Conducting financial transactions in accordance to the Islamic principles or Islamic laws, i.e.

shari'ah Introduction What is Islamic Finance (IF)? Shari'ah-based vs Shari'ah compliance Do they converge? Is IF meant only for Muslims? Is it exclusive or inclusive?

(1.1) Faith & belief (Aqidah) (1.2.a) Worship (Ibadah) Takaful, zakat & wealth planning (2.1) The Position of Money in Islam (2) Money as potential capital (1) The Islamic system (3.1) Conventional vs Islamic (3) Risk-sharing (3.2) Al-ghunm bil ghurm (4) Sanctity of contracts (5.1) Based on real economic activities (5) The materiality of the contracts (6) Shari'ah approved activites (7) Prohibition of excessive speculative behavior (8) Promotion of social justice (2) Sources of laws Principles of Islamic finance (1.3) Moral & ethics (Akhlaq) (2.1.a) The Holy Quran (2.1) Primary (2.1.b) The traditions or Known practices of the prophet (2.2.a) Ijma' (2.2.b) Qiyas (2.2.c) Istihsan (2.2) Secondary (2.2.d) 'urf (2.2.e) Almasalih almursala (2.2.f) Istishab (1.2.c) Jinayah (1.2.d) Politics, education, etc. (1.2) Shari'ah (1.2.b) Mu'amalat Money & capital markets Financial transactions

(1) Prohibition of riba (2.1.a) Time Value of Money (2.1.b) The Concepts of Risk & Uncertainty

Islamic Finance is just a small subset of the entire Islamic system

Week01 The Evolution of Islamic Financial Institutions & Markets

Brief Overview of Sources of Laws in IF

An introduction to Islamic Financial Institutions & Markets (IFIM) The Deliverables

ASAD: asa@inceif .org ICT: ict@inceif. org LMS: helpdesk@ inceif.org MPZ: mpisal@in ceif.org Project Paper due date (November 18, 2012) Final Exam (December 13, 2012) IFSB AAOIFI IIFM Deposit Insurance Corp Securities Commission Regulatory & standards setting agencies

Islamic Financial Institutions (IFIs)

Islamic Capital Market (ICM)

Contact info.

Regulatory & standard setting agencies 20% coursework - individual 20 MCQs 20 points 4 short essay questions 20 points Answer 3 out 5 long essay questions 20 points for each question

Introduction

Important Dates

Assessmen ts

a threehour final exam

The World Bank The International Monetary Fund (IMF) The Islamic Development Bank (IDB) The Bank of International Settlements (BIS) The European Central Bank (ECB) The Asian Development Bank (ADB) Supra-National Financial Institutions

Islamic Financial Institutions & Markets

100% final exam (converted to 80%)

Will be discussed in the next topic Historical background IF is a relatively young industry Very vibrant with very high growth rates Banking institutions Non-bank institutions

Roles & functions Tools Objectives Conduct of monetary policy Central bank

Financial institutions

Money market Capital market Mortgage market Futures market Stock market REITs, etc.

Financial markets

Cross border products recognition

Study by Fund@Work 2011: The Top 20 Shari'ah Scholars holding a board positions ranging from 14 - 85 Shortage of experienced & qualified scholars Shari'ah scholars is like a rock star, says one scholar based in Dubai Which body/jurisdiction to regulate? Does the body/jurisdiction has the enforcement authority?

Lack of shari'ah standards

In the 1960s

Mit Ghamr Bank in Egypt Malaysia's Pilgrimage Board OPEC crisis Dubai Islamic Bank

Shari'ah scholars governance

1970s

Faisal Islamic Bank Islamic Development Bank Iranian Islamic Revolution Bank Islam Malaysia Berhad

Issues & challenges ahead

Regulating shari'ah scholars

Takaful Malaysia Muhammad Baqir Al-Sadr

Historical Background

Najetullah Siddiqi 1980s Scholarly contributions by Islamic economists Monzer Kahf

Anas Zarqa

Accounting & auditing standards International disputes Government will

Regulatory framework Pool of skilled talents Depth & width of financial instruments Fastest growing industry: 15-20% per annum > 600 IFIs in > 45 countries Either full-fledged or windows Total assets: ~ $1.12 trillion Expected to reach $4 trillion in 2020 Important factors

M. A. Mannan Iraj Toutounchian Etc. 1st & 2nd Gulf Wars Increased in petro-$ Reaching out Product innovation 1990s-now New entrants to the industry Recent Development Economic crises: AFC of late 90s Global financial crisis of 2008

