I. Bhatti, 2009)
191 Islamic corporate governance as based on the ‘stakeholder model’ of corporate governance as shown below. Flowchart of Stakeholder Model of Corporate Governance (Source: Hassan (2008, p. 12))
192 Shari’ah Supervisory Board (SSB)
Also known as a Shari’ah Advisory Council (SAC), SSBs are a vital need for Islamic Banks and Institutions. Banks have their own Shari’ah councils which oversee contracts, issue fatwas, supervise and view procedures. The following points may shed light on the relationship between Islamic Financial Institutions (IFI) and SSBs. A correspondence should exist between the SSB and the internal reviewers of the institution for internal Shari’ah compliance. The institute or bank must accept the decisions made by the SSB. SSBs must review and monitor the implementation of procedures, transactions, products (current and new), investments etc undertaken by the IFI. The trust of stakeholders is needed as they expect that the IFI is following principles in line with their religious beliefs. Endorsement by the SSB is crucial in this aspect.
193 Shari’ah Advisor The SSB is made up of Shari’ah advisors. The Shari’ah advisor must be specialised in Islamic Knowledge as well as modern forms of finance and areas related to it. Their role is to decipher whether certain practices are halal (permissible) or not. Depending on the country, the Shari’ah advisor must take into consideration the local laws. Shari’ah advisors can work as part of a board and/or as individuals. It is useful for institutes to have Shari’ah advisors present within the establishment or easily available for general matters, especially the internal review process. This will help enhance the effectiveness, compliancy, handling of Shari’ah related enquiries etc. Shari’ah advisors should likewise research new products, initiate alternatives and provide or supervise training and education programs for current and upcoming practitioners.
194 Institution of Hisbah (Enjoining right conduct and forbidding what is wrong)
“Let there arise out of you a band of people inviting to all that is good, enjoining right conduct and forbidding what is wrong. Such are they who are successful” (Qur’an 3:103). Endorsement of enjoining the right and forbidding the wrong has its roots in the Qur’an and the Sunnah. For this reason the institution of Hisbah was formed under the historic Islamic state/Caliphate in order to regulate society with justice and righteousness, in accordance with the principles of Islam. Ibn Taymiyah taught that Hisbah relates to the areas where authority of governors, judges, or other specified public officers cannot reach. One hadith mentions, “Whoever of you sees something wrong, then change it with your hand, if you are not able to do so, then change it with your tongue, if you are not able to do so, then (detest it) with your heart.”
195 Institution of Hisbah Due to the importance of Hisbah, the Islamic state use to appoint qualified people to take on the more serious roles of Hisbah. Although individuals may apply Hisbah within their own capacity, there are issues that must be resolved by the scholars who are qualified to exercise the best resolve in accordance with the principles of Islam. Such is the case with Shari’ah advisors. Although Hisbah is a broad topic and covers all areas of the state, SSBs and Shari’ah advisors fulfil this role within the realm of Islamic finance and banking. Shari’ah advisors are therefore required to be competent in Shari’ah. Ibn Taymiyah mentioned, “Allah ordered us to command good and forbid evil. But commanding something must be preceded by knowing it; one who does not know the good will be unable to command it. And prohibiting evil must be preceded by knowing it; one who does not know it will be unable to prohibit it.” (Majmu’ Al-Fatawa, vol 15).
196 Institution of Hisbah The Muhtasib (one who practices Hisbah) should have the necessary experience, knowledge, patience and wisdom. The role is not to be taken by the ignorant. This would include those who are not grounded in experience, deep knowledge of Shari’ah, the aims of the Shari’ah and hikmah (wisdom). For example, Ibn Taymiyah also stated, “Commanding the good should not result in the loss of a greater good, or in an evil greater (than before). And forbidding an evil should not result in a greater evil, or in the loss of a greater good (than before)” (Al-Hisbah). Fill in the blan para
197 Qualifications of a Shari’ah board scholar?
“Then We established you on a way (shari’ah) regarding affairs. Therefore follow it, and do not follow the vain desires of those who lack knowledge” (Qur’an 45:18). There is concern of a lack of specialists in the growing sector of Islamic Finance. Likewise, there is no universal agreement on what is required to be a Scholar in this field. Then again there are various levels of scholarship and specialisation. One cannot be expected to have a degree and then instantly fill this role. There are also prominent scholars of the world who never had university degrees, however, they spent years studying under other scholars beyond what universities can offer. Some may have long experience in the banking/finance sector as well as education and or traditional scholarly learning etc.
