New Ethica Institute Handbook

I have always had admiration for these guys ever since they published their handbook in 2013 for general reading. It has some interesting articles as well as explanation on Islamic Banking contracts, samples of the contracts itself and Meezan Bank’s Guide to Islamic Banking, which I always find useful as a reference. As for their website, I go there for the Shariah fatwas and the Q&As, which discusses latest concerns in Islamic Banking.

So I quickly signed up for the free webinar scheduled for this week and found that I was not able to sign up as there were only 500 places for it available. Sigh, but anyway better luck next time. But at the same time I am given the link to the latest pre-launch handbook, presumably an update of the free handbook they issued in 2013 (click this link to go to that earlier posting)

Hopefully you can benefit and share the ebook with your friends as well. Do visit their website at http://www.ethicainstitute.com/ as there are many interesting stuff there. This includes “Ask an Islamic Finance Question” and “Search Islamic Finance Q&A”.  Check it out!!!

 

Happy reading and have a blessed year ahead in 2016. Wasalam.

 

Life as an Islamic Product Developer

Recently I have been asked on the function of developing Islamic products for the Bank, from one keen graduate looking to start a career in the industry. The graduate was not confident in the future of the industry and was seeking some advice.

 As a career choice, Islamic Banking remains a good option for many reasons. In my view, the industry is still a growing space, with discussions and researches still being done and far from finished. Slowly scholars are going to the forefront, and arguments on structures are becoming more sophisticated. So, it is an exciting time to be in the industry.
But how about product development itself? Is it worthwhile to enter this fray?

Life as an Islamic Banking product developer is not easy. Simply because not many knows what we are doing, and what it takes to be one. I always viewed being a product developer is as hard as being an imam in a community; you hold on your shoulders the responsibility of launching a product that the community must trust to be Shariah compliant. There is no heavier burden than this, and you must be willing to shoulder this responsibility. Not everyone willingly do this.

Eye of the Storm Product Developer

But being a product developer has its intrinsic advantages. Rarely a position in the Bank affords you access to all types of functions. As a developer who have to design, develop and launch an effective and successful product, you need to engage ALL parties in the Bank as your product needs to flow throughout the organisation. The detail involved is enormous and you are expected to be an expert in most of the touch points. Hard questions are asked by stakeholders in the Bank, and you are expected to be able to satisfactorily answer these. They won’t sign off the approvals if you fail this.

That’s why sometimes it takes a long time to develop and launch a product. Many people criticise us for being slow, unresponsive or too technical. But to reach the stage we can satisfy all parties, including Shariah Committees and Central Bank, a product will just remain a concept that is not developed and launched if we do not have a capable team that interacts effectively with all stakeholders.

In addition, Product Development requires us to be experts in various fields after a product is launched. This includes after sales support and damage control, especially if there were mistakes made, misselling of a feature or just general queries by customers. We also have to continue ensuring Shariah requirements are being met, as well as balancing the business requirements (which is generally profit driven).

Life is not easy here, despite appearances. It takes a lot of grit to survive as a developer, and you do need a certain amount toughness to handle the day to day tasks. But the rewards are great as it builds you into a competent and wholesome expert in the field after a few years. Patience is also needed and so is hard work.

To all the graduating students out there, do your best in the industry and fight this good fight. There is a bright future out there, as bright as you want it to be.

Presentation on Careers in Islamic Banking

VideoBlog : Islamic Finance

One of my ultimate dream is to have VideoBlogs for this site. I have dreamt it for quite some time but it has been hard to find the opportunity to create one according to what I envision. InshaAllah that day will come, although I am not sure I am photogenic enough to be on “TV”.

CDIFBut a friend has managed to realise that vision. Hussain Kureshi whom became an acquaintance a couple of years ago, took that bold step to make a difference. He self-produced a series on Islamic Finance, following the launch of his book (Contracts and Deals in Islamic Finance) and I must say I am impressed.

So when Hussain asked me if he can feature his VideoBlogs on this site, it was my absolute honour to have it. Please do visit and take a listen to the various topics he has elaborated upon. As at yesterday, there’s already 20 VideoBlogs (YouTube) that you can go through. Looking forward to more additions in the future.

Click on the picture of the book to go to the VideoBlog page. Happy listening.

Types of Sukuk

One of the topics that I hardly write about are Sukuk (islamic Bonds). Unfortunately, I am not greatly involved in many Sukuk deals, either by design or exposure. In my line of work, I get to see the legal documents, but somewhat uninvolved when it comes to actual structuring. There are many, many experts in the field so I will not even attempt to pretend what they do is easy.

IMG_3424

But I did come across this interesting presentation on the types of Sukuk. A presentation I saw on Linkedin by Camille Paldi on the Types of Sukuk provides an excellent introduction to the subject. With her permission, I attached herewith the presentation on Sukuk in pdf for your easy download.

Click here to read Types of Sukuk (PDF format)

Also, I notice Camille Paldi writes (via her presentation slides) a massive amount of literature on Islamic Banking, which is a trove of information for someone who seeks it. Do have a read on her other presentations as well.

Happy reading.

Most Commonly Used Islamic Banking Contracts

It is reaching the end of the year and I thought it will be good to have a quick look on how many Islamic Banking contracts that we have in and around the industry. Granted, I might miss some of the contracts as there are many banks offering hybrids nowadays. I do apologise for such shortfall, and will endeavour to update this chart as often as possible, should there be some interesting and new contracts being introduced in the Islamic Banking industry.

Common Islamic Contracts

For pdf, please click here

In general, common Islamic Banking contracts can be segregated into a few categories:

  • Gratuitous Contracts

These types of contracts are typically unilateral in nature where the contracts do not require mutual consent to be applied. It is just a one-way arrangement where one party provides a product or service based on mandates or scope of work and is at discretion to vary the terms without requiring the other party to specifically accept the changes. For example, the Hibah contract (Gift). One party provides the gift, and the other party receives the gift. It should be on a unilateral / discretionary basis by it not being “promissory”.

Another example is the contract of Qard (Loan). One party lends money to the other party, and the other party (borrower) undertakes to pay back the loan (original amount) when required by the lending party, without any expectation of additional return. But the other party (borrower) can pay more than the original amount (by way of Gift) but is not obliged to, and such additional gift do not require the borrower to obtain “consent” from the lender to be given. It is simply the payment of the loan, and any other gift (which is not obligatory). Such “gifts” avoid the definition of Riba’ by being not promissory.

