Islamic Banking

1. Islamic Banking BK 6503, BK5503 January Semester 2011 Prof. Saiful Azhar Rosly, Ph.D Department of Banking, INCEIF

3. Islamic banking and finance • Islamic finance has grown tremendously since it first emerged in the 1970's. Current global Islamic banking assets and assets under management have reached USD750 billion and is expected to hit USD1 trillion by 2010.There are over 300 Islamic financial institutions worldwide across 75 countries According to the Asian Banker Research Group, The World's 100 largest Islamic banks have set an annual asset growth rate of 26.7% and the global Islamic Finance industry is experiencing average growth of 15-20% annually.

4. Contents • Islamic Finance • Islamic Banking Business • Shariah Framework • Regulatory Framework • Legal Framework • Deposits • Financing Operations • Risk faced by Islamic banks

5. Islamic Finance Peter Drucker

6. Islamic Finance

7. The Emergence of Islamic Finance

8. Components of Islamic Finance

9. Three Facets of Islamic Finance

10. TOPIC 1Islamic Banking Business

11. Nature of the Banking Business

12. The Banking Business: Banks as Financial Intermediaries

13. Intermediation function of Conventional banking: Bank as a borrower and lender and carry financial risks Deficit Sector Bank as financial Intermediary Surplus Sector

14. A Bank as a Financial Intermediary • Make loans to customers • Borrows from depositors • Holds capital

15. Conventional Banks: Market for deposits and loans based on interest rates.

16. Asset Liability Loans $200m@10% Deposits $200m@ 5% The Banking Business profit = (iL x L) – (iD x D) = (0.1 x 200m) – (0.05 x $200m) = $20m - $10m = $10 million Capital Market for Deposit Market for Financing SL r r Sd iL 10% id 5% DL Dd L1 Loans D1 D eposit $200m $200m

17. Profit versus Financial Stability

18. Bank - Corporate Score Card (Actual versus Budget) • Operating Profit before Allowances for Loss • Profit before Tax and Zakat • Profit after Tax and Zakat • Return on Equity • Return on Asset • Fee based income to Total income • Productivity ratio • Overhead to total income • Staff cost per employee • Gross Financing to total deposit • Financing growth • Non-performing financing • Financing loss coverage • Risk-weighted Capital Ratio (RXCR)

19. Bank Regulation: The 3 Pillars of Basel II The new Basel Accord is comprised of ‘three pillars’… Pillar I Pillar II Pillar III • Minimum Capital Requirements • Establishes minimum standards for management of capital on a more risk sensitive basis: • Credit Risk • Operational Risk • Market Risk • Supervisory Review Process • Increases the responsibilities and levels of discretion for supervisory reviews and controls covering: • Evaluate Bank’s Capital Adequacy Strategies • Certify Internal Models • Level of capital charge • Proactive monitoring of capital levels and ensuring remedial action Market Discipline Bank will be required to increase their information disclosure, especially on the measurement of credit and operational risks. Expands the content and improves the transparency of financial disclosures to the market.

20. The Banking Business

21. Business of Leveraging CAR = 8%. CAR = Capital/ RWA; 0.08 = $100m/RWARWA = $1250m Financing Deposits • $1250m (for every $1 financing, it is supported with 8 cents of bank’s capital) • $1250m • Capital = $100m (Bank can raise up to $1.25billion of deposits from its $100m capital)

22. Risk-taking and Capital Allocation Financing Risk weights Capital • $100m 50% CAR = K/RWA 0.08 = K/ ($100 x .5) K = $4m (to make $100m loan at 50% RW, the bank needs to hold $4m)

23. Risk-taking and Capital Allocation Financing Risk weights Capital • $100m 150% CAR = K/RWA 0.08 = K/ ($100 x 1.5) K = $12m (to make $100m loan without collateral at 150% RW, the bank needs to hold $12m)

24. Risky Financing and Capital Stress

25. Conventional risk-weights Financing Risk-weights • Loans with collateral • Personal loan • Government bonds • Corporate bonds • Equities • 50% • 100% • 50% • 80% • 150%

26. Risk-weights: Islamic products Financing Risk-weights • Murabaha with collateral • AITAB (financial lease with collateral) • Government Sukuk • Corporate sukuks • Equities • Istisna • Bona fide Murabaha • 50% • 50% • 50% • 80% • 150% • 150% • 150% • 150%

27. Conventional Banking Balance Sheet

28. Conventional banking P & L

32. Islamic Banking within conventional financial system

33. Islamic banking: Bank as mudarib/agent and depositors as investors: as a mudarib, the bank manages deposit funds. Deficit Sector Bank as financial Intermediary Surplus Sector

34. Islamic banks as financial intermediaries

35. “Allah has allowed Al-Bay (trading) but prohibits Riba”(Al-Baqarah 275)

37. Trading Models

38. Trading (Al-Bay) Models

39. Business risk in Trading > Business risk in Islamic Banking

41. Islamic Banking Under Basel II

42. Types of Islamic banks

43. Islamic Financial Market

44. Dual-Banking System IBA 1983: Trading Contracts BAFIA 1989 : Lending and Borrowing Contracts

45. US Banking • Glass-Stegall Act 1932 Wall separating Commercial and Investment Banking and Insurance companies • The Gramm–Leach–Bailey Act 1999 Allowed commercial banks, investment banks, securities firms, and insurance companies to consolidate

46. Universal Banking • Retail Banking + Investment Banking + Insurance • Retail Banking: • Take deposits • Make loans • Investment Banking • Underwriting • Lead-Arrange • Insurance 1. Underwrite pure risk

47. Islamic Banking Under IBA 1983 BENEFITS MORE OUTPUT AND REAPING ECONOMIES OF SCALE

48. Simple Bank Organization Audit Shariah Advisory Committee

49. Islamic Bank’s Average Balance Sheet

50. Income Statement‘Reward comes with Risk”