Slides-Demystifying Islamic Finance Files/Business Mixe… · Credit was advanced to other poorer...

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OUTLINES

Part I Historical development

Part II Differences between Conventional & Islamic Banking

Part III Islamic Banking Terms

Part IV Islamic Finance Global Review

Part V International Institutions

Part VI Immediate Issues and Challenges

Conclusions

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PART I –Historical DevelopmentIn the modern era:

The first attempt to establish an Islamic bank was in the 1950’s – in the rural area of Pakistan

� Pious landowners deposit their funds without interest rewards

� Credit was advanced to other poorer landowners for agricultural improvements

� Although there was no shortage of borrowers, for the depositors, it was a once and for all effort

� Depositors took considerable interest on how the money was loaned out

Mit Ghamr Islamic Savings Bank started in Egypt by El-Naggar

� Based on German savings bank model

� Purpose is to mobilize the idle savings of the majority of Muslim within the Shariah and to provide halal returns on their saving as well.

� An experiment that was short lived (July 1963 – February 1967)

The Malaysian Pilgrimage Fund (Tabung Haji) was established in 1963

The Islamic Development Bank was established in 1974

Dubai Islamic Bank was established in 1975

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PART I –Historical Development (2)

In the modern era:

Kuwait Finance House was established in 1977 while Jordan Islamic Bank was established in 1978. Bank Islam Malaysia Berhad and Islamic Bank of Bangladesh were established in 1983.

Standard-setting organizations: the Bahrain-based Accounting & Auditing Organization for Islamic Financial Institutions (AAOIFI) was established in 1991 while the Kuala Lumpur-based Islamic Financial Services Board (IFSB) was established in 2002.

Impact of 9/11 – Reverse Capital Flight

� Perception of hostile climate in many Western jurisdictions, in particular, the United States, led to repatriation of dollars by Arab investors to Middle Eastern banks

� Islamic banks, along with conventional banks in the region, benefited from this reverse flight of capital

� Increase in Oil Prices Led to Dramatic Increase in Liquidity in the Gulf

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Since the late 1980s and early 1990s:

Conventional Banks Open “Islamic Windows”

� Conventional banks began to respond to requests from Muslim clients to offer products that complied with Islamic law

� As the size of the potential market became clear, conventional banks responded with the creation of divisions dedicated to Islamic banking

� Amongst conventional banks with “Islamic windows” are HSBC, Citigroup, Deutsche Bank, UBS, ABN AMRO and Standard Chartered Bank

Sukuk (Islamic Trust Certificates) market boom and bust

� Sukuk, intended to serve similar functions to a fixed income instrument/bond, was first issued internationally in 2001 (by Guthrie Group).

� Sovereigns that have issued international Sukuk includes Bahrain, Brunei, Indonesia, Malaysia, Pakistan and Qatar.

� By 2007 the Sukuk market has reached US$100 b. However, concerns over the impact of the global financial crisis on the GCC, marked by defaults of several Sukuk issuers, slowed down the growth of the Sukuk market.

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About 30 countries like Iran, Kuwait, Malaysia, Sudan, Turkey, UAE and Yemen have enacted specific laws and regulations for the establishment of IBF Institutions.

In most other countries, IBF Institutions are established by the same laws of conventional banks .

� The scenario above have resulted in lack of level playing field for IBF Institutions and the industry as a whole.

� Furthermore, since the distinctive characteristics of Sharī’ah-compliant financial transactions raise a number of issues related to the risks borne by the IBF Institutions, failure to adequately recognise and supervise these risks, could impose systemic risk to the entire financial system and jeopardise the stability and soundness of the industry.

� Hence, the need to develop uniform prudential and best practices standards that are tailored to the specific characteristics of these institutions is vital.

