1. Regulatory & Supervisory Issues – Regulators Perspective
Seminar on Islamic Finance
Banca d’ Italia
11th November 2009
Good Morning Ladies & Gentlemen.
The topic of our discussion today is on Regulatory & Supervisory issues –from the perspective of Central Bank of Malaysia.
Muhammad bin Ibrahim, Assistant Governor

2. Part I Part 2 Global Development Islamic Finance in Malaysia
Regulatory and Supervisory Issues
Shariah Governance
Risk Management
Islamic Deposit Insurance
Cross-border Supervision
1st part of my presentation will cover latest development of Islamic Finance both international & local.
And for the 2nd Part, I will touch on selected Regulatory & Supervisory issues confronting Islamic Finance.

3. Islamic finance… fastest growing segment in global financial system…
Islamic Assets under Management
USD750 billion & expected to hit USD1 trillion by 2010
Average growth rate of 15-20% p.a.
Islamic Mutual Funds
USD300 billion
Average growth rate of 23% p.a.
Takaful Contributions
USD7.2 billion
Growth rate of 13% p.a.
Global Market Capitalization of Dow Jones Islamic Index
USD10 trillion
Shariah Compliant Global Funds
680 funds
Global Outstanding Sukuk
USD107 billion
Average growth rate of 22% p.a.
Number of Islamic Financial Institutions (IFIs)
> 600 IFIs in the world
Today, Islamic finance has become a fast growing segment in the global financial system.
Number of Islamic Financial Institutions: The developments in Islamic Finance has been very encouraging . According to the IMF, the number of Islamic financial institutions has risen from a single organization in 1975 to more than 300 by It is recently reported in the Islamic Banker magazine 2009,that the total number of Islamic Financial Institutions had now reach 628.
Islamic assets under management : Projected to reach USD1 trillion by 2010 & expected continue to register double digit growth. (As reported by Islamic banker magazine 2009, Islamic assets had grown by 29% this year as compared to last year).
Islamic Mutual Fund: The total Islamic mutual funds is currently standing at USD300 billion & the global Takaful contribution is now standing at USD7.2 billion with 13% growth p.a.
Shariah Global Fund: It is estimated that there are 680 Shariah Compliant Global Funds where 350 new funds were launched between 2005 – 2007.
Sukuk: The Global Outstanding Sukuk is projected at USD107 billion where Malaysia continued to lead in global sukuk market.
Notes for AG: Untapped Potential
Potential customer base: world’s 1.5 billion Muslims
Bulk of world’s Muslim population is young: 60% of global Muslim population is under 25 years
Muslim high net worth individuals: USD1.5 – 1.8 trillion
Takaful penetration rate: Below 2% in Middle East Region
New petrodollar wealth – USD500 billion p.a.
Enormous potential in Islamic Finance…
Sources: McKinsey, The World Islamic Banking Competitiveness Report & ; PriceWaterHouseCoopers, Islamic Finance News, IFSB & National Authorities; Islamic Banker Research Group; Islamic Finance & Insurance & Investor Offshore Review

4. Rapid development of Islamic banking & finance have contributed to diversity in industry structure…
Various jurisdictions have their own Islamic banking & finance model to meet local requirement
Attributes
Adopting countries
Full transformation of financial system in accordance with Shariah
A comprehensive Islamic financial system co-exist with conventional system
Islamic products mainly offered by conventional banks through “windows”.
Lack of supporting infrastructure (e.g. Islamic money market & capital market) may constraint product offering
Iran, Sudan
Malaysia, Bahrain, Pakistan & UAE
UK, Hong Kong
Single Islamic Financial System
Dual Financial System
Following the establishment of IFIs in many parts of the world, we can cluster Islamic finance structure into 3 different groups.
1st group: Country with Single Islamic Financial System, e.g. Iran and Sudan (national aspiration to have full-fledged Islamic)
2nd group: Country with Dual Financial system such as Malaysia & Bahrain which has the necessary components & infrastructure to support the system.
3rd group: Conventional Banks Islamic windows, e.g. Hong Kong
Regulatory approach must be in line with the philosophy behind the different structure that the banks choose to operate.
(e.g. Regulation on the full-fledged Islamic financial system will be different from regulation on dual financial system).
The choice of structure depends on:
Regulatory policy decision (e.g. Iran choose to have single Islamic Financial System)
Institution’s preference (regulators must understand the rationale of such preferences, e.g. why certain bank prefers to set up Islamic operations under Islamic window rather than as full-fledged Islamic subsidiary?)
Industry / locality preference (regulators must understand the spirit behind certain locality preference as set by host supervisors – very important in supervising cross border Islamic banks).
Conventional Banks with Islamic Windows

