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riskupdate 2010 2010 The quarterly independent risk review for banks and financial institutions worldwide Risk Reward © Risk Reward Ltd UK. All rights reserved. Available by subscription only – not for sale or resale Islamic Finance FOUR ARTICLES INTRODUCING ISLAMIC BANKING AND FINANCE CONCEPTS WRITTEN BY MARK ANDREWS, HEAD OF ISLAMIC BANKING AND FINANCE, RISK REWARD LTD

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riskupdate 20




The quarterly independent risk review for banks and financial institutions worldwide

Risk Reward

© Risk Reward Ltd UK. All rights reserved. Available by subscription only – not for sale or resale


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There is much to both admire and praise about IslamicFinance. Its stated ethos and principles are probably as closeto a model for truly ethical and moral banking that has yetbeen developed and actually implemented on a large scale.

Based on the Quran, Islamic Finance offers its clients Shari’ahcompliant banking but the real meaning and to be fair, thetrue benefits of this, are often lost on Western observers,some of whom have tended to dismiss the sector as yetanother example of fundamentalist religious doctrine appliedto real life. But this cynical view is not only undeserved it isalso mostly inaccurate. In reality, even a cursory study ofIslamic Finance and its guiding principles will confirm it isindeed probably the most successful model for ethicalbanking to date. But it is not without its weaknesses, not leastof which is whether any institution can actually achieve theblueprint and live up to its full potential. The answer is almostcertainly “no” but does this detract from its merits?

The whole concept of Shari’ah compliant banking is byWestern terms still very much in its infancy. Someconventional banks have been trading for more than 400years, most for at least 50 and it is often a surprise to manyobservers that modern Islamic Finance actually started in itspresent format as recently as 1985. Of course trading andcommerce in the Islamic world is actually thousands of yearsold and pre-dates not only banking but Islam itself. Theremarkable legacy of this ancient history is that the basictrading contracts have been refined over millennia and stillsurvive, still work (in the main) and still underpin IslamicFinance.

The guiding principle of Islamic Finance is to provide bankingand financial services which are compliant with Shari’ah.Shari’ah is the Divine Law as revealed in the Quran (Book ofAllah SWT) and Sunnah (words or acts) of His ProphetMuhammad (PBUH).

The primary authority for Shari’ah is the Quran which means“the text of God” and is actually a blueprint for running asociety with detailed rules covering every aspect of aMuslim’s life including religious, family, community and ofcourse trading obligations. It stresses fairness, honesty,integrity and morality to all, even towards non- believers,which comes as a surprise to some people.

Next is the Sunnah which means ‘well known path’. It coversthe words, acts and tacit approvals of the Prophet (PBUH) asrecorded at the time and subsequently and includes theSayings (Hadith) which He used to lay down the law and givemoral guidance.

Next comes Ijma or “consensus/agreement” under whichsuitably qualified Islamic Scholars or Jurists are asked to ruleon points of Shari’ah law where the answer is not immediatelyavailable from the two senior sources. Then follows Qiyas or

“analogy”, which extends the law by applying commonunderlying attributes. Finally there is Ijtihad or “interpretation“, where Islamic Scholars are asked to rule on an apparentlyunique problem.

This structure seems to be comprehensive enough until youare reminded that the primary sources, the Quran and theSunnah, are actually 1,400 years old and chronicle the moral,commercial and religious challenges of that time. Eventhough the Prophet (PBUH) was clearly a pragmatist and maywell have accommodated some of the modern structuraldifferences, it is obviously a matter of faith that the historicaltexts are doctrine and must be applied literally and strictly.

Having to apply ancient standards to modern banking is andhas been a real challenge. Critics say it is disingenuousinvolving replication and retrospective “shoe horning” tomake it fit, but this dismissive swipe cheapens unreasonablythe value of what has been achieved in a very short time. Ifyou study the subject in detail it is hard not to congratulatemost scholars for reaching remarkably successfulcompromises even where the challenge seemed incapable ofbeing resolved.

Underpinning Islamic Finance are several basic rules whichcannot all be listed in detail in this article but the main onesare:

■ No uncertainty■ Trade must be in real goods and assets■ Sellers must be honest, totally frank and actually own what

they sell■ There can be no speculation or gambling ■ No trade in activities or products considered Haram or


These prohibited activities are generally well known andinclude no trade in pork, alcohol, armaments, pornography,etc.

The most significant basic rule and the one that perhaps mostdefines the ethos of Islamic Finance, is that all commercemust involve the real sharing of both profits and losses so thatall parties, including the bank, have a real and tangible stake inthe outcome of the transaction being undertaken.Consequently, and unlike a conventional bank which does, anIslamic Bank does not have a debtor or creditor relationshipwith its depositors and customers.

