Category Archives: Commodity Murabaha

Bai Al Inah and Interconditionality Issues

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I have been asked recently on the validity on a Bai Al Inah contract that had sparked controversies many years ago by claims that it is not a valid Islamic contract that is rejected by most Shariah scholars.

What do I think? As limited my Shariah knowledge is, the position of Bai Al Inah, and its counterpart Bai Bithaman Ajil (BBA), have always been that it is a structure of 2 standalone contracts of Musawamah (simple sale) and Murabahah (deferred cost-plus sale). The intention of these 2 contracts is for the purpose of obtaining cash or working capital through creation of debt. Both contracts are executed consequentially and valid as all the tenets of the contracts are met perfectly.

SO WHAT IS THE ISSUE THEN?
Generally both contracts of BBA and Bai Al Inah suffers from the same issue ie the existence of “Interconditionality” practices in their legal clauses in transaction documents. Both contracts have 2 standalone contracts i.e. one sale contract and one buy-back contract. Both contracts must be able to stand alone and the aqad is executed sequentially, which makes it valid based on trading rules.

The Aqad for the Bai Al Inah transaction uses the Bank’s own Assets for the underlying transaction, as the customer do not have any Asset to sell to the Bank in the first place. So Banks have been using their own Assets such as pieces of land, office hardware, office furnitures, company shares, investments in securities, machines, and any other valuable Assets that is identifiable, transferable and valuable.

CONTRACT #1 – SALE OF BANK’S ASSET (MURABAHAH) TO CUSTOMER IN BAL AL INAH 

These Assets are to be sold by the Bank to the Customer at a Sale Price (includes profit) and to be settled at a later date or at specific intervals. For example, the Bank sold its ATM equipment to the Customer at a price of RM180,000. This amount is to be paid back within 5 years (Deferred). This is a valid and perfected standalone contract. The debt created here remains valid until full settlement at the end of the 5th year.

CONTRACT #2 – BUY-BACK OF BANK’S ASSET (MUSAWAMAH) FROM CUSTOMER IN BAL AL INAH 

The Bank then makes an offer to Buy-Back the Bank’s Asset from the Customer at a simple sale transaction where the amount will be settled immediately. As the Customer intention is to obtain Cash or Working Capital, the Customer will generally agree to the Bank’s offer to Buy-Back the Asset at the current market price. For example, the Bank offers to buy-back the ATM equipment from the Customer at a price of RM100,000. This amount is to be paid immediately for settlement. Bank takes ownership of the ATM and pays the Customer RM100,000 cash. This is also a valid and perfected standalone contract

BUT WHAT HAPPENS IF THE CUSTOMER, AFTER COMPLETING CONTRACT #1, REFUSE TO ENTER INTO CONTRACT #2 AND DECIDE TO KEEP/TAKE THE DELIVERY OF THE ATM EQUIPMENT INSTEAD? THIS REPRESENTS A RISK TO THE BANK AS THE ASSET (ATM EQUIPMENT) IS NOW RIGHTFULLY OWNED BY THE CUSTOMER UPON COMPLETION OF CONTRACT #1

Because banks want to minimise risks, the interconditionality clauses are added to ENSURE that once the first sale contract (#1) is concluded, the second buy-back contract (#2) MUST be executed (mandatory). It goes on to say that if the second buy-back contract is not executed, then the first sale contract is invalid and restitution (going back to the original state) must be effected to recover the Asset already sold; in this case the ATM Equipment.

From Shariah point of view, it is problematic, because the first Aqad for the sale contract (#1), is a valid contract and completed under Aqad which meets all its trading tenets. To impose that another external event (i.e. the non-completion of the buy-back contract) that will invalidate a valid sale contract (already concluded and perfected), implies that the whole arrangement is superficial and do not carry real value.

This must not be the case, because the Aqad is already validly executed and is now running. Thus having the interconditional clauses is not favoured by Shariah and needs to be removed.

In Summary:
1) The Sale of Asset contract is valid on completion of Aqad
2) The Buy-Back of Asset contract is valid on completion of Aqad
3) If the Buy-Back of Asset contract (#2) is not completed, the Sale of Asset (#1) remains valid as the Aqad is already completed.
4) The requirement to force the Buy-Back of Asset contract to be completed via an interconditionality clause is problematic in substance. The notion of “one contract is only valid upon completion of another contract” does not sit well with Shariah.

Of course, for Banks, removal of such clauses from the documents represents a risk as the assets used for the transaction belongs to the Bank in the first place. The idea that the Customer cannot be compelled / forced to re-sell the assets back to the bank (or banks not allowed to buy-back) is a risk banks are not willing to take. As such impasse, the only way most banks can comply with the requirements to remove interconditionality in their contracts is to remove these contracts from their shelves.

There are still some Banks using products based on BBA or Bai Al Inah, but such usage is now limited to its uses are required by design (such as restructuring an existing Bai Al Inah account) and/or mainly transactions between financial institutions (not between banks and retail consumers) where the interconditionality clauses are not required/ can be ignored.

For the public, Tawarruq or Musyarakah Mutanaqisah or Ujrah structures are now used as acceptable replacements of both Bai Al Inah and BBA products, signalling the demise of these hugely unpopular products.

Wallahualam.

 

It is 2019. BBA and Bai Al Inah are Old News.

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WHY ARE YOU STILL ASKING ME ABOUT BBA AND BAI AL INAH?

It remains a mystery when people ask me why Malaysia continues to offer Bai Bithaman Ajil (BBA) and Bai Al Inah products, as according to them, these structures are based on elements of Hilah (trickery). It is a mystery because starting from 2012/2013 period, the instructions on Interconditionality issued by BNM to Islamic Financial Institutions requires that the provisions of “mandatory buy-back” must not appear in financing contracts such as Bai Inah and BBA. Because of this, Malaysian Islamic Banks have slowly weaned itself from such products and have since moved to other Islamic contracts.

