Off Balance Sheet Transactions

for
Islamic Banks

Lecture 11
 Balance Sheet
• A snapshot of the financial condition of a
company at a particular moment.
• It consists of three main elements:
• Assets - current & long-term
• Liabilities current & long term
• Net worth – capital reserves etc
• A= L + N
 Importance of Balance sheet
• Many ratios can be used to make financial decisions and
also to assess the risk of the company.
• Basle accord (2 & 3) use the balance sheet to assess
the capital cushion needed to mitigate credit, market and
operational risk.
• Islamic Banks balance sheet has some special
characteristics in that the current accounts are similar to
conventional banks, while other accounts rest mainly as
investment!! This has its own ripple effect in running the
Islamic banks as intermediaries and often off balance
sheet transactions are needed.
 On and off balance sheet
Transactions
• On-balance sheet financing is any form of direct debt or
equity funding of a firm. If the funding is equity, it appears
on the firm's balance sheet as owners equity. If it is debt,
it appears on the balance sheet as a liability. Any asset
the firm acquires with the funding also appears on the
balance sheet.

• Off-balance sheet financing, by comparison, is any form

of funding that avoids placing owners' equity, liabilities or
assets on a firm's balance sheet. This is generally
accomplished by placing those items on some other
entity's balance sheet. Such as an SPV.
Typical balance sheet of an Islamic bank

• What is the ‘balance-sheet’ of an economic firm?

• Stocks and flows in financial statements
– Balance sheet: (stock concept) gives snap shot of
financial position
– income statement: (moving film) reports inflows
minus outflows to measure operative efficiency on
accrual basis.
– cash flow statement: measures liquidity on cash basis.
 Balance sheet structure
of an Islamic Bank
• Assets’ Side :
• Cash/ cash equivalents (e.g. short term sovereign sukuk)
• Accounts Receivable (Murabaha, Ijara, Istisnaa, Salam)
• Interest-free Investment securities.
• Investments (mudarabah/ musharakah/ real-estate
• Inventories.
• Physical assets (equipments, etc) – net of depreciation.
• Liabilities & Net Worth side :
• Liabilities: interest-free demand deposits, interest-free saving deposits- no fixed
return term deposits.
• Unrestricted investment accounts : The Islamic alternative of Term Deposits.
• Net, worth : retained earnings + equity
 Restricted versus unrestricted investments

• Two alternative options of accepting Islamic banks’

deposits:
– unrestricted Investments: Here Bank acts as Musharik with
depositors.
– Bank can invest the funds in any investment activity without
seeking clients’ approval and mix the Bank’s own resources with
those of depositors.
– restricted Investments: Here, choice of investment activity
and the mixing of funds have to be done with the client’s
consent. Bank may act as Mudaraba or Agent against a
management fee.
• The latter is an off-balance investment – WHY??
 Reasons for Off balance
transactions
• Financial institutions often offer asset
management or brokerage services to their
clients. The assets in question (often securities)
usually belong to the individual clients directly or
in trust. Such as a Mutual fund (unit trust) or
Letter of Credit letter of Guarantee etc.

• Risk Management, flexibility in financing, asset

liability management, tax avoidance etc.
• Islamic Banks can also offer Islamic Unit trust
and Islamic letter of credit etc.
 Mutual investment funds

