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Preace
Foreword
Acronyms
Table o Contents
Task Force on Islamic Finance and Global Financial Stability 11
Introduction: Financial Crisis and the Financial Reorm Agenda 13
A. Appreciating the Islamic Finance Model 16
I. Key Principles
Box 1: Basic Principles o Islamic Finance 16
Box 2: Participatory Mode in Fund Mobilisation 17
Box 3: Distinct Features o Islamic Financial Transactions:Perspective onmusharakah mutanaqisah (Diminishing Partnership) 21
Box 4: Non-Prot/Unilateral Contracts in Islamic Finance 23
Box 5: Islamic Micronance:Ar-Rahnu 24
B. The State o Islamic Financial Services Industry 26
I. Increasing Signicance o Islamic Finance in the Global Financial System 27
II. Perormance o Islamic Banks 34
III. Perormance o Islamic Indices 37
C. Challenges and Strategies or Strengthening Financial Stabilityin the Islamic Financial System 40
I. Strengthening Islamic Financial Inrastructure 41
II. Accelerating Eective Implementation 48
III. The Establishment o a Platorm or Constructive Dialogue:
Islamic Financial Stability Forum 51
Conclusion 53
Appendix I : Standards and Guidelines Issued by the IFSB 54
Appendix II : Comparative Table on Standards and Guidelines Issued by the
Islamic Financial Service Board and Basel Committee on
Banking Supervision 57
Appendix III : Comparative Table on Standards Issued by Islamic Financial Service
Board and International Association o Insurance Supervisors 61
Appendix IV : Al-Quran: Surah Yusu (Joseph) Verses 43 - 49 68
Reerences 69
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5
PREFACE
The Task Force on Islamic Finance and Global Financial Stability was ormed
on 29 October 2008 in response to the recommendations o the Forum o
the Global Financial Crisis and its Impact on the Islamic Financial Industry,
which was organised by the Islamic Development Bank (IDB) Group. The Task
Force headed by H.E. Dr. Zeti Akhtar Aziz, Governor o Bank Negara Malaysia
includes an international group o eminent scholars, practitioners and experts
in Islamic inance.
The irst meeting o the Task Force on 20 January 2009 led to the ormation o
three working groups to (1) examine the conceptual aspects o Islamic inance
and its role in enhancing inancial stability; (2) conduct stocktaking o the state
o the Islamic inancial services industry ollowing the global inancial crisis;
and (3) examine the inancial architecture o the Islamic inancial industry
amidst the more challenging post crisis environment.
The report o the three working groups were presented and discussed at the second
meeting o the Task Force held at the IDB headquarters on 28 March 2009 in
Jeddah. This document has drawn on the work o the three reports, incorporating the
discussions and comments by the members o the Task Force. This report concludes
with recommendations to strengthen urther the institutional arrangements in the
Islamic nancial system.
As authorities worldwide are working hard to reorm inancial systems and
policies, this will be a suitable time to give the Islamic inancial industry
the opportunity to participate in the process. The global inancial crisis has
demonstrated that we ace common challenges. In joining and sharing lessons
with international organisations, we can work towards avoiding such inancial
crises in the uture. We believe that there is much that Islamic inance can
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contribute to this process. From this perspective, the new inancial order
would be more inclusive and more global in nature, lending it more support
and sustainability. Collectively, we hope that we will be able to build a more
stable and more peaceul world or the uture generations.
I would like to thank H.E. Dr. Zeti Akhtar Aziz or her pioneering endeavours
in supporting Islamic inancial industry in general, and or guiding the work
o the Task Force in particular. I would also like to thank each and every
member o the Task Force, as well as all the supporting sta at IRTI and IFSB.
I pray that this eort will be a helpul step towards the good o mankind and,
subsequently, or the blessings rom the Almighty.
Dr. Ahmad Mohamed Ali
President o the IDB Group
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FOREWORD
As a orm o nancial intermediation, Islamic nance incorporates several elements
that guide the process o the mobilisation and allocation o unds to generate
productive economic activity and inclusive development. Fundamental to Islamic
nance is the requirement that nancial transactions must be supported by real
economic activity. In addition, Islamic nance promotes prot sharing and hence
risk sharing. These elements limit the extent o leverage and place emphasis on
transparency and disclosure in the documentation o contracts. Embraced in its
entirety, Islamic nance promises to enhance the discipline that contributes towards
ensuring growth and nancial stability.
The global nancial crisis o 2008-09, unprecedented in modern history, has brought
to the oreront wide ranging issues concerning the stability and soundness o
nancial systems. This has prompted an extensive global re-examination by the
international community on the need or regulatory reorm and the adequacy o
the existing international nancial architecture and the search or a more enduring
solution. This Task Force on Islamic Finance and Global Financial Stability was
ormed to examine the key elements in Islamic nance that contribute to its viability
and resilience and to review the advancement o the Islamic nancial services
industry in the ace o the challenges o the current global environment.
Amidst this more challenging environment presented by the recent international
nancial crisis, the global expansion o Islamic nance has continued and its
development has remained dynamic. Today, Islamic nance has become one o the
astest growing nancial segments in the international nancial system. Its phase
o development that began in earnest as domestic-centric or Muslim economies,
has rapidly transormed in this recent decade to become internationally recognised
and accepted as a competitive and robust orm o nancial intermediation by all
communities. As Islamic nance extends its reach to serve the global community
and becomes an integral part o the global nancial system, it will however be
increasingly tested by risks and developments in the international nancial system.
The Islamic nancial services industry is also entering into a undamentally dierent
environment that will be signicantly infuenced by the international regulatory reorm
that is being undertaken in the post crisis era.
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For the Islamic fnancial services industry to thrive in this new environment and to
transition to the next level o development and trend towards greater international
integration, its level o resilience needs to be strengthened urther. Eight important
building blocks have been identifed in this report to urther strengthen the
oundations o the Islamic fnancial system. This is not only to ensure sustainedorderly development and integration o the industry into the international fnancial
system, but also to enhance the capacity o the industry to address the increased
risks and vulnerabilities in the newly evolving international fnancial environment.
While the endeavour to strengthen the Islamic fnancial system and the international
Islamic fnancial architecture is important in this highly integrated international fnancial
system, equally important is to have in place a platorm or greater international
engagement on the developments and issues concerning maintaining fnancial
stability in the Islamic fnancial system. Thus, included in the recommendations bythe Task Force is the proposal to establish the Islamic Financial Stability Forum (IFSF)
to serve as a platorm or the deliberation o issues relevant or ensuring fnancial
stability in the Islamic fnancial system. Whilst it will represent an important platorm or
addressing such challenges conronting Islamic fnance, the establishment o the IFSF
would also allow or an interace process with the international fnancial community in
the conventional fnance given the common interest o global fnancial stability.
In the course o preparing this report, numerous meetings were organised, including
consultations and consensus-building dialogues, to obtain views rom an extensivespectrum o participants in the Islamic fnancial system. This was aimed at achieving
a common understanding on the important issues aecting fnancial stability in the
Islamic fnancial system. I would like to take this opportunity to thank members o
the Task Force or their unwavering commitment and contribution to achieving our
mandate. It is hoped that the report will provide useul insights on Islamic fnance and
the important ocus that needs to be given to fnancial stability in the rapidly changing
international fnancial environment. Equally important is the capacity to contribute
to global fnancial stability. The priorities identifed in this report are also aimed at
strengthening urther the oundations that will ensure the sustainability and capacity oIslamic fnance to contribute towards global growth and a greater shared prosperity.
Dr. Zeti Akhtar Aziz
Chairperson, Task Force on
Islamic Finance and Global Financial Stability
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ACRONYMS
AAOIFI Accounting and Auditing Organization or Islamic
Financial Institutions
CDO Collateralised debt obligation
CIBAFI (General) Council or Islamic Banks and Financial
Institutions
CIS Collective investment scheme
IAH Investment account holders
IDB Islamic Development Bank
IFSB Islamic Financial Services Board
IFSI Islamic nancial services industry
IIFM International Islamic Financial Market
IIFS Institutions oering Islamic nancial services
IMF International Monetary Fund
IRTI Islamic Research and Training Institute
LOLR Lender o last resort
PSIA Prot sharing investment accounts
UPSIA Unrestricted prot sharing and loss bearing
investment accounts
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11Islamic Finance and Global Financial Stability
Task Force on Islamic Finance and
Global Financial Stability
I. Introduction
The Task Force on Islamic Finance and Global Financial Stability
(Task Force) was initiated by the Islamic Development Bank (IDB) on
29 October 2008 in response to the recommendations o the Forum
o the Global Financial Crisis and its Impact on the Islamic Financial
Industry, organised by the IDB Group.