198 Qualifications of a Shari’ah board scholar?
Therefore, the specialist must know the Shari’ah in detail as well as have necessary experience. If they are required to give ijtihad, they must be qualified to do so. As was mentioned in week 1, this requires an excellent understanding of the Qur’an, the Sunnah, established rulings, as well as a sound understanding of the Arabic language. It is important for the Shari’ah advisor to be familiar with accounting and auditing, economics and finance, as well as familiarity with the banking industry.
199 Shari’ah Standards Bodies
Shari’ah standards are issued by a number of organizations. They may be adopted by banks or financial institutions locally or around the world. The following are some prominent bodies. The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) AAOIFI is an Islamic international autonomous non-for-profit corporate body that prepares accounting, auditing, governance, ethics and Shari'a standards for Islamic financial institutions and the industry. Professional qualification programs (notably CIPA, the Shari’a Adviser and Auditor "CSAA", and the corporate compliance program) are presented now by AAOIFI in its efforts to enhance the industry’s human resources base and governance structures.
200 Shari’ah Standards Bodies
Shari’ah standards are issued by a number of organizations. They may be adopted by banks or financial institutions locally or around the world. The following are some prominent bodies. The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) AAOIFI is an Islamic international autonomous non-for-profit corporate body that prepares accounting, auditing, governance, ethics and Shari'a standards for Islamic financial institutions and the industry. Professional qualification programs (notably CIPA, the Shari’a Adviser and Auditor "CSAA", and the corporate compliance program) are presented now by AAOIFI in its efforts to enhance the industry’s human resources base and governance structures.
201 As an independent international organization, AAOIFI is supported by institutional members (200 members from 45 countries, so far) including central banks, Islamic financial institutions, and other participants from the international Islamic banking and finance industry, worldwide. AAOIFI has gained assuring support for the implementation of its standards, which are now adopted in the Kingdom of Bahrain, Dubai International Financial Centre, Jordan, Lebanon, Qatar, Sudan and Syria. The relevant authorities in Australia, Indonesia, Malaysia, Pakistan, Kingdom of Saudi Arabia, and South Africa have issued guidelines that are based on AAOIFI’s standards and pronouncements. (Adapted from the AAOIFI website
202 The Islamic Financial Services Board (IFSB)
The IFSB started operations on 10th March It serves as an international standard-setting body of regulatory and supervisory agencies that have vested interest in ensuring the soundness and stability of the Islamic financial services industry, which is defined broadly to include banking, capital market and insurance. As of April 2010, the IFSB consisted of 191 members and 50 regulatory and supervisory authorities as well as the International Monetary Fund, World Bank, Bank for International Settlements, Islamic Development Bank, Asian Development Bank and the Islamic Corporation for the Development of Private Sector, Saudi Arabia, and 138 market players and professional firms operating in 39 jurisdictions. Malaysia, the host country of the IFSB, has enacted a law known as the Islamic Financial Services Board Act 2002, which gives the IFSB the immunities and privileges that are usually granted to international organisations and diplomatic missions. (Adapted from the IFSB website, )
203 Islamic International Rating Agency (IIRA) IIRA was established to provide a wide range of services. The main purpose is to play a pro-active role in the development of financial markets by providing an assessment of the risk profile of entities and instruments which can be used as a basis for investment decisions. IIRA is a unique rating agency in that it provides a Shari’ah quality rating, credit rating, corporate governance rating and sovereign rating services. IIRA will also carry out research, analysis and evaluation of sectors, industries and entities. For this purpose, IIRA is building a strong database of individual firms and industries. IIRA is structured in a way to preserve its independence. It has a Board of Directors and a completely independent Rating Committee. Its Shari’a Board is made up of experts in the field. (Adapted from IIRA website
