Islamic Financial Institutions & Market

7/29/2019 Islamic Financial Institutions & Market

1/14

Week01

The Evolution of Islamic

Financial Institutions &

Markets

Introduction

What is Islamic Finance

(IF)?

Conducting financial transactions in accordance

to the Islamic principles or Islamic laws, i.e.

shari'ah

Shari'ah-based vs Shari'ah compliance

Do they converge?

Is IF meant only for Muslims?

Is it exclusive or inclusive?

Brief Overview of

Sources of Laws in

IF

(1) The Islamic

system

(1.1) Faith &

belief(Aqidah)

(1.2) Shari'ah

(1.2.a) Worship

(Ibadah)

(1.2.b)

Mu'amalat

Takaful, zakat &wealth planning

Money & capital

markets

Financial

transactions

(1.2.c) Jinayah

(1.2.d) Politics,education, etc.

(1.3) Moral &

ethics(Akhlaq)

(2) Sourcesof laws

(2.1) Primary

(2.1.a) The

Holy Quran

(2.1.b) Thetraditions or

Knownpractices of

the prophet

(2.2)

Secondary

(2.2.a) Ijma'

(2.2.b) Qiyas

(2.2.c)Istihsan

(2.2.d) 'urf

(2.2.e) Al-

masalih al-mursala

(2.2.f)

Istishab

Principles of Islamic

finance

(1) Prohibition of riba

(2) Money as potential

capital

(2.1) The Position of

Money in Islam

(2.1.a) Time Value of

Money

(2.1.b) The Concepts

of Risk & Uncertainty

(3) Risk-sharing

(3.1) Conventional vs

Islamic

(3.2) Al-ghunm bilghurm

(4) Sanctity of

contracts

(5) The materiality ofthe contracts

(5.1) Based on realeconomic activities

(6) Shari'ah approved

activites

(7) Prohibition of

excessive speculativebehavior

(8) Promotion of social

justice

Islamic Finance is just a

small subset of the entireIslamic system


2/14
mailto:[email protected]


3/14

HistoricalBackground

In the1960s

Mit GhamrBank in Egypt

Malaysia'sPilgrimage Board

1970s

OPEC crisis

Dubai IslamicBank

Faisal IslamicBank

IslamicDevelopment

Bank

Iranian Islamic

Revolution

1980s

Bank IslamMalaysia Berhad

Takaful Malaysia

Scholarlycontributions

by Islamiceconomists

MuhammadBaqir Al-Sadr

Najetullah Siddiq

Monzer Kahf

Anas Zarqa

M. A. Mannan

Iraj Toutounchian

Etc.Government will

Regulatory framework

Issues &challenges

ahead

Lack ofshari'ah

standards

Crossborder

productsrecognition

Shari'ahscholars -

governance

Study byFund@Work 2011:

The Top 20Shari'ah Scholars

holding a boardpositions ranging

from 14 - 85

Shortage ofexperienced &

qualified scholars

Shari'ah scholars islike a rock star, saysone scholar based

in Dubai

Regulatingshari'ah scholars

Whichbody/jurisdiction to

regulate?

Does thebody/jurisdiction has

the enforcementauthority?

