Islamic Banking and Finance - Credit and Finance Risk Analysis

Credit and Finance Risk Analysis - www.credfinrisk.com

Islamic Banking & Finance

Dow Jones Islamic Market (DJIM) Indexes

Dow Jones Citigroup Sukuk Index

Islamic Banking and Finance means that the financial transaction is compliant with Islamic law (spelled Sharia; Shari'a; Sharia’a; Shariah). Islamic Law principles are derived from the interpretation of scripture in the Koran (Quran; Qur'an) by making analytical comparisons (Qiyas) to which the scholars apply logic and reasoning (Ijtehad) in order to develop a consensus (Ijmaa) on the issue and the actual development of Islamic jurisprudence or Islamic law (Figh; Fiqh al Mu'amalat is Islamic commercial jurisprudence). Thus, Shariah is more than just enforceable legal rules. Rather, it is a set of divine principles that are an integral part of, and cannot be differentiated from, the Islamic faith.

The most well known principle related to banking and finance is that Islamic Law bans interest paying commercial financial transactions (and the receipt of interest thereof), which is equated with usury (Riba; Al-Riba; interest may not be charged and one may not purchase assets that that pay interest). Rather, instead of becoming a creditor, banking and finance activities are structured around the concept of sharing (Shirkah) investment risk and profits within an investment group.

The concept of Al Ghunm bil Ghurm indicates that a profit may only be earned by sharing in the risk of the activity or transaction.

In addition, the investment of funds must be used in the purchase or financing of permitted (Halal) assets, they may not be used in transactions that exclusively produce or promote alcohol, tobacco products, gambling, indecent publications (print and photo) or activites that are not permitted (Haram) under Shari'a.

Another important concept is that of "what is not owned cannot be sold" thus there must always be an agent (the financial institution) that owns the goods or assets that are being sold or rented (thus, islamic investment funds may not engage in short selling stocks).

Every financial institution that operates in this sector usually has a Shari'a Supervisory Board that reviews every transaction to determine that it is compliant with generally accepted principles. For instance, the standards articulated by the Shariah Committee / Board of Accounting and Auditing Organization of Islamic Financial Institution's (AAOIFI) are mandatory in Bahrain, the DIFC, Jordan, Qatar, Sudan and Syria, and regulators in countries including Malaysia, Saudi Arabia, Australia and South Africa also follow the guidelines set by the AAOIFI. Bonds included in the Dow Jones Islamic Market Indexes must also comply with AAOIFI standards for tradable sukuk.

Please note: Shari'a compliance is the essence of Islamic banking and finance, however the secular, civil / commercial / contract law of the respective nation where the principals are domiciled and / or where the transaction is consumated still provides the regulatory framework under which the various parties are protected, schedules / performance is completed and obligations are fulfilled as specified under the terms of transaction.

In addition, Islamic financing transactions are open to persons and companies of all faiths.

Deposit and Demand Accounts

Shari'a complaint banks may offer deposit and demand accounts. However, they do not pay interest. Rather, profits earned by the financial institution are pooled and distributed according to the pre-determined ratio between the institution and the depositors on a monthly basis (the bank functions as a Mudarib, or fund manager, in a Mudaraba partnership in which depositors are actually investors in the bank; see below). Thus, the depositors actually share in the risk of owning and operating the bank and the bank and its depositors are esentially partners (Shirkah) as depositors funds are utilized by the bank management to make prudent, direct investments.

A Wadiah (safekeeping) is similar to a conventional savings account. The principal amount of the deposit is usually guaranteed in full (the financial institution functions as custodian) and the depositor may be granted a hibah (gift) in exchange for the usage of the funds by the financial institution.

