Istisna’a Concept Paper

Yet another concept paper for us to read; BNM is really making us work hard for our salaries. The contract of Istisna’a is covered in this concept paper, traditionally used in a hybrid arrangement of a mortgage product for properties under construction. In the Middle East we are used to see Istisna’a as a standalone arrangement, and with this concept paper, it seems like a step by BNM in aligning the contracts used by Malaysian Islamic Banks with the practices in the Middle East.

With this Concept Paper, the way is paved for Istisna’a to finally stand alone as it’s own contract rather than part and parcel of another overarching structure, such as Musyaraka or Ijara.

But that doesn’t mean that it is not without its challenges. If Istisna’a is bundled amongst a variety of other contracts, many issues can be catered for in the other contracts and its documentation. Now, reading the CP, few glaring challenges needs a rethink if Istisna’a is to be the viable answer to properties under construction.

Istisna

Risk

The first, and perhaps the most significant item is the role of the Bank which leads to the next significant issue ie ownership. The CP envisioned scenario where the role between Bank and Customer is Bank as developer and Customer is, well… customer. This is a role reversal to what many banks are used to. The Istisna’a that I am used to seeing in Malaysia is that the Customer undertakes to construct the property (via their selected property developer); by this the construction risks remains with the Customer who undertakes the role of developer. The customer therefore ensures that the property is eventually delivered. Without recourse especially in cases of project abandonment.

But with the CP, the game changes. The Bank now must act as the party that’s responsible in delivering the property; effectively this means the role of the developer itself. The construction risks now lies with the Bank. The Bank must ensure that the property is delivered to specifications else the customer have room to renegotiate the terms of the Istisna’a, including cancellation of the whole transaction if the property is deemed to be “not as per requirements”. While the risks of such things happening is remote, the risks remains there and is real. Especially if we are dealing with small developers developing projects in remote areas. There is a real risk these small developers disappearing and the property, even if it got completed, is unsaleable due to location or market factors.

Ownership

The Sale & Purchase Agreements (S&P) is a document signed between the customer and the construction developer. The bank is not a party to this transaction, therefore the Bank’s name do not appear there. So how then, do we evidence ownership transfer and validating the contract between the Bank (as developers) and Customer? The developer will hardly want to transfer its rights and responsibilities to a Bank unless the Bank outright purchases the property, and during construction, how will it be possible?

Back in the day when Bai Bithaman Ajil (BBA) was the “deal of the day”, this curious creature called Novation Agreement was used. It is an agreement used to bind 3 parties to the arrangement, a tri-part ate agreement that developers sign to allow to transfer beneficial ownership to the Bank to allow the sale transaction between Bank and Customer. Not many developers want to sign this, but in instances where they did, it provided a way out on the issue of ownership before the sale. Yet this curious being has disappeared from the landscape, as many users gets jittery when there are more and more documents to sign.

It could be worth to consider this approach again, on an industry-wide basis rather than individual practitioners. Make it an industry document, get standard legal opinion, get buy-ins from developers on the need for this document and remove all the doubts on ownership. Novation Agreement might not be a bad thing but maybe some work needs to be done to satisfy the legal peculiarities relevant to each stakeholders.

Expertise

This is where the Banks lack when you consider Istisna’a contract in its spirit. Under Istisna’a, the responsibility to ensure the properties are completed, functional and deliverable to the customer rests on the shoulders of Banks. As a matter of principal, Banks are traditionally financial institutions, not geared to be engaged as “property developer”. The risk of development is always transferred to the developers, and not held by Banks. To have a unit set-up to monitor the construction of the properties requires specialised personnel who understands the nitty gritty of property development is hardly effective or efficient. Developers would also be wary of Banks trying to trespass into their territory of expertise. My view, let the developers be developers and Bankers remain bankers.

Istisna’a structures are fairly new in Malaysia; while it is being used in the market, but it always has been part of the larger collection of contracts in a financing arrangement. To have it stand-alone on its own, there is a need to re-think the legal requirements to ensure the Istisna’a can be accepted as a viable Islamic contract.

Ijara (Leasing) Concept Paper

Reading the Ijarah Concept Paper issued by BNM leaves me with one very strong impression; Is BNM seriously asking Islamic Banks in Malaysia to start offering Operating Lease to the customers?

In general, Malaysian Banks (as well as many Middle-Eastern Banks) employ the Financial Lease structures for the purpose of financing the purchase of Assets, Equipment or Property. Financial Lease usually refers to a financing arrangement where the Assets are “rented” to the Customer (Lessee) and at the end of the rental period, the Asset ownership is transferred to the Lessee via a Gift transaction, or a nominal amount Sale Transaction. This means Financial Lease is very similar to a Hire Purchase i.e. you hire, then at the end of the tenure, a purchase is executed. The risks and ownership expenses are borne by the Lessee and in the Bank’s books (Lessor), the obligation is recorded as a receivable.

