Assoc. Prof. Dr. Asyraf Wajdi DusukiHead, Research Affairs

International Shari’ah Research Academy for Islamic Finance (ISRA)

Public LectureInternational Institute of Advanced Islamic Studies (IAIS) Malaysia

28th April 2010

An Appraisal of Islamic Finance Instruments6

• Challenges of Realizing Maqasid al-Shari`ah5

Overview of the Islamic Finance Development 1

• The Polemics of Shariah-Compliant:

• Form vs Substance3

• Understanding Maqasid al-Shari`ah4

BBA Home Financing, Commodity Murabahah & Equity-Based Sukuk7

Conclusion8

Fundamentals of Islamic Financial Transactions2

IAISPublic

Lecture

Major Components of Islamic Financial Services

ISLAMIC BANKING

ISLAMIC CAPITAL MARKET

TAKAFUL/ISLAMIC

INSURANCE

Equity

Islamic Securities

Funds & Unit Trust

I-REITs

Venture Capital/ Private Equity

Derivatives

Takaful

Retakaful

Financing

Deposit

Investment

Pakistan

Hong Kong

Aims to become Islamic finance gateway to China

Plans to issue sovereign sukuk

Hang Seng Islamic China Index Fund in 2007

UK

Gov’t sets an objective to ‘entrench London as a global gateway for Islamic finance

5 FSA-approved Islamic banks and Takaful operators

Plans to issue sovereign sukuk, amend tax law on IF

UAE

Japan

Law passed allowing banks to do Islamic financeFrance

Passed rules/regulations to support Islamic finance activities

In process of licensing Islamic banks

Made fiscal & legal adjustment for IF transaction i.e. taxation guidelines on sukuk & murabaha

Singapore

Established first Islamic bank

Introduced tax neutrality for Islamic finance

Aspiring to be centre for Islamic finance

Launched Islamic ETF

South Korea

Parliament expected to pass the law related to offering of tax waiver on foreign investors’ interest income from sukuk issued

Thailand

Qatar

Sudan

Indonesia

Kuwait

Germany

Saxony-Anhalt state issued government sukuk

First Islamic bank to operate in 2010

Emerging interest on Islamic finance as viable alternative to the global financial system …

Saudi Arabia

Bahrain

Malta

Plans to position as Islamic finance hub for the Mediterranean

Jordan

Plans to tap sukuk market to finance its deficit

Turkey Announced IFC Istanbul in Sep ’09

with focus includes interest-free financial business

Brunei

Aim to become Islamic financial services hub for Asia

Muslim-majority countries offering Islamic finance (IF)

Non-muslim countries starting to offer IFCourtesy of Bank Negara Malaysia

Malaysia

Iran

Islamic finance… fastest growing segment in global financial system…

Islamic Assets under Management USD750 billion & expected to hit USD1 trillion by 2010

Average growth rate of 15-20% p.a.

Islamic Mutual Funds USD300 billion

Average growth rate of 23% p.a.

Takaful Contributions USD7.2 billion

Growth rate of 13% p.a.

Global Market Capitalization of Dow Jones Islamic Index

USD10 trillion

Shariah Compliant Global Funds 680 funds

Global Outstanding Sukuk USD107 billion

Average growth rate of 22% p.a.

Number of Islamic Financial Institutions (IFIs) > 600 IFIs in the world

Sources: McKinsey, The World Islamic Banking Competitiveness Report 2007-08, “Capturing the Trillion Dollar Opportunity”; PriceWaterHouseCoopers,Islamic Finance News, IFSB & National Authorities; Islamic Banker Research Group; Islamic Finance & Insurance & Investor Offshore Review

Enormous potential in Islamic Finance…

• Legal & Regulatory

– Islamic Banking Act

– Takaful Act

– Government Funding Act

– Capital Market Services Act

• Shariah Advisory Council

– Central Banking Act

• Dispute Resolution

– Judicial system: dedicated high court

– KL Regional Centre for Arbitration

– Financial Mediation Bureau

• Banking

– 17 Islamic banks

– 10 Islamic windows

– 3 International Islamic Banks

– 14 International Currency Business Units (ICBU)

