Introduction to Islamic

Finance & Banking

World Bank – BRSA - TKBB Joint Workshop on

“Innovative Product Development in Islamic Banks”
Istanbul, Turkey
March 2, 2017

Zamir Iqbal, PhD.

Lead Financial Sector Specialist
The World Bank Global Islamic Finance Development Center
Istanbul, Turkey
ziqbal@worldbank.org
Globalization of Islamic Finance…

Source: IFSB Financial Stability Report 2015, KFHR, IMF

Islamic Finance makes into G-20 agenda

2015- The G20 group of major nations has included discussion of Sukuk (Islamic bonds) as an
infrastructure financing tool in its annual agenda, a move that could potentially spur the use of project-
based Sukuk. In addition, Islamic Finance is subject of study under G20 themes of long-term investments
and Financial inclusion.
Brief Modern History of Islamic Finance
 Interest in reviving a banking and financial system started in early 1900s.

 1950s – Appearance of early writings about problems of conventional

economic systems and how Islam’s principles of economics offer an
alternative.

 1960s – End of colonialism and independence of countries

 1970s – Oil revenues (Perto-$) create demand for banking without interest. 1st
Islamic bank in Dubai is established.

 1980s – Growth of commercial banking

 1990s – Emergence of Islamic funds and investment banking

 2000s – Capital markets and Globalization

3
….there is increasing interest in Islamic finance from non-Muslim
countries

Recent transactions include sovereign issuance by United Kingdom (UK), South Africa, Hong Kong,
and Luxemburg.

UK
 2010 – The Financial Services and Markets Act 2000
Order 2010 was introduced by Treasury to support
Islamic finance and the issuance of corporate sukuk
within the UK
 2012 - The UK Government launched an Islamic Finance
Task Force with the aim of securing London’s status as
the Western hub for Islamic finance
 2013 - London hosted the World Islamic Economic
Forum during which the UK Prime Minister announced
plans to issue a Sukuk in 2014 and to turn London into a
global center of Islamic finance.
France
 2009 - The amendment of Article 2011 of the French
Civil Code relating to the formation of trusts was
interpreted as an important step towards permitting the
issuance of sukuk out of France
 2010 - Revision of specific tax regulations covering
Sukuk, ijarah, istisna and murabaha with a view to
removing discrepancies
Source: KFH Research
Luxembourg
 2010 - The Luxembourg Tax Authority published a circular to clarify
the tax treatment of murabahah and sukuk transactions, to ensure that
they benefit from the same tax treatment as conventional products
 2011 - Luxembourg’s CSSF published a note that clarified that no
specific legislation was required for Shariah compliant investment
funds, since Luxembourg’s current law contains no obstacles to it.
Germany
 2012 - German banking regulator hosted an Islamic finance conference
in Frankfurt during which the tax treatment of different Islamic
finance products was discussed.
Hong Kong
 2014- Hong Kong has raised $1bn in its debut Islamic bond issue.
South Africa
 2014- $500m sale was more than four times subscribed, with an order book
of $2.2bn according to the SA Treasury
Russia
 2016- Opened first Islamic Bank, The Partnership Banking Center in
March 2016.
Roadmap

I. MARKET TRENDS

II. HOW ISLAMİC BANKİNG WORKS?

III. REGULATORY AND SUPERVİSORY ENVİRONMENT

IV. STATE OF DEVELOPMENT OF ISLAMİC FİNANCE

I. Market Trends

6
Islamic Financial Assets

Source: ICD-Thomson Reuters Islamic Finance Development Report 2016

 Market Size – Islamic Banking

Islamic Banking Share in Total Banking Assets by Jurisdiction (1H2015)

Source: Financial Stability Report 2016, IFSB

 Islamic Financial Assets Have Been Growing Rapidly

Global Islamic Finance Assets by Sector Growth (2012 – 2021, US$ BN)

Source: ICD-Thomson Reuters Islamic Finance Development Report 2016

 Composition and Domicile of Islamic Assets

Breakdown of Islamic Finance Segments by Region (USD billion, 2015 YTD)

Source: Financial Stability Report 2016, IFSB

10
Growth of Banking Assets

Source: World Islamic Banking Competitiveness Report 2016, Ernst&Young

II. How Islamic Banking Works?

12
Theoretical foundations of Islamic Financial System

Risk
Sharing

Reduction of Information Asymmetry

(Gharar)
* Prohibits contracts with high uncertainty
(Speculation/Gambling)
* Requires Full Disclosure before, during and
after the contract

Prohibition of Interest (Riba)

Eliminates Debt contracts and Leverage
Materiality

Economic and Social Justice

Wealth, Ownership and Property Rights

Preservation of Property Rights, Protection of Property Rights
of Stakeholders, Significance of Rights of the Society
The role of Wealth, Money, and Capital, Sanctity of Contracts
How a banking system is designed without “Interest?”