204 Rating Agency Malaysia (RAM)
RAM Holdings is a leading provider of independent credit research and advisory services. Their forte is in the provision of unparalleled insights into the Malaysian bond market – to help guide their clients’ decision-making processes – and also in other value-added services that complement their requirements. RAM Holdings (formerly known as Rating Agency Malaysia Berhad) was established in November 1990 as a catalyst for the domestic debt-capital market and as the nation’s first credit-rating agency. Shareholders comprise both local and foreign financial institutions. (Adapted from the RAM Holdings website
205 The Malaysian Accounting Standards Board (MASB)
The MASB's mission is to develop and promote high quality accounting and reporting standards that are consistent with international best practices for the benefit of users, preparers, auditors and the public in Malaysia. In a wider context, the MASB seeks to contribute directly to the international development of financial reporting for the benefit of users, preparers and auditors of financial reports. (Adapted from the MASB website Others include: The International Islamic Financial Market (IIFM) The General Council for Islamic Banks and Financial Institutions (GCIBFI)
206 ISLAMIC BANKING - FIN5BNK
Topic 10: Zakah, Waqf & Wasiyyah Introduction to Zakah, Waqf & Wasiyyah Other Islamic Banking Concepts: Ar-Rahn (pawn broking) Al-Kafalah (Guarantee, Sponsorship, Surety) Al-Wakalah (Agency, Representation, Authorization) The Promise (Wa’d) Islamic Insurance – Takaful FACULTY OF LAW AND MANAGEMENT SCHOOL OF ECONOMICS AND FINANCE
207 Zakah for Islamic Banking كاةالز
Zakah is the third pillar of Islam and is usually described as alms-giving or a charity-tax. The Prophet Muhammad said, “Islam is built upon five (pillars): [1] The testimony that none has the right to be worshipped except Allah and Muhammad is the Messenger of Allah; [2] establishing Prayer; [3] giving Zakah; [4] pilgrimage to the Holy Mosque (in Mecca) and; [5] fasting (the month of) Ramadan” (Bukhari and Muslim). Definition of Zakah (or Zakat): the lexical meaning of Zakah has a dual connotation of increase and purification. Zakah is sometimes referred to as Sadaqah (Charity) in the Qur’an and Sunnah. It is referred to as a tax that only applies to those with sufficient wealth. Zakah is applicable on wealth (gold, silver, money), livestock (camels, cattle, sheep), and farm produce (grain, fruit).
208 The Muslim with a sufficient amount of savings (gold, silver, money) must give 2.5% of it in Zakah. This is done once per year and must be dispersed as a charity among the needy in the society. The ratio as well as the nisab (threshold) for livestock and farm produce is different to that of savings, therefore it will not be covered here. Nur Barizah Abu Bakar summarized some of the benefits of Zakah wherein he said: “Spiritually, paying zakat purifies and cleanses one from greed, selfishness, and arrogance. Economically, at least in theory, paying zakat will enhance economic prosperity by transferring surplus wealth to the poor. This will increase their purchasing power and, hopefully, lead to a higher demand for goods. Thus, zakat acts as a wealth-distribution mechanism to help close the gap between the rich and the poor. Ideally, it could help establish a more prosperous society.” (A Zakat Accounting Standard (ZAS) for Malaysian Companies)
209 Ruling (Hukm) on Zakah:
Zakah is fard (compulsory) for the Muslim who has the nisab. If the individual does not have the nisab, the obligation is lifted from them. The nisab is regarded as a threshold. Those who have savings at or above the nisab are obligated to pay Zakah. Nisab for Zakah on wealth (Zakat-ul-Mal): In the time of the Prophet, the nisab was fixed at twenty gold coins (dinars) or two-hundred silver coins (dirhams). Whoever possessed twenty gold coins was commanded to give ½ a gold coin (2.5% or 1/40) in Zakah. Those who had 200 silver coins were commanded to give 5 silver coins. Twenty gold coins in the time of the Prophet equated to 85 grams of gold and 200 silver coins equated to 595 grams.