Takaful

– 8 takaful operators

– 4 retakaful operators

– 7 ICBUs

• Fund Management

– 9 Islamic fund managers

– 35 Islamic fund management windows

– Legal firm

– Accounting

– Financial Intermediaries

– Financial Advisors

– Consultancy Service

– Payment, clearing and settlement, custodian

– Principal Dealers

– Listing on Bursa with authorise exchange status

Professional Service

Diversified PlayersGovernance

Infrastructure

Financial Markets

– Capital Market

– Money Market

– Foreign Exchange Market

– Commodity Market

– Bursa Suq Al-Sila

More than 30 years of experiences in developing Islamic

finance…

Malaysia: the world’s most comprehensive Islamic

financial system…

IslamicBanks & Takaful

Companies

IslamicCapital Market

IslamicMoney Market

Money market

Conventional Banks & Insurance

Companies

Capitalmarket

Malaysian Financial

SystemLabuan IBFC

FUNDAMENTALS OF ISLAMIC FINANCIAL TRANSACTIONS

7

Any transfer of wealth or property has to be made through a valid

contract or `aqad

Divine Sources (Quran & Sunnah)

Mutual Consent (Redho)

8

Theory of Contract in Islam

Islamic Contract

Gharar

RibaAl-Zulm

(Qimar)

Shariah Parameter in the Theory of

Contract(اسباب انتحريم)

RIBA PROFITS

What’s The

Difference?

NO COUNTER-VALUE

WITHCOUNTER-VALUE

(`IWAD)

Effort (Al-Kasb)

Risk (Al-Ghurm)

Liability (Al-Dhaman)

What’s The Difference Between Riba & Ribh

واحل اهلل البيع وحرم الربا“Allah permits trading but

prohibits Riba” (2:275)

وا البيع هثل الربا قالوا ا“They said that indeed trading

is just like riba” (2:275)

10

Qaidah Fiqhiyyah:يستحق الربح إها بالوال وإها بالعول وإها بالضواى

(Jamharatul al-Qawaid al-FiqhiyyahVol.1 P.332)

General Classification of Contract in Islam

Charitable Contracts(تبرعات)

Exchange Contracts(هعاوضات)

11

Cooperation Contracts(هعاواات)

Profit-making Contracts

Various forms of Islamic Contracts used in Banking Sales-based Contracts

Lease-based Contracts

Equity-based Contracts

Fee-based Contracts

Hybrid Contracts

BBA – deferred sale; Murabahah – cost-plus sale; Bai al-Inah, Bai al-Tawarruq

Ijarah Wa Iqtina; Ijarah Thumma Al-Bai’, Ijarah Muntahia Bitamleek

Mudarabah, Musyarakah

Kafalah/Dhaman (Guarantee); Wakalah (agency)

Musyarakah Mutanaqisah (Dimishing Partnership), AITAB etc.

Deposit-taking ContractsWadi’ah Yad Amanah; WadiahYad Dhamanah, Mudarabah; al-Qard

Promise/UndertakingWa`ad

12

Maslahah

Maqasid

Legal Structure

Infrastucture

How to

structure

financial

products that

comply with

Shariah…?

Viability?

We need to

finance our

car, house,

business…

14

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?

15

SHARIAH-COMPLIANT IS NOT JUSTABOUT:

• Satisfying the mechanics of financial operation;

• Fulfilling the legal documentation requirement

• Focusing on the legal form of a contract

VALIDITY vs. PERMISSIBILITY

16

VALID(SAHIH)contract that meets its

requirements and conditions

PERMISSABLE (HALAL)contract that is used

to obtain Halal (Permissible) ends.

Financial Contract MUST be BOTH HALAL (Permissable) & SAHIH (Valid)

A Valid Contract is not necessarily Halal (Permissable)

Validity (Sahih Qadaan) is based on the FORM of the

Contract while Permissibility (Sahih Diyanatan) is

Based on the SUBSTANCE of the contract and

the INTENTION of the contractors.

