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PRINCIPLES OF ISLAMIC BANKING

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1 PRINCIPLES OF ISLAMIC BANKING
Mustafa Dereci Group Manager Retail and Business Banking Marketing and Product Development OCTOBER 2011

2 CALIBRI BOLD 42 pt Islamic Economy and Other Practices
→ What is economics? “To utilize the limited resources in a way that maximum needs and wants are met to ensure the well being of all members of the human society.” → The four basic economic problems: Determination of Priorities Allocation of Resources (Land, Labor, Capital, Entrepreneur) Distribution of Income Development

3 CALIBRI BOLD 42 pt Islamic Economy and Other Practices Problems
Capitalism Socialism Determination of Priorities Every individual has unconditional & absolute right to participate in any business to maximize profits Concept of Selfish Interest Supply & Demand will determine the priorities. No individual has the right to participate in any business independently. Concept of collective interest. State will determine the priorities as per the overall planning. Allocation of Resources Market forces will decide where to invest resources Govt. will decide where to allocate resources Development Market forces will decide Govt. will decide Distribution of Income Land - Rent / Capital- Interest Labor – Wages / Entrepreneur- Profits Land – Rent fixed by Govt. Labor – Wages fixed by Govt. Right to Wealth Right to wealth is with the factors of production only. Right to wealth is with the Govt. which then distributes it among the factors of production.

4 CALIBRI BOLD 42 pt Problems of Capitalism
→ No bindings/ restrictions while maximizing profits. → Blindly follows market forces that creates exploitation of labor & poor people. → No moral value limitations. → Monopolies & Cartels are created that exploit the society as a whole. → Government & Industrialists join hands for mutual benefit and make laws that exploit common people. → Imbalance in the distribution of income due to which concentration of wealth takes place.

5 CALIBRI BOLD 42 pt Problems of Socialism
→ The other extreme of not even giving the natural freedom. → Perfect Planning is assumed to be the “Cure of all ills”. → Governments are assumed to be angels which can’t commit a deliberate mistake. → Cannot work without forceful dictatorship. → Creates overall inefficiency in the society. There is no incentive to work efficiently as there is no individual profit motive.

6 CALIBRI BOLD 42 pt Islamic Economy
→ Islam is a Deen which gives guidance for Aqaid, Ibadat, Mu’ashrat, Akhlaq & Mu’amalat. → Hidaya- famous nook of Fiqh has 70 % portion dedicated to Mu’amalat. → The humanitarian goal of achieving the well being of all members of the human family cannot be attained by concentrating primarily on the material constituents of well-being and making maximization of wealth as the main objective of Economics.

7 CALIBRI BOLD 42 pt Islamic Economy
→ It is also necessary to raise the spiritual content of well being and reduce all the symptoms of anomie, like family disintegration, heavy interest based debt payments, conflict and tensions, crime, alcoholism, drug addiction, and mental illness, all indicating lack of inner happiness and contentment in the life of individuals. → Optimization of human well-being as per the divine guidelines of Allah. → Islam accepts the market forces of supply and demand- Reference of Holy Quran. → Islam accepts the right to private property and accepts the right to maximize profits. But these rights are not unbridled and un conditional rather there are some prohibitions.

8 CALIBRI BOLD 42 pt Islamic Economy
→ In Islam there are three factors of production 1.Land 2. Labor 3. Entrepreneur → Entrepreneur & Capital is a single factor of production. → As interest is Haram hence the risk of profit & loss is with the capital. → Anyone investing capital must also take the risk of the investment. → In both Capitalism & Socialism the right to wealth is with those factors of production only that have taken part directly in the process of production. → Islam believes that the original ownership of everything is with Allah and without Allah’s “Taufeeq” no factor of production can produce anything.

9 Locating Islamic Economy
Locating Economics & Finance Within Islam ISLAM AQIDAH (Faith & Belief) SHARI’AH (Practices & Activities) IBADAT (Human Worshipping to Almighty God) MUAMALAT (Human-to-Human Activities) POLITICAL ACTIVITIES ECONOMIC ACTIVITIES OTHER ECONOMIC ACTIVITIES BANKING & FINANCIAL ACTIVITIES SOCIAL ACTIVITIES AKHLAQ (Moralities & Ethics)

10 Basic Principles of Islam
The Islamic worldview is based on tahwid (the oneness of God), risalah (God’s prophets as the source of Divine Guidance), akhirah (life-after-death, that is the continuity of life beyond death and a system of accountability based on Divine Law) It provides for freedom of action whereby each individual is viewed as an integral part of the whole. Individuals are expected to establish justice (‘adl) and promote beneficence (ihsan), resulting in attaining high levels of good life (hayat al-tayyebah) , both individual and collective. It aims to strike an appropriate balance between the needs of present and future generations (need fulfillment; respectable source of living; equitable distribution of income and wealth; growth and stability)

