Applied Shariah in Financial Transactions

1. Applied Shariah in Financial Transactions Assoc. Prof. Dr. Mohamad Akram Laldin Executive Director, ISRA

2. Presentation Outline 1 Essential Shariah Guidelines 2 Islamic Contracts and Products 3 Islamic Investment Products

3. Details • Essential Shari’ah Guidelines • Islamic Contracts and Products: • Deposit – taking Contracts • Sale – based Contracts • Lease – based Contracts • Equity – based & Hybrid Contracts • Fee – based Contracts • Other Supporting Contracts • Takaful • Investments Products

4. Transaction in Islam Any transfer of wealth or property has to be made through a valid contract or `aqad Divine Sources (Quran & Sunnah) Mutual Consent • Contracts in Islam is the linking of offer and acceptance, resulting in legal effects on the subject matter of the contract. • In Islamic law, `contracts includes both bilateral as well as unilateral

5. Essentials of Valid Contract CONTRACTUAL EXPRESSION SUBJECT MATTER CONTRACTING PARTIES Goods/ asset Price/ consideration Acceptance Offeree Offer Offeror • Clear • Corresponding of offer & acceptance • Of full contractual capacity • Legal authority to contract • As owner & in possession of asset • legal representative (agent, guardian etc.) • Something of value • Ascertainable • Legal

6. General Principles in Transaction CONTRACT AS BASIS OF TRANSACTIONS AVOID Mutual consent Lawful Contractual Objective Interest Uncertainties Gambling Other prohibitions Eg: liquor, pork

7. Freedom of Contract

8. Promote Maslahah Entitlement to Equal, Adequate, Accurate Info. Freedom from Riba Promote Brotherhood Freedom from Gharar A system grounded on moral and ethics Freedom from Dharar Characteristics of Shariah-compliant Banking and Financial System Entitlement to Transaction at Fair Price Freedom to Contract Freedom from Price control & Manipulation Freedom from Qimar & Maysir

9. Various Forms of Islamic Contracts Used in Banking Wadi’ahYadAmanah; WadiahYadDhamanah, Mudarabah; al-Qard Deposit-taking Contracts BBA – deferred sale; Murabahah – cost-plus sale; Bai al-Inah, Bai al-Tawarruq Sales-based Contracts Ijarah Wa Iqtina; Ijarah Thumma Al-Bai’, Ijarah Muntahia Bitamleek Lease-based Contracts Equity-based Contracts Mudarabah, Musyarakah Kafalah/Dhaman (Guarantee); Wakalah (agency) Promise/Undertaking Wa`ad Fee-based Contracts Musyarakah Mutanaqisah (Dimishing Partnership), AITAB etc. Hybrid Contracts 9

10. Conceptual Balance Sheet of an IFI Assets Liabilities Trade Finance (Mudarabah/ BBA) Custodial Services (Amanah/Wadiah) Deposits/Investments (Mudarabah/ Wakalah) Asset-backed Securities (Ijarah/Salam/Istisna) Fund Management/ Private Equity Venture Capital (Special Mudarabah/ Musyarakah) Fund Management (Mudarabah/ Special Mudarabah/Musyarakah) Fee-based Services/ Advisory (Wakalah/Jualah/Kafalah) Capital Owners’ Equity (Musyarakah)

11. Deposit-taking Contracts

12. DEPOSIT SERVICES PRODUCTS Saving/ Current Account Investment Account Negotiable Islamic Deposit Certificate (NIDC) Sale & Buy Back Arrangement (SBBA) Qard or Wadi’ah Yad Dhamanah Mudarabah Bay’ al-`inah Bay’ al-Dayn

13. Qardh (Loan) Qardh means non-interest bearing loan or benevolent loan The borrower is only obliged to pay the loan at its original amount to the lender within the agreed stipulated period of time In the Qard saving account, the bank will take deposit from the client and it is considered as a loan to the bank The bank is not allowed to promise any return as it will be constituted as riba Since it is a loan, the bank is allowed to utilise the fund and return back the deposit to the customer when they request them

