lecture 11 Off balance sheet transactions

Off Balance Sheet Transactions

for

Islamic Banks

Lecture 11

Balance Sheet

• A snapshot of the financial condition of a company at a particular moment.

• It consists of three main elements:

• Assets - current & long-term

• Liabilities current & long term

• Net worth – capital reserves etc

• A= L + N

Importance of Balance sheet

• Many ratios can be used to make financial decisions and also to assess the risk of the company.

• Basle accord (2 & 3) use the balance sheet to assess the capital cushion needed to mitigate credit, market and operational risk.

• Islamic Banks balance sheet has some special characteristics in that the current accounts are similar to conventional banks, while other accounts rest mainly as investment!! This has its own ripple effect in running the Islamic banks as intermediaries and often off balance sheet transactions are needed.

On and off balance sheet Transactions

• On-balance sheet financing is any form of direct debt or equity funding of a firm. If the funding is equity, it appears on the firm's balance sheet as owners equity. If it is debt, it appears on the balance sheet as a liability. Any asset the firm acquires with the funding also appears on the balance sheet.

• Off-balance sheet financing, by comparison, is any form of funding that avoids placing owners' equity, liabilities or assets on a firm's balance sheet. This is generally accomplished by placing those items on some other entity's balance sheet. Such as an SPV.

Typical balance sheet of an Islamic bank

• What is the ‘balance-sheet’ of an economic firm? • Stocks and flows in financial statements

– Balance sheet: (stock concept) gives snap shot of financial position

– income statement: (moving film) reports inflows minus outflows to measure operative efficiency on accrual basis.

– cash flow statement: measures liquidity on cash basis.

Balance sheet structure of an Islamic Bank

• Assets’ Side : • Cash/ cash equivalents (e.g. short term sovereign sukuk)• Accounts Receivable (Murabaha, Ijara, Istisnaa, Salam)• Interest-free Investment securities. • Investments (mudarabah/ musharakah/ real-estate • Inventories. • Physical assets (equipments, etc) – net of depreciation.

• Liabilities & Net Worth side : • Liabilities: interest-free demand deposits, interest-free saving deposits- no fixed

return term deposits.• Unrestricted investment accounts : The Islamic alternative of Term Deposits. • Net, worth : retained earnings + equity

Restricted versus unrestricted investments

• Two alternative options of accepting Islamic banks’ deposits:– unrestricted Investments: Here Bank acts as Musharik with

depositors. – Bank can invest the funds in any investment activity without

seeking clients’ approval and mix the Bank’s own resources with those of depositors.

– restricted Investments: Here, choice of investment activity and the mixing of funds have to be done with the client’s consent. Bank may act as Mudaraba or Agent against a management fee.

• The latter is an off-balance investment – WHY??

Reasons for Off balance transactions

• Financial institutions often offer asset management or brokerage services to their clients. The assets in question (often securities) usually belong to the individual clients directly or in trust. Such as a Mutual fund (unit trust) or Letter of Credit letter of Guarantee etc.

• Risk Management, flexibility in financing, asset liability management, tax avoidance etc.

• Islamic Banks can also offer Islamic Unit trust and Islamic letter of credit etc.

Mutual investment funds

• Investment fund are often called unit investment trusts in U.K, and Mutual funds in the U.S.A - popular fee-generating off-balance-sheet products.

• Objective: to invite investors’ subscriptions to a big single pool for the purpose of investment.

• Each subscribing investor will then hold a specific number of units in the given fund, priced at the time of subscription.

• Managed against a fee by a specialized investment departments of banks.

Mutual investment funds

• Value generated to the pool through utilization of funds in profitable transactions shall then be allocated to unit-holders on a per unit basis.

• This may lead to appreciation in unit value, in case of gain, or depreciation in case of loss.

• Open-end, and closed-end funds. • Investment funds, in general, differ in terms of return

prospects, risk, and liquidity provision. • Question . Other things equal, why should a closed-end

fund have a higher return prospect than an open-end fund?

Islamic Investment Funds:Structural properties.

• An Islamic investment fund must satisfy the following provisions :

• Manager/Investor relationship. Two Islamic alternatives: (1) Agency, (2) Mudaraba

• Funds utilization and return generation. This calls for two main conditions:1. avoidance of non-permissible activities, 2. avoidance of non-permissible financial modes.

• Negotiability: Since sale of debt is not permitted, use of Islamic modes in open-end funds must be adopted with caution (e.g in Murabaha). Asset-backed funds, like lease-based funds, may avoid this problem if properly structured.

Islamic Investment Funds:Structural properties.

• Negotiability is resolvable through Equity-based funds and lease-based funds. These are most popular in the Islamic banking industry.

• London-based Islamic Banker publishes on a regular the price quotations for a large number of Islamic banking funds.

Islamic Unit Trust• A pooled investment fund or collective investment, that

enables investors to share in a pool of professionally managed investments such as stocks and bonds. A Unit Trust fund is set up under a trust deed, which makes each investor or unit holders beneficiaries under the trust.

• To invest in a Unit Trust, an investor buys units (instead of shares) from the fund manager.

• Islamic ally the bank can establish one by using the wakalah or mudharabah methods. They will then buy and sell shares on behalf of the unit holders.

• Usually they will deal in shares following some filtering criteria. At times they can involve in money market or sukuk etc.

Filtering process

• Qualitative - core business is haram or halal.

• Quantitative – adoption of some financial ratios to set up same benchmark.

• Mix products – benchmark is used

• Purification- can be dividend or capital gains etc.