With one exception (Amanah or Trust accounts which are safecustody deposits and are not usually significant in numbers oramount) “depositors” are actually investors, all of whom agreeto invest alongside or via the Islamic bank and whose return isbased on a share of the banks actual profit and losses.Investors place money in the Islamic bank as trading partnersand are given a profit (and loss!) sharing share based on the

ISLAMIC FINANCE AN INTRODUCTIONThis is the first of three articles introducing Islamic Banking and Financeconcepts written by Mark Andrews, Head of Islamic Banking and Finance,Risk Reward Ltd.

Risk Update 2009 – Q2


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term,purpose, maturity, etcof the investment.

The actual investor accounts are based on theancient contracts of Amanah, Wikala, Wadia,Mudaraba and Musharaka but are generally also reported ascurrent accounts, investment accounts and special investmentaccounts by many Islamic Banks.

The key difference between Islamic “investors” and the“depositors” in a conventional bank is that Islamic investorsagree to share profits and losses whereas conventionaldepositors do not, especially the loss part! In theory,therefore, a loss making Islamic Bank could and should passon these losses to its investors who would see theirinvestments reduced as a consequence.

So far, this has not been put to the test in a major way and itis debatable whether an Islamic Bank could actually pass onlosses on a large scale, given that in reality most investorsregard their stakes as a one way bet. Would it trigger aNorthern Rock exodus? Possibly.

There are many myths about Islamic Finance principally thatit is banking for Muslims only. This is not true at all. Anyonecan open an investment account and apply for the full rangeof services on offer. Non-Muslims are welcomed.

The biggest challenge facing the sector is liquidity but not inquite the same sense that we use when looking atconventional banks. In a conventional bank liquidity is neededto repay depositors and liquidity “difficulties” usually meansthe bank cannot meet their withdrawal requests. It is fear

that drives this process and usually triggers panic, which inturn starts a wholesale stampede as depositors jostle to

get their money out first. Restoring confidence, veryquickly, is the only solution, something the authorities

failed to do with Northern Rock.

Faced with bank collapses in the West, all Islamicjurisdictions made it clear in unequivocal terms that

they stood fully behind the Islamic banks in theirterritories. As these territories included some of the richestcountries in the world, most Islamic investors are nowsatisfied that the risk of losing their money is minimal.Anecdotal evidence from various institutions suggestsinvestors having seen the worst are now relaxed and no majorwithdrawals have been reported.

The liquidity challenge in Islamic banks is actually a treasuryand profitability problem. There is no effective Islamic inter-bank market and banks cannot lend to or borrow from eachother in conventional terms. As a result a bank that finds itselfwith too many investments or is short of cash, has limitedoptions. The issues posed by this are beyond the scope ofthis article but typically surplus funds have to be held in lowor nil yielding cash form and shortfalls are met by seekingdiscreet deposits from sovereign departments on a “lender oflast resort” basis. This “super tanker” approach to liquiditymanagement will be a real constraint on future growth.

Islamic Finance: Part 2

In the next quarterly Risk Update we consider Riba or thebanning of interest and the asset side of an Islamic Bank,including Musharaka which should be the star of Islamicbanking but sadly is not.

Risk Update 2009 – Q2


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Understanding the Concept ofRibaIn over simplistic terms “Riba” means“interest” and Islamic Banks mayneither charge nor pay interest on theirfunds. Its prohibition is contentious insome quarters, especially amongst non-Islamic institutions, but the factremains that there is unanimoussupport amongst all Islamic Scholars fora total ban.

This ban or prohibition is oftenreported in critical terms by outsiders,which is ironic given that mostdeveloped economies have bannedinterest to some degree or other duringtheir histories. However a total and notjust partial ban seems both draconianand anachronistic at first sight.

There is also an unhelpful “elephant inthe room” which makes understandingmore challenging. It is quite a bigelephant actually and is normallydescribed thus: “If it is correct thatIslamic Scholars have banned thecharging or paying of interest of anykind and for any reason, why is it thatall Islamic bank accounts, deposits,savings plans, loans, bonds, leases,credit cards, in fact almost everyIslamic product, are linked in practiceto one kind of interest rate or another?This is surely either a fudge or iteffectively undermines the ruling!”

The standard answer to this accusationis that “linking something to an interestrate is not the same as actually chargingor receiving interest”. This is obviouslytrue in academic terms but it doesn’tconvert many doubters. Moreconvincing and comprehensiveexplanations are required to do thatand we will consider a few of these keyarguments next.

First and foremost, “Riba” as originallydescribed, is not the same as modernday interest and it is a bit confusing toconnect the two directly even thoughthe latter is now banned under Islam asif they were. Secondly, there is nodirect or accurate translation fromancient Arabic into English of the word“Riba”, which adds to the uncertainty.The closest modern approximation is“Usury” or “an unwarranted,unreasonable or unearned premium,excess or surplus which is neitherdeserved nor fair”.

As mentioned earlier, the prohibition ofinterest, especially usury, is notconfined to Islam and has a long historyspanning several traditions andcivilisations including our own. Whilsteveryone would accept that forbiddingUsury is both correct and morallyright, it is less clear to outsiders whyIslamic Scholars have decided to baninterest completely given the crucialrole it plays in Western economies. Thesimple answer is that an Islamiceconomy was and still is different.

