Proposed Financing Products:

Istisna & Salam

Presentation to

IBBs & Support Function

HabibMetro Islamic BankingApril 24, 2014

The Contents:Two Proposed Products: Istisna & Salam

1. What?2. Why?3. How?

4. Are the products risks manageable? 5. The Concluding Remarks

1.What?

Istisna & Salam Financing Facilities

Istisna:

Advance payment deferred delivery

price fully paid on spot or in tranches as per mutualagreement

Salam: full payment in advance deferred delivery

Definitions:

Istisna: A sale transaction where the seller undertakes toprovide the desired /required specific goods to thebuyer at a future date against either an advance pricefully paid on spot or in tranches as per mutualagreement between the parties but supply (i.e. thesubject matter of Istisna) is deferred.

Salam: An agreement to purchase, at a predeterminedprice, which is to be delivered on a specified future date

in a specified quantity and quality. The Islamic Bank as

the buyer makes full payment of the purchase price in

advance upon execution of a Salam contract.

Definitions:

Short term financing facilities (180days FC max)

Financing WK

To facilitate customers who require:

Cash Finance (CF)

Finance against firm orders

Export Pre shipment

Export Post Shipment: (the documents may onlybe used as security to get financing thereon)

Differentiating nature of the Facilities:

Manufacturing commodities through Istisna

Trading / Agriculture commodities through Salam

Purpose /Scope of Proposed Facilities

BANK CUSTOMER

Rs. 1 M

(EXPORT PROCEEDS)

Agen

t

Export Proceeds Rs. 1.0 M

Spot

Commodity for

Rs. 850,000 M

2.Why?

Market Practice: An analytical look at Industry ExposureIstisna & Salam Financing Facilities

Market Practice: Industry Exposure of Istisna & Salam (June13)

Total NPLs = Rs. 19.4Bn. Almost every IBI has ZERO of these two products except ONE IBI

3.How?

a. Stepwise description of Complete Transaction Cycle (Financial Cycle) identifying risks at each step

ISTISNA & SALAM PROCESS FLOW

1. Client and Bank sign an agreement to enter into

Master Istisna / Salam Financing Agreement (MFA)

Master Financing Agreement

Bank Client

Risk neither of Bank nor Customer

Istisna: Step #01: (MOU)

Client appointed as AGENT to sell the goods on Banksbehalf to its known and declared buyers once purchasedby the Bank (by the same client).

Agency

Agreement

Master Financing Agreement

Bank Client

Istisna: Step # 02: Relationship: Bank (Buyer) & Client (Seller). Upon delivery ofgoods, the client would sell in the capacity of Agent)

Risk neither of Bank nor Customer

Advance payment /disbursement to the Customer (seller) against future delivery

Agency

Agreement

Supplier

Master Financing Agreement

Bank Client

Istisna: Step#03:Relationship: Bank (Buyer) & Client (Seller)

Risk of Bank only (CR)

(Disbursement through Advance Against Istisna (like in Murabaha, however, this advance period may be of 30 to 60 days

The customer requests for disbursement (IA AppendixA) of Istisna Facility within approved Credit Line againstfuture delivery of goods, say 100 denim paints

Bank accepts the offer(IA Appendix B)

Advises the Agent to sell to its buyers as per agreement & bring

proceeds in time

Delivery of goods Customer

Bank Agent

Istisna: Steps #04

The risk related to commodity is of Bank. Goods holding risk which is minimal covered through Takaful /Insurance and repayment risk is mitigated through Corporate Guarantee besides other securities.

Relationship: Bank (Buyer) & Client (Seller)

The customer delivers the specified goods on maturity date (IA Appendix C)

The Bank after taking the possession of goods (IAA Appendix A) The Bank handover to the Agent to sell on banks behalf as per

Agency Agreement already in place (IAA Appendix B).

Goods Ownership (holding) & Selling Risks: MR + OR

The Agent (client) sells the goods to its ultimate (already declared)buyers and brings proceeds in time as per Agreement (IAA Appendix C.