5. Conventional Financial System Islamic Financial System
Malaysia has developed a comprehensive dual financial system…
Dual financial system
Constituents of Malaysian financial system
Conventional banking
Insurance
Money market
Capital market
Islamic banking
Takaful
Islamic money market
Islamic capital market
Malaysian
Financial System
Central Bank Act 1958 (CBA)
Conventional Financial System
Islamic Financial System
BAFIA 1989
Insurance Act 1996
Loan Local Act 1959
Treasury Bills Local Act 1946
Capital Market & Services Act 2007
Islamic Banking Act 1983
Takaful Act 1984
Government Funding Act 2005
Capital Market & Services Act 2007
Legal Governance
Malaysia has been recognized internationally as the role model that has successfully implemented a comprehensive dual financial system comprising both Islamic and conventional operating in parallel to each other. The components of our Islamic financial system now comprise the Islamic banking sector, the takaful sector, the Islamic capital and money markets that operate within Shariah framework.
The system is well supported by legal and regulatory framework i.e.:
Islamic Banking Act 1983; Takaful Act 1984; Government Funding Act 2005; and Capital Market & Services Act 2007.
The development of legal and regulatory framework for Islamic financial industry is premised on the principle of neutrality in ensuring “no worse off” treatment vis-à-vis conventional finance in terms of taxation, laws and regulations to catalyse its healthy growth.
The new Central Bank Act 2009 has further reinforced the commitment of the Central Bank to develop a dual financial system i.e. conventional and Islamic financial system.
As stipulated in the act, it is responsibility of the Bank now to ensure Islamic finance to be an important mandate for continuous & progressive development in the future. (Regardless whether the present governor will be replaced with a new one, the new governor has to ensure the continuation of the existence of Islamic Finance).
Main Regulatory Authorities
Bank Negara Malaysia – regulate & supervise both conventional & Islamic FIs
Securities Commission – regulate capital market & Islamic capital market
Central Bank of Malaysia Act 2009: “The financial system shall consist of conventional & Islamic financial system”… demonstrated Government’s commitment…
Sources: Bank Negara Malaysia, Securities Commission
FIs – Financial Institutions

6. Well established infrastructures
Malaysia… several notable achievements…
Sukuk market
(Islamic bonds)
World’s largest sukuk market ± USD66bil or 58% of total outstanding bonds)
Accounted 62% of total global sukuk outstanding
Sukuk issuance covers all sectors of the economy
Contributes to overall economic growth
Sukuk as new asset classes
Comprehensive system
Islamic banking
(17 Islamic banks, 3 International Islamic banks)
Takaful
(8 takaful operators, 4 retakaful operators, 1 international takaful operator)
Fund Management
(8 Islamic fund management companies,
144 Islamic unit trust funds)
Islamic money market
Total annual money market transactions: exceeded RM1 trillion
Shariah governance
Comprehensive Shariah Governance framework
Regulation & supervision
Capital adequacy, deposit insurance
framework, risk-based supervisory
framework, liquidity, disclosures & transparency
Dispute resolution
- Judicial system – dedicated high court
- Kuala Lumpur (KL) Regional Centre for
Arbitration – dedicated rules for Islamic
finance arbitration;
- Financial Mediation Bureau
Human capital development
Total solution approach for human capital development
Well established infrastructures
Over last a few decade, Malaysia has able to position themselves as thought leader in Islamic finance where it has strong and diversified players within the key sectors in the industry (Islamic Banking & Takaful), wide-range of products, vibrant financial market & well established infrastructure (legal, regulatory & human capital).
1. Sukuk
Sukuk or Islamic bond is one of Islamic financial instruments & become new asset classes,
And Malaysia has been recognised as global leader in Sukuk market, accounted 62% of total Sukuk outstanding globally;
Sukuk issuance in Malaysia is growing strongly and it covers all sectors of the economy and contributes to the overall economic growth of the country.
2. Human Capital
Malaysia has also placed a strong emphasis on human capital development alongside the development of the Islamic financial businesses in our pursuit to be the thought leader in the area of Islamic finance (eg. INCEIF, IBFIM,SIDC, ISRA)
Notes for AG:
Product Innovation - Malaysia has developed a broad array of Islamic financial products (i.e. financing, investments and deposits products) to meet the diverse needs of customers. There are more than 100 types of Shariah compliant products offered.
Sources: Bank Negara Malaysia, Securities Commission

7. Part I Part 2 Global Development Islamic Finance in Malaysia
Regulatory and Supervisory Issues
Shariah Governance
Risk Management
Islamic Deposit Insurance
Cross-border Supervision
Let’s move on to the 2nd part of the presentation…