210 Therefore, to find the nisab equivalent today for money, one must look to the current price of gold. There are scholars who say that the nisab should be based on the value of silver as it is lower in value and will enable an additional flow of funds to the needy. In Australia August 2010, the value of 85 grams of gold approximated AUS $ Anyone with this amount in net savings or more is liable to pay Zakah. If we were to use the value of silver to measure the nisab of money, the nisab would be approximately AUS $375. Note that the prices of gold and silver fluctuate, therefore, calculations must be based on current values. Before one calculates their savings, they must take into consideration any liabilities that must be paid. For example, each year when Uthman (the third Caliph) would announce to the people regarding Zakah, he would command the people to pay their debts first, then calculate their Zakah on what remains.
211 Administration of Zakah
According to Abul-Hasan Al-Mawardi (11th century), there are two kinds of Zakatable wealth. One refers to the hidden, such as one’s money, gold or silver. The other is the manifest wealth, such as farming produce and livestock. He mentions that the Islamic state employs experts to evaluate the manifest wealth and collect its share of Zakah. As for the hidden wealth, it can be handed over to the Zakah collectors, or it can be given by the individual on their own accord to those they know to be needy (Al-Ahkam As-Sultaniyyah: The Laws of Islamic Governance). Today a number of banks provide the service of deducting Zakah from the accounts of depositors/investors. Otherwise, it is the individuals own responsibility to give their Zakah each year to the needy or to charity organizations that specialize in the distribution of Zakah.
212 AAOIFI for example, in their accounting and auditing standards, have explained a number of recommendations regarding Zakah. They serve as guidelines for banks and businesses. Likewise the MASB (Malaysian Accounting Standard Board) has taken consideration of Zakah into their accounting and auditing guidelines for businesses. MASB has released what is known as TR i-1 Accounting for Zakat on Business. For example, the MASB states, “When an entity pays zakat on business, the amount of zakat assessed is recognized as an expense and included as a deduction from net income in the income statement of the entity. This treatment is appropriate as it reflects the discharge of a financial obligation of the entity” (MASB Technical Release i -1 Accounting for Zakat on Business).
213 In Malaysia where income is taxed, the government’s budget stipulates that Zakah is to be treated as a tax deduction. The Zakah may be deducted by the bank, then distributed through specific charity channels. According to the Shari’ah, Zakah is to be collected and redistributed within the same region. Generally the federal government does not get involved in the distribution of Zakah as it is the affair of individual states or provinces. Zakat-ul-Mal is given once per lunar year as it is based on the Islamic calendar. There is approximately 10 days difference between the solar and lunar year. As stipulated by AAOIFI, if businesses/industries want to give their Zakah in conformity with the solar year (e.g. for accounting purposes), then they must calculate % of net income for Zakah.
214 Waqf (Endowment) Waqf (plural Awqaf) refers to the specified assets that are to be used for nominated purposes. The following points will shed light on particular aspects regarding Awqaf: The specific assets given as waqf can include land, houses, mosques, farms, education centers, hospitals etc. When assets are given as waqf, they must be maintained as such. Waqfs are to be used by those who require their use. Therefore, Waqfs can be regarded as ongoing charities (Sadaqah Jaariyah). The assets may be nominated to specific persons to manage, yet, they must fulfill the specific purpose of their endowment. When a property is endowed, the property cannot be sold or given away. The building can be maintained, renovated, extended etc. The waqf may be relocated if there is a need for doing so. The asset simply becomes waqf by stipulation or pronouncement. Thereafter, it cannot be abrogated. The donor must own the assets to begin with and make clear written terms of the endowment.
