IFB product and service fundamentals basics

Basics about IFB

1. BASICS OF INTEREST FREE FINANCIAL SERVICES

2. Getting to Know Each Other Name Your Branch What do you Expect from this Training

3. Objective of the Training At the end of this course participants :- Enable to understand what IFB mean and its fundamental principles Understand Sharia based contracts Differentiate IFB from Conventional financial services; Identify Interest free banking products/services

4. Major contents of this course

5. Interest free finance background and basic principles

6. 1 Definition 2 Operating modalities 3 Sharia Financing Principles (Mu’amelat) 4 Historical Developments 5 Sharia or Islamic Law 6 Islamic financial contracts Outline

7. Quiz Define Interest Free Banking/Finance

8. Definition Interest free finance usually referred to us Islamic finance is commonly defined as A financial system operates according to Islamic law i.e. sharia’. Just like conventional financial system, interest free finance features banks, insurance companies, MFIs, capital markets and the likes. NBE Directive sbb-72-19 “Interest free banking business” refers to a banking business in which mobilizing or advancing funds is undertaken in a manner consistent with Islamic law or Sharia principles.

9. Sharia or Islamic law Devine principles governing the way of life Basic parts Iman – believe in the unseen Ibada – Religious rituals Mu’amelat – economic transactions Mu’asherah – Social interaction Akhlaq – Manner or behaviour

10. Source of Islamic law Primary sources QURAN: Direct revelation from Allah to the prophet Mohammed (PBUH) Sunnah: the sayings and deeds of the prophet Mohammed (PBUH) Secondary sources Ijma General agreement among Islamic scholars about religious matter Qiyas - Analogy Qualified sharia scholars consider rulings of previous cases and apply them to new cases of similar sort.

11. Sharia Compliance Parameters AAOIFI IFSB National Regulatory Framework Institution/Bank/ Sharia Advisory Committee Quran Sunna Ijmma Qiyas

12. Basic Principles of ‘Mu’amelat’… Based mainly on the following major prohibitions The prohibition of ‘riba’ (or interest) in financial transactions The exclusion of ‘gharar’ – contractual uncertainty The avoidance of Maysir or Qimar – gambling Avoiding investment in prohibited business

13. Quiz What do you think about the main reason of prohibiting ‘interest’, in most of the religions?

14. Debt-Laden Nigeria We begin by quoting President Obasanjo who said these words after the G8 summit in Okinawa in 2000: "All that we had borrowed up to 1985 or 1986 was around $5 billion and we have paid about $16 billion yet we are still being told that we owe about $28 billion. That $28 billion came about because of the injustice in the foreign creditors' interest rates. If you ask me what is the worst thing in the world, I will say it is compound interest.“ It seems unbelievable but, sadly, it’s typical. Developing countries start off with relatively small loans and remain saddled with huge amounts of growing debt for generations. And remember, this could be Nigeria, or any other poor country

15. Nigeria Cont.… How did borrowing just $5 billion end up in having to pay $44 billion in total? Let's open up a spreadsheet and find out. For the sake of simplicity we’ll just grow $5 billion into $44 billion between 1985 and 2000 and see what interest rate we get. It must've been a very high interest rate to get to $44 billion in such a short period of time. So let’s start off with 40% per annum then Group Exercise!

16. Nigeria Cont.… Table 1: $5 billion growing at 40% Year Debt 1985 5,000,000,000.00 1986 7,000,000,000.00 1987 9,800,000,000.00 1988 -- 1997 283,469,561,876.48 1998 396,857,386,627.07 1999 555,600,341,277.90 2000 777,840,477,789.06

17. Nigeria Cont.… Table 2: $5 billion growing at 30% Year Debt 1985 5,000,000,000.00 1986 6,500,000,000.00 1987 8,450,000,000.00 1988 -- 1997 116,490,425,612.41 1998 151,437,553,296.13 1999 196,868,819,284.96 2000 255,929,465,070.45

18. Nigeria Cont.… Table 2: $5 billion growing at 15.6% Year Debt 1985 5,000,000,000.00 1986 5,780,000,000.00 1987 6,681,680,000.00 1988 -- 1997 28,475,018,397.79 1998 32,917,121,267.85 1999 38,052,192,185.63 2000 43,988,334,166.59

19. Nigeria Cont.… It turns out that to grow $5 billion into $44 billion takes an interest rate of only 15.6%. Now on the face of it around 15% doesn't sound exorbitant. It doesn't seem unfair, and technically it isn't even illegal according to international law. In fact, we personally know of banks that charge high-risk credits upwards of 30% interest rates. But every day numerous countries find themselves in the same predicament as Nigeria. UNICEF estimates that over half a million children under the age of five die each year around the world as a result of the debt crisis. But as we’ve seen, it’s not the debt that’s the problem. It’s the compounding interest.

