1. Islamic Finance Within Conventional Banking System – Opportunities and Challenges 02 July 2010 III Astana Economic Conference By Musa Abdul Malek Executive Director and CEO HSBC AMANAH Malaysia

2. 2 Islamic Finance Window Operations Models for Establishing Islamic Finance Islamic Finance – Success Recipe Overview of Islamic Finance CONTENTS Challenges in Islamic Finance

3. 3 OVERVIEW OF ISLAMIC FINANCE

4. 4 OVERVIEW OF THE ISLAMIC FINANCE INDUSTRY Each region is contributing in a unique way …with worldwide momentum from retail to regulator involvement Examples Malaysia’s Islamic Banking Act 1983 and the Banking & Financial Institutions Act 1989 are enacted as separate statutes Kuwait adopted a new regulatory framework for Islamic finance in 2003, by introducing a new section into the Central Bank Law of 1968 Iran Government driven Market driven Saudi Arabia Malaysia United Arab Emirates Bahrain Kuwait Indonesia Brunei USA Pakistan Sudan Qatar Singapore Bangladesh Oman Turkey Egypt Sri Lanka South Korea China HIGH LOW Japan Hong Kong Asia-PacificMiddle EastOthers UK HIGH LOW Note: Circle sizes denote estimated size of the Islamic financial market in these respective countries Source: HSBC Amanah, Illustrative Comparison Model for the development of Islamic Markets and Regulations

5. 5 OVERVIEW OF ISLAMIC FINANCE Islamic Finance In The Last 30 Years  Islamic finance has followed in the wake of innovations in the global financial services industry  A natural progression of the Islamic finance industry: – competitive retail offerings – sophisticated corporate banking products – innovative project finance solutions 1970s  commercial banking 1980s  commercial banking  project finance & syndications 1990s  commercial banking  project finance & syndications  equity  Ijarah 2000s  commercial banking  project finance & syndications  equity  Ijarah  sukuk al ijarah  structured alternative assets 2005+  commercial banking  project finance & syndications  equity  Ijarah  sukuk al ijarah  structured alternative assets  liquidity management tools

6. 6  Of the total 1.6 billion Muslims globally, there are approximately 640 million in tier 1 & 2 markets.  Today, there are more than 390 Islamic banks and institutions spread across 75 countries. Total Global Islamic banking assets growth (USD bn) CAGR 28% CAGR 20% 2 640 Banking Assets in key markets (USD bn) 37% 7% Sources: The Banker, Oliver Wyman 1 2007 – 2008 asset figures are based from The Banker 2 Oliver Wyman growth estimates 2 ECONOMIC GROWTH IN SOME GEOGRAPHIES PrioritizationCountry Total Population (m) (% Muslim) GDP (% real change per annum) 20082009f2010f2011f2012f (Tier 1) Saudi Arabia24 (99%)4.3-0.13.95.95.2 UAE5.2 (76%)7.0-1.24.36.46.1 Malaysia26 (60%)4.6-3.86.366.0 Tier 2 Qatar1.2 (77%)15.29.88.8 2 9.47.5 Bahrain1.0 (98%)8.15.66.0 2 5.45.0 Pakistan176 (97%)0.62.42.944.0 Indonesia*240 (88%)6.13.85.36.26.1 Brunei0.4 (64%)0.6 1 na Na UK61 (3%)0.7-3.81.61.82 Bangladesh29 (88%)6.226.026.226.56.4 Egypt75 (85%)7.24.34.16.47 Tier 3 Turkey77 (97%)1.1-4.42.03.56 China1300 (2%)98.59 India1100 (13%)7.56 7.2 Iraq29 (97%)na Source: HSBC Group economic forecast. INDUSTRY COMMENTATORS SEE ISLAMIC FINANCE INDUSTRY CONTINUING ITS RAPID GROWTH Note: Key markets include Tier 1 and 2 markets Source: The Banker, Central Bank Reports 13% 4% 1 13% 5%

