ISLAMIC SYNDICATED FINANCE
IMTIAZ AHMAD PERVEZ
Syndicated finance techniques were first used by the Bank of England in 1694 and some of its features have been traced back to the latter part of the Middle Ages. However, in modern times it was not until 1968 that the first syndicated loan was arranged. This took place in New York for US$100m. In 1972 alone, over US $ll b worth of such business was handled. By 1981, the volume of syndicated transactions had reached the staggering figure of US $l78b.
And with the gradual removal of legal barriers between nations, the internationalisation of syndicated finance has seen tremendous growth in the past three decades.
Syndicated financing originally came into being to facilitate the mobilising of financial resources to meet growing trade and development needs. Over time, these considerations have been supplemented by many new advantages for both financiers and clients.
It has not been possible to correctly ascertain the history of Islamic syndicated finance. In so far as such commercial agreements are concerned, Islamic syndicated finance was for the first time introduced by the Faysal Islamic Bank of Bahrain EC through a US $50m short-term trade finance facility for the Turkish Petroleum Refineries Corporation (TUPRAC) in August 1987.
This was followed by a similar facility of the Cotton Export Corporation of Pakistan (Private) Limited, Karachi in September 1987. Since then, the Faysal Islamic Bank of Bahrain EC, itself has concluded 22 Islamic syndicated transactions participated in by 56 Islamic and traditional financial institutions. All the subject transactions have been oversubscribed and there have been no defaults.
In the meantime, the structure used by the Faysal Islamic Bank of Bahrain has been more or less adopted by a number of Islamic and conventional institutions, including the Islamic Development Bank, the Albaraka Group, the Arab Investment Company and Grindlays Bank, amongst others, to raise consortium finance on the principles of Islamic finance.
Under Islamic principles, the same objectives are achieved as in conventional practice, except for the fact that funds are tied to commercial and entrepreneurial transactions and purposes, and financial transactions are completely excluded.
Through this vehicle, the resources of various institutions are pooled together, including financial, technological skills, sophisticated credit evaluations and financing techniques, marketing/selling ability, network, monitoring and control. It also allows for large amounts of financing to be shared by a number of syndicate members thereby distributing risk while enhancing the quality of credit. It also allows small institutions to participate in quality transactions.
Syndicate members take upon themselves the various responsibilities of Mudarib (agent and manager) co-Mudaribs (co-managers, marketing/selling agents, redemption underwriters, market-makers, etc) and participants.
Mudaraba
Under the Mudaraba (Agent/Manager) contract, the Mudarib (in its capacity as agent and manager), co-Mudaribs (in their capacity as co-managers, marketing/selling agents, redemption underwriters, market-makers etc) and participating institutions (Rab Al-Maal, providing financial resources) enter into a mutual contractual relationship.
The major issues of the contract are:
i. The relationship and responsibilities of all the relevant parties are separately listed and agreed to between the parties.
ii. An account is opened in the books of the Mudarib to receive the amounts committed (or allocated in the case of over-subscription by the participating institutions.
iii. The participating institutions authorise the Mudarib to act on their behalf in accordance with the conditions stipulated in the Mudaraba contract and its attachments. The contract also stipulates the use of the funds and is supported by the legal documentation to be obtained by the Mudarib on behalf of, and for the benefit of, the participating institutions as approved by them under the contract.
iv. The disbursements are made by the Mudarib to all parties concerned on the same value date, unless otherwise stipulated.
V. Their fees for the Mudarib, Co-Mudaribs etc, and the share of profit attributable to each participating institution are duly stipulated.
vi. All documents of recourse are made out in the name of, and are held by, the Mudarib for action in future on behalf of the participating institutions in terms for the Mudaraba contract. Unlike traditional practice, no separate notes are made out in the individual names of the participating institutions.
Murabaha Financing
Under this form of contract, the Islamic financial institution purchases goods, raw materials, equipment, machinery or any other items of economic significance from a third party at the request of its clients and sells such goods to the client on spot or deferred payment basis at its own sale price. The difference between the purchase cost to the Islamic bank and its sale price forms the profit available to the Islamic bank from the relationship.
