Urooj ul Hasan Khan Team Leader Investment Banking Meezan Bank Limited

1. UroojulHasan Khan Team Leader Investment Banking Meezan Bank Limited

2. Agenda

3. Global Islamic Banking

4. Emergence of Islamic financial industry

5. Global Scenario – Growth & Potential • Islamic banking assets with commercial banks globally grew to $1.3 trillion in 2011, suggesting an average annual growth of 19% over past four years (2011: 24%). • The top four markets account for 84% of industry assets. • 13 Islamic banks have an equity base of more than US$ 1 billion. • Islamic banking assets are forecast to grow beyond the milestone of $2 trillion by 2014. • The industry’s average ROE was 12% in 2011. • The severity of performance challenge has prompted several institutions to initiate wide-ranging transformation programs, called the new 3 R’s for the industry: • Regulatory transformation – involving compliance risk, capital optimization, integrated balance sheet management and liquidity management • Risk transformation – around Shari’a governance, single data management framework, segment / product specific risk models • Retail banking transformation – strengthening customer centric operating model, channel integration and technology enablement.

6. Global Scenario – Growth & Potential One potential scenario shows global Islamic banking assets with commercial banks to reach $1.8 trillion in 2013 (2011: $1.3 trillion), representing average annual growth of 17% Islamic Banking Asset Growth (US$b)

7. Global Scenario – Growth & Potential Islamic banking growth outlook continues to be positive, growing 50% faster than overall banking sector in several core markets. In Saudi Arabia, market share of Islamic banking assets is now over 50%. Banking asset penetration (% of Nominal GDP) and Islamic banking market share of total assets (%) in 2011

8. Global Scenario – Growth & Potential • Top 20 Islamic banks make up 55% of the total Islamic banking assets and are concentrated in 7 countries, include: Saudi Arabia, Kuwait, UAE, Bahrain, Qatar, Malaysia and Turkey • Top three markets for Islamic Banking Assets (2011) • Saudi Arabia (US$207 billion) • Malaysia (US$ 106 billion) • UAE (US$75 billion) • New markets embracing Islamic Financial Industry are • Egypt (Issuing sovereign Sukuks & developing new regulatory framework for Islamic Banks) • Iraq (contemplating Islamic Banking legislation) • Libya (implementing its Islamic Banking framework) • Indonesia (Bank Indonesia projects that in 2013, growth of Islamic banking assets will be in the range of 36% to 58%)

9. Local Islamic Banking

10. Local Scenario – Growth & Potential • Islamic banking was formally launched in Pakistan in March 2002 when the first Islamic Banking license was awarded to Meezan Bank Limited. • There are currently 5 full fledge Islamic banks and 13 conventional banks having Islamic banking branches with a network of 1024 branches across Pakistan. • The industry has been maintaining strong growth momentum with over 50 percent average annual growth since inception; this growth trend is likely to gather further momentum with increasing awareness level and expansion of Islamic banking network in second and third tier cities. • In terms of total assets, Islamic Banking is 8.9% of the total banking industry. • Keeping in view the fact that approx 96% of the population of Pakistan is Muslim, Islamic Banking has the potential to grow to that level.

11. Local Scenario – Growth & Potential • There are currently 5 full fledge Islamic banks with a network of 657 branches and 13 conventional banks having 367 Islamic banking branches • The Islamic banks also has 73 sub-branches

12. Local Scenario – Growth & Potential No. of Islamic Banking Branches CAGR = 37.73%

13. Local Scenario – Growth & Potential Growth of Market Share for Islamic banks

14. Local Scenario – Growth & Potential Deposit Growth of Islamic Banking CAGR = 34.21%

15. Local Scenario – Growth & Potential Asset Growth of Islamic Banking CAGR = 32.36%

16. Concept of Islamic Banking

17. Ideology of Islamic Economics

18. Ideology of Islamic Economics • Islam as a “complete code of life” encompasses every aspect of human life. It provides directives as to how economic and financial activities should operate based on moral and just economic system. The source of Islamic morality stems from Shariah. • Two sources of law in Islam • Shariah—Revealed knowledge • Quran –Recited • Hadith/Sunnah—Un-recited • Fiqh– Derived knowledge through ijtihad (exertion) • Ijma (consensus) • Al-Qiyas (analogy) • Islamic laws can be broadly classified into two types • Ibadat (devotional acts) – Any worship which is not legalized by Shariah is void • Muamalat (dealings or transactions)—Transactions are permitted unless prohibited by Islamic law (principle of permissibility) • In muamalat, new transactions can be accommodated through ijtihad as long as they do not contain the prohibited (riba and gharar)

19. Ideology of Islamic Economics • Finance/ Banking in Islam (Matter of Muamalat) • Laws governing economic/financial activities • Principle of permissibility: All transactions are permitted except those explicitly prohibited by Islamic law • Prohibitions are riba and gharar, fraud, hoarding, exploitation of need, gambling, etc. • Obligations & Recommended (charity, honesty, interest-free loans, risk sharing, etc.)

