LONDON, 23 January 2006 — Construction finance based on the Islamic Istisna contract is set to increase both in the Muslim markets and elsewhere as structurers innovate new ways to make it more competitive in pricing and delivery especially in a conventional construction setting.
In the UK, for instance, London-based ABC International Bank, a wholly-owned subsidiary of the Arab Banking Corporation (ABC) Group in Bahrain, has pioneered a Parallel Phased Istisna (PPI), which it says sets “new standards for the provision of Shariah-compliant construction finance in the UK”.
Istisna, according to the Shariah scholars, is a forward sale contract of acquisition of goods by specification or order, where the price is paid progressively in accordance with the progress of a job completion. This is practiced for example for purchases of houses to be constructed where the payments made to the developer or builder are according to the stage of work completed.
In the case of another forward sale contract, Bai al Salam, the full payment, is made in advance to the seller, i.e. before delivery of the goods. In Islamic financing, the applications of Bai al Salam and Istisna are as purchasing mechanisms, whereas Murabaha and Bai Bithaman Ajil are for financing sales.
Istisna financing for building contracts, however, can be expensive because of the drawn-out nature of construction activity and the possible delays that can very often occur. As such the financing carries a cost of capital from the day it is disbursed.
ABC’s Parallel Phased Istisna (PPI) mitigates this scenario through the use of multiple phased Istisna contracts for specific parts of the construction cycle. In other words the construction project is broken up into several Istisnas which allows for a staggered financing and the drawdown of the funds, which subsequently carry a lower cost of capital.
ABC International Bank is in fact currently financing the construction of an inner-city residential development in Gotts Island in Leeds in Lancashire consisting of 183 residential flats and 72 parking spaces with a gross development value (GDV) of 33 million sterling pounds.
ABC entered into a contract with its equity partners, primarily investors from the GCC countries, and also has a separate contractual relationship with the developer, which in the case of Phase II of the Gotts Island Project is the UK-based Mayfair International Limited. The developer is not necessarily the same for all the three phases of the project. Mayfair International has also been active in projects in Dubai.
The Istisna contract over the last few years, says Richard Thomas, head of Islamic Asset Management Ltd., a subsidiary of ABC International Bank, has been increasingly used as manufacturing finance. “More specifically, Istisna has been used to provide a manufacturer with finance to purchase the raw materials required and assembled into a sellable product. The predetermined price for the assembly and the manufacturer’s product is agreed by both parties in advance. The product is then sold on by the bank at a ‘mark-up’ to a separate party via a parallel Istisna agreement.
“Traditionally, the financing for the construction process has been provided ‘up-front’ in full to the manufacturer for the entire cost of the raw materials regardless of the length the assembly period. To meet the demand of the ever-increasing and competitive Islamic finance market, the traditional Istisna structure would have to be refined in order to reduce the Bank’s ‘mark-up’ period,” explains Thomas.
In fact, in the Leeds transaction, ABC International Bank with the help of its Shariah Board led by Sheikh Nizam Yaquby of Bahrain, and the partners in the project, was to able to identify specific deliverable stages/products in a conventional construction program. Upon the identification of a key stage or product, says ABC International Bank’s Jonathan Bracknell, manager real estate finance, the bank would in turn be in a position to provide predetermined finance for each specific phase. The net effect is the creation of a “Master Istisna Agreement” incorporating a number of mini Istisnas.
Islamic bankers in London stress that it is important in a market such as the UK to reinforce the competitiveness of Shariah-compliant financial solutions. By doing this, contractors, developers and investors understand that Islamic banking can work.
The considerable involvement of the ABC Group in the creation of this unique product, adds Thomas, requires the financier to be significantly more involved in the development and the relevant professional parties than it had been previously.
This increased responsibility of the bank puts it in direct communication with the construction professional team involved in the development, which clearly identifies the bank’s role as an investor rather than a lender.
By distribution through its Bahrain sister entity ABC Islamic Bank, this opportunity is made available to more GCC investors in UK projects. In addition, the significant cost reduction made possible by reducing the bank’s “mark-up” provides the end-purchaser with a more attractive investment opportunity and makes Islamic finance comparative in price with its conventional counterpart.
