Islamic Finance by Mahmood Al- sheahabi

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islamic 346 contract 156 price 118 banks 112 project 112 commodity 96 salam 90 spv 80 risk 66 delivery 64 mosharaka 62 deferred 61 basis 60 conventional 60 payment 59 finance 58 sukuk 54 agreement 53 assets 53 debt 53

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no part of this book may be translated reproduced or used in any form graphic electronic or mechanical including photocopying recording taping or information storage and retrieval systems without permission of the author
islamic finance another form of financial engineering mahmood al sheahabi Call rights reserved to the author

in my position as the relationship officer for islamic institutions first at chemical bank chase manhattan bank and later on with asian capital partners of hong kong i worked very closely with leading islamic institutions and participated directly in developing innovative and ground breaking solutions for the islamic market
praise be to allah lord of universe and his blessings upon his messenger mohammed his family his companions his followers and all prophets and messengers of allah until the judgment day

skeptical views it is not a secret that many moslems have doubts about islamic banking despite their belief that it must be the right way because allah god has ordered us not to engage in usury however when they compare the results with conventional banking they cannot see the difference
obviously they did not want to realize that in commerce you create value and you risk your capital and you can make a profit or incur a loss while in pure lending your claim to your capital and profit is fixed regardless whether the borrower has made profit or not

in summary these exceptions by the prophet pbuh are simply ways to go around riba provided that there is strong socio economic reasons and most importantly not causing any harm to moslem community
as such state owned institutions are permitted to pay riba to the citizens of the same country applying the concept of father and children

the important thing to realize here is that our goal is to help the reader understand how islamic deals are structured and everybody is free to take the necessary sharia opinion on these applications
however we will not make any reference to any sharia board or scholar who has approved these situations nor we will mention any institution which has applied these solutions

obviously the treasury departments at islamic banks try very hard to manage the payments and receipts in a manner that the net settlement is very minimal but it is not possible to maintain a balanced cash position at all times therefore they revert to the following solutions debit and credit products the islamic bank enters into an arrangement with its correspondent bank that for every dollar of overdraft it will maintain a credit balance slightly higher than the overdraft amount
you could have a situation where the islamic banks has left million for days it could borrow for instance million for days in interest free loans or it could borrow million for days and so on

the program was very successful as the islamic bank had the option to invest through this sharia compliant cash management or to lend those balances interest free to chase who would invest them through the conventional overnight scheme and accrue the points earnings for the account of the islamic bank who would borrow interest free loans against the accumulated credit points
the investor would buy a pro rata interest in a pool of leased assets and could sell back his participation at any time provided he gave one day notice

obviously the transaction is pre arranged as the islamic bank would only accept to buy the commodity if it is assured that there is another credible buyer willing to purchase the commodity at a pre agreed price which basically reflects the interest rate prevailing during the period between the spot payment by the islamic bank and deferred payment by the ultimate buyer
usually these transactions are arranged by one party who would act as a principal either the supplier or the ultimate buyer of the commodity or as a broker arranger identifying either the supplier or the ultimate buyer for the commodity

title commodities spot purchase transfer spot purchasing commodity c a commodities agent user bank market deferred cash payment settlement spot deferred spot purchases cash b b payment and sales of settlement spot commodities financial insurer islamic bank a purchasing agent buys spot selected commodity from market place for cash in the name and on behalf of the islamic bank under the terms of a master commodity investment agreement signed with the bank as purchasing agent
repurchase agreement c purchasing agent sells the commodity to the user under to days payment ter miss the purchasing agent or another third party eligible guarantor issues a demand guarantee to islamic investor to insure the deferred payment of the user

case iv forward price agreement a commodity importer is concerned about price fluctuation needs to lock in a forward price he can use what is referred to bei al urboon to lock in a future price

hedging techniques a case i long term hedging platinum islamic platinum spot sale client spot sale payment us payment stg deferred deferred the broker bank a c the islamic client has a property in uk which he intends to sell after five years
a c the islamic client buys platinum from a broker which can be a separate legal entity within the bank network against deferred payment in stg

hedging techniques a case ii short term hedging platinum platinum spot sale islamic client spot sale pays us indian rupees spot deferred the broker bank a c the islamic client has an exposure in indian rupees because of the remittances to india that he wants to hedge
he buys platinum and pays us to the broker on spot the broker can be a separate legal entity within the bank network

