Islamic Finance Within Conventional Banking System – Opportunities and Challenges

Islamic Finance Within Conventional Banking System – Opportunities and Challenges

Overview of Islamic Finance


Islamic Finance – Success Recipe

Models for Establishing Islamic Finance

Islamic Finance Window Operations

1. Islamic Finance Within
Conventional Banking
System – Opportunities
and Challenges
02 July 2010
III Astana Economic Conference
By
Musa Abdul Malek
Executive Director and CEO HSBC AMANAH Malaysia

2. 2
Islamic Finance Window Operations
Models for Establishing Islamic Finance
Islamic Finance – Success Recipe
Overview of Islamic Finance

CONTENTS
Challenges in Islamic Finance

3. 3
OVERVIEW OF ISLAMIC FINANCE

4. 4
OVERVIEW OF THE ISLAMIC FINANCE INDUSTRY
Each region is contributing
in a unique way
…with worldwide
momentum from retail to
regulator involvement
Examples
Malaysia’s Islamic Banking
Act 1983 and the Banking &
Financial Institutions Act
1989 are enacted as
separate statutes
Kuwait adopted a new
regulatory framework for
Islamic finance in 2003, by
introducing a new section
into the Central Bank Law
of 1968
Iran
Government
driven
Market
driven
Saudi Arabia
Malaysia
United Arab
Emirates
Bahrain
Kuwait
Indonesia
Brunei
USA
Pakistan
Sudan
Qatar
Singapore
Bangladesh
Oman
Turkey
Egypt
Sri Lanka
South Korea
China
HIGH
LOW
Japan
Hong Kong
Asia-Pacific Middle East Others
UK
HIGHLOW
Note: Circle sizes denote estimated size of the Islamic financial market in these respective countriesSource: HSBC Amanah, Illustrative Comparison Model for the development of Islamic Markets and
Regulations

5. 5
OVERVIEW OF ISLAMIC FINANCE
Islamic
Finance In The
Last 30 Years
Islamic finance has followed in the wake of innovations in the
global financial services industry
A natural progression of the Islamic finance industry:
– competitive retail offerings
– sophisticated corporate banking products
– innovative project finance solutions
1970s
commercial
banking
1980s
commercial
banking
project
finance &
syndications
1990s
commercial
banking
project
finance &
syndications
equity
Ijarah
2000s
commercial
banking
project finance &
syndications
equity
Ijarah
sukuk al ijarah
structured
alternative
assets
2005+
commercial
banking
project finance &
syndications
equity
Ijarah
sukuk al ijarah
structured
alternative assets
liquidity
management tools

6. 6
9458
10073
11661
1476
1675
2027
0
2500
5000
7500
10000
12500
15000
2007 2008 2012
Conventional (UK) Conventional (non UK) Islamic
267
366
605
500
1500
262
235.0
67.0
76.0
0
200
400
600
800
1000
1200
1400
1600
2007 2008 2012E
Islamic AssetsGCCIranMalaysiaOthers
 Of the total 1.6 billion Muslims globally, there
are approximately 640 million in tier 1 & 2
markets.
 Today, there are more than 390 Islamic banks
and institutions spread across 75 countries.
Total Global Islamic banking assets growth (USD bn)
CAGR 28%
CAGR 20%
2

640
Banking Assets in key markets (USD bn)
37%
7%
Sources: The Banker, Oliver Wyman
1 2007 – 2008 asset figures are based from The Banker
2 Oliver Wyman growth estimates

