inter bank unrestricted wakalah - mr. ijlal alvi

Islamic Inter‐bank Market‐Liquidity Management ToolsLiquidity Management Tools Use of Wakalah Arrangement in IFI’s

Briefing/Workshop on Islamic Liquidity Management & Capital MarketMuscat Hall Bank Muscat Head Office OmanMuscat Hall, Bank Muscat Head Office, Oman5th & 6th May 2012

Ijlal Ahmed AlviChief Executive OfficerIIFMIIFM

Briefing/Workshop on Islamic Liquidity Management & Capital Market, 5th & 6th May 2012, Oman

Contents

1) E l ti f I l i Fi I d t & I l i C it l M k t1) Evolution of Islamic Finance Industry & Islamic Capital Markets

2) Liquidity Management in Islamic Finance Inter-Bank Unrestricted (On Balance Sheet) Wakalah Inter-Bank Unrestricted (On Balance Sheet) Wakalah

1Briefing/Workshop on Islamic Liquidity Management & Capital Market, 5th & 6th May 2012, Oman

What is International Islamic Financial Market (IIFM) ?Market (IIFM) ?

IIFM is the international Islamic financial market’s organization focused on the Islamic Capital & Money Market segment of the Islamic finance industry Its primary focus liesCapital & Money Market segment of the Islamic finance industry. Its primary focus lies in the standardization of Islamic financial products, documentation and related processes at the global level.

IIFM was founded with the collective efforts of the Central Bank of Bahrain BankIIFM was founded with the collective efforts of the Central Bank of Bahrain, Bank Indonesia, Central Bank of Sudan, Labuan Financial Services Authority (Malaysia), Autoriti Monetari Brunei Darussalam and the Islamic Development Bank (a multilateral institution based in Saudi Arabia).

Besides the founding members, IIFM is supported by its permanent member State Bank of Pakistan and further supported by a number of regional and international financial institutions as well as other market participants as its members. p p

The main strength of IIFM is pooling of expertise from banks, legal and other marketparticipants who work together under the guidance of Shari’ah scholars


What IIFM provides to the Industry?

Addressing the standardization needs of the industry & creating awareness

Universal platform to market participants through 'Global Working Groups' for thedevelopment of Islamic Capital and Money Market

Shari’ah harmonization in documentation products and processes Shari’ah harmonization in documentation, products and processes


Contents

1) E l ti f I l i Fi I d t & I l i C it l M k t1) Evolution of Islamic Finance Industry & Islamic Capital Markets

2) Liquidity Management in Islamic Finance Inter-Bank Unrestricted (On Balance Sheet) Wakalah Inter-Bank Unrestricted (On Balance Sheet) WakalahCollateralization


Evolution of Islamic Finance Industry & Islamic Capital MarketsIslamic Capital Markets

‐ Hedging & Risk Management‐ Liquidity Management Tools‐ Takaful & Re‐Takaful‐ Sukuk (Common & Hybrid)S d Al i A 2007+‐ Structured Alternative Assets

‐ Equity/ Funds/ Securities/ Indexes‐ Project Finance & Syndications‐Investment

Banking‐ Commercial Banking

2007+

‐ Sukuk (Ijarah, Musharaka, Istisna)‐ Structured Alternative Assets‐ Equity & Funds‐ Ijarah‐ Project Finance & Syndications

2000’s

‐ Equity‐ Ijarah‐ Project Finance & Syndications

Project Finance & Syndications‐ Commercial Banking

1990’s

‐ Project Finance & Syndications‐ Commercial Banking

‐ Project Finance & Syndications‐ Commercial Banking

1980’s

5

‐ Commercial Banking 1970’s


Islamic Capital Market Products vs Conventional Productsvs Conventional Products

Conventional Instrument

Characteristics Shari'ah Compliant Alternative

E it E it h ld th f th fi d ibl f d ti it A t dEquity Equity holders are the owners of the firm and responsible for conducting its affairs

Accepted

Preferred Stock A hybrid security that combines features of debt and equity ‐

Primes and Scores Equity is split into a prime component that has dividend and capital gains up to ‐a stated price and a score component that has capital gains above this

Warrants A long‐term call option on a firm's stock issued by the firm ‐

Synthetics Securities that allow combinations of assets to be obtained with low i

‐transaction costs

Acceptances A written promise to pay a given sum at a pre‐specified date Developed, but not negotiable

Commercial Paper A short‐term debt security that can be easily traded Developed, but not negotiable

BondsFloating Rate Bonds

A term obligation to make a series of fixed payments. The interest rate on the debt is based on LIBOR or the T‐Bill rate

