Islamic Finance: Islamic Financial System

What does an Islamic financial system look like?

In order to describe the characteristics of an Islamic financial system, we divide the description based on the elements of a financial system.

1. Banks

Islamic banks operate under the principle of sharia, in which its main characteristics is the total prohibition of interest. Thus, Islamic banks are required to establish their deposit and lending system mainly based on equity-participation basis. The end product would be almost like mutual-fund system in which the depositors lose when the banks loses, and the banks (as lenders) loses when their borrower loses. For more description of Islamic banks in Islamic financial system, refer to another post here. 

Islamic Finance: Central Bank Tools

What does a central bank in an Islamic monetary system look like? And what can it do?

Operating in a non-interest environment, the Islamic central bank cannot make use of some of central bank’s conventional policies to manage the country’s monetary base and money supply. Such policies include the setting of discount rate (e.g. Federal Funds rate, Repo rate, etc) used as reference for commercial banks, and open market operations with interest-bearing securities. However, the central bank in Islamic banking system can still utilize these tools in their operation:

• Reserve requirements
• Overall/Selective controls on credit flows
• Management of currency issues
• Open market operations with equity-based assets
• Moral suasion, a.k.a influence over the banks

Although the central bank cannot set the discount rate, it has an option to employ another type of rate which is still compliant to sharia principle, i.e. profit-sharing ratios between the commercial banks and the customers (lenders and depositors). 

Islamic Finance: Banks in Islamic Financial System

What do an Islamic financial institutions (in this case, banks) look like in the Islamic monetary system?

Islamic banking system is essentially an equity-based system in which depositors are treated as if they are “shareholders” of the bank. Thus, when the bank profits, the depositors profit. And when the bank loses, the depositor also loses.

One can also think of the commercial banks in Islamic banking system as closely resembling investment banks in western financial system, as the depositors of the investment banks are subject to profit sharing of the banks’ businesses.

Here are some of the characteristics:

1. Sources of Funds

Due to interest prohibition, Islamic banks will have to utilize a kind of “mutual fund” type packages to its depositors. In this case, Islamic banks separate the deposits into 2 forms: transaction deposits and investment deposits. Transaction deposit is the deposit made by depositors in order to be safeguarded by the bank. The Wadia type of contract can be used to base this deposit on. The depositors would not earn any interest on this deposit. On the other hand, the bank can offer a wide range of transaction services such as debit card, remittance, bills payment, checking facilities, etc and charge some fees for the services. It is been argued that this type of deposit must have 100% reserve requirement to guarantee the safety of full nominal amount of the deposit. Khan and Mirakhor (1994) believe that this 100% reserve system is in favor to non-reserve system because it offers more stability to the financial system as a whole. 

U.S. Banks’ Asset, Liabilities, & Income Structure: Investment vs Commercial Banks

This post is to summarize and compare some basic financial ratios between US commercial and investment banks. The purpose is to see the difference of the asset, liabilities, and income structure between the two groups.

The sample for this mini-study is the 20 biggest US Banks as taken from this list, which then are divided into 2 groups:

1. Investment Banks
   • Unfortunately, only 2 pure investment banks made into the top 20 US Banks list, i.e. Goldman Sachs and Morgan Stanley
2. Commercial Banks
   • From the remaining 18, we exclude 2 banks (HSBC North America Holdings and TD Bank US Holding) since both are subsidiaries from foreign banks, thus not listed in the U.S, and their separate financial information is unavailable.

Then we gather the financial data from the banks’ 2013 10-K filings (available from the EDGAR database containing SEC filings). Note: since Citizens Financial Group (NYSE:CFG) just went public on September 2014, we use the data from its 2013 annual report.

We calculate 17 financial ratios: 3 for asset-related ratios, 5 for liabilities-related, and 9 for income/expenses related ratios. Then we compare the simple average of the ratios between investment banks and commercial banks. To add some validity, we also calculate the t-test to judge whether the difference between the investment banks and commercial banks could be considered significant (using 5% confidence interval).

Swiss Shock 2015: Action by Swiss National Bank

On January 15th 2015, the central bank of Switzerland, the Swiss National Bank (SNB) shocked the financial world by applying these 2 policies simultaneously:

1. Reducing central bank deposit rate into an even more negative territory, from -0.25% to -0.75%
2. Removing the Swiss Franc (CHF) cap to Euro (EUR) which was previously maintained for 3 years (the cap policy started on September 2011)

The first move by SNB was actually quite predictable, as a logical move in preparation to face the coming Quantitative Easing (QE) policy by the European Central Bank (ECB) the week after. The ECB is preparing to lay down its plan for QE on Thursday, January 22nd.

What sends the world in shock was the second move, which was actually denied by its own vice president just 2 days before. The market was in turmoil after the announcement. The CHF rose up to 41% in just one day right after the announcement, and is still trading in high volatility until today (January 20th).  The real reason why SNB did this is still unclear, given the fact that the press announcement by Thomas Jordan (SNB chief) did not provide us with satisfying answers. However, some analyst suggests that this move is done because the SNB does not want to expand its balance sheet even further to maintain the value of CHF. It has been a pricey policy to buy the EUR whenever it’s falling in value (in order to prop up CHF so that it’s maintained at CHF 1.20 per EUR), and it would become even more pricey when the ECB is all-out with its QE.

