OverviewOfIslamicFinance 13122010

OVERVIEW OF ISLAMIC FINANCE
BY AZRUL AZWAR AHMAD TAJUDIN CHIEF ECONOMIST
ISLAMIC FINANCE COURSE : STRUCTURE & INSTRUMENTS

JOINTLY ORGANISED BY
13 DECEMBER 2010
STRICTLY PRIVATE & CONFIDENTIAL
CONTENTS
FINANCE AND ISLAM
Definition Essence of Islamic Finance Inherent Features of the IFSI and its Stability and Resilience Milestones of Shariah Contract Application
RISK MANAGEMENT FOR ISLAMIC FINANCIAL INSTITUTIONS

Four Generic Risks and Four Unique Risks Unique Risks for Islamic Financial Institutions Shariah Non-Compliance Risks
PAST, PRESENT AND FUTURE

Evolution of the IFSI: Early Days Evolution of the IFSI: Present Day Evolution of the IFSI: Beyond Nations with Large Muslim Populations Evolution of the IFSI: What the Future Holds Composition of the IFSI Islamic Financial System: Case of Malaysia Global IFSI Architecture: International Islamic Financial Infrastructure
Page 2 ISLAMIC FINANCE COURSE 13-17 DECEMBER 2010
CONTENTS (continued)
SELECTED IFSI SEGMENT: ISLAMIC BANKING
Fundamentals of Islamic Banking Overview of Islamic Banking Activities Review of Global Islamic Banking Resilience of Islamic Banking Amidst the Global Financial Crisis
SELECTED IFSI SEGMENT: ISLAMIC CAPITAL MARKET

Vibrancy of Islamic Capital Market Evolution of Sukuk Why Choose Islamic Securities
MOVING FORWARD
Challenges Emerging Mega-Trends in Islamic Finance The Islamic Finance and Global Stability Report
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ISLAMIC FINANCE COURSE 13-17 DECEMBER 2010
FINANCE AND ISLAM
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DEFINITION
Islamic finance, in contrast to conventional finance, involves the provision of financial products and services by institutions offering Islamic financial services (IIFS) for Shariah approved underlying transactions and economic activities, based on contracts that comply with Shariah laws. Shariah, the basis for finance that meets the religious requirements of Muslims in line with their aqidah, is the factor that distinguishes Islamic finance from conventional finance. Provision of these Shariah compliant financial products and services must add value to the real economy. These IIFS may comprise:
full-fledged Islamic financial institutions or market intermediaries Islamic subsidiaries or branches of conventional financial groups
From its original meaning of the way to the source of life, Shariah is now used to refer to a legal system with rules & principles and code of behaviour. To ensure compliance with Shariah rules & principles, IIFS rely on an external or inhouse Shariah committee or board comprising Shariah scholars.
ESSENCE OF ISLAMIC FINANCE

The underlying intentions or objectives of Islamic finance:
Elimination of riba (literally means increase or addition) i.e. usury or rent on money in all forms and intents Prohibition of involvement in haram or non-permissible transactions or economic activities such as alcohol, non-halal food, pork production, gaming/number forecasting, prostitution Prevention of excessive leveraging Strong direct linkages to productive economic activities Avoidance of maisir i.e. speculation or gambling and gharar i.e. preventable uncertainty or ambiguity in transactions Deterrence of zulm i.e. oppression and exploitation Introduction of safety net mechanisms for the benefit of the poor and the less-have through Zakat (tithe) or Islamic tax, sadaqah (alms), waqaf (trust) and qard hasan (benevolent loan) Upholding universal social, moral and ethical values with emphasis on maslahah (public interest) Achieving adalah i.e. justice and musawah i.e. fairness in the distribution of resources
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ESSENCE OF ISLAMIC FINANCE (continued)

Governing principles or applicable Shariah contracts in Islamic finance:
Equity-based or profit-sharing contracts Mudharabah (profit sharing and loss bearing), Musharakah (profit-and-loss sharing), Musharakah Mutanaqisah (diminishing Musharakah) Lease-based contracts Ijarah (leasing), Ijarah Muntahia Bittamleek Sale-based contracts Bai Bithaman Ajil (BBA), Murabahah (cost plus), Salam (forward delivery), Bai Inah Contracts to manufacture/produce Istisna Benevolent contracts Qard, Hibah Services-based contract Wadiah (safe custody), Wakalah, Kafalah, Rahnu, Sarf, Hiwalah
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INHERENT FEATURES OF THE IFSI AND ITS STABILITY AND RESILIENCE