Qard-el-hassan

Qard-el-hassan (sometimes spelled Qardhul Hassan) is a loan but only the principal amount of the initially disbursed loan is repaid, no interest or no additional amount in excess of the loan principal balance is returned at maturity. It is considered, or often referred toas, a benevolent relationship between two parties for social welfare / goodwill or for very short-term bridge finance purposes only. The recipient may pay back an amount in excess of the original amount (without ever having promised it up front or contractually) as a sign of appreciation for the extension of goodwill by the first party.

Musharaka

Musharaka (also spelled Musharakah) is similar to a syndicated loan among participants but instead of charging interest the profits from the activities being funded are shared among the participants. A Shirkat-ul-milk is the elective purchase and joint ownership of a specific property or equipment (which can usually be transferred to heirs upon death). A Shirkat-ul-‘aqd is a more commercial, contractual joint ownership structure utilized for investment by several parties (within this category, the Shirkat-ul-amwal indicates that all of the participants have invested capital into the transaction; A Shirkat-ul-A‘mal would indicate that the participants will jointly provide a service to a third party and then share the income earned (wages or Jua'alah) from providing the service; In both cases the proportion of profit sharing must be pre-determined and clearly be equitable to be a valid contract).

In the United States, residential property purchases are also structured under the concept of Musharaka (known as a diminishing Musharaka): the financial institution and the customer form a partnership (Shirkah) to own the property together. The bank then rents its interest in the property to the customer under one agreement. The customer also purchases the bank's interest in the property under a separate agreement. On completion of the purchase the bank's ownership interest is then transferred to the customer.

Murabaha

The Murabaha (also spelled Murabahah) is cost plus profit sales contract between the financial institution and the customer. The financial institution purchases business goods, equipment, property or an asset at the prevailing market price and takes ownership. The institution then sells the asset(s) to the customer at cost plus a profit (the cost is disclosed to the purchaser), and payments are then made in installments over a period of time agreed upon by both parties (payment may also be settled in a lump sum). The purchased goods must be clearly identified and can only be permitted (Halal) goods, they may not be goods that are not permitted (Haram) under Shari'a. Secondly, once the sales price between the financial institution and the customer is agreed to it may not be revised by either party as ambiguity (Al Maissar) regarding the price of materials is forbidden. However, the financial institution will usually authorize the customer to function as its agent (Agency Agreement) to negotiate the sale price and terms of delivery on its behalf as the bank may not have expertise in a particular industry or product nor have a relationship with supplier. In a Tawarruq, the customer purchases the product(s) from the institution however it is on a deferred payment basis. The customer then resells the it to another party for cash and pays of the deferred payment contract amount.

Mudaraba

The Mudaraba is a capital and services partnership between parties in which the financial institution and/or investor(s) (Rabb al Maal) provide the capital (Shaheb-Al-Maal) and another party (or parties), referred to as the Mudarib (also spelled Mudareb), provides the investment opportunity knowledge and expertise (similar to a fund manager), and then there is a pre-determined agreement on how the profits from the investment will be divided. The capital for investment can also be from a pool of investors. The same relationship is also evident between a financial institution and its depositors: the depositors provide funds (Rabb-ulmaa), the bank functions as the Mudarib and invests the funds under the Mudaraba concept and then shares the profits of the invested funds (deposits) on a monthly, pre-determined basis in lieu of interest payments. Conversely, if the investment fund or financial institution incurs a loss then all investors / depositors incur a loss on a pro-rata basis.

Bay' al-'arbun

A Bay' al-'arbun is an option sale transaction, which also requires that the potential purchaser put up a security deposit in advance as part payment towards the price of a product or commodity (which will be forfeited if the purchase is not consumated).

Istisna'

A Istisna' (also spelled Istisnah and istisna'a) is a contract for the manufacture of a specific product, asset or construction of real estate in which the price is paid in installments in accordance with the progress of the job (similar to project finance).

Salam (Bai Salam)

A Salam is a deferred delivery sale contract (utilized in commodity finance or manufactured goods) where specifications are determined at the time of the contract for a cash price paid in advance by the Islamic bank, as the buyer.