• Investment fund are often called unit investment

trusts in U.K, and Mutual funds in the U.S.A - popular
fee-generating off-balance-sheet products.
• Objective: to invite investors’ subscriptions to a big
single pool for the purpose of investment.
• Each subscribing investor will then hold a specific
number of units in the given fund, priced at the time of
subscription.
• Managed against a fee by a specialized investment
departments of banks.
 Mutual investment funds
• Value generated to the pool through utilization of funds
in profitable transactions shall then be allocated to unit-
holders on a per unit basis.
• This may lead to appreciation in unit value, in case of
gain, or depreciation in case of loss.
• Open-end, and closed-end funds.
• Investment funds, in general, differ in terms of return
prospects, risk, and liquidity provision.
• Question . Other things equal, why should a closed-end
fund have a higher return prospect than an open-end
fund?
 Islamic Investment Funds:
Structural properties.
• An Islamic investment fund must satisfy the following
provisions :
• Manager/Investor relationship. Two Islamic
alternatives: (1) Agency, (2) Mudaraba
• Funds utilization and return generation. This calls for
two main conditions:
1. avoidance of non-permissible activities,
2. avoidance of non-permissible financial modes.
• Negotiability: Since sale of debt is not permitted, use of
Islamic modes in open-end funds must be adopted with
caution (e.g in Murabaha). Asset-backed funds, like
lease-based funds, may avoid this problem if properly
structured.
 Islamic Investment Funds:
Structural properties.
• Negotiability is resolvable through Equity-
based funds and lease-based funds. These
are most popular in the Islamic banking
industry.
• London-based Islamic Banker publishes on
a regular the price quotations for a large
number of Islamic banking funds.
 Islamic Unit Trust
• A pooled investment fund or collective investment, that
enables investors to share in a pool of professionally
managed investments such as stocks and bonds. A Unit
Trust fund is set up under a trust deed, which makes each
investor or unit holders beneficiaries under the trust.

• To invest in a Unit Trust, an investor buys units (instead of

shares) from the fund manager.

• Islamic ally the bank can establish one by using the wakalah
or mudharabah methods. They will then buy and sell shares
on behalf of the unit holders.

• Usually they will deal in shares following some filtering

criteria. At times they can involve in money market or sukuk
etc.
 Filtering process
• Qualitative - core business is haram or
halal.
• Quantitative – adoption of some financial
ratios to set up same benchmark.
• Mix products – benchmark is used
• Purification- can be dividend or capital
gains etc.
 Filtering Criteria
• As buying and selling of shares is a relatively new
commodity, Muslim scholars and difference of opinion on
the its nature and also had different criteria, with the
objective of removing riba, gharar, maysir etc.
• Shares have been considered as the pro rata
representation in the ownership of the assets of a
company. As it is asset-backed hence the exchange of
shares for money is not considered as riba based.
However some Hanafi scholars consider this transaction
as a sale of huquq al-mujarradah.
 AAOIFI
• 1. total non-permissible income to total
income ≤ 5%
• 2. total loan on interest to Market
capitalisation ≤ 30%
• 3. total deposit on interest to market
capitalisation ≤ 30%
• NB. Total liquid Assets to total assets
 Bursa Malaysia
• 5% benchmark for companies that may have some non-
permissible elements.

• 10% bench mark for companies where the contributions

from the activities that involve the element of umum al
balwa (a prohibited element affecting most people and
difficult to avoid).

• 25% to assess the level of mixed contributions from the

activities that are generally permissible according to
Shari’ah and have an element of maslaha (public
interest) although there may be other elements that
could affect the shari’ah status of these activities
 FTSE Islamic Index
• Debt/Total Assets< 33%
• Cash and Interest bearing items/Total Assets
<33%
• Accounts receivable and cash/Total liquid assets
<50%
• Non compliant income other than interest/Total
income <5%
• Total Interest income/Total Income <5%
• Purification ratio 5% of Dividends
 Off-Balance Sheet Banking Services:
letters of credit and letters of guarantee

