Islamic Banking A Global Perspective & Inherent Risks

Islamic BankingA Global Perspective & Inherent Risks Presented by S. Furrukh Zaeem

Global Islamic Finance Industry Overview $1,086bn in global assets 24.4% growth in 2011 60% Sukuk growth in 2011 $109bn Sukuk issues in 9m 2012 (FY2010)

Exponential Growth Trend in Global Islamic Banking Global assets of Islamic Finance

Country wise Islamic Banking Assets Islamic Finance by country Islamic Finance by country

Country wise Islamic Banking Assets (cont…) OIC Countries by largest sharia-compliant assets, US$ Billion, 2011

Sukuk issues dominant in GCC & Non GCC MENA regions Sukuk issues by region Sukuk issues by country

Growth in Sukuk & Islamic Banking penetration Islamic finance penetration in selected countries Total global Sukuk issues ($bn) *2012 Sukuk issues (9-month), $40bn Q3 2012)

Islamic Banking penetration Islamic Finance penetration in selected OIC countries

Islamic funds Islamic funds worldwide Assets managed by Islamic funds

Current Position of the Islamic Banking Industry • Islamic finance has shown resilience during the past two years at a time when global recovery has slowed and conventional banking in Western countries has remained under pressure • It is not unaffected by broader global macroeconomic problems with some Islamic banks exposed to the volatile real estate markets • Banks account for the bulk of Islamic assets globally with funds and takaful making up the balance • Banks and funds are major investors in sukuk, which strengthened in 2011. Sukuk issuance was up 60% to a record $84bn: two thirds by Malaysian institutions • Considerable potential exists for expansion of Islamic finance with The Banker estimating that only 12% of Muslims worldwide use Islamic financial products • Extent of the industry’s penetration varies substantially. In Bangladesh, for example, Islamic banking accounts for 65% of total banking assets but only 4% to 5% in Turkey, Egypt and Indonesia • The market is currently most developed in Malaysia, Iran and the majority of countries that form the GCC • While scope for development exists in Western countries an appropriate legal and regulatory structure first needs to be designed and implemented

Key Developments Significant international developments in the past year have included: ● Launch in November 2011 by Thomson Reuters of the world’s first Islamic interbank rate, which is designed to provide an indicator for the average expected return on Sharia compliant short term interbank funding ● Oman’s decision in May 2011 to permit the establishment of Islamic banks in the country, the last of the six GCC states to do so. The aim is to tap into regional demand for Sharia compliant banking services and other products currently being met elsewhere in the region and therefore to curtail the current outflow of investment from Oman ● Qatar’s move in February 2011 of preventing conventional banks from offering Sharia compliant products through Islamic windows. The boundary is expected to provide opportunities for Islamic banks to gain market share

Challenges The challenges faced by Islamic banks with regard to liquidity management have been summarised by Mohammed Amin in New Horizon: ● There may be no lender of last resort: in the UK, for example, the Bank of England does not offer Sharia compliant facilities ● Liquidity requires assets to be structured so that they are resaleable, but Islamic bank assets, for compliance reasons, in practice cannot be resold at face value but only at a discount ● There is a shortage of Sharia compliant highly rated, liquid, short-term assets that are available to hold for liquidity purposes However… Eleven central banks that are members of the Islamic Financial Services Board agreed in October 2010 to establish the International Islamic Liquidity Management Corp (IILM) to help Islamic financial institutions work towards an Islamic money market and improve cash management. Products to have been proposed as candidates for new liquidity management tools include asset-backed structured commercial paper; sukuk repo alternative; and leased asset-backed instrument with strong

Risk? THE CHANCE THAT EVENTS OR ACTIONS WILL NOT HAVE THEIR PREVIOUSLY PLANNED OUTCOME

General Risks • Treasury operational risk • Credit risk • Liquidity risk • Currency risk • Interest rate risk • Capital risk • Personnel risk • Political & legal risk

Operational Risk • RISK OF LOSS DUE TO ERROR • Poor dealing/communications procedures • Failure to complete deal slips • Poor checking of deals after execution • Poor reconciliation • RISK OF LOSS DUE TO IGNORANCE • “I didn’t know how to do it but i tried ! ” • Avoided by application of strict imposition of procedures with proper follow-up checks & controls • AVOIDED BY ESTABLISHING CLEAR PROCEDURES • Unpaid items chased in specified time • All entries reconciled in a certain time • Dealing confirmations sent out in time • CHECKED BY EXCEPTION REPORTING • List all unpaid items by date • List unreconciled amounts on accounts • Report occasions when dealing limits have been threatened (but not broken)

