4 Emergence of Islamic financial industry First Islamic Bank setup in EgyptDubai Islamic Bank (first Islamic private commercial bank, 1975), the Faisal Islamic bank of Sudan (1977) and the Bahrain Islamic bank (1979).Iran fully converted its banking and economic system to an Islamic oneThe High Council of OIC (Organization of Islamic Conference) declared Takaful /Islamic insurance as Sharia'h compliant (1985)Amana Income Fund, the world’s first Islamic Mutual Fund was created in Indiana (1986)Sudan introduced Islamic Banking (1989)Islamic bond market emerged when the first tradable Sukuk were issued by Shell MDS in Malaysia (1990)Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) was established to advise on Islamic finance standards all over the world (1991)Islamic Financial Services Board (IFSB) setup in Malaysia to establish standards (2002)Islamic Bank of Britain became the first Islamic commercial bank established outside the Muslim world (2004)Islamic Finance posting 15-20% growth globallyOperating in about 75 Muslim & non-Muslim countries275 Islamic Financial Institutions globallyThe total Islamic banking assets raise to USD 1.3 trillions
5 Global Scenario – Growth & Potential Islamic banking assets with commercial banks globally grew to $1.3 trillion in 2011, suggesting an average annual growth of 19% over past four years (2011: 24%).The top four markets account for 84% of industry assets.13 Islamic banks have an equity base of more than US$ 1 billion.Islamic banking assets are forecast to grow beyond the milestone of $2 trillion by 2014.The industry’s average ROE was 12% in 2011.The severity of performance challenge has prompted several institutions to initiate wide- ranging transformation programs, called the new 3 R’s for the industry:Regulatory transformation – involving compliance risk, capital optimization, integrated balance sheet management and liquidity managementRisk transformation – around Shari’a governance, single data management framework, segment / product specific risk modelsRetail banking transformation – strengthening customer centric operating model, channel integration and technology enablement.
6 Global Scenario – Growth & Potential One potential scenario shows global Islamic banking assets with commercial banks to reach $1.8 trillion in 2013 (2011: $1.3 trillion), representing average annual growth of 17%Islamic Banking Asset Growth (US$b)
7 Global Scenario – Growth & Potential Islamic banking growth outlook continues to be positive, growing 50% faster than overall banking sector in several core markets. In Saudi Arabia, market share of Islamic banking assets is now over 50%.Banking asset penetration (% of Nominal GDP) and Islamic banking market share of total assets (%) in 2011
8 Global Scenario – Growth & Potential Top 20 Islamic banks make up 55% of the total Islamic banking assets and are concentrated in 7 countries, include: Saudi Arabia, Kuwait, UAE, Bahrain, Qatar, Malaysia and TurkeyTop three markets for Islamic Banking Assets (2011)Saudi Arabia (US$207 billion)Malaysia (US$ 106 billion)UAE (US$75 billion)New markets embracing Islamic Financial Industry areEgypt (Issuing sovereign Sukuks & developing new regulatory framework for Islamic Banks)Iraq (contemplating Islamic Banking legislation)Libya (implementing its Islamic Banking framework)Indonesia (Bank Indonesia projects that in 2013, growth of Islamic banking assets will be in the range of 36% to 58%)
10 Local Scenario – Growth & Potential Islamic banking was formally launched in Pakistan in March 2002 when the first Islamic Banking license was awarded to Meezan Bank Limited.There are currently 5 full fledge Islamic banks and 13 conventional banks having Islamic banking branches with a network of 1024 branches across Pakistan.The industry has been maintaining strong growth momentum with over 50 percent average annual growth since inception; this growth trend is likely to gather further momentum with increasing awareness level and expansion of Islamic banking network in second and third tier cities.In terms of total assets, Islamic Banking is 8.9% of the total banking industry.Keeping in view the fact that approx 96% of the population of Pakistan is Muslim, Islamic Banking has the potential to grow to that level.
11 Local Scenario – Growth & Potential There are currently 5 full fledge Islamic banks with a network of 657 branches and 13 conventional banks having Islamic banking branchesThe Islamic banks also has 73 sub- branches
12 Local Scenario – Growth & Potential No. of Islamic Banking Branches CAGR = 37.73%
13 Local Scenario – Growth & Potential Growth of Market Share for Islamic banks
14 Local Scenario – Growth & Potential Deposit Growth of Islamic Banking CAGR = 34.21%
15 Local Scenario – Growth & Potential Asset Growth of Islamic Banking CAGR = 32.36%
18 Ideology of Islamic Economics Islam as a “complete code of life” encompasses every aspect of human life. It provides directives as to how economic and financial activities should operate based on moral and just economic system. The source of Islamic morality stems from Shariah.Two sources of law in IslamShariah—Revealed knowledgeQuran –RecitedHadith/Sunnah—Un-recitedFiqh– Derived knowledge through ijtihad (exertion)Ijma (consensus)Al-Qiyas (analogy)Islamic laws can be broadly classified into two typesIbadat (devotional acts) – Any worship which is not legalized by Shariah is voidMuamalat (dealings or transactions)—Transactions are permitted unless prohibited by Islamic law (principle of permissibility)In muamalat, new transactions can be accommodated through ijtihad as long as they do not contain the prohibited (riba and gharar)
19 Ideology of Islamic Economics Finance/ Banking in Islam (Matter of Muamalat)Laws governing economic/financial activitiesPrinciple of permissibility: All transactions are permitted except those explicitly prohibited by Islamic lawProhibitions are riba and gharar, fraud, hoarding, exploitation of need, gambling, etc.Obligations & Recommended (charity, honesty, interest-free loans, risk sharing, etc.)
