Sharia compliance Issues in Islamic Banking Muhammad Najeeb Khan Sharia advisor HMB 25th Aug 2008 11/9/2018 mnajeebkhan@hotmail.om

OVER VIEW Islamic Banking must be viewed as an evolving system. Islamic Banking must be viewed as an change management Process. Need and Desire of Islamic Banking Its growth in last 25 years Conceptual Development of Islamic Banking 11/9/2018 mnajeebkhan@hotmail.om

OVER VIEW Islamic Banking as Financial Intermediation system. Distinguishing features of Islamic Banking Financial engineering in the light of Principals of Sahria Sharia Governance Structure Standardization as per AAOFI sharia standards Standardization as per Accounting Stanards 11/9/2018 mnajeebkhan@hotmail.om

Main Financial Contracts Debt creating Modes (Low Risk Category) 1. Qard Al-Hasan (interest- free loan) 2. Bai Muajjal (Price deferred sale) 3. Murabaha and Musawama 4. Salam (Commodity sale) 5. Istisna (Order to manufacture) Semi-debt Modes (Medium Risk Category) 1. Ijarah Sharing or Non-debt Modes (Full Risk Category) 1. Musharakah (Close to venture capital) 2. Specific Purpose Mudarabah 3. General Purpose Mudarabah 11/9/2018 mnajeebkhan@hotmail.om

Main Financial Contracts Trade Based Modes Profit & Loss Sharing Modes Lease Based Modes 11/9/2018 mnajeebkhan@hotmail.om

Islamic Financial Tools Murabaha – trade with markup or cost plus sale Mudaraba – profit sharing agreement Musharaka – equity participation Leasing (Ijara Wa Iqtina) – renting for beneficial use Salam and Parallel Salam – deferred sale contracts Istisna’a and Parallel Istisna’a – project finance Sukooks – Islamic bonds Ladies and gentlemen, I would now like to discuss the wide variety of products that Islamic finance offers. By discussing these tools of Islamic finance with you I would try to demonstrate that all normal business financing transactions can be accommodated by using one the tools to cater for the business requirement of that transaction. At the same time, the business can ensure that the principles laid down by Islam are adhered to within those business transactions. These instruments serve as the basic building blocks for developing a wide array of more complex financial instruments, suggesting that there is great potential for financial innovation and expansion in Islamic financial markets. “CLICK TO GO THE NEXT SLIDE” 11/9/2018 mnajeebkhan@hotmail.om

Murabaha – Cost Plus Finance Transfer of title to bank Transfer of title to customer Entrepreneur Vendor Financier Payment of purchase price (P) Payment of marked up price (P+X) Asset Purchasing Transaction Flow Chart Agency Agreement structure accordingly Acquisition of Title of the Asset Title to assets transferred to the customer at the time of purchase Payment to Supplier drectly One of the most popular forms of Islamic finance is trade with mark up or cost plus financing called Murabaha. It is widely used for short tem finance. It is based on a simple notion of purchase finance. In the typical structure of Murabaha, the financier purchases the goods to be financed from the vendor. He settles his obligations usually immediately by paying cash and acquires the title to goods. He then sells it to the entrepreneur at a cost plus price. The entrepreneur pays the purchase price by deferred payment over a defined period of time and hence the financing effect. The title of the goods transfers to the entrepreneur from the financier immediately on the sale. However, it is normal for the entrepreneur to offer the same or other assets to the financier as collateral. Given its simple and neat structure, almost 75% of all Islamic finance transactions are made on Murabaha basis. “CLICK TO GO THE NEXT SLIDE” 11/9/2018 mnajeebkhan@hotmail.om

