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Modern Islamic Banking

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NATALIE SCHOON

Products and Processes in Practice

Modern Islamic Banking

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This edition first published 2016

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Library of Congress Cataloging-in-Publication Data

Names: Schoon, Natalie, author.

Title: Modern Islamic banking : products, processes in practice / Natalie

Schoon.

Description: Chichester, West Sussex : John Wiley & Son, 2016. | Series: The

Wiley finance series | Includes bibliographical references and index.

Identifiers: LCCN 2015043806 (print) | LCCN 2015049132 (ebook) | ISBN

9781119127208 (hardback) | ISBN 9781119127222 (ePDF) | ISBN 9781119127215

(epub)

Subjects: LCSH: Banks and banking—Islamic countries. | Banks and

banking—Religious aspects—Islam. | Finance—Islamic countries. |

Finance—Religious aspects—Islam.

Classification: LCC HG3368.A6 S343 2016 (print) | LCC HG3368.A6 (ebook) | DDC

332.10917/67—dc23

LC record available at http://lccn.loc.gov/2015043806

Cover Design: Wiley

Cover Image: © javarman/Shutterstock

Set in 10/12pt and Times LT Std by SPi-Global, Chennai, India

Printed in Great Britain by TJ International Ltd, Padstow, Cornwall, UK

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To Basil for being my best friend, and for occasionally being patient

vii

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Contents

List of Figures xi

List of Tables xiii

Acknowledgements xv

About the Author xvii

Introduction xix

CHAPTER 1Historical Developments 11.1 The History of Finance 1

1.2 The History of Islamic Finance 5

CHAPTER 2Economic Principles 72.1 Early Economic Thought 7

2.2 The Prohibition of Interest 9

2.3 Modern Economics and Banking 36

2.4 Islamic Ethics 38

2.5 Contracts and Prohibitions 40

2.6 Sharia’a and Prohibitions 43

CHAPTER 3Islamic Finance Products Explained 513.1 Definitions 51

3.2 The Asset 52

3.3 Transaction Types 53

3.4 Bond-Like Instruments 63

viii CONTENTS

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CHAPTER 4Distribution of Islamic Products 734.1 Distribution Channels and Sharia’a Compliance 73

4.2 Sharia’a Compliant versus Sharia’a Based 74

4.3 Competition or Opportunity 75

CHAPTER 5Application of Islamic Products in Retail Finance 775.1 Current Accounts 77

5.2 Credit Cards 78

5.3 Deposit Accounts 79

5.4 Funds 83

5.5 Mortgage Products 84

5.6 Personal Loans 85

5.7 Transfers 87

CHAPTER 6Application of Islamic Products in Treasury 896.1 Interbank Liquidity 89

6.2 Hedging 94

6.3 Combination of Transaction Types 98

6.4 Asset-Based Securities 99

6.5 Syndication 99

CHAPTER 7Application of Islamic Products in Corporate Finance 1017.1 Trade Finance 101

7.2 Project Finance 103

7.3 Property Finance 108

7.4 Leasing 113

CHAPTER 8Application of Islamic Products to Private Equity 115

CHAPTER 9The Role of the London Metal Exchange 1179.1 The London Metal Exchange 117

9.2 Warrants 118

9.3 LME Base Metals 119

CHAPTER 10Asset Management 12110.1 Selection of Sharia’a compliant investments 122

10.2 Types of Funds 124

Contents ix

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CHAPTER 11Risks in Islamic Banks 125

CHAPTER 12Governance 12912.1 Roles 130

12.2 Social Responsibilities 132

12.3 Structures and Variations of Sharia’a Supervisory Boards 133

12.4 Serving on Multiple Boards 133

CHAPTER 13The Islamic Financial Infrastructure 13513.1 Regulatory Institutions 135

13.2 Socially Responsible Investments and Micro-finance 137

13.3 The Case for LIBOR 139

CHAPTER 14Capital Adequacy Concerns 14114.1 Challenges within the Basel Capital Adequacy Framework 141

