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Legal Framework and Governance in the (Arab) Islamic Finance Industry

Contents
1. 2.

Fundamentals of Islamic (Shariah Compliant) Finance

Basic requirements and philosophy Types of Islamic Finance Products Basic Assumptions Additional Matters

Overview of Islamic Finance Market

3. 4.

Use of Islamic Finance in Different Market Sectors Governance

Background Products and processes Regulator/operator issues Specific issues International Guidance Basel IFSB Standards Non executive functions

5. 6.

General Principles

Conclusion

Historical Background of the Islamic Banking

1950 Islamic Banking in Theory

1970 Islamic Banking in Practice 180 Islamic Financial Institutions (major)

The Purpose of Islamic Banking

Forbidden of Interest
Exodus Leviticus Deuteronomy Psalms Proverb
Nehemiah Ezakhiel 7 Verses of the Quran More than 40 sayings of the Prophet Muhammad

Fundamental Difference Between Conventional and Islamic banking

1. 2.

Procedures Interest

4. Speculation 5. Unlawful Products

3.

Uncertainty

6. Unlawful Services

Basic Banking Activities Deposit Collection Financing Other Services

Deposit (Frame work)

Wadi`a

(Trust) Qardhan hassana ( Loan) Mudaraba (Passive Partnership)

Working of Mudaraba

Various Forms of Financing

The Structure of Murabaha Contract

Modalities of Murabaha
The Bank Buys the asset from the Vendor The customer then buys the asset from the bank at a

mark-up price (P+X) , which is payable on a deferred payment basis. The period covering the deferred payment is effectively the period of financing. The title to the asset is transferred to the customer at the time of purchase but usually the customer provides the same or other assets as collateral to the bank for the period of financing.

The Structure of Contract Under Ijarah wa Iqtina

Modalities of Ijaarah
The bank buys the asset from the vendor The bank then leases the asset to the customer

Periodic rentals are collected by the bank

The title of the asset remains with the bank under as

operating ijaarah Title passes to the customer under a Lease ending with transfer of ownership, either gradually over the period of the contract, at the end.

Ijara (Leasing) Sukuk

Can be used for long term infrastructure projects by the mobilisation of short term deposits i.e. securitisation of Government tangible assets

Possible use in project financings, e.g. development of a Tourist Resort.

Musharaka

Modalities of Musharaka
Both the Bank and the customer contributes towards the

capital of the enterprise Under a diminishing Musharaka, the customer buys out the bank`s share over a period of time. The customer and the bank share in the profits according to the agreed proportions, which may be different from the proportions of capital contributed. Any losses of the enterprise will be borne by the customer and the bank according to their capital contributions.

Mudaraba (Passive Partnership)

Modus Operandi of Mudarabah

The bank

provides to the customer (mudarib) all the capital to fund a specified enterprise The customer contributes only entrepreneurship. The customer is responsible for the day to day management of the enterprise and is entitled to deduct its management fee( mudarib fee) from the enterprise`s profits. The mudarib fee could be a fixed fee (to cover management expenses) and a percentage of the profits or a combination of the two. A classical mudarib fee is based on a percentage of the profits only. The balance of the profit of the enterprise is payable to the bank If the enterprise makes a loss, the bank (as the fund provider or Rabbul Mal) has to bear all the losses unless the loss has resulted from negligence on the part of the mudarib.

The Structure of a Salam Contract

Modus operandi under Salam Contract

A

Salam (sometimes referred to as Salaf) is a short term agreement in which a financial institution makes full pre-payments for future delivery of a specified quantity of goods on a specified date. A Salam is primarily a deferred delivery sale contract usually used for commodity finance. It is similar to a forward contract where delivery is in the future in exchange for spot payment. To mitigate the asset risk a financier can enter into parallel Salam.

The Structure Under a Istisna Contract

Modalities of Istisna`
Istisna` is primarily a deffered delivery sale contract; similar to salam. It is similar to conventional work in progress financing for a capital project. In practice it is usually used for construction and trade finance such as pre shipment export finance.