II. Key mandates
The Task Force was entrusted with three mandates as ollows:
i. To analyse the role and relevance o Islamic nance in promoting
global nancial stability;
ii. To take stock o the progress o the Islamic nancial services
industry in the ace o the challenges o the current global nancial
environment; and
iii. To examine important strategies and key building blocks towards
urther strengthening the resilience o Islamic nance and advancing
global engagements towards promoting nancial stability in theIslamic nancial system as part o the current reorm process o the
international nancial system.
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12 Islamic Finance and Global Financial Stability
III. Members
The Task Force is headed by H.E. Dr. Zeti Akhtar Aziz, Governor o
Bank Negara Malaysia and includes an international group o eminent
scholars, practitioners and experts in Islamic nance. The members o
the Task Force are as ollows:
1. H. E. Tan Sri Dr. Zeti Akhtar Aziz, Governor,
Bank Negara Malaysia, Chairperson
2. Shaikh Saleh Kamel, Chairman, General Council o Islamic
Banks & Financial Institutions
3. Proessor Riaat Ahmed Abdel Karim, Secretary-General, Islamic
Financial Services Board4. Shaikh Youse Talal DeLorenzo, Chie Shariah Ocer and Board
Member, Shariah Capital, Inc.
5. Mr. Michael McMillen, Partner, Fulbright & Jaworski LLP,
New York
6. Mr. Sameer Abdi, Lead Partner - Islamic Financial Services
Advisory Services, Ernst & Young Bahrain
7. Dr. Mohd Daud Bakar, Chairman, Shariah Advisory Council,
Bank Negara Malaysia
8. Dato Khawaja Mohammad Salman Younis, ormer Managing
Director, Kuwait Finance House (Malaysia) Berhad
9. Pro. Dr. Volker Nienhaus, President, University o Marburg,
Germany
10. Dr. Abbas Mirakhor, ormer Executive Director, International
Monetary Fund
11. Dr. Ahmed Ali Abdallah, Advisor to Governor and Secretary
General, Shariah Supervisory Board, Central Bank o Sudan
12. Dr. Sami Ibrahim Al-Suwailem, Deputy Director, IRTI, Islamic
Development Bank Group
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13Islamic Finance and Global Financial Stability
Introduction:
Financial Crisis and the Financial Reorm Agenda
1. The global nancial crisis o 2008-09 has brought to the oreront
issues concerning the stability and resilience o nancial systems.
At the heart o the crisis is the near-breakdown o the unctioning
o the nancial intermediation process, amid a generalised loss o
condence in the nancial system.
2. Many actors have been cited as the cause o the crisis. They
include a combination o misalignments in the incentive structure
and unbridled nancial innovation which led to indiscriminate
lending and excessive risk-taking. Other contributory actorsinclude the erosion o sound prudential practices, with banks
compromising on underwriting and risk management standards in
pursuit o short-term gains and market share. While the banking
institutions had employed increasingly sophisticated nancial
engineering techniques to repackage mortgages into complex
structured securities, such nancial innovation was not supported
by commensurate enhancements to their governance processes
and risk management inrastructure and practices.
3. In the wake o the crisis, the global nancial community has
intensied eorts to reorm the international nancial architecture to
ensure its stability and resilience in a more challenging environment.
The challenge beore us is to not only undertake the necessary
regulatory reorm that will minimise potential risks, but to also build
a new nancial architecture that will promote greater eciency in
the nancial intermediation process, including across borders.
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14 Islamic Finance and Global Financial Stability
4. In the search or a new nancial architecture, there is a general
consensus on the need to return banking to its basic unction - to
provide nancial services that add value to the real economy. This
in act represents the very essence o Islamic nance. These are
the very elements ound in the Shariah principles that orm theoundation o Islamic nance. It is these inherent elements that
contribute towards the overall stability and resilience o the Islamic
nancial system. This oundation is urther reinorced by the values
that are extolled in Islamic nance that are similar to those ound in
ethical nance and socially responsible investment. The key strength
o the Shariah injunctions is its emphasis on a strong linkage to
productive economic activity, its inbuilt checks and balances and
its high level o transparency and disclosure. The Islamic nancial
services industry has thus been in a relatively stronger position toweather the global nancial crisis, demonstrating its robustness as
a stable orm o nancial intermediation. The inherent eatures o
Islamic nance have the potential to serve as a basis to address
several o the issues and challenges that have suraced in the
conventional nancial system during the current crisis. As the role
and relevance o Islamic nance in the global nancial system gains
signicance, it has potential to contribute to greater global nancial
stability and towards strengthening global growth.
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15Islamic Finance and Global Financial Stability
A: Appreciating the Islamic Finance Model
I. Key Principles
5. Islamic nance derives its key strength rom its inherent underlyingprinciples. Islamic nancial transactions must be accompanied
by an underlying productive economic activity that will generate
legitimate income and wealth, thereby establishing a close link
between the nancial transactions and productive fows. This
reduces the Islamic nancial system rom over exposure to risks
associated with excessive leverage and imprudent risk taking.
Thus, in the Islamic nance business model, nancing or equity
participation can only be extended to activities in the real sector
that have economic values. As a result, Islamic nancial assets are
expected to grow in tandem with the growth o underlying economic
activities (see Table 1 and Box 1).
Overarching Principles Towards achieving the objectives of Shariah (Maqasidal-Shariah)
High ethical values - justice, fairness, trust, honesty and integrity
Protection of religion, life, lineage, intellect and wealth
More equitable distribution of wealth
Materiality and Validity of Transactions
Economically productive underlying activitiesAvoidance of interest-based transactions No involvement in illegal and unethical
activities
Genuine trade and business transactionsAvoidance of speculative transactions
Embedded Governance
Mutuality of Risk Sharing Entitlement of prot contingent upon risk
taking
Honouring both substance and form ofcontract
Disclosure & Transparency
Table 1: Essential Features of Islamic Finance
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16 Islamic Finance and Global Financial Stability
6. Islamic nance promotes transactions that are based on prot and
risk sharing. It encourages participatory nance or active participationin the business, throughmudarabah (partnership o work and capital)
andmusharakah (joint venture) contracts (see Box 2 and Table 2). This
approach promotes participation in the risk-reward and nancial results
or outcome o such businesses. This risk sharing requires the IIFS to
undertake the appropriate due diligence on the viability o business
proposals. Oversight and review by the relevant parties such as
Shariah boards or Shariah compliant review process provide additional
saeguards against irresponsible practices. In contrast, conventional
nancial instruments generally separate such risks rom the underlyingassets. As a result, risk management and wealth creation may, at times,
move in divergent directions, with adverse consequences or eective
risk management. Conventional nancial instruments also allow or
the commoditisation o risks. This has led to its prolieration through
multiple layers o leveraging and disproportionate distribution, which, in
turn, could result in higher systemic risks, thus, increasing the potential
or instability in the nancial system.
Box 1: Basic Principles o Islamic Finance
Prohibitionofinterest(riba). Prohibition o riba a term literally an excess and
interpreted as any unjustiable increase o capital whether in loans or sales.
Moneyaspotentialcapital.Moneyisnotacommodity,butamediumof
exchange, a store value and a unit o measurement. Money represents purchasing
power and cannot be utilised to increase the purchasing power without any
productive activity. Islamic nance advocates the creation o wealth through trade
and commerce.
Risksharing.Becauseinterestisprohibited,suppliersoffundsbecomeinvestors,
rather than creditors.
Prohibitionofspeculativebehaviour.Islamicnancediscourageshoardingand
prohibits transactions eaturing extreme uncertainties (gharar), and gambling
(maysir).
Sanctityofcontracts.Islamicnanceupholdscontractualobligationsandthe
disclosure o inormation as a sacred duty. This eature is intended to reduce therisk o asymmetric inormation and moral hazard.
Shariahapprovedactivities.Onlythosebusinessactivitiesthatdonotviolate
the rules o the Shariah qualiy or investment. For example, any investment in a
business dealing with alcohol or gambling is prohibited.
Socialjustice.Anytransactionleadingtoinjusticeandexploitationisprohibited.