Credit Risk • ARISES FROM FAILURE OF COUNTERPARTY TO PAY OR REPAY • Customer fails to pay invoice • Customer fails to repay loan • Investment failure • Failure of counterparty in forward deal prior to settlement • Failure to deliver difference payment in derivative transaction • CONTROLLED BY STRICT APPLICATION OF DIVERSIFIED DEALING/CREDIT LIMITS • CREDIT ASSESSMENT NECESSARY • Can be a problem in the corporate environment • ASSISTED BY CREDIT ENHANCEMENT • Letters of credit • Bank or parent guarantees • OVERCOME BY USING SECURITIES AS COLLATERAL • Government paper is best • Beware long term erosion in securities’ value due to exchange rate movements or market movements • OVERCOME BY USING CASH COLLATERAL • Beware long term erosion in value due to exchange rate movements • LIMITS MUST STILL BE OBSERVED

Liquidity Risk • ARISES THROUGH INABILITY TO MEET MATURING LIABILITIES BECAUSE OF INSUFFICIENT LIQUID ASSETS • Not enough money to pay the bills • ARISES THROUGH • Insufficient working capital, slow debtors cycle, too high inventory • Poor cash management • Wrong choice of (illiquid) investments • Poor market liquidity (lack of depth) • CONTROLLED BY PROPER ROLLING CASH-FLOW ANALYSIS • Kept up-to-date this will show up cash flow gaps well ahead of their arrival • Must be done for every operational currency • BALANCE SHEET MANAGEMENT • Ensures right mix of assets & liabilities • Ensures proper choice of instrument • LACK OF MARKET LIQUIDITY • Helped by careful choice of instrument and/or currency • Market awareness to judge best time of day to deal • Careful cash planning avoids last minute “distressed” dealing

Liquidity Risk A SPECTRUM OF LIQUIDITY • Notes & coin • Bank current accounts • Deposit accounts • Certificates of deposit & bills • Time deposits • Government bonds • Corporate bonds • Shares • Land & buildings

Currency Risk • The change in the base or reporting currency value of an asset or liability or asset/liability mis-match brought about by a change in exchange rates • Must be managed not avoided • Can enhance corporate performance in profit centres • MANAGED & CONTROLLED BY HEDGING • Using rate fixing means • Using rate optimising means • OBSERVANCE OF CONTROLS • Limits & controls on banks • Limits & controls on bank dealers • Limits & controls on corporate dealers • SUPERVISED BY PROPER REPORTING OF POSITIONS • Manually or electronically

Interest RateRisk • The change in budgeted revenue from or expenditure to a source due to a change in prevailing interest rates. • The change in capital value of a fixed income structure due to a change in the market yield of similar structures. • The change in yield of a fixed income structure due to a change in the current value of that structure • The risk from day-to-day fluctuations in interest rates having an effect on the rollover mismatch of assets and liabilities – gapping • MANAGED & CONTROLLED BY HEDGING • Using rate fixing means • Using rate optimising means • CONTROLLED IN DEALING ENVIRONMENT BY STRICTLY OBSERVED AND SUPERVISED LIMITS • Limits & controls on banks • Limits & controls on bank dealers • Limits & controls on corporate dealers • SUPERVISED BY PROPER POSITION REPORTING • Manually or electronically

Political & Legal Risk • Failure to observe or adhere to terms of financial agreements/covenants • Financial penalties due to breaking laws through ignorance • Funds blocked overseas due to exchange control problems • Skilled tax advice not obtained • Other regulatory/compliance problems • Withdrawal of licences

Personnel Risk • RISK OF LOSS DUE TO THEFT OR FRAUD • Conversion • De-falcation of accounts • Counterfeiting • RISK OF LOSS DUE TO CONCEALING ERRORS OR DEALING LOSSES • Dealers checking own confirmations • Dealers settling own deals • COLLUSION IN SMALL OFFICES • Staff influencing each other • OVERDEPENDENCE ON CERTAIN MEMBERS OF STAFF IN SMALL OFFICES • Beware of specialists in certain fields • Difficult to supervise • Difficult to control • STAFF SHOULD NOT ASSESS THEIR OWN PROFITS WITHOUT SOME INDEPENDENT VERIFICATION