Accounting &auditing

standards

Internationaldisputes


4/14

Why_Does_IFIM_Exist

Introduction

1 IFIM asbackbone to the

economy

2 Positivecorrelation

between efficientfinancial system &economic growth

The "Black Box"Story

1 Surplus vs Deficit

Units

2 Direct vs IndirectFinance

2.1 Transaction Cost

2.2 Risk Sharing

2.3 InformationAsymmetry

2.3.1 AdverseSelection

2.3.2 Moral Hazar

The Structure ofIFIM

1 Islamic FinancialServices

1.1 Islamic Banking

1.1.1 Deposits &Investment

1.1.2 Financing

1.2 Islamic CapitalMarkets

1.2.1 Islamic

Securities/Sukuk

1.2.2 REITs

1.2.3 Funds & UnitTrusts

1.2.4 Islamic VC/PE

1.2.5 Derivatives

1.3 Takaful

1.3.1 Takaful

1.3.2 Re-Takaful

Roles & Functions ofIFIs

1 Efficient ResourceAllocation &Mobilization

2 Marketplace forMarket Participants

3 Profit opportunitiesfor surplus unit

4 Least cost offinancing for deficit

unit

Internationalization ofFinancial Markets

1 Examples

1.1 Eurodollar

1.2 Eurobond

1.3 Dow Jones Indices

1.4 FTSE Indices

1.5 Internationalizationof Sukuk

1.5.1 Sukuk issued invarious currencies

1.6 International IslamicLiquidity Management

1.6.1 Multi-CurrenciesInstruments

2 Integration of

Financial Market &

Measures of Financial

Integration

2.1 Interest Rate Parity

2.2 Saving-InvestmentCorrelations

2.3 Stock MarketLinkages

2.4 Degree of RegionalRisk Sharing

2.5 Banking SectorOpenness

2.6 Cross BorderLending & Borrowing


5/14

Understanding_Price_

Discovery_Mechanism

Introduction

Pricing of new

products: goods &

services markets

Market forces - supply

& demand

Cost of producing the

goods

Profit margin

Innovative efforts

Etc.

Pricing of new

products: financial

instruments

Market forces, still

Cost of funds

Profit margin

Innovative efforts

Etc.

Cost of producinggoods & services

Cost of materials

Cost of labor

Transportation

Promotions,

advertisements &marketing

Strategic ownership of

certain scientific knowledge

(exclusive knowledge)

Etc.

Cost of funds

Sources of funds

Deposits

Demand

deposits

Saving

accounts

Current

accounts

Investment

accounts

General

Specific

Financing/loans from the

financial markets

Fi i

Example: Understanding

the Base Lending Rate

(BLR) introduced by BNM

in 1991

Funding costs - adjusted for

cost of holding the required

minimum level of statutory

reserves & liquid assets

Administrative cost: staff,

overheads (exclude cost of

bad of doubtful debts)

Profit margin of 0.25% or

whatever is permissible

under specific jurisdiction

What about the

Base FinancingRate (BFR)?

Assignment: Please write a

one-page summary on thistopic before coming to next

class

Current Practice

Since the pricing mechanism is

almost absence in the Islamic

financial services industry, the

industry resorts to 'benchmarking'

Benchmarking against LIBOR (or

any other interest rates) is

permissible according to Sheikh

Taqi Usmani (Pakistan) & Sheikh

Nizam Yaquby (Bahrain)

Other scholars, including Sheikh

Nizam Yaquby, dislike the practice &

opined that the industry should

develop an Islamic price discovery

mechanism (Banker Middle East,

Dec 20, 2006)

ISRA has published a research article

on pricing mechanism for Islamic

Finance (available from www.isra.my)

The search for the right pricing

mechanism is an going research

agenda & top on the list of importance

for the IF practitioners, researchers,

teachers and students alike

Until we find such measures, we'll

rely on benchmarking

The Islamic I nterbank Benchmark

Rate (IIBR) recently developed by

Thomson Reuters & AAOIFI

Mainly on profit-loss

sharing (Mudharabah)

Based on

'trust' -

Amanah
http://www.sesric.org/event-detail.php?id=646


6/14

Islamic_Financial_Institutions:The_Islamic_Banking_System

Introduction

FinancialInstitutions:The Islamic

Banking

What's an Islamicbank?

How does an Islamicbank differ to a

'conventional' bank?