20 Riba Equation Of Riba What is Riba? The word “Riba” means excess, increase or addition. According to Shariah terminology, implies any excess compensation without due consideration.Equation Of RibaExtraGuaranteeRIBA
21 Prohibition Of Riba Prohibition of Riba in Quran: “Those who devour Riba shall rise up before Allah like men whom Shaitan has demented by his touch; for they claim that trading is like Riba. But Allah has permitted trading and forbidden Riba. He that receives an admonition from his Rabb and mends his ways may keep what he has already earned; his faith is in the hand of Allah. But he that pays no heed shall be among the people of fire and shall remain in it forever.”(Al Baqarah 275)“O you who believe, Fear Allah and give up what remains of your demand for Interest, if you are indeed a believer. If you do not, then you are warned of the declaration of war from Allah and His Messenger; But if you turn back you shall have your principal: Deal not unjustly and you shall not be dealt with unjustly.”(Al Baqarah 278 – 279)
22 Prohibition Of Riba Prohibition of Riba in Ahadith: Narrated by Jabir (RAA): The Prophet (SAW) cursed the receiver and payer of interest, the one who records it and the two witnesses to the transaction and said, “They are all alike [in guilt].”(Muslim)Narrated by Abu Hurayrah (RAA): The Prophet (SAW) said, “There will certainly come a time for mankind when everyone will take Riba and if he does not do so, its dust will reach him.”(Abu Dawood)Narrated by Abu Hurayrah (RAA): The Prophet (SAW) said, “On the night of Ascension I came upon people whose stomachs were like houses with snakes visible from outside. I asked Jibrael who they were, He replied that they were people who had received interest.”(Ibn-e-Majah)
23 Types of Riba First Type : Riba al Nasiah: Root word nasaa meaning to postpone - refers to the delayed payment Riba. When there is exchange of the same specie over a period of time, the amount exchanged has to be the same (qard hasan).If an excess is paid over the amount this will lead to riba al nasiah.Riba Al-Nasiah… Riba in loan contracts:Give out loan (principal sum)Repayment include additional amount because of delay in payment This is the riba prohibited in Al-Qur’an A.k.a. Riba al-Duyun, Riba Al-JahiliyyahImplication in Financing Transactions:financing using loan contracts.No extra is allowed
24 Types of Riba Second Type: Riba al Fadl: If there is exchange among the same specie of the ribawi goods, it has to be done on spot and should be of equal amounts.If the amounts exchanged are different then it will be riba al fadl.saying of the Prophet: “Gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates and salt for salt – like for like, equal for equal and hand to hand. If the commodities differ, then you may sell as you wish, provided that the exchange is hand to hand” (Muslim, Kitab al-Musaqat)The six commodities listed in the above Ahadith could be divided into two categories:Currency – gold and silverStaple food – wheat, barley, dates, salt
25 Summary of Riba Al-Fadl Types of RibaSummary of Riba Al-FadlImplication in Financing Transactions:Currency exchange – must be spot transactionNo forward currency transactions
26 Difference Between Trade & Usury Does similarity in risk and pricing profile make Islamic products doubtful in the eyes of Shariah?Suppose cash sale price is $10, deferred sale price payable in one month is $12. Now, the buyer requests for one month extension and seller increases the price to $14.Prophet (pbuh) allowed $2 profit for the deferred sale but prohibited $2 for the extension of time (riba al-jahiliyyah)The non-believers “used to say that it is same as we increase the price in the beginning of the sale, or we increase it at the time of maturity”.ButQuran says: “Trade is like usury, but God hath permitted trade and forbidden usury”(2:275)“The Holy Quran could have mentioned the difference between interest and profit in pure logical manner, and could have explained how the profit in a sale is justified while the interest is not. The Holy Quran could have also spelled out the evil consequences of riba on the economy. But this line of argument was intentionally avoided….once a particular transaction is held by Allah to be haraam, there is no room for disputing it on the basis of pure rational argumentation because Allah’s knowledge and wisdom encompasses all those points which are not accessible to ordinary reason.” (Mufti Taqi Usmani )
27 Islamic vs Conventional Banking Money + Money (interest) ClientMoney + Money (interest)Every Debt that pulls any kind of gain is Riba
28 Islamic vs Conventional Banking Whereas Allah has permitted trading and forbidden RibaIslamic BankingGoods & ServicesBankClientMoney
29 Islamic vs Conventional Banking Islamic bankingTransactions are asset-based/backedIt is socially-responsible banking because it operates under Shariah restrictionsDoes not permit financing of prohibited goods / IndustriesEthics and moral values play a major role in investment decisions. Not a choice but a mustConventional bankingTransactions are money lending and Riba basedInvolve in many impermissible transactions like Short selling, Sale of Debt, Speculation, artificial financial transactions, no sanctity for Islamic law of contract.Permit financing of prohibited goods / Industries like alcohol, casinos etc.A matter of choice
30 Islamic vs Conventional Banking From the previous slide, we find the differences are on three levels:i. Conceptual & socio-religious level:Not lending money.Cannot deal with interest & non permissible commodities/businesses.ii. Business model & governing framework:Actively participates in trade and production process.Governing framework as directed by Shariah Advisors and Shariah Board.iii. Product level implementation:Usually asset backed & involve trading/renting of asset.Implementation is not just a mere change of paper work and terms but it involves the right intention, the correct sequence of steps and timing of execution.
