Introduction to Islamic Finance & Banking

World Bank – BRSA - TKBB Joint Workshop on “Innovative Product Development in Islamic Banks”

Istanbul, TurkeyMarch 2, 2017

Zamir Iqbal, PhD.Lead Financial Sector SpecialistThe World Bank Global Islamic Finance Development CenterIstanbul, Turkeyziqbal@worldbank.org

Globalization of Islamic Finance…

Source: IFSB Financial Stability Report 2015, KFHR, IMF

Islamic Finance makes into G-20 agenda

2015- The G20 group of major nations has included discussion of Sukuk (Islamic bonds) as an

infrastructure financing tool in its annual agenda, a move that could potentially spur the use of project-

based Sukuk. In addition, Islamic Finance is subject of study under G20 themes of long-term investments

and Financial inclusion.

Brief Modern History of Islamic Finance

Interest in reviving a banking and financial system started in early 1900s.

1950s – Appearance of early writings about problems of conventional

economic systems and how Islam’s principles of economics offer an

alternative.

1960s – End of colonialism and independence of countries

1970s – Oil revenues (Perto-$) create demand for banking without interest. 1st

Islamic bank in Dubai is established.

1980s – Growth of commercial banking

1990s – Emergence of Islamic funds and investment banking

2000s – Capital markets and Globalization

3

UK 2010 – The Financial Services and Markets Act 2000

Order 2010 was introduced by Treasury to support

Islamic finance and the issuance of corporate sukuk

within the UK

2012 - The UK Government launched an Islamic Finance

Task Force with the aim of securing London’s status as

the Western hub for Islamic finance

2013 - London hosted the World Islamic Economic

Forum during which the UK Prime Minister announced

plans to issue a Sukuk in 2014 and to turn London into a

global center of Islamic finance.

France 2009 - The amendment of Article 2011 of the French

Civil Code relating to the formation of trusts was

interpreted as an important step towards permitting the

issuance of sukuk out of France

2010 - Revision of specific tax regulations covering

Sukuk, ijarah, istisna and murabaha with a view to

removing discrepancies

Luxembourg

2010 - The Luxembourg Tax Authority published a circular to clarify the tax treatment of murabahah and sukuk transactions, to ensure that

they benefit from the same tax treatment as conventional products

2011 - Luxembourg’s CSSF published a note that clarified that no specific legislation was required for Shariah compliant investment

funds, since Luxembourg’s current law contains no obstacles to it.

Germany 2012 - German banking regulator hosted an Islamic finance conference

in Frankfurt during which the tax treatment of different Islamic

finance products was discussed.

Hong Kong 2014- Hong Kong has raised $1bn in its debut Islamic bond issue.

South Africa 2014- $500m sale was more than four times subscribed, with an order book

of $2.2bn according to the SA Treasury

Russia

2016- Opened first Islamic Bank, The Partnership Banking Center in

March 2016.Source: KFH Research

….there is increasing interest in Islamic finance from non-Muslim countries

Recent transactions include sovereign issuance by United Kingdom (UK), South Africa, Hong Kong,

and Luxemburg.

Roadmap

I. MARKET TRENDS

II. HOW ISLAMİC BANKİNG WORKS?

III. REGULATORY AND SUPERVİSORY ENVİRONMENT

IV. STATE OF DEVELOPMENT OF ISLAMİC FİNANCE

6

I. Market Trends

Source: ICD-Thomson Reuters Islamic Finance Development Report 2016

Islamic Financial Assets

Market Size – Islamic Banking

Source: Financial Stability Report 2016, IFSB

Islamic Banking Share in Total Banking Assets by Jurisdiction (1H2015)

Islamic Financial Assets Have Been Growing Rapidly

Source: ICD-Thomson Reuters Islamic Finance Development Report 2016

Global Islamic Finance Assets by Sector Growth (2012 – 2021, US$ BN)

Composition and Domicile of Islamic Assets

10Source: Financial Stability Report 2016, IFSB

Breakdown of Islamic Finance Segments by Region (USD billion, 2015 YTD)

Growth of Banking Assets

Source: World Islamic Banking Competitiveness Report 2016, Ernst&Young

12

II. How Islamic Banking Works?

Risk

Sharing

Reduction of Information Asymmetry (Gharar)

* Prohibits contracts with high uncertainty (Speculation/Gambling)

* Requires Full Disclosure before, during and after the contract

Prohibition of Interest (Riba)

Eliminates Debt contracts and Leverage Materiality

Economic and Social Justice

Wealth, Ownership and Property Rights

Preservation of Property Rights, Protection of Property Rights of Stakeholders, Significance of Rights of the Society

The role of Wealth, Money, and Capital, Sanctity of Contracts

Theoretical foundations of Islamic Financial System

How a banking system is designed without “Interest?”

