1ST SESSION:
Overview on Supervision of
Islamic Banks
September 2011
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
1
Objectives of Presentation
(for both sessions)
To explain the main principles in banking supervision – modification required to
cater for specificities in supervision of Islamic banking
To highlight the Malaysian approach in supervising Islamic banks
To share Malaysian experiences (where ever applicable)
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
2
Starting Point:
How Different are Operation of Islamic banks?
(in theory and practice)
Islamic Banks
Conventional Banks
Source of
Funds
Investment from Investment Account Holders
(IAH)
Relationship: Investor – Entrepreneur
Deposits from customers
Relationship: Creditor - Debtor
Use of
Funds
Equity investment and profit-sharing venture
(Musharakah and Mudharabah)
Relationship: Investor – Entrepreneur
Loan to Borrower
Relationship: Creditor - Debtor
Financing and Trading of assets
Relationship: seller – purchaser
Level of funding from IAH is the most significant differentiating factor
• The investors-entrepreneur relationship changes the way Islamic banks operate:
• Investors (IAH) bear fully the investment risk (while the bank is only exposed to negligence risk). IAH
could therefore determine the investments/assets profile of the banks
• Islamic banks have greater fiduciary duty to protect IAH’s investment
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
3
The uniqueness of the activities and risks of Islamic banks
warrants special treatments in the following elements…
Risk
management
(DETAILED DISCUSSION
IN THE 2ND SESSION)
Capital
Requirement
Corporate
Governance
Market
Discipline
Supervisory
Approach
• In addition to the traditional banking risk, supervisors must acknowledge the unique risks in
Islamic banking e.g. asset price risk, rate of return risk, displaced commercial risk (DCR) and
equity investment risk.
• Supervisors must appreciate the risk transformation element and the additional aspects of
operational risk in Islamic banking
• Capital must be adequate to cushion for all risk including risks unique to Islamic banking as
identified through proper risk management process.
• The role of Shariah Board in the governance.
• Process and control to protect Investment Account Holder (IAH)
• Transparency of financial reporting in respect to investment accounts
• The need to spur market discipline among Islamic banks with regard to the appropriate and
timely disclosure of information on risks and returns
• Supervision of Islamic banks is very similar to conventional banks i.e. any supervisory
approach / framework may be relevant and applicable to Islamic banking supervision
• However, specific considerations are required to address specificities of Islamic banks
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
4
The uniqueness of the activities and risks of Islamic banks
warrants special treatments in the following elements…
Risk
management
Capital
Requirement
Corporate
Governance
Market
Discipline
Supervisory
Approach
• In addition to the traditional banking risk, supervisors must acknowledge the unique risks in
Islamic banking e.g.. asset price risk, rate of return risk, displaced commercial risk (DCR) and
equity investment risk.
• Supervisors must appreciate the risk transformation element and the additional aspects of
operational risk in Islamic banking
• Capital must be adequate to cushion for all risk including risks unique to Islamic banking as
identified through proper risk management process.
• The role of Shariah Board in the governance.
• Process and control to protect Investment Account Holder (IAH)
• Transparency of financial reporting in respect to investment accounts
• The need to spur market discipline among Islamic banks with regard to the appropriate and
timely disclosure of information on risks and returns
• Supervision of Islamic banks is very similar to conventional banks i.e. any supervisory
approach / framework may be relevant and applicable to Islamic banking supervision
• However, specific considerations are required to address specificities of Islamic banks
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
5
Assessing Capital Adequacy for Islamic Banks
Main Principle
Capital must be commensurate with overall level of risk i.e. including the unique Islamic banking risks
Challenges
Malaysian Experience
• How is capital framework modified to reflect the nature of
Islamic bank where risks (except operational risk) are
absorbed by IAH?
• Introduced the risk absorbent guidelines which laid out the
qualitative criteria for risk absorbent. Currently the risk
absorbent features is restricted to SIA only subject to
meeting the qualitative criteria.
• What is the appropriate level of capital charge for equity
investment risk? should it attract 300-400% RWA based
on IFSB CAS or 100-150% RWA based on the Basel 2
risk charge for non trading equity risk?
• Some of the unique risks such as RoR risk and the
additional aspects of operational risk are not addressed
under pillar 1
• Risk transformation and capital adequacy
• The capital charge for asset price risk of 15% is based on
the commodity price risk, is it sufficient for other asset
price risk particularly real estate?
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
• To ensure level playing field and competitiveness between
Islamic banks and conventional, the 100-150% RWA is
levied as the capital charge for equity investment risk.
• The unique risk and additional aspects of operational risk
which are not covered by the minimum capital
requirement were addressed under pillar 2 – supervisory
review process.
