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ISLAMIC FINANCE AND BANKING: CHALLENGES AND

OPPORTUNITIES

Lecture Outline

1.
2.
3.
4.
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6.
7.
8.
9.

Overview of Islamic Finance


Islamic Shariah and Contracts
Important Islamic Financial Contracts
Models of Islamic Banks
Global Financial Crisis and Islamic Financial
Solution
A Case Study of Financial Murabaha
A Case Study of Legal Stratagem: Tawarruq
A Case Study of Sukuk
Risk and Regulation of Islamic Financial
Industry
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ISLAMIC SHARIAH AND CONTRACTS

Islamic Shariaa: An overview


Islam as a complete code of life encompasses every aspect of human life. It
provides directives as to how economic and financial activities should operate
based on moral and just economic system. The source of Islamic morality stems
from Shariaa. The following diagram shows the position of banking and
financial activities within the framework of Islamic Sharia'a.
Islam

Aqidah
(Faith & Belief)

Ibadah
(Man-to-God worship)

Muamalat
(Man-to-man activities)

Political
Activities

Economic
Activities

Other Economic
Activities

Akhlaq
(Moralities & Ethics

Shariaa
(Practices & activities)

Social
Activities

Banking & Financial


Activities

Islamic Worldview

The

essence of Islam is tawhidoneness and sovereignty of God


(Allah)

Has

many implications

Allah

is the only source of value

Humans

are created equal

Resources

are trust from Allah

Humans

are vicegerents (khalifah)

Humans

have free-will

Muslimsubmission
Will

to the Will of God

of Godexpressed in revelation
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Sources of Islamic knowledge


Two

sources of knowledge in Islam

Revealed

knowledge (Shariah)

Quran
Hadith/Sunnah
Derived

knowledge (Fiqh)through ijtihad (exertion)

Al-Qiyas
Ijma

(Sayings/traditions of the Prophet)

(analogy)

(consensus)

Etc.

Sources of Law for Transactions


Two sources of law in Islam

ShariahRevealed knowledge

Quran Recited
Hadith/SunnahUn-recited

Fiqh Derived knowledge through ijtihad


(exertion)

Ijma (consensus)
Al-Qiyas (analogy)
7

Basic Approach to Islamic Law


Islamic laws can be broadly classified into
two types

Ibadat (devotional acts) Any worship which is not


legalized by Shariah is void
Muamalat (dealings or transactions)Transactions are
permitted unless prohibited by Islamic law (principle of
permissibility)

In muamalat, new transactions can be


accommodated through ijtihad as long as
they do not contain the prohibited (riba and
gharar)
8

Documentation of contracts in Islam


Islamic perspective for transaction involving time:
O you who belief! When you contract a debt for a fixed period, write it
down. Let a scribe write it down in justice between you. Let not the
scribe refuse to write as Allah has taught him, so let him write.
You should not be weary to write it (your contract), whether it be
small or big, for its fixed term, that is more just with Allah; more solid
as evidence, and more convenient to prevent doubts among
yourselves, save when it is present trade which you carry out on the
spot amongst yourselves, then there is no sin on you if you do not write
it down. But take witnesses whenever you make a commercial
contract. (Quran 2:282)

Essential Features of Islamic Contracts


Contract can be created by mutual agreement
Contract (aqd)an engagement and agreement
between two persons in a legally accepted,
impactful, binding manner
Basic elements of a contractoffer (ijab) and
acceptance (qabul) at free will
Contractual agreements outlines the rights and
duties of various parties in a transaction
Difference between a promise and contract

Moral obligation vs moral and legal obligation


Islamic Fiqh Academy Resolution on promise

10

Contracts-Islamic Nature
Freedom of contractsprovide the prohibited
elements are avoided
Some aspects of the contractual relationship
determined by Shariah/Fiqh to avoid

Injustice
Conflicts
Exploitation

Among others the following must be avoided in


financial contracts

Riba
Gharar

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RIBA
1. Riba
Literally means extra
Two types: Al-Nasiah & Al-Fadl
Prohibition in 4 stages. Final verse:
Oh you who believe! Be afraid of Allah and give up
what remains from Riba if you are believers. And if
you do no do it, then take a notice of war form Allah
and His messenger (2: 278-279)

Types of Riba
Riba al Fadl:

If there is exchange among the same specie of the ribawi


goods, it has to be done on spot and should be of equal
amounts.
If the amounts exchanged are different then it will be
riba al fadl.

