The CIMA Advanced Diploma in Islamic Finance (CADIF)

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

A global product for a diverse world
Chartered Institute of Management Accountants (CIMA) 26 Chapter Street, London SW1P 4NP, UK T. +44 (0)20 8849 2287 F. +44 (0)20 8849 2450 E. if@cimaglobal.com www.cimaglobal.com Second edition 2011 Published by Global Trade Media, a division of SPG Media Ltd
CIMA Advanced Diploma in Islamic Finance: ISBN 978-1-85971-634-2 Copyright 2011 CIMA All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, photocopying or otherwise, without prior permission of the copyright owner. No responsibility is assumed by the copyright holder for any injury and / or damage to persons or property as a result of products liability, negligence or otherwise, or from any use or operation of any methods, products, instructions or ideas contained in the material herein. Whilst every effort has been made to ensure the accuracy of the information in this publication, neither CIMA nor SPG Media Limited accept responsibility for errors or omissions. Printed by Williams Press
Contents
Contents
How to use this guide What is finance? Introduction Authors Chapter one Application of contracts in the structuring processes of Islamic financial products Chapter two Structuring process and related challenges in the Islamic financial services industry Chapter three Regulatory and prudential requirements and the supervisory review process for Islamic banking and financial products Chapter four Structuring deposits, investment accounts and money market instruments Chapter five Structuring financing facilities for working capital and consumer financing Chapter six Project financing: structures and strategic considerations Chapter seven Equity market regulations and issues of screening methodology for public-listed companies Chapter eight Structuring and strategic issues for Islamic funds Chapter nine Sukuk structuring and rating methodology Chapter ten Takaful models and issues of legal and rating requirements Chapter eleven Retakaful and retro-Takaful operations and industry in the global Retakaful market Chapter twelve Islamic derivatives as risk management tools for the Islamic financial services industry Conclusion Bibliography Sample examination Glossary of terms and contracts Index
4 9 14 21
22
48
74 100 126 160
188 220 250 284
322
346 372 376 378 390 404

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How to use this guide
Realising your potential with this study guide as a learning companion

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

We developed the CADIF as an extension of the CDIF. All candidates are encouraged to be familiar with the contents of the CIMA Diploma in Islamic Finance, which underpins much of the material included in this study guide. You will regularly see references such as this, CDIF/2/5/108-109, which means that key information you need is included in a Diploma study guide. The symbols relate first to the Diploma (CDIF), then the specific guide (2), then the chapter (5) and finally the relevant pages (108-109). So in this case you will find relevant information in Study Guide Two, Islamic Banking and Takaful, on pages 108-109 of chapter five. We would expect you to refer to this material before you proceed further in the relevant section. For those of you who joined the CADIF by direct entry, we recommend that you acquire copies of the CDIF study guides. These can be obtained by contacting: if@cimaglobal.com This study guide includes a glossary of the key terms and contracts used throughout CIMAs Islamic finance learning materials. For easy reference, these sections can also be found on the CIMA website www.cimaglobal.com/islamicfinance It is vital that you read these sections and that you refer to them regularly as you work through the guide. It is also important that you appreciate the relevance of several key aspects of the study guides. Each of these aspects is explained below and tips are offered, where appropriate, as to how you can get the most from your studies.
Language
The guide is written in English; however, Islamic finance relies to a great extent on a large number of Arabic terms and phrases, as well as a few in Latin. Islamic finance is built on a foundation of historic contracts, which have been used for centuries in Islamic commerce. These contracts, while straightforward in terms of content, are introduced by their Arabic names. These names, many of which are challenging to pronounce, will probably be new to you. The subtle differences between the meanings of some of them need to be understood, as that will be key to you pursuing a successful career in Islamic finance. In addition to the contract names there are many other Arabic terms used in the industry. You need to be comfortable with these terms and phrases as they are integral to the construction and delivery of the various contract types that underpin Islamic finance. By referring to the glossary you will soon be comfortable with such terms as Qard, Wakalah, Musharakah and Murabahah, to name but a few. The most challenging aspect of the study of Islamic finance will be your understanding of these terms and phrases, but, as with any new language, the sense of achievement you will feel once you become fluent in their use will make it worthwhile. You will also be able to impress your family, friends and business associates with your new-found language skills; after-dinner conversations and meeting presentations will never be the same again.
Self-study
Working on your own, particularly when the subject matter is new, is never an easy task. In writing this study guide, the authors have constantly put themselves in your position and attempted to create materials that will hold your interest. They have also tried to ensure that they are easy to follow and act as a complete learning experience. We believe that the guide you are about to read, and the additional reading we refer you to, will give you a thorough underpinning in the subject area. It will provide you with all you need to pass the final examination and to follow a successful and rewarding career in Islamic finance. The text regularly requires you to stop and attempt exercises or Islamic challenges to get you to interact with what you are reading. It is crucial to your understanding of the subject that you attempt these exercises or challenges honestly. The answers for the exercises are given at the end of the respective chapter to confirm your understanding. In addition, at the end of each chapter are a series of questions with which to test your new-found knowledge. Each set of questions relates to a case study that is assessed through a series of multiple choice questions and short essay questions. The final assessment you will be required to pass to achieve the award of CADIF will be assessed using a combination of multiple choice questions and essay questions. In this way we can ensure both breadth and depth of coverage in the assessments. We recommend that you attempt to answer the
multiple choice questions and practise essay writing as you progress through each chapter of the guide. Solutions are at the end of each chapter. The guide concludes with a series of mock examinations based around case studies. These have been devised to develop and test your knowledge beyond the written text in the module. The answers to these challenges can be found through a critical understanding and analysis of the written text. Islamic finance challenges form part of the text and should transmit critical knowledge to you. The guide concludes with a mock examination comprising general multiple choice and short answer questions and case-based multiple choice and short answer questions. Completing the mock examination is a good way of assessing whether you are ready or not to sit the final live assessment.
Learning outcomes
At the start of each chapter we list the learning outcomes that you should have achieved by the time you have worked through the chapter. These learning outcomes relate to the questions you will be required to answer in the assessment that you must pass to be awarded the CADIF. It is therefore vital to your success that you feel confident at the end of each chapter that you have achieved these outcomes. A useful tip would be to return to the learning outcomes once you have come to the end of each chapter and make sure that you are familiar with each of them. The questions and answers in each chapter have been created to test you in your achievement of these learning outcomes. Getting the right answer to these questions at the first attempt is a good sign that you are achieving the learning outcomes. An inability to answer them is a sure sign that you need to return to the detailed content of the chapter. The final examination will include questions relating to the chapters and respective learning outcomes (see below for more details).
Key points
The authors have highlighted key points that they feel you should remember. While the rest of the text is important to your understanding of the subject in question, these key points indicate the crucial element of the text.
Examples from real life

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

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

Each chapter includes a series of Islamic finance challenges. These have been devised to develop and test your knowledge beyond that which is required for the final examination. These have been devised to develop and test your knowledge beyond the written text in the module. The answer to these challenges could however be extracted or inspired through a critical understanding and
analysis of the written text. Islamic finance challenges form part of the text and should transmit critical knowledge to you. The final examination will test you on both the text and Islamic finance challenges as they collectively form the body of the knowledge in the module Unlike the exercise questions, the answers to these Islamic financial challenges are given immediately after the challenge.
Chapter summaries
At the end of each chapter we have included a summary listing the important points that you should have understood from your studies. These summaries help you to track the important sub-topics and the key points discussed in the guide.
Revision questions with answers

Each chapter ends with a series of questions and answers comprising a series of multiple choice questions and short essay-style questions related to a given case study. It is very important that you attempt each of these as they are indicative of those that will be used in your final examination.
Mock examination
For a comprehensive pre-assessment of your learning experience, you will find a mock examination at the end of the study guide. While the live questions will be different to those tested here, the areas and weightings of the topics covered will be the same. If you can answer these questions correctly you can be fairly confident that that you will be able to answer the live questions correctly and thus pass the test. You need to score 60% in the examination to pass. The questions asked have been created to test each of the learning outcomes listed at the start of each chapter. As mentioned above, the revision questions at the end of each chapter represent the type of questions you will be asked in the live examination. You should use both sets of questions to test your understanding of this challenging subject.
CIMA Islamic finance website

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

Islamic finance is constantly changing and CIMA will regularly update the study guides to reflect these changes. As changes to the hard copy guides can only take place during a reprint, we will keep you up to date by posting details on the website of changes that have occurred between print runs. Where necessary, we will also supply references to additional support material, including suggested further reading. Most changes to the material that we will highlight on the website will be for information purposes only and will not affect the assessments you sit. Where changes are deemed sufficiently important, CIMA may change the assessments to reflect this. Students will be emailed alerts about any new examinable material that appears only on the website. Where applicable, new material will be assessable three months from the date of the first alert and when it appears on the website.
The future
You are embarking on a new journey, which for many will be a gateway to new knowledge and experience. Like all journeys, you need to be properly prepared to meet all eventualities. This guide is, we believe, a vital part of a successful career in this exciting new development in global finance.
The final examination

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

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

Islamic finance involves the revival of trade and investment principles and practices established centuries ago in the context of a modern finance and financial system. As a relative newcomer to the finance industry, it has arisen because conventional finance does not meet the requirements of Shariah principles and rules, and does not conform to the beliefs and precepts of the religion of Islam. Key to the evolution of Islamic finance is the belief held by Muslims that absolute ownership belongs to God, and man as the servant and vicegerent acts in trust in administering wealth in a just and equitable manner. Oppressive behaviour, such as usury, is prohibited and the charging and receiving of interest is unacceptable. Hence, a moral code and social order is prescribed based on the Islamic belief system. The Quran is the absolute source of divine guidance and Shariah law according to Islamic belief. It instructs mankind to engage in activities that are lawful and good, and prohibits those that cause harm and dispute in the society. Among its prohibitions are trading in pork or pork products, and trading in intoxicants and games of chance. The teachings of Islam based on the Quran and Sunnah state that the entire value chain of activities relating to these prohibited activities is equally prohibited. This includes all aspects of the production, storage, transportation, marketing and advertising of such products and activities. In prescribing the form of economic activities under Islam, trade is encouraged, usury is prohibited and the acquisition of wealth is to be achieved through lawful means that promote mutual consent and goodwill. In this respect, interest as usury is replaced with profit from trade. Muslims believe that profit should involve decisions on risk preferences and choices, and that finance should be mobilised for acceptable personal and business purposes as prescribed by Shariah principles and rules. You will now realise that the conventional finance industry, as described at the start of this section, does not meet the requirements of Shariah principles and rules as it is priced and motivated by interest rates, takes risk in favour of lenders and is not generally concerned about the use or application of funds. In the last 40 years various financial institutions have attempted to develop financial products that are consistent with Shariah principles and rules. The cash surpluses generated from the extraction of oil in the Middle East and throughout South East Asia, both of which have substantial Muslim populations, focused attention on the need to develop a financial system that met the requirements of Muslims. Similarly, from the perspective of insurance, individuals who follow the teachings of Islam also wanted to insure themselves or their property against loss or injury, through risk-sharing and pooling arrangements that promote mutual goodwill and assistance in case of peril or hazard. Simple economic theory explains what happened next. With an estimated 1.8 billion Muslims worldwide, increasing cash balances from oil extraction and the demand for acceptable investment and insurance products, an industry developed to meet these requirements. Twenty-five per cent of all Muslims live in countries with a Muslim majority, which means that the demand for acceptable products in these countries is backed by the political will to underpin the industry with relevant legislation and legal systems. To date, probably as a result of substantial oil revenues, development in this sector has focused on two key regions of the world: the Middle East and South East Asia. However, an ever-increasing number of Muslims and non-Muslims worldwide are seeking out Islamic financial products. As a result of this increasing demand, financial institutions around the world have taken up the call for new products and almost all areas of the conventional financial industry have now been replicated or adapted in a way that is acceptable to Islamic beliefs and practices.
Shariah compliance
A vital part of Islamic financial activities is the requirement to achieve Shariah-compliant status, that is to ensure that the financial activities of the institution meet the requirements of the Shariah principles and rules prescribed in the Quran and the Traditions of the Prophet Muhammad. To achieve this, there is a need to establish adequate systems and controls in the form of an internal Shariah control system (ISCS). The ISCS provides assurance that all financial activities are conducted in accordance with Shariah principles. An internal Shariah review is a prudent if not a regulatory requirement to self-assess the degree of compliance that the financial institution adheres to in terms of all Shariah principles prescribed in the form of standards, guidelines and best practices by relevant governing bodies, such as the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) and Islamic Financial Services Board (IFSB).
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What is finance?
Shariah compliance is critical to an Islamic financial institutions (IFI) operations, and compliance must permeate throughout the organisation, its products and activities. The implications of Shariah noncompliance and risks associated with the IFIs fiduciary responsibilities towards different fund providers expose it to withdrawals, loss of income or the voiding of contracts. This, in turn, leads to a diminished reputation and/or the limitation of business opportunities.
Shariah advisory boards

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

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

The nature of IFIs has evolved since the 1960s to meet the various needs of Muslim communities, society and industry. From specialised financial institutions that promoted the welfare of Muslims during the earlier phase, these institutions have become innovative and enterprising financial institutions within the global financial industry. The financial intermediation of lending-based institutions is replaced with partnership and profit-sharing institutions that are directly involved in the financing of transactions, as well as engaging in equity partnerships.
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What is finance?
Loans and advances have been replaced by new financing vehicles that are based around sales, lease and equity contracts. The financing of sales and purchases, as well as leasing, involves trade contracts. Equity-based financing involves Mudarabah and Musharakah financing or investments. These contracts vary in their application to suit the purpose of financing, such as term or working capital financing, as well as matching customer requirements, such as retail or corporate, along with the financial institutions funding objectives. Fixed deposits are replaced with investment accounts where fixed determinable interest paid to depositors is replaced with profit-sharing dividends. The latter involves a predetermined profit-sharing ratio mutually agreed by both the financial institution and the investment account holder (IAH). For certain types of investments, the IAH can specify the area in which the funds are to be invested. In this respect IAHs can share in the profits with the financial institution for a given level of risk exposure. Other savings and current accounts are based on safe custody contracts or loan contracts that do not involve dividend payments. However, the financial institution may, at its discretion, declare dividends in the form of a gift (Hibah) to the account holders.
The Islamic capital market (ICM)

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

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

A Sukuk refers to the process of aggregating tangible assets, usufruct or an interest in a project or venture into divisible units or securities that reflect the proportionate ownership of that asset or usufruct or project. A Sukuk does not deal with receivables or financial assets. Sukuk holders each hold an undivided beneficial ownership interest in the underlying assets. Consequently, Sukuk holders are entitled to share in the revenues generated by the Sukuk assets. In short, Sukuks are monetary denominated participation certificates of an equal unit value to be issued
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What is finance?
to investors. These Sukuks represent their proportionate share in the ownership of the underlying assets and a pro-rated share in the income generated by those assets. Sukuks do not represent any indebtedness by the issuer to the investor. The return to the investors in a Sukuk is not fixed or guaranteed but is subject to the performance of this underlying asset. A Sukuk, which is performance-based, does not promise any fixed income.
The Islamic derivatives or Islamic structured products market

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

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

Introduction
The growth in the Islamic finance industry has outpaced the development of education in this area. This study system has been devised to meet the shortage in teaching materials and will introduce you to key areas of the Islamic finance industry as identified above. The core of the CADIF, which follows the CIMA Diploma in Islamic Finance (CDIF), is the theme of structuring, taking a broad view of the concepts of structuring within Islamic finance and progressing into the specific product structuring process that has been undertaken in the Islamic banking, capital market and Takaful sectors. You will be introduced to specific issues, including any limitations, of individual Shariah contracts that have been applied in developing existing Islamic banking and finance instruments in the global markets. You will also be shown that the product strategy ensures that each product is competitive in the individual markets within the respective legal and juridical boundaries that surround each market.
Terminology
Many of the technical terms used in Islamic finance are derived from Arabic. You will already have noticed the use of such words as Takaful, Shariah, Mudarabah, Musharakah, Hibah, Sukuk and Salam, which are all Arabic terms. For those of you with no experience in Arabic, these words and terms may prove challenging, but it is essential if you are to succeed in understanding much that underpins Islamic products and services that you master these concepts and terms. We have expanded the original glossary of terms that appeared in the CDIF for you to refer to and we have included a detailed explanation of the nature of the contracts, the key to all of the Islamic financial products and services. It is left to you to make the most of the glossary and contract explanations to maximise the benefit you gain from the guide.
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Introduction
Introduction
Introduction
The CIMA Advanced Diploma in Islamic Finance (CADIF) has been designed as a professional diploma for the Islamic financial services industry. The CADIF will enable you, as financial professionals and practitioners, to apply Islamic finance principles to the analysis of Islamic financial products and services, as well as to the development of innovative products or solutions for the Islamic financial services industry. The core of the CADIF is with the theme of structuring. It begins with a birds eye view of the broad concepts of structuring within Islamic finance and progresses into the specific product structuring process that has been undertaken in the Islamic banking, Islamic capital market and Takaful sectors. Each chapter of the CADIF introduces you to specific issues, including any limitations, concerning the individual Shariah contracts that have been applied in developing existing Islamic banking and finance instruments in global markets. You will be shown that the product strategy ensures that each product is competitive in the individual markets and within the respective legal and juridical boundaries that surround each market. The CADIF follows the CIMA Diploma in Islamic Finance (CDIF) with its core foundation modules of Islamic Commercial Law, Islamic Banking and Takaful, Islamic Capital Markets and Accounting for Islamic Financial Institutions. As the Advanced Diploma assessment will be based on your ability to grasp essential principles in Islamic finance and relate them to practical situations, the CDIF self-learning modules are essential learning materials. For those who have progressed from the CDIF, this will not be a problem, but we still recommend that you constantly refer to relevant sections in the CDIF guides as you progress through the Advanced Diploma. For those who have joined by direct entry, we recommend that you use the CDIF guides as essential reading before you commence your Advanced Diploma studies.
The CIMA Diploma in Islamic Finance

The CIMA Diploma in Islamic Finance (CDIF) provides foundation knowledge in the four distinctive areas of Islamic finance. This is presented in four separate study guides.
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Introduction
Study guide one: Islamic Commercial Law

Study guide one focuses on Islamic commercial law and its application to transactions within Islamic finance. The guide explains the importance of the Quran and the Traditions of the Prophet Muhammad as sources of Shariah, and highlights how Islamic jurisprudence has been adopted by modern scholars to explain and interpret the Shariah in an attempt to solve modern problems in Islamic finance. The guide also introduces students to the historic contracts involved in Islamic commercial law and explains what is meant by Shariah compliance.
Study guide two: Islamic Banking and Takaful Products and Services
Study guide two focuses on two key areas of Islamic finance: banking and insurance (Takaful). Here, students are introduced to developments that have taken place with regard to these Islamic financial industries and their related systems. The guide explores the sources of funds available to banks and how they are rewarded. It explains the various Shariah-compliant products developed by Islamic banks for their customers. The second section of the guide introduces students to the insurance (Takaful) industry, with a focus on the products and services developed in this area.
Study guide three: Islamic Capital Markets and Instruments

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

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

Introduction
The Advanced Diploma programme has been developed as an integrated self-learning module for professionals. It focuses on structuring and strategy within Islamic finance, explaining both the technical issues as well as the product strategies applied in the field of Islamic finance. On completion of the guide you will be able to develop and apply the specific technical skills required to analyse and structure Islamic financial products and services in light of Shariah, legal, accounting and risk considerations. You will also be able to analyse the impact of structuring on a financial institution and recommend a product strategy for given economic conditions and industry requirements. Throughout the guide, specific financial products or instruments from the banking, capital market and Takaful sectors are explained, often with examples of current practice, along with analysis, process-flow and reporting tools. The financial environment and relevant models of each financial sub-sector are explained to ensure that you understand the relevant policies and standards and regulatory considerations.
Assessment
You will be assessed in terms of your ability to analyse Islamic financial products and related contracts, and evaluate them based on relevant standards and best practices. The Advanced Diploma adopts a case-based, product-centred learning strategy that requires you to recommend, solve or construct solutions in developing Islamic financial products and related strategies. Hence it is important to note that the assessment is not segmented into individual chapters but will be based on multiple chapters throughout the module. This will help you achieve a systematic and coherent understanding of all the principles, issues and standards affecting Islamic financial products structuring and strategies. The learning process enables you to understand the structuring processes as well as the relevant product strategies for each financial sector. On completion, you will have an in-depth and coherent understanding of the structuring and strategic issues arising from the technical specification, Shariah requirements, regulatory requirements and related reporting considerations and risk implications for each product. The case-based assessment allows CIMA to evaluate your ability to formulate, construct, appraise and recommend appropriate product structures and relevant strategies.
Content
The Advanced Diploma comprises five main sections: Shariah contracts, structuring process and financial environment Islamic banking system and products Equity, Sukuk and fixed-income instruments Takaful and Retakaful models and policies Islamic risk-management tools and strategies.
Shariah contracts, structuring process and financial environment

Chapter one reviews the nature and importance of Shariah compliance in Islamic finance transactions, and explains the purpose and benefits of contracts adopted in structuring Islamic financial products. It outlines the sources of Shariah and methodologies of reasoning and interpretation, with special reference to financial product structuring. The chapter also explains how the object, elements and conditions of the contract are taken into consideration when structuring an Islamic financial product. Chapter two introduces you to the structuring process that is integral to the product development strategy of institutions offering Islamic financial products and services. It identifies the critical components of the process and explains them with reference to specific Shariah requirements. The chapter also considers the effect of varying financial environments and industry requirements in the adoption of a structuring process. Finally, the chapter highlights factors that may impair the structuring quality for Islamic financial products, as well as considering the possible consequences of a poor product structuring strategy. The importance of the purpose of Islamic financing contracts, and the relevant application of those contracts in designing Islamic financial products, as outlined in chapter one, is fundamental in ensuring the proper and effective adoption of appropriate contracts. Also, the behaviour of Islamic financial contracts will have an effect on the development of Shariah compliance to achieve
16
Introduction
financially viable and sustainable financial products and services. The chapter highlights the product requirements for an effective structuring strategy as well as the potential pitfalls in structuring. Finally, you will be shown how the structuring process and strategic considerations enable the Islamic finance industry to design, develop and implement a comprehensive strategy for the creation of Islamic financial products and services. Chapter three explains the banking environment in relation to the principal monitoring or governing agencies, in addition to regulatory or industry requirements. It also highlights the importance of regulatory requirements and supervisory issues that must be considered when structuring Islamic financial products. The chapter considers the specific Islamic banking risk framework and other relevant guidelines to illustrate their impact on the structure of Islamic financial products, as well as on the development of a growth strategy for different models of institutions and products within the industry.
Islamic banking system and products

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

Chapter seven explains the regulation of the Islamic capital market, with regards to the equity market. Specific focus is given to the importance and acceptability of stock-screening criteria for asCDIFaining Shariah-approved stocks. The chapter looks at comparative stock-screening criteria, explaining the basis and applicability of such criteria in different financial conditions. It highlights the impact of specific criteria on stock-screening to explain the inclusion or non-inclusion of a particular stock in the approved lists. Finally the chapter considers relevant strategies to achieve Shariah compliance status for stock based on established stock-screening criteria. Chapter eight provides you with an analysis of the different types of Islamic funds in terms of structure, features and economic behaviour. The discussion is limited to funds involved in commodities, gold, real estate, money markets and private equity investment. Specific focus is directed towards issues of structuring open-ended and close-ended funds, as well as exchanged traded funds (ETF) in relation to various underlying investment assets in the form of real estate funds,
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Introduction
commodity and gold funds, money market funds and private equity funds. This chapter considers the general performance of Islamic investments compared with conventional investments, particularly in the equity market. Finally, it introduces strategic considerations that could enhance the industry of Islamic asset management in the global market. Chapter nine introduces you to the structuring techniques of various Sukuk instruments, as well as the key issues relating to Sukuk as fixed-income instruments that are structured around different types of contracts with ancillary terms and conditions. The discussion covers the variety of product features that result from the possible different structures. A special discussion examines the structuring features of Sukuk post the AAOIFI pronouncement 2008, as the pronouncement has significantly affected previous structures and led to a decreasing number of Sukuk issuances. The chapter considers all Sukuk instruments issued before and after the AAOIFI pronouncement. The chapter examines the Sukuk rating methodologies adopted by relevant rating agencies, explaining and analysing them in terms of their usefulness and limitations. Finally, the discussion focuses on the impact of investor preferences and the effect that the changes in Shariah rulings have had on the structures and rating methodologies of Sukuk.
Takaful and Retakaful models and policies

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

Chapter twelve examines financial risk mitigation in the Islamic finance industry as exhibited by the product features of derivatives. It analyses the introduction of these structures and the challenges caused by variations in Shariah opinions, as well as changes in market conditions. The chapter also considers the application of financial arrangements using derivatives and their impact on market confidence in line with Shariah and regulatory requirements. Finally, it introduces you to the distinction between approved hedging mechanisms and non-approved speculative activities.
Learning outcomes
On completing this study guide you should have achieved the following learning outcomes:
Shariah contracts, structuring process and financial environment

Chapter one: Application of contracts in the structuring processes of Islamic financial products
By the end of this chapter you should be able to: suggest types of contracts, as a result of suitable analysis, deemed appropriate to particular products, based on intended or designed product features distinguish between Shariah-complaint products and Shariah-based products analyse the validity of contract conditions based on Shariah requirements assess the validity of product features based on contract conditions.
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Introduction
Chapter two: Structuring process and related challenges in the Islamic financial services industry
By the end of this chapter you should be able to: describe the structuring process in the development of Islamic financial products and services evaluate and analyse the impact of weaknesses in structuring financial products and services assess potential changes in industry requirements that have an impact on the structuring process.
Chapter three: Regulatory and prudential requirements and the supervisory review process for Islamic banking and financial products
By the end of this chapter you should be able to: explain the impact of the prevailing regulations and guidelines on Islamic finance distinguish and evaluate the impact of legislation in the dual banking system analyse the regulatory factors affecting the growth of Islamic financial services discuss the implications of a risk management framework and bank supervision for IFS.
Islamic banking system and products

Chapter four: Structuring deposits, investment accounts and money market instruments
By the end of this chapter you should be able to: analyse and evaluate the validity of underlying contracts in raising deposits and funds appraise prudential treatment in structuring Islamic deposits assess the implications of contract structures in meeting liquidity requirements
Chapter five: Structuring financing facilities for working capital and consumer financing
By the end of this chapter you should be able to: analyse and evaluate the validity and suitability of various underlying contracts in providing financing for different purposes discuss the risk features inherent in structuring financing products for both corporate and retail customers appraise the importance of a proper credit policy for Islamic consumer financing.
Chapter six: Project financing: structures and strategic considerations

By the end of this chapter you should be able to: analyse and evaluate the validity and compatibility of various underlying contracts to support project financing purposes recommend the relevant structure for different infrastructure project financing assess the risk features of project financing and propose appropriate instruments to mitigate relevant risk exposures.
Equity, Sukuk and fixed-income instruments

Chapter seven: Equity market regulations and issues of screening methodology for public-listed companies
By the end of this chapter you should be able to: assess the implications of various stock-screening criteria for Islamic-approved equities analyse the impact of specific stock-screening criteria on the acceptability of a particular stock recommend strategies for the inclusion of stock in Shariah-approved stocks and Islamic indices.
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Introduction
Chapter eight: Structuring and strategic issues for Islamic funds

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

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

Chapter ten: Takaful models and issues of legal and rating requirements
By the end of this chapter you should be able to: evaluate the various underlying contracts of Takaful analyse the impact of various Takaful management models on its participants and the Takaful operator analyse the impact of a Takaful fund deficit and underwriting surplus on the performance of Takaful funds explain relevant legal and rating requirements suggest appropriate Takaful policies and strategies for the sustainable growth of Takaful institutions and the Takaful industry.
Chapter eleven: Retakaful and retro-Takaful operations and industry in the global Retakaful market
By the end of this chapter you should be able to: evaluate the importance of the reinsurance business, its various structures and its application to Retakaful assess current global trends and issues affecting the re-pooling of Takaful funds to either Retakaful or reinsurance examine the validity and challenges of the reinsurance of Takaful contributions by conventional reinsurance companies recommend strategies for Retakaful and retro-Takaful in the development of the global Takaful and Retakaful industry examine governance issues affecting the Takaful and Retakaful industry.
Islamic risk management tools and strategies

Chapter twelve: Islamic derivatives as risk management tools for the Islamic financial services industry
By the end of this chapter you should be able to: assess the effective adoption of relevant contracts for derivatives analyse the impact of changes in market and Shariah rulings on derivatives evaluate the suitability of various types of derivatives to mitigate various financial risks analyse the distinction between hedging and speculation.
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Authors
Authors
Dr Mohd Daud Bakar

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

Dr Syed Musa Alhabshi is currently an Associate Professor with the Graduate School of Business, Universiti Tun Abdul Razak, Malaysia, and a fellow consultant with the International Institute of Islamic Finance and Amanie Business Solutions. He obtained a first class honours degree in business administration from the International Islamic University (IIUM), Malaysia, and was later awarded Doctor of Business Administration (Accounting and Finance) from Strathclyde University, UK. As a consultant with Centennial Group International, Dr Syed was involved in developing the Islamic Financial Services Board (IFSB) Prudential Standards. He has also served as a member of the Accounting, Auditing and Governance Standards Board of the Accounting Auditing Organization for Islamic Financial Institutions (AAOIFI). In Malaysia he has been involved in the development of MASB standards as well as conducting Islamic finance research and product development for regulators and industry.
Effendy Rahaman
Effendy Rahaman is a consultant with the International Institute of Islamic Finance (IIIF) and Amanie Business Solutions. He holds a degree in Business Management from the University of London, an MSc in International Economics (with Distinction) from Cardiff University, UK, and is currently pursuing his PhD in Economics from the University of Malaya in Malaysia, specialising in Monetary and Islamic Economics. Working with a team of industry specialists, Effendy primarily contributes to developmental work at both IIIF and Amanie. His expertise lies in the field of economic research and he has previously held several research assignments from the Malaysian Institute of Economic Research (MIER) and the International Centre for Education in Islamic Finance (INCEIF), an international Islamic finance university in Kuala Lumpur.
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Chapter one
Application of contracts in the structuring processes of Islamic financial products
Learning outcomes
By the end of this chapter you should be able to: suggest types of contracts, as a result of suitable analysis, deemed appropriate to particular products, based on intended or designed product features distinguish between Shariah-complaint products and Shariah-based products analyse the validity of contract conditions based on Shariah requirements assess the validity of product features based on contract conditions.
Indicative list of content

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

Islamic finance refers to financial business that complies with Shariah principles (CDIF/1/1/20). Islamic finance, like other financial systems, recognises the need for financial intermediation to achieve efficiency in the allocation of funds for productive activities. In this respect, financial institutions and financial markets are both essential components of a financial system to enable efficient mobilisation of funds. The salient features of Islamic finance, which are outlined in CDIF/1/1/23-25, include: the prohibition of interest the need for real transactional contracts involving underlying assets instead of lending money for interest the avoidance of uncertainty the avoidance of gambling the provision of deposits or financing based on profit and loss sharing the importance of adhering to the rights and liabilities arising from various transactional contracts
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the avoidance of dealing in non-halal goods or services the need for transactions to be consistent with the overriding principles of Islamic law in all terms, conditions and practices. These features provide the frame of reference for recognising Islamic financial activities, thus meeting Shariah compliance requirements.
1.1.3 What is Shariah compliance?

Essentially, Islamic finance is about avoiding prohibitive transactions and practices to achieve compliant status from a religious point of view. Of the features listed above, four are deemed to be fundamental to render a financial product compliant with Shariah principles. These are: avoidance of interest-based activities avoidance of uncertainty in transaction conditions avoidance of gambling activities avoidance of activities relating to non-halal goods and services.
As and when a financial product is free from these features, it may be considered compliant and acceptable.
1.1.4 Prohibited items or practices

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

In respect of financial and commercial transactions, the Quran commands the prohibition of interest, uncertainty in terms and conditions of the contract, gambling activities, and misappropriation of others property in an unjust manner, such as deceit, misrepresentation or fraud. The Quran also prohibits the consumption of intoxicants and non-halal food and drink. Islamic law has therefore been based on the principle, or maxim, of presumption of permissibility of any commercial matter or conduct until, and unless, evidence to the contrary is found or established. Applying this maxim in Islamic finance means that a proposed new product, or a new feature added to an existing approved product, can be advocated as compliant, unless or until an argument to the contrary is put forward. Arguments leading to prohibition are normally confined to the four identified practices or eventualities mentioned above.
Exercise 1.1
By reference to CDIF/1, identify where the prohibition of interest and the misappropriation of the property of others was founded in Islamic law.
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1.1.6 Shariah compliance

In Islam, social interactions in the form of commercial, financial, matrimonial or other forms of socially beneficial activities are not only permissible but encouraged. Divine guidance on acceptable conduct and moral action are revealed in the Quran and exemplified in the Traditions of the Prophet Muhammad. These two primary sources of Shariah are meant to preserve and promote the wellbeing of society, which is harmonious towards the common good, an important goal of Shariah. The general rule here is that all human activities are permissible unless prohibited under Shariah principles. For example, consumption should be directed to halal products and services that are beneficial to mankind. Essentially, the norms and values specified in the sources of Shariah and prescribed in the form of Shariah principles and rules are the basis for Shariah compliance. These have been documented as legal verdicts (Fatwas), Shariah rulings and resolutions of various supervisory boards, and Shariah standards set by relevant agencies. The salient features of Shariah compliance, that is the avoidance of prohibited activities and the fulfilment of mandatory requirements with regard to the terms and conditions of a particular contract, must be represented in both the process (means) and outcome (end) (CDIF/1/2/40-41).
Key point
A Shariah-compliant product requires the avoidance of all prohibitions and the fulfilment of all contract requirements.
Exercise 1.2
An exporter receives a Letter of Credit worth US$1 million issued by an importers bank to export printing equipment. The Letter of Credit will mature 90 days after the issuance date. The exporter seeks to liquidate the Letter of Credit by assigning it to an Islamic financial institution (IFI) for a cash payment of US$1 million. Would this practice be acceptable in Islamic finance? If you think it is, what could happen that would cause this practice to be non-compliant? In order to test your knowledge, the answer to this question may not be evident from the discussion so far. We recommend that you refer to CDIF/1/6/116 and CDIF/3/6/99-100 before attempting to answer this question.
1.1.7 Islamic financial products

When creating an Islamic financial product, its purpose, design and structure, legal documentation, operational process flow, accounting treatment, monitoring, recovery and restructuring (if any), IT support and risk management must all comply to Shariah principles and rules.
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Figure 1.1 Stages of product development
Recovery & restructuring Monitoring
* These processes are supported by IT Support & Risk Management
Accounting treatment
Operational process flow
Legal documentation
Product design and structure
1.1.8 Shariah compliance governance

To ensure that financial products and services are Shariah-compliant, various organs of Shariah governance have been established to guide and monitor institutions offering Islamic financial products and services. The Shariah Supervisory Board (SSB) provides direction in formulating legal verdicts (Fatwas) as well as Shariah endorsements on Islamic financial products (CDIF/1/2/42-43). Standard setting bodies such as the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) and the Islamic Financial Services Board (IFSB) promulgate Shariah governance, audit and prudential standards to guide the industry in adopting the prescribed or recommended practices (CDIF/1/11/184).
Exercise 1.3
Based on your knowledge of Islamic contract principles and giving reasons for your answer, which of the following does and does not describe a Shariah-compliant financial product? Product A Description A deposit that promises a fixed return based on a Murabahah-tawarruq transaction.1 Mutual fund issuing two classes of shares/units whereby class A takes precedence over class B in profit distribution and loss distribution (in the case of liquidation). The disbursement of profits in Musharakah not in accordance to capital contribution ratio. The rescheduling of a Murabahah facility for an extra profit due to the revised tenor of payment.
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1.2 Structuring of Shariah-compliant financial products

1.2.1 Design and structure of the product
For any financial product to be deemed Shariah-compliant, various parties must carry out a systematic analysis and evaluation concerning its design, structure and development, particularly at the origination phase. Islamic financial product initiatives arise by either adapting existing conventional products to meet Shariah requirements or by developing new products based on Shariah requirements without any link or reference to conventional financial product design and its economic benefit. The former are generally known as Shariah-compliant products, the latter are generally described as Shariahbased products.
Key points
Shariah-compliant financial products relate to an existing comparable conventional financial product, having the same economic benefit but excluding any prohibited elements. Shariah-based financial products are new products with features that are fundamentally derived from Shariah principles, with no comparison to any existing conventional financial product features.
1.2.2 Shariah-compliant products

Shariah-compliant products are based on existing conventional financial products, particularly with regard to their economic benefit and risk behaviour. These products, in general, do not differ from their conventional counterparts except that they are free from interest and other prohibited features. Examples include Islamic debit cards, Islamic credit cards, Islamic personal financing, call options and profit rate swaps.
Figure 1.2 Examples of Shariah-compliant products
Islamic credit cards
Islamic debit cards Shariah compliant products
Islamic personal financing
Islamic profit rate swaps
Islamic call options
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Urbun is essentially a down payment made by a buyer to a seller after both parties have entered into a valid contract. The down payment represents the commitment to purchase the goods.
A call option would give the right, not an obligation, to the holder to purchase an underlying asset at a certain agreed price in the future (strike price). If the holder of the call option decides not to exercise the option, the premium paid will be forfeited. This practice can be replicated in Islamic finance on the basis of the Urbun contract (CDIF/3/13/214).
1.2.3 Shariah-based products

Shariah-based products comprise financial products that are not only compliant to Shariah principles but are also based on features that are unprecedented in conventional financial products. These products are not found in a conventional financial system and thus may require, for example, a different treatment of risk management, accounting, corporate governance, security and collateral and legal requirements. Examples of such products include Mudarabah for an investment account, Sukuk, which reflects asset-based securitisation, house financing based on Ijarah with an option to purchase, or Musharakah mutanaqisah, which is based on Musharakah and a Letter of Credit.
Figure 1.3 Examples of Shariah-based products
Mudarabah investment account
Sukuk Shariah based products
Ijarah house financing
Musharakah letter of credit
Musharakah mutanaqisah house financing
Sukuk Ijarah, for example, gives Sukuk investors the right to benefit from the rental lease payment payable by the originator/lessee. However, it is different from conventional bonds as it allows Sukuk investors recourse to the originator/lessee to repurchase the leased asset from Sukuk investors in the case of default. This is made possible because Sukuk investors in the case of Sukuk Ijarah, unlike conventional bond holders, are owners of the leased asset (CDIF/3/7/106-107).
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Islamic finance challenge 1.1

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

The dichotomy between Shariah-compliant and Shariah-based products is more prevalent in dual banking systems when Islamic financial products retain most of the conventional product features to gain acceptance and be competitive. In the dual banking system, where both conventional and Islamic financial institutions operate within a similar financial environment and provide financial services to a common pool of customers, depositors, investors or issuers, the opportunity to expand the spectrum of financial products and services will always be explored by the relevant institutions. For example, a conventional bank that has established an Islamic window or Islamic subsidiary would be inclined to design similar product features for both Islamic and conventional products that can be supported by common shared bank services, such as legal, accounting, risk management and IT systems. Hence the motivation would be to benefit from economies of scale while engaging in a new market segment of Islamic finance.
Exercise 1.4
To benefit from its existing IT and risk systems, and support shared services that will be costeffective, the Islamic window of a conventional bank seeks to offer its clients an overdraft facility which is compliant to Shariah principles but has the same financial or economic benefit as its conventional overdraft. (a) Explain how the Islamic overdraft could be structured. (b) State whether the new overdraft would be deemed as Shariah-compliant or Shariah-based.
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An Islamic financial institution wants to offer a new product, similar to a conventional overdraft that would allow clients to benefit from the financing facility as and when required. The management of the institution decides not to use Tawarruq as the basis of this new product. They ask you to advise them as to the potential contracts that could be used for this purpose. They mention a few contracts such as Qard, Salam, Mudarabah and Musharakah for your consideration. Your response should briefly describe how these contracts may be constructed to have the same economic benefit as an overdraft facility.
Solution
An overdraft facility is meant to provide flexibility to clients to meet short-term obligations and is usually packaged as part of project financing or cash financing. Islamic finance recognises this short-term liquidity need and can support it with a range of contracts depending on the ancillary purpose to which the facility is attached. Where the customer requires minimal overdraft payments to support current account transactions, a few institutions may offer Qard, an interest-free loan. This would most likely be offered only to their privileged customers. In the case of project financing where identifiable assets are purchased as part of working capital financing, the revolving facility could be based on the Murabahah contract where every drawdown is accompanied by a sale contract. If such a facility represents a continuous commitment by the bank to provide cash or capital, then it may take the form of either Mudarabah or Musharakah capital, designated as a float to meet the short-term obligations. Generally, the economic benefit to the customer is that it allows flexibility in cash flow management, while the economic benefit to the bank is that it allows for an effective yield when providing financing to the client. Alternatively, an Islamic overdraft may be structured based on a Salam contract where the seller of Salam will get the cash in advance for his own use. This contract can provide cash financing that can replicate the conventional overdraft.
The flexibility provided by financial authorities to Islamic financial institutions to extend beyond the traditional lending and borrowing activities of the core banking system facilitates the development of either enhanced products or new financial products.
1.2.5 Shariah requirements for structuring financial products

Generally the structuring for Shariah-compliant financial products involves two stages: (a) developing the product concept; and (b) a review of the product concept by a Shariah board or committee. (a) Developing the product concept The client who intends to raise funds or provide financing to a particular customer will prepare and present a product concept of the intended financial product. The product concept should state: the purpose of the funding or financing the activity being funded the asset or project meant for fund utilisation the financing amount and the manner of disbursement the payment schedule the expected yield or return to the financier any form of security or collateral required to mitigate the risk exposure of the product.
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In addition, where relevant in specific jurisdictions, it is also necessary to consider the validity and enforceability of the product in the given legal framework. For instance, the application of bankruptcy remote Special Purpose Companies (SPCs) in Sukuk structures is made easier in countries that practise a common law legal system that accepts the concept of beneficial ownership, vis--vis legal ownership under the equity principle of common law. Companies can use SPCs to legally isolate high-risk projects/assets from the parent company and allow other investors to take a share of the risk. Some civil law countries such as Bahrain have had to introduce a special law on trust in their civil law jurisdiction to facilitate the incorporation of an SPC as the trustee holding Sukuk assets on behalf of, and in the interest of, the Sukuk holders. This legal structure has the benefit of protecting the interests of Sukuk holders during the tenor of the Sukuk. Creditors to the originator/legal owner of the asset/lessee will not be entitled to make any claim from the asset as the trust is held exclusively for the benefit of the beneficiaries/Sukuk investors. Tax implications arising from the product features may also have to be considered. Countries such as the UK and Singapore, that have amended their Stamp Duty Acts to avoid double stamp duty, are facilitating the development of Islamic financial products and services that have to use more than one transaction to achieve the economic benefit intended of a Shariah-compliant product such as Murabahah asset financing and Murabahah cash financing.
Table 1.1 Islamic financial product features and Shariah requirements

Product features Purpose of fund/financing Activity, asset or project for fund utilisation Financing amount Disbursement schedule Payment schedule Profit or yield determination or estimation and recognition Shariah requirements Specified and legitimate Legitimate and traceable
Specified with no interest income or obligation Specified and must observe contract requirements Specified and must observe contract requirements Irrespective of whether it is fixed (sale contract) or floating (Ijarah) or estimated (equity), the amount or the benchmark or the ratio must be fixed Legitimate assets and mechanisms, and must observe contract requirements
Security or guarantee
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(b) Reviewing the product concept by a Shariah board or committee. The second stage of the process involves a Shariah board or committee reviewing the product design and features to determine whether the product design and its features are permissible. The decision on permissibility is based on Shariah requirements that include, but are not limited to, whether: (a) the purpose of financing or fund raising is lawful and legitimate according to Shariah requirements (b) an identifiable asset, activity or scope of the project has been determined to ensure that the funds are utilised according to the designated purpose (c) the financing amount generated relates to a valid underlying Shariah-approved transaction, meaning it is sale or leased-based, or involves an equity claim (d) the choice of contract for the transaction is suitable for the funding or financing arrangement in that it fulfills the elements and conditions of the contract, as well as any ancillary conditions of other supporting contracts (e) where more than a single contract is executed, the process is permissible according to Shariah (f) the manner of disbursement is consistent with the conditions of the underlying contract (g) the determination and recognition of the yield or return is consistent with the conditions of the underlying contract (h) the payment schedule and re-schedule (if any) is consistent with the conditions of the underlying contract (i) the security arrangements, such as collateral or guarantee, which are meant to safeguard the interest of the financier, issuer or investor, are compatible with the purpose of financing, and are consistent with Shariah requirements.
Exercise 1.5
Given the excessive volatile market conditions, an asset management company launches an Islamic product known as an Islamic Capital Guaranteed Fund. This fund will be invested only in Shariah-compliant stocks. However, there is an undertaking by the fund manager to purchase back the units of shares in the fund at a price equivalent to its initial purchase cost if the index of the fund has depreciated less than the initial Net Asset Value (NAV) of the fund. (a) Would this product offering be complaint to Shariah principles? (b) Explain your reasoning for the answer given in (a) above. (c) Suppose the same asset management company has changed the strategy from a Capital Guaranteed Fund to a Capital Protected Fund, would the Shariah perspective be different from the previous product design and strategy?
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1.2.6 Purpose of funding and suitability of contracts

At this stage the product development manager would need to provide substantive information on product features and structure, taking into account implementation issues as well as the monitoring and redemption or restructuring of the product, where relevant. The most critical issues for the Shariah board or committee to assess are the purpose of funding or financing, as well as the validity and suitability of contracts used to support a particular financial product. For example, if the purpose of funding or financing is not permissible in Shariah, or is ambiguous and may involve elements of prohibited activities, a financial product will not be considered as compliant. Similarly, in the case where the sale contract is adopted but the subject matter of sale is unknown, uncertainty or Gharar will result in the financial product not being approved.
Table 1.2 Financial product structuring: Shariah considerations

Critical considerations in financial product structuring Is the purpose of the financial product lawful and proper? Do the elements of the contract form a valid and enforceable contract? Do the payment and yield avoid any prohibitive financial elements of the financial transaction?
Exercise 1.6
In a Murabahah commodity structure to facilitate cash financing as well as fixed-income financing products, one of the parties to the transaction must purchase a commodity from the original owner prior to selling the same commodity to the other counterparty, which is then paid via a deferred payment scheme. The following specifications of an underlying asset for this facility are described in the schedule of the Murabahah Financing Agreement as follows: a. b. c. d. e. Type of asset: Aluminium Quantity: 10 tons Quality: Grade A Location: Not available Identification: Not available
(a) Would this transaction based on the above specifications be a valid sale? (b) State the reason for the validity or invalidity of this sale.
Follow-up question:
(c) If the object of the sale was gold and not aluminium, and the location and identification were fully designated and identified, give reasons as to whether the Shariah ruling would be different.
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1.3 Juristic rulings and financial product structuring

1.3.1 The juristic rule formulation processes
The juristic rule formulation processes in reviewing financial products take into consideration both the sources and methodology of interpretation of Islamic commercial law. The sources of law, which refer to the Quran and the Traditions of the Prophet Muhammad, contains general principles of law and, where a rule or legal argument is used, substantive law (CDIF/1/3/55-56). The methodology of Islamic law is based on Ijtihad or legal reasoning, which adopts various tools and techniques, namely: Ijma, or consensus Qiyas, or analogical reasoning based on Illah, or ratio decidendi Istihsan, or juristic preference Maslahah, or public interest Sadd al-dharai, or blocking the means Urf, or customary practice Istishab, or presumption of permissibility.
The outcome of the legal interpretation is Fiqh, which is a set of practical rulings and laws governing a specific case law or issue that requires a specific solution (CDIF/1/3/60-64). Islamic legal theory, as a discipline, helps jurists interpret and deduce the law using guided and systematic reasoning. Reasoning cannot be void of Shariah guidance as the sources of law are absolute and immutable. The application of various juristic techniques in interpreting and deducing Islamic law has resulted in the development of various schools of Islamic legal thought. The four prominent schools of law are the Hanafi, Maliki, Shafii and Hanbali schools. (CDIF/1/3/66-68) The structuring of Islamic financial products may vary in acceptability based on the application of different juristic techniques by the various schools of law. It is important to be aware of such variations if this is exhibited in different Shariah rulings on Islamic financial products. For example, scholars are divided in their interpretation of a Tradition of the Prophet that a person must not sell something (to a third party) until, and unless, he has taken possession of the asset. While the majority of scholars have applied this prohibition to all types of asset, the Maliki school of law has qualified this prohibition to mean only food items. Therefore, a person may sell non-food items to a third party, even though he has not actually taken possession of the asset that has been sold.
1.3.2 Forms of juristic rulings

Jurists use a process to arrive at a legal ruling under the guidance of broad Shariah principles known as Ijtihad. The ruling could either be textual-based or human-based reasoning. The latter may, among others, be based on equity and consideration of custom. The process of determining a juristic ruling involves a systematic process based on the hierarchy of the sources of Shariah, as well as the appropriate application of juristic techniques in deducing the appropriate ruling for a Shariah-compliant activity or contract.
Table 1.3 Impact of juristic rulings on financial product structuring

Forms of juristic ruling Text-based reasoning Impact on financial product structuring
Consistent and firm legal view based on revealed Quranic text and relevant Prophetic traditions Permanence. Example: prohibition of usury/interest.
Human-based reasoning
Varies in accordance with the juristic techniques used in understanding the technicalities of the contract and their requirements Transient. Example: permissibility of a conditional sale with an option to re-purchase the same asset at the same face value in the future.
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1.3.3 Structuring and contract requirements

In Islamic finance the adoption of a valid and enforceable contract is the primary consideration in structuring an Islamic financial product. Generally the elements of contract comprise: (a) (b) (c) contracting parties (offeror and offeree) with legal capacity offer and acceptance the object and consideration.
The legal capacity of the contracting parties applies to both natural and legal persons. The nature and purpose of the object of the transaction are to be Shariah-compliant, known, determined and deliverable. The consideration must be lawful, precise and of a determinable value as well as deliverable. If any of these elements are found wanting, the contract is invalid and not enforceable, and hence will render the financial product non-Shariah compliant.
Table 1.4 Purpose and consideration of unilateral contracts

Elements Offeror and offeree Offer Acceptance Object Consideration Requirements Legal capacity to enter into contract for both natural and legal persons
Effective communication by offeror to transfer or receive benefit from offeree Effective communication by offeree to transfer or receive benefit from offeror Lawful, determinable, measurable & deliverable Lawful, determinable, measurable & deliverable
1.4 Financial product features and purpose of Islamic contracts

1.4.1 Bilateral or unilateral contracts
Either bilateral or unilateral contracts can be adopted for structuring a financial product. A bilateral contract arises from a counterparty exchange of considerations while a unilateral contract is where a consideration is transferred from one party to another for no reciprocal consideration. Bilateral contracts are categorised according to various commercial purposes for the benefit of both parties to the contract. Unilateral contracts have only one purpose, which is to provide a financial favour to one party for no consideration in return. Thus, bilateral contracts, unlike unilateral contracts, have many different financial motivations which each contract under the purview of a bilateral contract is designed to achieve. These are contracts for works or services, safe custody, security, partnership, leasing, sale and loan. Further sub-classification is based on the form of consideration, the subject matter of contract, the pricing, the payment modes or the delivery type. All of the above applies only to bilateral contracts and hence their classification.
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This can be illustrated in the following table:
Table 1.5 Purpose and consideration of bilateral contracts

Purpose Consideration Sub-features Contract type Jualah Wakalah
Provision of services for the benefit of the principal (services) Provision of safe custody for the depositor (safe custody) Security in favour of the party in whose interest the contract is concluded (security) Partnership to share the profit or profit and loss (partnership) Enabling the non-owner to benefit from the usufruct of anothers assets (lease)
Commission fee Agency fee
Safe custody fee
Wadiah
Transfer of debt Guarantee Pledge Capital only Capital & work
Hiwalah Kafalah Rahn Musharakah Mudarabah
Usufruct only Usufruct with ownership transfer option
Ijarah Ijarah muntahia bi tamleek Currency Financial assets Tangible assets Intangible assets/ rights Bay
Transfer of ownership from the original owner to another (sale)
Subject matter
Pricing
Discount Cost plus mark-up Negotiated Sale Cost price
Wadiah Murabahah Musawamah Tawliyah Salam Istisna Muajjal Istisna Salam
Payment
Advance Progressive Deferred
Delivery
Piecemeal or one-off delivery One-off delivery in the future
Provision of the right to use for no consideration (loan)
Non-monetary
Qard Ariyah
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Based on the respective purpose of the contract, one can identify appropriate exchange considerations that must be used as the basis of the financial transaction and hence the type of contract.
Exercise 1.7
In an Islamic financing scheme, the client may wish to acquire the asset on a deferred payment basis or may just wish to have the right to use the usufruct of the asset without having an ownership right over the asset. On the other hand, the client may have ultimately the option to either use the asset or acquire the asset as he wishes, without having any pre-agreed obligation for either. Also, the client may wish to purchase an asset, but have it delivered in the future for either a flexible scheme of payment or a lump sum payment. Alternatively, the client may invest in the asset with the view of benefiting from the income generated by the asset, but having the flexibility to liquidate the investment in the asset in an effective and low-cost manner. Given each of the possible requirements outlined above, state the respective contract that could be considered by an Islamic financial institution to meet the requirements of the above client.
1.5 Application of essential contract conditions to recognised contracts for financial products
The following is the brief summary of the contract classifications that match the financial product purpose and the purpose of the contracts in Islamic commercial law.
1.5.1 Work services

Here the financial services performed include collection or payment services. The contract would initially be considered work or serviced-based. The contract could be Wakalah or Jualah, depending on the nature of the reward payable to the worker or person who performs such a work. A Jualah contract is based on a fee that is only payable upon the successful performance of the required work. Wakalah could either be for a fee payment, which is paid irrespective of the successful performance of the required work, or it could include a no-fee payment feature.
Recognition criteria
Wakalah services rendered could be compensated with a fee or could be free of any fee. Jualah services rendered and where the required work expectation has been achieved should be compensated with a performance fee.
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1.5.2 Safe custody services

Depending on the specific circumstances, two contracts could be used in relation to the offer of safe custody services. Where financial institutions, acting in trust, hold funds or assets in safe custody for a third party, a Wadiah yad amanah contract would be adopted with a fee paid for the safekeeping services. Alternatively if the institution, as the custodian, wishes to utilise the funds with the permission of the depositor and, at the same time, guarantees the nominal value of the funds (in the case of monetary assets), a Wadiah yad dhamanah contract should be adopted.
Wadiah yad amanah safe custody of monetary and non-monetary assets. Wadiah yad dhamanah safe custody of monetary and non-monetary assets with permission to use those assets but to guarantee those assets in all circumstances.
1.5.3 Security
The appropriate contract to be used when a debt due to or from one party is transferred to another with the permission of the original creditor or debtor as a consideration for the purpose of settlement is known as Hiwalah. For example, a customer with a deposit amount placed in Bank A may request a third party to collect his debt from Bank A. Effectively, the customer has transferred his obligation to another party so that Bank A will have to affect the payment to this party, the creditor. The bank of an importer, which guarantees payment to an exporter according to the terms specified in a Letter of Credit, could provide this service using the contract of Kafalah. For example, when the goods specified in a Bill of Lading match those specified in the Letter of Credit the importer financial institution, being the guarantor, will undertake to disburse payments to the exporter. In addition, any pledge made by the customer to secure a line or facility can be made based on the Rahn contract. For example, a trader may pledge specified assets in favour of the financier to secure the payment obligation by the trader to the financier.
Hiwalah debt settlement via assignment of debt in favour of the principal creditor. Kafalah guarantee executed to guarantee the payment or delivery of asset to secure the interest of creditor or purchaser. Rahn pledge of asset to secure interest of creditor.
1.5.4 Partnership
Both the Musharakah and Mudarabah contracts can be used in cases of partnership. When two or more parties provide funds for a common commercial purpose, where the PSR is specified and agreed between them and the loss sharing ratio corresponds to their capital contribution, the appropriate contract would be Musharakah. Alternatively, if one party provides funds and the other provides the entrepreneurship, where the profit is shared between them (agreed PSR), but losses are borne by the capital provider, then a Mudarabah contract would be adopted.
Musharakah funds provided by two or more parties who mutually agree on a PSR and share losses based on their capital contribution. Mudarabah funds provided by one party and entrepreneurship by another, with both sharing profits and the provider of capital bearing the loss.
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1.5.5 Leasing
In cases where the customer prefers to benefit from the use of the asset while not owning it, financing through a lease based on the Ijarah contract could be considered. In this case the financial institution finances the customer by acquiring the asset and leasing it to the customer. Alternatively, if the customer prefers the right to own the asset to be embedded in the lease agreement, a contract of Ijarah muntahia bi tamleek (lease with purchase option) could be adopted.
Ijarah transfer of beneficial use of asset (usufruct) to the party who uses the asset for a consideration. Ijarah muntahia bi tamleek transfer of beneficial use of asset (usufruct) to the party who uses the asset for a consideration, plus an option to acquire the asset.
1.5.6 Sale
Financing through the sale of an asset is the most prevalent form of financing. The goods, which must be Shariah-compliant, could be tangible, financial, currency, receivables or intangible assets. When the financial institution assumes the position of a seller, it will purchase an asset at cost price and subsequently sell it at cost plus mark-up. This transaction makes use of the Murabahah contract. Alternatively, where deferred payment is required, the customer will request the financial institution to finance the purchase of an available standardised good or commodity, which the financial institution then sells to the customer on a deferred payment (Muajjal) basis for a negotiated price (Musawamah) without need to disclose the cost. Both structures enable the financing of the purchase of identifiable assets. Where an IFI completes the sale at cost to facilitate the delivery of goods, the appropriate contract is Bay al-tawliyah. Finally, an IFI may sell the asset it purchases at a price below the cost price to liquidate the commodities in a relatively shorter time to avoid storage problem. This sale is known as Bay al-wadiah. The common legal requirement of all Murabahah, Tawliyah and Wadiah sales is that the seller shall disclose the actual cost price in their quotation made to the purchaser. When payment is made in advance and the commodity is to be delivered in the future, a Salam contract is adopted. Alternatively, if the goods specified have to be manufactured or constructed and subsequently delivered, the sale contract used would be Istisna.
Murabahah sale sale of goods at cost plus mark up. Musawamah sale sale of commodities at negotiated price. Wadhiah sale sale of goods at a discounted price. Tawliyah sale sale of goods at cost. Muajjal sale sale with deferred payment feature. Salam sale sale with advance payment and deferred delivery of commodity. Istisna sale sale of goods yet to be manufactured or constructed with option of a flexible payment scheme.
1.5.7 Loan
When cash is extended as a loan for a specified period of time, the contract adopted is Qard. No return is allowed on the loan, although the borrower is legally required to return the loan capital to the lender. The loan capital is the liability of the borrower to repay in all circumstances. The lender can only demand for actual expenses incurred in providing this loan, such as paper work, telecommunication charges and lawyer fees.
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Table 1.6 Purpose and consideration of unilateral contracts

Purpose Will to bequest to posterity Waiver to set aside right Donation to discharge social obligation Gift to transfer asset with no reciprocal benefit Promise to undertake obligation to perform Consideration Asset Right to benefit or claim Asset Recipient Counterparty Beneficiary Contract type Wasiyyah Ifa Sadaqah
Asset
Recipient
Hadiah/Hibah
Undertaking to perform
Promisee
Wad
1.5.8 Will
Unilateral contracts are either adopted independent of other contracts or as enablers for other contracts. Bequests in the form of a will are made by the owner of wealth when such wealth is transferred to beneficiaries specified in the will. The application of the will is executed to enable continuity of the rights of ownership or claims on the wealth that is transferred to the beneficiary. This allows for business continuity as well as the relevant inherent financial rights, claims or liabilities.
1.5.9 Waiver
A waiver is a contractual right to relinquish the right to make a claim. For example, a lessor has a right to claim lease payments but may waive such payments for a specified period.
1.5.10 Donation
A donation is a benevolent act of charity where wealth, or the right to benefit from such wealth, is transferred to another party for no exchange consideration in aid of a charitable or social cause.
1.5.11 Gift
A gift is effected in financial transactions to enable the complete transfer of ownership of wealth or the right of claim. Similar to other unilateral contracts, there is no expected consideration payable by the recipient to effect the contract.
1.5.12 Promise
A promise is made to provide assurance to the party that benefits from such a promise that any benefit expected to accrue to such party will be fulfilled, or any disadvantage that may affect such party is avoided.
Wasiyyah A bequest in the form of a will to designated beneficiaries. Donation A charitable act of wealth transfer to a beneficiary. Gift A transfer of wealth in the form of an asset or return for the benefit of one party. Promise An undertaking to safeguard the interest of one party by securing a benefit or avoiding a disadvantage to that party.
Key point
While a bilateral contract aims to satisfy both parties to the contract financially, a unilateral contract seeks to financially reward only one party to the contract, that is, the recipient.
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Exercise 1.8
From a list of transactions described below, identify the type of contract(s) adopted for the transaction, explaining the criterion for your choice. A Financing arranged for the purchase of a property by a customer which is agreed at cost plus mark-up, with the property secured as collateral. A fund manager agrees to manage the equity fund on a fee basis where the profit and loss is shared exclusively among the investors. A leased asset is securitised for investors to benefit from the lease payments generated for the specified period. A deposit received will entitle the customer to share the profits earned from the banks financing and investment activities.

A proposal is developed by an IFI to launch Islamic Ijarah financing for vehicle and consumer goods for the retail market. The proposed tenor for this financing is five to seven years. Given the fact that the cost of the fund is volatile, the IFI proposes to make the rental rate floating, based on the discretion of the IFI taking into account the profit rate to be paid to its depositors with Profit Sharing Investment Accounts (PSIA), displaced commercial risk, as well the competitive rate in the market to achieve a degree of equilibrium between the IFIs depositors and the retail financing customers. The IFI also proposes to grant a rebate for early payment based on its sole discretion. Identify the type of contract involved and the potential Shariah issues involved in structuring this product based on the above features.
Solution
The above retail finance scheme is based on an Ijarah contract that is part of the bilateral contract. Although the illustration did not specify the actual classification of the Ijarah contract, it seems that the proposed Ijarah for this scheme is Ijarah muntahia bi tamleek whereby the vehicle or consumer good is intended to be transferred to the customer ultimately. The contract for the rebate for early payment is based on a gift contract which is unilateral in character. Under Shariah principles, the discretion of the IFI in fixing the floating rate of rental payment in an Ijarah contract is not permissible simply because Ijarah is a bilateral contract that requires the pricing formula to be agreed or fixed upfront to avoid uncertainty (Gharar). A certain established benchmark must be agreed upon to decide the future floating rate of rental. However, uncertainty in a unilateral contract such as a rebatebased transaction is permissible as the ultimate aim of the unilateral contract is not financial but rather a kind of reward or favour to the recipient.
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1.6 Conclusion
This chapter has introduced you to, and demonstrated the importance of, Shariah compliance in structuring Islamic financial products. By reviewing the sources and methodology of interpretation of Shariah principles governing Islamic commercial law, we have explained how Shariah rulings affect the structuring of Islamic financial products. Discussion on the formation and classification of contracts explained the importance of recognising the appropriate contract when matching the purpose of the contract with the intended or selected product features. Finally the overall structuring process that addresses Shariah requirements within the framework of Shariah governance and review was mapped out to enable you to determine Shariah compliance for different types of Islamic financial products in the banking, capital markets and Takaful sectors of the Islamic financial services industry
1.7 Summary
Having read this chapter the main points that you should understand are as follows: the products of the Islamic financial services industry evolve with respect to the expectations of both financiers and customers in each respective market Islamic finance recognises the need for financial intermediation to achieve efficiency in allocation of funds for productive activities the principle of presumption of permissibility in Islamic law is the Islamic legal maxim that dictates that all matters are deemed to be approved unless proven otherwise various organs of Shariah governance have been established to guide and monitor institutions offering Islamic financial products and services in terms of their compliance and performance Shariah-compliant financial products relate to existing comparable conventional financial products, having the same economic benefit but excluding any prohibited elements Shariah-based financial products are those with features that are fundamentally derived from Shariah principles, with no comparison to any existing conventional financial product features Shariah-compliant financial products are structured through the development of the product concept and a review of the product concept by a Shariah board or committee the validity and enforceability of the developed product in the given legal environment is an important consideration the structuring of Islamic financial products may vary in acceptability, based on the application of different juristic techniques that stem from the variety of methodologies of interpretation adopted by the various schools of law a valid and enforceable Islamic contract must comprise of contracting parties who possess legal capacity, an offer and acceptance, and the object matter and consideration the type of contract used as the basis of the financial transaction must reflect the appropriate exchange considerations identified.
1.8 Islamic finance case study

Structuring products and choice of contracts
First Time bank, a conventional bank, is at the initial stage in offering Islamic financial products. In a recent board meeting, the chairman raised the issue of the soundness and stability of Islamic financial products due to the controversy arising from new rulings on permissible products and nonenforceable contracts. The chief executive officer (CEO) updated the board by explaining that the Islamic Financial Authority is re-visiting the status of the financial services industry, particularly with reference to the legitimacy and acceptance of certain Islamic financial products. The CEO agreed to direct the Product Development Department to review the contract types adopted in the Islamic financial products offered by the bank and present a report at the next board meeting.
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Conventional Deposits Current Account Savings Account Fixed Deposit Loans and Advances Term loans Motor vehicle finance lease Personal loan
Islamic alternative offered Islamic Current Account - Qard Islamic Savings Account - Qard Islamic Investment Account - Mudarabah Murabahah term financing Ijarah motor vehicle finance Tawarruq
Notes:
When designing its Islamic deposit products, the bank promised dividend returns equivalent to conventional interest paid to customers. For its Murabahah term financing, the profit due to the bank accrues as long as the financing amount is outstanding without any additional mark-up. Its Ijarah vehicle financing calculates a profit rate similar to motor vehicle finance lease. Its Islamic personal financing provides cash financing and computes profit rates on a drawdown basis similar to that of an overdraft. As the product development manager of the bank, you are asked to review and analyse the contract types of the core banking products adopted by your bank.
Upon reviewing the Islamic financial products and consultation with a Shariah scholar, the product manager prepares the following report:
Review of First Time Islamic financial products

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

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

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

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

1. Which of the following features of the rate payable in the above-mentioned Islamic deposit is not consistent with Shariah principles? (A) Rate payable based on predetermined rate on outstanding deposit period (B) Rate payable to Murabahah fixed income depositors based on predetermined profit (C) Rate payable based on profit distributable to Mudarabah account holders (D) Rate payable based on floating rate of return on outstanding deposit
2. In the case of Murabahah term financing it is necessary to execute: (A) disbursement of cash payment to the customer for the approved amount (B) sale of goods to the customer at cost plus mark-up subsequent to cash purchase from the supplier (C) sale of goods to the customer at cost plus mark-up prior to cash purchase from the supplier (D) disbursement of cash to the customer to purchase the goods from the supplier.
3. In Ijarah financing of the First Time bank, which of the following features is not consistent with the Ijarah contract: (A) bank purchases and leases the assets to the customer (B) customer purchases and the bank leases the asset to the customer (C) customer sells the asset to the bank and leases the asset back from the bank (D) customer purchases and leases the asset to the bank
4. Which of the following products for providing cash financing is compliant with Shariah principles? (A) Cash financing based on Qard with a predetermined return (B) Cash financing based on Murabahah with a mark-up (C) Cash financing based on Wadiah with a predetermined return (D) Cash financing based on Musharakah with a predetermined return
5. Based on the information provided and using the structuring process described in this chapter, which of the following product features should be analysed and evaluated first? (A) Contract requirements (B) Customer expectations (C) Current banking practices (D) Customer cash flow requirements
Case study short essay questions

1. How appropriate are contracts identified for the Islamic financial products offered by the First Time bank? 2. Do the product features portray the underlying contracts adopted by the products? 3. State the essential purpose of the contracts relating to each product feature. 4. Recommend the structuring process that would take into consideration the relevant Shariah requirements.
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Chapter one answers

Exercise 1.1
The prohibition of usury (Riba) and the misappropriation of the property of others was specifically mentioned in the Quran in Chapter 2:275 and Chapter 4:29 respectively (CDIF/1/1/24).
Exercise 1.2
This practice could essentially be envisaged as permissible in principle as it has no element of interest, uncertainty, gambling or any dealing with non-halal goods and services. Without looking for specific evidence for its permissibility (CDIF/1/6/116) one can safely conclude, although on a preliminary basis, that this practice is, and should be, permissible because it is free from the prohibitive practices and transactions as outlined in Shariah. This practice could, however, be rendered non-compliant if the IFI exchanges the Letter of Credit for a cash value of below US$1 million. The transaction would then generate interest. This is against Shariah principles, as the monetary asset in terms of Islamic receivables worth US$1 million is not being exchanged for money on a par value.
Exercise 1.3
Product A Description The promised fixed return on deposit via a Murabahah-tawarruq contract is compliant as this contract is not equity-based. This is not compliant as the investors in the same fund must be treated equally in terms of profit sharing and loss distribution. The profit-sharing ratio in a Musharakah contract can be pre-agreed or be based on a capital-contribution ratio. The rescheduling of the Murabahah tenor of payment for extra profit due to a longer tenor is not compliant as the Murabahah selling price must be fixed at all time.
Exercise 1.4
(a) The structure of an Islamic overdraft could be based on the Tawarruq principle. A conventional overdraft facility provides a cash line that enables the customer to utilise the loan for any purpose. Similarly, Tawarruq enables a cash line for the customer to utilise the funds for any lawful purpose in a flexible manner. However, an overdraft has predetermined interest charged on any amount outstanding. Under Islamic finance this is prohibited as usury. Tawarruq involves a mark-up sale that generates profit for the specified credit period (CDIF/2/5/108). (b) This is simply a Shariah-compliant product because it is based on the same behaviour as the conventional overdraft in terms of its accounting and risk management scheme.
Exercise 1.5
(a) The product outlined would not be Shariah-compliant. (b) One reason for this is that the par value of the fund capital is guaranteed, which is inconsistent with Shariah principles. An equity contract should not guarantee either the capital or the profit. A guarantee in any form in equity-based funds, either by the partner or the manager of the fund as Wakil, would not be compliant.
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(c) If the fund adopted investment strategies, such as investment in Islamic fixed-income instruments, for example, Murabahah and Sukuk Ijarah, the fund could be described as an Islamic Protected Fund. Such funds never guarantee the capital, but it will seek, on a best efforts basis, to preserve the capital by investing in underlying assets that provide a fixed and secured income generated within a prescribed period.
Exercise 1.6
(a) The sale, as originally described, would not be valid. (b) The asset is uncertain as it cannot be identified with special reference to its location and identification. This invokes the prohibition of uncertainty or Gharar.
Follow-up answer
(c) If the object of sale was changed to gold, the sale would still be invalid as the payment of the purchase of gold, being a Ribawi (usurious) item must be paid on the spot. Although the new sale is free from uncertainty, it now invokes the interest prohibition, as gold, being a usurious item, is sold to another party on a deferred payment scheme instead of a spot transaction.
Exercise 1.7
While the Islamic financial institution (IFI) may use either Murabahah or Musawamah to affect a credit sale for the client, the IFI may offer an Ijarah contract for the transfer of the usufruct of the asset to the client. As for a client looking for the option of either the purchase or lease of the asset, Ijarah muntahia bi tamleek may be used to facilitate this commercial purpose. In the case of the purchase of an asset to be delivered in the future, either the contracts of Istisna or Salam may be used. While Istisna accepts flexible payment from the client, Salam requires a full payment paid in advance at the time of contract. As for the purpose of investment and easy liquidation, the IFI may also offer an investment fund based on a Musharakah contract. This will allow the client to invest in certain assets such as shares, properties and commodities through a mutual fund and other collective investment schemes such as real estate investment trusts (REITs) and exchange traded funds (ETFs) without the need to physically hold those assets to benefit from their income. Investments in assets using a Musharakah contract are relatively liquid for easy disposal.
Exercise 1.8
A A Murabahah financing contract could be used here to meet the need for the cost plus mark-up sale along with a pledge (Rahn) as an ancillary contract of security. The fund manager is being appointed on a Wakalah contract and the investors are pooling their funds based on a Musharakah contract. Securitisation of leased asset involves an Ijarah contract whereby the investors may benefit from the lease rental payments. Deposits received from customers on a profit-sharing basis are based on a Mudarabah contract.
Case study multiple choice answers

1 (A) Payment of predetermined or ex-ante rates on loans or Qard-based deposits are not Shariahcompliant as they are interest-based payments. Even on the Mudarabah investment deposits, only the PSR is pre-agreed and not the actual profit payment. 2 (B) Murabahah is a mark-up sale whereby both the contracting parties are made aware of the cost of the asset and agree upon the mark-up rate. The seller, which is the bank, must own the Shariah-compliant asset prior to selling it off to the customer. 3 (B) Under the Ijarah contract, only the party who owns the asset, or at least owns the beneficial use of the asset, can subsequently lease out the asset. In this case, the bank must own the asset or own the master lease to the asset to subsequently be able to lease the vehicle to the customer.
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4 (B) Predetermined returns are never allowed for Qard and Wadiah-based products. With regards to Musharakah, the only predetermined item is the PSR and not the actual returns. 5 (A) Islamic banking and finance is always underlined by Shariah contracts. The process of making the product features suitable to the contract requirements is always easier than vice versa as the product features can always be changed but the contract requirements must always be fulfilled.
Suggested solutions to case study short essay questions

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

Essential elements of the structuring process Essential Shariah principles in structuring Islamic financial products Essential strategic considerations in product structuring and development strategy Possible impact of weak structuring methodology in Islamic financial product development Case study: Shariah considerations in structuring products
2.0 Introduction
Chapter two introduces you to the structuring process that is integral to the product development strategy of institutions offering Islamic financial products. The critical components of the process are identified and explained with reference to specific Shariah requirements. The chapter also considers the effect of varying financial environments and industry requirements in the adoption of a structuring process. Finally, the chapter highlights factors that may impair structuring quality for Islamic financial products, as well as considering the possible consequences of poor product structuring strategy. As outlined in chapter one, the importance of the purpose of Islamic financing contracts, and the relevant application of those contracts in designing Islamic financial products, is fundamental in ensuring the proper and effective adoption of appropriate contracts. The behaviour of Islamic financial contracts, as outlined in chapter one, affects strategic considerations in the development of Shariah-compliant, financially viable and sustainable financial products and services. Both the product requirements for an effective structuring strategy, as well as the potential pitfalls in structuring, will be highlighted. Finally, you will see how the structuring process and strategic considerations enable the Islamic financial services industry to design, develop and implement a comprehensive strategy for Islamic financial products and services. This allows them to meet customer requirements and comply with Shariah principles and the legal framework in a cost-effective manner.
2.1 Essential elements of the structuring process
2.1.1 What is an Islamic financial product structure?
In general terms, a product, in the form of goods or services, represents the rights or obligations in ownership and use of the product, as well as the perceived economic benefits generated from the product. In the case of a sale of goods, the title of the goods is transferred from the seller to the buyer and the buyer benefits from the merchantable quality of the goods. Similarly, an owner may lease his vehicle to the lessee where the right of use is transferred to the latter. In the case of a financial product, the seller or the financier is able to provide financial services to the buyer allowing the buyer to benefit from the financial facilities. These financial facilities include loans, financing or investments services. Conventional financial products are recognised by features such as the loan or investment amount, interest rates or investment yields, payment schedules and investment periods. Islamic financial products with similar features must exclude interest and uncertainty in the contract conditions. The prohibition of interest has been well documented in the Quran and the Traditions
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Gharar relates to risk, uncertainty or hazard which may be to the disadvantage of one of the parties to an agreement.
of the Prophet Muhammad. Gharar in contracts can lead to unsavoury situations whereby one party may take advantage over another and act deceitfully, or it can create disputes between the counterparties. An Islamic financial product must also be based on valid Islamic financial transactions that potentially facilitate direct lawful production, trade and consumption activities. This is because Islamic finance is either asset-based or service-based financing that relates to real-economy activities. Conventional finance does not sell or lease any asset or service and therefore is not related to real production of wealth in the lending transaction between the lender and the borrower. An understanding of the elements of Islamic financial product structuring, which ensures that the product complies with Shariah principles and rules, is therefore essential.
Key point
Islamic financial products are based on valid Islamic financial transactions that facilitate lawful production, trade and consumption activities.
2.2 Islamic financial product structuring

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

Product structuring involves three phases: the design, development and implementation of the product. In the design phase, the product concept, purpose and features are identified and analysed to ensure that the product is coherent and is able to meet the expectations of the counterparties to the transaction. The development phase comprises activities, including legal documentation, operational and process flows documentation, marketing and promotion, accounting records and reporting systems, risk assessment and monitoring, IT systems and support, customer care and quality improvement. The implementation phase deals with the monitoring, control and review of the product with regards to the approved product design and its supporting documents. Each of these phases of Islamic financial product structuring must be considered to ensure that they each ultimately comply with both Shariah and industry requirements.
Key point
Islamic financial product structuring is a process that formalises counterparty financial expectations in the form of Islamic finance contractual rights and obligations that result in perceived lawful economic benefits to the parties and society.
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Exercise 2.1
An investor expects a guaranteed return of 5% per annum on capital invested and would like the financial institution to structure a financial product accordingly. Explain whether a product can be structured to meet the customers expectations and remain compliant to Shariah principles. What feature, if any, can be included in the structure to enhance the likelihood of receiving this expected profit and how can this structuring be put forward?
2.3 Critical elements of the Islamic financial product structuring process

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

Sources, methodology & contract guidelines Yes Appropriateness of product concept & purpose? Yes Choice of valid and enforceable contract? Yes Relevance of product features & contract requirements Yes Completeness of product manual & process flow Yes Appropriateness of product legal & supporting documentation Yes Adequacy of process flow & system support No No No No No No
Structural product review required to ensure product design is Shariah compliant
Legal & operational product review required to ensure product development is Shariah compliant
Yes
Product implementation is Shariah compliant
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The diagram illustrates the many stages of the process involved in structuring a financial product that is not only compliant to Shariah principles but also to other banking, legal and IT requirements. In the first stage of product structuring, the product development team of an Islamic financial institution (IFI), either for retail or corporate financing, will work on fulfilling all the requirements to make the proposed product acceptable from a basic Shariah and financial requirement. For IFIs that have an in-house Shariah compliance officer, the product development team will consult with this officer to vet the basic Shariah requirements. Otherwise, the IFIs may consult the Shariah supervisory board or any other external experts. Based on the different policies of the IFIs, the product features at this stage may have to be endorsed by its Shariah supervisory board before it can move to the next stage. Some IFIs may, however, complete the next stage before submitting the product features and its supporting documentation to their Shariah supervisory board for deliberation and endorsement. The next stage involves a bigger IFI team such as IT, legal and system development. Also, the involvement of an external legal firm to look at the documentation of this proposed new product may be crucial. The legal documentation should be not only compliant to Shariah principles but also, more importantly, to the laws of the country to make it admissible in the courts of law and enforceable. Equally important are the comprehensive and coherent IT and product manuals that must also be compliant to Shariah requirements. Implementation is the next stage where it is the responsibility of senior management of the IFIs to ensure that all practices and business conduct, from the level of marketing to recovery, if relevant, are in line with the approved Fatwa and manual of the products.
2.3.2 Elements of the structuring process

The elements of the structuring process identified in figure 2.1 above demonstrate the sequence required to facilitate an orderly and effective structuring of Islamic financial products. These elements are the established sources, methodologies and contract guidelines, product concepts and purposes, choice of valid and enforceable contracts, product features and contract requirements, product manual and process flow, product legal and supporting documentation and finally the process flow and system support. When these elements of the structuring process have obtained Shariah approval or endorsement, the Islamic financial product shall be deemed to be Shariahcompliant or Shariah-based as the case may be. The product structuring cycle completes with timely and effective monitoring, and a review that is undertaken after the product development process. Any fundamental breach of Shariah requirements in the product structure that is found postimplementation will need to be re-addressed and re-examined. In other words, a product may have satisfied all the theoretical requirements but may have some difficulties, for example, in following the required flow of contract in practice. Similarly, the product may be found not to have been implemented according to the prescribed guide or manual.
Exercise 2.2
In Islamic finance, discuss whether product structuring is limited to product design and product development only?
2.4 Product design/origination phase

The design phase determines the recognition, as well as legitimacy, of an Islamic financial product. Any failure on the part of a financial institution to meet Shariah requirements at this stage will affect the subsequent stages and will probably render the product non-Shariah compliant.
2.4.1 Compliance with Shariah principles and rules based on the sources and methodology of interpretation of Shariah principles
The Quran and Traditions of the Prophet Muhammad are the primary sources of Shariah principles and the ultimate references on the legitimacy of the adoption of any Islamic financial product or service. Applying the maxim of presumption of permissibility, any financial product must be free from any elements that are categorically prohibited by Shariah principles. Also, any form of legal reasoning (Ijtihad) exercised in interpreting or evaluating a financial product must be consistent with prescribed principles. In addition to sources of law, financial products and services must be in tandem with many established legal maxims that are well documented and articulated in Islamic law literature. The principle of the presumption of permissibility is one such maxim.
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For example, the Traditions of the Prophet Muhammad clearly mentioned that any hybrid contract between loan and sale executed between the same parties should be avoided as it may lead to interest, although in an indirect way. The lender of the money, although on an interestfree loan basis, shall not sell any asset to the borrower as the lender-cum-seller may take advantage of this to compute the interest on his loan in the sale price, thus leading to prohibited interest. This product, the provision of an interest-free loan, combined with a sale contract, may be commercially appealing, but it will not pass the test as it contradicts the prescribed prohibition as reported in the Traditions of the Prophet Muhammad.
2.4.2 Satisfaction of product concept, purpose and features that are consistent with Shariah principles, as well as structured for lawful and legitimate activities
Based on the broad guidelines for permissibility of Islamic financial products, the product concept is analysed in terms of its coherent and consistent structure and mechanism as well as its purpose and features, which must be Shariah-compliant at all times and in all circumstances.
2.4.2.1 Product purpose

As explained in chapter one, the purpose of a financial product must be lawful and for the common good and benefit of mankind. If any element is identified at this stage that is either prohibited or can cause harm, the product needs to have its purpose re-defined or be replaced with another product. In Islam, the purpose of the product must not only benefit the individual parties but also benefit the broader segment of society. The purpose of the contract must be compliant with Shariah principles, otherwise it will not obtain the necessary approval, even though the contract may be compliant, in terms of structure and feature, on its own merit.
For example, if the purpose of a financial product such as Murabahah or Ijarah financing is to finance the promotion and consumption of intoxicants that impair the human faculty of reasoning, then this product, with this ultimate purpose, must be rejected. There could be, however, some products that may be doubtful in terms of their ultimate purpose. An example is using Istisna financing for the construction of a building where the ultimate purpose is to sell the building after its completion to a conventional financial institution. Such a case must be discussed thoroughly with the Shariah scholars or advisers to ascertain the Shariah perspective on the proposed purpose.
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Syndicated Islamic financiers have agreed to finance the construction of a new building, designated to be the financial centre of a country, using both Istisna and a forward lease. However, upon completion of the building, the Islamic financiers will immediately have to sell the whole building to the project owner who will then lease the building to the respective financial institutions that are granted the right to occupy that building. Required Explain how the Istisna and forward lease operate in this structure, and explain whether this structure or mode of financing is compliant with Shariah principles, taking into account the ultimate purpose of the construction. Would the Shariah position be different if the Islamic financiers were to lease directly this building to different tenants in that financial centre building?
Solution
Financing the construction of a building using a combination of both Istisna and forward lease is a unique scheme of project financing. Essentially, the project owner or contractor will enter into an Istisna contract with the financier. The financier would request the contractor/project owner to build and deliver to the financier a complete asset in the future at an agreed price. The financier as the buyer shall disburse the Istisna financing amount to the project owner as per the progress payment schedule. Thereafter, the financier will enter into a forward lease contract with the project owner whereby the project owner as a lessee will pay the rental in advance under the forward lease contract to the financier. The rental payment, which will be fixed, is payable within the period of construction. Upon completion and delivery of the asset, the project owner-cum-lessee shall have the option to purchase the building. By purchasing the building from the financier, the project owner would become the ultimate owner of the building and may lease any part of the building to any tenant, irrespective of the activities of the tenants as the project owner is not an Islamic financier. The Islamic financiers are not involved in this leasing business and, therefore, their financing, using both Istisna and forward lease, is compliant as the financing ends up with the sale of the building to the project owner. Some scholars may object to this financing structure as this could be deemed as financing the construction of a building to be used by conventional financial institutions. If the Islamic financiers were to own and lease the building to respective tenants that include mainly conventional financial institutions then this would be seen as not compliant by all of the scholars as the ultimate purpose in that scheme is leasing the building to non-compliant tenants.
2.4.2.2 Product structure

The financial product structure comprises the essential product components that enable the product to be recognised as either a funding, financing or investment financial product. The product components include elements such as the financier/investor or customer/issuer, terms of financing or investments, authority or limits, scope of specified purpose, security arrangements and any other element essential to a product. The structure is determined by the validity of the elements representing contractual rights and obligations of the contracting parties as well as the permissible conditions of the contract. The product structure and related contract requirements for funding can be in the form of deposits, Sukuk or funds. Financing can be categorised based on types of assets and purpose of financing, as well as underlying sale or lease activity. Investments are represented in the form of rights of claim through direct equity participation or securitisation of assets.
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For example, if the product structure describes the cash contribution as a capital investment for profit and loss sharing, but the features of the product entail capital guarantee or profit guarantee or both, then this is not consistent with the prescribed financial product structure, which is claimed to be of profit and loss sharing in nature. The rights and obligations arising from this financial product structure obviously do not represent the inherent rights and obligations of any equity contract such as Mudarabah and Musharakah. However, if the product structure specifies that the project manager will be liable for capital redemption in the case of negligence or misconduct, or breach of his terms and conditions, then this would be in line with Shariah principles relating to damages that could lead to capital guarantee to safeguard the interests of investors. Hence capital guarantee on equity is possible only in the case of negligence, misconduct or breach of a project managers terms and conditions.
2.4.2.3 Product mechanism

The financial product mechanism represents the process adopted within a defined product structure. The mechanism can be described as the practical means to achieve what the product has been designed for. The mechanism includes measures such as the pricing of the product, the mode of mobilising surplus funds from economic agents and institutions and allocating them among deficit units, the manner of securing settlement or the means of promoting mutual goodwill between the counterparties. This represents the means to achieve the desired outcome where both the means and desired outcomes should be permissible according to Shariah requirements.
For example, if financing is provided to enable the services of the leased asset to be transferred to the lessee but the leased asset was impaired, then the lease contract is suspended until the lessor finds a replacement asset or the lessee has the right to terminate the lease contract. In this case, any financing income shall not be recognised, although the financing amount or the lease facility remains outstanding. This financial product, which is based on lease contract, would cease to operate whenever the leased asset is impaired, preventing the lessee from benefiting from the usufruct of the leased asset.
Key point
Product purpose, structure and mechanism are expected to be coherent and consistent with Shariah requirements in all aspects.
Exercise 2.3
A financial institution provides financing for the lease of machinery to a customer with a promise that the customer will purchase the machinery at the end of the lease period. During the period of financing the equipment becomes faulty and non-operational. The financial institution claims that lease payments should be made for the financing period. Evaluate the validity of this claim.
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2.4.3 Satisfaction of contractual elements to ensure a valid and enforceable contract

Any contract adopted for a particular Islamic financial product structure should reflect the essential elements of that contract. As explained in chapter one, essential elements of bilateral contracts, such as offer and acceptance, certainty of subject matter of contract and exchange consideration, must exist and be appropriate for the choice of contract. If any of the elements of the contract are not effectively executed, the contract will be void or voidable and hence not enforceable. Financing for the sale of an asset must reflect the effective exchange of considerations between payment and delivery of the goods. In an asset financing structure using a Murabahah transaction, the financier may appoint the customer to purchase the goods from the supplier on behalf of the financier. The financier may also disburse the payment of the purchase price to the customer to pay on behalf of the financier to the supplier. This would be followed by the sale of the goods from the financier to the customer at a cost plus mark-up profit. In the event where the customer did not purchase the goods from the supplier on behalf of the financier as instructed, the sale of Murabahah to the customer will be null and void since the ownership of the asset by the financier was never established.
2.4.4 Satisfaction of contract conditions of the underlying contract(s) that are represented in the Islamic financial product structure
Once the eligible elements of the contract have been ascertained, the specific contract conditions governing the effective execution of the elements of the contract need to be examined. Omission or non-observance of expressed or implied conditions of the contract will render the contract void or voidable and hence the Islamic financial product will not be approved. The following example using a Salam contract illustrates the above point. It is an essential condition in a Salam sale that full payment is made at the time of entering the contract. Where it is stipulated that a financial institution may defer such payment in view of receiving the goods in the future, the use of this contract would be void.

Due to customer demand for working capital facilities, a financial institution proposes a fixed-rate annual revolving credit facility to its business customers with specified drawdown limits based on customer credit standing. The facility applies the Commodity Murabahah structure contract in offering this facility to the customer. The customer is not obliged to notify the nature of utilisation of the financing amount for each drawdown. If the above revolving working capital facility is based on a Salam contract, explain what the required distinctive operating requirements for this financial product would be to be compliant with Shariah principles which are different from the Murabahah commodity structure. Analyse the product purpose, structure and process in relation to Shariah requirements.
Solution
A revolving credit facility is a ready line of cash financing that enables customers the flexibility to utilise funds for operational activities. Although the implied purpose of this facility is for business financing, the actual nature of business is not specified. This requires disclosure of the ultimate usage of the proceeds of the Murabahah to avoid using Murabahah proceeds for non-halal business activities. As a revolving credit facility, it is envisaged that there shall be a series of Murabahah structures as and when financing is required. A proper product design, process flow and execution according to the process flow are required to ensure the compliance. Salam is a forward sale contract with purchase price paid in advance to the Salam seller. From the point of view of working capital requirements, Salam could assist in providing working capital to the customer. However, under this structure, the financier who advances the money must be willing to take the market risk of the commodity bought under Salam. For all intents and purposes, this Salam contract must result in the delivery of the asset to the buyer in the future either actually or constructively.
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2.5 Product development phase

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

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

Perspectives Legal Statutory Operational Focus of functional representations/behaviour Legal obligation Sight (Time) deposits Outstanding amount owed by bank to customers for a defined period Liquidity and return exposures Obligation as liability Deposit motives, such as transaction, precautionary or investment motives Deposit as part of core banking process and online information management
Risk management Financial reporting Marketing
IT solutions and support
The above table highlights the various perspectives on the nature of a deposit that need to be effectively communicated and implemented by different departments within the financial institution. Any lack of congruence in product design and purpose will impede the product development process at the origination phase. Product documentation, known as the product manual, as well as product terms of reference or the Standard Operating Procedure, need to be developed in a comprehensive manner that articulates all the product concepts, structures, mechanisms and flows, as well as all the Shariah and functional requirements. Such documentation will provide coherence in documenting, communicating, reporting, implementing and controlling Islamic financial products.
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2.5.3 Approval of the operational process flow that is consistent with Shariah principles and rules
The product mechanism specified in the design stage is documented as a process flow. It describes how the product is originated, offered to the customer or issued, traded (where relevant), redeemed or restructured (where relevant), monitored and controlled. The principal process flow may interface with process flows from different functional and supporting processes. Such forms of interface ensure that the functional and supporting process objectives will be congruent to the product purpose and objectives. During this stage a matrix of objectives is identified for different functional requirements that are consistent with Shariah requirements specified for the product purpose. Any form of inconsistency with the requirements may affect the product development that could lead to product misrepresentation to the customer. The following illustration explains the above position.
Illustration: Predetermined rate for investment account holder An investment account holder places US$10,000 with an Islamic bank for a period of three months. The return is based on a 50:50 agreed PSR of income attributable to investment account holders (IAH). The bank imputes a predetermined 3.6% profit rate per annum in its IT system that accrues US$90 as the profit payout for the three months. Based on performance of the investment account funds it is found that the effective return on investment account holders (ROIAH) at the end of the three month period is 4%. The bank should therefore compensate the IAH for the difference and adopt an appropriate profit distribution engine to determine the profit rate distributable to the IAH.
For example, in Murabahah financing it is part of the requirements that the financier shall own and possess the asset prior to its sale to the customer at mark-up sale. However, if this is not specified in the process flow, the IFI may disburse the financing amount to the customer to purchase the asset at a predetermined mark-up rate. In this scenario, the IFI neither purchases the commodity from the supplier nor sells the commodity to the customer on Murabahah. The effect would be a money-for-money transaction for a premium that is prohibited. Therefore, the proper documentation of the process flow and procedure is important to determine that the right contract and product feature of a financial product is operationalised.
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2.5.4 Approval of the legal and supporting documentation that reflect Shariah principles and requirements, as well as product design, features and mechanism
Legal documentation is essential to ensure enforceability of the resulting financial contracts in a court of law within a particular jurisdiction. The approved product structure and mechanism must be reviewed in relation to the statutory legislation and financial law in practice to ascertain adequate and consistent legal representation of Shariah requirements as specified in the contracts. In particular, rights and obligations specified in the Islamic financing contracts are translated as legal rights and obligations with reference to the statutory definitions, as well as the legal definition and court interpretation of the financial law. Both the substantive and procedural aspects of the law are taken into consideration in drafting legal documentation to render the contract and its agreements valid and enforceable, as per law requirements within the particular jurisdiction in which Islamic finance operates.
The case of a deposit product is a good illustration in this context. The document relating to the deposit products of an IFI refers to the statutory definitions and relevant financial authority guidelines, such as central bank guidelines. The rights of depositors and obligations of the financial institution are established based on relevant case law as interpreted by the courts. These rights relate to procedures on acceptance of deposits, refunding of deposits, security, guarantee on deposit, consolidation and set-off using the deposit, redeeming depositors, as well as payment of returns due to depositors. Also, in the case of sales-based financing, the delivery of goods purchased by the customer from the IFI must be expressed and executed in the proper sequence as per the documentation. Goods should be purchased by the IFI from the supplier upon receipt of the purchase order from the customer. Subsequently the IFI sells the goods to the customer at the disclosed purchase price (cost) plus an agreed mark-up. Failure to execute the sequence accordingly implies non-effective transfer of legal title from the supplier to the IFI and subsequently to the customer as the ultimate purchaser.
Supporting documentation stems from the process flow and other related functional processes. These include records, bills, receipts and other supporting documents that relate to the process flows. The document flows should facilitate the tracking of documents that are concurrent with the respective process flows. Information captured, processed, communicated and reported must be consistent with the data requirements of the relevant processes that reflect Shariah requirements.
Key point
In conventional finance, most of the rights and liabilities are the result of one contract only; that is, the loan contract. In Islamic finance, rights and liabilities of the parties at any point of time are the result of various contracts such as trade or investment.
2.5.5 Approval of reports and disclosures that represent Shariah requirements pertaining to a financial product
When the legal documentation and supporting process flow documents are verified for Shariah requirements, the financial and risk-reporting functions need to be identified and specified in the overall product process flow. These include the accounting treatment of the product and the related contracts based on international reporting standards, product and contract guidelines, as well as risk management considerations based on relevant liquidity and solvency frameworks or guidelines from the financial authorities. At this stage both the accounting and risk issues are dealt with to determine the commercial viability of the product, as well as the associated financial risks to the financial institution in terms of solvency, liquidity and profitability. In addition, the product document needs to make specific reference to Shariah requirements when formulating accounting policies and treatment, as well as risk-mitigation techniques and tools for the product. Relevant international standard setting bodies such as the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) and the Islamic Financial Services Board (IFSB), which promulgate standards and best practices on financial reporting and governance, must be referred to accordingly.
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For example, an Islamic financial product concept, which adopts a lease arrangement ending with a sale contract (Ijarah thumma al-bay) has been endorsed by a financial institutions Shariah board. The financial institution reports the transaction as a finance lease as it only considers the amount outstanding for the leased asset to be reported as receivable with relevant credit risk exposures. In all material respects the reporting of accounting treatment and risk exposures does not address the lease (Ijarah) contract that requires a leased asset to be reported on the balance sheet. Both market and credit risks of the asset, based on the product structure and features, need to be considered in risk assessment.

The head of operations of an established IFI is particularly concerned when an Islamic financial product is approved by the board of directors (BOD) to be implemented by the institution. Of particular interest is the profit sharing feature of the Profit Sharing Investment Account (PSIA). According to the operations manager, the existing operational process flow of deposits accrues profit on outstanding deposits and reports interest expense on a monthly basis. Since the operational system does not cater for the profit sharing arrangement, the existing system computes distributed profit rate on the same basis. To what extent is the existing operational process flow suitable to cater for the PSIA?
Solution
The existing operational flow computes and accrues profit payouts to depositors on the contracted fixed profit rate based on an outstanding amount on a periodic basis. In the case of PSIA, the account holders have a right of claim on the income attributable to mobilisation of PSIA funds that is shared with the financial institution. Hence the process flow needs to take into consideration the amount of PSIA funds mobilised to generate the income and apply the profit-sharing ratio (PSR) to distribute such income to the PSIA. By applying the fixed profit-based computation, the operational flow is not effectively according the rights of the PSIA holders on the distributable profits but rather applying the imputed rate. Hence the financial institution is not effectively discharging its obligations to the PSIA holders.
2.6 Implementation and monitoring phase

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

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

The implementation stage will be guided by the internal control system that governs the process flow and related processes and procedures, as well as the relevant documents, records and reports generated from the process flow. The review of the internal control objectives will facilitate effective implementation of the product, as well as the reports and opinions expressed by the Shariah board on Shariah quality assurance in terms of corrective action and continuous improvement of the process flow.
2.6.3 Shariah review on the implementation, monitoring, redemption or restructuring of the products
Islamic financial products are deemed to commence the implementation stage when marketing and promotional documents are released after the product launch. The first interface with external customers is critical in terms of product image, acceptance and perceived value. In cases where Shariah approval is not properly sought, reputational risk and sometimes regulatory intervention could arise.
Illustration: Product misrepresentation A brochure printed by an IFI specifies a guarantee on capital invested with returns up to 10%, which will be redeemed and distributed to investment account holders only upon withdrawal after one year of the investment tenor. This is highlighted by the Shariah board to be non-Shariah compliant. A fundamental flaw is that the product structure is based on a Mudarabah contract. The capital should not be guaranteed and the return should be shared, based on a PSR according to expost performance. The brochure, however, reports otherwise and would have to be amended to adequately represent the products structure and features.
2.6.4 Shariah review

Shariah review, as explained in CDIF/1/12/213 is conducted by the Shariah board on a periodic basis. Information and reports generated in the product design, development and implementation phases relating to Shariah requirements should be presented for the boards review and where relevant for approval and endorsement. Prior to implementation, the product manual and related documents pertaining to Shariah matters should have been reviewed and endorsed accordingly. This will minimise possible misstatements or errors as the approved documents will provide guidance for the product implementation phase. During the product implementation phase, an internal Shariah review, as explained in CDIF/1/12/214, will be conducted by the internal audit department or designated unit on a more regular and sometimes ad hoc basis to determine product conformance, product acceptance and product quality as described earlier. Product conformance to internal Shariah control objectives includes conformance to the specified product features as well as the operational flow. For example, a revolving facility, based on a Murabahah contract, requires timely execution of the credit sale of assets at mark-up, which are identified by the customer and purchased by the IFI. Due to direct delivery of the goods to the customer from the supplier, no documentary evidence of the purchase of goods from the supplier by the IFI prior to the Murabahah sale to the customer is found. This omission affects the validity and enforceability of the Murabahah financing. As a result, the invalid profit arising from this particular transaction should be set aside for charity as per the Shariah boards decision. A Murabahah contract refers to a cost plus mark-up transaction between parties. It is the prevalent mode of asset financing undertaken by a large number of Islamic banks.
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In the case of product acceptance, the approval of both Shariah board and regulators is sought. Based on this consideration customers and investors would then decide on the perceived lawful economic benefits of the product. The influence of external factors on product implementation will be discussed in the next section of this chapter in order to analyse their impact on Islamic financial product structuring in different jurisdictions. Finally, a product quality criterion during the implementation stage is part of the internal monitoring process. It provides corrective measures and actions, and continuous improvement of the operational process flow. Islamic financial product quality relates to the purpose of the product and application of contract requirements. In the event that a non-compliant feature or practice is discovered, the structure and product mechanism, as well as the related processes and document flows, will need to be reviewed. A corrective action may involve a change to both product structure and the entire mechanism.
Illustration: Product misrepresentation For example, in the case where an Ijarah vehicle financing is approved by a bank and disbursed to the customer, it is agreed that the motor vehicle insurance is to be borne by the customer similar to conventional finance leases. A review of the product structure finds that the insurance costs should be borne by the bank and deducted as an expense from the lease income accrued, or received, from the customer.
2.6.5 Preparation of a report that expresses the opinion on the status of the Islamic financial products
A report is prepared on a periodic basis to provide findings of the Shariah review, as well as any certification or opinion expressed by the Shariah board on the Shariah status of the products. The report, where relevant, will rely on the internal Shariah review findings conducted on an on-going basis by the internal audit. The report is then tabled as the Shariah supervisory boards findings and later deliberated by the board of directors, or, where relevant, the regulatory or governing agencies.