8. Regulatory & supervisory issues in Islamic banking & finance…
Shariah Governance
Shariah compliance: apex of Islamic financial system
How to ensure comprehensiveness of Shariah compliance (that cover both ex-ante & ex-post aspects of all financial transactions)?
Risk Management
In addition to traditional banking risks, there are risks peculiar to Islamic banking - e.g. rate of return risk, displaced commercial risk (DCR), inventory risk & equity investment risk
Do Islamic bank regulators & supervisors have sufficient capacity & capability to look into these peculiar risks ?
Deposit Insurance
Deposit insurance was introduced in conventional banking system to instil public confidence & maintain financial stability
Is it necessary to introduce Islamic deposit insurance for Islamic banking institutions that operate in dual financial system?
What is the effective mechanism to introduce Shariah-compliant Islamic deposit insurance in an entrenched conventional banking system?
Cross-Border Supervision
Effective cross border supervision of Islamic banking & finance is instrumental in ensuring financial stability
Are Islamic banking’ supervisors ready to implement effective cross-border supervisory collaboration?
How to ensure Islamic banks which operate across multiple jurisdiction adhere to the common principles of strong governance & risk management?
Now I will discuss some regulatory & supervisory issues confronting Islamic banking & finance:
Shariah Governance
How to ensure comprehensiveness of Shariah compliance (that cover both ex-ante & ex-post aspects of all financial transactions)?
Risk Management
Do Islamic bank regulators & supervisors have sufficient capacity & capability to look into risks peculiar to Islamic finance such as equity investment risk & rate of return risk?
Deposit Insurance
Is it necessary to introduce Islamic deposit insurance for Islamic banking institutions that operate in dual financial system?
What is the effective mechanism to introduce Shariah-compliant Islamic deposit insurance in an entrenched conventional banking system?
Cross-Border Supervision
Are Islamic banking’ supervisors ready to implement effective cross-border supervisory collaboration?
How to ensure Islamic banks which operate across multiple jurisdiction adhere to the common principles of strong governance & risk management?

9. Shariah as overarching principle in Islamic finance
Shariah Governance: A credible Shariah structure that promotes integrity and confidence…
Malaysia’s experience:
Proper governance provides multi-layer assurance on Shariah compliance
Shariah Advisory Council given legislative stature as highest authority for Shariah matters in Islamic finance
Institutionalise mutual respect by recognising differences of Shariah interpretations in various jurisdiction
Accountability of Shariah committee of IFIs on decision, views & opinions related to shariah matters
Board & senior management with sufficient expertise & capability in dealing with issues specific to Islamic financial transactions
Emphasise the function of Shariah review & Shariah audit to provide check & balance
Timely disclosure on fatwa rulings
Shariah as overarching
principle in Islamic finance
SHARIAH COMMITTEE
MANAGEMENT
BOARD
Shariah Compliance Functions :
Shariah Review
Shariah Audit
* IFI- Islamic Financial Institution
Shariah is the hallmark of Islamic finance that serve as overarching principle for Islamic Financial transactions. It is imperative that IFIs have in place comprehensive Shariah Governance framework to ensure full-adherence to Shariah principles.
Malaysia has developed several governance policies on Shariah, among which:
Shariah Advisory Council at National level serves as the highest authority for Shariah matters in Islamic finance. This will ensure greater certainty & harmonisation of Islamic finance practices
Placing accountability on Shariah committee of IFIs on their decision, views & opinions related to shariah matters
Ensuring Board & senior management has sufficient expertise & capability in dealing with issues specific to Islamic financial transactions
Shariah review & Shariah audit to provide check & balance.
Fatwa Rulings: All Shariah rulings are publicly available.
Notes for AG:
a) Management – 1. Ensure executions of business & operations are in accordance with Shariah rules & principles; 2. Management should ensure that shariah compliance extends beyond the product approval stage, that is, how the product is operationalised in terms of marketing, documentation, disbursements and recovery; 3. Provide necessary support to Shariah committee
b) Board ultimately responsible for overall oversight of the IFI’s Shariah compliance. 1. Ensure executions of business & operations are in accordance with Shariah rules & principles; 2. Provide independence and necessary support to Shariah committee
c) Shariah Committee 1.Shariah Committee is responsible over the IFI’s compliant to Shariah; 2. All Islamic finance transactions need to be vetted by the Shariah Committee and Shariah officers shall report to the Shariah committee and management; 3. Shariah committee will be accountable on decisions, opinions & views related to Shariah matters.
d) Shariah Compliance Function 1. The extent of the shariah compliance review will need to be undertaken on a regular and continuous basis by the bank’s Shariah division; 2. There will be a requirement for shariah-compliance audits to be conducted by independent auditors to ensure that the integrity of shariah principles is not compromised.