Read the circular issued by Bank Negara Malaysia in 2012 on the practice of Bai Inah and their expectations by clicking this link (BNM Circular).

WE ARE STILL READING OLD BOOKS AND ARTICLES

In general, I still find that some learning institutions are incorrectly teaching students that the contracts are still alive and well in the Malaysian market. The text books used are still ones that predates 2011 and really, this is a disservice to students. When they come for interviews with our bank, it does not give the students any advantage or good impression as the syllabus remains outdated. Many do not know about the Policy Documents issued by Bank Negara Malaysia or the contracts covered by the policy documents. This really should be covered in a learning module as the latest requirements are captured in these documents. It is a good reference read, but it seems only practitioners and Shariah scholars are aware of these documents.

This is true as my last few interns also impressed the same. Tawarruq structures sounds alien to some of them, as their teachers prefer to teach BBA and Bai Inah  to unlock its controversies as points for discussion. Let us be clear that most banks NO LONGER offer Bai Inah or BBA, and those which does, offer it as a continuation for a legacy arrangement or due to certain unavailable scenarios, such as fresh new documentations are not obtained for Tawarruq arrangement (such as Wakalah to buy commodities). It is no longer offered as a product to the public and this is evidenced from the Banks website where the structures can no longer be found. And most of the time if used, this is a temporary fix allowed until the deal reaches expiry or the Tawarruq appointments are obtained.

And with Tawarruq arrangements now being ably supported by good infrastructure such as Bursa Suq As Sila trading platform and other commodity brokers worldwide, there is no issue of Darurah (emergency) to justify the continued usage of Bai Al Inah or BBA.

SO, WHERE HAVE WE GONE TO SINCE 2011?

In short, we have moved to the following contracts:

  1. Bai Bithaman Ajil (BBA) – Usually BBA is used for purchasing of properties (Home financing or Commercial properties financing), or sometimes for trade financing products. These usage is now done under the Tawarruq arrangement (using Commodity Murabahah) where the proceeds from the sale of Commodities is used to settle the purchases of houses or commercial properties. Alternatively, Musyarakah Mutanaqisah arrangement (Diminishing Partnership) is also used by many banks where houses or properties are purchased by the Bank and leased out to the customer, who then pays rental and gradually purchases the shares of the house and properties over time. So now, BBA has been replaced with Islamic arrangements of Tawarruq or Musyarakah Mutanaqisah. Other Islamic contracts has also been known to support some elements of BBA, such as Istisna’a (property construction), Murabahah (good sale at profit) or Ijarah / Ijarah Mausufah fi Dhimmah (forward lease).
  2. Bai Al Inah – Usually Bai Inah is deployed for Personal Financing or Working Capital Financing and even Islamic Credit Cards. Again, Tawarruq arrangements has generally replaced these usage with the end result of providing cash. On a smaller note, the contract of Ujrah (Services) is also deployed to support some requirements of personal financing (where purchase of goods and services are required) and Islamic Credit Cards. So now, Bai Al Inah has now been replaced by Tawarruq arrangements or Ujrah contract to meet the cash and working capital requirements.

The final controversial contract that Malaysia currently deploy is the Bay Ad Dayn (Discounted Sale of Debt), which serves a specific purpose in trade financing products. Eventually a common ground must be found to make this contract more globally accepted, or replaced with a better solution.

UPDATE YOUR STUDY NOTES, PLEASE

The main challenge nowadays is to innovate further by improving what we have. Criticisms are good, especially on the old structures. But we practitioners do hope the learning academia afford us a bit more confidence and trust, especially these criticisms and consequent issues are not “unknown” to us, since we lived and breathed in its controversies many years ago. The comments made in recent times are something we had encountered and resolved 10 years ago. We enhance and evolve, and it will be good to see new students coming into the market armed with the latest updates of what is happening and let’s move forward.

It is now 2019. Do not get stuck in the muddy past. These contracts have gone into the history books. We have so much to do in the future arena.

The Tawarruq Dilemma

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Islamic Banking in Malaysia is fast reaching a crossroad. While Islamic Banking continues to offer like-to-like conventional structures, the requirements by Shariah Committees and Policy Documents by Bank Negara Malaysia continues to challenge the way Islamic Banks implement and operationalise the products within a viable banking structure. Islamic Banks are becoming mindful of the need to comply fully to each policy requirements.

It is precisely this fear of being “non-compliant” to these requirements that pushes many Islamic Banks to develop the Tawarruq-based products into its most efficient form. As I have written earlier in Disruption : Islamic Contracts where I felt the Tawarruq arrangements has become the “go to” structure that Islamic Banks can easily comply with, the notion that other contracts such as Musyarakah or Ijarah or Mudharabah may now be left behind in its development due to perceived complexities. Or in some cases, difficulty to comply due to the existing banking set-up, especially in matters of risks, capital and operational processes which is intrinsically based on conventional banking infrastructure.

BUT CAN TAWARRUQ ALWAYS BE THE ANSWER?

It is generally accepted that a lot of processes in the Tawarruq arrangement can be complied with. There were strong operational support and infrastructure both internal and external, such as the London Metal Exchange (LME) and Bursa Suq Al Sila which has an efficient commodity platform specifically designed to support Tawarruq with or without commodity brokers, to the choice structure that bridges the middle-east players to most of the rest of the Islamic Banking geographies. But that is by no means that Tawarruq is a perfect solution for Banks.

Despite Tawarruq is now greatly used over the last decade or so, there are still contention points that remains amongst financial practitioners and Shariah scholars. Most scholars want to have the view that Tawarruq should be the “contract of last-resort” but what we see now are quite the opposite. It is the preferred choice being used not just for Working Capital requirements, but now also for Asset Financing, Mortgages, Trade Financing, Fixed Deposits, Structured Investments, and even Savings Account. Whenever an Islamic Bank hits a roadblock with a particular product being developed or requiring compliance to the latest rules, the tendency is always to consider Tawarruq as the solution.