A Shariah review report finds that a significant percentage of reported income for the year was accrued from overdue financing arrangements that were re-scheduled from the previous period. On further investigation, it is discovered that this arose from sales-based financing contracts in the form of penalties, as well as profits accrued in excess of the agreed mark-up profit. Suggest how this phenomenon could have occurred and explain the necessary corrective action.
Solution
When the Islamic financing products were approved and implemented, there may have been a lack of monitoring on the behaviour and performance of the products. An example is the automatic extension of the tenor of sales-based financing, in the case of the defaulted payment by the customer, for an extra profit on top of the agreed mark-up. In sales-based financing both the price and the profit are to be determined in advance. Unlike loans and advances where interest accrues when the loan is rescheduled or restructured, debt from sales-based financing does not accrue in the same manner. Hence any additional profit or penalty imposed from such delinquent behaviour is not regarded as income. However, a new contract to restructure the relationship is required to enable both parties to continue the financial arrangement in accordance with Shariah requirements. A restructuring mechanism using relevant compliant Shariah techniques and contracts is needed to address this issue. This may require cancelling the existing sales-based financing scheme and replacing it with one based on a different contract that would be able to accommodate the feature of extension of tenor. A mere rescheduling of the facility for an extra profit is not compliant as this goes against the very basic structure of a valid sale contract.
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2.6.6 The importance of Shariah governance

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

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

A product strategy is required to chart the direction of the product design, development and implementation in a manner that ensures it achieves the intended objectives and outcomes. The strategy may vary with the stage of the product life cycle in the industry, as well as industry and market factors that influence the product behaviour in a given environment. The following diagram depicts the essential strategic considerations affecting an IFIs policy as well as its implications. The strategic considerations are customer expectations or market behaviour, Shariah requirements, legal requirements, regulatory requirements and industry standards and best practice.
Figure 2.2 Structuring of Islamic financial products: Strategic considerations; business policy and impact analysis
Strategic considerations Customer expectations/market behaviour Shariah requirements Legal requirements Regulatory requirements Industry standards & best practices
Business policy
Business impact
Product design and development + customer relationship management
Market acceptance
Risk assessment & analysis
Reporting & disclosure requirements
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A product represented by customer expectations essentially requires a structure that takes into account how these expectations are to be met. These expectations may vary according to the different types of financial systems that have adopted Islamic financial activities and practices. Shariah principles and rules are derived from the established revealed sources of Islamic law and hence are universally applicable. However, the application of legal reasoning and interpretation may take into consideration customary practices of particular locality or jurisdiction supported by various forms of Shariah governance. The legal requirements relate to the application of Islamic law principles within each jurisdiction. Hence the laws may influence the enforceability and dispute resolution involving Islamic financial transactions. Regulatory requirements generally set the pace and direction of the industry requirements and reporting environment. Different jurisdictions adopt different approaches based on the respective regulatory framework in governing Islamic financial activities. A convergence towards Islamic financial practices through harmonisation and standardisation has been helped by international standards, guidelines and best practices that provide relevant benchmarks for industry practices. With these strategic considerations, the structuring of Islamic financial products will take a broader approach to product structure and acceptance, and to the business model and assurance which are integral parts of product policy. The policy implications can then be examined and analysed from the point of view of market response, acceptance and risk analysis, as well as reporting and disclosure issues.
2.7.2 Islamic financial systems and their impact on Islamic financial product strategy
The early developments of Islamic finance attracted varying socio-economic and political responses from the ruling authorities of various jurisdictions. The types of response that supported Islamic finance depended on the perceived need of the financial community to adopt either an alternative financial system or a financial intermediation mechanism, which either co-existed with or replaced the interest-based banking system. This led to the adoption of either the dual banking system or the single/sole banking system from 1979 onwards. From 1979 to 1994, most of the Islamic banks were established, operating in an environment that was denominated by conventional financial institutions. From 1994, particularly in Malaysia, all conventional financial institutions were allowed to set up Islamic windows operating in the same premises of conventional financial institutions.
2.7.3 The case for a dual banking system

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

As explained in CDIF/2/1/24, a financial system comprises several components, including both banking and non-banking institutions, regulatory bodies and agencies, and payment and settlement systems. The key component of any system is the financial services authority that ensures the soundness and stability of the system. Currently the financial industry is regulated either by a central financial authority or two separate financial authorities. Separate financial authorities for banking and capital market regulation and supervision are found in certain jurisdictions such as Malaysia, Saudi Arabia and Indonesia. Islamic financial activities operating within existing dual financial systems are generally governed by similar financial authorities. In this respect, similar regulatory policies in the form of Islamic financial instruments and guidelines are instituted to govern the IFIs, products and activities. The challenge faced by the Islamic finance community is to demonstrate to existing financial authorities the unique features of Islamic financial products and services that require a different regulatory response.
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The need to distinguish the identity of Islamic financial products from comparative conventional products as well as a need for Islamic financial products to be benchmarked, with the latter based on expectations of a common pool of depositors, investors, issuers and customers, poses a continuous challenge in developing Islamic financial products within the dual banking system. To a significant extent the transaction, safety and investment motives are similar for both conventional and Islamic products. However, the manner in which the contracts are structured reflects the importance of trading and real investments, as well as profit and loss sharing compared with pure conventional borrowing and lending activities.
2.7.5 Impact of separate legislation

In certain jurisdictions, such as Malaysia, separate legislation has been introduced to license and regulate IFIs in addition to licensed conventional institutions. The recognition of these institutions, such as Islamic banks and Takaful companies, emphasises the importance of shareholder commitment to Islamic finance. In addition, the need to safeguard and protect the interests of investors and depositors has been met by the promulgation of relevant banking and securities guidelines. Some jurisdictions have issued specific guidelines and requirements for IFIs to observe in addition to general financial laws and regulations. For example, the Central Bank of Bahrain and the Dubai International Financial Centre have issued special guidelines to the effect that all IFIs operating in their respective jurisdictions shall adhere to both the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) Shariah Standards and AAOIFI Accounting Standards. The development of Islamic financial products must take into consideration these statutes and guidelines. Generally these guidelines provide the overall assurances that protect depositors interests, ensure the integrity of the financial institutions and systems, and promote the soundness and stability of the overall financial system.
2.8 Possible impact of weak structuring methodology in Islamic financial product development
In any design and development process, specifying the right purpose and objectives, followed by a proper application of the relevant methods or tools, is critical to the successful implementation of the product. Hence any misspecification of product purpose or misapplication of the Islamic financing contract will result in the products failure.
2.8.1 Getting the structure right

During the early stages of the development, Islamic financial products and services, introduced under extenuating circumstances, had to be subsequently reviewed. Significant changes in industry requirements, as well as market demands, have brought about the need for Islamic financial products that either complement or substitute for conventional financial products. Various approaches were tried, including maintaining existing product structures and allowing for contract variations within similar economic conditions and financial consequences, as well as their possible permutations. In some cases this led to a significant replication of faulty product structures either due to fundamental errors in misspecification of product purpose or misapplication of contracts, or omissions of pertinent Shariah considerations.
For example, an Islamic deposit pays a promised or contracted return to depositors based on Wadiah, Qard or Mudarabah contract equivalent to the conventional fixed deposit. The promised or contracted return based on these contracts is not Shariah-compliant. However, an IFI may achieve the same economic benefit of a conventional fixed deposit by using a Murabahah commodity structure. This will be further explained in chapter four.
When a financing structure needs to consider flexibility in price, delivery or payment, an existing sales-based financing contract may not be appropriate. Some of the contracts are relevant when goods involve spot delivery with an established price upon conclusion of the contract. Hence such contracts will be restrictive and not appropriate for other forms of arrangement.
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For example, in some jurisdictions, such as Malaysia, a Murabahah contract has been used to finance construction projects. Obviously, Murabahah is not a suitable contract for this transaction as the project is still under construction. Furthermore, in the case of project delay, the purchaser will bear the risk of non-delivery as well as the liability to fully settle the Murabahah sale price to the vendor. There is a need to depart from this contract to a more suitable contract such as Istisna or a combination of both Istisna and a forward lease. Both of these contracts recognise the asset needs to be constructed, as well as the risks associated in the price and payment structure. This will be explained in the following chapter.
From the above example, it can be concluded that misspecification of product purpose and misapplication of Islamic finance contracts will result in two major consequences. First, the product may not be compliant and hence result in the contracts being void or voidable at the option of the parties to the contract. Second, market confidence in product structure viability in meeting the product purpose will be affected. In other words, product acceptance may be impaired.
2.9 Islamic financial product structuring process: the case for Profit Sharing Investment Accounts (PSIA)
The following grid provides a step-by-step approach toward designing, developing and implementing a specific Islamic financial product. It is based on the structuring process and the relevant Shariah and other requirements.
Table 2.2 Product design: Profit Sharing Investment Account

Description Product concept A profit sharing investment account that shares profit with the bank and is exposed to business risk Shariah requirements Based on Mudarabah contract requirement on the nature and type of capital. No guarantee of capital except for fiduciary performance of the IIFS Shariah-compliant or legitimate investment opportunities. Source of fund to be segregated, subject to qualification by the investors as to whether their investment is being made under a restricted or unrestricted investment mandate Contribution value to be ascertained ab initio and conditions on fund utilisation to be specified
Product purpose
Provide investment opportunity to depositors Source of funds for IIFS
Product structure
Capital provided by the investor is known and specified for a defined period. It may be restricted or qualified for specified purpose and may not commingle with other IFI funds Amount received will be mobilised on or off balance sheet for financing or investment. Capital is recovered before profits are distributed. Profit is derived after deducting direct cost of financing. Profits generated from utilisation of funds are shared according to mutually agreed PSR
Product mechanism
Subject to expressed qualifying conditions, funds outstanding shall be the determinant for loss exposure. Ex post-profit is derived from gross income and shared based on mutually agreed PSR
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Table 2.3 Product Development: Profit Sharing Investment Account

Description Operational process flow Product manual of investment account that describes the deposit, deposit utilisation, profit and loss determination, profit distribution and withdrawal processes Investment certificate that specifies contractual terms and requirements Shariah requirements Segregation of Shariah-compliant funds as well as specific conditions apply in the case of restricted Mudarabah contract requirements
Legal documentation
Contractual terms and requirements are subject to Mudarabah contract requirements and are legally enforceable Supporting documents that ensure the efficacy and traceability of the contract flows, as well as its timely and effective execution of contracts
Document process flow
Product manual specifies the relevant supporting documents that ensure the efficacy and traceability of the process flow, as well as its timely and effective execution of processes Relevant IT customer information file, processes and engines to enable proper information processing and management that facilitates achievement of Shariah-compliant objectives Timely and accurate update of investment account balances and performance of investment accounts, as well as proper utilisation of funds Investment account holder funds are used according to specified purpose, and fund performance is measured according to profit sharing arrangements Investment yield matches the risk preference or appetite of investment account holders for different investment horizon and other specified conditions Review of process flow of the investment account with reference to product structure and mechanism
IT System & Support
Information parameters take into consideration Shariah contract requirements. IT processes and engines observe the relevant contract conditions pertaining to profit computation Provide assurance to investors that funds are Shariah-compliant and that profit sharing nature is properly communicated Mudarabah contract conditions and requirements are observed during implementation
Reports and communication
Product conformance
Product acceptance
Investment account products are accepted based on Shariah standards and industry best practice
Shariah review
Investment account process flow is reviewed according to the Shariah governance framework and standards
Shariah opinion
Opinion expressed in the Shariah board report that all aspects of the investment account are Shariah compliant
Shariah opinion on investment account is expressed by Shariah board as prescribed by the Shariah governance framework and standards
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2.10 Conclusion
This chapter has demonstrated the importance of observing Shariah requirements in each part of the Islamic financial structuring process, that is the design, development and implementation phases. A detailed discussion of the elements of the structuring process emphasises that the process is not confined to product design, but instead involves or interfaces with other processes relating to legal documentation, operational process flow, reporting and risk management processes. Product failure to comply with Shariah requirements, as specified in the product structure, will result in legal, operational and risk-related issues that would be dealt with in the subsequent chapters.
2.11 Summary
Having read this chapter you should understand the following points: Islamic financial products must be based on valid Islamic financial transactions that facilitate lawful production, trade and consumption activities financial product structuring involves formalising the expectations of relevant parties based on the expressed contractual rights and obligations of counterparties the development of Islamic financial products can be instigated by either private or government initiatives product documentation needs to be developed in a comprehensive manner that articulates all the product concepts, structures, mechanisms and flows, as well as all the Shariah and functional requirements product documents need to make specific reference to Shariah requirements when formulating accounting policies and treatment, as well as risk-mitigation techniques and tools for the product customers expectations may vary according to the different types of financial systems that have adopted Islamic financial activities and practices; but Shariah principles and rules are derived from established revealed sources of Islamic law and hence are universally applicable Islamic financial products must be developed according to the regulatory requirements and guidelines of the jurisdictions where they are being offered.

Shariah considerations in structuring products and services
In a Shariah board meeting of an established financial institution, the chairman raises concerns on the Shariah-compliant status and market acceptance of Islamic financial products and services offered by its wholly owned Islamic bank subsidiary. As the CEO of the Islamic bank subsidiary you explain that a recent court decision, which was in favour of a customer of another IFI, was partly attributed to its inadequate structuring process and reliance on group-shared services when offering Islamic financial products. The BOD directs you to convene a product development meeting and prepare a report to recommend an appropriate strategy for the product development of Islamic financial products and services for your bank. The group product development manager furnishes you with the following list of financial products offered by your Islamic bank subsidiary. Deposits Islamic current account Islamic savings account Islamic fixed income account Islamic investment account Financing Murabahah property financing Ijarah vehicle financing Murabahah working capital financing Murabahah-tawarruq personal financing
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1. The primary objective of structuring Islamic financial products is to ensure that the financial product is: (A) Shariah-compliant only (B) Shariah-compliant and accepted by the Islamic financial services industry
(C) competitive and accepted by the Islamic financial services industry (D) a competitive alternative to interest-based financial products. 2. Depositors who expect a fixed return from deposits are offered deposits based on: (A) Mudarabah contract (B) Qard contract
(C) Commodity Murabahah contract (D) Wakalah contract 3. In the structuring process, the product operational process flow is documented in a product manual to facilitate the timely and effective: (A) execution of the contract requirements of the Islamic financial product (B) drafting of the legal documentation of the Islamic financial product
(C) development and promotion of the Islamic financial product (D) management and control of the non-performing Islamic financial product 4. At which phase of the Islamic financial product structuring process is Shariah endorsement sought? (A) At the design and development phase (B) At the implementation phase
(C) At the monitoring and control phase (D) At the reporting phase 5. In order to ensure proper monitoring of product compliance to Shariah principles and requirements throughout the lifecycle of a product, timely and effective Shariah review should be conducted: (A) On a specified periodic basis (B) At the implementation phase
(C) At the design and development phase (D) At any time during the life cycle of the product 6. Under what circumstances would product enhancement be required for Islamic financial products? (A) To achieve better market acceptance for a common pool of customers in a dual banking system (B) To rectify deficiencies in the existing product structure for a common pool of customers in a dual banking system
(C) To achieve better market acceptance for a differentiated pool of customers in a single banking system (D) To rectify deficiencies in the existing product structure for a common pool of customers in a single banking system
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1. Identify the key matters to be raised in the agenda for the special meeting on structuring of Islamic financial products. 2. From the list of Islamic financing products, it is observed that 80% of the financing comprises property and vehicle financing. Briefly state the essential Shariah considerations in the design and development stages of these products. 3. Due to unfavourable economic conditions and the tightening of monetary policy, a gradual increase of non-performing financing is observed. Identify relevant structuring issues in the implementation and monitoring stages that need to be addressed to avoid this happening in the future. 4. In your report to the board, highlight the essential considerations, structuring issues and recommendations necessary to ensure that the structuring process is effective for the Islamic bank subsidiary.
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Chapter two answers

Exercise 2.1
As a matter of principle, the customer will be advised that a return on capital in any investmentbased contract cannot be guaranteed in Islamic finance as the investor must share the possibility of loss with the investment manager or among the partners (CDIF/2/5/92-97). However, the customer could be introduced to direct investment in assets which can potentially provide a fixed income to the investors such as a specified investment return in a Murabahah commodity structure or Sukuk Ijarah. These two instruments represent an investors direct investment and participation in real assets with an obligation feature where the obligor in these Murabahah and Sukuk Ijarah instruments has to pay the investors the principal of the investment and the profit based on the obligation to pay any sum due to the investors. For example, investors who, say, invest US$100 million in a Sukuk Ijarah fund effectively invest their monies in Sukuk Ijarah. Based on an Ijarah contract, the originator/lessee may undertake to pay to the fund the principal and profit every six months at 2.5% (CDIF/3/7/106-107). In addition, the Islamic finance industry has also introduced a product that combines both Wakalah and Kafalah to enhance the probability of expected profit to investors. Although the originator/lessee under Sukuk Ijarah, for example, gives an undertaking to pay the lease rental payments on time, the issuer (who issues and manages the Sukuk Ijarah issuance as an agent under the principle of Wakalah), may give a guarantee (under the contract of Kafalah, to the Sukuk Ijarah investors or Sukuk Ijarah fund investors) to make good any shortage of lease rentals that may be due from the originator/lessee. This will further enhance the structure and render it a real fixedincome instrument for the investors, particularly those who are seeking Islamic fixed-income instruments with a guaranteed profit.
Exercise 2.2
In Islamic finance, as the fundamental objective of product structuring is to ensure compliance to Shariah principles, the process includes product design, product development and product implementation. This can only be fully achieved if a particular product is actually implemented in accordance with that process. Non-compliance may result from inappropriate implementation and not necessarily from product design or documentation. This is also why Shariah reviews and continuous monitoring of the product are vital.
Exercise 2.3
According to the Ijarah contract, lease payments are due, provided the beneficial use of the asset (usufruct) is transferred to the lessee. Although full disbursement is made by the financial institution to make the asset available for lease to the customer, the financial institution as the lessor has the right to claim only on the actual or possible utilisation of the asset. Since the asset is impaired, the lease payment should be suspended and will only recommence when the leased asset has been restored to use. The financial product structure only represents financial claims that directly relate to the operating lease contract.
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Case study multiple choice answers:

1. (B) 2. (C) 3. (A) 4. (A) 5. (A) 6. (A)
Suggested solutions to case study short essay questions:

1. The agenda for the special meeting on structuring of Islamic financial products should include the following: a. b. c. d. e. current status and performance of Islamic financial products and services offered to the Islamic financial services industry review of product concepts and features, as well as their purpose, structure and mechanism examination of product manuals and legal documents review of products, as well as document process flows and supporting documents evaluation of product quality in terms of conformance and acceptance based on Shariah review and relevant reports
2. The primary considerations in the design and development stages are that: a. b. the product purpose is Shariah-compliant and meets customers expectations; contracts are appropriate, their relevant requirements and conditions are effectively adopted and applied, and that they are adequately documented and communicated in the product manual.
3. In the case of asset-based financing, such as Murabahah and Ijarah, non-performing financing during unfavourable economic conditions will affect the payment period. In the case of Ijarah financing this will also affect the valuation of the leased assets because the asset may be situated in an area that is not favourable or the asset may belong to a particular sector which is more affected by the markets unfavourable conditions. All of this will affect the credit and market risk of this product based on Ijarah, which is now in default. Any form of rescheduling or restructuring should observe the relevant contract requirements and should not violate the conditions of the contracts. 4. A pertinent issue to be raised is the need for an internal Shariah control system that facilitates a Shariah review of the control objectives, which will be the basis for Shariah opinion expressed in the annual Shariah report. This empowers the internal Shariah review to effectively monitor the activities of the bank on a daily basis. An issue can also be raised in terms of heavy reliance on conventional support services, such as treasury and risk management departments, as well as IT core banking solutions. Moving forward, these critical services must be developed exclusively for the Islamic bank subsidiary.
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Chapter three
Regulatory and prudential requirements and the supervisory review process for Islamic banking and financial products
Learning outcomes
By the end of this chapter you should be able to: explain the impact of the prevailing regulations and guidelines on Islamic finance distinguish and evaluate the impact of legislation in the dual banking system analyse the regulatory factors affecting the growth of Islamic financial services (IFS) discuss the implications of risk management framework and bank supervision for IFS.

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

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

To ensure that central banks or security commissions have the authority to meet their regulatory objectives, they are usually vested with comprehensive legal powers via legislation (royal decree in monarchies) to regulate and supervise the financial system. An example would be the Central Bank Act (or Monetary Authority Act as the case may be) in countries such as Kuwait and the Kingdom of Saudi Arabia, which provides for the administration and objectives of the central bank (or monetary authority). Such acts usually enumerate the powers and the duties of the relevant central bank in relation to the issuance of currency, maintenance of external reserves, authorised business of the bank, the specific powers given to them to deal with ailing institutions and its relationship with the government and other financial institutions. Similarly, capital market regulators, such as the Securities Commission of Malaysia, would also be vested with an equivalent act, which among other things, would: supervise exchanges, clearing houses and central depositories act as a registering authority for corporation prospectuses have the authority to approve corporate bond issues regulate all matters relating to securities and futures contracts regulate the takeover and merger of companies issue licences and supervise those holding licences ensure the proper conduct of market institutions and licensed persons.
While the functions above underpin the responsibility of the regulatory authorities in protecting the investor, these same regulatory bodies are also obliged by statute to encourage and promote the development of the banking and financial markets as deemed fit by central governments.
3.2 Centralised or decentralised Shariah supervisory systems

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

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

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

The applicability of either centralisation or decentralisation within a Shariah supervisory system depends on the country that hosts the Islamic banking system. In countries where the Islamic banking and finance initiative is largely government-driven, centralisation would be more applicable. The same holds true vice versa. However, there are comparative advantages linked to both systems that could affect the choice. The centralised system creates a more structured banking and financial environment, with market players being guided in their conduct within the Islamic banking and finance system. A centralised system, with more guidelines and best practices set in place, should reduce the need for conflict resolution. In addition, the design of new Shariah-approved instruments will be centrally managed with information being disseminated from the central authorities. Centralised systems can also set other limits, such as how many financial institutions each Shariah scholar can represent domestically. A decentralised system on the other hand may provide a more open environment for Islamic product development and innovation. With decentralisation, IFIs do not have to wait for approval from central authorities on the design of their Shariah-compliant structures. Decentralisation usually results in a more competitive environment whereby the most efficient and cost-effective Shariah-compliant instruments gain an advantage over the rest. It also accommodates crossregional Islamic instruments where foreign investors are more likely to be inclined to accept market-driven Shariah instruments.
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Exercise 3.1
Imagine you are structuring a new Islamic deposit scheme in a system that is governed by a centralised Shariah supervisory system. Describe the peculiarities of that system that you are likely to encounter.
3.3 Islamic finance policies

In an attempt to promote the development of the Islamic finance industry some countries have amended their fiscal rules. An example is the Malaysia International Islamic Financial Centre (MIFC) initiative jointly undertaken by Bank Negara Malaysia (BNM), the Securities Commission of Malaysia, Labuan Offshore Financial Services Authority (LOFSA) and Bursa Malaysia. Under this initiative Islamic banks and banking units licensed under the Islamic Banking Act 1983, Takaful companies, units licensed under the Takaful Act 1984, and Foreign Islamic Fund Companies are given full tax exemption for 10 years (effective 2007 to 2016). In addition, local and foreign firms managing funds for foreign investors, established under Shariah principles and approved by the Securities Commission, are given full income tax exemption on management fees received. This exemption, which is also valid for 10 years until 2016, means that such firms avoid the concessionary 10% income tax charged on management fees received from foreign investors. Malaysia has also targeted Islamic stockbroking in this initiative. The pre-commencement expenses of Islamic stockbroking businesses are now allowed as deductions for tax purposes, if the business commenced within two years from the Securities Commission approval date (that is, until the end of 2009). A similar tax break for Islamic securities, where a deduction was allowed on expenses incurred on issuance of Islamic securities based on leasing (Ijarah), progressive sales (Istisna), profit sharing (Mudarabah) and profit and loss sharing (Musharakah) has been extended to 2010. To promote Malaysia as a hub for the Islamic capital market, Special Purpose Companies (SPCs) created will not be subject to tax and the company that establishes the SPC will be able to deduct, for tax purposes, the cost of issuing Islamic bonds or Sukuks. However, any income received by the SPC is deemed as income received by the company that establishes the SPC and is subject to tax. Currently, stamp duty exemption is given to instruments that are executed in accordance with Islamic principles. To encourage further development in this area, stamp duty exemption was increased by 20% to instruments used in Islamic financing for a period of three years until 2009. Historically, interest income received by non-residents, from banks and financial institutions established under the Banking and Financial Institutions Act 1989, was exempted from tax. However, profits and interest income received from other financial institutions, including those established under the Islamic Banking Act 1983, was subject to tax. To align the tax treatment, profits and interest income received from all financial institutions is now exempt from tax. The Securities Commission of Malaysia and the BNM issued a Joint Information Note on the Issuance of Foreign Currency-Denominated Bonds and Sukuk in Malaysia on 27 March 2007. One of the issues covered in this note was the income and withholding tax charged on investors of foreign currency-denominated Sukuk. Resident investors are exempt from payment of income tax on the profits received from foreign currency-denominated Sukuk issued in Malaysia. In addition, profits or income on non-residents investments in foreign currency-denominated Sukuks issued in Malaysia are fully exempt from withholding tax. Bahrain has a slightly different approach in developing its Islamic finance industry. Instead of incentivising investors to participate in its domestic industry, the Kingdom associates itself with international Islamic agencies by playing host to a number of organisations central to the development of Islamic finance, including the AAOIFI, the Liquidity Management Centre (LMC), the International Islamic Financial Market (IIFM), and the Islamic International Rating Agency (IIRA). By doing so, Bahrain has positioned itself at the centre of the Islamic finance industry. As these Islamic agencies gain popularity and acceptance in the market, other financial centres will follow the Kingdoms lead. In another development, the Dubai Financial Services Authority (DFSA) and the Securities Commission of Malaysia have signed a mutual recognition agreement, the first of its kind between two Islamic markets. This reciprocal liberalisation between two Islamic financial centres will enable cross-border marketing and distribution of Islamic funds with minimal regulatory intervention. The agreement facilitates the entry of Malaysian-approved Islamic funds into the DFSAs recognised jurisdiction notice. Likewise, Islamic funds that have been registered or notified with the DFSA will be accessible by Malaysian investors. Malaysian capital market intermediaries will benefit from a
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gateway to distribute their Islamic products to a fast-growing market while Malaysian investors will have access to a range of Islamic products from DFSA-approved Islamic funds.
Exercise 3.2
Mutual recognition policies between two jurisdictions are deemed to provide many benefits for both the regulators and investors. State some of the benefits of adopting this policy and highlight the options available in cases where this policy is not in place.
3.4 Tax laws and neutrality policies

Tax laws in each state are designed to find the best compromise between generating sufficient revenue for the state from income-generating activities and sustaining investments within the state. The introduction and development of Islamic finance alongside conventional finance across the different jurisdictions poses a challenge to regulators who have to ensure that the tax burden is not biased to either system. A key issue is that the conventional financial system is centred on the issue of loans and is interest-based, with tax laws developed to take this into account. The Islamic financial system on the other hand is, among other things, trade-based and is moving towards an equity-based system. As a result, financial activities in this system have to live with issues such as double-stamp duties. In an attempt to address such issues, several countries have begun amending their tax laws so as to level the playing field.
An example of where one country has attempted to redress existing tax bias would be Tax Neutrality Laws enacted in countries such as Malaysia. In Malaysia, it states under Section 2 (8) of the Income Tax Act that the disposal of an asset or a lease pursuant to an Islamic financing scheme approved by either the Central Bank or the Securities Commission shall be accorded the same tax treatment as that in conventional schemes so as to avoid unnecessary tax on the Islamic instruments. Prior to this tax neutrality policy, which was enacted in 2005, amendments were made to the Stamp Duty Act and Real Property Gains Tax in 1983 to avoid double stamp duty and tax on capital gains respectively.
3.4.1 Pure sale v financing

One of the ways Tax Neutrality Laws work is in recognising that the trade or sale activities between Islamic banks and their customers are not pure sales but are part of a financing process. The resulting transfer of assets between the customer and the developer will incur stamp duty as would, say, a mortgage loan in a conventional bank. In this way, the tax bias against the Islamic system of trading would be removed and the Islamic financial system would be able to develop and compete in the market on a level footing.
In Singapore, the policy has been to align tax treatment of Islamic contracts with the treatment of conventional financing contracts to which they are economically equivalent. In 2005, Singapore waived the imposition of double stamp duties in Islamic transactions involving real estate and accorded the same concessionary tax treatment on income from Islamic bonds as applied to conventional bonds. Three Shariah-compliant products were identified by the Singapore regulatory authorities in 2006 to ensure that they did not suffer excessive taxes due to the nature of their structuring. To further level the tax playing field for Sukuk, remission will be granted on stamp duty on immovable property in a Sukuk structure, that is in excess of its equivalent conventional bond issue.
Key point
Tax neutrality policies and the removal of double stamp duties have improved the competitiveness of Islamic financing instruments.
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3.4.2 Tax in GCC countries

Tax bias with regard to Islamic finance seldom arises in tax-haven countries such as in the Gulf Cooperation Council (GCC) whereby tax laws are generally focused on oil and gas companies. In Bahrain, income is only taxed on oil and gas companies. Generally, Islamic finance instruments issued in such countries will not be subject to tax. However, if an oil or gas company issues an Islamic financial instrument, income from the instrument will be subject to tax, but there are no specific regulations dealing with taxation of income. In some GCC countries, such as Saudi Arabia, tax is only levied on foreign or non-GCC nationality residents.
Exercise 3.3
The UK Financial Services Authority (FSA) removed the double payment of stamp duty land tax in 2003. Explain what this means and how it helps financial institutions structuring Islamic house-financing schemes.
3.5 Comparative analysis of Islamic banking business models and related products
3.5.1 Islamic finance regulations
The task of regulating the Islamic finance industry falls within the purview of the same regulatory organs identified above. Banking and capital market regulators have both adopted specific legislation, at varying levels, in the different regions that practise the business of Islamic banking and finance. As explained in CDIF/2/3/52-61, different countries have adopted either single or dual banking systems with either single or separate legislation to suit their local business environment. For instance, the Central Bank of Bahrain has adopted single legislation to manage its dual banking system. BNM on the other hand manages its dual banking system with separate legislation, by granting separate licences to conventional and Islamic banks. The regulatory authoritys stance in adopting either a centralised Shariah supervisory system or one that is more decentralised and more market-driven will also have an impact of the development of its Islamic finance industry, which will be discussed in the following sections.
3.5.2 Single or dual banking system

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

Issues Capital Single banking system Existing capital structure cost-effective as it only requires segregated capital accounting Cost sharing between Islamic windows and parent bank Can exist within the current branch banking set-up costeffective Islamic windows and its products can be branded and marketed within the ambit of the parent bank cost-effective Funds generated from the Islamic windows must be segregated from conventional funds Segregated set of accounts Dual banking system Requires fresh capital may be costly
Human capital
New organisational structure with a separate cost centre Requires its own branching network
Physical location
Branding and marketing
While it may retain some features of the parent banks branding, the marketing cost is borne on its own No segregation required as the business is fully Shariahcompliant Single set of accounts
Banking funds
Regulatory reporting
Table 3.2 Macro-economic considerations

Issues Payment system Single banking system Shares one payment system with conventional banking; segregation of Islamic funds can be promoted according to segregated accounts but will be limited to number of windows operating in the banking system Utilises conventional banking liquidity instruments as the Islamic windows may be too small to warrant viable and competitive Islamic liquidity instruments Dual banking system Dedicated payment system for Islamic banking; full segregation of Islamic funds is possible
Liquidity instruments
Developed market for Islamic liquidity instruments that can exist on its own; such instruments are usually initiated by the central banks; the Islamic money market provides an avenue for Islamic banks to expand their banking portfolios
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3.6 The role of central banks /monetary authorities

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

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

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

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

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

With separate Islamic banking legislation, an Islamic bank, with its different depository structure (restricted and unrestricted investment accounts, compared with conventional fixed-deposit accounts), can take advantage of a wider scope of banking that it may not have access to if it is licensed under the same legislation as commercial banks. Far from being less prudent, an Islamic bank can function as a universal banking entity, aligning them closer to German banks. Universal banking is an alternative mechanism to a stock market for risk-sharing, for providing information to guide investment and for contesting corporate governance. In Germany, where the stock market has historically been small, banks hold equity stakes in firms and have proxy voting rights over other agents shares. In addition, banks lend to firms and have representatives on corporate boards. If a banking relationship is a substitute for the stock market then cross-ownership with a bank should improve the performance of firms. German banks typically hold voting shares in commercial firms as part of their long-term portfolio and also serve as proxies for small shareholders, enhancing their corporate voting powers. German banks also take a more formal role in a firms affairs through their membership on supervisory boards. Historical empirical evidence shows that equity block holdings by German banks led to improved firm performance, while block holdings by non-bank firms did not lead to improved performance. This advantage has since been negated by the improved efficiency and liquidity of the German capital markets. The ability of banks to exercise due diligence on companies in which they have equity positions strengthens the argument in favour of universal banks. As a part equity owner, universal banks have better access to the financial information of the companies they have invested in. Universal banks in such jurisdictions will be in a better position to extend, for example, financing facilities to the companies they part-own. Universal banks involvement in the capital market is more crucial in jurisdictions where capital markets are less developed. Companies operating in such jurisdictions may face difficulties in raising capital cost efficiently on their own.
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Whether Islamic banks should be governed under a single or separate banking legislation naturally depends on the precedence that the newly established Islamic banks would enjoy upon incorporation. If existing banks in the economy already engage in equity or lease-based business as well as debt-based instruments, such as banks in the GCC, then a separate Islamic banking legislation would seem unnecessary. However, if the existing banks in the country only offer loans and debtbased business, as in Malaysia, the enactment of separate Islamic banking legislation could promote the development of Islamic banking in that jurisdiction.
3.8 Prudential requirements, supervision and Shariah review of Islamic financial products
Islamic banks appear to observe similar prudential requirements as those set for conventional banks. This is because much Islamic banking business corresponds directly to contemporary financial intermediation. Islamic banks source deposits from households, corporate and government sectors, and utilise such deposits to fund their asset portfolio. While the contractual relationships used differ between conventional and Islamic banks (debt arising from interest-bearing loans versus interestfree loans or safe custody, or debt arising from trading activities), the economic benefits are usually identical across the two banking sectors. As such, Islamic banks usually observe similar Capital to Asset Ratios (CAR) statutory reserve as well as liquidity requirements, as do conventional banks. There are, however, situations whereby the underlying relationships between Islamic banks and their customers are fundamentally different from that of conventional banks. In such instances the regulatory authorities, with the advice of International Islamic agencies, such as the IFSB, may implement an additional set of prudential requirements to better protect the customers.
3.8.1 The changing nature of deposit

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

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

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

The introduction of the PER and IRR are good examples of the improving prudential requirements that have been set specifically for Islamic banks. However, there are several Shariah as well as operational issues that must be addressed in managing such reserves. Managers of Islamic banks, for instance, must obtain the consent of the IAHs prior to allocating such reserves or in making distributions from them. The ceilings and floors of such reserves must also be approved by both the regulatory authorities and the account holders. Other issues would include whether an Islamic bank was required to set up one overall PER and IRR for all its relevant business, or separate reserves for each category. In addition, the Islamic bank would need to decide if there should there be different ceilings and floors for the different types of investment, that is one for the real estate investment portfolio and another for the car leasing portfolio. These bona fide issues would have to be resolved individually by each Islamic bank so the interest of their IAHs was best protected at all times.
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(a) Analyse the financial statements of the two international banks as given in table 3.3 below. (b) Describe the issues that are involved, both Shariah as well as operational, with regards to the allocation of PER within each bank. (c) Explain whether a higher PER allocation necessarily means a more profitable banking operation.
Solution
(a) The PER provides a cover over the future profit potential for IAH while the IRR provides a cover over the capital invested. The Malaysian bank is seen to be allocating higher percentages of PER as a percentage of income compared with the Bahraini bank during the profitable years 2003 and 2004. To do this, the managers of the Malaysian bank must operate within the maximum PER allocation guidelines of the regulatory authority (given at 15%). (b) In order to fulfil Shariah requirements, both banks must obtain consent from the IAH prior to allocating both PER and IRR. This is because the allocated amount accounts for actual profits that can be distributed to the IAH. This consent is obtained during the initial opening of the investment accounts. Once mandated, Islamic bank managers must decide what percentage of income can be allocated to the PER and IRR. This is a balancing act as the managers must keep in mind that the composition of the IAH would change over the years. A percentage too high would tax the IAH unfairly and one too low would result in insufficient reserves. (c) One possible explanation is that Malaysia has already instituted a deposit Takaful scheme that protects the capital of the IAH. Another explanation could be that the Malaysian banking system is well regulated and the Malaysian bank is already well capitalised. The PER fund for the Malaysian bank was reduced to zero at the end of 2005. This suggests that the Malaysian bank experienced a very bad year in 2005 and obtained permission from the IAH (a Shariah requirement) to disburse the full amount to the IAH in that year. It also appears that the bank paid out USD155,000 from the PER Fund to smoothen profits for IAH holders in 2004. The above permission is a requirement as different groups of IAH have placed funds at different timescales, some since 2003 and others at the start of 2005. As such, different groups of IAH have contributed different amounts to the PER and as such the managers must be operationally efficient in distributing the PER equitably.
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Table 3.3 Excerpts of financial statements of a Malaysian bank versus a Bahraini bank for the years 2003 to 2005
2003 Shareholders fund (SHF) Income derived from investment of depositors funds PER allocation for year PER fund IRR allocation for year PER as a % SHF PER allocated as a % income 2004 Shareholders fund Income derived from investment of depositors funds PER allocation for year PER fund IRR allocation for year PER as a % SHF PER allocated as a % income 2005 Shareholders fund Income derived from investment of depositors funds PER allocation for year PER fund IRR allocation for year PER as a % SHF PER allocated as a % income 202,828 206,089 1,986 11,227 0 0.00% 0.96% 337,911 54,199 4,795 5,995 0 1.77% 8.85% 323,108 169,904 7,176 9,241 0 2.81% 4.22% 294,047 44,241 1,200 1,200 3,350 0.41% 2.71% Malaysian bank (US 000) 309,202 158,809 2,065 2,065 0 0.67% 1.30% Bahrain bank (US 000) 281,980 32,671 0 0 0 0.00% 0.00%
3.9 Deposit insurance/Takaful

Deposit insurance schemes are not a new phenomenon. Given the importance of ensuring the stability of a nations financial system, such schemes have been adopted by more than 80 countries including the US, Canada, Taiwan, Japan, Germany, Indonesia and Hong Kong. The scheme offers an explicit guarantee that depositors will get their money back should a bank fail in its operations, replacing the implicit guarantee from the government. This represents part of the authorities concerted efforts to strengthen protection for depositors and is a clear signal to the banking community, as well as the general public, that financial institutions should no longer expect to be bailed out in the event of mismanagement and/or sheer lack of financial discipline on their part. Malaysias 2005 initiative to introduce a deposit insurance scheme represents the worlds first scheme that covers Islamic deposits. Operating via a third-party guarantee, the Islamic Deposit Insurance Scheme initially provided a maximum coverage of RM60,000 per depositor, per member institution for Islamic deposits. This effectively provides 95% coverage for the systems depositors, and 35% of the total deposited amount.
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Exercise 3.4
Explain the impact of the Islamic Deposit Insurance Scheme on the Islamic banking industry in Malaysia.

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

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

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

While the purpose of the Shariah compliance review is to provide comfort to the investors as well as the regulatory authorities that Shariah requirements have been met, the scope of the review is based on established Shariah principles, standards and guidelines. These benchmarks have been set by the Shariah advisory committees of the regulatory authorities, as well as those established inhouse by the financial institutions. The scope would also include adherence to the relevant acts that the financial institution has to comply with, as well as the best practices and standards promoted by international bodies such as the AAOIFI and the IFSB. The following table depicts the individual areas that the Shariah compliance review would address:
Table 3.4 Scope of Shariah compliance review

Technology i. Review of the application system to ensure it can support the Islamic product specifications and transactions ii. Review of the Islamic application access and control to ensure compliance to Shariah rules Operations i. Assessment of adequacy and effectiveness of policies and procedures of business activities ii. Review the contracts, products and services in accordance to Shariah rules iii. Review the product development, product branding and market development iv. Report new research and latest findings in Islamic banking People i. Review the staff roles and responsibilities in executing Islamic finance activities ii. Review adequacy of training and development of human capital Governance i. Review the key governance functions ii. Review the capital adequacy framework iii. Review the Islamic accounting standard and treatment iv. Review the liquidity framework of Islamic banking v. Assessment on risk management vi. Legal issues in Islamic finance industry vii. Profit distribution policy to IAHs and other depositors
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3.10.3 Benefits of a Shariah review process

A good example of the benefits of a Shariah review process comes from the Islamic capital market. Shariah equity mutual funds invest in common shares of companies and utilise a variety of Islamic stock-screening methodologies to ascertain their investable Shariah-compliant universe. As stated in CDIF/3/9/137, the Islamic equity screening methodology generally employs three screens: corebusiness activities, financial ratio and non-halal income. Shariah authorities have predetermined, through Fatwas, the permission levels of tainted income that can be tolerated for a stock to be labelled Shariah-compliant. It is through this process of periodic Shariah review that mutual fund managers can ascertain what the current levels of tainted income generated are and what must be cleansed. The cleansing process can take place through donating the tainted income to pre-identified charities. The Islamic mutual funds internal Shariah advisory committee is usually consulted prior to this cleansing process.
Exercise 3.5
A Shariah review examines whether the operations of the product are in line with the approved Fatwa. If the operations are found to be against the Shariah parameter prescribed in the Fatwa of the Shariah board, the board has to recommend correctional measures to comply with Shariah principles including, but not limited to, revocation of contract, disposal of any profit to charity and suspension of the whole facility at bank level. In the case of Sukuk issuance, a financial institution declares in an information memorandum that its Sukuk Musharakah proceeds will be utilised in financing the construction of a power plant in country A. The Shariah review is never undertaken throughout the tenor of the Sukuk. It is discovered after the maturity of the Sukuk that proceeds were actually used to invest in money market products, some of them not compliant to Shariah principles. Identify the causes of this non-compliance and the measures that must be taken to ratify and avoid this happening in the future.
3.11 Zakat treatment of Islamic finance investors

Zakat is a form of religious levy on the wealth of Muslims and has been discussed in CDIF/2/1/25. Based on wealth that exceeds the specified quantum for a defined period, it is meant for the poor and needy, as well as other specified beneficiaries mentioned in the Quran. As it is the third pillar of Islam, Zakat is obligatory for all Muslims who have the financial means to discharge such obligations. Zakat can therefore be viewed as an Islamic equivalent of a direct tax on property and income. It is levied on the total of the taxpayers capital resources and income that is not invested in fixed assets. Where an individual owns shares in a company, such resources include the companys capital, net profits, retained earnings and reserves not created for specific liabilities. Zakat payments by IFIs vary as each financial institution is supervised by their individual Shariah advisory boards. For instance, in Malaysia, the Kuwait Finance House pays a rate of 2.5775% on its opening reserve balances. Other institutions reportedly pay Zakat only on their business proceeds and not for their shareholders. Islamic banking industry practice is such that no Islamic banks pay Zakat for their depositors. The depositors settle their own Zakat obligations. Even in Muslim countries there may be no law or regulation imposing the payment of Zakat by IFIs. The Islamic Banking Act 1983 of Malaysia made the payment of Zakat by the shareholders of IFIs licensed under this Act compulsory. Thus, the Shariah board of these institutions is required, by virtue of the Act, to ensure the payment of Zakat by the IFIs on behalf of the shareholders. There was, however, no law imposing Zakat on individual Muslims be it depositor, investor or Sukuk holder. Zakat is a religious obligation for Muslims, payable on all wealth able to give a financial return. There is no specific date set for the payment of Zakat, but it should be paid on all wealth held for more than 12 lunar months. Zakat is not payable on the value of the individuals home, furniture, transport or tools of trade, nor is it paid on personal jewellery.
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As explained in the discussion on Takaful (CDIF2/8/149), the obligation to pay all the claims to the claimant is vested with the Takaful or risk fund. The Takaful company, or the operator, is merely a fund manager and not an insurer. There is, however, no law or written regulation to legally oblige the Takaful operator to undertake to provide this interest-free loan when the need arises. In practice, a Takaful fund can run into a deficit if the claims of a given period exceed the contributions and the reserves. Should the law prescribe on all Takaful operators to provide this interest-free loan fund from the very beginning of the operation, explain what the implication would be on a Takaful company from a commercial and Shariah perspective?
Solution
It would appear to be a good policy to ensure that the licensed Takaful company is solvent when the need arises to pay the outstanding claims that are beyond the limit of the Takaful fund. From a capitalisation perspective, if this fund could be considered as part of the capital of the Takaful company, then it will improve its capital adequacy while maintaining a solvency to pay claims if the Takaful fund is in deficit. However, if the law or regulation were to insist that this provision of an interest-free loan could not be deemed as part of the capital of the Takaful company, then the company may have to provide a larger capital base to create a better capital adequacy ratio. While some companies may be in the position to provide a larger capital base for both capitalisation and solvency requirements, some of the prospective Takaful companies may not be able to do that, thus affecting the growth of Takaful business. The provision of interest-free loans by the Takaful company in advance may pose a Shariah compliance issue as the Takaful company, being the lender, is also the agent or Wakil to manage the Takaful business and the Takaful fund investment for an agreed fee. As stipulated in Shariah principles, a loan contract shall not be combined with any other contracts that may give indirect benefit to the lender. The Takaful company, after lending out the money for this fund for solvency purposes, may charge higher Wakalah fees for managing the Takaful fund. This could be construed as indirect charging of interest, which is prohibited. The argument against this practice will be irrelevant if the management contract between the Takaful fund/policyholders and the Takaful company is based on Mudarabah simply because Mudarabah, unlike Wakalah, does not have a fixed-fee feature into which a possibility of an interest charge may be included.
3.12 Conclusion
This chapter looked into the various financial laws and regulations that govern IFIs and the Islamic instruments that they generate. The various financial regulatory organs and their functions were discussed, as well as the regulatory systems that they adopt. The chapter elaborated on the monetary, tax and legal policies adopted by these regulatory authorities that affect the development of the Islamic finance industry in its domestic market. Various Islamic banking models were analysed to provide justification as to how the business and legal environment determines which model would be most suitable in the jurisdiction. Issues on prudential requirements, supervision and Shariah review were also discussed to give you a holistic overview on the issues you would have to keep in mind as you undergo the Islamic product structuring process.
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3.13 Summary
Having read this chapter the main points that you should understand are as follows: adequate regulation and governance of the IFSI is required to maintain confidence in the financial systems financial legislation and licensing requirements determine the structure of each financial system the regulators policy to promote its Islamic finance industry through tax breaks or tax subsidies will have a major impact on the development of that industry tax neutrality policies and the removal of double stamp duties have improved the competitiveness of Islamic financing instruments Islamic finance instruments may require a unique set of prudential requirements different from conventional instruments because of different contracting relationships a Shariah review is an important process in ensuring that Islamic instruments maintain Shariah compliance at all times Islamic deposit insurance improves confidence in the Islamic banking industry.
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Comparative analysis of banking models in a dual banking system
Greenwich Bank is a traditional conventional commercial bank that has been operating in the UK since 1923. Its main banking focus is in the retail banking business and Greenwich has always maintained an average market share of 23% of the total deposits mobilised in the UK. Since 2004, Greenwich has had an Islamic banking window in the UK to cater for the growing interest in Islamic-compliant instruments. Greenwich is keen to export its Islamic banking expertise overseas, particularly to Malaysia and Bahrain, to tap into Islamic deposits there.

1. How can the Financial Services Authority promote and develop the Islamic banking and finance industry in the UK? (A) (B) (C) (D) 2. By issuing more Islamic liquid instruments in UK currency By providing tax subsidies to Islamic financial institutions and products By allowing multi-currency-based Shariah-compliant products By introducing special laws and regulation on Islamic finance
Which legislative system will best enable Islamic financial institutions to develop better in the UK? (A) (B) (C) (D) A separate legislative system A single legislative system A centralised banking legislative system A decentralised banking legislative system
3.
Why would an Islamic bank be more successful if it were a universal bank? (A) (B) (C) (D) Universal banks are given tax subsidies by most governments Universal banks are more cost-effective Islamic deposits and financing instruments are not necessarily debt-based Islamic depositors are more risk-tolerant
4.
Which of the following statements about PER is correct? (A) (B) (C) (D) PER is appropriated out of Mudarabah income before allocating a profit-sharing portion to the Mudarib PER is appropriated out of Murabahah income before allocating a profit-sharing portion to the Mudarib PER is appropriated out of Mudarabah income after allocating a profit-sharing portion to Mudarib Approval from the IAH is not required for the appropriation of PER
5.
A Shariah compliance review is an important process to: (A) (B) (C) (D) Ascertain that the Islamic finance instruments remain Shariah-compliant at all times Ascertain that the financial institution that issues Islamic finance instruments remain Shariah-compliant at periodic times Ensure that the Islamic finance instruments are tax-efficient Ensure that the Islamic finance instruments are profitable
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1. Continuing with the case study: (a) Explain the strategies that Greenwich Bank should have in its plan to work in Malaysia and Bahrain, as mentioned in the case study. (b) Explain the Islamic banking models that Greenwich Bank could potentially apply in these two jurisdictions, utilising the information contained in this chapter. (c) Outline the Islamic banking instruments Greenwich Bank can potentially offer in Malaysia and Bahrain. Give reasons for selecting these instruments. 2. Explain to Greenwich Bank how it could increase its Islamic banking operations in the UK, taking into account all regulatory requirements and limitations. 3. Operating in a dual banking system, one of the problems that Greenwich Bank could face is a displaced commercial risk (DCR), thus affecting the shareholders dividend. Recommend Shariah-compliant measures that would overcome this risk.
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Chapter three answers

Exercise 3.1
Operating in a centralised Shariah supervisory system, one would be expected to be well versed in the Shariah guidelines of the contracts and Islamic instruments that have already been approved by the central Shariah authorities. The structuring team may wish to adapt contracts that have been utilised in other IFIs to suit the features of their new products. This would appear to simplify the task as the principles of the chosen contracts would already have been specified in the guidelines of earlier instruments. The structuring team can then concentrate on any new features to ensure that they would appeal to the target consumers. However, when introducing a new Shariah contract to the domestic market, the structuring team would be best advised to seek guidance or best practice established by international Islamic agencies such as the AAOIFI and the IFSB in relation to the specific contract. This would help in gaining approval from both their internal Shariah advisory board and the centralised Shariah authorities. The team would, of course, have to ensure that the guidelines adopted from such international agencies did not conflict with the interpretation of Shariah principles in their own country. Consequently, a product that has not been approved in that jurisdiction cannot be introduced there although the product may have obtained Shariah approval from other Shariah boards in other jurisdictions. The structuring team should endeavour to find a solution that would achieve the same economic benefit, but using a different contract or product structuring. For example, an Islamic credit card based on the Murabahah commodity structure may not be accepted by the central Shariah board as the Murabahah commodity structure has not been approved for this purpose. However, an Islamic credit card may be introduced in that jurisdiction using a different contract such as Wakalah or Kafalah.
Exercise 3.2
The benefits of this policy include: a. Cost-effectiveness as there is no need to get clearance for the licensing and distribution of Islamic products once licensed and approved by the respective party to the agreement. b. Mutual recognition of different Shariah interpretations, if any. c. Cross-border investment opportunities for the investors in participating countries. However, in cases where this policy is not available, the Islamic asset management companies will have to set up a feeder fund in their respective country to raise funds to be channelled entirely to another fund manager overseas. The management of the fund will be undertaken by the overseas party.
Exercise 3.3
The UK FSA recognised that the trade or sale between the financial institution and the customer that takes place in an Islamic financing scheme is not a pure sale but is part of a financing process. Before this recognition was made, parties to an Islamic house finance scheme were required to pay stamp duty land tax on the sale between the original house owner and the financial institution and on the sale between the financial institution and the ultimate buyer. The removal of the double payment of stamp duty land tax, which would have occurred if the trade was taken as a pure sale, ensures that Shariah-compliant financial products are taxed in a way that is neither more nor less advantageous to equivalent conventional banking products. The amendment allows providers of an Islamic house-financing scheme to offer such instruments without facing any commercial disadvantage through unequal tax treatment. If the change had not been introduced, the Islamic instrument would be tax-inefficient compared with conventional mortgages. IFIs can therefore tap into otherwise conventional-only customer pools where they can attach innovative Islamic product features that are not offered in conventional mortgages. It also enables customers to take up these Shariah-compliant products without encountering uncertainty or disadvantage over tax treatment.
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Exercise 3.4
The Islamic Deposit Insurance Scheme provides assurance to Islamic depositors that their funds should be safe in Islamic banks. A large portion of Islamic deposited funds in Malaysia are based on the Wadiah yad dhamanah contract and as such would be utilised by the Islamic bank for its financing portfolio. The Islamic Deposit Insurance Scheme improves Islamic banks safe-guaranteed obligations. The scheme would also relieve the central bank from the burden of implicitly guaranteeing deposits. This system should further enhance the Malaysian financial industry, increasing the systems stability in the process. The migration from a flat-rate premium system to a risk-based premium system, which will be implemented at a later stage, would also encourage sound risk-management practices in the banking sector. With the newly introduced deposit insurance scheme, the credit ratings of financial institutions would play an even more crucial role, for depositors and banks alike.
Exercise 3.5
It seems that the issuer has breached the representation which they made in the information memorandum. The issuer may be subject to legal action as they have breached the disclosure statement made in the official document. The trustee who has been assigned to look after the Sukuk proceeds seemed to be negligent in not monitoring how the Sukuk proceeds were utilised. To some extent, it also reflects poor Shariah internal monitoring as the Shariah review has not been done either by the scholars who approved the Sukuk or by the internal Shariah officer of the arranger bank. This Sukuk product may be argued as null and void as the profit being distributed during the tenor was not derived from the project specified but from another project. Furthermore, the proceeds have been invested in non-approved instruments, the income of which must be disposed to charity. The causes for this non-compliant activity are due to a breach of terms and conditions by the issuer, negligence by the trustee, and poor Shariah review procedures. Given the above, it seems that the product is not compliant. The Shariah way of managing the issue is to examine how to describe this breach of contract. This could invoke many juristic discussions. One possibility is to deem this transaction as an extra action performed by the agent who is the managing partner/ issuer. Put simply, he has acted beyond his authority and therefore is liable for the capital of the Sukuk investors. Another possibility is that he is liable for both capital and reasonable profit according to the average market conditions as the managing partner has breached a clear-cut term and condition. Prudent measures to ensure compliance with regards to utilisation of Sukuk proceeds include periodical Shariah review of the operations of the issuer with regards to Sukuk proceeds, access to the formula of determination of profit and loss for every distribution of dividend and, if necessary, a site visit to ascertain the real undertaking of the project financing.

1 2 (B) Tax subsidies will allow Islamic instruments to be more tax-efficient and hence investors would be more willing to use them for investments. (A) UK banks have a historical bias towards a debt-based system with the traditional lenderborrower relationship firmly in place. To suit the equity-based contracts that Islamic finance are associated with, it may be more suitable that Islamic banks are separately licensed so they can take equity positions in companies or assets. (C) The universal banking concept allows an Islamic bank to match its equity-based deposits to equity-based financing instruments. The universal banking concepts still allows the Islamic financial institution to generate debt-based business but it simply gives an option for an equity-based business. (A) This is a fundamental feature of the PER. (A) Islamic instruments must at all times be Shariah-compliant.
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1 (a) The Malaysian financial industry operates a dual banking system with separate licensing. The Malaysian Central Bank has ceased allowing conventional banks to operate Islamic windows thus restricting all banking business in Malaysia strictly to Islamic. All existing Islamic windows are being converted to Islamic banking subsidiaries. As such, Greenwich Bank would have to apply for a new Islamic banking licence if it wishes to conduct Islamic banking business in Malaysia. The bank will not be allowed to export its Islamic window model to Malaysia. The Bahraini financial industry also operates a dual banking system, but via a single licence system. As with the Malaysian counterparts, the Islamic window model no longer exists in Bahrain. Greenwich Bank would need to incorporate a fully fledged Islamic bank in Bahrain in order to participate in the industry, and would also be restricted to solely undertaking Islamic banking business. (b) Separate licensing would mean that the Greenwich Bank Islamic operation in Malaysia will have the option of offering equity-based or leasing Islamic financing instruments to its potential customers, on top of the usual debt-based instruments. This may be a necessary pre-condition for the Islamic subsidiary in order to be competitive in the Malaysian market. Even though Bahrain operates a dual banking system based on a single legislation, the difference that the Islamic subsidiary would face there may not be as vast as previously expected. GCC banks have a history of originating as traders (either commodity or foreign exchange) prior to their banking history and, as such, are more capable of handling equitybased and leasing instruments compared with western banks. Bahraini banks also have an extensive history of managing operating leases and owning the leased assets in their books. As such, the single legislative nature of their banking licence does not impede Islamic banks in conducting their banking business. One major difference would lie in the Shariah authority in Bahrain, which is decentralised, compared with the centralised Shariah authority system in Malaysia. Greenwich Banks Islamic subsidiary would therefore enjoy autonomy in issues such as the selection of Shariah advisers to the bank, compared with the subsidiary operating in Malaysia. (c) Greenwich Bank would have to look beyond its history of debt-based instruments and quickly attain expertise on Islamic equity-based and leasing instruments. For instance, the Islamic subsidiary would have to offer operational leases and incorporate the leased assets in its balance sheet instead of only providing mortgages or vehicle loans. With regard to depository products, the Islamic subsidiary would have to be in a position to offer Islamic investment accounts. This equity-based instrument is also a point of departure for Greenwich Bank which would be used to mobilise deposits via debt or through the lender-borrower relationship. 2. Greenwich Bank would need to establish a fully-fledged Islamic bank or at least an Islamic subsidiary in the UK to pursue Islamic banking business earnestly. To date, there are already five fully-fledged Islamic banks in the UK and the first movers usually maintain the advantage. Although the issues over double stamp duty have been resolved by the FSA, Greenwich Bank would need to move away from solely utilising debt-based financing for its asset portfolio. It should take advantage of minimising the duration gap between its future Islamic asset and liability portfolios by utilising more equity-based Islamic contracts for both its depository as well as financing portfolios. This transition is made easier through a fully-fledged Islamic bank or subsidiary, especially for a bank that has an entrenched foundation in a credit-based traditional banking model. Prolonged utilisation of the Islamic window model would limit Greenwich Banks opportunity of entrenching itself in the Islamic banking industry. 3. The issue of DCR will always exist as long as the Greenwich Bank Islamic subsidiary sees the need to mitigate the risks assumed by the IAH by transferring them to the shareholders. Instead of doing that, Greenwich Bank may utilise a portion of the profits due to the IAH by setting up a PER and an IRR. The IAH should be reminded that the opportunity of being remunerated with superior returns over traditional depository returns would come with the price of extra risk assumption.
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Chapter four
Structuring deposits, investment accounts and money market instruments
Learning outcomes
By the end of this chapter you should be able to: analyse and evaluate the validity of underlying contracts in raising deposits and funds appraise prudential treatment in structuring Islamic deposits assess the implications of contract structures in meeting liquidity requirements.

Wadiah and Qard deposits for safe custody, payment and security Mudarabah investment deposits or accounts Murabahah fixed-income deposit Prudential considerations in structuring Islamic deposits Essential considerations for structuring Shariah-compliant money market and treasury instruments Case study formulating deposit strategies and meeting depositors expectations
4.0 Introduction
Deposits are a class of financial asset placed or deposited at licensed commercial banks. For both conventional and Islamic commercial banks, deposits are the primary source of funds. They are essentially liability instruments for deposit-taking institutions such as commercial banks, which absorb cash from their depository clients in various forms of deposit. The depository funds allow banks to extend various financing schemes that make up the banks asset portfolios. Technically speaking, banks mobilise deposits to undertake financing in real and financial assets or to provide financing to customers for the purchase of assets such as houses, vehicles, equipment, land and buildings. This chapter examines deposit structures using a variety of contracts and explains the importance of applying a structuring process in a framework that takes into account regulatory requirements. Suitable contracts will be identified by analysing deposit and investment account behaviour from both the corporate and individual perspective. Throughout the chapter, where appropriate, cost implications will be considered in relation to the Islamic deposit structuring process. In addition, the chapter highlights the impact of structuring on deposit behaviour as well as its implications in relation to the deposit framework. Finally, the chapter examines the requirement for Islamic money market instruments and treasury products and the various products offered in the Islamic finance services industry.
4.1 Pertinent features of Islamic deposits
There is a variety of Islamic deposits, ranging from sight or demand deposits to investment or time deposits. They share features with conventional deposits while retaining distinctive features of their own. We will start by considering the similarities, which include the need for liquidity, interest/profit sharing, customer relationships and guarantees.
4.1.1 Liquidity
One of the most important features that deposits share is that they are very liquid assets, regardless of whether they are structured under a conventional or Islamic finance scheme. In terms of liquidity, deposits are ranked second only after cash. Time deposits are obviously less liquid than, say, sight deposits, with the former requiring a pre-agreed committed tenure before withdrawal. The drawback from providing this liquidity is that deposit products are the lowest return-generating class of assets for banking clients, ranked only higher than cash, which essentially generates zero returns.
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4.1.2 Interest/profit sharing

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

Although deposit mobilisation between Islamic and conventional banks may appear similar, the underlying concepts and principles of the deposits are different. In conventional finance, deposits are structured strictly under a loan contract where the depositors are the lenders and the bank the borrower. This lender-borrower depositor-bank relationship need not necessarily manifest itself in Islamic deposits. The relationship can be lender-borrower if the Qard contract is utilised, but the relationship could be owner-trustee if the Wadiah contract is used, or even investor-manager if the Mudarabah contract is applied.
4.1.4 Guarantees
Another feature is that deposits in conventional banking are explicitly guaranteed by the bank that issues them and the regulator in their capacity as lenders of last resort. Recently, deposit insurance schemes have supplanted the regulators role of lenders of last resort. This issue will be discussed in more detail later in this chapter. In the case of demand or sight deposits, depositors fully expect banks to make good their deposits as and when they want to withdraw them. For time deposits, they would have to wait for the tenure to expire to recover the full amount. The inability of a bank to meet any withdrawal request from its depositors could trigger a run on the bank as was seen in 2008/09 during the credit crisis when many banks around the world were subject to concerns about their ability to repay depositors. Certain Islamic deposits, such as those under the concept of Mudarabah, cannot technically be guaranteed by the issuing bank and it remains to be seen whether the lenders of last resort facility will be made available to them.
Exercise 4.1
A customer has opened an Islamic investment account for the period of one year with an Islamic financial institution (IFI) using a Mudarabah contract. However, after six months the customer needs to withdraw his investment to meet pressing financial needs. The terms and conditions of the account have stipulated inter alia that the investment shall be for the agreed period. Advise the IFI on how to deal with this customer and how to improve the terms and conditions of the account moving forward.
4.2 Why people hold deposits

People hold money for many reasons and this affects the type of product they choose to invest in. Some people look for liquidity to meet their transactionary motives, while others hold money for precautionary reasons, that is, to meet unexpected demands. Table 4.1 below outlines the various definitions of money in the banking system. Deposits fall within the definition of money, that is M1 for demand/sight deposits or M3 which includes time deposits. The liquidity features of the various deposit products determine its classification. Demand deposits, for example, are very liquid and can be used by the deposit holder to pay for example via debit card, for goods or services, whereas time deposits are less liquid and cant be used for day-to-day transactions. As such, deposits fulfil the transactionary motive of holding money. On the other hand, the guarantee feature of deposits also fulfils the precautionary motive of holding money.
Key points
The transactionary motive of holding money refers to its use for purposes of business transactions and personal consumption. The precautionary motive of holding money refers to the demand for security or in cases of emergency.
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Table 4.1 Economic measures of money

M0 Currency (notes and coins) in circulation and in bank vaults, plus reserves that commercial banks hold in their accounts with the central bank (minimum reserves and excess reserves). M0 is usually called the monetary base - the base from which other forms of money (such as checking deposits, listed below) are created - and is traditionally the most liquid measure of the money supply. Currency in circulation, plus checkable deposits (checking deposits, officially called demand deposits, and other deposits that work like checking deposits), plus travellers cheques. M1 represents the assets that strictly conform to the definition of money: assets that can be used to pay for goods or services or to repay debts. Although cheques linked to checking deposits are gradually becoming less popular, debit cards linked to these deposits are becoming more popular. Like cheques, debit cards as a means to complete a transaction through their links to checkable deposits can also be considered as a form of money. Even in the case of travellers cheques, most users hold pre-paid cards rather than paper cheques. These will usually be foreign-currency denominated, and are not, therefore, part of the home countrys money supply. M1, plus savings deposits, time deposits less than US$100,000 and money market deposit accounts for individuals. M2 represents money and close substitutes for money. M2 is a key economic indicator used to forecast inflation. M2, plus large time deposits, institutional money market funds, short-term repurchase agreements, along with other larger liquid assets.
M1
M2
M3
The table above defines the different financial measures of money and ranks according to the level of liquidity, with M0 being the most liquid form of money. According to conventional wisdom, the more liquid the form of money is, the less it should be remunerated with returns or interest. For instance, cash or currency (M0) pays zero returns to the person holding it. Checkable deposits (M1) also generate lower returns to the depositors compared with time deposits (M2). While it is perhaps not applicable to the Islamic banking and finance industry where interest is prohibited, it is nevertheless useful for Islamic banking and finance managers to be aware of this as they are in competition for funds with conventional banks. This is, to a large extent, manifested in the types of contracts being offered to Islamic depositors. Both Wadiah and Qard contracts are liability contracts, which therefore constitute demand deposits. The Mudarabah is not a liability contract but rather represents a longterm investment and therefore has a different risk-reward profile. This will be discussed later in this chapter.
4.3 Costs considerations in structuring Islamic deposits

In addition to maintaining the features mentioned above, one has to consider the costs that are incurred as a result of structuring Islamic deposits.
4.3.1 Cost of funds

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

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

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

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

This is pertinent only for Islamic banks as conventional banks only operate on a loan contract. Islamic banks make use of a variety of deposit contracts, several of which may remunerate depositors through Hibah which is a discretionary gift such as in Qard or Wadiah-based deposit taking. Islamic banks can therefore manage the cost of remunerating their depositors through the choice of contract applied. Islamic banks do not have to promise ex-ante returns to their depositors and may reward their depositors with returns only if and when they are able to. This also applies to the equity-based contract of Mudarabah when profits are paid out by the banks only when there are actual profits being made, even though the profit sharing ratio has been pre-agreed. The only situation when Islamic banks have to make good promised returns is when they use trade-based contracts such as Murabahah, where the profits due to the depositors are pre-agreed from the mark-up sale transaction that underlines the contract.
4.4.3 Pooling
Islamic deposits can either be invested together as a pool through unrestricted investments, or can be identified with a specific type of investment through restricted investments (CDIF/2/4/70). Under unrestricted investments the resulting profit sharing ratio is based on profits earned through bank-wide operations, whereas the profit sharing ratio for restricted investments is limited to profits earned from specific investments.
4.4.4 Depositors expectations

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

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

The table below depicts the annual fixed deposit rates of AON Bank and the expected return for its Islamic windows Islamic investment account for durations from three months to five years. Given this scenario, what is likely to happen to the development of Islamic banking and finance?
Comparison between AON Banks FD rates and AONs Islamic windows Islamic investment accounts expected returns
1 mth
Fixed deposit rates/ per annum Expected investment account returns/ per annum 1.75%
3 mth
1.80%
6 mth
1.90%
9 mth
1.93%
1 yr
2.00%
3 yr
2.25%
5 yr
2.80%
1.50%
1.65%
1.70%
1.80%
1.85%
1.95%
2.40%
Solution
The Islamic investment accounts will be in direct competition with conventional fixeddeposit accounts for the pool of deposit funds. The Islamic alternative may have its own pool of customers who are motivated by religious convictions, but this doesnt mean that this pool should settle for less competitive returns compared with fixed-deposit customers. The rates tabled above show that returns are uncompetitive for all durations. This would not motivate Islamic depositors to place their funds in such accounts. On top of that, Islamic IAHs are expected to be burdened with higher risks, compared with conventional fixed-deposit customers. The Islamic investment account does not operate with guaranteed funds and, as such, potential account holders would expect a far higher return compared with conventional fixed deposit account holders. This scenario would certainly not augur well for the development of Islamic banking and finance. Islamic deposit instruments need to be more competitive than their conventional counterparts in order to woo new customers to this nascent segment. With this scenario, the Islamic window would find difficulties in mobilising deposit funds. The window would need to source more costly funds, such as issuing a Sukuk to fund its operations, and to build up a more profitable asset portfolio using the funds supplied by Sukuk.
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4.5 Operating cost

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

Overhead costs for financial institutions consist of all the indirect costs and other costs necessary to provide the financial products and services. A large portion of the financial institutions overhead costs relate to personnel expenses, in the form of salaries and wages, as well as administrative, marketing and information technology expenses. Many current Islamic banking institutions are established either as subsidiaries of larger banking conglomerates or operate as Islamic window facilities, or are fully fledged Islamic banks. Such institutions, in cases like the former scenario, often operate via a model known as shared services that seek to reap the benefit of economies of scale and also external economies that large banking conglomerates have in place. Services that are often shared between Islamic subsidiaries or windows and their conglomerate parent banking institutions are information technology services, marketing and distribution channels and personnel. The Islamic subsidiary or window is then allocated a percentage of the overhead cost from the parent conglomerate. This shared services scenario will not be applicable in the case of a fully-fledged bank as it would have its own internal resources, including human resource and information technology, as well as distribution channels at its disposal.
Key point
The shared services model can be used for Islamic windows or Islamic subsidiaries as these services are permissible in Islam to support the core banking operations.
Exercise 4.2
Outline the guidelines to which an Islamic bank can subscribe in order to achieve both operational efficiency and Shariah compliance.
4.5.2 Regulatory costs

Financial institutions are key players in ensuring the viability and stability of an economys financial system. Deposit-taking financial institutions are closely regulated by the monetary authorities as their business activities revolve around guaranteed deposits.
4.5.2.1 Capital adequacy ratio

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

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

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

Islamic current accounts provide the account holder with a guarantee on the principal amount deposited while entitling the account holder to receive funds on demand. The account holder can also issue cheques on the account to transfer legal ownership of funds to others. Also known as demand deposit accounts, they fulfil the precautionary and transactionary motives of depositors in holding money. There are two popular forms of current accounts in Islamic banking as shown in Figure 4.1 below:
Figure 4.1 Contract forms of current Account
Islamic current account
Wadiah/Qard current account
Mudarabah current account
Principle of safe custody/liability
Principle of profit sharing
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Table 4.2 Shariah structuring issues for Islamic current accounts

Account Wadiah current account Qard current account Mudarabah current account No explicit or implicit guarantee for depositors; bank may need to establish a reserve to guard against fiduciary risk
Depositors precautionary requirements
Trustee safe custody under Wadiah yad amanah or guaranteed safe custody under Wadiah yad dhamanah CDIF/2/4/74-75
Guarantee is implicit as it is a liability of the bank
Depositors transactionary requirements Charging of service fees for transactionary services provided
Non-issue under Shariah purview
Non-issue under Shariah purview; the fees are usually based on the type of services rendered, for example cheques and ATMs for withdrawals Funds deposited under Wadiah yad amanah must be kept in custody and not reinvested; non-issue for Wadiah yad dhamanah
Non-issue under Shariah purview; the fees are usually based on the type of services rendered
Non-issue under Shariah purview; the fees are usually based on the type of services rendered
Utilisation of deposited funds by the bank
Commingling of deposited funds
Non-issue under Wadiah contract
Non-issue under Qard
Non-issue under Mudarabah mutlaqah; if the underlying contract is Mudarabah muqayyadah, pooling of funds from other sources is not allowed; note that pooling can only occur with Islamic accounts, such as savings and current accounts; no pooling is allowed with conventional deposit accounts Pre-agreed profit sharing returns; if unrestricted investments are used then returns will be based on the banks overall returns
Returns for depositors
No ex-ante returns to be promised to depositors; the bank may award Hibah on its sole discretion; gifts upon account opening are construed as a promised return and are therefore prohibited Non-issue under Shariah purview as it is a guarantee on a liability contract
No ex-ante returns to be promised to depositors; the bank may award Hibah on its sole discretion; gifts upon account opening are construed as a promised return and are therefore prohibited
Application of Islamic deposit insurance
Non-issue under Shariah purview as it is a guarantee on a liability contract
May trigger a Shariah compliance issue as Mudarabah is a profit and loss sharing PLS contract and a guarantee by the IFI through this scheme may be objectionable Sophisticated households and corporates
Target depositors
General households and corporates
General households and corporates
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The primary aim of Islamic current accounts is to provide depositors with instruments to cover their transactionary and precautionary needs. As with table 4.2 above, the former is fully addressed in all three accounts while the latter appears to be lacking for the Mudarabah current account. It is true that the Mudarabah contract does not provide an implicit guarantee facility, but it can be utilised in well-regulated countries where the depositors are sophisticated and are confident in the established banks and the banking systems that operate there. The pull of a Mudarabah current account lies in the profit sharing feature whereby the depositors have a stake in the profits of a bank that they are already confident in. On top of that, the institution of Islamic deposit insurance will provide such depositors with an added safety net. For Islamic banks, issuing Mudarabah current accounts gives them an advantage in providing depositors with a profit sharing account, something they would not be able to do under a Wadiah or Qard arrangement. An important operational question that crops up in structuring Islamic current accounts is the level of service fees that an Islamic bank can charge. Banks are often in favour of charging fees in relation to the amount of funds deposited. This is acceptable under Shariah principles as the fees are imposed by the borrower or the custodian in the context of Qard and Wadiah current accounts, thus there is no possibility of any interest payment. However, an Islamic bank can rank the services it provides to different segments of clientele. For instance, premier depositors who maintain large deposits would be entitled to premium services such as dedicated banking branches or queues, or access to customer relationship managers, services that would not be rendered to depositors with lower account balances. The bank can in turn charge a higher service fee on these premier banking clients, rather than charging fees based on a fixed formula based on the amount deposited.
Exercise 4.3
A customer opens an Islamic current account using a Wadiah/Qard contract with a deposit of 50,000. One week later, the depositor issues a cheque to a third party amounting to 55,000. The cheque issued needs bank clearance. What are the options that the bank has in this scenario?
4.7 Structuring Islamic deposits: Islamic savings accounts

The Islamic savings account is offered to depositors primarily to fulfil their precautionary motives of holding money, as well as to meet some of their transactionary and investment needs where relevant. Figure 4.2 below illustrates the popular contracts used for Islamic savings accounts.
Figure 4.2 Forms of Islamic contracts in savings accounts
Islamic savings account
Wadiah/Qard savings account
Mudarabah savings account
Principle of safe custody/ liability
Principle of profit sharing
It is the contract underlying Islamic deposits that distinguishes the nature of relationships between the bank and the depositor. Table 4.3 below reflects on the matrix of Shariah issues to be considered when structuring Islamic savings account. Note that the deposit features relating to the account, depositors precautionary requirements and depositors transactionary requirements are very similar to those seen for Islamic current accounts.
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Table 4.3 Shariah structuring issues for Islamic savings accounts

Account Wadiah savings account Trustee safe custody under Wadiah yad amanah or guaranteed safe custody under Wadiah yad dhamanah Non-issue under Shariah purview Qard savings account Guarantee is implicit as it is a liability to the bank Mudarabah savings account
No explicit or implicit guarantee for depositors; bank may need to establish a reserve to guard against fiduciary risk
Depositors transactionary requirements Charging of service fees for transactionary services provided
Non-issue under Shariah purview; the fees are usually based on the level of services rendered, for example ATMs and internetbased services for withdrawals Funds deposited under Wadiah yad amanah must be kept in custody and not reinvested; nonissue for Wadiah yad dhamanah Non-issue under Wadiah contract
Non-issue under Shariah purview; the fees are usually based on the level of services rendered, for example ATMs and the internet
Non-issue under Shariah purview; the fees are usually based on the level of services rendered, for example ATMs and the internet
Utilisation of deposited funds by the bank
Non-issue under Shariah purview; under the Mudarabah muqayyadah contract, the funds would have a specific use
Non-issue under Qard
Non-issue under Mudarabah mutlaqah; if the underlying contract is Mudarabah muqayyadah, pooling of funds from other sources is not allowed; note as mentioned above in relation to the Islamic current accounts, pooling can only occur with Islamic accounts, such as savings and current accounts; no pooling is allowed with conventional deposit accounts Pre-agreed profit sharing returns; if unrestricted investments are used then the returns will be based on the banks overall returns
Returns for depositors
No ex-ante returns to be promised to depositors; bank can issue Hibah at its discretion; gifts upon account opening are construed as a promised return and are therefore prohibited Non-issue under Shariah purview as it is a third-party guarantee General households
No ex-ante returns to be promised to depositors; bank can issue Hibah at its discretion; gifts upon account opening are construed as a promised return and are therefore prohibited Non-issue under Shariah purview as it is a third-party guarantee General households
Application of Islamic deposit insurance
May trigger Shariah-compliance issue as Mudarabah is a PLS contract and a guarantee by the IFI through this scheme may be objectionable Sophisticated households
Target depositors
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The aim of Islamic savings accounts is primarily to provide depositors with instruments to cover their precautionary needs. However, savings accounts can also provide depositors with some returns as well as being flexible enough to accommodate some payment facilities, further fulfilling some degree of investment and transactionary motives of holding the deposits. As with the Islamic current account, the Mudarabah contract does not provide an implicit guarantee facility. However, it can be utilised in well-regulated countries where the depositors are sophisticated and confident in the established banks and the banking systems that operate there. The issue of returns on Islamic savings accounts, while not explicitly guaranteed by Islamic banks, can be provided for as long as the banks are not contracted to giving it. Savings accounts, however, do not offer as good returns compared with longer-term deposits, even in conventional banking. Similar to the Islamic current accounts, the important operational question of the level of service fees an Islamic bank can charge applies here as well. As the level of transactionary services here would presumably be less compared with the Islamic current account (current accounts are still the only accounts that provide cheque facilities), it is likely that Islamic banks would charge lower service fees for their Islamic savings accounts.
Key point
Islamic depository accounts are structured to meet the different motives of holding money. Islamic current and savings accounts are designed to meet depositors transactionary and precautionary motives.
4.8 Structuring Islamic deposits: Islamic investment accounts

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

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

Based on the contract of Mudarabah muqayyadah (restricted investment principle) the funds generated in this partnership agreement are restricted with regard to the manner as to where, how and for what purpose the funds are to be invested. Commingling of these funds with shareholders and other deposit funds is usually restricted. Such a restriction will limit the risk exposure of financing and investments to unrestricted investment funds only. As a profit-sharing remuneration scheme, the returns to restricted IAHs are confined to returns on a designated specific investment portfolio agreed on by the restricted IAHs.
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Table 4.4 Shariah structuring issues for Islamic investment accounts

Account Unrestricted investment account (Mudarabah mutlaqah)
No explicit or implicit guarantee for depositors; the bank may need to establish a reserve to guard against fiduciary risk
Restricted investment account (Mudarabah muqayyadah)

No explicit or implicit guarantee for depositors; the bank may need to establish a reserve to guard against fiduciary risk
Depositors transactionary requirements Charging of service fees for transactionary services provided Utilisation of deposited funds by the bank
Nil
Nil
Non-issue under Shariah purview; the fees are usually based on the level of services rendered
Non-issue under Shariah purview; the fees are usually based on the level of services rendered
Non-issue under Shariah purview, but the funds would have a specific use
Non-issue under the Mudarabah mutlaqah contract
Pooling of funds from other sources is not allowed as the underlying contract is Mudarabah muqayyadah
Returns for depositors Application of Islamic deposit insurance
Pre-agreed profit sharing returns based on the banks overall returns May trigger Shariah-compliance issues as Mudarabah is a PLS contract and a guarantee by an IFI through this scheme may be objectionable General and sophisticated households, corporates
Pre-agreed profit sharing returns based on the returns of the specific portfolio May trigger Shariah-compliance issues as Mudarabah is a PLS contract and a guarantee by an IFI through this scheme may be objectionable General and sophisticated households, corporates
Target depositors
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4.8.3 AAOIFI definitions

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

Offering restricted investment accounts results in a series of unique attributes, which do not affect other accounts.
4.8.4.1 Separate disclosure of restricted investments accounts

AAOIFI (FAS No. 6) requires that an IFI maintains separate disclosure of restricted investment accounts in the form of a statement of restricted investments. This implies that such financing or investment is off-balance sheet (contrasted with all other deposits which are on-balance sheet items) as the control on such funds depends on the restricted IAHs preference for assets with a particular risk profile. Since the funds are restricted to certain financing or investments specified by the restricted IAH, the financial institution must manage these funds and assets separately from its own assets. Performance of the assets is then reflected in the net value of the fund only.
4.8.4.2 Neither equity nor liability

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

With the consent of Islamic account holders, Islamic banks in some jurisdictions are now able to mitigate the undesirable fluctuations of income and remain competitive, particularly in terms of the deposit rates by utilising two forms of reserves: the profit equalisation reserve (PER) and the investment risk reserve (IRR). PER is the amount appropriated by the Islamic bank out of the Mudarabah income, before allocating the Mudarib share, to maintain a certain level of return on investment for IAHs and increase owners equity. IRR, on the other hand, is the amount appropriated by the Islamic bank out of the IAHs share of profit, after allocating the Mudarib share, to compensate against future losses for IAHs. In Malaysia, Islamic banks are allowed to make a monthly provision (for PER) up to 15% of the gross income plus net trading income, other income and irregular income, such as recovery of nonperforming financing (NPF) and write-back of provisions. The banks may write back the amount of PER into the total gross income in the event that prevailing rates have become less competitive. However, Islamic banks must at all times exercise prudence in building up and writing back the PER. PER has been adopted in other jurisdictions apart from Malaysia, but elsewhere it is done on an individual institutional basis and not in accordance with regulator regulation. For instance, Bahrains Shamil Bank began allocating PER in 2004, but the Central Bank of Bahrain has not stated how much can be allocated.
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Exercise 4.4
Between either unrestricted or restricted IAHs, which should be treated like an Islamic banks shareholders, if at all?

Explain why a Murabahah fixed-income deposit account is offered by reference to the features of the various Islamic deposit accounts against those of conventional deposit accounts. What issues do these accounts generate for Islamic banking operations?
Solution
The first feature that Islamic accounts do not offer is pre-agreed or ex-ante returns. All conventional deposit accounts offer the depositor some form of return prior to opening the account, but Islamic deposits structured under the contracts of Qard, Wadiah or Mudarabah cannot accede to this. This is important as any pre-agreed or ex-ante return would be construed as interest or Riba. However, ex-ante or pre-agreed returns can be offered under a Murabahah contract as it is a sale contract with the buyer and seller pre-agreeing to the mark-up over the underlying Shariah-compliant goods that will be sold. This may make the account more appealing to Islamic depositors. The next feature that the Murabahah account intends to replicate is a guarantee over the capital deposited. As you should be aware, Islamic investment accounts based on Mudarabah cannot be guaranteed by the Mudarib. Utilising the Murabahah-tawarruq structure, the capital deposited in this account can be guaranteed as the bank must make good the purchased amount under the sale contract. Coupled with the ex-ante or pre-agreed returns feature, this may rival the features of the fixed-deposit account in conventional banks. However, the Murabahah-tawarruq deposit account does come with issues for the Islamic banks. Operationally, this structure involves the utilisation of underlying Shariah-compliant assets and perhaps two sets of prime brokers. This signals the fact that it may be costly for the Islamic bank (or the Islamic depositors) to use this structure because of the cost of preparing the legal documentations involved. This may result in cost-inefficient depository products, and the case against it is multiplied if we are talking about numerous small deposit accounts. As such, the minimum balance requirements for the account are often large, in excess of GBP50,000 for some Islamic banks. On top of that, the Islamic bank may also be exposed to the market risk of owning the commodity, something that they probably would not want to be involved in. As before, the risks here are also escalated with the number of such deposit accounts on offer. This Murabahah-tawarruq facility may be an operationally tedious account to manage, especially if it is offered to the retail banking sector.
Murabahah-tawarruq is a contract to realise cash.
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4.9 Structuring Islamic deposits: Islamic fixed-income deposits

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

Account Depositors precautionary requirements Depositors transactionary requirements Charging of service fees for services provided Murabahah-tawarruq fixed-income deposits Guarantee is implicit as it is a liability for bank Nil Non-issue under Shariah purview; the fees are usually based on the level of services rendered, for example ATMs and internet banking facilities Non-issue under Shariah purview Non-issue Pre-agreed ex-ante returns for depositors Non-issue under Shariah purview as it is not an equity-based contract Corporate
Utilisation of deposited funds by the bank Commingling of deposited funds Returns for depositors Application of Islamic deposit insurance
Target depositors
These fixed-income deposits can also be utilised as money market instruments when Islamic banks face a shortfall of liquidity in the short-term and require a liquidity injection from the monetary authority at the discount window or from other surplus banks. One of the drawbacks of utilising liability generating contracts is that the banks would have to enter a new agreement when the current one lapses. An extension is possible, but the financing/surplus bank may not be able to charge additional fees for the extension as the profit rate has been agreed and cannot be altered. However, entering a new agreement is costly because of the additional legal and stamp duty incurred.
4.10 Islamic money market instruments and liquidity management

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

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

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

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

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

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

A relatively new Islamic money market instrument in the industry, particularly in the Middle East, Wakalah replicates some features of the Mudarabah inter-bank investment. It is, however, not organised through a market, but rather offered over the counter. Either a surplus or a deficit bank may initiate this transaction. For example, a surplus bank that is seeking to have a return of investment of x % may approach a deficit bank for a short period of investment. Technically, the surplus bank (the principal) will appoint and authorise the deficit bank (the agent) to invest the monies of the surplus bank, provided the investment return shall not be less than x%.
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In practice, the deficit bank will not accept this offer if it thinks it cannot generate the rate of return the surplus bank/principal seeks. However, if the realised profit is more than the expected x%, the surplus bank/principal will normally waive this amount to the agent as an incentive fee. This over-the-counter money market instrument is made possible because the investment amount is invested in the balance sheet or asset portfolio of the deficit bank/agent. Therefore, the investment portfolio and its expected return can be estimated, if not secured. Following this structure, the deficit bank/agent in this case cannot be a conventional entity as the investment by Islamic banks in the asset portfolio of a conventional bank would not be compliant. The opposite structure is compliant, however, as the conventional bank, here the surplus bank/principal, may invest in the asset portfolio of an Islamic bank which is a deficit bank/agent in this structure.
4.10.3.5 Commodity Murabahah

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

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

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

Whether it is an Islamic or conventional bank, a credit-based system translates to one similar feature: a liability portfolio that has a shorter tenure than its asset portfolio. There is also a duration gap between the liability and asset portfolios, with duration defined as a measure of the portfolios sensitivity to interest-rate movements. Islamic banks liabilities, made up of depository accounts, have shorter maturity and are thus less sensitive to the movement of the rates. On the other hand, their asset portfolios, made up of long-term (sometimes 30 years) financing, are longer in tenure and hence are more susceptible to rate movements. With this duration gap and a mismatch between the tenures, Islamic banks must be sufficiently liquid so they can somehow meet unexpected withdrawals from their depositors. Bank runs are the single largest worry for all banks as they can cause profitable, albeit illiquid, banks to collapse.
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Theoretically, for an Islamic bank based on a trading model that relies more on restricted investment accounts, there is less need to have liquidity instruments. Islamic investment funds are nonguaranteed deposits and Islamic banks can design their liability portfolios to have a tenure and duration closer to their asset portfolios. Islamic banks are also not obliged to be responsible in meeting account holders withdrawals in full as account holders are aware that their deposited funds have been invested in specific portfolios. However, operating in the current financial framework, IFIs must be able to achieve liquidity in all circumstances because of either early withdrawal of Islamic deposits or mismatch of assets and liabilities.
4.11.2 Planning for the tradability of Islamic liquidity instruments

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

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

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

The development of Islamic money market instruments in the Middle East has not been as systematic and organised as in Malaysia. One possible reason for this could be that, with the excess liquidity from its oil-producing activities, Middle Eastern banks may be awash with liquidity and do not require liquidity instruments. However, the Central Bank of Bahrains issuance of the Sukuk Salam perhaps shows that there is a need to provide short-term papers such as Treasury Bills, although this Sukuk is not tradable. Sukuk Salam never addressed the issue of a liquidity requirement from the point of view of a deficit bank. Middle Eastern and British-based Islamic banks have subsequently developed Wakalah fi alistithmar to act as an Islamic money market instrument to facilitate both surplus and deficit banks to manage their liquidity positions. These inter-bank investment activities are offered over the counter and are not subject to any regulation. Recently, given the crisis of liquidity faced by some IFIs in the United Arab Emirates following the global financial crisis, the Central Bank of UAE provided funding to a few Islamic banks through a Wakalah fi al-istithmar instrument. Given the significance and importance of the Wakalah fi al-istithmar instrument (CDIF/2/6/125), there is a legitimate need for its usage to be regulated among IFIs on the one hand, and the financial institutions and the Central Bank, on the other.
Key point
The existence of a liquid Islamic money market is an important consideration to promote the efficiency and profitability of the Islamic banking system.
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Exercise 4.5
Outline the main considerations that a central bank needs to take into account if it decides to issue a Sukuk Salam as an Islamic treasury instrument. Explain the risks it would have to consider and outline the limitations of the Sukuk as an Islamic treasury instrument.
4.11.2.4 Money market instruments the way forward

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

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

This section explores a problem faced by IFIs around the globe. In situations where liquidity is tight, IFIs will either rely on the Islamic inter-bank money market or the respective central bank for liquidity injections. While the present Islamic inter-bank money market is not that organised and regulated (except in the case of Malaysia and Bahrain), the injection by respective central banks may or may not take place depending on the availability of the funds and market conditions. Given the market conditions of 2008/2009, it is critical that a new independent institution is created to perform the role of lender of last resort for IFIs. The lack of liquidity seen in 2008/2009 may have caused IFIs to collapse. This could have been avoided through a systematic institutional approach. The role that the International Monetary Fund plays for conventional financial institutions can be given as an example. This lender of last resort function for IFIs can be assigned to an existing international Islamic bank, such as the Islamic Development Bank. An alternative is to create a new institution. The shareholders of this new institution can comprise all IFIs operating in the world. Islamic finance has, for all intents and purposes, developed most of the institutional and prudential requirements, except the lender of last resort or at least a global liquidity management house for IFIs.
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4.13 Conclusion
Structuring Islamic depository instruments requires the same level of skill as the structuring of interest-based deposit instruments. In addition, these accounts would require specific Shariah expertise as Islamic depository products are based on commercial Islamic contracts. The depository clients motives for demanding different forms of Islamic deposits must be properly addressed, that is the precautionary, transactionary and investment motives. Islamic banks involved in the structuring process then need to match the clients expectations of the features available with each Islamic commercial contract. Only then can Islamic deposit products become desirable to the pool of depositors. Islamic banks will manage their liability portfolios profitably and efficiently only when there is a sufficient pool of Islamic treasury and money-market products that provide liquidity for the Islamic banking industry. The establishment of a lender of the last resort for IFIs is seen as critical to ensure that IFIs remain sustainable during difficult liquidity conditions.
4.14 Summary
Having read this chapter the main points that you should understand are as follows: deposits are very liquid assets, ranked second only after cash Islamic deposits need not necessarily be structured using loan/debt Islamic deposits can be invested together as a pool or be restricted for specific investments a shared services model can be operated in an Islamic window or subsidiary, but not in a fullyfledged Islamic bank an Islamic investment account transforms the lender-borrower relationship to a partnership venture liquidity is an important consideration for Islamic banks that are based on the credit model and which operate on a guaranteed-deposit structure, as their liabilities are always more liquid and are of shorter tenure than their assets the Islamic money market provides IFIs with the facility for funding and adjusting portfolios over the short-term tradability of Islamic treasury and Islamic money market products will depend on the contracts that underline the product and will affect the liquidity in the market the development of new tradable instruments under new or different globally-accepted structures can only take place if Islamic banking practices across jurisdictions are harmonised the development of a lender of the last resort for IFIs is critical to ensure the sustainability of IFIs.

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

1. AIIB intends to place its surplus fund with the GCB on a short-time basis. Which of the following is NOT a suitable product for AIIB? (A) (B) (C) (D) 2. Sukuk Salam Wakalah fi al-istithmar Sukuk Ijarah Murabahah commodity structure
What would be the best deposit account for AIIB to offer to replicate the behaviour of a conventional fixed deposit? (A) (B) (C) (D) Islamic saving account based on Qard Islamic deposit based on the Murabahah commodity structure Restricted Mudarabah investment account Unrestricted Mudarabah investment account
3.
What are the suitable Islamic money market and treasury products that an AIIB subsidiary in Malaysia can participate in, as compared with a subsidiary in Bahrain? (A) (B) (C) (D) Sukuk Salam and Wakalah fi al-istithmar Sukuk Salam and Mudarabah inter-bank money market Mudarabah inter-bank money market and central bank Sukuk Ijarah Central bank Sukuk Ijarah and Sukuk Salam
4.
What are the intended purposes of structuring an Islamic saving account based on a Mudarabah contract? (A) (B) (C) (D) Transactionary, precautionary and investment Investment and precautionary Leveraging, investment and precautionary PER and IRR
5.
How should AIIB address the issue of the smooth and stable payment of profits to its Islamic investment account holders? (A) (B) (C) (D) Apply for Islamic deposit insurance Allow shareholders to absorb DCR Utilise a PER and IRR Not offer Islamic investment accounts based on Wakalah fi al-Istithmar

1. 2. 3. 4. 5. Identify the segments of the market that AIIB should focus on. Explain the pertinent features of Islamic deposits that AIIB must address with regard to its market segment. Identify the required contracts with the respective accounts that AIIB should utilise to deliver the features it needs to address. Explain the liquidity implications that the Islamic deposits generate for AIIB and state whether their Islamic deposits qualify for the Islamic deposit insurance scheme. Explain how AIIB can synergise with GCBs resources.
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Chapter four answers

Exercise 4.1
The customer is the owner of the deposited funds, the Rabb al-mal, under the Mudarabah contract used in this Islamic investment account. As such he can normally withdraw his funds or liquidate his position any time he chooses. Under Islamic finance, where the IFI does not allow premature withdrawal, the depositor has to be mindful that the funds may have been invested in an identified venture or ventures, and that he may not be able to recoup the original capital invested in the account. He may have to wait until the maturity of the agreed period of investment. Where IFIs allow premature withdrawal, they need to have addressed the issue of early withdrawals or early liquidation in their terms and conditions. Some IFIs allow the depositor to withdraw part or all of the funds during the term of the deposit but restrict the prospective profit distributed to him. For this to happen, the depositor must sign a waiver clause when the account is opened. Other IFIs are prepared to return the capital plus all the profits that have been earned up to the date of the withdrawal. The profit figure paid is based on the rate of profit of the previous accounting period and calculated on a daily, weekly, monthly or yearly basis, provided the investment venture is profitable, which is supported by evidence of the current accounting record.
Exercise 4.2
There are generally two sets of guidelines or best practices that a bank can subscribe to, one with operational efficiencies in mind, and the other involving Shariah compliance. The former affects the bottom line and includes appropriate cost allocations that can be assigned to, say, the parent bank and the Islamic window. Shared services include marketing events whereby the parent bank is keen to market its full range of services, including that offered by its Islamic window, in one single campaign. How the bank allocates the proportionate marketing costs to its Islamic window affects the profitability of the window. Another example is the utilisation of its backroom staff. The parent bank must be able to allocate the appropriate costs to the Islamic window in order to paint an accurate picture of the windows performance. The guidelines affecting Shariah compliance usually involve money and its reporting. Using the same analogy of a parent bank and its Islamic window, the bank must be able to segregate the funds of its windows. This means that the window has a separate set of accounts from the bank. Islamic funds cannot be commingled with funds generated from the conventional parent bank. For the Islamic subsidiary, the capital utilised to set it up must be distinguished from the banking conglomerate or parent banks capital. Usually, the IT system utilised in an Islamic subsidiary or Islamic window must be customised to better reflect the banking transactions that have taken place. For instance, the IT systems must be able to generate reports that do not contain entries such as interest-earned or interest expense, all of which are familiar entries from the reports of the parent conventional bank.
Exercise 4.3
The bank has the right not to honour this cheque as the amount exceeds the amount the customer deposited. If this was to occur the depositor would have to face the consequence of issuing a cheque without sufficient deposits in the account. Conversely, the bank may decide to grant an interest-free loan to the customer as a stop-gap measure, especially if the customer is of high net worth. This facility should have been set up in advance. Alternatively, the bank may provide a standby Islamic overdraft facility, based on Murabahah-tawarruq, to cover the higher amount of the cheque over the deposited amount. More likely, the bank would ask the customer to top up the account immediately so they can honour the cheque. The bank may facilitate this by granting an intra-day interest-free loan.
Exercise 4.4
The main difference between restricted and unrestricted IAHs lies in the investment scope of the funds mobilised. Funds mobilised from the former can only be invested in specific ventures or portfolios that have been pre-agreed. For the latter, its funds can be invested as and how the Islamic bank deems fit.
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From that analogy, the unrestricted IAHs should be treated more like shareholders, but in reality, they are not. One possible reason would be that funds mobilised are still depository funds and, as such, Islamic banks must follow regulatory guidelines on how such funds can be invested. International Islamic agencies have also developed means by which to manage the volatility of the returns of the invested funds, such as the PER. Shareholders in the IFIs, on the other hand, are not afforded such measures and may be exposed to displaced commercial risk as Islamic banks try their best to mitigate risks assumed by the IAHs. Islamic banks shareholders have the opportunity to realise capital gains if they liquidate their shareholdings. Investment account depositors are not afforded this opportunity and can only realise returns via a share in profits. Mudarabah investment account depositors also do not have voting rights in the Islamic bank.
Exercise 4.5
Salam refers to the contract for the purchase of a commodity on a deferred delivery in exchange for immediate payment. This means that the commodity buyer pays in full for the commodity at the execution of the Salam contract and the delivery of the commodity takes place at a pre-agreed future date. Applying this to an Islamic money market instrument, the central bank, through the use of its Special Purpose Vehicle (SPV), becomes the agent or Wakil that manages the operation of the Sukuk Salam. For more details of the structure of the Sukuk Salam refer to CDIF/2/6/124. Assuming that the tenure of the Sukuk is three months, the IFI would immediately receive upon its investment an undertaking by a third-party ultimate-commodity purchaser that he would execute this purchase at a pre-agreed purchase price, at a pre-agreed premium over the original amount that the IFI invested. Naturally, the central bank would have to consider the price volatility of the commodity in question. The bank wouldnt want to utilise a commodity that could present substantial market risk when the IFI funds are invested in the Salam commodity. The central bank must also consider the financial strength and legitimacy of the third-party ultimate commodity purchaser. The bank would want to limit the counterparty risk of the commodity purchaser. To militate against this, the central bank may request a performance guarantee from the purchaser to protect the interest of the investee IFI. The application of Sukuk Salam as an Islamic treasury instrument is limited because of the inability to effectively trade it in the market. Essentially, this structure creates a trade debt and is represented by the Sukuk Salam certificates held by the investee bank. According to AAOIFIs Shariah Standard 7, debt can only be traded or transferred at par and not at a premium or a discount. This will effectively limit the tradability option of the Sukuk and means it will usually be held by the investee IFI to maturity. Nevertheless, as an Islamic money market instrument, it is still viable in jurisdictions that are awash with liquidity.

1 (B) A newly established over-the-counter product, it looks ideal for short-term placements. However, GCB is a non-IFI and the funds placed on Wakalah cannot be invested in GCB, even in the short term. The other options are all suitable with compliant assets. (B) Murabahah deposits can actually generate a pre-agreed return and can guarantee the capital deposited. AIIB must, however, consider the operational costs of offering such accounts. (C) The Malaysian Central Bank has on offer both products, which no other central bank does. Sukuk Salam are only available in Bahrain. (A) It fulfils all the stated motives of holding money. (C) PER and the IRR are recommended by the Islamic Financial Services Board to manage the returns and the capital of the investment accounts.
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1. With the current three branches in Frankfurt, AIIB should focus on high-net-worth individual depositors as well as corporate depositors. It would have to forgo pursuing the general retail or household segments because small depositors would prefer to visit branches that are conveniently located in their respective area. With only three branches, AIIB would not appeal to most retail depositors. AIIB would have to leverage technology and its human resource pool to reach out to the high-net-worth and corporate depository clients. Considering that AIIB would be targeting sophisticated depositors from high-net-worth individuals and corporate customers, AIIB must bank on meeting the target depositors transaction requirements. This can be achieved through investments in information technology. AIIB must have an extensive network of ATMs as well as an established internet banking system, or at least the facility for its clients to use the ATMs of other banks. Customers must be able to transfer funds or make payments at any location through the ATMs or internet-based systems. AIIBs depository accounts must also be innovative and provide competitive returns. Riding on the brand name of its established parent company GCB, AIIB should focus upon the innovative Mudarabah contract for its current and savings accounts, rather than the run-ofthe-mill Qard or Wadiah contracts that are more suited to retail customers. The Mudarabah contract will allow for features such as account sweeping, that is automatically transferring amounts that exceed a certain level into a higher profit-earning account that will allow its sophisticated depositors the opportunity to generate more returns. For instance, AIIB can sweep amounts that exceed a pre-set US$10,000 limit from a customers Mudarabah current account into a higher return generating Mudarabah savings account. The focus on a Mudarabah contract would not impair AIIBs liquidity position. In fact, under the pure Mudarabah contract, AIIB cannot explicitly offer a guarantee on its deposit portfolio as Mudarabah is a profit-sharing arrangement. This would also mean that AIIBs deposits technically do not qualify for the Islamic deposit insurance scheme. Nevertheless, the brand name and the established value of its parent company GCB would militate against this lack of an explicit guarantee. AIIB can tap into the resources of GCB through being associated into GCBs marketing campaigns. This would not only be a very cost-effective exercise, but the association with GCB would also grant AIIB the credibility it would require to penetrate into the Islamic banking market. AIIB personnel can also utilise GCB extensive branch network to latch on to their prospective clients. AIIB brochures, for instance, can be placed within the GCB branch network to create brand awareness. GCB personnel will also be able to cross-sell AIIB products to its established clientele pool.
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Chapter five
Structuring financing facilities for working capital and consumer financing
Learning outcomes
By the end of this chapter you should be able to: analyse and evaluate the validity and suitability of various underlying contracts in providing financing for different purposes discuss the risk features inherent in structuring financing products for both corporate and retail customers appraise the importance of proper credit policy for Islamic consumer financing.

