islamic finance

November 2012

Islamic Banking and Finance

Introduction to Islamic Finance

Sharia structure


Sources of Guidance of Islamic Financial Operations

Compliance with Sharia is derived from :

• QURAN (Primary source of Sharia)

• SUNNAH (Practices of the Prophet)

• IJMA’ (Consensus)

• QIYAS (Analogy)

• IJTIHAD (reasoning of a group of qualified scholars, which is aimed at adapting Islamic rules to the contemporary world)


Quran

- Primary source for discerning the laws of God

- Binding to Jurists to have the first recourse to the QURAN for answers

- Evidence found in other sources are subject to the QURAN

- Example : « God has permitted trade and prohibited Riba »

Reference : Surat Al Baqara verse 275


Sunnah

- Literally means : « Well-known path »

- Words or Acts of the Prophet

- Sayings of the Prophet (SAW) used to lay down and give moral guidance

- Acts of the Prophet (SAW) which have a legal content (ex: method of praying)

- Tacit approval (silence) of the Prophet (SAW) on the action of one of his companions in his presence or in his knowledge


Ijma’

- Literally means agreement on a matter

- In its technical sense, it means « the consensus of the independant jurists from the Ummah of the Prophet Muhammad (SAW) after him

- Example : Jurists have reached a consensus (Ijma) that the selling of goods by a party who doesn’t own the goods and without the approval of the goods’ owner is void


Qiyas

- Literally means measuring or estimating one thing in terms of another

- Technically, it is the assignement of the legal rule of an existing case found in the texts of the QURAN, the SUNNAH, or IJMA’ to a new case whose legal rule is not found in these sources.

- Example : « Jurist looked into details of the prohibition of alcohol. After analysis, it was decided that the underlying reason is intoxication . Once this has been defined, the scholars would look at other liquids that intoxicate and extend the legal rule »


Ijtihad

- Number of meaning of Ijtihad

- Islamic scholars take into account the customs of a place that adress a problem but are not offensive to Sharia

- In some cases, Islamic Scholars develop their own preference from a solution to an apparently unique problem

- Fundamentaly, it is a personal exercise until other scholars are able to agree with the solution proposed by the innovator.


Authorities on interpretation

- Four different schools of jurisprudence make up the SUNNI world of Islam :- Maliki : North Africa

- Hanbali : Saudi Arabia and Gulf region- Hanafi : Eastern Europe , asia and Turkey- Shaafi’ : Malaysia and South east Asia- While the Shia world follow their own seperate schools (Mainly Irak

and Iran)

- The Islamic Fiqh academy (created in 1981 by the Organisation of Islamic Countries) is a body which meets periodically to discuss issues originated from Islamic thinking

- Sharia scholars or Sharia Board


Islamic Finance Principles - Concept

No intrinsic value in money :- Money as a way of exchange and a store of value not subject to trade

Fundamental principle :- Risk sharing partnership => Profit and Loss Sharing (PLS)- basically, no pain no gain


Islamic Finance Principles - Rationales

Requirements RationaleAsset backed Transactions must be backed by tangible

assetsProhibition of payment/receipt of Riba Prohibition of interest as incremental of debt

Prohibition of activities Considered harmful to the society (e.g. alcohol, pork, weapons, drugs, pornography business, etc…)

Prohibition of Gharar (uncertainty) and Maysir (gambling)

Subject of contract must exist, must be specifiable and measurable. Speculative trading in financial instruments is prohibited

Profit/Loss Sharing The bank act as an agent/partner with the depositor who is entitled to share the gains/loss of the investment

Sharia Compliant Transaction


Islamic Finance Principles – Riba

- Literally means « excess »

- Prohibition of payment/receipt of Riba interest as incremental of debt

- 2 types of Riba :

- Primary form : Riba al Naseeyah

=> Excess resulted from predetermined interest which a lender receives over and above the principal amount

- Second form : Riba al Fadl

=> Excess compensation without any conisderation resulting from an exchange or sale of goods (exchange of commodities contracts)


Islamic Finance Principles – Ethical dimension

- Undesirable sectors :• Tobacco• Alcohol• Arms or munitions• Gambling• Pornography• Conventional financial services

- Charitable aspects :• Interests donated to charity (cleansing / purification)• Zakat – charitable tax paid by muslims according to Quranic guidance


Islamic Finance Principles – Gharar and Maysir

- Gharar literally means « overall uncertainty »