Non-Conventional Aspects
As will be observed from the following characteristics of the Murabaha contract. Islamic banks deal in goods, not documents, and bear several risks until the contracts’ consummation. Because it is tantamount to trading, the contract is a legitimate Islamic banking operation. However, it must be noted that Murabaha has the following, non-conventional aspects.
i. The customer has the right to reject the goods if these do not conform to the required quality for which the contract was made.
ii. The Islamic bank is not permitted to assign the benefits of the recourse under the manufacturer’s warranty to the client if this should entail extra costs for the client. Islamic banks are responsible for providing services under such a warranty to the client and may, therefore, have to act as an intermediary between the client and the manufacturer and/or supplier.
iii. An Islamic bank is obliged to provide a breakdown of its costs and profits and all other expenses involved as are charged to the client under the sale price.
iv. The client only promises to purchase the goods and is not legally bound to take delivery upon their arrival.
v. Islamic banks always obtain the title to the goods before passing these on to the client.
vi. In countries where imports are subject to duties and taxes, the Islamic bank’s profit is treated as part of the purchase price and is, therefore, subject to such levies and taxes as are charged on imported items, which increases the cost of the import to the client. This is because financing by an Islamic bank is treated as trading and is not generally recognised as ‘debt’. Not surprisingly, trade financing by Islamic banks with countries where import taxes and duties on imported goods are charged, has not developed satisfactorily.
vii. The Murabaha contract provides for any short-term financing needs of the clients. Due to the inherent liquidity element that this form of financing carries, Murabaha financing is today quite popular with Islamic banks.
viii. For the purposes of accounting, in the case of Murabaha, where the ultimate income is both contractually determinable and quantifiable at the commencement of the transaction, the same is accrued on a straight-line basis over the period of the transaction.
Ijara Financing Contracts
Under this form of contract, the Islamic bank purchases an asset and leases it back to its client. The lease contract specifies the leasing period, the amount and timing of lease payments and the responsibilities of both parties during the life of the lease. Leases can be simple rental or more elaborate contractual arrangements committing the parties to future action.
Islamic principles of finance permit the purchase of assets for rental that may include a certain profit to the investor A commercial or individual client wishing to acquire the use of capital equipment may request the Islamic bank to purchase such assets and then oblige itself to rent such assets from the bank.
Subject to the fulfilment of certain conditions, the client has the option to purchase the assets during the term of the lease. The optional purchase price declines over the period of the agreement, but as the customer is not obliged to purchase, the Islamic bank will not normally take on substantial risk with respect to its residual value at the end of the lease period. If the client is obliged to purchase – this is known as an Ijara Wa Iqtina lease.
The two most frequently used types of leases are the operating lease and the financial lease. In the former, the Islamic bank is essentially acting as warrantor of the asset leased, although the client makes an undertaking as to the utilisation and maintenance of the asset. In the financial lease, the client must deal directly with the supplier or manufacturer and assumes the risk of loss.
The Ijara financing mode is ideal for the securitisation of Islamic financial paper provided that the paper is supported by a secondary market (even if created by a group of financial institutions facilitating redemption on demand). On the other hand, the underlying asset should be easily converted into cash and so it is imperative that the asset is of high quality and is marketable.
When the asset is of high quality, the Islamic bank may rely more on the asset than the credit risk of the client, which allows a client of relatively weak credit rating to obtain Ijara financing.
Mismatching
Leasing also permits some mismatching of short-term liabilities with long-term assets. This is because first, the instrument, being supported by the secondary market is marketable and convertible into cash on demand, and second, periodic rent reviews that reflect market conditions are permitted. However, at the present time. Islamic banks have tended to opt for commercial passenger aircraft, although the period of finance is medium-to long-term.
Mudaraba is a contract between the Islamic bank and the client, whereby the Islamic bank provides a specific amount of funds to the client for an enterprise in exchange for a highly predictable profit.
The client receives a share of the profit as compensation or fee for his/her know-how and management services.
Entrepreneurs with strong technical and managerial skills but without adequate financial strength often find it extremely difficult in the contemporary financial world to raise capital for the establishment of viable economic units.
They also find it difficult to find the money to carry out contracts which provide for sufficient cash flows and earning capability that will allow attractive returns on investors’ capital – in addition to permitting a reasonable compensation to the entrepreneur for his/her know-how and management.
But under this contract, the entire capital is provided by the Islamic bank, which looks to the client for management and technical know-how and basically to the feasibility – technical commercial, financial and legal -of the economic unit. The bank will provide adequate cash flows and earnings that will permit the repayment of the principal return on investment as well as incentive to the entrepreneur within a reasonable time frame.
Depending on the viability of the enterprise, this form of financing is highly conducive to the creation of new entrepreneurs who are technically proficient and have the ability to run specific enterprises to the highest levels of efficiency, but have no cash resources of their own.
The Islamic bank allows all costs of production – including the management expenses of the client and his/her labour as deductible expenditure. In addition, the client is permitted a fixed percentage of profit as the fee for his/her know-how and management, without which the enterprise would not be in existence and producing; this sum is normally 10-20 per cent of the total profits obtained, depending on the amount and quality of the client’s contribution.
This form of remuneration provides considerable incentives to the client to generate a high income and buy out the Islamic bank from the management fees earned out of the net profit of such an enterprise.
