LC Financing. Comparison between an Islamic and a conventional bank in Qatar - Essay Example

? LC Financing Comparison between an Islamic and a conventional bank in Qatar Introduction The field of trade finance is used to enable importers to purchase goods from abroad and even at times facilitate inland trade. Banks provide various solutions to reduce risks and help maximize trading potential. One of the main instruments in this branch of banking is a letter of credit (L/C). A L/C is “a letter from a bank guaranteeing that a buyer's payment to a seller will be received on time and for the correct amount” (Investopedia). The bank is obliged to cover the amount if the buyer is unable to make the payment, on presentation of shipping and other stipulated documents, and under specified conditions. It is a financial agreement – a secure mode of payment - between an importer and exporter for goods shipped (Finance). In Wall Street Words, David L. Scott defines a letter of credit as “a promise of payment in the event that certain requirements are met. A letter of credit essentially substitutes the credit of a third party (usually a large bank) for that of a borrower. In the case of municipal bonds, an LOC generally permits a trustee to draw six months' interest and sufficient funds to retire outstanding bonds at par in the event of default” (qtd. in Letter of Credit). Since L/Cs carry a risk for the issuing bank in case the client defaults, the bank assesses the client’s creditworthiness and financial position to evaluate his ability to pay in the future. In some cases, the bank may ask for a security to minimize chances of loss. There are various departments within the bank which cater to such analysis and evaluation in order to judge whether the customer is worthy of providing credit or not. If the customer simply is asking for a letter of credit then the bank assumes responsibility for the traded goods coming into the country. In that case, checks and balances are even stricter and require that the customer is of extremely good credit worthiness based on which financing and LC facilities are then provided. Corporate and commercial banking departments are formulated where teams sit and evaluate companies for their creditworthiness as well as their capacity to pay back the loans that they have taken. Other departments that may be involved in this case may include Risk Management department, Credit management department, Commercial Banking and Audit as well as a committee that is formulated especially to evaluate credit packages that are developed through the corporate or commercial banking departments. (Islam). Uniform Customs and Practice for Documentary Credits (UCP 600), issued by the International Chamber of Commerce, includes the latest rules which govern letter of credit transactions in international trade finance worldwide. What are L/C finance contracts? There are various financial solutions offered by banks for trade financing. L/C finance contracts are one of them, with modern banks offering a wide range of L/C financing products to meet complex needs of traders. One of these is export contracts through which the exporter's bank extends a loan to him. Trade loans are regarded as an important trade finance technique. They are especially suitable for wholesalers and manufacturers as they can be utilized for both one-off and regular purchases of raw materials, goods, etc. The bank can extend finance until payment from the on-sale of goods is provided by the client (Barclays). L/C finance contracts in Islamic bank Muslim jurists believe that reward for capital needs to be linked to the outcome of any project if financing is being extended by the bank. They are of the view that gains should be made via trade involving sale and purchase (Hanif 3). Islamic banks have thus come up with alternate, Shariah-complaint financial solutions for customers as compared to conventional banks. Murabaha is one of the most commonly used principles in Islamic trade finance. It refers to: “…a contract of sale and purchase at a profit margin between the supplier and the purchaser of the good. The cost and profit from the transaction must be known in advance and agreed by both parties to the contract. Under this principle, the financier would purchase goods and later resell them to the customers on a mark-up price, agreeable to both parties” (Chong, Abdullah and Anderson). Another principle is Istisna’a. This refers to a sale transaction where an asset is sold prior to coming into existence - an order to manufacture an asset for the buyer. The manufacturer, the bank’s customer, uses his own material to manufacture it. The price is fixed and specifications decided under Istisna’a, as mutually agreed between the parties involved (Bank). Both Murabaha and Istisna’a are used to meet customers’ working capital needs. They can use either for the purchase of raw materials for manufacturing or trading of goods. Istisna’a is used by businesses involved in the manufacturing of goods. It is suitable for exporters/manufacturers who have export orders in the form of Sight/Usance L/C . Murabaha meets the exact requirements of each customer. The bank purchases the commodity on behalf of the customer and sells it to the customer for an agreed level of profit. In other words, it is a sale on a deferred price rather than a loan with interest. So instead of advancing money, the bank purchases the good from a third party. But Murabaha is different from a normal sale as it involves disclosure of cost of goods sold. Another concept used by Islamic banks for trade financing is Wakalah. In this case, the bank fulfills the role of an agent of the importer, who deposits the full amount of the L/C to cover the import transaction, after which the bank