Rules for Investment

Primary business activity must be Shariah

Majority of assets are illiquid

Involuntary non permissible income must be less than

10 % and purified At the AGM interest based transactions must be apposed

The Structure of a Sukuk

Historical Background - Sukuks

Need for liquidity and good liquidity management Different periods between maturities of assets and deposits resulting in either surplus of non performing cash or a shortage of cash to fund investments Lack of:

active interbank and secondary market (mostly primary market trading) acceptable Shariah compliant instruments acceptable regulatory conditions limited available agency credit ratings unsophisticated market limited information flow The need for a more sophisticated capital, financial and insurance market.

Sukuks Legal Meaning

All this changed with the development of the Sukuks.

Definitions:

a) Participation Securities, coupons, investment certificates

b) Certificates of equal value, representing an undivided

beneficial ownership in the underlying assets

Types of Sukuks

MUDARABA SUKUK

A mudaraba is a partnership for profit between capital employed on one hand and work on the other. Mudarib/Rabbul-Mal

IJARA SUKUK

An ijara is essentially an Islamic leasing transaction which can be used as a financing tool.

DEVELOPMENT SUKUK (ISTISNA)

Istisna is defined as a contract of sale of specified goods to be manufactured with an obligation on the manufacturer to deliver them upon completion. Like turnkey projects.

MUSHRAKA SUKUK

Musharaka is a form of partnership whereby each party contributes assets or capital with a view to establishing a project or to share in an existing one.

Modus operandi Under Sukuk

Sukuks represent proportionate beneficial ownership, for a defined period the risk and returns associated with the cash flows generated from the assets belong to the sukuk holder. The characteristics of a sukuk are similar to a conventional bond with the difference being that they are asset backed.

Typical Project Financing Structure

Ijara (Leasing) Sukuk Case Study for a Project Financing of a Tourist Resort.

Works as follows:-

Sale of tangible assets to a special purpose restricted Mudaraba (SPV) assets are then leased to the interested parties through a Ijara lease the MUDARABA participation SUKUK will be issued and sold to public/investors with a guarantee of payments (usually from Government or international bank) required security will be given to SUKUK holders MUDARABA managed (on behalf of SUKUK holders) by MUDARIB MUDARIB signs and executes all relevant contracts ensures Shariah compliance transparency and efficient operation

Leasing Sukuk - Tourist Resort

SUKUK Holders
Periodic rentals and capital amount payments Sukuk proceeds Periodic rentals and capital amount payments Assets/Hotel (Beds) Sold

Seller

MUDARIB MUDARABA (SPV)

Lessee (Project Operator)

Project Assets

Sukuk proceeds

IJARA Lease For a fixed period of time and service agency

Legal Requirements for Bonds and Sukuks

Laws must allow the concept of trust. Important for Sukuks and Bonds. Contract law must recognize debt obligations and repayment obligations. Property laws must recognize the concept of security interests. Insolvency laws must give priority to security holders in the event of the insolvency of Issuers.

Market Requirements for Corporate Bonds and Sukuks.

A sufficient number of investors. A sufficient number of issuers. Investment professionals and other professional advisers

available to advise on structures, e.g. lawyers and accountants. The need for a secondary trading market to provide liquidity. Listing rules similar to your stock exchange listing rules. Effective legal documentation. Credit rating. Transparent dealings. Adequate investor protection

Enforcement

The need for a suitable enforcement regime. Protection of creditors rights. Enforcement of judgments in a timely and efficient manner. Possibility

of foreign arbitration. Consider sovereign guarantee for sukuk issues.

Fundamentals Islamic (Shariah) Finance

Quranic (Shariah Law) principles; Riba (interest/unjustified rewards/unlawful gain); Gharrar (uncertainty, risk, speculation); Halal (religiously permissible); Haram (not religiously permissible); Qard Hasan (good loan); Al-Wadia (safekeeping).