2
ECONOMIC GROWTH IN SOME GEOGRAPHIES
Prioritization Country
Total
Population (m)
(% Muslim)
GDP (% real
change per
annum)
2008 2009f 2010f 2011f 2012f
(Tier 1)
Saudi Arabia 24 (99%) 4.3 -0.1 3.9 5.9 5.2
UAE 5.2 (76%) 7.0 -1.2 4.3 6.4 6.1
Malaysia 26 (60%) 4.6 -3.8 6.3 6 6.0
Tier 2
Qatar 1.2 (77%) 15.2 9.8 8.8
2
9.4 7.5
Bahrain 1.0 (98%) 8.1 5.6 6.0
2
5.4 5.0
Pakistan 176 (97%) 0.6 2.4 2.9 4 4.0
Indonesia* 240 (88%) 6.1 3.8 5.3 6.2 6.1
Brunei 0.4 (64%) 0.6
1
na na Na Na
UK 61 (3%) 0.7 -3.8 1.6 1.8 2
Bangladesh 29 (88%) 6.22 6.02 6.22 6.5 6.4
Egypt 75 (85%) 7.2 4.3 4.1 6.4 7
Tier 3
Turkey 77 (97%) 1.1 -4.4 2.0 3.5 6
China 1300 (2%) 9 8.5 9 8.5 8.5
India 1100 (13%) 7.5 6 7.5 7.2 7.2
Iraq 29 (97%) na na na na na
Source: HSBC Group economic forecast.
INDUSTRY COMMENTATORS SEE ISLAMIC FINANCE INDUSTRY CONTINUING ITS RAPID GROWTH
Note: Key markets include Tier 1 and 2 markets
Source: The Banker, Central Bank Reports
13%
4%

1
13%
5%

7. 7
35
57
0
10
20
30
40
50
60
70
2008 2012E
3364
3768
6000
0
1000
2000
3000
4000
5000
6000
7000
8000
9000
10000
2007 2008E 2012E
420
562
1000
0
100
200
300
400
500
600
700
800
900
1000
2007 2008E 2012E
175
213
470
0
100
200
300
400
500
600
700
800
900
1000
2007 2008E 2012E
CAGR 22%
Islamic Retail Banking Assets (USD bn)
Islamic Wholesale Banking Assets (USD bn)
CAGR 19%
Source: Oliver Wyman
Note: Wholesale includes corporates, wealth funds and private clients.
CAGR 12%
Global Islamic Mutual Fund Assets (US bn)
Islamic Gross Takaful Contributions (USD m)
CAGR 12%
RISING ISLAMIC PENETRATION WITH GROWTH ACROSS DIFFERENT
INDUSTRY SECTORS
Source: Oliver Wyman
Source: Ernst & Young Source: Cerulli Associates Report
Penetration rates
2007 -2008
2008 -2012
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
0 20 40 60 80 100 120 140 160 180 200
Islamic Banking Assets (US bn)
I
s
l
a
m
i
c

B
a
n
k
i
n
g

P
e
n
e
t
r
a
t
i
o
n
UAE
Bahrain
Malaysia
Kuwait
Qatar
Indonesia
Pakistan
Egypt
Brunei
Bangladesh
Saudi Arabia
Sources: Oliver Wyman, Morgan Stanley, McKinsey, Zawya, Central Bank Reports
Being validated bottom up
with Countries

8. 8
ISLAMIC FINANCE – SUCCESS RECIPE

9. 9
ISLAMIC FINANCE PROPOSITION – Success Recipe
Success
Recipe
Majority or good percentage of population are Muslim
Market have strong demand for Shariah proposition but no issue to
consider conventional
Government resolute in pursuing Islamic finance agenda and
introduce conducive regulatory framework eg. Tax, legal etc.
Central Bank able to regulate Islamic financial institutions
Decide and provide guidelines on Shariah issues
Treatment of balance sheet - segregating or co-mingling
Provide framework to support and regulate the institutions
One stop centre to resolve issues by industry players
Sufficient talent to manage the business both the Shariah scholars
and practitioners

10. 10
MODELS FOR ESTABLISHING ISLAMIC FINANCE

11. 11
VARIOUS MODELS FOR CONSIDERATION
Comprehensiv
e infrastructure
to support the
business
License only to do
Islamic finance
business
Stand Alone
Islamic Finance
Islamic
Subsidiary
Leverage
infrastructure
from the parent
infrastructure
Separate Board
of Directors
Subsidiary of the
existing conventional in
the country
Supervise the
operations to
ensure Shariah
compliance
Using the main
Bank
infrastructure
to support the
business
Structure
Islamic
products for
distribution by
conventional
branches
A division within
the existing
conventional bank
Islamic window