11 Basic Principles of Islam
Accountibility before Allah Free-will (Ihsan) Responsibility (Fard) Divine arrangements (Rububiyya) Purification (tazkiyya)

12 Implications of the Basic Principles
Human beings can only proclaim credit for what he/she produces.. The needy and society have a right too; zakah, etc… Responsible use of rightful earnings by keeping the moral purposes of human beings in view; Individuals must not prevent others in society and nature from meeting their basic biological needs All people should have equal opportunities, without discrimination, to benefit from environmental and public resources. The creation of wealth, work, earning and production is necessary and good. What makes wealth bad is firstly, its single-minded pursuit; its misuse, abuse, conspicuous consumption, wastage or israf; and squandering or tabhdir; its exclusiveness to oneself and denial of the share of the society (zakah and other forms of sharing); and the use of socially and ethically wrong or unjust means to produce it – the immoral, prohibited modes, oppressive exploitation of human beings and creation of ecological imbalance or environmental disruption.

13 The Operational Impacts Of Islamic Economy
Islamic economic and financial system, on the one hand, aims to guarantee individual liberty, freedom of choice, private property and enterprise. On the other hand, it seeks to provide effective moral filters at different levels of life and activity and established institiutions in the voluntary sector, as well as through state apparatus to ensure economic development and social justice in the society. Islam does not prescribe a particular economic system but provides the core elements and principles, which form the basic philosophy of a system or an economy. Islam provides primarily normative principles for economics and finance.

14 CALIBRI BOLD 42 pt Islamic Finance-Main Considerations
→Divine Prohibitions Islam has prohibited some economic activities that are not allowed at any time at any place.( interest, gambling, hoarding, adultry, alcohol etc.) →Govermental Restrictions Islam allows Govt. to intervene where it feels appropriate , but these restrictions are temporary as per the need of the time. →Moral Considerations & Restrictions Life in this world is temporary and there is an eternal life hereafter.

15 CALIBRI BOLD 42 pt Islamic Finance-Main Considerations
→As interest is prohibited the risk of profit & loss is with the capital. → Anyone investing capital must also take the risk of the investment. → Islam ensures equitable distribution of wealth through the concept of primary and secondary ownership

16 CALIBRI BOLD 42 pt Islamic Banking
Islamic Banking is interest free Asset Backed banking governed by the principles of Islamic Shariah → Islamic Banking distinguishes from Conventional Banking in four basic principles: Interest Free Transactions Risk Sharing Asset & Service Backing Contractual Certainty( Gharar free contracts)

17 CALIBRI BOLD 42 pt Islamic Banking
→ Financiers are linked to the underlying transaction → Money is not a “Commodity” in itself, merely reflecting “Time Value” for a return → Gold and silver are not commodities, they are considered as money

18 Core Basic Tenets Of Islamic Finance
If something is immoral, one cannot profit from it To share reward, one must also share risk One cannot sell what one does not own In any transaction, one must clearly specify what he/she is buying or selling and what price is being paid; Haram + Haram ≠ Halal Haram + Halal ≠ Halal Thus: Islamic finance aims at removing speculation and ensuring value-enhancing activity

19 Islamic Finance as an Ethical Solution
Tenet Bound: - Fundamental tenants are derived from Sheriah - Absence of interes-based interactions - Avoidance of economic activity involving speculation - Prohibition on production of goods and services which contradict the values of Islam Principles based: Concept is grounded in ethics and values - Ethical investing - Emphasis on risk-sharing and partnership contacts - Credit and debt products are not encouraged Real Economy linked: Islamic finance offers an alternative financing paradigm - Asset- backed transactions with investments in real, durable assets - Stability from linking financial services to the productive, real economy - Restrains consumer indebtness as credit is linked to real assets Society Service: Islamic banking is community banking - Serving communities, not markets - Open to all-faith clients - Instruments of poverty-reduction are inherent part of Islamic finance (zakat & qard hasan) Thus, Islamic finance in essence a value and moral proposition and more than financial contracts.

