Islamic Finance Within Conventional Banking System – Opportunities and Challenges

02 July 2010III Astana Economic Conference

By

Musa Abdul Malek

Executive Director and CEO HSBC AMANAH Malaysia

2

Islamic Finance Window Operations

Models for Establishing Islamic Finance

Islamic Finance – Success Recipe

Overview of Islamic Finance

CONTENTS

Challenges in Islamic Finance

3

OVERVIEW OF ISLAMIC FINANCE

4

OVERVIEW OF THE ISLAMIC FINANCE INDUSTRY

Each region is contributing in a unique way

…with worldwide momentum from retail to

regulator involvement

Examples

Malaysia’s Islamic Banking Act 1983 and the Banking &

Financial Institutions Act 1989 are enacted as

separate statutes

Kuwait adopted a new regulatory framework for

Islamic finance in 2003, by introducing a new section into the Central Bank Law

of 1968

Iran

Governmentdriven

Marketdriven

Saudi Arabia

Malaysia

United Arab Emirates

BahrainKuwait

Indonesia

Brunei

USA

PakistanSudan

Qatar

Singapore

Bangladesh

Oman

TurkeyEgypt

Sri Lanka

South Korea

China

HIGH

LOW Japan

Hong Kong

Asia-Pacific Middle East Others

UK

HIGHLOW

Note: Circle sizes denote estimated size of the Islamic financial market in these respective countriesSource: HSBC Amanah, Illustrative Comparison Model for the development of Islamic Markets and Regulations

5

OVERVIEW OF ISLAMIC FINANCE

Islamic Finance In The Last 30 Years

Islamic finance has followed in the wake of innovations in the global financial services industry

A natural progression of the Islamic finance industry:

– competitive retail offerings

– sophisticated corporate banking products

– innovative project finance solutions

1970s

commercial banking

1980s

commercial banking

project finance & syndications

1990s

commercial banking

project finance & syndications

equity Ijarah

2000s

commercial banking

project finance & syndications

equity Ijarah sukuk al ijarah structured

alternative assets

2005+

commercial banking

project finance & syndications

equity Ijarah sukuk al ijarah structured

alternative assets liquidity

management tools

6

9458 1007311661

14761675

2027

0

2500

5000

7500

10000

12500

15000

2007 2008 2012

Conventional (UK) Conventional (non UK) Islamic

267366

605

500

1500

262

235.0

67.076.0

0

200

400

600

800

1000

1200

1400

1600

2007 2008 2012E

Islamic Assets GCC Iran Malaysia Others

Of the total 1.6 billion Muslims globally, there are approximately 640 million in tier 1 & 2 markets.

Today, there are more than 390 Islamic banks and institutions spread across 75 countries.

Total Global Islamic banking assets growth (USD bn)

CAGR 28%

CAGR 20%2

640

Banking Assets in key markets (USD bn)

37%

7%

Sources: The Banker, Oliver Wyman1 2007 – 2008 asset figures are based from The Banker 2 Oliver Wyman growth estimates

2

ECONOMIC GROWTH IN SOME GEOGRAPHIES

Prioritization CountryTotal

Population (m)

(% Muslim)

GDP (% real change per

annum)

2008 2009f 2010f 2011f 2012f

(Tier 1)Saudi Arabia 24 (99%) 4.3 -0.1 3.9 5.9 5.2

UAE 5.2 (76%) 7.0 -1.2 4.3 6.4 6.1Malaysia 26 (60%) 4.6 -3.8 6.3 6 6.0

Tier 2

Qatar 1.2 (77%) 15.2 9.8 8.82 9.4 7.5Bahrain 1.0 (98%) 8.1 5.6 6.02 5.4 5.0Pakistan 176 (97%) 0.6 2.4 2.9 4 4.0

Indonesia* 240 (88%) 6.1 3.8 5.3 6.2 6.1Brunei 0.4 (64%) 0.61 na na Na Na

UK 61 (3%) 0.7 -3.8 1.6 1.8 2Bangladesh 29 (88%) 6.22 6.02 6.22 6.5 6.4

Egypt 75 (85%) 7.2 4.3 4.1 6.4 7

Tier 3

Turkey 77 (97%) 1.1 -4.4 2.0 3.5 6China 1300 (2%) 9 8.5 9 8.5 8.5India 1100 (13%) 7.5 6 7.5 7.2 7.2Iraq 29 (97%) na na na na na

Source: HSBC Group economic forecast.