20. Riba What is Riba? The word “Riba” means excess, increase or addition. According to Shariah terminology, implies any excess compensation without due consideration. Equation Of Riba

21. Prohibition Of Riba • Prohibition of Riba in Quran: “Those who devour Riba shall rise up before Allah like men whom Shaitan has demented by his touch; for they claim that trading is like Riba. But Allah has permitted trading and forbidden Riba. He that receives an admonition from his Rabb and mends his ways may keep what he has already earned; his faith is in the hand of Allah. But he that pays no heed shall be among the people of fire and shall remain in it forever.” (Al Baqarah 275) • “O you who believe, Fear Allah and give up what remains of your demand for Interest, if you are indeed a believer. If you do not, then you are warned of the declaration of war from Allah and His Messenger; But if you turn back you shall have your principal: Deal not unjustly and you shall not be dealt with unjustly.” • (Al Baqarah 278 – 279)

22. Prohibition Of Riba Prohibition of Riba in Ahadith: Narrated by Jabir (RAA): The Prophet (SAW) cursed the receiver and payer of interest, the one who records it and the two witnesses to the transaction and said, “They are all alike [in guilt].” (Muslim) • Narrated by Abu Hurayrah (RAA): The Prophet (SAW) said, “There will certainly come a time for mankind when everyone will take Riba and if he does not do so, its dust will reach him.” • (Abu Dawood) • Narrated by Abu Hurayrah (RAA): The Prophet (SAW) said, “On the night of Ascension I came upon people whose stomachs were like houses with snakes visible from outside. I asked Jibrael who they were, He replied that they were people who had received interest.” • (Ibn-e-Majah)

23. Types of Riba • First Type : Riba al Nasiah: • Root word nasaa meaning to postpone - refers to the delayed payment Riba. When there is exchange of the same specie over a period of time, the amount exchanged has to be the same (qardhasan). • If an excess is paid over the amount this will lead to riba al nasiah. • Riba Al-Nasiah… Riba in loan contracts: • Give out loan (principal sum) • Repayment include additional amount because of delay in payment This is the riba prohibited in Al-Qur’an A.k.a. Riba al-Duyun, Riba Al-Jahiliyyah • Implication in Financing Transactions: • financing using loan contracts. • No extra is allowed

24. Types of Riba • Second Type: Riba al Fadl: • If there is exchange among the same specie of the ribawi goods, it has to be done on spot and should be of equal amounts. • If the amounts exchanged are different then it will be riba al fadl. • saying of the Prophet: “Gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates and salt for salt – like for like, equal for equal and hand to hand. If the commodities differ, then you may sell as you wish, provided that the exchange is hand to hand” (Muslim, Kitab al-Musaqat) • The six commodities listed in the above Ahadith could be divided into two categories: • Currency – gold and silver • Staple food – wheat, barley, dates, salt

25. Types of Riba Summary of Riba Al-Fadl • Implication in Financing Transactions: • Currency exchange – must be spot transaction • No forward currency transactions

26. Difference Between Trade & Usury • Does similarity in risk and pricing profile make Islamic products doubtful in the eyes of Shariah? • Suppose cash sale price is $10, deferred sale price payable in one month is $12. Now, the buyer requests for one month extension and seller increases the price to $14. • Prophet (pbuh) allowed $2 profit for the deferred sale but prohibited $2 for the extension of time (riba al-jahiliyyah) • The non-believers “used to say that it is same as we increase the price in the beginning of the sale, or we increase it at the time of maturity”. • But • Quran says: “Trade is like usury, but God hath permitted trade and forbidden usury”(2:275) • “The Holy Quran could have mentioned the difference between interest and profit in pure logical manner, and could have explained how the profit in a sale is justified while the interest is not. The Holy Quran could have also spelled out the evil consequences of riba on the economy. But this line of argument was intentionally avoided….once a particular transaction is held by Allah to be haraam, there is no room for disputing it on the basis of pure rational argumentation because Allah’s knowledge and wisdom encompasses all those points which are not accessible to ordinary reason.” (Mufti TaqiUsmani )

27. Islamic vs Conventional Banking Conventional Banking Bank Client Money Money + Money (interest) Every Debt that pulls any kind of gain is Riba

28. Islamic vs Conventional Banking Whereas Allah has permitted trading and forbidden Riba Islamic Banking Goods & Services Bank Client Money