17

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

ISLAMIC BANKING AND FINANCE

Ideal versusReality

Innovation versus

Replication

TheMisguided

Justification

Maqasid Shari’ah

• 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 basic essentials; dharurah(Al-Mansul, Fakhruddin Ar-Razi, p.24) .

Religion

Life

Intelect

Posterity

Wealth

Maqasid as-Shariah

(The Objectives of Shariah)

Preservation and Promotion

JusticeAlleviate Hardship Eliminate Prejudice

وها ارسلاك إال رحوة للعالويي“And We have sent you (O Muhammad) not

but a mercy to the whole universe”

(Al-Ambiya:107)

Maqasid as-Shariah in Islamic Finance

JusticeAlleviate Hardship Eliminate Prejudice

Preservation of Wealthحفظ انمال

Macro Maqasid

Micro Maqasid

Assessment on the transactional instrument and mechanism

Assessment on the overall impact and contribution

Ar-Rawaj (Distribution of Wealth) كي ال يكون دونة بيه األغىياء مىكم

انوسا ئم انمقاصدApproach in Realization of the

Objectives of Shariah

Maqasid as-Syariah in Financial Transactions

االصم في انمعامالت االنتفات انى انمعاوي

“The origin of Muamalat matters is by understanding its underlying wisdom”

To facilitate the needs of human being (Al-

Jumuah:10)

Ar-Rawaj or to ensure wealth is circulated among as many as

possible in a fair way (Al-Hasyr:7)

To promote transparency and accountability (Al-Baqarah:282)

To uphold and promote justice in acquiring wealth

ال يحل لوسلن باع هي اخيه وفيه عيب اال بيه له

“It is prohibited for a Muslim when he sells something which has defects to his brother unless he informs his brother about it” (Al-

Hakim)

To avoid dispute and ensure stability

To promote maslahahand avoid harm

Does ShariahCompliant

Instrument in Islamic Financ

practice manifest and realize the

noble objectives of Shariah?

Property Sale Agreement (PSA)

Sales & Purchase Agreement (S&P)

1. Beneficial ownership

1. 10% down payment

3. BBA price (deferred payment)

Property Purchase Agreement (PPA)

2. House

2. Cash price (90% balance)

3. House

BANK Customer

5. Bank pay developer

the 90% balance

BBA HOME FINANCING MODUS OPERANDI

Developer/Vendor

Fin. Amount : RM100KTenure : 25 yrs

(1981-2005)Single Rate : BFR-0Ceiling Rate : 9.90Ta’widh : 1%

Total Selling Price

Islamic Bankingvs

Convensional Banking

Loan Amount : RM100K

Tenure : 25 yrs

(1981-2005)

Single Rate : BLR-0

Ceiling Rate : -no-

Penalty : 8% compounded

Total Repayment

500

550

600

650

700

750

800

850

900

950

1000

1050

1100

81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

Islamic

Conventional

Years

Installment Amount

MOVEMENT OF BASED LENDING RATE (BFR)

The Issue

0 5 10 15

Financing/Loan Amount = 100,000

Annual Profit/Interest Rate = 10%

Annual Profit/Interest Amount = 10% x 100,000 = 10,000

Total Amount to be Paid in 15 years = 100,000 + (15 x 10,000) = 250,000

Customer defaults

after 2 years

Should the customer pay

100,000 + (2 x 10,000) = 120,000?

Should the customer pay

100,000 + (15 x 10,000) =

250,000?

or,

US$ 1 Million on spot

US$ 1.1 Million deferred

US$ 1 Million on spot

Broker A

Broker B

Commodity Murabahah Deposit Placement

Client/Islamic Bank

Conventonal Bank

Where is this proceed invested?

What is Sukuk?

Technical MeaningSukuk refers to securities,

notes, papers or certificates, with features of liquidity and tradability

(except for salam and murabahah sukuk)

Literal MeaningSukuk is the plural of sakwhich means certificates.

