Muhammad ayub understanding islamic finance phần 8 ppsx

358 Understanding Islamic Finance 14.2 PRODUCT DEVELOPMENT Product development means creating business, suggesting means to it, keeping in mind the realities and business prospects for the future. Product development with reference to Islamic finance refers to the process of developing assets, through innovation and research, in the form of products and services to cater to the customers’ demands in the most suitable way within the parameters of Shar ¯ ı´ah and the governing regulatory and legal boundaries. It also includes re-engineering of existing products in accordance with Islamic economic principles and the changing requirements of businesses. It helps banks to create more business opportunities and provides a competitive advantage over other market players. Effective product development creates synergy between the customers and the bank and thus assists the bank in better understanding the needs of its customers. A satisfied customer is often a repeat customer and tends to enhance the credibility of the bank. 14.2.1 Procedure for Product Development Product development requires assessment of need, generation of ideas, discussion with the Shar ¯ ı´ah advisor/board for deciding detailed procedures for the operation and implementation of the product, development of the procedures (preparation of an operational manual for guidance of staff members) and the final approval by the Shar ¯ ı´ah department of the bank. All possible risks have to be carefully analysed and risk mitigants devised to manage the risks. The Risk Management Division should also be involved to take into account the operational, asset-related and credit risks, accounting, taxation, regulatory and legal issues at the stage of product development. Deciding factors in this regard are: market survey; Shar ¯ ı´ah compliance (in terms of mode, nature of assets involved, process and documentation); risk profile of depositors; cash flow of clients on the assets side; risk mitigation measures; legal matters and managing mismatch – liquidity versus profitability. The product manual has to be discussed with the operations staff to ensure the smooth operation of the product in accordance with recognized procedures. IT support is an integral part of today’s business and needs to be properly worked out. Training of marketing and operational personnel is necessary before launching and imple- menting the product. They must know the salient features of the product and, more specifi- cally, its advantages over other available products in the market. Launching the product is the start of another process, i.e. revision and modification of the product’s features. In the light of the feedback, the product features may be modified to cater to the customers’ requirements in a more effective manner. A product may involve more than one mode to cater to the needs of the business in a Shar ¯ ı´ah-compliant and efficient manner. For example, a housing finance product based on Diminishing Musharakah may comprise the concepts of Shirkah, Ijarah, Istisna‘a and Wakalah. Product developers have to observe the rules of all the related modes. 14.3 THE NATURE OF FINANCIAL SERVICES/BUSINESS The major players in the finance industry include Islamic commercial banks, Islamic invest- ment banks and other non-banking Islamic financial institutions, Islamic funds and unit trusts, equity and debt market players, pilgrimage funds and other cooperative institutions and Takaful companies. The regulatory framework for these institutions is different in Financing Principles and Practices 359 different countries. While banks and non-banking institutions like investment banks are managed mostly by the central banks, equity and debt market businesses, funds, unit trusts, venture capital, etc. are governed by the Securities and Exchange Commissions in respec- tive jurisdictions. But there may be some slight differences in regulatory set-up in various jurisdictions. Islamic financial institutions (IFIs) obtain funds from a number of sources, which include: shareholders’ equity, customers’ general or investment deposits, inter-bank borrowings and, in some cases, the central banks. The bases for mobilization of funds are Mudarabah and Wakalatul Istism ¯ ar (agency). Unrestricted or restricted investment deposits are based on the principle of Shirkah, while current accounts are normally kept as loans and are not entitled to any return. 14.3.1 Management of Deposit Pools and Investments For the purpose of investment of funds, IFIs maintain common and separate pools or gen- eral and individual portfolios. The volume of investment deposits determines the banks’ investment strategies. If depositors are risk-averse, banks should also be risk-averse, invest- ing in less risky modes and avenues. Keeping in mind the depositors’ risk profiles, profitability and liquidity, they should invest through PLS modes in high-risk ventures and through debt-creating modes in low-risk investments. They should also deploy funds in financial markets and make fee-based earnings through investment management and services. The financing assets of Islamic banks are grouped into different investment pools with respect to the source of funds. The funds and financing assets can be allocated to the following investment pools: • general deposit pools (domestic or foreign currencies); • central bank’s refinance scheme pools (like the Islamic export refinance scheme of the State Bank of Pakistan); • treasury/financial institutions pool; • equity pool; • specific customers’ pools. The above pools are managed at the Head Offices or the Area Offices of the banks. The internal auditor and/or Shar ¯ ı´ah advisor have to take the following steps to ensure the Shar ¯ ı´ah compliance of deposit management with respect to investments by an Islamic bank: • Distinguish between various kinds of deposits offered by the bank under various schemes and to see that proper ratios for sharing profits/losses have been given and weightages assigned based on the tenors of deposits and disclosed to the deposi- tors; assigning different weightages on the basis of size of accounts of the same tenor, although permissible with proper disclosure to all depositors, has to be gener- ally discouraged, as it may lead to favouritism and injustice. It should also be ensured that the profit is allocated using the concept of daily product and the weightages system. • Ensure that the bank has not assured any fixed return to any individuals or group of depositors; if any projected rates have been quoted, the same must be subject to 360 Understanding Islamic Finance adjustments on the basis of actual performance of the relevant general or restricted pools of deposits. For example, an Islamic bank can tell any corporate client that it will invest its deposit in Ijarah and Murabaha activities, upon which it will be earning fixed return/rentals. But as there could be some defaults, and hence a loss of cost of funds to the bank, and the bank may also have to incur some ownership-related expenses in leases, it might not be possible to give any pre-fixed return; Shar ¯ ı´ah auditors should ensure that all such issues have been properly taken care of in respect of all pools maintained by the bank. In the case of large numbers of pools, they may take up a sampling method. They may like to obtain the bank’s correspondence with high-valued accounts to ensure that no fixed return is committed with them. • Auditors may also select a sample of transactions booked under various pools and obtain their respective agreements to check that the documentation and agreements approved for various activities have been used or there are some deviations. • It must also be ensured that the bank is performing its fiduciary responsibility as a Mudarib and Rabbul-m ¯ al in cases where the deposits are kept on a Shirkah basis and agency-related responsibilities in cases where deposits are based on a Wakalatul Istism ¯ ar basis. Any remunerative deposits should not be taken as loans by the bank. • If the bank’s own funds are also invested with those of the depositors in various pools, it should be ensured that the profits earned during the period have been distributed between the bank and depositors and among the depositors as per the agreed terms. After the distribution of the profit is made between the bank and the pools, the bank can donate a part of its own profit to any pool, provided it is not pre-agreed with the depositors/pool members. 14.3.2 Selection of the Mode for Financing The deployment of funds is still a major issue for IFIs as they do not have vanilla products available for meeting the needs of their customers. Islamic banks need to focus on the modes which best suit the requirements of the customers. Once a customer approaches the bank, they need to evaluate his requirements and offer the best possible product. Using Murabaha or Ijarah for every kind of need is neither feasible nor advisable. For example, Murabaha is not the right mode to provide financing for the purchase of sugar cane. Similarly, it may not be feasible for housing or other longer term investments in economies with high rates of inflation. Ijarah may not be feasible for projects entailing asset, market and counterparty risks, particularly for longer term project financing. In addition, Murabaha and Ijarah may not give better profit margins for the banks. Therefore, Islamic banks need to evaluate the flexibilities available in other modes of finance. Diversification is the best strategy for any bank – Islamic or conventional. It helps them in providing better customer service and earning better profit margins. A quick overview of the basic business features of Islamic modes of finance is given below: • Murabaha: Islamic banks purchase the goods and sell them on a profit margin; banks have to take ownership-related risks until the goods are sold to the customer; the asset risk is transferred to the client upon execution of Murabaha; there is less risk and a fixed return; normally for short-term financing. Financing Principles and Practices 361 • Ijarah: Islamic banks purchase nonconsumable assets and give them on lease, getting risk and reward of the ownership of the assets; conducive to the formation of fixed assets and medium- and long-term investments; the bank is an “accumulator” (if it keeps the assets in its ownership) or “distributor” (if it transfers the ownership and risks through securitization); return can be fixed or floating but asset-related risks remain with the bank until the termination of Ijarah. Ijarah is most suitable for financing the public sector and big corporations, provided they have unencumbered