opens the L/C. This is used to make payment after goods have been shipped and the exporter has presented the documents. A fee is charged by the bank for the service provided (Islam). LC Financing in Qatar Islamic Bank and Other Islamic Banks LC Financing in conventional banks is extremely different from how it is dealt with in Islamic banks. In Islamic banks all across the globe, LC Financing is taken as a short term or long term contract between the bank and the organization for whom the letter of credit was opened. This contract denotes some form of compensation against which risk has been taken by the bank, which the organization pays in the coming time period (depending on the tenure of the financing), covering the full price of the contract including the profit that the bank charges as its fee. There are various modes of payment that may be applied in this case to the LC financing that the bank wants to undertake and the company wants to have financed (Hanif, 3) As explained earlier, these modes may include Wakala which is applicable in some countries like Malaysia but discouraged in other countries like Pakistan; Murabaha which is one of the most popular modes of financing for most banks across the globe and Istisna, which is a similar product to Murabaha and again a popular choice for short term financing of Letters of Credit. In some cases, letters of credit may also be opened for a longer tenure. These longer tenure LCs are opened in cases where large equipment or machinery has been imported. Such cases arise when the organization has purchased but does not have the means to pay for the equipment. For such instances, products such as Ijarah are utilized as well. The product Ijarah generally can be understood as the operational lease since the Ijarah charges rentals to the organization which pays the bank for using the machinery or equipment while purchasing a part of the machinery over time. Thus, over the time period, the goods then become the property of the organization who can use it and consider it as an asset on its books in the future. As an operational lease, the company also does not have to mark it as long term debt which is also one of the major elements in Islamic banking that financing through Islamic modes is not debt but payment for compensation of services rendered. (Hanif, 3) When we consider the case of Qatar International Islamic Bank and Qatar Islamic Bank, we should also consider the various products that these banks have to offer. Both these banks provide Letters of Credit for its customers for operational and non-operational goods to be imported. In this respect, both these banks also provide ways and means of financing these goods that are coming on to the ports. The ideology behind their financing the goods is that such goods are the property of the bank till the time the organization has the means to afford these goods and can buy them from the bank. Both these banks offer the various products that were outlined earlier. For shorter term, which in some banks is also referred to as working capital, the banks offer short term products which are Murabaha, Wakala and Istina as working capital financing. For the longer term, where the organization has to purchase equipment or heavy duty machinery, the banks also offer Mudarba and Ijarah financing where the organizations can mark operational lease into their books and avail the financing against their letters of credit from these banks. (Hanif, 3) It must be noted that in most cases, LC financing has to be decided between the bank and the customer prior to the opening of the Letter of Credit. The only reason both Qatar International Islamic Bank and Qatar Islamic Bank perform this scenario is to make sure the trade financing mechanism is smooth and in compliance with Shariah rules and regulations. In any financial contract, it must be ensured that the price of purchase is decided before the contractual agreement. Otherwise, the agreement will be null and void as it becomes conditional in nature and conditional contracts are not legal or lawful in Islam. As a result, the bank and the customer decide prior to opening of the letter of credit, whether the LC will be financed through the bank, in which case, the bank will take ownership of the goods, or the customer will finance the LC itself, in which case the funds will be coming in from the customer. (Hanif, 3) Both the Qatar banks also offer another mode of financing for the Letters of Credit which may be considered as well. This is the buyback transaction which is not legalized in some countries or is frowned upon in others such as in Pakistan. However, in Qatar, this transaction is considered lawful and is performed by both Qatar International Islamic Bank and Qatar Islamic Bank. This transaction indicates that the company can gather funds in the longer or the shorter term if it needs funding, by selling its goods to the bank and then buying it in the future. This can be done in the case of LCs as well where the customer pays for the goods from its own pockets but later own requires funding from the bank. In that case, these banks in Qatar offer to purchase the goods in today’s date and sell at a higher rate in the future. This allows the company to raise funds and also utilize the goods as it deems fit. (Hanif, 3) L/C finance contracts in conventional bank Although different banks have various kinds of solutions, some common ones are: Import Bills - Collection Bill of Lading Endorsement: The client informs suppliers to send shipping documents to the bank. The bank then provides prompt advice and makes the payment as per the instructions. To take possession of shipment, after the L/C has been issued, endorsement authority of original transport document is required. Export L/C