If this is the approach, how much do we really need other Islamic contracts which only addresses a single problem or requirement? Shouldn’t we develop Tawarruq as far as it can take us and make other contracts as “supporting” contract to cater for specific nuances?

THE UNANSWERED QUESTIONS ON TAWARRUQ

Each year when Bank Negara Malaysia audit comes around, there will always be new compliance points to be proven and tested. Even at the level of understanding and interpreting the Policy Documents into processes and banking operations. Each Bank interprets the rules differently, and each banking set-up have different operational capabilities which more often than not, requires exceptional Shariah indulgence. So, the questions will remain unanswered whenever dispensation is obtained.

Many argue that the main issue of Tawarruq is actually the “intention” of the contract itself, and that intention is not to “trade in commodities” but to create debt via a trading transaction. This has been debated at length for many years in all types of forum, but we concede on some of the arguments by virtue of there being no other viable solution to cater for certain banking requirements. Islamic Banks, and its scholars, had to choose either:

  • Allowing for the Tawarruq arrangement with strict adherence to requirements until a solution arrives, or
  • Disallowing the Tawarruq arrangement which may result in customers being impaired in their Islamic business, which may result in the customer reverting to a conventional banking solution.

Is there a case of choosing the lesser of two evils?

Nonetheless, I won’t discourse what have been extensively discussed, but instead look at the operational issues of Tawarruq arrangements that I pick up going through the Tawarruq Policy Document. Among them that are still being debated in different forums are:

  1. The issue of Commodity Delivery – To demonstrate that the Tawarruq being practised by the Bank is real, the test of delivery of Commodity is a key qualifying factor. The Bank must have in place a mechanism that allows the customer an option to take delivery of the commodity whenever the customer calls for it, bearing in mind that may have not been the intention in the first place i.e. taking delivery of commodities. How a Bank prove this to Shariah Committee and regulators are crucial to demonstrate “real transaction” and paper transactions.
  2. The issue of Price Fluctuation – Depending on commodities, its price tend to fluctuate periodically, because these are actual live commodities being traded. Because of this, Banks have not been able to be precise in its documentation or price disclosures. Whatever price per commodity unit at 10am, it might change at  2pm, so how do you lock-in a specific price when the buy and sell of the commodity was not concluded immediately? The fact that Bursa Suq Al Sila states in its guidance notes that an Islamic Bank could not hold the commodities for more than 2 hours implies the issue of price fluctuation is a valid concern for Shariah Committees.
  3. The issue of Discrepancies of Terms – Because the Murabahah transaction in the Tawarruq arrangement is the most crucial contract, Scholars always insist on the details of the transaction to be as precise as possible to ensure what was offered was eventually rightly accepted. For example in a Personal Financing structure, the customer makes a credit application according to certain terms such as financing amount, or financing tenure, but what eventually gets approved might be a lesser amount or shorter tenure, which means differences in the initial “Agency” instruction to transact the commodity. Scholars question how do Banks re-engage customers with such “counter-offer” for their acceptance? At which point after the credit approval?
  4. The issue of Delay in Transactions – Some banks are more efficient than others. Some banks are able to conduct commodity trading on the same day while others can only do it in the next day after the day’s batch run. End of day batch runs are what conventional banking live by, and there is no motivation to conclude and consolidate all transaction in real-time; there is no requirements to do so. Batch runs allows for more systematic consolidation of records. But that becomes an issue for Islamic banks running next to a conventional banking proposition. So if an Islamic bank is limited to only end of day batch run to consolidate its records, it means the end of week transactions requirements will only be fulfilled on the next working day (across the weekend). This is a delay in the conclusion of the initial instruction given by customer to conduct Murabahah which may impact specific terms including price of commodity and its availability. There is also the danger of missing out delayed transactions as those instructions are not “current” anymore. There is a provision in the Policy Documents that “delay” in transaction should not be more than 2 days (T+2), but there are also periods where the off-days are more than that due to public holidays and other disruptions.
  5. The issue of Qard in Tawarruq – An extension of the above scenario where Commodity transactions are delayed, the next question will be “what is the status of the funds when no transaction is done?” Is it a Qard (Loan) contract until the transaction is fulfilled, or is it an Amanah (Trust) arrangement? In either case, for the scenario of Tawarruq Deposits, how do you accrue the profit for both contracts which forbids “interest” or “returns“? Profit is only realised once the Murabahah (trade) takes place. Without the trade being transacted, profit accruals can only be justified by arguing that Islamic banks should not penalise customers who, in this case, has done nothing wrong. Dispensation is always given for the reason of fairness. And this “Incidental Qard” issue has also been discussed at the Shariah Advisory Council of Bank Negara Malaysia, where the fatwa on Incidental Qard and its conditions were issued. But the fact that it was discussed, indicated that this issue is not as easily brushed aside as one like to think.
  6. The issue of Agency and Dual Agency – There are still some banks that feels the Dual Agency structure contributes greatly to the notion of “arranged” Tawarruq and thus stays away from it. The Dual Agency structure is where the customer appoints the Bank as both the Buying Agent and Selling Agent. This gives the Bank the full right to conduct trading without any Customer intervention (given mandate), which makes the “ability or option to take delivery of commodity” redundant or unnecessary requirement. It effectively removes the proof of Murabahah i.e. deliverability of the Commodity.
  7. The issue of Physical Commodity – One of the main contention is the ability to ascertain the availability of Commodity. While on paper it can be evidenced but nonetheless the challenge is to ensure the Commodity is identifiable and deliverable according to quantity. Efforts have been made to split into smaller denominations whenever needed, and commodities like Crude Palm Oil (CPO) is easier to be allocated. But there is always suspicion whether this is superficial where proof of otherwise is actually much more difficult to obtain. Where is the certainty that the assets being traded are the right physical ones?

