Islamic Finance Asia

Islamic Financial Services Board
Islamic Finance for Asia:
Islamic Finance for Asia: Development, Prospects, and Inclusive Growth

Development, Prospects, and Inclusive Growth
Asian Development Bank

6 ADB Avenue, Mandaluyong City
1550 Metro Manila, Philippines
www.adb.org

Level 5, Sasana Kijang, Bank Negara Malaysia
2, Jalan Dato‘ Onn, 50480 Kuala Lumpur, Malaysia
www.ifsb.org

*This publication is based on the presentations made during the ADB-IFSB on Islamic Finance for Asia:
Development, Prospects and Inclusive Growth & Roundtable Session for Regulators
4 November 2013 - 5 November 2013
Co-publication of the Asian Development Bank and the Islamic Financial Services Board
2015
The views expressed in this publication are those of the authors and do not necessarily reflect the views and
policies of the Asian Development Bank (ADB) and the Islamic Financial Services Board (IFSB) or its Board of
Governors or the governments they represent.
ADB and the IFSB do not guarantee the accuracy of the data included in this publication and accepts no
responsibility for any consequence of their use.
By making any designation of or reference to a particular territory or geographic area, or by using the term
“country” in this document, ADB and the IFSB do not intend to make any judgments as to the legal or other
status of any territory or area
Published in 2015 by


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© Asian Development Bank and the Islamic Financial Services Board.

CONTENTS
List of Figures, Tables, and Boxes i
Abbreviations iii
Foreword v
About the Contributors vii
Chapter 1: Islamic Finance for Asia: Innovation, Inclusion, and Growth 01
Overview of Islamic Finance in Global Markets 02
Islamic Finance in Asia: Progress and Opportunities 06
Asia’s Economic and Demographic Profiles 11
Asia’s Developmental Needs Moving Forward: Role of Islamic Finance 13
Conclusion 20
Chapter 2: Islamic Finance Stability, Resilience, and Regulatory Issues 23
The Role of Regulation in Promoting Financial Stability and Resilience 24
The Roles of Boardrooms and Courtrooms in Islamic Finance 28
Concluding Remarks 31
Chapter 3: Islamic Finance: Financial Inclusion as a Core Concept 33
Financial Inclusion and Its Importance 34
Concept of Financial Inclusion in Islam 35
Case Studies 38
Concluding Remarks 42
Chapter 4: Islamic Capital Markets: Potentials and Prospects for Development 43
A Global Overview 44
Malaysia’s Experience 46
The Philippines’ Experience and the Role of the Philippine Stock Exchange 48
Turkish Islamic Finance Experience 49
Chapter 5: Implementation of Global Prudential Standards for the Islamic Financial Services Industry 57
Supervision of the Finance Sector and Unique Risks in the Islamic Finance Sector 58
Preparation and Implementation of IFSB Prudential Standards 67
Role of Multilateral Development Banks and ADB Technical Assistance 80
Experience Sharing in the Implementation of IFSB Prudential Standards 83
Conclusion and Going Forward 86
Chapter 6: Legal and Regulatory Issues for Islamic Finance: Post-Crisis Scenario 89
Key Reasons for the Financial Crisis 90
Islamic Banks’ Resilience during the Crisis 91
Key Finance Sector Post-Crisis Reforms 91
Current Islamic Banking Paradigm 93
What is the Solution? 94
Conclusion 95
Chapter 7: Taking the Initiative for Islamic Finance: Role of Governments and the Private Sector 97
The Origin and Modern Growth of Islamic Banking and Finance 98
The Exemplar of Government and Private Sector Partnership in Promoting Islamic Finance 98
Islamic Finance: Global Context and Prospects 102
Demand for Innovation and Rigor of Sharīàh Governance to Meet Needs 103
Conclusion 105
Chapter 8: The Way Forward: Key Islamic Finance Challenges and Road Map for Asia 107
Islamic Finance: The Resilience Factors 108
Risks and Challenges Impacting the Industry 109
Moving Forward: A Road Map for Asia 110
REFERENCES
GLOSSARY
List of Figures, Tables, and Boxes
Figures
1.1: Global Islamic Finance Assets by Region (H1 2014E)

1.2: The Ecosystem of the Islamic Financial Services Industry
1.3: Islamic Finance Landscape in Asia (end-2013)
1.4: Global Islamic Banking Assets—Growth Trend by Region (2008–2014F)
1.5: Islamic Banking Assets in Asia by Domicile (2013)
1.6: Sukūk Outstanding by Region (2013)
1.7: Sukūk Outstanding in Asia (2013)
1.8: Islamic Funds Registered in Selected Asian Jurisdictions (number, 2013)
1.9: Takāful Gross Contributions by Region (2013F)
1.10: GDP Growth Trend and Projections for Asia (2006–2015F)
1.11: FDI Inflows to Asia (2000–2013)
1.12: Age Dependency Ratio in Asia (1990–2013)
1.13: Annual Infrastructure Investments Needs in Asia by Subregion
1.14: Infrastructure Sukūk Issuances by Country ($ million, 2001–H1 2014)
1.15: Republic of Indonesia – $1.5 Billion Global Sukūk due 2019
1.16: Sime Darby – Inaugural $800 Million 5-/10-yr Sukūk Offering
1.17: Malaysia Airport Holdings – $500 Million Sukūk Offering
1.18: Malaysia Airport Holdings – Mushārakah Structure
1.19: South and Central Asia – Account at a formal financial institution (% age 15+)
1.20: East Asia and Pacific – Account at a formal financial institution (% age 15+)
1.21: Largest Muslim Population by Country (2030)
1.22: Number of Sharīàh-Compliant Microfinance Institutions
1.23: Drivers Sustaining Islamic Finance in Asia
3.1: Share of Adults with an Account at a Formal Financial Institution (%)
3.2: Targeted Approaches to Enhance Inclusion
4.1: Major Islamic Indices for Equity Markets
4.2: Global Islamic Assets under Management by Domicile (as of 17 June 2014)
4.3: Global Sukūk Outstanding (2003–H1 2014)
4.4: Growth Drivers of the Sukūk Market
4.5: Malaysian Sukūk Primary Market Share vs. Global (2002–H1 2014)
4.6: Sukūk Capital Raised by Foreign Issuers in Malaysia (2008–Sep 2014)
4.7: Sukūk Issuances in Turkey (2010–H1 2014)
4.8: Sukūk Outstanding in Turkey (2010–H1 2014)
4.9: Development of the Regulatory Framework for Turkish Lease Certificates
4.10: Regulated Sukūk Structures
4.11: Eligibility for Creating Asset Lease Companies
5.1: Co-Risk Model
5.2: Types of Risks in Islamic Banking Transactions
5.3: Insufficient Supply of Short-Term Sukūk for Liquidity Management
5.4: Operational Framework of the Islamic Financial Services Board
i
List of Figures, Tables, and Boxes
5.5: Key Milestones for the Due Process

5.6: Islamic Financial Services Board Strategic Performance Plan 2012–2015
5.7: Standards Implementation by Regulatory and Supervisory Authorities – Overall
5.8: Standards Implementation in Regulatory and Supervisory Authorities with More than > 5.0% Market Share
5.9: Role of the IFSB and Multilateral Development Banks in Supporting Common Members Jurisdictions
7.1: Considerations of Muslim and Non-Muslim Customers in Adopting Islamic Finance
7.2: Development of Islamic Finance and Stakeholder Expectations
7.3: Position of Islamic Financial Activities within the Greater Islamic Economic System
Tables
3.1: Resource Shortfall for Poverty Alleviation and Potential of Zakah in Meeting the Gap
3.2: Akhuwat Microfinance Institution in Pakistan
4.1: Turkish Banking Sector Key Statistics (H1 2014)
5.1: Progression of the Islamic Financial Services Board Standards
5.2: Summary of Standards and Guidelines Implementation with Respect to Banking Supervisory Authorities
(as at end of 2010)
5.3: Summary of Standards Implementation by the Respondent Regulatory and Supervisory Authorities
5.4: Ranking of Challenges in the Standards Implementation
Boxes
1.1: Islamic Finance: The Salient Features

3.1: Issues with a Conventional Approach to Financial Inclusion
ii
Abbreviations
AAOIFI – Accounting and Auditing Organization for Islamic Financial Institutions

ACIA – ASEAN Comprehensive Investment Agreement
ADB – Asian Development Bank
AIC – Arab Investment Court
ALA – alternative liquidity approaches
ALC – asset lease company
ASEAN – Association of Southeast Asian Nations
AuM – asset under management
BCBS – Basel Committee on Banking Supervision
BIBF – Bahrain Institute of Banking and Finance
BNM – Bank Negara Malaysia
BSAS – Bursa Suq Al Sila
BSP – Bangko Sentral ng Pilipinas
CAGR – compound annual growth rate
CAR – capital adequacy ratio
CBMA – Central Bank of Malaysia Act 2009
CDO – collateralized debt obligation
CDS – credit default swap
CMB – Capital Markets Board of Turkey
ETF – exchange traded fund
FDI – foreign direct investment
GDP – gross domestic product
HQLA – high quality liquid asset
IAH – investment account holder
IAIS – International Association of Insurance Supervisors
IBBL – Islami Bank Bangladesh Limited
ICSID – International Centre for Settlement of Investment Disputes
IDB – Islamic Development Bank
IFI – Islamic financial institution
IFSB – Islamic Financial Services Board
IFSI – Islamic financial services industry
IIFM – International Islamic Financial Market
IIFS – institutions offering Islamic financial services
IILM – International Islamic Liquidity Management Corporation
IIRA – International Islamic Rating Agency
IMF – International Monetary Fund
INCEIF – International Centre for Education in Islamic Finance
IOSCO – International Organization of Securities Commissions
IRTI – Islamic Research and Training Institute
KFHR – Kuwait Finance House Research Limited
LCR – liquidity coverage ratio
MDB – multilateral development banks
iii
Abbreviations
MoU – memorandums of understanding

MSMEs – micro, small, and medium-sized enterprises
NBK – National Bank of Kazakhstan
NKEA – national key economic area (Malaysia)
NSFR – net stable funding ratio
OIC – Organisation of Islamic Cooperation
PER – profit equalization reserve
PRC – People’s Republic of China
PSE – Philippine Stock Exchange
PSIA – profit sharing investment account
REIT – real estate and investment trust
RIB – revenue-indexed bond
RSAs – regulatory and supervisory authorities
S&P – Standard & Poor’s
SBP – State Bank of Pakistan
SIFI – systemically important financial institution
SKRA – strategic key result area
iv
Foreword
The financial crisis of 2007-2008 that led to the global crisis, brought a sharp contraction in the growth rates
of global gross domestic product and, of aggregate global financial assets. The Islamic financial services
industry, however, grew at an estimated compound annual growth rate of 20% per annum during 2007–2013,
partly due to its limited exposure to risky financial instruments, growth from a low base as well as inherent
strengths, to reach estimated total assets of USD1.8 trillion as at year-end 2013. The Islamic banking sector,
which represents approximately 80% of total Islamic financial assets, was a major driver of this growth.1
In Asia, the strong growth of Islamic finance is led by Bangladesh, Brunei Darussalam, Indonesia, Malaysia,
and Pakistan. Azerbaijan, Hong Kong, China, Kazakhstan, Singapore and Thailand also have a growing niche
of Islamic finance. The strong growth of Islamic finance in Asia has been exemplified by the emergence of
large Islamic banks and the issuance of Sukūk, a capital raising instrument that provides undivided ownership
over underlying assets, as an attractive Sharīàh-compliant asset in the region. At the end of 2013, Islamic
banking and Sukūk in Asia represented 49% and 45%, respectively, of the global Islamic finance assets.2 This
growth can be witnessed not just in the size of total assets and the number of Islamic finance institutions and
products, but also in the development of underlying financial infrastructure supporting the industry, such as
legal and regulatory frameworks and human capital development.
Broadly speaking, the growth of Islamic finance has underscored its potential as an alternative financing source
for infrastructure and economic development in Asia, a source of investment financing in both advanced
and emerging economies, and as a means for diversifying funding and broadening risk exposures at both
institutional and macroeconomic levels. An additional dimension of Islamic finance is that it provides financial
services for all segments of the population, thus improving financial inclusion, including for those who are
currently unbanked or not inclined to use other financial products.
Further development of Islamic finance needs to address challenges related to capacity building needs of
supervisory authorities and market players, as well as the development of legal and regulatory frameworks that
can cater to the specificities of the Islamic finance industry.
The Asian Development Bank (ADB) and the Islamic Financial Services Board (IFSB) organised a conference
on Islamic Finance for Asia: Development, Prospects and Inclusive Growth and a Roundtable Session for
Regulators on 4–5 November 2013 at the ADB Headquarters in Manila, Philippines. This joint-publication
of the two organisations, which is authored by selected presenters of the conference and roundtable, is
produced against the backdrop of the growing importance of Islamic finance in ADB’s member countries.3 The
authors have presented their views on various aspects of Islamic finance, namely the growth and development
of Islamic finance in Asia, legal and regulatory issues, financial inclusion, the role of Sukūk, implementation
of the global prudential standards, initiatives undertaken by governments and the public sector, and the way
forward for Islamic finance in Asia. The conference has increased the awareness on Islamic finance among
ADB’s developing member countries, as a potential source for cofinancing projects.
1
IFSB Islamic Financial Services Industry Stability Report 2014
2
MIFC, Sustained Growth in Emerging Asia Offers Regional Expansion for Islamic Finance, March 2014
3
Malaysia, for example, targets to increase the share of its Islamic banking sector from 29% in 2010 to as much as 40% by 2020, while
Pakistan recently launched a strategic plan aimed at increasing the market share of its Islamic banking sector from the current 10% to
15% by 2018.
v
Foreword
The ADB and the IFSB would like to thank the contributors to this publication for their efforts. The publication
has benefitted from the review of a team at the IFSB Secretariat, headed by Assistant Secretary-General Zahid
ur Rehman Khokher4; a team at the ADB headed by Assistant General Counsel and Islamic finance practice
leader Ashraf Mohammad and Sani Ismail, Team Leader for the ADB-IFSB technical assistance and Kuwait
Finance House Research.
The Islamic Finance for Asia: Development, Prospects and Inclusive Growth is a useful resource for better
understanding the Islamic financial services industry in Asia, and a valuable reference for jurisdictions in other
regions that aim to understand, introduce and develop Islamic finance.

Mr. Stephen Groff Mr. Jaseem Ahmed
Vice President (Operations 2), ADB Secretary General, IFSB
March 2015

4
Other IFSB team members included Members of the Secretariat, Mustafa Taşdemir, Saad Bakkali, Siham Ismail, Rosmawatie Abdul
Halim and Ida Shafinaz Ab Malek.
vi
About the Contributors
Chapter 1: Islamic Finance for Asia: Innovation, Inclusion and Growth
Baljeet Kaur Grewal

Managing Director & Vice Chairman
KFH Research Limited (KFHR)
Baljeet Kaur Grewal is the Managing Director & Vice Chairman of KFH Research Limited (KFHR), the Investment
Research subsidiary of Kuwait Finance House. In her capacity, Baljeet heads the Global Economic & Investment
Research and Advisory teams at KFHR, the first Islamic bank worldwide to have a notable research presence
in Islamic finance. KFHR has won 14 awards of global excellence.
Prior to this, Baljeet was the Head of Investment Banking Research at Maybank Group, Malaysia. Prior to that,
she was attached to ABN AMRO Bank and Deutsche Bank, London, with experiences ranging from Credit
Structuring, Loan Syndication and Economic & Capital Market Research. She has broad experience in investment
banking, having participated in notable Islamic fund raising transactions in Asia & the Middle East as well as in
strategic planning and execution of investment banking organisational change. To date, she has undertaken
research in Islamic finance with a principle focus on debt capital markets and Sukuks in emerging markets.

Baljeet has a 1st Class Honours degree in International Economics from the University of Hertfordshire and an
MBA from University of Cambrdge, UK. She is also the recipient of the prestigious Sheikh Rashid al-Makhtoum
Award for Regional Contribution to Islamic Finance in Asia 2006, as well as accolades honouring women in
Islamic finance. She is also a regular speaker on Islamic Finance at University of Cambridge, UK.
Chapter 2: Islamic Finance: Stabiliy, Resilience and Regulatory Issues
Professor Simon Archer

Visiting Professor
University of Reading
Simon Archer is a Visiting Professor at the ICMA Centre, Henley Business School, University of Reading, UK,
with particular responsibility for Islamic Finance, and Adjunct Professor at INCEIF, Kuala Lumpur.
Previously, he was Professor of Financial Management at the University of Surrey, after being Midland Bank
Professor of Financial Sector Accounting at the University of Wales, Bangor. After studies in Philosophy, Politics and
Economics at Oxford University, he qualified as a Chartered Accountant with Arthur Andersen in London and then
moved to Price Waterhouse in Paris, where he became Partner in charge of Management Consultancy Services.
Since beginning an academic career, Professor Archer undertaken numerous consultancy assignments,
including acting as consultant to the Accounting and Auditing Organization for Islamic Financial Institutions
(AAOIFI) and the Islamic Financial Services Board (IFSB). He has been a Visiting Professor at a number of
universities and business schools, including IIUM in Malaysia, Bordeaux, Metz, Paris-Dauphine, HEC and EAP-
ESCP in France, Copenhagen Business School in Denmark, and Frankfurt and Koblenz in Germany.
Professor Archer is also the author and co-editor of a considerable number of works and academic papers on
international accounting and on issue in Islamic finance.
In 2010, Professor Archer received an award from the Central Bank of Bahrain and Kuwait Finance House,
Bahrain for his “outstanding contribution to the Islamic Financial Services Industry”.
vii
Madzlan Mohamad Hussain

Partner & Head, Islamic Financial Services Practice
Zaid Ibrahim & Co., Malaysia
Madzlan Mohamad Hussain is a partner and head of the Islamic Financial Services Practice of Zaid Ibrahim &
Co.
He has previously served the Islamic Financial Services Board (IFSB), an international standard-setting
organisation for prudential regulations of the global Islamic financial services industry, where he contributed
to the development of prudential framework in respect of corporate governance for all segments of Islamic
financial services and led the IFSB’s initiatives in highlighting legal issues in the global Islamic finance industry.
In his practice, besides advising Islamic financial institutions in the development and documentation of
products and execution of Islamic finance transactions, he has the experience of advising on various corporate
exercises including mergers and acquisitions, corporate and debt restructuring and the establishment of new
financial institutions. He has been enlisted as an expert consultant by the Islamic Development Bank (IDB),
the World Bank (WB) and the International Monetary Fund (IMF) in their technical assistance grants to several
countries which were keen to introduce Islamic banking laws.
Madzlan holds a Bachelor of Laws degree from the International Islamic University Malaysia and a Master of
Science in Islamic Economics, Banking and Finance from Loughborough University, United Kingdom. He was
a former Chevening Visiting Fellow at the Oxford Centre for Islamic Studies, United Kingdom and has done an
attachment with the Legal Department at the Federal Reserve Bank of New York.
Chapter 3: Islamic Banking: Financial Inclusion as a Core Concept
Dr. Zamir Iqbal

Lead Financial Sector Specialist
The World Bank
Dr. Zamir Iqbal is Lead Financial Sector Specialist at Finance and Markets Global Practice of the World Bank.
He heads the World Bank Global Islamic Finance Development Center in Istanbul, Turkey.
Prior to his current assignment, he had more than twenty years of experience with the World Bank Treasury
dealing with risk management, structured finance and assets management. His research interest includes
Islamic Finance, Financial Engineering, and Risk Management.
He has written extensively on Islamic finance and has published articles in reputed academic journals. He has
co-authored several books on Islamic finance on diverse topics including risk analysis of Islamic banks, financial
stability of Islamic finance, risk-sharing in Islamic finance, and Islamic finance and economic development.
He holds a Ph.D. in international finance from the George Washington University. He has also served as
Professional faculty at Carey Business School of The Johns Hopkins University.
viii
Chapter 4: Islamic Capital Market: The Role of Sukuk for Development
Murat Haholu
Head of Surveillance, Corporate Finance Department
Capital Markets Board of Turkey
Born in 1974, Murat Haholu graduated from University of Ankara, Law School, with LL.B degree in 1996. He
then started his career at the Capital Markets Board of Turkey in 1997. He worked for 4 years as an assistant
expert at the CMB. In 2001, he was appointed as an expert. He got his MBA degree at the Atilim University
in Ankara in 2004. Then in 2007, he went to the American University Washington College of Law. He holds
an LL.M degree on Business and Financial Regulation. In the CMB, he worked in many projects such as
securitization, public disclosure. He also worked in the project regarding the implementation of the European
Union Acquis into Turkish Capital Markets Law. Among the other projects he worked in are asset backed
securities and asset covered bonds. He is currently working in the project on Sukuk Issuances at the CMB in
the Department of Corporate Finance. Currently, he has been working as the head of surveillance, a division
of that department.
Chapter 5: Implementation of the IFSB Standards
Zahid ur Rehman Khokher

Assistant Secretary - General
Zahid has been working with the Islamic Financial Services Board (IFSB) since January 2008 and has
more than 15 years of regulatory and standard setting experience in the financial sector. He supervises the
standard-setting and research programme of the IFSB and provides immediate leadership and guidance
required by the relevant staff. He is also responsible for overseeing key initiatives, among others, Integrated
Result Based Management Framework and strategic performance planning for the Secretariat. His role also
involves cooperation and development of the Islamic financial services industry by fostering relationships with
IFSB members, multilateral development banks and other international organisations.
He is also member of the Basel Consultative Group and IAIS-IFSB Joint Working Group on Microtakaful.
He has also worked as Joint Director in the Islamic Banking Department of State Bank of Pakistan, where he
was involved in assignments related to the introduction and enhancement of Islamic prudential and regulatory
framework in the country. His experience in the central bank also includes on-site inspection, foreign exchange
supervision, and treasury.
Zahid is a Chartered Islamic Finance Professional (CIFP) from INCEIF, Malaysia (2009). He holds Masters in
Business Administration (2005), Computer Science (1998) as well as Statistics (1995). He also holds PGD in
Islamic banking and insurance from IIBI, London, UK (2001).
ix
Mohd. Sani Mohd. Ismail

Financial Sector Economist
Sani Ismail is a Financial Sector Specialist in the Southeast Asia Department of the Asian Development Bank
(ADB). In his role he leads the financial sector program in Indonesia, the private sector and SME development
program for Lao PDR, and ADB’s regional capital market integration program for ASEAN countries. Sani
is also leading ADB’s assistance program to support Afghanistan, Bangladesh, Indonesia and Pakistan to
implement prudential standards in Islamic finance. Before joining ADB in 2009, Sani worked in various roles in
the Market Development department of Securities Commission Malaysia for 7 years.
Chapter 6: Legal and Regulatory Issues for Islamic Finance Post-crisis
Saleem Ullah*
Director, Finance Department
State Bank of Pakistan
Saleem Ullah is a career Central Banker with over 18 year’s Central banking experience at various important
positions including Head Microfinance Division (MFD), Head Strategic Management, Director Agricultural
Credit, Director Development Finance and Director Islamic Banking.
As Head MFD from 2001 to 2005, he pioneered the development of regulatory and supervisory framework
for Microfinance Banks in Pakistan, which is considered as one of the most progressive in the world. Since
assuming the responsibilities as Director Islamic banking about 3 years back, he has taken several key
initiatives to improve the policy and regulatory environment to facilitate growth and development of the Islamic
finance industry on sound footings. The initiatives include development of detailed instruction on profit and
loss distribution and pool management policies of Islamic bank, development of Islamic microfinance model,
development of liquidity management solutions for Islamic banking Institutions.
By qualification, he is a business graduate of Bahaudin Zakariya University, Multan, Pakistan and an associate
member of Institute of Cost and Management Accountant of Pakistan. He has also done Masters in Public
Policy from Kennedy School of Government, Harvard University as a mid career student. His career spans over
18 years of central banking experience primarily in the areas of banking supervision and development finance.
Note: The views presented in the article are the author’s own and not those of State Bank of Pakistan.
x
Chapter 7: Taking the Initiative for Islamic Finance: Role of Governments and Private
Sector
Badlisyah Abdul Ghani

Executive Director / Chief Executive Officer, CIMB Islamic
Head, Group Islamic Banking, CIMB Group
Country Head, Middle East and Brunei, CIMB Group
Badlisyah Abdul Ghani is the Executive Director and Chief Executive Officer of CIMB Islamic, Head of the
Group Islamic Banking and the Country Head of Middle East and Brunei, CIMB Group.
As the Executive Director and Chief Executive Officer, he manages and oversees the overall Islamic banking
and finance franchise of CIMB Group known as CIMB Islamic.
He sits on various boards of companies and is currently the Alternate Director to Chairman of CIMB Principal
Islamic Asset Management Berhad; Alternate Director of CIMB-Principal Asset Management Berhad and
CIMB Wealth Advisors Berhad; Member of the Investment Committee of CIMB Principal Asset Management
Bhd; Director of CAPASIA Islamic Infrastructure Fund (General Partner) Ltd; Director of CIMB Middle East BSC
(C) Baharin and Director of Islamic Banking and Finance Institute Malaysia.
Badlisyah has 16 years of domestic, regional and global banking experience in various roles. He has been
recognised by top international publications as the “Top 20 Pioneer in Islamic Finance”, “Islamic Banker of
the Year” and awarded the “Outstanding Contribution to the Development of Islamic Finance” award for
his role in the global Islamic financial market. He sits on the Islamic Capital Market Consultative Panel of
Bursa Malaysia and both the Exchange Committee and the Licensing Committee of the Labuan International
Financial Exchange.
Badlisyah is 39 years old and holds a Bachelor of Laws degree from the University of Leeds, United Kingdom
and an alumni of the ICLIF Program.
xi
Chapter 8: The Way Forward: A Roadmap for Asia
Dr. Ishrat Husain

Dean and Director
Institute of Business Administration, Pakistan
Former Governor, State Bank of Pakistan
Dr. Ishrat Husain joined the elite Civil Service of Pakistan in 1964 and served in the field in Sindh and then
East Pakistan (now Bangladesh) and also held mid-level policy making positions in the Finance, Planning and
Development Departments before moving to Washington in 1979 to join the World Bank. He became the
Bank’s Resident Representative to Nigeria in 1983.
Ishrat Husain was appointed the Governor of Pakistan’s Central Bank in December 1999. He was conferred
the prestigious award of “Hilal-e-Imtiaz” by the President of Pakistan in 2003. The Banker Magazine of London
declared him as the Central Bank Governor of the year for Asia in 2005. He received the Asian Banker Lifetime
achievement award in 2006.
He was appointed the Chairman, National Commission for Government Reforms in May, 2006 with the status
of Federal Minister and held that position for two years reporting directly to the President and Prime Minister
of Pakistan.
In March 2008, he took over the charge of the office of the Dean and Director, IBA, Karachi – the oldest
graduate business school in Asia. During 2005-06 he was appointed by the Board of IMF as a member of a
three person panel to evaluate the IEO and was also a member of the Mahathir Commission 2020 vision for
the Islamic Development Bank (IDB). He also advised the IDB for creating its poverty reduction fund. He is
currently a member of Middle East Advisory Group of the IMF and the Regional Advisory Group of the UNDP.
He is currently the Chairman World Economic Forum Global Advisory Council on Pakistan. Since 2011 he is
serving as an independent Director on the Board of Benazir Income Support Programme (BISP) the largest
Social safety net and conditional cash transfer program targeted at the poor households of Pakistan.
Dr. Husain has maintained an active scholarly interest in development issues. He has authored 12 books and
monographs and contributed more than two dozen articles in refereed journals and 15 chapters in books.
His book “Pakistan: The Economy of the Elitist State” published by Oxford University Press in 1999 is widely
read in Pakistan and outside. He is regularly invited as a speaker to international conferences and seminars
and has attended more than 100 such events all over the world since his retirement as the Governor. He is
the Distinguished National Professor of Economics and Public Policy and serves on the Boards of several
research institutes, philanthropic and cultural organizations.
Ishrat Husain obtained Master’s degree in Development Economics from Williams College and Doctorate
in Economics from Boston University in 1978. He is a graduate of Executive Development program jointly
sponsored by Harvard, Stanford and INSEAD.
xii
Chapter 1
Innovation, Inclusion, and Growth
Baljeet Kaur Grewal
Overview of Islamic Finance in Global Markets
The inception of the global Islamic finance industry Services Board (IFSB), the Islamic Development Bank
can be traced back to the 1960s and 1970s when the (IDB), and other international agencies such as the
first modern Sharīàh-compliant financial institutions World Bank, the International Monetary Fund (IMF),
were set up in a few Middle Eastern countries and and the Asian Development Bank (ADB).
Malaysia along with the multilateral establishment
of the Islamic Development Bank. Since then, the The industry’s geographical presence has grown
global Islamic financial services industry has grown beyond its traditional markets in the Middle East
substantially over the last few decades (see Box 1.1 and Southeast Asia and includes new players
for salient features of Islamic finance), entering its fifth from diverse regions such as Europe, Central Asia,
decade of existence in the modern era. The industry’s and Africa. There are now more than 600 Islamic
assets have grown from $150 billion in the mid-1990s financial institutions operating across more than 70
to approximately $1.9 trillion as at the first half of 2014. economies including non-Organisation of Islamic
The sector has sustained (see Figure 1.1 for regional Cooperation (OIC) members such as the United
statistics) double-digit growth rates annually, achieving Kingdom, Luxembourg, Mauritius, and Singapore.
a compound annual growth rate (CAGR) of 16.94% In terms of product offerings, the industry is now
during 2009–2013. The global Islamic financial assets able to provide a wide range of products to meet
are well on course to surpass the milestone $2 trillion the varying needs of both retail and corporate
mark in 2014, fueled by geographical and sectoral customers. Moreover, the industry’s offerings now
expansions. In addition, active roles played by various include Sharīàh-compliant capital markets (equities
government and regulatory agencies in promoting and Sukūk or Islamic bonds), assets and funds
the development of Islamic financial markets in their management, as well as Takāful (Islamic insurance)
respective countries are serving to widen the outreach services. There are a number of conventional
of the Islamic financial services industry. This process banks that have introduced parallel Islamic banking
has been supported by the efforts of global multilateral operations.
entities including the likes of the Islamic Financial
Figure 1.1: Global Islamic Finance Assets by Region (H1 2014E)
MENA (Ex-GCC)
• Banking assets (593.9)
Other (North America and Europe) • Sukūk outstanding (0.3)
• Banking assets (71.1) • Islamic funds (0.4)
Sub Saharan Africa Asia
• Sukūk outstanding (6.4) • Takāful assets (7.7) GCC
• Banking assets (22.9) • Banking assets (213.5)
• Islamic funds (12.9) • Total assets (602.4)
• Sukuk Outstanding (0.3) • Banking assets (530.8) • Sukūk outstanding (177.2)
• Takāful assets (0.01) • Islamic funds (1.7) • Sukūk outstanding (85.3) • Islamic funds (25.9)
• Total assets (90.3) • Takaful assets (0.2) • Islamic funds (32.7) • Takāful assets (3.78)
• Total assets (25.1) • Takāful assets (8.23) • Total assets (420.3)
• Total assets (657.1)
Sub Saharan Africa
• Banking assets (22.9)
• Sukūk outstanding (0.3)
• Islamic funds (1.7)
• Takāful assets (0.2)
• Total assets (25.1)
E = estimate, GCC = Gulf Cooperation Council, H = half.

Note: Figures in brackets are in $ billion.
Source: KFH Research.
02
Box 1.1: Islamic Finance: The Salient Features
Islamic finance transactions must be free from the use of “Riba” (interest). Sharīàh, or Islamic law, prohibits
any increase in returns from commercial transactions without the reward seekers sharing the risks or stake
in the economic activity. As a result, returns on investments must be based on real economic activities
and/or underlying assets, performance on which the contractual relationship between parties is structured.
Transactions may also be based on sale-contracts where profits are legitimately earned from the sale of
underlying assets at a price which covers the asset’s original cost plus profit.
In general, Islamic financial mechanisms aim to promote profit and loss structures to ensure contracting parties
share the risks of venture among them. Apart from Riba, other elements prohibited in financial transactions are
excessive uncertainties in contractual performance (Gharar), and gambling and/or chance-based outcomes in
transactions (Maysir). In addition, transactions involving activities deemed impermissible in Islam such as alcohol
brewery, gambling, and casino operations are prohibited. Moreover, the financial contracts must be free from
any sort of coercion, corruption, and deception and the contracting parties must express their free mutual
consent in accepting a deal.
Figure B1.1.1: Salient Features of the Islamic Financial System

• Interest-based lending and the financing of unethical goods and services are prohibited.
• Returns on investments must be based on real economic activities and/or underlying
assets, performance.
• Islamic finance discourages hoarding and prohibits transactions with extreme uncertainties,
and gambling and related activities.
• Equity participation, temporary equities, credit sales, leasing, and other suitably designed
Salient
modes replace interest-based finance, thus promoting the practice of risk sharing.
Features
• Financial engineering to design new products and instruments must comply with the
Sharīàh requirements.
• Private property and free markets are basic to the economic system; any transaction
leading to injustice and exploitation is prohibited.
• Islamic finance upholds contractual obligations and the disclosure of information, which in
turn reduces the risk of asymmetric information and moral hazard.
While the industry has grown across various financial annual Sukūk issuances in the primary market have
segments, the Islamic banking sector continues surpassed the $100 billion in the last 2 years and are
to dominate the global portfolio of Islamic financial poised to once again achieve this feat in 2014 (first
assets accounting for an estimated 79.8% share half of 2014: $66.2 billion). In terms of global Sukūk
as at the first half of 2014. Assets with Islamic outstanding, the volume reached $286.4 billion in
banks and Islamic banking windows have grown the first half of 2014, up 16.8% from $245.3 billion
at a CAGR of 17.4% between 2008 and 2013. The in the first half of 2013. Takāful remains a nascent
Sukūk sector, however, is the top performing sector industry, constituting only an estimated 1.0% share
of the global Islamic finance industry, evidenced by of the global Islamic financial assets as of the first
the larger and more frequent issuances in the market half of 2014. On the other hand, the Islamic funds
by both existing and new debutant issuers. The sector has grown comparatively faster with assets
03
under management worth $75.1 billion as of the first initiatives and measures aimed at fostering greater
half of 2014. The sector has steadily grown fourfold use of Islamic financial instruments and mechanisms
from about 285 Islamic funds in 2004, to nearly to promote inclusive growth and Islamic financial
1,069 Islamic funds in the first half of 2014. These awareness, and providing a consistent basis for
developments are among several notable key trends prudential standards and Sharīàh governance.
that reflect the increasing interest and awareness of
Islamic finance globally. Efforts in strengthening market linkages and
facilitating internationalization of Islamic finance
Alongside the growing internationalization of were also among the key focus of the industry’s
the Islamic finance industry, its growth is being stakeholders. Forging cross-border linkages is
supported by improvements in the overall Islamic central to these aims as more efficient mobilization
finance architecture. Among key global bodies and allocation of funds across regions would bring
supporting Islamic finance growth (see Figure mutually reinforcing gains to the countries involved
1.2) and development include the IDB, IFSB, as well spur growth of the Islamic finance industry
Accounting and Auditing Organization for Islamic at large. The growth of the industry has also led to
Financial Institutions (AAOIFI), International Islamic the establishment of many higher academic and
Financial Market (IIFM), and the International Islamic training institutions around the world that now offer
Liquidity Management (IILM) Corporation. These academic programs in Islamic finance to develop the
organizations have been instrumental in taking pool of talent needed to drive the industry.
Figure 1.2: The Ecosystem of the Islamic Financial Services Industry
Global Islamic
Financial Assets:
Islamic Banking Islamic Capital Market
Global Islamic Financial $1.8 trillion (2013)
Infrastructure Institutions Assets with Islamic banks • From 2006 to 2013,
e.g. IFSB, IDB, IILM, AAOIFI and Islamic banking Sukūk issuances Rating Agencies
windows have grown at a increased at a CAGR
CAGR of 19.2% between of 34.1% from $11.5 Stock Exchanges,
Banking Commodity Trading
Multilateral Development 2007 and 2013 to reach an billion to $119.7 billion
79.8% Platforms
Institutions estimated $1.4 trillion • Islamic funds have
Sukūk grown from 285 to
15.0% 1,053 funds with Training, Education
Ministries and Takāful assets under and Research
Regulatory Bodies management of
Global Takāful total $73.7 billion as at
Funds Information,
contribution is estimated 9 Dec 2013
4.1% Services, Media and
Sharīah Authorities to be almost $20 billion Takāful Associations
and Scholars in 2013 with an average 1.1%
annual growth of 15.0%
363 full-fledged Islamic financial institutions, 108 Islamic

windows, 200 Takāful operators
Throughout the evolution of the industry, national sound corporate governance principles, and
regulatory bodies have been instrumental in accommodative legislative infrastructure. These are
supporting the growth and development of critical for the sustainable and sound expansion of
the industry by ensuring clarity on regulations, the Islamic finance industry while further boosting
gradual harmonization in industry standards, stakeholder confidence in this alternative financial
04
system. On the legislative and regulatory side, The IFSB also supports financial stability in the Islamic
diverse efforts are underway in Asia, the Middle financial system by issuing global prudential standards
East, Europe, and, lately, sub-Saharan Africa. Most and guiding principles for the industry, broadly
notably, Malaysia introduced the Islamic Financial defined to include the banking, capital markets, and
Services Act 2013, which came into effect on 30 insurance sectors. To date, the IFSB has published
June 2014, and this is arguably considered the 16 standards, 5 guidance notes, and 1 technical note
world’s first omnibus legislation on Islamic finance. on various aspects relevant for the financial viability
Hong Kong, China’s Legislative Council passed and stability of the Islamic financial institutions. The
the Loans (Amendments) Bill 2014 in March 2014 IFSB also regularly holds seminars, workshops, and
which enables the government to raise money forums on various topics relevant to prevailing market
through alternative bonds such as Sukūk. In the conditions and these serve as critical platforms for the
following subsections of this chapter, notable IFSB to engage with the industry stakeholders in order
regulatory developments currently taking place in to disseminate new information as well as obtain
Asia across the various Islamic finance sectors will feedback on newly emerging market challenges and
be highlighted. Furthermore, subsequent chapters needs. Particularly for financial stability, since 2010,
in this publication also present a case study analysis the IFSB has hosted the Islamic Financial Stability
on regulatory and legal developments in key Islamic Forum where leading industry experts present on
finance countries such as Malaysia while highlighting topics representing pressing industry challenges of
the present challenges and possible solutions on the time. The IFSB also publishes an annual Financial
the way forward. Stability Report and most recently has released the
Islamic Financial Services Industry Stability Report
Meanwhile, over the years, the focus of regulatory 2014 at its 11th Annual Summit, held in Mauritius.
bodies and multilateral agencies has also been
directed toward analyzing the stability and resilience The private sector has spearheaded the sector’s
of the Islamic financial system. In general, the growth through innovative product developments.
Islamic finance sector was found to have better Product innovation has enabled the sector’s offerings
weathered the global financial crisis of 2008–2009. to include a diverse range of financial products
Consequently, it has become of great stakeholder suited to meet the evolving market needs. In recent
interest to study the key Sharīàh principles which times, the Islamic finance industry’s scope is being
possibly contribute toward the relatively enhanced widened to penetrate into newer growth areas which,
stability and resilience of the Islamic finance for example, range from funding green, ethical, and
sector. The same is extensively discussed in many environment-friendly development projects to ones as
subsequent chapters of this publication, including diverse as enabling of international risk management
current pitfalls in Islamic financial practice which using Sharīàh-compliant hedging instruments.
could lead to instability risks. Furthermore, measures Islamic finance players are increasingly turning toward
to mitigate these risks are also provided by the financial engineering and innovations to develop
various authors across the chapters. Sharīàh-compliant products that can cater to modern
market needs.
05
Finally, the role of Islamic finance as a potential reasons. Islamic finance provides a Sharīàh-
catalyst for enhancing financial inclusion has also compliant and ethical alternative to meet the needs
received growing attention over the years. As of such segments. In addition, the variety of risk-
per surveys conducted by various international sharing contracts in Islamic finance further provide
institutions including the World Bank and Pew an ideal medium to all other borrowers as they do
Research Center, there exists a segment of society not have to bear all risks associated with engaging
that wishes to voluntarily exclude themselves from financial services. Implicitly, this would lower the cost
the formal financial system on account of religious of financing and doing business.
Islamic Finance in Asia: Progress and Opportunities
Asia is a pivotal part of both the global economy and the Islamic finance sector as a whole accounts for a
the Islamic financial system. The region is home to combined value of over $420 billion or an estimated
the largest portion of the Muslim population in the 23.4% of global Islamic financial assets. Islamic
world, while also being a key driving force of global asset management remains a nascent but budding
economic growth. At present, the Islamic financial industry in Asia which has seen steady growth post-
landscape in Asia is dominated by Islamic banking financial crisis. The Takāful industry accounts for less
and Sukūk sectors (see Figure 1.3 and 1.4). Overall, than 1.0% of regional Islamic financial assets.
Figure 1.3: Islamic Finance Landscape in Asia (end-2013)
Islamic Banking Sukūk Outstanding Islamic Funds AuM Takāful
$213.5 billion $177.2 billion $25.9 billion $3.8 billion

