Islamic banking

Presented By:

Muhibullah Zamani…12275

Ajeya patil 12240

anikit sarody 12347

Introduction of Islamic Banking

Islamic banking is banking system that is consistent with the principles of Islamic law and Shariah and its practical application through the development of Islamic economics. As such, a more correct term for 'Islamic banking' is ‘ Shariah compliant finance'. Sharia prohibits the fixed or floating payment or acceptance of specific interest or fees (known as riba, or usury) for loans of money. Investing in businesses that provide goods or services considered contrary to Islamic principles is also Haraam ("sinful and prohibited").

The Concepts Behind Islamic Banking

Riba (Charging of Interest) Gharar (Uncertainty) Maysir or Speculation Zakat Implying social justice and general welfare Conforming to Sharia Qard-e-hasna (benevolent loan) Profit and loss sharing (PLS) Prohibited Investments and Permissibility of Activities Hoarding

Riba (Charging of Interest)

The word "riba" means interest, usury, excess, increase or addition. premium that must be paid by the borrower to the lender Riba is the predetermined return on the use of money when money begets money, without being exchanged for goods or

services, or without indulging in any productive activity, it is called Riba

The term riba include the following points too: any form of unfair trade, market manipulation or engaging a

market participant to trade under duress risk-free debt contracts

Islam recognizes the time value of money, but only when it acts as capital, not when it is "potential" capital.

Gharar (Uncertainty): The existence of uncertainty in a contract is prohibited because it requires the occurrence of an event which may not ultimately occur. “Full disclosure” by both parties is the norm in contractual relationships. Any type of transaction where the (i) subject matter, (ii) the price, or both are not determined and fixed in advance amounts to “uncertainty”.

Maysir(Speculation): Speculation is similar to gambling, and therefore is prohibited. Derivative transactions like Options, Futures, Swaps and forward contracts (that ensure profit) are considered un-Islamic. They are also considered un-Islamic because for most of them, rates are determined by interest differentials

Zakat: A taxation system inherent in the Islamic system based on the principles of social justice and equity.

Implying social justice and general welfare: The basic principle is that everybody should be able to fulfill at least the basic needs.

Conforming to Shariah: The Quran and Hadith clearly specify the guidelines for individual, social, organizational, governmental behaviour, and thus become the basic pillar for any Islamic system, with the banking and financial system being no exception.

Qard-e-Hasna (benevolent loan), or Qard Hassan: Qard-e-Hasna means an interest free loan and is the only type of loan permitted by the Shariah. The guiding principle again is the social justice and general welfare.

Profit and loss sharing (PLS): It is an alternative to interest-based transactions.

Prohibited Investments and Permissibility of Activities: Investments should only support Halal (permitted) activities. So, investments involving products like pork, alcohol, pornography, arms & ammunitions, Cinema, Tobacco, Conventional Financial Services and activities like gambling are prohibited.

Hoarding: Hoarding money is considered improper in Islam; money is merely a means of exchange and should not be treated as a commodity. Islam encourages Trade and Enterprise, which can generate wealth for the benefits of the community as a whole with PLS as its core.

Some Instruments in Islamic banking

SOURCE OF FUNDS USE OF FUNDS

CURRENT ACCOUNT SAVING ACCOUNTS INVESTMENT ACC SPECIAL INVEST. ACC

MUDARABAH MUSHARAKAH MURABAHAH IJARAH (Leasing) IJARAH WA IQTINA (hire

Purchase) MUSHARAKAH

MUTANAQISAH LOAN ON SERVICE

CHARGE INTEREST FREE LOANS.

Current Deposits

Very Similar to standard commercial banks No return paid back to depositors Checking facilities Are Current deposits a loan to the bank from

depositors ? Are Current deposits a trust by depositors to banks ? Use of Current deposits by the banks on their own

risk.

Saving Deposits

Saving deposits without authorization to invest Saving deposits with authorization to invest Return to depositors who provide authorization to

invest. Saving deposits as a part of trust accounts. Saving deposit as Notice account

Special Investment

Concept of Wakalah The bank acts as a wakeel. Implements the

instruction of the Mawakkil. Special purpose investment, Specify, purpose,

sector, industry, or even project. The bank gets a fee for the services rendered. Full profit or loss goes to the depositor. The bank

will share in loss only in case of proven neglect.

Murabaha (Cost-plus financing) In a Murabaha transaction, the bank finances the purchase of

an asset by buying it on behalf of its client. The bank then adds a "mark-up" in its sale price to its client who pays for it on a deferred basis.