Riba al Nasiah

Root word nasaa meaning to postponerefers to the


delayed payment riba. When there is exchange of the
same specie over a period of time, the amount exchanged
has to be the same (qard hasan)
If an excess is paid over the amount this will lead to riba
al nasiah.
13

Riba Al-Nasiah
Riba in loan contracts:
Give out loan (principal sum)
Repayment include additional amount because of
delay in payment

This is the riba prohibited in Al-Quran


A.k.a. Riba al-Duyun, Riba Al-Jahiliyyah

Riba Al-Fadl
Riba in exchange contracts
Based on the saying of the Prophet:
Gold for gold, silver for silver, wheat for wheat,
barley for barley, dates for dates and salt for
salt like for like, equal for equal and hand to
hand. If the commodities differ, then you may
sell as you wish, provided that the exchange is
hand to hand (Muslim, Kitab al-Musaqat)

Summary of Riba Al-Fadl


The six commodities could be divided into two categories:
1. Currency gold and silver
2. Staple food wheat, barley, dates, salt
Type
Function Rule
Example
Same

Same

Equal amount
Spot

Gold gold
Dates dates
Quality does not play a role

Different

Same

Spot

Gold silver
Barley dates
USD RM

Different

Different

Free to trade

Gold wheat
RM - goods

Implication from prohibition of riba


Riba Al-Nasiah
financing using loan contracts?
No extra is allowed

Riba Al-Fadl
Currency exchange must be spot transaction
No forward currency transactions

Usage of Money

Loan

Saving

Invest

To help

Guarantee

Extra

Guarantee,
No extra

No extra

No
guarantee

The Riba Equation

Extra

Gua.

Riba

What is Gharar?
GhararExcessive risk, hazard, or ambiguity
Rulings from hadith
Four conditions should exist in a transaction for
gharar to have legal consequences

Uncertainty has to be excessive


Has to occur in exchange contracts
Has to concern the subject matter of the contract itself
(not something attached to it)
Should not fall in the public need category

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Types of Gharar
Gharar can exist in the essence or terms of
the contract
Uncertainty of whether something will take
place or not and the consequences of a
transaction are not clear
Two Sales in One
The Toss Sale
Suspended/conditional Sale
The Future Sale
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Types of Gharar
Gharar can exist in the object of the
contract
Subject matter of sale
Ignorance of the Attributes/Properties of the Object
Ignorance of the Quantity sold
Existence of the Object and the Ability to Deliver

Price of the Good


Ignorance of delivery time

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Implications of Islamic
Principles
1. Selling debt (at discount)riba
2. Futures/Optionsgharar

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IMPORTANT ISLAMIC FINANCIAL CONTRACTS

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Major Islamic Contracts used in


Financing
1. Partnerships musharakah or mudarabah
2. Sale (Exchange) Contracts
1. Deferred trading contracts
1. Price deferred sale (murabahah)
2. Object deferred sale (salam, istisna)

2. Leasing-sale of usufructs (ijarah)

3. Grantsinterest free loans (qard hassan) or


loans at service charges

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Murabahah
1. The financial institution buys and then sells
the good to the client at a mark-up
2. Price paid at a later date
3. The bank must own and posses the good
4. The profit rate and other terms should be
clearly specified in the contract
5. The bank can ask for guarantees or collateral
6. Murabahah bills of trade cannot be traded
(at discount)

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Salam
1. A pre-production sale of goodsselling
goods in advance
2. Can be used for homogenous goods
3. Used to finance the agricultural sector
4. The price has to be fixed and paid when the
contract is concluded
5. Goods delivered at a later date
6. The delivery time should be fixed
7. Parallel salam
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Istisna
1.