Islamic bank in adual-banking system

The Bank's Balance SheetSource: van Greuning & Iqbal.2009. Balance Sheet Analysis:Islamic vs. conventional. New

Horizon

The conventional bank

Assets

Loans & advances

Cash & cash balances withanother banks

Investment in associate,subsidiaries & JV

Financial assets held fortrading

Cash & balances with thecentral bank

Liabilities

Deposits

Due to banks & other financialinstitutions

Other liabilities

Sundry creditors

Equity & reserves

The Islamic bank

Assets (uses of funds)

Cash balances

Financing assets (murabaha,Salam, ijarah, istisna)

Investment assets(mudharabah, musyarakah)

Fee-based services (ju'ala,kafala, etc)

Non-banking assets (property)

Liabilities (sources of funds)

Demand deposits (amana

Investment accounts(mudharabah)

Special investment accou(mudharabah, musyaraka

Reserves

Equity capital

The Historical Development

Roles & Functions of theIslamic Banking System

PrimaryDeposits & financing

mobilizations

SecondaryFee-based services

ATM

Safe deposits

Ancillary servicesAr-rahn - Islamic pawning

system

Other Types of IslamicFinancial System

Finance companies

Saving institutions

Development institutions

Co-operative banks

Import-Export banks

The central banks

ProductDevelopment:Adaptaion vs.

Innovation

Early stage of development -adaptation

Entering into a mature stage -innovation

Issues: form vs. Substance

Banking & the FinancialMarket Regulations

To instill confidence andmarket discipline

Tighter as a result of therecent financial crises

Disclosure

Regulatory responses to

financial scandals

Enron, UBS, Lehman

Brothers, Dubai World, etc.

Exaggerated earnings

Failure to disclose relevantinformation

Roles of auditors

Proper oversight committee

Insuring Islamic Deposits(discussed separately)


7/14

Insuring Islamic Deposits

The rationale for depositinsurance

Started in the US after the Great

Depression

To provide confidence as wellas protection before the crisis

occurs

Its importance become moreprevalence in recent years due

to various financial crises

Most deposit insurance willcover less than 80% of the totaldespots in the banking system

Type of deposit insuranceImplicit

Explicit

BNM's Shar i'ah Resolution Types of funds

Islamic banking funds

Customers' deposits

Wadiah

Mudharabah

Qardul Hass

Corporate banking

Treasury activities

Deposit insurance in practiceBasic principle: no co-mingling

of funds

Rely on conventional depositinsurance

Islamic deposits are very small,thus no incentives for regulatorsto enforce the establishment of

deposit insurance scheme

Mixed-pool of funds

Premiums received fromconventional and Islamic banks

are put in the same pool and

returns on investments areshared based on % of

contributions from each sector

Separate pool of fundsPremiums received from Islamic

& conventional banks are putinto two separate pools

Way Forward

To separate the pool between

the Islamic & conventionalbanks


8/14

Non_Bank_Islamic_Financial_Institutions

Introduction

Banking institutions

Non-bank financialinstitutions

What is a non-bankfinancial institution

Not clearly defined

Normally providesbanking serviceswithout a bankinglicense or is notsupervised by a

national orinternational banking

regulatory agency

Typically, non-deposit taking

institutions

Facilitates bank-related financial

services, such as

investment, riskpooling, contractualsavings, and market

brokering

Accounted forapproximately $200billion in transactions

in the U.S. (1996)

Hedge/mutual fundcompanies

Regulatorychallenges in thewake of financial

crises

The [U.S] FinancialStability OversightCouncil (FSOC) onTuesday (10.10.11)

issued a moredetailed guidelines

for designatinginstitutions too big to

fail

Objectives: toprovide clarity to

insurance, mutualfund & hedge fund

companies

Systemicallyimportant financialinstitutions (SIFIs)are seen to pose

systemic risks to theeconomy in a

financial stressscenario

govern by theFederal Reserve &

State agencies (U.S)

The criteria: Sifi willhave more than

$50bn (36.3bn) intotal consolidated

assets and meet atleast one of theother criteria,

including whether it

has $3.5bn (

2.5bn)in derivative liabilitiesor

$20bn (14.5bn) inoutstanding loans

borrowed and bondsissued

Examples: GoldmanSachs & JPMorgan

Chase

Sifi ill b bj t

Roles & functions inpromoting IFIS

Strengthening the economy, asthey provide "multiple alternatives

to transform an economy'ssavings into capital investment[which] act as backup facilities

should the primary form ofintermediation fail." (Alan

Greenspan, 1999)

What other rolesthan you can think

of?