hedging techniques a case iii mitigating price volatility in oil financing oil the bank producer arranger prepaid future fixed floating amount physical oil price of price of oil us spot delivery oil islamic future physical oil commodity client delivery trader fixed price deferred cost plus profit a c the oil producer sells oil to the islamic investor in advance against future delivery of oil
a c the islamic investor immediately sells the oil spot to the commodity trader against deferred payment the commodity trader will enter into oil swap with the bank so commodity price risk is mitigated and value will be paid at maturity

hedging techniques a case iv using bie salam to a secure forward price islamic client advance payment forward price deferred delivery agreement of goods the bank back to back arrangement commodity trader a c a commodity importer in asia is concerned about price fluctuation needs to lockin a forward price
a c at maturity the client takes delivery of the commodity

concerning the issue that both legs of the transaction are deferred as the condition of the trade is that either the price or the commodity has to be exchanged on spot or as it referred to in arabic that either althamman the value or almothamman the object being valued must be delivered as the case in deferred morabaha whereby the commodity is delivered spot and the price is deferred
in fact if we carefully examine the mandatory promise to purchase under a letter of credit we can argue that the effect here is also trading deferred with deferred because the mandatory promise from legal point of view is a contractual obligation by the importer to purchase the goods that he is ordering the bank to purchase on his behalf

for instance two parties can agree to exchange a car that is to be manufactured against refrigerators or washing machines which are also to be manufactured some time in the future provided that both parties have clear understanding beyond any uncertainty of the descriptions of the products to be exchanged

but it will not directly receive the counter value in dollars and it will request the conventional bank to credit the dollars to its account with the conventional bank under what is referred to a blocked account which is obviously a non interest bearing account

the process in a morabaha deal is that the client importer will furnish a specific and detailed request of the goods he wants to buy import the bank would accept to purchase the goods from the supplier exporter on the condition that the client will on the delivery of the goods will buy the same at cost plus the mark up for the bank
trading which is referred to here is engaging in buying and selling of all kind of permissible commodities and assets while risking your efforts and capital and not like the case with usury where the financier wants to be assured of his capital and profits regardless of what happens to the actual transaction being financed

in this situation the islamic bank would arrange to sell the client a new commodity on a deferred payment basis and at the same time would find a buyer that will be willing to pay cash for the same commodity and in this way the client would receive new money in his account with which the islamic bank can settle the debt from the previous morabaha
so the bank can enter into a new and deferred payment foreign exchange by simply selling him dollars which the client would use to repay his debt on time and against the dollars the bank would buy riyals that the client would pay on deferred basis

the rationale for this was that the oil producer is taking market risk any way ie assuming the oil producer did not sell the same quantity on salam basis and kept the crude until the date of delivery the oil producer could only sell the oil for what the market is on the delivery date so the actual scenarios will be one of the following scenario one the market price will be exactly at
in addition to taking the performance risk delivery risk he is not allowed to hedge himself against price deterioration and in case of a default by the seller the buyer of salam has no right to claim compensation for loss of investment or for the indirect damages that could be caused to him with his clients particularly in a situation where he has entered into a parallel salam contract

the fourth group proposed two options as follows a c under an agency agreement the banks will appoint the oil producer as the sale agent to sell the crude on delivery date at no less than a minimum sale price msp which will be agreed upon in advance any excess over the msp can be shared according to one of the following options a the oil producer can take up to of the excess over the msp
on the surface it may look that the oil producer is losing but if you analyze the situation closely you will realize that from cash flow point of view the oil producer is benefiting much more than in the first two scenarios because had it not sold that quantity on salam basis and waited until the delivery date it would have only received dollars the actual market price but instead it was able to get extra four dollars in advance and for the whole period of the salam

a c the bank will provide a separate mandatory and irrevocable promise that if the market price on delivery date was higher than the salam purchase price plus the predetermined profit margin the bank will grant the excess in value to the oil producer as gift and that the bank would forego its rights to the remaining quantity of crude in favor the oil producer

exactly and in the same manner as we are forcing the ultimate buyer under morabaha to honor his promise to purchase the goods as the scholars have ruled that a promise is now mandatory because the bank based on this promise will be buying the goods we should use the same analogy also to make the seller of the salam contract live to his promise to deliver the produce or else be willing to compensate the buyer based on market prices should he decide to obtain the goods from the market