A pre-production sale used when an item/asset


needs to be manufactured/constructed
2. The price of the good should be known and time of
payment can be negotiated among the parties
3. The seller of the good (bank) can either
manufacture it or sub-contract itparallel istisna
4. The bank, however, liable for the goods delivered

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Ijarah
1.
2.
3.
4.
5.

A leasing contract involving sale of usufructs of


durable assets/goods
Ownership of the asset is not transferred to the
lessee
The asset can be transferred to a third party
The maintenance costs can be paid by the lessee if
included in the contract, but costs of total damage
of asset is borne by owner
The lessee can sub-lease the asset to third party
unless explicitly prohibited in the contract
(Similar to operating lease)
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Ijarah wa Iqtina
1. A hire-purchase leasing contractownership
is transferred to lessee at the end of the
contract period
2. Fiqhi objectionstwo contracts in one;
purchase contract cannot be binding
3. Banks give away the asset at nominal value
or as a gift at the end of the lease period
(Similar to financial lease)
30

Mudarabah
1. A form of partnershipone party supplies
the capital (rab-ul mal) other manages
(mudarib)
2. Profit shared among parties at an agreed
upon ratio
3. Loss borne by financier only
4. Financier cannot ask for a guarantee of
capital or return
5. Mudarabah can be restricted or unrestricted
31

Musharakah
1. A partnership contract in which all partners
contribute capital and labor
2. Like a mudarahah, but all partners manage
the project
3. The profit share among the partners at an
agreed upon ratio
4. Loss shared according to share of capital

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Murabahah
Traditional Murabahah/Bai al-Muajjal
Productspot

Pricefuture

Financing Mode in Islamic BanksDebt

The financial institution buys and then sells a good to the client at a
mark-up

Price paid at a later date

The bank must own and posses the good

The profit rate and other terms should be clearly specified in the contract

The bank can ask for guarantees or collateral


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Salam
Traditional Salam
Pricespot

Commoditiesfuture

Financing Mode in Islamic BanksDebt

Used to finance the agricultural sector


The price has to be fixed and paid when the contract is concluded
Commodities delivered at a later date
The delivery time should be fixed

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Istisna
Traditional Istisna
Paymentinstallments

Assetfuture

Financing Mode in Islamic BanksDebt

A pre-production sale used when an item/asset needs to be


manufactured/constructed

The price of the asset should be known and time of payment can
be negotiated among the parties

The seller of the asset (bank) can either manufacture it or subcontract it

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Ijarah
Traditional Ijarah
Asset (for rent)fixed period

Rental Payments

Financing Mode in Islamic BanksLeasing

A hire-purchase leasing contract

Ownership is transferred to lessee at the end of the contract period

Banks give away the asset at nominal value or as a gift at the end
of the lease period

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Mudarabah
Traditional Mudarabah
Fundsspot

Service/labour

Profit sharefuture

Profit sharefuture

Financing Mode in Islamic BanksEquity

Partnership between bank and clients

Used on the liability and asset sides

Profit shared among parties at an agreed upon ratio

Loss borne by financier only

Financier cannot ask for a guarantee of capital or return

Mudarabah can be restricted or unrestricted


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Musharakah
Traditional Musharakah
Funds & labour

Funds & labour

Profit sharefuture

Profit sharefuture

Financing Mode in Islamic BanksEquity

A partnership contract in which bank contributes capital and


managerial services

Like a mudarahah, but all partners manage the project

The profit share among the partners at an agreed upon ratio

Loss shared according to share of capital


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ISLAMIC BANKING MODELS

39

Operational Models of Islamic Banks


The global development of Islamic financial institutions has taken various
organizational forms and types according to the needs of the Islamic financial
communities in each country.
Some countries have adopted a dual-banking system, where conventional financial
institutions operate alongside fully-fledged Islamic financial institutions. Example,
Bangladesh and Malaysia.
Other countries have introduced a totally Islamic financial system, where only
Islamic financial institutions are allowed to operate. Example, Iran.
A further group of countries has decided that Islamic financial activities can be
carried out only by fully-fledged Islamic financial institutions which have to be
established alongside the conventional ones not allowed to offer islamic services
(in the case of Kuwait and Lebanon).
The evolution of the global Islamic banking and finance industry is being
continually refined in each country.