10. An illustration: Assets Liabilities
Risk Management: Equity investment transactions that involves profit risks sharing require distinct risk management & governance…
An illustration:
To manage risks associated with Mudharabah (profit-sharing) & Musharakah (partnership) contracts, equity-based transactions
Allow appointment of Board representatives on entities involved in such transactions
Board to ensure IBIs have sufficient understanding & expertise on Musharakah & Mudharabah transactions
Establishment of dedicated talent & oversight committee/ unit, e.g. in-house property development/ research department for property investment & development activities
Assets
To safeguard interest of Investment Account Holders (IAH)
Board’s fiduciary responsibilities in protecting depositors , particularly investment account holders (IAH)
Need to acknowledge IAHs’ right (1) to monitor the performance of their investments & the associated risks, (2) put into place adequate means to ensure that these rights are observed & exercised such as through sufficient disclosures
Liabilities
In managing equity investment transactions, there is a need for a distinct risk management & governance as it involves profit risk sharing.
On the asset side, BNM has issued specific guidelines on Musharakah & Mudharabah to provide guidances to IBIs.
Firstly, BNM has allowed appointment of board representative in investee company to monitor business performance of the bank’s exposure in the said entity,
Secondly, Board is to ensure IBIs have sufficient understanding & expertise on equity investment transactions
Finally, the guideline also outlined the need to establish a dedicated oversight committee/ unit, e.g. in-house property development/ research department/ function for property investment & development activities
On liabilities side, to safeguard the interest of Investment Account Holders (Mudharabah deposits)
Further disclosure is needed as there has been increasing use of structured deposits based on Mudharabah contracts where depositors are exposed to the risk of losing their capital. For example, depositors that provide specific Mudharabah (profit sharing & loss bearing) fund for property-related activities must understand the impact of real estate market conditions to his investment.
Note for AG:
What is Equity Investment Risk? Broadly defined as the risk arising from entering into a partnership for the purpose of undertaking or participating in a particular financing or general business activity as described in the contract; in which the provider of finance, shares the business risk, e.g private equity, venture capital.
Risk sharing helps inject greater market discipline because capital provider will need to monitor the performance as they are exposed to losing of their capital.
Malaysia’s experience:
In view of high risk nature of Mudharabah & Musharakah, BNM has issued specific guidelines on Musharakah & Mudharabah to provide guidance to IBIs
IBIs – Islamic Banking Institutions

11. Risk Management (cont…) Displaced Commercial Risk & Rate of Return Risk: How to mitigate the risk that depositors might not receive expected return?
An increase in benchmark rates: -
Effect : Investment Account Holders (IAH) have expectation of a higher Rate of Return (RoR).
Problem : Assets funded by IAH are mostly long term & fixed rate – hence, cannot be repriced higher until those assets mature
Solution (1): Islamic bank has to give up some portion of its return in order to pay a competitive rate to IAH & prevent them from leaving the bank (risk of flight to quality or liquidity risk)
Solution (2): Apart from the Bank foregoing their portion of profits in ensuring competitive returns, Bank could adopt Profit Equalisation Reserve (PER) as a mechanism to smoothen
income & to minimise displaced commercial risk (DCR)
Profit surplus competitive (rate > market)
Rate not competitive (rate < market)
Islamic Banking Institution’s Profit
PER
Islamic Banking
Institution’s Profit
PER is written back OR
Excess save as PER for rainy days
PER
In dual financial system, public at large has the choice to choose between conventional & islamic (when choosing to place their deposits). The problem may arise during situation of increasing interest rate environments where islamic bank’s return is lower than their conventional counterparts. As such, there could be a risk of deposit migration from Islamic to conventional (as depositors looking for higher return). The situation may be exacerbated further when most of the assets are mostly fixed rate & long term in nature. Hence the assets cannot be repriced higher until those assets mature resulted lower return to be given to depositors (as the return are based on performance of assets).
Solution (1): Islamic bank has to give up some portion of its return in order to pay a competitive rate to IAH & prevent them from leaving the bank (risk of flight to quality or liquidity risk)
Solution (2): Bank could adopt Profit Equalisation Reserve (PER) as a mechanism to address the impact of pro-cyclicality of their returns.
Other possible solutions:
(1) Minimise dependency on long-term fixed return assets in managing return to investors/depositors & introduce floating rate financing e.g. Ijarah (leasing) based contract
(2) For banks that do not adopt PER, there is a possibility of confidence crisis / run on the banks (should they cannot react to the expectation of depositors) - continuous monitoring is important to minimise the risk.
Other possible solutions:
(1) Minimise dependency on long-term fixed return assets in managing return to investors/depositors &
introduce floating rate financing e.g. Ijarah (leasing) based contract
(2) For banks that do not adopt PER, there is a possibility of confidence crisis / run on the banks
(should they cannot react to the expectation of depositors) - continuous monitoring is important to
minimise the risk.