Quranic ReferencesThe Quran (Book of Allah SWT )refers to the term Riba several timesbut no definition is available and nodetailed explanation is given in thepractices of the Prophet (PBUH).Islamic Scholars don’t know why, butthey believe there are two likelyreasons for this. Firstly, versescontaining Riba were revealed towardsthe end of the Prophet’s (PBUH) lifeand there may simply not have beenenough time for the issue to be raisedand explained. Secondly and perhapsmore likely, the concept was so wellknown (like Usury is for us today), thatno explanation was needed so everyoneknew and agreed that Riba was wrong.

At the time of the Prophet’s (PBUH)life, money was not regarded as a storeof value and was not created to behoarded for its own sake. This givesrise to one of the more powerfulIslamic arguments against interestwhich explains more clearly the logic ofthe total ban.

If several people enter into a businessventure together, then under Islamicrules, they must agree to share bothprofits and losses at the outset.Suppose each partner brings a differentskill or input to the venture such ascash, labour, know how, or assets? Itfollows that each will request a share ofthe projected profits (and loss) basedon the scarcity or demand for theirparticular contribution. In this way,everyone’s return is agreed at theoutset and is linked directly to theoutcome of the venture.

If the venture fails, all will lose. If itsucceeds, all will gain. No party canreceive a minimum or guaranteed shareeven if the venture fails, yet this isprecisely what would happen if thepartner with the cash charged interest,or the partner with the know howwanted his pre-calculated profit share,regardless. In both cases the returndemanded is deemed by IslamicScholars to be unfair, excessive,unearned and unreasonable because itis not trade related and not actuallyearned.

The Quran explicitly prohibits Riba soanything that can be defined as Ribamust be outlawed. The problem is,does this mean all interest or onlysome? There have many scholasticdebates, including attempts tolegitimize bank interest, but on balanceand after what is now centuries ofdeliberations, the unanimous current


In the first article in this series Mark Andrews, Head of Islamic Banking andFinance, Risk Reward Ltd, covered the basic principles of Islamic Bankingand described the funding sources of an Islamic Bank - or where it gets itsmoney from. In this article, he will begin to consider the other side of thebalance sheet, the asset side - or what an Islamic Bank does with its money.To do so, he challenges the reader to first deal with the issue of “Riba”because it is crucial to both understanding and accepting the basis on whicha modern Islamic Bank trades.

Risk Update 2009 – Q3


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view is that all interest is Riba and istherefore is banned. In fairness it ishard to see, irrespective of thescholastic arguments, how partialprohibitions/exclusions could workequitably in practice.

The prohibition on charging interestdoes not preclude using interest ratesas a reference point for calculatingprofit returns, as long as these returnsare not linked solely or directly tointerest rates themselves, as this wouldcreate uncertainty or Gharar as well asRiba, both of which are forbidden.

So there is no Islamic objection to abank using interest rates as a referencepoint to calculate the required profitreturn as long as the amount is certain,the return is fixed, the project is traderelated and the bank has a genuinestake in the outcome.

This takes us neatly back to thestandard answer that “charging interestand using interest rates as a referencepoint is not the same”. It is indeed “notthe same” and until a more reliable andindependent mechanism for measuringreturns and opportunity costs emerges,interest rates look set to retain theirbenchmark status.

So, if an Islamic bank cannot chargeinterest per se, but can use interest as areference point on an opportunity costbasis, how does it structure its productsto make a return? The answer is toprovide a range of services that aregenuinely profit (and loss) sharing andin which the bank’s required profitreturn or share is calculated usingbench mark interest rates, is agreedwith the client at the outset butactually depends on profit generationfor payment.

There is a further complication in thatto be Shariah compliant all lendingactivities have to be trade based, mustinvolve real goods and services, mustinvolve actual trade, avoid anyuncertainty, avoid prohibited practicesand must be carried out with theutmost integrity and good faith.

Applying these rules to an Islamicbank’s “lending” services has producedsome complex sounding products butonce these have been explored andunderstood it is relatively easy toidentify a conventional bank equivalent.

We will cover only one in this article

and that is theMusharaka,sometimes know asShirka whichtranslates to “sharing”and is the Islamicform of partnership.

MusharakaUnder a Musharakaone or more partiescontribute to thefinancing andmanagement of aSharia compliantproject agreeing toshare profits andlosses at the outset.

In the absence of anagreement profits andlosses are shared inaccordance with eachpartner’s capitalcontribution. Losses are alwaysattributed in accordance with capitalcontributions so the biggeststakeholders stand to lose/gain themost, which is fair.

In a Musharaka arrangement, theIslamic Bank contributes funds to thepartnership in return for an agreedprofit share, usually calculated byreference to short or medium terminterest rates depending on the lengthof the partnership. The bank can beeither a permanent or diminishingpartner and can take security eitherdirectly or from third parties.