Under gratuitous contracts, the Aqad is not greatly necessary (it being unilateral) but it will be ideal for all parties if an Aqad can be concluded upon.

  • Trading Contracts

Trading or transactional contracts are debt-based contracts. Very similar in nature and intention to a conventional loan, but requires specific Islamic contract to be perfectly executed to avoid riba’. Such contracts greatly involves the participation of 2 parties (sometimes 3 or multiple parties) and there is a defined Aqad executed to finalised the terms and conditions to the contract. These terms are to be defined and agreed upon within the Ijab/Qabul period for all parties to accept. Once accepted, any proposed further changes captured in the Aqad must be accepted by all parties by mutual consent.

A common example will be a Murabaha financing transaction, where the terms and conditions are agreed up-front in a bilateral agreement. A purchase price is discussed, together with the profit amount, selling price and the settlement tenure. Ownership of the asset (used as an underlying asset for the Murabaha) is also moved between the parties, and transactional sequence is observed. Any changes that is proposed outside the Aqad majlis will require approval and consent by all parties.

A Leasing contract is also deemed a bilateral contract although the owner of the asset has the right to unilaterally increase or revise the rental amount of the asset under hire / rental, the person who lease that asset will also have a right to remain in or exit out of the leasing arrangement, thus making it bilateral (where there is also a material change in the terms and conditions.

The perfection of Aqad holds great importance to Transactional Contracts to ensure the validity of the transactions.

  • Investment Contracts

These types of contracts deals more on equity and corresponding returns in the subject matter. It follows the concept of investment where such equity-based structures takes on the risks of the investments, and concentrate on the concept of entrepreneurship and risk-sharing. In such contracts, where there is an element of trust, bilateral arrangements are strictly adhered to. Changes to the terms and conditions requires explicit consent especially from the party that is in a disadvantageous position.

The most popular of these contracts is the Mudharabah, which is used in many depository products. However, although this is technically a deposit, these deposits must be utilised or deployed into economic transaction for the purpose of generating a return on the capital i.e. in this case, the Mudharabah deposit. Once profit is recognised (if ever…) then the profit must be distributed to the customers based on the agreed Mudharabah profit sharing ratios. The Bank, usually acting as a Mudharib (fund manager / entrepreneur) , will behave as a pure entrepreneur with the customer (as Rab Ul Mal), acting as the fund provider with the possibility that the investments is not up-to-market returns which can result in both loss in profit and loss of principal (principal not guaranteed).

Another example. Under a Musharakah structure, there  is even more defined roles that the all parties must take and agree under a bilateral arrangement. With Musharakah, each party will be required to contribute equity (or capital) and even contribute expertise into the partnership venture to ensure profit can be made. All terms and conditions are captured as part of the important Aqad. Any profits declared will be shared according to equity ratio or agreed profit sharing ratio, and any losses shall also be shared amongst partners, usually based on equity ratio or equity contribution.

  • Supporting Contracts

Supporting contracts are often important because they act to complete many aspects of services, products and banking. Many supporting contracts are created to cater mostly for specific situation and most of it requires proper Aqad as well. Such contracts are also considered a facility to provide specific outcomes for the customer. It also falls into a bilateral arrangement.

Popular contracts include the contract of Kafalah (guarantee) where a person can enter into a Kafalah to secure a financing facility by providing a letter of guarantee. Other contracts include Rahn (mortgage or pawn broking) that has specific terms to the arrangements, Hamish Jiddiyyah (security deposit) or even Wakalah (Agency for services)

  • Contractual Arrangements

Contractual Arrangement are not necessarily contracts on its own, but can be construed as a combination of contracts to achieve a certain objective. The arrangement itself is not legally binding, but what is inside those arrangements are usually standalone valid Islamic Banking contracts.

Take for example the contractual arrangement of Tawarruq. Inside a Tawarruq arrangement, it consists of several standalone Islamic Banking contracts. Firstly there is the contract of Wakalah (Agency) to purchase the commodities on behalf of the transacting party. Secondly, there is the contract of Commodity Murabahah where the commodities purchased will be sold at a Sale Price to the purchasing party. Once the Commodity ownership is transferred into the purchasing party, the purchasing party can make an offer to another party as a Musawamah (simple sale) to obtain the desired cash.

Other contractual arrangement is the arrangement for Wa’ad (Promise) usually used for FX transactions. A Wa’ad itself is not binding, but it can be enforced upon certain events where eventually an exchange can be made (Sarf) or even a Commodity Murabahah is executed to deliver certain obligations.

Again, these are not exhaustive list of contracts, and can easily be expanded in a short period of time. Innovations are done everyday, and it will be a matter of time until critical mass will push a contract to the forefront. I hope to keep updating this list more in the coming years.

Wallahualam.

Overview of the Sukuk Market, Forecast Study in 2015

Found this on the internet. A good overview of the Sukuk market.

OVERVIEW OF THE SUKUK MARKET, FORECAST STUDY IN 2015 Redha Al Ansari Senior Islamic Capital Markets Specialist Thomson Reuters.

Source: ⚡Presentation ‘OVERVIEW OF THE SUKUK MARKET, FORECAST STUDY IN 2015 Redha Al Ansari Senior Islamic Capital Markets Specialist Thomson Reuters.’

 

The Difference Between Islamic Banking Financing and Conventional Banking Loans

I know the title of this post is a mouthful, but I am insisting on the title. Simply because today I came across another round of bashing by individuals on Islamic Banking. Again, the contention is that Islamic Banking is no different from conventional banking; worse still it is claimed that Islamic Banking is more detrimental than conventional banking. How can this be? I watched the video and aghast by the level of ignorance to the nature of Islamic Banking. And gauging from the response by the rest of the audience, it seems that the audience themselves knows no better.

It seems that a lot of individuals are still unconvinced about Islamic Banking. Furthermore, the impression that it is worst-off than conventional banking needs to be addressed. Islamic Banking, while on the surface is still banking, but it is built on a totally different foundation. There are significant difference which is brought about by a single requirement; Shariah-compliance.

THE STRUCTURE 

The basic difference between Islamic Banking and conventional banking is the structure of how the Bank is set up. For a conventional banking, the purpose of set up is to collect deposit and to give loans. This is the shareholders understanding of what it should be. 2 very distinct function ie Collect Deposit and Give Loans, and the arrangement is managed by a Treasury function which tries to balance the returns to shareholders’ funds.

