Contracts and Deals in Islamic Finance: A User�s Guide to Cash Flows, Balance Sheets, and Capital Structures

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This book is dedicated to the memory of my father, the late Muhammad Azam Kureshi, who left this world too soon, and my grandfather, Ali Muhammad Baloch. Both men served their countries and not their pockets—a rare breed.

—Hussain Kureshi

To my mother, who held my hand and took me to the library; to my father, who writes every day and first encouraged me to write; and to my wife, a beautiful writer who keeps focusing and championing me.

—Mohsin Hayat

Foreword

It is difficult to describe the pride with which I commend the reading of this fine piece on Islamic finance. Hussain Kureshi came into contact with OCBC Al-Amin (and thus me) through our scholarship program with INCEIF, of which he is an inaugural recipient. Hussain duly completed his CIFP with distinction and went on to engage with us as a research assistant. We certainly did not expect him to also come out with a book on Islamic finance. But that is exactly what his trail-blazing approach and academic prowess have produced. Doubtless, he has set the standard, no, raised the bar, of expectations from future scholars.

Islamic finance, or offering shariah-compliant financial products to clients, is no longer confined to the domain of Muslim customers anymore. We at OCBC Al-Amin have experienced strong demand for shariah-compliant products from numerous non-Muslims as well, evidently because the structures offered to them at the right price make sense.

Islamic finance has gone beyond the stage of just making the headlines; it is now making money and attracting the attention of issuers of credit notes and investors. With countries like Luxembourg, the United Kingdom, and Hong Kong announcing issues of sukuk, we feel that a book that clearly spells out the process flows inherent in the structures and contracts has become necessary for the education of industry participants and aspirants alike. No book has covered aspects of process flows, accounting treatments, risk analyses, and shariah analysis in a single volume. Not until now. Hussain and Mohsin have an easy writing style, which mitigates the inevitable technicalities that come with this type of book, gently walking the reader through the contracts and structures step by step. The net result is a painless ride for individuals not familiar with the religion or the language to understand the contracts and the products.

We are already looking forward to the sequel to this work, which I understand will focus on Islamic derivatives and structured products. For now, you will certainly have more than enough to digest and ponder when you turn the page. I hope you enjoy this book as much as I did.

Syed Abdull Aziz Syed Kechik

Director and CEO

OCBC Al-Amin Bank Berhad

Preface

Contracts and Deals in Islamic Finance is a unique idea for which I have my professors and industry peers to thank. It is a collaborative effort between two conventional bankers with Islamic roots and aims at addressing some basic fundamentals of Islamic finance and banking and explores complex enhancements to traditional contracts that are the pillars of Islamic banking.

This work we hope will be of use not only to students, beginners, and practitioners, but banks, central banks and governments that are trying to get a grip on this subject.

This work has been designed keeping in mind the cynic and the skeptic who feels that Islamic finance is a mere twisting of legal terms to achieve ends that replicate loans. To such a cynic we can only ask him or her to read the book. The coauthor of this book, who approached the subject of Islamic finance with equal skepticism, however, at one point had to question his own assumptions and expectations.

One key aspect that is explored is what do we as Muslims expect from Islamic financial institutions (IFIs)? If we expect IFIs to finance us with money and then forgive the resulting debt obligations later on, then this is an unrealistic expectation, as we see later that IFIs are not financing borrowers using their own money, but that of their depositors. If we expect IFIs to offer loans on generous terms, on terms that make losses for the IFI, then this is also incorrect as Islam allows a Muslim a right to profit making within certain conditions. If we expect IFIs to finance us money and only ask to be repaid when and if we as borrowers generate profits from investing the mobilized funds, then this expectation can be accepted but provided the debtor fulfills certain covenants of contracts and acts with a sense of responsibility as well.

Is it the purpose of Islamic finance to reduce poverty, or to extend money to poor people? This expectation can be addressed, but fundamentally, this depends on the type of IFI concerned. If the IFI is engaged in microfinance, then the answer would be yes, but if the IFI exists for commercial reasons, in that it exists to make a profit, then an IFI can no more be expected to give loans to the poor with high risk of default than a shoemaker can be expected to sell shoes at cost price to the poor.

