Introduction to Islamic Finance & Banking World Bank BRSA - TKBB Joint Workshop on Innovative Product Development in Islamic Banks Istanbul, Turkey March 2, 2017 Zamir Iqbal, PhD. Lead Financial Sector Specialist The World Bank Global Islamic Finance Development Center Istanbul, Turkey ziqbal@worldbank.org
Globalization of Islamic Finance Source: IFSB Financial Stability Report 2015, KFHR, IMF Islamic Finance makes into G-20 agenda 2015- The G20 group of major nations has included discussion of Sukuk (Islamic bonds) as an infrastructure financing tool in its annual agenda, a move that could potentially spur the use of projectbased Sukuk. In addition, Islamic Finance is subject of study under G20 themes of long-term investments and Financial inclusion.
Brief Modern History of Islamic Finance Interest in reviving a banking and financial system started in early 1900s. 1950s Appearance of early writings about problems of conventional economic systems and how Islam s principles of economics offer an alternative. 1960s End of colonialism and independence of countries 1970s Oil revenues (Perto-$) create demand for banking without interest. 1 st Islamic bank in Dubai is established. 1980s Growth of commercial banking 1990s Emergence of Islamic funds and investment banking 2000s Capital markets and Globalization 3
.there is increasing interest in Islamic finance from non-muslim countries Recent transactions include sovereign issuance by United Kingdom (UK), South Africa, Hong Kong, and Luxemburg. UK 2010 The Financial Services and Markets Act 2000 Order 2010 was introduced by Treasury to support Islamic finance and the issuance of corporate sukuk within the UK 2012 - The UK Government launched an Islamic Finance Task Force with the aim of securing London s status as the Western hub for Islamic finance 2013 - London hosted the World Islamic Economic Forum during which the UK Prime Minister announced plans to issue a Sukuk in 2014 and to turn London into a global center of Islamic finance. France 2009 - The amendment of Article 2011 of the French Civil Code relating to the formation of trusts was interpreted as an important step towards permitting the issuance of sukuk out of France 2010 - Revision of specific tax regulations covering Sukuk, ijarah, istisna and murabaha with a view to removing discrepancies Source: KFH Research Luxembourg 2010 - The Luxembourg Tax Authority published a circular to clarify the tax treatment of murabahah and sukuk transactions, to ensure that they benefit from the same tax treatment as conventional products 2011 - Luxembourg s CSSF published a note that clarified that no specific legislation was required for Shariah compliant investment funds, since Luxembourg s current law contains no obstacles to it. Germany 2012 - German banking regulator hosted an Islamic finance conference in Frankfurt during which the tax treatment of different Islamic finance products was discussed. Hong Kong 2014- Hong Kong has raised $1bn in its debut Islamic bond issue. South Africa 2014- $500m sale was more than four times subscribed, with an order book of $2.2bn according to the SA Treasury Russia 2016- Opened first Islamic Bank, The Partnership Banking Center in March 2016.
Roadmap I. MARKET TRENDS II. III. IV. HOW ISLAMİC BANKİNG WORKS? REGULATORY AND SUPERVİSORY ENVİRONMENT STATE OF DEVELOPMENT OF ISLAMİC FİNANCE
I. Market Trends 6
Islamic Financial Assets Source: ICD-Thomson Reuters Islamic Finance Development Report 2016
Market Size Islamic Banking Islamic Banking Share in Total Banking Assets by Jurisdiction (1H2015) Source: Financial Stability Report 2016, IFSB
Islamic Financial Assets Have Been Growing Rapidly Global Islamic Finance Assets by Sector Growth (2012 2021, US$ BN) Source: ICD-Thomson Reuters Islamic Finance Development Report 2016
Composition and Domicile of Islamic Assets Breakdown of Islamic Finance Segments by Region (USD billion, 2015 YTD) Source: Financial Stability Report 2016, IFSB 10
Growth of Banking Assets Source: World Islamic Banking Competitiveness Report 2016, Ernst&Young
II. How Islamic Banking Works? 12
Theoretical foundations of Islamic Financial System Risk Sharing Reduction of Information Asymmetry (Gharar) * Prohibits contracts with high uncertainty (Speculation/Gambling) * Requires Full Disclosure before, during and after the contract Prohibition of Interest (Riba) Eliminates Debt contracts and Leverage Materiality Economic and Social Justice Wealth, Ownership and Property Rights Preservation of Property Rights, Protection of Property Rights of Stakeholders, Significance of Rights of the Society The role of Wealth, Money, and Capital, Sanctity of Contracts
How a banking system is designed without Interest? Prohibition of interest discourages debt and leverage Risk sharing Because interest is prohibited, pure debt security is eliminated from the system and therefore suppliers of funds become investors, rather than creditors. The provider of financial capital and the entrepreneur share business risks in return for shares of the profits and losses. Close linkage with the Real Sector of the economy Promotes Asset-backed Finance The system introduces a materiality aspect that links financing directly with the underlying asset so that the financing activity is linked to the real sector activity. There is strong linkage between the performance of the asset and the return on the capital used to finance it. Similarities with ethical and Socially Responsible Investments (SRIs). 14