12. Deposit Insurance in Islamic Finance…
Malaysia’s Experience:
Provide coverage when bank fails (3rd party guarantee with fee)
Deposit money
Depositors
Contribution (premium paid by Islamic bank)
Islamic Banks
Malaysia Deposit Insurance Corporation
Separate & Equitable Principles
Separate management of funds
Funded by contribution
(premium) collected
from Islamic banks
Pooled contribution
(funds) managed
separately
Invest in Shariah
compliant instruments
Islamic deposit
covered separately
from conventional
All coverage limit –
similar to conventional
Up to RM60k per
depositor per member
institution (covers 90% of total depositors)
Equivalent Coverage Limit
Separate deposit premium assessment system for Islamic & conventional
Separate supervisory assessment for Islamic & conventional banking institutions (inc windows)
Separate Premium Assessment
Separate payment in event of failure Islamic deposit insurance funds used only for Islamic banks
Deficit contribution – can raise funds from government based on Shariah principles
Separate Payout
The main objective of deposit insurance: to protect depositors against the loss of their deposits during bank failures & to promote stability of financial system.
When we introduced deposit insurance system in Malaysia (in 2005), an issue is that whether should we exclude Islamic deposits? No!
We cannot compromise on financial stability. Islamic bank should not be a source of vulnerability & we must avoid systemic risk.
Islamic banking must be as competitive vis-à-vis conventional banking.
Need separate Islamic deposit insurance operating parallel with conventional deposit insurance – in accordance to Shariah. How?
How to develop an acceptable Islamic deposit insurance mechanism that meets Shariah requirements?
Adopt kafalah bil ujr (guarantee with fee) where Malaysia Deposit Insurance Corporation as third party guarantor & Islamic financial institutions as guaranteed party.
As consideration for the guarantee, IFIs pay a fee to MDIC in a form of annual premiums.
Principles in developing Islamic deposits insurance – separation principle in terms of management of funds, premium assessment and payout; & equitable principle in term of equivalent coverage limit.
Notes for AG:
Separate management of Islamic deposit insurance funds & invest funds in Shariah compliant instruments;
Equivalent coverage for both conventional & islamic to avoid creating competitive distortions within financial system;
Separate differential premium system for Islamic & conventional given separate risk & examination assessment between the two – help promote incentives for sound risk management;
Separate payouts (Islamic deposits from Islamic Deposit Insurance funds).

13. Cross-border supervision: As Islamic financial institutions going global, supervisory issues require cross-border initiatives… 1
Understanding of supervisory philosophy & objective with regard to Islamic financial system within jurisdictions 2 4
Common understanding among supervisors especially on specific risks emanating from Islamic finance operations
Easy access to relevant information
HOST
HOME
Clarity of responsibilities of home & host supervisory authorities – Mutual respects of Shariah view? UNITY IN DIVERSITY
In recent years, Islamic finance has become more globalised with new establishments of Islamic banks in several jurisdictions, including in the key financial centres. These developments has raised the issue of cross border supervision that requires cross-border solutions and collaboration.
1st, it is important for supervisors to develop discussion platform to discuss these issues with the international standard setting body & central bank counterparts to ensure that the Islamic banks’ operations comply with international standards. The challenge is the capacity of the standard setting body to understand and to appreciate the peculiar features of Islamic finance when they wish to develop new standards or modify the existing standards. (e.g. International Accounting Standards Board & International Swaps and Derivatives Association).
2nd, there must be a common understanding among the supervisors on the specific risks emanating from Islamic finance operations.
Various cross-border supervisors must use common risk language for communication:
Common language – same understanding of risk interpretation peculiar to Islamic banking
Common language does not mean ONE supervisory approach
3rd, the next challenge is provide clarity of responsibilities with regards to the home-host supervisory authorities. An example would be in the area of mutual recognition of Shariah views among jurisdictions
Home supervisor (e.g. Malaysia supervising Maybank Islamic Subsidiary) is operating in an environment with proper Shariah requirement; whereas Host supervisors (e.g. Singapore supervising Maybank Singapore which offered Islamic products) is on market-driven approach and hence more relaxed Shariah requirement;
How to ensure home supervisors’ issues on Shariah is considered by host supervisors?
4th is on issue of easy access to relevant information. Regardless of the level of willingness to share the cross-border information, is the relevant and crucial information available in the first place?
If Islamic banks is structured the same way conventional bank is, it is likely that certain information is not readily available e.g. data on specific assets tagged to specific source of fund. 3
Cross border supervisory issues are generally similar to conventional banking. The differences lies in detailed application of Islamic banking & finance model