14. WADI’AH • Types: • Wadi`ah Yad Amahah • Wadi`ah Yad Dhamanah

15. How Bank Can Benefit From Wadiah Contract? The Wadi`ah Contract is combined with Guarantee contract (Dhaman or Kafalah) Wadi`ahYadDhamanah (Guaranteed Safe Custody)

16. DHAMAN / KAFALAH Wadia’ah + Dhaman: it converts the whole concept of wadi`ah to ‘guaranteed safe custody

17. Wadi`ah Yad Dhamanah The custodian is a trustee and guarantor to safeguard the deposited asset. The deposited asset/property need not be separated/segregated The deposited asset/property can be used for trading etc. The custodian has a right to any income derived from the utilisation of the deposited asset Depositor can take back the deposited asset at any time Wadi`ahYadDhamanah is like Qard (loan); therefore all principle of loan would be applicable Thus as a loan WYD cannot generate any pre-agreed benefit/income to the depositor, over and above the principal amount of deposit, otherwise tantamount to riba

18. Shariah Issues Current Account Saving Account

19. Mudarabah Mudarib is only liable for negligence or transgression or violation of contract terms

20. Issues To Be Considered • Investment from certain individuals and companies • Investment of a minor • Advertisement of gift prior to the contract • Guaranteeing profit/capital? • Variation of the ratio of profit and loss sharing • Pre-mature withdrawal of capital-mudarabah investment

21. Other Deposit Products / Structures • Commodity Murabahah Deposit-i • Structured based on Tawarruq • Structured Deposit Products • Pure Al-Qard Structures • Absolutely no returns or benefits provided to depositors • E.g., Al-Rajhi Malaysia’s savings and current accounts • Combination Structures • Each deposit split into stipulated portions (Mudarabah & Qard) • E.g., KFH Malaysia’s savings and current accounts

22. Sales-based Contract (Al-Bay`)

23. Murabahah & Bay` BithamanAjil Bay` `Inah Bay` Tawarruq Common Types of Sale-based contract Bay` Istisna’ Bay` Salam

24. Murabahah A sale; all sale conditions apply

25. Basic Shari`ah Rules on Sales • Subject of sale must be existing at time of sale • Subject of sale must be owned by seller at time of sale • Subject of sale must be in physical or constructive possession of seller at time of sale • Sale must be instant and absolute • Subject of sale must be of value • Subject of sale cannot be for haram use • Subject of sale must be specifically known and identified • Certainty of delivery • Certainty of price • Sale must be unconditional

26. Application of Murabahah in Finance(Murabahah To The Purchase Orderer ) • It is a sale in which two parties or more negotiate and promise each other to execute an agreement according to which the orderer asks the purchaser to purchase an asset of which the latter will take legal possession. • The orderer promises the purchaser to purchase the asset from him and give the ordered a profit thereon. The two parties would conclude a sale after the possession of the ordered to the asset.

27. Murabahah Trade Financing Customer buys commodity via murabahah on deferred payment terms Trader transfers Commodity to Bank Customer identify the commodity Bank buys commodity on cash basis Customer approaches bank and promises to buy commodity from bank

28. Bay` al-Inah?

29. Bay’ al-Inah: Personal financing How can I borrow RM100,000 to get married? Bank sells asset RM 150,000 Customer pays on deferred Banks Pays on cash basis RM 100,000 Customer sells back asset

30. Bay’ Al Inah

31. Tawarruq

32. Tawarruq Model of Home Financing 4.Property 4.RM200,000 2.RM350,000 Deferred 3.Electrical Appliances 3.RM200,000 2.Electrical Appliances 1.RM200,000 1.Electrical Appliances worth RM200,000 Customer Property Owner/Developer Electrical Appliances Wholesaler

33. Commodity Murabahah Deposit-i US$ 1 Million Cash US$ 1.1 Million deferred Broker B US$ 1 Million Cash Broker A

34. Ruling on Tawarruq

35. Bai’ Bithaman Ajil (BBA)

36. BBA HOME FINANCING MODUS OPERANDI Developer/Vendor 5. Bank pay developer the 90% balance Sales & Purchase Agreement (S&P) 1. 10% down payment 1. Beneficial ownership Property Sale Agreement (PSA) 3. BBA price (deferred payment) 3. House 2. House 2. Cash price (90% balance) BANK Property Purchase Agreement (PPA) Customer