Conventional Banking Structure (Diff)

But what is Islamic Structure then? In essence, how an Islamic Bank is supposed to be set up is based on the theory of “Sources and Application of Funds”. There should be a single flow between the deposits and the financing / investment use of funds; this means there is no distinct function. It is a single function where customer deposits or investment pool is used to fund financing portfolio or deploy into investment instruments, from which returns are derived and recognise. Once the returns are determined, these returns are “shared” between the Bank and the customers (deposit/investment). This “Profit Loss Sharing” structure demands a different way of managing the Bank, although not all Islamic Banks are able to successfully pull this off 100% (especially when the Islamic Banks are still under the parentage of a conventional bank).

Islamic Banking Structure (Diff)

In my personal view, the structure of an Islamic Bank is most suited if it is built around the Mudharabah structure. It fits perfectly on how the Bank is to be managed. It should be the backbone of any Islamic Banks, where the set-up is linked end to end resulting in sharing of actual returns arising from a Shariah-compliant financing/investment activity.

Finally, the processes in an Islamic Bank and conventional Bank are also different, simply due to the structure of which it has been set up. There is a broader requirement for oversight and research required to ensure the Islamic products and services meets Shariah requirements. A lot more layers to comply with, a lot more details needed.

Islamic Banking Diff (Structure)

THE SHARIAH COMMITTEE

Shariah Committee is the most important difference between an Islamic Banking business and conventional Banks. It provides an oversight accountability in ensuring that all the operations of an Islamic Bank is consistent with the rules of Shariah.

Shariah Committee (Diff)

There is a huge layer of governance surrounding an Islamic Banking proposition. Whatever features that it offers, it goes through regulatory oversight by the Shariah Advisory Council of BNM, and stricter scrutiny  by the Shariah Committee whom are not under the jurisdiction of the Bank but reports directly to the Board of Directors. The decisions (or “fatwa”) given by the Shariah Committee will be held solely by the committee themselves, therefore there is a huge responsibility for them. The Shariah Committee must ensure their decisions have taken into account all requirements of justice, customer protection, compliance to Sharia, interpretation to customary civil practices as well as practicality of implementation. In short, decisions must be clear, defensible and without any doubt to its validity.

SUSTAINABLE MAQASID OF SHARIA

In Islamic Banking, matters really are determined by intentions. And the intention is to ensure the Maqasid (Objectives) of Shariah are met.

Maqasid

These Objectives are a key consideration in setting up an Islamic Banking operation. But it does not mean the operation of Islamic Banking and the deployment of its funds are for charitable purposes. It is still a business that needs to be sustained by investing in Sharia-compliant economic activities, therefore it is misleading to assume Islamic Banking is a holistic endeavor that “should not charge interest” or merely to “provide assistance to the ummah”. There are costs for running an Islamic Banking business, and as far as possible it should be at par to the costs of running a conventional banking business. Returns on Shareholder capital is also important to ensure that capital is continued to be invested into Islamic Banking for it to grow. With growth comes the ability to continue supporting the ummah. The key word is sustainable banking. You cannot grow or even survive if you are not competitive.

THE PRODUCT & CONTRACTUAL RELATIONSHIP

Designing and launching an Islamic product is not easy. The amount of work that needs to be done in relation to the fundamental difference between an Islamic Bank and conventional Bank. The fundamental difference is the totally different outlook on what happens after entering a contract. The contract between a customer and a conventional bank is simple; a loan where interest is charged upon over a period of time.

Key Diff - Product (Example)

But look at an Islamic contract. It is much more complex structure, but once determined, it really makes total sense. The contract defines the relationship, the relationship defines the responsibilities and subject matter, the subject matter defines the sequencing and ownership requirements for the use in an economic transaction, the transaction defines the rewards and returns on the completion of the contractual obligation. Cause and effect, risks and compensating return, action and rewards.

What usually confounds practitioners (whom are not well versed in Islamic Banking contracts) are the level of detail. Some may consider the issues discussed in an Islamic Banking forum as “petty” but others expressed amazement in the level on consideration undertaken during discussions. For example, an Islamic Banking forum would discuss the nature of loan (Qard) and responsibilities of Qard, conditions of Qard, transferability of Qard, conclusion of a Qard Aqad (offer and acceptance), dissolution of Qard and implications of Qard when attached to other Islamic contract. This level of discussion is missing from the conventional banking space where in their view is that a loan is an amount given to customer where it is to be repaid back with interest.

OVERALL SUMMARY OF DIFFERENCES

There really are differences between Islamic Banking and conventional banking, and there are some of us trying very hard to make a difference in the compulsion towards Riba’. As a summary, below are some quick differences I have compiled from my earlier days in the industry on the differences between the models.

Difference 1

Difference 2

Difference 3

Difference 4

DNA OF ISLAMIC BANKS

For me, the main difference between Islamic Banking and conventional banking is that the concept of justice to customer is not regulatory driven; it is conceptually driven by the idea of Islamic Banking itself. A lot of conventional banking practices are developed to maximize returns while minimizing risk, and risk-transference is a key consideration for conventional banks. Regulators have to be vigilant in ensuring conventional banking toe the line to protect customer’s interests.

Islamic Banking, in its DNA is intended more than just being profitable. It is meant to be providing service to support the activities of the ummah (Muamalat) defined within Shariah-compliant transactions. There are specific rules that must be followed; breach of these rules means the penalties are non-negotiable i.e. whatever returns gained from these breaches must be given to charity. Care and consideration is a must. Justice and fairplay is always important in a decision by Shariah Committee. Release of customers burden is a priority.

AVOIDING FITNAH

Many customers still lack knowledge of what Islamic Banking is all about. They collate biased and misleading information from truncated and unverified sources on the internet, facebook postings that intends to be malicious rather than presenting the true picture, and comments by individuals who make generalized comments on their experience which may well be isolated cases due to misinformation, misunderstanding or just plain ignorance to the fact. And yet these comments are sensationalized, made viral and deemed to be the absolute truth without further exploration or verification.

Cut and paste seems to be the easy way forward. Yet people forget the discipline that is practiced by the companions of the Prophet; you must verify the information by determining it all the way to the source of the information, up to naming the individuals who made the first comments, and deciding whether the individuals are trustworthy and of good standing. This discipline is lost in this world of over-abundance of unverified information in the social media where direct accountability is undetermined, and it has become increasingly difficult to separate untruth from fact.