14. In essence, to ensure Islamic banking regulation & supervision is effective, the following elements should be considered..
Understand the Fundamental
Shariah as the backbone of Islamic banking & finance
Specific approach must be taken to ensure adherence to Shariah principles
Recognise the unique structure of Islamic banking & finance
Acknowledge the distinctive risks associate with Islamic banking finance
Appreciate the Uniqueness
Understand the industry in which the Islamic banking & finance exist
Tailor-made the regulatory & supervisory approach to the nature of the financial system
Full commitment on effort to resolve emerging system-wide issues
Recognise the Environment
Acknowledge the Challenges
Identify the pre-requisite for an Islamic financial institutions
Human capital
Infrastructure
Capacity & capability
Balancing the need for prudential regulation & strategic aspiration
We have addressed so far the regulatory & supervisory issues & challenges faced by Islamic finance. it is also important that if we wish to have an effective regulation & supervision of Islamic finance we must take into account four main elements:
The first, we must embrace the fact that Shariah is the backbone of Islamic finance & it cannot be compromised;
Secondly, we need to recognise and appreciate the uniqueness of Islamic banking & finance’s risk and its structure;
Thirdly, to recognise and understand the environment of the financial industry in which Islamic banking & finance operates. Therefore, the regulatory & supervisory approach should be tailor-made in line with the nature of the financial system;
Finally, to acknowledge the on-going challenges faced by Islamic banking & finance. We need not only identify the pre-requisite for an Islamic financial institutions, but also find ways to address these issues in developing human capital, infrastructure, capacity and capability for Islamic financial institutions to grow.

15. Informative websites:
- Bank Negara Malaysia
- Malaysia International Islamic Financial Centre (MIFC)
- Islamic Money Market
- Malaysian Government Securities Market
Securities Commission Malaysia
Malaysia Deposit Insurance Corporation
Global communications campaign launched in August 2008 carried the brand tagline “Islamic Finance Meets in Malaysia” to represent Malaysia as a global meeting place for those with surplus and those seeking funds, and a centre for knowledge seeking and networking.
To further differentiate itself from other competing Islamic financial centres, a new brand campaign will be launched in second half of 2009 with the tagline “Shaping Islamic Finance Together”.
The new campaign portrays Malaysia as the intellectual epicenter – promotes innovation and thought leadership in Islamic finance, thereby attracting global thought leaders and leading players. It suggest humility and togetherness in promoting and expanding global Islamic finance.
“Malaysia, a vibrant Islamic financial hub, shapes the future of Islamic finance through innovation and thought leadership to enable the collaboration with global talents and leading players”
Disclaimer: While every care is taken in the preparation of this presentation, no responsibility can be accepted for any errors.
Copyright: All or any other portion of this presentation may be reproduced provided acknowledgement of the source is made. Notification of such use is required. All rights reserved.

16. SUPPORTING SLIDES PART I

17. Emerging interest on Islamic finance as viable alternative to the global financial system …
Germany
Saxony-Anhalt state issued government sukuk
First Islamic bank to operate in 2010
South Korea
Parliament expected to pass the law related to offering of tax waiver on foreign investors’ interest income from sukuk issued UK
Gov’t sets an objective to ‘entrench London as a global gateway for Islamic finance
5 FSA-approved Islamic banks and Takaful operators
Plans to issue sovereign sukuk, amend tax law on IF
Turkey
Announced IFC Istanbul in Sep ’09 with focus includes interest-free financial business
Japan
Law passed allowing banks to do Islamic finance
Bahrain
Qatar
Pakistan
France
Passed rules/regulations to support Islamic finance activities
In process of licensing Islamic banks
Made fiscal & legal adjustment for IF transaction i.e. taxation guidelines on sukuk & murabaha
Malta
Plans to position as Islamic finance hub for the Mediterranean
Saudi Arabia
UAE
Kuwait
Thailand
Hong Kong
Aims to become Islamic finance gateway to China
Plans to issue sovereign sukuk
Hang Seng Islamic China Index Fund in 2007
Sudan
Indonesia
Jordan
Plans to tap sukuk market to finance its deficit
Singapore
Established first Islamic bank
Introduced tax neutrality for Islamic finance
Aspiring to be centre for Islamic finance
Launched Islamic ETF
Brunei
Aim to become Islamic financial services hub for Asia
Muslim-majority countries offering Islamic finance (IF)
Non-muslim countries starting to offer IF

