Islamic Finance & Sukuk ( April 2014)

Islamic Finance & Sukuk
Dr. Aly Khorshid

Course detais
• Islamic Finance (2 day’s course)
• Introduction to Islamic Finance
• Shariah requirements
• Prohibitions in Islamic Finance trading
• Islamic bank and the difference with conventional banks
•
• Shari’ah compliant products
• Musharakh (Joint Venture)
• Mudarabah (Profit sharing)
• Murabaha (Cost Plus)
• Ijarah (Rental)
•
• Shari’ah compliant products (Cont.)
• Istisna’a (Manufacturing)
• Salam (Future payment)
• Bay Bithaman ajil (Delayed payment)
• Qard Hassan (Interest free loan)
•
• Sukuk (Islamic Bonds) Type, structure, Index, trading
• Sukuk types
• Sukuk structure and application
• Securitizing Sukuk
• Sukuk Index
• Sukuk trading and secondary market
•

Course Structure
• Structure Islamic fund for investment and Project Finance
• Principals of Islamic investment
• Structured finance: An overview
• Structured product within Shari’ah compliant
• Sukuk structure an idea project finance investment
• Securitisation (asset-backed Securitisation)
•
• Product innovation Private equity, Wealth management in Islamic finance
• Islamic Private equity fund
• Wealth Management
• Islamic derivatives and hedge funds
•
• Islamic asset Management
• Shariah-compliant Portfolio Management
• Islamic asset management
• Shariah-compliant Asset Classes
• Sukuk, fixed income asset class
•
• Corporate Governance and Risk Management in Islamic Finance
• Governance frame work in Islamic finance institutions
• Shariah Board responsibilities and accountability
• Disclosures and Transparency
• Risk Management in Islamic Finance

Introduction to Islamic Finance
Shari’ah Compliant Products
Sukuk, Type, Structure, Index, and Trading
Structure Islamic Funds for Investment and Project
Finance
Product Innovation
Islamic Asset Management, Private equity
Corporate Governance and Risk Management in
Islamic Finance

Islamic Finance globally
There are 1.7 billion Muslims in the world(23% of total
world population) with annual growth of 15% (in 2020
Muslim population expected 25% of the world
population) , making it 2nd largest religion after
Christianity. Only 20% of those live in Arab Countries.
• Market of Sharia compliant assets approximately $1.2
Trillion

• Shari’ah requirements
• Prohibitions in Islamic Finance trading
• Islamic banks and the difference with conventional
banks

Shari’ah requirements
Shari’ah Law
Justice, equity, fairness and morality
• Values which underpin both the entire Islamic way of life.
• Shariah gives guidance as to what is, and what is not, acceptable
behaviour in all areas of a Muslim’s life (including economic and
commercial life).
• Shariah is based on the Qur’an and Sunnah of the Prophet
• Shari'ah is developed by Shari'ah scholars (Known as Schools of
thoughts) some 1000 years ago
• The recent Scholars known as Shari'ah advisors or Shari’ah board has
studied Fiqh Al-Mu'amalat able to explain Shari'ah law for recent
dealings.
• The principal of the Shari’ah Law is:
the permissibility, the prohibition is exceptional

Shari’ah Law
• Recent Islamic scholars who from time to
time re-examine the Shari'ah principals
and structure new financial instruments
must comply with principals of
• The of Shari'ah law ethics originate from:
– The Qur'an
– The Sunnah,
– Ijmaa' - consensus among the jurists,
– Qiyyas' - analogy and
– Ijtihad' - reasoning.

Prohibitions in Islamic
Finance trading

Prohibitions
In Islamic financial system
• Prohibition of Unfairness & Unjust
• Prohibition of Riba (usury)
• Prohibition of Gharar (Deception &
Speculation)
• Prohibition of Gambling
• Prohibition of Monopolies
• Prohibition of Short Sales
• Prohibition in money trading(Money is a

Prohibition
In Islamic
financial
system
Riba
Short Sale
Monopoly
Unfair &
Unjust
Contracts
Unlawful &
unethical
trade
Money
Trading
Gambling
Gharar
16

What is Riba?
• One of the main prohibitions is Riba
(usury)
• Riba is prohibited in Judaism, Christianity
before Islam and even in man-made
religions such as Hinduism and Buddhism
• Unearned increase in an exchange
contract without offering anything in
return
• Interest on money-lending is the most

What is Gharar?
• Gharar is an ambiguity in transactions
• Selling anything without owning it first
• Fraud and deception
• Absence of knowledge or uncertainty of delivery
• One party's risk higher than the other's
• Examples:
– Short-selling of stock where the cost of acquiring stock to meet
future obligations is unknown
– Any transaction without defining the subject accurately

Islam Perception of Money
• Because of the importance of money to all
human being, regardless of his or her beliefs
• Islam has addressed this issue in general
terms, and gave societies the choice to
develop their own financial systems, as long
as the system is
Fair & Just
To everyone

Islamic banks and the difference
with conventional banks

Difference between Conventional and Islamic Banks
Conventional Bank
• Banking activities not
consistent with
Christianity or Judaism
religion, based on secular
• Riba (Usury) is not an
issue
• Conventional banks invest
in any business generate
profits regardless of its
activities
Islamic Banks
• Islamic banks activity is
consistent with the
principles of Islamic law
(Shariah)
• Shariah prohibits renting
of money (Riba, usury)
• Islamic banks do not do
businesses contrary to its
ethics and prohibitions
(Haram, forbidden)

Conventional Bank
• Money is a commodity
and a medium of
exchange and store of
value
• Money can be sold at a
price higher than its
face value and it can
also be rented out
Islamic Banks
• Money is not a
commodity though it is
used as a medium of
exchange and store
value
• Money cannot be sold
at a price higher than its
face value nor it can't
ne rented out

• Time value is the basis
for charging interest on
capital
• Interest is charged even
in case the organisation
suffer losses
• Profit on trade of goods
or charging on
providing service is the
basis for earning profit
• Islamic Bank operates
on the basis of profit
and loss sharing

• No lending based profit
or loss sharing
• When money used as
commodities that leads
to high inflation
• Musharakh &
Mudarabah a tools for
Islamic bank business
• When using trade
related activities and
money linked to real
assets that leads to
economic development

• While disbursing cash
finance, running finance
or working capital
finance, no agreement
for exchange of goods &
services is made
• The exchange of
agreements for the
exchange of goods &
services is a must, while
distributing funds under
Murabaha, Salam &
Istisna'a contracts

• Conventional banking
has focus on financial
efficiency without
linking to the purpose
of lending
usually rests on
interest rates
• Islamic banking prefers
to link to the cause of
lending and not just the
financial efficiency
• whereas Islamic
banking does not.

has more formal and
legalized structures
• The main aim of
conventional banking is
to facilitate financial
activities
• Islamic banking is still in
its formative stage, is
practiced informally and
does not have strong
legal support in all
jurisdictions
• Islamic banking is based
on equitable
distribution of wealth
and income and
justifiable social
finance.