I had always advised friends and critics alike to be careful of what they “recommend” when dealing with Islamic Banking due to the huge responsibility of such recommendations. If they are ready to criticise Islamic Banking as “same as conventional” or “open to back-door riba” without full understanding of what it really is, they should be ready to take responsibility for that. If their basis of stating as such is based on “viral whastsapp message” or “comments by third party islamic practitioners” or “explaination by insiders in the industry” or “commentary by blogs”, I do appreciate if we as practitioners can be provided with these “sources” for us to verify its accuracy. Many times I find the comments are based on partial information, taken out of context, outdated writings or information as well as just being malicious without proper basis or discussion. Some are not even Shariah related or relevant to Islamic Banking practices, just operational and processes defects.

Do think of the implications: Should a person make such comments that “Don’t take Islamic Banking products because it is not really Islamic and there is a lot of trickery to it”, and the person listening to that comment thinks “Owh then there is no difference between Islamic product and conventional riba banks’ product” and proceeded to take Riba-based loan products, the implication is that the person who made the comment had directly influenced another person, in my view, in making a wrong and sinful decision. Will that person be responsible for this act of “pushing another Muslim into taking Riba products”? It is a heavy burden to take, not just immediate but in the hereafter. So be careful when a person makes that comment.

And to imagine what will happen when the person who took the Riba product commented to another person (and another) that someone commented that “there is no difference between Islamic Banking and Riba Banking…” . It will become a tree with a massive root, grown by the single seed of the original “defective” comment by the first person.

MashaAllah

Hopefully those doubtful questions on Islamic Banking should be directed to Islamic scholars, Islamic banking practitioners or relevant academicians with stature, knowledge and qualifications before the ummah believes and spread untruth that will, in the end, become a disservice to the religion of Islam by spreading “fitnah”.

ISLAMIC BANKING IS EVOLVING

Evolution

Granted, Islamic Banking is a 30 year old structure, with many building blocks are still in progress. But it has not stopped evolving to existing times as and when new regulations and Shariah decisions comes into discussion. It is not perfect yet, but practitioners are aware of the difficulties of meeting all the requirements without enhancements and considerations to practicality. There is a misguided assumption that academia are aware of all the shortfall of Islamic Banking practices and the industry had turned a blind eye to these. Nothing can be further than the truth. Islamic bankers, Shariah Committees and BNM are well aware of all of the issues raised by academia as well as other practitioners, with the benefit of global awareness as well. In truth, practitioners know more of the issues they faced on a day-to-day basis, as compared to academia where some of the issues had already been resolved by the industry but not made known to academia.

Criticisms are always welcome, but ideally it should be constructive on how to improve. It is a heavy responsibility to ensure the differences between Islamic Banking (based on Shariah) and conventional banking (based on lending) are managed diligently. It is an on-going evolution that I am confident one day will reach its apex. Ideas are welcome and proposed solutions considered in earnest. And as I have always said to my product team; If you’re not part of the solution, then you are part of the problem. So, let’s be the solution that we had always wanted.

Wallahualam

My earlier postings on similar conversation:

  1. Consequence for Choosing Islamic Banking
  2. Shariah Banking in Malaysia
  3. Conversations on Islamic Banking in Malaysia
  4. Choosing the Right Options

maxresdefaultMore videos at Islamic Bankers Resource Centre on YouTube

The Rise of Qardh

I wrote earlier in July 2014 about re-branding Wadiah following discussions the industry had with BNM. In that meeting, the key take-away was that there is an intention to re-brand Wadiah into Qard, to which the industry reacted negatively as Wadiah has always been used for short-term deposit structures where discretionary hibah “gifts” are given to depositors. BNM contention was that Wadiah do not meet the practice of the Bank where Wadiah was supposed to be taken as “safe-keeping based on trusteeship” (Wadiah Yad Amanah) or “safe-keeping with guarantee” (Wadiah Yad Dhamanah). The main argument was the under the Wadiah structure, the ownership of the fungible asset remains with the customer and the Bank has not obtained sufficient consent from the customer to utilise their funds, specifically for Wadiah Yad Dhamanah.

Wadiah 2014

The solution for the above conundrum, offered by BNM, is therefore, migrate to Qard-based products, where by virtue of it being a loan from the customer to the Bank, the ownership is transferred to the Bank allowing the Bank to utilise it as it pleases, while guaranteeing the loan amount upon demand (you have to repay back the loan).

As mentioned in my earlier writing, some industry players has clear reservation to convert Wadiah to Qard, seeing that the various guidelines are coming thick and fast to comply with requirements under Investment Accounts. Handling another major change in regulations will just hamper the industry’s growth.

Now, 16 January 2015. The revised Concept Paper for Wadiah was issued. We are given 1 month to respond with our feedback.

Wadiah CP

The biggest shock is that the paper has re-defined Wadiah as only Wadiah Yad Amanah i.e. safe-keeping trusteeship. There was NO mention of the contract that most Banks are currently using for Current Account / Savings Account i.e. Wadiah Yad Dhamanah (safe-keeping with guarantee) which allowed the Banks to utilise the funds for Bank’s activities. What this removal of definition means:

  1. The Bank takes Customer Assets and safely keeps as Wadiah in the Bank until a request to withdraw the Asset is made by the customer. The Bank must return the initial Asset to the customer upon request, with no obligation to provide any other benefits.
  2. The Bank does not have the right to utilise this Asset under Wadiah anymore #.
  3. If the Bank intents to utilise the money for purpose of generating returns, then the rules of Qard must apply i.e. for the Bank to obtain the right to utilise the money, the ownership of the money must be transferred to the Bank i.e. the customer no longer has financial and ownership rights when the funds are utilised by the Bank to generate returns. It is a loan by the customer to the Bank. As owner of the money now, the Bank has full rights to the returns. The Bank has no obligations to the customer except of return of the loan on demand. Discretionary hibah “gift” may be given, but questions may soon come on its validity when it is deemed as “Urf” (customary, no longer discretionary).

# Previously under the rules of Wadiah Yad Dhamanah, if the Bank intends to utilise fungible Assets deposited by customers to Banks such as money, sufficient consent must be obtained before the Bank utilise the money for other purpose (including for generating returns). In reality, this consent is really lacking especially for a daily product such as Current Account or Savings Account, resulting in insufficient rights to use customer’s fund to generate returns. The Banks are also not allowed to agree the returns up-front for the use of the money yet circumvents this by publishing historical rates of returns instead. This “historical return” soon was construed as non-discretionary and deemed as returns that is treated as Urf’. Therefore, Wadiah Yad Dhamanah was totally removed by BNM as a viable Islamic Banking concept, and now to be replaced by Qard (where ownership of funds are wholly transferred to the Bank).