Prohibition of interest discourages debt and leverage

Risk sharing

– Because interest is prohibited, pure debt security is eliminated from the system and therefore suppliers of funds become investors, rather than creditors. The provider of financial capital and the entrepreneur share business risks in return for shares of the profits and losses.

Close linkage with the Real Sector of the economy

Promotes Asset-backed Finance

– The system introduces a “materiality” aspect that links financing directly with the underlying asset so that the financing activity is linked to the real sector activity. There is strong linkage between the performance of the asset and the return on the capital used to finance it.

Similarities with ethical and Socially Responsible Investments (SRIs).

14

Commonality: Ethical Investing

Substantively: Islamic finance is “ethical finance and investing”.

Consider: Lutheran funds, Roman Catholic funds, “green” funds,

university investment programs (WARF-UW; UC-Berkley).

No investments in:

– Production or distribution of alcohol for human consumption

– Production of tobacco for human consumption

– Gambling

– Prostitution and pornography

– Defense and weapons

– Pornography

– Add constraint on interest-based debt => Islamic investment

Components of Islamic Financial System

16

Islamic Financial System

Non-banking Financial

Institutions

Takaful (Insurance)

Micro-financial institutions

Leasing Companies

Project Finance

Private Equity

Banking

Commercial Banking

Investment Banking

Capital Markets

Sukuk market

Stock Market

Mutual Funds

Money Markets

Key Contracts – building blocks

17

Contract Function Description

Amana Custody Trust. Placing something valuable in trust with someone for custody or safekeeping.

Bay’ al-Istisna Order to build Sale in order to manufacture or construct.

Bay-mua’jjal Deferred PaymentSale contract where the price of the product or underlying asset is agreed but the payment in

lump sum or installments is deferred to a specified future date.

Bay’ al-Salam Forward ContractSale by immediate payment against future delivery. Similar to conventional forward contract

but requires full payment at the time of contract.

Ijarah LeasingA sale contract that is not the sale of a tangible asset but rather a sale of the usufruct (the

right to use the object) for a specified period of time.

MudarabahTrustee finance

contract

An economic agent with capital (rabbul-mal) can develop a partnership with another agent

(mudarib) with skills to form a partnership with the agreement to share the profits. Although

losses are borne by the capital owner only, the mudarib may however be liable for a loss in

case of misconduct or negligence on his part.

MurabahahA cost-plus-sale

contract

A cost-plus-sale contract where a financier purchases a product, that is, a commodity, raw

material or supplied, for an entrepreneur who does not have its own capital to do so. The

financier and the entrepreneur agree on a profit margin, often referred to as a mark-up

which is added to the cost of the product. The payment is delayed for a specified period of

time.

MusharakahEquity

partnership.

Equity partnership. It is a hybrid of Shiraka (partnership) and Mudarabah combining the act

of investment and management.

Qard-al-hassan Benevolent Loan Charitable loans with no interest and low expectations of return of principal.

Sukuk Islamic BondPlural of the Arabic word Sakk meaning certificate, reflects participation rights in the

underlying assets.

Takaful Insurance Insurance contract through mutual or joint guarantee.

Wikala AgencyRepresentation. Entrusting a person or legal entity (Wakil) to act on one’s behalf or as one’s

representative.

Islamic Financial Intermediation (Banking)

Assets

Trade Financing, Leases,

Mudarabahfinancing

Partnerships (mudarabah and musharakah)

Securities Investments

Fees

Liabilities

Demand Deposits

Investments by Depositors

Capital

Key Highlights

Depositors are investors rather than lenders

Risk Sharing through Profit and loss sharing.

Assets and Liabilities are matched.

Ethical and socially responsible assets

A Stylized Balance Sheet of an Islamic Bank

Assets Liabilities

Trade Financing

(Salaam, Morabahah) Demand Deposits

(Amanah/ Waad)

Leasing / Rentals

(Ijarah / Istisna) Investment Accounts

(Mudarabah)Profit/Loss Sharing

Investments

( Mudarabah) Special Investment Accounts

(Mudarabah)Equity Investments

( Musharakah)

Fee for Services Capital

Equity

Reserves

20

III. Regulatory and

Supervisory Environment

Key Stakeholders

21

Islamic Development Bank Group (IDB, ICD, IRTI, ICIEC, ITFC)

Islamic Financial Services Board (IFSB)

Accounting and Auditing Organization of Islamic Financial Institutions (AAOIFI)

Multilaterals (The World Bank Group, IMF, Asian Development Bank)

International Islamic Financial Markets (IIFM)

International Islamic Rating Agency (IIRA)

International Center for Education in Islamic Finance (INCEIF)

Islamic Financial Services Board (IFSB)

IFSB is an international standard-setting organization with a membership of 185 participants, whose work complements the work of the Basel Committee on Banking Supervision, International Organization of Securities Commissions and the International Association of Insurance Supervisors. As of early 2014, the IFSB has issued 17 Standards, 5 Guidance Notes and 1 Technical Note for the Islamic financial services industry.

