Muhammad Ayub Understanding Islamic Finance phần 8 potx

352 Understanding Islamic Finance his effort or time spent. Therefore, Ju‘alah is not affected by the uncertainty with respect to the subject matter or the work to be done. This is why it is suitable for activities for which Ijarah is not. It is not a condition of Ju‘alah that the worker be specified and it is sufficient that an offer is issued to the general public, in response to which any person can undertake the work himself or with the help of others. However, if any worker is specified, then he himself will have to undertake the work or he can involve others with the express consent of the offeror. Ju‘alah is similar to agency, in which seeking help from others is valid. Ju‘alah per se is not a binding contract. Parties in a Ju‘alah contract are entitled to terminate the contract unilaterally. However, when the worker commences the work, it becomes binding and if the offeror revokes in between, he will have to give a reasonable wage to the worker. The basis for the entitlement of the worker to receive reasonable wages when the contract is revoked after commencement of work is that the work done by the worker is legally valid and loss is not to be caused to him. When the parties undertake not to terminate the contract within a specified period, they must observe such an undertaking. If the worker himself revokes the contract after commencing the work, he has no claim against the offeror, unless they had agreed to the contrary. The worker is considered a trustee as to the property of the offeror in his possession. As such, he is not liable for any loss except in the case of negligence, misconduct or violation of the stipulated conditions. 13.4.2 Subject Matter of Ju‘alah and Reward The subject matter of Ju‘alah is the work required to be done and the compensation agreed for the work. As Ju‘alah is a contract of exchange, it is necessary to indicate a task and the reward. The task should not be a legal or an employment obligation upon the worker and must involve some effort. The reward should be known and valuable, i.e. is permissible consideration, and deliverable when required, so as to avoid any uncertainty when the result is realized. The reward can also be a certain portion of the realized result. If the work to be realized is determined, a Ju‘alah contract is valid, despite uncertainty about the amount of work to be put in by the worker and the possibility of realization of the result. Ju‘alah can be used for undertaking various activities like extraction of minerals, finding any lost asset or property, collection of debts, getting any information for the benefit of the offeror, such as presenting a report on any subject or the project or undertaking any scientific invention, etc. For example, governments may ask some firms for extraction of minerals with the condi- tion that a specified amount of money will be given only to those who find any agreed-upon mineral with specified features. Ju‘alah can also be used for collection of due but defaulted debts, where the entitlement to compensation is contingent upon collection of agreed upon- debts/receivables. Compensation in this case can also be related to the amount of realized debts on a proportionate basis. For innovations, scientific discoveries and designs such as trademarks, the entitlement to compensation is contingent upon realization of the discovery or the accomplishment of the stipulated job. If Ju‘alah is used for brokerage activities, the entitlement to compensation will be contin- gent upon completion or execution of the contract for which the brokerage service has been sought. Some Accessory Contracts 353 An offeror can specify a time for accomplishment of a job, after which the worker will not be entitled to any reward except any stipulation or adjustment otherwise. For example, parties can agree that if work on the job is at an advanced stage but remains incomplete due to any genuine problem, the completion time may be increased with mutual consent. 13.4.3 Execution of a Ju‘alah Contract Ju‘alah can be concluded by an open or informal offer to the public. In this case, any person who hears or receives the offer and is interested to do the job may do so, either himself or through the assistance of another person. However, if a Ju‘alah contract is concluded with a specified worker, such a worker is obliged to perform the work himself. Conclusion of a Ju‘alah contract does not require a counter acceptance by another party (as is required in Ijarah), because the requirement of counter acceptance in Ju‘alah is practically unattainable, except when it is concluded with a specific worker who is obliged to perform the work himself. As against Ijarah/Ujrah, the claim to the reward is not enforceable until the completion of the required work. (In Ujrah, the worker who had agreed to work for a stipulated time is entitled to a wage if he has worked for the settled time, irrespective of the work being completed or not.) However, the worker is entitled to the reward prior to the completion of the work in the following situations: 1. When it is found that the worker has worked to realize a result in respect of a property that does not belong to the offeror and a legal decision to that effect has been issued. 2. When an accident that was not due to the negligence or misconduct of the worker causes impairment of the value of the subject matter of the contract; here, the worker is entitled to the full reward. The worker is not entitled to a reward if Ju‘alah is terminated unilaterally by either party before the commencement of work. However, when the contract is terminated by the offeror after the work is commenced, the former is obliged to pay to the worker the common market remuneration. 13.4.4 Parallel Ju‘alah Contracts A bank, after taking work, can get it done by others on the basis of a Parallel Ju‘alah. The two contracts will be independent of each other. The bank may play the role of the worker by signing a Ju‘alah contract. It may carry out the work itself or through another parallel contract with a third party, provided the first Ju‘alah contract does not require it to do the work itself. It is also possible for the bank to play the role of the offeror for performance, irrespective of whether it needs the work for its own benefit or for the fulfilment of its obligation in a Parallel Ju‘alah contract, taking into account that the two contracts remain independent. 13.4.5 Practical Process in Ju‘alah by Islamic Banks Ju‘alah can be used by Islamic banks for a number of services, directly or through a Parallel Ju‘alah contract with the following process (see Figure 13.1): 1. The customer negotiates with the bank for performance of uncertain work in a specified time for an agreed reward. 354 Understanding Islamic Finance 2. The bank agrees to perform the work after conducting a cost versus benefit analysis, and a Ju‘alah contract is entered into between the bank and the customer. 