CHAPTER 26

Treasury Operations of Islamic Banks

Introduction
The world’s financial markets are now taking serious notice of
the tremendous growth of Islamic banking in the international
markets. This can be substantiated by the fact that instead of
just having standalone Islamic funds and products, now more
and more banks and financial institutions are planning to
establish Islamic commercial banks or windows to provide
complete solutions to their Shariah sensitive customers.

Many innovative financial structures have been developed to

cater to different requirements of industrial and business
customers. However, as Islamic banking is still in its infancy stage,
emphasis has not been given on the development of inter bank
transactions and treasury operations under Islamic modes.

Recently, due to the entry of a number of new Islamic banks and

with the increase in balance sheets of the existing Islamic banks,
the need for development of Islamic treasury operations is being
acutely felt. Central banks of Bahrain and Malaysia have done
ramarkable development in this regard. However, Islamic banks
working in an environment where other Islamic banks either do
not exist or their operations are very small, face the real
challenge like Pakistan.

The purpose of this paper is to explore the ways through which

an Islamic bank can survive in such environment.

Need for Islamic Treasury Operation

Treasury operation of a conventional bank primarily involves
 268 Meezan Bank’s Guide to Islamic Banking

following operations:

1. Short term acceptances

2. Short term investment & liquidity management
3. Bill purchase & discounting of receivables (Factoring &
Forfeiting)
4. SPOT FX as well as, forward purchase and forward sale
5. Derivatives & options

The first two activities are usually practiced through the

borrowing and lending on the basis of interest/returns/yields
without underlying asset structures in the conventional
capital/money market. Involvement of Riba/interest in such
transactions renders them Haram/prohibited according to
Islamic Shariah. The last three (3rd, 4th and 5th) activities are
also not allowed in Shariah because of involvement of Gharar
as well as Riba.

However, one cannot disagree with the fact that all these
activities are extremely important for smooth running of any
bank and to facilitate trade and business. Therefore, there is a
strong need to develop Islamic alternatives to such products.

Suggested Solutions
Islamic alternatives for each operation are as under:

Short term Acceptances

In case Islamic banks need funds, they can access the short-term
money market on either of the following basis:

6. Musharakah/Mudarabah (Profit sharing/Fund Management)

7. Tawarruq
 Chapter # 26: Treasury Operations of Islamic Banks 269

Musharakah/Mudarabah contracts
In case Musharakah/Mudarabah are used for the purpose of
accepting funds from the market, following process may be
used:

1. Islamic bank will create or securitize a pool of assets

comprising Murabaha/Salam/Istisna and Ijarah
products/assets preferably booked with high rated clients of
the bank. The size of assets booked under Ijarah should be
at least 51% of the total pool size. However, if Hanafi School
of thought is adopted, then trading will be allowed even if
the non-liquid assets are less than 50% but the size of the
non-liquid assets should not be negligible, which means it
should at least be 10%.

2. The presence of the assets booked under the above-

mentioned modes (other than Musharakah and
Mudarabah), make the volatility of profits accruing in the
pool relatively lower.

3. Whenever the Islamic bank requires funds, they can contact

any financial institution (FI), which will invest in these Assets
on the basis of Musharakah/ Mudarabah only.

4. A specific weightage/ratio would be assigned to the FI,

keeping in view the agreed profit rate.

5. At the time of maturity of the investment, Islamic bank will

calculate the return on the pool and share of the FI would be
redeemed.

6. However, it is essential to have an effective pool management

system in the Islamic bank that can ensure that sources and
utilization of funds are known, balanced and verified at all
time.

7. Proper segregation of assets among different pools and their

 270 Meezan Bank’s Guide to Islamic Banking

profit sharing values (weightages) are assigned.

8. The FI pools are given a unique pool identification number

(pin) at the time of pool creation.

9. This pin is used for asset allocation, deal continuation and

other related accounting purposes.

10. Proper allocation of finanacing asset implies that related risk

and reward (profit or return) from the assets are properly
limited to a specific FI pool.

This arrangement can be employed if the volatility/ predictability

of profits in the pool is reasonably acceptable, so that the return
can be predicted easily.

However, it should be noted that the rules of Securitization in

Islamic finance should be adopted completely, details of which
may be explained separately.

Tawarruq
In some cases, Tawarruq arrangement can also be adopted in
the following manner:

11.Islamic bank will select a commodity/stocks, which is liquid

in nature (such as metals sold in Commodity Exchange or
shares of Microsoft Company etc.) with the consent of the
conventional bank.