KEY ELEMENTS OF ISLAMIC FINANCE
Direct link to real economy Money is not a commodity, just a medium of exchange Certainty-supported by underlying activities (prohibition of gharar i.e. uncertainty/ambiguity/misinformation or deceit/fraud) Prohibition of excessive leverage Prohibition of unethical elements, practices and activities e.g. hoarding Prohibition of maisir (gambling), riba (usury), zulm (oppression) Emphasis on fairness and justice
Different contractual relationships Equity-based Risk and reward sharing which helps ensure greater market discipline
Shariah values consistent with universal values
Greater transparency & disclosure: Additional Shariah governance Unique risks specific to Islamic finance Greater fiduciary duties & accountability
Although the Islamic financial services industry (IFSI) is not totally insulated from an economic slowdown given its strong linkages to real economic activities, it has proven to be more resilient in times of crisis, mostly thanks to its intrinsic stabilizers (or checks and balances) and in-built shock absorbent mechanisms which act as inherent hedge against distress and crisis.
INHERENT FEATURES OF THE IFSI AND ITS STABILITY AND RESILIENCE (continued)
These inherent features contribute towards the overall stability, soundness and resilience of the IFSI. Indeed, according to the Islamic Finance and Global Financial Stability Report, jointly published by the Islamic Financial Services Board (IFSB), the Islamic Development Bank (IDB) and the Islamic Research & Training Institute (IRTI) in April 2010, only 1 Islamic financial institution required Government assistance in 2008 to restructure as a result of the then global crisis as opposed to 5 of the worlds top conventional banks which received Government assistance amounting to US$163 billion or 26% of their combined equity. As at end-2009, no Islamic financial institution required any Government rescue scheme.
All Shariah values and elements embedded in Islamic finance, which are consistent with universal values, are similar to those that found in ethical finance and socially responsible investing (SRI).
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MILESTONES OF SHARIAH CONTRACT APPLICATION

2009 onwards
Tawarruq Business Financing Tawarruq Personal Financing Tawarruq Credit Card Murabahah with Novation Agreement Istisna convertible to Ijarah Bay and Ijarah (Sale and Lease Back) Musharakah Mutanaqisah Istisna with Parallel Istisna
1983-1990
1991-2000
2001-2005
2006-2008
Wadiah Current Account Wadiah Savings Account Mudharabah Financing Ijarah Financing BBA Financing Mudharabah Investment Account Murabahah LC Musharakah LC Wakalah LC Bay Dayn Trade Financing Murabahah Working Capital Financing
Sarf Forex Mudharabah Interbank Investment Musharakah Financing Bay Inah Credit Card
Bay Dayn, Musharakah, Mudharabah ICDO Wadiah Debit Card Bay Inah Overdraft Bay Inah Commercial Credit Card Bay Inah Personal Financing Bay Inah Negotiable Instrument of Deposit (NID)
Commodity Murabahah Profit Rate Swap Commodity Murabahah Forward Rate Agreement Ijarah Rental Swaps-i BBA Floating Rate Murabahah Floating Rate Istisna Floating Rate Ijarah Floating Rate Mudharabah Capital Protected Structured Investment Bay Inah Floating Rate NID Mudharabah Savings Multiplier Deposit Tawarruq Commodity Undertaking
Note - This listing is far from being exhaustive.
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RISK MANAGEMENT FOR ISLAMIC FINANCIAL INSTITUTIONS
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FOUR GENERIC RISKS AND FOUR UNIQUE RISKS

Management of the four generic risks for financial institutions, namely credit, market, liquidity and operational risks, is not straightforward in Islamic finance. The risks of financing with underlying assets such as Murabahah, Salam, Istisna and Ijarah may transform from credit to market and vice versa at different stages of the contract. For instance, under Murabahah and Ijarah contracts, an Islamic bank has to acquire a physical asset and then sell the asset back on credit or lease it. The risk to which this Islamic bank is exposed transforms from the price risk of holding the physical asset at the time of acquisition to credit risk at the time of sale on deferred payment or lease. In addition to these four generic risks, Islamic financial institutions will have to deal with another four unique risks:
Shariah non-compliance risk Rate of return risk Displaced commercial risk Equity investment risk
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UNIQUE RISKS FOR ISLAMIC FINANCIAL INSTITUTIONS

Types of risks Shariah non-compliance risk Rate of return risk Definition Risk arises from the failure to comply with the Shariah rules and principles The potential impact on the returns caused by unexpected change in the rate of returns
Displaced commercial risk The risk that the Bank may confront commercial pressure to pay returns that exceed the rate that has been earned on its assets financed by investment account holders. The Bank foregoes part or its entire share of profit in order to retain its fund providers and dissuade them from withdrawing their funds. Equity investment risk The risk arising from entering into a partnership for the purpose of undertaking or participating in a particular financing or general business activity as described in the contract, and in which the provider of finance shares in the business risk. This risk is relevant under Mudharabah and Musharakah contracts.
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SHARIAH NONNON-COMPLIANCE RISK