Ijara

Ijara (also spelled Ijarah, Ijara wa Iqtina, Ijara wa Iktana, ijara wa l-'iqtina, Ijarah wal Iqtina) is similar to a lease at a fixed rental rate. Ijara is only for assets such as a residential property, automobile or equipment. The financial institution essentially purchases the asset (and retains title of ownership) and then rents it to the customer “as is”. The rent is calculated so the financial institution earns the recovery of the cost of the asset (on an amortized basis) and a profit for offering the service. The calculation of rent with reference to LIBOR is sometimes, reluctantly, utilized. An ijara wal 'iqtina is similar to a lease purchase agreement in which the customer agrees to purchase the asset at a nominal value (or return the asset) at the end of the agreed period (similar to a finance lease; sometimes also referred to as Ijarah Muntahia bil-Tamleek, or sometimes spelled Ijarah Muntahiyah Bittamlik).

OCC Interpretive Letter #806, October 17, 1997 www.occ.treas.gov/interp/dec97/int806.pdf (.pdf format)
Outlines the 1997 approval of a residential net lease-to-own home finance product (ijara wa iqtina) proposed by the New York branch of United Bank of Kuwait.

The Ijara structure is starting to be utilized for both residential and commercial property purchases in the United States and Canada, and the structure has been approved by various Shariah scholar groups for nationwide use.

This is essentially a rent to own transaction (usually for both freehold or leasehold transactions; and refinance from an existing standard interest mortgage or from an existing Islamic product).

The purchase price with the seller is derived by the normal negotiation interaction. The price to purchase utilized by the financial institution is the negotiated sale price less the purchaser's down payment, plus $1.00 (at the end of the lease).

It is also entirely appropriate that the property be appraised by a third party appraiser using standard valuation principles.

The property can be leased for 10, 15, 20 or 30 years, depending on the structure agreed to by all of the parties involved.

The ability of the applicant lessee to make the monthly rent payment is determined by generally accepted credit analysis / underwriting guidelines and any additional guidelines or requirements that the financial institution may have.

The financial institution sets up a subsidiary, single-asset trust (the institute is the beneficiary) or limited liability corporation (LLC; the institution is the sole owner) to purchase and own the property. However, this increases administrative and legal expenses for the institution and increases tax reporting requirements (for each and every trust or LLC). This structure is similar to the bankruptcy-remote special purpose vehicles (SPV) created under U.S. law that have been used in conventional securitization transactions so the fact that the SPV is utilized in an ijara-based commercial real estate financing to comply with a religious law is irrelevant in the eyes of the secular law.

The lessee contractually agree to pay monthly rent to the trust or LLC (standard amortization calculations are utilized to determine the monthly rental payment based on the term of the lease and what the financial institution charges for similar mortgage loans).

Either the lessee or the trust / LLC is responsible for the payment of real estate property taxes and insurance premiums depending on what is negotiated contractually.

As the owner of record, the trust / LLC must have some type of indemnification from the lessee who is required to essentially maintain the property.

If the property is sold then the profit is passed through to the lessee (less any outstanding expenses) and the trust / LLC is terminated (again, the financial institution has this responsibility).

In the event of a material default under the lease, the financial institution’s remedies against the lessee for nonpayment is similar to those available to a lender on a traditional nonrecourse mortgage (the bank sells the property at auction to recover the balance owed under the terms of the lease).

The financial institution does not, and will not, actually hold real estate. It will not operate the property, pay taxes, insurance, and other charges, maintain upkeep of the premises, make repairs when necessary, assume liability for injuries or other accidents on the property, or otherwise exercise dominion and control over the property. The Lessee, and not the financial institution, will bear these responsibilities. Although the financial institution will have legal title to the property, it will not take actual possession of the property at any point during the lease term. The financial institution will only take possession of the property if the Lessee defaults or upon termination of the lease. If the financial institution does take possession of the property, it will take the property as OREO within the meaning of 12 U.S.C. § 29. Thus, despite the cosmetic appearance of the financial institution holding real estate, the substance of the transaction shows that the financial institution and the Lessee will have an arms-length, mortgagor-mortgagee relationship.

