ROLE OF MULTILATERAL INSTITUTIONS IN THE FORMATION OF ISLAMIC FINANCIAL POLICY

04 ROLE OF MULTILATERAL INSTITUTIONS IN THE FORMATION OF ISLAMIC FINANCIAL POLICY Islamic banking in its present form though can be traced back to four decades back; however, it has its values embedded in the ethics of Islamic society of 1400 years ago. Islamic finance is not just about prohibition of interest, its inherent strengths of being based on real economic activity, devoid of excessive leveraging, uncertainty, and speculation while encouraging investment disclosure and imprudent risk taking has attracted the world to this alternate financial system. Consequently, Islamic finance today exists around the globe catering not only to the financial needs of Muslims but also to non-muslim clientele. However, it was imperative to have distinct global infrastructure for Islamic financial industry to spur and sustain its growth. In this background along with growing number of institutions, many international and multinational organisations have emerged aimed at developing conducive and standardised regulatory framework for the development of Islamic finance industry. Multilateral institutions have played an important role in the development Islamic finance by building an enabling environment for Islamic finance to flourish and ensuring a level playing field with conventional finance. This chapter highlights key developmental roles of several multilateral institutions and standard-setting bodies that have established exclusively for Islamic finance industry namely Islamic Development Bank (IDB) Group, Islamic Financial Services Board (IFSB), Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), International Islamic Financial Market (IIFM) and International Islamic Liquidity Management Corporation (IILM). The role of World Bank as the most active infrastructure organisation of global regulatory environment, which has started working for Islamic finance industry, is also highlighted. Islamic Development Bank Group The Islamic Development Bank Group (IDB Group) is a South-South multilateral development finance institution established on October 20, 1975 with the objective to foster the economic development and social progress of member countries and Muslim communities individually and collectively, in accordance with the principles of Shari a (Islamic Law). To fulfil its objective IDB Group is engaged in a wide range of activities including: Project financing in the public and private sectors; PAGE 72

04 ROLE OF MULTILATERAL INSTITUTIONS IN THE FORMATION OF ISLAMIC FINANCIAL POLICY Development assistance for poverty alleviation; Technical assistance for capacity-building; Economic and trade cooperation among member countries; Trade financing; SME financing; Resource mobilization; Direct equity investment in Islamic financial institutions; Insurance and reinsurance coverage for investment and export credit; Research and training programmes in Islamic economics and banking; Awqaf investment and financing; Special assistance and scholarships for member countries and Muslim communities in non-member countries; Emergency relief; and Advisory services for public and private entities in member countries. The IDB Group is located in Jeddah, Kingdom of Saudi Arabia, with four regional offices in Morocco, Malaysia, Kazakhstan and Senegal, and 15 field representatives in selected member countries. The IDB Group comprises of five entities, namely: i. Islamic Development Bank (IDB); ii. Islamic Research and Training Institute (IRTI); iii. Islamic Corporation for the Insurance of Investment and Export Credit (ICIEC); iv. Islamic Corporation for the Development of the Private Sector (ICD); and v. International Islamic Trade Finance Corporation (ITFC). Islamic Development Bank (IDB) The vision of IDB is to become a world-class development bank, inspired by Islamic principles to transform the landscape of comprehensive human development in the Muslim world. To achieve its objective, IDB provides (i) financial resources for development activities in member countries and (ii) technical assistance for capacity building and scholarships for human capital development while it manages special funds and mobilizes resources through Shari a-compliant instruments. To become a member of IDB, a country is required to fulfil following the conditions: must become a member of the Organization of Islamic Cooperation (OIC); should pay the first instalment of its minimum subscription to the Capital Stock of IDB; and PAGE 73

ROLE OF MULTILATERAL INSTITUTIONS IN THE FORMATION OF ISLAMIC FINANCIAL POLICY 04 must accept such terms and conditions that may be decided by IDB Board of Governors. At present, membership of IDB stands at 56 countries from four continents (Africa, Asia, Europe, and South America). Islamic Research and Training Institute (IRTI) IRTI was established in 1981 as the research and training arm of IDB in helping the transformation of IDB Group into a world-class knowledge-based organisation. Towards this end, key objectives of IRTI are as follows: Undertake research, training and knowledge-creation activities on Islamic economics, banking and finance; Organize seminars and conferences on various subjects in collaboration with national, regional and international institutions; Undertake information management activities such as developing information systems for use in Islamic economics, banking and finance; and Maintaining databases on experts as well as trade information and promotion. Islamic Corporation for the Insurance of Investment and Export Credit (ICIEC) The ICIEC 1 was established in 1994 with the following objectives: Increase the scope of trade transactions from the member countries of the Organization of Islamic Cooperation (OIC); Facilitate foreign direct investments into member countries; and Provide reinsurance facilities to Export Credit Agencies (ECAs) in member countries. ICIEC fulfils these objectives by providing appropriate Shari a-compatible solutions like export credit insurance and reinsurance to cover non-payment of export receivables, investment insurance and reinsurance against country risks stemming mainly from currency inconvertibility and transfer restrictions, expropriation, war and civil disturbance, breach of contract and noncompliance with sovereign financial obligations. Moreover, ICIEC manages IDB Group Investment Promotion Technical Assistance Program (ITAP), set up in 2005 to unlock the development potential of member countries through a comprehensive and integrated program of foreign investment promotion and technical assistance. Islamic Corporation for the Development of the Private Sector (ICD) The ICD was established in 1999 to support the economic development of its member countries through financing private sector development in accordance with the principles of Shari a; and advise governments and private organisations to encourage the establishment, expansion and modernization of private enterprises. At present, its membership comprises of 52 IDB member countries from the continents of Africa, Latin America, Asia and Europe. 1. The ICIEC membership comprises of 40 IDB member countries from continents of Africa, Asia and Europe. PAGE 74