Unlike conventional financial institutions, Shariah non-compliance i.e. risk arising from the failure to comply with Shariah rules and principles, is among the key risks to manage for Islamic financial institutions. Among the four generic risks for financial institutions, Shariah non compliance falls under the operational risk category i.e. the potential loss resulting from inadequate or failed internal processes, people and system or external events.
Reputational risk related to Shariah compliance perception among and acceptance by customers vis--vis:
the Islamic financial institution as a whole specific products or services that the Islamic financial institution offers
Enforceability and validity risk of contracts particularly in the event:

adherence to Shariah rules and principles is disputed existence of multiple contracts absence of a singe agreed ruling (due most probably to differing Shariah interpretations across jurisdictions) lack of jurisdiction
PAST, PRESENT AND FUTURE
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EVOLUTION OF THE IFSI : EARLY DAYS

While first references to interest-free finance appeared in 1940s and more serious discussions and debates on fundamentals of Islamic finance took place in 1950s and 1960s, modern forms of Islamic financial institutions can be traced back to:
1962 when the Malaysian Govt set up Tabung Haji, a pilgrimage fund board 1963 when a small banking experiment was set up under cover in Mit Ghamr, Egypt, based on a German savings bank model but modified to comply with Shariah principles in particular profit-sharing (lasted until 1967)
The institutional development of Islamic finance in particular its banking segment began to gather speed with the establishment of:
Islamic Development Bank in 1974 Dubai Islamic Bank, the worlds maiden Islamic in 1975 Faisal Islamic Bank of Sudan in 1977 Faisal Islamic Egyptian Bank and Islamic Bank of Jordan in 1978 Islamic Bank of Bahrain in 1979 International Islamic Bank of Investment and Development, Luxembourg in 1980 Bank Islam Malaysia Berhad in 1983
EVOLUTION OF THE IFSI : PRESENT DAY

The IFSI has evolved from merely an alternative form of financial intermediation primarily to meet the Shariah compliance requirements of the Muslims in the Muslim world to become today a complete, competitive and integral component of the mainstream global financial system that serves both Muslims and nonMuslims worldwide. Islamic assets of the global IFSI are estimated to be worth about US$1 trillion as at end-2009, expanding at a compounded average growth rate (CAGR) of 14.1% from US$150 billion in the mid-1990s although the CAGR is higher in some regions such as the Gulf Cooperation Council (GCC). Today, there are more than 600 Islamic financial institutions operating in at least 75 countries although Islamic finance in some form or another, institutionalised or otherwise, is probably present in some 90 countries worldwide in the Muslim and the Western world. About a dozen of long-established and emerging financial centres worldwide aspire to become international centres for Islamic finance: Bahrain, Brunei, Doha, Dubai, Hong Kong, Jakarta, London, Luxembourg, Malaysia (especially Kuala Lumpur), Paris, Singapore, Tokyo
EVOLUTION OF THE IFSI: BEYOND NATIONS WITH LARGE MUSLIM POPULATIONS
Burgeoning interest in Islamic finance over the past decade among:

the so-called non-Muslim nations such as Australia, China, Germany, France, Holland, Italy, Hong Kong, Japan, Luxembourg, New Zealand, Russia, Singapore, South Africa, South Korea, the UK and the US the so-called non-traditional key Islamic finance markets in particular countries in Central Asia such as Kazakhstan, Kyrgystan, Tajikistan, Turkmenistan and Uzbekistan; in Eurasia such as Azerbaijan and in Africa such as the Comoros, Gambia, Kenya, Mali, Nigeria, Senegal, Tanzania
EVOLUTION OF THE IFSI: WHAT THE FUTURE HOLDS

BREAKDOWN OF SHARIAH-COMPLIANT ASSETS (AS AT END-2009)
11.70% 0.70% 5.50%
82.10%
Islamic banking
Takaful
Sukuk
Islamic funds
Source: GIFF Report 2010
Consensus forecasts expect the asset size of global IFSI to hit US$2 trillion in the next 3 to 5 years while forecasts for 2012 vary between US$1.2 trillion and US$1.6 trillion. There are still tremendous opportunities in the IFSI going by the Standard & Poors estimates that the overall potential market is valued at US$4 trillion. In asset terms, Islamic banking (82.1%) is the largest IFSI segment, followed by Sukuk (11.7%), Islamic funds (5.5%) and Takaful (0.7%) as at end-2009.
EVOLUTION OF THE IFSI : WHAT THE FUTURE HOLDS (continued)

Maturity Curve of the IFSI
Measure or success or profitability
Fast growth Saturation
High
Take off
Medium
Maturity
Early start
Low
Islamic finance probably stands here; best time in terms of business development as relatively still early in the fast growth phase
1960
1970
2000
20xx
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COMPOSITION OF THE IFSI