1.1 Eurodollar 1.2 Eurobond 1.3 Dow Jones Indices 1.4 FTSE Indices 1.5.1 Sukuk issued in various currencies 1.6.1 Multi-Currencies Instruments 1.5 Internationalization of Sukuk 1.6 International Islamic Liquidity Management Internationalization of Financial Markets 1 Examples

2.1 Interest Rate Parity 2.2 Saving-Investment Correlations 2.3 Stock Market Linkages 2.4 Degree of Regional Risk Sharing 2.5 Banking Sector Openness 2.6 Cross Border Lending & Borrowing

2 Integration of Financial Market & Measures of Financial Integration

1 IFIM as backbone to the economy Introduction 2 Positive correlation between efficient financial system & economic growth 1 Surplus vs Deficit Units 2.1 Transaction Cost The "Black Box" Story 2.2 Risk Sharing 2 Direct vs Indirect Finance 2.3 Information Asymmetry 2.3.1 Adverse Selection 2.3.2 Moral Hazard

1 Efficient Resource Allocation & Mobilization 2 Marketplace for Market Participants 3 Profit opportunities for surplus unit 4 Least cost of financing for deficit unit

Roles & Functions of IFIs

Why_Does_IFIM_Exist

1.1.1 Deposits & Investment 1.1.2 Financing 1.2.1 Islamic Securities/Sukuk 1.2.2 REITs 1.2.3 Funds & Unit Trusts 1.2.4 Islamic VC/PE 1.2.5 Derivatives 1.3.1 Takaful

1.1 Islamic Banking

1.2 Islamic Capital Markets

1 Islamic Financial Services

The Structure of IFIM

1.3 Takaful 1.3.2 Re-Takaful

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 Interbank Benchmark Rate (IIBR) recently developed by Thomson Reuters & AAOIFI Introduction

Current Practice

Pricing of new products: goods & services markets

Market forces - supply & demand Cost of producing the goods Profit margin Innovative efforts Etc.

Assignment: Please write a one-page summary on this topic before coming to next class

What about the Base Financing Rate (BFR)? Pricing of new products: financial instruments Understanding_Price_ Discovery_Mechanism

Market forces, still Cost of funds Profit margin Innovative efforts Etc.

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 Saving accounts Current accounts General Mainly on profit-loss sharing (Mudharabah) Specific

Example: Understanding the Base Lending Rate (BLR) introduced by BNM in 1991

Cost of materials Cost of labor Transportation Cost of producing goods & services Promotions, advertisements & marketing Strategic ownership of certain scientific knowledge (exclusive knowledge) Etc.

Based on 'trust' Amanah

Demand deposits Deposits Sources of funds Investment accounts Cost of funds Financing/loans from the financial markets Financing Placement/Reserve with the Central Bank Uses of funds

What's an Islamic bank? Introduction Insuring Islamic Deposits (discussed separately) To instill confidence and market discipline Tighter as a result of the recent financial crises Disclosure Exaggerated earnings Failure to disclose relevant information Roles of auditors Proper oversight committee Early stage of development adaptation Entering into a mature stage innovation Issues: form vs. Substance Finance companies Saving institutions Development institutions Co-operative banks Import-Export banks The central banks Deposits & financing mobilizations ATM Safe deposits Ar-rahn - Islamic pawning system Ancillary services Fee-based services Secondary Primary Roles & Functions of the Islamic Banking System Liabilities (sources of funds) The Islamic bank Other Types of Islamic Financial System Islamic_Financial_Institutions: The_Islamic_Banking_System Product Development:Adaptaion vs. Innovation The Bank's Balance Sheet Source: van Greuning & Iqbal. 2009. Balance Sheet Analysis: Islamic vs. conventional. New Horizon Liabilities Enron, UBS, Lehman Brothers, Dubai World, etc. Regulatory responses to financial scandals The conventional bank Banking & the Financial Market Regulations Assets Financial Institutions: The Islamic Banking How does an Islamic bank differ to a 'conventional' bank? Islamic bank in a dual-banking system Loans & advances Cash & cash balances with another banks Investment in associate, subsidiaries & JV Financial assets held for trading Cash & balances with the central bank Deposits Due to banks & other financial institutions Other liabilities Sundry creditors Equity & reserves Cash balances Financing assets (murabaha, Salam, ijarah, istisna) Assets (uses of funds) Investment assets (mudharabah, musyarakah) Fee-based services (ju'ala, kafala, etc) Non-banking assets (property) Demand deposits (amanah) Investment accounts (mudharabah) Special investment accounts (mudharabah, musyarakah) Reserves Equity capital The Historical Development