useable assets, and this is possible through the issuance of Ijarah certificates and Sukuk. • Salam: a forward sale with prepayment in full; fulfils the seller’s needs by providing him funds that he may use anywhere and offers the buyer a profitable business asset. It has vast potential, particularly in agriculture, agro-based industries and financing of overhead expenses of trade and industry; can be used for short- and, in selected cases, for medium-term financing. • Istisna‘a: also a forward sale with an order to manufacture or construct an asset with given specifications. It has the flexibility of payment of price, which can be immediate, deferred or in instalments. As manufacturing or construction also depends on the personal effort and commitment of the seller/manufacturer, Istisna‘a has an additional flexibility for controlling any delay in delivery of the asset by the seller. • Musharakah/Mudarabah: particularly suitable for consignment-based trade transactions, for short-, medium- and long-term project financing, import financing, preshipment export financing and working capital financing. Project financing can be conducted under Musharakah through the issuance of TFCs or Sukuk. • Diminishing Musharakah: for financing of fixed assets like houses, motor vehicles, machinery, etc. In particular, it is suitable for financing the purchase, construction and renovation of houses and commercial buildings. It may also involve “sale and lease- back” arrangements in cases where the property is already in the ownership of the customer. Box 14.1: Salient Features of Major Modes of Financing Features Diminishing Musharakah Ijarah Murabaha Period Long-term Long-term Short/long-term Rate Fixed/variable Fixed/variable Fixed Prepayment allowed Yes Yes Not allowed as a system Risk of the asset Joint Financier Financier/customer Uses Nonconsumable assets Nonconsumable assets Any Halal assets Late payments Controllable Controllable Loss to the bank 362 Understanding Islamic Finance Box 14.1: (Continued) Features Salam Istisna‘a Musharakah/ Mudarabah Period Short-term Short/long-term Short/long-term Rate Fixed Fixed Variable Prepayment allowed No May be structured Yes Risk of the asset Financier/customer Customer/financier Joint Uses Salam compatible Assets to be manufactured Any Halal business Late payments Loss to the bank Controllable No issue Box 14.2: Example of Using Salam and Murabaha Combined An Islamic bank can purchase cotton on the basis of Salam from growers while operating in the agricultural finance sector. In order to sell the cotton, it can take promise from a textile mill that it will purchase the cotton against an agreed price. Once the cotton is ready for delivery, the bank may appoint the textile mill its agent to take delivery of the cotton from the grower. When the mill informs the bank that it has taken delivery, the bank may sell the same to the mill (the promisor) for the already agreed price under a Murabaha transaction. The product is beneficial to the farmer as he gets cash for the future produce and manages the risk of a fall in price or his inability to market the cotton at the harvest time. The product is beneficial to the bank for the following reasons: funds are deployed for an extended tenure, with exposure on two different customers in different sectors; thus, risk is minimized. In a Salam transaction, a bank may end up with inventory, which creates problems for the bank. However, under the proposed structure, all problems related to inventory will be resolved. If structured properly, the bank can earn a better margin on the transaction. The product is also beneficial to the textile mill as the mill can shield itself from price fluctuation in the cotton season. It is a hedging mechanism for the mill. 14.3.3 Tenor of Financing Analysis of the cash flow of the customer is extremely important in Islamic banking for deciding the tenor of financing for any client. In conventional banking, bankers and customers focus on interest rates and obtain financing even in scenarios where the cash flows of the project mismatch with the repayment capacity. The customers believe that they will manage it through rollovers and other related facilities. Although this approach is not considered prudent, even according to the rules of conventional finance, it can work in individual cases. Financing Principles and Practices 363 It is, on the other hand, suicidal in Islamic finance, mainly because an Islamic bank cannot claim any liquidated damages against the loss of the cost of funds in cases of default. If the situation is not managed properly, the bank will face problems in payments by its customers. Therefore, the tenor of any financing facility must be determined carefully in consultation with the customer. 