Risk Management in Islamic Financial Instruments

COMCEC Coordination Office September 2014

Standing Committee for Economic and Commercial Cooperation of the Organization of Islamic Cooperation (COMCEC )

Risk Management in Islamic Financial Instruments

COMCEC Coordination Office September 2014

Standing Committee for Economic and Commercial Cooperation of the Organization of Islamic Cooperation (COMCEC)

This report has been commissioned by the COMCEC Coordination Office to Professor Dr. M. Kabir Hassan, University of New Orleans, USA in collaboration with Dr. Ali Ashraf, Frostburg State University, USA, Mamun Rashid, Nottingham University, Malaysia, William J. Hippler, III, University of La Verne, USA and Umar A. Oseni, International Islamic University, Malaysia and with help from graduate assistants. Views and opinions expressed in the report are solely those of the author(s) and do not represent the official views of the COMCEC Coordination Office or the Member States of the Organization of Islamic Cooperation. Excerpts from the report can be made as long as references are provided. All intellectual and industrial property rights for the report belong to the COMCEC Coordination Office. This report is for individual use and it shall not be used for commercial purposes. Except for purposes of individual use, this report shall not be reproduced in any form or by any means, electronic or mechanical, including printing, photocopying, CD recording, or by any physical or electronic reproduction system, or translated and provided to the access of any subscriber through electronic means for commercial purposes without the permission of the COMCEC Coordination Office.

For further information please contact: The COMCEC Coordination Office Necatibey Caddesi No:110/A 06100 Yücetepe Ankara/TURKEY Phone : 90 312 294 57 10 Fax : 90 312 294 57 77 Web: www.comcec.org

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CONTENTS

EXECUTIVE SUMMARY .......................................................................................................................................................... XVII

CHAPTER 1: OVERVIEW OF ISLAMIC FINANCE INDUSTRY ........................................................................................... 1

1.1 OVERVIEW OF ISLAMIC FINANCE INDUSTRY.............................................................................................................. 1

1.2 CURRENT STATUS OF ISLAMIC BANKS ......................................................................................................................... 2

1.2.1 Asia Region .................................................................................................................................................................................................... 3

1.2.2 Mena Region ................................................................................................................................................................................................. 3

1.2.3 Sub-Sahara Africa Region ....................................................................................................................................................................... 3

1.2.4 QISMUT Countries (Qatar, Indonesia, Saudi Arabia, Malaysia, Uae, Turkey) ............................................................... 3

1.3. CURRENT STATUS OF THE ISLAMIC CAPITAL AND SUKUK MARKET ............................................................... 5

1.3.1 Islamic Indices ............................................................................................................................................................................................. 6

1.3.2 Islamic Funds ............................................................................................................................................................................................... 7

1.3.2.1 Investment Focus of Islamic Funds ............................................................................................................................................... 7

1.3.2.2 Geographic Dispersion of Islamic Funds .................................................................................................................................... 8

1.3.3 Current Status of Sukuk Market .......................................................................................................................................................... 8

1.4. CURRENT STATUS OF THE ISLAMIC TAKAFUL MARKET ....................................................................................... 9

1.4.1 Driving Factors ......................................................................................................................................................................................... 10

1.4.2 Challenges and Recent Developments .......................................................................................................................................... 10

1.4.3 Recent Regional Trends ....................................................................................................................................................................... 11

1.5. CURRENT STATUS OF THE ISLAMIC MICROFINANCE .......................................................................................... 11

CHAPTER 2: RISKS IN ISLAMIC FINANCIAL INSTITUTIONS AND MARKETS ........................................................ 14

2.1 FINANCIAL INTERMEDIATION THEORY .................................................................................................................... 14

2.2 ISLAMIC FINANCIAL CONTRACTS ................................................................................................................................. 15

2.3 STRUCTURE AND FINANCIAL INTERMEDIATION PRACTICES OF IFIS ............................................................ 17

2.4 RISK PROFILE OF ISLAMIC FINANCIAL INSTITUTIONS ........................................................................................ 20

2.5 SUKUK MARKET RISK ....................................................................................................................................................... 26

2.6 TAKAFUL MARKET RISKS ............................................................................................................................................... 30

2.7 ISLAMIC MICROFINANCE RISK ...................................................................................................................................... 36

2.8 DERIVATIVE INSTRUMENTS IN ISLAMIC FINANCE ................................................................................................ 39

2.9 RISK MITIGATION AND REGULATION IN ISLAMIC FINANCE .............................................................................. 41

CHAPTER 3: ISLAMIC RISK MANAGEMENT INFRASTRUCTURE ............................................................................... 43

3.1. NATIONAL FINANCIAL ARCHITECTURE AND INFRASTRUCTURE ................................................................... 43

3.1.1 Financial Stability Infrastructure .................................................................................................................................................... 43

3.1.2 Banking Infrastructure ......................................................................................................................................................................... 44

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3.1.3 Securities Infrastructure ..................................................................................................................................................................... 45

3.1.4 Insurance Infrastructure ..................................................................................................................................................................... 45

3.1.5. National Financial Architecture and Infrastructures of Selected Countries ............................................................. 45

3.1.5.1 Malaysia ................................................................................................................................................................................................... 45

3.1.5.2 Turkey....................................................................................................................................................................................................... 46

3.1.5.3 Kingdom Of Saudi Arabia (K.S.A.) ................................................................................................................................................ 46

3.1.5.4 United Arab Emirates (U.A.E.)....................................................................................................................................................... 46

3.1.5.5 Bangladesh ............................................................................................................................................................................................. 47

3.2. INSTITUTIONAL DEVELOPMENT................................................................................................................................. 47

3.3. INFRASTRUCTURE DEVELOPMENT ............................................................................................................................ 49

3.3.1 Islamic Financial Services Board (IFSB) ...................................................................................................................................... 50

3.3.2 Implementation Challenges for IFSB ............................................................................................................................................. 51

3.3.4 International Islamic Financial Market ........................................................................................................................................ 52

3.4. CAPITAL MARKET DEVELOPMENT ............................................................................................................................. 52

3.5. LIQUIDITY MANAGEMENT: PRUDENTIAL REGULATION AND LIQUIDITY INFRASTRUCTURE ............. 53

3.5.1 Liquidity Infrastructure ....................................................................................................................................................................... 54

3.5.2 Some Recent Developments in Liquidity Management in Islamic Finance ................................................................ 55

3.5.3 Prudential Regulation ........................................................................................................................................................................... 55

3.6 ISLAMIC BANKING AND FINANCE REGULATION AND RISK MANAGEMENT IN OIC MEMBER

COUNTRIES .................................................................................................................................................................................. 56

3.7. SHARIAH-COMPLIANT LENDER OF LAST RESORT FACILITY ............................................................................ 60

3.8. DISPUTE RESOLUTION MECHANISM IN ISLAMIC FINANCIAL MARKETS AND IMPLEMENTATION ..... 60

CHAPTER 4: COMPARATIVE ANALYSIS OF RISK MATRICES FOR ISLAMIC AND CONVENTIONAL BANKS 62

4.1 BRIEF DESCRIPTION OF RISK MATRICES .................................................................................................................. 62

4.2 SAMPLE SELECTION CRITERIA ...................................................................................................................................... 63

4.3 ANALYSIS OF RISK MATRICES ACROSS MAJOR GEOGRAPHIC REGIONS ........................................................ 64

4.3.1 Asian Region .............................................................................................................................................................................................. 64

4.3.2 Mena Region .............................................................................................................................................................................................. 67

4.3.3 Sub-Sahara Africa Region .................................................................................................................................................................... 70

4.4 ANALYSIS OF RISK MATRICES ACROSS FIVE MAJOR COUNTRY JURISDICTIONS ........................................ 72

4.4.1 Malaysia ....................................................................................................................................................................................................... 72

4.4.1.1 Overview of Malaysian Islamic Finance Services Industries ......................................................................................... 72

4.4.1.2 Malaysian Banking Sector ............................................................................................................................................................... 73

4.4.2 Republic Of Turkey................................................................................................................................................................................. 75

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4.4.2.1 Turkish Banking Sector .................................................................................................................................................................... 76

4.4.2.2 Overview of Turkish Banking Sector Performance ............................................................................................................ 76

4.4.2.3 Risk Matrices ......................................................................................................................................................................................... 84

4.4.3 Kingdom Of Saudi Arabia (K.S.A.) ................................................................................................................................................... 87

4.4.4 United Arab Emirates (UAE) ............................................................................................................................................................. 90

4.4.4.1 U.A.E. Banking Sector ........................................................................................................................................................................ 90

4.4.4.2 Risk Matrices ......................................................................................................................................................................................... 90

4.4.5 Bangladesh ................................................................................................................................................................................................. 93

4.4.5.1 Bangladesh Banking Sector ............................................................................................................................................................ 93

4.4.5.2 Risk Matrices ......................................................................................................................................................................................... 94

4.4.6 Tunisia .......................................................................................................................................................................................................... 97

4.4.6.1 Tunisian Banking Sector .................................................................................................................................................................. 97

4.4.6.2 Risk Matrices ......................................................................................................................................................................................... 97

CHAPTER 5: SURVEY OF RISK MANAGEMENT PRACTICES OF ISLAMIC FINANCE INSTITUTIONS OIC

MEMBER COUNTRIES ............................................................................................................................................................. 101

5.1 UNDERSTANDING OF RISK IN ISLAMIC FINANCIAL INSTITUTIONS (IFIS) .................................................. 101

5.1.1 Dynamics of Risk Management in Islamic Contracts ...........................................................................................................101

5.1.2 Methodology ............................................................................................................................................................................................107

5.2 RISK PERCEPTION ........................................................................................................................................................... 107

5.2.1 Risks in Different Modes of Financing ........................................................................................................................................107

5.2.2 Major Challenges Facing IFIS ..........................................................................................................................................................110

5.3 RISK REPORTING ............................................................................................................................................................. 111

5.4 RISK MANAGEMENT ENVIRONMENT ........................................................................................................................ 112

5.5 RISK MEASURING AND MANAGEMENT TECHNIQUES ......................................................................................... 113

5.6 RISK MONITORING .......................................................................................................................................................... 114

5.7 INTERNAL AUDIT AND CONTROL .............................................................................................................................. 116

5.8 EXTERNAL CONTROLS AND LEGAL SYSTEM .......................................................................................................... 118

5.9 ARE IFIS HAPPY WITH EXISTING RM SYSTEM? .................................................................................................... 118

5.10 REACHING THE OBJECTIVES OF SHARI’AH .......................................................................................................... 119

5.11 CONCLUSION.................................................................................................................................................................... 121

CHAPTER 6: SUMMARY AND POLICY RECOMMENDATIONS .................................................................................... 123

6.1. RISK MITIGATION AND REGULATION IN ISLAMIC FINANCE ........................................................................... 123

6.2 SHARIAH HARMONIZATION IN PRODUCT DEVELOPMENT .............................................................................. 124

6.3 DEVELOPING SUPPORT INFRASTRUCTURE AMONG MUSLIM COUNTRIES ................................................ 125

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6.3.1 Legal ............................................................................................................................................................................................................125

6.3.2 Accounting and Auditing ...................................................................................................................................................................126

6.3.3 Rating Agencies ......................................................................................................................................................................................127

6.3.4 Talent Development ............................................................................................................................................................................127

6.4 INTERNATIONALIZATION OF ISLAMIC FINANCE ................................................................................................. 127

6.5 GOVERNANCE AND CONTROL OF ISLAMIC FINANCE .......................................................................................... 128

6.6 CAPITAL MOBILIZATION AMONG MUSLIM COUNTRIES .................................................................................... 129

6.7 FINANCIAL INCLUSION AND ISLAMIC MICROFINANCE AMONG MUSLIM COUNTRIES ............................ 129

6.8. RECOMMENDATIONS AND RISK MANAGEMENT IMPLEMENTATION .......................................................... 131

6.8.1 Recommendations from the Risk Management Survey .....................................................................................................131

6.8.2. IFSB Risk Management Implementation ..................................................................................................................................133

6.9. RECOMMENDATION, PERFORMANCE INDICATOR AND FUTURE INITIATIVES FOR THE DEVELOPENT

AND RISK MANAGEMENT IN THE ISLAMIC FINANCIAL SERVICES INDUSTRY .................................................. 134

6.9.1. Key Performance Indicators for Measuring Progress ........................................................................................................137

6.9.2 Key Initiatives for Implementation of the Goals ....................................................................................................................140

6.9.3 Support the Growth and Stability of the Islamic Finance Industry ..............................................................................140

6.9.4 Encourage Efficiency and Innovation in the Islamic Finance Industry ......................................................................141

6.9.5. Promote the International Growth of the Islamic Finance Industry ...........................................................................142

6.9.6 Promote the Integration of Islamic Finance Across Borders ...........................................................................................143

6.9.7 Enhance the Role of Islamic Finance in Promoting Economic Growth .......................................................................144

REFERENCES.............................................................................................................................................................................. 146

APPENDIX A: CASE STUDIES OF ISLAMIC FINANCIAL INSTRUMENTS ................................................................. 161

A.1. PERFORMANCE OF ISLAMIC MUTUAL FUNDS VERSUS CONVENTIONAL MUTUAL FUNDS .........................

...................................................................................................................................................................................... 161

A.1.1 Present Status of Islamic Mutual Funds ....................................................................................................................................161

A.1.2 Emergence of Islamic Indexes ........................................................................................................................................................161

A.1.3 Findings from the Recent Literature ...........................................................................................................................................162

A.1.3.1 Comparison Between Performance of Islamic and Conventional Mutual Fund.................................................162

A.1.3.2 Riskiness Of Islamic Portfolio And Conventional Portfolio ..........................................................................................162

A.1.3.3 Comparison of Performances Between Islamic Indexes and Conventional Indexes .......................................163

A.1.3.4 Investment Styles and Fund Performance............................................................................................................................163

A.2. SUKUK FAILURE AND LESSONS LEARNED ............................................................................................................. 164

A.2.1 The Concept of Sukuk .........................................................................................................................................................................164

A.2.2 Trends in Sukuk Industry .................................................................................................................................................................164

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A.2.3 Diversity among Sukuks ....................................................................................................................................................................165

A.2.4 Case on Kuala Lumpur Sentral Pvt. Ltd. (KLSSB): A Success Story ..............................................................................165

A.2.4.1 The Issuer and the Agent ..............................................................................................................................................................165

A.2.4.2 The Musharakah agreement and profit sharing ratio .....................................................................................................166

A.2.4.3 Capital Contribution ........................................................................................................................................................................167

A.2.4.4 Purchase Undertaking (PU) .........................................................................................................................................................167

A.2.5 Cases on Sukuk Defaults ....................................................................................................................................................................167

A.2.5.1 East Cameron Partners’ Sukuk Al-Musharakah .................................................................................................................167

A.2.5.1.1 Purpose of Sukuk Issuance .......................................................................................................................................................167

A.2.5.1.2 The SPV ..............................................................................................................................................................................................168

A.2.5.1.3 Type of contract .............................................................................................................................................................................168

A.2.5.1.4 ECP’s Sukuk Structure ................................................................................................................................................................168

A.2.5.1.5 Restructuring the ECP Sukuk ..................................................................................................................................................169

A.2.5.2 The Nahkeel Sukuk ..........................................................................................................................................................................169

A.2.5.2.1 Reasons for Insolvency/Default .............................................................................................................................................170

A.2.5.2.2 Bailout ................................................................................................................................................................................................171

A.3. ISLAMIC BANKING FAILURE AND LESSONS LEARNED ...................................................................................... 171

A.3.1 Status of Islamic Banking ..................................................................................................................................................................171

A.3.2 Recent financial crisis: How the Islamic banks have performed? .................................................................................171

A.3.3 Lessons learned .....................................................................................................................................................................................172

A.4 OVERNING LAW CLAUSES OF SELECTED SUKUK TRANSACTIONS ................................................................. 173

A.4.1 English Law and Exclusive Jurisdiction of the English Courts ........................................................................................173

A.4.2 English Law and Non-Exclusive Jurisdiction of the English Courts .............................................................................174

A.4.3 Sharī'ah as the Exclusive Governing Law..................................................................................................................................175

A.4.4 Provisions for Arbitration in Sukuk Transactions ................................................................................................................177

A.5 INSOLVENCY AND DEBT RESTRUCTURING IN ISLAMIC LAW .......................................................................... 178

A.6 DEBT RESTRUCTURING, DISPUTE MANAGEMENT AND DEFAULTS IN ISLAMIC FINANCIAL

TRANSACTIONS ........................................................................................................................................................................ 180

APPENDIX B: CREDIT RISK MEASUREMENT ................................................................................................................. 182

APPENDIX C: LIST OF BANKS, COUNTRIES AND REGIONS ........................................................................................ 183

APPENDIX D: SURVEY QUESTIONNAIRE OF RISK MANAGEMENT ........................................................................ 184

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Tables

Table 1.1: Breakdown of Islamic Financial Assets (in USD billion, as of 2012) ...................................................................... 2

Table 1.2: Islamic Indices Providers for Equity Markets ................................................................................................................... 6

Table 3.1: IFSI Industry ................................................................................................................................................................................... 48

Table 3.2: Types of Islamic Financial Instruments............................................................................................................................. 51

Table 3.3. Regulatory and Supervisory Structures and Laws and Regulations in OIC member countries ............ 57

Table 5.1 Types of Risks – Description and Influence ....................................................................................................................103

Table 5.2: Perception of Risks in Modes of Financing ....................................................................................................................108

Table 5.3: Regional Distribution for Perceptions of Credit Risk................................................................................................109

Table 5.4: Operational Risk and Presence of Risk Management System ...............................................................................109

Table 5.5: Challenges in Risk Management ..........................................................................................................................................110

Table 5.6: The Prerequisites to Risk Monitoring ..............................................................................................................................114

Table 6.1: Progress Made in Ten Areas for Legal and Supervisory Enablement ...............................................................125

Table 6.2: Ten-Year Framework Recommendations ......................................................................................................................135

Table 6.3: Key Performance Indicators for Measuring Progress ..............................................................................................137

Table 6.4: Key Initiatives ..............................................................................................................................................................................140

Table A.2: Remedial Measures for Sukuk Defaults and Near Defaults ...................................................................................181

Charts

Chart 1.1: Distribution of Islamic Banking Assets of QISMUT Countries ................................................................................... 4

Chart 1.2: 2008-2012 CAGR of QISMUT Countries ............................................................................................................................... 4

Chart 1.3: Islamic Funds and Takaful Assets By Region .................................................................................................................. 13

Chart 1.4: Banking Assets and Sukuk By Region ................................................................................................................................. 13

Chart 1.5: Total Islamic Finance Assets (USA billion) ....................................................................................................................... 13

Chart 4.1: Asset Quality Ratios for Asia Region ................................................................................................................................... 65

Chart 4.2: Capital Adequacy Ratio for Asia Region ............................................................................................................................ 65

Chart 4.3: Operational Efficiency Ratios for Asia Region ................................................................................................................ 66

Chart 4.4: Liquidity Ratio for Asia Region .............................................................................................................................................. 66

Chart 4.5: Asset Quality Ratios for MENA Region ............................................................................................................................... 68

Chart 4.6: Capital Adequacy Ratio for MENA Region ........................................................................................................................ 68

Chart 4.7: Operational Efficiency Ratios for MENA Region ............................................................................................................ 69

Chart 4.8: Liquidity Ratio for MENA Region .......................................................................................................................................... 69

Chart 4.9: Asset Quality Ratios for Sub-Saharan Africa Region ................................................................................................... 71

Chart 4.10: Capital Adequacy Ratio for Sub-Saharan Africa Region .......................................................................................... 71

Chart 4.11: Operational Efficiency Ratios for Sub-Saharan Africa Region ............................................................................. 71

Chart 4.12: Liquidity Ratio for Sub-Saharan Africa Region ........................................................................................................... 72

Chart 4.13: Asset Quality Ratios for Malaysian Banks ...................................................................................................................... 74

Chart 4.14: Capital Adequacy Ratio for Malaysian Banks ............................................................................................................... 74

Chart 4.15: Operational Efficiency Ratios for Malaysian Banks................................................................................................... 75

Chart 4.16: Liquidity Ratio for Malaysian Banks................................................................................................................................. 75

Chart 4.17: Non-Performing Loans (Gross) / Total Cash Loans (%)-Ratio ............................................................................ 77

Chart 4.18: Provision for Non-Performing Loans / Gross Non-Performing Loans (%)-Ratio ...................................... 77

Chart 4.19: Demand Deposit (Funds Collected) / Total Deposit (Funds Collected) (%)-Ratio .................................... 78

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Chart 4.20: Shareholder's Equity Ratios / Total Risk Weighted Assets (%)-Ratio ............................................................ 78

Chart 4.21: Net Income / Average Total Assets (%)-Ratio............................................................................................................. 79

Chart4. 22: Net Income / Average Shareholder's Equity (%)-Ratio .......................................................................................... 80

Chart 4.23: Total Interest (Profit Share) Income/Interest (Profit) Bearing Assets Average(%)-ratio .................... 80

Chart 4.24: Net Interest (Profit) Revenues (Expenses) / Average Total Assets (%)-Ratio ............................................ 81

Chart 4.25: Fees, Commission and Banking Services Revenues / Average Total Assets (%)-Ratio ......................... 81

Chart 4.26: Staff Performance ...................................................................................................................................................................... 82

(Average Total Assets / Average Number of Total Staff-Ratio & ................................................................................................ 82

Total Deposit (Funds Collected) / Average Number of Total Staff-Ratio) .............................................................................. 82

Chart 4.27: Profit (Loss) Before Tax / Average Total Number of Staff-Ratio ........................................................................ 82

Chart 4.28: Branch Performance (Total Deposit (Funds Collected)/Total Number of Branches-Ratio &

Loans/Total Number of Branches-Ratio) ............................................................................................................................................... 83

Chart 4.29: Weighted Average Maturity of Securities (Day)-Ratio ............................................................................................ 83

Chart 4.30: Weighted Average Maturity of Securities Held for Trading (Day)-Ratio ........................................................ 84

Chart 4.31: Asset Quality Ratios for Turkish Banks ........................................................................................................................... 85

Chart 4.32: Capital Adequacy Ratio for Turkish Banks .................................................................................................................... 85

Chart 4.33: Operational Efficiency Ratios for Turkish Banks ....................................................................................................... 86

Chart 4.34: Liquidity Ratio for Turkish Banks ..................................................................................................................................... 86

Chart 4.35 : Asset Quality Ratios for Kingdom of Saudi Arabia (K.S.A.) ................................................................................... 88

Chart 4.36: Capital Adequacy Ratio for Kingdom of Saudi Arabia (K.S.A.) ............................................................................. 88

Chart 4.37: Operational Efficiency Ratios for Kingdom of Saudi Arabia (K.S.A.) ................................................................. 89

Chart 4.38: Liquidity Ratio for Kingdom of Saudi Arabia (K.S.A.) ............................................................................................... 89

Chart 4.39: Asset Quality Ratios for United Arab Emirates (UAE) Banks ............................................................................... 91

Chart 4.40: Capital Adequacy Ratio for United Arab Emirates (UAE) Banks ........................................................................ 92

Chart 4.41: Operational Efficiency Ratios for United Arab Emirates (UAE) Banks ............................................................ 92

Chart 4.42: Liquidity Ratio for United Arab Emirates (UAE) Banks .......................................................................................... 93

Chart 4.43: Asset Quality Ratios for Bangladesh Banking sector ................................................................................................ 95

Chart 4.44: Capital Adequacy Ratio for Bangladesh Banking sector ......................................................................................... 95

Chart 4.45: Operational Efficiency Ratios for Bangladesh Banking sector ............................................................................. 96

Chart 4.46: Liquidity Ratio for Bangladesh Banking sector ........................................................................................................... 96

Chart 4.47: Asset Quality Ratios for Tunisian Banks ......................................................................................................................... 98

Chart 4.48: Capital Adequacy Ratio for Tunisian Banks .................................................................................................................. 99

Chart 4.49: Operational Efficiency Ratios for Tunisian Banks ..................................................................................................... 99

Chart 4.50: Liquidity Ratio for Tunisian Banks..................................................................................................................................100

Figures

Figure 2.1 Islamic Financial System (IFS) .............................................................................................................................................. 15

Figure 2.2: Islamic contracts and their linkages .................................................................................................................................. 18

Figure 2.3: Classification of Sukuk ............................................................................................................................................................. 27

Figure 2.4: Types of sukuks and different risk metrics .................................................................................................................... 29

Figure 2.5: Takaful – Cooperative Model ................................................................................................................................................ 31

Figure 2.6: Takaful- Mudarabah on Investments ................................................................................................................................ 31

Figure 2.7: Takaful- Wakalah ........................................................................................................................................................................ 32

Figure 2.8: Takaful- Modified Wakalah .................................................................................................................................................... 33

Figure 2.9: Takaful Model – Wakalah with Mudarabah on Investments ................................................................................. 34

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Figure 2.10: Takaful Model – Wakalah with Incentive Compensation ..................................................................................... 34

Figure 5.1: Influence of Low Return in IFI on Deposit ...................................................................................................................110

Figure 5.2: Risk Reporting ...........................................................................................................................................................................111

Figure 5.3: Establishing Strong Risk Management Environment .............................................................................................112

Figure 5.4: Risk Measuring and Management Techniques ...........................................................................................................113

Figure 5.5: Use of Accounting Reporting System ..............................................................................................................................114

Figure 5.6: Assessment of Profit-and-Loss Situation ......................................................................................................................115

Figure 5.7: Internal Control System ........................................................................................................................................................116

Figure 5.8: Actively Engaged in Research to Manage RM Problems ........................................................................................117

Figure 5.9: Requirement of Basel Committee Equally Applicable to IFIs .............................................................................117

Figure 5.10: Capital Requirement of IFI and Conventional Banks ...........................................................................................118

Figure 5.11: Satisfaction with Existing RM System ..........................................................................................................................119

Figure 5.12: Risk Management Framework of Islamic Banks ....................................................................................................120

Figure A.1: Structure of KLSSB Sukuk Musharakah.........................................................................................................................166

Figure A.2: East Cameron Gas Co. Sukuk Issuance ...........................................................................................................................168

Figure A.3: Structure of Nakleel Sukuk ..................................................................................................................................................170

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Glossary of Terms

Ahliyyah al-ada Having achieved puberty and possessing mental discrimination.

Ahliyyah al tabarru’ Legal capacity to create a waqf, i.e., having ahliyyah al wujuh and ahliyyah al-ada.

Ahliyyah al-wujuh In existence and having a legal entity.

Akarat The revenue or income bearing property that is endowed together with the hayrat for purposes of supporting the akarat,

Arkan The essential elements for the existence of a contract.

Aqil Baligh Puberty.

‘Aqidan Contracting party.

Batil Void.

Dhimah mustaqilah Legal entity. Dhimmi Entity.

Fasikh A Hanafi concept whereby a contract is void unless made valid by amendment, addition, or deletion of a condition.

Fiqh A set of Islamic rulings or law pertaining to a particular subject matter.

Fuqaha Muslim jurists.

Halal Concept by which activities, processes, actions and

products are measured as to their permissibility or licitness in accordance with Sharia’ requirements.

Hayrat Property that is endowed and intended for charitable use

Ijarah A contract of hire of usufruct. It can be either an employment of services (ijarah al-’amal) or the rental of

property (ijarah) in exchange for a fee or salary (ujrah) and rent (ujur), respectively.

Maqasid al-Sharia’ Purposes of the law.

XII

Mawquf -alaih The corpus of the endowed property, c o n s i s t i n g of hayrat and akarat.

Mawquf lahu The beneficiary or beneficiaries of waqf. These must already be in existence (ahliyyah al-wujub) or be a class of beneficiaries which are ascertainable or simply be for the public.

Mudharaba Mudharaba exists when a financier (rab ul-mal) invests funds with an entrepreneur (mudharib) to embark on a business venture, with the goal of sharing the profits from that venture (Mansuri, 2006). The Maliki school considers

mudharaba a form of partnership. This contract is used today in most equity investment.

The Sharia’ principles of profit and loss results in the financial downside to the financier being the loss of 100% of his investment (except where the loss is caused through negligence or wrong-doing of the mudharib), and the entrepreneur his sweat- equity. T h e profit ratio, however,

must be pre-determined beforehand. The rab ul-mal has no right to participate in the business, except with the consent of the mudharib, and in that instance, he only has supervisory rights and not final say. Neither rab ul-mal nor mudharib may guarantee the amount of profits that the other will receive, and neither may guarantee or indemnify the other against loss or liability (except in the case of

negligence or wrong-doing).

Musharaka A partnership where all partners contribute capital to the venture.

A partnership (shirkah al-’aqd) may be in equal shares (mufawadah) or in unequal shares (man), and the partners may agree a s t o the type of investment each would make, i.e. whether any or all partners would invest financially (shirkah al-amwal) or all partners would jointly labour (shirkah al-amal), or both1

(Mansuri, 2006).

Sharia' principles require that risk of financial loss must be shared according to the proportion of capital invested,

1 There is also another form called shirkah al-.wujuh consisting of one of the partners lending his name or reputation to the venture to

enable the other partners to purchase goods or trade. This form is not universally accepted by all the madhabs and, in any event, is not

pertinent to the discussions herein.

XIII

although the profit ratio can be set at agreed-upon levels, which have been predetermined. All partners are agents for each other with regards to partnership matters, and all are entitled to participate in the management of the partnership, although it is permitted that some may delegate this function to one of the other partners. In line with the profit-with-risk principle, despite an agreement as to the profit ratio, a partner may not guarantee the amount of profit that another partner may derive from the partnership. Conversely, a partner may not demand another partner to indemnify him against liability or loss.

In today's context, the musharaka concept is reflected in the joint-stock company, with the shareholders as partners of the venture. This concept is also used in multiple-party investor sukuk issuances.

Mutawalli Sometimes also referred to as a naazir. A person appointed to have temporal powers of supervision and management over the mawquf-alaih. He serves in the capacity of a trustee in so far as the beneficiaries are concerned.

Naazir See Mutawalli.

Nafaqa Financial maintenance for wives, children, and parents.

Qard ul-hasan A gratuitous contract of courtesy involving a friendly loan without the expectation of any reward for the same. There is a transfer of ownership of the funds, which indicates that the lender may not dictate to the borrower the purposes to which the funds may be used. The loan is also payable when the borrower is able.

Rushd Mental discrimination

Sadaqa Voluntary and non-compulsory charity or good works on the basis of ihsan (doing more than required). Charity is not restricted to financial or monetary giving, but also extends to those who carry out good deeds. Debt forgiveness is also considered as a charitable act, particularly when the debtor is in distress2.

Sahih Valid.

2 Al-Quran surah al-Baqarah verse 2:280

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Al-Sharia' The body of Islamic law or jurisprudence.

Shurut Conditions of a contract in order to make it valid.

Sighah The expression or declaration signaling the intention of the waqif to make a waqf.

Urf Custom of a place or community.

Wakalah Wakalah is one of the types of contracts under the category of itlaqat, or authorization. (Mansuri, 2006) It is a contract whereby a principal appoints an agent to carry out certain acts on his behalf in respect of an ascertained subject matter. Only the Hanafi school accepts a general agency (wakalah ammah), with the other madhabs recognizing only a specific agency (wakalah khassah). In the wakalah khassah, limits may be placed upon the agent's authority (restricted agency); otherwise it is an absolute agency. The agency relationship is one of trust and the agent, therefore, owes fiduciary duties towards his principal. These include carrying out his work with ordinary skill and diligence, acting without conflict of interest, keeping proper accounts, and not accepting secret profits.

Waqf (Pl. awqaf). An endowment of property for the purposes of

charitable and good works, as permitted by al"Sharia.

Waqf Muaqqat Limited duration waqf.

Waqif A person who founds or endows a waqf

Zakat Zakat is a compulsory annual poor-tax imposed on excess or surplus property (subject to certain conditions). There are eight specific beneficiaries whose needs at the time of the Prophet were greatest and the most urgent. These were the orphans, the destitute, the poor in need, those who were indebted, those new converts to Islam whose wavering hearts could be persuaded to the humaneness of the religion by assistance in times of need, slaves seeking freedom, those who strive in the cause of Islam to prevent injustice, and stranded travelers who travel for pious or permissible reasons. Zakat may also be used for those appointed the difficult task of collecting and distributing the zakat.

There are two main types of zakat or poor-tax that Muslims are subject to, and they are (a) zakat ul mal (a tax on surplus wealth) (b) and zakat ul fin (a poll tax).

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List of Abbreviations

AAOIFI Accounting and Auditing Organization for Islamic Financial Institutions

ABS Asset-backed securitization

ADB Asian Development Bank

ARCIFI Arbitration and Reconciliation Centre for Islamic Financial Institutions

BCBS Basel Committee for Banking Supervision

BCPs Basel Core Principles

CGAP Consultative Group to Assist the Poor

CIBAFI (General) Council for Islamic Banks and Financial Institutions

DJIMI Dow Jones Islamic Market Index

FATF Financial Action Task Force

FSA Financial Services Authority

FSAP Financial Sector Assessment Program

GCC Gulf Cooperation Council

GIFF Global Islamic Finance Forum

IAH Investment account holders

IAIS International Association of Insurance Supervisors

ICM Islamic Capital Market

ICR Insolvency and creditor rights

IsDB Islamic Development Bank

IFAI Islamic financial architecture and infrastructure

IFS Islamic financial services

IFSB Islamic Financial Services Board

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IFSI Islamic financial services industry

IIFM International Islamic Financial Market

IIFS Institutions offering Islamic financial services

IIIIs Islamic international infrastructure institutions

IIRA International Islamic Rating Agency

IMF International Monetary Fund

INBMFIs Islamic non-bank and microfinance institutions

IOSCO International Organization of Securities Commissions

IRTI Islamic Research and Training Institute

JFFC Joint Forum on Financial Conglomerates

LLR Lender of last resort

LMC Liquidity Management Centre

MBS Mortgage–backed securitization

NAV Net asset value

NBMFIs Non-bank and microfinance institutions

OECD Organization for Economic Co-operation and Development

OIC Organization of Islamic Conference

PSIA Profit Sharing Investment Account

REITs Real Estate Investment Trusts

SCM Securities Commission of Malaysia

SGC Shari’ah governance system

SRI Socially responsible investing

TFC Term finance certificates

WTO World Trade Organization

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EXECUTIVE SUMMARY

CHAPTER 1: OVERVIEW OF ISLAMIC FINANCE Following the global financial crisis of 2007, the Islamic finance industry has gained importance as it provides another alternative to diversify investible funds. The Islamic finance industry grew from having USD 150 billion in assets under management in the mid-1990s to USD 1.3 trillion in 2011. Around half of the total assets of the Islamic finance industry is geographically concentrated, with an estimated 47.06% of total assets being held in Islamic banks in the Middle East and Asia. Beginning in the mid-2000s, regulatory authorities in different jurisdictions started introducing and amending legislation to make the legal systems more supportive of the Islamic banking industry’s growth. Besides, following the financial crisis, the increased interest surrounding Islamic banking has increased the level of awareness among investors, regulators and other stakeholders. As a result, assets under Islamic bank management and Islamic banking windows have grown at a compound annual growth rate (hereafter CAGR) of 40.3% between 2004 and 2011 to reach USD1.1 trillion. The average return on equity for the top 20 Islamic banks was 12.6%, which is comparable to the 15% ROE of conventional banks. Over the past decade, the Islamic capital market has developed in terms of both sophistication and size. Increased demand for diversification of the Sharī`ah-compliant assets has fostered innovations in the Islamic capital market. With the development of Islamic debt (sukuk), Islamic indices, and equities, a vibrant Islamic capital market is facilitating cross-border capital flows and funding economic activities. Since the launch of the early Islamic indices in 1999, Islamic indices have expanded across both regional and economic geographies. Four major global Islamic index providers are: 1) Dow Jones Islamic Market Indices, 2) S&P Sharī`ah Indices, 3) MSCI Global Islamic Indices, 4) FTSE Global Islamic Indices. The growth of Islamic Funds is dependent on the availability of other Sharī`ah-compliant solutions. Despite the challenges associated with the limited number of Shriah-compliant assets, Islamic Funds have evolved as a significant niche segment and have experienced stable grown since 2004, because of the rising financial wealth in emerging Muslim economies and the oil-rich countries. By the end-2011, assets under management of Islamic funds grew to USD 60 billion from USD 29.2 billion in 2004, representing a CAGR of 10.8%. Sukuk is the Islamic alternative for conventional bonds. Over the last decade, Sukuk has evolved as an important and vibrant part of the Islamic financial system. In the mid-2000s, government institutions and central banks started short-term Sukuk programs to enhance market liquidity management. Following the sovereign debt crisis in Europe, slower global economic growth has left investors with fewer investment options, which has led to capital flows to emerging markets, commodities, and alternative investments such as Sukuk. Despite a

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slump of 54.1% in 2008, due to the global financial crisis, sukuk growth rebounded from 2009 onwards, achieving a CAGR of 60.1% through the end of 2012. While conventional insurance goes against Shariah, due to the elements of gharar and riba in insurance contracts, takaful embraces Islamic the principles of cooperation and mutual help. Takaful is the smallest Islamic asset class with USD 15.2 billion in 2011 and, thus, represents only 1.1% of global Islamic finance assets. Between 2007 and 2011, the global takaful market had a CAGR of 19.1%. Islamic microfinance is a burgeoning field with the potential to a have great economic and social impact. A global CGAP survey estimated there to be 380,000 customers of Islamic microfinance in 2007. Operations are currently concentrated in Indonesia, Bangladesh and Afghanistan.

CHAPTER 2: RISKS IN FINANCIAL INSTITUTIONS AND MARKETS This report attempts to aggregate and discuss the myriad of risk-related challenges to Islamic finance. It aims to examine the issues in the context of Islamic banking and IFIs both from theoretical and practical standpoints. Risk pervades Islamic banking in ways similarly to conventional finance; however, the idiosyncratic risks associated with Islamic finance, as well as the constrictive nature of the sector, due to the confines placed on it by the Shari’ah, add complexity. Accordingly, the purpose of this writing is to allow the reader to focus on risk as it applies to Islamic financial activities. Islamic risk management strategy, still in its incipient stages, will find guidance from this compilation and be able to reference the texts used in this paper’s production. The amalgam of entities involved in the financial services sector seems unending. Having said that, as the Islamic finance industry has and continues to develop within the context of the global financial sector, effective regulatory and other methods of stability become increasingly important. This holds especially true for risk-related practices, which are vital to the industry’s continued success. From risk measurement to risk management, there are a myriad of ways by which financial service institutions and professionals mitigate risk. At its core, Islamic banking vehicles aim to avoid any and all excessive risk. In fact, the fundamental differences between Islamic and conventional finance are rooted in the fact that maysir (speculation) and gharar (excessive risk) in all forms, both direct and indirect, are non-permissible elements that cannot be present within any Islamic business transactions. During the sector’s incipient stages, misinformation and a lack of full-scale effectiveness regarding practices concerning risk was expected. However, as a one trillion dollar-plus sector, the proper coalescence amongst Islamic financial institutions, policymakers, and regulatory agents in order to create a maintainable risk management industry sub-sector is necessary for the Islamic financial services industry (IFSI) to sustain growth.

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CHAPTER 3: ISLAMIC FINANCIAL INFRASTRUCTURE Globalization in the financial landscape is impacting the Islamic financial industry in a manner similar to its conventional finance counterpart; Islamic financial institutions and Islamic capital markets are becoming more and more interconnected across different jurisdictions. Islamic funds in one country making investments in other countries are becoming commonplace. Under such a dynamic financial landscape, coherence among the cross-country financial architectures and infrastructures has evolved as a pivotal issue for the future growth of the Islamic financial industry in general. Besides, the 2007 global financial crisis also emphasizes the need for cross-country cooperation among the regulators and prudential authorities. As Islamic finance co-exists with conventional finance in most country jurisdictions, the industry is subject to both the prevailing financial architecture and infrastructure for conventional finance and the legal framework of Shariah laws. Following the 2007 global financial crisis, the FSB has initiated regulatory reforms on the over-the-counter (OTC) derivatives market in 2010, resolution regimes in 2011, and deposit insurance systems in 2012 that are also relevant to the Islamic finance industry. Although OTC derivatives are an underdeveloped and underutilized instrument amongst IIFS, there is a potential for the IIFS to utilize OTC derivatives to hedge their risk exposure. The ISDA/ IIFM Tahawwut (Hedging) Master Agreement establishes the legal framework for the use of OTC derivatives in the Islamic market. The sudden collapse of Lehman Brothers and the following financial crisis have increased the pressure to regulate large banks known to be systemically important financial institutions (SIFIs). As the Islamic financial institutions generally do not meet the standards to be classified as a SIFI, such regulations do not apply to the IFSI. Basel III is a capital and liquidity framework created in 2012 to improve the quality and quantity of capital by converting debt to equity-based capital and introducing new leverage ratios. Although the new standard for the liquidity coverage ratio will not impact IIFS greatly, as Shariah already limits the debt-to-equity ratio to not exceed 33%, the new recommendations on liquidity may have varying effects on the IFSI. The new standards may force Islamic banks to diversify their products, develop products with longer-term features, and better align assets and liabilities in Islamic banks, all of which would affect the industry positively. The International Association of Insurance Supervisors (IAIS) provides a platform for insurance supervisors to exchange ideas and information; it has revised the Insurance Core Principles, Standards, Guidance and Assessment Methodology (ICP) in October 2011 to improve the global insurance supervision. The IFSB included some of the revised standards, especially in regards to corporate governance, in its own recommendations in ED-14: Standard on Risk Management for Takaful (Islamic Insurance) Undertakings.

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The Islamic finance infrastructure includes payment-settlement systems, financial markets and products, legal frameworks, regulators and supervisors, Shariah governance institutions, ratings agencies, data collectors, and research and development entities. A legal framework allows for the certainty and legitimacy of financial contracts. However, in Islamic finance, legal infrastructure is especially important in enforcing Shariah principles. The Shariah Board is the primary adjudicator of all matters regarding financial contracts and their relevance to Islamic law. Rating agencies similarly give investors the ability to compare companies, but from an unbiased, independent perspective. As most of the IIFSs are small in size, industry experts have emphasized diversification and specialization of instruments. The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and the Islamic Financial Services Board (IFSB) focus on strengthening the CG of IIFS. The International Islamic Financial Market (IIFM), the International Islamic Rating Agency (IIRA), the International Islamic Centre for Reconciliation and Commercial Arbitration (IICRA), the General Council of Islamic Banks and Financial Institutions, and the Islamic Development Bank Group (IDB) support the development of infrastructure to implement Islamic finance (ISRA 5). The Islamic Financial Services Board (IFSB) is set up as an international platform to promote and enhance the soundness of the industry by issuing global prudential standards and guiding principles for the Islamic financial services industry. Following the global financial crisis of 2007 and European sovereign debt crisis, the IFSB has undertaken a number of initiatives to address the development taking place in the global financial industry. Such initiatives include - the issuance of the IFSB’s Guiding Principles on Liquidity Risk Management for IIFS, the Guiding Principles on Stress Testing for IIFS, and ED-15: Revised Capital Adequacy Standard. The AAOIFI creates standards on accounting, auditing, governance, ethics, and Shariah for IIFS. In 2012, the AAOIFI issued seven new standards on governance, ethics, and customer protection and revised accounting standards on real estate investments. In addition, the AAOIFI is also reviewing the standards on investment accounts and Takaful and creating new governance standards for the Shariah Supervisory Board (IFSB 74). The Shariah-compliant Lender of Last Resort, or SLOLR, facility is a financial safety net. It differs from the traditional LOLR in that the financial contracts supporting its structure must be Shariah compliant. Open market operations (OMOs) and standing facilities are the two mechanisms used by RSAs for monetary operations of the central bank. According to a survey by the IFSB, RSAs made use of OMOs and standing facilities, but these two tools did not necessarily comply with Shariah and were not suitable for transactions with the IIFS. The survey also showed that, in a quarter of the RSAs’ jurisdictions, there were no SLOLR facilities; however, but they did distinguish between conventional financial service institutions and the IIFS. One of the major entities responsible for settling financial disputes is the International Islamic Centre for Reconciliation & Arbitration located in the UAE. The IICRA focuses on mediating and settling disputes between Shariah compliant financial or commercial institutions. Their work

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includes resolving disputes between the institutions themselves or institutions and their clients.

CHAPTER 4: COMPARATIVE ANALYSIS OF RISK MATRICES This chapter presents the comparative analysis of risk matrices for the Islamic and the conventional banks in the 57 OIC member Muslims countries categorized into three major geographical regions: a) The Asian region, b) The MENA (Middle East and North Africa) region, which also includes the GCC countries, and c) The Sub-Saharan African countries. Later, a similar analysis is conducted for five countries, Malaysia, Turkey, The United Arab Emirates, Kingdom of Saudi Arabia, and Bangladesh, which are home to large and growing Islamic finance industries. The financial statement data for the Islamic and conventional banks are collected from the BankScope Database. For each geographic region, a sample of conventional banks is selected as a control sample, where conventional banks are matched based on the total asset size of Islamic banks. The BankScope Database provides 35 risk matrices categorized into four major types: (a) Asset Quality Ratios, (b) Capital Adequacy Ratios, (c) Operational Efficiency ratios, and (d) Liquidity Ratios. However, only the major risk matrices under each category are discussed in this chapter. There are 41 Islamic banks listed in the BankScope database from Malaysia, Indonesia, Brunei, Singapore, Bangladesh, Philippines, Russia and Pakistan that are considered in the Asian region. The average asset size of these Islamic banks is 2,923.478 million USD, and Total Deposit volume accounts for of 2,545.458 million USD, with an average of 37.47 branches and 413 employees per bank. For the Asian region, the Asset Quality of the Islamic banks’ loan portfolio is rather poor, compared with that of their conventional counterparts, as evident by the Average Loan Loss Res/Gross Loans ratio and average loan loss reserve over gross loan ratios. Additionally, Islamic banks in the Asian region suffer from lower asset quality, compared to their conventional counterparts; however, the Islamic banks keep higher cushions in terms of capital adequacy. 68 Islamic banks from the 16 MENA countries (Bahrain, Egypt, Iran, Iraq, Jordan, Kuwait, Lebanon, Morocco, Oman, Qatar, Saudi Arabia, Syria, Tunisia, United Arab Emirates, West Bank and Gaza, Yemen) are selected for the analysis, based the data available in the BankScope database. The average asset size of the Islamic banks is this region is 5,847.867 million USD, and the average Total Deposit volume is 4,434.627 million USD. Islamic banks in the MENA region have on an average 28.51 branches and 550 employees. For the MENA region, although the Average Loan Loss Res/Gross Loans ratio is higher for the Islamic banks, other asset quality ratios are lower than their conventional counterparts. In general, Islamic banks hold a better loan portfolio, compared to their conventional counterparts. The higher capital adequacy ratios of the Islamic banks show that they keep a higher equity cushion in order to cover the risk exposure and avoid capital adequacy problems. A Higher Net Interest Margin for Islamic banks represents cheaper sources of funding. Interbank ratios for the Islamic banks are

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marginally lower than 100, which indicate that Islamic banks are generally borrowers in the interbank market, whereas their conventional counterparts are lenders. Among the Sub-Sahara African countries, only the Islamic banks from Sudan and Gambia are listed in the BankScope database. Sudan represents a unique financial system, where only Shariah compliant financial services are provided. Due to a lack of sufficient data, Islamic banks from Gambia are not included in the analysis. The sample includes 8 Islamic banks from Sudan, with an average asset size of 469.082 million USD and average Total Deposit volume of 224.137 million USD. Islamic banks in the region have on an average of 6.38 branches and 103 employees. Islamic banks in Sudan exhibit an average Loan Loss Res/Gross Loans ratio of 3.02% and a Loan Loss Res / Impaired Loans ratio of 4.91%, which is generally lower than many other peer Islamic banks in other geographic areas. In general, the Islamic banks in Sudan maintain a significant cushion to cover the risk exposure and potential capital adequacy problems. Most of the capital ratios are higher than other peer Islamic banks. Higher Equity / Net Loans reflects a better cushion to absorb losses on the loan book. In general, higher operating ratios represent a lower cost of funds, higher efficiency, and higher yields on equity and assets. Islamic banks in Sudan keep a significant portion of their portfolio invested in liquid assets; the high ratio of Liquid Assets / Tot Dep & Bor reflect better liquidity. The latter segments of the chapter present a comparative analysis of the risk matrices for the Islamic bank and conventional banks for the five major Islamic financial markets: a) Malaysia, 2) Turkey, 3) Kingdom of Saudi Arabia, 4) United Arab Emirates, and 5) Bangladesh. 15 Malaysian Islamic banks listed in the BankScope database are considered. The average total asset of the Malaysian Islamic bank sample is 5,727 million USD, with average deposits of 5,085 million USD. Asset Quality for the Islamic banks’ loan portfolio is rather poor, compared to that of their conventional counterparts. The Malaysian Islamic banks, on average, have higher net interest margins and net interest revenue to average assets, compared to conventional banks ratios, which reflects cheaper sources of funding. However, conventional banks have higher dividend pay-out ratios, ROE, and ROA. In Malaysia, both Islamic and conventional banks are, in general, borrowers in the interbank market. Islamic banks also exhibit higher liquidity. 4 Turkish Islamic banks listed in the BankScope database are included in the analysis. An average total asset of the Turkish Islamic bank is 5,540 million USD with average deposits of 4,470 million USD. Islamic banks have on average 1,786 employees and average 80.5 branches. Asset quality for the Turkish Islamic banks is mixed, when compared to their conventional banking competitors. In general, conventional banks in Turkey keep a higher capital cushion, compared to their Islamic banking counterparts. On the average, Islamic banks in Turkey maintain a better liquidity position, compared to the conventional banks. 4 Islamic banks from K.S.A. listed in the BankScope database are considered in the analysis. Asset Quality of the K.S.A. Islamic banks’ loan portfolios is relatively better, compared to that of their conventional counterparts. In general, Islamic banks in KSA maintain better capital adequacy, as evident by capital adequacy ratios. Higher Equity/Net Loans ratios for the Islamic banks reflect the fact that Islamic banks have a better ability to absorb losses on the loan book.

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In general, Islamic banks in KSA have a higher cost of funds and lower efficiency, which is reflected in lower ROEs. 8 Islamic banks from United Arab Emirates are considered for the analysis. Average total assets of the U.A.E. Islamic bank sample is 8,004 million USD, with average deposits of 6,137 million USD. Islamic banks, on average, employ 87 employees and have 8.89 branches. Asset Quality for the Islamic banks’ loan portfolio is rather poor, compared to that of their conventional counterparts. The higher Net Interest Margin of the conventional banks represents cheaper sources of funding that the conventional banks maintain over their Islamic banking counterparts. Conventional banks have also a higher dividend pay-out. 6 Islamic banks from Bangladesh listed in the BankScope database are used in the analysis. Average total assets of the Bangladesh Islamic bank are 1,584 million USD, with average deposits of 1,398 million USD. On average, Islamic banks in Bangladesh maintain 639 employees and have 28.67 branches. Asset Quality for the Islamic banks’ loan portfolios is rather poor, compared with that of their conventional counterparts. The Lower Equity/Tot Assets ratio for the Islamic banks, compared with that of the conventional banks, represents higher risk exposure and possibly capital adequacy problems for the Islamic banks. Higher Net Interest Margins for the conventional banks represent cheaper sources of funding for the conventional banks. This is also reflected in higher ROAs and dividend pay-outs for the conventional banks. The average Interbank Ratio for Islamic banks of 128.04% is higher than that of the conventional banks of 57.97%, which suggests that Islamic banks maintain additional liquidity.

CHAPTER 5: RISK MANAGEMENT PRACTICES IN IFIS Islamic financial institutions (IFIs) work in accordance with the Islamic Shari’ah. Islamic Shari’ah strictly prohibits all sorts of risky and speculative financial activities. Charging interest, or Riba, is completely prohibited. All forms of unsocial and unproductive investments are also strictly prohibited. The system promotes partnership and risk sharing among participants. This study analyses the risk management practices of 18 IFIs from across 14 countries of the MENA region, Southeast Asia and the South Asia. The most important risk is operational risk, followed by credit risk, liquidity risk and mark-up risk. These risks are relatively more important in the Mudarabah, Murabahah, and Musharakah models of financing, when compared to the Ijarah, Ijtisna, and Salam modes of financing. Regional differences in the risks are difficult to explain, due to limited sample size. However, the banks in the developing MENA and the Southeast Asian countries reflect better risk management practices and policies, when compared to other regions. Lack of understanding, the unavailability of Islamic money markets, and the limited regulatory framework in handling problem loans have been identified as the three major problems. These problems are closely connected to the types of risks IFIs are facing. Consequently, IFIs will face higher amounts of defaults in their financing and depositors are more likely to withdraw their funds. The IFIs did not follow uniform risk reporting standards. Most of these banks did not report country risk, price risk from commodities, or the operating risk from human resources,

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technology and operating procedures. A major portion of the banks did not have computerized risk management systems. These banks did not diversify their investments across countries, did not use loan grading mechanisms, and did not monitor the changes in the benchmarks that decide the rate of return for the stakeholders. Over half of these banks do not produce a country risk report. Risk monitoring has been very traditional in many banks. These banks use financial performance-based monitoring mechanisms. Another half of these banks did not continuously reappraise the value of collateral. Due to the lack of understanding of risk management practices and the limited use computer systems, most of the modern risk identification and management techniques could not be used. Traditional risk identification and management techniques, such as the internal rating system and maturity matching for liquidity management, are commonly used. Most of the banks are using financial reporting guidelines by either AAOIFI or a system that is locally established by modifying international standards. With minor exceptions, most of the banks already have strong internal control systems, even though they are not very happy with the existing risk management system in place. Bankers argued that the capital requirement for IFIs should be different than that of conventional institutions. The system initiated by the Basel committee may not be directly used in IFIs. IFIs are resilient to conventional risk not because of the internal control systems or assistance provided by external stakeholders. It is resilient because of the Shari’ah principles. These principles are at the core of Islamic risk management. Additionally, the Shari’ah supervisory board actively monitors the introduction and operation of new products. These actions are absent in conventional system. Hence, it is important to understand the basic norms of Shari’ah that will help this system to thrive on its own, instead of waiting for the proactive mechanism that may not yield any positive result.

CHAPTER 6: CONCLUSION Islamic financial institutions are exposed to risks pertaining to the investments and the financial products and services that they engage in. The degree of risk exposure varies from product to product, because of their underlying contractual format. In a Murabahah contract, the bank takes possession of the asset and, at least theoretically, the bank holds the asset for some time. This holding period is almost eliminated by the Islamic banks by appointing the client as an agent for the bank to buy the asset. In an Istisna contract, enforceability becomes a problem, particularly with respect to fulfilling the qualitative specifications. To overcome such counterparty risks, Fiqh scholars have allowed band al-jazaa (penalty clause). In several contracts, a rebate on the remaining amount of mark-up is given as an incentive for enhancing repayment. Fixed rate contracts such as long maturity instalment sales are normally exposed to more risk, as compared to floating rate contracts such as operating leases. Islamic financial institutions can engage in two broader sets of risk management techniques. The first type in comprised of standard techniques, such as risk reporting, internal and external audit, GAP analysis, RAROC, and internal rating. The second set includes techniques

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that either need to be developed or adapted, keeping in view the requirements for Shari‘ah compliance. The Ten-Year Framework formulated in 2007 elaborates a roadmap for the development of the Islamic finance industry for the next ten years. A mid-term review of the Ten-Year Framework was conducted in 2013, which suggests that the IFSI has shown great resilience in the face of recent tribulations in the global financial industry, especially in comparison to the conventional financial industry. However, the IFSI has not been entirely immune to the recent global financial crisis. A mid-term review of the Ten-Year Framework by the IFSB, IRTI, and IDB Group revealed that there was still a great deal of work to be done at the halfway point to achieve the goals set out in the recommendations of the Framework. While there has been much discussion surrounding the Framework, implementation has been a challenge. By grouping the 13 recommendations and an additional three new recommendations into three categories (enablement, performance and reach), the IFSB, IRTI, and IDB Group proposed over 70 initiatives to foster better implementation of the recommendations. The 70 initiatives were narrowed to 20 key initiatives using key performance indicators (KPIs). Opportunities for cross-border investments are limited due to the lack of generally accepted standards for Islamic finance, thus putting IIFSs at a competitive disadvantage to their conventional counterparts. Principle-based rules are needed, rather than ad hoc rules. According to the Islamic Research and Training Institute (IRTI), there has been good progress made on the Ten Year Framework’s recommendations with regards to improving the legal and regulatory frameworks in various countries (A Mid-Term Review 7). Cross-border harmonization will require the proper infrastructure to create the linkages within and between countries. Developing standardized Shariah compliant products is very important. The mid-term review of the Ten-Year Framework identified three indicators to determine the level of progress in Shariah harmonization in product development. First is the number and usage of standardized products with published structures and contracts. The second indicator is the volume of published research on product innovation and standardization. The third is the number and use of innovative products (A Mid-Term Review 106). There are three goals of Islamic corporate governance (CG), of which two are similar to conventional CG and one is unique to Islamic CG. Like conventional CG, Islamic CG includes protecting stakeholder interests and achieving the company’s objective. Islamic CG includes a third factor, which is to adhere to Shariah principles. Capitalization in the Islamic finance industry is a small in light of the whole financial industry. Few Islamic finance institutions are strongly capitalized and capable of expanding outside of their home country. In addition, Islamic banking institutions are perceived as less efficient in establishing capital, compared with conventional financial institutions. NBFIs fare better in comparison, with equity of USD 248.5 million and assets of USD 638.6 million. Increasing financial inclusion is important, as it can reduce inequality. Financial exclusion transpires in two ways: those who are involuntarily excluded, and those who voluntarily

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exclude themselves. Factors that result in financial exclusion of the poor include low income, high risk, price, and information asymmetry (Ahmed 204). However, Muslims may voluntarily exclude themselves from formal financial services, since Islam prohibits participation in interest-based mechanisms. Over the last four decades, microfinance has evolved as a unique financial institution that focuses on pro-poor financial inclusion and has grown in popularity. The concept of Islamic microfinance is a rather novel one, compared to conventional microfinance. To comply with Shariah laws, Islamic microfinance generally provides the poor with real assets instead of cash. Additionally, they can also utilize several types of financing and contractual arrangements, such as Qard-al-Hassan (interest free loans), Musharakah, Mudarabah, and other contracts. Microtakaful is a second way of increasing financial inclusion. Conventional insurance services are not Shariah compliant due to the inherent high level of uncertainty. Takaful is a mutual guarantee that functions by bringing together a group of people who contribute to a fund managed by a takaful operator (TO). There are three takaful models: mudarabah, wikala, and waqf. Mudarabah consists of a partnership relationship in which the participants contribute to a fund and the TO invests the funds.

