07 Islamic Banking - Financing - Part 2 imp.pptx

07 Islamic Banking - Financing - Part 2 imp

1. ISF 1101 – Foundation of Islamic Finance Islamic Banking Financing Products Part 2

2. Outline Salam Istisna ’ Mudarabah & Musharakah Financing Possible Reasons for Lack of Equity-based Financing Implementation Addressing Apprehension Towards Equity-Based Financing

3. Salam & Istisna’ – Exceptional Sale One basic condition for the validity of sale is that the commodity must be in ownership and physical possession of seller Commodity must be in existence Seller must own commodity Seller must have physical possession of commodity Two exceptions are made to this general Shari’ah principle – salam and istisna’

4. Salam Contract Sale whereby the seller undertakes to supply some specific goods to buyer at a future date in exchange for advanced payment made at spot At the time of the Prophet, this sale was intended to help small farmers who lack financial resources to grow crops Salam beneficial to seller because price is received in advance Salam beneficial to buyer because typically, the salam price is lower than the spot price The permissibility of salam is made exceptionally, subject to the strict observance of certain conditions

5. Conditions of Salam Price must be paid in full at spot Deferment of payment will entail sale of debt for debt Purpose of salam is to fulfill financing need of seller Imam Malik allows seller to voluntarily give concession of 2 or 3 days to make payment Salam commodity must be capable of being specified exactly in quantity and quality Salam cannot be for a particular commodity with specified origin E.g. product of a particular farm or field The following must be unambiguously and fully specified and agreed upon Quality and quantity of commodity Exact date, place and mode of delivery Salam cannot be applied to ribawi items which must be exchanged at spot E.g. exchange of gold and silver

6. Salam as Mode of Financing Salam suitable for agricultural financing Difference between salam price and market spot price – source of profit for bank Problem – banks will receive commodities, not money Banks are accustomed to dealing with only money, not equipped with competency to trade in commodities Key point – concept of financial institutions dealing with only money is foreign to the Shari’ah To earn a halal profit, banks have to deal with commodities in one way or the other Paradigm shift required A number of options to operationalize salam are available or have been used Parallel salam with third party Obtain promise to purchase from third party Parallel salam with original seller (buy-back)

7. Parallel Salam with Third Party Bank Commodity Producer Commodity Buyer Deliver goods in 6 months (July 2014) Pay $10,000 immediately (Jan 2014) Deliver goods in 3 months (July 2014) Pay $11,000 immediately (Apr 2014) First salam (Jan 2014) Second salam (Apr 2014)

8. Parallel Salam with Third Party (2) Given that the period of the second s alam is shorter, the salam price of the second salam is typically higher than the salam price of the first salam , hence the source of profit for the bank Bank engages in two salam contracts, one as buyer and the other as seller These two contracts must be independent of each other If commodity producer does not deliver goods as per first salam contract, bank must still deliver goods to commodity buyer as per second salam contract

9. Istisna’ Contract Contract whereby purchaser orders a manufacturer to manufacture a specific commodity Price and necessary specifications of the commodity are determined and agreed upfront Before work starts, any party may cancel the contract although there is moral obligation on the manufacturer to manufacture the commodity After work has started, the contract cannot be cancelled unilaterally Payment mode is flexible as long as mutually agreed Can be in advance, progressive with stages of work completed, upon delivery or deferred for periods after delivery Required materials sourced by the manufacturer Otherwise becomes contract of ijarah Time of delivery need not be fixed However, purchaser may fix maximum time for delivery, beyond which Purchaser not bound to accept goods and pay the price Financial penalty imposed for late delivery

10. Istisna’ as Mode of Financing Istisna’ can be used for the financing of assets that require construction One obvious application is in financing the purchase of real estate from property developers on the concept of “sell and build” Unfortunately, much of Islamic home financing have inappropriately used contracts like BBA and murabahah when istisna’ should have been used As with salam , a parallel istisna’ arrangement is used given that the bank has no competencies to build houses The bank engages a third party (contractor) It is essential that the two istisna’ contracts are independent of each other In the event that the contractor fails to deliver or delivers but with defects, the bank must be liable to the customer The bank has contracted to deliver the house to the customer as per stipulated and agreed specifications and must do so regardless of whether the contractor delivers

11. Parallel Istisna’ with Third Party Bank Bank Customer Developer/ Contractor Deferred payment schedule To deliver house as per specifications To deliver house as per specifications First istisna’ Second istisna’ Progressive payment