Accepted

Securitized Loans Pools of mortgages or other types of loans that are publicly traded Accepted

6

Index‐linked Securities Bonds where the payment is linked to an inflation index or a commodity price Emerging


Islamic Capital Market Products vs Conventional Productsvs Conventional Products

Conventional Instrument

Characteristics Shari'ah Compliant Alternative

Convertibles A bond that can be swapped for equity at a pre‐specified ratio or vice versa DevelopedConvertibles A bond that can be swapped for equity at a pre‐specified ratio or vice versa Developed

Islamic Hedging (Profit Rate & Currency Swaps)

Transactions in which different streams of income are exchanged New Development

Options The right to buy or sell a security on or before a specified date Limited Acceptability

Commodity Futures Financial Futures

Contracts for the future delivery of a commodity.Contracts for the future delivery of currencies, securities, or an amount of money based on an index

Emerging

y

Exchangeable Exchangeable Sukuk to equity‐linked instruments DevelopedCollateralization Secured financing and Sukuk tradability EmergingRepo The borrower sells securities outright to the lender and at the same time

agrees to buy equivalent securities from the lender at a specified price at some l d

Islamic Alternative needs to be

d l d hlater date developed, however, true risk taking by all parties is required


Contents

1) Evolution of Islamic Finance Industry & Islamic Capital Markets

2) Liquidity Management in Islamic Financeq y gInter‐Bank Unrestricted (On Balance Sheet) Wakalah


IIFM Master Wakalah Agreement ProjectIssues for Inter Bank MarketIssues for Inter‐Bank Market

Whether standardization should focus on both On-Balance Sheet and Off-Balance Sheet Wakalah products or should just consider On-Balance Sheet

Restricted and Unrestricted Wakalah

Target users – Islamic Inter-bank market or Asset Management

Operational process document development

Enforceability of the agreement


Issues in Inter‐Bank Unrestricted (On Balance Sheet)Wakalah(On Balance Sheet) Wakalah

Legal Challenges Wh t t i th l i l W k l h t th h ll i th f When restructuring the classical Wakalah arrangement, the challenge is therefore

to transform the risk of Wakalah to rank pari passu with a normal senior unsecured obligation of the deposit-taking institution while retaining the key Shari’ah feature of no explicit capital guarantee. This could be achieved by amending the Wakalahagreement to incorporate the following features:

I. Undertakings by the deposit‐taking institution relating to the basis on which funds are received and will be dealt with, including early termination if at any time the deposit‐taking institution believes that the expected maturity proceeds may be lower than that indicated to the client, i.e. the Wakalah becomes immediately repayable (placement amount plus accrued profit) if the there is reduction in the credit quality of one or more assets in Wakalah portfolio or if returns are too low to meet the target profit rate

II. Compensation to the client for any loss he may suffer due to the deposit‐taking institution’s failure to comply with the terms of the agreement, including circumstance where it negligently fails to adhere to (i) above.



Operations/Risk Management Framework It is essential that a comprehensive operational risk process is put in place for on It is essential that a comprehensive operational risk process is put in place for on-

balance sheet unrestricted Wakalah for Islamic inter-bank market

The deposit taking institution should implement robust front and middle office systems to monitor compliance with the legal structure and to achieve internal objectives of notto monitor compliance with the legal structure and to achieve internal objectives of not having to repay the deposit early thereby adverse impact on liquidity

Longer term assets in general produce a higher absolute return than short term assets. At the outset it is imperative that the deposit taking institution formally confirm andAt the outset it is imperative that the deposit taking institution formally confirm and record amongst others the following policy decisions through its relevant sanctioning authorities:

i All “debt” like transactions is automatically deemed components of the Wakalah pool unlessi. All debt like transactions is automatically deemed components of the Wakalah pool unless specifically excluded. Therefore, the pool typically comprises Sukuk, term financings and money market placements but excludes real estate, equity and quasi equity

ii. The decision to honor “indicative” profit rates should the Wakalah portfolio return fall below the rate indicated on any Wakalah, whilst recognizing that it would be objectionable to Shari’ah for this to be a condition of the placement



Operations/Risk Management Framework (continued) M d t d d l t th iti t d i t d i di id l d itt Mandate and delegate authorities to a designated individuals and committees, e.g.

the Treasurer and Asset & Liability Management Committee (ALCO) to monitor the portfolio daily (Treasurer) and weekly (ALCO) and consider the constituent components (assets and liabilities) of the Wakalah portfolio:

Include new assets entered into, for example day’s Commodity Murabahah and Wakalah money market transactions

Exclude any transactions (assets) where repayment is doubtful or likely to become doubtful. Advisable to agree mark to market thresholds on assets as indicators/guidelines