Appendix: Case Studies of Islamic Financial Instruments Over the last three decades, Islamic mutual funds have evolved as a growing alternative asset class that provides diversification opportunities to investors who look for Shariah compliant investment alternatives. Such growth of Islamic mutual funds has been fostered by the innovations in the financial product offerings of the Islamic financial services industry. The evolution of a wide range of sukuks and increasing demand for Shariah compliant products have enhanced the depth and breadth of the Islamic capital market. Following the global financial crisis of 2007, Islamic bonds, i.e. the sukuk industry, have hardly been affected. While sukuk issuance reached its all-time highest growth at the end of 2007, following the financial crisis and credit crunch in the global market, sukuk issuance has declined sharply. From 1997 to 2009, a staggering number of sukuks have defaulted, which has jolted investor confidence in sukuk. In addition, incongruent legal systems and the lack of specific prudential guidelines from regulators have also played a part in falling investor confidence. Both success and default stories surrounding sukuk issuances are presented in this chapter alongside a summary of the key empirical findings in the existing literature. The prevailing legal systems in Muslim countries are generally based on western legal systems, mostly English common law or the French legal system. However, shariah law is not given formal recognition in the legal systems in these countries; additionally, bankruptcy provisions and investor rights and protections are not well defined in these jurisdictions, which has made dissolving sukuk defaults more challenging. Islamic banks have remained rather unscathed during the financial crisis, because of their lack of participation in the derivatives markets. However, the slowing economic growth in Muslim

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countries, along with volatile macro-economic situations, has affected both Islamic and conventional banks alike in the post-crisis era (i.e., exchange rate and interest rate shocks). However, prudential regulations are less defined for Islamic banks. Specific challenges include the lack of a deposit insurance alternative for Islamic banks, the lack of commitment regarding the lender of last resort, and the lack of a consistent stance from regulators that would force Islamic bank managers to set aside a higher proportion of liquid assets in order to mitigate financial distress or the risk of a bank run

Risk Management in Islamic Financial Instruments

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CHAPTER 1: OVERVIEW OF ISLAMIC FINANCE INDUSTRY

This report presents a summary of risk management analysis for Islamic banks in the OIC member states, which comprises 57 countries in Asia and Africa. The member countries are: Afghanistan, Albania, Algeria, Azerbaijan, Bahrain, Bangladesh, Benin, Brunei-Darussalam, Burkina-Faso, Cameroon, Chad, Comoros, Cote D'ivoire, Djibouti, Egypt, Gabon, Gambia, Guinea, Guinea-Bissau, Guyana, Indonesia, Iran, Iraq, Jordan, Kazakhstan, Kuwait, Kyrgyz, Lebanon, Libyan, Malaysia, Maldives, Mali, Mauritania, Morocco, Mozambique, Niger, Nigeria, Oman, Pakistan, Palestine, Qatar, Saudi Arabia, Senegal, Sierra Leone, Somalia, Sudan, Suriname, Syrian, Tajikistan, Togo, Tunisia, Turkey, Turkmenistan, Uganda, United Arab Emirates, Uzbekistan, Yemen. Among the member countries, 157 Islamic banks from 31 countries are represented in the BankScope database as of 2013: Bahrain, Bangladesh, Brunei Darussalam, Cayman Islands, Egypt, Gambia, Indonesia, Iran, Iraq, Jordan, Kuwait, Lebanon, Malaysia, Maldives, Mauritania, Oman, Pakistan, Philippines, Qatar, Russia, Saudi Arabia, Singapore, Sudan, Syrian Arab Republic, Tunisia, Turkey, United Arab Emirates, United Kingdom, United States, West Bank and Gaza, and Yemen. Accordingly, only this subset of OIC member countries considered for the risk management analysis. Country macro-economic data are collected from the IMF, IFC, World Bank and IRTI reports. The remaining parts of this chapter present an overview of Islamic finance industry in general, followed by discussions on the current status of the Islamic banking sector, the Islamic capital market and Islamic microfinance.

1.1 OVERVIEW OF ISLAMIC FINANCE INDUSTRY

Over the last three decades, the Islamic finance industry (hereafter IFSI) has emerged as an effective alternative to conventional finance. Following the global financial crisis of 2007, the IFSI has gained importance as it provides another alternative to diversify investible funds. Since April 2010, the IFSI has expanded in new jurisdictions. The number of participating financial institutions has increased and countries have implemented regulatory reforms and provided various incentives for development. As a result, assets under management in the IFSI have reached USD 1.6 trillion as of the end of 2012, representing a 20.4% increase since 2011 (IFSB-IFSI 2013). According to the GIFF 2012 report, Islamic finance is “the fastest growing segment of the international financial system (GIFF 2012 14).” The Islamic finance industry grew from having USD 150 billion in assets under management in the mid-1990s to USD 1.3 trillion in 2011. Additionally, as of 2012, there were more than 600 Islamic financial institutions operating in 75 countries. With the growing demand for more ethical investment, a growing Muslim population around the world, and the diversity and strength of Islamic finance products, more countries are seeking to integrate Islamic financial principles and tools in their financial markets (GIFF 2012 11).

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Around 50% of total Islamic financial assets are geographically concentrated in Islamic banks in the Middle East and Asia. Although contributions the total assets invested in sukuk, Islamic funds and takaful institutions are relatively small at present, these alternate asset classes have enjoyed remarkable growth and have expanded the breadth and depth of the Islamic Financial Industry in general. Table 1 presents the summary distribution of Islamic Financial Industry Assets across major geographical regions.

Table 1.1: Breakdown of Islamic Financial Assets (in USD billion, as of 2012)

Banking

Assets

Sukūk

Outstanding

Islamic Funds’

Assets

Takāful

Contributions

Asia 171.8 160.3 22.6 2.7

GCC 434.5 66.3 28.9 7.2

MENA (exc. GCC) 590.6 1.7 0.2 6.9

Sub-Saharan Africa 16.9 0.1 1.6 0.4

Others 59.8 1.0 10.8 0.0

Total 1,273.6 229.4 64.2 17.2

Source: Regulatory authorities, Bloomberg, Zawya, IFIS, The Banker, KFHR

The Islamic finance industry is composed of four asset classes: banking, sukuk, funds, and takaful. A brief discussion on the present status of these four asset classes is presented in the following segments.

1.2 CURRENT STATUS OF ISLAMIC BANKS

In the early 2000s, Islamic banking was a niche market in most jurisdictions, with only a few institutions offering basic depository and financing instruments. Additionally, there was low awareness and demand for Islamic banking services, particularly in the Asia Pacific and developed markets. Beginning in the mid-2000s, regulatory authorities in different jurisdictions started introducing and amending legislation to make the legal system more supportive of the Islamic banking industry’s growth. In addition, following the financial crisis, increased interest about Islamic banking has increased the level of awareness among investors, regulators and other stakeholders. As a result, assets under management in Islamic banks and Islamic banking windows have grown at a compound annual growth rate (hereafter CAGR) of 40.3% between 2004 and 2011 to reach USD1.1 trillion. Among financial institutions and asset classes, Islamic banks have contributed to the overwhelming majority of the total assets managed over the last decade (“GIFF 2012 Executive Summary” 1). In 2013, the assets of Islamic commercial banks were expected to grow to USD $1.7 trillion. The average return on equity for the top 20 Islamic banks was 12.6%, which is comparable to the 15% ROE of conventional banks.

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1.2.1 Asia Region

At present, Islamic banking service is available in Malaysia, Indonesia, Brunei, Sri Lanka, Thailand, Singapore, Bangladesh, China, Philippines, Russia, Pakistan Kazakhstan, Azerbaijan and Afghanistan. Among them, Malaysia constitutes 72.1% of total assets, followed by Indonesia (10.8%), Bangladesh (5.4%), Pakistan (4.9%) and Brunei (3.4%), while other countries constitute the remaining 3.4%. (GIFF 2012)

1.2.2 Mena Region

A majority of Islamic banks in the MENA region belong to the private sector and co-exist with the conventional financial institutions, with the exception of Iran, where all banks are classified as Islamic banks, and the majority of them are state owned. Among the MENA countries, Bahrain, Kuwait, Qatar, Saudi Arabia, and The United Arab Emirates are home to some of the industry’s largest Islamic banks. Oman is the latest GCC member to introduce Islamic banking through the issuing of two full-fledged Islamic banking licenses. (GIFF 2012)

1.2.3 Sub-Sahara Africa Region

At present, 38 Islamic financial institutions are operating in Africa. The Islamic banking industry in Africa can be divided into four main regional markets: Kenya, Nigeria, Sudan and South Africa. Among these four regional markets, Sudan represents the highest proportion of Shariah-compliant banking services with 81.5% of total assets. Like Iran, the Sudanese financial system allows only Islamic banking. More recently, some African governments have taken measures to review and reform their respective banking laws to allow Islamic financial institutions to operate. The Central Bank of Nigeria has approved a banking license to launch the country’s first Islamic bank and has recently issued guidelines for non-interest banking. (GIFF 2012)

1.2.4 QISMUT Countries (Qatar, Indonesia, Saudi Arabia, Malaysia, Uae, Turkey)

Islamic banks are serving about 38 million people across the world, with two-thirds of the customers being concentrated in seven countries: Qatar, Indonesia, Saudi Arabia, Malaysia, UAE, Turkey, and Bahrain. Excluding Bahrain, the other six countries have been identified as rapid growth markets due to their economic growth potential and pertinence to the global economy. The six countries are referred to as QISMUT. QISMUT constituted more than three-fourths of the total global Islamic banking assets in 2012 and was observed to have a 5-year CAGR of 16.4% between 2008 and 2012 (EY 4-15). The country-by-country 5-year CAGR and share of the QISMUT Islamic banking assets can be viewed in Chart 1.1 and Chart1. 2.

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Chart 1.1: Distribution of Islamic Banking Assets of QISMUT Countries

Source: EY World Islamic Banking Competitiveness Report 2013-2014

Chart 1.2: 2008-2012 CAGR of QISMUT Countries

Source: EY World Islamic Banking Competitiveness Report 2013-2014

In addition, 17 Islamic banks currently possess USD $1 billion or more in equity and regulatory capital. 14 of the 17 banks are headquartered in the QISMUT countries. However, economic and political instability in highly populated Muslim countries has slowed the growth of the financial sector. The recent large-scale operational changes that leading banks have taken on is a second factor slowing growth (EY 4-20). Apart from the QISMUT countries, Islamic banking has been making strides in other parts of the world. In Africa, Nigeria, Kenya, Uganda, Tanzania, Zimbabwe, Malawi, Morocco, Algeria and Tunisia are all beginning to introduce Islamic banking. In India, the S&P and Bombay Stock

4%

15%

22%

9%

43%

7%

Indonesia

UAE

Malaysia

Qatar

Saudi Arabia

Turkey

11%

14%

20%

29% 31%

42%

0%

10%

20%

30%

40%

50%

Saudi Arabia UAE Malaysia Turkey Qatar Indonesia

5- Y

ear

CA

GR

(20

08-2

012)

QISMUT Countries

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Exchange launched an S&P BSE 500 Shari’ah index. Islamic banking is also beginning to be integrated in the more developed banking sectors of Hong Kong, Singapore, and the United Kingdom (EY 12).

1.3. CURRENT STATUS OF THE ISLAMIC CAPITAL AND SUKUK MARKET

Well-functioning capital markets require sufficient legal, regulatory, accounting and tax frameworks, established standards, market depth, and liquidity. Such conditions exist to an extent in the IFSI, but they are underdeveloped in this relatively nascent field, and the IFSI has the potential to further develop and strengthen its capital markets. Over the past decade, the Islamic capital market has developed in terms of both sophistication and size. Increased demand for diversification using Shari’ah compliant investments has fostered innovations in the Islamic capital market. With the development of Islamic debt (sukuk), Islamic indices, and equity, a vibrant Islamic capital market is facilitating cross-border capital flows and funding economic activities. At this time, the Islamic capital markets consist of Shariah compliant stocks, the Global Dow Jones Islamic Market Index (DJIMI), sukuk, other Islamic alternatives to conventional debt instruments, and a fledgling legal and tax framework. For conventional stock markets, stocks are screened based on debt-to-asset, liquidity-to-asset, and receivables-to-asset ratios. Shariah compliant stocks are similarly screened, but require an additional step. In order for stocks to be Shariah compliant, they must be screened based on the principles of Shariah. Islamic stock exchanges include: the Dow Jones Islamic Market Indexes, the FTSE Global Islamic Index Series, Global’s GCC Islamic Index, the Kuala Lumpur Shariah Index and the Jakarta Islamic Index (10 Year Framework 37-38). As mentioned previously, Islamic capital markets are relatively young and underdeveloped, compared to more conventional capital markets. As such, several types of instruments currently do not exist in the Islamic capital market. These include Islamic versions of primes and scores, warrants, synthetics, index-linked securities, convertibles, swaps, commodity futures, and financial futures. Other financial instruments are currently in development: preferred stock, bonds, floating-rate bonds, securitized loans, and options (10 Year Framework 41). Most of the development of Islamic financial instruments and products has focused on leveraging the efficiencies and profit-making effectiveness of conventional financial instruments. Therefore, most Islamic financial instruments are seen to be derivatives of conventional instruments. However, according to the report by the Islamic Development Bank, IFSB, and Islamic Research and Training Institute, engineers of financial instruments should focus more on creating independent products based on Shariah principles, instead of simply being substitutes for conventional financial products. Another weakness of the Islamic capital markets is the limited use of Shariah screening mechanisms. One of the reasons people choose to use Islamic finance is that their religious values exclude them from the conventional finance market. As such, a priority for Islamic finance participants is transparency. The users of Islamic finance desire to know with certainty

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that the products they purchase are Shariah compliant and do not violate any religious edicts. While tools to identify Shariah compliant shares are available, they are restricted in use by only a limited number of jurisdictions. Islamic rating agencies are another underdeveloped area in Islamic finance. To compete with conventional securities products, Islamic securities need to be evaluated by either an Islamic rating agency or an existing conventional rating agency that is able to perform an Islamic rating assessment (10 Year Framework 43-44).

1.3.1 Islamic Indices

Since the launch of Islamic indices in 1999, Islamic indices have expanded across both regional and economic geographies. Four major global Islamic indices providers are: 1) Dow Jones Islamic Market Indices, 2) S&P Shari’ah Indices, 3) MSCI Global Islamic Indices, 4) FTSE Global Islamic Indices. Following Table 1.2 summarizes the evolution of the Islamic indices and their major focus areas.

Table 1.2: Islamic Indices Providers for Equity Markets

Dow Jones Islamic

Market Indices

(a) Country Indices

- track Sharī`ah-compliant securities in 69 countries across both developed and

emerging markets

- Example: DJIM Canada, DJIM China, DJIM Kuwait, DJIM U.K., etc.

(b) Global/Regional Indices

- include regional, industry sector and market capitalization indices, as well as

specialized indices and custom measures

- Example: DJIM Asia Pacific, DJIM GCC, DJIM Europe, DJIM Emerging Markets

(c) Strategy/Thematic Indices

- Example: DJIM BRC, DJIM Global Finance and Takāful.

S&P Sharī`ah

Indices

(a) Major Indices

- In 2006, S&P applied Sharī`ah screens to three major indices – the S&P 500, the S&P

Europe 350 and the S&P Japan 500

(b) Regional Indices

- In 2007, S&P followed with the S&P GCC Sharī`ah and the S&P Pan Asia Sharī`ah

Indices, to cater for the demand for Sharī`ah product benchmarks for those regions

- Other regional indices: Europe 350 Sharī`ah, Global BMI Sharī`ah, BRIC Sharī`ah.

(c) Global Indices

- In 2008, S&P reviewed S&P Global Broad Market Index (BMI) Equity Indices for

Sharī`ah compliance and created the S&P Global BMI Sharī`ah index that includes 6,000

companies in 10 sectors and 47 countries.

(d) Market Cap Indices

- Example: IFCI Large-Mid Cap Sharī`ah, 500 Sharī`ah, etc.

(e) Sector Indices

- Global Healthcare Sharī`ah, Global Property Sharī`ah, etc.

MSCI Global

Islamic Indices

MSCI began its Islamic indices series in 2007. Later, the indices were developed to cover

over 50 developed and emerging countries and over 50 regions such as the GCC

countries and Arabian markets

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(a) Developed Market Indices: EU Islamic, World Islamic, North America Islamic, etc.

(b) Emerging Market Indices: BRIC Islamic, EM Asia Islamic, EM Eastern Europe

Islamic, etc.

(c) Frontier Market Indices: FM Africa Islamic, FM CEEC Islamic, etc.

(d) GCC and Arabian Market Indices: Arabian Markets Islamic, GCC Countries

Domestic Islamic, etc.

FTSE Global

Islamic Indices

FTSE introduced its Sharī`ah indices in 2006, starting with the FTSE Global Sharī`ah

Index Series, screened by Yasaar Sharī`ah scholars. Later, three Islamic indices were

launched in August 2006.

(a) Country Indices

- Austria Islamic, Germany Islamic, Singapore Islamic, etc.

(b) Global/Regional indices

- Global Islamic, Europe Islamic, Americas Islamic, Pacific Basin Islamic, etc.

(c) Industry Indices

- Physical Industrial Metals, etc.

1.3.2 Islamic Funds

While Islamic Funds provide important diversification benefits to Sharī`ah-compliant investors, they have been slow to develop sophistication and market depth. One important reason is that Islamic Funds are dependent on the availability of other Sharī`ah compliant solutions. Until the Islamic equity and fixed income (sukuk) markets develop in volume and depth, Islamic fund growth will be restricted. Despite such challenges, Islamic Funds have evolved as a significant niche segment and have experienced stable growth since 2004, because of the rising wealth in emerging Muslim economies and oil-rich countries. The number of Islamic funds has grown from 285 in 2004 to 1,029 at the end 2012. By the end of 2011, assets under management of Islamic funds grew to USD60 billion from USD29.2 billion in 2004, representing a CAGR of 10.8%. This increased to USD64 billion by the end of October 2012.

1.3.2.1 Investment Focus of Islamic Funds

Despite the global financial crisis and the prolonged sovereign debt crisis in Europe, Islamic funds have managed to grow in their asset volume and numbers. As the global equity indices have been underperforming, investors continue to search for alternative asset classes. Islamic equity funds witnessed steep declines in 2008 before rebounding in 2009 and 2010. However, the asset class lost 5.01% in 2011 in line with global equity market performance. Commodity funds have become an attractive safe haven, and they account for the best net performing asset class for Islamic investors between 2007 and 2011, growing by 41.81%. Mixed asset allocations and equity funds returned 33.05% and 32.31%, respectively, over the same period. Additionally, a growing proportion of funds have been allocated to money markets and Sukūk by investors with a lower risk appetite arising from concerns about the global economy. In terms of asset allocation, equities still continue to be the main asset class for Sharī`ah-compliant funds worldwide, worth over half of all assets.

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8

1.3.2.2 Geographic Dispersion of Islamic Funds

The majority of Islamic funds’ assets are concentrated in Saudi Arabia and Malaysia, followed by Ireland, the US and Kuwait, as of the end of October 2012. Malaysia remains the largest equity market for Islamic funds, followed by Saudi Arabia, the United States (US), Ireland and Kuwait being the other major markets. An overwhelming majority of funds raised in Saudi Arabia and Malaysia are channeled locally. Among the countries in the Asian region, Malaysia is the largest producer of Islamic Funds, accounting for 80.7% of the total assets under management worth USD13.1 billion in 188 funds. Besides Malaysia, Indonesia is the second largest market with 54 Islamic funds worth USD1.4 billion. The growth of Islamic funds in Malaysia is fostered by the government-led implementation of voluntary private retirement schemes (PRS). The private pension funds are seen as a supplementary option to the mandatory Employees Provident Fund (EPF) retirement scheme and are expected to boost the growth of Shariah-compliant funds. Among the MENA countries, Saudi Arabia remains the key market for Islamic investors, worth 33.2% of the global industry in 2011 with assets under management of USD19.9 billion. Kuwait is the second largest market with a 7.1% market share, followed by Bahrain (2.6%) and the UAE (2.2%). Other countries in region such as Egypt, Qatar, Tunisia and Morocco are developing their Islamic fund industries. More recently, South Africa has witnessed a number of Islamic funds launched over the years. Additionally, Mauritania and Nigeria have launched Islamic funds.

1.3.3 Current Status of Sukuk Market

Sukuk is the Islamic alternative for conventional government and corporate bonds. Over the last decade, Sukuk has evolved as an important and vibrant part of the Islamic financial system. Its stable growth is largely driven by the need for securitization among industry players to create market liquidity and also the need for fixed-term investments and credit facilities. In the mid-2000s, government institutions and central banks started short-term Sukuk programs to enhance market liquidity management. After the 2007 global financial crisis, business corporations remained shy to issue sukuk, given conventional spreads are rising to record highs. However, government entities have actively participated and entered the market in numbers that enhanced the debt capacity of the sukuk market. (IFSB 2013) Following the sovereign debt crisis in Europe, the slower global economic growth has left investors with fewer investment options, which has led to capital flows to emerging markets, commodities and alternative investments such as Sukuk. As much larger pools of outstanding sovereign Sukūk, acting as key benchmarks, were located in various jurisdictions and bond yields and Sukūk yields outside of Europe declined, the cost of borrowing has also become lower for corporations in recent years. These factors have fostered the growth of corporate Sukūk issuances and the number of sukuk outstanding has surged beyond the pre-crisis levels, pushing total global issuances to record highs.

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Since 2004, Sukūk issuances have increased at a CAGR of 45.2% through the end of 2012, from USD6.6 billion to USD131.2 billion. Despite a slump of 54.1% in 2008 due to the global financial crisis, the growth rebounded from 2009 onwards, growing at a CAGR of 60.1% through the end of 2012. The sukuk market is the second largest asset class with USD $178.2 billion in 2011. Malaysia was the first country to establish a sukuk market in 1990. Since then, others in Asia and the GCC region have followed. Countries typically issue two types of sukuk: Ijarah and Salam/ Istisna. Some countries are beginning to employ hybrid sukuks such as convertible and exchangeable as well (10 Year Framework 38-40). Islamic funds possessed USD 60 billion assets under management in 2011, which constituted about 4.5% of the global Islamic finance assets (GIFF 2012). Between 2008 and 2012, the volume of sukuk issuances increased by about six-fold. However, the trend reversed between 2012 and 2013, with sukuk issuances declining. 2012 was an exciting year for the sukuk market. The sukuk market attained the highest volume and highest number of issues in its history. Additionally, the first Islamic Basel III compliant Tier I structure came forth in Q3 2012 (EY 24).

1.3.3.1 Recent Regional Trends

Trends in Sub-Sahara Africa: In Sub-Sahara Africa, Gambia, Sudan, Kenya, and Egypt have issued sukuk. In April 2012, the Egyptian Ministry of Finance announced plans to issue a sovereign sukuk worth USD2.0 billion over the coming years. Additionally, South Africa is expected to be the next sovereign sukuk issuer in the region. Trends in Asia: Asia represents the most developed market for sukuk in both primary and secondary markets. At end 2012, Malaysia remained the largest sukuk issuer with 70.5% global market share, equivalent to USD46.8 billion, followed by Indonesia, which accounted for 7.0%, and Pakistan with 1.5%. In addition, Indonesia, Pakistan, Singapore and Brunei have also issued sukuks. Trends in MENA: The sukuk markets of the MENA region include a diverse range of market players, from financial institutions to real estate developers, and construction companies to energy producers. The market is dominated by the GCC countries, whose corporations issue in both local and foreign currencies. As of 2012, the GCC countries have issued a total of USD92.4 billion in primary market papers. In the recent years, a number of countries in the MENA region are looking to enter the sukuk market. Egypt has already announced plans to issue USD2.0 billion worth of short-term sukuks, while countries like Tunisia and Libya are in the process of amending the legislative process to support the issuance of sukuk following the recent political uprisings.

1.4. CURRENT STATUS OF THE ISLAMIC TAKAFUL MARKET

While conventional insurance goes against Shariah, due to the elements of gharar and riba in insurance contracts, takaful embraces Islamic principles of cooperation and mutual help.

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10

The first takaful operator was the Islamic Insurance Company, which opened in Sudan in 1979. Currently, takaful operators are concentrated in Malaysia, Sudan and Bahrain, which have the most developed regulatory environment for takaful (10 Year Framework 34). Takaful is the smallest Islamic asset class with USD 15.2 billion in 2011 and, thus, represents only 1.1% of global Islamic finance assets. Between 2007 and 2011, the global takaful market had a CAGR of 19.1% (“GIFF 2012 Executive Summary” 1). In 2010, global Takāful contributions reached USD8.3 billion. Although the actual to-date contribution is subject to uncertainty, the industry estimates the global total contribution to be at USD12 billion in 2012, with an average annual growth of 20%. At present, the Takāful market is highly concentrated in Malaysia and the GCC states. Between 2008 and 2010, in South-East Asia and Bangladesh, the industry showed a CAGR of 32.4% and 27.9%, respectively.

1.4.1 Driving Factors

Several factors have contributed to this growth: (a) Growing demand for Sharī`ah-compliant products, (b) Growth of ReTakāful capacity, (c) A more efficient distribution channel of Takāful products, (d) Growth in other financing products such as housing financing, (e) The introduction of micro-Takāful across the world to penetrate the poor sections of society.

1.4.2 Challenges and Recent Developments

Takaful is the most underdeveloped asset class in Islamic finance. Takaful lacks Shariah guidelines, even on the most basic issues. There is a lack of harmonization amongst jurisdictions with takaful operators, and operators use different terminologies and have different views on the concept of takaful. Further development of takaful is expected to increase assets under management and the number of clients. As banks and clients become less risk-adverse, they also become more competitive. However, these aspects of growth will be hampered unless there is a proper legal and regulatory framework. In many jurisdictions, takaful is placed under the same conditions and expectation as conventional insurance. Treating takaful and conventional insurance as equals puts takaful at a competitive disadvantage. With the rise in popularity of microfinance, micro-takaful has also been considered prime to take on a larger role in Islamic finance (10 Year Framework 35-37). The international community has begun to recognize more of the merits and advantages of Islamic finance. According to the GIFF 2012 report, each asset class was expected to grow during 2012. Growth in the Islamic finance industry was expected due to 1) an increasing awareness of Islamic finance and growing confidence in its viability as an alternative to traditional practices, 2) an increase in the number of countries adopting Islamic financial practices, and 3) increasing demand for Shariah-compliant products and investments (“GIFF 2012 Executive Summary”). Furthermore, during the recent global financial and European Debt crises, Islamic finance institutions fared better compared to traditional banking institutions. Three of the

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characteristics that allowed Islamic banks to avoid the severe setbacks during the global financial crisis included: domestic credit portfolios, high consumer loyalty and deposit stability, and high liquidity. In addition, Islamic banks saw net profits increase by 9%, compared to the 64% decline of net profits of conventional banks. Another indicator of the sagacity of Islamic banks was their decision to avoid trading in debt-based instruments and speculative defaults swaps, which were contributing factors for the European debt crisis (GIFF 2012 6-7). However, Islamic banks did suffer from the European Debt crisis. Islamic banks have investments in European stock markets and real estate markets. The investments are now vulnerable to currency fluctuations caused by the crisis and downgrades from ratings institutions due to exposure. Further research will have to be conducted to determine whether the resiliency of the Islamic banks was truly due to the principles upon which Islamic finance relies upon, or other factors, such as the lesser degree of integration of Islamic finance institutions with the global economy.

1.4.3 Recent Regional Trends

Trends in Asia: The takaful industry in the Asian region is concentrated in Malaysia, Indonesia, and Brunei and account for USD2.1 billion in gross takaful contributions. The Malaysian takaful industry has grown at a CAGR of 25.7% from 2006 and 2011. In Malaysia, only 54.0% of the population has a life insurance or family takaful policy, which represents a large potential market for Takaful in the country. Indonesia is another rapidly growing important takaful market. Known as the largest Muslim population in the world, Indonesia also provides a large potential market for takaful players as the current penetration rate is than 2.0%. Trends in MENA: The GCC accounts for gross takaful contributions worth USD8.3 billion, or 69.4% of the global takaful industry in 2011. Among the MENA member countries, Saudi Arabia emerged as the largest takaful industry with contributions of totaling 38.7% of the region. Zitouna Takaful, which was set up in Tunisia in 2011, is the latest institution established in the region. Trends in Sub-Sahara Africa: Among the countries in Sub-Sahara Africa, the first Takaful operator has commenced in Sudan in 1979. Since then, the Takaful industry has grown to include Mauritania, South Africa, Gambia, and Kenya, with total contributions reaching USD387.1 million.

1.5. CURRENT STATUS OF THE ISLAMIC MICROFINANCE

Islamic microfinance is a burgeoning field with the potential to have great economic and social impact. There is a high level of poverty and lack of access, both voluntary and involuntary, to traditional finance in many highly populated Muslim countries. Islamic microfinance provides the potential to narrow income gaps. CGAP surveys found that 20-40 percent of respondents in Jordan, Algeria and Syria stated religious values to be the reason why they did not participate

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in conventional microfinance programs. A global CGAP survey estimated there to be 380,000 customers of Islamic microfinance in 2007. Operations are currently concentrated in Indonesia, Bangladesh and Afghanistan. These three countries account for 80 percent of the global Islamic microfinance market (Karim, Tarazi, and Reille 1).

1.5.1 Regional Islamic Finance Development

The MENA region is the apotheosis of Islamic finance and the majority of Islamic banks residing in this region, which is understandable due to the majority Muslim population in the region. GCC has a diverse sukuk market and the largest takaful market. Particularly, Saudi Arabia possesses 33.2% of the global Islamic funds industry and 38.7% of the takaful market amongst MENA countries (GIFF 2012 9). The rapid growth of Islamic finance has resulted in Islamic finance institutions and practices spreading to other parts of the world, especially Asia, Europe and Sub-Saharan Africa. Possessing a large Muslim population, several countries in Asia offer Islamic banking. Malaysia has the most developed Islamic banks in the region, representing 80.7% of assets under management in the region and possessing a well-developed sukuk and takaful industry. There are five Shariah-compliant Islamic banks in the UK. Both Germany and France now have subsidiaries of Turkish and Moroccan banks, respectively. In addition, France has made some progress in creating the legal infrastructure to allow for Islamic banking operations. As of 2011, European Islamic funds constitute 8.3% of the global Islamic funds. Sukuk listings and takaful products have also appeared in several European countries. In Sub-Saharan Africa, there are 38 Islamic financial institutions, and governments are making headway to reform laws to allow for Islamic financial practices. Five countries, Gambia, Sudan, Kenya, and Egypt, have issued sukuks. South Africa has embraced Islamic finance as well. The country has several Islamic funds and takaful services, and plans to issue a sovereign sukuk (GIFF 2012 8-10). Islamic finance has been spreading at a slower rate in North America. In the United States, there are about 15 financial institutions that offer Shariah-compliant products and services. Three corporations, the IFC, East Cameron Gas Company, and GE Capital, offer sukuk, and Zayan Finance is the only takaful operator. The Dow Jones Islamic Market Index, the FTSE Global Islamic Index Series, and the S&P Shariah Indices were created as well (GIFF 2012 10).

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Chart 1.3: Islamic Funds and Takaful Assets By Region

Source: EY World Islamic Banking Competitiveness Report 2013-2014

Chart 1.4: Banking Assets and Sukuk By Region

Source: EY World Islamic Banking Competitiveness Report 2013-2014

Chart 1.5: Total Islamic Finance Assets (USA billion)

Source: EY World Islamic Banking Competitiveness Report 2013-2014

0

0,3

6

6,4

2,4

14,6

1,5

0,5

27,1

16,2

0 5 10 15 20 25 30

Other*

Sub-Saharan Africa

MENA

GCC

Asia

In USD Billion

Islamic Funds Assets Takaful Assets

144,8

411,1

462,6

14,5 42,9

120,8

55,6

0,1 0,2 1,5 0

50

100

150

200

250

300

350

400

450

500

Asia GCC MENA Sub-Saharan Africa Other*

In U

SD B

illio

n

Banking Assets Sukuk Outstanding

284,2

500,3 469,2

16,6 59,1

0

100

200

300

400

500

600

Asia GCC MENA Sub-SaharanAfrica

Other*

Risk Management in Islamic Financial Instruments

14

CHAPTER 2: RISKS IN ISLAMIC FINANCIAL INSTITUTIONS AND MARKETS

2.1 FINANCIAL INTERMEDIATION THEORY

Financial intermediaries, defined as institutions that connect the surplus and deficit agents of a market, are arguably the most important institutions within the world’s economies, as, in their absence, the global economy would, more likely than not, fall. Financial intermediaries do not produce anything, per say, but rather, they act as vehicles between various financial institutions of contrasting needs’ profiles in addition to being the site of other important financial functions. Examples of financial intermediaries include, most notably, banks, but also certain investment funds, such as pension and mutual funds. As a shaper to economics around the world, financial intermediation’s seemingly incomparable importance to economic health can be attributed largely to the fact that a large portion of every dollar of finance, globally and especially in the US, comes from banks.3Consequently, as “monitors”, financial intermediaries’ role in the context of banking is widespread. To be more specific, banks, upon their providing of bank loans in corporate finance, de facto play a role in corporate governance, acting as signals to firms in distress and bankruptcy; however, on the consumer side, banks’ demand deposits (checks, credit cards, etc.), which are typically redeemed at face value and put to the bank at par in exchange for currency, must be effectively cleared by banks, ideally in a timely manner (Gorton and Winton, 2002). Islamic financial intermediation, like all Islamic financial mechanisms, differs from its conventional counterpart, not only theoretically, but in practice as well. Islamic financial intermediation can be dated back to the early periods of Islam. Chapra and Ahmed (2002) examine the duties of sarrafs, or financiers, who undertook many of the basic financial intermediation functions between borrowers and lenders (Hawary, Grais and Iqbal, 2003). Udovitch (2002) found there to be evidence that some of the concepts utilized by sarrafs were adapted by late eighteenth century European financial engineers centuries later. Understandably, adaptations have taken place, both theoretically and in practice, since traditional Islamic financial instruments and methodologies were developed (Hawary, Grais and Iqbal, 2003). One convention that has remained in contemporary Islamic banking, is that all IFI activities are all firmly grounded in some sort of contractual agreement (viz.“Islamic methods” referenced above). Islamic financial contracts can be divided into two distinct types, transactional and intermediation. Transactional contracts govern activities, including exchange, trade, and financing, while intermediation contracts facilitate the proper execution of the former (Hawary, Grais and Iqbal, 2003). In the conventional space, banks refrain from certain functions of financial intermediation used by Islamic banks, namely, Shari’ah screening and Islamic instrument implementation. Theoretically, both systems facilitate the mobilization and the utilization of funds on the basis of profit sharing among depositors, the bank, and the entrepreneurs; however, in practice, Islamic banks typically employ funds by means of

3 Gorton, Gary, and Andrew Winton. "Financial Intermediation." NBER Working Paper Series 8928 (2002): 1-140. National Bureau of Economic

Research. Web.

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instruments that avoid interest, but are not profit sharing, i.e. mudaraba, which is the Islamic contract that is most frequently engaged in (Greuning and Iqbal, 2008). Islamic financial contracts vary in function, scope, and complexity. Thus, it is important that the reader understands the profile of contracts within the Islamic financial system. Please find an outline of the various Islamic financial contracts relevant to our discussion, largely derived from Hawary, Grais and Iqbal (2003).

2.2 ISLAMIC FINANCIAL CONTRACTS

For the purposes of efficacious comprehensibility, it is useful to divide the contacts into three categories: (1) Intermediation contracts: Mudaraba, Amana, Takaful, Kifala, Joala, Wakala; (2) Transaction Contracts: Qard Hasana; and (3) Asset-Based contracts: a. Trade Financing (Murabaha, Baimuajjal, bai salaam) b. Collateral-based (Ijara, Istisna) c. Equity Based: Musaharaka. Please see Figure 2.1, which was adapted from World Bank presentation materials from the International Conference on Islamic Banking: Risk Management, Regulation, and Supervision (2003).

Figure 2.1 Islamic Financial System (IFS)

Mudarabah

Kifala /Aqd-Daman

Ammanah

Takaful

Wikalah

Joala

Intermediation Contracts

Qard

Hassanah

Miscelleneous

Murabaha Bay Mua'ajal

Bay salam

Trade

Financing

Ijarah Istisna

Collateralised

Securities

Asset Based

Securities

Musharaka

Equity

Participation

Transactional Contracts

Profile of Contracts

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Mudaraba is a trustee finance contract, typically utilized under the framework of an Islamic partnership between an economic agent called rabbul-mal, who is the capital contributor, and another economic agent, mudarub, who does not make any capital contributions, but, instead, provides expertise in the deployment of the rabbul-mal’s monies. Amana and kifala (a third party) become the surety, or guarantor, for the payment of a debt, (if the person originally liable does not pay) and also act to supplement financial intermediation functions, allowing for brokerage, custodial services, insurance design, and consulting to take place. Wakala contracts, which operate on the basis of the agent receiving a fixed fee, do not share in profits, like in the mudaraba, along with Amanah (an entity representing the idea of safekeeping, in depository terms, and more generally, trust), are perceived as being practically less effective, and, as a result, are used with less frequency. Ju’ala, often utilized to offer consultations, fund placements, trusts, and other professional services, deals with offering a service for a pre-determined fee or commission as dictated in contractual terms. In said contract, one party pays another party a specified amount of money as a fee for rendering a specified service in accordance with the terms of the stipulated contract between the two parties. According to Vogel and Hayes (1998), due to the fact that ju'ala allows contracting on an object that may not exist (or come under a party’s control), it can be used to construct novel Islamic financing structures. Lastly, Takaful, a term being more frequently heard in the Islamic finance space, is a cooperative financial mechanism in which participants contribute funds (to be invested solely in interest free, Shari’ah compliant investments) into a Takaful pool, the source of the monies they will receive in the event of an insurance claim. Unlike traditional insurance mechanisms in which there is a naturally adversarial relationship between the insurer and the insured, in takaful pools, the insurer does not profit from higher premiums, but rather, often receives a fixed rate as compensation for properly allocating/compliantly investing funds over the course of the life of the pool.4 Transaction and Asset-Based Contracts Qard el-hasan, a benevolent loan, is, like zakat, a method of social welfare promotion. The contract’s most notable feature is its unilateral transactional framework. By that, it is meant that the recipient of the loan monies from the giving party is not obligated by contractual terms to pay the loan back. On the other hand, murabaha* 5 (mark-up transactions) and bay salaam (sale contract with deferred delivery, e.g. farmers selling prior to their crop’s yield) are trade-based agreements and are typically utilized in the context of commodities. Due to the constraints regarding liabilities in Islamic banking, the asset side of the industry allows for more expansive diversification of asset classes, i.e. greater variance among risk and maturity profiles. Examples of these assets include risk adverse, short-maturity investments derived from trade activities, like murabaha, bay mua’jal, and bay salaam.6 Typically, asset-backed

4 *In Western countries, in particular, takaful companies usually act as subsidiaries of larger non-compliant entities, meaning that sometimes

non-compliant companies dictate compliant investing on behalf of the pool in order to maximize the life of pool.

5 *Cost plus transactions in which a buyer and intermediary agree upon a to-be-paid price by the buyer, following the intermediary’s purchase

of the entity for sale

6 Hawary, Dahlia El, Wafik Grais, and Zamir Iqbal. "Regulating Islamic Financial Institutions: The Nature of the Regulated." International

Conference on Islamic Banking: Risk Management, Regulation and Supervision, Aug. 2003. Web.

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securities in the conventional space are a claim against a pool of assets, whereas in Islamic finance, they are claims to individual assets. This promotes equity participation. In addition, these Islamic assets are of relatively low risk, because they are collateralized against one, real asset (Hawary, Grais, and Iqbal, 2003). Ijara (Islamic leasing) and istisna*7 are the underlying contracts (respectively) that generate many collateralized Islamic securities. Usually, they have longer maturities than asset-backed securities. Another sub-class of transactional contracts in Islamic finance is musharaka, a form of Islamic contract that is, for all intents and purposes, similar to mudaraba, except participation is more equitable with regards to labor, which is provided jointly by the involved parties.

2.3 STRUCTURE AND FINANCIAL INTERMEDIATION PRACTICES OF IFIS

Now that we have defined the principal Islamic contracts underlying the types of financial activities outlined by a theoretical, two-tiered Islamic balance sheet (based on the “two windows” model discussed below), it is important to cover how those contracts are applied within the scope of the theoretical balance sheet of an Islamic bank found outlined next (Greuning and Iqbal, 2008). Note that the liabilities side is divided into two deposit windows: demand deposits and investment/special investment accounts. On the asset side, there is: Conventional practice Islamic method

Short-term trade finance Murabaha; Salaam

Medium-term investments Ijarah; Istisn’a

Long-term partnerships Musharakah

Fee-based services Joala; Kifala; etc.

On the liabilities side: Conventional practice Islamic method

Demand Deposits Amanah

Medium-term investments Mudarabah

Long-term partnerships Mudarabah; Musharakah

*The liabilities side also includes reserves and equity capital See below Figure 2.2, another, more visual description of Islamic contracts and their linkages to Islamic finance. 8

7 *Differs from ijara; pre-ordered production of an entity, with the raw materials provided by the buying agent. 8 Exhibit 2.3, “Islamic banking: Risk and contractual role” from Hawary, Dahlia El, Wafik Grais, and Zamir Iqbal. "Regulating Islamic Financial

Institutions: The Nature of the Regulated." International Conference on Islamic Banking: Risk Management, Regulation and Supervision, Aug.

2003.

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18

Figure 2.2: Islamic contracts and their linkages

Risk/contractual role of IFIs

Contract Trustee Partnership Principal/agent

Link to conventional

finance

Agency /

brokerage

Investment

banking

Conventional/

commercial banking

Liabilities —

funding sources

Demand deposits Amana (Trust) ✓

Investment

accounts

Mudarabah ✓

Special investment

accounts

Mudarabah ✓

Musharakah

(Partnership)

✓

Equity -

shareholders'

funds

Musharakah

(Partnership)

✓

Assets —

application of

funds

Transaction

contracts

Short-term trade

financing

Murabahah ✓

Bay salaam ✓

Bay mua'ajal ✓

Medium-term

investments

Ijarah, Istisna ✓ ✓

Mudarabah,

Musharakah

✓ ✓

Long-term

partnerships

Mudarabah,

Musharakah

✓

✓

Fee-based services

Joa'la, Kifala, etc. ✓ ✓ ✓

Of the two theoretical models discussed, the two-tier, mudaraba model amalgamates the liability and asset sides of the balance sheet (mudaraba funds the mobilization and utilization on the basis of profit sharing). The first tier contact is between the investor and the bank, where the bank, acting as a mudarib, invests on behalf of the investor. If profits are generated

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from the bank’s businesses related to the investors’ investment, the investor receives a share in those profits. The second tier is between the bank (as the fund supplier) and the entrepreneurs seeking funds in order to produce profits from specified economic activities, and those profits are shared with the bank according to a contractually dictated percentage. This model does not have any special reserve requirements on either the investment or demand deposits; however, in addition to investment deposits, banks would accept demand deposits, too, which would be repayable on demand (on the liability side). This feature of the model is in contrast with that of the “two-windows” model with regards to reserve requirements. The “two windows” model divides liabilities into two distinct windows, one for demand deposits that are strictly liabilities and the other for investment deposits, which are not. The depositor chooses in which window to invest.

In practice, the “two windows” model requires banks to hold a 100 percent reserve on the demand deposits, which are guaranteed by the bank, and zero percent on the investment deposits used by banks to finance instruments bearing risk, making the risk for demand account holders essentially non-existent. Investment account holders are investors/depositors who enter into a mudarabah contract such that profit-sharing investment deposits are not liabilities, as the investors share in profit accruals to the bank’s investments, which, in this case, are on the asset side (Greuning and Iqbal, 2008). Greuning and Iqbal (2008) state that, in some regions, Islamic banks will offer special investment accounts developed either on the basis of special purpose, restricted mudarabahs, or musharakah (P/L). Also worth discussing is that Islamic banking experts have cited the one-tier mudarabah model as being one of the more effective practical frameworks to engage in Islamic banking. Specifically, the liability side of this model is mudarabah based, PSIA, while, on the asset side, multiple fixed-income investment tools are often utilized, namely murabaha, ijarah, istisna, and others. Worth noting is that, through profit equalizing reserves being deducted from gross income and investment risk reserves being deducted from the income of PSIA depositors (after the bank’s share is deducted) to meet losses on PSIA financed investment, the model features inherent profit rate smoothing. Lastly, despite Islamic scholars’ disapproval of penalties for late payments and defaults, this model is often structured such that penalties are often effected, with the collected funds being given as charitable donations. Another model, like that above, utilizes fixed income investment tools on the liabilities and equities side; however, this model is most known for tawwaruq accounts on the asset side. Typically referred to in some way by tawarruq, such models utilize tawarruq, an Islamic financial structure that replicates a loan transaction and can be structured in such a way that it can replace many (and, in specific cases, all) different modes of Islamic investments, like salam, ijarah, istisna, etc. Since this model does not link the return on assets and liabilities, it can be argued that the stability of the model is weakened.

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2.4 RISK PROFILE OF ISLAMIC FINANCIAL INSTITUTIONS

Islamic banking, like conventional finance, is vulnerable to a wide range of risks. From credit and market risk to the myriads of vulnerabilities present within the global financial environment, Islamic business professionals must be attune to the dynamics of risk so that they are effectively able to mitigate them. As one would suspect, there are many risks specific to certain Islamic financial structures. Below, we examine the multitude of potential risks present in Islamic banking, as adapted from Hawary, Grais, and Iqbal’s presentation materials from the International Conference on Islamic Banking (2003). Credit risk is the failure of the counter party to meet the obligations stipulated by the contract. Such risk can be related to the timeliness by which the counter party engages in the requisite tasks placed upon them by the contracts, or their inability to effectively fulfill the agreed upon terms. Credit risk is often found in Islamic contracts like Bay mua’jal, mudaraba, musharaka and murabaha, in particular, where the actions of the counter party may be partly contingent on an amalgam of uncertain factors. One example could be the occurrence of a drought leaving the counter party unable to yield the agro-materials needed to complete a specified task. Credit risk could also be, on the depositors’ side, the risk that a bank does not honor withdrawal requests at face value/market value. Since murabaha, Istisna’a, Ijara, salaam, and other sales-based facilities make up the majority of the asset side of an Islamic bank (a figure, according to Sundarajan (2005) is between 80 and 100%), credit risks are of principal importance, as are the methods used to measure them. Effectively, there are two ways credit risk is measured: by a rating class system, which assigns probabilities of default to each counter party, and the credit value-at-risk method (Credit VAR). Both of these methods use the same approach in order to best estimate an expected loss on an exposure (or a portfolio of exposures), based on prospective credit events (default, rating downgrade, etc.) as well as to calibrate unexpected losses (deviations from the mean) that may occur, given some probability method (Sundarajan, 2005).

Market risk is another type of commonly encountered risk, and it deals with the risks associated with changes to the underlying market value of a pool of assets. Market risks are systematic, meaning that all investors in the market are susceptible to potential disruptions they may cause. Foreign exchange risk, for example, which is the risk of exchange rate movements on assets of foreign currency, is always present. Though for certain groups of investors, this may serve to their benefit, the risk that exchange rate risk could be detrimental is never absent from the market. Mark-up risk is another type of operating risk facing Islamic banks, and it details with the divergence between a contract’s mark-up, say, for example, a mudaraba contract, and that of the benchmark rate present in the market. This type of risk places Islamic banks utilizing contracts that entail deferred trades especially at risk. Exposure to various forms of market risk can be measured using traditional means commonly utilized in conventional risk management, namely (Sundarajan, 2005):

Net open position in foreign exchange Net open position in traded equities

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Net position in commodities Rate-of-return gap measures by currency of denomination Duration measures of assets and liabilities in the trading book

Aside from the market and credit risks discussed above, there are several other concerns of Islamic banks, namely those resulting from competition and other pressures coming from oppositional entities. These business risks include displaced commercial risk, which is the risk that an asset’s performance diverges from expectations for returns and liabilities. Within the context of certain Islamic contracts, investment depositors may have to forgo portions of the shares they are entitled to as mudaribs. Consequently, this type of risk can cause a bank’s return on equity to decline, potentially resulting in an adverse effect on the value of capital. In turn, shareholders are at risk of receiving lower shares of bank profits. Withdrawal risk, due to the inherent exposure faced by surges in deposit withdrawals could result in the bank being exposed to severe liquidity problems and the erosion of its franchise value. Insolvency risk is another, related risk confronting Islamic banks and is especially threatening to their reputations, which, in this incipient phase of the Islamic banking industry, are not well grounded in the minds of institutional investors and retail consumers alike. Next, we have three treasury risks of particular importance to our discussion of risks: (1) asset and liability mismanagement (i.e. ALM risk) could leave a bank with an unfavorable capital profile; (2) liquidity risk, the risk of a bank being unable to access sufficient liquidity and leaving them unable to meet their obligations (ex. a bank is unable to access deposits, on the bank side, and investors being unable to access the monies they have deposited at the banks); and (3) hedging risk, the possibility that a bank is unable to effectively mitigate their exposure to risks of all varieties. Regardless of how one interprets liquidity risk in the context of Islamic banking, it is with little doubt a significant risk consideration for Islamic financial institutions, due to the limited availability of Shari’ah compatible money market instruments (Sundarajan, 2005). Aside from the most frequented method of liquidity risk, the liquidity gap for each maturity bucket for each currency, the share of liquid to total assets (or to liquid liabilities) is another commonly used method (Sundarajan, 2005). Though many Islamic financial institutions disclose computed liquidity gap measures and, as a result, Sundarjan (2005) states that calculating the rate-of-return or reprising is relatively straightforward. Given the importance of equities and commodities in Islamic banks’ balance sheets, market risk is calculated, typically, using a variety of different VAR measures. For example, for both commodities and equities, VAR based on a 99 % confidence level could be computed and based on quarterly equity returns (mudaraba or musharaka profit rate) net of a risk free rate (or quarterly or monthly charges in commodity prices) (Sundarajan, 2005). With regards to commodity markets, the cancellation risks in murabaha and the fact that, according to Shari’ah, murabaha contracts must be sold at par, along with the Shari’ah prohibition of secondary salaam and Istisna’a contracts (both discussed in Sundarajan, 2005) make the potential for liquidity problems greater. Government risks are present more in certain regions, commonly where economies are still developing, than in others. Operational risks are the failure of internal processes relating to people or systems. Islamic banks are definitely not immune to this kind of risk, especially as

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risk management practices at these kinds of banks are not well embedded in the banking culture, at least not in places where Islamic banks are newly established. Understandably, both return on equity and assets could be affected if the bank suffers losses at the hand of operational issues. Specific facets of Islamic banking may create a banking environment conducive to operational dilemmas, which, according to Islamic finance expert, Sundararajan (2005), are:

I. The cancellation risks in non-binding Murabaha and Istisna’a contracts II. problems in internal control systems to detect and manage potential problems in

operational processes and back office functions III. technical risks of various sorts IV. the potential difficulties in enforcing Islamic Finance contracts in a broader legal

environment V. the risk of non-compliance with Sharia requirements that may impact on

permissible income VI. the need to maintain and manage commodity inventories often in illiquid markets

VII. the potential costs and risks in monitoring equity type contracts and the associated legal risks

Fiduciary risks, another type of government risk, are, in some ways, like insolvency risk, in that they could cause banks’ reputations to diminish in the eyes of the public. Essentially, fiduciary risk is the risk that a bank is facing legal recourse following a breach in contract and a failure to meet contractual stipulations. Besides the reputational risks involved, banks may face penalties, both direct and indirect. The latter is perhaps even more devastating and may include investors withdrawing their deposits, a selling off of shares, etc. Profit-sharing modes of financing, as you can see from the Figure 3, are perceived by the respondents as having a higher risk profile. In addition to displaced commercial risk, discussed earlier in this report, profit and loss sharing features introduces fiduciary risk, or becoming legally liable for a breach of the investment contract either for non - compliance with Shariah rules or for mismanagement of investors’ funds (AAOIFI, 1999) (Hawary, Grais, and Iqbal, 2003). This liability leaves banks exposed to potentially direct losses given that there may be breaches of fiduciary responsibility towards its depositors as well as indirect losses resulting from declines in the market.9 The last type of government risk is transparency risk, the risk that a bank’s decisions are based off a set of misinformation. Logically, decision-making based off potentially false information presents a host of possibly devastating consequences to both conventional and Islamic banks. Finally, we have systematic risks, which are risks that no bank can avoid. Business environment risks leave banks exposed to the problems pervasive within the institutional confines in which they do business. They include legal risks, namely the inability to enforce contractual agreements. Though many Islamic banks refrain from imposing late penalties in

9 As one would suspect, there are many risks specific to certain Islamic financial structures. To preface our discussion (s) concerning

idiosyncratic risk, I would like to present the following chart as a preface to that discussion, before defining the various risks we see in the

market place, as well as which/why those risks are specific to certain Islamic financial structures.

