Islamic Finance Potential Techniques of Minimizing its Risks

1. Islamic FinancePotential Techniques of Minimizing its Risks Prof. Dr. Mohd. Ma’sumBillah www.drmasumbillah.blogspot.com

2. UNDERSTANDING ISLAMIC BANKING Introduction It is essential to understand Islamic Banking with Executive nature, Its applied Principles & Instruments before identifying the awaiting risks & possible techniques to minimize them. Hence, the root of Islamic banking originates from a significant segment of Mu’amalat (Man-to-Man activities), which is the conduct of a Muslim’s economic activities within its economic system; apart from ‘Ibadat (Man to God Worship). Muamalat is within the framework of Shari’ah (Practices and Activities), which is one of the Islamic schemes of life apart from Aquidah (faith and belief) and Akhlaq (moralities and ethics).

3. Major Financing Arrangement in Islamic Banking Equity-financing and Debt-financing With regard to equity financing and debt financing, Islam allows both external financing to be practised. Equity financing is to be effected through Profit Sharing Contracts while debt financing is to be effected through Deferred Contracts of Exchange. This is indeed the foundation for establishing and developing the Islamic banking and financial system.

4. Differences in Equity-financing and Debt-financing In equity financing, there are practically no major differences. The contract of al-Musharakah (Joint Venture Profit Sharing) is, in essence, similar to the conventional concept of joint-stock company. To finance projects through equity participation, for example, would generally be the same under the Islamic equity financing as under the conventional equity financing.

5. The contract of al-Mudharabah (Trustee Profit Sharing) – whereby one party (the owner of capital) provides fund for the other party (the entrepreneur) to invest or trade and generate profit and both to share in the profit in pre-agreed proportions – while not widely practised is actually not totally unknown in the conventional banking system. An example of this is the portfolio management business.

6. However, the major differences between the Islamic financial system and the conventional financial system prevail in debt financing. Debt financing in the conventional system is almost totally based on interest-based lending while this is forbidden in the Islamic financial system. Conversely, the Islamic debt financing instruments of Deferred Contracts of Exchange are not generally known in the conventional financial system.

7. Notwithstanding, there are still some similarities even in debt financing. The contract of al-Ijarah (leasing) is practised in the conventional system. Likewise, the contact of Bai’al-Murabahah (Deferred Lump Sum Sale) is practised in credit sale and purchase.

8. Shari’ah Rulings in Banking Contracts • Banking Should Only Support Halal Activities وَلاَ تَأْكُلُواْ أَمْوَالَكُم بَيْنَكُم بِالْبَاطِلِ وَتُدْلُواْ بِهَا إِلَى الْحُكَّامِ لِتَأْكُلُواْ فَرِيقًا مِّنْ أَمْوَالِ النَّاسِ بِالإِثْمِ وَأَنتُمْ تَعْلَمُونَ (Al-Baqarah: 188) “And eat up not one another's property unjustly (in any illegal way e.g. stealing, robbing, deceiving, etc.), nor give bribery to the rulers (judges before presenting your cases) that you may knowingly eat up a part of the property of others sinfully".

9. Continue…… • Prohibition of Interest (Riba) يَا أَيُّهَا الَّذِينَ آمَنُواْ لاَ تَأْكُلُواْ الرِّبَا أَضْعَافًا مُّضَاعَفَةً وَاتَّقُواْ اللّهَ لَعَلَّكُمْ تُفْلِحُونَ (Ali `Imran: 130) “O you who believe! Eat not Riba (usury) doubled and multiplied, but fear Allah that you may be successful”.

10. Continue…… • Gharar (Uncertainty or Speculation) Is Prohibited يَا أَيُّهَا الَّذِينَ آمَنُواْ إِنَّمَا الْخَمْرُ وَالْمَيْسِرُ وَالأَنصَابُ وَالأَزْلاَمُ رِجْسٌ مِّنْ عَمَلِ الشَّيْطَانِ فَاجْتَنِبُوهُ لَعَلَّكُمْ تُفْلِحُون (Al-Maidah: 90) “O you who believe! Intoxicants (all kinds of alcoholic drinks), gambling, Al­Ansab, and Al­Azlam (arrows for seeking luck or decision) are an abomination of Shaitan's (Satan) handiwork. So avoid (strictly all) that (abomination) in order that youmay be successful”.