• Conventional banks
offer deposit insurance,.
• Return on investment is
fixed since lending is
offered on fixed interest
rate
• No deposit insurance
offered in Islamic
banking
• Return on investment is
variable since Islamic
banks offer profit& loss
sharing

Difference between Conventional and Islamic
Banks
does not have a moral
or ethical dimension
• Conventional banking is
supported by highly
active money markets
and overnight
borrowing facilities
• Islamic banking rests on
moral and ethical
dimensions
• Islamic banking is not
yet fully supported by
money markets

Banks
• Risk management tools
developed by trial and
errors and common
practice, but lacking
additional filters to avoid
financial crises
• Other banking practices
tools such as hedging and
derivative are highly
developed, formalized,
and widespread
• Risk management based
on conventional banks
tools plus additional
Shari’ah filters
• Other banking practices
tools hedging derivative
are not fully developed,
Those tools needs to be
developed

Banks
• There are several formal
educational and research
programmes available in
the domain of
conventional banking all
over the world
• This results into
conventional banking
having a steady flow of
qualified manpower
• Islamic banking still
lacking education and
research programmes
• Islamic banking faces a
severe shortage of skilled
staff

Banks
system has 100’s years
experience and function
deep in the global
banking system
• Islamic banking system
is still in the awareness
stage, although the
growth by 20% annually
but still less than 2% of
the global banking
system

Banks
• Conventional banking is
well supported by
governments
• Whereas Islamic
banking is still slowly
moving towards being
an accepted form
governments, The
differences are a
fundamental source of
uniqueness and identity
of Islamic banking

• Musharakh (Joint Venture)
• Mudarabah (Profit sharing)
• Murabaha (Cost Plus)
• Ijarah (Rental)
• Istisna’a (Manufacturing)

Islamic
finance
contracts
(Tools)
Musharakh
Mudarabah
Murabaha
Ijara
Contracts,
etc.
Ijara Wa
Iqtina
Salam
Istisna'a
Bai be
Thaman Ajil
Sukuk
Arbun
Qard
Hassan
Tawarruq
Home
Financing
Musaqaa
Muzara
35

• It’s a Partnership arrangement
• Musharakh involves a mutual contract to
participate in a commercial enterprise
• Management
– All partners may be involved in the management of the
enterprise
– Transparent management and accounts is essential
– Remuneration for the management is part of expanses
– Parties may agree in advance that one party, is a sleeping
partner, and the remaining management is compensated
for sole management role ( normally when banks or
finance institutions are involved)

• distribution of profit must be agreed at the time of
entering into the Musharakh contract
• the ratio of profit of each partner is determined as the
profit accrued on the capital invested
• Profit & loss shared according to the ratio of each party's
investment
• Capital can be monetary, commodities or in kind
• liability of each partner is recognized
• Termination of Musharakh by agreement

Musharakh versus equity investment
Musharakh
• Venture of limited
duration
• Partnership with joint
ownership
• No exit without
agreement of partners
• Investors obtain profit
share
• Little probability of asset
gains when venture
terminates
Equity investment
• Company exists in
perpetuity(no time limit)
• Exclusive ownership by
shareholders
• Exit at any time if
company listed
• Investors get dividends
• Focus on capital gains and
market value of equity

Musharakh investment fund
(equity financing)
• The Islamic financial institution and the customer provide financing
for a specified project in agreed proportions.
• All parties have the right to participate in the project but the parties
also have the right to waive such rights
• In the event of loss, both parties will bear the losses in proportion to
their participation
• Profits and losses are shared in proportion to the contributions
• The Islamic financial institution may receive an agreed management
fee.

Possible Musharakh structure
Investors
or banks
New
Musharakh partnership
Initial investment
Regular profit share payments
Musharakah
accounts
Existing
business
Finance Pay-outs
Proprietor(s)
Ownership

Musharakh Contract (Sharing contract)
• Client Enters Agreement with bank to Invest in a Project
• Client invests $80,000, Bank Invests $20,000
• Profit Share is Based on a 80%:20%
(they may agree on different percentage subject to negotiation)
43
Client invests $80,000 Bank invests $20,000
$100,000
Project

Scenario 1
• Musharakh Project makes $30,000 profit.
• Client receives 80% of profit $24,000
• Bank Receives 20% of profit $6,000
Alexandros Severis 09/06/2009 44
Client receives
$24,000
Bank receives $6,000
$30,000
Profit
20%80%

Scenario 2
• Musharakh Project $50,000 loss, Project value=$50,000
• Losses are borne according to their initial capital contribution
• Client receives proportion of investment (80% of $50,000) =
$40,000
• Bank receives proportion of investment (20% of $50,000) = $10,000
45
Client receives
$40,000
Bank receives
$10,000
Project makes loss
of $50,000
50,000 remaining.
80
%
20%

A special kind of partnership
– where one partner invests money with another
entrepreneur in a commercial enterprise.
– The investment comes from the first partner who is called
the “rabb-al-mal”, while the management and work is the
exclusive responsibility of the entrepreneur, who is called
the “Mudarib”.
Mudarabah may be contracted in two
forms:
Restricted Mudarabah
Rabb-al-mal may specify that his money is invested in
specific business.
Unrestricted Mudarabah
The Mudarib is given the discretion to invest the money

• The rabb-al-mal (investor) has no right to
participate in the management which is
managed only by the Mudarib
• The loss, if any, is on the rabb-al-mal
(unless the Mudarib is proven
negligent or dishonest)
• All goods purchased by the Mudarib are
solely owned by rabb-al-mal
• Distribution of the profit
(at a pre-agreed percentage, and it may
be agreed on a case- by-case basis)
• Termination by mutually agreed terms

• This arrangement involves two parties, the managing trustee
(Mudarib) and the beneficial owner (Rub al Maal).
• The Islamic financial institution may either put up all the funds
itself and undertake responsibility for investing them, Or
alternatively it can provide funds to the customer who then
acts as Mudarib.
• The funds provided will be usually of those of its investors
rather than the Islamic financial institution
• The Islamic financial institution acting as trustee for those
investors Thereby assuming fiduciary responsibilities.
• reward is a fixed share in the balance of the revenue
generated by the investments , the remainder goes to the
investors.
• No guarantee that the Islamic financial institution’s
investment will be returned or that a profit will be generated

• A buyer wishes to purchase commodity, he
is in need of finance:
• A financer will purchase the commodity
for the buyer, The financer specifically
stipulating, that the cost of acquiring the
commodity as well as the amount or
percentage of profit or mark-up price for
the commodity is agreed between the
buyer and the financer.
• The financer purchase the commodity and

• The subject matter (the commodity) must be:
• In the ownership of the seller at the time of sale
• property of value
• is in existence at the time of sale.
• The subject matter must be:
• Permissible product with the Shari’ah
• specifically known and identified by the buyer
• in the physical or constructive possession of the seller at the
time of sale.
• The sale must be instant and absolute.
• The delivery to the purchaser must be certain,
not dependent on a contingency or chance.

• Payment may be on the spot or at a later
agreed date.
• The profit may be determined by mutual
consent, either in the form of a lump sum
or a ratio of profit to be charged over the
cost.
• All expenses incurred by the seller are
included in acquiring the commodity (such
as freight, custom duty, etc.)
• The actual cost of the commodity is known

Case study of Murabaha
management through inter-bank deposits
• Bank purchases goods on behalf of a client and re-sells at
a mark-up, Ownership risk justify return to the bank.
• Uses of Murabaha contract in this transaction make an
Investment funds for the bank a profitable commodities
purchasing transaction, where the bank entering a
simultaneous contract to re-sell the commodity in one,
two or three months at a mark-up.
• Normally Islamic bank places funds for commodity
trading in the markets such as the London Metal
Exchange.

Murabaha Financing
(Installment Credit Sale)
• Deferred payment Sale/Installment Credit
Sale + Profit Mark-Up
• Closing & payment date must be clear
• Bank can appoint client as agent (if bank is
inexperienced)
• Technical ownership of good remains with
bank
• Bank may request
Collateral/Security/Guarantee 55
Bank Client
$10,000
$10,000+1000
Differed payment date

56
Car Dealership
Hummer
China
Islamic Bank
Request for 3 Hummer Cars
Buys 3 Hummers
3 x $60,000
($180,000)
Transfer ownership of
3 Hummers
Transfers 3 Hummers
Pays $150,000 + $30,000 mark
up
(on deferred date)
Murabaha Financing (Deferred Payment Sale
Example)

Commodity Murabaha (Liquidity
Management)
57
Islamic
Bank
Reliable &
Good Rating
Bank Acting
as Agent
Commodity
Broker A
Commodity
Broker B
Request Bank to buy
commodities
Transfer Commodities
Buy Commodities @ Spot
(as agent)
Sell Commodities
Deferred (Murabaha
Agreement)
Sell Commodities @ Spot
Transfer Cash SpotPrice + Mark up Deferred
* 2 Brokers so as to avoid twin sale!
•Mark up based on LIBOR
•3months-1year
•Deferred payment with letter of Credit

• Ijara is a contract which involves the transfer of usufruct
of a property or asset to another person in return for an
agreed consideration
• Ijara means selling the benefit or the use of a property
own by other party for a fixed rental price.
• Under this concept, the Bank makes available to the
customer the use of service of assets/ equipment such as
plant, office automation or motor vehicles for a fixed
period and price.