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the case of late payments (an explicit violation of Shari’ah), many do, unfortunately, and do so in order to deter risks of default and delinquency (Hawary, Grais, and Iqbal, 2003). These kinds of risks are most commonly found in areas laced with institutional corruption and a lack of stable development. Bankers in the Islamic world, like other parts of the developing world, see such risks more frequently than in the developed banking systems of the Western economics. Institutional risks are basically anything that could stand in the way of a bank’s effectiveness from a business perspective; however, by definition, diverging product definitions and practices most aptly describe this risk criterion. Lastly, we have regulatory risks, the risk of regulatory noncompliance, often the result of inept management decisions (which are often the result of a miscomprehension of compliance regulations), and this can be traumatic for developing banks. Islamic banks (particularly in areas where Islamic banking is new), are confronted with regulatory dilemmas more often than other banks. For example, (though the regulatory framework in the US is such that non-conventional banks are usually aware of the rigorous regulatory requirements placed upon them by the US government), according to US regulatory mandates, banks must not assume unnecessary risk. Having said that, most banking institutions in the US try to limit their investments (and those they offer for outside investment) to fixed-income entities and interest-bearing securities.3 As we know, financial structures involving interest-based mechanisms are stringently forbidden, and Islamic banks, theoretically, are encouraged to share risks with their clients. While financial engineers in the Islamic finance field have been able to design and implement Islamic products into the US market that are in good-standing with US regulatory statutes, including takaful insurance (which is based solely on the concept of shared-risk), the legal and compliance risks involved in such undertakings create situations where the costs (viz. the risks) outweigh the prospective benefits. Islamic banks, if found to be in regulatory noncompliance, can feel the effects rather acutely, as such banks are typically subject to penalties and other monetary castigations. The conventional financial landscape in which Islamic banking operates is not always conducive to making risk avoidance simple or, in some cases, even possible for Islamic banks seeking to implement various Islamic financial structures. Maroun (2002) argues that the lack of Shari’ah compatible instruments coupled with the lack of qualified market makers and informational data limitations have served as an impediment to the development of functioning secondary markets, something the industry must focus on in the coming years.10 Since long-term mudaraba, for example, can provide liquidity by allowing investors to trade certificates in the secondary market without having to directly redeem them with the bank that issued them, the establishment of International Islamic Financial Market (IIFM) and the Liquidity Management Center (whose mission is to advance such liquidity-producing activities) may prove helpful.11 Aside for ijara sukuk, which have been issued by the Bahrain

10 Maroun (2002) quoted in Hawary, Dahlia El, Wafik Grais, and Zamir Iqbal. "Regulating Islamic Financial Institutions: The Nature of the

Regulated." International Conference on Islamic Banking: Risk Management, Regulation and Supervision, Aug. 2003. 11 Maroun (2002) quoted in Hawary, Dahlia El, Wafik Grais, and Zamir Iqbal. "Regulating Islamic Financial Institutions: The Nature of the

Regulated." International Conference on Islamic Banking: Risk Management, Regulation and Supervision, Aug. 2003.

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Monetary Authority (BMA) (where a secondary market exists), the overwhelming proportion of transactions that occur are exclusive to the primary market only.12 Though there are regulatory impediments to the implementation of certain features specific to the Islamic finance industry, like profit-loss sharing mechanisms, some experts believe that PLS features have their own risks. In 1999, AAOIFI identified displaced commercial risk as the malefactor behind an Islamic bank being pressured (in order to retain investor loyalty) by having to expend to its depositors a rate of return that was greater than what would have been appropriate given the actual terms of the contract.13 This practice, which is wholly self-imposing, allows for situations to arise in which banks may forgo some, if not all, of shareholders’ profits, as exampled by the International Islamic Bank for Investment & Development in Egypt in 1998 (when the bank distributed no portion of its profits to shareholders, while all went to investment account holders; in fact, the distribution of funds that went to depositors amounted to a figure that exceeded the bank’s profits, the difference appearing in the bank’s accounts as “loss carried forward”).14 To conclude our outline contextualizing the different forms of risk facing Islamic financial institutions, there is one, non-systematic risk exclusive to Islamic banks termed Shari’ah risk that is of immense importance to our discussion. The spectrum that one may use to understand this kind of risk is expansive, as both the type of risk as well as more generally the field of Islamic finance is still defining itself as an industry. Shari’ah risk, according to much of the existing literature, deals with the risk of non-compliance with the Shari’ah. Shari’ah risk may be construed as an operational risk. Within the economic environments of many regions around the world, Islamic banks are under intense monetary and regulatory constraints, especially as compared to their conventional counterparts. That being said, aside from non-compliance issues borne out negligence in a due diligence capacity, in certain, more rare cases, non-compliance results from Islamic financial institutions’ circumventing Islamic regulations in order to attain some sort of monetary or other benefit. From a reputation standpoint, engaging in such activity may cause weary investors to become reticent to engage with the bank and, more generally, with the Islamic finance industry at large. Interestingly, as you may notice, unlike traditional law in finance, which normally serve to make transactions enforceable in court (providing transaction security), in Islamic finance, that role is reversed. Shari’ah risk is, contrarily, a risk that allows a transaction to be assessed and criticized on the basis of non-Shari’ah-conformity.15 In some ways related to Shari’ah risk is moral hazard, which will again be referenced later in this paper during our discussion of microfinance. In profit-loss sharing activities when using mudaraba, there are clear moral hazard problems. Since the rabbul-mal solely bears any losses (in case of a negative outcome), he cannot enforce the mudarib, the user of the funds, to take

12 Maroun (2002) quoted in Hawary, Dahlia El, Wafik Grais, and Zamir Iqbal. "Regulating Islamic Financial Institutions: The Nature of the

Regulated." International Conference on Islamic Banking: Risk Management, Regulation and Supervision, Aug. 2003. 13 Hawary, Dahlia El, Wafik Grais, and Zamir Iqbal. "Regulating Islamic Financial Institutions: The Nature of the Regulated." International

Conference on Islamic Banking: Risk Management, Regulation and Supervision, Aug. 2003. 14 Warde (2000) as quoted in Hawary, Dahlia El, Wafik Grais, and Zamir Iqbal. "Regulating Islamic Financial Institutions: The Nature of the

Regulated." International Conference on Islamic Banking: Risk Management, Regulation and Supervision, Aug. 2003. 15 Balz, Kilian. "Sharia Risk? How Islamic Finance Has Transformed Islamic Contract Law." Islamic Legal Studies Program Harvard Law School I.

Harvard University, Sept. 2008. Web.

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actions required to produce the expected level of returns.16 In addition to the fact that the bank cannot monitor or participate in the project (and is vulnerable to a potential loss of 100% of their principal investment in addition to its potential profit share if the entrepreneur’s books show a loss), the mudarib can exploit their position of control toward their own benefit, not that of the project as a whole.17 Generally, the user of the fund’s ability to increase their consumption of non-pecuniary benefits that don’t benefit the project (since such consumption is partly borne by the bank, as the benefits are consumed entirely by the entrepreneur) is not exclusive to mudaraba arrangements. In musharaka transactions, experts, Grais and others (2003), have argued that a moral hazard problem exists, too, despite the fact that the capital of the partner (musharik) will also be at stake.18 Policy Suggestions The paper above outlines many of the sources of risk within the Islamic finance sector as well as the potential reasons for their existence in the first place. There have been many suggestions as to how to best mitigate these risks, from industry-wide standardization in order to improve transparency and create a sustainable coalescence of Islamic financial entities to specific regulatory proposals. Having said that, Arun Sundarajan in his 2002 work on risk management presented several policy modifications concerning the improvement of Islamic financial institutions with regards to risk mitigation as well as prevention. He posited that appropriate measurement of credit and equity risks IFIs could potentially benefit from systematic data collection efforts, namely the establishment of credit (and equity) registries. Sundarajan (2002) states that such registries can be developed by including data on Islamic Finance contracts in existing credit registries, or by developing registries specifically for Islamic contracts. He mentions that doing so could be very useful as a first step toward adopting more pragmatic standards for Islamic finance. The latter, he claims, is based on adaptations of new Basel capital accord to incorporate the specific features of Islamic finance, as well as to serve as a transitional step toward more advanced capital measurements in due course. Sundarajan (2002) also claims that IFSIs would require both centralized and integrated risk management that help control different types of risks, while at the same time allowing disaggregated risk measurements to price specific contracts and facilities (including the risk-return mix offered to investment account holders). He mentions the significance of appropriate regulatory coordination and cooperation among banking, securities, and insurance supervisors in order for such policies to be effective. Another important point is that IOSCO Securities Regulatory Principles and Basel Core Principles for Effective Banking Supervision should be adapted to the specifics of Islamic Finance by issuing additional guidelines and advising on specific issues. In the context of Islamic Finance, doing so is vital to more advanced risk and

16 Hawary, Dahlia El, Wafik Grais, and Zamir Iqbal. "Regulating Islamic Financial Institutions: The Nature of the Regulated." International

Conference on Islamic Banking: Risk Management, Regulation and Supervision, Aug. 2003. 17 Errico & Farahbaksh (1998) and Lewis and Ahmed (2001) quoted in Hawary, Dahlia El, Wafik Grais, and Zamir Iqbal. "Regulating Islamic

Financial Institutions: The Nature of the Regulated." International Conference on Islamic Banking: Risk Management, Regulation and

Supervision, Aug. 2003. 18 Hawary, Dahlia El, Wafik Grais, and Zamir Iqbal. "Regulating Islamic Financial Institutions: The Nature of the Regulated." International

Conference on Islamic Banking: Risk Management, Regulation and Supervision, Aug. 2003.

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capital measurement approaches and the associated disclosures. Another important point he makes is that given the special nature of investment accounts, with its links to return on assets, fostering adequate Asset Liability Management, ALM, is critical. Though in the absence of hedging instruments and rate of return benchmarks, effective ALM would require the appropriate development of asset securitization, the promotion of Islamic Money markets through novel uses of such securitization, and the establishment of bench mark rates of returns using effective monetary operations. Generally, financial system infrastructure needs to be strengthened in order to provide a stronger platform for market development and to facilitate effective risk management. This, according to Sundarajan, should be accomplished in several steps. Capital markets need to be fostered with an emphasis on asset securitization by developing the needed preconditions relating to governance, accounting, and creditor rights. This would facilitate the securitization of bank loans and the development of investment account products as claims on such securitized asset pools, whose risk levels can then be made transparent and closely managed. Islamic Money markets and systemic liquidity arrangements should also be strengthened. Additionally, Sundarajan (2002) cited that disclosure regimes for IFSIs need to become more comprehensive and transparent, with a focus on disclosures of risk profile, risk-return mix and internal governance. He states that proper coordination of supervisory disclosure rules and accounting standards, and proper differentiation between consumer friendly disclosures to assist investment account holders, and market-oriented disclosures to inform markets would allow for such transparency. Supervisory review process should also monitor and recognize the extent of risk sharing by investment account holders in assessing capital adequacy. This would encourage more effective and transparent risk sharing with investment account holders. Specifically, he mentions that appropriate disclosure of risks borne by PSIA and shareholders should be a requirement for granting capital relief on account of PSIA. The measurement of these risks, and estimation of appropriate capital relief can be based on the VAR methodology as discussed in his work. Discussed in the next to sections of this paper are risk issues as they apply specifically to two “household” Islamic mechanisms, takaful and sukuk, as well as Islamic microfinance, a burgeoning subsector of the IFI industry.

2.5 SUKUK MARKET RISK

Sukuk are arguably the most well-known of the Islamic financial mechanisms discussed in this paper. Though it may seem counterintuitive, the development of the sukuk market has both allowed for an alleviation of certain risks, but has also created a new set of issues of its own. Two types of sukuk are relevant to this discussion, asset-backed and asset-based sukuk (Dusuki and Mohktar, 2010). Please see below, a chart depicting various classifications of these two kinds of sukuk.

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Figure 2.3: Classification of Sukuk

Source: Securities Commission, 2009

According to Duskuki and Mohktar (2010), asset-based sukuk are utilized for one reason, the fact that they allow the obligor to raise unsecured funding (meaning that they do not have to part with their asset to get money and can use the money raised for any purpose they want). Additionally, Dusuki and Mohktar posit that the sukuk’s proceeds do not necessarily go into any specific projects and the obligor can pay the holders of the bonds using money from any operations, not just those attached to the asset. Also, at maturity, the obligor pays back the investor’s capital and needs to provide an asset to facilitate the Shari’ah requirement, despite the asset never leaving their books (Duskuki and Mohktar (2010). This, according to Dusuki and Mohktar, means these sukuks fail to fulfill one of the most essential features of securitization, the ‘true sale’ requirement, which stipulates that the sale of the originator’s asset must fulfill all and accounting and legal requirements in order for the asset to be properly removed from the originator’s books (2010). According to a study performed by Dusuki and Mohktar, in the majority of asset-based sukuk structures, sukuk holders, who are supposed to own the underlying assets, do not have any interest in the asset, something that holds especially true for unsecured asset-based sukuk (the majority of the sukuk market). Another issue relating to the Shari’ah legitimacy of sukuks structured in this way is the fact that, in the case of foreclosure, sukuk holders receive what is due to them, even if the amount is insufficient after the assets disposal. Contrarily, asset-backed sukuks, whose funds are interconnected by a specific asset (project) attached to the bond, require the obligor to utilize monies generated from said asset, and at maturity, a true sale from a legal perspective must take place (Duskuki and Mohktar, 2010). From a fundamental standpoint, asset-backed sukuk holders cannot ask for such recourse

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since they, not the obligor, are viewed as the owners of the asset (Dusuki and Mokhtar, 2010). Dusuki and Mohktar make specific mention that in unsecured asset-based sukuk and sukuk holders do not create any claim or charge on the underlying asset. And so, they are normally ranked pari passu with other unsecured creditors of the obligor. However, in secured asset-based sukuk, the sukuk holders create charge or claim (either fixed or floating) on the asset. Interest rate risk is probably the risk factor examined above that concerns sukuk the most, despite the fact that sukuk rates, unlike conventional bond rates, rely on fixed market rates. This is the case because when market rates rise, fixed income values fall. For example, suppose in 01/2014, an investor purchases a 2 year sukuk bond at a 10% annual rate of return, but in 02/2014, market rates increase to 12%. Consequently, his asset earns 2% less than the newly risen market rates, leading to the investor’s suffering from reinvestment risk, i.e. the opportunity cost of investing at the new, higher rate (Arsalan, 2004). Additionally, one should note that, unless the rates in the market fall, then the negative effects of rising market rates will be sustained by the investor for the duration of their sukuk’s maturity. Another risk, which underlines the foundation on which sukuk’s have been developed, is the fact that these instruments are asset-backed, not asset-based, meaning that sukuk holders’ income is partly contingent upon the amount of revenue generate by the underlying asset. This is not the case in asset-based bonds, which have no P/L characteristics and, in some ways, from a theoretical perspective, offer more stability in this regard when compared to asset-backed bonds whose underlying assets could unpredictably fail to generate sufficient monies. Having said that, because sukuk holders, unlike conventional bondholders, possess the right to dispose of underlying assets, a way to mitigate asset-backed sukuk transactional risks. As mentioned earlier in this paper, sukuk, as an Islamic entity, have developed, as financial instruments, perhaps more than other Islamic entities. Please find Figure 2.4 outlining the risk characteristics of different sukuk structures, from which one can see that, not only are there several types of sukuk, from floating rate Ijara sukuk to Musharakah term finance sukuks (MTFS), but the ways by which credit, interest, and other risks are, for the most part, distinct from one another. FX risk, barring the fact that diversification could alleviate some exchange rate-related issues, will not deviate significantly between the different types of sukuk, given that FX rates are country, not instrument, specific. Price risk, on the other hand, is a characteristic of the underlying asset’s profitability.

Please see the chart below for a comprehensive outline of the various types of sukuks and how they are affected by different risk metrics.

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Figure 2.4: Types of sukuks and different risk metrics

Types of

Sukuk

Description

of Sukuk

structure

Credit Risk Rate of

return

(Interest

rate risk)

FX risk Price risk Other risks

Zero coupon

Sukuk

Istisna',

Murabahah

debt

certificates -

non-

tradable

Unique

basis of

credit risks

exist, see,

Khan and

Ahmed

(2001)

Very high

due to fixed

rate.

remains for

the entire

maturity of

the issue

If all other

conditions

are similar,

FX risk will

be the same

for all cases

of Sukuk.

However,

those Sukuk

which are

liquid or

which are

relatively

short term

in nature

will be less

exposed.

The

composition

of assets in

the Pool will

also

contribute

to the FX

risk in

different

ways. Hence

this can be

very useful

tool to

overcome

the FX risk

by

diversifying

the

pool in

different

currencies.

Price risk

relates to the

prices of the

underlying

commodities

and assets in

relation to

the market

prices.

Ijara Sukuk

are most

exposed to

this as the

values of the

underlying

assets may

depreciate

faster as

compared to

market

prices.

Maintenance

of the assets

will play an

important

Part in this

process.

Liquidity of

the

Sukuk will

also play an

important

part in the

risk. Salam is

also exposed

to serious

price risks.

However,

through

parallel

Liquidity risk

is serious as

far as the non-

tradable

Sukuk are

concerned.

Business risk

of

the issuer is

an important

risk

underlying

Sukuk

as compared

to traditional

fixed incomes.

Shari'ah

compliance

risk

is another one

unique in caw

of Sukuk.

Infrastructure

rigidities, i.e..

non-existence

of efficient

institutional

support

increases the

rise of Sukuk

as compared

to traditional

fixed incomes,

see

Swndararajan,

& Luca (2002).

Fixed Rate

Ijara Sukuk

Securitized

Ijara,

certificate

holder owns

part of asset

or usufructs

and earns

fixed rent -

tradable

Default on

rent

payment,

fixed rate

makes

credit risk

more

serious

Very high

due to fixed

rate,

remains for

the entire

maturity of

the issue

Floating Rate

ljara Sukuk

Securitized

ljara,

certificate

holder owns

part of asset

or usufructs

and earns

floating rent

indexed to

market

benchmark

such as

LIBOR -

tradable

Default on

rent

payment,

floating rate

makes

default risk

lesser

serious - see

previous

case

Exists only

within the

time of the

floating

period

normally 6

months

Fixed rate

Hybrid/Pooled

Sukuk

Securitized

pool of

assets; debts

must not be

more than

49%,

floating rate

possibility

exists -

tradable

Credit risk

of debt part

of pool,

default on

rents, fixed

rate makes

credit risk

serious

Very high

due to fixed

rate,

remains for

the entire

maturity of

the issue

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30

Musharakah

Term Finance

Sukuk (MTFS)

Medium

term

redeemable

musharakah

certificate

based on

diminishing

musharalah

- tradable as

well as

redeemable

Musharakah

has high

default risk

(see Khan

and Ahmed

2001),

however,

MTFS could

be based on

the strength

of the entire

balance

sheet

Similar to

the case of

the floating

rate. This is

however,

unique in

the sense

that the

rate is not

indexed

with a

benchmark

like LIBOR,

hence least

exposed to

this risk

contracts

these risks

can be

overcome.

Salam Sukuk Securitized

salam, fixed-

rate and

non-

tradable

Salam has

unique

credit risk

(see Khan

and Ahmed

2001)

Very high

Auto fixed

rate

Source: International Conference on Islamic Banking: Risk Management, Regulation, and Supervision (2003)

From the inherent discrepancies concerning asset-based vs. asset-backed sukuk to the objectives of the Shari’ah and the paradoxes existent in the current sukuk market, there are an amalgam of different risks important to interested investors and researchers.

2.6 TAKAFUL MARKET RISKS

In our discussion of the risks associated with Islamic insurance mechanisms, takaful, it is important for the reader to understand the transactional sequences as well as the different entities involved in the two main takaful structures, wakalah and mudarabah-based models, which are outlined in the following charts, as well as modified versions of those models on the pages following. The nature and fast expansion of the takaful industry has left glaring risk/Shari’ah gaps in the eyes of Islamic scholars, many of whom do not believe Islamic insurance, particularly life insurance, is a viable Islamic financial structure. Experts have cited many issues with both the mudaraba and wakalah models, namely issues pertaining to corporate governance. It should be made plain that, when people contribute money, they typically expect some sort of immediate or future remuneration. Thus, Hassan and Lewis posit the question, “Is it really co-operative in nature,” since the number of operators using the co-operative model is limited.19 Only a fraction of those who purchase these policies are also conscious that the premium is for mutual help, and though most takaful operators are actual

19 Hassan, Kabir, and Maryn K. Lewis. "Governance Issues in Islamic Insurance." FMA International, 2011. Web.

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“treasurers” of the fund. Purchasers often view them as the fund’s actual owners.20 One distinct feature of takaful, as mentioned above, is that the participant and the operator of the fund are clearly segregated, with the operator’s reward being contingent upon which kind of takaful model is used.

Figure 2.5: Takaful – Cooperative Model

Generally, the theoretical model, seen above, is, at its core, based on a mutually beneficial and cooperative framework. Historically, the main conflict that has arisen in the context of conversations concerning takaful models is that contributors may demand financial remuneration in exchange for their participation in the fund. Hassan (2014) states that this has allowed for the development of the two main takaful models, wakalah and mudarabah.

Figure 2.6: Takaful- Mudarabah on Investments

20 Al-Qyardawi (1989) quoted in Hassan, Kabir, and Maryn K. Lewis. "Governance Issues in Islamic Insurance." FMA International, 2011. Web.

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The above chart outlines the adaptations placed on the takaful model following the implementation of mudarabah activity with regards to the investment profit. Hassan and Lewis (2011) also state that, under a mudaraba contract, a profit is generated to be distributed between the rabb al-mal and the mudarib (entrepreneur or takaful operator); however, issues are borne out of the fact that, in the insurance arena, the profits from investments are not the same as surplus. Essentially, Shari’ah scholars cite the profit-sharing contract being applied in the model - the relationship between participants is one of tabaru (donation) as defined in the contract and not of mudaraba (profit sharing contract) - since it is impermissible for both the donation and mudaraba capital (contributed by the capital provider ) in the arrangement to be the same monies (Hassan and Lewis, 2011). Additionally, they state, “The requirement to provide a top up interest free qard hasan (in case of a deficit) in a mudaraba contract is by definition against the principle of mudaraba, which is a profit sharing contract, and in it the mudarib cannot be a guarantor” (Hassan & Lewis, 2011). Similar to conventional insurance contracts, shared underwriting may bring about an outcome as any ordinary business venture, not one of mutual assistance.

Figure 2.7: Takaful- Wakalah

Under a wakala contract, the operator would be receiving fixed fees for services rendered in managing the takaful fund and the investment portfolio, but not in the form of a performance fee geared to the surplus as an incentive for managing the takaful fund effectively. Basically, the whole operation is based on agency fees, not encompassing any aspects of P/L. Hassan and Lewis (2011) cite that there have been questions concerning whether or not wakala contracts are adequate in a competitive market environment, since the wakala operator’s fee is a fixed percentage of the total contributions, and so the fee is based on and recovered from the takaful fund. Being that a typical contract has a risk premium to which one may add expense margins and profit margins for the operator, both the expense and profit margin would need to be competitively priced on the volume of premiums for a single contract (Hassan and Lewis, 2011). In a conventional insurance contract, identification of these separately is not required, as the expense surplus in addition to the underwriting risk surplus both belong to the shareholders (Hassan and Lewis, 2011). Since, in takaful arrangements, the underwriting surplus belongs to the participants, an adequate risk premium needs to be identified

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separately, so sometimes a discount may be given to be competitive (Hassan and Lewis, 2011). Consequently, when charging the fee to the fund, the fixed percentage fee being removed may result in the fund’s having diminished monies, which are needed to pay claims in relation to the risk being undertaken. Another key issue of the model is that tabaru (donation) remains the property of the participants (unless consumed), since they hold the right to any surplus. As such, it becomes a conditional gift, bringing to question issues such as inheritance (not possible to measure the share of surplus in the pool at time of death) and zakat (in the case of the death of the person), as the donation is a conditional gift (Hassan and Lewis, 2011). Secondly, the relationship, being between the participants and the operator, as well as the participants (exchange of gift for a gift) leaves doubt about the contract becoming a contract of compensation (Hassan and Lewis, 2011). As found in Hassan and Lewis (2011), "contingency reserves may not be equitable between generations as the operator is likely to hold higher proportionate reserves in the early years for future contingencies. Since the participants keep changing on a continuous basis, it leads to an intergenerational equity issue. In a pure pooling arrangement, one should be able to call on members to actually contribute more in the case of a deficit on a pro-rata basis. This is not seen as practical in retail commercial insurance, and, therefore, alternative solutions may need to be explored for takaful.” Also, an obligation on future generations, however, will be different from those which may have given rise to the deficit (over the course of time, as membership of the pool of participants changes over), leaving another potential issue encompassed by this model. A solution to the last three issues has been sought in terms of the wakalah with waqf fund approach in Pakistan. Interested readers should reference Wahab, Lewis and Hassan, 2007, and Alhabshi and Razak, 2008, for further information on this.

Figure 2.8: Takaful- Modified Wakalah

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The modified mudarabah model is similar to the conventional framework seen above for mudarabah takaful models, but with a performance incentive for the fund’s operator, termed in the chart above as “underwriting surplus”. In this model, this surplus is shared between the operator and the participant, while the traditional model does not provide the operator with a share to the surpluses of the underwriting, nor does it monetarily incentivize the operator to produce such surpluses.

Figure 2.9: Takaful Model – Wakalah with Mudarabah on Investments

The above model provides an incentive to the operator to produce higher investment profits in the form of a stake, “X%”, in the investment profits, though it does not allow for the operator to share in underwriting surplus profits. This model, like the modified wakalah model, was designed so that the operator has reason to attempt to maximize profits, not just meet base-line expectations placed on them by the stipulations contained within their contract.

Figure 2.10: Takaful Model – Wakalah with Incentive Compensation

This model combines mudarabah components on the fund’s investments with an incentive for operators should they generate underwriting surpluses, as noted in the figure above. Another

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important issue worth noting is that the participants of takaful pools have a small stake in the decisions made for the fund (if a stake at all), while the operator’s actions, as you can see from the structure of the contract, have a significant impact on all decisions (Hawary, Grais, and Iqbal, 2003). As the IFSB (2006) notes, “because the interests of policyholders may diverge from those of the shareholders of the Takaful operator, whose board of directors is in principle acting on behalf of both groups but which is appointed only by the shareholders, there is reason to consider whether policyholder interests need to be represented within the governance structure. Such representation might, for example, extend to any committees established to decide on investment policy, since there may be issues around which investments are attributed to shareholders’ funds and which to policyholders’ funds.” (p.12)21 Going forward, structures for a takaful pool should also extend to shari’ah boards, as well as utilizing shura, the Islamic concept of mutual consultation (Iqbal and Lewis, 2006). Despite the fact that, as an industry, the Islamic banking sector should remain weary of extending Shari’ah compliancy too far and allowing for structures that are not truly in accordance with Islamic principles. Shari’ah boards should continue to seek to extend the confines of what financial structures are acceptable, particularly, Islamic project finance and infrastructure financing, which will prove to be critically important for Muslim countries (Hawary, Grais, and Iqbal, 2003). It is evident from the key issues listed above and the conversations pertinent to them (for both wakala and mudaraba-based takaful models) that most of the issues pertaining to takaful are issues regarding the Shari’ah compliancy of takaful, both generally and within the confines of specific takaful mechanisms, and the various governance risks surrounding the models. The heterogeneous interpretations of Islamic scholars, particularly as applied to takaful, concerning every facet of this Islamic structure, from auditing to modeling and account, have led to a lack of transparency and comparability in financial statements (Hawary, Grais, and Iqbal, 2003). In spite of this, the underlying theoretical conceptual design of takaful is a testament to the enhanced Islamic financial engineering taking place today; however, in practice, the risk-sharing (co-operative) advantages of takaful, specifically mudaraba-based models, are, through an amalgam of circumventions, offset (Hawary, Grais, and Iqbal, 2003). Islamic banks operate in mixed financial systems and, as mentioned before, cannot always practice finance in a wholly Islamic manner. One important example, which Baldwin (2002) cites, is that Islamic banks tend to remunerate investors with returns commiserate with the market at present, regardless of the bank’s actual margins and profitability, something that is obviously not in line with whichever Islamic banking is activity being engaged.22

21 IFSB (2006) quoted in Hawary, Dahlia El, Wafik Grais, and Zamir Iqbal. "Regulating Islamic Financial Institutions: The Nature of the

Regulated." International Conference on Islamic Banking: Risk Management, Regulation and Supervision, Aug. 2003. 22 Baldwin (2002) quoted in Hawary, Dahlia El, Wafik Grais, and Zamir Iqbal. "Regulating Islamic Financial Institutions: The Nature of the

Regulated." International Conference on Islamic Banking: Risk Management, Regulation and Supervision, Aug. 2003.

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2.7 ISLAMIC MICROFINANCE RISK

Lastly, it is important to discuss the risks involved with Islamic microfinance. It may seem counterintuitive, but there have been several important risks identified as being present within the scope of Islamic microfinance. Islamic finance’s conventional counterpart, conventional microfinance, which grew out of pioneering MFI institutions like the Grameen Bank in Bangladesh, is still developing, though it is considered one of Islamic banking’s rapidly developing subsectors. With goals of poverty alleviation and other core Islamic banking concepts, microfinance seems, at least on the surface, to capture the beauty and essence of Islamic finance. Microfinance institutions in the conventional market provide entrepreneurial entities and individuals with capital critical to their ventures, something traditional banking institutions (due to insufficient profitability projections and the reticence of banks to lend to the poor) under pursue. If such persons get access to capital, it is often at the hands of vulture lenders (who charge incredibly high interest rates with less than favorable lending terms). While one would think many, if not all, Islamic banks would have arms that provide micro financing that is not the case. In some ways, the credit risks that one may find in conventional and Islamic non-microfinance lending are alleviated to some degree by the group-based consciousness and team linkages created by a repayment environment that is conducive to effective repayment (given the fact that if the lending group is unable to pay back the loan monies, then they will not be given loans in the future), so that the group will not be disallowed from receiving more loans. However, that said, Ahmed, Ashraf, and Hassan (2002) state there are risks in providing credit to poor in developing countries, namely the fact that there is no evidence to suggest that providing poor people with credit will facilitate successful entrepreneurial projects (Hassan and Ashraf, 2013). As for conventional MFIs, Rahman (1999) cites asymmetric information issues and underlying moral hazard concerns, that is, that loan capital may eventually end up in the hands of male family members to be used for purposes other than those intended. Additionally, Bennett (1998) reports that high operating and administrative costs can range up to 400 percent per dollar lent, making economic consume enduring and unpredictable (Hassan and Ashraf, 2013). Liquidity pressures, too, are of concern to MFIs, due to the fact that, in general, MFI loans are short-term, which is also a cause for higher interest rates (Hassan and Ashraf, 2013). Besides the fact that charging fixed, even lower rates of interest to the poor may seem logical, in practice, it is not so simple, as many projects do not offer rates of return that are profitable enough such that the entrepreneurs can repay the principal plus interest, let one make any surplus after covering their debt service (Hassan and Ashraf, 2013).

Comparison of Islamic and non-Islamic NGOs (Hassan and Alamgir, 2002)

Islamic NGOs are late in coming to the field of rural development in general and microcredit/micro-investment in particular. On the other hand several hundred secular NGOs have been implementing microcredit programs since 1980s. Discussions with leaders of Islamic NGOs reveal that they were late to appreciate the roles of NGOs and in fact had hostile opinions about activities of secular NGOs. Gradually some of them appreciated that credit programs can be implemented by blending Islamic principles of investment and mechanism of mobilizing the poor, that is, the management practice of implementing microcredit

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programs.

Islamic NGOs has been managing mainly micro-investment/microcredit programs while secular NGOs are implementing other programs like non-formal education, health and sanitation etc. mainly with the financial assistance of external donors.

In microcredit program both groups of NGOs follow the same selection criteria to select their program beneficiaries. In fact Islamic NGOs are following the existing norms of selecting the poor people in rural areas. Normally the land ownership criteria such as families having maximum of 0.5 acres of land included in the programs.

Gender issues: Existing bias among NGOs is to include mostly women in their programs. Islamic NGOs are including both men and women. However, there are extreme examples where one Islamic NGO (Islamic Cultural Society), which accept men as members, and Islamic Bank accepts mainly women like secular NGOs.

Microcredit mechanism: Islamic NGOs have basically copied the microcredit mechanism developed by the Grameen Bank followed by all NGOs in Bangladesh. However, there might be small variations introduced by each NGO to suit its own situation. The basic mechanism is as follows: poor women and men are organized in groups who take responsibility of repayment of each other’s loan at the event of default. Groups meet once in a week to make the transactions, deposit savings and loan installments.

One basic requirement for receiving loan is to deposit small amount of money as ‘compulsory savings’. Islamic NGOs also follow the same procedure because it gives the poor members an opportunity to mobilize own capital, it’s a kind of cash collateral for the NGO and a part of the loan/investment operation may be financed by this fund. However, one important distinction may be noted here regarding payment of interest on members’ deposit. Secular NGOs pay a fixed rate of interest, 5-6% per annum, on deposit. On the other hand, Islamic NGOs provide variable rate similar to the Islamic Banks. The rate is computed at the end of the year considering the total income, deposit and expenses. Normally NGOs do not allow members to withdraw their savings deposits. In case of Muslim Aid it allows members to withdraw their savings.

The most significant difference between the Islamic NGOs and other NGOs centers on the issue of interest. Secular NGOs charge at the rate of 20-30% per annum on the cash credit provided to the members. However, Islamic NGOs do not provide any cash a loan. They apply the concept of ‘Bye Muazzal’ (sale on credit) and provide commodity adding certain percent of mark-up on the cost of the commodity. The rates vary among the organization. For example, Islamic Bank adds 12% and Muslim Aid Bangladesh adds 12.5% on the cost over a period of one year. Since the payments by the members are made every week, when computed according to the method of Finance the corresponding rate of interest with be approximately 24% and 25% respectively. The other terms and conditions of credit of these two groups of NGOs are similar. The loans are given for a period of one year and recovered in weekly installments. The amount of loan for both groups of NGOs varies between Taka 3000 to Taka 10,000.

The activities financed by both group of NGOs are same, the commonly available petty activities in the rural areas. Examples are poultry and livestock rearing, petty trade, financing agricultural inputs, rural vehicles, housing material, handlooms etc.

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Sources of fund: Common sources of fund for microcredit programs are members’ savings, grants from external (western) donors and currently from the Palli Karma Sahayak Foundation (PKSF), an organization established by the Government of Bangladesh to provide loan to successful NGOs. Islamic NGOs are fund starved although they have ample opportunity to expand and there is strong demand in the rural for Islamic micro financial services. Only Islamic Bank has adequate resources to expand its micro financial services. Four Islamic NGOs in the sample received some fund PKSF. International Islamic donor agencies normally do not provide fund for microcredit, they are more interested in relief and rehabilitation programs. Islamic NGOs also lack guidance for improving their management and professional skills. That makes Islamic NGOs as followers rather than leaders in the sector.

Future Trends: Both groups of NGOs will be focusing on two issues: expansion of programs by accepting more and more members and achieving financial viability of the programs

Ahmed, Ashraf, and Hassan (2002) claim that a diversion of microcredit for consumption purposes by the borrowers is one of the main reasons for credit default (in conventional microfinance), but can be resolved if IMFIs are designed in an integrated manner to include the two basic and traditional institutions of Islam, the Awqaf and the Zakah, with Islamic microfinance into a single model. Here is their model (Ahmed, Ashraf, and Hassan, 2002):

a. Organization: In modern times, management inefficiency and increased government involvement are two important factors leading to decrease in public participation in Zakat and Awqaf management funds. As a result, government and donor agencies are increasingly focusing on more private participation or NGO (nongovernment organizations) participation in different development initiatives. Considering these factors, we propose that an NGO abiding by Islamic ethics and norms with the poverty alleviation objective would be the ideal form of organization.

b. Mission and Vision: The vision of the NGO should be to create a poverty-free society based on the Islamic principles of equality, social justice, and balanced growth. The mission of the NGO should be collecting Zakat and Awqaf contributions from a specified locality and providing a credit facility to the poorest segment of society.

c. Objective: The main objective of the NGO should be to reduce poverty through the balanced growth and development of different segments of society. The NGO should focus primarily on developing microbusiness among the poor to enable them to attain a sustainable income growth and eventually get out of the poverty trap. In addition to its core service of providing collateral free microfinance to the hardcore poor, the NGO may also provide financing for other items such as education, health services, and house building.

d. Key Functions: Using an integrated approach, a single concern would be responsible for the management of Zakat, Awqaf, and Islamic financing. This organization would perform three key responsibilities:

1. Collecting and managing Zakat funds from prospective Zakat donors and other Zakat fund management institutions.

2. Collecting and managing Awqaf funds from prospective Awqaf donors, and other Awqaf fund management institutions.

In the initial phase, the NGO may concentrate on providing microfinance and collecting funds

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from other Zakat and Awqaf management organizations. However, as the organization becomes mature, it may engage in the management of Zakat and Awqaf funds.

e. Credit Delivery Model: The proposed single-model NGO may adapt the success model of Amanah Ikhtiar Malaysia (AIM),

a successful microfinance institution in Malaysia. The success

story of AIM provides empirical evidence that microfinance facilities may be delivered based on the adaptation of Islamic principles, group recovery, and a credit disbursement model similar to the Grameen Model.

In contrast to AIM, where the Malaysian government actively participates in lending interest-free capital and covers operational expenses, the proposed NGO may strive to be self-sufficient (meaning no government participation). In its initial stage, the NGO may undertake a few pilot projects to analyze the response of customers in different localities. Selection of such pilot projects may involve the following four-step process:

1. Selection of Locality: The NGO would focus on a location with a high poverty density. The selection of a locality would also depend on other factors such as: (a) a demographic study of the locality, (b) identification of probable microcredit project options, and (c) understanding of the prevailing infrastructure, which has important marketing and distribution impacts.

1. Selection of Population: After selecting a particular area, the NGO would select a target population. It may conduct a household survey, or use references from the existing survey data. Such populations can be selected on the basis of eligibility of Zakat funds or per capita income. In selecting individual members of the target population, persons eligible to receive Zakat contributions would be chosen first.

2. Training: This target population would be given vocational training in relevant areas. After successful completion of the training program, participants would be eligible for membership.

2.8 DERIVATIVE INSTRUMENTS IN ISLAMIC FINANCE

Commonly utilized in the conventional financial sector, derivatives can be defined as financial instruments whose value is, as indicated by the name ‘derivative’, derived from another variable. Options, forwards, futures, options and swaps are all examples of derivatives. Though derivatives, theoretically, were developed in order to mitigate risks, they, a result of speculative application, have become risks in and of themselves (Kunhibava, 2010). Certain derivatives practices, including credit default swaps, were being used at particularly high levels during the years preceding the financial crisis of 2007. Gharar is often discussed in the context of conversations surrounding derivatives and Islamic finance. Scholars have cited that, because derivatives often encompass the sale of one debt for another, the sale of nonexistent objects, and/or the sale of items before possession is taken, they are at odds with the principal Islamic finance guidelines outlined in the Shari’ah (Kunhibava, 2010). With regards to the forward contract, arguably one of the more simple derivatives, Kunhibava (2010) cites numerous issues that led to the development of the futures contract. Firstly, the necessity of multiple coincidences (a party interested in the forward contract must find another with diametrically opposing needs); secondly, since the forward price is arrived at by negotiation, one of the parties, who is in a better bargaining position than the other, may be able to impose a price on the other. Lastly, is the counterparty risk, i.e., the risk to one of the

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parties that the other will default. A futures contract is essentially the same as a forward contract, but standardized with respect to contract, size, maturity, product quality, place of delivery, etc. When sold on an exchange, the problem of multiple coincidences and counter party risk are solved (the exchange acts as the guarantor for each trade by being the buyer to each seller and the seller to each buyer), and the prices, being that they are arrived at through the interaction of many buyers and sellers, avoid situations where one party imposes upon another (Kunhibava, 2010). Having said that, in commodity futures, options are often utilized and not executed in such a way that actual delivery takes place. Contemporary scholars, for the most part, have ruled that a futures sale, which comprises deferment of both counter-values, is a sale of one debt for another and as such, it is forbidden (Kunhibava, 2010). Additionally, because both counter-values in future sales are nonexistent at the time of the contract (the money and the goods), it is not a genuine sale. Rather, it is a mere sale or exchange of promises (a sale can be valid if either the price or the delivery is postponed, but not both) (Kunhibava, 2010). In an option contract, payment of a premium is required to secure the right to buy (or sell) the underlying asset at a predetermined exercise price, which, according to Usmani is permissible, because an option is a promise, and such a promise is itself permissible and “normally binding on the promisor‟ (Kunhibava, 2010). However, Kunhibava (2010) writes that since an option transaction bears fees on the promises, it is impermissible under the Shari’ah. Due to their inherent speculative nature, innovative derivative instruments that satisfy the tenets of Islamic financial theory may not be feasible; however, through Islamic financial engineering, contentious compliant-derivative instruments have been developed. In Islamic finance, one of the first known efforts to join a sukuk with a derivative is the sukuk musharakah with detachable provisional rights to the allotment of warrants, issued by WCT Engineering in the first quarter of 2008 (Kunhibava, 2010). This financial structure, a sukuk joined with a warrant, enables the issuer to enter capital markets and allows for diversification of portfolios for investors through the feature of warrants (Kunhibava, 2010). Further, Islamic instruments that have derivative-like features or can/have be used to develop derivative-like instruments are salam, istisna, arbun, istijar, Islamic swaps, kiyar al-shart, wa’d and ji’lah (Kunhibava, 2010). Kunhibava (2010) posits that salam can be compared to a forward contract, barring the fact that in a salam contract, only one party defers his contractual obligation, while istisna (another deferred-sale contract, in which the price is paid in installments as the work progresses in manufacturing or building an object) can also act in the capacity of a deferred-sale derivative. Bay al-arbun, on the other hand, is similar to a call option, except that, in the call option, the down payment is not subtracted from the contract price (Kunhibava, 2010, notes, too, that the future price is known on the day of the contract agreement). Though many contemporary scholars have proposed its use as an Islamic derivative, namely Al-Amine

and Kamali, the legitimacy of bay al-arbun remains contested.

Introduced by CIMB in 2004, the common types of Islamic swap structures used are the Islamic Profit Rate Swap (IPRS) and the Islamic Cross Currency Swap (ICCS). Kunhibava (2010) states that the IPRS instruments are used to swap or exchange floating payment obligations with fixed payment obligations (or vice versa) for the purposes of hedging and that ICCS instruments are used to hedge against fluctuations in currency rates. This is done by

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swapping or exchanging a series of profit payments in one currency for another currency. She also notes that the common underlying Islamic contracts used by the banks in Islamic swaps are tawarruq, commodity murabahah and wa’d. At present, all Islamic derivative contracts are privately negotiated or concluded over-the-counter, which naturally brings into play issues of transparency, standardization, regulation and other risks discussed in this paper (Kunhibava, 2010). In addition to the Shari’ah questions surrounding derivatives, it will be many years before the Islamic banking community bears witness to their mass availability and frequent use.

2.9 RISK MITIGATION AND REGULATION IN ISLAMIC FINANCE

The following section was derived largely from Ahmed and Khan (2007). In order to be reductive with regards to bibliographical citations, this should be noted. The Risk identification and management available to the Islamic banks can be of two types. The first type comprises standard techniques, such as risk reporting, internal and external audit, GAP analysis, RAROC, internal rating, etc., which are consistent with the Islamic principles of finance. The second type, outlined by Ahmed and Khan (2007), consists of techniques that either need to be developed or are adapted, keeping in view the requirements for Shari‘ah compliance. Gharar can be mild and sometimes unavoidable; however, it could also be excessive and cause injustices, contract failures and defaults. A number of appropriate contractual agreements between counterparties work as risk control techniques. Ahmed and Khan cite:

To overcome the counterparty risks arising from the non-binding nature of the contract in murabahah, up-front payment of a substantial commitment fee has become permanent feature of the contract. To avoid fulfilling the promise by a client in taking possession of the ordered goods (in case of murabahah), the contract should be binding on the client and not binding on the bank. This suggestion assumes that the bank will honor the contract and supply the goods as contractually agreed, even if the contract is not binding on it.

Since the murabahah contract is approved with the condition that the bank will take possession of the asset, at least theoretically the bank holds the asset for some time. This holding period is almost eliminated by the Islamic banks by appointing the client as an agent for the bank to buy the asset.

In istisna contract enforceability becomes a problem particularly with respect to fulfilling the qualitative specifications. To overcome such counterparty risks, Fiqh scholars have allowed band al-jazaa (penalty clause). Again in istisna financing, disbursement of funds can be agreed on a staggered basis subject to different phases of the construction instead of lumping them towards the beginning of the construction work.

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In several contracts, a rebate on the remaining amount of mark-up is given as an incentive for enhancing repayment.

Fixed rate contracts such as long maturity installment sale are normally exposed to more risks as compared to floating rate contracts such as operating leases.

Due to absence of an environment with no Islamic courts or formal litigation system, dispute settlement is one of the serious risk factors in Islamic banking. To overcome such risks, the counterparties can contractually agree on a process to be followed if disputes become inevitable. Specifically, Islamic financial contracts include choice-of-law and dispute settlement clauses (Vogel and Hayes 1998, p.51). This is particularly significant with respect to settlement of defaults, as rescheduling similar to interest-based debt is not possible.

In order to manage interest rate risk, they advise the use of GAP analysis and the use of two-step contracts. Since it is impermissible for a guarantee to be provided as a commercial activity under Shari'ah, in a two-step contract, it can be provided by the Islamic bank’s participation in the funding process as an actual buyer that utilizes two mudarabah contracts (one as a supplier with the client and the other as a buyer with the actual supplier). Another mitigative function recommended by Ahmed and Khan is on-balance sheet netting, i.e. the matching out of mutual gross financial obligations and accounting for only the net positions of the mutual obligations. Immunization, in order to mitigate potential FX risks, and risk transferring techniques, including the use of credit derivatives, namely swaps and options contracts, are also functional for risk mitigation purposes. Please see the previous section on Islamic derivatives to learn more about the procedures through which these instruments are executed. Collateral, guarantees, and loan loss reserves are protective mechanisms in and of themselves, as they improve credit quality, so they allow for a reduction in credit risks. Ahmed and Khan (2007) conclude by citing that there is a need to introduce a risk management culture in Islamic banks and that the non-availability of financial instruments to Islamic banks presents a challenge to manage their ability to combat market risks, as compared to the conventional banks. As discussed in the last section, doing so may not be possible if Fiqhi related issues and Shari’ah decisions do not fall in the way of increased Islamic derivative development.

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CHAPTER 3: ISLAMIC RISK MANAGEMENT INFRASTRUCTURE

This chapter begins with a brief discussion of the national financial architecture and infrastructure that governs Islamic finance in general and in five countries with growing Islamic finance markets. In the following sections, discussions are focused on institutional development, infrastructure development, capital market development, best practices in risk management in Islamic finance, liquidity management, Shariah compliant lender of last resort facilities and dispute management issues in Islamic finance.

3.1. NATIONAL FINANCIAL ARCHITECTURE AND INFRASTRUCTURE

As the IFSI has grown and developed to take up more of the market share in the overall financial industry, the more important it has become for IIFS to adhere to international standards.

3.1.1 Financial Stability Infrastructure

Actors in both the conventional financial industry and Islamic financial industry have produced reports and other publications integral in shaping the infrastructure framework for Islamic finance. The Financial Stability Board is an international institution that monitors the global financial system and promotes the implementation of effective policies. The FSB has issued regulatory reforms on the over-the-counter (OTC) derivatives market in 2010, resolution regimes in 2011, and deposit insurance systems in 2012. These three reports are especially pertinent to the Islamic finance industry. OTC derivatives are an underdeveloped and underutilized instrument amongst IIFS, but IIFS do desire to utilize OTC derivatives. The ISDA/ IIFM Tahawwut (Hedging) Master Agreement establishes the legal framework for the use of OTC derivatives in the Islamic market. However, the most recent global economic crisis has starkly shown that financial industry leaders cannot throw caution to the wind when attempting to profit from OTC derivatives. The use of derivatives was considered a major factor in causing the global financial crisis since their damaging, negative effects on an interconnected global economy was not fully comprehended. As a result, IIFS may want to be more cautious in using OTC derivatives and allow for sufficient transparency and regulatory oversight. Resolution regimes seek to mitigate the impact of a failing financial institution that may result in significant harm to the overall financial system and the public. According to the FSB’s report Key Attributes of Effective Resolution Regimes for Financial Institutions, critical features of resolution regimes include cross-border cooperation, crisis management groups, resolvability assessments and recovery and resolution planning. The IFSB stated that resolution regimes would allow for a “more credible and disciplined IFSI (47).” The third regulatory reform is in regards to the deposit insurance systems. Islamic deposits make up a small fraction of the total deposits in the global financial system. An effective framework that supports protection to depositors and minimizes reliance on a government to keep failing banks afloat could strengthen the system. FSB

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recommended that the Core Principles for Effective Deposit Insurance System, or Core Principles, be used as a benchmark for changes in deposit insurance systems (IFSB 45-47). In 2011, the FSB along with the World Bank and International Monetary Fund made recommendations to emerging markets and developing economies (EMDE) for enhancing financial stability. The recommendations focused on the application of international financial standards, the promotion of cross-border supervisory cooperation, the expansion of regulatory and supervisory authority, the management of foreign exchange risks, and the development of domestic capital markets. The recommendations are relevant to the IFSI, since most of the countries employing Islamic finance are considered as EMDE, and they work closely with the FSB, World Bank and IMF.

3.1.2 Banking Infrastructure

After the financial crisis, there has been increasing pressure to regulate large banks known as systemically important financial institutions (SIFIs), whose actions have the capability to create ripple effects throughout the overall system. However, since no IIFSs meet the standards to be classified as a SIFI, such regulations do not apply to the IFSI. On the other hand, the regulations on SIFIs are also beginning to be applied, but with more leniencies, to banks considered domestic systemically important banks, or D-SIBs. In October 2012, the Financial Stability Board and Basel Committee on Banking Supervision created a framework to identify, manage, and prevent the failure of D-SIBs. D-SIBs will be required to adhere to a higher loss absorbency requirement, based on their degree of systemic importance. Governments are expected to implement the D-SIB framework starting in January 2016. IFSB is reviewing the D-SIBs framework and their analysis will be published in the revised IFSB-2 (IFSB 50-52.) The Basel III is a capital and liquidity framework created in 2012. The framework was created to improve the quality and quantity of capital by converting debt to equity-based capital and introducing a new leverage ratio. The new standard for the liquidity coverage ratio will not impact IIFS greatly, since Shariah already limits the debt-to-equity ratio to not exceed 33%. However, the new recommendations on liquidity may have varying effects on the IFSI. This impact is due to the lack of Shariah compliant liquidity instruments that will meet the Basel III standards. Islamic liquid instruments are not currently designed to be long-term. Furthermore, there is a lack of standardization of Islamic liquidity instruments, and a cross-border transfers of funds is difficult. Additionally, there is an over-reliance on retail funding. On the one hand, the new standards may force Islamic banks to diversify their products, develop products with longer-term features, and better align assets and liabilities in Islamic banks, all of which would affect the industry positively. On the other hand, the liquidity standards could concentrate risk to a few products and, thus, increase bank financing rates in an environment with already rising borrowing costs (IFSB 53-59).

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3.1.3 Securities Infrastructure

The International Organization of Securities Commission, BCBS and International Association of Insurance Supervisors published a report on asset securitization incentives in July 2011. The report included three recommendations: better transparency, standardized documents and less complex products, and standardization in global markets and sectors. The goals were to reduce information symmetries and increase liquidity. Two other reports by the IOSCO advocated for better cross border harmonization and development and regulation of investors in emerging markets. Such recommendations would apply to the Sukuk market in Islamic finance as well as efforts within the Islamic finance industry to improve cross-border activity and regulation for Shariah-compliant products (IFSB 60-61).

3.1.4 Insurance Infrastructure

The International Association of Insurance Supervisors provides a platform for insurance supervisors to exchange ideas and information. In October 2011, the Insurance Core Principles, Standards, Guidance and Assessment Methodology (ICP) were revised to improve global insurance supervision. Changes included a new principle on macro-prudential surveillance and the creation of a stronger linkage between IAIS standards and assessment criteria. The IFSB included some of the revised standards, especially in regards to corporate governance, in its own recommendations in ED-14: Standard on Risk Management for Takaful (Islamic Insurance) Undertakings. In July 2012, a draft called the Common Framework for the Supervision of Internationally Active Insurance was produced to improve supervision of multinational insurance groups (IFSB 62).

3.1.5. National Financial Architecture and Infrastructures of Selected Countries

Islamic financial institutions in all countries other than Iran and Sudan co-exist with their conventional banking counterparts in common regulatory frameworks. However, different jurisdictions have additional legal requirements to support Islamic finance.

3.1.5.1 Malaysia

Malaysia has formed a national Shariah Advisory Council at both the central bank and the securities commission levels which act as the ultimate authority for Shariah matters pertaining to Islamic finance. Islamic finance is regulated by a set of laws aimed at different operations, and are presented as follows: Islamic Banking:

Islamic Banking Act 1983 Banking and Financial Institutions Act 1989

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Takaful: Takaful Act 1984

Capital Market:

Capital Markets and Services Act 2007 Others:

Central Bank of Malaysia Act 2009 Government Funding Act 1983 Malaysia Deposit Insurance Corporation Act 2005

Offshore Financial Activities:

Labuan Islamic Financial Services and Securities Act 2010

3.1.5.2 Turkey

At present, the Turkish legal system does not provide any criteria to establish a Shariah board or comply with Islamic principles. Participating banks ensure self-governance through the appointment of a Shariah board to oversee its activities. However, the Turkish legal system requires Islamic financial institutions to follow additional laws such as: the Capital Market Law and the Communiqué on Principles Regarding Registration of Profit and Loss Sharing Certificates, which allows issuing Shariah compliant certificates.

3.1.5.3 Kingdom Of Saudi Arabia (K.S.A.)

The KSA is regarded as one of the key Islamic Finance markets since the establishment of the Islamic Developmental Bank back in 1975. The current infrastructure for Islamic Finance is governed under the Saudi Arabian Monetary Agency (SAMA), which is also the regulatory authority of the conventional financial system. Recently, Saudi Arabia’s cabinet has approved its first ever mortgage law within the country.

3.1.5.4 United Arab Emirates (U.A.E.)

Both the Islamic finance and conventional banking industries in the United Arab Emirates (UAE) are governed by the Central Bank of United Arab Emirates (CBUAE), established by the central bank under the Union Law No.10 of 1980. In addition, Islamic financial institutions in the U.A.E. are required to comply the following laws: Islamic Banking

Federal Law No.6 of 1985, which establishes the legal foundations for Islamic banks Capital Market

The Federal Law No.4 of 2000

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Takaful The Federal Law No. 6 of 2007. After which, a new insurance/Takaful Law was passed in 2010 to regulate the Takaful industry further

3.1.5.5 Bangladesh

Bangladesh is the home of 7 growing Islamic banks and a number of growing Takaful operators. The Islamic finance industry is regulated within the same legal framework as that of the conventional banking industry. However, the central bank of Bangladesh provides prudential regulations pertaining to Islamic banking and provides guidelines for Shariah compliant products and services. In late 2011, the government initiated discussions between the ministry of finance and top executives of Islamic banks to support the Islamic money market and the Islamic capital market in Bangladesh. Since 2008, the central bank has issued Shariah compliant mudaraba bonds to enhance liquidity management for the listed Islamic banks.

3.2. INSTITUTIONAL DEVELOPMENT

There are several types of Islamic institutions today, including banks, non-bank financial institutions, such as leasing and factoring companies and housing cooperatives, takaful operators, and capital markets players, such as brokerage houses and Islamic asset management companies. Malaysia’s Tabung Haji, created in 1962, is the oldest modern day Islamic finance institution (10 Year Framework 3-5). The spread of Islamic finance across the world has also brought on a number of multilateral institutions. The objective behind the creation of the multilateral institutions was to create standards and harmonize the efforts of Islamic financial institutions (A Mid-Term Review 97). The Islamic Development Bank was created in 1975 to foster economic development and social progress based on Shariah principles in Muslim countries (GIFF 2012 12). In the 1980s, more non-banking institutions began to form. Over the years, the Islamic finance industry has evolved to include several infrastructure institutions (10 Year Framework 3-5). The OIC Fiqh Academy was established in 1988 to advise banks and other providers of Islamic finance products on Shariah compliance and using Shariah to tackle modern day challenges (GIFF 2012 12). Universities and governments have played a critical role in developing Islamic finance as well. Universities have served as hubs for research on Islamic finance. Some governments have funded training and certification bodies. However, in the future, a major challenge to resolve will be to bridge the gap between academic institutions and financial service institutions to allow the research to be applied in the industry’s work (A Mid-Term Review 100-101).

