Case Studies in Islamic Banking and Finance

Contents

Cover

Series

Title Page

Copyright

Dedication

Preface

WHAT IS A CASE STUDY?

THE CASE METHOD AS A LEARNING TOOL

HOW TO DO A CASE STUDY

Introduction

WHAT ARE THE PRINCIPLES OF ISLAMIC BANKING AND FINANCE?

About the Author

Chapter 1: Case Study 1: Ijara Contract

1.1 LEARNING OUTCOMES

1.2 ROLE OF IJARA IN ISLAMIC FINANCE

1.3 THE IJARA CONTRACT AS A MODE OF ISLAMIC FINANCE

1.4 APPENDIX: IJARA FATWA

1.5 CASE STUDY QUESTIONS

Chapter 2: Case Study 2: Musharaka Contract

2.1 LEARNING OUTCOMES

2.2 ROLE OF MUSHARAKA IN ISLAMIC FINANCE

2.3 SUMMARY OF MUSHARAKA

2.4 SHARIA’A RULES FOR PROFIT AND LOSS WITH MUSHARAKA

2.5 MANAGEMENT OF MUSHARAKA

2.6 SHARIA'A RULES FOR MUSHARAKA

2.7 CASE 1

2.8 CASE 2

Chapter 3: Case Study 3: Diminishing Musharaka Contract

3.1 LEARNING OUTCOMES

3.2 DIMINISHING MUSHARAKA AS A MODE OF ISLAMIC FINANCE

3.3 SUMMARY OF DIMINISHING MUSHARAKA

3.4 SHARIA’A RULES FOR A DIMINISHING MUSHARAKA CONTRACT

3.5 WHAT IS THE DIFFERENCE BETWEEN IJARA WA IQTINA AND DIMINISHING MUSHARAKA?

3.6 APPLICATIONS OF DIMINISHING MUSHARAKA

3.7 CASE ASSUMPTIONS

3.8 SHARIA’A CONSIDERATIONS TO BE NOTED

3.9 PRACTICAL SHAPE OF THE TRANSACTION

3.10 CASE STUDY QUESTIONS

Chapter 4: Case Study 4: Mudaraba Contract

4.1 LEARNING OUTCOMES

4.2 MUDARABA AS A MODE OF ISLAMIC FINANCE

4.3 MUDARABA AND PLS – PURE ISLAMIC BANKING

4.4 CASE 1: SHARIA’A ISLAMIC BANK

4.5 MUDARABA CONTRACT WITH VARIOUS PARTNERS

Chapter 5: Case Study 5: Murabaha, Musharaka, Ijara and Ijara wa Iqtina Contracts