20 Islamic Banking Positive Impacts
Promoting the investment mindset as opposed to the banking mindset: Investing in real assets rather than promoting speculation and leverage Making meaningful real economy impact Investing in asset-backed instruments and real economy values Engagement of an under-served and previously un-banked market Providing an ethical banking solution to local communities to deepen the banking market Attracting foreign investment and cross-border partnership from Islamic financial institutions Attractive source of cross-market ventures and cross-border lines from Muslim countries

21 Prohibited Activities
Conventional banking & Insurance Alcohol Pork Defence Gambling Adult Entertainment Tobacco Other non-accepted activities as defined by the Sheri’ah Board

22 Controversies In Sheriah Governance
Conflicts of interest Confidentiality Fees (Scholars for dollars?) Scarcity of scholars Vs. High Demand Finding problems or finding solutions Dialogue between the deaf? Consistency issues Who takes the blame? Expectation management Resource planning

23 Challanges In Sheriah Governance
The scholars of different schools of thoughts (Madhabs) with different interpretations and opinions The number of scholars qualified in the jurisprudence of dealings (Fiqh-ul-muamalat) relatively limited The level of familiarity of the scholars with modern day financial services is limited Most of the management of IFI’s coming from conventional backgrounds with no or very little understanding of Shariah The expectations of the stakeholders (regulators, shareholders, customers & the management of IFI’s) from Islamic finance are very unrealistic

24 Typical Balance Sheet of an Islamic Bank
Liabilities Assets Capital PLSA Current Accounts 15 70 Murabaha Istisna Ijarah Salam Musharakah Mudharabah 90 2 5 1 Total 100

25 How is Islamic Finance Different from Conventional Finance?
Conventional financial institutions operate within a system based on debt and transfer of risk This raises the probability of disconnecting financial instruments from their underlying assets Some of the financial tools created to share risk actually resulted in a concentration and intensification of risk In contrast, Islamic finance emphasizes asset-backing for transactions and is anchored on the principle of risk sharing Shariah principles ensures a direct link between financial transactions and real sector activities Shariah principles also prohibit (Gharar), the use of excessive leverage and avoids many forms of controversial complex securitization

26 Performance of Islamic Finance During the Crisis
Islamic banks escaped the direct impact of the crisis, as they were not exposed to sub-prime and toxic assets A recent IMF Working Paper* found that the business model of Islamic banks helped them to mitigate the impact of the crisis As Islamic banking services are more connected to the real sector, initially performed well during the crisis yet were severely hit by the second round effects:

27 RETAIL BANKING PRODUCTS & SERVICES
BÖLÜM BAŞLIĞI CALIBRI BOLD 42 pt PRODUCTS & SERVICES RETAIL BANKING PRODUCTS & SERVICES

28 FOLLOW-UP TABLE FOR RETAIL BANKING PRODUCTS IN 2004
CALIBRI BOLD 42 pt Product Development Steps in İslamic Banks FOLLOW-UP TABLE FOR RETAIL BANKING PRODUCTS IN 2004 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 PHASE OF PRODUCT Concept Formation of the Project Team Feasibility Study and Market Research Budgeting Approval of the Advisory Board Approval of the Legal Advisors Approval of the Internal Audit Dept. Approval of the Financial Control Dept. Approval of the Top Management Approval of the BDDK Procedures Manual Approval of the Budget Implementation Through Related Depts. Documentation Testing Preparing Promotional Materials Training the Sales Staff Launching Advertisement Campaign Launching the Project Credits Products Car Finance Real Estate Finance Car Showroom Home Renovation Finance Home Appliances Finance Car Renovation Finance Education Finance Travel Finance Boat Financing Small Business Module Done Processing Pending

29 DEPOSIT PRODUCTS BÖLÜM BAŞLIĞI CALIBRI BOLD 42 pt

30 Participation Accounts
CALIBRI BOLD 42 pt Deposits Deposit Accounts Current Accounts Participation Accounts Gold Platinum Platinum+ Classic Silver

31 CALIBRI BOLD 42 pt Current Accounts No profit or loss No minimum cap
No tenor No profit or loss No minimum cap Withdraw and deposit any time Any currency denomination Based on Kard Al Hasen structure

32 CALIBRI BOLD 42 pt Profit and Loss Sharing Accounts
Flexible account tenors Profit or loss distribution Minimum cap applied Withdraw and deposit at maturity only TRL, USD, EUR denomination No preset yield guaranteed Based on Mudaraba agreement No capital guarantee

33 RETAIL BANKING PRODUCTS & SERVICES
CALIBRI BOLD 42 pt Profit and Loss Distribution PLS Accounts serve as fund pools Depositing fresh money or opening a new PLS account contribute to the level of the pool Water in the pool (fund) is invested in highly profitable projects Invested fund with its yield is added to the pool If investment returns loss, it negatively effect the pool level At maturity generated profit or loss is shared with customers RETAIL BANKING PRODUCTS & SERVICES