14.3.4 Shar ¯ ı´ah Compliance and Internal Shar ¯ ı´ah Controls Ensuring Shar ¯ ı´ah compliance is the most important job in Islamic banking. Any failure in this regard may cause systemic risk for Islamic banking and income loss for any bank. Audit should be conducted with regular intervals to ensure Shar ¯ ı´ah compliance. Internal auditors have to identify gaps in the process of financing and the operations department has to refine and amend the products and the procedures. Shar ¯ ı´ah compliance guidelines should be issued in specific formats with each product programme so that the Shar ¯ ı´ah audit may be carried out systematically. The product developers and implementers should adopt the policy of learning and improving from mistakes. Another purpose of the audit should be the education of staff members. Shar ¯ ı´ah boards of the banks have to play a crucial role in this regard. They should be in a position to offer recommendations as to how to amend the proposed structure of any product in order to make it feasible and Shar ¯ ı´ah-compatible. They should finalize the model documents and agreements for the modes of financing and try to ensure that banks follow them in all their transactions, in letter and spirit. Whenever a situation arises where there are difficulties in applying any of the formats, the management should bring the problem to the notice of its Shar ¯ ı´ah board to resolve the related issues. The personnel of Islamic banks have often been trained in conventional banking and are not familiar with Islamic banking. As Islamic banking is still in a process of evo- lution, even the senior management may not be experienced or up to date in the latest applications of the Shar ¯ ı´ah principles. Quite unintentionally, they may fail to carry out their Shar ¯ ı´ah board’s resolutions. For this reason, the board may like to inspect the bank’s transactions in detail and give advice as to where they could be improved for compatibil- ity with the Islamic principles. This would not only ensure that the bank is operating in accordance with Islamic law, but would also give the Shar ¯ ı´ah board itself an opportunity of gaining a deeper insight into the practical problems that arise. In addition, both the staff and the management would be given an opportunity to enhance their understanding and competence. Similarly, a large part of Islamic banks’ assets may comprise investments in equities/capital markets. Shar ¯ ı´ah boards must ensure the compliance of criteria for Islamic banks’ invest- ments in shares, equities, Sukuk and other avenues of business. This aspect of Shar ¯ ı´ah control should include prohibition of investment in companies with unacceptable business lines, which produce prohibited products and provide prohibited services like: • alcoholic beverages and tobacco products; • grocery stores dealing in Haram goods; • restaurants, casinos and hotels with bars for prohibited activities; • amusement and recreational services likely to involve indecent activities; • financial institutions which deal with interest; • companies of which: 364 Understanding Islamic Finance — the interest income ratio is more than (5) %; — the debt ratio (leverage) is more than (10–33) %; — total illiquid assets are less than 10–33 % of its total assets. If investment is made in the equity of such companies, Haram or interest-related income will have to be given to charity and the Shar ¯ ı´ah boards must ensure its credit to the Charity Account. The major functions of a Shar ¯ ı´ah supervisory board in the light of the AAOIFI’s Shar ¯ ı´ah Standard are given in the appendix to this chapter. Shar ¯ ı´ah Controls in Respect of Various Modes In order to ensure Shar ¯ ı´ah compliance, Shar ¯ ı´ah boards should specify certain controls for modes which respective banks are using, particularly in respect of commonly used products like Murabaha and Ijarah, which are susceptible to being used as back doors to interest. Murabaha in various goods may involve different aspects needing close monitoring, for example, Murabaha in perishable goods, shares of joint stock companies, particularly when the transactions involve dual side agency agreements (the client is appointed agent to purchase the asset on behalf of the bank and also given funds for payment to the supplier), Tawarruq and other by-products of major Islamic modes. We outline internal controls in respect of some commonly used modes below. Murabaha – Internal Shar ¯ ı´ah Controls 1. The Internal Control Department/Shar ¯ ı´ah Board should ensure that accounting in Murabaha is made similar to that of a trade transaction instead of a financial transaction. In this respect, the AAOIFI’s Accounting Standard on Murabaha may be consulted or there could be adaptation keeping in mind the international accounting standards and the local business practices. Some banks record only the disbursement of the total amount including mark-up. This is against the substance of Shar ¯ ı´ah-compliant Murabaha. 2. To ensure that banks are not involved in rollover of Murabaha transactions, strict internal controls should be applied. The price of the goods cannot be changed if the customer does not pay on time. Accordingly, there is no prospect for a rollover of Murabaha transactions. Nevertheless, it should also be kept in mind that a master Murabaha facility that a bank approves for a client as MoU, entails multiple Murabaha transactions, and if it is necessary to extend credit, a new Murabaha should be initiated against new goods with a fresh offer and acceptance and complete process of trade. However, some banks resort to arrangements in which they disburse the amount payable by their client against a new but fictitious Murabaha (only book entries), credit the amount to the client’s account and then debit his account against the old Murabaha. In some cases, banks might not be making even the book entry for the new Murabaha and there might be simple rollover of the previous Murabaha, including the previous receivables plus mark-up for the new term. Shar ¯ ı´ah boards will have to restrict the banks from such operations. Return on such rollovers must go to the Charity Account. 