12. 12
ISLAMIC WINDOW OPERATIONS

13. 13
ISLAMIC ‘WINDOWS’ OPERATIONS
Windows
Operations
A division within the conventional bank
Preferably to be headed by a Muslim
Need to set up Shariah Committee and Shariah department to ensure
business undertaken is Shariah compliance
Minimum to have own product development team and dedicated IT team
Sharing the same system platform – tweak to meet with Shariah
Accounting treatment eg. penalty fee not compounded
Wordings on the statement and advises must be Shariah
compliance
Leverage from existing infrastructure thus cost to do the business is
lower
Preferable for the balance sheet to be separated

14. 14
ISLAMIC ‘WINDOWS’ OPERATIONS
Windows
Operations
ADVANTAGES
•Sharing the same infrastructure
•Sharing the same system platform – tweak to meet with Shariah
•Cost to do the business is lower
•Inclusive proposition
DISADVANTAGES
•Always guided by the conventional banking way
•Business requirements may conflict with Shariah
•CHALLENGES
•Awareness on Islamic finance amongst the internal customers is low
•Shariah compliance to be the main driver for the business
•Potential canabalising the conventional business

15. 15
CHALLENGES IN ISLAMIC FINANCE

16. 16
CHALLENGES IN ISLAMIC FINANCE
Challenges
Strategy and Plan to develop the right
business model
Willingness to invest in Human
Capital Development
Information system to cater to Islamic
Finance transactions
Replication v. Authenticity
Comprehensive Shariah Governance
& Audit *
Meeting evolving consumers’ demand
Risk Management*
Legal, Regulatory & Accounting
Framework*
Wealth Management

17. 17
SHARIAH GOVERNANCE AND FRAMEWORK

18. 18

Islamic Financial Services Board (IFSB) Guiding Principles of Risk Islamic Financial Services Board (IFSB) Guiding Principles of Risk
Management indicates:Management indicates:

Shariah Compliance is categorised as higher priority in relation to Shariah Compliance is categorised as higher priority in relation to
identified risks and;identified risks and;

There must be a comprehensive and sound Shariah Compliance There must be a comprehensive and sound Shariah Compliance
framework and mechanism in place.framework and mechanism in place.
SHARIAH COMPLIANCE IS FUNDAMENTAL IN
ISLAMIC BANKING AND FINANCIAL INSTITUTIONS
IFSB

19. 19
The business of the Company will be transacted in
ACCORDANCE with the :
MEMORANDUM & ARTICLES OF ASSOCIATION OF MOST
ISLAMIC FINANCE INSTITUTIONS PROVIDE:
Islamic
Principles Rules Practices
In this respect, the Company is PROHIBITED from
carrying out any transactions which involve any
elements that are not in compliance with the Islamic
principles, rules and practices.
Compliance

20. 20
SHARIAH STRUCTURE
Shariah
Committee
Shariah Dept
Internal Policies,
Procedures,
Guidelines, Manuals,
Matrix & Certificates
Shariah
Structure
Term Of Reference of Shariah
Committee
Rulings of Shariah Committee
Shariah Advisory & Development
Shariah Compliance & Review
Shariah Research
Shariah Compliance Manual
Guidelines on the Shariah Committee
Shariah Compliance Certificate
Guidelines on Services & Transactions

21. 21
LEGAL, REGULATORY & ACCOUNTING FRAMEWORK

22. 22
LEGAL, REGULATORY & ACCOUNTING FRAMEWORK
Legal
Need a Robust
Structure
Regulatory
Flexible yet
decisive
Accounting
AAOFI vs IFRS

