Fundamental of Islamic Finance (Slides)

Asian Regional Public Debt Management Forum, 5th November 2009

Assoc. Prof. Dr. Asyraf Wajdi Dusuki Head, Research Affairs International Shari’ah Research Academy for Islamic Finance (ISRA)

Outline • •

• Islamic Finance Master Class

•

•

Defining Shariah Compliant Shariah Parameter in Structuring Islamic Financial Products Underlying Principles of Islamic Finance Fundamental Characteristics of Shariah Compliant Finance Illustrations of various 2 Islamic Finance and Takaful Instruments

Dharurah!

Maslahah

Viability? Maqasid

Legal Structure

We need to finance our car, house, business…

How to structure financial products that comply with Shariah…?

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What is Shariah? • Literally means ‘path to watering place’ • Technical meaning – Path to tread for guidance in this world – Commands, prohibitions, values prescribed by Allah for His slaves either through Al-Quran or As-Sunnah (the teachings of the Prophet Muhammad s.a.w.) • Normally, the Sharī’ah is described as ‘Islamic Law’. But the boundaries of Sharī’ah extend beyond the limited horizons of law (Sardar 2003). • Sharī’ah is a set of norms, values and laws that go to make up the Islamic way of life (Ahmad 2003). According to one observer, the Sharī’ah is the “epitome of Islamic thought, the most typical manifestation of the Islamic way of life, the core and kernel of Islam itself” (See in Schact (1964)).

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ISLAM & Components of Shariah I`tiqadiyah (Belief)

`Amaliyah (Dealings)

Ibadah (Human with Creator)

Economics

Family Law

Akhlaqiah (Morality)

Muamalah (Human with human)

Criminal Law

Politics

Issues in Islamic banking and finance

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Approach in Deriving Hukm Syar’i (Islamic Legal Ruling) Ibadah • Fixed • Determined by God • Original Ruling is prohibited unless there is a valid justification that explains its permissibility • Otherwise, it is considered bidaah (innovation)

Muamalah • Combination of fixed and flexibility • Based on premise:

‫اﻷﺻﻞ ﻓﻲ اﻷﺷﻴﺎء اﻻﺑﺎﺣﺔ‬ “The original ruling is permissible” • Unless there is a clear and valid justification that suggest otherwise • Understanding the ‘illat (rationale) and maslahah 7

What is Maqasid As-Syariah? • It outlines the objectives and wisdom (hikmah) as prescribed by Shariah (Allah & His Prophet s.a.w.) in all its rulings to protect and preserve the benefits and interests (maslahah) of society. • What is Maslahah? – is the benefits or interests which are deemed necessary from Syariah perspectives to protect and preserve the five darurah. (AlMansul, Fakhruddin Ar-Razi, p.24) 8

‫وﻣﺎ ارﺳﻠﻨﺎك إﻻ رﺣﻤﺔ ﻟﻠﻌﺎﻟﻤﻴﻦ‬

“And We have sent you (O Muhammad) not but a mercy to the whole universe”

Alleviate Hardship

(Al-Ambiya:107)

Eliminate Prejudice

Justice

Maqasid as-Shariah (The Objectives of Shariah)

Religion

Wealth

Intelect Life

Posterity

Preservation and Promotion

Preservation of Wealth ‫ﺣﻔﻆ اﻟﻤﺎل‬ Alleviate Hardship

Eliminate Prejudice Justice

Maqasid as-Shariah in Islamic Finance Macro Maqasid

Micro Maqasid

Assessment on the overall impact and contribution

Assessment on the transactional instrument and mechanism

Ar-Rawaj (Distribution of Wealth) ‫آﻲ ﻻ ﻳﻜﻮن دوﻟﺔ ﺑﻴﻦ اﻷﻏﻨﻴﺎء ﻣﻨﻜﻢ‬

‫اﻟﻮﺳﺎ ﺋﻞ اﻟﻤﻘﺎﺻﺪ‬ Approach in Realization of the Objectives of Shariah

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Any transfer of wealth or property has to be made through a valid contract or `aqad Theory of Contract in Islam

Divine Sources (Quran & Sunnah)

Mutual Consent (Redho)

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Shariah Parameter in the Theory of Contract (‫)اﺳﺒﺎب اﻟﺘﺤﺮﻳﻢ‬

