Sharia compliance Issues in Islamic Banking

1. Sharia compliance Issues in Islamic Banking Muhammad Najeeb Khan Sharia advisor HMB 25th Aug 2008 mnajeebkhan@hotmail.om

2. OVER VIEW • Islamic Banking must be viewed as an evolving system. • Islamic Banking must be viewed as an change management Process. • Need and Desire of Islamic Banking • Its growth in last 25 years • Conceptual Development of Islamic Banking mnajeebkhan@hotmail.om

3. OVER VIEW • Islamic Banking as Financial Intermediation system. • Distinguishing features of Islamic Banking • Financial engineering in the light of Principals of Sahria • Sharia Governance Structure • Standardization as per AAOFI sharia standards • Standardization as per Accounting Stanards mnajeebkhan@hotmail.om

4. Main Financial Contracts • Debt creating Modes (Low Risk Category) 1. Qard Al-Hasan (interest- free loan) 2. Bai Muajjal (Price deferred sale) 3. Murabaha and Musawama 4. Salam (Commodity sale) 5. Istisna (Order to manufacture) • Semi-debt Modes (Medium Risk Category) 1. Ijarah • Sharing or Non-debt Modes (Full Risk Category) 1. Musharakah (Close to venture capital) 2. Specific Purpose Mudarabah 3. General Purpose Mudarabah mnajeebkhan@hotmail.om

5. Main Financial Contracts mnajeebkhan@hotmail.om

6. Islamic Financial Tools • Murabaha – trade with markup or cost plus sale • Mudaraba – profit sharing agreement • Musharaka – equity participation • Leasing (Ijara Wa Iqtina) – renting for beneficial use • Salam and Parallel Salam – deferred sale contracts • Istisna’a and Parallel Istisna’a – project finance • Sukooks – Islamic bonds mnajeebkhan@hotmail.om

7. Murabaha – Cost Plus Finance Transfer of title to bank • Asset Purchasing • Transaction Flow Chart • Agency Agreement structure accordingly • Acquisition of Title of the Asset • Title to assets transferred to the customer at the time of purchase • Payment to Supplier drectly Transfer of title to customer Entrepreneur Financier Vendor Payment of marked up price (P+X) Payment of purchase price (P) mnajeebkhan@hotmail.om

8. Murabaha – Cost Plus Finance Transfer of title to bank • Physical inspection • Asset Purchasing evidence • If client is agent more then one bank • Sharia Standard/ accounting standard • Usually the customer then provides same or other assets as collateral Transfer of title to customer Entrepreneur Financier Vendor Payment of marked up price (P+X) Payment of purchase price (P) mnajeebkhan@hotmail.om

9. MUDARABA INVESTMENT ACCOUNT HOLDERS ISLAMIC BANK ISLAMIC BANK ENTREPRENEUR ISSUES The Bank may enter into Mudaraba contract in the following two ways: MUDARIB RAB-UL-MAL DEPOSITS INVESTMENTS mnajeebkhan@hotmail.om

10. Mudaraba – Profit Sharing Arrangement • Identical to a fund structure • Investors contribute finance; Manager contributes expertise • Liability of Manager is limited with incentive to perform • Investment objectives either specific or left on Manager discretion • Managers’ fees based on profit • Fairly widely used form of finance in Islamic banking and capital markets Investors (Rab-ul-Mal) Contribution of finance Venture (Mudaraba) Profit and capital repayment Contribution of expertise Manager (Mudarib) Fees based on profit earned mnajeebkhan@hotmail.om

11. COMPLIANCE ISSUES on liability side • POINTS NEED FURTHER RESEARCH • Pool Management on the basis of Mudaraba • Treatments of pool • Expense allocation • Profit determinationh • Movements of funds between pools • Weightages • Expenses related to the bank(mudarib) mnajeebkhan@hotmail.om

12. Musharaka – Equity Participation • Analogous to classical joint venture • Both entrepreneur and investors contribute to capital • Risks and returns are shared in proportion to capital contribution • Normally used for project finance or venture capital • Usually for medium term transactions • Financing of fixed assets etc. Entrepreneur (Musharik) Venture (Musharika) Contribution of capital Profit and capital repayment Investors (Musharik) Contribution of capital Profit and capital repayment mnajeebkhan@hotmail.om

13. Leasing (Ijara Wa Iqtina) • Another popular instrument – 15% of the transactions • Sharia Standard/ Accounting standard • Asset ownership risk with owner; operational risks with lessee • Features close to a financial lease • Used for machinery, equipment, property, vehicles, aircraft etc. • Sale and lease back transaction Beneficial use of asset Transfer of asset Entrepreneur (Lessee) Financier (Lessor) Vendor Lease rentals Payment of purchase price mnajeebkhan@hotmail.om

14. Salam and Parallel Salam – Deferred Delivery • Primarily a deferred delivery sale contract • Similar to a forward contract where delivery in future in exchange for spot payment • To mitigate asset risk financier can enter into a parallel salam • Usually used for commodity finance Delivery of asset at future date Delivery of asset at future date Entrepreneur Financier Commodity Owner Advance payment of purchase price Payment of purchase price on delivery mnajeebkhan@hotmail.om

15. Sukuks Sukuks – Islamic Bonds • Sukuks represent proportionate beneficial ownership • For a defined period the risk associated with and return cash flows generated from the assets belong to Sukuk holders • Sharia structure of transaction • Early stages of development • New sharia guidelines Transfer of assets Issued Entrepreneur Asset SPV/ Trust Investors Cash Cash mnajeebkhan@hotmail.om

16. Conclusion • To develop proper internal sharia audit Mechanism • Awareness and training of staff specially product related compliance • Awareness and training of client and his related staff specially product related compliance mnajeebkhan@hotmail.om

17. JAZAKALLAH Thank you mnajeebkhan@hotmail.om