Source: Adapted from Askari, et. al (2010)
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Unrestricted InvestmentAccounts
Mudharabah (profit sharing and loss bearing)
Table 2: Islamic Banking Balance Sheet: Distinct Contractual Relationship
Assets Liabilities
InventoryReal estates/Automobiles
Asset-backed TransactionsMurabahah (cost plus) / Ijarah
(leasing) /Istisna(manufacture) / Salam
(forward delivery)
Current/ Demand DepositsWadiah (Safe custody) / Qard(Loan)
Profit Sharing TransactionsMudharabah (profit sharing & lossbearing) /Musharakah (profit & loss
sharing)
Fee Based Servicese.g. Ujr(fee) Equity
Distinctcharacteristic-
ownership of assets Akin to demand
deposits but exhibitdifferently as it
prohibits gifts upfront/predetermined return
Akin to fixeddeposits but uses
profit sharing basiswhere return basedon performance of
assets
Profit Equalisation Reserves Distinct
characteristic as
prudential tool
Akin to loans butlegal position of
lender & borrower isreplaced by different
contractualrelationship
Investor-entrepreneurrelationship
Islamic Rate of Return Management (Asset Driven)
Return on Assets InvestmentReturns
Cost of FundsReturn on Lending
Conventional Asset & Liability Management (Liability Driven)
Unrestricted Investment
Accounts
Mudharabah (profit sharing and
loss bearing)
Restricted InvestmentAccounts
Mudharabah (profit sharing andloss bearing)
Box 2:Participating Mode in Fund Mobilisation
FinancialintermediationthroughIIFSinvolvesmobilisingfundsfromsaversor
investors with excess liquidity, using a combination o non-return-paying currentor demand accounts and prot sharing investment accounts (PSIA), and providing
these unds to rms or individuals or nancing assets or business activities. The
banker-customer relationship is not the conventional debtor-creditor relationship
but is based on dierent contracts that are entered into by the IIFS and the
customer.
AtypicalIslamicbankingbalancesheetisasfollows:
Liability Side: The liability structure o Islamic banks (i.e. unding structure) is
characterised by two distinct categories o unds:
o Non-return-paying demand/current accounts or which the principal is
guaranteed; and
o PSIA which reer to deposit products structured based on mudharabah (prot
sharing-loss bearing contract) where customers and Islamic banks agree to
share prots generated rom the assets unded by PSIA based on a mutually
agreed prot sharing ratio, while the loss shall be borne by the customers.
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18 Islamic Finance and Global Financial Stability
Mobilisingfundsonaprotsharingbasismeansthat,inprinciple,thevalueof
liabilities adjust accordingly in response to any change in the price o assets. Even
i the price o the nanced assets remains unchanged, the expected returns or the
partners may all (or example, because o weak demand), which will subsequently
reduce the prot to be shared.
Thismodusoperandiservesasamajorconstraintonleverageandtheresultant
credit creation, and ensures a better alignment o the values o assets and liabilities.
The use o prot sharing modes to mobilise unds may imply that Islamic banks
ollow a model that is closer to that o mutual unds, which in principle, are less
vulnerable to runs and panics than the conventional banking model1.
Asset Side: On the asset side, Islamic banks enter into dierent nancing modes
which have a distinct intrinsic characteristic dictated by its underlying Shariah
principles.
o The wide range o nancing modes based on trade and commerce oered by
Islamic banks, such asmurabahah (cost-plus credit sale nancing),istisna
(manuacturing or construction nancing contract),salam (orward sale o
ungible goods or immediate payment),ijarah (leasing), etc. indicates that the
IFSI has a sucient range o products that can be used in meeting the needs
o its customers; and
o An Islamic bank may enter into joint venture as a means o nancing where
the Islamic bank acts as joint partner in a specic economic activity based ona pre-specied prot-and-loss sharing arrangement.
Thisformofintermediationisnotmerelythecollectionofaspreadbetweenthe
cost o unds mobilised and the return on unds advanced in the context o the
conventional debtor-creditor relationships but a more active economic role involving
either the provision o assets or services or entering into partnerships.
1 Khan and Mirakhor, 1987; Cowen and Kroszner, 1990; Jacklin, 1993
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7. The key thrust o Islamic nancial transactions is to have high
degree o transparency and disclosure in preserving the rights and
responsibilities o the parties to a contract. Islamic nance requires
the Islamic nancial institutions to undertake the appropriate due
diligence on the viability o business proposals and to meet therequirement or transparency and disclosure. Market conduct
disclosure and customer relationship management orm the core o
these principles. Addressing the inormation asymmetry between
Islamic banking institutions and the depositors/investors is o vital
importance. Under themudarabah principles, there is a need or
disclosure by Islamic nancial institutions to investors on how the
unds are being managed so as to provide the assurance that the
underlying business operations, the risk prole and the risk control
mechanisms are in place. Disclosure o the true and air value othe Islamic banking operations in the nancial statements is also
essential or depositors to undertake an inormed assessment
o the banks perormance. In the case o equity and investment
instruments, proper screening processes and disclosures are
imperative to increase the level o assurances that the investments
are invested in a Shariah compliant manner. The unds o the
Islamic investment product and those o the nancial institution in
which Shariah injunctions are not observed must be completely
segregated. This calls or the maintenance o separate accountsand disclosures, evidencing the complete segregation o unds.
Non-commingling o unds is essential and should be enshrined
and expressly stated in the statutes or the prospectus. The role
o the Shariah board in ensuring that all aspects o the business
operations o Islamic nancial institutions are in accordance with
the Shariah principles, adds another level o oversight which
inherently saeguards against irresponsible practices. These in-
built dimensions o governance and risk management contribute
to saeguarding Islamic nance rom the potential risks o nancialstress arising rom excessive leverage or speculative activities.
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20 Islamic Finance and Global Financial Stability
8. These distinct eatures o Islamic nance represent the core
principles in determining whether a particular transaction or
institution all within the parameters o Shariah. When embraced
in its entirety, these essential Shariah eatures reduce the risk o
nancial instability. These principles are also integral to the orderlydevelopment o innovative Islamic nancial products and services.
Financial innovation in Islamic nance must be within these Shariah
parameters and tested against the Maqasid al-Shariah (objectives
o the Shariah), where the primary objective is the realisation
o benets to the people. This demands the internalisation and
preservation o Shariah principles in Islamic nancial transactions,
both in orm and substance in order to ensure that the religious
and ethical principles are not compromised. This is illustrated in
the example omusharakah mutanaqisah, an equity-based contractwhich has been widely accepted in many jurisdictions (see Box 3).
These inherent eatures o Islamic nance signicantly contribute
towards the nancial stability o the Islamic nancial system.
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Box 3: Distinct Features o Islamic Financial Transactions: Perspective
onMusharakah Mutanaqisah (Diminishing partnership)
Musharakah mutanaqisah can be applied in home nancing products. Based
on the joint-ownership concept, the banking institution and the customer
contribute their respective shares o the capital required to acquire the property
according to a mutually-agreed, pre-determined ratio at the beginning o the
contract. The banking institution leases the property to the customer who
undertakes to incrementally acquire the ull ownership o the property rom the
banking institution over an agreed period. Once the customer has ully acquired
the banking institutions share o the property, the partnership comes to an
end with the customer becoming the sole owner o the property. This contract
incorporates elements o both sale and lease (ijarah) contracts, which are integral
in ensuring that no element oriba (interest) is involved in themusharakah
mutanaqisah transaction.
TheapplicationofShariahprinciplesinmusharakah mutanaqisah contracts
creates distinct relationships, rights and obligations o the parties to the
contracts. As a result, banking institutions are exposed to both market risk
associated with the joint ownership o the underlying asset, as well as credit risk
associated with the obligation on the part o the customer to acquire, and on the
banking institution to sell its share o ownership in the asset. This distinct risk
exposure requires the banking institution to adopt more robust methodologies
supported by reliable and timely data and systems that are able to detect and
provide best estimates o potential losses arising rom adverse developments
in the credit prole o the customer. The risk management processes and
inrastructure o a banking institution oering such a product also need to be
dynamic in identiying, measuring, controlling and managing all the relevant
risks associated withmusharakah mutanaqisah transactions. Chart 1 shows the
key risk exposures and risk management practices at the dierent stages o a
transaction inmusharakah mutanaqisah, as well as additional risk mitigants that
can be introduced.
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22 Islamic Finance and Global Financial Stability
9. The essential eatures o Islamic nance, notably its value
proposition o the sharing o risks and prots is reinorced by an
ethical approach to nancial transactions. Thus, this also involves
greater attention to non-prot transactions and the segments o
society with scarce capital, as well as attention to responsible
and ethical nancing. In this regard, the Islamic nancial services
industry is also attractive and viable or the less privileged
segments o society that generally do not have recourse or unds
except rom the inormal or shadow nancial sector. In the process,
the economic empowerment o the less ortunate would elevate
their status rom the non-bankable to the bankable segment,
thereby beneting the borrowers, the nancial system, and the
community at large, as well as increasing nancial inclusion (see
Box 4 and 5). The promotion o a more inclusive nancial system
T0: Acquisition ofProperty by the
Bank and Customer
Risk Management
Provide appropriatemechanism tocompensate the banksloss of future incomearising from earlysettlement.