- Maysir means « gambling »

- May be defined as preventable ambiguities or omissions in contracts

=> ex : Buying a house , the price of which need to be specified in the future or price is fixed but specification is to be defined in the future

- Consequence of this principle : Buying and selling in most types of derivatives products for any purpose including speculation is strictly forbidden


Islamic Finance Principles - Contracting

- Aqd litterally means contract- Majority of scholars defined the following requirements :

- Contracting parties (Mature and sane)- Subject Matter (Valuable, Existence, Ownership, Ability to deliver, Specific)

=> consequence : speculation like short selling is forbidden- Offer and acceptance : consent of the parties is fundamental element in concluding a

contract- Price : should not be uncertain or depending on future events

- Classification of contracts :- Sahih litterally means « valid » which could be either :

- Nafiz : enforceable- Mawqoof : unforceable until authorized

- Fasid : voidable- Batil : invalid


Islamic Finance Principles - Implications

Implications => All products need to be approved by the Sharia scholars

This may have sevral implications :

-Costs

-Timing

-Latitude of flexibility


Special feature : Sharia board

One distinct feature of the modern Islamic banking movement is the role of the Sharia boards boards made up of Islamic jurists and scholars available to an Islamic

financial institution for guidance and supervision in the development of Sharia compliant products, which have to approve all transactions :• Sharia board ensures that investments structures are in line with Islamic law• Sharia board has the responsibility of laying down the underpinning Sharia

principles and rules that the institution should adhere to• Sharia board Publish annually, a report concerning the level of Sharia'a

compliance of the entity• The Sharia Board is not responsible for:

- Shareholders’ money- Funds operation management- Funds portfolio management


Supranational authorities governing Islamic Finance

- AAOIFI (1991) : Accounting and Auditing Organisation for Islamic Financial institutions=> Benchmark of islamic accounting and auditing standards (56 standards)

- IFSB (2002) : Islamic financial Services Board=> Standard setting body of regulatory and supervisory agencies (complementing BASEL II

Capital Accord)

- IIFM (2001) : International Islamic Financial Market=> Development of Global Islamic capital and money market

- GCIBFI (2001) : General Council for Islamic Banks and Financial Institutions=> Promoting industry in theory and practice

- LMC (2002) : Liquidity Market Council=> Creation of active Islamic inter-bank market

- IIRA (2005) : International Islamic Rating Agency=> Rating of Islamic Financial institutions


The components of the Islamic Banking and Finance industry

1) Banks

- Investment & Investment management

=> ex : Al-Meezan

- Generic Banking services (current accounts, transfers, credit cards, home finance, etc.)

=> ex : Al-Meezan and islamic banking windows of the banks

2) Equity and Capital Markets

3) Insurance companies : Takaful


Operating structures of Islamic Banks

1) Window model=> Operating structure where a conventional bank simultaneously carries out Islamic Financial activities but assure clients of segregated accounting and operations for conventional and islamic activities (ex : Askari, standered chartered)

2) Branches=> Similar to window model but services are offered through dedicated channels

3) Subsidiaries=> Seperate legal entity (subsidiary) set up specifically to undertake Islamic Financial services activities – Formulate and manages its own policies

4) Fully-fledged islamic banks=> Pure Islamic banks which offers only Islamic Financial services


Balance Sheet of an Islamic Bank

Assets• Cash & equivalents• Murabaha financing• Mudarabah financing• Musharakah Financing• Sukuk• Assets for trading (securities,

inventory,other assets)• Invetsments (not for trading)• Other assets• Fixed asets

Liabilities• Customer current accounts

(not remunerated)• Due to banks and financial

institutions• Payables• Other liabilities• Sukuk issued• Profit sharing Invetsment

Account (restricted vs unrestricted)

• Equalization reserve• Share Capital & Reserves


The Islamic Financial instruments

Islamic monetary instruments

Islamic debt-like instruments

Islamic asset-like instruments

Hybrid Islamic Finance instruments

Takaful (Insurance)


The Islamic Financial instruments

Islamic Financial instruments

Hybrid instruments :Securitization - SukukStructured products

Equity like instruments :- Equity

- Mudaraba-Musharaka

-Invetsment funds

Debt like instruments :- Murabaha

- Ijara- Salam

- Istisna’a

Monetary instruments :- Current account

-Term deposits & PSIA- Tawarruq

- Arbun

Takaful (insurance)


Islamic Monetary instruments

- Current accounts

- Term deposits or PSIA (Profit Sharing Investment Account)

- Tawarruq

- Arbun


Islamic Monetary instruments – Current accounts

- Used for day to day cash management. No return is paid to depositors

- Used for higher return savings account

- Banks may sometimes pay a return, depending on their own profitability.

