Applications of Contracts in Banking and Finance
Prof. Habib Ahmed
Durham University Business School
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Presentation Plan
• Approaches to Innovation
• Islamic Financial Products
– Banking
– Takaful
– Sukuk
– Derivatives
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Traditional Contracts
• Key contracts
– Asset based—Ijarah (existing owned, existing leased, and future assets), Manfah (existing and futures assets)
– Sale based-- Murabahah, Istisna, Salam
– Equity based-- Mudarabah, Musharakah
– Agency based- Wakala
• Supporting contracts
– Gift (hiba), guarantee (kafala), mortgage (rahn), etc.
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Approaches to Innovation
Approaches to financial engineering:
•‘Reverse engineering’—an Islamic replication of a conventional product is engineered
– Contractual stipulations (mode) are fulfilled in a legalistic manner
•‘Innovative engineering’—come up with Shari’ah based products
– Start with the market segment and needs and then come up with new products satisfying the need and the form/spirit of Islamic law
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Approaches to Product Development
The specific methods used to develop products are:
1.Adapt traditional contracts to contemporary products
2.Adapt conventional financial products
3.Combine existing nominate contracts—financial/legal engineering
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Adapting Traditional Contracts
• Arboon as call option• Call option—pay a fee for the right to
purchase an object at a specific price in the future
• Arboon—a down-payment paid by buyer to secure an object for a period of time. If the buyer does not purchase the object, seller keeps the advance
• Used in capital-protected funds– Invest 97% in fixed income assets, 3% to buys
options on stocks. If the market price is greater than strike price, option is exercised
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Adapt Conventional Products• Eliminate undesirable components from
conventional financial products • Stocks and mutual funds
• Eliminate according to industries (gambling, alcohol, financial sector, arms, etc.).
• Financial ratios
Criterion DJIM S&PS
1. Total debt/Market Capitalization Less than
33%
Less than
33%
2. Cash and interest-bearing
securities/Market capitalization
Less than
33%
Less than
33%
3. Account receivables/Market
capitalization
Less than
33%
Less than
49%
4. Non-permissible income and other
interest income/Total revenue
- Less than 5%
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Combination of Contracts:Financial Murabahah
Contracts used:1. A promise (wad) to purchase by client2. Security deposit (hamish jiddiyah)—to be used in
case of non-fulfilment of promise3. Sale contract 1 (bay’): between vendor and bank 4. Sale contract 2: between bank and client
(murabahah/bay muajjal)5. Agency contract (wakala): between bank and client
(to purchase on behalf of bank)6. Pledge/guarantee (rahn/kafala)—collateral to secure
the debt.7. Clause in the contract—in case on non-repayment
on time, a penalty will be charged
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Combination of Contracts:Diminishing Musharakah
Contracts used:1. Promise (wad) to rent for the term of the contract.2. Promise (wad) to purchase units at different
stages.3. Create a joint ownership (musharakah) (of the
asset)4. Lease (ijarah) agreement (bank leases to client)5. Actual purchase of units of asset.6. Legal mortgage (rahn)7. Trust deed
Presentation Plan
• Approaches to Innovation
• Islamic Financial Products
– Banking
– Takaful
– Sukuk
– Derivatives
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Use of Islamic Contracts in Products
• Unlike in conventional sector, in Islamic finance different modes of financing can be used for a product
• Various modes have different risk-return features
• Product development team decides what contract to use in a specific product
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Financing Durables (1)
• Murabahah based financing
– Client promises to buy good/asset from bank
– The bank buys the good/asset and sells it at a markup to the client
– The price is paid back to the bank in installments
• Used by: Dubai Is Bank, Meezan Bank, Bahrain Is. Bank
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Financing Durables (2)
• Ijarah wa iqtina based financing
– A promise to lease by the client
– The bank buys the assets and rents it to the client for a specific period of time.
– At the conclusion of the term, the asset is given to the client at gift or sold at a token price.
• Used by: Meezan Bank
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Financing Durables (3)
• Diminishing musharakah based financing– Bank and client jointly own an asset that is divided
into a number of units.
– Client uses the asset, pays rent on the bank's share and periodically buys units/shares of the asset from the bank.
– Over time the client becomes the owner of the asset by purchasing all units owned by the bank.
