Islamic Banking and Finance

• Islamic banking has grown rapidly over the past decadeand currently continues to grow, while many conventional banks and financial institutions write off $billions ofbad debt. In 30 years Islamic banking has developed fromlocal provision to providers of established international financial products. This book explains the principles of Islamic banking and finance. It then provides a guide to Islamic finance products such as istisna'a, murabaha,musharaka, mudaraba, ijara, sukuk and salam, so that the reader can understand the key concepts and main vocabulary of Islamic finance. It goes on to discuss theapplication of Islamic products to a variety of financialcontexts (e.g. asset management, treasury, riskmanagement, raising finance, tax). It also providesguidance on the regulatory frameworks for Islamicfinance.

Table of Contents. v

Figures. x

Tables. xi

Foreword. xiii

1            Introduction. 1

2            Historic Developments. 3

2.1                 The History of Finance. 3

2.2                 The History of Islamic Finance. 8

3            Economic Principles. 11

3.1                 Early Economic Thought. 11

3.2                 Modern Economics and Banking. 14

3.3                 Contracts and Prohibitions. 15

3.3.1         Law of contract. 16

3.3.2         Contract validity. 18

3.3.3         Principles of Contract Applied to Financial Instruments. 19

3.4                 Sharia’a and Prohibitions. 19

3.4.1         Usury. 20

3.4.2         Uncertainty and Gambling. 22

3.4.3         Impact of Prohibitions on Islamic Finance. 23

4            Islamic Finance Products Explained. 25

4.1                 Definitions. 25

4.2                 The Asset. 27

4.3                 Transaction Types. 28

4.3.1         Partnership Contracts. 29

4.3.1.1      Joint Venture. 29

4.3.1.2      Passive Partnership. 30

4.3.2         Instruments with Predictable Returns. 32

4.3.2.1      Deferred Payment Sale. 32

4.3.2.2      Leasing. 33

4.3.2.3      Short Term Production Finance. 35

4.3.2.4      Long Term Production Finance. 36

4.3.3         Other Instruments. 37

4.3.3.1      Contract of Exchange. 37

4.3.3.2      Letters of Credit. 38

4.3.3.3      Guarantee. 39

4.3.3.4      Unilateral Promise. 40

4.3.3.5      Down Payment. 40

4.3.3.6      Agency Agreement. 41

4.4                 Bond-Like Instruments. 41

4.4.1         Bonds. 41

4.4.2         Sukuk. 42

4.4.2.1      Generic Structure. 43

4.4.2.2      New AAOIFI Sukuk rules. 45

4.4.2.3      Sukuk Based on Partnership Transactions. 46

4.4.2.4      Sukuk Based on Predictable Return Transactions. 47

5            Distribution of Islamic Products. 53

5.1                 Distribution Channels and Sharia’a Compliance. 53

5.2                 Sharia’a Compliant versus Sharia’a Based. 54

5.3                 Competition or Opportunity. 55

6            Application of Islamic Products in Retail Finance. 57

6.1                 Current Accounts. 57

6.1.1         Qard Al Hassan. 57

6.1.2         Amanah or Wadia. 58

6.2                 Credit card. 58

6.3                 Deposit Accounts. 60

6.3.1         Restricted and Unrestricted Investment Accounts. 61

6.3.2         Capital Certainty and Capital Adequacy. 62

6.3.3         Accounting Treatment. 62

6.3.4         Reserves. 63

6.4                 Funds. 64

6.5                 Mortgage Products. 65

6.6                 Personal Loans. 67

6.6.1         Secured Personal Loans. 67

6.6.2         Unsecured Personal Loans. 69

6.7                 Transfers. 70

7            Application of Islamic Products in Treasury. 73

7.1                 Interbank Liquidity. 73

7.1.1         Deposit Given. 74

7.1.2         Deposit Taken. 76

7.1.3         Variation on Commodity Murabaha. 77

7.1.4         Agency Contract. 79

7.2                 Hedging. 80

7.2.1         Derivatives. 80

7.2.2         Option to Buy or Sell 81

7.2.3         Foreign Exchange Requirements. 81

7.2.3.1      Currency Swaps. 82

7.2.4         Profit Rate Swap. 83

7.2.5         Selling an Asset Forward. 84

7.3                 Combination of Transaction Types. 84

7.4                 Asset-Based Securities. 85

7.5                 Syndication. 85

8            Application of Islamic Products in Corporate Finance. 89

8.1                 Trade Finance. 89

8.2                 Project Finance. 91

8.2.1         What is Project Finance?. 92

8.2.2         Appropriate Islamic products. 95

8.2.3         The Project Finance Market. 97

8.3                 Property Finance. 98

8.3.1         Property Finance – A Practitioners View.. 98

8.3.2         Suitable Transaction Types. 101