31 Islamic Modes of Financing MurabahaSalamIstisnaIjarahMudarabaMusharakaDiminishing Musharaka
32 Islamic Modes of Financing Murabaha:A sale of goods in which seller discloses profit to the purchaser.The bank buys and then sells the good to the client at a pre-agreed price.Price paid at a later date.The bank must own and posses the good.The profit rate and other terms should be clearly specified in the contract.The bank can ask for guarantees or collateral.Murabaha bills of trade cannot be traded (at discount)
33 Islamic Modes of Financing Salam:A pre-production sale of goods - selling goods in advance.Can be used for homogenous goods.Used to finance the agricultural sector.The price has to be fixed and paid when the contract is concluded.Goods delivered at a later date.The delivery time should be fixed.Parallel salam.
34 Islamic Modes of Financing Istisna:A pre-production sale is used when an item/asset needs to be manufactured/constructed.The price of the good should be known and time of payment can be negotiated among the parties.The seller of the good can either manufacture it or sub-contract it (Parallel Istisna).Once delivered, the bank will sell the goods either directly or through agent.
35 Islamic Modes of Financing Ijarah:A leasing contract involves sale of usufructs of durable assets/goods.Ownership in the asset is retained by the lessor. The asset can be transferred to a third party or the lessee at the end of the tenorThe lease payments are calculated by aggregating;Fixed element (equivalent to principal on the conventional facilities).Variable element, generally on the basis of a reference such as K plus a fixed marginService amount usually equal to the amount paid to the company/ customer (in its capacity as service agent under the service agency agreement).Cost of total damage of asset is borne by owner.Lessee can sub-lease the asset to third party unless explicitly prohibited in the Ijarah contract.
36 Islamic Modes of Financing Mudaraba:A form of partnership – one party supplies the capital (Rab-ul- Maal) other manages (Mudarib)Profit shared among parties at a pre-agreed ratio.Loss borne by financier (Rab-ul-Maal) only.Financier cannot ask for a guarantee of capital or return.Mudaraba can be restricted or unrestricted.
37 Islamic Modes of Financing Musharaka (Shirka-tul-Aqd):A partnership contract in which all partners contribute capital and labor.One partner can be the managing partnerProfit is shared among the partners at a pre-agreed ratio.In case of loss, sharing on the basis of share in capital.One partner can not guarantee the return or capital of other partner.
38 Islamic Modes of Financing Diminishing Musharaka (Shirka-tul-Milk):Joint ownership contract between bank and customer to jointly own the Asset.Contract of lease between the bank (as lessor) and customer (as Lessee) whereby lessor leases its undivided ownership in the Asset to lessee.The maintenance cost can be paid by the lessee if included in the contract, but costs of total damage of asset is borne by lessor to the extent of its ownership.From time to time customer purchases ownership share in Asset from the bank to increase its ownership.Upon maturity, the customer acquires 100% ownership in the Asset.Bank
40 Project Finance – An Overview Defined by International Project Finance Association (IFPA):“The financing of long-term infrastructure, industrial projects and public services based upon a non-recourse or limited recourse financial structure where project debt and equity used to finance the project are paid back from the cash-flow generated by the project.”Non-recourse financing refers to the fact that the sponsor’s liability is restricted to the amount of capital invested. Certain projects are structured with limited recourse, which means that the sponsors are liable for any additional capital infusions the project may require due to cost overruns or shortfalls in cash flow in the initial phase of the project (i.e. the construction phase).
41 Project Finance – An Overview Often referred to as a new financing technique, project finance is actually centuries old and predates corporate finance.The earliest example of project financing dates back to 1299 when the English Crown negotiated a loan from the Frescobaldi, a leading Italian merchant bank of that period, to develop the Devon silver mines.“Project finance” is not the same thing as “financing projects” because projects may be financed in many different ways. For instance, large-scale public sector projects can be financed by the public sector’s issuance of debt, whereas private sector projects are funded by large companies raising corporate loans against their balance sheets (a full recourse finance) for eg. Financing for capacity enhancement.