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

In conventional banking, loans and advances are provided to corporate and retail customers to help them meet their respective financing requirements. For corporate clients these products range from short-term working capital loans, mezzanine (bridging) loans, equipment loans and special purpose loans to long-term property loans. In retail banking, types of financial products range from overdrafts, debit, charge and credit cards, vehicle loans and long-term residential mortgages. Essentially, each loan arrangement, whether in corporate or retail banking products, involves the determination of an interest rate payable on the amount of the loan provided for a specified period.
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While repayment capacity is important in both corporate and retail financing, the ability of the corporation as well as the retail customers to service the loan depends on the business cash flow and ability to make monthly payments. The cash flow pattern or cycle of the business activity, as presented by the applicant to the bank in the form of a cash flow statement, provides a basis upon which to recommend an appropriate type of loan for a corporate customer. In the case of retail loans, the income capacity of the borrower provides the basis for determining the amount and period of any loan to be granted to the applicant. In either case a primary concern of the banks as lenders is the recovery of the loan and interest and the establishment of relevant security arrangements to achieve this objective in the case of default by the customer. The need for security specifically relates to the creditworthiness of the borrower. In particular, various forms of security, such as pledge, guarantee and assignment, are structured into the product to secure the payment of the loan with interest.
Key point
Cash flow analysis, financial ability for repayment and creditworthiness of the borrower are important in conventional corporate and retail financing.
5.1.2 Conventional corporate and retail finance: interest spread

From a conventional banks perspective the interest income earned should be sufficient to achieve a required level of interest spread, that is the difference between interest income and interest expense which is the cost of funds. The determination of the interest rate charged to the customer also takes into account various components of credit risk exposures. These include default risk, liquidity risk and marketability risk, all of which help determine the term structure of the interest rate. In addition, other factors, such as exchange rate volatility and inflation are imputed where relevant when providing such loans. The bank also needs to be cognisant of the regulatory requirements relating to loan concentration in certain customer and asset categories, as well as the impact of credit risk exposures on the computation of capital adequacy requirements. For example, a secured loan will attract a lower risk weight compared with an unsecured loan in determining the total risk weighted assets for the computation of capital adequacy ratio. The amount of loan disbursed to the customer also takes into consideration the mortgaged asset value referred to as the loan to asset value (LTA).
Exercise 5.1
A conventional commercial bank launches a special product aimed at its privileged customers. The bank intends to offer a special house loan facility at a competitive rate of interest, as well as a special discount interest rate for credit card customers. In order to qualify for this offer, the customer must agree to mortgage their house with the bank as security to repay the house loan facility and credit card facility. Explain the basis and justification for this conventional product structuring from a credit and risk perspective.
5.2 Islamic banking products for corporate and retail finance

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

Islamic banking offers both business and retail banking products that adopt appropriate contracts suitable for the different types of products. Islamic banks address the needs of the customer by reference to similar terms of finance with respect to the amount, period and income generated from the financing activity, as well as the importance of appropriate security arrangements. However, the terms of financing are related to the product structure, which is based on a selected contract suitable for the product. The selection of the relevant contract, as will be illustrated later, must meet both the commercial requirements of financing including security requirements, as well as Shariah compliance requirements. Based on the cash flow pattern arising from the business needs and qualitative creditworthiness for retail needs, Islamic financial products are designed to match the cash flow expectations, as
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well as the risk preference and risk exposures of the counterparty. In this respect the choice of contract adopted for the Islamic financial product, which represents the rights and obligations of the counterparties, must also include the financiers right to benefit from the form of return or yield, as well as the related obligation or liability to risk. Contracts in the form of equity transactions implemented in Islamic financial products will have different risk-return implications for the bank, as well as economic benefits to the customer, compared with debt-based financing.
An example is a customer who requests 90-day financing for the import of goods with a letter of credit application to an Islamic bank. The bank can provide both Murabahah and Musharakah letters of credit. Since this request is to finance the purchase of imported goods, the customer requests Murabahah financing at a mark-up rate specified by the bank. The bank is exposed to credit risk that may be secured by a guarantee or collateral upon disbursement of the financing amount and subsequent delivery of the goods to the customer. Alternatively, the bank can issue a letter of credit based on the Musharakah contract to enable it to share in the profit earned on the sale of the imported goods. Under this contract the bank would expect a higher yield than the Murabahah rate to account for the business risk imputed in the market price risk of the goods, as well as the credit risk for possible non-payment by the customer.
5.2.2 Ancillary contracts to secure the interest of the creditor

The contracting parties may consider adding ancillary contracts to secure the interest of the creditor such as guarantee (Kafalah), promise (Wad) or pledge (Rahn) to provide assurance to the bank on performance or recoverability of the financing amount. These ancillary contracts would be executed as part of the Islamic financial product to ensure that relevant risks such as market and credit risks are mitigated.
Key point
Aspects of security and risk management also apply to Islamic banking financial products in addition to cash flow and creditworthiness analysis of the customer seeking Islamic finance.
5.2.3 Agreed return

Unlike the interest rate determination of conventional financing, the rate of return determined for Islamic financing is based on a mutually agreed selling price or rental amount in the case of sale or lease-based transactions respectively. Alternatively, an estimated profit rate based on a mutually agreed profit-sharing ratio is determined when the parties engage in an equity-based transaction. The ex-post profit is realised subject to the performance of the activity. In this manner, the financing rate is directly related to real economic business activities from which the profit element of the financing activity is derived. The traceability of the profit to lawful business activities is an important consideration in Islamic financing.
Key point
Profit rate determination is based on a mutually agreed selling price or lease payment in sale or lease financing contracts. Traceability of legitimacy of profit is based on the validity of the contract, as well as the sale or lease of lawful object, or lease for a legitimate purpose.
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Critics argue that Islamic finance is just another form of conventional finance that does not fundamentally differ in its financial intermediary functions of money-for-money transactions. Although it is claimed to be based on sale or lease, or partnership contracts, Islamic finance is no different from conventional finance that simply advances loans in return for interest. Instead of calling the premium interest, Islamic banks consider this as profit. Therefore, according to some critics and analysts, Islamic house financing, Islamic letters of credit and Islamic working capital financing, among others, are essentially loan contracts with disguised interest. How would you respond to such an opinion and contention?
Solution
Although Islamic finance shares many common financial and regulatory features with conventional finance, such as the credit analysis of customers, the requirement of security (where relevant) and capital adequacy requirements, it fundamentally differs from the conventional finance structure. Generally the rights and obligations of the Islamic financier and customer relate to real economic benefits and loss exposures identified in trading and investment transactions. In the case of Murabahah house finance, for example, it is incumbent on the Islamic bank to purchase the house from the vendor before selling it to the customer at the mark-up price. This structure of finance involves two sets of transactions that invoke stamp duty in some jurisdictions such as Malaysia, Singapore, and the UK. Amendments to the regulations in those jurisdictions had to be made to avoid double stamp duty. Obviously, this would not be necessary if Murabahah financing was simply a loan contract. In the case of lease-based financing, the cost of Takaful is borne by the lessor. If the lessor is just a lender, such a requirement from the Shariah perspective is not relevant. In the case of profit sharing-based financing, the difference is more obvious. In a venture being financed using an equity contract, the capital provider cannot impose on the manager the requirement to repay the capital and any agreed profit where the venture suffers a loss. In a conventional loan contract, the borrower must repay the principal and interest irrespective of the profitability of the venture. In Sukuk-based transactions such as Sukuk ijarah, the investors may have recourse to the leased asset in the case of default as Sukuk is an assetbased securitisation, not simply an IOU instrument as is the case with conventional bonds.
5.2.4 Regulatory requirements and risk exposure

Regulatory requirements placed on banks within each jurisdiction apply equally to Islamic financing. These include customer limits and credit risk exposures computed in to satisfying capital adequacy requirements, which safeguard the interest of depositors and investment account holders. However, specific contract variations and resulting risk exposures may result in different risk weights as identified by standards imposed by the Islamic Financial Services Board (IFSB).
For example, unrestricted investment account funds mobilised by an Islamic bank in the form of financing are identified to segregate the risk exposures of the financing assets. In the computation of the capital adequacy ratio, risk-weighted assets will exclude assets funded by investment account funds.
In this chapter, while Islamic financial products for business customers are discussed with specific reference to working capital, Islamic financial products for retail customers are discussed with reference to asset and cash financing, as well as various cards facilities such as debit, charge and credit cards respectively.
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5.3 Working capital financing

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

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

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

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

The revolving credit facility allows the customer to effectively draw down specified amounts of funds for a defined period. For example, a 50,000 facility could be approved for a customer to purchase goods or equipment within a year from the date of approval. The Murabahah contract can be adopted for such a facility to provide short-term finance for the purchase of operating assets. The assets in question must be identifiable and can be sold at cost plus mark-up. Essentially, Islamic banks will agree to provide this facility as a line of credit up to a fixed financing amount within an agreed period of time. During this period, the customer may request the bank to purchase assets that the bank will subsequently sell to them at cost, plus an agreed mark-up profit. Such assets are typically tangible assets for the immediate use of the customer in their business activities either as a producer, exporter or developer. In developing a revolving Murabahah working capital agreement, the profit rate will either be fixed or based on the prevailing cost of funds according to an agreed benchmark such as LIBOR. During this period, the customer may utilise this facility up to the limit at any time. If the customer has made some payment to earlier transactions under the Murabahah agreement, the existing limit will revert back to the maximum originally agreed. For example, where a financier agreed to make available US$1 million and the business has asked the bank to buy assets to the value of US$200,000, which it subsequently paid, the facility would revert to US$1 million. At the end of the tenor, both parties may agree to renew the facility agreement or the facility will lapse.
5.4.1.1 Safeguarding the interests of the bank in Murabahah working capital financing
To safeguard the interest of the bank, some conditions may be imposed on the customer. For example, the customer must maintain a certain level of debt to equity ratio or be restricted from entering into other borrowings/financings. Islamic finance does not allow banks to impose commitment fees for the lost opportunity cost where a customer does not fully utilise the facility, as there is no basis to justify the loss under Islamic commercial law. An illustration of the terms of revolving working capital financing based on a Murabahah contract is presented in table 5.1.
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Table 5.1 Basis for terms of revolving Murabahah working capital financing
Terms of financing Approved financing amount Financing amount Financing period Financing rate Mark-up profit Disbursement Payment Security Basis Total amount of inventory purchase required per annum Amount of inventory per order quantity Inventory turnover Mark-up rate derived from selling price for each order quantity Selling price, less cost of financing for each order quantity Upon purchase for each order quantity During the financing period based on sales receipts Floating charge on inventory purchased Third-party guarantee on timely payment
5.4.1.2 Prescribed flow of Murabahah working capital financing

When structuring revolving Murabahah working capital financing, it is necessary to determine its purpose, its anticipated operating cash flows, as well as any security arrangement (where relevant). The creditworthiness of the customer is then assessed and evaluated to decide on the credit financing amount, the profit rate, the limit of credit exposure and the payment schedule or period. An agreement is then made to specify the financing terms of the revolving credit facility using the Murabahah contract. Figure 5.1 outlines the contract process that is executed for Murabahah financing to take effect.
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Figure 5.1 Revolving working capital financing - Murabahah contract
(5) Sale of goods (6) Deferred payment for goods
(1) Purchase order to purchase the goods on behalf of the bank
Customer
(3) Notification to the bank of goods delivery
Islamic financial institution
(2) Purchase goods on behalf of bank
Supplier
(4) Cash payment to the supplier
Step 1
Description Based on the facility being approved, the customer initiates a purchase order with the Islamic bank to purchase specified goods from the supplier as agent of the bank. Upon obtaining approval, the customer purchases the asset from the supplier on behalf of the bank. Goods purchased are delivered to the supplier as the purchasing agent who then notifies the bank. Cash payment by the bank is made to the supplier, as per the purchase price. The bank subsequently sells the goods on credit at cost plus mark-up for the credit period specified, as per the terms of the revolving credit. The customer makes payment including the mark-up to the bank, either in instalments or by full payment at the end of the credit period.
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The above steps constitute a single purchase request transaction by the customer that is concluded with the sale by the bank and payment from the customer. Several similar transactions could be executed according to the needs of the customer, provided the total purchase price at any point in time does not exceed the approved credit limit specified for the facility.
Key point
An important criterion when adopting the Murabahah contract for revolving working capital financing is that the current asset is identifiable and the mark-up on pre-determined costs can be specified. The total purchase price at any point in time shall not exceed the approved credit limit.
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Exercise 5.2
A bank approved a 500,000 revolving Murabahah facility for a customer at a mark-up rate of 12% per annum on 1 January for a period of two years. The following transactions are identified: The customer submitted purchase request for goods valued at 200,000 and obtained financing in January. In February the customer made another request for goods valued at 250,000 for which the bank has agreed to enter into the second Murabahah transaction. No payment had been received as yet by the bank as far as the first Murabahah sale is concerned. In March, the customer paid half of the total Murabahah selling price for the January transaction and made a request for the purchase of additional goods valued at 200,000.
1. Based on the information above, what is the Murabahah selling price charged to the customer for purchases made in January and February respectively? 2. Should the bank accept part payment for the January purchase? 3. What would be the status of the outstanding debt? 4. Should the bank approve the purchase request in March? Explain the basis for your answer. 5. Based on this product structure, what are the possible limitations? In implementing Murabahah working capital financing, several product features warrant special attention. Non-observance of these features would render the contract either void or voidable, as well as expose the bank to credit and operational risk.
5.4.1.3 Effective delivery, security and timely payment

Upon determining the products concept and purpose, as well as identifying the Murabahah contract for its financing, it is important to examine the certainty of delivery of goods and assurance of payment by the debtor. In legal documentation, ancillary contracts are considered to ensure effective delivery and timely payment of the outstanding debt. Based on Figure 5.1, the requisition made by the customer may be accompanied by a deposit or advance in the form of Hamish Jiddiyah (security deposit) or Urbun payment (earnest money). This represents the commitment of the customer to purchase the goods ordered that have met goods specifications and conditions. Failure to take delivery of the goods will result in the deposit or advance being forfeited, or compensation being charged by the bank for any loss on disposal of the goods. In order to ensure the purchase, the customer may be required to promise to undertake the purchase of the goods upon acquisition of the requested goods by the bank. From the risk management perspective, without this purchase undertaking the bank is exposed to possible adverse changes in the value of the goods represented by market risk. Alternatively, a purchase undertaking based on Wad (unilateral promise) by the customer can be documented to mitigate the market risk exposure of the bank if the customer did not proceed with the purchase of the asset as promised. Upon disbursement made to the supplier of the goods at cash price, the Islamic financial institution (IFI) will then execute the Murabahah sale to the customer. Security for the financing amount may be in the form of a pledge (Rahn) or guarantee (Kafalah) to ensure the financier will get payment either from the sale proceeds of the pledged asset or from a third party.
Key point
Effective and timely delivery and payment of goods in a Murabahah contract requires proper documentation and recording of the purchase and sale of goods by the bank to the customer.
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During the period of financing, the customer may be faced with seasonal or, sometimes, cyclical demands for their goods and hence the approval limit of the facility may need to be increased or the period extended. Based on the facility agreement concluded between the customer and the bank, the total amount of the facility and the financing rate can be reviewed on a periodic basis. This ensures flexibility in facilitating the customers response to their business cycle. The Murabahah contracts that are executed within the facility agreement for each purchase transaction will then make specific reference to this agreement and hence observe the approval limit, as well as the agreed financing rate and financing period.
5.4.1.4 Delinquent customers

In cases where the customer is not able to meet scheduled payments for the financing facility, the account may be classified as delinquent or even non-performing if the delay extends beyond a certain period from the payment due date. Based on the Murabahah contract, both the principal and the profit accrued during the period is recognised as the debt due by the customer. A penalty may be imposed for the delay. As such charges are meant to deter delinquent customers, proceeds must be distributed as charity after allocating the actual expenses to the bank as a result of the default. Similar to loans, Murabahah financing with instalment payments adopts an amortisation table to recognise profits from the outstanding principal balance. The effective rate applied on a periodic basis is computed from the quoted financing rate to the customer. For example, 12% per annum is recognised as 1% effective yield on the outstanding balance of Murabahah receivable on a monthly basis. Hence the mark-up price is computed based on the monthly effective yield and not the annual rate.
For example, a customer obtains 100,000 financing for two years to purchase equipment. At 12% per annum and an effective yield of 1% on a monthly basis the monthly instalment is 4,707 for 24 months. The Murabahah selling price is 112,976. The mark-up is 12,976 as deferred profit. The first instalment paid or due will recognise a profit of 1,000, and subsequent profit will proportionately reduce with the outstanding balance. With no payment made in the case of delinquency, the effective yield for the month will accrue and thus the total mark-up will exceed the selling price. Since the mark-up does not change with a similar selling price any delay will reduce the effective yield to the bank.
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A two-year master agreement for a revolving Murabahah facility is concluded between an IFI and one of its customers for an approved limit of 500,000 at a mark-up rate of 6% per annum. During the period the customer purchases equipment for 300,000 payable in one year. At the end of the year, the customer has difficulty in settling the amount and requests an extension of one year at the same rate. Identify the consequences of non-payment as well as the application for extension of the period.
Solution
Although the facility approval is 500,000, the purchase value is only 300,000, therefore not all of the financing amount is utilised. The total period of financing is two years but the payment is scheduled for one year. The issue arising from the primary feature of Murabahah contract is the disclosure of cost plus mark-up. Based on the facility agreement, the maximum mark-up that can be earned from Murabahah sales is (0.06 X 500,000 X 2) 60,000 for the two years. If the Murabahah financing for the 300,000 purchase is structured for the two-year period the total mark-up would be 36,000. Hence if the Murabahah contract is concluded for a two-year credit period, any accelerated payment in one year can benefit from a potential rebate, therefore an extension period is not required because outstanding payments can be re-scheduled for the whole two-year period. In this case the customer may continue to make payment for the financing amount, as well as the profit agreed for the two-year period. However, if Murabahah financing for the 300,000 purchase is structured for one year, with a mark-up of 18,000, the payment will then be in arrears and the payment cannot be re-scheduled with an additional mark-up beyond the contracted period. Alternatively, the financing of 318,000 which is due in one year, must be restructured according to compliant restructuring processes. An increase in the profit rate due to the extension of the period is not compliant as the mark-up has already been pre-agreed. Any extension can only take place at no additional cost to the customer.
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5.4.2 Murabahah-tawarruq term working capital financing

Unlike Murabahah working capital financing, the Murabahah-tawarruq contract is adopted to enable working capital financing to be made available to the customer in the form of cash. Information relating to Murabahah-tawarruq is available in CDIF/2/5/108-109. By executing a series of sale-andpurchase contracts between several parties, the customer can obtain cash financing in the form of working capital. The same structure can be used to provide an Islamic overdraft that provides a credit facility for the customer to utilise as and when cash is needed. The basic structure is presented in the following diagram.
Figure 5.2 Murabahah-tawarruq working capital financing
Commodity exchange
Broker A
(2) Payment of commodity (4) Deferred payment (6) Payment of commodity
Broker B
(1) Delivery of commodity
Islamic financial institution
Customer
The customer applies for working capital financing in the form of cash financing and provides information about the purpose of the financing and his anticipated operating cash flow. The bank assesses and evaluates the creditworthiness of the customer and decides on the credit financing amount, its credit limit, as well as the tenor of financing or line of credit.
Step 1
Description Upon granting the facility, the bank purchases the commodity based on the full amount of the facility from Broker A. Cash payment (disbursement) is made to Broker A. The bank sells the commodity to the customer at cost plus mark-up on credit sale. The customer pays deferred instalments on the financing amount. The customer sells the commodity to Broker B for cash to effectively obtain the financing amount. The customer sells the commodity to Broker B for an amount that equals his working capital requirements.
2 3 4 5
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Given that a conventional overdraft is an open line of credit to enable a customer to draw down from the current account on a needs basis, subject to an approved limit and interest charged on the outstanding balance, as well as a fee imposed for early settlement, is an Islamic overdraft concept or term acceptable to Shariah principles?
Solution
Looking at the meaning and application of a conventional overdraft, this cannot be replicated in Islamic finance as a customer cannot use the facility beyond that which was already allocated. For example, if a customer is provided with Murabahah working capital financing to purchase assets up to US$500,000, more money cannot be obtained when the limit is utilised. However, in business practice, there could be circumstances where the customer may need extra money to support urgent or unexpected expenses or opportunities. Here Islamic finance ought to provide this cash line facility in addition to Murabahah working capital financing for asset financing. In this case, the bank may enter into a Murabahah-tawarruq transaction to create a credit line facility for the customer. The agreed amount, which is due to the customer, will be deemed as a credit line facility that may be used as and when the need arises. Unlike a conventional overdraft, the fee for early settlement is not compliant to Shariah principles as the money created in the account is actually the customers and there should not be any penalty for not using it. The bank may, however, decline to award the rebate for any early settlement unless the financial situation warrants such a rebate. All in all, this product should not be called an Islamic overdraft as there is no overdraft action in a Murabahah-tawarruq transaction.
5.4.2.1 Additional flexibility of Murabahah-tawarruq

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

Based on the Murabahah contract, the cost plus mark-up pricing principle is adopted and the selling price is agreed at the point of disbursement. Effectively, the profit from Murabahah-tawarruq financing is earned for the financing period and imputed in the payment due from the customer. Thus the customer is expected to fully utilise the financing amount during the financing period. Hence the customer may not be able to reduce the overall cost of financing if the utilisation amount is below the approved financing amount.
Key point
A distinction between Murabahah working capital and Murabahah-tawarruq cash financing is the effective transfer of goods to the customer. An ultimate transfer of ownership of asset occurs in the former but not in the latter, where cash is the sole purpose of financing.
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Exercise 5.3
A customer obtains Murabahah-tawarruq financing for an amount of 500,000 at a markup profit rate of 6% per annum (0.5% per month) for a period of two years (24 months). The customer is expected to pay a monthly instalment of 22,160. During the first year, the customer withdraws 100,000 each quarter and makes regular instalment payments. In the second year, no drawdown is made and the customer requests that the payments be rescheduled for an additional six months. Any request for the deferment of the payment period will lower the effective yield on the financing amount as income to the bank. Hence the bank will be reluctant to accede to such request unless it is compensated for by additional returns over the extension period. However, the customer argues that since the remaining 100,000 has not been withdrawn, the bank should consider adjusting the effective yield to provide flexibility to the customer. Based on the above arguments, discuss the Shariah implications of extending the payment period and the resulting status of the financing contract.
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A conventional bank launches a new financing product for small and medium enterprises (SMEs) in the form of a combination of a term loan and an overdraft facility against residential or commercial property. This product is useful for professional service firms, sole proprietors, proprietorship firms, partnership firms or private limited companies with a steady annual turnover exceeding an agreed benchmark. The benefits of this new product include, inter alia: 1. loan up to 80% of the market value of the property 2. flexibility to opt for a pure term loan or a combination of a term loan and overdraft 3. loan up to a maximum of US$500,000 4. tenure up to 12 years 5. overdraft facility up to a maximum of 50% of the total sanctioned limit 6. attractive interest rate. This product has been marketed as a flexible product to fulfil short-term and long-term business requirements, be it working capital requirements or for business expansion by unlocking the potential value of the customers property. Based on the above features of the financial product, convert this product to a Shariahcompliant product while maintaining the main terms and features of the above conventional product.
Solution
The example above is a form of secured financing as the liability of the customer is secured against the property of the customer, be it residential or commercial property. However, the total combined loan to value (LTA) for both term loan and overdraft (80% plus 50% of the value of property) is 130%. Therefore, the excess of 30% of the value of the property remains unsecured. This is a commercial risk that is applicable to both conventional and Islamic finance. As for the term loan, Islamic finance may offer Murabahah term financing for 12 years or revolving Murabahah working capital financing with a periodic review limited to US$500,000. However, term financing is less flexible than the revolving credit with specified mark-up and single drawdown. As for the overdraft, Islamic finance may offer a Murabahahtawarruq facility to allow the customer to have the credit line of up to 50% of US$500,000, that is US$250,000 at any time. Alternatively, an Islamic bank may offer working capital financing (for asset purchases) as well as working capital financing (cash) using equity-based working capital financing. In this case, the Islamic bank will provide US$500,000 as equity financing to this business customer, plus US$250,000 as standby equity financing as and when required. However, the rate of profit cannot be specified with a fixed return, unlike the above structure using Murabahah and Murabahah-tawarruq contracts.
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5.4.3 Mudarabah/Musharakah working capital financing

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

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

Musharakah, or diminishing Musharakah working capital, is a facility that involves capital contribution by both the bank and the customer. In practice the product can be structured on either a constant or diminishing capital contribution. In a constant Musharakah structure, capital is redeemed at the end of the period thus enabling the customer to utilise the total outstanding capital balance throughout the financing period. In the case of diminishing Musharakah, the customer will follow a payment schedule to pay the banks capital throughout the period. The loss exposure of the bank is limited to the capital outstanding at any time during the financing period. A constant Musharakah financing structure provides flexibility in terms of utilisation of the outstanding balance for a wide variety of expenditures as per the specified-approved business purpose, with maximum commitment of capital provided by the bank. Diminishing Musharakah working capital on the other hand limits the banks capital to the outstanding balance at a time subject to the payment schedule.
A customer has secured a tender to supply and service computers to a government agency. The value of the tender at 1 million includes 30% of potential service income for maintenance in the next three years. The total cost of computer parts is estimated at 350,000. The customer anticipates a gross income of 650,000. Operational expenses are estimated at 400,000. Hence, net income is derived as 250,000 for the next three years. If the bank provides Musharakah working capital financing, the expected net income is shared between the bank and the customer based on a mutually agreed profit-sharing ratio for a disbursed financing facility of 750,000, that is 75% of the total value of the tender. The banks loss exposure is limited to the financing amount. With an effective annual rate of 5% per annum, the bank is expected to earn (0.05 X 750,000 X 3) = 112,500 based on a profit-sharing ratio of 45:55 between the bank and the customer. The bank can secure payment by ensuring that payment proceeds are assigned to the bank trust account prior to payments to the customer or profit distribution.
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5.5 Comparative analysis of working capital financing

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

Murabahah Murabahah-tawarruq Mudarabah/ Musharakah Specified by type of purchase transaction or business purpose Based on total operating expenditure required during the period Based on estimated returns shared according to a mutually agreed profit-sharing ratio Total funds are made available upon approval for any expenditure, including utilities, for business purpose Effective cost of funds is imputed against the risk preference and expected return shared by the bank A single withdrawal of the full amount is possible based on capital available The payment schedule in the case of diminishing Musharakah is agreed in advance and recovered prior to the end of financing period A third-party performance guarantee on customers performance, as well as a priority claim on capital over profits, can be exercised
Purpose of financing
Specified by type of purchase transaction
Specified by type of purchase transaction
Approve limit
Based on estimated total purchase value of transactions for a specified period Mark-up price is specified upon granting the facility and applied to each transaction Amount of financing is made available for each purchase transaction not exceeding the overall limit Subject to each purchase transaction credit period for the specified rate
Based on estimated total purchase value of transactions for a specified period Mark-up price is specified upon granting the facility and applied to the main/ principal transaction
Determination of cost of funds
Availability of funds
Total amount of financing is made available upon execution of the primary/ principal transaction
Effective cost of funds
Total cost is imputed based on the single primary/principal purchase transaction
Flexibility of withdrawal
Each withdrawal is subject to approval of the purchase transaction All payments are to be made within the specified credit period for each transaction not to exceed in the total financing period of the approved facility A collateral and guarantee of financing amount, as well as profits, can be secured accordingly
A single withdrawal is approved based on the primary/principal transaction All payments are to be made within the financing period of the approved facility
Flexibility of payment
Security
A collateral and guarantee of financing amount, as well as profits, can be secured accordingly
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Exercise 5.4
If the purpose of financing is to obtain cash without the customer taking delivery of the goods at a predetermined rate, what would be the appropriate financing structure?
5.6 Islamic retail financing

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

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

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

A credit card authorises the holder to buy goods or services on credit without having to use cash. The issuer of the card grants a line of credit to the consumer (or the user) from which the user can borrow money for payment to a merchant or for cash advances. Normally, the holder will enjoy an interestfree period from the posting date of the transactions to the point where they settle the full account with one payment. Where they only make a partial or minimum payment toward the amount, they will be charged interest, called financial charges, for all purchases paid through the card from the date of the transactions. A credit card transaction is different to that occurring with a charge card. A charge card requires the outstanding balance to be paid in full each month. Thus, a charge card could be deemed to be compliant if full payment is made on time as it will be free from interest. In contrast, credit cards allow the consumers to revolve their balance, at the cost of having interest charged. Credit cards generally provide a higher risk adjusted return than other types of financing. Card issuers earn income from three sources: charging cardholders fees; charging financing cost on outstanding balances; and discounting on the charges that merchants accept on the purchases. The fees charged at specified amounts per annum are based on the issuance and maintenance of the card. Sometimes because of market competition the card issuers waive such charges. Finance charges are based on a specified annual rate with a higher effective rate due to monthly or daily compounding. On average, discount on merchants is earned at between 2% to 5% per purchase.
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The basic model of credit card issuing process is shown as per the figure below:
Figure 5.3 Credit card transaction process
Individual
Retail outlet 2
Card issuing bank 3
Clearing network 3
Local merchant bank
2 Steps 1. Individual uses a credit card to purchase merchandise from a retail outlet 2. Retail outlet deposits the sales slip or electronically transmits the purchase data at its local bank Fees None
The merchant bank discounts the sales receipt; at 3% discount, the bank gives the retailer 97 in credit for each 100 receipt The bank that issued the card charges the merchant bank an interchange fee equal to 1% to 1.5% of the transaction amount for each item handled The bank that issued the card charges the customer interest and an annual fee for the privilege of issuing the card; a card issuing bank also serves as a merchant bank
3. Local merchant bank forwards the transaction information to a clearing network, which routes the data to the bank that issued the credit card 4. The bank that issued the card sends the individual an itemised bill for all purchases
The above credit card transaction process applies to Islamic credit cards except when the bank charges interest to the customer for the outstanding credit. Therefore, Islamic credit cards need to be restructured to avoid interest. Most credit cards require a minimum payment by the customer to the credit card issuing bank to ensure the card remains active.
5.6.1.3 Avoiding interest

In response to this prohibitive element, Islamic banks have adopted Islamic finance contracts such as Murabahah-tawarruq to avoid charging interest payments for outstanding credit. Essentially, a credit card is a form of cash financing to the customer for personal expenses. It also enables the customer to avoid carrying or holding cash by managing credit purchases with timely payments to the credit card issuing banks. In certain cases consumerism may influence the customer to spend more than they need to or are able to pay out of future income. Such behaviour is not consistent with Islamic teachings that encourage prudent spending and saving for the future. However, the need to possess credit cards to meet immediate payments is necessary with proper expense monitoring, as well as adequate planning for cash disbursements. A similar structure of Murabahah-tawarruq, which is applied in the case of term working capital financing, is adapted to facilitate customer credit card financing. The basic credit card process model is shown in the following diagram.
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Figure 5.4 Islamic credit card process models

Stage 1: Agreement between customer and credit card issuing bank Applies for credit facility to the issuing bank
Customer
Islamic bank
Approval of facility based on credit standing. Customer will enter into a Murabahah commodity transaction with the issuing bank to create a credit facility which represents the monetary value of the Islamic credit card
At this stage, the card issuer/Islamic bank will purchase a certain commodity from the vendor/ commodity broker A. The value of this commodity relates to the value of credit granted to the cardholder later. Subsequently, the card issuer/Islamic bank will sell the same commodity to the cardholder/customer at the Murabahah selling price that comprises both the cost and agreed markup. The card issuer/Islamic bank will facilitate the cardholder/customer to sell the commodity to the market/commodity broker B at a price that is the value of the credit card to be issued by the Islamic bank. Pursuant to this contract, the cardholder has a credit line to be utilised to pay for the goods or services using the card instead of cash.
Stage 2: Credit card transaction process B. Purchase goods and services from retail outlets
Customer
Retail outlet
E. Payment for outstanding purchase
A. Murabahah sale of goods to customer at specified mark-up rate
D. Cash payment after discount is remitted to retailer
C. Submits request for cash payment
Card issuing bank
Clearing network
Local merchant bank
F. Outstanding payments between the banks shall be set-off
Stage 2 of the credit card process illustrates the parties involved in the transaction. Step A shows the origination of the credit facility through a Murabahah sale by the card issuing bank. Step B describes the purchase by the cardholder of goods or services from the retail outlets. Steps C and D describe the internal transactions between the retail outlet and the local merchant bank in relation to submitting the request for cash payment by the retail outlet and the cash payment remittance to the retailer by the local merchant bank. Finally, steps E and F show that payment by the customer to the card issuing bank and settlement between the banks based on set-off arrangement. As highlighted by the circle, the outstanding credit is created and monitored by the card-issuing bank for customer credit purchases.
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Exercise 5.5
A credit card issued by an Islamic bank adopted an Islamic contract that specified a 12% per annum mark-up rate on a monthly basis for every customer purchase not exceeding a credit limit of 5,000. For each purchase transaction, the mark-up price is applied on a monthly basis if the payment period exceeds two weeks from the credit billing date. The customer presents the card to a retail outlet and purchases goods valued at 4,000 in the month of January. Upon receipt of the credit card billing amount at the end of January, the customer pays 2,000 and defers payment of the balance. In February the customer purchases 3,000 worth of goods and pays 1,500 at the end of the month. a. Explain the relevant contracts that enable the transaction to be executed when the card is presented to purchase goods from the retailer. b. State the basis for fees collected by the credit card issuing bank to facilitate payment transactions. c. Compute the Murabahah-tawarruq profit and amount earned for each credit purchase transaction.
5.6.1.4 The Kafalah contract

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

This Islamic credit card is known as an uncovered credit card as the basis of the repayment is not supported by any account owned by the customer. However, Islamic credit cards that are structured on the Murabahah-tawarruq structure will be supported by a pool of money in the account of the customer, thus known as a covered Islamic credit card.
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A covered Islamic credit card is based on the Murabahah-tawarruq structure. It offers some advantages to the cardholders in comparison to non-covered Islamic credit cards based on Kafalah. However, it has been argued by some practitioners that covered Islamic cards are simply debit cards. Discuss.
Solution
The Murabahah-tawarruq structure allows an Islamic credit card to operate in a similar way to that of a conventional credit card in terms of the revolving feature and the profit or interest to be paid by the cardholder. Little adjustment is required to be made to the existing operating procedures of this facility. Both credit cards may look similar, but they are fundamentally different; while one provides a loan for interest; the other provides credit within the approved Shariah principles. Also, this structure allows the cardholder to invest his account created from Murabahah-tawarruq in a Mudarabah investment account at the card issuing bank, the profit of which can be used to set-off any payment outstanding arising from the usage of the credit cards. It therefore seems that the above claim is valid and justified as the outstanding payment created by the utilisation of the credit card is directly debited to the Murabahahtawarruq account, which was created prior to the issuance of this credit card. However, from another perspective, the totality of this structuring has created a credit line for the cardholder that can now be used through this card. This is an innovative structure that offers a compliant product to replicate the functions of a conventional credit card. Although it may not replicate fully the conventional credit card, Islamic credit cards based on the Murabahah-tawarruq structure make the payment of goods or services possible without resource to cash.
5.6.2 Islamic personal financing using the Murabahah-tawarruq structure

In addition to the credit facility offered via charge and credit cards, Islamic banks may offer Islamic personal financing or rather cash financing using the Murabahah-tawarruq structure.
For example, an annual credit card limit of 5,000 can originate from a series of sale and purchase transactions of the Murabahah-tawarruq structure at an annual profit of 500. The customer may utilise the line for any purchase of goods and services during the year not exceeding the limit, and pay the profit accordingly.
5.7 Islamic personal financing: Ijarah

In addition to the above, Islamic finance has developed a scheme of personal financing using the concept of Ijarah or service of a person or a hire contract. In this case, two hire contracts exist between the service provider and the financier, and subsequently between the financier and the ultimate user. The second contract is known as a sub-hire that effectively transfers the services from the ultimate provider to the ultimate user. This scheme of financing has been used in a few sectors such as tourism, medication and education.
For example, a customer seeks financing for a two-week holiday package in Bali, Indonesia, which costs US$20,000. This includes air tickets for four people, land transportation and hotel arrangements. The bank may finance this customer with a full lease payment of US$20,000 to the holiday package provider as the rightful lessee to benefit from the package, and subsequently sub-lease it to the customer at US$22,000 which can be paid within one year. The first contract is essentially a lease contract over the services of the whole package. The bank will have beneficial use (services) of the package by paying the fee for this package. The bank will subsequently lease this service to the customer at a higher service fee.
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5.8 Residential property financing: conventional

Residential property financing refers to financing the construction, acquisition or leasing of residential properties. In conventional banking, term loan facilities are offered to the customer. No other forms of financing are available in conventional banking, particularly for retail banking customers.
Key point
Property financing may vary with various stages of property construction and development such as bridging, project and term financing. In the case of retail banking, term financing is the form of financing provided to customers.
5.8.1 Conventional property financing for retail customers

Financing for residential property is focused on meeting the needs of buyers who intend to occupy or lease such properties. The profile of residential property buyers can be identified by their age group and lifestyle, as well as their income capacity to acquire such property. Hence, financing structures are designed to accommodate their specific profile to enable them to achieve their purpose of property financing. For example, in the early stage of their career, property buyers are inclined to lease rather than purchase a property. This behaviour is most apparent in conventional lending when interest rates increase more significantly than property rental. Alternatively, when property prices decline significantly, property buyers are inclined to purchase property in lieu of market rebound to realise a capital gain. In certain jurisdictions, loans are made available to homebuyers to purchase residential property under construction; upon sale of the completed property, the anticipated increase in property price will record a capital gain to the homebuyers.
Key point
In the case of residential property financing, motivations to acquire property may vary with the desire to occupy, lease or invest in the property. Although property financing may vary at different stages of property construction, development and sale, this section deals with term financing or end financing. In other words financing is directed to the customer who will purchase the property. In conventional banking, property loans to homebuyers are essentially classified as mortgages, where the lending is secured by the propertys value. In the credit appraisal, the buyers willingness and ability to pay the loan and interest, and the property value as collateral to the loan, are primary determinants in the loan approval process. In addition, the property would be covered by relevant insurance policies to safeguard the financial interest in the property. Mortgage reducing term assurance is another form of insurance used to secure repayment to the bank or building society in case of the death or disability of the homebuyer. The status of the property, whether completed or under construction, has resulted in different loan schemes that enable the customer to acquire the property. In the case of completed property, the loan granted will be at a specified margin of the property value.
For example, 90% margin of the property value of 150,000 implies the loan amount of 135,000 and the customer pays the seller or developer the balance of 15,000.
Alternatively a property under construction involves a gradual loan disbursement by the bank at each stage of the development based on the percentage of completion. The customer will service the interest during the construction period and subsequently make instalment payments of both principal and interest for the remaining loan period. Similarly the initial payment by the customer to the developer takes into consideration the margin of finance provided by the bank.
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Key point
In property financing, security of recovery of the loan amount, plus any interest, is addressed by the value of the property as well as other guarantees and insurances, including mortgage reducing term assurance (MRTA).
5.9 Islamic property financing: residential property

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

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

A Murabahah property financing arrangement can be executed when the property identified by the customer is purchased at cost for cash and sold to the customer at cost plus mark-up for deferred payment. Upon receipt of the customer request, the bank may require a security deposit as well as an undertaking to purchase the property to effect the promise. In cases where the customer breaches such promise, the bank has the right to reduce losses by disposal of the property, as well as claiming any residual outstanding loss from the customer. Upon acquisition of the property, the bank pledges the property as collateral for the Murabahah sale to the customer. In addition, the bank may obtain a guarantee from third parties to ensure the customers timely payment of the financing amount and mark-up. Other forms of assurance, including Takaful protection for fire and payment upon death of the customer, are also considered in most property financing arrangements. The payment schedule may include regular payments or instalments comprising the principal and profit portion. The profit, based on the mark-up, is predetermined and is contracted upon the sale of property by the bank to the customer. The basis of profit recognition is made known to the customer and can be
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computed from the outstanding balance as per the date of payment, also referred to as the constant rate of return. In most cases, the instalment amount is skewed towards earlier profit payment. Any early settlement on the part of the customer provides an option for the bank to consider waiving the unearned profit portion of the mark-up. In some cases, the bank uses this option to sustain existing customers. This occurs when the market profit rates decline to a level not attractive for customers to pay the mark-up specified in the selling price. Any delay or delinquency on the part of the customer exceeding three months in certain jurisdictions of non-payment would classify the financing amount as non-performing. Hence, profit is suspended until payment continues. Failure to settle the outstanding financing amount and profit gives the bank the right to dispose of the property and recover all principal and profit due to the bank.
5.9.3 Completed property: Ijarah muntahia bi tamleek (lease)

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

From an equity financing perspective, the bank can jointly own the property and subsequently lease it to the customer for a defined period. During the financing period the equity share is transferred to the customer based on the contract of diminishing Musharakah (Musharakah mutanaqisah). The rental income due to the bank is proportionate to the banks capital contribution. In other words, the lease payment is apportioned according to the banks outstanding capital contribution for the period.
For example, in year five of a 20-year financing period, the banks outstanding capital is 75% of the property purchase price. Hence, the lease payment payable to the bank for the year will be 75% of the specified lease payment amount.
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Exercise 5.6
An Islamic bank offers the following three financing packages for the customer to purchase a completed property: Home financing Package I Package II Banks selling price at cost plus mark-up of 5% with monthly regular instalments for a maximum period of 20 years Lease payment payable, with an option to purchase the property at a price based on a fixed formula during the lease period; market rental rate is contracted and reviewed on a periodic basis Initial part payment to co-own property and subsequently lease to own the property at the end of the financing period for a maximum of 20 years
Package III
Based on the above description, identify and analyse the appropriate contracts for each home financing package, and suggest any customer preferences that could arise for each type of package.
5.9.5 Property under construction

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

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

When financing of a motor vehicle is based on outright sale of the vehicle, such as Murabahah financing, the bank can recover the outstanding financing amount in the form of a receivable, as well as the mark-up profit realised during the period of financing. The product structure does not facilitate re-possession of the vehicle but acts as security to recover proceeds from the disposal value of the vehicle. In most cases the disposal value is lower than the recoverability of the financing amount and profits, and outstanding claims need to be brought to a court of law. In certain jurisdictions, legislation in the form of statutes, such as a hire-purchase act, specify the mode of financing and charges, as well as the financiers right to repossess the vehicle given the risky nature of the type of asset financed. A more appropriate contract is leasing or Ijarah with the option for the customer to purchase the vehicle. The bank as lessor owns the asset and hence, at any time, would be able to repossess the asset because of termination of the lease by expiry of the lease period, default or negligence on the part of the customer. Total lease payments amount to the total financing amount, plus the rental income.
Exercise 5.7
A customer obtains financing to lease a motor vehicle from a bank and is required to make regular instalment payments for a period of three years. At the end of the second year, the vehicle is involved in an accident and the total loss is confirmed by the Takaful loss adjuster. Explain the status of the lease financing in these circumstances and suggest who is liable for the loss.
5.11 Consumerism from an Islamic perspective

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

Generally, banks are required to observe customer credit limits to avoid the overconcentration of financing to a particular individual or market segment, including credit cards. Hence, when such limits are exceeded, the banks exposure can destabilise its solvency. If this phenomenon is prevalent in the industry, systemic risk is anticipated which can effectively destabilise the financial system. In such a situation the primary contracts become poor-quality receivables, affecting any effort towards securitisation of the debt or towards credit enhancement to improve the rating of the issuers instruments. The subprime crisis of 2008/9 was related to poor credit customer financing that subsequently defaulted and escalated into a crisis of confidence in financial instruments related to consumer loans. This phenomenon is not confined to conventional loans and may affect Islamic customer financing if prudential policy and regulatory mechanisms are not in place to check excessive customer credit.
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Therefore, although Shariah requirements are specified for financing structures to enable customer financing, including cash financing, ethical as well as moral conduct is strongly encouraged in consumption behaviour to realise the overall purpose of meaningful life and the goals of Shariah.
5.12 Conclusion
In this chapter you were shown that structuring for working capital and consumer financing exhibit common features. We explained that working capital financing, meant for short-term business cycles, requires certainty in relation to the corporate cost of financing. Therefore it would require the adoption of Murabahah or Murabahah-tawarruq contracts to facilitate either assetpurchase transactions or cash financing respectively. We showed that this also applies to consumer financing. We introduced the idea that challenges faced with regard to early payment are mainly due to the lack of flexibility in pricing structure since rates are predetermined. We explained that attempts to build in a discretionary rebate system may not be sufficient to make the products competitive. Finally, other service-based contracts, such as Ijarah and Musharakah, were explored where services are identified or assets are not determinable. These are more useful for medium to long-term financing.
5.13 Summary
Having read this chapter the main points that you should understand are as follows: the important considerations for borrowings are financial capacity for repayment and the creditworthiness of the borrower appropriate Shariah contracts that address the needs of the customer must be suitably applied for different types of financing products in Islamic banking contracting parties may consider adding ancillary contracts to secure the interest of the creditor, such as guarantee (Kafalah), promise (Wad) or pledge (Rahn) to provide assurance to the bank on the performance or recoverability of the financing amount the rate of return determined for a financing amount is based on a mutually agreed selling price or rental amount in the case of sale or lease-based transactions respectively working capital refers to current assets that relate to short-term or immediate cash flow needs and these are matched with short-term obligations to determine the level of net working capital effective and timely delivery of goods in a contract requires proper documentation and recording of the transaction by the bank to the customer a distinction between Murabahah working capital and Murabahah-tawarruq cash financing is that the effective transfer of goods to the customer, as ultimate purchaser, occurs in the former but not in the latter, where cash is the sole purpose of financing Islamic credit cards can be generated under Murabahah-tawarruq or Kafalah structures Islamic personal financing can be structured under Murabahah-tawarruq or Ijarah structures Islamic property financing, which enables the property buyer to occupy, lease or invest in a property, can be structured around suitable contracts such as Murabahah or Ijarah muntahia bi tamleek a unique feature of vehicle financing is the moveable nature of the property which is exposed to peculiar risks and perils that specified contracts can safeguard in the interest of the bank Islam provides specific guidelines to avoid wastage, which is held to be prone to evil, and help the individual avoid consuming more than they need or can afford.
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5.14 Islamic Finance case study

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

1. Cash flow statement analysis as the pertinent consideration for customer credit evaluation is particularly relevant in: (A) (B) (C) (D) 2. retail banking and wholesale banking investment banking and retail banking corporate banking and investment banking personal financing and working capital financing
Based on the case outlined above why would a personal financing structure based on Murabahah be suitable for tuition fees? (A) (B) (C) (D) Because it is an identifiable Because of the flexibility of cash availability on draw down basis Because of the fixed payment schedule during the financing period Because of quantifiable services in monetary terms
3.
In terms of the customers ability to pay, which of the following should be considered in order to approve the personal financing structure? (A) (B) (C) (D) Net customer earnings for payment of financing amount Post-doctoral earning capacity to pay the financing amount Mortgage Takaful for his house financing Credit facility via Islamic credit cards
4.
Based on the annual tuition fee payment schedule, when would the payment for personal financing be affected? (A) (B) (C) (D) During the study period During and post financing period During financing period Post financing period only
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5.
Which of the following structures would be suitable for the credit card financing of US$20,000? (A) (B) (C) (D) Murabahah structure Murabahah-tawarruq structure Ijarah structure Musharakah structure
6.
Which of the following would mitigate the banks risk exposures in relation to the personal financing and credit card facility? (A) (B) (C) (D) Salary assignment, house mortgage and mortgage Takaful House mortgage and Islamic credit card Allowance deduction from university appointment Government guarantee on his employment

1. 2. 3. 4. 5. 6. Suggest a financing scheme suitable for the applicant to use to pay his course tuition fees. Identify the distinguishing features of the personal and cash financing schemes suitable for tuition fees and cash financing. State the IFIs risk implications of these two structures and the security arrangements required to mitigate the risk exposures. An employee has been given the task of preparing a comprehensive proposal for the bank to consider the applicants request. What should be the essential considerations of the proposal? If the applicant had no mortgage or had the mortgage but not the mortgage Takaful, how would this affect the consideration of the customers financing request? If the applicant was applying for financing for his family holiday to Disneyland Paris, (rather than tuition fees) what should be considered in order to approve or disapprove his request?
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Chapter five answers

Exercise 5.1
Providing a secured house loan facility is a normal conventional banking practice in the market. The value of the mortgage will, among other considerations, significantly influence the LTV to the customer. The interest rate charged for the secured loan is normally lower than on unsecured loans such as credit cards. In the case of default, the secured loan will benefit from the proceeds of the sale of the mortgaged asset pursuant to the order of sale by the court, unlike the unsecured credit card facility. With a lower credit risk, a relatively low interest rate can be charged for the secured borrowing. With a credit card facility, where no collateral or guarantee is available, the card issuer is exposed to a higher degree of credit risk and hence charges a higher interest rate to the customer. The above proposal is exceptional as the customer may enjoy a relatively low interest rate for both the house loan and credit card facility compared with normal banking practice. While this product benefits the bank and the customer, it may also lead to excessive consumer financing as it may encourage the customer to use their credit card excessively because of the relatively low interest rate charged compared with a normal credit card.
Exercise 5.2
1. The banks selling price for each customer purchase is based on the amount disbursed at cost plus mark-up for the two-year or remaining period at the time of sale. Usually the maximum period of two years is applied and the mark-up will then be (200,000 X 0.12 X 2) 48,000 for the first Murabahah financing and (250,000 X 0.12 X 2) 60,000 for the second Murabahah financing. However, if the second purchase is limited to financing for 23 months then the markup is lower than 60,000. Based on a monthly rate of 1%, the mark-up is less (250,000 X 0.01 X 1) 2,500, which is 57,500. 2. The payment schedule is specified by the terms of Murabahah revolving credit financing. These may vary in frequency and affect the effective Murabahah rate charged to the customer. For example, 12% per annum is translated as a monthly effective rate of 1% compounded monthly, a quarterly effective rate of 3% compounded quarterly and semi-annual rate of 6% compounded semi-annually. In the case of a monthly basis, the customer has delayed payment in February. Alternatively, if a quarterly or semi-annual payment is required, the customer has made an early payment and part settlement. In either case the total amount of profit earned should not exceed the agreed mark-up. 3. The bank may accept the part payment, but the bank is not obliged to waive the deferred profit and may decide accordingly when full settlement for each transaction is made or upon termination, or expiration of the revolving facility. 4. In March the outstanding financing amount is (250,000 + 100,000) 350,000. With the purchase request for 200,000 the total outstanding amount would exceed the limit by 50,000. Operationally the bank has to consider increasing the credit limit for additional financing to be provided. With the approval of the new limit, the third Murabahah sale can be concluded, but the new profit rate must be mutually agreed between the two parties as this rate is not expressed in the earlier master agreement. 5. Subject to the amount of revolving financing credit made available to the customer, the maximum mark-up profit will be (500,000 X 0.12 X 2) 120,000 on a straight line annual basis. Any early settlements may reduce the profit accordingly. Furthermore, only selective purchases of big ticket items can be effectively monitored by the bank. If financing involves numerous purchases of nominal items, it becomes an onus on the bank to provide and monitor such financing. In this case a Murabahah-tawarruq structure is applicable as the utilisation of the financing amount need not be asset-specific. In addition, a Musharakah structure does not require identification of the asset purchased using the financing amount.
Exercise 5.3
Extending the payment period longer than the two-year credit term is not an issue under the Shariah. An issue arises when the bank seeks to charge additional fees or penalties to consider the extension request of the customer. While this feature of charging additional fees is common in conventional overdrafts when extensions are being considered, it cannot be
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undertaken under Islamic finance particularly when the underlying contract is Murabahah and the mark-up or profit has already been pre-agreed at 6% per annum of the financing amount drawn down. In this exercise, the maximum profit the bank can charge is 6% per annum of the US$400,000 drawn down.
Exercise 5.4
From the customer perspective, cash financing is meant for customer consumption not known to the bank. A Murabahah sale requires identification of goods purchased and sold that meet Shariah requirements. In the case of Murabahah-tawarruq, a series of sale-and-purchase transactions are made to facilitate the cash disbursement to the customer based on agreed terms of financing. The customer does not take delivery of goods and does not need to disclose the utilisation of cash financing. Hence, Murabahah-tawarruq is a suitable contract for such financing.
Exercise 5.5
a. The execution of the purchase of goods or services by the cardholders can be explained in terms of the very structure of Islamic credit cards. If the cards were to be issued on the basis of Murabahah-tawarruq, the cardholder simply assigns the merchants to get payment from his account at the issuing bank. To some extent, it looks similar to the debit card as the payment of the credit card is automatically debited from the account created for the cardholder under the Murabahah-tawarruq structure between the card holder and the card issuer. As for Islamic credit cards issued based on Kalafah, the cardholder simply requests the merchant to seek recourse from the issuing bank as the guarantor for the payment of the purchases made by the cardholder. b. Upon issuing the credit card to the customer, the issuing bank has to maintain the payment services as well as monitor the credit purchase behaviour and credit standing of the customer. Fees paid to the issuing bank are recognised as Ujrah for services rendered by the issuing bank. c. Based on the transactions, the customers purchase in January amounted to (4,000 2,000) 2,000 in credit for a period of one month. The customers purchase in February amounted to (2,000 + 3,000 - 1,500) 3,500 in credit for a period of one month. Hence, profit earned by the bank is as follows: Based on the Murabahah-tawarruq contract, the 5,000 purchase can be paid over one year at a mark-up profit of (5,000 X 0.01 X 12) = 600 for the year or 50 for each month. Although payments are made in each month the profit chargeable is fixed at 50 per month for the credit line.
Exercise 5.6
Package I should adopt the Murabahah financing package where the customer purchases the house from the bank at cost plus mark-up. The customer should be able to commit to regular instalments during the financing period which is subject to a fixed rate specified in the agreement. Any changes in the rate will affect the bank and customer inversely. Any decrease in market profit rate will influence the customer to re-finance at a lower cost while an increase in the market profit rate will affect the banks ability to match with a higher cost of funds. Package II adopts the Ijarah contract with flexible lease payments payable by the customer. Although the customer has an option to purchase the house during the lease period, at lease period renewal the rental rate may be revised to reflect the market rental rate. As an investor, the customer may choose to purchase the house at a price that is certain according to the fixed formula (which is not subject to the market value) or continue to lease if the payments in aggregate are lower than the purchase price. Package III adopts the Musharakah contract where the customer jointly owns the property upon acquisition. During this period, share of ownership is transferred to the customer and rental income is paid to the bank as a lessor. The customer may be granted the flexibility to re-schedule the capital transfer while continuously paying a lease to the bank as per the outstanding capital contribution.
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Exercise 5.7
Due to the total loss scenario, the bank/lessor will not be entitled to claim the rental payment since the customer/lessee will not be able to benefit from the usufruct of the leased vehicle. The bank may claim the value of the vehicle from the Takaful company. If the accident is proven to have resulted from the negligence of the customer, the customer may be requested to compensate the bank for losses not covered by the Takaful policy.

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

1. Ijarah personal financing would be the most flexible as it allows the customer to schedule payments during and post the financing period. 2. Personal financing may adopt the Ijarah structure while cash financing may adopt the Murabahah-tawarruq structure. The former involves effective services rendered to the customer while the latter allows only a credit line to the customer. 3. Both Ijarah and Murabahah-tawarruq structures can be secured in the form of pledged assets, the assignment of salaries (Hiwalah), and a guarantee by a third party (Kafalah). 4. The prime concerns in this question are creditworthiness, including capacity and willingness to make payment, the forms of security for the financing amounts, as well as the payment schedule. Also to be considered are the quality of financing in terms of the promotion of the social well-being of the applicant, as well as a suitable financial product structure to facilitate timely disbursement and payment, and effective yield to the bank. 5. If the customer applies with no mortgage or related security arrangements, a higher risk premium is applied to the financing rate. Hence, other risk mitigation arrangements, such as an assignment or guarantee, should be considered. 6. The family holiday is considered a service package similar to the education package. The considerations for financing depend on the customers creditworthiness and economic standing, as well as payment behaviour. From a longer-term perspective the enhanced potential capacity of the customer as per the education package is, however, absent as the consumption behaviour does not relate to personal development but only a form of social benefits.
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Chapter six
Project financing: structures and strategic considerations
Learning outcomes
By the end of this chapter you should be able to: analyse and evaluate the validity and compatibility of various underlying contracts to support project financing purposes recommend the relevant structure for different infrastructure project financing assess the risk features of project financing and propose appropriate instruments to mitigate relevant risk exposures.

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

Project financing normally involves many participants or stakeholders in the finance transaction. The main participants in any project financing are: the government; equity funders, also known as the sponsors, who set up a special purpose company (SPC) or project management company; nonrecourse debt funders; construction/engineering consultants; environmental impact assessment consultants; and any affected communities. The government is responsible for creating an enabling environment for project finance transactions to take place through its legal system and other associated legislation, such as agreements, permits, property rights and concession rights. Equity funders are the owners of the project management company or the SPC. They contribute equity to this new entity that is independent from the legal entities of the equity providers. They are technically known as sponsors. It is important to limit the liability of the SPC to this company and not to the entities of the equity providers. The SPC is created to borrow the necessary monies and to manage the design and construction of the project. The same company may be the operator post-construction or it may appoint another party as the operator that is in control of the construction and operations, as well as the management of the project.
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Non-recourse debt funders are lenders and financiers who provide the financing scheme for this project to be undertaken without recourse to the equity provider from the independent company, in addition to equity provided by the sponsors. The construction or engineering consultant is the company responsible for the engineering, procurement and construction (EPC). The environmental impact assessment consultant assesses whether the project meets the minimum standard of both national and international environmental-related legislation and agreements. Affected communities include those who are directly or indirectly affected by the project.
6.1.2 Project financing: large scale

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

Another peculiar feature of project financing is that project assets usually serve as collateral against the repayment of the loan. In the case of default, the financing could be either of nonrecourse or limited recourse. In a non-recourse loan, lenders only have recourse to the underlying project assets as collateral and not the personal assets of the borrower. In the case of limited recourse financing, the lenders may have recourse to the sponsors/equity holders. Any other financial arrangements that depart from these two important features are inappropriate for project financing in its technical sense. The following hypothetical case is an example of conventional project financing.
The Electric-Power Co. is an established contractor and operator of a commercial power plant. It has been granted a concession by the government to design, construct, operate and maintain an independent power station. The electricity authority of the country has signed the power purchase agreement (PPA) under which the Electric-Power Co. undertakes to supply a certain capacity of electricity to the electricity authority for a certain period of time at an agreed price. The project to be undertaken, according to specifications in the concession agreement, entails the design, construction, commissioning and operation of two steam-electric coal-fired units, each with a nominal 700MW net capacity; common coal unloading, storage and handling facilities; and a 500KV switchyard. The project also includes the construction of transmission lines connecting the plant to the National Grid. The whole project is expected to be completed within two years from the date of the PPA. The estimated cost for the whole project is United Arab Emirates Dirham (AED) 1 billion. Under a project finance scheme, the Electric-Power Co. will have to set up an SPC (project management company) called Electric-Power Holdings Inc. Electric-Power Co. (and other stakeholders, if any) will have to invest equity into this company, say, 10% of the estimated cost, that is AED 100 million. Electric-Power Holdings Inc. will later sign a construction contract with Electric-Power Co. to build this power plant based on the specifications in the PPA. In order to support the construction cost, Electric-Power Holdings Inc. will need to secure financing through either a loan or a bond. A government or bank guarantee may be useful to facilitate or enhance the financing by other commercial banks. Also, the off-take by the countrys electricity authority will address the issue of the market risk, in case there is no buyer for the electricity at an agreed price. After the completion of the project, the electricity will be supplied to the countrys electricity authority pursuant to the PPA and all proceeds payable to Electric-Power Co. will be used to repay the loans or bonds. In the case of a default in the non-recourse loan, the only collateral available to the lenders is confined to all project assets including the revenue-producing contracts, that is the PPA.
Key point
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Key point
Project financing is a financing scheme for long-term infrastructure and development projects through loans that are secured by the project assets and paid entirely from project cash flow. The following diagram illustrates the various components of the conventional financing structure from the initial sponsor to the repayment from the proceeds that flow after production begins.
Figure 6.1 Simplified conventional project finance structure

Financier Sponsor $ Equity Financier Financier
Financier arranger
$ Debt
Repayment
Project company Company set-up Construction Operation & production
Advisory Services Financial arranger Technical consultant EPC contractor Subcontractors Equipment supplier Operator
Feedstock supply contract
Feedstock suppliers The spot market Off-takers
Sales of goods and payment proceeds
Operation & maintenance contract
Equipment supply contract
The above is a simplified example of a possible project financing in the energy and power sector that has been modelled on a conventional financing scheme. We will now look at how Islamic finance may contribute to such financing while maintaining the salient features of project financing, as well as addressing various types of risks common in project financing.
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Exercise 6.1
Given the above description of project financing in a conventional finance scheme, which of the following may prove challenging from a Shariah perspective? (A) The off-take agreement (B) The fact that collateral is limited to project assets only (C) Funding supplied by syndicated financiers (D) The establishment of the project management company as the SPC

Why might infrastructure project financing lend itself more towards Islamic finance compared with other forms of financing such as a credit facility or overdraft?
Solution
There are a number of reasons why infrastructure project financing, unlike other forms of financing, is more inclined to Islamic financing. Any list you have produced should include some or all of the following: They are asset-based. They are non-speculative projects. They may require some equity. They often result in some socio-economic benefits.
6.1.4 Project financing: products and instruments available

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

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

In Islamic finance the most appropriate contract that matches the conventional project financing scheme in terms of the repayment of the financing amount and collateral is the contract of Istisna (CDIF/1/6/113). An Istisna contract relates to the sale of assets to be constructed by the seller according to the descriptions and specifications of the buyer. In the context of Islamic financing, the Islamic financial institution (IFI) could be the buyer as financier, or seller as the intermediary to the ultimate buyer. The government or any government-linked companies may place an order for an IFI or syndicated Islamic financiers to build and deliver, say, a new hospital for the government at an agreed price payable within a defined period. Such an order, placed by the government, would constitute the first Istisna contract in the process. Islamic financiers are not construction companies or hospital operators and hence enter into another Istisna contract with a contractor or developer to purchase the complete hospital as specified in the first contract. Islamic financiers will act as the Istisna buyer to purchase the hospital from the construction company, thus forming the second Istisna contract. To render this Parallel Istisna arrangement compatible with the technical description of project financing, two conditions have to be met (CDIF/1/7/131). It has to be a condition that the source of payment by the government to the Islamic financiers is derived solely from the cash flows of the hospitals activities for the next 10 years. It also has to be incorporated into the Istisna contract that the collateral was assigned in favour of the Islamic financiers. Should the government default, the Istisna payment is limited only to the proceeds generated by the hospitals assets, including its future revenue.
Exercise 6.2
Given the scenario above, explain whether the Parallel Istisna structure suggested would meet modern project financing requirements in terms of financing either the contractor or the concessionaire who has won the contract to build the hospital. The Istisna contract described above may not be relevant and practical to the practice of project financing in the industry. This is because the government or body that needs the new hospital, bridge or telecommunications server will not award the contract to an IFI as it is neither a contractor nor developer. IFIs, similar to conventional financial institutions, are merely the financial intermediaries. Usually, a government that engages the private sector will seek to transfer project risks and costs to this party, and will only therefore approach reputable contractors or builders to construct and deliver what is needed. Only subsequent to this would the contractor approach the financier for the required cost of the construction. Thus, despite the fact that this proposed Parallel Istisna appears in many textbooks and Shariah standards, it is only useful for consumer financing where an individual, say, asks a bank to build a house for him. Such Parallel Istisna would not be useful in the real project financing market.
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A gas-producing country sign a contract to produce, process and transport natural gas to its neighbouring countries, which have signed a contract to purchase the natural gas for the next 10 years. The project involves: a. the development of gas wells and installation of two platforms in the producing country b. two multiphase sea lines from the wellheads to the processing plant c. a gas processing and compression plant at a specific location in the producing country d. an offshore pipeline from that identified location to a gas station in one of the neighbouring countries e. gas receiving facilities in the identified location. The gas-producing country is seeking a Shariah-compliant instrument to finance the construction of the offshore pipeline (item d above) to transport the refined natural gas to the identified gas station. The estimated construction cost of the offshore pipeline is US$1 billion. On behalf of the gas-producing country, the facility arrangers approach several IFIs to obtain Islamic project financing using an Istisna contract. Required Prepare an outline of the required Istisna structure needed to finance the project.
Solution
The above request would not suit a Parallel Istisna structure that requires a pair or backto-back Istisna involving three independent parties. In this scenario, there will only be two parties: the gas producing country and the financiers. Parallel Istisna between two parties is not compliant according to the Accounting and Auditing Organisation for Islamic Financial Institutions (Shariah Standard No 11: Clause 2/2/4). A new Islamic financial product must be structured to facilitate this financial requirement that is unique in terms of product requirements and features. In the scenario, it is envisaged that the Islamic financier(s) may finance this project using a combination of two contracts to give the effect of real project financing and at the same time provide some risk management tools for the financiers. A widely used structure in financing green field or new projects, such as constructing a new pipeline, is the combination of an Istisna contract and a forward-lease contract. Under this structure, Islamic financiers enter into an Istisna contract with the gas-producing country to purchase the complete pipeline at a fixed price with payment based on the progress of the project. This payment will be used by the seller/gas-producing country to support the construction costs of the gas pipeline therefore meeting the financing requirements. Upon completion, the seller of the Istisna is under an obligation to deliver the complete pipeline to the Islamic financiers, who are the purchasers of the Istisna asset. To allow the Islamic financiers to earn a profit from the provision of this Istisna financing to the client, they will enter into a forward-lease agreement with the gas-producing country, normally on the same day that the Istisna contract between the two parties is concluded. Under this forward-lease contract, the gas-producing country will enter into a forward-lease for the pipeline from the Islamic financiers/lessors for a fixed rental. Under a forward-lease contract, the financier/lessor can collect the rental in advance even though the leased asset is still under construction. The total amount is essentially the payment for the Istisna financing facility plus some profit to the Istisna financiers. This is a good example of Islamic project financing as it easily meets the two conditions of typical project financing. At the same time it relates to market practice where the contractor or project owner approaches the financier directly to seek financing. The Istisna financing that requires a pair or back-to-back Istisna contracts, known as Parallel Istisna, may be difficult to apply in the real market.
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6.2.2 Istisna and forward-lease arrangement

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

Under the private finance initiative (PFI) or public-private partnership (PPP), build-operate-transfer (BOT) is a relatively popular product. It is a form of project financing where a government awards a concession to the private sector to design, construct and operate a project using its own financial resources to finance the costs. Although the concessionaire is expected to finance the construction cost, the government will allow them to operate the project for an extended period to cover the cost of construction and earn an expected return.
For example, in a highway project, a government may award the right to fix and collect a toll to a concessionaire company over a long period of time. In some cases, there will be a clause in the concession agreement requiring the government to compensate the concessionaire for any shortfall in expected revenue. This form of project financing is popular in India, China, Japan, Malaysia, Croatia and the Philippines and a version known as BOOT (Build-Own-OperateTransfer) is popular in Canada, Australia and New Zealand. Again, the whole intention of both BOT and BOOT is for the government to transfer the cost of funding to the private sector, together with the projects risks.
Key point
PFI and PPP allow governments to transfer project risks, as well as project costs to the private sector. BOT/BOOT have the same characteristics as other typical project financing: the lenders/financiers will look primarily at the potential cash flow of the project instead of the credit assessment of the concessionaire the collateral is largely confined to project assets, its rights and future income.
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6.2.3.1 Shariah acceptance of BOT/BOOT

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

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

Originally developed as a refinancing scheme for companies to raise cash by selling unencumbered assets with the purpose of taking it back on lease, this arrangement has been widely adopted in Sukuk Ijarah, which has been popular among both sovereign and corporate issuers. Given the structure of Sukuk Ijarah (CDIF/3/7/106-107), the project management company or sponsors must have an identified asset that can be sold to investors for an agreed price. The proceeds of this sale will be used by the originator/owner of the asset to support the construction cost of a particular project that the originator wishes to undertake. Sukuk Ijarah will not be relevant in the case where the project management company does not already own an unencumbered asset. The investors will lease the same asset back to the originator/project management company for a fixed or floating rental payment as the case may be. The rental payment is structured in this manner to compensate the investors for their financing cost. In this structure, the originator may give an undertaking to repurchase the leased asset at any price in the case of default. This feature of Sukuk Ijarah is not only compliant to AAOIFI Shariah Standards, but also provides a better rating for the structure as the obligation of the originator to redeem the principal and pay the profit is backed by the purchase undertaking and leased asset. The issue of the Sukuk structure and its rating will be discussed in chapter eight.
Exercise 6.3
A plot of land is designated for the development of a medical city. The land is awarded to a project management company to develop for the government of Qatar. The company wishes to issue Sukuk to cover the cost of the construction. What would be the best Sukuk structure to finance this project?
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A piece of land is awarded to a project management company for a period of 30 years. This land is not valid for any sale or transfer of ownership. Also, the property in the form of apartments and hotel rooms built on this land cannot be sold to anyone other than citizens of the country. Non-citizens are not qualified to purchase any of the properties. However, it is the intention of the project management company to have global Muslim ownership without breaching the laws of the land. The land is designated for five-star Islamic serviced apartments and hotels catering to Muslim pilgrims going to the Holy Land of Mecca. The project management company is contemplating issuing Sukuk to raise the required funds of about Saudi riyals (SR) 1 billion. Outline the salient features of Sukuk that would suit the above scenario.
Solution
The above scenario is a relatively viable project as the volume of visitors to the Holy Land is growing steadily. However, the fact that the land is not valid for any transfer will render the structure of Sukuk Ijarah impossible. This is because Sukuk Ijarah would require the originator or party that requires the funding to sell his asset to the investors who are the Sukuk Ijarah investors. The fact that this land could not be sold to other foreign investors would make Sukuk Ijarah, which is based on sale followed by lease, not legally valid. In the event that Sukuk Ijarah was used, investors may lose their beneficial interest on the land and the property on it as the sale may be deemed invalid. Other possible Sukuk structures include Sukuk Mudarabah and Sukuk Musharakah. In this case, the investors will be exposed to all the risks related to project financing. Upon completion, the properties may be sold to nationals or leased. Neither scenario will satisfy the project management companys intention of global representation and ownership. It is against this background that Sukuk Intifa (certificates of investment in the Usufruct) may be proposed not only to finance this project but also to meet the developers visionary outlook of a property owned and subscribed to by a global Muslim population. AAOIFI Shariah Standard No 17 allows the securitisation of both existing and future Usufruct. The above scenario relates to the securitisation of future Usufruct. Under this structure, the issuer will issue certificates of investment, or Sukuk, to interested investors to purchase the right to stay in the apartments and hotels when they are ready. The proceeds of this subscription, SR 1 billion, will be used by the project company to develop this project. Upon completion, the Sukuk Intifa holders will have the right to stay a few nights a year in that property as prescribed in the Sukuk Investment Prospectus. Sukuk holders will also appoint the project management company as the operator to maintain and manage the property for a fee under a Wakalah agreement. Should the Sukuk holders wish to sub-lease their right to the Usufruct, they may do so to another visitor for a rental that is normally based on market value. If the Sukuk holders need to liquidate their investment certificate, they may dispose of this investment certificate in the market. This Sukuk structure is able to meet the financing requirements of this project and is also able to meet the legal framework and constraints of the project. Alternatively, this could also be called the Islamic securitisation of time sharing.
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6.3 Supporting contracts for Islamic project financing

There are a few contracts and arrangements supporting project financing from the Shariah perspective that may not necessarily satisfy the textbook description of project finance. These include the contracts and arrangements below.
6.3.1 Equity-based financing: Mudarabah and Musharakah

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

The Mudarabah contract structure was used for participation term certificates (PTCs) in Pakistan in the early 1980s. PTCs were introduced to replace interest-based ventures. They are transferable corporate instruments based on the principle of profit sharing where PTC holders have a share in the profit of the company or the project as the case may be. The same logic and behaviour will also apply to Musharakah investment certificates, except that the managing partner in the Musharakah venture must also contribute some capital to the project to entitle him to a share of the profit and to bear losses in proportion to his investment. PTCs may be used as a vehicle to finance the construction of, for example, a hospital to be subsequently leased to the government. This could take the form of a build-lease-operate-transfer where the managing partner of the Mudarabah or Musharakah investors, as the case may be, will use the investment capital to build the hospital and, after completion, lease it to the government for a certain period of time with an option given to the government to purchase it in the future under a put option scheme. Holders of PTCs would benefit from the rental paid by the government and, perhaps, from the capital gains if the property were sold at a higher price. This Mudarabah or Musharakah structure can effectively provide Islamic project financing to the client seeking an Islamic project financing scheme based on equity structure.
Exercise 6.4
Using the case scenario in Islamic finance challenge 6.2, could the Mudarabah or Musharakah contract be used to finance the construction of a gas pipeline? Explain whether the same contract can be used to finance items a, b and d of that scenario?
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Given the above discussion regarding the possibility of using both Mudarabah and Musharakah contracts in Islamic project financing, explain whether Mudarabah or Musharakah are suitable for project financing as dictated by its typical features of cash flow orientation and project asset-based collateral.
Solution
Technically, both contracts dictate that the project management company as the managing partner shares the profit that is generated solely from the cash flow of the project. This is very similar to any typical equity investment by investors in a project management company. However, in the case of default, investors providing capital under either Mudarabah or Musharakah contract will rank second to other creditors who provide financing based on Islamic debt-based financing such as Istisna, Ijarah or Murabahah. In this respect, investors assume not only the typical project risks but also the investment rate of return risk. From a financial structuring perspective, the agreed profit-sharing ratio needs to be higher than the margin of profit given to financing providers using debt-based transactions. Another relevant issue is related to the enforcement of collateral in such an equity-based structure. As established earlier, equity-based contracts do not have the feature of either principal guarantee or profit guarantee. There is no concept of indebtedness in equity-based contracts and, therefore, the use of collateral may not be relevant to protect the interest of the equity financiers. Shortfall of any expected profit will not trigger the default clause. The investors in this structure are vulnerable to capital loss if the project was to suffer a great loss. To mitigate the risk of moral hazards to the project management company, the document pertaining to these contracts should have a relevant clause on the negligence, misconduct or breach of the terms and conditions by the project management company. Such a clause would mean that the collateral may be used to redeem the investment capital only. This is a permissible clause and practice since it is a guard against the negligence or misconduct of the project management company.
6.3.3 Convertible Mudarabah and Musharakah

Islamic project financing may also consider raising funds through Mudarabah and Musharakah contracts with an option given to equity financiers to convert their investment capital into shares of the project management company or the parent company. This convertibility feature gives some flexibility to the equity financier to either opt for the profit sharing generated from the project itself or convert their investment into shares of the project management company, or the parent company if the prospect of the profitability at the company level is higher than the expected profit at the project level. The formula of the conversion should be agreed in advance to avoid any dispute. This allows the investors flexibility as they may choose between a profit-sharing ratio and a stake in the sponsors company. Financing using both Mudarabah and Musharakah may be structured as a banking product provided by Islamic banks or a capital market product using the vehicle of Sukuk.
6.3.4 Quasi-equity financing

Risk involves exposure to loss due to an uncertain outcome and is fundamentally a non-prohibitive outcome under the purview of the Shariah. In the Islamic financial industry, risk is inevitable in all Islamic financial transactions. The wholesale adoption of risk within the Islamic finance sphere is further evidenced by the maxim that there can be no return from a position of zero risk. A total equity structure may not be appealing to some Islamic investors as exposure to loss is a central feature of normal equity financing. Quasi-equity financing (QEF) addresses the need for a financing vehicle that provides for flexibility, capital protection and, at the same time, addresses various economic cycles. QEF relies on the security of cash flows and requires a detailed awareness, identification, assessment and qualification of all business and financial risks. QEF can be traded in the capital market at a capital gain as it is linked to the issuers profitability performance. QEF represents a different class of equity as compared with preference shares as it excludes any cumulative right to receive return or any preferential treatment over and above ordinary shareholders. Preference shares are not compliant to Shariah principles as they hold a priority to
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returns or dividends pay-out over ordinary shareholders. During the financing stage, QEF investors have a profit-sharing claim over the returns of the venture that ends after the invested capital is redeemed or when the QEF is converted into equity. QEF allows investors to accumulate losses until the venture is able to fully redeem the capital. The accumulation of loss means that the financing is not deemed to be in default, although the issuer is not financially able to generate the expected return or redeem the investment capital. The financing period will be further extended should the investors feel that they are not able to absorb the loss within the original financing tenure. It equates the position of QEF holders to equity holders given the same business risk absorbed by both parties, primarily profit and loss sharing. This suits the nature of long-term project financing as the investors may redeem their capital plus profit at a certain time or they may defer the redemption of the capital in the case of loss until the venture is able to provide profit. It has the element of debt-based financing with regards to the agreed time of capital redemption in the case of profit, as well as an element of equity in the case of loss. QEF addresses the need for a financing vehicle that provides flexibility and, at the same time, the various economic cycles. QEF can be traded in the capital market at a capital gain as it is linked to the issuers profitability performance. This can fuel and enhance the size of the capital markets where 100% of companies (equity and debt) could be traded at attractive returns. QEF allows an investor to gauge first hand the operations and capabilities of the investee company prior to investing in the investees equity. This is a very important factor in todays volatile markets as it is linked to the issuers profitability performance with cash returns and redemption features. As a financing option, QEF does not cause concern to an otherwise sound and profitable company during volatile times. It provides financial stability that enhances the continuity of companies in bad times. QEF is a financing mode that can potentially enhance a banks profitability in good times with stronger debt recovery prospects in bad times. QEF may offer Shariah-compliant financing relative to conventional preference shares as well as senior debt. Although in the case of liquidation it will rank pari passu (on equal footing) to other equity holders, it will rank alongside debt due to its specified payment or redemption schedule. Thus, QEF investors will be paid their share of profit prior to the profit distribution to shareholders of the project management company.
Key point
Project financing via equity-based contracts can be based on Mudarabah or Musharakah, with or without the convertibility option, as well as on quasi-equity financing with both a convertibility option and a loss accumulation feature.
6.3.5 Murabahah working capital financing

Islamic financiers may finance part of the project using either a Murabahah structure for asset financing or a Murabahah commodity structure for cash financing. While the first structure purchases raw materials and equipment at cost and subsequently sells them to the project company at cost plus profit, the second structure facilitates cash financing. Both of these structures assist the developer in getting either the necessary raw materials on credit or in providing a cash facility to cover any liquid expenses such as salaries or fees. More information about the generic Murabahah financing structure can be found in CDIF/2/5/100.
6.4 Risk exposures for varying contracts using different financing project arrangements and entities
Risk identification and allocation is central to any project finance. Risk management lies at the heart of project financing. Unlike other asset financing, a project being developed is vulnerable to a number of technical, environmental, economic and political risks. The risk associated with project finance, the method of controlling it and the party accepting the risk are shown in the following table:
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Table 6.1 Matrix of project finance risk

Risk category Risk to be controlled Method of controlling Fixed-price contract Completion guarantee/standby funding Proven technology Insurance Operation Targeted plant performance Performance guarantee Engineers review Turnkey contract* Supply Resource costs increase Availability of raw material input Price fluctuation of raw material supply Supply contract Contingency reserves Commodity hedging Analyse future availability of raw materials, reserves, future demand etc. Market offtake Demand/price falls for project output Competition International Currency and financing rate volatility Political risk Currency hedging Political risk insurance Composition of project consortium * Turnkey contacts involve a project being constructed by a developer and sold or turned over to a buyer in a ready to use condition. There are three basic tenets in dealing with risk in project finance: risk identification and analysis risk allocation risk management. Financiers Market control Fixed price contract Financiers Financiers Financiers Party normally accepting the risk in financing Contractor/equipment supplier Sponsors Financiers Insurance company
Construction
Cost overruns Completion delay Technology Force Majeure
6.4.1 Risk identification and analysis

Normally the project sponsors will prepare a feasibility study that will be reviewed by the financiers who may engage independent expert consultants to verify and vet all the potential risks. Issues that are relevant at this stage are whether the costs of the project have been properly assessed and whether the cash flow streams for the project have been properly calculated. Some risks are analysed using financial models to determine the projects cash flow and the ability of the project to meet the repayment schedules. Different scenarios are examined by adjusting economic variables such as inflation, interest rate or cost of funds, exchange rates when foreign currency transactions are involved and prices for the inputs and outputs of the project. Such issues will be discussed in more detail in chapter twelve.
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6.4.2 Risk allocation

After ascertaining the various risks and impact of these risks on the project and relevant stakeholders, the risks are allocated by the parties through the negotiation of the contractual framework. Risk allocation is the process of identifying, delineating and apportioning risks among various project participants with conflicting interest. Ideally, a risk should be allocated to the party that is the most appropriate to bear it, that is the party in the best position to manage, control and insure against it, and with the financial capacity to bear it.
6.4.3 Risk management

All the risks identified and allocated must be managed to minimise the possibility of the risk occurring and to minimise its impact if it does. Since financiers take relatively greater risks in any project, they need to get more disclosure and control over the project. This may involve the financiers monitoring the project closely if they are not directly involved. They may also impose strict reporting obligations on the project company and have control over the projects accounts. Various mitigating measures for relevant risks will be discussed in the next section.
Key point
Risk in project financing involves risk identification, risk allocation to the appropriate parties and participants and risk management using acceptable risk management tools. The following table summarises the key risk elements in project financing, their likely impact, the party most likely to assume the risk and the tools to mitigate this risk either in pre-completion or post-completion risk.
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Table 6.2 Pre-completion risk

Issue Project is not completed on time Impact Incremental project cost due to increased capitalised financing fees and fixed costs Loss of revenue Damages payable to off-taker Project is not completed within budget Higher project cost leading to potential cash flow shortfall to complete the project EPC contractors on turnkey basis Party to assume risk EPC contractors on a turnkey basis Mitigation Sufficient budgeted contingencies for increased cost Adequate construction all risks and delay start-up insurance cover Sufficient delay liquidated damages payable by EPC contractors World reputable EPC contractors. Adequate cost contingencies and cost overrun facilities EPC are on fixed price, lump sum and date certain basis Project fails to meet operational specifications Higher operating expenses EPC contractors Sufficient performance liquidated damages payable by the EPC contractors Parent technology World-reputable EPC contractors Sufficient warranties from equipment suppliers Interconnecting or auxiliary facilities fail to be completed on schedule Failure to obtain necessary permits on time for the implementation of the project Loss of revenue The project cannot be tested to ascertain project completion Party responsible for the construction of the interconnecting or auxiliary facilities In the event that the party responsible for these facilities is the off-taker, it will be deemed complete and revenue payment will commence
Project fails to complete on time and within budget Higher project cost
Before financial closing sponsor Post-financial closing EPC contractors/ shareholders/ project financiers
In most cases, project financiers would require that all material permits and licenses are obtained prior to initial disbursement The sponsors extensive network and legal counsel are critical in securing all the permits required Budgeted project contingencies and cost overruns
Force majeure affecting the project
Project fails to complete on time and within budget Higher project costs Physical damage to the project
Project insurers
Comprehensive project insurable package
Political force majeure affecting the project
Loss/delay of revenues
Political risk insurer
Secure political risk insurance Credible track record of host government
Sponsor risk
Sponsor does not have the resources to perform their obligations that could cause construction delays, project abandonment or cost overruns Sponsor may not have adequate resources to satisfy its financial obligations
Sponsor
Reputable sponsors with proven track record Credit enhancement of the sponsors equity contribution Upfront equity injection prior to initial disbursement
Financing risk
Financing rate volatility may lead to cost overruns Lack of financing to complete the project
Shareholders/ financiers
Adequate financial hedging programme Committed equity and senior debt Adequate project contingency and excess cost overruns by sponsors
Foreign exchange risk
Currency movement could increase the total project cost for EPC
EPC contractor
Matching of currency between EPC contract(s) and financing Financial hedging instruments
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Table 6.3 Post-completion risk

Issue Feedstock supply risk Impact Project will be restricted from normal operation due to lack of feedstock supply. Incremental cost in sourcing alternate feedstock Incremental cost in adjusting project to take in different feedstock supply Reduced project cash flow. Technology/ operation risk Non-fulfilment of obligations under off-take agreement Revenue loss Higher operation and maintenance expenses Inability to secure parts from third-party supplier due to propriety technology Market risk Lack of demand that could lead to reduced revenues Equipment/ technology supplier while warranty is valid; thereafter shareholders/ financiers Market recognised proven technology Extended supplier warranty Adequate insurance programme Party to bear Financiers Mitigation Primary feedstock readily available and tradable Back-up supply of feedstock
Tradable commodities Detailed market studies by independent market consultants Secure long-term offtake contract
Off-taker/ counterparty risks Regulatory risk arising from change in law
Off-taker unable to meet its financial obligations causing cash flow impact Higher operation and maintenance cost Lower project returns
Extensive due diligence on the financial position of the off-taker Risk-sharing agreement
Shared between shareholders/ financiers and offtaker (if off-taker is a governmentowned equity) Insurers
Natural force majeure affecting the project
Physical loss or reduction of revenues Higher cost
Comprehensive insurance programme to cover all physical loss from the project and loss of revenues Off-taker remains liable for payment of products not taken
Natural force majeure affecting offtaker (usually state entity) Foreign exchange risk Political force majeure affecting the project offtaker
Off-taker unable to uplift product from the project
Off-taker
Increase in plant operation expenses Loss or reduction of revenues
Hedging counterparty Political risk insurers
Financial hedging programme Adequate political risk insurance
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The above summary is not meant to be exhaustive. An example of a specific situation is in airport project financing. The typical risks associated with building a new airport are related to traffic issues such as landing fees, airline commitments and conflict between main and secondary airports. They are also related to political issues such as competition between airports and national and provincial class, or environmental and operating issues such as an inexperienced operator.

Your employers, an Islamic financing company, are required to finance the construction of a new highway. This new highway is to link a countrys main port to the capital city to ease traffic on existing government roads. The new operators will be allowed to charge vehicles a toll for using the highway and this concession is valid for 10 years. Before deciding the most suitable contract to finance the construction, as a risk manager you have been requested to outline the various risks that may affect its viability. Outline these risks and explain how they may affect the cash flow of the project.
Solution
Of critical consideration is the quality of future traffic flow. This requires appropriate and independent traffic studies from reputable consultants. It should be noted that the existing free highway next to the tolled road may reduce future traffic using the new highway. This also relates to a possible tariff escalation in the future that will depend on whether the government will be willing to compensate the project company should the collected toll fall short of the expected volume. Indirectly, this leads to a political risk as the intervention of the government to help the project company may be seen as a bail out. Equally critical is the infrastructure risk of whether the rights to interchanges and rights of ways can be easily awarded by the relevant agencies. A lack of interconnection or interchanges will render the new highway unviable. The challenges in operating a project are always relevant in project financing that involves technical and maintenance costs. The global economic situation may also affect the level of traffic as the new highway will be largely dedicated to the transport of imported and exported goods. Fundamentally, the viability of any project financing scheme will always be based on accurate cash flow projections. The above discussion should impress upon you that Islamic project financing schemes must be equally concerned with the risks involved as well as Shariah compliance concerns.
6. 5 An illustration of a project financing model using multiple Shariah contracts and their relevant project risks
The following example has been created to illustrate the various options open to those seeking finance for large projects. Many of the issues outlined will be further expanded in subsequent chapters. The government of a developing country awards a concession to a power plant company, Global Light, which is based overseas. The company has been operating for the past 20 years in the design, building and maintenance of power plants in its home country as well as overseas. The company has a few complete power plants in its home country that are generating power for the power purchaser and ultimately for the public at large. The market value of these power plants is only US$300 million. The government, which is the concession awarder, agrees to assign land for the company to build the power plant on, thus reducing the cost of land purchase. However, the government stipulates in the concession agreement that, after 30 years of operation, the power plants and land must return to the government for no consideration. The government signs an offtake agreement as well, which means that it will undertake to purchase the output of this power plant at a certain agreed price upon its production. To facilitate fund raising for this project, the company (concessionaire) establishes a limited liability company known as Global Power to own and operate the project. The equity holders of this project company are both the concessionaire (80% equity) and several other electricity companies in the host country (20% equity). There are several Islamic and conventional financial institutions that are willing to provide Islamic financing and conventional loans respectively through syndicated financing, combining both Islamic and conventional facilities. The lead
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arranger of this syndicated financing is the Infra Bank, which is a conventional international bank. The IFIs agree among themselves to finance this project using Islamic financing concepts. The funds allocated to the Islamic finance tranche are US$1 billion, while the remaining US$1 billion will be made through loans by a syndicated group of conventional banks. All financing by both Islamic and conventional banks will be secured by a combination of the cash flows from the operation of the project and the assets comprising the project and other assets owned or held by the project company pursuant to assignment agreements. The primary categories of assets of the project company include various contracts (including feedstock or raw materials for industrial process and other input and off-take agreements), other real property rights and interests, approvals and licences, intellectual property rights (including technology rights and licences), cash, bank accounts, accounts receivable, immovable, the assets comprising the project itself, computers, office equipment, and other personal property. One of the options for Islamic financing is Murabahah working capital financing to finance the acquisition of the raw material and equipment on credit sale or to facilitate cash financing to the project company. Islamic financiers may agree to finance an amount of US$100 million to be pro-rated or otherwise among all the financiers using this structure. Also, given the fact that this project company has a few complete power plants, the project company decides, based on the advice of the finance adviser, to issue Sukuk Ijarah worth US$300 million using the structure of sale and lease back. Under this structure, the project company as the originator may give an undertaking to repurchase the leased assets at a price equivalent to the outstanding amount of the Sukuk at the point of default by the originator, thus proving a good rating for this Sukuk. This is also compliant with the recent pronouncement of AAOIFI on Sukuk (refer to section 9.2 of chapter nine). Following this Sukuk structure, the project company is not being financed directly by the Islamic banks but from capital market investors. Islamic banks and other investors may subscribe to this Sukuk to finance the cost of construction of this power plant. Alternatively, the project company may enter into an Istisna contract with the syndicated Islamic financiers, followed by a forward-lease contract to facilitate the project financing using the Shariah-based construction contract. The use of the Istisna and forward-lease structure may complete the total funding required to undertake an Islamic finance tranche for this project. In other words, these three contracts can be collectively structured into a US$1 billion Islamic project financing. The project company or the syndicated Islamic financiers, as the case may be, may instead opt for just one financing structure for the US$1 billion facility. This is a commercial decision of both the project company and the financiers. In addition, the project company may raise funds from Islamic investors through either a Mudarabah or Musharakah contract. This could be a total investment by only Islamic investors or a combination of both Islamic investors and non-Islamic funds, or a conventional loan as the case may be. The investors may invest directly in the project managed by the project company or in the SPC, whereby the Islamic investors delegate the investment and management of the SPCs fund/assets to the project company. The issue of a combination of Islamic funds and a conventional loan in the SPC will be discussed in chapter eight. The project company will use the funds to purchase the land and undertake the development of the project. The project company may construct the project itself or may enter into an Istisna contract with another construction company. The project company will sell the developed land to the ultimate purchasers. The proceeds from the sale of the land will be shared among the various investors proportionately. At the level of the project company, Islamic financiers may invest as equity providers under either a Mudarabah contract, a Musharakah contract or through quasi-equity financing. Alternatively, an asset management company may set up an Islamic infrastructure fund to raise the funds by issuing shares or units to corporate and public investors in the form of mutual funds. All these structures are possible from the Shariah perspective. The challenges arising from this equitybased structure are related to the fact that the project company may have to arrange loans amounting to US$1 billion with interest via conventional banks. Islamic investors in the project company, either as direct investors or through Islamic funds, are not supposed to deal with an interest-based loan. The situation would be different if the total financing provided to the project company was made up entirely of Shariah-compliant financing instruments.
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The above scenario has illustrated how many Shariah-compliant financing modes could be used either to finance the project company or to invest in the project company itself as the equity investor. Also, in providing this financing in various forms, Islamic financiers must take into consideration relevant project risks that are associated at every phase of the project, pre- and post-completion. Some of these risk management tools, such as currency hedging, will be discussed in forthcoming chapters. Islamic insurance or Takaful will also be considered to provide the indemnity where relevant.

During the global economic crisis of 2008/2009, many public infrastructure projects were delayed or cancelled because of either the lack of liquidity of financial institutions or a lack of confidence among the investors, both institutional and public. However, new projects such as schools, universities, hospitals, bridges, highways and power plants are always central to the growth of a country, as well as to the needs of the public at large. At the time, many governments announced stimulus packages to revive their economies through public spending on infrastructure projects. The support of the private sector, such as banks, insurance companies and other mutual funds, was equally important to complement the governments efforts to stimulate their economies through the development of the infrastructure sector of their countries. Having put these initiatives in place, infrastructure project financing may remain insignificant because of the greater risks that the financiers have to assume. Risks may include project risks, as well as the risk of mismatching the assets and liabilities of the financiers as the deposit is short-term while project financing is medium to long-term. Given the benefit of hindsight, suggest what the major problem was behind the economic crisis of 2009 and outline a possible solution that could be useful to both financiers and government.
Solution
While there may be many answers to this question, you should cover many of the key issues in the following solution. One of the lessons learnt from the global crisis of 2008/2009 was the over-reliance on leveraged or excessive borrowing. Although Islamic debt financing instruments, such as Murabahah, Istisna and Ijarah, are compliant, their excessive use may render the project being financed in default if there is any delay of the completion to affect the cash flow of the project. Given this background, more exposure to equity financing or investment would be appreciated. Therefore, the sponsors of the project should be able to provide a higher amount of equity to the project management company. Also, funding for the project management company may be a combination of both debt and equity-based instruments. However, Islamic financiers and investors tend to be reluctant to commit to higher equity financing as the risks are too great. To resolve this issue, a new financing structure may be needed to give some comfort to all stakeholders in this project financing. One of the proposals may be to invite all potential financiers to be shareholders in the project management company for a certain project. Obviously, an off-take agreement by the government or any government-linked company will further enhance the future marketability of the product, thus significantly reducing market risk. Following that, all potential financiers and investors, including the government, would provide proportional financing to the project. The project management company, which is owned by all the shareholders/sponsors, would be responsible for managing the construction according to agreed specifications and milestones. Irrespective of the mode of financing, this mutual shareholding and financing would create a sense of collective responsibility and monitoring for the benefit of all. Any form of government guarantee is also a credit enhancement to the financiers. This would effectively instil confidence among investors and financiers in a very commercial manner without burdening the government and its public expenditure. Normally, the government would prefer to transfer project risks and costs to the private sector from the very beginning. However, in this instance, the government would be expected to take some of the cost and risk to stimulate private-sector financing. In short, project financing may take the form of private equity, instead of being a pure banking and capital market product, as all investors are general as well as limited partners, as widely applied in any private equity fund structure.
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Key point
Islamic project financing can offer a variety of schemes of financing to meet the needs of relevant scenarios and their inherent risks.
6.6 Sharing of collateral in syndicated financing

One issue that needs to be highlighted is the position of the charge over project assets, as the charge is being shared between Islamic and conventional financiers. In practice, all the project assets, as described above, are essentially held for the interest of all the conventional lenders and Islamic financiers. We need to consider whether the sharing of the charge among Islamic financiers and conventional lenders would be compliant. Islamic finance allows for a syndication of financiers of both conventional and IFIs in providing the funding for a project. Modes of financing by IFIs will be compliant even though the financing amount is applied to the same project or parts of the project where conventional financing is also applied. The obligation of the project management company to pay all the financial obligations is normally secured by the project assets. The concept of collateral is known as Rahn in Islamic commercial law. Rahn implies that a debtor/pledgor will pledge his assets in favour of his creditor/ pledgee to secure the payment of all the debtors obligations. In the case of default, the creditor/ pledgee is entitled to sell the pledged asset to the market upon obtaining the necessary approval from the court or related agencies. In Islamic commercial law, a pledge will give priority to the pledgee with respect to sale proceeds over other creditors. Assuming that all the conventional lenders and Islamic financiers have the same charge over the project assets, then there is no preference of one group of financiers over the other based on the principle of pari passu whereby each and every creditor/lender in providing the financing will rank equal to each other and have a pro rata share in the proceeds of the sale of these assets. However, if Islamic financiers have agreed to take the second charge/pledge, they will only be entitled to claim from any outstanding proceeds of the sale of the pledged asset after satisfying all the financial obligations of the first-party chargees, who would be the conventional lenders. In brief, Islamic commercial law allows both pari passu as well as different rankings of charge.
Key point
Collateral in syndicated financing can be shared between Islamic financiers and conventional lenders either on a pari passu basis or on a different ranking.
6.7 Conclusion
You should realise from having read this chapter that project financing is an important asset class in Islamic finance. Within Islamic project financing, financers become directly integrated into real-life, business-generating economic activities. Project financing also sits well with the objective of the Shariah which is to promulgate business development and risk taking. Individual project financing arrangements allow for the use of various sources of funding ranging from syndicated Islamic financing to Sukuk. Key to this is the requirement that the business-generating assets that are financed in this way must be Shariah compliant and will generate Shariah compliant cash flow streams. The chapter also showed that Islamic project financing deals must be large enough to be successful in attracting additional capital participation. However, the inclusion of multiple financing sources adds structural complexity to an already complex financing structure. As such, transparency of the financing structure and proper legal documentation, in addition to adequate regulatory oversight, are key considerations in structuring any project financing deal. We explained that at the launch of the project financing deal, the income generating asset does not exist and as such the financiers are potentially exposed to additional risk during the development phase. This, and the quality of the financed asset, are issues that have historically plagued Islamic
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project financing. This may be why Islamic project financing deals are often limited to sovereign backed infrastructure projects or those backed by established corporations. We suggest that the industry needs to identify different and innovative Shariah-compliant ways to manage the risks undertaken by financiers or investors if they wish to improve the uptake of Islamic project financing.
6.8 Summary
Having read this chapter the main points you should understand are as follows: project financing funds long-term infrastructure and development projects through loans secured on project assets which are repaid entirely from the project cash flows the source of payments in Islamic project financing is the financial revenue derived from the subsequent project cash flows, while the collateral in non-recourse loan/financing, in the case of default, is generally limited to the projects assets unlike Parallel Istisna, Istisna combined with forward-lease arrangements suits the practice of project financing and has been widely accepted by the Islamic finance industry the consideration for an Istisna purchase could be in the form of cash, tangible goods or the usufruct of an asset for a fixed future period; the usufruct could be derived from any asset or from the asset under construction project financing via equity-based contracts could be based on Mudarabah or Musharakah, with or without a convertibility option, or by quasi-equity financing with both a convertibility option and a loss accumulation feature risk in project financing involves risk identification, risk allocation to the appropriate parties and participant and risk management using acceptable risk management tools Islamic project financing allows for the participation of various sources of funding ranging from bank financing, syndicated financing or Sukuk.

Islamic project financing Solid Engineering Co. (SECO) is a real estate developer. It wishes to develop and construct multilevel residential apartments on a piece of land that they have on lease for 100 years. This project is known as Residential AAA. Prior to the construction, SECO signs a sale and purchase agreement with 1,000 purchasers for 1,000 apartment units. Under the agreement, these units are to be delivered to the end purchasers after 24 months from the date of the agreement. To facilitate the cost of construction, a financial adviser arranges a number of Islamic financial facilities comprising both equity and debt-based financing. A number of Islamic infrastructure funds commit to placing the equity investment in the project under Musharakah financing. This facility entitles the investors to convert their certificates of investment to shares of SECO if they so wish. SECO also forms a limited liability SPC, known as Solid Construction Inc (SCI), to get the financing from a few Islamic financiers. SECO is still in the process of getting approval from the Environmental Department as the land is part of a hill where construction may result in some environmental damage. Approval by other relevant agencies to construct these residential apartments is pending the approval of the Environmental Department. The Islamic financiers decide to finance the construction cost using an Istisna contract and a forward-lease arrangement. To secure the interest of Islamic financiers, all the project assets, including the sale and purchase agreement, will be treated as collateral with the Islamic financier having priority over equity financiers. With regards to the forward lease, the rental payment will be floating based on an agreed benchmark. There will be a put option agreement allowing Islamic financiers/owners to force SCI to purchase units of the apartments at a price equivalent to any outstanding financing amount. This agreement is useful in the case of a default by SCI in the payment of rent. Also, there will be a call option agreement allowing SCI to purchase the apartments from the Islamic financiers at a certain agreed price. Islamic financiers will appoint SCI to manage these residential apartments for a pre-arranged management fee. To mitigate the environmental risk, Islamic and equity financiers require that SCI invest in an insurance scheme to cover all possible penalties that may be caused by not adhering to some aspects of the environmental regulations.
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1. When financing a project, which of the following is not compliant with Shariah principles? (A) (B) (C) (D) 2. Parallel Istisna between the contractor and the financier Sale and lease-back arrangement Quasi-equity financing with a loss accumulation feature Murabahah working capital requirement financing
What are the most relevant risks involved in the above project financing? (A) (B) (C) (D) Construction and market risks Political and technology risks Environmental and construction risks Supply and market risks
3.
A back-to-back Istisna arrangement, although compliant with Shariah principles, is deemed impractical and not useful in modern project financing. How could this arrangement be used to facilitate smooth project financing from the financiers perspective? (A) (B) (C) (D) By using Built-operate-transfer (BOT) By awarding the construction contract to a consortium of Islamic financiers By including project financing with the off-take agreement By ensuring that the contractor is also the operator when the asset is complete
4.
Identify the differences between an Istisna forward-lease arrangement and a sale and lease-back arrangement in Islamic project financing. (A) (B) (C) (D) While an Istisna forward-lease arrangement applies to assets under construction, a sale and lease-back arrangement applies only to the refinancing of the asset. While an Istisna forward-lease allows fixed and floating rental payments, sale and leaseback only allows a fixed rental payment. While an Istisna forward-lease arrangement appeals more to short-term financiers, sale and lease-back appeals more to medium and long-term financiers. While an Istisna forward-lease arrangement is universally acceptable, sale and leaseback is only acceptable by some Shariah boards.
5.
Given the scenario that the financing amount was sourced in US$, but that the payment of capital/principal and profits would either be under equity financing or that debt-based financing was to be in United Arab Emirates Dirham (AED), risk could be hedged by: (A) (B) (C) (D) comprehensive insurance policy and the quality of the sponsors currency hedging and the fixed price of EPC fixing the cost of financing and comprehensive insurance policy guarantee from the sponsors and currency swap.
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1. Given the schematic flow of the above transactions, outline any major Shariah issue that would need to be addressed and explain how these issues could be ratified to make it compatible to Shariah principles? Propose other potential financial structures that could facilitate the financing of the cost of the construction of the project outlined. Instead of obtaining only Shariah-compliant financing instruments to finance the construction of these residential apartments, SCI could decide to operate a syndicated financing scheme combining both conventional lenders and Islamic financiers. If it goes ahead with this, what would be the immediate impact on the above transactions and how could this be addressed from a Shariah structuring point of view? In the case where there is no sale and purchase agreement signed between SEO and the ultimate purchasers, what tools could be proposed to mitigate this market risk as far as the financiers are concerned? Assuming that the project to be constructed is a new power plant using solar energy and that the financiers to this project insist on providing capital market products only, how would you propose to structure the financing scheme for SCI?
2. 3.
4.
5.
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Chapter six answers

Exercise 6.1
(C) The issue that may be questionable from the Shariah perspective is the supply of funding from syndicated financiers. The issue here is that the form of financing could be through either an interest-based loan from a commercial bank or a bond with the obligation of the issuer to pay back the principal and interest. The other features, such as the off-take agreement, the nature of collateral and the SPC are neutral to Shariah considerations.
Exercise 6.2
Although the above structure meets all the technical features of a modern project financing scheme, it does not effectively serve the financial requirements of the contractor. The relationship between the awarding party, the building contractor and the financiers, however, is not as per the scheme. Conventionally, the awarding party finds a building contractor who then seeks finance to complete the project. Under Parallel Istisna, the awarding party approaches the financier who then seeks out a building contractor to develop and deliver the required hospital to the financier prior to its ultimate delivery to the awarding party. Using the above illustration of Parallel Istisna, it is clear that the Islamic financier will not finance the contractor or concessionaire on the construction cost of this hospital, except in the case where the government or any other awarding party has initially requested the Islamic financier to construct and deliver the same hospital to the awarding party; that is a back-to-back Istisna arrangement. In practice, this seldom happens as the awarding parties, such as government agencies, always award the construction contract to a developer which will then seek financing from a financier, be it a conventional or Islamic financier. The awarding party will not approach the financier for this project financing.
Exercise 6.3
Relatively speaking, Sukuk Ijarah seems most attractive as the originator would be awarded a piece of land that can be used as the underlying asset for the sale-and-lease-back arrangement. The land may be sold to Sukuk investors at a price that is required by the originator to develop the medical city. Suppose that the required cost of construction is US$700 million, then the land can be sold to the investors at US$700 million. The same piece of land may then be leased to the originator at the floating rental, based on the rate of a certain agreed benchmark that is pegged to the US$700 million financing amount. Depending on the Shariah arguments of the issuers and investors Shariah board, the land, which is essentially bare but earmarked for the future project, may be sold at any price based on the willing seller/willing buyer principle. Also, the same bare land may be leased out for a certain rental payment. Some scholars may find this objectionable as the price of the land should reflect its market value. Also, some scholars may argue that bare land does not have any usufruct to be leased out, thus rendering this land an invalidly leased asset. However, this kind of Sukuk has been issued by the Qatar government. The government has given the undertaking to repurchase the lease asset at a price that is equivalent to the outstanding amount of Sukuk in the case of default. This structure is also compliant with the 2008 AAOIFI pronouncement on Sukuk.
Exercise 6.4
Unlike an Istisna or Ijarah contract, Mudarabah or Musharakah are more flexible as they can be used to finance the construction of an asset, as well as finance working capital requirements. As explained, project finance requires the involvement of many participants, such as construction or engineering consultants, as well as environmental impact assessment consultants. The fees payable to these consultants may be financed using Mudarabah or Musharakah investment capital. The Mudarabah and Musharakah contracts are, therefore, useful in financing all aspects of project financing, including items a-d of the above scenario.
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1 (A) For a Parallel Istisna to be Shariah-compliant, it has to consist of two Istisna contracts undertaken by three different parties. The first Istisna is contracted between the purchaser and the financier, while the second is contracted between the financier and the contractor. Parallel Istisna between two parties (that is financier and contractor only) is noncompliant. (C) The project involves construction on land that is part of a hill. The construction may result in some environmental damage to society. (B) To facilitate the Istisna scheme, Islamic financiers must be awarded the Istisna contract first from the purchasers. These financiers can then award the subsequent Istisna contract to the contractor for construction purposes.
2 3
(A) By definition, Istisna is applied when the asset needs to be constructed, while a sale requires the asset to be in existence at the time of the sale. Pricing through fixed or floating benchmarked rates does not define the contracts and the contracts can be applied for either short or long-term financing. (B) Shariah-compliant currency hedging mechanisms have been established and the processes would have to strictly comply with guidelines such as spot currency transactions. Fixing the EPC cost through currency hedging is important to ensure that EPC costs do not carry the volatility of the currency markets.

