Advanced Financial Management Islamic Finance Presentation by Fathimath

Advanced Financial Management Islamic Finance Presentation by, ❏ Fathimath Zuhra KR (17 ACO 6) ❏ Haneena Yasmin CA (17 AC 08) III BCom Professional YIASCM, Balmatta, Mangalore.

CONTENT ➔ Introduction ➔ Major difference ➔ Concept ➔ Methods ➔ Advantages ➔ Disadvantages

Introduction Is it moral or ethical to wish wealth into existence without any underlying productive activity happening? Islamic Finance is based on the principle that money must never spontaneously generate money. Instead capital must be made fruitful or fecundated by labour, material or intellectual activity or be invested in a wealth creating activity.

Islam therefore prohibits the payment of interest on loans, so observant Muslims require specialised alternative arrangements from their banks. Many of the largest global financial companies, including Deutsche Bank and JPMorgan Chase, have established thriving subsidiaries that strive to meet these requirements Consequently Islamic Finance frowns upon speculation and applauds risk sharing.

Difference between Islamic Finance & other finance Equity Financing not Lending ● Under Islamic finance laws, interest cannot be charged or received due to the lack of underlying activity. Therefore, Joint ventures under which the lender and the borrower share profits and risks are common because of the strict prohibition of the giving and taking of interest.

● Due to a ban on speculation, Islamic transactions must be based on tangible assets such as commodities, buildings or land. Islamic banking has its emphasis on equity financing rather than lending. Investing in businesses that provide goods or services considered contrary to the principles of Islam is haraam (forbidden) while those that are permitted are halaal.

Interest (riba) & how returns are made ● Interest is called riba and an instrument that complies with the dictates of Fiqh al-Muamalat (Islamic rules on transactions) is described as sharia-compliant. Instead of charging interest (deemed to be money making money), the lender agrees to buy the asset or part of the asset themselves (asset making money) ● Shariah-compliant mortgages, for instance, are typically structured so that the lender buys the property and leases it out to the borrower at a price that combines a rental income and a capital payment.

● At the end of the mortgage term, when the price of the property has been fully repaid, the house is transferred to the borrower. ● Riba is absolutely forbidden in Islamic finance. Riba can be seen as unfair from the perspective of the borrower, the lender and the economy. For the borrower, riba can turn a profit into a loss when profitability is low. For the lender, riba can provide an inadequate return when unanticipated inflation arises. In the economy, riba can lead to allocative inefficiency, directing economic resources to sub-optimal investments.

Methods 1. Equity finance (mudaraba) eg. Profit sharing ● A type of partnership in which one partner provides the capital (the provider of the finance) while the other provides expertise and management. ● Each gets a prearranged percentage of the profits, but the partner providing the capital bears any losses. ● Although provisions can be made where losses can be written off against future profits.

● Mudaraba is a concept to provide capital to somebody undertaking the work. ● It could be understood as being similar to the function of an employed manager of a company. ● The provider of the finance is not involved in the executive decision-making process. ● As the profits are shared with the manager and the capital provider but the losses are beared only by the capital provider this mode is also named profit sharing – loss bearing. ● Before the manager gets his share, the losses, however, if any, needs to be recovered. A wage could be negotiated.

2. Debt finance (sukuk) eg. Bond issue ● Sukuk is an Arabic term in plural (singular Sakk) meaning certificates. It is the root of the English word for cheque. Sukuk are securitised assets or business. ● The company sells the certificate to the investor, who then rents it back to the company for a predetermined rental fee. The company promises to buy back the bonds at a future date at par value.

● Sukuks must be able to link the returns and cash flows of the financing to the assets purchased, or the returns generated from an asset purchased. This is because trading in debt is prohibited under Sharia. As such, financing must only be raised for identifiable assets.

3. Venture capital(musharaka) Eg. Joint venture Musharaka is the Islamic contract for establishing a joint venture partnership. In musharaka, two or more parties contribute capital to a business and participate with the related profits and losses. ● Simple Musharaka The profit and the losses needs to be shared. This method is recommended by Muslim economists as being the most fair and just method.

● In a Musharaka contract all parties may take part in the management or some parties may not take part in the management (silent partnership). ● Losses need to be born proportionately to the capital provided by each party (pro rata). Regarding the profits there is a disagreement between the schools whether other than pro rata distribution is permissible.

4. Trade credit (murabaha) Let’s say that you, a small businessperson, wish to go into business selling cars. A conventional bank would examine your credit history and, if all was acceptable, grant you a cash loan. You would have to pay back funds on a specific maturity date, paying interest each month along the way. You would use the proceeds to buy the car—and meet other expenses—yourself.

● But in a murabaha transaction, instead of just giving you the cash, the bank itself would buy the cars. You promise to buy them from the bank at a higher price on a future date. The markup is justified by the fact that, for a period, the bank owns the property, thus assuming liability. At no point in the transaction is money treated as a commodity, as it is in a normal loan.

● A murabaha must be asset-based however, so it can’t help a small businessman who needs a working-capital loan to meet payroll and other expenses. To get such capital from an Islamic financial institution, an entrepreneur would have to sell the bank an equity interest in his business. This is far riskier for the bank and thus much harder to obtain.

5. Lease finance (ijara) ● A transaction where a benefit arising from an asset is transferred in return for a payment, but the ownership of the asset itself is not transferred. Most often the lessee returns the asset (and its benefits) to the lessor. Basically an operating lease. ● An alternative is for the lessee to buy the asset at the end.

● However some jurists do not permit this latter arrangement on the basis that it represents more or less a guaranteed financial return at the outset to the lessor, in much the same way as a modern interest-based finance lease. ● The terms of ijara are flexible enough to be applied to the hiring of an employee by an employer in return for a rent that is actually a fixed wage.

Some generally agreed conditions for ijara are as follows : ● The leased asset must continue to exist throughout the term of the lease. Items which are consumed in the process of usage, ammunition for instance, cannot be leased. ● In contrast with most conventional finance leases, the responsibility for maintenance and insurance of the leased item under ijara remains that of the lessor throughout. ● A price cannot be pre-determined for the sale of the asset at the expiry of the lease. However, lessor and lessee may agree the continuation of the lease or the sale of the leased asset to the lessee under a new agreement at the end of the initial lease period.

Advantages of Islamic finance Remember there should always be a link between the economic activity and the financing of that economic activity. ● Access to Islamic finance is not restricted to Muslim communities, which may make it appealing to companies that are focused on investing ethically. ● Speculation is not allowed, reducing the risk of losses. ● Excessive profits not allowed, only reasonable mark-ups.

● Banks cannot use excessive leverage and are therefore less likely to collapse. ● The rules encourage all parties to take a longer-term view leading to a more stable financial environment. ● Co-operation and profit creation through ethical and fair activity benefits the community as a whole.

Disadvantages of Islamic Finance ● Sharia interpretations of innovative financial products is not always agreed upon. Some Murabaha are based on prevailing interest rates rather than economic or profit conditions. ● Documentation is often tailor-made for the transaction, so high transaction/issue costs. ● Islamic finance institutions have extra compliance increasing issue / transaction costs. Banks need to know more than usual so more due diligence work is required.

● Islamic banks cannot minimise their risks as hedging is prohibited. ● Some Islamic products may not be compatible with international financial regulation. ● Trading in Sukuk products has been limited, especially since the financial crisis. ● With no interest - it is hard to claim some Islamic instruments as debt - therefore losing the tax benefit and increasing the WACC. ● Can be difficult to balance the interests of the financial institution with those of other stakeholders.

Any queries? ? ? . . . . THANKS ALL!!!