29. Islamic vs Conventional Banking • Islamic banking • Transactions are asset-based/backed • It is socially-responsible banking because it operates under Shariah restrictions • Does not permit financing of prohibited goods / Industries • Ethics and moral values play a major role in investment decisions. Not a choice but a must • Conventional banking • Transactions are money lending and Riba based • Involve in many impermissible transactions like Short selling, Sale of Debt, Speculation, artificial financial transactions, no sanctity for Islamic law of contract. • Permit financing of prohibited goods / Industries like alcohol, casinos etc. • A matter of choice

30. Islamic vs Conventional Banking From the previous slide, we find the differences are on three levels: • i. Conceptual & socio-religious level: • Not lending money. • Cannot deal with interest & non permissible commodities/businesses. • ii. Business model & governing framework: • Actively participates in trade and production process. • Governing framework as directed by Shariah Advisors and Shariah Board. iii. Product level implementation: • Usually asset backed & involve trading/renting of asset. • Implementation is not just a mere change of paper work and terms but it involves the right intention, the correct sequence of steps and timing of execution.

31. Islamic Modes of Financing • Murabaha • Salam • Istisna • Ijarah • Mudaraba • Musharaka • Diminishing Musharaka

32. Islamic Modes of Financing • Murabaha: • A sale of goods in which seller discloses profit to the purchaser. • The bank buys and then sells the good to the client at a pre-agreed price. • Price paid at a later date. • The bank must own and posses the good. • The profit rate and other terms should be clearly specified in the contract. • The bank can ask for guarantees or collateral. • Murabaha bills of trade cannot be traded (at discount)

33. Islamic Modes of Financing • Salam: • A pre-production sale of goods - selling goods in advance. • Can be used for homogenous goods. • Used to finance the agricultural sector. • The price has to be fixed and paid when the contract is concluded. • Goods delivered at a later date. • The delivery time should be fixed. • Parallel salam.

34. Islamic Modes of Financing • Istisna: • A pre-production sale is used when an item/asset needs to be manufactured/constructed. • The price of the good should be known and time of payment can be negotiated among the parties. • The seller of the good can either manufacture it or sub-contract it (Parallel Istisna). • Once delivered, the bank will sell the goods either directly or through agent.

35. Islamic Modes of Financing • Ijarah: • A leasing contract involves sale of usufructs of durable assets/goods. • Ownership in the asset is retained by the lessor. The asset can be transferred to a third party or the lessee at the end of the tenor • The lease payments are calculated by aggregating; • Fixed element (equivalent to principal on the conventional facilities). • Variable element, generally on the basis of a reference such as K plus a fixed margin • Service amount usually equal to the amount paid to the company/ customer (in its capacity as service agent under the service agency agreement). • Cost of total damage of asset is borne by owner. • Lessee can sub-lease the asset to third party unless explicitly prohibited in the Ijarah contract.

36. Islamic Modes of Financing • Mudaraba: • A form of partnership – one party supplies the capital (Rab-ul- Maal) other manages (Mudarib) • Profit shared among parties at a pre-agreed ratio. • Loss borne by financier (Rab-ul-Maal) only. • Financier cannot ask for a guarantee of capital or return. • Mudaraba can be restricted or unrestricted.

37. Islamic Modes of Financing • Musharaka (Shirka-tul-Aqd): • A partnership contract in which all partners contribute capital and labor. • One partner can be the managing partner • Profit is shared among the partners at a pre-agreed ratio. • In case of loss, sharing on the basis of share in capital. • One partner can not guarantee the return or capital of other partner.

38. Islamic Modes of Financing • Diminishing Musharaka (Shirka-tul-Milk): • Joint ownership contract between bank and customer to jointly own the Asset. • Contract of lease between the bank (as lessor) and customer (as Lessee) whereby lessor leases its undivided ownership in the Asset to lessee. • The maintenance cost can be paid by the lessee if included in the contract, but costs of total damage of asset is borne by lessor to the extent of its ownership. • From time to time customer purchases ownership share in Asset from the bank to increase its ownership. • Upon maturity, the customer acquires 100% ownership in the Asset. Bank

39. Project Finance

40. Project Finance – An Overview • Defined by International Project Finance Association (IFPA): “The financing of long-term infrastructure, industrial projects and public services based upon a non-recourse or limited recourse financial structure where project debt and equity used to finance the project are paid back from the cash-flow generated by the project.” • Non-recourse financing refers to the fact that the sponsor’s liability is restricted to the amount of capital invested. Certain projects are structured with limited recourse, which means that the sponsors are liable for any additional capital infusions the project may require due to cost overruns or shortfalls in cash flow in the initial phase of the project (i.e. the construction phase).

41. Project Finance – An Overview • Often referred to as a new financing technique, project finance is actually centuries old and predates corporate finance. • The earliest example of project financing dates back to 1299 when the English Crown negotiated a loan from the Frescobaldi, a leading Italian merchant bank of that period, to develop the Devon silver mines. • “Project finance” is not the same thing as “financing projects” because projects may be financed in many different ways. For instance, large-scale public sector projects can be financed by the public sector’s issuance of debt, whereas private sector projects are funded by large companies raising corporate loans against their balance sheets (a full recourse finance) for eg. Financing for capacity enhancement.