Murabaha – Cost Plus Finance Transfer of title to bank Transfer of title to customer Entrepreneur Vendor Financier Payment of purchase price (P) Payment of marked up price (P+X) Physical inspection Asset Purchasing evidence If client is agent more then one bank Sharia Standard/ accounting standard Usually the customer then provides same or other assets as collateral One of the most popular forms of Islamic finance is trade with mark up or cost plus financing called Murabaha. It is widely used for short tem finance. It is based on a simple notion of purchase finance. In the typical structure of Murabaha, the financier purchases the goods to be financed from the vendor. He settles his obligations usually immediately by paying cash and acquires the title to goods. He then sells it to the entrepreneur at a cost plus price. The entrepreneur pays the purchase price by deferred payment over a defined period of time and hence the financing effect. The title of the goods transfers to the entrepreneur from the financier immediately on the sale. However, it is normal for the entrepreneur to offer the same or other assets to the financier as collateral. Given its simple and neat structure, almost 75% of all Islamic finance transactions are made on Murabaha basis. “CLICK TO GO THE NEXT SLIDE” 11/9/2018 mnajeebkhan@hotmail.om

INVESTMENT ACCOUNT HOLDERS ISSUES MUDARABA The Bank may enter into Mudaraba contract in the following two ways: RAB-UL-MAL MUDARIB INVESTMENT ACCOUNT HOLDERS ISLAMIC BANK DEPOSITS MUDARABA PARTIES TO THE CONTRACT Rub-ul-mal. The owner of the capital. Mudarib. The party offering to provide professional, managerial and technical know-how. ISLAMIC BANK ENTREPRENEUR INVESTMENTS 11/9/2018 mnajeebkhan@hotmail.om

Mudaraba – Profit Sharing Arrangement Investors (Rab-ul-Mal) Contribution of finance Venture (Mudaraba) Profit and capital repayment Contribution of expertise Manager (Mudarib) Fees based on profit earned Identical to a fund structure Investors contribute finance; Manager contributes expertise Liability of Manager is limited with incentive to perform Investment objectives either specific or left on Manager discretion Managers’ fees based on profit Fairly widely used form of finance in Islamic banking and capital markets Mudaraba can be termed as a profit sharing arrangement. It is a coming together of expertise and finance. One party brings expertise to the table. He is known as Mudareb. The other party or parties bring finance to the table. They are known as Rab-ul-Mal. Mudareb gets his fees on performance of his expert duties out of the profits of the venture. His fee is profit linked. No fixed fees are chargeable except specific expenses, identified before hand. However, the Mudareb does not share downside with the investors, should the venture makes losses. Mudaraba is identical to an investment fund in which managers handle a pool of funds. The agent-manager has relatively limited liability while having sufficient incentives to perform. The capital is invested in broadly defined activities, and the terms of profit and risk sharing are customized for each investment. The maturity structure ranges from short to medium term and is more suitable for trade activities. “CLICK TO GO THE NEXT SLIDE” 11/9/2018 mnajeebkhan@hotmail.om

COMPLIANCE ISSUES on liability side POINTS NEED FURTHER RESEARCH Pool Management on the basis of Mudaraba Treatments of pool Expense allocation Profit determinationh Movements of funds between pools Weightages Expenses related to the bank(mudarib)   11/9/2018 mnajeebkhan@hotmail.om

Musharaka – Equity Participation Entrepreneur (Musharik) Venture (Musharika) Contribution of capital Profit and capital repayment Investors (Musharik) Contribution of capital Profit and capital repayment Analogous to classical joint venture Both entrepreneur and investors contribute to capital Risks and returns are shared in proportion to capital contribution Normally used for project finance or venture capital Usually for medium term transactions Financing of fixed assets etc. Musharaka is an equity partnership in which two or more parties bring finance together to run a venture. Unlike Mudaraba, in Musharaka, all parties share in risk and rewards according to their equity commitments. In Musharaka structure Entrepreneurs also contributes capital along with the investor and his status is the same as other investors in so far as the affairs relate to his investment. For performing other duties the entrepreneur may get rewarded separately prior to determining the net share of profit or loss. Musharaka is similar to a classical joint venture. Both entrepreneur and investor contribute to the capital (assets, technical and managerial expertise, working capital, etc.) of the operation in varying degrees and agree to share the returns (as well as the risks) in proportions agreed to in advance. Traditionally, this Islamic financing tool has been used for financing fixed assets and working capital of medium- and long-term duration. “CLICK TO GO THE NEXT SLIDE” 11/9/2018 mnajeebkhan@hotmail.om

