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  • CA-3.4 CA-3.4 Istisna'a and Parallel Istisna'a

    • Introduction

      • CA-3.4.1

        This Section sets out the minimum capital adequacy requirement to cover credit and market (price) risks arising from entering into contracts or transactions that are based on the Sharia rules and principles of Istisna'a.

        January 2015

    • Principles of Istisna'a

      • CA-3.4.2

        Istisna'a and parallel Istisna'a contracts would attract a risk weighting as per the credit standing of the respective counterparties (See Section CA-4.2).

        January 2015

      • CA-3.4.3

        An Istisna'a contract refers to an agreement to sell to or buy from a customer, a non-existent asset which is to be manufactured or built according to the ultimate buyer's specifications and is to be delivered on a specified future date at a predetermined selling price.

        January 2015

      • CA-3.4.3A

        In an Istisna'a contract, price and other necessary specifications must also be fixed and fully settled between the buyer and manufacturer/builder. The payments by the buyer in Istisna'a may be made in advance, during the period of construction reflecting stages of completion, or deferred to a specified future date. The contract of Istisna'a is a binding contract that cannot be cancelled unilaterally by either party once the manufacturing work starts. If the subject matter does not conform to the specification agreed upon, the buyer has the option to accept or to refuse the subject matter.

        January 2015

      • CA-3.4.3B

        The subject matter on which transaction of Istisna'a is based is always an item which needs to be manufactured or constructed, such as a ship, an aircraft or a building, and it cannot be an existing and designated asset. Istisna'a may also be used for similar projects such as installation of an air-conditioner plant in the customer's factory, or building a bridge or a highway.

        January 2015

      • CA-3.4.3C

        The price of an asset under this contract is agreed or determined on the contractual date, and such a contract is binding. The price cannot be increased or decreased on account of an increase or decrease in commodity prices or labour cost. The price can be changed subject to the mutual consent of the contracting parties, which is a matter for the commercial decision of the Islamic bank licensee and can result in a lower profit margin and a capital charge as outlined in Paragraph CA-3.4.24.

        January 2015

    • Roles and Exposure of a Bank in an Istisna'a Contract

      • CA-3.4.4

        In practice, an Islamic bank licensee can play different roles while engaging in the contract of Istisna'a, as follows:

        (a) Islamic bank licensee as a seller (al-sani') in Istisna'a contract:
        (i) In many cases, an Islamic bank licensee acts as a "seller" in the Istisna'a contract and engages the services of a contractor (other than the client) by entering into another Istisna'a contract as buyer11 or using some other Shari'a compliant contract such as Murabahah; or.
        (ii) If a parallel Istisna'a contract is used for manufacturing the asset, the Islamic bank licensee acts as a buyer in the parallel contract. The Islamic bank licensee as an intermediary calculates its cost in the parallel contract and fixes the price of Istisna'a with its client that allows it to make a reasonable profit over his cost. The two contracts, however, need to be totally independent of each other. In order to secure the payment from the ultimate buyer (i.e. the customer), the title deeds of the underlying asset, or any other collateral, may be required by the Islamic bank licensee as a security until the complete payment is made by the ultimate buyer; and
        (b) Islamic bank licensee as a buyer (al-mustasni') in Istisna'a contract:
        (i) In some cases, an Islamic bank licensee can act as a "buyer" in an Istisna'a contract where it can have an asset constructed by a contractor: (i) for its own account (which can be, for example, subsequently sold or leased on a Murabahah or Ijara basis, respectively); or (ii) on the basis of the ultimate customer's specifications; or
        (ii) If the parallel Istisna'a contract is used in this scenario with the ultimate customer, the Islamic bank licensee acts as seller in the parallel contract.

        11 Where two such parallel Istisna'a contracts exist, it is customary to refer to one of the contracts as a "parallel Istisna'a". Typically, it is the contract which is entered into second which is referred to as the "parallel Istisna'a".