1. One potential major Shariah issue is that the residential apartments were sold to the ultimate purchasers before the project financing based on Istisna and forward-lease was signed. This will create an anomaly in a Shariah juristic discussion because under the Istisna contract concluded between SCI and the Islamic financiers, the owner of these units, after their completion, will be the Islamic financiers/purchasers of the Istisna asset. Subsequent to that contract, the Islamic financier will lease the assets under construction to SCI and will expect SCI to pay the rental for this forward lease. For all intents and purposes, prior to selling the units to the ultimate purchasers after 24 months of the sale and purchase agreement, SCI shall ensure that it has actually purchased the units from Islamic financiers under the call option agreement. The ownership of Islamic financiers will cease and subsequently the lease contract will be terminated. This is to allow SCI to become the legal owner of the units prior to passing the title to the ultimate purchasers. One practical commercial issue is whether SCI is able to make the full lease payment for it to exercise the call option agreement within two years. Obviously, if all the ultimate purchasers have made the full payment to SEO, then it would be easy for SCI to settle the outstanding payment under a lease agreement and invoke a call option agreement. The issue of land that is on lease to SEO/SCI is not relevant from the Shariah perspective as an Istisna asset could be built on the land of the contractor or the purchaser, or on a piece of land belonging to a third party. 2. In addition to equity investment via Islamic funds and the Istisna and forward-lease arrangement, the above project may be financed using the concept of sale and lease-back. Depending on the Shariah view on long-term leases, such as 100 years, the land may be sold to the Islamic financiers with a view to leasing it back to SCI thus providing a financing amount to SCI. The sale and lease-back arrangement has been used in many Islamic finance facilities even on the basis of a long-term lease. Another potential structure would be the Murabahah commodity structure to facilitate cash financing to SCI. Obviously, financing through equity such as Mudarabah and Musharakah is also possible where the market risk is being reduced because of the sale and purchase agreement signed between SCI and the ultimate purchasers. 3. Where financing will be syndicated to both Islamic and conventional financiers, the position of Islamic equity investors may be affected. If Islamic infrastructure fund investors have invested in SCI as the project management company, then SCI is not in a position to borrow conventionally as this goes against Shariah principles because Islamic investors are the owners of the company. However, if Islamic infrastructure fund investors were to invest at the project level with no ownership in SCI, then the Islamic equity investment may co-exist with conventional financing,
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although Islamic investors rank lower than conventional and Islamic debt-based financiers in terms of the right to profit and liquidation. 4. The market risk of this project may be mitigated through options such as a guarantee by a third party or an off-take agreement by the sponsors. Alternatively, financiers may prepare the proposal for securitisation of these properties using an asset-backed transaction to be offered to the countrys mortgage corporation or to an Islamic real estate investment trust (REIT) fund. 5. Constructing a power plant using alternative energy such as solar is more risky than constructing residential units as it involves many risks such as technology and feedstock risk. The margin of profitability will likely be higher in this financing. A potential structure that can be used is Sukuk Ijarah, which is based on sale and lease-back with the underlying asset being the land on a longterm lease. Also, equity-based financing, as well as quasi-equity financing may be useful for this long-term financing. The development of this power plant could be financed using either a private equity fund to invest in SCI or an infrastructure fund. Interestingly, under an Islamic private equity fund, investors may finance SCI through Murabahah, but the right to receivables arising from the Murabahah facility could be converted into the shares of SCI through the principle of Wad or unilateral undertaking by SCI to sell its shares to these investors. This structure will eventually be a capital market instrument as well.
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Chapter seven
Equity market regulations and issues of screening methodology for public-listed companies
Learning outcomes
By the end of this chapter you should be able to: assess the implications of various stock-screening criteria for Islamic-approved equities analyse the impact of specific stock-screening criteria on the acceptability of a particular stock recommend strategies for the inclusion of stock in Shariah-approved stocks and Islamic indices.

Regulatory requirements pertaining to Islamic equity capital markets Factors affecting the inclusion or non-inclusion of stock in Islamic-approved stocks and Islamic indices Comparative stock-screening methodologies and criteria Strategies for making a public-listed stock compliant Case study: Screening of a public-listed company in various market conditions and commercial realities
7.0 Introduction
A natural progression in the growth of the Islamic financial services industry is the emergence of a distinct Islamic equity capital market, where investment activities and products are structured in accordance with Shariah principles. As with the Islamic banking industry, an effective legal, regulatory and supervisory framework is required to provide the essential foundation for the functioning of a modern equity capital market and to ensure that it is adequately regulated. Equity capital market regulation seeks to oversee the interests of listed companies, the provision of investor protection and the maintenance of investor confidence, as well as the need to protect the reputation and integrity of the market as a whole. As stated in CDIF/3/1/21, capital markets perform the function of effectively mobilising funds in any society through a direct financing process. To protect investors, the markets therefore require a high degree of effective governance through monitoring and the production of relevant and material information to all stakeholders. This chapter focuses on equity screening for both public-listed and private limited companies, as well as strategies to convert a public-listed company into a compliant company so that a wider group of investors can become involved. The discussion of mutual funds, private equity funds, various other funds, Sukuk and derivative products, which form part of Islamic capital markets, is included in chapters eight, nine and twelve respectively. In this chapter we explain the regulation of the Islamic capital market with regards to the equity market. Specific focus is given to the importance and acceptability of stock-screening criteria for ascertaining Shariah-approved stocks. We also look at comparative stock-screening criteria, explaining the basis and applicability of such criteria in different financial conditions. The impact of specific criteria on stock-screening is highlighted to explain the inclusion or non-inclusion of a particular stock in the approved lists of stock. Finally, we consider relevant strategies to achieve Shariah-compliance status for stock based on established stock-screening criteria.
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7.1 Islamic capital markets and regulatory requirements

We mentioned in chapter three that capital markets in various jurisdictions are regulated by either their respective central banks or separate regulatory authorities that focus exclusively on capital market regulation. Supervision in Bahrain is undertaken by the Capital Markets Supervision Directorate of the Central Bank of Bahrain and in Singapore by the Capital Markets Department of the Monetary Authority of Singapore. In Malaysia, supervision is achieved through the Malaysian Securities Commission (SC), in the United Arab Emirates via the Securities and Commodities Authority (SCA) of the United Arab Emirates, and in Saudi Arabia via the Capital Market Authority (CMA) of the Kingdom of Saudi Arabia. Often backed by law, a regulatory act or royal decree, the main objective of capital market regulators is to maintain a transparent, fair and efficient capital market to ensure investor protection and market stability. The Islamic capital market is usually a subset of the jurisdictions capital market as a whole and, as such, regulators have to be mindful that the regulations relating to the Islamic sector are as fair and unbiased as possible, while maintaining the objectives that have been set for that countrys capital market.
7.1.1 The structure of a capital market

Typically, a capital market is an amalgam of three distinct individual markets, each of which carries its own lines of products and services, as shown in the diagram below.
Figure 7.1 Typical capital market structure
Capital market
Equities market
Fixed income market
Derivatives market
Supporting the individual markets is a settlement system that ensures the secure handling of transactions in predominantly dematerialised securities (securities that only exist in the form of an entry on an account). This system enables the processing of transactions on both the primary market (on which new securities are issued) and the secondary market (on which financial instruments already in circulation are exchanged). The system ensures the settlement of transactions based on instructions sent by the two counterparties to the transaction (dual-notification principle). It also ensures that delivery of, and payment for, the securities occurs simultaneously and irreversibly (delivery against payment principle). The system settles transactions on a gross basis (transaction by transaction).
7.1.2 Using the existing infrastructure

The Islamic capital market in most jurisdictions takes the structure of and utilises existing infrastructure that has already been established for conventional capital markets. Regulators in Bahrain and Malaysia, for example, only prescribe guidelines for the establishment of Islamic funds to invest in Shariah-compliant shares already listed on the countrys stock exchange. From the Shariah perspective, there is no requirement to make the stock exchange compliant as the various Islamic funds screen the stocks listed on the exchange according to their own selected or accepted Shariahapproved screening methodologies.
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The development of various stock-screening methodologies, Islamic indices and various forms of Islamic funds are not in conflict with the existing structure of contemporary stock exchanges in many jurisdictions. The structure of the stock exchanges and their rules of listing and trading, as well as other administrative issues, will not affect the compliance of the investment made by various Islamic funds investing in some of the stocks listed in those exchanges. An issue may only arise if the entire stock exchange itself seeks to obtain Shariah-compliance status. This is particularly relevant where the stock exchange has become a public-listed company and has sought to be classified as Shariahapproved where Islamic investors could invest in any of its shares.
Key point
Islamic stock screening, Islamic indices and Islamic equity-based funds may co-exist within existing stock exchange structures as the Shariah screening standard can be applied to the equities listed on the exchange without affecting the very structure of the exchange.
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After a few years of operation, a stock exchange in a given jurisdiction announces that it will be transformed into a full Islamic stock exchange in two years time. At the time of the announcement, almost 70% of its listed companies are not regarded as compliant to Shariah principles, based on an international Shariah standard of stock screening as per AAOIFI Shariah Standard (No 21). Outline the challenges that face the stock exchange in achieving its goal and explain the necessary measures that need to be undertaken to render this exchange fully Shariah-compliant in two years time.
Solution
An exchange is merely a platform to facilitate the issuance and trading of shares in one common place. It is here that companies can float their shares for public participation and where investors can trade their shares systematically in a cost-effective manner. Being a platform, the exchange may list companies that are both compliant and non-compliant with Shariah principles. Many exchanges around the world have adopted this approach, for example the Bahrain Stock Exchange, the Bursa Malaysia, the Singapore Exchange and the Saudi Stock Exchange. As suggested in the challenge, the shareholders of a specific exchange may decide to launch a dedicated Islamic stock exchange or convert an existing exchange into a fully dedicated Islamic exchange. In order to convert the exchange in question, several measures must be put in place. The stock exchange must first establish a Shariah supervisory board to begin work on the prescribed screening guidelines so companies can meet a standard agreeable to the Shariah board of the stock exchange. The Shariah board may adopt any of the established internationally recognised Shariah stock-screening criteria or may devise its own stock-screening criteria. This is to facilitate the acceptance of new companies in future listings so they would be compliant from the date of inception and to guide the conversion of existing listed companies into Shariah compliance. The exchange must decide how to deal with the income generated from non-compliant companies, including any relevant fees payable to the exchange during the two-year conversion period.
Relatively speaking, it is more challenging and demanding to convert an existing exchange into Shariah compliance than to convert a banking or insurance entity. There is always the risk that many companies will not be willing to be listed on this exchange because of this restriction of compliant core activities and financial management, unless they specifically seek Islamic-based investors. If they are of the latter category, they may decide to be listed on this exchange for a better profile and subscription by investors. The latter scenario will also help the exchange to significantly achieve its vision at the same time as it enhances public-listed companies seeking the right branding and profiling among Islamic equity investors. The exchange should assist existing non-compliant companies to make their balance sheet compliant by facilitating or advising them on securing facilities of Islamic leverage, as well as Islamic investment product opportunities. Having said this, the issue of how to convert companies that were essentially set up to undertake commercial activities that are not compliant remains outstanding. The fees earned from non-compliant companies should be channelled to a charity. This can only be done with the agreement of the shareholders of the stock exchange as this policy will render these fees as non-recognised income. Given the objective of the challenge, shareholders would agree to this policy as they have already announced their intention to make the exchange Shariah-complaint.
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7.2 Shariah governance structure in Islamic capital markets

Shariah compliance is the key distinguishing feature of the Islamic equity capital market. In order to be deemed Shariah-compliant, Islamic equity capital market products and services need to undergo a pre-defined vetting and approval process by Shariah advisers. While some jurisdictions have established regulatory requirements for the appointment of Shariah advisory bodies in Islamic banking, there is presently no standardised requirement across jurisdictions governing Islamic capital market activities with respect to the qualifications and appointment of the Shariah advisers.
7.2.1 Self-regulation
As with the Islamic banking regulatory system outlined in chapter three, the Shariah certification process in the Islamic equity capital market is carried out through two different methods. The first is through a market-centred approach whereby the exchange, issuing entities, or the fund management companies have their own in-house independent Shariah advisory bodies that screen and endorse their Islamic equity capital market products and services. This process is driven by private sector-led initiatives and is not mandated by any specific regulatory or policy requirement. This approach can be seen in jurisdictions such as Bahrain, Saudi Arabia, Kuwait, Qatar and the UK. This is also true for internationally recognised Islamic indices such as the Dow Jones Islamic Market (DJIM), the London Stock Exchange (FTSE) Islamic Index, the Morgan Stanley Islamic Index and Standard and Poors (S&P) Islamic Index. These organisations have developed their own respective Islamic indices with the collaboration of their Shariah supervisory boards without any direct control from any agency or regulator.
7.2.2 Centralised regulation

The second regulatory method takes a centralised approach whereby the centralised regulatory authority assesses Shariah compliance and issues the appropriate Shariah certification for Islamic equity capital market products and services under its purview. Authorities for the Dubai Financial Market and the Malaysian Securities Commission have used this approach. The Shariah certification process is undertaken at the exchange or regulators level, wherein the exchange and regulatory authorities have established their own Shariah advisory bodies to formally advise on issues pertaining to Islamic equity capital market products and services. In the case of Malaysia (effective May 2007) the Securities Commission of Malaysia has allowed Bursa Malaysia (in partnership with the FTSE Index) to screen stocks using only the FTSE Islamic Index screening criteria, which are different from the Securities Commissions. The new Islamic index is called the Bursa FTSE Hijrah Index. However, to ensure that there is no direct conflict between these two criteria, the FTSE Islamic Index can only further screen stocks that have been approved by the Securities Commissions screening filter. This is to ensure that stocks approved by the FTSE Islamic Index screening will not contain any stock that is not initially approved by the Securities Commissions screening methodology. Islamic funds, such as those in Malaysia and Bahrain, would also be legally required by regulators to form individual Shariah advisory boards to ensure that their Islamic equity capital market instruments comply with the Shariah standards that have been set by these exchanges and regulators. While the appointment of the Shariah board at the fund level is a standard practice in Islamic asset management, the appointment of a Shariah board at the regulator or the stock exchange level is peculiar to a few regulators and exchanges, for example in the Malaysian and Dubai financial markets.
Exercise 7.1
ABS is a public-listed company listed in Bursa Malaysia. According to its last audited financial report, this company has total assets of RM750 million and a 12-month trailing average of market capitalisation of RM978 million. The report shows that it has conventional leverage of RM195 million and interest income of RM18 million. The company also has RM274 million in cash and interest-bearing instruments. While the total revenue of the company is RM590 million, the profit before tax is RM200 million. Based on CDIF/3/9/145-146, would this company pass the screening filter of the Securities Commission of Malaysia and would the company be approved according to the FTSE Islamic Index screening? State the reasons for either the inclusion or non-inclusion of this company by the respective screening methodologies.
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7.3 Shariah compliance issues in the Islamic capital market

Shariah compliance issues, as taken into consideration in the above Shariah governance model, include product approval and eligibility criteria for issuing parties, reporting requirements and disclosure.
7.3.1 Product approval and eligibility criteria for issuing parties

All equity capital market instruments, ranging from equities to managed funds, must undergo a product-approval process overseen by regulatory authorities and by the respective Shariah board. Islamic equity capital market instruments are treated in the same way and are subject to an additional layer of product approval known as Shariah certification. This is overseen by either the Shariah authorities set up by the regulators or by individual Shariah boards, or by both, depending on which Shariah governance structure the jurisdiction follows.
Taking an example of the listing of an Islamic equity, the issuer must fulfil the listing requirements of: paid-up capital, whereby the floor amount will be taken into consideration when considering main board or second board listings percentage of paid-up capital in public hands, of which the authorities may put a floor figure of 25% minimum profit track records for three or five uninterrupted years minimum forecast after-tax profits minimum period of business operations, perhaps five years.
The requirements set out in the example above are no different from those that are observed by nonIslamic equity issuers. However, an Islamic equity issuer, such as in Malaysia, may have to undergo what is known as a pre-IPO (initial public offer), or its equivalent Shariah compliance review, whereby the issuer would have to furnish relevant information that may not be available in the financial accounts to determine compliance of its securities with the principles of Shariah. As such, subject to certain conditions, companies whose activities are not contrary to Shariah principles will be classified as Shariah-compliant securities. This process can be undertaken by the regulators Shariah authorities or the relevant exchange. Financial information, such as the level of contribution of interest income received by the company from conventional fixed deposits or other interest-bearing financial instruments, is taken into account, in addition to dividends received from investments in Shariah non-compliant securities. As stated, the pre-IPO screening exercise described above is peculiar to Malaysia and is also noncompulsory. The practice is adopted by companies that may require the pre-IPO screening exercise as a marketing tool to attract Islamic investors who are yet to be convinced of the companys Shariah compliance. To date, regulators in various jurisdictions rarely screen the equities listed in their domiciled exchanges pre- or post-IPO. In some cases, additional regulatory requirements are imposed on Islamic financial intermediaries, such as requiring professionals to have adequate knowledge in Shariah law as well as requirements related to the internal controls of the intermediary. For instance, the guidelines on Islamic fund management from Malaysias Security Commission states that an Islamic fund manager must appoint a Shariah compliance officer who is well-versed in Islamic fund management and has adequate Shariah knowledge on Islamic finance and capital markets. Whatever the approach taken by the regulator, it is critical that regulators are well apprised of developments within this market segment, particularly where there is a significant level of activity occurring in the market.
7.3.2 Reporting requirements and disclosure

The main issues that must be addressed in relation to accounting and auditing standards are: comparability and reliability of information internationally acceptable standards quality of accounting and auditing standards.
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7.3.2.1 Adopting international standards

The application of accounting standards and practices for Islamic equity capital market transactions is not uniform across jurisdictions, but there is a common approach among Islamic financial institutions (IFIs) to apply International Accounting Standards (IASs) for financial reporting. In Bahrain, the financial statements comprise consolidated financial statements of the company and its subsidiaries in accordance with International Accounting Standard 27. However, there are also separate initiatives by several jurisdictions to formulate and adopt accounting standards that are tailored specifically for their local Islamic equity capital market transactions. In the UAE, financial statements are prepared in accordance with International Financial Reporting Standards and Shariah rules and principles as determined by the companies Shariah supervisory boards and applicable requirements of UAE laws. As a result, Musharakah income is accounted for on the reducing balance method on a time-apportioned basis that reflects the effective yield on the asset, while Ijarah income is recognised on a time-apportioned basis over the lease term.
7.3.2.2 Developing international standards

The challenge of formulating a robust financial reporting framework for the Islamic financial services industry arises from the fact that Islamic finance is still undergoing substantial development and innovation. The current approach to developing financial standards for Islamic transactions is to benchmark against international standards such as IASs to ensure consistency with globally accepted standards and modify them, where necessary, to ensure financial statements fairly present the financial position, financial performance and cash flows of the IFI.
7.3.2.3 The requirement of additional information

In the case of an Islamic product offering, issuers are generally required to provide additional statements in the offer document relating to Shariah aspects. For instance, statements in the prospectus of an Islamic fund should cover matters such as the role and responsibilities of the funds Shariah adviser. This can be achieved by inserting the following statement: The role of the Shariah adviser to the Fund is to ensure that the operations and investments of the Fund are Shariah-compliant. The responsibility for ensuring proper compliance of the Fund with Shariah principles in all relevant aspects rests solely with the Manager. In most situations, the product issuer must undergo an accreditation process whereby the business activities and the method of financing it adopts must be scrutinised to ascertain whether it meets with Shariah principles. It should be noted that these Shariah screening procedures are implemented differently in different jurisdictions. While some jurisdictions have incorporated the Shariah approval process into the regulatory framework, others have opted for an informal process that is not subject to any level of regulation by the authorities. This issue shall be explained further in Section 7.5 of this chapter.

Explain whether it is better to develop best practices or specific regulatory guidelines with regards to disclosure, or whether it is preferable to allow issuing parties to decide how best to disclose information to their potential investors.
Solution
The question has often been raised of whether it is desirable to develop best practices or specific regulatory guidelines to ensure that the disclosures made accord the investor with full information on Shariah compliance. Central to this is the integrity and reliability of the Shariah approval process and the credibility of such approval processes. The issue is whether material information is being disclosed and is relevant to an investment decision. If interpreted as such, general disclosure requirements can be applied to the offer documents or similar documents in relation to Shariah compliance. This would imply a need to ensure that the duties and liabilities of advisers and officers of the issuer, with regards to their exercise of due diligence in the provision of this additional information, are appropriately regulated.
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7.3.2.4 Voluntary disclosure

Generally, non-financial statement disclosures are still voluntary. However, there is a trend towards increasing the extent of non-financial statement disclosures to ensure that the investor receives adequate information. With respect to this, regulators may want to consider encouraging disclosures in relation to meeting the specific investment needs of investor groups. One must note that the requirement for Shariah compliance is a continuous process. It is possible that the business activities of the issuer may change over time, for example, arising out of mergers and acquisitions, and may result in a company or investment product no longer being Shariah-compliant. For this purpose, Shariah compliance assessments need to be conducted continuously, perhaps on a periodic basis. It should be noted that if the nature of a company, an activity or asset changes in nature to the point of being non-Shariah compliant at any point in time, the impact of non-Shariah compliance will extend to all other related products of the company, such as debt, collective investment schemes and structured products. Shariah funds that have invested in these assets must be aware of the risks that arise from a change in the Shariah status of the assets. Subsequently, it should be noted that requirements for disclosures outlining the process to manage such risks should be routinely provided to investors.
7.4 Additional functions of capital markets regulatory authorities

To ensure better regulation of markets, on the domestic as well as international level, and to maintain just, efficient and sound markets, regulatory authorities must: exchange information on their respective experiences in order to promote the development of domestic markets unite their efforts to establish standards and effective surveillance of securities transactions provide mutual assistance to ensure the integrity of the markets by a vigorous application of the standards and by effective enforcement against offences. In relation to Islamic equity capital market products and activities, regulators should also consider issues related to the clarity and consistency of regulation and its application. Furthermore, regulators should consider and/or review capital market laws to ensure that they adequately deal with the risks associated with the new products structures based on Shariah principles. In this regard, regulators, such as the Central Bank of Bahrain, have sought to mitigate these risks through enhanced disclosure requirements for specific Islamic products. Because of the unique aspects of Islamic capital market products and services, it could be held that specialised regulation for the Islamic capital market may be more appropriate. While most jurisdictions apply exactly the same set of regulations in terms of product approval, as well as standards for intermediaries and other regulated entities (such as collective investment schemes), some jurisdictions have developed additional regulations, rules and guidelines catering to Islamic capital market activities. For example, Bahrain has issued Guidelines for Issuing, Offering and Listing of Debt Securities, which lay down clear requirements and conditions for issuers as well as for each class of debt securities, such as Islamic bonds. Malaysia has in place additional requirements for Islamic Sukuk within its Guidelines on the Offering of Private Debt Securities. Pakistan has developed specific legislation (Mudarabah Companies and Mudarabah (Flotation and Control) Ordinance 1980) to regulate Mudarabah companies, which are the main issuers of Islamic equities. In many cases, these regulatory requirements relate to additional disclosures as a result of the structure of the product.
Exercise 7.2
Outline whether you believe it is necessary for regulatory authorities to employ dedicated staff to govern Islamic capital market regulations or whether this function should be delegated to existing capital market staff.
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7.5 Factors affecting inclusion and non-inclusion of a stock in Islamicapproved stocks

An equity investor in a company participates in the share capital of the company, therefore, technically, becoming a part-owner, particularly from a Shariah perspective. The investor is, therefore, ultimately responsible for the companys primary business activities as well as its financial activities in the sense of its borrowing and investment. The Islamic investor needs to consider whether the potential investable companies are involved in Shariah non-compliant core activities. This is referred to as sector screening, which is the most fundamental and critical aspect of screening. Prior to the mid-1990s, Shariah scholars tended to rule out investment in the equity/stock market because of a high prevalence of non-compliant practices. It was beyond the ability of ordinary Muslim investors as individuals or funds to make these activities compliant to the teachings of Islam. Equity markets operating in various stock exchanges, even in Muslim-dominated countries, were viewed as conflicting with Shariah principles and therefore not eligible for investment by Muslims. This deprived Muslims from investing in stocks and equities that could have been listed and traded in an organised market.
7.5.1 Developing screening methodologies

Realising the importance of investment in this market and the complications surrounding the Shariah compliance of companies and their shares, there were attempts in the mid-1990s to develop a methodology for screening that would be acceptable to the teachings of Islam, at least in the current financial landscape. Early efforts by the RHB Islamic Index in Malaysia, followed by the Dow Jones Islamic Market Index, opened up new opportunities for screening stocks deemed compliant to Shariah principles. This reflects the interface between Islamic teaching principles and modern institutions to offer opportunities to Islamic communities to be part of the modern global financial market, albeit subject to certain limitations and restrictions as per Shariah requirements.
7.5.2 Core activity screening

At present, a few screening methodologies have been advocated and developed to screen stocks listed in various stock exchanges. These methodologies agree on the importance of screening the core activities of the company. Thus, any company that undertakes a core activity which is non-compliant would not be approved for Islamic investors. The list of sectors or core business activities that are commonly viewed as non-compliant (CDIF/3/9/138-140) includes the following: a. conventional financial institutions that are interest-based, including banks, finance houses and leasing companies b. insurance and reinsurance companies c. entertainment-related industries d. manufacturing, packing, distribution or sale of tobacco products e. manufacturing and sale of weapons or military equipment f. manufacturing, packing, distribution or sale of non-Halal food and beverages, particularly pork and alcoholic products g. pornography or the production or distribution of such h. gambling or casinos i. other immoral and unethical activities.
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The following table lists the sectors excluded by many stock exchanges as a consequence of the above prohibited list of activities. The list includes, but is not limited to, the following sectors:
Table 7.1 List of prohibited sectors

Defence Recreational products Hotels Banks Property and casualty insurance Investment services Insurance brokers Distillers & vintners Tobacco Media agencies Recreational services Full line insurance Mortgage finance Specialty finance Food products Food retailers & wholesalers Gambling Restaurants and bars Life insurance Consumer finance
7.5.3 Balance sheet screening

In addition to screening the sector or core activities of the companies, most established Islamic indices also screen the balance sheets of these companies to examine relevant information that may affect its Shariah compliance. Basically, the financial screening will examine the following items: a. the debt or leverage of the company compared with either the market capitalisation or total assets b. the cash and interest-bearing assets of the company as a proportion of market capitalisation or total assets c. the cash and account receivables compared with either the market capitalisation or total assets of the company d. interest income and other non-compliant income compared against the total revenue of the company The details relating to this financial screening were outlined in CDIF/3/9/141-142.
Key point
The core activities and the relevant financial ratios of a company are both subject to Shariah screening to obtain Shariah approval status.
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Islamic stock indices are useful for investors to find out the performance of a certain basket of shares that constitute the index. Also, a given index is based on certain prescribed index methodologies with regards to, for example, market capitalisation, sector and geographical area. They are also useful for investors to determine compliant stocks as all the stocks that constitute the index are considered compliant to Shariah principles. This may appeal to institutional investors such as Islamic mutual funds. Given your understanding of how an index is developed and how an index should behave, explain, with reasons, whether existing Islamic indices, such as the DJIM and FTSE Islamic Index, can be useful for retail investors who seek to invest in approved shares across the global market.
Solution
The existing Islamic indices provided by Dow Jones, FTSE, S&P and others have been instrumental in the development of Islamic equity capital markets. Fund managers as well as institutional investors have been subscribing to them on an ongoing basis. However, such indices are usually out of the reach of the average retail investor. One of the main reasons is the cost of subscribing to these indices, as the substantial fees would only make it costefficient for institutional investors. Another reason why such indices may not be applicable to retail investors is that the constituents are largely made up of highly capitalised companies, some of which may be too expensive for the average investors to get involved with. Furthermore, the constituents of these indices are non-exhaustive as the index providers do not screen all the companies that are available in all jurisdictions. Retail investors as such would not have a full idea of the actual universe of investable equities, even if they did manage to subscribe to these premium services. The challenge is thus to generate a screening engine that is able to screen all stocks available across the world while making them available in a cost-effective manner to the average retail Islamic investor. The generation of an exhaustive, worldwide Islamic equity universe is quite a challenge considering the different screening methodologies that have been adopted in different parts of the world. On top of that, the volatility of the various stock markets and the adoption of new business activities by current Shariah-compliant companies, such as mergers and acquisitions, would result in the frequent exit and re-entry of companies into the Shariah-compliant universe. The service provider must be able to reconcile the differences between the screening methodologies, as well as effectively trace developments within each constituent equity, to be able to generate a robust worldwide screening engine for the use of both institutional and individual investors.
7.6 Analysis of sector-based screening: scope and challenges

Shariah principles categorise certain commercial activities as non-permissible for Muslims to invest in. Investment in the shares of any company engaged in such activities as its main business is clearly not permissible under Shariah principles because of the doctrine of ownership and ownership liability. An IFI may provide financing based on Murabahah to these non-compliant companies as the relationship is purely commercial and debt-based financing. Through this debt-based financing, IFIs cannot be deemed to be involved in the business activities of this company. However, a Muslim or Islamic-based investor, upon investing in shares in this company, may be said to be involved in the prohibited activities of the company as investment via shares would make them proportionate owners and hence be liable for the conduct of the company.
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7.6.1 Companies that are mainly compliant

Sector-based screening is equally important as there would be instances of business firms that are primarily engaged in permissible activities but have a part of their operations involved in activities that are not permissible. For instance, companies involved in the hotel or airline industry may serve alcoholic drinks as part of their operations, although their main activity is to provide accommodation and transportation to travellers. It is for this reason that some screening methodologies have also provided another income-screening method that tolerates prohibited income up to 5% of the total revenue of the company. Therefore, a company whose core activity is compliant but engages in a secondary activity which is not compliant may be subject to this income screening. However, to all intents and purposes, all companies are subject to this non-Halal income screening irrespective of whether they do or do not have a core prohibited activity because any company may have received some income that is not compliant to Shariah principles in the course of their core business activity. This non-Halal income includes all income arising from interest payments (interest income), income from selling a prohibited item and service, such as non-Halal food and drink, tobacco-related products and pornographic materials. The aggregate of this income will be deemed as one total income to comply with the 5% ratio.
For example, ABC is an IT-based company that produces anti-virus software for individual and company users. The total revenue of this company last year was US$100 million. In addition to developing and selling this software, the company has also deposited their non-invested cash in a conventional bank which generates US$2 million in interest income. The company also operates a few IT-based centres for public users wherein it sells liquor, non-Halal food and adult movies. The total income from these products is reported to amount to US$6 million. On the aggregate basis, this company has effectively received an income from interest, liquor, non-Halal food and pornography amounting to US$8 million, which represents 8% of the total revenue. Under the income-screening criterion, this company, although essentially an IT-based company, will not be compliant for Islamic investors.
7.6.2 Screening for indirectly linked prohibited items

Another challenge is screening companies offering services that are indirectly linked to one or more prohibited core activities; for example, a security company that offers security services in the form of security personnel or security alarms for clients including banks, casinos, universities, factories or commercial properties. Applying a general sector screening methodology as prescribed would result in this company being held to be compliant. However, if the Shariah board of the Islamic index provider or screening company were to request a detailed breakdown of this security companys clients, the company may be deemed non-compliant if the majority of the clients are of non-compliant industries. Such additional screenings are designed to avoid approving a security company that is dedicated to, or specialises in, providing protection to either casinos or conventional banks. Otherwise, any company that provides security services for all types of clients may be deemed compliant. Similarly, a company that produces bottles for various purposes may be deemed compliant from the core-activity perspective. However, if the company specialises in producing bottles exclusively for the liquor industry, then it should be disapproved.
7.6.3 Determining the percentage of non-compliant activity

It can sometimes be difficult to ascertain the exact percentage of non-Halal income from audited financial reports alone. Liquor income, for example, is more often than not included under food and beverage that may be both Halal and non-Halal. Similarly, interest income may be mixed with profit paid by IFIs. This is often recorded under the item interest income in the financial reports of the company, even though some of the companys cash is deposited with IFIs, thus yielding non interestbased returns. The stock-screening company will have to undertake more thorough research in order to have a more accurate assessment of the company. This may include either field trips to the relevant companies to ascertain the nature and degree of their non-Halal income, or following up any announcement or corporate findings through direct discussion with the companys management to gain a breakdown of some of the income.
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Key point
Sector-based screening is the most critical screening to exclude prohibited core activities as well as to ascertain the ratio of non-Halal income to total revenue of the company. While some sectors are easily screened, others require more thorough investigation to obtain an accurate picture of the activities involved.
Exercise 7.3
World-Wide Ads is an advertising company that helps companies market their products and services more efficiently and effectively. Its total income is recorded as US$40 million and clients include conventional financial institutions, gambling companies, universities and hotels. Per the previous years audited financial report, it has interest income of US$250,000. Outline the issues to be considered in screening this company from the commercial activity perspective in order to ascertain its Shariah compliance status.
7.6.4 The defence industry

Out of all the prohibited activities, the defence industry is the one that scholars differ over most. The defence industry is not clearly prohibited by Shariah principles. However, due to the perception that weapons are developed to cause war, the industry has a negative image. Islamic investors should not invest in weapon-based companies as this would support the development of the industry and, consequently, support wars where people die, including children, women and the elderly. As this is a matter of perception and preference, some screening companies or authorities, such as the Dubai Financial Market, have excluded the defence industry from the list of prohibited industries or sectors, provided these companies are licensed by the respective jurisdictions. The argument is that the industry is important to defend a country from unlawful aggression and oppression.
7.6.5 Screening for ethical and social acceptability

Recent developments have led to stocks being screened beyond what is prohibited by Shariah principles. This has led to attempts by some index providers to screen companies beyond their core activities and examine their ethical make-up before they can be included in the Shariahapproved list. Socially responsible investment (SRI) combines the social, ethical and environmental considerations of the investor with their financial objectives. In short, SRI seeks to invest in companies that contribute positively to the world and avoids or excludes those that harm society or the environment. Conventional SRI and Islamic core activity screening criteria has a common investment perspective on sectors such as gambling, alcohol, tobacco and weaponry. For Islamic screening to be closer to SRI, methodologies must take into account a few additional aspects such as avoiding companies that use child labour or contribute to pollution or global warming.
7.6.6 Screening sustainability

The Dow Jones Sustainability Indices, launched in 1999, are the first global indices tracking the financial performance of the leading sustainability-driven companies worldwide. The indices provide asset managers with reliable and objective benchmarks to manage sustainability portfolios. Corporate sustainability is a business approach that creates long-term shareholder value by embracing opportunities and managing risks deriving from economic, environmental and social developments. A growing number of investors perceive sustainability as a catalyst for enlightened and disciplined management, and, thus, a crucial success factor. As a result, investors are increasingly diversifying their portfolios by investing in companies that set industry-wide best practices with regards to sustainability.
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Companies listed on the index undergo a review process where they are continuously monitored for their corporate sustainability performance. The objective is to verify a companys involvement and management of critical environmental, economic and social crisis situations that can have a highly damaging effect on its reputation and core business. This can be ascertained through corporate reports on companies involvement in, for example, excessive logging activities, or water pollution by disposing toxic materials into rivers, lakes and sea, or in not adhering to carbon credit policy as agreed in the Kyoto Protocol. In addition, the consistency of a companys behaviour is reviewed in line with its stated principles and policies. The Islamic screening methodology may be applied to shares that are included under this index, thus ensuring a combination of both positive and negative screening.
Key point
Islamic screening is complimentary to SRI screening by combining both negative and positive screening of companies to ascertain Shariah compliance as well as SRI-compliance.

Explain whether you support the consideration of SRI in screening stocks from the Shariah perspective, in addition to the existing Shariah screening methodology.
Solution
Shariah screening is largely a negative screening exercise that involves avoiding investments that do not meet the prescribed standards set. SRI employs both negative and positive screening methodologies, an added process that eventually ranks the investments that can be made. From one angle, the inclusion of positive screening would make Shariah screening a more sophisticated tool as investors would be able to generate a preferred list of companies to invest in, in accordance to Shariah perspectives. However, it may be difficult to set the criteria or benchmarks for the positive screening as it is rather abstract and may not be well articulated.
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Table 7.2 Financial ratio screening comparative overview

Dow Jones Islamic Market Index Standard & Poors Islamic FTSE Islamic Market Index Morgan Stanley Islamic Index Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) Average market capitalisation
Denominator or basis used
Average market capitalisation
Average market capitalisation
Total assets
Total assets
Thresholds Conventional leverage Cash and interest income-bearing instruments Cash and accounts receivable 33% 33% 33% 33.33% 30%
33%
33%
33%
33.33%
30%
33%
49%
50%
70%
70%
7.7 Analysis of financial behaviour of the company for screening purposes

Three aspects are generally considered while studying the financial structure of a business from a Shariah viewpoint. These are: debt or leverage taken by the company that results in interest expense cash and interest-bearing instruments that result in interest earnings or income to the company cash and receivables of the company that reflect the liquidity position of the company. Table 7.2 above illustrates various benchmarks for the financial ratio screening adopted by various Islamic index providers and Shariah standard-setting agencies (such as AAOIFI). Each of these ratios will be critically discussed below. The first two thresholds are crucial for Shariah-based screening as they relate to either interest expenses or interest income. The third aspect, as explained in CDIF/3/9/143-144, relates to issues of tradability of shares in the market. Each of these aspects has some practical issues and challenges. These will be considered in the following sections.
7.7.1 Indebtedness of the company

Currently, most organised businesses rely on banks to part finance their activities. This is partly due to the need for fluctuating working capital and the ready availability of bank capital for financing and maintaining ongoing trade, and its expansion in the face of unforeseen exigencies of business. Apart from working capital needs, banks also finance the acquisition of fixed assets in the case of major expansion or diversification of business activities. Because of fluctuating conditions, it becomes almost inevitable for even a moderately-sized company to access bank capital, at least for working capital purposes. This is accentuated by the fact that many public-listed companies, which are listed on international exchanges, are based in countries where Islamic banking products are not readily available. This results in the need to borrow from conventional banks for interest that is non-permissible. While investing in these equities and becoming part-owner of such a company may be, strictly speaking, against Islamic norms, tolerance may be needed as this is the reality of the modern commercial world. However, a limit must be put in place to avoid excessive
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conventional borrowing by the companies. The most acceptable standard (DJIM, Standard & Poors, FTSE and Morgan Stanley) is 33% of the market capitalisation or total assets, as the case may be. The measure used to assess the level of indebtedness of a company is the debt to market capitalisation of a 12-month trailing average or total assets of the company. Although acceptable screening methodologies do not qualify this debt with conventional debts, the implied meaning of this requirement is to restrict borrowing to conventional borrowing or leverage only. Therefore, if a company were to obtain financing through Shariah-compliant instruments, this requirement is no longer relevant. Indeed, a company may get financing of up to 100%, provided it is Shariahcompliant financing.
7.7.2 Conventional debt

Conventional debt could be classed as normal banking facilities, bonds or preference shares. However, in the context of the current practice of stock screening, it is not clear whether the term conventional debt includes all of the above or if it is limited to only conventional banking facilities, such as working capital loans, overdrafts and term loans. At the present time, it seems that this requirement does not include bonds and preference shares. In other words, conventional bonds and preference shares are excluded from the calculation of total conventional debt. Also, from a Shariah perspective, inter-company borrowing, although it generates interest, does not lead to prohibited lending. Interest is only relevant and prohibited when it takes place between two independent parties and not between the parent company and its subsidiaries. Therefore, in the screening exercise, any interest generated from inter-company loans must also be excluded.
7.7.2.1 The effect of the global financial crisis of 2008/9

With the advent of the global financial crisis in 2008, many public-listed companies experienced the decline of market capitalisation. This may lead to the exclusion of those companies from the list of Shariah-approved shares as the denominator against which debt is measured will be smaller than before the financial crisis. Suppose the total conventional debt of a company in 2007 was US$100 million and the market capitalisation of the company in the same year was US$1 billion, then the ratio of debt to market capitalisation in 2007 was only 10%, which is below the 30% limit. However, suppose, in 2008, given the fact that the stock market was affected by the global financial crisis, the market capitalisation of the same company declined to US$200 million, while the total debt is US$100 million, then the ratio of debt to market capitalisation will be more than the 30% cap.
Many public-listed companies that are Shariah-compliant may now become non-compliant as their ratio of debt to market capitalisation exceeds 30%. The exclusion of these companies, relatively speaking, is due to a technical reason or a commercial reality beyond anyones control.
7.7.2.2 Interest-based earnings

Banks play a major role in facilitating transactions. The cash flows of all companies are routed through banks. As a result, businesses have to maintain accounts with banks. These accounts attract some nominal interest. In addition, at times, companies have to keep security deposits with banks and others to cover performance guarantees and assurances. These accounts also earn the company interest. When it has excess funds, a company may also deploy the excess short-term liquidity in bank deposits and securities as a measure of treasury management. For an outsider investing in the equity of a company, it is difficult to judge whether and to what extent interest accruing to a company is inadvertent and involuntary or planned and deliberate. It is not feasible to expect the investor to investigate this aspect.
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7.7.2.3 Acceptable levels of interest

To ensure that the interest earnings of a company do not substantially contribute to its revenue, it is essential to set limits to the proportion of cash and interest-bearing instruments to either the market capitalisation or total assets of the company. Similar to the issue of debt to market capitalisation or total assets, the ratio of 30% or 33% will be applied, pending the relevant screening criteria as discussed above. This is to ensure that the company does not earn a large amount of income from interest income instead of operating income from its approved core activities. As explained earlier, the actual interest income generated from these deposits will be further screened under non-Halal income screening, which is subject to a 5% ratio to the total revenue of the company.
7.7.2.4 Achieving Shariah compliance

Some public-listed companies are keen to be included in one of the established Islamic indices because management believes this will render their shares more liquid as the indices have a wider pool of investors, both Islamic and conventional. However, upon checking their balance sheets, they may discover that their inclusion in one of the Islamic indices would require them to reduce their conventional leverage, reduce their cash and interest-bearing instruments, reduce their non-Halal income, or reduce their liquid asset proportion to illiquid assets to meet the ratios prescribed by the respective Islamic index providers. The common obstacle for these companies is mainly leverage and interest-bearing instruments. Among the strategies that these companies may adopt is to obtain Islamic financing either through Sukuk, which is a capital market product, or a Murabahah-tawarruq structure, which is a banking product, or a combination of both.
Key point
Public-listed companies may endeavour to make their financial ratios compliant by the redemption of conventional debt through Islamic finance and by managing its cash through Shariah-compliant deposits and liquid instruments.
Suppose company XRS is a manufacturing company and has a liability of a conventional loan of US$300 million, which exceeds the ratio of 33% of the ratio of debt to market capitalisation or total assets. XRS may secure any Islamic financing in whatever form, the proceeds of which can be used to redeem the outstanding conventional debt. By so doing, the ratio of debt to either market capitalisation or total asset may be reduced as leverage through Islamic financing will not be counted in the total debt or leverage of the company. To engage in this redemption process, the financial adviser must consider the cost of the funds involved to attain new financing to redeem the old financing. The company may not want to proceed if the cost of new funding is too expensive. Irrespective of this financial consideration, this is the most effective way of reducing conventional debt to qualify the company for Shariah-approved stocks. Also, the company may need to transfer the cash management of the company to Islamic shortterm deposits and liquid instruments so as to address the requirement of having less than 33% in conventional deposit and investment products. At the same time, this will also address the screening of non-Halal income.
7.7.3 Cash and receivables/payables of the company

Under Shariah law, cash and debts cannot be traded except at par value. In applying this ruling to the valuation put on a companys shares, Shariah scholars have considered a company as the bundle of assets and liabilities (reported on its balance sheet), including fixed assets, investments, cash, inventory, receivables, payables and debts. The traded price of its equity can hence be considered as representing value paid for the underlying assets and liabilities. If the fixed assets and investments of a company are negligible (as happens for trading companies), then the remaining assets and liabilities will mainly comprise of debts, deposits and stocks. In equity trading, the price of equities traded is driven by future expectations of prices and not by the book value of the company. Hence, if stocks (inventories) are valued at market prices, one can end up with a residual value for the cash and debts of the company, which can be out of line with their par values.
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Set out below is an excerpt from the financials of Malaysias Bank Muamalat for 2008. Based on the financial report, explain whether the shares of this Islamic bank can be subscribed to and traded in the market freely.
BANK MUAMALAT MALAySIA BERHAD (Incorporated in Maylaysia) BALANCE SHEETS AS AT 30 SEPTEMBER 2008 (30 RAMADHAN 1429) Group 30 September 31 December 2008 2007 Note RM000 RM000 ASSETS Cash and short-term funds Securities: Held-to-maturity (d)i Available-for-sale (d) ii Financing of customers (e) Statutory deposits with Bank Negara Malaysia Other assets Investment in subsidiaries Deferred tax assets (net) Goodwill Property, plant and equipment Prepaid land and lease payment Total Assets 3,433,693 30,891 2,903,681 6,239,252 308,871 80,554 46,917 1,218 44,608 13,089,685 4,466,215 30,891 3,302,350 5,585,247 288,471 63,152 23,013 1,219 44,530 269 13,805,357 3,432,591 30,891 2,903,681 6,239,252 308,871 81,32 10,722 46,917 44,530 13,098,757 4,465,895 30,891 3,302,350 5,585,247 288,471 63,406 10,723 23,013 44,427 269 13,814,692 Bank 30 September 31 December 2008 2007 RM000 RM000
Notes:
i. Securities held-to-maturity and available-for-sale (items (d)i & (d)ii respectively) are made up of Islamic capital market instruments such as Islamic commercial paper, Sukuk, Islamic bonds, Islamic notes etc.(refer to CDIF 3/6/89-100)
ii. Financing of customers (item (e)) refers to Islamic banks home and vehicle financing activities utilising financing instruments structured under various contracts, such as Ijarah, Ijarah thumma al-bay or Musharakah.
Solution
The financial report shows that the cash and account receivables of this Islamic bank amount to more than the 50% (DJIM/FTSE/S&P) and 70% (AAOIFI) of the total assets benchmarks set. Following the above stock selection, the shares of this Islamic bank can only be bought and cannot be sold as the shares of the bank represents more liquid assets than illiquid assets, thus becoming a monetary asset. A monetary asset is always subject to rules of interest in the exchange; in other words it can only be traded at par value and any premium or discounts to the par value would be regarded as interest. The restriction to par value would thus limit the tradability of this banks equity in the market.
The measure or parameter most commonly used to judge compliance on this score is the percentage of current assets or receivables or net current assets to total assets (or total market capitalisation) of the company. Alternatively, the numerator can be net receivables instead of net current assets. The cut-off value of the parameter is usually set in the range of 45% to 49% as explained in CDIF/3/9/143-144. However, the stock-screening criteria of AAOIFI Shariah Standard (No 21) have increased the ratio of liquid assets to illiquid assets to 70%. Thus, a company whose total asset is US$100 million and has a total cash and account receivable of US$60 million is a compliant company under AAOIFI stockscreening criteria, but not under all other international Islamic stock-screening criteria. Subsequently, the shares of the company may be traded in the market freely without any restriction of par-value transaction. Following other stock-screening criteria, the shares of this company may be bought but cannot be sold except on a par value basis to avoid an interest element in buying one monetary asset (a liquid asset) for another monetary asset (another liquid asset) at a different price.
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7.8 Comparative stock-screening methodologies and criteria

Currently, equity market players, ranging from portfolio managers, institutional investors and regulators use various screening methodologies to generate their universe of Shariah-compliant equities, each with their own specific objectives. In the case of index providers, their selection criteria and weightings are likely to be biased to the more intensely traded and higher market capitalisation stocks, primarily derived with the intention of providing investors with a measure to judge the current state of the market against that prevailing on an earlier day or likely to prevail in future. These Islamic indices also enable investors to assess how a particular stock is doing in relation to the overall market. In defining the screening methodologies to identify Shariah-compliant equities, the aim is to select those stocks from the market universe that function within the minimum realistically acceptable deviations from Shariah stipulations, keeping in mind the nature of the environment. In judging the Shariah compliance of any equity, one has to consider not only the nature of the business it is engaged in but also the way the business is structured. Table 7.2 above shows a comparison of Shariah equity screening criteria that has been applied in the various markets.
7.8.1 Screening for acceptable business activities

Activities of Shariah-compliant companies cannot be inconsistent with Shariah. Therefore, based on revenue allocation, if any company has business activities in the Shariah inconsistent group or sub-group of industries it is excluded from the Islamic index universe. The established categories of industries that are inconsistent with Shariah (see table 7.1) are alcohol, pork-related products, conventional financial services (banking, insurance, etc.), hotels, entertainment (casinos/gambling, cinema, pornography, music, etc.), tobacco, and weapons and defence industries. The non-permitted areas documented in the Dow Jones, FTSE, S&P and FTSE-Bursa Hijrah Shariah indices are exhaustive. It appears they have resorted to being extra cautious, resulting in the exclusion of even Shariah-compliant units in an industry if most units in that industry are not compliant. Hotels, media and broadcasting for instance (under the entertainment category), do not have anything intrinsically objectionable about their activities. However, as a practice, hotels do serve non-Halal foods and alcoholic beverages. Similarly, media coverage and broadcasting may include material with nudity or obscene images. However, for a provider of market information it may not be easy or feasible to obtain and keep abreast of such details about operations of specific units in industries where most units tend to be Shariah non-compliant.
7.8.2 Screening for acceptable financial ratios

After removing companies with unacceptable primary business activities, the next step is to identify and remove companies with unacceptable levels of debt/leverage, liquid assets and receivables by applying the following screens. The Shariah basis of these financial screens has been discussed in CDIF/3/9/142-143.
7.8.2.1 Debt/leverage
The acceptable level of indebtedness is set at less than 33% across Dow Jones, FTSE and S&P screening criteria. Dow Jones uses market capitalisation as a denominator, whereas FTSE and S&P use total assets and a trailing 12-month average market value of equity (similar to market capitalisation). The ratio of debt to total assets that Dow Jones formerly used would have been a more rational approach. It gives a measure of how much of a companys operations are being financed by the Shariah non-compliant debt component. Such a ratio, therefore, clearly follows from the objective sought. However, the debt to total asset ratio is the most static ratio among the three as companies assets are not frequently marked-to-market. The change to the trailing market capitalisation (and its equivalent) denominator produces a more dynamic, hence more accurate, ratio. Nevertheless, this dynamic ratio has generated criticism in times of market volatility. For instance, in the short run, the debt numerator will not change but the denominator may plunge with a market crash. This was a consequence of the 2008 financial crisis, which resulted in a number of equities falling out of the Shariah-compliance listings as their market capitalisation fell rapidly in the short term.
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The question with regards to the tolerance levels of debt is unavoidable, with the ideal perhaps being 0%. Because of conventional financial wisdom that requires companies to rely consciously on moderate debt levels to leverage profitability, Shariah scholars tend to settle for a debt ratio of 30% or 33% to equity on the argument outlined in CDIF/3/9/143.
7.8.2.2 Receivables to market capitalisation

Screening criteria stipulate certain maximum ratios of receivables or liquid assets as one of the screens for checking Shariah compliance. Its rationale, as explained in CDIF/3/9/144, is to preserve the idea that a companys equity reflects its business assets and not its monetary assets. If the company has a higher ratio than that prescribed, there would be a question of whether its equities can be traded at any value other than par. However, it is equally wrong to treat a company whose equity is publicly traded in the modern world as simply a bundle of accounting assets and liabilities, defined on its balance sheet. Some very vital and valuable assets of the company may not figure on its balance sheet at all. Marketing assets such as brands, distribution networks and logistical arrangements, as well as licences, quotas, permits and access to lucrative but protected markets do not normally appear on balance sheets. There are also other intangibles such as the companys public image, the value of key individuals in the companys top management, marketing, production and research teams that dont appear on the balance sheet. The question is how to ascertain the value of the intangibles with regards to the market value of the physical assets that the company holds. Until such a methodology is developed, it is best to be prudent in accounting for the receivables to asset ratio.
7.8.2.3 Cash
As with the debt/leverage ratio above, the difference between the Dow Jones/ S&P criteria and the FTSE lies in the denominator where the former utilises a dynamic 12-month trailing average market capitalisation/market equity value and the latter uses total assets as the denominator.
7.9 Share price fluctuations

There is often no rationale behind the way share prices fluctuate. The only definite statement that can be made about price movements on the equities market is that they are largely driven by sentiments about future earnings and movements. What creates those sentiments on a particular day is an unpredictable matter. It can be past performance, news of current performance, expectations of future results, market manipulations, demand-supply imbalances, government policies, political developments or international price movements. Often in the span of a few weeks or a couple of months, the share price of an equity share can skyrocket or nosedive. It is not unusual to find over a year share prices rising to more than double or sinking to less than half their original values, when there is no apparent change in their underlying business activities.
7.9.1 Sudden price fluctuations

A practical problem of using market capitalisation is that with sudden market movements a company that was considered Shariah-compliant one day has to be considered Shariah non-compliant the next day if there is a downward price fluctuation. As a result, Islamic investors would have to compulsorily exit, leading to further downward pressure and even further destabilising the companys price. Similarly an opposite movement could lead to a corresponding (although more muted) upward move. All this occurs with no change in the companys operations. Such market destabilisation would also be an unhealthy and wholly avoidable consequence of involving market capitalisation in the screening norms.
7.9.2 Unlisted companies

Another practical problem in using market capitalisation as the denominator in the screening norms for selecting companies for investment is that such screening ratios cannot be used to screen unlisted companies. A similar argument would apply (to a lesser extent) to infrequently traded companies or companies with low floating stocks. Often, due to the low liquidity associated with such scripts, even fundamentally strong companies of this group quote very low book values.
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Exercise 7.4
Based on table 7.2 above, assess the compliance status of the company whose financials are given below. Where applicable, apply the stock screening criteria that best suit this company. Aquaflo is a water treatment company in Qatar that processes sea water into drinkable water. It then sells the processed water to Qatar. The following are extracts of the financials of the company: a. b. c. d. e. Average market capitalisation (2008) Total asset (2008) Conventional leverage (2008) Cash and interest bearing instruments (2008) Cash and accounts receivable : Qatari Rial 441, 529,000 : Qatari Rial 682, 281,000 : Qatari Rial 51,343,000 : Qatari Rial 151,224 : Qatari Rial 440,000,000
7.10 New developments in screening methodology due to global financial crisis

7.10.1 Adapting the screening process to account for changing market capitalisation
The financial crisis of 2008/9 posed a new challenge, especially for Islamic indices and Islamic equity funds that adopt market capitalisation as the denominator in the screening process. Therefore, some Shariah boards exercised their Ijtihad, resulting in at least three approaches, especially for stockscreening criteria using market capitalisation as the denominator. 1. The first approach is to use the previous years market capitalisation that is based on the financial report of 2007, until market conditions recover. The current and prevailing market capitalisation of the company will be suspended for screening purposes until the market is seen to recover to its normal position. 2. The second approach is to use a 36-month instead of a 12-month trailing average of market capitalisation to show a more stable market capitalisation for the company under review. This period will cover the years 2006, 2007 and 2008 on an average basis for the purpose of screening, based on its financial report ended 31 December 2008. 3. The third approach is to change the denominator from market capitalisation to total assets, if this is possible, particularly for Islamic funds following Islamic indices that adopt the market capitalisation principle. However, certain Islamic index providers that use market capitalisation in their screening methodologies may not necessarily be able to switch to total assets if this has always been their standard screening methodology. They may then adopt the first two approaches if they wish to maintain the denominator of the market capitalisation to avoid the exclusion of many constituents because of this abnormal market condition.
Key point
The debt to market capitalisation or total asset ratio refers to total conventional debt, excluding Islamic finance debt, in proportion to market capital capitalisation or total assets.
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Table 7.3 Illustration of the decline of market capitalisation of a public-listed company (real scenario)
XX AIRWAYS GROUP, INC.

P2008 (US$ 000s) Net sales or revenues Operating income Non-operating interest income Interest expense on debt Earnings before interest and taxes (EBIT) EBIT & depreciation (EBITDA) Cash & short-term investments Short-term investments Cash Total assets Total assets - as reported Receivables (Net) Other investments Total debt Total shareholders equity Working capital Total capital Funds from operations Capital expenditures (additions to fixed assets) Enterprise value Market capitalisation Preferred stock Minority interest Net debt Z Score 12,118 (606) 83 253 (1,957) (1,717) 1,240 20 1,220 7,214 7,214 293 778 3,996 (505) (580) 3,129 (609) 929 3,638 882 2,756 0.309 2007 (US$ 000s) 11,700 445 172 273 707 896 2,176 226 1,950 8,040 8,040 374 877 3,148 1,439 844 4,470 472 523 2,323 1,351 972 1.978 2006 (US$ 000s) 11,557 664 153 295 699 898 2,366 1,249 1,117 7,576 7,576 388 753 3,002 970 691 3,877 599 232 5,552 4,916 636 2.289 2005 (US$ 000s) 5,077 (171) 30 147 (188) (93) 1,585 452 1,133 6,964 6,964 353 792 2,960 420 (100) 3,169 (111) 44 4,392 3,017 1,375 0.733 2004 (US$ 000s) 2,339 (55) 8 80 (9) 45 3,563 127 3,436 4,721 1,475 109 102 3,461 616 3,361 4,077 110 219 102 1.187
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Exercise 7.5
Based on the above illustration of a company, apply the screening methodology of both the DJIM and FTSE Islamic Index. What are your observations regarding this company when comparing the financials of 2007 and 2008? Also, if the Islamic fund was to follow the proposal of adopting a trailing 36-month average market capitalisation for this company instead of the previous years trailing 12-month average, what would be the result of the screening process?
7.11 Conclusion
Shariah compliance is the key distinguishing feature of the Islamic capital market. Islamic capital markets need to be efficiently regulated, not only to ensure adequacy and transparency of information provided to investors, but also to build confidence that the Islamic capital market instruments comply with Shariah principles at all times. Shariah regulatory structures can take the form of either a centralised model or one that is led by private initiatives or market forces. The applicability of either model will depend on the jurisdictions within which the instruments are on offer. Subsequently, the Shariah screening criteria adopted by a fund manager will once again depend on the jurisdictions within which the Islamic fund is on offer. The fund manager can apply any of the established Shariah screening methodologies from DJIM, FTSE or AAOIFI, to name a few. It is important for the manager to understand the different limits that have been set between each screening methodology and the different denominators applied for each financial ratio as they can affect the results of Shariah financial screening.
7.12 Summary
Having read this chapter the main points that you should understand are as follows: an effective legal, regulatory and supervisory framework is required to provide the essential foundation for the functioning of a modern equity capital market the Islamic capital market takes the structure of and utilises infrastructure that has already been established for conventional capital markets the development of various Shariah stock-screening methodologies, Islamic indices and various forms of Islamic funds are not in conflict with the existing structure of contemporary stock exchanges Islamic equity capital market products and services need to undergo a pre-defined vetting and approval process by Shariah advisers the challenge to formulating a robust financial reporting framework for the Islamic financial services industry arises from the fact that Islamic finance is still undergoing substantial development and innovation voluntary disclosures of non-financial statements are a good step in increasing transparency and ensuring that the investor receives adequate information both the core activity and the relevant financial ratios of the company shall be subject to Shariah screening to obtain Shariah approval status sector-based screening is the most critical screening step to exclude prohibited core activities, as well as to ascertain the ratio of non-Halal income to total revenue of the company in judging the Shariah compliance of an equity one has to consider not only the nature of the business it is engaged in but also the way the business is structured.
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Screening of public-listed company in various market conditions and commercial realities
QPP is a public-listed company in the property sector, which is listed on the Tadawul Stock Exchange in the Kingdom of Saudi Arabia. Its core activities are buying land that has the potential for the construction of both commercial and residential properties, as well as developing the properties for either outright sale or long-term lease. Considering the economic boom that the country is experiencing and the large inflow of expatriates, the supply of properties, particularly residential properties, is extremely scarce. The company has also developed and owns properties outside the Kingdom, in the UK, the US, Malaysia, India and China. The properties owned outside the Kingdom are both residential and commercial properties, such as shopping complexes, offices and warehouses. In addition, the company has ventured into the hospitality and leisure sector of hotels and resorts inside and outside the Kingdom of Saudi Arabia. At present, the company owns and operates luxury hotels in China, Malaysia and India. It also owns and operates a few serviced apartments in the UK, the US and Germany, in addition to a few serviced apartments in the Kingdom itself. Apart from this core activity, the company has a subsidiary company investing in an engineering company in a European country to produce military equipment. The following are the extracts of last years audited financials for the company.
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Table 7.4 QPP INC (US$ million)

2008 Net sales or revenues Operating income Interest income Interest expense on debt Earnings before interest and taxes (EBIT) EBIT & depreciation (EBITDA) Cash & interest-bearing securities Total assets Receivables (Net) Other investments Total debt Total shareholders equity Working capital Total capital Funds from operations Capital expenditures (additions to fixed assets) Enterprise value Preferred stock Minority interest Net debt Z Score 1,063 146 12 79 134 (255) 1890 10,544 4978 47 300 1,884 2,798 271 34 4,690 729 626 3,336 0 2007 1,199 181 14 81 240 292 1998 11,566 3789 227 334 1,746 2,712 246 35 4,321 1,678 10 2,634 0 2006 1,234 246 17 144 338 379 1766 17,066 1456 530 700 1,886 3,395 259 36 5,035 2,747 10 2,278 0
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1. RTS is an electricity company that has a conventional debt of US$200 million against its market capitalisation of US$500 million and total assets of US$ 700 million. It seeks to make its shares compliant according to the DJIM standard. Given the above financials, what is the most important action RTS must undertake to achieve compliance with the DJIM standard? (A) (B) (C) (D) Reduce its conventional debt to lower than US$165 million Reduce its total assets to US$500 million Reduce its conventional assets through Islamic private equity funds Reduce its conventional loan to lower than US$225 million
2. The weaponry industry is deemed non-compliant by most Islamic index providers and stockscreening companies and authorities except in the: (A) (B) (C) (D) Morgan Stanley Islamic Index Dubai Financial Market FTSE Islamic Index Bursa-FTSE Hijrah Index
3. In a bear market, the level of trading of shares may not be active thus affecting the volume of trading that later affects the market capitalisation of some companies. Which of the following is not a temporary solution to address the issue of a high decline of market capitalisation to avoid the exclusion of companies? (A) (B) (C) (D) Suspending the market capitalisation consideration until the market stabilises Extending the 12-month trailing market average to a longer period Changing the ratio of debt and cash and interest-bearing instruments against market capitalisation to 70% Converting the market capitalisation screening methodology to a total asset screening methodology
4. Which of the following activities may affect the inclusion of QPP into the approved stocks as per established Shariah stock-screening criteria, according to sector-based screening? (A) (B) (C) (D) Service apartments outside the Kingdom of Saudi Arabia Sale of land on credit sale Hotel operations outside the Kingdom of Saudi Arabia Hotel and resort operations in Kingdom of Saudi Arabia
5. If QPP was to reduce its conventional leverage through either Sukuk or Murabahah-tawarruq, how much new funding would be required to redeem the conventional debt to make the company eligible in 2008 to be considered compliant under DJIM? (A) (B) (C) (D) US$60 million US$50 million US$40 million US$30 million
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6. An Islamic property fund was established in Bahrain in 2008 to invest in various Shariah compliant companies that are related to the property sector. The prospectus for the fund mentions that it will subscribe to DJIM when selecting a particular company for investment. Applying the DJIM criteria strictly will exclude some potential companies from the approved stocks as the market capitalisation of these companies will have significantly fluctuated downwards given the global financial crisis in 2008. What is the immediate option available to this fund if it was to invest in these companies whose market capitalisation has dropped due to market conditions? (A) (B) (C) (D) Choice of using either market capitalisation or total asset Suspension of the calculation of total assets Converting all the leverage and investment to Shariah-compliant leverage and investment Using a trailing 36-month average market capitalisation

1. Using the FTSE Islamic index and Morgan Stanley Islamic Index stock-screening criteria respectively, convert the financials as given above to the relevant financial ratios to ascertain the compliance of this company. If the above company were to be reviewed and screened according to DJIM, AAOIFI, Standard & Poors Islamic Index, and Securities Commission of Malaysias stock screening respectively, with regard to financial ratio screening, what measures would need to be taken to achieve the compliance objective? Suppose the income from liquor and non-Halal food sold in its four hotels is quite substantial compared with the total revenue of the company, what measures could be taken to achieve compliance status? If QPP was later acquired by another property company that primarily owns and operates fivestar hotels in Europe and North America, would this affect the screening criteria and, if so, why? SRI Islamic Index is a hypothetical new Islamic Index. Do you think that the QPP company will be included in the constituents of this new index (irrespective of the financial ratio screening) and, if so, why?
2.
3.
4. 5.
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Chapter seven answers

Exercise 7.1
One of the Securities Commission (SC) of Malaysias screening criteria is the 10% benchmark that looks into issues such as interest income as a percentage of profit before tax. ABS interest income percentage works out to be: RM18 million/RM 200 million x 100% = 9% This figure does not exceed the SCs 10% benchmark and hence ABS will pass the SCs screening criteria. FTSE on the other hand applies additional financial screens and ABS FTSE financial screening results are as follows: Leverage: Total debt/Total assets = RM195 million/RM750 million x 100% = 26% Cash: (Cash + interest-bearing securities)/Total asset x 100% = RM274 million/RM750 million x 100% = 36.5% Non-Halal Income = RM18 million/ RM590 million x 100% = 3% ABS would not be included in the FTSE Islamic Index/Islamic-approved stocks as per the FTSE Islamic Index criteria it fails the cash and interest-bearing instrument screening, which is currently set at 33%, even though it passes the non-Halal income screen, which is currently set at 5%. Although ABS passes the Securities Commission Shariah Advisory Screening, it will not pass the Bursa FTSE Hijrah Index. However, its screening by the FTSE Islamic Index will only be done after the first screening by the Securities Commission of Malaysia.
Exercise 7.2
Several regulatory authorities have dedicated staff who look into product origination, innovation and expansion opportunities available within this market segment, with a view to creating regulatory incentives to promote the growth of this market segment. Labuan (Malaysias offshore financial centre), for instance, has established an Islamic Financial Development Division, while the Malaysian Securities Commission has an Islamic Capital Market Department. In addition to developmental work, these dedicated units, together with other relevant supervisory departments, work together with respect to regulatory functions such as licensing, supervision, inspection, investigation and enforcement, with specific reference to Islamic capital market activities. On the other hand, Muslim countries where the capital markets are comparatively small in the number of companies listed and that are already geared towards business activities that are generally Shariah-compliant may not separate regulatory oversight. Gulf Cooperation Council (GCC) nations, such as Saudi Arabia and Kuwait, may not necessarily require dedicated Islamic capital market oversight, as perhaps the only non-Shariah compliant business activities that they need to apply additional oversight to applies to interest-based financial institutions. Prohibited industries, such as the manufacture of alcoholic beverages, do not exist in those homogenously Muslim-dominated countries and thus the markets would require less supervision.
Exercise 7.3
Advertising is Shariah-neutral. The act of providing such a service does not contradict any Shariah principles. Advertising is a competitive industry whereby market leaders often lead the way with innovative advertising campaigns, delivered in cost-effective ways. Advertising campaigns are often delivered via various media ranging from print, radio, television and the internet. None of these media on their own contravene Shariah principles in any way.
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The question of whether World-Wide Ads can pass the Shariah screening exercise rests on financial ratios applied. Interest income is definitely a consideration for most screening methodologies: Dow Jones, FTSE and S&P limits it to i) 5% of non-Halal income and ii) less than 33% (including cash) of a companys total assets or market capitalisation. World-Wide Ads non-Halal income forms only 0.6% of its total income of US$40 million, which makes it Shariah-compliant, on the basis that it does not have any other source of non-Halal income. From the non-Halal income screening perspective, World-Wide Ads would likely pass the Shariah screening exercise. The question that has to be considered concerns World-Wide Ads clientele. If it is wholly made up of companies within the prohibited industries list, then World-Wide Ads should be excluded from the Shariah-approved stocks, even though its core business activity does not fall within one of the prohibited sectors or activities. If the clientele is mixed, the question is whether income from noncompliant companies can be accurately ascertained. If so, then the Shariah board of the screening party may be able to ascertain the amount of income generated from non-compliant clients through the revenue earned from advertising conventional banking products and services, as well as gambling activities. If the total income from these clients, plus any interest income, exceeds 5% of the total revenue, then this company should be disqualified from the list of approved Shariah stocks. Given the fact that this company is an advertising company, it will pass the first sector screening but fail the non-Halal income screening if the total impure income was to exceed 5% of the total revenue of the company.
Exercise 7.4
It seems that Aquaflo will only be compliant under the Morgan Stanley Islamic Index screening criteria of financial ratios. The use of total assets instead of market capitalisation and a 70% ratio for liquid and illiquid asset proportions instead of 49%, as adopted by Morgan Stanley, will render this company compliant. The company will not be compliant under other stock-screening criteria. The summary of the financial results of this company under the Morgan Stanley Islamic Index screening criteria is as follows: Denominator/basis used: Total assets Numerator/aspects Conventional leverage Cash and interest incomebearing instruments Cash and accounts receivable Qatari Rial,000 51,343 151,224 Qatari Rial 682,281,000 Ratio 8% 22% Threshold 33.33% 33.33% Compliance Complied Complied
440,000
65%
70%
Complied
Exercise 7.5
The major difference between the screening methodologies of DJIM and FTSE is the denominator that they each utilise to generate their leverage and cash percentages. DJIM employs a dynamic 12month moving market capitalisation as the denominator whereas FTSE uses a more static total asset figure. To reflect the differences, the table below shows the leverage and cash percentages for the company from 2005 to 2008.
2008 DJIM Leverage % Cash % FTSE Leverage % Cash % 453% 141% 55% 17%
2007 233% 161% 39% 27%
2006 61% 48% 40% 31%
2005 98% 53% 43% 23%
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The exercise above is not generated to test whether XX Airways is a Shariah-compliant company via the financial screen. Its result shows that there is a wide difference between the leverage and cash percentages for the same company utilising the two different denominators. For instance, the FTSE leverage screen shows a 39% figure in 2007, but under DJIM the figure is 233%. In the same year, the FTSE cash screen gave a figure of 27% (permissible as it is below 33%), but the DJIM screen shows a non-permissible figure of 161%. The major difference shown above is due to market volatility where the XX Airways value went down steeply, but its asset value is yet to be adjusted. The real question is which of the screening methodologies should be applied as there would be instances (not here) whereby one company would be included in the FTSE Shariah-compliant list and not in the one generated by DJIM. That question must, however, be deliberated by the Shariah board and the management of the entity that is looking to invest in the company. The utilisation of a 36-month trailing average market capitalisation would indeed improve the results to the DJIM financial ratio screen. This is especially so for companies that have seen a downward spiral to their value of market capitalisation over the past few years. The result for XX Airways using this denominator is as follows:
2008 DJIM Leverage % Cash % 168% 52%
Notice that the company still fails the DJIM screening criteria, but its results are much closer to the FTSE results as shown above. A possible explanation is that the companys market capitalisation fell too rapidly and by too much in 2007 and 2008.

1 2 (A) According to DJIM, conventional debt or leverage ratio cannot exceed 33% of the companys market capitalisation. (B) It is a fact that the weaponry industry is regarded by most Shariah screening bodies as noncompliant. The exception to this is found with the screening body at Dubai Financial Market which argues that weaponry is critical to defend ones country from unlawful aggression, a legitimate cause. (C) Changing the debt as well as cash and interest-bearing ratios as suggested here will not improve the market capitalisation denominator used for screening purposes. Unlike the rest of the answers this will affect the calculation of the financing ratio screening. (C) The hotel industry is one of those industries that is usually flagged during screening, due to alcohol being served within the premises. However, hotels in Saudi Arabia cannot and do not serve alcohol, and as such can be categorically included as a Shariah-compliant business activity. What would affect QPP inclusion as an approved Shariah stock is the participation in the hotel business outside Saudi Arabia. Hotel businesses elsewhere therefore require screening. (A) DJIM uses market capitalisation as a denominator in calculating the leverage ratio. The 2008 figure states that the company has a leverage ratio of 41%, with the conventional debt of US$300 million. To reduce it to an acceptable 33% or at about US$240 million, the company must issue a Sukuk or Murabahah-tawarruq financing amounting to US$60 million. (D) Trailing market capitalisation as a denominator in calculation of financial ratios is a feature of DJIM screening methodology.
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1. The financial screening results using FTSE and Morgan Stanley screening methodologies are given in the table below. One should note that both methodologies employ total assets as the common denominator. The main difference lies within the receivables criterion; receivables ratio FTSE less than 50% while Morgan Stanley is less than 70%.
year 2008
QPP Ratio
FTSE Islamic Index
Morgan Stanley Islamic Index Pass Pass Pass
Leverage ratio Receivables ratio Cash and interest-bearing instrument ratio Non-Halal income ratio
2.85% 47.21% 17.92%
Pass Pass Pass
8.22%
Fail
Fail
2.
To achieve Shariah compliance under the indexes prescribed, QPP must first reduce the receivables ratio to one that is below the prescribed threshold. Dow Jones has set a threshold of 33% of market capitalisation; S&P accepts a figure of 49%, while AAOIFI allows a receivables ratio of up to 70%. The issue here is that the methodologies use market capitalisation as the denominator instead of total assets, which can be a problem in times of falling market values. The ratio is not relevant for the Securities Commissions screening as it does not feature in its criteria. The next issue for QPP is to reduce its non-Halal income. One source may be the interest the company receives from placing its cash deposits in conventional banks. If possible, QPP should place those deposits in Islamic banking institutions, if available, so it does not lose out on potential returns. The most commendable option for QPP to achieve Shariah compliance in this regard is to refrain from conducting business that involves liquor and non-Halal food. However, this option may not be feasible in most countries as the needs of other communities must be dealt with. One possible option for QPP is to outsource the liquor and non-Halal food to a third party. The third party must be located outside the hotel premises to avoid a lease contract between the hotel and the operator. In all likelihood, the acquiring company will not be compliant as the western-based hotel operator would most likely generate a large portion of its business revenue from the sale of liquor and non-Halal food in its premises, especially in Europe and North America. Therefore, it may be likely that QPP would fall out of the Shariah compliance list if the acquiring company intends to run QPP like the rest of its operations. However, it could be that the acquiring company intends to keep QPP as a niche market and preserve its compliance status. There is no issue of ownership by the parent company on QPPs compliance status if it can be determined that QPPs operations and financials remain Shariah-compliant. However, if the two companies are merged, there will be consequences for the financial ratios as the seemingly conventional investor companys leverage and other ratios would impede the Shariah compliance of the newly merged companies. The idea behind socially responsible investing is to provide investors with an investable universe made up of socially responsible companies with good corporate values. The provision of liquor and military equipment may go against the benchmarks of SRI screening, which would affect QPPs entry into the SRI list. While the case of the provision of liquor is clearly unacceptable with the SRI, the weaponry industry is still arguable, as some military equipment, such as military satellites to forecast weather and climate change and military equipment to deal with catastrophic events, are not necessarily destructive. Above all, some may argue that military equipment, even in the form of weapons, is useful and needed to defend ones country from illegitimate and unlawful aggression and invasion. This is the argument put forward by Dubai Financial Market Shariah stock screening, which excluded weaponry from the prohibited list of activities.
3.
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Chapter eight
Structuring and strategic issues for Islamic funds
Learning outcomes
By the end of this chapter you should be able to: evaluate structuring features and issues of various Islamic funds assess relevant criteria and recommend policies for Shariah-compliant funds analyse the suitability of structures involving commodities and gold funds, real estate funds, money market funds and private equity funds evaluate strategic issues for the further development of Islamic funds

Structuring features and issues of Shariah-compliant funds Structuring requirements for Shariah-compliant commodity and gold funds Structuring requirements for Shariah-compliant money market funds Structuring requirements for Shariah-compliant private equity funds Strategic issues for the development of Islamic funds Case study: structuring and strategic issues of Islamic private equity funds
8.0 Introduction
Investments may be made directly by individual investors into respective assets such as bonds or Sukuk, shares, property and commodities. Alternatively, investors may pool together their investment into a collective scheme or fund where their investment activities are managed by a professional fund manager. The management of collective investments gains prominence with the development of capital markets where financial securities are traded in established stock exchanges. This model clearly provides investors with the opportunity to invest in many more assets in terms of value and diversification than would otherwise be possible if they were to invest individually. Since the introduction of such collective funds as investment vehicles, the opportunity for smaller investors to participate in investments that enable risk diversification has been an important factor in their establishment. In general, Islamic funds portray similar expectations of investors preference towards risk diversification in equity investments and other asset classes as occurs in conventional funds. The funds operate around an agreed trust deed that caters for Shariah-compliant requirements in all permissible investments. Collective investment schemes may be formed under company law or by legal trust or statute. The nature of the scheme and its limitations are often linked to its legal structure and associated tax rules within a given jurisdiction. Central to this legal requirement is the establishment of a Shariah supervisory board to assist the fund management in compliance with Shariah principles in terms of the legal structure of the fund, investment activities, redemption, as well as the trading of units and shares of the fund. This chapter analyses the structure, features and economic behaviour of different types of Islamic funds. The discussion is limited to funds involved in commodities, gold, real estate, money markets and private equity investment. Focus is directed towards the issue of structuring open-ended and close-ended funds, as well as exchanged traded funds (ETF) in relation to various underlying investment assets in the form of real estate funds, commodity and gold funds, money market funds and private equity funds. This chapter also highlights the general performance of Islamic investment compared with conventional investments, particularly in the equity market. Finally, you will be introduced to strategic considerations that could enhance the industry of Islamic asset management in the global market.
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8.1 Islamic funds

As stated in the introduction, investments may be made directly by individual investors or investors may pool together their investment into a collective scheme whereby their investment activities are managed by a professional fund manager. Management costs will be reduced as they are borne proportionately by each and every investor in this scheme. Collective investment schemes may be formed under company law or by legal trust or statute. The nature of the scheme and its limitations are often linked to its legal structure and associated tax rules within a given jurisdiction. The focus of this chapter is on collective investment schemes conducted in accordance with Shariah principles. A collective investment scheme pools investments from a group of investors, allowing them to participate in a wider range of investments than would otherwise be feasible and to share in its costs and benefits. Such schemes are referred to as mutual funds, investment funds or simply funds. Although investments may be restricted to geographic regions, specific industries, currency denominations or investment styles, such as growth-based funds or value-based funds, it remains collective in nature as it needs to have investment from more than one source in a number of diversified assets. By investing in such schemes, investors are issued with shares, units or certificates of investment to reflect their ownership claim on the underlying assets of the investment. Investors will either be subscribing to the investment fund or exiting or disposing of their interest in the fund. The disposal or the tradability of the shares and units, where relevant, is peculiar to collective investment schemes as physical possession of the underlying assets of the investment rarely takes place. All investment and divestment activities are done through these shares or units of investment issued by the fund manager. A collective investment scheme will pool all investors into one type of fund, which is a separate legal entity. The fund will represent the undivided ownership of the investors in the underlying investment assets. In this case, an individual investor has given his rights and liabilities to the fund to act on his and other investors behalf. The fund, being a separate legal entity acting on behalf of the investors, must undertake its operation according to the wishes of the investors. Therefore, if the investors were to seek Shariah-compliant investment activities, then the fund must behave accordingly. The scheme may also pose relevant Shariah issues that otherwise would not be a problem if investment was to be exercised by an individual Muslim investor. An individual Muslim investor may purchase gold or currency on spot and subsequently sell the same gold or currency to another third party on spot basis for a capital gain. This is allowable under Shariah principles as long as the transaction is spot. However, if an investor was to invest in a collective investment scheme of gold fund, and was subsequently issued with a share or unit, he could not sell this share or unit in the secondary market based on the net asset value (NAV) of the fund. This action may be deemed as selling gold not at par value, therefore breaching the principle of selling gold for money at par value to avoid Riba.
Key point
Collective investments may result in a number of Shariah issues that would not otherwise be so with individual investment activities by a Muslim investor.
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Scenario one A Muslim investor pays 1 million to purchase gold bullion from a gold supplier or to purchase an apartment in the City of London. In addition to his cash investment of 500,000, the investor borrows 500,000 from a conventional bank to complete the transaction. He then decides to sell his gold or property to another party either at spot or on a credit basis. Explain whether this is an issue from a Shariah perspective. Scenario two An Islamic fund of 100 million has a mandate to invest in gold or real estate assets. The fund manager issues units to the investors as evidence of their ownership interest in the fund and its underlying investment assets. The fund allows the unit holders to sell these units in the secondary market in order to exit the investment. The fund also borrows 50 million from a conventional bank to purchase gold or properties in excess of the equity contribution of the fund investors. Explain whether this would be an issue from a Shariah perspective and contrast and compare to the first scenario.
Solution
Both scenarios would result in a number of relevant Shariah issues. There are no Shariah issues with an individual investor purchasing or selling his investment assets except with regard to the sale of gold, which must be done on a spot basis (as gold is a Ribawi item). He may also take out a conventional loan as this has to do with his personal conduct (although it is not actually compliant with Shariah principles given that he is a Muslim). However, the fund needs to be compliant in all respects if the institution has a mandate to be Shariahcompliant. In this case, Shariah issues will be insignificant as the transactions are physical and directly linked to specifically identified commodities or property. In the case of the Islamic fund, all potential Shariah issues originate from the fact that units and shares are issued to investors as evidence of their proportionate and undivided ownership of the underlying investment assets. This opens the door for these shares and units to be traded in the secondary market, which may not be compliant if the underlying assets are gold, cash or receivables. This, however, does not apply to investment in real estate. Borrowing using a conventional loan is also objectionable as the fund is acting as an agent for the investors. Therefore, structuring Islamic funds according to Shariah principles is critical in contrast to individual investments, irrespective of the investment assets.
8.2 Structuring issues of Shariah-compliant funds

Structuring any compliant fund would require a thorough examination of at least five issues: the underlying investment assets the financial activities of the fund the contractual terms and conditions the clauses and terms of the investment contracts the cleansing or purification of non-Halal income.
8.2.1 The underlying investment assets

The underlying investment assets, which are the central focus of any Shariah-compliant fund, must be compliant. While some investment assets are obviously permissible, such as grain, oil and metals, others may need Shariah screening, such as bonds, Sukuk, properties, shares, money market and treasury products. For example, if a fund has invested in the equity of public-listed companies then shares or stocks must be compliant according to established Shariah screening criteria as discussed in chapter seven. Failure to meet these criteria would affect the integrity as well as the credibility of the fund. The necessary screening methodology for other asset classes, such as properties and Sukuk, will also need to be carried out if the fund is structured as a property or Sukuk fund.
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8.2.2 The financial activities of the fund

The financial activities of the fund must be equally compliant to Shariah principles. Thus, an Islamic fund is not allowed to raise funds through conventional borrowing. Furthermore, all investments by the fund must be conducted in a manner compliant to Shariah principles be it for short-term or longterm investments using the cash available in the fund (either from the initial investment proceeds or capital gains and dividend payments). The cash management of the fund must be channelled towards Islamic-approved deposit or investment schemes. In addition to the funds leverage and investment, all risk management techniques, such as currency hedging, investment via call options (if relevant), must be compliant to Shariah principles.
8.2.3 The contractual terms and conditions

The terms and conditions of the contractual arrangement between the investors and other parties, such as the fund manager, the fund administrator and the trustee should also be Shariah-compliant. A fund could be based on either the Mudarabah or Musharakah contract. In practice, most Islamic funds are based on a Musharakah contract where investors are co-partners who share profits and losses as specified in the deed of agreement of the fund. The relationship between the pool of investors and the fund manager is also an important element of the structure of a fund. In most cases, the fund manager is appointed as an agent based on a Wakalah contract.
8.2.4 The clauses and terms of the investment contracts

In addition to the important contractual issues that govern the relationship among investors and between the pool of investors and the fund manager, all clauses and terms of the investment contracts must be Shariah-compliant. For example, an Islamic mutual fund investing in compliant equities may propose to issue two classes of shares, namely class A and class B for two classes of investors. Shariah principles may allow the distinction of relevant rights and liabilities of these two classes of shareholders, such as the right of voting or different fees structures. However, Shariah principles will not allow any preferential treatment between the two classes with regards to profit distribution and loss bearing in the case of liquidation of the fund if all the investors are Musharakah investors.
8.2.5 The cleansing or purification of non-Halal income

The term sheet or information memorandum of an Islamic investment fund must address the issue of cleansing or purifying non-Halal income generated by the fund. Some of this income may be due to the screening criteria that allowed the fund to invest in relevant underlying assets that generated a portion of non-Halal income. This can occur in investments in items such as shares and properties. It can also occur by accident where the Shariah compliance status of the underlying asset has changed as a result of corporate re-structuring, as in the case of mergers and acquisition or market movements. Generally, non-Halal income is measured against the total revenue of the underlying assets. This amount must be purified from either the dividend received (in the case of shares) or rental income (in the case of properties).
Key point
The structuring of Islamic funds looks at five main issues: the underlying investment assets, the financial activities of the fund, the contractual terms and conditions, the clauses and terms of the investment contracts and the cleansing or purification of non-Halal income. Table 8.1 shows a summary of the features of a typical property fund that can be found in its information memorandum.
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Table 8.1 Summary of LM Australian Alif Fund (based on Information Memorandum issued 17 April 2009) (LM Investment Management Ltd, www.LMaustralia.com)
Investment objective To provide profit to the unit holders relevant to the risk return of the Fund, whilst adhering to Shariah principles; and To provide an investment with a stable unit price. The Funds investment remit covers investment in existing property direct property, property development, other managed funds, joint ventures and compliant business investment. All investments are into asset classes are in accordance with Shariah principles. Thirty-six months. Arrangements may be able to be made with the manager for different investment terms, for example, five years. Investment may be arranged for most currencies. USD JPY SGD CHF THB GBP CAD EUR HKD AUD Investments in the Fund can be hedged in the relevant currency against Australian dollar currency movements, while an AUD investment is not hedged. Direct investment in properties Investment in property development and on-sale Other Shariah-compliant property funds Joint ventures with other property developers
Assets
Investment term
Currencies
Investment strategy
Shariah investment guidelines Reinvestment of distributions/profit Payment of distributions/profit
The fund precludes investment in certain businesses, such as alcohol, pornography, gambling and conventional financial institutions. Distributions are automatically reinvested upon the 12-month anniversary of the investment. When the manager has been instructed by the investor to pay annual distributions, distributions are paid within 30 business days of the annual anniversary of the investment. At the end of the initial 36-month term of the investors original investment (unless the investor elects to have the distribution paid direct to the account nominated on the Application Form), the capital and the profit is automatically reinvested in the originally nominated currency for further 36-month investment terms unless either the investor notifies the manager to reinvest the investment for different investment terms, or a withdrawal notice is received by the manager. Investments are made for a fixed term of 36 months. AUD$5,000 At least 90 days prior to the expiration of the fixed 36-month term. Multiples of AUD$5,000. AUD$5,000. Units are issued on application. The unit price is variable and as at the date of this Information Memorandum is AUD$1.00 per unit. No entry or exit fees are payable provided the investment is held for the full investment term.
Automatic rollover
Investment term Minimum investment Withdrawal notice Minimum withdrawal Minimum balance Unit pricing
Fees
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Exercise 8.1
Based on the above summary, outline any other areas that should be incorporated in this summary to ensure its complete compliance with Shariah principles.
8.3 Fund structures and the Shariah perspective

Funds can be structured in a variety of ways and some may have Shariah implications. The following section briefly discusses the various forms that a fund structure can take and when and how some of these structures may affect Shariah-compliance issues either at the issuance/origination or at the trading stage.
8.3.1 Open-ended funds

As discussed in CDIF/3/10/157-158, an open-ended fund is essentially a fund that allows the fund manager to issue new shares or units on a demand basis. It also gives investors the right to redeem the shares or units from the fund based on the prevailing net asset value (NAV) of the fund that can only be made available at the end of each trading day. The issuance of new shares and redemption of existing shares will affect the NAV of the fund. The NAV is the basis of the price of new shares or units to be issued or redeemed for existing shares or units. This feature of the open-ended fund does not pose any Shariah issues as the NAV is an acceptable benchmark for all investors and the fund manager.
8.3.2 Close-ended funds

Unlike an open-ended fund, a close-ended fund is a fund listed and traded on an exchange. The number of shares or units in this fund must be limited to the volume of the issue at the inception of the fund, that is to say no more shares or units will be issued to the market. These shares or units, unlike in the case of an open-ended fund, may be traded on a secondary market subject to market forces. If demand for the shares or units is high, investors may trade at a premium to NAV. However, if demand is low then they may trade at a discount to NAV. Like open-ended funds, close-ended funds should not pose any problems relating to Shariah compliance. The exception occurs when the underlying investment asset is gold, silver, currency or receivables. The trading of these underlying assets in the secondary market, at a price different from their face value, must be avoided so as not to lead to a Riba transaction.
8.3.3 Exchange traded fund (ETF)

An exchange traded fund (ETF) is an open-ended fund that can be traded on a daily basis (CDIF/3/10/158). ETF offers public investors undivided interest in a pool of securities and other assets, and therefore are similar to traditional mutual funds, except that shares or units in an ETF can be bought and sold throughout the day like stocks on a securities exchange. ETF allows the trading of its shares or units at any time of the day instead of at the end of each trading day and are not redeemed by the fund (as in the case of an open-ended fund). The main difference between an ETF and a close-ended fund is that one of its shares or units represents a basket of underlying assets as contained in a particular index to which the ETF is linked, whereas a close-ended fund is not linked to an index. An ETF is normally described as an index tracking fund or, to be more precise, a listed index-tracked fund as it is listed on an exchange and it tracks a particular index that is used as a benchmark for the funds performance. Unlike other funds, irrespective of whether they are open-ended or close-ended, the investment portfolio in an ETF is already linked to a specified index so the fund manager does not need to re-balance it. An ETF is the logical progression of an equity market environment. The equity market began with stock trading. As retail investors did not have the time and expertise to pick and trade stocks this gave rise to mutual funds in both open-ended and close-ended forms. As mutual funds were usually unable to beat the market return (as measured by certain indices), the index fund was created. As mutual funds and index funds are not listed and traded, the market invented ETF, which is a listed index fund. From a structuring point of view, ETFs do not pose a Shariah challenge except when the underlying asset is gold, silver or receivables. This is relevant to the issue of trading rather than the issuance and origination of such funds. If the trading of ETF on these assets can be prevented, then an ETF can be structured around Shariah sensitive-based assets such as gold, silver and monetary assets.
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Key point
Islamic funds may be structured as open-ended, close-ended or exchange traded funds.
Exercise 8.2
An Islamic asset management company is considering the launch of two Islamic ETFs, one for shares and the other for gold bullion. Outline any specific structuring issues that many relate to either ETF.
8.4 Structuring requirements for compliant commodity and gold funds

The following sections look at the structuring requirements for commodity and gold funds.
8.4.1 Commodity funds

A commodity is an investment asset that investors may be interested in. This investment is perceived either as an alternative to traditional investment assets, such as shares and bonds, or as a diversification of the investment. A commodity includes a wide range of assets, such as oil, gold, corn, soya and metal, which offer an alternative investment for investors in addition to shares and bonds. The fund is normally structured to facilitate a collective investment in commodities that are important to global market needs, such as oil, precious stones, metals and grains. The vehicle of investment may take the form of open-ended, close-ended or ETF. A commodity fund is any fund that has a direct holding in real commodities. For example, aluminium or grain funds are true commodity funds. From a Shariah perspective, a Shariah-compliant commodity fund must exclude any fund that has a holding in commodity-linked derivative instruments such as futures and forwards. In the conventional market this is a common mutual fund strategy for investing in the commodities market in a situation where investors have no desire to take delivery of the commodities but simply want to profit from price changes in the market. An Islamic commodity fund must actually own and possess the underlying commodities. During the ownership period, investors must bear all the risks associated with these commodities as the market can be volatile. Central to this risk is the liquidity and market risk of the commodities in question. An Islamic fund investing in commodities-related assets ought to provide relevant Shariah-compliant hedging instruments to mitigate the liquidity as well as the market risks. Commodity funds do not pose any specific challenges to Shariah structuring except in relation to risk management as Islamic funds cannot participate in forwards or futures markets as practised in the conventional commodities market. The Shariah issue will be more relevant when underlying commodities involve precious metals, such as gold and silver, as these assets are usurious items. The next section considers gold funds as a sub-section of commodity funds.
Key point
A commodity fund, with the exception of gold and silver, is a compliant fund provided it is free from futures, forwards and options contracts in its business transactions.
Exercise 8.3
Based on your understanding of conventional futures and forwards contracts as outlined in CDIF/3/13/211-213, which of the following contracts would be a suitable Shariah-compliant alternative to mitigate market risk in the commodities market and why? (A) Wad and Musharakah (B) Wad and Salam (C) Murabahah and Salam (D) Urbun and Murabahah
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A few financial institutions have seen the potential of investing in grain-based commodities. They have issued an investment paper under which all participating financial institutions will invest up to US$10 million to achieve the target minimum investment of US$100 million. The syndicated investors have appointed Green Investments Ltd to manage the investment portfolio for a fee of 5% per annum. Green Investments Ltd has been in the commodities market for the past 20 years and has been buying grain from farmers on a forward contract. Occasionally, Green Investments Ltd purchased the grain on a credit sale for a two-month period. Green Investments Ltd would also normally sell the grain to the ultimate purchasers or producers on credit terms. The average profit from such transactions has been 10% of the investment amount per annum for the past five years. Based on these facts, propose how the product could be restructured into a Shariah-compliant investment scheme.
Solution
This is essentially the typical flow of transactions in the commodities market involving grain trading. The above description of the transaction may result in Shariah compliancy issues as Green Investments Ltd may have used a forward contract that is not compliant to Shariah principles (CDIF/3/13/211-212). However, if Green Investments Ltd was to use a credit sale arrangement when buying grain from farmers, then this will be acceptable. To mitigate the market risk, Green Investments may want to use either the Wad, Salam or Urbun contracts, depending on what would be more relevant to the risk profile of the parties. These alternative contracts cannot replicate the full features and benefits of conventional forward and futures contracts, but may offer some aspects of risk management for the Islamic investors. For example, in the case of Wad, Green Investments Ltd may request the farmers to undertake to promise to sell a certain quantity of a specific grain to the fund in two months time at a specific price. This will protect both parties from market volatility during the intervening period. With regards to the investment vehicle, a Mudarabah investment certificate may be issued by Green Investments Ltd to pool investments from all participating Islamic-based investors. While the loss is to be borne by the investors, the profit is to be shared between the investors and Green Investments Ltd. Alternatively, a Shariah-compliant commodity fund may be formed to invite the investors to invest in this pool under a Musharakah contract. The Musharakah investors will later appoint Green Investments Ltd to manage the investment for a fee of 5% per annum. In both structures, the fund cannot borrow conventionally if it is in need of more funds.
8.4.2 Structuring compliant gold funds

Gold is also seen as a commodity and gold funds, like other commodity funds, must have actual direct holdings in the commodity. For example, a gold fund holds gold bullion. Investors will own the bullion in proportion to their investment interest in the fund. However, from a Shariah perspective, gold should be treated differently from other commodities. In Shariah, gold and silver take the position of currencies and, therefore, cannot be sold except on par value and spot basis as per Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) Shariah Standard (No: 8). This will be discussed later. The following diagram illustrates the general structure of a typical Shariah-compliant gold fund.
228
Figure 8.1 Gold fund structure

Investors 1 Fund manager Gold fund 5
Fund management vehicle 2 Physical gold bullion 3
Returns (capital gains)
Step 1 Step 2
Investors place their investment money in the gold fund. A fund manager purchases the physical gold bullion in an allocated form that is identifiable. The fund manager manages the asset through its management vehicle for a period of time, usually a long-term strategy. The fund gets its returns by calculating the net asset value (NAV) at the end of the holding period. The NAV per share is calculated by dividing the fund assets, minus liabilities, to the number of shares issued or outstanding. The fund then distributes the profit, if any, to the shareholders in the form of a capital gains distribution.
Step 3
Step 4
Step 5
The Shariah-compliant gold fund is structured with the intention of gaining long-term capital appreciation as investors take the view that the value of gold will appreciate over time. The fund primarily invests in physical gold bullion in certain specific gold commodity markets throughout the world such as Dubai Gold and Commodity Exchange. In this arrangement the physical gold bullion is purchased in an allocated form which will be identified and tagged, and kept in a secure place. The prime reasons for investing in gold are: Gold is one of the most effective value-preserving commodities. Demand for gold is ever-increasing due to its reduced supply. Gold itself possesses excellent durability as the metal never degrades. It is tradable at any time in every location.
8.4.2.1 Restrictions relating to gold funds

At this stage it is appropriate to highlight a few issues that relate to a gold fund vis--vis other underlying assets in a commodity fund. These issues include, but are not limited to, the following: As previously explained, the structure of any fund could be open-ended, close-ended or ETF. An openended fund structure would seem more suitable for a gold fund to ensure that shares or units are not traded in the secondary market. Any secondary trading of these shares or units may be questionable as gold can only be sold or exchanged for money at face value instead of at a value based on the NAV of the gold fund or at the market value based on market forces. The structure of an ETF gold fund may result in Shariah compliancy issues as an ETF may be traded in the secondary market unless the exchange, while approving the ETF gold fund, for example, prevents its trade until it matures.
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In order to satisfy the Shariah requirement of real ownership of the gold bullion by investors, the units or shares of the respective investors must be traceable to an identified piece of gold bullion. Also, the fund must make it possible for investors to take physical delivery of the gold bullion if they wish. However, all the expenses pertaining to the delivery and transportation and insurance must be borne by the respective investor. In the case of early redemption of the unit or share of the fund, the fund may have a policy that no investor can redeem an investment until the fund matures. However, the fund may allow investors, under strict circumstances, to liquidate their position by buying the units or shares at the prevailing market price, based on the NAV of the fund. This is only allowed for redemption and not for trading purposes. The investor normally cannot exit the investment until it matures to be compliant to Shariah principles. However, in some exceptional cases, such as when the investor is in dire need of cash and subject to the scrutiny of the fund manager, the fund manager may redeem this share or units based on NAV to allow early redemption. This is the only mechanism to allow early redemption since the fund disallows secondary trading of the units. It is also relevant to pose the question of whether an Islamic investor may invest in gold-related investment structures, such as the equities of worldwide companies engaged in the exploration, mining, production or processing of this precious metal. The view of scholars is divided on this matter as the shares of these public-listed companies in the exchange are liquid and tradable. There is a concern that investment in these companies may lead to the trading of cash for gold as the companys assets comprise gold, even though it is still involved in the mining process.
Key point
Shares and units in a gold fund, unlike a normal commodity fund, must not be tradable in the secondary market to avoid a Riba transaction. While trading is not permissible, redemption of the shares and units in the gold may be permissible subject to certain requirements.
Exercise 8.4
An Islamic fund proposes to launch an Islamic money market fund comprising 30% Sukuk Ijarah and 70% investment in gold bullion. The fund intends to use an exchange traded fund as its investment vehicle. Would this structure be compliant to Shariah principles as per AAOIFI Shariah standards and if it is not compliant, what would you propose to make it compliant?
8.5 Shariah real estate funds / Shariah real estate investment trust (REIT)
Investment in real estate or landed property may take the form of a normal mutual fund or real estate investment trust (REIT). A discussion of Islamic REITs was made in CDIF/3/12/189-201. The following is a typical structure of a real estate fund which takes the form of a mutual fund.
Figure 8.2 Islamic real estate funds

Investors
Fund manager
Fund management vehicle
Direct property
(existing property)
Joint venture
Property development
(new property construction)
House financing
Property companies
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8.5.1 Islamic mutual funds and Islamic REITs investing in real estate
The relevant issues of both Islamic mutual funds and Islamic REITs investing in real estate are as follows: The screening methodology must be established to screen the mixed use of real estate, compliant use and non-compliant use. Unlike in the equity sector, the global Islamic finance industry has not provided a universal Shariah standard for screening real estate properties. Therefore, the development of this sector may be affected. Some guidelines, for example, have prescribed a maximum of 20% for non-Halal lease income as the benchmark (as in the case of the Securities Commission of Malaysia), while other Islamic real estate funds may adopt a zero tolerance for nonHalal rental income. By reference to the screening used for stocks, one may infer that a maximum 5% benchmark could be advocated to screen non-Halal rental income. The non-Halal income generated from non-compliant tenants must be given to charity to purify the tainted income to the fund. Any financing by the fund to enhance its investment capabilities must be undertaken according to Shariah principles. In other words, although the fund may leverage, it should only do that in a manner that is Shariah-compliant.
8.5.2 Real estate funds versus REITs

Although both real estate funds and REITs operate in a similar way, that is, to acquire property and lease it to tenants for a rental income, REITs may have a different investment strategy. Among other possibilities, the property owner may leverage it using the scheme of REITs. In this case, the owner may pool the assets, which are compliant, such as hospitals, universities and residential apartments, with a view to selling them to Islamic REITs at a certain price. The proceeds of this sale may be used by the owner for other property development or activities deemed fit that are not related to Islamic REITs and its investors. The owner of the properties, and Islamic REITs investors are two different and independent parties. Islamic REITs as a fund will issue units to investors to evidence undivided interest of the investors in those assets that the Islamic REITs fund is buying from the owner. These assets could be subsequently leased back to the owners as the operator, given their expertise in managing those assets before the acquisition by the Islamic REITs. The lease rental paid is the income to be distributed proportionately among the Islamic REIT investors.
8.5.3 Financing or leveraging Islamic REITs

Pertinent to both real estate fund and Islamic REITs is the issue of financing or leverage to enhance their financial capabilities to acquire more properties, exceeding the equity portion of the fund. In an Islamic fund or Islamic REITs all financing activities should be compliant. These can be facilitated either through Islamic banking products or capital market products such as Sukuk. The challenges arise if the fund was to increase its profitability by undertaking a relevant joint venture with other property developers to secure a higher degree of profit since they will be involved from the very beginning of the project. The joint venture between Islamic real estate funds or REITs with other property developer companies must be structured according to Islamic principles. For example, the new joint venture company, which is formed by both an Islamic fund and another developer company, should not borrow a conventional loan to finance the cost of the project. It has to obtain Shariah-compliant project finance, even though the entity which seeks this financing is not an Islamic fund. The Islamic fund as co-owner is liable for its financial conduct.
Key point
Islamic real estate funds and Islamic REITs may only invest in compliant properties, although these properties may generate some non-Halal rental income from their tenants. The tolerance level must be decided by the funds Shariah supervisory board in the absence of globally accepted property screening criteria.
231

An Islamic property fund in India is considering investing in the real estate sector using several investment strategies. The following strategies have been shortlisted by the fund management company: Purchase of new residential apartments in the city of Mumbai to lease them out to expatriates working in the city with the minimum rental payment of Indian Rupee (INR) 200 million per year. Purchase and manage serviced apartments in the same city. Purchase and manage three-star hotels in the city of Bangalore. Joint venture (JV) with local developers to build new houses in various main cities in India of up to 500 units. While the Islamic property fund will provide the equity of up to INR10 billion to the JV company, the other venture partners will provide a small amount of equity of INR1 billion. However, the JV company will later borrow up to INR10 billion from a conventional bank to finance the cost of the construction.
Based on the above information, advise whether these proposed investment strategies are compliant with Shariah principles and, in the case of any that are not compliant, propose the investment structure required to make them compliant with Shariah investment guidelines.
Solution
The Islamic property fund may invest in (a) and (b) without generating any Shariah issues as the main purpose of residential apartments and serviced apartments is essentially accommodation and lodging. Serviced apartments, as widely observed around the world, do not provide any food and beverage to its guests or visitors and, therefore, the issue of income from non-Halal food and drink is avoided. However, the proposed investment in the hotels may pose a Shariah investment issue as the hotels may offer non-Halal food and drink. Subject to a non-Halal income tolerance ratio subscribed to by this Islamic fund, the fund may continue with this investment if the income from non-Halal food and drink is below the prescribed ratio. This non-Halal income is, however, always subject to a cleansing or purification requirement. Alternatively, the fund may outsource the food and beverage services to a third party of which the fund has no relationship in terms of ownership of the premise or the management of this third party servicer. If either of these options is not possible, then the fund must drop this investment target. As for the investment via joint venture, the proposed structure of establishing the JV company, the leverage to be undertaken by the JV company using a conventional loan appears to be non-compliant as the company is jointly owned by both an Islamic fund (via equity contribution of INR10 billion) and the local partners (via equity contribution). An Islamic fund, being the owner of this new JV, should not borrow through a conventional loan as this will generate interest payments that are an expense to the fund. A possible solution is for the JV company to seek Islamic financing, such as Murabahahtawarruq, if available. If it is not available, which is quite likely in this case, another structure may be proposed. The act of conventional borrowing must be done by the local partners and the proceeds of this loan will be contributed as equity in the new JV company, which is also contributed by the Islamic fund. In this case, the company will be getting a total equity of INR21 billion contributed by the Islamic fund (INR10 billion) and local partners (INR11 billion, whereby INR10 billion is raised through a conventional loan). In this structure, the company will not be involved in conventional borrowing, and will be compliant with Shariah principles.
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8.6 Islamic money market funds

Money market funds are mutual funds that invest in liquid, short-term instruments. These funds seek to limit exposure to losses due to credit, market and liquidity risks. Liquidity and capital preservation are the two pertinent features of money market funds that investors look for. These features are also required by Islamic investors who, in addition, require that the instruments invested by their money market funds are Shariah-compliant. Unlike conventional fund managers, who have at their disposal a plethora of debt and interest-based instruments to suit their money market portfolios, Shariah-compliant money market instruments are still comparatively in the infancy stage. To date, Islamic fund managers allocate their Islamic money market funds to investments in either Commodity Murabahah, Wakalah fi al-istithmar or short-term Sukuk such as Sukuk Ijarah.
An example of this is the Boubyan Financial Fund. The fund aims to maintain stability on returns through its investment in Shariah-compliant financial instruments, including asset-backed Sukuk, Sukuk Ijarah, Sukuk Musharakah, Sukuk Murabahah and other Shariah-compliant Sukuk and regular Murabahah deals that are typically based on the Murabahah-tawarruq structure. The fund invests the available surplus funds in Shariah-compliant short-term Murabahah deposits and aims to realise competitive or higher returns than traditional money market Kuwaiti Dinar returns over the short and medium term. It seems that this fund will only invest in those assets that are liquid, fixed-income and short-term in nature. This is the very basic feature of any money market fund, be it Islamic or conventional. The extract of the term sheet for Boubyan Financial Fund is below:
Table 8.2 Term sheet for Boubyan Financial Fund

Maximum subscription Fund type Fund tenor Net asset value Subscriptions and redemptions Funds custodian Selling agents 50% of Total Issued Units Open-ended Ten years, renewable subject to majority approval Calculated on weekly basis Weekly (one month after launch of fund) Gulf Clearing Company (Bahrain) Boubyan Bank and any other financial institutions appointed by the fund manager Deloitte & Touche, Bahrain 0.625% p.a. of net asset value (NAV) Central Bank of Bahrain (CBB)/Laws of the Kingdom of Bahrain and State of Kuwait
Auditor Management fees Fund registration/governing law
Abstract of term sheet sourced from Boubyan Bank, www.bankboubyan.com
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As per the comparative performance of this fund vis--vis other money market funds, the table below explains that the performance of the Boubyan Islamic money market is comparatively better.
Table 8.3 Comparative performance of Islamic money market fund

Cumulative by % 4 Wks Boubyan Financial (KWD) LGC Money Market (Other Currencies) 0.71 4.64 1 Yr 7.46 -12.64 YTD 2.65 6.09 Annualized by % 3Yr 7.39 1.3 5Yr -2.61 10Yr -3.79
Figure 8.3 Comparative performance of Boubyan Financial and LGC money market funds
13000 12000 11000 10000 2006 2007 2008 LGC - Money Market Other 2009 9000
Boubyan Financial (KWD)
Historical performance sourced from Lipper Fund Screener
The Boubyan Financial Fund was originally launched at US$10,000 per unit. The orange-labeled graph in figure 8.3 above represents the net asset value (NAV) per unit throughout the duration of the fund. The fund grew steadily from 2006 until the first quarter of 2009, with the fund recording a NAV of US$11,242 when this report was generated.
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8.6.1 The performance of a sample of Islamic money market funds

Table 8.4 below shows the performance of a sample of Islamic money market funds that have more than a years track record (sourced from Coast Investment Islamic Funds Analysis 2008).
Table 8.4 Performance of Islamic money market funds

N Periods Geometric mean % Arithmetic mean % Standard deviation % 24.75 Beta Alpha Sharpe ratio Highest return % Lowest return % Median %
KSE Weighted Index First Investment Al-Muthana Fund Al Dar - AlDar M. Mkt Fund Boubyan Boubyan Financial Fund KMEFIC - Amwal Islamic M. Mkt Fund
88
37.44
39.59
0.309
0.027
0.446
20.25
-14.26
45.78
88
5.17
5.18
0.4
-0.004
0.004
-0.597
0.68
0.26
4.94
51
6.71
6.72
0.53
0.002
0.005
0.392
0.91
0.28
6.98
33
2.65
2.78
5.15
0.002
0.003
-0.178
0.71
-5.84
7.22
24
7.64
7.64
0.17
-0.001
0.006
2.882
0.7
0.53
7.7
Source: Coast Research
The table depicts the performance of the funds through various statistical measures. It is evident that the Boubyan Financial Fund is the most volatile, while the Amwal Islamic money market is the least volatile. Al Dar money market fund posted the highest returns followed by Boubyan financial funds. However, when looking at Sharpe ratio values, which are calculated on an annual basis, it is clear that Amwal Islamic money market funds managed to post the highest risk-adjusted return as represented by the highest Sharpe ratio value. Meanwhile, Al-Dar came in second for posting the highest Sharpe ratio. In terms of Alpha, another statistical measure that shows the excess returns of the fund, Amwal Islamic money market fund has the highest Alpha while Boubyan financial has the lowest. Additionally, the Al Muthanna fund and the Amwal Islamic money market fund both have a negative Beta while the rest of the funds have a positive Beta. Table 8.5 below shows another example of an Islamic money market fund from Saudi Arabia:
Table 8.5 below shows another example of an Islamic money market fund
Al-Badr Murabahah fund SAR Base currency of the fund Currency exposure Fund objective Saudi Riyals SAR &USD Al-Badr Murabahah fund US$ US Dollar USD &SAR
To achieve returns at low risk, to strictly adhere to Shariah compatible commodity trading and interest free financing models, as well as to enable investors to access their investment, if required, at short notice. To invest in non interest bearing International Trade finance transactions with reputed local international counterparties, to invest in Islamic Sukuks, Murabahah funds and any other Islamic instruments that fulfill the fund objectives in the view of the manager. Low
Investment policy
Risk/return profile
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8.6.2 Shariah-compliant money market funds

Shariah-compliant money market funds are needed to allow investors with excess capital to invest in short-term, but safe or low-risk investment instruments that are basically fixed-income instruments. This kind of fund may be appealing to Islamic financial institutions and other Islamic funds that need to manage their cash according to Shariah principles, as well as other retail investors through a dedicated Islamic mutual fund investing only in money market instruments or in a combination of equity and money market instruments. However, as the underlying investment asset of this fund may contain monetary assets, such as receivables arising from a Murabahah-tawarruq structure, the shares or units of this fund are not meant for trading in the secondary market. If the fund intends to make the shares and units of the fund tradable, then the fund should contain some other asset classes, such as Sukuk Ijarah, to make it a hybrid fund instead of a fully fledged money market fund. A ratio of 30% (for Sukuk Ijarah) and 70% (for monetary assets) is an acceptable benchmark as per AAOIFI Shariah Standard (No: 21).
Key point
The Islamic money market is crucial not only for Islamic investors who seek to benefit from the performance of this fund and its underlying assets, but also for many other Islamic funds that need to manage their cash in the short term and via liquid Islamic investment instruments.
Exercise 8.5
Asset allocation is central to any fund management. An Islamic equity or real estate fund may have 80% invested in stocks or properties respectively and 20% in cash or Islamic money market instruments. The fund needs to maintain some investment in cash or money market instruments in the expectation of redemption by the unit holders (particularly in the case of an open-ended fund). However, if the stock market or real estate sector is expected to face a decline, the fund may decide to invest 60% of the investment amount in Islamic money market instruments either through direct investment or through another Islamic money market fund. Would this switch of investment decision affect the tradability of the shares and units of either equity or real estate funds?