42 Project Finance – An Overview Main Features Of Project FinanceA project is established as a separate company, which operates under a concession obtained from the host government.The project manager provides a major portion of the project’s equity, thereby tying the provision of finance to the management of the project.The project company operates with a high ratio of debt to equity, with lenders having only limited recourse to the government or to the equity holders in the event of default. This limited recourse is vital as it lowers the risk of sponsors or equity providers becoming liable for injecting additional equity to meet debt obligations.The long-term financiers of the projects have recourse only on project cash flows.Sponsors or creditors are repaid or earn a return solely from the revenue that is generated by sale of the project’s output.
43 Project Finance – An Overview Main Features Of Project FinanceThe project company enters into comprehensive contractual arrangements with suppliers and customers.The contractual arrangements are designed to allocate each major risk in a project to the party that is best able to appraise and control that risk. For example, the main contractor is obviously best suited to ensure that construction is completed within the budget and on schedule. He therefore enters into a turnkey contract that specifies a fixed price and penalties for delays, and is usually required to post a performance bond. A turnkey contract refers to a business arrangement where the project or asset being constructed is delivered in a complete state.
44 Project Finance – An Overview Characteristics of Infrastructure FinanceInvestment:Capital intensive (i.e. investment amount are usually lumpy, large and incurred during the initial stages of the project).Enjoy economies of scale.Maturity:Long operational lives and requires long tenure financing.Maturity can vary from 5 to 20 years.Costs and Returns:Stable rates of return linked with the cash flows of the project.Cost of credit usually high due to high risk involved.Uncertainty in the longer-run and higher cost of funds can make some viable projects unprofitable.
45 Project Finance – An Overview Source of financing can be either from public or private institutions orcombination of both.Public source:Budgets allocation from government;Specialized public bodies and development banks; andSovereign Wealth FundsSovereign GuaranteesPrivate source:Syndicated financing by banks/financial institutions;Infrastructure funds;Private equity funds; andIssuance of capital market instruments (i.e. bonds and Sukuk)
46 Project Finance – Major Participants Government: The project company usually needs to obtain a concession from the host government to undertake the project. The government may also establish a new regulatory framework, guarantee currency convertibility, and provide environmental permits.Project sponsors or owners: A separate company is established to undertake the project. Sponsors are generally the project owners with equity stake and will generally be involved in project construction and management.Project company: The project company is a single purpose entity created to execute the project. Controlled by the sponsors, it is the project’s hub through its contractual arrangements with operators, contractors, suppliers and customers.Contractor: The contractor is responsible for constructing the project according to the specifications outlined in its contract. Primary contractors will then subcontract with local firms for different components of the construction.Operator: Operators are responsible for maintaining the quality of the project’s assets and ensuring maximal operational efficiency.
47 Project Finance – Major Participants Suppliers and customers: The supplier provides the critical input, like fuel for a power plant project. The customer is the party willing to purchase the project’s output.Lenders: Infrastructure projects involve substantial funding, raised as debt from a syndicate of lenders such as banks and specialized lending institutions.Multilateral agencies: The World Bank, IFC and regional development banks are often lenders or co–financiers of infrastructure projects in developing countries.Export credit agency (ECA): Because infrastructure projects in developing countries often require imported equipment from developed countries, ECAs are routinely approached by contractors to support these Projects.Other important parties include: Insurers, legal and financial advisors (assemble the transaction given the number of important contracts and help structure the financing for the project) and the trustee (responsible for monitoring the project’s progress).
48 Project Finance – Major Agreements Project Documents:EPC/ ECCO&M contractInput /Fuel Supply AgreementOff-Take Agreement e.g. PPASponsor DocumentsProject Funds AgreementShareholders AgreementsIn case of Islamic FacilityInvestment Agency AgreementDeclaration of TrustMusharaka AgreementManagement AgreementPayment/ Ijara AgreementPurchase UndertakingSale UndertakingSecurity DocumentsHypo/ mortgageShare Pledge AgreementDirect AgreementsGuaranteeOther DocumentsCommon Terms Agreement
49 Project Finance – Global Potential Estimate of Global Infrastructure Financing Needs:The Organisation of Economic Cooperation and Development (OECD) estimates that approximately USD71 trillion would be needed globally by 2030 for investment in road, rail, telecoms, electricity and water infrastructure.Emerging markets would require a total of USD21 trillion for infrastructure investments in the next decade.The GCC region would require approximately about USD2 trillion by 2020 for infrastructure investment.
51 Islamic Project Finance “The way to understand Islamic finance is to replace the word ‘Islamic’ with the word ‘Structured.’ Like any structured finance deal, you have constaints that must be overcome with creativity and innovation. Here, the principles are based on the principles of Shari’a. The question is how to structure the deal given these constraints.”