20. Now how would Islamic finance handle things differently? Using the $5 billion example, Islamic banks could provide $5 billion of financing for infrastructure, literacy, healthcare, or sanitation programs, to name a few. An Islamic bank could have arranged for the $4 billion construction of a natural gas pipeline and delivered it to Nigeria for $5 billion using an Istisna. Or taken an equity stake in a highway project and shared in profits and losses using Musharakah or Mudarabah. Or purchased commodities and sold them at a premium using a Murabaha. These names may sound new to you, but as we explain them in our training modules, they’re much like conventional equity, trade, and lease-based

21. Prohibition of Riba or interest

22. Prohibition of “Gharar ” Transparency in transactions Making informed decisions Avoiding Mischiefs Speculation Hoarding Contractual conditions Entering into transactions with clear expectations of outcomes

23. Prohibition of Qimar or Meysir

24. Prohibiting ‘haram’ transactions

25. Quiz When do you think IF financial services came to existence?

26. Historical developments Doing business in accordance with Islamic finance principles has a history associated with the coming of the prophet Muhammed (PBUH) – over 1400 years. Basic known transaction of such sort at those days includes Mudarabah – joint venture investment Salam – forward delivery contract for agricultural products 7 th to 9 th century Institutions known as Dhiwan Al Jahbidia has been providing sharia-based wealth management service Management of deposit Fund transfer (including Sak – certificate of deposit) Provision of interest free loans Payment services Exchange of currency

27. Historic developments … 11 th to 13 th century – diversification of Mudarabah to European countries 13 th century onwards– diversification of European countries to other parts of the world, breaking down of the Islamic central government, emergence of various religious sects and similar other factors forced the decline of institutions working with Islamic principles

28. Historic developments … 20 th Century 1950’s and 1960’s – Mudarabah investment gets back to the market – in Egypt 1970’s – innovative trading products like murabaha has been introduced 1980’s and onwards – obtained wide range of acceptance standard setting organs emerged More products as Ijarah, Istisna and Salam has been introduced

29. Current global status Fast growing industry An average growth rate of 15% to 20% per annum Islamic Finance asset of about 4 trillion US dollars, 70% goes to Islamic banking It is being considered as an important mechanism of financial inclusion Obtaining international acceptance Standard setting organs – trying to promote uniform practice; like AAOIFI IFSB

30. Local developments

31. Local developments… 24 Banks 20 window services 4 Full-fledged service Permission of interest free Microfinance operation Permission of Takaful operation

32. Local developments… FY ending Number of accounts (in millions) Value of deposit ( in millions of Birr) Growth Rate Jun-18 2.26 23,162.83   Jun-19 3.77 40,690.06 76% Jun-20 5.65 57,748.23 42% Jun-21 8.94 97,664.41 69% Jun-22 11.92 131,972.76 35% Jun-23 16.86 186,375.00 41% Jun-24 22.9 232,732.00 25% Average 48%

33. Local developments… FY ending Value of Outstanding Financing (in millions) Growth Rate F/D ratio Jun-18 3,388.18   14.6% Jun-19 5,839.01 72% 14.3% Jun-20 13,383.45 129% 23.2% Jun-21 25,876.00 93% 26.5% Jun-22 42,341.00 64% 32.1% Jun-23 72,732.00 72% 39.0% Jun-24 106,432.00 46.3% 45.7% Average 79.3%  

34. Operating modalities Full-fledged Islamic financial service Fully owned subsidiaries of conventional financial services Dedicated branches Window service in conventional branches

35. Islamic contract law To avoid possibility of gharar financial transactions are mainly required to be done via written contracts with clear terms and conditions Contract –aqd A valid contract is always legally binding and enforceable A valid contract requires existence of six specific elements; an offerer, an offeree, an offer, an acceptance, subject matter and consideration (price)

36. Contracts of safety and security Wadia (safeguarding contract) In such contract a property owner gives his property to another party for purpose of safeguarding In Islamic banks significant part of checking and saving accounts are based on Wadia contract To utilize the fund the depositor has to provide permission The permission shall be stressed usage on Sharia compliant businesses Hiwala (transfer contract or remittance) In such contracts debt is transferred from one debtor to another After the debt is transferred to the second debtor, the first debtor is free from obligation Used for money remittance services in Islamic banks

37. Contracts of safety and security… Kafala A third party accepts an existing obligation and becomes responsible for fulfilling someone’s liability In principle income cannot be generated from a Kafalah contract An administrative fee may be charged by the third party to assume the obligation Used in Islamic banks to issue guarantees: bid bond, performance bond, advance payment… Rahn (collateral or pledge contract) Pledging a property against an obligation is permitted by Sharia

38. Contract of agency - wakalah The Arabic word wakalah means representing someone A wakil is an agent who acts on behalf of that someone A wakalah contract can facilitate many trading transactions In a wakalah contract the wakil acts only as dictated by the principal Do not have the freedom to act by his own

39. Contract of exchange - Sarf Sarf refers to exchange of one currency with another or similar currency Rate of exchange should be agreed between the parties on the spot Engaging in forward exchange contracts is prohibited The exchange should be hand to hand Possession of full amount in both sides Physical or constructive possession Same currency exchange should be with equal units of value