A leading scholar of Islamic finance, in an address at a major Islamic conference, commented on the term Islamic money market as part of Islamic fund schemes. He was reported to have said: Money in Islam is a medium of exchange and has never been a commodity. The term Islamic money market fund, which some Islamic funds have used, from my perspective, may be misleading, if not an actual deviation from Islamic finance teachings. This should be addressed by all stakeholders to avoid continuous confusion in the market. Explain whether you agree with his remarks and state why.
Solution
From a technical perspective, the term Islamic money market fund will be very confusing not only for Islamic investment communities but also for general investment communities. Ideally a new term should be created to replace the above term to reflect the actual nature of the fund. Among other proposals is Islamic fixed-income fund or Islamic liquid fund. This is to avoid giving the impression that money has a market in which it can be traded. Some of the components of this fund may have their own nomenclature if they are solely based on that underlying asset, such as a Sukuk fund or Wakalah fund or Murabahah fund, where relevant and applicable. However, the problem arises when a single fund tends to invest in all of these investment assets that combine many different features. They tend to share common features such as fixed income and liquid instruments. Moving forward, a new term that reflects the true nature of this fund should be adopted.
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8.7 Shariah requirements of structuring private equity funds

As stated in CDIF/3/11/180, private equity essentially refers to investments in shares of companies that are not freely tradable in the open market. The funds used for private equity investments are raised privately. The fund is normally a closed-end fund as investors may have to invest for a fixed period of time before they can liquidate their investment; that is upon the maturity of the fund. Unlike mutual funds or unit trusts that are invested in public-listed companies shares, private equities are seen as more focused in their investment strategies in that they typically do not invest in a wide portfolio of companies. Also, private equity funds tend to take control of the management of the investee companies.

Explain whether the same stock screening methodologies described in chapter seven (section 7.5) should be applicable to screening the private companies that Islamic private equity funds intend to invest in. Give reasons why there may be a need to devise another screening methodology, given that the primary purpose of investing in private companies is to have management control over the investee companies.
Solution
The above hypothesis is a valid and relevant issue. Essentially, Islamic private equity funds may need to have a different screening methodology as the ultimate purpose of the fund is to have control over the management of investee companies. Management control is not present in the investment process in the shares of public-listed companies. Thus, investee companies in Islamic private equity investments must be totally compliant to Shariah principles from the very beginning of the investment mandate. As investment via private equity funds results in management control, the tolerance given in the context of screening public-listed companies, such as cash and interest-bearing instruments, as well as conventional leverages, are no longer relevant in Islamic private equity screening. However, to all intents and purposes, this methodology is still relevant if the Islamic private equity funds were to invest as minority investors with other conventional private equity investors as majority investors in any investee company simply because management control ceases to exist if Islamic private equity funders are the minority shareholders. This is a viable alternative to allow an Islamic private equity fund to participate in private equity investment activities, that is to participate as minority shareholders. Although the participation is merely a minority shareholding that gives Islamic private equity fund no control, the purpose of management control can still be achieved. Both Islamic private equity and conventional private equity, as its majority co-investor, will be managed by the same management company, that is a general partner or SPV, to effectively manage the companies as desired by both the funds, Islamic and conventional.
8.7.1 Shariah screening requirements for private companies

Shariah screening requirements for private companies are relatively strict compared with publiclisted equities. The key issue relates to the management control that private equity investors hold over investee companies. Under Shariah principles, such control would necessitate that the private equity fund ensures that the company invested in must be totally Shariah-compliant if the Islamic private equity fund were to invest as majority or ultimate investors. The reason for this requirement is that investors do not have management control over these public-listed companies to ensure that all their financial activities are compliant. In the case of a private equity investment strategy, the objective is always to take management control of the company. Therefore, Islamic private equity funds, as the ultimate investor and manager of the company, are not supposed to take any conventional leverage, even for a small amount or percentage, because paying interest is categorically prohibited for an entity that is either owned or controlled by Islamic investors seeking a totally Shariah-compliant investment.
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Key point
Islamic private equity funds may entail ownership and management control over investee companies. Any company owned and controlled by Islamic private equity funds must not conduct activities that are non-compliant to Shariah principles.
8.7.2 Options available to allow Islamic private equity investors to participate in this asset class
There are at least three possible solutions for Islamic private equity investors to participate in this asset class. 1. Shariah scholars would allow Islamic private equity funds to invest as minority investors in the investee company, together with other conventional private equity investors. This is referred to as co-investment or parallel investment. 2. Islamic private equity funds may be allowed to invest in the investee companies as majority investors on the provision that a certain grace period is given to the management of the investee company to convert all their activities to meet Shariah requirements in the fullest sense, such as zero exposure to either interest-based financing or interest-based income. 3. The third solution is for Islamic private equities to provide financing via Murabahah-tawarruq, instead of equity, which can be technically converted into the shares of the investee company, subject to those shares being compliant at the time of conversion.
8.7.3 Options in practice

With regards to the first solution, several Islamic private equity funds have devised a mechanism to invest in permissible companies that may have conventional gearing in their portfolios by taking a minority stake in such ventures. This means that the Islamic private equity funds will acquire the investee company alongside a conventional private equity fund that is the majority shareholder. Under this mechanism, the Islamic private equity fund does not have a controlling share in the investee company (the conventional private equity fund does) and hence the same financial tolerance limit made available to mutual funds or unit trusts investing in public-listed companies will also be at their disposal, albeit requiring several adjustments in calculation, such as total assets being used as the denominator. This is because the shares of the private companies are not actively traded in the market; hence market capitalisation is not relevant or applicable.
8.7.4 Co-investment
From a structuring point of view, take the example of private equity firm Horizon Capital, which plans to establish two partnership entities. The first entity is a conventional limited partnership (LP One) and the second is the Islamic limited partnership (LP Two). Horizon Capital will be the general partner (GP) for both LP One and LP Two, acting as the manager for both LP investors. The GP will invite Islamic investors to subscribe to an Islamic private equity fund in the vehicle of LP Two for, say, US$500 million, while investors for a conventional private equity fund will raise say US$1 billion. Both LPs will be managed by the same GP. The GP, aware of the specific requirements of the Islamic investors of LP Two, will screen potential companies to identify those that are compliant according to established stock screening as prescribed for public-listed companies. Upon ascertaining these companies from both commercial and Shariah considerations, the GP will make an investment in these companies with the aim of acquiring and managing these companies, which is a usual practice in private equity investment. However, the GP will allocate a majority shareholding to LP One investors, such as 70%, and the remaining investment will be allocated to LP Two investors. In this respect, Islamic investors are not deemed the majority investors and are therefore allowed to invest in companies that pass the Shariah screening test but may have some non-compliant financial activities. In the final analysis, Islamic private equity funds, following this alternative, will only be possible if the private equity firm or GP is committed to having two partnership entities investing in the same target company.
8.7.5 Achieving complete compliance via dedicated investment

Another permissible alternative is to allow Islamic private equity funds, in the form of a limited liability company (LLC), to invest as majority shareholders in investee companies, even though they are not fully compliant at the time of investment. Normally, this fund is given a two to three-year
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period by its Shariah supervisory board to convert the financial activities of these companies in line with Shariah principles with regards to leverage and investment activities. It should be mentioned that these companies must have permissible core activities at the time of investment; otherwise the approval for this investment strategy may not be possible. An equally important consideration is that the conversion programme, in terms of period and feasibility, must be probable and achievable. Therefore, this special approval or concession may not be given to companies that are located in jurisdictions that do not provide any Islamic financial products and services to convert existing leverage and interest-based investment to Shariah-complaint financing and investment. With regards to interest-based investment, approval may be given for the company to invest in noninterest bearing accounts, such as a current account that pays no interest. In conclusion, approval may be limited to companies that are likely to get access to Islamic financial products, particularly Islamic financing instruments for leveraging purposes.
Key point
Islamic private equities may co-invest with conventional private equities in the same investee company or invest as the majority shareholder in that company on the provision that the investee company shall be converted into a fully compliant company within a prescribed period.
Exercise 8.6
Care Services LLC is a company specialising in providing home care services for elderly citizens who need accommodation and the necessary support to live in a reasonable lifestyle without the support of family members. The company provides this service for a certain payment to cover operational costs as well as to earn an operating profit. The scheme of payment consists of contributions from both the government and the individual participants. The governments total grant for this scheme is US$100 million per annum and the total contribution by the participants is US$30 million per annum. While the total assets of the company in the last audited account was US$300 million, profit before tax was US$30 million. The company did not take out a loan from the bank as the funds contributed by both the government and participants were sufficient to cover both the expansion and operating expenses of the centre. However, the company has invested its cash in conventional banks that generated an interest payment of US$5 million. The total cash in interest-based instruments is US$50 million. Medina Equity is a private equity fund that seeks to invest in this company. This company has assigned you to outline the possible issues and strategies involved in setting up an Islamic private equity fund to invest specifically in Care Services LLC. Prepare the outline of your professional advice and perspective.
8.7.6 Investing through both equities and loan an example

In conventional private equity business, it has been observed that a private equity fund may not necessarily invest in investee companies through equities. It may invest through both equities and loans that would then be convertible to the equities of the companies. This is a prudent way of investing, particularly when the fund is not certain of the performance and value of the investee company. Suppose a conventional potential investee company needs US$20 million to expand its new line of business to generate more future profit. The private equity fund has some reservations about the potential of this new line of business, even though the investee company has been generally successful in creating new value in the past. In this context, the private equity fund may decide to contribute US$10 million as equities in the investee company and another US$10 million as a loan to the investee company. The manner of conversion of this loan to equities will have to be agreed upon upfront. Suppose the agreement has fixed that where the net tangible asset (NTA) of the investee company reaches a certain level, the lender of the loan may convert it into equities of the company at the ratio of 1:2, that is, for every dollar of loan, the lender will get two shares in the company. If the NTA does not increase as per the expectation of the lender, the investee company will have to repay the loan plus interest.
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8.7.7 Acceptability of converting loans to equity within Islamic private equity funds
Islamic private equity funds may also be interested in having a similar investment scheme when deciding on an appropriate investment strategy to bring better value to investors. This is relevant in a case where the investee company is not yet fully compliant but has the potential to become fully compliant in the future. In some cases, Islamic private equity funds will need to finance the investee company through both equity and financing or through financing exclusively. However, we need to ask if devising a financing scheme that is convertible to the shares of an investee company would be permissible under Shariah principles. Under Shariah principles, a loan or a debt cannot be simply converted into equities as per the AAOIFI Shariah Standard (No: 13). Thus, Islamic private equity funds would have to provide financing through a Murabahah-tawarruq structure (CDIF/2/5/108-109), but the fund is not allowed to simply convert the account receivable to a number of shares based on an agreed formula. This, then, will not fit into the intended scheme of both financing and conversion of debt into equities.
8.7.8 Achieving acceptability

The Islamic private equity fund market has devised a scheme of financing that can effectively achieve the purpose of converting Islamic debts into equities. The following is an illustration of this innovative scheme.
Suppose the investee company needs US$20 million for its business expansion and the Islamic private equity fund, due to its business risk analysis, can only agree to provide US$10 million in the form of equities and the remaining amount in the form of Murabahah-tawarruq. Prior to Murabahah-tawarruq financing, the investee company can give an undertaking under the principle of Wad or a unilateral promise to sell a number of its shares to an Islamic private equity fund in the future. This is subject to the performance of the company as per the agreed net tangible asset at a price that equals the amount payable under the Murabahah-tawarruq financing. This undertaking will give the Islamic private equity fund an option, not an obligation, to either convert this account receivable arising from Murabahah-tawarruq financing to shares of the investee company or to demand this amount at the time of the maturity as a debt payable.
Under the above example, there is no direct conversion of Islamic debt into equities in the structure. Instead, the investee company will undertake to sell a number of its shares to the financier at an agreed price in the future and the price of this sale is set-off against the outstanding payment under a Murabahah-tawarruq structure.
Key point
Loans convertible into equities may be replicated in Islamic finance through a Murabahahtawarruq structure. Here the investee company undertakes to sell its shares to an Islamic private equity fund by setting-off the payment due under a Murabahah-tawarruq structure for the consideration of the shares.
8.8 Comparison of performance between Islamic and conventional-based investments

Islamic finance has developed a set of prudential and ethical criteria for investing, especially through the stock markets or exchanges. By means of these criteria, unacceptable companies are identified and screened out. Criteria include tests at the level of a companys primary business and at the level of its financials or capital structure. Shariah screening criteria have been used by major international index providers to establish specialised Islamic market indexes.
8.8.1 Performance in good or bad times

During the stock market turmoil witnessed in 2008/09, Islamic indexes, although they fell, fared somewhat better in relative terms because of the exclusion of bank and insurance stocks, which failed to pass through the screens owing to the nature of their business (dealing in interest). Since Islamic indices do not have any exposure to these interest-based financial institutions, the impact of the financial crisis affecting this financial sector has not adversely affected Islamic indices.
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Figure 8.4 Comparative performances of Islamic index and conventional index

1,200 1,100 1,000 900 800 700 600 500 400
5/23/08 12/5/08 2/29/08 3/14/08 3/28/08 6/20/08 8/29/08 10/10/08 10/24/08 11/21/08 12/19/08 4/25/08 1/30/09 2/1/08 4/11/08 5/9/08 6/6/08 7/4/08 7/18/08 8/1/08 9/12/08 11/7/08 11/2/08 1/2/09 2/15/08 8/15/08 1/16/09
S&P Global BMI
S&P Global BMI Shariah
Source: OBrien, OBrien, Christopher, Applying Globally Accepted Shariah Standards across Markets, Standard & Poors, March 2009.
Figure 8.4 above compares Standard & Poors (S&P) global Shariah index with its global conventional index. In 2008, the S&P global index lost 42.5%, while its Islamic counterpart lost 36.8%. The S&P 500 lost 38.6%, while its Islamic counterpart lost 28.9%. However, it should be mentioned that the real performance of Islamic investments depends not only on the sector and financial ratio screening but also global market conditions. It goes without saying that during the time when the shares of financial institutions are buoyant, the performance of any conventional index with significant exposure to the financial industry will outperform an Islamic index. Therefore, Islamic investors and fund analysts must examine the performance of a fund or an index against one another.
8.9 Strategic issues for further development of Islamic funds

By and large, Islamic funds have appealed to a wide spectrum of Islamic investors in various asset classes. The development of these funds has given opportunities to many investors seeking an Islamic-based investment. However, there are some issues that need to be addressed to enhance the growth and development of this sector.
8.9.1 Retail investors participation

Most of the current Sukuk funds and Islamic money market funds are not designed for retail investors. Therefore, the need for retail investors participation could be promoted to enhance the wider investors participation by the creation of Islamic fixed-income funds that are based on a Sukuk and Murabahah commodity for retail investors. Otherwise, the individual retail investors may not be financially able to invest in either Sukuk or Murabahah commodity instruments as direct investment would require a minimum investment amount that is relatively large for individual investors.
8.9.2 Analysis of performance

An update and thorough analysis of the performance of various Islamic funds around the globe is required. As fund performance is the acid test of any fund management, the need for analysis is crucial to provide proper and relevant information to the Islamic investment community. At present, there is no leading performance measurement firm that specialises in Islamic funds worldwide. Rating agencies should perhaps also rate Islamic asset management companies for better disclosure to the investing public.
8.9.3 Innovation and product development

Continuous innovation is required to spearhead product development in the area of Islamic investment. Product development, if not product innovation in the case of Islamic ETF and REITs, is an interesting example of how Islamic investment products can be structured along the lines of conventional sophisticated products, subject to necessary modifications, to render Islamic funds
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more cost-effective and, in some jurisdictions, tax effective. Islamic private equity is always close to Islamic investment principles in terms of choice of business activities and business development, as well as control and management. Many compliant projects and business developments may be financed through private equity using both the equity and debt structure, where relevant.
8.9.4 Proper financial planning schemes

Islamic investment is an integral part of financial planning for individuals, corporate entities or institutions. The Islamic community, as a whole, needs a proper financial planning scheme and modules to suit not only the commercial terms of the financial planning but also, more importantly, the Shariah requirements of each and every investment strategy and instrument. Only with an effective scheme will Islamic-based investment activities flourish to a level that is fulfilling and meaningful.
8.9.5 Better integration between financial markets around the world

Integration can be improved with additional investment in infrastructure, such as the development of standardised Shariah-compliant documentation. Cross-jurisdiction transactions have often been conducted using bilateral documentation that may yet withstand the test of legal scrutiny and proceedings. Standardised International Swaps and Derivative Association (ISDA)-like documentation, for Shariah-compliant money market or treasury transactions, using Murabahahtawarruq or Wakalah fi al-istithmar contracts, would immensely improve the effectiveness of the Islamic fund manager. The same may be emulated in the field of Islamic REITs, Islamic ETF and other investment vehicles and structures where relevant and applicable. Also, mutual recognition of Islamic investment products between two or various jurisdictions, such as the Securities Commission of Malaysia and the Dubai Financial Services Authority, makes the whole Islamic investment market more cost-effective, coherent and global.
8.10 Conclusion
The advent of Shariah-compliant funds gives rise to Islamic investment opportunities not only for institutional or high-net-worth investors but also to average Islamic retail investors who are now able to diversify their investment risks. In general, Islamic funds portray similar expectations of investors preference towards risk diversification in equity investments and other asset classes, based on an agreed trust deed that caters to Shariah-compliant requirements in all permissible investments. Structuring any compliant fund would require a thorough examination of the underlying asset under management, the financial activity of the fund, the contractual agreement between the contracting parties and the terms and conditions of the investment. Whether it is a Shariah commodity, gold, real estate or money market fund, the fund can usually exist as an open-ended, close-ended or exchange traded format. Each of these forms of Shariahcompliant funds must correspond to the different Shariah standards that have been established by AAOIFI and other Shariah authorities that govern the jurisdictions of the funds domicile. For Islamic private equities, the Shariah requirements placed upon them are stricter only because private equity investors are usually the majority stakeholders of the companies they invest in and, hence, are able to influence business operations. The issue of whether the Islamic funds must be 100% Shariah-compliant or can be allowed to display the usual tolerance levels prescribed by Shariah screening agencies thus depends on questions of ownership and control over business processes and activities.
8.11 Summary
Having read this chapter the main points that you should understand are as follows: Shariah-compliant investments may be made directly by individual investors into respective assets such as bonds or Sukuk, shares, property and commodities, or through collective investment schemes Islamic funds provide similar expectations of investors preference towards risk diversification in equity investments and other asset classes based on an agreed trust deed that caters for Shariahcompliant requirements in all permissible investments collective investments may pose some Shariah issues that are not otherwise relevant to investment activities by an individual Muslim investor, such as financing schemes that the funds participate in most Islamic funds are based on a Musharakah contract among the investors of the fund Shariah does not allow preferential treatment between shareholders with regards to profit distribution and loss bearing as all investors are Musharakah investors
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Islamic funds can undertake leverage but they have to do this in a Shariah-compliant manner to ensure tradability, Islamic money market funds usually subscribe to the acceptable AAOIFI Shariah Standard ratio of 30% (for Sukuk Ijarah) and 70% (for monetary assets) Shariah screening requirements for private companies are relatively strict compared with publiclisted equities because of the issue of management control over investee companies that private equity investors hold Islamic private equities may co-invest with conventional private equities in the same investee company or may invest as the majority shareholder in that company on the provision that the investee company shall be converted into a fully compliant company within a prescribed period.

Structuring Shariah-compliant private equity funds for healthcare services
TRA BioCapital (the Fund) is a growth capital fund dedicated to investments in the life-science and healthcare service industries, primarily across the Middle East and North Africa (MENA) and South Asia region. The Fund is comprised of two limited partnerships (LP), one of which, TRA Islamic Limited, is Shariah-compliant, the other a conventional outfit named TRA Equity Limited. Investments generally focus on the pharmaceutical industry, by far the largest segment of the life sciences industry, including manufacturing, licensing, regulatory approval, development, marketing and distribution of patent-protected novel biologies and classical chemical drugs, specialty pharmaceutical products, vaccines, generics, bio-generics and over-the-counter (OTC) drugs. Other life sciences target markets include medical devices, diagnostics, molecular diagnostics, imaging, laboratory services and clinical development services. A second focus of the Fund is the fast-growing healthcare services sector, where the focus is on specialised clinics. The Fund is managed and advised by an international investment team with strong operating credentials working out of offices in Frankfurt. The originator of this fund project, the TRA Capital Life Sciences Practice, has a long track record of 75 investments in the sector over a 30-year period. The team of professionals at TRA Capital have established themselves as the leading providers of equity capital in pharmaceutical and biotech markets in Europe and the north eastern region of the US. The fund has identified two potential biotechnology companies that it is very keen to invest in. One is Hilal-Smith Chemicals, a pharmaceutical start-up located in Bahrain, the other is Star-Biotechnicals, a market leader in laboratory devices located in India. TRA Capital Life Sciences is looking to reach Islamic investors for these investments to showcase its capabilities as a player in Islamic private equity investments. To date, the fund has accumulated US$350 million, of which US$150 million comes from TRA Islamic Limited and US$200 million from TRA Equity Limited. The relevant financials of these two investee companies are given over. Year 2008 Hilal-Smith Chemicals (US$ million) 115 27 12 100 33 25 1.1 Star-Biotechnicals (US$ million) 175 43 18 170 45 48 3
Current market value Revenue Cash & interest-bearing securities Total assets Receivables Total debt Interest income
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1. Which of the following is NOT common to both public equity funds and private equity funds from a Shariah perspective? (A) (B) (C) (D) 2. Screening of non-Halal income and core activities of the investee company Management control for private equity and permissibility of the tolerance ratio of prohibited financial activities Management control from private equity funds and non-tolerance ratio of prohibited financial activities Cleansing of impure income generated from non-Halal income
Screening requirements for private companies are stricter than the public companies due to: (A) (B) (C) (D) the issue of management control the issue of market capitalisation where public companies are usually larger the concern over corporate governance of smaller private companies the fact that private companies are more vulnerable to excessive leverage
3.
Co-investment is a strategy that is often utilised in Islamic private equity investment, whereby: (A) (B) (C) (D) the Islamic LP will usually assume the role of the majority investor, leading the conventional LP the Islamic LP will usually assume the role of the minority investor, behind the conventional LP both the conventional and Islamic LP must place investments of equal amount neither the conventional nor the Islamic LP can assume a position of less than 33% in the private equity investments
4.
Which of the following is the definitive feature of an Islamic Commodity fund? (A) (B) (C) (D) An Islamic commodity fund must engage in Shariah-compliant financial activities in both the financing and investment activities An Islamic commodity fund must undertake cleansing or purification of any non-halal income generated during its operations An Islamic commodity fund must own and possess the underlying commodities, whereby the investors must bear all the risks associated with these commodities. An Islamic commodity fund must utilise Shariah-compliant contracts and documentation at the time of origination as well as at the time of the liquidation
5.
Based on the above case of TRA BioCapital, which of the potential investee companies may pose a problem for TRA Islamic Limited? (A) (B) (C) (D) Hilal-Smith Chemicals Star-Biotechnicals Both Hilal-Smith and Star-Biotechnicals None of them
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1. Using the FTSE Islamic index stock-screening criteria, convert the financials as given above into the relevant financial ratios required to ascertain the compliance of both the investee companies. Can TRA Islamic Limited invest in Hilal-Smith Chemicals as the majority shareholder? Give the reasons for your answer. Suppose TRA Bio-Capital decided to establish only Islamic private equity funds to invest in these two companies; what are the relevant issues to be highlighted? Assume that instead of raising funds through private equity funds, Hilal-Smith Chemicals decides to float its shares for the initial public offering (IPO) in both the Dubai NASDAQ Exchange under the governance of the Dubai Financial Services Authority and in the Bursa Malaysia under the Securities Commission of Malaysia, but is seeking an Islamic IPO. Advise the company on this exercise. Star-Biotechnicals is reported to have acquired new technology for its business after the investment from TRA Bio-Capital was made. However, this new technology is not yet proven and there is always a technology risk. TRA Bio-Capital prefers to invest as the creditor instead of as equity investors unless the technology has been proven. This debt will later be converted into shares of Star-Biotechnicals in the future according to an agreed milestone. TRA Bio-Capital has decided that both TRA Islamic Limited and TRA Equity Limited should contribute US$50 million each for this financing exercise. Propose an outline under Shariah-compliant financing for TRA Islamic Limited to participate in this financing exercise.
2. 3. 4.
5.
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Chapter eight answers

Exercise 8.1
Although the above summary has addressed most of the potential Shariah issues, the fund manager and its Shariah supervisory board must address the issue of cash management, currency hedging and the modus operandi of joint ventures as one of the funds potential strategies to create more value. While cash management and currency hedging may be easily addressed, the involvement of the fund in joint ventures with other property developers either through equity or debt or both may pose Shariah-compliance issues. This is because the Islamic fund must only use Shariah-compliant instruments to finance joint-venture partners. Also, the purification or cleansing policy must be incorporated to alert the investors about this requirement as this will also affect the net income of the fund.
Exercise 8.2
The underlying shares of an Islamic ETF must be compliant to Shariah principles. There are no specific requirements for the tradability of the shares and units of this ETF. However, for an Islamic ETF investing in gold, structuring needs to take into consideration the ownership of the gold bullion by the fund, the ability to deliver the physical gold bullion to those investors who may need to redeem their investment through the physical redemption of the gold and the non-tradability of the shares or units of the ETF during the life of the fund. However, the investors may liquidate their investment by selling their shares or units to the fund manager based on the NAV of the fund.
Exercise 8.3
The alternative to conventional hedging contracts is a Shariah-compliant contract that either uses the principle of Wad, which is a unilateral promise to buy or sell a commodity in the future at a fixed price, or the Salam contract where both the buyer and seller have locked in the price in the future, although the payment must be fully made in advance. The correct answer is therefore (B) Wad and Salam.
Exercise 8.4
It appears that the above proposed structure is compliant as the breakdown of assets, both physical assets (represented by the Sukuk Ijarah asset) and financial or monetary assets (represented by gold), is within the permissible ratio under AAOIFI Shariah Standard (No 21). According to that standard, a combination of tangible or physical assets and financial assets (such as debt or currency and gold through analogy) must not exceed a ratio of 70/30 to allow this asset as a hybrid fund to be traded, even if not at face value. There is no reason, therefore, to make any amendment to the proposed structure. However, if the fund were to follow other Shariah standards, such as the Dow Jones Islamic Market (DJIM) or FTSE, or any other Shariah view that accepts a lower ratio of these two assets of the fund, then the composition of Sukuk Ijarah must be increased to dilute the prevailing nature of the gold assets.
Exercise 8.5
The switch of the balance of the investment of either equity or real estate funds may affect the tradability of the shares or units, particularly for Islamic funds that subscribe to the Fatwa that the financial asset of the funds, such as money market instruments, must not exceed the tangible asset of the fund comprising either equity or real estate. However, this is acceptable under the AAOIFI Shariah standard as previously explained. Even for those who subscribe to the 50% benchmark, it is always advisable to ascertain the nature of each and every money market instrument as some are not financial or receivable-based, such as Wakalah fi al-istithmar, Sukuk Ijarah and Sukuk Musharakah. Therefore, generally speaking, a fund that combines either equity or commodity, or property with Islamic money market instruments, either for cash management or investment purposes or both, is generally considered compliant with regards to its origination and trading since it has a mixture of underlying investment assets, tangible and financial.
Exercise 8.6
The provision for care services for the elderly is essentially a Shariah-neutral business activity. There is, therefore, potential for Care Services LLC to be invested in by an Islamic private equity fund. With the business activity acceptable, the next avenue in ensuring Shariah compliance will be the financials of the company. Having zero debt, it is easier for Care Services LLC to achieve Shariah compliance as it does not have to convert any existing loans. The question now would be to determine whether the company is too liquid and to outline the action plans available to handle its interest income.
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In assuming that Medina Equity will be the majority shareholder of Care Services LLC, it has to effectively manage the interest income collected. The first option is to see whether there are any Islamic banking and finance facilities available in the domiciled jurisdiction. If available, Care Services would then have to divert its cash from conventional banks and reinvest it into Islamic banking instruments. This would immediately remove the potential of any further interest income and Medina Equitys Shariah board would likely grant it a specified duration to achieve this. On the other hand, if Islamic banking and finance facilities are not available, a co-investment with another conventional equity fund would be an option. While Islamic private equity investors would invest less than 50% to Care Services, the remaining equity would be contributed by conventional private equity investors. This is because the current financials of Care Services have some noncompliant activities and income. The third solution is for Islamic private equity funds to provide an Islamic financing scheme to an investee with a view to converting this financing amount to the shares of the investee company if applicable.

1 (C) All the mentioned activities (other than C) are common to investment in both public equity and private equity funds. However, as private equity funds result in management control of the investee private company, the tolerance ratio of prohibited financial activities would not be given to the private equity investment scheme. 2 (A) Shariah screening requirements for private companies are stricter compared to public-listed equities, with the key issue relating to the management control that private equity investors hold over investee companies. Tolerance given to the investment in publiclisted companies is due to the fact that investors do not have management control over these public-listed companies to ensure that all of their financial activities are compliant 3 (B) As the minority shareholder in the private equity deal, the Islamic LP or investors are not deemed the majority investors and are therefore allowed to invest in companies which pass the Shariah screening test but may have some non-compliant financial activities within the tolerance level. 4 (C) The Islamic commodity fund must indeed be invested in commodities with real ownership and possession. The other choices are common features of any Islamic fund. 5 (B) Star Biotechnicals have a non-Halal income percentage of about 7% of its revenue. This is in excess of the normal tolerable limit of 5%.
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1. The life sciences and healthcare service industries are fundamentally Shariah-compliant industries. As such, the business activities undertaken in these industries are Shariah-compliant. Before pursuing investment strategies, it may be useful to look into the screening ratios that can be generated for both companies. Utilising FTSE screening methodology, the results are displayed in the table below: Year 2008 Leverage ratio Receivables ratio Cash ratio Non-Halal income ratio 2. Hilal-Smith Chemicals 25.0% 33.0% 12.0% 4.1% Star-Biotechnicals 28.2% 26.5% 10.6% 7.0%
Based on the above ratio, or at least based on the FTSE Islamic Index, it appears that TRA Islamic Limited may not be able to invest as the majority shareholder because the investee company of Hilal-Smith Chemicals is not fully Shariah-compliant as it has some financial activities that are not compliant. Therefore, the proposal to co-invest with TRA Equity Limited will be accepted, provided the majority equity investment is provided by TRA Equity Limited. However, TRA Islamic Limited may invest as the majority investor on the condition that the fund manager is able to convert all financial activities of Hilal-Smith Chemicals into fully compliant activities within two years of the date of the investment. It appears that both the Bahraini and Indian companies pass most of the screening ratios that have been set, apart from the non-Halal income ratio for Star-Biotechnicals, which is higher than the 5% allowed. However, one has to remember that Shariah screening is usually applied under the context that one is not the majority holder/owner of the company and thus would not be able to participate in the management of the companies. This screening methodology will, therefore, only be applicable if the fund invests in either or both Hilal-Smith Chemicals or Star-Biotechnicals with the Islamic LP, TRA Islamic Limited, taking a minority share of the private equity deal. If this happens, the fund would only need to reduce the non-Halal income from Star-Biotechnicals to a value below 5% of its revenue. As soon as the minority-stake strategy is not being considered and TRA Islamic Limited is the majority shareholder of the private equity deal, the Shariah-screening methodology will cease to apply and the fund will have to fully convert either or both the companies it invests in into 100% Shariah compliancy. This means that there can be no conventional leverage, interest or non-Halal income in either Hilal-Smith Chemicals or Star-Biotechnicals, while the cash and receivable ratios can be maintained. This may not be an issue for Hilal-Smith Chemicals as Shariah-compliant banking and financing instruments are available in Bahrain, but it may be a challenge in India. Complications will arise if there are insufficient Islamic banking and finance facilities in India for Star-Biotechnicals to effectively place, for example, its cash deposits to avoid an interest income. It is extremely likely that the Shariah advisers of the fund would allow some lead time (perhaps a year) for the company to redirect its cash placements. If the Islamic banking and finance facilities are not available, the company may be given the option to either place its cash in non-interest bearing conventional accounts or be given leeway to cleanse their interest income by donating them to suitable charities. As mentioned, the fund will be given some lead time for this conversion to take place and by the end of that time its Shariah board and Islamic investors would fully expect that the companies are fully Shariah-compliant.
3.
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One should note that the US$150 million (accumulated in TRA Islamic LP) would not be sufficient to invest fully in both companies targeted or even in the US$175 million-valued StarBiotechnicals. The fund may be in a position to take up Shariah-compliant financing facilities to make up the balance required. For instance, at the fund level, the fund may take up a US$140 million (US$115 + US$175 US$150) Murabahah-term financing for a period of perhaps five years to finance the purchase of Star-Biotechnicals. There is no issue on how much Shariahcompliant leverage the fund can undertake and there are instances where such leverage can reach up to 100% of the value of its equity. This may be a viable option, especially if there are non-Islamic banking and financing facilities in India and if Star-Biotechnicals is an extremely valuable investment proposition. 4. IPO Hilal-Smith Chemicals must be aware of the Shariah regulatory scenarios prevalent in the two markets that it seeks to list in. For instance, Nasdaq Dubai is bound by AAOFI Shariah standards and as such Hilal-Smith Chemicals must follow the stock screening of AAOIFI. One of the pertinent features of the AAOIFI screening methodology is that the company can extend its receivable ratio by up to 70% of its total asset. With regards to an IPO in Bursa-Malaysia, the stock-screening methodology in Malaysia does not take into account financial ratios, apart from interest income. Hilal-Smith Chemicals may also take up the pre-IPO screening process in order to improve marketability. TRA Islamic Limited may have to resort to the Murabahah-tawarruq option to finance the investment. Murabahah-tawarruq financing can be technically converted into the shares of Star-Biotechnicals, subject to those shares being compliant at the time of conversion. Prior to Murabahah-tawarruq financing, Star-Biotechnicals should give an undertaking under the principle of Wad or unilateral promise to sell a number of its shares to TRA BioCapital in the future. This is subject to the performance of the company as per the agreed NTA, at a price which equals the amount payable under the Murabahah-tawarruq financing. This undertaking will give the Islamic private equity fund an option, not an obligation, to either convert this account receivable arising from Murabahah-tawarruq financing to shares of Star-Biotechnicals or to demand this amount at the time of the maturity as a debt payable. Obviously, there is no direct conversion of Islamic debt into equities in this structure. Instead, Star-Biotechnicals will undertake to sell a number of its shares to TRA BioCapital at an agreed price in the future and the price of this sale is set-off against the outstanding payment under a Murabahah-tawarruq structure.
5.
Notes:
1. The discussions in this chapter exclude issues related to public equity investments that are limited to the screening process and purification of any tainted dividends/income. Both of these issues were addressed in chapter seven of this study guide and chapters ten and eleven of study guide three (Islamic Capital Markets and Instruments) of the Diploma in Islamic Finance. 2. A ratio developed to measure risk-adjusted performance. The Sharpe ratio is calculated by subtracting the risk-free rate from the rate of return for a portfolio and dividing the result by the standard deviation of the portfolio returns. The Sharpe ratio tells us whether a portfolios returns are due to smart investment decisions or a result of excess risk. 3. Alpha is a measure of performance on a risk-adjusted basis. Alpha takes the volatility (price risk) of a mutual fund and compares its risk-adjusted performance with a benchmark index. The excess return of the fund relative to the return of the benchmark index is a funds Alpha. A positive Alpha of 1.0 means the fund has outperformed its benchmark index by 1%. Correspondingly, a similar negative Alpha would indicate an underperformance of 1%.
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Chapter nine
Sukuk structuring and rating methodology
Learning outcomes
By the end of this chapter you should be able to: analyse contracts as well as appreciate the issuer and investor expectations involved in structuring different forms of Sukuk analyse the impact of product features on the validity and tradability of Sukuk evaluate rating methodologies for Sukuk instruments.

Structuring various forms of Sukuk: debt-based, asset-based, project based and asset-backed Comparative Sukuk structures and related issues An illustration of Sukuk structures for different types of financing arrangements Rating methodologies for various Sukuk structures Case study: structuring of Sukuk and Sukuk rating exercise post-AAOIFI pronouncement
9.0 Introduction
A Sukuk is an innovative product for raising Islamic funds to support financing requirements through the use of capital market instruments. Sukuk have generally been seen as an alternative to conventional bond instruments that are organised in a capital market instead of a banking market. Conceptually, a Sukuk is an investment instrument that is intended to reward investors. A Sukuk provides a new form of funding structure for all categories of issuers: governments, corporations and banks. Since its introduction in 1990 through the Sukuk Musharakah for Shell MDS in Malaysia, it has developed into various forms in different jurisdictions, applying sophisticated structures. Today, investors not only have a choice between local currency and non-local currency-denominated Sukuk, they can also have their pick in terms of types of Sukuk, tenures, underlying assets, structures, issuers and risk profiles. In this chapter, we consider the structuring techniques of various Sukuk instruments. We also consider the key issues relating to Sukuk as fixedincome instruments structured around different types of contracts with ancillary terms and conditions. The discussion highlights the variety of product features that result from the different structures. A special discussion will examine the structuring features of Sukuk post the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) pronouncement of 2008, as this significantly affected previous structures and led to a decreasing number of Sukuk issuances. The chapter considers all Sukuk instruments issued prior to and after the AAOIFI pronouncement. Particular reference will be given in the chapter to the Sukuk rating methodologies adopted by relevant rating agencies. These will be explained and analysed in terms of their usefulness and limitations. Finally, the discussion will focus on the impact of investor preferences and how changes in Shariah rulings have affected the structures and rating methodologies of Sukuk.
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9.1 General introduction to Sukuk

Securitisation is a process for raising finance based on predictable cash flows relying on either the creditworthiness of the issuer/borrower or a particular set of assets which have a steady income stream. Securitisation has become the preferred practice by governments and corporations to raise funds using instruments such as bonds and notes. In Islamic finance, the securitisation process was facilitated by the introduction of Sukuk. The Sukuk market has, until recently, represented a significant part of the Islamic financial system and played a key role in facilitating the funding requirements for some key economic developments, and corporate project financing. A Sukuk refers to the process of aggregating the receivable or tangible assets or usufruct, or an interest in a project, as the case may be, into pieces or securities that reflect proportionate ownership of these underlying assets. A Sukuk does not deal with receivables or financial assets except in the case of some Malaysian Sukuk. Sukuk holders each have an undivided beneficial-ownership interest in the underlying assets. Consequently, Sukuk holders are entitled to share in the revenues generated by the relevant assets in the case of Sukuk Mudarabah and Sukuk Musharakah. As for Sukuk Ijarah, the revenues are generated by the lease rental payments paid by the obligor/lessee to the issuer/ special purpose vehicle (SPV), which then proportionately distributes the revenue to the Sukuk Ijarah investors. It is important to understand that Sukuks, unlike bonds, are not debt certificates or IOU instruments, with the exception of some Malaysian Islamic bonds and Sukuk that are based on receivable securitisation. Sukuks, by and large, are certificates that provide evidence of an investment in either an asset or a project, which is typically an income-generating asset or a project. The return to investors is not fixed or guaranteed but is subject to the performance of this underlying asset. The issuing of Islamic bonds or notes, particularly by the Malaysian market prior to the development of Sukuk Ijarah, was contentious mainly because the trading of these securities was based on the sale of debt concept. This is because these Malaysian Islamic bonds were essentially based on the securitisation of receivables and to be Shariah-compliant any trading of these securities must be based on the par value to avoid Riba in the transaction. Receivables have been perceived by the majority of scholars as representing monetary assets. Therefore, the trading of those securities must be based on face value to avoid the element of Riba, which requires an equal amount in the exchange of money. For more information on Sukuk, prior to 2008, refer to CDIF/3/7/104-115. Generally, prior to 2008, no Shariah issues arose other than the Sukuk structure that is based on the securitisation of receivables as manifest in some Malaysian Sukuk. Towards the end of 2007, market practitioners and scholars began questioning the validity of some practices in this area, mainly with regard to Sukuk based on the Mudarabah, Musharakah or Wakalah contracts. The key issue related to the inclusion of a purchase-undertaking clause in the relevant information memorandum. The inclusion of this clause was deemed to ultimately lead to a capital guarantee to the Sukuk investors, which is not compliant under Shariah principles. In equity-based contracts, investors are exposed to the risk of the loss of their capital. Any arrangement by the issuer (either as partner or managing partner, or agent of investment) to effectively provide such a capital guarantee renders the contracts null and void.
9.2 AAOIFI pronouncement 2008

In February 2008, the AAOIFI produced an announcement to go with its existing Shariah Standard 17 relating to investment Sukuk. The AAOIFI pronouncement in 2008 can be summarised as follows: Sukuk issuances have to be backed by real assets, the ownership of which has to be legally transferred to the Sukuk holders in order to be tradable. Sukuk must not represent receivables or debts except in the case of a trading or financial entity selling all its assets, or a portfolio with a standing financial obligation in which some debts owing by third parties, incidental to physical assets or usufruct, are unintentionally included. The manager of the Sukuk is prohibited from extending loans to make up for any shortfall in the return on the assets, whether acting as a Mudarib (investment manager) or Sharik (partner) or Wakil (agent for investment). Guarantees to repurchase the assets at nominal value upon maturity, with the exception of Sukuk Ijarah structures, are also prohibited. The Shariah supervisory board is required to give closer scrutiny to the documentation and subsequent execution of the transaction.
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9.2.1 Reasons for the announcement

The AAOIFI felt this addendum to the existing Shariah Standard 17 was necessary for the two main reasons set out below.
9.2.1.1 Inclusion of purchase undertakings

As stated above, most of the equity-based Sukuk, such as Sukuk Musharakah, Sukuk Mudarabah and Sukuk Istithmar incorporated a clause of purchase undertaking to be used in the event of the issuer/ partner failing to pay the expected periodical profit payments. This clause, when used, rendered the capital of Sukuk guaranteed, as the issuer/partner was undertaking to purchase the outstanding Sukuk at a price that was equivalent to the outstanding principal and profit matured up to the point of default. This effectively guaranteed the payment of principal to the Sukuk investors. Any principal guarantee in an equity-based contract is not in accordance with Shariah principles. As highlighted in AAOIFI Shariah Standard 17, it is permissible for the issuer to undertake, through the prospectus of issue, to purchase the Sukuk at market value. However, it is not permissible for the issuer to undertake to purchase the Sukuk at their par or nominal value.
9.2.1.2 Profit smoothing

It had also been observed that the issuers of some of these Sukuk smoothed profit payments by estimated periodic profit payment using the issuers funds instead of the real income generated by the underlying asset or project. This practice was employed to avoid triggering a possible default as documented in the prospectus or information memorandum of the Sukuk. It also had the effect of providing a guarantee on the profit, which is not in line with equity-based contracts that dictate profit sharing as well as loss sharing.
9.2.2 Effect of the pronouncement on Sukuk issuance

The above two practices, which were common in the Sukuk market up to the time of the pronouncement, prompted the AAOFI Shariah Board to take action so as to correct the practice. In this chapter we introduce you to various types of Sukuk and explain how these Sukuk must align themselves to the AAOIFI pronouncement of 2008 to make them acceptable. The new structuring of Sukuk post this pronouncement has affected the process of rating Sukuk as the previous rating system was based on the merit of purchase undertaking, which proved no longer to be valid and justified. The comparative percentage of the respective Sukuk issuance before and after the 2008 AAOIFI pronouncement is illustrated in the following diagram. The decline in issuance is a direct market response to the AAOIFI pronouncement of February 2008.
Figure 9.1 The growth of the global Sukuk market 2000-2008*

80000 70000 60000 US$ million 50000 40000
32,172.89 48,114.82 75,238.70
30000 20000
12,033.76
10000 0
336.3 780 985.83
7,209.53 5,717.06
2000 2001 2002 2003 2004 2005 2006 2007 2008

Tabulated by IIIF Data source from IFIS
Year
*to May 2008
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The predictable result of this pronouncement was the increase of Sukuk Ijarah and the decline of all Sukuk based on equity contracts. This can be seen in the following diagram.
Figure 9.2 Comparison of the same period in 2007 with the same period post-AAOIFI pronouncement in 2008
6000 5000 4000 3000 2000 1000 0 2007 March-June
Tabulated by IIIF, data sourced from IFIS
Post AAOIFI pronouncement
Sukuk Ijarah Sukuk Musharakah Sukuk Mudarabah
2008 March-June
When comparing the same four-month period (March-June) for 2007 and 2008 (post AAOIFI pronouncement), one can see a trend in Sukuk issuance, which affects not only the structure and the design but also the growth of the Sukuk in general. There is a clear increase in the issue of Sukuk Ijarah as a means of raising capital as the Sukuk Ijarah structure and practice was excluded from the pronouncement. On the other hand, there is a clear decrease in the issuance of Sukuk Mudarabah and Musharakah. Prior to the pronouncement, these latter Sukuk were structured to provide recourse to the originator/issuer through an undertaking by them to repurchase the underlying assets at a price representing the face value of the Sukuk at maturity, or following the event of a default in the terms of the Sukuk. Shortfalls in periodic distribution amounts were similarly covered by the originator/ issuer in the event that insufficient returns were generated by the Sukuk assets. Sukuk Musharakah, which was by far the most popular Sukuk vehicle in 2007, experienced the largest fall as a result of the pronouncements made by AAOIFI in 2008.
Exercise 9.1
Which of the following issues prompted the AAOIFI Shariah Board to issue its official pronouncement on Sukuk in February 2008? Give reasons for your answer. (A) (B) (C) The existence of Sukuk structures that were devoid of underlying tangible assets The undertaking by the issuer to purchase the equity-based Sukuk at par value in the event of default by the issuer to pay the expected profit The undertaking by the issuer to provide liquidity facilities to ensure a profit payment in the event of a lower-than-expected profit, but subject to that facility making good at maturity The undertaking by the issuer to purchase the equity-based Sukuk at market value in the event of a default
(D)
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9.2.3 Effect of the AAOIFI pronouncement on Sukuk rating

As a result of the AAOIFI pronouncement, the rating of Sukuk has become more challenging as equity-based Sukuk are no longer in a position to provide any guarantee for the redemption of investment capital. This is because the clause on purchase undertaking by the issuer is no longer valid and acceptable. This also affects the rating exercise as the performance of Sukuk, post the AAOIFI pronouncement, will depend less on the creditworthiness of the originator/issuer and more on the performance of the assets or projects, as in the case of conventional asset-backed securities or non-recourse project financing. This pronouncement has essentially transformed Sukuk into an equity instrument instead of a fixed-income instrument. This has resulted in many fixed-income investors, such as Takaful operators, pension funds and other institutional investors, whose mandate is confined to fixed-income instruments, now having no access to Sukuk instruments. Consequently, the rating methodology as applied to bond instruments will no longer be relevant to equity-based Sukuk instruments as equity and bonds, from the contractual rights and liabilities perspective, have different financial behaviours. The issue of rating will be more challenging in jurisdictions where rating is mandatory before Sukuk can be issued and traded in the financial market. This would be the case in the Malaysian and Indonesian exchanges and in a number of western jurisdictions such as the Luxembourg Financial Centre. The challenges of Sukuk rating since the AAOIFI pronouncement will be discussed more fully later in this chapter. The AAOIFI pronouncement may also, in some jurisdictions, bring about the issue of Shariah risks. Shariah risk centres on the issue of Shariah compliance, with the risk often borne out of the operations of the Islamic Financial Institution (IFI) or the Islamic financial instruments. It can be generated through cross-boundary transactions whereby a Fatwa issued in one jurisdiction is not accepted in another. Shariah risk issues emerge where the adoption of AAOIFI standards and pronouncements are not accepted in all jurisdictions. This may deter cross-boundary transactions. This situation is not without precedence. Different views on the application of Islamic contracts, for instance, have existed throughout the history of Islamic finance industry. These Shariah risks can be minimised if there is a move towards the adoption of globally accepted Fatwas or Shariah standards.

Many believe that the decline of the Sukuk issuance in 2008 and 2009 was largely due to Sukuk becoming less attractive instruments as a result of the AAOIFI pronouncement. To what extent is this contention technically accurate?
Solution
The AAOIFI pronouncement affected the issuance of Sukuk, particularly Sukuk based on equity contracts such as Mudarabah and Musharakah. However, the pronouncement did not affect the issuance of Sukuk Ijarah, even though Sukuk Ijarah also has a provision for a purchase undertaking by the originator/lessee to repurchase the leased asset in the event of default by the originator/lessee. Sukuk Ijarah essentially requires the originator to have an asset for the purpose of sale and lease back. This therefore restricts the issuance of this kind of Sukuk as it requires the issuer to own an asset that can be sold to Sukuk investors for a certain period of time, as the originator/owner will repurchase this asset at either event of default or maturity of the Sukuk. As shown in figure 9.1, most of the Sukuk, in terms of number and size of issuance prior to the 2008 AAOIFI pronouncement, comprised Mudarabah, Musharakah and Sukuk Istithmar instead of Sukuk Ijarah as there was no requirement for the issuer to own an asset when issuing this kind of Sukuk.
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9.2.4 The global financial crisis of 2008/09

The global financial crisis of 2008/09 also contributed to the decline of Sukuk issuances with fund raising decreasing significantly in a distressed economy. There was no need to issue new bonds or Sukuk where projects being financed were either cancelled or suspended because of the financial crisis. This also affected the yield of the Sukuk as the rating of Sukuk in this financial environment would be low. Therefore, a higher yield for investors reflects higher costs to the issuer. Both the AAOIFI pronouncement and the global financial crisis can be seen to have contributed to the decline in Sukuk issuance, especially in jurisdictions badly affected by the global financial crisis.
Key point
The decline of Sukuk in 2008, compared with 2007, was mainly due to the AAOIFI pronouncement on Sukuk in February 2008 and the global financial crisis in 2008/09.
9.3 Broad categories of Sukuk structuring

Conventional bonds can either be classified as straightforward IOUs, which offer a fixed income, or as asset-backed securities, which offer a variable income based on the performance of the underlying asset. There are two key ways to classify Islamic Sukuk. From the point of view of the underlying asset against which the Sukuk are issued they can be classified into four broad categories: debt-based Sukuk asset-based Sukuk project-based Sukuk asset-backed Sukuk.
From the contractual perspective governing the relationship between the issuer and the investors, Sukuk may be classified into two broad categories: debt-based Sukuk equity-based Sukuk. The following discussion results in a slight overlap between these different bases of Sukuk classification, but the overlap and correlation between them is highlighted, where relevant, in each category of Sukuk. The following tables show the basis for classifying Sukuk and are a guide for Sukuk structuring as well as for the application of the respective rating methodology to various Sukuk structures.
Table 9.1 Classification of Sukuk based on the underlying asset

Underlying asset Debt-based Sukuk Sukuk type Sukuk Murabahah and Sukuk Istisna Pertinent features The pay-off to the investors is dependent on the credit risk of the issuer. The pay-off to the investors is not linked to the underlying asset, although the asset could be used as collateral. The payment is linked to the credit risk of the originator. The pay-off to the investors is based on cash flows and the quality of the project asset The pay-off to the investors is based on the performance of the assets
Asset-based Sukuk
Sukuk Ijarah
Project-based Sukuk
Sukuk Musharakah, Sukuk Mudarabah and Sukuk Istithmar
Asset-backed Sukuk
Sukuk Ijarah, Sukuk Musharakah, Sukuk Mudarabah and Sukuk Istithmar
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Table 9.2 Classification of Sukuk based on the contractual relationship between the issuer and investor
Underlying asset Debt-based Sukuk type Sukuk Murabahah, Sukuk Istisna and Sukuk Ijarah Pertinent features The pay-off to the investors is dependent on the credit risk of the issuer. Investors participate in providing equity to invest in Sukuk assets
Equity-based Sukuk
Sukuk Murabahah, Sukuk Musharakah and Sukuk Istithmar
Although all of the above Sukuk must relate to an asset or project in some way, they have many different legal and economic implications, and different rating approaches, as the underlying assets may have different economic and legal functions. The classifications in table 9.1 not only distinguish one Sukuk from another but also demonstrate the chronological development of the Sukuk instruments. As the Sukuk market begins maturing, each new issuance represents a step-up on the ladder of sophistication. Sukuk issuances have begun moving away from the bricks-and-mortar debt-based issuances to project-based issuances that pay specific attention to the underlying assets being constructed. These sophisticated Sukuk issuances are commensurate with the demands of Islamic investors who are always looking for more innovative products to fulfil their investment appetite. The next sections will look at these four broad categories of Sukuk, based on their chronological development in the market. The salient features of each Sukuk will be underpinned to allow you to appreciate their economic and financial behaviour, and understand how these features relate to respective rating methodology.
Key point
The basis of securitisation of the underlying asset in Sukuk can be debt-based or asset-based, or project-based or asset-backed. The contractual basis between the issuer and investor could be either debt or equity.
9.4 Debt-based Sukuk

As explained in CDIF/3/6/89-91, Islamic receivables, such as those arising from Murabahah, Istisna and Ijarah, may be securitised into papers known either as Islamic bonds or Sukuk. As mentioned in CDIF/3/6/95-100, this instrument is only available in Malaysia where this structure has been deemed compliant by the Malaysian Shariah authorities in contrast to other jurisdictions. These papers evidence the right of the holder of the Sukuk or the Sukuk investor to receive the payment as stated in the primary and secondary notes of the Sukuk. This structure resembles the structure of conventional bonds that are simply IOUs, except that the receivables in an Islamic Sukuk structure must originate from Islamic-approved contracts that create these future receivables. Receivables must not originate from interest-based loans as is the case with conventional bonds. Under this structure, the issuer may obtain the required funding from the investors through an approved Islamic debt instrument, such as Murabahah, Tawarruq, Ijarah or Istisna. The Sukuk will be issued by the issuer as evidence that the investors have a legal claim on the amount of financing plus the mark-up or profit which is embedded in all these contracts. In conclusion, this is a form of debtbased financing as the issuer is essentially indebted to the investor as a result of getting financing using debt-based financing contracts.
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9.4.1 Rating of debt-based Sukuk

The most suitable corporate rating methodology to be applied to debt-based Sukuk is linked to the credit quality of the obligor/issuer, be it a government or corporate bodies. This is known as the corporate rating methodology. The quality of assets or projects used in Murabahah, Tawarruq, Ijarah or Istisna contracts is not relevant to the financial ability of the obligor/issuer to pay the primary and secondary notes. Such assets or projects are used merely to facilitate the creation of Islamic receivables that can be securitised in the form of an IOU. Although the issuance of these Sukuk based on Islamic receivables is not objectionable to international Shariah standards as per the AAOIFI Shariah Standard (No 17), the trading of these Sukuk on the secondary market at market value is unacceptable to some contemporary scholars. While Shariah authorities in Malaysia have allowed the trading of this Sukuk at market value based on market forces, other Shariah authorities have objections on the tradability of this Sukuk as receivables arising from these contracts are seen as monetary assets that need to be exchanged only at par value.
9.4.2 Solution to trade Islamic bonds at market value

To enable this debt-based Sukuk to be traded on the secondary market, even at a discounted price, it has been proposed that secondary market investors would need to purchase the Sukuk from primary investors, that is Sukuk holders, in exchange for another commodity instead of money. For example, suppose a company has entered into a Murabahah-tawarruq contract with financial investors who ultimately invest cash of Malaysian ringgit (RM) 500 million. However, the company will be indebted to these financial investors for an amount of RM600 million. Lets further assume that the debt is to be paid over a period of five years at six monthly intervals. The debt owed to the financial investors can be securitised in the form of Sukuk Murabahah that gives the right to Sukuk Murabahah holders to claim the payment as documented in the Sukuk Murabahah notes from the issuer/debtor. These investors/creditors may normally only sell this Sukuk to other investors at the secondary market, according to AAOIFI Shariah standards, at the face value of the Sukuk, which may not, however, be commercially appealing to secondary market investors. It has been proposed that secondary market investors could purchase the Sukuk or the receivables of Murabahah-tawarruq worth RM600 million (collectively for the purpose of the illustration) for a commodity worth RM580 million at the spot market. The issuer of the Sukuk/debtor will then sell this commodity to the spot market for the price of RM580 million, effectively realising the disposal of the Sukuk. The secondary market investors will, however, have the right to claim RM600 million from the issuer if they hold the Sukuk for the full five years. They could themselves sell the Sukuk on the basis of an exchange of the Sukuk for a commodity to avoid the sale of receivables for money not at face value. Although this proposal has not yet been put into practice, it has been approved by the Shariah boards of many IFIs. The issuance of Sukuk based on this concept is universally accepted even under AAOIFI Shariah Standards. It may require some institutional restructuring of the existing secondary market to facilitate the sale of debt-based Sukuk for a commodity. If that is not workable, then an over-thecounter transaction may be proposed to allow this transaction to take place. This Sukuk is classified as debt-based because the Sukuk investors, immediately after its issuance, would have no claim on the underlying assets that were initially used for the sole purpose of creating the Islamic receivables. The ownership relationship, as well as any other legal relationship between Sukuk investors and the underlying assets, ceases to exist immediately after the conclusion of a sale-and-purchase contract. Furthermore, Sukuk investors would not have a right of recourse to those assets unless they were made collateral to secure the payment of Islamic obligations arising from the debt-based contract. In this case, it is obvious that this kind of Sukuk is not an asset-based Sukuk as investors lose the link with the underlying assets immediately after the Sukuk issuance.
Key point
Debt-based Sukuk, which is only common in Malaysia, is evidence that the Sukuk holder has a right to claim a certain amount of money from the issuer of the Sukuk. This claim arises from a debt-based contract between the issuer and the investor. Although this Sukuk may be issued as per international Shariah standard, its tradability, based on market value, may not be universally Shariah-compliant except following special arrangements of trading such as being traded at par or exchanged for a commodity at any agreed price.
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Exercise 9.2
Explain why the sale of a receivable for a commodity, even at a discounted price, is permissible, while the sale of a receivable for money at a market value different from its face value is not permissible according to AAOIFI Shariah Standards. The following diagram illustrates how Sukuk Murabahah could be structured. Murabahah Liquidity Company (MLC) Inc. has issued Sukuk Murabahah based on the Murabahah-tawarruq contract. The structure and key terms and conditions of that structure are given in the diagram.
Figure 9.3 MLC Sukuk Murabahah structure
Vendor A
Vendor B
Buy commodity via Broker A Cash
Cash
Cash
1 MLC Inc
Sell commodity via Broker B
3
Sell commodity on deferral Cash
Sukuk investors
Issue MLC Sukuk Murabahah Cash
Corporate XYZ
Occurs on the same day Occurs upon maturity day
Trustee
The process flow is as follows: 1. Investors appoint MLC Inc. as its agent to buy, for example, aluminium as the commodity asset. Subsequently, MLC Inc. appoints Broker A as its agent to carry out the said role. On the issue date, MLC Inc. issues a trust certificate (Sukuk Murabahah, for example RM$100 million for one year) as evidence of the investors undivided beneficial interest in the aluminium. A trustee is appointed to protect the interest of the Sukuk holders by way of a declaration of trust. 2. On the purchase date, MLC Inc., through Broker A, purchases aluminium from Commodity Vendor A on a cash basis. The asset purchase price payment to Vendor A is paid to a settlement account that Broker A (acting as the payment agent for the purchase and sale of a commodity transaction) holds in trust, as satisfaction of the asset purchase price from MLC Inc. 3. On the same day, MLC Inc. sells the commodity to corporate XYZ (which essentially requires the funding) on a deferred contract basis at the asset sale price (for example RM120 million) for an agreed tenure (for example one year). 4. Subsequently, Corporate XYZ sells the aluminium to Commodity Vendor B through MLC Inc. (acting as the payment agent for Corporate XYZ in the sale of the commodity) at a price that is equal to its asset purchase price (for example RM100 million) on a cash basis. The asset purchase price payment to Corporate XYZ is paid from the settlement account (as in step 2 above) as satisfaction of the asset purchase price from Vendor B. 5. Upon maturity, Corporate XYZ pays the whole asset sale price (RM120 million, assuming the profit distribution payable of RM20 million is paid upon maturity) to MLC Inc., which subsequently returns the money to investors and redeems the Sukuk. Note:
Profit distribution payable, if any, to the Sukuk investors is equivalent to the instalment payment payable by Corporate XYZ to MLC Inc. and is determined at the point of tender of MLC Sukuk Murabahah to the investors. The frequency of the profit distribution to the investor is either on a semi-annual basis or at any agreed stipulated period.
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Exercise 9.3
Based on the structure and the objective of the Sukuk mentioned in the example above, and assuming that this structure is being developed in Malaysia, discuss the following issues: Would all IFIs in Malaysia be able to participate as investors in this Sukuk? What would be the impact of this structure on IFIs in Malaysia that subscribe to AAOIFI Shariah Standards? What would be the most suitable Sukuk instrument for creating Islamic liquidity instruments that would appeal to all Islamic investors worldwide?
9.4.3 Sukuk Istisna as an example of debt-based Sukuk and debt-based financing

As stated above, Shariah authorities in Malaysia have allowed the trading of Sukuk at market value based on market forces. Other Shariah authorities, meanwhile, have raised objections on the tradability of this Sukuk as receivables arising from these contracts are seen as monetary assets that require to be exchanged at par value. The following example is an illustration of a debt-based Sukuk, as practised in Malaysia using an Istisna contract. Turbo Company (the Company) is an independent power producer that has been awarded a concession to construct, operate and own a 3,000 MV coal-fired power plant in Malaysia. The cost of the construction is expected to be about RM1 billion. A local electricity company has signed a power purchase agreement as an off-take agreement to purchase electricity in the future at an agreed price. The Company is new, with no fixed assets on its balance sheet and has decided to issue Sukuk Istisna following the Shariah concept approved by Malaysian regulators. Following a Sukuk programme, the obligor/issuer will only issue Sukuk, up to a maximum of RM1 billion, as and when the funds are required instead of one-off issuance. This is normal practice in project finance. The Sukuk investors, through the issuer, may enter into an Istisna contract to purchase specifically described assets from the Company, which it has to construct and deliver in the future to the investors for an agreed price, for example RM200 million, as the first series of the issuance. Under this leg of the contract of Istisna, the investors will pay the Istisna purchase price of RM200 million to the Company. This amount of money is the amount required by the Company to start the first phase of the project, for example building the foundations of the power plant. Subsequently, the Company will enter into a second leg of the Istisna contract to purchase the same described asset from the Sukuk investors. This will also need to be constructed and delivered in the future for a price higher than the first Istisna purchase price of, for example RM220 million. By entering into the second leg of the Istisna contract, the Company has created a financial obligation that is payable to the Sukuk investors. The Company, as the obligor, will issue the primary notes worth RM200 million and the secondary notes that are attached to the primary notes amounting to RM20 million, which will mature at, say, six months intervals for a three-year period. In reality, the financial ability of the Company/issuer/obligor to pay this obligation, namely the primary notes and secondary notes, is not linked to the performance of this power plant to generate its future cash flow. What has been securitised is merely the requirement of the issuer to pay this financial obligation to the Sukuk investors. Therefore, the debt-based Sukuk investors take on the credit risk of the obligor rather than the risk of the underlying asset, which is the asset under construction. Investors have no claim on the assets immediately after the issuance of Sukuk Istisna except where the asset was made collateral for the payment of the Sukuk Istisna. This is different from project-based Sukuk (to be discussed later) whereby the pay-off to the investors is linked, or will be linked, to the performance of the project in terms of cash flows and quality of the project asset.
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Exercise 9.4
In the above example, the structure of the Sukuk Istisna has used two legs of an Istisna contract, namely a sale-and-buy-back arrangement between two parties. By reference to CDIF/3/6/98-99, compare this structure to Parallel Istisna. Explain why this structure is not well accepted outside Malaysia and outline the proposals, if any, that have been made to make it compliant to investors who are adhering to international Shariah standards in their investment decision.
9.5 Asset-based Sukuk

In contrast to the debt-based Sukuk described above, asset-based Sukuk investors have some relationship with, or claim on, assets that are used to facilitate the issuance of Sukuk. However, from the financial obligation perspective, asset-based Sukuk are similar to debt-based Sukuk as the performance of the underlying asset has no significant impact on the credit quality of the obligor/ issuer, particularly from a rating methodology perspective and, therefore, on the quality of timely payment to Sukuk investors. The rating of the asset-based Sukuk relies primarily on the quality of the credit risk of the obligor/issuer and the position of the Sukuk investors vis--vis other secured or nonsecured creditors. The asset is present in this structure only for the purpose of Shariah-fulfilment, rather than to serve as a source of profit or capital redemption or payment. The risk that investors take is still largely related to the credit-risk assessment of the issuer/obligor in timely redemption of the Sukuk. Although the analysis of the asset in this structure may be significant from a Shariah contractual perspective, it is not significant from the financial one.
9.6 Sukuk Ijarah: an illustration of an asset-backed Sukuk

The structure that typically applies to an asset-backed Sukuk is that of the Sukuk Ijarah, which is based on the sale-and-lease-back concept (CDIF/3/7/106-107). In this structure, the obligor is normally the party that has an unencumbered asset and who is willing to transfer the beneficial ownership of this asset by selling it to the Sukuk investors in exchange for an amount of money. Subsequent to the sale of the asset, based on a beneficial ownership transfer, the Sukuk investors will lease the asset back to the obligor for an agreed rental payment, which includes the principal amount of financing, plus profit. This description of the Sukuk Ijarah highlights several technical and operational issues that need to be taken into consideration while structuring this type of Sukuk.
9.6.1 Ownership of the asset by the obligor/originator

Sukuk Ijarah will not be possible without the ownership of the asset by the obligor/originator. Here the term ownership requires the obligor to own an asset free from any claims or encumbrances. Where there is any claim, lien or encumbrance over the asset, consent for the sale from the relevant party who holds the lien or encumbrance must be sought prior to the sale of the asset to affect a valid and enforceable sale contract.
9.6.2 Eligibility of asset to be sold

The asset must be eligible for sale under both Shariah principles and the law of the country. Obviously, assets that are impure from the Shariah perspective, such as conventional bank buildings or casinos or factories producing liquor and non-Halal food, are not valid assets for a sale from the Shariah perspective. Legal restrictions on the assets may also apply, such as lands designated exclusively for certain prescribed individuals, for example natives or government-owned buildings that are not eligible for transfer. In such cases, these assets may not be sold unless special permission is granted, where relevant and applicable.
9.6.3 Assets must be leasable

The asset must not only be sold legally, according to Shariah requirements, but must also be of a type that can be leased out. This is because the Sukuk Ijarah structure requires two contracts, namely a sale followed by a lease contract. Many assets can be owned that are not necessarily leasable, such as shares, Sukuk, gold, silver, currency and petrol. Such assets cannot be used to facilitate the issuance of Sukuk Ijarah.
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9.6.4 Transfer of beneficial ownership

The sale of an asset may be made on the basis of the transfer of beneficial ownership, instead of the transfer of legal ownership. This concept of beneficial ownership transfer is only valid and recognised in jurisdictions that apply English law principles. Beneficial ownership transfer derives its validity from the Trust concept that recognises legal ownership vis--vis beneficial ownership under the equity principles of law instead of common law. Following this concept, an owner may sell his asset to another party while maintaining the legal title of the asset. The purchaser, although not having a legal title, will be deemed by the law as the beneficial owner until a legal transfer is complete. Countries that apply civil law principles may not accept this concept of beneficial ownership transfer unless these countries decided to pass a special law on Trust, as in the case of the Trust Law in Bahrain enacted in 2006 and the Sukuk Law enacted in Indonesia in April 2007. Otherwise, a transfer of beneficial ownership to facilitate Sukuk Ijarah may not be acceptable in a court of law in the case of a dispute. For example, in the United Arab Emirates the law only recognises the legal transfer of ownership with a title.
9.6.5 Legal transfer of ownership

There is technically no issue in applying a legal transfer of ownership. However, this may complicate operational issues, such as the recording of the asset, the valuation of the asset and its impact on the balance sheet of the owner. Also, in the case of government-based Sukuk Ijarah, the assets of the government may not be allowed to be disposed of to foreigners under local laws. The reason why a beneficial ownership transfer has been used in the past is to protect the interest of the issuing party so the underlying assets will not be transferred from the books of the obligor/originator, especially when the obligor/originator is the government.
9.7 Advantages and disadvantages of Sukuk Ijarah

9.7.1 Disadvantages and limitations of Sukuk Ijarah
Having explained the features and requirements of asset-based Sukuk in the form of Sukuk Ijarah, mention should be made of the limitations of Sukuk Ijarah from the obligor/originator perspective, which include, but are not limited to, the following: As it is based on assets, Sukuk Ijarah will restrict the obligor/originator from selling the asset, even where the obligor/originator may need to liquidate this asset for cash requirements or where they have an opportunity to generate a better income from its sale. As a result, the terms of the Sukuk Ijarah will often include a clause giving the issuer the right to replace the leased asset with another asset as and when needed, but subject to the consent of the investors. Also, to facilitate the issuance of Sukuk Ijarah, the issuer must have an asset that can be leased out under either a commercial requirement or the laws of the country. The issuer may have many assets; however, these may be restricted from being sold and/or leased out under relevant laws, therefore restricting the use of these assets for this issuance.
9.7.2 Advantages of Sukuk Ijarah

Despite the disadvantages mentioned, Sukuk Ijarah has many advantages to offer to both the issuer/ obligor and the investors: Sukuk Ijarah provides flexibility in fixing the rental payment. Rental, unlike profit payments in a sale contract, may be fixed or variable according to an agreed benchmark. Also, both the obligor and investors may mutually vary the rental amount and lease period without the need to enter into a new contract. The leased asset may be declared a Trust asset for the benefit of the Sukuk investors. Therefore, this asset will not be accessible to other creditors of the obligor should the obligor be declared insolvent and bankrupt. The nature of the leased asset as a Trust asset under the Sukuk Ijarah has made the structure distinct from conventional bonds. In this instance investors may have recourse to this Trust asset in the case of default and solvency of the obligor, with a priority over other creditors, whether secured or non-secured. Although Sukuk Ijarah has a purchase undertaking for the obligor to purchase the leased asset in the case of default, it is not affected by the 2008 AAOIFI pronouncement. This is because Sukuk Ijarah is not based on an equity contract. Also, the obligor who gives the purchase undertaking is not a partner to Sukuk Ijarah investors and therefore the undertaking does not lead to a capital guarantee.
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Key point
Asset-based Sukuk, normally manifested in Sukuk Ijarah, reflects the sale of the asset followed by the lease contract, whereby the Sukuk holders will have the claim on ownership over the underlying asset throughout the tenor of the Sukuk while benefiting from income in the form of rental payment.
Exercise 9.5
Compare and contrast Sukuk Istisna and Sukuk Ijarah in terms of the principal parties involved, its structure, tradability, security, pricing mechanism, limitations and their acceptability in the global Islamic investment community.
9.8 Sukuk Ijarah of the Qatar Government

The Qatar Government issued one of the earliest Sukuk Ijarah following the Government of Malaysia. Unlike the Sukuk Ijarah of Malaysia, Qatars used a piece of land earmarked for the development of a medical city. At the time of issuance, there was no development on the land. The land was sold to the issuer that the Government of Qatar then incorporated at US$700 million. Subsequently, on behalf of the investors, the issuer leased the same land back to the obligor at a rental payment with a formula based on the floating rate of LIBOR. The process is set out in the diagram below.
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Figure 9.4 Qatar Sovereign Sukuk Ijarah
Qatar government 1 3 3 2
Land for the development of a medical city
Qatar global Sukuk QSC (SPV) 5 7 Sukuk investors Sukuk certificates 6
Step 1
The Government of Qatar sells land parcels valued at US$700 million to Qatar Global Sukuk QSC, an SPV. The plot of land is to be used for the development of the Hamad Medical City located in Doha, Qatar. The Qatar Global Sukuk pays a purchase price of US$700 million to the Qatar Government for the land. The Qatar Global Sukuk leases out land parcels under a master Ijarah agreement to the Government of Qatar. Under the terms of this lease, the Government of Qatar agrees that the Qatar Global Sukuk shall not, under any circumstances, be liable to the Government or to any third party for any cost, claim, demand, loss, damage or expense of any kind or nature caused directly or indirectly by, or out of, the use of any part or the whole of the land parcel. The Government of Qatar pays semi-annual lease rentals under the master Ijarah agreement, plus the margin. The Qatar Global Sukuk securitises the asset and issues Sukuk certificates to investors. Investors purchase the Sukuk certificates. The proceeds received from the investor as the result of the Sukuk issuance are then paid to the Government to complete the arrangement for the purchase of land. The investors are reimbursed periodically by distributions from the Qatar Global Sukuk, which originated from Government rental payments on the land parcels.
Step 2
Step 3
Step 4
Step 5
Step 6
Step 7
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Many Shariah-based organisations and boards, such as the International Islamic Academy of Fiqh and Dallah Barakah, have issued Fatwas on the position of intangible assets, such as trade name, copyright, design, brand name, patent, as valid and eligible assets that can be sold and leased. The relevant Fatwas also impose damages on any person who infringes these rights to compensate the loss to the owner of these assets because of the infringement. Intel Soft Inc. is a software company that has invented new smart and intelligent software that can transcribe a recorded message from a mobile phone into an email format, which can then be automatically sent out to the concerned party. The software is known as Smart Transformer. The company sells this software to the business community for a fee. The company is now developing new software to perfect the previous software. To finance the project, the company seeks to issue Sukuk Ijarah and has asked your professional opinion on its structuring. Advise Intel Soft Inc. on the possibility of using this structure and the relevant points to be considered if it is deemed possible. Suppose this structure is not possible; what alternative would you suggest for this company to leverage Sukuk on this important asset?
Solution
Software is an intangible asset that can generate income for its owner. It is also deemed a valid brand name or trademark if it is registered and patented under the relevant laws of intellectual property. Based on the above Fatwa, the Company may issue Sukuk Ijarah to raise new funding to cover the cost of enhancing the existing software. This is because the Fatwa has alluded to the fact that this kind of asset is valid and can be sold as well as leased out. It is, therefore, treated no differently from any tangible assets. Following this argument, it is clear that the Company may sell this asset, subject to the proper valuation by experts, to Sukuk Ijarah investors for the investors to lease back the rights to the Company. In doing so, a few important points must be considered. This right must be able to be sold under the law, otherwise the whole structure may not proceed. Also, the lease contract period between the investors and the Company must not exceed the permitted right of this trademark or brand name under the law. In addition to this structure, we could propose a project-based Sukuk. Following this structure, investors will be invited by the issuer to pool their investments together to purchase this right at X price, for example, 600 million. This amount will be used by the Company to cover the cost of developing enhancements to the existing software, which is the purpose of issuing this Sukuk. The investors will later appoint the Company to manage the business of this software for a management fee. However, any income generated from this software business will be divided among the investors proportionately and transparently. This structure has transformed the Sukuk structure from an asset-based to a project-based Sukuk, which will be discussed in the next section of this chapter.
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9. 9 Project-based Sukuk
Similar to asset-based Sukuk, project-based Sukuk are a relatively new innovation of Islamic finance in the fixed-income market as they depart completely from the notion of IOU to profit and risk sharing. However, this Sukuk structure is fundamentally different from asset-based Sukuk. It is based on profit and loss sharing in which Sukuk investors will have to consider the risk of the venture more than the credit risk of the issuer. This is because the pay-off to Sukuk investors is based on actual income generated by the underlying project upon which the Sukuk are issued. The proceeds of the Sukuk will be used to finance the project. The income generated from the project, be it manufacturing or construction or plantation or services, will be distributed among the investors proportionate to their investment capital. There is no guaranteed payment by either the obligor or the issuer as in the case of debt-based and asset-based Sukuk. As a result of these factors the rating exercise will be different. The rating of a bond, as applied in a conventional bond market, has been confined to the credit risk of the issuer/borrower. The rating agency never rated the project risk more than the credit worthiness of the issuer/borrower. This was one of the issues that led to the practice of purchase undertaking in most project-based Sukuk prior to the AAOIFI pronouncement in 2008 to enhance the credit rating and be rated according to corporate-rating instead of project finance-rating methodology.
Key point
Project-based Sukuk, which is ideal for project financing, is structured on the basis that Sukuk investors will receive payment from the subsequent performance of the underlying project being constructed or developed.
9.9.1 The SABIC Sukuk Istithmar

The typical structure of a project-based Sukuk is represented by the SABIC Sukuk Istithmar. This Sukuk has managed to attract several accolades. For example, it was the first Sukuk to be launched in Saudi Arabia under the new Capital Market Law (date of issuance: 29 July 2006). It is also the first fully tradable Sukuk to be issued in Saudi Arabia and the first Sukuk to be settled/cleared through Tadawul (Saudi Stock Exchange). The issuer, Saudi Basic Industries Corporation SABIC, is a holding company for a group of companies that constitute the Middle Easts largest non-oil industry company and the 10th largest international petrochemical company in the world (as measured by revenues). The underlying Sukuk assets are based on marketing rights, that is the right given to SABIC as a holding company to market all products produced by all its affiliates and subsidiaries for a marketing fee. The structure of SABICs Sukuk Istithmar is as follows:
Figure 9.5 SABIC Sukuk Al-Istithmar

Reserve
7 Sabic undertakes to buy Sukuk at years 5,10 &15 based on an agreement 6. Extra income are placed in Reserve
SABIC (Issuer)
2 3 4,5
Sukuk holders
1. Sukuk assets under custody during the Sukuk life
SABIC Sukuk LLC (custodian)
2. Sabic issues Sukuk (representing ownership in Sukuk assets) 3. Sukuk holders pay Issue proceeds 4. SABIC manages Sukuk assets for the Sukuk holders 5. Distributions are paid from income of the Sukuk assets (income from Sukuk assets is expected to comfortably exceed coupon and extra amount)
Secondary market
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An issue raised during the Shariah structuring phase was that of the 20 years of marketing rights that form the basis of the Sukuk assets. These marketing rights have been defined as the limited rights and obligations of SABIC in certain marketing contracts that underpin the marketing services that SABIC provides to its manufacturing affiliate and subsidiaries. Essentially, all of the subsidiaries of SABIC signed this marketing agreement with SABIC as the holding company to market the products of all the subsidiaries for a fee. The sole income would be the marketing fees to be paid by all subsidiaries if the holding company was to market and sell the products produced by its subsidiaries. This issue was deliberated further and the outcome is below. It was suitable for SABIC to be the holding company. In addition to being a holding company, managing and coordinating its investments, SABIC has a research and technology unit (holding over 200 registered patents) and a marketing business unit. This marketing unit incurs certain costs (the cost of marketing and selling products to thousands of global customers) and receives fees in return for this marketing effort. The fee is a percentage of the quantity of products sold. Therefore, the marketing rights were a valid venture that could generate income to the investor, providing investment capital to SABIC marketing works and services. The Sukuk entitles Sukuk holders with a 20-year right in the defined net income from these marketing services, subject to certain terms and conditions. The track record of the marketing fee income was reported as:
Marketing fee income

Year 2003 2004 2005 Total marketing fee income (SAR 000s) 1,121,493 1,670,648 2,140,600
Against the illustrated cost and expenses

Year 2003 2004 2005 Total costs and expenses (SAR 000s) 47,813 84,528 93.182
The net income derived from this investment is paid quarterly to Sukuk holders, up to a specific amount (based on a benchmark linked to LIBOR). Any surplus income is kept as a reserve and buffer to allow for profit distribution if future net income declines. The reserve also functions to pay every five years throughout the 20-year life of Sukuk an extra amount equal to 10% of the face value of Sukuk. Therefore, by the end of 20 years, the Sukuk holders will get 40% of the face value of Sukuk as well as the quarterly profit distribution. If there is any surplus in revenue at the end of 20 years or earlier (if the Sukuk are to be purchased by SABIC under purchase undertaking), the remaining balance is to be paid to SABIC as an incentive. In addition to the 10% extra amount paid to Sukuk holders every five years, SABIC provides Sukuk holders with a purchase undertaking under which it is to purchase the Sukuk for a specific amount at each pre-arranged date. This purchase undertaking is both irrevocable and individual. However, the purchase price will decrease over time, representing the remaining life of the Sukuk. The price decreases from 90% of the face value at the end of year five to 60% in year 10 and 30% in year 15. At the end of year 20, the Sukuk has no value as its life has expired. This is an investment by the Sukuk investors to enhance the marketing capabilities of SABIC, which entitles the Sukuk investors to the profit generated from the marketing fees.
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9.9.2 The Emirates Airlines Sukuk

Another good example is the Sukuk Musharakah for Emirates Airlines (2005). The Emirates Airlines Sukuk is the largest corporate issuance to date. This deal was structured under the Musharakah concept and was the second Sukuk Musharakah listed on the Luxembourg Stock Exchange. The US$550 million Sukuk issue has a seven-year maturity period with a semi-annual coupon, except for the first coupon which was payable in 12 months. The Sukuk was priced at 0.75% above the relevant US% LIBOR rates. Emirates and the issuer of the Sukuk certificates, Wings FZCO (a special purpose issuer), entered into a Musharakah agreement whereby both Emirates and Wings had undivided ownership of the Musharakah assets made up (on the closing day) of capital contributions raised from the issue of Sukuk and the land contributed by Emirates, as evidenced by the usufruct letter. Subsequently, the Musharakah assets constituted all revenues and assets acquired from the application of the Musharakah capital, that is to say rental income generated from the development of the land. The structure of the Emirates Airline Sukuk is shown in the diagram below:
Figure 9.6 Emirates Airlines Sukuk Musharakah
Emirates as obligor
Emirates as lessee
Exercise price
Sale of units
Lease of new Emirates Group headquarters
Musharakah
Wings FZCO as partner Emirates as partner
Usufruct letter
Wings FZCO (the issuer)

Periodic distribution amounts Dissolution distribution amount Proceeds Certificates
Emirates
Investors
Pursuant to the terms of the issue, Wings FZCO issued US$-denominated floating rate trust certificates. Wings FZCO used the proceeds of the Sukuk issue to contribute to the venture between Wings FZCO and Emirates. The venture was to develop and lease to Emirates a new engineering centre and headquarters on land situated near Dubais airport. Profit, in the form of lease returns generated from the joint venture, will be used to pay the periodic coupon on the trust certificates. The trust certificates have been listed on the Luxembourg Stock Exchange.
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Emirates and Wings FZCOs participation in the venture is represented by a specified number of units of the trust certificates generated. During the lifespan of the transaction, Emirates is scheduled to purchase units from the issuer. This reflects the amortisation schedule of the Sukuk certificates. The issue, oversubscribed by almost 50%, was closed at US$550 million as originally targeted. The deal was a joint effort of a prestigious consortium of local, regional and international banks, led by Dubai Islamic Bank (DIB). The issue was managed by a six-member group of banks acting as joint lead managers including DIB, National Bank of Abu Dhabi, Gulf International Bank B.S.C., Standard Chartered Bank, HSBC and UBS.
9.10 Asset-backed Sukuk

Asset-backed securities are the real form of securitisation as they expose the investors to real value and risk of the underlying asset. Asset-backed Sukuk, as explained in CDIF/3/8/121-128, involve securitisation of an asset whereas the investors can only expect the returns from the cash flows of the underlying assets that are not linked to the credit risk of the originator/owner of the asset. These assets could be financial assets or physical assets. Under this type of Sukuk, investors generally do not have access to the asset owner, likewise they are safeguarded from the latters financial plights. This is because asset-backed Sukuk would require the owner of the asset to sell his asset on a true sale concept without having any purchase undertaking to repurchase the asset at its outstanding face-value. In some cases, the owner/originator may undertake to repurchase the asset by giving a put option to the Sukuk investors. However, the purchase price must not be based on the face value of the outstanding Sukuk. Ideally, it should be based on market value to reflect a valid sense of a true sale concept. In short, asset-backed Sukuk are characteristically non-recourse Sukuk with the underlying assets forming the sole source of profit and capital payments. The following is a hypothetical illustration of an asset-backed Sukuk, which could also be linked to an Ijarah contract. Ship It Right (SIR) is a logistic company that owns a series of warehouses. As the company is looking for new funding to expand its business overseas, it may decide to sell the warehouses to the SPV/issuer on behalf of the investors. This sale shall be a true sale and there is no purchase undertaking by the company. The warehouses may be leased back to the same company, say for a period of five years, for it to continue operations with the existing clients. The lease rental income is the sole source of payment for the Sukuk investors. The investors have no right of recourse to the company if the lease rental income does not meet the minimum periodic distribution of profit/coupon. The company may, however, undertake to purchase back the asset at market value on the maturity date.
Figure 9.7 Asset-backed Sukuk
Asset-backed Sukuk investors 1

Sukuk proceed
SIR company (owner)
2
Sale of asset
SPV/Issuer
3
Lease of asset
SIR Company (lessee)
4
Call options to purchase the asset at market evaluation
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Key point
Asset-backed Sukuk entitles the Sukuk investors to the real value and risk of the underlying asset that is transferred to the Sukuk investors under a true sale concept, which allows no recourse to the original owner under any circumstances. The original owner may have the call option over the asset but it should be based on the market value of the asset at the time of the exercise of the call option.
9.11 Possible new structures for Sukuk

Possible new Sukuk may use other innovative structures. One of these structures could be to securitise the right to use future services such as the use of an apartment. This is in line with AAOIFI Shariah Standard (No. 17) that allows the securitisation of both existing and future services of an asset. The following illustration describes how a future service can be used as the underlying asset to raise necessary funding.
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A five-star apartment complex is being developed in the Holy Land of Mecca. As part of the master plan for the ongoing improvements of the Holy Cities of Mecca and Medina, the Waqf (endowment), owning significant properties, has entered into strategic plans to modernise and expand facilities for pilgrims and visitors. In Mecca, King Abdul Aziz Waqf is developing a multiplex of high-rise towers. Zam Zam Towers is a-sub-project secured by an affiliate of the Kuwait-based International Lease Investment Company (an Islamic Development Bank-sponsored entity) called Munshaat Real Estate.
Figure 9.8 Project structure

King Abdul Aziz Waqf
28 yr BOT contract Transfer Zam Zam Towers back to Waqf after 28 years
Bin Laden group of companies

24 yr lease Sukuk proceeeds
Issue USD390 mil Sukuk Al-Intifa
Munshaat real estate

Sukuk proceeeds
Sukuk investors
Realising that the long-term ownership of the buildings would ultimately go to the Waqf, and there are limitations on non-Saudi Arabian ownership of real property, Munshaat re-characterised the property into multiple estates: the ground belonged to the Waqf; the building could belong to Munshaat as a Gulf Cooperation Council company, ultimately controlled by the Jeddah-based Islamic Development Bank; and the Manfaat, or benefit of the space, could be sold for up to 24 years. Munshaat, then entered into a BOT contract with the Waqf, governed by the reversionary lease, and sub-contracted construction of a 31-storey, 1,240-unit building to a prominent Saudi Arabian builder. The US$390 million contract was funded by an issuance of Islamic securities or Sukuk known as Sukuk al Intifaa or Sukuk for use or services. These securities or Sukuk represent a fractional ownership of the right to use a specific part of the building during a specific period. The shares were priced according to season, unit location and view. The shares were made fully exchangeable and represent a 24-year guaranteed right to utilise, for a specific time each year, a pre-specified space. The securities or Sukuk were sold prior to construction, thereby funding the construction. The Sukuk or securities represent a forward lease for the property, meaning that Munshaat bears a refund risk if the project is not completed. Among the novel features of this project is that the holder of Sukuk may elect to benefit from a number of options: he or she may simply show up at the reserved time; exchange times through a specialised affiliate of Munshaat; contract for Munshaat to sub-lease the contracted time to a willing tenant who wishes to visit Mecca at that time; or sell the Sukuk to a willing buyer for a profit or loss, with that buyer then acquiring all of the attendant rights and benefits of the Sukuk. The underlying property rights represented in the Sukuk, however, are limited in time and nature. Since the Sukuk represent a specific form of property, the certificates may be sold on an instalment basis. This facilitates one of the goals of the sponsor Munshaat: to make it easy for a large number of people to acquire the certificates and access and use the property that they represent. The Sukuk al Intifaa issuance has established a model that is easily replicable in global markets. Based on an adaptation of a classical series of concepts, all of which centre on the flexible approach to the sale and utilisation of property facilities, this is the first modern lease in Islamic finance that is based on securitisation of (future) services.
Key point
Current or future services may be securitised in the form of Sukuk through which the Sukuk holders will financially benefit by the sub-leasing of these services to a third party for a rental payment.
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9.12 Rating methodology for Sukuk

Rating, as understood in conventional terms, is the expression of an opinion about the ability and willingness of an issuer to meet financial obligations in a timely manner. The same meaning of rating is applicable in the context of Islamic finance with specific reference to Sukuk. The current rating of Sukuk by many international or local rating agencies, while ascertaining the ability and willingness of the issuer to make relevant payments to the investors, does not examine the quality of the Shariah approval for the Sukuk. This is because the Shariah quality rating is currently beyond the scope of many international and local rating agencies. The rating agencies will, however, consider whether the Sukuk instrument is enforceable according to the law of the relevant country as part of its due diligence and in this regard they may take cognisance of the Shariah approval as part of the enforceability issue, where relevant. The exception to this are the recent efforts of Bahrains International Islamic Rating Agency (IIRA). IIRA has developed a Shariah Quality Rating that is designed to provide information and independent assessment regarding the level of Shariah compliance by an IFI. IIRA uses a scale of AAA to B to rate Shariah Quality Compliance, with AAA being the highest possible rating and B being the lowest. This rating methodology places institutions on a single comparable scale in an independent, impartial framework prepared by IIRAs Shariah scholars. This rating methodology is specifically applied to institutions offering Islamic financing instruments, rather than rating the actual financial instruments or Sukuks. Conceptually, a Sukuk is an investment instrument that is intended to reward the investors for their investment. However, the investors may need an independent rating to ascertain the ability of the issuer to make payments and other obligations arising from the Sukuk instrument. Ratings for Sukuk may take a different form from ratings for conventional bonds. One fact to be considered is that Sukuk are essentially based on many different contracts that give rise to many different legal and economic implications. The focus of the rating for Sukuk must therefore take into consideration the contractual dimension of the Sukuk, in addition to what is crucial in a general rating exercise, where relevant and applicable. Conventional bonds are all about the obligation of the issuer to pay a certain amount of principal and interest, based on a loan contract. The credit worthiness of the issuer is the main, if not the only, consideration in rating for a conventional bond. The only exception lies in conventional asset-backed securities that behave as an equity instrument instead of a loan obligation or simply an IOU.
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Why is the rating of a Sukuk as an investment instrument important compared with investments in other asset classes such as property or equity funds?
Solution
Creditworthiness is a requirement for any party looking to borrow. A party will be allocated borrowings or financing if it can display to the financier that it has the ability, as well as the commitment, to fulfil the repayment obligations. Within the banking systems, the financing bank conducts credit analysis on all its borrowers, according to the banks credit criteria, to select the suitable financing pool. On the other hand, the capital markets investors rely on the analysis of rating agencies to signal to them the quality of credit that the potential issuing parties possess. Sukuk, like conventional bonds, are issued in the capital markets, to the same pool of investors who are comfortable with the credit rating processes that are requirements of any bond issuance. Therefore, Islamic investors worldwide also expect these Sukuk to be rated, even though, unlike conventional bonds, some Sukuk structures are not entirely dependent on the usual credit-rating mechanisms (because, for example, of returns dependent on projects). Sukuk ratings, which were primarily based on credit ratings, are now moving towards the ratings of specific features pertinent in every Sukuk. For instance, project-based Sukuk are now being rated based on a combination of credit as well as project financing ratings. The challenge now is not to rate all Sukuk issuance but to establish the correct rating methodologies for the different Sukuk structures. The answer as to why Sukuk needs to be rated while Islamic property or equity funds do not lies with the categories of investments that each asset class belongs to. The latter is purely an investment tool whereby the investors are exposed to all risks and profit potentials that the fund invests in. Sukuk, on the other hand, has an in-built capital redemption scheme whereby investors expect that their capital layout will eventually be redeemed by the issuers. The investors expect managed risk and they look forward to the ratings results to see whether the Sukuk investments are commensurate with their risk appetite.
Key point
Sukuk, unlike other capital market products, need to be rated as they involve capital redemption by the issuer, which is, technically speaking, a contingent liability on the issuer.
9.12.1 Issues to be considered in Sukuk rating

Several issues need to be considered in Sukuk rating. The following are general considerations applicable to all types of Sukuk. However, each Sukuk structure may have additional considerations for the rating, which will be discussed in the next section.
9.12.1.1 Source of payment to the Sukuk holder/investor

Any investor in Sukuk will expect some return on their investment in addition to capital redemption. Therefore, the first task is to ascertain how the issuer would seek to pay all the expected payments. Obviously, a debt and asset-based Sukuk will be different from a project-based or asset-backed Sukuk in terms of the source of payment to the Sukuk holders. This will be highlighted in discussion of various types of Sukuk and their rating methodologies.
9.12.1.2 Credit enhancement structures

Credit enhancement structures enhance the ability of the issuer to pay all the expected payments in all relevant circumstances. This includes, among others: the charge of an asset as the collateral and the assignment of the proceeds of any sale or investment income to Sukuk investors; the creation of a trust on the leased asset or investment asset for the benefit of Sukuk investors; and purchase undertaking in equity-based Sukuk.
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9.12.1.3 Legal and judicial aspects

Investors need to consider the legal and jurisdictional aspects of the Sukuk transaction, such as its enforceability, recognition of choice of law, insolvency and security-related matters. For example, some jurisdictions in the Middle East, such as Saudi Arabia, may raise questions about which parties obligations would be enforceable in local courts and whether they would recognise English law in that jurisdiction, and whether the security offered would be enforceable. Uncertainties pertaining to the legal environment surrounding Sukuk issuances affect the rating grade of the Sukuk.
9.12.1.4 Assessment of key parties to the transaction

An assessment of key parties to the transaction would need to be carried out, including their roles in the transaction, such as originator (borrower), lessee or obligor, guarantor, contract servicer and financial adviser.
Exercise 9.6
Suggest why established rating methodologies for Sukuk do not include Shariah ratings.
9.12.2 Rating debt-based Sukuk

As debt-based Sukuk is similar to conventional bonds in terms of risk and reward, a corporate rating methodology will usually be applied to grade the rating for Sukuk based on debt securitisation. Under this methodology, the rating of the Sukuk will be largely based on the underlying business and operations of the issuer. In other words, the credit quality of the corporate obligor will be the key driver affecting the credit risk of the Sukuk, with the final assigned rating dependent upon the ranking of Sukuk vis--vis other existing senior unsecured obligations of the issuer. Applying this methodology, a rating agency will examine relevant factors that may affect the credit risk of the issuer. The quality of rating will, however, not be linked to the underlying asset, which was used to facilitate the issuance of this Sukuk, as this asset and its performance has no impact on the future ability of payment. Those factors that are relevant to the issuers credit risk are summarised in the following diagram.
Figure 9.9 Corporate rating methodology: analytical framework

Management analysis
Industry analysis
Business analysis
Financial analysis
Growth potential Industry vulnerability Barriers to entry/ exit Threats of substitutes Level of competition
Market position Business diversity Operating efficiency Cost structure
Earning Cashflow analysis Capital structure Liquid position Financial flexibility Financial policy
Track record Capacity to overcome adversity Risk appetite Succession plan Goals, philosophy and strategies
Source: Malaysian Sukuk Market Handbook, RAM Ratings Services Berhad (2008)
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Each of the above factors will be analysed to gain a comprehensive view of the business of the issuer. An industry analysis is important because it provides the setting for the appraisal of company-specific risk factors and establishes the relative importance of these factors in the overall credit evaluation. Pertinent aspects across all industries include the rated entitys size; supply-and-demand dynamics, growth prospects, competitiveness, vulnerability to technological changes, capital requirements and other entry provisions or barriers, and government policies. The same detailed examination will be applied to business analysis, financial analysis and management analysis. This methodology does not differ from any rating exercise for any conventional bond, which is a straightforward IOU instrument.
9.12.4 Rating project-based Sukuk

Project-based Sukuk needs a different methodology of rating from both debt-based and asset-based Sukuk. The focus is no longer on the credit risk of the issuer. The examination will focus on the ability of the underlying project asset to generate sufficient cash flows to make all the relevant payments under the Sukuk. The methodology of rating used for this Sukuk is known as a project finance rating methodology. The two key elements in the rating are the quality of the cash flows and the asset of the project. While the periodic cash flow stream is relied on as the sole source for profit (that to be distributed to, or shared with, the Sukuk investors), the project assets are usually secured as collateral for the Sukuk investors in the event of default or dissolution of the Sukuk. In this context, principles of rating for conventional project-finance transactions are largely used to ascertain the relevant rating grades for Sukuk that are linked to projects.
9.12.3 Rating asset-based Sukuk

Although the structure of asset-based Sukuk, such as Sukuk Ijarah, is different from Murabahah or Sukuk Istisna, it shares largely the same methodology of rating, based on the corporate rating methodology already described. The ability of the issuer to make a timely payment of the lease rental obligations and to purchase the leased asset does not depend on the performance of the underlying leased asset. Also, the proceeds arising from Sukuk Ijarah may not necessarily be used to finance the underlying asset that facilitated the issuance of Sukuk Ijarah. Therefore, the source of payment may be linked to other business activities of the originator/obligor in the case of Sukuk Ijarah. Having said this, Sukuk Ijarah have a distinctive feature in the structure that debt-based Sukuk may not have. In most Sukuk Ijarah, the seller/originator/lessee will issue a purchase undertaking to repurchase the leased asset on maturity or any interim date at a pre-determined price. At maturity, or dissolution event, the seller/lessor will have to repurchase the leased asset from the investors. This risk is linked to the financial strength of the credit risk of the seller/lessee. What makes Sukuk Ijarah different from debt-based Sukuk is that the leased asset, in some Sukuk Ijarah, is declared as a trust for the benefit of Sukuk investors. The creation of a trust over this asset has given preference to Sukuk Ijarah investors over other creditors of the seller/lessee in the case of liquidation. This will add positively to the rating, although, in the final analysis, it will boil down to the financial ability of the seller/lessee to repurchase this asset from the investors at a predetermined price.
Key point
Sukuk structured as an asset-based securitisation is subject to corporate rating methodology that focuses more on the creditworthiness of the issuer instead of any other elements, including the underlying asset.
9.12.4 Rating project-based Sukuk

Project-based Sukuk needs a different methodology of rating from both debt-based and asset-based Sukuk. The focus is no longer on the credit risk of the issuer. The examination will focus on the ability of the underlying project asset to generate sufficient cash flows to make all the relevant payments under the Sukuk. The methodology of rating used for this Sukuk is known as a project finance rating methodology. The two key elements in the rating are the quality of the cash flows and the asset of the project. While the periodic cash flow stream is relied on as the sole source for profit (that to be distributed to, or shared with, the Sukuk investors), the project assets are usually secured as collateral for the Sukuk investors in the event of default or dissolution of the Sukuk. In this context, principles of rating for conventional project-finance transactions are largely used to ascertain the relevant rating grades for Sukuk that are linked to projects.
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Figure 9.10 Project finance rating methodology: analytical framework
Project foundation
Project funding
DSCR Analysis
9.12.4.1 Key business risk areas

The rating exercise begins with an evaluation of the project foundation or key business risk areas, involving contractual requirements, regulatory environment, operational challenges, technology complexity of the project assets, demand risk, credit strength of the off-taker and construction risk (if the underlying asset has yet to be physically completed). In addition, specific areas of risk that can either reduce or defer the expected amount of cash that the project can generate must be identified.
9.12.4.2 Review of project funding

The next step involves a review of the project funding or its capital structure, in line with the proposed financing terms. As most projects comprise a combination of senior debt, equity and/or junior/subordinated hybrid instruments, emphasis is thus placed on the project companys ability to generate and conserve adequate cash reserves to prioritise the debt-servicing requirements of the most senior Sukuk instruments, followed by the more junior securities, before any equity distributions can be made. A well-structured debt redemption profile that matches the projects cash flow generation pattern is crucial in project finance ratings assessment.
9.12.4.3 Debt service coverage ratios

The first two steps generate the debt service coverage ratios (DSCRs) utilised to measure the availability of cash flows in relation to the annual debt servicing requirements of the Sukuk. Generally, the stronger the DSCRs, the higher the rating assigned to the Sukuk. The level of debt coverage will also play a part in determining the amount that can eventually be distributed to the shareholders of the project.
9.12.4.4 Construction risk

Notwithstanding the DSCRs, a projects Sukuk rating can also be capped by construction risk. Construction risk is a function of the contractors expertise and experience, where the complexity of works, the construction programme and the contract type are duly considered. Upon completion of the construction, the ratings for the project-based Sukuk should revert to the ratings that are commensurate with its DSCR level. Where applicable, a Sukuk rating can also be constrained by the rating of the projects off-taker. This is because the quality of project cash flows typically hinges on the ability of one or a few off-takers to make timely payments for the services rendered by the project. The failure of these entities will severely affect the project companys ability to meet its Sukuk obligations.
Key point
Rating project-based Sukuk adopts a project finance rating methodology that examines key business risk areas, project funding, debt service coverage ratio and construction risk.
9.12.5 Rating asset-backed Sukuk

Asset-backed Sukuk are essentially non-recourse to the issuer and the source of payment (both profits and capital) is derived directly from the underlying assets of the Sukuk. Subsequently, the credit risk of the Sukuk is determined by the performance and the credit quality of these underlying assets. With no recourse on the issuers assets, Sukuk investors are also safeguarded from any of the issuers financial liabilities. While the underlying asset class will play a part in how asset-backed Sukuk is being rated, the generic rating approach is given as:
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Figure 9.11 Asset-backed/structured finance methodology: analytical framework
Asset risk assessment
Payment structure assessment
Legal and tax assessment
Servicer and trustee review
The ratings will focus on the robustness of the underlying assets in generating sufficient funds to meet the issuers periodic financial obligations, and an assessment of the expected realisable values of the assets upon maturity. It is vital to identify the intrinsic risks in the underlying assets with respect to their historical operational and performance data. Any potential impairment of cash flow must be ascertained as a result of possible delinquency or default on the Sukuk assets. The analysis is done while considering existing regulations governing business practices of the sponsor and the nature of the assets and consequent cash flow profile under various stress scenarios. The aim here is to examine the adequacy and timing of the cash flow vis--vis the financial obligations on the Sukuk, in accordance with the stated priority of payments under the transaction. Should a cash flow mismatch occur, it is important to see that this can be addressed. Besides emulating the defined payment flow other material factors that could affect the cash flow in the transaction, such as profit rates, prepayments on the asset and reinvestment rate, will also be built into the cash flow model. The adequacy and forms of credit enhancements will be evaluated by way of stress-testing the cash flow model. The level of stress applied will correspond to the assigned ratings. Generally, more rigorous stress tests are applied to higher-rated Sukuk. Structural features and the adequacy of each structural feature in addressing its intended purposes will be taken into consideration. Examples of structural features include credit enhancement, earlywarning mechanisms, such as trigger events, early-amortisation events and profit rates, as well as hedging arrangements for currency-exchange risk. While the usual tax and legal review may be undertaken, one particular issue that needs to be specifically addressed is the regulation that supports the separation of the underlying assets from the bankruptcy of the asset originator. Other legal issues that will be examined include the means by which the assets are transferred to the issuer, enforceability and the perfection of security interest. The rating exercise may also include a review of all transaction documents, such as the trust deed, sale and purchase agreement, servicing agreement, swap agreement, guarantee investment contract, credit-support agreement and liquidity-support agreement.
Key point
Rating asset-backed securities examines the quality of the underlying asset with regard to its cash flow and expected future income.
Exercise 9.7
Identify the similarities and differences between rating methodologies of project-based and asset-backed Sukuk.
9.12.6 Implications of a potential Sukuk default

The possibility that the Sukuk issuer will default by failing to make good either coupon payments or the payment of the principal amount in a timely manner is inherent in all Sukuk issuances. To mitigate such instances of default the Sukuk will normally undergo a rating process, which also takes into consideration the existence of contingencies including credit enhancement tools such as guarantees, sinking funds and letters of credit, created to supplement the main instrument and reduce the default risk on specific issues. Unlike a conventional bond issuance, it is still not mandatory for a Sukuk issuance to undergo the rating process in some jurisdictions. This lack of regulatory requirement may act to prohibit development within the Sukuk industry. The potential default of any Sukuk would have negative implications for the industry, affecting the popularity of Sukuk as viable capital funding instruments within the Islamic finance industry. Unlike conventional bonds, which are typically debt-based, some Sukuks are issued under equity or
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participatory contracts that leave the Sukuk investors with little recourse to the issuer. The default of any type of Sukuk may therefore have a bigger effect on investors confidence compared with the effect of a similar situation within the traditional bond industry.
9.13 Conclusion
This chapter has shown you that Sukuk are an important funding vehicle for the Islamic capital market. The Sukuk market has been growing at a remarkable pace since its establishment in 1990. The market has seen a variety of new and innovative structures applying a variety of different Islamic contracts to suit the features required. The development of this nascent yet important industry is overseen by Shariah authorities such as AAOIFI. It is the role of such international standard-setting agencies to address peculiarities in the industry, as demonstrated when the Shariah Board of AAOIFI issued the 2008 Sukuk pronouncement to amend practices arising with the issuance of some Sukuk. The chapter explained how Sukuk can be classified; either based on the underlying assets or based on the contractual relationship between the issuer and the investor. You were introduced to the different structuring issues that have arisen from structuring debt-based Sukuk and project-based Sukuk, along with the different types of financing arrangements available. This chapter also introduced you to the concept of ratings for Sukuk and elaborated on the methodologies used to rate different types of Sukuk. Developing robust and consistent rating methodologies for the different types of Sukuk is an important consideration, especially if one wants to see further integration between the Islamic capital markets around the world.
9.14 Summary
Having read this chapter the main points that you should understand are as follows: equity-based Sukuk should not have any clause that effectively guarantees the capital of the Sukuk the AAOIFI pronouncement on Sukuk of 2008 made equity-based Sukuk with the clause of purchase undertaking by the issuer non-compliant post the AAOIFI pronouncement, Sukuk, particularly those of an equity nature, must be free from any purchase undertaking or liquidity facility and must essentially reflect the ownership of the underlying asset or project Sukuk can be classified into four broad categories based on the underlying asset against which the Sukuk is issued: debt-based Sukuk, asset-based Sukuk, project-based Sukuk and asset-backed Sukuk Sukuk may also be classified based on the contractual perspective governing the relationship between the issuer and the investors, that is to say either debt-based or equity-based Sukuk from the financial obligation perspective, asset-based Sukuk is similar to debt-based Sukuk as the performance of the underlying asset has no significant impact on the credit quality of the obligor/issuer project-based Sukuk is a relatively new innovation of Islamic finance in the fixed-income market as it departs completely from the notion of IOU to profit and risk sharing the 2008 Sukuk pronouncement by AAOIFI has readdressed the features of equity-based Sukuk and affected the rating processes of Sukuk the current rating of Sukuk by many international or local rating agencies, while ascertaining the ability and willingness of the issuer to make relevant payments to the investors, does not examine the quality of the Shariah approval for the Sukuk the rating methodologies applied on debt-based and asset-based Sukuk is largely based on credit ratings, although the creation of a trust for some asset-based Sukuk will add positively to its rating project-based Sukuk requires a different rating methodology as the focus is no longer on the credit risk of the issuer but on the ability of the underlying project asset to generate sufficient cash flows to make all the relevant payments under the Sukuk asset-backed Sukuk will be rated on the robustness of their underlying assets in generating sufficient funds to meet the issuers periodic financial obligations, and an assessment of the expected realisable values of the assets upon maturity the development of acceptable rating systems is important to ensure that the investors understand the nature of the Sukuk issued and the risks involved, and to minimise the possibility of Sukuk defaults in the future.
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Sukuk structuring and Sukuk rating post the AAOIFI pronouncement The International Islamic Bank (IIB), a multi-national bank, has many project development projects located in various member countries, covering the infrastructure and energy capacity building sector for the benefit of member countries. The rating of IIB is AAA, as awarded by a few international rating agencies. Any paper or bond issued by IIB, based on that rating grade, will enjoy a relatively low rate of interest in the range of 3% to 3.25% per annum. Given current market conditions, any other commercial paper or bond issued by another corporation, even for the same identified projects, will only be granted an A grade, which will attract at least 5% interest per annum. The board of the directors of IIB decides to issue Sukuk to attract Islamic investment funds from member countries to invest in a few identified projects involving a new highway construction of 800km connecting all member countries, as well as an alternative power plant to supply power to all member countries in a more cost-effective manner. However, IIB decides not to utilise the existing fixed assets that it has to facilitate the issuance of Sukuk Ijarah, as IIB seeks to avoid negative carry to its assets. IIB also seeks to have a good rating grade for this Sukuk not less than an AA grade, if not an AAA grade. In other words, IIB is not willing to raise funds from capital market investors to which they would have to pay a higher profit rate as IIB was enjoying a good investible grade, thus lowering the cost of borrowing. The outlines of the Sukuk features have been prescribed by IIB and include the following terms. Sukuk proceeds are to be invested in the above two identified projects as well as the general business of IIB. The Sukuk tenor will only be for five years as the investors may not prefer a long-term investment. The Sukuk issuance must be globally accepted and approved to appeal to a wide group of investors, particularly IFIs and investment houses. The rating grade of the Sukuk must not be less than AA. The Sukuk may have the option of convertibility to shares of a subsidiary of the issuer, which is a telecommunication company providing services throughout the member countries. IIB is willing to provide a guarantee for capital redemption, if relevant and applicable. IIB will not be the issuer. The issuer of the Sukuk will be a project finance company that is a subsidiary of IIB.