04 ROLE OF MULTILATERAL INSTITUTIONS IN THE FORMATION OF ISLAMIC FINANCIAL POLICY International Islamic Trade Finance Corporation (ITFC) The ITFC was established in 2007 and presently comprises of 37 members from Africa and Europe. The main objective of ITFC is to promote trade among OIC member countries. ITFC works towards achieving this through trade finance and Trade Cooperation & Promotion Program (TCPP). Being a member of the IDB Group, ITFC has unique access to governments in its member countries and therefore it works efficiently as a facilitator to mobilize private and public resources towards achieving its objectives of fostering economic development through trade. Achievements of IDB Group IDB Group has played pivotal role in establishing and strengthening Islamic financial industry in the world. Its significant achievements mainly include: Supportive role in establishment of infrastructural organisations like Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), General Council of Islamic Banks and Financial Institutions (GCIBAFI), International Islamic Financial Market (IIFM), Islamic International Rating Agency (IIRA) and International Islamic Liquidity Management Corporation (IILMC), etc Equity investment for establishing more than 30 Islamic banks and Islamic financial institutions (IFIs) across various jurisdictions Issuance of sukuk program. The first resource mobilization was the issuance of a maiden sukuk in 2003. In 2005, IDB established a US$1 billion Medium Term Note (MTN) Program to tap the global capital market resources in more regular and organized basis. The program allows IDB to issue sukuk in various currency denominations Islamic Financial Services Board (IFSB) The IFSB is an international standard setting body for Islamic financial industry. It was inaugurated in November 2002 with the signing of the Articles of Agreement by founding members including Bahrain Monetary Agency, Bank Indonesia, Bank Markazi Jomhouri Iran, Central Bank of Kuwait, Bank Negara Malaysia, State Bank of Pakistan, Saudi Arabian Monetary Agency, Bank of Sudan and Islamic Development Bank. The organisation became operational in March 2003 in Kuala Lumpur, Malaysia, under the specially enacted law; Financial Services Board Act 2002, which gives IFSB the immunities and privileges akin to that of international organisations and diplomatic missions. Over the years membership of IFSB has grown to 189 consisting of 65 regulatory and supervisory authorities, 8 international inter-governmental organisations and 116 market players. With respect to three categories of membership of IFSB (see Box 5.1), 30 fall into the category of Full Membership, 28 Associate Membership and 131 Observer Membership. Organisational Structure All members form the General Assembly, but the Council is the senior executive and policy making body. Two main offices work under Council, namely the Secretariat and Technical Committee. The Secretariat is the permanent administrative body, which is headed by a fulltime Secretary-General appointed by the Council while Technical Committee is responsible for advising the Council on technical issues. Technical Committee consists of up to fifteen persons selected by the Council and each member gets a term of three years. Working Groups, Task Force and Editing Committee work under Technical Committee. PAGE 75

ROLE OF MULTILATERAL INSTITUTIONS IN THE FORMATION OF ISLAMIC FINANCIAL POLICY 04 BOX 4.1: CATEGORIES OF MEMBERSHIP AT IFSB The IFSB has three categories of membership; i. Full Membership: This category is available to the supervisory authority responsible for the supervision of the banking industry, securities and/or insurance/takâful industries of each sovereign country that recognises Islamic financial services, whether by legislation or regulation or by established practice, and international inter-governmental organisations that have an explicit mandate for promoting Islamic finance. ii. Associate Membership: This category is available to any central bank, monetary authority or financial supervisory or regulatory organisation or international organisation involved in setting or promoting standards for the stability and soundness of international and national monetary and financial systems which does not qualify or does not seek to become IFSB Full member. iii. Observer Membership: This category is available to any: a. national, regional or international professional or industry association; b. institution that offers Islamic financial services; or c. firm or organisation that provides professional services, including accounting, legal, rating, research or training services to any aforementioned institutions in (a) and (b) Source: IFSB Website Functions IFSB is aimed at enhancing the soundness and stability of Islamic financial services industry through issuing global prudential standards and guiding principles broadly covering areas like banking, capital market and insurance. The procedure of preparing standards and guidelines has been defined by the Council (see Box 5.2 for Steps of Issuing Standard). Since its inception, the IFSB has issued twenty-four Standards, Guiding Principles and Technical Note for the Islamic financial services industry. The published documents are on the areas of: 1. Risk Management (IFSB-1) 2. Capital Adequacy (IFSB-2) 3. Corporate Governance (IFSB-3) 4. Transparency and Market Discipline (IFSB-4) PAGE 76

