The Basics of Islamic Finance – Part II

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Trade Financing Matters welcomes this guest post by Gohar Jawahir Bilal, Managing Partner North Sea Capital, UK

Conventional finance followed trade growth from West to East.  Today, South to South trade is increasing and estimated to be 46% of global financing compared to 35% in 2001. This is creating global opportunities for conventional and Islamic finance. Global Islamic assets are estimated to be $4.1trill of which $1trill are with Islamic banks (1% of global bank assets) confirming that growth will attract global players. The rules of Islamic finance promote contributing to the economy, encouraging trade – buying / selling assets and goods. What better place to find such assets than trade transactions facilitating corporates and staying plugged into the real economy!

Commodity Murabaha Structure

Banks typically use the “commodity murabaha” structure to facilitate Letter of credit (LC), open account and inventory financing. Commodity murabaha is a cumbersome financial structure. Let me demonstrate.

You want to buy a bag of sugar for a $100. You open a $100 LC, and you want your bank to fund this and pay the bank later.  Remember my prior post and follow “ownership” i.e. what you own you can sell at any price. Also, don’t get distracted by the type of commodity I mention below.  The objective is for the Bank to give me $100 financing.

    1. The bank will initially buy a commodity “typically a metal” = for $100 from an accredited commodity broker. Assume bank buys Aluminum = $100. Because it will own it, it can now sell this at any price.
    2. Bank will sell Aluminum to you for $105 = $100 principal + $5 profit.
    3. Ownership will transfer from bank to you. You buy this asset for $105 and agree to pay in 1 month. This means you have an obligation = $105 = debt payable the bank at end of 1 month = tenor.
    4. You now own Aluminum for which you owe the bank $105 in one month; but you don’t want Aluminum; you want cash= $100 to pay sugar bag seller.
    5. While you could sell this asset at any price, typically this is a back to back transaction, where the objective is to crystallize the asset i.e. get the cash ($ 100). So you will sell the Aluminum for $100 (via bank as your agent to another accredited broker).

 

Why a metal and not sugar?

Banking facilitates the flow of money with limited involvement in physical trade of assets as this creates additional risks for banks. This is where the challenges begin for Islamic finance. Banking regulations are fundamentally designed for debt whereas Islamic finance is built around ownership. At the very least Islamic finance must operate in a “regulated environment” to keep checks, balance and discipline. Effectively the objective to use a metal in a commodity murabaha is to have a tangible asset whose sale/purchase effectively results in an obligation (debt) on the client and booked as loan on the bank’s balance sheet. The commodity is a means of exchanging and itself does not impact the balance sheet. The commodity murabaha is executed using certain metals and the list of metals is standardized.

According to industry studies, nearly 80% of Islamic bank assets are murabaha. The structure has limitations. For example: because murabaha is sale at a profit it can only be used for short term transactions as profit once fixed cannot be changed plus the obligation can only be transferred at par. The operational execution is not efficient, paper intensive with a potential for increased operational risk if not properly streamlined. The upside is that existing regulations and accounting rules allow booking this as a loan; documentation and processes are standardized by large banks and clients are aware of the structure. There is a school of thought that believes this product is like conventional interest and for Islamic finance to progress, it needs to move away from murabahas towards structures that are truly linked to trade and risk –reward sharing.

Islamic banks use supporting infrastructure like UCP 600 and clauses, terms are reviewed to ensure that interest does not enter the Islamic transactions. Also, we can tailor the BAFT - IFSA Master Participation Agreements (MPA) to suit Islamic trade finance i.e. an Islamic MPA. Conventional banks who want to expand their business with Islamic banks or in regions where Islamic finance is growing can develop the same.

In Islamic finance, while there is a current focus on Islamic Bonds (called Sukuk), the biggest growth potential is in Islamic trade finance particularly in Inventory, receivables, payable finance, pre-payment loans and asset backed finance. While there are solutions, they are not main stream and can be significantly improved. Institutions with structuring, placement capabilities, less cumbersome infrastructure, ability to put in place technical platform are better positioned to offer competitive, efficient trade finance solutions tapping a wider investor base. With growth in Africa, Asia and the Middle East despite the slump in oil prices global economies will need essential goods and commodities and institutions with the ability to design favorable + competitive solutions for their client – like all times will find opportunities both in Islamic and conventional space.

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