1. Sukuk Ijarah has not been subjected to a review by the AAOIFI Shariah board although it has a purchase undertaking by the issuer to purchase the asset underlying Sukuk at a price equivalent to the par value of the outstanding Sukuk. Which of the following has rendered this purchase undertaking by the obligor irrelevant from the Shariah perspective? (A) (B) (C) (D) 2. The purchase undertaking is by the originator and not the issuer The purchase undertaking is on the obligation to purchase a leased asset The purchase undertaking in Sukuk Ijarah is based on an agreed price The purchase undertaking relates to equity redemption
The guarantee for capital redemption in equity-based Sukuk is only permissible in the case of: (A) (B) (C) (D) default by the issuer in paying all the expected periodical profits the downgrading of the Sukuk rating to a lower rating grade negligence and misconduct of the issuer liquidation of the issuer
3.
Based on the case study scenario, which of the following Sukuk may not be relevant for IIB to consider? (A) (B) (C) (D) Sukuk Ijarah Sukuk Istithmar Sukuk Musharakah Sukuk Mudarabah
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4.
What are the requirements to make convertibility of Sukuk to shares of a given company compliant? (A) (B) (C) (D) The rating of both Sukuk and shares must be equal, and there must be approval from ordinary shareholders The certainty of the conversion formula and compliance status of the company shares The redemption of Sukuk by the issuer prior to conversion of Sukuk into shares The conversion is only possible in the case of profitability of the issuing company
5.
Which of the following does the term hybrid Sukuk refer to? (A) (B) (C) (D) A Sukuk that combines both tangible and intangible assets as the underlying asset A Sukuk that combines both financial and fixed assets A Sukuk that combines both assets under construction and assets already completed A Sukuk that combines both debt financing and equity financing

1. 2. What are the possible structures of Sukuk that IIB may consider issuing? Which is your preferred structure and what is the basis of your preference? Being the subsidiary to a multi-national bank, the issuer as the project company may not attain the rating grade of AAA. What measures can be proposed to achieve the highest possible investable rating grade? Assuming that the project financing of the two projects in the case study needs at least 10 years to generate sufficient cash flows to redeem capital and pay off all expected profits, is the proposal to make a five-year Sukuk viable from an investors perspective? Can Islamic-backed securities be structured to apply to the above case study scenario and what is the justification for your opinion? Applying what you have learned in chapter six on Islamic project financing, what would you suggest to make the above Sukuk more viable and appealing to investors?
3.
4. 5.
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Chapter nine answers

Exercise 9.1
(B). The undertaking of the issuer to purchase the outstanding Sukuk, in the case of a default by the issuer at par value, leads to a capital guarantee in the contracts of equity that is not compliant with Shariah principles. This term in the contract will make equity-based Sukuk non-compliant as there is an implicit guarantee in relation to the capital in all circumstances. The other terms and practices are compliant and acceptable to Shariah principles.
Exercise 9.2
Even if receivables originate from Islamic-approved contracts, they are deemed by many scholars to be money or monetary assets. Therefore, the sale of receivables for money can only be at face value to avoid interest by excess (Riba al-fadl) because of an inequality of the counter values. However, if money or monetary assets were to be exchanged for a commodity, this strict requirement is no longer relevant as the amount of money or monetary asset in the form of a receivable does not need to match the actual amount or value of the commodity. A commodity, as a matter of principle, may be sold at either X or Y price as per the willing buyer, willing seller concept. Thus, the proposal to sell Islamic receivables arising from Islamic contracts in exchange for a certain commodity is permissible, although it technically leads to the discounting effect of receivables disposed before their maturity date.
Exercise 9.3
IFIs in Malaysia that subscribe to the Shariah Standards as prescribed by the AAOIFI, may participate in this Sukuk as the primary investors in the primary market instead of the secondary market, either as the seller or the purchaser. Other IFIs that do not necessarily subscribe to AAOIFI Shariah Standards may, however, participate in both the primary and secondary markets. Malaysian IFIs may participate in this Sukuk if the product is seen as an investment product and not a liquidity product, which could only be sold on the secondary market at face value. The sale of this Sukuk at face value may not be attractive to secondary market investors. In this context, the sale of this Sukuk for a commodity on an over-the-counter basis may be possible if this is allowed under the laws of Malaysia. The best suited instrument for liquidity purposes is the Sukuk that is either asset-based such as the Ijarah contract or equity-based such as Mudarabah and Musharakah. These Sukuk may be traded freely in the secondary market, thus achieving the purpose of liquidity management. The Sukuk holder may sell down his portfolio as and when he needs the liquidity to meet his current liabilities.
Exercise 9.4
The sale-and-buy-back arrangement in an Istisna contract has been deemed to be a form of Inah contract, which is not approved under AAOIFI Shariah Standard No. 11. It is different from a Parallel Istisna arrangement as there must be three independent parties involved in a Parallel Istisna and the two Istisna contracts must be independent from each other. The ultimate purchaser in a Parallel Istisna is neither the financier nor the ultimate contractor. If the ultimate contractor failed to deliver the asset to the financier (as the purchaser of Istisna), the financier (as the seller) shall not be exempted from the liability to deliver the required asset to the ultimate purchaser. While sale and buy back of Istisna is not approved, the Parallel Istisna is approved by AAOIFI Shariah Standard (No 7). The Sukuk Istisna is not accepted by the AAOIFI Shariah Standard on two accounts. The first is that the underlying contract of sale and buy back is an Inah arrangement; the second is the nature of securitisation, which is purely debt-based. The Sukuk issued by the issuer/obligor simply represents the obligation of the issuer to pay a certain amount of money created by the second leg of the Istisna contract. Although the mere issuance of this Sukuk is acceptable, the tradability of this Sukuk at the secondary market, based on market value, is not acceptable to avoid the sale of monetary debt for cash. The sale of pure debt or receivables, except at face value, is not approved by AAOIFI Shariah Standards. Alternatives to raising required funding using Sukuk without creating Sukuk Istisna are available through Sukuk Musharakah, Sukuk Mudarabah or Sukuk Istithmar respectively, all of which are project-based Sukuk and use equity-based contracts. Unlike Sukuk Istisna, investors in this alternative Sukuk structure must take on the risk of the project under construction instead of the credit risk of the issuer/obligor. The rating of this Sukuk will be primarily based on the viability of the project and its inherent risks. These alternative Sukuk have transformed from simple IOUs
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to certificates of equity investment whereby the Sukuk holders will only benefit from the profit generated by these projects and, therefore, must bear the losses of the project.
Exercise 9.5
Sukuk Istisna is a debt-based Sukuk that is based on receivables arising from the Istisna sale that the issuer (buyer) owes the investors (seller). The Sukuk principally involves two parties and the security for the issuance lies in the project assets that are to be developed. As it is a debt-based Sukuk, it is non-tradable and its pricing mechanism is based on a fixed principal and fixed coupons. Sukuk Istisna is, however, not globally acceptable. On the other hand, Sukuk Ijarah is a globally accepted asset-based Sukuk. To structure this Sukuk requires an asset to be sold to the investors for the investors to subsequently lease the asset back to the owner/originator. Like the above Sukuk, it involves two principal parties and the security of the Sukuk is based on a put option or purchase undertaking placed on the leased assets placed by the originator/lessee. The Sukuk can either be based on a fixed or floating lease/rental pricing mechanism. Sukuk Ijarah is tradable under international Shariah standards.
Exercise 9.6
Rating methodologies are limited towards analysing whether the Sukuk issuers are able to meet their payment obligation towards their investors, based on the legal environment where the issuance has taken place. Rating agencies are unable to conduct Shariah ratings because they do not have the expertise to carry out the exercise as well as to establish the Shariah rating methodologies. The expertise housed within rating agencies is usually limited to legal, tax and financial expertise.
Exercise 9.7
The main similarity between ratings of project-based and asset-backed Sukuk lies in the fact that the focus of the ratings on both types of Sukuk will be the cash flow generated from the underlying asset. The credit standing of the issuers in both Sukuk should have a minimal impact on their ratings. However, for the asset-backed Sukuk, the underlying asset must be in a condition to generate those returns with immediate effect, whereas in a project-based Sukuk the assets that are to generate those returns have yet to be built or constructed before the Sukuk is launched.

1. (B) The purchase undertaking in Sukuk Ijarah does not lead to a capital guarantee. The purchase undertaking relates exclusively to the undertaking by the originator/lessee to purchase the leased asset at a price that could be equivalent to the Sukuk outstanding amount. 2. (C) Equity-based contracts would object to any capital guarantee by the managing partner in all circumstances except in the case of negligence and misconduct, as well as a breach of the terms and conditions. 3. (A) Sukuk Ijarah is obviously not relevant as IIB has excluded the possibility of using the existing assets of IIB to avoid the negative carry and avoid restriction on the usage or disposal of those assets in future. 4. (B) Conversion of Sukuk to shares requires a certainty of the conversion formula and the fact that the shares of the company are compliant to Shariah principles. 5. (B) Hybrid Sukuk refers to an underlying asset of Sukuk that combines both financial assets, such as Islamic account receivables, and fixed assets, such as land, building and equipment.

1. Given the nature of IIB and the pre-set mandate for the issuance of Sukuk, the subsidiary of IIB may issue Sukuk Musharakah, Sukuk Mudarabah or Sukuk Istithmar as they are all applicable for project financing. Sukuk Ijarah will be disregarded as IIB seeks to avoid the negative carry. Relatively speaking, Sukuk Musharakah will be more preferable as both the issuer, that is the subsidiary of IIB, and the investors will contribute capital to the venture. This gives more comfort to Sukuk investors as the issuer is also contributing capital, as compared to Sukuk Mudarabah and Sukuk Istithmar. From the issuers perspective, capital contribution can be in the form of cash or kind (such as in the case of Sukuk Musharakah for Emirates Airlines).
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2.
The rating will be based on the performance of the underlying asset, which is a new power plant and highway. The rating methodology will be based on project-financing methodology. Among the measures to improve the rating of the Sukuk is an off-take agreement, a guarantee by IIB on the performance of the issuer of all expected works whereas the loss caused by the negligence or misconduct of the issuer/subsidiary will be borne by IIB, and all the risk management techniques in project-financing (as discussed in chapter six). If the full realisation of cash flow will only take place in Year 10 of the project, the issuer may issue a new Sukuk Musharakah to redeem the existing Sukuk Musharakah after five years. Alternatively, the Sukuk Musharakah can be structured on the basis of quasi-equity (as discussed in chapter six). Since the assets are still under construction, the application of asset-backed securities may not be relevant. Normally, asset-backed securities will apply to an asset that is in the position to generate steady income stream for the investors. However, upon the completion of the project financed by Sukuk Musharakah, which is project-based Sukuk, the Islamic asset-backed securities may be issued to redeem this Sukuk and allow the new investors to benefit from this assets cash flows. Among the proposed suggestions are the following: a) The off-take agreement b) The Sukuk investors are also the equity owners of the project company c) To convert Sukuk Musharakah to Sukuk Ijarah, if it is relevant and applicable to have a fixed-income Sukuk instead of variable income based on the performance of the asset d) Quasi-equity of Sukuk Musharakah
3.
4.
5.
Notes:
1 From a chronological point of view, the chairman of the Shariah Board of AAOIFI issued a personal comment on the practice of purchase undertaking of Sukuk towards the end of 2007, which was the first of the negative signals appearing in relation to Sukuk issuance. However, Sukuk issuance remained high to the end of 2007. Sukuk were still issued based on purchase undertaking until the official pronouncement in February 2008. 2 See Moodys Structured Finance Updates: Global Sukuk Issuance: 2008 Slowdown Mainly Due to Credit Crisis But Some Impact from Shariah Compliance Issues www.moodys.com There is now an International Islamic Rating Agency based in Bahrain that cites Shariah risk. However, the agency is not issuing ratings for Shariah compliance. It currently only issues ratings for Shariah compliance procedures based on requests from Islamic financial institutions. To date, it has not issued ratings for any product. The global acceptance by investment communities and their regulators of any product rating, which may come out of this agency in future if it decides to embark on rating product such as Sukuk from a Shariah perspective, will only be tested as and when such an event takes place.
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Chapter ten
Takaful models and issues of legal and rating requirements
Learning outcomes
By the end of this chapter you should be able to: evaluate the various underlying contracts of Takaful analyse the impact of various Takaful management models on its participants and the Takaful operator analyse the impact of a Takaful fund deficit and underwriting surplus on the performance of Takaful funds explain relevant legal and rating requirements suggest appropriate Takaful policies and strategies for the sustainable growth of Takaful institutions and the Takaful industry.

Comparative underlying contracts of Takaful Takaful management models and its impact on participants and shareholders The treatment of a Takaful fund deficit or surplus Legal and rating requirement issues Strategies to enhance the Takaful industry vis--vis the conventional insurance industry Case study: Legal ownership of the Takaful fund and the distribution of an underwriting surplus
10.0 Introduction
The protection and preservation of life and property, as well as religion, intellect and family, are among the fundamental goals of Shariah to ensure a peaceful and harmonious society. In the light of uncertainty, such as death or the loss or destruction of property, there is a need for the financial consequence of peril or hazard to be mitigated. Generally the approach to dealing with risk is either to transfer it or pool it among respective members or participants. Conventional insurance became popular because risk was eliminated through the transfer of its financial consequence to a third party that guaranteed indemnity. Various insurance schemes that cater to a wide spectrum of insurable risks have since been introduced to absorb the risk of the participant for a price known as a premium. The fact that modern insurance transfers risk from the insured to the insurer for a financial consideration known as a premium implies a wager on the uncertain event that has yet to occur or may not occur. This fundamentally breaches the nature of an approved contract in Islamic law where the subject matter shall be certain and not tantamount to a game of chance (Maisir) or a lack of knowledge that could be detrimental to one of the parties (Gharar). The concept of Takaful, or the mutual obligation to contribute as well as provide financial assistance to a member of the fund who may be financially affected by a future event, was adopted as a suitable alternative to conventional insurance. This chapter outlines the key differences between Takaful and conventional insurance, looking at its purpose, structure and perceived benefits. It introduces various Takaful models that distinguish the different roles played by Takaful operators, as well as their level of engagement in managing Takaful funds. It explains the treatment of deficits or underwriting surpluses that can occur in a Takaful fund and analyses the impact this may have on the performance of the fund. The chapter outlines relevant legal and rating issues to allow you to understand the regulatory framework for the Takaful industry. Finally, the chapter considers the ways and means by which further support can be given to promote the growth of this nascent industry.
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10.1 The need for Takaful operations

As stated in the introduction, the importance of the protection and the preservation of life and property, as well as religion, intellect and family, are among the fundamental goals of Shariah to ensure a peaceful and harmonious society. Conventional insurance transfers the financial consequence of risk to a third party which guarantees indemnity for such risk. The fact that modern insurance transfers the risk from the insured to the insurer for a financial consideration, known as a premium, implies a wager on the uncertain event that has yet to occur or may not occur. This fundamentally breaches the nature of an approved contract in Islamic law. However, if the subject matter is uncertain by nature, such as risk in the insurance industry, an appropriate contract can be identified and selected to suit that subject matter while remaining compliant with Shariah principles.
Key point
The modern insurance structure amounts to the imposition of a wager on an uncertain event. This raises the issue of Gharar, which is prohibited under Shariah law. The table below, adapted from Takaful Islamic Insurance: Concepts and Regulatory Issues, 1 shows a comparison between conventional insurance and Takaful.
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Table 10.1 Comparison between conventional insurance and Takaful

Conventional insurance (proprietary) Contractual relationship
A policy in the form of an exchange contract (sale and purchase) between the insured (policyholder) and the insurance company Policyholders pay a premium to the insurer
Conventional insurance (mutual)
Takaful
A policy in the form of a risk-sharing contract between the individual insured and the pool of insured as represented by the cooperative insurance company
A combination of Tabarru contract (donation) and contractual relationship between (a) the individual participants and the pool of participants, and (b) participants and the Takaful operator (TO)
Responsibility of policyholders/ participants
Policyholders pay contributions to the pool in the form of premiums paid to the cooperative insurance company; any underwriting surplus belongs to the policyholders, who are also liable for any deficit; annual surpluses are normally retained in underwriting reserves out of which any annual deficits are normally met Pool is liable to pay claims according to the policy using the underwriting fund
Participants make donations (Tabarru) to the scheme, as well as an element of savings in life Takaful where a plan includes such a component; any underwriting surplus belongs to the policyholders who may (based on various Shariah interpretations) share the surplus with the TO as an incentive or performance fee; although the participants under the concept of mutual indemnity may be required to contribute more contributions in the case of the deficit of the Takaful fund, the TO may undertake to provide an interest-free loan to pay outstanding claims
Liability of the insurer/ operator
Insurer is liable to pay claims according to the policy using the underwriting fund and, if necessary, shareholders funds Access to share capital and debt with possible use of subordinated debt There are no restrictions apart from those imposed for prudential reasons
The TO acts as the administrator of the scheme and pays the Takaful benefits from the Takaful (underwriting) fund; in the event of the impending insolvency of a Takaful underwriting fund, the TO may be expected to provide an interest-free loan to the Takaful fund to enable it to meet its obligations Access to share capital by the TO but not to debt, except for any interestfree loans from the operator to the underwriting fund
Access to capital
No access to share capital, but access to debt with possible use of subordinated debt
Investment of fund
There are no restrictions apart from those imposed for prudential reasons
Assets of the Takaful funds are invested in Shari ah-compliant instruments
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10.1.1 Mutuality in Takaful

Islam promotes the spirit of mutual goodwill and assistance among mankind, both in normal as well as adverse conditions. Since life is plagued with uncertainty, the importance of mutual cooperation towards the common good of mankind is always encouraged if not enjoined. Uncertainty poses economic and financial consequences and challenges. With the anticipation of potential challenges in the form of peril or hazard, the need for mutual financial assistance is recognised in Islam as one of the approved forms of risk distribution; hence the concept of Takaful or the mutual obligation to contribute as well as provide financial assistance as a result of the financial consequence of peril potentially affecting a member of the group who has contributed to that common fund. Takaful is a Shariah-compliant system of insurance based on the principle of mutual support. Takaful participants mutually contribute compensation to the aggrieved party contingent upon the occurrence of a defined peril. These are designated contingencies, risks or hazards against which participants seek to protect themselves when subscribing to a Takaful policy. The various types of peril for which Takaful provides indemnity include the financial wealth of the family, loss of income and medical costs due to illness or death, loss in value of property due to fire or theft, as well as other potential losses due to a recognisable and financially quantifiable event.
10.1.2 General (or non-life) Takaful

General or non-life Takaful includes home Takaful, motor Takaful and personal accident Takaful. 10.1.2.1 Home Takaful Home Takaful comprises house owner and householder policies. A house owner Takaful policy covers the policyholders home against loss or damage caused by floods, fires and other such perils. It not only protects the policyholders house, but also the garage, outbuildings, walls, gates and fences around the property as well as permanent fixtures and fittings. A householder Takaful policy covers the loss or damage to the contents of the policyholders residential property. A policyholder may participate in a house owner Takaful or a householder Takaful, or both for complete coverage. 10.1.2.2 Motor Takaful Motor Takaful covers against loss or damage to the policyholders vehicle due to accidental fire, theft or accident. It also covers bodily injury or death of a third party as well as loss or damage of a third partys property. There are two types of cover for a motor Takaful plan: Third party cover protects against a third partys death, bodily injury and/or property damage. Comprehensive cover protects against a third partys death, injury and/or property damage as well as loss and/or damage to the policyholders vehicle due to accidental fire, theft or an accident. 10.1.2.3 Personal accident Takaful Personal accident (PA) Takaful is an annual plan that provides policyholders or their beneficiaries with compensation in the event of death, disablement or injuries arising from an accident. A policyholder can either participate in a PA Takaful for him/herself or a group plan for his/her family. PA Takaful is also available for short durations, for example when travelling abroad, to cover the policyholder should any accident occur during the travel period. 10.1.2.4 Medical Takaful Medical and health Takaful gives the policyholder cover for the cost of private medical treatment, like hospitalisation, surgery and treatment, if the policyholder is diagnosed with certain illnesses or is involved in an accident. The cover acts as a stand-alone policy or can be added to a basic family Takaful plan, providing better coverage and benefits from both policies. Health Takaful is a rapidly growing sector as it is increasingly being made compulsory in Gulf Cooperation Council (GCC) countries.
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10.1.2.5 Family (or Life) Takaful Family Takaful provides the policyholder with a protection policy and long-term savings. The policyholder or beneficiary is provided with financial benefits in case of a tragedy. At the same time, the policyholder enjoys an investment return because part of his/her contribution is deposited in an account for the purpose of savings. The policyholder has a choice of maturity periods and there is no forfeiture in the event of cancellation. The policyholder is also entitled to personal tax relief when participating in family Takaful, where relevant and applicable. 10.1.2.6 Investment linked Takaful An investment-linked Takaful is a family Takaful plan that combines investment and Takaful cover. The policyholders contribution gives him/her Takaful cover, which includes death and disability benefits, and also an investment in a variety of Shariah-approved investment funds of his/her choice. Family Takaful penetration, at present, lags far behind general and health Takaful, as Muslims tend to have greater inhibitions when it comes to life insurance. However, with the development of innovative family Takaful products and the increasing education of Muslims as to why family Takaful is Shariah-compliant, it is reasonable to assume that family Takaful will grow substantially.
Exercise 10.1
Compare and contrast Takaful and Kafalah contracts in terms of parties to the contract, rights and obligations, payment and special requirements from a Shariah perspective (refer to CDIF/1/6/117 and CDIF/1/7/128 to refresh your understanding of a Kafalah contract).
10.1.3 Takaful regulation

As there is no supra-national regulatory body, the regulation for the Takaful industry is quite fragmented, posing a risk due to a lack of consistency across the regions. This is part of the issue the Takaful industry is facing (see section 10.7.1). The Shariah compliance of a product is in most cases vetted by the Shariah board of the provider. Despite this, Takaful operators are starting to emerge in secular countries. The UK, for example, has one company operating as a fully-fledged Takaful provider: Principal Insurance, under the brand name Salam Halal. It offers general Takaful policies and has been in operation since 2008. It is possible for international institutions in EC jurisdictions to establish what is called an Islamic window of Takaful. The main distributors in the UK include HSBC, RBS, Standard Chartered and Lloyds TSB. In the UK for example, there are no regulatory restrictions to a conventional insurer operating a Takaful window, as long as the window, like the remainder of the business, operates in accordance with UK financial services laws contained in the Financial Services and Markets Act 2000 and secondary legislation. The window will also need to meet governance standards and rules in the FSA Handbook as well as operate in accordance with company law. Ensuring the Shariah compliance of the Takaful window is the remit of a Shariah board which will need to be put in place. The Shariah board will examine the products offered through the Takaful window as well as the other aspects of the Takaful operation (for example, ensuring that donations are segregated from conventional premiums and ensuring that, on the investment side, the donations are invested in Shariah compliant investments). In the GCC and Asia also, international institutions have established Takaful operations, tapping into the rich potential of the industry, among them Allianz, Aviva, Fortis, Zurich and Axa.
10.1.4 Social or business model?

The motivation towards the protection of life and property in the form of the preservation of financial wealth in Islamic tradition has been made possible through contracts such as gift, donation, Sadaqah, Zakat and loan. These are essentially social contracts that have promoted mutual as well as social benefits since the early days of Islam. Equally, the establishments of cooperatives that promote the common interest and welfare of members has been the foundation of mutual aid and financial assistance throughout the history of Islam. Although this cooperative model has been effective in the past, the model is faced with challenges when applied to a much broader range and a larger scale of contingent events such as occur in the modern world.
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The validity and relevancy of the Tabarru contract in the form of a donation poses the question of whether, in its simplest form, it is an effective instrument in making the Takaful practice commercially and legally feasible in the contemporary world. The question arises as to whether the industry of Takaful can be based on a contract that is social in nature and whether, in practical terms, the donation by the participants could be a real and outright act of giving away ones money to help the other participants in the same group. AAOIFI Shariah Standard (No 26) defines Takaful as:
An agreement between persons who are exposed to risk to protect themselves against harms arising from those risks by making contributions on the basis of a commitment to donate. Thereafter, the insurance fund is established and treated as a separate legal entity which has an independent financial liability. The fund will cover compensation against harms that befall any of the participants due to the occurrence of the insured risks (perils) in accordance with the terms of the policy.
Exercise 10.2
Briefly identify the key words or terms used in the AAOIFI definition of Takaful above and explain them from both the Shariah and modern finance perspectives. The approach by the AAOIFI in looking at the definition of Takaful has changed the social contract of donation to a more legalistic and structured concept in that there is a commitment by the prospective participant to donate. With this more structured and legalistic form of contract of donation, it has been argued that there is no harm for any member in the society to donate to the pool with the intention of benefiting from this pool if they were to be inflicted with a prescribed risk. This is commonly known in Islamic commercial law discourse as a conditional gift or donation. The Shariah and practical issues arising from this concept will be discussed in the next section.
Key point
Takaful in its modern form involves a commitment by participants to donate to a fund that is a separate legal entity in order for this fund to compensate the participants in the case of loss, thus achieving mutual indemnity.
10.2 The underlying principles of a Takaful contract

Juristic discourses on the status of Tabarru in the context of donation in Takaful have expanded the application of the principle of Tabarru. A number of juristic texts available in Islamic jurisprudence have indicated that a gift with a condition of consideration is compliant with Shariah principles. In other words, there is no harm in someone donating something with a view to benefiting from his donation in the future. The benefit that he expects to receive may depend on a few contingent events; therefore it becomes a conditional donation. Although a gift with an expectation of future consideration is lawful, classical scholars have different views in ascertaining the character of this action. While some scholars view it as a sale, others regard it as a gift. The following is a quote from a leading juristic text contained in a comparative juristic book of Islamic law: As for the gift for a consideration, the scholars have different views. While both Imam Malik and Abu Hanifah have approved, Imam Shafii, Abu Dawud and Abu Thur have not approved such a transaction. The reason for the disagreement is whether it (a gift for a consideration) is a sale for non-specified price or is it not a sale with an uncertain price? Those who perceive it as a sale for an uncertain price argue that this is a sale with uncertainty (Gharar), which should be prohibited. Those who do not perceive it as a sale for an uncertain price hold this transaction as permissible. It appears that Imam Malik recognised the similarity between the societal customary practice at that point in time and the condition in the case of gift for a consideration, i.e. permissibility of gift for similar consideration.
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The above citation, particularly from the point of view of the Maliki school of law, implies that a gift, even for a consideration, does not render the gift contract a sale contract. The substance of a gift contract remains and all the relevant principles of a gift are to be applied, in particular so that no consideration is required in a gift contract. Subsequently, should there be any form of consideration proposed in return by the recipient of the original gift, this consideration could be uncertain or could be of a different value to the original gift without rendering the contract void. Applying this basic argument to Takaful means that a participant may donate a total sum of US$100,000, but he may only receive compensation upon the occurrence of certain prescribed peril of an amount of US$1 million or some other amount. There is no need to ascertain how much he will benefit from the scheme, although he has already donated US$100,000 as this is essentially a gift contract.
10.2.1 The commitment to donate concept outright donation or contingent donation?

There are at least four approaches to formulating the Takaful contract that provides mutual indemnity among the participants. As previously stated, AAOIFI recognises that Takaful is based on the undertaking or commitment by participants to donate to a Takaful fund. However, AAOIFI did not discuss the contractual implications of this act. One may argue that this donation is an outright donation that is now vested with the Takaful fund. Put simply, after the participants have paid their contribution or donation to the Takaful fund, the ownership of this donation is transferred from that moment to the Takaful fund, which is a separate legal entity. The participants or their beneficiaries have no claim on this donation subsequent to that donation action. However, the Takaful fund, which is a separate legal entity, may prescribe in the donation fund deeds or its terms and conditions that the fund may give away part or all of the donation fund to anyone who deserves the indemnity, including the participants who have donated to the fund initially, and this may also include the underwriting surplus. Others may argue that, although it is a donation, ownership of the donation is still vested with the participants/donors until and unless there is a claim. Thus, the transfer of ownership of this donation is contingent upon the claim. Put simply, if there is no claim or if the claim is less than the committed amount of donation, the ownership of the amount committed for the donation will still be vested with the participants. Consequently, any underwriting surplus will have to revert to the participants if their donations are not used, as the claims are less than the committed amount of the donation. The first approach involves an outright donation contract, the second approach is a placement followed by a donation. However, both are essentially based on a conditional donation.
10.2.2 Conditional gift concept

Another approach is based on the Maliki school of law that a gift can be conditional on the intention of getting the reward from the recipient. This is known as Hadiah al-thawab where one gives a donation in the hope that the recipient will reward him in the future as and when he needs it. This has been the norm in society when one gives gifts and financial assistance, either in cash or in kind, to a relative or friend during certain social occasions such as a marriage, death or calamity. Under this social scheme, which is not contractually binding, if the donor was to experience, for example, the marriage of his children or the death of his close relative, the original recipients will reciprocally provide gifts and assistance to reward what the donor has done earlier. The Maliki school of law argues that this practice is similar to a sale contract, except that the uncertainty of the object of sale is tolerable. The distinction between this concept and the conditional donation lies in the fact that the conditional gift concept perceives the whole scheme as a sale contract, but the requirement to have the consideration to be certain is waived. Applying this concept to a modern Takaful scheme means that each and every participant would, for example, provide donations to the Takaful fund, such as US$1,000 each, to help a participant whose house has caught fire. The recipient of this gift will also provide a gift for this fund to reward those who have contributed to the restoration of his house.
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Waqf - permanent endowment
10.2.3 Takaful based on a Waqf structure

Another approach is where a separate Waqf fund is created using a Takaful operators shareholders fund. For example, the Takaful operator using its shareholders fund will create this Waqf fund at 5,000 (a nominal amount) to legally establish the Waqf fund for the benefit of the participants of the Takaful. The proponents of this approach have strongly argued against the conditional donation or conditional gift as elaborated above. The conditional donation or gift is viewed as unacceptable because of the conditionality element. The donation or gift, from a Shariah perspective, must be exclusive and outright without any conditionality. Following the Waqf fund approach, participants will donate their contribution to a fund placed under Waqf administration as a separate legal entity. Ultimately, the donation by the participants will be deemed as part of the Waqf fund or as Waqf assets. Also, the Waqf fund, as a separate legal entity, may decide how to use this fund either for the benefit of the participants or non-participants, thus there is no conditionality in the donation or gift contributed by the participants. If the Waqf fund decides to pay the claim from this fund, then it is a decision of this Waqf entity that has no relationship with the participants who had donated earlier. Applying this concept to the modern Takaful scheme means that the Takaful operator must create a Waqf fund by contributing a nominal amount of money. All the contributions by the participants on the basis of donation, for example a total of 1 billion, will be given to this Waqf fund, thus converting the whole fund into a Waqf fund that will have no legal relationship with the participants/ donors. In the case of a claim, the payments will be made from this Waqf fund, using all the proceeds from the donation contribution up to 1 billion. As part of Waqf principles, the initial Waqf contribution by the Takaful operator, that is 5,000, will not be used to pay the claims. Any deficit will be covered through an interest-free loan to be advanced by the Takaful operator.
Exercise 10.3
From your assessment of the Waqf fund model for the modern Takaful scheme, would the structure be sufficient to neutralise the arguments against conditionality of the donation or gift as practised in other Takaful contracts using a conditional donation or gift?
Key point
From a contractual point of view, the contract among the participants in a Takaful scheme can be based on conditional donation, be it outright or contingent, or conditional gift or donation ultimately placed under a Waqf fund.
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A pure risk transfer is neither recognised nor permissible in Islam because of features that are not Shariah-compliant. The application of the Tabarru principle is meant to address this anomaly. What are the risk implications of not transferring but pooling risk in the case of a Takaful scheme?
Solution
Any form of financial exchange of pure risk is uncertain and considered Gharar, and hence prohibited. A risk transfer is based on a financial exchange contract between pure risk and insurance premium. Effectively the insurer is liable to compensate claims from the premium earned as revenue as well as from a shareholders fund. In the case of a Takaful contribution, the risk is pooled among participants through a donation and the Takaful operator as the managing agent earns a Wakalah fee for services rendered. In the event of an underwriting surplus, the insurance company will benefit exclusively from such a consequence and alternatively, in the case of a deficit, it will bear all the losses. A Takaful underwriting surplus, on the other hand, will be owned collectively by the participants. However, if a deficit arises, the participants may need to top up their contributions and the Takaful operator is under no obligation to provide an interest-free loan (Qard). However, it would be impractical for the Takaful operator to demand this extra contribution. More often than not, Takaful operators have to provide this interest-free loan to pay for any outstanding claims. This is the only anomaly in the risk distribution model in Takaful. This requires the Takaful company to explore a mechanism to determine the contribution by the policyholders and to adequately manage the risk fund in the interest of the policyholders, particularly in the case of total claims exceeding the risk fund.
10.3 Impact of Wakalah vis--vis Mudarabah models

The features of both Mudarabah and Wakalah-based Takaful management were explained in detail in CDIF/2/8/152. The models used may have an impact on the surplus distribution to the participants as well as the return on equity to the shareholders of the Takaful company.
10.3.1 Mudarabah model of Takaful management

The Mudarabah model, as the name suggests, is a profit-sharing model whereby Takaful participants provide the capital in terms of contributions and the Takaful operator provides management. The contract should specify how the profit generated is to be shared, as some practices may include the sharing of underwriting surplus between the participants and the operator. Generally, such sharing arrangements may allow the operator to share in the underwriting surpluses resulting from the operations, as well as any favourable investment performance on the invested contributions. From a practice point of view, Mudarabah works on the following basis: the Takaful operator (shareholders) incurs all the expenses of running the business and in return is entitled to a share of the underwriting excess and investment profit. As a business model, this is a difficult model to manage, as expenses are fixed or known, but income (including surplus and investment profit) is not and can be volatile. However, from a participants perspective, this is a good model as the participant does not contribute directly to the operators costs. All contributions are effectively available to meet claims. Only when there is an excess of contributions over claims will the operator be compensated for expenses incurred, and even then only to the extent of shares of the surplus as a kind of profit sharing with the Takaful participants. To date, there has been a convergence in the application of the Mudarabah model of Takaful management. The Mudarabah profit-sharing arrangements are now more limited to the sharing of investment profits generated by invested contributions as well as investment returns arising from the invested underwriting surpluses.
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10.3.2 Wakalah model of Takaful management

The Wakalah model operates somewhat differently. Takaful participants pay contributions to the Takaful fund. Out of this gross contribution the Takaful operator will deduct a certain percentage as the Wakalah management fee. The Takaful operator will share neither in the risk of the Takaful fund investment nor in the profit of the funds investment return. It should be noted that the Takaful operators remuneration may, depending on the terms of the contract, include a performance or incentive fee, charged against any surplus, as an incentive to manage the Takaful fund effectively. From a practice point of view, the Wakalah model is easy to explain and manage. Generally the Takaful operator runs the Takaful operation and charges a fee. In other words, under this management model, the Takaful operator can only make a profit by ensuring that the expense of managing the operations is less than the fee, inclusive of an incentive fee where relevant. Under the Wakalah management model, the Takaful operator may also seek to share in the underwriting surplus under the purview of the incentive fee as described above. This will put them in a better position than a Mudarabah-based model as the Takaful operator under the Wakalah-based model may have a fixed fee paid upfront and a floating income based on the quantity of the underwriting surplus. The question of the sharing of the surplus will be discussed in the next section of this chapter.
The following is a hypothetical scenario of the three possible models of managing a Takaful business, namely the Mudarabah model (without sharing in the underwriting surplus), the Wakalah model (without sharing in the underwriting surplus) and the Wakalah model (with a share of the underwriting surplus). In the first model (model A), we will assume that the investments profit-sharing ratio between the participants and the Takaful operator is 50:50. In the Wakalah model (model B), the Wakalah fee is fixed upfront at 50% of the gross contribution, but the Takaful operator gets no share of the surplus. In the third scenario (model C), the Wakalah fee is fixed at 30% and the Takaful operators share in the underwriting and investment surplus is 50:50. Suppose the following are the financials for this hypothetical scenario. Gross contribution : Kuwait Dinar (KD)100 million Investment profit : KD10 million Underwriting surplus : KD20 million Management expenses : KD30 million Applying the above financials to the three scenarios, the following results emerge: Model A Mudarabah income generated from a 50% share in investment profits Takaful operator (KD5 million, which ultimately means the Takaful operator loses KD25 million); participants (KD25 million) Takaful operator (KD50 million as gross income and KD20 million as net profit before tax); participants (KD30 million) Takaful operator (KD45 million gross income and KD15 million as net profit before tax); participants (KD15 million)
Model B
Wakalah fee generated from only 50% gross contribution
Model C
Wakalah fee generated from only 30% gross contribution and 50% share in underwriting surplus and investment profits
Whether model A is better for the participant or the Takaful company than model B will depend on the actual underwriting surplus plus the investment profit. The ultimate results for both the Takaful operator and the participants will change if the financials change. Therefore, whichever model the Takaful company adopts, the calculation of fees or profit sharing is critical in order to appropriately reward the shareholders in terms of return on equity.
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Key point
Each of the Mudarabah and Wakalah models of Takaful management will influence the degree of profitability of the Takaful operator given the various management expenses, claims, investment returns and underwriting surplus.
10.3.3 Determining the Wakalah fee

The following discussion examines the parameters for determining the Wakalah fee for the Takaful operator. The Wakalah fee is usually determined as the sum of: management expense distribution cost, including commission profit to the operator. A key issue to consider is what determines a fair profit to the operator. The standard benchmark of profitability for an enterprise is return on equity (ROE). Given a certain ROE requirement, the greater the capital required to underwrite the business, the higher the profit required for a set volume of business. Thus, if the statutory solvency requirement for Takaful is high, the profit margin to the operator would need to be correspondingly high. The question of ROE is an issue for the Takaful industry, which is licensed and regulated in a similar way to that governing deposit-taking institutions. Takaful companies are regulated much like conventional insurance companies, and as such would be required to put up high amounts of shareholders capital, similar to that required from commercial banks. However, the difference here is that the Takaful companies do not own the Takaful fund; they are simply managers as these funds are owned by the participants. Takaful companies here operate much like investment banks or unit trusts and yet are required to proffer a much larger capital outlay. This would severely affect the ROE due to the Takaful companies as the capital outlay might not accurately represent the type of business they are conducting in the industry.
Exercise 10.4
A new Takaful operator is commencing business operations and has yet to decide whether it should undertake the pure Wakalah model or the hybrid Wakalah-Mudarabah model, which allows it to have a share in the surpluses generated. The pure Wakalah model will earn the operator a fixed 32% of the gross contribution, whereas the hybrid model will pay the operator a fixed 18% fee plus a 30% profit-sharing return based on the surpluses generated. Devise a formula for how the operator would behave given these facts and explain what is the minimum projected surplus required to entice the operator to choose the hybrid model if the gross contribution is US$120 million.
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3 months ended 30 September 2008 AED Attribution to shareholders Shareholders investment and other income 16 751,621 Wakalah fees from policy 15 11,660,818 Murdarib shares from policyholders 15 81,738 General and administrative expenses 17 (5,843,648) Increase in provision of loan to policyholders fund 11 (3,396,369) Net profit/(loss) for the period 3,254,160 976,265 6,438,705 183,603 (4,526,750) (3,349,288) (277,465) 9,917,523 29,668,338 286,243 (17,333,331) (8,728,701) 13,810,072 8,607,277 21,172,743 466,302 (12,502,164) (9,040,345) 8,703,813 2007 AED 9 months ended 30 September 2008 AED 2007 AED
The above is an extract from the financial statements of a Takaful company operating out of the UAE. Using the limited information provided, answer the following questions: a. Under what model is the Takaful company likely to be operating and why? b. In your opinion, were the figures for 2008 good for the Takaful company and its participants? c. Calculate the gross contribution to the Takaful fund, given that for the nine months ended 30 September 2008 the Takaful operator got 22% on the Wakalah service fee. Assuming that the Takaful company got a further 12% on the profit-sharing of surpluses, calculate the combined investment and underwriting surpluses.
Solution
a. It is likely that the Takaful company is operating under the hybrid Wakalah and Mudarabah model. This is because the financial statement shows that the company is earning both Wakalah service fees and Mudarib profit-sharing returns. Most likely, the Wakalah fee is charged on administration of the Takaful operations and the Mudarabah profit sharing is based on the investment income of the Takaful fund. b. In terms of the business generation, 2008 appears to be a good year for the Takaful company. Looking at the longer nine-month financial record, the Wakalah fees jumped some AED8 million over the course of one year. It signals that the company has managed to attract more participants, thereby increasing their service fees. However, it might not be a good year for the participants. Although the number of participants looks to have increased, profit-sharing returns (to the Mudarib) appear to have fallen by some AED180,000. Assuming that the profit-sharing ratios did not change, this means that the Takaful investments did not do as well as in the previous year. This is quite understandable given the global financial crisis in 2008 that affected many investment products, both Islamic and conventional. c. Gross Contribution = AED29,668,338/0.22 = AED134,856,080 Combined surpluses = AED286,243/0.12 = AED2,385,358
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10.4 The management and investment of a Takaful fund

A significant component of the management of Takaful resides in the pricing, collection, claims payment and distribution of surpluses.
10.4.1 Pricing considerations

In general, all direct costs of the Takaful operator to the fund and benefits due to participants must be priced into the Takaful product as fees and incentive fees (arising from sharing in the underwriting surplus). This takes into consideration the basic principles of pricing insurance or Takaful product contributions, which should be adequacy, non-excessiveness and response. The adequacy requirement relates to the ability to cover operating expenses as well as to meet claims for losses by the beneficiaries. A non-excessive contribution requirement refers to the higher-than-risk-adjusted premium or contribution by the participant. Finally, responsiveness relates to the flexibility in determining the contribution or premium after taking into consideration any changes in industry loss-exposure experience as well as changes in the economic environment. For example, if the contribution paid to the Takaful operator after the deduction of expenses is inadequate to cover the risk imputed, based on the mortality rate, this will result in inadequate funds to meet the claims and therefore a deficit. A higher than anticipated contribution would alert the regulator of the inappropriate conduct of the Takaful operator based on the fair price policy. This may be because of opportunistic behaviour or speculative risks not disclosed or provided for accordingly. A lack of flexibility in the pricing mechanism may arise if a delay or adjustment of the contribution does not reflect changes in market expectations, industry requirements and economic conditions. To illustrate this, Bank Negara Malaysia (the Malaysian Central Bank) has very stringent pricing guidelines for Takaful operators in order to improve operational cost efficiency of their Family Takaful business. The guidelines were introduced in 2003 with the objective of encouraging fairer pricing of products and better returns for participants. The Takaful Operators now have more flexibility regarding the distributors commission scales, benefits and expenses of management. This means that the Takaful Operator is better placed to compete with insurance companies by offering Takaful products as an attractive alternative medium of savings to the public.
10.4.2 Takaful costs

Takaful costs generally comprise the cost of marketing, administration and claims. The cost of marketing varies with the type of marketing channels adopted by the Takaful operator. These include advertising, printing of brochures, commission and training costs. Insurance brokers and financial intermediaries are two major types of marketing channels that can be adopted. In the case of an agency sales force, training costs and high commissions are expected to generate high growth and profitable sources of business. On the other hand, in the case of financial intermediaries such as Bancassurance (Takaful-offered or marketed through banks instead of through Takaful branches and agents), lower costs can be anticipated, but with relatively lower-growth prospects. A comparison of the characteristics of the two distribution channels is shown in the table below:
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Table 10.2 Takaful distribution channels

Agency sales force A big selling force must be established to market the Takaful nationwide Time required to build image, subject to reputation and size of distribution channel, such as brokers Selling strategies may vary with culture of the agency force Costly to train and maintain employees/ agents Stand alone Takaful products Financial intermediaries (FI) Existing branches of the FI will act as agents to market Takaful products nationwide More time-efficient as the FIs have a good image and are trustworthy
Established and standardised IFI distribution channels will minimise such variation Low training costs
Takaful products can be packaged with the FIs other financial products Less price sensitive but subject to internal competition between different types of FI financial products Bank privy to customers financial standing
Highly competitive pricing
Prone to misrepresentation in selling of risks
Exercise 10.5
Based on Table 10.2, what would be the best strategy for a newly licensed Takaful company that is a subsidiary of a well-established commercial bank to distribute its Takaful products?
10.4.3 Pricing process

The pricing process involves several parties: the Takaful operators technical committee, the actuary and the Shariah board that validates the business. Actuarial as well as the Shariah aspects are adequately considered. The technical committee is represented by the various functional departments, namely the actuarial/pricing department, the underwriting department, the claims department, the marketing department, the investment department, the IT department and the accounts department. Inputs from the actuary and Shariah board specifically address possible alternative product designs, structures and processes that are financially sound and Shariahcompliant. Such interactions would result in innovative Takaful products.
For example, during a Takaful product development process various issues are considered in pricing the contribution after consulting the actuarial/pricing, underwriting, claims and marketing departments. Since the product is structured as an ancillary to unit-linked investment funds, higher return payouts are expected to the participants. However, upon setting the target investment return over and above the principal amount in lieu of the Takaful coverage, the investment department is alerted to the constraint that there is a limited universe of Shariahapproved stocks available to achieve that investment target. As a result the product needs to be re-balanced between sufficient contributions to meet claims and attractive returns to bring in investor-oriented participants.
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10.4.4 The surplus distribution process

Upon pricing the contribution made by participants for family or general Takaful funds, the contribution is then collected, either in a lump sum or via regular contributions, from the participants and placed into the fund. As described earlier, the funds are held in trust by the Takaful operator on behalf of the participants. Any surplus arising from the difference between contributions and claims, as well as other fees or expenses paid to the operator, is collectively owned by the participants. The surplus distribution process is based on actuarial valuation. Based on the present value of all guaranteed benefits to be paid from the risk fund, any excess would be surplus, which is available for distribution. The actual distribution would either be on an annual basis (yearly drip) or at the maturity of the contract. It may also take into consideration a provision for the contribution to a contingency fund or other claims stabilisation reserves. When the surplus is accumulated until maturity, an asset share study is performed, whereby the overall surplus is allocated to the participants.
10.4.4.1 The pricing model

A key component of the surplus distribution process involves the pricing model. The pricing model considers the following information when determining the gross contribution: type and period of plan gender type, age and habits hazardous to health (in the case of family Takaful) sum assured amount and frequency of contribution payments profit rate on financing investment return net of investment mortality rate expenses incurred by the contributor (entrance fee, acquisition fee, administration fee, Takaful fund fee) expenses incurred by the Takaful operator (marketing, distribution, administration).
10.4.4.2 Mortality rate

An important macro determinant is the mortality rate, which is a measure of the number of deaths (in general, or because of a specific cause) in a population, scaled to the size of that population, per unit time. The mortality rate is typically expressed in units of deaths per 1,000 individuals per year. Thus, a mortality rate of 9.5 in a population of 100,000 would mean 950 deaths per year in that entire population. The factors affecting a given death rate are as follows: age of a countrys population nutrition levels and standards of diet access to clean drinking water hygiene levels levels of infectious diseases social factors, such as conflicts and levels of violent crime amount and quality of healthcare available.
10.4.4.3 Pricing models for Wakalah family Takaful

The following table lists five different models used for pricing Wakalah family Takaful.
Table 10.3 Pricing models for Wakalah family Takaful

Type of charges Percentage of single contribution charge Yearly per policy charge Percent p.a. NAV (Net Asset Value) Percentage of death benefit charge Model 1 20% Model 2 15% Model 3 15% Model 4 15% Model 5 15%
RM 20
RM 15 0.35%
RM 10 0.2% 5% 1.35%
Source: adapted from Dr. Engku Rabiah Adawiah Engku Ali and Scott P. Odierno, Essential Guide to Takaful (Islamic Insurance), CDIF Publication, 2008, page 94.
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Model 1 charges all expenses upfront and tends to be less competitive in terms of fixed quantum compared with other models. With a single charge it requires minimal administrative capabilities to secure subsequent payments. Models 2, 3 and 4 require more actuarial work to estimate a yearly per policy charge. Effectively this provides flexibility to the fixed quantum fee charged upon initiation. Model 3 includes investment effort based on a specified percentage of NAV of investments as a component of the total charges. This requires the operator to be more active on investments to ensure adequate funds to meet claims. Alternatively, a Mudarabah profit-sharing arrangement can be included as an incentive to the Takaful operator as a partner or an investment agent. Finally, Model 5 places more emphasis on investment strategies with a higher percentage rate per annum on NAV.
10.4.4.4 Effect of the chosen model on the Takaful operators cash flow
The impact of the model chosen, for example, on the first five years of the Takaful operators cash flows would be as follows: Assumptions: Single contribution Takaful mortgage plan Sum assured: $100,000
Single contribution: $2,700 Expenses: Year 1 = $160 + 10% of single contribution amount
Renewal = $10 (Please refer to Table 10.2 above for fees due to Takaful operator)
Table 10.4 Takaful operators cash flow from Wakalah family Takaful models
Year 1 1 2 3 4 5 Model 1 RM110 (RM10) (RM10) (RM10) (RM10) Model 2 (RM5) RM10 RM10 RM10 RM10 Model 3 (RM2) RM13 RM13 RM13 RM13 Model 4 (RM5) RM10 RM10 RM10 RM10 Model 5 (RM6) RM21 RM21 RM21 RM21
Source: adapted from Dr. Engku Rabiah Adawiah Engku Ali and Scott P. Odierno, Essential Guide to Takaful (Islamic Insurance), CDIF Publication, 2008, page 95
As an illustration, the operators cash flow for Year 1 under model 1 is: Wakalah fee due = 20% of single contribution amount = $540 The operators cash flow for Year 1 = $540 - $160 (10% of single contribution amount) = $110 The operators cash flow for Year 2 onwards = annual renewal fee = $10
Note:
For models 2 to 5 the NAV is the contribution less the Walakah fees paid out For model 4 the death benefit charge is $120
From the above table it can be seen that model 1, because of its upfront charges, records negative cash flows beyond the first year. Model 4 provides a constant stream of cash while model 5 records more favourable cash flows under its mortality rate assumptions.
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If the mortality rate were to increase then the Takaful operator shareholders would need to top up the risk fund when maturity value is reduced significantly. Changes in investment return will affect the net surplus balance and the high renewal expenses borne by the operator will reduce shareholder profit. This is very obvious in a Takaful scheme, unlike the conventional insurance, as investment returns will form part of the underwriting surplus. Therefore, the higher the investment profit, the higher the surplus would be. However, any significant increase of the Takaful operators management cost and expenses will reduce the degree of profitability of the Takaful operator. In other words, both the investment activities of the Takaful fund and the operating expenses of the Takaful operator must be well managed to generate a better return for the Takaful operator.
Exercise 10.6
Do you think it is necessary for a Takaful company to apply a successful Takaful pricing model without modification from one country to another? Give reasons for your answer.
10.5 Issues on the administration of a Takaful fund deficit and underwriting a surplus
The administration and management of a Takaful fund based on the pricing of contributions, as discussed in the previous section, effectively influences the financial impact of the fund in the case of either a surplus or deficit. This section will illustrate the impact of the structure of a Takaful fund on the treatment of any surplus or a deficit at the origination, management and distribution phases.
10.5.1 Ownership of the Takaful fund

Before discussing the issue of surplus and deficit of a Takaful fund, it would be appropriate to give the juristic background of the issue. It should be obvious that the Takaful fund is a separate fund that does not belong to the Takaful operator or shareholders of the Takaful company. Generally speaking, the fund is owned by all the participants who have donated a financial contribution to the fund. Depending on the management contract between the Takaful fund and the Takaful operator, the fund will be managed by the Takaful operator either as the agent (Wakil under the Wakalah model) to the fund or as a manager (Mudarib under the Mudarabah model) or as both (CDIF/2/8/152). In all scenarios, the Takaful company or operator will have no ownership right in the fund. The Takaful operator will have the right to claim either fees or a profit share or both. A question which needs to be answered is whether participants in a Takaful fund are also its owners. To answer this question, it is appropriate to relate the question to market practice. In general Takaful (home, motor, travel), all contributions made by participants are viewed as donations. A donation is an outright gift to another party who is the recipient. Participants technically lose ownership over the contributions that they make. However, because of the concept of a contingent donation or a conditional gift, which was discussed in the previous section, the participants have a right to the fund according to the terms and conditions attached to the Takaful policy. One may conclude that although the participants do not have an ownership right over the Takaful fund, they have a right to claim from the fund in situations already prescribed in the Takaful policy terms and conditions. The issue is significantly different in family Takaful (savings, education, marriage, retirement) where the contribution by the participants is viewed more as investment capital rather than a donation. Only a portion of the contribution is earmarked for donation purposes to meet all the claims. The remaining amount is managed as investment capital to generate returns for the participants. This does not transfer the ownership of the fund to a third party. The ownership interest in the fund is still vested with the participants, either as the investors or as the potential claimants of the donation in the case of death or permanent disability, or surplus of the risk fund. Currently, there is a trend to diversify the investment portfolio proposed to the Takaful participants. Islamic financial institutions have become far more aware of the necessity to better diversify their asset portfolios and the growing Islamic bond (Sukuk) market should help widen the range of asset classes eligible for investment as well as help spread the risk. The Takaful fund is made of direct investment in Shariah-compliant securities as well as mutual funds and unit trusts. Financial institutions such as Prudential, Citigroup and Deutsche Bank all offer Islamic structured investments to their customers. The product guarantees capital protection on the initial sum invested for the duration of the Takaful programme as well as a yearly profit should the investment perform well.
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In both general and family Takaful schemes, ownership rights over the fund have never been shifted to a Takaful company. Therefore, in the case of a surplus, all the funds that are available should not be claimed by the Takaful company. By way of extension, in the case of liquidation of the Takaful company, it should be upheld that the creditors of the Takaful company have no right of recourse to the Takaful fund as the fund is not part of the Takaful operators assets. The same principle applies in the case of the underwriting of a surplus whereby all the surpluses should be distributed exclusively and proportionately among all participants. The participants in the Takaful policy may, however, agree on another arrangement that will bind all participants to a new scheme. They may, for example, agree to award some of the underwriting surplus to the Takaful operator as a performance or incentive fee. They may agree to create a reserve account out of this underwriting surplus or may agree to give away this underwriting surplus to a charitable organisation, either during the lifetime of the Takaful policy or in the event of liquidation.
Key point
Takaful participants contribute to the Takaful fund. The ownership of the fund is vested with the Takaful participants and this should be reflected in all circumstances throughout the life of the fund. This relates to investment income, surplus distribution and liquidation of the Takaful company.
10.5.2 The obligation of a Takaful company in the case of a deficit of the Takaful fund
A Takaful deficit arises when claims exceed total contribution and the risk fund is insufficient to meet future claims. This is the consequence of several factors such as an ineffective pricing strategy, changes in event occurrence rate such as mortality, reduced investment rate of return or an inadequate reserve of funds. In such a situation the Takaful operator often extends Qard (loan) to top up the participants funds to meet future claims. The top-up is normally temporary in nature, that is if there is any subsequent surplus generated in the subsequent period, all liabilities due to the Takaful operator, including Qard and other expenses, would have to be paid. However, concerns arise if the Qard remains outstanding in subsequent periods. The Takaful operator needs to review the pricing of contributions from future participants or upon renewal of existing participants to impute the higher potential loss. For example, a no-claims bonus or discount, in the case of general Takaful, is only granted to participants who have not claimed in the previous period, which is similar to conventional practice. Existing Takaful Acts in many countries do not specifically prescribe the obligation of the Takaful company to provide Qard, a benevolent loan or an interest-free loan, to the Takaful fund should the fund be in deficit and unable to pay all outstanding claims. Among contemporary solutions available is for regulators to issue guidelines requiring that Takaful-licensed companies provide this loan should the need arise. In other jurisdictions, this obligation is incorporated into the articles of association of the Takaful company. Both approaches could satisfy the requirement of rendering the Islamic insurance industry prudent as the risk of potential non-payment of claims by the Takaful fund is mitigated by a third-party undertaking to make good all the outstanding payments.
Key point
Although an interest-free loan is expected from the Takaful operator from a practical point of view, this has not been firmly addressed from a regulatory perspective.
10.5.3 Distribution of surpluses

The issue of the distribution of a surplus arises when contributions exceed claims and other expenses; this may include returns from investment of the surplus. The three modes of surplus distribution specified by AAOIFI standards are pro rata, selective and off-setting. The pro rata mode distributes the surplus plus profits among participants in proportion to the premiums paid. The selective mode distributes the surplus and profits among participants that do not claim. Finally, the offsetting mode takes into consideration the amount claimed and offsets it from the underwriting surplus that appears to be equitable to all participants. Under the off-set scenario, each participant is allocated a surplus sum pro-rated against the premium contributed. The amount that will be finally distributed to the participant is the net of the allocated surplus, less any individual claims made. The choice of distribution eventually impacts the participants expectation of the Takaful operators policy on pricing the contribution and the consequent equity in distribution. A more challenging structural issue would be the status of the Takaful fund and surplus from a Shariah perspective. A
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detailed discussion on the distribution of surpluses took place in CDIF/2/9/168. Essentially, the following is a summary of the juristic views: a surplus may be distributed to the participants exclusively; the scholars are agreeable to this practice a surplus may be given to a charity based on the terms and conditions of the Takaful policy; the scholars are also agreeable to this a surplus may be distributed to the participants, a charity or to a reserve account to build up the Takaful fund for the long term; this is also an acceptable practice to the scholars a surplus may be distributed between participants and the Takaful operator; while AAOIFI Shariah Standard No (26) does not allow this practice, the Shariah supervisory boards of some Takaful companies have allowed this sharing on the basis of an incentive fee payable to the Takaful operator for their excellent service in managing the fund, which is in a position of surplus instead of a deficit. In discussing the possible distribution policies relating to surplus, it should be noted that , as a technical term, a surplus in the Takaful industry refers to the difference between the residual from the total premiums, plus investment returns net of all claims, expenses and relevant provisions and reserves (CDIF/2/9/167-170). Both family and general Takaful result in underwriting surpluses. However, relatively speaking, general Takaful, in most cases, will record a negative surplus and not a positive surplus. This is because all of the contributions plus investment profit will be used to pay all the claims that are short-term in nature. Suppose the gross Takaful contribution is US$300 million and the Wakalah fee is US$90 million and the total claims in one financial year period are US$200 million, then the underwriting surplus is only US$10 million at the end of the financial year. The residual of this amount will be always negative compared to family Takaful. To illustrate, Table 10.5 below is an excerpt of the financial statements of a Malaysian-based Takaful company. As this is quite a new set-up, both the general and family Takaful funds are showing current fund values below the level of contributions collected. However, the negative surplus for the family Takaful is only some 4% of contributions, up from some 31% in the preceding year. The negative surplus for the general Takaful is calculated at 49% of contributions, with the figure for the preceding year at 59%. It is thus conceivable for a positive surplus to appear in the family Takaful, although unlikely in the general Takaful.
Table 10.5 Excerpt of a Takaful companys financial statements

BALANCE SHEET AS AT 31 MARCH 2007 (CONT)
Note TAKAFUL FUNDS General takaful fund Family takaful fund 21 22
2007 RM 34,377,968 149,686,168
2006 RM 22,192,846 62,895,837
FAMILY TAKAFUL RVENUE ACCOUNT FOR THE YEAR ENDED 31 MARCH 2007 Note 2007 RM 160,202,043 156,054,032 2006 RM 93,169,358 92,113,960
Revenue Family takaful fund
14 14
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10.6 Legal and rating requirements issues

The discussion of these issues is important to provide an understanding of what is needed for the Takaful industry to be legally sound and prudent, as well as favourably rated. This discussion becomes more important as Takaful (or insurance) is a business practice where the contribution is paid before the services are rendered. Proper regulation and supervision is important to protect the interest of the participants who have paid contributions before they receive any compensation.
10.6.1 Legal requirements

Legal requirements, for the purpose of this section, include capital adequacy and solvency margin, the segregation of accounts and disclosure.
10.6.1.1 Capital adequacy

Capital adequacy refers to the Takaful operator having sufficient financial resources to meet claims as they fall due. There should also be a solvency margin as determined by the respective regulators. The margin represents the excess of assets over liabilities and provides a useful buffer against any unexpected claims. Under the Wakalah and Mudarabah models, initial capital adequacy concerns will need to be addressed, possibly through the shareholders of the Takaful operators paid-up capital, cash reserves or paid-up earnings. For example, the Central Bank of Bahrain requires that Takaful operators maintain all Takaful funds, subject to available capital and solvency requirements. Each Takaful fund must maintain and calculate its solvency requirements as if it was a separately licensed insurance firm. With regards to capital adequacy requirements, the base requirement is for the Takaful operator to maintain capital available in excess of the required solvency margin and minimum fund at all times. The minimum fund that must be maintained by each Takaful fund is as follows:
Table 10.6 Minimum fund requirement

Category 1 firm : Category 2 firm: Category 3 firm: Category 4 firm : BD300,000 BD500,000 BD400,000 The relevant minimum fund for Category 1 or 2 (depending upon the type of general business underwritten) plus the Category 3 minimum.
The Central Bank of Bahrain defines the various categories listed in table 10.6 as follows: Category 1 firm a Takaful/insurance firm whose licence is limited to any of the following types of insurance: fire; damage to property; and miscellaneous financial loss. Category 2 firm a Takaful/insurance whose licence includes any of the following types of insurance: marine cargo and marine hull; aviation; motor; engineering; liability; and any other general insurance class not specifically mentioned. These may only be in addition to any Category 1 activities. Category 3 firm a Takaful/insurance firm whose licence includes any of the following types of insurance: family/life insurance of all types; personal accident whose term is over one year; and savings fund accumulation insurance. Category 4 firm a Takaful/insurance firm, licensed prior to 1 April 2005 and whose licence includes any of the types of insurance specified in Category 3 and in Category 1 or 2, or both. For each Takaful fund, the required solvency margin is calculated on the basis of premiums written and claims insured by the fund. A risk factor is applied to reflect the differing risk profiles for the different classes of insurance. The requirement of a capital adequacy and solvency margin is common to other jurisdictions. It is included in the Takaful Act of Malaysia (sections 13 and 14) and the Dubai Financial Services Authoritys Prudential Insurance Business Module (No 4).
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10.6.1.2 Segregation of accounts

Among other requirements in Takaful, each Takaful operator must establish and maintain a Takaful fund for each of the classes of business carried out by the operator. All receipts of the operator attributable to the business must be paid into the Takaful fund. The funds assets are only to be used to meet liabilities and expenses properly attributable to the underlying business to which the fund relates. Also, the assets of any Takaful fund must be kept separate from the other assets of the operator.
10.6.1.3 Disclosure
Takaful firms must provide participants and shareholders with clear information about the performance of their business. Other aspects of disclosure in the case of the Malaysian Takaful Act involve permission to be given to the regulator to inspect the Takaful operators books and records. A refusal is an offence and carries with it the possibility of a fine.
10.6.2 Rating a Takaful company

The manner of operating Islamic insurance on the basis of donations instead of premiums impacts on how rating agencies rate Takaful companies in discharging their duties and obligations. The main basis for rating within the insurance sector is the financial strength of the insurance company and this also applies to the Takaful industry. The participants of the Takaful policy may need to know the financial strength of any Takaful operator before they can decide on a subscription. The rating exercise of a Takaful operator may bring some benefits to the company, as this rating grade will demonstrate the adequacy of internal steering and risk-management systems, in addition to financial strength. Given the differences between Takaful and conventional insurance it would seem appropriate to ask how a typical rating agency effectively rates a Takaful company. It appears appropriate that the rating outlook for any Takaful company is based on the rating methodology used for conventional mutual insurance, as both are similar in many respects. However, the credit strengths and weaknesses of a typical Takaful company are influenced by a number of considerations that do not apply to a conventional mutual insurer. The following is a brief illustration of the general rating methodology for any mutual insurance company with additional considerations for a Takaful company, where relevant. The Takaful company must be submitted to the following reviews: 2 industry review organisational review operational review management review financial review.
10.6.2.1 Industry review

a. The competitive environment in the sector, expected market development and customer loyalty The clarity and transparency of the products, together with the characteristics of the client base, may lead to greater loyalty than would generally be found at a conventional insurer. This greater loyalty is evident at many Islamic banks despite the fact that they do not pay interest, and the experience of Takaful firms might well prove to be similar. Currently, there is limited data to support this hypothesis and the rating agency will take a reasonable view in each case. b. Reputational and strategic risk This can be a risk for firms that market themselves as Shariah-compliant, with the possibility that they could be deemed to be not in compliance by influential clerics, either internally or externally. Such a determination could affect existing participants, as well as the ability of the firm to attract new ones. It is important to note, however, that the rating agency will not approve, certify or evaluate Shariah compliance. The agency is usually well-versed in credit issues but is not well placed to determine what is or is not in compliance with Islamic principles, which is a complex and subjective area. The agency will rely on the firms Shariah board and, where applicable, national (that is regulatory) Shariah councils in this regard.
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c. Effectiveness of the business model Different jurisdictions have differing restrictions on the permitted business forms (for example Wakalah and Mudarabah) and in some cases, on the contributions that can be charged (fees) or the maximum permitted Wakalah fee or split of profits. In order to be a viable business over the long term, a commercial Takaful firm needs to be able to offer a suitable return on capital to the shareholders of the Takaful operator. In the presence of some restrictions, together with the small size of many firms and the Shariah requirement to avoid excessive profitability, it may prove a challenge for some companies to achieve adequate returns.
10.6.2.2 Organisational review

The ability of a Takaful operator or fund to source additional resources if required is a key consideration for any form of insurer. The financial strength of a parent organisation is especially important for Takaful windows or subsidiaries of established insurers. Where the Takaful firm is part of a group, the rating agency will use its group rating methodology to assess whether any uplift is applicable to the rating of the Takaful fund.
10.6.2.3 Operational review

This section of analysis will be largely similar to the agencys approach to conventional insurers and will consider items such as underwriting expertise, brand and franchise value, distribution capabilities, market share, business mix and administrative capabilities. As noted, the rating agency will generally consider the operations of both the Takaful operator and fund separately, as well as the extent to which they complement each other. This assists the agency in isolating the firms strengths as well as areas of potential weakness. However, of particular importance for the assessment of the Takaful fund will be an assessment of the products offered to determine the level of risk that is associated with them. The agency will also assess the Takaful business model that is used (mutual, Wakalah, Mudarabah, or a combination of these) and the agreed fees or split of profits between the Takaful fund and the operator.
10.6.2.4 Management review

One of the most challenging and important areas of the agencys review is that of management and corporate governance. This is as true for a Takaful firm as for any other form of insurance enterprise but there are also additional corporate governance considerations to take into account. A separation of assets between the Takaful operator and the Takaful fund can lead to heightened principal-agent challenges (that is challenges arising from one party managing the interests of another where incentives are not fully aligned). Both Wakalah and Mudarabah contracts offer protection to the operator from downside risk and, in the absence of mitigating factors, can potentially encourage greater risk to be taken by the Takaful operator. The agency will consider the degree to which incentives are aligned between parties and the effect that these incentives are likely to have on the actions of the operator.
10.6.2.5 Financial review

a. Asset risk The core assets for insurance companies are typically concentrated in high-quality liquid assets. If the assets were to be invested in high-risk assets, a proper monitoring mechanism must be put in place. This may affect the Takaful investment assets as the Shariah-compliant assets for the Takaful company may differ from the normal assets for conventional insurance, such as Sukuk, compliant equities and properties. Some of these instruments, such as Sukuk, may not have any credit enhancements, thus affecting the rating. b. Capital adequacy Capital adequacy is critical for an insurer because regulators require a minimum capital ratio for the company to continue to underwrite and operate as a licensed Takaful operator. Ironically, although the Takaful operator is not technically an insurer, it is incumbent on any licensed Takaful company to have enough capital adequacy to be financially able to absorb the operating expenses as well as to provide an interest-free loan to the Takaful fund as and when the need arises. c. Profitability An insurers earning capacity its quality and sustainability is a critical component of its creditworthiness because earnings are the primary determinant of its ability to meet its policy and financial obligations. This is also an ironic situation as the Takaful operator is not technically an insurer. However, from a prudent and rating perspective, this aspect reflects the soundness of the financial ability of the Takaful company in discharging future duties and obligations.
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d. Reserve adequacy/liquidity and asset/liability management As for property and casualty insurance, inadequate loss reserves have been a key cause of company failures over the past decade. When a property and casualty insurers loss reserves develop unfavourably, the impact on the companys financial profile and flexibility can be material, as seen by a decrease in capital, increased operating and financial leverage ratios, and a reduced dividendpaying capacity to the holding company. As for life-insurance companies, a lack of liquidity can have adverse effects on a companys ability to meet the demands on its liabilities. As a result, financial problems, real or perceived, can lead policyholders to surrender their policies. If that happens, the insurance company could be ruined and it may prompt regulatory intervention or the companys insolvency. In the case of Takaful, the profit-sharing mechanism of long-term Takaful products may have certain distinctive features. For example, the determination, crediting and payment of profit-sharing on life policies, among others, will need to be examined when evaluating a Takaful companys asset and liability management. e. Financial flexibility This relates to the ability of the insurance company to source both internal and external capital funding for additional growth or acquisitions, and to meet unexpected financial demands. With regards to a Takaful company, on-going profit-sharing under the Mudarabah model may subject the company to competitive pressures. These are variable as the return on investment of contributions invested depends on the overall market performance in either the equity or debt capital markets or even bank deposits. Therefore, it is more critical for Takaful companies that subscribe to the Mudarabah model of management to manage its mismatch of fixed expenses and floating rate income. In addition to these critical factors, the rating exercise will also examine qualitative considerations, such as the management characteristics of the company, the degree of corporate governance being upheld by the company and the risk-management strategies adopted by the company. Furthermore, a proper accounting policy and disclosure, plus the regulatory environment in which Takaful company operates may also affect the quality of its rating.
Exercise 10.7
Explain why the focus of the rating exercise for any insurance company is largely based on future financial performance and financial strength instead of the current financial condition of the insurance company.
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Suppose a regulator in a given jurisdiction requires that all Takaful operators are rated with at least an AA. However, from the rating agencys perspective, there are two extra conditions to be met for Takaful companies to be eligible for this rating quality. These two extra conditions are the provision of a Qard account of 30% of the total amount insured in case of a deficit of the Takaful fund, and the need to create a profit reserve account for those Takaful companies that use a Mudarabah-based Takaful management model. It has been determined that 10% of the profit realised from the investment should be channelled into this reserve account until the reserve achieves 20% of the total amount insured. Explain whether these conditions are compliant with Shariah principles and whether they are useful in improving the quality of rating for Takaful companies.
Solution
These conditions imposed by the rating agency for the purpose of achieving the AA rating are not in conflict with Shariah principles. The provision of a Qard account in favour of the Takaful fund, which is effective from the start date of Takaful business operations, does not make the Takaful scheme non-compliant. Also, the creation of a profit reserve account to put aside some investment profit in a Mudarabah-based model of Takaful management does not conflict with any Shariah principles. A similar approach has been applied in Islamic banking products in the form of a profit equalisation reserve (PER). These two conditions will definitely enhance the financial strength of Takaful companies.
10.7 Takaful policies and strategies for the sustainable growth of Takaful institutions and industry
This section discusses issues and challenges that may have a negative impact on the growth of the Takaful industry. It also examines the critical factors that can alleviate the performance of Takaful in Islamic-based countries, if not in the whole global market.
10.7.1 Challenges and issues facing the Takaful industry

Various challenges may have an adverse impact on the development of the Takaful industry. These include the following: a. The religious perspective or rather misunderstanding that life is something that cannot be insured Muslims, as believers, must accept Divine destiny and an act to avoid this may be seen as questioning that Divine destiny. This has severely restricted demand, particularly for personal and life-product lines. b. Regulatory and fiscal issues, whereby it has been observed that the insurance sector that includes Takaful has historically lacked regulation This has discouraged insurance operators from underwriting the business and subsequently led to reduced customer awareness. A lack of fiscal incentives aimed at encouraging long-term savings, together with a high level of state support, have affected the development of family Takaful as a long-term savings scheme. Tax exemption for dividends paid under a Takaful scheme is one means to promote long-term investment or saving schemes. Undercapitalised Takaful operators result in the inability of many Takaful operators to underwrite specific and highly sensitive risks such as marine Takaful. This coupled with a limited re-Takaful capacity has further adversely affected the Takaful market share.
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c. Costly and ineffective distribution channels These can render the distribution of Takaful products and services either more expensive or less accessible when compared with conventional insurance products and services. In the majority of cases, Takaful remains deeply embedded within the overall wealth management operations of global financial institutions which typically offer the full range of conventional as well as Islamic banking services. It inevitably results in potential internal conflicts of interest between the Shariah-compliant technicians within the bank who are responsible for product design and development, and the retail network responsible for delivering the product to the customer. The conflict arises because very few of the leaders in the Bancatakaful sector have stand-alone sales forces able or willing to dedicate all their resources to the promotion and distribution of Takaful. Instead, distribution takes place through a generalist sales team, which may be dividing its time between promoting credit cards and current accounts alongside Takaful. To remedy this issue, senior management should offer a level playing field where the sales incentives are similar for conventional insurance and Takaful products. d. Shariah Fatwas on the use of conventional insurance while applying for Islamic banking products These may also have resulted in the slow development of the Takaful industry. This occurred early on in the development of Islamic banking whereby the customer, after obtaining Islamic financing for house financing or vehicle financing, was not obliged to subscribe to Islamic insurance to insure the house or vehicle. Instead, the house or vehicle buyer was given the freedom to insure the asset under either a Takaful scheme or a conventional insurance scheme. This was justified in the early days of Islamic banking where Takaful products may not have existed, were limited or were too expensive. e. The present Takaful regulatory framework is either underdeveloped or non-existent In some Muslim countries, this has adversely affected market confidence because participants need to be protected as their savings through Takaful involves, in most cases, a long-term outlook and sustainability of both the product and the operator. Figure 10.1 below shows the insurance penetration levels (inclusive of Takaful) based on a countrys GDP. One would notice that insurance penetration is low in Muslim countries, where most of them report a figure of less than 5% of GDP, compared with countries such as the UK where it stands at 16%.
Figure 10.1 Insurance penetration and GDP per capita for select countries (2006)
18% 16% 14% 12% 10% 8% 6% 4% 2% 0%
Malaysia UAE KSA Thailand Oman Morrocco Indonesia Jordan Tunisia Russia Turkey Pakistan Egypt Kuwait Nigeria Bangladesh Algeria India Italy France USA Germany Canada Singapore South Africa UK
Qatar
5000
10000
15000
20000
25000
30000
35000
40000
45000
Current OIC member states (2008)
Nominal GDP per capita in 2006 at PPP exchange rates (US$ per person)
50000
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The potential for growth in Takaful is vast in Muslim countries. In recent years, Takaful has shown a very robust growth: between 2005 and 2007, global gross Takaful contributions posted an average compound annual growth rate (CAGR) of 30%. Predictions from specialists range between US$7 billion and US$8 billion worth of Takaful contributions by 2012, with an average CAGR of 18%. Countries such as Malaysia, Indonesia, Kuwait, UAE, Jordan and Qatar as well as Saudi Arabia have been developing Takaful industries in their domestic market. Most of the Takaful growth however has been concentrated in two countries: Saudi Arabia and Malaysia. Saudi Arabia, which has 37 Takaful operators, remains the largest Takaful market with contributions reaching SAR10.9 billion (US$2.91 billion) in 2008, representing a 27% growth since 2007. In Malaysia, which has 10 Takaful operators, Takaful assets grew by 20% in 2008 to reach RYM10.5 billion (US$2.97 billion), while new business contributions expanded by 98% to RYM1 billion (US$283 million). However, there are still hurdles to be resolved, including Shariah sensitivities that have severely restricted demand, particularly for personal and life-product lines. In the Middle East, there is no insurance-buying culture and confusion exists between Takaful and conventional insurance, probably because there isnt enough public education on risk and risk management. Culturally, the extended family systems in Muslim countries have historically acted as the primary source of financial support to the dependent population, particularly the elderly, thereby reducing the need for Takaful. However, there is an increasing trend for professional individuals on an average income to plan on the medium term (savings and childrens education) or longer term (retirement). As most emerging markets have predominantly young demographics, this can only mean that the customer base will grow as years go by. For example, in Malaysia, where 32% of the population is less than 15 years old, it means that in about ten years time, a third of its population (almost 10 million people) could be potential Takaful customers. In 2008, market penetration reached 8.2% in Malaysia, on a par with some Western countries where insurance is an integrated part of life.
10.7.2 Critical success factors for Takaful industry

Irrespective of the above challenges and issues, there are some factors that have been identified as critical to the sustainable growth of the Takaful industry. While some of these factors are essentially a response to the above challenges, some are natural requirements for any industry in the financial market to grow and remain sustainable, particularly after the global financial crisis of 2008-09. These factors, inter alia, are as follows: a. Comprehensive regulation of Takaful products and services to instil confidence in the public at large We have seen how Takaful has been regulated in Bahrain and Malaysia to protect the interest of participants under both mandatory and prudential requirements. In countries where a Takaful act or regulation has not been put in place, efforts must be made to establish regulation to standardise and protect this industry for the interest of all stakeholders. In Malaysia, the Technical Committee of the Islamic Financial Services Board (IFSB) has recently approved the issuance of an Exposure Draft (ED) of Guiding Principles on Governance for Islamic Insurance (Takaful) Operations, for public consultation. The ED aims to complement other international governance standards, while addressing the specificities of the governance of Takaful operations. b. Capital adequacy requirements of any Takaful operator company These must be addressed more seriously as Takaful is a service that provides indemnity to the claimants. Also, the requirement of having a strong interest-free loan fund will not only improve the rating of Takaful operators, but also the confidence of participants in the long term. c. Greater demand and desire for a Shariah-compliant scheme of protection either from the financier or from customers of IFIs Customers are now looking for a wide range of Shariah-compliant schemes for mutual indemnity to protect against all possible risks in their lives, such as education of their children, annuity payments after retirement age, health and medical Takaful and travel Takaful for the loss of luggage or delay of flights. d. Revised Shariah Fatwas on aspects of the full package of Islamic financing and Islamic protection Where relevant and applicable, the Shariah supervisory boards of many IFIs have required that Muslim customers also subscribe to Takaful to insure assets or projects financed by IFIs.
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e. Privatisation of welfare services to insurance and Takaful companies This may also contribute to enhancing the demand for the Takaful product offerings in a given jurisdiction. For example, a Takaful annuity scheme may be an alternative to the government pension scheme, thus reducing the burden on the government by transferring the cost of welfare to the private sector, which could be more competitive and cost-effective. f. Effective and cost-effective distribution channels of Takaful products and services This will assist the continued development and offering of these products and services to society. Takaful products and services, unlike banking products and services, are appealing and relevant to all groups in society. The flexibility of making these products available to society on a value-formoney, cost-effective and effective time-management basis will affect the growth of Takaful in the near future.
Figure 10.2 Cumulative Annual Growth Rate (%, 2004-2007) of the Takaful sector by country
Saudi Arabia remains the largest Takaful market in the GCC with contributions of US$ 1.7 billion in 2007
Gross Takaful contributions in the GCC (US$m)

CAGR (2005-2007)=29% 2,046 1,579 1,238 770 645 2004
15 25 31 54 15 34 42 83 34 50 65 90 59 76 109 124
CAGR 2005-2007 Takaful penetration*
1,695
Bahrain Qatar UAE Kuwait
98% 50% 62% 22%
0.11% 0.32% 0.04% 0.07% 0.10% 0.15% 0.03% 0.03% 0.76% 0.85%
1,340
1,065
Saudi Arabia 26%
2005
2006
2007(e)
Malaysia remains the largest Takaful market in South East Asia with contributions of US$0.8 billion in 2007
Gross Takaful contributions in the South East Asia (US$m)

CAGR (2005-2007)=33% 951
35 35 94
692 417 544

24 30 77 27 30 75
CAGR 2005-2007
Takaful penetration*
30 32 80
797
Brunei Thailand Indonesia Malaysia
14% 8% 12% 39%
0.28% 0.26% 0.01% 0.01% 0.05% 0.05% 0.23% 0.32%
534
412
343 2004 2005 2006 2007(e)
Source: Ernst & Young World Takaful Report 2009
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Over the past few years, as shown in figure 10.2 above, growth in the Takaful sector has largely outpaced that witnessed in conventional insurance sectors (29% in the Middle East and 33% in Asia compared to 0.7%3 on average for conventional insurance). One reason for this is the shape of demographics in countries where Takaful is being offered. In countries such as Saudi Arabia, Jordan and Malaysia the young (25 years old or younger) make up some 30% or more of their domestic population. This demographic feature infers a significant future demand for Takaful products, partly due to improved public perception of Takaful products, better education and a higher level of financial sophistication. Muslim countries also report cumulative annual growth rates in the Takaful sector of between 5% to 10% from 2003 to 2007, which links to the increasing demand of Takaful products there. On top of that, the developing Islamic banking and finance assets in these countries require the application of more Takaful-derived risk-management products to be utilised. To keep this Takaful industry developing, assets held and financed by the Islamic financial services industry should use Takaful to underwrite risk. Shariah scholars are increasingly looking to use Takaful capacity to indemnify risks that have in the past used conventional insurance. There has been a tendency to rely less on Darurah (necessity) to justify the use of conventional insurance. The challenge is always to figure out how to tap into and facilitate such demand by developing Takaful operators that have the capacity and expertise necessary to provide a competitive alternative to conventional insurance offerings.
10.7.3 Main issues faced by the Takaful industry

The following are the main issues identified by Ernst and Youngs Islamic Finance Services Group4 as facing the Takaful industry today: High risk investment portfolio having exclusively Shariah-compliant investments limits the pool of funds to choose from Lack of human resources expertise especially acute in specialist fields such as life Takaful, risk management and Shariah compliance Competition the need to operate adequate technology and systems in order to have a competitive edge especially against big international players Global economic downturn the collapse of the equity market in the GCC and the reduction in lending in Asia have affected the family Takaful offering in those regions Enterprise risk management has been slow to develop as Takaful is a relatively nascent industry; the importance of risk management has been underlined in the industry, especially by the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) Varying regulatory regimes have impeded growth in Takaful; regulatory authorities have not caught up on the rapid growth of Takaful, especially in the last four to five years
Figure 10.3 Takaful globally in 2009

Financial Compliance
Regulatory regimes
Global economic downturn
Investment portfolios
Enterprise risk management

Key to symbols
Competition
Human resources
Up from 2008 Down from 2008
Strategic
Operational
New entry
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10.8 New critical issues for the Takaful industry

Takaful has developed from humble beginnings to become a global phenomenon. As it develops globally, it should embrace the highest standards of consumer protection as well as legal requirements, such as rating and transparency. Among new issues for the industry are the legal status of the Takaful fund and the requirement of the provision of interest-free loans (Qard) by the Takaful operator from the date of its inception. This will provide assurance that the Takaful operator is not only solvent, but has the financial means to pay all the claims if the Takaful fund experiences a deficit.
10.8.1 The trust concept of a Takaful fund

Having established the principle of law pertaining to the ownership right of the Takaful fund, as discussed in section 10.5.1 above, it is pertinent to question the extent to which the Takaful fund is protected in the case of liquidation of the Takaful company. A key question that needs to be addressed is whether there are any legal provisions in existing legal frameworks to effectively enforce the complete separation between the shareholders fund and the Takaful fund. This could be addressed either through the guidelines issued by the respective regulator or through the respective Takaful act (if any). The existing or new Takaful acts or guidelines must clearly prescribe that the Takaful fund should be a separate legal entity. As to how this separate legal entity is to be organised from a legal perspective, either as a Special Purpose Vehicle (SPV) or a limited liability company or any other legal creation, it is up to respective legal frameworks to address. Alternatively, it may be proposed that the Takaful fund is registered as a trust fund, in countries which recognise English principles of equity, whereby the Takaful company is the trustee and the participants, in the case of claim and surplus distribution, are the sole beneficiaries. A trust fund should not be affected by the insolvency of the trustee who is the legal owner of the fund from a trust law perspective as the fund is created solely for the benefit of the beneficial owners or beneficiaries, or simply the participants in the Takaful scheme. This may give more legal protection to the Takaful fund, particularly in the case of liquidation, as the Takaful fund should be regarded as a separate legal entity
10.8.2 The requirement of the provision of an interest-free loan from the date of the inception of a Takaful company
Section 10.5.2 above explained various practices with regard to providing interest-free loans in the case of a deficit occurring in a Takaful fund. It is anticipated that regulators, where relevant and applicable, may stipulate that a Takaful company provide or set aside a Qard account in favour of the Takaful fund from the date of its inception, on top of its capital requirement. The provision of this account from the outset will secure the payment of all claims in cases where Takaful funds suffer a deficit. This could enhance the ratings grade of this Takaful company as the interest of the participants will be protected because of the availability of a dedicated fund to pay the outstanding claims should the Takaful fund experience a deficit. However, there are a number of inter-related issues that require thorough consideration. These issues include the following: a. The provision of a Qard account by the Takaful company must not affect the capitalisation of the Takaful company. The fund provided for by a Qard account must not be seen as part of the capital of the Takaful company, otherwise it would be detrimental to its capital requirement. In other words, the provision of this fund as a separate fund or account should not lead to the decrease of capital of the licensed Takaful company as this will eventually affect the capital requirement of that licensed Takaful company. Otherwise, the Takaful company will have to provide more capital for both capital requirements, as well as for the interest-free loan fund. b. From the Takaful companys perspective, the investment return from this Qard account must be beneficial to the shareholders who are the lenders in the context of the contract. Otherwise, there is no incentive for the Takaful company to provide a substantial amount as the Qard account would bring no benefit to them. Most importantly, the provision of this Qard account must be compliant with Shariah principles, not only with regard to the very purpose of providing this account as a reserve or standby account, but also to all relevant issues arising from a Qard contract, such as the benefit accruing to the shareholders/lender, the contractual relationship between the Takaful company and the participants.
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It is to be noted that the provision of Qard from the very beginning of the operation, could be significant in terms of rating as the monies would have been transferred to the accounts of the Takaful fund from the very beginning. While it is now under the ownership of the Takaful fund, the fund is obliged to repay this money whether it actually uses the money or not. Subsequent to that principle of Shariah, all the investment returns from this money are the sole entitlement of the borrower, that is the Takaful fund, as the fund is under a liability to repay it. This feature may not be beneficial to the Takaful company that provides the loan as the lender from the very beginning. Also, under the Shariah principle of Qard, the lender cannot stipulate any return for himself either in cash or in kind. Any agreement for the borrower to share or deliver the return of this investment to the lender is strictly prohibited as this leads to Riba (interest). Having said this, since Qard is a liability contract, it may assist the Takaful company in the aspect of capitalisation. This is because the right of the Takaful company (lender) to collect the repayment of the loan could still render the loan given out as part of capital. The provision of a Qard account may serve both rating and capitalisation purposes well. Alternatively, it may be proposed that the provision of a reserve account under a trust concept could be a more holistic solution. Under this proposal, the Takaful company can create a trust account with a certain amount of money equivalent to a Qard amount. This account can then be managed by the Takaful company as the trustee. To meet rating and regulatory requirements, the trust deed must clearly mention that the beneficiary for this trust account will be the Takaful fund, but it is to be invoked only in the case of a deficit of the fund. To reinforce the rating requirements, the trust deed should clearly mention that the deed is irrevocable. For the benefit of the Takaful company it may continue with the investment of trust assets. The investment income may be ploughed back into the reserve account. On the issue of capitalisation, it is to be noted that this requires the legal argument that the trust account is as good as capital for the Takaful company as the money will only be used for a specific purpose, that is in the case of a deficit of the Takaful fund. In normal circumstances, the monies in the trust account are to be kept intact and returned to the settlor who is also the Takaful company if the trust expires.
10.9 Conclusion
The basis for Takaful has always been the protection and the preservation of life and property as well as religion, intellect and family. Islam promotes the spirit of mutual good will and assistance among mankind, both in good as well as adverse conditions. With the underlying Tabarru contract or Waqf concept as the basis, and the application of Takaful business based on the contracts of Wakalah and Mudarabah, we have seen how the Takaful industry is equipped with the necessary tools to penetrate into the global insurance industry. A series of developments or innovations is required to ensure that Takaful can flourish as part of the global finance industry. Innovation can begin with any facet of the industry, for example it would be possible to look at the concept on which Takaful is based. It has been explained how the Takaful industry began alongside the concept of Tabarru, with the spirit of mutual assistance being the key feature. This feature was maintained when the concept of Waqf was introduced, and will always be central when a new concept is applied. The Wakalah and Mudarabah business models have been popular to date, but this shouldnt deter the future adoption of different contracts that can better represent the relationship and protect the interest of the Takaful operators and policyholders. From a governance point of view, improved regulations will always bode well for the Takaful industrys future development. To date, regulations for the Takaful industry are often based around conventional insurance regulations. While there are many instances where the wholesale adoption of regulations is justifiable, there are also instances whereby such action limits the development of Takaful companies. One such example has been capital adequacy requirements that justify the insurance companys position as owner of the insurance funds but limit the position of the Takaful operator, which is technically the manager of the Takaful funds. Such regulatory misgivings must be addressed to ensure that the Takaful industry in not unnecessarily burdened. The potential for the Takaful industry to flourish is huge when one considers the low insurance penetration in many Muslim countries, as well as the lack of application of Takaful products in Islamic capital market instruments. The Takaful companies themselves must be better equipped to undertake a more diversified portfolio. Issues such as mandatory rating requirements, as well as improved transparency and corporate governance, are just some issues identified that will help the Takaful industry take the next big leap.
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10.10 Summary
Having read this chapter the main points that you should understand are as follows: preservation of financial wealth in Islamic tradition has been made possible through social contracts of gift, donation, Sadaqah, Zakat and loan the approach by the AAOIFI in looking at the definition of Takaful has changed the social contract of donation to a more legalistic and structured concept in that there is a commitment by the prospective participants to donate the underlying principles of a Takaful contract can be based on a concept of donation, a concept of conditional gift, or a Waqf structure the choice of a Takaful model based on Wakalah, Mudarabah or a hybrid of the two is dependent on business conditions any surplus arising from the difference between contributions and claims, as well as other fees or expenses paid to the operator, is collectively owned by the participants provisions can be made for the contribution to a contingency fund or other claims stabilisation reserves the Takaful operator can extend a Qard to top up the participants funds to meet future claims if a deficit does occur the Shariah supervisory boards of some Takaful companies have allowed Takaful surplus sharing between the operator and the participants on the basis of an incentive fee payable to the Takaful operator for their successful management of a Takaful fund the regulatory framework for the Takaful industry in some Muslim countries is either underdeveloped or non-existent, and this has proved to be a challenge in the development of the industry; this has adversely affected market confidence because participants need to be protected as their savings through Takaful involve, in most cases, a long-term outlook and sustainability of both the product and the operator a Takaful fund, as a separate legal entity, must be clearly defined and institutionalised the requirement of having the interest-free loan fund from the outset could be useful for ratings purposes as well as for promoting market confidence.