18. Shariah & Legal infrastructure Comprehensive Capital & Money markets
Instituting a comprehensive Islamic financial system in overall financial system in Malaysia…
Shariah
Legal & Regulatory
Dispute Resolutions
Shariah Advisory Council
Shariah Committee members requirements at Bank level
Shariah Parameters
Shariah Governance
Islamic Banking Act
Takaful Act
Government Funding Act
Capital Market Services Act
Deposit Insurance Act
Guidelines & Policies
Judicial system – dedicated high court on Islamic Finance
KL Arbitration Centre
Financial Intermediation Bureau
Shariah & Legal infrastructure
Islamic Banking
Takaful
Human Capital
Diversity of players supported by Human Capital & Advisory Institutions
17 Islamic Banks
10 Islamic windows
6 DFIs offering IBs
3 International IBs
14 International Currency Business Units
8 Takaful operators
3 re-takaful operators
1 International Takaful Operators
5 International Currency Business Units
International Centre for Education in Islamic Finance (INCEIF)
Islamic Banking & Finance Institute (IBFIM)
International Shariah Research Centre (ISRA)
Advisory (e.g. KPMG,Deloitte)
Capital Market
Money markets
Fund Management
Comprehensive Capital & Money markets
58% of outstanding private debts are Sukuk
Global leader in Sukuk - 62% of total outstanding sukuk globally
87% permissible counters
Islamic inter-bank money market
Diverse short-term Islamic money market Instruments
8 approved Islamic fund management companies
35 fund management companies with Islamic mandate
149 Islamic Unit Trust funds

19. Single Islamic Banking System Conventional Banks with Islamic Windows
Rapid development of Islamic banking business have also contributed to the diversity in industry structure…
Various jurisdictions have their own Islamic banking model to meet local requirement
Single Islamic Banking System
Dual Banking System
Conventional Banks with Islamic Windows
Full transformation of economic system in accordance with Shariah led to existence of single banking system
Country: Iran, Sudan and Pakistan
A comprehensive Islamic banking system co-exist with conventional system
Country: Malaysia, Bahrain, Kuwait, Qatar and UAE
Islamic products offered by conventional banks through “windows”.
Lack of support infrastructure (e.g. Islamic money market & capital market) may constraint product offering
Country: Singapore and UK
Supervisors must understand the rationale behind different structure of the Islamic banks under their purview. – Supervisory approach must be in line with the philosophy behind the different structure that the banks choose to operate
The choice of structure depends on:
Institution preference (Supervisors must understand the rationale of the preference)
Industry / locality preference (Supervisors must understand the spirit behind certain locality preference as set by host supervisors – very important in supervising cross border Islamic banks)

20. SUPPORTING SLIDES PART II

21. Islamic banking institution’s balance sheet…similar in terms of products but different in terms of contractual relationship…
Islamic Rate of Return Management (Asset Driven)
Level of funding from IAH is the most significant differentiating factor
Return on Assets
Investment Returns
Assets
Liabilities
The investors-entrepreneur relationship changes the way Islamic banks operate:
Investors (IAH) bear fully the investment risk (while the bank is only exposed to negligence risk). IAH could therefore determine the investments/assets profile of the banks
Islamic banks have greater fiduciary duty to protect IAH’s investment
Inventory
Real estates/Automobiles
Demand Deposits
Wadiah (Safe custody) / Qard (Loan)
Investment Accounts
Mudharabah (profit sharing)
Asset-backed Transactions
Murabahah (cost plus) / Ijarah (leasing) /
Istisna’ (manufacture) / Salam (forward delivery)
Specific Investment Accounts
Mudharabah (profit sharing)
Profit Sharing Transactions
Mudharabah (profit sharing & loss bearing) /Musharakah (profit & loss sharing)
In Islamic banking, the banker-customer relationship is not debtor-creditor relationship (i.e. pure lending) but is based on different contract that is entered into by the Islamic banks and the customer. Liability Side
The liability structure of Islamic banks (i.e. funding structure) is characterised by two distinct categories of deposits:
1st category is demand deposits which is not subject to risks associated with banking business & for which principal is guaranteed;
2nd category is profit sharing investment deposits which involve risks and hence eligible to share the profits earned from banking business. Unlike conventional banking where returns are predetermined, profit sharing depositors of IB know their returns at the maturity of deposits & these returns are subject to the earnings of the assets that is shared between the IB & profit sharing depositors Asset Side
On the assets side, Islamic banks enter into different financing modes that have varying risk characteristics, ranging from the low risks sales & lease based modes (Murabahah & Ijarah) to the high risk equity-based modes of finance. Each of these modes of finance has a distinct intrinsic characteristic dictated by its underlying Shariah principles, and thus entail different risk profile.
-Inventory of real estates/automobiles:
The bank may stock real estates or automobiles with a view to resale under a murabahah contract or to lease under an Ijarah contract
-Murabahah/Ijarah/Istisna’/Salam are in the form of receivable from customers - which are based on underlying genuine trade & business activities
There are also equity investment in capital ventures & equity financing which are based on Musharakah and Mudharabah contracts, where Islamic bank becomes partner of the company in which the return is based on actual performance of the company's biz, the bank is also exposed to the risk of losing their capital. “Risk sharing helps to inject greater market discipline”.
Profit Equalisation Reserves
Equity
Fee Based Services
e.g. Qadr Hassan (Benevolent Loan)
To minimise Shariah & legal risks of various contracts - understanding Shariah requirements are essential when drafting legal documentations… 21