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PART II –Differences between Conventional & Islamic Banking

INTEREST

Conventional Banking: Essential

In Islam:-

“Those who devour usury will not stand except as strands one whom the Evil One by his touch hath driven to madness. That is because they say: “Trade is like usury,” but Allah hath permitted trade and forbidden usury…” (II 275, part)

“Allah will deprive usury of all blessing…” (II 276, part)

Interest is prohibited, so basis of banking must be different.

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PART II –Differences between Conventional & Islamic Banking (2)

Conventional Banking – Lending of money on interest

Interest is prohibited in Islam, so on what basis is Islamic banking done?

Based on trade – for trade there must be goods or assets. Thus in every Islamic banking there is asset-backed or economic activity-based financing.

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PART II –Differences between Conventional & Islamic Banking (3)

THE UNDERLYING TRANSACTION

So Islamic banking is not conventional banking with a change of name or conventional banking in green garb.

Islamic banking documents cannot be produced from conventional loan documents – by changing interest to profit; there are no Islamic loans (except Qard al-hasan, which is interest-free)

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PART III –Islamic Financial Products

Some Islamic banking terms:-

Hibah Gift

Wadia Deposits

Wakalah Agency

Rahnu Pledges

Hawala Transfer of Debt

Wadiah Deposits (Guaranteed Custody)

Ujr Fee for services rendered

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PART III –Bai Bithamin Ajil (Term financing)

Customer’s intention:-

Wishes to acquire asset but does not have funds to pay immediately

Mechanics:-

Bank purchases asset at purchase price (Purchase Price = Facility Amount)

Bank sells assets to customer (Selling Price = purchase price + profit)

Selling price is normally paid by the instalments

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PART III –Murabahah (Cost-plus / mark-up sale)


Needs working capital e.g. to buy goods for trade but has no funds for purchase

Mechanics:-

Customer identifies goods to purchase

Bank purchases or appoints Customer as agent to purchase goods

Bank pays purchase price to seller

Bank sells goods to customer at agreed price = cost price + Bank’s profit, which amount the customer will pay at an agreed date

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PART III -Mudharabah (Partnership financing)


Customer has a project but does not have capital to carry it out. Needs capital

Mechanics:-

Bank (Rab-al Mal) provides capital to Customer (Mudharib)

Project is undertaken by Customer and Bank merely supervises

Customer agrees to repay from income of project

Both parties to agree on ratio for distribution of profit

Any loss is borne entirely by Bank

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PART III -Musharakah (Joint venture profit sharing)

Another type of project financing

Mechanics:-

Both Customer and Bank will provide capital for project in agreed proportions

Will share profit in agreed proportions (need not be the same as capital ratio)

Both may manage project but may also waive right of participation

Customer will return capital at an agreed date

If there is a loss, both parties will share the loss based on capital contribution ratio

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PART III –Ijara (Leasing)


Needs to lease equipment or machinery

Mechanics:-

Bank buys equipment and leases the usufruct (equitable interest) to Customer for rental free

Duration of lease and rentals are agreed in advance

Ownership of equipment remains with the Bank

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PART III –Bai al-Dayn (Sale of debt)

A contract by which owner of a debt sells to another at an agreed price

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PART IV –Islamic Finance Global Overview

Broad Categorization of Legal Systems in which IBF Institutions operate

• those claiming fully Sharīah-based legal systems such as Iran, Saudi Arabia and Sudan;

• those with partially Sharīah-based legal systems such as Malaysia, Indonesia, Bahrain and the United Arab Emirates (UAE); and

• those with fully secular-based legal systems such as the United Kingdom (UK), the United States of America (USA) and Singapore.

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PART IV –Islamic Finance Global Overview (2)

A survey exercise in 2007 produces a list of law and regulations applied for IBF Institutions in over 30 jurisdictions

Leading jurisdictions such as Bahrain, Kuwait, Malaysia and the UAE have issued separate laws for IFSI. Few others, like Bangladesh and Jordan embed sections on Islamic finance in the existing banking laws.