Leasing (Ijara Wa Iqtina) Beneficial use of asset Transfer of asset Entrepreneur (Lessee) Vendor Financier (Lessor) Payment of purchase price Lease rentals Another popular instrument – 15% of the transactions Sharia Standard/ Accounting standard Asset ownership risk with owner; operational risks with lessee Features close to a financial lease Used for machinery, equipment, property, vehicles, aircraft etc. Sale and lease back transaction Ijara (Leasing) is another popular form of financing tools. It accounts for about 15% of all Islamic transactions. The financier (Lessor) purchases the asset from the vendors and leases its beneficial use to the lessee in return for payment of a periodic rental. Different forms of leasing are permissible, including leases where a portion of the installment payment goes toward the final purchase (with the transfer of ownership to the lessee). Features of Ijara Wa Iqtina lease are close to conventional financial lease. Leasing is designed for financing vehicles, machinery, equipment, and aircraft. “CLICK TO GO THE NEXT SLIDE” 11/9/2018 mnajeebkhan@hotmail.om

Salam and Parallel Salam – Deferred Delivery Delivery of asset at future date Delivery of asset at future date Financier Entrepreneur Commodity Owner Advance payment of purchase price Payment of purchase price on delivery A deferred-delivery sale is similar to a forward contract where delivery of the product is in the future in exchange for payment on the spot market. These contracts are termed Salam. These contracts are normally used for commodity finance, where deferred delivery is a common structure in use. The financier buys the commodity from the owner by making an advanced payment of the purchase price. However, though the title transfers, the delivery of the commodity is agreed to be made at a future date. In order to avoid the risk of commodity remaining with the financiers, specially if it is a bank, a parallel Salam contract is entered into with the entrepreneur, whereby the entrepreneur enters into a back to back contract with the financier to purchase the commodity. However, the purchase consideration between the entrepreneur and the financier is payable at the time of the delivery and hence the impact of financing the purchase comes into effect. “CLICK TO GO THE NEXT SLIDE” Primarily a deferred delivery sale contract Similar to a forward contract where delivery in future in exchange for spot payment To mitigate asset risk financier can enter into a parallel salam Usually used for commodity finance 11/9/2018 mnajeebkhan@hotmail.om

Sukuks – Islamic Bonds Asset SPV/ Entrepreneur Trust Investors Transfer of assets Sukuks Issued Entrepreneur Asset SPV/ Trust Investors Cash Cash Sukuks represent proportionate beneficial ownership For a defined period the risk associated with and return cash flows generated from the assets belong to Sukuk holders Sharia structure of transaction Early stages of development New sharia guidelines Sukuks are termed as Islamic bonds. In effect, Suk is the form of an Asset Backed Security and, therefore, has all the flexible features to provide a capital market security financing framework. Sukuks represent a beneficial ownership of an underlying pool of assets and also the right to the cash flows for capital and profit repayments. The Sukuks structure is similar to asset backed securities transactions that are quite common in conventional capital markets. Entrepreneur transfer the assets in to a special purpose vehicle (the SPV). The SPV issues asset backed securities, the Sukuks to investors at large. From the proceed the SPV pays the entrepreneur the sale price of the assets sold to the SPV. From the cash flows generated by the assets pooled the SPV pays the profit and redeems the Sukuks on the due dates. The only but major difference between conventional asset backed securities and the Sukuks is that in its Islamic form the SPV can not leverage the transaction, which is quite common in the conventional structures. “CLICK TO GO THE NEXT SLIDE” 11/9/2018 mnajeebkhan@hotmail.om

Conclusion To develop proper internal sharia audit Mechanism Awareness and training of staff specially product related compliance Awareness and training of client and his related staff specially product related compliance 11/9/2018 mnajeebkhan@hotmail.om

JAZAKALLAH Thank you 11/9/2018 mnajeebkhan@hotmail.om