• Used by: Meezan Bank
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Financing Durables (4)
• Tawarruq based financing
– Bank buys commodity and sells it to the client at a mark-up
– The client appoints the bank as an agent to sell the commodity to a vendor
– Money deposited in client's account
– Amount due to bank paid back in installments
• Used by: HSBC Amanah
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Presentation Plan
• Approaches to Innovation
• Islamic Financial Products
– Banking
– Takaful
– Sukuk
– Derivatives
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Insurance—Shari’ah Perspectives
• OIC Fiqh Academy Resolution 9 (9/2) 1985 forbids conventional insurance– Gharar (uncertainty about the object of sale and
outcome)
• Islamic viewpoint—risks can be mitigated but approach has to be different
• Takaful based on • Tabarru’ (gift or donation)—Gharar does not exist
in gratuitous contracts• Ta’awun (mutual assistance) • Avoid riba in transactions (applies to assets)
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Takaful—Introduction• Key features
– Takaful Operator (TO)—shareholders establish a takaful company with their own fund (Shareholders’ Fund-SF)
– Takaful participants contribute (tabarru) to Participants’ Risk Fund (PRF)
– SF and PRF are separate—shareholders do not take any underwriting risks
– Hybrid of commercial (SF) and mutual insurance (PRF) models
• Types of takaful– General (casualty)
– Family (life)
TakafulParticipants
Takaful Fund
PRF
Investment Profit/ Underwriting Surplus
Distributable Surplus/Profit
Shareholders’ Fund
Operating Expenses
Profit
Dividend
Taka
fulO
per
ato
r
Wakala General Takaful
Wakala fee
(% of contribution)
Retained
[Source: IFSB (2009)]19
TakafulParticipants
Takaful Fund
PRF
Investment Profit/ Underwriting Surplus
Distributable Surplus/Profit
Shareholders’ Fund
Operating Expenses
Profit
Dividend
Taka
fulO
per
ato
r
Mudarabah GeneralTakaful
Mudarabah Share
(% of Profit )
Retained
[Source: IFSB (2009)]20
Presentation Plan
• Approaches to Innovation
• Islamic Financial Products
– Banking
– Takaful
– Sukuk
– Derivatives
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Sukuk-definition
• Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) defines sukuk as:
“Certificates of equal value representing after closing subscription, receipt of the values of certificates and putting it to is as planned, common title to shares and rights in tangible assets, usufructs and services, or equity of a given project or equity of special investment activity”
2323
Obligor(undertakes future sale
of commodity for the investors)
SPV
Investors1 2a
Salam Proceeds
Undertaking Sukuk Certificates
Commodity Commodity Sale Proceeds
Sukuk CertificatesProceeds
2b
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Sukuk al-Salam
• Sale of well-defined quality and quantity of commodity
• Fixed rates of return
• Sukuk al-salam not negotiable
5 Commodity Sale
CommodityBuyer
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Sukuk al-Salam: Example
Sukuk name/date Sukuk al-Salam/Aug. 1, 2007 (Issue no. 75)
Sukuk base Aluminium
Obligor Government of Bahrain
Issuer Central Bank of Bahrain
Purpose of Offering Short-term liquidity
Tenor 91 days
Issue size BD 6 million
Expected rate of
return
5.06%
Credit enhancers Guaranteed by Bahrain Government
Governing Law Bahraini Law
Redemption/ Principal
repayment
With price at maturity
Rating None
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Sponsor/
Originator/
Obligor
SPV
Investors
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• Sukuk al ijarah are negotiable
• Can have fixed/flexible rates
• Risks of assets transferred to certificate holders (though issuer can
guarantee the capital)
• Transfer of assets back to Issuer can take place is 2 ways:
a. Periodic payments include rent and amortization (capital)
b. Bullet payment at maturity (the Issuer buys back the assets)
2a
Purchase Price of
Assets
Sale/Transfer of Assets
Lease of Assets
Sukuk Certificates
Rental Payment Periodic Rental
Payments
Sukuk Certificates
Proceeds
2b
4b
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4a
3
Sukuk al-Ijarah
Sale/Transfer of Assets
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Sukuk al-Ijarah: ExampleSukuk name/date Qatar Global Sukuk/Oct. 8, 2003
Sukuk base Certain Land Parcel in Qatar
Obligor State of Qatar (lessee of leased assets)
Issuer Qatar Global Sukuk QSC
Purpose of Offering Construction of Hamad Medical City
Tenor 7 Years
Issue size USD 700 million
Expected rate of
return
Semi-annual lease rentals (Libor+ credit spread+
amortization payment)
Credit enhancers Guaranteed by Qatari Government
Governing Law English and Qatari Law
Redemption/ Principal
repayment
With rental payments (amortization with rental
payments)
Rating A+ (S&P)
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Presentation Plan
• Approaches to Innovation
• Islamic Financial Products
– Banking
– Takaful
– Sukuk
– Derivatives
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Forwards: Shari’ah Perspectives
• Conventional derivatives are prohibited under Islamic commercial law
• AAOIFI Standard No. 20 ‘Commodities in Organised Markets’:
– “5/1/2 It is not permitted according to the Shari’ato undertake futures contract either through their formation or trading”
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Foreign Exchange Forward• Current Ex. Rate (ER): 1£=$1.5
– A needs $1500 after 3 months (price £1000 today)
– B will need £1000 after 3 months (price $1500 today)
• If after 3 months, ER: 1£=$1.4– A has to pay $1500/1.4=£1071.4
– B has to pay £1000x1.4=$1400
• If after 3 months, ER: 1£=$1.6– A has to pay $1500/1.6=£937.5
– B has to pay £1000x1.6=$1600
• Hedging foreign exchange risk can be considered essential need for businesses
• Forward: – A pays forward price to buy $1500 at ER: £1=$1.5 (long position)– B pays forward price to buy £1000 at ER: £1=$1.5
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Reverse Engineering:Islamic Synthetic Forward
• Client wants to buy $1500 in 3 months and hedge against risk at ER: £1=$1.5
• Tawarruq-based Forward – Bank buys copper (C) at price £1000 and sells at price
£1050 to the client payable in 3 months– Client sells C to broker and gets £1000– The client buys aluminium (A) at price £1000 and sells to
the bank at price $1500 payable in 3 months– The bank sells A to broker and gets bank £1000
• After 3 months:– Bank pays the client $1500 – Bank gets £1050 from client
[Note £50 is the fees for the transaction]