Joint FEDJoint FED--IMFIMF--WB October 2015 SeminarWB October 2015 Seminar

Challenges in Islamic Bank Challenges in Islamic Bank ggSupervisionSupervisionTuesday October 20 2015

Mohamed Norat (MCM, IMF)

Tuesday, October 20, 20152:00 PM – 3:00 PM

OutlineOutlineOutlineOutline

• What is Islamic Finance

• Islamic Finance growth and geographic dispersion

• Islamic bank balance sheet structure

• Risks in Islamic banks

f• Supervisory and Regulatory Frameworks for Islamic banks

• Policy MessagesPolicy Messages

WHAT IS ISLAMIC FINANCE?WHAT IS ISLAMIC FINANCE?

Islamic finance (IF) refers to the provision of financialservices in accordance with Islamic jurisprudence

CrossCross

j p(Shari’ah)

Cross-Sectoral

• Banking

Cross-Sectoral

• Banking

Products

• Sales with deferred

Products

• Sales with deferred

Principles

• No interest

Principles

• No interest Banking• Leasing• Securities (Sukuk)

& equitiesI t t f d

Banking• Leasing• Securities (Sukuk)

& equitiesI t t f d

Sales with deferred payments

• Lease• Fee-based services

P fit h i

Sales with deferred payments

• Lease• Fee-based services

P fit h i

No interest • Avoid excessive

uncertainty• Asset based

St thi l

No interest • Avoid excessive

uncertainty• Asset based

St thi l • Investment funds• Insurance• Micro-finance

• Investment funds• Insurance• Micro-finance

• Profit-sharing financing

• Profit-sharing financing

• Strong ethical basis

• Strong ethical basis

3

ISLAMIC BANKING IS GROWING RAPIDLY…ISLAMIC BANKING IS GROWING RAPIDLY…

1800

2000

GCC

Islamic Banking Assets Growth Trend (2008-14)($US in billions)

1400

1600 MENA (excl. GCC)Asia

1000

1200

600

800

200

400

4

02008 2009 2010 2011 2012 2013 2014

…TO BECOME SYSTEMIC IN A DOZEN OF COUNTRIES

…TO BECOME SYSTEMIC IN A DOZEN OF COUNTRIESOF COUNTRIES…OF COUNTRIES…

Islamic Finance Markets by Systemic Significance

Systemic Importance

P t ti l S t i I t i Mid t Gi C t G thPotential Systemic Importance in Mid-term Given Current Growth

Present, Non-Systemic

… SUKUK ALSO GROWING WITH INCREASED INTERNATIONALIZATION

… SUKUK ALSO GROWING WITH INCREASED INTERNATIONALIZATIONINCREASED INTERNATIONALIZATIONINCREASED INTERNATIONALIZATION

Global Sukuk Issuance($US in billions)

175

200

700

800 ($US in billions)Sukuk Issued (right scale)

125

150

500

600

75

100

300

400

25

50

100

200

6

002001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

…AND SOVEREIGN SUKUK ISSUANCE 2014-2015 YTD…AND SOVEREIGN SUKUK ISSUANCE 2014-2015 YTD

UK:

LUXEM-

BOURG:$253

2014 2015 YTD2014 2015 YTDPAKISTAN:

$1.5 bn

UK:$343 mn

mn

HONG KONG SAR:$1 bn

TURKEY:$2.4 bn

THE GAMBIA:$16 mn

SENEGAL:

$205 mn BRUNEI:$316 mn

BANGLA-DESH:

$2 mn

UAE: (1)

<$5 bnBahrain:$1.5 bn

$316 mn$2 mn

MALAYSIA:$6.4 bn

Qatar:$3 bn

INDONESIA:$617 mn

7

Sukuk IssuersExpression of Interest

Source: Bloomberg, Gulf News, Rasameel Research.(1) Total sovereign direct borrowing was ~$5.2 billion 2012, a portion of which was Sukuk.

… WHILE THEY ARE INCREASINGLY USED TO FUND INFRASTRUCTURE

… WHILE THEY ARE INCREASINGLY USED TO FUND INFRASTRUCTURETO FUND INFRASTRUCTURETO FUND INFRASTRUCTURE

30,000Total Infrastructure Sukuk Issuance

($US in millions)

25,000

30,000 ($US in millions)

15,000

20,000

5,000

10,000

0

,

001

002

003

004

005

006

007

008

009

010

011

012

013

14E

20 20 20 20 20 20 20 20 20 20 20 20 20 201

8

Islamic v Conventional Balance SheetIslamic v Conventional Balance SheetIslamic v Conventional Balance SheetIslamic v Conventional Balance Sheet

Assets Liabilities

More real asset inventory holdings(real estate, automobiles, commodities)

Demand DepositsNo return on deposits

Investment Assets (Profit Sharing) & Financing Assets-investments in business ventures

Profit Sharing Investment Accounts-Compensated return earned from asset side

-more leasing/rental-more equity structures and instruments-returns contingent on profits

-Profit sharing reserves-Principal not guaranteed

Fee based Services-Charges and fees are important

Capital-mostly equity far less debt instruments

Example - Auto Murabaha Example

RisksRisks• Similar categories of risks between Islamic and conventional banks:

– Credit Risk - Market Risk - Liquidity Risk. – Operational Risk -AML/CFTOperational Risk AML/CFT

• Risks unique to Islamic Banks (additional risks): Displaced commercial risk Rate of return risk– Displaced commercial risk - Rate of return risk

– Equity investment risk - Shariah compliance risk

• Islamic banks need different treatment for: – Liquidity (HQLA limited -run-off, drawdown rates, haircuts)– Exposure limits (greater concentration risk)– Capital Charges (for new instruments, higher for greater

concentration, market risks on commodities)– Risk weights (for new instruments, higher for Islamic, limited hedging)– AML/CFT – Layering makes funds harder to track – more attention

required to KYC and AML/CFT.