Negotiation: If a client requires financing and provides all the documentation (such as sight and outstanding documents) under L/C as pledge, Export L/C negotiation service is provided before the payment by issuing bank. Export L/C advising service is provided after the credit of deferred payment from issuing bank is received. Import Bills - Collection: For timely foreign exchange payments, banks provide import bills for collection financing, on receipt of documents and delivery of goods. Packing Loan:  This refers to pre-shipment financing against irrevocable L/Cs. Companies can apply if they need financing because of any problems in stock, manufacture and shipping after the L/C has been received. Companies can also refund the loan after goods have been shipped. Export L/C Confirmation/Discounting: In export L/C confirmation the bank confirms export L/Cs and gives guarantee of payment for document provided in compliance with the credit. Export L/ C discounting signifies negotiation of documents (if there are no discrepancies). The discounted value of the invoice can then be advanced. Forfaiting: This refers to the purchase of an exporter's receivables -- the amount owed by the importer to the exporter – at a discount. The purchaser (forfeiter) is then paid by the importer for debt settlement (Finance). This service is provided by the bank after credits of deferred payment are received from issuing bank. Shipping and Airway Guarantee: For companies that have applied for L/C service, the bank may facilitate prompt clearance of goods until bills of lading are received. This is done by issuance of a shipping/airway guarantee in favor of the carrier to avoid price fluctuations and demurrage charges (ICBC). LC finance contracts in HSBC Hong Kong and Shanghai Banking Corporation Limited (HSBC) is regarded as one of the largest banks and financial services organizations in the world. With its head office in London, the bank’s network includes 7,200 offices in more than 80 countries in Europe, Asia-Pacific, Americas, the Middle East and Africa (hsbc.com). At HSBC (Qatar), stated conditions on the L/C include (but are not limited to) the time frame, stipulated documents against which payment will be made and the maximum amount to be paid. The following methods of L/C financing are used by the bank: Deferred Payment: Payment is made on a specified or determinable future date. A nominated bank incurs deferred payment undertaking to pay at maturity. Negotiation: A nominated bank discounts documents presented under a L/C with recourse (liability) to the drawer. Acceptance: Usance drafts are drawn on an accepting bank (generally in the country of the beneficiary). Negotiation is made to the beneficiary on a ‘without-recourse basis’ (transfer of instrument without assuming any liability). The bank which agrees to be an accepting bank, takes on issuing bank risk and charges an acceptance commission as a result. HSBC offers a full range of special L/Cs for importers: Back-to-back DC (Documentary Credit or L/C) – The beneficiary of an export L/C can request the issue of back-to-back DC. The bank takes the original master L/C as a form of security and sets up a facility prior to issuance. Transferable DC: This can be transferred by the original beneficiary to another beneficiary (or several beneficiaries if partial shipment is allowed). But the DC cannot be transferred further by a second beneficiary. Standby DC - This has simple terms and is issued to cover the non-performance of one party to the contract. It generally states an amount to be paid to the beneficiary if he submits a signed statement or other documents showing default by the applicant. Revolving DC – This can be used for a continuous trading cycle/regular shipments. The terms and conditions state that the amount is renewed or reinstated sans any specific amendments. There are two types of revolving DCs offered by HSBC: Revolve around time: This needs to give a maximum amount which can be drawn within each time period. Revolve around value: This is automatically reinstated upon usage, within a given time period (hsbc.com.qa). Comparison of L/C finance contracts in Islamic and conventional banks An Islamic bank’s activities include all conventional banking activities, with the exclusion of lending and borrowing on the basis of interest (Al-Jarhi and Iqbal 1). L/C finance contracts are not treated as a guarantee by Islamic banks. They provide a fee-based service which facilitates trade. As discussed earlier, Islamic banks issue L/Cs on the basis of principles such as Murabaha, Istisna’a or Wakalah. All operations are governed by Shari’ah boards in the banks. Islamic banks are allowed to charge a handling commission - a service charge to for processing L/Cs, documents and payments. The amount of fee varies with the service and the amount of the L/C. The bank can charge its client issuing commission, postage charges, advising or confirmation fee and so on (Islam). Both Islamic and conventional banks provide financing ‘to productive channels for reward. However, their financing agreements are different as conventional banks offer loans for a fixed reward while Islamic banks cannot since they do not charge interest, only profit on investments. Islamic banks can do business by providing the asset to the client. In the case of Murabaha, if a payment is delayed by the customer, the bank cannot charge extra as it will not account for time value of money like conventional banks. However, it can impose a penalty on defaulter, if this has been stipulated in the original contract (Hanif 4-5). Fees, Fines and Interest – Good Shipment and Arrival Fines, Fees and Interest in Conventional Banking There is a marked difference in the way fines are charged in conventional banking with