• The subject matter must of a value and use
• The ownership remains with the lessor of the property or
asset.
• All liabilities emerging from the property or asset is to be
borne by the lessor
• liabilities arising from the use of the property shall be
borne by the lessee.
• The period of lease must be determined in a clear term.

• The lessee uses the leased property only as specified in
the Ijara agreement.
• The lessee is liable to compensate the lessor for any
damage caused by his negligence or misuse on the
property.
• Risk on the property in terms of damage or loss caused
by factors beyond the control of the lessee rest on the
lessor.
• Property jointly owned by more than one person can be
leased out, and the rentals shall be distributed amongst
the joint owners

• A joint owner of a property can lease his proportionate
share to his co-sharer only, and not to any third party.
• The leased asset is fully identified by the parties.
• The rental for the whole lease period must be
determined at the time of the contract.
• It is permissible to fix a different amount of rent for
different phases of the lease.
• The lessor cannot increase the rent unilaterally.

• The rent can be payable in advance and remain as “on
account or in trust” towards the rent when due.
• The lease period commences from the date the asset has
been delivered to the lessee.
• If the leased property has lost its purpose or function of
lease, the lease shall be terminated.

• The lessee may be charged a late penalty for late rental
payment; however, this payment is disbursed for
charitable purposes only.
• If the lessee contravenes any term of the lease
agreement, the lessor is entitled to terminate the lease
unilaterally.
• If the leased property is insured under Takaful, its
expenses should be borne by the lessor and not the
lessee.

• At the end of the lease period, the lessor may agree to
transfer the leased property to the lessee at a mutually
agreed price.
• The lessee may only sub-lease the property if the lessor
expressly agrees to such sub-lease.
• The lessor may sell the whole or a part of the leased
property to a third party whereby the relation of the
lessor and the lessee will thereafter be between the new
owner and the existing lessee.

Ijara Investment Fund
•This encompasses the leasing of machinery, equipment, buildings and other
capital assets.
•The Islamic financial institution will purchase the asset in question and
lease it to the ultimate customer for an agreed rental
•The rental may be fixed in advance or subject to occasional review by a
mutually agreed
•The attitudes of Islamic financial institutions towards insurance of the asset
vary
•some Shariah committees imposing an obligation on the lessee to insure
the asset
•Premiums are likely to be paid by the Islamic financial institution, even if
they are recovered through rentals or otherwise.

Ijara Thumma Al Bai’ (Hire purchase)
• Parties enter into contracts forming a complete lease/buyback
transaction.
• The first contract is an Ijara that outlines the terms for leasing or
renting over a fixed period,
• Second contract is a Bai (Sale) that triggers a sale or purchase once
the term of the Ijara is complete.

Ijara-Wa-Iqtina (Rental ends with purchase)
• The Islamic bank provides equipment, buildings or other assets to
the client against an agreed rental together with a unilateral
undertaking that the client's ownership in the asset will be
transferred to the lessee.
• The undertaking or the promise does not become an integral part of
the lease contract.
• The rentals as well as the purchase price are fixed in such manner
that the bank gets back its principal sum along with profit over the
period of lease.

Other forms of Ijara
• Ijara Wa Iqtina/Ijara Montahia Bittamleek
– Lease with acquisition/ Lease ending in Ownership
– At the end of rental period Lessee buys asset.
• Ijara Mawsoofa Bil Thimma
– Combination of construction finance followed by a redeemable lease
– which buys the project (Forward priced lease)
• If there is a history of late payments or evidence of poor treatment of
• the asset, the lease can be re-priced.

Customer =
Lessee
Bank =
Lessor
Supplier
lease title
rental
payments
end of contract:
return of asset
purchase
price
2
14
3
5
today
delivery
future
payments
return
Ijarah Structure (Operating Lease)

Customer =
Lessee
Bank =
Lessor
Supplier
lease title
rental
payments
lessee as service agent
purchase
price
2
14
3
3
purchase of asset
purchase price
end of
lease
period
5
6
bank’s perspective: purchase undertaking ≈ put option
lessee’s perspective: sale undertaking ≈ call option
purchase
today
delivery
future
payments
purchase
Ijarah Wa Iktina Structure (Financial Lease)

House Purchaser
Islamic Bank
House is leased by
Islamic Bank to the
house purchaser
*Bank could appoint Purchaser to buy House from seller
72
•Bank has some form of ownership until end
•Purchaser pays ‘rent’ to the bank
•Rent could be fixed for length of lease or
readjusted periodically

• Istisna'a contracts normally for high value products such
as Airplane's military equipment's
• Is an order to a manufacturer to manufacturer a specific
commodity by the purchaser.
• Istisna'a shares similarity with Salam in terms of selling a
particular commodity which is yet to exist at the point of
sale transaction.

• The price is fixed mutually by the parties
• The specification of the manufactured commodity is agreed in
advance and determined by the parties
• Istisna'a creates moral obligation on the manufacturer to
manufacture
• Cancellation before the start of manufacture by giving notice to the
other party (venality may be charged ).
• After manufacturing started, the contract cannot be cancelled
unilaterally.
• The buyer has the option to reject the manufactured goods if they
do not comply with the specification agreed in the contract.

Istisna'a from of Financing
• Istisna’a used to provide financing especially in the housing finance
sector.
• The financier constructs the house then enters into a parallel
Istisna'a contract with a third party or he may hire the service of a
contractor (other than the client).
• Istisna'a allows the parties to fix the time of payment.
• The payment may also be on an installment basis
• In order to secure the payment of installments; the financier keeps
the deed as security
• If the government wants to construct a highway, it may enter into a
contract of Istisna'a with a builder. The price of Istisna'a may be the
right of the builder to operate the highway and collect toll fees for a
specified period.

Project Financing with Istisna’a
• Contract to acquire goods on behalf of a third party
• Price paid to a manufacturer in advance of goods being purchased
• Payments received cover wages and costs of input supplies
• Applied to production of specific items
• Delivery at an agreed date
• The modern BOT (buy, operate and transfer) agreement may also be
formalized on the basis of Istisna'a.

Istisna'a structure
Project
Islamic
bank
Client
Payment for
supplies
Completion of project
Deferred payment

Istisna’a Structure
Customer Bank Manufacturer
title to asset
on completion
sale or lease contract
(Ijara Wa Istisna’)
advance
payment
of purchase
price
(instalments)
1
2
4
3
purchase contract
(Istisna’)
title to asset
on completion
5
6
e.g.
advance
rental
payments
during
construction
today
payment delivery
future
Istisna'a’ Structure

• Salam (Future payment)
• Bay Bithaman ajil (Delayed payment)
• Tawaroq
• Qard Hassan (Interest free loan)
• Case study, Comparison between Islamic
Finance tools vs. conventional investment
tools

Salam
(Advance payment for later delivery)
Salam is a sale contract, whereby the seller undertakes to supply
specific goods to the buyer at a future date in exchange for an
advanced price fully paid on the spot.
Payment in advance with deferred delivery is Salam contract is
not a forward sale;
Therefore it’s subjected to some strict conditions:
• The objects of this sale are goods and cannot be
commodity such as gold, silver or currencies.
• Salam covers almost everything that is capable of being
definitely described as quality and workmanship.

Salam
Standard elements of the contract cont.
• The price of Salam may be fixed at a lower rate than the price of such
commodity paid on the spot. The difference between these 2 prices may
be a valid profit for the buyer.
• In order to ensure that the seller delivers the commodity at the agreed
date, the buyer may ask the seller to offer security in the form of
guarantee or mortgage.
• The buyer pays the full price to the seller at the time of sale.
• This is necessary to avoid being similar to sale of a debt against a debt,
which is prohibited.