- Losses are not in practice passed on to depositors and are absorbed trough the banks’ reserves

- 3 forms :

- Amanah form (applied globally)

=> entrusted to the bank for safe keeping and should be returned in whole

- Wadia form (applied in Malaysia)

=> Wadia is a promise to return the money to the depositor

- Qard hassan

=> loan without interest or yield between the client and the bank

- Complete segrergation of funds and no overdrat facility on these acounts


Islamic Monetary instruments – Term deposits or PSIA

- PSIA = Profit Sharing Invetsment Account

=> These are specific to Islamic Finance industry

- Considered as investment accounts under the mudaraba format

=> Islamic banks receive funds from the PSIA holders who place their funds on the basis of the mudaraba profit and loss sharing bearing account

- Deposits are fixed term and cannot be cashed in before maturity (some exceptions)

- The profit-sharing ratio varies between institutions and could be a function of the banks profitability or that of the portfolio of end borrowers

- Can be Restricted or Unrestricted

- Application of equalization reserves



- Restricted :

- Like collective investment scheme

- The asset allocation is restricted as set out in the contract

- No secondary market but invetsors may be able to to withdraw their funds (including unredistributed profits but less any losses) before

maturity with the agreement of the bank

- The scheme is not a seperate legal entity but operates as a mudaraba agreement (bank = mudarib and client = rab al mal)

- The bank is entitled to a percentage of the invetsment income for a financial period as its fee for investment management but does not

share in any periodic losses



- Unrestricted :

- The asset allocation is not restricted by contract. The bank as a mudarib will place the funds in any Sharia compliant investment at its sole discretion.

- Less risky than the restricted PSIA as the bank tries to mitigate the risk by placing money in a basket of Sharia compliant investments

- Lack of transparency

- Corporate governance issue as the funds from the holders are co- mingled with other funds at the banks disposal => possible conflict interests with regard to the choice and riskiness of investments and the allocation of the income from those investments

- Different applications in different countries


Islamic Monetary instruments – Tawaruq

- Contract whereby the bank sells to its client a commodity with a forward payment (also called reversed murabaha)

- The client sells it immediately to a third party on spot generating therewith some cash availabilty

- Usually no exposure on market to the price risk fluctuation of the commodity as actions (i) to (iv) are undertaken simultaneously


Islamic Monetary instruments – Arbun

- Pre-purchase of right to acquire asset :

- Deposit/down payment for the purchase of an asset at a later date which will be kept by the seller in case the sale does not happen. This down payment constitues a part of the purchase price and thus is not refundable.

- Because of its similarity to an option, it has met with varying levels of approval from the school of islamic jurisprudence

- Usually combined with a murabaha product

- Most acceptable to Hanbali scholars


Islamic Debt like instruments

- Murabaha

- Ijara

- Salam

- Istisna


Islamic Debt like instruments - Murabaha

- Literally means « profit »

- Contract where the bank upon request by the customer purchases the asset from a third party and resells it to the customer on a deferred payment basis

- Sale of goods at cost plus an agreed profit mark up

- Difference between a murabaha and a loan :- The bank must have some form of actual ownership constructive or physical- The maturity can be extended but may not result in an increase in the mark-up

or a penelaty fee. Any of these would violate the basic principle riba- If the payment is late, no form of penalty may be charged for the profit of the

creditor (even though a tird party colection agent can recover costs of collection


Islamic Debt like instruments - Murabaha

1. Definition of needs and goods specifications

2. Binding promise to buy which can be structured using Arbun

3. IB buys the goods at spot from the seller

4. Spot Delivery of goods to the Bank

5. Spot Delivery of goods to the Client

6. Payment of instalments or deferred payment at P + margin

=> Profit declared as a mark-up

=> Buyer knows seller’s cost


Islamic Debt like instruments – Commodity Murabaha


Islamic Debt like instruments – Commodity Murabaha

1. Islamic bank instructs the conventional bank as agent to invest say US 10 million for one month.2. The conventional bank buys a commodity from a broker A, value spot on behalf of the Islamic bank. 3. The conventional bank sells the commodity at cost plus mark-up on a deferred payment basis (one month) to Broker B. Buying and selling is very fast (less market fluctuation exposure)4. On maturity (in one month) the conventional bank pays to the Islamic bank profit (mark up) plus the original investment of US 10 million.5. Commission will be payable to the conventional bank as agent (approximately 25 basis points) and to the commodity brokers (approximately $50 per 1 million of the commodity) on buying and selling the commodities. These commissions will be built into the price quoted to the Islamic bank are not accounted for separately.6. The mark-up is typically based on the LIBOR as a benchmark which makes these transactions comparable to traditional interbank deposits.