50.8% 42.2% 6.2% 0.9%
AuM = asset under management.
Source: KFH Research
The strong growth momentum of Islamic finance is philosophy behind the conventional banking system
driven by many factors. Central to this is the core is the use of the “interest rate,” which provides an
values of Islamic finance itself. Islamic financial opportunity for lenders with surplus funds to earn
institutions (IFIs) endeavor to provide economically fixed rates of returns by loaning their funds out to
viable financing alternatives in the global financial borrowers who must repay the borrowed amount
system, framed within the boundaries set by Sharīàh and an additional price (interest rates) at a future
principles. These institutions run parallel to the date. Sharīàh prohibits returns from commercial
conventional financial institutions and more or less transactions without the reward seekers sharing the
perform all those functions that a modern financial risks or stake in the economic activity. As a result,
institution is expected to provide. The difference lies returns on investments must be based on underlying
in their philosophies and operations. The fundamental economic activities and/or assets on which the
06
contractual relationship between transacting parties Figure 1.4: Global Islamic Banking Assets—Growth
is structured. Thus, a fully compliant Islamic economy Trend by Region (2008–2014F)
would eliminate the two fundamental reasons
1,800
for the widespread bankruptcies during crisis
1,600
periods—legally binding liabilities of corporations
1,400
to service their debts outstanding according to
1,200
the predetermined rates and excessive leveraging
$ billion
1,000
beyond their economic value.
800
600
From a broader perspective, the asset-based nature 400
and risk-sharing aspects of Islamic finance can be 200
utilized for greater integration with the real economy 0
and improve the overall economic balance between 2008 2009 2010 2011 2012 2013 2014F
Others Africa (excl. North Africa) Asia
real and finance sectors. Asian markets also have
MENA (excl. GCC) GCC
the largest concentration of Muslims in the world,
which facilitates a ready market for the introduction F = forecast, GCC = Gulf Cooperation Council, MENA = Middle East and
North Africa.
and distribution of Sharīàh-compliant products and
Source: Central banks, CEIC, annual reports, KFH Research
services.
Other growing jurisdictions for Islamic banking
Islamic Banking: Surging Stakeholder Interest
services include Indonesia and Sri Lanka. In other
parts of Asia, several jurisdictions with large Muslim
Islamic banking in Asia has witnessed an increasing
populations, such as India, the People’s Republic
number of new entrants either by way of new
of China (PRC), and most of the Commonwealth of
institutional setups or by existing conventional banks
Independent States, remain largely untapped, which
leveraging on their conventional setups. Realizing
highlights new market opportunities for Islamic
its sizable market potential for Muslim and non-
financial institutions to penetrate. The East Asian
Muslim banking customers alike, many stakeholders
powerhouses (e.g., Japan, Republic of Korea, and
(including both public and private entities) are
Hong Kong, China) have also shown interest in
intensifying efforts to make fast progress to advance
developing Islamic banking markets locally as well
in the Islamic finance industry. Among the developed
Islamic banking jurisdictions in Asia are Malaysia, as to create windows of opportunity for issuers to
Bangladesh, Pakistan, and Brunei Darussalam. tap the Sukūk market via their shores.
Malaysia is one of the global leaders for Islamic
financial services and held an estimated 10.0% In 2014 to date, a number of Islamic banking-
share of the global Islamic banking assets as at the related developments have taken place across
end of 2013. Comparatively, Indonesia, Pakistan, Asia that indicates strong growth prospects for
and Brunei Darussalam have smaller shares, but this segment. Notably in India, the world’s second
their growth and regulatory developments in recent most populated country, the Reserve Bank of
years have enabled them to expand their volume of India, the country’s central bank, has begun a
Sharīàh-compliant banking assets. As at the end of review of regulations on Islamic banking in India.
2013, Malaysia contributed 70.5% of the regional In this regard, the central bank is reported to
Islamic banking assets ($135.5 billion), followed by have established an internal committee consisting
Indonesia (9.5%, $20.2 billion) and Pakistan (5.3%, of senior central bank officials amid calls for a
$10.2 billion), while other countries contributed to re-evaluation of Islamic banking regulations in the
the remaining 14.7% (see Figure 1.5). country.
07
Similarly in the Philippines, the country’s central Other notable developments include the International
bank, Bangko Sentral ng Pilipinas (BSP), has sought Bank of Azerbaijan, the country’s biggest bank,
the help of Malaysia in developing the Islamic banking currently working with national authorities on drafting
industry. The BSP has been holding talks with Bank an Islamic banking law in Azerbaijan. Meanwhile
Negara Malaysia (BNM) regarding the creation of in Tajikistan, the law on Islamic banking activity,
a framework for Islamic banking in the Philippines. approved in draft form by the country’s lower
In September 2013, the BSP submitted a request chamber of parliament in May 2014, came into force
to the government to have its charter amended on 5 August 2014 with the aim of granting licenses to
allowing the bank to issue Sharīàh-compliant financial institutions operating on Sharīàh principles
instruments to Islamic banks, in particular interbank and regulating their activities.
lending products.
Figure 1.5: Islamic Banking Assets in Asia by Domicile
(2013)
Among existing markets, the Malaysian Islamic
banking practice is shifting toward a contract-based Others
14.7%
regulatory framework by providing legal recognition Pakistan
to the contractual requirements in accordance with 5.3%
Sharīàh. The shift is in line with the new Islamic Indonesia
Financial Services Act 2013. In this regard, the 9.5%
Sharīàh Advisory Council of BNM is enhancing

the existing Sharīàh parameters on various Malaysia
70.5%
Islamic finance contracts in order to introduce new
Source: Central banks, CEIC, annual reports, KFH Research.
Sharīàh standards that set out mandatory and
optional requirements applicable in Islamic financial
transactions along with guidelines on operational Sukūk Market: Rapidly Expanding Frontiers
parameters to enable uniformity of Sharīàh rulings
across institutions. The Sukūk markets in Asia have been sparked by
a series of developments and commitments from
potential players in the last 5 years. A number of
In Pakistan, the central bank, State Bank of Pakistan
new jurisdictions have been home to Sukūk issuance
(SBP), launched a 5-year strategic plan for Islamic
during 2013 as sovereigns and particularly corporates
finance in February 2014 which targets an increase
eye the opportunity to secure lower funding costs and
in the sector’s share of banking system assets from
diversify funding sources. Malaysia has maintained
around 10.0% as of December 2013 to 15.0% by its dominance in Sukūk issuances over the years
2018. More recently, this target has been revised globally, with countries from the Gulf region catching
to achieve a 20.0% share by December 2018. The up. Malaysian new Sukūk issuances accounted for
Sharīàh Governance Framework issued by the SBP 68.8% (see Figure 1.6) of the global primary Sukūk
has also come into effect starting 1st October 2014. market share as at the end of 2013 followed by
The framework by SBP aims to further strengthen Indonesia (4.68%), Pakistan (0.37%), and Brunei
the overall Sharīàh compliance environment in Darussalam (0.33%). Among other economies
Islamic banking institutions (IBIs) in Pakistan while that have issued Sukūk (see figure 1.7) in Asia are
institutionalizing the Sharīàh compliance function Singapore, Kazakhstan, and Hong Kong, China that
in IBIs. The regulator is also finalizing details on an are looking to diversify their funding options following
Islamic liquidity framework, consisting of an Islamic liquidity constraints in international markets. Malaysia,
interbank money market and a Muḍārabah-based being a leader in global Sukūk issuances, has also
placement facility run by the central bank. made progress in cross-border issuances as part of
the efforts to facilitate greater mobilization of funds
across regions.
08
Figure 1.6: Sukūk Outstanding by Region (2013) In Pakistan, SBP is currently in the process of
finalizing details on a Sharīàh-compliant liquidity
Others
MENA 2% Sub-Saharan framework ahead of the country’s proposed US
(exc. GCC) Africa
0.11%
dollar sovereign Sukūk issuance later this year. The
0.12%
current shortage of sovereign Sharīàh-compliant
debt instruments has been highlighted as one of
the industry’s most pressing problems by industry
GCC
participants, along with a lack of public awareness
32% Asia regarding the sector and the quality of regulatory
66% support. Pakistani regulators are taking necessary
GCC = Gulf Cooperation Council, MENA = Middle East and North Africa. steps to address these challenges and any remedies
Source: IFIS, Bloomberg, Zawya, KFH Research. for liquidity management are likely to include Sukūk
instruments which will spur new Sukūk issuances in
Figure 1.7: Sukūk Outstanding in Asia (2013) the country.
Singapore
0.37% Brunei Darussalam
Hong Kong,
0.09%
Meanwhile, the Sukūk market is expected to kick
China
0.04% Indonesia off in the Kyrgyz Republic as well in the near future.
7.81% Kazakhstan On behalf of the Kyrgyz Republic, the State Service
Pakistan 0.04%
2.34% for Regulation and Supervision of Financial Markets
has signed an agreement with legal firm Simmons &
Simmons through which the latter will advise the
government on its Islamic finance endeavors which
include growing the domestic Sukūk and Takāful
Malaysia
markets. The consultancy services will be funded by
89.31% the IDB through a technical assistance grant.
Source: IFIS, Bloomberg, Zawya, KFH Research.
Islamic Funds: Growing Potential
During the first half of 2014, a number of regulatory
developments took place across several Asian Sukūk Asia has been an important part of the growing
markets. Notably in Malaysia, the Malaysian Prime global wealth in recent years, as strong fundamental
Minister in 2013 introduced the Socially Responsible economic growth has produced a larger number
Investment Sukūk Initiative in the Malaysian Annual of high net worth individuals and created the need
Budget 2014, which seeks to encourage sustainable for more wealth management products. Islamic
and responsible investments. In this regard, the funds registered in Asia are primarily dominated by
Securities Commission Malaysia is currently in Malaysia with a total of 266 funds registered as of
the process of finalizing a framework for socially the end of 2013, followed by Indonesia (70), Pakistan
responsible Sukūk and the framework is expected to (55), and Thailand (4) (see Figure 1.8).
be launched in the third quarter of 2014. Following
this framework, Malaysia is expected to take a lead Malaysia is the second largest market by assets
in spearheading issuances of socially responsible under management behind Saudi Arabia, with
Islamic bonds which will further drive growth in the approximately $16.4 billion in assets or 22.0% of
global Sukūk industry. the industry total. Malaysia’s Islamic finance industry
benefits from a well regulated environment, with
09
a transparent legislative system and supporting In another development, in March 2014, Malaysia
infrastructure. This makes it a particular prime listed its second tradable Sharīàh-compliant
destination for wealth management, and in particular exchange traded fund (ETF), managed by i-Vcap
Islamic wealth management, given the domestic Management. This development is indicative of the
population demographics as well as its regional increasing investor appetite for the new investment
positioning both geographically and as a hub for tool (which offers a low-cost, passive approach to
Islamic finance. investing in a Sharīàh-compliant equity portfolio) in
Malaysia and larger Asia as a whole. Bursa Malaysia
In the first half of 2014, there were a number of currently has five listed ETFs, including i-Vcap’s
favorable Islamic-funds-related developments in MyETF-DJIM25 which was the first Islamic ETF in
Malaysia which are likely to spur further momentum Asia.
in the Islamic funds market. For instance, effective
from June 2014, foreign firms have been allowed Takāful: Potential Development Prospects
to assume complete ownership over unit trust
management companies in Malaysia. This permits Another developing sector is the Takāful sector. The
foreign managers to market funds to retail investors; development and growth of Islamic finance in Asia
prior to the removal of barriers, the distribution of (see Figure 1.9 for regional breakdown) presents
foreign-owned funds (of wholesale kind only) was strong opportunities for Takāful operators to expand
limited to Malaysian residents whose net worth their geographical outreach in the region given that
exceeded RM3 million ($935,000). many of the Asian economies are emerging markets
with relatively large populations, strong economic
Meanwhile, Malaysia’s state pension fund, the growth performances, and generally low insurance
Employees Provident Fund, is studying the possibility penetration rates. At present, the Takāful industry
of establishing the world’s first stand-alone state- in Asia is firmly established in Malaysia, which
backed Islamic pension fund, looking at the viability contributes the major share. However, other countries
of such a fund from accounting, legal, and Sharīàh from South and Southeast Asia such as Bangladesh,
compliance standpoints. Presently, the fund invests Pakistan, Indonesia, and Brunei Darussalam are also
a third of its portfolio in Sharīàh-compliant securities; further developing their Takāful markets, capitalizing
however, there is a strong demand from depositors on their established regulatory frameworks that
for wholly Sharīàh-compliant investments. help support the growth and expansion of the
domestic Takāful industry. In comparison, newer
Figure 1.8: Islamic Funds Registered in Selected jurisdictions such as Afghanistan and Kazakhstan
Asian Jurisdictions (number, 2013)
have also witnessed the introduction of Takāful
Thailand products. Additionally, there is a strong potential
Pakistan 4 to offer Takāful services in other Asian economies
55
considering Islamic finance such as Azerbaijan, the
PRC, Japan, the Kyrgyz Republic, the Philippines,
and Hong Kong, China.
Indonesia
70
Malaysia
266
Source: Bloomberg, KFH Research.
10
Figure 1.9: Takāful Gross Contributions by Region licenses between the general and family Takāful
(2013E) segments and provides a time period of 5 years for
20,000 existing composite operators to bifurcate between the
18,000 two segments. This measure aims to achieve a stronger
16,000 business focus in either family or general Takāful for
14,000
Takāful operators and also bring Malaysian insurance
12,000
10,000
laws to be in parallel with international insurance laws.
8,000 A framework for the provision of basic family Takāful
6,000 and life insurance products through direct channels
4,000 has been set as one of the critical targets in 2014 for
2,000
Malaysia’s financial services, a National Key Economic
0
2007 2008 2009 2010 2011 2012 2013E Area (NKEA), as part of the government’s Economic
Middle East (Non-Arab) Saudi Arabia Transformation Programme.
Malaysia GCC (excl. Saudi Arabia)
Southeast Asia (excl. Malaysia) Africa Finally in Pakistan, based on an original regulatory
South Asia Levant
amendment introduced in 2012, the regulator had
E = estimate, GCC = Gulf Cooperation Council. allowed the introduction of Takāful windows by
Source: World Islamic Insurance Directory, EY, KFH Research. conventional insurance companies as a measure
that was likely to spur the Takāful market share in
Among recent Takāful-related developments in the country. However, a group of five existing Takāful
Kazakhstan, legislative changes to the country’s operators in Pakistan had earlier challenged this
Islamic finance law regarding Ijārah (or Islamic leasing) ruling in court citing such a measure would distort
and Takāful were put forward last year by a special the Islamic insurance industry in Pakistan. Recently
committee of the National Bank of Kazakhstan in April 2014, the group reached a groundbreaking
(NBK), which is responsible for Islamic finance agreement out-of-court with the plaintiffs agreeing
development, to the government. The legislation is to withdraw their petition challenging the Takāful
currently awaiting approval by parliament, with the Rules 2012 while leaving the provision about window
expectation that it will be ratified and adopted at operations fully intact. As such, the biggest players of
some point this year. conventional insurance in Pakistan have announced
the launch of their Islamic window operations this
In the more established market of Malaysia, the Takāful year which is expected to result in tremendous
industry is expected to witness notable changes in the expansion of the Islamic insurance segment in
following years as Section 16 (1) of the Islamic Financial Pakistan, a country with a low insurance-to-gross
Services Act 2013 critically enforces separation of domestic product (GDP) penetration rate of 0.7%.
Asia’s Economic and Demographic Profiles
As the most dynamic region in the world, Asia has 6.4% annually in Asia in 2014–2015. Currently, three
an important role to play in shaping the agenda for of the world’s four largest economies by purchasing
balanced and sustainable growth. Economic growth power parity (PPP) are Asian; the PRC, India, and
in Asia continues to outpace the rest of the world, Japan (see Figure 1.10) already account for a quarter
with the region rapidly increasing its importance in the of the world economy, with that share increasing to
global economy, and real GDP growth will average 30.0% by the end of the decade.
11
Figure 1.10: GDP Growth Trend and Projections billion, the PRC again ranked second in the world
for Asia (2006–2015F) and narrowed the gap with the United States, the
country with the largest global inflows. Meanwhile,
12
inflows to ASEAN countries rose by 7.0% in 2013,
10 to $125 billion, while FDI inflows to South Asia rose
by 10.0% to $36 billion. For some low-income
8
6.4 6.3 countries in developing Asia, weak infrastructure
% y-o-y
6 has long been a major challenge in attracting FDI

4
and promoting industrial development. Moving
forward, rising intra-regional FDI in infrastructure
2 industries, driven by regional integration efforts and
0 enhanced connectivity between subregions through
the establishment of inter-subregional corridors,
2006
2007
2008
2009
2010
2011
2012
2013
2014E
2015F
is likely to accelerate infrastructural buildup and

E = estimate, F = forecast, GDP = gross domestic product, y-o-y = year promote economic development. The ten ASEAN
on year.
member states and their six free trade agreement
Note: The Asia aggregate includes the People’s Republic of China; Hong
Kong, China; India; Indonesia; the Republic of Korea; Malaysia; the
partners have launched negotiations for the Regional
Philippines; Singapore; Taipei,China; Thailand; and Viet Nam. Comprehensive Economic Partnership. In 2013,
Source: Bloomberg, KFH Research. combined FDI inflows to the 16 negotiating members
amounted to $343 billion, accounting for 24.0% of
A by-product of Asia’s larger economic significance global FDI flows.
in the world economy is deeper regional integration.
Intra-regional trade increased by 280.0% over the Figure 1.11: FDI Inflows to Asia (2000–2013)
10-year period through 2012, with shipments within 500
Asia currently accounting for a fifth of world trade. 450
400
Australia and Hong Kong, China, for instance,
350
are reaping the benefits of the sustained activity; 300
$ billion
increased mining capacity in Australia allows 250

significantly larger commodity exports to meet the 200
demand in the PRC and the rest of Asia, while 150
Hong Kong, China continues to function as a major 100
50
regional trade and services hub. Furthermore, the
0
Association of Southeast Asian Nations (ASEAN)
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
Economic Community, to be operational in 2015, will

further deepen trade ties within Asia. East Asia South Asia
Southeast Asia West Asia
Asia continues to be the world’s top recipient Developing Asian Developed Asian
economies economies
region of foreign direct investment (FDI),
accounting for nearly 30.0% of global FDI inflows, FDI = foreign direct investment.
according to United Nations Conference on Trade Source: UNCTAD, KFH Research.
and Development (UNCTAD). Total inflows to

developing Asia (excluding West Asia) amounted Asia is the world’s largest and most populous
to $382 billion in 2013, 4.0% higher than in 2012 continent with a population of 4.3 billion people,
(see Figure 1.11). FDI inflows to East Asia rose by making up 60.0% of the world’s current human
3.0% to $221 billion in 2013. With inflows at $124 population. With roughly 1.4 billion and 1.2 billion
12
people respectively, the PRC and India currently The falls in birthrate across Asia mean that there is
account for 36.3% of the world’s population and are currently a concentration of working-age population
expected to account for roughly the same share in in most Asian countries. Economists call this feature
the next 30 years. Nevertheless, the overall numbers of population transition (see Figure 1.12) in Asia
hide the fundamental changes that will have the demographic dividend, because it provides
occurred by then. The bulk of population growth in the opportunity for more productive investment of
capital and for a stronger focus on developing the
Asia over the next three and a half decades will be in
human capital of the next generation of workers,
South Asia, a result not of high birthrates but of the
both essential features of economic development.
large number of people of childbearing age, itself the
Economies such as Japan and the Asian tiger
product of past higher levels of fertility. economies of the Republic of Korea and Taipei,China
benefited from the demographic dividend during
Figure 1.12: Age Dependency Ratio in Asia
their earlier periods of high economic growth.
(1990–2013)
Capturing the demographic dividend is now a major
90
objective in the progress of development in Malaysia,
80
Thailand, Indonesia, and the PRC. The economies of
Age Dependency Ratio
70
South Asia and elsewhere also need to ensure that
60
they capitalize on this source of growth potential.
50
40
The above trends and statistics show various
30
prospects for Islamic finance to grow in this region.
20
Being the most populous region in the world, Asia’s
10
favorable demographic structure, comprising a
0
significant young population and a rising middle-
1990
1995
2000
2005
2006
2007
2008
2009
2010
2011
2012
2013
income segment, constitutes a huge and growing

Central and West Asia East Asia consumer market, which can heighten the demand
South Asia Southeast Asia
The Pacific for a wider spectrum of Islamic financial products
and services, thus increasing opportunities in retail
Source: ADB, KFH Research.
and investment banking, Takāful, and fund and
wealth management businesses in the region.
Asia’s Developmental Needs Moving Forward: Role of Islamic Finance
Islamic finance has firmly established itself as an upgrade the existing facilities while developing new
alternative funding source in several emerging ones to correspond to the growing population.
markets. Against the backdrop of global Furthermore, the fiscal and revenue expenditures
macroeconomic challenges and financial pressures of various governments are expected to increase
in major markets, the fast expanding pool of global in support of the various development projects as
Sharīàh-compliant liquidity has become an attractive well as to stimulate national economies in the light
source for various sovereigns, government-related of growth challenges in the world economy. Surging
entities, and corporates to tap into in order to meet Asian exports, which are key determinants of economic
their financing needs. Specific to Asia, the trends and growth in most export-oriented Asian economies,
statistics highlighted earlier show various prospects also require necessary funding support in the form of
for Islamic finance to grow in the region. trade financing products. On the retail side, being the
most populous region in the world, Asia’s favorable
Asia’s growth and developmental needs moving demographic structure, comprising a significant young
forward require substantial amounts of investments population and a rising middle-income segment,
in the region’s infrastructure sector in order to constitutes a huge and growing consumer market.
13
Islamic finance has promising potentials to meet the investment is needed for new capacity investments
various funding needs highlighted. The industry’s in infrastructure, while the remaining 32.0% is
offerings include economically viable products that allocated for replacement of existing assets. East
are combined with the benefit of being ethically and Southeast Asia will need the most funds by the
compliant. To date, Islamic finance has provided end of 2020, as both regions require about 66.55%
financing solutions across several sectors including of total Asian infrastructure investment needs.
(i) infrastructure financing, (ii) government fiscal and Strengthening bond markets, promoting public–
revenue expenditure financing, (iii) corporate and retail private partnerships, and improving the financial
financing, (iv) ethical investment solutions to corporate environment (see Figure 1.13) to spur foreign
and retail investors, (v) trade financing for international investment flows are among the key focus of Asian
trade, and also (vi) Islamic insurance services. government and financial authorities to support the
large infrastructure financing requirements.
Sukūk instruments have been specifically instrumental
in being used as a medium to channel the Sharīàh- Figure 1.13: Annual Infrastructure Investments Needs
in Asia by Subregion
compliant funds to the various deficit entities in Asia
and elsewhere. In 2014, debut sovereign issuances
South Asia,
took place in the United Kingdom, Senegal, the $215 billion
Emirate of Sharjah, Luxembourg, and Hong Kong, East and
China. Going forward, Islamic finance has the Southeast Asia,
$497 billion
potential to partly support the various growth and
development plans of Asian economies by providing
the necessary financing.
Central Asia, The Pacific,
$33 billion $548 million
Infrastructure Needs: Islamic Capital Market
Source: ADB.
Opportunities
Figure 1.14: Infrastructure Sukūk Issuances by Country
The infrastructure sector has seen a large portion (2001–H1 2014)
of the raised Sukūk funds directed to development 30,000
projects, largely driven by infrastructure projects
25,000
from both the Gulf Cooperation Council
(GCC) and Southeast Asian regions. Between 20,000
$ million
2001 and 2013, a total of $84.3 billion worth of

15,000
infrastructure Sukūk was issued by nearly 10 different
countries. The market for infrastructure Sukūk has 10,000
generally (see Figure 1.14) been dominated by 5,000
issuances from Malaysia.
0
1H14
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
It is reported that in the 10-year period from 2010

Malaysia UAE Indonesia
to 2020, the 32 developing member countries of Pakistan Saudi Arabia Kuwait
the Asian Development Bank (ADB) are expected Other Brunei Darussalam Iran
to be in need of $8.22 trillion as infrastructure Nigeria
investments. With this estimation, the amount H = half, UAE = United Arab Emirates.
needed for investment annually will reach up to $747 Source: IFIS, Zawya, Bloomberg, KFH Research.
billion over 2010–2020. About 68.0% of the total
14
Using infrastructure Sukūk, Asian economies can and Mushārakah. Collectively, these three structures
partly support the huge infrastructure investment accounted for more than 79.0% of all issuances during
needs in the region. Sukūk have played a significant the second half of 2010 until the first half of 2013. The
role in funding the infrastructure sector (see Figure central merit of Mushārakah Sukūk is that it promotes
1.15 – Figure 1.18 for Sukūk case studies) over the principles of risk sharing where investors and issuers
past decade, with proceeds raised from issuances agree to share profits and absorb losses based on
being utilized for both low- and high-profile actual outcomes of the underlying business activity.
projects. The very nature of Sukūk, combined
with their flexibility, allow them to be structured in Overall, from 2001 to 2013, Malaysian-domiciled
various ways. This has attracted corporate and infrastructure Sukūk accounted for 67.5% of all
sovereign entities to choose Sukūk as a viable infrastructure Sukūk issuances, followed by Saudi
alternative financing instrument. Infrastructure Arabia with 20.0% and the United Arab Emirates
Sukūk can be structured using various types with 10.8%. Other notable countries that have
of Sharīàh contractual principles. Among the issued infrastructure Sukūk include Qatar, Indonesia,
foremost principles utilized are Ijārah, Murābahah, Pakistan, and Kuwait.
Selected Case Studies of Sukūk Issuances in Asia
Figure 1.15: Republic of Indonesia – $1.5 Billion Global Sukūk due 2019
Key Offer Terms Transaction Highlights

Issuer Perusahaan Penerbit SBSN Indonesia III  Largest single tranche international Sukūk
Obligor The Republic of Indonesia offering from an Asian (non-Middle East)
Documentation $5 billion Trust Certificates Issuance sovereign issuer
Program  The transaction marks Indonesia’s largest
Tenor 5.5 years
international Sukūk offering, its fourth
Size $1.5 billion
international Sukūk transaction since 2009
Coupon 6.125%
and the second issued under its existing Trust
Yield 6.125%
Certificates Issuance Program
Maturity 15 March 2019
 The transaction was well-received by
Listing Singapore Stock Exchange (SGX-ST)
investors, accumulating a $5.7 billion
Distribution Statistics orderbook across 300 accounts globally
• Highly receptive transaction, resulting in a
Allocation by Allocation by
Geography Investor Type well-diversified investor base
- Markets were very receptive of the
Indonesia Other CB/SWF Ins Co
15% Asia 7% 4% transaction, driven by the scarcity value
25% PB
7%
of high-quality emerging market sovereign
US Funds issuers
24% 34%
Europe
Bank - High-quality orderbook with a
16%
34%
number of global real money account
Middle East
20% participation in a meaningful manner,
including a strong 24.0% participation
from US accounts
CB/SWF = Central Banks / Sovereign Wealth Funds, PB = Private Banks, Ins Co = Insurance Companies.
Source: Presentation by Usman Ahmed at the IFSB-ADB Conference Nov 2013.
15
Figure 1.16: Sime Darby – Inaugural $800 Million 5-/10-yr Sukūk Offering

Obligor Sime Darby Berhad  1st Malaysian and 1st Sukūk issuer globally
Issuer Sime Darby Global Berhad to issue in the G3 international debt markets in
Tenor 5-year due 10-year due 2013
2018 2023
 Lower-ever coupon by any corporate
Issuer Size $400 million $400 million
globally in the US dollar Sukūk market and the
Coupon 2.053% 3.290%
lowest-ever US dollar coupon by a Malaysian
Settlement T + % (29 January 2013)
borrower in both the 5-year and 10-year tenors
Distribution Statistics  Rare international G3 Sukūk offering in Asia
Allocation by Allocation by from one of the leading conglomerates in
Geography Investor Type Malaysia which achieved a rating a notch
above the sovereign
5 Year Tranche  Priced 40bps over a theoretical new 10-
EU/ME Public/PB year Malaysia sovereign bond
17% Insurance 6% • Optimal pricing outcome amid robust
10%
demand from a high-quality diverse
Banks FM investor base
19% 65%
Asia
- Final pricing was at the tight end of
83% revised guidance with an orderbook of
10 Year Tranche about $4.2 billion (5-year) and $4.5 billion
(10-year) achieving and overwhelming
Public/PB
17% oversubscription of about 10.9 times
Europe
43% FM
Insurance 50%
14%
Asia
57%
Banks
19%
EU/ME = European Union / Middle East; PB = Private Banks; FM = Fund Managers.
16
Figure 1.17: Malaysia Airport Holdings – $500 Million Sukūk Offering

Issuer Malaysia Airports Holdings Berhad  1st dual tranche offering by MAHB and
(MAHB) 1st Mushārakah Sukūk by MAHB with all
Issuer Ratings AAA/A3 (RAM / Moody’s) previous Sukūk in AI Ijara format
Issue Ratings AAA (RAM)  Rapid-fire intraday execution enabled by
Islamic Principle Mushārakah Mushārakah format a week after Information
Tenor 3-year due 5-year due Memorandum was released to investors
2016 2018  Despite challenging market conditions, the
Issue Size RM250 million RM250 million final pricing for both tranches was 5 basis
Par Coupon (s.a) 3.85% 4.15%
points inside of the wide end of the initial
Settlement 6 September 2013
price guidance
 3 times and 4 times orderbook
Distribution Statistics
oversubscription for 3-year and 5-year
Allocation by respectively
Investor Type • MAHB completed its inaugural issuance
of RM500 million Senior Sukūk via a dual
3-Year Tranche 5-Year Tranche
tranche offering pursuant to the new Senior
Others Others Sukūk Programme
8% 10% AM
Insurance
2%
AM
28%
26% • Optimal pricing outcome amid robust
Insurance demand from a high-quality diverse invertor
22%
base
- Tapping of the capital markets was
Banks
62% Banks
42%
very timely and allowed the company to
seize a good market window to achieve
AM = Asset Managers. low-cost funding
17
Figure 1.18: Malaysia Airports Holdings – Mushārakah Structure
1 Sukūk Trustee and Malaysia Airports Holdings Berhad (MAHB) to enter

Master Purchase a Mushārakah agreement
Undertaking • For the purpose of undertaking a venture consisting of investments in the
Sharīah-compliant airport operations business of the issuer which entails
4 the collection of passenger service charge, landing and parking fees, and other
charges to airlines
Issue Sukūk • Sukuk holders shall appoint MAHB as the managing partner of each
Mushārakah Venture
2
2 Sukūkholders to provide capital to the Mushārakah Venture

• Capital contribution is made through the subscription of the Sukūk
MAHB Sukuk holders Mushārakah
(Issuer/ Mushārakah (represented
Managing • MAHB to contribution the business as a capital contribution to the
Venture by Sukūk Musharakah Venture
Partner/ Trustee)
Obligor) • Upon issuance of the Sukūk Mushārakah , the proceeds shall be invested
with MAHB for the purposes of undertaking the Mushārakah Venture
1 2
Identity Proceeds 3 Income from the Mushārakah Venture to be distributed
Business (Mushārakah
Capital) • Distribution to each partner is based on a profit-sharing ratio
• Any losses incurred in the Mushārakah Venture shall be borne by each partner
3
Income from 4 MAHB to provide a Master Purchase Undertaking
Mushārakah Venture
• Shall execute a transfer/sale agreement for the purchase of the
Sukūkholders’ undivided beneficial interest in the Mushārakah Venture
at the relevant exercise price
• Purchase of the sukuk holders undivided beneficial interest in the Mushārakah
Venture would dissolve such Mushārakah Venture
Financial Inclusion in Asia: Role of Islamic Finance
Asia’s rapid growth in recent decades has lifted hundreds of millions out of extreme poverty, but the region
remains home to two-thirds of the world’s poor, with more than 800 million Asians still living on less than $1.25
a day and 1.7 billion surviving on less than $2 a day (ADB 2012). One reason for this could be the low rates of
financial inclusion among the needy segments of the society. According to the World Bank, financial inclusion
is an important driver of economic growth and poverty alleviation as access to finance can boost job creation,
raise income, reduce vulnerability, and increase investments in human capital. However, several countries in
Asia with large Muslim populations including Pakistan, Afghanistan, Indonesia, and others have low financial
inclusion rates (see Figure 1.19 and Figure 1.20).
18
Figure 1.19: South and Central Asia – Account at a Figure 1.20: East Asia and Pacific – Account at a
formal financial institution (% age 15+) formal financial institution (% age 15+)
80 120
70
100
60
World Average: 50% 80 Regional Average: 55%
50
World Average: 50%
40 60
Regional Average: 29%
30
40
20
20
10
0 0
Sri Lanka
Kazakhstan
Bangladesh
India
Albania
Nepal
Uzbekistan
Azerbaijan
Pakistan
Afghanistan
New Zealand
Australia
Singapore
Japan
Rep. of Korea
Hong Kong, China
Mongolia
Thailand
Malaysia
People’s Rep. of China
Lao PDR
Philippines
Viet Nam
Cambodia
Lao PDR = Lao People’s Democratic Republic.
Source: World Bank, KFH Research.
In Asia, inclusive growth, defined as economic Islamic microfinance has the potential to expand
growth with equality of opportunity, is one of the financial inclusion at unprecedented levels
three strategic objectives of ADB. Income disparities throughout the Muslim world. Among the world’s
and unequal access to economic opportunities and top 10 countries with the largest Muslim populations
social services remain key issues in Asia despite are five in Asia. By 2020, it is estimated that more
the region’s robust economic growth. To achieve than 60.0% of the global Muslim population will be
the vision of an Asia and Pacific free of poverty, residents in Asia. Currently, an estimated 1.28 million
as laid out in ADB’s guiding Strategy 2020, ADB clients use Sharīàh-compliant microfinance services,
supports pro-poor growth in its developing member a fourfold increase since 2006, according to the
countries that is inclusive and environmentally survey released in April 2013 undertaken by the
sustainable, and draws on the region’s increasing Consultative Group to Assist the Poor. It is reported
levels of cooperation and integration. ADB supports there are now 255 Islamic microfinance institutions
partner governments, commercial and rural around the world, with a total outstanding loan
banks, cooperatives, and semiformal institutions, portfolio amounting to $628 million. Approximately
including nongovernment organizations, to ensure 70.0% of the providers (see Figure 1.22) of Islamic
permanent access to institutional financial services microfinance services are from East Asia, the
for the region’s poor people and their micro-and Pacific, and South Asia. According to the survey,
small businesses. Financial inclusion includes an estimated 1.28 million clients in 19 countries
microfinance, SME finance, and other provisions of use Sharīàh-compliant microfinance services and
financial services to poor individuals, among others approximately 82.0% of these clients reside in only
savings facilities, insurance, remittances, and access three countries—Bangladesh (445,000 clients),
to financial markets. Sudan (426,000 clients), and Indonesia (181,000
clients).
19
Figure 1.21: Largest Muslim Population by Country Figure 1.22: Number of Sharīàh-Compliant
(2030) Microfinance Institutions
300
Sub-Saharan
Africa 4
250
MENA 72
200
million
150 Europe
and Central
100 Asia 3
East Asia South Asia
50
and Pacific 12
164
0
Pakistan
Iran
Iraq
Indonesia
India
Egypt
Turkey
Afghanistan
Bangladesh
Nigeria
MENA = Middle East and North Africa.
Source: Pew Research Center. Source: El-Zoghbi and Tarazi (2013), KFH Research.
The opportunities for Islamic microfinance are promising, underpinned by strong economic growth in
emerging markets, government ambition to reduce poverty levels and enrich the standard of living, the
growing preference for Sharīàh-compliant products, and a large bourgeoning Muslim population. Islamic
finance presents opportunities for greater financial inclusion in Asia, particularly in Bangladesh, Afghanistan
(see Figure 1.21), Indonesia, and Pakistan. The survey by the Consultative Group to Assist the Poor has
shown that in Afghanistan, Pakistan, and Indonesia, for example, adults prefer to seek financing from family
and friends and informal credit unions rather than loans from financial institutions that charge interest. In
order for the industry to reach its full potentials in eliminating poverty, governments and regulators across the
developing world should consider integrating Islamic microfinance into countries’ mainstream banking and
financial systems. This will help create greater awareness of products, encourage product innovation, improve
access to microfinance, widen and strengthen the distribution channels, as well as result in real economic
growth across all levels of the socioeconomic fabric.
Conclusion
Asia is a pivotal part of both the global economy and be undertaken to facilitate an enabling Islamic finance
the Islamic financial system. Looking forward, Islamic industry within new jurisdictions and to advance
finance has a promising opportunity to partly fill the developed Islamic financial markets to the next level.
role of providing the necessary financial intermediation Regulation and legislation enhancement, expansion of
required by Asia. The Islamic financial system offers the Sharīàh talent pool, and greater product innovation
alternative financing mechanisms to emerging markets (see Figure 1.23) to cater for the awareness and diverse
to support their economic development drive in diverse demographic needs of the Asian population are among
areas such as infrastructure needs, enhancing trade key areas for improvement. In particular, the industry is
relationships with OIC member countries, supporting expected to explore product and process innovation
capital expenditure needs of governments, and helping to offer partnership financing that are best suited to
to improve the financial inclusion ratios of various cater for specific needs of lower-income populations
jurisdictions. Islamic finance development in this and at the same time to clearly define market segments
region is expected to further support the economic and develop robust risk assessment models to better
growth of the region. However, more effort needs to penetrate unbanked segments.
20
Figure 1.23: Drivers Sustaining Islamic Finance in Asia
Global Islamic Demand for Toward an