215 Waqfs have served as a beneficial way of providing public services in Muslim countries over the centuries such as universities, roads, infrastructure etc. Revenue generated via the waqf should be put back into the waqf (such as management, payment of staff/contractors, development etc) or given in charity. Waqfs may also be used today under Takaful arrangements. The contributors to the waqf are covered if any losses occur. This is seen as a way of mutual help and not a means to make profit. Since waqfs are not necessarily for profit making, they are not widely discussed in contemporary Islamic finance literature. However, since waqfs provide needs and assistance for particular beneficiaries, this may limit dependence on public sector finance.
216 Inheritance (Faraa’id) and Bequests (Wasaya [plural])
When a Muslim passes away, their wealth and estate is to be shared among certain relatives as it is stipulated in the Qur’an and Sunnah. These heirs are from the immediate family such as the spouse, children and parents. In the case of no ascendants or descendants, then the brother and or sister receive a share. Under a state that does not acknowledge Islamic laws of inheritance, then a will should stipulate who the recipients of the deceased should be and their share of inheritance according to the Shari’ah. As for the Wasiyyah (Bequest, Will), the recipients must not be from the regular heirs as they are automatically included to receive their share. A hadith states, “No bequest (wasiyyah) may be made for a (standard) heir” (Ahmad, Abu Dawud, Tirmithi).
217 Wasiyyah applies to a share for those who are not immediate relatives
Wasiyyah applies to a share for those who are not immediate relatives. One may stipulate where they want a portion of their wealth to go, such as to a friend, a charity organization etc. There is a maximum limit that can be bequeathed from one’s wealth. Sa’ad (the Prophet’s Companion) asked if he can bequeath 2/3 of his wealth, the Prophet said “No”. He then asked ½? The Prophet answered “No”. He then asked, “1/3?” Thereupon the Prophet said, “Yes, one third; and even one third is too much. Indeed, O Sa’ad, it is better to leave your inheritors rich after you than to leave them as a burden, begging people…”(Bukhari, Muslim and others). When the individual passes away, (1) any remaining debts are to be paid off first, then (2) the bequeathed portion is given to the specified recipients, then (3) the inheritance (Faraa’id) is distributed to the inheritors in accordance with the Shari’ah (as mentioned in the Qur’an 4:12).
218 Other Islamic Banking Concepts Ar-Rahn (pawn broking)
Ar-Rahn (or sometimes pronounced Rahnu) is a form of collateralized borrowing. It is narrated in Bukhari that the Prophet Muhammad pawned his armor with a man in Madina for a supply of food. Islamic banks may offer this as a way of providing immediate cash-flow needs for the borrower. It is a form of micro-financing as it is usually used for small amounts of cash. The money is lent as a Qard Hassan (benevolent loan) while the collateral is kept by the creditor as an Amanah (trust) or for Wadi’ah (safekeeping).
219 Some of the regulations surrounding Ar-Rahn are:
Banks require a small safekeeping fee for the collateral. The collateral must be worth more than the borrowed amount. A tenure period must be stipulated (e.g. 6 months). The debtor must own the collateral. Whenever the term ends, the creditor can demand the money back. If the debt is repaid, the creditor must return the collateral. If the debt cannot be repaid, the creditor can deduct it from the collateral. If the collateral (e.g. gold jewelry) sells above the borrowed amount, the creditor can only retrieve the same amount of money that was lent to the debtor. Any excess must be given to the debtor. If the collateral sells below the borrowed amount and the creditor cannot recover the debt, the rest of the amount remains due from the debtor. The agreement must be written down and stipulate the term (starting and closing dates), the name of the debtor, the collateral under custody and its condition (e.g. free from defects).
220 Al-Kafalah (Guarantee, Sponsorship, Surety)
Al-Kafalah existed in the time of the Prophet. He allowed one who is deemed to be wealthy to backup another individual if the individual defaults or dies. This serves as a useful guarantee today for those involved in shipping (such as in Malaysia). In this case the bank serves as the guarantor. These banks also charge a service fee for the guarantee. Al-Wakalah (Agency, Representation, Authorization) This involves nominating another person to act as an agent (Wakeel) on one’s behalf usually for a fee. There are a number of verses in the Qur’an and hadiths that elaborate on Wakalah.