The Ijara structure is also being adapted for a credit card-type purchase.

The purchaser must select a product that they agree to lease to own from the list of merchants and durable goods that are pre-approved by the financial institution.

The card is then swiped by the sales person.

The financial institution retaines ownership of the product.

The purchaser is then authorized to receive the product on the behalf of the financial institution (essentially as its agent).

The rental payments are made in installments based on a pre-approved schedule (for instance, monthly for 24 months.

Ownership of the product is transferred to the purchaser at the end of the lease agreement (all installment payments have been completed). In the event that the lease terms are not completed the financial institution is responsible for the residual value sale of the product.

The Ijara structure can also be utilized for project finance.

Sukuk

On November 19, 2009, General Electric Capital Corp., GECC, the finance subsidiary of General Electric Co., issued its first sukuk, and the first Sukuk for a major U.S. company, a 5-year $500 million bond, which was priced with a 3-yr fixed coupon 3.870% (spread of 175 basis points over U.S. Treasurys). Goldman Sachs, Citibank, Kuwait's Liquidity House, and the National Bank of Abu Dhabi were the underwriters of the issue.

Sukuk is a Sharia-compliant, capital markets product alternative to conventional debt (bond). Sukuk issues are listed on the Dubai International Financial Exchange (DIFX) and there are also an index maintained by Dow Jones (investment-grade, U.S. dollar-denominated, Shari'ah-compliant fixed-income securities). While the sukuk issues are more expensive than conventional bonds it is Sharia-compliant because returns are derived from underlying physical assets. The Sukuk represents a proportionate beneficial ownership (evidenced by a certificate) in the underlying physical asset(s), which will be leased to a customer in order to produce a rental return on the Sukuk. Thus, a Sukuk is not the debt instrument of an issuer.

A Sukuk can be based on an Ijara structure. For instance, the Dar Al Arkan Sukuk, which was issued by Dar Al-Arkan Real Estate Development Company (Dar Al-Arkan; residential real estate developer in Saudi Arabia) and closed in July 2007, is a $1.0 billion Sukuk traded on the Bahrain Stock Exchange (BSE), the Dubai International Financial Exchange (DIFX) and Malaysia’s Labuan International Financial Exchange (LFX). The funds are invested in the construction of residential properties within Saudi Arabia.

There is a repo market for Sukuk issues. International Sukuk are cleared through Euroclear / Clearstream.

There was some controversy early in 2008 when Sheikh Muhammad Taqi Usmani, a well respected scholar from Pakistan and the Chairman of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), publicly indicated that he believed certain aspects of Sukuk issues were not Shari'a compliant. The key to the analysis was that it in certain Sukuk issues it is considered more appropriate if investors were actually the legal owners of the underlying assets rather than nominal holders because of the existence of an existing guarantee clause in some Sukuk to repurchase the issue even if it is not profitable (Shari'a guidelines indicate that participants must share in profit or losss from the transaction).

In June 2009, a Chapter 11 bankruptcy court filing in the United States challenged the legal structure of the Sukuk issue. In 2006, East Cameron Partners LP was the first U.S. domiciled company (Houston, Texas) to issue a Sukuk transaction ($166 million), which at the time was structured to transfer the ownership of production revenues (royalties) from various gas field properties the company owned into a Special Purpose Vehicle (SPV, a bankruptcy remote entity). In U.S. bankruptcy court the company argued that the structure was actually a loan secured by the revenue stream. the initial ruling by the judge in the case upheld the Sukuk structure that the transfer had been a true sale / transfer of assets. Thus, Sukuk "bond holders" are separate from creditors of the company.