04 ROLE OF MULTILATERAL INSTITUTIONS IN THE FORMATION OF ISLAMIC FINANCIAL POLICY 5. Supervisory Review Process (IFSB-5) 6. Governance for Collective Investment Schemes (IFSB-6) 7. Special Issues in Capital Adequacy (IFSB-7) 8. Guiding Principles on Governance for Islamic Insurance (Takaful) Operations (IFSB- 8) 9. Conduct of Business for Institutions offering Islamic Financial Services (IIFS) (IFSB-9) 10. Guiding Principles on Shari'a Goverance System (IFSB-10) 11. Standard on Solvency Requirements for Takaful (Islamic Insurance) Undertakings (IFSB-11) 12. Guiding Principles on Liquidity Risk Management (IFSB-12) 13. Guiding Principles on Stress Testing (IFSB-13) 14. Standard on Risk Management for Takaful (Islamic Insurance) Undertakings (IFSB-14) 15. Revised Capital Adequacy Standard (IFSB-15) 16. Revised Guidance on Key Elements in the Supervisory Review Process (IFSB-16) 17. Core Principles for Islamic Finance Regulations (IFSB-17) 18. Recognition of Ratings on Shari'a-Compliant Financial Instruments (GN-1) 19. Guidance Note in Connection with the Risk Management and Capital Adequacy Standards: Commodity Murabahah Transactions (GN-2) 20. Guidance Note on the Practice of Smoothing the Profits Payout to Investment Account Holders (GN -3) 21. Guidance Note in Connection with the IFSB Capital Adequacy Standard: The Determination of Alpha in the Capital Adequacy Ratio (GN-4) 22. Guidance Note on the Recognition of Ratings by External Credit Assessment Institutions (ECAIS) on Takaful and ReTakaful Undertakings (GN-5) 23. Quantitative Measures for Liquidity Risk Management (GN-6) 24. Development of Islamic Money Markets (TN-1) In addition, the IFSB is actively involved in the promotion of awareness of issues that are relevant or have an impact on the regulation and supervision of the Islamic financial services PAGE 77

ROLE OF MULTILATERAL INSTITUTIONS IN THE FORMATION OF ISLAMIC FINANCIAL POLICY 04 BOX 4.2: STEPS OF ISSUING STANDARD Working Groups (WG) are formed by the Technical Committee (TC) for drafting of standards/guidelines. Since members of the WG render their services on part-time basis, therefore a full-time project manager is assigned to each WG. In addition to the project manager, each WG is also assigned a part-time consultant who is well knowledgeable in the international standard/guideline that is relevant to the standard/guideline that is being prepared. The General Secretariat in consultation with the Technical Committee (TC) and other relevant regulatory bodies and organisations compile a list of the standards/guidelines that it deems necessary to be prepared. However, Council approves the final list. Each WG meets to discuss the initial study of the standard/guideline assigned to it. The WG may require that the initial study should be revised and resubmitted in light of the comments made by its members. The WG submits the revised document to the TC for discussion, amendment, and approval. The project manager and the consultant use the document approved by the TC as the basis for the preparation of a draft. A workshop may be held on the topic of each standard/guideline to be prepared. This enables the WG to embark on an engagement process with the various relevant supervisory and regulatory bodies (both members and non-members of the IFSB) and elicit their views on the issues raised in the document approved by the TC. Based on the feedback from the workshop the WG provides the project manager with guidelines to prepare an exposure draft of the standard/guideline to submit to the TC. The TC then discusses and amends the draft of the exposure draft to submit to the body of Shari a scholars (in accordance with Article 30 (e)) for endorsement that the document complies with Shari a rules and principles. The WG then addresses the remarks of the body of Shari a scholars, if any, and ask the project manager and the consultant to revise the draft of the exposure draft accordingly. The WG discusses, amends and approves the revision made by the project manager and the consultant to submit the revised draft to the body of the Shari a scholars for endorsement. The revised document is submitted to the TC which discusses and amends the revised draft of the exposure draft before its approval for issuance as an Exposure Draft (ED). The ED is posted on the website of the IFSB for comments by all interested parties within stipulated time by WG. In cases where it is deemed appropriate, the TC shall decide to hold public hearing(s). The WG attends the public hearing and receives the comments of the participants on the ED and respond to their queries. PAGE 78

04 ROLE OF MULTILATERAL INSTITUTIONS IN THE FORMATION OF ISLAMIC FINANCIAL POLICY The project manager together with the consultant analyse all the comments received on the ED and present them to the WG with suggestion as to the necessary revision to the ED. The revised ED is again referred to the body of Shari a scholars to endorse the compliance of the document with Shari a rules and principles before its submission to the TC for discussion and amendment, if any. The TC then decides whether the revision made in the ED warrants that the ED should be distributed for further comments or not. The TC presents the revised ED to the Council for consideration and formal adoption. The Council may adopt and approve for issuance the ED in the form of a standard/guideline. industry. This mainly takes the form of international conferences, seminars, workshops, trainings, meetings and dialogues. The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) AAOIFI, formerly known as Financial Accounting Organization for Islamic Banks and Financial Institutions, was established in accordance with the Agreement of Association, which was signed by Islamic financial institutions on February 26, 1990 in Algiers. AAOIFI as an international autonomous non-profit making corporate body was registered on March 27, 1991 in the State of Bahrain. The organisation was mandated to enhance the confidence of users of the financial statements of Islamic financial institutions (IFIs) and to encourage these users to invest in these institutions and to use their services. AAOIFI key objectives are: 1. To develop accounting and auditing thoughts relevant to IFIs; 2. To disseminate accounting and auditing thoughts relevant to IFIs and its applications through training, seminars, publication of periodical newsletters, carrying out and commissioning of research and other means; 3. To prepare, promulgate and interpret accounting and auditing standards for IFIs; and 4. To review and amend accounting and auditing standards for IFIs. AAOIFI is supported by 200 institutional members from 40 countries including central banks, IFIs, and other participants from the international Islamic banking and finance industry, worldwide (see Box 5.3 for membership categories at AAOIFI). The governance structure of AAOIFI can be grouped into two broader categories - General Assembly consisting of Board of PAGE 79

