Financial Risk Manager

Over the last three decades Islamic banking and finance has developed into a full-fledged system and discipline reportedly growing at the rate of 15 percent per annum. Today, Islamic financial institutions, in one form or the other, are working in about 75 countries of the world. Besides individual financial institutions operating in many countries, efforts have been underway to implement Islamic banking on a country wide and comprehensive basis in a number of countries. The instruments used by them, both on assets and liabilities sides, have developed significantly and therefore, they are also participating in the money and capital market transactions. In Malaysia, Bahrain, Pakistan and a few other countries of the Gulf, Islamic banks and financial institutions are working as a system parallel with the conventional system.

Owing to the growing amount of capital availability with Islamic banks, the refining of Islamic financing techniques and the huge requirement of infrastructure development in Muslim countries there has been a large number of project finance deals in the recent past particularly in the Middle East region. Islamic banks now participate in a wide financing domain stretching from simple Shariah-compliant retail products to highly complex structured finance and large-scale project lending. These projects include power stations, water plants, roads, bridges and other infrastructure projects. Bahrain is the leading centre for Islamic finance in the Middle East region. The establishment of the Prudential Information and Regulatory Framework for Islamic Banks (PIRI) by the BMA in conjunction with AAOIFI has gone a long way towards establishing a legal and regulatory framework to meet the specific risks inherent in Islamic financing structures.

Islamic banking has been defined as banking in consonance with the ethos and value system of Islam and governed, in addition to the conventional good governance and risk management rules, by the principles laid down by Islamic Shariah.

Interest free banking is a narrow concept denoting a number of banking instruments or operations, which avoid interest. Islamic banking, the more general term is expected not only to avoid interest-based transactions, prohibited in the Islamic Shariah, but also to avoid unethical practices and participate actively in achieving the goals and objectives of an Islamic economy.

Islamic Shariah prohibits ‘interest’ but it does not prohibit all gains on capital. It is only the increase stipulated or sought over the principal of a loan or debt that is prohibited. Islamic principles simply require that performance of capital should also be considered while rewarding the capital. The prohibition of a risk free return and permission of trading, as enshrined in the Verse 2:275 of the Holy Quran, makes the financial activities in an Islamic set-up real asset-backed with ability to cause ‘value addition’.

Islamic banking system is based on risk-sharing, owning and handling of physical goods, involvement in the process of trading, leasing and construction contracts using various Islamic modes of finance. As such, Islamic banks deal with asset management for the purpose of income generation. They will have to prudently handle the unique risks involved in management of assets by adherence to best practices of corporate governance. Once the banks have stable stream of Halal income, depositors will also receive stable and Halal income.

The forms of businesses allowed by Islam at the time the Holy Quran was revealed included joint ventures based on sharing of risks & profits and provision of services through trading, both cash and credit, and leasing activities. In the Verse II:275, Allah the Almighty did not deny the apparent similarity between trade profit in credit sale and Riba in loaning, but resolutely informed that Allah has permitted trade and prohibited Riba.

Profit has been recognized as ‘reward’ for (use of) capital and Islam permits gainful deployment of surplus resources for enhancement of their value. However, along with the entitlement of profit, the liability of risk of loss on capital rests with the capital itself; no other factor can be made to bear the burden of the risk of loss. Financial transactions, in order to be permissible, should be associated with goods, services or benefits. At macro level, this feature of Islamic finance can be helpful in creating better discipline in conduct of fiscal and monetary policies.

Steps for Islamization of banking and financial system of Pakistan were started in 1977-78. Pakistan was among the three countries in the world that had been trying to implement interest free banking at comprehensive/national level. But as it was a mammoth task, the switchover plan was implemented in phases. The Islamization measures included the elimination of interest from the operations of specialized financial institutions including HBFC, ICP and NIT in July 1979 and that of the commercial banks during January 1981 to June 1985. The legal framework of Pakistan's financial and corporate system was amended on June 26, 1980 to permit issuance of a new interest-free instrument of corporate financing named Participation Term Certificate (PTC). An Ordinance was promulgated to allow the establishment of Mudaraba companies and floatation of Mudaraba certificates for raising risk based capital. Amendments were also made in the Banking Companies Ordinance, 1962 (The BCO, 1962) and related laws to include provision of bank finance through PLS, mark-up in prices, leasing and hire purchase.