Islamic Debt like instruments – Ijara

- literally means to give something on rent.

- Ijara contract is an agreement wherein a lessor (mu’ajjir) leases physical asset or property to a lessee (musta’jir) who receives the benefits associated with ownership of the asset against payment of predetermined rentals (ujrah). Ijara is for a known time period called ijara period.

- utilized by banks as a mode of financing to provide the customers with short to medium-term financing to lease

- Ijara is comparable (but not identical) to conventional leasing contract.

- Ijara is less risky as compared to other financing structures

- Liability is known from day one – No surprises or uncertain exposure.

- Strict compliance with Sharia and the applicable law is required for enforceability.



Customer

Islamic Bank

Step 1Promise to

leaseStep 3

Acquisition of the Property through purchase agreement

Step 4Purchase Price

Title & Possession tothe Property

Step 6Lease Rental

Step 5Lease of the Property

to the customer throughLease Agreement

Usufruct of the Property

Step 2Purchase Offer

Owner / Developer



• Ijara: 3 types- Simple Ijara (Operating lease)- Ijara Muntahia Bittamleek (Finance lease)- Ijara Mawsoofa Bil Thimma (Forward lease)

• Simple Ijara :- Commonly known as operating lease. Also called a service lease, or a true lease. - It is a short-term arrangement.- Full cost of the equipment or property is not amortized during the primary lease period.- Lessee may cancel the lease any time he wishes to do so, with a prior notice according to

the contract.- In an Ijara, the title of the equipment or property always remains with the lessor

irrespective of how much the lessee has paid out as lease installments. Consequently, the risks and responsibilities of ownership are always borne by the lessor.

- Ownership of the asset remains with the lessor (bank), the asset reverts to the bank at the end of the lease period. The bank may then lease it out to another customer if the asset is in good shape.



• Ijara Muntahia Bittamleek- commonly known as financial lease- Also called “Ijara-thumma-al-Bay‘” (lease-sale) or "Ijara-wa-Iktina'a"- The lessee is offered the option of ultimately purchasing the asset or property at the end

of Ijara period at a predetermined price.- Full cost of the asset or property is amortized during the lease period.- Can not be cancelled except if the lessor is compensated for any losses.- The bank remains the owner till the very end bearing all the risks and responsibilities - The customer is responsible for only the rentals as long as he uses the equipment or

property. He becomes the owner only if, and when, he exercises his option - This Ijara involves two different contracts to be executed at two different stages :

• First a leasing contract (ijara) with a unilateral promise (wa’ad) to sell the asset to the customer at a predetermined price.

• Once the lease expires and lessee has made all payments, the lessor is obliged to fulfill his promise to sell by executing the contract of sale (bay’)

• the sale contract is independent of the ijara contract.



• Ijara Mawsoofa Bil Thimma - Commonly known as forward lease- Lease of specified items which are to be delivered after manufacturing or

construction- Lease of the underlying assets starts on the date of delivery of the asset to the

lessee and the lessee’s obligation to pay rental triggers with the commencement of the lease.

- An investor receives return on its investment out of the amount received from the lessee on account of rental which is adjusted against the actual rental.

- Although investment in assets under construction through may not be free from certain downsides, it still has potential to serve both the parties, i.e. customer and financier – addressing the Project Financing requirements.

- Appropriate structure for project financing


Islamic Debt like instruments – Ijara vs Murabaha

- Ijara, like murabaha is a debt-based financing. In both cases, the bank is not a natural owner of the asset (sold under murabaha or given in lease under ijara.) It acquires ownership upon receiving a request from its customer.

- Similar to murabaha, the ijara rentals are also paid in installments over time to cover the cost of the asset or value of investment for the bank plus a fair return on investment.