9/14

Central Bank Under the DualBanking System

Introduction

What is a central bank andwhy does it matter?

Single Islamic system

Only shari'ah law exists:everything is defined as

operating under shari'ahExamples?

Dual-Banking System

Exists dual-laws in parallelfor the Islamic as well as the

convention system,respectively

Examples?

Hybrid System

Single law exists and appliedto both, Islamic as well as

conventional FIs

Examples?

The Structure of a CentralBank

Board Members

Governor

Deputy Governors

Directors/GMs/etc

Financial Policy

Treasury

Research

HR

Investment

Etc

Roles & Functions of aCentral Bank

Issuer of currency & keepsreserves safeguarding the

value of currency

Acts as a banker & financial

adviser to the Government

Promotes monetary stability

& sound financial structure

Lender of last resort

Shari'ah supervisory

The Conduct of a MonetaryPolicy

Tools

OMO

Temporary: repurchase orreverse repurchase to add ordrain reserves in the banking

system

Permanent: to buy or sellsecurities to add or drain

reserves in the financialsystem

The interbank rate: banklends excess reserves to

other depository institutionsovernight

Discount Lending/Window

The Discount Windowfunctions as a safety valve in

relieving pressures inreserve markets

To alleviate liquidity strainsin a depository institution andin the banking system as a

whole

To ensure the basic stabilityof the payment system bysupplying liquidity during

times of systemic stress

Primary credit rate: 0.75%

Seasonal credit rate: 0.20%

Secondary creditrate:1.25%

Reserve Requirements

TargetsOperating targets

Immediate targets

Goals

Price stability

High employment

Sustainable growth rate

Selected MonetaryFramework

Exchange rate targeting

Monetary targeting

Inflation targeting

Interest rate targeting

Current Issues in Monetary

Policy

Quantitative Easing (QE):

What's it?

Shari'ah compliance

instruments

The depth & width of the

interbank money market


10/14

Islamic Financial Markets:The money market

Financial instruments with

maturity less than 12months

Objectives: asset-liabilitymismatch

What is asset-liability

mismatch?

Assets are long, whileliabilities are shorts

Market place

Islamic interbank moneymarket at Bank Negara

Malaysia

Pasar Uang Antar Bank

hosted by Bank Indonesi

Liquidity Management

Center in Bahrain

International Islamic

Liquidity Market

Instruments: Examples

from BNM's IIMM

Government investment

issue (GII)Qardul Hassan & Al-Inah

Up to 3 years

Mudharabah interbankinvestment

Mudharabah0-12 months

Wadiah interbank

acceptanceWadiah yad dhamanah

Not specified

Malaysia Islamic treasury

bill (MITB)Bai al-Inah

3,6,9 months

Bank Negara NegotiableNote (BNN-Note)

IjarahUp to one year

Islamic accepted bill (IAB)

MurabahahNot specified

Islamic Debt Securities

BBA, Mudharabah,Murabahah

3-15 years

Cagamas MudharabahBond

Mudharabah -> BBAUp to 10 years

Islamic negotiable

instrument of depositMudharabah

Not specified

Negotiable Islamic debttifi t

AAOIFI defines


11/14

Islamic FinancialMarkets: IslamicCapital Market

The sukuk market:What's sukuk?

AAOIFI definessukuk as certificates

of equal valuerepresenting

undivided shares inthe ownership oftangible assets,usufructs and

services or (in theownership of) the

assets of particularprojects or specialinvestment activity

Why invest in sukuk?