However, it remains a high-risk financing mode. Although the client has sufficient incentives to make the unit a success, he/she has no capital committed to the enterprise. The Islamic bank, therefore, makes great efforts to scrutinise the feasibility of projections provided by the client using the most sophisticated credit risk evaluation, analysis techniques and criteria for its decision-making process.
Following credit approvals, the Islamic bank takes all necessary steps to guard, as far as is possible, against completion and operational risks and such common causes of project failures as completion delays, cost overrun, technical obsolescence and failures, changes in regulatory risk factors, raw material shortages and ineffective marketing, as a part of its moves to require the enterprise to be managed to the highest standards to ensure that the projections are achieved.
And after the project’s completion, the Islamic bank maintains a strict check on operational risks such as the quality, quantity, availability and price of raw materials, and changes in the regulatory and environmental conditions, productivity and effective output at desirable cost levels, adequacy of infrastructure and continued availability of qualified and skilled labour and managerial personnel.
If required. Islamic banks may put a member on the clients’ board of directors to keep abreast of the developments taking place within the enterprise.
Cross-border Mudaraba financing involves several additional risks. Political and regulatory risks are among the most important – as are tax factors. Meanwhile, local laws in certain countries do not permit banks to take an equity stake in the manner prescribed.
The Mudaraba relationship is characterised by the following points:
a) The relationship is entered into between the parties for a certain duration in which the repayment of capital is provided for on the basis of mutual agreement.
b) The determination of profit redistribution and principal repayment is agreed between the two parties for a fixed period of time as well as the date on which the determination is carried out, including when the balance sheet and income statements are submitted to the parties for necessary determination.
c) From the net profit after payment of all costs, including management costs (including the salary of the client), the client is paid his/her management fee at the rate prescribed under the relationship contract. The balance of the profit goes to the Islamic bank for distribution to the investors.
d) While, under this mode of financing, fixed ratios are permissible, fixed amounts of profit for either party are not permitted.
e) Liability for loss rests solely with the Islamic bank unless it is proved that the client was grossly negligent in the performance of his/her trust functions, in which case the entire loss is borne by the client.
f) If two or more Islamic banks are involved in providing capital for the Mudaraba, the distributable part of the profit (i.e., after payment of management fees), is distributed between them on a pro-rata basis according to the amount invested by each.
g) Each party exercises business discretion strictly in terms of the relationship contract and discretionary authorities so approved. This avoids confusion and provides a clear-cut functional process.
h) The Mudaraba capital is only consumed for the purposes approved under the relationship and the client have no authority to invest the capital in other ventures without the prior approval of the Islamic bank.
i) For the duration of the relationship, the client is not permitted to introduce his/her personal or any other external capital into the unit unless provided for and previously approved by the Islamic bank
j) It is expected that the client will achieve the projections provided to the Islamic bank at the time of the initiation of the relationship, on the basis whereof the Islamic bank decided to enter such a relationship.
Should the actual results fall short of these projections, the Islamic bank will be within its rights to seek a full explanation and the client is obliged to provide the same. Should such an explanation be found unsatisfactory, the Islamic bank may seek recourse against the client for misrepresentation,
k) Unless provided for in the relationship contract, or approved by the Islamic bank as being imperative for the success of the enterprise, the client is not allowed to appoint another manager of the enterprise.
I) Mudaraba is not permitted to obtain financing from a third party without the prior permission of the Islamic bank. However, the client may engage in such trade credit operations as are normal within the type of business and are duly provided for in the relationship,
m) The liabilities of the Islamic bank under the Mudaraba are limited to the extent of its capital provided to the client under the contract. Creditors have no recourse to other assets of the Islamic bank, should any of their claims remain unsettled from the resources of the enterprise,
n) Either party in the Mudaraba contract has the right to terminate the contract. If there are more than two partners, the contract may continue in favour of the remaining partners. However, many Islamic jurists agree that at the time of the termination of the contract, all goods and capital should have been converted into cash.
Even in the case of a fixed-period contract, it will be illegitimate to bind the partners to not terminating the contract until the date of maturity. The Mudaraba also terminates upon the death of any one of the partners.
This last principle can make the contract problematic, especially if the contract is for a long-term project. Modern scholars of Islamic economics have recommended that certain principles for the contract, such as this one, be revised, in order to eliminate undue advantage or disadvantage to either party.
Conventional equities are one of the most desirable Islamic financing vehicles. However, exceptions do have to be made in the following areas:
a) The main line of business of many companies is in areas that are considered to be Islamically unacceptable.
b) A number of the corporate entities themselves issue interest-based debt instruments.
Investment in equities is generally risky, and in order to get around this there has to be a wide range of companies invested in. But owing to the reasons outlined above, it may be difficult for an Islamic bank to choose a suitably diversified range of investments. These factors have made equity investment relatively unattractive and complex for many Islamic banks.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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