I. ISLAMIC FINANCE IN GENERAL
Islamic finance is a system that all types of financial activities and transactions are performed pursuant to Islamic principles. All types of manners and activities prohibited in Islamic belief are considered to be prohibited and not applied in this system.
The key element prohibited in Islamic law is the interest; accordingly the system is based on this prohibition to a certain extent. In an increase in trade, both parties share risk and income equally. However, risk is totally on the indebted party in a transaction with interest. Therefore, interest is prohibited in Islamic finance in order to prevent this issue. In this respect, creditor can not demand an increment from the debtor which is predetermined in proportion to the capital.
Islamic religion also prohibits activities that include uncertainty. Subject of the agreement should be known and definite in bilateral contracts in line with the principle of equality. For instance, there is a regulation in insurance business that compensation for indefinite loss which would arise from risks whose realizations in the future are uncertain is undertaken in return for the payment of premium. For this reason, since such regulation is an indefinite field of activity, it is prohibited in Islamic finance.
In line with the foregoing, illicit activities mean income which is only earned through the other party’s lost. In this respect, games of chance such as gamble, bet may be an example of this issue.
Islamic financial service sector is divided into three categories, namely Islamic Banking, Islamic Insurance and Islamic Capital Markets. Islamic Finance Groups may be listed as Commercial Islamic Banks, Islamic Insurance Institutions, Islamic Investment Institutions, Islamic Investment Banks and Islamic Asset Management Companies.
II. METHODS OF ISLAMIC FINANCE
Islamic finance system is constitutively based on interestfree finance techniques which are developed within the scope of principles of profit and loss participation and difference between purchase and sale. Mudaraba and Müşaraka are the finance methods based on profit and loss participation. Moreover, Murabaha and İcara methods have a wide range of usage area in accordance with earnings based on purchase-sale and leasing.
Mudaraba (effort/capital participation): Mudaraba gathers capital and effort together. One party puts in his capital whereas the other party conveys his knowledge, experience and effort to the job. These two entrepreneurs’ aim is to realize a joint project. In the end, profit is shared between parties pursuant to the rate which was determined and agreed on previously, and in case of a loss capital owner bears all loss. The loss of the party who relays his effort is to waste his effort and to obtain anything in return for such. Mudaraba is an agreement and accordingly the whole capital is covered by an Islamic bank. On the other hand, the entrepreneur finances his project with fund provided from the bank. Therefore, the bank should be careful and diligent on entrepreneur’s choice. In this system, Islamic bank covers the loss except for the case of breach of the agreement terms by the entrepreneur. This method is not often applied in practice.
Müşaraka (profit/loss participation): Parties gathers capital and effort together in this method. Provided that one of the parties is a bank, two or more parties generally enter into an unincorporated partnership pursuant to terms of the agreement in order to provide financial support to a definite investment or activity and they share profit and loss in proportion to their shares at the end of such investment or activity. In this context, parties may share different rates of profit although they invest in different rates of capital; however loss is shared in proportion to their shares in the partnership. All shareholders invest in Müşaraka; each shareholder has the right in the management and they have unlimited liability. Ownership of all assets is also joint.
Murabaha (cost plus sale with profit margin):Murabaha is a system that provides finance allocation by way of purchasing goods with advance payment and selling these goods with a due date. Islamic bank purchases the goods requested by the customer and sells them to the customer by adding certain costs and profit. Bank takes all risks regarding the goods for the duration it holds the goods; and ownership of the goods belongs to the institution which provides finance until the goods arrive to the end customer. Accordingly, bank enters into two different agreements with both the seller and its customer and price, delivery date and payment plan should be determined in the agreements. In this case, real goods should be traded and they should be purchased by a third party. Price of the goods cannot be increased in the case that buyer does not pay the price of the goods. One of the most significant characteristics of Murabaha different from the interest is that payment cannot be paid in cash to the buyer; banks should pay directly to the seller independently from the buyer. Murabaha is commonly preferred more than Mudaraba and Müşaraka since it provides the opportunity for a shorter term profit.