52 Islamic Project Finance – Product Structures A scheme to finance the cost of construction whereby the mode and the purpose of financing are Shariah compliant.Mode of financing can be either by way of obtaining direct financing from financier or by way of issuing Islamic securities.CategoriesMode of FinancingAsset basedIjarah (on existing/ future assets i.e. forward lease), Ijarah in tranches, DMDebt BasedIstisna (manufacturing/ commissioning), Murabaha (cost plus profit)Equity BasedMudaraba, MusharakaAgency BasedWakalaCombinationIstisna cum ijarah, wakala cum ijaraha
54 Islamic Project Finance – Istisna Cum Ijarah CategoriesMode of FinancingCompanySui Southern Gas Company Limited (“SSGC”)PurposeTo finance construction of 18” Dia X 53 pipeline from Dhader to Abbe-e-GhamFacility AmountPKR 1,000 million.Tenor3 years.Grace15 months.
55 Islamic Project Finance – Istisna Cum Ijarah Payment of periodic lease rentals after construction and advance lease rentals during construction54Right to use Financiers’ Share in Asset on Ijarah.FinanciersProvide Funds & appoint SSGC as Saani to construct assets12Construct assets either by itself or through agent3Project AssetSSGC deliver the asset to the financiers
56 Islamic Project Finance – Istisna Cum Ijarah Process Flow:Financiers provide funds to SSGC for construction of project assets as Saani.SSGC can either construct asset by itself or appoint a construction contractor (ECC) for the same by the completion date in accordance with the Specifications and cost agreed. The Istisna price will be paid to the Manufacturer by the Musharaka in advance.On completion date, SSGC will deliver the project assets to financiers.During the construction period, Ijarah rentals will not be recognized as income and will appear as liability under Advance Rentals.Financiers will lease the Asset under Ijarah to SSGC as lessee whereby SSGC will have an exclusive right to use Financiers’ share in the Asset in consideration for Ijarah Rentals comprising of principal plus profit both.The project assets will transfer to SSGC at the end of the tenor.SSGC will undertake to purchase the assets in the event of default.
57 Islamic Project Finance – Istisna Cum Ijarah AgreementsPartiesDescriptionAgency AgreementInvestment Agent & FinanciersFinanciers appoint Investment Agent.Procurement AgreementInvestment Agent and SSGC (as Saani )Parties appoint SSGC as manufacturer (Saani) for construction of Project Asset.Management AgreementSSGC and Investment AgentTo appoint SSGC as Managing Co-owner for structural maintenance, insurance and security of Project Asset once completed.Ijarah AgreementInvestment Agent (Lessor) & SSGC (Lessee)To take on lease the Project Asset.Purchase UndertakingBy SSGC to Investment AgentTo undertake purchase of the Project Asset at EOD.Sale UndertakingBy Investment Agent to SSGC Investment AgentTo undertake Sale of the Project Asset to SSGC at the end of tenor.
63 Islamic Project Finance – Wakala Cum Ijarah CategoriesMode of FinancingCompanyFoundation Wind Energy (“FWE”)PurposeTo set up Wind Power Generation Complex.Project CostUSD 134 millionFacility AmountPKR 10,000 million.Tenor12 years.Grace2 years.ProjectConstruction of 50 MW wind power project, situated at Kutti Kun, District Thatta, Sindh.
64 Islamic Project Finance – Wakala Cum Ijarah FWE(Project Company)Project Assets3Construction and Management5Right to use the assetsPeriodic lease rentalsAppoint as Agent to construct the assetsFunds12Deliver the Project Assets on completion6Financiers4
65 Islamic Project Finance – Wakala Cum Ijarah Process Flow:Financier will appoint FWE as their Wakil (Agent) to construct the Project Assets on behalf of the financier.FWE (as Agent) will enter into the arrangement with Nordex to manufacture and supply the wind turbine and construct a wind-based power generation complex for the financiers.Financiers will inject the funds in the project company as and when required by FWE.FWE will be deemed to commence usage of financiers’ share in asset as it completes and will take the asset on lease, after completion, through the lease commencement notice signed by both the parties.FWE will make periodic payments of lease rental comprising of principal and profit both for using the Project Assets.Financiers undertake to transfer the Project Assets at the end of the Tenor.FWE undertakes to purchase the Project Assets in the event of default.
66 Islamic Project Finance – Wakala Cum Ijarah AgreementsPartiesDescriptionInvestment Agency AgreementInvestment Agent & FinanciersFinanciers appoint Investment Agent.Procurement AgreementInvestment Agent and FWE (asWakil)Parties appoint FWE as manufacturer (Wakil) for construction of Project Asset.Management AgreementFWE and Investment AgentTo appoint FWE as agent for structural maintenance, insurance and security of Project Asset once completed.Ijarah AgreementInvestment Agent (Lessor) & FWE (Lessee)To take on lease the Project Asset.Purchase UndertakingBy FWE to Investment AgentTo undertake purchase of the Project Asset at EOD.Sale UndertakingBy Investment Agent to FWE Investment AgentTo undertake Sale of the Project Asset to FWE at the end of tenor.