Accordingly, the State Bank issued detailed criteria in December 2001 for establishment of full-fledged Islamic commercial banks in the private sector. Al Meezan Investment Bank received the first Islamic commercial banking license from SBP in January 2002 and the Meezan Bank Limited (MBL) commenced full-fledged commercial banking operation from March 20, 2002. Further, all formalities relating to the acquisition of Societe Generale, Pakistan by the MBL were completed, and by June, 2002 it had a network of 5 branches all over the country, three in Karachi, one in Islamabad and one in Lahore. The MBL now maintains a long term rating of A+ and short term rating of A1+, assessed by JCR VIS Credit Rating Co Ltd, signifying a consistent satisfactory performance.

The Government as also the State Bank are mainly concerned with stability and efficiency of the banking system and safeguarding the interests, particularly, of small depositors. With this concern in mind it has been decided to operate Islamic banking side by side with traditional banking. The approach is to institute best practice legal, regulatory and accounting frameworks to support Islamic banks and investors alike. The year 2002-2003 witnessed strengthening measures taken in the areas of banking, non-bank financial companies and the capital markets.

Islamic Banking Institutions of Pakistan are offering a wide range of Shariah Compliant products & services. Murabaha is dominating the financing portfolio of IBIs. Similarly, Ijara, Musharaka and Diminishing Musharaka are also used depicting a noticeable share in total financing of IBIs. However, Mudaraba, Salam and Istisna portfolios still needs to be triggered. May be, in the coming years, by introduction the Shariah compliant Agricultural products, their share get increased. Presently, these financing have relatively small share as compared to Murabaha and Diminishing Musharaka.

A comprehensive range of Islamic Banking products and services is being offered, in order to meet customer's demand of Shariah Compliant Banking, in the following areas:

 Corporate /SME Banking
 Investment Banking
 Trade Finance
 General Banking
 Consumer Banking

Islamic Banking products have to be approved by the Bank's Shariah Advisor as instructed vide IBD Circular 2 of 2008. As per Shariah requirements, funds and products of Islamic Banking are managed separately from the Conventional Banking side. All funds obtained, invested and shared in Halal modes & investments, under supervision of the Shariah Advisor.

In order to ensure compliance with minimum Shariah standards by the banks conducting Islamic banking in Pakistan, the Commission for Transformation of Financial System set up in the SBP approved essentials of Islamic modes of financing.

These are model agreements which have been approved in line with Supreme Court Judgement on Riba. These include Musharaka, Mudaraba, Murabaha, Musawama, Leasing, Salam and Istisna. These model agreements are expected to facilitate the existing Islamic banking sector in creating awareness about Islamic banking products and to develop such products. These model agreements, however, can be modified, in conformity to the products designed by the banks conducting Islamic banking business. But to bring any kind of change in these model agreements, banks conducting Islamic banking operations, will seek approval of the Shariah Board of Islamic Commercial Banks or Shariah Adviser of banks having Islamic banking branches, ensuring that such changes are consistent with the principles of Shariah.

The industry over the years has managed to offer a wide array of products encompassing almost the entire range of Islamic modes of financing that are able to cater to the needs of majority of the sectors of the economy.

Asset Side


The segments covered by the industry through various Shariah compliant modes such as Murabaha, Mudaraba, Musharaka, Ijarah, Diminishing Musharaka, Salam, Istisna, Wakala and Islamic Export Refinance etc. include

• Corporate / Commercial,
• Agriculture,
• Consumer,
• Commodity Financing,
• SME sector,
• Treasury & Financial Institutions.

Also with the increased issuance of Sukuk by corporates investments of IBIs in these Shariah compliant instruments is on the rise.

Liability Side


On the Liability side, Islamic Banking Industry offers various Shariah compliant deposit schemes that are available for customers to invest their funds. These include

• Current Accounts,
• Basic Banking Account,
• Savings Accounts,
• Term Deposits of various maturities, and
• Certificates of Investment etc.

