Introduction to Shariah Compliant Structures and Business Applications

1
Introduction to Shariah Compliant Structures and
Business Applications
1St East and Central Africa Conference on
Islamic Banking

• Mohammad Haris
• Deputy General Manager,
• Corporate Banking, Structured Finance
• Product Development
• April 28, 2009

2
Presentation Outline
1St East and Central Africa Conference on
Islamic Banking

• Part I Shariah compliant structures
• Murabaha
• Ijarah
• Musharaka
• Mudarabah
• Part II Business solution
• Financing Requirements
• Working Capital 
• Asset/Project /BMR Financing
• Trade Requirements
• Imports
• Exports
• Fx

3
Shariah Compliant Structures
1St East and Central Africa Conference on
Islamic Banking

• Murabaha

4
Murabaha
1St East and Central Africa Conference on
Islamic Banking

• Murabaha is a particular kind of sale
• where the transaction is done on a cost plus
  profit basis i.e. the seller discloses the cost
  to the buyer and adds a certain profit to it to
  arrive at the final selling price
• The distinguishing feature of Murabaha from
  ordinary sale is
• - The seller discloses the cost to the buyer
• - And a known profit is added

5
Murabaha
1St East and Central Africa Conference on
Islamic Banking

• Since Murabaha is a sale transaction - rules of
  Shariah regarding sale should be understood to
  judge if a Murabaha transaction is valid

6
Basic Rule for Murabaha
1St East and Central Africa Conference on
Islamic Banking

• Asset to be sold
• must exist.
• should be in ownership of the seller at the time
  of sale.
• should be in physical or constructive possession
  of the seller.
• should not be used for un-Islamic purpose.
• Sale price should be determined.
• Forward sale is not allowed.

7
1St East and Central Africa Conference on
Islamic Banking
Process Flow
8
Shariah Compliant Structures
1St East and Central Africa Conference on
Islamic Banking

• Ijarah

9
Ijarah
1St East and Central Africa Conference on
Islamic Banking

• Ijarah is a term which means To give something
  on rent
• The term Ijarah is used in two situations
• It means To employ the services of a person on
  wages e.g. A hires a porter at the airport to
  carry his luggage
• Another type of Ijarah relates to paying rent for
  use of an asset or property

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Ijarah
1St East and Central Africa Conference on
Islamic Banking

• Ijarah is an Islamic alternative of Leasing.
• Leasing backed by an acceptable contract is an
  acceptable transaction under Shariah.
• The question of whether or not the transaction of
  leasing is Shariah compliant depends on the terms
  and conditions of the contract.
• Several characteristics of conventional
  agreements may not conform to Shariah thus making
  the transaction un-Islamic and thereby invoking a
  prohibition.

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Process Flow
1St East and Central Africa Conference on
Islamic Banking
12
Rules of Ijarah
1St East and Central Africa Conference on
Islamic Banking

• Ownership of the leased asset remains with the
  Lessor
• All rights and liabilities relating to ownership
  are borne by the Lessor.
• Subject matter of Lease should be Valuable,
  Identified and Quantified.
• The period of Lease must be determined in clear
  terms.
• The Lessor cannot increase the rent unilateral

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Rules of Ijarah
1St East and Central Africa Conference on
Islamic Banking

• The Lessee is responsible for damage to the asset
  caused by fraud or negligence.
• Normal maintenance is Lessees responsibility
• If the leased asset is destroyed, the lease will
  terminate.
• Lease rentals for the entire lease period must be
  fixed

14
Shariah Compliant Structures
1St East and Central Africa Conference on
Islamic Banking

• Musharaka

15
Definition
1St East and Central Africa Conference on
Islamic Banking

• Musharakah means Sharing.
• The word Musharakah has been derived from
  Shirkah which means being a partner
• Musharakah is basically a kind of partnership in
  which the partners join together with different
  contributions, work or obligation for the common
  objective of undertaking business and trade in
  accordance with the principles of Shariah.

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Types of Musharakah
1St East and Central Africa Conference on
Islamic Banking

• Shirkat-ul-Milk
• It means joint ownership of two or more persons
  in a particular property.
• Shirkat-ul-Aqd
• This is the second type of Shirkah which means
• A partnership effected by a mutual contract in
  which the partners join together with different
  contributions, work or obligation for the purpose
  of earning profit.