3. The client who is being paid an amount for purchase of the commodity on behalf of the bank may not purchase the commodity for a long time and use the funds for arbitrage or any other asset that might not be permissible, e.g. for purchase of interest-based securities or shares in interest-based companies. Therefore, it has to be ensured that the client Financing Principles and Practices 365 purchases the commodity within a given maximum time and gives declaration to the bank. It may also be indicated in the agency agreement that the given funds are an Am ¯ anah and their use for any unauthorized purpose is not allowed by Shar ¯ ı´ah. The Shar ¯ ı´ah board may also advise the bank to make payment directly to the supplier. 4. It also has to be ensured that the goods purchased by the client in Murabaha to Purchase Orderer exist at the time of offer and acceptance – i.e. have not been consumed by the client in his production cycle. For this purpose, the bank should identify the time within which declaration has to be made by the client in respect of various goods. 5. Although legal title is not necessary from a Shar ¯ ı´ah point of view and simple transfer of ownership transfers the risk and reward to the buyer, for genuine Murabaha, it is recommended that the title of ownership is transferred to the bank in the form of any documentary evidence. But banks, in order to avoid payment of transfer charges, purchase the goods in the name of the client; thus, they do not become owner of the goods in any way. A Shar ¯ ı´ah board must ensure that not only is the title of goods in the name of the bank at the time of sale to the client, but also the bank retains all risks and rewards related to ownership until the goods are sold to the client. This reduces the chances of making the Murabaha a back door to interest. 6. It must also be ensured that all documentation requirements, particularly if the client is also an agent of the bank, are being fulfilled properly. The board should not allow any change in the format of the master Murabaha agreement without its prior approval. 7. Mark-up should be charged from the time when the bank sells the commodity on credit to the client and not from the date of disbursement of funds to the supplier or to the client (as agent). Any part of the mark-up should not be referable to the intervening period, i.e. between disbursement and declaration/acceptance by the bank. Hence, Islamic banks should calculate their Murabaha profit from the date they sell the commodity to the client. However, they may apply any rate in consultation with the customers. 8. A Shar ¯ ı´ah board should put in place effective controls to ensure that banks do not resort to buy-back techniques in the case of Murabaha transactions. The companies from which goods are being purchased for sale on a Murabaha basis should not be the sister concerns of the customer’s company, i.e. the customer’s share in ownership of such companies should not be more than 50 %. 9. Banks, upon financing, normally take demand promissory notes (DP notes) from the client. As Islamic banks’ financing is based on the underlying trading/leasing contracts, they should get DP notes only after executing the Murabaha sale and creation of liability, e.g. after the sale of goods. If such a note is necessary at the time of disbursement for the sake of security, it can be of the principal amount only, i.e. excluding the mark-up or profit margin. Auditors have also to look into the overall or master agreement, a kind of MoU, between the bank and the purchaser/customer, whereby the bank promises to sell or the purchaser promises to buy the commodity from time to time on an agreed rate of profit added to the cost. Some Shar ¯ ı´ah boards have also allowed in the Murabaha structure the use of Tawarruq, i.e. the client selling the goods in the market purchased from the bank to get cash for any consumption or business activity. In this case, the Shar ¯ ı´ah board must ensure that the process of genuine Murabaha is completed, fulfilling the Shar ¯ ı´ah essentials, and that the cash realized by the client is intended for any Halal business/purpose. 366 Understanding Islamic Finance With regard to documentation in Murabaha, the auditor should ensure that the bank has received proper invoices for the goods and has taken delivery of the assets either by itself or through an agent authorized for this purpose. The date on invoices must not be later than the date of declaration by the client serving as agent. Sale is concluded when the bank accepts the offer, whereby the ownership, as well as the risk relating to the asset, is transferred to the customer. Ijarah – Internal Shar ¯ ı´ah Controls The other major mode Islamic banks are using is Ijarah, along with its variants like the leasing part of Diminishing Musharakah in financing of fixed durable assets. The following may be some of its controls: 1. The Shar ¯ ı´ah board should ensure that ownership title of the leased asset is transferred to the bank, i.e. the lessor. If it involves import, the bank should import in its name directly or through an agent/client. It has been observed that to avoid some taxes/charges, assets are imported in the name of the client/lessee. This is not advisable and the minimum that should be ensured is that a “counter deed” should be signed between the bank (lessor) and the client (lessee) for transfer of the ownership to the lessor. 