Takaful

Takaful (mutual guarantee / guaranteeing each other) is a cooperative insurance agreement in which a group of individuals share the risk of potential loss to any one of them. If one member of the cooperative suffers a loss then the other members contribute a proportional amount of their investment (and a proportional amount of any profits) to that member. It is essentially the same as Tabarru, which is the concept of extending a donation or contribution with the intention assisting other participants in a time of need. The structure is not only for commercial purposes, that is also a personal accident Takaful plan. However, there must always be the mutual support / commitment component of the structure as uncertainty (gharar) related to an unknown pay out in the future is consider forbiden (Haram).

Al-Wakalah

An Al-Wakalah (sometimes spelled Wakala) is a person or financial institution that functions as an agent to either manage and invest capital or act as an intermediary in a transaction (usually for a fee). An 'adl is similar such that they function as a trustee in a variety of transactions.

Johara

Islamic Law indicates that persons of the opposite sex who are not related should minimize contact as much as possible. Thus, Johara provides separate banking and financial services for women in a special Johara bank branch.

Regulatory

As indicated above, financial institutions that operate in the Islamic banking and finance sector usually cooperate with a Shari'a Supervisory Board that reviews transaction structures to determine that it is compliant with generally accepted Shari'a principles. however the secular, civil / commercial / contract law of the respective nation where the principals are domiciled and / or where the transaction is consumated still provides the regulatory framework under which the various parties are protected, schedules / performance is completed and obligations are fulfilled as specified under the terms of transaction.

For instance, the standards articulated by the Shariah Committee / Board of Accounting and Auditing Organization of Islamic Financial Institution's (AAOIFI) are mandatory in Bahrain, the DIFC, Jordan, Qatar, Sudan and Syria.

The Shariah Advisory Council set up at Bank Negara Malaysia is the Shari'a authority that provides advice on the Shari'a matters pertaining to Islamic banking and takaful in Malaysia.

On the operational side, the Islamic Financial Services Board (IFSB) issues capital adequacy standards for institutions offering only Islamic (non-insurance) financial services.

Information Resources

Dow Jones Islamic Market Indexes www.djindexes.com/islamic/index.cfm?go=overview

International Association for Islamic Economics (IAIE) www.iaie.net/

Islamic Financial Services Board (IFSB) www.ifsb.org/

Islamic Banks

Please, if you know of a bank that we did not include or if you find that a link is no longer operating then E-mail us at: info@credfinrisk.com