T0 TM: Lease Rental &
Transfer of BanksOwnership
Tn: Customer Default
Risk Management
1. Incorporation of
purchase undertaking
(wad) as risk mitigant
(exit strategy) in the event
of default.
2. Use of security instruments (charge
on the underlying property) against the
non payment of rental.
Risk Management
Risk Management
Pre-agreed rental pricebased on nancialmarket indicators.
TM: Full Transferof BankingInstitutionsOwnership toCustomer
RATE OFRETURN RISK
Potential loss infuture incomearisingfrom earlysettlement
LEGAL RISK
Enforceability of
contract and
recognition of
benecial ownership
under the law
CREDIT RISK
Non-payment ofrental by thecustomer
MARKET RISK
Arising from theuctuation of marketprice (in the case oftransactions withoutwad)
Chart 1: Management of Key Risks inMusharakah Mutanaqisah Contracts
2. Proper assessment of customer
credit prole and valuation of the
property.
1. Ensure comprehensive
agreement to cover the rights and
obligations under joint ownership.
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23Islamic Finance and Global Financial Stability
Box 4: Non-Proft/Unilateral Contracts in Islamic Finance
Whilethenon-protdomaininIslamicnancehasbeeninoperationformany
centuries, it is less well known. This domain comprises institutions such aszakat,
sadaqah,awqafand similar philanthropic and social responsibilities, which are
considered just as essential as the or prot domain within Islamic nance. They
alsoperformbenecialeconomicsupportinservingthesafetynetarrangement.
Zakatmaybecomparedtoatypeofwealthtax,beinganobligationrelated
to dened types o assets rom which a part is to be paid by the owner o the
assets when the assets reach a certain amount (nisab). For example,zakat
on savings requires, inter alia, a holder o idle unds to contribute at a rate o
2.5% per annum to the eligible beneciaries. It becomes payable i the holders
monetary unds have been idle or one year. This negates the incentive or
hoarding, which the Holy Quran takes a strong position against.
Awqafrepresents the creation o an endowment whereby an asset or pool oassets is dedicated in perpetuity, primarily or charitable purposes. Historically,
awqafhas proven to be a useul institution in mobilising idle assets or
addressing poverty, as the beneciaries oawqafcan enjoy the benets o
education, healthcare, basic inrastructure and entrepreneurial assistance.
Theeconomicempowermentofthelessfortunate,ifcarriedoutinasystematic
and structured manner, may elevate them rom the non-bankable to the
bankable segment, thereby beneting the individuals themselves, the nancial
system, and the community at large, as well as increasing nancial inclusion.
would in turn improve the nancial intermediation process and
enhance the overall ecacy o nancial policies. Finally, through
increased nancial fows across borders, Islamic nance can
also contribute to closer economic and nancial linkages across
the world by promoting mutually reinorcing growth in the worldeconomy.
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24 Islamic Finance and Global Financial Stability
Box 5: Islamic Microfnance:Ar-Rahnu
TheAr-Rahnu (Islamic pawn broking) scheme can demonstrate its role as a
viable microcredit product o the nancial institutions in meeting the dierent
customer requirements. Firstly, it represents a credit channel to those who want
to use theAr-Rahnu scheme to obtain nancial resources to meet their daily
nancial requirements; and secondly, it can be a credit channel to those who
require temporary working capital, particularly or small businesses.
The objective oAr-Rahnu is to create an alternative nancing channel to the
conventional pawn broking, that is not only more transparent but that also
complies with Shariah principles.Ar-Rahnu is a orm o microcredit product
where the borrower places valuable assets, such as gold, jewelry, as collateral
or the nancing. In the conventional pawn-broking, interest is charged on theloan and the collateral will be used in the event o deault. In theAr-Rahnu
scheme, there is no element o interest and the nancing is usually given on
qard (loan). However, the borrower must pledge a valuable asset as collateral on
the nancing. The maximum amount o the nancing as practised in Malaysia,
Brunei and Indonesia is around 60 to 75 per cent o the value o the pledged
item. The nancial institution (the lender) would accept the pledge on wadiah
(sae-custody) concept where the nancial institution promises to sae-keep
the pledged asset until the nancing is settled. The nancial institution would
impose a charge on the borrower or services rendered which may includetakaul coverage and security or the pledged asset. In the event o a deault,
the pledged item will be sold to a third party. The proceeds will be used to settle
the outstanding balance while any excess will be returned to the borrower,
unlike conventional pawn broking where the excess will not be returned to the
borrower.
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25Islamic Finance and Global Financial Stability
10. In summary, the eatures and value proposition inherent in the
Islamic nancial model can have the potential to contribute to
global nancial and economic stability through the ollowing
channels:
a. Finance can only be extended to projects, trade, economicand commercial transactions. Financial assets can thereore
grow in proportion to the growth in real economic activities and
minimise the possibility o excessive leverage.
b. Dont sell what you dont have is one o the undamental
principles o Shariah, which restricts the possibility o excessive
speculation.
c. Investments in public and private equities have to pass a set o
screening processes where social and ethical responsibilities
are an integral part o investment decisions.
d. Preserving genuine liquidity (as opposed to synthetic liquidity)
urther adds to the stability o the IIFS.
e. Managing procyclicality (such as dynamic provisioning) is
strongly encouraged where the concept has been narrated in
the Holy Quran2.
2 Surah Yusu - verses 43 to 49. Reer to Appendix IV or details
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26 Islamic Finance and Global Financial Stability
B. The State o Islamic Financial Services Industry
11. The crisis had initially emanated rom the sub-prime market in an
advanced economy largely due to excessive credit activity in the
sub-prime mortgage sector. This was primarily acilitated through
nancial derivatives such as Collateralised Mortgage Obligations
(CMO), Collateralised Debt Obligations (CDO) and Credit Deault
Swaps (CDS). With integrated nancial markets and cross border
capital fows, the crisis spread to all regions o the globe resulting
in a sharp decline in investor condence, which consequently saw
the evaporation o liquidity in the global nancial system.
12. Islamic nancial institutions, which are subject to Shariahregulations, are orbidden rom investing in such derivative
instruments and thereore did not have exposure to such
derivatives. Also the holding o shares or the investment in
conventional nancial institutions which are involved in usury
orriba are not permitted. The combination o these actors
minimised the impact o the nancial crisis on Islamic nancial
institutions. However, the subsequent tightening o liquidity
and credit in the global nancial markets did adversely impact
all nancial institutions in general, including Islamic nancialinstitutions. As the nancial crisis become prolonged, the global
recession, the collapse in commodity and oil prices, and the sharp
erosion o asset values that ollowed, aected the perormance o
the Islamic nancial institutions.
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28 Islamic Finance and Global Financial Stability
14. While the Islamic nancial services industry currently represents
approximately only 1% o global assets, it has been growing
by more than 20% annually since 2000. As at the end o 2007,
the combined revenue o international Islamic nancial services
is estimated to amount to USD53 billion, while Islamic protstotalled USD15 billion and is expected to more than double to
USD32 billion over the next 5 years. It is estimated that by 2012,
Islamic assets will reach about USD1,600 billion, with revenues o
USD120 billion.
15. Several key developments highlight the increasing signicance o
Islamic nance in the global nancial system:
a.The expanding asset base
. The industry hasrecorded strong growth with total Islamic banking assets o
USD660 billion at the end o 20073. In terms o geographical
distribution, the Middle East is now the largest Islamic nance
market, accounting or about 80% o global Islamic nance
assets. Chart 2 illustrates the regional distribution o
Islamic assets, revenues and prots and the relative regional
Muslim population4.