Returns vs. priceInformed investors:Decisions to invest

Risk structure

Present in allinvestment portfolios

Incorporated ininvestment decisions

Rating

Assessment of theunderlying assets

Sukuk structure:asset-backed vs.

asset-based

Instruments

Mudharabah Sukuk MudharabahMedium- to Long-

Term

Musyarakah Sukuk Musyarakah Medium- to Long-Term

Ijarah Sukuk IjarahMedium- to Long-

Term

Murabaha Sukuk MurabahahMedium- to Long-

Term

Salam Sukuk SalamMedium- to Long-

Term

Istisnaa Sukuk Istisnaa Medium

Hybrid SukukMurabahah,

mudharabah, Ijarah,etc.

Medium- to LongTerm

Sukuk default

Possible sources

Large SingleExposure on Single

Group

Property bubbles

Over reliance onforeign liquidity

Kuwait InternationalInvestment Group

($152.5 mil.)

Kuwaiti InvestmentDar ($100 mil.)

Legal Recource(Sukuk Structures)

MIFC

Asset-based:Allows the inclusion of the

actual asset which may not belegally recognised to be

owned outright by the sukukholders

Recourse only toultimate issuer & notany particular asset

No legal claim onassets

Rely on credit risk ofthe obligator

Asset-backed:Grants the sukuk holder a

share of the concrete assetor business venture, and a

share of the riskcommensurate with the "truesale" ownership of the asset

Recourse on specificassets

Subjected to qualityof assets

Full recourse tounderlying assets

Way forward

The International Islamic Financial Market(IIFM) is midst of preparing a master

agreement for the asset-backed sukuk

Investors need not only to understand the risk, thequality of assets, & transparency, but also to

understand the restructuring process, expectationsof recovery & length of the process of any types of

sukuk structures

Establishing better legal infrastructure &

corporate governance

Consumer education, disclosure beyond thesukuk prospectus: Investors' confusion that

they have recourse to certain underlyingassets, in most sukuk, investors only

subjected to beneficial right to the underlying,rather the title itself - no claim to theunderlying itself when sukuk is up for

restructuring.

When the Salam


12/14

The Mortgage &Futures Markets

The Islamic Mortgage

Ijarah

Musyarakah(Partnership)

Bai Bithamin Ajil(BBA)

Deferred payment

Some BBA contracbundled with al-ina

contract

MusyarakahMutanaqisah

(DecliningPartnership)

The Islamic FuturesMarket

Issues in Salamcontract

Some elements ofgambling?

When the Salamcontract is applied

into financial contracts- especially for

hedging purposes

Possession vs.ownership

Instruments can onlybe sold if theownership isestablished

Gharar (uncertainty)

What is Salamcontract?

Payment spot

Delivery on an agreedfuture date

Product must bespecified, but cannot

be too or wellspecified. Why?

Examples of Salamcontract

Widely used inagricultural products

as a way for farmer toraise working capital

or financial need

The list of shariah compliant index are


13/14

Shariah ScreeningProcess

What is a shariahscreening process?

Why do we need ashariah screening

process?

Widely used andacceptable standards

FTSE Global IslamicIndex Series

Dow Jones IslamicMarket Indexes

Securities Commissionof Malaysia

Methods of ShariahScreening Process

(Example from FTSEGIIS)

Qualitative methods(Screening by types of

industries)

Gambling & gaming relatedindustries

Pork and other non-halalfood production

Conventional finance, banking,asset management, insurance & etc.

Hotel & casinos

Alcohol

Weapon, arm manufacturingactivities, etc

Quantitative methods(Screening by looking at financialratios, after passing the qualitative

methods)

Debt to Asset ratio =< 33%

Cash and interest bearing itemsratio to Total Assets =< 33%

Account Receivables & Cash toTotal Assets =


14/14

Supra-NationalFinancial

Institutions

The World Bank

Bank is headquartered inWashington, D.C.