Economic
Finance Islamic Financial Challenges Enabling
Diversification
Expansion Inclusion Environment
Global economic Islamic banking and SMEs cater to a Challenges involve Sound policy and
recognition for the Sukūk market rather large part of government bodies, standard setting to
emerging markets have both grown the economy capabilities of Islamic ensure structured
presents tremendously and financial providers, environment for
opportunities for have become The increasing shift and customer Islamic financial
Asia mainstream financial of consumer awareness inclusion
systems preferences to
Potentially increase subscribe to Islamic Issues range Coherent
financing activities Islamic micro- financial products from product development of
from Islamic financing can play provides an development and Islamic financial
finance in current a major role by opportunity for pricing to sound infrastructure to
economic climate supporting the Islamic policy setting by the promote mobilization
to support SME SMEs with access micro-financing to government of Islamic micro
financing to adequate gain market share finance
financial resources
Enhanced role of
Multilateral and
Regulatory bodies
SMEs = small and medium-sized enterprises.
21
Chapter 2
Islamic Finance Stability, Resilience,
and Regulatory Issues
Professor Simon Archer
Madzlan Mohamad Hussain
Islamic Finance Stability, Resilience, and
Regulatory Issues
This chapter focuses on the role of legal and regulatory Islamic financial institutions. The chapter also provides
infrastructure in promoting financial stability and insights on the roles and responsibilities of the courts
resilience in Islamic finance. It starts from the discussion – including its officials such as judges and lawyers –
on latest regulatory developments at the global level which will have direct influence and contribution in
and their implications on the regulation of Islamic determining whether Islamic financial institutions will
financial services industry, specifically on Islamic retain their stability and resilience, as they cannot
banks. It is followed by a discussion on corporate afford to be hampered by prolonged and unresolved
governance and responsibilities of governing organs in disputes affecting their reputation and credibility.
The Role of Regulation in Promoting Financial Stability and Resilience
One of the principal aims of regulation of the finance corporate governance failures and lapses, many of
sector is to promote financial stability and the resilience which came to light during the financial crisis that
of financial institutions (microprudential regulation) and began in mid-2007.” Another, quantitative, aspect
of the financial system as a whole (macroprudential of risk management was addressed by the BCBS
regulation). It has to be said that, as was shown by in Principles for Sound Stress Testing Practices and
the financial crisis of 2007–2008 and the subsequent Supervision (May 2009).
global recession, its effectiveness in achieving this
aim has been quite limited. A major factor in this In this part, the capital and liquidity provisions of
ineffectiveness was the failure of institutions (in most Basel III are first reviewed, followed by an examination
cases banks) that were considered “too big to fail” of the main implications of these for Islamic finance.
because of the systemic consequences that their
failure would entail, and which were therefore “bailed Capital Provisions of Basel III
out” at the public expense by the central banks or
other public agencies. In a number of cases (e.g., In June 2011, the BCBS published a revised version
Spain), this led to previously healthy public finances of its Basel III: A Global Regulatory Framework
becoming precarious. for More Resilient Banks and Banking Systems
(December 2010). This key document set out the
As a consequence, the Basel Committee on Banking BCBS’s proposals for both a revised capital regime
Supervision (BCBS) made a number of significant and a new liquidity risk management framework.
additions and revisions to its Basel II framework,
by issuing the various components of Basel III. The The three tiers of capital in Basel II are replaced by
main changes relate to liquidity risk, which was two tiers, distinguished by their loss absorbency
largely overlooked by Basel II, and loss absorbency characteristics. Tier 1 consists of common equity
of capital, with the objective of reducing the need for (Common Equity Tier 1 – CET1) and additional
“bailouts” at public expense by introducing a greater tier 1 (AT1) instruments. The latter are required to
element of loss-absorbent capital instruments be of permanent duration and to be subordinated to
some of which would act to “bail in” the holders all other forms of capital other than common equity,
of such instruments. One should also mention the but are not expected to absorb losses while the
qualitative aspects of corporate governance and institution is a “going concern.” Tier 2 (T2) consists
risk management, a subject addressed by the of instruments that become loss absorbing at the
BCBS in its October 2010 document Principles point of the institution’s non-viability; in other words,
for Enhanced Corporate Governance. This was a the holders of such instruments are “bailed in” by
revision of its earlier 2006 guidance on this topic, absorbing losses when the institution is a “gone
subsequent to which, as is noted in paragraph 6 concern” so as to remove or reduce the need for
of the 2010 document, there were “a number of “bailouts” at public expense.
24
Regulatory Issues
Designing AT1 and T2 capital instruments, which ‘liquidity phase’ of the financial crisis that began in
offer just the required degrees of loss absorbency 2007, many banks – despite adequate capital levels –
in “going concern” and “gone concern” scenarios, still experienced difficulties because they did not
has proved challenging in the case of conventional manage their liquidity in a prudent manner.”
banks.
Both the LCR and the NSFR are challenging for
In addition, the minimum capital requirements in banks, and their implementation is being phased in
Basel III are higher than in Basel II and include gradually from 2015 onward in the case of the LCR,
two buffers. The “capital conservation buffer” is and delayed until 2018 in the case of the NSFR. The
a mechanism that allows the industry supervisor LCR requires banks to hold a stock of high quality
to require an institution whose capital has fallen liquid assets (HQLA) sufficient to cover expected
below the required minimum level to suspend profit cash outflows over a 30-day period in conditions
distributions until its capital has been restored to of liquidity stress. The main difficulty is the tight
the required minimum level. The “countercyclical definition of HQLA, which may be in short supply in
buffer” is a macroprudential tool that allows the emerging market economies as well as for Islamic
supervisor to require institutions to hold additional banks. The NSFR requires banks to match the
capital in periods of economic boom to mitigate maturities of (i) the funds tied up in its assets and off-
the systemic risk of excess credit buildup during balance sheet exposures (required stable funding)
such periods. Another macroprudential measure given their liquidity characteristics and residual
in Basel III, intended to mitigate the “too big to fail” maturities; and (ii) the portion of funds available from
problem, made provision for supervisors to require capital, liabilities, and other sources expected to be
systemically important financial institutions (SIFIs) to reliable (available stable funding) over a 1-year time
hold additional capital. horizon. Application of this metric has the effect of
constraining banks’ traditional ability to earn a spread
Liquidity Provisions of Basel III from maturity transformation, and for this reason has
encountered opposition from the industry.
In September 2008, the BCBS published its
Principles for Sound Liquidity Risk Management and Main Implications of Basel III for Islamic Banks
Supervision. This was followed by Basel III: A Global
Regulatory Framework for More Resilient Banks and Aforementioned developments have implications for
Banking Systems (December 2010, revised June Islamic banks in a number of areas of capital and
2011), and then by Basel III: The Liquidity Coverage liquidity regulation, as discussed in the following:
Ratio and Liquidity Monitoring Tools (January
2013) and Basel III: The Net Stable Funding Ratio – Components of Eligible Capital and Minimum
Consultative document (January 2014). The latter Capital Requirements
two documents develop the sections of the 2010/11
document that deal with liquidity risk, by setting Due to Sharīàh compliance reasons, Islamic banks
out quantitative metrics for monitoring exposures are prohibited from issuing capital instruments such
to liquidity risk over 30-day (liquidity coverage ratio as preferred shares or subordinated debt securities.
or LCR) and 12-month (net stable funding ratio or This presents them with particular challenges if they
NSFR) time horizons. As the BCBS pointed out in wish to issue instruments that qualify as AT1 capital
its 2013 document (paragraph 2), “during the early or as T2 capital.
25
Regulatory Issues
AT1 Capital would be held by a bankruptcy remote special

purpose vehicle, and bankruptcy remoteness would
To meet the AT1 criteria, capital instruments must be make it impossible for the assets to be exchanged
perpetual in terms of maturity and subordinated to for common shares. Another possibility might be
the claims of depositors and general creditors of the convertible Muḍārabah Sukūk, but these would not
bank. An Islamic bank may issue “general obligation” have the quasi-fixed income characteristics of Ijārah
Mushārakah Sukūk, the holders of which share pari Sukūk and would therefore be less appealing.
passu with common shareholders both in the bank’s
profits and losses and in its obligations to creditors In either case, there is a potential Sharīàh issue of
(that is the significance of “general obligation”). Such Gharar (uncertainty) with respect to the terms of
Sukūk are thus in substance a form of nonvoting conversion, as in the circumstances the value of the
common shares. Their lack of governance rights may common shares would be uncertain and probably
be compensated by a greater share of profits (but very low.
not of losses) pro rata to their share of equity capital;
however, this would make them particularly dilutive Minimum Capital Requirements
from the common shareholders’ point of view.
Apart from the issues concerning eligible AT1 and
It is unclear how Islamic banks could issue AT1 T2 instruments, the application of the new minimum
instruments that would rank before the common capital requirements to Islamic banks does not
shares. One possibility, subject to Sharīàh approval, appear to be problematic. In general, Islamic banks
might be a form of conditionally convertible equity are more generously endowed with common equity
(Mushārakah or Muḍārabah) Sukūk. These would than conventional banks. However, it is worth noting
have claims over assets financed by the Sukūk (and that the application of the countercyclical buffer may
over the Sukūk holders’ share of income therefrom) raise issues of the appropriate measure to use in
ranking before those of shareholders, provided the economies largely based on hydrocarbons or other
trigger for conversion into common equity (the capital natural resources.
ratio falling to a specified level such as 5.125%)1 had
not been reached. Liquidity Provisions
T2 Capital It is widely acknowledged that liquidity risk

management raises particular problems for Islamic
The challenge in Islamic finance is to design Sharīàh- banks. With regard to funding liquidity, various
compliant instruments (Sukūk) such that the holders facilities that are routinely available to conventional
are “bailed in” if the issuer reaches the point of banks, such as interbank markets, collateralized
nonviability and would fail if not rescued in some borrowing via sale and repurchase agreements
way. “Bailing in” is intended to remove or reduce the (repo) and central bank lender of last resort facilities
need for a “bailout” at public expense. are not Sharīàh-compliant, and Sharīàh-compliant
alternatives are unavailable in many cases. As
One possibility would be convertible asset-based regards market liquidity, there is a severe shortage
Ijārah Sukūk with the conversion trigger being the of Sharīàh-compliant income-producing HQLA. In
point of non-viability, at which point the assets would emerging market economies, there may indeed be
be exchanged for common shares according to a a shortage of any kind of HQLA denominated in the
prespecified exchange ratio. The Sukūk could not local currency.
be asset backed, as in that case the Ijārah assets
1
See Basel III Definition of Capital – Frequently Asked Questions (December 2011), paragraph 16.
26
Regulatory Issues
Liquidity Coverage Ratio Net Stable Funding Ratio
The BCBS has to some extent taken account of the It remains to be ascertained whether the NSFR
shortage of HQLA in Basel III: The Liquidity Coverage poses any particular problems for Islamic banks that
Ratio and Liquidity Monitoring Tools (January it does not already pose for conventional banks. The
2013), by permitting so-called alternative liquidity increasing use by Islamic banks of term deposits
arrangements (ALAs) in “jurisdictions with insufficient based on Commodity Murābahah Transactions in
HQLA” (paragraphs 55–68). Paragraph 68 refers place of profit sharing investment accounts may,
specifically to “Sharīàh-compliant banks” and states however, reduce their available stable funding by
that “national supervisors in jurisdictions in which subjecting them to refinancing risk, especially when
Shari’ah compliant banks operate have the discretion the Commodity Murābahah Transactions-based
to define Shari’ah compliant financial products (such deposits have short maturities.
as Sukuk) as alternative HQLA applicable to such
banks only, subject to such conditions or haircuts Role of the Islamic Financial Services Board
that the supervisors may require.” It is not clear how
much of a concession this is, since presumably such In carrying out its mission, the Islamic Financial
Sukūk or other financial products would have to Services Board (IFSB) addresses key issues relevant
meet the criteria for HQLA at least in terms of credit to the financial stability and resilience of the Islamic
quality and liquidity. financial services industry by issuing standards
and other guidance. With respect to the Islamic
It would seem that such discretion would be most banking sector, the IFSB revised its standard on
likely to be used in conjunction with Option 3 of the Capital Adequacy in response to Basel III, issuing
ALA, which permits the additional use of Level 2 IFSB-15 in January 2014, following new standards
assets subject to greater “haircuts.” Option 3 is on Liquidity Risk Management (IFSB-12) and on
normally restricted to Level 2A assets, for which Stress Testing (IFSB-13) issued in March 2012.
the credit quality criterion is a minimum of AA–, and IFSB-12 is being supplemented by a guidance
the liquidity criterion is being traded in large, deep, note on the quantitative measures of liquidity risk
and active repo or cash markets with a proven management (LCR and NSFR) which is in the course
record as a reliable source of liquidity in the markets of preparation. The guidance note focuses mainly on
even during stressed market conditions; that is, a the LCR and related issues, since the LCR is due
maximum decline of price or increase in “haircut” to be implemented gradually from January 2015,
over a 30-day period of significant liquidity stress whereas the NSFR is not due to be implemented
not exceeding 10.0%. Possibly the discretion would until January 2018 and some details have yet to be
allow a version of Option 3 to be extended to Level finalized following the publication of a consultative
2B assets, for which the liquidity criterion in particular document in January 2014. A substantially revised
may be less constraining but the “haircut” may be as standard on the supervisory review process for
high as 50.0%. Islamic banks is currently at the exposure draft stage
(ED-16).
For the Takāful sector, the IFSB has issued standards

on governance (IFSB-8, December 2009), solvency
(IFSB-11, December 2010), and risk management
(IFSB-14, December 2013).
27
Regulatory Issues
The Roles of Boardrooms and Courtrooms in Islamic Finance
As Islamic finance is an industry which is still in its • Financial losses due to inadequate risk
infancy and is undergoing rapid growth around management and poor investment or financing
the world, the effectiveness of regulatory and legal decisions
infrastructure for Islamic finance will always be • Losses elsewhere in the industry through
tested in both the boardrooms and the courtrooms. systemic risk
In boardrooms, organs of governance such as the
board of directors, senior management, and the
Failures in the courtroom (i.e., failures of any of
Sharīàh supervisory boards will have pertinent
the officials such as the judges and lawyers to,
roles to ensure that the Islamic financial institutions
among others, duly uphold the law and interpret its
uphold sound business decisions, preserve integrity,
and appropriately comply with laws and regulations applications correctly) may result in
including Sharīàh. The prevalent commercial and
contractual nature of relationships between the • injustice to parties in dispute;
Islamic financial institutions and their stakeholders • unfair infliction of financial loss to the disputing
means that disputes may arise from time to time— parties or even to the public;
which certainly need to be resolved, and the • lack of compliance with Sharīàh rules and
courtrooms shall then play a role. Legal officials principles, and incorrect interpretation of
such as judges and lawyers will have direct influence Sharīàh-compliant contracts;
and contribution in determining whether Islamic • reputational damage to Islamic financial
financial institutions will retain their stability and institutions and the industry; and
resilience, since businesswise they cannot afford to • systemic pressure on the rest of the market.
be hampered by prolonged and unresolved disputes
as this may affect their reputation and credibility.
While some judges or lawyers may not feel
comfortable with public expectations on their roles
In this respect, the importance of continuous
strengthening of the infrastructure cannot be vis-à-vis Islamic finance disputes, the court cannot
overemphasized as the roles of boardrooms and abdicate this duty, especially in cases where parties
courtrooms are linked, not least because failures in in the dispute may have nowhere else to turn for
the boardroom tend to end up before the courts. dispute resolution. Although greater use could be
made of arbitration and mediation if competent
Failures in the boardroom (i.e., failures of any of authorities were available, the court remains an
the organs of governance such as the board of important legal infrastructure without which the
directors, senior management, and the Sharīàh industry may not be able to operate in vacuum.
supervisory boards to serve their specific duties
and responsibilities) may bring about the following The Challenge: Creating an Orderly and Effective
consequences: Interface
• Breaches of the law or of regulations

It is reasonable to anticipate that there will be
• Breaches of Sharīàh rules and principles
complex interactions between the boardroom and
and resultant reputational damage and loss
of income. Although Sharīàh compliance is courtroom, including possible mismatches between
ultimately the responsibility of the board of civil law and Sharīàh, as well as lengthy discussions
directors, the influential role played by the senior between the various organs of governance and
management and Sharīàh supervisory board legal officials. As such, a major challenge is to bring
cannot be underestimated and hence obviously about an orderly and effective interface between
in this respect the organs of governance share the requirements of Sharīàh rules and principles in
collective accountability. financial and commercial matters, including the legal
28
Regulatory Issues
and regulatory framework. There are also legitimate In terms of dispute resolution, a number of other
expectations among the public to see the court serve institutional arrangements can play an important
the law and deliver justice to Islamic finance disputes role. Authorities may adopt strategies that best
in a cost-efficient and timely manner—a standard at suit their legal systems and requirements. These
least comparative to disputes involving conventional include, among others, the establishment of special
finance transactions. courts within the judicial system with judges that
are fully conversant with Sharīàh issues in finance
Although ideally legal officials must be well versed and commerce. Such courts should have access
in the technical aspects of Islamic finance, they are to, and be guided by, authoritative Fatāwa (Sharīàh
currently in the process of evolving their knowledge resolutions) where these are available within the
and developing their learning curves. In this regard, jurisdiction. It is also important that high-quality law
attention needs to be paid to the impact that a reports be published so as to record precedents
single decision by the legal authority can have on the and assist the jurisprudential processes of qiyyaas
Islamic finance industry as a whole. (analogy) and ijma (consensus), which are conducive
to the harmonization of thinking among Sharīàh
An effective legal and regulatory framework for jurists. At the same time, it should be possible to
Islamic finance would provide the following: lighten the burden on the courts and avoid the costs
and delays of litigation by making more systematic
• an enabling environment that accommodates use of arbitration and mediation using Sharīàh and
and facilitates the development of what is Islamic finance experts as arbitrators and mediators.
arguably still a young industry;
• a clear and efficient system that preserves the For cross-border disputes, it would be most valuable
enforceability of Islamic finance contracts in a to have an internationally recognized adjudicating
context of “legal pluralism,” that is the coexistence
body, such as an International Islamic Arbitration
of civil law (whether based on the common law or
Tribunal or possibly an International Islamic Finance
on statutes) and the Sharīàh; and
Court, to achieve resolution of such disputes. This
• a credible and reliable forum for the settlement
would require individual countries to give recognition
of legal disputes arising from Islamic finance
to such an international body and to agree to
transactions.
implement its decisions.
An enabled environment should include legislation

Feasibility of an International Mechanism for
that oversees the licensing process and supervisory
Dispute Resolution
aspects of Islamic financial institutions. In addition,
it must include a tax regime that does not place
The feasibility and prospects for such a mechanism
Islamic finance in a disadvantaged position, while
are indeed promising. As it is and for illustration, an
also incorporating supportive infrastructure, such as
initiative along a similar structure has been started
financial reporting standards that take into account
through investment treaties. The following are a few
specificities of Islamic finance, and establishment
of facilities for developing human resources for the examples:
Islamic finance industry. The process can substantially
benefit through active initiatives by multilaterals such • The Organsation of Islamic Cooperation (OIC) is
as the IFSB and the Islamic Development Bank (IDB) a union of 57 Muslim member states through
since this can expedite sharing of experience among the Agreement for Promotion, Protection and
regulatory and supervisory authorities as well as Guarantee of Investments among the OIC
foster adoption of international prudential standards Member States (OIC Agreement), which, to
date, has been signed by 33 member states and
and best practices.
29
Regulatory Issues
ratified by 27. It sets out the minimum standards (ACIA), which entered into force on 29 March
applicable to incoming capital and investment 2012. The ACIA contains, among others, legal
between member states. In 2012, in the case of protections such as the right of investors to
Hesham al-Warraq v. Indonesia, an arbitration submit investment disputes to the International
tribunal which proceeded based on United Centre for Settlement of Investment Disputes
Nations Commission on International Trade (ICSID) for arbitration. However, this treaty
Law (UNCITRAL) Arbitration Rules decided includes a number of limitations, in particular by
that the OIC Agreement did allow investors to requiring, where applicable, specific approval
take host states to arbitration. As under the by the competent state authority and by
OIC Agreement, decisions of tribunals are final limiting the possibility of “treaty shopping” (by
and binding, each contracting party is under an anticipating the possibility of member states to
obligation to implement an award in its territory deny the benefits of the treaty to certain types of
as if it were a final and enforceable decision of investments). Investors intending to invoke the
its national courts, irrespective of whether that protection of this treaty accordingly need to take
contracting party is party to the dispute. The particular care to ensure that their investments
agreement contains a so-called “fork in the road” fall within the scope of protection under this
provision, meaning that an investor is precluded treaty.
from bringing simultaneous proceedings before
an arbitral tribunal and national courts. It is therefore important for stakeholders of the
Islamic finance industry, whether in the boardroom
• Another working model can be exemplified by or courtroom, to increase their understanding and
the Unified Agreement for the Investment of awareness of the international dispute resolution
Arab Capital in the Arab States (Arab Investment mechanisms available to them and collaborate with
Agreement), which is an investment treaty the respective authorities to see how Islamic finance
concluded between the members of the League can be part of such treaties and invariably benefit
of Arab States. Under the Arab Investment from the same.
Agreement, a specific body—namely the Arab
Investment Court (AIC)—is established for the In addition to dispute resolution mechanisms, the
purpose of hearing disputes brought under it. legal and regulatory infrastructure should provide
The AIC is seated at the permanent headquarters (in conjunction with the IFSB and other international
of the League of Arab States in Cairo and is standards) authoritative guidance for Islamic financial
composed of at least five serving judges each institutions.
with a different Arab nationality (which must not
be the same nationality as either of the parties Selected Important Developments in Malaysia, a
to the dispute). In 2013, in a case arbitrated Premier Islamic Financial Center
before the AIC, Mohamed Al-Kharafi & Sons
Co., a Kuwaiti company, successfully won an As a well-recognized Islamic financial center,
arbitration award against the Government of Malaysia has shown its ability to understand the
Libya. complexities of issues arising in the boardrooms
as well as courtrooms when it comes to ensuring
• Besides this, the Association of Southeast stability and resilience of the Islamic finance industry.
Asian Nations (ASEAN), which is a regional Hence, the Malaysian model in regulating and
grouping for cooperation mainly in areas promoting effectiveness of the boardrooms and
concerning economic development, has courtrooms is worth considering by regulatory and
also taken up a similar initiative through the supervisory authorities.
ASEAN Comprehensive Investment Agreement
30
Regulatory Issues
Besides adopting international best practices for Islamic finance dispute are binding on the courts and
boardroom (i.e., governance) functions as is the arbitrators. Although there have been contentions
case in most jurisdictions, the Malaysian central bank raised as to whether such provisions are in fact
has taken a further initiative by issuing three sets of constitutional, considering they may deprive the
guidelines which are highly relevant to the above: court from the necessary independence, the courts
in Malaysia have ruled that their powers to make
(i) Guidelines on the Introduction of New Products, findings on facts or to apply a law on the facts and
according to which any new products offered make decisions remains intact and unfettered, as
by Islamic financial institutions require BNM the Sharīàh Advisory Council’s role is limited to
approval; ascertaining the Islamic law on any financial matter
(ii) Sharīàh Governance Framework, which and issuing a ruling upon reference made to it.
requires that the board of directors and BNM has also acted as amicus curiae in a number
senior management share a responsibility of cases, thus ensuring that the court has access
for supporting the Sharīàh Committee in the to legal arguments from the prudential regulator’s
oversight of Sharīàh compliance issues; and perspective. The effect of these measures has been
(iii) Sharīàh Standards, which set out the basic to substantially reinforce the effectiveness of the
requirements that must be adhered to in the dispute resolution process, whether by the court
documentation and operation of some products or by arbitration, and this has helped strengthen
so as to minimize the risks of errors and failures public confidence in the competence of the court
in Sharīàh compliance. and arbitrators to resolve complex Islamic finance
disputes with access to assistance from the right
These guidelines have been instrumental in helping Sharīàh experts.
to ensure that the boardrooms of Islamic financial
institutions are always cautious and prudent in their In sum, as a result of the above, Malaysia may
decision making. be said to have an enabled environment that
accommodates and facilitates the development of
In addition, the Malaysian legal infrastructure has the Islamic finance industry. Malaysia instills a clear
been reinforced by the Central Bank of Malaysia and efficient system that preserves the enforceability
Act (CBMA) 2009. Sections 56–57 of the CBMA of Islamic finance contracts and provides a credible
provide that resolutions of the Sharīàh Advisory and reliable forum for the resolution of disputes
Council of BNM on any matters that arise in an arising from transactions in Islamic finance.
Concluding Remarks
Financial regulation is concerned with two main sets of directors, and of capital and liquidity requirements
of issues: the protection of investors and customers as addressed by this chapter. The Islamic financial
for financial products (financial conduct), and the services industry would derive no benefit from being
financial stability and resilience of finance sector under-regulated, and the IFSB is working to facilitate
institutions and of the sector as a whole (prudential— the inclusion of the Islamic financial services industry
micro and macro). In the case of Islamic finance, in the global system of financial regulation with due
issues arise of corporate governance, compliance, regard to the specificities of the institutions that
the legal system, and the responsibility of the board make it up.
31
Chapter 3
Islamic Finance: Financial Inclusion as
a Core Concept
Dr. Zamir Iqbal
Islamic Finance: Financial Inclusion as a
Core Concept
There is evidence suggesting that financial Muslim-majority countries. In a sample of 41,922

development and improved access to finance in a individuals in 39 countries, where Muslims make up
country, referred to as financial inclusion, is not only between 5.0% and 95.0% of the total population, self-
able to accelerate economic growth but can also reported Muslims were less likely (i) to have a formal
reduce income inequality and poverty. Enhancing account and (ii) to save at a formal financial institution
the access to and the quality of basic financial (Figure 3.1). The low level of financial inclusion among
services (such as availability of credit, mobilization of Muslims is explained by either factors of voluntary
savings, insurance, and risk management) facilitates exclusion (such as religious considerations) or those
sustainable growth and productivity, especially for of involuntary exclusion (such as discrimination, lack of
micro, small, and medium-sized enterprises (MSMEs). financial literacy, lack of collateral, etc.). Interestingly,
Despite the essential role of financial inclusion in the among the cited barriers, religion is the least frequent:
progress of achieving efficiency and equality in a only about 7.0% of the total Muslim population in 148
society, as of the latest count (Demirguc-Kunt and countries around the world said religion was their
Klapper 2012), close to 2.5 billion people around the main reason for not having a formal bank account
globe, or about 70.0% of the adult population, have (Demirguc-Kunt, Klapper, and Randall 2013).
no access to basic financial services.
Figure 3.1: Share of Adults with an Account at a
Access to finance is an issue of particular significance Formal Financial Institution
to the so-termed nonbankable members of society. In 60
the case of prospective entrepreneurs, they invariably
lack adequate collateral to qualify for traditional
bank financing. Therefore, alternative mechanisms 40
have been developed for such client groups such
%
as microfinance, small and medium-sized enterprise

(SME) finance and micro-insurance. These techniques 20
have been partially successful in enhancing financial

inclusion but not without challenges.
0
East Asia Europe Middle South Sub-
Two of the leading indicators of access to finance and and East Asia Saharan
Pacific Central and North Africa
are the holding of a formal bank account and the
Asia Africa
receiving of credit from a financial institution.
Muslims Non-Muslims
Although inaccessibility of finance is a serious issue
for all developing countries, it is especially severe in Source: Demirguc-Kunt, Klapper, and Randall (2013).
Financial Inclusion and Its Importance
Understanding the linkage of financial inclusion have been shown empirically to be a key driver of
with economic development is important. There is economic growth and development.1 Development
a voluminous literature in economics and finance economists suggest that the lack of access to
on the contribution of finance to economic growth finance for the poor deters key decisions regarding
and development. The main reason why finance, human and physical capital accumulation. For
financial inclusion, or access to finance matters example, in an imperfect financial market, poor
is that financial development and intermediation people may find themselves in the “poverty trap,”

1
Recent experimental evidence from three randomized impact evaluations suggests that while increasing access to credit does not
produce the kind of dramatic transformations expected by earlier literature, it does appear to have some important, albeit more modest,
outcome.
(Source: Bauchet et al. 2011)
34
Core Concept
as they cannot save during harvest-time or borrow or education reform focusing on schooling, savings,
to survive starvation. Without a predictable future or fertility changes, can lead to reduction in income
cash flow, the poor are also incapable of borrowing inequality and poverty. The other school of thought
against future income to invest in education or health attributes market failure and imperfect information
care for their children. Modern development theories leading to financial market frictions as the obstacle
analyzing the evolution of growth, relative income to growth (Stiglitz and Weiss 1981). Indeed, financial
inequalities, and economic development offer two market frictions can be the critical mechanism for
tracks of thinking. One track attributes imbalances in generating persistent income inequality or poverty
redistribution of wealth and income in the economy traps. Financial market imperfections, such as
as an impediment to growth, while the other track information asymmetries and transactions costs,
identifies financial market imperfections as the key are likely to be especially binding on the talented
obstacle (Demirguc-Kunt, Beck, and Honohan poor and the micro- and small enterprises that lack
2007). Proponents of the redistribution of wealth collateral, credit histories, and connections, thus
theory claim that redistribution can foster growth and limiting their opportunities and leading to persistent
a focus on redistributive public policies, such as land inequality and slower growth.
Concept of Financial Inclusion in Islam
The core principles of Islam lay great emphasis on financing, and the other through specific instruments
social justice, inclusion, and sharing of resources of redistribution of wealth among society. Both risk-
between the haves and the have-nots (see Figure sharing financing instruments and redistributive
3.2). Islamic finance addresses the issue of instruments complement each other to offer a
financial inclusion from two directions: one through comprehensive approach (see Box 3.1) to enhance
promoting risk-sharing contracts, which provide financial inclusion, eradicate poverty, and build a
a viable alternative to conventional debt-based healthy and vibrant economy.
Figure 3.2: Targeted Approaches to Enhance Inclusion
Extreme Poverty Poverty

Low Income
(Below poverty line) (Above poverty line)
Redistributive Pillar Redistributive Pillar Redistributive Pillar

• Zakah • Qard Al-Hassan • Hybrid solutions
• Sadaqat • Zakah (applications with market-
• Waqf • Waqf based solutions)
• Khairat
• Khumus
Risk-Sharing Pillar Risk-Sharing Pillar Risk-Sharing Pillar

• Collective risk sharing • Microfinance • Micro, small, and medium-
through collective (Murābahah, Mushārakah) sized enterprises (MSMEs)
support during crisis • Micro-Takāful
Source: Author’s
35
Core Concept
Box 3.1: Issues with a Conventional Approach to Financial Inclusion
The experience with microcredit or microfinance since its inception has been mixed, as there is a growing
concern that initial expectations were overestimated. The following is a summary of the key challenges facing
the microfinance industry in achieving a sustainable impact on poverty alleviation:
(i) High interest rates. Conventional microfinance institutions are often criticized for charging very high
interest rates on loans to the poor. These high rates are justified by these institutions as an outcome of
high transaction costs and high risk premiums. However, this imposes undue stress on the recipient to
engage in activities that produce returns higher than the cost of funding, which may not be possible in
many cases.
(ii) Not every poor individual is a microentrepreneur. Merely making the capital accessible to the poor is
not the solution, without realizing that not every poor individual or recipient of microcredit has the skills set
or the basic business sense to become an entrepreneur.
(iii) Diversion of funds. There is the risk that the funds will be diverted to nonproductive activities such as
personal consumption. In some cases, microcredit may lead the poor into a circular debt situation where
borrowing from one microlender is used to pay off the borrowings from another lender.
(iv) Large-scale fund mobilization. While some microfinance institutions have had a significant impact on
poverty, others have been less successful; microfinance institutions generally cannot mobilize funds on a
large scale and pool risks over very large areas in the way that more traditional, formal financial institutions
can.
(v) Product design. The financial services needs of poor households may require different product features
with different payment and delivery structures as opposed to typical debt-based lending.
(vi) Absence of private sector participation. As mentioned above, due to limited supply, coverage,
products lineup, and funding by the informal, semiformal, and non commercial sectors, the effectiveness
of microfinance institutions is often compromised.
Source: Author’s compilation.
Economic development and growth, along with social Islam ordains risk sharing through three main venues:
justice, are the foundational elements of an Islamic
economic system. All members of an Islamic society (i) contracts of exchange and risk-sharing
must be given the same opportunities to advance instruments in the finance sector;
themselves; in other words, a level playing field, (ii) redistributive risk-sharing instruments which
including access to the natural resources provided the economically more able segment of society
by Allah. For those without work and for those who utilize in order to share the risks facing the less
cannot work (including people with disabilities), able segment of the population; and
society must afford the minimum requirements for a (iii) the inheritance rules specified in the Koran
dignified life by providing shelter, food, health care, through which the wealth of a person at the time
and education. Islam emphasizes financial inclusion of passing is distributed among present and
more explicitly, but two distinct features of Islamic future generations of inheritors.
finance—the notions of risk sharing and redistribution
of wealth—differentiate its path of development
significantly from the conventional financial model.
36
Core Concept
The Islamic system advocates risk sharing in of reasons, are unable to work; hence, the resources
financial transactions, and a financial system based they could have used to produce income and wealth
on risk sharing offers various advantages over the were utilized by the more able.
conventional system that is based on risk shifting.
Use of risk-sharing instruments could encourage The Koran considers the privileged individuals able
investors to invest in sectors such as MSMEs which as trustee-agents in using these resources on behalf
are perceived as high-risk sectors. Given an enabling of the low-income segments. In this view, property is
environment, investors with a matching risk appetite not a means of exclusion but inclusion in which the
are likely to be attracted to providing capital for these rights of those less able in the income and wealth of
sectors. This argument can be supported by the the more able are redeemed. The result would be a
growing market for private equity in general, but with balanced economy without extremes of wealth and
reduced information asymmetry, the MSME sector poverty. The operational mechanism for redeeming
can also attract private equity funds.2 With increased the right of the less able in the income and wealth
availability of funds for these sectors, one could of the more able are the network of mandatory and
expect an increase in financial inclusion in the system. voluntary payments such as Zakat (2.5% on wealth),
Khums (20.0% of income), and payments referred to
The second set of instruments meant for redistribution as Sadaqat.
are used to redeem the rights of the less able in the
income and wealth of the more able. Contrary to The most important economic attribute that
common belief, these are not instruments of charity, operationalizes the objective of achieving social
altruism, or beneficence, but these are instruments justice in Islam is that of the distribution–redistribution
of redemption of rights and repayment of obligations. rule of the Islamic economic paradigm. Distribution
takes place post-production and sale when all
In practical terms, the Koran makes clear that creating factors of production are given what is due to them
a balanced society that avoids extremes of wealth commensurate with their contribution to production,
and poverty, a society in which all understand that exchange, and sale of goods and services.
wealth is a blessing provided by the creator for the Redistribution refers to the post-distribution phase
sole purpose of providing support for the lives of all when the charge due to the less able are levied.
of humankind is desirable. The Islamic view holds Islam’s redistributive instruments include set of
that it is not possible to have many rich and wealthy mechanisms comprising either mandatory levies
people who continue to focus all their efforts on (Zakat, Khums, etc.), philanthropic contributions
accumulating wealth without simultaneously creating (Sadaqat and Waqf, or benevolent loans (Qard Al-
a mass of economically deprived and destitute. The Hassan). These means are essentially repatriation
rich consume opulently, while the poor suffer from and redemption of the rights of others in one’s
deprivation because their rights in the wealth of the income and wealth. Redeeming these rights is a
rich and powerful is not redeemed. To remedy this, manifestation of belief in the oneness of the creator
Islam prohibits wealth concentration, imposes limits and its corollary, the unity of the creation in general
on excessive consumption through rules prohibiting and of humankind in particular. It is the recognition
israf (overspending), itlaf (waste), and itraf (ostentatious and affirmation that God has created the resources
and opulent spending). It then highly recommends for all of humankind who must have unhindered
that the net surplus, after moderate spending and access to them. Even the abilities that make access
consumption necessary to maintain a modest living to resources possible are due to the creator. This
standard (savings through reduced consumption), be would mean that those who are less able or unable
shared with the members of society who, for a variety to use these resources are partners of the more able.