5.1 LEARNING OUTCOMES

5.2 CASE 1: MURABAHA CONTRACT

5.3 CASE 2: MUSHARAKA CONTRACT

5.4 CASE 3: IJARA: OPERATING LEASE CONTRACT

5.5 CASE 4: IJARA WA IQTINA: FINANCE LEASE CONTRACT

5.6 CASE 5: MUDARABA WITH MURABAHA CONTRACTS

Chapter 6: Case Study 6: Islamic Home Finance

6.1 LEARNING OUTCOMES

6.2 SHARIA’A-COMPLIANT MORTGAGES

6.3 SHARIA’A-COMPLIANT STRUCTURES FOR ISLAMIC HOME FINANCE

6.4 APPENDIX 1: MANZIL HOME PURCHASE PLANS (MURABAHA)

6.5 APPENDIX 2: DEVON BANK

6.6 APPENDIX 3: MANZIL HOME PURCHASE PLANS (IJARA)

6.7 APPENDIX 4: DEVON BANK

6.8 APPENDIX 5: MEEZAN ‘EASY HOME’ DIMINISHING MUSHARAKA AGREEMENT

6.9 CASE STUDY QUESTIONS

Chapter 7: Case Study 7: Sources of Finance for Islamic Banks

7.1 LEARNING OUTCOMES

7.2 WHERE DO ISLAMIC BANKS GET THEIR MONEY FROM?

7.3 SOURCES OF FUNDS FOR ISLAMIC BANKS

7.4 CASE STUDY QUESTIONS

Chapter 8: Case Study 8: Financial Statement Analysis for Islamic Banks

8.1 LEARNING OUTCOMES

8.2 HOW DO THE FINANCIAL STATEMENTS OF ISLAMIC BANKS DIFFER FROM THOSE OF CONVENTIONAL BANKS?

8.3 CASE STUDY ACTIVITIES

8.4 CASE STUDY QUESTIONS

Chapter 9: Case Study 9: Islamic Investment Prohibitions

9.1 LEARNING OUTCOMES

9.2 MUSLIMS HAVE STRICT RULES ABOUT WHAT THEY ARE ALLOWED TO INVEST IN

9.3 ISLAMIC INVESTMENT PROHIBITIONS

9.4 THE PROHIBITION OF INTEREST (RIBA)

9.5 ZAKAT AND ISLAMIC PROHIBITIONS

9.6 CASE STUDY QUESTIONS

Chapter 10: Case Study 10: Opening an Islamic Bank Within a Western Regulatory Framework

10.1 LEARNING OUTCOMES

10.2 FIRST ISLAMIC BANK IN THE EUROPEAN UNION

10.3 ISSUES IN CREATING AN ISLAMIC BANK WITHIN A WESTERN REGULATORY FRAMEWORK

10.4 CASE STUDY QUESTIONS

Chapter 11: Case Study 11: Leverage and Islamic Banking

11.1 LEARNING OUTCOMES

11.2 LEVERAGE AND ISLAMIC BANKING

11.3 WHAT IS FINANCIAL LEVERAGE?

11.4 FINANCIAL TERMINOLOGY: A GUIDE

11.5 CASE STUDY ASSUMPTIONS

11.6 CASE STUDY QUESTIONS

Chapter 12: Case Study 12: Impact of Non-performing Loans on Islamic and Conventional Banks

12.1 LEARNING OUTCOMES

12.2 ISLAMIC BANKING PRINCIPLES INVOLVE RISK SHARING, WHICH SHOULD MAKE THEM LESS VULNERABLE THAN THEIR CONVENTIONAL COUNTERPARTS

12.3 EQUITY-BASED VERSUS DEBT-BASED BANKING

12.4 CASE STUDY ASSUMPTIONS

12.5 CASE STUDY QUESTIONS

Case Study Answers

CASE STUDY 1: IJARA CONTRACT

CASE STUDY 2: MUSHARAKA CONTRACT

CASE STUDY 3: DIMINISHING MUSHARAKA CONTRACT

CASE STUDY 4: MUDARABA CONTRACT

CASE STUDY 5: MURABAHA, MUDARABA, IJARA AND IJARA WA IQTINA

CASE STUDY 6: ISLAMIC HOME FINANCE

CASE STUDY 7: SOURCES OF FINANCE FOR ISLAMIC BANKS

CASE STUDY 8: FINANCIAL STATEMENT ANALYSIS FOR ISLAMIC BANKS

CASE STUDY 9: ISLAMIC INVESTMENT PROHIBITIONS

CASE STUDY 10: OPENING AN ISLAMIC BANK WITHIN A WESTERN REGULATORY FRAMEWORK

CASE STUDY 11: LEVERAGE AND ISLAMIC BANKING

CASE STUDY 12: IMPACT OF NON-PERFORMING LOANS ON ISLAMIC AND CONVENTIONAL BANKS

Glossary

Bibliography

BOOKS

AAOIFI PUBLICATIONS

ARTICLES AND PAPERS

ALSO PUBLISHED BY THE AUTHOR

Index

For other titles in the Wiley Finance series

please see www.wiley.com/finance

This edition first published in 2011

© 2011 Brian Kettell

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To my wife Nadia, our son Alexei and daughter Anna.

