Demystifying Islamic Finance

Warren Edwardes

Demystifying Islamic Finance Leasing Life Conferences The New Horizon: Islamic Leasing’s Rising Star 27 April 2004

1/27

Demystifying Islamic Finance

• Warren Edwardes, ceo, Delphi Risk Management Ltd• Islamic Leasing’s Conference• Millennium London Mayfair Hotel London W1 • 27th May 2004 • Full article on: http:// dc3.co.uk/islamicleasingintro.htm• Islamic banking and finance news: http:// dc3.co.uk/ibnews• Contact: [email protected]

Warren Edwardes


2/27

QuotesHappy the man who far from schemes of

business, like the early generations of mankind, ploughs and ploughs again his ancestral land with oxen of his own breeding, with no yoke of usury on his neck.

Roman philosopher, HoraceJulius Caesar limited interest to 8 1/3 %

Warren Edwardes


3/27

QuotesNeither a borrower nor a lender be; For loan oft

loses both itself and friend and borrowing dulls the edge of husbandry.

Shakespeare’s «hamlet», a Danish father advising his son

Warren Edwardes


4/27

QuotesThose who devour usury will not stand except

as stands one whom the evil one by his touch hath driven to madness. That is because they say: "trade is like usury but Allah hath permitted trade and forbidden usury.”

The Koran: Surah 2, verse 275

Warren Edwardes


5/27

Jargon: Latin used by lawyers• In haec verba

– Verbatim• Nunc pro tunc

– Retroactive• Caveat emptor

– Let the buyer beware

http://www.equalparenting.ca/munby/www.timmins101.com/messages/messages/1/254.html?988753263

Warren Edwardes


6/27

Jargon: Greek used by derivatives dealers

• Delta

– Sensitivity of an option price to changes in the price of the underlying equity

• Theta

– Sensitivity of an option price to changes in time

Warren Edwardes


7/27

Jargon: Arabic used by Islamic bankers

• Ijara– Leasing

• Muqarada– Mudaraba

• Mudaraba– Profit-sharing

Warren Edwardes


8/27


• Alwadiah– Safe keeping

• Baimuajjal– Deferred-payment sale

• Baisalam– Pre-paid purchase

Warren Edwardes


9/27


• Murabaha or Shirka– Cost-plus or mark-up

• Musharaka– Equity participation

• Qard Hasan– Benevolent loan (interest

free)

Warren Edwardes


10/27

Overview • Hallal vs. Haram

– Not just about Hallal Chicken Tikka Masala but also about finance

• Interest, usury, riba used interchangeably but are different

• Essentially three dimensions of Islamic finance1. Riba free - Profits and Loss Sharing PLS2. Riba free – trade related mark up3. Ethical dimension

Warren Edwardes


11/27

Overview – 1. Profit & Loss Sharing

• Profit & Loss Sharing – basically, no pain no gain

• Venture capital, non-recourse project finance, equity investment vs lending

• US / UK banking models vs German, Japanese, Spanish banking

Warren Edwardes


12/27

Overview – 2. Markup• Mark up - predetermined profit.

– Predominates 87% Pakistan, 63% Iran– Investors’ risk aversion– Borrowers’ protection of equity interests

• Tax similarities - interest versus capital gains tax• Interpretations change

– Treasury bills, foreign exchange, zero coupons, circular transactions.

• Various jurisdictions / opinions– Gulf, Malaysia, London

Warren Edwardes


13/27

Overview – 3. Ethics• Ethical dimension - undesirable investments sectors

– Tobacco, Alcohol, Armaments, Gambling• Charitable aspects

– Interest donated to charity– Can the borrower afford to repay?– Faith does not mean soft option for bankers. No

easy touch

Warren Edwardes


14/27

Riba is more than Usury• Excessive interest

– UK usury laws on excessive interest abolished in 1854– South Africa and US (except Virginia and Delaware) have

usury laws• Early repayment penalties• No distinction between fair and unfair interest• Trade is allowed• Repayment only if borrower is able to?• Section 233 loans – dividends or interest• “Unearned” income taxed at 97% in the UK

Warren Edwardes


15/27

Key Islamic Financial Instruments PLS

• Mudaraba / Modaraba– PLS no pain no gain– Rabbulmal - capital provider / investor– Mudarib - entrepreneur / borrower– Profits split between Rabbulmal and Mudarib as

agreed– Losses only to financier.

• Looks like non-recourse project finance

Warren Edwardes


16/27


• Shirka– Generalised Mudaraba – More than 2 parties– Non contractual - Al Milk, – Contractual Ul Uqud

• Looks like syndicated non-recourse project finance

Warren Edwardes


17/27


• Musharaka– Equity investing– Limited partnership– Profits distributed according to pre-agreed formula– Fair share of profits? 95% to investor?

• Looks like normal equity investments or fund management

• Sounds like “shares”• Loss sharing? Limited liability to investment.

Warren Edwardes


18/27

Key Islamic Financial Instruments PLS• Al- Wadiah

– Retail savings account– Cheque books bill payments, credit cards etc.– Dividend paid subject to profits through the year– Only profits no loss of capital– Short term accounts

• Looks like with profits bonds• Other retail

– Prizes, gifting of interest to charity, no transaction fees

Warren Edwardes


19/27

Key Islamic Financial Instruments – Mark-up

• Murabaha– Mudaraba / Musharaka on bank liability side– Murabaha / Morabaha on asset side. – Locked-in return– Bank buys asset on behalf of client / borrower and then sells it for

deferred payment– Title transfers at outset or on payment at maturity– Interest into capital gains? Use of Libor

• Sounds like “Repo” a sale and repurchase agreement

Warren Edwardes


20/27

Key Islamic Financial Instruments - mark-up

• Baimuajjal– Property financing on a deferred basis– Payment in instalments or lump sum with mark-up– Predetermined profit.

• Ijara– Leasing type transaction– Title stays with lessor– Option to buy goods on maturity of contract– Ijara wa iqtina is renting then purchase

Warren Edwardes


21/27

Key Islamic Financial Instruments - Mark-up

• Baisalam– Manufacturers financing of production– Bank buys & pays for goods at a discount before manufacture– Commodity futures contract? A derivative?– Similar to Bankers Acceptance – BAs

• Al Bay Bithaman Ajil– BBAs popular in Malaysia– Financing sales by deferred instalments– Trade not debt

Warren Edwardes


22/27

Key Features of Islamic Banking• Interest free• Trade related and perceived need for funds• Pure form of Islamic Banking? – profit & loss

sharing• Avoids exploitation - no usury• Ethical investments

– Alcohol, tobacco, gambling, armaments, pornography etc

Warren Edwardes


23/27

Demystifying Islamic Finance

• Warren Edwardes, ceo, Delphi Risk Management Ltd• Islamic Leasing’s Conference• Millennium London Mayfair Hotel London W1 • 27th May 2004 • Full article on: http:// dc3.co.uk/islamicleasingintro.htm• Islamic banking and finance news: http:// dc3.co.uk/ibnews• Contact: [email protected]

Documents

Demystifying Islamic Finance