2
Before the financial crisis, several microfinance programs were able to issue bonds and raise funds from the private sector as the
microfinance sector was considered a profitable one.
37
Core Concept
As mentioned earlier, there are two pillars which For those in poverty but who are above the poverty
constitute the framework for financial inclusion. The line, the objective would be to use the redistributive
first pillar consists of the core principle of risk sharing, instruments to provide livelihood sustainability,
which is promoted through permitted contractual basic needs, and training to prepare them for active
agreement for undertaking business transactions participation in economic activities, and the use risk-
as well as through the concept of risk sharing with sharing instruments to develop microfinance and
less fortunate members of the society through self- microinsurance (microTakāful) schemes. Research has
help and exhibition of solidarity during difficult and shown that such a combination could be a catalyst for
unexpected times of economic distress. The second getting people out of poverty and into the mainstream
economy. Finally, the third segment of low-income
pillar consists of Islam’s instruments of distribution
individuals will have less dependence on redistributive
and redistribution as explained earlier. These two
instruments and will be suitable candidates for risk-
pillars can be combined in varying degrees to
sharing instruments to develop MSMEs that could
combat different segments of society who are
provide sustainable incomes. It has been suggested
denied access to finance. For example, the segment
that in order to stimulate growth through the MSME
facing extreme poverty (i.e., those below the poverty
sector, financial engineering can be used to develop
line) will be most eligible for receiving financing and hybrid solutions where some redistributive instruments
financial assistance through the redistributive pillar are combined with risk-sharing instruments to find
rather than engaging in any business transactions. market-based financing solutions (Iqbal and Roy 2013).
However, during an economic crisis or a natural
calamity, other fellow Muslims are advised to go The next section sheds light on how the issue of
beyond the minimum prescribed contribution and financial inclusion has been tackled in select Muslim
share these risks with voluntary contributions. countries by applying Islamic instruments of risk
sharing and redistribution.
Case Studies
One of the instruments of redistribution is Zakah, shortfall in terms of percentage of gross domestic
which has a great potential as the main resource of product (GDP) in several Muslim countries (Table
social spending supporting poverty alleviation in an 3.1). Even minimum resources available through
Islamic society. The argument is not only theoretically Zakah could cover the resource shortfall for incomes
true, but can be supported by empirical evidence.3 below $1.25 per day in two of the most populous
Mohieldin at al. (2011) determine whether the Zakah Muslim countries (i.e., Pakistan and Indonesia).
collection in Organisation of Islamic Cooperation
(OIC) countries is sufficient to cover the estimated This does not mean that Zakah is a totally new
shortfall of resources to alleviate poverty. Using this mechanism of poverty reduction as it is already
estimation, they find supporting evidence that 20 out distributed to the poor in several Islamic countries.
of 39 OIC countries can actually alleviate poverty However, an argument can be made that proper
among those living with an income under $1.25 collection, streamlining, accountability, prioritization,
per day using resources generated through zakah and allocation to productive activities can have
collection alone. In a recent study by the Islamic a significant impact on enhancing access and
Development Bank (IRTI 2014), it is shown how opportunity for the poorer segments of society,
Zakah resources can be utilized to cover a resource which will ultimately lead to a reduction in poverty.
3
See Kahf (1989), Shirazi (2006), and Mohieldin et al. (2011).
38
Core Concept
Table 3.1: Resource Shortfall for Poverty Alleviation and Potential of Zakah in Closing the Gap (% of GDP)
Resource shortfall per annum for zakah zakah zakah
incomes below (1) (2) (3)
Country $1.25 per day $2.00 per day under 3 different estimation methods
Malaysia 0.012 0.020 1.105 2.364 2.665
Pakistan 0.709 5.201 1.727 3.694 4.164
Indonesia 0.411 2.831 1.582 3.383 3.814
Bangladesh 5.596 23.100 1.560 3.336 3.761
Tajikistan 1.554 8.192 1.698 3.633 4.095
GDP = gross domestic product.
Source: IRTI (2014).
Waqf (endowment) is another Islamic instrument are managed properly and fully utilized, it could
which has great potential for enhancing financial yield an annual return of 10% resulting in expected
inclusion.4 For example, the estimated market annual cash flows of $2 billion which amounts to
valuation of registered awqaf assets in India is approximately 0.325% of the country’s GDP, which
approximately $20 billion, as estimated by the Report could be sufficient to pull India’s Muslim population
on Social, Economic and Educational Status of the of over 138 million people out of poverty (IRTI 2014).
Muslim Community of India (2006).5 If such assets
Pakistan
There are several institutions in Pakistan offering to families and the institution has maintained a very
microfinance, but only a few offer Sharīàh-compliant low operating cost because of their operating model.
microfinance. Akhuwat is one of the leading institution’s The institution features operating out of mosques or
offering innovative Sharīàh-compliant microfinance churches and the majority of staff work as volunteers,
services based on the underlying contract of Qard-Al- thus keeping the costs at a minimum compared to
Hassan. The scheme has made a significant impact other microfinance institutions. The performance of
in alleviating poverty at the lowest cost possible the institution is remarkable, and it enjoys one of the
since the financing is based on interest-free lending highest recovery rates among its peers (see Table 3.2).
Table 3.2: Akhuwat Microfinance Institution in Pakistan

Key Features Cost Structure Progress Total
• Interest-free loans (Qard-ul-Hassan) Total Loans 300,000
• Use of mosque / church Interest Zero Amount RS. 4 billion
Disbursed ($40 million)
• Family loans Processing Active Loans 140,000
Zero
• Local philanthropy Fee Percentage Recovery 99.8%
• Volunteerism Number of Cities 110
Profit Zero
• Borrowers become donors Number of Branches 157
• Simple operations leading to cost Application
Zero
efficiency Fee
Source: Akhuwat
4
A waqf (plural awqaf) is the product of a voluntary endowment of assets to a trust, whose usufruct is earmarked for charitable purposes
specified by the founder. The latter appoints a trustee over the waqf who is responsible for the implementation of stipulations inside the
waqf deed. The trustee is compensated for the services rendered either from the earnings generated by the waqf or through a fixed
remuneration package.
5
The report was prepared by a committee appointed by the Government of India under the chairmanship of Justice Rajinder Sachar
(popularly known as the Sachar Committee).
39
Core Concept
Bangladesh
Approaches to financial inclusion in Bangladesh Historically, people of South Asia, especially

took different dimensions at different points in time. Bangladesh, are well known for their endowment
The post-liberation era observed expansions in rural activities. Haji Mohammad Mohsin Trust, Hamdard
branches of the nationalized banks and promotion of Laboratories (WAQF) Bangladesh, Anjuman Mufidul
cooperative societies. This was followed by private Islam (AMI), and others fall in this category. Recently
banks in the 1980s, including Grameen Bank and banks have come forward to manage endowment
microfinance institutions. At a later stage, the Islamic funds. Currently, five Islamic and three private
microfinance division of Islami Bank Bangladesh commercial banks with Islamic windows have cash
Limited (IBBL) was established in the 1990s, taking waqf deposit schemes. A cash waqf is a way to allow
a “finance plus” approach and preference for women depositors and other contributors to make cash
in microfinancing. These steps and the supportive contributions to an endowment which is maintained
by the Islamic bank. In 2012, waqf funds of five
measures of the central bank have taken Bangladesh
Islamic banks stood at Tk460 million.
to a leading position in South Asia with regard to
financial inclusion parameters.
There are still unmet demands for microfinance as
about 30.0% of the population live below the poverty
IBBL’s model of financial inclusion is based on a
line. Demand for Islamic microfinance services are
two-pronged approach: financial inclusion and on the rise with the participation of the Islamic banks
social inclusion. The model targets the rural poor and in the financial inclusion campaign. At present, 15
urban poor through its flagship programs, the Rural Islamic microfinance institutions hold only 2.96% of
Development Scheme and Urban Poor Development total members covered and 4.37% of the amounts
Scheme. Through a graduation process, the eligible financed. This shows room for growth of Islamic
beneficiaries can move on to start SMEs. Under social microfinance. An average of Tk75.00 million per
inclusion, the program takes care of health services, year was for social safety net spending under the
education, training, relief, and rehabilitation of the Rural Development Scheme during the last 4
ultra-poor to enable them to become bankable. The years. Growth in the number of members has been
bank has a separate corporate social responsibility observed at 6.5%, 16.0%, and 21.0%, respectively,
program that complements the financial inclusion in 2010, 2011, and 2012.
drive. Islamic finance in Bangladesh has experienced
a faster growth than its conventional counterpart. Financial inclusion goes on increasing with the
expansion of existing programs and creation of
Banking, insurance, and nonbank financial newer groups’ access to Islamic microfinance. IBBL
institutions are among the prime actors in this through its Rural Development Scheme now has
segment of finance. Currently, there are eight full- a presence in 15,507 villages with 733,520 group
fledged Islamic banks and two nonbank financial members, of which 94.0% are female. The bank
launched a new microfinance program, the Urban
institutions with Islamic operations in Bangladesh.
Poor Development Scheme, in May 2012 to extend
Islamic bonds are also operational. Islamic banks
micro-investment facilities to slum dwellers in the
presently account for almost 25.0% of the domestic
urban areas. Social Islami Bank Limited has recently
banking system. Between 2008 and March 2013,
joined hands with a nongovernment organization,
they grew at a pace of 26.0% per year, surpassing
Muslim Aid Bangladesh, to partly finance their
the growth of conventional private commercial banks microfinance activity. Financial inclusion has further
at 22.0% per year. deepened by opening of 599,472 farmers accounts
and 105,114 school students accounts at a minimum
balance of Tk10. The Association of Muslim Welfare
40
Core Concept
Activities in Bangladesh, a federation of 320 Islamic poor on the principle of equity and justice proved their
microfinance institutions, has 101,943 investment worth as more contributory toward poverty alleviation
clients who received Tk2.05 billion in 2010. in Bangladesh. Hence, Islamic microfinance has
become a popular model with substantial growth in
Islamic microfinance institutions working among the comparison to peer microfinance operators.
Philippines
Bangko Sentral ng Pilipinas (BSP) recognizes that (ii) Expanded physical network. Circular 694
financial inclusion is a worthy policy objective that can enables banks to establish a presence in areas
be pursued alongside the promotion of stability and where it may not be immediately economically
efficiency in the financial system. Working toward the feasible to set up a full bank branch by allowing
achievement of both financial stability and financial a “stripped down” or simple branch called a
inclusion requires at least the same amount of microbanking office (MBO). This addresses
energy, imagination, and serious attention. BSP has problems of cost and branch viability. MBOs are
taken several measures in establishing a supportive operationally attached to a nearby full branch.
regulatory environment that can allow market- It also allows areas that are unserved and/or
based solutions to address financial access issues. underserved to have access to a wide range of
The general approach is to promote an enabling financial services that these MBOs can provide
environment based on the proportionate application ranging from loans, savings, remittances, e-money
of sound and generally accepted regulatory and conversion, bill payments, payout services, and
supervisory principles. This is the approach that was limited foreign exchange purchases.
taken in mainstreaming microfinance in the banking
sector. The success of microfinance efforts has (iii) Expanded virtual reach. Circulars 649
emboldened BSP to move toward a more ambitious (9 March 2009) and 704 (22 December 2010)
goal of increasing access to financial services for all. on electronic money, electronic money issuers,
and electronic money network service providers
BSP has undertaken specific measures that bear provide the platform for an efficient retail
the potential of increasing access to finance payments platform, foster the establishment of
in a significant way. The bank is focusing on a ubiquitous agent network, and provide scope
facilitating conventional microfinance, but given the for outsourcing automated systems, network
developments in Sharīàh-compliant microfinance infrastructure, and a network of agents in
and increasing demand by the local Muslim relation to the e-money business.
population, BSP is developing its capacity to better
understand the dynamics of Sharīàh-compliant (iv) Lower barriers to customer acquisition.
microfinance to enhance access to finance to those Circular 706 provides scope for banks to have
who are currently excluded from the system due to a risk-based and tiered system of classifying
their preference for Sharīàh-compliant products. customers (i.e., low, average, high risk);
establishes a framework for applying reduced,
On the conventional side, BSP has taken the average, and enhanced due diligence, customer
following measures: acceptance, retention, and identification process
based on the level or risk of the customer;
(i) Expanded range of products. Circular 694 and allows the outsourcing to or relying on a
expanded the microfinance products to include third party for the face-to-face requirement of
microenterprise loans, microfinance plus (for growing Know-Your-Customer (KYC), and gathering of
enterprises), microdeposits, and microinsurance. information and documents.
41
Core Concept
(v) Informed and protected consumers. Circulars Taken together, BSP sees these recent issuances
730, 754, and 755 updated rules implementing the as groundbreaking measures that can unlock
Truth in Lending Act to Enhance Loan Transaction the potential of reaching the large populations
Transparency. These updated rules will help of unbanked in the Philippines. In all of these
ensure the protection of consumers, promote undertakings, proportionate regulation is the
healthy competition among credit providers, and necessary approach. Useful innovations need
enable the smooth and orderly functions of the not be stifled but instead allowed to operate in
entire financial system. This regulation is also very an environment where the risks associated with
timely as calls for enhanced consumer protection such innovations are adequately understood and
are intensifying, specifically as affirmative financial addressed and where there is a judicious and
inclusion policies lead to the availability of an ever proportionate application of sound principles.
widening range of financial products and services.
Concluding Remarks
Access to finance is hampered by information are more likely to have a bigger financial inclusion
asymmetries and market imperfections which need mandate under their purview and more resources
to be removed before enhancing finance. When it and staff dedicated to working on these matters.
comes to developing countries’ finance sectors,
which are not very well developed and the formal The growth of Islamic microfinance will depend to
finance sector is underdeveloped, it is important a large degree on whether financial institutions can
that attention is paid to improve institutions develop sufficiently attractive financial products and
critical for finance sector development. Improved services, which are competitive with conventional
access to finance in many developing countries products in terms of pricing, transparency,
is constrained by an underdeveloped institutional processing time, and burden on the client. Sharīàh-
framework, inadequate regulations, and a lack of compliant microfinance and SME financing is limited
specialist supervisory capacity. Policy makers need in its scope and scale because of lack of knowledge
to take steps to enhance key legal, information, and concerning Sharīàh products, of accounting
regulatory institutions in their country. and regulatory standards for Sharīàh-compliant
microfinance, and of adequate monitoring and
Regulators should make financial inclusion a priority. supervisory setups.
Despite the significance of financial inclusion, it
is observed that it is still not a priority for financial By integrating Sharīàh-compliant products and
regulators in most OIC countries. The OIC countries customer information into the formal finance
need to develop a regulatory and supervisory sector, it will not only enhance access but also help
framework that supports wide financial inclusion integrate Islamic finance with conventional finance.
based on sound risk management and with sufficient For example, by bringing borrowers’ information to
consumer protection. Financial inclusion should be credit bureaus, financial institutions of all types could
considered a goal alongside prudential regulation extend access to new customers, while managing
and financial system stability. The Consultative Group risks and costs more effectively. This will also help
to Assist the Poor and World Bank Financial Access Sharīàh-compliant financial institutions to expand
survey (2010) of financial regulators worldwide found their funding source and enhance their risk-sharing
that regions that include financial access in their mechanism, as an institution with its clients’ credit
strategies and mandate their financial regulators to information available to the public can establish
carry such agendas are also those that reform the its reputation much more easily than one with an
most. Regulators with a financial inclusion strategy informal credit history system.
42
Chapter 4
Islamic Capital Markets: Potentials and
Prospects for Development
Murat Haholu
A Global Overview
The introduction of Islamic finance during the 1970s raising capital in ways that comply with Islamic
had predominantly been based on developing principles. As of today, the global Islamic capital
Sharīàh-compliant banking systems. However, market is a multisector segment that includes
post-1990s onward, there has been considerable holistic financial instruments including Sukūk (Islamic
interest across the key Islamic finance markets of bonds), Islamic equities, Islamic funds, and other
the Gulf Cooperation Council (GCC) and Malaysia Islamic structured products including real estate
to develop appropriate Sharīàh-compliant capital and investment trusts (REITs) and exchange-
market products and services. Sharīàh-compliant traded funds (ETFs). The Islamic equity sector has
financial instruments notably serve various critical firmly established itself in key global bourses and
functions in an economy ranging from funding capital jurisdictions and the world’s major financial index
requirements, enabling growth in wealth and assets, providers, such as Dow Jones, Standard & Poor’s,
while also providing short- to long-term liquidity and FTSE, all have Sharīàh-compliant equity listings
for diverse purposes. The added advantage of the (see Figure 4.1) which have allowed the Sharīàh-
Islamic capital market instruments is the ethically compliant equity and funds market to blossom. As
compliant nature of product structuring which aims an example, the Dow Jones Islamic Market indices
to achieve economically viable financial practices cover more than $10 trillion market capitalization
combined with principles of ethics and sustainability. in over 40 countries. These developments have
Since the early 2000s, the global Islamic capital enhanced the attractiveness of Islamic financial
market has been growing in depth and size across markets as an asset class for investment.
jurisdictions, with numerous entities across sectors
Figure 4.1: Major Islamic Indices for Equity Markets
Dow Jones Islamic Market Indices
FTSE Global Islamic Indices and S&P Shariah Indices

1999:
Country, Global, MSCI Global Islamic Indices
Regional, Blue Chip, 2006:
and Strategy/Thematic Country, Global, Russell-Ideal Rating
Indices Regional, Market Cap, 2007: Islamic Indices
and Industry/Sector Developed Market,
Indices Emerging Market, 2013:
Frontier Market, and Global, Regional, and
Regional Indices Market Cap Indices
Source: Dow Jones, S&P, FTSE, MSCI, Russell Investments, KFH Research.
44
The listing of Sharīàh-compliant equities and indices issuance momentum (see Figure 4.3) in the sector
effectively allows development of Islamic mutual has particularly surged during the post-financial-
funds and structured products by the Islamic finance crisis years and the volume of issuances averaged
suppliers (Najeeb and Vejzagic 2013). There are now over $95 billion per year during 2010–2013. The
more than 1,049 mutual funds, managing an estimated greater momentum, particularly after the financial
$72.5 billion in assets, that are compliant with Islamic crisis, highlights the relevance and applicability of
principles. Saudi Arabia and Malaysia are the two the Islamic finance sector to the global markets. In
leading Islamic capital market domiciles, holding more modern times, Sukūk have evolved from a basic
than 60.0% of total Islamic fund assets globally. In corporate financing instrument to serve a variety of
purposes in the global financial markets including as
addition, the stock market capitalization of the two
means of financing:
bourses in these countries, Bursa Malaysia (see Figure
4.2) and Saudi Tadawul, is the largest among the key
(i) sovereign fiscal needs,
Islamic finance hubs: as at the end of 2013, Bursa
(ii) countries’ infrastructural spending requirements,
Malaysia’s total market capitalization stands in excess
(iii) corporate budgetary and debt refinancing
of $450 billion while that of the Saudi Tadawul similarly needs,
stands at approximately $467.4 billion. (iv) Islamic banks’ capitalization instruments,
(v) Islamic banks’ liquidity management
Figure 4.2: Global Islamic Assets under Management
by Domicile (as of 17 June 2014)
instruments, and
(vi) instruments of investments for both individual and
Pakistan UAE institutional investors (e.g., fund management
Kuwait 1% 1%
Singapore
Indonesia 2% companies, Takāful operators, etc.).
1%
2% Other
South Africa 2% In particular, since the first global sovereign issuance
3%
Ireland by Malaysia in 2002, Sukūk are widely being pursued
4% Saudi Arabia by various sovereigns globally. Sovereign Sukūk
United States 36%
5% issuances constitute more than 60.0% of total Sukūk
Luxembourg issuances in the last three and half years (2011 until
8% the first half of 2014). A number of high-profile non-
Muslim jurisdictions including the United Kingdom,
Jersey Luxembourg, and Hong Kong, China have also now
10%
issued sovereign Sukūk.
Malaysia
25% Figure 4.3: Global Sukūk Outstanding (2003–H1 2014)
UAE = United Arab Emirates. 350 2009−2013
Source: Bloomberg, Zawya, KFH Research. CAGR: 21.62%
300
250
On the debt component of the Islamic capital
$ billion
200
markets, the global Sukūk market is a notable
segment, having developed from only one issuance 150
in the 1990s to over $100 billion worth of issuances 100
in the last 2 years (2012–2013). The tremendous 50
popularity of Sukūk in recent years is evident with
0
its robust growth in amounts outstanding at a
2003
2004
2005
2007
2008
2009
2010
2011
2012
2013
1H14
2006
compound annual growth rate of 21.6% during

2009–2013, making it the fastest expanding CAGR = compound annual growth rate, H = half.
segment of the Islamic finance industry. The Source: KFH Research.
45
Over the years, Sukūk have also evolved in terms Figure 4.4: Growth Drivers of the Sukūk Market
of their structures and the markets now have
instruments structured on a variety of underlying Growing Familiarity
contracts (e.g., Murābahah, Mushārakah, Ijārah,
etc.) with both fixed and flexible returns. The Greater Awareness
Growing Drivers
instruments also come with a variety of tenors and
maturities. Of late, the evolution in Sukūk structures
Historically Low Cost of Funds
has been to develop perpetual Sukūk for banking
institutions in order to comply with the capital
adequacy requirements of the Basel III standards. Governmental Development Initiatives
To date, a total of 30 jurisdictions (Organisation of
Islamic Cooperation [OIC] and non-OIC alike) have Substantial Capital Funding Requirements
tapped the Sukūk market to raise funds in a Sharīàh-
compliant manner (excluding offshore jurisdictions). Source: KFH Research.
Going forward, Sukūk are likely to be the main source of growth in Islamic capital markets underpinned by
a number of growth drivers (see Figure 4.4). Over the last 2–3 years, Azerbaijan, France, Gambia, Jordan,
Kazakhstan, Luxembourg, Mauritius, Nigeria, Turkey, Yemen , and Hong Kong,China have entered the global
Sukūk markets to tap into the fast-growing global pool of Sharīàh-compliant liquidity funds.
Overall, the Islamic capital market is one of the most promising sectors of the global Islamic finance industry
and is expected to play a greater role in Islamic finance. The growing pool of wealth in the major Islamic
finance jurisdictions of the GCC and Southeast Asia, combined with the willingness of regulators to support
the development of an Islamic capital market, promises to drive the sector to greater heights.
Malaysia’s Experience
The Malaysian Islamic capital market is worth over The Malaysian Islamic capital market has a long
RM1.5 trillion, accounting for 56.0% of the overall history of innovative evolution that has driven the
Malaysian capital market as at the beginning of 2014. growth and expansion of this sector. For example,
Malaysia’s Islamic capital market offerings include Malaysia established two Islamic unit trust funds
a holistic product ecosystem comprising Sharīàh- back in 1993, effectively paving the way for the
compliant equity, debt, funds, and structured development of the Islamic fund management
products. The marketplace is comprehensively industry. Malaysia is also noted for its creative
backed by robust and clear legislation and guidelines leadership in launching the first Islamic REITs in the
by the regulator, Securities Commission Malaysia. In world and the introduction of Asia’s first Islamic ETF
addition, a centralized body, the Sharīàh Advisory spearheading efforts in developing Islamic capital
Council of Securities Commission Malaysia maintains market structured products.
oversight of the compliance aspects of all Islamic
products and offerings. The sector’s growth and As of the first half of 2014, approximately 73.5% of
expansion are duly supported by domestic ancillary total securities listed in Bursa Malaysia are Sharīàh
firms such as rating agencies, asset managers, compliant. These effectively translate into a market
training and education providers, as well as efficient capitalization of more than RM1 billion ($300 million).
trading platforms and/or exchanges. The Islamic benchmark indices, Emas (21.7%) and
46
Hijrah (24.2%), both have outperformed the main On the debt component of Islamic capital markets,
KLCI index (17.7%) on a year-on-year basis as at the Malaysia is once again regarded to be the pioneer
end of the first half of 2014. In the Islamic funds sector, in issuing Sukūk. The Malaysian central bank issued
Malaysia domiciles 185 Sharīàh-compliant unit trust Government Investment Issues way back in 1983
funds with a net asset value of RM45.3 billion as at to help address the liquidity management issues in
the first half of 2014. Approximately 16.7% of total their first Islamic bank, Bank Islam (Cizaka 2011).
assets under management in the country are Sharīàh Ten years later when the Islamic banking segment
compliant; an increased proportion compared to the was opened for competition, the central bank
14.8% in the first half of 2013. Furthermore, there introduced an Islamic money market on 3 January
are 64 Sharīàh-compliant wholesale funds in the 1994, marking an important milestone in the liquidity
country with a net asset value of RM17.8 billion. management of Islamic banks (Najeeb and Vejzagic
In addition, Malaysia domiciles two Islamic ETFs 2013). Since then, Malaysia has positioned itself as
accounting for 31.5% of the total ETF market in the the global leader in Sukūk issuances and in provision
country and also three Islamic REITs accounting for of liquidity management services for Islamic financial
41.9% of the total REITs market. Sharīàh-compliant institutions. In the first half of 2014, the Malaysian
wealth management on structured products and Sukūk market accounted for 63.0% of global new
private equity and/or venture capital is also thriving Sukūk issuances; it has sustained its leadership in
in the Malaysian financial markets. the Sukūk market since 2001 (see Figure 4.5).
Figure 4.5: Malaysian Sukūk Primary Market Share vs. Global (2002–H1 2014)
140 100
90
120
80
100 70
$ billion
60
80
50
%
60
40
40 30
20
20
10
- 0
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 1H14
Global Issuance 2.50 5.75 6.64 11.50 25.52 46.02 20.63 28.02 45.15 85.07 131.18 119.71 66.20
Malaysia Issuance 2.28 4.10 4.37 8.21 13.50 25.68 6.47 20.41 32.83 60.92 97.08 82.36 41.69
H = half.
The Malaysian Sukūk market is also internationally attractive and is a preferred domicile among foreign issuers. A
total of 23 Sukūk tranches by 11 different issuers from 7 different jurisdictions have tapped the Malaysian Sukūk
market between 2008 and September 2014, a number far higher than any other onshore Sukūk jurisdiction.
Collectively, these 23 Sukūk tranches have raised almost RM12 billion in proceeds for the various issuers.
Among the various regions, the Asian issuers (Singapore; Hong Kong, China; and Kazakhstan) have raised
47
the most volume, accounting for 53.0% of the total Moving forward, the Malaysian Islamic capital market
proceeds raised by foreign issuers in the between has a strong growth potential in meeting the financial
2008 and September 2014. Comparatively, the GCC needs of the new and upcoming market sectors
issuers (Saudi Arabia, United Arab Emirates, and which include the likes of the global halal industry,
Kuwait) have raised nearly 40.0% (see Figure 4.6) the global green financing sector, the alternative
of the volume in the sample period, and this figure Islamic segments (e.g., Awqaf), and meeting
includes issuances by the multilateral Islamic regulatory requirements (e.g., Basel III). Furthermore,
Development Bank. In 2014, a Turkish participation in line with the Securities Commission’s Capital
bank also tapped the Malaysian Sukūk market Market Masterplan 2 which calls for widening the
raising RM800 million. international base of the Malaysia Islamic capital
market, there are four key focus areas as a way
Figure 4.6: Sukūk Capital Raised by Foreign Issuers in forward for the industry:
Malaysia (2008–Sep 2014)
7,000 10 (i) Responsible innovation accounting for various

environmental, social, and economic concerns
6,000
8 (ii) Mobilization of foreign funds
5,000 (iii) Increase in foreign currency deals within Malaysia
RM million
4,000 6 (iv) Attracting global players with the best talent in

%
3,000 the marketplace

4
2,000
2 In a nutshell, Malaysian Islamic capital market
1,000 propositions are widely being utilized by local
0 0 and international stakeholders, leveraging on the
2008 2009 2010 2011 2012 2013 Sep-14
country’s sound and robust ecosystem for Sharīàh-
Global Issuance Malaysia Issuance
compliant financing.
The Philippines’ Experience and the Role of the Philippine Stock Exchange
The Government of the Philippines has announced the Philippines has strength (e.g., agriculture, textile,
that they will allocate P400 billion (about $9 billion) electronics, and automotives). As such, Sukūk
for public infrastructure projects in 2014, which is up could be one of the possible fund-raising options to
35.0% from the allocation in 2013. Further, by 2016, support the economic growth of the Philippines.
the allocation is expected to rise to P820 billion
(equivalent to $19 billion). In the Philippines, gross One of the strategies that the Philippine Stock
domestic product (GDP) growth remains strong. Exchange (PSE) could adapt is offering a variety of
The Philippines’ GDP is among the highest in Asia, products to the markets, particularly businesses.
expanding quarter on quarter at an average of about The ethical investment climate plays a very important
7.0% since first quarter of 2012. role in capital markets. In the PSE’s road shows
across the Philippines, especially in the south, there
Sukūk are among the Sharī’ah-compliant fund- was already a demand for products compliant
raising tools that could be explored in the country to with Sharī’ah standards. In the Philippines, the
fund various projects including infrastructure Sukūk Muslim population accounts for 10.0% of the total
could be used to fund economic activities in which population.
48
In terms of Islamic finance development thus far, the Sharī’ah advisor assist the PSE could be efficient
PSE has an Islamic index calculated by Standard from a timing perspective, to help the PSE achieve
& Poor’s. It has also engaged a Sharī’ah advisory its short-term objectives. Government support is
consultant, Ratings Intelligence, to provide guidance also an important factor as regulatory facilitation is
on different standards and practices. The PSE necessary to remove arbitrage, tax inequalities, and
has conducted market education and awareness other national coordination.
campaigns to educate the public on Islamic finance,
including organizing an industry briefing and a By 2015, the objective is to have an Association of
roundtable on Islamic finance. The PSE requested Southeast Asian Nations (ASEAN) integrated finance
the assistance of the National Commission of community, to which the ASEAN finance ministers
Muslim Filipinos, a government entity, to form a have committed. The private sector is very much
technical working group, composed of the insurance aware not only that rationalization of regulations is
commission, the central bank, the tax authority, the needed but also that, from a business perspective,
securities commission, the Institute of Islamic Studies the competitiveness of the Philippine capital market
of the University of the Philippines, and the only would be very critical because the financial markets
Islamic bank in the Philippines, Al Amanah Islamic will be integrated.
Bank. The objective of the technical working group
is to pave the way for a Sharī’ah-compliant stock Despite the lack of a legal and regulatory framework,
screening. The end result is to have an identifier for the PSE has found a very pragmatic way to move
the stocks that are compliant with the standards of forward with some conflicting targets by the end of
Islamic finance. the year. There will be a list of Sharī’ah-compliant
equities, and by the second quarter of 2015, there
As for the challenges in the Philippines, the lack will be a Sharī’ah index of such equities. The PSE
of local Sharī’ah experts and limited numbers of is also pushing for a new law on Islamic finance,
Sharī’ah advisors are key issues. The Philippine in particular the equalization of tax treatment for
Islamic finance market is in need of training its own conventional and Islamic finance instruments.
experts. In this regard, having a general, reputable
Turkish Islamic Finance Experience
The Turkish participation (as Islamic finance is referred to in Turkey) sector is rapidly emerging as a frontrunner
in the global Islamic banking industry. The Partnership Banks Law No. 5411, approved in November 2005,
paved the way for the development of the country’s participation banking industry (see Table 4.1 for Islamic
banking sector statistics).
Table 4.1: Turkish Banking Sector Key Statistics (H1 2014)

Assets Loans Deposits
Type Number (TL billion) (% share) (TL billion) (% share) (TL billion) (% share)
Depository 32 1,579.0 89.9 974.7 89.0 917.6 93.5
Development and 13 76.8 4.4 58.7 5.4 - -
Investment
Participation 4 100.2 5.7 61.7 5.6 63.9 6.5
Total 49 1,756.0 1,095.1 981.5
– = These are specialized financial institutions that do not raise deposits from public.
Source: Central Bank of Turkey, KFH Research.
49
There are also a growing number of sovereign Sukūk commitment to the global Sharī’ah-compliant
benchmarks that are encouraging corporations to finance industry. As at the first half of 2014, the
issue securities, thereby deepening the country’s volume of Turkish Sukūk outstanding amounted to
capital market and liquidity flows. Sukūk (or $7.6 billion, representing a tremendous exponential
participation/lease certificates as they are known jump since the country’s first issuance in 2010 worth
in Turkey) have attracted considerable interest (see $100 million (see Figure 4.8) by Kuveyt Türk.
Figure 4.7) in the Turkish capital market since the
issuance of the country’s first sovereign Sukūk in As the holistic participation finance sector expands
September 2012. The Government of Turkey’s in the country on the back of firm regulatory support,
inaugural $1.5 billion sovereign Sukūk in 2012 participation banking is expected to also benefit in
sent investors a clear signal about the country’s tandem with the overall sector’s expansion in assets.
Figure 4.7: Figure 4.8:

Sukūk Issuances in Turkey (2010–H1 2014) Sukūk Outstanding in Turkey (2010–H1 2014)
4,500 8,000 7,583.0

{69.3%}
4,000 CAGR (2010–2013): 276.3%
7,000
3,500
6,000 5,326.4
3,000
{587%} 5,000
$ million
$ million
2,500
4,000
2,000
1,500 3,000
1,000 2,000 1,354.6
500 {250%} 1,000 450.0
100.0
0 0
2010 2011 2012 2013 1H14 2010 2011 2012 2013 1H14
CAGR = compound annual growth rate, H = half.
Note: Figures in { } indicate year-on-year change in annual issuances.
Source: Bloomberg, IFIS, Zawya, KFH Research.
In terms of the regulatory framework, Turkish the Turkish domestic Sukūk market has seen $200
Islamic financial services are regulated by three million issuances which were made by three issuers.
separate regulators. The participation banking Turkish Treasury has also issued sovereign revenue-
sector is regulated by the Banking Regulation and indexed bonds (RIBs), with two issuances per year.
Supervision Agency, the Sovereign Sukūk market Returns on sovereign RIBs are indexed to revenues
falls under the purview of the Turkish Treasury while of state-owned enterprises. Currently, RIBs do not
other capital market instruments and products (e.g., hold too much attention and not all participation
equities) are regulated by the Capital Markets Board banks invest in sovereign RIBs as these securities are
of Turkey (CMB). This fragmented approach allows not suitable for their mandate. The treasury ended
each regulator to focus on their own objectives and the RIB program in early 2012 and launched the first
duties without being exposed to overall reputation sovereign Sukūk in September 2012, followed by the
and contamination risks of other sectors. second sovereign Sukūk in October 2013. The two
issuances amounted to $2.75 billion. In addition, the
Turkish Islamic capital markets are still in their infancy. treasury has issued two domestic Sukūk amounting
However, there have been some cross-border to $1.7 billion.
issuances amounting to $1.2 billion. In addition,
50
The aim of the issuance is to promote the Islamic there is no trust mechanism in Turkish law which is
financial market in Turkey and create a benchmark based on codified civil law, an ALC is designed as a
curve for the upcoming private sector issuances. joint stock corporation with minimum requirements.
This also underlines the government support and
policy on Islamic finance policy in Turkey. These In early 2011, major tax exemptions were granted
are vital to encourage the development of a Sukūk for issuers and investors. The CMB has levelled the
market in the relevant country. registration fee imposed on Sukūk issuances. In
mid-2012, an amendment was made to the Public
At this this point in time, there is strong support from Finance and Debt Management Law in order to
the government and the state institutions regarding smooth the way for sovereign Sukūk issuances,
the sovereign issue. The upcoming third Bosphorus which was immediately followed by the first Turkish
bridge project and other highways may be financed sovereign Sukūk issuance by the Turkish Treasury
by sovereign Sukūk issuances according to latest worth $1.5 billion.
announcements by the government.
Following these improvements in the Turkish Sukūk
To this end, Sukūk issuers have enjoyed more market, a new Capital Market Law was published in
favorable pricing in Turkey compared to conventional late 2012 and put into effect on 30 December 2012.
instrument issuers globally. Various factors have An ALC is counted as a “capital market institution,”
contributed to this phenomenon. For instance, that is, it is regulated and supervised by CMB, giving
robust regulatory frameworks contributed to the extra protection and confidence to investors.
growing trend of Sukūk issuances. In comparison to
their conventional counterparts, the inherent nature Following the new law, a new Sukūk regulation has
of the involvement of assets and project financing been prepared, taking into account both new law
has been a positive feature of Sukūk and contribute provisions and demands expressed by the private
to their favorable issuance terms. A strong demand sector. The new Sukūk regulation, Communique No.
for Sukūk has also been a main driver of competitive III-61/1, was enacted in June 2013.1
pricing.
There were some limitations in the first Sukūk
Regulatory Framework for Turkish Sukūk Market regulation so that only Ijārah Sukūk was regulated.
The old regulation was based on transfer of an asset
The development of the regulatory framework and issuers eventually ran out of assets. Furthermore,
for Turkish lease certificates has notably evolved eligible underlying assets were constrained to
over the past few years starting 2010. The first tangible goods, property, and intangible assets.
Sukūk regulation was introduced in 2010 by the Some early challenges in Turkey included lack of
CMB regarding lease certificates (see Figure 4.9) a trust mechanism, of tax neutrality, and of a legal
and asset lease companies. This regulation was framework. Today, these have all been overcome.
designed basically to enable interest-free financing The old Sukūk regulation was mainly designed to bring
and investment in capital markets and therefore about an “interest-free bond” structure into Turkish
regulate the most popular and basic Sukūk type of capital markets. Hence, it was crucial to create a
its time: the Ijārah Sukūk. level playing field for Ijārah Sukūk with conventional
products. In order to resolve the tax inequalities
The regulation also introduced the establishment of between Ijārah Sukūk and conventional bonds, a law
an asset lease company (ALC) as an issuer to fulfill granting specific tax exemptions granted for lease
a special purpose vehicle’s role for issuances. Since certificates was enacted in February 2011.