34 CALIBRI BOLD 42 pt Profit and Loss Distribution Deposit (TL) 100
From Deposit to Profit Deposit (TL) 100 Legal Reserve (6%) 6 Liquidity (10%) 10 Net Fund to Invest 84 Return on Investment (15%) 12.60 Bank’s Share on P/L (20%) 2.52 Customer’s Share on P/L (80%) 10.08 Income Tax (15%) 1.51 Net Profit for Customer 8.57 Net Profit Rate 8.57%

35 CALIBRI BOLD 42 pt Profit and Loss Generation
Unit Value: the coefficient which is assumed as 100 for the first day of the participation bank that accepts fund to ist participation accounts. Unit value changes when profit or loss is made. Account Value: the coefficient colculated by dividing the amount deposited to the unit value. Unit Account Value: The value determining the the current value of the participation account and calculated through multiplying the unit value by the account value and the amount on which the account holder may lay claim to.

36 CALIBRI BOLD 42 pt Profit and Loss Generation Account Opening Date
Tenor 30 Days Account Balance TL Unit Value 100 Account Value ÷ 100 = 2.000 Account Closing Date Unit Value 101,15 Unit Account Value 101,15 X = TL Profit Rate (101,15 ÷ 100) - 1= 1,15% New Account Balance X 1,0115 = TL

37 CALIBRI BOLD 42 pt Fund Collection Products Current Account
Participation Account (Classic, Silver, Gold, Platinum, Platinum+ Accounts) Savings Account ( Family, Youth and Child Savings Account) Precious Metals Current Accounts Precious Metals Participation Accounts Investment Account Flexible Maturity Participation Accounts Salary Account Gold denominated gift cheque Tenant’s Accounts

38 CALIBRI BOLD 42 pt Banking Services VIP Package Special Fund Pool
Forward transactions Foreign currency buy and sell Check services Promissory Note services Safe box International and local money transfers Moneygram Gold bullion

39 LOAN PRODUCTS BÖLÜM BAŞLIĞI CALIBRI BOLD 42 pt

40 CALIBRI BOLD 42 pt Main Islamic Loan Products Musharaka
Murabaha Musharaka Icara (Leasing) Mudaraba Istisna’ Kard Al Hasen Salam Tawarruq

41 CALIBRI BOLD 42 pt Mudaraba Concept
Investor provides Mudarib all the capital to fund a specific enterprise. Mudarib does not contribute capital but contributes to management and expertise Mudarib is responsible for the day-to-day management of the enterprise and is entitled to deduct its management fee (Mudarib fee) from profits. If the enterprise makes a loss, the investor has to bear all the losses unless the loss has resulted from negligence on the part of the Mudarib

42 CALIBRI BOLD 42 pt Murabaha Concept
Murabaha refers to contracts in which a financial institution purchases goods upon the request of a client, who makes deferred payments that cover costs and agreed-upon profit margin for the financial institution. Murabaha is the most widely used instrument at Kuveyt Turk with 90% of total contracts being Murabaha based.

43 CALIBRI BOLD 42 pt Murabaha Concept Supplier
3. Customer buys the goods as Bank’s agent. Cost: $100 4. Disbursement of the Facility. Facility Amount: $100 Customer 1. Execution of Murabaha Agreement. 2. Bank appoints the Customer as its agent to buy the goods. Sale Bank 5. Bank will immediately sell the goods at $110 (cost plus a profit margin)

44 CALIBRI BOLD 42 pt Musharaka Concept
Musharaka is a partnership between parties in which one or several parties supply working capital. Musharaka is widely used for joint venture investments. Both the investor and the enterprise contribute towards the capital The enterprise and the investor share in the profits according to the agreed proportions Any losses of the enterprise will be borne by the investor and the enterprise according to their contributions

45 Musharakah Shirkah or sharing
Musharakah involves a mutual contract to participate in a commercial enterprise Determination of returns Proportional distribution agreed in advence, usually relating to investment shares Net profits of the business Losses must be shared in proportion to amounts invested Management All partners may be involved in the management of the business May agree in advance that one party a sleeping partner

46 Musharakah versus equity investment
Venture of limited duration Partnership with joint ownership No exit without agreement of partners Investors obtain profit share Little probability of asset gains when venture terminates Equity Investment Company exists in perpetuity Exclusive ownership by shareholders Exit at any time if company listed Investors get dividends Focus on capital gains and market value of equity

47 CALIBRI BOLD 42 pt Ijara Concept
Ijara is a lease purchase contract in which a financial institution purchases capital equipment or property and leases it to an enterprise. The bank buys the assets from the vendor The bank then leases the asset to the customer The bank collects periodic rentals The title of the asset remains with the bank under an operating Ijara. Title passes to the customer under an Ijara muntahia bittamleek, either gradually over the period of the contract or at the end.