INDUSTRY COMMENTATORS SEE ISLAMIC FINANCE INDUSTRY CONTINUING ITS RAPID GROWTH

Note: Key markets include Tier 1 and 2 markets Source: The Banker, Central Bank Reports

13%

4%

1

13%5%

7

35

57

0

10

20

30

40

50

60

70

2008 2012E

3364 3768

6000

0

1000

2000

3000

4000

5000

6000

7000

8000

9000

10000

2007 2008E 2012E

420562

1000

0

100

200

300

400

500

600

700

800

900

1000

2007 2008E 2012E

175 213

470

0

100

200

300

400

500

600

700

800

900

1000

2007 2008E 2012E

CAGR 22%

Islamic Retail Banking Assets (USD bn)

Islamic Wholesale Banking Assets (USD bn)

CAGR 19%

Source: Oliver WymanNote: Wholesale includes corporates, wealth funds and private clients.

CAGR 12%

Global Islamic Mutual Fund Assets (US bn)Islamic Gross Takaful Contributions (USD m)

CAGR 12%

RISING ISLAMIC PENETRATION WITH GROWTH ACROSS DIFFERENT INDUSTRY SECTORS

Source: Oliver Wyman

Source: Ernst & Young Source: Cerulli Associates Report

Penetration rates 2007 - 2008 2008 - 2012

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

0 20 40 60 80 100 120 140 160 180 200

Islamic Banking Assets (US bn)

Isla

mic

Ba

nkin

g P

en

etr

ati

on

UAEBahrain

Malaysia

Kuwait

Qatar

Indonesia

Pakistan

Egypt

Brunei

Bangladesh

Saudi Arabia

Sources: Oliver Wyman, Morgan Stanley, McKinsey, Zawya, Central Bank Reports

Being validated bottom up with Countries

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ISLAMIC FINANCE – SUCCESS RECIPE

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ISLAMIC FINANCE PROPOSITION – Success Recipe

Success Recipe

Majority or good percentage of population are Muslim

Market have strong demand for Shariah proposition but no issue to consider conventional

Government resolute in pursuing Islamic finance agenda and introduce conducive regulatory framework eg. Tax, legal etc.

Central Bank able to regulate Islamic financial institutions

Decide and provide guidelines on Shariah issues

Treatment of balance sheet - segregating or co-mingling

Provide framework to support and regulate the institutions

One stop centre to resolve issues by industry players

Sufficient talent to manage the business both the Shariah scholars and practitioners

10

MODELS FOR ESTABLISHING ISLAMIC FINANCE

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VARIOUS MODELS FOR CONSIDERATION

Comprehensive infrastructure to support the

business

License only to do Islamic finance

business

Stand Alone Islamic Finance

Islamic Subsidiary

Leverage infrastructure from the parent

infrastructure

Separate Board of Directors

Subsidiary of the existing conventional in

the country

Supervise the operations to

ensure Shariah compliance

Using the main Bank

infrastructure to support the

business

Structure Islamic

products for distribution by conventional

branches

A division within the existing

conventional bankIslamic window

12

ISLAMIC WINDOW OPERATIONS

13

ISLAMIC ‘WINDOWS’ OPERATIONS

Windows Operations

A division within the conventional bank

Preferably to be headed by a Muslim

Need to set up Shariah Committee and Shariah department to ensure business undertaken is Shariah compliance

Minimum to have own product development team and dedicated IT team

Sharing the same system platform – tweak to meet with Shariah

Accounting treatment eg. penalty fee not compounded

Wordings on the statement and advises must be Shariah compliance

Leverage from existing infrastructure thus cost to do the business is lower

Preferable for the balance sheet to be separated

14

ISLAMIC ‘WINDOWS’ OPERATIONS

Windows Operations

ADVANTAGES

• Sharing the same infrastructure

• Sharing the same system platform – tweak to meet with Shariah

• Cost to do the business is lower

• Inclusive proposition

DISADVANTAGES

• Always guided by the conventional banking way

• Business requirements may conflict with Shariah

• CHALLENGES

•Awareness on Islamic finance amongst the internal customers is low

•Shariah compliance to be the main driver for the business

•Potential canabalising the conventional business

15

CHALLENGES IN ISLAMIC FINANCE

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CHALLENGES IN ISLAMIC FINANCE

Challenges

Strategy and Plan to develop the right

business model

Willingness to invest in Human

Capital Development

Information system to cater to Islamic

Finance transactions

Replication v. Authenticity

Comprehensive Shariah Governance

& Audit *

Meeting evolving consumers’ demand

Risk Management*

Legal, Regulatory & Accounting

Framework*

Wealth Management

17

SHARIAH GOVERNANCE AND FRAMEWORK

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Islamic Financial Services Board (IFSB) Guiding Principles of Risk Islamic Financial Services Board (IFSB) Guiding Principles of Risk

Management indicates:Management indicates:

Shariah Compliance is categorised as higher priority in relation to Shariah Compliance is categorised as higher priority in relation to

identified risks and;identified risks and;

There must be a comprehensive and sound Shariah Compliance There must be a comprehensive and sound Shariah Compliance

framework and mechanism in place.framework and mechanism in place.