Salam
Standard elements of the contract
• It can only be effected on commodities whose quantities and quality can
easily be determined.
• Salam is a mechanism that ensures the seller has the property required
for the transaction.
• Salam cannot be effected on a product from a particular field or farm, The
quality of the commodity must comprehensively specified in the contract,
leaving no ambiguity which may lead to dispute.
• The quantity of the commodity is agreed upon in unequivocal terms.
• The exact date and place of delivery must be specified in the contract.
• Salam commodities must be paid for by money not an exchange of other
commodity

Salam
Parallel Salam contract
• After purchasing the commodity, the bank may sell it through
a parallel contract of Salam for the same date of delivery. The
period of Salam in this parallel contract is shorter and the
price is higher, thus the difference between the price of the
first Salam transaction and the second, which is the profit to
the bank.
• If the parallel Salam is not feasible, unless the bank can obtain
a unilateral promise from a third party buyer to purchase the
commodity.
• the bank enters into two different contracts. In the first
contract, the bank is the buyer and in the second, the bank is
the seller.

Salam
Parallel Salam contract
• Being merely a promise and not the actual sale, the buyer need not have
to pay the price in advance. Thus a higher price may be fixed and as soon
as the commodity is received by the bank it will be sold to the third party
at a pre-agreed price, according to the terms of the promise.
• The conditions and obligations of each contract are independent of each
other (enforcement and performance are not contingent on each other).
• Parallel Salam is allowed with a third party only. The seller in the first
contract cannot be made buyer in the second contract because it will be a
buy-back contract and prohibited by Shariah.
• Even if the purchaser in the second contract is a separate legal entity, but
it is fully owned by the seller in the first contract, the arrangement is not
allowed.

Bay’ al Salam Structure
Customer Bank Supplier
sale of asset
delivery deferred
advance
payment
in full
(discounted)
1
23
4
purchase
price in full
(plus premium)
today
payment delivery
future
sale of asset
delivery deferred
Bay’ Salam Structure

Salam V Forward
Transactions
• Forward transactions
– Only deposit is paid, and delivery is uncertain
– Permissible even if traded prior to execution, as are
futures and options
• Salam
– Financier pays price of commodity in advance in full
– Quantity and delivery date and place specified
– Financier may enter parallel Salam to sell commodity at a
slightly higher price if period is shorter to delivery
– Price differential represents financier’s profit
– Risk involved to justify profit as time period of contracts
may not coincide and financier could be exposed

Istisna'a V Salaam
Istisna'a
•The subject is to be
manufactured
•Payment accepted by
installment
•Can be cancelled before
manufacturing
commences
•Delivery time can be
renegotiated
Salaam
•The subject does not
have to be manufactured
•Payment in full in
advance
•Can’t be cancelled once
contracted
•Delivery is fixed

Arbun (Deposit)
• The Arbun is contract provides for the
purchaser to make a deposit (which forms
part of the purchase price) for the purchase
of particular assets at a later date
• The sale of the assets not proceed if the
purchaser elects not to proceed and the
Arbun forfeited
• Arbun in modern day financing has met with
varying levels of approval amongst the
schools of Islamic jurisprudence.

Tawaroq
(Opposite of Murabaha)
 Murabaha
 Bank buys and owns the commodity
 Commodity sold to the client at a mark-up
 Parallel or reverse Murabaha
 A client is in need of liquid cash, he has
commodity stock.
 He authorizes the bank or an institution nominated by
the bank to sell the commodity for a service
commission
 The client may purchase his own commodity stock at a
price plus mark-up at deferred payment

Bay Bithaman ajil (Delayed
payment)

Qard Hassan (Interest free loan)

• Sukuk types
• Difference between Sukuk and Bonds
• Sukuk structure and application
• Securitising Sukuk
• Sukuk issuance and index
• Sukuk trading and secondary markets
• Case Study

What Sukuk look like
• Essential difference between Bonds & Sukuk
• Kinds of Sukuk
• Types of Sukuk
• Ijara Sukuk
• Mudarabah Sukuk
• Istisna'a Sukuk
• Musharakh Sukuk
• Salaam Sukuk
• Corporate governance for Islamic finance
97

What is a Sukuk?
• AAOIFI:
– ‘certificates of equal value representing
undivided shares in the ownership of
tangible assets, usufructs and services or (in
the ownership of) the assets of particular
projects or special investment activity’
– Arabic Sakk – plural Sukuk
• “check” derived from Sakk
• AAOIFI does not refer to application or
uses of Sukuk
• Only to classification 98

100
Types of Sukuk
• Musharakh and Mudarabah Sukuk –
Partnership transaction
– Often used to manage the relationship
between different parties
– Often in combination with Salam or Istisna'a
Sukuk
• Murabaha Sukuk
• Mudarabah Sukuk
• Istisna’a Sukuk
• Ijara Sukuk
– Sale and Lease Back

101
Party to Sukuk structure
• Issuer
• Corporate or government raising funds (originator)
• Special Purpose Vehicle (SPV)
– Asset Acquisition
– Bankruptcy remote
– Tax efficient jurisdiction
– Trustee
• Investor
• Manager (representing Sukuk investors)
• Servicer (to collect cash from assets, maintenance of assets.
Sometimes performed by the originator)
• Bank
• Holding bank to receive fund from Sukuk101

102
Basic Sukuk structure
102
Issue
Maturity

Legal Documents in issuing
Sukuk
• Purchase agreement
• Master Ijarah agreement
• Sellers Declaration of trust
• Service agency agreement
• Insurance (Takaful) agreement
• Purchases Undertaking Deed
• Sale Undertaking agreement
103

104
Sukuk Structure
• Sukuk obviously cannot bear interest.
• For Sukuk to be Shari’ah compliant, the
Sukuk holder must have part in the assets
being financed.
• The Sukuk holder’s return is income
generated(Ijara) by the issuer
• He own proportional ownership of the
project.
• Typically, a bankruptcy remote issuer (SPV)

105
Sukuk structure
• The issuer  issues the Sukuk certificates,
to the Sukuk holders who acquire
proprietary interest in the assets of the
issuer.
• The nature of this proprietary interest will
depend on the view taken by the Scholars
• The minimum ownership requirement for
the Sukuk holder is an entitlement to
income generated by the assets.
• The issuer, acting as trustee, collects such

106
Bond Structure
• A conventional, plain vanilla bond is a
simple debt
• The note holder’s return for providing
capital to the note issuer takes the form of
interest.
• The Bond holder’s return on his
subscription proceeds is an income
generated by the debit generated from
the cash flow, he own debit and promises

107
Bonds Sukuk
• A bond is an
obligation to pay to
bond holders, on
certain specified
dates, interest and
principal.
• Primary level –
loan contract to
create
indebtedness
• A Sukuk holder is an
owner in the
underlying assets
• Sukuk holders are
entitled to share in the
revenues
• Primary Level – not a
loan contract, because
of prohibition from

108
Bonds Sukuk
• The loan
indebtedness is
securitized with zero
coupon
• Bonds are sold to
investors which are
backed by the
underlying cash
flows
• Bonds (if specified
• The financial rights
under the contract
are securitized
• Sukuk sold to
investors which are
backed by underlying
assets
• Sukuk cannot be
converted once they
are issued

109
Bonds Sukuk
• Bonds depend
solely on the
creditworthiness of
issuer; in the case of
issue failure, bond
holders join the
pool of general
creditors seeking
the assets of a
bankrupt company
• Sukuk holders are
secured creditors
as they own part of
the underlying
asset; even if
failure occurred,
Sukuk holders are
paid before any
secured or
unsecured

110
Bonds Sukuk
• Bond holders are
not concerned with
asset-related
expenses
• The underlying
contract for bonds
only depends on
the issuer
• Rights of bond
holders are not
• Asset-related
expenses is attach to
Sukuk holders
• The underlying
contract for Sukuk
issuance is a
permissible contract
such as lease or any
of the 14 categories
defined by AAOIFI
• Proportional

Special Purpose Vehicle(SPV)
• An SPV must have independent and professional directors
or Trustee
• The SPV must be sufficiently “bankruptcy remote”;
• The SPV is ultimately responsible to ensure that its assets
are managed with due care and in the best interests of the
Sukuk holders
• The SPV and the securities issued must not carry the same
name as the Originator or be similarly identified
• The SPV must keep proper accurate accounts its assets,
liabilities, income and expenditure to be transparent
• To comply with all regulatory reporting requirements in the
jurisdiction
111