THE REAL QUESTION IS WHETHER THE ABOVE CAN REALLY BE RESOLVED

So is there any other alternatives to Tawarruq? The above questions have so far not been answered satisfactorily and scholars while do not prohibit its usage, still frown on how much Tawarruq has impacted everyday banking life. It is truly a “love/hate relationship,

I believe there is such “replacement” contract that can address most, if not all, of the above concerns. But it needed to be proofed and challenged and at the end of the day, we question such necessity and thus the rising dilemma to replace it after all the work done. Tawarruq has really taken root with so much invested in perfecting the structure, and expertise in its documents and mechanism. It solves a lot of problems, yes. But will Tawarruq be the end of innovation for Islamic Banking?

I like to think there must life beyond Tawarruq. It just needed courage to acknowledge the big task required for such massive structural changes in replacing Tawarruq. Such replacement must not just be an equal substitute but also addresses the Shariah concerns. That is the ultimate test of any Islamic Banking contract; the reason for being.

Real Cost of Tawarruq

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Recently, the topic of Tawarruq & Commodity Murabahah has been popular in the industry as both BNM and Shariah scholar have been asking operational questions on the implementation of Tawarruq arrangement in the industry. It seems, even with the Policy Documents, there are still some divergence in terms of operations and understanding of the minimum Shariah requirements for Tawarruq. Each financial institutions have their own operational abilities and processes that differs from one another; to have a standardised platform may be a bigger challenge than imagined.

The rise of Tawarruq in recent years should really not be a surprise to many observers. We are seeing that most financial institutions in Malaysia now consider a Tawarruq structure a “must have”, because there really is no options as other Banks also deals in it. It has become norm, and while scholars might take a view that Tawarruq should be a “last resort” option, there have been so much effort invested into making Tawarruq an efficient machine. Just take a look at the Bursa Suq Al Sila and what it is capable today.

Question : Is it Cash or Committed Limit?

The latest consideration of Tawarruq is on the treatment of Tawarruq funds after the transaction. What is it exactly and how is it been managed within the Bank, with the Capital Adequacy Framework for Islamic Banks (CAFIB) implemented a few years ago (latest update this year 2017). In particular, when a customer is approved a certain limit (let’s say $1,000,000) and a single Tawarruq is done for $1,000,000 for the line (instead of multiple small Tawarruq for each usage of the amount within the $1,000,000 limit), where does the money goes, and what is it exactly in the eyes of Sharia?

To clarify, upon the completion of Tawarruq, real money of $1,000,000 is generated. Cash. It is not a “line” in the conventional terms, but it is money (actual cash) now belonging to the customer. He can draw out the money anytime.

But the practice is that the money is kept in the Bank’s books unless requested by the Customer, and by keeping this the Bank will give a “rebate” on the money kept in the Bank, similar treatment as if a “principal payment” is made (although it is re-drawable). In the meantime, the Bank utilises the money (taken as principal payment made) for its own banking business activities.

The question that I believe we will have to eventually address are on the following:

  1. The Tawarruq is done on a single transaction for the full amount, therefore it is a full release of capital (i.e. fully funded). As such, it should have a “capital charge” consideration if it is not fully utilised by the customer. Bank has released fully the funds to customer (therefore Bank should be entitled to earn a full profit on the amount). The formula for profit would be $1,000,000 x Profit Rate – Cost of Capital. Note the Cost of Capital is on the full amount.
  2. Then, the subsequent mechanism instead is as follows: since the customer did not fully utilise the funds, the customer is given a “rebate”. For example the customer only uses $50,000 of the $1,000,000. The formula for rebate is that ($1,000,000 less $50,000 = $950,000) x Profit Rate x period unutilised. Banks earn full Profit Rate on $50,000 and gives rebate based on $950,000.
  3. Of course, Banks will utilise the $950,000 meanwhile but at what I imagine are for short-term instruments because the $950,000 is customer’s money (i.e. committed amount) and can be requested at anytime. Bank needs the funds to be as liquid as possible. So the Bank do not earn a lot from this “short term investment”.
  4. Also, there is concurrent discussion as to when the amount is kept and used by the Bank, what is the underlying contract used for this “unutilised, principal payment which is drawable on demand” amount? Is it kept by the Bank as Qard (loan), Wadiah (safekeeping), Amanah (trust) or can it be taken as Tawarruq deposit (monetised obligation) or Mudharaba (investments)? Different Banks have differing views on this, but I suspect BNM is trying to standardise this understanding and practice.
  5. But more importantly, while the Bank is giving customers “rebate” on the amount they do not utilise (but committed by the Bank), is there also “rebate” on Cost of Capital then? It seems unfair when it doesn’t. Tawarruq proceeds are deemed fully drawdown (based on full amount) and incurs full Capital Charge but is earning returns based on “only” the utilised amount. The rebate formula is very specific, and it does not contain the amount for “rebate” Capital Charge.

In the conventional Banking world, this is not so much of an issue. Their approach is simple: if the amount is “committed” to the customer, 2 things will happen:

  1. Once the amount is drawdown i.e. utilised by the customer (lets say $50,000 utilised of the $1,000,000), then full price is charged on the $50,000
  2. On the amount unutilised i.e. $950,000 the Bank will charge a “Commitment Fee” of 1.0% per annum (or any negotiated rate) on the unutilised (but committed) portion. While 1.0% per annum do not usually cover the full Capital Charge on the $950,000 it somewhat compensates the charge as the Bank (because $950,000 is still a “limit” and not Cash payout) can still use the unutilised amount in its day to day banking activities i.e. investment in short term financial instruments.

Scholars generally do not agree with the concept of Commitment Fees, and there is specific BNM guidelines prohibiting the charge of Commitment Fees in these specific scenarios.

The Capital Charge factor

I still think there is a disconnect somewhere that while we aim to achieve the same end result by the practice of Ibra’ i.e. “Rebate”, but with Capital Cost coming into play, it may eventually seem that the cost of running an Islamic Banking business can be higher than a conventional Bank. It really depends on how we interpret the guidelines and the treatment on Tawarruq especially the single Tawarruq structure where the full amount is transacted i.e. whether it is a full Capital Charge or otherwise.