2. If an identified asset is to be leased, e.g. a 2007 model Toyota car manufactured by company ‘ABC’, it must be ensured that the bank acquires the ownership before entering into an actual Ijarah agreement. Prior to that it would only be a “promise to lease”. 3. The Ijarah asset, the lease period and the rental must be defined properly. It also needs to be seen that the intended use of the asset is permissible. 4. In situations where a floating rental is stipulated, the first rental should be specified and then a certain benchmark applied for determination of future rental along with a proper floor and cap. In addition, rental for the subsequent period should be agreed in absolute value before the start of the period. 5. It has to be ensured that conventional insurance is not taken, particularly when Takaful is available. 6. Ijarah and Bai‘ are entirely different types of transactions in terms of their implications for the parties involved. Therefore, the two transactions should not be mixed in such a way that their respective Shar ¯ ı´ah essentials are not fulfilled. Transfer of ownership to the lessee should not be an integral condition of the lease agreement. It could be a unilateral undertaking or promise, not binding on the other party. A separate contract has to be entered into for transfer of ownership of the asset to the client at the end of the lease term. 7. A Shar ¯ ı´ah board should ensure that expenses relating to purchase and ownership of the asset are borne by the bank. As such, expenses that are necessary to maintain the overall corpus of the asset are the lessor’s responsibility. 8. As per the AAOIFI’s Accounting Standard for Ijarah, accounting for Ijarah-based financ- ing should be similar to that of operating lease and not that of finance lease. 9. It should be ensured that if rental is received in advance, the same cannot be treated as bank’s income, even if an accounting period is lapsed. An auditor should check the delivery orders to ensure that the asset had been delivered at the time of commencement of the lease period and accrual of the rent. 10. Any penalty received by the bank in cases of default or late payment of lease rentals should be given to charity, as approved by the Shar ¯ ı´ah board. Financing Principles and Practices 367 Other Modes – Internal Shar ¯ ı´ah Controls Similarly, for all other modes which an Islamic bank is using, a Shar ¯ ı´ah board should identify the minimum controls which must be ensured so as to maintain the sanctity of Islamic business products. For example, in Diminishing Musharakah, different documents relating to the creation of partnership, leasing and sale of units to the other party must be independently enforceable. All expenses relating to ownership must be borne by the parties in the proportion of their ownership. If a jointly purchased asset is not capable of being leased (like an open plot of land), it cannot be leased to charge rental, because it is only a commercial asset and can give profit only upon its sale. If commercial assets are involved, the nature of the partnership will be that of Shirkatul‘aqd and the units may be sold only at market or agreed-upon value at the time of sale. Similarly, they can be revalued only keeping in mind their actual value, and if it is prestipulated that units will be revalued by ( )% per month/annum, without regard to the actual value, the transaction will become usurious. In the case of Musharakah agreements for financing, profit rates are projected in the agreements with the customers on the assets side. The Shar ¯ ı´ah department will need to ensure that payments to banks under projected rates are subject to an approved final adjustment procedure. Treatment of loss, if any, by the bank management is also crucial and it must be ensured that loss is borne by the partners in proportion of their share in the joint investment. Further, investments in shares of joint stock companies should be subject to the screening criteria approved by the Shar ¯ ı´ah board and in the case of any non-compliance, the dividend income or the capital gain from non-Shar ¯ ı´ah-compliant investments must go to the Charity Account. An Islamic bank’s placements with other institutions should be only on any of the Shar ¯ ı´ah- compliant bases and any income from non-Shar ¯ ı´ah-compliant placements must go to charity. It should also be ensured that the bank fulfils the necessary disclosure requirements and profits are distributed among shareholders and various categories of depositors according to the already disclosed criteria/ratios/weightages. Finally, the use of charity fund proceeds has to be overseen by the Shar ¯ ı´ah board. Generally, it is left to Islamic banks themselves as to whom and how they disburse such funds. However, if regulators in respective countries do not advise any procedure/avenues for disbursement of charity funds, Shar ¯ ı´ah boards must ensure that these are used for the uplift of the poor or for social welfare projects in the respective economies/societies and are not used for any other purpose not conforming to the Shar ¯ ı´ah tenets. 