Over the past 10 years, the IFSI has experienced phenomenal growth as evidenced by the increasingly widening diversity of Islamic financial institutions, product range as well as capabilities, resources infrastructure across the entire Islamic financial system. As the Islamic financial system can perform all functions related to finance such as fund mobilisation and reallocation, asset allocation, payment & settlement services, remittance services, risk mitigation & transformation, among many others, the IFSI consists of 5 major segments:
Islamic banking (retail/consumer banking, commercial banking, SME banking, corporate banking, investment banking, treasury, wealth management/private banking, etc) Islamic interbank or money market Islamic capital market (equity market, Sukuk market, derivatives market) Islamic insurance/re-insurance or Takaful/re-Takaful Islamic asset management/fund management
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ISLAMIC FINANCIAL SYSTEM: CASE OF MALAYSIA

Islamic Financial System
Islamic Banking
Islamic financings Islamic deposits Islamic investment accounts
Takaful/Re -Takaful
Takaful /ReTakaful products Takaful linked investments
Islamic Interbank Money Market
Islamic Asset/Fund Management
Islamic Capital Markets
Derivatives
Islamic Profit Rate Swap Islamic Foreign Exchange Swap Islamic CrossCurrency Swap
Equity
Islamic Unit Trusts Islamic REITs Islamic Stockbroking Islamic Indexes Shariah Compliant Securities
Debt
Islamic Securities Islamic Medium Term Notes Islamic Commercial Papers Exchangeable Sukuk
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GLOBAL IFSI ARCHITECTURE: INTERNATIONAL ISLAMIC FINANCIAL INFRASTRUCTURE

Apart from market players in the 5 major segments, namely Islamic banking, Islamic interbank money market, Islamic capital market, Takaful/Re-Takaful and Islamic asset management/fund management, the architecture of the Islamic financial system also includes its institutional infrastructure organisations, which can be categorised under the following areas:
Payment-settlement system Financial markets including market microstructures, trading and clearance systems Support facility providers, legal institutions and framework, safety net, liquidity support providers Regulators and supervisors including monetary authorities/central banks, licensing authorities and industry regulators Governance infrastructure, including Shariah governance institutions Standard setters for financial supervision and infrastructure, including financial reporting, accounting and auditing, capital adequacy & solvency, risk management, transparency & disclosure and corporate governance, among others Rating and external credit assessment institutions Financial statistics and information providers
GLOBAL IFSI ARCHITECTURE: INTERNATIONAL ISLAMIC FINANCIAL INFRASTRUCTURE (continued)

At the global level, these international Islamic financial infrastructure organisations which are mostly international organisations or multilateral agencies are concentrated in 4 countries, namely Bahrain, Malaysia, Saudi Arabia and United Arab Emirates. Bahrain:
Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) International Islamic Ratings Agency (IIRA) Liquidity Management Centre (LMC) International Islamic Financial Market (IIFM) General Council for Islamic Banks and Financial Institutions (CIBAFI)
Malaysia:
Islamic Financial Services Board International Centre for Education in Islamic Finance (INCEIF) International Shariah Research Academy for Islamic Finance (ISRA) International Islamic Liquidity Management Corporation
GLOBAL IFSI ARCHITECTURE: INTERNATIONAL ISLAMIC FINANCIAL INFRASTRUCTURE (continued)

Saudi Arabia:
OIC Fiqh Academy Islamic Development Bank (IDB) and Islamic Research & Training Institute (IRTI)
United Arab Emirates:

Arbitration and Reconcialiation Centre for Islamic Finance
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SELECTED IFSI SEGMENT : ISLAMIC BANKING
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FUNDAMENTALS OF ISLAMIC BANKING

Islamic banking is the most mature IFSI segment:
having grown and is expected to continue growing at a faster pace than that of conventional banking strong presence in the Middle East, South East Asia, Northern & East Africa and South Asia while making inroads into Europe and North America
Financial relationship in Islamic banking is participatory in nature with riskreward profile is guided by socio-economic principles:
Risk sharing through partnership in ventures building expertise and understanding of ventures being financed, importance of viability of ventures instead of solely creditworthiness of customers and know-your-customer culture Balancing act between pursuit of profit and fair and equitable distribution of wealth/income
The debtor-creditor or borrower-lender relationship in conventional banking transforms to mudarib (entrepreneur/capital user or investment manager)rabbul mal (capital owner/provider or financier/investor) or more specifically:
Entrepreneur-investor or joint-venture relationship for Mudharabah and Musharakah contracts Buyer-seller relationship for Murabahah and Ijarah contracts Agent-principal relationship for Wakalah contracts
OVERVIEW OF ISLAMIC BANKING ACTIVITIES
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REVIEW OF GLOBAL ISLAMIC BANKING