Takeover Defense Tactics

When being threatened by hostile takeover attempt from another company, defensive companies could employ some tactics to prevent (or at least to discourage) the hostile takeover. We divide the tactics based on their types, i.e. the pre-offer (prevention) and post-offer tactics. Many of the tactics have fancy names. Some of the tactics commonly employed include:

A. Pre-offer

1. Staggered Board

Dividing the terms of the board members into several levels (usually 3), and only 1 level is elected periodically. This will make it harder for the hostile bidder to gain control of the target company’s board.

2. Super-majority

Creating a provision that requires a high percentage of board vote in order to approve a merger (usually 80%). This will increase the number of shares needed by the bidder to get the target’s board to approve the merger.

3. Fair Price

Super-majority provisions waived if bidder pays all stockholders the same amount. This will prevent two-tier offers from the bidder (in which the first tier is usually a preliminary offer to round up supports for the next conclusive tier).

4. Poison Pill

Issuing rights to preferred stocks to existing stockholders other than the hostile bidder (or someone suspected as being a hostile takeover culprit). The rights can be exercised after a tender offer by the bidder or when accumulation of large stock by outside party occurs. For example, when an existing shareholder suddenly builds up his holding into 20% of the company (thus suspected as being a hostile takeover culprit), other shareholders can exercise a right to buy company’s share at steep discount, thereby diluting the effect of the hostile takeover suspect’s control in the company. This move will make it more expensive for the bidder to acquire target’s stock and accumulate shares needed for considerable influence in the board.

Before resorting to this poison pill, the target company may try to employ a milder type of defense (called Scorched Earth Defense) to make itself unattractive to the bidder, for example by restructuring debt terms to expire soon after the proposed takeover date, or by selling the “crown jewel” of the company.

Poison pills tactic is still allowed in the U.S. but is illegal in many countries including those in Europe.

5. Dual-class Recapitalization

Issuing a new class of stock to existing stockholders which has high voting rights but low dividends or marketability (uninteresting to sell). Usually accompanied by an option to convert the new stock class into ordinary common stock after some time. This will give more voting power to existing stockholders to fend off hostile bidder when a proxy fight occurs.

6. Golden Parachute

Setting a provision in the CEO compensation plan that includes big bonus (either in cash or stocks, or both) for him if the company is acquired by other company. This will discourage the bidder from making further effort to takeover the target company.

7. Lobster Trap

Setting a provision that prohibits a party with more than some portion (usually 10%) of convertible securities (convertible bonds, warrants, rights, convertible preferred stocks) to convert his holding into a voting common stock. This will make it harder for the hostile bidder to acquire necessary stocks to build up control in target company.

B. Post-offer takeover defenses

1. Targeted Repurchase / Greenmail

Repurchasing a block of shares held by shareholders. May also include an effort to repurchase the block of shares already owned by potential hostile bidder (at a premium of course). This will eliminate potential bidder.

2. Standstill Agreements

Limiting the ownership of stocks by any party to a specific amount or a specific time period. This will also eliminate potential bidder.

3. Litigation

Filing suit against the hostile bidder for violating antitrust or corporate law. This will fend off the hostile bidder, or at least delay the takeover process.

4. Asset Restructuring/Crown Jewel Defense

Purchasing assets unwanted by the bidder, or selling assets most liked by the bidder. When the target company sells assets/business part most liked by the bidder, this effort is called Crown Jewel Defense, for the target selling its “crown jewel” (most valuable part) of the company. This will reduce the target company’s appeal to the hostile bidder, therefore discouraging him to continue with his bid.

5. Liability Restructuring

Issuing shares to friendly party and then repurchasing it (usually at premium) after the takeover fails to occur. This will make it more difficult for the bidder to acquire enough shares to achieve control / to propose a proxy fight.

Another alternative of liability restructuring involves increasing debt to a very high level, so that it deters the interest of the bidder. This mounting up debts by the target company is called Jonestown Defense.

6. White Knight

Engaging a friendly party (“the white knight”) to merge with the target company to sidestep the merger offer by the unwanted hostile bidder. Unlike liability restructuring, the target company does not simply sell shares to the white knight but instead fully merges with it. In some cases, the white knight itself has been having an interest in the target company after all.

7. Pac-man Defense

Counter-attacking the hostile bidder by buying the bidder’s shares and take major control in the company. This will stop the takeover effort from the bidder. Since this tactic requires vast amount of resources, usually the target company who wants to employ this tactic also seek help from other friendly party.

