Introduction to Shariah Compliant Structures and Business Applications

1. 1St East and Central Africa Conference on Islamic Banking Introduction to Shariah Compliant Structures and Business Applications Mohammad Haris Deputy General Manager, Corporate Banking, Structured Finance & Product Development April 28, 2009

2. 1St East and Central Africa Conference on Islamic Banking Presentation Outline • 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. 1St East and Central Africa Conference on Islamic Banking Shariah Compliant Structures Murabaha

4. 1St East and Central Africa Conference on Islamic Banking Murabaha • 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. 1St East and Central Africa Conference on Islamic Banking Murabaha • Since Murabaha is a sale transaction - rules of Shariah regarding sale should be understood to judge if a Murabaha transaction is valid

6. 1St East and Central Africa Conference on Islamic Banking Basic Rule for Murabaha • 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 Payment of Sale Price (6) Acceptance + Transfer of Title (5) Bank Customer Agreement for Murabaha (1) Offer to Purchase (4) Supplier Asset (3) Payment (2)

8. 1St East and Central Africa Conference on Islamic Banking Shariah Compliant Structures Ijarah

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

10. 1St East and Central Africa Conference on Islamic Banking Ijarah • 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.

11. 1St East and Central Africa Conference on Islamic Banking Process Flow Transfer of title (3) Lease Agreement (4) Undertaking to Lease (1) Vendor Bank Customer Payment to Purchase Assets (2) Rental Payment (5) At the end of Contract period client purchase the assets And Transfer of Title (6)

12. 1St East and Central Africa Conference on Islamic Banking Rules of Ijarah • 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

13. 1St East and Central Africa Conference on Islamic Banking Rules of Ijarah • The Lessee is responsible for damage to the asset caused by fraud or negligence. • Normal maintenance is Lessee’s responsibility • If the leased asset is destroyed, the lease will terminate. • Lease rentals for the entire lease period must be fixed;

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

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

16. 1St East and Central Africa Conference on Islamic Banking Types of Musharakah 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.

17. 1St East and Central Africa Conference on Islamic Banking Rules of Musharaka 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.

18. 1St East and Central Africa Conference on Islamic Banking Rules Of Musharaka 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 partner’s investment • Not in lump sum amount • A sleeping partner cannot share the profit more than the percentage of his capital.

19. 1St East and Central Africa Conference on Islamic Banking Rules Of Musharaka 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.

20. 1St East and Central Africa Conference on Islamic Banking Rules Of Musharaka 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.

21. 1St East and Central Africa Conference on Islamic Banking Processflow Partner A Shariah Compliant Business Funds Partner B Profit

22. 1St East and Central Africa Conference on Islamic Banking Shariah Compliant Structures Mudarabah

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

24. 1St East and Central Africa Conference on Islamic Banking Types of Mudarabah • 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)

25. 1St East and Central Africa Conference on Islamic Banking Processflow Depositors Shariah Compliant Assets, Financing Funds Expertise Asset Manager Profit

26. 1St East and Central Africa Conference on Islamic Banking Diff b/w Musharaka & Mudarabah 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

27. 1St East and Central Africa Conference on Islamic Banking Business Solution - Financing Requirement Working Capital Financing Using Murabaha (Sale) Mode of Financing

28. 1St East and Central Africa Conference on Islamic Banking Murabaha Murabaha is a particular kind of sale where the transaction is done on a “cost plus profit” basis

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

30. 1St East and Central Africa Conference on Islamic Banking Murabaha – Illustration • 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.

31. 1St East and Central Africa Conference on Islamic Banking Process Flow Differed payment of Kes 106 Mio (7) Acceptance of Sale + Transfer of Title (6) Bank Customer Agreement for Murabaha (1) Agency Agreement to source cotton supplier (2) Offer to Purchase cotton at Kes 106 Mio in 6 months (5) Cotton Supplier Delivery of Cotton (4) Payment of Kes 100 Mio (3)

32. 1St East and Central Africa Conference on Islamic Banking Issues in Murabaha Rollover in Murabaha Rebate on early payments Penalty for late payments

33. 1St East and Central Africa Conference on Islamic Banking Business Solution - Financing Requirement Asset/Project Financing Using Ijarah (Leasing) Mode of Financing

34. 1St East and Central Africa Conference on Islamic Banking Ijarah • Ijarah is a term which means “To give something on rent” • Ijarah is an Islamic alternative of Leasing.

35. 1St East and Central Africa Conference on Islamic Banking Illustration • 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. 1St East and Central Africa Conference on Islamic Banking Process Flow Truck Title (3) Lease Agreement (4) Undertaking to Lease (1) Vendor Bank Customer ksh10m (2) Rental Payment (5) (At the end of Lease period) Truck Title (6)

37. 1St East and Central Africa Conference on Islamic Banking Difference b/w Conventional Lease & Ijarah • 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.

38. 1St East and Central Africa Conference on Islamic Banking Difference b/w Conventional Lease & Ijarah • 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.

39. 1St East and Central Africa Conference on Islamic Banking Business Solution- Financing Requirement Asset/Project Financing Using Diminishing Musharaka (Partnership)Mode of Financing

40. 1St East and Central Africa Conference on Islamic Banking Diminishing Musharaka • 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

41. 1St East and Central Africa Conference on Islamic Banking Illustration • 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. 1St East and Central Africa Conference on Islamic Banking Illustration • Bank’s share is divided into sixty units. • Customer agrees to buyout Bank’s share (units) on monthly basis and the Undertaking is executed by the customer. • Customer pays the rent for the usage of the Bank’s 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

44. 1St East and Central Africa Conference on Islamic Banking Business Solution - Trade Requirement Trade Finance Products

45. 1St East and Central Africa Conference on Islamic Banking Trade Finance Products • 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. 1St East and Central Africa Conference on Islamic Banking Letter of Credit • 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.

47. 1St East and Central Africa Conference on Islamic Banking Business Solution - Trade Finance Requirement Import Financing Using Murabaha (Sale), Ijarah (Leasing) and Musharaka (Partnership) Mode of Financing

48. 1St East and Central Africa Conference on Islamic Banking Import Murabaha • 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. )

49. 1St East and Central Africa Conference on Islamic Banking Import Ijarah • 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.

50. 1St East and Central Africa Conference on Islamic Banking Import Musharaka • 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.