Started in the US after the Great Depression To provide confidence as well as protection before the crisis occurs The rationale for deposit insurance Its importance become more prevalence in recent years due to various financial crises Most deposit insurance will cover less than 80% of the total despots in the banking system Deposit insurance in practice Basic principle: no co-mingling of funds Implicit Insuring Islamic Deposits Type of deposit insurance Explicit Islamic banking funds Wadiah Separate pool of funds BNM's Shari'ah Resolution Types of funds Qardul Hassan Corporate banking Treasury activities Customers' deposits Mudharabah

To separate the pool between the Islamic & conventional banks Islamic deposits are very small, thus no incentives for regulators to enforce the establishment of deposit insurance scheme

Way Forward

Rely on conventional deposit insurance

Premiums received from conventional and Islamic banks are put in the same pool and returns on investments are shared based on % of contributions from each sector Premiums received from Islamic & conventional banks are put into two separate pools

Mixed-pool of funds

Strengthening the economy, as they provide "multiple alternatives to transform an economy's savings into capital investment [which] act as backup facilities should the primary form of intermediation fail." (Alan Greenspan, 1999) What other roles than you can think of?

Roles & functions in promoting IFIS

The [U.S] Financial Stability Oversight Council (FSOC) on Tuesday (10.10.11) issued a more detailed guidelines for designating institutions too big to fail Objectives: to provide clarity to insurance, mutual fund & hedge fund companies Systemically important financial institutions (SIFIs) are seen to pose systemic risks to the economy in a financial stress scenario

Banking institutions Non-bank financial institutions Not clearly defined Normally provides banking services without a banking license or is not supervised by a national or international banking regulatory agency Introduction What is a non-bank financial institution Typically, nondeposit taking institutions Facilitates bankrelated financial services, such as investment, risk pooling, contractual savings, and market brokering Regulatory challenges in the wake of financial crises Non_Bank_Islamic_ Financial_Institutions Accounted for approximately $200 billion in transactions in the U.S. (1996)

govern by the Federal Reserve & State agencies (U.S)

has $3.5bn (2.5bn) in derivative liabilities or $20bn (14.5bn) in outstanding loans borrowed and bonds issued Examples: Goldman Sachs & JPMorgan Chase Sifis will be subject to prudential standards including tough capital and liquidity rules This could result in higher operating costs for compliance for Sifis, leaving them at a disadvantage (Fitch) If any material financial distress at the non-bank institution, or its nature, scope, size, scale, concentration, interconnectedness or mix of its activities could pose a threat to financial stability, the non-bank company will be categorised as a Sifi.

The criteria: Sifi will have more than $50bn (36.3bn) in total consolidated assets and meet at least one of the other criteria, including whether it

Hedge/mutual fund companies Pension funds Asset management companies Development Financial Institutions Leasing companies Awqaf & baitul mal institutions Types of non-bank IFI Discount & guarantee houses General Takaful/insurance Family Venture capital companies Pawn or Ar-rahn Currency exchanges

Implications

Central bank Securities commission Payment Services Directive (PSD) a regulatory initiative from the European Commission to regulate payment services and payment service providers throughout the European Union (EU) and European Economic Area (EEA)

Micro financing warehouses

Regulatory Agencies (depending on jurisdiction)

Quantitative Easing (QE): What's it? Shari'ah compliance instruments The depth & width of the interbank money market Exchange rate targeting Monetary targeting Inflation targeting Interest rate targeting Temporary: repurchase or reverse repurchase to add or drain reserves in the banking system Permanent: to buy or sell securities to add or drain reserves in the financial system The interbank rate: bank lends excess reserves to other depository institutions overnight The Discount Window functions as a safety valve in relieving pressures in reserve markets To alleviate liquidity strains in a depository institution and in the banking system as a whole To ensure the basic stability of the payment system by supplying liquidity during times of systemic stress Primary credit rate: 0.75% Seasonal credit rate: 0.20% Secondary creditrate:1.25% Reserve Requirements Lender of last resort Operating targets Targets Immediate targets Price stability High employment Sustainable growth rate Goals Shari'ah supervisory Roles & Functions of a Central Bank Acts as a banker & financial adviser to the Government Promotes monetary stability & sound financial structure Discount Lending/Window Issuer of currency & keeps reserves safeguarding the value of currency Central Bank Under the Dual Banking System Tools Directors/GMs/etc HR The Conduct of a Monetary Policy Investment Etc Hybrid System OMO Selected Monetary Framework Introduction Dual-Banking System Single Islamic system Only shari'ah law exists: everything is defined as operating under shari'ah Examples? Exists dual-laws in parallel for the Islamic as well as the convention system, respectively Examples? Single law exists and applied to both, Islamic as well as conventional FIs Examples? Board Members Governor Deputy Governors Financial Policy The Structure of a Central Bank Treasury Research Current Issues in Monetary Policy

What is a central bank and why does it matter?