• Letter of Credit :
• L/C is the widespread means of payment in international trade,
particularly in the context of importers paying price of goods to
exporters.
• L/C is opened by importer with national bank (issuer of L/C) in favour
of an exporter
• Issuer of L/C is legally obliged to pay the exporter fully through inter-
bank transferences.
• Payment becomes due as soon as exporter presents pre-specified set
of documents proving, among other things, shipment of goods as
required by the importer.
• Apart from documentary proofs, no bank bears liability towards goods -
is it Shariah compliant?
 L/C in Islamic banks
• Sight L/C as opposed to deferred L/C
• Different viewpoints on L/C by Shariah Scholars – agency/ daman
etc.
• As long as L/C involves no conventional financing, it is Shariah
compliant service to be offered against fee.
• What makes Fee income Permissible?
• if service offered by the bank is permissible one (halal), and if the
production of the service involves exertion of human effort ( mental
or physical) and the possible use of supportive material ( paper,
electric power, rented building, etc), then it is a permissible fee.
 L/C Fee Structure
• Banking fee is then set to recover both labour cost (time
and effort) and the material cost used up in the productive
process of the service.
• It is customary to express worker’s wage in units of time
because production takes time.
• Therefore, L/C banking fees can be expressed per unit
time over the period needed to complete the production
and delivery of a particular service (e.g. weekly or monthly
rates).
• L/C can act as basis for Islamic financing (Murabaha L/C;
Ijara L/C etc).
 Risk Management of Islamic L/C
Financing
• Problem arises on how to guarantee exporter’s
moral integrity to deliver genuine goods. This is
apart from insurable commodity risk.
• It is bound to rise in all cases where L/C relates
to Islamic financing modes (murabaha, Ijarah,
Salam etc) [ recall ownership risk]
• Daman al-Drarak (DAK) is practiced by many
Islamic banks as a hedge against exporter's
failure to deliver genuine goods.
• DARAK daman is where ‘third party’ guarantees
exporter’s integrity. In this case it could be the
client himself !
 L/ G in Islamic Banking
• An LG (letter of guarantee) is a document issued by
Bank to the order of Client, to the benefit of a Third
Party (e.g. government, supplier of petrol etc); e.g.
performance bond in public/ private works.
• It is an assurance to Third Party that in the event of
Client’s failure to honour an agreement with that
party ( e.g. completing an infrastructure project, or
paying a deferred price to a supplier) Bank will stand
ready to compensate Third Party up to a certain limit.
 L/ G in Islamic Banking
• L/G is permissible as act of benevolence in Islamic
jurisprudence where it is called kafala.
• The mainstream standpoint in Islamic jurisprudence is to
maintain kafala as act of benevolence and therefore kafala
cannot be offered against a fee.
• Nonetheless, as in the processing of qard hasan, there
are considerable labour and material costs to be covered in
the provision of kafala.
• Hence, Islamic banks are allowed to cover such costs in
the processing of LG’s under the strict condition that any
excess amount would be an illegitimate price of kafala.
• OIC fatawas is that we cannot charge for guarantee. Some
scholars have made hiyal!!
 Reading Materials
• Faizal Manjoo (2005), Reviewing the concept of shares Towards a legal
dynamic perspective, Paper delivered at the 6th International Conference in
Islamic Economics and Finance, Islamic Economics and Banking in the 21st
Century, Hilton Hotel, Jakarta, Nov. 21-24,2005, Vol 2.
• Ulrich Derigs and Shehab Marzban (nd), “Review and analysis of current
Shariah-compliant equity screening practices” (University of Cologne
Germany). Available at www.emeraldinsight.com/1753-8394.htm
• Ulrich Derigs and Shehab Marzban
• AAOIFI Shariah Standards on shares
• Dow Jones Islamic Market Index, FTSES Islamic Index, Bursa Malaysia
Criteria available on respective websites.
• Resolutions of the Shariah Advisory Council of the Securities Commission of
Malaysia 2nd Edition. Available on their website.
• Fahim Khan (2010), “Islamic Banking in Europe: the regulatory challenge” in
Islamic Banking and Finance in the European Union A Challenge, (ed) F
Khan & M Porzio, Edward Elgar Publishing Ltd, Cheltenham. Pp 61-75
• A. Mirakhor & Z. Iqbal (2007), An Introduction to Islamic Finance Theory and
Practice, John Wiley & Sons (Asia) PtE Ltd, Singapore. Pp. 114-120