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Rules of Musharaka
1St East and Central Africa Conference on
Islamic Banking

• Management of Musharaka
• Each partner has a right to take part in
  Musharaka management.
• The partners may appoint a managing partner by
  mutual consent
• One or more of the partners may decide not to
  work for the Musharaka and work as a sleeping
  partner.

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Rules Of Musharaka
1St East and Central Africa Conference on
Islamic Banking

• Rules for Profit Distribution
• The ratio of profit distribution must be agreed
  at the time of execution of the contract
• The ratio must be determined as a proportion of
  the actual profit earned by the enterprise
• Not as percentage of partners investment
• Not in lump sum amount
• A sleeping partner cannot share the profit more
  than the percentage of his capital.

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Rules Of Musharaka
1St East and Central Africa Conference on
Islamic Banking

• Illustration for Profit Distribution
• If A and B enter into a partnership and it is
  agreed between them that A shall be given Rs.
  10,000/- per month as his share in the profit,
  and the rest will go to B, the partnership is
  invalid.
• Similarly, if it is agreed between them that A
  will get 15 of his investment, the contract is
  not valid.
• The correct basis for distribution would be an
  agreed percentages of the actual profit accrued
  to the business.

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Rules Of Musharaka
1St East and Central Africa Conference on
Islamic Banking

• Rules for Loss
• In the case of a loss, each partner shall suffer
  the loss exactly according to the ratio of
  investment.
• Profit is based on the agreement of the parties,
  but loss is always subject to the ratio of
  investment.

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Processflow
1St East and Central Africa Conference on
Islamic Banking
Partner A
Shariah Compliant Business
Funds
Partner B
Profit
22
Shariah Compliant Structures
1St East and Central Africa Conference on
Islamic Banking

• Mudarabah

23
Mudarabah
1St East and Central Africa Conference on
Islamic Banking

• This is a kind of partnership where one partner
  gives money to another for investing in a
  commercial enterprise.
• The investment comes from the first partner who
  is called Rabb-ul-Maal (Investor)
• The management and work is an exclusive
  responsibility of the other, who is called
  Mudarib (Manager)
• Profit is shared as per agreed ratio
• All losses are borne by Investor

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Types of Mudarabah
1St East and Central Africa Conference on
Islamic Banking

• Un-restricted Mudarabah
• No restriction from the Rabb-ul-Mal (Investor)
  regarding the business.
• Restricted Mudarabah
• Some restrictions implemented from the
  Rabb-ul-Mal (Investor)

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Processflow
1St East and Central Africa Conference on
Islamic Banking
Depositors
Shariah Compliant Assets, Financing
Funds
Expertise
Asset Manager
Profit
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Diff b/w Musharaka Mudarabah
1St East and Central Africa Conference on
Islamic Banking

• Musharakah
• In Musharaka all partners invest
• Both parties can work
• Loss is shared according to contribution
• Mudarabah
• In Mudarabah one party invests (Investor) and
  other party works (Manager)
• Profit is shared as per agreed ratio
• All losses are borne by Investor

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Business Solution - Financing Requirement
1St East and Central Africa Conference on
Islamic Banking

• Working Capital Financing
• Using Murabaha (Sale) Mode of Financing

28
Murabaha
1St East and Central Africa Conference on
Islamic Banking

• Murabaha is a particular kind of sale where the
  transaction is done on a cost plus profit basis

29
Murabaha Illustration
1St East and Central Africa Conference on
Islamic Banking

• The Customer and the bank sign Master Financing
  Agreement along with Agency Agreement.
• Customer identifies and finalizes a purchase deal
  for cotton with a supplier.
• Customer makes a written request to the bank for
  the purchase of Raw Cotton.
• The bank disburses funds amounting to KES. 100
  million to the supplier.

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Murabaha Illustration
1St East and Central Africa Conference on
Islamic Banking

• Agent/Bank purchases and takes possession of the
  Cotton.
• The Customer then makes an offer to purchase it
  at KES 106 million to be paid after six months by
  signing the Offer.
• The bank accepts the offer and the sale is
  concluded whereby ownership as well as risk is
  transferred to the Customer.

