Risk Assessment & Regulatory Framework

In Islamic Banks

The Lebanese Experience

Dr Amine Awad
Executive Director, Lebanons Banking Control Commission
Member of the Higher Banking Council
Coordinatior of Basel III Implementation Task Force
Washington D,C. October 18, 2012

Banking Control Commission

Outline
Preface: What is Islamic Banking
Major Islamic Banking Rules & Standards
Brief History of I.B.s in Lebanon
Major Regulations for I.B.s in Lebanon
Liquidity in I.B.s
Challenges Facing the Development of I.B.s
List of Islamic Banking Regulations

Banking Control Commission

Preface
Islam encompass all aspects of Muslims life.
Islamic Law or Sharia: derived from the holly Qoran and
the Sunna (Practices of the Prophet).
Islamic Financial Model, as seen today, is based on the
following 5 major principles:
Principle 1: Everyone involved in a transaction should be well informed
and not misled or cheated.
Principle 2: Islam encourages economic activities but makes a clear
distinction between activities Allowed and activities
Forbidden (Exp: Transactions involving Alcohol, pork,
gambling etc)

(Cont.)
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Banking Control Commission

Preface (Cont.)
Principle 3: The major Sharia rule prohibits muslims of Riba
(i.e. usury or interest). Islamic Banking has developed
mechanisms that replaced interest income by cash flows
from productive sources (Exp: Profit from trading in assets,
rental income, leasing etc)
Principle 4: The Islamic Banking Model is based on a Risk and Profit
sharing (and Loss bearing); so Sharia Compliant
transactions are similar to Equity based Transactions.
Principle 5: Contractual Certainty : Uncertainty or ambiguity that can
lead to disputes render a contract void under Sharia.

Banking Control Commission

Major Islamic Banking

Rules & Standards
As Islam is based on Sharia, there are 4 major Schools
(Mazahib) of Al Fikh, i.e. the Interpretation of the Sharia
Rules, from the extreme rigorous to the easiest:

MALIKI

HANBALI

SHAFII

HANAFI
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Banking Control Commission

Major Islamic Banking

Rules & Standards
In the early 90s the Islamic Banking Industry decided that
the existing International Standards applying to
Conventional Banking were inadequate to cater its needs.
In 1991, the AAOIFI (Accounting & Auditing
Organization for Islamic Financial Institutions) was created
in Bahrain.
Over the years AAOIFI has developed new Standards for
Islamic Financial Institutions (I.F.I.) and has taken
significant steps to encourage the application and
enforcement of its standards.
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Banking Control Commission

Major Islamic Banking

Rules & Standards
AAOIFI objectives are to:
* Develop Accounting and Auditing thoughts for IFIs
* Disseminate these thoughts
* Preface and Review Accounting and Auditing Standards for
IFIs, that respect Sharia.

AAOIFI also created two diplomas for Islamic Banking:

* C.I.P.A. (Certified Islamic Public Accountant)
* C.S.A.A. (Certified Sharia Advisor & Auditor)
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Banking Control Commission

Major Islamic Banking

Rules & Standards
In 2012, there are:
* 26 Accounting Standards

* 5 Auditing Standards
* 7 Governance Standards

* 45 Sharia Standards
* 2 Codes of Ethics
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Banking Control Commission

Brief History of I.B.s in Lebanon

Until February 2004, date of adoption of the Law No 575 on Islamic

Banking, there was no Islamic banks in Lebanon, except one (Al Baraka Bank), which was operating as a Conventional Bank,
respecting the sharia.
Presently there is a small Islamic Banking Sector in Lebanon with 5
Banks, 2 of them are affiliated to large Lebanese Conventional banks
and 3 are affiliated to large Foreign Islamic banks (Bahrani, Qatar &
Iraq).
Lebanon decided to set the legal framework of an Islamic Banking
Sector because of the two following major factors:

Islamic Banking is growing rapidly worldwide (annual growth rate

is estimated at 15% for the last 7 years)
Excess of Liquidity in the Middle East Region
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Banking Control Commission

Some Figures of the Islamic Banking Sector in

Lebanon
2006

2007

2008

2009

2010

2011

June
2012

Number of I.B.

Total Number
of Branches

10

12

13

16

17

18

18

2006

2007

2008

2009

2010

2011

June
2012

Total Footings
(Incl. Assets under
Management)

340

460

607

771

799

870

920

Total Deposits
(Restricted +
Unrestricted A/Cs)

167

250

269

323

408

534

565

Total Equity

112

112

130

134

136

131

129

)In USD Million)

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Major Regulations for I.B.s

Banking Control Commission

No Islamic Windows are allowed only Independent Islamic Banks

can offer Islamic banking services and products:

. To put a Chinese wall between Conventional and Islamic Banking and avoid
misleading non transparent practices.

. To have a clear competitive market for Islamic Finance

Minimum Capital for an I.B. is USD 100 Million (with exceptions in
some cases)
The 15% cash Hamesh Al Jaddia )Margin) is mandatory, in Murabaha
Transactions.(= Margin against Trade Finance Transactions)
The legal liability of Al Amer Bil Shiraa )Client) is mandatory in
Murabaha transaction.(including all types of Collaterals)
Financing of Real Estate Development Projects (L.T.V.) should not exeed
60% of the projects value
All types of R.E. Intermediation and/or Financing Speculation on R.E. are
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prohibited

Banking Control Commission

Major Regulations for I.B.s

There are many circulars issued by B.D.L. and B.C.C.L. to set the legal
and regulatory framework of the various types of Islamic Transactions :
Murabaha (Retail & Trade Finance Transactions)
Musharaka or Mussahama (Project Financing Transactions)
Ijarah & Ijarah Muntahia Bitamlik (Leasing Transactions)
Mudaraba (Profit sharing between the bank and the Client)
Salam (Advances against Future delivery of assets)
Istisnaa (Advances against manufacturing of an asset to be
delivered to the Islamic Bank)
Sukuk (Bonds) (Islamic Asset Backed Instruments)
Islamic Mutual Funds
(Cont.)
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Major Recent Regulations for I.B. (Cont.)

Banking Control Commission

On the other hand B.D.L. issued four important Circulars:

- In August 2004, Circular # 94, setting Limit for I.B.s Investments in
R.E. (50% of the Total Investment Portfolio)
- In February 2007, Circular #107, drawing a specific form of Balance
Sheet (including Off Balance Sheet items) and P & L Account for
I.B.(B.C.C.L. will issue in the next couple of weeks a Condensed B/S).

- In September 2007, Circular # 112, on Corporate Governance

Practices in I.B. :
* Mandating Corp . Gov. Unit (with a Non Executive Board
Member) (+) Sharia Audit Unit (reporting to B.o.D. and Sharia
Board), in addition to other B.o.D Committees (as for Conventional
Banks)
* List of Disclosures for full transparency
* Role: - Protect the interests of the customers and other stakeholders
- Supervise and develop the systems relating to Corporate
Governance
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Banking Control Commission

Major Recent Regulations for I.B. (Cont.)

- In May 2008, Circular # 116, on new Capital Instruments (Tier2) in
I.B.s, including:
* Kard Al Hassan (Subordinated Loan) (Perpetual = i.e. minimum 5 years
no capital guarantee, not redeemed except from free distributable profits)
* Cash Contribution (with no return and for the whole life of the Bank)
- In May 2008, Circular # 163, on the pre - conditions to Sell Islamic

Financial Products
* I.B. must obtain B.D.L. prior approval to sell any Islamic Financial Product
to the public (to avoid misleading and protect consumers of Islamic
financial services)
- In July 2008, Circular # 178, on Investments of I.B.:

* Total Lending of I.B.s to their Affiliated Companies, should not exceed

30% of the banks Equity )and 10% per company)
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Methodology of Regulation /
Supervision of I.B.s

Banking Control Commission

- Joint Task Force (Between B.D.L. and B.C.C.L.) specialized in

Islamic Banking that sets the Legal and regulatory framework of

the I.B. Activities ( Mainly: Capitalization, Provisionning, Risk
Management Approach, Int. / Ext. / Shariaa Audit etc)
- On Site Examination Team, specialized in Shariaa Compliant
Banking Transactions.
- B.D.L. and B.C.C.L. are in the process of preparing a
Consolidated Balance Sheet between a Conventional Bank and an
Islamic Bank, that respects IAS/IFRS as well as IFSB/AAOIFI
Standards:
* Because some Lebanese Conventional Banks have an
Islamic Subsidiary in Lebanon
* Some others have an Islamic Subsidiary abroad
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Banking Control Commission

Liquidity Management In I.B.s

In addition to the methodology of Management of
Liquidity in Conventional Banks, many specific ratios
are used to measure the liquidity in I.B.s; the most used
by the I.I.R.A. (Islamic International Rating Agency)
are:
LR (1) = Liquid Assets (a)

Liquid Liabilities

(b)

LR = Liquid Assets
Total Liabilities
(2)

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Banking Control Commission

Liquidity In I.B.s
LR (3) = Loans
Core Funding (c)
LR (4) = Interbank Borrowings
Total Assets

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Banking Control Commission

Definitions of Liquidity Elements

(a) Liquid Assets of I.B.s = Cash + Cash Equivalent
+Placements with Banks & F.I.s +Liquid Investments
(b) Liquid Liabilities in I.B.s = Deposits + Borrowings
from Bank & F.I.s
(c) Core Funding in I.B.s = Deposits + Capital
Investments in Affiliates Investments in Fixed Assets
Large Deposits (> 5% of Equity) Reserves with
Central Banks
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Liquidity In I.B.s

Banking Control Commission

In a recent study (published in 2009), made by 4 experts

on the Financial Performance of Malaysian I.B.s v/s
Conventional Banks, the authors reached the following
conclusion:
Average of Net Loans to Total Assets ratio for Islamic
banks stood at 45.2%, which is lower than Conventional
banks (57.1%). This means that Islamic banks are more
liquid than Conventional banks.
The Financing to Deposit Ratio for Islamic banks (49.2%)
is lower than Conventional banks (68.1%) by 18.9%, this
indicates that Islamic banks are more liquid than
Conventional banks.
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Banking Control Commission

Liquidity In I.B.s
Looking at these ratios, we could say that Islamic banks
seem to have better liquidity ratios in comparison to
Conventional banks.
According to Haron (2004) Islamic banks experienced
excess liquidity given the lack of Islamic Financial
Instruments in the market for the Islamic bank to invest
in. Besides, the lower assets tied to net loans of Islamic
banks compared to Conventional banks which resulted
in higher liquidity may be due to the stringent financing
policy (i.e. must comply with Sharia unlike the
Conventional banks).
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Banking Control Commission

Comparative Liquidity in I.B.s v/s C.B.s

(Malaysia)
Liquidity

I.B.s

C.B.s

Net Loans / Tot Assets

45.2

57.1

Net Loans / Dep & ST Funding

49.2

68.1

Net Loans / Tot Dep & Borrowings

48.8

66.0

Liquid Assets / Dep & ST Funding

45.1

30.4

Liquid Assets / Tot Dep &

Borrowings

44.7

28.5

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Banking Control Commission

3 Liquidity Ratios (in I.B.s)

Level 1 (on-B/S)

=(Cash + Central Bank + Nostro Banks + Murabaha with Central Bank + Murabah with Banks
(B/S) - Vostro Banks -Banks Unrestricted investment accounts) / (current accounts including
margins on LC's & Hamish Jaddiyya + Sundry Creditors)
Level 2 (on-B/S & off- B/S unrestricted murabaha with banks)
= (Cash + Central Bank + Nostro Banks + Murabaha with Central Bank+ Murabah with Banks
(B/S) + Murabaha with Banks unrestricted-Vostro Banks -Banks Unrestricted investment accounts)
/ (current accounts including margins on LC's & Hamish Jaddiyya + Sundry Creditors +
Unrestricted Investments Accounts + Profits to be distributed on unrestricted investments accounts)
Level 3 (on-B/S & off-B/S unrestricted & restricted murabaha included)
= (Cash + Central Bank + Nostro Banks + Murabaha with Central Bank + Murabah with Banks
(B/S) + Murabaha with Banks unrestricted+ Murabah with Banks Restricted-Vostro Banks -Banks
Unrestricted investment accounts -Restricted Wakala (banks)) / ( current accounts including margins
on LC's & Hamish Jaddiyya + Sundry Creditors + Unrestricted Investments Accounts + Profits to
be distributed on unrestricted investments accounts + restricted Investments Accounts + profits to
be distributed on restricted investments accounts))
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Banking Control Commission

Challenges Facing the Development of I.B.

1) Sharia Arbitrage: as the Regulator / Supervisor is not in a position to
assess the suitability of the different scholars consulted by the Islamic Banks.
However the references are the I.F.S.B. (Islamic Financial Services
Board) Principles and the AAOIFI Standards
2) Absence of Capital Adequacy Standard: for I.Bs )Basel II & Basel III)
3) Human Resources: There is a shortage of experienced professionals in the
Islamic Financial Sector. This needs more education and trainings.
4) Contracts & Documentation Risk: Equivalent to the Legal Risk in
Conventional Banks.
If a transaction reveal to be Sharia non compliant, the Asset can be
converted into liability in the Islamic Banks B/S (in addition to the Zakat
Penalty)
5) Reputational Risk.
Mainly due to lack of transparency or to wrong presentation of the Islamic
products and services and their underlying risks.

P.S. The B.C.C.L. Try to apply the Risk Identification, Assessment and
Quantification in I.B.s under the Pillar II.

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Banking Control Commission

List of Most Important Islamic Banking

Rules in Lebanon

BDL Circular # 94, dated August 2004: Practice of

Islamic Banking in Lebanon
BDL Circular # 95, dated August 2004: Conditions of
Establishment of an I.B. in Lebanon
BDL Circular # 96, dated October 2004: MURABAHA
BDL Circular # 97, dated January 2005 & BCCL Circular
# 246 :MUSHARAKA (or MUSSAHAMA)
BDL Circular # 98, dated June 2005: Islamic Collective
Investment Schemes
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Banking Control Commission

List of Most Important Islamic Banking

Rules in Lebanon
BDL Circular # 99, dated June 2005 & BCCL
Circular # 247: IJARAH & IJARAH
MUNTAHIA BITTAMLEEK
BDL Circular # 100, dated July 2005 & BCCL
Circular # 249: MUDARABA
BDL Circular # 101, dated December 2005 &
BCCL Circular # 253 : BAI SALAM
BDL Circular # 102, dated December 2005 &
BCCL Circular # 254: ISTISNAH

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Banking Control Commission

List of Most Important Islamic Banking

Rules in Lebanon

BDL Circular # 107, dated February 2007: I.B. Financial

Statements
BDL Circular # 112, dated September 2007: Corporate Governance
in I.B.
BDL Circular # 116, dated May 2008: Capital Instruments in I.B.
BDL (Intermed.) Circular # 163, dated May 2008: Islamic
Financial Products
BDL (Intermed.) Circular # 178, dated July 2008: Limit for I.B.s
lending to their Affiliates

P.S: Central Bank Website: www.bdl.gov.lb

Banking Control Commission Website: www.bccl.gov.lb
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Banking Control Commission

Discussion

E Mail: amawad@bccl.gov.lb
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