221 Al-Wakalah can be used as a contract to support or facilitate the transfer of capital.
For example, the one who seeks out to buy a machine for their company may approach the bank for its finance. The intended buyer requires the bank to purchase the goods, then when the bank has possession of the goods, will make a contract with the bank to purchase the goods BBA-Murabahah. The bank may require a wakeel in this case to purchase the goods. The wakeel could be the intended buyer as they know best what goods they will require. Therefore, they purchase the goods as an agent for the bank who then takes ownership. The bank then makes a contract to sell the goods with the mark-up in price and deferred payments.
222 The Promise (Wa’d) There is concern regarding the nature of a unilateral promise, is it legally binding or not. It is regarded as a moral obligation however there is discrepancy on whether it can be enforceable by law. The bank cannot make a contract to sell the goods before it takes possession of it. Nor can it make two contracts in one. The promise comes about when the intending buyer approaches the bank for the finance of certain merchandise. The bank only buys the goods based on a promise that the customer will buy it from the bank BBA-Murabahah. If the customer defaults in their promise, the bank will be left with the merchandise. For this reason, many scholars (such as the OIC’s Islamic Fiqh Academy) support the promise as legally binding.
223 Islamic Insurance – Takaful
Although conventional insurance dominates the scene, the major criticisms of conventional forms of insurance relate to the elements: of Maysir (chance games), Gharar (ambiguity) and Riba (interest). Takaful is the modern form of ‘Islamic insurance’. Takaful made its debut some thirty-odd years ago in Sudan and Saudi Arabia, thereafter, other countries followed suit and new models evolved. An insurance system that was practiced during the time of the Prophet Muhammad (over fourteen centuries ago) forms the basis for the modern day Takaful concept. In case of a calamity, individuals of a particular tribe sought to contribute from their own resources until adversity was relieved (Ayub 2007).
224 Islamic Insurance – Takaful (cont)
A clear example of this can be found in a hadith collected by Imam Bukhari wherein an infant died in the womb as a result of an altercation between two women. Therefore, blood money was to be paid by the paternal relatives of the accused women as compensation for the dead (unborn) child (Bukhari 1971). This combined effort of the tribe from the father’s side was known as ‘Aaqila. It is from this very concept where modern Islamic insurance (Takaful) emerged. Takaful comes from the Arabic word kafala which means to guarantee. Takaful could therefore refer to a shared responsibility, shared guarantee or mutual undertakings (Kettle 2008). Although a number of Takaful models exist, companies generally follow the same concept where participants pay a fee known as tabarru’ (donation) or musahanah (contribution). Participants thereafter share the risk or responsibility.
225 Islamic Insurance – Takaful (cont)
This differs from conventional insurance where a premium is paid to transfer the risk to a third party while in Takaful risk is shared based on the basis on mutual help and joint responsibility. Takaful companies provide cover for cars, property, medical needs, life etc. In general, the money from contributors is placed in a pool that is utilized for investment, paying the Takaful operator and most importantly, to cover the losses of contributors if they make a claim.
226 Popular Wakalah-Mudarabah Takaful Model
This model is a combination of Wakalah and Mudarabah. Wakalah is used for the Takaful operator, while the profits made via Mudarabah are shared between the operator/shareholders and the participants/contributors according to a fixed ratio as cash dividends or distributions. The Hybrid model, with the combination of Wakalah and Mudarabah, gives the agency the incentive to invest in a good way as the profits are shared between contributors and shareholders. Other models, like modified Mudarabah one, distributes surplus and profit (combined) amongst shareholders and contributors but this criticised as not being shariah compliant because contributions do not form part of Mudarib’s investment capital.
228 ISLAMIC BANKING - FIN5BNK
Topic 11: Global Islamic Finance Industry The performance of Islamic Banking Practices Middle East Case Pakistan Case Malaysian Case Indonesia Singapore Sudan FACULTY OF LAW AND MANAGEMENT SCHOOL OF ECONOMICS AND FINANCE
229 The performance of Islamic Banking practices
Islamic banking and finance is the fastest growing industry in the financial world. It has been experiencing exponential growth in three regions of the world namely the Middle East, South Asia and Southeast Asia. Each nation appears to have its own opinion on how to administer certain Islamic financial products. This is hampering efforts for a globalized system of Islamic banks.