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1St East and Central Africa Conference on
Islamic Banking
Process Flow
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Issues in Murabaha
1St East and Central Africa Conference on
Islamic Banking

• Rollover in Murabaha
• Rebate on early payments
• Penalty for late payments

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Business Solution - Financing Requirement
1St East and Central Africa Conference on
Islamic Banking

• Asset/Project Financing
• Using Ijarah (Leasing) Mode of Financing

34
Ijarah
1St East and Central Africa Conference on
Islamic Banking

• Ijarah is a term which means To give something
  on rent
• Ijarah is an Islamic alternative of Leasing.

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Illustration
1St East and Central Africa Conference on
Islamic Banking

• Customer request financing for a truck costing
  Kes. 10 million.
• Islamic Bank agrees to finance the cost.
• Undertaking to lease is signed.
• Bank makes payment to truck supplier and take
  possession.
• Bank and customer sign the lease agreement for 3
  years.
• The customer uses the truck and pays regular rent
  for 3 years.
• At the end of 3rd year, the customer buys the
  truck from the bank at nominal value and
  ownership is transferred.

36
Process Flow
1St East and Central Africa Conference on
Islamic Banking
37
Difference b/w Conventional Lease Ijarah
1St East and Central Africa Conference on
Islamic Banking

• Risk and rewards of ownership lies with the owner
• Once and if the asset is destroyed, the lease
  agreement is terminated
• Late payment penalty cannot be booked as income
  by the Lessor.
• Lease and Sale agreement should be separate and
  non contingent.

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Difference b/w Conventional Lease Ijarah
1St East and Central Africa Conference on
Islamic Banking

• The Lessor cannot increase the rent unilaterally
• Expenses to be borne by the parties
• Lessor- expenses relating to the corpus of the
  asset
• Lessee- actual operating/overhead expenses
  related to running the asset
• Rent is charged after delivery of the asset to
  the Lessee.

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Business Solution- Financing Requirement
1St East and Central Africa Conference on
Islamic Banking

• Asset/Project Financing
• Using Diminishing Musharaka (Partnership)Mode
  of Financing

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Diminishing Musharaka
1St East and Central Africa Conference on
Islamic Banking

• It involves taking share in the ownership of a
  specific asset and then gradually transferring
  complete ownership to the other partner.
• This concept is based on Declining ownership of
  the financier
• Three components
• Joint ownership of the Bank and customer
• Customer as a lessee uses the share of the bank
  
• Redemption of the share of the Bank by the
  customer

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Illustration
1St East and Central Africa Conference on
Islamic Banking

• Customer request financing for a property costing
  Kes. 10 million.
• Islamic Bank agrees to provide financing up to
  60 of the cost.
• Joint Ownership Agreement is executed between the
  bank and the Customer.
• Bank will purchase 60 share in the property by
  paying Kes. 6 million to supplier.
• Customers pays its share of Kes. 4million.

42
Illustration
1St East and Central Africa Conference on
Islamic Banking

• Banks share is divided into sixty units.
• Customer agrees to buyout Banks share (units) on
  monthly basis and the Undertaking is executed by
  the customer.
• Customer pays the rent for the usage of the
  Banks units.
• Rental reduces after purchase of each unit by the
  customer.
• After five years ownership of the asset is
  completely transferred to the customer.

43
1St East and Central Africa Conference on
Islamic Banking
Process Flow
Gradual Transfer of Ownership
Bank
Customer
Joint Partnership Musharaka
Payment of Rental and Purchase of Unit
Supplier
Kes 6m
Kes 4m
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Business Solution - Trade Requirement
1St East and Central Africa Conference on
Islamic Banking

• Trade Finance Products

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Trade Finance Products
1St East and Central Africa Conference on
Islamic Banking

• Sight Usance LCs
• Import Financing through Import Murabaha
  Musharaka
• Export Financing through Musawamah Agency
  Musharaka
• Forex transactions Spot and forward
• Collaterally Managed Assets financing through
  Murabaha

46
Letter of Credit
1St East and Central Africa Conference on
Islamic Banking

• Shariah allows that the bank may charge service
  charges for providing various services in the
  course of issuing LCs.
• However, these service charges should be
  developed keeping in view the reasonable cost
  estimates.
• For example if the importer extends the LC, less
  service charges should be collected as less
  services would be required for extension in the
  period of the LC.