12. Comparison of Salam and Istisna’ Salam Istisna’ Delivery of goods In the future In the future Payment of price Spot Flexible (spot, progressive, on delivery, in installments after delivery, or some combination) Type of goods Homogenous commodities with a ready market Assets requiring construction or tailor-made manufacturing Suitable sector Agriculture Construction, small batch manufacturing

13. Mudarabah An arrangement whereby the owner of some property ( rabbal mal ) gives a specified amount of capital to another person ( mudarib ) who is to act as the entrepreneur to trade with the capital Profit of the venture will be shared between the two parties according to a mutually agreed ratio Profit sharing cannot be a fixed amount or a fixed percentage of capital contribution Profit sharing must be a percentage of the profit Mudarib cannot claim salary or fee other than daily expenses of food Losses will be borne by the rabbal mal as the financier The mudarib bears the frustration of fruitless effort Exception – if mudarib negligent or dishonest he has to bear losses Types of mudarabah Unlimited mandate ( mudarabah mutlaqah ) Limited mandate ( mudarabah muqayyadah ) Rabbal-mal cannot participate in management of the business [general opinion of jurists] Exception [Hanbali] : rabbal-mal can participate Is a stakeholder in the business Might have valuable contribution that is mutually beneficial

14. Musharakah An arrangement whereby two or more persons contribute to the capital with their property for the purpose of trading with the joint capital, the profit of which, shall be shared among the partners Salient features of musharakah Profit to be shared according to mutually agreed ratio Losses to be borne strictly according to ratio of capital contribution All partners have the right to participate in the management of the business or trade Difference of opinion amongst fiqh schools on what constitutes acceptable capital Money, physical commodities, intangible assets, creditworthiness

15. Mudarabah & Musharakah Financing Basic principles Cannot entail mere advancing of money Must involve equity or participation in the business Financier must share in any losses incurred by the business, according to proportion of capital investment Profits can be distributed in any mutually agreed ratio Some applications Project financing Financing from inception of the business Single transaction financing Export or import financing Replace functionality of conventional letter of credit (LC) Working capital financing Profit determination on the basis of constructive liquidation, with the aid of accounting methods Asset financing For e.g., musharakah mutanaqisah

16. Some Issues in Mudarabah and Musharakah Financing Securitization of mudarabah & musharakah Mudarabah / musharakah certificate represents proportionate ownership in assets of the business concern / partnership, and can be a negotiable instrument Issue – when mudarabah / musharakah assets are substantially in liquid form (cash or receivables), can the certificate be traded? Sharing of gross profit only When mudarabah / musharakah financing affects only part of a business concern Fixed assets, indirect expenses and overheads not exclusively attributable to the mudarabah / musharakah venture Provide higher percentage of profit to compensate

17. Role of Equity-based Financing in Islamic Economics Mudarabah and musharakah as financing instruments are the earliest to be proposed in literature on Islamic banking Some scholars argue that mudarabah and musharakah are the principal alternatives for replacing interest-bearing transactions That murabahah , ijarah and BBA are derivatives and complements of the primary instruments ( mudarabah and musharakah ) These instruments should be restricted to cases where mudarabah and musharakah are not applicable Use of equity-based financing instruments can promote distributive justice To alleviate concentration of wealth and income disparities via equitable reallocation of productive resources Islamic concept of development includes moral, spiritual and material aspects Money and property are social tools to achieve social good Bank’s objective should be maximization of social benefit not purely profit maximization

18. Possible Reasons for Lack of Equity-based Financing Implementation Risk Mismatch with Sources of Funds Two-tier mudarabah remains a theoretical model Bank Mudarabah investment account holder Bank Customer (Entrepreneur) Rabbal-mal Rabbal-mal Mudarib Mudarib First-tier mudarabah ( deposits) Second-tier mudarabah (financing) Due to the following two factors, mudarabah deposits are relatively much less risky when compared to mudarabah financing Third party guarantee of deposits (BNM / PIDM) Expectations of depositors

19. Focus on credit risk General risk (market risk / systematic risk) Uncontrollable, cannot be avoided (e.g. structural changes in the economy, changes in consumer spending preferences) Specific risk (issuer risk / non-systematic risk / credit risk) Can be eliminated via risk management methods, tools and instruments Majority of financing products are fixed return arrangements Sale contracts without ownership risk on the part of the bank Bank only exposed to specific risk (credit risk) Because contemporary Islamic banking is credit-driven, focus on risk management issues will always revolve around mitigating credit and default risk Products prone to market risks (such as mudarabah , musharakah ) will be deemed not viable to the banking business In addition, skills, knowledge and experience of banking personnel and management In the area of credit risk management, not market risk management Possible Reasons for Lack of Equity-based Financing Implementation (2)