        January 2015

      • CA-3.4.5

        This Section makes distinctions between two types of exposures in Istisna'a financing, as follows:

        (a) Exposure to customer:

        The receipt of the selling price by the Islamic bank licensee is dependent on the financial strength or payment capability of the ultimate customer or the contractor (cases (a) and (b) of Paragraph CA-3.4.4 respectively), where the source of payment is derived from the various other activities of the ultimate customer or contactor and is not solely dependent on the cash flows from the underlying asset/project; and
        (b) Exposure to asset (i.e. exposure to the cash flows from the completed asset): The receipt of the selling price by the Islamic bank licensee is dependent partially or primarily on the amount of revenue generated by the asset being manufactured or constructed by selling its output or services to contractual or potential third-party buyers. This form of Istisna'a faces "revenue risk" arising from the asset's ability to generate cash flows, instead of the creditworthiness of the ultimate customer or project sponsor (cases (a) and (b) of Paragraph CA-3.4.4 respectively). Such exposure normally arises when an Istisna'a contract is used in project finance and BOT (build, operate, transfer) transactions.
        January 2015

      • CA-3.4.6

        In the Istisna'a contract, the Islamic bank licensee assumes the completion risk12 that is associated with the failure to complete the project at all, delay in completion, cost overruns, occurrence of a force majeure event, and unavailability of qualified personnel and reliable seller(s) or sub-contractors, including any late completion penalty13 payable to the ultimate customer due to non-fulfilment of required specifications.

        12 In conventional project financing, the completion risk is normally borne by the project sponsor/contractor, and not by the bank, because the project sponsor/contractor has most often been asked to provide an undertaking to cover cost overruns.

        13 Normally, the contract between the bank and the contractor will specify in a penalty clause the latter's liability for penalties in case of delays for which it is responsible.

        January 2015

    • Capital Adequacy Requirements

      • CA-3.4.7

        The exposures under Istisna'a involve credit and market risks, as described below. Credit exposures arise once the work is billed to the customer, while market (price) exposures arise on unbilled work-in-process (WIP).

        January 2015

      • CA-3.4.8

        There is a capital requirement to cater for the credit (counterparty) risk of the Islamic bank licensee not receiving the selling price of the asset from the ultimate customer or contractor, either in pre-agreed stages of completion and/or upon full completion of the manufacturing or construction process. (The risk of a customer failing to complete such a transaction in project finance is referred to as "off-take risk" — see Appendix CA-5.)

        January 2015

      • CA-3.4.9

        This Section also sets out the capital adequacy requirement to cater for the market risk that an Islamic bank licensee incurs from the date of manufacturing or construction, which is applicable throughout the period of the contract on unbilled WIP inventory.

        January 2015

      • CA-3.4.10

        This Section is applicable to both (a) Istisna'a contracts that are executed without any parallel Istisna'a contracts, and (b) Istisna'a contracts that are backed by independently executed parallel Istisna'a contracts.

        January 2015

    • Bank as a Seller (al sani') in an Istisna'a Contract

      • Istisna'a with Parallel Istisna'a

        • CA-3.4.11

          In cases where an Islamic bank licensee enters into a parallel Istisna'a contract to procure an asset from a party other than the original Istisna'a customer (buyer), the price risk relating to input materials is mitigated. The Islamic bank licensee remains exposed to the counterparty risk of the parallel Istisna'a seller in delivering the asset on time and in accordance with the Istisna'a ultimate buyer's specifications. This is the risk of not being able to recover damages from the parallel Istisna'a seller for the losses resulting from the breach of contract.

          January 2015

        • CA-3.4.12

          The failure of the parallel Istisna'a seller to deliver a completed asset which meets the ultimate buyer's specifications does not discharge the Islamic bank licensee's obligations to deliver the asset ordered under an Istisna'a contract, and thus exposes the Islamic bank licensee to potential loss in making good the shortcomings or obtaining the supply elsewhere.

          January 2015

      • Credit Risk

        • Exposure to Customer

          • CA-3.4.13

            The receivable amount generated from selling of an asset based on an Istisna'a contract with full exposure to the customer (ultimate buyer) must be assigned a RW based on the credit standing of the customer as rated by an ECAI that is approved by the CBB. Refer to Section CA-4.2 for the RW. In cases where the ultimate buyer is unrated, a RW of 100% applies.