AB Bank (Bangladesh) www.abbank.com.bd/islami-banking.html

Abu Dhabi Islamic Bank www.adib.ae/

Affin Bank Berhard (Malaysia) www.affinbank.com.my/

Ahli United Bank (UK) PLC (United Kingdom) www.iibu.com/

Ajman Bank (UAE) www.ajmanbank.ae/

Al Baraka Bank Lebanon www.al-baraka.com/

Al Islami Financial Services (IFS) (United Arab Emirates) www.ifs.ae/

Al Rajhi Bank (Malaysia) www.alrajhibank.com.my/

Albaraka Bank (South Africa) www.albaraka.co.za/

AlBaraka Banking Group (Bahrain) www.abg.bh/

AlBaraka Islamic Bank (Pakistan) www.albaraka.com.pk/

Albaraka Türk (Turkey) www.albarakaturk.com.tr/

Arab Gambian Islamic Bank (Gambia) www.agib.gm/

Arab Islamic Bank (Palestinian) www.arabislamicbank.com/

Asian Finance Bank (Malaysia) www.asianfinancebank.com/

Badr-Al Islami Banking (United Arab Emirates) www.badralislami.com/

Bank Islam (Malaysia) www.bankislam.com.my/

Bank Muamalat (Indonesia) www.muamalatbank.com/

Bank Muamalat (Malaysia) www.muamalat.com.my/

Bank of Whittier (United States) www.bankofwhittier.com/

BankIslami Pakistan Limited (Pakistan) www.bankislami.com.pk/

Banque Albaraka d'Algérie www.albaraka-bank.com/

CIMB Islamic Bank Berhad (Malaysia) www.cimbislamic.com/

Citi Islamic Investment Bank (Bahrain) www.citiislamic.com/ciib/homepage/

Dawood Islamic Bank Limited (Pakistan) www.dawoodislamic.com/

Dubai Islamic Bank (United Arab Emirates) www.dib.ae/

Emirates Islamic Bank (United Arab Emirates) www.emiratesislamicbank.ae/

EONCAP Islamic Bank Berhad (Malaysia) www.eoncap-islamicbank.com.my/

Export Import Bank of Bangladesh Ltd. www.eximbankbd.com/

Faisal Islamic Bank (Sudan) www.fibsudan.com/

Faisal Islamic Bank of Egypt www.faisalbank.com.eg/FIB/

Faisal Private Bank (Switzerland) SA www.faisalfinance.com/

First Gulf Bank (United Arab Emirates) www.fgb.ae/

First Leasing Bank (Bahrain) www.1stleasingbank.com/

First Security Islami Bank Limited (Bangladesh) www.fsblbd.com/

Gatehouse Bank (United Kingdom) www.gatehousebank.com/

Gulf International Bank BSC (Bahrain) www.gibonline.com/

Hong Leong Islamic Bank (Malaysia) www.hlib.com.my/

HSBC Amanah (Malaysia) www.hsbc.com.my/1/2/amanah/hsbc-amanah

ICB Islamic Bank Ltd. (Bangladesh) www.oriental-bank.com/

Islami Bank Bangladesh Ltd. (Bangladesh) www.islamibankbd.com/

Islamic Bank of Asia (Singapore) www.islamicbankasia.com/

Islamic Bank of Britiain www.islamic-bank.com/

Jordan Islamic Bank www.jordanislamicbank.com/

Khaleeji Commercial Bank (Bahrain) www.khcbonline.com/

Kuwait Finance House (Bahrain) B.S.C. www.kfh.bh/

Kuwait Finance House (Malaysia) Berhard www.kfh.com.my/

LARIBA American Finance House (United States) www.lariba.com/

Maybank Islamic Berhard (Malaysia) www.maybank2u.com.my/maybankislamic/index.shtml

Meezan Bank (Pakistan) www.meezanbank.com/

Noor Islamic Bank (United Arab Emirates) www.noorbank.com/

Perbadanan Tabung Amanah Islam Brunei (TAIB) www.taib.com.bn/

Prime Bank Limited (Bangladesh) www.prime-bank.com/islami_banking.htm

Qatar International Islamic Bank (Qatar) www.qiib.com.qa/

Qatar Islamic Bank (Qatar) www.qib.com.qa/

RHB Islamic Bank Berhard (Malaysia) www.rhbislamicbank.com.my/

Saba Islamic Bank (Yemen) www.sababank.com/

Saudi British Bank (Saudi Arabia) www.sabb.com/

Seyad Shariat Finance Limited (India) www.shariatfinance.net/

Shahjalal Islami Bank Ltd. (Bangladesh) www.shahjalalbank.com.bd/

Shamil Bank (Bahrain) www.shamilbank.net/

Sharjah Islamic Bank (United Arab Emirates) www.sib.ae/

Social Investment Bank Ltd. (Bangladesh) www.siblbd.com/

Tamweel Home Finance (United Arab Emirates) www.tamweel.ae/

UBS Islamic Finance www.ibb.ubs.com/mc/islamicfinance/

University Islamic Financial Corporation (United States) www.universityislamicfinancial.com/

Takaful

Islamic Arab Insurance Company (United Arab Emirates) www.salama.ae/

Takaful Malaysia www.takaful-malaysia.com/

Wethaq Takaful Insurance Company (Kuwait) www.wethaq.com/

Return to Main Page

Credit & Finance Risk Analysis