SHARIAH COMPLIANCE IS FUNDAMENTAL IN ISLAMIC BANKING AND FINANCIAL INSTITUTIONS

IFSB

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The business of the Company will be transacted in ACCORDANCE with the :

MEMORANDUM & ARTICLES OF ASSOCIATION OF MOST ISLAMIC FINANCE INSTITUTIONS PROVIDE:

Islamic Principles Rules Practices

In this respect, the Company is PROHIBITED from carrying out any transactions which involve any elements that are not in compliance with the Islamic principles, rules and practices.

Compliance

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SHARIAH STRUCTURE

Shariah Committee

Shariah Dept

Internal Policies,

Procedures,

Guidelines, Manuals,

Matrix & Certificates

Shariah Structure

Term Of Reference of Shariah Committee

Rulings of Shariah Committee

Shariah Advisory & Development Shariah Compliance & Review Shariah Research

Shariah Compliance Manual Guidelines on the Shariah Committee Shariah Compliance Certificate Guidelines on Services & Transactions

21

LEGAL, REGULATORY & ACCOUNTING FRAMEWORK

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LEGAL, REGULATORY & ACCOUNTING FRAMEWORK

Legal

Need a Robust Structure

Regulatory

Flexible yet decisive

Accounting

AAOFI vs IFRS

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LEGAL FRAMEWORK – Need a robust structure

Ensure compliant with Shariah but yet enforceable under applicable secular law

Current transactional practise with respect to existing legal opinion

- Different islamic jurisprudence interpret Shariah differently

- Lack of binding precedents and published decision

- Is Shariah compliance considered in judgement eg Zulkifli vs Affin Bank (Malaysia),

Investment Dar vs Lebanon Blom Bank

Untested certainty/predictability for Shariah compliant transactions in different jurisdiction

Willing to change to accommodate Shariah requirements eg. legal ownership over home financing if structure based on Ijarah or Musyarakah

Legal

24

REGULATORY FRAMEWORK – Flexible yet decisive

Willing to change the act to accommodate Islamic Finance

- Land Code

- Tax issue eg. VAT, property gain tax

Propose to adopt tax neutralityRegulatory

25

ACCOUNTING FRAMEWORK (AAOIFI vs IFRS)

Accounting 1

AAOIFI

Develop the accounting, auditing and banking practices through relating to the activities of the Islamic Financial Institutions (IFIs)

Prepare, promulgate and interpret accounting and auditing standards for IFIs in order to harmonize the accounting practices and auditing procedures

Review and amend the accounting and auditing standard for IFIs to cope with developments in the accounting and auditing through practices

26

ACCOUNTING FRAMEWORK (AAOIFI vs IFRS)

Accounting 2

IASC Foundation and IASB

To develop a single set of high quality, understandable, enforceable and globally accepted international financial reporting standards (IFRS) through its standard-setting body of IASB

To promote the use and rigorous application of those standards

To bring about the convergence of national accounting standards and IFRS to high quality solutions

Main Differences AAOIFI and IFRS

AAOIFI

Specific for Islamic industry

Accounting, Auditing, Ethics, Governance & Sharia

IFRS

Entire economic & social activities

Specific to accounting

27

ACCOUNTING FRAMEWORK (AAOIFI vs IFRS)

Accounting 3

Consideration

Standalone and fully Islamic Group – AAOIFI

Subsidiary with conventional parent – IFRS

Window – IFRS

Rationale for window to adopt IFRS

Consolidation

Accounting treatment eg. Unrestricted investment as a separate item instead of presented as liabilities (along with other liabilities) in IFRS

28

RISK IN ISLAMIC FINANCE

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Credit Risk Market Risk Insurance Risk Sustainability Risk Liquidity Risk Pension Fund Risk Residual Value Risk Reputation Risk Operational Risk

RISK MANAGEMENT IS

Accounting

Business Continuity

Fiduciary

Fraud

Information

Legal

Compliance

Operations

People

Tax

Technology

Shariah Risk ManagementEmbedded within the conventional

business risk management framework

Non-compliance with Shariah rules and regulations

New product due diligence including simplification of product complexities

Application of Late Payment / Penalty for default in a Shariah compliance manner

Advise on debt restructuring

Changes in fatwa resulting in existing product being non-compliance

Advising / guiding with ongoing Shariah requirements

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MAJOR SHARIAH RISKS Concentrated reliance on a single

broker for transacting commodity murabaha (substantial Global Business is based on this structure)

Untested legal infrastructure (case laws or court proceedings) supporting products

Major RisksCredibility of “Commodity Murabaha” / “Tawarruq” structure questionable

Manual Processes increase operational risks

Lack of inter-bank market creates challenges in matching assets and liabilities

Identification of new brokers required and find alternative to existing commodity (eg. Bursa Al Sila’)

Using experienced legal counsel for preparing documentation and structures

Looking to diversify to other structures.

To address concerns raised.

Rationalisation of product range. Long term, automation and standardisation required

This has to be addressed and financial linkages required

RISKS ACTIONS

Thank You