7. 7 CAGR 22% Islamic Retail Banking Assets (USD bn) Islamic Wholesale Banking Assets (USD bn) CAGR 19% Source: Oliver Wyman Note: Wholesale includes corporates, wealth funds and private clients. CAGR 12% Global Islamic Mutual Fund Assets (US bn) Islamic Gross Takaful Contributions (USD m) CAGR 12% RISING ISLAMIC PENETRATION WITH GROWTH ACROSS DIFFERENT INDUSTRY SECTORS Source: Oliver Wyman Source: Ernst & Young Source: Cerulli Associates Report Being validated bottom up with Countries

8. 8 ISLAMIC FINANCE – SUCCESS RECIPE

9. 9 ISLAMIC FINANCE PROPOSITION – Success Recipe Success Recipe  Majority or good percentage of population are Muslim  Market have strong demand for Shariah proposition but no issue to consider conventional  Government resolute in pursuing Islamic finance agenda and introduce conducive regulatory framework eg. Tax, legal etc.  Central Bank able to regulate Islamic financial institutions Decide and provide guidelines on Shariah issues Treatment of balance sheet - segregating or co-mingling Provide framework to support and regulate the institutions One stop centre to resolve issues by industry players  Sufficient talent to manage the business both the Shariah scholars and practitioners

10. 10 MODELS FOR ESTABLISHING ISLAMIC FINANCE

11. 11 VARIOUS MODELS FOR CONSIDERATION Comprehensive infrastructure to support the business License only to do Islamic finance business Stand Alone Islamic Finance Islamic Subsidiary Leverage infrastructu re from the parent infrastructu re Separate Board of Directors Subsidiary of the existing conventional in the country Supervise the operations to ensure Shariah compliance Using the main Bank infrastructu re to support the business Structure Islamic products for distribution by conventional branches A division within the existing conventional bank Islamic window

12. 12 ISLAMIC WINDOW OPERATIONS

13. 13 ISLAMIC ‘WINDOWS’ OPERATIONS Windows Operations  A division within the conventional bank  Preferably to be headed by a Muslim  Need to set up Shariah Committee and Shariah department to ensure business undertaken is Shariah compliance  Minimum to have own product development team and dedicated IT team  Sharing the same system platform – tweak to meet with Shariah Accounting treatment eg. penalty fee not compounded Wordings on the statement and advises must be Shariah compliance  Leverage from existing infrastructure thus cost to do the business is lower  Preferable for the balance sheet to be separated

14. 14 ISLAMIC ‘WINDOWS’ OPERATIONS Windows Operations ADVANTAGES Sharing the same infrastructure Sharing the same system platform – tweak to meet with Shariah Cost to do the business is lower Inclusive proposition DISADVANTAGES Always guided by the conventional banking way Business requirements may conflict with Shariah CHALLENGES Awareness on Islamic finance amongst the internal customers is low Shariah compliance to be the main driver for the business Potential canabalising the conventional business

15. 15 CHALLENGES IN ISLAMIC FINANCE

16. 16 CHALLENGES IN ISLAMIC FINANCE Challenges Strategy and Plan to develop the right business model Willingness to invest in Human Capital Development Information system to cater to Islamic Finance transactions Replication v. Authenticity Comprehensive Shariah Governance & Audit * Meeting evolving consumers’ demand Risk Management * Legal, Regulatory & Accounting Framework * Wealth Management

17. 17 SHARIAH GOVERNANCE AND FRAMEWORK

18. 18  Islamic Financial Services Board (IFSB) Guiding Principles of Risk Management indicates:  Shariah Compliance is categorised as higher priority in relation to identified risks and;  There must be a comprehensive and sound Shariah Compliance framework and mechanism in place. SHARIAH COMPLIANCE IS FUNDAMENTAL IN ISLAMIC BANKING AND FINANCIAL INSTITUTIONS IFSB

19. 19 The business of the Company will be transacted in ACCORDANCE with the : MEMORANDUM & ARTICLES OF ASSOCIATION OF MOST ISLAMIC FINANCE INSTITUTIONS PROVIDE: Islamic Principles Rules Practices In this respect, the Company is PROHIBITED from carrying out any transactions which involve any elements that are not in compliance with the Islamic principles, rules and practices. Compliance

20. 20 SHARIAH STRUCTURE Shariah Committee Shariah Dept Internal Policies, Procedures, Guidelines, Manuals, Matrix & Certificates Shariah Structure  Term Of Reference of Shariah Committee  Rulings of Shariah Committee  Shariah Advisory & Development  Shariah Compliance & Review  Shariah Research  Shariah Compliance Manual  Guidelines on the Shariah Committee  Shariah Compliance Certificate  Guidelines on Services & Transactions

