Islamic Banking in Azerbaijan Baku, Azerbaijan 16 th – 17 th September 2008

Introduction - Short History of Islamic Banking……………………………………………..3 - Classical Islamic Banking……………………………………………………………3 - Modern Islamic Banking……………………………………………………………..3 - Emerging Islamic Capital Markets………………………………………………….4 - Basic of Islamic Banking……………………………………………………..6 - Major modes of Islamic financing……………………………………………8 - Islamic Micro-financing …………………………………………………… Islamic Banking in Azerbaijan………………………………………………16 - TuranBank practice in Islamic Banking (ICD’s fund utilization)…………17 - TuranBank’s role…………………………………………………………………… Clients role…………………………………………………………………………….17 - Disbursement procedure…………………………………………………………….19 - Collection procedure…………………………………………………………………20

Classical Islamic Banking - 8 th – 12 th Century - Early forms of proto-capitalism and free market - Caliphate regime (from the Arabic خلافة or khilāfa, was the Islamic form of government representing the political unity and leadership of the Muslim world). - Earliest trade activity elements of the Middle ages were mainly in Spain, Mediterranean and Baltic states. Modern Islamic Banking - Early of 1960s led to establishment FI in Egypt and Malaysia. - In 1972, the Islamic Development Bank was set-up with the mission to provide funding to projects in the member countries. - The first modern commercial bank, Dubai Islamic Bank opened it doors in By the 1990s, Islamic banking had attracted the attention of several western commercial banks - There are more than 300 financial institutions operating on the basis of non- interest based instruments in more than 75 different countries

Emerging Islamic Capital Markets - Developing process started during 1980s and 1990s - Primary instruments included cost-plus-sale or purchase finance (Modaraba’); leasing (Ijara’); trust financing (Modaraba’); and equity participation (Musharika’). - Main emerging markets includes: Middle-East, South-East Asia, South Asia, and North Africa - Islamic funds in Global Financial institutions is said to be at US$1.3 trillion while the Islamic Financial Market is estimated to be US$400 billion in size, with an annual growth rate of 12% - 15 % - More than 100 Islamic Equity Funds managing assets in access over US$5.0 billion - Estimated annual growth for Islamic Capital Market is between 15% to 20%

Emerging Islamic Capital Markets - The total worldwide Muslim population is 1.5 billion, representing a sizeable 24% of total world population of 6.3 billion - Shari'a-compliant assets, growing over the last 20 years, represent an estimated US$ 300 billion banking assets & approximately $400 billion Capital Market

Basic of Islamic Banking An Islamic banking and financial system is a rule-based system comprising a set of rules and laws, collectively referred to as Sharia’ governing economic, social, political and cultural aspects of Muslim societies. Sharia originates from: - The Quran (Moslems’ holy book) - Sunna (prophet Muhammad preaching and practise) - Ijtihad (the opinion of Islamic jurists on particular issue) - Ijma (the consensus of the Islamic community on a particular issue) - Qiyas or analogy (the application of accepted principles by analogy to new cases) not a source relied upon by all schools The central tenet of the financial system is the prohibition of Riba – a term literally meaning “an excess” and interpreted as “any unjustifiable increase of capital whether through loans or sales”.

Basic of Islamic Banking Other principles of Islamic doctrine: - Advocating risk sharing; - Promotion of entrepreneurship; - Discouragement of speculative behaviour; - Preservation of property rights; - Transparency; and - The sanctity of contractual obligations. The system can be fully appreciated only in the context of Islam’s teachings on the work ethic, wealth distribution, social and economic justice, and the expected responsibilities of the individual, society, the state and all stakeholders.

Major Modes of Islamic financing Mudarabah: A form of partnership where one party provides the funds while the other provides expertise and management. The latter is referred to as the Mudarib. Any profits accrued are shared between the two parties on a pre-agreed basis, while loss is borne by the provider(s) of the capital. Shirkah: A contract between two or more persons who launch a business or financial enterprise to make profits. In the conventional books of Fiqh, the partnership business has been discussed under the option of Shirkah that, broadly, may include both Musharakah and Mudarabah. Murabaha: Literally it means a sale on mutually agreed profit. Technically, it is a contract of sale in which the seller declares his cost and the profit. This has been adopted by Islamic banks as a mode of financing. As a financing technique, it can involve a request by the client to the bank to purchase a certain item for him. The bank does that for a definite profit over the cost which is stipulated in advance. Musawamah: Musawamah is a general kind of sale in which price of the commodity to be traded is bargained between seller and the purchaser without any reference to the price paid or cost incurred by the former.

Major Modes of Islamic financing Musharakah: Musharakah means a relationship established under a contract by the mutual consent of the parties for sharing of profits and losses in the joint business. It is an agreement under which the Islamic bank provides funds which are mixed with the funds of the business 6 enterprise and others. All providers of capital are entitled to participate in management, but not necessarily required to do so. The profit is distributed among the partners in pre-agreed ratios, while the loss is borne by every partner strictly in proportion to respective capital contributions. Bai‘ Muajjal: Literally it means a credit sale. Technically, a financing technique adopted by Islamic banks that takes the form of Murabaha Muajjal. It is a contract in which the seller earns a profit margin on his purchase price and allows the buyer to pay the price of the commodity at a future date in a lump sum or in instalments. He has to expressly mention cost of the commodity and the margin of profit is mutually agreed. The price fixed for the commodity in such a transaction can be the same as the spot price or higher or lower than the spot price. Bai′ Salam: Salam means a contract in which advance payment is made for goods to be delivered later on. The seller undertakes to supply some specific goods to the buyer at a future date in exchange of an advance price fully paid at the time of contract.