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Table 3.1: IFSI Industry

Source: Islamic Research and Training Institute, 2014

Private Sector Public Sector Multilateral

Standard

Setting

Central banks

Capital markets

authorities

Takaful regulators

National Shariah

boards

Other supervisors

Accounting and

Auditing

Organization for

Islamic Financial

Institutions (AAOIFI)

Islamic Financial

Services Board

(IFSB)

Organization for

Islamic Cooperation

(OIC) Fiqh Council

Market

Catalysts

Private liquidity

management

platforms

Rating agencies

Arbitration

bodies

Interbank markets

Shariah-compliant

deposit insurance

providers

Liquidity

management

platforms by stock

exchanges and

central banks

International Islamic

Liquidity

Management

Corporation (IILM)

International Islamic

Financial Market

(IIFM)

International Islamic

Court for Resolution

and Arbitration

(IICRA)

International Islamic

Rating Agency (IIRA)

Information

and research

Private

universities

Research

institutes

Data providers

Public universities

Public research

bodies

Statistics agencies

Shariah academies

and research

institutions

Islamic Research and

Training Institute

(IRTI)

Training Private

universities

Training and

accreditation

institutes

Public universities

Public training and

accreditation

programs

Islamic Research and

Training Institute

(IRTI)

Professional

Services

Shariah advisers

Law firms

Audit and

assurance firms

Consulting firms

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The future of Islamic finance institutional development is focused on producing a strong and highly capitalized IIFS, building the human capacity with expert finance professionals and management teams, having an active inter-bank market, and expanding the knowledge base of consumers (10 Year Framework 51). ” For example, the IFSB Council, Technical Committee and other working groups are focused on improving the human capital and technological capabilities of Islamic finance (A Mid-Term Review 98). Since the creation of the Islamic Development Bank in 1975, several financial institutions have established themselves as critical members of the industry with specific expertise regarding areas of Islamic finance. The International Islamic Centre for Reconciliation and Arbitration (IICRA) is an independent, non-profit organization that mediates disputes between financial or commercial institutions that applies Shariah principles (A Mid-Term Review 99). Most recently, in 2010, the International Islamic Liquidity Management Corporation was created to facilitate cross-border Islamic liquidity management (GIFF 2012 12).

3.3. INFRASTRUCTURE DEVELOPMENT

The Islamic finance infrastructure includes payment settlement systems, financial markets and products, support facility providers, legal institutions, regulators and supervisors, Shariah governance institutions, standard setters, ratings agencies, data collectors, knowledge management and human resource development programs, and research and development entities (10 Year Framework 5-6). Traditionally, legal infrastructure is necessary to support operations and growth and mitigate negative business practices, such as collusion and anticompetitive behavior. A legal framework allows for certainty and legitimacy of financial contracts as well. However, in Islamic finance, legal infrastructure is especially important to enforce Shariah principles. As further evidence of the pertinence of Shariah, another piece of Islamic finance infrastructure is the Shariah Board. The Shariah Board is the primary adjudicator of all transactions regarding financial matters and their relevance to Islamic law. It is necessary to have accounting and auditing tools. Regular and reliable financial reporting reduces information asymmetry and allows companies in the industry to be compared to one another. Similarly, rating agencies give investors the ability to compare companies from an unbiased, independent perspective (GIFF 2012 13). Since most IIFSs today are small, industry experts have emphasized diversification and specialization of instruments. The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and the Islamic Financial Services Board (IFSB) focus on strengthening the CG of IIFS. The International Islamic Financial Market (IIFM), the International Islamic Rating Agency (IIRA), the International Islamic Centre for Reconciliation and Commercial Arbitration (IICRA), the General Council of Islamic Banks and Financial Institutions, and the Islamic Development Bank Group (IDB) support the development of infrastructure to implement Islamic finance (ISRA 5).

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3.3.1 Islamic Financial Services Board (IFSB)

The Islamic Financial Services Board (IFSB) is set up as an international platform to promote and enhance the soundness of the industry by issuing global prudential standards and guiding principles for the Islamic financial services industry. Its mission is to promote the development of a prudent and transparent IFSI through introducing new, or adapting existing, international standards consistent with Sharī`ah principles. The function of the Islamic Financial Services Board is to provide supervision and regulation of IIFS to promote stability of the IFSI, which includes banking, capital markets and insurance sectors (10 Year Framework 6). The IFSB creates new or modifies existing international finance standards to comply with Shariah so IIFS can integrate the standards in their own work. Three of the IFSB’s initiatives include the Guiding Principles on Liquidity Risk Management for IIFS, Guiding Principles on Stress Testing for IIFS, and Exposure Draft-15: Revised Capital Adequacy Standard. The Liquidity Risk Management for IIFS was created for both IIFS and supervisory authorities to better manage liquidity risk. Following the global financial crisis of 2007 and European sovereign debt crisis, the IFSB has undertaken a number of initiatives to address the development taking place in the global financial industry. Such initiatives include the issuance of the IFSB’s Guiding Principles on Liquidity Risk Management for IIFS, the Guiding Principles on Stress Testing for IIFS, and ED-15: Revised Capital Adequacy Standard. The Stress Testing for IIFS was published in response to the recent global financial crisis and discusses stress testing from the BCBS and the Committee of European Banking Supervisors. The stress testing framework provided IIFS with stress testing scenarios and advised on how to identify and manage shocks. It was intended for supervisory authorities to use as surveillance to tool to determine the stability of the IFSI, to identify weaknesses in the system, and to design policies. For IIFS, risk management evolved due to differences in the operations and balance sheet structures of Islamic institutions and that of traditional financial institutions. In order to conduct stress testing, the risk factors causing the stress need to be identified. Risk factors specific to IIFS include credit risk, market risk, liquidity risk, rate of return risk, displace commercial risks, investment risks for Mudrabah and Musharakah, and Shariah non-compliance risk. Unlike the other risk factors, the Shariah non-compliance risk is a qualitative risk factor, rather than a quantitative risk factor. Furthermore, according to the IFSB, certain characteristics such, as Shariah compliancy in risk mitigation, securitization, real estate investment and commodity Murbahah transactions need to be considered in the design of stress tests. While it is important to consider and incorporate the Islamic characteristics of risk, the stress tests for IIFS must also complement existing international standards. RSA were to begin implementing the Guiding Principles on stress testing by 2013. However, challenges to implementation include, but are not limited to, weak disclosure regimes on stress testing practices, lack of regulatory guidelines, lack of expertise on the stress test models, and lack of good data (IFSB 66-71). The ED-15 was issued in November 2012 and provided guidelines on the application of capital adequacy regulations and macro-prudential tools, with emphasis on integrating the new features of the Basel III standards, such as the capital conversion buffer, the counter-cyclical

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buffer, and the leverage ratio, into IIFS. Since Islamic instruments are asset-based, profit-sharing, agency or Sukuk, they are exposed to credit risk and/or market risk. Table 2 shows the different types of Islamic instruments. Market risk arises from the cost of the asset to the IIFS while the credit risk is based on the selling or leasing the asset to a second party. For profit-sharing instruments such as Musharakah and Mudarabah, the risk is takes the form of credit risk. The only exception is when the investments are in assets for trading purposes, which become exposed to market risk. (IFSB 71-72).

Table 3.2: Types of Islamic Financial Instruments

Type Islamic Instrument

Asset based on sale or purchase of an asset

Murabahah

Salam

Istisna

Sukuk

Asset-based on selling benefits of an asset Ijarah

Profit-sharing Musharakah

Mudarabah

Agency Wakalah

Source: IFSB-IFSI Stability Report, 2013

The ED-15 focused on five specific areas on improving capital adequacy standards. The draft delineated the need to create a capital adequacy framework that would buffer exposure from risk and address the capital adequacy requirements of risk exposures. A third objective was on maintaining high-quality regulatory capital components that agree with Shariah principles. Another standard revision was in regards to enhancing the capacities of capital adequacy treatment of Sukuk issuances and securitization processes. Finally, the draft recommended IIFS adopt international best practices on capital adequacy. Implementation of ED-15 was expected to begin on January 1, 2014 (IFSB 72). Other efforts by the IFSB to further develop the infrastructure of the IFSI include improving the supervisory review process through the revision of the IFSB-5, issuing a new Guidance Note on integrating the Basel III liquidity standards into the IIFS, and creating a new Working Group for the IFSB Core Principles for Effective Regulation and Supervision of Institutions in the IFSI. The last initiative intends to create benchmarks to determine the quality of supervisory systems in various jurisdictions and establish a baseline for Islamic finance supervisory practices (IFSB 72-73).

3.3.2 Implementation Challenges for IFSB

So far, the IFSB has issued 16 published standards. While the IFSB has been making progress in issuing Standard and Guiding Principle (SAG) for the IFSI, the full potential benefits of the SAGs has yet to be captured. Authorities within the financial sector in jurisdictions with Islamic finance show interest in adapting to the IFSB’s standards, but implementation of the recommendations has been paltry. Some regulatory and supervisory authorities (RSA) believe that Islamic finance makes up such a small part of the overall financial market and is at such an

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early stage of development within their countries that implementation of the SAGs is not warranted. RSAs in countries are able to reason in this manner since the SAGs are voluntary, and, therefore, the IFSB does not have the power to enforce implementation of its recommendations. In addition, the RSAs have the authority to determine the timeline for implementation of the SAGs. Currently, countries are in different stages of implementation with half of the IFSB members working with a three to five year timeline and others with shorter timelines. As of 2011, the first published standard, IFSB-1, has only been fully implemented by three of 24, or 13 percent of the RSAs. Another 25 percent are in progress of implementing IFSB-1 while 38% are planning to implement. 25%, or 6, of the RSA have opted not to implement IFSB-1. The degrees of implementation are similar for the other IFSB publication standards. IFSB-2 and IFSB-3 had the highest figures for complete implementation, with 24%, or 6, RSAs fully implementing the standards. On the other side of the spectrum, IFSB-6 and IFSB-11 have zero RSAs with complete implementation; instead, 64% do not plan to implement IFSB-6 and 59% for IFSB-11. Due to the low implementation rates, the IFSB took initiative to provide support for the implementation process and to make the process easier for countries. The IFSB has created a group of best practice standards for implementation. It provides technical assistance through customized workshops for each of its member countries. In addition, the IFSB has created e-learning programs to aid members on technical work and capacity building (IFSB 75-77). The AAOIFI creates standards on accounting, auditing, governance, ethics, and Shariah for IIFS. In 2012, the AAOIFI issued seven new standards on governance, ethics, and customer protection. The more stringent standards were in response to the 2008 global financial crisis. Additionally in 2012, AAOIFI revised accounting standards on real estate investments. In the pipeline for the organization in 2013 were also plans to review standards on investment accounts and Takaful and create new governance standards for the Shariah Supervisory Board (IFSB 74).

3.3.4 International Islamic Financial Market

The IIFM is concerned with the Islamic capital and money market. Its work includes standardizing Islamic financial products, documentation, harmonizing Shariah across borders and promoting wider acceptance of Shariah, and providing a central platform for other financial services bodies to come together. In 2012, the IIFM and the International Swaps and Derivatives Association issued the Mubadalah al-Arba’ah (profit rate swap) product standard.

3.4. CAPITAL MARKET DEVELOPMENT

The Islamic capital market has been growing over the last decade with the development of equity market indices, Islamic funds and sukuk markets. There are currently four major Islamic index providers for equity markets: Dow Jones, S&P, MSCI, and FTSE . The indices are used to benchmark the performances of Shariah compliant securities. The four indices cover

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over 50 countries. The Dow Jones covers the most with 69 countries. The Dow Jones World Islamic and MSCI World Islamic indices have fared better since 2008, compared to their conventional counterparts, the Dow Jones World and MSCI World Indices. The better performances of the Islamic indices are due to the Islamic indices having fewer constituent companies and higher market capitalizations. Furthermore, the Islamic indices experienced growth in the number of company constituents in the basic materials, healthcare, and technology sectors. Since growth in financial sector services was smaller, the Islamic indices were less affected by the financial crisis (IFSB 17-19). Islamic funds have grown from USD 29.2 billion in 2004 to USD 64 billion in 2012. The funds are retail driven and the main asset class is equities, which make up half of all assets. Islamic funds have grown due to many reasons, including the rising wealth in Muslim countries. The funds’ assets under management are heavily concentrated in Saudi Arabia and Malaysia, which possess 70.3% of global assets. Another factor influencing the growth of Islamic funds is the attractiveness of commodity funds after the financial crisis. According to the IFSI Stability Report 2013, commodity funds were the “best net performing asset class for Islamic investors between 2007 and 2011, growing by 41.81% (23).” Even with the substantial growth, Islamic funds face challenges in their lack of sophistication and market depth, as well as comparatively low volumes in the equity and fixed income markets (IFSB 21-23). The sukuk market has grown due to a greater demand for market liquidity, fixed-term investments and credit facilities. Short-term sukuk programs were first introduced in the mid-2000s. The sukuk market saw a CAGR of 45.2% between 2004 and 2012, with the market growing from USD 6.6 billion to USD 131.2 billion. Corporate sukuk issuance has surpassed pre-crisis levels due to declines in the cost of borrowing. Malaysia has the largest and most developed sukuk market that attracts both local and foreign companies. More countries are developing sukuk markets, including several MENA countries. Saudi Arabia and the UAE have the strongest sukuk markets amongst the GCC, and Libya, Egypt and Tunisia are making efforts to create a regulatory environment that will allow for sukuk markets in the future. The 2008 financial crisis negatively affected the sukuk market. There has been greater volatility in sukuk yields due to investor uncertainty concerning the market. Post-crisis, investors sought out short-term, high quality papers in place of riskier, long-term investments. However, Sukuk yields did perform better, compared to U.S. ten-year treasury bonds between 2011-2012. Challenges that sukuk development faces are the after effects of the 2008 financial crisis and Europe’s debt crisis, as the United States implements more risk-adverse regulations and European countries adopt greater austerity measures. Furthermore, investors perceive sukuk to be a costly product, due to the added expenditures on Shariah compliance, the complexity of transactions and a lack of precedent on performance (IFSB 24-32).

3.5. LIQUIDITY MANAGEMENT: PRUDENTIAL REGULATION AND LIQUIDITY INFRASTRUCTURE

According to Iqbal, risk management instruments and mechanisms are underdeveloped in the IFSI. A better understanding of the environment is necessary to monitor and mitigate risk.

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Monitoring risk is critical to catch problems early and prevent risk from spreading widely and deeply. One way to mitigate risk is through diversification. Diversification includes diversifying geographically and across sectors by expanding the depositor base. Financial risk can be further prevented by reducing client exposure, which can lead to declining risk for intermediaries, such as banks. It is important to manage corporate governance risks that include operational, fiduciary, transparency, Shariah, and reputation risks (ISRA 4). Shari’ah non-compliance risk is defined as “the risk that arises from IFI’s failure to comply with the Shariah rules and principles determined by the Shariah board of the relevant body in the jurisdiction in which the IFIs operate.” It is difficult to measure Shariah risk, since no risk management model exists for it (ISRA 23-24). Iqbal proposes a four-pronged strategy for Islamic risk management. He advices the need to understand derivatives in a Shariah context, expanding the role of financial intermediaries, applying takaful, and using financial engineering to develop synthetic derivatives and off-balance-sheet instruments (“Iqbal Paper 4” 10-12)

3.5.1 Liquidity Infrastructure

The Stability Report 2013 describes liquidity management as “one of the most challenging tasks faced by IIFS (103).” The challenges IIFS face is due to many reasons. Shariah restricts interest-based transactions, the transfer of debt, and the use of specific instruments. In countries that operate both conventional and Islamic finance systems, the Islamic finance industry is at a disadvantage, as it lacks Shariah compliant instruments that, for example, can mop up excess liquidity or allow Islamic banks to hold risk-free government papers (Grais 3-4). In addition, there is inactivity in secondary market, weak supervisory tools, and a lack of Shariah compliant open market operations to meet monetary policy objectives. As a result, IFSI in a majority of the jurisdictions in the world are obliged to maintain a higher level of cash, given the absence of Sharī`ah-compliant, high-quality liquid assets (HQLA), vis-à-vis their conventional counterparts. Besides, the dominance of uncollateralized interbank transactions such as commodity Murābahah transactions (CMT), interbank Muḍārabah, and interbank Wakālah results in increased counterparty risk apprehension in bilateral arrangements in stressed market conditions. Due to such market conditions, the liquidity problems with one or more IIFS can augment the potential for systemic risk in crisis times. (IFSB 2013) The Islamic Finance and Global Financial Stability Report issued by the IFSB-IDB-IRTI in April 2010 outlined some important aspects on which the industry needs to focus its attention:

Enhancing the financial resilience and stability by the developing a robust national and international liquidity infrastructure to enhance liquidity provisions through monetary policy and money market operations Developing a set of comprehensive, cross-sectorial prudential standards and a supervisory framework covering Islamic banking, Takāful and the capital market

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Strengthening the financial safety net mechanism – namely, LOLR facilities and emergency financing mechanisms – as well as deposit insurance, all of which need to be compatible with Sharī`ah principles.

3.5.2 Some Recent Developments in Liquidity Management in Islamic Finance

Effective liquidity risk management requires a functioning system of business laws. Countries with IIFS or those with ambitions to have IIFS put great emphasis creating a supportive legal structure for IIFS. Liquidity infrastructure also requires a viable securities and exchange market. Developments in security and exchange markets include the creation of an electronic Islamic interbank platform for short-term liquidity management through a proprietary scoring system in the UAE and an electronic multi-currency and multi-commodity trading platform in Malaysia. An Islamic money market and a multitude of Shariah compliant instruments and trading mechanisms are also necessary for liquidity infrastructure. Malaysia’s Islamic Interbank Money Market, which was established in 1994, is an example of a well-functioning intermediary that provides Shariah compliant programs such as Murdarabah Interbank Investment and the Commodity Murabahah Programme. An example of diversifying instruments can be seen in Bahrain, Indonesia, Malaysia and Sudan’s efforts to use sukuk issuance programs to integrate Islamic finance into their public expenditure programs (IFSB 79-84).

3.5.3 Prudential Regulation

Financial regulation is necessary to protect markets, institutions and consumers. Countries with both conventional and Islamic finance systems use one of three frameworks to regulate Islamic finance. Some countries, such as Bahrain and the UAE, maintain two separate regulatory systems. Others, such as Lebanon, create special laws for the IIFS and conventional finance systems. In the third type of framework, the IIFS follows the same regulations as conventional finance institutions. Saudi Arabia and Egypt function in this manner (Grais 5). The IFSB has published several reports to provide guidance to IIFS on liquidity management, such as the FSI Development, Ten-Year Framework and Strategies (in May 2007), IFSB Technical Note on Issues in Strengthening the Liquidity Management of IIFS (in March 2008), and the Report on Islamic Finance and Global Financial Stability (in April 2010) (IFSB 103). In 2012, the IFSB released its Guiding Principles on Liquidity Risk Management for IIFS. The report laid out 23 principles for IIFS and RSAs. For IIFS, the principles covered governance, identifying managing and reporting liquidity risks, and foreign exchange liquidity risks (IFSB 86). The IIFS will have to adopt the Basel III liquidity standards, but the Islamic financial industry will face challenges in meeting the standards, due to its underdevelopment. For example, the volume of Shariah compliant instruments and sukuk are not high enough to meet the requirements of Level 1 and 2 assets as delineated by the standards. The capital requirement is expected to increase by 25-40%. The Basel Committee has recognized discrepancies between Islamic and conventional banks and has allowed for exceptions in meeting standards (IFSB 89-90). Even with some leniency, Islamic banks will have to be

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innovative and find new ways to improve the efficiency of liquidity management. Dr. Sandeep Srivastava at Ernst & Young recommends that Islamic banks “ [set] up a structured fund transfer pricing framework, [measure] risk in a more rigorous manner, and [adopt] a structured cost allocation mechanism (EY 21).

3.6 ISLAMIC BANKING AND FINANCE REGULATION AND RISK MANAGEMENT IN OIC MEMBER COUNTRIES

We present salient features of existing regulation and supervisory mechanism in the IDB member countries in 3.3.23 Most of the Member countries have adopted international standards including Basel Committee’s core principles of capital adequacy and international accounting standards and IFSB guidelines for capital and regulatory risk management. A number of countries have adopted AAOIFI guidelines and standards. A few countries have a growing Islamic banking and finance sector (for example, Bangladesh) without having a specific Islamic banking law. A few countries have allowed small banks to merge to create a viable banking organization. Pakistan which implemented a 100% Shariah banking now retracted from it and started a dual banking model in line with Malaysian dual banking model. Turkey has implemented a Participatory banking law to bring more clarity to this growing Islamic banking sector. Iran, Malaysia, Pakistan and Turkey have implemented both offsite and onsite supervision systems to better regulate this industry. Many countries are now implementing best practices in risk management in Islamic banking. In many countries, Islamic banking regulations have been introduced and in other countries, Islamic banks are operated under special guidelines from their regulatory authorities. May countries have separate laws for banking and securities industry? Only one regulator (Bank Negara Malaysia) regulates both banking and insurance industry. There is a trend now in many countries to have a universal banking regulation for Islamic finance industry by a one mega-supervisor. There is also a trend to separate the macro-monetary functions of the central bank from the supervisory functions either under a separate entity (like Bank of England, 1998) or under a fire-walled supervisory authority within the Central bank. In a number of countries, banking supervision and regulation is different from non-banking regulation and supervision. There are separate securities regulation to regulate the capital market and insurance regulation to supervise insurance industry. In a few countries, conventional countries are allowed to open Islamic branches or windows (Malaysia and Bangladesh). Qatar, most recently, changed its banking law only to allow full-fledged Islamic banks, no conventional is allowed to own and operate either branches or windows. In a few countries, the authorities allow private banks to have their own shariah supervisory boards without any central bank control (for example, Bangladesh). Malaysia and Sudan have

23 M. Umar Chapra and Tariqullah Khan (2000): Regulation and Supervision of Islamic Banks, Occasional Paper #3, Islamic Research and Training Institute, Jeddah, Saudi Arabia

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Central Shariah Board to oversee the functions of Islamic finance industry. The council of guardians in Iran provides guidelines for Islamic finance industry. There is still an on-going debate about what role the shariah board plan-a supervisory role or certification role of islamicity of products.

Table 3.3. Regulatory and Supervisory Structures and Laws and Regulations in OIC member countries

Country Important Regulation, Supervisory Authorities and Risk Management Framework

Bahrain Regulated by the Bahrain Monetary Agency (BMA) ♦BMA regulates both commercial banks and

investment banks (securities firms); insurance companies are under separate regulatory authority

♦Dual banking (Islamic and conventional) banking system; Basel capital requirements and core

principles adopted for both groups, ♦Four Islamic banking groups: a) Islamic commercial banks, b)

Islamic investment banks, c)Islamic Offshore banks, and d) Islamic banking windows in conventional

banks ♦Consolidated supervision ♦International Accounting Standards adopted, ♦Each Islamic bank

must have a Sharī‘ah board ♦Compliance with AAOIFI standards under active consideration

♦Investment deposits, current accounts and capital allocation for assets must be declared, ♦Mandatory

liquidity management by adopting the standardized maturity buckets of assets ♦Islamic and

conventional mixed system

The Gambia Regulated by the Central Bank of Gambia(CBG) ♦Islamic banking law exists ♦ Dual system ♦Separate

Sharī‘ah board required ♦Compliance with Basel capital requirements and core principles and

International Accounting Standards not clear

Indonesia Regulated by the Central Bank of Indonesia (Bank Central Republic Indonesia – BSRI) ♦Separate

regulatory bodies for banks and securities firms♦ Separate Islamic banking law does not exist; Islamic

(Sharī‘ah) banking is covered by added section in the banking law (Act No. 10 1998 and Act No. 23

1999)♦Separate Sharī‘ah board required ♦Islamic windows allowed♦ Consolidated supervision ♦Basel

capital requirements and core principles adopted ♦International Accounting Standards adopted

♦Major financial transformation in process to strengthen bank capital and solvency ♦Active Sharī‘ah

bank development strategy in place by the government

Iran Regulated by the Central Bank of Iran (Bank Jamhuri Islamic Iran) ♦All banks in the public sector with

a plan for minority privatization ♦Bank regulation and supervision is strongly affected by monetary as

well as fiscal and other government policies ♦Single (Islamic) banking system under the 1983 Usury

Free Banking Law ♦Modes of finance are defined by this Law ♦Recent policy orientation towards

adopting the Basel capital and supervisory standards and International Accounting Standards ♦No

Sharī‘ah board for individual banks ♦Onsite and offsite supervisory methods and objectives defined

and applied ♦Banks and insurance companies are supervised by different regulatory authorities

Jordan Regulated by the Central Bank of Jordan (CBJ) ♦Separate regulatory bodies for banks and securities

firms ♦Islamic banking law exists ♦Dual system ♦Separate Sharī‘ah board required ♦Consolidated

supervision♦ Basel capital requirements and core principles adopted ♦International Accounting

Standards adopted

Kuwait Supervised by the Central Bank of Kuwait (CBK) ♦CBK regulates both commercial banks and

investment banks (securities firms); insurance companies are under separate regulatory authority

♦Dual banking system ♦Two Islamic banking groups: a) Islamic commercial banks, and b) Islamic

investment banks. Conventional banks not allowed having Islamic banking windows. ♦Consolidated

supervision ♦Basel capital requirements and supervisory standards adopted ♦International

Accounting Standards adopted ♦Separate Islamic banking law under active consideration ♦Separate

Sharī‘a hboard for each bank necessary

Malaysia Regulated by the Central Bank of Malaysia (Bank Nagara Malaysia – BNM) ♦Insurance companies and

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banks under same regulatory authority; securities firms under separate authority ♦Private banks

♦Dual banking system ♦Islamic windows allowed in conventional banks ♦Consolidated supervision

♦Basel capital requirements and core principles adopted ♦International Accounting Standards

adopted ♦CAMELS rating system adopted ♦Onsite and offsite supervision well defined with clear

objectives ♦Separate Sharī‘ah boards at institutional level in the BNM and Securities Exchange

Commission ♦Islamic money market and liquidity arrangement exists ♦Ministry of Finance closely

associated with the supervision of Islamic banks

Pakistan Regulated by the Central Bank of Pakistan (State Bank of Pakistan-SBP) ♦ Securities firms, and

Insurance Companies are regulated by separate regulatory bodies ♦Major banks in the Public Sector;

bank regulation and supervision effected by government policies ♦Islamic banking law does not exist

♦Mudārabah Companies Law exists ♦Sharī‘ah board concept does not exist ♦ Islamic banks are not

identified distinctly ♦Basel capital requirements and supervisory standards adopted ♦Bank merger is

on cards to strengthen capital ♦ Concept of onsite and offsite supervision exists ♦Major financial

transformation is called for by the Supreme Court of Pakistan to introduce Islamic banking and

financial system; a Financial Services Transformation Committee has been established by the SBP.

Qatar Regulated by the Central Bank of Qatar (CBQ) ♦Dual banking and separate regulatory system ♦No

separate Islamic banking law exists ♦Islamic banks supervised by special directives of CBQ ♦Separate

Sharī’ah boards for banks required ♦Standardized transparency requirements for Islamic banks exist

Sudan Regulated by the Central Bank of Sudan (CBS) ♦Single (Islamic) system ♦Islamic banking law in place

♦Separate Sharī’ah boards for banks required, also the Central Bank has a Sharī‘ah Supervisory Board

♦Substantial public sector control; supervision and regulation is effected by other government policies

♦Evolution of financial instruments underway ♦Compliance with the capital adequacy and supervisory

oversight standards of the Basel Committee not clear ♦Major bank merger is planned to strengthen

bank capital

Turkey Regulated by the Banking Regulation and Supervision Agency (Bankacılık Düzenleme ve Denetleme

Kurumu – BDDK ♦Banks and securities firms regulated by separate bodies ♦Law about Special Finance

Houses covers Islamic banks ♦Dual system; no Islamic windows allowed ♦Basel Committee capital

adequacy requirements and supervisory standards recently introduced ♦Major financial

transformation underway ♦Onsite and offsite supervision concepts and methods exist

UAE Regulated by the Central Bank of UAE ♦Islamic banking law exists ♦Dual system ♦Islamic banking

windows allowed ♦Separate Sharī‘ah boards required ♦Basel Committee capital adequacy

requirements and supervisory standards in place ♦International Accounting Standards in place

Yemen Regulated by the Central Bank of Yemen (CBY) ♦Islamic banking law exists ♦ Dual system ♦Islamic

banking windows allowed ♦Separate Sharī‘ah board required ♦Major policies and standards set by the

CBY are equally applicable to all banks ♦Separate supervisory office for Islamic banks inside the CBY

under active consideration ♦Compliance with the Basel standards not clear

Bangladesh Regulated by Bangladesh Bank, the central bank of the country ♦Dual banking system ♦Window

banking has recently criticized but still available ♦ moving towards Basel II full implementation, and

running Basel III quantitative impact studies ♦separate divisions in central bank to monitor Islamic

banking activities, but now separate law for Islamic banking.

Brunei-

Darussalam

Authority Monetary Brunei Darussalam monitors the monetary issues in Brunei ♦currency is pegged

to Singaporean Dollar ♦separate control authority under AMBD for insurance capital market and

banks ♦both on-site and off-site supervision available using risk-based approach ♦will be

implementing Basel II fully shortly ♦IOSCO standards were also followed ♦dual banking system is

currently at operation.

Comoros Central Bank of Comoros monitors the regulatory issues ♦follows Basel banking supervision standards

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♦central bank is in the midst of developing a new regulatory frameworks for the financial industry

♦has an agreement with Bank of Tanzania for supervision of banks ♦ information on Islamic banking

or banking system was not reported.

Djibouti Central Bank of Djibouti is the primary regulator ♦dual banking system in operation ♦issued separate

law on the establishment of Islamic banking ♦has separate law for monitoring various banking risks

♦maintains the Basel standards for calculating minimum capital requirements

Egypt The economy is monitored by the Central Bank of Egypt ♦both on-site and off-site supervision systems

are present ♦separate Basel II implementation unit ♦long history of Islamic banking ♦dual banking

system ♦expect to see Islamic capital market activity soon.

Iraq Central Bank of Iraq maintain the regulatory atmosphere ♦dual banking system ♦long history of

banking but abrupt political condition has been the major challenge ♦from 2003-04, banks follow

international standards on minimum capital requirement.

Kazakhstan The National Bank of Kazakhstan is the Central Bank ♦dual banking available with only one Islamic

bank ♦no separate Islamic banking act or law ♦follows Basel for risk supervision and prudential

guidelines ♦expects to see the country as the Islamic finance hub of Central Asia.

Lebanon Banque Du Liban or Bank of Lebanon is the Central Bank of Lebanon ♦freely floating exchange rate

♦banking secrecy act is active ♦established free banking zone ♦dual banking system ♦separate law on

Islamic banking operation (from 2004) ♦implementing Basel II capital adequacy accord

Libya The Central Bank of Libya is the center of financial and monetary authority ♦dual banking is active but

expects to change it entirely to Islamic banking ♦recognizes the importance of Basel regulation but has

not yet implemented Basel II

Maldives Maldives Monetary Authority is the Central Bank of Maldives ♦dominated by foreign banks ♦dual

banking available with only one Islamic bank ♦Sukuk market is active ♦separate Islamic banking

regulation act of 2011 ♦implementing Basel II regulations

Morocco Bank Al-Maghrib is the Central Bank of Morocco ♦recognizes Basel II and currently implementing it

♦expects to see more from Islamic banking in future ♦presence of separate Islamic law was not found

Mozambique Bank of Mozambique is the Central Bank ♦July 2014 saw the introduction of a partnership between

Islamic and conventional banks ♦policies in place for dual banking ♦from January 2014; all banks must

implement Basel II.

Nigeria Central Bank of Nigeria recently announced extension of duration to implement the Pillar 1 of Basel II

♦dual banking system ♦no separate law for Islamic banking

Oman Central Bank of Oman established separate regulation for Islamic banking ♦adhered to Basel III capital

adequacy norms ♦dual banking system ♦Islamic window banking ♦Issuance of Sukuk in near future.

Palestine Palestine Monetary Authority controls the financial sector ♦dual banking ♦no window banking ♦no

specific Islamic banking law ♦Basel II is at the implementation stage ♦no Islamic capital market

activity present at this moment

Somalia Central Bank of Somalia is the Central Bank ♦No Islamic windows ♦no dual banking – only Islamic

banking ♦no separate Islamic banking law ♦yet to formulate standards in relation to Basel standards

♦Central Bank recently change the fee structure to a minimum that is required while chartering a bank

Saudi Arabia Saudi Arabian Monetary Association oversees the fiscal policies and regulates the financial sectors

♦dual banking system ♦Islamic banking regulation ♦Basel III implementation since 2013.

Sources: Compiled from Chapra and Khan (2000) Exhibit 1 and authors’ compilation from Central Bank websites and

National Islamic Finance Regulation.

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3.7. SHARIAH-COMPLIANT LENDER OF LAST RESORT FACILITY

The Shariah-compliant Lender of Last Resort, or SLOLR, facility is a financial safety net. It differs from the traditional LOLR in that the financial contracts to support the structure must be Shariah compliant. Open market operations (OMOs) and standing facilities are the two mechanisms used by RSAs for monetary operations of a central bank. According to a survey by the IFSB, RSAs made use of OMOs and standing facilities, but the two tools did not necessarily comply with Shariah and were not suitable for transactions with IIFS. The survey also showed that, in a quarter of the RSAs’ jurisdictions, there did not exist SLOLR facilities, but they did distinguish between conventional financial service institutions and the IIFS. However, nine of the 24 RSAs said that they did have SLOLR facilities and did not distinguish the IIFS from conventional financial service institutions. This result raises a critical issue for the reputability of the IIFS, since conventional LOLR facilities do not comply with Shariah. The lack of SLOLR facilities in some countries is due to missing legal and regulatory frameworks and the small size of the IIFS. The RSAs who have developed a mechanism to provide SLOLR have used Muḍārabah, Mushārakah, Murābahah, Commodity Murābahah, Tawarruq, Qarḍ with Rahn as Shariah compliant mechanisms to provide SLOLR. Each of these mechanisms has their own strengths and weaknesses. The major constraints to the development of SLORL, according to the RSAs participating in the IFSB survey, were the need to modify existing laws and regulations, having a range of Shariah compliant good collaterals available, and setting procedures and guidelines on SLOLR (IFSB 104-114). IIFS provides a guideline on some relevant questions pertaining to SLOLR that may be asked: How are SLOLR mechanisms structured by RSAs? Is an SLOLR mechanism available in the IFSI for IIFS? What is the current assessment of the development of SLOLR facilities as a safety net? Have the monetary tools used by the RSAs been adapted to cater to specificities of IIFS? What are the key challenges and issues that need to be addressed before developing the

SLOLR facilities as a safety net? More recently, the Islamic Financial Services Board (IFSB) has undertaken initiatives to address the guidelines for SLOLR to enhance the risk management and stability of the Islamic financial services industry; the relevant IFSB publications include:

Guiding Principles of Risk Management, December 2005 Technical Note on Issues in Strengthening the Liquidity Management of IIFS: The Development of Islamic Money Markets, March 2008

3.8. DISPUTE RESOLUTION MECHANISM IN ISLAMIC FINANCIAL MARKETS AND IMPLEMENTATION

Effective and efficient dispute resolution requires clarity of the laws governing contracts and agreement on the specific mechanisms to be used in resolving a dispute (Grais 10). One of the major entities responsible for settling financial disputes is the International Islamic Centre for

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Reconciliation & Arbitration (GIFF 2012 12), which is located in the UAE. As mentioned previously, the IICRA focuses on mediating and settling disputes between Shariah compliant financial or commercial institutions. Their work includes resolving disputes between the institutions themselves or institutions and their clients (A Mid-Term Review 99-100).

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CHAPTER 4: COMPARATIVE ANALYSIS OF RISK MATRICES FOR ISLAMIC AND CONVENTIONAL BANKS

This section begins with a brief description of the risk matrices that are used in analyzing the risk management of conventional and Islamic banks from different geographic regions. Later, a brief discussion is provided on the methodology of sample selection. Then, the following section presents a comparative analysis of risk management for conventional and Islamic banks across the geographic regions. Finally, similar comparative analysis of risk management for conventional and Islamic banks is provided for five major Islamic finance markets: Malaysia, Turkey, United Arab Emirates, Kingdom of Saudi Arabia and Bangladesh.

4.1 BRIEF DESCRIPTION OF RISK MATRICES

Risk matrices provided by the BankScope Database can be broadly categorized into four major types: a) Asset quality ratios, b) Capital Adequacy ratios, c) Operational efficiency ratios, and d) Liquidity ratios. While 35 risk matrices are computed in process of risk analysis, only the major risk matrices under each category are presented in this report. The following discussion is a brief overview of the risk matrices used later. Asset Quality Ratios24 Loan Loss Res/Gross Loans: The loan loss reserve over gross loan ratio indicates

how much of the total portfolio has been provided for, but not charged off. It is a reserve for losses expressed as percentage of total loans. Given a similar charge-off policy, the higher the ratio, the poorer will be the quality of the loan portfolio.

Loan Loss Prov / Net Int Rev: Loan loss provision over net interest revenue presents the relationship between provisions in the profit and loss account and the interest income over the same period. Ideally, this ratio should be as low as possible. In a well-run bank, if the lending book is higher in risk, this would be reflected by higher interest margins. If the ratio deteriorates, this means that risk is not being properly remunerated by margins

Loan Loss Res / Impaired Loans: The loan loss reserve over impaired loans (non-performing loans) ratio relates loan loss reserves to non-performing or impaired loans. The higher this ratio, the bette the bank is and the more comfortable we will feel about the assets quality.

NCO / Net Inc Bef Ln Lss Prov: Net charge-off over net income before loan loss provision ratio is measured similarly to charge-offs, but against income generated in the year. The lower this ratio, the better, other things being equal.

Capital Adequacy Ratios Equity / Tot Assets: This ratio measures the ability of the bank to withstand

losses. A declining trend in this ratio may signal increased risk exposure and possibly capital adequacy problem.

24 All definitions of Asset Quality, Capital, Operations and Liquidity were obtained from the BankScope database

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Equity / Net Loans: this ratio measures the equity cushion available to absorb losses on the loan book

Equity / Liabilities: This leverage ratio is simply another way of looking at the equity funding of the balance sheet and is another way of looking at capital adequacy.

Operational Efficiency ratios Net Interest Margin: This ratio is the net interest income expressed as a

percentage of earning assets. The higher this ratio, the cheaper the funding or the higher the margin the bank is commanding. Higher margins and profitability are desirable as long as the asset quality is being maintained

Net Int Rev / Avg Assets25: Net Interest Income over average assets indicates that the item is averaged using the net income expressed as a percentage of the total balance sheet

Pre-Tax Op Inc / Avg Assets: This is a measure of the operating performance of the bank before tax and unusual items. This is a good measure of profitability unaffected by one off non trading activities.

Return On Avg Assets (ROAA) Return On Avg Equity (ROAE) Dividend Pay-Out: This is a measure of the amount of post tax profits paid out to

shareholders. In general, the higher the ratio the better, but not if it is at the cost of restricting reinvestment in the bank and its ability to grow its business.

Liquidity Ratios Interbank Ratio: this is money lent to other banks divided by money borrowed

from other banks. If this ratio is greater than 100, then it indicates the bank is net placer, rather than a borrower, of funds in the market place, and is therefore more liquid.

Net Loans / Cust & ST Funding: This loan to deposit ratio is a measure of liquidity, and high values denote lower liquidity.

Net Loans / Tot Dep & Bor: This ratio has deposits and borrowings, with the exception of capital instruments, as its denominator.

Liquid Assets / Tot Dep & Bor: This ratio is similar to those mentioned above, but looks at the amount of liquid assets available to borrowers as well as depositors.

4.2 SAMPLE SELECTION CRITERIA

For each geographic region, a sample of conventional banks is selected as control sample, where conventional banks are matched with Islamic banks from each country, based on the closest total asset size. Later, risk matrices are calculated for both the Islamic and conventional banks, and a comparative analysis is provided. A similar methodology is used in analyzing

25 The acronym "AVG" stands for the arithmetic mean of the value at the end of year t and t-1

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bank risk matrices for the five selected countries: Malaysia, Turkey, United Arab Emirates, Kingdom of Saudi Arabia and Bangladesh.

4.3 ANALYSIS OF RISK MATRICES ACROSS MAJOR GEOGRAPHIC REGIONS

Among the 57 OIC member countries, 31 countries are considered in the sample based on data availability. These country jurisdictions are generally categorized into three major geographical regions: a) Asian region, b) MENA (Middle East and North Africa) region (which also includes GCC countries), and c) Sub-Saharan African countries.

4.3.1 Asian Region

Islamic banks listed in the BankScope database from Malaysia, Indonesia, Brunei, Singapore, Bangladesh, Philippines, Russia and Pakistan are considered the sample for the Asian region. Based on the data availability, 41 Islamic banks from the mentioned 8 countries are selected for the analysis. The sample includes 41 Islamic banks with an average asset size of 2,923.478 million USD and Total Deposit volume of 2,545.458 million USD. Islamic banks in the region have on, an average, 37.47 branches and 413 employees.

4.3.1.1 Risk Matrices

Asset Quality Ratios Chart 4.1 shows that, for the Asian region, the Asset Quality for the Islamic banks’ loan portfolio is rather poor, compared to that of their conventional counterparts. Average Loan Loss Res/Gross Loans ratio and average loan loss reserve over gross loan ratio for the Islamic banks are 3.42% and 22.11%, which are higher than those of their conventional counterparts of 2.88% and 10.69%, respectively. However, the Islamic banks in general keep higher loan loss reserves, which are represented by higher Loan Loss Res / Impaired Loans ratios. Capital Adequacy Ratios Although the Islamic banks in the Asian region suffer from lower asset quality, compared to their conventional counterparts, the higher Capital Adequacy ratios imply that the Islamic banks keep higher cushions in terms of capital adequacy. Higher Lower Equity/Tot Assets, higher Equity/Net Loans and higher Equity / Liabilities show the additional capital cushion held by the Islamic banks. See Chart 4.2. Operational Efficiency ratios In general, higher operating ratios represent a lower cost of funds, higher efficiency, and higher yields on equity and assets, as shown in Chart 4.3. Higher Net Interest Margins for the Islamic banks represent cheaper sources of funding. However, Pre-Tax Op Inc / Avg Assets ratios of around 0.83% are similar for both the Islamic and conventional banks. The Returns On Avg Equity (ROAE) are higher for the Islamic banks. However, in general, the conventional banks provide higher dividends.

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Liquidity Ratios Interbank Ratios are lower than 100% for both Islamic and conventional banks, which indicate that both types of banks are net borrowers. However, higher ratios of Net Loans / Cust & ST Funding and Net Loans / Tot Dep & Bor. reflect lower liquidity for the Islamic banks, although Islamic banks tend to hold more liquid assets. See Chart 4.4.

Chart 4.1: Asset Quality Ratios for Asia Region

Source: BankScope Database 2013

Chart 4.2: Capital Adequacy Ratio for Asia Region

Source: BankScope Database 2013

3,42

22,11

68,83

27,87

2,88

10,69

58,04

10,26

0

10

20

30

40

50

60

70

80

Loan Loss Res / GrossLoans

%2011

Loan Loss Prov / Net IntRev%

2011

Loan Loss Res / ImpairedLoans

%2011

NCO / Net Inc Bef Ln LssProv

%2011

ASIA Islamic

ASIA Convetional

11,14

17,19

31,03

23,99

7,12

8,84

21,70

7,96

0

5

10

15

20

25

30

35

Tier 1 Ratio%

2011

Total Capital Ratio%

2011

Equity / Net Loans%

2011

Equity / Liabilities%

2011

ASIA Islamic

ASIA Convetional

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Chart 4.3: Operational Efficiency Ratios for Asia Region

Source: BankScope Database 2013

Chart 4.4: Liquidity Ratio for Asia Region

Source: BankScope Database 2013

5,90

3,66 4,05

0,84 0,41

7,60

6,57

2,02 1,71 1,53

0,83 0,72

6,40

16,78

0

2

4

6

8

10

12

14

16

18

Net InterestMargin

%2011

Net Int Rev /Avg Assets

%2011

Non Int Exp /Avg Assets

%2011

Pre-Tax OpInc / Avg

Assets%

2011

Return OnAvg Assets

(ROAA)%

2011

Return OnAvg Equity

(ROAE)%

2011

Dividend Pay-Out%

2011

ASIA Islamic

ASIA Convetional

82,48

42,10

53,48

30,38

76,30

31,54

40,95

19,03

0

10

20

30

40

50

60

70

80

90

Interbank Ratio%

2011

Net Loans / Tot Assets%

2011

Net Loans / Dep & STFunding

%2011

Liquid Assets / Dep & STFunding

%2011

ASIA Islamic

ASIA Convetional

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4.3.2 Mena Region

For the analysis of the MENA Islamic banking sector, only the Islamic banks listed in the BankScope database are considered. Such Islamic banks are domiciled in Bahrain, Egypt, Iran, Iraq, Jordan, Kuwait, Lebanon, Morocco, Oman, Qatar, Saudi Arabia, Syria, Tunisia, United Arab Emirates, West Bank and Gaza, Yemen. Based on data availability, 68 Islamic banks from the mentioned 16 countries are selected for the analysis. The sample includes 68 Islamic banks with an average asset size of 5,847.867 million USD and average Total Deposit volume of 4,434.627 million USD. Islamic banks in the region have on average 28.51 branches and 550 employees.

4.3.2.1 Risk Matrices

Asset Quality Ratios For the MENA region, although the Average Loan Loss Res/Gross Loans ratio is higher for Islamic banks, other asset quality ratios are lower. In general, Islamic banks hold a better loan portfolio, compared to their conventional counterparts. Average Loan Loss Res/Gross Loans ratio and average loan loss reserve over gross loan ratio for the Islamic banks are 7.69% and 9.78%, compared to that of their conventional counterparts of 3.21% and 16.05% respectively. (See Chart 4.8) Capital Adequacy Ratios Higher capital adequacy ratios for the Islamic banks show that they keep higher equity cushions to cover risk exposure and avoid the capital adequacy problem. All of the four capital adequacy ratios are, on average, higher for the Islamic banks, compared to those of the conventional banks. See Chart 4.6. Operational Efficiency ratios In general, higher operating ratios represent a lower cost of funds, higher efficiency, and higher yields on equity and assets. The higher Net Interest Margins of the Islamic banks represent cheaper sources of funding. Pre-Tax Op Inc / Avg Assets, Return On Avg Assets (ROAA) and Return On Avg Equity (ROAE) are all higher for the Islamic banks. However, the conventional banks pay out more dividends, around 16.74%, compared to 8.46% for Islamic banks. See Chart 4.7. Liquidity Ratios Interbank Ratios of greater than 100 indicate the bank is a net lender, rather than a borrower, and implies higher liquidity. Interbank ratios for the Islamic banks are marginally lower than 100, which indicate that the Islamic banks are generally borrowers in the interbank market, whereas their conventional counterparts are lenders (See Chart 4.8). The higher Liquid Assets / Tot Dep & Bor ratios for the Islamic banks of 63.31%, compared to the conventional banks’ 17.27% indicate that Islamic banks tend to hold more liquid assets in their portfolio.

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Chart 4.5: Asset Quality Ratios for MENA Region

Source: BankScope Database 2013

Chart 4.6: Capital Adequacy Ratio for MENA Region

Source: BankScope Database 2013

7,70 9,78

35,23

3,12 3,22

16,05

53,38

13,09

0

10

20

30

40

50

60

Loan Loss Res / Gross Loans%

2011

Loan Loss Prov / Net Int Rev%

2011

Loan Loss Res / ImpairedLoans

%2011

NCO / Net Inc Bef Ln LssProv

%2011

MENA ISLAMIC MENA Convetional

9,94 14,53

45,38

64,45

8,58 10,51

14,08

9,23

0

10

20

30

40

50

60

70

Tier 1 Ratio%

2011

Total Capital Ratio%

2011

Equity / Net Loans%

2011

Equity / Liabilities%

2011

MENA ISLAMIC MENA Convetional

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Chart 4.7: Operational Efficiency Ratios for MENA Region

Source: BankScope Database 2013

Chart 4.8: Liquidity Ratio for MENA Region

Source: BankScope Database 2013

2,14 1,44

2,95

0,72 0,72

4,92

8,46

1,80 1,56 1,34 0,70 0,70

4,26

16,74

0

2

4

6

8

10

12

14

16

18

Net InterestMargin

%2011

Net Int Rev / AvgAssets

%2011

Non Int Exp / AvgAssets

%2011

Pre-Tax Op Inc /Avg Assets

%2011

Return On AvgAssets (ROAA)

%2011

Return On AvgEquity (ROAE)

%2011

Dividend Pay-Out%

2011

MENA ISLAMIC MENA Convetional

99,70

30,75

53,95 63,31

111,59

31,63

41,41

17,27

0

20

40

60

80

100

120

Interbank Ratio%

2011

Net Loans / Tot Assets%

2011

Net Loans / Dep & ST Funding%

2011

Liquid Assets / Dep & STFunding

%2011

MENA ISLAMIC MENA Convetional

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4.3.3 Sub-Sahara Africa Region

Only the Islamic banks from Sudan and Gambia are listed in the BankScope database. Based on data availability, 8 Islamic banks from these two countries are selected for this analysis. Sudan represents a unique financial system, whereby only Shariah compliant financial services are provided. Due to lack of sufficient data, Islamic banks from Gambia are not included in the analysis. The sample includes 8 Islamic banks from Sudan, with an average asset size of 469.082 million USD and average Total Deposit volume of 224.137 million USD. Islamic banks in the region have, on average, 6.38 branches and 103 employees.

4.3.3.1 Risk Matrices

Asset Quality Ratios For the Sub-Saharan region, especially for Sudan, only the Islamic banks are considered, as the legal system in Sudan now sustains only Islamic, Shariah compliant banking. Islamic banks in Sudan exhibit an average Loan Loss Res/Gross Loans ratio of 3.02% and a Loan Loss Res / Impaired Loans ratio of 4.91%, which is generally lower than many other peer Islamic banks in other geographic areas. (See Chart 4.9) Capital Adequacy ratios In general, the Islamic banks in Sudan maintain a significant cushion to cover their risk exposure and possibly capital adequacy problem. Most of the capital ratios are higher than other peer Islamic banks. Higher Equity / Net Loans reflect a higher cushion to absorb losses on the loan book. (See Chart 4.10) Operational Efficiency ratios In general, higher operating ratios represent lower cost of funds, higher efficiency and higher yields on equity and assets. Although Islamic banks in Sudan do not exhibit high Net Interest Margins (2.57%), they have healthy ROAEs and provide higher dividend payouts (20.43%), compared with their peers in other regions. (See Chart 4.11) Liquidity Ratios Islamic banks in Sudan keep a significant portion of their portfolio invested in liquid assets. The high ratio of Liquid Assets / Tot Dep & Bor reflects higher liquidity. (Refer to Chart 4.12)

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Chart 4.9: Asset Quality Ratios for Sub-Saharan Africa Region

Source: BankScope Database 2013

Chart 4.10: Capital Adequacy Ratio for Sub-Saharan Africa Region

Source: BankScope Database 2013

Chart 4.11: Operational Efficiency Ratios for Sub-Saharan Africa Region

Source: BankScope Database 2013

3,02

-8,55

4,92

-2,45

-10

-8

-6

-4

-2

0

2

4

6

Loan Loss Res / GrossLoans

%2011

Loan Loss Prov / Net IntRev%

2011

Loan Loss Res / ImpairedLoans

%2011

NCO / Net Inc Bef Ln LssProv

%2011

SUB SAHARAN Islamic

7,31 5,08

39,18

19,17

0

5

10

15

20

25

30

35

40

45

Tier 1 Ratio%

2011

Total Capital Ratio%

2011

Equity / Net Loans%

2011

Equity / Liabilities%

2011

SUB SAHARAN Islamic

2,57 1,80 2,77 0,48

1,55

10,33

20,43

0

5

10

15

20

25

Net InterestMargin

%2011

Net Int Rev /Avg Assets

%2011

Non Int Exp /Avg Assets

%2011

Pre-Tax Op Inc /Avg Assets

%2011

Return On AvgAssets (ROAA)

%2011

Return On AvgEquity (ROAE)

%2011

Dividend Pay-Out%

2011

SUB SAHARAN Islamic

SUB SAHARAN Islamic

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Chart 4.12: Liquidity Ratio for Sub-Saharan Africa Region

Source: BankScope Database 2013

4.4 ANALYSIS OF RISK MATRICES ACROSS FIVE MAJOR COUNTRY JURISDICTIONS

This section presents a comparative analysis of the risk matrices for the Islamic and conventional banks for five major Islamic financial markets: a) Malaysia, 2) Turkey, 3) Kingdom of Saudi Arabia, 4) United Arab Emirates, and 5) Bangladesh.

4.4.1 Malaysia

4.4.1.1 Overview of Malaysian Islamic Finance Services Industries

Malaysia is the largest Islamic financial hub in the Asia-Pacific region, with total Islamic financial assets worth USD272.5 billion as of the end of 2011. Malaysia is home to a wide range of investment, wholesale, retail and structured products for a range of purposes and sectors. Islamic financial institutions currently use a wide range of Shariah contracts and innovative instruments, such as profit and FOREX rate swaps, which have been accepted globally. (GIFF 2012) The country also provides an efficient regulatory environment that is conducive for the Islamic financial services industries (IFSI). Under the existing legal framework, both conventional and Islamic financial systems coexist and work together harmoniously in a competitive environment.

16,46

47,72 49,88

0

10

20

30

40

50

60

Interbank Ratio%

2011

Net Loans / Tot Assets%

2011

Net Loans / Dep & STFunding

%2011

Liquid Assets / Dep & STFunding

%2011

SUB SAHARAN Islamic

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4.4.1.2 Malaysian Banking Sector

The following analysis uses data from 15 Malaysian Islamic banks for which data is available on the BankScope database. The banks are: Alkhair International Islamic Bank Berhad, Asian Finance Bank Berhad, OCBC Al-Amin Bank Berhad, Standard Chartered Saadiq Berhad, Al Rajhi Banking & Investment Corporation (Malaysia) Berhad, Alliance Islamic Bank Berhad, Kuwait Finance House (Malaysia) Berhad, HSBC Amanah Malaysia Berhad, Affin Islamic Bank Berhad, Bank Muamalat Malaysia Berhad, RHB Islamic Bank Berhad, AmIslamic Bank Berhad, Public Islamic Bank Berhad, Bank Islam Malaysia Berhad, CIMB Islamic Bank Berhad, Maybank Islamic Berhad and Hong Leong Islamic Bank Berhad. Average total assets in the Malaysian Islamic bank sample is 5,727 million USD, with average deposits of 5,085 million USD.

4.4.1.3 Risk Matrices

Asset quality ratios For the Malaysian banking sector, the Asset Quality for the Islamic bank loan portfolio is rather poor, compared to those of their conventional counterparts. Average Loan Loss Res/Gross Loans ratios and average loan loss reserve over gross loan ratios for the Islamic banks are 3.20% and 33.83%, which are higher than those of their conventional counterparts of 2.98% and 4.02%, respectively. (See Chart 4.13) Capital Adequacy ratios Islamic banks in Malaysia, in general, maintain higher capital adequacy ratios in both the Tier 1 Ratio (13.62%) and Total Capital Ratio (15.74%), compared to their conventional counterparts, with 8.89% and 11.14%, respectively. Islamic banks also maintain higher Equity / Liabilities ratios, compared to conventional banks. (See Chart 4.14) Operational Efficiency ratios Chart 4.15 shows that Malaysian Islamic banks, on average, have higher net interest margins (3.02%) and net interest revenue to average assets (2.29%), compared to the conventional banks ratios of 2.16% and 1.67%, respectively. These reflect the cheaper sources of funding for Islamic banks. However, conventional banks have higher dividend payout ratios and yields on equity and assets. Liquidity Ratio An Interbank Ratio of greater than 100 indicates that the bank is a net lender, rather than a borrower and resembles higher liquidity. Both Islamic and conventional banks are, in general, borrowers in the interbank market, but Islamic banks have higher liquidity. For the Islamic banks, Net loans to total assets (52.86%) and net loans to deposits and short term funding (60.59%) are higher, compared to those of conventional banks of 48.43% and 58.05%, respectively (See Chart 4.16)

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Chart 4.13: Asset Quality Ratios for Malaysian Banks

Source: BankScope Database 2013

Chart 4.14: Capital Adequacy Ratio for Malaysian Banks

Source: BankScope Database 2013

2,99 4,02

126,20

6,75 3,20

33,83

116,29

80,98

0

20

40

60

80

100

120

140

Loan Loss Res / GrossLoans

%2011

Loan Loss Prov / Net IntRev%

2011

Loan Loss Res / ImpairedLoans

%2011

NCO / Net Inc Bef Ln LssProv

%2011

Malaysia Conventional Malaysia Islamic

2,99 4,02

126,20

6,75 3,20

33,83

116,29

80,98

0

20

40

60

80

100

120

140

Loan Loss Res / GrossLoans

%2011

Loan Loss Prov / Net IntRev%

2011

Loan Loss Res / ImpairedLoans

%2011

NCO / Net Inc Bef Ln LssProv

%2011

Malaysia Conventional Malaysia Islamic

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Chart 4.15: Operational Efficiency Ratios for Malaysian Banks

Source: BankScope Database 2013

Chart 4.16: Liquidity Ratio for Malaysian Banks

Source: BankScope Database 2013

4.4.2 Republic Of Turkey

Located between Asia and Europe, Turkey has a developed financial market with a large potential consumer base for the Islamic financial services industry. Turkey is home to a diverse option of deposit and financing facilities for both corporate and commercial clients. The Islamic capital markets remain relatively nascent, however, with Ijarah being the main principle for fund raising activities. The country has a well-regulated stock exchange that has both sukuk and Shariah-compliant ETFs listed. In addition, the central bank supports Shariah-

2,16 1,68 1,15 1,40 1,12

13,58

49,81

3,03 2,29 2,13 0,21 0,35 7,35 11,28

0

10

20

30

40

50

60

Net InterestMargin

%2011

Net Int Rev /Avg Assets

%2011

Non Int Exp /Avg Assets

%2011

Pre-Tax OpInc / Avg

Assets%

2011

Return OnAvg Assets

(ROAA)%

2011

Return OnAvg Equity

(ROAE)%

2011

DividendPay-Out

%2011

Malaysia Conventional Malaysia Islamic

34,04

48,44

58,05

31,36

87,19

52,86 60,59

27,32

0

10

20

30

40

50

60

70

80

90

100

Interbank Ratio%

2011

Net Loans / Tot Assets%

2011

Net Loans / Dep & STFunding

%2011

Liquid Assets / Dep & STFunding

%2011

Malaysia Conventional Malaysia Islamic

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compliant money market instruments known as lease certificates to enhance liquidity for the Islamic banks.