The portfolio return is compared to the returns indicated. If indicated returns fall below the portfolio return this is flagged and a specific decision noted to honor indicative returns. This decision should be post event communicated to the deposit taking institution’s Shari’ah supervisory body for recordingdeposit-taking institution s Shari ah supervisory body for recording



O ti /Ri k M t F k ( ti d)Operations/Risk Management Framework (continued)

Constant monitoring to the portfolio for any material deterioration in asset quality is essential and required in this process. These deterioration assets may be excluded from the portfolio before losses are sustained; however, this is subject to further deliberation

The proposed operational process, subject to further development, is key element p p p p j p yof the unrestricted Wakalah as on-balance sheet product.



Indicative Rate of Return & Guarantee on Return

“If the Wakil (Agent) makes a profit by the maturity date, the profits belong to the Muwakkil (Investor), and the Wakil is entitled for Wakalah fee in pre-agreed amount or pre-agreed percentage of asset under management Conversely if a lossamount or pre agreed percentage of asset under management. Conversely, if a loss is made this loss is borne by the Muwakkil in the absence of gross negligence, fraud or willful default by the Wakil”

In a normal market, feasibility reports may be relied on by the Muwakkil in order to decide whether to invest with the Wakil or not, however where the market is volatile relying on such reports may be a problem. Where the economy is

d b d ff l l d d fwitnessing a downturn, it becomes difficult to rely on predicted rate of return; hence, a methodology based on operational process mentioned earlier could be incorporated to overcome this issue.



Other IssuesA Capacity RiskA. Capacity Risk

The issue of guaranteeing a minimum return on the Muwakkil's investment raises further questions in relation to the capacity of the Wakil to give such guarantees and whether or not the Wakil can renounce his obligations under the Wakalah agreement on the basis of lack of

icapacityAs per our research most of the institutions are now including the capacity risk clause as a standard clause in their master agreement

B Mi i f F d V I lB. Mixing of Funds Versus InsolvencyBased on general market practice, when a Muwakkil invests money with the Wakil under a Wakalah, such money is usually mixed with the Wakil's own pool of funds. In the event that the Wakil becomes insolvent, the Muwakkil's money will be mixed with the Wakil's other money and may well be treated by the liquidator in certain jurisdiction’s law governed insolvency as part of the Wakil's liquidation assets. For this reason, in some jurisdictions, where there is an absent insolvency remote trust laws, investors are advised to consider this risk when investing their funds under a Wakalah agreement. Due to this reason it is recommended that a reference pool of assets is created and should be managed as per the proposed Wakalah operational process.



Other Issues (continued)C Changing of the Reference Asset PoolC. Changing of the Reference Asset Pool

Changing of the reference asset pool as and when required under operational process guidelines (may have legal implications e.g. under U.A.E. law this can be categorized as discretionary investment rather than a deposit). Moreover, it is proposed that the pool of

b d f l d i lassets to be treated as reference pool and not investment pool.Deposit-taking institutions may have several pool of asset and may have a certain pre-agreed method/formula to calculate Muwakkil’s return from those several pool of asset. Return to Muwakkil must be based on actual investment pool with flexibility on calculation method

D. Honoring Indicative Versus Low Portfolio ReturnA policy of honoring an indicated profit rate, in the event the portfolio return is lower than the indicated profit rate or certain assets from the reference pool need to be taken out due to not meeting the criteria under the operational process, may have Shari’ah, legal, accounting treatment and shareholders implications and these need to be addressed. On the other hand the requirement of taking Shari’ah approval on each instance will become cumbersome and if in principle an Islamic bank’s Shari’ah board allows then it does not need p pto approve individual transactions.



Other Issues to be Researched) Wh t ill b i d t k th W k l h t d d t l ith la) What will be required to make the Wakalah standard agreement comply with laws

of jurisdictions where Islamic finance is practiced?

b) Issues related to central bank regulations, accounting treatment, capital allocation d b d d lneed to be studied extensively

c) Should operating standard be made as compulsory for using the Wakalahdocument?

d) Transfer of risk from fund placing institution back to fund taking institution and its impact to shareholders equity is a critical factor to be addressed in light of Shari’ahand also its legal implicationsg p

e) The possibility of funds taking entity to be able to disclose the asset pool, if required, to the Muwakkil in order to address the issue of transparency in most of the Wakalah arrangementthe Wakalah arrangement


Thank YouThank You

i f @iif [email protected]

inter bank unrestricted wakalah - mr. ijlal alvi

Economy & Finance

islamic development

islamic finance industry

development of islamic

market iifm

market participants

i fii d t

central bank of sudan

documentation products