Basic Requirements and Philosophy

true risk sharing; no exploitation of a weaker position; not socially unproductive; not economically wasteful; promotes economic and social development; and charitable (zakat).

Overview of Islamic Finance Market

Islamic and Dual Banking Systems Retail Islamic finance products offered for a number of years, some low key e.g. Middle Eastern banks, others high profile e.g. HSBC Islamic Windows in major Global Banks Islamic Bank of Britain Primary Market: initially basic finance products Compatibility with conventional products

Arab nations Follow the same Islamic Banking Rules

Arab culture is diverse

There are 22 Arab nations

Types of Islamic Finance Products:

Equity; Trade Financing; Asset Financing Lending; Wholesale & Retail Products:

loans; partnership investments; forex; fund transfers; letters of credit; securities safe keeping; investment management and device;

Islamic Finance (Contd):

Al-Wadia (safekeeping): usually not remunerated; Takaful (Insurance); Funds Work; SUKUK/Securitisation (Capital & Secondary Markets); and Derivatives/Funds Management.

Basic Assumptions

Underlying asset must be acceptable Different interpretations on what proportion of asset must not be haraam Proposed structure of transaction has to be acceptable No prohibited activities (proportionate approach) Need to account for regulatory requirements and comply with two sets of law (Shariah and law of country)

Additional Matters

Zakat (specified amounts to be allocated from disposable income); Shariah Boards competition, pragmatic approaches; Urf (custom); Darura (overriding necessity); Maslaha (general interest to justify); Hiyal (ruse)

Use of Islamic Finance in Different Market Sectors

Real Estate Project Financing

Co-financings (Power, LNG, Oil & Gas)

Retail Banking
Depositors Investment Account Holders

General Leasing

Ijara

Asset Finance Bond (SUKUK) Issuance Private Equity Funds Insurance (Takaful) Capital Markets (Sukuk/Arboun/Salaam)

Governance

Background

Developing, structuring and marketing Shariah compliant financial products can be cumbersome and complex IIFS needs to account for regulatory requirements and comply with two sets of jurisprudence/law (Shariah and the law and regulations of relevant jurisdiction)

Products and Processes

Products and Processes need to be effective from the following viewpoints:

Understandable Competitively priced Tax effective Available and transparent Not administratively burdensome Not alien to regulatory requirements

Governance of institution offering Islamic financial services needs to be the same

Regulator/Operator Issues

Scope for the continuing development of good corporate governance in the field of Islamic finance No inconsistency with Shariah

Specific Issues

Islamic finance industry needs to, in particular, focus on issues regulators will be concerned with Remember that Shariah-compliance will not normally be an issue for non-Islamic countries or where Shariah is not part of a general legal framework Shariah Supervisory Board presence and scrutiny therefore essential

Specific Issues (cont)

Islamic finance industry regulators need to consider regulation of Shariah Supervisory Board Islamic financing industry need for a unified front to regulators Standardisation of models used, terminology and treatment Dissemination of codes of best practice Practical Adaptability

Guidance

Many forms of International and National Guidance available OECD principles UK Stock Exchange Combined Code Cadbury Report Hempel Report Higgs Report

Guidance (cont)

France/Germany: different forms of governance models US: Sarbannes-Oxley Other/Corporate Governance Standards Country Specific Accounting and Industry Specific IFSB guidance

Principles outlined Comply or Explain

Basel

Basel Committee on Banking Supervision

1999 paper 2006 paper

General Principles

Establish Good Governance Policy as a principle of Shariah Monitoring and work of

Board Committees Executive Management Shariah Supervisory Board Internal and external auditors Different Stakeholders

Mechanisms of balancing the roles of different stakeholders i.e.) shareholders, management, IAHs

Non Executive Functions

Role of non-executive directors/managers

Guidance Oversight Compliance issues Future compliance policy