Legal ownership of the Takaful fund and the distribution of an underwriting surplus Takaful XYZ is among the pioneer Takaful operators in the Islamic financial services industry and has offered a broad range of both family and general Takaful products. With an increased liberalisation of financial services and globalisation of the Takaful product, Takaful XYZ needs to revisit its domesticoriented Takaful products and allow them to be benchmarked against incumbent global Takaful operators working within the same jurisdiction. In light of this development, it has realigned its family Takaful product business model towards international standards and best practices as well as to be in the position to be a competitive global provider of Takaful products. A press release relating to family Takaful issued by Takaful XYZ disclosed the following: In line with the companys objective of becoming more competitive in the market, the company is now undergoing a transitional phase of moving from the Mudarabah to the Wakalah model. While existing products are based on the Mudarabah model, all new products to be introduced will be based on the Wakalah model, with the exception of general Takaful businesses, which will continue to operate on the Mudarabah model. In the Mudarabah model, contributions are credited into the participants risk fund. All surpluses generated from this fund are distributed evenly between participants and the company. In the Wakalah model, all contributions and Wakalah fees will be credited into the participants risk fund. The Wakalah fee will cover both commission and expenses allocated upfront. Surplus generated from the fund will be distributed to the company and the participants at certificate termination. In his speech, the chairman of Takaful XYZ added that the Wakalah model is globally accepted and this shift is rather timely for the company as it will be in line with the company strategy to expand its distribution channel and grow the companys agency network.
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1. Actual ROE to shareholders in a Wakalah-based Takaful management model is based on: (A) (B) (C) (D) 2. the amount of claim and investment income against surplus surplus and investment income against operating expenses surplus and the amount of claims vis--vis total paid-up capital the amount of Wakalah fees against the operating expenses
Which of the following factors is not relevant to rating Takaful with due diligence? (A) (B) (C) (D) Product risk and diversification Model adopted by the Takaful company Liquidity of Takaful assets Capital adequacy
3.
By adopting the upfront payment of fees as indicated by the chairman of XYZ Takaful, what would be the impact on a Takaful operators performance? (A) (B) (C) (D) Significant cash inflow in the second year only Significant cash inflow in the first year only Regular cash flows beyond the first year Higher cash flows due to investment performance
4.
In relation to underwriting surpluses, which of the following reasons makes the Wakalah model a preferred model in the global Takaful market? (A) (B) (C) (D) The Wakalah model, with the upfront fee payment, is essentially based on the underwriting surplus The Wakalah model provides fixed fees for fixed expenses incurred on the surplus The Wakalah model restricts the Takaful operator from investing the surplus on behalf of the participants The Wakalah model allows the Takaful operator to share underwriting surpluses with the participants as an incentive fee
5.
Which of the following is NOT a reason for the low penetration of Takaful (and indeed insurance in general) in Muslim countries? (A) (B) (C) (D) Poor economic growth figures over the past decade, which have reduced the demand for Takaful Lack of public education on the issues on risk and risk management under Shariah Extended family support systems in Muslim countries have historically acted as the primary source of financial support to the dependant population Lack of an efficient regulatory environment to govern over the industry
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1. 2. 3. Based on the case information, analyse the impact of the Wakalah model compared to the Mudarabah model on participants interest. In terms of competitive pricing for contributions, would the Wakalah model be as attractive to participants as other models that expected a higher return on investments? As mentioned in the above case, the Takaful management model of XYZ Takaful will be migrating from the Mudarabah model to the Wakalah model except in the case of general Takaful business. What are your observations on this policy? Normally, the Takaful operator is expected to provide a Qard facility only when the Takaful fund experiences a deficit. Suppose that the rating agency requires that this Qard fund be created from the date of incorporation of the Takaful company for it be rated and licensed; what would be your proposal to fulfil this requirement in the best interest of the shareholders and Takaful participants? Briefly discuss the implications of XYZ Takaful adopting a distribution policy upon termination of the policy and not evenly distributing it during the policy period, under both the Wakalah and Mudarabah models of management.
4.
5.
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Chapter ten answers

Exercise 10.1
Although the root word of Takaful is derived from Kafalah, which literally means guarantee, the arrangements of Kafalah are different from Takaful. A Kafalah contract refers to a guarantee by one party (guarantor) to another party in the interest of a third party who will benefit from such a guarantee. Takaful, on the other hand, is a mutual guarantee among several parties as participants against a contingent event in the form of a peril or hazard affecting one of the members. In the case of Kafalah the third party can claim any loss in value from the guarantor, but in the case of Takaful the participants are only indemnified by the Takaful fund contributed by the participants respectively. In the case of Kafalah, as per Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) Shariah Standard (No.5), any payment to the guarantor is not permissible. On the other hand, a Tabarru contract, in the form of a donation, is executed when a contribution is made to the pool of Takaful funds and this fund is created from the very beginning of the Takaful contract. In the case of Kafalah, the availability of the money to pay the third-party beneficiary of the guarantee may only be made available when the guaranteed event takes place. A Kafalah contract is a commercial contract or undertaking of a guarantee by a third party, while Takaful is a collective scheme of mutual help among its members.
Exercise 10.2
Several key words or terms are used in the definition. They include: Agreement between persons to protect themselves. This agreement is not between these persons and another party such as the Takaful operator but is essentially only between themselves. This is the very meaning of Takaful; that one party, while providing help to another, is also indemnified by the other party. Commitment to donate the contribution by the participant. Unlike a simple donation, which may or may not be given by a person, this commitment to donate signifies a legal undertaking that obliges the person to donate. Failure to donate under this scheme may prevent the participant from obtaining what he may be expecting back from the scheme as the benefits are conditional upon his fulfilling his commitments. Separate legal entity of the Takaful fund. Separate legal entity is a concept recognised by modern law to the effect that the fund has its own assets and liabilities independent from the party who manages the fund. Compensation in the case of peril. This scheme alludes to the point that those who have committed to donate and have donated to this scheme can expect compensation as per the terms of the policy.
Exercise 10.3
This is an innovative structure to neutralise the issue of conditionality of the donation or gift. The contributions, in the form of donation or gift by the participants, are ultimately owned by the Waqf fund, which is a separate legal entity from the participants. If this is taken superficially, then the conditionality issue of the donation or gift may be addressed and solved from a purely technical and juristic perspective. However, given that the Takaful contract is based on a set of contracts, the conditionality issue is still relevant. This is because each participant has to understand the nature of the Takaful contract under which they have to donate and that their donation is put under the Waqf fund created by the Takaful operator. That knowledge of this process flow indirectly renders their donation or gift conditional. The participants of this Takaful scheme only donate to this fund if they know that their donation will be ultimately placed in a Waqf fund from which claims will be made. In reality, no participant will donate to this fund without being made aware of the entire flow of the scheme as they, like other participants, would seek to be indemnified if they were to experience any of the prescribed risks.
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Exercise 10.4
Assuming that the operating expenses remain the same, regardless of whether the operator chooses the pure Wakalah or hybrid model, the operator will always choose the hybrid model if the projected returns of the hybrid model is greater that the pure Wakalah model. For example: 0.18x + 0.30y > 0.32x Where x is the gross contribution, given US$120 million y is the projected surplus then: 0.30y > 0.32x 0.18x y > (0.14x)/0.30 y > $56 million From the above example, the projected surpluses must always be greater than US$56 million for the operator to operate the hybrid model, based on the given gross contributions of US$120 million.
Exercise 10.5
The best marketing and distribution strategy is through Bancassurance or Bancatakaful using the branches of its parent bank institutions or other banks that participate in selling this Takaful product. Not only will the cost of marketing benefit from economies of scale, but the products can also be sold more aggressively as the Takaful product can now be sold from and through the many branches of the participating banks in this Bancatakaful scheme. The administration cost of this option comprises information technology costs, underwriting costs, policy issuance and general management costs. The claims cost comprises actual claims, claims handling or legal cost and Retakaful cost. Cost levels vary with product pricing requirements and strategy.
Exercise 10.6
This is a subjective question. A Takaful pricing model is dependent on several factors, with regulatory costs being just one of them. On top of that, the pricing model is also based on actuarial work. To apply one successful pricing model to another country, one must be sure that the regulatory cost is similar in both countries. The new country under consideration must also exhibit similar demographics, such as mortality rates, which is connected to the availability of medical services and quality of life. This will play a part on whether the pricing model will be as successful there.
Exercise 10.7
This rating methodology is quite logical because the obligations of the insurance company normally lie in the future. Most of the payouts will be over a long period of time and the financial strength of the company in the future is crucial. Any element that may adversely impact the future financial strength of the insurance company will subsequently adversely affect the rating of the company.

1 (A) Under the Wakalah model, the income due to the operator comes by way of the negotiated Wakalah service fees, which is usually based on the gross contributions. As such, the claims, surpluses and investment income do not come into play. The model undertaken by the Takaful company, if everything else remains equal, does not affect the ratings of the Takaful company. The rest of the answers are those included in the rating factors of consideration, as given in the text. XYZ Takaful adopted Wakalah model 1 which reports high cash flow in period 1 only. Even under the Wakalah model, the Takaful operator will invest the fund on behalf of the participants. The issue is not whether the operator can do this, but whether they can have a share in the investment returns. In general, Muslim countries have experienced positive economic growth, especially in oil-producing countries. However, this has still not resulted in high Takaful (or insurance) growth figures.
(B)
3 4
(B) (C)
(A)
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1. In the Wakalah model, the fee paid to the Takaful operator is transparent and specified for the risk fund, as well as the savings/investment fund. The Wakalah model is easy to manage as the Takaful operator charges a fee and runs the Takaful operation. However, the participant would be contributing to the operational expenses as they are taken as a percentage of the gross contribution. The Mudarabah is a difficult model to manage, as expenses are fixed or known, but income (except surplus and investment profit) is not and can be volatile. In this model, it is the operator that has to manage their operational costs. As compared to model 5, the Takaful operator will earn a lower income as a specified fee is charged and not shared according to a mutually agreed profit-sharing ratio. This Wakalah model may be an attractive pricing model as the cost will be known to the participants beforehand. However, the question on how attractive it would be for the participants would depend on the actual performance of the year. For instance, should it be a good investment year, the participants would not have to remunerate the Takaful operator more under the Wakalah model. However, if it is a bad year, the Wakalah fees payable to the operator would look large compared with what they would have to pay under the Mudarabah model. The Wakalah-based Takaful management is simpler for both the Takaful operator and participants. However, to exclude the general Takaful business from this new model will create another issue from a Shariah perspective. This is because general Takaful, unlike family Takaful, will only bring an underwriting surplus instead of an investment profit. From a Shariah perspective, an underwriting surplus is not profit. It is the excess of contributions over claims. Should an underwriting surplus be shared between the manager and the policyholders, it will result in the reduction of the capital in the form of contributions, thus resulting in a loss position. The manager under the Mudarabah principle is not entitled to remuneration in the event of a loss. Under the Mudarabah model, the capital provider and the manager will only share in the investment profit. The provision of Qard from the commencement is acceptable for rating purposes. While the Qard fund is now under the ownership of the Takaful fund, the Takaful fund is obliged to repay this amount whether they actually use the money or not. On top of that, Shariah principles prescribe that any investment return from Qard funds is the sole entitlement of the Takaful fund as the fund is under liability to repay it. This feature is not beneficial to the Takaful company that provides the loan from the very beginning. In addition, the Takaful company cannot demand any return, either in cash or in kind. Any agreement for the borrower to share or deliver the return of this investment to the lender is strictly prohibited as this leads to Riba (interest). Although this practice may help in getting the required rating, it may not assist the Takaful company in the aspect of avoiding further capitalisation. The fund contributed for this purpose will not be counted as part of the necessary capitalisation because the Qard fund is not part of the capital of the Takaful operator. Another solution may be needed to satisfy the rating requirements as well as the capitalisation requirements or enhancement. An alternative solution is the provision of a reserve account under a trust concept. Under this proposal, the Takaful company can create a trust account with a certain amount of money equivalent to a Qard amount. This account can then be managed by the Takaful company as the trustee. To meet rating and regulatory requirements, the trust deed must clearly mention that the beneficiary for this trust account shall be the Takaful fund, but it is to be invoked only in the case of a deficit of the fund. To reinforce the rating requirements, the trust deed shall clearly mention that the trust deed is irrevocable. For the benefit of the Takaful company, they may continue with the investment of the Trust asset. The investment income may be ploughed back into the reserve account. 5. For ease of administration, any surplus and profits should be evenly distributed throughout the policy period. Where it is accumulated until the termination or the end of the policy, the Takaful operator must be efficient enough to accurately identify what is accrued to each participant and what is due to the operator. This situation is made more complicated when the operator is moving from the Wakalah model of operation to the Mudarabah model as the calculation of the surplus due to the policyholder, for instance, would be different to the surplus due under the Mudarabah model.
2.
3.
4.
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Notes:
1. Archer, S., Nienhaus, V., Rifaat, A.A.K., 2009, Takaful Islamic Insurance: Concepts and Regulatory Issues, John Wiley & Sons, UK 2. Fitch methodology for rating a Takaful company 3. Takaful Industry Performance 2008, Takaful Ikhlas 4. Ernst & Young, World Takaful Report 2009
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Chapter eleven
Retakaful and retroTakaful operations and industry in the global Retakaful market
Learning outcomes
By the end of this chapter you should be able to: evaluate the importance of the reinsurance business, its various structures and its application to Retakaful assess current global trends and issues affecting the re-pooling of Takaful funds to either Retakaful or reinsurance examine the validity and challenges of the reinsurance of Takaful contributions by conventional reinsurance companies recommend strategies for Retakaful and retro-Takaful in the development of the global Takaful and Retakaful industry examine governance issues affecting the Takaful and Retakaful industry.
Retakaful and retro-Takaful operations and industry in the global Retakaful market

Overview of the reinsurance market, its structures and the application of Retakaful in the global market Challenges and trends in the Retakaful industry Reinsurance of Takaful premiums Retakaful and retro-Takaful practices Governance issues affecting the Takaful and Retakaful industry Case study: Shariah and strategic issues on reinsurance vis--vis Retakaful
11.0 Introduction
Chapter eleven expands the discussion of Takaful operations focusing on re-Takaful and retro-Takaful. The challenges faced by Retakaful operators in an emerging industry across different sovereign states are analysed and explained. In particular, this chapter elaborates on the various forms of reinsurance and Retakaful arrangements in the form of facultative and treaty types on a proportionate or non-proportionate basis. It discusses the reasons for allowing the reinsurance of Takaful contributions by conventional reinsurance companies and offers a critical examination of the Shariah concession of such reinsurance arrangements under the principle of necessity. The chapter also illustrates the arrangement of a Retakaful company to retro-cede some of the risks to another Retakaful or reinsurance company (retro-cedent companies).
11.1 Overview of the reinsurance industry
The conventional insurance industry has evolved with demands for insurance coverage for largescale exposures and specific lines of high risk that a single insurance company would not be able to indemnify. As a result, insurance companies may transfer risk to a reinsurance company that would be in a better position in terms of capital and expertise to deal with the degree or nature of the risk. In the case of Takaful, direct or primary Takaful operators may have to pool the relevant risks to an even larger pool of mutual indemnity, called a Retakaful fund, which is managed by a larger capitalised Retakaful company. You were introduced to the concept and features of both reinsurance and Retakaful in CDIF/2/9/171-176. To reiterate, reinsurance is a means by which an insurance company can protect itself with other insurance companies against the risk of loss arising from large claims. Individuals and corporations obtain insurance policies to provide protection for various risks, for example hurricanes, earthquakes, lawsuits, collisions, sickness and death. Reinsurers, in turn, provide insurance to insurance companies.
11.2 The need for reinsurance

As part of its responsibility to manage a portfolio of risks for the benefit of its policyholders and shareholders, there are various reasons why a conventional insurance company would choose to reinsure.
11.2.1 To increase risk cover to clients

The principal benefit of reinsurance is to allow the insurance company to assume greater individual risks than its size would otherwise allow, and to protect an insurance company against losses. Hence reinsurance allows an insurance company to offer higher limits of protection to a policyholder than its own assets would otherwise allow. For example, if the principal insurance company can write
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only US$10 million in limits on any given policy for a single policyholder, it can reinsure (or cede) the amount of risk which is in excess of US$10 million. With reinsurance a carefully planned hedge strategy can be adopted by the insurance company.
11.2.2 To manage risk cover and minimise capital

Reinsurance enables a more predictable return for the insurance company since larger losses are transferred to the reinsurer. In effect this also reduces the amount of capital that may be required by the regulator under capital adequacy requirements to provide coverage, and effectively reduces the cost of capital.
11.2.3 To create a manageable portfolio

A more manageable and profitable portfolio of insured risks can be achieved with reinsurance. This is done by creating a more balanced and homogenous portfolio of insured risks that lends greater predictability to portfolio results on a net basis (after reinsurance). This is reflected in income smoothing as mentioned above.
11.2.4 To avoid increases to capital

Since an insurance companys underwritings are limited by its balance sheet (known as the solvency margin), upon reaching the limit an insurer may need to increase its capital, or buy surplus relief reinsurance. Buying reinsurance on a quota share basis is considered a better option to turning clients away or having to raise additional capital.
11.2.5 To allow for arbitrage

Reinsurance also provides an opportunity for an insurance company to engage in arbitrage when the reinsurance premium rate is lower than that of the insurance company. A typical wholesale retail synergy can benefit the insurance company in a vertical integration of insurance institutions. A re-insurer may charge a higher premium to the insurance company to cover the loss of specialised equipment and subsequently retro-cede a portfolio of such equipment at a lower premium from other reinsurance companies. The differential premium rate is risk free profit to the reinsurance company. Where the reinsurance and insurance company are in the same group of companies, the vertical integration of the insurance business prevents the differential premium benefiting a third party. In other words, any differential premium rate is retained in the group of insurance and reinsurance companies.
11.2.6 To be able to offer specialised risk

Reinsurance support, accompanied by the relevant reinsurers expertise, may benefit the insurer with regards to a specific (specialised) risk and helps their rating ability in odd risk situations. In cases where large-scale risk exposure or specialised risks are beyond the capacity and competency of the insurance company, the reinsurance company, with its greater capacity and with relevant qualified technical expertise, will be able to support the insurers accordingly.
11.2.7 To manage exposure and reduce costs

As a commercial entity, an insurance company that manages larger exposures will benefit from reinsurance by transferring excess exposures to a reinsurance company. At the same time, this can help achieve a more balanced portfolio with a lower cost of funds, and it allows for expert support. If an insurance company plans to expand its insurance business with the same paid-up capital, it may absorb a percentage of the additional risk exposure by transferring the balance to a reinsurance company. The insurance company has effectively expanded its business segment with either a larger customer base or a broader segment of the industry. Similarly it may also benefit from a higher insurance premium rate at a lower-ceded reinsurance rate by transferring the exposure.
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11.3 Retakaful models

A Retakaful operator, as a professional risk administrator, operates on the same model as a Takaful operator.
11.3.1 Mudarabah (profit-sharing model)

The operator acts as a Mudarib (entrepreneur) and the cedants as capital providers. A contract details how underwriting surplus and investment profits are shared, for example 60% to Retakaful and 40% to cedants.
11.3.2 Wakalah (agency model)

The Retakaful operator acts as the agent and administers the funds on behalf of the cedants. In return he receives a Wakalah fee, for example 20% of Retakaful contribution, to cover the operating expenses and profit margin. In this model the income is fixed, but it is commercially less attractive, as there is no upside potential from the investment of a Retakaful fund. The current trend of operations for Retakaful companies is a combination of the two models, that is Wakalah on underwriting and Mudarabah on investment activities.
11.4 The case for Takaful and Retakaful

In the case of Takaful and Retakaful, similar benefits may be achieved from commercial consideration, although the modus operandi for the two concepts is significantly different. The issues and challenges in the case of the emerging Takaful industry are different from the conventional insurance industry as it is based on mutual indemnity and risk pooling rather than risk transfer. Section 11.5 will discuss the various types of reinsurance structures that exist and explain how these structures can also be applied to Retakaful practices without breaching Shariah principles.
Key point
Reinsurance, among other benefits, allows insurance companies to provide wider and higher coverage beyond its capital through risk transfer. It also provides income smoothing, surplus relief, arbitrage and the relevant technical expertise to direct insurers in managing a specific line of risk.
Exercise 11.1
Reinsurance contributes to enhancing the capacity of conventional insurance companies through the effective transfer of risk, enabling large exposures to be transferred to a reinsurer. Explain how this would be different in the case of Retakaful and Takaful operators.
11.4.1 Cede and retro-cession

The term cede technically means the assignment of rights to another entity, while retro-cession is the transfer of risk from one reinsurer to another reinsurer. Effectively, both terms refer to risk that is transferred to another party and is therefore not in line with Shariah requirements. Risk in Islamic law must not be transferred to a third party for a price. In Takaful, the term cede must not be taken as the transfer of risk. It simply means the pooling of the contributions of various Takaful funds to mutually contribute to another pool of funds for mutual indemnity in the future.
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Limitless Takaful-re is a Retakaful company that has been established since 2007. To date, only one Takaful company has decided to cede some of its specifically high-risk contributions to a Retakaful fund. The Retakaful company later retro-ceded this risk to a retro-cession insurance company. In late 2008, the regulator revoked Limitless Takaful-res licence. In your opinion, what could have been the reason for the revocation of this licence?
Solution
Given the facts of the case, it seems that the Retakaful licence may have been revoked because Limitless Takaful-re was not able to attract more than one Takaful company to participate in its Retakaful scheme. Irrespective of what has actually led to the nonparticipation of other Takaful operators, it seems that Limitless Takaful-re failed to comply with the minimum requirement of being a Retakaful company, which is to pool the risks from more than one Takaful fund to realise the very meaning of mutual contribution and mutual indemnity. There is no realisation of the pooling of risks in this Retakaful fund if only one Takaful operator participated in the past two years of its incorporation. However, in conventional practice, this licence may be maintained, even though it is not commercially viable as there is no anomaly in the concept of reinsurance practice based on the transfer of risk. The fact that Limitless Takaful-re has retro-ceded the contribution it received to another retro-cession insurance company may be acceptable from a Shariah perspective, as will be discussed later. This, therefore, may not be the reason for this revocation. The retro-cession could be an issue if it is not allowed under the laws of the country.
11.5 Types of reinsurance or Retakaful: treaty and facultative policies

Reinsurance or Retakaful policies are written according to the needs of the insurance or Takaful company, principally relating to the proportion of risks to be shared and whether a total scheme or case-to-case basis (facultative) is agreed upon between the insurance or Takaful company and the reinsurance or Retakaful company. In other words, the reinsurance or Retakaful company may accept the transfer of all risks underwritten by a primary insurance or Takaful company as a total scheme of insurance or Takaful, or it may select some of the risks based on a case-to-case basis.
11.5.1 Treaty reinsurance or Treaty Retakaful

Treaty reinsurance or Treaty Retakaful policy is a standing agreement by the reinsurer/Retakaful operator to accept all risks transferred or pooled by the insurer/Takaful operator that fall within the scope of the agreement which is reviewed on an annual or periodic basis. In Treaty reinsurance or Treaty Retakaful, the ceding insurance or Takaful company is contractually bound to cede, and the reinsurance/re-Takaful company is bound to assume a specified portion of a type or category of risk insured by the ceding company. Treaty Retakaful, as a matter of principle, does not separately evaluate each of the individual risks assumed under its treaties and, consequently, after a review of the ceding companys underwriting practices, relies on the original risk underwriting decisions made by the ceding primary policywriters. Such dependence subjects Retakaful operators, in general, to the possibility that Takaful operators may not have adequately evaluated the risks to be pooled. Therefore, the contributions ceded may not adequately compensate the Retakaful company for the risk assumed, at least from a commercial perspective. The Retakaful operators evaluation of the ceding companys risk management and underwriting practices, as well as claims settlement practices and procedures, usually impact the pricing of the Retakaful treaty.
11.5.2 Facultative reinsurance or facultative Retakaful

A facultative reinsurance/Retakaful policy is offered by the reinsurer/Retakaful operator to an insurance company/Takaful operator on a case-by-case basis. This arrangement is optional whereby there is no obligation for either the Takaful operator or Retakaful companies to enter into arrangements on all the risks. In facultative Retakaful, the Takaful company cedes and the Retakaful operator assumes all or part of the risk assumed by a specified Takaful policy. Facultative Retakaful is negotiated separately in the case of each contract that is to be considered by the Retakaful operator. Facultative Retakaful is normally subscribed to by ceding companies for individual risks not covered by their Retakaful
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treaties, for amounts in excess of the monetary limits of their Retakaful treaties or for unusual risks. Retakaful administrative expenses and, in particular, personnel costs are higher relative to contributions written on facultative business because each risk is individually underwritten and administered. The ability to separately evaluate each risk considered for Retakaful, however, increases the probability that the Retakaful operator can price the contribution higher to accurately reflect the risks involved in this risk pooling.
11.5.3 Proportional reinsurance or proportional Retakaful

Proportional reinsurance/Retakaful (also referred to as quota share-and-surplus reinsurance/ Retakaful) involves one or more reinsurers taking a stated percentage share of each policy that an insurer or Takaful operator produces (underwrites). This means that the reinsurer or Retakaful operator will receive that stated percentage of each dollar of premiums and will pay that percentage of each dollar of losses in the case of a claim. In addition, the reinsurer or Retakaful operator will allow a ceding commission to the insurer/Takaful operator to compensate the insurer/Takaful operator for the costs of writing and administering the business (for example, agents commissions, modelling and paperwork). By purchasing proportional reinsurance/Retakaful the initial cover limit of the Takaful operator to the customer can be increased through Retakaful by any amount. Premiums and losses are then shared on a pro rata basis. These could be in the form of a quota share or a surplus share. Surplus treaties are also known as variable quota shares.
Example of quota share in Retakaful A Takaful operator may subscribe a 50% quota share treaty of Retakaful and share half of all contributions and respective claims with the Retakaful company. If a claim of US$500,000 is made against the Takaful operator for a policy specified in the treaty, then US$250,000 of this claim will be borne by the Retakaful funds, whereas the remaining will be borne by the relevant Takaful operators.
Example of surplus share in Retakaful If a retained line of the Takaful operator is US$100,000, a nine-line surplus treaty of the Retakaful would then accept up to US$900,000 (nine lines). Therefore, if the Takaful operator issues a policy for US$100,000, it would keep all the contributions and absorb claims from that policy. If it issues a US$200,000 policy, it would give (cede) half of the premiums and losses to the Retakaful (one line each). The maximum capacity would be US$1 million.
11.5.4 Non-proportional reinsurance or non-proportional Retakaful

Non-proportional Retakaful only responds if the loss suffered by the Takaful operator exceeds a certain amount called the retention or priority. An example of this form of Retakaful is where the Retakaful operator is prepared to accept losses of up to US$1 million and purchases a layer of Retakaful of, say, US$4 million in excess of US$1 million. If a loss of US$3 million occurs, then the Takaful operator will retain US$1 million and recover US$2 million from the Retakaful operator. In this example, the Takaful operator will retain any loss exceeding US$5 million unless it has purchased a further excess layer (second layer) of, say, US$10 million in excess of US$5 million.
11.5.4.1 Excess of loss-and-stop loss

The main forms of non-proportional reinsurance/Retakaful are excess of loss-and-stop loss. Excess of loss is a form of reinsurance or Retakaful under which recoveries are available when a given loss exceeds the Takaful operators retention as defined in the agreement. Stop loss, on the other hand, is a form of reinsurance or Retakaful under which the Retakaful operator pays some or all of a Takaful operators aggregate retained loss in excess of a predetermined dollar amount or in excess of a percentage of contribution. In practice, the excess of loss is more commonly adopted compared with a stop loss.
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Example A Takaful company may insure commercial property risks with policy limits up to US$10 million and then subscribe to Retakaful for any risk in excess of US$5 million. In this case a loss of US$6 million on that policy will result in the recovery of US$1 million from the Retakaful.
Key points
The transfer or re-pooling to share the loss exposure of a Takaful operator could be proportional or otherwise depending on the risk preference of the Takaful operator and the willingness of the Retakaful operator. Proportional implies similar risk preference, while nonproportional such as excess loss implies ability and willingness of Retakaful to manage and cover higher-than-expected risk exposures. The transfer or re-pooling to share may be on a deal-by-deal basis, referred to as facultative, to unique risk features or a standing agreement, such as a treaty, because of the anticipated volume of relatively predictive risks.
Exercise 11.2
In a proportionate treaty arrangement between Takaful ABC and Retakaful XYZ it is agreed that a 50% quota share for claims on a fire policy would be covered. During the year, Takaful ABC underwrites a fire policy for $200,000. Based on the arrangement of proportionate treaty quota share, how would the contribution and claim be shared between the Takaful and Retakaful operators?
11.6 Comparative Retakaful and reinsurance arrangements

Reinsurance between an insurance company and a reinsurance company involves the effective transfer of a portion of risk or a specified loss in excess of the insurance companys risk loss limit. At the same time, the proportionate risk or specified loss exposure is re-pooled by a group of Takaful operators to be managed by a Retakaful company. The comparative features and implications of the different contractual arrangements are shown in the table below.
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Table 11.1 Comparison of reinsurance and Retakaful contractual terms

Features Origination of risk Insurance payment Reinsurance Risk exposure of insurance company Insurance premium is a form of revenue to the insurance company The reinsurance premium is a form of revenue to the reinsurance company Retakaful Risk exposure of participants managed by Takaful operator(s) Takaful contribution is received on behalf of the participants
Reinsurance payment
Contribution received from the Takaful operator is on behalf of the participants and is pooled into the risk fund of the Retakaful fund remitted from other Takaful operators When differential rates between the Takaful and Retakaful rates are in favour of the Takaful operator, the Takaful operator will arbitrage against the Retakaful operator, excluding the underwriting risk, which is not transferred but shared among a larger pool of policyholders
Differential rates
When differential rates between insurance and reinsurance companies are in favour of the insurer, the insurer will arbitrage the rate against the reinsurer, which includes the underwriting risk All expenses are borne by the insurance company; a bonus or claim discount payment to the insurance company is also a form of reinsurance expense
Expenses
Expenses relating to fund administration are borne by Wakalah fees and deducted from participants gross contributions, while management expenses are borne by the Retakaful operator; performance or incentive payments to the Takaful operator from savings/investment participant accounts are paid out to Takaful operators from any investment returns to participants funds The underwriting surplus is owned by the Takaful operators participants and shared if pooled during Retakaful; in the case of a Mudarabah model the surplus is shared with the Takaful operator and Retakaful operator Could be shared between the Retakaful operator, Takaful operator and participants
Ownership of the underwriting surplus
The insurance company exclusively owns the surplus
Investment returns from the underwriting surplus Payment of claims
Exclusive to the reinsurance company
The reinsurance company pays a proportionate or excess loss claim to the insurance company No distribution of the underwriting surplus to the insurance company
The Retakaful company pays a proportionate or excess loss claim to participants from the participants contribution ceded to the Retakaful operator The underwriting surplus with the Retakaful operator is re-distributed by the Takaful operator to the respective participants or could be shared between the Retakaful operator and the Takaful operator(s) on behalf of the participants
Distribution of underwriting surplus
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Exercise 11.3
Explain whether a Retakaful company would be required to provide interest-free loans in the event of the Retakaful fund experiencing a deficit and why.

A Retakaful company has decided not to distribute the underwriting surplus to participating Takaful operators that have made claims during the tenor of the coverage. This action is being taken to reward Takaful operators who have been prudent in their underwritings, resulting in fewer claims. Any underwriting surplus will be distributed between the reserve account (30%), the Retakaful operator as the incentive fee (20%) and the Takaful operators who either have no claims or only have claims below the prescribed threshold (50%). Explain whether the above practice would be acceptable from the Shariah and good practice perspectives of a Retakaful business.
Solution
Retakaful (and Takaful) by definition are co-operative and mutual in nature and, as such, participants are entitled to a return of any surplus of the Retakaful fund (Takaful fund) operated by a Retakaful operator (Takaful operator). However, a Retakaful operator may choose to establish relevant terms and conditions that may disqualify any Takaful operator with claims above a certain threshold. If any Takaful operator incurs claims exceeding this limit, this company may not receive a share of the underwriting surplus. This is a policy designed to encourage more prudent underwriting policies by participating Takaful operators in a scheme of Retakaful. This type of action is compliant with Shariah principles as these terms and conditions have been agreed upon by all participating Takaful operators. Scholars are, however, divided on the issue of Retakaful operators having a share in the underwriting surplus. The distribution of the underwriting surplus to a reserve account allows for the building of a reserve to pay for future claims should the Retakaful fund be in deficit.
11.7 Trends and challenges of Retakaful in the global reinsurance market

This section looks at general trends in the global reinsurance and Retakaful market, highlighting the challenges that the Retakaful industry is faced with. While Takaful started operating in 1979 in Sudan and the United Arab Emirates, Retakaful only started in 1985, mostly by companies based in Saudi Arabia. In 1985, Al Baraka launched the first Retakaful operator Best-Re. Subsequently, two other Retakaful operators were launched in Saudi Arabia: the Islamic Takaful and Re-Takaful Company and the Islamic Insurance & Reinsurance Company (AMAN). In Asia, MNRB Retakaful was incorporated in Malaysia in 2006 and Takaful Re, the Emirati Retakaful operator, widened its geographical footprint from its base in Dubai to the Far East in January 2008. The Retakaful expansion has also prompted some of the biggest conventional players to offer Retakaful services in the Middle East and Asia. For example, Hannover Re has a standalone Retakaful operation in Bahrain, and Munich Re obtained a Retakaful license in Malaysia.
11.7.1 Retakaful operators and reinsurance

In 1985, the new Retakaful operators were faced with many commercial difficulties. As newcomers to an industry that had existing global reinsurance companies with larger capital capabilities and a proven track record, Retakaful companies had to compete with much larger companies. As a result, they were not able to attract enough contributions from Takaful companies, which during this period were also relatively new and small. This commercial difficulty left some of these new Retakaful companies with no option but to take risks from direct conventional insurers. This was further complicated by the fact that some of the Shariah supervisory boards of the newly established Takaful companies approved on a temporary basis the reinsurance of some of their risks to reinsurance companies, because of a number of technical and commercial reasons, for the sole benefit of the Takaful companies.
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Another reason this practice took place was the lack of capacity by existing Retakaful companies to take larger risks because of their small capital compared with conventional reinsurance companies. Also, the fees charged by these Retakaful companies were relatively high compared with what was offered by conventional reinsurance companies. The level of professionalism, financial strength, claims-paying ability and the cost of conventional reinsurance companies proved to be more competitive, suiting the newly established Takaful companies that needed to be cost-effective and prudent in ceding their risks.
11.7.2 The challenges of the Retakaful industry

The challenges of the Retakaful industry relate to commercial issues as well as issues of Shariah and technical expertise. These issues are summarised below.
11.7.2.1 Shortage of fully capitalised Retakaful companies

There are only a few Retakaful companies in the global Takaful industry market. Relatively speaking, the existing Retakaful companies are still under-capitalised compared with conventional reinsurance companies. Most of these companies are not aggressive enough in their approaches to underwriting and marketing, which are always restricted by the capital adequacy issue. As a result, although the industry has a number of Retakaful companies, there is still a need for conventional reinsurers, especially for large risks or specialised lines of risk. The dilemma for the Retakaful industry is the limited size of the ceded contribution and the Takaful industrys capacity. Retakaful companies will not grow unless they are able to increase their capacities and/or market share. The focus on Takaful businesses only could also be a constraint. However, underwriting a conventional risk from a conventional direct insurer is not compliant with Shariah principles. Furthermore, a retro-Takaful capacity (retro-cession) is not yet available in the current global Retakaful market.
11.7.2.2 Adapting to change

Despite being in the market for more than 20 years, many Retakaful companies are still on a learning curve and lack professionalism, adequate capital and a suitable rating. Since the 1990s, two of the first three operators no longer exist; one has merged and the other has ceased underwriting. Retakaful operators must consider the rating issue as a priority that means fulfilling the requirements of rating agencies in terms of capital adequacy, solvency margins, operating performances, financial flexibility and liquidity.
11.7.2.3 Size of market

The Takaful niche market is still small and it is a challenging task for existing operators to write only Takaful businesses. The case of Best-re is a good illustration of this commercial reality. As the first Retakaful company in the world in 1985, it would have closed down by now had it not underwritten conventional risk.
11.7.2.4 Lack of specific expertise

Not only are these Retakaful companies small, they have little or no expertise in insuring specific risks, such as off-shore marine insurance. The need to have in-house expertise on specialised lines of risk is crucial in Retakaful companies, otherwise this kind of risk will have to be reinsured or retroceded to conventional reinsurance companies.
11.7.2.5 Competition with conventional reinsurers

Retakaful companies are also bound to compete with conventional operators that are appealing to Takaful niche market opportunities. Direct Takaful companies managers are very sensitive to the cost argument, ratings and past relations with the conventional reinsurance industry. Many Retakaful companies have to compete on a global basis with international players and regional reinsurers, which makes their successful market penetration more difficult and even more challenging.
11.7.2.6 Lack of a regulatory framework

Excepting Malaysia and Bahrain, many jurisdictions have no specific regulations on Retakaful. This lack of a regulatory framework adversely affects further growth of Retakaful companies. The existence of relevant laws or guidelines will ensure that Retakaful businesses are regulated and supervised, therefore enhancing transparency and disclosure, which is crucial in a global market environment.
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11.7.2.7 Acceptability of using conventional reinsurance

The Shariah concession or temporary approval for Takaful companies to reinsure some of its risks to conventional reinsurance companies must be critically reviewed. This concession was granted principally under the basis of Darurah (necessity), at a time when there was a legitimate lack of Retakaful capacity in the market. This review process is timely as many new Retakaful companies have been established. Therefore, the onus is on the Takaful companies to convince their respective Shariah supervisory boards that they have a real and bona fide justification to enter into a reinsurance arrangement. Otherwise, each Takaful company must enter into a Retakaful arrangement either with a local, regional or global Retakaful operator. The continual uptake of conventional reinsurance facilities in light of expanding Retakaful capacities would retard the growth potential of the Retakaful industry. At the same time, Takaful operations would not achieve full Shariah compliance as long as they continue to cede into conventional reinsurance. The initial Shariah concession was a temporary solution driven out of necessity and should not be taken as permanent.
Key points
Re-Takaful, as a new establishment, faces many challenges in the global reinsurance market, ranging from capital adequacy, rating, expertise, competition, legal framework, small market size of Takaful business and Shariah temporary approval on conventional reinsurance.
11.8 Internal controls relating to investments in a Retakaful fund

Internal controls ensure that any investment risks are minimised. The review of a groups system of internal controls ensures its effectiveness, adequacy and integrity. The review process is continuous, and is designed to manage rather than eliminate risk. This should adequately safeguard shareholders investments and the groups assets. The following board committees are established, each with specific responsibilities and each having their own Terms of Reference clearly defining their duties and obligations in assisting and supporting the board of directors: the risk management committee the investment committee. An effective risk management framework is essential to a group in its quest to achieve its corporate objectives, continued profitability and enhancement of shareholders value in todays rapidly changing market environment. With this in mind, a dedicated board committee known as the Risk Management Committee of the Board (RMCB) is established to develop and oversee the implementation of an enterprise-wide risk management framework.
11.8.1 The Risk Management Committee of the Board (RMCB)

The RMCB is responsible for: reviewing and recommending risk management strategies, policies and risk tolerance for the boards approval `reviewing and assessing the adequacy of risk management policies and framework for identifying, measuring, monitoring and controlling risks as well as the extent to which these are operating effectively ensuring adequate infrastructure, resources and systems are in place for effective risk management, ensuring that the staff responsible for implementing risk management systems perform those duties independently of the groups risk-taking activities reviewing the managements periodic reports on risk exposure, risk portfolio composition and risk management activities.
11.8.2 The investment committee

The investment committee, on the other hand, examines strategic investment proposals and makes decisions to optimise a groups returns on its investment activities. The members of the investment committee should meet regularly to ensure active involvement and that they keep up to date on the latest events in the market.
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11.8.3 Other key elements of internal control

Suitable controls and management information systems should be in place to enable an appropriate investment strategy to be implemented. Suitable controls should be in place to ensure exposures to investments are within the limits approved and set. Suitable systems should be in place to check on assets and liabilities mismatch. Appropriate procedures should be in place for assessing the credit-worthiness of counterparties with whom the group is dealing. Appropriate procedures should be in place for setting the prudent limits of aggregate exposure to certain categories of assets. The investment strategy and policy should be communicated clearly to the investment managers, internal and external, and the work of the investment managers should be monitored closely. Systems should also be in place, including stress tests and scenario testing, to consider the impact of a possible deterioration in investment conditions.
11.8.4 Other challenges faced by Retakaful operators

Achieving a critical mass: The key challenge for the Retakaful operator is attracting Retakaful contributions to reduce claims volatility and to achieve economies of scale. Retakaful awareness and acceptance: There is often misunderstanding about how Retakaful companies operate as their model is similar to conventional reinsurers. They need to raise awareness with Takaful operators. Lack of retro-Takaful capacity Market environment: Competition with conventional reinsurers is unavoidable so local Retakaful operators need to be on par for rates, services and financial security. Limited options: Options are limited for Shariah-compliant investment of Retakaful contributions. Also, there is the issue of lower investment returns as well as lack of long-term and high-grade financial instruments.
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As at April 2008, there were nine Retakaful operators serving the Takaful industry as per the table below. The capacity of a Retakaful operator is generally measured by capital adequacy and ratings. However, the operational capacity of any Retakaful company has yet to realise its full potential.
Table 11.2 Retakaful operators (as of April 2008)

Company Incorporation Capital (US$m) GPW for Takaful (US$m) 340 (nonlife) Rating Takaful model Business model
ACR Retakaful Saudi Re
2006
Paid-up: 620
A-(excellent) (AM Best) BBB+ (stable) outlook (S&P)
Takaful only
2007
Paid-up: 267
Convetional and Takaful Takaful only
Al-Faier re Labuan Retakaful
2008
Paid-up: 178.5 Issued & paid-p: 150
Comp: 1997 Retakaful: 2007 2005
11.0 (2007 est)
Wakalah for Retakaful and investment BBB stable (S&P) stable Wakalah policyholders Mudarabah for investment
Convetional and Takaful
Takaful Re
Paid-Up: 125 Authorised: 500
20.3 (2007)
BEST Re
1985
100
10-12 (2005 est)
BBB + (S&P) A (AM Best)
Takaful/ conventional mix Conventional /Takaful
Hannover Re
2006
Paid-Up: 55 Authorised: 150 Paid-Up: 31 Authorised: 154
15 (2007)
A stable (S&P)
Wakalah/ Mudarabah
MNRB Retakaful
2006
Started operation in 2007
Nil yet A (parent company)
Wakalah, operational Mudarabah/ Wakalah on investment
Takaful only for treaty. Allowed on Halal risk from conventional Takaful/ conventional mix
ARIL
1997
Paid-Up: 14.1 Authorised: 50
10.8 (20052006)
Not rated
Mudarabah
Source: Middle East Insurance Review and FWU Group
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The following table illustrates Retakaful capacities based on the value of business by sector.
Table 11.3 Capacities of Retakaful operators (as of April 2008)

(US$ million) ARIL BEST Re Takaful Re Hannover Re Labuan Retakaful MNRB Retakaful
Property/Eng Proportional 2 2 5 30 per program 3 3
Non-proportional Marine Proportional
30 per program
1.5
Non-proportional Family Takaful
3 0.1
4 1 per life 1 per life
1.5
3 1.66 to 3.33
Facultative (Fac) capacity Property 12 PML 12 6 20 PML 30 PML 3 3
Marine
4
Source: adapted from Middle East Insurance Review, August 2008 PML = Probable Maximum Loss
In terms of Retakaful treaties, Retakaful companies are able to absorb almost 90% of the required capacity as at April 2008.
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The next table shows that there are only a few cases of Takaful or co-operatives (KSA1 & 2 and Far East 3). The available Retakaful capacity cannot meet existing demand and this requires additional conventional capacity.
Table 11.4 Sample Takaful/Cooperatives treaties capacities

US$ million Property Engineering Accident Marine NonMarine XL Marine XL Motor XL
Africa
Sudan Middle East KSA 1 KSA 2 Kuwait UAE 1 UAE 2 Far East Company 1
30
12.5
0.5
2.25
122 60 11.2 34 17.75
122 60 11.2 34 17.75 1.0 1.5 2.5 20.5
26 8 1.5 8.5 2.4 4
13 4 1.5 2.5
30
Company 2 Company 3
39 73.8
16.8 29.7
2.4 9
16.2 15.7
9 7.5 6
Source: adapted from Middle East Insurance Review, August 2008
11.8.5 Opportunities for facultative policies

Opportunities for facultative policies are available, but the ability to meet demand also depends on other qualitative factors. To accelerate and provide leadership in the facultative business, Retakaful operators need to enhance their technical expertise to assist, price and write substantial shares as well as provide direction to Takaful operators. In addition, they need to offer solutions for specific lines and benefit from Bancatakaful by offering family Takaful, personal accident or medical Takaful off the shelf.
11.8.6 Completing the Takaful chain

The most important challenge in coming years is the need to provide a complete Takaful chain by creating a retro-Takaful capacity, which is now the missing link. Retakaful companies must be able to re-pool and spread risk among themselves so as to re-balance portfolios.
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11.8.7 Other constraints on the industry

In terms of future development and growth, the Takaful and Retakaful industry is an emerging industry that needs to be benchmarked against the 500-year-old conventional insurance industry. The Takaful and Retakaful industries are lacking in technical competence in areas of underwriting, quantitative analysis, financial analysis and product development. There is a dearth of Shariah scholars familiar with Takaful activities and Takaful practitioners conversant with Shariah principles. The industry needs jurist verdicts to address standards or best practices to guide the industry in addressing emerging issues. The robustness of various Takaful business models and pricing mechanisms is evolving as the industry matures. This only contributes to the accelerated learning curve required among industry participants, as well as the convergence towards more stable and sound Takaful practices. The adoption and implementation of systems and processes for Takaful operations also faces challenges in terms of the adequacy, resilience and completeness of the system when incorporating Shariah principles and requirements.
Exercise 11.4
Having considered the challenges to the Retakaful industry as discussed above, what would your proposal be to make the establishment of a new Retakaful company more successful compared with other Retakaful operators?

An existing Retakaful company needs to underwrite conventional insurance risks to survive market competition as the Takaful market share is too small to cover the cost of operations, not to mention rewarding shareholders. The company consults you on the possibility of underwriting conventional risk, but the conventional risk-based underwriting is limited to only 30% of the total amount of risk insured by this Retakaful company at any point in time. Outline the issues and propose a solution, if possible, to this request. You are advised to use your general knowledge as well as the skills that you have developed in this module.
Solution
The above scenario is a complicated issue that some Retakaful companies may face. From the Shariah perspective, a Retakaful company must not insure conventional risk for two reasons. The first is related to the nature of conventional insurance business practice, which is the transfer of risk instead of the pooling and distribution of risk among participating Takaful funds. The second reason is related to the underlying properties or activities that are being insured by conventional insurance companies. Two proposals could be relevant to this discussion: a. The Retakaful company may insure this conventional risk up to a limit of 30% of the total insured amount, provided some of the fees arising from this underwriting are channelled to charity in a manner similar to contributions made by public-listed companies that have some non-Halal income. Although this proposal may have some similarity to established stock-screening criteria and purification methodologies, its behaviour and outcome are not similar. The shareholders of the Retakaful company have direct control over the activities of the company and fees charged are known and not unpredictable from share performance, in contrast to investors in public-listed companies. b. Another proposal would be for this Retakaful company to negotiate with the cedent company or direct insurer to use a Retakaful contract arrangement instead of a reinsurance contract. Under this arrangement, the insurance company will not transfer their risk but will pool its risk with that of other Takaful operators which participate in this Retakaful fund. This may be accepted by some scholars, provided that the underlying properties or activities do not involve properties or activities that are non-compliant with Shariah principles, such as casinos, hotels, alcohol warehouses or factories, or financial institutions buildings. Retakaful based on a facultative policy (as will be discussed later) may suit this proposal better.
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11.9 Retakaful and retro-Takaful

Section 11.7 outlined the challenges faced by the Retakaful industry in the early period of its development. These challenges led many Takaful operators to reinsure some of their excess risks with conventional reinsurance. This practice has been justified by the following Shariah arguments (CDIF/2/9/172): a. the absence of Retakaful companies or the inability of existing Retakaful companies to cover all of the underwriting risks of Takaful operators, or some specific lines of risk that are beyond the expertise of Takaful operators b. the transfer of risk from a Takaful operator to a reinsurance company should be proportionate to the actual or estimated need of the risk transfer; the transfer cannot be based on a simple needs basis as Takaful operators have an obligation to ensure all their activities are compliant, including reinsurance. This is the Shariah position commonly practised since the early 1980s. The capacity of the existing Retakaful companies is still insufficient to cover the overall needs for Retakaful and the requirements of Takaful operators around the globe. The option to reinsure is subject to thorough scrutiny by both the management of the Takaful operators and their Shariah supervisory boards based on a mismatch of needs and capacity. This is to avoid the prolonged use of the Fatwa that permits reinsurance by a Takaful operator on a necessity basis. This is important so as not to render the operations of Takaful companies non-compliant, as well as not to adversely affect the growth of the Retakaful industry.
11.9.1 The test of right of first refusal

The test of right of first refusal could be applied to the policy either by the regulator or by the Shariah supervisory board of Takaful operators to safeguard this requirement. Every time a Takaful company needs to transfer some of its risks to a third party, the offer shall go to any Retakaful company that is best suited to manage this excess or specific risk. Only where this or any other Retakaful company in the same capacity were to decline this kind of risk would the Takaful operator be entitled to transfer the risk to a conventional reinsurance company at the same cost or lower than the amount offered to the Retakaful companies. A proper policy on this requirement and its monitoring is crucial to sustain the further development of the Retakaful industry.
11.9.2 Mutual support and commitment

It may also be time to propose that a new corporate structure of Retakaful companies be developed to ensure mutual support and commitment by all Takaful operators. One such proposal is for governments or relevant parties, be they semi-government or corporate bodies, to establish a new Retakaful company whereby the shareholders are all Takaful operators in a particular country or region. The ownership of this company could be opened to other Takaful operators around the world. This proposal may be useful to attract all Takaful operators to jointly invest in a single entity that is beneficial to all shareholders.
11.9.3 The need for retro-Takaful

In addition to the need for Retakaful, there is also a need for retro-Takaful, an Islamic version of conventional retro-cession. Retro-cession is essentially the act of a reinsurance company retroceding some of the risks ceded to the reinsurance company to yet another reinsurance company. In the context of Retakaful, companies may re-pool their risk with other Retakaful operators. This is known as a retro-Takaful as it is based on risk distribution among Retakaful companies, managed by another company known as a retro-Takaful company. A Retakaful company that re-pools risk by sharing contributions from Takaful operators with other Retakaful operators is a retro-cessionaire. A Retakaful company that accepts the contribution from various Retakaful companies for risk sharing is a retro-cedent.
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For example, a Retakaful company that provides proportional or pro rata Retakaful to Takaful companies may wish to protect its own exposure to risks by buying excess of loss protection by sharing this risk with another Retakaful operator through retro-Takaful. Alternatively, a Retakaful company that provides excess of loss Retakaful protection may wish to protect itself against any accumulation of losses in different branches of business that may become affected by the same catastrophe. This may happen, for example, when a single windstorm causes damage to property, automobiles, boats and aircraft, and loss of life all at the same time.
11.9.4 The development of spirals

The process of Retakaful can sometimes continue until the original Retakaful company unknowingly gets some of its own business (and therefore its own liabilities) back. This is known as a spiral and is common in some specialty lines of business, such as marine and aviation. Sophisticated Retakaful companies are aware of this danger and through careful underwriting attempt to avoid it. The same principles of Shariah that are applicable to Retakaful will be applicable to retro-Takaful. In the event that there is no retro-Takaful capacity, some Retakaful companies may have to retro-cede some of these risks to a conventional retro-cession insurance company. In this case, all the Shariah guidelines imposed on Takaful companies reinsuring with conventional reinsurance companies will have to be followed.
Exercise 11.5
Outline whether there is a need for a retro-Takaful company to be incorporated at the present time and why.
11.10 Governance issues affecting the Takaful/Retakaful industry

Because of the nature of risk distribution in Takaful compared with risk transfer in the case of conventional insurance, six guiding principles specific to Takaful operations affecting Takaful and Retakaful operators have recently been introduced in an exposure draft Guiding Principles on Governance for Islamic Insurance from the Islamic Financial Services Board (IFSB). The exposure draft comprises three parts as follows: reinforcement of relevant good governance practices as prescribed in other relevant internationally recognised governance standards for insurance companies, while addressing the specificities of Takaful undertakings a balanced approach that considers the interests of all stakeholders and calls for their fair treatment an impetus for a more comprehensive prudential framework for Takaful undertakings. The IFSB develops standards and guidelines on best practices for the Takaful industry in order to achieve the following four objectives: to provide benchmarks for use by Takaful supervisors in adapting and improving regulatory regimes or, where necessary, establishing new ones to address regulatory issues, such as risk management and financial stability, for the Takaful industry to provide appropriate levels of consumer protection in terms of both risk and disclosure to support the orderly development of the Takaful industry in terms of acceptable business and operational models, and the design and marketing of Takaful products.
Exercise 11.6
A Takaful operator invites prospective participants to subscribe to a Takaful plan based on existing conventional insurance guidelines and regulatory requirements. Upon receipt of a premium contribution from the participants, the Takaful operator only reported the claims and redemption value without disclosing the surplus from the contribution. State the implications of objective (iii) (above) in governing such a practice.
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11.10.1 The guiding principles

The guiding principles apply to all Takaful undertakings, irrespective of their legal status.
Principle 1.1: Takaful operators (TOs) shall have in place in Takaful undertakings that they manage a comprehensive governance framework appropriate for their Takaful business models in which the independence and integrity of each organ of governance shall be well defined and preserved, and the mechanisms for proper control and management of conflicts of interest shall be clearly set out.
The importance of the independence and integrity of each organ of governance is to clearly define their respective roles and responsibilities. This is followed by the administration of effective and adequate mechanisms for proper control and management of conflicts of interest between the manager, as an agent based on Wakalah and Mudarabah contracts, and participants for protection and investment purposes.
Principle 2.2: TOs shall adopt and implement procedures for appropriate disclosures that provide Takaful participants with fair access to material and relevant information.
Among the essential mechanisms to ensure effective governance is the provision of appropriate disclosures to policyholders on material and relevant information. Such information facilitates proper accountability of the Takaful operator as well as the policyholders decision on surplus and investments.
Principle 3.1: TOs shall ensure that they have in place appropriate mechanisms to properly sustain the solvency of Takaful undertakings.
The solvency of Takaful undertakings rests with policyholders and not the shareholders as in the case of conventional insurance. However, the Takaful operator as a Wakil (agent) should employ an appropriate method of provisioning for estimated contingent liabilities. They should also retain an underwriting surplus as reserves play a crucial part in ensuring the solvency and sustainability of Takaful undertakings as a business concern. The operator should not exacerbate charges through fees or profit-sharing that deprive the surplus due to the policyholders. In addition, the Qard facility shall be made available in the case of deficits.
Principle 3.2: TOs shall adopt and implement a sound investment strategy and prudently manage the assets and liabilities of Takaful undertakings.
A sound investment strategy will consider the investment risk preferences of both the shareholders and participants by clearly communicating the investment criteria and expectations on such returns. It is primarily in the interest of policyholders that the surplus increases proportionately with the shared return. Proper administrative procedures are instituted to safeguard the risk fund in the interest of the policyholders. Because of the distinct nature of Takaful and Retakaful businesses, which places a higher degree of trust on the operators to manage the policyholders funds for both protection and investment purposes, these guiding principles are meant to ensure that an adequate governance framework, mechanisms and control over appropriate disclosures are adopted. These would instil greater confidence in the participants in terms of safety of the risk fund, as well as the soundness of the strategies applied to the investment fund.
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11.11 Conclusion
This chapter has shown that the contract of Tabarru is extended and applied in Retakaful operations in the form of proportionate or non-proportionate facultative or treaty arrangements. Ceding the risk in Retakaful practice does not actually transfer the risk but re-pools the risk among various Takaful funds. Occasionally, as and when the need arises, Retakaful companies need to collaborate with reinsurance companies to retro-cede their large risk exposures. This phenomenon is expected to persist until new forms of retro-cession provide greater participation by reinsurance companies in a Shariah-compliant manner. The lack of expertise in the Retakaful industry to provide leadership to Takaful operators in new categories of risk is pertinent to the growth of the Takaful industry as a whole. Finally, additional governance principles promulgated by IFSB require a more extensive governance framework, mechanisms and control to protect the interest of the participants.
11.12 Summary
Having read this chapter the main points that you should understand are as follows: the principal benefit of reinsurance is to allow the insurance company to assume greater individual risks than its size would otherwise allow, and to protect an insurance company against losses the term cede technically means the assignment of rights to another entity, while retro-cession is the transfer of risk from one reinsurer to another Treaty Retakaful policy is a standing agreement by the reinsurer/Retakaful operator to accept all risks transferred/pooled by the insurer/Takaful operator that fall within the scope of the agreement, which is reviewed on an annual or periodic basis in facultative Retakaful, the ceding Takaful company cedes and the Retakaful operator assumes all or part of the risk assumed by a specified Takaful policy proportional reinsurance/Retakaful involves one or more reinsurers taking a stated percentage share of each policy that an insurer or Takaful operator underwrites to accelerate and provide leadership in the facultative business, Retakaful operators need to enhance their technical expertise to be able to assist, price and write substantial shares, as well as provide direction to Takaful operators retro-Takaful is an Islamic version of conventional retro-cession, the act of a reinsurance company retro-ceding some of the risks ceded to the reinsurance company to yet another reinsurance company the Islamic Financial Services Board (IFSB) has recently introduced an exposure draft, Guiding Principles on Governance for Islamic Insurance, to tackle the nature of risk distribution in Takaful, compared with risk transfer in the case of conventional insurance the challenge is to provide a complete Takaful chain by creating a retro-Takaful capacity, that is where Retakaful companies can re-pool the risk with other Retakaful companies so as to rebalance their portfolios and spread the risk.
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Shariah and strategic issues on reinsurance vis--vis Retakaful The Best Cover Retakaful company is seeking to be licensed as a Retakaful company in one of the GCC (Gulf Co-operation Council) countries. Its stated mission is to actively contribute to the growth and development of the Takaful industry in accordance with Shariah principles by offering world-class standards in products, services and rating. Instead of offering the services to all lines of Takaful risk, the company decides to focus on general Retakaful that will cover the risks of property, engineering, marine and liability. It will also provide Retakaful capacities for engineering projects against all risks including construction, erection and machinery breakdown cover. The company will write the risks based on either proportional or non-proportional Retakaful loss. However, the company will not underwrite aviation, off-shore marine energy or long-tail liability covers. According to the regulators rule book, the required solvency margin is calculated on the basis of the premiums written and claims incurred by the fund. A risk factor is applied to reflect the differing risk profiles of different classes of Takaful. Also, all Takaful and Retakaful firms to be licensed in that jurisdiction must organise and operate their business according to the Wakalah model. Specifically, in exchange for the provision of management services to Takaful operators, the shareholders for the Retakaful company receive a specific consideration, which is a Wakalah fee that cannot exceed 30% of the gross contributions ceded. For Takaful assets invested on behalf of the Takaful operators, the Retakaful operator will use the Mudarabah model and receive a set percentage of the profits generated from the investment portfolio. In addition, any new Retakaful company must include in its articles of association a commitment to provide interest-free loans in the case of a deficit in the Retakaful fund. However, the Retakaful company must not recover its total interest-free loan from the Retakaful fund in a period of less than two years.

1. Based on the model prescribed by the regulator above, what is the most relevant issue to be considered by this new Retakaful company? (A) (B) (C) (D) 2. Amount of interest-free loan Expenses of the company Underwriting surplus Investment profit
If a Takaful company were to approach this Retakaful company for the risk of off-shore marine energy, what will the response of the Retakaful company be? (A) (B) (C) (D) Advise the Takaful company to reinsure with a conventional reinsurance company Underwrite this risk and proceed with retro-cession Advise the Takaful company to seek Retakaful services from other Retakaful companies Offer a non-treaty Retakaful product
3.
Suppose the total expenses of the Retakaful company are US$100 million, the gross contribution is US$500 million and the investment profit due to the Retakaful company is US$20 million, how much would this Retakaful company achieve in terms of its net profit (before tax and Zakat) based on the Wakalah model. (A) (B) (C) (D) US$150 million US$70 million US$50 million US$100 million
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4.
The policy that the Retakaful company must not recover its interest-free loan from a Retakaful fund in less than two years would adversely affect: (A) (B) (C) (D) the cost of capital the rating of the company the investment income of the Retakaful fund the underwriting surplus.
5.
Which of the following Takaful operator policies would be suitable to be ceded on a facultative non-proportionate basis to the Retakaful company? (A) (B) (C) (D) Motor vehicle policies for luxury cars Mortgage plan for condominiums A high technology plant producing micro-chips Family group Takaful for professional workforces

1. The above Retakaful company has been approached by a Takaful company that seeks to subscribe a 40% quota share treaty of Retakaful on an engineering risk of US$50 million. A claim of US$10 million is made against the Takaful operator. Describe what a quota share treaty of Retakaful is and how the claim will be paid by the Retakaful company. What are the options available to the Retakaful company in the case study if Takaful companies choose to cede risks of aviation, off-shore marine energy and long-tail liability covers to it? Explain how you make this new Retakaful company successful in underwriting sufficient business. What are the risks if the Retakaful company in the case study were to confine its business lines of risk coverage exclusively to aviation and off-shore marine energy? What are the critical success factors of Retakaful in direct competition with conventional reinsurance?
2. 3. 4. 5.
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Chapter eleven answers

Exercise 11.1
Based on the principle of Tabarru, as discussed in chapter ten, the Takaful operator on behalf of the participants may cede the contributions of the participants at the level of a Takaful fund to a Retakaful operator. In doing so the capacity of the Takaful operator to underwrite new business is also enhanced. From an industry perspective, larger exposures are distributed among the participants of several Takaful operators. Essentially, Retakaful pools the contributions of various Takaful operators who cede some or all of the contributions of their Takaful fund participants into one common pool, known as a Retakaful fund. If the prescribed risk involves one of the risks in this new pool, the Retakaful operator will use this pool to pay all the claims arising from this risk. Effectively, the participants at the primary level have also agreed to contribute to that common pool of funds to provide mutual indemnity at another level among participants of various Takaful operators.
Exercise 11.2
Since it is a 50% quota share for a claim proportionate treaty, the 50% contribution received by the Takaful ABC will be channelled to Retakaful XYZ. Takaful ABC will earn the Wakalah fee from its participants and will pay part of the Wakalah fee to Retakaful XYZ. Upon the event of a claim of $200,000 from a participant of Takaful ABC, it will escalate a $100,000 proportionate claim to Retakaful XYZ. Both Takaful and Retakaful will share the claim from the funds available in both the Takaful and Retakaful risk fund respectively.
Exercise 11.3
As a matter of comparison, there is no structural difference between a Takaful company and a Retakaful company in terms of their expected roles and obligations. Although the obligation to pay all the claims irrespective of types of Retakaful, proportionate or otherwise, treaty or non-treaty, falls upon the Retakaful fund, the shareholders of a Retakaful fund must make this provision in the case of a deficit. This is required under law to sustain the survival of either the Takaful or the Retakaful business practice. Thus, the requirement of capital adequacy and the solvency margin are equally applicable to both Takaful and Retakaful companies respectively.
Exercise 11.4
The most important requirement for a new Retakaful company is to have a good rating, such as an A rating, which would appeal to global stakeholders such as regulators and Takaful companies. The rating will enhance the attractiveness of the Retakaful operator and increase the willingness of some operators to deal with this company. Following that, any new Retakaful company will have to decide whether to offer either the full range of lines of risk or a specialised line to suit a niche Takaful market. A proper business segment risk analysis by the company is crucial to underwrite sufficient businesses from Takaful companies.
Exercise 11.5
The answer depends on the current capacity of Retakaful companies. If the capacity is still insufficient, then some Retakaful companies may have to retro-cede some of the contributions of primary Takaful participants to a conventional retro-cession insurance company. In this case, there is a need to establish a retro-Takaful company. However, if the existing capacity of Retakaful companies is relatively sufficient and stable, the need for this retro-Takaful company may not be that relevant if it cannot underwrite sufficient business from Retakaful companies. Only with the availability of sufficient data on this need can the question be addressed satisfactorily.
Exercise 11.6
Based on the above objective, the disclosure of the allocation of contribution to risk and investment funds is pertinent to ensure that participants are aware of mutual risk protection and investment risk exposures. The management of an underwriting surplus or deficit in the interest of the participants needs to be disclosed accordingly, subject to the regulatory prudential guidelines of the particular jurisdiction as well as any punitive measures.
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1 2 3 (B) (C) (B) Since the Wakalah model is adopted and a maximum cap of 30% for a Wakalah fee is specified, the operator should be efficient in minimising its expenses. Although general Takaful services are provided, certain risk areas, such as off-shore marine, may require specialist cover not available with the company. Net profit = Wakalah fee - expenses + investment profit = [0.3 X (500) 100] + 20 = US$70 million 4 (A) An interest-free loan by the Retakaful operator to support the deficit arising from claims implies utilisation of shareholder funds without a specified return. Effectively, the cost of capital is higher with higher loans. Facultative policies are negotiated on a case-by-case basis and customised to the specific risks of the Takaful operator. In the case of a high-technology plant producing microchips, such risks of the specialised industry sector is negotiated on a case-by-case basis.
(C)

1. 2. With a 40% quota share treaty of US$50 million policy, the Retakaful operator will address the US$4 million claim by the policyholder. It appears that this Retakaful company will not underwrite risks relating to aviation, off-shore marine energy and long-tail liability covers as these are specialised lines of risk that require appropriate expertise. However, instead of declining the request by Takaful operators, this Retakaful company may accept this risk but will need a back-to-back arrangement of retroTakaful; otherwise, a retro-cession is needed to take away the risk from the Retakaful company. There could be many proposals to make this new Retakaful entity more competitive and successful. It may invite existing Takaful companies to become shareholders in the new entity so there is a commercial reason to cede the risk at the level of Takaful operators to this Retakaful entity. Also, a strong rating grade for the new company through sufficient capitalisation and an interest-free loan fund in the case of the deficit of the Retakaful fund, among others, will appeal to many parties including regulators, Takaful operators and retroTakaful or retro-cession insurance companies. It is also crucial for the new entity to ascertain the primary need in the Retakaful industry so it can fill the gap more effectively instead of providing the same services that other Retakaful operators are offering. The decision to be specialised in particular lines of risk could be useful or bad depending on the market-gap analysis and technical expertise of the Retakaful company or retro-Takaful or retro-cession companies. If the Retakaful market lacks an operator with the technical expertise and financial capacity in these lines of risk, then the above decision is not only timely but also fulfilling. However, if there is no significant need for this kind of risk or there is a considerable need but the Retakaful company is lacking the expertise and financial capabilities, then the above decision will be risky and unjustified, unless the company has the full support of another retro-cession company in this line of risk. The critical success factors for Retakaful are also similar to those necessary to make the Takaful industry more prominent. These include capital adequacy, proper rating grades, effective and efficient distribution channels, an adequate and robust legal framework, as well as technical expertise. Factors peculiar to Retakaful are the policies of certain regulators and Shariah boards to make Retakaful, if not mandatory, then the first right to be considered by Takaful companies when considering the pooling of risks to a larger Retakaful fund. All of these factors must be undertaken collectively to make the strongest impact on the positive growth of Retakaful industry in the modern world.
3.
4.
5.
Notes:
1. FWU Group in Malaysia 2. Takaful Ikhlass Investment Policy incorporating Bank Negara Malaysias regulations and guidelines 3. Munich Re Canada, June 2006 4. The IFSB exposure draft Guiding Principles on Governance for Islamic Insurance (Takaful) Operations can be found at www.ifsb.org
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Chapter twelve
Islamic derivatives as risk management tools for the Islamic financial services industry
Learning outcomes
By the end of this chapter you should be able to: assess the effective adoption of relevant contracts for derivatives analyse the impact of changes in market and Shariah rulings on derivatives evaluate the suitability of various types of derivatives to mitigate various financial risks analyse the distinction between hedging and speculation.

Importance of derivatives as hedging instruments in Islamic financial services industry Shariah-compliant derivatives as risk-mitigation tools Applied Shariah contracts in Shariah-compliant hedging instruments Types of Shariah-compliant hedging instruments for currency, market and investment risks Need for Islamic hedging mechanism to hedge real and bona fide financial risk Case study: currency hedging mechanism and issues
12.0 Introduction
Islamic financial instruments are continuing to develop and increase in sophistication to meet investor needs. The banking, capital markets and Takaful sectors have witnessed a plethora of product innovation that should improve the competitiveness of the Islamic finance industry. In periods of innovation it is inevitable that new issues will arise to accompany this drive for sophistication. One issue is the question of Islamic risk management and the related hedging instruments under the purview of Shariah principles. This chapter examines financial risk mitigation in the Islamic finance industry as exhibited by the product features of Shariah-compliant derivatives. The introduction of these structures and the challenges caused by variations in Shariah opinions, as well as changes in market conditions, are analysed and evaluated. We also consider the application of financial arrangements using derivatives and their impact on market confidence in line with Shariah and regulatory requirements. Finally, we examine the distinction between approved hedging mechanisms and non-approved speculative activities.
12.1 Risk management for Islamic finance
Two key questions need to be addressed in Islamic finance: what is the Shariah position on risk and should it be avoided, hedged or simply accepted as a business reality? Risk taking or risk exposure is fundamentally a non-prohibitive item under the purview of the Shariah principles. In the eyes of the Islamic finance industry, risk is associated with, and is inevitable in, all Islamic financial transactions to justify profit earning. It is inherent in all financing and investment assets that underline most Islamic financial transactions.
12.1.1 Risk versus uncertainty

A distinction that needs to be made is that risk is not the same as uncertainty. Under no circumstances can uncertainty (Gharar) exist in the context of Islamic financial transactions. Gharar, as opposed to risk (known in Arabic as Makhatir), relates to any uncertain element affecting the object of the sale. This includes the quantity, price, delivery details and quality of the object being sold or leased, which could be detrimental to one of the parties if not clearly specified. Uncertainty relating to elements not clearly specified must be avoided in any contract of exchange such as sale or lease. From a contractual perspective, uncertainty of the elements can be removed if the relevant or concerned party provides reasonable disclosure of information. Risk or Makhatir on the other
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hand relates to the uncertain outcome of the transaction and cannot be avoided by parties to the transaction as it relates to the credit, market, business or investment risks that are beyond their control. An example is an exporter who sells goods to an importer. The exporter may be exposed to currency risk if the payment is to be made in the future and in a different currency. This form of risk is different from uncertainty as this type of risk cannot be avoided. Risk is an unavoidable and inevitable outcome of all commercial transactions involving almost all types of asset classes such as currency, shares, Sukuk and commodities, as well as the expected profit from either trading or investment activities. Modern financial theories have advanced many financial techniques in an attempt to manage risk. Management of risk includes hedging and distribution, as well as transfer of risks to third parties that are willing to assume part or all of the risk for a consideration. Islamic law does not object to efforts to manage risk as the proper management of risk encourages more real economic activities in society, therefore improving wealth creation and wealth distribution. In a business world where modern currencies are no longer tied to the Gold Standard, one can easily understand, for example, how mitigating currency risk in international trade encourages transactions across different jurisdictions involving the use of different currencies. One can also appreciate the impact on international trade if currency risk hedging was not available. Economic and financial realities in the financial market, including the effects of inflation and deflation, the floating character of the cost of funds, and the mismatch between long-term assets (financing) and short-term liabilities (deposits), potentially pose many challenges to Islamic businesses and Islamic financial activities alike. They must be understood in the context of the current socio-political landscape, which is essentially based on the concept of nation states instead of one state and one standard for the whole world. Central to these challenges is the need to develop financial techniques of risk management using derivatives instruments while incorporating relevant Shariah principles into the realities of contemporary business.
Key point
While uncertainty (Gharar) in the elements of a contract must be avoided to render the contract valid, risk (Makhatir) is fundamentally a non-prohibitive item that can be mitigated to reduce the negative impact on the outcome of the business or financial activity.
Exercise 12.1
Flexi Produce is a London-based global trading company that procures staples such as barley, wheat, coffee and soy in West Africa. These staples are sold on credit to various food producers around the globe at a mark-up price that is normally paid two months after the point of sale. The company has recently signed a variety of contracts with various farmers in West Africa. These contracts are based on a forward contract whereby the company and the respective farmers agree to buy and sell a particular specified commodity at a certain US Dollar price. The payment and delivery of the specified commodity will take place six month from the date of the contract. The company has also entered into a forward (Foreign Currency Exchange) FOREX with its bank in London to hedge its forward currency risk as the payment of credit sales to food producers will be in other currencies, such as Singapore Dollars, Japanese Yen, Chinese Yuan Renminbi (CNY) and Euros. Based on the above description and relevant discussions in CDIF/1/1/26-29, identify whether the following elements involve Gharar, Makhatir or Riba. Credit sale of staples based on a certain mark-up Forward contract whereby the 2 counter values are deferred Forward currency contract Purchase of staples in US$ and sale of the same in other currencies on credit Future delivery of staples for an advance payment
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12.2 Overview of hedging and derivatives

The next section defines the key terms of hedging and derivatives that are the central concepts to this chapter. Other key terms such as forward, options and swaps are discussed later in the chapter.
12.2.1 Hedging and derivatives

From a general financial perspective, hedging is an attempt by a party to reduce the level of risk faced in a financial transaction. Generally speaking, the hedger, unlike a speculator, is someone who has a real risk to mitigate. A hedger, unlike a speculator, is a person who is being exposed to risk prior to undertaking any hedging instruments. The reason that has led him to resort to this hedging instrument is to hedge his real exposure to the risk arising from his other commercial or financial transactions. A speculator, on the other hand, may participate in these hedging instruments in an attempt to benefit from this instrument. Prior to this, he has no real risk to hedge. In some contexts, hedging is the process of ensuring that the actual flow of funds is sufficient for investment and financing activities planned by financial institutions. In the context of asset-liability management, hedging is defined as an attempt to remove any imbalance between the assets and liabilities of a company. Hedging is not a product per se but in most cases it is the reason for entering the derivates markets. Hedgers use derivatives to offset exposure resulting from their business activities. Hedgers employ a variety of techniques, such as futures contracts, options, interest rate swaps and forward FOREX, to offset the risk of loss from price fluctuations in the market. A customer in Islamic finance who needs to hedge currency risk exposure may have to use an Islamic forward FOREX through a compliant structure. Hedging is not an instrument, but a strategy designed to minimise exposure to unwanted business risk while allowing the business to profit from an investment activity. The instruments used in hedging purposes are mainly derivatives in nature.
12.2.2 Criteria or characteristics of hedging instruments

The basic criteria or characteristics of hedging instruments are: sensitivity to price, calculated based on changes in the value of assets or liabilities for each degree increase in profit/interest; the value is usually in percentage changes practicality, notably in terms of costs; this means that the use of hedging instruments must be cost-efficient and the hedging may not exceed the amount of financing necessary to ensure that no losses are incurred. Derivatives generally refer to products whose value is derived from other underlying assets. The financial benefit or gain of these products is essentially based on the performance of another product. In short, a derivative investment is a financial asset that derives its value from its underlying asset. The underlying asset could be a commodity or another financial asset. Therefore, unlike stocks and bonds that represent a direct claim, derivatives can be thought of as a claim on a claim.
Key point
Hedging is an activity conducted to reduce real business risk using relevant derivatives instruments.
12.3 Basis and rationale of conventional derivatives products

The basis of calculating risk in the conventional financial market is largely based on interest or rather the premium over the cost of borrowing. Interest or cost of borrowing is applied not only to moneylending activities but also, ironically, to currency risk, market risk and interest rate risk. Interest, which is the premium for money loaned out, has been accepted as the central foundation of a modern financial landscape, including derivative products. The following is a brief illustration of how interest influences the financial behaviour of conventional derivatives products and instruments.
12.3.1 Conventional forward contracts (non-currency)

To help you understand the nature of a conventional forward contract (non-currency), we will use an example of a company that has just made an investment decision.
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A real estate company, mutual fund or a REIT (real estate investment trust) decides to invest in the shares of a public-listed company that is undertaking a variety of infrastructure projects around the world. Aware that the value of the projects may fluctuate over time, which would subsequently affect the value of the shares of this company, the company is advised not to purchase the shares on a spot basis at US$90 per share. Instead, it is advised to purchase the shares on a forward basis in one years time at a fixed price of US$100.50 per share. The conventional forward contract requires the price to be fixed for the future payment and future delivery of the underlying asset. If each share is worth US$150 in one years time, then the investor company may purchase it through the forward contract and sell it immediately, if it likes, to record a profit of US$49.50 per share. However, if each share is only worth US$50 in one years time, then the company is still obliged to purchase it for US$100.50 per share. The loss is US$50.50 per share. The counterparty, having entered into this forward contract to sell the shares in one years time, will have to assume the market risk of the shares in one years time. Having considered the above scenario you should now be asking yourself: Why is this counterparty willing to assume this risk? Is this financial behaviour justified, at least in conventional finance theory, as this forward contract tends to be a rather highly speculative? Would the price of US$100.50 per share constitute the fair value of the share in one years time? The answer to some of these questions can be found in the conventional financial market. There is no obligation for the investor and the counterparty to enter into this forward contract. The counterparty may, however, borrow US$100 from a bank and purchase the shares in the spot market, and then hold them for one year for the future delivery. Let us suppose that one years interest rate is 0.5% per annum and that shares are expected to pay a dividend of $0.20 during the year. In one years time, the counterparty has to repay the US$100 borrowed plus $0.50 interest, although the actual funding cost may be set-off by the US$0.20 dividend received. The net cash flow per share in one years time is minus US$100.30. Therefore, the counterparty in the forward transaction should have charged at least US$100.30 in the forward contract to break-even in the transaction. Thus, US$100.30 is the fair or theoretical forward purchase price using this calculation, which is backed by the interest expense rate. Obviously, the counterparty will charge a forward purchase price that is higher than US$100.30 to make some profit. This shows how the interest rate influences the pricing of a forward contract deal, although the underlying asset is the share and not the loan of money.
12.3.1.1 Forward FOREX

The same behaviour is observed in conventional forward FOREX, which is used to hedge currency risk. The interest rate is still relevant and significant to the calculation of the value of the currency in the future.
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A Malaysian company exports goods to a client, an importer in Bahrain. The Bahraini company pays for the goods in Bahrain Dinar (BD) amounting to BD10 million and the payment is due in two months time. The current spot rate of FOREX is 1 BD/1.5 RM (Malaysian Ringgit), which means that one Bahrain Dinar buys 1.5 Malaysian Ringgit. If the invoice was due for immediate settlement, then the Malaysian company could sell the BD10 million on the spot FOREX market and receive in return RM15 million. However, the payment is due in the future. If the Bahrain Dinar weakens over the next two months, the Malaysian company will end up with fewer Malaysian dollars, potentially eliminating its profit margin for the export transaction. To add more reality to the scenario, suppose that the Malaysian company incurs a total cost of RM13.5 million on the deal and aims to achieve a margin over the cost of at least 10%. If the spot exchange rate in 2 months time is 1.5, then the Malaysian exporter will receive RM15 million for selling the BD10 million paid by the client resulting in a profit of 11% over the Malaysian Dollar costs incurred. On the other hand, if the spot rate turns out to be 1.4, then the Malaysian company will receive only RM14 million for selling the BD10 million; the profit is only RM500,000 and the margin of profit is approximately 4%. If the spot rate turns out to be 1.2, then the Malaysian company will suffer the loss out of currency loss.
Given the above scenario, the Malaysian company decides to enter into a forward FOREX to hedge the currency risk that results from being paid in Bahrain Dinar in two months time. The company could enter into a two-month forward FOREX with its bank at the agreed rate of exchange of BD/ RM1.4926. Following the agreed rate of exchange in two months time, the Malaysian company will pay BD10 million it received from its Bahraini client to the bank/counterparty and will receive in return RM14,926,000.
12.3.1.2 Calculating the FOREX exchange rate

The exchange rate in the future is fixed by the bank/counterparty. The formula used traces the price of interest for the currency involved in this forward FOREX contract to achieve what is deemed to be a fair value of rate of exchange in two months time. The theoretical or fair rate for entering into an outright forward FOREX deal is primarily established by the spot exchange rate and the interest rates of the two currencies involved. To help us understand whether the exchange rate of one BD to RM1.4926 is fair or otherwise (from a conventional finance theory), let us assume the following market information: BD/RM spot FOREX exchange rate = 1.5 RM interest rate = 3% per annum = 0.5% for 2 months BD interest rate = 6% per annum =1% for 2 months According to the above available data, BD1 equals RM1.5 on the spot FOREX market. BD can be invested for two months at an interest rate of 1% for the period. RM can also be invested at a rate of 0.5% for the same period. In the spot market, BD100 equals RM150. However, BD100 invested today would grow to BD101 in two months time. RM150 would grow at a somewhat slower rate because the RM interest rate is lower at 0.5% for the same period of two months. In two months time, it would be worth RM150.75. Therefore, the value of BD against RM in two months time is: BD101 = RM150.75 Therefore: one BD = 150.75/101 = RM1.4926 The above illustrations explain how to calculate a fair value of the shares and currency in the forward market using the basis of interest expense and interest income respectively. Although Islamic finance has no relationship with interest expense or interest income, it essentially has to deal with these and other situations as its client may face these financial realities and their inherent risks. How Islamic finance is supposed to deal with these situations is discussed later in this chapter.
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12.3.2 Conventional options

An option is essentially a contract that gives a party the right, not the obligation, to purchase or sell an underlying asset at a later date at a fixed price. However, to enjoy this right this party is expected to pay a premium to the seller of this right. This premium will be forfeited if the party concerned does not continue with the right to either sell or purchase. Without this mechanism, a purchaser of shares, for example, must pay US$1 million to purchase XYZ shares at a spot price. This will expose him to a market risk for the shares as the value of the shares may depreciate after they have been purchased. Therefore, from a risk-management perspective, the purchaser may, for example, pay US$100,000 to get the right to purchase these shares in the future if the option price is profitable to the buyer of the right. If the value of the shares depreciates, he may decide not to go ahead with the deal, but his loss is limited to US$100,000, the cost of the option to purchase.
12.3.3 Conventional swaps

Hedging is also important using both the swap and credit default swap techniques. Swaps could be applied to currencies as well as interest rate risk as far as the conventional financial market is concerned. A swap is essentially an arrangement to swap or exchange the fixed to floating involving either an asset or an obligation. In the following example an interest rate swap is highlighted. A Malaysian company exports goods to a Bahraini company. Suppose the Malaysian company has borrowed RM10 million from a commercial bank on a 10-year repayment schedule. The interest payment on the loan is made annually in arrears, with the next payment due in exactly one years time. The rate of interest is reset every year according to the 12-month RM interest rate, plus a margin charged by the lending bank at 75 basis points (0.75%) per annum. Since the rate of interest on the loan is reset annually, based on the floating interest rate of the country and a fixed margin, the Malaysian company is exposed to rising interest rates that would increase its borrowing costs and hence could potentially affect its profitability. Here the company may need to hedge its exposure to interest rates which are floating over 10 years. Conventionally, the company will approach another bank/counterparty to swap its floating asset for a fixed obligation to avoid a significant mismatch between the companys floating liabilities and fixed assets.
In swap transactions between a company and a bank/counterparty, the notional amount or principal must be fixed at the outset against which the floating rate and fixed rate of interest will be calculated. This notional rate is never exchanged; it is used to calculate the payments at every interval, such as one year in the above example. Prior to this swap deal, the company is contractually obliged to repay the loan to the lending bank at an interest rate that is floating over 10 years based on the prevailing interest rate. The company would prefer to have a floating asset from another bank/ counterparty, which is also based on the floating rate as per the prevailing cost fund, to effectively use this asset to repay the obligation which is floating in character. Financially, using a floating asset to repay a floating obligation would be perceived as likely to hedge the risk of increasing the cost of borrowings which are floating in character. For this purpose, the counterparty bank will agree to make a return payment on regular future dates based on a variable rate of interest applied to the notional principal. The company, in return for receiving a floating income from the bank/counterparty to the swap deal, will agree to pay a fixed rate of interest applied to the same notional amount on regular future dates to this counterparty bank. When a floating payment is made, the rate is reset to establish the next floating payment in the sequence based on a benchmark return rate, such as KLIBOR in the case of a Malaysian company and a Malaysian lending bank. The bank/counterparty will agree to make a return payment on regular future dates based on a variable rate of interest applied to the same notional principal. When a floating payment is made, the rate is reset to establish the next floating payment in the sequence, based on a benchmark reference rate such as KLIBOR in the above case.
Key point
Futures, forwards, options and swaps are traditional instruments in conventional derivatives markets designed to hedge different types of risks involving, for example, currencies, commodities, interest rates and shares.
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The basis of pricing of conventional derivatives products and instruments has been primarily based on interest. Explain whether this would be relevant to Shariah-compliant derivatives instruments.
Solution
The pricing mechanism in Islamic finance has been very complicated and, to a considerable extent, tricky and confusing. The reference to conventional cost of funds is also observed in both retail and corporate Islamic banking products, such as house financing, car financing, Islamic credit cards, as well as project finance and Sukuk. Therefore, the reference to interest in pricing Shariah-compliant derivative instruments is not an exception to other Islamic financial transactions. This is permissible as the interest is merely a reference point instead of being an integral component in the structure of the Islamic-based derivatives products. The price of an Islamic call option, for example, may take into consideration the interest income that this option may generate if this amount of money were to be deposited in interest-bearing account.
12.3.4 Credit default swaps

A discussion on conventional derivatives would not be complete without making reference to credit default swaps (CDS). CDSs became popular in the early part of the 21st century and were the core of the toxic debt problem. Many of the big financial institutions collapsed in 2008/09 as they had a large exposure to CDS acting as the seller of protection or rather an insurer or guarantor. A CDS is a form of insurance against default on a loan or a bond. It involves two parties, namely the buyer of protection and the seller of protection. Essentially, the buyer of protection sells any risk over the reference asset that is to be protected to another party, who is the seller of protection. The asset in question can be a loan or a bond or a set of such obligations. The borrower or the issuer of the bond is called the referenced credit. The buyer of the protection pays a periodic premium to the seller of so many basis points per annum applied to the par value of the referenced asset. In the case of some credit events, the seller of the protection has to take delivery of the referenced asset and pay a set amount of money to the buyer of the protection (normally the par value of the asset). Or the buyer of the protection can retain the asset but he is paid cash in compensation. The credit events may include bankruptcy, insolvency, failure to meet a payment obligation when due, and a credit ratings down-grade below a certain level. Obviously, the CDS manifests a clear risk transfer from the creditor/investor to an insurer for a premium or payment that is based on a certain percentage of the par value of the asset and is, therefore, non-approved from the Shariah perspective. If the underlying asset or reference asset falls below the standard of good quality in terms of repayment by the borrower/issuer, the seller of the protection will likely bear a great loss, as occurred in the case of the sub-prime related assets in the global financial crisis of 2008/09.
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Based on your knowledge of the concept of Takaful (CDIF/2/7/134), outline whether risk transfer, in contrast to risk distribution, is permissible under Islamic commercial law. If your answer is no, outline a solution to risk transfer according to Shariah principles with special reference to CDS.
Solution
Based on the universally accepted Shariah principles, risk can be transferred from one party to another. However, scholars are divided on whether the risk can be transferred for a premium payable to the seller of protection, such as an insurance company, as well as the seller of protection in the case of CDS. The majority of scholars are of the view that risk, being an invalid asset for sale, as by its very nature it is uncertain in character, cannot be transferred or sold for a consideration. A minority of contemporary Muslim scholars argue that a risk, provided it is compliant, can be transferred to another party who is the risk-taker for a fee or premium. The solution to risk transfer should be risk distribution or risk pooling as practised in Takaful. Whether CDS can be structured in line with the risk distribution concept to be compliant to Shariah principles is a matter for Islamic financial innovation in the future. The fact that CDSs were blamed for the collapse of many financial institutions in the 2008/09 financial crisis was due to the CDS exposure to poor-quality underlying assets. The question of the acceptability of CDS from a Shariah perspective is not necessarily related to the quality of underlying assets which the CDS is exposed to and hence would require a more comprehensive approach to assess the validity and viability of such an instrument.
12.4 Risk management guiding principles

Contemporary Shariah scholars, who are directly involved in the Islamic finance industry, are of the opinion that the requirement to manage and reduce business risk is consistent with Shariah principles. This is based on the need to maintain the value of the asset involved, if possible, or to limit its exposure to depreciation. However, the mechanisms, instruments or contracts that can be used in managing this risk must be consistent with the principles of Shariah. Not all risks can be eliminated. There are risks that need to be maintained as an integral part of the contract feature and structure without which the contract lacks its legitimacy as an asset-based, compared to a money-lending, transaction.
12.4.1 Classification of risk

Risk can be classified either as that which comes as part and parcel of the contract or that which can be mitigated.
12.4.1.1 Risk that must be assumed as part and parcel of the contract
This type of risk cannot be evaded and is contractually mandatory as it is integral to the contracts legal structure and behaviour. It is based on the justification that the feasible benefits received by someone are based on the degree of risk of loss that is assumed. For example, in a sale and purchase contract, a seller is required to bear all risks associated with the commodity until the commodity is sold and delivered to the buyer. After the buyer has taken over the ownership, all of the risk is transferred from the seller to the buyer. This means that any loss, depreciation or falling commodity value will become the buyers responsibility, upon the ownership transfer.
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12.4.1.2 Risk that can be mitigated or hedged

This category of risk falls outside the risk described above. This form of risk can either be absorbed or mitigated. To apply such risk mitigation techniques, the following rules must be observed. a. Managing this category of risk must not violate the principle of returns must only be made available for those who bear risks. b. Risk mitigation instruments or techniques must not contain any element of Gharar. c. Risk mitigation instruments must uphold Shariah principles and only be applied on the type of risks that can be mitigated. d. Risk management must be confined to addressing real and bona fide risk (hedging) instead of taking advantage of market and currency risk (speculation).
12.5 Guidelines on Islamic risk management as per IFSB guiding principles

The Islamic Financial Services Board (IFSB) has set out 15 principles of risk management for institutions that offer Islamic financial services. Known as the Guiding Principles, the essential feature is that Islamic financial institutions (IFIs) are required to comply with Shariah rules and principles, especially the prohibition of generating profits without bearing any risks. The implementation of the Guiding Principles must be undertaken in compliance with Shariah and within the legal framework of the jurisdiction in which the IFI operates and should be commensurate with the size, complexity and nature of each IFI. The Guiding Principles were developed to complement Basel Committee on Banking Supervision (BCBS) guidelines that set out sound practices and principles pertaining to credit, market, liquidity and operational risks of financial institutions. The Guiding Principles address the controls from the perspective of IIFS; however, each supervisory authority has a responsibility to establish an appropriate enabling environment for these controls to be effectively implemented.
12.5.1 Risk management and reporting

Under Guiding Principle 1, the IFI must have in place a comprehensive risk management and reporting process, including appropriate board and senior management oversight, to identify, measure, monitor, report and control relevant categories of risks and, where appropriate, to hold adequate capital against these risks. The process should take into account appropriate steps to comply with Shariah rules and principles, and ensure the adequacy of relevant risk reporting to the supervisory authority. The other principles are grouped into six categories of risk. 1. Credit risk the IFI should have in place a strategy for financing, using various instruments in compliance with Shariah, whereby it recognises the potential credit exposures that may arise at different stages of the various financing agreements 2. Equity investment risk the IFI should have in place appropriate strategies, risk management and reporting processes in respect of the risk characteristics of equity investments, including Mudarabah and Musharakah investments. 3. Market risk the IFI should have in place an appropriate framework for market risk management (including reporting) in respect of all assets held, including those that do not have a ready market and/or are exposed to high price volatility. 4. Liquidity risk the IFI should have in place a liquidity management framework (including reporting) taking into account separately, and on an overall basis, its liquidity exposures in respect of each category of current accounts, unrestricted and restricted investment accounts. 5. Rate of return risk the IFI should establish a comprehensive risk management and reporting process to assess the potential impact of market factors affecting rates of return on assets, compared with the expected rates of return for investment account holders (IAHs). Since the return on investment to the IAH is shared with the IFI, based on a mutually agreed profit-sharing ratio, the return on assets of the IFI would have a direct impact on the IAHs expectations. Any mismatch of expectations of IFI performance and expected distributed return to the IAH is translated as the rate of return risk. 6. Operational risk the IFI should have in place adequate systems and controls to ensure effective and efficient performance, and compliance with organisational objectives and regulatory requirements. This would include a Shariah board/ adviser to ensure compliance with Shariah rules and principles.
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Key point
Risks relevant to the Islamic finance industry are credit risk, equity investment risk, market risk, liquidity risk, rate of return risk and operational risk.
Exercise 12.2
Compare and contrast market risk and liquidity risk in the context of Islamic finance.
12.6 Application of risk management techniques in Islamic banking

The Islamic banking sector has seen the successful implementation of some risk-management techniques as laid out by the IFSBs Guiding Principles. The adoption of profit equalisation reserves (PER) and investment risk reserves (IRR) has been applied in various jurisdictions to smooth the dividend payout to Islamic banks IAHs as forms of risk mitigation. As described in chapter four, PER is the amount appropriated by the Islamic bank out of the Mudarabah income, before allocating the Mudarib share, to maintain a certain level of return on investment for IAHs and increase owners equity. The IRR refers to the amount appropriated by the Islamic bank out of the IAHs profit share only to guard against future losses for IAHs. It is meant to smooth the payment of profits from IAH funds in the event of the non-performance of the IFI or the impairment of its assets. The use of reserves as an institutional risk-mitigation measure to safeguard depositors and investors risk exposure is an alternative to derivatives for market-risk exposure.
12.6.1 Application of risk management techniques in Islamic capital markets

It is in the Islamic capital market where the debate on Islamic risk management instruments or techniques is being hotly contested. Its conventional counterparts are so synonymous with speculative activities that any venture into the realm of derivatives would be seen by some within the Islamic finance industry as a road into the prohibited world of speculation. It may be that this conclusion is being reached without proper consideration. Speculation exists and persists because of the existence of a market that fuels it. Prohibiting the establishment of a secondary market or removing the ability of an Islamic capital market risk management instrument to be traded (restricting it to the primary issuance) limits the scope of speculation. This allows such instruments to fulfil the role they were designed to undertake; that is, simply to manage risk. One also needs to be mindful that not all conventional risk-management concepts can be applied to suit Islamic finance. Futures, for instance, is one that would have to be avoided.
12.7 Proposed Islamic contracts for Shariah-compliant hedging tools

12.7.1 Shariah-compliant currency hedging
Understanding the need to hedge currency risk, Islamic finance has advocated and made use of at least two Islamic-approved contracts, namely Wad and Murabahah-tawarruq. These contracts have been used to assist Islamic-finance customers in hedging their real exposure to currency risk. Currently, the exchange rate of FOREX cannot be controlled. A contractual mechanism must be put in place to contractually hedge this risk as contractual terms can be controlled compared with market movement affecting the exchange rate of FOREX in the future.
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12.7.1.1 Wad structure

Under the Wad structure, which is based on unilateral promise, the exporter in Malaysia, as in the previous example, may undertake to buy the Malaysian Ringgit for the Bahrain Dinar from a counterparty bank in two months time at RM1.4926 for one Bahrain Dinar (RM1.4926/BD 1). In two months time, the importer in Bahrain will pay him BD10 million after which he will sell this BD10 million for Malaysian Ringgit to his counterparty bank as per the above Wad at the promised exchange rate of RM1.4926/1/BD. Ultimately, the Malaysian exporter will be getting RM14,926,000 from his sale of BD10 million, irrespective of the prevailing exchange rate of BD/RM at the time of exercising this Wad. What is more important is that this RM14,926,000 covers his production cost in Malaysia amounting to RM13,500,000. To be compliant with Shariah principles, only one party can give the undertaking or promise to buy or sell the currency to avoid the mutual promises or Muwadah. Without this hedging technique, he may suffer a loss that was due to the fluctuation of the exchange rate of FOREX involving Malaysian Ringgit and Bahrain Dinar. Under normal circumstances, he would have to hedge this risk using conventional forward FOREX, which would not be compliant to Shariah principles.
Key point
A Wad (unilateral promise) issued by one party to buy or sell a type of currency at a certain exchange rate in the future is used by the party to hedge exposure to the currency risk.
12.7.1.2 Murabahah-tawarruq structure

The Murabahah-tawarruq option for Shariah-compliant currency hedging can manifest itself in a variety of forms to suit the requirements of the parties involved, in this case the Malaysian exporter as the counterparty bank. Using the same example as above, that is the Malaysian exporter needing to hedge against the depreciation of the Bahraini Dinar in two months time, a Murabahah structure may be of use. In this case, the exporter would enter into a sale transaction with the counterparty bank for a commodity, say copper at spot, on a two-month, deferred-payment basis. The bank would deliver the copper to the exporter who would in turn dispose of the commodity to a commodity broker (which can be arranged by the counterparty bank), who would pay for the copper in RM. The RM to BD exchange rate that the exporter would finally have achieved will be a function of the deferred marked-up sale price agreed upon by the exporter and the counterparty bank. At the completion of the two months, the exporter would pay the counterparty bank the BD10 million that the Bahraini importer has forwarded to him. Under this Murabahah-tawarruq structure, both the counterparty bank and the Malaysian exporter are contracting parties in the Murabahah transaction. Both parties are liable to carry out the transaction until completion where each has recourse against the other. This is unlike the Wad structure, explained above, whereby only the counterparty bank, as the promisee of the Wad, has recourse to the promisor exporter. The question on whether the exporter can effectively achieve the same RM1.4926/1/BD exchange rate of the Wad example would depend on the transaction costs that is involved in the Murabahah sale, which is not present in the Wad structure. However, the final exchange rate achieved under this should be similar to the one generated under the Wad structure above.
Exercise 12.3
Assuming that the Malaysian exporter did not hedge his currency risk and that the foreign exchange rate in two months time is RM1.2/BD1, what would be the net selling price received by the Malaysian exporter in two months time?
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12.7.2 Islamic swaps

The technical definition of a swap agreement is a bilateral transaction in which both parties agree to make periodic payments together, to exchange two streams of different cash flows or funds. Notional values (the nominal or face amount that is used to calculate payments made on that underlying asset/instrument) are often used, which means that the principal amounts generally do not change hands. This notional amount is being used as the reference amount on which the principal cost of the commodity under Murabahah as well as the mark-up of Murabahah will be based. A swap agreement can be made with cash assets/liabilities in the same/different currencies or between fixed-rate profits/interest and floating rate profits/interest. There are several types of financial swap that are popular and widely used in the conventional financial system: Profit/interest rate swap this type of swap is very popular and frequently found in the current market. It involves the exchange of payments between fixed-rate profits/interest with floating rate profits/interest, which is adjusted periodically. Currency swap this involves the exchange of one currency with another. Commodity swap this is applied based on the price of goods/commodities that are to be sold, such as gas, oil, or other natural source, whereby the parties associated with the fixed-price payment of the commodity exchange for a floating price payment. Equity swap equity swaps consist of the exchange flow between two payments/financing instruments based on the performance of a basket of equities or an equities benchmark or index. The main goals of the swap instruments can be defined as the following: To manage financial risk in comparison to other derivative products, swaps can be used more effectively, especially in managing volatility in either the currency or profit/interest-rate markets. This instrument is considered an effective medium to long-term risk management instrument. The effectiveness of swap instruments lies in the fact that the cash flow can be structured to reap maximum profitability. To reduce financing costs capital markets are imperfect and comparative borrowing advantages occur between countries due to regulatory conditions, operating costs and tax. The adoption of generic or plain vanilla swap instruments can reduce the cost of financing or capital. To operate on a larger scale the use of swaps as hedging mechanisms, especially during a downturn when prices plunge, allows institutions to operate on a larger scale. Although the cost of hedging instruments can be high, the benefits of economies of scale usually outweigh institutions original positions if no hedging instruments were applied.
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Bank A has a floating obligation to its customers in the form of Mudarabah investment accounts, in the sense it has to pay a relevant dividend according to the prevailing market rate to maintain the competitiveness of the Islamic investment account. These accounts are normally for a short period from one month to five years. At the same time, Bank A has a steady income at a fixed rate, normally from long-term financing, such as 10 to 20 years. Apart from facing the displaced commercial risk, Bank A may have serious problems managing its assets and liabilities. The fixedrate financing by Bank A will not change, irrespective of market conditions. If the aggregate rate of profit for Bank A is 8% for a five to 10-year period, and the prevailing aggregate rate for the dividend of Mudarabah investment account is 6% for a one month to 36-month deposit, then Bank A will not need to be worried about an asset-liability mismatch if the rate of the dividend remains at 6% throughout this period. However, if the rate of return or expected dividend increases to 8% in one years time, as a consequence of the increased cost of funds in the country, then Bank A will make a loss if it was to use its shareholder funds to smooth the payment of dividends to its Mudarabah investors. This could lead to a serious impact on the performance of the bank and threaten its survival. A profit rate swap will assist Bank A to hedge against this risk, that is the mismatch risk between the assets and liabilities of Bank A. Bank A could enter into a Murabahah-tawarruq contract for a five-year period under which Bank A will purchase a commodity from the counterparty bank at the fixed rate of 8% per annum, which is payable every six months. The notional amount for this transaction can be fixed, for example, at US$100 million. Therefore, the actual profit rate that Bank A would pay to the counterparty bank is 8% of this US$100 million notional amount. The payment of this profit will be made every six months. Bank A will also undertake to sell a commodity to the counterparty bank under a Murabahah-tawarruq structure, but the profit will be variable every six months based on a certain agreed benchmark, such as LIBOR plus 2%. Therefore, every six months, Bank A will receive a payment from the counterparty bank of the Murabahah profit that is linked to the agreed benchmark. In this swap deal, instead of paying both the Murabahah sale price under the first and second Murabahah contract, the two payments will be set-off between Bank A and the counterparty bank every six months. Ultimately, Bank A will receive a floating payment every six months to match its floating obligation towards its depositors. This mechanism will help Bank A to hedge its asset-liability risk of mismatch, thus ensuring its viability.
Key point
Islamic swaps aim to exchange floating rate obligations/returns with fixed-rate obligations/ returns or vice versa.
12.7.3 Swaps and gambling

In general, swaps are used for the purpose of hedging or managing risks faced by institutions to protect the value of assets that are exposed to market volatility. It is a financial instrument which, in the hands of a different group of audience, can be utilised for speculative activities. Speculation is behaviour, much akin to gambling, and can be applied to any financial instrument in the market. To effectively govern against it, focus should not only be on the financial instrument, but more pertinently on the players who exhibit this behaviour.
12.7.4 Murabahah and Wad Islamic FX swap

Shariah-compliant swaps have been structured and approved by various Shariah advisers based on the need to hedge against volatility in the market. The instruments are not meant as tools to be used for speculative activities. These swap instruments must, therefore, comply with the principles that have been set by the Shariah and may replicate the same economic benefits generated by conventional swap instruments. Currently, there are two different structures of Islamic FX swaps in the market. One is based on Murabahah and the other uses the concept of Wad.
12.7.4.1 Murabahah Islamic FX swap

The Murabahah structure usually involves two separate sets of Murabahah for the swap to be achieved.
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For example, an investor has US$14.5 million and wishes to invest in Euros without exposing himself to currency risk. For the purposes of this example, the spot rate for US$ to Euro is US$1.45 for every 1. If the investor switches to US$ at spot, he will get 10 million today. Assuming he goes through with this, he also wants to change back to US$ in one year. If in the mean time the US$ has appreciated to US$1.40 per Euro, the investor would only get US$14 million back, losing US$0.5 million in the exchange. If the US$ has depreciated to the Euro to US$1.50 per Euro, the investor will earn US$0.5 million instead.
Should the investor in the example above utilise a FX swap instead, he can fix the forward rate and would not be exposed to any volatility in the currency market. From a Shariah perspective, a noncompliance issue would arise if someone tried to execute a currency exchange in the future with rates determined today. This is contrary to Shariah principles and goes against the AAOIFI Shariah Standard No. 1 on Currency Exchange. This issue can be resolved with the proper structuring of Islamic FX swaps. The Murabahah Islamic FX swap structure utilises the sale and purchases of two different commodities, say steel and copper. With regards to the example above, one of the Murabahah transactions takes place today, or on day one, as shown in the diagram below:
Figure 12.1 First leg of the Murabahah Islamic FX swap
Broker A
Broker B
USD
USD
Bank
1 Investor
The investor has US$14.5 million and intends to buy steel for the amount in cash. The bank as an agent locates Broker A for the commodity and the purchase is made with the bank as an agent. The investor then sells the steel to the bank on credit terms for a period of one year at a price of US$14.5 million, plus mark-up The bank disposes the steel to Broker B in cash and obtains US$14.5 million.
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Figure 12.2 Second leg of the Murabahah Islamic FX swap
Broker C
Broker D
EURO
EURO
Bank
4 Investor
The bank then buys copper from Broker D in cash for 10 million. The bank then sells the 10 million copper on a one-year credit to the investor at 10 million, plus mark-up. The investor disposes of the copper through the bank to Broker C, thus obtaining 10 million. The economic implication of the above transaction is that the investor has successfully been able to switch US$14.5 million for 10 million, which he can invest for a period of one year. At the end of the year, the investor needs to pay back the bank 10 million, plus mark-up. The bank also needs to pay the investor US$14.5 million plus mark-up, resulting in both parties receiving the currencies they started with. Hence their positions are effectively hedged with the Murabahah Islamic FX swap. The salient point to note on the swap structure is that the contract features of Murabahah must be fully adhered to at all times. For instance, the asset or the commodity that underlies the transaction must be in existence at the time of the contract. It is also pertinent to note that different commodities must be utilised for the two legs of the transaction.
Exercise 12.4
Based on figures 12.1 and 12.2, explain why there is a need to have two legs of Murabahah transactions in this swap arrangement.
12.7.4.2 Islamic FX swap via Wad

The second structure in the FX swap is based on the concept of Wad. It involves a spot currency exchange whereby the same investor exchanges the US$14.5 million for 10 million with the bank. He can invest the Euros obtained for the same one-year period. The investor would then give the bank a Wad to exchange US$14.5 million using Euros, at a rate agreed by both parties to be executed one year from the date. With regards to the swap objective, the investor and the bank would end up with the currency they each started out with. Unlike the Murabahah structure described above, the Wad structure does not give the investor the perfect hedge. This is because Wad is a unilateral promise and recourse is only available on the promisor, who is the investor. If the bank or promisee does not deliver the currency on the prescribed date, the investor does not have any recourse on the bank and thus may be stuck with the Euros that he exchanged one year before. However, if on the prescribed exchange date the investor refuses to enter the exchange to US$ with the bank, the bank has full recourse on the investor. The bank may have recourse up to the actual damages that it suffers because of the breach caused by the promisor. This is normally measured by looking at the differential between the promised exchanged rate and the actual exchange rate that the bank utilised to dispose of the US$ to the third party.
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12.8 Islamic cross-currency swap

As with the Murabahah Islamic FX swap, the Islamic cross-currency swap also applies the Murabahah contract in its structure. Unlike the former, it not only involves the exchange value of the principal at the beginning and end of the transaction, but also the exchange of a stream of related cash flows. As such, a series of Murabahah contracts are conducted to effect this cross-currency swap. For example, a company has US$10 million for investments. The company wants to invest in Malaysian Ringgit (MYR) but is hesitant to assume the exchange rate risk. The company could invest the US$10 million in a MYR-denominated Sukuk Ijarah that has a maturity of three years and pays rental coupons every six months. To allow the company to manage the currency risk while investing in the MYR Sukuk Ijarah, the bank would have to carry out a series of Murabahah to effectively generate the cross-currency swap. It is a three-legged transaction as follows: 1. Initiation Exchange of the principal value US$10 million to MYR35 million takes place. The company must receive the MYR35 million which they would invest in the Sukuk Ijarah. At the same time, the company issues a Wad to the bank to exchange the MYR35 million back to US$ at the same MYR3.5/USD1 exchange rate in three years time (upon the maturity of the Sukuk Ijarah). 2. During the swap Every six months for a period of three years, the company receives rental coupons from the Sukuk in MYR. Naturally, the company does not want the exposure to MYR and thus the bank effects a Murabahah Islamic FX swap transaction, as set out above in figures 10.1 and 10.2, every six months to eliminate the companys exposure to currency risk brought about by the coupon payments. In total, there are six sets of such transactions to handle the bi-annual coupons. In addition, to ensure that the company does not withdraw from such transactions, it is asked to provide Wad or an undertaking that it will proceed with the series of transactions with the bank. The difference in these six-monthly Murabahah transactions is that they should only be conducted in cash and not involve any credit. 3. Maturity This is the stage where the principal amounts are channelled back to the originating parties. The Sukuk Ijarah matures, thereby reimbursing the MYR35 million back to the company, and the bank undertakes to exchange the US$ back to the company by fulfilling the Wad provided in the initiation leg at the original MYR to US$ rate. As with the FX swap, cross-currency swaps aim to protect the currency risk of the investor. In this example, the company has US$10 million. The exchange rate at the beginning was US$/MYR = 3.50. In the first leg, the company obtained MYR35 million. Should the US$ depreciate to the MYR to 3.40 after the three years, the company would suffer losses. If the US$ appreciates against the MYR to 3.60, then the company would gain. To absorb zero currency risk, the company enters a crosscurrency swap so that it gets the same principal as at the beginning of the exchange. The cash flow arising from the Sukuk is also effectively hedged against the currency risks.
Exercise 12.5
Compare and contrast Islamic FX swaps using Wad and Islamic cross-currency swaps.
12.9 Islamic profit rate swap

An Islamic profit rate swap is an agreement to exchange profit rates between a fixed-rate party and a floating rate party or vice versa. It is implemented through the execution of a series of underlying contracts to trade certain assets under the Shariah principles of Murabahah. Each partys payment obligation is computed using a different pricing formula. In an Islamic profit rate swap, the notional principal is never exchanged as it is netted off. Only the flow of funds will be exchanged. The exchange involves the fixed to floating profits swap.
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For example, airline company East-West Ltd has purchased a plane worth GBP100 million with Ijarah financing. Its rental obligation must be paid every six months, based on LIBOR, which is currently at 5%. East-West Ltd is keen to manage its cost considering the volatility of LIBOR. Should LIBOR increase to 6%, it would have to pay an additional GBP1 million every year for financing the purchase of the plane. To manage its position, East-West Ltd is keen to enter an Islamic profit rate swap, that is to move away from a floating rate obligation to one that is based on a fixed rate. The swap structure will involve a three-legged transaction: 1. Initiation This is the provision of Wad by the investor (in this case East-West Ltd) to the bank to execute a series of Murabahah transactions. This is to ensure that the investor does not renege from undertaking the transactions as pre-agreed. 2. Transactions during the swap: East-West Ltd must make payments every six months to its Ijarah financiers based on the floating LIBOR. To effectively obtain fixed-rate obligations, East-West Ltd must undertake Murabahah transactions with the bank just prior to making payments to its financiers. Effectively, East-West Ltd must purchase a commodity from the bank at fixed rates, for example 5.5%. This translates into East-West Ltd paying the bank GBP2.75 million every six months. At the same time, the bank purchases a different commodity from East-West Ltd at floating rates, pegged to the LIBOR. This effectively hedges East-West Ltds position with regards to the Ijarah financiers and the only obligation that remains is the 5.5% fixed rate to the bank. The Murabahah transactions must be conducted in cash and there must be no credit granted to either party. 3. Set-off On the dates of the transactions, neither party East-West Ltd or the bank will pay the actual value involved. They must set off their individual obligations to each other and settle only the difference. The current LIBOR determines whether the bank pays East-West Ltd (if LIBOR goes above the fixed 5.5%) or if East-West Ltd has to compensate the bank (if LIBOR goes below the fixed 5.5%). The main advantage of the profit rate swap is being able to manage the financing cost of the borrowing companies. The movement of financing rates can severely impact on the financial position of the company if it is not appropriately hedged. One has to note that once hedged (to a fixed rate) the financed company will always pay the fixed rate, even if the benchmark rates falls to well below the original figure. The difference between the benchmarked rates and the fixed rate accrue to the bank that offers this instrument. The following diagram summarises the process flow of the transactions between East-West Ltd and the counterparty bank.
Figure 12.3 Structure of Islamic profit rate swap
Islamic profit rate swap counterparty (bank) Purchase commodity from East-West at floating rates bsed on LIBOR
Purchase commodity from Bank at 5.5% fixed rate East-West Ltd
Ijarah financier
Pays floating rate financing obligation every six months
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Conditions must be observed in this transaction, particularly pertaining to the Murabahah-tawarruq structure. There must be a real transaction between East-West Ltd and its counterparty bank whereby the asset is sold and transferred to the buyer and the buyer takes on ownership risk. In the case of default by East-West Ltd, to continue with the floating Murabahah-tawarruq structure East-West Ltd may be made to incur the actual loss suffered by the counterparty bank if it were to purchase the commodity from the market based on the prevailing market price. This would be deemed as a breach of the promise, which is binding on the promisor.