40. Financing Contracts

41. Characteristic Interest Free Banking System Conventional Banking Business framework Functions and operating modes are based on Shari’a , and Islamic banks must ensure that all business activities are in compliance with Shari’a requirements. Functions and operating modes are based on secular principles, not religious laws or guidelines. Interest charging Financing is not interest ( riba ) oriented and should be based on risk-and-reward sharing. Financing is interest oriented, and a fixed or variable interest rate is charged for the use of money. Interest on deposits Account holders do not receive interest (riba) but may share risk and rewards of investments made by the Islamic bank. Depositors receive interest and a guarantee of principal repayment. Risk sharing in equity financing Islamic banks offer equity financing with risk sharing for a project or venture. Losses are shared on the basis of the equity participation, whereas profit is shared on the basis of a pre-agreed ratio. Risk sharing is not generally offered but is available through venture capital firms and investment banks, which may also participate in management. Restrictions Islamic banks are allowed to participate only in economic activities that are Shari’a compliant. For example, banks cannot finance a business that involves selling pork or alcohol. Conventional banks may finance any lawful product or service. Penalty on default Islamic banks are not allowed to charge penalties for their enrichment. They may, however, allow imposition of default or late payment .Penalties may be donated to a charity Conventional banks normally charge additional Interest in case of late payments or defaults. Avoidance of gharar Transactions with elements of gambling or speculation are discouraged or forbidden. Speculative investments are allowed. Customer relationships The status of an Islamic bank in relation to its clients is that of partner and investor. The status of a conventional bank in relation to its clients is one of creditor and debtor. Shari’a supervisory board Each Islamic bank must have a supervisory board to ensure that all its business activities are in line with Shari’a requirements. Conventional banks have no such requirement. Statutory requirements An Islamic bank must be in compliance with the statutory requirements of the National bank of the country in which it operates and also with Shari’a guidelines. A conventional bank must be in compliance with the statutory requirements of the central bank of the country in which it operates and in some places, the banking laws of state or other localities. Sharia contracts Trade-based Contracts Lease-based Contracts Equity-based Contracts Lending Money. Deposit-taking Contracts Wadiah , Amanah, Qard Mudarabah Murabahah, Istisna, Salam Ijarah Mudarabah, Musharakah Hawalah /Money transfer/, Wakalah /Agency/, Kafala /Guarantee/, Sarf /Forex / Qard Al Hassan Fee-based Contracts IFB Contracts/Aqd/

42. Summary – On basic principles

43. Any Question 43 ?

44. Interest free banking Products

45. Outline 1 Rationale to launch IFB services 2 IFB fee based services 3 IFB Deposit Products: Principles & Features 4 IFB Financing Products: Principles & Features 5 Basic requirements to IFB service

46. What were the motivational factors to start IFB service in Ethiopia?

47. Rationale to Launch IFB in Ethiopia Promoting financial inclusion; The existence of interest believed to be major cause for low level of financial inclusion; The existence of large potential; Enabling environment - Issuance of Proclamation No. 592/2008 and NBE Directive SBB 51/2011;

48. Rationale to Launch IFB in Ethiopia … Muslim scholars endorsement & positive response; Proactive response of the existing commercial banks; The existence of tailor-made facilities; Helps to mobilize new customers & retain the existing one; IFB is increasingly common Globally.

49. Brainstorming 49

50. Characteristic Interest Free Banking System Conventional Banking Business framework Functions and operating modes are based on Shari’a , and Islamic banks must ensure that all business activities are in compliance with Shari’a requirements. Functions and operating modes are based on secular principles, not religious laws or guidelines. Interest charging Financing is not interest ( riba ) oriented and should be based on risk-and-reward sharing. Financing is interest oriented, and a fixed or variable interest rate is charged for the use of money. Interest on deposits Account holders do not receive interest (riba) but may share risk and rewards of investments made by the Islamic bank. Depositors receive interest and a guarantee of principal repayment. Risk sharing in equity financing Islamic banks offer equity financing with risk sharing for a project or venture. Losses are shared on the basis of the equity participation, whereas profit is shared on the basis of a pre-agreed ratio. Risk sharing is not generally offered but is available through venture capital firms and investment banks, which may also participate in management. Restrictions Islamic banks are allowed to participate only in economic activities that are Shari’a compliant. For example, banks cannot finance a business that involves selling pork or alcohol. Conventional banks may finance any lawful product or service. Penalty on default Islamic banks are not allowed to charge penalties for their enrichment. They may, however, allow imposition of default or late payment .Penalties may be donated to a charity Conventional banks normally charge additional Interest in case of late payments or defaults. Avoidance of gharar Transactions with elements of gambling or speculation are discouraged or forbidden. Speculative investments are allowed. Customer relationships The status of an Islamic bank in relation to its clients is that of partner and investor. The status of a conventional bank in relation to its clients is one of creditor and debtor. Shari’a supervisory board Each Islamic bank must have a supervisory board to ensure that all its business activities are in line with Shari’a requirements. Conventional banks have no such requirement. Statutory requirements An Islamic bank must be in compliance with the statutory requirements of the National bank of the country in which it operates and also with Shari’a guidelines. A conventional bank must be in compliance with the statutory requirements of the central bank of the country in which it operates and in some places, the banking laws of state or other localities. Basic Requirements to IFB Service Ensuring Shariah compliance of IFB as per international standards and the NBE directive; Establishing the Shariah Advisory Board/Committee; Establishing a separate Ledger and Financial Reports; Keeping all data separate; Ensuring segregation of activities from the conventional banking.