A Musharaka project is akin to equityfinance and is almost as close to ethicaland pure trade related banking as it ispossible to get. The genuine sharing ofprofits means the bank has a real stakein the outcome of its “clients” businessand forces it to concern itself veryclosely with the management andcompletion of the scheme. The factthat the scheme must be Shariahcompliant means it is genuinely wealthand trade enhancing and is concernedwith beneficial activities only.

All well and good so far, except thatvery few banks are active in this marketat present. Why?

The main problem is that as with equityfinance, the due diligence process for aMusharaka is considerable as is theongoing management and monitoringobligation. The costs of this directinvolvement by the bank cannot usually

be rewarded adequately by the profitsharing arrangement neither can thevery real risk of incurring losses be builtin sufficiently. The net result is thatwhilst the Musharaka remains theshining example of Islamic ethics andprinciples, the hard truth is that it isnot used that much in practice becauseit cannot be made to pay commerciallyin a modern banking environment.Other Islamic products require muchless supervision, earn just as much forthe bank and are therefore thepreferred offerings.

In Islamic Finance: AnIntroduction – Part 3 (Global RiskUpdate Q4 2009) we will coverthese preferred “lending”products and will show how Ribainfluences their structure. We willalso explain why the two mainofferings, Murabaha (means“sale”) and Ijara (means roughly“lease”) are the two key offerings.

Risk Update 2009 – Q3


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INVESTMENTSWhilst the terms “loan” or “lending” are commonly used, evenby Islamic banks, they are not strictly correct in an Islamiccontext because an Islamic bank is engaged in mutual tradingboth with and alongside its clients on both sides of the balancesheet. An Islamic bank has a direct interest in the outcome ofall these trading transactions, sharing both profits and losseswith its partners/clients. Unlike a conventional bank wheredepositors are creditors and borrowers are debtors and there isalmost no mutuality at all, an Islamic bank has partners,investors, principals and agents at every level.

So an Islamic bank does not “lend”, it “invests”!

So how does an Islamic “invest” its funds? The answer is“very carefully” and for this reason only a handful of theIslamic products available are actually used in practice. Thishas caused Islamic banks – on the investment side at least – tobecome rather narrow specialists, dealing mainly in twoproducts; split between Murabaha (akin to a loan) and Ijara

(akin to leasing operations). Most Islamic banks will advertisea wide range of Islamic investment products, includingmortgage funding but most – in fact nearly all - have the lion’sshare of their investments in either Ijara or Murabaha form.Why is that?

THE COMMON QUESTIONSBefore answering the question and as a preliminaryexplanation, let us consider Islamic banking from thecustomer’s viewpoint, as an investor (in our language,depositor) in an Islamic bank. During the author’s informaldiscussions with Islamic banking staff, especially those dealingregularly with clients, three questions emerge that are nearlyalways asked by every prospective investor (depositor) in thebank.

The first is “Promise me this is an Islamic Bank?” This is aparticularly common question when a “windows” or“branches” approach is being used by the bank but is alsoasked of wholly Islamic institutions. Some Islamic banks have

ISLAMIC FINANCE –AN INTRODUCTION – PART IIIMark Andrews ACISI IFQ, is Risk Reward ‘s Director of Islamic Banking andFinance. He has been an investment and retail banker for over 25 yearsand a qualified specialist in Islamic banking and finance. Since 2007 Markhas worked in most countries in the Gulf and Egypt advising on Islamicbanking products and risk. In this third article in a series he considers howan Islamic Bank “advances” its funds, or in old fashioned banking terms, howit “makes its money”.

Risk Update 2010 – Q1


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questioned the wisdom of operating “windows” as a result ofthis constant scrutiny and to be frank, there is something“other worldly” about entering a conventional bank andfollowing signs for “Islamic banking, this way!”The second question is “Is my money safe?” which isinteresting, given that for those of us banking withconventional banks, the prospect of an Islamic bank failingwould mean we are probably all doomed! In nearly everyIslamic jurisdiction either the State or the Regulator has madeit clear that investors will not be allowed to lose their moneyand whilst nothing is impossible, it is hard to imagine anIslamic bank in the GCC in particular, being allowed to fail.The prospect of investors “sharing or bearing losses” as theyagreed when they signed up (most don’t realise this by theway!), seems as remote as it can ever be.

The last question is “Am I getting the best return?” towhich the answer is invariably “yes, of course”, because theanswer “no, the bank down the road is more competitive thanus!” might be career limiting!

Once these three common questions are satisfied, mostclients, I am told, are then happy to take nearly everythingelse on trust. Is this any different from a conventional bank?Probably not in the case of the last two questions and itmeans that just like any financial institution, an Islamic bank’scost of funds has to be set at a high enough level to attractnew and retain existing investments. This obviously meansthat on the other side of the balance sheet the bank mustmake investments (loans) at a higher level of projected returnthan it pays for its source funds (deposits), to make a profit.So far, so good. But what is the easiest way in risk/rewardterms to achieve this? Well, by using the simplest and mostremunerative products which just so happen to be Murabahaand Ijara!

