Islamic Banking and Finance

November 2012

Sharia structure

Introduction to Islamic Finance Slide 2

Sources of Guidance of Islamic Financial Operations

Compliance with Sharia is derived from : QURAN (Primary source of Sharia) SUNNAH (Practices of the Prophet) IJMA (Consensus) QIYAS (Analogy) IJTIHAD (reasoning of a group of qualified scholars, which is aimed at adapting Islamic rules to the contemporary world)
Slide 3

Introduction to Islamic Finance

Quran

- Primary source for discerning the laws of God

- Binding to Jurists to have the first recourse to the QURAN for answers

- Evidence found in other sources are subject to the QURAN

- Example : God has permitted trade and prohibited Riba

Reference : Surat Al Baqara verse 275

Introduction to Islamic Finance Slide 4

Sunnah

- Literally means : Well-known path - Words or Acts of the Prophet - Sayings of the Prophet (SAW) used to lay down and give moral guidance - Acts of the Prophet (SAW) which have a legal content (ex: method of praying) - Tacit approval (silence) of the Prophet (SAW) on the action of one of his companions in his presence or in his knowledge
Introduction to Islamic Finance Slide 5

Ijma

- Literally means agreement on a matter - In its technical sense, it means the consensus of the independant jurists from the Ummah of the Prophet Muhammad (SAW) after him - Example : Jurists have reached a consensus (Ijma) that the selling of goods by a party who doesnt own the goods and without the approval of the goods owner is void

Introduction to Islamic Finance Slide 6

Qiyas

- Literally means measuring or estimating one thing in terms of another - Technically, it is the assignement of the legal rule of an existing case found in the texts of the QURAN, the SUNNAH, or IJMA to a new case whose legal rule is not found in these sources. - Example : Jurist looked into details of the prohibition of alcohol. After analysis, it was decided that the underlying reason is intoxication . Once this has been defined, the scholars would look at other liquids that intoxicate and extend the legal rule

Introduction to Islamic Finance Slide 7

Ijtihad

- Number of meaning of Ijtihad - Islamic scholars take into account the customs of a place that adress a problem but are not offensive to Sharia - In some cases, Islamic Scholars develop their own preference from a solution to an apparently unique problem

- Fundamentaly, it is a personal exercise until other scholars are able to agree with the solution proposed by the innovator.

Introduction to Islamic Finance Slide 8

Authorities on interpretation
- Four different schools of jurisprudence make up the SUNNI world of Islam : - Maliki : North Africa - Hanbali : Saudi Arabia and Gulf region - Hanafi : Eastern Europe , asia and Turkey - Shaafi : Malaysia and South east Asia - While the Shia world follow their own seperate schools (Mainly Irak and Iran) - The Islamic Fiqh academy (created in 1981 by the Organisation of Islamic Countries) is a body which meets periodically to discuss issues originated from Islamic thinking - Sharia scholars or Sharia Board

Introduction to Islamic Finance Slide 9

Islamic Finance Principles - Concept

No intrinsic value in money :

Money as a way of exchange and a store of value not subject to trade

Fundamental principle :
Risk sharing partnership => Profit and Loss Sharing (PLS) basically, no pain no gain

Introduction to Islamic Finance Slide 10

Islamic Finance Principles - Rationales

Requirements
Asset backed Prohibition of payment/receipt of Riba Prohibition of activities

Rationale
Transactions must be backed by tangible assets Prohibition of interest as incremental of debt Considered harmful to the society (e.g. alcohol, pork, weapons, drugs, pornography business, etc) Subject of contract must exist, must be specifiable and measurable. Speculative trading in financial instruments is prohibited The bank act as an agent/partner with the depositor who is entitled to share the gains/loss of the investment

Prohibition of Gharar (uncertainty) and Maysir (gambling) Profit/Loss Sharing

Sharia Compliant Transaction

Introduction to Islamic Finance Slide 11

Islamic Finance Principles Riba

- Literally means excess - Prohibition of payment/receipt of Riba interest as incremental of debt - 2 types of Riba : - Primary form : Riba al Naseeyah => Excess resulted from predetermined interest which a lender receives over and above the principal amount - Second form : Riba al Fadl => Excess compensation without any conisderation resulting from an exchange or sale of goods (exchange of commodities contracts)