References:

Ruback, Richard. Chapter 3: An Overview of Takeover Defenses. Mergers and Acquisitions. University of Chicago Press. 1987. Available online at: http://www.nber.org/chapters/c5821.pdf

http://www.investopedia.com/articles/stocks/08/corporate-takeover-defense.asp

http://en.wikipedia.org/wiki/Takeover#Tactics_against_hostile_takeover

http://money.howstuffworks.com/hostile-takeover3.htm

Islamic Finance: Types of Contracts

There are several types of financial contracts in the field of Islamic finance. Some of them serve as substitution to existing conventional finance contract, and some of them are special contracts only exist in Islamic finance. Below are just simple definitions of some of the transaction contracts in Islamic finance; note that these contracts are limited to transaction contracts for goods (physical products) and business, and excluding Islamic financial funds to be operated in capital market, such as Sukuk, Wakala, and Takaful:

1. Mudharaba

 Conventional equivalent: Trust fund agreement

In mudharaba (partnership), one party (rab al mal) gives money to another party (mudharib), which then invests the money into a business/economic activity. Both parties share any profit from the investment based on pre-agreed ratio, but if the investment goes bad, only the first party (who gives money) can lose money, while the other one loses his time & energy. The mudharib can also receive fixed fee for its service in managing rab al mal’s money. This contract is widely used by Islamic banks to accept deposits from its depositors, in which the depositors become the rab al mal, and the bank becomes mudharib. This contract is also used when Islamic banks make loans to its customers, in this case the bank becomes the rab al mal, and the customers become the mudharib (which then used the money for whatever business they might have).

2. Musyaraka

Conventional equivalent: Joint Venture

Unlike Mudharaba where a party acts only as provider of capital while the other acts only as fund manager, in Musyaraka all parties contribute both capital , skills, and labors needed in its venture. Any profit/loss made will be shared among all partners.

How Much Do Indonesian Banks Rely on Interest Income?

This post is to compare the income structure between the world’s 50 biggest banks vs Indonesia’s 50 biggest banks. We’re going to compare the portion of income derived from interest vs non-interest, to see whether Indonesian banks are still relying too much on interest income and not getting enough income from other sources as compared to the world’s biggest banks.

The figures we are going to compare here is the percentage of income derived from “net interest income” to the total operating income. In simple terms:

 

The data are mostly the 2013 figures, except for Japanese banks which is the March 2014 fiscal year figures.

Daftar Bank Terbesar di Indonesia Berdasarkan Total Aset

Post ini adalah versi Bahasa Indonesia dari post https://rifqilazio.wordpress.com/2015/01/06/list-of-banks-in-indonesia-based-on-assets/. Daftar ini disusun berdasarkan data finansial yang disediakan oleh Otoritas Jasa Keuangan (OJK) di website-nya. Database yang sangat bagus dan sederhana tersebut bisa diakses dari http://www.ojk.go.id/id/kanal/perbankan/data-dan-statistik/laporan-keuangan-perbankan/default.aspx . OJK mengklasifikasikan bank-bank di Indonesia ke beberapa kategori:

1. Persero –> bank yang mayoritas sahamnya dimiliki negara
2. BUSN (Bank Umum Swasta Nasional) devisa –> bank yang telah memiliki sertifikat dari BI untuk melakukan transaksi berbasis valuta asing, seperti transfer ke luar negeri, ekspor-impor, jual-beli valas, dll.
3. BUSN non-devisa –> tidak bisa melakukan transaksi berdasarkan valas
4. Bank campuran –> bank yang dibentuk dari perjanjian joint venture antara bank di Indonesia dengan bank asing
5. Bank Pembangunan Daerah (BPD) –> bank yang beroperasi terbatas hanya di daerah tertentu
6. Kantor cabang bank asing (KCBA)
7. Bank syariah –> bank yang beroperasi berdasarkan prinsip syariah
8. Bank Perkreditan Rakyat –> bank yang tujuan utamanya adalah memberikan kredit ke masyarakat lokal, pekerja lokal, atau pebisnis lokal, dan tidak bisa memberikan jasa lalu lintas pembayaran.

List of Biggest Banks in Indonesia Based on Assets

For the same post in Indonesian, please refer to https://rifqilazio.wordpress.com/2015/01/06/daftar-bank-di-indonesia-berdasarkan-total-aset/.

This list is compiled based on financial data publicly available from Indonesian Financial Service Authority (Otoritas Jasa Keuangan = OJK) site, which has done a marvelous job in compiling all periodic publication of banks into one simple database. The database can be accessed from http://www.ojk.go.id/id/kanal/perbankan/data-dan-statistik/laporan-keuangan-perbankan/default.aspx .

Please note that the OJK classifies banks into several categories:

1. State-owned banks
2. Foreign exchange banks –> certified banks who are capable of conducting forex-based transactions, e.g. overseas transfer, export-import assistance, forex trading, etc.
3. Non-foreign exchange banks –> not capable of conducting forex-based transactions.
4. Joint Venture banks –> banks created from a joint venture agreement between Indonesian bank and foreign bank
5. Regional banks (BPD) –> banks whose operational are limited to one specific regional area
6. Branches of foreign banks
7. Sharia banks –> banks conducting their operations based on sharia principles
8. Rural bank (BPR) –> banks whose main purpose are to provide credit to local entrepreneurs, or workers, and are not capable to provide transfer payment services.