(Istisna Financing Facility adjusted within Financing Cycle

Istisna: Steps #05

Corporate Guarantee is in place to make the client (Agent) responsible to bring the sale proceeds in time

Relationship: Bank (Principal) & Client (Agent)

Selling to buyersAgent

Ultimate Buyers

Bank

Istisna Facility adjusted against Proceeds

Foreign/Local

Goods Sold: CR

3.How? .

b. Accounting Treatment

Client: M/s. ABC Textile Mills

Export Bill: USD 10,000

Exchange Rate: 100

Discounting Factor: 15%p.a. (at minimum)

Contract Date: 1st January 2013

Maturity Date (export Bill: 30th April 2013

Entitlement: [(10,000X100)-10,000X100X15%)] = 850,000

Goods to be manufactured: Denim Pants

Quantity: 100

Contract Price (agreed b/w parties: USD 100/Unit (i.e. Rs.10,000)

Purchase Price (Bank to Pay): Rs. 8,500/pant (850,000/-total)

Calculation of Minimum Selling Price (MSS): Rs. 8,779/Unit

Banks Profit: Rs. 27,945 (i.e. profit amount)

Agency Fee: Rs. 1,000/-

Accounting Entries: Assumptions

1. Payment of Purchase Price (Jan 01, 2013)

Advance against Istisna Financing Facility Rs. 850,000/-Dr

Demand Deposit IBB Rs. 850,000/-Cr

2.Delivery of Goods:(April 10, 2013)

Istisna Goods Rs. 850,000/-Dr

Advance against Istisna Financing Facility Rs. 850,000/-Cr

At the time of execution of contract: (Jan 01, 2014)

Agency Expense Rs. 1,000/-Dr.

Demand Deposit IBB Rs.1,000/-Cr.

3. Selling of Goods on cash basis (April 30, 2013)

Istisna Financing Rs. 1,000,000/-Dr

Istisna Goods Rs. 850,000/-Cr

Deferred Istisna Income Rs. 150,000/-Cr

4. Maturity of Contract/payment of facility: (April 30, 2013)

Demand Deposit IBB Rs. 1,000,000/-Dr

Istisna Financing Rs. 1,000,000/-Cr

Deferred Istisna Income Rs. 28,945/-Dr

Income on Istisna Rs. 28,945/-Cr

5. Payment of INCENTIVE: (April 30, 2013)

Deferred Istisna Income Rs. 121,055/-Dr

Demand Deposit IBB Rs. 121,055/-Cr

Records asset at full amount of Purchase Price as Advance

Rs. 1.0MBank

Rs. 0.850M

Istisna Financing is recorded at Rs. 1.0M including deferred Istisna Income of Rs. 0.150M (i.e. Pft. 0.029M+ Ag.Fee)+(Incentive 0.121M)

Asset

Rs. 0.850M

Defrd. Pft. Rs.0.150M

Profit can only be accrued once goods sold

ISTISNA SUMMARIZED ACCOUNTING TREATMENT

Mkt. Value is Rs.1M

PP is Rs.0.850M

Diff. is the profit + incentive Fee + Agency Fee

4.Are the products risks manageable?

Products Risks & MitigatesIstisna & Salam Financing Facilities

S. No Key Risk Mitigates

1PERFORMANCE

RISK

Inherent risk f the product Business Proposal should give clear

details

If unable to perform, Bank would terminate the contract /disbursement

in installments

2

QUALITY OF

COMMODITY

RISK

Agent responsible while taking delivery To rectify/repair/replace the goods Bank has option to reject the goods

3PRICE RISK

Ultimate buyers Parallel Istisna /Salam may be another

way out.

The Key Risks with mitigation

S. No Key Risk Mitigates

4INCREASED COST

OF

MANUFACTURING

Increased cost will be borne by the

customer

In case of force majeure events in

which case Istisna price may be

increased with mutual consent

5NON -

PERFORMANCE OF

AGENT

Bank must check the track record of list of potential buyers

Goods in case of Credit MUST be sold against LCs to minimize the risk

6 DEFAULT RISK If the Agent found negligent, the loss

would be recovered from the Agent

The Key Risks with mitigation

The risks at various stages of the transaction

Product Stages

Adv. Pmt against

Contract to deliver

Goods Delivered (to

Bank)

Sale of Goods via Agent (Client)

Client commits to manufacture commodity / provide commodity after certain time period-CR

-IBB receives goodMR

-Inferior Quality goods OR

-No additional charges levied once goods sold / in case of default-CR

-Commodity pricing / repricing risk-MR

-Commodity holding-MR

Mitigates

Exposure should be well secured by obtaining guarantees, mortgage, hypothecations, pledge, etc

- Ultimate orders in place

- Agent is made responsible for quality risk

- To cover through Incentive mechanism

- Bank purchases at much lower price

- Agent is made responsible for quality & holding risks

5.