67 Islamic Project Finance – Wakala Cum Ijarah AgreementsPartiesDescriptionEquipment Procurement & Construction ContractsFWE & ContractorsContractors take the responsibility for construction and completion of the ProjectOperation and Maintenance (O&M) ContractFWE & O&M ContractorTo operate and maintain the Project.Power Purchase AgreementFEW & NTDCTo purchase the electricity from FEW.GOP GuaranteeBy Govt. of Pakistan to FinanciersTo guarantee the obligations of FWE.Implementation AgreementRelevant Govt. Authority and FWE.Government support for the Project.Security DocumentsBy FWE to Investment AgentTo create security in favour of Investment Agent.Common Terms AgreementFWE, Investment Agent and Financiers.To agree on general terms used under facility agreements, security document etc.
69 Islamic Project Finance – Tranches Ijarah CategoriesMode of FinancingCompanyPakistan International Bulk Terminal (“PIBT”)PurposeTo finance Company’s capex plan.Project CostUSD 184 million.Local FacilityPKR 4,100 million.Tenor12years.Grace3 years.ProjectTo set up a dedicated Cement, Coal and Clinker Terminal atPort Qasim with a handling capacity of 11 million tones per annum.
70 Islamic Project Finance – Tranches Ijarah PIBT(Project Company)Project Assets3Construction and Management5Right to use the individual Project AssetsPeriodic lease rentalsFunds to construct the Project AssetsManage construction as Agent (Wakil)21Deliver the individual assets (part of project asset) as and when completed.6Financiers4
71 Islamic Project Finance – Tranches Ijarah Process Flow:PIBT (as Agent) will construct a dirty cargo handling terminal at Port Qasim.Financiers will inject funds as and when required by PIBT.PIBT as agent, will construct the Project Asset and will also enter into supply, construction and other contracts on behalf of the Musharaka.PIBT will be deemed to commence usage assets as soon as each asset/section are come into the usable condition and will take such asset/section on lease thereby making rental payments to its financiers’ for using each individual assets.Financiers undertake to transfer the Project Assets at the end of the Tenor.PIBT undertakes to purchase the Project Assets in the event of default.Benefit:It helps the Islamic financiers to recognize the Advance Lease Rental as soon as any individual asset, part of the project asset, is completed and in usable condition.
72 Islamic Project Finance – Tranches Ijarah AgreementsPartiesDescriptionAgency AgreementInvestment Agent & FinanciersFinanciers appoint Investment Agent.Procurement AgreementInvestment Agent and PIBT (Agent)Parties appoint PIBT as agent to construct the Project Asset.Management AgreementPIBT and Investment AgentTo appoint PIBT as agent for structural maintenance, insurance and security of Project Asset once completed.Ijarah AgreementInvestment Agent (Lessor) & PIBT (Lessee)To take on lease the Project Asset.Purchase UndertakingBy PIBT to Investment AgentTo undertake purchase of the Project Asset at EOD.Sale UndertakingBy Investment Agent to PIBT Investment AgentTo undertake Sale of the Project Asset to PIBT at the End of Tenor.
73 Islamic Project Finance – Tranches Ijarah AgreementsPartiesDescriptionEquipment Procurement and Construction ContractsPIBT and ContractorsContractors take the responsibility for construction and completion of the Project.Implementation AgreementRelevant Govt. Authority and PIBT.Government support for the Project.Project Funds AgreementPIBT, Sponsors & Investment AgentTo undertake contribution from Sponsors of the Project.Security DocumentsBy PIBT to Investment AgentTo create security in favour of Investment Agent.Common Terms AgreementPIBT, Investment Agent and Financiers.To agree on general terms used under Islamic facility agreements, security document etc.
74 Islamic Project Finance – Combination with DM Diminishing Musharaka CategoryIjarahDiminishing MusharakaConstruction of Project AssetBy project company as Saani/ Wakil/ Managing Co-ownerSameDelivery of Project AssetOn completionOwnershipFinancier will own 100%Financier and sponsor will jointly own the Project Assets, normally in 80:20 ratio.Periodic PaymentLease Rental comprising of principal and profitLease Rental comprising of profit only. Principal will be repaid periodically through purchase of financier’s share in Musharaka Assets under purchase undertaking.At MaturityProject Assets will be transferred to sponsor either through sale at a nominal amount or by way of giftThe project company periodically purchases the financier’s Musharaka Share and subsequently project assets are gradually transferred.
76 Islamic Project Finance – Sukuk CategoriesMode of FinancingCompanyLiberty Power Tech Limited(“LPTL”)PurposeTo setup a new project under the name of LPTL.Project CostUSD 241 million.Issue SizePKR 15,000 million.Tenor12 years.Grace2 years.ProjectTo setup a 200 MW power plant on the BOO (Build Operate Own) concept, based on Residual Furnace Oil (RFO) in Faisalabad.