Utilisation of Money

In any circumstances, Banks do utilise the Customers’ money for banking activities, including investments. If we retain Wadiah under this new BNM definition, then it will greatly impair Islamic Banks if we are not able to utilise collected funds for generating profit. The Wadiah moving forward will only apply for Safe Deposit Box services where the Bank can charge a minimal fee for safe-keeping services. Trying to apply it to anything else will be a challenge.

Wadiah 2015

The Qard guidelines needs to come sooner than later. At least the Exposure Draft or the Concept Paper needs to be available for discussion and for Banks to assess the Impact going forward. The impact by IFSA 2013 will be fully felt right after the coming months of June 2015, and this new regulation will further add to the re-branding of Islamic Banking currently taking place in Malaysia.

Equity-based Financing vs Debt-based Financing

Recently I have been asked again on why Islamic Banks still uses a lot of Debt-based Financing products, instead of moving to Equity-based Financing products, which on perception was supposed to be more “Islamic”.

Yes, ideally an equity-based financing do equate to a more “Islamic” structure, if your definition of being more “Islamic” is risk-sharing. Not all structures must be risk-sharing; transfer of risks are definitely acceptable in Islamic Banking circle. The idea is an age old idea; if you undertake a low-risk structure or there is no risks for the bank (where all risks are transferred to customers) then technically the bank should earn low returns for it. If the risks are higher i.e. Bank carries the risks, Banks would be entitled to higher returns. High risk equates to High returns.

TYPES OF RISKS 02

BUT IN REALITY, ARE COMMERCIAL BANKS SET UP LIKE THESE?

If an Islamic Bank operates in the same environment as a conventional Bank, it is difficult to imagine having two models running side by side I.e. the Islamic Banks operating an equity-based business and conventional Banks operating a debt-based business. The risk profile of these banks would be significantly different, and this affect many areas in banking; risk rating, cost of funding, profile as well as capital requirements. The bank with the perceived higher risk rating will ultimately become less competitive.

The real truth is that the shareholders of traditional banking set up expects the following: medium to high returns on their equity at the lowest risk and operating cost as possible. In short, their “investment” must record the best Return on Investment (ROI) as possible. Based on this view, debt-based financing can fill that criteria.

SO WHAT ARE DEBT-BASED FINANCING STRUCTURES?

EQTYvsDEBT

Many have the perception that equity-based structures and debt-based structures are dependent on the types of contract employed by an Islamic Bank. To a certain extent, this may be true. Certain contracts by nature promotes the sharing of risks (which is equity financing) while others rely on the transfer of risks (which is debt financing). For example, a Musyaraka (partnership) structure is traditionally an equity financing structure, where the Bank and customer enters into a partnership arrangement with both parties giving capital into the venture. Risks on the venture is shared according to equity ratio, and so is the returns where it will also be shared. The risk factor is therefore elevated because there is a possibility of losses being shared between Bank and customer.

Musyaraka

So, many Banks prefer the safer haven of Debt-based financing. How, then, do you change a Musyaraka structure into debt-based? Simply by providing a purchase undertaking, a document agreed and signed which states that should the venture go bust, then the customer agrees to undertake the purchase of the Bank’s remaining share in the venture thus making the amount to be immediately due by the customer. This is in a way, an indemnity given by the Customer to provide assurances during contractual breaches. By having a purchase undertaking document, the risks are effectively transferred to the customer in times of default. The Musyaraka therefore still works where profits are shared during the good times, but dissolves in spirit during bad times when purchase undertaking document takes effect.

Equity Financing2

The talk about having an equity-based financing is usually moot with the use of purchase undertaking document. The element of risks is removed for the Bank, and puts the product on par with its conventional banking product equivalent.

So will we ever see Equity-based financing?

I believe you need real political will for this. You need:

  1. Shareholders who understand the risk nature of equity based contracts, the way venture capitalist understand venture capitalism. Risk and return are greatly considered but more importantly, the possibility of losses.
  2. Bank with a risk appetite outlined for greater risk-taking. The risks to be understood and accepted. Then the venture in entered into with eyes open although it will take time for a Bank to understand the business risks they take under equity-based structures.
  3. Customers willing to stomach the losses or share the spoils of profits. It will take even longer time for customers themselves to be able to accept the structures under equity-based. Customers must be able to understand that they are active partners in a venture, the responsibilities and also the sharing aspect of it; they don’t just share the losses with the Bank, but also the profits or gains with Banks as well and this can be above and beyond what they can traditionally accept.

To achieve this, it will take significant paradigm change for everyone when they have only the financing structures in mind. In actual fact, such structures are already common in the consumer psyche as there are similar structures when they deal in unit trusts, shares or other types of investments, where risks are taken. But to flip it into an “equity financing” concept will remain a challenge to Islamic Banks that are serious to offer something significantly “Islamic”.

Session #1

Today I had the pleasure of sharing experiences with some post-graduate individuals on the new happenings in Islamic Banking in Malaysia. I thoroughly enjoyed the session and answering their “tough” questions and happy to see so many passionate people in Islamic Banking in one room.

One of the questions that resounded loudly throughout the room was the question regarding product development. I was asked if businesses greatly influence the development of a product or does the Sharia Advisory Council have a stronger say. An interesting question but I think the room agreed that the main influence will come from consumers; it is still consumer demand that drives it.

We could have developed the most Sharia compliant structure that even conventional banks do not offer and create significant differentiation, but again the next question would be: Would consumers understand, accept and buy the product? A lot of resources will be invested into such development, but the key question is that who is going to take it. While it is ideally attractive but practically defective. Not because there is a Sharia issue or product design, but whether it will suit the consumers  needs simply and practically.

So, Islamic Banking is also driven by the same consumers who drives the conventional businesses. How then, do we change the mindset that Islamic Banking should be more than just a copy of conventional products? Economically, we are set In thinking that banking as a way to expand wealth. One of the participants asked if there is a possibility to change a whole culture to understand and view Islamic Banking as a viable distinct alternative to capitalist conventional banking. Whether culturally the mindset of consumers can be changed to demand Islamic Banking provide different solutions to the same problem, specifically introducing a totally different way of banking. An interesting thought if it can be done, but it feels nothing short of re-genesis to make that cultural change. Someone has to start that spark, and we really need that someone.