Approved Standards1. Risk Management2. Capital Adequacy3. Corporate Governance4. Transparency and Market Discipline5. Supervisory Review Process6. Governance for Collective Investment Schemes7. Special Issues in Capital Adequacy8. Guiding Principles on Governance for Islamic Insurance (Takaful) Operations9. Conduct of Business for Institutions offering Islamic Financial Services10. Guiding Principles on Shariʿah Governance System11. Standard on Solvency Requirements for Takaful Undertakings12. Guiding Principles on Liquidity Risk Management13. Guiding Principles on Stress Testing14. Standard On Risk Management for Takaful Undertakings15. Revised Capital Adequacy Standard16. Revised Guidance on Key Elements In The Supervisory Review Process of Institutions Offering Islamic

Financial Services17. Core Principles for Islamic Finance Regulation (Banking Segment)

Islamic Financial Services Board (IFSB)

Standards under Development

1. Revised Guidance on Key Elements in the Supervisory Review Process of Institutions Offering

Islamic Financial Services (excluding Islamic Insurance (Takaful) Institutions and Islamic

Collective Investment Schemes)

Guidance Notes and Technical Note

1. Recognition of Ratings on Shariʿah-Compliant Financial Instruments

2. Guidance Note in Connection with the Risk Management and Capital Adequacy Standards:

Commodity Murabahah Transactions

3. Guidance Note on the Practice of Smoothing the Profits Payout to Investment Account Holders

4. Guidance Note in Connection with the IFSB Capital Adequacy Standard: The Determination of

Alpha in the Capital Adequacy Ratio

5. Guidance Note on the Recognition of Ratings by External Credit Assessment Institutions

(ECAIS) on Takaful and Re-Takaful Undertakings

6. Development of Islamic Money Markets (Technical Note)

Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI)

The Accounting and Auditing Organization for Islamic Financial Institutions(AAOIFI) is an Islamic

international autonomous non-for-profit corporate body that prepares accounting, auditing, governance,

ethics and Shari'ah standards for Islamic financial institutions and the industry.

Issued Standards

Accounting Standards

Auditing Standards

Ethics Standards

Governance Standards

Shari’ah Standards

Guiding Notes

Guidance Note on First time Adoption of AAOIFI Accounting Standards by an Islamic Financial

Institution

Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI)

ACCOUNTING STANDARDSConceptual Framework FOR Financial Reporting by Islamic Financial InstitutionsFAS 1- General Presentation and Disclosure in the Financial Statements of Islamic Banks and Financial InstitutionsFAS 2- Murabaha and Murabaha to the Purchase OrdererFAS 3- Mudaraba FinancingFAS 4 - Musharaka FinancingFAS 5- Disclosure of Bases For Profit Allocation Between Owners’ Equity and Investment Account HoldersFAS 6- Equity of Investment Account Holders and their EquivalentFAS 7- Salam and Parallel SalamFAS 8- Ijarah and Ijarah Muntahia BittamleekFAS 9- ZakahFAS 10-Istisna'a and Parallel Istisna’aFAS 11- Provisions and Reserves FAS 12-General Presentation and Disclosure in the Financial Statements of Islamic Insurance CompaniesFAS 13- Disclosure of Bases for Determining and Allocating Surplus or Deficit in Islamic Insurance CompaniesFAS 14- Investment FundsFAS 15- Provisions and Reserves in Islamic Insurance CompaniesFAS 16- Foreign Currency Transactions and Foreign Operations FAS 17- InvestmentsFAS 18- Islamic Financial Services offered by Conventional Financial InstitutionsFAS 19- Contributions in Islamic Insurance CompaniesFAS 20- Deferred Payment SaleFAS 21- Disclosure on Transfer of AssetsFAS 22- Segment Reporting FAS 23- ConsolidationFAS 24- Investments in AssociatesFAS 25- Investment in Sukuk, Shares and Similar InstrumentsFAS 26 - Investments in Real Estate

AUDITING STANDARDS

A S 1- Objective and Principles of AuditingA S 2- The Auditor’s ReportA S 3- Terms of Audit EngagementA S 4- Testing for Compliance with Shari’a Rules and Principles by an External AuditorA S 5- The Auditor’s Responsibility to Consider Fraud and Error in an Audit of Financial Statements