230 The performance of Islamic Banking practices (cont)
There are several reasons for these differences. The main reason is because the application of the theoretical aspects of the Islamic banking system differs from country to country, and under different economic conditions and social environments. Another reason for the differences is due to the different math-habs (Schools of religious Law). There are four main math-habs, namely Hanafi, Shafi’i, Maliki and Hanbali. These math-habs play an important role in developing Islamic Jurisprudence in countries around the world.
231 Middle East Case
232 Middle East Case The practice of IBF acquired significant shape and momentum by the end of 1970s due to increases in the general economic prosperity of the Middle Eastern countries. The Middle Eastern Islamic financial institutions (IFIs) received increasing socio-political-economic support for their growth and prosperity. Many reputable Islamic banks came into being, including the Nasser Social Bank Cairo ( ), Islamic Development Bank (1975), Dubai Islamic Bank (1975), Kuwait Finance House (1977), Faisal Islamic Bank of Sudan (1977) and Dar Al-Maal Al-Islami (1980)
233 Middle East Case (cont)
The Middle Eastern Economies are highly promising, featuring a stable currency and lower interest rates and inflation over the years. Having gone through radical restructuring in recent times, Middle Eastern markets are now more regulated, transparent and integrated at both the regional and international levels. The Middle Eastern regions also enjoy greater political stability, law and order and are therefore emerging as a hot spot for International business, finance and investment.
234 Middle East Case (cont)
Bahrain is the biggest hub of IBF affairs worldwide. The country hosts 33 Islamic banks and 26 Takaful (insurance), and three re-takaful companies which operate at both the domestic and international level. Bahrain is also a hot spot for international trading in Sukuk (certificates), Islamic equity funds, mutual funds and other investment instruments. Most of the Islamic institutions such as AAOIFI, IIFM, IIRA are located in Bahrain, with the country also planning to establish its own Sukuk Exchange Centre in the future.
235 Middle East Case (cont)
Iran is embarking upon a nationwide IBF practice after the Islamic revolution in In the first two decades, Iranian IBF practice remains highly centralized and isolated from both the Islamic and conventional markets. The Iranian government is keen on increasing its interactions with Islamic banks and financial institutions, as well as the conventional financial market worldwide. Jordan’s Islamic bank has been the pioneer of IBF since It held 10.1% of the total investment of the Jordanian banking industry in 2006.
236 Middle East Case (cont)
Kuwait also hosts the largest number of IFI and ranks third in term of Islamic banking assets, which are worth US$22.7 billion (Khojah2006). The country hosts the oldest and biggest Islamic bank, with Kuwait finance House (KFH) established in 1977. In Lebanon during the year 2006, four new Islamic banks emerged, namely BLOM Development Bank, Arab Finance House, Al-Baraka Bank, and Lebanon and Credit Libanie. The Central bank of Lebanon has a plan to introduce sukuk and takaful services in its market over the next couple of years.
237 Middle East Case (cont)
Qatar is another hot spot for IBF in the Middle East. There are four major Islamic banks in Qatar, namely Qatar Islamic bank (1983), Qatar International Islamic bank (1991), Doha Islamic Bank (2006) and Al Rayan Bank (2006). Other IFIs include; First Finance company, Investment House, Al-Jazeera Islamic Company and Islamic Financial Securities which mainly offers Islamic retail products and brokerage services to Muslim clientele. Qatar Islamic Insurance company has emerged as one of the leading insurance service providers in the country.
238 Middle East Case (cont)
IBF activities have achieved a rapid growth in Saudi Arabia over recent years. There are two major IBF players in Saudi Arabia, namely Al-Rajhi Banking and investment corporation and Bank Al—Jazera. Conventional banks are also serving the IBF clientele by establishing their own Islamic window and subsidiaries. Other IBF includes Al Bilad, Amlak Finance, and Dallalah Al Baraka SAAB Takaful Company. In July 2006 SABIC signed under a written agreement for its Sukuk issuance for a total amount of SAR 3billion.