I know what BNM usually advise i.e. it is a full Capital Charge. But this concurrently means, without Commitment Fees on the unutilised Customer portion, it may result in extra costs for the Bank. Now I am not suggesting we introduce Commitment Fees for Islamic Banking; this idea of Commitment Fees is a conventional banking concept for recovering opportunity costs, which may not sit well under Shariah consideration.

But in the world we operate today (where each $$$ is risk weighted to a cost), this translates to “Actual Costs” incurred by the Bank, based on the interpretation for the “single full amount Tawarruq transaction”. And Shariah may want to consider this as it is a real “Actual Costs” and not opportunity costs. By letting the money sit still, the Bank incur real, actual costs which is not recoverable as per guidelines. It may have started as “recovering opportunity costs” but if you really think about it, this is above opportunity costs. Maybe in the conventional space, they may even revise Commitment Fees to recover BOTH Opportunity Costs as well as Capital Charge.

So, my question is this: should both the industry and Shariah scholars re-look at the basis of Commitment Fees (in the context of how Tawarruq works), or re-think about the “Rebate” mechanism and perhaps have an adjusted formula to factor in a “Rebate on the Capital Charge”?

Can Shariah consider this mechanism to recover a real cost incurred by an Islamic Bank?

In the meantime, Happy Ramadhan to all, and may you have blessed month ahead.

Is Islamic Finance Suffering from the Wrong Model of Implementation?

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One of the things that attract me to maintain this website on Islamic Banking is the opportunity to interact and share ideas with the various practitioners and academicians in the industry. There are many discussion topics and we intend to bring such discussions to the open table as constructive as possible. Interaction with Ms Rosana is always interesting as she dare explore the Islamic Banking model itself, making comparison to other similar models in the market across geographies. And I do share some of her views on the industry, and I have written about it to some extend in my earlier postings. What is interesting about Ms Rosana is that she is taking the discussion a necessary step further in evaluating the existing Banking model, as to whether it is the right model to begin with. She has written a short discourse on this topic and looking to explore in-depth its implication in the near future.

She welcomes constructive feedback, comment and discussion points for this posting and hopes to decide on the next step forward gauging from your kind response. Do read and give us your opinion and comments. Thank you.

Is Islamic Finance Suffering from the Wrong Model of Implementation?

By Rosana Gulzar Mohd

In this blog’s latest post ‘Disruption: Islamic contracts’, there holds an imminent danger. The Islamic banks in Malaysia are not so much inching towards becoming just like the interest-based conventional banks they were supposed to replace but in fact, running towards them. Even as the industry celebrates its trillion size assets and formerly astronomical growth, there lies a darker truth. In a recent class I taught on the dichotomy between Islamic banking theory and practice, a participant, a new ‘Islamic’ banker, came up to me and wanted to discuss commodity murabaha. She said her team had just tabled the product for the bank’s approval but she did not feel comfortable. The head of the Shariah committee also seemed disappointed. His comment, according to her, was that we no longer need Shariah advisers. The industry only needs commodity murabaha experts now.

Post-IFSA 2013 which fines and jails CEOs and everyone above and below for any wrongdoing and a flurry of policy documents telling banks how to implement Shariah contracts, ‘Islamic’ banks in Malaysia are seeking refuge in tawarruq. Musharakah and mudarabah? All that is left of profit and loss sharing contracts, which some scholars say are at the heart of the ideal Islamic financial system, is the policy documents by Bank Negara Malaysia (BNM). I would be pleasantly surprised if anyone can show me a bank which is genuinely implementing them. The supposed mudarabah-based products brought on by IFSA, namely the investment accounts and the IA platform, are currently being mutilated to look almost like any guaranteed and fixed return deposit. The IAP, I believe, are unlikely to be successful for laughable reasons.

When commercial banking, with its inherent tendencies for excesses, profit maximisation and desensitisation to social welfare, is the problem, how does crowdfunding through commercial banks become the solution? Won’t the banks still look for credit-worthy companies with an almost guaranteed future to fund? Who then takes care of the small and medium-sized entrepreneurs who are also seeking financing? Are not the SMEs the backbones of the economy? Not to mention, where is the upholding of Islamic values such as justice, equitability and social well-being? Granted there are other organisations in Malaysia meant to help the lower incomes and SMEs but why do ‘Islamic’ banks call themselves ‘Islamic’ if they are far from embodying the ideal values in Shariah? Unfortunately, this sad state of affairs extends to other parts of Islamic finance such as takaful (apparently ‘Islamic’ insurance), sukuk, the other beauty pageant contestant in this parade, and other capital market products such as interest rate, oh wait, ‘profit’ rate swaps.

How did BNM envision the success of IFSA with no changes to the current environment? We are still in a dual system where ‘Islamic’ banks are pitted head-to-head against interest-based conventional banks. ‘Islamic’ assets are still only a quarter of the entire system despite the country allowing all sorts of controversial contracts such as bai al dayn, bai al inah and the one that takes the cake, tawarruq. Where are the educational campaigns to explain to customers this shift in the industry that the central bank expects to happen?

When customers, including ‘Muslims’, have been accustomed to deposit guarantees and fixed returns their whole lives, how do banks suddenly sell them an ‘investment account’ that promises neither? Is it any surprise that conventional bankers are using this as a selling point? They are telling customers to avoid ‘Islamic’ products because there are no guarantees. Theirs still do. When the chiefs of ‘Islamic’ banks themselves seem cloudy in their understanding of the new regulations, how did BNM envision people on the street, who are banking with its ‘Islamic’ banks, to embrace the changes? A deputy director unfortunately got defensive when I asked. Other central bankers claimed ignorance because they “are not from that department”.