is it for the account of the project sponsor or for account of the financier if it is for account of the sponsor then when the project is completed the title to the project is automatically transferred to the project sponsor and the recourse of the financier the islamic bank would be limited to a debt obligation against the project sponsor
since project finance deals take an average between years to complete it is not possible to mark to market the exposure in the same manner as the commercial banks can do as they are permitted to capitalize interest every days based on current market rates

a c the insuring party is the owner the spv and not the sponsor and cost of the insurance to be added to the total cost of the project
the sharia scholars need to be realistic and realize that industrial projects are not like other common assets that are easily leased to whoever is willing to pay more

the situation gets more complex if the project is supported by export credit agencies eca technically the islamic banks will have no rights to the assets in case of default because the eca would rank ahead of them in enforcing actions
so islamic banks role here would be limited to being financier as they will have no recourse to the assets

legal structure trust deed islamic trust charity company trust trustee nominal capital nominal capital contribution funded participation spv banks security assignment lessee the project co
contractor

financing structure mosharaka construction payment master construction agreement consecutive construction phase istisna istisna drawdowns drawdowns contractor spv istisna istisna pre completion guarantee ijara payments lease and sale lessee the guarantor agreements ijara project co
payment

to give comfort to the islamic bank it was granted a mortgage over the vessel upon delivery assignment of the insurance relating to the vessel an assignment of shipping contract during predelivery stage and an assignment of the refund guarantee in relation to shipbuilding contract
mosharaka in istisna with refinancing in ijara motenakesah mosharaka in the istisna is the most suitable method to go around the mark to market issue repricing as it works like an open ended fund which is evaluated on a daily basis to reflect market value based on work in progress

it is like someone building a house and selling it while partly constructed and not completely fished certainly no one would expect the owner to sell the house without giving any consideration to the work already executed otherwise he could be considered as safeeh fool under the sharia

furthermore the islamic investor will not be the legal owner of the vessel but still will be the lessor of its beneficial interest in the vessel
mosharaka investor as a mosharaka fund as a mosharaka partner partner the shipping co

mosharaka lease structure for expansion project this proposal was submitted for an expansion of a petrochemical plant on the basis of combining conventional and islamic finance definition a mosharaka the mosharaka in its broadly known definition is the islamic equivalent of joint venture agreement where partners contribute capital and share the profit and loss equally
the islamic investor has reservations on giving a mandatory promise to sell as then it could be regarded as a deferred sale agreement thus would not qualify as a lease structure which means we would not be able to refinance and also have a variable rate instrument ie no re pricing clause

whereas the ijara payment could be paid in full at completion and still meet the requirements of sharia boards it has been proposed to divide the ijara payment into i a advance ijara payment paid at completion and ii the balance of the ijara payment allocated evenly over the remaining scheduled mosharaka payments

the documentation has been structured in a way as to protect against the removal of the manager by providing a vote of of the holders of the mosharaka is required in order to remove the manager if they are grossly negligent in the performance of their duties
given the fact that the mosharaka is only for two years and that return is only accrued and not paid in cash and that the return is libor based the project company should receive a favorable accounting treatment

so for zakat the project company can prepare another set of accounts in fact many local corporates are turning to islamic finance because of this this does not mean that the project company will be violating the zakat s law as the islamic banks would be paying for it because they would be reporting it as an asset on their books and under sharia there is no double payment for zakat

the project company not providing any additional security to the islamic banks as the relationship between all lenders would be governed by an inter creditor agreement subject to english law which would supersede any implicit or explicit understanding under the sharia
the project company would be getting at least the same deal if not a better one for the following reasons a variable rate instrument with the flexibility to have all lenders pari passu in terms of yield and the security package

on behalf of the mosharaka fund manages and is a party to the epc contract
institutions as mosharek mosharaka master agreement mosharaka fund the project co

on behalf of the mosharaka fund owns and manages the assets which are in turn leased to the project co under the lease agreement
institutions as mosharek mosharaka master agreement mosharaka fund the project co