51. Characteristic Interest Free Banking System Conventional Banking Business framework Functions and operating modes are based on Shari’a , and Islamic banks must ensure that all business activities are in compliance with Shari’a requirements. Functions and operating modes are based on secular principles, not religious laws or guidelines. Interest charging Financing is not interest ( riba ) oriented and should be based on risk-and-reward sharing. Financing is interest oriented, and a fixed or variable interest rate is charged for the use of money. Interest on deposits Account holders do not receive interest (riba) but may share risk and rewards of investments made by the Islamic bank. Depositors receive interest and a guarantee of principal repayment. Risk sharing in equity financing Islamic banks offer equity financing with risk sharing for a project or venture. Losses are shared on the basis of the equity participation, whereas profit is shared on the basis of a pre-agreed ratio. Risk sharing is not generally offered but is available through venture capital firms and investment banks, which may also participate in management. Restrictions Islamic banks are allowed to participate only in economic activities that are Shari’a compliant. For example, banks cannot finance a business that involves selling pork or alcohol. Conventional banks may finance any lawful product or service. Penalty on default Islamic banks are not allowed to charge penalties for their enrichment. They may, however, allow imposition of default or late payment .Penalties may be donated to a charity Conventional banks normally charge additional Interest in case of late payments or defaults. Avoidance of gharar Transactions with elements of gambling or speculation are discouraged or forbidden. Speculative investments are allowed. Customer relationships The status of an Islamic bank in relation to its clients is that of partner and investor. The status of a conventional bank in relation to its clients is one of creditor and debtor. Shari’a supervisory board Each Islamic bank must have a supervisory board to ensure that all its business activities are in line with Shari’a requirements. Conventional banks have no such requirement. Statutory requirements An Islamic bank must be in compliance with the statutory requirements of the National bank of the country in which it operates and also with Shari’a guidelines. A conventional bank must be in compliance with the statutory requirements of the central bank of the country in which it operates and in some places, the banking laws of state or other localities. Brainstorming Why do we segregate IFB fund from the conventional? How do we segregate IFB fund from the conventional? Do we segregate the physical cash?

52. What do you think the difference between IFB & Conventional banking service?

53. Characteristic Interest Free Banking System Conventional Banking Business framework Functions and operating modes are based on Shari’a , and Islamic banks must ensure that all business activities are in compliance with Shari’a requirements. Functions and operating modes are based on secular principles, not religious laws or guidelines. Interest charging Financing is not interest ( riba ) oriented and should be based on risk-and-reward sharing. Financing is interest oriented, and a fixed or variable interest rate is charged for the use of money. Interest on deposits Account holders do not receive interest (riba) but may share risk and rewards of investments made by the Islamic bank. Depositors receive interest and a guarantee of principal repayment. Risk sharing in equity financing Islamic banks offer equity financing with risk sharing for a project or venture. Losses are shared on the basis of the equity participation, whereas profit is shared on the basis of a pre-agreed ratio. Risk sharing is not generally offered but is available through venture capital firms and investment banks, which may also participate in management. Restrictions Islamic banks are allowed to participate only in economic activities that are Shari’a compliant. For example, banks cannot finance a business that involves selling pork or alcohol. Conventional banks may finance any lawful product or service. Penalty on default Islamic banks are not allowed to charge penalties for their enrichment. They may, however, allow imposition of default or late payment .Penalties may be donated to a charity Conventional banks normally charge additional Interest in case of late payments or defaults. Avoidance of gharar Transactions with elements of gambling or speculation are discouraged or forbidden. Speculative investments are allowed. Customer relationships The status of an Islamic bank in relation to its clients is that of partner and investor. The status of a conventional bank in relation to its clients is one of creditor and debtor. Shari’a supervisory board Each Islamic bank must have a supervisory board to ensure that all its business activities are in line with Shari’a requirements. Conventional banks have no such requirement. Statutory requirements An Islamic bank must be in compliance with the statutory requirements of the National bank of the country in which it operates and also with Shari’a guidelines. A conventional bank must be in compliance with the statutory requirements of the central bank of the country in which it operates and in some places, the banking laws of state or other localities. Money +Money (Interest) MONEY BANK CLIENT BANK CLIENT Money Goods & Services Conventional Banking Interest Free Banking Service Basic Difference: IFB vs. Conventional