Personnel Risk • CONTROLLED (BUT NEVER TOTALLY AVOIDED) • Proper reporting lines but flexible • Good supervision by top management (no absentee landlords !) • CONTROLLED BY STRICT SEGREGATION OF DUTIES • Proper password tiering procedures • CONTROLLED BY GOOD EMPLOYEE RELATIONS • Beware of disgruntled employees • AVOID OVER-RELIANCE ON INDIVIDUAL MEMBERS OF STAFF

Types of Dealing Limits • Money market limits (cash amount) • Fx limits (cash amount) • Derivative limits (cash equivalent) • Market limits (by instrument) • Personal limits (cash amount) • Team limits (cash amount) • Client limits (cash amount) • Maturity limits (cash amount gapping by day, by week, by month, by year)

Islamic Banking in Pakistan • Islamic Banks in Pakistan • Al Baraka Bank • Bank Islami Pakistan • Burj Bank • Dubai Islamic Bank • Meezan Bank • Conventional Banks having Islamic Banking in Pakistan • Askari Bank • Bank Alfalah • Faysal Bank • Habib Metropolitan Bank • Habib Bank • MCB Bank • Standard Chartered Bank • Bank of Khyber • United Bank

Major Islamic Banking Products • Ijarah • Mudaraba • Musharakah (Standard and Diminishing) • Murabahah • Istisna • Salam • Bai Muajjal • Wakala • Wadiah

Major Islamic Banking Products Ijarah A leasing arrangement in which the usufruct of the asset is sold to the lessee at a predetermined price with the lessor retaining ownership and rights of the asset. Mudaraba A contract between two parties; an investment manager and a capital owner. Profit is distributed according to the ratio agreed upon between the two parties. Financial loss is borne by the capital owner. Musharakah (Standard & Diminishing) Similar to a Mudaraba contract except that both partners participate in the management and also share the profit and loss. Profit shared according to agreed ratios, however the loss is distributed in proportion to the share of each individual in total capital. In a diminishing partnership the financier (bank) and the beneficiary enter a partnership to own an asset. The financier is then required to sell his share gradually at an agreed price according to a schedule.

Major Islamic Banking Products Murabahah A sales contract in which a client orders an Islamic Bank to purchase a commodity at specific price with the promise of purchasing the commodity from the bank at a deferred price which includes a profit markup. Istisna A contract in which a party orders a manufacturer to provide a commodity in which the delivery date, price, and payment date are all defined within the contract. Sukuk (Islamic Bonds) Sukuks are financial certificates which are the Islamic equivalents of bonds. Sukuks comply with Shariah Law and therefore, the payment of interest is not permissible. Salam A sales contract in which the price is paid in advance at the time of contracting against the delivery of the purchased goods/services at a specified future date. Salam contracts are usually applied to fungible commodities

Major Islamic Banking Products Bai Muajjal A sales contract in which the parties agree that the payment of the price will be deferred. The bank earns a profit margin on the purchase price while allowing the buyer to pay the price at a future/deferred date in installments or as a lump sum. The term literally translates to ‘credit sale’ Wakala An agency contract in which the client, seeking to be financed, acts as the agent of the bank in order to acquire the asset, which is then sold to the client in installments. Agents can be compensated with a fixed, variable or performance-based payment structure. Wadiah A safekeeping deposit is a guaranteed deposit in which the usage of the deposit in subject to the permission of the depositor, however, the depositor is not entitled to partake in the profits or losses. This is a very common form of deposit within Islamic Banking within Malaysia.

Conclusion • Despite substantial growth in the industry in recent years, there exists great potential within Islamic Finance • Islamic Finance penetration (slide 8) varies significantly within Muslim countries, providing an opportunity for expansion in many countries, including Pakistan. Furthermore, Islamic Finance also possesses the potential for growth through non-muslims that may favour Islamic Banking facilities • It is important to note that the share of Islamic Finance only accounts for 1% of global financial assets currently

Islamic Banking A Global Perspective & Inherent Risks