While BNM seems keen to reform the industry, perhaps the answer it has been looking for is that the Islamic finance industry, and within it, Islamic banking, has been built the wrong way. Trying to make it work in the commercial banking space is what has led to the frequent comment that it is like squeezing a square peg into a round hole. Commercial banking, with its profit maximisation mantra and desensitisation to social welfare, is antithetical to the Shariah ideals of justice, equitability and social well-being as embodied in the maqasid. And isn’t it the one that has been leading the world from one crisis to another? Why then are we so busy emulating them? Isn’t it time the powers that be wake up and face facts?

So why did all the big organisations in Islamic finance, from the global standard-setters such as AAOIFI and IFSB to each country’s central banks and each ‘Islamic’ banks’ Shariah committees condone these practices? Perhaps because they were the easiest thing to do and allows for a fast build if the intention is to grab fame and fortune through one’s achievements in Islamic finance. The countless Islamic finance awards and conferences and the effusive back slapping there are testaments to this. Bankers are such happy people.

So what is the solution? I believe it is cooperative banking. The true, genuine type practiced in Europe and not the ones in Muslim countries because they are largely used to fund political cronies and thus suffer from questionable management and corruption. My next article will thus explain cooperative banking, how the model works and why they are a better fit for Islamic finance than the current commercial banking model. In the meantime, I look forward to your thoughts. Students of Islamic finance intuitively get it when I explain these arguments while some practitioners acquiesce (quietly agree). Another group reminds me of this statement in a book by Upton Sinclair, who ironically was also an investigative journalist (uncovers scandals and corruption) as I was in my former life and whose solution to the 1930s Depression in California is to create cooperative ventures for the unemployed. The idea, to his surprise, received wide support but his bid to run as governor was waylaid, according to him, by the oppositions’ “dirty tricks”. He wrote this statement in his book about the political adventure, “It is difficult to get a man to understand something, when his salary depends on his not understanding it.” The reaction of the other group of bankers brings to mind this quote.

What do you think about her assessment and commentary on the Islamic Banking model? Do give us your feedback in the comment box. Thank you.

Check out her other contributions in the following page : Writings Rozana Gulzar Mohd 

Disruption : Islamic Contracts

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Under IFSA 2013, it is no longer about Product Innovation. It is about Product Compliance.

2 weeks ago I had a session with some bright individuals discussing the Islamic contracts commonly used in Corporate Banking financing structures. We went through almost all the available Islamic financing contracts such as Murabaha, Ijara, Musyaraka and Mudharaba, where I highlighted that all these contracts now have their own Policy Document issued by Bank Negara Malaysia (BNM). The Policy Documents, in my opinion, are a concise version of a lot of Sharia regulations and great reading source. It becomes a reference point where management roles and responsibilities are outlined, operational behaviour laid down, and theoretical basis is justified and explained.

It is a matter of time, I told the participants, that these Policy Documents are taken in their full context and finally developed into a comprehensive structure with clear compliance to Sharia requirements. We, as Islamic Bankers, are in for an exciting period of development where we will have a chance to develop “real” Islamic banking contracts.

The moment I said that, I realised it is NOT TRUE!!!

THE IMPACT OF IFSA 2013

The popular belief is that IFSA 2013 is meant to realign all the Islamic Banking regulations in the Islamic Banking Act, Takaful Act and various major guidelines into a single overarching Act. IFSA 2013  consolidates the various practices into more clarity and re-classification of concepts. However, the perception that Islamic Banking in Malaysia as an innovative development hub would no longer hold true. “Innovation” was the key thinking and pride-point prior to IFSA 2013; now I believe the right word is “Compliance”.

163170_477596024332_7522334_nWhen we first started the Islamic Banking journey in late 1990’s and early 2000s, BNM encouraged a lot of product innovation from Banks as there were no existing guidelines. We looked at the various structures that provides the desired outcomes and discussed with Shariah Committee on the design and component of products without breaching Sharia rules. BNM was supportive on us developing these “innovative” products. Some may have been controversial (such as Bai Inah, Bay Ad Dayn, Wadiah and Bai Bithaman Ajil) but it encourages discussions alongside the mantra that “whatever is not explicitly prohibited, is permissible“. Sometimes we were forced to think outside of the box, especially for sophisticated products mirroring conventional. We also received support from Sharia Committees whom temporarily approved “innovative” products with the understanding that over time, a better solution were developed as replacements.

Now with the issuance of the Policy Documents, such innovation becomes limited. Innovation is now ring-fenced around compliance to Shariah rules (either from regulators or internal Shariah Committee), and the Banks are expected to follow these rules to the letter. Breaches to these rules becomes the responsibility of the Bank’s Shariah Committee and detailed deliberation is greatly expected to provide the solution. Compliance first; if it is not covered in the documents, it probably cannot be done without a lot of effort.

CHOOSING THE SIMPLEST ALTERNATIVE

With compliance now being the vogue vocabulary with BNM, Banks had to look hard to the Policy Documents to ensure the requirements are identified and gaps filled for fear of breaches or fines. The gap analysis falls into the line whether “are we complying to the requirements?” and not “how do we do this without it becoming a gap or compliance issue?”. Both Shariah and Bank’s Product teams would now look on how to comply with Policy Documents instead of using the Policy Documents as a reference to develop a product.

What I noticed since 2014 is the obsession to comply with Islamic contract requirements, and if the team feels it is difficult to comply, the next logical step is to avoid such contract altogether and seek an alternative contract which is easier to comply with. For example, the Murabaha Policy Document issued in 2014. I have to say it is a beautiful document, and outlines the requirements for Murabaha Purchase Orderer (MPO) that reflects the full Sharia requirements of ownership transfers, risk taking, profit and management of actual assets.

These requirements, which in the eyes of many Banks, may be difficult to fully comply with due to many reasons: shortage of expertise, systems infrastructures limitation, people understanding, complicated processes, operational risks, credit issues and fund management requirements. Instead of the risk of breaching the Policy Documents, Banks opt for something less “complicated” which offers “similar” structure. The default solution is Tawarruq Arrangement i.e. Commodity Murabaha.