- In ijara, ownership of property is not transferred throughout the ijara period while the customer receives the benefits of using the asset.

- In murabaha on the other hand, the benefits and risks of ownership of the asset are transferred to the customer along with ownership.

- Both products involve cash outflows for customer or cash inflows for the bank over a definite future time period. Those flows are cover the cost of the asset and provide for a fair return on the asset to the bank.

- However, these cash flows are predetermined in case of murabaha and no subsequent increase or decrease is allowed. In case of ijara, however, the rentals could be flexible and be made to reflect the changing economic and business conditions


Islamic Debt like instruments – Ijara vs Murabaha

Different reasons why a customer will choose ijara (leasing) rather than murabaha (borrowing) from the bank to purchase the needed asset.1. It is easier to lease than borrow for short-term needs.2. To avoid different types of risk3. Ijara mostly do not require credit evaluation.4. Gives more freedom of changing equipment as technology advances5. Easier to get finance through leasing for companies with credit standing; these kinds of companies may not be able to borrow from banks or the public and if they do, have to pay high rate of interest.6. In many cases, leases can be advantageous from taxing point of view. Since equipment leased remains the ownership of the lessor and hence the lessor pay the taxes.7. In many countries, leasing is an off-balance-sheet financing. The asset itself is kept on the lessor's balance sheet, and the lessee reports only the required rental expense for use of the asset.


Islamic Debt like instruments – Salam

Purchase or sale of a commodity for deferred delivery in exchange for immediate payment


Islamic Debt like instruments – Istisna

Customer

Islamic Bank

Step 1Promise to

Purchase onParallel Istisna

basis

Step 3 Purchase of the described Property

through Istisna Agreement

Step 4Istisna Purchase Price

Delivery of the describedProperty after completion

Step 6Parallel IstisnaPurchase

Price

Step 5Sale of the describedProperty on Parallel

Istisna basis

Delivery to the Customer after

at completion

Step 2Purchase Offer

Owner / Developer


Islamic Debt like instruments – Istisna

• Agreement for manufacturing goods and commodities, allowing cash payment in advance and future delivery of the goods and commodities or a future payment and future delivery

• In Istisna sale, the seller sells a described property to be delivered to the purchaser once the same is completed.

• Istisna requires combination of either lease of the purchased assets back to the seller or sale of the purchased assets to the customer, provided that the purchase is not from the same customer.


Islamic Debt like instruments – Salam vs Istisna

- There are number of differences :- Under Salam, deliverables have commodity-like characteristics and must be

fungible like base metals or grain

- Under Istisna, deliverables are manufactured goods or constructed property

- Under Istisna, the price may be paid in advance, according to progress or in instalments post delivery

- Under Salam, the price must be paid in advance

- Under Salam, the contract may be cancelled

- Under Istisna, the contract may be cancelled unilaterally before work starts


Islamic Equity like instruments

Equity Mudaraba Musharaka

Investment in equities is acceptable if the fund does not invest in prohibited activities (industrial screening) and underlying respect the financial ratios (financial screening)

Purification : For interest on cash and underlying not 100% sharia compliant

Partnership in profit between Capital and Work

Agreement in which the investor (the rab- al-mal) provides the necessary finance while the recipient (mudarib or manager) provides professional, managerial and technical know-how towards carrying out the venture, trade or service with an aim of earning profit

Form of partnership between the Islamic Bank and its client

Each party contributes capital in equal or varying degrees, to establish a project or share in an existing one


Sharia compliant equities

Islamic stocks selection(Industry “sin” screen)Conventional Banking and Insurance

Alcohol (including distribution)

Pork (complete supply chain)

Weaponry (complete supply chain)

Gambling (Hotels, casinos, …)

Adult entertainment (complete supply chain)

Islamic stocks selection(Financial screen)Total Debt / market capitalization < 33%Interest income / Total revenue < 5%Account receivables / Total assets < 45% Ratios used by DJIM (Dow Jones Islamic Market) FTSE Global Islamic Index use the following :

Total Debt / Total Asset < 33%


Mudaraba

Investor (Rab el Mal) :- invests the capital

- has an absolute right to information

- risks loosing the capital

Expert-Manager (Moudarib) :- invests expertise

- empowered alone to make business

decisions

- doesn’t share financial losses (Looses time and efforts)

=> Similar to discretionary asset management


Two-tiers mudaraba


Musharaka Profit sharing and loss sharing contracts - Capital quantified and specific