The Concluding Remarks

The exposure must be on very selected basis.

Financed the tested customer having ultimate buyers with good track history.

Advance against Istisna financing period to be kept at minimum (i.e. 30 days).

Ultimate buyer wise limit of the sub division.

The Concluding Remarks

Thanks

Financing Product:

Al - Bai

Presentation to

IBBs & Support Function

HabibMetro Islamic BankingApril 24, 2014

What is Al Bai Financing

Why we need this product

Transaction Process Flow

The Accounting Entries

Presentation Outline

What is Al-Bai Financing

HMB Al Bai is a sale and agency based financing facility for customers who

sell finished goods on credit basis

The facility will enable the customers to sell their finished goods stock,

meet their working capital requirements and enjoy benefits of cash sales.

Under this concept the Bank will purchase the finished goods of the

Customers and will appoint the Customer as its agent to sell the same goods

in the market /export on behalf of the Bank and adjust the facility at

maturity date either with export proceeds / local sale receipts.

It is necessary for the validity of Finished Goods transaction that the price is

fixed with the consent of the parties (Bank and the customer) and that the

necessary specification of the required items is fully settled between them.

The Finished Goods price is ideally paid on Spot with immediate delivery

of Goods by the customer. Subsequently the customer shall sell the goods

on behalf of the bank and adjust the facility at maturity date (within facility

tenor).

Customer

1. HMB Al Bai Agreement

HMB-IBB2. Delivery of Goods

3. Agency Agreement

Local Buyer

4. Sale of Goods

5. Sale Proceeds

6. Agency / Incentive Fee

1. Client and Bank sign an agreement to enter into

Master Al - Bai Financing Agreement (MFA)

Master Financing Agreement

Bank Client

Risk neither of Bank nor Customer

Istisna: Step #01: (MOU)

Client appointed as AGENT to sell the goods on Banksbehalf to its known and declared buyers once purchasedby the Bank (by the same client).

Agency

Agreement

Master Financing Agreement

Bank Client

Istisna: Step # 02: Relationship: Bank (Buyer) & Client (Seller). Upon delivery ofgoods, the client would sell in the capacity of Agent)

Risk neither of Bank nor Customer

Advance payment /disbursement to the Customer (seller) against future delivery

Agency

Agreement

Supplier

Master Financing Agreement

Bank Client

Istisna: Step#03:Relationship: Bank (Buyer) & Client (Seller)

Risk of Bank only (CR)

(Disbursement through Advance Against Al-Bai (like in Murabaha, however, this advance period may be of 120 days

The customer requests for disbursement (advance

payment) of Al Bai Facility within approved Credit Line

against future delivery of goods, say 100 denim paints

after 100 days (Facility tenor / Financing Cycle is

120days)

Advises the Agent to sell to its buyers as per agreement & bring

proceeds in time

Delivery of goods Customer

Bank Agent

Istisna: Steps #04

The risk related to commodity is of Bank. Goods holding risk which is minimal covered through Takaful / Insurance and repayment risk is mitigated through Corporate Guarantee besides other securities.

Relationship: Bank (Buyer) & Client (Seller)

The customer delivers the specified goods on maturity date(i.e. the Bank after taking the possession of goods handoverto the Agent to sell on banks behalf as per AgencyAgreement already in place).

Goods Ownership (holding) & Selling Risks: MR + OR

The Agent (client) sells the goods to its ultimate (already declared)buyers and brings proceeds in time as per agreement.

(Al-Bai Financing Facility adjusted within Financing Cycle

Istisna: Steps #05

Corporate Guarantee is in place to make the client (Agent) responsible to bring the sale proceeds in time

Relationship: Bank (Principal) & Client (Agent)

Selling to buyersAgent

Ultimate Buyers

Bank

Istisna Facility adjusted against Proceeds

Foreign/Local

Goods Sold: CR