1
For the text of the regulation, see www.cmb.gov.tr/apps/teblig/displayteblig.aspx?id=473&ct=f&action=displayfile
51
Figure 4.9: Development of the Regulatory Framework for Turkish Lease Certificates
2010 2011 2012 2013

• First Sukūk • Tax • New Capital • New CMB
regulation inequalities Market Law Sukūk
introduced: compared to put into effect regulation
Communique conventional regulating the introduced:
No: III/43 products ALC and lease Communique
(Ijarah Sukūk) solved certificates No: II-61/1
• Asset lease • Law (new Sukūk
company (ALC) amendment structures)
introduced as done to enable
an SPV sovereign
Sukūk
issuances
SPV = special purpose vehicle; CMB = Capital Markets Board of Turkey.
Source: Presentation (Capital Markets Board of Turkey).
The following are the main points regulated in the new Capital Market Law regarding Sukūk and ALCs:
• All kinds of assets and rights can take place in • In the event that the issuer cannot fulfill its
the portfolio of an ALC. In other words, an ALC obligations arising from Sukūk in due time, its
can issue lease certificates based on all kinds of management is transferred to a designated
rights without any limitations. public institution, its permission of activity is
• An ALC cannot deal with any other activity except cancelled, or it goes bankrupt, the income
the ones indicated in its articles of association generated from the assets in its portfolio shall
and no real rights may be established in favor be used primarily in the payments to be made to
of third persons on the assets and rights it Sukūk holders. The CMB is authorized to take all
holds except those permitted in its articles of kinds of measures for the purpose of protecting
association. the rights of Sukūk holders.
• An ALC cannot lease or transfer these assets • The CMB has the authority to determine
and rights against the interests of lease certificate principles and procedures concerning the
holders. Until lease certificates have been establishment of an ALC and its articles of
redeemed, the assets and rights taking place in association, activity principles, types and
the portfolio of an ALC cannot be pledged other qualities of the assets and rights an ALC can
than for the purpose of collateral, cannot be put take over and the keeping of the records related
up as collateral, cannot be attached even for the to them, and ALC management, liquidation, and
purpose of collecting public receivables, cannot termination principles.
be included in the bankruptcy estate, and
cannot be subject to any cautionary injunction
even when the management or audit of the
issuer is transferred to a public institution.
52
Figure 4.10: Regulated Sukūk Structures
Management agreement
Ownership based Sukūk
based Sukūk Partnership based Sukūk
(Ijārah/Wakālah)
(Ijārah/Wakālah) (Mudārabah/Mushārakah)
Recourse to underlying
No recourse to underlying
assets.
Purchase and sale based Contractor Agreement

Sukūk (Murābahah) based Sukūk (Istisnā) Combination of Sukūk
Recourse to underlying
Other Sukūk Types
The lease certificates designed and the Sukūk ALC may issue different Sukūk at a given time. The
structures include but are not limited to the following: new regulation, therefore, specifies that all rights
and responsibilities relating to these underlying
• lease certificates based on ownership (Ijārah assets and rights are to be monitored and reported
(see Figure 4.10) or Wakālah Sukūk – true sale) separately for each issuance. This will effectively
• lease certificates based on management eliminate the commingling risk with regard to an
agreements (Ijārah or Wakālah Sukūk) ALC’s assets.
• lease certificates based on partnership
(Mushārakah and Mudārabah Sukūk) For lease certificates based on ownership or an
• lease certificates based on purchase and sale independent contractor agreement (Ijārah/Wakālah
(Murābahah Sukūk) – true sale or Istisnā), the issue amount has been
• lease certificates based on contractor restricted to 90.0% of the underlying asset’s fair value.
agreements (Istisnā Sukūk) Circumstances that necessitate the determination
• combination of those mentioned above and any of the market value of assets and rights are stated
other structure accepted by the CMB. clearly and must be as per International Valuation
Standards by appraisal firms approved by the CMB.
The CMB issuance fee is also lowered for Sukūk Meanwhile, in order to prevent conflict of interests
issuances to offset inherent costs associated with between an ALC and the originator, an independent
underlying transactions which do not exist when board member requirement has been introduced for
compared with conventional debt instruments. voting on critical decisions.
In the new regulation, the “one ALC one issue rule” For lease certificates based on management
has been annulled since the new law gives the agreements and purchase and sale, originators can
CMB the authority to determine types and qualities only be companies eligible to create an ALC by the
of the assets and rights an ALC can take over and regulation and determination and use of market
keeping of records related to them. Therefore, an value of assets and rights have been broadened.
53
Figure 4.11: Eligibility for Creating Asset Lease Companies
REITs
Banks
Listed companies
Eligible to
Investment firms Eligible only
finance
with broad to finance
themselves
authorization themselves
and others Corporations with
an investment
grade rating
Mortage
finance
corporations State-owned
enterprises
REIT = real estate and investment trust.
The sponsors of an ALC have been broadened since These decisions may be defined in articles of
an ALC is counted as a capital market institution in association or on a case-by-case basis under CMB
the new law. According to the regulation, an ALC can oversight.
be founded by banks, investment firms of a certain
capacity, or mortgage finance corporations. These There are two types of securities that can be
are eligible to finance themselves and others, while designed as Islamic financial instruments in Turkish
the following are eligible only to finance themselves capital markets. These are asset-backed securities
(see Figure 4.11): and real estate certificates. According to the
regulation of asset-backed securities, an “asset
• listed real-estate investment companies, finance fund” must be created and the assets must
• first and second group corporations as defined be transferred from the originator to the fund’s
in the CMB’s corporate governance regulations, portfolio. On the other hand, asset-based securities
• corporations with an investment grade rating are debt securities secured by the assets in the fund
note, and portfolio.
• Treasury subsidiaries.
Fund assets may comprise the following:
In some cases, a conflict of interest between
investors and the originator may occur. In order to (i) Receivables arising from consumer loans other
protect the investors and prevent such conflicts of than residential mortgage loans, commercial
interest, the new regulation has some provisions, mortgage loans, vehicle loans, project finance
including the following: loans, and business loans given by banks and
finance companies
• There must be an independent board member (ii) Receivables arising from lease agreements
in an ALC. made by the authorized institutions
• One board member must have a Capital Market (iii) Receivables arising from sale of real estate
Activities Advanced Level License. properties belonging to the Housing
• Important decisions are tied to the independent Development Administration of Turkey
board member’s affirmative vote.
54
(iv) Any cash equivalent short-term investments aimed at investing the proceeds of the assets in the fund
portfolio
(v) Assets in the reserve accounts
(vi) Other assets approved by the CMB
The real estate certificate is a security issued by the issuers to finance real estate projects to be constructed
or in the process of being constructed. Redemption of real estate certificates by the issuer can be done in two
ways: The investor may be redeemed in exchange for a property from the real estate project or for fair value
of the real estate certificate determined by a valuation report.
Overall, the participation finance sector is set to flourish in the near future, driven primarily by encouraging
initiatives undertaken by the Turkish authorities and the rising demand for participation-structured financial
products and services inside the country. Turkey’s growing linkages with major Islamic finance hubs—such as
Malaysia and those in the GCC—promise to present additional growth opportunities for participation financial
institutions by helping them leverage on cross-border expertise.
Turkey is internationally recognized as being one of the top emerging markets and has a dynamic and growing
economy which offers a wide range of promising investment opportunities. Especially in terms of capital
markets, Turkey has a great potential. Thus, in compliance with national efforts to expand the securities
market in Turkey, developing the Islamic side of the capital markets is also very crucial in terms of diversifying
the range of products—and more importantly to reach more investors nationally and globally. The new Sukūk
regulation has moved the Turkish private Sukūk market one step forward. The CMB continues to work with
the industry to set high regulatory standards and create resilient Sukūk models.
55
Chapter 5
Implementation of Global Prudential
Standards for the Islamic Financial
Services Industry
Zahid ur Rehman Khokher
Mohd. Sani Mohd. Ismail
Implementation of Global Prudential Standards
for the Islamic Financial Services Industry
Supervision of the Finance Sector and Unique Risks in the Islamic Finance Sector
Macro- and Microprudential Approach to Finance Sector Supervision
This chapter attempts to address important aspects unpublished documents of the Cooke Committee,
of implementation of the global prudential standards which was the precursor to the Basel Committee on
for the Islamic financial services industry. The theme Bank Supervision (BCBS). After the global financial
of the chapter corresponds to the ultimate objective crisis, which later transformed into a broad-ranging
of the implementation of prudential standards economic crisis, the term has seen a revival among
prepared by the Islamic Financial Services Board regulators and policy makers, and there is now wider
(IFSB) which is to enhance the soundness and agreement on its relevance. Macroprudential refers to
stability of the Islamic financial services industry (IFSI) an approach with explicit consideration of the threats
and the financial systems where institutions offering to the stability of the financial system as a whole.
Islamic financial services (IIFS, also referred to as In essence, the macroprudential approach looks at
“Islamic banks”) operate either fully or side by side the financial system as a single portfolio. Indicators
with their conventional counterparts. Overall, the used in macroprudential analysis include data on
chapter discusses various perspectives, including capital adequacy, leverage, asset quality, liquidity,
approaches to finance sector supervision, key risks and sensitivity to systematic risks and degree of
in the Islamic finance sector, an overview of the correlation or linkages in the financial system.
IFSI, the development of supervisory and prudential
standards, concerted implementation efforts to This approach differs from the microprudential
promote the adoption of standards, and the nature approach in that the latter is primarily concerned with
of support multilateral development banks can risk assessment of individual financial institutions.
provide to facilitate this objective. The Warwick Commission (2009, p. 12) summed the
distinction best in its publication: “microprudential
Without going into detail on the cause of the global regulations examine the responses of an individual
financial crisis, two key observations can be derived. bank to exogenous risks. It does not incorporate
First, the stable inflation path as achieved over a endogenous risk, and it neglects the systemic
quarter century prior to the crisis was insufficient to implications of common behavior.” The distinction
preserve financial stability. Stable inflation is important is important because both conceptually and in
but not sufficient. Second, the macroeconomy practice it is possible to have a situation where
and financial system are not necessarily self- the risk management of individual institutions is
correcting. This leads to a focus on strengthening deemed acceptable, but these risks may collectively
the regulatory systems in order to achieve the create systemic instability. This is especially true
objectives of financial and macroprudential stability. in the case where risk may be multiplied through
In particular, there is a consensus that the regulation collateralized debt obligations, which may then lead
and supervision of financial institutions need to go to a concentration of risks at the systemic level, yet
beyond a microprudential perspective and adopt a which may not be evident if regulators are to just
macroprudential orientation.1 assess risk at the individual institution level. In fact,
microprudential regulations on their own may make
The term “macroprudential” is not new (Clement a bad situation worse by creating a domino or spiral
2010). In fact, it was first used in the late 1970s in effect that leads to systemic instability. An example

1
Source: Borio C. (2011); Central banking post crisis: What compass for uncharted waters? BIS Working Papers No. 353
58
is when individual banks sell off toxic assets, which co-risk model, distress dependence matrix, and the
may be recommended using the regulatory matrix default intensity model (IMF 2009).
often prescribed by a microprudential approach
(University of Warwick, 2009). However, there can The International Monetary Fund (IMF) describes the
be no sellers without buyers and when major banks co-risk model as a methodology that “draws from
are selling the same class of toxic assets, what is market data, but focuses on assessing systemic
deemed prudent on an individual level may lead linkages at an institutional level.” (IMF 2009, chapter 2,
to systemic risk. It is therefore understandable p. 2) Figure 5.1 shows how using the co-risk model
then that the Bank of England (2009) described would have identified the degree of linkages of the
macroprudential policy as the missing piece of financial institutions. This would have then made it
the jigsaw between macroeconomic policy and clear that failure of the companies in the center of
the regulation of individual financial institutions the diagram would set off cascading consequences
(microprudential regulations). affecting all other institutions and ultimately the
financial system. This gave rise to the phrase “too
Since the global financial crisis, regulators of connected to fail” instead of the conventional “too big
the financial system have developed several to fail.” The risk linkages may not have been captured
methodologies to assess finance sector linkages. using a traditional microprudential approach.
The four most often cited are the network approach,
Figure 5.1: Co-Risk Model
94
142
Lehman 204
Brothers Wachovia Wells Fargo
180
155 158 204 490
176 163
Merrill Lynch Bear Stearns Morgan Stanley
441 155
246 97
135 102 103
154
Bank of 456 390
AIG Citigroup
America
117 114
136 466
JPMorgan
Goldman Sachs Chase & Co.
Source: Bloomberg, LP.; Primark Datastream; and IMF staff estimates.
59
However, this is not to say that macroprudential revised capital adequacy, and revised supervisory
regulations are the silver bullet for financial regulations review process. To fully appreciate the importance of
and that the microprudential approach is irrelevant. implementing the IFSB prudential standards (covering
On their own, they are necessary but not sufficient both macro- and microprudential aspects), it is critical
for effective financial regulations. The international to understand the different types of risk in Islamic
consensus, including the Bank for International finance.
Settlements (BIS) and the IMF, has described them
as complementary and not substitutes. In fact, the Risks in Islamic Finance Transactions
modern regulator needs various tools from regulatory
to supervisory and enforcement to regulate the Islamic finance generally has been less affected by
financial system in a prudent manner. In the IMF the global financial crisis compared to its conventional
Executive Board’s discussion on macroprudential counterpart. This was largely because Islamic finance
policy, the board welcomed the analysis of had limited exposure to structured products such
interactions between macroprudential policy as collateralized debt obligations (CDO) and credit
and other policies and highlighted that effective, default swaps (CDS) which undermined conventional
macroprudential policy needs to be complemented finance. There are features of Islamic finance that
by appropriate monetary, fiscal, and other finance make it potentially more stable and more resilient in
sector policies which are to be supported by strong facing unexpected economic circumstances. This
supervision and enforcement (IMF 2013). is provided that Islamic finance stays true to its twin
tenets of materiality or validity of transaction and
The question then is: How does this consensus affect mutuality of risk sharing. The former means that
Islamic finance? Has Islamic finance developed to a transactions in Islamic finance must be backed by
stage that it can be considered to be systemically genuine trade and business transactions and not just
important if not on a global scale then at least for transactions on paper. There is a one-to-one mapping
some countries? Although comparatively the IFSI only of financial transactions with the underlying asset (IFSB
represents approximately 1.0% of global assets, the 2010). This principle would disqualify contracts and
annual growth rate of approximately 20.0% since 2000 transactions such as CDOs as the underlying asset
underlines its significance. In terms of global assets, would just be multiple layers of securitized debt, such
Islamic finance grew from $1.5 trillion at the end of that the real asset is far removed from the investor.
2012 to an estimated $1.8 trillion by the end of 2013. Further, a clear distinction between conventional
This means that Islamic finance assets grew at an bonds and Sukūk is that unlike conventional bonds,
estimated compound annual growth rate of 17.04% Sukūk represent more just than the credit risk of the
during 2009–2013. IFSI assets are expected to surpass issuer, but also an ownership stake in a project which
the $2 trillion mark in 2014.2 In summary, Islamic was funded by the investors buying the Sukūk. This
finance is now too large to ignore and, in a number principle was emphasized by the Accounting and
of countries, is approaching systemic importance. Auditing Organization for Islamic Financial Institutions
Thus, the reasonable approach would be to develop (AAOIFI) in 2008 pronouncing that, “Sukūk, to be
the macroprudential framework to complement the tradable, must be owned by Sukūk holders, with all
existing microprudential tools in Islamic finance. It is rights and obligations of ownership, in real assets,
apt that the majority of the standards issued by the whether tangible, usufructs or services, capable of
IFSB since 2012 have focused on developing both being owned and sold legally…” (AAOIFI Statement
the micro- and macroprudential framework including on Sukuk, February 2008).
standards on liquidity risk management, stress testing,
2
All statistics are obtained from the IFSB’s Islamic Financial Services Industry Stability Report 2014. Further details on growth and
development of Islamic finance are provided in the section “Growth Dynamics of the Islamic Financial Services Industry.”
60
The second principle, mutuality of risk sharing, simply liquidity risk, (v) rate of return risk, and (vi) operational
means that Islamic finance encourages risk sharing risk including governance and inadequate internal
between the financial institution or entrepreneur and controls. Unique risks to Islamic finance include
investors. Profit in dollars and cents are not to be disproportionate exposure to real estate assets,
declared upfront; distribution of profit is based on and an overreliance on commodities in structuring
the real outcome of the entrepreneurship. The two contracts may affect IFIs’ balance sheet when there
most popular partnership contracts are Mudārabah is significant movement in the price of commodities.
and Mushārakah. If a Mudārabah transaction suffers
a loss, then the capital providers lose their capital The next section does not seek to cover all the
whereas the entrepreneurs lose their time and different types of risks in Islamic finance.3 See Figure
effort. The entrepreneurs are not liable for the loss 5.2, which summarizes the risk into six categories.
of capital unless the loss is a result of negligence There are of course other ways to categorize
or fraud. In Mushārakah contracts, any loss is the risks, including (i) financial, (ii) operational, (iii)
distributed according to the ratio of investment. This business, and (iv) event risks.
principle that ties the distribution of profit or loss to
Figure 5.2: Types of Risks in Islamic Banking
the actual outcome of the transaction, provided that
Transactions
they are accompanied by proper due diligence and
disclosure, reduces the risk to all parties.
Credit Risk in Risk of losses based on default of the
Sales-Based borrower or deterioration of borrower’s
Empirically, there is some evidence that Islamic Contracts payment capacity
finance fared better than the conventional system
during the financial crisis of 2008–2009. For Equity
Depends on bank’s equity exposure
example, while the assets under management Risk
(AuM) in the global mutual fund industry dropped
by 27.0% in 2008 ($19 trillion) from $26.1 trillion Same as conventional finance but
Market Risk and aggravated due to limited capital
in 2007, the AuM of the Islamic fund management Rate of Return market products especially for
industry actually grew during the same period Risks hedging purposes
from $48.7 billion in 2007 to $51.4 billion in 2008
(Ernst & Young 2010). However, Islamic finance is Limited availability for Sharī’ah compliant
Liquidity Risks money market instruments and lender
not immune to risks, including unique risks peculiar of last resort facilities
to the sector. There are after all several examples
of Sukūk defaults, such as those involving East
Governance, inadequate internal
Cameron Partners in the United States, Investment Operational Risks controls, and conflict of interest.
Dar in Kuwait, and the Saad Group in Saudi Arabia.
There was also the prominent case of near default
Additional Risks:
of the Nahkeel Sukūk in Dubai totaling $3.5 billion. • Contracts dependent on commodities subject Islamic
Adverse market conditions, credit crunch, and asset finance to movement in commodity prices –Price of oil
and commodities impact IFIs balance sheets
bubble deflation coupled with unique risks such as • Disproportionate exposure to real estate
sectoral concentration in real estate assets posed
significant challenges to Islamic finance. The risks
IFI = Islamic finance institution.
can be categorized as follows: (i) credit risk in sales-
Source: Based on Karim and Archer (2007).
based contracts, (ii) equity risk, (iii) market risk, (iv)

3
Karim and Archer (2007) provides a detailed explanation of all categories of risk in Islamic finance.
61
Before delving further, a qualifier needs to be The focus of the next subsection is on Mudārabah
added. It was noted earlier that one of the risk risk and liquidity risks as these are peculiar and
mitigation features of Islamic finance is risk sharing particularly relevant to Islamic finance and merits
through either Mudārabah or similar equity-based closer analysis. Understanding these risks will also
contracts for mobilization of funds. A Mudārabah demonstrate the importance of implementing the
contract, in particular when used as a substitute IFSB standards.
for a conventional deposit, has the potential to
minimize the risk for financial institutions as they are Risks in Managing Profit-Sharing Investment
not obligated to provide a fixed amount of return Accounts
or dividend in conventional finance to depositors.
This replaces interest-based financing with mutual As noted earlier, Islamic banks can structure
risk sharing. Taken this way, fund providers (called Mudārabah contracts, in particular unrestricted
investment account holders or IAH) are treated akin investment accounts, as substitutes for a
to investors and the “deposit” is commonly known in conventional deposit. Using this type of contract, the
Islamic finance as a profit-sharing investment account banks take on the role of Mu arib (working partner)
(PSIA). Investors have the option of investing either and the depositors are considered Rabb-ul-Mal
in a restricted investment account which resembles (capital provider) and referred to as IAH. The returns
a mutual fund or in an unrestricted investment they get should in theory depend on the profit of the
account which resembles a conventional deposit investment made by the Islamic banks. However, in
where the financial institution is given discretion in reality, Islamic banks face competitive pressure from
their investment-making decision so long as they their peer Islamic banks and, in a country with a dual
are Sharīàh-compliant. Mushārakah contracts, on banking system, from other conventional banks as
the other hand, where both parties provide capital well. In fact, for conventional banks which operate
for a particular entrepreneurship is a good model an Islamic window as part of their operations the
for venture capital where the angel investor or competitive pressure is within the same entity. If
venture capitalist can provide the seed capital and Islamic banks provide a lower rate of return, then
the entrepreneur shares some of the financial risk investors may decide to withdraw their investments
by also contributing some capital. Since the exact and place them in another Islamic bank. With the
amount of profit is not determined upfront and the exception of those who are investing out of religious
loss is distributed based on capital contribution of conviction, others may even withdraw and deposit
each party, this should lead to sound due diligence. their capital in a conventional bank offering a higher
dividend rate. This happens especially in jurisdictions
However, upon closer inspection of the portfolio of that do not have a working Sharīàh-compliant
Islamic banks, it is evident that the percentage of deposit insurance scheme, where the IAH under
these risk-sharing contracts in their portfolio is limited the Mudārabah contract is exposed to capital loss.
compared to contracts based on sale for profit. Therefore, Islamic banks that adhere strictly to the
Statistics show that Islamic banks prefer Murābahah principles of a Mudārabah contract could potentially
contracts (sale for profit) which can be used for face mass withdrawal, which in extreme cases can
retail financing, with figures of up to 41.0% of their lead to a bank run. There may also be supervisory
portfolio, compared to risk-sharing instruments such pressure from the regulator for the bank to set
as Mudārabah and Mushārakah, which only stand at aside funds to smooth the profit payout to the IAH
11.0% and 12.0%, respectively (Karim and Archer (Sundararajan 2010).
2007). There are of course legitimate reasons for
this. Regardless, it does suggest that the mutuality
of the risk-sharing principle is not popular at least in
Islamic banks.
62
This has led to a practice common among Islamic the technique of PER, which mitigates this risk, there
banks known as smoothing the profit payout to are still reasons for concern, especially for the IAHs.
IAHs. This practice, in certain ways, resembles
the income smoothing in accounting terms, which Chief among them are disclosure, corporate
means the use of accounting techniques to level out governance, and what is known as intergenerational
net income fluctuations from one period to the next.4 transfer.7 On disclosure, the same survey showed
Some examples of income-smoothing techniques that some banks do not reveal the extent of profit
include deferring revenue during a good year or smoothing in their annual reports and to their IAHs.
delaying the recognition of expenses in a difficult Aside from the issue of transparency, this creates
year because performance is expected to improve a two-fold problem for the IAH. First, unlike the
in the near future. IFSB Guidance Note 3 (Practice of shareholders, the IAHs do not have an avenue to
Smoothing the Profits Payout to Investment Account provide express approval (or disapproval) when a
Holders) (GN-3) covers this practice in detail. This portion of their profit is set aside in the PER. Hence
part will only cover the four techniques practiced by in the absence of disclosure, the IAHs will be left
Islamic banks in brief: completely unaware that a portion of their profit is
being withheld in the PER for the future. Second, the
(i) Reducing the profit of the bank as Mu arib nondisclosure of profit smoothing may also create
(ii) Transferring from shareholders’ current or an artificial impression that the investment is making
retained profits to an IAH subject to shareholder returns in line with the expectations of the IAH when
approval in truth the investment is underperforming. The issue
(iii) Profit equalization reserve (PER), where a certain of corporate governance is potentially even more
amount from the investment profits is set aside serious. The establishment of a PER mechanism
before allocation among the shareholders (especially if not disclosed) has the potential to
and the IAH and the calculation of the bank’s negatively affect the IAH while benefiting the bank
Mudarib share of profits and their shareholders. In effect, the IAHs are sharing
(iv) Investment risk reserve, where a reserve is in the reduction of profit that would otherwise only
maintained by setting aside amounts from the be shouldered by the bank and its shareholders, had
investment profits attributable to the IAH, after they smoothed the profit using the first and second
deducting the bank’s Mu arib share of profits to techniques described, especially as IAHs do not
cover losses of the capital invested by the IAH.5 have a vote on forgoing a portion of their profit and
the establishment of the PER. Even if such terms are
An IFSB survey supported through ADB’s technical included in the Mudārabah contract signed upon
assistance program demonstrated that the practice opening of the account, these terms are likely to
of smoothing is indeed prevalent among Islamic be general, vague, and not ones clearly explained
banks, in particular the first three techniques to the IAHs. This then creates a conflict of interest
outlined (Sundararajan 2010). In the case of the for the bank in its role as Mudarib and may affect
first and second techniques, where risk of return is its fiduciary obligation to protect the investments of
transferred from the IAHs to the bank, this may lead the IAH.
to displaced commercial risk.6 Even when banks use

4
However, in Islamic banks, the objective and techniques adopted for smoothing profit payouts have some conceptual differences with
the accounting term for income smoothing.

5
Some definitions are taken from IFSB Guidance Note 3.

6
Displaced commercial risk is covered in detail in the IFSB Standard for Institutions (Other Than Insurance Institutions) Offering Only
Islamic Financial Services (IFSB-1), Guidance Note 3 and 4.

7
IFSB Guidance Note 3 covers other issues of concern, including liquidation, capital adequacy, and harmonization.
63
Finally, as in any pooling of funds over a time period, assets were sold and financial institutions that had
there is always an issue with intergenerational transfer. very thin liquidity ran for capital. When the interbank
Put simply, this means that an IAH who forgoes a market locked up, the crisis became systemic.
portion of the profit in a given year may not benefit Without liquidity, banks may face a run, which will
from the smoothing of profit through PER if the IAH have an adverse effect in the real sector as banks
is a short-term investor and withdraws his or her provide financial intermediation for businesses and
investment before the use of the PER. Often, the IAHs retail customers. Such is the importance of liquidity
are asked to agree, upon signing of their contract, management that many international organizations
to forfeit their claim to the PER if they withdraw their such as the Financial Stability Board and the BCBS
investment. While it is also possible that a new IAH have issued guidelines and standards for liquidity
may benefit from profit smoothing from the PER to risk management. One of the Group of Twenty’s
which the IAH did not contribute, one IAH’s gain does medium-term recommendations on prudential
not justify the loss of another IAH. oversight states: “Supervisors and central banks
should develop robust and internationally consistent
IFSB Guidance Note 3 provides some guidance approaches for liquidity supervision of and central
to supervisory authorities on supervision of profit bank liquidity operations for cross border banks”
smoothing. These include (i) the board of directors (Statement from G20 Summit, Washington, 15
playing an oversight role and paying due attention November 2008).
to the bank’s policies on displaced commercial risk
and smoothing of profits with particular attention on Liquidity risk is equally relevant to institutions
the bank’s fiduciary duty to the IAH; (ii) the setting offering Islamic financial services (IIFS), especially
up of a Governance Committee as recommended due to the limited Sharīàh-compliant money
in IFSB-3 (Corporate Governance Standards), to market instruments. Despite the growth in
safeguard the interest of the IAH, in particular where Sharīàh-compliant financing, cross-border
there is a conflict of interest; (iii) adequate and proper Sharīàh-compliant liquidity management remains
disclosure of the practice; and (iv) clear terms and a challenge and short-term Sukūk issuances are
conditions to be incorporated in the PSIA contract in short supply given that the majority of Sukūk in
and in a language that can be comprehended by an the market are not suitable for efficient Sharīàh-
average reasonable person.8 While there is no one- compliant liquidity management either due to tenor
size-fits-all solution, the supervisory authority should or currency mismatches, nontradability or lack of
pay due attention to these guidance and related rating, or a combination thereof (see Figure 5.3
recommendations in the IFSB standards. After all, showing insufficient short-term Sukūk for liquidity
investor protection is one of the key functions of a management). Other instruments that are available
supervisory authority. for liquidity management carry large transaction
costs due to complicated structures, and are not
Liquidity Risk sufficiently flexible in a systemic crisis. The closest
alternative available is central banks’ short-term
The global financial crisis has highlighted liquidity Sukūk, which are not regularly issued in international
risk as a major source of concern. Market turmoil currencies. This problem is exacerbated by
emphasized the significant linkages between differences in Sharīàh interpretation, which
liquidity risk management, bank capital adequacy, makes certain contracts unacceptable in certain
money markets, monetary operations, and the jurisdictions. For instance, instruments based on Bai
importance of a systemic liquidity infrastructure. Ul Inah (sale and buyback agreement) and Bai Ul
The global financial crisis was exacerbated by a Dayn (debt trading) are not widely accepted across
combination of credit and liquidity shocks as toxic jurisdictions.
8
Detailed guidance can be found in Guidance Note 3
64
Figure 5.3: Insufficient Supply of Short-Term Sukūk for Liquidity Management
172
121
70
47
43 41
32 37 36
13 8 25
15
12 11 9 9 814 16
6 1 8 86 528 61 5 4
2 2 2
RM Others $ RM Others $ RM Others $ RM Others $

2009 2010 2011 2012
0–6 months 6 months–1 year 1–2 years 2–5 years >5 years
Note: Numbers indicate Sukūk issuances in different currencies by tenor.
Source: Bloomberg.
This places IIFS at risk during a credit crunch as they made the following recommendations to resolve the
do not have sufficient short-term assets to obtain aforementioned problems:
liquidity. The alternative of holding a higher percentage
of cash reserves is unsatisfactory in the good times as • Design Islamic money market and Islamic
it places Islamic finance institutions at a competitive government financing instruments with desirable
disadvantage compared to their conventional characteristics (i.e., relatively low risk, simply
counterparts and in turn will create pressure to match designed, regularly issued, widely held, and
the dividends offered by conventional banks, as supported by a robust payment and settlement
discussed earlier. The underdeveloped money market system).
and lack of available instruments also mean that IIFS • Incorporate Islamic government finance
instruments as an integral part of the overall
will have difficulty in complying with new international
public debt and financing program, and foster
standards such as Basel III, which require banks to
the development of an Islamic government
hold greater levels of high-quality liquid instruments
securities market.
issued by the public and private sectors, such as
• Actively use Islamic government finance
government securities as well as liquid corporate instruments in market-based monetary
instruments. In addition, the limited money market operations of the central bank to manage liquidity
instruments also hamper the central banks’ liquidity in the Islamic money market.
management since liquidity vis-a-vis IIFS can only be • Develop efficient trading arrangements and the
managed through transactions involving Sharīàh- associated market microstructure for Islamic
compliant money market instruments. money and government finance instruments, and
develop in parallel the foreign exchange markets.
In order to study the issues related to the Islamic • Provide supervisory guidance and incentives
money market and liquidity risk management, the for effective liquidity risk and asset liability
IFSB issued its Technical Note in March 2008, which management by IIFS, and foster in parallel
privately issued Islamic money market securities.
65
The IFSB also issued Guiding Principles on Liquidity which was endorsed by the IFSB Council in April
Risk Management for Institutions Offering Islamic 2010. ADB has supported the establishment of the
Financial Services (IFSB-12) in March 2012. IFSB–12 IILM through its participation in the task force and
delineates a set of guiding principles for the robust technical working groups. As of January 2014,
management of liquidity risk by IIFS and their the IILM Governing Board consists of the central
vigorous supervision and monitoring by supervisory banks and monetary agencies of Indonesia, Kuwait,
authorities, taking into consideration the specificities Luxembourg, Malaysia, Mauritius, Nigeria, Qatar,
of the IIFS, while complementing relevant international Turkey, the United Arab Emirates, and the Islamic
standards and best practices. Apart from specifying Development Bank Group.
the prerequisites of liquidity infrastructure, this
document outlines 23 guiding principles comprising Since its establishment the IILM has issued two
1 general principle, 14 guiding principles for the IIFS, 3-month A-1 rated Sukūk. The first issuance
and 8 guiding principles for supervisory authorities. amounted to $490 million in August 2013 and the
second amounted to $860 million in January 2014.
The guiding principles for the IIFS specify the As of June 2014, the first Sukūk ($490 million) has
structure of the liquidity risk management been reissued in November 2013, February 2014,
process and provide necessary guidance on the and May 2014, while the second Sukūk ($860 million)
identification, measurement, monitoring, control, has been reissued in April 2014. All issuances were
reporting, and mitigation of liquidity risk. Those for fully subscribed by IILM-appointed participating
supervisory authorities outline important elements dealers. The total amount of the IILM’s outstanding
of the supervisory framework to monitor the Sukūk as of January 2014 is $1.350 billion.9 Its fifth
liquidity positions and the liquidity risk management issuance was on 23 April 2014 worth $860 million.
framework of IIFS that include, among others, The IILM’s ability to reissue the Sukūk of August
initiatives for the development of a robust national 2013 and subsequently issuing four more Sukūk in
liquidity infrastructure, supervisors’ contingency 2014 should allay any concern of the IILM having
planning for IIFS, and supervisors’ role as provider of a one-off issuance. In its August 2014 issuance,
Sharīàh-compliant liquidity support to IIFS. the IILM lengthened maturities by auctioning $400
million in 6-month Sukūk.
An important development in liquidity risk
management in Islamic finance is the establishment Another source of concern is whether the Sukūk will
of the International Islamic Liquidity Management be actively traded in the secondary market. If the
Corporation (IILM). The IILM was founded on 25 primary dealers buy and hold the Sukūk, then the
October 2010 to address this constraint with instruments will not reach the hands of IIFS, which
the mandate to facilitate cross-border liquidity would not help IIFS liquidity management. While
management among IIFS by making available the IILM is planning an important pioneering role
a variety of Sharīàh-compliant instruments, on in support of liquidity management, there remains
commercial terms, to suit the varying liquidity the need for complementary action at the national
needs of these institutions. The establishment of level by sovereigns to meet the demand of IIFS
the IILM was based on the recommendation of the and to bring the market to a tipping point to begin
High-Level Task Force on Liquidity Management secondary trading.
9
Information obtained from press releases on the IILM website.
66
In early 2014, there was also an announcement by the Sukūk issuances comparable to that for issuances of
governments of the United Kingdom, Luxembourg, conventional bonds. Likewise, Luxembourg issued
and Hong Kong, China of their interest to issue Sukūk. its first 200 million euro ($254 million) 5-year Islamic
The United Kingdom issued its inaugural 5-year £200 bond in October 2014, becoming the first AAA-rated
million Sukūk in July 2014. Demand was very strong, government to issue euro-denominated sukuk.
with orders totaling around £2.3 billion. Similarly,
in September 2014, Hong Kong, China issued its While all these developments bode well for the
inaugural Sukūk, with an issuance size of $1 billion industry, the resolution of structural problems faced
and a tenor of 5 years, making it the world’s first US by the IFSI will need concerted efforts by stakeholders
dollar-denominated Sukūk originated by an AAA- in the multilateral development banks (MDBs).
rated government. The Sukūk saw strong demand The deliberations in this section also highlight the
from global investors, attracting orders exceeding importance of the IFSB’s role in providing guidance
$4.7 billion. The Sukūk issuance comes after the on liquidity risk management, aiming to enhance the
legislative changes made in Hong Kong, China in overall financial stability of the IFSI and make the case
July 2013 which provide a taxation framework for for why MDBs should support its work.
Preparation and Implementation of IFSB Prudential Standards
This section on the role of the IFSB and the been the key features of the development trajectory
implementation of the IFSB Standards begins with a of the IFSI. According to the IFSB Islamic Financial
brief discussion on the growth dynamics of the IFSI. Services Industry Financial Stability Report (2014),
This is followed by a discussion of the IFSB’s mandate total Islamic finance assets grew to an estimated $1.8
and objectives and an overview of its operational trillion by the end of 2013. Islamic banking remains
framework and progression of the standards from the the dominant sector within the IFSI with approximately
first- to second-generation standards. The dynamics 80.0% of total Islamic financial assets. The IFSI is
of standards preparation covering the due process estimated to chart a compound annual growth rate of
of the IFSB standards preparation are covered later. 17.04% between 2009 and 2013.
This due process outlines how the IFSB ensures that
various stakeholders of the IFSI are involved in various For the Islamic banking industry, the pace of growth
stages of the standards preparation. The progress has been moderating recently, but the average
of the IFSB standards implementation, covering the growth rate of more than 17.0% after 2009 is still
findings of IFSB standards implementation surveys impressive. Islamic banking assets are concentrated
conducted in 2011 and 2013 are also presented, in the Gulf Cooperation Council (GCC) countries
demonstrating how the results are fed into the and in Southeast Asia. However, some non-GCC
IFSB’s results-based Strategic Performance Plan Middle East and North African countries have
2012–2015. Finally, the implementation challenges experienced a rapid expansion in recent years or
and strategies to enhance the implementation of the made a new entry (Jordan, Yemen, Tunisia, Libya,
IFSB Standards are outlined and discussed, followed and Morocco) last year. On the other hand, the size
by a concluding section. of the Takāful industry is still too small to make a
significant contribution to the stability of Islamic
Growth Dynamics of the Islamic Financial banking.10 Regardless of regional differences, the
Services Industry further growth of Takāful would benefit not only from
awareness campaigns but also from the availability
In recent years, growth in the size and number of of more fixed-income investment instruments such
institutions, resilience, and geographic expansion have as Sukūk of longer tenures.