54. Difference: IFB vs. Conventional Characteristic Interest Free Banking System Conventional Banking Business framework Functions and operating modes are based on Shari’a , and Islamic banks must ensure that all business activities are in compliance with Shari’a requirements. Functions and operating modes are based on secular principles, not religious laws or guidelines. Interest charging Financing is not interest ( riba ) oriented and should be based on risk-and-reward sharing. Financing is interest oriented, and a fixed or variable interest rate is charged for the use of money. Interest on deposits Account holders do not receive interest (riba) but may share risk and rewards of investments made by the Islamic bank. Depositors receive interest and a guarantee of principal repayment. Risk sharing in equity financing Islamic banks offer equity financing with risk sharing for a project or venture. Losses are shared on the basis of the equity participation, whereas profit is shared on the basis of a pre-agreed ratio. Risk sharing is not generally offered but is available through venture capital firms and investment banks, which may also participate in management. Restrictions Islamic banks are allowed to participate only in economic activities that are Shari’a compliant. For example, banks cannot finance a business that involves selling pork or alcohol. Conventional banks may finance any lawful product or service. Penalty on default Islamic banks are not allowed to charge penalties for their enrichment. They may, however, allow imposition of default or late payment .Penalties may be donated to a charity Conventional banks normally charge additional Interest in case of late payments or defaults. Avoidance of gharar Transactions with elements of gambling or speculation are discouraged or forbidden. Speculative investments are allowed. Customer relationships The status of an Islamic bank in relation to its clients is that of partner and investor. The status of a conventional bank in relation to its clients is one of creditor and debtor. Shari’a supervisory board Each Islamic bank must have a supervisory board to ensure that all its business activities are in line with Shari’a requirements. Conventional banks have no such requirement. Statutory requirements An Islamic bank must be in compliance with the statutory requirements of the National bank of the country in which it operates and also with Shari’a guidelines. A conventional bank must be in compliance with the statutory requirements of the central bank of the country in which it operates and in some places, the banking laws of state or other localities. Interest & guarantee of principal Interest oriented Characteristic Interest Free Banking System Conventional Banking System Business framework Functions and operating modes are based on Shariah principles and secular laws Functions and operating modes are based on secular principles Interest Impermissible to deal with interest Charge for the use of money and pay interest for depositors Risk sharing Islamic banks offer equity financing with risk sharing Risk sharing is not applicable Restrictions Deal with only Shariah permissible business activities Engaged with lawful business activities irrespective of permissibility. Penalty on default Penalties imposed for default or late payment but not considered as an income to the bank rather donated for charity Conventional banks normally charge additional Interest in case of late payments or defaults and is income for the bank

55. IFB vs. Conventional . . . . 55 Characteristic Interest Free Banking System Conventional Banking Business framework Functions and operating modes are based on Shari’a , and Islamic banks must ensure that all business activities are in compliance with Shari’a requirements. Functions and operating modes are based on secular principles, not religious laws or guidelines. Interest charging Financing is not interest ( riba ) oriented and should be based on risk-and-reward sharing. Financing is interest oriented, and a fixed or variable interest rate is charged for the use of money. Interest on deposits Account holders do not receive interest (riba) but may share risk and rewards of investments made by the Islamic bank. Depositors receive interest and a guarantee of principal repayment. Risk sharing in equity financing Islamic banks offer equity financing with risk sharing for a project or venture. Losses are shared on the basis of the equity participation, whereas profit is shared on the basis of a pre-agreed ratio. Risk sharing is not generally offered but is available through venture capital firms and investment banks, which may also participate in management. Restrictions Islamic banks are allowed to participate only in economic activities that are Shari’a compliant. For example, banks cannot finance a business that involves selling pork or alcohol. Conventional banks may finance any lawful product or service. Penalty on default Islamic banks are not allowed to charge penalties for their enrichment. They may, however, allow imposition of default or late payment .Penalties may be donated to a charity Conventional banks normally charge additional Interest in case of late payments or defaults. Avoidance of gharar Transactions with elements of gambling or speculation are discouraged or forbidden. Speculative investments are allowed. Customer relationships The status of an Islamic bank in relation to its clients is that of partner and investor. The status of a conventional bank in relation to its clients is one of creditor and debtor. Shari’a supervisory board Each Islamic bank must have a supervisory board to ensure that all its business activities are in line with Shari’a requirements. Conventional banks have no such requirement. Statutory requirements An Islamic bank must be in compliance with the statutory requirements of the National bank of the country in which it operates and also with Shari’a guidelines. A conventional bank must be in compliance with the statutory requirements of the central bank of the country in which it operates and in some places, the banking laws of state or other localities. Interest & guarantee of principal Interest oriented Characteristic Interest Free Banking System Conventional Banking System Avoidance of uncertainty (Gharar) Transactions with elements of gambling or speculation are forbidden. Speculative investments are allowed. Customer relationships The status of an Islamic bank in relation to its clients is that of partner and investor. The status of a conventional bank in relation to its clients is one of creditor and debtor. Shariah supervisory board Each Islamic bank must have a supervisory board to ensure that all its business activities are in line with Shariah requirements. Conventional banks have no such requirement. Statutory requirements Must be in compliance with the Shariah principles and Central bank requirements Required to in compliance with central bank and other secular laws

56. IFB DEPOSIT PRODUCTS

57. Content 57 IFB Deposit Products: Principle & feature Saving Account Current Account Investment Account Pool Management Profit Smoothening