Other similar terms:•Taskik – process of dividing assets into

papers (sukuk)•Tawriq – to render something into cash

SUKUK

AAOIFI“Investment sukuk are certificates of equal value representing undivided

shares in ownership of tangible assets, usufructs and services (in the ownership

of) the assets of particular projects or special investment activity”

Malaysian Securities Commision“A document or certificate which represents the value of an asset”

• Asset – may include financial asset such as receivables and debts, as well

as non financial assets like tangible assets, usufructs and services.

Types of Sukuk

Asset-Based Asset-Backed Hybrid

Sales-Based Lease-BasedPartnership-

BasedAgency-Based

Salam

Istisna

IjarahMuntahiyah

bi Tamlik

IjarahMawsufah fi

Zimmah

Musharakah

Wakalah bi Istithmar

Exchangeable

Convertible

BBA

Murabahah

Ijarah Mudarabah

The Nature and Type of Asset represented by the SukukThe Underlying Contracts

in the Sukuk Structures

Bases for SukukClassification

The Technical and Commercial Features of

the Sukuk

Debt-based

Tangible assets

Usufructs

Rights in investment

projects

Special investment

activities

Asset-based (normal)

Asset-Backed (ABS)

Hybrid Structure(convertible & exchangeble )

Sales-based

Lease-based

Partnership-based

Agency-based

Exhibit 1: Mudharabah Sukuk

CAPITAL

Investors(Rabb al-Mal)

Issuer(Mudarib)

Invests in project

Outcome Of

Project

Issues Mudarabah Sukuk

Contract of Mudarabah

Profit shared in accordance to

pre-agreed proportions

(X,Y)

Loss isborne by both partners based

on ratio of capital

contribution

Y% to rabb al mal

X% to Mudarib

1

2

3

Exhibit 2: Musharakah Sukuk

CAPITAL

Investors(sharik/partner)

Issuer(sharik/partner)

Invests in project

Outcome Of

Project

Issues Musharakah Sukuk

Contract of Musharakah

Profit shared in accordance to

pre-agreed proportions

(X,Y)

Loss? borne totally by

rabb al-mal

Y% to investors

X% to Issuer

1

2

3

Does Sukuk Similar to Bond?

Essential Features of Mudarabahand Musharakah Sukuk

• In both structures the issuer issues certificates evidencing the capital contribution of the investors and ‘indicative profit rate’ to be paid as periodic coupon distribution.

• However, 2 important principles need to be abided:

1. Capital cannot be guaranteed

2. Returns cannot be guaranteed

EQUITY-BASED SUKUK DEBT-BASED STRUCTURE

Purchase Undertaking at

Par

Liquidity Facility“top-up facility”

Redemption of capital at par

(Capital Protected)

Periodic coupon payment remain

intact(Return

Protected)

Re

plic

atin

g C

on

ven

tio

nal

Bo

nd

Re

plicatin

g Co

nve

ntio

nal B

on

d

Macro Maqasidvs.

Micro Maqasid

Source of Financial Crisis and Economic Instability

Proliferation of Debt

Conclusion• Need to revisit the credit enhancement mechanisms in Equity-based sukuk

• Widespread use of credit enhancement in structuring mudharabah and musharakah replicate conventional bond features which transformed from equity to debt-based structure.

• Consequently these instruments proliferate debt-based financing which accentuates more harm (mafsadah) than benefits (maslahah).

• In final analysis, restricted view of understanding Shariah, by only focusing on the legal forms of a contract need to be changed. Instead, the substance that has greater implications to the realisation of Maqasid al-Shariah should be equally looked into especially when structuring a financial product.

• Otherwise, Islamic banks will just appear as an exercise of semantics; their functions and operations are really no different from conventional banks, except in their use of euphemisms to disguise interest and circumvent that many Shariah prohibitions.

43

واهلل اعلم

وشكراAssoc. Prof. Dr Asyraf Wajdi Dato' Dusuki

Head of Research AffairsInternational Shari'ah Research Academy for Islamic Finance (ISRA)

2nd Floor, Annexe Block,Menara Tun Razak,

Jalan Raja Laut,50350 KL

T: +603 2781 4211F: +603 2692 4094M: +6012 6188005

www.isra.my