In all my sincerity, I am glad to know there are individuals who do understand the challenges in Islamic Banking, no matter what their aspirations. I am but a tiny speck in their learning development and hope to see more individuals like these who are able to one day make a difference in Islamic Banking.

As requested, I attach the presentation slides used today and hope it can be of some use to its readers.

Pool Management, Profit Calculation & Distribution Mechanism (ppt)

Thank you friends, for your support, and don’t give up the good fight, no matter how tough the challenges might seem.

Is Risk Based Pricing Compatible with Islamic Banking?

As the deadline of 1st January 2015 to comply with the new Reference Rate Framework looms closer, Banks are scrambling to ensure the system is adequately able to cater for the new pricing regime.

To refresh what this initiative is all about, BNM has earlier in March 2014 issued the final paper for the Reference Rate Framework, the purpose being to move Banks to be more transparent in their pricing regime and start thinking about risk-based pricing more seriously. It is also expected to push Banks to be more efficient in their operations; the more efficient the funding infrastructure, collections and recovery teams in the Bank, the lower the expected risks associated to the pricing which means bigger “savings” on the margin for the Bank.

Which was fine when I read it a few months ago. For a quick recap, do read my earlier post:

Please Click Here

But the more we go into this Reference Rate project, the more confused I get. Reading again and again and comparing it with the earlier Guideline issued by BNM on Risk Informed Pricing (issued 13 December 2013), I realised while earlier we understood the concept of “building the element of risk into how we calculate pricing”, this Reference Rate Framework talks about something else. Something I am inclined not to agree to.

Before that, what is Risk-Informed Pricing or Risk-Based Pricing?

I am not sure if there is a difference between the two, but the general understanding of what is Risk-based pricing and the explanations in the BNM paper on Risk Informed Pricing sound similar; both  talk about Expected Loss being the justification of charging a higher financing rate to consumers deemed to be “credit unworthy”. There is an element of discrimination but certain rules have been put in place such as factors that should NOT be used to determine price, such as race, colour, religion, national origin, gender, marital status or age, but that leaves a lot of interpretation by Banks on what can be defined as “risk” factors of a consumer. Wiki even went to comment that the pricing convention hurts the financially disadvantage from access to affordable capital or financing. This leads to predatory lending where Banks may offer exorbitant rates to desperate customers as they have no choice but to enter into an unsustainable financing schemes that they will eventually default.

Does Risk-Based Pricing make sense for Islamic Banking?

In that sense, how do we, Islamic Bankers, deal with Risk-based pricing in the context of the new Reference Rate regime? Is there such as thing as risk-based pricing for Islamic Banking?

Personally, I view Risk-Informed Pricing to be in contradiction to Islamic Banking and what we are supposed to do for consumers. Many efforts have been made to ensure consumers are not unnecessarily burdened but instead to provide assistance. We understand the Bank’s needs to discourage consumer “who couldn’t afford it” to not borrow further and bring themselves into unsustainable debts. But the way of the world, with the Basel II accord being an important international standard,  risk is deemed to have a direct impact on Bank’s capital and therefore must be addressed accordingly via effective risk management where one of the methods for this is to have risk-informed pricing. Therefore, upon assessment of an application from a consumer, a “risk-informed” price will be offered for their consideration; a price where all the elements of risks (including Expected Loss) are built into additional costs and premiums.

Islamic Banking, like it or not, will still fall under such standards, and therefore will already “penalise” a certain unfortunate consumer upfront with a “risk-informed” pricing. Not something consistent with what I feel Islamic Banking should do.

What is it that I am confused about with the Reference Rate Framework?

While we have woken up and accepted that the world now is moving towards “risk-informed pricing”, we try to find ways to soften the burden to  consumers by regulating “late payment charges” and”early settlement charges”. The Late Punitive pricing was also off the radar for both conventional banking and Islamic banking.

But with this new framework, there is not only “Risk-Informed pricing” or “Risk-Based Pricing” but also “Risk-Adjusted Pricing”. Adjusted means Banks can adjust pricing AFTER a future event happening.

This concern basically boils down to this particular clause in the framework paper.

Risk based pricing

Usually, risk-based pricing means initially a price that is adjusted to cater to the risk are given upfront. But with 8.10, what this means is that if the credit risk profile or creditworthiness of the customer changes during the tenure of the financing, the pricing i.e. the Bank’s spread may be revised to compensate for the higher risks. Definition of changes of the “credit risk profile” or “creditworthiness”, based on our clarification with BNM, refers to default situation. Therefore, if a customer’s creditworthiness is compromised and becomes worse-off, then the Bank, in its facing additional risk for continuing to finance the customer, may revise the Bank’s spread to mitigate the higher risks. If you are a good paymaster for 1 year but on the 13th month is out of a job and unable to pay your home instalments, you are now “not-creditworthy” and the Bank has the “right” to mitigate that risk and charge a higher spread i.e. higher returns.

Unless I’m reading this standard wrong, this is a gross expansion to risk based pricing, where the facility rates are adjusted based on the customer’s prevailing risk profile.

RAP

Yes, if the customer’s risk profile shows good credit standing (therefore deemed a “low credit risk”), theoretically the customer may enjoy a low financing rate for their facility due to the low possibility of default to the Bank. This is definitely a benefit to the customer. But on the flipside, if the customer initial credit rating is already “marginal or bad”, they possibly will be offered an “elevated” Bank’s spread to mitigate the potential risks of financing an “unworthy” customer. Therefore the initial pricing will be higher than usual. This is the basis of risk-based pricing, which can be a beneficial tool for the Bank.

To make things worse, should the customer have no choice but to take the financing at a higher rate, they are open to further “elevation” if during the course of the financing, things go sour in their payment. The event of default will trigger the option to “revise” the rate further. This means a “marginal or bad” customer will be holding on two levels of risk-adjusted pricing; the first during the initial approval, and the second on default events during the financing period.

It seems there is now a backdoor to the Late Payment Charges (LPC) that the Islamic Banks have been restricted to. While it is difficult to charge Penalty (Gharamah) due to various restrictions, allowing Banks to directly revise upwards the banking spread actually resolves the issue of cost compensation that Banks were not able to charge before. In fact, if you really think about it, there is really no need for the LPC guidelines anymore; on default, Banks can raise the pricing spreads and it goes directly (and fully) into its income books.

How will this be acceptable to an Islamic Banking structure? Allow me to express my utmost shock to this.