58. 58 Characteristic Interest Free Banking System Conventional Banking Business framework Functions and operating modes are based on Shari’a , and Islamic banks must ensure that all business activities are in compliance with Shari’a requirements. Functions and operating modes are based on secular principles, not religious laws or guidelines. Interest charging Financing is not interest ( riba ) oriented and should be based on risk-and-reward sharing. Financing is interest oriented, and a fixed or variable interest rate is charged for the use of money. Interest on deposits Account holders do not receive interest (riba) but may share risk and rewards of investments made by the Islamic bank. Depositors receive interest and a guarantee of principal repayment. Risk sharing in equity financing Islamic banks offer equity financing with risk sharing for a project or venture. Losses are shared on the basis of the equity participation, whereas profit is shared on the basis of a pre-agreed ratio. Risk sharing is not generally offered but is available through venture capital firms and investment banks, which may also participate in management. Restrictions Islamic banks are allowed to participate only in economic activities that are Shari’a compliant. For example, banks cannot finance a business that involves selling pork or alcohol. Conventional banks may finance any lawful product or service. Penalty on default Islamic banks are not allowed to charge penalties for their enrichment. They may, however, allow imposition of default or late payment .Penalties may be donated to a charity Conventional banks normally charge additional Interest in case of late payments or defaults. Avoidance of gharar Transactions with elements of gambling or speculation are discouraged or forbidden. Speculative investments are allowed. Customer relationships The status of an Islamic bank in relation to its clients is that of partner and investor. The status of a conventional bank in relation to its clients is one of creditor and debtor. Shari’a supervisory board Each Islamic bank must have a supervisory board to ensure that all its business activities are in line with Shari’a requirements. Conventional banks have no such requirement. Statutory requirements An Islamic bank must be in compliance with the statutory requirements of the National bank of the country in which it operates and also with Shari’a guidelines. A conventional bank must be in compliance with the statutory requirements of the central bank of the country in which it operates and in some places, the banking laws of state or other localities. IFB Deposit Modalities

59. 7-Oct-24 59 Interest Free Banking Service: Training

60. Wadiah: Definition 7-Oct-24 60 Literally Wadiah means deposit; i.e., the deposit of fund or asset; The term Wadiah relates to the concept of saving deposit where one person/party hands over his/her funds or assets to another person/party for the purpose of safekeeping. Safekeeping the fund/asset from harm, damage, loss or theft.

61. Wadiah: Principles 61 The fund/property deposited for safekeeping purpose; The deposit is guaranteed for full return on demand; The depositor should allow the safekeeper to use the fund for permissible activities The person with whom the fund/property is deposited may use it for permissible activities at its own risk.

62. Opened for the purpose of safekeeping; No benefit (financial/non-financial) attached to the account; Bank gives guarantee to return in full/ partial to customers on demand; Operated using passbook and digital banking services. Wadiah: Feature

63. What are the basic similarities & differences between Wadiah Saving and Conventional Saving Accounts? Questions for Group Discussion

64. 7-Oct-24 64 Interest Free Banking Service: Training

65. Current account of IFB operated based on: Wadiah or Qard Contracts. Current Account

66. Literally Qard is loan; AAOIFI define Qard as “the transfer of ownership in fungible wealth to a person on whom it is binding to return wealth similar to it”; One of the modern application of Qard is Current Account in which the fund is considered as loans not as deposit; Many banks use Qard for current account; Qard: Definition & Principles

67. IFB Current Account: Features 67 Opened by a businessmen who need access to their account frequently; The bank guarantees the full return of the deposit on demand ; Operated by checkbook and digital banking service; Opened and operated by literate individual.

68. Group Discussion Question 68 Describe basic similarities and the differences between IFB and Conventional current accounts?

69. 7-Oct-24 69 Interest Free Banking Service: Training

70. Restricted Investment Accounts 70 It is the owner of the fund (customer) specify the fund to be used in a particular place or business for a fixed or for specified purpose The Bank act as an intermediary or agent of the depositors to place funds on their behalf in various business ventures or investment proposals

71. Unr estricted Investment Accounts 71 An account where the investor fully authorizes the bank to invest the funds without restrictions as to where, how and what purpose the fund should be invested as long as the usage of the funds is Shari’ah compliant.

72. Mudarabah: Definition 72 Mudarabah refers a partnership in investment that one provides the fund and the other provides the management, expertise, labor and Time Rabb-ul-Maal – literally defined as owner of the fund. The capital provider in a Mudarabah contract. Mudarib- literally defined as working partner. In a Mudarabah contract it is the manager of the fund who contributes his/her expertise, labor and time.

73. Mudarabah: Principles 73 Partnership for profit sharing whereby one party provides fund and the other labour/expertise; Both parties share profit based on pre-determined profit sharing rate; No prior guarantee for the return of principal or benefit; Financial loss, if any, solely incurred by the owner of the capital/fund (Rab-ul-mal).

74. Mudarabah: Principles 74

75. Mudarabah: Application & Operation 75 Depositing money in a Bank without any pre-defined condition; The management of the fund is left to the Bank (Mudarib), Owner of the fund become a silent partner; The bank shares profit with the customer based on pre-agreed rate;

76. Mudarabah: Application . . . . 76 Loss or significant reduction on investible fund is compensated with Profit Equalization Reserve (PER) and Investment Risk Reserve (IRR); If the reserve couldn’t cover the loss, it will entirely be borne by the depositor/investor (unless there is evidence of negligence or any other cause on the part of the Bank);

77. Mudarabah: Features 77 This account opened for the purpose of profit sharing; Contractual agreement signed between both parties to facilitate the management of the fund Deposit is not guaranteed; Banks may put restriction on withdrawal; May operate using passbook or check book or certificate.