Introduction to Islamic Finance Slide 12

Islamic Finance Principles Ethical dimension

- Undesirable sectors : Tobacco Alcohol Arms or munitions Gambling Pornography Conventional financial services

- Charitable aspects : Interests donated to charity (cleansing / purification) Zakat charitable tax paid by muslims according to Quranic guidance

Introduction to Islamic Finance Slide 13

Islamic Finance Principles Gharar and Maysir

- Gharar literally means overall uncertainty

- Maysir means gambling

- May be defined as preventable ambiguities or omissions in contracts => ex : Buying a house , the price of which need to be specified in the future or price is fixed but specification is to be defined in the future - Consequence of this principle : Buying and selling in most types of derivatives products for any purpose including speculation is strictly forbidden

Introduction to Islamic Finance Slide 14

Islamic Finance Principles - Contracting - Aqd litterally means contract - Majority of scholars defined the following requirements :
-

Contracting parties (Mature and sane) Subject Matter (Valuable, Existence, Ownership, Ability to deliver, Specific) => consequence : speculation like short selling is forbidden Offer and acceptance : consent of the parties is fundamental element in concluding a contract Price : should not be uncertain or depending on future events
Sahih litterally means valid which could be either : - Nafiz : enforceable - Mawqoof : unforceable until authorized Fasid : voidable Batil : invalid

- Classification of contracts :

Introduction to Islamic Finance Slide 15

Islamic Finance Principles - Implications

Implications => All products need to be approved by the Sharia scholars

This may have sevral implications :
-Costs -Timing -Latitude of flexibility

Introduction to Islamic Finance Slide 16

Special feature : Sharia board

One distinct feature of the modern Islamic banking movement is the role of the Sharia boards

boards made up of Islamic jurists and scholars available to an Islamic financial institution for guidance and supervision in the development of Sharia compliant products, which have to approve all transactions :
Sharia board ensures that investments structures are in line with Islamic law Sharia board has the responsibility of laying down the underpinning Sharia principles and rules that the institution should adhere to Sharia board Publish annually, a report concerning the level of Sharia'a compliance of the entity The Sharia Board is not responsible for: - Shareholders money - Funds operation management - Funds portfolio management
Introduction to Islamic Finance Slide 17

Supranational authorities governing Islamic Finance

- AAOIFI (1991) : Accounting and Auditing Organisation for Islamic Financial institutions => Benchmark of islamic accounting and auditing standards (56 standards)
- IFSB (2002) : Islamic financial Services Board => Standard setting body of regulatory and supervisory agencies (complementing BASEL II Capital Accord) - IIFM (2001) : International Islamic Financial Market => Development of Global Islamic capital and money market - GCIBFI (2001) : General Council for Islamic Banks and Financial Institutions => Promoting industry in theory and practice - LMC (2002) : Liquidity Market Council => Creation of active Islamic inter-bank market - IIRA (2005) : International Islamic Rating Agency => Rating of Islamic Financial institutions
Introduction to Islamic Finance Slide 18

The components of the Islamic Banking and Finance industry

1) Banks

- Investment & Investment management

=> ex : Al-Meezan - Generic Banking services (current accounts, transfers, credit cards, home finance, etc.) => ex : Al-Meezan and islamic banking windows of the banks 2) Equity and Capital Markets 3) Insurance companies : Takaful
Introduction to Islamic Finance Slide 19

Operating structures of Islamic Banks

1) Window model
=> Operating structure where a conventional bank simultaneously carries out Islamic Financial activities but assure clients of segregated accounting and operations for conventional and islamic activities (ex : Askari, standered chartered)

2) Branches
=> Similar to window model but services are offered through dedicated channels

3) Subsidiaries
=> Seperate legal entity (subsidiary) set up specifically to undertake Islamic Financial services activities Formulate and manages its own policies