Islamic banks are supposed to take a genuine commercial risk between the purchase of the asset from the seller and the sale of the asset to the person requiring the goods.

Title to the goods financed may pass to the bank's client at the outset or on deferred payment

Applications of Murabaha

1-In domestic trade 3-consumer durables

2-In foreign trade 4-In financing real estates

IJARAH

It involves leasing of machinery, equipment, buildings and other capital assets. The financier purchases the asset and leases it to the end-user for an agreed rental which may be fixed in advance or subject to occasional review by a mutually acceptable third party, e.g. an international firm of accountants. Insuring of the asset remains a contentious

Ijara Wa Iqtina

This is a leasing structure coupled with a right available to the lessee to purchase the asset at the end of the lease period (Bay’ al Wafa). The lessee agrees to make payments into an Islamic investment account (with right to all profits) to be used in or towards financing the ultimate purchase of the asset. The instrument has been used increasingly in a range of asset classes including ships, aircrafts, telecom equipment and power station turbines, etc.

Bai salam or Bai’ Salaf (Purchase with deferred delivery)

It is a short-term commodity finance contract usually of agricultural or manufactured products Pays to the seller full negotiated price of a product delivery at a later date quality and quantity of the sold products are specified. The counter-party risk in Al Salam is one-sided as it lies

with the buyer unless security is provided by the seller. bank paying for the producer's goods at a discount

Difference b/w Salam & Murabaha

Salam In Salam, purchased goods

are deferred, price is paid on spot.

In Salam price has to be paid in full in advance.

Salam is not executed in the particular commodity but commodity is specified by specifications.

Salam cannot be effected in respect of things, which must be delivered at spot. e.g. Salam b/w wheat and barley.

Murabaha In Murabaha purchased

goods are delivered at spot, price may be either on spot or deferred.

In Murabaha price may be on spot or deferred.

Murabaha can be executed in particular commodity.

Murabaha can be executed in those things.

Conditions for As salam

1.Only for the quality and quantity of commodities which have been specified exactly.

2.The quality of the commodity is fully specified, leaving no ambiguity.

3.The quantity of the commodity is agreed upon in unequivocal (clear) terms. If the commodity is quantified in weights according to the usage of its traders, its weight must be determined, and if it is quantified through measures, its exact measure should be known.

4.The exact date and place of delivery must be specified in the contract.

5. Salam cannot be effected in respect of things which must be delivered at spot. It must be in an agreed period of delivery.

6.Salam cannot be effected on a particular commodity or on a product of a particular field or farm.

For example, if the seller undertakes to supply the wheat of a particular field, or the fruit of a particular tree, the salam will not be valid, because there is a possibility that the crop of that particular field or the fruit of that tree is destroyed before delivery, and, given such possibility, the delivery remains uncertain. The same rule is applicable to every commodity the supply of which is not certain.

Original Salam- illustration “Pak Hassan have 5 acres of land that could be cultivated

with paddy. He could produce 5 tonne of paddy in 6 months. However, Pak Hassan does not have enough money to start the project. He approaches an Islamic bank for financing.

The bank bought 5 tonne of paddy from Pak Hassan using a Salam contract at a price of RM 1.20/kg. The market price of paddy was RM 1.80/kg. Therefore the bank paid the total selling price (1.20 x 5,000 kg = RM6,000) to Pak Hassan on Day 1.

Pak Hassan used this money to start his project. The project cost was RM 3,500.

After 6 months. Pak Hassan delivered 5 tonne of paddy to the Islamic bank.”

Pak Hassan would gain a gross profit of RM 2,500 (Salam price – Project Cost).

The Islamic bank could make profit by selling the paddy in the market at RM1.80/kg. Then, the bank would enjoy a gross profit of RM3,000 [(1.80-1.20)x5000 kg].

Both parties in Salam will face the risk of price movement. Risks:

If the price of paddy goes up, Pak Hassan would have to forego the opportunity of making higher profit because he has sold the paddy to the bank at the salam price, while the bank may enjoy a higher profit than the above.

On the other hand if the paddy price goes down to say RM1.00/kg, then Pak Hassan will be in a comfortable position because he has already sold to the bank at RM1.20/kg. The bank will now face the risk of loss because it could not recover its cost.

Parallel Salam To manage the risks in first salam contract, the bank will

usually enter into a parallel salam i.e. the bank will find another party (maybe paddy wholeseller) and enter into a another salam contract so, it could sell the paddy to the wholeseller at a fixed price.