Or, the teams looks at Ijara Policy Document. It outlines further the roles and responsibilities of lessor and lessee, while the asset remained in the Bank’s ownership throughout the lease tenure. Again, if a roadblock occurs where a Bank cannot fully comply… Tawarruq Arrangement provides a quick solution. With very defined rules outlined in Tawarruq Policy Documents, the Banks are confident that offering Tawarruq will not breach any guidelines.

Tawarruq, therefore becomes the default Islamic contract in the market. When I asked the participants during case-studies to the question “What contracts should be used for this structure?”, the answers are unanimous “Tawarruq”. And they are not wrong.

DISRUPTION IN ISLAMIC CONTRACTS

155228_469014969332_6259944_nMaking Tawarruq as the “all-problems-solved” structure is having an unfortunate result to the industry. While the issuance of the Policy Documents as a reference was to galvanise the development of various Islamic contracts, the Banks have an easy way out in Tawarruq. Now, the rest of the contracts are in danger of being sidelined in favour of continuous development in Tawarruq.

For example, the Home Financing product which had evolved from BBA in the 1980s to Diminishing Musharaka in the 2000s. When BBA was introduced, practitioners and Sharia teams identified several practical issues that over a period of time needed to be resolved such as ownership transfer, rights to sell, and sale of properties under construction. These issues led to the development of Diminishing Musharaka as an alternative solution.

But with Diminishing Musharaka, there are still operational and legal issues that have yet to be resolved until today. For example, the “right” contract to be used for period of construction, the application of Ijara and the extensive outlining of Wakalah roles and responsibilities. Failure to understand the issues and provide real solutions puts the Bank at risk. There are also legal infrastructures that have yet to be addressed such as land joint-ownership by the Bank (as a partner), and different practices of land offices for the registration of Bank as a partner. These are roadblocks (and credit risks) to the Banks to take the structure further.

THE DOUBLE-EDGE SWORD OF TAWARRUQ

25547_378676189332_2665364_nMalaysia is in danger where I foresee that one day the industry itself will became the absolute global expert in Tawarruq and Commodity Murabaha. With Bursa Suq Al Sila as the leading commodity trading platform for the country, backed by the government (as a national bourse), the Tawarruq structure is expected to evolve into an efficient Islamic-structure engine. The processes of Commodity Murabaha will become seamless, and may even integrate into a Bank’s core banking system, the operation for buying and selling commodity will become commonplace and familiar, and this will result in effective processing, awareness of Shariah risks, compliance to trading requirements and well as reduction in overall operational risks.

Banks will one day become so well versed in Tawarruq, they will question the need for other types of Islamic contract, where they may not able to fully comply with.

With such development, more and more:

  1. capital investments will be made into perfecting the Tawarruq infrastructure, and Banks will also be able to comply with BNM requirements by investing in human capital familiar with Tawarruq.
  2. product structures will be developed around Tawarruq and once these products are established, it will be difficult to unwind as a prefered product simply due to the ease of the Tawarruq contract requirements.
  3. variations and hybrid products will be introduced based on Tawarruq, or containing elements of Tawarruq to solve “difficult scenarios” for compliance.

We will one day have an innovative and world class Tawarruq product, but no development in the other major Islamic contracts. Innovation will stall and Banks will choose quick returns and operational ease of Tawarruq. It is a dilemma of the industry where it is heading to “one” major solution for almost all “sale-based products”.

It is unfortunate if Banks chose to abandon the other contract alternatives, where such contracts will never reach its full operational and theoretical potential.

Hoping that a Bank will take the lead to develop products based on all the various Policy Documents instead of relying on only Tawarruq and its variations. The industry needs expansion and enhancement and by focusing on only Tawarruq, the industry will not be able to explore exciting products and expand its horizon. The Policy Documents, as beautifully written as they are, may tragically one day just becomes an academic relic issued by BNM.

Wallahualam.

Earlier writings on Tawarruq and Commodity Murabahah:

  1. Reliance on Commodity Murabahah
  2. Financing : Commodity Murabahah and Tawarruq

Interesting article in LinkedIn

Reliance on Commodity Murabahah

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A few days ago, several Banks in Malaysia officially made available Deposit products based on Commodity Murabaha transactions.

Looks like Commodity Murabaha (CM), or in another variation is called “Tawarruq” has now expanded its domain from Financing-based to Deposit-based products. More and more banks will have to rely on this structure on both sides of the balance sheet. Bai-Inah based portfolio used to consist of nearly 80% of the overall financing portfolio of some banks; now with the push for Commodity Murabaha structures in financing to avoid interconditionality issues in Bai-Inah, it is expected that Commodity Murabaha financing to eventually replace the Bai-Inah portfolio.

Now with the introduction of CM for Deposits, the popularity of commodities will take a sharp rise! Bursa Malaysia will have their hands busy supplying the industry with commodities to support the underlying transactions. Islamic bankers will also have their hands full buying and selling commodities between the bourse and the customers, either as buying agents or principal purchasers!

Commodity Murabahah Deposits

I am not sure whether this is necessarily a good thing.

The industry will now shift from having a Bai-Inah-heavy portfolio into a Commodity-Murabaha-heavy portfolio. Concentration risks towards one Islamic contract will grow, and the question is that whether Banks will take the time to develop other contracts into viable propositions instead of just building the CM infrastructure. Do bear in mind that a lot of infrastructural work needs to be done to ensure CM remains the flagship contract for years to come.

The specific risks that Banks faced when offering CM products are manifold; shortage of commodities, delays in transactions,  wrong sequencing of purchase and sale of commodity, errors in commodity prices and description, delivery of commodities issues, ownership issues and ownership evidencing. All these requirements needs to be watertight to ensure income from these CM transactions don’t just go to charity. Whenever there is an Asset involved in the transaction, all the factors need to come together to ensure Sharia compliance.