            January 2015

        • Exposure to Asset

          • CA-3.4.14

            When the project is rated by an ECAI, the RW based on the credit rating of the ultimate buyer is applied to calculate the capital adequacy requirement. Otherwise, the RW must be based on the "supervisory slotting criteria" approach for specialised financing (project finance), as set out in Appendix CA-5, which carries RWs as given below:

            Supervisory Categories Strong Good Satisfactory Weak
            External credit assessments BBB- or better BB+ or BB BB- to B+ B to C-
            Risk weights 70% 90% 115% 250%
            January 2015

          • CA-3.4.15

            Istisna'a financing with an "Exposure to Asset" structure is required to meet the characteristics as set out below in order to qualify for the above RW:

            (a) The segregation of the project's liabilities from the balance sheet of the Istisna'a ultimate buyer or project sponsor from a commercial and accounting perspective which is generally achieved by having the Istisna'a contract made with a special-purpose entity set up to acquire and operate the asset/project concerned;
            (b) The ultimate buyer is dependent on the income received from the assets acquired/projects to pay the purchase price;
            (c) The contractual obligations give the manufacturer/ constructor/ bank a substantial degree of control over the asset and the income it generates — for example, under the BOT arrangement where the manufacturer builds a highway and collects tolls for a specified period as a consideration for the selling price; and
            (d) The primary source of repayment is the income generated by the asset/project rather than relying on the capacity of the ultimate buyer.
            January 2015

        • Exclusions

          • CA-3.4.16

            The capital requirement is to be calculated on the receivable amount, net of:

            (a) Specific provisions;
            (b) Any amount that is secured by eligible collateral (as defined in Section CA-4.7); and
            (c) Any amount which is past due 90 days or more (see CA-4.2).
            Amended: July 2017
            January 2015

          • CA-3.4.17

            Any portion of an Istisna'a contract that is covered by an advanced payment must carry a RW of 0%, or the amount of the advanced payment must be offset against the total amount receivable or amounts owing from progress billings.

            January 2015

        • Applicable Period

          • CA-3.4.18

            The credit RW is to be applied from the date when the manufacturing or construction process commences and until the selling price is fully settled by the Islamic bank licensee, either in stages and/or on the maturity of the Istisna'a contract, which is upon delivery of the manufactured asset to the Istisna'a ultimate buyer.

            January 2015

        • Offsetting Arrangement between Credit Exposures of Istisna'a and Parallel Istisna'a

          • CA-3.4.19

            The credit exposure amount of an Istisna'a contract is not to be offset against the credit exposure amount of a Parallel Istisna'a contract because an obligation under one contract does not discharge an obligation to perform under the other contract.

            January 2015

      • Market Risk

        • Exposure to Customer

          • (a) Istisna'a with Parallel Istisna'a

            • CA-3.4.21

              If the seller is allowed to vary the selling price of the asset, then the price risk must be calculated in accordance with Paragraph CA-5.2.2.

              January 2015

            • CA-3.4.20

              There is no capital charge for market risk to be applied in addition to provisions in Paragraphs CA-3.4.13 to CA-3.4.19, subject to there being no provisions in the Parallel Istisna'a contract that allow the seller to increase or vary its selling price to the Islamic bank licensee, under unusual circumstances. Any variations in a Parallel Istisna'a contract that are reflected in the corresponding Istisna'a contract which effectively transfers the whole of the price risk to an Istisna'a customer (buyer), are also eligible for this treatment.

              January 2015

          • (b) Istisna'a without Parallel Istisna'a

            • CA-3.4.23

              The unbilled WIP inventory is held subject to the binding order of the Istisna' ultimate buyer and is thus not subject to inventory price as described in Section CA-5.6.

              January 2015

            • CA-3.4.22

              A capital charge of 1.6% is to be applied to the balance of unbilled WIP inventory to cater for market risk, in addition to the credit RW stated in Paragraphs CA-3.4.13 to CA-3.4.19.