12.Conventional bank will purchase the commodity from market

and would sell the commodity to Islamic bank on Murabaha
basis.
 Chapter # 26: Treasury Operations of Islamic Banks 271

3. After taking delivery, the Islamic bank will sell it to the

market on spot basis. In this way, Islamic bank will obtain the
required liquidity.

4. Islamic bank will pay the price of the commodity to

conventional bank on the due date.

Some institutions have developed products which are known as

Commodity Murabaha and Reverse Murabaha on the
aforementioned principles.

However, it should be noted that acceptability of Tawarruq

transaction as a mode of financing is a bit controversial subject
among the scholars. Some scholars allow this transaction to be
used as a mode of financing where each party transacts,
purchasing/ selling the commodities directly without making the
other as his agent to accomplish such transactions on his behalf.
Secondly, this transaction should be used only where no other
alternative except interest based financing is available. Therefore,
specific approval from Shariah Advisor should be obtained for
each transaction.

Placement and Liquidity Management

A major problem with Islamic banks is of Placements and
Liquidity Management. Islamic banks generally have problems
of surplus liquidity, rather than the lack of it. These issues may
be resolved in the following manner:

Musharakah/Mudarabah
Some conventional financial institutions such as leasing companies
and investment banks book assets in both Islamic and
conventional ways. Islamic bank should coordinate with these
institutions to segregate the accounting processes of assets
booked under
 272 Meezan Bank’s Guide to Islamic Banking

Islamic structures. After the segregation process, a pool of these

assets can be created.

Whenever Islamic banks have excess liquidity, they can place

their funds in these asset pools on the basis of Musharakah or
Mudarabah in the same way as the bank borrows liquidity from
conventional bank. The process would be reverse of the
borrowing product. Therefore, Profit and loss will be shared
between the financial institution and the Islamic bank as per
the principles of Musharakah and Mudarabah.

Islamic Bonds (Sukuks)

Dealing in conventional bonds is not permissible according to
Shariah because of the following two aspects.

1. Firstly, they represent a portion of Debt payable by the issuer.

Earning of any kind of profit on them falls under the
category of Riba/Prohibited Returns.

2. Second aspect of Bonds pertains to the trading of Bonds.

Shariah prohibits trading of debts (Bai Dayn) as it involves
Gharar (Uncertainty), because if the debt is sold to a third
person and the borrower defaults in repayment of loan,
there would not be recourse to the buyer of debt to
receive the debt from the seller of debt. Therefore, it is
uncertain (not confirmed) for the buyer of debt whether he
would be able to get the amount receivable from the
debtor or otherwise. Therefore, Shariah only allows Hawalah
(assignment of Debt), whereby the assignee of the debt has
recourse to the assignor in case the debtor/borrower
defaults in repayment. In short, since the sale of debt is not
allowed in Islam, therefore, the sale of bond even at their
face value is also not allowed.
 Chapter # 26: Treasury Operations of Islamic Banks 273

So it is very essential requirement to explore such alternatives

of Bond which can be traded freely in the secondary market in
Shariah compliant way. These alternatives can be developed
through the securitization of assets. The security created through
the securitization of assets represents the proportionate
ownership of the holder in illiquid or tradable assets. Trade of
such securities is permissible, as it will be tantamount to the
sale/ purchase of holder's proportionate share in the assets,
which is allowed in Shariah.

For the purpose of securitization, pool of assets needs to be

created and the operations of the pool would be as follows:

1. The Portfolio may contain mixture of Ijarah and Murabahah

assets. However, the proportion of Ijarah assets should be
greater than 50% of the total worth of the pool. As
mentioned above, if Hanafi school of thought is adopted,
trading will be allowed even if the non-liquid assets are less
than 50% but the size of the non-liquid assets should not
be negligible, which means at least 10%.

2. Every subscriber can be given a certificate, which represents

his proportionate ownership in the assets of the portfolio.

3. The Profit earned by the portfolio would be distributed

among the subscribers according to their ratio of
investment, after deduction of management fee of the
manager.

4. Loss, if any would also be shared among the subscribers on

pro rata basis.

5. Certificates can be bought and sold in the secondary market

at any value.
 274 Meezan Bank’s Guide to Islamic Banking

The above structure can be used to issue long-term bonds by

the governments and large corporations.

Government of Bahrain has successfully issued Salam Sukuk as

an Islamic alternative to treasury bills and Ijarah Sukuk as an
alternative to Bonds. Details of which can be obtained from
Bahrain Monetary Agency.