3 Oliver Wyman, 20094 Oliver Wyman, 2009
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29Islamic Finance and Global Financial Stability
Subcontinent Southeast Asia North Africa Turkey Iran GCC Levant RoW
0%
10%
20%
30%
40%
50%
60%
70%
90%
100%
Muslim population Islamic assets Islamic revenues Profit pools
80%
Regional breakdown as follows:Levant : Israel, Jordan, Lebanon, Palestine, Syria
GCC: Qatar, Bahrain, Kuwait, UAE, Saudi Arabia, Oman
North Africa: Algeria, Egypt, Libya, Mauritania, Morocco Tunisia, Sudan
Southeast Asia: Cambodia, Laos, Thailand, Vietnam, Philippines, Brunei, East Timor, Indonesia, Malaysia, SingaporeSubcontinent: India, Pakistan, Bangladesh, Bhutan, Nepal
Source:The Next Chapter in Islamic Finance Higher Rewards But Higher Risks (Oliver Wyman)
Chart 2: Muslim population, Islamic assets, revenues and profit
pool breakdown by region, 2007
A more recent survey encompassing the top 500 IIFS showed
that assets held by ully Shariah-compliant banks including
Islamic banking windows o conventional banks rose by 28.6%
to USD822 billion, rom USD639 billion in 20085. During this
period, the worlds top 1,000 conventional banks achieved anannual asset growth o just 6.8% as o July 2009 to amount to
USD96,395 billion.
b. Strong perormance. The strong perormance o Islamic
nancial institutions amid the crisis has urther supported its
growing signicance. Table 4 shows the comparison in terms
o aggregate size and perormance o Islamic banks and
conventional banks in the Gul region (Saudi Arabia, Kuwait,
Qatar, United Arab Emirates and Bahrain).
5 The Banker, Nov 2009
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30 Islamic Finance and Global Financial Stability
c. Growing signifcance across regions, beyond predominantly
Muslim markets and jurisdictions. From being concentrated
in Muslim populated regions, Islamic nance has drawn
signicant participation by non-Muslims. Exceptional growthin Islamic nance has been registered not only in the Muslim
world, where its growth is premised on religious considerations,
but now spans across the western world and the Asia Pacic
region where the growth is driven by commercial and business
considerations. Although the Middle East and Asia remain by ar
the largest Islamic nancial markets in the world, other regions
and countries are also pursuing Islamic nance as a new asset
class. Its potential or growth and development in the uture
has triggered strong interest rom beyond Islamic incumbents.Chart 3 includes non-Muslim countries such as Australia, China,
France, Germany, Hong Kong, Italy, Japan, Korea, Luxembourg,
Singapore and United Kingdom, in which there are some
initiatives in introducing Islamic nance in their nancial systems.
China has issued its rst licence or Islamic banking, while ve
Islamic banks have been established in the United Kingdom
as at end 2009. Countries such as France, Korea and Japan
have also initiated changes to their legal and tax structure to
acilitate the introduction o Islamic nancial products into theirmarkets. Other countries including Hong Kong and Australia
have indicated their intention to advance this orward. This trend
is expected to contribute towards greater cross-border fows in
terms o increased trade and investment transactions, thereby
strengthening economic linkages.
Conventional Banks Islamic Banks
Assets (USD billions) 1,135,669 232,189
Prots (USD billions) 22,008 7,666
Asset growth 2007-08 16.3% 38.2%
Prot growth 2007-08 6.1% 20.1%
Prots/Assets 1.9% 3.3%
Source: El-Jarhi, 2009. Islamic windows in conventional banks are not included in Islamic banks.
Table 4: Islamic and Conventional Banks in the Gul Region, 2008
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31Islamic Finance and Global Financial Stability
Chart 3: Emerging interest in Islamic Finance
d. Rapid expansion of the sukuk market. With regard to Islamic
securities or sukuk, Thomson Reuters reported that the sukuk
market grew rom USD6 billon to USD24 billion between 2004
and 2007. However, in 2008, the sukuk market registered
a decline o about 30% due to the uncertainty in the global
capital markets6. Nevertheless, as the overall market conditions
improved, the sukuk market rebounded in the second hal o
2009 (see table 5). The huge potential in the Sukuk market is
evident rom the active participation o global players including
international investment banks, Islamic banks and securities
frms that have participated in the issuance o sukuk.
6 Tayyebi, 2009
Germany
Saxony-Anhalt stateissued governmentsukuk
First Islamic bank tooperate in 2010
Pakistan
Hong Kong
Aims to become Islamicfinance gateway to China
Plans to issue sovereignsukuk
Hang Seng Islamic ChinaIndex Fund in 2007
United Kingdom Government sets an objective to
entrench London as a globalgateway for Islamic finance
5 FSA-approved Islamic banks
Plans to issue sovereign sukuk,amend tax law on Islamic finance
UAE
Japan Law passedallowing banks toconduct Islamic
finance
France Passed
rules/regulations tosupport Islamic financeactivities
In process of licensingIslamic banks
Made fiscal & legaladjustment for IFtransaction i.e. taxationguidelines on sukuk &murabaha Singapore
Established first Islamic bank
Introduced tax neutrality for Islamicfinance
Launched Islamic ETF
South Korea
Parliament expected to pass thelaw related to offering of tax
waiver on foreign investors interest
income from sukuk issued
Qatar
SudanKuwait
SaudiArabia
Bahrain
Jordan
-
Muslim-majority countries offering Islamic finance (IF)Non-Muslim countries starting to offer Islamic finance
Indonesia
Brunei
Malaysia
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32 Islamic Finance and Global Financial Stability
e. Growth potential o takaul in new and existing markets.
Takaul premium contributions have grown rom USD1.4 billion
in 2004 to over USD3.4 billion in 2007. The largest global
markets include Saudi Arabia and Malaysia. Saudi Arabia
remains the largest takaul market in the GCC with contributions
o USD1.7 billion in 2007. Malaysia remains the largest takaul
market in Asia with contributions o USD0.8 billion in 2007.
The other markets or takaul are Bahrain, Sudan, Kuwait and
Indonesia. Globally, takaul continues to record rapid growth in
new and existing markets7.
. Strong upside potential o Islamic und management
industry. In terms o Islamic unds, Shariah-compliant
investible assets in 2008 in the GCC and Asia reached
USD736 billion compared to USD267 billion in 20078
. Thisrepresents a potential annual revenue pool o USD3.86
billion or the Islamic asset management industry. Fund sizes
however remain small, with more than 50% having assets
under management o USD20 million or less.
7 Ernst & Young, 2009a8 Ernst & Young, 2009b
Sukuk issuance shows improvement from 2008 setbackUSD billion
30
25
20
15
10
2001
Source: Dealogic
02
5
0
03 04 05 06 07 08 2009Year -
to - date
Table 5
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33Islamic Finance and Global Financial Stability
g. Development o comprehensive Islamic fnancial
inrastructure. Several key institutions have been established
to provide the inrastructure or the continuous growth o Islamic
nance. Among the key institutions are the IFSB, AAOIFI and
specialised institutions that provide Islamic nancial servicessuch as rating agencies, deposit insurance corporations and
mortgage corporations. IFSB, an international prudential
standard setting body was established in 2002 to develop and
disseminate prudential standards or regulation and supervision
o the Islamic nancial services industry. AAOIFI, an accounting
and auditing organisation, is responsible to develop accounting
and auditing standards or the Islamic nancial institutions.
Several international rating agencies have developed ratings
methodologies that recognise and incorporate the uniqueeatures o Islamic nance. Specic scheme on Islamic
deposit insurance has also been developed, while mortgage
corporations have issued sukuk to acilitate the widening
o asset classes available to investors in the Islamic capital
markets. Complementing these initiatives are the eorts by the
central banks in issuing Islamic monetary instruments which is
integral to the unctioning o the Islamic money market and the
Islamic nancial system.
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34 Islamic Finance and Global Financial Stability
9 Ernst & Young, 2009
II. Perormance o Islamic Banks
16. The resilience o the Islamic nancial institutions during the recent
crisis epitomises the intrinsic strengths in Islamic nance, which
purpose and objectives are guided by the Shariah principles.
A study on the perormance o the top 10 conventional banks with
the top 10 Islamic banks indicate the ollowing9:
a. The combined market capitalisation o top 10 conventional
banks suered a decline o 42.8% vs. 8.5% decline in market
capitalisation by Islamic banks or the period between
December 2006 and May 2009.
b. Aggregate net prots o conventional banks ell dramatically
rom USD116 billion in 2006 to a net loss o USD42 billion in
2008. In contrast, Islamic banks net prot increased 9% duringthe same period rom USD4.2 billion to USD4.6 billion while
our o the conventional banks experienced losses (none o the
Islamic banks suered losses in 2008).
c. Between 2006 and 2008, total assets o conventional banks
grew by 36% to USD17.4 trillion while assets o the Islamic
banks grew by 55% rom USD94 billion to USD147 billion. The
growth in total equity during this period was 24% and 36% or
conventional and Islamic banks, respectively.
d. Conventional banks leverage ratio (Assets/Equity) was
16.6 times in 2006 which increased urther to 18.2 times in
2008. This was nearly three times the leverage ratio o Islamic
banks, which was 5.8 times in 2006 and 6.6 times in 2008.
e. Five o the top 10 conventional banks received government
nancial assistance to the extent o USD163 billion in aggregate,
or 26% o the aected banks combined equity. In contrast, only
one Islamic nancial institution required government assistance
to restructure and trading o its shares was suspended. As at
end 2009, none o the Islamic banks needed any government
rescue scheme.