10
According to the IFSB Islamic Financial Services Industry Financial Stability Report (2014), the Takāful industry can, in principle, contribute
to the stability of the banking sector through a reduction of asset and credit risks; general Takāful compensates for a “deterioration” in
financed assets, and family Takāful protects families with outstanding financing amounts (such as home financing) against default in case
of an untimely death of the breadwinner.
67
Besides Islamic banking and the Takāful industry, Clauses 4 (a) and (b) of the IFSB Articles of
the Islamic capital market with long- and short-term Agreement state that the objectives of the IFSB,
Sukūk is also crucial for the IFSI. The Sukūk market among others, are to promote the development of a
is one of the fastest growing segments of Islamic prudent and transparent IFSI by introducing new or
finance with an annual growth rate of more than adapting existing international standards consistent
40.0% from 2005 to 2012. The Sukūk market does with Sharīàh principles, and recommending these
not exist in isolation as it is closely linked with the for adoption. In other words, instead of reinventing
global conventional capital markets. It is noted that the wheel, the IFSB actually builds on the wisdom of
conventional corporations are active in the Sukūk other international standard-setting bodies but adds
market both as issuers and investors, and the pricing value to the framework through a “cross-sectoral
of Sukūk is largely dependent on demand and supply approach” of financial regulation and additionally
in the global market for debt securities. This demand strict compliance with Sharīàh rules and principles.
and supply is largely influenced by monetary policy In this respect, the IFSB serves Islamic finance
in the United States (e.g., tapering its quantitative in a way that is comparable to its counterparts in
easing policy), which has reduced the demand conventional finance—the BCBS, the International
for both conventional bond and Sukūk issuances Organization of Securities Commissions (IOSCO),
in these markets, and, as a consequence, Sukūk and the International Association of Insurance
issuances—particularly corporate Sukūk—dropped Supervisors (IAIS).
significantly.
In addition to its primary mandate of issuing
Overall, growth of the IFSI will continue to be prudential standards and guidelines for the IFSI
supported by and helping the member jurisdictions implement
them, the IFSB Articles of Agreement also identify
• rapid geographical spread, beyond additional roles, which play a complementary role to
predominantly Muslim markets and jurisdictions; the principal mandate. These roles, which are part
• expansion of Islamic financial services beyond
of the objectives of the IFSB, include liaising and
the banking sector (i.e., into Takāful, capital
cooperating with relevant organizations currently
markets, and other sectors);
setting standards for the stability and the soundness
• emergence of Sukūk as one of the most
of the international monetary and financial systems
attractive of Sharīàh-compliant assets;
and those of the member countries. Similarly, the
• development of global Islamic financial
IFSB is expected to encourage cooperation among
infrastructure to ensure the resilience and stability
member countries in developing the IFSI and to
of the industry (e.g., IDB, IFSB, AAOIFI, and IIFM);
facilitate training and personnel skills development
• encouraging demographics and growing
in areas relevant to the effective regulation of the
awareness of Islamic finance products and
industry and related markets. Moreover, the IFSB
services; and
is also mandated to undertake research into, and
• cross-border liquidity management tools.
publish studies and surveys on, the IFSI and establish
a database for the industry.
About the IFSB and Its Objectives
The IFSB is an international standard-setting body In realizing this mandate, the IFSB membership
for the regulatory and supervisory agencies that have comprises stakeholders from different segments
a vested interest in ensuring prudential standards of the financial industry covering regulatory and
and in promoting the soundness and stability of the supervisory bodies of the banking industry,
IFSI, that is broadly defined to include banking, the securities and/or insurance/(Takāful industries), and
capital market, and insurance (Takāful). market players. As at April 2014, the 184 members
68
of the IFSB comprise 59 regulatory and supervisory Asian Development Bank, Islamic Development
authorities (RSAs), 8 international intergovernmental Bank, Islamic Corporation for the Development of the
organizations, 111 financial institutions and Private Sector, Islamic Corporation for the Insurance
professional firms, as well as 6 self-regulatory of Investments and Export Credit, and International
organizations (industry associations and stock Islamic Liquidity Management Corporation (IILM).
exchanges) operating in 45 jurisdictions. This representation of the different stakeholders from
the various segments of the financial industry in its
The eight international intergovernmental membership greatly assists the IFSB in adopting an
organizations are the World Bank, International integrated risk-based approach to the supervision of
Monetary Fund, Bank for International Settlements, IIFS.
Operational Framework and Progression of IFSB Standards
In order to achieve its objectives, the IFSB’s operational framework (see Figure 5.4) includes various
components, such as development of prudential standards, facilitation of standards implementation,
awareness programs, annual events, and other activities. In addition to developing prudential standards,
the IFSB also conducts research and coordinates initiatives on industry related issues, as well as organizes
roundtables, seminars, and conferences for regulators and industry stakeholders. The IFSB is actively involved
in promoting awareness of issues that are relevant or have an impact on the regulation and supervision of the
IFSI. This mainly takes the form of international conferences, seminars, workshops, trainings, meetings, and
dialogues staged in various countries.
Figure 5.4: Operational Framework of the Islamic Financial Services Board
IFSB
Initiatives
Development
Awareness Annual
of Prudential Others
Program Events
Standards
Standard IFSB Database

Seminars Conferences
Development Summit Projects
Facilitating Islamic
Roundtable
Implementation Financial Research
Discussions
of the Standards Stability Forum
Public
Lecture
IFSB = Islamic Financial Services Board.
Source: IFSB.
69
On the development of prudential standards, in order more intricate and innovative. Corresponding to
to ensure the soundness and stability of the IFSI, the fundamental changes in the global regulatory
as of March 2014, the IFSB has issued a range of environment over the years, the IFSB has been in
prudential and supervisory standards, including 16 the process of issuing a number of revised standards
standards and guiding principles, 5 guidance notes, and guiding principles including new “second-
and 1 technical note to address the specific nature of generation” standards to capture the sophistication
IIFS operations for the banking, Takāful, and capital of the IIFS operations and global reforms in the
market sectors. The first series of standards issued form of Basel III. The introduction of second-
by the IFSB, from IFSB-1 through IFSB-11, covered a generation standards such as IFSB-12 (Liquidity
wide range of prudential and regulatory issues for the Risk Management), IFSB-13 (Stress Testing), IFSB-
three IFSI sectors. With the fast pace of growth of the 15 (Revised Capital Adequacy Standard), and IFSB-
IFSI and its interconnectedness through cross-border 16 (Revised Supervisory Review Process) has been
transactions, the IIFS have transformed themselves well received by the IFSB members and industry
to handle all kinds of transactions, from simple to (see Table 5.1 lists the standards issued by the IFSB).
Table 5.1: Progression of Islamic Financial Services Board Standards

First-Generation Standards Second-Generation Standards (as at H1-2014)
• IFSB-1: Risk Management (December 2005) • IFSB-12: Liquidity Risk Management (March
• IFSB-2: Capital Adequacy (December 2005) 2012)
• IFSB-3: Corporate Governance (December • IFSB-13: Stress Testing (March 2012)
2006) • IFSB-14: Risk Management for Takāful
• IFSB-4: Transparency and Market Discipline Undertakings (December 2013)
(December 2007) • IFSB-15: Revised Capital Adequacy Standard
• IFSB-5: Supervisory Review Process (December (December 2013)
2007) • IFSB-16: Revised Supervisory Review Process
• IFSB-6: Governance for Islamic Collective (March 2014)
Investment Schemes (December 2008)
• IFSB-7: Capital Adequacy Requirements In Progress Standards
for Sukūk, Securitisation, and Real Estate • Core Principle for Islamic Finance Regulation
Investments (December 2008) (Banking) - Expected 2015
• IFSB-8: Governance for Islamic Insurance • Guidance Note on Quantitative Measures for
(Takāful) Undertakings (December 2009) Liquidity Risk - Expected 2015
• IFSB-9: Conduct of Business (December 2009) • Guiding Principle for ReTakāful (Islamic insurance)
• IFSB-10: Sharīàh Governance Systems Undertaking - Expected 2016
(December 2009)
• IFSB-11: Solvency Requirements for Takāful
(Islamic Insurance) Undertakings (December 2010)
• TN-1: Islamic Money Market and Liquidity (March
2008)
• GN-1: Capital Adequacy (Credit Ratings
Assessments) (March 2008)
• GN-2: Capital Adequacy (Commodity
Murābahah Transactions) (December 2010)
H = half, IFSB = Islamic Financial Services Board.
Note: The second generation of standards were mainly driven by the IFSB Study on Implications of Global Financial Reforms on the Islamic Financial Services
Industry (2009–2010).
Source: IFSB.
70
Due Process of Preparing the IFSB Standards
As a standard-setting body, the IFSB is tasked, This due process includes four stages: (i) preparation
among others, to assess and identify the needs of stage (i.e., undertaking various preparatory steps
the IFSI to determine the appropriate standards and before the project commences); (ii) development
guiding principles to be developed. The preparation of stage (i.e., accomplishing various milestones
standards by the IFSB follows a lengthy due process toward developing the exposure draft); (iii) public
involving various stakeholders of the IFSI to produce consultation stage (i.e., disseminating the exposure
high-quality, best practice, implementable standards draft to a wide audience and engaging various
as outlined in its Guidelines and Procedures for stakeholders of the IFSI in reviewing the draft); and
the Preparation of Standards/Guidelines and the (iv) finalization and adoption stage (i.e., revising the
Standard Operating Procedures, which were exposure draft based on the public consultation
approved by the Council at its 2nd meeting in Bahrain process and thereafter recommending the standard
on 30 April 2003 and 16th meeting in Khartoum on 6 to the IFSB Council for adoption). A summary of the
April 2010, respectively. key milestones for the due process is illustrated in
Figure 5.5.
Figure 5.5: Key Milestones for the Due Process
Working Preliminary TC Approval

Group Meetings Exposure Draft Technical Sharīàh on Exposure Draft Issuance of
(WG) (PED) Committee (TC) Meeting (ED) ED by TC
Issuance of Final Approval Sharīàh Working Public Hearing and

Prudential Approval by by TC Meeting Group Workshop
Standard Council
Source: IFSB.
Referring to Figure 5.5, the preparation of the standards/guidelines requires the establishment of working
groups, which comprise representatives from RSAs from countries that are full members of the IFSB, national
or international organizations involved in setting or promoting standards, regional or international professional
or industry associations, as well as market players and professional services firms. The involvement of
supervisory bodies and intra-governmental organizations in the preparation of standards ensures that there
is wider participation and representation of different regions and regulatory regimes. It also helps in wider
acceptability of IFSB standards at the supervisory level, which ensures wider implementation and adoption of
these standards when issued.
71
Apart from the working group meetings, the due and other best practices suggested in the IFSB
process also involves two Sharīàh Board meetings standards and thus support the early adoption by
(Sharīàh Board of the Islamic Development Bank) to various jurisdictions.
ensure that the standards comply with Sharīàh rules
and principles, before issuing the exposure draft and Progress on the Implementation of IFSB
final standard. Before Sharīàh Board meetings, the Standards
draft is translated into Arabic, which is then reviewed
by the Arabic Editing Committee consisting of IFSB This subsection relates to the implementation of IFSB
members. During the entire timeline of the project, prudential standards. As an international standard-
the IFSB Technical Committee11 is kept abreast of setting organization, the impact or value of the IFSB’s
the developments in order to ensure that the project operations is critically linked to whether its standards
remains on track and that its underlying objectives are adopted and they actually shape the regulation
are met on a timely basis. After five working group and supervision of Islamic finance at the jurisdiction
meetings, which involve conducting surveys and level in a way that promotes the resilience and stability
working on the preliminary exposure draft, the of the IIFS and financial system in general. Therefore,
final exposure draft is approved by the Technical the issuance of any standards and guidelines by the
Committee for public consultation for about 3 months. IFSB (either new or revised) does not mark the end of a
journey for the development of a prudential framework
During the public consultation phase, the exposure in a specific area. Rather, it marks a platform for
draft is sent out to all IFSB members, along with other additional work to be undertaken to further strengthen
industry stakeholders, for written feedback. The the soundness and stability of the IFSI. The IFSB
IFSB also organizes workshops or public hearings Secretariat therefore ensures that upon issuance
as a part of the public consultation with the aim of of standards and guidelines, concerted efforts are
creating public awareness and receiving broader undertaken to implement the standards across the
participation of stakeholders (such as member jurisdictions. Hence, the need for assessing the status
and nonmember RSAs, MDBs, market players, of the standards’ implementation in the IFSB member
academics, Sharīàh scholars, and the public at jurisdictions is of greater attention in order to support
large) that have a vested interest in Islamic finance. implementation efforts and strategies.
After revising the document based on the public
consultation phase, the document is then revised It is important to note that similar to other international
and discussed by the working group and reviewed standard-setting organizations such as the
by the Sharīàh Board. After their clearance, the BCBS, IFSB members implement its standards
document is submitted to the Technical Committee and guidelines on a voluntary basis as the IFSB
for their and recommendation to the IFSB Council for does not have enforcement powers. The IFSB,
adoption of the standard. The IFSB Council gives the nevertheless, is mandated to assist its members in
final approval to adopt the standard. adopting its standards and guidelines. Each IFSB
member is entitled to determine its own timeline for
This due process provides an overview of robust implementation based on the market and industry
process of standards preparation by the IFSB dynamics in its territory and/or jurisdiction. The
which ensures wider participation of the industry implementation in this sense is influenced by priorities
stakeholders in various stages of the due process. of various supervisors within a jurisdiction taking
The active involvement of the IFSI stakeholders also into account finance sector development, human
helps wider appreciation of the guiding principles resources, and economic factors, among others.
11
According to Article 29, the Technical Committee is the body responsible for advising the IFSB Council on technical issues within its
terms of reference (as determined by the council).
72
Implementation Survey Results
The IFSB Secretariat conducted a Survey of (iii) The implementation plans in these countries are
Implementation in 2011 among the IFSB members in framed mostly in terms of a 3–5-year time frame,
conjunction with the preparation of the IFSB Strategic although in some countries the time frame is
Performance Plan 2012-2015. The survey was the shorter in view of the progress that has been
first time that the IFSB collected factual, systematic made.
information on the implementation progress. The (iv) The standards that feature most frequently
following (see Table 5.2) are the key findings: in terms of completion, or advanced stage of
progress in implementation, are typically the
(i) Of the responding jurisdictions, nine have ones issued earliest. IFSB-1 through IFSB-6
already implemented one or more standards. Of feature prominently in these categories, and are
those nine jurisdictions, five have implemented the ones most frequently cited as planned for
three or more standards. implementation.
(ii) Nineteen jurisdictions are in the process of
implementing, or have plans to implement one
or more standards.
Table 5.2: Summary of Standards and Guidelines Implementation with Respect to Banking Supervisory
Authorities (as at end of 2010)
IFSB- IFSB- IFSB- IFSB- IFSB- IFSB- IFSB- IFSB- IFSB- IFSB- IFSB-
1 2 3 4 5 6 7 8 9 10 11
1: Complete 3 6 6 4 4 0 2 1 1 1 0
(13%) (24%) (24%) (16%) (16%) (0%) (8%) (5%) (4%) (4%) (0%)
2: In progress 6 4 5 8 4 3 3 3 4 6 2
(25%) (16%) (20%) (33%) (16%) (14%) (13%) (14%) (17%) (25%) (9%)
3: Planning 9 9 9 6 10 5 10 6 11 11 7
(38%) (36%) (36%) (24%) (40%) (23%) (42%) (29%) (48%) (46%) (32%)
4: Do not plan to 6 6 5 7 7 14 9 11 7 6 13
(25%) (24%) (20%) (28%) (28%) (64%) (38%) (52%) (30%) (25%) (59%)
Base 24 25 25 25 25 22 24 21 23 24 22
Notes:
1. Values in table indicate number of jurisdictions.
2. Complete: implementation is complete
3. In progress: implementation is in progress
4. Planning: not yet in progress, but planning to implement
5. Do not plan to: not in progress and no plan to implement, e.g., because not relevant to supervisory authority
6. Base: total number of jurisdictions.
Source: IFSB Standards Implementation Survey (2011).
73
In its Strategic Performance Plan, the IFSB identified SKRAs require the IFSB Secretariat to conduct an
four strategic key result areas (SKRAs), which include annual survey on standards implementation among
SKRA 1: Formulation, Adoption and Implementation, its member RSAs with the aim to follow up on the
Publicizing and Promoting Prudential Standards for progress of the standards implementation and to
Islamic Finance, and SKRA 2: Technical Assistance assess the support required by the authorities in
and Capacity Building (see Figure 5.6). These two implementing the standards.
Figure 5.6: Islamic Financial Services Board Strategic Performance Plan (2012-2015)
SKRA 1 SKRA 2 SKRA 3 SKRA 4
Formulation,
Adoption and
Cooperation
Implementation, Technical Communication
Enhancement
Publicizing and Assistance and and Information
(creating platform
Promoting Prudential Capacity Building Sharing
for cooperation)
Standards for Islamic
Finance
• Increased adoption of • Increased adoption of • Improved cooperation • Improved understanding

the IFSB standards by IFSB standards by the with members of the of issues or problems
the regulatory and regulatory and IFSB faced by members of
supervisory authorities supervisory authorities • Improved cooperation the IFSB
• Expansion of coverage with nonmembers of the • Increased utilization of
of the IFSI issue areas IFSB Islamic financial
databases for quality
decision-making by
members
• Increased satisfaction of
members with the
services provided
by the IFSB
IFSB = Islamic Financial Services Board, IFSI = Islamic financial services industry, SKRA = strategic key result area.
Source: IFSB Strategic Performance Plan (2012–2015).
Following this, the IFSB undertook its second IFSB Standards Implementation Survey in 2013 to assess
the status of the IFSB standards, with a view to formulating policy recommendations for the implementation
process over the medium to longer term, and examining implementation and technical assistance strategies
how the IFSB can assist its members accelerate and strengthen the process of implementing the standards.
A total of 33 RSAs responded to the survey.
The following are the key findings of the 2013 survey:
• Implementation of standards has increased significantly in 2 years. Overall, the survey found that
13 RSAs (40.0%) out of the total of 33 implemented one or more IFSB standards, in 7 RSAs (21.0%)
implementation was already in progress, 10 RSAs (30.0%) planned to implement at least one standard,
and 3 RSAs (9.0%) did not plan to implement any of the standards. The results indicate a considerable
improvement from the 2011 survey results with regard to the rate of implementation (see Figure 5.7).
74
Figure 5.7: Standards Implementation in Regulatory and Supervisory Authorities with More Than 5.0% Market Share
Do not
Plan to
13 RSAs
(40%): one or
more standards
ted
mple 7 RSAs
Co (21%): at least
Planning
one standard
ss
10 RSAs
In Progre
(30%): at least
one standard
3 RSAs (9%)
RSAs = regulatory and supervisory authorities.
Moreover, considering the implementation by 18 RSAs where the market share of Islamic finance assets in the
respective sector is more than 5.0%, implementation is much stronger. In these jurisdictions, it was observed
that 10 RSAs (55.0%) implemented one or more IFSB standards, in 3 RSAs (16.0%) implementation was in
progress, 5 RSAs (27.0%) planned to implement at least one standard, and no RSA was in the “do not plan
to [implement]” category (see Figure 5.8).
Figure 5.8: Standards Implementation by Regulatory and Supervisory Authorities – Overall Basis
10 RSAs
(55%): one or
more standards
Pla
nn 3 RSAs
ing
(16%): at least
Completed one standard
s
res
rog 5 RSAs
In P (27%): at least
one standard
No RSA
IIFS = institutions offering Islamic financial services, RSAs = regulatory and supervisory authorities.
• More RSAs are planning to implement standards. Another important finding is that all the IFSB
standards in the banking sector were already implemented completely by one or more RSAs
(see Table 5.3). Moreover, out of 9 RSAs who implemented at least one standard completely, all of
them are full members of the IFSB, except one central bank, and most of them have a more than 5.0%
market share of assets in the respective sector. The results also show that about 20 (80.0%) RSAs had
an implementation status ranging from “completed” to “planning to implement” the IFSB standards. Only
three RSAs, who are associate members of the IFSB, did not plan to implement any IFSB standards
because of insignificant shares of assets in IIFS and also because of absence of regulatory and supervisory
frameworks for this sector in their respective jurisdictions.
75
Table 5.3: Summary of Standards Implementation by the Respondent Regulatory and Supervisory Authorities
(2013)
IFSB- IFSB- IFSB- IFSB- IFSB- IFSB- IFSB- IFSB- IFSB- IFSB- IFSB- IFSB- IFSB-

1 2 3 4 5 6 7 8 9 10 11 12 13
1: 6 6 4 4 3 2 3 4 6 7 1 1 3
Completed (24%) (24%) (16%) (16%) (12%) (33%) (13%) (67%) (19%) (21%) (17%) (4%) (12%)
2: In 5 4 7 5 5 3 2 1 4 9 1 4 1
progress (20%) (16%) (28%) (20%) (20%) (50%) (9%) (17%) (13%) (27%) (17%) (16%) (4%)
11 12 11 13 13 1 13 1 14 11 3 15 17
3: Planning
(44%) (48%) (44%) (52%) (52%) (17%) (57%) (17%) (44%) (33%) (50%) (60%) (68%)
4: Do not 3 3 3 3 4 - 5 - 8 6 1 5 4
plan to (12%) (12%) (12%) (12%) (16%) - (22%) - (25%) (18%) (17%) (20%) (16)
Base 25 25 25 25 25 6 23 6 32 33 6 25 25
Sector B B B B B C B T C C T B B

Notes:
1. Complete: implementation is complete
2. In progress: implementation is in progress
3. Planning: not yet in progress, but planning to implement
4. D
o not plan to: not in progress and no plan to implement, e.g., because not relevant to supervisory authority
Sectors: B: Banking, C: Islamic Capital Market, T: Takāful, C: Cross Sector (covering three sectors)
5. Base: total number of jurisdictions?
Based on the implementation status, the RSAs planning to implement the standards were asked to indicate
the approximate time frame under three given options—within 1 year, 1–3 years, or 3–5 years—for complete
implementation of each of the IFSB standards. The results show that a few of the RSAs will implement the
standards within 1 year; however, most RSAs indicated that they were accelerating their time frames for
standards adoption from the 1–5 years indicated in the 2011 survey to a 1–3 year duration.
Implementation Challenges
The 2013 survey also collected information on challenges faced by RSAs to implement the IFSB standards. The
key challenges were categorized mainly into seven areas and the RSAs were asked to rank those challenges
on a scale of 1–5 (1 being the most significant and 5 the least significant). The lower the mean value, the higher
the importance level of any given challenge. Table 5.4 exhibits the ranking order of challenges based on the
mean values and compares the results with the 2011 survey.
76
Table 5.4: Ranking of Challenges in the Standards Implementation

2013 Survey 2011 Survey
Challenges Mean Rank Base Mean Rank Base
Need to change regulatory and supervisory framework 2.40 1 29 2.70 1 25
Lack of personnel with relevant knowledge/ experience/
2.50 2 30 3.00 2 25
training
Cost of implementation 3.38 3 29 3.90 3 25
Institution size and complexity 3.45 4 29 4.10 4 25
Lack/poor quality of data to support implementation of the
3.60 5 30 4.10 4 25
standards
The results show that in 2013, the rankings of the various challenges were mostly similar to those in the 2011
survey, though low mean scores point to an increasing intensity of these challenges. The “need to change the
regulatory and supervisory framework,” and “lack of personnel with relevant knowledge/experience/training”
are considered the two key challenges faced by RSAs, as depicted by the lower mean values compared to
others. The results also suggest a higher need of RSAs on capacity building initiatives to assist in staff training.
Strategies to Enhance Implementation of the IFSB Standards
Facilitating the Implementation of IFSB Standards Workshops
Since November 2007, the IFSB Secretariat has The following are some of the key FIS initiatives:
been conducting a series of workshops called
“Facilitating the Implementation of IFSB Standards • IFSB–FIS regional/country workshops. These
(FIS) Workshops” to assist its members in the are designed to facilitate the implementation
adoption and implementation of the standards in their in respective countries and regions. So far,
respective jurisdictions. This is in line with the IFSB regional workshops have been conducted to
Council’s directive to focus on facilitating standards target RSAs and market players in Africa, the
implementation among its member countries. The Middle East, Southeast Asia, and Central Asia.
IFSB Secretariat has therefore accorded this activity • IFSB–FIS RSA workshops. These are
highest priority and has allocated more resources specifically tailored for the IFSB member RSAs.
to carry it out. To date, the IFSB has organized Three dedicated workshops for each sector—
Islamic banking, Takāful, and Islamic capital
145 workshops in 26 countries, which have in total
markets—are held annually. The workshops
trained more than 2,000 participants representing
facilitate discussion among the representatives
a wide range of stakeholders in the IFSI. The FIS
on pertinent issues and sharing of their
workshops cover the IFSB published standards and
experiences on the implementation of IFSB
these modules are continuously being developed
standards within the regulatory community.
and improved for the benefit of the IFSB members,
• IFSB–FIS technical assistance workshops.
and the industry at large. Since October 2009, some These are specifically tailored workshops in
of the FIS workshops have been supported by selected jurisdictions where member RSAs
technical assistance from the Islamic Development request the IFSB to cover specific standards
Bank and ADB under the capacity building initiative. either because they have plans of their
implementation or they have implemented
them and would like to train their staff on the
technicalities of the subject matter.
77
Responding to members’ feedback as shown in IFSB plans to convert a majority of its standards into
the 2011 survey undertaken for the purpose of e-learning modules by 2015.
developing the Strategic Performance Plan, the IFSB
started introducing “country experience sessions” Partner Activities
in the FIS workshops. These sessions encourage
the sharing of experiences among IFSB member The IFSB has also signed memorandums of
institutions, particularly regulatory and supervisory understanding (MoUs) with various strategic
authorities, on the main issues, challenges, and partners, which are aimed, among others, at further
successes in implementing the IFSB standards within penetration of its implementation efforts. The
their jurisdictions. Among the participating institutions MoU partner activities include providing technical
sharing their experiences are the Central Bank of assistance to facilitate the implementation of the IFSB
Bahrain, International Monetary Fund, Central Bank standards and to promote the development of the
of Jordan, State Bank of Pakistan, Bank Negara IFSI in member countries. MoU partner activities play
Malaysia, Central Bank of Sudan, Banque Du Liban, an important role in facilitating the implementation of
and Sudan Financial Services Company. the IFSB standards in a variety of ways. The following
are the roles of some of the partners:
The 2013 survey also asked respondents to identify
whether or not they require FIS workshops to be Islamic Development Bank
conducted in their countries within the given 3-year
period (2014–2016). Results indicate that all of the The Islamic Development Bank (IDB) is a founding
countries have requested for FIS workshops to member of the IFSB and is represented on the IFSB
be conducted in their jurisdictions to facilitate the Council. It has been member of the Task Force on
implementation of the IFSB standards. Respondents Islamic Finance and Global Financial Stability 2010.
also provided information on the prioritization Earlier in 2007, the IFSB and IDB/IRTI accomplished
of the standards and expected time frame for joint work on the Ten-Year Framework and Strategies
implementation. These results will provide a basis for for Islamic Financial Services Industry Development.
planning the FIS workshops activities in the future. This document has recently been revised by both the
institutions in the form of a mid-term review. The IDB
E-learning has also participated in most IFSB working groups,
and has also provided technical assistance grants for
In addition to workshops, partner activities, and various projects including (i) IFSB’s Compilation Guide
technical assistance initiatives as will be discussed, on Prudential and Structural Islamic Financial Indicators,
the IFSB plans to complement the workshops with (ii) Disclosures to Promote Transparency and Market
e-learning programs to ensure a wider dissemination Discipline, and (iii) Implementation of IFSB Standards.
of the IFSB standards. The program is expected to
foster (i) global awareness and understanding from Recently in 2013, the IFSB received new technical
regulators and supervisors as well as market players assistance from the IDB to support the FIS regional
and industry experts on the IFSB standards, and program on newly developed and existing Takāful
(ii) the implementation of the IFSB standards by the standards, as well as to support the regional
industry to promote the resilience and stability of the workshops in French-speaking countries. The IFSB
IFSI at the global level. In 2011, the IFSB introduced successfully conducted workshops in three countries
the FIS E-Learning Programme (Development in 2013, some of which were supported by this
E-Learning Programme for IFSB-1). In 2013, the technical assistance.
IFSB finalized its e-learning project for IFSB-6. The
78
Asian Development Bank have organized three fora covering risk management,
corporate and Sharīàh governance, Takāful, and the
The Asian Development Bank (ADB) is an associate Islamic capital market sectors. The IFSB will continue
member of the IFSB and, as of July 2014, it is the to coorganize the executive forum with INCEIF and
largest provider of technical assistance funds to the will look at opportunities of replicating the model in
IFSB. The details of its technical assistance support other countries.
and participation in IFSB activities are provided later.
The ADB launched its first technical assistance Bahrain Institute of Banking and Finance
support to the IFSB through joint funding with the
IDB. The IFSB and the Bahrain Institute of Banking and
Finance organized a high-level training event in
International Association of Insurance Supervisors Manama, Bahrain in October 2014. Since an MoU
signed 22 March 2012, the IFSB has partnered with
The International Association of Insurance the Bahrain Institute of Banking and Finance through
Supervisors (IAIS) and the IFSB established a its speakers program, where IFSB staff conduct
joint working group in 2005 to produce an issues training programs on the supervision of IIFS.
paper on the applicability of the existing IAIS Core
Principles on the Takāful sector and regulatory and Technical Assistance
supervisory standards to be developed by the IFSB
on Takāful. This joint working group prepared the Technical assistance is another important area
paper titled “Issues in Regulation and Supervision in which the IFSB is working closely with its MoU
of Takāful (Islamic Insurance),” which was issued in partners and other member organizations. The
August 2006, providing a background to Takāful as importance of this area has been reflected in the
well as an analysis of the applications of IAIS Core 2013 survey. In the survey, the member RSAs were
Principles to the Takāful industry. Based on the asked to rank three types of technical assistance
themes identified in this paper, the IFSB has to date options for enhancing implementation of the IFSB
issued three standards and one guidance note for standards. The options for technical assistance
the Takāful sector. In 2014, both institutions started offered by the IFSB were (i) to organize more FIS
another joint initiative in the form of a research workshops, (ii) to provide direct technical assistance
paper focusing on regulatory issues prevailing in to the RSA for implementation, and (iii) to prepare
the microTakāful sector and its role in enhancing more technical notes/explanatory notes/tool kits for
financial inclusion. the facilitation process.
International Centre for Education in Islamic Finance The results of the survey show that 18 out of 32
RSAs (56.0%) preferred to seek direct technical
In 2013, the IFSB and the International Centre for assistance from the IFSB as the most important
Education in Islamic Finance (INCEIF) successfully option for implementing the IFSB standards. On the
developed the joint high-level training program other hand, 10 RSAs (31.0%) ranked organizing FIS
“IFSB–INCEIF Executive Forum on Islamic Finance.” workshops as the most important option of technical
This forum aims to provide a platform for global assistance. Meanwhile, all the RSAs mentioned their
leaders in Islamic finance to discuss selected interest in organizing FIS workshops in their countries
emerging issues faced by the global IFSI. The forum during 2014–2015. Only five RSAs responded that
places emphasis on issues related to supervisory preparing more materials is the most important
and prudential regulation, both at the national and option for facilitating the implementation process.
international levels. Since 2013, the IFSB and INCEIF
79
The IFSB and ADB signed an MoU in 2012, to provide a higher level of support to selected
following which both ADB and the IFSB have developing member countries of ADB and IFSB in
been jointly implementing a regional technical addressing capacity impediments. In addition, a
assistance to common member countries. The comparative study that will outline the experience
technical assistance has various components, of jurisdictions that have successfully implemented
including one on facilitating the implementation of selected IFSB standards is being conducted and
the IFSB standards in common member countries. will explore the challenges and difficulties of the
Furthermore, a pilot project is being planned experiences in this process.
Role of Multilateral Development Banks and ADB Technical Assistance
As mentioned earlier, as an international standard- of certain rights and privileges. Whether this new
setting body of regulatory and supervisory approach can be replicated by other setters is
agencies for Islamic finance, the IFSB promotes the doubtful. It is, however, premature to contemplate
development of a prudent and transparent IFSI by such an approach in Islamic finance given its
introducing new or adapting existing international relative stage of development and the challenge in
standards consistent with Sharīàh principles, and implementing prudential standards.
recommends them for adoption. The final part
of this statement provides an indication of the This then creates an opportunity for MDBs to play
potential role of MDBs in partnering with the IFSB. a role in implementation of IFSB standards. Beyond
Adoption of IFSB standards is voluntary in nature. supporting the IFSB in developing such standards,
The previous section has provided an overview of by providing technical assistance and inputs, MDBs
the IFSB’s work program to support its members can leverage their relationships with supervisory
in the implementation of its standards through authorities in Islamic finance to help them adopt these
FIS workshops and other initiatives.12 This is not standards. This can be done in various ways through
dissimilar to the role of other standard-setting bodies direct engagement at the regional and national level,
such as the BCBS, IOSCO, and the IAIS. Having and, in the case of sovereign operations, adoption
said that, IOSCO in 2013 put some teeth into the of IFSB standards can be supported through
requirement of its members to be a full signatory technical assistance and budget support provided
to its Multilateral Memorandum of Understanding under a finance sector reform program agreed with
Concerning Consultation and Cooperation and the the government. The prerequisites of taking this
Exchange of Information. IOSCO has provided a approach are explained next. Figure 5.9 summarizes
deadline and members who remain nonsignatories the role of the IFSB and the potential role of MDBs
may face several actions, ranging from having in helping common members implement prudential
their name published on the IOSCO website and standards.
noncooperation of other members, to suspension
12
Between November 2007 and December 2011, the IFSB conducted 95 FIS workshops. Bangladesh, Brunei Darussalam, Indonesia,
Malaysia, the Maldives, and Pakistan were some of the beneficiaries.
80
Figure 5.9: Role of the IFSB and Multilateral ADB’s Support through Technical Assistance
Development Banks in Supporting Common Members
Jurisdictions
ADB, in recognition of the growing significance
of Islamic finance among its developing member
International Prudential
countries, joined the IFSB as an observer in 2003
Standards (Islamic Financial
Services Industry) and became an associate member in 2006. As of
2014, ADB has provided three regional technical
assistance grants to the IFSB for the benefit of
IFSB MDBs their common members. The first ADB technical
• Develop and issue standards • Support development and
assistance project, Development of International
• Socialize standards, capacity implementation of standards
building, and training • Direct engagement with Prudential Standards for Islamic Financial Services,
• But does not have DMCs through TAs, budget was approved in 2005.13 The goal of this technical
enforcement mechanism support and policy dialoque
(missing link) assistance was the development of Islamic finance
as a viable, sustainable, alternative finance mode
DMC = developing member country, IFSB = Islamic Financial Services
that can catalyze economic development and
Board, MDB = multilateral development bank, TA = technical assistance. reduce poverty. Several outputs were achieved
Source: IFSB. under this technical assistance, including
preparation of international prudential standards for
There are two prerequisites for MDBs to advocate market transparency and discipline as well as key
for adoption of the IFSB standards as part of a principles for the development of an appropriate
finance sector reform package: (i) need to evaluate legal framework for asset securitization. In addition,
importance of the IFSI in the developing member it also supported the first phase of the Prudential
country, and (ii) evaluate importance of standards and Structural Islamic Finance Indicators project,
which included the preparation of the Compilation
adoption within the overall finance sector reform
Guide on Prudential and Structural Islamic Finance
agenda of developing member countries. The
Indicators (2008).
evaluation of the two prerequisites will determine the
appetite and readiness of the supervisory authority
ADB support for the IFSB was sustained through the
to undertake the reform program, especially as
technical assistance, Development of Prudential and
adopting standards will likely include some legislative Supervision Standards for Islamic Financial Markets,
amendments or passing of new legislation. approved in 2009.14 The impact sought by this
technical assistance is greater harmonization and
A key asset for MDBs such as the ADB is its broader mutual recognition in Islamic finance markets
knowledge of the unique characteristics of the and in Southeast Asia through the establishment of
country, including its legal architecture and regulatory international prudential standards for Islamic financial
framework. It is likely that technical assistance will be institutions, an effective regulatory and supervisory
required over the medium term to build a range of framework, and a robust legal and liquidity
capabilities related to adopting and implementation infrastructure for the development of Islamic finance.
of IFSB standards, and the broader financial The following key outputs were included under the
infrastructure and enabling environment needed. technical assistance:
Such technical assistance can have a work plan to
implement a few standards in a given time period (i) supporting implementation of standards through
and, once this is completed, move on to the next workshops on issues of capital adequacy and
phase of implementation. risk management of Islamic banks, Sukūk,
and governance related to Islamic collective
investment schemes;

13
$400,000, with $200,000 cofinanced with the IDB.