Government investment issue (GII) Qardul Hassan & Al-Inah Up to 3 years Mudharabah interbank investment Mudharabah 0-12 months Wadiah interbank acceptance Wadiah yad dhamanah Not specified Malaysia Islamic treasury bill (MITB) Bai al-Inah 3,6,9 months Bank Negara Negotiable Note (BNN-Note) Ijarah Up to one year Islamic accepted bill (IAB) Murabahah Not specified Islamic Debt Securities BBA, Mudharabah, Murabahah 3-15 years Cagamas Mudharabah Bond Mudharabah -> BBA Up to 10 years Islamic negotiable instrument of deposit Mudharabah Not specified Negotiable Islamic debt certificate BBA Not specified

Financial instruments with maturity less than 12 months What is asset-liability mismatch? Assets are long, while liabilities are shorts Islamic interbank money market at Bank Negara Malaysia Instruments: Examples from BNM's IIMM Islamic Financial Markets: The money market Market place International Islamic Liquidity Market Pasar Uang Antar Bank hosted by Bank Indonesia Liquidity Management Center in Bahrain

Objectives: asset-liability mismatch

The sukuk market: What's sukuk?

AAOIFI defines sukuk as certificates of equal value representing undivided shares in the ownership of tangible assets, usufructs and services or (in the ownership of) the assets of particular projects or special investment activity Informed investors: Decisions to invest Present in all investment portfolios Risk structure

Returns vs. price

Why invest in sukuk? 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, the quality of assets, & transparency, but also to understand the restructuring process, expectations of recovery & length of the process of any types of sukuk structures Establishing better legal infrastructure & corporate governance Consumer education, disclosure beyond the sukuk prospectus: Investors' confusion that they have recourse to certain underlying assets, in most sukuk, investors only subjected to beneficial right to the underlying, rather the title itself - no claim to the underlying itself when sukuk is up for restructuring. Asset-based: Allows the inclusion of the actual asset which may not be legally recognised to be owned outright by the sukuk holders Asset-backed: Grants the sukuk holder a share of the concrete asset or business venture, and a share of the risk commensurate with the "true sale" ownership of the asset Islamic Financial Markets: Islamic Capital Market Way forward Musyarakah Sukuk Ijarah Sukuk Instruments Murabaha Sukuk Salam Sukuk Istisnaa Sukuk Hybrid Sukuk Legal Recource (Sukuk Structures) MIFC Possible sources Ijarah Rating

Incorporated in investment decisions Assessment of the underlying assets Sukuk structure: asset-backed vs. asset-based Medium- to LongTerm Medium- to LongTerm

Mudharabah Sukuk

Mudharabah Musyarakah

Medium- to LongTerm Medium- to LongTerm Medium- to LongTerm Medium Medium- to LongTerm

Murabahah Salam Istisnaa

No legal claim on assets Rely on credit risk of the obligator

Recourse only to ultimate issuer & not any particular asset

Murabahah, mudharabah, Ijarah, etc. Large Single Exposure on Single Group Property bubbles Over reliance on foreign liquidity

Subjected to quality of assets Full recourse to underlying assets

Recourse on specific assets

Kuwait International Investment Group ($152.5 mil.) Sukuk default Kuwaiti Investment Dar ($100 mil.) Dubai's Nakheel ($80-95 mil.) Seven sukuk defaults in Malaysia (RM714 mil.) Pakistan's Mapple Leaf sukuk for a major cement company ($95 mil.) Go to thecityuk.com, p.6

ICM Stylized Facts

When the Salam contract is applied into financial contracts - especially for hedging purposes Instruments can only be sold if the ownership is established

Some elements of gambling? Issues in Salam contract Possession vs. ownership Gharar (uncertainty) Payment spot Delivery on an agreed future date Product must be specified, but cannot be too or well specified. Why? Widely used in agricultural products as a way for farmer to raise working capital or financial need The Mortgage & Futures Markets Bai Bithamin Ajil (BBA) What is Salam contract? The Islamic Futures Market The Islamic Mortgage Musyarakah Mutanaqisah (Declining Partnership)

Ijarah Musyarakah (Partnership) Deferred payment Some BBA contracts bundled with al-inah contract