Parallel salam – when there are 3 parties involved in salam contract.

Assume the wholesale price of paddy is RM 1.50/kg. Pak Hassan sold to the bank 5 tonne of paddy at RM1.2/kg

on Salam basis. The bank paid Pak Hassan RM6,000 on Day 1. The bank sold the 5 tonne of paddy to the wholeseller at

RM1.40/kg on Salam basis.

The transaction between Pak Hassan and the Islamic bank is the first Salam (Salam 1) while the transaction between the Islamic bank and the wholeseller is the second Salam (Salam 2).

This is known as Parallel or back to back salam. One important note is that, if Pak Hassan fails to deliver

in the first Salam, the bank would still have to honor the second Salam.

That’s why it is important to finance generic goods using Salam, because the bank could buy paddy in the open market and still honor the second Salam in the event, if the first Salam fails.

Istisna

It involves a deferred delivery sale contract similar to salam.

It is also similar to conventional work-in-progress financing of capital projects like construction

It is also used for trade finance such as pre-shipment export finance

the seller ( Al Sani’), based upon an order from purchaser (Al Mustasni’), undertakes to manufacture or have manufactured/ acquired the subject item (Al Masnoo’) as per purchaser’s specifications.

The price, payment structure and the date of delivery are fixed in advance

Parallel Istisna Being a construction or manufacturing contract, Istisna’ is

very suitable for project financing.

Example: Commercial or residential buildings, road construction, aircraft and vessel construction

The seller could either manufacture the commodity on his own or he could find another sub-contractor to do the job. This will result in parallel or back to back istisna’.

Client asks the bank to construct a house for him with clear specification. The cost to construct the house is RM300,000.

The bank agrees and signs an Istisna’ contract with the client. (The bank is the seller in the first Istisna’. The selling price that the bank charges is RM450,000 – i.e. Cost of construction plus profit to the bank).

The bank then finds a contractor for the construction and asks him to handle the project.

The contractor agrees and signs an Istisna’ contract with the bank. (Now the contractor is the seller in the second Istisna’. The contractor charges the full construction cost, say RM400,000 ).

Upon completion, the contractor delivers to the bank and the bank delivers to the client.

Payment in this contract could be very flexible. Banks would release progressive payment i.e. payment

according to stages of completion of construction. Being the seller in the first Istisna’, the bank is liable to any

non-completion of the house or any non-conformance to specification risk.

Therefore, it is very important to have a project management team to ensure the selection of projects to be financed using Istisna’ is carefully made.

Differences between Salam and Istina

Bai Istina always needs manufacturing,

construction Payment is in staggered cancelled before the manufacturer

starts the work. The asset manufactured must meet

specification of the order and the buyer has the right not to take possession of the asset if the specifications are not met.

The time of delivery is not much fixed.

Any penalty for charged late delivery can reduce the price of an Istisna contract

Bai As Salam May or may not manufacturing paid in full in advance once effected, cannot be cancelled

unilaterally, The object of the Salam is a liability

on the seller to deliver, thus should be in the form of fungible goods i.e. easily replaced from the market should the seller be unable to deliver.

The time of delivery is an essential part of the sale in Salam while it is not necessary in Istina

The penalty amount is paid to charity (not taken as benefit for the buyer).

Other Financing Techniques

Jo’alah: A party undertakes to pay another party a specified amount of money as a fee for rendering a specified service in accordance with the terms of the contract stipulated between the two parties. This mode usually applies to transactions such as consultations and professional services, fund placements, and trust services.

Certificates of sale: It has been suggested that consumers buying consumables on credit would issue 'certificates of sale' similar to letters of credit. These could be encashed by the seller at the bank at a discount. This seems very similar in structure to Bai salam.

Syndication: Islamic Financial Institutions are increasingly prepared to participate in large project financing, and are getting ready to compete with their conventional counterparts. The syndication works on the techniques discussed above, most popular being the Mudarabah contract modified to suit the technicalities.

Sukuk is the Arabic name for a financial certificate or an Islamic bond. It is not a fixed-income, & not interest-bearing bonds.

Sukuk refer to securitization, a process in which ownership of the underlying assets is transferred to a large number of investors.

Mudharabah (Profit sharing)

Mudharabah is a profit sharing arrangement between twoparties,that is, an investor and the entrepreneur. The investorwill supply the entrepreneur with funds for his business

venture and gets a return on the funds he puts into the business based on a profit sharing ratio that has been agreed earlier.The principle of Mudharabah can be applied to Islamic

banking operations in 2 ways: 1)between a bank (as the entrepreneur)and the capital

provider2) between a bank (as capitalprovider) and the entrepreneur.