ROLE OF MULTILATERAL INSTITUTIONS IN THE FORMATION OF ISLAMIC FINANCIAL POLICY 04 Trustees, the Executive Committee and the General Secretariat; and Technical Boards, namely the Accounting Board, the Shari a Board, and the Governance and Ethics Board. A total of 88 standards have been issued so far (see Box 5.4 for Process of Standard Development & Revision), which includes 48 on Shari a, 26 on accounting, 5 on auditing, 7 on governance and 2 codes of ethics. AAOIFI has gained assuring support for the implementation of its standards, which are now adopted in the Kingdom of Bahrain, Dubai International Financial Centre, Jordan, Lebanon, Qatar, Sudan and Syria. The relevant authorities in Australia, Indonesia, Malaysia, Pakistan, Kingdom of Saudi Arabia, and South Africa have issued guidelines that are based on AAOIFI s standards and pronouncements. AAOIFI is also making efforts to enhance the industry s human resources base and governance structures. In this regard the most significant is the professional qualification programs such as the Certified Shari'a Advisor & Auditor (CSAA) targeted at equipping candidates with the requisite technical understanding and professional skills on Shari a compliance and review processes and the Corporate Compliance Program. In addition, AAOIFI also conducts workshops, seminars and conferences to raise awareness as part of its promotional activities for Islamic banking and finance. BOX 4.3: CATEGORIES OF MEMBERSHIP AT AAOIFI Founding Members: This category consists of IFIs that are signatories to the Agreement establishing AAOIFI, and those that have been subsequently accepted as founding members. These are the Islamic Development Bank, Dallah Al Baraka, Faysal Group (Dar Al Maal Al Islami), Al Rajhi Banking & Investment Corporation, Kuwait Finance House, and Albukhary Foundation. Associate Members This category comprise of A. IFIs and companies that comply with Islamic Shari a rules and principles in all their transactions. B. Islamic Fiqh academies and learning institutions. Associate members shall have the right to participate in the meetings of the General Assembly but without a right to vote. They shall also have the right to take part in AAOIFI s events and receive AAOIFI s publications at special rates. An associate member is entitled to enjoy the rights of the founding members provided the following terms are satisfied: A. File an application in this respect. B. Obtain an initial approval by the Board of Trustees of this application. C. Fulfill all the financial obligations of the founding members from the date of the initial approval. PAGE 80

04 ROLE OF MULTILATERAL INSTITUTIONS IN THE FORMATION OF ISLAMIC FINANCIAL POLICY (D) Issuance of a final resolution on this application by the General Assembly. Members comprising of regulatory and supervisory authorities These members comprise of regulatory and supervisory authorities that supervise IFIs. Members representing regulatory and supervisory authorities have the right to participate and vote in the meetings of the General Assembly. They also have the right to take part in AAOIFI s events and receive AAOIFI s publications at AAOIFI s members rates. Observer Members This category comprise of A. Organizations and associations responsible for regulating the accounting and auditing profession and/or those responsible for preparing accounting and auditing standards. B. Practicing certified accounting and auditing firms that have interest in the accounting and auditing practices of IFIs. C. Financial institutions engaged in financial activities of Islamic institutions. D. Users of financial statements of IFIs. Observer members have the right to participate in the meetings of the General Assembly but without a right to vote. They also have the right to take part in AAOIFI s events and receive AAOIFI s publications at special rates. BOX 4.4: PROCESS IN STANDARDS DEVELOPMENT & REVISION In carrying out the standards development and revision processes of AAOIFI standards, the relevant standards board works with AAOIFI General Secretariat and, if deemed necessary with external consultants. The relevant standards board may also form committees or working groups, in coordination with the General Secretariat, to assist with the board s work programs. Such committees or working groups may comprise of representatives of the relevant standards boards together with other representatives of the international Islamic finance industry stakeholders. Major steps of the process are as follows; The relevant standards board, in coordination with the General Secretariat, formulates a tentative work program or agenda to include potential new standard to be developed, or existing standard to be reviewed. During this process suggestions and feedback from the international Islamic finance industry as well as members of AAOIFI standards boards are incorporated. PAGE 81

ROLE OF MULTILATERAL INSTITUTIONS IN THE FORMATION OF ISLAMIC FINANCIAL POLICY 04 Members of the General Secretariat and/or external consultant/s prepare the preliminary study or research that is discussed with the relevant committee or working group (if applicable) and the relevant standards board. Subsequently, a consultation note is prepared that outlines proposed major points of a new standard, or proposed major changes to an existing standard. Feedback of relevant committee or working group (if applicable) and the relevant standards board on consultation note is solicited. After the agreement of relevant standards board on consultation note, it is released to the international Islamic finance industry and beyond, for comments and suggestions. The consultation note may also be submitted to technical workshops, public hearing meetings and/or similar forum. After incorporating comments and suggestions an exposure draft of the standard is developed which is subject to discussions with the relevant committee or working group (if applicable) and the relevant standards board. After the agreement of relevant standards board on exposure draft, it is released to the international Islamic finance industry and beyond, for comments and suggestions. The exposure draft may also be submitted to technical workshops, public hearing meetings or/and similar forum. Subsequent to the exposure draft, a final new or revised standard will be prepared which is discussed with the relevant committee or working group (if applicable), and approval by the relevant standards board. Upon approval by the relevant standards board, the final standard is then issued to the international Islamic finance industry. However, issued standards are subject to continuous review. Revision to the standards is carried out, through the above processes, as and when necessary. International Islamic Financial Market (IIFM) Founded in 2002 and restructured in 2007, the International Islamic Financial Market (IIFM) is responsible for developing Shari a-compliant financial contracts and product templates relating to Islamic capital and money market, trade finance and corporate finance. The creation of IIFM, as a standard-setting organisation, has been linked to a joint effort led by six founding member countries to strengthen an Islamic global prudential Shari a-compliant standard agreements regime. This is being done through financial documentation and product templates standardization, independent Shari a enhancement and guidelines for new products and, transparency in transactions and financial contracts as well as legal certainty in case of unexpected adverse events. PAGE 82