Explain whether an Islamic profit rate swap is relevant if all of the assets and liabilities of IFIs are standardised to either fixed or floating.
Solution
Should the scenario hold true and all the assets and liabilities are perfectly matched, then profit rate swaps are not relevant for IFIs. However, there is a danger of having fixed-rate profits for longer-term financing. Even though such IFIs, with their perfectly hedged portfolios, do not require these profit rate swaps, it may be that their customers would require them to match their own asset and liability portfolios. A company may pay fixed-rate financing instalments to the bank, but may also receive floating rate-based payments from their own clients. Therefore, even though the financial institutions may not need these profit rate swap instruments on their own, they may need to provide them for their clients.
12.10 Islamic call options

As for the call option, an Urbun contract may be used to lock in the future price of a selected commodity. This gives the right, not obligation, to the purchaser to proceed with the full payment or not, in which case the contact will be terminated. Although Urbun is a valid sale contract, the purchaser may only enjoy the benefit of the sale upon the full settlement of the purchase price. If he fails to pay, or decides not to pay for whatever reason, the Urbun payment that he has made to the seller shall be forfeited by the seller. To some extent, the Urbun payment may be viewed as security to the seller because if the full payment is not made until the end of the period of the right to fully settle, that payment will be used to compensate the loss of the seller for his waiting time and for failing to market his asset to other potential buyers. The Urbun sale, like any other sale contract, requires the seller to own the asset as the legal owner. The sale of the asset is already complete but pending the full settlement of the purchase price by the buyer. This concept can be structured to replicate the call option as practised in conventional market practice to hedge the market risk of the investment asset. However, to bring it into line with conventional practice, the purchase price must be adjusted as the premium in the conventional market is not part and parcel of the option strike price. This means that any payment made by the buyer will not be deemed as a price for the option. This payment will be deemed as part payment of the total purchase price of an underlying asset, which will be considered if the buyer was to proceed with the full payment later. Also, an Islamic option is not tradable in the secondary market unlike the conventional options. This feature is very important in order to establish that any payment paid in an Islamic call option is not an asset that can be sold to a third party. It is simply a part payment of the total agreed price to purchase an underlying asset. This part payment is not eligible for sale under Islamic commercial law as it only gives the right to the purchaser to pay the total outstanding payment on the underlying asset. A part payment is not in itself an asset that can be sold or purchased.
Key point
Unlike conventional options, Islamic options cannot be traded in the secondary market as Islamic options simply represent part payment of a total agreed purchase price.
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Following these principles, a prime broker in the equities market may offer to sell a basket of shares to an Islamic fund under the Urbun concept. Conventionally, the strike price could be US$100 per share and the premium might be US$10 per share. A call option holder will then have to pay US$100 per share if he were to exercise his rights to purchase these underlying shares as the US$10 paid for each call option will not be counted as part of the purchase price. To suit the Shariah requirements, these shares (which are compliant) may be sold to this Islamic fund at US$110 per share. If the Islamic fund/investor was to exercise his rights, he will have to pay another US$100 per share as US$10 paid per share is part of the purchase price. In practice, the Islamic fund/investor will authorise the fund manager to sell this basket of shares, after making the full payment of US$110 per share to a third party, if the market price is above the strike price. Thus, the Urbun mechanism may minimise the loss as well as give an opportunity for the investor to benefit from the upside of the market.

To answer this challenge you need to research the concept of US and European options. Based on the practice of Islamic options as described above, what would be the best suited options for Islamic investment funds US or European options?
Solution
US options unlike European options give the option holder the right to exercise his option at any time in the period of option. In contrast, European options only entitle the option holder to exercise his right at the time when the option matures. Therefore, the option holder is not entitled to exercise this option although the market value of the underlying asset of the options is higher than the strike or exercise price. The above description of Islamic options in the context of an investment fund is more relevant to a US options feature. This gives the right to the fund manager under Wakalah contract to exercise the strike price and to immediately sell the underlying assets to the market for capital gains for investors.
12.11 Hedging versus speculation

Hedging is a strategy designed to minimise exposure to business risks, such as a rise in material costs, while still allowing the business to profit from producing the goods involved. Hedging is an important risk management tool to ensure that businesses are not subject to excessive business risks. Speculation on the other hand is a financial action that does not generate a consistent value or provide a safety net to the business activity undertaken. Speculation typically involves the lending of money or the purchase of assets, equity or debt, but in a manner that has not been given thorough analysis or is deemed to have a low margin of safety or a significant risk of the loss of the principal investment. Speculators may rely on an asset appreciating in price due to any of a number of factors that cannot be well enough understood by the speculator to make an investment-quality decision. For an airline, the cost of jet fuel is a key factor in whether the business does or does not make a profit. Typically, the airline company would hedge its jet fuel costs by purchasing in the forward market in an attempt to manage the companys overheads. On the other hand, a high-net-worth individual, who has no business affiliation to the airline industry, can also participate in the forward jet fuel market. One party is considered a hedging entity; the latter is purely a speculator. It should be noted that the instrument used with the forward market for jet fuel would be the same for the hedger and the speculator. In light of this, Islamic finance has taken the proactive step to discourage speculation. No Islamic derivatives or risk-management instruments are allowed to be traded. For example, if a company has invested in a Shariah-compliant option via Urbun, then it would have to exercise it or let it lapse. There can be no transfer of that instrument to a different party, apart from at par or with zero extra consideration. Without the tradability option, it is less likely that Shariah-compliant derivative instruments would remain attractive in the eyes of the speculators. Although Islamic options based on Urbun cannot be traded like conventional options, the standardisation of their usage in that limited scope is still possible. A template document on Islamic options using a format similar to the ISDA (International Swaps and Derivatives Association) may be useful to facilitate the global transactions using this concept of risk management.
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12.12 Conclusion
Risk management is a significant feature in Islamic finance and cannot be taken for granted. The need for effective risk management in Islamic finance is a bona fide need as the risks that Islamic finance are exposed to are different to those faced by conventional finance. A substantial amount of effort has been made to identify, measure and mitigate, as well as to manage, these risks. Islamic finance products may be exposed to market risk, operational risk and rate of investment return risk. The challenge becomes more demanding as all risk management tools must be compliant to Shariah principles. Currently, most of the tools used emanate from the conventional finance system, including options, forwards, futures and swaps. Against this background, Islamic finance professionals and scholars should look to various contracts where they could develop Shariah-compliant risk management tools using approved contracts and principles, such as Wad, Murabahah, coupled with, for example, Wad and Urbun. Some scholars would confine risk-management tools to traditional contracts, while others have attempted to re-engineer conventional tools to become Shariah-compliant tools. These tools can be used in Islamic finance to manage risk, particularly financial risk, more properly and systematically and, at the same time, comply with Shariah principles.
12.13 Summary
Having read this chapter the main points that you should understand are as follows: risk relates to the outcome of a transaction that the parties to the transaction cannot avoid as it relates to the market risk or investment risk which is beyond control Islamic law does not object to efforts to manage risk as the proper management of risk improves wealth creation and wealth distribution under the principles of Shariah, not all risk can be eliminated as there are also risks that need to be maintained as integral parts of the contract feature and structure the Islamic Financial Services Board has set out 15 principles of risk management for institutions that offer Islamic financial services, known as the Guiding Principles risks relevant to the Islamic finance industry are credit risk, equity investment risk, market risk, liquidity risk, rate of return risk and operational risk hedging is an important risk-management tool to ensure that businesses are not subject to excessive business risks; speculation on the other hand is a financial action that does not generate a consistent value or provide a safety net to the business activity undertaken Shariah-compliant swaps have been structured and approved by various Shariah advisers based on the need to hedge against the volatility found in the market the Murabahah Islamic FX swap structure usually involves two separate sets of Murabahah for the swap to be achieved in an Islamic profit rate swap, the notional principal is never exchanged as it is netted off.
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Currency hedging mechanism and issues
Implex Pte Ltd is a Singaporean company that imports goods from SFN Inc, an exporter located in Canada. The Singaporean company has imported Canadian Dollars (CAD) 10 million worth of goods and the payment is due in two months time. However, Implexs paying bank is Singaporebased and will pay in SGD (Singapore Dollars) equivalent. The current spot rate of FOREX is CAD1/ SGD1.5, which means that one Canadian Dollar buys 1.5 Singapore Dollars. If the invoice was due for immediate settlement, then the Singaporean company would exchange CAD10 million on the spot FOREX market and pay the SGD15 million. However, the payment is due in the future. If the Canadian Dollar strengthens over the next two months, Implex will end up paying more Singapore Dollars, potentially eliminating its profit margin for the import transaction. The Singaporean company can dispose of the goods at SGD16.5 million on the deal and aims to achieve a margin over the cost of at least 10%. If the spot exchange rate in two months time is 1.5, then Implex will effectively pay SGD15 million for the goods, resulting in a profit of 10% over the Singapore Dollar costs incurred. Implex, therefore, would want to hedge its currency risk on the CAD over the two-month period.

1. Which of the following Shariah-compliant hedging is suitable for Implex? (A) (B) (C) (D) 2. Shariah-compliant profit rate swap Shariah-compliant Murabahah FX swap Shariah-compliant forward sale based on Salam Shariah-compliant call option
Under AAOIFI Shariah standard on currency exchange, identify why forward contracts, as applied in conventional currency forwards, cannot be utilised for Islamic currency swaps? (A) (B) (C) (D) Currency exchange in Islamic law must be conducted only on spot Currency is a valid item for Salam sale Currency exchange was never allowed under Islamic law Currency is a medium of exchange
3.
What would be the implication to Implex should it consider a Shariah-compliant FX swap via Wad? (A) (B) (C) (D) Implexs position is completely hedged The instrument is non-compliant Implex would not be perfectly hedged, as the promisor has no recourse should its counterparty renege on the final transaction Implex would have to conduct a cost-related feasibility study as the Wad structure is the most costly instrument in the market
4.
Should Implex consider a Shariah-compliant cross-currency swap? (A) (B) (C) (D) Yes, as it is a Shariah-compliant option Yes, because it is cost-effective No, because cross-currency swaps are not cost-effective No, because Implexs short-term position only involves principal amounts with no additional cash flow
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5.
Can Implexs currency hedging activities be considered as speculative? (A) (B) (C) (D) No, because the instruments considered are Shariah-compliant instruments Yes, because Implex has no business interest in dealing with foreign currencies Yes, because the instruments utilised are derivative instruments No, because Implex has actual currency risk exposure when dealing with foreign companies

Further to the case study above, the Singaporean company decides to take up one of the available Shariah-compliant currency hedging mechanisms that are available in the market. Assume that the two-month CAD/SGD forward rate today is 1.5125 and the volatility is 20% of todays spot CAD/ SGD rate stated above. 1. Outline the financial implication should Implex leave its position unhedged and the SGD depreciates to SGD1.6 per CAD after the two months. What is the implication should the SGD depreciate even more to SGD1.8 per CAD after the two months? Outline the process Implex would have to undertake should the company choose to utilise a Shariah-compliant currency forwards instrument, assuming that the forward CAD/SGD rate offered by the bank is 1.5125. Outline the process Implex would have to undertake should the company choose to utilise the Shariah-compliant currency swap. Suppose on the two-month execution date the spot CAD/SGD rate has risen to 1.7 SGD per CAD; with regards to the Shariah-compliant currency swap, what would be the outcome of the transaction? Outline the process Implex would have to undertake should the company choose to utilise the Shariah-compliant currency swap.
2.
3. 4.
5.
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Chapter twelve answers

Exercise 12.1
Credit sale of staples based on mark-up (Makhatir) Forward contract whereby the 2 counter values are deferred (Gharar) Forward currency contract (Riba) Purchase of staples in US$ and sale of the same in other currencies on credit (Makhatir) Future delivery of staples for an advance payment (Makhatir)
Exercise 12.2
Liquidity risk is the risk of not being able to meet the demand for withdrawals or short-term obligations. This may arise because of a lack of liquid instruments in the form of securities or assets that cannot be traded to realise cash in the short term. Market risk on the other hand is the risk that the value of an investment will decrease because of volatility in the market. For both types, risk is usually analysed at the point of disposal, where the former is the result of no takers of the asset in question and the latter is the result of a fall in value. Such risks can also be inter-related, an example being a residential propertys value plummeting (market risk) due to it being too large and expensive for small investors to purchase (liquidity risk).
Exercise 12.3
Even if the Malaysian exporters position remains unhedged, he will still receive BD10 million for the sale of the goods in two months. However, the question is what the BD10 million would be worth to him at the end of the day. If the Malaysian Ringgit appreciates to RM1.20 to the BD, then the exporter will only receive RM12 million. He would face a loss of RM1.5 million as his costs were RM13.5 million in total.
Exercise 12.4
Under the Islamic FX swap structure, the contracting parties always end up with the original currencies they started with. The two-legged Murabahah transactions are conducted to generate an obligation by each of the contracting parties. The investor will have the Euro obligation and the bank will have the US$ obligation, which they both have to settle at the end of the one-year period. The two Murabahah transactions are therefore important to ensure that the currency swap actually takes place.
Exercise 12.5
Both instruments mentioned in the question are Shariah-compliant derivative instruments that hedge against exposure to currency risk. Along with mitigating these exposures, the parties involved in these transactions always end up with the original currencies that they started with. The Wad structure is the simpler of the two as it only involves exchanging the principal sum. The crosscurrency swap on the other hand also involves swapping a stream of cash flow in between, often done on a prescribed date that matches a regular dividend, profit or coupon payments. A crosscurrency swap is often known as a medium to long-term instrument, whereas the Wad structure is often used on a short-term or ad hoc basis. The pertinent difference between the two lies in the fact that the cross-currency swap generates a perfect hedge for the investor, whereas in the Wad structure the promisor will always be open to non-delivery risk by the bank or promisee.
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1 2 3 (B) (A) (C) Through a process of elimination, profit rate swap is the wrong instrument while Wad contract applied in (C) and (D) leaves Implexs position not completely hedged. Actual AAOIFI Standard on Currency exchange Although Wad is a compliant principle to hedge currency risk, it cannot offer perfect hedging as the counterparty bank (the promisee) may not agree to sell or buy the currency that Implex would need in the future and there is no basis for Implex to enforce this on the counterparty bank. Cross-currency swaps are longer-term instruments designed to swap cash flows in the interim.
4 5
(D) (D)

1. If the spot rate turns out to be 1.6, Implex will have to pay SGD16 million in exchange for the CAD10 million; the resulting profit will only be SGD500,000 and the margin of profit will be approximately 3.3%. However, if the spot rate turns out to be 1.8, then the Singaporean company will have to pay SGD18 million on the transaction. As such, Implex would suffer a loss of SGD1.5 million out of the currency exchange. 2. To enter a Shariah-compliant currency forward transaction with a bank, Implex would have to find a bank that is willing to enter in this transaction. Once the bank has been identified, Implex would simply issue a Wad to the bank to exchange SGD15,125,000 for CAD10 million in two months time. Through the provision of the Wad, the bank has recourse on Implex. On the transaction date, Implex must present the CAD10 million equivalent in SGD to the bank, failing which Implex would be liable for potential damages. However, Implex as the promisor would not have any recourse on the bank. Should the bank refuse to transact on the date (perhaps if the SGD has depreciated more against the CAD), there is nothing that Implex can do with regards to the currency exchange. As a precaution, it is perhaps best for Implex to work with banks that have a history of undertaking such transactions to minimise the likelihood of non-action. 3. The Shariah-compliant FX swap essentially involves two sets of Murabahah transactions between Implex and the chosen bank, one conducted to generate a liability for the bank in SGD and the other generating a liability for Implex in CAD. After the transactions, Implex would have CAD10 million in cash that can be invested in Islamic money market instruments. At the end of the two months, the bank would have swapped Implexs position back to SGD, which the company would then utilise to make payments for the imported goods. Implexs currency risk position is effectively hedged under this instrument. Although Wad is a compliant principle to hedge currency risk, it cannot offer perfect hedging as the counterparty bank (the promisee) may not agree to sell or buy the currency that Implex would need in the future and there is no basis for Implex to enforce this on the counterparty bank. 4. Regardless of the direction of the two-month CAD/SGD spot rates, the rates accommodating the two Murabahah transactions in the Shariah-compliant currency swap have already been fixed on the transaction date. Both Implex and the bank are aware of the obligations that they have generated and as such there will be no diversion away from the transacted rates/prices. That is a feature of the Murabahah transaction; the mark-up is always known and agreed upon by both parties and there will be no digression from it. 5. Implex Pte Ltd can use the Murabahah Islamic FX swap to mitigate against the foreign exchange volatility of SGD to CAD. To do so, Implex would need to source a counterparty bank that is familiar with Murabahah transactions. The Murabahah Islamic FX swap structure utilises the sale and purchase of two different commodities, say, steel and copper. Implex, for instance, would be required to buy steel (in SGD) with the bank acting as an agent to locate a steel broker A. The purchase is made with the counterparty bank as an agent. Implex then sells the steel to the counterparty bank on credit terms for a period of two months at a CAD price plus mark-up. The bank then disposes of the steel and obtains its cash.
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Continuing with the example, the bank would then sell copper to Implex, on a two month credit term. The copper sold by the bank will be based on a SGD price plus mark-up. Implex would then dispose of the copper, through the bank as an agent, to a copper broker obtaining cash. When the two month credit term matures, Implex will pay its SGD obligation to the counterparty bank while the bank would pay Implex its CAD obligation, resulting in Implex obtaining the CAD to pay SFN Inc. Hedging, unlike speculation, helps institutions like Implex to hedge real currency risk arising for its business.
Notes:
1 2 www.ifsb.org/standard/ifsb1.pdf As an example of the complementary nature of the IFSB Guiding Principles to the BCBS principles, BCBS published its 17 Guiding Principles on Sound Liquidity Risk Management and Supervision covering Governance of Liquidity Management, Management of Liquidity Risk, Public Disclosure and Role of Supervisors. IFSBs Guiding Principles on liquidity risk focus on the peculiarities of Islamic banking instruments, that is Islamic investment accounts as well as the displaced commercial risk that arises. Islamic Finance Services Board (IFSB) Guiding Principles of Risk Management for Institutions (other than Insurance Institutions) offering only Islamic Financial Services, Dec 2005.
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Conclusion
Conclusion
Concluding notes on this study guide

This diploma has been designed to enable financial professionals and practitioners to apply Islamic finance principles to the analysis of Islamic financial products and services, as well as to the development of innovative products or solutions for the Islamic financial services industry. Here, we highlight some of the key issues addressed as you journeyed through the guide.
Structuring Islamic financial instruments
CIMA has positioned the process of structuring Islamic financial instruments as the focal point of the CADIF. You need to be proficient in this key process. For this, you should be knowledgeable in the area of Islamic commercial law and familiar with the wide range of Islamic banking and financial products, as well as the legal and juridical impediments that surround the Islamic business environment.
The importance of Shariah compliance

Having worked through the preceding 12 chapters you will realise that Shariah compliance is the key feature of any Islamic financial product. Whether the product comes from Islamic banking, the Islamic capital markets or the Takaful sector, it must always remain compliant. As you will have seen, the failure to comply with Shariah requirements can result in legal, operational and riskrelated issues. We demonstrated the importance of Shariah compliance when structuring Islamic financial products. By reviewing the sources and methodology of interpretation of Shariah principles governing Islamic commercial law, we showed you how Shariah rulings affect the structuring process. You now know the importance of choosing the appropriate contract to ensure that the commercial features of the financial product are in line with the contracts features and requirements. We have shown that the importance of the structuring process is not confined to product design but involves or interfaces with other processes relating to legal documentation, operational process flow, reporting and risk-management processes.
Governance and the development of Islamic finance

You were also introduced to the various financial laws and regulations that govern Islamic financial institutions and the Islamic instruments that they generate. You saw that the different application of monetary, tax and legal policies adopted by the various regulatory authorities affects the development of the Islamic finance industry in its different markets. We presented various Islamic banking models to show how the business and legal environment determines the model most suitable in different jurisdictions. Issues on prudential requirements, supervision and Shariah review were introduced to allow you to develop a holistic overview of the issues you will have to keep in mind as you go through the Islamic product structuring process.
Matching clients expectations with suitable products/services

You should now understand why Islamic banks need to match clients expectations in holding various forms of Islamic deposits to the features that are available with each Islamic commercial contract.
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Conclusion
This point was highlighted when we explained, for example, how Islamic banking instruments such as Islamic depository instruments are structured, requiring the same level of skill as structuring for interest-based deposit instruments as well as Shariah expertise.
Challenges facing the industry

We introduced you to some of the challenges facing the industry, including the issue of early payment. The problem here is the lack of flexibility in the pricing structure of contracts of exchange where prices or rates are fixed and predetermined. We explained that attempts to build a discretionary rebate system to resolve this issue may not be efficient enough to make the resulting products competitive. To counter this, we showed how the use of other service-based contracts, such as Ijarah and Musharakah, has been explored where services are identified or assets are not determinable.
The Islamic capital market

We then turned our focus to the key distinguishing features of the Islamic capital market. We explained that Shariah regulatory structures can take the form of either a centralised model or one that is led by private initiatives or market forces. The applicability of either model will depend on the jurisdictions within which the instruments are offered. You would have seen that the Shariahscreening criteria adopted by fund managers depend on the jurisdictions within which the Islamic fund is being offered. You should also realise that while fund managers can apply any of the established Shariah-screening methodologies, the different limits that have been set between each methodology and the different denominators applied for each financial ratio affect the results of Shariah financial screening.
Shariah-compliant funds
We showed you that the advent of Shariah-compliant funds has generated Islamic investment opportunities, not only for institutional or high-net-worth investors, but also for average Islamic retail investors who are now able to diversify their investment risks. You saw how Islamic funds portray similar expectations of investors preference towards risk diversification in equity investments and other asset classes in a Shariah-compliant manner. You should, therefore, be aware that the structuring of any Islamic fund requires a thorough examination of the underlying asset under management, the financial activity of the fund, the contractual agreement between the contracting parties and the terms and conditions of the investment in line with the various Shariah standards that have been established.
Islamic private equities

We stated that the Shariah requirements placed upon Islamic private equities are stricter to account for the fact that private equity investors are usually the majority stakeholders of the companies they invest in and can, therefore, influence business operations. You should now appreciate that the question of ownership and control over business activities affects the issue of whether the intended investee companies must be 100% Shariah-compliant or whether these companies can be allowed to display the usual tolerance levels prescribed by Shariah screening agencies.
The changing face of Sukuk

We then turned our attention to the Sukuk as an important funding vehicle for the Islamic capital market. We explained that growth in the Sukuk since its establishment in 1990 has been strong and that a variety of new and innovative structures have been developed, applying a variety of different Islamic contracts to suit the features required. You have also seen how international standard-setting agencies address peculiarities in the industry through their pronouncements, such as that of AAOIFI in 2008 to amend practices arising with the issue of some Sukuk. At the same time we introduced you to the different structuring issues that have arisen from the development of various Sukuk as well as illustrating the different types of financing arrangements now available. We also introduced you to the concept of ratings for Sukuk and explained the methodologies used to rate different types of Sukuk. We emphasised that developing robust and consistent rating methodologies for the different types of Sukuk is an important consideration if we are to see further integration between Islamic capital markets around the world.
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Conclusion
The Takaful industry

On turning to Takaful, we reiterated that Takaful has always been based upon the concept of protection and the preservation of life and property, as well as religion, intellect and family. We showed that the use of the underlying Tabarru contract or Waqf concept and the application of Takaful business based on the contracts of Wakalah and Mudarabah ensures the Takaful industry is equipped with the necessary tools to penetrate into the global insurance industry.
The effect of regulation on the Takaful industry

We emphasised that, from a governance point of view, improved regulations will always bode well for the Takaful industrys future development. To date, regulations for the Takaful industry have often been based around the wholesale adoption of conventional insurance regulations. While this may be justifiable for many reasons, we explained that there are also instances where this action could limit the development of Takaful companies. For example, the capital adequacy requirements that justify the insurance companys position as owner of the insurance funds limit the position of the Takaful operator, who is technically the manager of the Takaful funds.
The need to innovate within the Takaful industry

While we suggested that the potential for growth in the Takaful industry is huge we also showed how Takaful companies must be better equipped to offer a more diversified portfolio to meet that potential demand. Issues such as mandatory rating requirements, as well as improved transparency and corporate governance, are just some issues identified that will aid the Takaful industry to take the next big leap. We then explained how the contract of Tabarru is extended and applied in Retakaful operations in the form of proportionate or non-proportionate facultative or treaty arrangements. We also showed that Retakaful companies, on occasion, need to collaborate with reinsurance companies to retrocede their large risk exposures. This phenomenon is expected to persist until new forms of retrocession provide greater participation by reinsurance companies in a Shariah-compliant manner. We suggested that the lack of expertise in the Retakaful industry to provide leadership to Takaful operators in new categories of risk will have an effect on the growth of the industry as a whole. We also suggested that additional governance principles promulgated by the IFSB would require a more extensive governance framework, mechanisms and controls to protect the interest of the participants.
Risk management within Islamic finance

Finally we explained why risk management is a significant feature in Islamic finance. The need for effective risk management is essential as Islamic finance is exposed to different risks than its conventional counterpart. You will have seen that the challenge becomes more demanding in Islamic finance as all risk-management tools must be compliant to Shariah principles. We explained that most of the tools currently used emanate from the conventional finance system. Islamic finance professionals (including you) and scholars now need to identify possible alternatives and solutions to develop Shariah-compliant risk management tools that use approved Shariah contracts and principles. We hope that you have enjoyed the journey through this guide and that you now feel confident, not only to sit the final assessment required for the award from CIMA, but to take an active part in the development of this young, exciting and dynamic subject. We at CIMA would like to wish you well.
If you have any comments regarding this guide, please forward them to if@cimaglobal.com
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Bibliography
Bibliography
Bibliography
1 AAOIFI Shariah Standard 2005, Accounting and Auditing Organization for Islamic Financial Institution, Bahrain. 2 Al-Bashir, M. 2009, Risk Management in Islamic Finance: An Analysis of Derivatives Instruments in Commodity Markets, Brill Academic Publishers. 3 Ali, E.R.A.E. & Odierno, H.S.P. 2008, Essential Guide to Takaful (Islamic Insurance), CDIF Publication, Kuala Lumpur. 4 Archer, S. & Karim, R. A. (eds) 2002, Islamic Finance: Innovation and Growth, Euromoney Books and AAOIFI. 5 Archer, S. & Karim, R.A.A. (eds) 2007, Islamic Finance: The Regulatory Challenge, John Wiley & Sons (Asia) Pte Ltd. 6 Archer, S., Karim, R.A.A. & Nienhaus, V. 2009, Takaful Islamic Insurance: Concepts and Regulatory Issues, Wiley Finance. 7 Ayub, M. 2008, Understanding Islamic Finance, The Wiley Finance Series, Wiley. 8 Bakar, M. D. 2004, Development of a Supportive and Effective Legal Framework for the Islamic Financial Services Industry, a paper presented at the International Seminar on Challenges Facing the Islamic Financial Services Industry, organised by the Islamic Financial Services Board, Bali, Indonesia, April 2004. 9 Bidar, D., Chatterji, R. & Uberoi, P. 2009, Promises on the Horizon: an Introduction to the Wad, Allen & Overy, London. 10 Cox, S., Kraty, B. & Thomas, A. (eds) 2005, Structuring Islamic Finance Transactions, Euromoney Books. 11 Ernst & Young World Takaful Report 2009. 12 Gatti, S. 2007, Project Finance in Theory and Practice: Designing, Structuring, and Financing Private and Public Projects, Academic Press. 13 Greuning, H. V. & Iqbal, Z. 2007, Risk Analysis for Islamic Banks, World Bank Publications. 14 Hayes, S.L. & Vogel, F.E. 1998, Islamic Law and Finance, Kluwer Law International. 15 Iqbal, M. & Molyneux, P. 2005, Thirty Years of Islamic Banking: History, Performance and Prospects, Palgrave Macmillan, London. 16 Jaffer, S. 2004, Islamic Asset Management: Forming the Future for Sharia-Compliant Investment Strategies, Euromoney Institutional Investor. 17 Jaffer, S. 2005, Islamic Retail Banking and Finance: Global Challenges and Opportunities, Euromoney Institutional Investor. 18 Jaffer, S. 2007, Managing Takaful and Assurance Networks, Euromoney Books, Euromoney Institutional Investor Plc. 19 Jaffer, S. 2009, The global reach of Islamic banking and Takaful, Euromoney Encyclopedia of Islamic Finance, Khurshid, A. (ed), Euromoney Institutional Investor PLC, London. 20 Jobst, A.A. 2007, Derivatives in Islamic Finance, paper presented at the International Conference on Islamic Capital Market, Jakarta, Indonesia ( jointly organised by Islamic Research and Training Institute (IRTI) of the Islamic Development Bank (IDB) of Saudi Arabia and Muamalat Institute, Jakarta, Indonesia), August 2007. 21 Khan, T. 2002, Financing Build, Operate, and Transfer (BOT) Projects: The Case of Islamic Instruments, Islamic Economic Studies, Volume 10, IRTI, Islamic Development Bank, Sep 2002. 22 Khorshid, A. 2007, Islamic Insurance: A Modern Approach to Islamic Banking, Routledge. 23 Khorshid, A. (ed) 2009, Euromoney Encyclopedia of Islamic Finance, Euromoney Institutional Investor PLC, London. 24 Khorshid, A. (ed) 2009, Sukuk and Securitization, Euromoney Encyclopedia of Islamic Finance, Euromoney Institutional Investor PLC, London.
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Bibliography
25 Khorshid, A. 2009, Understanding derivatives within Islamic finance, Euromoney Encyclopedia of Islamic Finance, Euromoney Institutional Investor PLC, London. 26 Mahlknecht M. 2009, Islamic Capital Markets and Risk Management, Risk Books, London. 27 Nathif, A. & Thomas, A. 2004, Islamic Bonds: Your Guide to Structuring, Issuing and Investing in Sukuk, Euromoney Institutional Investor. 28 OBrien, C. 2009, Applying Globally Accepted Shariah Standards Across Markets, Standard & Poors. 29 RAM Ratings Services Berhad, Malaysian Sukuk Market Handbook, 2008. 30 Rayner, S.E. 1991, The Theory of Contracts in Islamic Law, Graham and Trotman, London. 31 Toutounchian, I. 2009, Islamic Money and Banking: Integrating Money in Capital Theory, Wiley. 32 Usmani, M.T. 2002, An Introduction to Islamic Finance, Springer, New York. 33 www.moodys.com, Global Sukuk Issuance: 2008 Slowdown Mainly Due to Credit Crisis But Some Impact from Shariah Compliance Issues, Moodys Structured Finance Updates.
IFSB Published Standards:

34 IFSB-1: Guiding Principles of Risk Management for Institutions (other than Insurance Institutions) offering only Islamic Financial Services (IIFS). 35 IFSB-2: Capital Adequacy Standard for Institutions (other than Insurance Institutions) offering only Islamic Financial Services (IIFS). 36 IFSB-3: Guiding Principles on Corporate Governance for Institutions Offering Only Islamic Financial Services (Excluding Islamic Insurance (Takaful) Institutions and Islamic Mutual Funds. 37 IFSB-4: Disclosures to Promote Transparency and Market Discipline for Institutions offering Islamic Financial Services (excluding Islamic Insurance (Takaful) Institutions and Islamic Mutual Funds). 38 IFSB-5: Guidance on Key Elements in the Supervisory Review Process of Institutions offering Islamic Financial Services (excluding Islamic Insurance (Takaful) Institutions and Islamic Mutual Funds). 39 IFSB-6: Guiding Principles on Governance for Islamic Collective Investment Schemes. 40 IFSB-7: Capital Adequacy Requirements for Sukuk, Securitisations and Real Estate investment. 41 GN-1: Guidance Note In Connection with the Capital Adequacy Standard: Recognition of Ratings by External Credit Assessment Institutions (ECAIs) on Shariah-compliant Financial Instruments.
IFSB Exposure Drafts:

42 ED8: Guiding Principles on Governance for Islamic Insurance (Takaful) Operations. 43 ED9: Conduct of Business for Institutions offering Islamic Financial Services (IIFS). 44 ED10: Guiding Principles on Shariah Governance System.
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Sample examination

Sample examination
You are allowed three hours to answer this question paper. You are allowed 10 minutes reading time before the examination begins during which you should read the question paper. However, you will not be allowed, under any circumstances, to start typing. You are strongly advised to carefully read ALL the question requirements before attempting the question concerned (that is, all parts and/or sub-questions). You are required to answer all questions. Not answering a question will severely affect your ability to pass the examination. Section A comprises 20 multiple choice questions (MCQs) and is worth 20 marks. Section B comprises 10 MCQs worth 10 marks and five short answer questions relating to a given hypothetical case worth 35 marks (total marks: 45). Section C comprises five general short answer questions worth 35 marks. Total marks available: 100 Required pass mark: 60%
Section A
General multiple choice questions (worth 1 mark each) Total: 20 marks The indicative time for answering this section is 36 minutes 1. What consideration is often provided for in a Wakalah-based service contract? (A) (B) (C) (D) 2. A commission fee A management fee A performance fee A share of any surplus
The difference between a conventional financial lease and one prepared under Ijarah muntahia bi tamleek is that: (A) (B) (C) (D) the lessor under Ijarah muntahia bi tamleek must bear the ownership risks and expenses, while under a conventional financial lease they are borne by the lessee the lessee under Ijarah muntahia bi tamleek must own the leased asset, while in the conventional financial lease it is owned by the lessor the rental in Ijarah muntahia bi tamleek must be at a fixed rate and cannot be based on a floating rate the leased asset in Ijarah muntahia bi tamleek cannot be securitised and made tradable on a secondary market.
3.
Identify the correct statement on IRR. (A) (B) (C) (D) IRR is appropriated out of Mudarabah income before allocating a profit-sharing portion to the Mudarib. IRR is appropriated out of Mudarabah income after allocating a profit-sharing portion to the Mudarib. IRR is designed to mitigate solely fiduciary risk. IRR is designed to mitigate solely credit risk.
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Sample examination
4.
Hibah can only be paid out to Qard savings account holders if: (A) (B) (C) (D) the rate is pre-agreed and benchmarked to the prevailing cost of funds it is contracted before the account is opened the amount is competitive with interest rate benchmarks it is not contracted or pre-agreed.
5.
An Islamic bank can pay pre-agreed fixed profits on Murabahah-tawarruq deposit accounts because: (A) (B) (C) (D) it is based on a Murabahah sale with a pre-agreed profit payable to the depositor it is based on an undertaking by the bank to pay an agreed profit to the customer it is based on the sale of commodities between the bank and the customer it is done for the purpose of asset financing.
6.
The difference between Murabahah working capital financing and Murabahah-tawarruq term working capital financing is that: (A) (B) (C) (D) the former requires the sale of underlying commodities while the latter does not the latter requires the sale of underlying commodities while the former does not the former allows for cash to be made available to customers the latter allows for cash to be made available to customers.
7.
Under which of the following contracts have Islamic credit cards been structured? (A) (B) (C) (D) Musharakah Salam Murabahah-tawarruq Ijarah
8.
Parallel Istisna, though a Shariah-compliant concept, is not necessarily relevant in Islamic project financing because: (A) (B) (C) (D) it requires the project owner to award the contract to construct to the IFI for the IFI to require another developer to construct, while the project owner is the intended contractor it requires the project owner to award the contract to construct to the developer for the developer to seek the financing from the IFI the project owner needs to secure syndicated financing from more than one financier the project financing requires the construction of the asset on the basis of build, operate and transfer (BOT).
9.
Which of the following financing structures is non-compliant under international Shariah standards for Islamic project financing as per AAOIFI? (A) (B) (C) (D) A sale and lease back arrangement A build, operate and transfer (BOT) arrangement A construction and forward lease arrangement A sale and buy-back under Istisna arrangement
10. State the rationale for Shariah equity screening methodologies applied in screening the financial ratio of a public-listed company. (A) (B) (C) (D) The equity investments are normally minority stakes and as such the Islamic investors do not have control over the companys financial activities. The equity investments normally result in majority stakes and as such the Islamic investors have control over the financial activities of the company. The financial screening allows for investments to be made in a company whose primary business activities are non-compliant provided it has passed the financial screening. It is a means of ensuring the degree of purification of tainted income received by the company.
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Sample examination
11. Identify the correct statement pertaining to the Shariah methodology of equity screening. (A) (B) (C) (D) Under Shariah principles, market capitalisation is the preferred denominator to be used for some of the financial screening ratios. Under Shariah principles, total assets are the preferred denominator to be used for some of the financial screening ratios. Shariah principles are neutral on the basis of the measurement of the value of the company as long as it accurately reflects the worth of the company. Financial ratio screening is an option to be used for Shariah equity screening for publiclisted companies.
12. Identify which of the following is peculiar only to gold funds compared to other portfolios of mutual funds or ETFs. (A) (B) (C) (D) The traceability of ownership to the gold bullion The mechanics involved for secondary trading The storage of the physical gold bullion The valuation methodologies of the NAV
13. Which of the following contracts is popular for Islamic money market instruments in the GCC countries? (A) (B) (C) (D) Musharakah CDIFificate Mudarabah Interbank Money Market Wakalah fi-Istithmar Sukuk Salam
14. According to AAOIFI, Sukuk Istithmar can be traded in the secondary market if: (A) (B) (C) (D) 20% of its underlying Sukuk assets are made up of leasing assets 35% of its underlying Sukuk assets are made up of leasing assets 80% of its underlying Sukuk assets are made up of Murabahah assets 90% of its underlying Sukuk assets are made up of Istisna assets.
15. Which of the following is not relevant to the determination of the Wakalah fee in the Wakalah-based Takaful management model? (A) (B) (C) (D) Management expenses Distribution costs, including commissions Profit to the operator Retakaful expenses
16 Which of the following are features of distributing Takaful policies via a financial intermediary (FI)? (A) (B) (C) (D) The requirement that a new selling force be established by the FI to market the Takaful products That Takaful products be offered as standalone products by a separate department That Takaful products can be packaged with the FIs other financial products and distributed through the same workforce of the bank That highly qualified staff of the bank are required to underwrite the risk of Takaful products
17. The concept of cede in the context of Takaful and Retakaful refers to: (A) (B) (C) (D) the transfer of risk the pooling of risk the sale of risk the removal of risk.
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Sample examination
18. Which of the following is a contributing factor to there being a low number of Retakaful companies in the market? (A) (B) (C) (D) Insufficient Takaful companies Business restrictions due to capital adequacy issues Uncompetitive pricing Most of the risks are absorbed by the primary Takaful companies
19. The Islamic FX swap via Wad methodology does not provide the customer with a complete hedge because: (A) (B) (C) (D) the promisor who is the customer does not have recourse to the promisee counterparty bank should the bank decide not to proceed with the necessary transaction the promisee who is the customer does not have recourse to the promisor bank should the bank decide not to proceed with the transaction the bank does not make any margin payment the bank is entitled to change the currency exchange rate as it wishes.
20. Which feature of Urbun limits its applicability as a fully viable Islamic contract to replicate a conventional call option? (A) (B) (C) (D) It is a bilateral contract. It involves the placement of a form of deposit to be deemed as margin. It is non-tradable and the deposited amount must be calculated as a part of the consideration amount for the exercise price. It is tradable and the deposited amount is not calculated as part of the consideration amount for the exercise price.
Section B
Case study: multiple choice questions (worth 1 mark each) and short answer questions (worth 35 marks) Total: 45 marks The indicative time for answering this section is 81 minutes. Case study: Global Pearl Investment Global Pearl Investment (GPI) has set up an Islamic fund to invest in a Shariah-compliant manner in the development of real estate assets that include both residential and commercial developments in Jeddah City in Saudi Arabia. The fund aims to raise capital of SR1 billion. The fund also aims to raise financing up to SR800 million to support the acquisition of other properties should they meet the investment criteria of the fund. The project will involve the construction of a mixture of properties consisting of beachfront villas, town homes, luxury apartments, penthouses, luxury hotels, marinas and schools with related infrastructure and community facilities. The fund aims to achieve an IRR to investors of 20% net of fund expenses and fees payable to the sponsor and manager. However, neither the sponsor nor the manager can guarantee that the fund will achieve such or any other return or that investors will receive back all or any of their capital contribution. Relevant features of this fund include: a. b. the fund, at any point in time, cannot incur indebtedness of more than 50% of the aggregate value of the real estate assets owned by the fund the fund aims to realise its target return through the sale of the residential units to individual purchasers that could include the investors, if they wish; the holding company of GPI has also given a purchase undertaking to buy these units at a purchase price which is equal to 110% of the total development costs for these units should there be no individual buyers after the completion of the residential units the fund may also seek in the future to leverage some of its commercial assets by either issuing Sukuk or converting the assets into Islamic REITs, based on market conditions at the time of the exercise of these two options the tenants of commercial assets may include hotel operators, financial institutions, retail operators, education services providers and health and fitness operators.
c.
d.
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Sample examination
The following figures and estimates have been compiled by the fund to demonstrate that investment in this fund is viable and promising. a. Residential real estate demand and supply Considering the economic boom that Saudi Arabia is currently experiencing, and the large inflow of expatriates, supply is extremely scarce in the residential sector. Higher wealth and spending capacity within the indigenous population has led to substantial increases in house prices and rents. Demand for residential units is even higher for non-Saudis. According to estimates from a global property company based in London, monthly rents in this GPI project are around SR20,000 for a one-bedroom apartment, SR25,000 for a two-bedroom apartment and SR10,000 for a studio, while the average monthly rent for medium-end properties in other locations in Jeddah is around SR8,000. b. Offices The shortage of office space in Jeddah is driving rents up. In light of the economic boom that the country is currently experiencing, and the increasing number of foreign companies opening up in the city, Jeddah is short of office space. According to another international property company, the vacancy rate in the office segment in Jeddah is currently less than 2%. Accordingly, the shortage has induced large hikes in property prices and rents in the commercial segment. c. Retail Jeddah offers substantial opportunity for the retail sector. Increasing wealth and a growing population dominated by highly paid expatriates, generates a demand for high-end retail space. Jeddahs retail scene has witnessed the arrival of a few shopping malls with established anchor tenants such as Carrefour, Geant and Tesco hypermarkets. Based on the above case study, attempt the following questions. Cast study multiple choice questions 1. The above fund could best be described as an: (A) (B) (C) (D) 2. Islamic REIT Islamic mutual fund which is close-ended Islamic real estate fund Islamic ETF
In which sector is the screening of assets necessary to ensure that the fund is compliant with Shariah principles? (A) (B) (C) (D) Hotels Residential Retail Office
3.
If an Islamic private equity fund were to invest in this fund up to 60% of the required equity, what would be the most crucial consideration for the Islamic private equity fund to consider? (A) (B) (C) (D) The core activities of the fund The mode of financing that the fund intends to use The capital guarantee The exit mechanism of the investment
4.
Which of the following is a suitable alternative structure to achieve the objective of the fund given the forecasts by the various property consultants? (A) (B) (C) (D) Sukuk Intifa Sukuk Ijarah Islamic ETF Islamic REITs
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Sample examination
5.
Having explained the potential of this fund in the given market, what is the most relevant risk for the fund? (A) (B) (C) (D) Market risk Rate of return risk Operational risk Credit risk
6.
Suppose the fund seeks to raise the funding in currencies other than the Saudi Riyal. Which of the following are appropriate Shariah-compliant mechanisms to hedge against currency risk? (A) (B) (C) (D) Urbun and Salam techniques of sale Unilateral Wad and Murabahah currency hedging Forward and future currency exchange using Wad and Urbun Spot currency exchange and Urbun sale
7.
Suppose the intended fund was to be incorporated in Hong Kong and received commitments of investment from Islamic investors up to an amount equivalent to SR1 billion. What is the most likely issue that the fund would face operating out of Hong Kong in contrast to Saudi Arabia? (A) (B) (C) (D) Purification of dividends Expected IRR Cash management Capital guarantee
8.
Suppose a fixed income investor decides to invest in the fund. As the fund does not provide any guarantee of fixed income, which of the following techniques is relevant to the investor? (A) (B) (C) (D) Profit rate option Profit rate swap Capital protected fund Islamic call option
9.
Which of the following Sukuk would be relevant to finance the above project? (A) (B) (C) (D) Sukuk Ijarah Sukuk Murabahah Sukuk Salam Sukuk Musharakah
10. Should the project owner decide to securitise the whole infrastructure development based on asset-backed securities/Sukuk, which of the following rating methodologies is relevant in arriving at a rating grade for such securities/Sukuk? (A) (B) (C) (D) Cash flow Project financing Quality of collateral Creditworthiness of the issuer
Case study short answer questions 1. The proposal suggests that the fund will invest through equity and financing instruments to ensure it has sufficient funds to develop and construct these assets. As an Islamic fund, the financing must be compliant to Shariah principles. Explain how GPI can raise the funds in a Shariah-compliant way. (7 marks) The fund, subject to CDIFain market indications and forecasts, may confine its investment portfolio to residential real estate as the expected IRR could be higher than other sectors of the property portfolio, such as commercial properties and offices. Outline the Shariah considerations relevant to this investment strategy and explain whether your answer would be different if the fund were to invest in residential properties in London, United Kingdom. (6 marks)
2.
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Sample examination
3.
Explain the relevant screening criteria for GPIs investment vehicle and outline the rationale for these screening criteria. (6 marks)
4.
Assume that the following financials relate to the fund after three years in operation. a) Total Islamic leverage is SR600 million Total rental lease payments for the last year (year three) amount to SR300 million Total market value of the real estate assets owned by the fund is SR1.8 billion Total cost of construction is SR1.3 billion Total amount of equity used is SR 1 billion It is estimated that the increase of rental rate each year after the completion of the assets will be 10% Explain whether the fund has breached any of the investment guidelines and, if so, explain how any breach can be addressed. ( 3 marks) Explain the recourse, if any, to investors if this fund is liquidated after three years and the market conditions are not as promising as expected by the above estimates? (3 marks)
b)
5.
The fund seeks to leverage its assets after their completion through either Sukuk or REITs. Outline the structures for both of these possibilities and explain how they relate to the fund in question based on the financials given in question 4. (10 marks)
Section C
General short answer questions not directly related to the case study (worth 7 marks each) Total: 35 marks The indicative time for answering this section is 63 minutes. 1. A fund to develop properties in a particular country may consider forming a joint venture company with other property developers in that country to develop real estate assets that need the experience and technical knowledge of co-partners. However, these dedicated assets need funding that is more than the capital committed to this joint venture company. Propose a solution for managing this funding requirement that complies with Shariah principles. (7 marks) 2. A few Islamic financial institutions are interested in providing syndicated financing to a property fund. Describe the best financing instrument for providing this project financing and explain what is required to make it a viable financing scheme. (7 marks) 3. Outline the options available to an Islamic bank to participate in any specific project financing using the funds of its depositors. In your answer, outline specific prudential strategies to protect the interest of the depositors. (7 marks) 4. In providing house financing to its customer, an Islamic bank has decided to package the financing with relevant Takaful products. Explain how the bank could offer these products in a manner which is financially affordable to the customers. (7 marks) 5. IFIs, like conventional financial institutions, are exposed to various risks. Compare and contrast the market risk and liquidity risk which may affect IFIs. (7 marks)
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Sample examination
Answers Section A
1. 2. (B) A Wakalah service contract is remunerated by a pre-agreed management fee for the services rendered by the agent or Wakil. (A) Under Ijarah muntahia bi tamleek, though it may end with the transfer of ownership of the leased asset to the lessee, as in the case of a conventional financial lease, the lessor/ financier is regarded as the owner of the assets in terms of liability and obligation. Thus, he is liable for all ownership risks and expenses such as Takaful cost, major maintenance, etc. (B) IRR is the amount appropriated by the Islamic bank from the investment account holders, after allocating the Mudarib share, to cater for future losses for investment account holders. (D) Contracting or pre-agreeing to returns on a Qard contract is tantamount to Riba. As such, returns can be paid to Qard accounts only if they are entirely at the discretion of the bank and not pre-contracted. (A) Profit based on a mark-up on cost price is a feature of Murabahah and thus can be used when structured into the fixed income deposit account. Payment of fixed profits is not an issue as long as it is applied to the appropriate contract such as Murabahah-tawarruq which creates the obligation on the bank to pay the principal and profit to the depositor. (D) Cash financing is a feature of the Murabahah-tawarruq model while Murabahah working capital financing will finance the customer in purchasing goods, inventories and commodities from the vendor or supplier. The Tawarruq leg of the structure allows for the disposal of the underlying assets to generate the required cash intended by the customer. (C) The Murabahah-tawarruq contract has been applied to structure Islamic credit cards as it allows the bank to provide cash financing equivalent to the credit limit granted to the customer or the cardholder. Also, the bank or the card issuer can charge a pre-agreed profit rate via the mark-up feature of the Murabahah-tawarruq contract. (A) The description is exactly why parallel Istisna cannot take place in the real market. The project owner, while seeking financing, will also be undertaking the construction works. In order to do this, the IFI, as the first contractor under the parallel Istisna arrangement, must appoint the project owner to develop and construct as the second contractor under the arrangement. This will lead to a sale and buy-back arrangement between the two same parties, which is prohibited under AAOIFI Shariah standards. This parallel Istisna seems to work quite well in retail financing between the customer (who is asking for financing), the Islamic bank and the real contractor. However, it does not fit in well with project financing unless the project owner decides to fully outsource the construction work to a third party. (D) Sale and buy-back arrangements or simply Bay al-Inah are non-compliant under international Shariah standards because it seems to be fictitious without any real transactional motive and purpose.
3. 4.
5.
6.
7.
8.
9.
10. (A) These screening methodologies are largely meant for minority investments of equities. If the investments are for a majority stake in these companies, the investors would be expected to ensure the investee companies are fully Shariah-compliant without any tolerance given to some of the financial ratios. 11. (C) The Shariah principles are indeed neutral on market capitalisation or total assets, or any other basis, as a measure for giving a proper valuation of the company, against which some financial screening will be applied to asCDIFain the level or degree of non-compliant financial activities of the company. 12. (B) Secondary trading cannot be allowed in gold fund investments as gold is a Ribawi or usurious item and can only be traded at par. However, the gold fund may establish a mechanism for early redemption for the investors to redeem their investment from the fund and not from the market. 13. (C) Wakalah fi-Istithmar is a versatile contract and is often used to manage excess liquidity in the GCC countries and, to some extent, is deemed an effective money market instrument to manage the assets/liabilities of an Islamic bank.
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Sample examination
14. (B) AAOFI has established a maximum 70:30 percent allocation between debt-based or financial asset-based and real assets for the Sukuk to satisfy the tradability rule and requirement. Any instrument with less than 70% debt based assets can be traded in the secondary market. 15. (D) Answers (A), (B) and (C) are the actual composition of the Wakalah fees chargeable whereas the Retakaful expenses are to be borne by the Takaful fund. 16. (C) Distribution via financial institutions would indeed allow the Takaful products to be packaged into the existing financial products that the financial institutions offer and market via their normal selling forces. 17. (B) Technically, cede in Takaful and Retakaful means the pooling of the contributions of various Takaful funds to mutually contribute to another pool of funds for mutual indemnity in the future. Hence, it means pooling of risk.
18. (B) Retakaful companies are not aggressive enough in their approaches to underwriting and marketing as they are usually not sufficiently capitalised. As a consequence, Takaful companies often cede their business to existing conventional reinsurance, thereby limiting the growth of Retakaful companies. 19. (A) Wad is a unilateral promise and, as the promisor, the customer does not have any recourse on the bank should the bank renege from the currency exchange rate which is to be entered in the future. 20. (C) As with all Islamic derivative instruments, tradability cannot be a feature. Islamic derivative instruments are designed exclusively for risk management and can only be used as instruments to hedge risk. Having said this, Urbun is quite similar to the other features of a conventional call option such as the forfeiture of the Urbun money if the transaction is aborted by the buyer of the Urbun.
Section B
Case study multiple choice answers 1. (C) This is a typical real estate fund that is also based on a mutual fund concept with a feature of a close-ended fund. However, as it is a dedicated investment in real estate assets, it is best known as a real estate fund. Islamic REITs are normally structured for complete assets that have a ready or potential income stream. Also, REITs are listed on the exchange and can be traded. Islamic ETF are also listed and traded on the exchange. (D) As the fund is invested in Saudi Arabian properties, only the office segment needs screening from a Shariah perspective as it may have tenants from conventional financial institutions. While there are no Shariah issues with regard to residential properties (irrespective of the location of the building), retail and hotel segments in Saudi Arabia are normally compliant because non-halal foods and drinks are not allowed in that country. (B) It seems that an Islamic private equity fund has no problem in investing in this fund even as a majority shareholder as the core activity is fully compliant. The only scrutiny that it has to undertake is the nature of the financing that this fund has made. If the financing is Shariahcompliant, then there is no need for either a co-investment strategy or a dedicated investment for conversion purposes. However, if the financing is done on a conventional basis, the conventional debt to equity ratio must not exceed 33% and, even if the ratio is below the stipulated percentage, the fund can only invest as the minority shareholder. Other factors, such as expected IRR or an exit mechanism, are not relevant. (A) While Sukuk Ijarah is only relevant and applicable for complete assets, the Islamic ETF is not a financing instrument. Islamic REITs, on the other hand, may not suit this funding requirement as the assets are still under construction, thus there is no immediate income stream to the proceeds of this Sukuk may be used to fund the construction of the assets together with the equity portion of the fund. Upon completion, the Sukuk investors will have the right to use these assets or sub-lease them to third party tenants, or they could sell this right to another investor. Sukuk Intifa is useful for assets that are complete and assets that are under construction as Islamic finance allows the securitisation of existing as well as future usufruct or services.
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(C) As the holding company of GPI has given a purchase undertaking subject to the completion of the assets, the most relevant risk would be the risk of the non-completion of the designated assets, which relates to operational risk. Other risks, though relevant, are not of prime concern. (B) Wad can be utilised for a simple Shariah-compliant hedging mechanism but the position of the promisor is uncovered should the promisee fail to deliver. For both parties to have cover, it usually calls for a Murabahah swap transaction, which involves the utilisation of underlying Shariah-compliant assets in two Murabahah transactions. (C) Unlike Saudi Arabia, which has a host of Islamic banks as well as Islamic liquid instruments, Hong Kong would present a challenge for the fund on the issue of cash management. The current lack of Islamic banks and liquidity instruments in Hong Kong may result in cash management services generating minimal returns and this could affect the returns on the fund. (B) A profit rate swap will allow the fixed income investor to obtain fixed rate profits or returns that will better match his expectations. The profit rate swap would be designed to be carried out periodically or whenever the fund pays out returns to the investor. (D) The provision that neither the sponsor nor the manager are in a position to guarantee that the fund will achieve the expected return or that Sukuk investors will be able to receive back any of their capital contribution is an indication that Sukuk Musharakah, with its no guarantee feature, is the most likely candidate.
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10. (B) Project financing ratings focus on the ability of the underlying project asset to generate sufficient cash flows to make all the relevant payments. The two key elements in the rating are the quality of the cash flows and the asset of the project. While the periodic cash flow stream is relied on as the sole source for profit (to be distributed to, or shared with, the investors), the project assets are usually secured as collateral for the investors in the event of default or dissolution. Proposed solutions to case study short answer questions 1. The Murabahah-tawarruq structure or a forward lease contract followed by an Istisna contract are two Shariah-compliant products that can be used to raise Islamic funds. The Murabahahtawarruq is easier in terms of structuring and legal documentation compared to a forward lease and Istisna structure or arrangement and its legal documentation. While Murabahah-tawarruq provides cash financing to the fund, the forward lease allows the financiers to commence the collection of rental payments, even though the leased asset, which is already prescribed, is still under construction. The financier will subsequently enter into the Istisna contract as the buyer to require the project company to construct and deliver the same prescribed asset to the financier for a specific purchase price that is meant to cover the cost of the construction. The former payment is construed as the financing cost to the project company, or the fund in this context. Essentially, investments in the residential sector will not be subject to a thorough and complicated Shariah screening as the main purpose of this sector is accommodation and lodging that is compliant to Shariah principles. There are, however, some additional factors that should be considered in some cases of residential properties, such as restaurants, swimming pools, spas and related facilities forming part of the property. These services, if attached and integral to the residential properties, may raise Shariah issues, for instance the selling of non-halal food or drinks in the restaurants. The other facilities may expose men and women to improper commingling, which is objectionable from the Shariah perspective. While this scenario could not exist in Jeddah, it could happen in London, where a more thorough screening and assessment would be required. Shariah equity screening criteria usually involve the screening of financial ratios (leverage to equity, receivables to equity as well as cash to equity). They also involve screening business activities and this is the imperative point to note in considering property, with respect to commercial property investment. In commercial property investment, the business activities of the tenants determine whether the property can be invested in. If the business activities of the tenants are non-compliant with Shariah principles, for instance one of the prohibited activities in the equity screening criteria, then it is best to refrain from proceeding to invest with Shariah funds. The reason for this is that the revenue generated (the rent collected) would be generated from non-compliant sources. The issue is less clear when it involves mixed-purpose commercial properties where there is a combination of tenants with both Shariah-compliant and non-
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Sample examination
compliant businesses. There are several ways to look into this issue. One is that should the noncompliant income generated constitute less than 5% of the total income generated from the property, then the property can be invested in. This is acceptable to some scholars. Another view is that such properties cannot be invested in because there is clearly non-halal rental income irrespective of the degree or percentage of that income compared to the total. The Shariah guidelines issued in Malaysia on Islamic REITs, for example, have tolerated the percentage of non-halal income up to 20% of the total rental revenue. There is currently a divergence of opinion due to the absence of internationally acceptable Shariah property screening criteria. 4. (a) It seems that the fund has not breached any investment guidelines as the level of the funds debt has not exceeded 50% of the aggregate value of the real assets owned by the fund. (b) If the market value of the assets dropped significantly, which could lead to a loss position, the investors may have recourse to the holding company of GPI to purchase all the assets at the value of 110% of the total development costs of the assets, which were valued at SR1.43 billion. 5. One option is to issue asset-backed securities or Sukuk whereby the fund may pool all the assets and sell those assets on a true-sale concept to the asset-backed Sukuk investors, for example at SR2 billion. The Sukuk investors will contribute proportionately up to SR2 billion to purchase these assets from the fund. The Sukuk investors will later benefit from the lease rental income for a CDIFain period of time, such as five years, which is the tenor of Sukuk issuance. Upon the expiry of the Sukuk tenor, the assets can be sold to the market at the prevailing market value. The proceeds of this sale may be used to redeem the Sukuk investment and any shortfall would be borne by the Sukuk investors as there is no recourse to the originator, namely the Islamic fund, which is a pertinent feature in the case of an asset-backed Sukuk. During the Sukuk tenor, based on the estimated increase of the rental rate by 10% each year, the Sukuk investors will proportionately share SR330,000,000 for the first year and up to SR483,153,000 in the fifth year. Another option for the Islamic fund is to sell these assets to Islamic REITs, for example at SR2 billion. Islamic REITs will issue units of up to SR2 billion and will use these proceeds to purchase these assets from the fund. Upon this purchase, the Islamic REITs can either lease back the assets to the fund, if the fund wishes to continue the operation of managing these assets, or the Islamic REITs may lease the assets to a third party operator or tenants. The Islamic REITs may also sell some of these assets to a third party as and when the Islamic REITs deem it fit to dispose of them. Investors in asset-backed Sukuk and Islamic REITs, unlike investors in real estate fund, are not vulnerable to the construction risk. They are only exposed to market risk and liquidity risk.
Section C
Proposed solutions to general short answer questions 1. The joint venture company, unlike the fund, is owned by two parties namely the fund and third party property developer company. If this joint venture were to raise funds through conventional financing, this may pose a Shariah issue to the fund which should not be involved in any financial activities that are not compliant to Shariah principles. As for the other property development company, it may borrow conventionally. In this case, there are two options available to the Islamic fund. The first is for the Islamic fund to convince the co-investor to obtain Shariah-compliant financing to finance the cost of construction of jointly developed assets. Alternatively, the joint venture company will only be formed after the property development company has obtained a conventional loan. Both parties will contribute to this new joint venture company in the form of equity, though the equity of one partner may be raised through a conventional loan facility. This is possible as the joint-venture company is a separate legal entity and is not involved in the conventional borrowing. Project financing based on Istisna with a forward lease arrangement may be the best option. To begin with, a project company needs to be established for any project financing. The sponsor or the shareholders in this project company will provide some equity. In order to attract participating Islamic financinal institutions to provide equity financing to this project, they may have to be offered a share in the project company. If, for example, the funding requirement is AED300 million, the project company will undertake to deliver to the Islamic financiers syndicate CDIFain prescribed assets under an Istisna contract for payment of the AED300 million. The proceeds will be used to finance the construction of the designated asset. Upon completion of the project, the assets will be delivered to the Islamic financiers syndicate under
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Sample examination
the Istisna contract for them to lease to the project company/fund under a forward lease contract, for example at AED400 million, for a period of five years. The fund may then sub-lease these assets to end tenants. 3. An Islamic bank may participate in any medium to long term project financing. The bank may use the general Mudarabah investment account based on Mudarabah Mutlaqah or it may create a special Mudarabah investment account based on Mudarabah Muqayyadah, whereby the depositors will not be allowed to withdraw their capital until the end of the financing. In order to protect the interest of these two groups of investors, the bank may apply both PER and IRR to smooth the payment of expected profits as well as to create a reserve for the investors. The bank may require a customer applying for house financing to subscribe to MRTA Takaful or Family Takaful (with the assignment of the Takaful benefit to the bank) or to subscribe to both Takaful products, which are equitable to both parties, particularly in the case of the premature death of the customer or his permanent disability. The bank may partner with other Takaful providers for these two products or may market these products through Bancatakaful for a marketing fee. However, not all customers may have sufficient funds to subscribe, particularly to MRTA Takaful, which requires a single payment. In this context, the bank may finance the customer through cash financing using the Murabahah commodity structure. Liquidity risk is the risk of not being able to meet the demand for withdrawals or short-term obligations and this may arise due to a lack of liquidity instruments in the form of securities or assets that can be traded to realise cash in the short term. Market risk, on the other hand, is the risk that the value of an investment may decrease due to volatility in market factors. For both types of risk, the risk is usually analysed at the point of disposal of the investment asset, where the former is the result of no takers of the asset in question and the latter is the result of a fall in value. Such risks can also be interrelated, an example being a residential propertys value plummeting (market risk) due to it being too large and expensive for small investors to purchase (liquidity risk).
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Glossary of terms and contracts
Glossary

Absentes a contract where the parties are not present at the time of agreement Al-kharaj bi al-daman the concept that reward should correspond to risk involved Amanah is not a contract as such, but is a feature or a requirement in some specific contracts that impose on one of the parties to disclose the actual cost price, such as in Murabahah sale as compared to negotiated price sale (Musawamah) with no requirement for such disclosure. Amanah relates to the part of the buyer/seller relationship that is based on trust. This might occur where the financial institution buys goods from a third party vendor on the request of the institutions customers, which will subsequently purchase the goods from the financial institution. Upon purchasing the goods from the vendor, the financial institution assumes risks relating to the specified asset until the point of purchase by the buyer. An Amanah, or trusteeship, is required of the seller/financier to disclose the actual cost of the goods purchased from the vendor before selling it to the customer at cost plus mark-up.
Another example of Amanah being introduced into an Islamic financial arrangement would be Wadiah Yad-Amanah, which is where a bank as the custodian undertakes the task of safekeeping the assets or funds deposited by a customer in a safe custody contract, based on trusteeship. It is executed between two parties, namely the depositor (owner) and the bank (custodian). The liability of the custodian triggers only in cases of negligence and misconduct. This is to distinguish between safe custody contracts, which are based on liability, and this safe custody contract, which relies on trusteeship. It establishes the liability of one of the parties, whereby a contract that is featured as Amanah will not inflict any legal liability on the part of the custodian, except in the case of negligence and misconduct. Key principles of Amanah Requires a true and honest disclosure of the cost price in all Amanah-based sales. Establishes liability on trustees only in cases of negligence and misconduct.
Aqd contract Ariyah provision of the right to use for no consideration (loan) Ashum shares Bancassurance insurance offered or marketed through banks instead of through insurance
branches or agents
Bancatakaful Takaful offered or marketed through banks instead of through Takaful branches
and agents
Bay sale Bay al-dayn the sale of debt Bay al-inah sell and buy-back to obtain cash Bay al-murabahah sale of a commodity at cost price plus a known profit Bay al-tawliyah sale at cost without profit or loss Bayal-wadhiah sale below the cost price or at a discounted price Bay muajjal deferred payment sale
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Bayt al-mal government treasury Glossary Bulugh physical puberty Darurah a necessity or emergency. This is a condition in which aspects of Shariah may be suspended
in order to preserve life, or to assure the safety of the Muslim community, or an individual.
Dayn a debt or the obligation to deliver an asset Diminishing Musharakah see Musharakah Mutanaqisah Fiqh Islamic substantive law Fiqh al-muamalah Islamic commercial law Gharar uncertainty Gharar fahish major uncertainty Gharar yasir minor uncertainty Hadiah al-thawaab a gift with the intention of getting the reward from the recipient in the future Halal acceptable and lawful Hamish jiddiyyah a security deposit paid by a party prior to entering into an exchange contract such as sale and lease, for his commitment for this intended contract. Should the party fail to enter into the contract, the other party can use the deposit to cover any losses incurred. Hanafi particular school of law Hanbali particular school of law Haram unacceptable or prohibited Hasuna pleasing, appealing or nice Hibah gift Hiwalah transfer of debt/right to claim Hukm a ruling in the Quran or the Traditions of the Prophet Muhammad, or derived through reasoning of jurists Ibra can be defined as a discount or rebate. An example of Ibra in practise might be where a bank which is owed a set amount from one of its clients and accepts less for early payment. This practice of discount or rebate avoids unjust enrichment and maintains the competitiveness of the bank.
Key principles of Ibra Relates to the forfeiting of rights to claim. Involves a discount or rebate for early repayment of an amount owed.
Ifa waiver to set aside right Ijarah a lease contract
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Ijarah ala al-ashkhas hire of people Glossary Ijarah al-ayan lease of the asset Ijarah Mausufah fi al-dhimmah a lease on a specific description of the property to be
constructed and delivered in the future whereby the lease payment may be collected prior to the delivery of the asset
Ijarah muntahia bi tamleek where an option to transfer the title of the asset to the customer
is provided for in the lease, the lease arrangement is Ijarah muntahia bi tamleek. It is also known as Ijarah Thumma al bay (lease followed by sale) or Ijarah wa al-iqtina (hire and purchase). The objective of this financing is to transfer the legal title of the leased asset to the lessee at the end of the lease period. At the end of this contract, the bank will surrender its ownership of the asset to the client in consideration of the total accumulated rental claim that is inclusive of the profit. The concept Ijarah muntahia bi tamleek is an alternative to finance leasing and in particular hirepurchase financing. There are several forms of Ijarah muntahia bi tamleek financing which reflect the different modes of transferring the ownership of the asset such as gift, sale and transfer of equity claim from the lessor to the lessee. Key principles of Ijarah muntahia bi tamleek Involves a lease with an option to purchase the leased asset. At the end of the lease period title transfers to the lessee. Several forms exist to reflect the mode of transfer of ownership.
Ijarah mustaqbal forward Ijarah Ijarah tasqhilliyyah refers to an operating lease, where the financial institution transfers
the usufruct (right of beneficial use) of a particular property to another person in exchange for a rent claimed from the lessee. The financial institution, such as a bank, will purchase an asset, for example plant and machinery, from a vendor and lease it to the lessee or client at an agreed rate for a defined period. The operating lease will clearly state that the lessee has the right over the usufruct in exchange of a rental claim. The ownership of the asset will not be transferred to the lessee during the period of the Ijarah contract. At the end of each Ijarah period, the bank will negotiate a new lease with the lessee and the lease period will continue until the bank chooses to scrap the asset. No option or right to purchase is granted to the lessee. Key principles of Ijarah tasqhilliyyah Involves a straightforward operating lease. At the end of the lease period title does not transfer to the lessee. A t the end of the lease period the owner of the asset will negotiate a new lease or sell/scrap the asset.
Ijarah thumma al-bay see Ijarah Muntahia Bi Tamleek Ijarah wa al-iqtina see Ijarah Muntahia Bi Tamleek Ijtihad interpretation Ijma consensus or agreement of all Muslim scholars over interpretation Illah effective cause or ratio legis In rem action relating to property rather than the person Inter absentes not physically present Inter praesentes contract physically present 392
Istihsan equity consideration Glossary Istishab presumption of permissibility Istisna is a contract to build, manufacture, construct or develop the object of sale at a definite
price, over a defined period of time, according to agreed specifications between the parties. An Istisna contract can be established between a bank and contractor, developer or producer that allows the bank to make progress payments as construction progresses. Istisna financing is provided in the form of advance progress payment(s) to the customer who builds, manufactures, constructs or develops the object of sale. Upon completion of the project, the asset is delivered to parties who agreed to take delivery of the asset. Parallel Istisna arises when the party that intends to take delivery provides advance progress payment to the bank to engage the builder, manufacturer, contractor and developer. Variations of timing and cash flow expectations, between the purchaser and the parties that deliver the object of sale, are bridged by the bank. Key principles of Istisna Involves the purchase of an item that has yet to be built, manufactured or constructed. Progress payments are normally made by instalments as construction progresses. On completion of the project the asset is delivered to those that originally commissioned it. P arallel Istisna is where those that commission the asset make progress payments to the financier as the asset is constructed by another contractor or developer. P arallel Istisna allows for any mismatch in the timing or amount of cash flows between those that commission the asset and those that construct it.
Istisna muwazi (parallel Istisna) see above Jualah commission-based Kafalah is a contract of guarantee or surety that provides assurance in terms of performance and value when the object of the transaction is exposed to adverse change due to varying outcomes. In trade financing, a bank guarantee is issued when the owner of goods discharges the liability for the goods on behalf of a third party. Such guarantees are often used in cases of goods being imported. The exporter knows that the goods will be paid for and can feel free to allow the goods to be uplifted by the importer. The importer may be required to offer some form of collateral as surety and will normally pay a fee for the service. The purpose of a Kafalah contract is to facilitate international trade.
Key principles of Kafalah Involves a guarantee or surety. Used when something being bought or sold could change in value if exposed to adverse conditions. Often used when importing/exporting goods. Facilitates international trade.
Litera legis literal rule Madhhab school of Islamic law Madhahib plural of Madhhab Mafsadah evil and harm Maisir game of chance Majallah al-ahkam al-adliyyah the Islamic Civil Code of the Ottoman Empire Makhatir risk which is integral in any business or commercial dealings Mejelle English translation of Majallah al-Ahkam al- Adliyyah
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Glossary
Maliki particular school of law Maqasid objectives and ultimate purposes of Islamic law Maslahah what is good or beneficial Maslahah mursalah benefit or interest / unrestricted public interest Muajjal deferred (see Bay muajjal) Mudarabah (capital provider Rabb al-mal, entrepreneur Mudarib) a Mudarabah contract is a
profit sharing contract. Under a Mudarabah contract, the capital provider agrees to share the profits between themselves and the entrepreneur at an agreed ratio or percentage. (1) As a source of capital for a business venture, a businessman might consider undertaking a commercial project financed by funds from a bank under a Mudarabah contract. If agreeable, the bank supplies the finance to the businessman on the understanding that both parties will share the profits of the venture. (2) As a deposit taking activity, money deposited in a bank by an individual or institution under a Mudarabah contract is treated as an investment in the bank by the individual or institution. The bank will use this investment to help make profits from its trading activities, i.e. financing of individuals and businessmen. Under the Mudarabah contract, the bank will have agreed to give the depositor a share of its profits in return for the investment, based on a pre-agreed ratio. Investment financing through Mudarabah is a commitment to participate in the risk associated with business ventures, with the aim of sharing the profit generated from a given business venture. Parties to the Mudarabah contract will only benefit if the venture is successful. Should the project fail, the financier will lose his investment, whereas the businessman will only lose the time and effort expended on the project. In general, conditions imposed and agreed on by both parties limit the mobilisation of the funds raised under a Mudarabah contract, such as pooling with other funds, types of business venture or investment, as well as profit and loss sharing among the funds. In the case of a savings account, a Mudarabah contract without conditions and restrictions is usually adopted, which is intended for public and retail investors. Mudarabah, unlike Musharakah, does not entitle the capital provider to an executive function in the management of the business venture. Key principles of Mudarabah Profit sharing contract. Returns depend on a profit being earned. Conditions could apply to what the investment can be used for. Requires a commitment to participate in the risk associated with business venture. he businessman only loses the time and effort expended on the project, where the financier T assumes the financial loss. Does not entitle the financier to any say in the running of the venture.
Mudarabah muqayyadah This type of contract is used in specific bank accounts known as
restricted investment accounts (RIAs), where the bank acts as an agent for the investor(s) simply by acting upon their instructions. Here, the funds deposited based on the Mudarabah contract are never really under the control of the bank because the depositor(s) determine the manner as to where, how and for what purpose the funds are to be invested. Commingling of the funds raised under this type of contract with the banks shareholder and other deposit funds is usually restricted or prohibited. The returns distributed to restricted investment account holders (RIAHs) is based on an agreed profit sharing ratio confined to the returns earned on a designated specific investment portfolio involving the funds agreed upon by the RIAHs. Any distribution between the bank and the depositor will be in accordance with an agreed profit sharing ratio, or agency fee if the contract is based on wakalah or agency for investment. Mudarabah profits or income distributable to RIAHs are derived from the performance of designated financing assets or investments managed by the bank.
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Key principles of Mudarabah muqayyadah Financial institutions act as entrepreneurs or agents for investors. Investors decide where funds will be invested. Commingling of funds is either restricted or prohibited. Returns paid to investors come only from returns earned on the specified investments.
Glossary
Mudarabah mutlaqah unlike Mudarabah Muqayyadah, this contract relates to investment accounts where the account holder fully authorises the bank to invest the funds without restrictions imposed by the account holder and is in accordance to the Shariah principles and rules. The funds are pooled with the banks shareholder funds and other deposits to facilitate financing and investments by the bank. The returns depend on the level of profits earned, and are shared and distributed across the varying classes of investment account holders based on different investment horizons from one to 60 months or more. Usually, returns to investment account holders are computed and accrued on a month-to-month basis. The investment account holder must submit written notice to Islamic banks prior to the withdrawal of funds and a minimum notification period is required. Mudarabah profits or income distributable to unrestricted investment account holders are derived from the performance of the banks financing assets and investments.
Key principles of Mudarabah mutlaqah Financial institutions fully authorised to invest deposited funds without restrictions. Commingling of funds can take place. Returns paid to investors come only from returns earned across all investments of the financial institution. Returns paid to investors depend on class and time horizon of investment.
Muhammad the Last Prophet of Islam Mujtahid the person who performs Ijtihad Muqasah set-off Murabahah a Murabahah contract refers to a cost plus mark-up transaction between parties.
Murabahah financing is the prevalent mode of asset financing undertaken by a large number of Islamic banks. It represents a significant portion of Islamic bank financing of either short term or long term asset financing. Under this contract, a three party arrangement is made where the customer places an order with the financial institution to purchase goods from a supplier. The customer can pay a security deposit with the financial institution and the amount of financing outstanding can be secured either in the form of collateral or a guarantee. The financial institution, having purchased the goods from the supplier, then sells them to the customer at a credit price including mark-up, with a fixed credit period. The nature of the buyer and seller relationship is based on the principle of trust (Amanah), mentioned above, where the seller upon purchasing the goods from the vendor must honestly disclose to the customer the actual cost price of the purchase, prior to selling the asset to the customer under a Murabahah. Under this contract, the customer is always aware of the mark-up, i.e. it is set in advance, and pays the Murabahah selling price either on an instalment basis or at the end of the financing period. The mark-up or profit agreed in the price does not change over the period. Hence there is a price ceiling for the Murabahah financing to ensure certainty in the price. Rebates may be granted for early settlement, provided the rebate provision is not contractually documented in the contract. On the other hand, provision for penalty charges for delinquent payments could be included in the contract as a form of compensation but to be distributed to charity as the provision is only to deter moral hazard behaviour. The bank may take some of this compensation money to cover the actual cost incurred by the bank due to the default. Compensating for loss of opportunity cost or cost of funds is not acceptable. Key principles of Murabahah Cost plus mark-up arrangement. Usually involves a financial institution, the customer and a third party vendor. Based on a relationship of trust between the parties.
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Can be secured by collateral or guarantee.
Glossary
Sets a fixed priced between the financier and customer. The price is paid over an agreed period of time. Early repayments are allowed and can result in a reduction of the overall price charged. Penalties can be applied for late payment as a deterrent.
Murabahah-tawarruq contract to realise cash Murabahah li al-amir bi al-shira Murabahah to the purchase orderer Musawamah negotiated sale, a general kind of sale in which the price of the commodity to be
traded is bargained between the seller and the purchaser without any reference to the price paid or cost incurred by the seller.
Musharakah a Musharakah contract is a form of equity partnership investment. It is similar to

equity investment in a conventional capital market but the investments made must be confined to stocks and financial securities or other assets that are consistent with the principles of Shariah. Note, partnership contracts come in three forms, namely Shirkah al-Amal (work partnership), Shirkah al Wujoh (partnership by reputation) and Shirkah al-Amwal (partnership by capital). Musharakah financing is based on Shirkah al-Amwal (partnership by capital). As a form of equity based financing, like Mudarabah investment financing, Musharakah financing is a commitment by the financier to participate in risks associated with business ventures. Musharakah also means a joint enterprise in which all partners share the profits or losses of the venture. While the profit sharing ratio may be negotiated, the loss sharing ratio must always be proportionate to capital contribution. It also allows the institution to be involved in the executive decision on administration, operations and management of the business activity. The financial institution would be able to mitigate any form of operational risks by assuming an element of control in the conduct of business. The Musharakah financing mechanism operates on a capital contribution basis for a defined existing or potential project or assets. The outstanding financing amount could increase or decrease depending on the demands for funding during the financing period. At any point in time, the outstanding capital contribution provides the basis for determining the profit or loss sharing ratio. As a profit and loss sharing arrangement, Musharakah takes various forms, depending on the parties capital contribution and their effort in managing the venture. Musharakah is considered as the most flexible form of equity financial claim that can be adopted for various economic sectors, including services, production and distribution. Key principles of Musharakah Profit and loss sharing contract. The financier invests in the venture. Requires the participants to work in partnership. The financial institution or lender has a say in the running of the project. Relates to a specific project or asset. Returns depend on a profit being earned. Allows for the level of finance outstanding to fluctuate up or down. Requires a commitment to participate in the risk and loss associated with business venture.
Musharakah mutanaqisah is a variety of Musharakah contract, where the term Mutanaqisah

means to diminish. Thus, Musharakah mutanaqisah, also referred to as Diminishing Musharakah, means a form of partnership which creates an avenue for the capital provider to reduce or be free of the joint ownership after the initial investment period has been satisfied. As mentioned above, a normal Musharakah contract allows for fluctuating levels of investment, but a Musharakah Mutanaqisah contract specifically relates to a reducing investment. Diminishing Musharakah provides an avenue for the financial institution to systematically reduce its exposure over the financing period, with planned and scheduled redemption of the contribution amount. This form of finance is often used in the purchase of a house in the form of a joint venture. The financier contributes the bulk of the house price with the individual customer contributing the
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remaining balance. The joint venture accepts rental repayments from the individual who is now living in the house. The rental is split between the financial institution and the homebuyer with the homebuyers share going toward the redemption or dilution of the financiers shareholding. Key principles of Musharakah mutanaqisah As with Musharakah above. Allows for planned diminution in investment to the point where the financier exits the venture Effectively finances the customer to acquire an asset through a joint venture scheme.
Glossary
Parallel Istisna see Istisna two contracts operated in parallel Parallel Salam see Salam two contracts operated in parallel Praesentes where the parties to the contract are present at time of agreement Qard interest free loan Qiyas analogy Qiyas al-tard extension of a legal rule from one case to another due to a material similarity Qur an the Holy Book revealed to the Prophet Muhammad Rahn pledge Ray personal opinion Ratio decidendi legal basis Rem see in rem Riba interest/usury Riba al-fadl interest by an excess of countervalues Riba al-nasiah interest by deferment in the delivery Ribawi usurious or interest-based Rushd prudence Sadaqah voluntary charitable contribution by a Muslim seeking to please Allah Sadd al-dharai blocking the means Sahm a share Salam refers to the purchase of a commodity for deferred delivery in exchange for immediate payment.
Thus, in a Salam contract, the price is paid in full and in advance while the commodity is deferred to an agreed date in the future. This type of contract might be used where the commodity price is subject to change. The buyer is locked with the purchase price at contract date and thus hedged against price increase. Stringent conditions are applied to ensure a binding and legally enforceable contract such as reasonableness of delivery and specifications of quality type and quantity of commodities. Any variations of quality and quantity of goods as well as timeliness of delivery would not affect the agreed price. The object of a Salam contract must be commodities that can be specified clearly, due to the non existence of the object of sale at the time when the contract is concluded. The detailed features and specifications of the product of sale must be agreed upon to avoid ambiguity that would render
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the contract unknown to the parties. When there arises a disparity or mismatch in terms of types, quality and timing of delivery, the buyer has either the choice to take delivery without discount or premium on price, or to revoke the contract. Advance payment made by the bank to the seller or exporter to deliver or produce the goods constitutes Salam financing. Parallel Salam is based on two independent Salam contracts whereby the financier will be both the seller and the buyer in this arrangement. In the first Salam contract, the IFI will be the buyer of the Salam asset by providing a full payment to the seller against a future delivery of an asset. Then, this IFI may enter into a Salam contract as a seller with another party for a shorter period of delivery of the asset. the spread between the first and second Salam contracts is the profit earned by the IFI through this parallel Salam arrangement. Key principles of Salam Involves a forward purchase of a commodity Full payment is made at the beginning of the contract period Goods are received at the end of the contract period The goods must be clearly identifiable Remedies available for failure to complete the contract as specified P arallel Salam is useful to finance the ultimate producer as the IFI is neither the ultimate producer nor the user.
Glossary
Sanadat al-dayn certificates of debt Shafii particular school of law Shari`ah sacred law revealed by God Almighty Shirkah partnership Shirkah al-mufawadah equal partnership Sukuk certificates of investment Sukuk al-Ijarah certificates of investment in leased assets Sukuk al Intifaa Sukuk for use or services Sukuk Istithmar certificate in investment Sunnah The Traditions of The Prophet Muhammad Taawun cooperation Tabarru donation contract Tadawul Saudi Stock Exchange Takaful is an Arabic term derived from the root word kafala, meaning to guarantee. To be more
precise, it is derived from the verb Takafala meaning to mutually guarantee and protect one another. Therefore, literally, it means mutual help and assistance. It can be noted that the contract of Takaful is based on the concept of helping one another, whereby each and every participant contributes to the common fund in order to provide financial assistance to any member who needs help, as defined in the mutual protection scheme. In principle, Takaful is very similar to conventional mutual insurance in terms of its philosophy and structure. However, it differs significantly from conventional mutual insurance as all its operations should be based on Islamic principles, including investment activities, the establishment of the Shariah board and causes for legitimate claim, which exclude causes such as suicide and death under the influence of alcohol.
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Key principles of Takaful Relates to the idea of mutual guarantee. Used in the context of mutual help of assistance. S imilar to conventional mutual insurance. but differs in terms of investment portfolio and legitimate causes for claims. Claims restricted under Shariah principles.
Glossary
Takharuj exit from partnership by selling the shares to another party Tanazul is an act to waive certain rights of claim in favour of another party in a contract. In Islamic
finance, it is applied where the right to share some portion of the profits is given to another party. For example, in a Mudarabah contract, the capital providers may agree to limit the rate of return to a defined percentage whereby the excess can be given to the manager as an incentive or performance fee. The decision of the investors to waive their right to the profit is based on the principle of Tanazul that is specified as a condition of the contract to waive such a right. Key principles of Tanazul Involves the waiving of rights in favour of someone else. ften seen where the capital providers agree to waive their right to a portion of the profits in a O venture in favour of, say, a manager on the project.
Taskeek securitisation Tawarruq buy spot and sell deferred payment or vice versa to facilitate cash liquidity Tawliyah sale at cost price Tijarah private commercial transactions Ujr fees paid in lieu of service to be provided by the service provider (not the same as Ujrah, which is rent) Ummah Islamic nation Umum balwa common plight and difficult to avoid Urf customary practice Urbun is essentially a down payment made by a buyer to a seller after both parties have entered
into a valid contract. The down payment represents the commitment to purchase the goods. If the buyer is able or decides to pay the remaining outstanding payment during a prescribed period, the amount paid as down payment will be counted as part of the purchase price. Otherwise, the down payment will be forfeited by the seller. This is the original version of Urbun in Islamic commercial law. This feature is often used to mirror the behaviour of conventional options by providing an opportunity to the buyer (the person making the down payment) to benefit from the market up-side (call option) of the underlying asset and by limiting the potential loss to the amount paid under the down-payment scheme. Key principles of Urbun I nvolves the payment of a down payment to secure an option or right to purchase something in the future. Mimics the economic benefits of purchasing conventional options. If the option to complete the purchase is not taken up the down payment is forfeited.
Usufruct the right to use
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Usul al-fiqh Islamic legal theory providing principles and guidelines on interpretation Glossary Wad is a feature attached to a contract and is a unilateral promise made by one party to
another, binding on the party that makes the promise. In financing transactions this feature provides assurance that the transaction will be executed as per the specifications of the contract. For example, an importer who has foreign exchange transaction exposure in terms of payment of imports in foreign currency upon delivery of goods might hedge the risk of appreciation of foreign currency by undertaking a promise to buy the foreign currency in the future that matches the real exposure to currency risk of import transaction upon delivery. Key principles of Wad Involves a unilateral promise made by one party to another. Binds the promisor to fulfil some obligation in the future. Ensures that the contract is fulfilled as set out in the terms
Wadhiah sale sale of goods at a discounted price Wadiah yad dhamanah guaranteed safe-custody deposit contracts Wakalah is a contract between an agent and principal. This contract enables the agent to render services and be paid a fee (Ujrah). For example, in a case where the importer applies for a letter of credit based on Wakalah, the importer will authorise the bank to issue the letter of credit on his behalf to the exporters bank. The issuing bank will act as the agent to process the issuance of the letter of credit and for this will impose a fee on the importer for the services rendered.
Key principles of Wakalah Involves an agency contract between an agent and principal. Used as a facility to enable transactions to take place. The agent earns a fee (Ujrah) for his services.
Wakalah fi al-istithmar agency in investment Wakil agent Waqf permanent endowment Wasiyyah will contract Zahiris literalists Zakat is a form of religious levy on the wealth of Muslims. It is based on wealth that exceeds the specified quantum for a defined period (where relevant) and is meant for the poor and needy as well as other specified beneficiaries mentioned in the Quran. It is the third pillar of Islam and is made obligatory for Muslims who have the financial means to discharge such obligations. Methods of Zakat computation are prescribed to facilitate determination of Zakatable wealth as well as the prescribed rate. In the case of investment or deposit funds, there is no specific date set for the payment of Zakat, but it should be paid on all accumulated wealth for the period of twelve lunar months. Zakat is not payable on the value of the individuals home, furniture, transport or tools of trade, nor is it paid on personal jewellery.
Key principles of Zakat Religious levy on wealth of Muslims who possess a certain amount of specific assets. Payable on all accumulated wealth held for the period of 12 lunar months. Not payable on specified items that are personal in character.
400
Glossary 401
Notes
402
Notes
403
Index
Index
Index
Bay al-tawliyah 39 Bay al-wadiah 39 Bilateral contracts 35-37 Build-operate-transfer (BOT) 167-168 Commodity Murabahah 117 Deposit insurance 88, 107 Displaced Commercial Risk 104-105 Forward FOREX 350-351 Hiwalah 38 Ijarah 39, 148 muntahia bi tamleek 39, 151 vehicle financing 43 Investment Risk Reserve 86 Islamic capital markets 190-211, 373 Islamic current accounts 107-109 Islamic deposits 43, 101-115 Islamic derivatives 346-365 and hedging 349 Islamic finance policies 78-79 Islamic funds 220-243 close-ended 226 commodity funds 227 exchange traded funds 226 gold funds 228-230 money market funds 233-236 open-ended 226 real estate funds 230-231 Islamic investment accounts 111-114 Islamic money market instruments 115-119 Islamic personal financing 43 Islamic savings accounts 109-111 Islamic swaps 358-364 Istisna 165-167 Jualah 37 Juristic rulings 34-35 Kafalah 38, 147 Liquidity 101, 115-119 Mudarabah 38, 89, 102, 116, 170-171 investment account 28, 29, 111 muqayyadah 111 mutlaqah 111 working capital financing 142-143 Murabahah property financing 150-151 Murabahah-tawarruq 114, 115, 145-146, 148, 357 working capital financing 138-140, 143 Murabahah term financing 43 Murabahah working capital financing 132-141, 143, 172 Musharakah 38, 170-171 mutanaqisah 28, 151 working capital financing 142-143 Personal financing 148 Profit Equalisation Reserve 85, 86 Profit Sharing Investment Account 66-67 Project financing 161-181 Property financing 150-152 Quasi-equity financing 171-172 Rahn 38 Real estate investment trust (REIT) 230-231 Retail financing 144-148 Retakaful 325-34 and retro-Takaful 338-339 facultative 326-327 Mudarabah model 325 non-proportional 327 proportional 327 Treaty 326 Wakalah model 325 Retro-Takaful 338-339 Salam 56 Shariah compliance 23-33, 89-91, 372, 373 currency hedging 356 Islamic capital markets 193-211 Islamic funds 223-225 money market funds 237-240 Shariah supervisory systems 76-77 Sukuk 373 asset-backed 269 asset-based 261 Ijarah 28, 168, 254, 261-265 Istisna 260 Murabahah 256-259 project-based 266-269 rating 272-278 Salam 117 structuring 250-271 Tabarru 50 Takaful 88, 92, 284-314, 374 and Retakaful 325-326 Mudarabah model 293 Wakalah model 294-295, 299-300 Tax laws 79 Unilateral contracts 35-37,40 Vehicle financing 152-153 Wadiah yad amanah 38 Wadiah yad dhamanah 38 Wakalah 37 fi al-istithmar 116-117, 118 Working capital financing 131-144 Zakat 91
404
Islamic finance is a fascinating and dynamic multidisciplinary area of the international financial services sector. As an established niche of the finance industry it is set to grow at an exponential rate over the next few years. The current annual industry growth rate is estimated to be between 15% and 20%.
As a result of the rapid growth experienced in this emerging area and the distinctive nature of the products and services offered, most individuals and finance organisations have minimal exposure to, and understanding of, its unique and profound nature, resulting in a significant skills shortage. To date, few institutions offer qualifications in the subject, nor do any professional bodies offer a global qualification. CIMA, in conjunction with the International Institute of Islamic Finance Inc., has developed a tiered learning approach to meet this global shortage in human capital. Having launched the CIMA Diploma in Islamic Finance in 2007, CIMA has now developed the Advanced Diploma in Islamic Finance (CADIF) for those who wish to apply the knowledge they have already gained. The Advanced Diploma comprises a single module that builds on the strong foundation of knowledge and skills developed in the certificate. Students are introduced to the broad concepts of structuring within Islamic finance as well as the product strategy adopted to ensure that each product is competitive in the individual markets and within the respective legal and juridical boundaries that surround each market. The CADIF builds upon the CIMA Diploma in Islamic Finance with its core foundation modules of Islamic Commercial Law, Islamic Banking and Takaful, Islamic Capital Markets and Accounting for Islamic Financial Institutions. The CIMA Advanced Diploma in Islamic Finance learning system includes:
comprehensive syllabi leading to a higher professional qualification

in Islamic finance step by step coverage directly linked to specific learning outcomes fusion between theory and practice chapter summaries contemporary and user friendly glossary of Islamic finance terms self learning and self assessment approaches extensive question practice revision sections for each chapter a full length mock examination at the end of the guide.
All materials included in the CIMA Advanced Diploma in Islamic Finance have been subject to the scrutiny of a global advisory panel comprising experts in all the areas covered within the module. CIMA is proud to be the first professional accounting body to offer a truly global suite of products in this area your passport to success in Islamic finance.
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Advanced Diploma in Islamic Finance

A global product for a diverse world

CIMA Advanced Diploma in Islamic Finance

CIMA Advanced Diploma in Islamic Finance

74 100 126 160

188 220 250 284

346 372 376 378 390 404

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How to use this guide

Realising your potential with this study guide as a learning companion

CIMA Advanced Diploma in Islamic Finance

How to use this guide

The advanced diploma

CIMA Advanced Diploma in Islamic Finance

How to use this guide

Examples from real life

Exercises and answers

Islamic finance challenges

CIMA Advanced Diploma in Islamic Finance

How to use this guide

Revision questions with answers

CIMA Islamic finance website

Assessment of materials found on the website

CIMA Advanced Diploma in Islamic Finance

How to use this guide

The final examination

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CIMA Advanced Diploma in Islamic Finance

Islamic finance in the context of conventional finance What is finance?

What is Islamic finance?

CIMA Advanced Diploma in Islamic Finance

Shariah advisory boards

The importance of contracts

Islamic financial institutions: products and services

CIMA Advanced Diploma in Islamic Finance

The Islamic capital market (ICM)

The Islamic equity market

The Islamic fixed-income instruments or Sukuk market

CIMA Advanced Diploma in Islamic Finance

The Islamic derivatives or Islamic structured products market

Accounting and analysis of Islamic financial transactions

Advanced Diploma in Islamic Finance: Content

CIMA Advanced Diploma in Islamic Finance

The CIMA Diploma in Islamic Finance

CIMA Advanced Diploma in Islamic Finance

Study guide one: Islamic Commercial Law

Study guide three: Islamic Capital Markets and Instruments

Study guide four: Accounting for Islamic Financial Institutions

CIMA Advanced Diploma in Islamic Finance