11. Continue…… • Preserve the Unity of Mind and Sincerity in Banking Contracts and Dealings يَا أَيُّهَا الَّذِينَ آَمَنُوا لِمَ تَقُولُونَ مَا لَا تَفْعَلُونَ كَبُرَ مَقْتًا عِندَ اللَّهِ أَن تَقُولُوا مَا لَا تَفْعَلُونَ (As-Saff: 2-3) “O you who believe! Why do you say that which you do not do? Most hateful it is with Allah that you say that which you do not do”.

12. Continue…… • Every contractual party should honour contractual promises يَا أَيُّهَا الَّذِينَ آمَنُواْ أَوْفُواْ بِالْعُقُودِ (Al-Maidah: 1) "O you who believe! Fulfill (your) obligations”

13. Continue…… • Every Transaction Must Be Performed With Utmost Good Faith and Mutual Goodwill يَا أَيُّهَا الَّذِينَ آمَنُواْ لاَ تَأْكُلُواْ أَمْوَالَكُمْ بَيْنَكُمْ بِالْبَاطِلِ إِلاَّ أَن تَكُونَ تِجَارَةً عَن تَرَاضٍ مِّنكُمْ (An-Nisaa: 29) O you who believe! Eat not up your property among yourselves unjustly except it is a trade amongst you, by mutual consent.

14. Guidelines of Islamic Banking • Making Money from Money is not Permissible; • Profit and Loss Sharing; • Complete segregation of funds; • The existence of a Shari’ah supervisory board;

15. Continue…… • Management committed to Islamic financial concepts; • Safeguarding Muslim investors' funds from negligence, trespass, and fraud; • Compliance with the standards of the AAOIFI.

16. Principles / Instruments of Islamic Banking • Musyarakah وَإِنَّ كَثِيرًا مِّنْ الْخُلَطَاء لَيَبْغِي بَعْضُهُمْ عَلَى بَعْضٍ إِلَّا الَّذِينَ آمَنُوا وَعَمِلُوا الصَّالِحَاتِ (As-Shaad:24) "And, verily, many partners oppress one another, except those who believe and do righteous good deeds” • Mudharabah Holy Prophet pbuh: ‘The hands of Allah will always work together with the two parties in the partnership so long as they do not betray one another’

17. Continue…… • Al-Wadi’ah Maintain the trust and deliver the trusted items to its beneficiary إِنَّ اللّهَ يَأْمُرُكُمْ أَن تُؤدُّواْ الأَمَانَاتِ إِلَى أَهْلِهَا وَإِذَا حَكَمْتُم بَيْنَ النَّاسِ أَن تَحْكُمُواْ بِالْعَدْلِ إِنَّ اللّهَ نِعِمَّا يَعِظُكُم بِهِ (An-Nisaa: 58) “Verily! Allah commands that you should render back the trusts to those, to whom they are due; and that when you judge between men, you judge with justice…….”.

18. Continue…… Sale & Purchase Types of Islamic Debt Financing Available Acquisition of Asset/Property al-Bai Bithaman Ajil / Deferred Instalment Sale Financing The Acquisition of Assets (Contract: al-Bai Bithaman Ajil / Deferred Instalment Sale) a) The Bank may finance the Borrower who wish to acquire a given asset say, land, but to defer the payment for the asset for a specific period or to pay by instalments under the principle of al-Bai Bithaman Ajil.

19. Continue…… b) The Bank first determines the requirements of say, Borrower, in relation to his period and manner of repayment. c) The Bank purchase the asset (land) concerned d) The Bank subsequently sells the said asset to the borrower at an agreed price which comprises: § the actual cost of the asset to the Bank and § the Bank’s margin of profit

20. Continue…… and allows the borrower to settle the payment by instalments within the period and in the manner so agreed. It is a simple contract whereby the Bank purchases the items on cash basis and sells such items on deferred payment basis to customers requiring financing.

21. Continue…… Under the retail banking activities of the banks, one of the popular financing items is house financing and may be extended for purpose to purchase a new house, to purchase existing completed house, to build a house on his own land and as a refinancing facility. In general the bank requires the repayment to be made by monthly instalment which will commence one month after the disbursement of the funds.