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35Islamic Finance and Global Financial Stability
Chart 5: Market capitalisation of top 10 conventional and Islamic banks
pre & post crisis
17. Chart 4 compares the changes in market capitalisation, net
prot/(loss), total assets and equity between conventional banksand Islamic banks pre and post crisis. The ollowing charts (chart
5-8) show the perormance o individual banks with respect to
market capitalisation, protability, assets and leverage.
100.0
(%)
50.0
(50.0)
(100.0)
(150.0)
0.0
Change in total
assets
Change in net
profit / (loss)
Change in market
capitalisation
Change in equity
Top 10 Conventional banks
Top 10 Islamic banks
Chart 4: Changes in market capitalisation, net proft, assets and
equity - pre and post crisis
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36 Islamic Finance and Global Financial Stability
Chart 6: Net profit/(loss) of top 10 conventional and Islamic banks
pre & post crisis
Chart 7: Total assets of top 10 conventional and Islamic banks
pre & post crisis
Chart 8: Leverage ratios (Assets/Equity) of top 10 conventional and
Islamic banks pre & post crisis
Sources:
Companyannualreportsandwebsites;nancialdatabasewebsites(ThomsonReutersetc.)
TheBanker,November2008reportontop500Islamicnancialinstitutions Ernst&YoungAnalysis
Note:
AllnancialgureshavebeenconvertedtoUSDoncurrentexchangerates.
AllguresareforDecemberyear-end,exceptMitsubishiUFJFinancialwhichhasMarchyear-end.Its2006
numbersareactuallyfor12monthsendedMarch2007.Its2008numbersareasof30September2008,thelast
reportedgures.Netprotfor2008isforsixmonths.
The2008numbersforInvestmentDararefor9monthsupto30September2008.
Asof1April2009,theKuwaitStockExchangesuspendedtradinginInvestmentDarssharesuntilfurthernoticeas
aresultofthepostponementofthereleaseofitsfullyearnancialresultsfortheyearended31December2008.
Thelistoftop10Islamicbanksintermsof2006marketcapdoesnotincludesomelargeIranianbankswhichclaim
to be Shariah compliant but their market data is not easily available.
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37Islamic Finance and Global Financial Stability
18. It is important to note, however, that the above observations are
subject to some important caveats:
a. The size o the Islamic banks is a raction o that o the
conventional banks. The top 10 Islamic banks market
capitalisation was only 3.1% o the top 10 conventional banksmarket capitalisation in 2006. While this has improved to 4.8%
in 2008, it remains small. The size o Islamic bank assets as a
percentage o total bank assets was less than 1% in 2008.
b. In the case o Gul-based Islamic banks, their relatively large
exposure to the real estate sector has been a key reason or
their weaker perormance. As a result, they suered rom price
corrections in the Gul property market.
c. Islamic banks are currently in an evolutionary and transitory
phase where there is a concentration o their assets in a ew
products which have been careully structured to largely
replicate the risk and return characteristics o conventional
nancial products. To the extent that this is diluting the
distinctiveness o Islamic nance, it could also expose the
Islamic banks to the destabilising orces inherent in the
conventional nancial system.
III. The Perormance o Islamic Indices
19. The Islamic nancial services industry has developed a stringent
set o criteria or investment, specically to acilitate investments
in the various stock markets around the world. These criteria
represent part o the screening process to identiy companies
which business activities do not comply with a minimum Shariah
compliant standard, thereby rendering their stocks ineligible or
purchase by Shariah based investors. The criteria include tests
at the level o a companys primary business and at the level o
its nancial or capital structure. In the more recent decade, such
Shariah screens have been adopted by the major international
index providers to establish specialised Islamic market indices.
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38 Islamic Finance and Global Financial Stability
20. During the recent stock market crash, Islamic indices had allen
together with the conventional stock indices across the world,
but to a lesser extent. This could be due to the exclusion o
conventional banking and insurance stocks rom Islamic indices,
including stocks that ailed to pass the screens owing to thenature o their business (e.g. dealing in interest). Other companies
that were designated as being non-Shariah compliant are those
involved in gambling and other certain entertainment.
Dow Jones Islamic Market World Developed Index versus MSCI World Index
Total Return in USD
Dow Jones Islamic Market World Developed Index MSCI World Index
0.4
0.5
0.6
0.7
0.8
0.9
1
1.1
1.2
1.3
12/3
1/20
06
2/28
/200
7
4/30
/200
7
6/30
/200
7
8/31
/200
7
10/3
1/20
07
12/3
1/20
07
2/29
/200
8
4/30
/200
8
6/30
/200
8
8/31
/200
8
10/3
1/20
08
12/3
1/20
08
PercentReturns(%)
Chart 9: Dow Jones Islamic Index vs. MSCI World Index
Source: Aka, 2009
21. As shown in Chart 9, during 2007-2008, the total returns on the
Dow Jones Islamic Market World Developed Index declined by24.7%, while the outturn or its counterpart/proxy, the Morgan
Stanley World Index declined by 34.7%10.
10 Aka, 2009
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39Islamic Finance and Global Financial Stability
Chart 10: S&P Global Sharah Index vs. S&P Global Index
Source: OBrien, 2009
22. A similar outcome is apparent in Chart 10, which compares the
perormance o the Standard & Poors Global Shariah Index
vis--vis its Global Conventional Index. In 2008, the S&P Global Index
lost 42.5%, while its Islamic counterpart ell by 36.8%. This trend
is mirrored in the perormance o the S&P 500, which lost 38.6%,compared with its Islamic counterpart which declined by 28.9%.
23. Going orward, it is envisaged that the strong growth in Islamic
nance will be sustained, given the potential or widening the
current range o Islamic nancial products and services on oer,
as well as increasing demand, particularly rom the high number o
untapped markets.
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40 Islamic Finance and Global Financial Stability
C: Challenges and Strategies or Strengthening FinancialStability in the Islamic Financial System
24. The recent international nancial crisis has revealed that ragilities
exist in the worlds nancial system, including in the moreadvanced economies. These have brought to the oreront key
issues regarding nancial intermediation, nancial innovation and
the regulatory and surveillance ramework that needs to be put
in place to provide the necessary oversight over such activities.
Although the Islamic nancial services industry was relatively
less aected by the crisis, its underlying causes bear important
lessons or the Islamic nancial industry going orward. This is
even more important as Islamic nance operates within the global
nancial system that is characterised by increasingly large andvolatile cross-border capital fows amid an environment o deeper
international nancial integration.
25. To support the orderly development o Islamic nance or
sustained global nancial stability, it is vital to accelerate the
development o critical building blocks o the Islamic nancial
system to respond to the changing economic and nancial
landscape. This is important to ensure a more integrated Islamic
nancial services industry globally that is able to withstand shocks
and adverse market developments through putting in place
building blocks that will strengthen the resilience o the Islamic
nancial system and by the application o mutually acceptable
rules and standards.
26. Moving orward, three key areas o priority warrant greater policy
attention to urther strengthen and enhance the entire Islamic
nance ecosystem:a. Strengthening the inrastructural building blocks o the Islamic
nancial services industry to urther enhance the industrys
resilience;
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41Islamic Finance and Global Financial Stability
b. Accelerating the eective implementation o Shari'ah and
prudential standards and rules to acilitate the creation o a more
stable, ecient and internationally integrated Islamic nancial
services industry; and
c. Creating a common platorm or the regulators o the Islamicnancial services industry to enhance constructive dialogue.
I. Strengthening Islamic Financial Inrastructure
27. It is critical to build the robust components o the nancial
inrastructure as well as strengthen the key institutions, at both the
national and international level, to ensure the stability and dynamism
o Islamic nancial system. This report has identied eightbuilding blocks aimed at urther strengthening the Islamic nancial
inrastructure at the national and international levels to promote a
resilient and ecient Islamic nancial system.
Comprehensive set o cross-sectoral prudential standards
28. The frst building block in securing nancial stability is the
development o a set o comprehensive, cross sectoral prudential
standards and supervisory ramework covering Islamic banking,
takaul and capital market which takes into account the specicities
o the IIFS.