And the way we are going, it seems that CM will probably have 80% of the financing pie and 70% of the deposits pie in a typical Islamic Bank’s balance sheet in 3-5 years time. With IFSA deadlines on June 2015, this ratio could come sooner rather than later.

Will the development of other contracts be further left behind since the shift now is on CM? Maybe, historically Malaysian Banks follows the “Urf Tijari” route of following what the other bank is doing. We have seen this when Bai Bithaman Ajil (BBA) was introduced; nothing else was developed in the market but BBA. It was the same with Bai Inah.

But there is other opportunities for development of other Islamic contracts, although I don’t imagine this is the case for Malaysia while we busy ourself becoming commodity traders. Oman, on the other hand, has rejected tawarruq totally,  focusing on other contracts such as Ijara and Musyaraka. This is a good development, as no countries has seriously looked at developing complex, high-risk structures. Maybe once the thinking to shift to understand the transactional and Sharia risks of the new products is made, perhaps the market can warm up to the idea that Sharia compliant banking can be a different way of banking.

Pro-Active Compliance of Regulatory Guidelines

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There are days I wish I was a multi-millionaire with vast resources, cool regulatory connections, tech-savvy and excellent people motivator. Someone who sees the new regulations for the opportunity it is and the potential in it.

If I was, I’d quit my cosy banking job and set-up my own company that provide services to all Malaysian Banks to support the compliance of the new guidelines. Instead of all the banks scrambling to meet the requirements, they can just outsource all their problems to my set-up to run it. One stop solution to all your headaches.

Perhaps I am writing this out of frustration because I do not have the resources for it. Or perhaps I am writing this for my own interest, hoping someone like Bruce Wayne takes up the challenge and make all our jobs easier. Maybe some of us can get an offer to join this company. That’s wishful thinking I bet.

What would this company / set-up offer to banks? Hmmm where do we start.

Balancing Act

Compliance with the Investment Account Guidelines.

All Banks do not generally set up their operations to work like fund houses where you have fund managers running their investment desks. Neither are there an infrastructure to manage and monitor the fund or portfolio performance, nor having mechanisms to create mark-to-market valuations of the portfolio. Reading the Investment Account guidelines makes one think that the banking model itself has to change to a pure Mudharaba trading house. A dedicated fund house with ready systems supporting the investment requirements and offering their services to Islamic Banks will ease the burden at Banks to develop their own infrastructure.

Tawarruq Guidelines.

This can be a huge component of businesses in the near future. As BNM place more and more emphasis on the big 3 of Musyaraka, Mudharaba and Murabaha, more and more focus will be placed on building the long term infrastructure to support this. Warehousing infrastructure, including managing physical assets and commodities belonging to the Banks, will support the Murabaha envisioned by BNM. A re-vamp of the credit policies and a different approach to risks assessment will support Musyaraka. Mudharaba will encourage the Bank’s “entrepreneurial appetite”  as Banks take a more hands-on approach to investments. Ensuring a compliant structure and supporting the requirements of Sharia on sequencing, documentation, management of commodities, ownership transfers, usufruct and beneficial ownerships and valuation must be developed for the long run. A company which offers these services, or provides an IT platform for this, are something that can reduce the stress placed on the industry.

Special Purpose Vehicles (SPVs).

There a easy lot of opportunities for SPVs to flourish in the Islamic banking market. To support the ownership issues, an SPV can be a useful conduit for the movement of assets which will then create the underlying transactions. Huge deals are done on SPVs. Complicated structures need them. This is a viable legal solution for across border deals. The only question is; what do we do with the SPVs once the transaction is done? Rent it out to another entity, I presume. Either way, SPVs are created for win-win situations for everybody.

The IFSA 2013 is like a large pool of compliance that needed development. There are many opportunities out there and with the coming of even more complicated regulations, Banks are always finding ways to meet the requirements set in the regulations. Some will be creative solutions, while others will address the fundamental requirements of the transaction. Whatever they may be, it will only provide possibilities where fortune smiles on the brave. Take that chance. Hopefully, you will succeed to make all our lives easier.

Back To Wadiah

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Investment Account Guidelines

True to form, BNM have called for an urgent discussion with the industry players on the implementation of the IFSA. The message is very simple; industry players are given time to comply to the IFSA i.e. no later than 30 June 2015. During this time, we are asked to either:

  1. Retain Mudharabah and Wakala structures to comply with the Investment Account guidelines; or
  2. Move the Mudharabah and Wakala structures into an alternative structure.

Obviously no one has the answer to both options. Especially for Current Account and Savings Account now offered under Mudharabah. To retain a simple product such as Savings Account under Mudharabah, the Bank needs to comply with tedious risk profiling of customers and numerous disclaimers on investments. Customers will be confused by this arrangement, and we foresee many will stay away. Marketing wise, it is a nightmare. Operationally as well, if we were to comply with the investment disclosures. Gone will be the simple structures that customers are used to.

Bringing the Current Account and Savings Account into Commodity Murabahah structures is the most viable solution in Shariah’s perspective. However, operationally tedious, money required for system development, revised documentation and more importantly, building customer awareness and acceptance will be the main challenges for the industry to move to this alternative.

Committees were promptly set-up to discuss solutions, and as expected, there can be no commercial viability into moving to Commodity Murabahah, at least not in such a short period of time. For Time Deposits it is possible, but how to address the daily deposits and withdrawals of funds in a Current or Savings Account under Commodity Murabahah?

The easy solution; take a step backwards.

Wadiah is suddenly the solution. Most Banks has decided to migrate back into Wadiah structures, even with limited value proposition. Hang on, this is not the solution. Perhaps only workable for a short term stop-gap measure, but definitely not feasible for moving forward, especially when there is a conventional banking alternative.

Wadiah is definitely not the solution for deposit building. But then, what else is there? Until someone comes up with a brilliant solution, we will have to make the best of what Wadiah has to offer.