Inter bank unrestricted wakalah - mr. ijlal alvi

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

Briefing/Workshop on Islamic Liquidity Management & Capital Market
Muscat Hall Bank Muscat Head Office Oman
Hall, Office,
5th & 6th May 2012

Ijlal Ahmed Alvi
Chief Executive Officer
IIFM

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

Contents

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

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

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

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 lies
industry.
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 Bank
Bahrain,
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 market
participants 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 the
development of Islamic Capital and Money Market

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


Contents

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

 Inter-Bank Unrestricted (On Balance Sheet) Wakalah
 Collateralization


Evolution of Islamic Finance Industry &
Islamic Capital Markets
Islamic Capital Markets
‐ Hedging & Risk Management
‐ Liquidity Management Tools
‐ Takaful & Re‐Takaful
‐ Sukuk (Common & Hybrid)
‐SStructured Alternative Assets
d Al i A 2007+
‐ Equity/ Funds/ Securities/ Indexes
‐ Project Finance & Syndications‐Investment
Banking
‐ Commercial Banking

‐ Sukuk (Ijarah, Musharaka, Istisna)
‐ Structured Alternative Assets
‐ Equity & Funds
2000’s
‐ Ijarah
‐ Project Finance & Syndications
Project Finance & Syndications

‐ Equity
‐ Ijarah
Project Finance & Syndications
1990’s

1980’s

‐ Commercial Banking 1970’s


Islamic Capital Market Products
vs Conventional Products
Conventional Products
Conventional Characteristics Shari'ah Compliant
Instrument Alternative
Equity
E it Equity holders are the owners of the firm and responsible for conducting its
E it h ld th f th fi d ibl f d ti it Accepted
A t d
affairs
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 ‐
transaction costs
i
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
Bonds A term obligation to make a series of fixed payments. Accepted
Floating Rate Bonds The interest rate on the debt is based on LIBOR or the T‐Bill rate

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

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


Islamic Capital Market Products
vs Conventional Products
Conventional Products
Conventional Characteristics Shari'ah Compliant
Instrument Alternative
Convertibles A bond that can be swapped for equity at a pre‐specified ratio or vice versa
A bond that can be swapped for equity at a pre‐specified ratio or vice versa Developed

Islamic Hedging (Profit Transactions in which different streams of income are exchanged New Development
Rate & Currency
Swaps)
Options The right to buy or sell a security on or before a specified date Limited Acceptability

Commodity Futures Contracts for the future delivery of a commodity. Emerging
Financial Futures Contracts for the future delivery of currencies, securities, or an amount of
money based on an index
y
Exchangeable Exchangeable Sukuk to equity‐linked instruments Developed
Collateralization Secured financing and Sukuk tradability Emerging
Repo The borrower sells securities outright to the lender and at the same time Islamic Alternative
agrees to buy equivalent securities from the lender at a specified price at some needs to be
later date
l d developed, however,
d l d h
true risk taking by all
parties is required


Contents

1) Evolution of Islamic Finance Industry & Islamic Capital Markets

q y g
Inter‐Bank Unrestricted (On Balance Sheet) Wakalah


IIFM Master Wakalah Agreement Project
Issues for Inter‐Bank Market
Issues 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
Legal Challenges
 Wh restructuring th classical W k l h arrangement, the challenge i th f
When t t i the l i l Wakalah t th h ll 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 Wakalah
agreement 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
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 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 and
record amongst others the following policy decisions through its relevant sanctioning
authorities:
i.
i All debt like transactions is automatically deemed components of the Wakalah pool unless
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 and d l t authorities t a d i t d i di id l and committees, e.g.
Mandate d delegate th iti to designated individuals d itt
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
deposit taking institution’s Shari’ah supervisory body for recording



Operations/Risk Management Framework (continued)
O ti /Ri k M tF k ( ti d)
 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 p
p p p process, subject to further development, is key element
j p y
of 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 loss
pre agreed management Conversely,
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
witnessing a d downturn, it b
becomes d ff l to rely on predicted rate of return;
difficult l d d f
hence, a methodology based on operational process mentioned earlier could be
incorporated to overcome this issue.


Other Issues
A. Capacity Risk
A 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
capacity
i
As per our research most of the institutions are now including the capacity risk clause as a
standard clause in their master agreement

B. Mixing of Funds Versus Insolvency
B Mi i fF d V I l
Based 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 Pool
C 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
assets to b treated as reference pool and not i
be d f l d investment pool. l
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 Return
A 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 p
to approve individual transactions.


Other Issues to be Researched
a) Wh t will b required t make th W k l h standard agreement comply with l
) What ill be i d to k the Wakalah t d d t l ith laws
of jurisdictions where Islamic finance is practiced?

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

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

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’ah
and also its legal implications
g 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 arrangement


Thank You
Thank You

info@iifm.net
i f @iif t
www.iifm.net

Inter bank unrestricted wakalah - mr. ijlal alvi

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