Shocked

Simply put, risk-adjusted pricing and Islamic Banking do not make good companions. I understand the intention is to ensure customers don’t over-finance beyond their means, but to impose this for “default” customers  does not seem right as this looks very similar to a punitive action to consumers. I hope I am wrong about this, but as I know it, my conventional banking counterpart is already building this capability in their system. As this is a BNM standard now, I wonder how soon until we are asked to follow suit to comply with such requirements.

I am recording my official concern to this to my organisation’s Sharia committee. Hopefully it is a misunderstanding on my part. I would welcome this correction in understanding on my behalf.

Concept Paper on Liquidity Coverage Ratio

Fresh off the press, the Concept Paper on Liquidity Coverage Ratio is issued by BNM today.

Off-hand, there has been a lot of concerns with the issue of treatment of deposits, especially in the light of the treatment of Mudharaba Deposits as Investment Accounts, and the Wadiah with limitations on Hibah and perhaps the reclassification as Qardh. Each Bank had decided on a course of action with regards to how deposits are being treated and managed. There is expected to be shifts in the deposit structure of each Bank and worries that with the new changes, there will be deposit flight from the Islamic banking financing system.

The Liquidity Coverage Ratio (LCR) Concept PaperLiquidity Coverage Ratio talks about the Bank having enough liquidity to withstand liquidity stress scenarios by maintaining sufficient High Quality Liquid Asset (HQLA).

The LCR is part of BNM’s effort to meet Basel III initiative to ensure high quality capital and liquidity strength of Banks. This is part of the framework that includes Net Stable Funding Ratio (NSFR) and Liquidity Risk Management Standards.

 

The areas covered under the CP includes:

  1. Application of the LCR by Banks
  2. Implementation timeline and transition requirements
  3. Definition of eligible stock of HQLA
  4. Treatment of cash-flow items for LCR computation.

Bankers will really need to digest this document to fully appreciate  the intention of the paper. We have until end of November to come back with feedback on the issues on implementation of the LCR.

The effective date of this CP is 1 June 2015.

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.

Rebranding Wadiah

A few days ago we had an interesting session with the Malaysian regulators. The agenda listed as “Discussion on the Wadiah Concept Paper”, a paper which was issued in December 2013, and had caused quite a stir in the industry. The main content of that paper was the treatment of Hibah (gift) payments on balances maintained in the Wadiah accounts, and the underlying rules of Wadiah.

For clarity, Wadiah (safe keeping) contract is used in Malaysia for savings / transactional type of accounts. The intention is that the customer enters into a relationship with the bank as a Wadi’ (custodian of deposit) and Mudi’ (owner of capital / depositor). The mandate is purely on a custodial basis. In practice, the customer places funds with the bank for the purpose of safe keeping, therefore the bank must become just a custodian of the depositors money. However, it is unlikely that the bank just receives the funds and not utilise it for an economic activity.

Because of this use of funds by the bank, Malaysian scholars view it is only fair as a good banking practice, that some discretionary returns may be given to customer for the use of the customer’s funds. This returns, while not promised up-front, has over a period of time, become customary (Urf’) in its execution and distribution. The whole arrangement is known as Wadiah Yad Dhamanah (safe custody with guarantee). As I understand it, only Malaysia offers this contract for Savings and/or Current Account products in the world.

In all other geographies, the Current Account and/or Savings Account commonly use either the Qard (interest-free loan) contract, or the Mudharaba (profit sharing entrepreneurship) contract.

Wadiah vs Qard Update

All these years, we are of the view that there is a identifiable difference between Wadiah and Qard. Under Qard, the arrangement is where the customer provides the bank with a loan i.e. the deposit amount which must be returned to the customer upon demand. While Wadiah also operates the same way, the only difference is that Wadiah allows for the granting of discretionary Hibah arising from the use of the customer’s funds.

So it was a small surprise to note that in the Wadiah Concept paper issued in December last year, there is a specific mention that while there is a differentiation in relationship for Wadiah and Qard, the rules of Qard will also apply to Wadiah. The issue of discretionary Hibah is also raised that if the Hibah is paid consistently, it becomes customary (Urf’) and therefore can no longer be viewed as “discretionary”.

That is why I was surprised that the meeting a few days ago asked this question; “What are the views of Islamic Banks if the Wadiah contract is now demised and replaced by Qard, while the practice of paying discretionary Hibah is retained even for Qard? Would the banks be open to this “change in name only” while the principles of the product remains the same?”

My concerns with this direction are:

  1. Such allowance to continue to provide Hibah on a Wadiah (in name only) will only be temporary and will eventually turn to what is practiced in the middle east i.e. no payment of Hibah.
  2. Confusion may ensue as there will be two separate rules governing a Qard i.e. different rules in Malaysia and what is being practised elsewhere. This opens up the Malaysian-version of Qard to criticism and I believe, sooner than later, consolidation of practice and understanding will happen.
  3. The investment effort to be spent into Wadiah products will now no longer make sense. Eventually, Wadiah will cease to be a savings-and-deposit-building proposition for the Bank. It will revert into a basic, transactional and low balance proposition, which might not be attractive for Banks to further invest into. Other options will now take prominence.

Will Wadiah also survive this re-branding of Islamic Banking in general in Malaysia? We are expecting some changes to surface this end of year and it will put further pressure on the industry which is already reeling from the existing changes that was introduced. From where I am sitting, it seems that soon, Wadiah will be re-branded into a version of Qard, as a pre-cursor of eventually becoming “pure” Qard.

Looks like another one will soon bite the dust.

Interconditionality in Bai-Inah

One of the most controversial contracts that resides in Malaysia is the Bai Inah contract. For many years, Malaysia have been taking heat on its use from international forums. The major reasons for this critique is that Bai Inah, while having an underlying transaction in its structure, argues critics, smells suspiciously like a loan with interest. There have been many opinions to this, but I must admit that each argument has its own merits and rationale, and it is difficult to draw the line here.

What is Bai Inah?

But before going further, what is Bai Inah? Why is it always under the Islamic finance microscope for scrutiny? Why are feathers always ruffled when discussing Bai Inah?

Bai Inah Malaysia

 Please Click Here

Reliance on Commodity Murabahah

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.

Goods and Services Tax on Islamic Products

Goods Services Tax (GST)  will be one of the hot topics for the years to come in Malaysia, when the GST finally comes into place in 2015 to replace the Services Tax. Many arguments have been made on both side of the political divide but the reality is that GST will be implemented and have a huge impact on how services and goods are being priced.