4) Fully-fledged islamic banks

=> Pure Islamic banks which offers only Islamic Financial services

Introduction to Islamic Finance Slide 20

Balance Sheet of an Islamic Bank Assets

Liabilities

Cash & equivalents Murabaha financing Mudarabah financing Musharakah Financing Sukuk Assets for trading (securities, inventory,other assets) Invetsments (not for trading) Other assets Fixed asets

Customer current accounts (not remunerated) Due to banks and financial institutions Payables Other liabilities Sukuk issued Profit sharing Invetsment Account (restricted vs unrestricted) Equalization reserve Share Capital & Reserves

Introduction to Islamic Finance Slide 21

The Islamic Financial instruments

Islamic monetary instruments Islamic debt-like instruments Islamic asset-like instruments Hybrid Islamic Finance instruments Takaful (Insurance)

Introduction to Islamic Finance Slide 22

The Islamic Financial instruments

Islamic Financial instruments
Takaful (insurance)

Monetary instruments : - Current account -Term deposits & PSIA - Tawarruq - Arbun

Debt like instruments : - Murabaha - Ijara - Salam - Istisnaa

Equity like instruments : - Equity - Mudaraba -Musharaka -Invetsment funds

Hybrid instruments : Securitization - Sukuk Structured products

Introduction to Islamic Finance Slide 23

Islamic Monetary instruments

- Current accounts - Term deposits or PSIA (Profit Sharing Investment Account) - Tawarruq - Arbun

Introduction to Islamic Finance Slide 24

Islamic Monetary instruments Current accounts

- Used for day to day cash management. No return is paid to depositors - Used for higher return savings account

- Banks may sometimes pay a return, depending on their own profitability.

- Losses are not in practice passed on to depositors and are absorbed trough the banks reserves - 3 forms :

- Amanah form (applied globally)

=> entrusted to the bank for safe keeping and should be returned in whole - Wadia form (applied in Malaysia) => Wadia is a promise to return the money to the depositor - Qard hassan => loan without interest or yield between the client and the bank - Complete segrergation of funds and no overdrat facility on these acounts
Introduction to Islamic Finance Slide 25

Islamic Monetary instruments Term deposits or PSIA

- PSIA = Profit Sharing Invetsment Account
=> These are specific to Islamic Finance industry

- Considered as investment accounts under the mudaraba format

=> Islamic banks receive funds from the PSIA holders who place their funds on the basis of the mudaraba profit and loss sharing bearing account

- Deposits are fixed term and cannot be cashed in before maturity (some exceptions) - The profit-sharing ratio varies between institutions and could be a function of the banks profitability or that of the portfolio of end borrowers - Can be Restricted or Unrestricted - Application of equalization reserves

Introduction to Islamic Finance Slide 26

Islamic Monetary instruments Term deposits or PSIA

- Restricted : - Like collective investment scheme

- The asset allocation is restricted as set out in the contract

- No secondary market but invetsors may be able to to withdraw their funds (including unredistributed profits but less any losses) before maturity with the agreement of the bank

- The scheme is not a seperate legal entity but operates as a mudaraba agreement (bank = mudarib and client = rab al mal)
- The bank is entitled to a percentage of the invetsment income for a financial period as its fee for investment management but does not share in any periodic losses

Introduction to Islamic Finance Slide 27

Islamic Monetary instruments Term deposits or PSIA

- Unrestricted : - The asset allocation is not restricted by contract. The bank as a mudarib will place the funds in any Sharia compliant investment at its sole discretion. - Less risky than the restricted PSIA as the bank tries to mitigate the risk by placing money in a basket of Sharia compliant investments - Lack of transparency - Corporate governance issue as the funds from the holders are co- mingled with other funds at the banks disposal => possible conflict interests with regard to the choice and riskiness of investments and the allocation of the income from those investments - Different applications in different countries

Introduction to Islamic Finance Slide 28

Islamic Monetary instruments Tawaruq

- Contract whereby the bank sells to its client a commodity with a forward payment (also called reversed murabaha) - The client sells it immediately to a third party on spot generating therewith some cash availabilty - Usually no exposure on market to the price risk fluctuation of the commodity as actions (i) to (iv) are undertaken simultaneously
Introduction to Islamic Finance Slide 29