Nadia keeps the whole fleet on an even keel with only the occasional shipwreck.

Preface

The Islamic finance industry is in the midst of a phenomenal expansionary phase, exhibiting average annual growth rates of about 15 per cent in recent years. This rapid growth has been fuelled not only by surging demand for Sharia'a compliant products from financiers from the Middle East and other Muslim countries, but also by investors around the world, thus rendering the expansion of Islamic finance a global phenomenon. Besides its wide geographical scope, the rapid expansion of Islamic finance is also taking place across the whole spectrum of financial activities, ranging from retail banking to insurance and capital market investments.

Educational and training material for the Islamic banking and finance industry is, however, lagging far behind the speed at which the industry is evolving. Indeed the lack of quality educational and training material has now become a serious obstacle to effective training and education. This book, the first ever case study book on Islamic banking and finance, is designed to enable students and practitioners to test their understanding of the underlying principles. Emphasis is placed on case studies and tests of the basic concepts. Suggested answers are provided.

The case study method was pioneered at Harvard Law School. A case study is expected to capture the complexity of a single case, and the methodology which enables this has developed within the social sciences. Such methodology is applied not only in the social sciences, such as psychology, sociology, anthropology, and economics, but also in practice-oriented fields such as environmental studies, social work, education, and business studies but has, until now, not been available to the Islamic finance industry.

WHAT IS A CASE STUDY?

A case study is a description of an actual business situation involving a decision to be made or a problem to be solved. It can be a real situation that actually happened just as described or where portions have been disguised for reasons of privacy. Most case studies are written in such a way that the reader takes the place of the manager whose responsibility is to make decisions to help solve the problem. In almost all case studies, a decision must be made, although that decision might be to leave the situation as it is and do nothing.

A case study is a research methodology common in social science. It is based on an in-depth investigation of a single individual, group, or event. Case studies may be descriptive or explanatory. The latter type is used to explore causation in order to find underlying principles. Rather than using samples and following a rigid protocol (strict set of rules) to examine a limited number of variables, case study methods involve an in-depth, longitudinal (over a long period of time) examination of a single instance or event: a case. They provide a systematic way of looking at events, collecting data, analysing information, and reporting the results. As a result the researcher may gain a sharpened understanding of why the instance happened as it did, and what might become important to look at more extensively in future research. Case studies lend themselves to both generating and testing hypotheses.

THE CASE METHOD AS A LEARNING TOOL

The case method of analysis is a learning tool in which students and Instructors participate in direct discussion of case studies, as opposed to the lecture method, where the Instructor speaks and students listen and take notes. In the case method, students teach themselves, with the Instructor being an active guide, rather than just a talking head delivering content. The focus is on students learning through their joint, co-operative effort.

Assigned cases are first prepared by students, and this preparation forms the basis for class discussion under the direction of the Instructor. Students learn, often unconsciously, how to evaluate a problem, how to make decisions, and how to orally argue a point of view. Using this method, they also learn how to think in terms of the problems faced. In courses that use the case method extensively, a significant part of the student's evaluation may rest with classroom participation in case discussions, with another substantial portion resting on written case analyses. For these reasons, using the case method tends to be very intensive for both students and Instructor.

HOW TO DO A CASE STUDY

While there is no one definitive Case Method or approach, there are common steps that most approaches recommend are followed in tackling a case study. It is inevitable that different Instructors will do things differently; this is part of life and will also be part of working for others. This variety is beneficial since it will show participants different ways of approaching decision making.

Instructors seeking to apply the case study methodology should follow an organised format as discussed below.

Beforehand (usually a week before), the participants get:

1. the case study,

2. (often) some guiding questions that will need to be answered, and

3. (sometimes) some reading assignments that have some relevance to the case subject.

Participants then work in completing the case and the procedure can be divided up into three components:

1. what participants need to do to prepare before the class discussion,

2. what takes place in the class discussion of the case, and

3. anything required after the class discussion has taken place.