- Profit distribution as per contract

- Losses repartition as per share of capital

Musharaka Contract between X and Y:- X Investment: 80.000 USD

- Y Investment: 20.000 USD

- Profit repartition: X 70%, Y 30%

Project generates 10.000 USD profit :- X receives: 7.000 USD

- Y receives: 3.000 USD

Project looses 10.000 USD :- X looses: 8.000 USD

- Y looses: 2.000 USD


Hybrid Islamic Financial instruments

Sukuk Structured Product

Sukuk are certificates of equal value representing common title to shares and rights in tangible assets, usufructs and services, or equity of a given project or equity of a special investment activity

14 types of sukuk foreseen by AAOIFI

Asset based (90% of issues) vs Asset backed

Asset backed refers to securities/Sukuk backed by income generating assets sold/transferred by an originator to a buyer/issuer (usually an SPV);

The main source of repayment => revenue from underlying Sukuk assets;

Securitization

Combination of two or more plain vanilla products


Sukuk (Islamic Bonds)

Saudi Electricity Company (SEC) Sukuk• Sukuk Assets comprise : - the right to undertake the following services for 20 years:

→ Reading electricity consumption and maintaining meters

→ Preparing, issuing & distributing electricity bills and the corresponding entitlement to levy charges according to the applicable regulation (CMR 169).

- and the right to levy and receive the charges relating to them

• The instrument is tradable during its life

• SEC appointed to continue to manage the services

• For certain Specified Customers only (exclude industrial, agricultural and governmental customers)


Sukuk (Islamic Bonds)


Takaful (Islamic insurance)

Takaful literally means “guaranteeing each other”

Sharia compliant alternative to conventional insurance

Can be thought of as a mutual insurer within a shareholder wrapper i.e. the shareholders operate the company on behalf of the policyholder and any insurance surplus is distributed back to the policyholders

Based on solidarity, co-operation & mutuality

Products are broadly similar to conventional insurance

Free of uncertainty (‘gharar’), gambling (‘maisir’) and interest (‘riba’)

Investments must be Sharia compliant (Sukuk bonds, collective investment schemes etc)

In theory and in practice in the more mature Islamic Finance economies, it is price competitive with equivalent conventional products

Insurance deficit will be financed with Qard Hassan (interest free loan)

The interest free loan will be paid as soon as surpluses arise


Takaful (Islamic insurance)

PricewaterhouseCoopers

Premiums

Claims Expenses Reinsurance

Capital & Reserves

Investment Income

Conventional Insurance

S/H Fund

Capital

P/H (or Takaful)Fund

Reserves

Contributions

Fees & Loan

Expenses

Investment Income

Takaful Company

Claims ReTakaful


Legal & Tax structures

Overview of Islamic Funds industry


Accounting, auditing, reporting and compliance principles

AAOIFI – Introduction

AAOIFI & IFRS - Comparison on structural objectives

AAOIFI & IFRS - Categories of accounting standards for IFIs

AAOIFI & IFRS - Examples of main differences

Adoption of AAOIFI Standards

How AAOIFI Standards support Islamic Finance Industry

Compliance and reporting requirements


AAOIFI - Introduction

- Responsible for formulation and issuance of international Islamic finance standards.

- Has issued 68 standards : 25 accounting standards; 5 auditing standards; 6 governance standards (incl. on Shari’a supervision); 2 codes of ethics;30 Shari’a standards (rules for application of Shari’a).

- Also developing new standards and reviewing existing standards.

- Supported by over 170 institutional members from over 35 countries.

- Members include central banks and regulatory authorities; Islamic and conventional financial institutions; accounting and auditing professions; and Islamic financial support services providers.


AAOIFI & IFRS - Comparison on structural objectives


AAOIFI & IFRS – Categories of standards for IFIs

1. AAOIFI standards issued because IFRS / IASB standards cannot be adopted in whole by Islamic financial institutions (IFIs)=> Cases where application of IFRS / IASB standards leads to Shari’a compliance issuesdo not fully cover characteristics of Islamic banking and finance.=> AAOIFI’s FAS 1 (General Presentation and Disclosure in Financial Statements of IFIs) covers IAS 1 (Presentation), 7 (Cash Flow), 18 (Revenue), etc.