14
$850,000, with $425,000 cofinanced with the IFSB.
81
(ii) assisting the IFSB in developing legal and assistance will focus on implementation of standards
liquidity infrastructure needed for Islamic and systematic gathering of macroprudential data.
finance’s sound development and effective Implementation of standards will take two different
supervision; approaches. First, through workshops and capacity
(iii) supporting the IFSB in working out strategies building activities provided by IFSB and, for the first
for Islamic capital market development in time, development of an e-module platform so that all
coordination with the IFSB’s ongoing work on members can better understand the IFSB standards
liquidity infrastructure; using interactive modules online. The e-module
(iv) assisting the IFSB in preparing a diagnostic platform is not a substitute for the regular financial
study in the area of interface between positive implementation standards workshops; rather, they will
laws and Sharīàh across all types of Sharīàh- complement each other. The e-modules can provide
compliant asset securitization contracts; and a basic understanding of the standards which then
(v) assisting the IFSB in implementing the next enables FIS workshops to delve into a more technical
phase of the Prudential and Structural Islamic discussion and with the potential of harnessing
Finance Indicators project based on the the “reverse linkage” model. A feature of this latest
compilation guide already developed under technical assistance is that while the activities will
the previous technical assistance. The new benefit all common members of ADB and the IFSB,
phase included piloting the project in selected the technical assistance is dedicated to supporting the
countries. central banks of Afghanistan, Bangladesh, Indonesia,
and Pakistan.
Under the technical assistance, a book titled
Strategies for the Development of Islamic Capital Earlier in this chapter, the importance of the
Markets was also published in March 2011. The macroprudential framework in Islamic finance was
technical assistance was closed in September 2011. discussed. One prerequisite of any macroprudential
ADB took the opportunity to assess the performance work is data gathering of financial institutions. This
of this technical assistance to guide the design and is a particular challenging area for Islamic finance as
implementation of future assistance. Some of the there is no systemic and comparable data collection.
key points from this assessment are that there needs The technical assistance will attempt to address this
to be a better link between activities in regional challenge by reviewing the Prudential and Structural
technical assistance on Islamic finance with national Islamic Finance Indicators project partially developed
development programs, particularly in the finance in the earlier technical assistance and look to make
sector, and that countries that have implemented significant progress in this area.
the IFSB’s prudential standards could play a role in
helping other countries by sharing their experience In addition to supporting the IFSB and its members
through “reverse linkage.”15 through regional technical assistance, ADB has also,
where possible, played a role in developing Islamic
The most recent technical assistance, Implementing finance in its finance sector programs. For example,
Prudential Standards in Islamic Finance, was approved the 2012 finance sector program in Indonesia had
in November 2012 and will be used to support a component that encouraged the development of
activities until at least the end of 2015. The technical Islamic finance. There was also a direct reference to

15
Based on ADB (2012).
82
the IFSB standards. One of the policy actions identified participated in the working groups supporting the
and agreed with BAPEPAM-LK (Pengawas Pasar Task Force. In addition, ADB is involved in the
Modal dan Lembaga Keuangan; Indonesian Capital promotion of the development of best international
Market Supervisory Agency and Financial Institution) practices for Islamic finance by participating in IFSB
was the issuance of Takāful regulations based on the working groups to develop international standards
IFSB’s Guiding Principles on Governance for Takāful including the Core Principles for Islamic Finance
undertakings.16 ADB can and should continue looking Regulation Working Group. The working group was
to adopt this approach in its finance sector programs established to review the core principles available
in Southeast Asia and beyond. for conventional financial systems and prepare a
principles document for the IFSI to facilitate a review
Beyond providing technical assistance to the of the sector from the perspective of cross-sectoral
IFSB and common member countries, ADB has regulation and supervision. ADB is also a member
also supported the establishment of the IILM of the IFSB Joint Working Group on MicroTakāful
through participation by the ADB staff in the High (Islamic Micro Insurance) sector and the IFSB
Level Task Force chaired by Governor Zeti Akhtar Working Group on Guiding Principles for ReTakāful
Aziz of Bank Negara Malaysia. ADB staff also (Islamic Reinsurance) Undertakings.
Experience Sharing in the Implementation of IFSB Prudential Standards
This section covers a case study of the State Bank standards is at par with reputed standard-setting
of Pakistan (SBP) in implementing IFSB standards. bodies such as the BCBS, IOSCO, and the IAIS,
which ensures buy-in and ownership of member
Implementation of Banking Standards Issued by institutions in the provisions and recommendations
the IFSB of the standards and guidelines. Furthermore,
the IFSB’s supportive role in the implementation
Having in place a comprehensive regulatory and of its standards through workshops, seminars,
supervisory framework is critical to ensure that the and conferences provides much-needed support
financial market operates on a sound footing. The and guidance to the industry for adoption of the
existence of an elaborate regulatory environment not standards.
only helps promote market stability but also adds to
the confidence and trust of the general public. Ever The prudential standards issued by the IFSB
since the evolution of Islamic finance at the global help promote soundness and stability of Islamic
level, the regulatory bodies have been engaged financial markets, and contribute significantly toward
in developing a suitable regulatory framework standardizing and harmonizing the practices of
responsive to the specific risks and operating nature this evolving Sharīàh-compliant financial discipline.
of the IFSI. The role and contribution of the IFSB The standards ensure greater certainty about
in developing prudential standards and facilitating the regulatory environment and interpretations
the member countries in the implementation of across jurisdictions, minimize opportunities for
the standards has been highly commendable. The regulatory arbitrage, and play an instrumental role in
consultative mechanism and rigorous process internationalizing Islamic finance.
adopted by the IFSB for the development of the

16
As of August 2012, all financial regulators in Indonesia including BAPEPAM-LK were merged into a single regulator known as OJK
(Otoritas Jasa Keuangan; Indonesian Financial Services Authority of Indonesia).
83
SBP and the Securities and Exchange Commission responsibility for ensuring Sharīàh conformity of
Pakistan (SECP) are the two regulators for the Islamic banks’ operations rests with the board of
finance sector in Pakistan with SBP overseeing directors. The framework, effective from July 2014,
banks (including microfinance and Islamic banks) is aimed at institutionalizing the Sharīàh compliance
and development finance institutions and SECP function and improving the Sharīàh compliance
regulating nonbank financial institutions including environment in Islamic banks and thus would be
insurance (Takāful) and capital markets. Accordingly, instrumental in enhancing public trust in Sharīàh
the adoption of IFSB standards related to Islamic permissibility of Islamic banking products.
capital markets and Takāful fall under the regulatory
domain of SECP whereas SBP deals with the Furthermore, for adoption of another key
standards and guidelines applicable on Islamic recommendation of the IFSB Standards on
banks. Corporate Governance and Transparency and
Market Discipline on safeguarding the interests of
SBP has adopted the incremental approach to investment account holders, SBP has undertaken
adopting and implementing the IFSB standards. another initiative of issuing a detailed set of policy
This approach is followed not only for the adoption instructions to Islamic banking institutions on profit
of IFSB standards but also for the overall regulatory and loss distribution and pool management. The
and supervisory framework for Islamic banks. As instructions, which standardize the local practices
per this approach, the overall recommendations on the subject, also focus on enhancing disclosures
and guidelines of IFSB standards are reviewed to enable the investment account holders to make
to identify the gaps in the prevailing framework. informed decisions about placing funds in or
Specific regulations are issued to fill the key gaps, withdrawing funds from Islamic banks. The profit
keeping in view the need and specificities of the local distribution framework requires the creation and
environment. management of pools based on the policy approved
by the board of directors and Sharīàh board as
SBP has so far adopted the IFSB Standard on Risk virtual enterprises with distinct and verifiable assets,
Management whereas the adoption of the IFSB liabilities, income, and expenditure. It also prescribes
Standards on Corporate Governance and Sharīàh the expenses that can be charged to the pool and
Governance are at an advanced stage of adoption. that borne by banks as Mudarib, the profit sharing
SBP is expected to issue a comprehensive Sharīàh ratio, and the range of weightages. The framework,
Governance Framework soon, which coupled with effective since December 2012, has standardized
its existing corporate governance framework for the the profit computation and distribution policies
overall banking industry (including Islamic banks) and practices of Islamic banks and has been well
would make its Sharīàh and corporate governance received by the industry and Islamic banks’ clients.
framework fully in line with the recommendations
of the IFSB corporate and Sharīàh governance In order to adopt the IFSB Standard on Capital
standards. The Sharīàh governance framework Adequacy, SBP carried out an impact study to
developed through extensive consultation with all assess the impact on Islamic banks’ capital adequacy
the key stakeholders explicitly defines the Sharīàh- ratio (CAR) under the IFSB standard formula and
related roles and responsibilities of all key organs supervisory discretion approach. The study revealed
of Islamic banks including the board of directors, that the consolidated CAR of full-fledged Islamic
executive management, and the Sharīàh board. banks as per Basel II was 20.5%, whereas the same
The framework emphasizes that the role of Sharīàh rose to 43.1% as per the IFSB standard formula.
boards for Sharīàh compliance is very important The same as per the IFSB supervisory discretion
and critical; nonetheless, the primary and ultimate formula with 50.0%, 70.0%, and 80.0% Alpha (risk
84
absorbant factor for PSIAs in Islamic banks) remained (v) Implementation of the IFSB standards is not
at 29.0%, 25.1%, and 23.5%, respectively. The CAR mandatory; rather, it depends on the discretion
of the overall Islamic banking industry as per Basel II of the respective jurisdictions.
remained at 18.15%, compared to 35.83% as per the
IFSB standard formula. The CAR of the entire industry In light of the challenges mentioned earlier, the
as per the IFSB supervisory discretionary formula following recommendations are made to improve
with 50.0%, 70.0%, and 80.0% Alpha remained at the implementation of the IFSB standards across the
24.61%, 21.55%, and 20.28%, respectively. Hence, jurisdictions:
the study concluded that the industry was adequately
capitalized even with Alpha close to 1. Since after the (i) The efforts for enhancing the capacity levels
issuance of the Revised Capital Adequacy Standard and promoting better understanding of the
(IFSB-15) in December 2013, SBP has been working IFSB standards may be intensified and more
on implementing this important standard. awareness and technical seminars both at the
pre- and post-implementation stages may be
Issues and Challenges for the Implementation of conducted.
IFSB Standards (ii) The level of collaboration and cooperation
among the jurisdictions may be strengthened
Notwithstanding progress made by the IFSB through bilateral agreements and MOUs
to develop prudential standards for the IFSI; between the IFSB and its member countries for
the implementation of such standards across implementation of the standards.
jurisdictions remains a challenge. The following are (iii) To demonstrate ownership of the standards, the
the main issues impeding the implementation of the adoption and implementation of the standards
IFSB standards: should be made mandatory for IFSB council
members. The council member countries/
(i) Problems with consistent understanding of the central banks not providing plans to implement
IFSB standards across the jurisdictions and the standards in their respective jurisdictions
limited capacity to review the existing regulatory may be replaced with countries willing to adopt
framework and the guidelines provided in the the standards.
IFSB standards, which could help identify the (iv) A transparent and credible assessment process
gaps and develop rules and regulations to fill the may be developed to assess the level of
gaps. compliance with the IFSB standards.
(ii) Not all jurisdictions demonstrate the desired (v) Considering the growing significance of Islamic
level of ownership of Islamic finance and reflect finance in the global, regional, and national
the need for a separate regulatory framework. financial landscape, efforts may be undertaken
(iii) The current Islamic banking paradigm more or to cover Islamic finance under the umbrella of
less has a similar risk profile to conventional finance sector assistance programs.
banks, which, sometimes, reduces the urgency (vi) Greater and effective collaboration among IDB,
for issuing specific standards for this sector. IRTI, and the IFSB to address the issues with the
(iv) No formal mechanism to assess compliance current Islamic banking paradigm is necessary.
of legal, regulatory, supervisory, and Sharīàh
compliance frameworks with the IFSB and other
global standards is in place.
85
Conclusion and Going Forward
As the global industry enters its next phase of stability of the financial system. In this respect, the
growth in an increasingly challenging economic IFSB facilitates the implementation of its standards
and financial environment, this necessitates the and guiding principles by working together with its
need to have in place a comprehensive regulatory members and partners in a variety of ways.
framework to ensure a resilient and stable industry
moving forward, in particular given the escalating The IFSB has also tracked the progress of the
cross-sectoral nature and interconnectedness of implementation through rigorous efforts at its
the industry. However, along with the development secretariat. The results of the recent survey in 2013
of various supervisory and prudential standards— indicated that there has been noteworthy progress
corresponding to the fundamental changes in the in the implementation of the IFSB standards in the
global regulatory environment arising from the member countries. Not only have more jurisdictions
Basel III capital and liquidity frameworks and related adopted or are in the process of implementing IFSB
measures—a sustained level of implementation standards, there has been an early take-up of the
is crucial to keep the industry abreast with the “second-generation” standards issued after the
changing and evolving global financial system. These financial crisis. The results also highlight that that
standards, if effectively enforced and implemented the planning time frame for adoption of standards
by the relevant national regulatory authorities, would is shortening from 3–5 years in the 2011 survey
certainly contribute to enhancing financial soundness to 1–3 years in the latest survey. The 2013 survey
and stability in the IFSI. results also indicate a critical challenge for the
IFSB to ramp up efforts for the implementation of
This chapter started by emphasizing that the prudential standards among member jurisdictions
development of Islamic finance requires a by undertaking various measures such as offering
comprehensive regulatory and supervisory approach relatively longer term engagement through technical
comprising both macro- and microprudential assistance.
frameworks. This becomes apparent when it is
understood that although Islamic finance may not Other international organizations, such as the BCBS
have the same exposure and risks of conventional and the Financial Stability Board, rely on peer
finance, it has its own set of risks, including some pressure to obtain adherence to a set timetable
which are unique to Islamic finance. The IFSB for the adoption of standards. These tools include,
standards help the RSAs, industry players, and other among others, finance sector assistance programs,
stakeholders of the IFSI to understand these risks and supervisory colleges, and peer reviews. The IFSB
adopt international best practices, consistent with Standards Implementation Surveys have pinpointed
Sharīàh principles, to supervise and operate the IIFS. key impediments facing the member jurisdictions,
Especially for the RSAs, it is of paramount importance which suggest that peer pressure alone will not be
that they have sufficient infrastructure, skills, and sufficient to drive the progress on implementation. In
domestic guidelines to effectively supervise the fact, given the nature of the impediments, which are
operations of the IIFS. The prerequisites to supervise in the areas of the legal and regulatory frameworks
these institutions include a sound understanding of as well as specialized skills and knowledge, a
the risks involved in Sharīàh-compliant transactions formal requirement to make the IFSB standards
and how such risks are to be monitored and compulsory will also be ineffective. Based on these
supervised. Therefore, a consistent regulatory observations, there is need also for the provision
approach to supervise the IIFS across borders can of substantial technical assistance, combined with
help ensure that growth of these institutions is on opportunities for the sharing of experiences between
a sound footing and thus contributes to the overall countries. Such technical assistance could enable
86
jurisdictions to address the skills, capabilities, and sound financial systems.17 When the core principles
other weaknesses that act as binding constraints to for Islamic finance regulations are developed, these
policy, regulatory, and market development. In order should be included as a benchmark for regulation
to undertake these initiatives, the IFSB has been and supervision of the Islamic finance sector.
working on finding the resources and organizational
modes and partnerships that help committed The role of MDBs can also be enhanced and will
jurisdictions meet the challenges they face. In the require a more systemic approach. This will have
past decade, a major source of support for the to begin with the integration of Islamic finance in
implementation of the IFSB standards has been the the finance sector operational plans, road maps,
assistance from MDBs, primarily ADB and the IDB. and country partnership strategies. This will provide
There is a need, however, to continue to innovate. The the opportunity to strategize support for the
development of the e-module platform to support the development of Islamic finance and implementation
implementation of standards is consistent with this of prudential standards from the outset, instead of
approach. Another area that shows great promise is on an ad hoc basis as and when the opportunity
the development of core principles of Islamic finance presents itself. Finally, with tighter resources, MDBs
regulations that is being pursued by the IFSB. In and the IFSB can also consider leveraging each
analyzing financial stability of countries with an active other’s experience and expertise through closer
Islamic finance sector, an assessment should also collaboration and joint activities, possibly even joint
be made on the adoption and implementation of missions. The combination of the IFSB’s Islamic
these standards by the Islamic financial institutions finance expertise and MDBs’ finance sector experts
in these countries. Currently, the Financial Stability should produce synergies that will be very useful for
Board includes 12 standards as key standards of their common members.

17
See Financial Stability Board. Key Standards for Sound Financial Systems. www.financialstabilityboard.org/cos/key_standards.htm
(accessed 21 February 2014).
87
Chapter 6
Legal and Regulatory Issues for Islamic
Finance: Post-Crisis Scenario
Saleem Ullah
The global financial crisis of 2007–2009 has had operating in a dynamic global business environment
far-reaching implications not only for the financial where intensive reforms of the global regulatory and
systems but also for the real economies across the supervisory framework are being undertaken, there
globe. The crisis is regarded as even more severe is a vital need to continuously review and update the
compared to the Great Depression of the 1930s IIFS legal and regulatory framework to ensure that
in terms of its magnitude, geographical coverage, they remain sound and stable and have satisfactory
and impact on macroeconomic variables (i.e., risk measurement and management systems.
aggregated demand and unemployment). The
negative implications of the crisis are still being felt During the IFSB–ADB Conference on Islamic Finance
in various forms—for instance, the global economic for Asia, jointly organized by the Islamic Financial
slowdown, lingering European debt crisis, and low Services Board (IFSB) and the Asian Development
trust in the financial system’s ability to withstand Bank (ADB) and held in Manila in November 2013,
economic and noneconomic shocks. a roundtable session for regulatory and supervisory
bodies was also held to discuss legal and regulatory
The institutions offering Islamic financial services issues that the Asian Islamic finance industry needs
(IIFS), however, generally performed better and to face in the post-financial-crisis environment.
remained resilient during the crisis due to inherent This chapter specifically first covers the roundtable
checks and balances prescribed by Sharīàh that discussions which, among others, include the
did not allow IIFS to invest in toxic assets and background of the crisis and the resilience of IIFS
derivatives.1 The limited integration of IIFS with during the crisis and reasons thereof. Second,
global financial markets also helped them to fare the chapter discusses the key legal, regulatory,
better in testing times. Policy makers, regulatory and supervisory reforms initiated by conventional
and supervisory agencies, and global standard- regulatory and standard-setting bodies, the needs for
setting bodies, after undertaking extensive diagnosis such reforms, as well as the implications for the legal
of the crisis, have introduced a host of new and regulatory framework for IIFS in the changed
regulations including enhanced capital requirements, scenario. Third, the chapter also analyzes the issues
stringent liquidity requirements, increased focus on related to current Islamic banking practices, the
macroprudential regulations, and more intensive reforms needed in the Islamic finance paradigm, and
supervision of derivatives to avoid a recurrence challenges in the transition toward a more robust
of any such crisis in future. As the IIFS are also financial infrastructure.
Key Reasons for the Financial Crisis
The global financial crisis 2007–2009 was preceded financial products changed the banking model from
by imprudent risk taking behavior by financial “originate and hold” to “originate and disburse.”
institutions leading to highly leveraged credit Traditionally, banks originate loans and hold them
expansion. The underlying systemic vulnerabilities until maturity which provides the necessary incentive
were neither recognized nor mitigated. The to banks to prudently appraise the loans and
epicenter of the crisis was subprime residential ensure their effective monitoring postdisbursement
mortgages, which fueled a housing price bubble in (Brunnermeier 2009). Risk shifting, contrary to risk
the United States.2 How did this enormous credit sharing, became the underlying principle of the
expansion become possible? In fact, innovations in new banking model. Moreover, to give impetus to

1
An IMF study by Imam and Kpodar (2010) shows that Islamic banking and finance (IBF) observed double-digit annual growth globally
during the last decade and has progressed from a niche to a large industry in many countries.

2
Brunnermeier (2009) and Mishkin (2011) provide insights on the crisis in temporal order.
90
Finance: Pos-Crisis Scenario
originating the loans, lending standards and prudent banking practices were also compromised in pursuit of
high rewards and bonuses. Through securitization, illiquid financial assets (such as residential mortgages, auto
loans, credit card loans, etc.) were transformed into marketable debt securities. The most notorious structured
credit products and asset-backed securities (ABSs) are collateralized debt obligations (CDOs) backed by
mortgages, corporate bonds, and loans. These CDOs were then sold across the globe. The role of credit
rating agencies which assigned very high ratings to the CDOs was also highly questionable as they failed to
assess the quality of the underlying assets of the CDOs.
Islamic Banks’ Resilience during the Crisis
While some conventional financial institutions, Zaheer, Ongena, and van Wijnbergen (2013) also
including financial giants such as Lehman Brothers, opined that the main reason for the resilience of
were collapsing, and Bear Stearns, American IIFS during the crisis was the Sharīàh prohibition
International Group (AIG), and many others were on interest-based products and sale of debt so that
being bailed out by the United States Federal IIFS could not invest in the instruments that were
Reserve, the credit and overall assets of the Islamic badly affected during the financial meltdown (i.e.,
banking system were expanding.3 Islamic banks not derivatives and other similar products based on
only have weathered the storm but also registered toxic assets like subprime mortgages). In another
a respectable growth during the turmoil. Assets of study covering 141 countries over the period
the 500 largest Islamic banks grew around 30.0% 1995–2007, Beck, Demirgüç-Kunt, and Merrouche
from $39.5 billion in 2008 to $822 billion in 2009, (2013) discovered that Islamic banks have a higher
the period during which the conventional financial intermediation ratio and higher asset quality, and are
institutions deleveraged their positions through better capitalized.
sale of their assets (International Financial Services
London 2010). The resilience of IIFS during the crisis It was these inherent and built-in control mechanisms
could be attributed to (i) the asset-based nature prescribed by Sharīàh that ring-fenced the Islamic
of financing which ensures growth of the financial banks against the severe shocks created by the crisis
assets in tandem with the growth of real assets and and exposure to speculative and risky avenues. Apart
thus checks for creation of artificial asset bubbles; from the Sharīàh prohibitions and ethical nature of
(ii) Sharīàh prohibition of investment in speculative the business of Islamic banks, the broader enabling
avenues, sale of debt, and short selling which environment and business conditions (including
largely close the door for investments in derivatives legal and regulatory framework, risk management
considering their highly risky and speculative nature; systems, human resources capacity, etc.) of Islamic
(iii) lack of exposure investment in toxic assets such banks were either the same or at a comparatively
as CDOs, again primarily due to Sharīàh restrictions; less developed stage than those of conventional
and (iv) the ethics-based nature of IIFS business. banks.
Key Finance Sector Post-Crisis Reforms
After the financial crisis in the United States and the subsequent sovereign debt concerns in some European
states, proposals have been put forward to strengthen the regulatory framework, including through significantly
enhanced capital requirement and enhanced market discipline. The reforms introduced for this purpose

3
For details, see Hassan and Dridi (2010).
91
include the Basel III capital and liquidity frameworks. recognizes the special nature of these deposits as its
Basel III4 significantly enhanced capital requirements supervisory discretion criteria for the computation of
for banks and also prescribed stringent criteria for the capital adequacy ratio (CAR) allows supervisory
eligibility of an instrument to be part of regulatory authorities to treat the savings deposits (profit sharing
capital. It also introduced capital conservation and investment accounts, or PSIAs) as zero, partial, or
countercyclical buffers to help control systemic full risk-absorbent. The zero risk-absorbent PSIAs
risks arising from the interconnectedness of behave just like conventional deposits, whereas
financial institutions and procyclicality. Furthermore, fully risk-absorbent PSIAs are equity natured
additional capital requirements for systemically and thus require no capital to provide cushion to
important banks, both at the global and domestic such depositors against credit and market risk. In
level, were also introduced. The introduction of the practice, however, the savings deposits are not fully
leverage ratio is also aimed at strengthening the risk-absorbent as the IIFS in most of the jurisdictions
capital base and discouraging excessive leveraging. use various profit-smoothening tools including Hiba
The other key reforms initiated include more (paid from IIFS capital and reserves) to pay market-
stringent liquidity requirements through introduction comparable returns to their depositors. The profit
of the liquidity coverage ratio and net stable funding distribution framework issued by the State Bank
ratio, complementing microprudential supervision of Pakistan, however, does not allow IIFS to give
with macroprudential supervision to identify system- Hiba to the savings depositors from its capital and
wide risks and imbalances, and more extensive reserves.
supervision of the derivatives markets. Furthermore,
some jurisdictions have developed proposals for The European Parliament in April 2014 approved
“problem banks resolution” to avoid system-wide a financial framework called the Single Resolution
implications of their failure. Mechanism for restructuring of the banks facing
severe solvency problems.5 The Single Resolution
The reforms and corrective measures introduced Mechanism will ensure that a failing bank in the
at the global level are largely in line with Sharīàh banking union is handled promptly and efficiently,
principles. The revised capital adequacy standard without shifting costs to the taxpayers and the real
Basel III significantly enhanced the size and quality of economy. It will also minimize the need for bailouts
the banks’ capital to improve their ability to withstand of failing banks through taxpayer money and help
exogenous as well as endogenous shocks. Islamic central banks and regulatory bodies in ensuring
finance principles also encourage and allow equity financial system stability. The bail-in of failing banks is
based contracts and discourage debt based one of the key components/tools of the mechanism,
contracts. The savings deposits of Islamic banks under which the failing bank will be “recapitalized”
are largely based on equity-natured Muḍārabah through allocation of the bank’s losses to the equity
which insulates Islamic banks from insolvency risk holders and then to creditors/depositors of the
due to the pass-through nature of these deposits. failing bank. Thus, in case of financial distress in
In a number of jurisdictions, the savings deposits the bank, the creditors/depositors would be treated
are categorized as quasi equity or redeemable as shareholders (burden sharing). Accordingly, a
capital. The IFSB capital adequacy standard also problem bank, for which a private investor could not
4
Basel III has been developed to strengthen the capital position both by increasing liquidity and decreasing leverage in the banks.
Regulations about the structure of the banking system are proposed in the Volcker rule, Vickers initiatives, and Liikanen proposals.
These initiatives broadly try to end implicit too-big-to-fail subsidies by reducing economies of scope (Gambacorta and Rixtel 2013)
as the diversification by the large global banks has been intertwined with a high concentration of financial services in a few large and
complex financial conglomerates (Boot 2011).
5
The banking union under a single supervisory mechanism would be operational in late 2014. For details, see http://europa.eu/rapid/
press-release_IP-13-674_en.htm?locale=en
92
be attracted, will still continue to provide banking securities should be related to the performance of
services without the necessity of a bailout by the overall economy.
taxpayer funds. This sort of mechanism was actually
practiced in the case of the Bank of Cyprus. The These examples from the conventional financial
largest bank of Cyprus completed its recapitalization system amply demonstrate that the Islamic finance
process through bail-in of depositors in July 2013. principles are not just theoretical and utopian
The bank transformed 60.0% of major depositors concepts, but rather provide the basis for a practical,
(over 100,000 euros) into its shareholders. Bailed-in viable, and stable financial system. The size, severity,
depositors hold around 81.0% of the bank’s share and magnitude of the financial crisis of 2007–2009
capital. have probably forced the economists and policy
makers to explore alternate solutions and systems
The ban on short selling soon after the financial to ensure financial system stability and to develop a
crisis 2007–2009 in different countries including just and equitable financial and economic system. It
the United States, the United Kingdom, France, is therefore high time for Islamic economists, finance
Germany, Switzerland, Ireland, and Canada is professionals, practitioners, and Sharīàh scholars
also a reflection of Islamic banking and finance to develop practical solutions that meet the Sharīàh
principles, as in Sharīàh (Islamic law) one cannot objectives of equity, justice, and transparency and
sell an object unless he or she owns it. Similarly, provide better value propositions to the masses.
the issuance of a gross domestic product indexed This would require significant changes in the current
bond6 by Greece during the crisis is also in Islamic banking paradigm, which although it meets
congruence with Islamic banking and finance the minimum Sharīàh requirements is not fully
precepts as returns on any general government aligned with the objectives of Sharīàh.
Current Islamic Banking Paradigm
Notwithstanding the aforementioned features of well as monitoring) or to compromise on some of

Islamic finance, which are the sources of stability in the the processes to reduce the transaction costs, albeit
Islamic financial system, the current Islamic finance at a risk of weakening Sharīàh permissibility of the
paradigm is focused on offering Sharīàh-compliant products/transactions.
alternates (replicas) of conventional products with
more or less similar risk profiles and economic There is now a growing trend of replacing asset-
outcomes. Furthermore, most of the Islamic based financing with more flexible cash-based
finance transactions are debt based and priced on products (e.g., salam-cum-wakalah, istisna-cum-
conventional benchmarks. The asset-based nature wakalah, etc.), which behave more or less like
of Islamic banks transactions, though it ensures the working capital in conventional banks. While these
productive use of the financial resources, increases transactions and products do pass the Sharīàh
the transaction cost due to additional processes permissibility tests, they lack real-sector link and are
introduced to comply with Sharīàh requirements. meant for extending financing to the clients based on
This puts Islamic banks at a relative disadvantage conventional benchmarks rather than undertaking
vis-à-vis conventional banks, thus compelling them real trade and/or business activity envisaged and
to give price discounts to compensate the clients encouraged by Sharīàh principles. Similarly, one can
for increased transaction costs (documentation as see the growing urgency in some of the jurisdictions

6
The returns of these bonds are benchmarked on nominal gross domestic product growth rates to be achieved during different periods.
93
to introduce Sharīàh-compliant derivatives to hedge different types of risks on Islamic banking institutions’
balance sheets. Even on the liability side, Islamic banks in some key jurisdictions have started raising fixed
return deposits using commodity Murābahah. These developments raise important issues for both the Public
and Private sectors. One issue is in striking a balance between strengthening risk mitigation measures, whilst
avoiding the use of instruments that are similar to those implicated in the global crisis. A second issue relates
to the Islamic banking paradigm, if not reformed and aligned with Maqasid Sharīàh, and whether it will lose
its separate identity and converge to the conventional system. With exposure to almost similar risks and
vulnerabilities as those of conventional banks, there would hardly be any need for a separate and distinct legal
and regulatory framework for Islamic finance.
What Is the Solution?
Based on the various issues and challenges ethics-based nature. One of the fundamental issues
highlighted above in the current Islamic financial with the current Islamic banking paradigm is its focus
system, the following are some proposed solutions: on developing Islamic structure of conventional
products with more or less similar risk and reward
• Transition of Islamic banking toward a paradigm profiles. This approach has not only made Islamic
which is in line with Maqasid Sharīàh banks inefficient vis-à-vis conventional banks due
• Transition from “replicas” to “original” Sharīàh- to greater transaction costs but has also been a
permissible products having a better value source of negative perception for the Islamic finance
proposition for the clients, economy, and society industry.
• Transformation from risk shifting toward a risk-
sharing mechanism on both sides of the balance The Islamic banks under the paradigm
sheet envisaged in this chapter will have three
• Bringing “realism” to the products and arms: (i) commercial banking arm to provide
transactions payment system related services, remittances,
• Financial intermediation plus model trade facilitation through letters of credit, etc.;
• Universal banking model with commercial (ii) investment banking arm to make risk and reward
banking, investment banking, and real trade sharing (equity natured) investments in different
arms Sharīàh-permissible business avenues; and
• Segregation of payment system deposits and (iii) real trade/business arm to undertake different
investment accounts real business activities with a clear demarcation
• Development of supportive and effective legal, between banking and real business activities. Islamic
regulatory, and risk management framework banks will have two broad categories of deposits:
• Development of supportive monetary policy (i) the Qard-based current deposits attracting a
regime including Sharīàh-based money creation significantly large reserve requirement and investing
mechanism the remaining portion in high-quality liquid assets
to ensure smooth functioning of payment system,
The above proposed solutions would enable an and (ii) investment deposits of varying maturities
appropriate portfolio different paradigm of the Islamic and risk profiles to be invested in an appropriate
financial system, based on Sharīàh principles of portfolio based on risk and reward sharing principles
justice, transparency, and equity that would create including funding the investment banking and real
value for all the stakeholders and ensure financial business arms of the bank.
system stability due to its risk sharing as well as
94
This model, if developed and implemented policy makers are largely compatible with the Islamic
professionally with sound risk management systems, finance principles gives further credence to the
will significantly improve the return profiles of Islamic utility and practicality of these principles for ensuring
banks both for the investment account holders financial system stability.
(depositors) and shareholders and will enhance
turnaround to the recognition and acceptability of However, in many jurisdictions the existing legal and
Islamic finance as a distinct viable and competitive regulatory framework which has been developed
financial system that offers a better value proposition keeping in view the nature of business and risk
to its users and society as a whole. The critics of profile of conventional banks, does not provide
Islamic finance believe that the Islamic economic adequate recognition of the needs of the Islamic
and financial system exists only in theory and is not banking paradigm. The regulators and policy makers
practical. While it is true that the system in its entirety thus should make an objective assessment of the
is not operative in any jurisdiction, however, the utility of the Islamic finance system (compatible with
recent crisis has amply exposed the fault lines and the Sharīàh objectives of a fair and just financial
vulnerabilities of the conventional financial system, and economic system) for financial system stability
and there has been increased awareness of the need and related socioeconomic objectives and, if
for alternative approaches that could ensure financial satisfied, with its utility, initiate suitable changes in
system stability and promote ethical conduct. the framework to allow Islamic banks to adapt their
Further, as discussed in the earlier section that the business model in line with Maqasid-Sharīàh.
reforms introduced by conventional regulators and
Conclusion
The latest financial turmoil in the United States and In the aftermath of the current financial crisis, Islamic
the sovereign debt crisis in European countries banking and finance has an opportunity to offer the
pose a key question to academics and policy world a financial system less prone to financial crises
makers: How can the financial system avoid these due to the inherent features of its business model.
debacles? Some preventive and curative measures Islamic structures require the investors to share in
have been suggested in this regard. The European the returns of the bank, whether positive or negative.
Commission suggested a bail-in, instead of a bailout, Thus, the (investment) depositors of an Islamic bank
of the failing bank by transforming creditors of the are its time-limited shareholders, depending upon
failing bank into shareholders. This type of solution the maturity of the investment deposits. Since this
has already been applied to the Bank of Cyprus in provides an extra equity cushion for Islamic banks,
the recent Cyprus crisis. The preventive measures the loss absorption capacity of an Islamic bank is
consist of mainly the Basel III Accord, in which higher than that of conventional bank. The fact is
minimum capital requirements have been enhanced. that conventional finance is proposing the features of
A stringent liquidity requirement has been imposed Islamic finance only for the “failing” banks and not for
on the banks requiring them to maintain conservative the “successful” bank; that is, the proposed Single
liquidity ratios (e.g., liquidity coverage ratio and Resolution Mechanism only shares the downside of
net stable funding ratio). Moreover, micro- and the bank’s business with the creditors but not the
macroprudential supervision has been proposed to upside.
regulate the finance sector.
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The strength and comparative advantage of Islamic proposition to its clientele and society as a whole. The
finance is in equity-natured transactions on both the existing legal and regulatory framework, however,
assets and liabilities sides of Islamic banks’ balance does not provide the necessary space to Islamic
sheet. This would not only enhance their stability with banks to move toward this paradigm. Similarly, the
minimum insolvency risk (due to the pass-through existing risk management systems of banks are not
nature of profits and losses), but would also ensure tailored to manage the risks associated with this
equity-natured participation of a large number of paradigm. The regulatory and supervisory bodies
depositors in different real sector projects. The thus, in consultation with the practitioners and
equity-natured portfolio of financing and investments other stakeholders, should initiate studies to assess
are also likely to significantly enhance the returns the feasibility of the proposed paradigm and make
to the depositors and would improve acceptability necessary amendments in the legal, regulatory, and
and recognition of Islamic finance as a distinct, risk management frameworks to allow a gradual
viable, and competitive system offering better value movement toward the new paradigm.
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Chapter 7
Taking the Initiative for Islamic Finance:
Role of Governments and the Private
Sector
Badlisyah Abdul Ghani
Role of Governments and the Private Sector
In order to have an effective discourse on the kind As an exemplar of government’s instrumental role in
of initiatives for Islamic finance that governments the development of Islamic finance, Malaysia took it
and the private sector in any jurisdiction should be upon itself to build and develop the Islamic banking
pursuing, it is important to understand the philosophy and finance industry back in the 1960s, immediately
of Islamic finance. The emergence of Islamic finance after gaining independence in 1957. Despite the
is considered one of the important events of the challenging political and economic environment at
millennium, an event that to a certain extent has that time, the Government of Malaysia laboriously
contributed to the dynamics of the world’s economic built up the industry from scratch through trial and
and political changes. The paradigm shift has the error. It has been a progressive 50-year journey,
potential to forge greater international financial linkages and the regulatory, legislative, tax, and supervisory
between countries, particularly among the Islamic frameworks established in Malaysia for the Islamic
countries. Islamic finance can contribute toward a finance industry can be seen being emulated by
more optimum allocation of wealth across borders and many countries all over the world.
help the world’s Muslim population participate more
actively in financial and economic activities.
The Origin and Modern Growth of Islamic Banking and Finance
Islamic finance aims to provide economically viable Sultanate until 1511, and in the Ottoman Empire
financial intermediation alternatives, framed within (Turkey) until 1918. It is a system which has existed
the boundaries set by Islamic principles. These for the last 1,435 years but had lost its way due
activities involve the intermediation between the to changing political and legal systems across the
haves and have-nots across all customer segments Islamic world in the last millennia. It has been a slow
in a manner consistent with Sharīàh. It was a system lesson relearning what is available under the system
developed under the reign of the Muawiyad and over the last 50 years. Malaysia, as one of the global
the Abbasid Caliphates from the year 661 to 850, centers of Islamic finance, has been at the forefront
and thereafter it was spearheaded by great Islamic of this modern day rediscovery and redevelopment
empires such as those in Andalusia (Spain) until the of the industry.
year 1031, in Granada until 1492, in the Malacca
The Exemplar of Government and Private Sector Partnership in Promoting Islamic Finance
In 1963, the Government of Malaysia via legislative The initiative that led to the establishment of the
enactment formed Tabung Haji or the Pilgrimage initial formal, regulated framework for Islamic
Fund, the first of its kind in the world. Tabung Haji finance was done through a very strategic public–
enabled Muslims to save their money in a formal private partnership. A group of private individuals
institution and enjoy good returns on their deposits (as representatives of the banking industry) and
in compliance with Sharīàh. As a next milestone, public sector officials collaborated in the drafting of
in the early 1980s, Malaysia took steps to set up a a white paper on Islamic banking and lobbied the
commercial Islamic bank. government and parliament to enact a new law for
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the same. The pioneering Islamic Banking Act was the Interest Free Banking Scheme (later known as
ratified in 1983 and saw the immediate establishment Islamic Banking Scheme or Skim Perbankan Tanpa
of the country’s first licensed Islamic bank. This was Faedah) was introduced which allowed all licensed
followed by the enactment of the 1984 Takāful Act conventional banks to offer Islamic banking products
and establishment of the country’s first licensed and services, provided separate funds are created
Takāful company in the same year. for the latter to ensure there was no comingling of
funds. The scheme led to the success in penetrating
Ten years after the incorporation of the first licensed a wider customer base for the Islamic banking
Islamic bank and Takāful company, the government system in Malaysia: the Islamic banking share grew
realized that Islamic banking and finance had more from a mere 1.0% over a period of 10 years since the
to offer to the country and could actually become establishment of the first Islamic bank to about 6.0%
one of the main components of the mainstream practically overnight. The Government of Malaysia
financial market alongside the conventional system. has therefore realized that Islamic finance is equally
It was possible to use Islamic finance as the key for demanded by non-Muslims due to its economic
a more inclusive national development. As a result, value propositions (see Figure 7.1).
Figure 7.1: Considerations of Muslim and Non-Muslim Customers in Adopting Islamic Finance
Shariah facilitates unlimited market for IFIs through innovative