8.4                 Leasing. 107

8.4.1         Determination of Rental Payments. 108

9            The Application of Islamic Products to Private Equity. 109

10          The Role of the London Metal Exchange. 111

10.1.1      The London Metal Exchange. 111

10.1.2      Warrants. 111

10.2               LME Base Metals. 113

11          Asset Management. 115

11.1               Selection of Sharia’a compliant investments. 115

11.1.1      Industry Screen. 116

11.1.2      Financial Screen. 116

11.1.3      Application of the Industry and Financial Screen. 117

11.1.4      Non-Compliance. 118

11.2               Types of Funds. 118

11.3               Asset Management – A Practitioners View.. 119

11.3.1      Core and Satellite Asset Allocations. 120

11.3.2      Secret 1: Index Trackers Consistently Outperform Active Funds. 122

11.3.3      Secret 2: Sharia’a Compliant Indices Outperform Conventional Indices  126

11.3.4      Secret 3: Sharia’a Indices are Liquid. 127

11.3.5      Secret 4 - How Islamic Money Market Assets Can Avoid Interest. 129

11.3.6      Our Recommendations. 130

12          Risks in Islamic Banks. 131

13          Sharia’a Supervisory Board. 135

13.1               Roles. 135

13.1.1      The Advisory Role. 136

13.1.2      The Approval Role. 136

13.1.3      The Audit Role. 137

13.2               Social Responsibilities. 137

13.3               Corporate Governance. 138

13.4               Structures and variations of Sharia’a Supervisory Boards. 140

13.5               Challenges facing Sharia’a Supervisory Boards. 141

14          The Islamic Financial Infrastructure. 143

14.1               Regulatory Institutions. 143

14.1.1      Financial Regulators. 143

14.1.2      The Fiqh Academy. 144

14.1.3      Islamic Development Bank. 144

14.1.4      Islamic Financial Services Board. 144

14.1.5      Accounting and Auditing Organisation for Islamic Financial Institutions  144

14.1.6      International Islamic Financial Markets. 145

14.2               Socially Responsible Investments and Micro Finance. 145

14.2.1      Socially Responsible Investments. 145

14.2.2      Micro Finance. 146

14.3               The Case for LIBOR. 147

15          Tax in the United Kingdom.. 149

15.1               Tax Issues for Islamic Banking in the United Kingdom.. 150

15.1.1      VAT and Islamic finance. 151

15.1.1.1         Partnership contracts. 151

15.1.1.2         Home Purchase Plans. 151

15.1.1.3         Cost plus financing. 152

15.1.2      VAT compliance. 154

15.1.2.1         Commodities. 154

15.1.2.2         Interest. 154

15.1.3      The VAT issue going forward. 154

15.2               Stamp Duty Land Tax. 155

15.3               Background to the UK Government Policies. 155

15.3.1      Changes to Taxation and Regulatory Policy since 2003. 156

15.3.1.1         Changes in 2003. 156

15.3.1.2         Changes in 2005. 156

15.3.1.3         Changes in 2006. 156

15.3.1.4         Changes in 2007. 157

15.3.2      Announcements in 2008. 157

15.3.2.1         Commercial Sukuk: current SDLT treatment. 158

15.3.2.2         Proposed Legislative Framework. 160

15.3.2.3         Tax treatment of alternative finance investment bonds. 162

16          Capital Adequacy under Basel II 163

16.1               Introduction. 163

16.2               Capital Adequacy and Minimum Capital Requirements. 163

16.3               Challenges in Islamic Finance. 169

16.3.1      Balance Sheet Size and Loss Data History. 170

16.3.2      Equity Treatment. 170

16.4               IFSB Capital Adequacy Standards. 171

16.4.1      The Definition of Capital 171

16.4.2      Credit Risk Mitigation. 172

16.4.3      Market Risk. 173

16.4.4      Operational Risk. 174

16.4.5      Capital Adequacy for Different Transaction Types. 174

16.4.6      Capital Adequacy for Sukuk. 176

16.4.6.1         Sukuk held as investment in the banking book. 176

16.4.6.2         Sukuk in the trading book. 178

16.4.6.3         Sukuk origination. 178

16.5               Capital Adequacy for Islamic Banks around the World. 179

16.6               Expected Future Developments in Capital Adequacy. 179

17          How to Value a Bank. 181

17.1               The Components. 182

17.1.1      Growth. 182

17.1.2      Risk. 182

17.1.3      Returns. 183

17.1.4      Capital and its Cost. 183

17.2               The Models. 183

17.3               The Special Case of Banks. 184

17.4               The Special Case of Islamic Banks. 185

17.5               Can a Bank be Valued?. 185

18          The Future. 187

Appendix A – Definitions. 191

Selected Bibliography. 195

Index     197