14.3.5 Operational Controls Islamic banks’ assets are normally risk-based. They may finance projects on the basis of equity participation and profit-sharing in addition to debt-based modes of trade and leasing. Therefore, the soundness of their operations needs a type of control that goes beyond merely ensuring the solvency of debtors. To ascertain operational soundness, the regulators need to undertake the following procedures: 1. The application of consolidated and acceptable accounting standards suitable for Islamic modes of financing. 2. A review of project financing operations to ensure soundness of the bank’s performance in preparing feasibility studies and evaluations and follow-ups on project implementation. [...]... see AAOIFI, 2004–5a, Standards on Set-off, 2004–5, pp 46– 48; Standard on Trading in Currencies, clause 2/10, p 8 3 78 Understanding Islamic Finance The framework of the IERS is based on the concept of Shirkah The State Bank shares in the actual profit of the Musharakah pool maintained by the Islamic bank that provides export finance under various Islamic modes However, if the actual profit of the pool... http://www.kfh.com/english/index.asp http://www .islamic- commerce.net/index.php?name=News&file=article&sid=331  384 14.5 Understanding Islamic Finance ISLAMIC BANKS’ RELATIONSHIP WITH CONVENTIONAL BANKS Islamic banks represent a link in the chain of the financial system It seems inconceivable that they could operate totally in isolation, disregarding conventional banks on the basis of the prohibition of interest An Islamic banking... holders and the depositors 8 The author is grateful to Mr Faisal Shaikh of Bank Islami Pakistan for sharing knowledge on practical issues of Islamic finance, particularly for this chapter 9 AAOIFI, 2004–5b, Governance Standard No 1, Shar¯´ah Supervisory Board, para 13 ı 10 AAOIFI, 2004–5b, Governance Standard No 1, Shar¯´ah Supervisory Board, para 16 ı 388 Understanding Islamic Finance The Shar¯´ah board’s... that, in addition to the surplus maintained by 386 Understanding Islamic Finance the Islamic banks, foreign banks have been accepting dealing on the basis of mutual agreements by simple exchange of letters, to enable Islamic banks to avail confirmation facilities up to an agreed ceiling without charging interest if the accounts are overdrawn In consideration, Islamic banks undertake to abide by the following:... profitability and cash flow of the fund users They can provide working capital finance, trade finance, consumer finance and project finance to public and private sector entities through individual or syndicate arrangements Financing Principles and Practices 387 Along with Shar¯´ah compliance, profitability and liquidity, Islamic banks need to keep in ı mind the impact of their financing policies and... the loss 14.4.2 Trade Financing by Islamic Banks Trade finance operations of banks play an important role in the overall economic development of any country, through facilitating imports and exports Since it usually involves assets, the conversion of the trade finance operation to Islamic modes is relatively easier Islamic banks can use Musharakah/Mudarabah in trade finance to build a profitable and...3 68 Understanding Islamic Finance 3 An evaluation of the performance of the bank in monitoring and controlling the enterprises it finances by way of equity participation This would also include looking into the ability of the bank to deal with the problems facing enterprises,... values Return-free loans based on Tabarru‘, which are noncommutative contracts, are exempt from this general rule Some of the implications of this rule of Islamic finance in respect of modern transactions are discussed below 376 Understanding Islamic Finance When a contract is concluded for the sale of an amount of currency, possession must be taken for the whole amount at the time of concluding the... projects, some central banks provide to the commercial banks or NBFCs a refinance facility against their disbursement to the priority areas This refinance is normally based on interest, but it is possible to provide such refinance in a Shar¯´ah-compliant manner For ı example, the central bank in Pakistan (SBP) provides an Islamic export refinance scheme (IERS) on the basis of Musharakah Its main features... specialized jurists in Islamic commercial jurisprudence It may also include other experts in areas of Islamic financial institutions with knowledge of Islamic jurisprudence relating to commercial transactions The Shar¯´ah board is entrusted with the duty of directing, reviewing and supervising the ı activities of the Islamic financial institution in order to ensure that it is in compliance with Islamic Shar¯´ah . SERVICES/BUSINESS The major players in the finance industry include Islamic commercial banks, Islamic invest- ment banks and other non-banking Islamic financial institutions, Islamic funds and unit trusts,. follow-ups on project implementation. 3 68 Understanding Islamic Finance 3. An evaluation of the performance of the bank in monitoring and controlling the enterprises it finances by way of equity participation rule. Some of the implications of this rule of Islamic finance in respect of modern transactions are discussed below. 376 Understanding Islamic Finance When a contract is concluded for the sale