Current Account is mostly being offered on Qard basis whereas Mudaraba is the preferred mode used by Islamic banks for offering savings accounts, term deposits & certificates of investment.
Others

Some full fledged banks are also offering investment banking products and services including Sukuk Arrangement, Financial Advisory, Private Placement, Syndication, Trusteeship, Underwriting, Structured Finance, Listing on Capital Markets, Project Financing, Mergers & Acquisitions etc. Further, a variety of other ancillary services are also being offered in a Shariah compliant manner such as

• Bonds & Guarantees,
• Letters of Credit
• Remittances ( local & International),
• Online banking,
• ATM/debit card ( including Visa),
• Safe deposit lockers and
• Utility bill payments etc.
• Collection of export bills, assignment of export / local bills
• Inter-Bank funds transfer facility through ATM,
• E-Statement facility,
• Lockers,
• Phone Banking and 24 /7 Call Centre service.
• Deposit accepting ATMs

By Aamer Allauddin (FCCA), Member ACCA Pakistan Members

Introduction

In the organized sector of Pakistan the concept of Modarabas emerged in 1979 as a result of the Government's initiatives towards Islamization of the economy. For this purpose a Council named the Council of Islamic Ideology was set-up. This Council was given the task of devising a blueprint for the Islamization of the economic and financial sectors. The promotion of Modarabas was an important component of this blueprint.

The Modaraba Concept

The term Modaraba is an Arabic term and implies a contract between two parties, whereby one party, the Rab-ul-mal entrusts money to the other party called the Mudarib, to put in his management expertise and utilize it in agreed manner. Profits of the Modaraba are shared in a pre agreed ratio and losses in the proportion of the capital invested. In other words, it is an arrangement between a capital provider and an entrepreneur, whereby the entrepreneur can mobilize the funds of the former for business activity. The entrepreneur provides expertise and management.

For example a bank would make Shariah compliant investments and share the profits with the customer, in effect charging for the time and effort. If no profit is made, the loss is borne by the customer and the bank takes no fee. The bank is compensated for the time value of its money in the form of a floating rate that is pegged to the debtor's profits.

Legal Framework

Modaraba Companies and Modaraba (floatation & control) Ordinance was promulgated in 1980 to provide the statutory framework for organizing business enterprises according to the injunctions of Islam. This piece of legislation refined the Modaraba concept and brought it in conformity with the prevalent corporate structure. The Modaraba Companies and Modaraba Rules, 1981 have been framed under the Ordinance.

Types of Modaraba

The two types of modaraba practiced in Pakistan are:

1. multipurpose modaraba with more than one objective

2. specific purpose modaraba with a particular purpose

Modarabas can further be divided into two categories:

1. Modaraba al Muqayyadah (restricted Modaraba) is where the Rab-ul-mal specifies a particular business or place of business for the Mudarib.

2. Modaraba al Mutlaqah (non-restricted Modaraba) is where the Rab-ul-mal affords full freedom to the Mudarib to undertake any business the latter wishes. However, the Mudarib is not allowed to provide finance to anyone without the consent of the Rab-ul-mal. The Mudarib is authorized to do what is normal in the course of business, but anything beyond the normal routine of the business concerned will require permission from the Rab-ul-mal. The Mudarib is also forbidden to have another partnership or Mudarib, or mix his own investments in the modaraba concerned without having first obtained the Rab-ul-Mal's consent.

A modaraba may be either for a fixed period or for an indefinite period (perpetual modaraba). A modaraba floated for a fixed period or for a specific purpose shall be wound up by the Modaraba Management Company itself on the expiry of the period fixed for the modaraba or the accomplishment of the purpose of the modaraba, as the case may be.

Nature of Business

Majority of the modarabas in Pakistan are in the financial sector, although there is no restriction on the nature of business except that it should be according to the injunctions of Islam. The business / financing activities currently undertaken by modarabas in Pakistan are ijarah/leasing, morabaha, musharika, trading, equity/portfolio financing and manufacturing /distribution.