Operating Lease vs Financial Lease

But reading the questions posed in the CP, one can’t help but escape the notion that BNM is toying with the idea that eventually, “pure” lease, or Operating Lease will become one of the products that is made available by Islamic Banks. Pure Ijara means that the Bank now takes on the ownership risks associated with the Assets. All ownership-related expenses will now be borne by the Asset owner, namely the Bank. Many Ijara structures nowadays delegates such responsibilities to the Customers by appointing the Customer as an Agent to upkeep the Asset, and it is in the best interest of the Customer to ensure the Asset is in good working condition. Under a pure Ijara structure, ownership will always be with the Bank, and therefore the Bank will incur these cost and shouldering the responsibilities.

So what happens under Operating Lease?

  1. The Bank will always own the Asset. No transfer of ownership will be made.
  2. As owners of the Asset, it is the responsibility of the Bank to incur expenses and upkeep the Asset
  3. The Bank must always monitor the market value of its Assets. We might not have the right expertise for this, and may need to outsource this function.
  4. Even after the completion of the primary lease period i.e. all payments has been made according to schedule, the Bank must continue to manage and monitor the Assets by extending the leasing arrangement into a secondary lease (which earn very little).
  5. To have this monitoring  capabilities, full time employees need to be hired to manage the portfolio.
  6. The inherent risks for Operating Lease must be seriously looked into by the Bank. The risk of loss of Asset, devaluation of Asset value and maintenance of Assets must be internally catered for.
  7. The costs of setting up a unit to manage the Asset may not be cost effective.
  8. The way the risks are mitigated. Credit approvals must take into account the various risks offered by the product  and take into account the risk appetite of the Shareholders. In short, the Shareholders did not provide funds for the purpose of making in a “high” risk use of their funds. Their mandate is simple; safe, reliable investments and use of Asset.
  9. The stamp-duty for an Asset ownership structure is more expensive than the stamp-duty of a financing structure.

Why has no Banks seriously exploring and offering pure Ijara? The answer is simple; The high cost of setting up and maintaining the business, coupled with the operational requirements of offering a pure Ijara product, and the risks that the Islamic Bank faces, makes it a difficult product to offer.

Operating Lease is not an easy proposition as a lot of infrastructure needs to be built. More importantly, an Islamic Bank is not set-up to take on such high risks on their portfolio. In general, the Banks wants stability in its business model and not take unnecessary risks on its books. Personally, I have seen the operation of the Operating Lease in the first Bank I worked in (actually its a finance company), and it took a lot of effort to build the infrastructure to fully support the Leasing (financing) structure. Ijara Financing provides an easier alternatives but that does not mean Islamic Banks should not start exploring Operational Lease. This might one day meet the lofty aspirations of the BNM; to offer products that meets the international understanding of how an Islamic Banking product should work.

At the moment, we are staying off the Operating Lease structures to ensure continued sanity.

New Reference Rate Framework (Concept Paper)

To read the New Reference Rate Framework Concept Paper, click here

One of the papers currently being floated around for discussion is the new Reference Rate paper. While no date is indicated for the paper to be effective, [Update : today it was announced that effective date by 2 January 2015] its implication will be significant to both the banking system in Malaysia, Islamic and non-Islamic. The main purpose of the paper is the way Banks price their financing product must now be different. Gone will be the Base Lending Rates (BLR) and Base Financing Rates (BFR), and welcome the new defined term; Prime Financing Rate (PFR).

The intention is this; a lot of the things that go into the BLR/BFR are pricing related to risks, and these premiums are loaded into the base borne by customers. This leaves the margin (or customer spread) that is charged becomes somewhat “clean” as a return to the bank, with the exception of impairments (loan/financing defaults). In addition, banks earn “additional” returns from the “savings” built into the BLR/BFR itself. As a lot of risk premiums are built into the base rate, if these risks do not materialise, the bank technically “earns” this savings. You charge the customer in the base rate some premium for the expected risks, but you get the benefit for it. Ideal scenario.

It is therefore no surprise that some good banks, that are able to manage their risks effectively, are pricing their financing at a base-minus rate. It is now common to see home financing packages being priced at BFR minus 2.0% p.a., and the BFR being 6.60% p.a., the pricing is therefore 4.40% p.a. In theory, taking into account the actual cost of funds, adding only the “necessary” premium to cater for risks that is beyond the bank’s control, the base-minus rate still makes decent money for the Banks.