Fully Shariah-based jurisdictions like Iran, Pakistan, Saudi Arabia, and Sudansometimes experience uneasy interactions between the legal system and prevailing banking practices.

Fully secular-based jurisdictions like Singapore, the UK and USA retains same banking law but have initiated friendly tax treatment for IBF Institutions.

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PART IV –Islamic Finance Global Overview (3)

A survey exercise in 2007 produces a list of law and regulations applied for IBF Institutions in over 30 jurisdictions

Jurisdictions with Muslim minorities such as Thailand, Sri Lanka and Philippineshave enacted laws dedicated for IBF Institutions

Despite being lesser known, jurisdictions such as Brunei, Gambia, Djibouti, Kazakhstan, Kyrgyz, Lebanon, Syria, Turkey and Yemen have also enacted special laws for IBF.

International Financial Centres like Brunei, Dubai, Labuan and Qatar also develop their framework for IBF to become a competitive hub for the global IBF industry.

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AAOIFI – Comparable to the IASB

� Established on 27 March 1991 by several Islamic Banks.

� Is an industry initiative backed by the IDB with mandates to prepare accounting, auditing, governance, ethics and Sharī’ah standards for IBF Institutions and the industry.

� Its standards have been adopted by authorities in Bahrain, Jordan, Lebanon, Sudan, Syria, Dubai IFC and Qatar IFC.

PART V –International Institutions

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AAOIFI – Comparable to the IASB

Standards and Guidelines issued by the AAOIFI:

� 25 Accounting Standards

� 5 Auditing Standards

� 7 Governance Standards

� 2 codes of ethics

� 41 Sharī’ah standards

PART V –International Institutions (2)

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IFSB – Comparable to the Basel Committee, IOSCO and IAIS

� Established on 3 November 2002 by 9 founding members.

� Is an umbrella body in the Islamic financial services industry with the broadest stakeholders representations (195 members, including 53 supervisory and regulatory authorities from the banking, capital markets and Islamic insurance (Takāful) sectors in 41 jurisdiction, as well as 6 international inter-governmental organisations, and 136 market players (financial institutions, professional firms and industry associations).

� Malaysia, the host country of the IFSB, has enacted a law known as the Islamic Financial Services Board Act 2002, which gives the IFSB the immunities and privileges that are usually granted to international organizations and diplomatic missions.


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IFSB Prudential Standards


IFSB

Banking TakafulCapital Markets

Risk Management

Capital Adequacy

Corporate Governance

Transparency &

Market Discipline

Supervisory Review Process

Technical Note Islamic

Money Markets

Recognition of Rating by ECAI

Special Issues in Capital

Adequacy

Governance of Islamic Collective Investment Schemes

Governance of Takaful

Operations

Shariah Governance

Market Conduct

Issues in Regulation of Takaful

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International Islamic Financial Markets (IIFM) – Com parable to the ISDA

� Established on 1 April 2002 by 7 founding members.

� Focuses on standardization of Islamic financial products, documentation and related processes in the Islamic capital market and money market segments of the industry.

� Have cooperated with ISDA in producing the Islamic Master Ta’HawwutAgreement for Islamic derivatives


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International Islamic Liquidity Management Corporat ion (IILM) – An Innovation

� Established on 25 October 2010 by 13 founding members in recognition of the acute lack of liquidity management infrastructure for IBF Institutions.

� Mandated to issue high quality Sharī`ah-compliant financial instruments at both the national level and across borders, in an integrated manner, thereby enhancing the soundness and stability of the jurisdictions in which they operate.