respect to trade financing; when compared to the fines applied in Islamic banking. The conventional bank generally earns its funding from LC financing through a certain percentage that it applies to the amount of the LC. This is the interest rate on the LC that the bank earns when it has opened the LC. The conventional bank has a large scope in earning money through a letter of credit. (Hanif, 3) The various fees and charges primarily include the LC opening fee that may be a flat fee or a variable fee based on the amount of the LC. Secondly, LC charges that are part of the goods being shipped are also considered in the fee charged to the customer for the letter of credit and are a percentage of the amount of the LC. In addition, in case the LC has become late, or the shipped goods are on port, the customer is automatically given running financing or working capital financing so that the goods can be released from port. This is something that a conventional bank cannot perform as the goods are in the custody of the bank but the property of the customer and therefore cannot be touched. In case of conventional banking, the bank can very easily take custody of the goods and pay for them against running finance lines against which the customer will have to pay interest till the funds remain outstanding. (Hanif, 3) In addition to that, the conventional bank also charges late fee and interest in case the LC goods are late while the Islamic bank does not have the capability to perform such an act as it is signed in an Islamic Bank’s LC contract that the goods are the property of the customer and thus late fee cannot be charged. For an Islamic bank, the notions of fee, fines and interest on opening Letters of Credit are extremely different in comparison to a conventional bank and in most cases, restrictive as well since the bank cannot earn its dues in some respects through opened letters of credit. (Hanif, 3) Fines, Fees and Interest in Islamic Banking As mentioned earlier, trade financing and LC are markedly different in Islamic banking in comparison to conventional banking, in terms of the money they earn through Letters of Credit. For Islamic banks, the only way they can actually earn funds through letters of credit is the service fee that they charge on the LCs. These service charges escalate if payment from the customer becomes late. These service charges bear some explanation as they imply the services rendered by the banking staff to open and to handle the LC. Moreover, in case the LC payment becomes late, then the bank charges a certain percentage extra for the paper work and services that the staff has to perform in order to manage the LC that has become late. However, the scope for an Islamic bank to earn on an LC is extremely limited in comparison to any conventional bank, as is explained earlier. Therefore, in some cases, customers who do not even believe in Islamic banking, would generally try to open LCs through Islamic banks because such banks have a limited chance to cover their costs and can only charge very small and limited fees against opening and managing of such Letters of Credit.(Hanif, 3) Conclusion The paper aimed to study in complete detail the various elements that are involved in with opening Letters of Credit and financing these LCs through various means and methods that are part of Islamic as well as conventional or regular commercial banks. The various banks under consideration in this assignment were Qatar International Islamic Bank, Qatar Islamic Bank as the two Islamic banks, against the conventional bank, Hong Kong and Shanghai Banking Corporation Limited (HSBC). The study aimed to understand the various types of letters of credit that are opened by banks and the different financing mechanisms that are used. It has been noted that conventional banks enjoy significant flexibility with respect to the modes of financing that they can offer and the amount of fees and interests that they can earn on these modes of financing as well as on the letters of credit opened for its customers. On the other hand, Islamic banks have limited products that they can offer to their customers especially with respect to opening of letters of credit and allowing financing on these products. Even after that, the amount of fee and interests that they can earn through these products, are extremely limited; while the terms and conditions to be met in order to correctly execute the letter of credit and its financing are extremely rigid and critical. In that case, organizations find it cheaper to work with an Islamic bank to open their LCs while the Islamic banks find it difficult to manage letters of credit because for these banks, the LCs are not a viable option to earn money. On the other hand, for conventional banks, letters of credits can be a viable option to earn money as there are various products that can be offered along with opening of LCs which can help these conventional banks to earn money. Therefore, market conditions and rates allow customers to shop for the best options be they Islamic or conventional banks. Works Cited Al-Jarhi, Mabid Ali and Munawar Iqbal. "Conventional VS Islamic Banking System." AIMS-UK. . Bank, Meezan. Working Capital Finance Solutions. . Barclays, Corporate. Trade Loans. . Chong, Rosita, et al. "Economics Of Islamic Trade Financing Instruments." 2009. Citibank. Trade Services and Trade Finance. . Finance, Trade. What is trade finance? . Hanif, Muhammad. "Differences and Similarities in Islamic and Conventional Banking ." International Journal of Business and Social Science (2011): 3. hsbc.com. About HSBC. . hsbc.com.qa. Import Services. . ICBC. Trade Financing. . Investopedia. Letter of Credit. . Islam, Financial. 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