Sovereign Sukuk vs.
Corporate Sukuk
• Sovereign
• Issued by Government
• Sets benchmark
• Ijara structure –
preferred
• Sukuk Holders are
Domestic owners or/
and international
owners (Unless
Sovereign Law passed
by the parliament)
• Corporate
• Issued by Corporate
company (no
guarantee)
• Ijara more difficult
• Variety of structures
• Musharakh,
• Mudarabah,
• Wakala
• Istisna'a
• Sukuk Holders domestic
or/and International
owners

Who buys Sukuk
• Islamic banks
– Liquidity management
– Balance sheet usage
• Islamic Funds
– Asset diversification
• Islamic Pension funds, Takaful
– Fixed income, annuity type income
• Large investors
• Non-Islamic investors – all of above
113

Project Finance Sukuk
• Financing of large projects
infrastructure and industrial projects
(Sovereign Sukuk manly)
• Equity – based on projected cash flows
rather than balance sheet of project
sponsors
• Typically non recourse loans, secured
by project assets, including revenue-
producing contracts
• Debt and Equity 114

Project Finance Sukuk
115
Source – DIFC Guide
Book

116
Types of Sukuk
• Mudarabah Sukuk ( Financing)
• Musharakh Sukuk (partnership company)
• Murabaha Sukuk (Financing, and
Investment)
• Intifaa Sukuk ( Operate and use)
• Istisna'a Sukuk (Manufacturing)
• Salaam Sukuk ( Future delivery)
• Ijarah Sukuk (Rental)
• Hybrid Sukuk (Mix basket )

117
Principals of Sukuk
• A debt ( Murabaha Sukuk)
• An asset (Ijarah Sukuk)
• A project (Istisna'a Sukuk)
• A business ( Musharakh Sukuk)
• An Investment (Istithmar Sukuk

118
Musharakh Sukuk
Key Contract types
• Musharakh involves a mutual contract
between Issuer & SPV (for Sukuk Holders) to
participate in a commercial enterprise for a
specific period( from 5-20 Years)
• Management
– All partners (SPV is one partner) may be involved in the
management of the project
– Remuneration for the management is part of expanses

119
Musharakh Sukuk
• Musharakh is a relationship established
under a contract by the mutual consent of
the parties for sharing of profits and losses
in the joint business.
• It is a partnership arrangement between two
or more parties to finance a business
venture whereby all parties contribute
capital for the purpose of financing the
project.
• Any profit derived from the venture will be

120
Musharakh Sukuk
• The Musharakh Sukuk can also be
structured with all investors putting capital
in a Musharakh and appointing the issuer
as their agent to manage the project.
• The issuer will issue certificates evidencing
the capital contribution of the investors
and the ‘indicative rate of profit’.
• Profits, if any, will be shared between the
Musharakh participants at an agreed

Mudarabah Sukuk
• Similar to Musharakh Sukuk
• Mudarabah involves a mutual contract
between Issuer & SPV (for Sukuk Holders) to
participate in a commercial enterprise for a
specific period( from 5-20 Years)
• Management
– Issuers are the sole management of the project
– SPV is not involved in the management of the project

122
Mudarabah Sukuk
• The profit is to be shared in according to a pre-agreed ratio.
• A contract is made between Issuers and SPV to finance a
business venture and issue Sukuk.
• The profit will be distributed based on a pre-agreed ratio.
• The loss shall be borne solely by the issuers of the Sukuk
(Obligator) in the event of any loss.
• Mudarabah Sukuk give their owner (issuer) the right to
redeem the Sukuk for the original value plus the profit
agreed.

123
Murabaha Sukuk
• Murabah is the sale of goods at a price comprising the
purchase price plus a margin of profit by parties
concerned.
• Sukuk al-Mudarabah are certificates of equal value issued
for the purpose of financing the purchase of goods
through Murabah contract, so that the certificate holders
become owners of the Murabah commodity.
• The issuer of the Sukuk certificate is the seller of the
Murabah commodity

124
Murabaha Sukuk
• The subscribers are the buyers of that
commodity
• The realized funds are the purchasing cost
of the commodity.
• The certificate holders own the Murabah
commodity and are entitled to proportion
of the final sale price.
• It is short term Sukuk

Murabaha Sukuk structure
125
Issuer
Obligator S P V
Sukuk
owners
Payment
Initial transfer of title Final transfer of title
Part Income
generated

126
Ijarah Sukuk
• Sukuk al-Ijarah will offer a high degree of
flexibility
• They are issued as sovereign Sukuk by
government, municipalities, awqaf or any
other asset users,
• private or public companies, financial
intermediaries or directly by users of the
leased assets Sukuk al-Ijarah is completely
negotiable and can be traded in the

127
Ijarah Sukuk
• Ijarah Sukuk is a contract which involves the
transfer of usufruct of a property or asset to
another (SPV) in return for an agreed regular
consideration
• Sukuk al-Ijarah are subject to risks related to
pay the rental installments.
• Market risks arising from potential changes
in asset pricing and in maintenance and
insurance costs.

128
Istisna'a Sukuk
• Istisna'a is a contractual agreement for
manufacturing goods and commodities
• Cash payment in advance and future
delivery or a future payment and future
delivery.
• A manufacturer or builder agrees to
produce or build a well described good or
building at a given price on a given date in
the future.

129
Istisna'a Sukuk
• Istisna'a can be used for providing the
facility of financing the manufacture or
construction of houses, plant projects and
building of bridges, roads and highways.
• Sukuk al-Istisna'a are certificates that carry
equal value and are issued with the aim of
mobilizing the funds required for producing
products that are owned by the certificate
holders.

130
Istisna'a Sukuk
• The issuer of these certificates is the
manufacturer (supplier/seller);
• The subscribers are the buyers of the
intended product
• the funds realized from subscription are
the cost of the product.
• The certificate holders own the product
and are entitled to the sale price of the

131
Salam Sukuk
• Salam is the sale of a specific commodity,
• Well defined in its quality and quantity,
• Delivered to the purchaser on a fixed date in
the future against an advanced full payment
of price at spot.
• Sukuk al-salaam are certificates of equal
value issued for the purpose of mobilizing
salaam capital so that the goods to be
delivered on the basis of salaam come to the

132
Salaam Sukuk
• The certificates or the sale price of the
salaam goods sold through a parallel
salaam
• Salam-based securities may be created and
sold by an SPV
• The funds mobilized from investors are paid
as an advance to the SPV for deliver at
future date.
• SPV can also appoint an agent to market

133
Salaam Sukuk
• The issuer of the certificates is a seller of
the goods of salaam
• Subscribers are the buyers of the goods
• The funds realized from subscription are
the purchase price (salaam capital) of the
goods.
• The holders of salaam certificates are the
owners of the salaam goods and are
entitled to the sale price

134
Obligator
s
(Undertaking future sale of
commodities for the investors)
Obligator
(Sells commodity on salaam basis)SPV
(Special purpose Vehicle)
Salam Sukuk
Holders
(Investors)

135
Secondary Sukuk Trading
• The market for Sukuk is maturing and
there is an increasing demand for
secondary Sukuk market
• Sukuk have confirmed their viability as an
alternative means to mobilize medium- to
long-term savings and investments from a
huge investor base.
• Investors are able to focus on the
underlying asset and viability of a project

136
Secondary Sukuk trading
• Different Sukuk structures have been
emerging over the years but most of the
Sukuk issuances to date have been Sukuk
al-Ijarah.
• Since they are based on the undivided pro-
rata ownership of the underlying leased
asset, it is freely tradable in the secondary
Sukuk market at par, premium or discount.
• Tradable Sukuk represent tangible assets or

137
Liquidity management in Sukuk
• It provides adequate protection for the
separate interests with the emphasis on
equity and the concept of trusteeship.
• Mudarabah, or participation financing, is
also commonly used in partnerships for
the acquisition or development of real
property.
• Istisna’a can also be used to provide
property development financing for the