MURABAHA – AN ANCIENT CONTRACTMurabaha and Ijara are two of six ancient trading contracts,which predate Islam itself and are reckoned to be thousandsof years old. Both have underpinned trading in the Middleand Far East for millennia and were adopted by the Prophet(PBUH) because they worked so well and still do.

Because Muslims may not charge interest but can make aprofit, the basic trade deal, the Murabaha, is a “cost plus”transaction in which the seller supplies goods to the buyer ata price which includes his disclosed costs plus a disclosedprofit. When accepting the goods, the buyer agrees to theselling price and is aware of how much profit is being made(the argument being he can choose not to buy if he dislikesthe price). If the buyer requires time to pay, then this can begranted, usually in return for a higher price including a biggerprofit. This is one of the ways that the time value of moneycan be covered under Islam without charging interest.

Before the reader cries “fiddle”, let us consider some of theIslamic rules surrounding Murabaha transactions which aredesigned to encourage fair trade. First the seller must ownand possess the goods which must be under his control. Thegoods must have a fungible value and there must be nouncertainty about quantity, quality or delivery dates. Theseller may not take advantage of the buyer, may not cheat,deliberately mislead, overcharge or be anything other thanscrupulously honest with him or her. Delivery and transfer ofownership must take place when the transaction is concluded.Once the deal has been done, it cannot be amended withoutthe express approval of both sides. There is also the usual

prohibition on trade in haram items (alcohol, guns, porkproducts etc.)

These ancient Murabaha trading rules are clearly framed toavoid disputes or problems and no doubt evolved over time.They were adopted by the Prophet (PBUH) because theyworked so well. In fact a deal in which the seller has to bescrupulously honest and reveal both his cost price and hisprofit margin is remarkably refreshing to Western eyes whereusually neither is disclosed.

INTERNATIONAL DIFFERENCESProvided the rules set out above are followed, a Murabaha canbe for almost any amount and in theory any time periodalthough the range is usually 6 months to 10 years dependingon the bank which will also set minimum and maximum loanamounts.So Islamic Banks provide Murabaha facilities for clients whowant to purchase almost any item that qualifies. But there aresome complications as a result of differing interpretationsbetween Scholars which make the process slightly differenteven between banks based even in the same country. Take anexample of a client wanting to purchase a car for US$ 30,000and being offered 100% funding on a Murabaha over a 4 yearperiod.

For the transaction to be Islamic, the Islamic bank must bethe owner and supplier of the car which means it mustpurchase and take delivery from the supplier before selling toits client. This creates a delivery risk as the client could walkaway before the transaction is complete. Some banks insist ona promise to complete from their client, others go further andask for a non refundable deposit (Arbun). Some IslamicScholars are happy with either a promise or an Arbun or both,others are not saying it is not Islamic. (Luckily and at the riskof spoiling the story 99.99% of clients applying for funding donot walk away once the deal has been agreed!)

The second point of difference is delivery. Some Scholarsinsist the Islamic bank takes physical possession and in ourexample must store the vehicle in a warehouse prior todelivery. Others are happy for ownership to pass on paper, inother words there is constructive delivery only.

RETURNS ON MURABAHA – USUALLY HIGHDespite these differences, Murabaha s are priced at thehigher end of the consumer funding scale and use asbenchmarks the appropriate EIBOR, SIBOR or othermedium/long term rate measurement. The risk/reward profileis at the better end of the scale for the bank, the transactionsare simple (albeit document hungry), easy to establish, can beused for almost any purpose, are simple to manage andnormally well secured. So from the Bank’s viewpoint this isrelatively easy high coupon lending.

The only serious drawback is that the banks reward (profitmargin ) must be fixed at the outset, when the Murabaha isagreed and delivery concluded, so the returns have to be sethigh enough to absorb rate movements against the bank.Either that or the portfolio must be turned over regularly sothat the impact is diluted.

NEXT ISSUE – PART 4In the next article we will consider Commodity Murabaha – acontroversial product in some areas, but not in others andIjara.

Risk Update 2010 – Q1


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In this fourth article we will look at some interesting currentIslamic developments, we will continue to consider how anIslamic Bank “raises” its funds, or in old fashioned bankingterms, where it “gets its money from”. We will look again atthe Murabaha, which still accounts for the lion’s share of mostIslamic banks “lending” or more correctly, investmentactivities – but will concentrate on Commodity Murabaha atone time a controversial product, now widely accepted.

Summary of Source of Islamic Bank Funds It might first be helpful to summarise the source of theIslamic Banks funds (their liabilities) which are all mainlyshort term and are usually a mixture of current accounts(Amanah, Wakala and Wadia – Amana is rare despite being the name ofHSBC’s impressive Islamic operation) and deposit or term accountequivalents, mainly Mudaraba with some Musharaka.