İcara (lease financing): İcara is similar with the leasing activities of traditional banking system; however, instead of direct sale, ownership of the goods passes to the buyer at the end of leasing term in this system. Islamic banks lease an equipment or building to one of their customers with a fixed amount and for a fixed period. There is a predetermined and fixed income in this agreement. It differs from the classic loan since here the loan is not provided in cash to the lessee.
SUKUK (ISLAMIC BONDS)
Sukuk is an instrument issued pursuant to the abovementioned Islamic finance methods (being without interest). Sukuk means “certificates” in Arabic. Bills and bills of exchange are called “bond”, and “sak”s which are Islamic bonds are called “Sukuk”.
Sukuk indicates a right to own or benefit from an asset. The right/claim in Sukuk is not only about cash-flow right, but also about ownership right. While, traditional bills of exchange are securities with interest, Sukuk is basically a security which consists of ownership right in an “asset box”. Sukuk is taken into account by comparing the traditional bills of exchange since, instead of interest, it gives to its enterpriser a share out of profit/income obtained from the asset it is funded .
A bill of exchange may be considered to be a loan based certificate, and Sukuk may be considered to be an asset based certificate. A bill of exchange is a bill of debt released in order to find a loan. On the other hand, Sukuk buyer has a full right of disposition on the relevant asset. Consequently, Sukuk buyer has right to have a share from the income obtained from Sukuk assets, as well as the revenue arising from the sale of assets. Another distinctive characteristic for Sukuk and bill of exchange is that Sukuk represents ownership on the relevant asset in proportion to its share whereas bill of exchange represents investor’s debt.
Moreover, unlike other bonds, Sukuk has to be based on an asset. In the interest-free banking model, provision of cash loan facilities and providing non-business loan facilities are prohibited. The participation bank, as the institution which provides loan facilities, has to know where it transfers the collected funds. Likewise, Sukuk system works this way; a real trade relationship and visible material fact are sought at the core of all issued certificates.
In order to understand the Sukuk system, first the Asset Based Security (ABS) system should be observed. In the ABS system, a company, which has receivable portfolio, sells this portfolio to a special purpose vehicle (SPV) and this company converts the portfolio to a security. In the meantime, investment banks intermediates to the sale of these securities to the investors. Since receivables arising from the real trade relationships or lease agreements are subject to the asset-based securitization, Sukuk could be defined as an asset-based bond.
Sukuk investments made by Sukuk holders give full right of disposition on the relevant asset and grant right to have a share from the income obtained from Sukuk assets, as well as the revenue arising from the sale of the assets. Sukuk represents proportional ownership and a Sukuk holder, for a certain period, owns risk and income arising from a cash-flow originated from a certain asset. Sukuk differs from a share certificate as Sukuk issuance has a certain due date and the ownership is limited to a certain asset of the company.
Characteristics of Sukuk certificates may be specified as follows:
- They are specified as interest-free bond.
- They are equal valued certificates. They represent ownership power with indivisible shares.
- They provide establishment of right in favor of certificate holders on the assets subject to the special projects or special investments,
- They are based on assets. (“asset-based”/”assetbacked”)
- Generally, the base assets are transferred to a Special Purpose Vehicle (SPV).
- They establish rights on income arising from assets. & They have the capability to be quoted in the organized markets and may be valorized by the rating agencies.
- They may be traded in secondary markets.
Their income may be fixed or flexible. Sukuk removes due date incompatibility as a long-dated funding instrument in respect of financial institutions which conduct interest-free banking.
III. INTEREST-FREE BANKING AND SUKUK IN TURKEY
Participation Banks in Turkey have formed lease certificates which are similar instruments to Sukuk. Sukuk structure provided first in Communiqué on the Principles of Lease (Ijara) Certificates and Asset Lease Companies of Capital Market Board published in the Official Gazette dated on April 1, 2010 is “Sukuk Ijara”. Issuance of Sukuk by financial institutions and firms in Turley has become possible inside and outside Turkey by means of this Communiqué. In addition, in January 2011, certain tax exemptions regarding Sukuk have been regulated.
Participation Banks currently conducts Sukuk activities in Turkey are Albaraka Türk Katılım Bankası A.S., Asya Katılım Bankası A.Ş., Kuveyt Türk Katılım Bankası A.Ş. and Türkiye Katılım Bankası A.Ş.. Kuveyt Türk Katılım Bankası A.Ş. has issued Sukuk for the first time at the end of 2011.