What Structure using Islamic Finance
tools do you think suitable for
Investment fund and Project Finance

major market players
in Islamic finance
rating
agencies
information
services,
media,
associations
consultancy
(legal, com-
mercial,
Shari’ah)
training,
education,
research
standard
setters,
regulators,
stock
exchanges,
financial
centres, …
Shari’ah compliant
financial instruments
infrastructure of the
Islamic finance industry
• mudarabah
• musharakah
• …
capital market instruments
• Shari'ah compliant stocks
• Islamic securities (sukuk)
• Islamic derivatives …
• murabahah
• ijarah
• …
interest-free finance contracts
Islamic
banks
specialized
Islamic finan-
cial service
providers:
investment
companies,
house finance
companies, …
conventional
market players
Islamic
subsidiariesIslamic
windows
Sukuk
14%
Takaful
(Re-Takaful)
1%
prohibition of riba (interest),
gharar (uncertainty), maysir
(gambling),
problem: form vs. substance
investment & commercial banks 81%
Islamic
funds
4%
estimated total volume of
Shari'ah compliant assets
2012F: 1,6 trillion US dollars
AAOIFI, IFSB,
BIS, BNM, CBB,
SBP, DFSA,
FSA, …
Bursa Suk Al-
Sila’ (Malaysia),
DIFC (Dubai),
IIFM, IILM, …
Moody’s,
S&P, Fitch,
RAM Ratings,
IIRA, …
BIBF, IRTI,
World Bank,
IBFIM, INCEIF,
universities, …
Source of data: GIFF 2012.
KPMG, E&Y,
PwC, Deloitte,
Yasaar,
Amanie, …
Dow Jones,
FTSE, MSCI,
Thomson Reuters,
RedMoney, …
Proposed Structure Islamic Funds for Investment and Project Finance

• Islamic private equity fund
• Wealth management
• Islamic derivatives and hedge
funds(Shari’ah restrictions & application)
• Islamic Forward currency exchange,
Currency options, profit rate swaps, and
FOREX

• Structure Shari’ah-compliant Portfolio
Management
• Islamic asset management, Equity market,
private equity, venture capital and unit
trust
• Equity and stock screening for Shari’ah
compliant
• Shari’ah-compliant Asset Classes, Sukuk,

• Governance framework in Islamic finance
institutions
• Shari'ah Board responsibilities and
accountability
• Disclosures and transparency
• Risk Management in Islamic Finance
• Case Study

Overview of Corporate
Governance
• Corporate governance aims at providing
institutions with a body of rules and
principles
• to ensuring that good practices guide
overall management
• It has now come to mean the whole
process of managing a company
• Set of incentive structure to address
principal-agent 148

Overview of Corporate
Governance
• Issues and ensure that executive management
serves the long-term best interests of the
shareholders
• The company in conformity with the laws and
ethics of the country.
• Balancing the power between the Chief
Executive Officer (CEO), the board, and the
shareholders
• Auditing, balance sheet and off-balance
disclosure,
149

Islamic financial institutions present
potential Corporate Governance
issues?
• Since the inception of modern Islamic
banking, the number and reach of Islamic
financial institutions worldwide has risen from
one institution in one country in 1975, to
more than 300 institutions operating in more
than 75 countries.
• Product and service innovation through the
development of Shari’ah compliant
mortgages, leasing, securitization, Sukuk and
Takaful have also contributed to growth in
Islamic finance. 150

Corporate Governance Aims to
provide
• Institutions with a body of rules and principals
to ensure good practice of management
• Ensure that the executive management
service long term best interest of the
shareholders and public
• Ensure that the institution sustainable value in
conformity with the law and ethics of the
country
• Ensure Transparency in the institution
activities 151

The corporate governance framework should
promote transparent and efficient markets, be
consistent with the rule of law and clearly
articulate the division of responsibilities among
different supervisory, regulatory and
enforcement authorities.
• A. The corporate governance framework
should be developed with a view to its
impact on overall economic performance,
market integrity and the incentives it
creates for market participants and the
promotion of transparent and efficient
markets. 152

• C. The division of responsibilities among
different authorities in a jurisdiction should be
clearly articulated and ensure that the public
interest is served.
• D. Supervisory, regulatory and enforcement
authorities should have the authority, integrity
and resources to fulfill their duties in a
professional and objective manner.
153

Shari’ah Supervisory Board
Roll, responsibility & accountability

Why Shari'ah Board Members’
Accountability Is Vital
A
• It gives worldwide credibility for the Islamic finance system.
B
• It creates confidence among investors and the public in the Islamic
finance system.
C
• It demonstrates that conventional finance institutions can adopt Islamic
financial transparency.
D
• It presents personal credibility to individual Shari’ah board members.
• It demonstrates that the Islamic finance system is compatible with the
Dr. Aly Khorshid 155

E
conventional finance system.
F
• It introduces Islamic risk management tools into global finance.
G
• It reflects Islamic principles in the terms of transparency, ethics, fairness,
justness, and honesty.
H
• It allows management and shareholders to seek advice on Shari’ah matters

I
• It allows the creation and structuring of new Shari’ah-compliant
products within the global internationally developed market
J
• It strengthens the global respect of fatwa issued for product
development that is Shari’ah-compliant.
K
• It introduces Shari’ah auditing standards to the global financial
market
L
• It strengthens the corporate governance of Islamic financial
institutions

M
• It embeds the values of Islamic finance into the business
operations and governance of financial institutions.
N
• It ensures Islamic ethical principles are preserved within
the global market
O
• It ensures Islamic ethical principles are preserved within
the global market
P
• It ensures the adoption of Basel II and Pillar II, particularly
in regard to money laundering and capital adequacy
issues, within Islamic finance institutions

Basic duties of Shari’ah
scholars
• Advising management and shareholders on
Shari’ah matters;
• Structuring new Shari’ah-compliant products
within the global internationally-developed
standard;
• Issuing fatawa for Shari’ah-compliant product
development
• Proposing Islamic risk management tools to
management;
• Enforcing Shari’ah auditing standards in the

• Instilling Islamic finance values into financial institutions’
business operations and governance;
• Conducting and/or supervising Shari’ah audits to ensure
compliance;
• Ensuring Islamic ethical principles are preserved within the
institution;
• Protecting consumers’ rights from abuse and fraud.
• Ensuring the adoption of Basel II and Pillar II, particularly in
regard to the prevention of money laundering and capital
adequacy issues within their institution
• Ensuring management accountability to the shareholders and
customers

Education
• there is no program in place for educating
and training the new generation of
Shari’ah board members.
• Shareholders and clients of IFIs expect
their investment to be protected by
professionals adhering to strict standards
of corporate governance.
• To protect the system from abuse and
fraud there must be corporate governance
• Dr. Aly Khorshid 161

Shari'ah Approval Process
Phase 1
Identify Shari’a Options
Activities
 Determine our clients’
needs and business
objectives
 Identify potential high level
Shari'a product structures
 Discuss available options
with our clients
 Work through the
commercial and practical
considerations with our
clients
Deliverables
 Preliminary Shari'a Report
Phase 2
Finalise Shari'a Structure
Activities
 Review selected product
structure
 Liaison with Shari'a
Scholars on the structure
design
 Identify required legal
documentation
 Prepare draft Fatwa
 Review of structure by
Shari'a Board and issue of
Fatwa on structure
Deliverables
 Fatwa on Shari'a Structure
Phase 3
Review Legal Documentation
Activities
 Review legal documents for
compliance with Shari'a
laws and the structure
Fatwa granted
 Liaise with Shari'a Scholars
and the clients’ legal team
during the documentation
drafting
 Legal documentation
reviewed by Shari'a Board
and issue of Fatwa on
documentation
Deliverables
 Fatwa on Legal
Documentation
 Throughout the process, Dar Al Istithmar adheres to relevant Shari'a industry standards, including the AAOIFI Shari’a Standards
 All processes are monitored through an internal quality assurance process and frequent consultation with the Chairman of the Shari'a Supervisory Board.
Client selects
methodology
& builds
detailed
structure
Client
produces
legal
documents