22. Selected BNM Guidelines
Formulation of separate guidelines* to reflect distinct features of Islamic finance…
Selected BNM Guidelines
Corporate Governance Guidelines
Board & senior management oversight
Governance principles peculiar to Islamic banking
Capital Adequacy Standards
Capital adequacy framework based on IFSB* Capital Adequacy Standard
Risk profiles & exposures determined based on underlying Shariah contracts
PSIA Risk Absorbent Framework
Assets funded by PSIA does not require capital if comply with certain requirements
Shariah Governance Guidelines
Governance of Shariah Committee of Islamic Financial Institutions (IFIs)
Duties & responsibilities of IFIs in ensuring Shariah compliance
Guidelines on Financial Disclosure
Comprehensive guidelines as a basis for disclosure and presentation of reports and financial statements
Rate of Return Framework
Standardise method on calculation of rate of return for Islamic banking
Islamic Money Market Guidelines
Policies governing Islamic Money Market Operations
Firewalls for Islamic window operation
Segregation of funds, separate accounting, clearing & settlement system
Musharakah & Mudharabah
Policies & regulatory provisions that govern the exposure of IBIs under Musharakah and Mudharabah contracts.
Property Development & Investment Activities
Policies relating to property development & property investment activities by Islamic BankingInstitutions (IBIs)
… and streamline with International Standards (IFSB#)
* Note: Selected BNM Guidelines which can be downloaded at
# IFSB- Islamic Financial Services Board

23. International best practices for an effective risk management process
Manage risks peculiar to Islamic financial transactions requires different approaches & mindset…
Bringing capital requirement closer to true economic risk of the Islamic banks
Optimise benefit from the more advanced capital measurement approach which promotes better risk management practices [e.g. Internal ratings based approach]
Market risk
Shariah
non-
compliance
risk
Credit risk
Avoid dependency on long-term fixed return assets in managing return to investors/depositors
Product development to diversify returns profile
International best practices for an effective risk management process
Equity
investment
risk
Rate of
return risk
Islamic banking institutions need a robust risk management practices that caters for risks peculiar to Islamic financial transactions. Towards this end, we can note significant progress by Islamic Financial Services Board (IFSB) that has so far issued 7 international prudential standards encompassing areas such as risk management, capital adequacy, corporate governance, supervisory & market discipline, supervisory review process, real estate & sukuk securirisation, and Islamic collective investment scheme.
For instance, the IFSB’ Standards on Capital Adequacy has addressed risk transformation at different stages of Shariah contracts, bringing capital requirement closer to their actual risk profile. While most Islamic banks are still under the standardised risk measurement approach, these banks should aspire to apply the more advance approaches, not only to ensure alignment of capital to actual risk but more importantly to reap the benefits of better risk management practice embedded within the more advanced approaches.
Current financial crisis & movements in interest rates have increased the importance of Islamic banks to understand the relationship between income from assets and the expectation of returns by depositors. The nature of most Islamic financing which are debt-based with fixed return profile pose challenges for Islamic banks in managing expectations of fund providers’ return which may be influenced by changes in interest rate in conventional market.
Liquidity wise, Islamic banks shall continue to innovate to ensure diversity in Shariah-compliant liquidity instruments that should provide avenue for liquidity management especially during stressed market conditions. While Islamic banks may encounter challenges to fully apply statistical methodologies in profiling liquidity behaviour, they should strive to ensure that prerequisites to enable behavioural model (such as availability & reliability of data) are met.
Liquidity
risk
Enhance liquidity management capabilities & increase availability of Shariah-based Islamic financial market instrument
Explore behavioural model to adequately reflect liquidity risk profile of Islamic products

24. Capital adequacy standard addressed peculiar risk on Islamic finance incl. inventory & transformation of risk…
Ownership
by the Bank
Payment installments
at Selling Price
Receiving asset
EVENT
Sell the asset
Maturity date
RISKS
Ownership risk
(Inventory Risk)
Credit risk
Risk transformation at different stages of Shariah contracts, bringing capital requirement closer to their actual risk profile…

25. Concept of risk management in Islam
Text in Quran
Further he said: "O my sons! Do not enter the capital of Egypt by one gate: but go into it by different gates. However know it well that I cannot ward off you Allah’s will for none other than He has nay authority whatsoever. On Him do I put my trust and all who want to rely upon anyone should put their trust on Him alone."
(Surah Yusuf: Verse 67)
Hadith from Prophet Muhammad S.A.W
Prophet Muhammad noticed a Bedouin leaving his camel without tying it and he asked the Bedouin “Why didn’t you tie down your camel?” The Bedouin answered, “I put my trust in God.” Muhammad replied, “Tie your camel and put your trust in God.”
Text in Quran
Hadith from Prophet Muhammad S.A.W