4.4.2.1 Turkish Banking Sector

The following analysis consists of 4 Turkish Islamic banks for which data is available on the BankScope database. The banks are: Albaraka Turk Participation Bank-Albaraka Turk Katilim Bankasi AS, Kuveyt Turk Katilim Bankasi A.S.-Kuwait Turkish Participation Bank Inc, Asya Katilim Bankasi AS-Bank Asya and Turkiye Finans Katilim Bankasi AS. Average total assets for the Turkish Islamic bank sample is 5,540 million USD, with average deposits of 4,470 million USD. Islamic banks have, on average, 1,786 employees and an average number of 80.5 branches each.

4.4.2.2 Overview of Turkish Banking Sector Performance

The following analysis on the overall performance of the Turkish banking sector is based on the dataset provided by The Turkish Banking Sector Interactive Bulletin 2014 (see: http://ebulten.bddk.org.tr/ABMVC/en ) that discloses financial statements, information, and key financial performance ratios for the Turkish financial sector. The financial ratios are calculated as the sector average for participating institutions and depository institutions and can be broadly categorized into four broader types: a) Asset Quality, b) Capital adequacy, c) Operational Efficiency and d) Liquidity. Yearly interval data for the period of 2003 to 2014 are used for the following analysis. Generally, Islamic banks and financial institutions are identified as participation institutions, while the conventional banks and financial institutions are identified as deposit institutions in the Turkish Banking Sector Interactive Bulletin 2014 database. Asset Quality Two ratios, a) Non-Performing Loans (Gross) / Total Cash Loans (%)-Ratio and b) Provision for Non-Performing Loans / Gross Non-Performing Loans (%), ratios are cited in the database. Chart 4.17 and Chart 4.18 graphically present the trends for Non-Performing Loans (Gross) / Total Cash Loans (%)-Ratio and Provision for Non-Performing Loans / Gross Non-Performing Loans (%)-Ratio, respectively. During the 2005 to 2014 period, the average Non-Performing Loans (Gross) / Total Cash Loans (%) Ratio has been steadily decreasing (from 5.67% in 2005 to 2.88% in 2014) over the years for the depository institutions, which are conventional banks. For the Islamic banks, identified as participation institutions, the trend is also decreasing (from 5.74% in 2005 to 3.77% in 2014), but the ratios are generally higher, compared to the conventional banks, which suggests a lower asset quality for Islamic banks. The Provision for Non-Performing Loans / Gross Non-Performing Loans (%)-Ratio is also showing a downward trend in general as a result of improving asset quality for both Islamic banks (from 69.22% in 2005 to 63.19% in 2014) and conventional banks (from 89.49% in 2005 to 77.45% in 2014). However, in general, conventional banks keep higher provisions, compared to the Islamic banks.

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Chart 4.17: Non-Performing Loans (Gross) / Total Cash Loans (%)-Ratio

Source: Turkish Banking Sector Interactive Bulletin 2014

Chart 4.18: Provision for Non-Performing Loans / Gross Non-Performing Loans (%)-Ratio

Source: Turkish Banking Sector Interactive Bulletin 2014

Capital Adequacy Ratios For capital adequacy, two ratios are considered, a) Demand Deposit (Funds Collected) / Total Deposit (Funds Collected) (%) Ratio and b) Shareholder's Equity Ratios / Total Risk Weighted Assets (%) Ratio, which are presented in Chart 4.19 and Chart 4.20, respectively. The Demand Deposit (Funds Collected) / Total Deposit (Funds Collected) (%)-Ratio does not reveal any specific trend over the 2005 to 2014 period for the conventional and Islamic banks; however, the Islamic banks, in general, tend to have higher ratios, compared to the conventional banks. On the other hand, Islamic banks generally maintain lower Shareholder's Equity Ratios / Total Risk Weighted Assets (%)-Ratios, compared to their conventional counterparts. (see Chart 4.19 and Chart 4.20).

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Chart 4.19: Demand Deposit (Funds Collected) / Total Deposit (Funds Collected) (%)-Ratio

Source: Turkish Banking Sector Interactive Bulletin 2014

Chart 4.20: Shareholder's Equity Ratios / Total Risk Weighted Assets (%)-Ratio

Source: Turkish Banking Sector Interactive Bulletin 2014

Operational Efficiency Ratios Two sets of operational efficiency ratios are analyzed. The first set consists of the return ratios, namely a) Net Income / Average Total Assets (%)-Ratio, b) Net Income / Average Shareholder's Equity (%)-Ratio, c) Total Interest (Profit Share) Income / Interest (Profit) Bearing Assets Average (%)-Ratio, d) Net Interest (Profit) Revenues (Expenses) / Average Total Assets (%)-Ratio Fees, and e) Commission and Banking Services Revenues / Average Total Assets (%)-Ratio, as depicted in Chart 4.21 through Chart 4.25, respectively. From 2005 to 2014, ROA or Net Income / Average Total Assets (%) for the conventional banks has been consistently higher than those of the Islamic banks. However, for both types of banks, ROAs are decreasing over time. A similar trend is also evident for ROEs, or Net Income /

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Average Shareholder's Equity (%). Generally, ROEs for conventional banks are higher than those of Islamic banks. The Total Interest (Profit Share) Income / Interest (Profit) Bearing Assets Average (%) Ratio exhibits a decreasing trend for both the conventional banks (from 6.14% in 2005 to 3.32% in 2014) and the Islamic banks (from 5.49% in 2005 to 3.12% in 2014), and the ratios are consistently higher for the conventional banks. The Net Interest (Profit) Revenues (Expenses) / Average Total Assets (%) Ratio also shows a similar decreasing pattern for both conventional banks (from 2.45% in 2005 to 1.38% in 2014) and Islamic banks (from 2.20% in 2005 to 1.29% in 2014). The Fees, Commission and Banking Services Revenues / Average Total Assets (%) Ratio represents the contribution of non-interest earning revenues and also shows a consistent downward over the sample period for both the conventional and Islamic banks; however, the ratios are generally higher for the Islamic banks.

Chart 4.21: Net Income / Average Total Assets (%)-Ratio

Source: Turkish Banking Sector Interactive Bulletin 2014

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Chart4. 22: Net Income / Average Shareholder's Equity (%)-Ratio

Source: Turkish Banking Sector Interactive Bulletin 2014

Chart 4.23: Total Interest (Profit Share) Income/Interest (Profit) Bearing Assets Average(%)-ratio

Source: Turkish Banking Sector Interactive Bulletin 2014

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Chart 4.24: Net Interest (Profit) Revenues (Expenses) / Average Total Assets (%)-Ratio

Source: Turkish Banking Sector Interactive Bulletin 2014

Chart 4.25: Fees, Commission and Banking Services Revenues / Average Total Assets (%)-Ratio

Source: Turkish Banking Sector Interactive Bulletin 2014

The Second set of operational efficiency ratios focuses on the uses of branches (see Chart 4.26 and Chart 4.27) and the performance of staff (see Chart 4.28). The Average Total Assets/Average Number of Total Staff Ratio exhibits an increasing trend for both the conventional banks (from USD 2446.44 asset /per staff in 2005 to USD 8428.96 asset /per staff in 2014) and the Islamic banks (from USD 1459.42 asset /per staff in 2005 to USD 5590.46 asset /per staff in 2014). However, the ratios are generally lower for the Islamic banks. Similarly, the Total Deposit (Funds Collected)/Average Number of Total Staff ratios show an increasing trend for both conventional banks (from USD 1602.80deposit /per staff in 2005 to USD 4642.83deposit/per staff in 2014) and Islamic banks (from USD 1315.39 deposit /per staff in 2005 to USD 3478.24 deposit/per staff in 2014).

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The Profit (Loss) Before Tax / Average Total Number of Staff Ratio has also increased during the sample period, from 41.58% in 2005 to 57.29% in 2014 for the conventional banks and from 15.96% in 2005 to 44.21% in 2014 for the Islamic banks. At the branch level, both the Total Deposit (Funds Collected)/Total Number of Branches Ratio and Loans/Total Number of Branches Ratios exhibit upward trends, which are similar to the staff efficiency ratios.

Chart 4.26: Staff Performance (Average Total Assets / Average Number of Total Staff-Ratio &

Total Deposit (Funds Collected) / Average Number of Total Staff-Ratio)

Source: Turkish Banking Sector Interactive Bulletin 2014

Chart 4.27: Profit (Loss) Before Tax / Average Total Number of Staff-Ratio

Source: Turkish Banking Sector Interactive Bulletin 2014

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Chart 4.28: Branch Performance (Total Deposit (Funds Collected)/Total Number of Branches-Ratio & Loans/Total Number of Branches-Ratio)

Source: Turkish Banking Sector Interactive Bulletin 2014

Liquidity Ratios Two liquidity ratios are analyzed, a) Weighted Average Maturity of Securities (Day) Ratio and b) Weighted Average Maturity of Securities Held for Trading (Day) Ratio. An Increasing trend in the Weighted Average Maturity of Securities (Day) Ratio suggests that, in general, Turkish conventional banks are investing more in less liquid assets. However, the trend is otherwise different and downward since 2007 for Islamic banks. Generally, the Islamic banks tend to hold lower ratios (568.91 in 2009 and decreasing towards 419.09 in 2014), compared to their conventional counterparts (1203.20 in 2009 and increasing towards 1938.50 in 2014). The trend in the Weighted Average Maturity of Securities Held for Trading (Day) Ratio is rather stable for conventional banks. However, for the Islamic banks, the trend shows some interesting caveats. After 2008, Islamic banks have stopped holding securities for trading purpose, as the ratios are zero since 2009.

Chart 4.29: Weighted Average Maturity of Securities (Day)-Ratio

Source: Turkish Banking Sector Interactive Bulletin 2014

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Chart 4.30: Weighted Average Maturity of Securities Held for Trading (Day)-Ratio

Source: Turkish Banking Sector Interactive Bulletin 2014

4.4.2.3 Risk Matrices

The following the comparison between the risk matrices for Islamic and conventional banks in the Turkish banking sector is based on the BankScope dataset. Asset Quality Ratios Asset qualities for the Turkish Islamic banks are mixed when compared to their conventional banking competitors. While the Average Loan Loss Res/Gross Loans ratio is lower for Islamic banks at 2.11%, compared to that of the conventional banks of 4.97%, other ratios are higher. (See Chart 4.31) Capital Adequacy ratios In general, conventional banks in Turkey keep a higher capital cushion, compared to their Islamic banking counterparts. Chart 4.32 shows that The Equity / Tot Assets ratio and the Equity / Net Loans ratio of the Islamic banks, at 9.76% and 10.87%, respectively, are lower than those of the conventional banks, at 10.52% and 15.29%, respectively. These ratios reflect the fact that Islamic banks in Turkey may be prone to insolvency risk compared to conventional banks at the advent of financial crisis. Operational Efficiency ratios In general, higher operating ratios represent lower cost of funds, higher efficiency, and higher yields on equity and assets. Higher ratios for NIM, Net Int Rev/Average Asset and Non Int Exp/ Avg Assets for the Turkish conventional banks (4.93%, 4.45% and 4.47%), compared to those of the Islamic banks (3.48%, 2.94% and 3.19%) reflect that conventional banks, in general, enjoy benefits from cheaper sources of funding. However, the Return On Avg Assets (ROAA) and Return On Avg Equity (ROAE) are both higher for Islamic banks (1.24% and 11.05%),

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compared to that of conventional banks (1.04% and 8.23%). However, conventional banks have higher dividend payout ratios. (See Chart 4.33) Liquidity Ratios Chart 4.34 shows that, on average, Islamic banks in Turkey maintain a better liquidity position, compared to conventional banks. The Interbank ratio of 139% for the Islamic banks suggests that they are lenders to the interbank market, while the conventional banks are borrowers on average, with an average interbank ratio of 82.97%. Higher ratios of Net Loans / Cust & ST Funding and Net Loans / Tot Dep & Bor. imply lower liquidity, which is the representative trend for conventional banks, compared to Islamic banks.

Chart 4.31: Asset Quality Ratios for Turkish Banks

Source: BankScope Database 2013

Chart 4.32: Capital Adequacy Ratio for Turkish Banks

Source: BankScope Database 2013

4,97 6,20

105,86

19,08

2,12

18,61

76,29

14,86

0

20

40

60

80

100

120

Loan Loss Res / Gross Loans%

2011

Loan Loss Prov / Net Int Rev%

2011

Loan Loss Res / ImpairedLoans

%2011

NCO / Net Inc Bef Ln LssProv

%2011

Turkey Conventional Turkey Islamic

10,52

15,30

22,36

13,70

9,76 10,87 11,21

9,28

0

5

10

15

20

25

Tier 1 Ratio%

2011

Total Capital Ratio%

2011

Equity / Net Loans%

2011

Equity / Liabilities%

2011

Turkey Conventional Turkey Islamic

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Chart 4.33: Operational Efficiency Ratios for Turkish Banks

Source: BankScope Database 2013

Chart 4.34: Liquidity Ratio for Turkish Banks

Source: BankScope Database 2013

4,93 4,45 4,47

0,79 1,05

8,23

12,83

3,48 2,94 3,19

1,08 1,24

11,05

3,61

0

2

4

6

8

10

12

14

Net InterestMargin

%2011

Net Int Rev / AvgAssets

%2011

Non Int Exp /Avg Assets

%2011

Pre-Tax Op Inc /Avg Assets

%2011

Return On AvgAssets (ROAA)

%2011

Return On AvgEquity (ROAE)

%2011

Dividend Pay-Out%

2011

Turkey Conventional Turkey Islamic

82,96

56,02

74,53

26,22

139,11

54,43

67,09

14,27

0

20

40

60

80

100

120

140

160

Interbank Ratio%

2011

Net Loans / Tot Assets%

2011

Net Loans / Dep & STFunding

%2011

Liquid Assets / Dep & STFunding

%2011

Turkey Conventional Turkey Islamic

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4.4.3 Kingdom Of Saudi Arabia (K.S.A.)

One of the pioneers in establishing the Islamic Developmental Bank back in 1975, The Kingdom of Saudi Arabia (hereafter KSA), is an oil-rich vibrant economy with an existing large market for Islamic financial services. In addition, the increased state spending for infrastructure projects going forward provides a huge potential for growth in Shariah-compliant project finance. KSA is the home of one of the world’s largest Islamic banks and has established Islamic finance research bodies. At present, both conventional banks and Islamic banks are governed by the same legal system under the supervision of the Saudi Arabian Monetary Agency (SAMA). More recently, Saudi Arabia’s cabinet approved its first ever mortgage law within the country.

4.4.3.1 Saudi Banking Sector

The following analysis consists of 4 KSA Islamic banks for which data is available on the BankScope database. The banks are: Bank AlBilad, Alinma Bank, Islamic Development Bank, and Al Rajhi Bank Average total assets of the KSA Islamic bank is 22,997 million USD, with average deposits of 14,941 million USD. Islamic banks in KSA employ an average of 3,532 workers across 153.75 branches. Risk Matrices Asset Quality Ratios Chart 4.35 shows that, for the KSA banking sector, the Asset Quality for the Islamic banks’ loan portfolio is better, compared to that of their conventional counter parts. The Average Loan Loss Res/Gross Loans ratio for the Islamic banks is 2.73%, which is lower than that of their conventional counterparts of 4.68%. However, the conventional banks maintain higher loan loss reserves (130.55%), compared to the Islamic banks with 120.84%. Capital Adequacy ratios In general, Islamic banks in KSA maintain better capital adequacy, as evident by the capital adequacy ratios. A Higher Equity / Tot Assets ratio for the Islamic banks of 18.54% represents less risk exposure and a higher capital cushion during the financial crisis, compared to that of the conventional banks of 16.24%. Higher Equity/Net Loans ratios for the Islamic banks reflect that Islamic banks more cushions to absorb losses on the loan books. (See Chart 4.36) Operational Efficiency ratios In general, Islamic banks in KSA have higher cost of funds and lower efficiency, which is reflected in a lower ROE. Chart 4.37 shows that a Higher Net Interest Margin for the Islamic banks of 4.079% represents cheaper sources of funding, compared to the conventional bank ratio of 2.73%. In addition, the Pre-Tax Op Inc / Avg Assets ratio is lower for Islamic banks at 0.91%, compared to the conventional bank ratio of 1.70%. Also, in general, conventional banks provide higher dividend payouts at an average of 44.70%, compared to the Islamic bank average of 13.98%.

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Liquidity Ratios An Interbank Ratio of greater than 100 indicates the bank is net lender, rather than a net borrower and resembles higher liquidity. Both the Islamic banks (175.29%) and conventional banks (185.63%) maintain higher interbank ratios, which means that both types of banks are lenders to the interbank market. A higher ratio for Net Loans / Cust & ST Funding maintained by the Islamic banks (61.75%) represents lower liquidity, compared to conventional banks (53.73%). (See Chart 4.38)

Chart 4.35 : Asset Quality Ratios for Kingdom of Saudi Arabia (K.S.A.)

Source: BankScope Database 2013

Chart 4.36: Capital Adequacy Ratio for Kingdom of Saudi Arabia (K.S.A.)

Source: BankScope Database 2013

4,67 12,66

130,55

3,45 2,73

16,51

120,84

4,80

0

20

40

60

80

100

120

140

Loan Loss Res / GrossLoans

%2011

Loan Loss Prov / Net IntRev%

2011

Loan Loss Res / ImpairedLoans

%2011

NCO / Net Inc Bef Ln LssProv

%2011

KSA Conventional KSA Islamic

16,24 18,10

26,11

16,12 18,54 20,62

52,54

71,54

0

10

20

30

40

50

60

70

80

Tier 1 Ratio%

2011

Total Capital Ratio%

2011

Equity / Net Loans%

2011

Equity / Liabilities%

2011

KSA Conventional KSA Islamic

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Chart 4.37: Operational Efficiency Ratios for Kingdom of Saudi Arabia (K.S.A.)

Source: BankScope Database 2013

Chart 4.38: Liquidity Ratio for Kingdom of Saudi Arabia (K.S.A.)

Source: BankScope Database 2013

2,74 2,44 1,84 1,71 1,69

12,71

44,70

4,08 3,45 2,99 0,91 1,87

9,41

13,98

0

5

10

15

20

25

30

35

40

45

50

Net InterestMargin

%2011

Net Int Rev /Avg Assets

%2011

Non Int Exp /Avg Assets

%2011

Pre-Tax Op Inc/ Avg Assets

%2011

Return On AvgAssets (ROAA)

%2011

Return On AvgEquity (ROAE)

%2011

Dividend Pay-Out%

2011

KSA Conventional KSA Islamic

185,63

53,73 65,47

18,51

175,29

61,76 65,41

21,15

0

20

40

60

80

100

120

140

160

180

200

Interbank Ratio%

2011

Net Loans / Tot Assets%

2011

Net Loans / Dep & STFunding

%2011

Liquid Assets / Dep & STFunding

%2011

KSA Conventional KSA Islamic

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4.4.4 United Arab Emirates (UAE)

Located in the Gulf region, the U.A.E. provides vibrant environment for the Islamic financial services industry to grow. The country has a relatively comprehensive regulatory environment to promote Islamic finance. More recent developments in the Islamic banking sector are aimed at innovating instruments to cater for market demand, especially Shariah-compliant liquidity instruments. In addition, the U.A.E. provides infrastructure and advanced facilities to promote foreign investors. The country also provides attractive business opportunities for foreign direct investors, like many Free Trade Zones across UAE with attractive incentives for new startups, i.e. 100.0% tax exemption.

4.4.4.1 U.A.E. Banking Sector

The following analysis consists of data from 8 U.A.E. Islamic banks for which data is available on the BankScope database. The banks are: (8) Ajman Bank, Tamweel PJSC, Noor Bank, Sharjah Islamic Bank, Emirates Islamic Bank PJSC, Al Hilal Bank PJSC, Abu Dhabi Islamic Bank - Public Joint Stock Co., Dubai Islamic Bank PJSC, and Amlak Finance PJSC . Average total assets of the U.A.E. Islamic bank are 8,004 million USD, with average deposits of 6,137 million USD. Islamic banks, on average, employ 87 workers across 8.89 branches.

4.4.4.2 Risk Matrices

Asset Quality Ratios Chart 4.39 shows that, for the U.A.E. banks, the Asset Quality of the Islamic banks’ loan portfolios is rather poor, compared to that of their conventional counterparts. The average Loan Loss Res/Gross Loans ratio and average loan loss reserve over gross loan ratio for the Islamic banks are 5.01% and 38.84%, which are higher than that of their conventional counterparts at 4.52% and 27.99%, respectively. In addition, Islamic banks also maintain lower loan loss reserve/ impaired loans ratios (70.23%) and a negative average NCO/ Net Inc Bef Ln Loss Prov ratio (-2.71%), compared to those of the conventional banks of 73.86% and 11.61%, respectively. Capital Adequacy ratios In general, Islamic banks in the U.A.E. maintain lower Equity / Tot Assets ratios (13.15%), compared to conventional banks with an average of 13.15%, which represents higher risk exposure. Additionally, the Equity / Net Loans and Equity / Liabilities ratios for the Islamic banks are 21.08% and 17.64%, which are lower than those of the conventional banks of 25.84% and 20.00%, respectively. (See Chart 4.40) Operational Efficiency ratios A higher average Net Interest Margin for the conventional banks (3.26%) represents cheaper sources of funding that the conventional banks enjoy over their Islamic banking counterparts (2.86%). In addition, Chart 4.41 also shows that conventional banks provide higher ROAs and

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ROEs (1.30% and 8.08%), compared to Islamic banks (0.52% and 3.19%, respectively). Conventional banks have also higher dividend payouts. Liquidity Ratios Interbank ratios for both the conventional banks (344.15%) and Islamic banks (150.37%) in the U.A.E. are greater than 100%, which means that both types of banks are net lenders and maintain higher levels of liquidity. However, Higher ratios of Net Loans / Cust & ST Funding and Net Loans / Tot Dep & Bor for Islamic banks (59.58% and 83.84%), compared to conventional bank (57.14% and 77.5%, respectively) suggest that the Islamic banks have relatively lower liquidity. (See Chart 4.42)

Chart 4.39: Asset Quality Ratios for United Arab Emirates (UAE) Banks

Source: BankScope Database 2013

4,52

27,99

73,86

11,61

5,01

38,84

70,23

-2,71

-10

0

10

20

30

40

50

60

70

80

Loan Loss Res / GrossLoans

%2011

Loan Loss Prov / Net IntRev%

2011

Loan Loss Res / ImpairedLoans

%2011

NCO / Net Inc Bef Ln LssProv

%2011

U.A.E. Conventional U.A.E. Islamic

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Chart 4.40: Capital Adequacy Ratio for United Arab Emirates (UAE) Banks

Source: BankScope Database 2013

Chart 4.41: Operational Efficiency Ratios for United Arab Emirates (UAE) Banks

Source: BankScope Database 2013

14,78

20,34

25,84

20,00

13,16

16,84

21,08

17,64

0

5

10

15

20

25

30

Tier 1 Ratio%

2011

Total Capital Ratio%

2011

Equity / Net Loans%

2011

Equity / Liabilities%

2011

U.A.E. Conventional U.A.E. Islamic

3,26 2,80 2,08

1,06 1,30

8,08

27,83

2,86 2,54 2,81

0,84 0,52

3,19

17,00

0

5

10

15

20

25

30

Net InterestMargin

%2011

Net Int Rev /Avg Assets

%2011

Non Int Exp /Avg Assets

%2011

Pre-Tax Op Inc/ Avg Assets

%2011

Return On AvgAssets (ROAA)

%2011

Return On AvgEquity (ROAE)

%2011

Dividend Pay-Out%

2011

U.A.E. Conventional U.A.E. Islamic

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Chart 4.42: Liquidity Ratio for United Arab Emirates (UAE) Banks

Source: BankScope Database 2013

4.4.5 Bangladesh

Bangladesh represents a vibrant market for Islamic banking over the last couple of decades. At present, seven (7) full-fledged Islamic banks are operating with a total of 615 branches and maintaining a growth rate of around 10.0%-12.0% per year. In addition, sixteen (16) other scheduled commercial banks, including two foreign banks with 22 branches and seven other Islamic insurance companies are also providing Islamic banking and insurance services. Islamic banks operate in the same legal environment as their competing conventional commercial banks. In addition, Islamic banks are also required to abide by the guidelines for conducting Islamic banking issued by the Central Bank of the country.

4.4.5.1 Bangladesh Banking Sector

The following analysis consists of data from 6 Islamic banks of Bangladesh for which data is available on the BankScope database. The banks are: (6) Islamic Banks: ICB Islamic Bank Limited, Social Islami Bank Ltd, First Security Islami Bank Limited, Al-Arafah Islami Bank Ltd., Shahjalal Islami Bank Ltd., and Islami Bank Bangladesh Limited. The average total asset of the Bangladesh Islamic bank is 1,584 million USD, with average deposits of 1,398 million USD. On average, Islamic banks in Bangladesh employs 639 workers across 28.67 branches.

344,15

57,14 77,45

25,88

150,38

59,58 83,84

19,12

0

50

100

150

200

250

300

350

400

Interbank Ratio%

2011

Net Loans / Tot Assets%

2011

Net Loans / Dep & STFunding

%2011

Liquid Assets / Dep & STFunding

%2011

U.A.E. Conventional U.A.E. Islamic

Risk Management in Islamic Financial Instruments

94

4.4.5.2 Risk Matrices

Asset Quality Ratios Chart 4.43 shows that, for the Bangladesh banking sector, the Asset Quality of the Islamic banks’ loan portfolios are poor, compared to that of their conventional counter parts. The average Loan Loss Res/Gross Loans ratio and average loan loss reserve over gross loan ratio for the Islamic banks are 7.75% and 73.49%, which are higher than those of their conventional counterparts at 2.83% and 16.53%, respectively. However, the Islamic banks, in general, keep a higher loan loss reserve, which is reflected by a higher average Loan Loss Res / Impaired Loans ratio of 120.41%, compared to that of conventional banks at 70.28%. Capital Adequacy ratios In Bangladesh, the lower average Equity/Tot Assets ratio for Islamic banks (2.51%), compared to that of conventional banks (9.11%) represents a higher risk exposure and a possible capital adequacy problem for the Islamic banks. Additionally, the Tier1 ratio and Equity/Net Loans ratio are negative at -1.49% and -3.99%, respectively, which symbolizes possible solvency risk. (See Chart 4.44) Operational Efficiency ratios Chart 4.45 shows that, in general, higher operating ratios represent lower cost of funds, higher efficiency and higher yields on equity and assets. A higher average Net Interest Margin for the conventional banks (4.69%), compared to Islamic banks (4.02%) represents cheaper sources of funding that the conventional banks enjoy. This is also reflected in the higher ROAs and dividend payouts for the conventional banks. Liquidity Ratios An Interbank ratio of greater than 100 indicates the bank is a net lender, rather than a borrower and resembles higher liquidity. The average Interbank Ratio for Islamic banks (128.04%) is higher than the conventional bank ratio (57.97%), which suggests that Islamic banks hold additional liquidity. Lower operating efficiency may be caused by the additional liquidity that the Islamic banks are required to maintain, due to the lack of short-term Shariah compliant investment tools. However, Islamic banks maintain higher Net Loans / Cust & ST Funding and Net Loans / Tot Dep & Bor ratios (79.09% and 18.33%, respectively), compared to conventional banks (65.02% and 17.51%, respectively), which suggests the overall lower liquidity situation for the Islamic banks. (See Chart 4.46)

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Chart 4.43: Asset Quality Ratios for Bangladesh Banking sector

Source: BankScope Database 2013

Chart 4.44: Capital Adequacy Ratio for Bangladesh Banking sector

Source: BankScope Database 2013

2,83

16,54

70,28

7,33 7,76

73,49

120,41

5,45

0

20

40

60

80

100

120

140

Loan Loss Res / GrossLoans

%2011

Loan Loss Prov / Net IntRev%

2011

Loan Loss Res / ImpairedLoans

%2011

NCO / Net Inc Bef Ln LssProv

%2011

Bangladesh Conventional Bangladesh Islamic

3,96

9,12

11,42

10,31

-1,50

2,52

-4,00

1,66

-6

-4

-2

0

2

4

6

8

10

12

14

Tier 1 Ratio%

2011

Total Capital Ratio%

2011

Equity / Net Loans%

2011

Equity / Liabilities%

2011

Bangladesh Conventional Bangladesh Islamic

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Chart 4.45: Operational Efficiency Ratios for Bangladesh Banking sector

Source: BankScope Database 2013

Chart 4.46: Liquidity Ratio for Bangladesh Banking sector

Source: BankScope Database 2013

4,69 3,93

3,34 2,73

1,39

15,82

19,59

4,04 3,42

4,68

2,44

-0,93

18,15

-5

0

5

10

15

20

25

Net InterestMargin

%2011

Net Int Rev / AvgAssets

%2011

Non Int Exp /Avg Assets

%2011

Pre-Tax Op Inc /Avg Assets

%2011

Return On AvgAssets (ROAA)

%2011

Return On AvgEquity (ROAE)

%2011

Dividend Pay-Out%

2011

Bangladesh Conventional Bangladesh Islamic

57,98 53,78

65,02

17,51

128,05

72,83 79,09

18,33

0

20

40

60

80

100

120

140

Interbank Ratio%

2011

Net Loans / Tot Assets%

2011

Net Loans / Dep & STFunding

%2011

Liquid Assets / Dep & STFunding

%2011

Bangladesh Conventional Bangladesh Islamic

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4.4.6 Tunisia

Located at the northern part of Africa, Tunisia is an emerging financial market with a potential consumer base for Islamic financial services industry. At present, Islamic banking market share accounts for 2.2% of the total banking assets as of 2011. The Islamic financial market comprises three Islamic banks, one full-fledged takaful company, and one Islamic fund. More recently, the World Economic Forum’s 2011 Global Competitiveness Report has ranked Tunisia top amongst the African countries. The country per capita GDP is USD 3,687.34 and over the last decade it has grown at an average 4.13% rate. Among the total population of 10.5 million, around 98% is Muslim. However, the country needs to enhance legal and regulatory framework to support a conductive environment for Islamic banks to compete with the conventional banking counterpart.

4.4.6.1 Tunisian Banking Sector

Tunisia is home to three Islamic banks and a number of conventional banks. Among them, one Islamic bank and seventeen conventional banks are represented the BankScope database. Islamic banks are in general smaller banks with lower asset size as compared to their conventional counterparts. Average total asset of the Tunisian Islamic bank sample is 493.58 million USD with average deposit of 301.15 million USD. On the other hand, average total asset of the Tunisian conventional bank sample is 1,830.41million USD with average deposit of 1,266.610 million USD.

4.4.6.2 Risk Matrices

Asset Quality Ratios Asset qualities for the Tunisian Islamic banks are poor compared to their conventional banking competitors. Average Loan Loss Res/Gross Loans ratio is higher for Islamic banks (2.72 %) compared to the conventional banks (2.50%); on the other hand, Loan Loss Prov/Net Int Rev is negative for Islamic banks (-4.32%) compared to conventional banks (19.38%). (See Chart 47) Capital Adequacy ratios In general, Islamic banks in Tunisia keep higher capital cushion as compared to their conventional banking counterparts. Chart 48 shows that Equity/Net Loans of the Islamic banks 22.81% is higher than the same for the conventional banks, 8.13%. Besides, Equity/Net Loans of the Islamic banks 12.48% is higher than the same for the conventional banks, 6.46%. Operational Efficiency ratios In general, higher operating ratios represent lower cost of fund, higher efficiency and higher yield of equity and asset. Higher ratios of NIM, Net Int Rev/Average Asset and Non Int Exp/ Avg Asset for the Tunisian conventional banks (4.93%, 4.45% and 4.47%) as compared to the same of the Islamic banks (3.48%, 2.94% and 3.19%) represent that conventional banks in general enjoy benefit from cheaper sources of funding. However, the yield of Return On Avg Assets (ROAA) and Return On

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Avg Equity (ROAE) are both higher for the Islamic banks (1.24% and 11.05%) compared to the same of conventional banks (1.04% and 8.23%). But, the conventional banks have higher dividend payout ratio. (See Chart 4.49)

Net

Interest

Margin

%

2013

Net Int

Rev / Avg

Assets

%

2013

Non Int

Exp / Avg

Assets

%

2013

Pre-Tax

Op Inc /

Avg Assets

%

2013

Return On

Avg Assets

(ROAA)

%

2013

Return On

Avg Equity

(ROAE)

%

2013

Dividend

Pay-Out

%

2013

Islamic 1.407 1.3655 0.765667 1.432833 1.415667 8.949333 0

Conventional 1.288938 1.156917 1.580448 0.617573 0.533073 5.263042 0.452708

Liquidity Ratios Chart 4.50 shows that, on the average, Islamic banks in Tunisia maintain a better liquidity position compared to the conventional bank. Interbank ratio of 139% of the Islamic banks suggests that they are lenders to interbank market while the conventional are in general borrowers, with average interbank ratio as 82.97%. For the Higher ratios of Net Loans / Cust & ST Funding and Net Loans / Tot Dep & Bor. represent lower liquidity which is the representative trend for the conventional banks as compared to the Islamic banks.

Interbank

Ratio

%

2013

Net Loans /

Tot Assets

%

2013

Net Loans / Dep &

ST Funding

%

2013

Net Loans / Tot

Dep & Bor

%

2013

Liquid Assets / Dep

& ST Funding

%

2013

Islamic 300.3363 30.7675 37.02433 37.00367 40.69917

Convent

ional 90.13026 32.76673 43.55769 38.42176 11.56496

Chart 4.47: Asset Quality Ratios for Tunisian Banks

Source: BankScope Database 2013

2,73

-4,32

30,35

2,50

19,38

10,61

-10

-5

0

5

10

15

20

25

30

35

Loan Loss Res / Gross Loans%

2013

Loan Loss Prov / Net Int Rev%

2013

Loan Loss Res / Impaired Loans%

2013

Islamic Conventional

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Chart 4.48: Capital Adequacy Ratio for Tunisian Banks

Source: BankScope Database 2013

Chart 4.49: Operational Efficiency Ratios for Tunisian Banks

Source: BankScope Database 2013

22,81

12,48

8,13 6,46

0

5

10

15

20

25

Equity / Net Loans%

2013

Equity / Liabilities%

2013

Islamic Conventional

1,41 1,37

0,77

1,43 1,42

8,95

1,29 1,16 1,58

0,62 0,53

5,26

0,45

0

1

2

3

4

5

6

7

8

9

10

Net InterestMargin

%2013

Net Int Rev /Avg Assets

%2013

Non Int Exp /Avg Assets

%2013

Pre-Tax Op Inc/ Avg Assets

%2013

Return On AvgAssets (ROAA)

%2013

Return On AvgEquity (ROAE)

%2013

Dividend Pay-Out%

2013

Islamic Conventional

Risk Management in Islamic Financial Instruments

100

Chart 4.50: Liquidity Ratio for Tunisian Banks

Source: BankScope Database 2013

300,34

30,77 37,02 37,00 40,70

90,13

32,77 43,56 38,42

11,56

0

50

100

150

200

250

300

350

Interbank Ratio%

2013

Net Loans / Tot Assets%

2013

Net Loans / Dep & STFunding

%2013

Net Loans / Tot Dep &Bor%

2013

Liquid Assets / Dep &ST Funding

%2013

Islamic Conventional

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CHAPTER 5: SURVEY OF RISK MANAGEMENT PRACTICES OF ISLAMIC FINANCE INSTITUTIONS OIC MEMBER COUNTRIES

5.1 UNDERSTANDING OF RISK IN ISLAMIC FINANCIAL INSTITUTIONS (IFIS)

Risk is the uncertainty that the actual result might be different from what is originally expected. Commercial banks take deposits and deploy them into industrial and private projects. The prospects of these projects largely depend on various socio-economic factors. A sudden change of these factors may alter the original estimations made by commercial banks. Islamic financial institutions (hereinafter IFIs) solve this problem by integrating the banking contracts with various partnership-based contracts. Among these, the Mudarabah and the Musharakah contracts are based on profit and loss sharing principles. One of the major differences between these PLS-based contracts and those of conventional financial institutions is that IFIs consider their customers as partners and share in the uncertainty with themat an agreed upon ratio. However, not all the contracts of IFIs are equally practiced. The application of these contracts is still in an emerging stage in purely Islamic economies and in economies that accommodate dual banking system.

In order to maintain a healthy financial atmosphere, IFIs are expected to observe risks in various contracts and processes on a regular basis and integrative risk management plans into the strategic vision of the institution. This section is an attempt to identify risks in various financial activities conducted by IFIs in OIC member countries. OIC cooperation countries include developed, emerging and developing countries, which accommodate a range of conventional, mixed and Islamic financial services. For instance, Malaysia is a practicing Islamic country and visions the synchronicity of people from various races, namely Chinese, Malay, Muslims, and Indians. Shari’ah guidelines and practices would be much wider in scope and, at the same time, less stringent in Malaysia, when compared to the counterparts from the Arabian and African peninsula. Therefore, IFIs expect a gradual change in governmental direction, i.e. from the Shari’ah Advisory Council in Malaysia, to bring along a positive change in the mind-set of the stakeholders. Even though the social and legislative barriers have been identified as major obstacles in Islamic finance, it is equally important to consider the efficiency of the internal system in order to incorporate the increasing demand from the industry and society. To that respect, past studies investigate the perception of the risk by managers of IFIs on the risk management systems in different countries. This study widens this understanding into OIC countries.

5.1.1 Dynamics of Risk Management in Islamic Contracts

There exists a consensus that the contracts that are used in Islamic finance have a strong built-in risk management system. The most recent example of the global crisis of 2007-08 taught us that an unjustified profit making incentive for the conventional financial institution drove

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these century old institutions into catastrophic increases in leverage that were supported by gradual deregulation in the financial industry. Additional leverage was collected to invest in short-term profit making by sacrificing the long-run stability of the entire system. Islamic Shari’ah prohibits unjustified profit making by charging interest, undertaking excessive risky investments, engaging into corruption, and living in ignorance. Moreover, if a customer does not get a loan in a conventional bank, bank managers adjust the credit rating of the customer in order to accommodate the loan, which eventually increases the cost of the loan. In IFIs, there are number of partnership arrangements to suit the demand of the customers. For instance, if an individual cannot share capital s/he cannot ask for a Musharakah contract, but can still find a Mudarabah contract based on entrepreneurial skill. Entrepreneurial skill is more important in IFIs, while conventional finance places it in the credit risk matrix. Since IFIs run on profit-loss-sharing contracts, the employees of IFIs’ have to be as equally qualified as the loan-seekers in order to manage the entrepreneurial challenges. In order to understand the financing need of a specific set of entrepreneurial ventures, IFIs’ must have strong internal mechanisms to work closely with these partners. Innovation in IFIs drives us towards using more complex instruments. IFIs should have highly trained management and systems in order to understand the challenges posed by these innovations. For instance, various IFI contracts rely heavily on changes in market prices of commodities. The management of IFIs should have a system of identifying the changing market prices and decide on a plan to diversify these risks. Since the use of derivative financial instruments for IFIs is still very limited, it is the clear knowledge and the built-in internal mechanisms that can save IFIs. The following sections will shed light on what managers of IFIs think about risks in their operations, about the reporting of risks in IFIs, and the readiness of IFIs’ in handling these challenges. This study, which is profoundly influenced by other existing studies, has included four major types of risks faced by IFIs. These risks are the operational risk, the credit risk, the liquidity risk and the mark-up risk. Six major types of modes of financing were considered. These are the Mudarabah, Musharakah, Murabahah, Ijarah, Salam and Ijtisna. The primary objective of this study is to analyse the perception of the risk managers of IFIs towards the types of risks, risk identification, measurement and management procedures, and other risk-related issues in selected banks. Financial institutions are in the business of managing risk for their clients. In a conventional setting, banks are risk managers. Risks are also available in Islamic forms of business. However, the Islamic financial institutions try to minimise these risks based on Shari’ah principles. Islamic Shari’ah saves the IFIs from a large part of the risk by prohibiting a number of risky activities, including speculation and investing in a highly uncertain business environment. Due to a proactive avoidance from risky business, the identification of the remaining risky activities becomes easier. However, due to peculiar types of financial activities of IFIs that are primarily through trading, conventional risk-identification models do not directly fit into IFIs. Consequently, due to cross border collaboration and other operating challenges, IFIs have to prepare to understand their risk patterns and the ways in which to share those risks with their partners. Table 5.1 offers a detailed review of the risks faced by IFI.

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Table 5.1 Types of Risks – Description and Influence

Type of risk Definition Institution Depositors

Bank Shareholders Demand Investment

Transaction

Risks

Credit risk Credit risk is

failure of

counter - party

to meet his or

her obligations

timely and on

the agreed

terms of the

contract

The bank faces

counter - party

risks in the

various forms of

contracts: such

as, Bay mua’jal,

mudaraba,

musharaka

murabaha,

They face

the risk that

the bank

does not

honor

requests for

withdrawals

at face value

They face the risk

that the bank does

not honor requests

for withdrawals at

market

value

Market risk

Market risk is

the risk

associated

with change in

the market

value of held

assets

Mark– up risk

is risk of

divergence

between the

murabaha

contract mark

– up and the

market

benchmark

rate

The bank may

incur losses if

the benchmark

rate changes

adversely

Foreign

Exchange risk

is the risk of

the impact of

exchange rate

movements on

assets

denominated

in foreign

currency

This exposes the

bank to risks

associated with

their deferred –

trading

transactions

Business

Risk

Business risk

Business risk

results from

competitive

pressures from

existing

counter parts

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Type of risk Definition Institution Depositors

Bank Shareholders Demand Investment

Displaced

Commercial

risk is the risk

of divergence

between

assets’

performance

and

expectations

for returns on

liabilities

Displaced

commercial risk

may adversely

affect the value

of the bank’s

capital. Return

on equity goes

down

Shareholders

are exposed

to the risk of

not receiving

their share of

the bank’s

profit

Investment

depositors

may have to

forgo

receiving

their

mudarib

share

Withdrawal

risk where the

bank is

exposed to the

risk of

withdrawal of

deposits

Withdrawal risk

exposes the

bank to liquidity

problems and

erosion of its

franchise value

Insolvency

risk is the risk

of bank’s

failure to meet

its obligations

when they fall

due

Insolvency risk

may expose the

bank to loss of

its reputation

Insolvency risk exposes the different

stakeholders to counter – party risks

Treasury

Risks

Asset &

Liability

Management

(ALM) risk

Asset &

Liability

Management

(ALM) risk is

a balance sheet

mismatch risk

resulting from

the difference

in terms and

conditions of a

bank’s

portfolio on its

asset & liability

sides

This may

adversely affect

the bank’s

capital

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105

Type of risk Definition Institution Depositors

Bank Shareholders Demand Investment

Liquidity risk Liquidity risk

is the risk of

bank’s inability

to access liquid

funds to meet

its obligations

The bank is

exposed to risk

of failure to

honor requests

for withdrawals

from its

depositors

They face

the risk of

not being

able to

access their

deposits

when they

need to

Hedging risk

Hedging risk is

the risk of

failure to

mitigate &

manage the

different types

of risks

This increases

the bank’ s

overall risk

exposure

Governance

Risk

Operational risk Operational

risk is the risk

of failure of

internal

processes as

related to

people or

systems

The bank incurs

losses due to

occurrence of

that risk hence

may fail to meet

its obligations

towards the

different

stakeholders

This risk

adversely

affects return

on equity

This risk

adversely

affects

return on

assets

Fiduciary

risk

- Fiduciary risk

is the risk of

facing legal

recourse action

in case the

bank breaches

its fiduciary

responsibility

towards

depositors and

shareholders.

- Risk of loss of

reputation

Legal recourse

may lead to

charging the

bank a penalty

or

compensation.

This may lead to

withdrawal of

deposits, sale of

shares, bad

access to

liquidity or

decline in the

market price of

shares if listed

on the stock

exchange

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Type of risk Definition Institution Depositors

Bank Shareholders Demand Investment

Transparency

risk

Transparency

risk is the risk

of

consequences

of decisions

based on

inaccurate or

incomplete

information

which is the

outcome of

poor

disclosure

Losses may occur as a result of bad decisions based on inaccurate

or incomplete information

System

Risks

Business

environment

risk

Business

environment

risk is the risk

of poor broad

institutional

environment

including legal

risk whereby

banks are

unable to

enforce their

contracts.

Business

environment

risk increases

banks’ exposure

to counter -

party risk as

weak contracts

are not easily

enforceable

Institutional

risk

Institutional

risk is the risk

of divergence

between

product

definition and

practices

Institutional

risk exposes the

bank to counter

-party risks due

to the unsettled

nature of the

contract

Regulatory

risk

Regulatory risk

is the risk of

non -

compliance

with

regulations

due to

confusion, bad

management

or mistakes

Banks may be

penalized for

non-complying

with the rules or

regulations. It

could be an

issue with the

regulator or

supervisor

Source: Adopted from Haawari, Grais and Iqbal (2003)

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5.1.2 Methodology

Khan and Ahmed (2001) conducted a rigorous survey on the risk management perception of the IFIs in various countries. This study undertakes a similar approach. The survey questionnaire used in Khan and Ahmed (2001) has been modified for this study. The questionnaire includes questions/ statements on six different areas that include the severity of risk in various contracts, risk reporting standards, the risk management environment, risk monitoring, and the presence of strong internal mechanisms that help IFIs deal with challenges.

A total of 18 banks have been surveyed. Senior officials responsible for risk identification, measurement and management took the survey. In order to keep the sample unidentified, a regional category is reported. Out of a total of 18 banks, 12 banks were from the MENA region, two banks were from South Asia, and three banks were taken from the South East Asian region. One bank was surveyed from the Central Asian region, which was coded as ‘others’. MENA is the largest region in terms of the number of Islamic banks and the volume of Islamic activities. Malaysia, Indonesia and Brunei drive Islamic banking operations in Southeast Asia. Pakistan and Bangladesh are strongly contributing to Islamic financial operations in South Asia. Appendix C shows the list of banks that were used in this analysis. Appendix D gives the questionnaires used in this study. It was initially planned to distribute multiple questionnaires to IFIs of the OIC member countries. However, due to a number of limitations inherent in the methodology and with the cooperation from the IFIs, the study limits its coverage within the successful banks in the selected countries. The study used a structured questionnaire. Using the Surveymonkey.com web survey mechanism, 18 survey questionnaires were ultimately received. These range across three different regions: MENA, Southeast Asia and South Asia. More importantly, they are from 14 different countries, and the participating IFIs have been highly successful in their operations. The unit of analysis is individuals. These individuals were responsible for risk management and/or risk monitoring and credit departments. A list of these individuals was collected from authors of past studies and other academic sources in order to feed the list into surveymoneky.com for data collection. A total of 37 individuals were asked to participate voluntarily, of which nearly 50% were returned. Due to the anonymity principle of the survey research, this study will not reveal an individual identity of the participants and their banks. We have conducted the analysis, however, using the regional categorization of the IFIs. A number of frequency distributions and cross-tabulations have been used to explain the contract specific perception of risk and the strengths and weaknesses of the IFIs with respect to managing that risks. 5.2 RISK PERCEPTION

5.2.1 Risks in Different Modes of Financing

Risk is the uncertainty that outcomes will not match those that are expected. Table 5.2 shows the risk perceptions of the risk managers of the IFIs in selected banks. There are six categories of contracts with respect to four major types of risks that are analysed. If we consider the

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addition of the responses given as ‘important’ and ‘critically important’, both credit and operational risks are considered important in the Murabahah mode of financing. Mark-up risk is the second largest risk in the Murabahah mode of financing.

The credit and the operational risks are the two most important risks for banks in all the remaining five modes of financing as well. Except for the Murabahah, operating risk has been considered as relatively more important than the credit risk in the remaining five modes of financing. In other words, IFIs have to concentrate on investing in developing an efficient system, technologies, and building efficient human capital in order to reduce operational risks. Despite a diverse experience with liquidity and mark-up risks, the respondents chose liquidity risk as the third important risk, followed by mark-up risk.

Table 5.2: Perception of Risks in Modes of Financing

Contracts Risks 1 2 3 4 5 Total % Missing

Murabahah Credit 5.6 11.1 11.1 38.9 27.8 94.4 5.6

Mark-up 5.6 22.2 16.7 22.2 27.8 94.4 5.6

Liquidity 5.6 11.1 33.3 16.7 27.8 94.4 5.6

Operational 0 0 27.8 44.4 22.2 94.4 5.6

Mudarabah Credit 5.6 11.1 27.8 55.6 100.0

Mark-up 11.1 16.7 33.3 22.2 16.7 100.0

Liquidity 5.6 5.6 33.3 33.3 16.7 94.4 5.6

Operational 66.7 33.3 100.0

Musharakah Credit 5.6 11.1 22.2 61.1 100.0

Mark-up 11.1 16.7 27.8 27.8 16.7 100.0

Liquidity 5.6 33.3 38.9 22.2 100.0

Operational 11.1 50.0 38.9 100.0

Ijtisna Credit 11.1 5.6 5.6 38.9 38.9 100.0

Mark-up 5.6 11.1 33.3 22.2 27.8 100.0

Liquidity 11.1 44.4 27.8 16.7 100.0

Operational 16.7 44.4 38.9 100.0

Ijarah Credit 5.6 16.7 11.1 27.8 38.9 100.0

Mark-up 5.6 44.4 11.1 22.2 16.7 100.0

Liquidity 11.1 38.9 27.8 22.2 100.0

Operational 5.6 11.1 50.0 33.3 100.0

Salam Credit 11.1 11.1 38.9 38.9 100.0

Mark-up 5.6 11.1 22.2 33.3 27.8 100.0

Liquidity 5.6 5.6 22.2 38.9 27.8 100.0

Operational 11.1 38.9 50.0 100.0

Notes: 1 = Critically Unimportant, 2 = Unimportant, 3 = Neutral, 4 = Important, 5 = Critically Important. Values are in

Percentage (%).

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Extending Table 5.2 into Table 5.3, which offers a regional distribution of the perceptions of credit risk, the study reports that credit risk are more important in Mudarabah, Musharakah and Ijarah modes of financing. A separate analysis conducted for liquidity risk shows a different picture. According to geographical categorizations, Murabahah is the most important mode of financing that faces operational risk, followed by Mudarabah, and Musharakah contacts. Operational risk was also important for the Ijarah mode of financing; however, operational risk was found to be the least important for the Salam mode of financing.

Table 5.3: Regional Distribution for Perceptions of Credit Risk

Region Murabahah Mudarabah Musharakah Ijtisna Ijarah Salam

1 2 3 4 5 1 2 3 4 5 1 2 3 4 5 1 2 3 4 5 1 2 3 4 5 1 2 3 4 5

MENA 0 2 2 3 3 0 0 2 2 7 0 1 2 1 7 2 1 1 3 4 1 2 1 2 5 0 2 1 4 4

SA 0 0 0 1 2 0 0 0 1 2 0 0 0 1 2 0 0 0 1 2 0 0 0 1 2 0 0 1 0 2

SEA 0 0 0 3 0 0 0 0 2 1 0 0 0 1 2 0 0 0 2 1 0 1 0 2 0 0 0 0 3 0

Others 1 0 0 0 0 1 0 0 0 0 0 0 0 1 0 0 0 0 1 0 0 0 1 0 0 0 0 0 0 1

Notes: 1 = Critically Unimportant, 2 = Unimportant, 3 = Neutral, 4 = Important, 5 = Critically Important. Values are in

frequencies. SA = South Asia, SEA = Southeast Asia

Table 5.4: Operational Risk and Presence of Risk Management System

Have Formal RM

System

Murabahah Mudarabah Musharakah Ijtisna Ijarah Salam

3 4 5 4 5 3 4 5 3 4 5 2 3 4 5 3 4 5

No 0 0 1 1 1 0 1 1 0 0 2 0 0 1 1 0 1 1

Yes 5 8 3 11 5 2 8 6 3 8 5 1 2 8 5 2 6 8

Notes: 1 = Critically Unimportant, 2 = Unimportant, 3 = Neutral, 4 = Important, 5 = Critically Important. Values are in

frequencies. RM = Risk Management.

Table 5.4 further extends the analysis of important types of risks in different modes of financing. This table sheds light on operational risk. Most of the IFIs have a formal risk management system. Only two IFIs argued that their system is yet to take a complete shape. According to the ‘important’ and ‘most important’ responses, the Mudarabah mode of financing faces mostly operational risk, which is followed by the Murabahah and Musharakah modes of financing. The analysis of credit risk on a similar ground also finds similar results. Hence, it is safe to conclude that the chronology of the risks in order of importance starts with operational risk, and extends to credit risk, liquidity risk and mark-up risk. In terms of the most challenging modes of financing, Mudarabah is most pronounced, followed by Murabahah and Musharakah.

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Table 5.5: Challenges in Risk Management

Problems 1 2 3 4 5

Lack of understanding 5.6 5.6 0.00 50.0 38.9

Rate of return of IFI 5.6 16.7 22.2 27.8 27.8

Islamic money market 0.00 5.6 16.7 50.0 27.8

Derivative 0.00 5.6 22.2 33.3 38.9

Legal system 0.00 11.1 16.7 33.3 38.9

Regulatory system 0.00 5.6 11.1 44.4 38.9

Notes: 1 = Critically Unimportant, 2 = Unimportant, 3 = Neutral, 4 = Important, 5 = Critically Important. Values are in Percentage (%).

5.2.2 Major Challenges Facing IFIS

Among six different problems, Table 5.5 shows that a lack of understanding is the major challenge facing IFIs. Lack of understanding is directly connected to availability of efficient human capital for IFIs. One of the major components of operational risk is the unavailability of efficient Islamic bankers. This is a true reflection of the most important type of risk, as operational risk was seen as most important. The next problem is the absence of Islamic money markets in many regions. In the absence of such markets, IFIs will face liquidity shortages. Hence, this coincides with the third most important risk for IFIs, liquidity risk. Finally, the absence of efficient regulatory frameworks to deal with problem borrowers and guide other general banking activities is the third most important problem. This problem is connected to credit risk, which is the most important risk.

Figure 5.1: Influence of Low Return in IFI on Deposit

39%

50%

11%

Most of them willwithdraw

A fraction will withdraw

None or very few willwithdraw

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The Rate of return, which is directly connected to mark-up risk, has severe influence on bank deposits in IFIs. According to Figure 5.1, 39 percent of the respondents believed that lower rates of return in IFIs, compared to conventional banks, would force a major portion of the deposit-holders to withdraw their funds. This phenomenon is also connected to ‘displaced commercial risk’. We conducted an extended analysis by decomposing these problems into regional groups. Regulatory and lack of understanding problems are closely connected to developing MENA countries and South Asian countries.

5.3 RISK REPORTING

Risk reporting is an essential component of efficient risk management. The IFIs are required to report partially or in full content, the amount of risk taken in various financial activities. IFIs produce a number of risk reports. Figure 5.2 provides explanations of the presence of various risk reports. Not all the reports were equally important, and, thus, were not prepared by all IFIs. IFIs did not report changes in commodities prices, which might be of concern for the Salam mode of financing. The country risk report was not needed, as the IFIs were not globally diversified. However, we must consider the country risk report very important for cross-border banking activities in the future. Operational risk was not reported fully as well. Hence, operational risk remains an influential risk among IFIs.