3. The bank finds a worker with the expertise to perform such uncertain work on his behalf and a Parallel Ju‘alah contract is made with him. 4. The work is completed by the worker and an agreed wage or reward is paid to him by the bank. 5. The bank collects its reward from the customer with whom the initial Ju‘alah contract had been entered into. Similarly, banks can take services from others on the basis of Ju‘alah. Recovery of nonperforming debts is one such example. Customer Worker ISLAMIC BANK 4 3 1 5 Parallel Ju´alah contract Negotiation to perform an uncertain work in specified time Receiving of reward on completion of work xxxxxxxxx xxxxxxx 2 Ju´alah contract Accomplishment of work for an agreed entitlement Figure 13.1 The Ju‘alah process 13.4.6 Some Islamic Financial Products Based on Ju‘alah Collection of Debts Ju‘alah contracts can be used for collecting due debts where the entitlement to the reward is related to realization of all or part of the debt. For example, a Ju‘alah contract for recovery of debt is entered into between “A Bank” and “B Ltd”. The contract provides for the reward Some Accessory Contracts 355 as a percentage of the amount collected on the basis of Ju‘alah. The reward can also be paid in advance in full or in part, before completion of the work. However, in such a case, the worker shall not be absolutely entitled to reward until the required result is realized and the payment shall be made “on account” to him. Securing Permissible Financing Facility Ju‘alah contracts can be used to secure permissible financing, in which a worker is required to do some form of service, like preparing of feasibility, that will make the bank agree to provide the facility to the offeror. Brokerage Ju‘alah contracts may also be used in brokerage activities, where entitlement to reward is attached to the signing of a contract which is intermediated by the broker. 13.5 BAI‘ AL ISTIJRAR (SUPPLY CONTRACT) Istijrar is not a specific mode; it is rather a repeat sale/purchase arrangement of normal sale in which a seller agrees to sell various amounts/units of a commodity from time to time. The seller may also deliver the commodity agreed upon once in a number of consignments and the price may be determined in advance, with every consignment or after the delivery of all consignments. The terms and conditions of repeat sale may be of any normal cash or credit sale. An agreement may take place between the buyer and the supplier, whereby the supplier agrees to supply a particular product on an ongoing basis, for example monthly, at an agreed price and on the basis of an agreed mode of payment. This is a modus operandi by which a master agreement is signed for financing on an ongoing basis under any suitable normal modes. As it is a normal day-to-day business, Shar ¯ ı´ah scholars give some relaxation on the matter of fixation and payment of price if the arrangement does not involve Gharar. 6 Such types of arrangement take place between wholesalers and retailers. Normally, the seller goes on delivering specified goods at the price known to the buyer and the buyer makes payment on a monthly basis or as agreed between them. A supplier of bread may go on supplying bread to a retailer for a month and may take payment once after the month. However, if any formal or informal contracts take place on the basis of any specific mode, like Murabaha or Salam, their conditions and Shar ¯ ı´ah essentials have to be fulfilled. In the case of Murabaha, for example, separate offer and acceptance would be needed for every consignment, based upon requisition of the client. 6 Obaidullah, n.d., pp. 101, 177. 14 Application of the System: Financing Principles and Practices 14.1 INTRODUCTION By now we have discussed the philosophy and features of Islamic finance, given an overview of the products and financial services possible in the Islamic framework and also the major modes that form the basis of Islamic financial products. Direct or indirect financial intermediation by banking or non-banking institutions involves mobilization of resources from the surplus units in an economy and their supply to the deficit units. The deposits side of banks has been discussed in the necessary detail in Chapters 8 and 12. Some areas of financing by Islamic banks have also been discussed in chapters on the basic modes; but the investments or financing side needs detailed discussion in terms of the principles underlying prudent Shar ¯ ı´ah-compliant investment practices and some specific areas of financing, enabling readers to fully understand the functioning of Islamic banking and finance. In the present chapter we shall discuss the principles governing Islamic financing and how these can be implemented for proper functioning of the system. Prudent financing requires vigorous product development and implementation along with prudence, proper risk management and Shar ¯ ı´ah compliance. It is pertinent to observe that “money earning money” does not fit into the Islamic structure; money has to be invested in goods that may yield profit on the basis of risk/liability-taking and value addition. Islamic banks have to conduct business in a win–win scenario, just like any other business, while avoiding non-Shar ¯ ı´ah compliant elements like interest, Gharar, gambling and other unethical practices. For this purpose, they have to design instruments and diversified investment portfolios that may generate profit with sufficient liquidity to fulfil the expectations and demands of the depositors. To maximize profits, they need to look for investments that yield the highest return, minimize risks and provide adequate liquidity, albeit keeping in mind the business ethics prescribed by the Shar ¯ ı´ah. The Islamic banking and finance industry is facing a number of challenges. The biggest challenge is to develop products of investment and financing which not only are in accordance with the Shar ¯ ı´ah principles but also meet the ever-growing and changing needs of trade, business and industry, both in the private and public sectors. Only this way can they meet the challenge of confidence-building and enhancing the integrity of Islamic financial institutions. Innovation is the most critical success factor in the current financial era. A Shar ¯ ı´ah inspired and compliant product innovation process is different from the conventional product development process, as it has to follow the additional parameters of conformity with Shar ¯ ı´ah tenets. It requires common efforts of the Shar ¯ ı´ah scholars and the bankers. 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 [...]... 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... 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:... 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... 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 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... 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... 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... with Islamic banking is conformity with the legal framework in vogue Unlike conventional banking, Islamic banking products might need complete re-engineering with a slight change in the legal framework, for which Islamic banks may get regulators’ guidance It is possible that an Islamic bank may have to develop the same product on an entirely different structure to accommodate the legal framework As Islamic. .. 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 philosophy and features of Islamic finance, given an overview of the products and financial services possible in the Islamic framework and also the major modes that form the basis of Islamic financial