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Pakistan

Hong Kong

� Aims to become Islamic finance gateway to China

� Plans to issue sovereign sukuk

� Hang Seng Islamic China Index Fund in 2007

UK

� Gov’t sets an objective to ‘entrench London as a global gateway for Islamic finance

� 5 Full-fledged Islamic banks,17 windows and 1 takaful operator

� Plans to issue sovereign sukuk, amend tax law on IF

UAE

Japan

• Law passed allowing banks to do Islamic financeFrance

� Passed rules/regulations to support Islamic finance activities

� In process of licensing Islamic banks

� Made fiscal & legal adjustment for IF transaction i.e. taxation guidelines on sukuk & murabaha

Singapore

� Established first Islamic bank

� Introduced tax neutrality for Islamic finance

� Launched Islamic ETF, REIT, Sukuk

South Korea

• Parliament expected to pass the law related to offering of tax waiver on foreign investors’interest income from sukuk issued

Thailand

Qatar

Sudan

Indonesia

Kuwait

Germany

� Saxony-Anhalt state issued government sukuk

� First Islamic bank to operate in 2010

GLOBAL REACH OF IBF

Saudi Arabia

Bahrain

Malta

� Plans to position as Islamic finance hub for the Mediterranean

Kenya

� Adjustments recently made to banking sector to facilitate Shariah compliant operations

Turkey� Announced IFC Istanbul in Sep

’09 with focus includes interest-free financial business

Muslim-majority countries tapping Islamic finance

Non-muslim countries announcing plans to develop Islamic finance

Australia

�KFH has established a branch

�Victoria state allows IBF

Total banking assets end 2009: US$950 billionPotential total banking assets: US$5 trillion (Moody’s report)

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PART VI -Immediate Issues and Challenges

a) Lack of Prudential Database

• Compared to its conventional counterpart, IBF industry lags behind in many infrastructural aspects

• For example, comprehensive financial disclosure is more the exception then the rule and most stakeholders of IBF industry

• The public generally have limited knowledge on IBF

• Accounting practices, legal requirements and regulatory procedures still vary considerably between different jurisdictions

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PART VI -Immediate Issues and Challenges (2)

b) The cost of Haphazard Policy Decisions and Lack of Level Playing-Field

• In some countries, the supervisors have developed specific guidelines for IBF industry

• Other countries, they have opted generally to apply these institutions the same prudential policies as those they employ in supervisingconventional banks

• Such differences raises concerns that compliance with multiple supervisory and regulatory regimes would impose additional costs on IBF industry

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PART VI –Remarks

Areas that warrants greater policy attention:

Strengthening the infrastructural building blocks of the IBF industry to further enhance the industry’s resilience

Accelerating the effective implementation of Sharī’ah and prudential standards and rules to facilitate the creation of a more stable, efficient and internationally integrated IBF industry

Creating a common platform for the regulators of the IBF industry to enhance constructive dialogue

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PART VI –Remarks (2)

Whether a state’s legal system is fully Islamized or not has little bearing on the extent to which it is able to establish a satisfactory legal framework for IBF. Countries with no experience implementing Islamic law could achieve the desired results by adopting concrete measures, and those with Islamic law forming a significant component of its laws might still face with legal obstacles and anomalies in relation to IBF.

A conducive environment that facilitates a more harmonious interface between Sharī’ah principles and the national legal framework, ensures transparency and minimizes commercial risk and uncertainty. It is certainly those factors which have spurred leading jurisdictions such as Bahrain and Malaysia.

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PART VI –Remarks (3)

Countries interested in introducing IBF in their jurisdictions now have ample precedents to assist them in structuring an enabling and supportive legal and Sharī’ah compliance framework for the industry. Most measures, especially for non-banking financial activities, require only small modifications and can be accommodated with reasonable ease in existing national legal frameworks.

Greater cohesion and collaboration between Sharī’ah scholars and IBF professionals to increase competence.

More IBF Institutions have now gone global – raising enough incentive for the stakeholders to be spurred further in promoting the ethical spirit of IBF.

Contact Details

Dr Nik Norzrul ThaniChairman / Senior Partner

Tel : + 603 2087 9887Fax : + 603 2094 4888Email : [email protected]

Zaid Ibrahim & Coa member of ZICOlawLevel 19 Menara MileniumPusat Bandar Damansara 50490 Kuala LumpurMalaysia

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