GOVERNANCE STANDARDS

G S 1-Sharia Supervisory Board: Appointment, Composition, Report G S 2- Shari’a ReviewG S 3- Internal Shari’a ReviewG S 4- Audit & Governance Committee for Islamic Financial InstitutionsG S 5- Independence of Shari’a Supervisory BoardG S 6- Statement on Governance Principles and Disclosure for Islamic Financial Institutions G S 7- Corporate Social Responsibility Conduct and Disclosure for Islamic Financial Institutions

ETHICS

Code of Ethics for Accountants of Islamic Financial InstitutionsCode of Ethics for the Employees of Islamic Financial Institutions

Legal Framework for Islamic Financial Institutions (IFIs)

Specific

Laws

Some countries like Iran, Kuwait, Malaysia,

Sudan, Turkey, UAE and Yemen have

enacted specific laws to regulate the

establishment of IFIs.

Same laws of

conventional

banks

Supervision

of IFIs

In other countries, IFIs are established by

the same laws of conventional banks.

Law

s r

egula

ting I

FIs

In all the countries in which they operate,

IFIs are supervised by their respective

supervisory and regulatory bodies.

27

IV. State of Development of Islamic Finance

Islamic Finance Indicator

Which Countries have the best developed Islamic Economy for Islamic Finance?

176

84

78

66

51

51

43

38

35

33

0 20 40 60 80 100 120 140 160 180 200

Malaysia

Bahrain

United Arab Emirates

Saudi Arabia

Oman

Pakistan

Kuwait

Qatar

Indonesia

Sudan

TOP 10İSLAMİC FİNANCE

Source: State of the Global Islamic Economy Report 2015/16, Thomson Reuters

* CRITERIA

1. Financial (Size of Islamic Finance Assets and Number of Islamic Finance Institutions)

2. Governance (e.g. Regulation for Islamic Finance and Disclosure Index Score)

3. Awareness (Number of Related News Articles, Islamic Finance Education Institutions, Research papers, and events)

4. Social (Value of Zakat and Charity and CSR Disclosure Index Score)

Adoption of IFSB Standards

Number of Countries which adopted IFSB Standards

Source: Comparative Study on the Implementation of Selected IFSB Standards,

IFSB Working Paper Series, WP-04/10/2015, October 2015

Adoption of AAOIFI Standards

Source: AAOIFI website

AAOIFI auditing, governance and ethics

standards are not part of mandatory

regulatory requirement for Islamic

finance. Instead, these standards are used

voluntarily by leading Islamic financial

institutions across all major Islamic

finance jurisdictions.

Mandatory regulatory

requirement in jurisdictions

As basis of of national

accounting standards in

jurisdictions

Shari’ah

Standards

Accounting

Standards

Shari’ah

Standards

Accounting

Standards

Bahrain Bahrain Indonesia Indonesia

Oman Jordan Malaysia Pakistan

Pakistan Oman

Sudan Qatar

SyriaQatar Financial

Centre

Islamic

Development

Bank

Sudan

Syria

Islamic

Development

Bank

In other jurisdictions including Brunei,

Dubai International Financial Centre,

France, Egypt, Jordan, Kuwait, Lebanon,

Saudi Arabia, Qatar, Qatar Financial Centre,

South Africa, United Arab Emirates and

United Kingdom as well as in Africa,

Central Asia and North America, AAOIFI

Shari’ah standards and/or AAOIFI

accounting standards have been used

voluntarily as basis of internal guidelines by

leading Islamic financial institutions.

Islamic Finance Sub-Indicators

Source: Islamic Finance Development Report 2015, ICD-Thomson Reuters

REGULATION SUB-INDICATORS TOP

COUNTRIES

Indicator Value

Malaysia 100

Pakistan 100

Bahrain 100

Nigeria 100

Indonesia 100

Iran 83

Maldives 67

Unidet Arab Emirates 67

Qatar 67

Sudan 67

Brunei Darussalam 67

Kazakhstan 67

SHARIA GOVERNANCE SUB-

INDICATORS

TOP 10 COUNTRIES

Indicator Value

Bahrain 142

Malaysia 116

Kuwait 106

Bangladesh 92

Sudan 89

Oman 70

Indonesia 57

Pakistan 56

Lebonan 53

Egypt 48

GOVERNANCE INDICATORS

TOP 10 COUNTRIES

1- BAHRAIN 93

2- MALAYSIA 90

3- KUWAIT 67

4- PAKISTAN 66

5- OMAN 62

6- INDONESIA 58

7- SUDAN 54

8- UNITED ARAB EMIRATES 54

9- QATAR 52

10- MALDIVES 48

Thank You

For your further questions please contact:

Zamir Iqbal

World Bank Global Islamic Finance Development Center

T: +90 212 385 3443

E-mail: ziqbal@Worldbank.org

mailto:ziqbal@Worldbank.org

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