• Structured training programme to supervisors
• Undertake a study on the adequacy of capital for real
estate price risk.
6
In ensuring capital adequacy vis-à-vis the unique nature of
Islamic banks, IFSB had issued Capital Adequacy Standard
(which BNM adopted… with several local modification)
Capital Adequacy
Requirement
Risk transformation & capital charges
on different contracts
Alpha ~ Risk absorbent feature of Profit
Sharing Investment Accounts (PSIA)
How does supervisor account for different
risks embedded in one contract?
How is capital framework modified to
reflect the nature of Islamic bank where
risks (except operational risk) are
absorbed by PSIA?
Main Principle
Capital must be commensurate with overall level of risk i.e. including the unique Islamic
financial risks
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
7
To understand the different embedded risks within a particular
contract, supervisors need to understand the concept of risk
transformation…
e.g.. Non-binding Murabahah structure:
The bank purchases an asset (e.g.. a
house) for reselling at mark up
Market Risk
Transformation
Customer approaches the bank and
buy that house with a deferred
settlement
Credit Risk
What is the capital charge on a Murabahah contract for financing a
residential real estate?...
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
8
Risk Transformation and hence, capital charge for Murabahah
contract depends on the nature of purchase order by the
customers
Non-binding Purchase Order
Stage of contract
Credit RW
Market Risk Charge
Asset Available for Sale
(on Balance Sheet)
NA
15%
Asset is sold to customers –
payment due from customer
Based on customer’s
rating (similar to Basel II)
NA
Binding Purchase Order
Stage of contract
Asset Available for Sale
(on Balance Sheet)
Credit RW
Based on customer’s
rating (similar to Basel II)
Market Risk Charge
NA
Asset is sold to customers –
payment due from customer
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
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Quite similar to Murabahah, capital charge for Ijarah contract
depends on the nature of promise to lease…. And type of Ijarah
Operating Ijarah
Stage of contract
Credit RW
Market Risk Charge
Asset Available for Sale
(on Balance Sheet)
Based on customer’s rating (similar
to Basel II) ~ only if promise to lease
(PL) present and binding
15% risk charge (if no PL or
PL is non-binding)
Asset is leased to customers – Lease
payment due from customer
Based on customer’s rating (similar
to Basel II)
Residual risk: 100% RW
Maturity of the lease
NA
15% risk charge
Ijarah Muntahiah bi Tamleek (IMB)
Stage of contract
Credit RW
Market Risk Charge
Asset Available for Sale
(on Balance Sheet)
Based on customer’s rating (similar
to Basel II) ~ only if promise to lease
(PL) present and binding
15% risk charge (if no PL or
PL is non-binding)
Asset is leased to customers – Lease
payment due from customer
Based on customer’s rating (similar
to Basel II)
NA
Maturity of the lease
NA
NA
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
10
Capital Adequacy Standard issued by IFSB recognised
PSIA as risk absorbent…
Banks assume all risks
Conventional formula
Capital Base
•
in view of the obligation to protect the
principal value of deposits arising
from lender borrower relationship
between bank and depositors
•
Required to allocate adequate capital
against risk exposures
RWCR =
Total Risk Weighted Assets (RWA)
(credit + market + operational risk)
Standardised formula under CAS issued by IFSB
Capital Base
RWCR =
Total RWA
Less
Credit and Market RWA
funded by PSIA
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
IBs are not exposed to the credit
and market risks of assets funded
by PSIA funds
• In view that these risks are assumed by
the IAH
• CAS recommended that risk weighted
assets (RWA) funded by PSIA be
deducted from the computation of
RWCR
11
In practice, the standard also recognised that IB may not pass all
losses due to credit and market risks to IAH as a strategy to
remain competitive
Standard Formula
Capital Base
RWCR =
Total RWA
Less
Credit and Market RWA
funded by PSIA
Supervisory Discretion Formula
Capital Base
RWCR =
Total RWA Less Credit and Market RWA Add
funded by PSIA
(α)
Credit and Market RWA
funded by Unrestricted PSIA
Capital Base
RWCR =
Total RWA Less Credit and Market RWA Less (1 - α)
funded by Restricted PSIA
Credit and Market RWA
funded by Unrestricted PSIA
• Alpha (α) represents the percentage of credit and market risks absorbed by IB instead of the IAH as a consequent of
income smoothening practice or Displaced Commercial Risk (DCR).
