islamic finance presentation (16!4!07)

8/9/2019 Islamic Finance Presentation (16!4!07)

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Introduction to Islamic

Finance

April 16, 2007 Amsterdam



2

Contents

The Principles of Islamic Banking

Role of Islamic Banking

Some Basic Structures

- Murabaha

- Sukuk

- Ijara

- Musharakah

Issues for banks

Impact on borrowers

1

2

3

4

5

6

7

8

9



3

The Principles of Islamic Banking

y A system of banking which is consistent with Islamic Law (Sharia¶h) and

principles

y Three main guiding ideas:

± Prohibition of interest (riba) whether or not usurious

± The equitable sharing of profits and losses on transactions but avoidance of uncertainty

(gharar ) which could lead to dispute ± Underlying transaction should be consistent with Islamic beliefs (e.g. not involving alcohol,

gambling etc)

y The acceptability of each transaction is approved, from an Islamic perspectiveby a qualified authority on Sharia¶h

Islamic banking is based on a

few simple principles



4

Role of Islamic Banking

y From just one Islamic financial institution in 1975, there are now about 300

Islamic financial institutions in 75 countries (IMF estimates). Recent estimatesshow Islamic banking institutions¶ assets at more than US$300 billion, andanother US$400 billion in financial investments

y Growth in emerging market economies, high oil prices coupled with greater

inclination towards investing in local economies is fueling the growth of theIslamic finance industry

y GCC HNWIs hold an estimated total wealth of more than US$1.6 trillion. Highoil prices are resulting in a huge rise in regional liquidity. Even developed

countries like UK, Singapore, Japan andChina are now actively looking to tapIslamic finance¶s lucrative liquidity pool

y Interest in the industry is not limited to an estimated 1.6 billion Muslims

worldwide

Islamic banking is a fast

growing sector of the finance

industry with origins in the

Middle East but with growing

presence around the world



5

Role of Islamic Banking - investment

Greatest interest in Islamic

banking has been in the area

of investments

45% of Assets Under

Management (AuM) in GCC is

Islamic

More than 60% of AuM inSaudi Arabia is now Islamic

Source: McKinsey& Company Islamic Banking Competitiveness Report 2006



6

Role of Islamic Banking ± wholesale banking

After capturing significant

market share in the retail

banking sector (20% in 2006),

Islamic wholesale banking will

experience a new wave of

growth

Increasingly government and

public sector companies arefinancing in Sharia¶h

compliant manner and be

attuned with the trend led by

the public

Note: w holesale banking inc l ud es

asset manag ement, c orporate

banking , d erivat iv es, pr o j ec t &

st ruc t ur ed f inanc e, and d ebt capi t al

mark et s

Source: McKinsey& Company Islamic Banking Competitiveness Report 2006



7

Islamic Banking - Investor rate them at higher multiples

HSBC looked at a sample of 36

listed banks in GCC including

largest listed banks in terms of

market cap complemented with

some smaller pure Islamic

Banks

Based on this sample, pure

Islamic banks trade at higher

multiples than conventional

banks both on a P/E and P/B

basis

This may reflect superior

growth prospects as well as

higher investor pool demanding

limited stocks

P/B ratio total banks

P/B conventional banks

P/B Islamic banks

P/E ratio total banks

P/E conventional banks

P/E Islamic banks

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8

Basic Structures - Murabaha

y Under the Murabaha structure, the financier purchases an asset on behalf of the

borrower and then resells the asset to the µborrower¶

y So for e ample, an Islamic mortgage could be structured as a Murabaha

transaction:

± Bank purchases the property for USD X

± Bank sells the property to Borrower for cost plus agreed profit, USD (X + x )

± Borrower assumes risks of ownership

± Borrower pays Bank USD (X + x ) in instalments over a period of years

y Or a corporate revolver would work such that:

± On each drawdown, the Bank purchases a commodity

± The Bank sells the commodity to the Borrower for a deferred payment

± Borrower sells the commodity back into the market at cost to realise cash

± On the deferred payment date (e.g. 3 months later ), Borrower pays cost + profit