SHARE OF GLOBAL ISLAMIC BANKING ASSETS BY COUNTRY (AS AT END-2009)
7.0% 2.0% 2.0% 3.0% 6.0% 8.0%
36.0%
10.0% 10.0% 16.0%
Iran
Saudi Arabia
Malaysia
UAE
Kuwait
Bahrain
Qatar
UK
Turkey
Others
Source: GIFF Report 2010
As at end-2009, according to the Banker Top 500 Islamic Institutions, Islamic banking assets are mostly concentrated in Iran (36%), followed by Saudi Arabia (16%), Malaysia (10%), UAE (10%), Kuwait (8%) and Bahrain (6%). Region-wise, the 5 GCC countries hold the most Islamic banking assets with 43%. Top 7 countries account for 89% of global Islamic banking assets. Having grown by 15%-20% p.a. on average over the past decade to about US$780 billion in 2009 from around US$150 billion in the mid-1990s, Islamic banking assets are expected to expand by more than 20% in 2010 to reach US$956 billion to contribute more than 80% to IFSI assets.
RESILIENCE OF ISLAMIC BANKING AMIDST THE GLOBAL FINANCIAL CRISIS

Apart from intrinsic stabilisers and in-built shock absorbent mechanisms, other main contributing factors to the resilience of Islamic banking during the 20082009 global financial crisis:
Credit portfolios are mostly domestic concentration of credit portfolios in domestic customers Focus on retail banking rather low risk of a bank run due to high consumer loyalty and deposit stability Most Islamic banks are highly capitalised and have ample liquidity limited risk of solvency or crisis of confidence among counterparts in the interbank money market
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SELECTED IFSI SEGMENT : ISLAMIC CAPITAL MARKET
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VIBRANCY OF ISLAMIC CAPITAL MARKET

Islamic capital market which comprises equity, Sukuk and derivatives markets, remains the fastest growing IFSI segment globally with a CAGR of 40%. Current Islamic capital market assets are estimated to be worth US$130 billion. While the derivatives market has lagged far behind the other 2 Islamic capital market subsets, the Sukuk market assets saw a CAGR of between 10%-15% over the past decade to hit approximately US$100 billion at present. Based on Zawyas Sukuk Quarterly Bulletin for the 3Q2010, some US$27.857 billion were raised worldwide via Sukuk issuance during the first 9 months of 2010, a 62% jump from a year ago. Global Sukuk issuance is expected to top the US$30 billion mark by end-2010 and could even exceed the all-time high of US$35.5 billion set in 2007 in the best-case scenario given:
continuous global economic recovery despite at a much slower pace since the 2H2010 more sovereign issues expected reflecting continued Government fundraising to finance fiscal spending and for benchmarking purposes still low levels of interest rates despite monetary tightening or normalisation process in developing Asia while most developed economies maintain record low interest rates gradual private investment revival
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VIBRANCY OF ISLAMIC CAPITAL MARKET (continued)

In some jurisdictions such as Malaysia, the Sukuk market is even much bigger than the conventional bond market, reflecting increasing investor appetite and demand for Shariah-compliant assets. In fact, Malaysia has the worlds largest Sukuk market, in both denominations combined (MYR and non-MYR). As at end-June 2010, Malaysias local currency Sukuk outstanding stood at RM246.5 billion or equivalent to US$76.42 billion. Whether from the perspectives of issuers or investors, the Sukuk yield seems more attractive than its conventional counterpart. In general, investors are more eager to grab Islamic offerings rather than their conventional peers as evidenced by the customary high over-subscription for new Sukuk issues.
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EVOLUTION OF SUKUK
1990
Introduction & market familiarisation Development of markets, players & products Very limited growth Confined to some countries only e.g. Malaysia Limited structures (debt bonds): * Bai Bithaman Ajil * Murabahah * Qard Hasan
2000
2004
Acclelerated growth in market size & players Broader & deeper market Better market understanding Innovative & new product structures (non-debt) * Mudharabah, Musharakah * Islamic ABS * Istisna-Ijarah * Convertible Sukuk * Exchangeable Sukuk
2008 and beyond
Better growth in market size players Additional product features/structures: * Istisna * Salam * Ijarah * Intifa Intoduction of Sukuk in the global market * Malaysia Global Sukuk (2002) * Qatar Global Sukuk (2003) Stronger growth of the Sukuk market globally
Maturing & globalisation More breadth & depth More accelerated growth Moving towards globally accepted & highly competitive structures Activating the secondary market for Sukuk More & more product innovation Unlocking new asset classes Development of Sukuk yield curve & pricing benchmark
Source: Securities Commission Malaysia
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WHY CHOOSE ISLAMIC SECURITIES?