78. IFB FINANCING

79. CONTENT Trade Based Financing Lease Based Financing Equity Based Financing Loan Based Financing

80. IFB Financing 7-Oct-24 80 Interest Free Banking Service: Training

81. 1. Murabaha Murabaha A sale transaction Cost of acquiring asset and profit earned should be disclosed to buyer Asset has to exist, and be owned and possessed by seller at time of contract execution Sharia compliant – adherence to strictly followed procedures Combines An ordinary sale Credit component

82. Hence, serves as asset financing instrument Note: a murabaha cannot be used to simply lend cash Murabaha cannot be used to finance services It is the most widely used IF Banking product Minimum risk Profit of the financial institution is known before hand

83. 83 Parties in Murabaha $130,000 (deferred payment, including profit mark up) $100,000 (spot payment) Goods (immediate delivery) Customer Bank Goods Supplier Goods (immediate delivery)

84. Murabaha Prerequisites Subject Matter Must exist at time of contract execution Bank (as seller) must own the asset and have possession Physical – Actual corporal possession Constructive – Any form of documentary evidence that proves ownership Usability should also be confirmed in a constructive possession Must be sharia compliant item of value Must be a tangible good clearly identified and quantified

85. Murabaha Prerequisites… Price of subject matter Price of Murabaha may be charged in different forms: Profit should be disclosed as specific amount Payment Spot Deferred Installment Lump sum (at the end of lending period)

86. Murabaha Prerequisites… Price of subject matter… Cost of Murabaha asset must be declared Generally, all direct expenses must be indicated Indirect expenses such as administrative charges are mostly assumed by the bank For direct expenses the bank is not obliged to give a breakup of the costs In case some indirect costs are included the bank should provide a breakup of such costs If the asset is bought on deferred payment bases this fact must be disclosed in the contract

87. Important Steps in Murabaha 1. Purchase requisition 2. Master Murabaha Facility Agreement between the bank and client 3. Client’s unilateral promise to purchase goods and bank’s acceptance of collateral 4. Agency agreement between the bank and client or a third party 5. Possession of the goods by agent on behalf of the bank 6. Exchange of offer and acceptance between client and bank 7. Transfer of possession from bank to client Note: sequence of these steps are crucial to assure sharia compliance

88. Some points of caution in Murabaha Sharia validity of Murabaha is sensitive to following the sequence of the seven steps A Murabaha is invalid if the goods are consumed either partially or fully before making offer and acceptance A Murabaha is invalid for the goods that the customer already bought Murabaha is not applicable for services Deferred Murabaha is not permitted for items serving as medium of exchange such as Gold, Silver and paper money. Only a spot Murabaha can be conducted for such items

89. Default in a Murabaha There is no concept of penalty for late payment in a Murabaha transaction Rather, a charity clause can be established at time of Murabaha execution as a deterrent In case of a default the client is obliged to pay to a designated charity This amount cannot be taken into bank’s income It should either be given away immediately or maintained in a charity pool account for subsequent disbursement.

90. Management of early repayment Bank may unilaterally grant rebate for early repayment This should not however Be made a practice Stipulated as condition Demanded by client

91. 91 Murabaha vs. Conventional Loan Aspect Conventional Loan Murabaha Subject matter Amount of money Commodity Parties Lender and borrower Financier and finance Rollover Typically applicable Impermissible Collateral Put up before the loan is processed After the commodity is purchased Cost transparency Not a condition Stipulated/ a condition

92. 92 Murabaha vs. Conventional Loan Aspect Conventional Loan Murabaha Compensation Interest Profit Ownership The lender remains the owner of funds The purchaser becomes the owner of the commodity Liability The amount of loan in addition to interest (repayment plus interest) The commodity full price (cost plus profit) Contract structure Interest based lending agreement and transaction A sale contract

93. 2. Ba’i-Salam Salam Sale where price paid in full at contract’s execution Delivery is deferred to future date Subject matter need not exist and be owned and possessed by seller at Salam’s execution The origin of salam dates back to the time of the prophet Mohammed (PBUH), allowed subject to certain conditions It’s basic purpose is to allow farmers sell in advance to fulfil immediate requirements like spending for seeds and providing their family until the time of harvest and thereby avoid lending on interest.

94. Similarly the traders of that time had also imported and exported some good through advance payment mechanism. Hence, Salam can be applied on sharia complaint homogeneous commodities The bank as buyer of the salam goods have the following options To enter into a parallel salam with a third party with a higher price To obtain a unilateral promise from a potential buyer with a higher price

95. Ba’i –Salam… seller/customer undertakes to supply specific goods to the buyer/bank at a future date in exchange of an advanced price fully paid at spot ; The supply/delivery of purchased goods is deferred to a fixed date. The bank buys the farm output to be produced in the future against the full spot payment of the price which may be utilized by the farmer to meet his/her financing needs.