Filtering Criteria

• As buying and selling of shares is a relatively new commodity, Muslim scholars and difference of opinion on the its nature and also had different criteria, with the objective of removing riba, gharar, maysir etc.

• Shares have been considered as the pro rata representation in the ownership of the assets of a company. As it is asset-backed hence the exchange of shares for money is not considered as riba based. However some Hanafi scholars consider this transaction as a sale of huquq al-mujarradah.

AAOIFI

• 1. total non-permissible income to total income ≤ 5%

• 2. total loan on interest to Market capitalisation ≤ 30%

• 3. total deposit on interest to market capitalisation ≤ 30%

• NB. Total liquid Assets to total assets

Bursa Malaysia • 5% benchmark for companies that may have some non-

permissible elements. • 10% bench mark for companies where the contributions

from the activities that involve the element of umum al balwa (a prohibited element affecting most people and difficult to avoid).

• 25% to assess the level of mixed contributions from the activities that are generally permissible according to Shari’ah and have an element of maslaha (public interest) although there may be other elements that could affect the shari’ah status of these activities

FTSE Islamic Index

• Debt/Total Assets< 33%• Cash and Interest bearing items/Total Assets

<33%• Accounts receivable and cash/Total liquid assets

<50%• Non compliant income other than interest/Total

income <5%• Total Interest income/Total Income <5%• Purification ratio 5% of Dividends

Off-Balance Sheet Banking Services: letters of credit and letters of guarantee

• Letter of Credit :• L/C is the widespread means of payment in international trade,

particularly in the context of importers paying price of goods to exporters.

• L/C is opened by importer with national bank (issuer of L/C) in favour of an exporter

• Issuer of L/C is legally obliged to pay the exporter fully through inter-bank transferences.

• Payment becomes due as soon as exporter presents pre-specified set of documents proving, among other things, shipment of goods as required by the importer.

• Apart from documentary proofs, no bank bears liability towards goods - is it Shariah compliant?

L/C in Islamic banks

• Sight L/C as opposed to deferred L/C • Different viewpoints on L/C by Shariah Scholars – agency/

daman etc. • As long as L/C involves no conventional financing, it is Shariah

compliant service to be offered against fee.• What makes Fee income Permissible? • if service offered by the bank is permissible one (halal), and if

the production of the service involves exertion of human effort ( mental or physical) and the possible use of supportive material ( paper, electric power, rented building, etc), then it is a permissible fee.

L/C Fee Structure

• Banking fee is then set to recover both labour cost (time and effort) and the material cost used up in the productive process of the service.

• It is customary to express worker’s wage in units of time because production takes time.

• Therefore, L/C banking fees can be expressed per unit time over the period needed to complete the production and delivery of a particular service (e.g. weekly or monthly rates).

• L/C can act as basis for Islamic financing (Murabaha L/C; Ijara L/C etc).

Risk Management of Islamic L/C Financing

• Problem arises on how to guarantee exporter’s moral integrity to deliver genuine goods. This is apart from insurable commodity risk.

• It is bound to rise in all cases where L/C relates to Islamic financing modes (murabaha, Ijarah, Salam etc) [ recall ownership risk]

• Daman al-Drarak (DAK) is practiced by many Islamic banks as a hedge against exporter's failure to deliver genuine goods.

• DARAK daman is where ‘third party’ guarantees exporter’s integrity. In this case it could be the client himself !

L/ G in Islamic Banking

• An LG (letter of guarantee) is a document issued by Bank to the order of Client, to the benefit of a Third Party (e.g. government, supplier of petrol etc); e.g. performance bond in public/ private works.

• It is an assurance to Third Party that in the event of Client’s failure to honour an agreement with that party ( e.g. completing an infrastructure project, or paying a deferred price to a supplier) Bank will stand ready to compensate Third Party up to a certain limit.

L/ G in Islamic Banking

• L/G is permissible as act of benevolence in Islamic jurisprudence where it is called kafala.

• The mainstream standpoint in Islamic jurisprudence is to maintain kafala as act of benevolence and therefore kafala cannot be offered against a fee.

• Nonetheless, as in the processing of qard hasan, there are considerable labour and material costs to be covered in the provision of kafala.

• Hence, Islamic banks are allowed to cover such costs in the processing of LG’s under the strict condition that any excess amount would be an illegitimate price of kafala.

• OIC fatawas is that we cannot charge for guarantee. Some scholars have made hiyal!!

Reading Materials• Faizal Manjoo (2005), Reviewing the concept of shares Towards a legal

dynamic perspective, Paper delivered at the 6th International Conference in Islamic Economics and Finance, Islamic Economics and Banking in the 21st Century, Hilton Hotel, Jakarta, Nov. 21-24,2005, Vol 2.

• Ulrich Derigs and Shehab Marzban (nd), “Review and analysis of current Shariah-compliant equity screening practices” (University of Cologne Germany). Available at www.emeraldinsight.com/1753-8394.htm

• Ulrich Derigs and Shehab Marzban• AAOIFI Shariah Standards on shares• Dow Jones Islamic Market Index, FTSES Islamic Index, Bursa Malaysia

Criteria available on respective websites. • Resolutions of the Shariah Advisory Council of the Securities Commission of

Malaysia 2nd Edition. Available on their website. • Fahim Khan (2010), “Islamic Banking in Europe: the regulatory challenge” in

Islamic Banking and Finance in the European Union A Challenge, (ed) F Khan & M Porzio, Edward Elgar Publishing Ltd, Cheltenham. Pp 61-75

• A. Mirakhor & Z. Iqbal (2007), An Introduction to Islamic Finance Theory and Practice, John Wiley & Sons (Asia) PtE Ltd, Singapore. Pp. 114-120