Commonality: Ethical Investing Substantively: Islamic finance is ethical finance and investing. Consider: Lutheran funds, Roman Catholic funds, green funds, university investment programs (WARF-UW; UC-Berkley). No investments in: Production or distribution of alcohol for human consumption Production of tobacco for human consumption Gambling Prostitution and pornography Defense and weapons Pornography Add constraint on interest-based debt => Islamic investment
Components of Islamic Financial System Islamic Financial System Banking Capital Markets Money Markets Non-banking Financial Institutions Commercial Banking Sukuk market Takaful (Insurance) Investment Banking Stock Market Micro-financial institutions Mutual Funds Leasing Companies Project Finance Private Equity 16
Key Contracts building blocks Contract Function Description Amana Custody Trust. Placing something valuable in trust with someone for custody or safekeeping. Bay al-istisna Order to build Sale in order to manufacture or construct. Bay-mua jjal Deferred Payment Sale contract where the price of the product or underlying asset is agreed but the payment in lump sum or installments is deferred to a specified future date. Bay al-salam Forward Contract Sale by immediate payment against future delivery. Similar to conventional forward contract but requires full payment at the time of contract. Ijarah Leasing A sale contract that is not the sale of a tangible asset but rather a sale of the usufruct (the right to use the object) for a specified period of time. An economic agent with capital (rabbul-mal) can develop a partnership with another agent Mudarabah Trustee finance (mudarib) with skills to form a partnership with the agreement to share the profits. Although contract losses are borne by the capital owner only, the mudarib may however be liable for a loss in case of misconduct or negligence on his part. Murabahah A cost-plus-sale contract A cost-plus-sale contract where a financier purchases a product, that is, a commodity, raw material or supplied, for an entrepreneur who does not have its own capital to do so. The financier and the entrepreneur agree on a profit margin, often referred to as a mark-up which is added to the cost of the product. The payment is delayed for a specified period of time. Musharakah Equity Equity partnership. It is a hybrid of Shiraka (partnership) and Mudarabah combining the act partnership. of investment and management. Qard-al-hassan Benevolent Loan Charitable loans with no interest and low expectations of return of principal. Sukuk Islamic Bond Plural of the Arabic word Sakk meaning certificate, reflects participation rights in the underlying assets. Takaful Insurance Insurance contract through mutual or joint guarantee. Wikala Agency Representation. Entrusting a person or legal entity (Wakil) to act on one s behalf or as one s representative. 17
Islamic Financial Intermediation (Banking) Assets Trade Financing, Leases, Mudarabah financing Partnerships (mudarabah and musharakah) Securities Investments Fees Liabilities Demand Deposits Investments by Depositors Capital Key Highlights Depositors are investors rather than lenders Risk Sharing through Profit and loss sharing. Assets and Liabilities are matched. Ethical and socially responsible assets
A Stylized Balance Sheet of an Islamic Bank Assets Trade Financing (Salaam, Morabahah) Liabilities Demand Deposits (Amanah/ Waad) Leasing / Rentals (Ijarah / Istisna) Investment Accounts Profit/Loss Sharing (Mudarabah) Investments ( Mudarabah) Special Investment Accounts Equity Investments (Mudarabah) ( Musharakah) Fee for Services Capital Equity Reserves
III. Regulatory and Supervisory Environment 20
Key Stakeholders Islamic Development Bank Group (IDB, ICD, IRTI, ICIEC, ITFC) Islamic Financial Services Board (IFSB) Accounting and Auditing Organization of Islamic Financial Institutions (AAOIFI) Multilaterals (The World Bank Group, IMF, Asian Development Bank) International Islamic Financial Markets (IIFM) International Islamic Rating Agency (IIRA) International Center for Education in Islamic Finance (INCEIF) 21