04 ROLE OF MULTILATERAL INSTITUTIONS IN THE FORMATION OF ISLAMIC FINANCIAL POLICY IIFM has issued seven standard agreements/products covering areas of Islamic Cross Currency Swap 2, Master Collateralized Murabahah Agreement, Inter-Bank Unrestricted Master Investment Wakalah Agreement, Islamic Profit Rate Swap, Tahawwut (Hedging) Master Agreement, Master Agreements for Treasury Placement (see Box 5.5 for the brief overview of standard agreements/products) while projects in progress include Product Templates on Islamic Foreign Exchange Forward, Islamic Credit Support Arrangement, Risk Participation Agreement (funded and unfunded) and Sukuk standardization. The realization of objectives of IIFM, indeed, requires hard work and continuous cooperation with financial institutions, regulators, legal experts and other market participants worldwide especially since the standards issued by the Islamic main standard-setting bodies are voluntary. This implies that these standards are offered for adoption without being mandated in law. Some standards become mandatory when they are adopted by regulators as the legal requirements in some jurisdictions. For example, for liquidity management, the Central Bank of Bahrain launched a new Shari a-compliant Wakalah liquidity management tool aimed at absorbing excess liquidity of local Islamic retail banks. The master agreement has been developed based on IIFM s Inter-Bank Unrestricted Master Investment Wakalah Agreement (published in 2013). Saudi Arabian Monetary Agency (SAMA) has also commissioned all the Islamic banks in the Kingdom to adopt the Tahawwut (Hedging) Master Agreement (published in 2010) in their Shari a-compliant hedging transactions. As evidenced above, IIFM plays an important role through the formation of Islamic financial policies in many jurisdictions across the globe through its standardization of the Shari a compliant agreements and product templates. However, IIFM is aware of the challenges to achieve a general consensus in the industry in the formation of Islamic financial policies. In this regard, IIFM has adopted a simple strategy in order to enhance its role in the formation of the Islamic financial policy across the globe. Major components of the strategy are as follows: 1. To get countries to agree to introduce the standards published by IIFM to the financial institutions in their respective jurisdictions, and let these institutions to commit to a level playing field with regard to these standards. 2. To develop more efficient and effective mechanisms for monitoring and encouraging the adoption of IIFM standard agreements. 3. To encourage the regulators to foster more support for IIFM initiatives so that, it will be able to develop effective international standards. 4. To focus on working with regulators closely to strengthen IIFM role in the formation of Islamic financial policies, not only through the issuance of master standard agreements and product templates, but also by organizing topic specific briefing seminars, workshops on IIFM standards, industry consultative meetings and publications. 5. To publish research papers and reports such as consultative papers on important topics like Islamic Alternative to Repo, Sukuk Standardization, IIFM Sukuk Reports etc. as a key source of information. IIFM with its entrusted mandate has a central role to play in pioneering new forms of international cooperation to support a more pluralistic international Islamic financial regula- 2. Two standards are applicable to this product. PAGE 83

ROLE OF MULTILATERAL INSTITUTIONS IN THE FORMATION OF ISLAMIC FINANCIAL POLICY 04 tory order. However, to achieve its objective IIFM is aware of challenging aspirations which include: developing effective practical mechanisms through its standards development process for implementation, encouraging Shari a-compliance and harmonization, promoting the development of effective Shari a-compliant global financial master agreements and encouraging consensus on their content, establishing its legitimacy within member as well as non-member BOX 4.5: BRIEF OVERVIEW OF STANDARD AGREEMENT/PRODUCTS ISSUED BY IIFM By now IIFM has published standards relating to Islamic hedging and liquidity management in response to the most urgent need to have universally acceptable solutions to risk mitigation and liquidity management. The published standards and its brief description are presented below. IIFM Standard 1: IIFM Master Agreements for Treasury Placement This was the first ever global standard documentation published in Islamic finance for liquidity management purpose. The Master Agreements for Treasury Placement (MATP) comprises of standalone Master Murabahah Agreement and a Master Agency Agreement. The standard documentation involves Commodity Murabahah based on two structures namely: (i) Commodity Murabahah under Agency Agreement, and (ii) Commodity Murabahah based Principle to Principle. The Agreement was published in 2008 and based on IIFM recent survey MATP is widely used in Islamic inter-bank market particularly involving cross border trades. IIFM Standard 2: International Swaps and Derivatives Association (ISDA) /IIFM Tahawwut (Hedging) Master Agreement In March 2010, the Tahawwut Master Agreement (TMA) was jointly published by IIFM and ISDA and marked the introduction of the first globally standardised documentation for OTC Islamic hedging products. TMA is a framework document that provides a globally standardised early termination and close-out mechanism and other legal and Shari'a provisions for privately negotiated and widely accepted Islamic hedging products. The master agreement is designed to facilitate the risk management function of IFIs including providing a legal framework. Under the TMA, Islamic hedging products can be transacted. In order to provide clarity and transparency the TMA also includes an Explanatory Memorandum. IIFM Standard 4 and IIFM Standard 3: ISDA/IIFM Islamic Profit Rate Swap (IPRS) (Mubadalatul Arbaah) Standard Product Templates In March 2012, in its efforts to accelerate the use of TMA, IIFM and ISDA jointly published the first hedging product template. The IPRS provides the industry access to robust and well developed product documentation under the TMA. It provides protection to IFIs balance-sheet from wide swings in fixed and floating profit rates as well as enabling them to manage their cash-flow risk for various Islamic capital market instruments such as Sukuk. Two sets of IPRS templates have been published; (i) Wa ad based template that involve a two Sales structure and (ii) Wa ad based template with a single Sale structure. (The IPRS standard templates also include a product description for guidance purposes). PAGE 84