Figure 5.2: Risk Reporting

It is clear why IFIs have operational, credit, liquidity and mark-up risks. In order to fully understand the risk profile of the banks, the IFIs must report the types and propensity to such risks in a formal manner. These reports should also be monitored at a periodic basis. While the risk perceptions and reporting face limitations, IFIs are analyse the existing internal environment. The start of this environmental scanning is to gather information on the ideal risk management requirement and policies and procedures that are considered prerequisites to efficient risk management.

0

20

40

60

80

100

100 94,4 83,3 100 100 83,3 55,6 72,2 55,6 88,9

No (%) Yes (%)

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5.4 RISK MANAGEMENT ENVIRONMENT

5.4.1 Establishing an Appropriate Risk Management Environment, Policies and Procedures

The board of directors is responsible for the overall objectives, policies and strategy of the bank towards risk and its management policies. The risk appetite should be communicated throughout upper management. The board of directors should ensure management takes the necessary actions to identify, measure, monitor, and control these risks. Senior management is responsible for establishing policies and procedures that manage risk according to the board of director’s appetite for risk. The policies and procedures include maintaining a review process, limiting risk taking, establishing an adequate system of risk measurement, promoting a comprehensive reporting system, and an ensuring an effective system of internal controls.

Figure 5.3: Establishing Strong Risk Management Environment

Figure 5.3 shows that most of the banks have already established a strong risk management environment. Loan grading has been a problem for 39 percent of the banks. Loan grading helps bank identify the riskiness of the borrowers. A problem with this grading system will lead to more defaults, which can be translated into higher credit risk. A massive drawback of the poor internal mechanism is that over 70 percent of the banks did not have computerized risk management tools. Diversification across countries, sectors, and industries has been another important problem area. The IFIs were not internally diversified. Also, the problem of monitoring benchmark rates has contributed to mark-up risk. Since IFIs do not have efficient human capital and the use of computers was very limited, the IFIs reported facing difficulties with operational and mark-up risks.

0

20

40

60

80

100

88,9 94,4 94,4 94,4 94,4

61,1

27,8

94,4

27,8

83,3 83,3 94,4 88,9

55,6

No (%) Yes (%)

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5.5 RISK MEASURING AND MANAGEMENT TECHNIQUES

Banks must establish regular management information systems for measuring, monitoring, controlling, and reporting different risk exposures. IFIs can use a number of techniques to measure and manage risks. This study asked the respondents to identify whether they are familiar with the techniques. Gap and duration analysis are similar in principle. Gap identifies the dollar gap, while the duration gap analyses the gap in maturity for rate sensitive assets and liabilities. These techniques are especially important for liquidity risk management. Both earnings at risk and value at risk methods use confidence intervals, which is sometimes difficult for managers to interpret. Simulation techniques and best-worse case analyses fall largely under the scope of scenario analysis. Extensive mathematical and management skills are required to perform and interpret the outcomes of these analyses.

Figure 5.4 summarises the findings. Duration analysis, earnings at risk analysis, Value at risk analysis, risk adjusted rate of return on capital analysis, and simulation techniques were not utilized properly by the banks. One of the reasons could be the limited computerized management of risk. The traditional method of maturity matching is quite popular among IFIs. The results imply that IFIs do not use sophisticated techniques to measure and manage risks. It is not a necessity that banks should be using these techniques. Perhaps a combination of some of the techniques may enrich the experience of the managers by helping them in making informed decision. It is important to note that IFIs have moved to the internal rating based approach required by Basel III. This approach offers flexibility and freedom to IFIs, but increases the level of commitment and responsibility towards the efficient management of the banks.

Figure 5.4: Risk Measuring and Management Techniques

0

20

40

60

80

100

Gap analysis Durationanalysis

Maturitymatching

Earnings atrisk analysis

VAR analysis Simulationtechniques

Best vs.Worse casescenarios

Risk adjustedrate of

return oncapital

Internalrating

systems

83,3

66,7

94,4

66,7 61,1

77,8 88,9

72,2 83,3

No (%) Yes (%)

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5.6 RISK MONITORING

IFIs must ensure the presence of an appropriate risk monitoring environment. IFIs have to continuously monitor the collateral taken against different modes of financing. Risk ratings should be analysed regularly. IFIs must have a system in place that enables them to monitor the rates of commodities, currencies, and the returns offered by other banks. One of the typical items that can be used to monitor the business risk of clients is to have a detailed idea of the type of businesses in which its clients are involved. Consequently, quarterly or monthly performance data can be collected from clients and can be adjusted with the market performance in order to further analyse upcoming challenges. A number of components are involved in this decision. Table 5.5 offers a description of the set of prerequisites. Around 50 percent of the banks do not reappraise the collateral unless it is required. One third of these banks do not regularly check the status of the guarantor. Half of the sample banks have never conducted a country risk rating. Major emphasis is given on analysing the business performance of the borrower, which is the most traditional of all pre-requisites.

Table 5.6: The Prerequisites to Risk Monitoring

Issues Never (%) Occasionally (%) Regularly (%)

Appraisal of the collateral 16.7 27.8 55.6

Confirming guarantor's intention 11.1 22.2 66.7

Review country ratings 50.0 11.1 38.9

Review borrower's business performance 11.1 5.6 83.3

Figure 5.5: Use of Accounting Reporting System

The use of an accounting system affects the style of financial reporting. Different countries use different reporting and accounting systems. The most popular among these systems is the one provided by AAOIFI. This Bahrain-based organization provides standards for accounting-

International

22%

AAOIFI

45%

Others

33%

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115

related matters. Similarly, to deal with other financial matters, Malaysia has established the IFSB. Malaysian Islamic banks also have to follow local standards. As countries slowly move towards a combined Islamic financial reporting system, the job of bankers is expected to be more complex in terms of balancing the culture and depth of Shari’ah practices in accordance with their own banking system.

Figure 5.5 illustrates the use of various accounting reporting systems. As countries are slowly adopting the International Financial Reporting System, one third of the banks have moved to a market specific accounting reporting system. These localized reporting standards are either modified versions of AAOIFI or are completely new, being driven by a mixture two or more systems. For instance, many Malaysian banks follow the Malaysian Accounting Standard Board (MASB) regulations. The Bank Negara Malaysia, Securities Commission, Shari’ah Advisory Council and the Islamic Financial Services Board (IFSB) also have contributed in the development of the Islamic Financial Reporting System for IFIs in Malaysia. However, almost a half of the sample banks are still using AAOIFI accounting reporting standards. Since the sample in this study is biased towards MENA, the dominance of AAOIFI is expected.

Figure 5.6: Assessment of Profit-and-Loss Situation

Banks periodically monitor their profit and loss scenario, and whether these are affected by any major events. As monitoring is expensive, it is suggested that IFIs have frequent computerized monitoring of their profit and loss scenario. End of day processing of the profit and loss scenario may help bankers better prepare for adverse situations. Figure 5.6 explains how frequently the IFIs appraise their profit and loss situations. Some highly technology-based IFIs do it daily through a report called the ‘end of day processing report (EDP)’. However, it is highly challenging for the remaining IFIs to maintain a daily report. The cost of monitoring is an important aspect, which is expected to rise with a more frequent monitoring exercise. IFIs have to devise an optimal plan to balance the cost and benefits of frequent monitoring. Internationally, conventional banks monitor large loans very frequently, but lengthen the monitoring of smaller loans to a monthly or quarterly basis.

Daily

28%

Weekly

11%

Monthly

61%

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Figure 5.7: Internal Control System

5.7 INTERNAL AUDIT AND CONTROL

The most important risk to IFIs is operational risk. This risk is the result of internal mismanagement that is connected to the efficient management of systems, people and technology. At a certain point in time, IFIs have to conduct a survey on the strength of their internal control system. Internal audit is conducted in most IFIs to understand the problems and to undertake necessary exercises to remedy the problems. Apart from a very basic RM system, the IFIs need to make sure that the technology in place is updated one and fully secured. There must be internal auditors and an internal Shari’ah supervisor board to investigate the introduction of new products by IFIs.

Figure 5.7 illustrates the internal control system of the banks. A major portion of the banks did have an internal control system to swiftly manage changes in the risk management system. With sudden changes in commodities prices or changes in the rate of return, IFIs with this kind of internal control mechanism would be able to manage the risk. It is important to reduce role conflict among the employees of IFIs. All the banks in the sample avoided role duality within the staff of the risk management division. Banks had contingency plans to manage disasters and accidents. Almost all the banks had internal auditors to review and verify risk management frameworks and monitor the outcome of the frameworks. Having an internal auditor ensures the safety of the entire system, as the auditor goes through all the necessary components of the risk management framework and finds problems that need immediate attention.

All the banks had sufficient safety management for data used to keep records customer information. These banks had to go through a tough Shari’ah screening process to in order to introduce a new product. The Shari’ah supervisory board (SSB) works as a guiding light to the new product development process that eventually may lead to a built-in risk management tool

0

10

20

30

40

50

60

70

80

90

100

Internalcontrol

system todeal withchanges

Separation ofduties to

avoid roleduality

Contingencyplan tomanage

disasters

Internalauditor to

review andverify RM

system

Backups ofsoftware and

data files

Shari'ahboard

clearance fornew product

Securitizationto raise fund

Investmentrisk reserve

83,3

100 88,9 94,4 100 100

44,4

72,2

No (%) Yes (%)

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for the bank. It is also important for IFIs to seek permission from the SSB for new product introduction. This is an integral part of the ethical identity of the IFIs. Over half of the IFIs did not use securitization to capitalize on existing assets. Securitization can be a highly risky activity if human error cannot be controlled. The recent global financial crisis was primarily started when banks engaged in securitization of their good and bad loans that had been pooled together. Having an investment risk reserve is common. In order to manage displaced commercial risk, IFIs are recommended to keep a reserve of funds in order to pay the investment account holders the difference between the rate of conventional and IFIs. If the reserve is not kept, IFIs will fail to keep the customers. In order to understand the effectiveness of the internal control system and to identify new challenges, IFIs must establish an active research institute. Banking is a sophisticated industry. It involves a unique set of macroeconomic, regulatory and international regimes. To maintain a healthy financial condition, IFIs are required to engage in active research, organize research seminars to share the findings from research, and motivate researchers to undertake research on the relevant issues by offering them funds and research scholarships. These initiatives can be part of the bank’s corporate social responsibility policy, or simply can be taken as an initiative to identify the risk inherent in IF system. Figure 5.8 illustrates the active use of research in risk management. One third of the banks did not have a research component. This may have severe influence on risk management effort of these IFIs.

Figure 5.8: Actively Engaged in Research to Manage RM Problems

Figure 5.9: Requirement of Basel Committee Equally Applicable to IFIs

No 33%

Yes 67%

No 18%

Yes 82%

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5.8 EXTERNAL CONTROLS AND LEGAL SYSTEM

In addition to internal control mechanisms, IFIs must comply with the regulations of central banks and other international organizations. The Basel Committee for Banking Supervision (BCBS) publishes Basel capital adequacy requirements for banks that help them to keep the adequate level of capital as a cushion against risk. However, IFIs have differing opinions on the role of Basel regulation and the requirement of more or less capital, compared to conventional counterparts. Banks are slowly moving towards an internal rating system that will decide the capital adequacy of each bank. IFIs, with few exceptions, are yet to follow that lead. A portion of IFIs are still of the opinion that the Basel committee capital regulation should not be considered for IFIs. In order to minimize this problem, central banks of Islamic countries have already introduced modified versions of the Basel capital requirement guidelines for the Islamic banks of their regions. As the Basel guidelines are slowly moving towards an internal rating based capital adequacy approach, all the IFIs have to invest to develop their internal efficiency. In this respect, respondents believed that the capital requirements of IFIs should be different in many cases. More than 50 percent of the respondents supported different levels of capital requirements for IFIs.

Figure 5.10: Capital Requirement of IFI and Conventional Banks

5.9 ARE IFIS HAPPY WITH EXISTING RM SYSTEM?

With the existing limitations, are the respondents happy with the risk management system of their banks? Over half of the respondents were not happy with the existing system. The Islamic financial system is growing very fast at over 15 percent rate every year. The industry will face more challenges in the future and IFIs have to be ready with strong internal and external systems to face those challenges. Figure 5.11 is an indication that bankers want to do more with their risk management systems. They know about their limitations and would like to bring positive changes to risk the management frameworks in their banks. The chart also

less 28%

Same 44%

More 22%

Others 6%

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indicates room for development in the internal and external systems of the Islamic financial systems in terms of strengthening internal mechanisms and widening cross border banking with other countries.

Figure 5.11: Satisfaction with Existing RM System

5.10 REACHING THE OBJECTIVES OF SHARI’AH

The benefits of the Islamic financial system are already well established in financial systems. Among many, the system does not allow unnecessary profit making, unadjusted for risk, and the system promotes social development through partnership and entrepreneurship. Risk is a part of any business, but IFIs cannot take any investment activity where the risk is excessive. Perhaps this is the reason that saved the Islamic system from the recent crisis of 2007-08. That is how the IF system started gaining momentum among Muslims and non-Muslims.

Risk management at IFIs is primarily proactive. The system does not allow any speculative, highly risky engagement in gambling by bankers. In addition, the partnership nature of the contracts allows the parties involved to share the risk and profits, based on agreed upon ratios. Hence, it becomes the responsibility of the parties, not only the IFIs, to ensure the cost of the risk. In fact, the risk sharing mechanism is already integrated in the system. As a secondary proactive mechanism, IFIs must establish effective internal mechanisms to continuously look for loopholes in the system. In addition to internal control systems, IFIs are equally open to control by internal auditors and the scrutiny of the Shari’ah supervisory board.

The tertiary level of the risk management system comes from the use of derivative techniques, which is heavily criticized in the Islamic financial system. These are proactive mechanisms to risk management. Finally, the last resort of risk management rests with external stakeholders. These external stakeholders include the Basel committee and the central bank of each country. Figure 5.12 illustrates the risk management framework of IFIs. Shari’ah principles at the very core and the supervisory board clearly differentiate the uniqueness of IFIs, compared to conventional banks. Overall, in theory, if the system works, IFIs should be more resilient to risk than their conventional counterparts.

Yes 47%

No 53%

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Figure 5.12: Risk Management Framework of Islamic Banks

Overall, the study finds that operating risk is the most important risk for IFIs. The second most important risk is credit risk, which is followed by liquidity risk and mark-up risk. Among many problems, the lack of understanding of the Islamic financial system has been the most important problem in IFIs. A number of studies conducted in various Islamic countries report that credit risks and operating risks are the major risks in IFIs (Khan & Ahmed 2001; Rosman 2009). Liquidity risk is sometimes more acute in markets with no secondary backup for banks (Rosman 2009). However, more importantly, IFIs found varied levels of risks were associated with various modes of financing. As stressed by the IFSB (2005), IFIs may face more credit risk in Mudurabah or Musharakah kind of partnership contracts, whereas the market rate of return problem can be associated with the Ijarah mode of financing.

A study by Hassan (2009) on IFIs of Brunei Darussalam and by Al-Tamimi and Al-Mazrooei (2007), conducted on the foreign IFIs of United Arab Emirates, reported that credit risk and operational risks are among the top challenges for the selected banks. Quite contrary to these studies, Khan and Ahmed, (2001) in their cross-country study, reported mark-up and operational risk as most important, while credit risk as not very important.

This study has the largest sample thus far, covering 18 banks from 14 countries. Khan and Ahmed (2001) covered 17 banks from 10 countries. Khan and Ahmed (2001) reported a lack of understanding is the primary problem that risk managers face in IFIs. Two important conclusions can be drawn from these two cross-cultural studies. Firstly, a number of countries have basic problems with Islamic finance infrastructure, which, when addressed, can help

International authority

Central Bank

Shari'ah Supervision

Internal Auditor

Internal Control

Shari'ah Principles

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widen the knowledge of Islamic risk management frameworks. Secondly, little has been done over the last thirteen years in these countries.

Risk management and reporting is highly context-dependent. Reporting of risky activities is sensitive to ownership and the country of operation. Most of the earlier studies reported that IFIs did not fully report their country risk (see Khan and Ahmed 2001). This study has similar findings. Hence, IFIs have not diversified their operation through cross-border arrangements. This might be a contributing factor that saved IFIs from the global financial crisis. However, increasing financial diversity and the needs of customers will push IFIs beyond their region of origin. Consequently, a set of cross-border risk will emerge.

5.11 CONCLUSION

Risk is the uncertainty that must be considered carefully, as banks deal with future uncertainties. Various types of risk also affect IFIs. Some of these risks are similar to those of the conventional banks. Studies on various countries and banks report that credit risk, operational risk, mark up risk, and liquidity risk are the major financial risks affecting IFIs. The magnitude of the impact of each of these risks varies across the type of financing contracts the IFIs engage in. For instance, Mudarabah, Musharakah and Murabahah are the financing modes mostly influenced by these risks, when compared to Ijarah, Salam and Ijtisna.

This study is aimed at exploring the dimensions and determinants of efficient risk management in IFIs. The participants are selected from OIC member countries. An online questionnaire method was utilized to collect data from the risk management officials across regions. A total of 18 bank managers from 14 countries replied within the stipulated time, which is quite profound given the limited time for responding. This study crossed the benchmark set by the past studies, especially the one by Khan and Ahmed (2001) that had covered 13 countries.

There were a number of sections in the questionnaire. The questions were related to overall perceptions about four categories of risk across six modes of financing. This section was followed by questions on internal control system, core problems behind inefficient risk management systems, the basic necessity to establish an efficient risk management system, and the types of risk management instruments available to IFIs, among many. There were questions using both dichotomous (yes or no) and scale properties (five and three point scale). The study further categorized the sample into four regions: MENA, South Asian, Southeast Asian, and others.

The study reports that operating risk is the most important risk for the IFIs in the sample. By operating risk, we mean the lack of system, human capital and cutting edge technology in handling customers’ demands. Credit risk is the second most important risk. Credit risk is the uncertainty that the customer would fail to pay their loan payments back to the IFI, due to a number of economic and social factors. The other two important risks are liquidity risk and mark up risk. Liquidity risk has always been a threat for IFIs. The services offered by Islamic money markets to solve the liquidity problem are extremely limited to certain countries. Among the six modes of financing, these risks influence the three primitive levels of Islamic

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contracts more than the modern contracts. Mudarabah, Musharakah and Murabahah are the three partnership contracts that are severely affected by the four categories of risk. In addition, mark up risk has special implications for Murabahah.

A lack of understanding, limited use of technology, limited or no diversification across various products and regions, among others, are the major problems identified by the bank managers. Also, bank managers identified limited securitization and the unavailability of Islamic money market instruments as barriers to efficient liquidity management. The Islamic regulatory system is inadequate to reduce problem loans. IFIs have already established risk reporting systems. However, country risk was not analyzed and reported, as many IFIs are not globally diversified. Bankers did not use technology to manage risks. Many of the modern tools were unknown to IFIs. Operating risk was reported very poorly.

Most of these banks have used AAOIFI risk management guidelines and the guidelines suggested locally by the central banks. Since many countries did not have sufficient Islamic banking regulations, a portion of these banks opted to use other internationally accepted standards of risk management and reporting systems. Two thirds of the bankers had active engagement in research and development in order to identify problems beforehand. Bankers do believe that Basel regulations are only partially applicable to IFIs. Hence, there is need for full-fledged Islamic regulation of risk management and control.

This study offers a risk management framework showing that IFIs are the strongest institutions in risk management if they make use of the Shari’ah-based banking system. Islamic Shari’ah is the core risk management system, which is also supported by internal and external control mechanisms. Many of these controls are absent in conventional financial system. This study suggests investing in the training of employees, investment in education and technology, investment in relationship building with other banks and customers, and diversification of banking operations among like-minded neighboring countries. Risk management operations must be robust to the changes in banking operations. Eventually, the stability of banking operations should be given higher importance than the size of operations.

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CHAPTER 6: SUMMARY AND POLICY RECOMMENDATIONS

6.1. RISK MITIGATION AND REGULATION IN ISLAMIC FINANCE

The following section was derived largely from Ahmed and Khan (2007). Risk identification and management available in Islamic banks is of two types. The first type is comprised of standard techniques, such as risk reporting, internal and external audit, GAP analysis, RAROC, internal rating, etc., which are consistent with the Islamic principles of finance. The second type, outlined by Ahmed and Khan, consists of techniques that either need to be developed or adapted, while keeping in view the requirements for Shari‘ah compliance. Gharar can be mild and sometimes unavoidable; however, it could also be excessive and cause injustices, contract failures, and defaults. A number of appropriate contractual agreements between counterparties work as risk control techniques. Ahmed and Khan cite:

“To overcome the counterparty risks arising from the non-binding nature of the contract in murabahah, up-front payment of a substantial commitment fee has become permanent feature of the contract. To avoid fulfilling the promise by a client in taking possession of the ordered goods (in case of murabahah), the contract should be binding on the client and not binding on the bank. This suggestion assumes that the bank will honor the contract and supply the goods as contractually agreed, even if the contract is not binding on it.”

Since the murabahah contract is approved with the condition that the bank will take possession of the asset, at least theoretically, the bank holds the asset for some time. This holding period is almost eliminated by the Islamic banks by appointing the client as an agent for the bank to buy the asset. In istisna, contract enforceability becomes a problem particularly with respect to fulfilling the qualitative specifications. To overcome such counterparty risks, Fiqh scholars have allowed band al-jazaa (penalty clause). Again, in istisna financing, the disbursement of funds can be agreed upon on a staggered basis, subject to different phases of the construction, instead of lumping them towards the beginning of the construction work. In several contracts, a rebate on the remaining amount of mark-up is given as an incentive for enhancing repayment. Fixed rate contracts such as long maturity installment sales are normally exposed to more risk, compared to floating rate contracts, such as operating leases. Due to the absence Islamic courts or formal litigation system, dispute settlement is one of the serious risk factors in Islamic banking. To overcome such risks, the counterparties can contractually agree on a process to be followed if disputes become inevitable. Specifically, Islamic financial contracts include choice-of-law and dispute settlement clauses (Vogel and Hayes 1998, p.51). This is particularly significant with respect to settlement of defaults, as rescheduling similar to interest-based debt is not possible. In order to manage interest rate risk, the use of GAP analysis and the use of two-step contracts are advised. Since it is impermissible for a guarantee to be provided as a commercial activity

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under Shari'ah, in a two-step contract, financing can be provided through the Islamic bank’s participation in the funding process as an actual buyer. Islamic banks utilize two mudarabah contracts (one as a supplier with the client and the other as a buyer with the actual supplier). Another mitigative function recommended by Ahmed and Khan is on-balance sheet netting, i.e. the matching out of mutual gross financial obligations and accounting for only the net positions of the mutual obligations. Immunization in order to mitigate potential FX risks and risk transferring techniques, including the use of credit derivatives, namely swaps and options contracts, are also functional for risk mitigation purposes. See the previous section on Islamic derivatives to learn more about the procedures through which these instruments are executed. Collateral, guarantees, and loan loss reserves are protective mechanisms, in and of themselves, as they improve credit quality and allow for a reduction in credit risks. Ahmed and Khan conclude by citing that there is a need to introduce a risk management culture in Islamic banks and that the non-availability of financial instruments to Islamic banks presents a challenge to managing their ability to combat market risks, compared to conventional banks. As discussed in the last section, doing so may not be possible if Fiqhi-related issues and Shari’ah decisions do not fall in the favor of increased Islamic derivative development.

6.2 SHARIAH HARMONIZATION IN PRODUCT DEVELOPMENT

Developing standardized Shariah compliant products is very important. The mid-term review of the Ten-Year Framework identified three indicators to determine the level of progress in Shariah harmonization in product development. First is the number and usage of standardized products with published structures and contracts. The second indicator is the volume of published research on product innovation and standardization. The third is the number and use of innovative products (A Mid-Term Review 106). Shariah harmonization amongst Muslim countries and other countries implementing Islamic finance can be achieved by instituting centralized and decentralized research and development of Islamic financial products. Currently, there is a lack of agreement amongst countries and institutions on how to make Sukuk, Takaful, personal finance and liquidity management products Shariah compliant. However, enabling research and academic institutions to conduct more thorough research on Islamic finance can result in a greater diversity and conceptual clarity of Islamic financial products (A Mid-Term Review 125). Another way of improving Shariah harmonization is by establishing national boards. National boards can help fill the void of Shariah scholars at each institution. Furthermore, by establishing a national board, available Shariah scholars have more time to expend on product development. Creating a national board is a very centralized mode of ensuring Shariah compliancy. Other countries have opted to implement a more decentralized model that will allow for a diversity of views and allow banks to have greater flexibility in adopting standards

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and minimizes the central bank’s time and resources on Shariah issues (A Mid-Term Review 29).

6.3 DEVELOPING SUPPORT INFRASTRUCTURE AMONG MUSLIM COUNTRIES

6.3.1 Legal

Recommendation 8 of the Ten-Year Framework focuses on creating a legal, regulatory and supervisory framework for the IFSI that will be conducive to growth. Table 6.1 indicates the ten legal and supervisory areas identified and their progress. The models for the regulatory bodies vary from country to country. Flexibility of the legal and supervisory frameworks is necessary, due to the great variety in the size, function, products and operations of the institutions. As IRTI states, “The laws should provide for tiered regulation, whereby different institutions would be regulated with different intensities depending on their sizes, functions, products and operations (38).” Different approaches include creating regulations that vary depending on the legal format of the institution, or a model where all financial institutions are treated the same. The KPIs of this recommendation include the percentage of member countries with tax neutrality and legal enablers of Islamic banking. Adoption of social media was identified as a second indictor (A Mid-Term Review 107).

Table 6.1: Progress Made in Ten Areas for Legal and Supervisory Enablement

Recommendation Enablement Progress to Date

1. Liquidity support, such as lender of

last resort (LOLR) facilities

Central banks have generally positioned themselves as lenders

of last resort, even in times of crisis, for all banks (both

conventional and Islamic) under their supervision. Whether

the financing to Islamic banks would be undertaken on a

Sharī`ah-compliant basis is often less clear.

2. Neutrality regarding capital

requirements to be accorded to

assets of Islamic banks as

compared to those of conventional

banks

As noted earlier, Islamic banks are generally subject to the

same capital requirements as their conventional counterparts.

The unique attributes of the assets of Islamic banks call for

appropriate risk-weighting. The IFSB standards have covered

this aspect and have been recently updated and enhanced by

IFSB-15 (Revised Capital Adequacy Standard).

3. Sharī`ah-compliant return on bank

reserves held at central banks

Greater focus is required by central banks to provide Sharī`ah-

compliant returns on statutory reserves; only a minority of

member countries do so today.

4. Appropriate treatment of

investment accounts for

mandatory reserves and capital

The IFSB has produced standards on the treatment of

investment accounts.

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requirements

5. Investment opportunities in

sovereign issues

Most member countries have not yet issued sovereign Sukūk

or other Sharī`ah-compliant instruments. Two large economies

that have done so in recent years are Turkey and Indonesia.

6. Proper understanding of Islamic

banking services and their equal

treatment vis-à-vis conventional

product

As noted earlier, most central banks treat Islamic products on

par with their conventional counterparts.

7. A clearer understanding of the

Sharī`ah governance structures

and efforts to facilitate them

further

Some member countries have specific requirements for

Sharī`ah governance; most do not.

8. Extension of safety net systems

such as Sharī`ah- compliant

deposit insurance

Only 31% of regulators in our survey reported having

Sharī`ah-compliant deposit insurance in their jurisdictions.

Throughout recent crises, deposits and investment accounts of

Islamic banks have enjoyed the safety nets available to all

licensed banks.

It is noted that “investment accounts” based on Mud a rabah or

Mushārakah may not qualify for deposit insurance in certain

jurisdictions.

9. Ensuring that the legal system is

supportive

Among regulators responding to our survey, 65% reported

having banking regulations for Islamic banking. Such

regulation, however, does not always ensure that commercial

laws and the overall legal system support Islamic banking.

Forty-two per cent (42%) reported having “guidance for

Sharī`ah- compliant contracts”.

10. Ensuring tax neutrality for Islamic

financial contracts

Among regulators responding to our survey, 46% reported tax

neutrality for Islamic banking contracts. Additional focus is

thus required in the tax neutrality of Islamic banking contracts.

The matter of Zakāh treatment also calls for consideration.

Source: Islamic Research and Training Institute 2014

6.3.2 Accounting and Auditing

The seventh recommendation pertains to enhancing the implementation of accounting and auditing standards for the IFSI. Its KPIs involve finding the percentage of members requiring compliance with Islamic accounting and auditing standards and determining the level of collaboration between standard setting bodies such as the Basel Committee, IAIS, IOSCO, and IASB (A Mid-Term Review 106). Within the IFSI, central banks and supervisors will need to adopt and implement both the general standards, such as the Basel standards, and industry specific standards, such as the AAOIFI. Governments, private institutions and multilateral bodies will each have a role to play. Governments will have to facilitate the adoption of the standards. Private institutions, who will be clients and investors to these accounting and auditing services, will serve as to ensure accountability, as they will demand proper compliance to Shariah. Multilateral organizations will provide international standards and

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increase advocacy and awareness of accounting and auditing standards. They may provide technical assistance to supervisors as well (A Mid-Term Review 117).

6.3.3 Rating Agencies

IFRS reporting standards do not fully reflect the performance of the IIFS. IFRS standards do not take into account attributes of IIFS such as “the nature of IIFS products, their practice to set up reserve funds to smooth profit distribution and protect risk sharing depositors’ principal, the commitment to distribute Zakat (Grais 9).” In 2008, conventional banks experienced more downgrades in ratings, compared to Islamic banks (IFSB 44). The International Islamic Rating Agency was created in 2005 with the goal of improving the local and international recognition of the Islamic finance industry. It also intends to help improve transparency in the industry (GIFF 2012 12).

6.3.4 Talent Development

According to the fifth recommendation, actors in the Islamic finance industry will need to develop and utilize its human capital and technology to be more competitive with traditional financial institutions. The progress of organizations in this area can be identified by the percentage of countries that have access to Islamic finance education and the level of access to web-based specialized Islamic finance training. Another indicator is the number of professionals with certifications and industry-specific qualifications (A Mid-Term Review 106). Improving human capital and technology will expand the reach of Islamic finance. To attain better human capital and technology, there needs to exist an enabling regulatory environment. For example, access to finance can be increased if regulations allow different methods of banking, such as mobile banking, to exist and function (A Mid-Term Review 127-128).

6.4 INTERNATIONALIZATION OF ISLAMIC FINANCE

There has been a great deal of effort to standardize Islamic finance practices across countries and promote greater cooperation. This has been achieved through the creation of the Ten-Year Framework and the work of organizations such as the IDB Group, IFSB, AAOIFI, and the IIFM. Through internationalization, countries and institutions intend to share best practices to further the growth of the IFSI. There is ample room for formal collaboration (A Mid-Term Review 44). Opportunities for cross-border investments are limited, due to a lack of generally accepted standards for Islamic finance, thus putting the IIFS at a competitive disadvantage to conventional counterparts. Principles-based rules are needed, rather than ad hoc rules (Grais 6-7). According to the Islamic Research and Training Institute (IRTI), there has been good progress made on the Ten Year Framework’s recommendations on improving the legal and regulatory frameworks in various countries (A Mid-Term Review 7). This judgment was based on the number of collaborative projects between countries that offer Islamic financial services (A Mid-Term Review 107). A recommended initiative from the Mid-Term Review is to link

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Islamic financial markets across borders to improve efficiency and maximize returns, while reducing transaction costs. Other recommendations include creating a Technical Assistance and Linkages Network and regional working groups. A critical need for the IFSI is technical assistance. The Technical Assistance and Linkage Network would be an international body that would be composed of several types of institutions, including government, central banks and private companies. The Network would provide recommendations to member countries and help standardize regulations across all Islamic financial sectors. Other multilateral institutions such as the IDB group and IFSB can play a similar role, as well. Regional institutions such as the GCC and ASEAN can similarly help in the effort to harmonize. While regional bodies may result in differing methodologies and understanding, they are easier to coordinate (A Mid-Term Review 122-124). Cross-border harmonization will require the proper infrastructure to create the linkages within and between countries. To determine the progress of linkage development, the several identified KPIs include the number of initiatives countries take to link domestic IFSI with regional and international financial markets, issuances of cross-border Islamic financial instruments, and observer or delegate status for Islamic financial infrastructure bodies on international regulatory bodies (A Mid-Term Review 122-124). The AAOFI has been working towards harmonizing Islamic accounting, auditing, and Shariah standards. The IIFM has focused on harmonizing the Islamic financial markets while the IFSB is focused on prudential regulatory standards. In an effort to achieve the goals set forth in the Ten-Year Framework, the IILM was created in 2010, as a result of the collaboration between many bodies, including central banks, monetary authorities, and multilateral organizations. The IILM’s focus is on developing and implementing short-term Islamic financial instruments (A Mid-Term Review 98).

6.5 GOVERNANCE AND CONTROL OF ISLAMIC FINANCE

There are three goals of Islamic Corporate Governance (CG), two of which are similar to conventional CG and one unique to Islamic CG. Like conventional CG, Islamic CG includes protecting stakeholder interests and achieving the company’s objective. Islamic CG includes a third factor, which is to adhere to Shariah principles (ISRA 2). The Shariah governance system is defined as “set of institutional and organizational arrangements through which IFIs ensure that there is an effective independent oversight of Shariah compliance over the issuance of relevant Shariah pronouncements, the dissemination of information and an internal Shariah compliance review (IFSB, 2009, p. 2).” The first recommendation of the Ten Year Framework focuses on improving the Islamic financial sector by creating an enabling an environment with more transparency and healthy competition. The three KPIs identified are 1) progress on World Bank governance metrics, 2) the percentage of member countries with free market financial systems, and 3) the level of transparency in Islamic banks, compared to traditional banks (A Mid-Term Review 105). Upholding proper Shariah compliance requires several agents. They include a Shariah board, both internal and external Shariah review units, and an internal Shariah compliance unit (ISRA 22). The industry’s level of Shariah compliance, the effectiveness of corporate governance, and transparency can be measured by three indicators. One is the number of member countries

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with national Shariah standards or national Shariah boards. The number of countries adopting international Shariah standards in their supervision framework can also be used. According to an IFSB and IRTI survey, only 35% of the regulator respondents have established Shariah governance standards. This percentage will need to increase to negate skepticism of Islamic banks and their compliancy to Shariah (A Mid-Term Review 30). A third indicator is the deepness of corporate governance standards and the disclosure standards of Islamic financial institutions (A Mid-Term Review 106). Institutional reforms may be capable of enhancing regulatory implementation and enforcement. Governance and Shariah compliancy may be improved with the establishment of national Shariah boards, or documenting all fatwa related to Islamic financial services (A Mid-Term Review 122).

6.6 CAPITAL MOBILIZATION AMONG MUSLIM COUNTRIES

Capitalization in the Islamic finance industry is small, compared with the financial industry as a whole. Few Islamic finance institutions are strongly capitalized and capable of expanding outside of their home countries. In addition, Islamic banking institutions are perceived as less efficient in acquiring capital, compared with conventional financial institutions. NBFIs fare better in comparison. Recommendation 2 from the Ten-Year Framework calls for enhancing the capitalization and efficiency of the IIFS. The IFSB standards attempt to “ensure that capital adequacy regulations suit the risk exposure of Sharī`ah-compliant contracts, provide adjustments required in the capital adequacy ratio (CAR) for profit-sharing investment accounts, and offer eligibility criteria and the contractual structure for issuing capital instruments that meet the criteria of going concern and gone concern capital (24).” Progress in this area is measured using four indicators: 1) average capital adequacy, 2) the average ROE of Islamic banks, 3) the average ROE of takaful companies, and 4) the market capitalization of member country capital markets. Examples of the progress in improving capital mobilization can be seen in the creation of the Tahawwut Master Agreement, the Mubadalat al-Arbah (Islamic profit rate swap), the Islamic Interbank Unrestricted Master Investment Wakalah Agreement, and the Master Agreement of Treasury Placement (A Mid-Term Review 99, 105). One of the twenty key initiatives in the Mid-Term Review is the number of securities proposed to fund public infrastructure projects to build Islamic capital markets. Long-dated sukuks would be used to finance infrastructure projects. Therefore, Sukuk returns would be linked to infrastructure projects that can generate revenue. Using long-dated sukuks would also allow the sukuks to be listed and traded on exchanges and be traded based on the latest market prices (A Mid-Term Review 126-127).

6.7 FINANCIAL INCLUSION AND ISLAMIC MICROFINANCE AMONG MUSLIM COUNTRIES

Increasing financial inclusion is important, as it can reduce inequality and propagate economic growth. Financial exclusion transpires in two categories: those who are involuntarily excluded and those who voluntarily exclude themselves. The poor are more easily vulnerable to shocks and do not have proper access to financial services, including savings, credit, and insurance (Ahmed 203). Factors that result in financial exclusion of the poor include low income, high

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risk, price exclusion, and information asymmetry (Ahmed 204). Muslims voluntary exclude themselves from formal financial services since Islam prohibits participation in interest-based mechanisms. In Muslim countries, 20 to 40 percent of the population chooses to eschew conventional microfinance services that utilize interest-based instruments. Financial exclusion results in inefficiencies and higher costs, especially for the poor. Exclusion forces people to find other means maintaining savings, such as converting cash into jewelry or gold. However, this results in higher transaction costs than if the cash was saved in a financial institution. In addition, people without access to financial services expend more time and energy in managing their money (IFSB 140). There are four types of organizational models for providing financial services to the poor: commercial, non-profit, mutuals or cooperatives, and community-based organizations. Non-profits, mutuals and cooperatives, and CBOs are also driven by social motives. They are able to reach farther and deeper into low-income communities, but struggle with financial sustainability. Commercial firms are driven by profit. Their approach results in greater efficiency and sustainability, but their services are not always accessible to the poorest of the poor (Ahmed 208). One type of financial service that focuses on pro-poor financial inclusion and has grown in popularity over the last four decades is microfinance. Microfinance institutions provide credit to the poor. Some also provide services for savings and risk mitigation. With the lack of development and level of poverty in many Islamic countries, Islamic microfinance can be leveraged to provide access to financial services to the poor in those countries. In compliance with Shariah, Islamic microfinance provides the poor with real assets instead of cash (IFSB 5). Islamic microfinance institutions have several Shariah-compliant financial instruments they can utilize. Qard-al-hassan is interest free loans. To comply with the stipulation that transactions must involve real objects, transactions can occur as partnerships (sharikat) or exchange contracts (mu’awadat). Through sharikat, profits can be shared either by musharakah or mudarabah. In musharakah, two or more parties contribute funds and the profit is divided based on a pre-determined ratio. Mudarabah differs in that it involves only two parties, and one party provides the funds, while the other party manages the funds. Similar to musharakah, profits are divided based on a pre-determined ratio. The most popular MFI model is the Grameen model for group-based microfinance. The effectiveness of microfinance in reducing poverty is a polarized and debated issue, with examples of great success and failure (Ahmed 205-206). Opponents of Islamic microfinance argue that it is too costly. Traditional microfinance in many cases is cost inefficient, since it cannot take advantage of economies of scale. With the additional costs from Shari’ah compliance, Islamic microfinance becomes even more costly (Grais 12-13, IFSB 133). However, according to Grais, Islamic microfinance has the ability to bundle several services that can help reduce costs (Grais 13). In addition, the IFSB recommends that areas with small Islamic microfinance industries implement regulations gradually, starting with licensing, accounting, disclosure and governance (IFSB 133). The price-deferred sale (bay-mua’jjal) is a form of exchange contract. In bay mua’jjal, an object is exchanged, and the recipient is allowed to pay the price of the object at a later time. Two types of bay-mua’jjal include 1) mark-up sale

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(murabahah), where the MFI can buy a good and sell the object at higher price, and 2) ijarah, where the MFI can lease objects for a fixed price and time. Microtakaful is a second way of increasing financial inclusion. Conventional insurance services are not Shariah compliant, due to the inherent high level of uncertainty. Takaful is a mutual guarantee that functions by bringing together a group of people who contribute to a fund managed by a takaful operator (TO). There are three takaful models: mudarabah, wikala, and waqf. Mudarabah consists of a partnership relationship in which the participants contribute to a fund and the TO invests the funds. The TO retains a certain amount of the profit, and the rest is divided amongst the participants. In the wikala model, the TO’s compensation is not dependent on the investment s/he makes. Instead, the TO acts as an agent and charges fixed management fees for his service. The third model is waqf, where the participants add to a waqf fund that the TO creates. The TO can choose to either be a partner or agent with the waqf model (Ahmed 211-213). Furthermore, to target the poorest of the poor, mandatory zakat and voluntary waqf funds can be used to create grants and interest-free loans for MFIs (Ahmed 211-212).

6.8. RECOMMENDATIONS AND RISK MANAGEMENT IMPLEMENTATION 6.8.1 Recommendations from the Risk Management Survey We offer the following recommendations from the survey done in chapter 5. (a) Training, research and development IFIs must ensure proper training for their staff on various updated technologies that bankers have to rely on for better analysis of the issues relevant to risk management in IFIs. IFIs should increase investment in research and development activities to find challenges beforehand.

(b) Collaboration among IFIs and with external stakeholders Active collaboration with international organizations may offer valuable insights into challenges from various dimensions. In the absence of a strong secondary market, banks can form a platform within themselves to solve liquidity problems. This kind of collaboration will also help in preparing a strong country risk report.

(c) Investment in technology In order get better estimations and communication updates, IFIs must invest in new technologies to make sure that the staff is getting the right information at the right time. Since the basic setup of the risk management system is already established, IFIs need to upgrade their experience using cutting edge technology.

(d) Stop competing with conventional banks Even though it is not entirely possible for many years to come, IFIs must stop competing with the conventional banks. Conventional banking risks and those of IFIs are never the same. Many IFIs are operating in dual banking systems and are primarily threatened by monetary systems

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controlled by un-Islamic principles. However, Islamic banks should operate solely based on the Shari’ah. (e) Going back to basic – Shari’ah based versus Shari’ah compliant Gradually, IFIs must have a plan to go back to Shari’ah based risk management systems. As illustrated in Figure 4.12, Shari’ah based financial operations is the first line of defense. If IFIs sacrifice in the first line of defense, the rest of the system will collapse. Hence, the most important element of risk management in IFIs is to bring back the wisdom of Shari’ah into operations.

(f) Diversification IFIs are still struggling to diversify their portfolio of operations across countries, sectors and industries. Perhaps it is easier to diversify across industries and sectors. However, IFIs have to ensure that there exist experts on those sectors and industries among the staff who can guide the risk management process for that specific sector. In fact, IFIs should have experts on each sector or industry they are dealing with. This goes back to the notion of having effective training for employees.

(g) Role conflict: social versus operational It is important to understand that the risk management division exists solely for the purpose of operational sustainability. It may not yield any social value addition in the immediate term. Islamic banks are more closely tied to social development goals than conventional banks. However, the objective of the risk management division is to make IFIs fit for social development. Hence, there should not be any role conflict between the overall objective of the IFIs and the specific objectives set for the risk management division.

(h) Investing in education system In order to get good employees, many IFIs are now directly connected to educational institutions. They are financing studies by brilliant students and bringing them into the banking sector after the successful completion of their studies. Some of these educational institutions are specialized in banking and financial sector education. IFIs may offer cases to discuss in universities in order to build awareness about risk management practices and strategies. As the Islamic financial system is relatively new, there is a need for an integrative approach between the banks and the regulators in order to bring a proactive, long-term change in the way we see risk management today.

(i) Legal system IFIs are lucky if they are in a system that does not tolerate habitual defaulters. Banks must assist the government and the regulatory authority in introducing a healthy legal atmosphere for all. In many countries, there is no Islamic banking law to guide the IFIs. In addition to the ordinary legal system, IFIs must work out an operating practice that abides by the laws of Shari’ah.

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6.8.2. IFSB Risk Management Implementation

The Islamic Financial Services Board (IFSB) compiled 15 principles for the Islamic financial services industry.26 Many of these recommendations are crafted based on the Basel Committee on Banking Supervision (BCBS) sound practices and principles, but are augmented to confirm the tenets of Islamic Shariah. We argue that the Regulatory and Supervisory authorities can implement these guidelines to build up a competent risk management infrastructure in OIC member countries to deal with specific risks in these countries. We reproduce these guidelines under separate risk categories below:

1. General Requirement

Principle 1.0: IIFS shall have in place a comprehensive risk management and reporting process, including appropriate board and senior management oversight, to identify, measure, monitor, report and control relevant categories of risks and, where appropriate, to hold adequate capital against these risks. The process shall take into account appropriate steps to comply with Shariah rules and principles and to ensure the adequacy of relevant risk reporting to the supervisory authority.

2. Credit Risk

Principle 2.1: IIFS shall have in place a strategy for financing, using various instruments in compliance with Sharī`ah, whereby it recognizes the potential credit exposures that may arise at different stages of the various financing agreements.

Principle 2.2: IIFS shall carry out a due diligence review in respect of counterparties prior to deciding on the choice of an appropriate Islamic financing instrument.

Principle 2.3: IIFS shall have in place appropriate methodologies for measuring and reporting the credit risk exposures arising under each Islamic financing instrument.

Principle 2.4: IIFS shall have in place Sharī`ah-compliant credit risk mitigating techniques appropriate for each Islamic financing instrument.

3. Equity Investment Risk

Principle 3.1: IIFS shall have in place appropriate strategies, risk management and reporting processes in respect of the risk characteristics of equity investments, including Muḍārabah and Mushārakah investments.

Principle 3.2: IIFS shall ensure that their valuation methodologies are appropriate and consistent, and shall assess the potential impacts of their methods on profit calculations and

26 Islamic Financial Services Board (IFSB), “Guiding Principles of Risk Management for Institutions

(Other than Insurance Institutions) Offering only Islamic Financial Services, December 2005

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allocations. The methods shall be mutually agreed between the IIFS and the Muḍārib and/or Mushārakah partners.

Principle 3.3: IIFS shall define and establish the exit strategies in respect of their equity investment activities, including extension and redemption conditions for Muḍārabah and Mushārakah investments, subject to the approval of the institution’s Sharī`ah Board.

4. Market Risk

Principle 4.1: IIFS shall have in place an appropriate framework for market risk management (including reporting) in respect of all assets held, including those that do not have a ready market and/or are exposed to high price volatility.

5. Liquidity Risk

Principle 5.1: IIFS shall have in place a liquidity management framework (including reporting) taking into account separately and on an overall basis their liquidity exposures in respect of each category of current accounts, unrestricted and restricted investment accounts.

Principle 5.2: IIFS shall assume liquidity risk commensurate with their ability to have sufficient recourse to Sharī`ah-compliant funds to mitigate such risk.

6. Rate of Return Risk

Principle 6.1: IIFS shall establish a comprehensive risk management and reporting process to assess the potential impacts of market factors affecting rates of return on assets in comparison with the expected rates of return for investment account holders (IAH).

Principle 6.2: IIFS shall have in place an appropriate framework for managing displaced commercial risk, where applicable.

7. Operational Risk

Principle 7.1: IIFS shall have in place adequate systems and controls, including Sharī`ah Board/ Advisor, to ensure compliance with Sharī`ah rules and principles.

Principle 7.2: IIFS shall have in place appropriate mechanisms to safeguard the interests of all fund providers. Where IAH funds are commingled with the IIFS’s own funds, the IIFS shall ensure that the bases for asset, revenue, expense and profit allocations are established, applied and reported in a manner consistent with the IIFS’s fiduciary responsibilities.

6.9. RECOMMENDATION, PERFORMANCE INDICATOR AND FUTURE INITIATIVES FOR THE DEVELOPENT AND RISK MANAGEMENT IN THE ISLAMIC FINANCIAL SERVICES INDUSTRY

The Ten-Year Framework was created in 2007. The document lays out a roadmap for the development of the Islamic finance industry, which the challenges the industry is expected to face in the next ten years, as well as the recommendations for addressing the challenges. A

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mid-term review of the Ten-Year Framework was conducted in 2013. The mid-term review analyzed the impact of recent events on the IFSI. The mid-term review also examined the progress made on the recommended initiatives, examined gaps in implementation, and analyzed other issues with the listed priorities and initiatives in the Ten-Year Framework. Through the mid-term review, it was determined that the IFSI has shown great resilience in the face of recent tribulations in the global financial industry, especially in comparison to the conventional financial industry. However, the IFSI has not been entirely immune to the recent global financial crisis. While economies around the world have weakened, including countries using Islamic finance, the financial crisis has impacted the IFSI’s asset values, investments, and approach to financial regulation. The resilience of the IFSI has served as an indicator to Western countries of the pertinence and potential of Islamic Finance (A Mid-Term Review 2-5). Table 6.3 lists the Ten- Year Framework’s 13 original recommendations and three new additions from the mid-term review. The Mid-Term Review categorized the recommendations into three categories: enablement, performance, and reach (A Mid-Term Review 6).

Table 6.2: Ten-Year Framework Recommendations

Enablement

1 Facilitate and encourage the operation of free, fair and transparent markets in the

Islamic financial services sector

5 Develop the required pool of specialized, competent and high-caliber human capital

6 Promote the development of standardized products through research and innovation

8 Develop an appropriate legal, regulatory and supervisory framework, as well as an IT infrastructure that

would effectively cater for the special characteristics of the IFSI and ensure tax neutrality

9 Develop comprehensive and sophisticated interbank, capital and hedging market

infrastructures for the IFSI

12 Foster collaboration among countries that offer Islamic financial services

14* Develop an understanding of the linkages and dependencies between different

components of Islamic financial services to enable more informed strategic planning to be undertaken

Performance

2 Enhance the capitalization and efficiency of institutions offering Islamic financial services (IIFS) to

ensure that they are adequately capitalized, well-performing and resilient, and on par with international

standards and best practices

4 Enhance Sharī`ah compliance, effectiveness of corporate governance and transparency

7 Enhance the implementation of the international prudential, accounting and auditing standards

applicable to the IFSI

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11 Strengthen and enhance collaboration among the international Islamic financial infrastructure

institutions

15* Foster and embrace innovative business models, including new technologies and delivery channels, in

offering Islamic financial services

Reach

3 Enhance access by the large majority of the population to financial services and enhance access to

funding for SMEs and entrepreneurs

10 Promote public awareness of the range of Islamic financial services

13 Conduct initiatives and enhance financial linkages to integrate domestic IFSI with regional and

international financial markets

16* Strengthen contributions to the global dialogue on financial services, offering principles and

perspectives to enhance the global financial system

Source: Islamic Research and Training Institute (2014): Islamic Financial Services Industry Development: Ten Year

Framework and Strategies, A Mid-Term Review

The mid-term review of the Ten-Year Framework by the IFSB, IRTI, and IDB Group revealed that there was still a great deal of work to be done at the halfway point to achieve the goals set out in the recommendations of the Framework. The IRTI, et al. concluded that, while “concrete progress” has been made towards all of the recommendations, none have been entirely achieved, and more focus is required by member countries in order to implement the 16 recommendations (A Mid-Term Review 7-16). While there has been much discussion surrounding the Framework, implementation has been a challenge. In grouping the 13 recommendations and the additional three recommendations into three categories of enablement, performance and reach, the IFSB, IRTI, and IDB Group proposed over 70 initiatives to aid in the better implementation of the recommendations. The 70 initiatives were narrowed to 20 key initiatives using key performance indicators (KPIs).

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6.9.1. Key Performance Indicators for Measuring Progress

The Midterm Review of Ten-Year Framework also provided a number of KPIs against which the progress of Islamic financial industry development can be measured. Table 6.3 shows those KPIs.

Table 6.3: Key Performance Indicators for Measuring Progress

No. Recommendation Key Performance Indicators

1

Facilitate and encourage

the operation of free, fair

and transparent markets

in the Islamic financial

services sector

1.1 Progress made by member countries on World Bank

governance metrics

1.2 Percentage of member countries operating free market

financial systems

1.3 Level of transparency of Islamic banks compared with

conventional counterparts

2

Enhance the capitalization to

ensure that they are

Adequately capitalized, well-

performing and

resilient, and on par with

international standards and

best practices

2.1 Average capital adequacy of Islamic banks

2.2 Average ROE of Islamic banks

2.3 Average ROE of Takāful companies

2.4

Market capitalization of member country capital markets

3

Enhance access by the large

majority of the population

to financial services, and

enhance access to funding

for SMEs and entrepreneurs

3.1 Percentage of population with access to financial service

3.2 Number of Islamic microfinance institutions in member

countries

3.3 Percentage of Islamic banks offering SME and entrepreneurial

finance

3.4

Number of member countries with SME and entrepreneurial

finance programs (public sector or NGOs) that are Sharī`ah

compliant

4 Enhance Sharī`ah compliance,

effectiveness of corporate

governance and transparency

4.1 Number of member countries with national Sharī`ah

standards or national Sharī`ah boards

4.2 Number of countries adopting international Sharī`ah

standards in their supervision framework

4.3 Corporate governance standards and disclosure standards of

Islamic financial institutions

5 Develop the required pool

of competent, skilled and

high-calibre human capital

and ensure utilization of

state-of-the-art technology

5.1 Percentage of countries with Islamic finance education

available (within general educational institutions or

specialized Islamic finance institutes)

5.2 Access to specialized Islamic finance training through

internet-based platforms

5.3 Number of professionals receiving industry-specific

qualifications

6 Enhance the development

of standardized products

through research and

6.1 Number and usage of standardized products with

published structures and contracts

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innovation 6.2 Volume of published research on product innovation and

standardization

6.3 Number and usage of innovative products

7 Enhance the implementation

of the international

prudential, accounting

and auditing standards

applicable to the IFSI

7.1 Percentage of members requiring compliance with applicable,

Islamic finance industry-specific prudential, accounting and

auditing standards as generated by industry standard-setting

bodies

7.2 Collaboration with international standard-setting bodies such

as Basel Committee, IAIS, IOSCO and IASB

8 Develop an appropriate

legal, regulatory and

supervisory framework, as

well as an IT infrastructure

that would effectively

cater for the special

characteristics of the IFSI

and ensure tax neutrality

8.1 Percentage of member countries with tax neutrality, legal

enablement and other basic enablers of Islamic banking as

enumerated in ten recommendations from the 2007

8.2 Framework and reviewed in this document

Level of new and social media adoption by IIFS

9 Develop comprehensive and

sophisticated interbank,

capital and hedging

infrastructures for the IFSI

9.1 Percentage of member countries with domestic Islamic

interbank markets

9.2 Number of member countries with developed regulatory

and market infrastructure for Islamic capital markets

10 Promote public awareness

of the range of Islamic

financial services

10.1 Percentage of member countries with market share of Islamic

finance of 10% or greater

10.2 Percentage of Islamic banking, Takāful, Islamic capital

markets and Islamic microfinance activities as a proportion of

the total for the respective sector in member countries

10.3 Number of member countries with awareness-raising

programmes on Islamic finance (as standalone programmes

or part of broader financial literacy)

11 Strengthen and enhance

collaboration among

the international Islamic

financial infrastructure

institutions

11.1 Number of collaborative projects between infrastructure

Institutions

11.2 Impact assessment analysis of collaborative projects between

infrastructure institution

12 Foster collaboration among

countries that offer Islamic

financial services

12.1 Number of collaborative projects (multilateral and bilateral)

between countries that offer Islamic financial Services (e.g.

technical assistance on regulation, public awareness

campaigns, etc.)

13 Conduct initiatives and

enhance financial linkages

to integrate domestic

IFSIs with regional and

international financial

markets

13.1 Number of initiatives under way in member countries to link

domestic IFSIs with regional and international financial

markets (e.g. the facilitation of introductions between IFSIs

and overseas capital market participants)

13.2 Issuances of cross-border Islamic financial instruments

13.3 Observer or delegate status for Islamic finance services

infrastructure bodies on international regulatory bodies

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14 Develop an understanding

of the linkages and

dependencies between

different components of

Islamic financial services

to enable more informed

strategic planning to be

undertaken

14.1 Regular tracking of the industry-level KPIs

14.2 Re-visiting the framework strategies at the end of the Ten-

Year period

14.3 Inclusion of Islamic finance statistics in the national and

regional statistics of member countries

14.4 Participation in the Islamic Financial Sector Assessment

Programme (iFSAP), an initiative that provides

supplementary templates on Islamic finance for the World

Bank–IMF Financial Sector Assessment Program

14.5 Participation in self-assessment, peer review and/or IMFWB

FSAP on the basis of Core Principles for Islamic Finance

Regulation

15 Foster and embrace

innovative business models,

including new technologies

and delivery channels, in

delivering Islamic financial

service

15.1 Percentage of IIFS utilizing internet, mobile banking and other

forms of alternative channels

15.2 Introduction of innovative business models such as peerto-

peer financing, crowdfunding, digital payments, etc.