Islamic Monetary instruments Arbun

- Pre-purchase of right to acquire asset : - Deposit/down payment for the purchase of an asset at a later date which will be kept by the seller in case the sale does not happen. This down payment constitues a part of the purchase price and thus is not refundable. - Because of its similarity to an option, it has met with varying levels of approval from the school of islamic jurisprudence - Usually combined with a murabaha product - Most acceptable to Hanbali scholars
Introduction to Islamic Finance Slide 30

Islamic Debt like instruments

- Murabaha - Ijara - Salam - Istisna

Introduction to Islamic Finance Slide 31

Islamic Debt like instruments - Murabaha

- Literally means profit

- Contract where the bank upon request by the customer purchases the asset from a third party and resells it to the customer on a deferred payment basis
- Sale of goods at cost plus an agreed profit mark up - Difference between a murabaha and a loan :
The bank must have some form of actual ownership constructive or physical The maturity can be extended but may not result in an increase in the mark-up or a penelaty fee. Any of these would violate the basic principle riba If the payment is late, no form of penalty may be charged for the profit of the creditor (even though a tird party colection agent can recover costs of collection

Introduction to Islamic Finance Slide 32

Islamic Debt like instruments - Murabaha

1. Definition of needs and goods

specifications
2. Binding promise to buy which can be

structured using Arbun

3. IB buys the goods at spot from the

seller
4. Spot Delivery of goods to the Bank
5. Spot Delivery of goods to the Client 6. Payment of instalments or deferred

payment at P + margin
=> Profit declared as a mark-up => Buyer knows sellers cost

Introduction to Islamic Finance Slide 33

Islamic Debt like instruments Commodity Murabaha

Introduction to Islamic Finance Slide 34

Islamic Debt like instruments Commodity Murabaha

1. Islamic bank instructs the conventional bank as agent to invest say US 10 million for one month.
2. The conventional bank buys a commodity from a broker A, value spot on behalf of the Islamic bank. 3. The conventional bank sells the commodity at cost plus mark-up on a deferred payment basis (one month) to Broker B. Buying and selling is very fast (less market fluctuation exposure) 4. On maturity (in one month) the conventional bank pays to the Islamic bank profit (mark up) plus the original investment of US 10 million. 5. Commission will be payable to the conventional bank as agent (approximately 25 basis points) and to the commodity brokers (approximately $50 per 1 million of the commodity) on buying and selling the commodities. These commissions will be built into the price quoted to the Islamic bank are not accounted for separately. 6. The mark-up is typically based on the LIBOR as a benchmark which makes these transactions comparable to traditional interbank deposits.

Introduction to Islamic Finance Slide 35

Islamic Debt like instruments Ijara

- literally means to give something on rent.

- Ijara contract is an agreement wherein a lessor (muajjir) leases physical asset or property to a lessee (mustajir) who receives the benefits associated with ownership of the asset against payment of predetermined rentals (ujrah). Ijara is for a known time period called ijara period.
- utilized by banks as a mode of financing to provide the customers with short to medium-term financing to lease - Ijara is comparable (but not identical) to conventional leasing contract. - Ijara is less risky as compared to other financing structures

- Liability is known from day one No surprises or uncertain exposure.

- Strict compliance with Sharia and the applicable law is required for enforceability.

Introduction to Islamic Finance Slide 36

Islamic Debt like instruments Ijara

Customer

Usufruct of the Property

Step 5 Lease of the Property to the customer through Lease Agreement

Owner / Developer
Step 1 Promise to lease Step 3 Acquisition of the Property through purchase agreement

Step 6 Lease Rental

Step 2 Purchase Offer

Step 4 Purchase Price

Title & Possession to the Property

Islamic Bank

Introduction to Islamic Finance Slide 37

Islamic Debt like instruments Ijara

Ijara: 3 types - Simple Ijara (Operating lease) - Ijara Muntahia Bittamleek (Finance lease) - Ijara Mawsoofa Bil Thimma (Forward lease) Simple Ijara : - Commonly known as operating lease. Also called a service lease, or a true lease. - It is a short-term arrangement. - Full cost of the equipment or property is not amortized during the primary lease period. - Lessee may cancel the lease any time he wishes to do so, with a prior notice according to the contract. - In an Ijara, the title of the equipment or property always remains with the lessor irrespective of how much the lessee has paid out as lease installments. Consequently, the risks and responsibilities of ownership are always borne by the lessor. - Ownership of the asset remains with the lessor (bank), the asset reverts to the bank at the end of the lease period. The bank may then lease it out to another customer if the asset is in good shape.