a conventional bank that wants to reduce its credit exposure to a client without the knowledge of the client usually in the conventional market sells such risk on silent basis through un funded participations so the party which is buying the risk will take the full credit risk against a fee without the need to fund the transaction
however un funded risk participations are not suitable for islamic banks because first they cannot provide guarantees as they cannot charge for them and second is that islamic banks are cash rich and are desperate for a way to park their huge liquid positions so the solution is as follows a c to create a special purpose vehicle spv through which a transaction will be channeled

a c the obligation of the spv to pay the deferred payment to the islamic bank is explicitly conditional upon the obligors performance under the loan or the security
a c the morabaha transaction is rolled over periodically to coincide with the rollover cycle interest rate cycle of the instrument being funded

the spv will source the commodity in the spot market and will sell it on deferred payment to the target company which in turn sells the commodity on spot basis and receives cash this can continue as an evergreen line of credit
any law firm would be more than willing to set up a trust for a fee and occasionally they use charitable trusts in order to make it immune from legal action who would want to go after a charitable organization

it is worth mentioning that the government of the united states when it decides to block or freeze any asset it will not just look at who owns the asset but also who controls it
the islamic investor relinquishes any legal title to the spv thus the islamic investor maintains no ownership interest in the spv

and lease them back to the target co simultaneously with sale of target co
the islamic banks will have no ownership interest in the spv financing structure

bank takes mortgage lien on and or security interests in assets and collateral assignment of target co s obligations under the lease
bank makes conventional loan to spv spv purchases assets of target co

for future delivery of commodities target co delivers commodities spv resells commodities to third party buyer at cost plus profit
bank makes conventional revolving loan to spv spv makes advance payment to target co

this concept has been appealing to the islamic market because on one hand islamic finance is supposed to be asset backed financing and on the other the islamic market lacks tradable securities equivalent to the debt securities in the conventional market
section nine securitization securitization is a concept that was developed by us banks to convert an illiquid and long term loan into a security in order to broaden the placement of the exposure to non bank organizations such as pension funds insurance companies and private investors

the modharaba sukuk could be issued through a trust special purpose vehicle spv on the basis of equal units and must be registered in the name of the participant of common interest in the capital of the spv
types of securities though islamic securities are equity based instruments technically speaking they can be classified in two main categories equity linked securities and libor linked securities the equity linked securities modharaba sukuk the word sukuk means deeds or title deeds

on the other hand the modhareb the underwriter would still have the flexibility to protect the client from any capital loss or to adjust the net amount payable based on the market value of the clients ownership in the spv which would effectively be the net asset value of the spv
the modhareb underwriter is also permitted to buy back the sukuk at the higher value of either the nominal price or the market price to protect the client from losing a portion of his capital provided that this was not a pre condition at the time of the issue and was not announced to the investors prior to their subscription

why not sell the contract back to the original seller who might be very happy to buy the contract back given the circumstance we had situations during the early days of islam when certain groups who did not wish to embrace the new religion and decided to leave madinah city but had debts against moslems they requested to be paid before they leave the city while those debts had not been due yet
on the other hand the buyer of a salam contract might find himself forced to liquidate sell his contract because he might be facing liquidity crunch the market might be moving against him prices might be falling or his expectation that the seller might not be able to deliver or perhaps he might have a much better opportunity to reinvest his money or it might be politically incorrect to continue investing his money in the same way

the bank can fund this withdrawal from new deposits being sourced from another party the replacement deposit or will source funds internally to replace this shortfall but certainly the bank will not break any of its contracts with other clients in order to pay this deposit ie in case of a salam contract to sell back the debt to original seller of the salam or in case of a morabaha contract to buyback the debt

the solution that has been recommended by some scholars for the istisna sukuk to qualify as tradable instrument is to have al sanea the manufacturer the seller of the istisna issue the sukuk on the basis of his real property and capital assets provided that the value of these assets are more than of the value of istisna contract
it is worth mentioning here that in calculating the zakat amount the religious tax the scholars have ruled that capital assets such as buildings machinery plant and equipment are to be excluded because these are not part of the trading portfolio and that zakat to be paid only on income generated from these assets and other tradable assets such as commodities