04 ROLE OF MULTILATERAL INSTITUTIONS IN THE FORMATION OF ISLAMIC FINANCIAL POLICY IIFM Standard 5: IIFM Inter-Bank Unrestricted Master Investment Wakalah Agreement Published on 3rd June 2013, the inter-bank has been specifically designed to provide alternate liquidity management product to the Islamic finance industry in order to reduce over reliance on commodity Murabahah based transactions. The important features of this standard documentation is Wakil s discretion to invest the funds, use of general treasury pool (segregated and un-segregated asset pool), anticipated profit, early termination, replacement of asset, on-balance sheet accounting assessment, etc., The Unrestricted Wakalah standard includes a detailed operational guidance memorandum on the mechanics of this agreement as well as how it should be applied by the transacting parties. In addition, the operational guidance memo also provides valuable recommendations to be taken into consideration at the time of entering into unrestricted Wakalah investment transactions. IIFM Standard 6: IIFM Master Collateralized Murabahah Agreement (MCMA) The MCMA was published on 16th November 2014 and it provides a mechanism for access to liquidity on a collateralized basis utilizing Sukuk and other Islamic securities portfolio as collateral. It is an important new tool for IFIs as they seek to address the increased global regulatory focus on liquidity and collateral. Collateralized transactions based on Murabahah provide a level playing field for IFIs by giving them option to tap funds from central banks in case of liquidity short-fall. The MCMA is accompanied by an operational guidance memorandum which covers the operational procedures which may be implemented by potential users of the MCMA. IIFM Standard 7: ISDA/IIFM Islamic Cross Currency Swap (Himaayah Min Taqallub As aar Assarf (ICRCS) Standard Product Template The ICRCS standard template was published on 26th November 2015 as the second hedging product template under the TMA. With ICRCS the Islamic financial institutions can manage risk in transactions exposed to fluctuations in currencies and rate-of-return mismatches. The ICRCS standard template also includes a product description for guidance purposes. countries and clarifying its relationship with other Islamic global standard-setting organisations. The International Islamic Liquidity Management Corporation (the IILM) The IILM was established on October 25, 2010 by central banks, monetary authorities and multilateral organisations and received the status of an international institution under IILM Act 2011 issued by Malaysia. The current shareholders of IILM are from the central banks and monetary agency of Indonesia, Kuwait, Luxembourg, Malaysia, Mauritius, Nigeria, Qatar, Turkey, the United Arab Emirates and the Islamic Development Bank. The organisation is operational under the governance structure comprising of the General Assembly, Governing Board, Board Executive Committee, Board Audit Committee, Board Risk Management Committee and Shari a Committee. IILM aims at fostering regional and international co-operation by building a robust liquidity management infrastructure at national, regional and international PAGE 85

ROLE OF MULTILATERAL INSTITUTIONS IN THE FORMATION OF ISLAMIC FINANCIAL POLICY 04 levels. This is being done by creating a variety of Shari a-compliant instruments, on commercial terms, to suit the varying liquidity needs of IFIs and subsequently, enhancing cross-border investment flows, international linkages and financial stability. In April 2013, the IILM announced the launch of its inaugural short-term Sukuk Programme, which was rated A-1 by Standard and Poor s Rating Services. Subsequently, the IILM inaugural Sukuk of US$490 million were issued with a tenor of 3 months and were fully subscribed. The IILM Sukuk Programme marks the first of many things, not only for Islamic finance but also in the conventional space for several reasons. Firstly, it is the first Shari a-compliant, shortterm, highly rated, tradable, US Dollar-denominated instrument in the market. Secondly, it is the first money market instrument backed by sovereign assets in the form of sukuk. Finally, it has the first multi-jurisdictional primary dealer network that facilitates distribution to investors worldwide. The IILM sukuk are expected to complement the intermediate and long-term sukuk currently available in the market. Role of World Bank as Infrastructure Organisation for Islamic Finance Industry Multilateral Development Banks (MDBs) have played significant role in the economic and financial development of emerging and low-income countries. In addition to providing direct financial assistance, MDBs, provide advisory services to their clients to facilitate overall economic development in those countries. The World Bank Group, as the leading MDB on the globe has been providing significant amount of financial assistance to its client countries and helped them through advisory services in establishing the necessary environment that will enable sustainable development in various sectors such as infrastructure, healthcare, education, and finance. In compliance with the Sustainable Development Goals initiated by the United Nations in 2015, the World Bank has redefined its goals as the eradication of extreme poverty and promotion of shared prosperity. Islamic finance has gained a remarkable momentum during the last decade, especially after the global financial crisis. It has already become systematically important in several countries such as Malaysia, Saudi Arabia, Pakistan, Bahrain, and Indonesia. Furthermore, Islamic finance has been recognised in some non-muslim developed markets of the World such as the UK and Luxemburg. Due to its core principles of risk sharing and asset-backed/based finance, Islamic finance seems to be a viable tool for promoting economic growth, strengthening systemic stability and enhancing the financial inclusion of low-income segments of societies and thereby contributing to the eradication of extreme poverty via boosting shared prosperity. World Bank Group as the Leading Multilateral Development Institution Figure 1 below summarizes basic products and services of World Bank Group Institutions (see Box 5.6 for the role of multilateral banks) for its client countries. Under the World Bank Group, the World Bank offers services to public sector while International Finance Corporation (IFC) and Multilateral Investment Guarantee Agency (MIGA) offers services to private sector of client countries. The products offered by the World Bank, can be classified as financial instruments intended for development projects, advisory services and analytics. Financial instruments that could facilitate development include Investment Project Financing (IPF), Program for Result (PFoR), and Development Policy Financing (DPF). IPF instruments are intended to support specific projects in developing countries, the PFoR type of financing includes the support of government programs with a specific goal and capacity building objective while DPF tools are to sponsor policy and institutional reforms. All of these instruments can be in the form of loans and grants. Advisory services and analytics (ASA) are utilized either as assistance to PAGE 86