 Prohibition of interest discourages debt and leverage

 Risk sharing
– Because interest is prohibited, pure debt security is eliminated from the system
and therefore suppliers of funds become investors, rather than creditors. The
provider of financial capital and the entrepreneur share business risks in return for
shares of the profits and losses.

 Close linkage with the Real Sector of the economy

 Promotes Asset-backed Finance

– The system introduces a “materiality” aspect that links financing directly with the
underlying asset so that the financing activity is linked to the real sector activity.
There is strong linkage between the performance of the asset and the return on the
capital used to finance it.

 Similarities with ethical and Socially Responsible Investments (SRIs).

14
Commonality: Ethical Investing

 Substantively: Islamic finance is “ethical finance and investing”.

 Consider: Lutheran funds, Roman Catholic funds, “green” funds,

university investment programs (WARF-UW; UC-Berkley).

 No investments in:
– Production or distribution of alcohol for human consumption
– Production of tobacco for human consumption
– Gambling
– Prostitution and pornography
– Defense and weapons
– Pornography

– Add constraint on interest-based debt => Islamic investment

Components of Islamic Financial System

Islamic
Financial
System

Non-banking
Banking Capital Markets Money Markets Financial
Institutions

Commercial Takaful (Insurance)

Sukuk market
Banking

Micro-financial
Investment institutions
Stock Market
Banking

Leasing
Companies
Mutual Funds

Project Finance

Private Equity

16
Key Contracts – building blocks

Contract Function Description

Amana Custody Trust. Placing something valuable in trust with someone for custody or safekeeping.
Bay’ al-Istisna Order to build Sale in order to manufacture or construct.
Sale contract where the price of the product or underlying asset is agreed but the payment in
Bay-mua’jjal Deferred Payment
lump sum or installments is deferred to a specified future date.
Sale by immediate payment against future delivery. Similar to conventional forward contract
Bay’ al-Salam Forward Contract
but requires full payment at the time of contract.
A sale contract that is not the sale of a tangible asset but rather a sale of the usufruct (the
Ijarah Leasing
right to use the object) for a specified period of time.
An economic agent with capital (rabbul-mal) can develop a partnership with another agent
Trustee finance (mudarib) with skills to form a partnership with the agreement to share the profits. Although
Mudarabah
contract losses are borne by the capital owner only, the mudarib may however be liable for a loss in
case of misconduct or negligence on his part.
A cost-plus-sale contract where a financier purchases a product, that is, a commodity, raw
material or supplied, for an entrepreneur who does not have its own capital to do so. The
A cost-plus-sale
Murabahah financier and the entrepreneur agree on a profit margin, often referred to as a mark-up
contract
which is added to the cost of the product. The payment is delayed for a specified period of
time.
Equity Equity partnership. It is a hybrid of Shiraka (partnership) and Mudarabah combining the act
Musharakah
partnership. of investment and management.
Qard-al-hassan Benevolent Loan Charitable loans with no interest and low expectations of return of principal.
Plural of the Arabic word Sakk meaning certificate, reflects participation rights in the
Sukuk Islamic Bond
underlying assets.
Takaful Insurance Insurance contract through mutual or joint guarantee.
Representation. Entrusting a person or legal entity (Wakil) to act on one’s behalf or as one’s
Wikala Agency
representative.

17
Islamic Financial Intermediation (Banking)

Key Highlights
Assets Liabilities
 Depositors are investors rather
than lenders
Trade Financing, Demand Deposits
Leases,  Risk Sharing through Profit and
Mudarabah
financing loss sharing.

 Assets and Liabilities are

Investments by
Partnerships Depositors matched.
(mudarabah and
musharakah)
 Ethical and socially responsible
Securities assets
Investments

Fees Capital
A Stylized Balance Sheet of an Islamic Bank

Assets Liabilities
Trade Financing
(Salaam, Morabahah) Demand Deposits
(Amanah/ Waad)

Leasing / Rentals
(Ijarah / Istisna) Investment Accounts
Profit/Loss Sharing (Mudarabah)
Investments
( Mudarabah) Special Investment Accounts
Equity Investments (Mudarabah)
( Musharakah)
Fee for Services Capital
Equity
Reserves
III. Regulatory and
Supervisory Environment

20
Key Stakeholders

Islamic Development Bank Group (IDB, ICD, IRTI, ICIEC, ITFC)

Islamic Financial Services Board (IFSB)

Accounting and Auditing Organization of Islamic Financial Institutions

(AAOIFI)

Multilaterals (The World Bank Group, IMF, Asian Development Bank)

International Islamic Financial Markets (IIFM)

International Islamic Rating Agency (IIRA)

International Center for Education in Islamic Finance (INCEIF)

21
 Islamic Financial Services Board (IFSB)

IFSB is an international standard-setting organization with a membership of 185 participants, whose work
complements the work of the Basel Committee on Banking Supervision, International Organization of Securities
Commissions and the International Association of Insurance Supervisors. As of early 2014, the IFSB has issued
17 Standards, 5 Guidance Notes and 1 Technical Note for the Islamic financial services industry.