Operating Models
Model options Characteristics Shari’a Aspects
Shari’a Compliant
Islamic Banks
Due to rapid development of Islamic Finance,
new banks are being set-up which are fully
Shari’a Compliant and offer retail as well as
whole sale banking facilities.
Since 2004, five fully Islamic banks have been
set up in the UK, out of which one is a retail
bank where as other four are whole sale banks.
From Shari’a perspective, these are at the
lowest risk due to:
• No dealing in conventional / interest based
products
• No risk of mixing of Islamic Funds with
conventional.
• More involvement of Shari’a Scholars in day to
day activities of the bank.
Conventional bank
with an Islamic
subsidiary / Finance
Vehicle
This model is used by conventional banks which
want to extend their services into retail and
whole sale Islamic Banking as well as retaining
the conventional customer portfolio.
This model is used by HSBC, Standard
Chartered, Citi etc.
From Shari’a perspective, Islamic subsidiaries /
finance vehicles are considered at a lower risk
due to:
• Bespoke IT system and infra-structure for
Islamic Products.
• Segregation of Islamic Funds, cash flows,
assets and liabilities from conventional.
• Involvement of Shari’a Scholars in day to day
activities of the Islamic Finance Vehicle.
Conventional bank
with an Islamic
Window
This set-up is primarily used by conventional
investment banks which want to provide its high
net worth individuals and institutional customers
access to Shari’a Compliant investments and
Structured products.
This model is followed by Deutsche Bank,
Barclays Capital etc.
From Shari’a perspective, Islamic windows are
considered to be high risk primarily due to:
• IT Systems and infra-structure of conventional
banks may not be not be flexible enough to cater
requirements of Islamic Products.
• Funds generated from Shari’a Compliant
sources are not segregated from funds
generated from conventional activities.

Contrast of Shari'ah Governance with
Existing Governance Structure
FUNCTIONS TYPICAL FINANCIAL
INSTITUTION
ADDITIONS IN IFIS
Governance Board of Directors Shari’ah Board
Control Internal Auditor
External Auditor
Internal Shariah Review
Unit
External Shariah Review
Compliance Regulatory and
Financial Compliance
Internal Shariah
Compliance Unit

Voluntary Standards on Shari’ah
Governance
AAOIFI Governance Standards
1. Shari’ah Supervisory Board:
Appointment Composition and Report
•At least 3 members (no directors or
shareholders)
•Requirements for report suggest
Shari’ah board must play a deep role in
review of bank’s operations.
•Recommendation to publish fatwas,
rulings and guidelines
2. Shari’ah Review
•SSB forms opinion, but Shari’ah
compliance rests with management
•Examination includes contracts,
agreements, policies, products,
transactions, memorandum and articles
of association, financial statements,
reports (especially internal audit and
central bank inspection), circulars, etc.
•complete and unhindered access to all
records, transactions, and information
from all sources including professional
advisers and the IFI employees.
3. Internal Shari’ah Review
•Internal division or part of internal
audit
•Examination and evaluation of the
adequacy and effectiveness of the IFI’s
system of internal Shari’ah control and
the quality of performance in carrying
out assigned responsibilities.
The SSB review procedures shall normally include:
• obtaining an understanding of the management’s awareness, commitment and compliance control procedures for
adherence to the Shari'ah;
• reviewing of contracts, agreements, etc.;
• ascertaining whether transactions entered into during the year were for products authorised by the SSB;
• reviewing other information and reports such as circulars, minutes, operating and financial reports, policies and
procedures, etc.;
• consultation/co-ordination with advisors such as external auditors; and
• discussing findings with an IFI’s management.

Risk Management in Islamic
Finance
• Risk is exposing to danger and/or hazard
• A possibility that the outcome of an action or
event could bring adverse impact resulting in
loss
• Banks are exposed to greater risk and loss
because they are stack holders of other
people money
• Risk is defined in ISO 3100, is intended to be a family of
standards relating to risk management codified by the
International Organization for Standardization

• Risk management can therefore be considered the
identification, assessment, and prioritization of risks
followed by coordinated and economical application
of resources to minimize, monitor, and control the
probability and/or impact of unfortunate events.
• Risks can come from uncertainty in
financial markets, project failures, legal
liabilities, credit risk, accidents, natural
causes and disasters as well as
deliberate attacks from an adversary.
• The strategies to manage risk include
transferring the risk to another party,
avoiding the risk, reducing the negative

Potential Risk treatment
• Once risks have been identified and assessed,
all techniques to manage the risk fall into one
or more of these four major categories:
• Avoidance (eliminate)
• Reduction (mitigate)
• Sharing (outsource or insure)
• Retention (accept and budget)
168

Corporate
Risk
Management
Credit Risk
Operational Risk
Strategic RiskReputation RiskLiquidity Risk
Price Risk
Rate of Return Risk
Funding (A/L) Risk;
Prepayment Risk;
Spread Risk;
Option Risk.
Market Risk;
Volatility Risk;
Option Risk;
Basis Risk
Funding Mismatch Risk;
Debts Risk;
Risk of Loss on Inv. sales
Compliance Risk;
Regulatory Risk;
Public Relations Risk;
Shareholder Relations Risk
Competitive Risk;
Political Risk;
Legal Risk;
Product Risk
Internal Control Risk;
Systems (IS/IT) Risk;
Accounting Risk;
Settlement Risk
Default Risk;
Counterparty Risk;
Concentration Risk
SOURCES OF RISK
Shari’ah
Non-compliance Risk

TYPES OF RISKS FACED BY
IFIS
IFI
Market
Equity
Investment
Rate of Return
Displaced
Commercial
Operational
Sharia’h Non
Compliance Transparency
Fiduciary
Credit

Risk Avoidance
• Not performing an activity that could carry risk”for example
would be not buying a property or business in order to not
take on the liability that comes with it”.
• Not flying in order to not take the risk that the airplane was
to be hijacked.
• Avoidance may seem the answer to all risks,
• But avoiding risks also means losing out on the potential
gain that accepting (retaining) the risk may have allowed.
• Not entering a business to avoid the risk of loss also avoids
the possibility of earning profits
171

Hazard Prevention
• Hazard prevention refers to the prevention of
risks in an emergency.
• The first and most effective stage of hazard
prevention is the elimination of hazards.
• If this takes too long, is too costly, or is
otherwise impractical, the second stage is
mitigation.
• Prevents hazardous events occurring
172

Risk Reduction
• Involves methods that reduce the severity of
the loss or the likelihood of the loss from
occurring” for example, sprinklers are
designed to put out a fire to reduce the risk of
loss by fire” This method may cause a greater
loss by water damage and therefore may not
be suitable.
• But what choice can have? Complete loss, or
partial loss
173

Risk Retention
• Involves accepting the loss when it occurs.
• True self insurance falls in this category.
• Risk retention is a viable strategy for small risks where
the cost of insuring against the risk would be greater over
time than the total losses sustained.
• All risks that are not avoided or transferred are retained
by default.
• Includes risks that are so large or catastrophic that they
either cannot be insured against or the premiums would
be infeasible.
174

Risk Sharing
• The term of 'risk transfer' is often used in
place of risk sharing in the mistaken belief
that you can transfer a risk to a third party
through insurance or outsourcing.
• In practice if the insurance company or
contractor go bankrupt or end up in court,
the original risk is likely to still revert to the
first party.
175

Risks in Islamic Banks
• Shari’ah Non-Compliant Risk
• Commodities and Investment Risk: arising
from holding inventory under
Murabaha(commodities) or assets lease under
Ijara
• Rate of return Risk: Similar to interest rate risk
• Equity position Risk: arising from equity
exposure in Musharakh & Mudarabah
financing contract
• Pricing Risk: Uncompetitive products due to

RISK’s FOR conventional BANKS
OPERATIONAL
FOREIGN
EXCHANGE
REPUTATION RISK
RATE OF
RETURN
EQUITY
INVESTMENT
RISK
SOLVENCY
&
LIQUIDITY
Interest
Rate Risk
MARKET
CREDIT
RISK