Major Modes of Islamic financing Leasing (Ijarah, Kira'): Letting on lease. Sale of a definite usufruct of any asset in exchange of definite reward. It refers to a contract of land leased at a fixed rent payable in cash and also to a mode of financing adopted by Islamic banks. It is an arrangement under which the Islamic banks lease equipments, buildings or other facilities to a client, against an agreed rental. Operating Lease (Ijarah-wal-Iqtina‘): A mode of financing, by way of Hire- purchase, adopted by Islamic banks. It is a contract under which the Islamic bank finances equipment, building or other facilities for the client against an agreed rental together with a unilateral undertaking by the bank or the client that at the end of the lease period, the ownership in the asset would be transferred to the lessee.

Islamic Microfinancing Islamic Alternatives to Microfinancing Different alternatives: - Islamic MFIs - Islamic Banks - Specialized Institutions Group based microfinancing can be used Islamic MFIs – Features (1) Islamic MFI retains the basic operational format of MFIs - Going to the clients - Weekly/Monthly Repayments - A social/development program (to fulfil the social role of Islamic finance)

Islamic Microfinancing IMFIs have some distinguishing features: - Sources of Funds Other than external sources, can also use funds from zakah, awqaf, and other forms of charities - Use of funds (Mode of Financing) Sale based and hiring modes (murabahah, salam, ijarah) Profit-sharing modes (Musharakah and mudarabah)

Islamic Microfinancing Islamic MFIs-Features (2) - Amount transferred to the poorest As Islamic modes are sale based the price of the asset is paid (no deductions are allowed) - Group Dynamics Islamic values of brother/sister-hood improves cooperation among the group members - Financing the poorest Zakat and other charities can supplement MFI activities (non-diversion of funds)

Islamic Microfinancing Islamic MFIs-Features (3) - Social Development Program behavioral, ethical, and social aspects in light of Islamic teachings - Targeting the family through women Spouse co-signs the contract Dealing with women more efficient and convenient Women disseminate knowledge to children - Dealing with Arrears/Default Less aggressive and use Islamic teachings to recover loans

Islamic MFIs and Sustainability - Mitigating Credit Risk (CR) CR mitigated by social collateral (group-based lending) - Solving Moral Hazard (MH) Problem As asset/good given instead of Cash, chances of diversion and default decreases - Economic Viability High administrative costs Reasonable finance costs - Islamic MFIs can resolve the CR problem and the MH problem, but not the Economic Viability problem

Islamic Banking in Azerbaijan - First bank in Azerbaijan operating on a non-interest basis and also under Islamic principles is Kauthar Bank. - ICD (Islamic Corporation for the Development of the Private Sector – Islamic Development Bank affiliate) is the First international Islamic financial institution which defined credit lines to the Azeri Bank under Islamic principles. - Currently Azerbaijan which are presents Islamic Banking tools to there are 7 banks in clients and also 5 of them utilize ICD’s line of financing for the USD 20 mln. - TuranBank - International Bank of Azerbaijan - Rabitabank - UniBank - Bankstandard - Kauthar Bank - AmrahBank - ICD invested to equity of Caspian International Investment Company initially USD 3 mln. which will be increased in 2009 to the USD 70 mln.

TuranBank’s practice in Islamic Banking All presented practise are based on Murabaha mode of financing and mainly implemented under ICD’s line of financing. TuranBank’s role: - Identify and apprise clients & sub projects; - Prepare all legal documentation (Murabaha agreement); - Disburse to suppliers; - Follow-up project implementation and post implementation monitoring; - Ensure on time collection from clients and transfer of payments to ICD; - Guarantee full payment to ICD; Client’s role as authorized by Murabaha Agreement Terms: - Procure and take delivery of assets (refer to Murabaha agreement for full details) - Commit to purchase assets from ICD (promise to buy) - Commit to payment

The structure of the Line The ICD TuranBank Client Collateral / security Guarantee commission Disbursement Repayment Identification, appraisal, recommendation Guarantee Agency fee ICD Escrow Account Operational Account Supplier

Disbursement Procedure 1. Project Proposal 2. Disbursement request 3. Undated receipt 4. Letter of Guarantee 1. Identification 2. Appraisal 3. Structuring the deal 4. Collateral package 5. Fix murk-up 6. Prepare documentation TuranBank Client / Sub-Project Supplier Disbursement within 30 days ICD is notified immediately Operational Account Disbursement according to project req. ICD Letter of acceptance

Collection Procedure ICD FITuranBank Escrow Account Client / Sub-Project Repayment to Escrow account Principal + ICD murk-up Notification

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