Islamic Financial Services Board (IFSB) IFSB is an international standard-setting organization with a membership of 185 participants, whose work complements the work of the Basel Committee on Banking Supervision, International Organization of Securities Commissions and the International Association of Insurance Supervisors. As of early 2014, the IFSB has issued 17 Standards, 5 Guidance Notes and 1 Technical Note for the Islamic financial services industry. Approved Standards 1. Risk Management 2. Capital Adequacy 3. Corporate Governance 4. Transparency and Market Discipline 5. Supervisory Review Process 6. Governance for Collective Investment Schemes 7. Special Issues in Capital Adequacy 8. Guiding Principles on Governance for Islamic Insurance (Takaful) Operations 9. Conduct of Business for Institutions offering Islamic Financial Services 10. Guiding Principles on Shariʿah Governance System 11. Standard on Solvency Requirements for Takaful Undertakings 12. Guiding Principles on Liquidity Risk Management 13. Guiding Principles on Stress Testing 14. Standard On Risk Management for Takaful Undertakings 15. Revised Capital Adequacy Standard 16. Revised Guidance on Key Elements In The Supervisory Review Process of Institutions Offering Islamic Financial Services 17. Core Principles for Islamic Finance Regulation (Banking Segment)
Islamic Financial Services Board (IFSB) Standards under Development 1. Revised Guidance on Key Elements in the Supervisory Review Process of Institutions Offering Islamic Financial Services (excluding Islamic Insurance (Takaful) Institutions and Islamic Collective Investment Schemes) Guidance Notes and Technical Note 1. Recognition of Ratings on Shariʿah-Compliant Financial Instruments 2. Guidance Note in Connection with the Risk Management and Capital Adequacy Standards: Commodity Murabahah Transactions 3. Guidance Note on the Practice of Smoothing the Profits Payout to Investment Account Holders 4. Guidance Note in Connection with the IFSB Capital Adequacy Standard: The Determination of Alpha in the Capital Adequacy Ratio 5. Guidance Note on the Recognition of Ratings by External Credit Assessment Institutions (ECAIS) on Takaful and Re-Takaful Undertakings 6. Development of Islamic Money Markets (Technical Note)
Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) The Accounting and Auditing Organization for Islamic Financial Institutions(AAOIFI) is an Islamic international autonomous non-for-profit corporate body that prepares accounting, auditing, governance, ethics and Shari'ah standards for Islamic financial institutions and the industry. Issued Standards Accounting Standards Auditing Standards Ethics Standards Governance Standards Shari ah Standards Guiding Notes Guidance Note on First time Adoption of AAOIFI Accounting Standards by an Islamic Financial Institution
Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) ACCOUNTING STANDARDS Conceptual Framework FOR Financial Reporting by Islamic Financial Institutions FAS 1- General Presentation and Disclosure in the Financial Statements of Islamic Banks and Financial Institutions FAS 2- Murabaha and Murabaha to the Purchase Orderer FAS 3- Mudaraba Financing FAS 4 - Musharaka Financing FAS 5- Disclosure of Bases For Profit Allocation Between Owners Equity and Investment Account Holders FAS 6- Equity of Investment Account Holders and their Equivalent FAS 7- Salam and Parallel Salam FAS 8- Ijarah and Ijarah Muntahia Bittamleek FAS 9- Zakah FAS 10-Istisna'a and Parallel Istisna a FAS 11- Provisions and Reserves FAS 12-General Presentation and Disclosure in the Financial Statements of Islamic Insurance Companies FAS 13- Disclosure of Bases for Determining and Allocating Surplus or Deficit in Islamic Insurance Companies FAS 14- Investment Funds FAS 15- Provisions and Reserves in Islamic Insurance Companies FAS 16- Foreign Currency Transactions and Foreign Operations FAS 17- Investments FAS 18- Islamic Financial Services offered by Conventional Financial Institutions FAS 19- Contributions in Islamic Insurance Companies FAS 20- Deferred Payment Sale FAS 21- Disclosure on Transfer of Assets FAS 22- Segment Reporting FAS 23- Consolidation FAS 24- Investments in Associates FAS 25- Investment in Sukuk, Shares and Similar Instruments FAS 26 - Investments in Real Estate AUDITING STANDARDS A S 1- Objective and Principles of Auditing A S 2- The Auditor s Report A S 3- Terms of Audit Engagement A S 4- Testing for Compliance with Shari a Rules and Principles by an External Auditor A S 5- The Auditor s Responsibility to Consider Fraud and Error in an Audit of Financial Statements GOVERNANCE STANDARDS G S 1-Sharia Supervisory Board: Appointment, Composition, Report G S 2- Shari a Review G S 3- Internal Shari a Review G S 4- Audit & Governance Committee for Islamic Financial Institutions G S 5- Independence of Shari a Supervisory Board G S 6- Statement on Governance Principles and Disclosure for Islamic Financial Institutions G S 7- Corporate Social Responsibility Conduct and Disclosure for Islamic Financial Institutions ETHICS Code of Ethics for Accountants of Islamic Financial Institutions Code of Ethics for the Employees of Islamic Financial Institutions
Laws regulating IFIs Legal Framework for Islamic Financial Institutions (IFIs) Specific Laws Some countries like Iran, Kuwait, Malaysia, Sudan, Turkey, UAE and Yemen have enacted specific laws to regulate the establishment of IFIs. Same laws of conventional banks In other countries, IFIs are established by the same laws of conventional banks. Supervision of IFIs In all the countries in which they operate, IFIs are supervised by their respective supervisory and regulatory bodies.