Risk’s For Islamic Banks
OPERATIONAL
FOREIGN
EXCHANGE
REPUTATION RISK
RATE OF
RETURN
EQUITY
INVESTMENT
RISK
SOLVENCY
&
LIQUIDITY
SHARIAH
COMPLIANCE
MARKET
CREDIT
RISK

Shariah
Compliance
Inspection
(By the Central
Bank)
Internal Shariah
Review / Audit
(Internal
Function)
Shariah
Compliance
Consideration by
External Auditor
/ External
Shariah Audit
Shariah Review
(Performed by
the Shariah
Board / Advisor)
Shariah
Supervisory
Board / Shariah
Advisor
Shariah Compliance Risk
The lack of consensus on
Shari'ah interpretation
adds a
considerable risk
element

TYPES OF RISKS
Credit Risk
•Risks related to failure by
IFIs’ customers or
counterparties to meet their
obligations to the IFIs.
•For example, default in
financing payment by
customers can result in loss
of income and capital.
Equity Investment
Risk
•Risks in holding equity
instruments for investment
purposes. For example,
shares or profit-sharing
instruments in Mudaraba
and Musharaka
transactions.
•Equity instruments expose
IFIs to risks that value of
investment capital may be
impaired or that the
companies (in which IFIs
have invested) may fail to
generate profit.
Market Risk
•Risks related to movement
of profit benchmark rates,
foreign exchange rates,
equity prices and
commodity prices.
•Fluctuations on these rates
or prices can impact IFIs’
earnings.
Liquidity Risk
•IFIs use their customers’
deposits and investment
funds to finance IFIs’
financing/investment
activities.
•IFIs are exposed to risks that
they may be unable to
match any increase in
financing/investment
activities with
corresponding increase in
deposits/investment funds.
Rate of Return Risk
•IFIs have to manage
expectation of their investment
account holders and IFIs’ own
ability to generate returns from
IFIs’ assets.
Displaced
Commercial Risk
•IFIs may be under market
pressure to pay returns to its
investment account holders
that are higher than what has
been earned from the IFIs’
assets (therefore, IFIs may
waive their rights on their
Mudarib share of profits).
Operational Risk
•Risks from inadequacy or failure
of internal processes and
controls; from non-compliance
to Shari’a; or from external
events.
•These risks may lead to
withdrawal of deposits, loss of
income, or cancellation of
contracts.
Consequential
Business Risk
•Consequential Business Risks
•Related to development in
external market place.
•Adverse changes to markets,
counterparties, economic and
political environment.
•Reputational Risks
•Related to failures in
governance, business strategy
and process.
•Negative publicity will impact
their market position,
profitability and liquidity.

RISKS INHERENT IN IFIs
Source of Funds (Liabilities Side)
Features Implications
External Funds
Interest Free Deposits (Current Account Equivalent) -
Qard Hasan
Profit Sharing Investment Accounts (Interest Bearing
Deposit Equivalents)
Restricted PSIA (Off Balance sheet)
Liquidity Risk
Operational Risk
Shariah Non-compliance Risk
Rate of Return Risk
Transparency Risk
Fiduciary Risk
Internal Funds
Equities
Operational Risk
Rate of Return Risk
Reputational Risk
Displaced Commercial Risk

RISKS INHERENT IN IFIs
Uses of Funds (Assets Side)
Features Implications
Asset Based
Murabaha in place of short term loans: where non-
binding order is recognised; Murabaha; MPO may
expose the IFI to unwanted assets:
- Lower Price at the point of disposing the assets
- Operational Issues such as storage
Ijarah and Ijarah Muntahia Bittamleek (IMB) assets in
place of longer term conventional loans
Salam and Istisna give rise to non-financial assets
Salam – hedge with parallel salam and/or promise
Parallel Istisna – WIP inventories
Risk Transfer
Credit Risk or Market Risk
Operational Risk
Consequential Risk (RRR, DCR and Systemic)
Risk Combined
Credit Risk / Market Risk
Operational Risk
Profit and Loss Sharing
-Musharaka
Profit Sharing and Loss Bearing
-Mudaraba
Investment in Real Estate
Capital Impairment Risk
Credit Risk
Market Risk
Operational Risk
Equity Investment Risk
Market Risk, Liquidity Risk, Rate of Return Risk

Management of Credit Risk
• Policy on credit selection criteria.
• Processes on credit approval, review and monitoring.
• Credit exposure portfolio based on borrower type (retail / commercial /
corporate), financing type, economic sector, country/region.
• Policy for determining and allocating provisions for doubtful debt and
estimated impairment of financing assets.

Management of Equity
Investment Risk
• Policy on investment selection criteria.
• Processes on investment approval, review and monitoring.
• Investment exposure portfolio based on types of investment,
expected returns, holding periods, risk tolerance.
• Policy for methods of valuation for the investments.
• Exit strategy from the investments.
• Restricted Mudharaba / Musharaka Mutanakasah

Management of Market
Risk
• Identification of underlying market risks in IFIs’ financing or
investment activities. For example, commodity-based investment
carries risks on movement of commodity prices.
• Quantification of market risk exposure (through valuation and
pricing methodology) and monitoring of that exposure.
• Policy on provisions to support probable losses of impairment of
assets.
Mitigated by:
• Deal structure Murabaha.
• Regulatory restrictions.
• Hedging techniques through structured commodities.

Management of Liquidity
Risk
• Framework to measure, monitor and report liquidity exposures.
• Adequate funding capacity (access to IFIs’ own financing
arrangement or to additional capital).
• Portfolio of customers’ funds (current account deposits, restricted /
unrestricted investment account funds).
• Holding of other assets (eg., tradable securities) that can be
liquidated to cover any shortages.

Primer on Rate of Return Risk (1/3)
187
Conventional banks, through the asset transformation function,
mismatch the maturities of their assets and liabilities.
• This mismatching expose banks to refinancing risk
Liabilities $10M
Assets $10M
210
Period 1 Period 2
Deposits rate 1% 2.5%
Loan rate 2% 2%
Profits $100,000 ($50,000)

188
• The dual banking system exposes Islamic banks to interest rate risk
• Ability of depositors to switch between the two banking systems forces
Islamic banks to pay a rate of return equivalent to the market interest rate
• Co-movement in rates – Changes in conventional bank interest rates
Granger Cause changes in Islamic bank rates of returns
Conventional IslamicIslamic if equal or higher
rate of return
10% 20%70%

189
• Under the pressure from the markets, some Islamic banks are
smoothing returns
• When the bank return on its investments is lower than the market
interest rate, it draws on its PER
• In this case, banks are exposed to certain types of risks in a similar way
to that of conventional banks
Liabilities
• Debt-like instruments
• Investments
• Current accounts
• Investment Accounts
Profit Equalization Reserve
AssetsAssets

Management of Rate of Return Risk /
DCR
• Profit Equalisation Reserves: amount appropriated out of IFIs’ income
(before allocating Mudarib share) in order to maintain a certain level of
return to their investment account holders.
• Investment Risks Reserves: amount appropriated out of investment
account holders’ income (after allocating Mudarib share) in order to
cushion effects of risks of future investment losses on investment
account holders.
• Cash flow forecasting on IFIs’ future earnings and expected payments
to investment account holders.
Difference between the rate of return risk and the interest rate risk:
 Greater uncertainty in the case of Islamic banks given the nature of the assets (it includes
Musharaka and Mudaraba)
 Although IAHs expect a rate of return comparable to the market interest rate, the return on
such accounts is not predetermined

Management of Operational Risk
• Framework for internal processes and controls, incorporating
documentation of operational procedures, review of compliance to those
procedures, and internal audit programme.
• Shari’ah advisory and compliance structure including Shari'ah Supervisory
Board and management structure for Shari'ah compliance.
• Compliance to auditing standards.
• Segregation of duties.

Musharaka Contract (Sharing
contract)
• Client Enters Agreement with bank to Invest in a Project
• Client invests $80,000, Bank Invests $20,000
• Profit Share is Based on a 80%:20%
(they may agree on different percentage subject to negotiation)
193
Client invests $80,000 Bank invests $20,000
$100,000
Project

Islamic Finance & Sukuk ( April 2014)

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