No modaraba shall be a business which is opposed to the injunctions of Islam and the Registrar shall not permit the floatation of a modaraba unless the Religious Board has certified in writing that the modaraba is not a business opposed to the injunctions of Islam.

Formation & Management

The Mudarib establishes a Modaraba Management Company (MMC) with the approval of the Registrar of Modarabas. No modaraba company shall operate without registration with the Registrar. Modaraba Management Company means a company engaged in the business of floating and managing a Modaraba. Essentially the MMC is the Mudarib and can establish a series of Modarabas for different business ventures with the approval of the Registrar and the Religious Board, bearing in mind that each modaraba is separate and distinct from the other and also from the MMC. The Registrar scrutinizes the application and after he is satisfied, submits it to the Religious Board for approval.

The Religious Board is constituted by the Federal Government and the role of its members shall be to examine and review the prospectus of a modaraba and certify that the business undertaken by the modaraba complies with Shariah principles, before the public offer is made.The Registrar may grant authorization certificate to float a modaraba only after clearance of the proposal by the Religious Board.

Following registration of the MMC, the Mudarib applies to make a public offer of modaraba funds through a prospectus. The Modaraba cannot commence business till the minimum amount stated in the prospectus has been raised, the modaraba certificates thereof have been allotted and a prescribed declaration in this regard signed by Chief Executive has been filed with the Registrar.

The Modaraba is a legal person and can sue and be sued in its own name through the MMC, and the assets and liabilities of each modaraba shall be separate and distinct from those of another modaraba as also from those of the MMC.

Profit and Loss sharing

Both parties i.e. the Mudarib and the Rab-ul-mal agree right at the outset on the proportion of profit that each is entitled to. This is based on mutual consent, as no specific proportion is defined under Shariah law. In the case of absence of a predetermined distribution ratio, the profit shall be shared equally.

Neither the Mudarib nor the Rab-ul-mal is allowed to allocate a specific amount of profit to any party, nor can profit be tied at specific rate to the capital. For example, they cannot agree to the Mudarib getting Rs. 10,000 of the profit or the Rab-ul-mal receiving a 15% share of the capital. However, proportionate sharing of the profit is allowed, such as 10% of profit to Mudarib and 90% of profit to Rab-ul-mal.

The law requires that the MMC subscribes at least 20% of the total amount of subscription in each modaraba floated by it. In order to compensate it, the MMC will get as remuneration, a fixed percentage of the net annual profit of the modaraba which shall not exceed 10% of such net annual profit as shown in the audited profit and loss account of the modaraba. The distribution of profit shall include distribution in cash or issue of bonus certificates out of the capitalized profit or any other security.

Tax Treatment of Modarabas

Under clause 100 of Part I of the Second Schedule to the Income Tax Ordinance, 2001, the income of non-trading modarabas is exempt from income tax, provided not less than 90% of its profits (as reduced by the amount transferred to a mandatory reserve) are distributed to the certificate holders. For the purpose of determining the distribution of ninety per cent, the profits distributed through bonus certificates to the certificate holders shall not be taken into account.

Future Outlook

Modarabas have a dynamic and progressive role to play in the Islamization of the financial system of the country. There is an appropriate infrastructure in place with nearly 30 years of practical experience. However, despite this, the modaraba sector has not performed as expected and their contribution in the financial sector has been insignificant. The total market capitalization of modarabas is still a tiny fraction of financial sector cap.

Modarabas have not been very successful in mobilization of savings or deposits or diversification of their products to differentiate from other market players such as leasing companies. Today the bulk of their business is primarily leasing which does not provide any market niche or comparative advantage to the sector. However, a point to note is that there have been a few successful models of modarabas engaged in manufacturing.

Modarabas need to innovate, improve their products and operational capabilities and at the same time become more competitive in their cost of funding. Reliance on banks would always place them at a cost disadvantage and there is a need to tap other sources which remain unrealized and do not flow to the banking sector. There are many savers who do not want to use the banking system and are looking for Shariah compliant products. In order for the equity base of Modarabas to expand, the Modaraba Association of Pakistan has been encouraging mergers and consolidations of the existing Modarabas. There is further room to grow and develop the sector given the increasing demand for Islamic products.