products and services as they are beneficial for both Muslims
and non-Muslims customers.
Muslims: Non-Muslims:
• Islamic financial market:
Want products and • Banking Want products and
services that provide • Money Market services that provide
them value and meet • Debt Capital Market them value .
their personal and • Equity Capital Market
preferred Sharīah • Derivatives Do not care about
application as found • Private Equity Sharīah compliance but
under the different • Takāful care about ethical
school of laws- • REITs business and social
Hanbali • Asset Management responsibilities, which
Maliki • Wealth Management are embedded under
Shafei • Non FI Services Sharīah principles.
Hanafi • Other Financial Products and
...and many more Activities
IFI = Islamic financial institutions; REITs = real estate and investment trust; FI = financial institution.
Source: Author’s own illustration.
Knowing that the integrity of the Islamic financial market and the stability of the overall financial market must
be protected to provide certainty of business to the private sector players, the government amended the
Banking and Financial Services Act 1989 to ensure an orderly undertaking of the regulated Islamic finance
activities. All Islamic finance activities must be done by the conventional bank as a licensed Islamic window
operating as “a bank within a bank” with its own capital allocation as well as separate balance sheet and profit
and loss account. This created the right kind of industry discipline among the industry players. The Islamic
window framework introduced by the government brought about proper risk management and asset liability
management in the Islamic finance industry with an emphasis on an end-to-end Sharīàh-compliant system.
This also went a long way to build consumer confidence in the broadening industry base from among the
Muslim and non-Muslim customers.
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The Islamic banking share of the market today is of total outstanding corporate issuances in Malaysia.
approximately 26.0% of overall banking assets and The country is now home to the largest Sukūk market
is growing faster than that of conventional finance. in Asia and the world.
With Islamic banking proving to be an efficient and
important component of the overall financial market Recognizing the demand for equity investment
in Malaysia, the government decided that the among Islamic investors, the Government of
country must have a holistic, robust, and sustainable Malaysia introduced the world’s first regulated
Islamic financial market encompassing all sectors Islamic index in the early 1990s. This was followed
including banking, insurance, money market, by various regulatory guidelines to promote Islamic
and capital market. As such, the government has equity activities such as the Guidelines on Sharīàh-
introduced numerous initiatives for the development Compliant Stocks, Guidelines on Islamic Initial
of the Islamic capital market. With foresight, the Public Offerings, Guidelines on Islamic Real Estate
soft launch of this industry was back in 1984 when Investment Trusts, and Guidelines on Islamic
the government issued the first Islamic treasury Warrants. With active participation by the private
papers which were initially intended to help liquidity sector to manage their business consistent with
management of Bank Islam Malaysia. the criteria set under the Islamic index as well as
undertake all the different Islamic equity products
The continued issuance of benchmark sovereign facilitated under the various guidelines, Malaysia
Sukūk instruments by the government established today hosts one of the largest Islamic stock
a good benchmark yield curve that allowed the exchanges where over 60.0% of companies listed
private sector to confidently undertake corporate are Sharīàh-compliant.
Sukūk issuance in 1990s. In fact, the first ever
corporate “bond” issuance in the country was a With a strong Islamic banking sector and Islamic
Sukūk. Shell MDS (Malaysia) issued the world’s capital market (both equity and debt), there was
first rated corporate Sukūk in 1990 to the amount increasing demand for Islamic asset management in
of RM150 million. This was a sign of Malaysia’s the private and public sector investing communities.
significant Islamic finance potential and a source of Existing licensed asset managers were allowed
considerable value proposition for Shell, one of the to offer Islamic fund management services in the
world’s largest corporates. Again, there has been a late 1990s through the addition of new provisions
strong partnership between the government and the under the existing regulation. The industry has seen
private sector in the development of the Islamic debt phenomenal growth in the Malaysian market as
capital market in Malaysia. players in the market undertook the activities to meet
the vast demand. Malaysia has arguably one of the
Since the government established the Islamic largest Islamic asset management industries in the
Securities Guidelines in 2004 through a joint public– world, challenged only by Saudi Arabia in terms of
private sector consultative committee, various types assets under management.
of Sukūk issuances have been structured in the
Malaysian capital market with tenures of less than Islamic asset management has also gone beyond
12 months to a 50-year Sukūk and lately perpetual unit trusts to include alternative investments such
Sukūk. Nearly two-thirds of total outstanding Sukūk as private equity funds, real estate investment
today have been issued out of Malaysia, and the trusts, exchange trade funds, and so on. Both the
country dominates the primary Sukūk market private and public sectors have played their roles in
with about half of all new Sukūk issues completed facilitating these efforts. In order to promote broader
every year. Corporate Sukūk have outstripped Islamic finance activities, the Government of Malaysia
conventional bonds with a more than 60.0% share has introduced new licenses for foreign currency
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asset management activities with seed funding given Islamic derivatives instruments, as they were critical
to qualified international fund managers. In order for for the industry that had reached a significant size to
Malaysian Islamic funds to be marketable in other be able to manage risk well. This has since allowed
parts of the world, the industry players ensured Malaysian Islamic banking players to be more
acceptance of these funds on foreign platforms effective in growing their Islamic finance business in
such as the Undertaking for Collective Investment in the local as well as regional markets.
Transferable Securities Directive that allows them to
sell in the European Union. Today, Malaysia’s Islamic financial market is to a
very large degree complete, comprising the banking
A financial market without the ability to manage risk sector, the interbank money market, the debt and
effectively and efficiently cannot be sustainable and equity capital market, asset management, Takāful,
stable. As such, the Malaysian regulator facilitated other nonbanking financial activities, and the
the introduction of a formal Islamic derivatives derivatives market as well, hence meeting diverse
market in 2004. Once again, the government and the stakeholder needs (see Figure 7.2).
private sector worked together closely to develop the
Figure 7.2: Development of Islamic Finance and Stakeholder Expectations
Development of Islamic finance is subject to basic stakeholders expectations and

Maqasid Al-Shariah in each financial activities that is undertaken...
Stakeholders’ Expectations
Customers Shareholders Governments/Regulators Employees
Good, Real Sharīah Protect public Protect Good

Maximize
competitive compliance of interest, nation systemic employment
profitability
products their choice building integrity opportunities
Serious and
No fraud and Maximize committed
Wealth Social Proper wealth
misrepresen- financial employer in
creation responsibilities distribution doing the
tations inclusion
business
Note: Maqasid Al-Shariah means in whatever we do we must serve the interests of all human beings and to save them from harm.
This influences how stakeholders’ expectations are articulated and propagated.

The role that the government and the private sector in Malaysia have played in taking Islamic finance to its
current state could be replicated, with certain adjustments, by any government and private sector in the world.
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Islamic Finance: Global Context and Prospects
The industry has been growing at approximately India’s state of Kerala has allowed Islamic banking to
20.0% per year, driven partly by Islamic investors be done through the nonbanking financial institutions.
seeking more ethical forms of investment, rising It is a commendable beginning, but it is not the
Muslim wealth, international business interest in same as having it done under the financial market
liquidity-abundant economies of the Gulf, and regulatory framework to accord Islamic consumers
accompanying supporting initiatives of government similar protection as available under conventional
and multilateral organizations. Together with strong finance. South Africa already has a history of Islamic
economic growth across emerging Islamic countries, finance spearheaded by the Bahrain-based Albaraka
this provides a good impetus for the Islamic finance Banking Group; more recently, local banks such
industry globally, as it will further drive both public as ABSA, First National, Nedbank, and Standard
and private sector interest in many jurisdictions. Bank have entered the market in a much more
committed drive, especially in retail banking and
Many economies with predominantly non-Muslim asset management. The Government of South Africa
populations, including the United Kingdom, Japan, issued a much awaited Sukūk in September 2014.
South Africa, France, and Hong Kong, China, are
seeking to tap into the growing demand for Islamic The next phase of industrialization—which will see an
financial products and services. In this light, many annual infrastructure investment requirement for Asia
have announced initiatives for Islamic finance. For of about $750 billion up to 2020—cannot be financed
example, the United Kingdom has several locally solely out of equity or government revenue. There
incorporated Islamic banks and issued a debut will be an increasing reliance on the debt markets
Sukūk in mid-2014. London is eyeing the coveted for Sukūk and for financing syndications. Islamic
position of an Islamic financial hub in the Western finance is set to leverage its position because of its
world. Singapore has similar aspirations in Asia. The competitive pricing and now increasingly acceptable
Monetary Authority of Singapore has introduced structures for a wider investor base. The extra tier of
regulatory changes to facilitate syndicated Sharīàh compliance is no longer a barrier to entry
Murābahah transactions, Sukūk, and Islamic funds for Islamic finance, as witnessed by the subscription
and is planning to do more to strengthen Islamic of an increasing number of conventional banks in
finance’s footing in the country. Corporate interest in Europe, the United States, Asia, and South Africa to
Islamic finance, reflected in several Sukūk issuances, Islamic instruments such as Sukūk and Murābahah
have benefitted from such facilitation by the financial syndications. These banks are now increasingly
regulatory authority. comfortable with the risks associated with these
instruments so long as a strong enabling environment
Following the first Sukūk issued out of the United is present to provide certainty of business. Such
States by a gas company, East Cameron Partners certainty can only be there if governments take a
in Houston in 2006, corporates in the United strong role for its facilitation.
States, United Kingdom, Japan, and the European
Union have shown interest in utilizing the structure An area of high potential for Islamic finance is in
to raise funds to refinance existing corporate poverty reduction. With more than 650 million
debt or to finance working capital and expansion Muslims across the globe living in poverty (El-
activities, including acquisitions. A number of foreign Zoghbi and Tarazi 2013), there is a compelling
companies—including Tesco, Aeon, and Nomura— reason for governments and private sectors to
have tapped the Islamic finance marketplace in push for further development of the industry to
Malaysia which boasts sophisticated regulations and promote financial inclusion. Greater availability of
a ready base of Islamic investors. Sharīàh-compliant products and services of various
102
kinds (including microfinance and microTakāful) will or developmental agenda, the industry requires
eventually lead to greater participation of the Muslim continuous improvement and innovation , supported
population in both domestic and global economic by the government and the private sector, to meet
activities. Whatever the factors driving the Islamic the growing appetite for Islamic financial products
finance industry globally, be it a profit seeking and services.
Demand for Innovation and Rigor of Sharīàh Governance to Meet Needs
The evolution of sophisticated Islamic financial only for leasing activity. However, in the industry, a
products that have been structured based on singular Sharīàh principle can be used to facilitate
multiple Islamic concepts has resulted in a new various activities. As such, Ijārah can be used to for
wave of innovation over the last 50 years since the a financial lease, operational lease, home financing,
rediscovery of Islamic finance. These products have corporate financing, small and medium-sized
become competitive and efficient both in terms of enterprise financing, car financing, project financing,
structure and pricing. Nonetheless, many seem to credit cards, and Sukūk. The financial activity carried
have looked upon innovation in Islamic finance over out is the real substance of the transaction and not
the recent years with suspicion. necessarily the underlying Sharīàh principle.
Innovation in Islamic banking and finance must be There is also a view that an Islamic financial activity
looked at from a demand perspective and in a way can only be facilitated by a singular Sharīàh principle.
that complies with Sharīàh on a jurisdictional basis This, however, is inaccurate. Each financial activity
subject to local parameters in any one country, such could be structured using a combination of different
as the law of the land, market conventions, culture, Sharīàh principles. For example, home financing
and customs. Herein lies the problem, however: can be facilitated using the Bai Bithaman Ajil,
What is right under Sharīàh in any one country? Murābahah, Ijārah, or Mushārakah Mutanaqisah.
Moreover, in a single financial activity, various
In Malaysia, both the government and the private principles may be used, as in the example of a
sectors have approached Sharīàh governance Mushārakah Mutanaqisah home financing facility in
in a very pragmatic manner. Understanding this Malaysia which combines the principles Bai (sale),
pragmatic role is critical for any initiative to take Mushārakah (joint ownership), and Ijārah (leasing).
Islamic finance forward in any jurisdiction. Islamic
banking and finance industry typically comprise many These approaches are not only pragmatic but are
types of activity—banking, asset management, debt also consistent with the Sharīàh requirement for
capital market, and so on. transparency and are in line with the need to manage
systemic risk in the financial market. Both the
The common market perception is that each government and the private sector must communicate
Sharīàh principle needs to be fitted into a specific the right information to the public, for without proper
activity. As an example, there is a predominant disclosure, the real impact on systemic risk cannot be
thought that the Sharīàh principle of Ijārah is used appreciated and monitored (see Figure 7.3).
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Figure 7.3: Position of Islamic Financial Activities within the Greater Islamic Economic System
IFI undertakes specific activities under Sharīah and the business and
operating model it adopts reflects these and so does the innovation it
undertakes under each.
Sharīah
Fiqh
Muamalat Ammah
Muamalat
Economy
Commerce
Finance
Trading Equity
Mura- Baitul- Cap Banking
Aqidah Ibadah Politics
kahat mal Market
Limited Debt Cap Deposit Financing
Akhlak Jinayah Social Zakat
Com Market
Public Partner- Private Interbank Investment
Others service ship/JV Equity
Others Others Fund

Mgmt Takaful Others
IFI = Islamic finance institution, JV = joint venture.
Banking activities within the Sharīàh-compliant other schools among the users of Islamic financial
system must be undertaken by a licensed bank, products and services, since each jurisdiction has to
seeing that banking is a regulated activity in all deal with international counterparts and customers.
countries. Similarly, Islamic insurance must be From a practitioner’s perspective, private sector
operated by a licensed Takāful company. Regulated intermediaries must facilitate the differing demands
Islamic debt or equity capital market transactions among the customers, regardless of the possible
must be facilitated by licensed investment banks. It differences in Sharīàh preferences. The governments
is hence evident that the Sharīàh-compliant system and regulators must provide an enabling environment
is very similar to conventional finance, except that to facilitate this.
its activities must be done differently in accordance
with the Sharīàh requirements. However, how these Under the Islamic Banking Act 1983, which was
contracts are applied may differ from one jurisdiction recently replaced by the pioneering Islamic Financial
to another depending on local parameters adopted. Services Act 2013, Malaysia defines Islamic banking
activities generically as those activities that are not
Differences of interpretation of Sharīàh principles are in contradiction with Sharīàh. This essentially allows
allowed, and such flexibility is in fact one of the best for all recognized interpretations under any Sharīàh
features of Sharīàh. Amongst Sunnis, there are four school of thought, thus creating a market where
major schools of thought in Islamic jurisprudence. demand and supply determine the most efficient and
However, a jurisdiction may have followers from effective structures.
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Furthermore, Islamic finance activities fall under Sharīàh in the whole market between 1983 and
the Muamalat section of Sharīàh. Under Muamalat 1996, underscoring the importance of private sector
(human-to-human relationship), all matters are involvement in managing industry integrity and
allowed unless proven impermissible specifically propagating innovation. Centralization of Sharīàh
under the Quran and authentic Hadith. This differs supervision also limited unproductive debate among
from Aqidah (human-to-God relationship), which is Islamic financial institutions regarding the superiority
applicable only to Muslims, where all matters are not of their products based on Sharīàh criteria and
allowed unless it is proven permissible specifically. instead has promoted greater transparency and
Therefore, appreciating permissible differences in disclosure.
Sharīàh is imperative when undertaking Islamic
banking and finance activities. In Malaysia, although the decisions of the Sharīàh
Advisory Council are binding on Islamic financial
In doing this, the industry needs to take guidance institutions, the financial regulator does not get
from experts in Sharīàh. In Malaysia, there exists involved in dictating what operational Sharīàh
a regulated enterprise-wide Sharīàh governance preferences must be adopted by the market. The
framework established under the Islamic Financial regulator simply provides an enabling process that
Services Act 2013. The financial regulator, through allows the players to have their products cleared
the Sharīàh Advisory Council, ultimately governs as financial products consistent with Sharīàh. The
all Sharīàh matters in the Islamic banking and regulator clears all such Sharīàh applications as long
finance industry in the country. All licensed Islamic as they are justifiable under the sources of Sharīàh
financial institutions are required to have a Sharīàh and, once cleared, plays the role of ensuring market
committee, appointments to which are subject confidence through monitoring and supervision it.
to regulatory approval. Prior to the legislation of Thus, the regulator supervises the management of
the present Sharīàh governance framework, the Sharīàh so as to ensure the stability of the market
Sharīàh committee of Malaysia’s first licensed and systemic integrity and does not enforce Sharīàh
Islamic bank was used as the ultimate arbiter of preferences upon market players.
Conclusion
The global Islamic finance industry is a business- Both the government and private sector must play
driven industry that caters to the needs of multiple their part within a partnership to take Islamic finance
stakeholders, irrespective of religious beliefs held. to where it needs to be in the larger scheme of
Neither the government nor the private sector can things. The government enables and facilitates, while
take the initiative for Islamic finance forward without the private sector executes. The cons of only one
the other. Finance is a regulated activity, and Islamic dominating the push for Islamic finance is clear: The
finance, as one form of finance involved in financial industry would not grow and, if there is development,
intermediation across all known types of financial it would be weak without a real impact to the
activities with consumers, thus must be regulated. country. Hence, the public–private partnership must
If regulation is refused, then regulators would not be exist to take the initiative of Islamic finance to great
fulfilling the basic reasons for their existence, which heights in any particular jurisdiction. The pros of this
is to provide an inclusive financial market and a proposition can be clearly seen from the success in
stable financial system to support the government’s the Malaysian financial market—the world’s largest
objective of providing an optimal mechanism for and most dynamic marketplace for Islamic finance.
wealth distribution among the populace and greater
national development.
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Chapter 8
The Way Forward: Key Islamic Finance
Challenges and Road Map for Asia
Dr. Ishrat Husain
The way forward for the global Islamic finance critical question posed forward is: What makes Islamic
industry1 has to be built upon an edifice where finance more stable and resilient against anticipated
the distinctive and unique characteristics and the shocks vis-à-vis conventional banks? Would it be the
fundamentals of Islamic finance are closely set out, Sharīàh-compliant financial instruments themselves
understood, and disseminated widely. In this regard, a or the practices and processes of Islamic finance?
Islamic Finance: The Resilience Factors
The Islamic financial system is built-in with principles the shareholding risks are limited to their equities and
of Sharīàh that naturally incorporate several factors there is an underlying sense of assurance that the
promoting market discipline, stability, resilience, government bailout using taxpayer money can save
and overall ethical practices that instill prudence the day. However, if the risky investments pay off,
and soundness in transactions. An Islamic banking it will result in magnified profits for the shareholders
system promotes a unique underlying relationship and management of these investment banks.
between the depositors and shareholders; by use
of partnership and risk-sharing contracts such as In Islamic finance, leveraging on borrowed funds from
Muḍārabah, deposits structured as special accounts the money markets is not a norm as Islamic banks
have the propensity to absorb losses as opposed to usually have ample liquidity at their disposal and it is
passing them in entirety to shareholders alone. This the dearth of productive assets that keeps deposits
enables the capital adequacy ratios of Islamic banks underdeployed. As a result, Islamic finance follows
to be at comparatively higher levels than those of a course of natural rather than unnatural growth,
conventional banks as the loss-absorbing properties because it does not permit the existence of invented
of special investment accounts reduce the burden or contrived money. These factors contribute toward
on the equity capital. a relatively stronger confidence of depositors in
Islamic banks and it is widely regarded that during
Meanwhile, the Sharīàh prohibition on investments the peak of the crises, several conventional finance
involving exposures to highly risky and uncertain depositors transmitted their funds to Islamic banks
contractual outcomes is an important source for safekeeping. The asset-based and/or asset-
of financial stability. As such, Islamic financial backed nature of financial transactions in Islamic
institutions are shielded from investments in highly finance helps establish a link with the real economic
leveraged and toxic assets such as securitized sector and limits risks growing out of proportion
derivatives and other exotic products in conventional beyond the real economy.
finance. During the onset of the global financial crisis,
several conventional investment banks were found Furthermore, Islamic banks did not participate in
to be highly leveraged on funds from the money exotic structuring of securitized assets which deeply
markets and then placing these borrowed funds affected the major conventional banks. Exotic
on risky investments for quick gains. Excessive risk products such as collateralized debt obligations,
taking is a natural consequence of the asymmetric which resulted from slicing and dicing various loan
relationship between appropriation of rewards and portfolios into structured financial assets, would
incurrence of risks among conventional finance not obtain Sharīàh compliance from the Sharīàh
players. In an event of market financial downside, supervisory boards of Islamic banks.
1
This chapter is based on the panel discussion that took place at the final session of the Conference. The panel was led by two
chairpersons: Rajat M. Nag (Former Managing Director General of the Asian Development Bank) and Jaseem Ahmed (Secretary-General
of the Islamic Financial Services Board). In addition, the panel consisted of three speakers: Richard Thomas (Chief Representative for
Gatehouse Bank in Malaysia), Baljeet Kaur Grewal (Managing Director and Vice Chairman of Kuwait Finance House Research), and
Madzlan Mohamad Hussain (Partner at Zaid Ibrahim and Co. in Malaysia)
108
Overall, it is a combination of Sharīàh-compliant financial instruments as well as practices and processes in

compliance with Sharīàh that contributes toward the stability and resilience of Islamic finance.
Risks and Challenges Impacting the Industry
During the first phase of the global financial crisis holders which still remains the prime raison d’être
of 2008–2009, Islamic banks were largely insulated for the existence of these banks. In contrast, the
from adversities as they did not carry any contrived dilution of social responsibility may deviate from its
products on their books. However, in the second distinctive and unique feature. The line between
phase, when the broader economy was impacted following ethical values, which is the core proposition
and disposable household incomes were reduced, of Islamic finance, and earning adequate returns at
real estate prices fell drastically. Real estate was the the same time in a market that is volatile and that has
natural hedge for Islamic banking transactions and high credit risks and other business risks is not at all
as real estate prices went tumbling down, Islamic easy and straightforward.
banks were also adversely affected. However,
Islamic banks did not require any taxpayer bailouts Another risk identified from past practices is that
as was witnessed in the case of major conventional of poor quality in Islamic financial institutions’
banks. In some cases, Islamic banks recapitalized management. People entrusted with the task of
themselves through the Sukūk market. Islamic managing these institutions have come mainly from
financial institutions had relatively higher capital a background of conventional finance and failed to
adequacy which provided a better cushion in case appreciate the peculiar set of complexities involved
they incurred unanticipated losses. in Islamic finance. This inadequacy of a trained and
uniquely focused managerial pool and human talent
One of the fundamental challenges of the Islamic across the industry remains an obstacle to its growth.
financial system is the need for a holistic and robust
ecosystem including regulations. As the system is The other challenge is to have strong and supportive
still gradually building its resilience, and the regulatory governance systems at the level of individual
system, standards, infrastructure, and institutions institutions. Islamic banks have to ensure they
are beginning to evolve, it remains largely untested. instill confidence and nurture trust among their
The adoption of the regulations and standards by stakeholders by adopting best governance practices
the central banks has been a slow process and that incorporate features enjoined under Sharīàh.
confined to only a few countries, even among the Any deviations, scams, scandals, or shortcuts
large membership of the Islamic Financial Services will put the industry a step back. Accordingly, the
Board (IFSB). Some IFSB members have stated incentive structures and compensation packages
that the binding constraint is the lack of adequately should be designed in a way that avoids the pitfalls
trained and experienced human capital, rather than of conventional financial institutions (i.e., excessive
anything else. bonus payments based on inflated indicators).
Bonuses should be payable when the actual results
On the other hand, the Islamic finance industry from the investments financed by the banks become
faces a crucial challenge of balancing between available and not when the quarterly or annual profits
maintaining profitability in a competitive environment at aggregate levels are announced.
and sustaining social responsibility. There is
apprehension that any trade-off that strengthens A prominent risk from a business perspective is the
social responsibility may be achieved at the cost comparatively higher transaction cost of Islamic
of making profits for the shareholders and account finance because of the additional requirement of
109
Sharīàh compliance. When every transaction is held Finally, promotion of awareness about Islamic finance
up because it has to be reviewed and endorsed and financial literacy are critically important but have
by the Sharīàh board, an element of uncertainty is been neglected so far. There is no clearly defined
added. If the edicts and opinions of Sharīàh boards responsibility as to who is going to carry out this
were standardized and could be made available for function. In some countries, it has been a state-led
ready reference, the structuring of transactions would approach for promoting Islamic finance; in others, it
not take up many resources, be it time or human. has been left to market forces through a demand-
The manufacturing and marketing of preapproved led approach to develop the system. Although there
Sharīàh-compliant products on a large scale will may be no uniform answer to this issue and each
mitigate this risk. Transaction costs can be reduced country will have to customize in relation to its own
if the probability of predefault and postdefault events circumstances, governments or central banks have
is minimized by careful screening and forceful to take the lead by putting in place credible legislative,
monitoring under Islamic finance modes. institutional, and regulatory structures. Market
players, the media, educational institutions, and
Meanwhile, the issue of liquidity availability for Islamic chambers of commerce and industry have to play an
banks has been a long-standing concern affecting equally important role. Overall, the future road map
the industry. Unlike conventional banks, which have for Islamic finance should be based on its unique
recourse to an active interbank money market, selling proposition and on a proper governance
Islamic banks do not enjoy such a facility. The framework in which the roles and responsibilities of
absence of liquidity management instruments puts the Sharīàh board and the extent of its autonomy
Islamic banks at a serious disadvantage relative to are clearly defined vis-à-vis other shareholders and
their competitors in the market. management.
Moving Forward: A Road Map for Asia
In the next 10 years, Asia has an $8 trillion Asia is a pivotal part of both the global economy and
investment gap that needs to be financed. This is the Islamic financial system, operating as a driving
an investment gap which may not be funded by force of world economic growth. At present, the
conventional finance alone. On the contrary, the Islamic financial landscape in Asia is dominated by
asset-backed nature of Islamic finance provides a the Islamic banking and Sukūk sectors, which have
better match for infrastructure projects. There are driven Asia’s robust growth trajectory in recent
tremendous opportunities for Asia to expand the years, accounting for a combined value of over $390
Islamic finance industry in order to support the fast billion or 21.7% of global Islamic financial assets
growing economies of the region. Islamic finance as at the end of 2013. Islamic asset management
is able to support many strategic areas such as remains a nascent but budding industry in Asia
financial inclusion, infrastructure investment needs, which has seen steady growth following the financial
and insurance penetration as well as further attract crisis. The Takāful industry accounts for less than
funds to flow into the region. Asian markets are 1.0% of regional Islamic financial assets, despite
home to a large Muslim population, which facilitates a significant growth in the number of Takāful
a ready market for the introduction and distribution operators, highlighting considerable potential growth
of Sharīàh-compliant products and services, for the future.
particularly for retail banking and Takāful. The
progress that Asian countries have made represents The Islamic finance road map for Asia needs to start
more opportunities for the region to benefit from this by making a realistic assessment and taking stock of
rapidly growing Sharīàh-compliant industry. the needs and requirements of the various markets.
110
It will then be feasible to match different Islamic a pioneering role in guiding and steering the process
financial solutions with the requirements of the of development of Islamic finance. The progress is
market. Some of these solutions have already been impressive and Islamic finance represents more than
tried in advanced Islamic economies and can be 25.0% of the country’s banking assets and nearly
modified and adapted. In other cases, solutions have 57.0% of its capital market. Individual countries
to be found by engaging the various stakeholders need to assess the structures and maturities of their
in these countries. The road map should be a financial markets when designing and delivering
constellation of developing policy, having an enabling appropriate Islamic finance regulations. If successful
environment, developing the laws, strengthening ecosystems from other countries are introduced
the regulatory framework, and making progress in in a market without testing or investigation, the
capacity building. adaptation may not always be successful.
Some countries in Asia have progressed well in terms To end, Islamic finance has the potential to be an
of developing their Islamic finance industry because alternative to the existing financial system, but it still
of the promotional support by the central banks. For faces many challenges and risks that have to be
example in Malaysia, Bank Negara Malaysia played managed and mitigated first.
111
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Glossary
1. Bay Ul Dayn The sale of payable right either back to the debtor or to another third party.
The payable right (debt) can be either money or commodity.
2. Bay Ul Inah A contract involving the sale and buy-back transaction of assets by a seller.
A seller sells an asset to a buyer on a cash basis and later buys it back on a
deferred payment basis where the price is higher than the cash price. It can
also be applied when a seller sells an asset to a buyer on a deferred basis
and later buys it back on a cash basis, at a price which is lower than the
deferred price.
3. Commodity A Murābahah-based purchase and sale transaction of Sharīàh-compliant
Murābahah commodities, whereby the buyer purchases the commodities on a deferred
payment basis and subsequently sells them to a third party on a cash
payment basis.
4. Diminishing Diminishing Mushārakah or Mushārakah Mutanaqisah is a form of partnership
Mushārakah in which one of the partners (customer) promises to buy the equity share of
the other partner (financier) gradually until the title to the equity is completely
transferred to the buying partner. The transaction starts with the formation
of a partnership, followed by the financier leasing his equity share to the
customer throughout the tenure of the lease, the customer will gradually
buy the other financier’s share at market value or the price agreed upon at
the time of entering into the contract. The “buying and selling” contract is
independent from the partnership contract and should not be stipulated in
the partnership contract since the buying partner is only allowed to give only
a promise to buy. It is also not permitted for one contract to be entered into
as a condition for concluding the other.
5. Fatāwa (sing. fatwa) A juristic opinion or pronouncement of facts given by the Sharīàh board, a
mufti, or a faqīh on any matter pertinent to Sharīàh issues, based on the
appropriate methodology.
6. Fiqh Knowledge of the legal rulings pertaining to conduct, which has been acquired
from specific evidence in the Sharīàh.
7. Hamish al jiddiyyah An amount of security deposit held as collateral by the institution offering
Islamic financial services (IIFS) upon giving a binding promise. The purpose of
Hamish al jiddiyyah is to determine the financial capacity of the customer and
his seriousness in fulfilling the binding promise. The IIFS will take the amount
of actual damage from the Hamish al jiddiyyah in case the customer breaches
his undertaking.
8. Hibāh A unilateral transfer of ownership of a property or its benefit to another without
any counter-value from the recipient.
9. Ijārah An Ijārah contract refers to an agreement made by an institution offering
Islamic financial services to lease to a customer an asset specified by the
customer for an agreed period against specified installments of lease rental.
An Ijārah contract commences with a promise to lease that is binding on the
part of the potential lessee prior to entering the Ijārah contract.
10 Ijma: Consensus, usually on a given issue as represented by the agreement of the
jurists.
11. Istisnā` An Istisnā` contract refers to an agreement to sell to a customer a non-
existent asset, which is to be manufactured or built according to the
buyer’s specifications and is to be delivered on a specified future date at a
predetermined selling price.
12. Islamic window An Islamic window is part of a conventional financial institution (which may
be a branch or a dedicated unit of that institution) that provides both fund
management (investment accounts) and financing and investment that are
Sharīàh-compliant.
13. Mu’amalat Economic transaction related to exchange of goods and services including
financial transactions.
14. Muḍārabah A Muḍārabah is a contract between the capital provider and a skilled
entrepreneur whereby the capital provider would contribute capital to an
enterprise or activity, which is to be managed, by the entrepreneur as the
Muḍārib (or labor provider). Profits generated by that enterprise or activity
are shared in accordance with the terms of the Muḍārabah agreement while
losses are to borne solely by the capital provider unless the losses are due to
the Muḍārib’s misconduct, negligence, or breach of contracted terms.
15. Murābahah A Murābahah contract refers to a sale contract whereby the institution offering
Islamic financial services sells to a customer a specified kind of asset that is
already in their possession at cost plus an agreed profit margin (selling price).
16. Murābahah for the An MPO contract refers to a sale contract whereby the institution offering
Purchase (Murābahah Islamic financial services.(IIFS) sells to a customer at cost plus an agreed
lil Amir bi Shira`) (MPO) profit margin (selling price), a specified kind of asset that has been purchased
and acquired by the IIFS based on a promise to purchase from the customer,
which can be binding or non-binding.
17. Mushārakah A Mushārakah is a contract between the institution offering Islamic financial
services and a customer to contribute capital to an enterprise, whether existing
or new, or to own a real estate or movable asset, either on a temporary or
permanent basis. Profits generated by that enterprise or real estate/asset are
shared in accordance with the terms of Mushārakah agreement while losses
are shared in proportion to each partner’s share of capital.
18. Qard A non interest bearing loan intended to allow the borrower to use the loaned
funds for a period with the understanding that the same amount of the loaned
funds would be repaid at the end of the period.
19. Qiyas The process of analogical reasoning as applied to the deduction of juridical
principles from the Qur’an and the Sunnah.
20. Salam A Salam contract refers to an agreement to purchase, at a pre-determined
price, a specified kind of commodity not available with the seller, which is to
be delivered on a specified future date in a specified quantity and quality. The
institution offering Islamic financial services, as the buyer, makes full payment
of the purchase price upon execution of a Salām contract. The commodity
may or may not be traded over the counter or on an exchange.
21. Sharīàh Divine Islamic law that encompasses all aspects of human life as revealed in
the Qur’an and the Sunnah.
22. Sharīàh supervisory A specific body set up or engaged by the institution offering Islamic financial
board services to supervise its Sharīàh compliance and governance system.
23. Sukūk (sing. Sakk) Sukūk (certificates), each of which represents the holder’s proportionate
ownership in an undivided part of an underlying asset where the holder
assumes all rights and obligations to such an asset.
24. Tabarru’ Grant of property by a person with complete legal capacity without any
compensation. In the context of Takāful operations, Tabarru’ is the amount
of contribution to be relinquished by the Takāful participant as a donation for
fulfilling the obligation of mutual help and to be used to pay claims submitted
by eligible claimants.
25. Takāful Takāful is derived from an Arabic word which means solidarity, whereby a
group of participants agree among themselves to support one another jointly
against a specified loss. In a Takāful arrangement, the participants contribute
a sum of money as tabarru’ (donation) into a common fund, which will be
used for mutual assistance of the members against specified loss or damage.
26. Urbūn Urbūn is earnest money held as collateral (taken from a purchaser or lessee)
to guarantee contract performance after a contract is established.
27. Wa`d A promise to perform certain action(s) in the future.
28. Wadīàh An amount deposited whereby the depositor is guaranteed his or her fund in
full.
29. Wakālah An agency contract where the customer (principal) appoints the institution
offering Islamic financial services as an agent (wakīl) to carry out business on
their behalf.
30. Waqf An endowment of charitable trust in the meaning of holding certain property
and preserving it for the confined benefit for a certain charitable objective and
prohibiting any use or disposition of it outside that specific objective.
31. Zakah An obligatory contribution or tax which is prescribed by Islam on all Muslim
persons having wealth above an exemption limit at a rate fixed by the Sharīàh.
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Islamic Financial Services Board

Islamic Finance for Asia:

Islamic Finance for Asia: Development, Prospects, and Inclusive Growth

Asian Development Bank

Islamic Financial Services Board

Islamic Finance for Asia:

Asian Development Bank

Islamic Financial Services Board

ISBN 978-92-9254-907-7(Print), 978-92-9254-908-4 (e-ISBN)

© Asian Development Bank and the Islamic Financial Services Board.

1.1: Global Islamic Finance Assets by Region (H1 2014E)

5.5: Key Milestones for the Due Process

1.1: Islamic Finance: The Salient Features

AAOIFI – Accounting and Auditing Organization for Islamic Financial Institutions

MoU – memorandums of understanding

Chapter 1: Islamic Finance for Asia: Innovation, Inclusion and Growth

Baljeet Kaur Grewal

Chapter 2: Islamic Finance: Stabiliy, Resilience and Regulatory Issues

Professor Simon Archer

Madzlan Mohamad Hussain

Chapter 3: Islamic Banking: Financial Inclusion as a Core Concept

Dr. Zamir Iqbal

Chapter 4: Islamic Capital Market: The Role of Sukuk for Development

Chapter 5: Implementation of the IFSB Standards

Zahid ur Rehman Khokher

Mohd. Sani Mohd. Ismail

Chapter 6: Legal and Regulatory Issues for Islamic Finance Post-crisis

Badlisyah Abdul Ghani

Chapter 8: The Way Forward: A Roadmap for Asia

Dr. Ishrat Husain

Overview of Islamic Finance in Global Markets

Figure 1.1: Global Islamic Finance Assets by Region (H1 2014E)

E = estimate, GCC = Gulf Cooperation Council, H = half.

Source: KFH Research.

Box 1.1: Islamic Finance: The Salient Features

Figure B1.1.1: Salient Features of the Islamic Financial System

Figure 1.2: The Ecosystem of the Islamic Financial Services Industry

363 full-fledged Islamic financial institutions, 108 Islamic

Source: KFH Research.

Islamic Finance in Asia: Progress and Opportunities

Figure 1.3: Islamic Finance Landscape in Asia (end-2013)

Islamic Banking Sukūk Outstanding Islamic Funds AuM Takāful

$213.5 billion $177.2 billion $25.9 billion $3.8 billion

AuM = asset under management.

Source: KFH Research

Sharī`ah Advisory Council of BNM is enhancing

Source: Bloomberg, KFH Research.

Asia’s Economic and Demographic Profiles

6 has long been a major challenge in attracting FDI

is likely to accelerate infrastructural buildup and

increased mining capacity in Australia allows 250

Economic Community, to be operational in 2015, will

according to United Nations Conference on Trade Source: UNCTAD, KFH Research.

and Development (UNCTAD). Total inflows to

income segment, constitutes a huge and growing

Asia’s Developmental Needs Moving Forward: Role of Islamic Finance

2001 and 2013, a total of $84.3 billion worth of

It is reported that in the 10-year period from 2010

Selected Case Studies of Sukūk Issuances in Asia

Key Offer Terms Transaction Highlights