Examples of Salam contract

The list of shariah compliant index are updated in every six months due to changing business nature of a particular industry say due to merger & acquisition, restructuring & etc What happen to a Muslim investors' holding position when their stocks change in status, from shariah compliant to non-shariah compliant? Where's the 33% ruling coming from? Is there justification in using the one-third criterion? Gambling & gaming related industries Pork and other non-halal food production Conventional finance, banking, asset management, insurance & etc. Hotel & casinos Alcohol Weapon, arm manufacturing activities, etc Debt to Asset ratio =< 33% Cash and interest bearing items ratio to Total Assets =< 33% Account Receivables & Cash to Total Assets =<50% Total interest and non shariah compliant income =<5% of Total Revenue Methods of Shariah Screening Process (Example from FTSE GIIS) Qualitative methods (Screening by types of industries) Other a related issues

What is a shariah screening process? Why do we need a shariah screening process?

FTSE Global Islamic Index Series Shariah Screening Process

Widely used and acceptable standards

The principles are the same: Qualitative & Quantitative Methods

Dow Jones Islamic Market Indexes

Quantitative methods (Screening by looking at financial ratios, after passing the qualitative methods)

Securities Commission of Malaysia

Established in 1944, the World Bank is headquartered in Washington, D.C. MISSION Our work is challenging, but our mission is simple: Help reduce poverty. The International Bank for Reconstruction and Development (IBRD) lends to governments of middle-income and creditworthy low-income countries The International Development Association (IDA) provides interest-free loanscalled credits and grants to governments of the poorest countries

Research on Islamic financial services industry Best practices Regulatory/supervisory roles Globally accepted standards Does the Islamic financial services industry needs to emulate and establish similar institution (other than IDB)? How Do We Approach This Topic? What lessons could we learn from the effectiveness of these institutions in dealing with global financial crises? How do these institutions promote Islamic financial services industry?

Yes & No. Why?

The World Bank

The Agencies

one policy fits all might not work best for all countries Examples: Asian financial crisis 1997; subprime crisis -> global financial crisis & European financial crisis, the PIGS countries Effective vs. ineffective policy description

The International Finance Corporation (IFC) provides loans, equity and technical assistance to stimulate private sector investment in developing countries The Multilateral Investment Guarantee Agency (MIGA) provides guarantees against losses caused by noncommercial risks to investors in developing countries The International Centre for Settlement of Investment Disputes (ICSID) provides international facilities for conciliation and arbitration of investment disputes They agreed on a framework for international economic cooperation, to be established after the Second World War They believed that such a framework was necessary to avoid a repetition of the disastrous economic policies that had contributed to the Great Depression

Liquidity support Regulatory reform The ECB is the central bank for Europe's single currency, the euro The ECBs main task is to maintain the euro's purchasing power and thus price stability in the euro area The euro area comprises the 17 European Union countries that have introduced the euro since 1999 Approximately 1.8 billion people in the region are poor and unable to access essential goods, services, assets and opportunities to which every human is entitled

Number of member countries: 188 countries The IMF was conceived in July 1944, when representatives of 45 countries meeting in the town of Bretton Woods, New Hampshire

The European Central Bank (ECB)

The IMF came into formal existence in December 1945, when its first 29 member countries signed its Articles of Agreement It began operations on March 1, 1947. Later that year, France became the first country to borrow from the IMF working to foster global monetary cooperation

ADB aims for an Asia and Pacific free from poverty

Private sector financing Financing Operations Public sector financing Trade finance Other focus areas IDB is an international financial institution established in pursuance of the Declaration of Intent issued by the Conference of Finance Ministers of Muslim Countries held in Jeddah in Dhul Q'adah 1393H (December 1973) Establishment The Inaugural Meeting of the Board of Governors took place in Rajab 1395H (July 1975), and the Bank was formally opened on 15 Shawwal 1395H corresponding to 20 October 1975 To foster the economic development and social progress of member countries and Muslim communities individually as well as jointly in accordance with the principles of Shari'ah i.e., Islamic Law 56 countries Must be OIC member Accept the terms and conditions of the Articles of establishment

The Asian Development Bank (ADB)

Supra-National Financial Institutions The International Monetary Fund (IMF)

secure financial stability facilitate international trade promote high employment and sustainable economic growth reduce poverty around the world to serve central banks in their pursuit of monetary and financial stability Objectives to foster international cooperation in those areas and to act as a bank for central banks promoting discussion and facilitating collaboration among central banks

Objectives

Purpose

The Islamic Development Bank (IDB)

Membership

supporting dialogue with other authorities that are responsible for promoting financial stability conducting research on policy issues confronting central banks and financial supervisory authorities acting as a prime counterparty for central banks in their financial transactions serving as an agent or trustee in connection with international financial operations

The Bank of International Settlements (BIS)

Mission