77 Islamic Project Finance – Sukuk (Shirkat-ul-Milk) MusharakaLPTL as Trustee & IssuerLPTL(as Partner)Sukuk Holders2SukukCash & other assets (Land) in tranches1aCash in tranches to purchase the undivided ownership in project land.1bCash & other assets in tranchesLPTL(as Manager)3Construction & delivery of Power Plant4Rental PaymentsMusharakaLPTL= Trustee & IssuerLPTL(as User)Renting of Sukuk Holders undivided share in Power PlantSukuk Holders57Periodic Distributions6Rental Payments
78 Islamic Project Finance – Sukuk (Shirkat-ul-Milk) Process Flow:LPTL and Sukuk Holders enter into a Musharaka to construct and then own undivided share in the Power Plant. Sukuk will be issued by LPTL, as Issuer, to the Sukuk Holders against the cash contribution towards Musharaka.The Sukuk Holders will purchase the undivided ownership in the land while the Project Company contribute its share in kind (the remaining portion of undivided ownership in land). This will enable the financiers to charge rental as income from the very day musharaka is created.LPTL (as managing co-owner) will get the Power Plant constructed as per specification at an agreed cost.Sukuk Holders’ undivided share in Musharaka Assets (Power Plant) will be rented to LPTL on completion of the construction in consideration of Periodic Rentals which include Base Rental (Principal) and Variable Rental (Profit).LPTL undertakes to purchase the Sukuk Holders’ Musharaka share on maturity or in the event of default.
79 Islamic Project Finance – Sukuk (Shirkat-ul-Milk) AgreementsPartiesDescriptionAgency AgreementIA& FinanciersFinanciers appoint Investment Agent.Procurement AgreementInvestment Agent and LPTL (Agent)Parties appoint LPTL as agent to construct the Project Asset.Management AgreementLPTL and Investment AgentTo appoint LPTL as Managing Co-owner for structural maintenance, insurance and security of Project Asset once completed.Ijarah AgreementInvestment Agent (Lessor) & LPTL (Lessee)To take on lease, Investment Agent’s share in the Project Asset.Purchase UndertakingBy LPTL to Investment AgentTo undertake purchase of Investment Agent’s share in the Project Asset at EOD.Sale UndertakingBy Investment Agent to LPTL Investment AgentTo undertake Sale of Investment Agent’s share in the Project Asset to LPTL at the End of Tenor.Declaration of TrustLPTL, Investment Agent & FinanciersFor the purpose of declaration of trust and issuance of Sukuk to investors.
80 Islamic Project Finance – Sukuk AgreementsPartiesDescriptionEquipment Procurement and Construction ContractsLPTL and ContractorsContractors take the responsibility for construction and completion of the ProjectOperation and Maintenance (O&M) ContractLPTL and O&M ContractorTo operate and maintain the Project.Fuel Supply AgreementLPTL & SupplierTo guarantee fuel supply from the supplier for operations of the Project.Power Purchase AgreementLPTL & PurchaserTo guarantee purchase of Power from the Project.Project Funds AgreementLPTL, Sponsors & Investment AgentTo undertake contribution from Sponsors of the Project.Security DocumentsBy LPTL to Investment AgentTo create security in favour of Investment Agent.Common Terms AgreementLPTL, Investment Agent and Financiers.To agree on general terms used under Islamic facility agreements, security document etc.
82 Islamic Project Finance – Mudarba Provide periodic lease rentals (Adv. Or actual)73Give funds as agent to construct the assetsAppoint SPV as Mudarib1Project CompanySPVFinanciersProvide Funds as Rabul MalLease the assets back26Construct assets either by itself or through agentShare the agreed profit percentage with Financiers85Project Co. will deliver the assets4Project Company
83 Islamic Project Finance – Musharaka Provide periodic lease rentals (Adv. Or actual)Sponsors(As Musharaka Partner)612Give funds as agent to construct the assetsBoth Musharaka Partner provide funds towards Musharaka (create musharaka)Project CompanyMusharakaLease the assets back5Financiers(As Musharaka Partner)Construct assets either by itself or through agentSponsors(As Musharaka Partner)43Project Co. will deliver the assets8Project CompanySharing of profit at agreed ratioMusharakaFinanciers(As Musharaka Partner)
85 Project Finance – Risk & Mitigates Construction Risk:Construction is the most risky phase in infrastructure project. During construction phase, we may face the risk of cost overrun, missed deadlines, defaults/ delays in construction of the facility, design or its non-conformity to the desired specifications etc. These risks often come from the following different factors:Any modifications or changes in the characteristics of the facility, during the construction phase.Poor estimates of cost or construction delays or cost over run.Technical or financial failure of the constructors.Mitigates:Different operators are outsourcing these risks through turnkey construction contracts, with fixed price and a fixed date of delivery. Generally, manufacturers bear risks associated with construction. Indeed, sponsors of the project company seek to transfer to contractors and incorporate clauses for liquidity damages.As lenders, they can allocate a portion of the risks related to the construction jointly with the sponsors by establishing a line of credit with major additional funding to cover the additional costs or delays encountered during the construction phase.