21. 21 LEGAL, REGULATORY & ACCOUNTING FRAMEWORK

22. 22 LEGAL, REGULATORY & ACCOUNTING FRAMEWORK Legal Need a Robust Structure Regulatory Flexible yet decisive Accounting AAOFI vs IFRS

23. 23 LEGAL FRAMEWORK – Need a robust structure  Ensure compliant with Shariah but yet enforceable under applicable secular law  Current transactional practise with respect to existing legal opinion - Different islamic jurisprudence interpret Shariah differently - Lack of binding precedents and published decision - Is Shariah compliance considered in judgement eg Zulkifli vs Affin Bank (Malaysia), Investment Dar vs Lebanon Blom Bank  Untested certainty/predictability for Shariah compliant transactions in different jurisdiction  Willing to change to accommodate Shariah requirements eg. legal ownership over home financing if structure based on Ijarah or Musyarakah Legal

24. 24 REGULATORY FRAMEWORK – Flexible yet decisive  Willing to change the act to accommodate Islamic Finance - Land Code - Tax issue eg. VAT, property gain tax  Propose to adopt tax neutrality Regulatory

25. 25 ACCOUNTING FRAMEWORK (AAOIFI vs IFRS) Accounting 1 AAOIFI  Develop the accounting, auditing and banking practices through relating to the activities of the Islamic Financial Institutions (IFIs)  Prepare, promulgate and interpret accounting and auditing standards for IFIs in order to harmonize the accounting practices and auditing procedures  Review and amend the accounting and auditing standard for IFIs to cope with developments in the accounting and auditing through practices

26. 26 ACCOUNTING FRAMEWORK (AAOIFI vs IFRS) Accounting 2 IASC Foundation and IASB  To develop a single set of high quality, understandable, enforceable and globally accepted international financial reporting standards (IFRS) through its standard-setting body of IASB  To promote the use and rigorous application of those standards  To bring about the convergence of national accounting standards and IFRS to high quality solutions Main Differences AAOIFI and IFRS  AAOIFI  Specific for Islamic industry  Accounting, Auditing, Ethics, Governance & Sharia  IFRS  Entire economic & social activities  Specific to accounting

27. 27 ACCOUNTING FRAMEWORK (AAOIFI vs IFRS) Accounting 3 Consideration  Standalone and fully Islamic Group – AAOIFI  Subsidiary with conventional parent – IFRS  Window – IFRS Rationale for window to adopt IFRS  Consolidation  Accounting treatment eg. Unrestricted investment as a separate item instead of presented as liabilities (along with other liabilities) in IFRS

28. 28 RISK IN ISLAMIC FINANCE

29. 29  Credit Risk  Market Risk  Insurance Risk  Sustainability Risk  Liquidity Risk  Pension Fund Risk  Residual Value Risk  Reputation Risk  Operational Risk RISK MANAGEMENT IS  Accounting  Business Continuity  Fiduciary  Fraud  Information  Legal  Compliance  Operations  People  Tax  Technology Shariah Risk Management Embedded within the conventional business risk management framework  Non-compliance with Shariah rules and regulations  New product due diligence including simplification of product complexities  Application of Late Payment / Penalty for default in a Shariah compliance manner  Advise on debt restructuring  Changes in fatwa resulting in existing product being non-compliance  Advising / guiding with ongoing Shariah requirements

30. 30 MAJOR SHARIAH RISKS Concentrated reliance on a single broker for transacting commodity murabaha (substantial Global Business is based on this structure) Untested legal infrastructure (case laws or court proceedings) supporting products Major Risks Credibility of “Commodity Murabaha” / “Tawarruq” structure questionable Manual Processes increase operational risks Lack of inter-bank market creates challenges in matching assets and liabilities Identification of new brokers required and find alternative to existing commodity (eg. Bursa Al Sila’) Using experienced legal counsel for preparing documentation and structures Looking to diversify to other structures. To address concerns raised. Rationalisation of product range. Long term, automation and standardisation required This has to be addressed and financial linkages required RISKS ACTIONS

31. Thank You