48 Ijara Concept Operating ijara is a pure leasing arrangement - Two parties to the contract, lessor and lessee - Rental payment provides an income stream - Contract of fixed duration but renewal possible Owner and lessee responsibilities - The lessee can be requiered to maintain equipment on a periodic basis - Owner responsible for loss or damage to asset beyond control of lessee -Lessee can indemnify owner against misuse or negligence caused by lessee

49 Conditions & Limitations of Ijara
Property being leased must have a valuable use House or business premises should be occupied, not a mere speculative purchase Leased property cannot be used for purposes other than specified in the leasing department Non halal use would contravene shariah Restrictive covenants may be included in new leases but uncertainties of conversion with existing leases

50 Hire Purchase Ijara wa iqtina or ijara muntahia bittamleek is a hire purchase contract Leased asset passes as a gift or a sale at the end of the lease period Purchase possible during the lease period if the remaining rental installments paid Gradual transfer of ownership also possible rather than an outright sale Lower risk as lessee has ownership stake

51 CALIBRI BOLD 42 pt Istisna’ Concept
Istisna’a is primarily a deferred delivery sale contract similar to Salam. It is similar to conventional work in progress financing for capital project. In practice it is usually used for construction and trade finance such as pre-shipment export finance.

52 Istisna’ Concept Contract to acquire goods on behalf of a third party Price paid to a manufacturer in advance of goods being purchased Payments received cover wages and costs of input supplies Applied to production of specific times Delivery at an agreed date

53 Parallel Istisna Concept
Islamic Investors Operator Deferred Payments Payment for sale of receivables Payment for supplies Project Manager Investment Bank Facility handover & payment to project manager

54 Tawarruq Concept Bank buys and owns the commodity
Commodity sold to the client at a mark-up Purchaser can authorise bank to sell commodity for a service commission Sale value deposited into clients account Client repays amount plus mark-up as deferred lump sun or in installments

55 Tawarruq Concept Vendor Islamic Bank Client Third Party
Initial transfer of title Final transfer of title Vendor Islamic Bank Client Payment Deferred Payment Plus Mark-Up Sale Payment Tawarruq Third Party

56 Salam Concept Financier pays price of commodity in advance in full
Quantity and delivery date and place specified Financier may enter parallel salam to sell commodity at a slightly higher price if period shorter to delivery Price differential represents financier’s profit Risk involved to justify profit as time period of contracts may not coincide and financier exposed

57 Parallel Salam Concept
Payment in full at inception Investor Asset for 90 day delivery Euros Payment to Investor after 30 days, Euros Asset delivery to client Euros Client Sale of asset for spot price Euros

58 Wakala Concept A contract appointing an agent to act on behalf of a principal party Parallel with granting a power of attorney or an enduring power of attorney Wakil may be paid a fee, rather than sharing in profit as with mudarabah

59 Wakala Structure Shariah Board Principal Wakil Investments

60 CALIBRI BOLD 42 pt Fund Utilization Products Home Equity Loan
Mortgage Loan Auto Loan Personal Loan (Home renovation, Education, Travel, Home/Office equipment loans) Small Business Loan Decreasing installment home loan Consumer Price Indexed loan Rent Finance Leasing Letter of Guarantee Letter of Credit

61 CARD PRODUCTS BÖLÜM BAŞLIĞI CALIBRI BOLD 42 pt

62 CALIBRI BOLD 42 pt Card Products Principal Member of Member of

63 CALIBRI BOLD 42 pt Card Products Classic Cards PersonalCredit Cards
Gold Cards Platinum Cards Commercial Cards Business Classic Cards Business Gold Cards Palmiye Cards Debit Cards

64 ADC PRODUCTS BÖLÜM BAŞLIĞI CALIBRI BOLD 42 pt

65 CALIBRI BOLD 42 pt ADC Products POS Services Internet Branch Banking
ATM Services Kiosk Services SMS Banking Telephone Banking Mobile Banking Bill Payment Tax Payment Customs Payment Salary Payment Social Security Payment Corporate website management

66 CALIBRI BOLD 42 pt ADC Products-ATM Membership of Common Point
Network (6000 ATM) 1.5 Million Transactions a year Mark-up on cash advance Not permitted

67 CALIBRI BOLD 42 pt ADC Products-POS Membership of Common Point
120 ATM Membership of Common Point Network (6000 ATM) 1.5 Million Transactions a year Mark-up on cash advance Not permitted

68 Thank You BÖLÜM BAŞLIĞI CALIBRI BOLD 42 pt


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