• Where α equal to:
–‘0’ means IB pass 100% of the credit and market risks to IAH ; and
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS –‘1’ means IB absorb 100% credit and market risks risk absorb by IB
12
We in Malaysia take a stance… the responsibility to prove the level
of displaced commercial risk is at the hand of the banks
1
Establish governance of PSIA
• Outline the role of the Board of Directors and senior
management in managing PSIA funds
2
Establish PSIA contract that
incorporate adequate provisions
to facilitate effective risks transfer
• Explicitly stipulate that losses arising from the assets
funded by PSIA shall be borne by the IAH
• Ensure the PSIA contract is legally enforceable
3
Identify and match the PSIA
funds with the assets funded by
these funds
• Enhanced the capability to identify and tag the assets
with PSIA funds enable to facilitate the measurement of
risks and return to IAH
• Clarity in identifying and accounting of losses arising
from assets funded by PSIA funds will contribute to the
effective transfer of risk to IAH
4
Disclose relevant information
pertaining to the PSIA funds to
the IAH on a timely basis
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
• Access to relevant information enables IAH to
make an informed investment decision
• Facilitate IAH to assess the risks and return profile
of the investment portfolio as well as monitoring
the performance of the investment
13
The uniqueness of the activities and risks of Islamic banks
warrants special treatments in the following elements…
Risk
management
Capital
Requirement
Corporate
Governance
Market
Discipline
Supervisory
Approach
• In addition to the traditional banking risk, supervisors must acknowledge the unique risks in
Islamic banking e.g.. asset price risk, rate of return risk, displaced commercial risk (DCR) and
equity investment risk.
• Supervisors must appreciate the risk transformation element and the additional aspects of
operational risk in Islamic banking
• Capital must be adequate to cushion for all risk including risks unique to Islamic banking as
identified through proper risk management process.
• The role of Shariah Board in the governance.
• Process and control to protect Investment Account Holder (IAH)
• Transparency of financial reporting in respect to investment accounts
• The need to spur market discipline among Islamic banks with regard to the appropriate and
timely disclosure of information on risks and returns
• Supervision of Islamic banks is very similar to conventional banks i.e. any supervisory
approach / framework may be relevant and applicable to Islamic banking supervision
• However, specific considerations are required to address specificities of Islamic banks
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
14
Bank Negara Malaysia has develop several regulatory and supervisory guidance
to ensure Islamic banks practice proper corporate governance especially in
Shariah management…
•The Governance of Shariah Committee – 2004
• Financial Reporting for Islamic Banks - 2005
• Corporate Governance for Licensed Islamic Banks – 2007
The elements of the frameworks include:
 Compliance with shariah
 The role of shariah committee in the governance
 Controls for protecting IAH’s rights
 Transparency of financial reporting
Internal audit & control
External Auditors
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
Supervisors role:
to ensure elements of Shariah
governance is effectively in place
15
Shariah Compliance:
Supervisory Perspective & Governance Structure
AUDIT COMMITTEE
True & fair opinion
Express Shariah
Opinion on IFI
SHARIAH BOARD/
SHARIAH COMMITTEE
EXTERNAL
AUDITOR
Formulate
Policy
Shariah
Review
Testing for
Shariah
Compliance
Attest
Shariah
Endorsement
Shariah Review/
compliance Unit
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
INTERNAL
AUDIT
Internal Shariah
Review
Internal control
system
16
…strong governance require full market awareness and greater
disclosure
Strong Governance Structure
Enhanced Disclosure
 The equity participation concept trigger
fiduciary duty of the bank vis-à-vis costumers
protection is crucial. Therefore, disclosure
requirement must be more than those
expected of conventional counterparts.
 However, how much is enough? Supervisors
must strike the balance between cost
efficiency and meaningful disclosure and the
need to protect proprietary information
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
Full Market Awareness
Market as a whole must understand the
uniqueness of Islamic banking.
However, we must ensure signals trigger such
as rating agencies basing their assessment
from the correct angle and consider the
uniqueness of Islamic banking e.g.. rating
methodology for sukuk musharakah /
mudharabah should be based on the risk profile
of the contract.
17
The uniqueness of the activities and risks of Islamic banks
warrants special treatments in the following elements…
Risk
management
Capital
Requirement
Corporate
Governance
Market
Discipline
Supervisory
Approach
• In addition to the traditional banking risk, supervisors must acknowledge the unique risks in
Islamic banking e.g.. asset price risk, rate of return risk, displaced commercial risk (DCR) and
equity investment risk.
• Supervisors must appreciate the risk transformation element and the additional aspects of
operational risk in Islamic banking
• Capital must be adequate to cushion for all risk including risks unique to Islamic banking as
identified through proper risk management process.
• The role of Shariah Board in the governance.