IV. State of Development of Islamic Finance 27
Islamic Finance Indicator Which Countries have the best developed Islamic Economy for Islamic Finance? TOP 10 İSLAMİC FİNANCE 0 20 40 60 80 100 120 140 160 180 200 Malaysia Bahrain United Arab Emirates Saudi Arabia Oman Pakistan Kuwait Qatar Indonesia Sudan Source: State of the Global Islamic Economy Report 2015/16, Thomson Reuters 176 84 78 66 51 51 43 38 35 33 * CRITERIA 1. Financial (Size of Islamic Finance Assets and Number of Islamic Finance Institutions) 2. Governance (e.g. Regulation for Islamic Finance and Disclosure Index Score) 3. Awareness (Number of Related News Articles, Islamic Finance Education Institutions, Research papers, and events) 4. Social (Value of Zakat and Charity and CSR Disclosure Index Score)
Adoption of IFSB Standards Number of Countries which adopted IFSB Standards Source: Comparative Study on the Implementation of Selected IFSB Standards, IFSB Working Paper Series, WP-04/10/2015, October 2015
Adoption of AAOIFI Standards Mandatory regulatory requirement in jurisdictions Shari ah Standards Accounting Standards As basis of of national accounting standards in jurisdictions Shari ah Standards Accounting Standards Bahrain Bahrain Indonesia Indonesia Oman Jordan Malaysia Pakistan Pakistan Sudan Syria Islamic Development Bank Oman Qatar Qatar Financial Centre Sudan Syria Islamic Development Bank In other jurisdictions including Brunei, Dubai International Financial Centre, France, Egypt, Jordan, Kuwait, Lebanon, Saudi Arabia, Qatar, Qatar Financial Centre, South Africa, United Arab Emirates and United Kingdom as well as in Africa, Central Asia and North America, AAOIFI Shari ah standards and/or AAOIFI accounting standards have been used voluntarily as basis of internal guidelines by leading Islamic financial institutions. AAOIFI auditing, governance and ethics standards are not part of mandatory regulatory requirement for Islamic finance. Instead, these standards are used voluntarily by leading Islamic financial institutions across all major Islamic finance jurisdictions. Source: AAOIFI website
Islamic Finance Sub-Indicators REGULATION SUB-INDICATORS TOP COUNTRIES Indicator Value Malaysia 100 Pakistan 100 Bahrain 100 Nigeria 100 Indonesia 100 Iran 83 Maldives 67 Unidet Arab Emirates 67 Qatar 67 Sudan 67 Brunei Darussalam 67 Kazakhstan 67 GOVERNANCE INDICATORS TOP 10 COUNTRIES 1- BAHRAIN 93 2- MALAYSIA 90 3- KUWAIT 67 4- PAKISTAN 66 5- OMAN 62 6- INDONESIA 58 7- SUDAN 54 8- UNITED ARAB EMIRATES 54 9- QATAR 52 10- MALDIVES 48 SHARIA GOVERNANCE SUB- INDICATORS TOP 10 COUNTRIES Indicator Value Bahrain 142 Malaysia 116 Kuwait 106 Bangladesh 92 Sudan 89 Oman 70 Indonesia 57 Pakistan 56 Lebonan 53 Egypt 48 Source: Islamic Finance Development Report 2015, ICD-Thomson Reuters
For your further questions please contact: Zamir Iqbal World Bank Global Islamic Finance Development Center T: +90 212 385 3443 E-mail: ziqbal@worldbank.org Thank You
Disclaimers 2012 The International Bank for Reconstruction and Development / The World Bank 1818 H Street NW Washington DC 20433/ Telephone: 202-473-1000/ Internet: www.worldbank.org E-mail: feedback@worldbank.org Allrights reserved. This work is a product of the staff of the International Bank for Reconstruction and Development/The World Bank. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of the Executive Directors of the World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of the World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. Rights and Permissions The material in this publication is copyrighted. Copying and/or transmitting portions or all of this work without permission may be a violation of applicable law. The International Bank for Reconstruction and Development / The World Bank encourages dissemination of its work and will normally grant permission to reproduce portions of the work promptly. For permission to photocopy or reprint any part of this work, please contact the World Bank Treasury.