In essence, IFIs exist not to make benevolent loans, to give charity, or to eradicate poverty, but to generate profits for shareholders and capital providers from providing financingproviders from providing financing through shariah-compliant financial products.

IFIs are as entitled to profit as any other commercial enterprise within the halaal industry. They are a component of a halaal economy and play the role of financial intermediaries.

The world of finance is rather different than the world of service providers, trading, or manufacturing. In the world of manufacturing, inventors evolve into entrepreneurs and raise funds through different means, either from banks or by selling shares in their businesses. The created entity, the firm, however, uses its own funds to manufacture goods and then sells them at a profit. Traders purchase goods from one market at a cost price and sell them in another market at a profit, at times in different countries and in different currencies. Service providers also use their capital to set up certain infrastructures to enable them to operate and then charge customers a price for the services they render.

Financial institutions are unique in that they are set up by shareholders who combine their capital to set up a retail bank, a commercial bank, an investment bank, an asset management company, a brokerage firm, a mutual fund, a finance company, or an insurance company. But shareholders do not lend their money to borrowers in the case of the banking model.

Shareholders provide capital to set up a conventional bank and then mobilize deposits from households, businesses, corporations, governments, and international investors, and lend these monies to households, businesses, corporations, governments, and international borrowers. Banks, if they mean to refer to shareholders, do not lend their own money; they leverage on their own capital to borrow from surplus economic units and lend to deficit economic units, making a spread between the income earned from financing activities and the expensed paid as cost of mobilizing deposits. Islamic banks do no different, but perform these same functions using shariah-compliant contracts for mobilizing profits, extending financing, recording profits, and sharing profits and expenses.

The principles of the shariah govern how these activities are conducted, but the core activity of an Islamic bank and a conventional bank are the same. Depositors in essence give their consent to bankers to extend financing with their moneys out to qualified borrowers provided that the customer has no exposure to the risk of losing capital or expected profit from the borrower's default. If we were to look at the concept of risk sharing, this would not be much different from conventional depositors and requiring guarantee on their principle amounts. More on that later. Islamic bankers like conventional bankers must have the expertise in identifying suitable candidates for financing, and must have the expertise in mitigating all the risks involved in credit finance and other aspects of managing money.

Asset management firms raise funds from investors and invest these funds in financial assets for a return. Asset managers have the expertise in raising funds and in knowing how to invest them in different market circumstances to get a positive return on investments. Fund managers perform this function either on a principal and agency basis, or on commission basis. Islamic fund managers do the exact same thing except they must mobilize funds from halaal sources and invest them in shariah-compliant assets. Scholars have established various criteria for determining whether a certain asset is shariah-compliant.

Investment bankers and Islamic investment bankers fulfill the same roles in an economy. Islamic investment bankers may have fewer assets at their disposal due to the restrictions on investments in derivatives. However, Islamic investment bankers help companies raise money through initial public offerings, underwrite issuances of sukuk, raise funds from investors, sell financial products, and make investments in various assets to earn returns. Islamic investment bankers, however, must perform all these functions according to contracts and processes permitted by shariah.

Similar to insurance companies that underwrite risk, takaful companies underwrite risks as well. Insurance companies factor their cost of insuring risks into the premiums they charge by a simple formula, probability of event occurring × sum assured. Takaful companies underwrite risks in a similar fashion but use different contracts of tabarru and wakala to perform the same function.

Islamic brokerage firms must adapt to trading practices that are shariah-compliant, but in every other way are similar in their roles to conventional brokers.

Islamic banks use the same methodologies of financial mathematics, econometrics, and financial modeling to develop models of risks and returns as conventional banks and also use a benchmark interest rate to discount future cash flows to a present value. These elements are part and parcel of the Islamic financial system. Islamic financial institutions use the same T-accounts methods of accounting that we are all familiar with. Assets, liabilities, equity, debt, income, expenses, and so on, are all parts of an IFI's balance sheets. However, how different economic events are recorded to be shariah-compliant can be unique in many cases.