Conventional Bank LossesConventional Bank Lossesse

s

U t d l f

Conventional Bank LossesConventional Bank Losses

Pillar 2 and

cyof

loss Unexpected losses from

Pillar 1 Credit, market, &Operational risks

Pillar 2 andLow probabilityHigh Impact lossesTail risk

Freq

uenc Tail risk

Size of lossests

IncomeProvisions Minimum Capital Capital buffers

Insurance

s m

itig

ant

Risk transferDerivativesLo

ss

Islamic bank LossesIslamic bank Lossesse

s

Islamic bank LossesIslamic bank LossesUnexpected losses fromCredit, market, Low probability

cy o

f los

s

Operational risks

Losses from unique Islamic riskIncluding PSIA losses

Low probabilityHigh Impact lossesTail risk

Freq

uenc Including PSIA losses

Size of losses

Fnt

s

Size of losses

IncomeProvisions

CapitalProfit sharing investment account

Capital buffersTakafuls

mit

igan

Profit-sharing reserves Loss sharing

Loss

Quasi-deposits that act as loss-absorbing instruments

ISLAMIC FINANCE OFFERS THE PROMISE OF SUPPORT TO GROWTH & STABILITY

ISLAMIC FINANCE OFFERS THE PROMISE OF SUPPORT TO GROWTH & STABILITYSUPPORT TO GROWTH & STABILITY…SUPPORT TO GROWTH & STABILITY…

Inclusive growth Financial stability

Financial inclusion Less leverageGreater incentive

SME access

Infrastructure

Greater incentive for risk managementInfrastructure

investment Loss-absorbency

13

ISLAMIC FINANCE STANDARD SETTERS ESTABLISHEDSETTERS ESTABLISHED

ISLAMIC CONVENTIONAL

IFSB AAOIFI FSB BCBS

Adaptation

IILMI DB IASBIAISIILMIsDB IASBIAIS

IF ImplicationsIIFMCIBAFI IADIIOSCO

p

14

Regulatory FrameworkRegulatory FrameworkRegulatory FrameworkRegulatory Framework• Need legal framework that recognizes Islamic banking

• Potentially higher capital charges and risk weights to account for complex-layered risks

• Determination of HQLA and set: run off drawdown rates and haircuts• Determination of HQLA and set: run-off, drawdown rates and haircuts for assets

• Decide on NPA definitions for Islamic banks

• Need regulation regarding treatment of loss-absorbent liabilities

• What is appropriate scope of depositor insurance: only demand deposits or PSIA as well?

Capital Adequacy Ratio Example - Capital Adequacy Ratio Example

Supervisory FrameworkSupervisory Framework

Complexities & distinctiveness of Islamic banks call for:

Careful licensing of Islamic bank and products as this poses:

greater governance challenges and greater governance challenges, and

determination of shariah compliance by qualified body

Enhanced disclosure requirements

Additional early warning systems Additional early warning systems

More granular on-site visits to deal with complex layered risks

Need for Training as supervisory capacity & knowledge is weak

Policy ChallengesPolicy Challengesf d df d d(safety and soundness)(safety and soundness)

• Changes to legal accounting LOLR frameworks needed as precondition• Changes to legal, accounting, LOLR frameworks needed as precondition

• Understanding the underlying nature of Islamic Banking:

Does it involve additional risk-taking incentives (given risk sharing)?

In what areas does it warrant different regulatory approach?

• Understanding banking system vulnerabilities – need for greater disclosure:

No consistent set of FSIs that are able to account for Islamic bankNo consistent set of FSIs that are able to account for Islamic bank

specificities

Which indicators should be followed for surveillance purposes? Which indicators should be followed for surveillance purposes?

Auto Murabaha ExampleAuto Murabaha ExampleAuto Murabaha ExampleAuto Murabaha ExampleMurabahaSettled by4

Buyer S llInstallmentsOver Time

12

Buyer Seller

Goods

Murabaha ContractAnd

Purchase orderMark-up

BankBuys and

Stores GoodsFor buyers

1

3

2

GoodsTo buyeragreed

Islamic Bank

Bank buys goods without availability of prospective buyerIslamic v Conventional Balance Sheet

CommodityCommodity--Sale Home ExampleSale Home Example3

4

CommoditySeller Bank

Metal

Spot Cash Payment

3rd party seller

1 5 6

ha ent

age

Deferredpayments

Spot Cash

3 party seller and 3rd party

buyer are often affiliates M

urab

ahA

gree

me

Mor

tga

Tawarruq-MurabahahContract

amount + Profitamount

711

Metal

M l

PurchaserMutawariq

CommodityBuyer

7Metal

Spot Cash Payment8

2Property Purchase Contract Mutawariq

Islamic v Conventional Balance Sheet

PropertySeller

2

Property Payment

Property Purchase Contract

9Property 10

Capital Adequacy Ratio ExampleCapital Adequacy Ratio ExampleIFSB formula for capital adequacy ratios (different from Basel)

• Standard formula:Eligible Capital

[Total RWA (credit + market risks) + Operational risk– RWA funded by PSIA (credit + market risks)]

• Supervisory Discretion Formula (alpha usually 30 percent):

Eligible Capital

[Total RWA (credit + market risk) + Operational risk – RWA funded by RPSIA (credit + market risk) (1 ) RWA f d d UPSIA ( dit k t i k)– (1-α) RWA funded UPSIA (credit + market risk)

– α RWA funded by PER & IRR of UPSIA (credit + market risk)]Regulatory Framework