16 Strengthen contributions

to the global dialogue on

financial services, offering

principles and perspectives

to enhance the global

financial system

16.1 Participation by Islamic infrastructure institutions and

regulators in reviews of the overall financial system at

international forums (e.g. the G20, Basel Committee, IMF/

World Bank, etc.)

16.2 Explicit reference and consideration of Islamic finance

principles in communiqués and proceedings of key

international forums (e.g. the G20, Basel Committee,

IMF/World Bank, etc.)

16.3 Number of dialogues held between OIC central banks, stock

exchanges and regulatory authorities on various issues of

Islamic finance

16.4 Number of papers prepared or events organized providing

Islamic perspective on the current and long-term strategic

issues pertaining to the global financial system

Source: Islamic Research and Training Institute (2014): Islamic Financial Services Industry Development: Ten Year

Framework and Strategies, A Mid-Term Review

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6.9.2 Key Initiatives for Implementation of the Goals

Table 6.4 provides the key initiatives that should be implemented in stages in order to make progress in the Islamic financial industry and risk management capacity.

Table 6.4: Key Initiatives

Enablement

Integrate Islamic finance in national development plans

Introduce national Islamic financial services master plans

Enhance regulatory implementation and enforcement

Harmonize, where possible, regulation and regulatory frameworks across borders

Adopt and strengthen national Sharī`ah governance frameworks

Where mandates overlap, align the positions of industry bodies

Link Islamic financial markets across borders

Form a “Technical Assistance and Linkage Network”

Form regional working groups

Foster information-providing institutions that support the provision of Islamic finance

Incorporate Islamic finance data in statistical and official reporting

Performance

Institute centralized R&D for Islamic financial products in addition to the decentralized R&D

Establish diversified financial institutions

Demonstrate the industry’s distinctive value proposition

Fund public infrastructure projects to build Islamic capital markets

Reach

Revitalize Zakāh and Awqāffor greater financial inclusion and make them an integrated part of

Islamic financial system

Ensure that regulations allow for the use of new technology to provide affordable services

Engage with newly opened markets

Foster the financing of a wider set of economic sectors

Brand Islamic financial services for wider markets

Source: Islamic Research and Training Institute (2014): Islamic Financial Services Industry Development: Ten Year

Framework and Strategies, A Mid-Term Review

6.9.3 Support the Growth and Stability of the Islamic Finance Industry27

A main goal of the international Islamic finance community is to encourage the continued growth and stability of the Islamic finance industries across the globe. Initiatives aimed at accomplishing this goal include, but are not limited to, strengthening Shari’ah governance frameworks, encouraging more diversified institutions, promoting Islamic finance, and improving financial data and reporting practices.

27 Islamic Research and Training Institute (2014): Islamic Financial Services Industry Development: Ten Year Framework and Strategies, A Mid-Term Review

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Perhaps the most important aspect of an Islamic financial institution is the Shari’ah advisory board. The Shari’ah board is a major governance component of an Islamic financial institution, as it ensures the institution’s practices are consistent with the principles of Islam. Encouraging successful Shari’ah oversight is therefore and important driver of the Islamic finance industry. The role of Shari’ah governance should be to acknowledge and implement all rulings on Islamic finance issues. In addition, Shari’ah boards can provide standard contracts for Islamic financial products and services. Establishing proper governance and Shari’ah practices will help insure the strength of the industry and insure the public trust.

In addition, encouraging more diversified Islamic financial institutions can help the overall growth of the industry. The conventional finance industry has begun to shift towards non-bank financial intermediation, due to advantages in technology and regulation. The Islamic finance industry stands to benefit from perusing more diversified practices as well. The diversification of the Islamic finance industry can involve expanding the products and services offered as well as engaging in non-bank actives such as Mud a rabah and Taka ful firms. A more diverse Islamic finance industry will not only help the industry grow, but will also better service the economy by offering more robust products and creating more stable institutions.

Another key to industry growth is providing for more efficient and accurate information. There has often been criticism with regards to the availability and accuracy of information related to Islamic financial institutions. Hence, there is a need for the production of more accurate reporting from Islamic financial institutions. Improvements in the reliability and availability of reported data can help practitioners better manage Islamic financial institutions and increase the public trust in reported statistics.

Finally, the Islamic finance industry needs to continue to demonstrate the value of Islamic finance in order to encourage its continued growth. Islamic finance has some distinct benefits. The most obvious benefit is the use of Shari’ah principles to guide the operations of Islamic financial institutions, which is a valuable service for Muslims around the world. However, Islamic finance has value beyond simply being Shari’ah compliant. The additional benefits of Islamic finance include more closely linking financial activities with the real economy, a focus on overall economic stability, and a desire for socially beneficial financial outcomes. It is important that the Islamic financial industry successfully communicates and promotes these benefits. Islamic finance has the capacity to benefit society beyond the Muslim world, and successfully communicating those benefits can drive industry growth.

6.9.4 Encourage Efficiency and Innovation in the Islamic Finance Industry28

Another key initiative for the Islamic finance industry going forward is the continued promotion of innovation and efficiency within the industry. For example, national credit bureaus can help both conventional and Islamic financial institutions make more informed financial decisions. Thus, establishing credit and business rating institutions can help drive improvements in Islamic financial institutional efficiency. In addition, promoting technical

28 Islamic Research and Training Institute (2014): Islamic Financial Services Industry Development: Ten Year Framework and Strategies, A Mid-Term Review

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advances can also drive efficiency. Technical Assistance networks can provide new financial institutions and emerging markets with assistance in establishing technical solutions that will improve operational efficiency.

Another way in which operations among Islamic financial institutions can be improved is through improvements in industry research and best practices. Developing methods of conducting valuable industry research will help foster efficiency and innovation in the industry.

In addition to improvements in innovation and efficiency within the industry, regulations must also be crafted in such a matter that fosters new innovations within the industry. The recent financial crisis drew attention to the impact that financial innovations can have on economic outcomes. Regulations can have a significant impact on the degree and speed at which innovations are adopted within the industry. Therefore, regulations must be crafted in order to ensure that innovations in the financial industry can be appropriated evaluated and, if appropriate, implemented, in order to create a more robust financial sector.

6.9.5. Promote the International Growth of the Islamic Finance Industry29

Enhance National Islamic Finance Agendas

Countries around the world are beginning to take steps to improve their economic outlook and engage in international trade. A crucial part of this process includes the use of the banking and financial systems to fund projects that lead to improved infrastructure, social well-being and, ultimately, economic growth. Islamic finance has a key role to play in this process, and a key initiative is to promote the advancement of the Islamic finance industry through the implementation of national development plans that acknowledge the role of Islamic financial institutions and promote their growth.

Encouraging developing nations to include the Islamic financial industry in their respective national development plans can help the worldwide growth of the Islamic financial industry as well as provide enhanced mechanisms for economic growth and wellbeing in emerging markets. Additionally, a key component of encouraging Islamic finance in the development plans of countries is the establishment of Master Plans that incorporate specific development goals.

Islamic finance Master Plans can provide specific strategic guidance for the implementation of policies related to the Islamic finance industry that are specific to the needs and circumstances of individual countries. The goal of developing a national Islamic finance Master Plan is to identify specific areas of the industry that need to be addressed in order to promote a healthy financial sector and encourage balanced growth of the Islamic finance industry. For example, Master Plans should promote the growth of a complete Islamic finance sector, which includes banking institutions as well as non-bank Islamic financial institutions such as Takāful

29 Islamic Research and Training Institute (2014): Islamic Financial Services Industry Development: Ten Year Framework and Strategies, A Mid-Term Review

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companies. In addition, Islamic finance Mater Plans should include key performance indicators than can be measured and monitored over time in order to analyze and evaluate the success of the Master Plan.

Master Plans should also play a key role in the development of governance practices within the Islamic finance industry. The Master Plan should guide Islamic financial institutions in the establishment of governance practices that uphold Islamic principles, promote stability in the industry, and ensure accurate and efficient information production and dissemination. Industry best practices such as IFSB and AAOIFI guidelines should be used as standards for developing these policies. Finally, national development and Master Plans should also focus on establishing regulatory regimes that promote the growth of a vibrant and stable Islamic finance industry.

Improve Regulatory Standards

Given the highly regulated nature of the finance industry, countries should develop laws and regulations that encourage the appropriate balance between the growth and stability of the Islamic finance industry. Islamic financial institutions have some unique characteristics that should be considered when developing a national financial regulatory structure. Issues pertaining to capital adequacy and risk management in the Islamic finance industry are of particular concern, and appropriate regulatory practices need to be established.

Additionally, regulatory practices need to be sensitive to the lessons learned from the recent financial crisis. In particular, a more specific focus on non-bank Islamic financial institutions should be implemented. Additionally, policy makers should develop a financial supervision structure that is sensitive to issues surrounding recent innovations in both technology and new financial products. A regulatory regime is needed such that Islamic financial institutions are not overburdened by regulation and can continue to grow and innovate, while simultaneously imposing restrictions that ensure a stable and efficient financial industry. The Islamic finance Master and national development plans can play a key role in insuring that an effective regulatory regime is established.

6.9.6 Promote the Integration of Islamic Finance Across Borders30

There has been substantial growth in the Islamic finance industry in many countries around the world; however, there remains room for further integration of the Islamic financial markets across international borders. Many international transactions involving Islamic financial products do not flow through a centralized marketplace. Developing markets that facilitate trading in international Islamic financial products will have several advantages. Firstly, more integrated international markets will make price discovery faster and more efficient. In addition, standardized international markets can lower the costs and the risks associated with international transactions, which will encourage more efficient flows in international Islamic financial products. Developing computerized markets that link

30 Islamic Research and Training Institute (2014): Islamic Financial Services Industry Development: Ten Year Framework and Strategies, A Mid-Term Review

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international financial transactions is one potential solution for fostering more integrated Islamic markets.

Major obstacles for creating more integrated markets are cross-border differences in markets and regulations. For example, differences in taxation, accounting standards, disclosure requirements, and other regulatory discrepancies make it difficult to establish standardized international markets. Consequently, a main goal in developing more integrated markets is to encourage consistent regulatory policies across international borders. International cooperation in developing uniform international standards and regulations with regards to Islamic financial products will allow the international Islamic financial markets and institutions to become more prominent and efficient.

As countries strive to achieve the goals of providing more robust international Islamic financial markets and regulatory standards, the development of regional working groups can play a key role. Economies often develop important trade relationships with other counties in the region, such as the European Union and ASEAN region. These countries often share common legal, regulatory, and economic systems, and, therefore, develop important trade relationships. From an Islamic finance perspective, establishing regional working groups along these lines can help to integrate financial markets and grow the Islamic finance industry. By working together to standardize financial products and regulations, these regions can help to foster more integrated and efficient international markets for Islamic financial products. In addition, regional working groups can also work together to share knowledge and develop industry best practices with regards to Islamic financial institutions. This type of cooperation can help foster efficiency and growth of the Islamic finance industries among the member countries.

Finally, a major goal of the international Islamic finance community is to encourage access to and the growth of new markets for Islamic financial products. Developing integrated markets for Islamic products, standardizing international regulations, and establishing cross-border working groups all help to integrate the market for Islamic financial products and promote new market growth. Integrated, standardized markets allow for smaller, less-developed countries to gain access to the international marketplace. As a result, the international community of Islamic finance can help encourage the growth of Islamic finance in emerging markets, which can help to promote emerging market economic growth and alleviate poverty.

6.9.7 Enhance the Role of Islamic Finance in Promoting Economic Growth31

Islamic finance can also play an important role in promoting international economic growth. In many countries throughout the world, there is a need for vital infrastructure projects, such as roads, transportation, and power, and project finance is often a major obstacle to their completion. Islamic finance may provide an opportunity for emerging economies to finance these crucial infrastructure projects. For example, a sukūk type security could be issued such that the returns are linked to the infrastructure project’s returns. Additionally, these securities could be established with a long time dimension and be issued in small denominations, which

31 Islamic Research and Training Institute (2014): Islamic Financial Services Industry Development: Ten Year Framework and Strategies, A Mid-Term Review

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would allow smaller investors to participate. Such an Islamic finance arrangement would allow for vital infrastructure projects to be undertaken in emerging economies without the need to overburden the budgets of emerging governments. As a result, emerging economies can experience more consistent growth and more stable governments.

Zakāh and Awqāf also play an important role in Islamic economies. An important tenant in Islam provides for the care of those in need and the fairness of economic transactions. Zakāh and Awqāf are two mechanisms that not only accomplish those religious goals, but also can have positive impacts on the alleviation of poverty and fostering equal access to economic opportunities. Therefore, there are several aspects of Islamic finance that can have a positive external effect on promoting economic growth and fairness, especially in emerging economies. As a result, a healthy Islamic financial system can help to reduce poverty and promote economic growth through equality.

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REFERENCES

“AAOIFI Publishes Work Plan for Islamic Accounting and Governance Standards”, www.iasplus.com.

“Executive Summary.” 2012. Global Islamic Finance Forum 2012. p.1

“Global Islamic Finance Industry.” 2012. Global Islamic Finance Forum 2012. pp.5-14

Abderrezak, F. (2008). The Performance of Islamic Equity Funds: A Comparison to Conventional, Islamic and Ethical Benchmarks. Retrieved April 1, 2011, from Failaka:http://www.failaka.com/downloads/AbderrezakF_Perf_IslamicEquityFunds.pdf

Abdul Karim, Mastura, M. Kabir Hassan, Taufiq Hassan and Shamsher Mohamed, “Captial Adequacy and Lending and Deposit Behavior of Conventional and Islamic Banks,” Pacific Basin Finance Journal, 2014 (On-line)

Abdul Majid, Mariani and M. Kabir Hassan, “The Impact of Foreign-Owned Islamic Banks and Islamic Bank Subsidiaries on the Efficiency and Productivity Change of Malaysian Banks” King Abdul Aziz University Journal of Islamic Economics, Volume 24, No. 2, 2012

Abdullah, F., Hassan, T., & Mohamad, S. (2007). Investigation of performance of Malaysian Islamic unit trust funds, Managerial Finance, 33 (2), 142-153.

Abdullah, L. H., Mohamad, S., Rahman, N. N. A., Razif, N. F. M., & Saripudin, K. N., (2012), Case Study on Sukuk Musharakah Issued in Malaysia. Middle-East Journal of Scientific Research 12 (2): 168-175, 2012, ISSN 1990-9233

Abdullah, S. B., Hafizuddin, M., Majid, H. A., & Shahimi, S., (2011), Sukuk Defaults and Its Implication: A Case Study of Malaysian Capital Market, working paper presented in 8th International Conference on Islamic Economics and Finance

Abdul-Wahab, Abdul Rahim, Mervyn Lewis and M. Kabir Hassan (2007), ‘‘Islamic Takaful: Business Models, Shari’a Concerns and Proposed Solutions’ Special Issue on Islamic Finance in Thunderbird International Business Review, Volume 49, Number 3 (May-June), Pages:371-396

Adebayo, R. Ibrahim and M. Kabir Hassan, “Ethical Principles of Islamic Financial Institutions,” Journal of Economic Development and Cooperation, Volume 34, No 2 (2013)

Adeyemi, Adewale and M. Kabir Hassan,” Islamic Micro-financing,” Handbook on Islam and Economic Life, Edward Elgar Publishing Company, December 2014.

Ahmad and Ibrahim (2002). A Study of Performance of the KLSE Shariah Index, Malaysian Management Journal, 6 (1&2): 25-34.

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Ahmad, A U Faruq, M. Kabir Hassan and Abul Kalam Muhammad Shahed, “Zakah and Redistributive Justice in Islam,” Journal of Muamalat and Islamic Finance Research, Volume 3, No. 1 (2006): 1-22.

Ahmad, A.U.F. and M. K. Hassan (2006), The Adoption of the UK Finance Bill Proposals on Islamic Finance into Islamic Banking in Australia, Review of Islamic Economics, Volume 10, No. 1, 2006: 41-57

Ahmad, A.U.F. and M. K. Hassan (2006), The Time Value of Money Concept in Islamic Finance,’ The American Journal of Islamic Social Sciences, Volume 23, Winter 2006, Number 1: 66-89.

Ahmad, A.U.F. and M. K. Hassan (2007a), ‘Regulation and Performance of Islamic Banking in Bangladesh,’ Special Issue on Islamic Finance in Thunderbird International Business Review Review, Volume 49, Number 2 (March-April), pages: 251-278

Ahmad, Abu Umar Faruq and M. Kabir Hassan (2011), Developments in Islamic Finance Practice: The Experience of Australia, Chapter 16 in Islamic Capital Markets: Products and Strategies, edited by M. Kabir Hassan and Michael Mahlknecht. John Wiley and Sons, 2011, London, UK.

Ahmad, Abu Umer Faruq and M. Kabir Hassan, "Legal and Regulatory Issues of Islamic Finance in Australia" International Journal of Islamic and Middle Eastern Finance and Management, Volume 2, No 4, 2009: 305-322.

Ahmad, Abu Umer Faruq and M. Kabir Hassan, “Riba and Islamic Banking,” in Journal of Islamic Economics, Banking and Finance, Volume 3, No 1, January-June 2007: 9-42

Ahmed, Habib, (2010), Financial crisis: risks and lessons For Islamic Finance

Ahmed, Habib and Tariullah Khan (2007), “Risk Management in Islamic Banking,” Chapter 10 in M. Kabir Hassan and Mervyn Lewis, Handbook on Islamic Banking, Edward Elgar Publishing Company, London, UK.

Ahmed, Habib. “Financial Inclusion and Islamic Finance: Organizational Formats, Products, Outreach and Sustainability.” Economic Development and Islamic Finance. pp. 203-225

Alam, Nafis, M. Kabir Hassan and Mohammad Aminul Haque, “Are Islamic Bonds Different from Conventional Bonds? International Evidence from Capital Market Tests” Borsa Istanbul Review, November 7, 2013 online

Albaity, M. and Ahmad, R, (2008), Performance of Shariah and Composite Indices: Evidence from Bursa Malaysia, Asian Academy of Management Journal of Accounting and Finance, 4(1): 23-43.

Alhenawi, Yasser and M. Kabir Hassan, “What does the US REIT Market has in store for Nonconventional Investors? The Case of Shariah Compliance,” Journal of Investing, Winter, 2013: 1-22

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Ali, S. S., (2007), “Financial distress and bank failure: Lessons from closure of Ihlas finans in turkey”, Islamic Economic Studies, Vol. 14, No. 1 & 2, Aug. 2006 & Jan. 2007

Al-Munajjid, M. S. (2013, January 25). Should he claim bankruptcy so that interest charges will be waived from him? Retrieved from Islam QA: http://www.islam-qa.com/en/ref/149092/bankruptcy

Alpay, Savas and M. Kabir Hassan, “A Comparative Efficiency Analysis of Interest-free Financial Institutions and Conventional Banks in Turkey,” Review of Islamic Economics, Forthcoming

Al-Suwailem, Sami and M. Kabir Hassan, An Islamic Perspective of Financial Engineering, Chapter 18 in Islamic Capital Markets: Products and Strategies, edited by M. Kabir Hassan and Michael Mahlknecht. John Wiley and Sons, 2011, London, UK.

Al-Tamimi, H., & Al-Mazrooei, M. 2007. Banks’ risk management: a comparison study of UAE national and foreign banks. The Journal of Risk Finance 8 (4):394-409.

Al-Zoubi, H. A. and Maghyereh, A. I, (2007), The Relative Risk Performance of Islamic Finance: A New Guide to Less Risky Investments, International Journal of Theoretical & Applied Finance, 10(2), 235-249.

Ashraf, Ali and and M. Kabir Hassan, “An Integrated Islamic Poverty Alleviation Model” Chapter 14 in Contemporary Islamic Finance: Applications, Innovations and Best Practices, edited by Karen Hunt-Ahmed, John Wiley and Sons, 2012

Ashraf, Ali, M. Kabir Hassan and William Hippler, “Performance of Micorfinance Institutions in Muslim Countries,” Humanomics, 2014 (On-line)

Awad, A., & Michael, R. E. (2010). Iflas and Chapter 11: Classical Islamic Law and Modern Bankruptcy. The International Lawyer , 44, 975-1000.

Basel Committee on Banking Supervision Reforms – Basel III, www.bis.org.

Bashir, Abdel-Hameed and M. Kabir Hassan, “Financial Development and Economic Growth in Some Muslim Countries,” Chapter 6 in Islamic Perspectives on Sustainable Development, Edited by Munawar Iqbal, Published by Palgrave-MacMillan, 2005, New York, pages 148-174.

BinMahfouz, S., & Hassan, M. K. (2014). A Comparative Study between the Investment Characteristics of Islamic and Conventional Equity Mutual Funds in Saudi Arabia. working paper.

BinMahfouz, Saeed and M. Kabir Hassan, “A Comparative Study between the Investment Characteristics of Islamic and Conventional Equity Mutual Funds in Saudi Arabia, “Journal of Investing, Winter 2012, Vol. 21, No. 4: pp. 128–143.

BinMahfouz, Saeed and M. Kabir Hassan, “Sustainable and Socially Responsible Investing: Does Islamic Investing Make a Difference?” Humanomics, Volume 29, No 3 (August, 2013): 164-186

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Boumediene, Aniss and M. Kabir Hassan, “Basel III Relevance for Islamic Banks: A Case Study of Al-Rajhi Bank of Saudi Arabia” Journal of Banking Regulation, 2014 Forthcoming

Boustany, I. G., (2006), New sukuk technology, (International Financing Review, Middle East).

Brown, Kym, M.K. Hassan and Michael Skully, ‘Operational efficiency and performance of Islamic banks,’as chapter 7 in M.K. Hassan and Mervyn Lewis (editors), Handbook of Islamic Banking, Published by Edward Elgar Publishing Company, U.K. and U.S.A., April 2007.

Chapra, M. Umar and Tariqullah Khan (2000), Regulation and Supervision of Islamic Banks, IRTI Occasional Paper 3, Saudi Arabia

Choudhury, Masudul Alam and M. Kabir Hassan (2001a). “The Role of Zakat in an Interactive Model of No-Wage Labor Force Activity,” Review of Islamic Economics, Number 10, 2001: 41-66.

Chowdhury, Masudul Alam, M.K. Hassan and Md. Sharif Hussain, ‘Zakat in an Islamic Macro-Economic Model,’ Chapter 4 in Zakat and Poverty Alleviation, Islamic Economics Research Bureau, Dhaka, Bangladesh, October, 2003.

Dow Jones Official Website; http://www.djindexes.com/ (access in August 2011).

Elfakhani, Said, M.K. Hassan and Yusuf Sidani, ‘Islamic mutual funds,’as Chapter 16 in M.K. Hassan and Mervyn Lewis (editors), Handbook of Islamic Banking, Published by Edward Elgar Publishing Company, U.K. and U.S.A., April 2007.

Ernest & Young, (2010), Islamic Funds & Investments Report 2010 Post Crisis: Waking Up to An Investor-Driven World.

Ernst & Young. 2013. World Islamic Banking Competitiveness Report 2013–14

European Central Bank Annual Report 2011.

European Systemic Risk Board Established, 16 December 2010, www.ecb.int.

Fama, E. and French, K.R., (1992), The Cross-Section of Expected Stock Returns, Journal of Finance, 47, 427-465.

Farook, Sayd Farook, M. Kabir Hassan and Gregory Clinch, “ Islamic Bank and Financial Stability: Further Evidence” in Islamic Finance: Risk, Stability and Growth, edited by Mehmet Asutay and Abdullah Turksitani, Gerlach Press, Cambridge, UK (July 2013): Forthcoming

Farook, Sayd M. Kabir Hassan and Gregory Clinch, “Profit Distribution Management by Islamic Banks: An Empirical Investigation,” Quarterly Review of Economics and Finance , Volume 52, Issue 3 (August 2012): 333-347

Farook, Sayd, M. Kabir Hassan and Gregory Clinch, “Islamic bank incentives and discretionary loan loss provisions,” Pacific Basin Finance Journal, December 8, 2014 (On-line)

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Farook, Sayd, M. Kabir Hassan and Roman Lanis, “Determinants of Corporate Social Responsibility Disclosure: The Case of Islamic Banks,” Journal of Islamic Accounting and Business Research, Volume 2, Issue 2, 2011: 114-141

Fidler, S., (2009), Defaults pose latest snag in islamic-bond market, Wall Street Journal

Financial Sector Assessment Program for Islamic Financial Industry (iFSAP), Published by IRTI, World Bank and IMF, 2010

Financial Stability Board, Key Attributes of Effective Resolution Regimes for Financial Institutions, October 2011.

Financial Stability Board, Policy Measures to Address Systemically Important Financial Institutions, 4 November 2011.

Financial Stability Board, Report Effects of Regulatory Reforms on Emerging Market and Developing Economies, June 2012.

Financial Stability Board, Thematic Review on Deposit Insurance Systems, 8 February 2012.

Forte, G., & Miglietta, F. (2007), Islamic Mutual Funds as Faith-Based Funds in a Socially Responsible Context, Retrieved May 2011, from Social Science Research Network (SSRN): http://ssrn.com/abstract=1012813.

Ghoul, W., & Karam, P., (2007), MRI and SRI Mutual Funds: A Comparison of Christian, Islamic (Morally Responsible Investing), and Socially Responsible Investing (SRI) Mutual Funds, The Journal of Investing, 16 (2), 96–102.

Girad, Eric and M. Kabir Hassan, “Is there a Cost to Faith-Based Investing? Evidence from FTSE Indexes,” Journal of Investing, Volume 17, Number 4, Winter 2008: Spring 2008: 112-121

Girard, E., & Hassan, M. K., (2005), Faith-Based Ethical Investing: The Case of Dow Jones Islamic Indexes, FMA papers.

Girard, E., & Hassan, M. K., (2008), Is There a Cost to Faith-Based Investing: Evidence from FTSE Islamic Indices, The Journal of Investing (17), 112-121.

Girard, Eric and M. Kabir Hassan, “Faith-Based Ethical Investing: The Case of Dow Jones Islamic Indexes” in Islamic Economic Studies, Volume 17, No 2 (January 2010)

Global Islamic Asset Management Report , Published by

Global Islamic Finance Report, with Islamic Finance Country Index , Published by

Global Takaful Insights, Published by Ernest and Young, 2013

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Goud, Blake and M. Kabir Hassan (2011), Islamic Finance in the United States, Chapter 14 in Islamic Capital Markets: Products and Strategies, edited by M. Kabir Hassan and Michael Mahlknecht. John Wiley and Sons, 2011, London, UK.

Grais, Wafik. “Islamic Banking: Policy and Institutional Changes.”

Haawari, D. A. E., Grais, W., & Iqbal, Z. 2003. Regulating Islamic Financial Institutions: The Nature of the Regulated In International Conference on Islamic Banking: Risk Management, Regulation and Supervision. Jakarta, Indonesia

Hakim, S., & Rashidian, M., (2004), How Costly is Investor’s Compliance to Sharia?, Paper Presented at the 11th Economic Research Forum Annual Conference in Sharjah, U.A.E. on December 14-16, Beirut, Lebanon.

Hamoudi, H. A. (2011). The Surprising Irrelevance of Islamic Bankruptcy. ABI Law Review , 19, 505-522.

Hassan, A. 2009. Risk Management Practices of Islamic banks of Brunei Darussalam. The Journal of Risk Finance 10 (1):23-37.

Hassan, M Kabir (2001a), ‘Nuances of Islamic Mutual Funds’, Islamic Horizons, 30 (3), 16-18.

Hassan, M. K. and Junayed Masrur Khan, “Zakat, External Debt and Poverty Reduction Strategy in Bangladesh,” Journal of Economic Cooperation, Volume 28, 4 (2007): 1-38

Hassan, M. K., and K.A. Hussein (2003b), ’Static and dynamic efficiency in the Sudanese banking system’, Review of Islamic Economics, 14, 5-48.

Hassan, M. K., Khan, Abu N. F., & Ngow, T., (2010), Is faith-based investing rewarding? The case for Malaysian Islamic unit trust funds, Journal of Islamic Accounting and Business Research, 1 (2), 148 – 171.

Hassan, M. Kabir (1999a). "Islamic Banking in Theory and Practice: The Experience of Bangladesh," Managerial Finance . (Published from the U.K) Volume 25, Number 5, 1999: 60-113.

Hassan, M. Kabir (2000). “Success and Failure of Various Groups of OIC Countries,” Monograph Published by Islamic Economics Research Bureau, Dhaka, Bangladesh. Published: January, 2000

Hassan, M. Kabir (2003c). “Regional Economic Blocs Among OIC Countries and the Prospect of Islamic Common Market,” The Middle East Business and Economic Review, Volume 15, Number 1, July 2003: 52-87

Hassan, M. Kabir (2006), “The X-Efficiency of Islamic Banks,” Islamic Economic Studies, Volume 13, Number 2 (February): 49-77.

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Hassan, M. Kabir (Board of Editors). Islamic Banking. Commissioned and Published by Islamic Economics Research Bureau, Dhaka, Bangladesh, Second Edition, November 2008

Hassan, M. Kabir and Adnan Q. Al-Dayel (1999b). "Stability of Money Demand Under Interest-Free Versus Interest-Based Banking System," Humanomics, Vol. 15, No.4, and Volume 15, No. 1, 1998/1999: 167-186

Hassan, M. Kabir and Dewan A. H. Alamgir. “Micorfinancial Services and Poverty Alleviation in Bangladesh: A Comparative Analysis of Secular and Islamic NGOs,” Chapter 4 in Islamic Economic Institutions and the Elimination of Poverty, Edited by Munawar Iqbal, and published by Islamic Foundation, Leicester, U.K. 2002.

Hassan, M. Kabir and Eric Girard (2008). “Malaysia: A Shariah-Consistent Incubator” Proceedings of the Symposium on Islamic Banking and Finance: Global Perspective on Ethics and Financial Policies,” organized as part of the National Center of Excellence for Islamic Studies-Australia, The University of Melbourne, Annual Conference, 2008 sponsored by the Australian Government, Australian Research Council, Bond University and Monash University.

Hassan, M. Kabir and Eric Girard, “Shariah-Consistent Investment Vehicles in Malaysia,” Chapter 9 in The Foundations of Islamic Banking: Theory, Practice and Education, Edited by Mohamed Ariff and Munawar Iqbal, Edward Elgar Publishing, London, 2011; pp: 153-183

Hassan, M. Kabir and Faridul Islam (2001b). “Prospect and Problems of a Common Market: An Empirical Examination of the OIC Countries,” American Journal of Islamic Social Sciences, Volume 18, Number 4, Fall, 2001: 19-46.

Hassan, M. Kabir and Imtiaz Mazumder (2001). “Islamic Finance and Monetary Stability: An Empirical Investigation” Proceedings of the Fourth Harvard University Forum on Islamic Finance, 2001.

Hassan, M. Kabir and Issouf Soumare,” Guarantees and Profit-Sharing Contracts in Project Financing,” Journal of Business Ethics, Forthcoming, 2014

Hassan, M. Kabir and Jung-Suk Yu. “Stock Exchange Alliances in the Organization of Islamic Conference Countries,” Review of Islamic Economics, Volume 11, Number 3, 2007 (December).

Hassan, M. Kabir and M. A. Mannan Chowdhury, “Basel II and Islamic Banking Regulation,” American Journal of Islamic Social Sciences (AJISS), Volume 27, Winter (2010): 74-101

Hassan, M. Kabir and Mahmood Ahmad, “Substitutability of Zakat Fund in the Budget of the Government of Bangladesh,’ Chapter 6 in Zakat and Poverty Alleviation, Islamic Economics Research Bureau, Dhaka, Bangladesh, October, 2003.

Hassan, M. Kabir and Mamaun Rashid, “Market Values of Islamic Banks and Ethical Identity,” American Journal of Islamic Social Sciences, Volume 31, Issue 2 (2014): 43-74

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Hassan, M. Kabir and Mehmet F. Dicle (2005), “Basel II and Regulatory Framework for Islamic Banks,” Journal of Islamic Economics and Finance, Volume 1, Number 1, July-December 2005: 17-36.

Hassan, M. Kabir and Mehmet F. Dicle, “Basel II and Corporate Governance of Islamic Banks,” in Integrating Islamic Finance into the Mainstream: Regulation, Standardization and Transparency, edited by Nazim Ali, Islamic Finance Project, Islamic Legal Studies Program, Harvard Law School, 2007

Hassan, M. Kabir and Mervyn K. Lewis (Editors). Critical Writings in Islamic Finance. Edward Elgar Publishing Company, Uk and USA, July 2007.

Hassan, M. Kabir and Mervyn K. Lewis (Editors). Handbook of Islamic Banking. Edward Elgar Publishing Company, UK and USA, April 2007: 443 Pages.

Hassan, M. Kabir and Mervyn Lewis, Handbook on Islam and Economic Life, Edward Elgar Publishing Company, December , 2014 (Forthcoming)

Hassan, M. Kabir and Michael Mahlknecht (Editors), Islamic Capital Markets: Products and Strategies, John Wiley and Company, March 2011.

Hassan, M. Kabir and Ouidad Yousfi, “Moral Hazard in Islamic Profit-loss Sharing Contracts and Private Equity,” Handbook on Islam and Economic Life, Edward Elgar Publishing Company, December 2014.

Hassan, M. Kabir and Rasem Kayed, “Global Financial Crisis and Islamic Finance Response,” ISRA Bulletin, Volume4, December 2009, page 13.

Hassan, M. Kabir and Rasem Kayed,” Islamic Financial System: Risk Management and Social Justice,” ISRA International Journal of Finance, Volume1, Issue 1, December 2009: 33-58

Hassan, M. Kabir and Shah Abdul Hannan (1994). "An Inquiry into the Contribution of Islam to Modern Economic Science", Thoughts on Economics, Vol.4, No. 1&2, January-June, 1994: 1-15.

Hassan, M. Kabir and Umar A. Oseni, “The Regulation and Supervision of Sukuk in Global Capital Markets,” Handbook on Islam and Economic Life, Edward Elgar Publishing Company, December 2014.

Hassan, M. Kabir Hassan and Eric Girard, “Shariah-Consistent Investment Vehicles in Malaysia,” Chapter 9 in The Foundations of Islamic Banking: Theory, Practice and Education, Edited by Mohamed Ariff and Munawar Iqbal, Edward Elgar Publishing, London, 2011; pp: 153-183

Hassan, M. Kabir Hassan, “Cost, Profit and X-Efficiency of Islamic Banks in Pakistan, Iran and Sudan,” in Islamic Financial Architecture: Risk Management and Financial Stability,” Conference Proceedings of International Conference on Islamic Banking: Risk Management, Regulation and Supervision, held in Jakarta, Indonesia, September 30-October 1, 2003.

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Hassan, M. Kabir Rasem N. Kayed and Umer Oseni, Introduction to Islamic Finance, Pearson Publishing Company, May, 2013

Hassan, M. Kabir, Md. Yusuf Imran, Mamunur Rashid, and Abdullah Ibneyy Shahid, “Ethical Gaps and Market Value in the Islamic Banks of Bangladesh,” Review of Islamic Economics, Volume 14, No 1(2010): 49-75

Hassan, M. Kabir, (2002), ‘Risk, Return and Volatility of Faith-Based Investing: The Case of Dow Jones Islamic Index’, paper in Proceedings of 5th Harvard University Forum on Islamic Finance, Harvard University.

Hassan, M. Kabir, “Return Volatility, Predictability and Dynamic Relationships in the Stock Markets of the Member Countries of the Organization of Islamic Conference,” Chapter 7 in Islamic Perspectives on Sustainable Development, Edited by Munawar Iqbal, Published by Palgrave-MacMillan, 2005, New York, pages 185-213.

Hassan, M. Kabir, “Value-at-Risk (VAR) Analysis of Islamic Banks, “in Islamic Financial Architecture: Risk Management and Financial Stability,” Conference Proceedings of International Conference on Islamic Banking: Risk Management, Regulation and Supervision, held in Jakarta, Indonesia, September 30-October 1, 2003.

Hassan, M. Kabir, Abu Nahian Faisal Khan, Thiti Ngow, "Is faith-based investing rewarding? The case for Malaysian Islamic unit trust funds", Journal of Islamic Accounting and Business Research, Vol. 1 Iss: 2, pp.148 – 171

Hassan, M. Kabir, Benito Sanchez and Jung-Suk Yu, “Financial Development and Economic Growth in the Organization of Islamic Conference Countries,” Journal of King Abdul Aziz University-Journal of Islamic Economics , Volume 24, No. 1, pp: 145-172 (2011)

Hassan, M. Kabir, Benito Sanchez and M. Ershad Hussain, “Economic Performance of the OIC Countries and the prospect of an Islamic Common Market,” Journal of Economic Cooperation and Development, Volume 31, No 2, 2010: 65-121

Hassan, M. Kabir, Benito Sanchez, and M. Faisal Safa, “Impact of financial liberalization and foreign bank entry on Islamic banking performance,” International Journal of Islamic and Middle Eastern Finance and Management, Volume 6, Issue 1 (2013): 7-42

Hassan, M. Kabir, Joseph Farhat and Bashir Al-Zubi (2003a). “Dividend Signalling Hypothesis and Short-Term Asset Concentration of Islamic Interest-Free Banking,” Islamic Economic Studies, Volume 11, Number 1 (September, 2003): 1-30.

Hassan, M.K., & Hesham, M., & Al-Henawi, Y., (2010), Analysis of Islamic Versus Conventional Mutual Funds in Saudi Arabia, Journal of King Abdul Aziz University, Islamic Economics, 23 (2), 161-198.

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Hassan, M.K., & Hesham, M., (2011), “Performance of Islamic Mutual Funds in Saudi Arabia,” Paper Presented at the 8th International Conference on Islamic Economics and Finance, December 19-21, 2011, Doha, Qatar

Hassan, M.K., and A. H. Bashir (2005), ‘Determinants of Islamic banking profitability’ in Munawar Iqbal and Rodney Wilson (editors), Islamic Perspectives on Wealth Creation, Edinburgh: Edinburgh University Press.

Hippler, William and M. Kabir Hassan, “Entrepreneurship and Islam: An Overview,” Economic Journal Watch, 11(2), May 2014: 170-178

Hoepner, A. G., Rammal, H. G., & Rezec, M. (2009), Islamic Mutual Funds' Financial Performance and Investment Style: Evidence from 20 Countries, Retrieved May 2011, from Social Science Research Network (SSRN): http://ssrn.com/abstract=1475037

Hussein, K. A., (2004), Ethical Investment: Empirical Evidence from FTSE Islamic Index, Islamic Economic Studies 12 (1), 21-40.

IDB Group, IRTI, IFSB. 2007. Ten-Year Framework and Strategies.

IDB Group, IRTI, IFSB. 2014. Ten-Year Framework and Strategies: A Mid-Term Review.

IFSB. 2005. Guiding Principles of Risk Management for Institutions (Other than Insurance Institutions) Offering Only Islamic Financial Services Malaysia IFSB.

IFSB. 2013. Islamic Financial Services Industry Stability Report 2013. Kuala Lumpur, Malaysia: IFSB.

IIFM. (2013), Sukuk Report: A Comprehensive Study of the Global Sukuk Market, Manama, Kingdom of Bahrain: International Islamic Financial Market.

Ilias, S., (2009), Islamic finance: overview and policy concerns, Pennsylvania, DIANE Publishing, 2009.

Iqbal, Zamir and Abbas Mirakhor. ”Islam’s Perspective on Financial Inclusion.” Economic Development and Islamic Finance. pp. 179-199

Iqbal, Zamir. 2007. “Challenges Facing Islamic Financial Industry.”

IRTI Knowledge Review Vol.2 No.1

Islamic Finance and Global Financial Stability, Published by IDB, IRTI and IFSB, 2010

Islamic Finance Development Report, with Islamic Finance Development Indicator , Published by

Islamic Financial Services [Excluding Islamic Insurance (Takāful) Institutions and Islamic Collective Investment Schemes], 1 November 2012.

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Islamic Financial Services Board (2011), “Revised Compilation Guide on Prudential and Structural Islamic Financial Indicators”, 2011

Islamic Financial Services Board (IFSB), “Guiding Principles of Risk Management for Institutions

(Other than Insurance Institutions) Offering only Islamic Financial Services, December 2005

Islamic Financial Services Board, ED-14: Standard on Risk Management for Takāful (Islamic Insurance) Undertakings, 1 November 2012.

Islamic Financial Services Board, ED-15: Revised Capital Adequacy Standard for Institutions Offering

Islamic Financial Services Board, IFSB-1: Guiding Principles of Risk Management for Institutions (other than Insurance Institutions) offering only Islamic Financial Services, December 2005.

Islamic Financial Services Board, IFSB-12:Guiding Principles on Liquidity Risk Management for Institutions Offering Islamic Financial Services, March 2012.

Islamic Financial Services Board, IFSB-13:Guiding Principles on Stress Testing for Institutions offering Islamic Financial Services, March 2012.

Islamic Financial Services Board, Issues and Constraints in The Adoption of Basel III Liquidity Standards for Institutions Offering Islamic Financial Services, 25 July 2012 (unpublished).

Islamic Financial Services Board, Strategic Performance Plan 2012-2015, 29 March 2012.

Islamic Financial Services Board, Survey Report: Revised Guidance on Key Elements in The Supervisory Review Process of Institutions Offering Islamic Financial Services, 23 January 2013 (unpublished).

Islamic Financial Services Industry Development: Ten-Year Framework and Strategies, A Midterm Review, Published by IDB, IRTI and IFSB, 2014

Islamic Financial Services Industry Development: Ten-Year Framework and Strategies, Published by IDB, IRTI and IFSB, 2009

Islamic Financial Services Industry Stability Report, Published by

Islamic Funds and Investments Report , Published by Ernest and Young, 2013

Islamic Social Finance Report, Published by IRTI and Thomson-Reuters, 2014

ISRA. 2011. “ Corporate and Shari’ah Governance in Islamic Financial Institutions.” Islamic Financial System: Principles and Operations. pp. 1-48

Jemma Dridi, J., & Hasan, M., (2010), The Effects of the Global Crisis on Islamic and Conventional Banks: A Comparative Study, IMF working paper series, WP/10/201

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Jensen, M. C., (1967), The Performance of Mutual Funds in the Period 1945-1964, Journal of Finance, 23 (2), 389-416.

Kayed, Rasem N. and M. Kabir Hassan, “The Global Financial Crisis and Islamic Finance,” Thunderbird International Business Review, Volume 53, Issue 5 (September/October, 2011) : 551-564

Kayed, Rasem N. and M. Kabir Hassan (Authors), Islamic Entrepreneurship, Routledge Publishing Company, December , 2010.

Kayed, Rasem N. and M. Kabir Hassan, “Islamic Entrepreneurship: A Case Study of Saudi Arabia,” Journal of Developmental Entrepreneurship, Volume 15, Issue 4 (December 2010): 379-413

Kayed, Rasem N. and M. Kabir Hassan, “Saudi Arabia's economic development: entrepreneurship as a strategy,” International Journal of Islamic and Middle Eastern Finance and Management, Volume 4, Issue 1 (2011): 52 - 73

Kayed, Rasem N., Michael Mahlknecht and M. Kabir Hassan, The Current Financial Market Crisis: Lessons Learned, Risks and Strengths of Islamic Capital Markets compared to the Conventional System, Chapter 17 in Islamic Capital Markets: Products and Strategies, edited by M. Kabir Hassan and Michael Mahlknecht. John Wiley and Sons, 2011, London, UK.

Khaleq, A. H. A., (2012), Case Studies on Sukuk Issuance, presented in “Regional Workshop - Developing Government Securities under Islamic Finance”, Amman, Jordan, 24 September, 2012

Khan, Mohammad Saif Noman, M. Kabir Hassan and Abdullah Ibneyy Shahid, “Banking Behavior of Islamic Bank Customers in Bangladesh,” Journal of Islamic Economics, Banking and Finance, Volume 3, No. 2 July-December 2007: 159-194

Khan, T., & Ahmed, H. 2001. Risk Management: An Analysis of Issues in Islamic Financial Industry. IRTI/IDB Occasional Paper No 5, Jeddah: Islamic Development Bank.

Kilborn, J. J. (2011b). Foundations of Forgiveness in Islamic Bankruptcy Law: Sources, Methodology, Diversity. American Bankruptcy Law Journal , 85 (4), 323-361.

Lahsasna, Ahcene and M. Kabir Hassan (2011), The Shariah Process in Product Development and Approval in ICM. Chapter 2 in Islamic Capital Markets: Products and Strategies, edited by M. Kabir Hassan and Michael Mahlknecht. John Wiley and Sons, 2011, London, UK.

Latham, and Watkins, 2011, Case study-east cameron partners sukuk, in Latham and Watkins, ed.: Policy Brief on Corporate Governance for Islamic Banks and Financial Institutions in the Middle East and North Africa Region (Hawkamah, The Institute for Corporate Governance 2011).

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Mansor, F., & Bhatti, I. M., (2011), Risk and Return Analysis on Performance of the Islamic Mutual Funds: Evidence from Malaysia, Global Economy and Finance Journal, 4 (1), 19-31.

Manṣūr, ‘. a.-M. (2012). Iflās al-sharikāt wa-atharuhu fī al-fiqh wa-al-niẓām (1st ed.). Riyadh: Dār Kunūz Ishbīlyā lil-Nashr wa-al-Tawzī‘.

McMillen, M. J. (2006), ‘Islamic capital markets: developments and issues,’ Capital Markets Law Journal , 1 (2), 136-172.

McMillen, M. J. (2012, June 7). An Introduction to Shari'ah Considerations in Bankruptcy and Insolvency Contexts and Islamic Finance's First Bankruptcy (East Cameron). Retrieved January 25, 2013, from Social Science Research Network: SSRN: http://ssrn.com/abstract=1826246 or http://dx.doi.org/10.2139/ssrn.1826246

Merdad, Hesham and M. Kabir Hassan, “ Islamic Mutual Funds Performance in Saudi Arabia” Chapter 20 in Contemporary Islamic Finance: Applications, Innovations and Best Practices, edited by Karen Hunt-Ahmed, John Wiley and Sons, 2012

Merdad, Hesham, M. Kabir Hassan and Yasser Al-Henawi, “Analysis of Islamic Versus Conventional Mutual Funds in Saudi Arabia,” Journal of King Abdul Aziz University: Islamic Economics, Volume 23, No. 2: 161-198 (2010)

Moghul, U.F. and A.A. Ahmed (2003), ‘Contractual Forms in Islamic Finance Law and Islamic Inv. Co. of the Gulf (Bahamas) Ltd. v. Symphony Gems N.V. and Ors.: A First Impression of Islamic Finance.,’Fordham Int'l L.J., 27, 150-194.

Muhamed, N. A., & Radzi, R. M., (2012), “An International Comparative Study on Shariah Governance Supervision of Sukuk Defaults”, Journal of Islamic Economics, Banking and Finance, Vol. 8 No. 3, July - Sep 2012

Muhammad, N. and Mokhtar, M. (2008), Islamic Equity Mutual Fund Performance in Malysia: Risk and Return Analysis, Proceedings of the Malaysian Finance Association (MFA) Conference 2008.

Ngene, Geoffrey and M. Kabir Hassan, “Momentum and Non-Linear Price Discovery in Sovereign Credit Risk and Equity Markets in the Organization of the Islamic Cooperation (OIC) Countries,” Malaysian Journal of Economics, 46(2): 2012: 101-114

Oseni, U.A. (2012), ‘Introduction,’ in S. N. Ali (Ed.), Building Bridges Across Financial Communities: Faith-Based Finance, Social Responsibility, and the Global Financial Crisis, Cambridge: Islamic Finance Project, 1-16.

Oseni, Umar A. and M. Kabir Hassan (2011), ‘The Dispute Resolution Framework for the Islamic Capital Market in Malaysia: Legal Obstacles and Options,’ in M. Kabir Hassan and Michael Mahlknecht (eds), Islamic Capital Markets: Products and Strategies, London: John Wiley and Sons, paper 4.

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Oseni, Umar A. and M. Kabir Hassan (2011), The Dispute Resolution Framework for the Islamic Capital Market in Malaysia: Legal Obstacles and Options, Chapter 4 in Islamic Capital Markets: Products and Strategies, edited by M. Kabir Hassan and Michael Mahlknecht. John Wiley and Sons, 2011, London, UK.

Oseni, Umar A. and M. Kabir Hassan, “Islamic Microfinance,” Encyclopedia of Management, Wiley-Blackwell Publishing Company, 2014: Forthcoming

Oseni, Umar A., Hunud Abia Kadouf, Abdul Haseeb Ansari, and Abdul Azeez Maruf Olayemi (2012), ‘The Value Proposition of Islamic Financial Intermediation: Some Current Legal and Regulatory Challenges’, Australian Journal of Basic and Applied Sciences, 6 (11), 239-245.

Oseni, Umar and M. Kabir Hassan (2014), “Revisiting the Governing Law Clause in Sukuk Transactions,” Journal of Banking Regulation, Forthcoming

Oseni, Umar, M. Kabir Hassan and Dorsaf Matri, “An Islamic Finance Model for the Small and Medium Enterprises in France,” Journal of King Abdul Aziz University: Islamic Economics, Volume 26, No 2 (2013): 157-186.

Oseni, Umer Oseni and M. Kabir Hassan, “The Emergence and Development of Islamic Banking,” Islamic Finance: Instruments and Markets, Bloomsbury Press, London, UK, 2010

Parashar, S. P., & Venkatesh, J., (2010), Banks and Bank Systems, Journal of Islamic Economics, Banking and Finance, Volume-5, Number-1, Issue 4, 2010

RAM Ratings. April 2010, 2009 Corporate-Default & Ratings-Performance Study (1992–2009), RAM Rating Services Berhad, Kuala Lumpur.

Rashid, Mamunur, Islam Abdeljawad, Siti Manisah Nagalim and M. Kabir Hassan, “Customer-Centric Corporate Social Responsibility: A Framework for Islamic Banks on Ethical Efficiency,” Management Research Review, Volume 36, Issue 4 (2013): 359-378.

Rashid, Mamunur, M. Kabir Hassan and Abu Umar Faruq Ahmad, “Quality Perception of the Customers Towards Domestic Islamic Banks in Bangladesh,” Journal of Islamic Economics, Banking and Finance, Volume 5, No. 1, January-March (2009): 109-132

Rosman, R. 2009. Risk Management Practices and Risk Management Processes of Islamic Banks: A Proposed Framework. International Review of Business Research Papers 5 (1):242-254.

Rubio, Francisco, M. Kabir Hassan and Hesham Merdad, “Non-Parametric Performance Measurement of International and Islamic Mutual Funds,” Accounting Research Journal, Volume 25, No. 3 (2012): 208-226

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Samad, Abdus and M. Kabir Hassan (2000), “The Performance of Malaysian Islamic Bank During 1984-1997: An Exploratory Study,” International Journal of Islamic Financial Services, Volume 1, Number 3, October-December, 1999.

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Son, Poihun Son, M. Kabir Hassan, Shamsher Mohamed and Taufiq Hassan, “The Assets and Liabilities Gap Management of Conventional and Islamic Banks in the Organization of Islamic Cooperation (OIC) Countries” Applied Financial Economics, Volume 24, Issue 5 (March 2014): 333-346

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Tag El-Din, Seif El-Din and M.K. Hassan, ‘Islam and speculation in the stock exchange,’ as Chapter 15 in M.K. Hassan and Mervyn Lewis (editors), Handbook of Islamic Banking, Published by Edward Elgar Publishing Company, U.K. and U.S.A., April 2007.

Warde, I. (2011). Islamic Finance: Bankruptcy, Financial Distress and Debt Restructuring. Retrieved January 26, 2013, from Islamic Finance Project: http://ifp.law.harvard.edu/login/view_pdf/?file=Bankruptcy_Panel.pdf&type=lectures

Wijnbergen, S.V.. & Zaheer, S., (2013), Sukuk Defaults: On Distress Resolution in Islamic Finance, Duisenberg school of finance - Tinbergen Institute Discussion Paper, TI 13-087 / VI / DSF 57

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World Islamic Banking Competitiveness Report, Published by McKinsey & Co (2008–2010), Ernest and Young (2011–2013)

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APPENDIX A: CASE STUDIES OF ISLAMIC FINANCIAL INSTRUMENTS

The growth of Islamic mutual funds is partly driven by the recent developments in the Islamic indexes and the evolution of Islamic capital markets, especially the innovations in shariah compliant financial instruments. This chapter begins with a discussion on the evolution of Islamic mutual funds, Islamic indexes, and a brief summary on the existing literature on Islamic mutual fund performance. The following section presents lessons learned from recent sukuk failures. Section three discusses lessons learned from Islamic banking failure. The following section discusses the Governing Law Clause and the importance of proper legal documentation in Islamic finance. Section five elaborates on the sukuk legislation and provides an overview of selected jurisdictions. Section six presents the issue of insolvency and debt restructuring in Islamic Law. Finally, this section concludes with a discussion on debt restructuring, dispute management, and defaults in Islamic financial Transactions.

A.1. PERFORMANCE OF ISLAMIC MUTUAL FUNDS VERSUS CONVENTIONAL MUTUAL FUNDS

A.1.1 Present Status of Islamic Mutual Funds

The Islamic mutual funds industry is the fastest growing segment in Islamic finance. The industry enjoyed a robust annual growth between 15% and 20% during the 1990’s and early 2000’s (Hakim and Rashidian, 2004). By the end of 2010, the size of the global Islamic finance assets has been estimated around $939 billion, out of which the global assets under the management for the Islamic mutual fund industry accounts for $52.3 billion in more than 700 managed mutual funds. Saudi Arabia represents the largest home market for the Islamic mutual funds industry in terms of total assets under management, around $22.7 billion with 174 managed mutual funds, which accounts for 44% of the total global Islamic mutual fund assets under management (Ernest &Young, 2010).

A.1.2 Emergence of Islamic Indexes

To cater to the growing demand of Islamic finance, conventional banks have started offering Islamic products and services, which include the global banks such as HSBC, Lloyds TSB, Barclays, Citibank and Deutsche Bank. In addition, prominent investment banks such as Merrill Lynch and Morgan Stanley have also gotten involved in the process. Several in Islamic market benchmarks have also been introduced by globally reliable, mainstream index providers, including FTSE, Dow Jones, MSCI and S&P, in order to track the performance of Islamic capital markets. At the end of 2007, there were about 60 DJ Islamic indexes that vary by size, industry and region, with 95 Islamic mutual funds tracking the DJIMI (Ghoul and Karam, 2007).

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A.1.3 Findings from the Recent Literature

The evolution of Islamic indexes has enhanced the growth of Islamic mutual fund industry as they provide benchmarks for a passively managed investment strategy. However, to analyze the performance of the Islamic mutual fund industry, it’s important to investigate actively managed funds that demonstrate different transaction costs, management fees, management skills, and costs associated with implementing social responsibilit. Despite the growing interest in Islamic finance, only a few empirical studies, like Merdad, et al. (2010) and BinMahfouz and Hassan (2014) analyze the plausible impact of the Sharia screening criteria on the investment characteristics and performances of Islamic equity mutual funds. BinMahfouz and Hassan (2014) analyze the risk and investment style of Islamic equity mutual funds in Saudi Arabia, the worlds’ largest home market for the Islamic mutual funds industry.

A.1.3.1 Comparison Between Performance of Islamic and Conventional Mutual Fund

One may argue that conventional mutual funds are more likely to outperform their Islamic mutual funds counterparts, because they are restricted to Sharia compliant stocks only. This may lead to riskier investment portfolios, due to restricting the Islamic investment portfolios to a relatively lower level of diversification. However, the majority of previous studies find evidence that Sharia screening criteria do not seem to have an adverse impact on either the performance or the risk of Islamic investment portfolios, compared to their conventional counterparts. Earlier studies, like Wilson (2001) and Ahmed (2001), find that Islamic mutual funds are financially viable and Sharia compliant investments can compete on a commercial risk/return basis. Later, Elefakhani, et al. (2005), Kraeussl and Hayat (2008) and Abderrezak (2008) show that, on average, there is no statistically significant difference between the risk adjusted performance of Islamic equity mutual funds and their Islamic and conventional market benchmarks. This is based on the different geographical markets that are examined. Confirming previous studies, Hoepner, et al. (2009) show that Islamic equity mutual funds do not significantly trail their international benchmarks. However, they find that, in non-Muslim countries, Islamic mutual funds tend to underperform their market benchmarks. By using a matched sample approach, Abdullah et al. (2007), Hassan et al. (2010) and Mansor and Bhatti (2011) indicate that the performance differences between Malaysian Islamic mutual funds and their conventional fund peers are marginally significant.