• Process and control to protect Investment Account Holder (IAH)
• Transparency of financial reporting in respect to investment accounts
• The need to spur market discipline among Islamic banks with regard to the appropriate and
timely disclosure of information on risks and returns
• Supervision of Islamic banks is very similar to conventional banks i.e. any supervisory
approach / framework may be relevant and applicable to Islamic banking supervision
• However, specific considerations are required to address specificities of Islamic banks
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
18
Effective Market Discipline
How prepared is the Islamic banking market?...
ISSUES
Pre-conditions for effective market discipline:
 Market must understand and fully appreciate the nature and risk of Islamic banks
 All parties (players, customers, investors, other supervisors, rating agency) are on the same wavelength to ensure
consistent understanding of market signals and react accordingly.
UNTIL AND UNLESS THE CRITERIA ARE MET, SUPERVISORS CANNOT PUT FULL RELIANCE ON MARKET DISCIPLINE TO
REGULATE ISLAMIC BANKING INDUSTRY
EFFECTIVE MARKET DISCIPLINE
Strong Governance Structure
 Islamic bank’s fiduciary duty towards IAH is significant and therefore there should be high
supervisory expectation with regards to this fiduciary responsibility.
 There must also be supervisory expectation on the role of Shariah Supervisory Board for Islamic
banks especially in ensuring the banks’ operations are Shariah compliant.
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
19
The uniqueness of the activities and risks of Islamic banks
warrants special treatments in the following elements…
Risk
management
Capital
Requirement
Corporate
Governance
Market
Discipline
Supervisory
Approach
• In addition to the traditional banking risk, supervisors must acknowledge the unique risks in
Islamic banking e.g.. asset price risk, rate of return risk, displaced commercial risk (DCR) and
equity investment risk.
• Supervisors must appreciate the risk transformation element and the additional aspects of
operational risk in Islamic banking
• Capital must be adequate to cushion for all risk including risks unique to Islamic banking as
identified through proper risk management process.
• The role of Shariah Board in the governance.
• Process and control to protect Investment Account Holder (IAH)
• Transparency of financial reporting in respect to investment accounts
• The need to spur market discipline among Islamic banks with regard to the appropriate and
timely disclosure of information on risks and returns
• Supervision of Islamic banks is very similar to conventional banks i.e. any supervisory
approach / framework may be relevant and applicable to Islamic banking supervision
• However, specific considerations are required to address specificities of Islamic banks
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
20
Malaysia’s Risk-based Supervisory Framework has been modified to fit the need for the
risk assessment of Islamic banks taking into account the unique risks in Islamic banking
Risk Based Supervisory Framework (RBSF)
Modification done to fit the Islamic banking model
Identification of Significant Activities
 Supervisors must acknowledge the universal
concept of Islamic banking – various activities
could be carried out in addition to traditional
banking business e.g.. real estate development
and auto trading.
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
Identification of Inherent Risk
 Supervisors must acknowledge unique risks
emanating from Islamic banking business e.g..
asset price risk, rate of return risk, displaced
commercial risk and equity investment risk
21
Risk Matrix - Sample
ALM
X
Ratings:
• High
• Above Average
• Moderate
• Low
X
OVERALL
X
Capital
Earnings
Composite Rating
Direction of Risk
Net Risk
X
Info &
Comm.
Treasury
Compliance
X
Internal
Audit
X
Risk
Management
X
Senior
Management
Commercial/
Corporate
Banking
Board
Oversight
X
Operational
management
X
Overall IR
X
Strategic
House Financing
Technology
X
Liquidity
Market/
Asset Price
X
Rate of
Return
Operational
Equity
Investment
Credit
Auto Financing
Direction of Risk
Risk Management Control Functions
(RMCF)
INHERENT RISK (IR)
Materiality
Significant
Activity
Review of
Significant
Activities
(Including
Effectiveness of
Risk
Management
Functions)
X
X
X
Time Frame
“x”: potential area of which supervisors need to pay attention to the
uniqueness of Islamic banking operation.
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
22
Supervisors need to focus on the Shariah governance & compliance, and the
presence of appropriate resources and infrastructure catering the uniqueness
of Islamic banking…
Operational Management
• Appropriate policies &
procedures to cater for the
uniqueness
• Understanding of the
concept and unique
products by the front liners
Risk Management
• Need to have a pool of
expertise to understand the
uniqueness of Islamic
banking in order to identify,
measure, control and
monitor the unique risks
effectively.
• Measurement methodology
must be tailor-made to fit
Islamic banking model
Unique
elements in
RMCF of
Islamic banks
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
Board Oversight
• The presence of effective
and independent Shariah
advisory committee
• Board members must be
well equipped with the
knowledge of Islamic
banking – ensure
appropriate strategic
direction of the Islamic
banks.