Islamic banks recognize entries such as unearned income, constructive liquidation, future income, and so on, much in the same fashion as conventional banks.

One may, therefore, rightfully ask, What is the difference between Islamic banking and conventional banking? An initial response would be that the vision to date behind Islamic banking has been to provide conventional financial products in a shariah-compliant manner. So there has been no incentive so far to be different; the incentive has to only be shariah-compliant.

Is there a difference between a wedding contract in a Christian church and a wedding contract in a mosque? One may well argue that both contracts contain positive and negative covenants that assign rights to each party of the contract and impose simultaneous limitations on each party to the contract. On the surface, both contracts of a Christian marriage and a Muslim marriage may well be similar, but Islam allows certain things that Christianity may not allow and Islam may forbid certain rights to either party that the Christian worldview may allow. Both contracts would require two parties having the legal capacity to contract, an offer, an acceptance, certain terms and conditions imposed by one party over the other, and some terms and conditions imposed by the worldview of the religions in question. The differences would be minor but yet are differences nevertheless. This is the kind of subtlety of differences that lies in the discussion of some of the broader issues in Islamic finance, such as risk sharing and equity.

Our approach to the subject must be built carefully, without emotion, without preconceived assumptions (no bank is sponsoring the authorship of this book), and with an open mind. If the reader wishes to explore the texts and do further research to substantiate his or her understanding of the subject material, we would feel well satisfied in having sparked the curiosity of an intelligent mind.

The models offered are by no means perfect. The Muslim world is just beginning to wake up from the slumber of colonialism and is trying hard to find its identity in an ever-changing world. Archives of records lie buried deep within many libraries all over the Muslim world and need to be explored to create better alternatives to trade and financial intermediation than what we have been able to develop so far.

For the time being, the reader must appreciate and accept the realities: the world is dominated by Western powers, it is dominated by debt, interest-bearing contracts dominate the world of finance, and scholars are trying to tap into the world of finance with the best possible contracts they have at their current disposal. As much as Islamic banking can serve as an alternative to conventional banking in certain ways, it still has some ways to go to be robust enough to replace it completely.

So, having laid the ground rules and expectations at the outset for this book, we say Bismillah (In the name of Allah the Beneficent, the Merciful).

Acknowledgments

It is part of the traditions of Islam to acknowledge one's teachers. To honor this tradition I have to recognize the team at International Centre for Education in Islamic Finance (INCEIF) in Kuala Lumpur, Malaysia. I thank Professor Yusuf Saleem for encouraging me to write my first paper on salaam, which was published in the ISRA Journal of 2014; Professor Ezamshah for his eloquent explanation of risk and how to price risk; Professor Rosly, who painstakingly answered every question I had; Professor Azam, who is as elegant as he is knowledgeable; Professor Razak for dropping the one pearl of wisdom that the rate of zakat should be the minimum profit rate applied to a credit financing contract; Professor Pisal for his humorous anecdotes; and last but not least, Professor Yusuf. I also thank Mohammad Ghaith Mahaini for urging me to write in the first place.

I would be doing an injustice if I did not extend a word of thanks to all my fellow students who tolerated me for a year, when I asked question after question, hogging the professor's attention. Izzaty, Nur Fatin, Tariq, and all the rest, thanks for putting up with me. I also congratulate INCEIF for providing students from all over the world a platform to study Islamic law and finance. Few places are left in the Muslim world where one can argue on shariah in a nondogmatic environment. Professor Ahsenne has to be congratulated on that.

The face of INCEIF for me has been Dr. Abbas Mirakhor, Dr. Al Habshi, and the famous D. Vicary to whom I am indebted for the wonderful institution they have set up.

I acknowledge the warmth and hospitality of the peoples of Malaysia who gave me and my family a home and an environment conducive for me to finish my program.