86 Project Finance – Risk & Mitigates Lease Default Risk:If the Project Assets are not delivered to the Investment Agent, the Investment Agent cannot lease the same to the Lessee under the Forward Lease arrangement. Under Shariah, the Forward Lease Agreement has to be terminated and the financiers has to return the Advance Lease Rentals already paid by the Lessee.Mitigates:In this case, since the Lessee or its appointed contractor is also the Wakil/ Saani, the financier normally include arrangement of liquidity damages to set-off the obligation to return the Advance Lease Rentals.Operating-related risks:Risk of insufficient revenue and/ or income, arises from an incorrect estimation of project revenues, of the factors used to calculate the costs of management, maintenance or renewal and major repairs.Financiers normally include arrangement of third party undertaking like Govt. guarantee, minimum off take guarantee, minimum toll guarantee etc.
87 Project Finance – Risk & Mitigates Political/ Policy Risk:In addition to the above, political stability and economic environment of the host state of the project are important for assessing the conditions of the project's success.These risks might be caused by political decisions taken against the project directly such as changing tax regimes, nationalization, expropriation, confiscation, not obtaining permits or imposing other regulatory constraints directly affecting the profitability of the project.Mitigates:Political risks cannot be controlled by private partners in case of Public Private Partnership projects. These are usually borne by the government or govt. agencies.Another way to minimize such risk is to involve some large multilateral agencies like world bank, IFC, ADB, IDB etc.. Involvement of such agencies will restrict government for making unfavorable amendments.
89 Islamic Project Finance – Constrains & Challenges Sharia’ah IssuesIslamic financial transactions appear to be more complex than their conventional counterparts.Difference of opinions among Shari’ah scholars, not only in different countries, but even within a single jurisdictions.Sharia principles are often expressed in general terms, allowing for considerable discretion on how to apply these principles. Because there are different schools of Islamic jurisprudence, they may construe certain precepts differently. Within each school there are also majority and minority views on various issues, either of which may be applied in any particular case. Therefore, a document or structure may be accepted by one Sharia committee of a bank but rejected by a different Sharia committee.Controversies in certain financing instruments among Shari’ah scholars:Organised tawarruq (i.e. has been declared unlawful by the Islamic Fiqh Academy).Murabaha Based sukuk structures are permitted in some jurisdictions.
90 Islamic Project Finance – Constrains & Challenges Issue of accruing income on forward lease contracts. During the construction period Advance Rental is a liability .Islamic debt-based instruments have inherent problems of tradability and liquidity. In order to make instrument tradable in light of Shariah the instrument should by back by at least 20% ownership in the tangible assets.Delay in payments is another concern. Conventional lenders can charge interest/ penalty while Islamic Financiers cannot.In case of Total Loss or destruction securities like cash collateral and receivables cannot be enforced (major risk).Under the Shariah laws unilateral promises are enforceable and therefore they perform a very important roles is Islamic agreements like in case of forward Ijarah/ DM where customer; (i) promises to take assets on lease once completed, and (ii) gives a purchase undertaking to purchase back assets in case of EoD or at maturity. These promises are not yet challenged in court of law and pose the risk that the customer may dishonor his commitments.Takaful coverage is not available for such large projects.
91 Islamic Project Finance – Constrains & Challenges Legal & Contractual issuesProblems may arise in settling disputes involving Islamic contracts in jurisdictions that do not have supporting Islamic laws, thereby creating uncertainty about Islamic financial transactions. These structures had never been tested in a major litigation and it was unclear whether a court might pierce the corporate veil and assert liability on Islamic investors. Even in case of default, it is unclear whether Islamic law or English law would prevail.Integrating Islamic financing with conventional financing in a single deal, raises further complications regarding inter-creditor arrangements. In case of default, Islamic investors who own specific assets in the project could claim those assets. Although this structurally puts an Islamic investor in a better position than a conventional lender, who is usually only a beneficiary of security but this would violate the pari passu treatment of most inter- creditor arrangements. Pari Passu treatment refers to the fact that all creditors holding the same securities should have equal claim on project assets. The standard solution, opted in most of the project finance deals, is for Islamic investors to forgo their rights in case of liquidation or default.
92 Islamic Project Finance – Constrains & Challenges Shariah advisors and legal professionals face the challenge of structuring the transaction that satisfies both Shariah principles and legal/regulatory requirements of the host country. Particularly the governing laws is one of the important legal issues to be solved. Most large project financings involve multiple and diverse parties and jurisdictions. The choice of law is rather ambiguous, to say the least, and raises a whole set of questions. One is whether and to what extent the parties can validly agree on Islamic law as a governing law of a financial transaction.Issues Related to Market ParticipantsLimited number of sources in providing long-term Islamic funds for infrastructure project as Islamic financial sector is still developing.Islamic financial principles and the legal implications of Islamic instruments are not clearly understood by many market participants.Leveling Playing Field/Standardization:The Islamic structures set out above can potentially trigger multiple tax duties (for example, stamp duties) on the sale and transfer of assets. It is very important for the Islamic finance that the governments should provide tax neutrality.Need laws and regulations that able to reduce legal and regulatory disparities between Islamic and conventional finance.Need for risk mitigation organizations and instruments that can be used to support infrastructure financing (e.g. takaful companies).