Compliance Function
• Day-to-day compliance
framework must be robust to
ensure compliance to Shariah
requirement
• All elements of compliance
from compliance officers to
internal audit should be
sufficiently trained to
understand the uniqueness of
Islamic banking
23
Assessing Quality of Risk Management for Islamic Banks
Challenges
Risk transformation:
• Do supervisors have the ability
to unbundle the risks involved?
(especially if they doubt that
the banks have done it
effectively)
• Do Islamic banks have the
capability to capture this risk
transformation?
To ensure that capital charge
reflects the risk
transformation
• The unique risks are still
posing great challenges to
supervisors :
–What is the appropriate
supervisory approach?
–Do we have the
competencies and expertise
to supervise these risks
effectively?
• Illiquidity of Islamic hedging
instruments
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
Going Forward…
• What is the institution
aspiration on Business
structure (activity-based vs.
contracts-based)
• Supervisor should change their
perspective according to the
need of the institution vis-à-vis
the industry aspiration
24
Thank You
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
25
2nd SESSION:
Essential Elements in the RiskBased Supervision of Islamic
Banking Institutions
September 2011
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
26
How Different is the Balance Sheet of Islamic banks?
Assets
Conventional banks
do not have this
Loans in
Conventional banks
Conventional banks
do not have this
Inventories
Real estates/Automobiles
Receivables from:
Murabahah/Ijarah/
Istisna’/Salam
Profit Sharing Transactions
Mudharabah/Musharakah
Fixed Assets
Liabilities
Demand Deposits
Wadiah/custodian
General Investment Accounts
Mudharabah
Specific Investment Accounts
Mudharabah
Currents and
Savings accounts
in Conventional banks
Conventional banks
do not have this
Investment Linked
Deposit (ILD)
accounts in
Conventional banks
Equity
Would supervisors be capable of assessing beyond the figures in financial statements?
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
27
As Islamic banking supervisors, we need to understand the
different structures used by the Islamic banks and able to
recognise the unique risk emitting from those structures…
Islamic Financing
& Investment
Islamic Deposits &
Funding
Islamic FX &
Money Market
Core Banking
Products & Risks
Where are Risks Coming From?
ALM Operations
RoR Risk &
Displaced
Commercial Risk
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
Income smoothing
Mechanism
28
In supervising the ALM operations, bank supervisors need to be
mindful of ALM risks & the use of income smoothing mechanism
in mitigating the risks…
ALM Operations
ALM-related Risks
Rate of Return
(RoR) Risk
Displaced
Commercial Risk
Income Smoothing
Mechanism
Profit Equalisation
Reserves (PER)
Investment Risk
reserves (IRR)
Other operational risk issues to be considered…
• The need to have additional contracts as shariah enabler e.g. commodity murabahah contract to
facilitate Islamic Profit Rate Swap for hedging against RoR risk
• Absence of Standard Agreement for Derivatives contract like ISDA
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
29
What is Rate of Return (RoR) risk?
• Fundamentally if an Islamic bank assets are funded by Profit Sharing Investment Account (PSIA)
both the credit and market risk (including RoR risk) will be solely borne by the (Investment Account
Holder) IAH
• Based on this fundamental, how would the Islamic banks expose to RoR risk? In order to answer
that, we first need to understand what is RoR risk?
Assets
Liabilities
Asset-backed Transactions
Profit Sharing Investment
Accounts (PSIA)
Receivables from Long Term
Murabahah (deferred settlement)
Mudharabah
Long Term fixed Return on
Assets
Long Term Fixed Returns to
investor
An increase in benchmark rates may result in IAH having expectation of
a higher RoR, However if the assets funded by them are long term and fixed rate,
IAHs’ return could not be repriced higher until those assets mature
However, due to competitive pressure.....
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
30
The bank has to displace the RoR risk from IAH to the bank in order to prevent massive
withdrawal of investments (liquidity risk) and this is termed as displaced commercial risk:
Before a hike in benchmark rate
Fixed return
Fixed rate
Murabahah
Mudharib
(Islamic
Bank)
PSIA Holders
After a hike in benchmark rate
Islamic bank has to give
up some portion of its
return in order to pay a
competitive rate to IAH
and prevent them from
leaving the bank (liquidity
risk)
Fixed rate
Murabahah
Mudharib
(Islamic
Bank)
PSIA Holders
Portion of Islamic bank’s
income gave up to IAH
Displaced Commercial Risk (DCR) has brought back RoR risk to the bank
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
31
Assessment of RoR risk – Measuring the RoR risk
• Methods for measuring the interest rate risk in the banking book of conventional banking i.e.