I give a warm acknowledgment to the support of my mother, Mrs. Bilquise Azam Kureshi, who patiently mentored me through the challenges of going back to school at the age of 42. I acknowledge team oomi zoomi, which consists of Inaya, Azam, and Sophiya, who were forced to be separated from their homeland and loving grandparents, Mamajaani, Mamo, and Dado, to keep me company while I finished my studies and the book. Finally, I cannot thank Hannah, my wife, enough for putting up with missing out on her career and my mood swings. I am indebted to you for that.

A final word of acknowledgment to Septya Iriani Mukhsia, whose input was invaluable and without whom the book possibly would never have been finished. I also acknowledge OCBC AL Amin Bank Berhad for affording me a scholarship to finish my studies. They have not supported the book directly but their financial help certainly made it possible for me to continue my research.

I thank Moorad Choudhry, who is possibly one of the most prolific writers on banking and finance. To him I owe a word of thanks for the encouragement. Gladys and Jeremy at John Wiley & Sons, thank you for patiently taking all my calls, and then again, where would you find a writer who submits material weeks before deadlines?

—Hussain Kureshi

I acknowledge my family, which has always been supportive of my projects. Even though my two boys, Zidaan and Araz, would rather play with me, they understand the value of work. I also acknowledge my colleague and office manager, Nasir Rabbani, who for many years has organized, documented, researched, MS Excel-ed, and made available anything and everything upon request. His work has always been invaluable.

My thoughts and ideas have evolved through people I've met along the way—friends, restaurant owners, entrepreneurs, emerging market CEOs, financiers, investors from New York, Hong Kong, Kuala Lumpur, Islamabad, Karachi, London, Singapore—people such as Glen Taylor, Yee Hui Wong, Punit Khanna, Kaman Leung, Iqbal Latif, and many more.

And last but not least, I acknowledge my coauthor, who did the heavy lifting for this project. Hussein is passionate, thoughtful, and driven by what he believes.

—Mohsin Hayat

Product Offerings

Introduction

The authors of this work would like to develop the understanding of the concepts of shariah and Islamic finance as the book progresses so that readers make up their own mind about the conclusion we offer. We encourage active reading and analyses and not passive reading, as we have been fortunate enough to have had mentors and teachers who encouraged learning, questioning, and understanding and not mere dogmatic rote learning.

The reader must understand that within the universe of Islamic finance money cannot be lent from one party to another with the intent of making a gain on the repayment of the loan. Conventional finance is built on the permissibility of this transaction whether it takes place between a depositor and a bank or it takes place between a borrower and a bank. To date, the aim of Islamic Finance has been to replicate the cash flows that take place in disbursing and servicing a loan with a sequence of sale contracts. For the best part of financial engineering in the industry, spot sales are combined with deferred payment sales to construct cash flows that resemble those of a loan. The underlying sales contracts must involve a permissible asset and the sale contract must abide by the laws of contracts of bai. Thus, much of the discourse in Islamic finance is a legal discourse based on the rights and obligations imparted to various parties in various contracts under varying circumstances.

Before proceeding further we therefore wish to highlight some salient features and legal maxims that affect the conduct of affairs of trade in Islam. As we have all learned our religion from our mothers, fathers, and tutors, whose memories are very sacred to us all, we do not want to tread on any sensitive grounds without giving due warnings.

We request the reader to consider what rules, if any, other than the rule of riba, apply to commercial transactions in Islam. The first rule that may come to mind is to be fair in one's dealings.

The texts offer no specific standards of fairness, but offer stories that give guidelines or parameters of what can be deemed fair. We discuss the rule of one-third in due course as well as to expound on it. The texts have been very specific, to the decimal place on one commercial transaction, which is that of inheritance, where detailed methodologies of calculation are ordained for the distribution of wealth of a deceased. Specific workings are also offered for the calculations of zakat. The texts, however, do not offer specific calculations of how a merchant, trader, or manufacturer may calculate his or her profit margin on goods or services rendered, so the discussion of riba is not about excessive interest or unfair interest, it is about interest in its absolute sense of the term, which is money returned in excess of money borrowed.