Definitions Regarding Sukuk System
Fund Organization (Originator): It is defined as the institution that intends to provide fund from the capital markets. Originator could ensure the procurement of fund with the assets it owns (or it leased from third parties in certain circumstances).
Asset Lease Company (ALC): This company is an SPV established as a joint stock company by the Originator with the sole purpose of Sukuk issuance.
Assets That Maybe Subject to Sukuk: These assets are defined as all kinds of movables or real properties as well as immaterial assets which would be leased or purchased by the ALC.
Sukuk (Lease Certificate): Sukuk is a security issued by ALC in order to ensure financing of the assets it acquired by way of purchasing and leasing and that procures its owner the right to have a share from the income obtained from such assets in proportion to his share.
Operation of Sukuk System
- Originator establishes an ALC in order to issue Sukuk.
- Originator transfers the relevant assets to the ALC and ALC issues Sukuk in order to ensure finance of the assets it acquired and pays the amount collected from the third parties in return for Sukuk to the Originator as the transfer price.
- ALC re-leases the assets it acquired to the Originator and obtains lease income; and periodical payments of issued Sukuk to the Sukuk holders are made from such lease income.
At the expiry of the due date assets are re-transferred to the Originator and the transfer price is paid to investors in proportion to their shares.
Lease Certificate and Asset Lease Companies
Pursuant to the new Communiqué on Lease Certificates published in the Official Gazette dated June 7, 2013, ALCs may (i) issue lease certificate, (ii) take over and lease all kinds of assets on its own behalf and on lease certificate holders’ account, and pay income obtained from assets to the certificate holders in proportion to their shares, and (iii) transfer the assets subject to lease, to the Originator at the end of lease agreement in accordance with the conditions agreed previously.
Pursuant to the Communiqué on Lease Certificates, ALCs cannot (i) use loan, become indebted and use the assets they own for any activities other than the ordinary performance of activities mentioned above, irrespective of the name under which; (ii) establish a real right on the assets they own in favor of third parties; (iii) transfer the asset to any person other than the originator which fulfills all of its obligations arising from lease agreement.
Potential Application Area of Sukuk in Turkey
- Sukuk may be used for the purpose of Treasury (Government) loans.
- Public institutions may generally resort to the issuance of Sukuk in infrastructure and investment projects.
- Municipalities may resort to Sukuk on infrastructure and other investment projects.
- Housing Development Administration of Turkey (TOKİ) may resort to the issuance of Sukuk on project basis, or it may prefer Sukuk as an instrument for procurement of long-term fund by using its own immovable stocks as the base asset.
- Corporate companies in Turkey may issue Sukuk by utilizing their own assets (all kinds of movables and real properties and immaterial rights) as the base asset.
- Since shopping malls have lease income from their own real properties, they may issue sukuk by way of such properties.
Real Estate Investment Companies may issue Sukuk
Why Would Companies in Turkey Issue Sukuk?
- Provision of a low-cost financing may be aimed by converting the assets in the companies’ balance sheet to fund.
- Access to a broad investor mass may be aimed by producing a product which is in compliance with Islamic law rules.
- All transfer transactions between ALC and Originator are free from any taxes.
The Originator which provides the fund by way of Sukuk does not pay any taxes for the fund inflow. (Sukuk instruments are taxed in terms of investors the same with other bills of exchange and bonds.)
Sukuk is one of the important financial instruments in accordance with interest-free banking principles which were developed for the purpose of increasing finance in international capital markets. Private corporations, public institutions and financial institutions use the issuance of Sukuk as an investment instrument. In Turkey, Sukuk is nowadays recognized as an alternative investment instrument for medium and long-term savings.
Despite the fact that different kinds of Sukuk have been presented to the market in the course time, most of the Sukuk certificates issued to date are İcara Sukuk. The capability of trading in secondary markets has increased the functionality of Sukuk as an alternative investment instrument. In Turkey, even if other types of Sukuk attract less attention than İcara Sukuk, they have recently started to have an important role for investors in developing markets to participate in certain projects such as airports, bridges, and barrages (public procurement projects).