A.1.3.2 Riskiness Of Islamic Portfolio And Conventional Portfolio

Furthermore, empirical studies find that Islamic investment portfolios tend to be less volatile and less vulnerable to systematic risk than conventional investment portfolios. Abdullah et al. (2007) and Muhammad and Mokhtar (2008) show that Malaysian Islamic funds are less

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sensitive to market volatility, compared to their conventional counterpart funds and their market benchmarks, indicating less exposure to the systematic risk. Merdad et al. (2010) find that, regardless of the benchmark used, systematic risk for Islamic funds is always lower than their conventional counterparts during the financial crisis period. Likewise, Hakim and Rashidian (2002), Hakim and Rashidian (2004) and Girard and Hassan (2005) show that the US Dow Jones Islamic index seems to be less sensitive to the volatility in systematic risk, compared to their conventional counterpart indices. Al-Zoubi and Maghyereh (2007) find less risk associated with the Dow Jones Islamic Market Index (DJIM), compared to the Dow Jones World (DJW) broad market basket of stocks. Merdad et al. (2010) also suggest that Islamic mutual funds managed by HSBC in Saudi Arabia tend to underperform their conventional counterparts during the full period and the bullish period, but they outperform conventional funds during bearish periods and financial crises.

A.1.3.3 Comparison of Performances Between Islamic Indexes and Conventional Indexes

Similarly, Hussein (2004), Hakim and Rashidian (2004), Girard and Hassan (2005 and 2008) and Hashim (2008) show that the performance of Islamic market indices, such as FTSE and the Dow Jones Islamic Indices family, does not differ significantly from their conventional counterpart indices. This is consistent with Ahmad and Ibrahim (2002) and Albaity and Ahmad (2008), who find that the performance difference between the Kuala Lumpur Syariah Index (KLSI) and the Kuala Lumpur Composite Index (KLCI) is not statistically significant; however, the Kuala Lumpur Syariah Index (KLSI) is less risky than the Kuala Lumpur Composite Index (KLCI).

A.1.3.4 Investment Styles and Fund Performance

With regards to the investment style associated with Islamic investment portfolios, the majority of previous studies find that the Sharia screening process tends to influence the investment style, compared to unrestricted conventional counterparts. Girard and Hassan (2005 and 2008) and Abderrezak (2008) indicate that Islamic investment portfolios seem to be more exposed to small and growth companies. Forte and Miglietta (2007) and Kraeussl and Hayat (2008) indicate a growth cap bias associated with Islamic indices. Hoepner et al. (2009) find small cap bias associated with Islamic mutual funds, but not growth. However, they did not document a small cap tilt with Islamic mutual funds in GCC and Malaysian markets. More recently, Hassan et al. (2010) show that Malaysian Islamic mutual funds tend to be small cap oriented, compared to their conventional counterparts. Merdad and Hassan (2011), however, improve on this methodological shortcoming by expanding the dataset to 143 mutual funds in Saudi Arabia and employing multi-index CAPM measures. The results show that, over the entire sample period, there was no statistical difference in performance between Islamic and conventional fund portfolios.

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More recently, BinMahfouz and Hassan (2014) provide empirical evidence that the Sharia screening process does not seem to have an adverse impact on the absolute or the risk adjusted performance of Islamic equity mutual funds in Saudi Arabia, compared to their conventional counterpart equity mutual funds. This is regardless of the subgroup examined, or the market benchmark. In addition, the systematic risk analysis shows that, in most cases, Islamic equity mutual funds in Saudi Arabia tend to be significantly less exposed to market risk, compared to their conventional counterpart equity mutual funds and market benchmarks. Thus, the assumption that Sharia investment constrains lead to inferior performance and riskier investment portfolios, because of limited investment universe, seems to be rejected.

A.2. SUKUK FAILURE AND LESSONS LEARNED

This section begins with an overview of the concept of sukuk, its evolution and a brief account on statistics on sukuk defaults, followed by two cases on sukuk issuances: a success story and a default story. Finally, in the concluding segment, some key lessons learned from the sukuk failures are summarized based on the existing literature on sukuk.

A.2.1 The Concept of Sukuk

AAOIFI defines sukuk as “certificates of equal value representing undivided shares in ownership of tangible assets, usufructs and services or (in the ownership of) the assets of particular projects or special investment activity”. Sukuks are commercial papers that provide an investor with ownership in an underlying asset. Essentially, it is an asset-backed trust certificate evidencing ownership of an asset or its usufruct. Although the objective of sukuk is to provide a stable income, its structure must adhere to the principles of shariah. Besides, unlike conventional bonds, sukuk need to have an underlying tangible asset transaction, either in ownership or master lease agreement. In addition, Sukuks can be of various types, depending on the underlying contracts or principles of financing and trades used in the structuring process. The AAOIFI has issued standards as guidelines for 14 different types of sukuk, which can be classified as tradable and non-tradable, and development and industrial project financing. However, the most common principles used in sukuk structuring are mudharabah, musharakah, murabahah, ijarah, BBA , salam, and istisna‟ (Abdullah et al, 2011).

A.2.2 Trends in Sukuk Industry

The sukuk industry has grown since the mid-1990s with the increasing demand for a Shariah compliant, predictable income security. The recent years have witnessed a strong growth in global sukuk issuance, which led to explosive growth in 2007. However, following the global subprime crisis, the sukuk market did not do well, and the global sukuk issuance had declined by more than 50% by then end of 2008. This is the first such drop since 2001, the inception of the sukuk industry.

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This slowdown in the Sukuk industry in 2008 is partly due to the global economic downturn, and the international sukuk market faced lower levels of liquidity, resulting from declines in oil prices and less investor confidence (Ilias, 2009). Although the sukuk market has made a recovery in issuance to $20 billion during 2009 (IFSL, 2010), the market is still being tested by the lack of investor confidence following a series of high profile sukuk defaults (Muhamed and Radzi, 2012).

A.2.3 Diversity among Sukuks

Sukuks, since their early inception, have evolved as an innovative financial instrument to cater different financing needs. Sukuks raise funds through different contractual setups for different purposes. Khaleq (2012) provides a set of examples on the diversity of scope and contractual obligations used in Sukuk issuance.

Sovereign Sukuks aim to raise funds for state governments and are similar to sovereign bonds in terms of scope. For example: Pakistan issued an Ijara-based Standalone sukuk in 27 January 2005 followed by Dubai issued an Ijara-based Programmed sukuk in 3 November 2009. Private Sukuks are used to raise funds for corporations and are similar to corporate bonds in terms of scope. For example: Durrat KhaleejAl-Bahrain (Istisna’a and Ijara-based sukuk, 25 January 2005); Al Thani (Musharaka based sukuk, 3 October 2007). Quasi-Sovereign aim to raise funds for public private partnerships and are in between sovereign bonds and corporate bonds in terms of scope. For example: Dubai World (Mudaraba-based, 3 July 2007), Nakheel (Equity Linked, 14 December 2006).

In economic terms, there are three common types of sukuk, namely fixed-income sukuk, asset-backed sukuk (ABS), and hybrid sukuk (Zawya, 2009).

A.2.4 Case on Kuala Lumpur Sentral Pvt. Ltd. (KLSSB): A Success Story

Although a diverse range of sukuks exist in the sukuk industry, a simple case of sukuk issued by a Malaysian corporation is considered in this segment. Abdullah et al (2012) provides a lucid description and detailed analysis of Kuala Lumpur Sentral Pvt. Ltd. (KLSSB) that has issued sukuk musharakah in 2006. Figure A.1 illustrates the structure of the sukuk.

A.2.4.1 The Issuer and the Agent

Kuwait Finance House (Malaysia) Ltd. (KFHMB) was engaged as the Shariah Advisor for the sukuk issued by Kuala Lumpur Sentral Pvt. Ltd. (KLSSB). Under the arrangement, KLSSB enters into a musharakah agreement with the eligible investors for the purpose of undertaking a Musharakah Venture. The interests of the investors in the Musharakah Venture are

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Trustee

overseeing the

Musharaka

Investors

KLSSB(as

Wakeel to

Investors)

KLSSB

KLSSB issues

sukuk and

receives proceeds

in return

Proceeds from PU

for Sukuk

redemption and

profit payments

5 1

KFHM

4

Purchase Undertaking

Musharakah

partners

appoint KLSSB

as the project

Agent

2 3

Musharakah Venture to sell Project Lands

Distributable

profit to be

shared semi-

annually based on

an agreed profit

sharing rate of

99%-1% to

KLSSB and Sukuk

Holders

Stake of Musharakah

partners based on

their capital

contributions of

74:26 from KLSSB

(in kind) and Sukuk

holders (in cash)

Source: Abdullah et al (2012) and RAM(2010)

represented by KLSSB in its capacity as agent (wakil) and initial trustee for the investors. KLSSB, as the agent of the Investors, issues the sukuk to the investors.

A.2.4.2 The Musharakah agreement and profit sharing ratio

The Musharakah Venture, based on their respective capital contributions (Musharakah Capital), are as follows: a) KLSSB - 26% in kind (RM254 million) and b) Investors - 74% (RM720 million). Distributable profits between the musharakah partners are agreed based on the Profit and Loss Sharing Ratio: a) Sukukholders: 1% (to be capped at RM1,000 p.a.) and b)KLSSB: 99%. If losses are incurred, the loss shall be allocated in accordance with the outstanding Capital Contribution Ratio which is on a basis Diminishing Pursuant to the share installment schedule."

Figure A.1: Structure of KLSSB Sukuk Musharakah

Trustee

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A.2.4.3 Capital Contribution

In the sukuk issued by KLSSB, investors contribute the capital required of up to RM720 million in cash, and KLSSB provide a form of land valued at RM 254 million.

A.2.4.4 Purchase Undertaking (PU)

According to studies of the KLSSB sukuk, it is found that there is a PU feature. KLSSB uses its portion of the Distributable profit and/or proceeds of its advances to the Musharakah Venture to purchase the sukukholders’ share in the Musharakah Venture in accordance with a pre-agreed 6 monthly schedule (each installment is payable by KLSSB and is referred to as a “Share Installment”). Such obligation of KLSSB will be evidenced by a deed of undertaking to be executed by KLSSB in favor of the Issuer and Trustee (“Purchase Undertaking”).

A.2.5 Cases on Sukuk Defaults

From 1997 to 2009, a total of 70 sukuk issued by 46 issuers have defaulted in Malaysia only that accounted for RM12.9 billion (Abdullah et al, 2011). Wijnbergen and Zaheer (2013) provide detailed accounts on four cases on sukuk defaults that are frequently cited in the literature, namely: a) East Cameron Partners’ Sukuk Al-Musharakah, b) Musharakah Sukuk of Investment Dar Company (TID), c) Golden Belt 1( Saad) Ijarah Sukuk and d) The Nahkeel Sukuk provides a detailed list of sukuk defaults, their types and regulatory aspects. In this segment, two prominent sukuk default cases are presented: 1) East Cameron Partners’ Sukuk Al-Musharakah, and 2) The Nahkeel Sukuk.

A.2.5.1 East Cameron Partners’ Sukuk Al-Musharakah

East Cameron Partners’ Sukuk Al-Musharakah is the first sukuk issued by a company based in the United States and rated by Standard & Poor’s as having a CCC+ rating. In July 2006, East Cameron Partners (ECP) issued a sukuk worth USD165.67 million with a maturity period of 13 years.

A.2.5.1.1 Purpose of Sukuk Issuance

ECP was incorporated in Houston, Texas as a private oil and gas exploration company in 2002. Later, the company acquired leasehold interests in oil and gas production in federal oil and gas leases administered by Minerals and Management Services (MMS) of the US Department of Interior (Boustany, 2006). The objective of the originator was not shariah compliant financing, rather the issuer, ECP, simply understood the sukuk structure to be an affordable and flexible financing tool to raise the funds.

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A.2.5.1.2 The SPV

A SPV was formed, namely the East Cameron Gac Company (ECGP), incorporated in the Cayman Islands.

A.2.5.1.3 Type of contract

A Musharakah (co-ownership/joint venture) type of contract was used as the underlying contract in which sukuk investors had the ownership “Overriding Royalty Interest (ORRI)” in two gas properties located in the shallow waters offshore the State of Louisiana through an SPV acting as a trustee of the sukuk holders. Like the sukuk investors, the originator also contributed its funds into the musharakah. The assets of the musharakah were co-owned by the sukuk holders and the originator company, ECP.

Figure A.2: East Cameron Gas Co. Sukuk Issuance

A.2.5.1.4 ECP’s Sukuk Structure

The issuer, East Cameron Gas Company (ECGP), incorporated in Cayman Islands, issued sukuk worth USD165.7 million. The proceeds from sukuk issuance were used to buy the ORRI from the Purchaser SPV, mentioned in a Funding Agreement for USD$ 113.8 million.

The remaining amount, USD 51.9 million was set aside for future development, a reserve account and the purchase of put options for natural gas to hedge against the risk of fall in gas prices.

ECP Purchase SPV Issuer SPV Sukuk Holders

3 2 1

4 5 6

U.S.A. Cayman Islands

1 – Sukuk Subscription of $165.67 million

2 – Funding $ 165.67 million

3 – Purchase of ORRI $113.84 million

Source: East Cameron gas Co. FIR 2006 and Wijnbergen and Zaheer (2013)

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Next, the originator contributes his share of the capital in the form of a transfer of ORRI into the purchaser SPV.

The purchaser SPV, holding ORRI in the properties, is entitled to around 90 percent of ECP’s net revenue generated though gas production.

The production is sold to two off-takers with Merill Lynch as a backup off-taker. Proceedings of the oil and gas sale are transferred to an allocation account. After paying

around 20 percent to government and private ORRI, the remaining amount would be transferred to the Purchaser SPV. The purchaser SPV would allocate 10 percent for the originator and the remainder for payment of expenses, periodic sukuk returns and redemption amount.

Once the sukuk is mature, the issuer SPV would redeem all the sukuk against the amount left to be transferred to the sukuk holders.

An expected return of 11.25 percent was offered to the sukuk investors to be paid quarterly. A reserve account was also maintained as a credit enhancement, dedicated to meet any shortfall in return with the moneys reserved in the account.

A.2.5.1.5 Restructuring the ECP Sukuk

East Cameron Partners defaulted on periodic payments to the sukuk holders, due to the financial problems arising from the shortfall in oil and gas production. On 16 October 2008, East Cameron Partners filed a petition for bankruptcy protection under chapter 11 of the US Bankruptcy Code in the United States Bankruptcy Court in Louisiana to reorganize their debts and operations, but the bankruptcy court apparently rejected East Cameron’s argument saying that “[sukuk] holders invested in the sukuk certificates in reliance on the characterization of the transfer of the royalty interest as a true sale” (Fidler, 2009). This verdict by the court is an important precedent about the protection of sukuk holders’ rights. It sets the precedent that asset-backed sukuk are, in fact, bankruptcy proof, and the transfer of assets to the Sukuk SPV are shown to be safe from the bankruptcy of the originating company. (Wijnbergen and Zaheer, 2013). Based on the court ruling, East Cameron Partners filed a revised lawsuit; however, stakeholders preferred to resolve the case through negotiations. Finally, the underlying sukuk assets were transferred to the issuer for the benefit of sukuk investors and, according to the terms of the sale, the assets of East Cameron Partners were sold to the Sukuk investors (Latham and Watkins, 2011).

A.2.5.2 The Nahkeel Sukuk

The Nahkeel sukuk is a Dubai-based, high profile sukuk, and one of the largest sukuk issuances in the history of the industry. The sukuk were listed on the Dubai International Financial Exchange on December, 14 2006, maturing in 3 years on 15 December 2009. The objective was to raise a total of USD3.5 billion to finance a property development project in one of the public sector enterprises of Dubai, Nahkeel Co. PJSC. A special purpose vehicle (SPV), Nahkeel Development Limited, was incorporated with limited liability in the Jebel Ali Free Zone.

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Since they were issued by a public sector enterprise, the sukuk were given the status of a sovereign bond by the rating agency. Investors assumed an implicit government guarantee for the sukuk. The sukuks were rated A1 by Moody’s and A+ by Standard & Poor’s. The Structure of the Nakheel sukuk were based on asset based Ijarah manfaa (Salah, 2010), in which sukuk holders, via an SPV, buy the leasehold interest of the primary assets without transferring the title of the assets to them. The sukuk holders only had rights on the stream of income generated by the assets, and not on the assets themselves. Figure A.3 depicts the structure of the Nakheel Sukuk.

Figure A.3: Structure of Nakleel Sukuk

A.2.5.2.1 Reasons for Insolvency/Default

Following the global financial crisis 2007-09, the macroeconomic situation led the Dubai government to seek a standstill for USD59 billion debt owed by the Dubai World, including Islamic sukuk of 3.5 billion (Smith and Kiwan, 2009). There were various factors which caused Dubai World to, in effect, default. Huge short term borrowings, falling oil prices, the bursting of the real estate price bubble due to excessive supply of residential and commercial properties, and a liquidity mismatch owing to short term liabilities and long term receivables from the property development, all contributed to the failure of Dubai World (IMF (2010 )). In the end, the sukuk’s default was triggered by the specific financial condition of the obligor. For the first half of 2009, the company had a net exposure of AED 12.8 billion to the parent company, Dubai World. It is more than likely that, if the concentration of funds in related parties had been managed prudently, the standstill request for at least the Nahkeel sukuk could have been prevented.

Sukuk Holders

Nakheel Developent Ltd.

(SPV/ Issuer/ Purchaser)

Nakheel Holding 1

LLC (Seller)

Nakheel Co.

3

Certificates Sukuk Proceeds

Leasehold Rights Purchase Price

Funds

2

1

3 year lease of

Sukuk Assets

Nakheel Holdings 2

(Lessee)

4

Source: Wijnbergen and Zaheer (2013)

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A.2.5.2.2 Bailout

Eventually, outright default was prevented through the bailout by Abu Dhabi at the eleventh hour, and all the sukuk holders were paid out accordingly (IMF (2010 )).

A.3. ISLAMIC BANKING FAILURE AND LESSONS LEARNED

A.3.1 Status of Islamic Banking

Islamic finance is one of the fastest growing segments of global financial industry. It is estimated that the size of the Islamic banking industry at the global level was close to US$820 billion by the end of 2008 (Dridi and Hasan, 2010). In some countries, it has become systemically important and, in many others, it is too big to be ignored. Several factors have contributed to the strong growth of Islamic finance, including (i) strong demand in many Islamic countries for Shariah-compliant products, (ii) progress in strengthening the legal and regulatory framework for Islamic finance, (iii) growing demand from conventional investors, including for diversification purposes, and (iv) the capacity of the industry to develop a number of financial instruments that meet most of the needs of corporate and individual investors.

A.3.2 Recent financial crisis: How the Islamic banks have performed?

Existing literature overtly suggests that Islamic banks have outperformed commercial banks in Muslim countries during the financial crisis (see: Parashar and Jyothi Venkatesh(2010), Dridi and Hasan (2010), Habib Ahmed (2010) and others). Dridi and Hasan (2010) is one of the recent papers to analyze the performance of Islamic banks and commercial banks. They use bank-level data covering 2005 to 2010 for about 120 IBs and CBs in eight countries, Bahrain, Jordan, Kuwait, Malaysia, Qatar, Saudi Arabia, Turkey, and the UAE, to investigate (a) if Islamic banks performed differently, compared to conventional banks, (b) the factors behind any difference, and (c) future challenges for Islamic banks. Dridi and Hasan (2010) find that: Islamic banks performed differently than commercial banks during the 2007 global

financial crisis. Because of their business models, Islamic banks had limited exposure in the derivatives

products and were less connected globally and were less affected during the financial crisis.

However, during the post-crisis period 2008-2009, the performance of Islamic banks was not significantly different than the commercial banks. One important reason is that both Islamic and commercial banks were affected by the common macro-economic factors and a slow growth trend in the sample countries following the financial crisis.

In addition, the larger Islamic banks have performed better than the smaller ones, which may be driven by better diversification, economies of scale, and stronger reputation.

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Islamic bank credit and asset growth were at least twice as high as that of commercial banks during the crisis, suggesting a growing market share going forward and larger supervisory responsibility. External rating agencies‘ re-assessment of IBs‘ risk was generally more favorable or similar to that of CBs.

A.3.3 Lessons learned

Ali (2007) is one of the early studies to analyze financial distress in the Islamic banking sector in Turkey during the 2001 banking crisis. Some causes of financial distress in Islamic banks are very unique to the nature of the contracts permissible in Islamic finance; however, Islamic banks are also prone to the causes that are common to their conventional counterparts. Ali (2007) analyzes the factors behind the failure of Ihlas Finans House in Turkey during the banking crisis of 2001 and reveals the following: A combination of liquidity crunch and exchange rate shock and lack of confidence among

the depositors caused a run on Ihlas Finans before it collapsed. Lack of appropriate regulatory system for Islamic finance was an important cause for

Special Finance Houses (SFH) collapse. As the deposits of Islamic banks are not protected by the Central Bank guarantee, Islamic

banks should be more prudent in raising funds and investing them. Islamic banks should set aside a higher proportion of assets in liquid form to accommodate

some withdrawal requests. Banks should have some crisis management plan that should consider various possible

scenarios and possible actions from the managers in such situations. Managers in Islamic banks should be aware of the macro-economic factors that affect both

Islamic and conventional banks. As the size of Islamic financial industry grows, its exposure to macro-level shocks also increases.

Habib Ahmed (2010) analyzes different facets of the 2007 global financial crisis and puts forward a set of policy and practice recommendations that may enhance the stability and resilience of the Islamic finance industry. Habib Ahmed (2010) summaries that: With few exceptions, most of the Muslim countries have adopted Western legal models

that do not support the unique features of Islamic financial activities. In this context, Muslim countries need to formulate and initiate legal changes that should support the Islamic financial contracts. In addition, for the development of Islamic capital markets and sukuk markets, in particular, bankruptcy laws and disclosure requirements need to be promulgated by the regulatory authorities.

Regulators should also provide appropriate guidelines for liquidity management in Islamic banks that plays a crucial role in managing the liquidity risk during the financial distresses.

The regulators also need to ensure the protection of consumers and investors through an alternate arrangement, similar to the deposit insurance shields in commercial banks. Otherwise, the managers in the Islamic banks should maintain more balance in cash and liquid assets.

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A.4 OVERNING LAW CLAUSES OF SELECTED SUKUK TRANSACTIONS

This section draws heavily from Oseni and Hassan (2014). This section presents and analyses the governing law clauses of a selection of 10 sukuk transactions as contained in their prospectuses. While it may not possible to review each sukuk transaction, for research convenience, they have been classified into four main categories, based on the manner they were drafted. First, the sukuk transactions that choose English law and the exclusive jurisdiction of the English courts. Second, sukuk transactions that partly provide for the English law and jurisdiction. Third, sukuk transactions that provide for Sharī'ah as the exclusive law for the interpretation of the underlying agreements. And fourth, sukuk transactions that provide for arbitration as an alternative form of dispute resolution.

A.4.1 English Law and Exclusive Jurisdiction of the English Courts

When sukuk financing first made its initial debut in the global scene, there was a general trend of choosing English law as the governing law in Sukuk Prospectuses, and the English courts had exclusive jurisdiction to hear and determine any dispute, claim or action arising from such transactions. Even though this general trend still subsists, there are now new approaches to the drafting of the governing law clauses of sukuk transactions. The reason for the preference of English jurisdiction and the English law is not farfetched. Most of the leading law firms drafting Sukuk Prospectuses are English or western firms with offices across the Southeast Asian and GCC countries. As some of the Sharī'ah scholars interviewed argued, this is what the stakeholders want, and it does not necessarily violate the fundamentals of Islamic commercial law. Some practitioners have also argued that for the sake of certainty in huge investments such as sukuk, there is a need for a more formal forum for dispute resolution. Or else, the investors will not want their huge investments to go down the drain, because of weak regulatory and legal infrastructure. A consideration of a leading English case would provide a more practical angle and help to support the case that choice of law clauses are of great significance in the drafting of sukuk contracts. A number of English court decisions have explored the extent of application of Shariah in transactions involving Islamic finance products. One common denominator of most of the cases is the Shariah defence, often pleaded by the defaulting party or the defendant in order to persuade the court about the inapplicability of Shariah rules, since the contract in question is void ab initio in the eyes of Shariah. The first instance where the English court ruled on an Islamic financial transaction is in the case of Islamic Investment Company of the Gulf (Bahamas) Ltd v Symphony Gems NV & Ors [2002] WL 346969 (QB Comm. Ct 13 February 2002). In this case, involving a murabahah facility, the parties had agreed on the choice of law and jurisdiction as being English law. After examining the nature and terms of the contract and listening to expert opinion, the court held that the English law principles of contract must apply to the purported murabahah contract, despite the fact that the expert opinion revealed that the agreement in issue did not have the essential characteristics of a murabahah contract. This is premised on clause 25 of the agreement which provides that “[t]his Agreement and each Purchase Agreement shall be governed by, and shall be construed in accordance with,

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English law....” With this clause, the parties have agreed that the transaction, as well as any purchase agreement made pursuant thereto, shall be governed and construed in accordance with the English law. In addition, clause 26 of the underlying agreement provides for an irrevocable submission to the jurisdiction of the English court. It is important to observe that party autonomy is of paramount importance in the choice of law and jurisdiction. Therefore, the court construed the agreement as an English law contract, which validated the seemingly invalid murabahah contract. This case “illuminates the challenges and tensions within the industrial complex of Islamic finance as it seeks to exist and thrive in a commercial reality, where the regulatory framework and its associated assumptions (both theoretical as well as those of commercial practice) differ markedly from those of Islamic law and the contemporary Islamic financial industry” (Moghul & Ahmed, 2003: 155). In the Prospectus of GE Capital Sukuk Ltd., it is provided that all the underlying contracts except the Guarantee will be construed in accordance with the English law. The Guarantee contract is governed by the New York State law. All the parties in the sukuk transaction agreed that they shall submit to the exclusive jurisdiction of the English courts, and any judgment obtained in any proceedings before such courts shall be binding and enforceable in any other jurisdiction. A similar provision was inserted in the controversial Goldman Sachs sukuk where the underlying contracts are to be construed in accordance with the English law, New York laws and the laws of Cayman Islands, respectively. This totally excludes the Sharī'ah as the governing law. Sharī'ah can only be invoked during the proceedings through the call for expert opinions from Sharī'ah scholars, which are not necessarily binding on the courts.

A.4.2 English Law and Non-Exclusive Jurisdiction of the English Courts

While maintaining a middle course, there are Sukuk Prospectuses that provide for a mixed legal and regulatory regime, owing to the fact that the stakeholders in the transaction are in different jurisdictions. Therefore, this category partly provides for English law as the governing law, while emphasizing the non-exclusivity of the jurisdiction of English courts in determining any claim or action under the Prospectus. That is, while some underlying contracts are construed under the English law, others are construed under the laws of other jurisdictions. In addition, any of the parties in the transaction can bring an action in other jurisdictions, though the English courts are preferred. This seems to be the most complex category, because other related issues, such as recognition and enforcement of foreign judgments set in. To this end, it is pertinent to observe that some of the countries in the GCC are not signatories to the Convention on the Recognition and Enforcement of Foreign Arbitral Awards of 1958 (New York Convention). Worse still, many of those countries in the GCC region do not have bilateral treaties on the enforcement of foreign judgments, which makes it difficult to enforce an English judgment in jurisdictions like UAE, Abu Dhabi, Kuwait, Qatar and Saudi Arabia. Examples of Sukuk Prospectuses which fall under this category include the QIB Sukuk, Nakheel Sukuk, and 1Malaysia Sukuk Global.

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If the judgment were to be enforced in Qatar, under current Qatari law, due to the lack of reciprocity of enforcement of judgments between Qatar and England, the Qatari courts would be unlikely to enforce such judgment without re-examining the merits of the claim and may not observe the choice by the parties of English law as the governing law of such Transaction Documents. In addition, even if English law is accepted as the governing law, this will only be applied to the extent that it is compatible with mandatory provisions of Qatari law and public policy and morals in Qatar. This may mean that the Qatari courts may seek to interpret English law governed documents in accordance with Qatari law principles and there can, therefore, be no certainty that in those circumstances the Qatari courts would give effect to such documents in the same manner as the parties may intend (Qatar Islamic Bank, 2010: 15). This has led to problems of uncertainty of some jurisdictions, which amounts to a legal risk in the transaction. As will be seen in the recommendations of this study, a different view is presented, because most of these so called jurisdictions with uncertain legal frameworks could effectively utilize binding arbitration, where experts constitute the arbitral tribunal for the resolution of the securities disputes.

A.4.3 Sharī'ah as the Exclusive Governing Law

Despite the prevailing practices in the global sukuk market, there are still some jurisdictions that insist on the stipulation of Sharī'ah-compliant dispute resolution processes and that the governing law shall be the Sharī'ah. Though this is a new approach to the drafting of sukuk prospectus, it represents the proper style. Among the 10 sukuk transactions reviewed in this study, it is only the Saudi Electricity Company Sukuk Prospectus (SE Sukuk) that provides for mandatory application of Sharī'ah as well as the Laws of the Kingdom of Saudi Arabia, which by virtue of Article 1 of its Constitution is an Islamic state governed by the Sharī'ah. According to the SE Sukuk, the Sukuk documents are to be construed in accordance with the laws and regulations of Saudi Arabia. Apart from this governing law, the jurisdiction that can hear and determine any matter arising from the transaction lies with the Committee for the Resolution of Securities Disputes (CRSD) and the Appeal Panel. The CRSD and its Appeal Panel has exclusive jurisdiction to hear any suit, action or proceedings arising from the sukuk transaction. This ousts the jurisdiction of foreign courts in any claim or action relating to the transaction. In the SE Sukuk, it is clarified: Prospective Sukukholders should note that to the best of SEC’s knowledge, no securities of a similar nature to the Sukuk have previously been the subject of adjudicatory interpretation or enforcement in the Kingdom of Saudi Arabia. Accordingly, it is uncertain exactly how and to what extent the Sukuk, the Conditions and/or the Sukuk Documents (as defined below) would be enforced by a Saudi Arabian court or the Committee for the Resolution of Securities Disputes, the Appeal Panel, or any other Saudi Arabian adjudicatory authority (Saudi Electricity Company, 2010: 9). It is clear from the foregoing provision in the Prospectus that the SE Sukuk, in the event of any claim, action or suit, will be the litmus test for the certainty of the proceedings and enforceability of the award of the panel in Saudi Arabia. This is expected to serve as a model

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for other jurisdictions such as Malaysia and the UAE, who both have similar panels in their respective ICM. However, there are cases where the choice of law clause is ambiguously drafted. This was the case in Beximco Pharmaceuticals Ltd & Ors v. Shamil Bank of Bahrain E.C. [2004] EWCA Civ 19. In this leading case, Shariah has been presented as being in conflict with English law, and the appellant brought an appeal against the claimant, Shamil Bank of Bahrain, in relation to a single issue, which is incidentally related to the jursdiction . In this case, the lender, Shamil Bank of Bahrain, agreed to provide a financing facility to the borrowers, Beximco Pharmaceutical Ltd and others in 1995. The financing scheme was a murabahah (mark-up sale contract), which is an interest-free working capital facility. In the event of default, there were a number of termination events under the murabahah agreements. This triggered formal court proceedings in the form of an application for summary judgment. The borrowers agued that, since Shariah prohibits interest on loans, the murabahah agreements were disguised loans involving interest, and, as such, the agreements were invalid and unenforceable. The High Court granted summary judgment to Shamil Bank of Bahrain while concluding that Shariah principles did not apply, as Shariah cannot trump the application of English law. While the borrowers were initially refused permission to appeal in the decision of Moris J., they were, however, granted the permission to file an appeal “relating to the construction and effect of the form of the governing law clause contained in the financing agreements” by Clarke LJ. The said governing law clause of the murabahah financing agreements provides: “Subject to the principles of the Glorious Sharia’a, this Agreement shall be governed by and construed in accordance with the laws of England.” This was a litmus test for the English courts to hand down their position on which law applies – “the Glorious Sharia’a” or the Laws of England? This was fundamental in construing the applicable law in the financing agreement, which will invariably clear the way for the determination of the substantive suit. In summary, the appellants raised the usual Shariah defence, which is now generally being considered as “a lawyer’s construct” in Islamic finance litigation. The main issue before the Court of Appeal was whether the murabahah arrangement fell foul of relevant principles of Shariah regulating such a transaction, which would lead to freedom from liability on the part of the borrowers under the financing facility. After considering the diverse positions of expert witnesses and applying relevant English principles, the court came to the conclusion that Shariah principles do not apply, which makes the financing scheme enforceable. Since two systems of law cannot be applicable to a particular contract, the issue boils down to the construction of the governing law clause. As indicated by the court, the borrowers would have been successful if they had validly incorporated the relevant Shariah principles applicable to the contract: The fact that there may be general consensus upon the proscription of Riba and the essentials of a valid Morabaha agreement does no more than indicate that, if the Sharia law proviso were

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sufficient to incorporate the principles of Sharia law into the parties’ agreements, the defendants would have been likely to succeed. [Para 55] In Sayyed Mohammed Musawi v. R. E. International (UK) Ltd. & Ors [2007] EWHC 2981 (Ch), involving the applicability of the “Shia Sharia law”, similar to the “principles of the Glorious Sharia’a” mentioned in the above case, the issues of choice of law was brought to the forefront. Though the parties agreed the Shia Sharia law is applicable to the contract, which was not a contentious issue in the case, the judge held that “at common law the proper law of a contract had to be either English law or the law of another country, and the courts would not apply any other system to a contract.” [Para 19]. Hence, the court concluded that the applicable law in the case was English law. The above cases reflect the polemics of the governing law clause in Islamic finance transactions. Such polemics are also present in sukuk transactions, which require some immediate solutions. The interaction between Shariah and English law and the seeming convergence of laws happening in some jurisdictions calls for a way forward.

A.4.4 Provisions for Arbitration in Sukuk Transactions

The paradigm shift to alternative dispute resolution processes in civil and commercial transactions has largely influenced the dispute resolution agreement in the governing clauses of Sukuk Prospectuses. The Saad Sukuk Prospectus partly provides for the likelihood of arbitration in the settlement of disputes between the company and any other party. However, in more emphatic terms, the DanaGas Sukuk Limited Prospectus provides that “[a]ny disputes which may arise out of or in connection with the Transaction Documents may be finally settled under the Rules of the London Court of International Arbitration” (Dana Gas, 2007: 38). Adopting such rules does not preclude the applicability of Sharī'ah in the arbitration proceedings. It depends on how the parties expressly provide for the applicable substantive law for such proceedings. Essentially, arbitration serves as a preventive and remedial measure for protecting the sukuk holders (Jarrar, 2009). This will be more effective when the arbitration proceedings are conducted based on the Islamic arbitration principles, which are not as restrictive as the conventional rules of arbitration. The use of friendlier and less formal procedures for resolving securities disputes such as arbitration and conciliation will allow for expert arbitration panels where parties can clearly stipulate in their dispute resolution agreement that any dispute arising from the sukuk transaction shall be resolved by an arbitration panel duly constituted by the triad of a lawyer, Sharī'ah scholar, and finance expert. There is no doubt that this three-man panel will be more appropriate for disputes involving sukuk transactions, since the arbitrators are experts in all aspects of the transaction in dispute. Even if the arbitration tribunal is mandatorily required to use lex arbitri (the law of the seat of arbitration) under the relevant laws, the mere fact that they are experts in all required aspects is an added value to the proceedings. It goes without saying that there are now regional and international institutions that have calibrated their arbitration rules to accommodate Islamic finance disputes, including disputes arising from sukuk transactions. Examples of such institutions are the Kuala Lumpur Regional Centre for

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Arbitration and the International Islamic Centre for Reconciliation and Commercial Arbitration (IICRA). An attempt to explore alternative dispute resolution (ADR) in a summary judgment that was set aside involving an Islamic finance facility was made in Gulf International Bank BSC v Ekttitab Holding Company KSCC and Al Madina [2010] EWHC B30 (Comm). Though the summary judgment was obtained by the claimant, the court set it aside on technical grounds. One striking direction of the court, which is rare in Islamic finance litigation, is the directive from Simon J. to the parties to explore ADR in accordance with the rules of the court: “I also propose to allow the parties time to engage in neutral evaluation in alternative dispute resolution of this matter. It seems to me that relevant time should be set aside for that purpose and it is likely to bear fruit in this case” [Para 16]. From the record of court proceedings, it was crystal clear that the parties were willing to explore ADR with a view to considering out-of-court settlement as an alternative to summary judgment. During a seminar recently, Stilt critically asked about “what the appropriate tribunals for dispute resolution of such bankruptcy or other cases of insolvency would be” when it comes to sukuk defaults. She quickly added: “Regular courts are not always that helpful or knowledgeable as we found out, and often arbitration bodies are chosen by parties involved” (Islamic Finance Project, 2011). This points to the often-repeated fact that dispute resolution in any sukuk prospectus is at the centre of the whole transaction.

A.5 INSOLVENCY AND DEBT RESTRUCTURING IN ISLAMIC LAW

There are incidences which are used by both the proto-jurists and modern scholars to establish certain basic rules of bankruptcy. Just as in the modern laws, insolvency leads to bankruptcy even though the latter may be preceded by the process of debt restructuring. Hence, there are historical precedents in the Sunnah detailing some practices among the proto-Muslims during the prophetic era. For instance, it was reported that the Prophet prevented Mu‘ādh from disposing his property, because his debts outweighed his assets. Since he was insolvent, the Prophet, being the head of state who also exercised judicial powers, sold the Mu‘ādh b. Jabal’s property and paid off the creditors.32 Muslim jurists have endeavored to differentiate between financial distress (’i‘sār) and bankruptcy (iflās), and insolvency (taflīs). While Al-Qurtubi defines financial distress as a situation where one finds himself in a difficult situation due to lack of funds, Abu Jayib (1408) describes bankruptcy as a situation where one’s debt outweighs his assets and there is no way the later can settle the former. Fruthermore, there is a sharp line of distinction between insolvency (taflīs) and bankruptcy (iflās). Once someone has become insolvent, he may be

32 This hadith was related in Sunan Al-Baihaqi, vol. 6, p. 48. Talkhis al-Khabir, vol. 3, p. 37. Al-

Mausu’ah al-Fiqhiyyah, vol. 5, p. 301.

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declared bankrupt and the creditors can get relief from the entire of all his properties.33 This is done through an interdiction (hajar) on his properties by the creditors. The bankruptcy proceedings should ordinarily be managed by a constitued authority, usually the qādi. All the properties of the bankrupt person are sold with the exception of some necessaries such as food, drink and clothing. The proceeds of such sale are divided among the creditors. If the debt of any of the creditors is something concrete and recognizable among the properties of the bankrupt person, it is restored immediately without selling it. The conceptual basis of the three concepts of i‘sār, iflās, and taflīs are found in the principles of social responsibility highlighted in the Qur’an: “And if the debtor is in a hard time (has no money), then grant him time till it is easy for him to repay, but if you remit it by way of charity, that is better for you if you did but know.”34 This legal rule does not suggest that the debtor should evade repayment of a debt (McMillen, 2012). While contractual transactions are meant to be fulfilled as a general principle, this exception of debt restructuring or cancellation is meant for special circumstances. In a related prophetic precedent, it is reported that the Prophet once said: “If anyone would like Allah to save him from the hardships of the Day of Resurrection, he should give more time to his debtor who is short of money, or remit his debt altogether.”35 Nevertheless, Islam recognizes insolvency and once a competent court In his interpretation of this verse, Al-Qurtubi (2006/1427: 417) in his compedium of legal rulings of Qur’an explains the need for the judge to seize the property of a person who is insolvent, except for his personal effects which are of utmost necessity, such as his old clothes and books if he is scholar. This is further justified by a prophetic saying, which provides: "If a man finds his very things with a bankrupt, he has more right to take them back than anyone else."36 Though there are different of opinions among the Muslim jurists on some of the issues, the general Sharī‘ah principles on bankruptcy are summarized thus: A debtor may be deemed bankrupt if he has no wealth, or he has wealth, but it will not

cover the debt that is currently due. With regard to debts that are not yet due, the one who owes them cannot be deemed bankrupt.

The bankrupt individual may have his assets frozen if his creditors or some of them request that, so that he will not harm them by that.

If his assets are frozen, then any transaction he does, whether buying or selling, establishing a waqf or giving a gift, is not valid.

The ruler or qādi (judge) may sell his property in order to pay off his debts and leave him nothing, except what is necessary for him, such as his dwelling, his books, his clothing, the

33 A relevant hadith on this principle provides: “He who finds his property intact with a man (who

bought it but who later on) became insolvent (or a person who became insolvent), he (the seller) is

entitled to get it more than anyone else.” Related by Bukhari and Muslim. 34 Qur’an 2: 280. 35 Related by Muslim. 36 Related by Muslim.

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tools of his trade, and the capital of his business; he may sell everything apart from that (Al-Munajjid, 2013).

It may not be necessary at this point to go into the details of Sharī‘ah rules on insolvency. These have been comprehensively examined recently by Manṣūr (2012), with particular reference to insolvency of corporate bodies. Kilborn (2011b) gives a comprehensive foundation on Islamic bankruptcy law. Hamoudi (2011) berates the attitude of Muslim countries in neglecting the fine principles of Islamic bankruptcy law, and Awad & Michael (2010) examine the Islamic law of bankruptcy as understood in the Sunni jurisprudence.

A.6 DEBT RESTRUCTURING, DISPUTE MANAGEMENT AND DEFAULTS IN ISLAMIC FINANCIAL TRANSACTIONS

While issues relating to insolvency are recognized in Islamic law, emphasis is placed on debt restructuring and amicable dispute management that serves the purpose of all stakeholders. The desirability of conciliation and forbearance is emphasized in Qur’an 2: 280 (Warde, 2011). This basis of debt restructuring established in the Qur’an is further explained in a number of prophetic precedents. ‘Abdullah b. Ka’b b. Malik once narrated that Ka'b demanded his debt back from Ibn Abi Hadrad in the Mosque and their voices grew louder till Allah's Apostle heard them while he was in his house. He came out to them raising the curtain of his room and addressed Ka'b, "O Ka'b!" Ka'b replied, "Labaik, O Allah's Apostle." (He said to him), "Reduce your debt to one half," gesturing with his hand. Kab said, "I have done so, O Allah's Apostle!" On that, the Prophet said to Ibn Abi Hadrad, "Get up and repay the debt, to him."37 The Prophet served as the judge during the early period of Islam and had cause to settle a number of disputes in a manner acceptable to all the parties. He encouraged the creditor to reduce the amount of debt and the debtor to pay off the debt as soon as possible, thereby avoiding a situation where the latter will be declared bankrupt. As Warde (2011) rightly posited, “[t]he judge (qadi) was the central figure in finding an appropriate resolution to the cases brought before him. What resulted was an ad hoc attempt at compromise as opposed to systematic receivership. Assuming good faith, both sides were expected to make concessions. Typically there would be a reduction of debt and a change in terms based on the debtor’s ability to pay”. It therefore follows from the above discussion that there cannot be debt restructuring without appropriate steps toward dispute management among the stakeholders involved in a particular transaction. For disputes involving insolvency, it thus appears a number of amicable dispute resolution processes are applicable (Oseni, Ansari, & Kadouf, 2012). Notable among these processes are compromise of action, conciliation, arbitration, and litigation. That is, any case involving insolvency should begin with compromise, and, if not resolved amicably, it may proceed for conciliation and arbitration, and ultimately end in litigation. Compromise of action is meant to create an avenue for the parties to discuss debt restructuring and make such compromise, or any other arrangement they deem expedient, with the creditors. While the compromise of action procedure does not involve a third party neutral who is empowered to make a binding

37 Vol. 3, Book 41, Hadith No. 600.

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ruling, conciliation and arbitration may involve such a third party whose decision may be binding on the parties. But any settlement agreement that emanates from the compromise of action proceedings, which is duly signed by the parties, should be enforceable by the courts. While the East Cameron case involved a junk sukuk issuance, which ended up in the U.S. courts, the Nakheel debacle was properly managed through appropriate steps toward debt restructuring with the creditors. After reaching a compromise with the trade creditors, it completed the $10.9 billion debt restructuring in the first half of 2011. Recently, as part of its restructuring plan, it issued $32.94 million sukuk on 7 January 2013, which represents the third tranche in the restructuring process. In 2009, the Investment Dar also defaulted on a $100 million sukuk, and it was restructured in 2011. Part of the arrangement was to convert part of the claims of the creditors into equity in the company. In a similar vein, the near-default Dana Gas sukuk issue is being resolved through compromise of action. Dana has proposed a $920 million debt restructuring deal where it offered bondholders $70 million in cash, while the remaining $850 million debt will be refinanced. At present, the shareholders are still considering this offer, but there are indications that some of them will agree with the proposed plan.

Table A.2: Remedial Measures for Sukuk Defaults and Near Defaults

Name of Sukuk Immediate Cause of Default or

Near-default

Exit Strategy / Remedial

Measure

Year of

Default

The Investment

Dar

Default on a $100 million debt

repayment

Debt restructuring to revive the

sukuk sales

2009

Golden Belt 1

(Saad Group)

Default in repayment of $650 million

to Citicorp Trustee Co. Ltd.

Dissolution of the Trust 2009

East Cameron

Partners

Filing of one of the parties (East

Cameron Partners) for bankruptcy

Bankruptcy proceedings 2008

Nakheel Delay in repayments of $4 billion

sukuk

Default narrowly averted with the

rescue of Abu Dhabi

2009

IIG Funding

Limited

Inability to make periodic distribution

to sukuk holders

Looming debt restructuring plan 2012

Dana Gas Inability to repay outstanding $920

million of the sukuk, issued in 2007,

on time and in full

Presently seeking consensual deal

on sukuk by weighing options of

repayment

2012

Source: (Oseni, 2012)

What can be gleaned from Table A.5 above is the preference of stakeholders for remedial measures as exit strategies for the sukuk debacle. Apart from the extreme situation where a party has to commence bankruptcy proceedings, it appears parties prefer debt restructuring, which agrees with the Qur’anic principles of forbearance and forgiveness in issues relating to debt. Be that as it may, a clear legal framework is necessary for debt restructuring in cases of sukuk defaults. The proposed Islamic bankruptcy law should be comprehensive enough to accommodate pre-default issues that may require debt restructuring. A looming default should ordinarily trigger the process of debt restructuring. Managing the dispute at its early stage will help prevent an escalated dispute that may end up in bankruptcy proceedings.

Risk Management in Islamic Financial Instruments

APPENDIX B: CREDIT RISK MEASUREMENT

Sundarajan (2005) states that the measurement of three components, which allow us to calculate loss, (1) the probability of default, (2) potential credit exposures at default, and (3) loss given default, are key requirements of the New Basel Capital Accord. Aurn Sundarajan (2005) offers specific equations for calculating risk in investment deposit returns, which can be calculated based on the variance of RI. VAR (RI) = (A/DI)2 [VAR (RA – Sp) + VAR (RP) – 2Cov(RA-Sp, RP)] + (AK/DI)2 VAR (RE) (5) Similarly, the risk in return to capital can be found by calculating the variance of RK and its components based on an equation. Mudaraba Profit(RM) can be written as (ignoring Investment Risk Reserves for simplicity) RM = A(RA-PA) – ARP – K RK Where RA = return on assets, Rp = Profit Equalization Reserves (as a % assets) Sp = Provisions as a % of assets, RK = Return on Capital assigned for the purpose of computing distributable Mudaraba income. Rate of Return for Investment Account holders (RI) can then be calculated by applying the agreed share on Mudaraba income. RI = αRM/DI = α [A (RA-Sp-RP-K RK)] / DI The total return on capital can be calculated to ensure that total income accruing to banks’ own funds - equal to assigned return on capital plus income earned as a Mudarib – provides as required return on equity of RE. RE = (1-α) RM/K + RK Combing (1) & (2) RI = A (RA-Sp-RP) - KRE

DI RK = 1 RE ─ (1- α) A (RA-Sp-RP) α α K The equations above were extracted from Sundararajan (2005).

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APPENDIX C: LIST OF BANKS, COUNTRIES AND REGIONS

Serial Bank Country Region

1 Islamic Bank Bangladesh Limited Bangladesh South Asia

2 Habib Bank Limited Pakistan South Asia

3 Bank Islam Malaysia Berhad Malaysia Southeast Asia

4 Bank Muamalat Indonesia Indonesia Southeast Asia

5 Bank Islam Brunei Darussalam Berhad Brunei Darussalam Southeast Asia

6 Al-Hilal Bank Kazakhstan Central Asia

7 Abu Dhabi Islamic Bank – Egypt Egypt MENA

8 Bank Melli Iran Iran MENA

9 Al Rajhi Bank Jordan MENA

10 Bahrain Islamic Bank Bahrain MENA

11 National Bank of Bahrain Bahrain MENA

12 Kuwait Finance House Kuwait MENA

13 Qatar National Bank Qatar MENA

14 Emirates Islamic Bank UAE MENA

15 Dubai Islamic Bank UAE MENA

16 Al Rajhi Bank KSA MENA

17 Riyad Bank KSA MENA

18 Arab National Bank KSA MENA

Risk Management in Islamic Financial Instruments

APPENDIX D: SURVEY QUESTIONNAIRE OF RISK MANAGEMENT

Part I: Risk Perception

(Please circle ONLY ONE number that best reflects your opinion, NS = Not Serious, CS= Critically Serious)

CS NS

5 4 3 2 1

Risk Perception-Overall Risks Faced by Islamic Financial Institutions

1 Credit Risk 5 4 3 2 1

2 Mark-up Risk 5 4 3 2 1

3 Liquidity Risk 5 4 3 2 1

4 Market Risk 5 4 3 2 1

5 Operational Risk 5 4 3 2 1

Risk Perception-Risks in different Modes of Financing

1 Murabahah Credit Risk 5 4 3 2 1

Mark-up Risk 5 4 3 2 1

Liquidity Risk 5 4 3 2 1

Operational Risk 5 4 3 2 1

2 Mudarabah Credit Risk 5 4 3 2 1

Mark-up Risk 5 4 3 2 1

Liquidity Risk 5 4 3 2 1

Operational Risk 5 4 3 2 1

3 Musharakah Credit Risk 5 4 3 2 1

Risk Management in Islamic Financial Instruments

185

Mark-up Risk 5 4 3 2 1

Liquidity Risk 5 4 3 2 1

Operational Risk 5 4 3 2 1

4 Ijtisna Credit Risk 5 4 3 2 1

Mark-up Risk 5 4 3 2 1

Liquidity Risk 5 4 3 2 1

Operational Risk 5 4 3 2 1

5 Ijarah Credit Risk 5 4 3 2 1

Mark-up Risk 5 4 3 2 1

Liquidity Risk 5 4 3 2 1

Operational Risk 5 4 3 2 1

6 Salam Credit Risk 5 4 3 2 1

Mark-up Risk 5 4 3 2 1

Liquidity Risk 5 4 3 2 1

Operational Risk 5 4 3 2 1

7 Diminishing Musharakah Credit Risk 5 4 3 2 1

Mark-up Risk 5 4 3 2 1

Liquidity Risk 5 4 3 2 1

Operational Risk 5 4 3 2 1

Risk Perception-Additional Issues regarding Risks faced by Islamic Financial Institutions

1 Lack of understanding of risks involved in Islamic modes of financing 5 4 3 2 1

Risk Management in Islamic Financial Instruments

1 Short-term Islamic financial assets that can be

sold in secondary markets

5 4 3 2 1

2 Islamic money markets to borrow funds in case

of need

5 4 3 2 1

3 Inability to use derivatives for hedging 5 4 3 2 1

4 Inability to re-price fixed return assets (like Murābahah) when the benchmark rate

changes.

5 4 3 2 1

5 Lack of legal system to deal with defaulters. 5 4 3 2 1

6 Lack of regulatory framework for Islamic banks. 5 4 3 2 1

Part II: Risk Management Environment

Establishing an Appropriate Risk Management Environment, Policies and Procedures

Yes No

1 Do you have a formal system of Risk Management in place in your organization?

2 Is there a section/committee responsible for identifying, monitoring, and controlling

various risks?

3 Does the bank have internal guidelines/rules and concrete procedures with respect to the

risk management system?

4 Is there a clear policy promoting asset quality?

5 Has the bank adopted and utilized guidelines for a loan approval system?

2 The rate of return on deposits has to be similar to that offered by other banks. 5 4 3 2 1

3 Withdrawal Risk: A low rate of return on deposits will lead to withdrawal of funds 5 4 3 2 1

4 Fiduciary Risk: Depositors would hold the bank responsible for a lower rate of return

on deposits

5 4 3 2 1

Risk Perception: Lack of Instruments/Institutions related to Risk Management

Risk Management in Islamic Financial Instruments

187

6 Are mark-up rates on loans set taking account of the loan grading?

Maintaining an Appropriate Risk Measuring, Mitigating, and Monitoring Process

yes No

1 Is there a computerized support system for estimating the variability of earnings and risk

management?

2 Are credit limits for individual counterparty set and are these strictly monitored?

3 Does the bank have a policy of diversifying investments across different countries

4 Does the bank have a policy of diversifying investments across different sectors (like

manufacturing, trading etc.)?

5 Does the bank have a policy of diversifying investments across different Industries (like

airlines, retail, etc.)?

6 Does the bank have in place a system for managing problem loans?

7 Does the bank regularly (e.g. weekly) compile a maturity ladder chart according to

settlement date and monitor cash position gaps?

8 Does the bank regularly conduct simulation analysis and measure benchmark (interest)

rate risk sensitivity?

9 Does the bank have in place a regular reporting system regarding risk management for

senior officers and management?

Part II: Risk Reporting

Maintaining an Appropriate Risk Measuring, Mitigating, and Monitoring Process-Risk Reports

yes No

1 Capital at Risk Report

2 Credit Risk Report

3 Aggregate Market Risk Report

4 Interest Rate Risk Report

5 Liquidity Risk Report

Risk Management in Islamic Financial Instruments

6 Foreign Exchange Risk Report

7 Commodities & Equities Position Risk Report

8 Operational Risk Report

9 Country Risk Report

Part IV: Risk Measuring and Management Techniques

Maintaining an Appropriate Risk Measuring, Mitigating, and Monitoring Process-Measuring and Management

Techniques

Yes No

1 Credit Ratings of Prospective Investors

2 Gap Analysis

3 Duration Analysis

4 Maturity Matching Analysis

5 Earnings at Risk

6 Value at Risk

7 Simulation techniques

8 Estimates of Worst Case scenarios

9 Risk Adjusted Rate of Return on Capital

10 Internal Rating System

Part V: Risk Monitoring

Maintaining an Appropriate Risk Measuring, Mitigating, and Monitoring Process- Risk Monitoring

Regularly Occasionally Never

1 Does the bank periodically reappraise collateral

(asset)?

Risk Management in Islamic Financial Instruments

189

2 Does the bank confirm a guarantor’s intention to

guarantee loans with a signed document?

3 If loans are international, does the bank regularly

review country ratings?

4 Does the bank monitor the borrower’s business

performance after loan extension?

International AAOIFI Other

5 Does the accounting standard used by the bank comply

with the following standards?

Daily Weekly Monthly

6 Positions and Profits/Losses are assessed?

Part VI: Presence of Internal Control

Adequate Internal Controls

Yes No

1 Does the bank have in place an internal control system capable of swiftly dealing with

newly recognized risks arising from changes in environment, etc.?

2 Is there a separation of duties between those who generate risks and those who manage

and control risks?

3 Does the bank have countermeasures (contingency plans) against disasters and accidents?

4 Is the Internal Auditor responsible to review and verify the risk management systems,

guidelines, and risk reports?

5 Does the bank have backups of software and data files?

Part VII: Other Important Issues

Other Issues related to Islamic Financial Institutions

Yes No

1 Is your bank actively engaged in research to develop Islamic compatible Risk Management

Risk Management in Islamic Financial Instruments

instruments and techniques?

2 When a new risk management product or scheme is introduced, does the bank get

clearance from the Sharī‘ah Board?

3 Does the bank use securitization to raise funds for specific investments/projects?

4 Do you have a reserve that is used to increase the profit share (rate of return) of

depositors in low-performing periods?

5 Is your bank of the view that the Basel Committee standards should be equally applicable

to Islamic banks?

6 Is your organization of the view that supervisors/regulators are able to assess the true

risks inherent in Islamic banks?

7 Does your organization consider that the risks of investment depositors and current

accounts shall not mix?

Capital Requirement in Islamic Banks compared to Conventional Banks

Less Same more

Do you think that the capital requirements for Islamic banks

as compared to conventional banks should be

www.comcec.org

C

O M C E

CC

O M C E

C