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Operational Models of Islamic Banks


The Windows Model
This refers to the operating structure where a conventional bank simultaneously
carries out Islamic financial activities. Under this structure, the bank assure clients
of segregated accounting and operations for conventional and Islamic activities.
Branches
Under this structure, the Islamic financial services are offered through dedicated
service delivery channels. For example, a conventional bank sets up a number of
branches that offer only Islamic financial services.
Subsidiaries
This refers to the operating structure where a separate legal entity (a subsidiary),
owned by a conventional bank or other financial institution (a parent), is set up
specifically to undertake Islamic financial services activities.
Fully-fledged Banks
Fully-fledged Islamic banks are set up to participate solely with Islamic financial
services, offered through their own service delivery channels.
41

Support Institutions for Islamic Banking Industry

Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI)


The International Islamic Financial Market (IIFM)
The International Islamic Rating Agency (IIRA)
The Islamic Financial Services Board (IFSB)
The Islamic Research and Training Institute (IRTI),
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The General Council for Islamic Banks and Financial Institutions (GCIBFI)

Ideal Islamic Banking Model


Two-tier mudarabah model
Profit-loss sharing modes of financing on both the asset and liability
side
Assets
Mudarabah/musharakah
financing

Liabilities and Equity


Profit-sharing investment
accounts (PSIA-Mudarabah
based)
Demand Deposits (qard
hasan)
Capital

43

Features of Ideal IB Model


PLS (risk-sharing) assets would imply robust investments leading to
economic growth
Choosing projects that make good economic sense
Monitoring of the investments closely
Equity financing usually long-term
Sharing risks of assets by the liability side makes the bank more stable
Losses covered by PSIA and capital

44

Islamic Banking in Practice


Some Islamic banks started with PLS financing modes
Risks of equity-financing different from that of debtfinancing
Banks lost money
Resorted to modes that had lower risks
Started using fixed-income debt instruments
Murabahah
Ijarah
45

Islamic Banking Practice: 2nd Best Model


One-tier Mudarabah with Multiple Investment Tools

Liability SidePSIA (Mudarabah based)


Asset Sidemultiple investment tools, dominated by fixed-income
contracts (murabahah, ijarah, istisna, etc.)
Assets
Murabahah
Ijarah
Istisna
Mudarabah/Musharakah,
etc.

Liabilities and Equity


PSIA-Mudarabah based
Demand Deposits (Qard
hasan)
Capital
Reserves

46

Other Features of 2nd Best Model


PSIAprofit-rate smoothing
Profit Equalizing Reserves (PER)-amount deducted from gross income
to smooth PSIA returns
Investment Risk Reserves (IRR)-amount deducted from the income of
PSIA depositors (after deduction of banks share) to meet losses on
investments financed by PSIA

Penalties
Penalties charged on late payments and defaults
Most Shariah scholars do not approve this, but used to discipline
delinquencies
Funds collected given to charities
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Tawarruq
C

A
2

3
B

Tawarruqmonetization
1. A buys a commodity on deferred payment from B
2. A then sells the commodity to C spot to get cash

Allowed by a minority of the Scholars (in the Hanbali and


Hanafi schools)
48

Organized Tawarruq

Broker
Client

Bank

The client wants a personal loan and approaches the bank


1.

Bank buys commodity from a broker paying spot (for 100)

2.

Bank sells the commodity to client payable at a future date (for 110)

3.

The client sells commodity to broker spot (for 100)


[The client appoints the bank as agent to sell the commodity. The bank sells the
commodity spot to the broker for 100 on behalf of the client and deposits the
money in his account.]