37. Financing Facility: Islamic Banking vs. Conventional Banking Islamic Home Financing Convensional Home Loan Loan Amount : RM100K Tenure : 25 yrs (1981-2005) Single Rate : BLR-0 Ceiling Rate : -no- Penalty : 8% compounded Total Repayment RM240,996.96 RM245,982.72 Fin. Amount : RM100K Tenure : 25 yrs (1981-2005) Single Rate : BFR-0 Ceiling Rate : 9.90 Ta’widh : 1% Total Selling Price

38. MOVEMENT OF BASED LENDING RATE (BFR)

39. Lease-based Contract (al-Ijarah)

40. Ijarah (Leasing) • Ijarah contract is a form of exchange contract (`aqd al mu`awadah) – usufruct vs. rent. • Ijarah (Operating Lease) means leasing of asset pursuant to a contract under which a specified permissible benefit in the form of a usufruct is obtained for a specified period in return for a specified permissible consideration. • It is a manfaah (usufruct) type of contract whereby a lessor (owner) leases out an asset to its customer at an agreed rental fee and pre-determined lease period upon the `aqad (contract). The ownership of the leased equipment remains in the hands of the lessor.

41. Ijarah Muntahiah Bi Tamlik (Financial Lease)   • IjarahMuntahiah Bi Tamlik has similar rules to the ordinary Ijarah except that it is associated with a promise by the lessor to transfer ownership at the end of the Ijarah period via a separate sale agreement or gift.

42. DIRECT LEASING 3. Bank pays airplane manufacturer 5. Bank lease airplane to airline 4. Airplane manufacturer delivers airplane to bank 7. At the end of lease term airline take ownership 6. Airline pays rental 2. Airline approaches bank to seek financing 1. Airline places order with airplane manufacturer

43. Ijarah Mausufah Fi Zimmah (Forward Lease) • IjarahMausufahFiZimmah means an ijarah contract which is executed for an asset undertaken by the lessor to be delivered to the lessee according to accurate specifications, even if the asset is not owned by the lessor.  • During the period that the leased asset/property is under construction, the lessor may ask the lessee to pay a certain portion of pre agreed lease rental as a forward lease. • The forward lease rental payment will be considered as a debt to the lessor until the delivery of the leased asset to the lessee. • IjarahMausufahFiZimmah can be in a form of Ijarah or IjarahMuntahiyah Bi Tamlik.

44. Salient feature of Ijarah

45. Cont’d… • The purpose and mode of usage should be agreed upfront • The lessor could be the legal owner or the equivalent (agent, natural or legal guardian) • The leased asset is a trust in the hands of the lessee. • The rental payment commences after the delivery of the leased asset, actually or constructively. • The lease contract terminates upon the loss / non-existence of the usufruct • Lease contract is a bilateral contract. Any termination, in normal cases, must be mutually agreed.

46. Equity-based & Hybrid Contract

47. Musharakah

48. Musharakah(Profit Loss Sharing) Venture • Application: • Home Financing: • Diminishing • Musharakah • Sukuk • Equity Shares • Project Financing • Letter of Credit Profit or Loss Capital Partners Profit n Loss Sharing

49. Musyarakah Mutanaqisah(Diminishing Partnership) • Musyarakahmutanaqisahis a form of Musyarakah (partnership) in which one of the partner promises to purchase the equity share of other partner gradually until the title of the equity is completely transferred to him. • This transaction starts with the formation of partnership, after which buying and selling of the equity take place between the two partners. • One partner may lease his share of the asset to the other partner on Ijarah (lease) basis. • The partnership will come to an end with one partner being the sole owner of the asset or business venture.

50. Musyarakah Mutanaqisah (Modus Operandi) Bank leases its 90% share of property to customer Customer pays rent for usage of Bank’s 90% share of property Customer gradually buys share of property from Bank Customer’s monthly installment payments 90% 10% 0% 100%