42. Project Finance – An Overview • Main Features Of Project Finance • A project is established as a separate company, which operates under a concession obtained from the host government. • The project manager provides a major portion of the project’s equity, thereby tying the provision of finance to the management of the project. • The project company operates with a high ratio of debt to equity, with lenders having only limited recourse to the government or to the equity holders in the event of default. This limited recourse is vital as it lowers the risk of sponsors or equity providers becoming liable for injecting additional equity to meet debt obligations. • The long-term financiers of the projects have recourse only on project cash flows. • Sponsors or creditors are repaid or earn a return solely from the revenue that is generated by sale of the project’s output.

43. Project Finance – An Overview • Main Features Of Project Finance • The project company enters into comprehensive contractual arrangements with suppliers and customers. • The contractual arrangements are designed to allocate each major risk in a project to the party that is best able to appraise and control that risk. For example, the main contractor is obviously best suited to ensure that construction is completed within the budget and on schedule. He therefore enters into a turnkey contract that specifies a fixed price and penalties for delays, and is usually required to post a performance bond. A turnkey contract refers to a business arrangement where the project or asset being constructed is delivered in a complete state.

44. Project Finance – An Overview • Characteristics of Infrastructure Finance • Investment: • Capital intensive (i.e. investment amount are usually lumpy, large and incurred during the initial stages of the project). • Enjoy economies of scale. • Maturity: • Long operational lives and requires long tenure financing. • Maturity can vary from 5 to 20 years. • Costs and Returns: • Stable rates of return linked with the cash flows of the project. • Cost of credit usually high due to high risk involved. • Uncertainty in the longer-run and higher cost of funds can make some viable projects unprofitable.

45. Project Finance – An Overview • Source of financing can be either from public or private institutions or • combination of both. • Public source: • Budgets allocation from government; • Specialized public bodies and development banks; and • Sovereign Wealth Funds • Sovereign Guarantees • Private source: • Syndicated financing by banks/financial institutions; • Infrastructure funds; • Private equity funds; and • Issuance of capital market instruments (i.e. bonds and Sukuk)

46. Project Finance – Major Participants Government: The project company usually needs to obtain a concession from the host government to undertake the project. The government may also establish a new regulatory framework, guarantee currency convertibility, and provide environmental permits. Project sponsors or owners: A separate company is established to undertake the project. Sponsors are generally the project owners with equity stake and will generally be involved in project construction and management. Project company: The project company is a single purpose entity created to execute the project. Controlled by the sponsors, it is the project’s hub through its contractual arrangements with operators, contractors, suppliers and customers. Contractor: The contractor is responsible for constructing the project according to the specifications outlined in its contract. Primary contractors will then subcontract with local firms for different components of the construction. Operator: Operators are responsible for maintaining the quality of the project’s assets and ensuring maximal operational efficiency.

47. Project Finance – Major Participants Suppliers and customers: The supplier provides the critical input, like fuel for a power plant project. The customer is the party willing to purchase the project’s output. Lenders: Infrastructure projects involve substantial funding, raised as debt from a syndicate of lenders such as banks and specialized lending institutions. Multilateral agencies: The World Bank, IFC and regional development banks are often lenders or co–financiers of infrastructure projects in developing countries. Export credit agency (ECA): Because infrastructure projects in developing countries often require imported equipment from developed countries, ECAs are routinely approached by contractors to support these Projects. Other important parties include: Insurers, legal and financial advisors (assemble the transaction given the number of important contracts and help structure the financing for the project) and the trustee (responsible for monitoring the project’s progress).

48. Project Finance – Major Agreements • Project Documents: • EPC/ ECC • O&M contract • Input /Fuel Supply Agreement • Off-Take Agreement e.g. PPA • Sponsor Documents • Project Funds Agreement • Shareholders Agreements • In case of Islamic Facility • Investment Agency Agreement • Declaration of Trust • Musharaka Agreement • Management Agreement • Payment/ Ijara Agreement • Purchase Undertaking • Sale Undertaking • Security Documents • Hypo/ mortgage • Share Pledge Agreement • Direct Agreements • Guarantee • Other Documents • Common Terms Agreement

49. Project Finance – Global Potential • Estimate of Global Infrastructure Financing Needs: • The Organisation of Economic Cooperation and Development (OECD) estimates that approximately USD71 trillion would be needed globally by 2030 for investment in road, rail, telecoms, electricity and water infrastructure. • Emerging markets would require a total of USD21 trillion for infrastructure investments in the next decade. • The GCC region would require approximately about USD2 trillion by 2020 for infrastructure investment.

50. Islamic Project Finance