2. AAOIFI standards issued for specific Islamic banking and finance practices that are not covered by IFRS / IASB standards=> Financial transactions and practices are unique to Islamic banking and finance=> AAOIFI’s FAS 2 (Murabaha & Murabaha to the Purchase Orderer), FAS 7 (Salam & Parallel Salam).

3. IFRS / IASB standards that can be adopted by IFIs=>IAS 10 (Events after Balance Sheet Dates), IAS 24 (Related Party Disclosures).


AAOIFI & IFRS – Example of main differences

PSIA (Profit Sharing Investment Account) :- IFI’s major source of funds generally managed by IFI based on Mudaraba investment management profit-sharing agreement.- Under Mudaraba investment management, IFI is not liable for loss arising from investments (except due to IFI’s misconduct, negligence, etc) – based on AAOIFI Shari’a standard.- AAOIFI accounting standards require ‘unrestricted’ investment account funds to be presented in statement of financial position as a separate item between liabilities and owners’ equity.- In contrast, based on IFRS, these would be presented as liabilities (along with other deposits).

IJARA (Leasing) :- IFI’s major financing mechanisms : Operating Ijarah and Ijarah Muntahia Bittamleek (leasing that ends with transfer of asset ownership to lessee).- For both, asset ownership rests with IFI throughout the lease term.- In Ijarah Muntahia Bittamleek, there must be independent contract for transfer of asset ownership.- As per AAOIFI accounting standards both Operations needs to be treated similar to Operating Lease.- In contrast, based on IFRS, both operations (especially if lease term is for major part of economic life of lease asset) would normally be classified and treated as Finance Lease.


Adoption of AAOIFI standards

AAOIFI standards are mandatory in 9 jurisdictions (and supranational entity) :Bahrain, Dubai International Financial Centre, Jordan, Qatar, Qatar Financial Centre, Sudan, South Africa (for investment management), Syria, and Islamic Development Bank Group.

AAOIFI standards are also adopted as guidelines or basis for national standards in jurisdictions including :Brunei, Indonesia, Kuwait, Lebanon, Malaysia, Pakistan, Saudi Arabia, and United Arab Emirates.

Overall, AAOIFI standards are used by all IFIs across the world.


How AAOIFI standards support Islamic Finance industry


AAOIFI standards – challenges and issues

- Global adoption of AAOIFI standards• In some countries, the standards are adopted in entirety and made mandatory by relevant national authorities.

• In others, they are adopted as basis of local standards issued by national authorities.

• Adopted in all major Islamic finance centres.

• Challenges in achieving global adoption include prohibitive local framework and differing Islamic

finance practices.

- Application of Sharia standards• Some jurisdictions do not have national framework for Sharia application on Islamic finance practices.

• AAOIFI Sharia standards are for Islamic finance practices that have been accepted internationally.

• Diversity in Islamic finance practices means there are practices that have not been covered by AAOIFI Sharia standards.


AAOIFI standards – challenges and issues (continued)

- Adequacy of AAOIFI standards• AAOIFI has to keep up with new products and services introduced in the markets.

• Development of standards depends on Shari’a pronouncement for such products and services.

• Meanwhile, existing standards must be constantly reviewed to reflect market development.

- Scope of AAOIFI standards• AAOIFI standards are only for Islamic financial institutions.

• AAOIFI standards are not designed for adoption by customers of Islamic financial institutions.

• Development of general Islamic accounting standard – requires broadening of role and mandate of AAOIFI.


Compliance and reporting requirements

- Interest bearing cash or investments are not authorized

- In case of interests earned, this will be purified in the cleansing process

- No overdraft on cash. In case of Interests, these will be compensated to the fund by originator.

- Islamic stocks selection : - Industrial screening (sectors prohibited)

- Financial screening (debt leverage ratios)

-Non compliant stocks :

- Fluctuation of financial data

- Evolution of the global financial market

- Mergers and acquisitions

- Temporary non-compliance => Stocks remain within the stocks universe

- Short-term non-compliance => The dividends for the period are not distributed

- Permanent non-compliance => Disinvestment occurs


Compliance and reporting requirements (continued)

- Signed Sharia Board report needs to be included in the financial statemens to be compliant with AAOIFI standards

- Cleasing to be performed :

- Purification of interest received (on overdrafts)

- Purification non-compliant portion of dividend income received (calculated using financial ratios data

- Can be linked to partial non compliant activities of underlying companies

- Information obtained from third party or already included in sharia compliant indexes

- Calculation process should be reviewed by Sharia Board

islamic finance

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