Embedded Tawarruq In Inter-Bank Investment Wakala

 


01 July, 2019   178 views   M. Burhan Arbouna
Banking Sector Report

By Dr. Mohammed Burhan Arbouna

 

When one reviews financial statements of Islamic banks in Oman, it is easy to detect the following headings either under the assets or liabilities:

  1. Wakala Bi al-Istithmar, (2) Inter-Bank Wakala Investments, (3) Inter-Bank Wakala, (4) Due from Banks, (5) Due to Banks, (6) Customer Wakala

The “organized tawarruq is defined by OIC fiqh Academy as “a purchase by a liquidity seeker (mustawriq) of commodity from a local market, international market or similar markets on a deferred payment basis, where the financier, in view of a prior agreement with the liquidity seeker (mustawriq), would arrange for its reselling, either by itself or by an appointed third party, at a lower price, usually”. A non-organized tawarruq is defined by OIC Fiqh Academy as “a purchase by a person (mustawriq) of a commodity at a deferred price for the PURPOSE of reselling it for CASH at a lower price, usually, to a party other than the party from whom it was initially bought for CASH PURPOSES or bi qasd al-hussul ala al-naqd”. The purpose of seeking liquidity using tawarruq is mentioned in AAOIFI standard no. 44 on liquidity: Its Soliciting and Deployment. The definition of OIC Fiqh Academy of non-organized tawarruq is in line with AAOIFI definition, which makes no any difference between “organized and non-organized”. In the above definitions, the purpose of seeking cash, helping to place extra (excess) money with interest based banks, the money going to London metal exchange, being compassionate or not are not the issue. The main issue is whether or not such a transaction leads or would lead to interest transaction. In the organized tawarruq definition, the OIC Fiqh Academy sees an element of interest transaction due to the nature of the structure in terms of execution process as explained in the definition: purchase-sale-agency-sale combination. This combination in the eyes of OIC Fiqh Academy is leading to getting loan on interest in the name of sale and purchase. In the non-organized tawarruq, the OIC fiqh academy sees that the structure involve not in any interest transaction due to dismantling the combinations, where each arrangement stand alone.  

After the above brief, it is good to turn to the main topic, which is whether or not inter-bank placements on wakala between Islamic financial institutions in any jurisdiction and their local and international counter-parties, including jurisdictions that prohibit tawarruq or CM may directly or indirectly involve in one way or the other in a form tawarruq, be it organized or non-organized, as per the technical and professional definitions above.       

Although tawarruq using commodity murabaha structures is said to be allowed under necessity only under the regulatory rules of Oman, I am not able to see any note on commodity murabaha tawarruq in the financial statements of the Omani Islamic banks. It is not even used to convert conventional loans for people who do not have assets to sell and lease back. This gives a good indication that when Islamic banks started in Oman, only those who have property to be purchased and leased back to them have shifted from conventional banks to Islamic banks, if such shift had ever happened. It is therefore easy to conclude that, in the absence of tawarruq or CM, the individuals or corporates who borrowed on clean basis had no choice but to remain with conventional banks to the maturity of their loans. So almost the larger part of the clients of these Islamic banks are fresh clients who were not involved in the banking sector prior to the establishment of Islamic banks in Oman. This means there was no any necessity for the banks to use commodity murabaha tawarruq since the inception of Islamic banks in Oman. Hence, our analysis will concentrate on the wakala terminology and due from or to the banks in the context of treasury business and liquidity management. Liquidity management is a technique to maintain easily disposable liquid assets and manage short-term liabilities which can be received to meet other obligations. Usually in Islamic banks, liquid assets are sukuk, shares and similar instruments. When an Islamic bank solicit liquidity for investment on the basis of wakala, it is assumed that it has liquid assets or investments in which these wakalas can be invested to generate very short term income for the depositors which are the Islamic financial institutions. In addition, the wakala assets should be assets that can be easily liquidated to return the funds on maturity as these wakalas are short-term in nature, some of which are only 3 to 4 days. There are other wakalas on overnight basis which make up to 3% income or profit! 

When we use the term investment wakala, inter-bank wakala investment and wakala especially when it is classified as liability, it suggests that the bank requested “financing” on wakala basis to fund businesses that are in the pipe line. The reason being that the bank believes, based on accurate and diligent feasibility studies, it will achieve the anticipated profit and more incentive for it to make money otherwise fee alone will not cover its expenses not alone making profit. Therefore, the logic behind wakala is the assumption that these funds are used to fund investment activities of the receiving bank, hence the investments would not be possible in short term basis which is main task of treasury business for liquidity management purposes. The effective short-term Wakala investment is the asset backed wakala exemplified in the commodity purchase and sale. The assets based Wakala, which means investment by commingling with funds of the wakil to create economic value for the business is another form of Wakala bi al-Istithmar for long term or deposit like investments and not effective fund placements in the context of treasury business. Where a bank wants a short-term income it goes without saying that such an Islamic bank knows, in advance, it will involve ii the asset backed Wakala Investment, which is mentioned in AAOIFI standard on CS using Commodity Murabaha.