A quick look at the GST finds that Sharia compliant banking, while having all its contracts requiring underlying transactions, asset ownership and movement of actual goods, the impact that the GST may have on Islamic contract will remain similar to what impacts a conventional banking product. There is not expected to have a “worse-off” effect on Sharia compliant banking.

GST

It is heartening to see that Customs has made an effort to understand the various Islamic banking contracts and how it works, and identify potential transactional points where a GST may be imposed. I find the attached document (GST Industry Guide – Islamic Banking (As at 1 November 2013)) extremely useful summary of the intended GST implementation on Sharia banking contracts.

10 particular contracts have been identified and the GST points are outlined accordingly.

Please Click Here

The Consequence of Choice

It was a day where nerves were frayed and feathers ruffled.

A huge potential customer comes. The intention is that they wanted to move all their accounts to Sharia-compliant banking, as they intend to “Islamicize” their business. All the available structures were laid out to the customer, the processes and the documentary procedures were explained for their understanding.

But suddenly, comes the golden question… “Do you have any products that looks and behave like a conventional product that we are familiar with? We are not comfortable with all these Islamic terms and documentations, so can we have something that does not require us to sign all these documents?”.

I was left speechless.

Sharia-compliant banking is based on contractual relationships. There are many relationships; Musyaraka, Murabaha, Ijara, Mudharaba, Istis’na… Various and many depending on use, intention, and desired outcome. There must be an underlying transaction, governed by specific rules and tenets, and pays attention even to sequencing requirements, ownerships, rights and usufruct.

Documentary Islamic

Fundamentally it is different from a conventional banking structure, which is loan based and interest charging. Thus documentation for a non-Sharia banking product is essentially one core document; Facility Agreement. But that may not necessarily be the case for Sharia banking, where documents are crucial evidence for the underlying transaction, ownership and obligations.

To make that conscious decision to shift to Sharia-banking is admirable. But to insist on a structure they are used to in conventional banks makes this effort superficial. It is frustrating to explain that each Sharia-compliant product behaves in a certain manner and must comply with the tenets captured in various documents; no matter how much a customer envision the product feature and documentation should be instead. A Sharia-compliant 1-month Term Deposit based on Qardh (ease of documentation) but with guarantee of returns? How would we pull that off? It is a contradiction in concepts.

Customers need to understand that to choose Sharia-banking is to accept the rules and trimmings that comes with this model. It is not the same as the conventional model, although at many times we try to replicate what’s available in the conventional space to avoid confusion. Replication is there for convenience but the DNA of Sharia-compliant banking is different. With replication then enhancement and eventual replacement, we hope awareness in Sharia-compliant products may come in gradual stages.

I think it all boils down to the lack of understanding what is required for us to offer Sharia-compliant banking. The layers we go through are numerous, stricter regulatory requirements and Sharia rules to follow. Turnaround times for Sharia-compliant product is understandably slower, where there is intense scrutiny on contractual relationships, legality and Sharia-sensibilities.

It is tough to be an Islamic banker. We manage perceptions, expectations and responsibility not only to the Bank’s customers, but also to general consumers. To choose this model, consumer must be open to the fact that Sharia-compliant banking is similar but definitely not the same as a conventional model. There is a lack of awareness of what is involved but we need to be open to an idea. Everyone knows the conventional model, therefore do take time to understand Sharia-compliant banking as a new learning instead on trying to hammer a conventional-familiarity into a model which works based on risk-sharing, relationships, and contractual certainties and tenets.

May I have a calm week ahead.

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:

 

Pro-Active Compliance of Regulatory Guidelines

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.

Banking with Non-Islamic Banking Institutions

I remember many years ago being in an interesting conversation with my Bank’s Sharia Advisor on the topic of accepting funds from an organisation which deals with non-sharia compliant activities. What was the view on taking funds you know were generated from doubtful sources. Whether it is reputationally acceptable to take in deposits from customers involved in gambling, usury and prohibited activities.

Some institutions were reluctant to take in these institutions as customers, even though they were huge, cash-rich corporations. The worry is on the perception that we Islamic bankers are supporting them via our activities, that they benefit from their patronage of our bank. Some even said that taking their “dirty” money and putting it into our pool of “clean” funds will result in co-mingling of the funds. The fact that we provide services to non-Sharia compliant institutions, bothered some quarters.

My advisor said it simply. Why not we take their funds? If you don’t take it, where would it then go? It will go back into the conventional system, generate more money, providing more funds to allow the conventional banks to loan the money to more customers. This will grow the conventional pool of funds, increase the loans portfolio in interest-lending and further strengthen a conventional banks profit. Islamic banks will then have to grow organically, fighting for the piece of pie that’s available against huge conventional banking giants.

Take the money. Invest in Islamic industry. Grow our books. Invest in Sharia-compliant manner. And provide good returns to the conventional depositors and investors. Change their mind by proving that Islamic banking is universal. That the model is viable. Innovative, competitive and fair. Provide the alternative for a feasible banking structure. Give da’wah and awareness on Islamic banking and its underlying principles. Prove we can co-exist side by side.

Probably one of the wisest things I have heard. Although not many will have the same sentiment to this. So it is ok to agree to disagree.
Investment by Conventional Banks
But what if it is the other way around? Can an Islamic Bank invest or place their deposits with a conventional banking counterpart, who deals in non-compliant activities? The answer is obviously a NO. Depositors funds, taken under a Sharia-compliant contract, should be used for sharia approved activities only. Morally, it is wrong to paint a picture that the Bank is Sharia-compliant but is actually a deposit collection arm of the Non-Sharia-compliant bank. It’s misleading and damaging to the Islamic bank to have this reputation.

Investment in Conventional Bank

Yet, is there a solution to this argument? What if we still deposit funds into a conventional bank, yet with a strict condition put on the use of these fund for Sharia compliant investments only? Will that be enough to allay the concerns? If it does, what is the relationship that will be between us and a conventional bank? Can we appoint a conventional bank as our “Wakeel” to execute Sharia compliant transactions?

Personally, I do have reservations on this. Conventional banks do not have any compulsion on the execution of a transaction whether Islamic or otherwise. They do not bother about its use or matters such as sequencing or ownership. Their law is civil law, and is dependent on the legal documentation. This, then, is merely passing of money to a conventional entity, when our depositors have trusted us to invest in Sharia compliant activities. Can we be assured that the monies passed over be used according to our requirements? How do we get this assurance?

What is your Bank doing? Can this be a possible model?