MISSIONOur work is challenging, but

our mission is simple:Help reduce poverty.

The Agencies

The International Bank for Reconstruction and

Development (IBRD) lends to governments ofmiddle-income and creditworthy low-income

countries

The International Development Association

(IDA) provides interest-free loanscalledcredits and grants to governments of the

poorest countries

The International Finance Corporation (IFC) providesloans, equity and technical assistance to stimulate

private sector investment in developing countries

The Multilateral Investment Guarantee Agency (MIGA)

provides guarantees against losses caused by non-commercial risks to investors in developing countries

The International Centre for Settlement of Investment

Disputes (ICSID) provides international facilities forconciliation and arbitration of investment disputes

The InternationalMonetary Fund (IMF)

Number of member countries: 188 countriesThe IMF was conceived in July 1944, when

representatives of 45 countries meeting in thetown of Bretton Woods, New Hampshire

They agreed on a framework for internationaleconomic cooperation, to be established after

the Second World War

They believed that such a framework wanecessary to avoid a repetition of the disast

economic policies that had contributed to tGreat Depression

The IMF came into formal existence inDecember 1945, when its first 29 member

countries signed its Articles of Agreement

It began operations on March 1, 1947. Later thatyear, France became the first country to borrow

from the IMF

Objectives

working to foster global

monetary cooperation

secure financialstability

facilitate

international trade

promote high employmentand sustainable economic

growth

reduce poverty around

the world

The Bank ofInternational

Settlements (BIS)

Objectives

to serve central banks in their pursuitof monetary and financial stability

to foster international cooperation in

those areas and to act as a bank for

central banks

Mission

promoting discussion and facilitatingcollaboration among central banks

supporting dialogue with other

authorities that are responsible forpromoting financial stability

conducting research on policy issuesconfronting central banks and

financial supervisory authorities

acting as a prime counterparty forcentral banks in their financial

transactions

serving as an agent or trustee in

connection with international financialoperations

The Islamic DevelopmentBank (IDB)

Establishment

IDB is an international financial institutionestablished in pursuance of the Declaration of

Intent issued by the Conference of FinanceMinisters of Muslim Countries held in Jeddah in

Dhul Q'adah 1393H (December 1973)

The Inaugural Meeting of the Board of

Governors took place in Rajab 1395H (July1975), and the Bank was formally opened

on 15 Shawwal 1395H corresponding to 20October 1975

Purpose

To foster the economic development and social progress

of member countries and Muslim communities

individually as well as jointly in accordance with theprinciples of Shari'ah i.e., Islamic Law

Membership

56 countries

Must be OIC

member

Accept the terms andconditions of the Articles

of establishment

The AsianDevelopment Bank

(ADB)

ADB aims for an Asia and Pacific freefrom poverty

Approximately 1.8 billion people in the region

are poor and unable to access essential goods,services, assets and opportunities to whichevery human is entitled

Financing Operations

Private sector financing

Public sector financing

Trade finance

Other focus areas

The EuropeanCentral Bank (ECB)

The ECB is the central bank for Europe'ssingle currency, the euro

The ECBs main task is to maintain the

euro's purchasing power and thus pricestability in the euro area

The euro area comprises the 17

European Union countries that have

introduced the euro since 1999

How Do We

Approach ThisTopic?

How do these institutions promoteIslamic financial services industry?

Research on Islamic financial

services industry

Best practices

Regulatory/supervisory roles

Globally accepted standards

Does the Islamic financial services

industry needs to emulate andestablish similar institution (other

than IDB)?

Yes & No. Why?

What lessons could we learn fromthe effectiveness of these

institutions in dealing with global

financial crises?

Effective vs. ineffective policy

description

one policy fits all might not

work best for all countries

Examples: Asian financial crisis 1997; sub-prime crisis -> global financial crisis &

European financial crisis, the PIGScountries

Liquidity support

Regulatory reform

Documents

Islamic Financial Institutions & Market