Introduction to Islamic Finance Slide 38

Islamic Debt like instruments Ijara

Ijara Muntahia Bittamleek - commonly known as financial lease - Also called Ijara-thumma-al-Bay (lease-sale) or "Ijara-wa-Iktina'a" - The lessee is offered the option of ultimately purchasing the asset or property at the end of Ijara period at a predetermined price. - Full cost of the asset or property is amortized during the lease period. - Can not be cancelled except if the lessor is compensated for any losses. - The bank remains the owner till the very end bearing all the risks and responsibilities - The customer is responsible for only the rentals as long as he uses the equipment or property. He becomes the owner only if, and when, he exercises his option - This Ijara involves two different contracts to be executed at two different stages : First a leasing contract (ijara) with a unilateral promise (waad) to sell the asset to the customer at a predetermined price. Once the lease expires and lessee has made all payments, the lessor is obliged to fulfill his promise to sell by executing the contract of sale (bay) the sale contract is independent of the ijara contract.

Introduction to Islamic Finance Slide 39

Islamic Debt like instruments Ijara

Ijara Mawsoofa Bil Thimma - Commonly known as forward lease - Lease of specified items which are to be delivered after manufacturing or construction - Lease of the underlying assets starts on the date of delivery of the asset to the lessee and the lessees obligation to pay rental triggers with the commencement of the lease. - An investor receives return on its investment out of the amount received from the lessee on account of rental which is adjusted against the actual rental. - Although investment in assets under construction through may not be free from certain downsides, it still has potential to serve both the parties, i.e. customer and financier addressing the Project Financing requirements. - Appropriate structure for project financing

Introduction to Islamic Finance Slide 40

Islamic Debt like instruments Ijara vs Murabaha

- Ijara, like murabaha is a debt-based financing. In both cases, the bank is not a natural owner of the asset (sold under murabaha or given in lease under ijara.) It acquires ownership upon receiving a request from its customer.
- Similar to murabaha, the ijara rentals are also paid in installments over time to cover the cost of the asset or value of investment for the bank plus a fair return on investment. - In ijara, ownership of property is not transferred throughout the ijara period while the customer receives the benefits of using the asset. - In murabaha on the other hand, the benefits and risks of ownership of the asset are transferred to the customer along with ownership. - Both products involve cash outflows for customer or cash inflows for the bank over a definite future time period. Those flows are cover the cost of the asset and provide for a fair return on the asset to the bank. - However, these cash flows are predetermined in case of murabaha and no subsequent increase or decrease is allowed. In case of ijara, however, the rentals could be flexible and be made to reflect the changing economic and business conditions

Introduction to Islamic Finance Slide 41

Islamic Debt like instruments Ijara vs Murabaha

Different reasons why a customer will choose ijara (leasing) rather than murabaha (borrowing) from the bank to purchase the needed asset.

1. It is easier to lease than borrow for short-term needs.

2. To avoid different types of risk 3. Ijara mostly do not require credit evaluation. 4. Gives more freedom of changing equipment as technology advances 5. Easier to get finance through leasing for companies with credit standing; these kinds of companies may not be able to borrow from banks or the public and if they do, have to pay high rate of interest. 6. In many cases, leases can be advantageous from taxing point of view. Since equipment leased remains the ownership of the lessor and hence the lessor pay the taxes. 7. In many countries, leasing is an off-balance-sheet financing. The asset itself is kept on the lessor's balance sheet, and the lessee reports only the required rental expense for use of the asset.