Therefore, even at 4.40% p.a., there is still room for the Bank to earn a margin, after deducting actual cost of funds. I believe the new Reference Rate framework aims to address this issue somewhat.

The concept paper was issued in January 2014 and this will change the way we price the financing portfolio. Under the concept paper, the base pricing shall only consist of the following:

  1. Cost of Funds (COF) – this is essentially the equivalent to interbank borrowing rate or cost of capital
  2. Statutory Reserve Requirement (SRR) – this is a regulatory reserve requirement for financial prudence

As you can see, these components of the new Prime Financing Rate (PFR) leaves very little room for Banks to manoeuvre the rates. COF is market driven, based on interbank lending rates, while SRR is a regulatory requirement based on specific percentage. BNM know that these are the most rigid components to pricing, therefore this may be a deliberate composition selection by BNM aimed at institutions to re-think the pricing formula.

And under the new regime of PFR, the following should no longer be built into the base rate. These costs, if the Banks want it, should be a part of the margin to the Banks loaded into the customers.

  1. Operating Costs
  2. Administrative Costs
  3. Credit Risk Premium
  4. Liquidity Risk Premium
  5. Any profit margin

Prime Financing Rate

These cost, if to be taken by the Bank, must therefore be part of the margin charged onto the customer. Customer will now know what components go into their financing i.e. The margin is now reflective of the risk the Bank perceive onto the customer. The higher the customer’s risk profile, the higher the margin can be.

As such, the 2.50% p.a. maximum margin chargeable onto the base rate should no longer be applicable. As at January 2014, the BLR / BFR is 6.60% and at a margin of +2.50%, the maximum rate chargeable is 9.10% p.a. Under the new regime, the dynamics may now be different for example the PFR could be 3.90% and the margin +5.00% which adds up to 8.90%. In absolute terms it’s cheaper but the customer might balk at the +5.00% margin when they are used to +1.00% or even -1.00% margins.

This is actually a good framework as Banks will have to be more competitive in pricing as the lower the margin, the more risks you are taking on your customers as the risk pricing is built into the margin. Additionally, the concept paper restricts the bank from quoting a price lower than the PFR, and this will make sense because it won’t eat into the Bank’s Cost of Funds. While you can have a BFR-2.00% (i.e. 4.60%), a PFR-2.00% won’t make sense as the PFR component, for example priced at 3.90% will give a net financing rate of 1.90%, and eats into the cost of funds.

In short, the pricing for financing moving forward will be based on the creditworthiness of the customer. Any changes in pricing will be reflecting the changes in operating costs, portfolio defaults or funding strategies. It gives the Bank more flexibility to determine pricing based on agreed scenarios or specific events.

This is a positive development. Banks now have the ability to decide on how to price a product based on real strategies and existing capabilities. Customers will have more transparencies in terms of what they are being charged. This will also spur competition among Banks, and provide better products and services to consumers, especially if the Bank gets its risk profiling right and able to effectively manage its default. All this will require a critical re-think on how a product profitability is determined, and a re-think of how the right management can provide a sustainable financing portfolio.

Note: On the Deposit Rates requirements, there are not much in the Concept Paper itself. Most of the requirements on Deposits are captured under the various EDs such as Wadiah, Hibah, Wakalah and the Investment Account Concept Paper. The only notable mention on the Deposit Rates section is that for Basic Savings Account, returns should be paid irrespective of the account balance and shall not be lower than 0.25% per annum. Also, there is a clause that mentions for Islamic Current Accounts, any hibah/dividend payments should not exceed 2.00% per annum. This, in my opinion, runs counter to the ED on Wadiah (which allows the Bank pure discretionary payment of Hibah, and therefore should not be governed by a capped rate) and the Investment Account Concept Paper (which states that the Bank must reward the customer dividends due to them, based on actual portfolio performances, therefore should not be limited to only 2.00% per annum). These point are against the spirit of Wadiah and Mudharabah, as well as against the Competition Act. We understand BNM is discussing this point internally after receiving industry feedback, and may consider removing this from the framework. We wait with bated breath for this framework to be properly issued.

UPDATE : The 2.0% per annum maximum cap on the Islamic Current Account has been removed via BNM circular dated 20 March 2014. Indeed this puts us back on the right playing field with conventional banking.

For some news on the above topic, please find the following newspaper articles:

 

Readings : December Papers x 3

Murabaha

And to close off the year, BNM gave us a further 3 reading gifts for us to enjoy our holidays:

  1. Murabahah (2013)
  2. CP Mudarabah (SR,OP, OR)
  3. CP Musharakah (SR,OP,OR)

The Murabahah Standards looks interesting, and so is the Mudarabah Concept Paper. Do have a read and tell us what you think.

Looking forward to the coming holidays.