Islamic securities are increasingly gaining popularity as the preferred financing option in view of the following benefits or appeal factors in general: Cost effectiveness
Better yield given greater demand from a wider investor base and lower cost of funds. Spread differentials are by about 15-30 bsp. No stamp duty. Lower all-in costs Tax deduction for issuers Tax neutrality for SPVs An array of Shariah contracts to cater to varying investors risk appetites Larger investor base, both local & global players
Tax incentives (for both issuers and investors) Flexibility Diverse investor base Greater transparency Enhanced security for investors
Obligation of full disclosure to investors Prohibition of excessive leveraging Collateralized or backed by assets
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MOVING FORWARD
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CHALLENGES
Lack of coordination and policy synchronisation between authorities within and across jurisdictions e.g. between the Government (Ministry of Finance), the central bank/monetary authority and the securities regulator of a country; overlapping activities among the existing major international infrastructure institutions such as the IDB, IFSB, AAOIFI, IIFM, etc Achieving greater harmonisation and convergence across jurisdictions in terms of products & services, practices and systems could be a daunting task given diversity in Shariah interpretations and opinions arising from the existence of different mazhab or schools of thought in the Muslim world. To bridge this gap:
The need for a global authority for Shariah matters or at least a universally accepted Shariah governance framework? Implementation of mechanisms to ensure greater acceptance of Islamic financial products and services across jurisdictions
wider cross-country representation on the Shariah committees or Shariah supervisory boards (SSBs) of Islamic financial institutions e.g. the presence of more Shariah scholars from the Middle East in the SSB of Malaysian financial institutions further financial sector liberalisation measures that allow entry of more Islamic financial institutions from other jurisdictions e.g. opening of the Malaysian financial sector that allows entry of more Islamic banks from the Middle East
CHALLENGES (continued)
Given the specialist nature of Islamic finance, the IFSI requires well-trained and high calibre workforce with specific skills sets to cater to specificity of Islamic finance. The global IFSI suffers from a shortage of Islamic finance talents at almost all levels especially the middle and senior management. The IFSI in particular Islamic financial institutions face the difficulty of building a talent pool with the right combination of knowledge in Islamic law and modern finance while addressing the issue of poaching by competitors within the country and other aspiring Islamic financial hubs given their lucrative remuneration packages. The IFSI needs to find the most effective ways of how to attract, retain and develop Islamic finance experts.
Shortage of Shariah scholars with adequate financial acumen or expertise required to apply Shariah law to financial products & services Shortage of financial experts with adequate Shariah knowledge to accelerate product innovation
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Market related issues that could hamper growth of the IFSI
Inexistence or limited existence of a secondary market in many jurisdictions although growing, the secondary market for Islamic securities/financial instruments in particular Sukuk remains generally sparse, illiquid and inactive due to the tendency to hold them until maturity. Virtual absence of a domestic Islamic money market as well as practical and tradable Shariah compliant short-term money instruments for both monetary operations (as a transmission channel for the implementation of central banks monetary policy) and liquidity management of Islamic financial institutions in many jurisdictions. Controversy surrounding most derivatives contracts among Shariah scholars in some jurisdictions in particular in the Middle East although nobody can deny how crucial Shariah compliant derivatives instruments for liquidity management and hedging purposes. Hence, the establishment of a joint working group in 2006 between the International Swaps and Derivatives Association (ISDA) and IIFM towards creating a standardised master agreement for Shariah compliant derivatives transactions with the hope of reaching a common ground eventually.
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Absence of conducive legal and regulatory environment as well as supportive tax framework in many countries with keen interest in Islamic finance.
No enabling legislation that allows and facilitates activities of Islamic financial institutions. In early Nov 2010, the Kerala High Court ruled the legal impossibility for banks in India or their branches abroad to undertake Islamic banking activities. Absence of tax neutrality regime to facilitate Islamic financial transactions in some jurisdictions.
A far-reaching shift in product development and innovation model towards conception of original and unique Shariah based Islamic financial products and services from merely a re-engineering of conventional financial products and services (adapted and modified just to meet Shariah requirements and circumvent its prohibitions) i.e. Shariah compliant financial products and services that mimic or replicate or mirror their conventional peers. Product innovation and sophistication or Islamic financial engineering based on market dynamics should constantly:
Meet the ever-changing customer needs and expectations of all walks of life without compromising adherence to Shariah rules and principles Offer an increasingly diversified range of competitively priced, cost-effective, reliable and high quality Shariah compliant financial solutions
Although the number of Muslims is estimated to total around 1.57 billion or equivalent to about 22.9% of the worlds population at present, the size of the IFSI is only a fraction of the global financial system as most Islamic financial institutions have small capital structure. The presence of more highly capitalised Islamic financial institutions will contribute positively to the soundness and stability of the financial system as a whole. In a highly competitive environment, being big may translate into:
Larger economies of scale, better cost-efficiency, greater capacity (deeper pockets) to finance larger and riskier projects Greater capability to innovate due to more extensive financial muscles Increased potential for regional or even global expansion Increased ability to withstand systemic occurrences such as a bank run
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EMERGING MEGAMEGA-TRENDS IN ISLAMIC FINANCE

