Overview of Islamic Finance

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
Page 3
FINANCE AND ISLAM
Page 4
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.
Page 5
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
Page 6
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
Page 7
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
Different
contractual
relationships
Equity-based
Risk and reward sharing
which helps ensure greater
market discipline
Prohibition of unethical elements,

practices and activities e.g. hoarding
Prohibition of maisir (gambling), riba
(usury), zulm (oppression)
Emphasis on fairness and justice
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.
Page 8
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).
Page 9
MILESTONES OF SHARIAH CONTRACT APPLICATION
1983-1990
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
1991-2000
Sarf Forex
Mudharabah Interbank
Investment
Musharakah Financing
Bay Inah Credit Card
2001-2005
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)
2009
onwards
2006-2008
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
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
Note - This listing is far from being exhaustive.
Page 10
RISK MANAGEMENT FOR

ISLAMIC FINANCIAL
INSTITUTIONS
Page 11
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
Page 12
UNIQUE RISKS FOR ISLAMIC FINANCIAL INSTITUTIONS

Types of risks
Definition
Shariah non-compliance
risk
Risk arises from the failure to comply with the Shariah rules and
principles
Rate of return risk
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.
Page 13
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
Page 14
PAST, PRESENT AND FUTURE
Page 15
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
Page 16
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
Page 17
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
Page 18
EVOLUTION OF THE IFSI: WHAT THE FUTURE HOLDS

BREAKDOWN OF SHARIAH-COMPLIANT ASSETS
(AS AT END-2009)
5.50%
11.70%
0.70%
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.
Page 19
EVOLUTION OF THE IFSI : WHAT THE FUTURE HOLDS (continued)

Maturity Curve of the IFSI
Fast
growth
Measure or
success or
profitability
Saturation
High
Take off
Maturity
Medium
Early start
Islamic finance probably

stands here; best time in
terms of business
development as relatively
still early in the fast
growth phase
Low
1960
1970
2000
20xx
Page 20
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
Page 21
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
Derivatives

Islamic Profit Rate

Swap
Islamic Foreign
Exchange Swap
Islamic CrossCurrency Swap
Page 22
Equity

Islamic Capital
Markets
Debt
Islamic Unit Trusts

Islamic REITs
Islamic Stockbroking
Islamic Indexes
Shariah Compliant
Securities
Islamic Securities
Islamic Medium
Term Notes
Islamic
Commercial
Papers
Exchangeable
Sukuk
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
Page 23

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
Page 24

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
Page 25
SELECTED IFSI SEGMENT :

ISLAMIC BANKING
Page 26
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
Page 27
OVERVIEW OF ISLAMIC BANKING ACTIVITIES
Page 28
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%
36.0%
8.0%
10.0%
10.0%
Iran
Saudi Arabia
Malaysia
UAE
Kuwait
16.0%
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.
Page 29
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
Page 30
SELECTED IFSI SEGMENT :

ISLAMIC CAPITAL MARKET
Page 31
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
Page 32
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.
Page 33
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
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
2008 and beyond
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
Page 34
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
Tax incentives (for both

issuers and investors)
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
Flexibility
An array of Shariah contracts to cater to varying

investors risk appetites
Diverse investor base
Larger investor base, both local & global players
Greater transparency
Obligation of full disclosure to investors

Prohibition of excessive leveraging
Enhanced security for

investors
Collateralized or backed by assets
Page 35
MOVING FORWARD
Page 36
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
Page 37
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
Page 38
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.
Page 39
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
Page 40
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
Page 41
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
Page 42
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.
Page 43
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.
Page 44
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
Page 45

(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
Page 46

(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
Page 48

Overview of Islamic Finance

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OVERVIEW OF ISLAMIC FINANCE

BY AZRUL AZWAR AHMAD TAJUDIN

ISLAMIC FINANCE COURSE : STRUCTURE & INSTRUMENTS

STRICTLY PRIVATE & CONFIDENTIAL

RISK MANAGEMENT FOR ISLAMIC FINANCIAL INSTITUTIONS

PAST, PRESENT AND FUTURE

Evolution of the IFSI: Early Days

ISLAMIC FINANCE COURSE 13-17 DECEMBER 2010

Fundamentals of Islamic Banking

SELECTED IFSI SEGMENT: ISLAMIC CAPITAL MARKET

ISLAMIC FINANCE COURSE 13-17 DECEMBER 2010

FINANCE AND ISLAM

ISLAMIC FINANCE COURSE 13-17 DECEMBER 2010

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

Prohibition of unethical elements,

Greater transparency & disclosure:

ISLAMIC FINANCE COURSE 13-17 DECEMBER 2010

INHERENT FEATURES OF THE IFSI AND ITS STABILITY AND RESILIENCE

ISLAMIC FINANCE COURSE 13-17 DECEMBER 2010

MILESTONES OF SHARIAH CONTRACT APPLICATION

Wadiah Current Account

Bay Dayn, Musharakah,

Note - This listing is far from being exhaustive.

ISLAMIC FINANCE COURSE 13-17 DECEMBER 2010

RISK MANAGEMENT FOR

ISLAMIC FINANCE COURSE 13-17 DECEMBER 2010

FOUR GENERIC RISKS AND FOUR UNIQUE RISKS

Shariah non-compliance risk

ISLAMIC FINANCE COURSE 13-17 DECEMBER 2010

UNIQUE RISKS FOR ISLAMIC FINANCIAL INSTITUTIONS

Rate of return risk

The potential impact on the returns caused by unexpected change

ISLAMIC FINANCE COURSE 13-17 DECEMBER 2010

SHARIAH NONNON-COMPLIANCE RISK

Enforceability and validity risk of contracts particularly in the event:

ISLAMIC FINANCE COURSE 13-17 DECEMBER 2010

PAST, PRESENT AND FUTURE

ISLAMIC FINANCE COURSE 13-17 DECEMBER 2010

EVOLUTION OF THE IFSI : EARLY DAYS

The institutional development of Islamic finance in particular its banking segment

Islamic Development Bank in 1974

ISLAMIC FINANCE COURSE 13-17 DECEMBER 2010

EVOLUTION OF THE IFSI : PRESENT DAY

ISLAMIC FINANCE COURSE 13-17 DECEMBER 2010

EVOLUTION OF THE IFSI: BEYOND NATIONS WITH LARGE MUSLIM

Burgeoning interest in Islamic finance over the past decade among:

ISLAMIC FINANCE COURSE 13-17 DECEMBER 2010

EVOLUTION OF THE IFSI: WHAT THE FUTURE HOLDS

Source: GIFF Report 2010

ISLAMIC FINANCE COURSE 13-17 DECEMBER 2010

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

Islamic finance probably

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 Profit Rate

Islamic Unit Trusts