A Mudaraba is an investment for profit where the investorsentrust their money to a professional manager, in this case theIslamic Bank. Under a Mudaraba the investors take an agreedshare of the profits but bear all the losses unless the manageris negligent. Most Islamic bank investors probably do notrealise that the bank normally bears ALL the losses andunderstandably it is not the first item on an Islamicpromotional brochure!

Safety and Islamic BanksHowever, before you withdraw your money you need torecognise that Islamic banks have proved to be far safer andfar more conservative than conventional banks because theiractivities are restricted, allowing them to build up impressivereserves, including profit equalisation reserves. Equalisationreserves are available to make up any shortfalls in indicativeprofit returns on Mudaraba investments, which to the writer’sknowledge, have never been negative or even nil. This iscombined with the bank not taking high levels of risk andavoiding gearing.

In practice, it is almost inconceivable (but not impossible!)that an Islamic bank would make such huge losses that it hadto pass these on entirely to investors in the form of negativereturns and that it would actually do so. The reputational riskconsequences are obvious and most commentators believethe regulatory bodies would step in long before thishappened. Money invested in an Islamic bank in a stablecountry is probably as safe as an investment anywhere.

ISLAMIC FINANCE –CURRENTDEVELOPMENTSMark Andrews ACISI IFQ, is Risk Reward ‘s Director of Islamic Banking andFinance. He has been an investment and retail banker for over 25 yearsand a qualified specialist in Islamic banking and finance. Since 2007 Markhas worked in most countries in the Gulf and Egypt and the Far Eastadvising on Islamic banking products and risk. In this fourth article in aseries, he considers some topical issues, looks at Murabaha in detail andexplains why this is a staple product.

Risk Update 2010 – Q2


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Restricted v Unrestricted MudarabaThe interesting features of Mudaraba vehicles is that they areshort term, usually repayable quickly or on demand and areunique to Islamic banks. Customers are neither depositorsnor shareholders and the regulation of the products haschallenged some authorities. This is because they can be“restricted” investment account holders (RIAH), or“unrestricted” (UIAH). A RIAH defines the range of Shariacompliant investments that can be acquired. This investment

by the bank on behalf the investors can be separated easilyfrom other Bank funds and usually has a clear and definableaudit trail

On the other hand, UIAH allow the bank to invest the fundsas it sees fit in ANY Sharia compliant scheme so the riskprofile is usually much higher and is not clearly defined.Worse still from a regulatory viewpoint, client’s money is co-mingled with the Bank’s own money and auditing oridentifying the funds in a separate “bucket” is usually notpossible. This is prohibited in many jurisdictions includingSaudi Arabia.

However at the risk of labouring the point ANY investmentin an Islamic bank is probably safer than in a conventionalcounterpart because they do not engage in such riskyactivities and as an industry have not made significant losses.

Current Islamic DevelopmentsDubai still hits the headlines with worries about the timing ofthe property recovery although perhaps the bottom of themarkets has still not been reached. The market probably willrecover eventually as Dubai has established itself successfullyas a “playground” and does indeed potentially have a longterm future. When, is the real issue, plus who can survive thenecessary wait!

On the regulatory front, there is some encouraging evidenceof a coming together between the GCC, dominated by SaudiArabia and the Far East, especially Malaysia with severalrecent high level meetings taking place. The almost universaladoption of the IFSB (a Malaysian initiative) by the leading

Islamic players is a move towards the goal everyone wishesfor but cannot yet see how to achieve. Namely a supremeSharia “college” so the variations and contradictions in Fatwarulings, even in the same country, can be either eliminated orbetter managed.

Insiders say the Fatwa contradictions make Islamic Banking“challenging & interesting”. To an outsider at the very least, itlooks unhelpful.

Islamic Bank outlooksThe Dubai Islamic Bank, the oldestIslamic Bank established in 1975recently disclosed that 8.7% of itsassets (loans) are non-performing.This is an exceptionally high figurebut is less surprising given its 35%shareholder, the Emirate of Dubaiitself, will have expected the Bank topioneer many of the prestigious andflagship developments in theEmirate, especially during the recentboom.

What an outsider cannot tell is howmany loans are either in the “delayand re-issue” category or are“Zombie” loans – already dead butthe bank dares not crystallise themyet.

First Gulf Bank on the other hand,the Abu Dhabi based Islamic bank,which has significant links with the

ruling Zayed family, continues to announce spectacularlyimpressive figures. First quarter returns for 2010 are up acrossthe board and with only 2% of assets (loans) provisioned butnot all considered lost.

New ProductsTo the astonishment of some, Dubai Islamic Bank (DIB),which has a reputation for being very strict in its ShariaCompliance where new products are concerned, has justlaunched a Salam product using salt to provide finance topersonal individuals. Basically with some clever but Shariacompliant manoeuvring the client gets unencumbered moneynow in return for an agreed future liability using salt as theShariah vehicle to accommodate this. More information isavailable on their web site.