Battle of deposits in particular the pursuit of current and savings accounts (CASA) and other types of low-cost deposits as a cheaper funding source for Islamic banks and a shield against risk of liquidity crunch, which was encountered at the height of the global financial crisis in 2008-2009 when banks were reluctant to lend to each other in the interbank market. With more Islamic financial institutions of diverse backgrounds joining the bandwagon, the ensuing heightened level of competition should benefit customers particularly in terms of pricing and variety of Islamic financial products and services. Promoting Islamic finance as ethical and responsible finance and/or socially responsible investing (SRI) as a next stage to reach non-Muslim clientele especially in the Western world, as a response to concerns among some nonMuslims over the terms Islamic and Shariah as well as to build the bridges between Islamic finance and conventional finance with emphasis on:
fairness and justice concepts wealth preservation and sustainable development for the benefit of humankind other social, moral and humanitarian values
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EMERGING MEGAMEGA-TRENDS IN ISLAMIC FINANCE (continued)

Leveraging on the immense opportunities of the halal food industry, estimated to be worth US$640 billion currently and anticipated to make up at least 20% of the worlds food product trade in the near future. The so-called halal industry should incorporate both food and non-food including Islamic finance to enable halal end-to-end processes. Increasing popularity of microfinance or financing for SMEs and microenterprises among Islamic banks especially as an entry point to penetrate into new non-key traditional Islamic finance markets with sizeable Muslim populations in Asia and Africa given their large portion of low-income group capitalising on the underbanked or underserved segment of the population that may have shunned (conventional) financial services all this while partly because of the religious reasons. Since only 5% of low-income households worldwide have access to financial services, Islamic banks, through microfinance will help achieve greater financial inclusion, which is one of the essential pre-requisites for creating a balanced and sustainable economic development. Out of 8 Millennium Development Goals that the World Bank introduced in September 2000, at least three, namely Eradicating Extreme Poverty and Hunger, Promoting Gender Equality and Empowering Women and Developing a Global Partnership for Development can be achieved through increased financial inclusion.
EMERGING MEGAMEGA-TRENDS IN ISLAMIC FINANCE (continued)

Gradual phase-out of Bai Inah and Tawarruq contracts in developing products and services, to replace Musharakah Mutanaqisah or Ijarah applicable. Bai Inah-like contracts while minimising universally acceptable Islamic financial with alternatives such as Murabahah, Muntahia Bittamleek or Wakalah where
More in-depth studies and research work to prove that equilibrium is possible in an interest-free open economy i.e. in an economy where there are no interestbearing assets, only equity shares exist while all financial arrangements are based on risk and reward sharing. In this model, since all financial assets are contingent claims that represent ownership claims to real capital i.e. no debt instruments with fixed and/or predetermined rates of return, return to financial assets must be determined by return of the real economy.
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THE ISLAMIC FINANCE AND GLOBAL FINANCIAL STABILITY REPORT

The Islamic Finance and Global Stability Report published in April 2010 highlighted 3 key areas of priority to further strengthen and enhance the IFSI:
Strengthening the infrastructural building blocks of the IFSI to further enhance its resilience Accelerating the effective implementation of Shariah and prudential standards & rules to facilitate the creation of a more stable, efficient and internationally integrated IFSI Creating a common platform for the regulators of the IFSI to enhance constructive dialogue
Strengthening Islamic financial infrastructure

Comprehensive set of cross-sectoral prudential standards and supervisory framework Development of a robust national and international liquidity management infrastructure Strengthening financial safety nets Shariah-compliant lender of last resort facilities, emergency financing mechanisms and deposit insurance
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THE ISLAMIC FINANCE AND GLOBAL FINANCIAL STABILITY REPORT (continued)

Effective crisis management and resolution framework Bank insolvency laws and the arrangements for dealing with non-performing assets, asset recovery and bank restructuring as well as bank recapitalisation Accounting, auditing and disclosure standards, supported by adequate governance arrangements Development of the macro-prudential surveillance framework and financial stability analysis Strengthening rating processes by re-examining and improving the related core processes to encourage greater transparency on the risks involved Capacity building and talent development
Accelerating effective implementation

Implementation of prudential standards issued by the IFSB Mutual understanding of Shariah views on key issues across jurisdictions Emphasis for Islamic finance to be a more inclusive system within a broader Islamic financial ecosystem
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THE ISLAMIC FINANCE AND GLOBAL FINANCIAL STABILITY REPORT (continued)

Establishment of a platform for constructive dialogues
A strategic forum for conducive and constructive dialogues among regulators/supervisors and other stakeholders of the international Islamic financial system in particular Islamic financial institutions
Page 47