Approved Standards
1. Risk Management
2. Capital Adequacy
3. Corporate Governance
4. Transparency and Market Discipline
5. Supervisory Review Process
6. Governance for Collective Investment Schemes
7. Special Issues in Capital Adequacy
8. Guiding Principles on Governance for Islamic Insurance (Takaful) Operations
9. Conduct of Business for Institutions offering Islamic Financial Services
10. Guiding Principles on Shariʿah Governance System
11. Standard on Solvency Requirements for Takaful Undertakings
12. Guiding Principles on Liquidity Risk Management
13. Guiding Principles on Stress Testing
14. Standard On Risk Management for Takaful Undertakings
15. Revised Capital Adequacy Standard
16. Revised Guidance on Key Elements In The Supervisory Review Process of Institutions Offering Islamic
Financial Services
17. Core Principles for Islamic Finance Regulation (Banking Segment)
 Islamic Financial Services Board (IFSB)
Standards under Development

1. Revised Guidance on Key Elements in the Supervisory Review Process of Institutions Offering
Islamic Financial Services (excluding Islamic Insurance (Takaful) Institutions and Islamic
Collective Investment Schemes)

Guidance Notes and Technical Note

1. Recognition of Ratings on Shariʿah-Compliant Financial Instruments

2. Guidance Note in Connection with the Risk Management and Capital Adequacy Standards:
Commodity Murabahah Transactions
3. Guidance Note on the Practice of Smoothing the Profits Payout to Investment Account Holders
4. Guidance Note in Connection with the IFSB Capital Adequacy Standard: The Determination of
Alpha in the Capital Adequacy Ratio
5. Guidance Note on the Recognition of Ratings by External Credit Assessment Institutions
(ECAIS) on Takaful and Re-Takaful Undertakings
6. Development of Islamic Money Markets (Technical Note)
 Accounting and Auditing Organization for Islamic Financial
Institutions (AAOIFI)

The Accounting and Auditing Organization for Islamic Financial Institutions(AAOIFI) is an Islamic
international autonomous non-for-profit corporate body that prepares accounting, auditing, governance,
ethics and Shari'ah standards for Islamic financial institutions and the industry.

Issued Standards

Accounting Standards
Auditing Standards
Ethics Standards
Governance Standards
Shari’ah Standards

Guiding Notes

Guidance Note on First time Adoption of AAOIFI Accounting Standards by an Islamic Financial
Institution
 Accounting and Auditing Organization for Islamic Financial
Institutions (AAOIFI)
ACCOUNTING STANDARDS AUDITING STANDARDS
Conceptual Framework FOR Financial Reporting by Islamic Financial
Institutions A S 1- Objective and Principles of Auditing
FAS 1- General Presentation and Disclosure in the Financial Statements of A S 2- The Auditor’s Report
Islamic Banks and Financial Institutions A S 3- Terms of Audit Engagement
FAS 2- Murabaha and Murabaha to the Purchase Orderer A S 4- Testing for Compliance with Shari’a Rules and Principles by
FAS 3- Mudaraba Financing an External Auditor
FAS 4 - Musharaka Financing A S 5- The Auditor’s Responsibility to Consider Fraud and Error in an
FAS 5- Disclosure of Bases For Profit Allocation Between Owners’ Equity Audit of Financial Statements
and Investment Account Holders
FAS 6- Equity of Investment Account Holders and their Equivalent
GOVERNANCE STANDARDS
FAS 7- Salam and Parallel Salam
FAS 8- Ijarah and Ijarah Muntahia Bittamleek
G S 1-Sharia Supervisory Board: Appointment, Composition, Report
FAS 9- Zakah
G S 2- Shari’a Review
FAS 10-Istisna'a and Parallel Istisna’a
G S 3- Internal Shari’a Review
FAS 11- Provisions and Reserves
G S 4- Audit & Governance Committee for Islamic Financial
FAS 12-General Presentation and Disclosure in the Financial Statements of
Institutions
Islamic Insurance Companies
G S 5- Independence of Shari’a Supervisory Board
FAS 13- Disclosure of Bases for Determining and Allocating Surplus or
G S 6- Statement on Governance Principles and Disclosure for
Deficit in Islamic Insurance Companies
Islamic Financial Institutions
FAS 14- Investment Funds
G S 7- Corporate Social Responsibility Conduct and Disclosure for
FAS 15- Provisions and Reserves in Islamic Insurance Companies
Islamic Financial Institutions
FAS 16- Foreign Currency Transactions and Foreign Operations
FAS 17- Investments
FAS 18- Islamic Financial Services offered by Conventional Financial ETHICS
Institutions
FAS 19- Contributions in Islamic Insurance Companies Code of Ethics for Accountants of Islamic Financial Institutions
FAS 20- Deferred Payment Sale Code of Ethics for the Employees of Islamic Financial Institutions
FAS 21- Disclosure on Transfer of Assets
FAS 22- Segment Reporting
FAS 23- Consolidation
FAS 24- Investments in Associates
FAS 25- Investment in Sukuk, Shares and Similar Instruments
FAS 26 - Investments in Real Estate
Legal Framework for Islamic Financial Institutions (IFIs)