Two consequences flow from this. Firstly other banks aresurprised that the DIB Sharia board has agreed the product isSharia compliant. Secondly, that DIB is targeting high ticketpersonal lending, presumably to replace property andconstruction where its books must be all but closed inpractice if not publicly. Personal finance to HNW borrowersis not especially risk free.

Murabaha –The Islah Product BriefingDealt with in the last article but in summary it is a cost pluscontract with all elements disclosed, Shariah compliant, withno uncertainty etc. A Murabaha can be for almost any amountand in theory any time period although the range is usually 6months to 10 years depending on the bank which will also setminimum and maximum loan amounts.

Risk Update 2010 – Q2



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The attraction for Islamic Banks who provide Murabahafacilities is the returns are high, it is a relatively simpleproduct to market and sell and the risk profile is low. Themain drawback is rates are fixed at the outset and the averageterm is 5 years. This creates an immediate mismatch withfunding sources (nearly all short term) and leaves the bankvulnerable to increases in the cost of funds (interest rates). A large portfolio of well spread and maturing Murabahaprotects partially against interest rate fluctuations as new,higher return products replace maturing lower return deals,but not completely. In addition a Murabaha cannot be turnedquickly into cash in a crisis.

To remind ourselves how a Murabaha works:

TawarruqMeans to “monetise” and is also called “Commodity”,“Reverse” or “Two Tier” Murabaha although each has aslightly different construction in different jurisdictions.

In most cases two separate Murabaha contracts are used tocreate cash and a loan liability.

In simple terms, imagine you bought a car on a Murabaha for$20,000 from a bank on one year terms. The bank wouldcomplete the deal by creating a “loan” or Murabaha liabilityof say $22,000, if the rate of the return (profit) required bythe bank is 10%).

At this point you have the vehicle and a $22,000 loan. Allvery normal.

Imagine you simultaneously sold the car to another dealer for$20,000 or something very close as it is a still brand new andunused, using a Murabaha contract with payment on delivery.

You now have $20,000 cash and a 1 year liability of $22,000(the loan amount). By using two separate Shariah compliantcontracts you have created a cash loan.

When they were first introduced, these transactions met withstrong resistance in some quarters with scholars condemningthem. The grounds are it is Riba, no real trade taking place,no intention to take delivery or ownership of the goods andnothing beneficial to the community has occurred. Theobjections were even stronger if the buyer and seller of thegoods was the same party – especially if it was the IslamicBank.

This is how it works:

This form of funding has become a vital component of shortterm investment operations by Islamic Banks using permittedcommodities (Gold and Silver forbidden as they were once“money”), to invest or acquire funds in a similar fashion toconventional inter-bank markets.

Sharia objections are beginning to fall away as the practicebecomes established and many scholars approve them on thebasis that some trading benefit accrues and as long as thereare two separate parties on the buy and sell side. However,not all banks agree.

Next Article In the next article, as well as debating topical Islamic issues,we will consider Ijara and the ways banks avoid being lockedin to long term fixed rentals by using a two contract system.




Sale: payment deferred12 months100 spot pricecommodities

Similar to a 5% interest-bearing loanby Bank to Customer

100 spot pricecommodities

100 cash 100 cash100 spot pricecommodities

105 total deferredpayments

Tawarruq example






Sale of item/commodity

Sale of item/commodity

Deferredpayment(cost plus

profit margin)in lump sum


A Murabaha Transaction


Risk Update 2010 – Q2


Page 11: Islamic Finance - Risk Finance Articles by MCA.pdf · islamic finance four articles introducing islamic banking and finance concepts

The IFQ is a ground-breaking qualification that covers Islamicfinance from both a technical and a sharia perspective,providing the first international benchmark in the area ofIslamic finance.

It provides delegates with an understanding of the influence ofsharia in a business context and prepares delegates to holdkey positions in the Islamic finance and takaful (Islamicinsurance) industries.

The qualification and training course are appropriate forexisting and new employees and those seeking a career inIslamic finance. Since its launch, the exam has been taken inover 40 countries.



Since its inception the IFQ has beenhighly acclaimed as it contributes tothe widening and deepening of theskills of financial practitioners. We areconfident that this third edition willfurther confirm its pertinence to thefinancial industry at large.

Key Features of the IFQ

Provides an essential knowledge of the general principles of sharia (fiqh al muamalat) and itsapplication to Islamic banking and finance.

Covers the different types of Islamic financecontracts and products available.

Examines the practices used in the Islamicfinancial markets and the principles behindinvestment selections.

Employing IFQ holders indicates that a companyis contributing to the development andpromotion of high ethical standards amongst itsstaff.

Initiated and supported by the Central Bank ofLebanon (Banque du Liban).

Awarded jointly by the Chartered Institute forSecurities and Investments (recognised by Ofqual, the UK government education regulator) and l’Ecole Supérieure des Affaires (ESA).

Available internationally.

Who Should Attend?

All banking and finance professionals eitherworking within an Islamic financial institution orintending to do so and any other professionalsworking in the field who wish to develop their skillsand understanding of Islamic finance.