Earnings at Risk (EAR) and Economic Value of Equity (EVE) can be adopted for measuring the
RoR risk of Islamic banks by focusing on the substance (from the risk perspective) of the Islamic
banking products as e.g..:
 Fixed Ijarah, Murabahah and BBA financing can be modelled as fixed rate loans
 Floating Ijarah can be modelled as floating rate loans
 BBA (with Ibra’ Feature) financing can be modelled as floating rate loans with cap
 Tweaking needed:
 PSIA should be slotted only in the 1 week to 1 month bucket or earlier
o What is the rationale?
Unlike conventional bank’s fixed deposit where the rate is fixed rate, PSIAs’ are subjected
to monthly performance of the assets being funded and hence reprice monthly
 Segregations by the source of fund e.g.. funded by GIA, SIA or Shareholders’ fund
(including other non-PSIA fund)
o What is the rationale?
Islamic bank has the option whether to pass the RoR risk to investors (GIA and SIA)
or absorb them
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
32
Balance sheet structure and the level of inherent RoR risk
Assets:
Liabilities
Long Term Fixed rates
Mudharabah (Profit Sharing)
deposits
Floating rates
Fixed rate deposits
Assets:
Liabilities
Medium Term Fixed rates
Mudharabah (Profit Sharing)
deposits
Floating rates
Fixed rate deposits
Assets:
Liabilities
Medium Term Fixed rates
Mudharabah (Profit Sharing)
deposits
Floating rates
Fixed rate deposits
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
H
I
G
H
L
O
W
33
Income smoothing mechanism – risk mitigant to
minimise displaced commercial risk
• Profit Equalisation Reserves (PER) and Investment Risk Reserve (IRR) are utilised to
ensure rate stability – avoid volatility on return to IAH which can lead to lack of
competitiveness during the economic downturn
• However, Malaysia choose PER over IRR approach to minimise moral hazard as PER
require the bank to contribute to the reserves as oppose to IRR which contain only
investors’ contribution.
A portion of distributable profit is kept-aside during good times and will be
released during bad times
PER
• Provision made at gross level i.e.
both bank’s and investors’
portion is deducted
• Used to cover shortfall in profit
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
IRR
• Provision made at net level i.e.
only investors’ portion is
deducted
• Used to cover shortfall in profit
and principal
34
For several Islamic contracts, similar concepts are used to
structure different products on the balance sheet…
Core Banking
Products & Risks
Islamic Deposits &
Funding
Islamic Financing
& Investment
Islamic FX &
Money Market
MUDHARABAH
(profit sharing)
COMMODITY
MURABAHAH
WAKALAH
(agency)
SARF
(exchange)
IJARAH
(leasing)
MURABAHAH
(profit plus)
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
ISTISNA
(project financing)
MUDHARABAH &
MUSHARAKAH
(profit sharing)
35
Normally, Islamic banks would opt for IJARAH and/or Ijarah Muntahia
Bittamleek (IMB) for the Auto Financing – What are the unique risks which
supervisors need to pay attention in these contracts?
A customer enters into a Promise to Lease (PL) with an Islamic Financial Institution (IFI)
requesting the IFI to purchase a specified kind of asset with a promise to lease. The PL may
be binding or non binding depending on the applicable shariah interpretations
Customer submits Ijarah
contractual application
IFI acquires assets from supplier
If customer opts not to fulfil the non-binding PL, the IFI will
be exposed to fluctuation in the value of the asset
MR
Compliance with Shariah principles in terms of operations.
OR
Sign direct Ijarah contract
Yes
Ijarah Muntahia
Bittamleek?
Contract Mature
Sign direct sale contract
No
Contract Mature
Asset return to lessor
The lessor is responsible for defects throughout the Ijarah
period in the event that takaful/ insurance is not sufficient
OR
MR
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
Fluctuation in the carrying value of the asset will
expose the IFI to asset price risk
36
The widely used contract for Islamic House Financing is
MURABAHAH – What are the unique risks which supervisors
need to pay attention in this contract?
Murabahah for the Purchase Orderer (MPO)
2
Agent identify specific
asset from a supplier.
CUSTOMER
1
SUPPLIER
Cash Payment
IFI executes a
Promise to Purchase
(PP) with customer
and appoints
customer as an
agent to acquire the
asset.
ASSET
4
5
Customer will settle the
sale price on deferred
payment over a specific
tenor.
IFI sell the asset to
Customer through
Murabahah contract.