For maximum effectiveness, it is essential that the instructor manages all three components.

It must be stressed that the newness of the industry means that designing quality educational and training material is fraught with problems, particularly with case studies. In addition to this newness the industry also faces the challenge of changing Sharia'a interpretations of many of the products. In addition the existence of different schools of Islamic jurisprudence (Fiqh) combined with controversies revolving around sukuk (Islamic bonds) has certainly created some uncertainties as to how the contracts are being applied. Recent high profile court cases have also created uncertainties about the applications of some of the contracts.

These factors lead to the potential for controversy over some of my suggested case answers. No doubt some of the answers will be disputed. I cannot claim to have universal answers and would ask that readers please assume that these may change over time.

If readers do feel strongly that they have an alternative case answer I would certainly welcome a dialogue. Indeed if anyone wishes to provide me with reasons for their proposed alternative solutions I would urge them to please do so. It is this dialogue which is so important for the health and future of the industry and I look forward to an active debate with the readers. My email is [email protected]

No answers to Case Studies 8 and 10 are provided. In one case it involves an Excel spreadsheet which should be simple to set up and the second case has the answers within the case itself.

Companion texts, Introduction to Islamic Banking and Finance and The Islamic Banking and Finance Workbook are available from the publishers.

Introduction

WHAT ARE THE PRINCIPLES OF ISLAMIC BANKING AND FINANCE?

Islamic financial institutions are those that are based, in their objectives and operations, on Qur'anic principles. They are thus set apart from ‘conventional’ institutions, which have no such religious preoccupations. Islamic banks provide commercial services that comply with the religious injunctions of Islam. Crucially, these banks provide services to their customers free from interest, (the Arabic term for which is riba), and the giving and taking of interest is prohibited in all transactions. This prohibition makes an Islamic banking system differ fundamentally from a conventional banking system.

Technically, riba refers to the addition in the amount of the principal of a loan according to the time for which it is loaned and the amount of the loan. In earlier, historical times there was a fierce debate as to whether the term riba relates to interest or usury, although there now appears to be consensus of opinion among Islamic scholars that the term extends to all forms of interest.

In Islamic law (the Sharia'a), riba means an addition, however slight, over and above the principal. According to the Federal Sharia'a Court of Pakistan the concept covers both usury and interest; is not restricted to doubled and redoubled interest; applies to all forms of interest, whether large or small, simple or compound, doubled or redoubled; and the Islamic injunction is not only against exorbitant or excessive interest, but also against even a minimal rate of interest. Financial systems based on Islamic tenets are therefore dedicated to the elimination of the payment and receipt of interest in all forms, and this taboo makes Islamic banks and other financial institutions different in principle from their conventional counterparts.

There is a range of modern interpretations of why riba is considered haram (forbidden) but these are strictly secondary to the religious underpinnings.

The fundamental sources of Islam are the Holy Qur'an and the Sunnah, a term that in Ancient Arabia meant ‘ancestral precedent’ or the ‘custom of the tribe’, but which is now synonymous with the teachings and traditions of the Prophet Mohammed as transmitted by the relaters of authentic tradition. Both of these sources treat interest as an act of exploitation and injustice and as such it is inconsistent with Islamic notions of fairness and property rights. Although it is often claimed that there is more than this to Islamic banking, such as its contribution towards economic development and a more equitable distribution of income and wealth, its increased equity participation in the economy and so on, Islamic banking nevertheless derives its specific raison d'être from the fact that there is no place for the institution of interest in the Islamic order.

This rejection of interest poses the central question of what replaces the interest rate mechanism in an Islamic framework. Financial intermediation is at the heart of modern financial systems. If the paying and receiving of interest is prohibited, how do Islamic banks operate? Here profit and loss sharing (PLS) comes in as a substitute for interest as a method of resource allocation and financial intermediation.

In fact, the basic idea of Islamic banking can be stated simply. The operations of Islamic financial institutions primarily are based on a PLS