20. Lack of political will Leadership or authorities fail to appreciate , understand and/or accept the role of equity-based financing in an Islamic economy Concentration of wealth arguably leads to accumulation of political power and influence One of the roles of equity-based instruments such as mudarabah is to reduce wealth disparities As such, it would be in the best interest of the affluent to resist widespread mudarabah financing via wielding its political influence As banking and finance is a function of the economy that a government typically regulates, political will is required “Bankers will think like bankers” No precedence of Islamic banks Current ‘Islamic’ bankers falling back on years of conventional banking practice and experience Perhaps a different pool of people required in the development and implementation of banking required E.g. venture capitalists Possible Reasons for Lack of Equity-based Financing Implementation (3)

21. Moral hazard Actions of mudarib reflecting inherent conflict of interest Luxurious ‘business’ expenditures Related party transactions Non- or under- declaration of profits Lack of honest and trustworthy entrepreneurs Mudarabah is a trust-based relationship Lack of capable entrepreneurs Information asymmetry Possible Reasons for Lack of Equity-based Financing Implementation (4)

22. Shortcomings in Infrastructure and Support Systems Banking IT systems designed for conventional banking Transaction processing systems (TPS), customer relationship management (CRM) systems, enterprise resource planning (ERP) systems, data mining and warehousing software Accounting and auditing Lack of standards Lack of qualified accountants and auditors Lack of legal framework and environment Arbitration and resolve of disputes Practical difficulties in objectively identifying negligence on the part of the mudarib Lack of equal tax treatment for equity-based financing Equity financing at competitive disadvantage vis-à-vis conventional debt financing alternative Lack of exit mechanisms Possible Reasons for Lack of Equity-based Financing Implementation (5)

23. Addressing Apprehension Towards Equity-Based Financing Risk of Loss Argument Financiers will bear losses which will be passed on to depositors Depositors will withdraw deposits from banks Suggested approach Prudent and diligent analysis of business to which equity financing is made Diversification of equity financing portfolio Promotion of paradigm shift That legitimate profit-taking is only with the undertaking of risk Islamic financial institution cannot merely deal with money exchanges No complete separation between financing sector and the trade and industry sector

24. Addressing Apprehension Towards Equity-Based Financing (2) Dishonesty Argument Dishonest entrepreneurs will exploit equity-based instruments by under-declaring profits Suggested approach Proper controls , monitoring and auditing Punitive measures against transgressors legislated to deter dishonesty Physical and monetary penalties Defamation and denial of further financing facility

25. Addressing Apprehension Towards Equity-Based Financing (3) Trade or business secrets Argument Entrepreneur or business operator has to disclose business secrets, which form the business’s competitive advantage, to the bank Suggested approach Confidentiality agreement between the entrepreneur and the bank Severe penalties in the event of breach of that contract to maintain secrecy

26. Addressing Apprehension Towards Equity-Based Financing (4) Unwillingness to Share Profits Argument Profitability dilemma Profitable or capable entrepreneurs not willing to share profits with bank, prefer conventional loans because returns to entrepreneur would be higher Less competent entrepreneurs more than willing to share business with bank because downside risk minimized Hence banks will end up financing unprofitable ventures run by less competent entrepreneurs Suggested approach Moral persuasion – that riba -based financing is sinful Gradual but eventual phasing out of interest-based lending Making (risk-sharing) equity financing the only way to obtain financing

27. Discussion – Profit Sharing for Consumption Financing? While profit sharing modes of financing like mudarabah and musharakah may be suitable for production financing, can such a concept be applied to consumption financing? The profit element is absent in consumption financing A possible approach Profit sharing takes place between the financial institution and the provider of consumption goods/services The provider of consumption goods/services sell on credit or deferred payment terms

28. Other Islamic Banking Financing Products & Services The nature of this course is introductory or foundational We are not able to cover all areas of Islamic banking Some topics left out for other courses Financing for businesses/corporate clients Murabahah , ijarah , working capital financing, etc. Issues of bay’ al- dayn and bank guarantees International trade instruments (e.g., letter of credit) Leasing issues – operational versus financial lease Investment banking Advisory, security issuance, underwriting, mergers & acquisitions, syndicated financing, etc.