29. The IFSB has issued a whole spectrum o prudential and
supervisory standards which constitute the equivalent o Basel II
in Islamic nance covering risk management, capital adequacy,
corporate governance, transparency and market discipline. These
standards take into account international prudential standards
across the banking, investment and securities and insurancemarkets issued by the Basel Committee on Banking Supervision
(BCBS), the International Organization or Securities Commission
(IOSCO) and International Association o Insurance Supervisors
(IAIS), respectively, and simultaneously cater eectively or the
specicities o Islamic nancial rms, their risks and Shariah
compliance. Appendix I provides a ull list o the standards and
publications issued by the IFSB.
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42 Islamic Finance and Global Financial Stability
30. Signicant eorts to issue comprehensive prudential standards or
the Islamic banking sector have contributed towards establishing
an internationally consistent ramework or Islamic banking that
is equally robust as those applicable to the conventional banking
sector. This includes a sound capital adequacy rameworkequivalent o Basel II or Islamic banking. Appendix II provides
comparison between IFSB and BCBS standards.
31. However, greater attention is needed to expedite work on a more
comprehensive set o prudential standards or the takaul sector.
IFSB spearheads this eort through a number o key initiatives.
In August 2006, IFSB and IAIS issued an Issues paper on the
applicability o the existing insurance core principles11 (ICPs) to the
regulatory and supervisory standards or takaul to be developed
by the IFSB. Some o the ICPs are universally applicable and
require no adaptation to apply to takaul. However, some o the
ICPs appear to require some adaptation, or example, in the areas
o corporate governance, nancial regulation and market conduct.
In December 2009, IFSB issued a standard on the governance o
takaul. A standard on the solvency o takaul is at an advanced
stage o preparation. Appendix III shows the comparison o
standards between IAIS and IFSB.
32. It is also important to ensure closer cooperation among
policymakers and nancial supervisors with dierent mandates
and in dierent jurisdictions in order to enhance the resilience and
stability o the IFSI. In this regard, the IFSB has emphasised the
need or the adoption o a coordinated cross-sectoral approach
to the regulation and supervision o IIFS that encompasses the
banking, the investment and securities market and the takaul
sectors. To address contagion risks, the regulation o non-nancialactivities o nancial conglomerates would also need to be
appropriately structured.
11 The IAIS insurance core principles (ICPs) provide globally accepted principles or the regulation and supervision oinsurance sector.
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43Islamic Finance and Global Financial Stability
Development o a liquidity management inrastructure
33. Thesecond building blockin enhancing nancial resilience and
stability o the IFSI is the development o a robust national and
international liquidity inrastructure, which encompasses the
potential or monetary policy and money market operations. Thisis important not only to reduce the cost o intermediation, but
also to infuence the level o liquidity in the nancial system and
achieve eective management o monetary policy. Robust liquidity
management inrastructure is also vital in preserving nancial
stability or central banks to perorm the lender o last resort
(LOLR) unction and to provide liquidity to the market. The ability
o IIFS to weather a liquidity crunch is contingent upon the access
to a robust liquidity management inrastructure, which is currently
still underdeveloped in most o the jurisdictions in which Islamicnancial services are oered. The tools or liquidity risk management
presently available or use by IIFS remain rudimentary and markets
are insuciently liquid, leading to ineciencies in normal times (due
to low returns on liquid assets) as well as the potential or systemic
risks in times o crisis owing to the relative limited liquidity o the
instruments involved.
34. Towards addressing this, the IFSB has established a High LevelTaskorce on Liquidity Management (HLTF), mandated to develop
a liquidity ramework to acilitate and oer liquidity solutions to
market players so as to promote better liquidity management by the
Islamic nancial institutions. The HLTF is also mandated to study
the viability o the proposal to establish an entity which would issue
Shari'ah compliant instruments that are highly liquid and transerable
in the secondary nancial market.
Strengthening fnancial saety nets
35. The third building blockrelates to the strengthening o the nancial
saety net mechanism, namely, LOLR acilities and emergency
nancing mechanisms as well as deposit insurance, all o which
need to be compatible with Shariah principles. While the current
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44 Islamic Finance and Global Financial Stability
practice o managing liquidity through interbank Murabahah or
Wakalah arrangements, structured nance and enhanced deposit
schemes may unction well under normal market conditions, more
ecient and tradable Shari'ah compliant nancial instruments are
required or LOLR acilities and emergency nancing operationswhen inter-bank liquidity comes under pressure in a crisis situation.
This calls or the development o an adequate range o tools and
instruments or LOLR and emergency nancing operations that are
consistent with the core objectives and principles o Shari'ah both in
orm and in economic substance.
36. Deposit insurance, together with prudential supervision and the
LOLR unction, represent the other key components o the nancial
saety-net arrangements or sustaining nancial stability, especially
when conronted with a nancial shock. The implementation o
a well-designed Shari'ah compliant deposit insurance scheme
or Islamic nancial services is particularly challenging given the
intricacies o the unding structure o IIFS. The on balance sheet
unding structure o IIFS in almost all countries is composed mainly
o current accounts and unrestricted prot sharing and loss bearing
investment accounts (UPSIA), and in most IIFS, these investment
accounts constitute the major source o unding. While explicit
depositor protection may be provided or current accounts under
a Shari'ah compliant (takaul based) deposit insurance scheme,
an issue arises when insurance coverage is provided or UPSIA.
Contractually, UPSIA should bear their own commercial risks, as
in the case o investors in a collective investment scheme (CIS).
While Shari'ah requirements in this respect would be met by the
UPSIA themselves being the participants in the scheme, providing
insurance coverage or UPSIA might raise several concerns relating
to matters such as: the appropriate air value o UPSIA that should
be insured; the evaluation o the riskiness o the underlying assets;
the quality o the asset management or the purpose o setting
the levels o the takaul contributions and the unlevel playing eld
between UPSIA as investors in IIFS vis--vis investors in a CIS.
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46 Islamic Finance and Global Financial Stability
refect the risk characteristics o IIFS. In parallel, urther progress
is needed in updating the accounting and auditing standards or
IIFS to that o the international standards, in order to complement
the developments in prudential and risk management standards.
Above all, there needs to be a monitoring and assessmentmechanism to encourage countries to implement the standards.
Macro-prudential surveillance
40. Thesixth building blockreers to the development o the macro-
prudential surveillance ramework and nancial stability analysis,
which is an integral part o the strategy to strengthen the resilience
o the Islamic nancial system and to minimise the risks o nancial
ragility. The traditional micro prudential supervision approach
cannot eectively address system-wide stress that might develop
due to common exposures o nancial institutions. In this respect,
there is a need to have a macro prudential surveillance ramework
that complements the traditional micro prudential supervision o
individual institutions.
41. One o the challenges in the implementation o this macro prudential
ramework relates to the development o indicators that would not
only provide a basis or the assessment o nancial soundnessand risk to vulnerabilities o the nancial system as a whole and
its components, but also acilitates an analysis and assessment o
how these indicators might interact with broader macroeconomic
developments. Such an assessment o systemic implications would
enhance the ability to anticipate the potential threats to nancial
stability. In this regard, the IFSB has embarked on an initiative to
establish a global database o prudential Islamic nance statistics.
This would contribute towards standardising the measurement
methods and reporting structures o key nancial soundnessindicators or Islamic nance, thereby promoting international data
comparability. As timely and accurate inormation and statistics is
key enabler to this process, it is thereore necessary to ensure that
similar advancement in inormation technology is made to cater or
the unique characteristics and eatures o Islamic nance.
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47Islamic Finance and Global Financial Stability
Strengthening rating processes
42. Theseventh building blockis to review the rating process or
Islamic institutions or instruments by re-examining and improving
the related core processes to encourage greater transparency on
the risks involved. A robust rating process is an integral part o
the building blocks to address the apparent ailure o the rating
agencies to assign accurate ratings on new, complex securities,
beore the onset o any crisis12.
43. Rating agencies need to ully appreciate the unique eatures,
characteristics and risk proles o Islamic institutions and
instruments. It is important to adopt a more holistic rating
process, encompassing the duciary aspects and credit riskwhile giving due consideration to the transparency and visibility
o the underlying transactions and the quality o the management.
44. The rating and methodology process also need to be
re-examined to encourage greater transparency. As Islamic
nancial institutions are involved in duciary relationship, the
rating process should emphasise on the management o risk
sharing in certain products and services (such as PSIA), and must
be recognised in the credit rating assessment.