In the analysis of the terminologies under discussion, it is noted that there is no expressed notes in the financial stattements of Islamic banks in Oman to suggest the underlying business of wakala especially in the context of the fact that some banks do not include them in their self-financed investments, which suggest that these wakala funds have specific areas of deployment and, in most cases, it will be in the asset backed wakala investment. Having said this, there are two possibilities for deployment of these funds:

  1. They may be merged with the general wakala pool and then earn profit as the pool is constructively liquidated daily, but this approach is more of pure investment rather than liquidity management.  
  2. They may be used to purchase goods and resell them at a profit and distribute the profit to the wakala investment amount owners and the wakil earn a fee and retain part of the profit as incentive if the sale proceeds passes certain threshold. There are two situations, to the best of my knowledge, in this option:
  1. the bank acting on behalf of the muwakkil would purchase goods or commodity or tangible assets (land, building and the like) and sell them at a profit to a third party for a payment term spread over certain tenure after which the profit and the principal when received shall be passed to the fund owner (AAOIFI standard no. 20 on Commodity Sale (CS) in the Organized Markets called this Wakala bi al-istithmar). The purchaser may be in immediate need to put the goods into use or production or the purchaser may be a holding trader who buys and sells when prices goes up and make profit exemplified in the difference between the selling price and purchasing price. But when the business of the purchaser is strategized on the basis of immediate payment of the full price, then the purchaser is using the state of purchase of goods to create liquidity which can be recycled in another more profitable businesses. This approach means the initial relationship between the wakil and muwakkil is investment wakala but the underlying business that creates financial benefit for the muwakkil as a fund owner is buying and selling of goods to an entity who will resell such goods to create a liquidity to be used in a business that will create a financial income higher than the selling price and the profit all together. This is the approach of AAOIFI standard no. 44 on Liquidity: its Soliciting and Deployment. This exercise is what I termed as an investment wakala with “embedded tawarruq
  2. another option for the investment wakil to earn profit for the muwakkil in the absence of a third party liquidity seeker and in the presence of a condition in the wakala agreement that the wakil should not invest in businesses except such businesses that make a certain threshold of profit (see AAOIFI standard no. 46 on Wakala bi al-Ithtismar clause 10/2), the wakil have no option but to offer to purchase the goods bought on behalf of the muwakkil under inter-bank investment wakala on murabaha basis (and usually this is the case because the wakil will not approach the muwakkil to place investment with the wakil unless the wakil is in need of liquidity whether or not it will be co-mingled with the wakil’s general pool)  through an exchange of offer and acceptance (assuming the offer and acceptance are properly exchanged), after which a murabaha liability is created against the wakil to pay the principal and the expected profit which ends up to be a fixed one due to the sale and purchase (CM) nature embedded in the structure (AAOIFI standard 20 on CS). The wakil will then sell the goods in the market and get liquidity or cash (AAOIFI standard (30) on Tawarruq and 44 on Liquidity). This is what I called a wakala embedded with tawarruq without which the wakala would not function economically and effectively based on the parties’ intention not to incur losses as much as possible, a state that gives the muwakkil (investors/wakala depositors) some comfort needed in the banking and treasury relationship.
  3. When we come to assets due from banks or due to banks, there is no explanation of the underlying business. At the face value, all Islamic banking products may be used to create assets due from banks and liabilities due to banks. But since banks are generally not in the business of buying and selling consumable goods for usage in the similar way as the ordinary customers do, the flag of tawarruq using commodity (CM) remains the possible tool, which means banks purchase goods from each other using the wakala relationship tool, creating a liability and then resell them either to make money on the spread, which is usually not the case, or resell them to create liquidity which is logical in the context of Islamic banking instruments and treasury practices. Hence, the embedded tawarruq through commodity murabaha, tawarruq or CM appears clearly in the business structure of inter-bank wakala investments of the banks, which amounts to creating assets due from or due to the banks.
  4. Therefore, what is happening in the inter-bank wakala investment which appear in these financial statements is neither organized tawarruq nor non-organized tawarruq, but rather a form of commodity murabaha tawarruq which may be termed as “embedded tawarruq”, a term which is borrowed from an article titled “Embedded Option” by Prof. Tariqullah Khan. It may also be termed as “hybrid wakala-tawarruq Investment, belated tawarruq or closed ended tawarruq”. The reason is that at the face value the preliminary contractual relationship is agency but the economic value is realized via the process of embedded tawarruq, which is functionally executed through commodity murabaha.     

Written by Dr. Mohammed Burhan Arbouna

On 1/7/2019.


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