14.2 IFSB Capital Adequacy Standards 142

14.3 Capital Adequacy for Islamic Banks around the World 148

14.4 Expected Future Developments in Capital Adequacy 149

CHAPTER 15How to Value a Bank 15115.1 The Components 152

15.2 The Models 153

15.3 The Special Case of Banks 154

15.4 The Special Case of Islamic Banks 154

15.5 Can a Bank be Valued? 155

CHAPTER 16The Future 157

GLOSSARY 159

SELECT BIBLIOGRAPHY 161

INDEX 163

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List of Figures

Figure 2.1: Dimensions of Islam 39

Figure 3.1: Simple musharaka transaction 55

Figure 3.2: Simple mudaraba structure 55

Figure 3.3: Simple murabaha structure 56

Figure 3.4: Operating lease 57

Figure 3.5: Finance lease 57

Figure 3.6: Simple salam structure 58

Figure 3.7: Simple istisna structure 59

Figure 3.8: Simple parallel istisna structure 59

Figure 3.9: Parties involved in a letter of credit transaction 61

Figure 3.10: Simple arbun structure 62

Figure 3.11: Generic sukuk structure 65

Figure 3.12: Sukuk al musharaka 67

Figure 3.13: Sukuk al mudaraba 67

Figure 3.14: Sukuk al ijara 68

Figure 3.15: Sukuk al salam 69

Figure 3.16: Sukuk al istisna 70

Figure 5.1: Two-tier mudaraba or wakala structure for savings accounts 80

Figure 5.2: Two-tier mudaraba or wakala structure for fund management 83

Figure 5.3: Lease for personal finance 85

Figure 5.4: Murabaha for personal finance 86

Figure 5.5: Commodity murabaha for personal finance 87

Figure 6.1: Simple commodity mudaraba structure 89

Figure 6.2: Commodity murabaha, deposit given 90

Figure 6.3: Commodity murabaha, cash and warrant flow 91

Figure 6.4: Reverse commodity murabaha, deposit taken 92

Figure 6.5: Reverse commodity murabaha, cash and warrant flow 92

Figure 6.6: Tawarruq 93

Figure 6.7: Two-tier wakala structure for liquidity management 94

Figure 6.8: Exchange of deposits 97

Figure 6.9: Profit rate swap 98

Figure 7.1: Murabaha in trade finance 102

Figure 7.2: Tawarruq in trade finance 103

Figure 7.3: Musharaka transaction in project finance 106

Figure 7.4: Istisna in project finance 107

Figure 7.5: Lease applied to property finance 109

xii LIST OF FIGURES

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Figure 7.6: Sale and lease-back applied to property finance 109

Figure 7.7: Salam for property development 110

Figure 7.8: Istisna in property finance, financing developer 111

Figure 7.9: Istisna in property finance, financing end client 111

Figure 7.10: Tawarruq in property finance 112

Figure 7.11: Finance lease 113

Figure 8.1: Musharaka transaction for private equity 115

Figure 12.1: Sharia’a approval process for a new product or structure 131

Figure 12.2: Sharia’a approval process for changes to an existing product or structure 131

Figure 12.3: Role of the SAB within the industry 132

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List of Tables

Table 1.1: Selected entries from the Code of Hammurabi 2

Table 3.1: Selected word list 51

Table 7.1: Rental payment components 114

Table 9.1: LME base metals 119

Table 11.1: Types of risks for conventional banks 126

Table 14.1: Risk weight for sukuk in the trading book (IFSB) 147

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Acknowledgements

When I first started to research Islamic finance, the thing I missed most was a book that

would give me some indication of how this new type of finance fitted in with other parts of

the financial industry. With that not being available, I started to compile a large selection of

notes, which eventually made their way into this book. It has been discussed and debated with

many people around the world, and it has been proofread and commented on by some of my

best friends. I have listened to feedback from students, scholars and practitioners and hope I

have not omitted any valuable information.

It all started when I was living in Bahrain and Kuwait, and I owe a lot of what I know

about Islamic finance to Professor Simon Archer who supervised my PhD thesis and his

co-supervisor Professor Rifaat Abdel Karim. The list of other people who have helped and

supported me is too long to include in just a page, and I would be too worried lest I acciden-

tally omitted anyone. Suffice to say, you know who you are and you have my heartfelt thanks

and appreciation. Any mistakes, errors and omissions that remain are mine.

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xvii

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About the Author

Natalie Schoon is Principal Consultant with Formabb, providing advisory services and

training for financial institutions in Islamic finance, treasury, risk management, and rules

and regulations. She is on the board of advisors of Noriba Investing, which manages halal investment portfolios for its clients, and is a visiting fellow at the ICMA Centre in Read-

ing. She is also an accredited trainer for the Islamic Finance qualification offered by the

Chartered Institute of Securities and Investments. Natalie is a Chartered Financial Analyst

and Certified Anti Money Laundering Specialist, and holds a PhD in Financial Valuations

for Banks and Islamic Banks, an MBA in Banking and Finance and a Master of Laws in

Islamic and Middle Eastern Law (with Distinction). She has worked for financial institutions

including ABN Amro, Gulf International Bank, Barclays capital and the Bank of London and

the Middle East. She has designed and implemented Islamic financial structures for a fund

lending to agricultural and agriculture-related businesses for a USAID-funded programme in

Afghanistan and is currently working on a solution for access to (Islamic) finance for female

entrepreneurs.

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