Capacity building and talent development
45. Finally, as the eighth building block, international Islamic
supranationals and developmental bodies need to consider
more involvement in capacity building to promote global
nancial stability. Islamic nance is an industry that is dynamic
and complex with rapid product innovation. To excel and
produce results in a more challenging globalised environment,practitioners and stakeholders in the Islamic nancial services
industry need to be highly qualiied and equipped with the
12 For instance, during the onset o the crisis, rating agencies competed with each other to rate MBS and CDOsecurities issue by investment banks as the remuneration and incentives are three times more than grading lesscomplex, traditional corporate bonds.
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48 Islamic Finance and Global Financial Stability
requisite technical knowledge and skills. O importance is the need
or more collaborative eorts by various research and training
institutions in dierent jurisdictions to design and oer capacity
building modules in key areas across multiple jurisdictions.
Collaboration in this area would also enhance capacity buildingamong countries and Islamic nancial services industry players to
develop the best practices and standards, harmonise o Shari'ah
practices, review standards to acilitate policy development and
implement o standards and policy ramework.
46. Eorts to enlarge the human capital pool are imperative to keep
pace with the rapid growth o Islamic nance. Investments in
human capital development through specialised training and
educational institutions are important to support the global
development o Islamic nancial services industry. Talent
development and educational institutions specializing in Islamic
nance that have been established in several jurisdictions should
be encouraged to orge strategic alliances across borders.
II. Accelerating Eective Implementation
47. Going orward, steps need to be taken to implement the eight
building blocks. Eective implementation is important to ensureenhanced resilience o the industry and greater linkages among
Islamic nancial institutions and markets. There are three
dimensions to this process:
a. Implementation o the prudential standards;
b. Mutual understanding o Shari'ah views globally on key issues
in Islamic nance; and
c. Emphasis to encourage an inclusive system.
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49Islamic Finance and Global Financial Stability
Implementation o the prudential standards
48. Theimplementation o the prudential standards that have
been issued by the IFSB is important. This is critical in the
harmonisation o prudential standards, in promoting and enhancing
the soundness and stability o Islamic nancial services industry,
as well as in contributing towards the consistent development o
Islamic nance across dierent jurisdictions. Several jurisdictions
have implemented the prudential standards issued by the IFSB,
which have been designed based on the unique eatures o Islamic
nance and will contribute towards ensuring its soundness and
stability. This should be supported by a transparent and credible
assessment process which would serve to assist jurisdictions in
evaluating their level o compliance with international standards and
make recommendations or improvements such as peer reviews or
the Financial Sector Assessment Program (FSAP) process.
Mutual understanding o Shari'ah views on key issues across
jurisdictions
49. This is essential as varying interpretations o Shari'ah in key
issues in dierent countries or markets add to the complexity
when cross-border transactions are involved. Mutual recognition
o nancial standards and products across jurisdictions wouldacilitate the integration o Islamic nance across the world and in
bridging the global markets. This convergence and harmonisation
is taking place with the greater engagement among the regulators,
practitioners and scholars in Islamic nance across jurisdictions.
The industry also needs to develop innovative and diversied
Islamic nancial instruments which can be readily accepted by the
Islamic nancial institutions in various jurisdictions.
50. Key to this is to ensure that a consistent interpretation across
jurisdictions is applied to the issues acing the industry. It is important
or the industry to have a general understanding o the undamentals
o Islamic nance and in embracing the uniqueness o Islamic nancial
structures and their risk proles. The industry needs to recognise
the theoretical merits o Islamic nance as espoused by Shari'ah
objectives and principles. When embraced in its entirety, these
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50 Islamic Finance and Global Financial Stability
essential eatures reduce the risks o nancial instability. While
innovation is to be encouraged, it must be consistent with the
essential eatures o Islamic nance that are in compliance with
the principles o Shari'ah and aligned to the objectives o Shari'ah.
This is an important transormation o Islamic nance rom thedominant strategies pursued in previous decade o emulating the
products and services o its conventional counterpart. This would
separate Islamic nance rom the same misalignments between
assets and liabilities prevailing in the conventional system, and
thus reduce the risks o nancial panics. In attaining a sucient
degree o dierentiation, Islamic nance can become a valuable
partner within the global nancial system.
Emphasis or Islamic fnance to be a more inclusive system
51. Islamic nance also emphasises the development o a more
inclusive system, within a broader Islamic nancial ecosystem.
The hardships o the vulnerable segments o the society are oten
compounded during economic and nancial crises. In the Islamic
nancial ecosystem, the institutions ozakat andawqafcontribute
towards alleviating such hardships. In addition, greater access
to nancial services enables broader participation in the nations
development process. Islamic nance, in achieving the objectiveso Shari'ah (Maqasidal-Shari'ah), makes nancial services relevant
or a larger segment o the world population. Micronance is an
important part o this initiative.
52. Eective strategies or the development o micronance have been
developed by the cooperatives, non-governmental organisations,
the Islamic banking institutions throughzakat/awqafunds and
multilateral institutions including Islamic Development Bank
(IDB). With enhanced and strengthened resources, multilateralinstitutions such as the IDB can have a larger role in improving
services to the Islamic micronance sector.13
13 A recent IRTI document on Strategies and Framework or Development o Islamic Micronance Servicessuggests a number o specic initiatives that would go a long way in strengthening nancial inclusion andenhancing accesses o the poor to nancial services.
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51Islamic Finance and Global Financial Stability
III. The Establishment of a Platform for Constructive Dialogue:
Islamic Financial Stability Forum (IFSF)
53. Key to achieving fnancial stability is to have a strategic platorm
or conducive and constructive dialogue among the regulators
o the international Islamic fnancial system. As Islamic fnance
continues to become an integral part o the global fnancial system,
there is scope or the current ramework o cooperation to be
strengthened and broadened to address the new challenges that
have emerged.
54. In this regard, the Task Force recommends the establishment
of an Islamic Financial Stability Forum or IFSF based at the
IFSB, which shall, inter alia, be a broad-based and constructivestrategic platorm or IFSB members to achieve the primary
objective o building cross-border dialogue in eorts to promote
fnancial stability within the Islamic fnancial system. The
objective o the IFSF will be to acilitate better understanding
o emerging developments in the Islamic fnancial system and
their implications or national and global fnancial stability. The
IFSF also would have the potential to promote collaboration and
cooperation in remedial policies to prevent, contain and manage
emerging issues in Islamic fnance.
55. It is envisaged that the IFSF will provide a strategic platorm
or IFSB to enhance collaboration in Islamic fnance to promote
stability in the IFSI and the global fnancial stability. The IFSF will
be a dedicated orum to promote cooperation and collaboration
among its members in areas such as surveillance, sharing o
experiences in crisis prevention, management and resolution,
implementation o international standards as well as international
cooperation in capacity building and in the development o
emergency inrastructure and acilities.
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52 Islamic Finance and Global Financial Stability
56. It is envisaged that the IFSF can serve as the orum to deliberate
on the ollowing agendas:
a. Establish an integrated mechanism or macro-monitoring o the
developments in the global Islamic nancial services industry;
b. Assess vulnerabilities and emerging risks to Islamic nancial
systems and the implications or global nancial stability
including cross nancial systems assessments;
c. Propose and advise on policy actions and responses to deal
with the identied risks and vulnerabilities;
d. Establish an integrated crisis management and resolution
ramework and arrangements and ensure the continued
eective and ecient unctioning o the ramework and
arrangements;e. Develop a communication mechanism to collaborate and
exchange inormation and experiences with the IIFS, regional
ora and regulators/supervisors on nancial stability issues;
. Promote cooperation and coordination among relevant
authorities and Islamic nancial institutions on nancial stability
by acilitating reviews and implementation o international
standards; and
g. Focus attention on issues o coherence and convergence, and
on opportunities to increase the eciency, integrity and stability
o Islamic nancial markets.
57. As Islamic nance will continue to be an integral part o the global
nancial system, it is important to have an integrated initiative, both
or conventional and Islamic nance, to preserve nancial stability
at the global level. Key to this is to maintain an interace between
the Financial Stability Board and IFSF so as to ensure there would
be constructive exchange rom the perspectives o conventionaland Islamic nance to maintain global nancial stability.
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53Islamic Finance and Global Financial Stability
Conclusion
58. Islamic nance continuous expansion to become an integral part
o the international nancial system, presents unique opportunitiesand challenges. Islamic nance needs to urther strengthen its
resilience to withstand all possible market imperections and
uture shocks. It has to draw on its intrinsic strengths to solidiy its
posi
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