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Business Solution - Trade Finance Requirement
1St East and Central Africa Conference on
Islamic Banking

• Import Financing
• Using Murabaha (Sale), Ijarah (Leasing) and
  Musharaka (Partnership) Mode of Financing

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Import Murabaha
1St East and Central Africa Conference on
Islamic Banking

• The customer opens the LC from the Bank as an
  agent of the Bank.
• The bank assumes ownership of the goods until
  they arrive at the port and are sold to the
  customer.
• Upon receipt of documents Bank makes payment to
  the foreign supplier.
• The Bank sells the goods to the customer on
  Murabaha (i.e. cost plus profit basis. )

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Import Ijarah
1St East and Central Africa Conference on
Islamic Banking

• The Importer places order with the foreign
  supplier on behalf of Islamic Bank.
• The importer signs undertaking to lease.
• The Importer opens the LC from Islamic Bank as an
  agent of the Bank.
• Upon receipt of documents Islamic Bank makes
  payment to the foreign supplier.
• The bank will enter into an Ijarah agreement with
  the customer.
• After the term of Ijarah agreement is completed,
  the bank may sell the asset to the importer at an
  agreed price.

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Import Musharaka
1St East and Central Africa Conference on
Islamic Banking

• The bank and the importer will sign Musharaka
  Agreement.
• The bank and the importer may agree on any profit
  sharing ratio.
• The bank will make payment to the exporter after
  receiving the documents.
• Importer will sell the commodity in local market.
• The bank and the importer will share the profit
  as per the agreed ratio.

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CM Murabaha
1St East and Central Africa Conference on
Islamic Banking

• Bank and the customer sign master murabaha
  agreement and agency agreement
• Customer finalizes terms with CM company.
• Customer opens the LC thru the bank as its agent
  to import commodity.
• Bank makes payment upon arrival of documents
• Upon arrival of shipment, bank will release
  import documents to CM.
• Customer will request bank to release commodity
  in tranches
• Bank will release the commodity in tranches after
  signing offer and acceptance.
• Bank will calculate murabaha price after adding
  all costs incurred to date and applying profit
  rate.
• The transaction will complete once the customer
  has paid for the entire consignment for its
  release.

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Business Solution - Trade Finance Requirement
1St East and Central Africa Conference on
Islamic Banking

• Export Financing
• Using Musharaka (Partnership) and Wakala (Agency)
  Mode of Financing

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Export Musharaka
1St East and Central Africa Conference on
Islamic Banking

• The exporter has a confirmed order to export
  commodity backed by LC
• The bank and the exporter will sign Musharaka
  Agreement.
• The bank and the importer may agree on any profit
  sharing ratio.
• The bank and the exporter will contribute their
  share of funds.
• The exporter will ship the commodity through the
  bank in accordance with LC terms. The documents
  will be couriered to the importer
• The bank will receive export proceeds and will
  share it with the exporter as per agreed ratio.

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Purchase and Agency
1St East and Central Africa Conference on
Islamic Banking

• The exporter has a confirmed export order backed
  by LC
• The exporter has already procured the commodity
  and is ready for shipment.
• The bank will buy the commodity prior to
  shipment.
• The bank will arrange to ship the commodity.
• The documents will be couriered to the importer.
• The bank will receive export proceeds and will
  settle the o/s exposure along with booking
  profit.

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Business Solution - Trade Requirement
1St East and Central Africa Conference on
Islamic Banking

• FX Deals

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Spot Fx Deals
1St East and Central Africa Conference on
Islamic Banking

• Trading of currency with another currency is
  allowed so far as the delivery of one or both is
  not deferred.
• The counter values of the same currency must be
  of equal amount.

57
Forward Cover
1St East and Central Africa Conference on
Islamic Banking

• A bilateral promise to buy or sell currency on a
  future date is not allowed
• However, a promise from one party is permissible.

58
1St East and Central Africa Conference on
Islamic Banking
Thank you
59
1St East and Central Africa Conference on
Islamic Banking
Q A