04 ROLE OF MULTILATERAL INSTITUTIONS IN THE FORMATION OF ISLAMIC FINANCIAL POLICY Figure 1: PRODUCTS AND SERVICES PROVIDED BY WBG INSTITUTIONS PUBLIC SECTOR PRIVATE SECTOR FINANCIAL PRODUCTS DEVELOPMENT FINANCING INSTRUMENTS Investment Project Financing (IPF) Program for Results (PforR) Development Policy Financing (DPF) INVESTMENT SERVICES Loans Syndicated Loans Quasi-equity Finance Equity Finance Risk Management Services Trade Finance and Supply Chain GUARANTEE PRODUCTS Currency Inconvertibility and Transfer Restriction Expropriation War, Terrorism, and Civil Disturbance Breach of Contract Non-honoring of Financial Obligations ADVISORY SERVICES AND ANALYTICS ADVISORY SERVICES ADVISORY SERVICES Firm Level Advice PPP Transaction Advice Quasi-equity Finance Advice to Governments and Non-government Institutions to Improvethe Enabling Environment Source: The World Bank Group a client country or as public service. These services cover a wide range of products, such as reports on key economic and social issues, sector studies, policy notes, knowledge sharing workshops, conferences, evaluations, and training programs together with the collection and compilation of data on various development issues. ASA are financed through the Bank s own administrative budget and/or donors via Bank Executed Trust Funds or clients themselves through so-called reimbursable Advisory Services (RSA) operations. PAGE 87

ROLE OF MULTILATERAL INSTITUTIONS IN THE FORMATION OF ISLAMIC FINANCIAL POLICY 04 BOX 4.6: ROLE OF MULTILATERAL INSTITUTIONS The list of multilateral development banks with either global or regional mandate includes the World Bank Group (WBG), African Development Bank (AfDB), Asian Development Bank (AsDB), European Bank for Reconstruction and Development (EBRD),Inter-American Development Bank (IDB), and Islamic Development Bank Group (IDBGs). These institutions are established to provide financial support to developing countries for economic development purposes. The context of the financial assistance ranges from the support of investment projects in sectors such as energy, transportation, healthcare, agriculture, and technical assistance to implement policy reforms in various areas while the form of the financial assistance can be either through loans, equity investments or guarantees for loans. The significant role of these multilateral development banks is depicted by the premise that the total amount of loan provided by these institutions exceeds US$90 billion during FY 2015. Figure 2: WORLD BANK GROUP FINANCING IN PARTNER COUNTRIES (AMOUNT OF COMMITMENTS BY FISCAL YEAR, US$ BILLION)* 70 60 50 56.3 51.2 50.2 58.2 59.8 40 30 20 10 0 2011 2012 2013 2014 2015 IBRD IDA IFC MIGA Recipient-Executed Trust Fund WBG Total Source: World Bank Annual Report, 2015 *The data includes IBRD, IDA, IFC, and Recipient-Executed Trust Fund (RETF) commitments, and MIGA gross issuance. PAGE 88

04 ROLE OF MULTILATERAL INSTITUTIONS IN THE FORMATION OF ISLAMIC FINANCIAL POLICY Figure 3: DISTRIBUTION OF WORLD BANK GROUP COMMITMENTS BY REGION FOR FY2015 ( %) 25.0% Sub-Saharan Africa 16.7% Latin America and the Caribbean 18.3% South Asia DISTRIBUTION OF WORLD BANK GROUP COMMITMENTS BY REGION FOR FY2015 ( %) 16.7% Europe and Central Asia 15% East Asia and Pacific 8.3 % Middle East and North Africa Source: World Bank Annual Report, 2015 The mandate of IFC mainly covers the support for private sector companies in client countries through loans, syndicated loans, quasi- equity or equity finance, risk management services, and financing trade and supply chain. In addition, IFC has an Asset Management Company for the management of third party capital through investing in IFC operations in developing countries. Furthermore, IFC offers advisory services for firms, for public-private partnership projects, and for governmental and non-governmental institutions to improve the enabling environment that will contribute to private sector development. MIGA, on the other hand, offers guarantee services for investments in client countries against currency inconvertibility and transfer restrictions, expropriation, war, terror, and civil disturbance, breach of contracts, and non-honouring of financial obligations. As illustrated in Figure 2, since 2011, the World Bank Group institutions provide, annually, US$55.13 billion financial assistance to client countries on average. International Bank for Reconstruction and Development (IBRD) and International Development Association (IDA) are two main institutions providing more than 70% of annual average financial assistance PAGE 89