              January 2015

      • Foreign Exchange Risk

        • CA-3.4.24

          Any foreign exchange exposures arising from the purchasing of input materials, or from Parallel Istisna'a contracts made, or the selling of a completed asset in foreign currency must be included in the measures of foreign exchange risk described in section CA-5.5.

          January 2015

    • Bank as a Buyer (al mustasni') in an Istisna'a Contract

      • Istisna'a with Parallel Istisna'a

        • CA-3.4.25

          In cases where an Islamic bank licensee enters into Parallel Istisna'a to sell an asset to an ultimate customer, its price risk relating to input materials is mitigated. The Islamic bank licensee remains exposed to the counterparty risk of the Istisna'a supplier in delivering the asset on time and in accordance with the parallel Istisna'a ultimate buyer's specifications. This is the risk of not being able to recover damages from the Istisna'a supplier for the losses resulting from the breach of contract.

          January 2015

        • CA-3.4.26

          The failure of the Istisna'a supplier to deliver a completed asset which meets the ultimate buyer's specifications does not discharge the Islamic bank licensee's obligations to deliver the asset ordered under a parallel Istisna'a contract, and thus exposes the Islamic bank licensee to potential loss in making good the shortcomings or obtaining the supply elsewhere.

          January 2015

      • Credit Risk

        • Exposure to Customer

          • CA-3.4.27

            The receivable amount generated from selling of an asset based on a parallel Istisna'a` contract with full exposure to the ultimate customer must be assigned a RW based on the credit standing of the customer as rated by an ECAI that is approved by the CBB. Refer to Section CA-4.6 for the RW. In cases where the ultimate buyer is unrated, a RW of 100% applies.

            January 2015

        • Exposure to Asset

          • CA-3.4.28

            When the project is rated by an ECAI, the RW based on the credit rating of the "off-taker" (third-party buyer) is applied to calculate the capital adequacy requirement. Otherwise, the RW must be based on the "supervisory slotting criteria" approach for specialised financing (project finance) as set out in Appendix CA-5, which carries RWs as given below:

            Supervisory Categories Strong Good Satisfactory Weak
            External credit assessments BBB- or better BB+ or BB BB- to B+ B to C-
            Risk weights 70% 90% 115% 250%
            January 2015

          • CA-3.4.29

            The "Exposure to Asset" Istisna'a structure is required to meet the characteristics as set out in Paragraph CA-3.4.22.

            January 2015

        • Exclusions

          • CA-3.4.30

            The capital requirement is to be calculated on the receivable amount, net of: a) specific provisions; b) any amount that is secured by eligible collateral as defined in Section CA-4.7; and c) any amount which is past due by more than 90 days as set out in Section CA-4.2. These other amounts are to be risk weighted as described in the concerned Sections.

            January 2015

          • CA-3.4.31

            Any portion of a parallel Istisna'a contract covered by an advance payment carries a RW of 0%, or the amount of the advanced payment is offset against the total amount receivable from the ultimate customer or amounts owing from progress billings.

            January 2015

        • Applicable Period

          • CA-3.4.32

            The credit RW is to be applied from the date when the manufacturing or construction process commences and until the selling price is fully settled by the Islamic bank licensee, either in stages and/or on the maturity of the Istisna'a contract, which is upon delivery of the manufactured asset to the parallel Istisna'a ultimate buyer.

            January 2015

        • Offsetting Arrangement between Credit Exposures of Istisna'a and Parallel Istisna'a

          • CA-3.4.33

            The credit exposure amount of a parallel Istisna'a contract is not to be offset against the credit exposure amount of an Istisna'a contract (or vice versa) because an obligation under one contract does not discharge an obligation to perform under the other contract.

            January 2015

      • Market Risk

        • Exposure to Customer

          • CA-3.4.34

            There is no capital charge for market risk to be applied in addition to provisions on credit risk, subject to there being no provisions in the Istisna'a contract that allow the supplier to increase or vary its selling price to the Islamic bank licensee, under unusual circumstances. Any variations in a parallel Istisna'a contract that are reflected in the corresponding Istisna'a contract which effectively transfers the whole of the price risk to a parallel Istisna'a customer (ultimate buyer) are also eligible for this treatment.

            January 2015