Some countries like Iran, Kuwait, Malaysia,

Sudan, Turkey, UAE and Yemen have
Specific enacted specific laws to regulate the
Laws regulating IFIs

Laws establishment of IFIs.

Same laws of In other countries, IFIs are established by

conventional the same laws of conventional banks.
banks

In all the countries in which they operate,

Supervision IFIs are supervised by their respective
supervisory and regulatory bodies.
of IFIs
IV. State of Development of Islamic Finance

27
Islamic Finance Indicator

Which Countries have the best developed Islamic Economy for Islamic Finance?

TOP 10
İSLAMİC FİNANCE

0 20 40 60 80 100 120 140 160 180 200

Malaysia 176
Bahrain 84
United Arab Emirates 78
Saudi Arabia 66
Oman 51
Pakistan 51
Kuwait 43
Qatar 38
Indonesia 35
Sudan 33
Source: State of the Global Islamic Economy Report 2015/16, Thomson Reuters

* CRITERIA
1. Financial (Size of Islamic Finance Assets and Number of Islamic Finance Institutions)
2. Governance (e.g. Regulation for Islamic Finance and Disclosure Index Score)
3. Awareness (Number of Related News Articles, Islamic Finance Education Institutions, Research papers, and events)
4. Social (Value of Zakat and Charity and CSR Disclosure Index Score)
Adoption of IFSB Standards

 Number of Countries which adopted IFSB Standards

Source: Comparative Study on the Implementation of Selected IFSB Standards,

IFSB Working Paper Series, WP-04/10/2015, October 2015
Adoption of AAOIFI Standards

As basis of of national
Mandatory regulatory In other jurisdictions including Brunei,
accounting standards in
requirement in jurisdictions Dubai International Financial Centre,
jurisdictions
France, Egypt, Jordan, Kuwait, Lebanon,
Shari’ah Accounting Shari’ah Accounting Saudi Arabia, Qatar, Qatar Financial Centre,
Standards Standards Standards Standards South Africa, United Arab Emirates and
Bahrain Bahrain Indonesia Indonesia United Kingdom as well as in Africa,
Central Asia and North America, AAOIFI
Oman Jordan Malaysia Pakistan
Shari’ah standards and/or AAOIFI
Pakistan Oman accounting standards have been used
Sudan Qatar voluntarily as basis of internal guidelines by
leading Islamic financial institutions.
Qatar Financial
Syria
Centre
AAOIFI auditing, governance and ethics
Islamic standards are not part of mandatory
Development Sudan regulatory requirement for Islamic
Bank finance. Instead, these standards are used
Syria voluntarily by leading Islamic financial
institutions across all major Islamic
Islamic
finance jurisdictions.
Development
Bank

Source: AAOIFI website

Islamic Finance Sub-Indicators

REGULATION SUB-INDICATORS TOP

COUNTRIES GOVERNANCE INDICATORS SHARIA GOVERNANCE SUB-
TOP 10 COUNTRIES INDICATORS
Indicator Value TOP 10 COUNTRIES
Malaysia 100 1- BAHRAIN 93
Indicator Value
Pakistan 100 2- MALAYSIA 90
Bahrain 142
Bahrain 100 3- KUWAIT 67 Malaysia 116
Nigeria 100 4- PAKISTAN 66 Kuwait 106
Indonesia 100 5- OMAN 62 Bangladesh 92
Iran 83 6- INDONESIA 58 Sudan 89
Maldives 67 7- SUDAN 54 Oman 70
Unidet Arab Emirates 67 8- UNITED ARAB Indonesia 57
Qatar 67 EMIRATES 54 Pakistan 56
Sudan 67 9- QATAR 52 Lebonan 53
Brunei Darussalam 67 10- MALDIVES 48 Egypt 48
Kazakhstan 67

Source: Islamic Finance Development Report 2015, ICD-Thomson Reuters

 Thank You

For your further questions please contact:

Zamir Iqbal
World Bank Global Islamic Finance Development Center
T: +90 212 385 3443
E-mail: ziqbal@Worldbank.org
Disclaimers
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