There are other parameters of legal rulings within the discourse of Islamic commercial law, and this extends to three or four additional prohibitions. Shariah discourages elements of uncertainty in contracts, or gharar, and it forbids speculation and gambling, or maysir. The texts also admonish hoarding of goods, admonish purchasing goods from caravans outside the city limits before they enter the city to inflate prices, and prohibit the circulation of wealth among the few. Some can argue that these five or six principles are sufficient to develop a judicious and fair economic system.

The Muslim world has manifested various economic models in various times in history. In peace time, there seems to be a preference for free markets, and in war time, there seems to be preference to command economic policies, especially in the distribution of wheat.

This work does not tackle the topic of using fiat money in an economy and having a gold-backed currency, as this is the work of currency experts and monetarists, both of which we are not.

To revert back to our legal maxims, we have identified four core legal maxims and two supplementary ones, which are all that is available for a believer to follow in order to develop an economic system of which a financial system is a part.

The reader should be aware that Islam stipulates specific conditions under which an individual has a right to earn a profit. These conditions are that an individual may be either a provider of capital, or a provider of labor, or assumes certain liability for events (or assumes risk) in order to be entitled to any profit from any economic venture. We discuss this in detail in subsequent chapters.

The reader should be additionally aware of the prohibition of certain trade practices, like selling what one does not own. This was a prohibition identified in the texts by the Prophet Muhammad (saw), but the Prophet (saw) extended exceptions to this condition for certain specific kinds of transactions that involved agricultural goods and made-to-order goods. The sale contracts of salaam and istisna are exempt from this condition.

The reader should be additionally aware that Islam limited the sale of certain goods to be on spot basis. These goods are referred to as ribbawi items. Such goods can only be bought or sold in a spot transaction where buyers and sellers are present.

The reader may be unaware of the permissibility of the difference between a spot price and a credit price or a deferred price. This permissibility allows a seller of goods to charge a price X for the sale of goods if the buyer pays the full purchase price on spot, and allows the seller to sell the same goods at a price Y, which is greater than X, if the buyer pays in installments in the future or via a balloon payment, but takes immediate possession of the goods at time of contract initiation.

Another prohibition is that two contracts cannot be part of one contract, or that one contract cannot be conditional on another. Party A cannot sell a good to Party B on the condition that he sells another good to Party A or even to Party C.

These prohibitions are not chronologically organized in the texts, nor are they neatly arranged in a chapter of any handbook. These prohibitions have been passed on by the Law Giver in different situations and within specific circumstances. The historical background and context of these rulings are touched on where necessary.

The reader may have discovered that certain assumptions may not be adequate. A Muslim in general may think that there are specific criteria for calculating profit over a cost price; after all, we are always bargaining with sellers in the bazaars, but yet none exist. However, several other legal maxims exist of which the ordinary Muslim of today may not have heard.

To be fair to all Muslim readers of various backgrounds and levels of education we examine the contracts that are the fundamental pillars of Islamic finance. We examine their classical structures (as they were used in the time of the Prophet [saw]), and we shall identify the enhancements made to these contracts to adapt to the modern economic times of today. We leave it up to the reader to decide if these enhancements defeat the purpose of prohibitions, circumvent them to achieve impermissible outcomes, or are beneficial innovations that are for the good of the ummah (Muslim Community). The reader may also conclude that the amendments made are necessary to achieve the goals of modern economic life, but may question whether the goals of modern economic life are worth striving for. Let us say at the outset, that discussion is beyond the scope of this work.

We begin our discussion with the most controversial contract in Islamic finance, that of bai al inah, but before we do, here is a word on who the Law Giver is today. In 620 A.D. the Law Giver was Allah (swt) who spoke through Muhammad (saw) and appointed him as another Law Giver for mankind. No Muslim contests that there is no other primary source of law in Islam. But how many laws did the Law Giver actually spell out? The reality is very few. As times changed, situations changed, the Prophet (saw) left our world, as did His companions, the successors of his companions and the successors of successors. New dominions came under Muslim rule, and Islamic law evolved over time. In the case of selling what one does not own, the enhancements came by the original Law Giver himself.