Introduction to Islamic Finance Slide 42

Islamic Debt like instruments Salam

Purchase or sale of a commodity for deferred delivery in exchange for immediate payment

Introduction to Islamic Finance Slide 43

Islamic Debt like instruments Istisna

Customer

Delivery to the Customer after at completion

Step 5 Sale of the described Property on Parallel Istisna basis

Owner / Developer
Step 1
Promise to Purchase on Parallel Istisna basis

Step 3 Purchase of the described Property through Istisna Agreement

Step 6
Parallel Istisna

Step 4 Istisna Purchase Price Step 2 Purchase Offer

Delivery of the described Property after completion

Purchase Price

Islamic Bank

Introduction to Islamic Finance Slide 44

Islamic Debt like instruments Istisna

Agreement for manufacturing goods and commodities, allowing cash payment in advance and future delivery of the goods and commodities or a future payment and future delivery In Istisna sale, the seller sells a described property to be delivered to the purchaser once the same is completed. Istisna requires combination of either lease of the purchased assets back to the seller or sale of the purchased assets to the customer, provided that the purchase is not from the same customer.

Introduction to Islamic Finance Slide 45

Islamic Debt like instruments Salam vs Istisna

- There are number of differences :
Under Salam, deliverables have commodity-like characteristics and must be fungible like base metals or grain Under Istisna, deliverables are manufactured goods or constructed property Under Istisna, the price may be paid in advance, according to progress or in instalments post delivery Under Salam, the price must be paid in advance Under Salam, the contract may be cancelled Under Istisna, the contract may be cancelled unilaterally before work starts

Introduction to Islamic Finance Slide 46

Islamic Equity like instruments

Equity
Investment in equities is acceptable if the fund does not invest in prohibited activities (industrial screening) and underlying respect the financial ratios (financial screening)
Purification : For interest on cash and underlying not 100% sharia compliant

Mudaraba
Partnership in profit between Capital and Work
Agreement in which the investor (the rab- al-mal) provides the necessary finance while the recipient (mudarib or manager) provides professional, managerial and technical know-how towards carrying out the venture, trade or service with an aim of earning profit

Musharaka
Form of partnership between the Islamic Bank and its client
Each party contributes capital in equal or varying degrees, to establish a project or share in an existing one

Introduction to Islamic Finance Slide 47

Sharia compliant equities

Islamic stocks selection

Islamic stocks selection

(Industry sin screen)

Conventional Banking and Insurance Alcohol (including distribution) Pork (complete supply chain) Weaponry (complete supply chain) Gambling (Hotels, casinos, ) Adult entertainment (complete supply chain)

(Financial screen)
Total Debt / market capitalization < 33% Interest income / Total revenue < 5% Account receivables / Total assets < 45%
Ratios used by DJIM (Dow Jones

Islamic Market)
FTSE Global Islamic Index use the

following :

Total Debt / Total Asset < 33%

Introduction to Islamic Finance Slide 48

Mudaraba
Investor (Rab el Mal) :
- invests the capital - has an absolute right to information - risks loosing the capital

Expert-Manager (Moudarib) :
- invests expertise - empowered alone to make business decisions - doesnt share financial losses (Looses time and efforts) => Similar to discretionary asset management
Introduction to Islamic Finance Slide 49

Two-tiers mudaraba

Introduction to Islamic Finance Slide 50

Musharaka

Profit sharing and loss sharing contracts

- Capital quantified and specific

- Profit distribution as per contract

- Losses repartition as per share of capital

Musharaka Contract between X and Y:

- X Investment: 80.000 USD

- Y Investment: 20.000 USD

- Profit repartition: X 70%, Y 30%

Project generates 10.000 USD profit :

- X receives: 7.000 USD - Y receives: 3.000 USD

Project looses 10.000 USD :

- X looses: 8.000 USD

- Y looses: 2.000 USD

Introduction to Islamic Finance Slide 51

Hybrid Islamic Financial instruments

Sukuk
Sukuk are certificates of equal value representing common title to shares and rights in tangible assets, usufructs and services, or equity of a given project or equity of a special investment activity

Structured Product
Combination of two or more plain vanilla products

14 types of sukuk foreseen by AAOIFI

Asset based (90% of issues) vs Asset backed Asset backed refers to securities/Sukuk backed by income generating assets sold/transferred by an originator to a buyer/issuer (usually an SPV); The main source of repayment => revenue from underlying Sukuk assets;

Securitization
Introduction to Islamic Finance Slide 52

Sukuk (Islamic Bonds)

Saudi Electricity Company (SEC) Sukuk

Sukuk Assets comprise : - the right to undertake the following services for 20 years:
Reading electricity consumption and maintaining meters Preparing, issuing & distributing electricity bills and the corresponding entitlement to levy charges according to the applicable regulation (CMR 169).