23. 23
LEGAL FRAMEWORK – Need a robust structure
Ensure compliant with Shariah but yet enforceable under
applicable secular law
Current transactional practise with respect to existing
legal opinion
- Different islamic jurisprudence interpret Shariah differently
- Lack of binding precedents and published decision
- Is Shariah compliance considered in judgement eg Zulkifli vs Affin Bank (Malaysia),

Investment Dar vs Lebanon Blom Bank
Untested certainty/predictability for Shariah compliant
transactions in different jurisdiction
Willing to change to accommodate Shariah requirements
eg. legal ownership over home financing if structure
based on Ijarah or Musyarakah
Legal

24. 24
REGULATORY FRAMEWORK – Flexible yet decisive
Willing to change the act to accommodate Islamic
Finance
- Land Code
- Tax issue eg. VAT, property gain tax
Propose to adopt tax neutrality
Regulatory

25. 25
ACCOUNTING FRAMEWORK (AAOIFI vs IFRS)
Accounting 1
AAOIFI
Develop the accounting, auditing and banking practices through
relating to the activities of the Islamic Financial Institutions (IFIs)
Prepare, promulgate and interpret accounting and auditing
standards for IFIs in order to harmonize the accounting
practices and auditing procedures
Review and amend the accounting and auditing standard for IFIs
to cope with developments in the accounting and auditing
through practices

26. 26
ACCOUNTING FRAMEWORK (AAOIFI vs IFRS)
Accounting 2
IASC Foundation and IASB
To develop a single set of high quality, understandable,
enforceable and globally accepted international financial
reporting standards (IFRS) through its standard-setting body of
IASB
To promote the use and rigorous application of those standards
To bring about the convergence of national accounting
standards and IFRS to high quality solutions
Main Differences AAOIFI and IFRS
AAOIFI
Specific for Islamic industry
Accounting, Auditing, Ethics, Governance & Sharia
IFRS
Entire economic & social activities
Specific to accounting

27. 27
ACCOUNTING FRAMEWORK (AAOIFI vs IFRS)
Accounting 3
Consideration
Standalone and fully Islamic Group – AAOIFI
Subsidiary with conventional parent – IFRS
Window – IFRS
Rationale for window to adopt IFRS
Consolidation
Accounting treatment eg. Unrestricted investment as a
separate item instead of presented as liabilities (along
with other liabilities) in IFRS

28. 28
RISK IN ISLAMIC FINANCE

29. 29
Credit Risk
Market Risk
Insurance Risk
Sustainability Risk
Liquidity Risk
Pension Fund Risk
Residual Value Risk
Reputation Risk
Operational Risk
RISK MANAGEMENT IS
Accounting
Business Continuity
Fiduciary
Fraud
Information
Legal
Compliance
Operations
People
Tax
Technology
Shariah Risk Management
Embedded within the conventional
business risk management framework
Non-compliance with Shariah rules and
regulations
New product due diligence including
simplification of product complexities
Application of Late Payment / Penalty for
default in a Shariah compliance manner
Advise on debt restructuring
Changes in fatwa resulting in existing
product being non-compliance
Advising / guiding with ongoing Shariah
requirements

30. 30
MAJOR SHARIAH
RISKS
Concentrated reliance on a single
broker for transacting commodity
murabaha (substantial Global
Business is based on this structure)
Untested legal infrastructure (case
laws or court proceedings)
supporting products
Major Risks
Credibility of “Commodity Murabaha”
/ “Tawarruq” structure questionable
Manual Processes increase
operational risks
Lack of inter-bank market creates
challenges in matching assets and
liabilities
Identification of new brokers required
and find alternative to existing
commodity (eg. Bursa Al Sila’)
Using experienced legal counsel for
preparing documentation and
structures
Looking to diversify to other
structures.
To address concerns raised.
Rationalisation of product range.
Long term, automation and
standardisation required
This has to be addressed and
financial linkages required
RISKS ACTIONS

31. Thank You