Wassalam

Thank You
The information contained in this presentation may be meaningful only with the oral presentation and is of the personal view of the presenter and does not necessarily represent an official opinion of Bank Islam Malaysia Berhad. For further information, please contact: Azrul Azwar Ahmad Tajudin Chief Economist Strategic Planning, Managing Directors Office Bank Islam Malaysia Berhad Email: azrulazwar@bankislam.com.my Direct Line: +603-20888075

OverviewOfIslamicFinance 13122010

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OverviewOfIslamicFinance 13122010

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OVERVIEW OF ISLAMIC FINANCE

BY AZRUL AZWAR AHMAD TAJUDIN CHIEF ECONOMIST

ISLAMIC FINANCE COURSE : STRUCTURE & INSTRUMENTS

STRICTLY PRIVATE & CONFIDENTIAL

RISK MANAGEMENT FOR ISLAMIC FINANCIAL INSTITUTIONS

PAST, PRESENT AND FUTURE

SELECTED IFSI SEGMENT: ISLAMIC CAPITAL MARKET

ISLAMIC FINANCE COURSE 13-17 DECEMBER 2010

FINANCE AND ISLAM

ISLAMIC FINANCE COURSE 13-17 DECEMBER 2010

ESSENCE OF ISLAMIC FINANCE

ISLAMIC FINANCE COURSE 13-17 DECEMBER 2010

ESSENCE OF ISLAMIC FINANCE (continued)

ISLAMIC FINANCE COURSE 13-17 DECEMBER 2010

INHERENT FEATURES OF THE IFSI AND ITS STABILITY AND RESILIENCE

Shariah values consistent with universal values

ISLAMIC FINANCE COURSE 13-17 DECEMBER 2010

MILESTONES OF SHARIAH CONTRACT APPLICATION

Note - This listing is far from being exhaustive.

ISLAMIC FINANCE COURSE 13-17 DECEMBER 2010

RISK MANAGEMENT FOR ISLAMIC FINANCIAL INSTITUTIONS

ISLAMIC FINANCE COURSE 13-17 DECEMBER 2010

FOUR GENERIC RISKS AND FOUR UNIQUE RISKS

ISLAMIC FINANCE COURSE 13-17 DECEMBER 2010

UNIQUE RISKS FOR ISLAMIC FINANCIAL INSTITUTIONS

ISLAMIC FINANCE COURSE 13-17 DECEMBER 2010

SHARIAH NONNON-COMPLIANCE RISK

Enforceability and validity risk of contracts particularly in the event:

PAST, PRESENT AND FUTURE

ISLAMIC FINANCE COURSE 13-17 DECEMBER 2010

EVOLUTION OF THE IFSI : EARLY DAYS

EVOLUTION OF THE IFSI : PRESENT DAY

EVOLUTION OF THE IFSI: BEYOND NATIONS WITH LARGE MUSLIM POPULATIONS

Burgeoning interest in Islamic finance over the past decade among:

EVOLUTION OF THE IFSI: WHAT THE FUTURE HOLDS

Source: GIFF Report 2010

EVOLUTION OF THE IFSI : WHAT THE FUTURE HOLDS (continued)

Fast growth Saturation

ISLAMIC FINANCE COURSE 13-17 DECEMBER 2010

COMPOSITION OF THE IFSI

ISLAMIC FINANCE COURSE 13-17 DECEMBER 2010

ISLAMIC FINANCIAL SYSTEM: CASE OF MALAYSIA

Islamic Interbank Money Market

Islamic Asset/Fund Management

Islamic Capital Markets

ISLAMIC FINANCE COURSE 13-17 DECEMBER 2010

GLOBAL IFSI ARCHITECTURE: INTERNATIONAL ISLAMIC FINANCIAL INFRASTRUCTURE

GLOBAL IFSI ARCHITECTURE: INTERNATIONAL ISLAMIC FINANCIAL INFRASTRUCTURE (continued)

GLOBAL IFSI ARCHITECTURE: INTERNATIONAL ISLAMIC FINANCIAL INFRASTRUCTURE (continued)

United Arab Emirates:

ISLAMIC FINANCE COURSE 13-17 DECEMBER 2010

SELECTED IFSI SEGMENT : ISLAMIC BANKING

ISLAMIC FINANCE COURSE 13-17 DECEMBER 2010

FUNDAMENTALS OF ISLAMIC BANKING

OVERVIEW OF ISLAMIC BANKING ACTIVITIES

ISLAMIC FINANCE COURSE 13-17 DECEMBER 2010

REVIEW OF GLOBAL ISLAMIC BANKING

10.0% 10.0% 16.0%

Source: GIFF Report 2010

RESILIENCE OF ISLAMIC BANKING AMIDST THE GLOBAL FINANCIAL CRISIS

ISLAMIC FINANCE COURSE 13-17 DECEMBER 2010

SELECTED IFSI SEGMENT : ISLAMIC CAPITAL MARKET

ISLAMIC FINANCE COURSE 13-17 DECEMBER 2010