ROLE OF MULTILATERAL INSTITUTIONS IN THE FORMATION OF ISLAMIC FINANCIAL POLICY 04 Figure 4: POVERTY HEADCOUNT RATIO AT US$1.25 A DAY (PPP) (% OF POPULATION) 45 40 35 40.50 42.11 36.86 42.40 40.82 34.88 30 25 20 27.60 23.80 23.51 25.72 20.32 17.54 15 OIC World 1990 1995 2000 2005 2010 2014 Source: World Development Indicators, the World Bank, authors calculations amount. More than 16% of annual average financial assistance are composed of IFC supports and investments in private sector firms. When the region wise distribution of financial assistance is analyzed as in the Figure 3, Sub-Saharan Africa appears to take the biggest portion from the WBG operations, which amounts to 25% of financial assistance during financial year 2015. Shares of South Asia, Latin America and Caribbean, Europe and Central Asia, and East Asia and Pacific regions are between 15% and 18% while the Middle East and North Africa region received the lowest portion of the financial assistance. Islamic Finance: Relevance to World Bank Goals Islamic finance has experienced a period of remarkable growth worldwide during the last decade. The amount of global Islamic financial assets have reached to $2 trillion dollars covering bank and non-bank financial institutions, capital markets, money markets and insurance (takaful). This corresponds to a cumulative average annual growth rate of around 16% since 2009. The amount of assets are expected to exceed US$3 trillion by 2018. 3 3 City UK Report, November 2015 and MIFC, 2015. PAGE 90

04 ROLE OF MULTILATERAL INSTITUTIONS IN THE FORMATION OF ISLAMIC FINANCIAL POLICY Figure 5: SURVEY MEAN INCOME PER CAPITA, BOTTOM 40% AND TOTAL POPULATION, (2005 PPP US$ PER DAY) 6.0 5.26 5.0 4.16 4.0 3.0 2.0 1.26 2.73 1.47 3.13 1.63 2.08 1.0 0.0 OIC 2007 (Bottom 40%) 2007 Total Population 2014 (Bottom 40%) 2014 Total Population World Source: World Development Indicators, the World Bank, authors calculations The fact that Muslims compose one-fifth of the world population (about 1.6 billion) highlights the growth potential of Islamic finance worldwide. In addition, the data on the level of economic and financial development in Organization of Islamic Cooperation (OIC) member countries suggests that these countries have a long way to go towards achieving the twin goals of the World Bank. Figure 4 indicates the level of extreme poverty throughout the OIC countries and the world through the proportion of population living below US$1.25 a day in terms of purchasing power parity (PPP). From 1990 to 2014, the percentage of population living under the threshold level has decreased from 40.5% to around 23.5% in OIC countries, depicting an average annual reduction of 2.3%. On the other hand, the proportion of population suffering from extreme poverty has decreased from 42.4% to 17.5% level corresponding to around 3.6% average annual reduction in extreme poverty worldwide. This highlights the fact that OIC countries have lagged behind the world average in terms of eradicating extreme poverty and there is a need for policies in OIC countries to address this challenge. Furthermore, as displayed in Figure 5, when income per capita per day for the bottom 40% of the population was used as a measure of shared prosperity, OIC countries appear to have a need for development in terms of this criteria, as well. In 2007, the per capita income PAGE 91

ROLE OF MULTILATERAL INSTITUTIONS IN THE FORMATION OF ISLAMIC FINANCIAL POLICY 04 Figure 6: INFRASTRUCTURE NEED AND INVESTMENT IN MENA (% OF GDP) 14.0 12.0 10.0 8.0 Oil Importers 6.0 4.0 2.0 0.0 MENA Oil Importers Other Oil Exporters GCC Infrastructure Needs (Average, Next Decade) Total Investment Spending (Average, 2000s) Source: World Development Indicators, the World Bank, authors calculations per day was US$1.26 for the bottom 40% while it was US$2.73 for the whole population in OIC countries. These rates have increased to US$1.47 and US$3.13 respectively in 2014. In absolute terms, these income levels are lagging behind the world averages in both 2007 and 2014. However, in terms of share, in 2007, a person from the bottom 40% of the population was earning 46.1% of the daily per capita income in OIC countries and in 2014, this ratio increased to 46.9%. In contrast, the proportion of the daily per capita income for the bottom 40% of the income pyramid to that of total population of the world was 39.1% in 2007 and the ratio increased to 39.5% in 2014. In other words, between 2007 and 2014, the improvement, in the income level of the bottom 40% has been better in OIC countries relative to whole population. But as suggested earlier, the absolute terms are still very low and thus, pointing to the need for further development in terms of income inequality. Another dimension which highlights the possible contribution that Islamic finance could provide is the need for infrastructure investments in MENA countries. It is estimated that by 2020, there will be annual infrastructure investment needs of US$106 billion that corresponds PAGE 92