Losses suffered shall be borne by the capital provider.

Mudharabah (Profit sharing)

1) You supply funds to the bank after agreeing on the terms of the Mudharabah arrangement.

2) Bank invests funds in assets or in projects.3) Business may make profit or incur loss.4) Profit is shared between you and your bank

based on a preagreed ratio.5) Any loss will be borne by you. This will

reduce the value of the assets/ investments and hence,the amount of funds you have supplied to the bank

Musharakah (Joint venture)

In the context of business and trade,Musharakah refers to a partnership or a joint business venture to make profit. Profits made will be shared by the partners based on an agreed ratio which may not be in the same proportion as the amount of investment made by the partners. However, losses incurred will be shared based on the ratio of funds invested by each partner

DIMINISHING MUSHARAKAH

Two partners start business in Shirkah to

EARN PROFIT

One of the partners undertakes to

purchase the share of another partner gradually every month or each year.

Financing for Construction Of House

1. Valuation of plot will be made. This value will be investment of client in Musharakah Agreement and bank’s financing for construction will be investment of bank.

2. Musharakah Agreement will be signed between bank and client in which investment of everyone will be agreed. It will also be agreed that client as working partner will be responsible for construction.

Financing for Construction Of House

3. Both the partners will be owner of the property in same ratio as ratio of investment.

4. The property will be in the name of the client.5. This is Shirkat-ul-Milk.6. According to the ratio of ownership, each one is

responsible for the loss.7. Bank will divide its own part of asset into units,

which is promised by the client to purchase on pre-agreed price.

Financing for Construction Of House

8. After completion of house, Ijarah Agreement will be signed and bank will give his share of house on rent. Before completion of construction, rent cannot be charged.

9. Rent may be fixed on prevailing market value or with mutual consent.

10. Bank’s monthly profit may also be decided, as monthly rent of the house and principal amount will be recovered in the unit price.

Financing for Construction Of House

11. In Ijarah Agreement, a lump sum amount of rent is necessary to be fixed for a certain period. Rent for the rest of the period, may be linked with agreed Benchmark.

12.Before one year, client cannot purchase bank’s units.

13.Each unit will be purchased on the basis of Offer & Acceptance.

PART II UNIQUE RISKS OF ISLAMIC

BANKS

Islamic modes of finance:Unique risk factors

Liquidity originated market risk Transformation of credit risk to

market risk and market risk to credit risk at various stages of a contract

Bundling of credit risk and market risk

Market risk arising from owning the underlying non-financial asset until maturity of a contract or until the ownership is transferred to customer

Treatment of default

Unique balance sheet features of IBs from market risk perspective …1

In traditional banks, market risk is mostly in the trading book

In Islamic banks, market risk is concentrated in the banking book due to Murabahah, Ijara, Salam, Musharakah and Mudharabah in the banking book asset portfolio

Hence it is unique for Islamic banks that market risk and credit risk are strongly bundled together

Credit (default) risk An unexpected loss in a bank’s income due

to delay in repayment or non-repayment in full by the client as contractually agreed

Default risk covers over 80% of risks in an average bank’s banking book asset portfolio

It is the cause of over 80% cases of bank failures

Default risk, also causes market risk and liquidity risk

Treatment of default: In Islam, compensation-based restructuring of credit is the most well known form of Riba, namely, Riba Al Jahiliyah – this highly necessitates credit risk management

Moral issues in loan loss reserves Collateral quality (restrictions on use of

sovereign bonds) Insurance – clients’ insurance and facilities

insurance Diverse modes and bundled risks

Unique credit risk features of IBs ….1

Unique credit risks of IBs…. 2

Mudharabah / Musharakah Default event undefined Collateral not allowed

Salam / Istisna’ Counterparty performance risk Separation of market risk from default risk

difficult Catastrophic risk high

Murabahah Baseline default risk, but counterparty risk

due to embedded option (Murabahah, binding non-binding matter) also exists

Conglomeration of risks – each mode having various risks, credit, liquidity, market, reputation,

Credit risk

2.5

2.7

2.9

3.1

3.3

3.5

3.7

Market risk

2.5

2.7

2.9

3.1

3.3

3.5

3.7

Liquidity risk

2

2.2

2.4

2.6

2.8

3

3.2

3.4