96. Features of Ba’i –Salam (Advance Payment) The marketability and price stability of the agricultural crops to be financed should be identified at first hand. The Bank being the purchaser of Salam commodity, there is a need for a Parallel Salam to re-sell the commodity on yield without making one contract dependent on the other. 96

97. Features of Ba’i –Salam (Advance Payment) 97

98. 3. Istisna’ (Work-in-Progress) Work-in-progress (Istisna’) financing is a mode of sale, at an agreed price; The bank places an order to a manufacturer/contractor to manufacture, assemble or construct, a specific commodity for a purchaser/customer of the bank to be delivered at a future date. Istisna’ contract shall be entered between the Bank and the customer, on the other hand, the bank enter into a Parallel Istisna’ contract with the third party manufacturer/Contractor. 98

99. Features of Istisna ’ (Work-in-Progress) The parties (the bank and the customer) can enter into a contract before the seller/manufacturer assumes the title of the goods to be manufactured/ constructed. The agreement should describe complete specifications of the goods/assets/services or manufactured items sale price, date and place of delivery. The price and mode of payment to the manufacturer must be known at the conclusion of the contract. 99

100. Istisna’ Vs. Salam ISTISNA The subject of Istisna is always a thing to be manufactured. The price in Istisna does not necessarily need to be paid in full in advance. Time of Delivery can be flexible with reduction in price. The contract can be cancelled before the manufacturer starts working. SALAM The subject can be any thing. The price has to be paid in full in advance. Fixed time of delivery is an essential part of the sale The contract cannot be cancelled unilaterally.

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102. 1. Ijarah (Leasing) Ijarah “To give something on rent” defined as “transferring of usufruct (legal rights to use property) to another person for an agreed period, at an agreed consideration/amount”. The bank purchases a real asset (the bank may even purchase the asset as per the specifications provided by the prospective client) and leases it to the client. In the period of lease, the asset remains in the ownership of the bank but the physical possession of the asset and its right of use is transferred to the lessee 102

103. Feature of Ijarah (Leasing) A lease payment schedule based on the amount and terms of financing is agreed upon by the bank and the lessee. The rental (differentiated or similar) must be determined at the time of contract for the whole period of lease. The bank could determine the rental on the basis of the aggregate cost incurred in the purchase of the asset. The lease period shall commence from the date on which the leased asset has been delivered to the lessee/customer. The leased property should be insured at the expense of the lessor/bank. The useful life of the leased asset should not be less than five years. 103

104. 104

105. 1. Mudarabah / Profit sharing Mudarabah is a partnership agreement where one party invest all capital and the other manages the business, simply to say the other party is responsible for management of day to day businesses. Rabb-ul-Maal – capital invested by party, literally translated as the owner of capital. Mudarib – the fund manager. Profits shall be distributed in the proportion mutually agreed in the contract(as percentage of profit and not a fixed sum ) Financial losses of the Mudarabah shall be borne solely by the capital provider.

106. 2. Musharakah/Joint Venture Musharakah comes from the word Shirkah, which literally means sharing. It is defined as a contract between partners on sharing of both capital and profit. Musharakah means relationship established under a contract by the mutual consent of the parities for sharing of profits and losses arising from a joint enterprise or venture. It is impermissible to fix a certain percentage of return on capital invested. Profits shall be distributed in the proportion mutually agreed in the contract whilst losses are shared by all partners in proportion to their capital.

107. 107 Musharakah Vs. Mudarabah MUSHARAKAH All partners invest Management of the business by any/all partners All partners share the loss to the extent of the ratio of their investment All partners share in the ownership of the assets pro-rata to their investment Musharakah is a partnership in profit and capital , MUDARABAH One party, Rabb ul Maal, invests Management of the business by Mudarib Only Only Rabb ul Maal suffer the loss provided that the Mudarib acted with due care while the mudarib suffers the loss of his labor . The assets are owned by the Rabb ul Maal and no share is owned by the Mudarib. Mudarabah is a partnership in profit not in capital.

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109. 1. Qard ul Hassan /Benevolent Loan This is a loan that involves no interest. The principle is paid at a later date without any increase. If one borrows Birr 100 Mil, they will repay Birr 100 Mill at a later date. 109

110. Qard ul-Hassen: Potential users 110 Serves as a tool for the bank to fulfill its social responsibilities People engaged in small and Micro business; Customers of a bank – for their temporary cash shortage ; No direct or indirect benefit shall be expected from such kind of loan

111. Discussion 111 Which IFB Financing product preferred: 1. By customers. Why? 2. By banks. Why?

112. Other IFB Services

113. IFB Service: Kafalah (Guarantee) 113 A letter of guarantee facility /Kafala/ is a written promise issued by a bank / irrevocable obligation The Bank compensate to the beneficiary in the event that the obligor fails to honor his/her/its obligations in accordance with the terms and conditions of the contract. The Bank shall require guarantee in the form of accepted collateral based on the guarantee value. Major types of Kafalah: bid bond, performance bond, advance payment, suppliers credit guarantee . . . .

114. 114 THANK YOU FOR YOUR ATTENT ION

115. Any Question 115 ?