(Transfer of title to
Customer)
OR
IFI
3
IFI will purchase the asset
from supplier. (Transfer of
ownership to IFI)
MR
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
IFI may need to sell the
goods in the open
market if customer
cancel the non-binding
PP
Shariah Compliance Risk:
Sequent of transaction is important
i.e.. the IFI should not sell the asset
to the customer until it takes
possession of the asset
37
ISTISNA’A is the preferred choice of contract in project-based
financing – What are the unique risks which supervisor need to
pay attention in this contract?
ISTISNA'A CUSTOMER
(Buyer)
Price Risk relating to
input materials
2
4
1
ORDERED
GOODS
RAW MATERIAL FOR
MANUFACTURING
MR
5
Late Delivery
of completed
goods by
Parallel
Istisna’a seller
3
IFI
OR
9
7
6
RAW MATERIAL FOR
MANUFACTURING
ORDERED
GOODS
10
PARALLEL ISTISNA'A
(Seller)
PROCESS FLOW
1 Customer approaches IFI to manufacture or build something
OR
2 IFI can ask customer to furnish an urbun (security deposit)
3 IFI has the option to manufacture or build the asset on its own (no. 6)
4 Delivery of an ordered goods
5 Flexibility in term of time of payment and mode e.g... lump sum/installment.
6 Enter into Parallel Istisna'a to procure an asset from a party other than the original Istisna’a customer
7 It is possible that the IFI to give guarantee to the Parallel Istisna'a seller.
8 Parallel Istisna'a seller shall obtain own materials
9 Delivery of an ordered goods
10 Flexibility in term of time of payment and mode e.g... lump sum/installment.
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
8
Legal Risk:
Claims on the Parallel
Istisna’a seller for noncompletion of works
(litigation cost, legal
claims etc.)
38
Equity Investment Risk:
the main peculiar risk on the balance sheet of an Islamic bank
What is Equity Investment Risk?

broadly defined as the risk arising from entering into a partnership

for the purpose of undertaking or participating in a particular financing or
general business activity as described in the contract;

in which the provider of finance, shares the business risk

e.g.. private equity, venture capital
Why Equity Investment Risk exist?
Contract of Sale (Bai’)
Partnership (Shirkah)
Equity-based
ISLAMIC
CONTRACTS
Others
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
Due to equity
based financing
under Islamic
contract :
• Musharakah
• Mudharabah
Leasing (Ijarah)
39
MUSHARAKAH: contract (normally used in Commercial/Corporate Banking)
that attracts equity investment risk –
What are the unique risks which supervisor need to pay attention to?
Business failure due to lack of
proper feasibility studies, poor
selection of partner and key
management
B
A
N
K
•
•
Bank and customer provide capital for the project e.g... RM6 million
from bank and RM4 million from customer.
Both parties agree on profit sharing ratio (e.g.. 70:30) i.e. 70% of
gross profit to be distributed to customer and remaining 30% to
bank.
Equity investment
risk is evidenced by
the risk to assume
the loss based on the
equity ratio
30%
PROJECT
PROFIT
OR
C
U
S
T
O
M
E
R
The issue of
human talent
and system to
manage the
specific project
70%
OR
60%
EIR
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
LOSS
40% Early termination of
partnership by one of the
partner.
40
MUDHARABAH Financing: slight variation to Musharakah –
also attract equity investment risk
B
A
N
K
1
• Bank provides capital to customer e.g.. RM3 mil
• Both parties agree on profit sharing ratio. (e.g..
60:40) i.e. 60% of gross profit to be distributed to
bank 40% to customer/partner.
60%
Equity
investment risk
is even greater
as the loss is
100% borne by
the bank
OR
2
C
U
S
T
O
M
E
R
2. PROJECT
40%
Business failure due to lack of
proper feasibility studies, poor
selection of partner and lack of talent
& system at the bank
3. PROFIT
IF
EIR
100%
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
4. LOSS
41
In view of high-risk nature of Musharakah & Mudharabah
investment & financing, BNM has issued specific guidelines…
No restriction on funding so long
assessment on the appropriateness
of fund and effective management of
liquidity are in placed.
To ensure credible corporate governance
practices:
• BOD must ensure necessary expertise &
qualified personnel are in place
•Shariah governance framework must be in
place
•establishment of oversight committee based on
materiality
Appointment of board representative from IFI in the
invested entity to safeguard IFI interest.
• Subject to materiality
• the board rep must be ‘fit and proper’
• Roles & responsibilities governed by T&C agreed
• Mechanism to monitor the effectiveness of board
representative
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
Availability of a comprehensive risk management
infrastructure, system and internal control
• Strategies, Policies & procedures
• Valuation methodology
• Exit strategy and mechanism
BNM M&M
Guidelines
Subject to other prudential
limits e.g... SCL
Subject to capital adequacy
requirement
Disclosure of risk management
policies and practices in financial
statements
42
DIMINISHING MUSHARAKAH (an alternative for house financing): an
attempt to benefit from three different contracts – what are the unique risks
which supervisor need to pay attention in this contract?