Raed H. CharafeddineFirst Vice-Governor, Banque du Liban

Chairman, Advisory Council for Islamic Finance

The professional qualifications and membership body for the securities and investment industry +44 (0)20 7638 5558 [email protected]





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Page 12: Islamic Finance - Risk Finance Articles by MCA.pdf · islamic finance four articles introducing islamic banking and finance concepts

Assessment Structure

The IFQ is a two-hour, 100 multiple-choice question exam.

The pass mark is 70%.

Preparation, using the accompanying workbook, requiresapproximately 100 hours of personal study time.

CISI Membership

Individuals who successfully complete the IFQ are eligible tobecome Associate Members (ASI) of the Institute. For further details visit

“ ”I would strongly recommend this qualification to staff working and seeking to work in

the Islamic finance industry. This prestigious, global qualification offers essentialknowledge of the general principles of sharia with respect to its application to Islamicbanking and finance. The IFQ is a key qualification in this growing market.

Sultan Choudhury, Commercial DirectorIslamic Bank of Britain

Endorsed by the Financial Services Skills Council(FSSC)

The IFQ features on the FSSC Recommended List ofExaminations. The FSSC is an employer-led body with aremit to provide advice and guidance to employers in thefinancial services sector on suitable qualifications for theirstaff.

Advisory Council for Islamic Finance

The IFQ was initiated by theCentral Bank of Lebanon(Banque du Liban) and wasjointly created by L‘EcoleSupérieure des Affaires (ESA)and the Chartered Institute for Securities and Investments(CISI). These bodies convened the Advisory Council forIslamic Finance (ACIF), a group of experts to developthe qualification.

The ACIF oversees the IFQ. The ACIF chairman is Raed H.Charafeddine, First Vice-Governor, Banque du Liban.





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ACCREDITED TRAINING PROVIDER +44 (0)20 7638 5558 [email protected]

Page 13: Islamic Finance - Risk Finance Articles by MCA.pdf · islamic finance four articles introducing islamic banking and finance concepts

Masterclass A five-day intensive course

Session 1: The Basis of Islamic Banking and FinanceThe principles and concepts which underpin Islam; theplace of banking and finance within Islam; the sources and interpretation of Islamic law; introduction to the role of the sharia supervisory board.

Session 2: An Introduction to Islamic Banking and Finance The basis of Islamic banking and finance; the development of the Islamic finance and banking industry; the main components of the Islamic banking industry and its operating structures.

Session 3: Islamic Law of Contr acts Principles of Islamic business including the avoidance of riba and gharar; the concept of wa’d (promise); the elements of a valid contract; the different types of contract; the purchase and sale of currencies.

Session 4: Financial Techniques Applied by Islamic BanksThe nature of Islamic current accounts; the nature of the major contracts – mudaraba, musharaka, murabaha, ijara, salam, istisn’a; the use of letters of credit and guarantees in Islamic finance contracts.

Session 5: Financial Statements for Islamic Banks The framework of International Financial Reporting Standards; contents of the main financial statements; the need for specific Islamic accounting standards; therole of AAOIFI and IFRS.

Session 6: Islamic Corporate Governance The different approaches to corporate governance; additional challenges presented by Islamic banks; the role of the sharia supervisory board and corporate governance issues in takaful.

Session 7: Islamic Asset and Fund Management The purpose of investment in Islam; prohibited industries; replicating conventional deposit structures using murabaha and mudaraba; investment funds using Ijara; the Islamic stock selection process and therole of the sharia supervisory board.

Session 8: Islamic Bond Market - Sukuk The nature of sukuk compared with conventional bonds; issuing sukuk; different types of sukuk; AAOIFI standards for sukuk and rating sukuk issues.

Session 9: Islamic Insurance - Takaful The nature and structure of takaful compared with conventional insurance; remunerating the insurance operator and sharia governance of takaful undertakings.

For information on public & inhouse courses please contact your local training provider or Risk Reward Limited. +44 (0)20 7638 5558 [email protected]





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All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recorded or otherwise without the prior permission of the copyright owner.

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ACCREDITED TRAINING PROVIDER +44 (0)20 7638 5558 [email protected]

For more information on * Islamic Risk Training * Islamic Risk Management * Islamic Internal Audit *

+44 (0)20 7638 5558 � [email protected] �

Public & In-House Courses Available Worldwide

Page 15: Islamic Finance - Risk Finance Articles by MCA.pdf · islamic finance four articles introducing islamic banking and finance concepts

60 MoorgateLondon EC2R 6ELUnited Kingdom

Office hours: London (GMT)09.00am – 19.00pm Monday – Friday

telephone: +44 (0)20 7638 5559fax: +44 (0)20 7638 5571

email: [email protected]:

Dennis Cox – CEOtelephone: +44 (0)20 7638 5558email: [email protected]

Lisette Mermod – Commercial Directortelephone: +44 (0)20 7638 5559email: [email protected]

Nick Barcia – New York Officetelephone: 1-914-619-5410email: [email protected]

For further information please contact: