Islamic Finance Within
Conventional Banking
System – Opportunities
and Challenges
02 July 2010
III Astana Economic Conference
By
Musa Abdul Malek
Executive Director and CEO HSBC AMANAH Malaysia
CONTENTS
Overview of Islamic Finance
Islamic Finance – Success Recipe
Models for Establishing Islamic Finance
Islamic Finance Window Operations
Challenges in Islamic Finance
2
OVERVIEW OF ISLAMIC FINANCE
3
OVERVIEW OF THE ISLAMIC FINANCE INDUSTRY
Each region is contributing
in a unique way
Government
driven
Asia-Pacific
Malaysia
Bahrain
HIGH
Examples
Brunei
Malaysia’s Islamic Banking
Act 1983 and the Banking &
Financial Institutions Act
1989 are enacted as
separate statutes
Iran
Kuwait
Qatar
Indonesia
Singapore UK
Bangladesh
Oman
Sri Lanka
Hong Kong
Kuwait adopted a new
regulatory framework for
Islamic finance in 2003, by
introducing a new section
into the Central Bank Law of
1968
Others
Pakistan
Sudan
…with worldwide
momentum from retail to
regulator involvement
Middle East
LOW
Japan
South Korea
USA
China
LOW
Egypt
United Arab
Emirates
Saudi Arabia
Turkey
HIGH
Market
driven
Note: Circle sizes denote estimated size of the Islamic financial market in these respective countries
Source: HSBC Amanah, Illustrative Comparison Model for the development of Islamic Markets and Regulations
4
OVERVIEW OF ISLAMIC FINANCE
 Islamic finance has followed in the wake of innovations in the
global financial services industry
 A natural progression of the Islamic finance industry:
– competitive retail offerings
Islamic Finance
In The Last 30
Years
– sophisticated corporate banking products
– innovative project finance solutions
2005+
2000s
1990s
1980s
1970s
 commercial
banking
 commercial
banking
 project
finance &
syndications
 commercial
banking
 project
finance &
syndications
 equity
 Ijarah
 commercial
banking
 project finance &
syndications
 equity
 Ijarah
 sukuk al ijarah
 structured
alternative
assets
 commercial
banking
 project finance &
syndications
 equity
 Ijarah
 sukuk al ijarah
 structured
alternative assets
 liquidity
management tools
5
ECONOMIC GROWTH IN SOME GEOGRAPHIES
Country
Total
Population (m)
(% Muslim)
Saudi Arabia
UAE
Malaysia
Qatar
Bahrain
Pakistan
Indonesia*
Brunei
UK
Bangladesh
Egypt
Turkey
China
India
Iraq
24 (99%)
5.2 (76%)
26 (60%)
1.2 (77%)
1.0 (98%)
176 (97%)
240 (88%)
0.4 (64%)
61 (3%)
29 (88%)
75 (85%)
77 (97%)
1300 (2%)
1100 (13%)
29 (97%)
Prioritization
(Tier 1)
Tier 2
Tier 3
GDP (% real
change per
annum)
2008
4.3
7.0
4.6
15.2
8.1
0.6
6.1
0.61
0.7
6.22
7.2
1.1
9
7.5
na
2009f
-0.1
-1.2
-3.8
9.8
5.6
2.4
3.8
na
-3.8
6.02
4.3
-4.4
8.5
6
na
2010f
3.9
4.3
6.3
8.82
6.02
2.9
5.3
na
1.6
6.22
4.1
2.0
9
7.5
na
2011f
5.9
6.4
6
9.4
5.4
4
6.2
Na
1.8
6.5
6.4
3.5
8.5
7.2
na
2012f
5.2
6.1
6.0
7.5
5.0
4.0
6.1
Na
2
6.4
7
6
8.5
7.2
na
 Of the total 1.6 billion Muslims globally, there
are approximately 640 million in tier 1 & 2
markets.
 Today, there are more than 390 Islamic banks
and institutions spread across 75 countries.
Source: HSBC Group economic forecast.
INDUSTRY COMMENTATORS SEE ISLAMIC FINANCE INDUSTRY CONTINUING ITS RAPID GROWTH
Total Global Islamic banking assets growth (USD bn)
Banking Assets in key markets (USD bn)
1600
15000
12500
1200
CAGR 28%
1000
10000
640
800
600
267
1476
37%
366
1675
2027
5%
4%
7%
5000
605
13%
7500
1500
76.0
67.0
400
200
13%
CAGR 20%2
1400
9458
10073
2007
2008
11661
235.0
500
2500
262
0
2007
2008
Islamic Assets
1
2012E
GCC
Sources: The Banker, Oliver Wyman
1 2007 – 2008 asset figures are based from The Banker
2 Oliver Wyman growth estimates
Iran
Malaysia
Others
2
0
Conventional (UK)
Note: Key markets include Tier 1 and 2 markets
Source: The Banker, Central Bank Reports
Conventional (non UK)
2012
Islamic
6
RISING ISLAMIC PENETRATION WITH GROWTH ACROSS DIFFERENT
INDUSTRY SECTORS
Islamic Retail Banking Assets (USD bn)
1000
Penetration rates
2007 - 2008
2008 - 2012
900
800
CAGR 22%
700
50%
600
Kuwait
Being validated bottom up
with Countries
45%
500
400
300
Saudi Arabia
100
175
213
2007
2008E
0
35%
Islamic Banking Penetration
470
200
40%
2012E
Source: Oliver Wyman
30%
Brunei
Qatar
Islamic Wholesale Banking Assets (USD bn)
Malaysia
25%
1000
900
Bangladesh
20%
CAGR 19%
800
Bahrain
700
UAE
15%
600
Pakistan
1000
500
10%
400
300
Indonesia
Egypt
5%
562
420
200
100
0%
0
0
20
40
60
80
100
120
140
160
180
200
2007
2008E
2012E
Islamic Banking Assets (US bn)
Sources: Oliver Wyman, Morgan Stanley, McKinsey, Zawya, Central Bank Reports
Source: Oliver Wyman
Note: Wholesale includes corporates, wealth funds and private clients.
Global Islamic Mutual Fund Assets (US bn)
70
Islamic Gross Takaful Contributions (USD m)
10000
CAGR 12%
9000
60
CAGR 12%
8000
50
7000
6000
40
5000
30
20
57
4000
6000
3000
35
2000
10
3364
3768
2007
2008E
1000
0
0
2008
2012E
Source: Cerulli Associates Report
2012E
7
Source: Ernst & Young
ISLAMIC FINANCE – SUCCESS RECIPE
8
ISLAMIC FINANCE PROPOSITION – Success Recipe


Majority or good percentage of population are Muslim

Government resolute in pursuing Islamic finance agenda and
introduce conducive regulatory framework eg. Tax, legal etc.
Success 
Recipe

Market have strong demand for Shariah proposition but no issue to
consider conventional
Central Bank able to regulate Islamic financial institutions




Decide and provide guidelines on Shariah issues
Treatment of balance sheet - segregating or co-mingling
Provide framework to support and regulate the institutions
One stop centre to resolve issues by industry players
Sufficient talent to manage the business both the Shariah scholars
and practitioners
9
MODELS FOR ESTABLISHING ISLAMIC FINANCE
10
VARIOUS MODELS FOR CONSIDERATION
Stand Alone
Islamic Finance
License only to do
Islamic finance
business
Comprehensive
infrastructure to
support the
business
Leverage
Islamic
Subsidiary
Islamic window
Subsidiary of the
existing conventional
in the country
A division within
the existing
conventional bank
Separate
Board
of
Directors
Structure
Islamic
products for
distribution by
conventional
branches
infrastructu
re
from
the parent
infrastructu
Using
re
the main
Bank
infrastructu
re
to
support the
business
Supervise
the
operations
to
ensure
Shariah
compliance
11
ISLAMIC WINDOW OPERATIONS
12
ISLAMIC ‘WINDOWS’ OPERATIONS




Windows 
Operations
A division within the conventional bank
Preferably to be headed by a Muslim
Need to set up Shariah Committee and Shariah department to ensure
business undertaken is Shariah compliance
Minimum to have own product development team and dedicated IT team
Sharing the same system platform – tweak to meet with Shariah
 Accounting treatment eg. penalty fee not compounded
 Wordings on the statement and advises must be Shariah
compliance

Leverage from existing infrastructure thus cost to do the business is
lower

Preferable for the balance sheet to be separated
13
ISLAMIC ‘WINDOWS’ OPERATIONS
ADVANTAGES
•
•
•
•
Windows
Operations
Sharing the same infrastructure
Sharing the same system platform – tweak to meet with Shariah
Cost to do the business is lower
Inclusive proposition
DISADVANTAGES
•
•
Always guided by the conventional banking way
•
CHALLENGES
Business requirements may conflict with Shariah
• Awareness on Islamic finance amongst the internal customers is low
• Shariah compliance to be the main driver for the business
• Potential canabalising the conventional business
14
CHALLENGES IN ISLAMIC FINANCE
15
CHALLENGES IN ISLAMIC FINANCE
Meeting evolving consumers’
demand
Strategy and Plan to develop the
right business model
Comprehensive Shariah
Governance & Audit
Challenges
*
Legal, Regulatory & Accounting
Framework*
Information system to cater to
Islamic Finance transactions
Risk Management*
Replication v. Authenticity
Willingness to invest in Human
Capital Development
Wealth Management
16
SHARIAH GOVERNANCE AND FRAMEWORK
17
SHARIAH COMPLIANCE IS FUNDAMENTAL IN
ISLAMIC BANKING AND FINANCIAL INSTITUTIONS


IFSB

Islamic Financial Services Board (IFSB) Guiding Principles of Risk
Management indicates:
Shariah Compliance is categorised as higher priority in relation to
identified risks and;
There must be a comprehensive and sound Shariah Compliance
framework and mechanism in place.
18
MEMORANDUM & ARTICLES OF ASSOCIATION OF MOST
ISLAMIC FINANCE INSTITUTIONS PROVIDE:
The business of the Company will be transacted in
ACCORDANCE with the :
Compliance
Islamic
Principles
Rules
Practices
In this respect, the Company is PROHIBITED from
carrying out any transactions which involve any
elements that are not in compliance with the Islamic
principles, rules and practices.
19
SHARIAH STRUCTURE
Shariah
Committee
Shariah
Structure
Shariah Dept
Internal Policies,
Procedures,
Guidelines,
Manuals, Matrix &
Certificates
 Term Of Reference of Shariah
Committee
 Rulings of Shariah Committee
 Shariah Advisory & Development
 Shariah Compliance & Review
 Shariah Research




Shariah Compliance Manual
Guidelines on the Shariah Committee
Shariah Compliance Certificate
Guidelines on Services & Transactions
20
LEGAL, REGULATORY & ACCOUNTING FRAMEWORK
21
LEGAL, REGULATORY & ACCOUNTING FRAMEWORK
Legal
Regulatory
Accounting
Need a Robust
Structure
Flexible yet
decisive
AAOFI vs IFRS
22
LEGAL FRAMEWORK – Need a robust structure
 Ensure compliant with Shariah but yet enforceable under
applicable secular law
 Current transactional practise with respect to existing
legal opinion
- Different islamic jurisprudence interpret Shariah differently
Legal
- Lack of binding precedents and published decision
- Is Shariah compliance considered in judgement eg Zulkifli vs Affin Bank (Malaysia),
Investment Dar vs Lebanon Blom Bank
 Untested certainty/predictability for Shariah compliant
transactions in different jurisdiction
 Willing to change to accommodate Shariah requirements
eg. legal ownership over home financing if structure
based on Ijarah or Musyarakah
23
REGULATORY FRAMEWORK – Flexible yet decisive
 Willing to change the act to accommodate Islamic
Finance
- Land Code
- Tax issue eg. VAT, property gain tax
Regulatory
 Propose to adopt tax neutrality
24
ACCOUNTING FRAMEWORK (AAOIFI vs IFRS)
AAOIFI
 Develop the accounting, auditing and banking practices through
relating to the activities of the Islamic Financial Institutions
(IFIs)
Accounting 1
 Prepare, promulgate and interpret accounting and auditing
standards for IFIs in order to harmonize the accounting
practices and auditing procedures
 Review and amend the accounting and auditing standard for
IFIs to cope with developments in the accounting and auditing
through practices
25
ACCOUNTING FRAMEWORK (AAOIFI vs IFRS)
IASC Foundation and IASB
 To develop a single set of high quality, understandable,
enforceable and globally accepted international financial
reporting standards (IFRS) through its standard-setting body of
IASB
Accounting 2
 To promote the use and rigorous application of those standards
 To bring about the convergence of national accounting
standards and IFRS to high quality solutions
Main Differences AAOIFI and IFRS
 AAOIFI
Specific for Islamic industry
Accounting, Auditing, Ethics, Governance & Sharia
 IFRS
Entire economic & social activities
Specific to accounting
26
ACCOUNTING FRAMEWORK (AAOIFI vs IFRS)
Consideration
 Standalone and fully Islamic Group – AAOIFI
 Subsidiary with conventional parent – IFRS
 Window – IFRS
Accounting 3
Rationale for window to adopt IFRS
 Consolidation
 Accounting treatment eg. Unrestricted investment as a
separate item instead of presented as liabilities (along
with other liabilities) in IFRS
27
RISK IN ISLAMIC FINANCE
28
RISK MANAGEMENT IS
Embedded within the conventional
business risk management framework









Credit Risk
Market Risk
Insurance Risk
Sustainability Risk
Liquidity Risk
Pension Fund Risk
Residual Value Risk
Reputation Risk
Operational Risk
Shariah Risk Management
 Non-compliance with Shariah rules and
regulations
 Accounting
 Business Continuity
 Fiduciary
 Fraud
 New product due diligence including
simplification of product complexities
 Application of Late Payment / Penalty for
default in a Shariah compliance manner
 Information
 Legal
 Compliance
 Operations
 People
 Tax
 Technology
 Advise on debt restructuring
 Changes in fatwa resulting in existing
product being non-compliance
 Advising / guiding with ongoing Shariah
requirements
29
MAJOR SHARIAH RISKS
RISKS
Concentrated reliance on a single
broker for transacting commodity
murabaha (substantial Global
Business is based on this structure)
Major Risks
ACTIONS
Identification of new brokers required
and find alternative to existing
commodity (eg. Bursa Al Sila’)
Untested legal infrastructure (case
laws or court proceedings)
supporting products
Using experienced legal counsel for
preparing documentation and
structures
Credibility of “Commodity Murabaha”
/ “Tawarruq” structure questionable
Looking to diversify to other
structures.
To address concerns raised.
Manual Processes increase
operational risks
Rationalisation of product range.
Long term, automation and
standardisation required
Lack of inter-bank market creates
challenges in matching assets and
liabilities
This has to be addressed and
financial linkages required
30
Thank You