- and the right to levy and receive the charges relating to them
The instrument is tradable during its life SEC appointed to continue to manage the services For certain Specified Customers only (exclude industrial, agricultural and governmental customers)

Introduction to Islamic Finance Slide 53

Sukuk (Islamic Bonds)

Introduction to Islamic Finance Slide 54

Takaful (Islamic insurance)

Takaful literally means guaranteeing each other Sharia compliant alternative to conventional insurance

Can be thought of as a mutual insurer within a shareholder wrapper i.e. the shareholders operate the company on behalf of the policyholder and any insurance surplus is distributed back to the policyholders
Based on solidarity, co-operation & mutuality

Products are broadly similar to conventional insurance

Free of uncertainty (gharar), gambling (maisir) and interest (riba) Investments must be Sharia compliant (Sukuk bonds, collective investment schemes etc) In theory and in practice in the more mature Islamic Finance economies, it is price competitive with equivalent conventional products Insurance deficit will be financed with Qard Hassan (interest free loan) The interest free loan will be paid as soon as surpluses arise
Introduction to Islamic Finance Slide 55

Takaful (Islamic insurance)

Conventional Insurance
Premiums

Takaful Company
Contributions

Investment Income

Investment Income S/H Fund Capital

Fees & Loan P/H (or Takaful) Fund Reserves

Capital & Reserves

Claims

Expenses Reinsurance

Expenses

Claims

ReTakaful

Introduction to Islamic Finance PricewaterhouseCoopers Slide 56

Legal & Tax structures

Overview of Islamic Funds industry

Introduction to Islamic Finance Slide 57

Accounting, auditing, reporting and compliance principles

AAOIFI Introduction AAOIFI & IFRS - Comparison on structural objectives AAOIFI & IFRS - Categories of accounting standards for IFIs AAOIFI & IFRS - Examples of main differences Adoption of AAOIFI Standards How AAOIFI Standards support Islamic Finance Industry Compliance and reporting requirements

Introduction to Islamic Finance Slide 58

AAOIFI - Introduction
- Responsible for formulation and issuance of international Islamic finance standards.
- Has issued 68 standards : 25 accounting standards; 5 auditing standards; 6 governance standards (incl. on Sharia supervision);

2 codes of ethics;
30 Sharia standards (rules for application of Sharia). - Also developing new standards and reviewing existing standards. - Supported by over 170 institutional members from over 35 countries. - Members include central banks and regulatory authorities; Islamic and conventional financial institutions; accounting and auditing professions; and Islamic financial support services providers.

Introduction to Islamic Finance Slide 59

AAOIFI & IFRS - Comparison on structural objectives

Introduction to Islamic Finance Slide 60

AAOIFI & IFRS Categories of standards for IFIs

1. AAOIFI standards issued because IFRS / IASB standards cannot be adopted in whole by Islamic financial institutions (IFIs)
=> Cases where application of IFRS / IASB standards leads to Sharia compliance issuesdo not fully cover characteristics of Islamic banking and finance.
=> AAOIFIs FAS 1 (General Presentation and Disclosure in Financial Statements of IFIs) covers IAS 1 (Presentation), 7 (Cash Flow), 18 (Revenue), etc.

2. AAOIFI standards issued for specific Islamic banking and finance practices that are not covered by IFRS / IASB standards
=> Financial transactions and practices are unique to Islamic banking and finance => AAOIFIs FAS 2 (Murabaha & Murabaha to the Purchase Orderer), FAS 7 (Salam & Parallel Salam).

3. IFRS / IASB standards that can be adopted by IFIs

=>IAS 10 (Events after Balance Sheet Dates), IAS 24 (Related Party Disclosures).