SHARI’AH-COMPLIANCE PARAMETERS IBF Contract s

9 Lawful Objective/Purpose 9mutual consent No coercion, fraud, misrepresentation , influence, mistake etc.

No Prohibited elements Nonhalal

Riba Gharar

Maysi r

HOW TO MAKE MONEY IN ISLAM? ‫ﺣ ﱠﺮ َم اﻟﺮﱢﺑﺎ‬ َ ‫ﷲ اﻟﺒﻴ َﻊ و‬ ُ ‫واﺣ ﱠﻞ ا‬

‫ﻗﺎﻟﻮُا ِا ﱠﻧﻤَﺎ اﻟ َﺒ ْﻴ ُﻊ ﻣِﺜ ُﻞ اﻟ ﱢﺮﺑَﺎ‬

“Allah permits trading but prohibits Riba” (2:275)

“They said that indeed trading is just like riba” (2:275)

RIBA NO COUNTER-VALUE

PROFITS What’s The Difference?

WITH COUNTER-VALUE (`IWAD)

15 Effort (Al-

Risk (Al-

Liability (Al-Dhaman)

General Classification of Contract in Islam

Profit-making Contracts

Charitable Contracts (‫)ﺗﺒﺮﻋﺎت‬

Exchange Contracts (‫)ﻣﻌﺎوﺿﺎت‬ Cooperation Contracts (‫)ﻣﻌﺎوﻧﺎات‬

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Deposit-taking Contracts

Various forms of Islamic Contracts used in Banking

Sales-based Contracts

Lease-based Contracts

Equity-based Contracts

Fee-based Contracts

Promise/Undertaking Wa`ad

Hybrid Contracts

Wadi’ah Yad Amanah; Wadiah Yad Dhamanah, Mudarabah; al-Qard BBA – deferred sale; Murabahah – cost-plus sale; Bai al-Inah, Bai alTawarruq Ijarah Wa Iqtina; Ijarah Thumma Al-Bai’, Ijarah Muntahia Bitamleek

Mudarabah, Musyarakah

Kafalah/Dhaman (Guarantee); Wakalah (agency) Musyarakah Mutanaqisah (Dimishing Partnership), AITAB etc.

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Major Components of Islamic Financial Services ISLAMIC BANKING

ISLAMIC CAPITAL MARKET

Financing

Equity

Deposit Investment

Islamic Securities Funds & Unit Trust I-REITs Venture Capital/ Private Equity Derivatives

TAKAFUL/ ISLAMIC INSURANC E Takaful Retakaful

Promote Maslahah Freedom from Riba

Entitlement to Equal, Adequate, Accurate Info.

Promote Brotherhood

Freedom from Gharar

Freedom from Dharar

Freedom to Contract

Characteristics of Shariah-compliant Banking and Financial System Freedom from Price control & Manipulation

Freedom from Qimar & Maysir

A system grounded on moral and ethics Entitlement to Transaction at Fair Price

Some illustrations of Islamic Financial Products Available in the Market

BBA HOME FINANCING MODUS OPERANDI 5. Bank pay developer the 90% balance

Sales & Purchase Agreement (S&P)

Developer/Vendo r

1. 10% down payment

1. Beneficial ownership

Property Sale Agreement (PSA) 3. BBA price (deferred payment) 3. House

2. House 2. Cash price (90% balance)

BANK

Property Purchase Agreement (PPA)

Customer

Tawarruq Model of Home Financing 4.Property 4.RM200,000 Customer

Property Owner/Developer 3.RM200,000

cal i r t s lec 3.E liance App

1.RM200,000 1.Electrical Appliances worth RM200,000 Electrical Appliances Wholesaler

2.RM350,000 Deferred 2.Electrical Appliances

Musyarakah Mutanaqisah (Modus Operandi) Bank leases its 90% share of property to customer

90%

10%

0%

100%

Customer pays rent for usage of Bank’s 90% share of property Customer gradually buys share of property from Bank Customer’s monthly installment payments

ILLUSTRATION of Musharakah Mutanaqisah Customer’s Share

MM

Bank’s Share

100 The asset is now mine. Thanks to

Islamic Bank

90

90%

80

80%

70 Customer now owns 100% of the Assets

60

60% 50%

50 40 30 20

10%

70%

10

40% 30% 20% 10% Bank’s share = “0”

Commodity Murabahah Deposit Placement US$ 1 Million on spot Client US$ 1.1 Million deferred

Broker A Where is this proceed invested?