pre delivery islamic financing risk profile partially enhanced performance risk on the vendor and asset secured risk on the user management owner servicing agent a purchase sale contract contract vendor b single c final purpose user vehicle discounted xy purchase advance price fully transferable islamic certificates d or units of a close end performance bond on xy of islamic supply banks s a the purchase contract may provide for installment payments occurring to a pre set schedule setting milestone dates at different stages of completion of the supplied goods

a c the spv would continue to be financed by islamic investor s either through new islamic certificates each representing a percentage ownership in the pool of goods owned by spv or units of a close ended fund specifically set up to invest in spv

the moderate view is that because the income which was attributed to the borrowing was the result of such borrowing and the effort of the company therefore only of the attribution to be paid to charity
the most extreme view by certain islamic institutions is not to invest at all in companies where their charters permit them to borrow conventionally but these institutions will not have a problem in providing credit facilities to such companies

currency notes really represent the equity of the country which issues them thus the holder of a currency note effectively owns equity in the issuer which undertakes to substitute the holder of the notes with the equivalent in goods or services
we have experienced many financial crises in the gulf region in the last two decades such as the souk almanakh crises in kuwait all of which were related to speculation either in shares or real estate and were not related to currency trading yet no one has banned trading in shares or real estate

the creditor buys from the debtor a commodity on salam basis ie future delivery against the settlement of the debt if the debtor agrees then the deal is lawful
he knows for sure that he cannot pay in yen so he agrees with his bank to pay instead in local currency

we wonder if the debt is a bearer instrument such as a post dated check would it be acceptable to trade it with a third party logic says yes because a bearer check is as good as receiving value provided obviously the credit risk is acceptable

lncidentally in the arab world it is referred to the king or the amir or the sheikh or the leader or the president as the father of the nation
however citizens of a country are permitted to buy bonds issued by their local government in the same currency in which the bonds are issued whether they are zero coupon or interests bearing bonds

the prophet pbuh made certain exceptions when he declared that there is no riba between the father and his son the master and his slave the man and his wife and in charging riba to a non moslem but not paying to him
as we explained earlier if we to scrutinize all financial instruments including the equities we will find them all being nothing but debts because at the end of the day none of these instruments would give recourse to the real property

the contract to stipulate that any rise in the price of the commodity above that minimum price or the majority of the upside will be for the account of the supplier the seller of the salam
our problems are much bigger than interest rates the entire islamic economies are interlinked with the western economies and all our savings and wealth are sensitive to interest rates and some other things which are more important we have to also recognize that the average islamic investor has very little appetite for risk

this in itself should be enough justification for the sharia scholars not just to approve the structure but also to promote the concept throughout the islamic countries
islamic banks have been using what is called an exchange of deposit agreement ie exchanging interest free loans but this generally requires simultaneous exchange of deposit and it is not really an effective solution for very short term borrowings such as overnight money

the company will keep separate accounts for each bank participant and will give credit points for each deposit it receives and charge points for the loans it makes to each member at the end of each quarter it will settle the surpluses or deficits with each member through either borrowing interest free loans or placing with the company interest free deposits
this company in time can act as market maker in short term inter bank instruments and other sukuk or treasury stocks that are listed on the stock market and as an independent entity it can facilitate business dealings of islamic banks in general by serving as a legitimate counter party in holding title or acting as trustee

on the other hand allah has ordered us not to leave things to peoples conscious as he clearly demanded that we must document debts and must have two witnesses so that the debtor does not even think not to honor his obligation and it is the duty of the debtor to document the debts which in this case is the islamic bank
there is no mechanism currently in place which ensures that there will be no switching of profits and losses between these two beneficiaries profits could be overstated in order to attract more investors or losses could be understated so that investors are not scared away obviously employees loyalty is to their employers shareholders

this motive can be clearly tested by making a comparison between the return the shareholders are allocating for themselves and the return the poor depositors are getting on the modharaba deposits which are co mingled with the shareholders funds

Please note, This is an auto generated summary based on sentances position in the document and other factors

DOCUMENT WORD ANALYSIS

Main Category

AlHuda Material\islamic banking

KeyWords

contract price sale asset financing lease client purchase ijarah payment profit musharakah lessee amount commodity housing agreement contracts ownership project

DOCUMENT REFERENCES

Number of Pages

80

Published Date

2004-08-03 20:53:13

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Islamic Finance by Mahmood Al- sheahabi

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Top 20 FREQUENT WORDS

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