22. Continue…… • Bai’ Al-Murabahah (Deferred Payment Sale) Prophet Muhammad pbuh; ‘Blesses are on these three: deferred sale and purchase, mudharabah & mixing flour for the household not for sale’ (Ibnu Majah)

23. Continue…… • Bai’ al-Salam (In-Front Payment Sale) يَا أَيُّهَا الَّذِينَ آمَنُواْ إِذَا تَدَايَنتُم بِدَيْنٍ إِلَى أَجَلٍ مُّسَمًّى فَاكْتُبُوهُ (Al-Baqarah:282) “O you who believe! When you contract a debt for a fixed period, write it down….”

24. Continue…… • Bai’ al-Istisna’ (Purchase by Order or Manufacture) According to Hanafi’s mazhab, bai’ al-Istisna’ is permissible based on the following reasons: • It is a common practice in the society (`urf) • The need of society (public interest) • Not against any of the Shari`ah rulings

25. Continue…… • Al-Ijarah (Leasing) وَإِنْ أَرَدتُّمْ أَن تَسْتَرْضِعُواْ أَوْلاَدَكُمْ فَلاَ جُنَاحَ عَلَيْكُمْ إِذَا سَلَّمْتُم مَّآ آتَيْتُم بِالْمَعْرُوفِ وَاتَّقُواْ اللّهَ وَاعْلَمُواْ أَنَّ اللّهَ بِمَا تَعْمَلُونَ بَصِيرٌ (Al-Baqarah:233) “And if you decide on a foster suckling-mother for your children, there is no sin on you, provided you pay (the mother) what you agreed (to give her) on reasonable basis. And fear Allah and know that Allah is All-Seer of what you do.”

26. Continue…… Financing the Use of Services of Assets (Contract: al-Ijarah / Leasing) a) The Bank may finance its customers to acquire the right to use the services of a given asset say, building complex, under the principal of al-Ijarah. b) The Bank first purchases the asset, the said building complex required by the customer.

27. Continue…… c) Subsequently the Bank leases the asset to the customer for a fixed period, lease rental and other terms and conditions say, option to buy (own) agreed by both parties where the customer (borrower) may subdivide the building and sell. Banks are also actively involved in financing under the concept of al-Ijarah whereby the Bank will purchase the asset and lease them to corporate customers and retail customers.

28. Continue…… Syndication Services (Contract: al-Ujr / Fee) When a lead Bank is unable to raise fund beyond its capability or desire to spread the risk, a syndicated loan may be arranged by the lead Bank for a fee. Securitisation and Debt Trading (Contract: Bai al-Dayn / Debt Trading) Facilities of al-Bai-Bithaman Ajil and al-Ijarah, are modes of debt financing. They give rise to debt which could be traded in the market through securitisation. Securitisation can take place either in the form of a Bill of Exchange or a Promissory Note.

29. Continue…… No security One important feature of participatory financing is that the borrowers need not provide security for the financing they receive. The project or object itself is the security. This should contribute positively towards increase economic and social development.

30. Conventional Financing vs Islamic Financing as practised in the Malaysia Conventional FinancingIslamic Financing the property being purchased the property is purchased by is pledged as security the institution Guarantor (s) as additional surety not required in most cases require proof of income require proof of income require full disclosure of other require full disclosure of other financial commitments financial commitments proof of ability to repay is very proof of ability to repay is very important important Interest is levied Administrative charge is imposed

31. Islamic Banking Risks & Smart Techniques Of Minimization • Identification of Potential Risks in Islamic Banking Operations: • Understanding Risk • Regulatory Risk • Operational Risk • Management Risk • Political Risk • Socio-Cultural Risk • Spiritual Risk • Technical Hazard • Natural Hazard • Moral Hazard • Hazard through Corporate Policies

32. Continue…. • Impact of Failure to Minimize the Risks: • Losses in: -Profits; -Public Confidents; -Spiritual Advantages. • Damages in: - Corporate Image; - Emotional Enrichment; - National Dignity. • Ending Up

33. Continue…. • Smart Techniques of Risk Minimization: • Enrichment of Customers’ Rating Practices; • Possible Takaful Coverage; • Maximum Care in Decisions & Dealings; • Innovative Skill Enrichment Programs; • Self- Esteeming; • Brotherhood & Solidarity; • Dynamic Planning & Smart Action; • Corporate Muhasabah (Mutual Remarks); • Adapting Rationalism & Avoiding Emotionalism; • Honesty & Commitment while Avoiding Negligence & Selfishness; • Meeting of Words & Actions is Essential; • Mutual Respects, Standard PR, Wisdom & Patience.

34. Thank You