Diminishing Musharakah is a form of partnership in which one partner (i.e.. customer) promises to gradually
acquire the equity share of the other partner (i.e.. the bank) until the share of ownership is completely
transferred to the customer.
• Compliance with Shariah principles in terms of
usage and operations.
• How to enforce the promise?
% of bank’s
ownership in the
property
Periodic rental payment (Rental is calculated
based on banking institution’s prevailing share)
OR
Lease rental & gradual transfer of banking
institution’s ownership
0%
To
Acquisition Date
Tn
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
Tm
Maturity Date
43
The element of “wa’ad” (promise) in diminishing Musharakah would create
different spectrum of complication particularly in the case of default
– who will bear the risk/loss?
To
Tn
Acquisition of
property by both
parties
Tm
Default Event/Early Termination
• Without wa’ad, the asset will be sold and the proceeds will be
divided according to the latest ownership shares of the banking
institution and customer.
• With Wa’ad, the customer is obliged to acquire the banking
institution’s remaining share. This create debts to be paid by the
customer to the banking institutions.
Proceeds from disposal
of property
Surplus
Equity investment
risk is evidenced
by the risk to
assume the
shortfall based on
the equity ratio
Shortfall
Without Wa’ad
Any surplus will be shared by the bank
and customer based on the last
ownership ratio (if the bank help to find
buyer for the property).
Shortfall shared by the bank and customer
based on the last ownership ratio.
- Bank will have to assume the shortfall based
on equity ratio on top of credit risk of the
borrower.
With Wa’ad
Any surplus will be returned to the
customer.
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
With Wa’ad
Shortfall fully borne by the customer
- Effectively no risk to be borne by the bank,
other than credit risk of the borrower.
EIR
Does it really work?
Without Wa’ad
44
Tweaking/adding of contracts for replicating conventional
treasury products creates additional operational risk in treasury
operation of Islamic banks
TREASURY
Money Market
The need to have additional contracts
as Shariah enabler e.g.. commodity
murabahah contract
FX Operation
The use of ‘wa’ad’ in FX forward which
resulted in a unilateral type of contract
Commodity Murabahah for MM operation:
How it works in Malaysia
Shariah requirements of exchange contracts for currency:
• Payment and delivery must be immediate
• Same value if same currency
t0
Lending bank
Borrowing bank
tm
BROKER B
BROKER A
CM
House
tm
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
So, how to operationalise forward FX?
• Use of Wa’ad concept
• The issue of legal binding arise (again)
Movement of commodity (all at t0)
Movement of short term MM fund
45
Main contract used for funding/deposits is MUDHARABAH…
very much investor-entrepreneur relationship
Mudharabah Deposits
D
E
P
O
S
I
T
O
R
1
• Depositor provides capital to bank e.g.. RM300,000
• Both parties agree on profit sharing ratio. (e.g..
60:40) i.e. 60% of gross profit to be distributed to
bank 40% to customer/partner.
General operation of
the bank
60%
2
General /
Specific pool
B
A
N
K
40%
Specific project
PROFIT
IF
100%
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
LOSS
46
Some banks offer alternative contracts for deposit-taking activity i.e..
WAKALAH deposits… very much investor-agent relationship
Wakalah Deposits
1
D
E
P
O
S
I
T
O
R
• Depositor provides funds to bank e.g... RM300,000
• The bank act as an agent and invest the fund accordingly.
The would normally charge a fixed fee to ac as an
investment agent
• In some circumstances, depositors would only agree to
take up profit up to certain amount, any excess would be a
performance-based incentive fee to the bank
General operation of
the bank
General /
Specific pool
Specific project
Fixed fee +
incentive fee
All profit to depositors –
up to agreed amount to
be received
2
B
A
N
K
PROFIT
IF
100%
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
LOSS
47
CONCLUSION (for both sessions)
• In essence, supervision of Islamic banks is very similar to
conventional banks i.e. any supervisory approach / framework may
be relevant and applicable to Islamic banking supervision
• However, Islamic banking supervisors must acknowledge the
unique nature of Islamic banking
• Efforts must be put in place to improve the skill set of banking
supervisors in understanding the uniqueness – we do not need
different set of supervisors; same resources with enhanced
competencies in appreciating Islamic banking operation
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
48
Thank You
(Q & A)
ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS
49