US$ 1 Million on spot Broker B

Islamic Bank

Istisna’ Arrangement (1) Lessor is the beneficial owner of the to Construct vessel and the lessee is the registered owner and operator of the vessel Vessel (2) Lessor will lease its beneficial interest in

Engage in construction

Ship Builder

the vessel

Forward Lease Agreement

Istisna’ Agreement Seller/Lessee

(1) Purchaser and the Seller agree that the Seller will build the Vessel (2) Purchaser agrees to pay the Istisna’ cost as the price for the Seller per forming the works (3) Seller agrees to sell by way of Istisna’ to Purchaser its beneficial interest in the constructed Vessel and Purchaser agrees to purchase the constructed vessel for the Istisna; cost.

ORPHAN SPV (Mudarib/Purchas er/ Lessor Mudarabah Agreement

Financier (Rabbul-Maal)

No Claim

Profit Premium

Insurance Company

BASIC MECHANISM OF INSURANCE

Policy holder Peace of mind

Compensation

Calamity

Why is conventional insurance not Shari’ahcompliant? •

Element of uncertainty (gharar) – There is uncertainty of what the insurance policy-holder is “buying” or paying for • If no loss occurs Ö Policy-holder receives nothing • If loss occurs Ö Policy-holder gets compensation in varying amounts Premium

Insurance Company

•

•

Coverage

Insurance Policy-holder

Element of gambling (maysir) – The insurance company is gambling that total premiums collected will exceed total claims and thus producing underwriting surplus (profit) – Total claims is predominantly affected by chance (will of God) Element of riba – Insurance fund commonly invested in interest-bearing securities

ISLAMIC ALTERNATIVE TO INSURANCE

BASIC DESCRIPTION OF TAKAFUL INSDUSTRY Takaful Operator

Takaful Participants

Manages fund for a fee or share in profits on investment

Takaful Fund

• • •

•

Contribute via unilateral contract (tabarru’at)

Takaful participants contribute to a takaful fund based on the concept of mutual assistance The contribution is done via reciprocal/mutual donation (tabarru’at) and does not represent a commercial “sale of coverage” Takaful entails a unilateral, charitable contract (tabarru’at) in contrast with the conventional insurance contract which is a bilateral exchange contract (mu’awadat) Gharar is tolerated in a charitable unilateral contract

Models of Takaful

Between Participants and Takaful Operator

Among Participants

Tabarru` (mutual indemnity)

Wakalah (Agency)

Mudarabah (Partnership)

Hybrid

Waqf (Endowment)

MODUS OPERANDI (MUDARABAH MODEL) Takaful Participants Contribute 2nd

Tabarru`

Contract

Mudarabah

1st contract

1. 2.

Takaful Funds Manage

Invest

Takaful Operator

Profit, if any, is shared between the two based on certain ratio or percentage & loss, if any, will be borne by the capital provider alone

unilateral contract valid though no acceptance and consideration from the recipient

Pay Claims

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MODUS OPERANDI (WAKALAH MODEL) Takaful Participants Wakalah fee 2nd

Contribute

Tabarru`

Contract

Wakalah

1st contract

Risk Fund

-retakaful -reserves -claims -investment income -stabilization reserves

Manage Takaful Operator

Surplus 33

In a nutshell as a Muslim, a man needs to abide with Shariah!

Every Transactions Must Be Shari`ah Compliant!

What Does it Mean By Shari`ah Compliance? 34

SHARIAH-COMPLIANT IS NOT JUST ABOUT: • Satisfying the mechanics of financial operation; • Fulfilling the legal documentation requirement • Focusing on the legal form of a contract

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VALIDITY vs. PERMISSIBILITY

Validity (Sahih Qadaan) is based on the FORM of the Contract while Permissibility (Sahih Diyanatan) is A Valid Contract is not necessarily PERMISSABLE (HALAL) VALID(SAHIH) Based on the SUBSTANCE of the contract and Halal (Permissable) contract that is used contract that meets its to obtain Halal (Permissible) ends. requirements conditions theandINTENTION of the contractors. 36 Financial Contract MUST be BOTH HALAL (Permissable) & SAHIH (Valid)

Shariah-Compliant Requires • Financial Contract to be Shariah compliant both in terms of FORM and SUBSTANCE • Operation to be Shariah compliant • Islamic banking to be more ethical • Socially Responsible

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