Introduction to Islamic Finance Slide 61

AAOIFI & IFRS Example of main differences

PSIA (Profit Sharing Investment Account) :
- IFIs major source of funds generally managed by IFI based on Mudaraba investment management profitsharing agreement. - Under Mudaraba investment management, IFI is not liable for loss arising from investments (except due to IFIs misconduct, negligence, etc) based on AAOIFI Sharia standard. - AAOIFI accounting standards require unrestricted investment account funds to be presented in statement of financial position as a separate item between liabilities and owners equity. - In contrast, based on IFRS, these would be presented as liabilities (along with other deposits).

IJARA (Leasing) :
- IFIs major financing mechanisms : Operating Ijarah and Ijarah Muntahia Bittamleek (leasing that ends with transfer of asset ownership to lessee). - For both, asset ownership rests with IFI throughout the lease term. - In Ijarah Muntahia Bittamleek, there must be independent contract for transfer of asset ownership. - As per AAOIFI accounting standards both Operations needs to be treated similar to Operating Lease. - In contrast, based on IFRS, both operations (especially if lease term is for major part of economic life of lease asset) would normally be classified and treated as Finance Lease.

Introduction to Islamic Finance Slide 62

Adoption of AAOIFI standards

AAOIFI standards are mandatory in 9 jurisdictions (and supranational entity) :

Bahrain, Dubai International Financial Centre, Jordan, Qatar, Qatar Financial Centre, Sudan, South Africa (for investment management), Syria, and Islamic Development Bank Group.

AAOIFI standards are also adopted as guidelines or basis for national standards in jurisdictions including :
Brunei, Indonesia, Kuwait, Lebanon, Malaysia, Pakistan, Saudi Arabia, and United Arab Emirates.

Overall, AAOIFI standards are used by all IFIs across the world.

Introduction to Islamic Finance Slide 63

How AAOIFI standards support Islamic Finance industry

Introduction to Islamic Finance Slide 64

AAOIFI standards challenges and issues

- Global adoption of AAOIFI standards
In some countries, the standards are adopted in entirety and made mandatory by relevant national authorities. In others, they are adopted as basis of local standards issued by national authorities. Adopted in all major Islamic finance centres. Challenges in achieving global adoption include prohibitive local framework and differing Islamic finance practices.

- Application of Sharia standards

Some jurisdictions do not have national framework for Sharia application on Islamic finance practices. AAOIFI Sharia standards are for Islamic finance practices that have been accepted internationally. Diversity in Islamic finance practices means there are practices that have not been covered by AAOIFI Sharia standards.

Introduction to Islamic Finance Slide 65

AAOIFI standards challenges and issues (continued)

- Adequacy of AAOIFI standards
AAOIFI has to keep up with new products and services introduced in the markets. Development of standards depends on Sharia pronouncement for such products and services. Meanwhile, existing standards must be constantly reviewed to reflect market development.

- Scope of AAOIFI standards

AAOIFI standards are only for Islamic financial institutions.

AAOIFI standards are not designed for adoption by customers of Islamic financial institutions.
Development of general Islamic accounting standard requires broadening of role and mandate of AAOIFI.

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Compliance and reporting requirements

- Interest bearing cash or investments are not authorized

- In case of interests earned, this will be purified in the cleansing process

- No overdraft on cash. In case of Interests, these will be compensated to the fund by originator. - Islamic stocks selection :
-Non compliant stocks :

- Industrial screening (sectors prohibited) - Financial screening (debt leverage ratios)

- Fluctuation of financial data - Evolution of the global financial market - Mergers and acquisitions - Temporary non-compliance => Stocks remain within the stocks universe - Short-term non-compliance => The dividends for the period are not distributed - Permanent non-compliance => Disinvestment occurs

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Compliance and reporting requirements (continued)

- Signed Sharia Board report needs to be included in the financial statemens to be compliant with AAOIFI standards - Cleasing to be performed : - Purification of interest received (on overdrafts) - Purification non-compliant portion of dividend income received (calculated using financial ratios data - Can be linked to partial non compliant activities of underlying companies - Information obtained from third party or already included in sharia compliant indexes - Calculation process should be reviewed by Sharia Board

Introduction to Islamic Finance Slide 68