Issuance of Islamic Sukuk can also play a significant role in

liquidity management. A number of Islamic countries have
issued Sukuks for this purpose including Bahrain, Malaysia,
and Qatar. The Government of Pakistan has also issued such
certificates, initially in foreign currency and then in Pak Rupees.
As discussed above, the interesting thing about Sukuks is that
they can be traded at any value/price in the secondary market
just as any other treasury bill/bond. This feature of sukuks also
helps in managing liquidity in the same manner as Treasury
bills/bonds are used in the conventional market.

Reserve Requirement:
The central bank should also grant special permissions for
managing SLR and other statutory requirements through
maintaining SLR without interest. Sukuks can also be used for
this purpose. The Government of Pakistan (issued) sukuks are
being given the SLR eligibility by the State Bank of Pakistan which
is one of the major reasons for their success.

Forward Purchase and Sale of Currencies

Forward Purchase and Sale of currencies play a very important
role in facilitating imports and exports to hedge their proceeds.
Islamic bank cannot enter into forward sale/purchase contracts.
However, in case of genuine need of trade financing where
importers or exporters want to hedge/cover the risk of the
 Chapter # 26: Treasury Operations of Islamic Banks 275

fluctuation/volatility of the market, they can enter into promises

to sell/buy as against sell/purchase of foreign currencies at future
dates. The actual sale will take place on agreed date, but it
should only be used for genuine needs of trade, not for any
speculative transactions. Therefore, Shariah scholars have
issued guidelines for this purpose, which must be followed at
the time of execution of these transactions.

Spot Sale and Purchase of currencies can be traded in the same

manner as practiced conventionally. The term spot refers to the
delivery of both the currencies on the same day of execution of
Sale Contract whereas under the conventional system, the term
spot refers to delivery of both the currencies after two days of
execution of Sale Contract. Therefore, in all those transactions
where delivery of either of the currency is deferred (irrespective
of the number of days), they will not fall under spot sale but
Islamic Alternative of Promise to Sell/Buy will be used in such
transactions.

Bill Purchase
Bill purchase and its discounting is not allowed in Shariah as it
involves Bai Al Dain (sale of debt) and Riba. However, assignment
of debt (Hawalah Al Dain) is allowed.

The lawful alternatives of bill purchase and discounting as per

shariah may be resorted to through the following modes:

1. Musharakah/Mudarabah
2. Wakalah & Hawalah
3. Bai Salam of Currencies
4. Tawarruq
5. Murabaha
 276 Meezan Bank’s Guide to Islamic Banking

The mode of Musharakah is discussed as follows whereas the

remaining four methods have been discussed in Chapter 28.

Musharakah/ Mudarabah
The bank will enter into a Musharakah arrangement with the
exporter. The bank will invest with the exporter, an amount
equivalent to the existing receivables of the exporter (which are
to be discounted), for manufacturing/supplying of goods to
specifically identified customers of the exporter. Profit from these
customers of exporter will be shared between the bank and the
exporter as per agreed ratios. Profits can be shared at either of
the following levels:

1. Operating Profit Level

2. Net Profit Level.

The bank may agree with exporter that it will earn x% at

operating profit level and so on. The important thing is that the
bank and the exporter need to agree that some percentage of
profit earned from identified clients will be shared between
the parties. The bank can also hold existing receivables of
customer as security against this Musharakah. The security
can be used if any negligence is proved on the part of the
exporter.

Additionally, the bank may encash the bill on due date and
subsequently adjust them against the actual profits and losses.

Call and Put Options and Derivatives

The Option to Sell and Option to Purchase (Call and Put Options)
are allowed in Shariah. However, fee charged on the options
separately or transferring or selling these option which is known
as “Derivatives” having Gharar are not permissible because these
Options are right to sell/purchase of a subject matter given by
 Chapter # 26: Treasury Operations of Islamic Banks 277

the buyer/seller to seller/buyer and this right cannot be sold as

per Shariah.

Similarly, short sale is not allowed in Shariah, as Islam prohibits

selling anything which is not owned and possessed (physically or
constructively) by the seller. Therefore, long sell (after taking
possession) is allowed and short sale is not allowed. However,
it can be structured through promise to sell in case of any
genuine need.

It should also be noted that to sell a thing before ownership and

possession is allowed only in Bai Salam and Bai Istisna
transactions. Therefore, if required, transactions can be
structured by using any of the these modes complying with all
the conditions of Salam and Istisna.

Conclusion
Majority of the existing financial systems can be transformed
into a Shariah compliant structure if they are beneficial to trade
and real businesses. There is a strong need for a greater
interaction of Shariah scholars and finance professionals for the
development of smooth and practicable Shariah compliant
systems and procedures. Universities can also play a very
important role in creating such environment.