The Mu rabaha is a sale

contract with a fixed profit on

a deferred payment

This allows for the financing

of assets on a basis similar to

an interest bearing loan



9

Basic Structures - Sukuk

y Whereas a conventional bond is a promissory note, Sukuk ¶s are financial

certificates evidencing the ownership of assets

y The underlying transaction can take a number of forms but essentially rely on

some form of income generating asset to provide the means of payment of thevariable return rent (c.f. interest)

y Sukuk ¶s have been issued widely by borrowers in the Middle East and Asia andeven in Europe (German state of Sa ony-Anhalt ¼100million issue in 2004)

y In the United States, the East Cameron Gas Company, a Te as e ploration

company, became the first U.S. entity to make a sukuk issue in order to attractdemand from investors in the Arab world. The company sold US$165 million of

sukuk backed by royalties from the company¶s hydrocarbon reserves off the

coast of the Gulf of Me ico

y Sukuk ¶s issued to date total around US$27 billion

The S ukuk is the Islamic

equivalent of a bond



10

Basic Structures - Ijara

y With the Ijara structure, the financier purchases assets from the borrower and

leases them back over an agreed term in return for agreed rental payments

y The rental payments comprise two elements:

± Fi ed element: essentially the repayment element

± Variable Element: essentially the interest element

y Ownership of the asset will typically return to the borrower at the end of thelease through a purchase mechanism agreed at the outset (making theoperating lease a finance lease)

y This is a structure commonly used in the financing of major projects

y Ownership liabilities remain with the lessor (i.e. banks)

y Variable element can be linked to LIBOR (subject to cap and floor )

y Rent payments cease when asset is destroyed or becomes unusable

The Ij ara is effectively an

operating lease

If the borrower agrees to

purchase the asset at the

end of the term it becomes

a finance lease



11

Basic Structures - Musharakah

y Under the Musharakah structure, the financier and the borrower form a joint

venture

y The JV does not need to be incorporated but should maintain separate records

to ensure segregation of assets

y Funds from the financier are provided together with funds from the borrower and

the profits are shared between both parties at an agreed split

y Losses must be shared based on relative shares of initial investment

y This can be an effective means to procure a new asset, for e ample a newproject

The Musharak ah structure

is the most preferred

contract from a Sharia¶h

perspective



12

Basic Structures ± An e ample

y A project could be financed using a combination of an Ijara for the assets and a

Murabaha for the working capital

y For asset procurement, the banks and sponsors enter into joint ownership

arrangement to procure a new asset, contributing bank finance and equityrespectively

y Through a procurement contract the project company (SPV) is maderesponsible for constructing/procuring the new assets utilising funds provided bybanks and sponsors

y Once the asset is complete, the financiers lease their portion of the asset, usingan Ijara, to the borrower with lease payments covering the repayment andfunding cost elements

y The working capital requirements are met by the project company utilising the

Murabaha structure outlined earlier

A major project might be

financed through the

combination of two or more of

the basic structures



13

Challenges for Banks

y Under some of the more common structures (e.g. Ijara) banks are required to

own assets ± the risks associated with ownership need to be dealt with as theycan be substantial in some industries

y Strictly speaking the payment of commitment fees is prohibited although there

are means to structure around this restriction

y Default interest is e pressly prohibited under Islamic finance documents

y Legal precedence is lacking and there is still limited standardisation of Sharia¶h

guidelines

There are slightly different risk

return characteristics between

conventional and Islamic

financing structures



14

Impact on Borrowers

y Islamic structures are generally recognised by the accounting and ta

authorities on the basis of underlying intent of the financing structure; i.e.transactions are generally treated as though there were a conventionalborrowing facility

y Islamic financing structures offer another source of potential liquidity beyond the

conventional bank and bond markets

y Using Islamic finance can also be used as means to promote the ethical

standards of a company to a particular investor base to enhance share

performance

y Documenting Islamic finance transactions tends to be longer given the lack of uniformity in structures and the unfamiliarity of many conventional banks

Islamic structures offer

diversity of finding without

generally incurring

negative accounting or tax

treatments



15

Conclusions

y Islamic financing is not as complicated as it can first appear

y Global µIslamic¶ funds are a substantial potential source of liquidity

y Specialist advice is needed if this market is to be tapped effectively



16

Q & A

islamic finance presentation (16!4!07)

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