The question to ask is who is the rightful Law Giver today? Every Muslim country is today either a democracy or a monarchy with Iran being the only official theocracy. Within democracies, elected members of Parliament pass laws in a country. If these members of Parliament are Muslims, it can be expected that they will pass laws within the guidelines set by the shariah. In a monarchy, the monarch is the Law Giver and in a theocracy, the cleric. In the space of Islamic finance certain bodies have been set up that are funded by the various Muslim countries, and these bodies have gathered together a bodice of shariah scholars who now issue legal guidelines or fatwas. They assemble in an ijmah and pass certain rulings based on their research and understanding. Whatever we as authors of this work are commenting on is not based on fatwas we have individually devised.

A reader can also argue: Who gave shariah scholars the authority or the right to pass fatwas? The answer is no one. These fatwas are not binding legislation of all member countries, although some are; however, the infrastructure of developing a sound education system of developing shariah scholars and having benchmarks for their qualifications is sadly missing from the Muslim world and we acknowledge that. Any reader of Islamic finance should view the websites of the following entities:

Accounting and Auditing of Islamic Financial Institutions (AAOIFI)

Islamic Financial Services Board (IFSB)

Islamic Development Bank

International Shariah Research Academy

Organization of Islamic Countries Fiqh Academy

Bank Negara Malaysia Shariah Advisory Council

Shariah boards of the Central Banks of various countries

Dow Jones Islamic indices

We also advise the reader to download a version of Sahih Muslim and the Holy Quran in his or her language to keep as a reference.

Chapter 1

The Islamic Finance Space

As a historical religion, Islam has been in existence for 1,400 years. The word religion comes from the Latin word religio, which means to bind oneself.¹ Religious principles bind mankind to a way of life that is meant to be pleasing to God. Human history provides enough evidence that mankind has not always followed religious principles in their true spirit and has had to pay the consequences from time to time.

Finance has been around as long as man has inhabited this earth. The most basic form of finance in prehistory was money lending and remains so today. All the Semitic religions of Christianity, Judaism, and Islam warn mankind against the practice of usury, which allows interest to be the reward for money lent. Islam is not the only religion to forbid the taking of interest. The word used in the Quran is riba,²

Finance was also an integral part of the Muslim empires of the Ummayads, the Abbasids, the Fatimids, the Mamlukes, the Seljuks, and also of the Ottomans. Islam dawned on Arab traders (most previous Prophets were either craftsmen or farmers). The Prophet ([saw] peace be upon him) himself was a trader. Trade has such an importance on the fabric of Islam that the Quran itself endorses trade or bai.³

What kind of trade did Islam permit? Certainly Islam permitted certain trade practices and forbade others, like hoarding of goods,⁴ inflating prices by meeting merchants outside city walls and buying their goods before they come to market,⁵ or selling goods not in one's ownership.⁶ These obligations had an impact on the trading practices endorsed within the Muslim world. Principles of fairness, keeping one's oath, fulfilling terms of contracts were endorsed not just in conversation but in the Quran itself.⁷

Much of the Muslim world remained an agriculture-based economy, with a monarchical political system of rule. The Muslim world is famous for its bazaars, where traders came from across the globe to trade wares and to be exposed to this new religion that had shown its face on the pages of history. Although much of Orientalist literature⁸ focuses on the military conquests of the Muslim rulers, little is talked about of the impact of trade with the Muslim world, or the institutions of trade. Scholars such as Donald Quateart are working on archives found in the libraries of Istanbul to give a more clear picture of what life was like in the most recent episode of Islamic history, that of the Ottoman Empire.

In an empire as vast as the Ottoman Empire with Istanbul being the center of trade for much of the civilized world, trade and finance must have gone hand in hand. There is no evidence of the existence of modern-day banks in Istanbul; certainly, however, the oldest banks and banking families belonged to Italy and lived in the 1500s. There is also no concrete evidence of cooperatives, or benevolent funds that could be the prototype of modern-day insurance. We would have to wait until the libraries of Istanbul reveal these secrets to come to any conclusion.

However, with vast stores of grain coming from different parts of the Empire where different currencies were employed it is not difficult to imagine that some informal structures of commodity exchanges must have existed, some mechanisms must have been developed to hedge