239 Middle East Case (cont)
The entry of Syria into IBF club is amongthe most recent developments in the Middle East. By the end 2006 the Syrian government permitted three Islamic banks namely Al-Sham bank, Saudi Dalat, Al-Baraka Bank and Syrian International Islamic bank to launch their operation in the country. Moreover the other Takaful companies, namely Aqeelah Insurance company, Al-Nour Insurance company and Syria-Qatari company were established as well and are ready to operate in the Syrian market after receiving their licenses from the Syrian Insurance supervision Committee.
240 Pakistan Case The government of Pakistan embarked upon the project of transforming the banking and finance sector on Islamic lines in the early 1980s. It assigned this task to the Ministry of Finance. The Ministry then advised the State Bank of Pakistan (SBP) to take necessary steps to evolve the IBF practice on the basis of the 1980 CII Report.
241 Pakistan Case (cont) The Superior Task Force suggested the overhauling of the banking laws that contained the provision of interest and promulgating new laws to cover IBF practice. PBC made the following major changes to conventional banking laws and systems to provide the required legal and regulatory framework for the IBF system. The 1962 Banking Companies Ordinance (BCO) give discretionary powers to the SBP for regulating the banking and finance sector of Pakistan. The 1962 BCO was amended to allow banks to perform manufacturing and trading activities under the systems of PLS, mark-up in price (bai muajjal/murabaha), leasing and hire-purchase.
242 Pakistan Case (cont) The SBP took the first step towards Islamization by directing all banking institutions to open PLS counters in 7,000 domestic branches across the country from January 1981. The SBP allowed banks to invest PLS funds to finance interest-free trading. The foreign banks working in Pakistan also showed keen interest in adopting the new system. They sent their top officials to overseas Islamic banks for training and better understanding of the IBF practice
243 Malaysian Case Malaysia is the second largest hub of IBF. In 1983, the Malaysian government established the first Islamic bank - Bank Islam Malaysia Berhad - and then introduced IBF in the country under a duel system by 1993. Presently there are 12 fully-dedicated Islamic banks, 35 commercial banks, 10 merchant banks and 5 development banks in Malaysia which offer IBF products and services.
244 Malaysian Case (cont) The Malaysian government has devised a roadmap targeting a 20 percent share of the total banking industry for Islamic banking by 2010. The Malaysian government has established separate legal, tax and regulatory frameworks for IFIs. The country is the pioneer of Islamic capital market and hosts the first international Sukuk centre.
245 Indonesia Indonesia, the biggest Muslim populous country of the world, embarked upon the IBF venture by establishing Bank Muamalat Indonesia in 1992. Presently IBF assets represent 1.8 percent the total Indonesian banking assets. Bank Indonesia has formulated a 10-year roadmap for growth and development of IBF operations up to 6 percent of the total Indonesian banking industry by 2011.
246 Singapore Singapore has been actively involved in promoting IBF operations in Southeast Asia since The country aims to become an international trading centre in Islamic property funds, hedge funds, Sukuks and wealth management. The Singapore Stock Exchange has listed Shariah-compliant indices, namely Lion 30 and FTSE-SGX Asia Shariah 100 Index. The Monetary Authority of Singapore is committed to introduce changes to its tax and regulatory systems to facilitate proper growth and development of IBF in the country.
247 Sudan The first Islamic bank in the North African region was in Sudan.
Faisal Islamic Bank Sudan was established in 1977. The government of Sudan passed the Islamic Shariah banking act in 1984, which required the whole banking and finance sector of Sudan to be transformed onto Islamic lines by July Prolonged political and economic turmoil in the country however has prevented IBF from growing and prospering. Since January 2005, IBF practices has been revived in Sudan under a dual banking system. There are four Islamic banks in northern Sudan.