At the end of the transaction, the client walks away with 100 and owes the bank 110
payable in the future
[Bai alInah: No third party involvedbank and client do the selling and buy-back]

THE CHRONOLOGY OF THE DEBATE OVER TAWARRUQ


OIC FIQH ACADEMY

Three rulings on the matter:


19th
(2009)

* Banned the application of


organized tawarruq:

17th
(2003)

Financier

*Two types of Tawarruq:


15th
(1998)

*Permissible:
*Condition:
-The customer
not sell the
commodity to
its original seller

Tawarruq Fiqhi/
Haqiqi
(Real Tawarruq)

Tawarruq Munazzam/
Masrafi
(Organized Tawarruq)

Transaction

Explicitly?
Mustawriq
Implicitly?
Common practice?

50

49

OIC Fiqh Academy: 17th Session


TAWARRUQ

Tawarruq Fiqhi/ Haqiqi


(Real Tawarruq)

Tawarruq Munazzam/ Masrafi


(Organized Tawarruq)
Violations of Shariah Principles:
1) Issues pertaining to commodities
)(
2) Issues pertaining to possession &
delivery )(
3) Issues pertaining to Bay al-Inah
4) Issues pertaining to agency
)(
5) Issues pertaining toTawaatu
()
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Issues Pertaining to Commodities )(

AL-ZUHAYLI:
The subject matter must meet all
the specifications & conditions of
good commodities

VALID

AL-QURADAGHI:
Spoiled commodities are used in modern
organized tawarruq

Broker

Bank

Junk
(10 years stored)

ABU GHUDDAH: Lack of proper monitoring


Redundancy of commodities
52

Issues Pertaining to Possession & Delivery


)(

Nett off

Seller 1
Buyer

Buyer 1

Seller
US $10,000
Netting
arrangement

INVALID SALE
(Bay fasid)

US $ 8,000

Customer
(constructive
possession)
53

Issues Pertaining to Bay al-Inah

Sell

Seller

Buyer
Sell

The commodity (object of tawarruq) must be sold


to a party other than the one from whom it was
purchased on a deferred-payment basis ( a third
party) so as to avoid inah, which is strictly
prohibited. More over, the commodity should not
return back to the seller by virtue of prior
agreement or collusion between the two parties, or
according to custom

Buy

AAOIFI, 2008: Shariah Standard No.30, Article 4/5:

3rd party
54

Issues Pertaining to Agency


)(
Organized tawarruq
AAOIFI, Article 4/7-4/10
Buy
(delayed price)

Buy

Sell

Bank/Agent

Client

Sell

Market

3rd Party

Requirement:
1) The bank or its agent
should not sell the
commodity on the
customers behalf if the
customer initially bought
that commodity from the
bank; neither should the
bank arrange a proxy
third party to sell this
commodity
2) Instead, the client should
sell the commodity either
himself or through his
own agent. At the most,
the bank should provide
the client the information
needed to sell the
commodity.

55

Implications of Tawarruq
Tawarruq and Greshams Law (bad money drives away good money)
Tawarruq is driving all other modes away
Tawarruq replicates a loan transaction
The resultthird best model of Islamic banking

56

Islamic Banking Practice: 3rd Best Model


Fixed Liability with Multiple Investment Tools

Liability SideFixed-income investment accounts (using tawarruq)


Asset Side has multiple investment tools, dominated by fixedincome contracts (tawarruq, murabahah, ijarah, istisna, etc.)
Assets
Cash
Tawarruq
Murabahah
Ijarah
Istisna
Mudarabah/Musharakah,
etc.

Liabilities and Equity


Fixed income investment
accounts (tawarruq)
Demand Deposits (Qard
hasan)
Capital
Reserves

57

Other Features of 3rd Best Model

Assets side
Initially different modes used for different purposes
Durablesmurabahah, ijarah
Agriculturesalam
Real estate construction-istisna

Tawarruq can replace all of the above (similar to a loan)

Liability side
Fixed-income investment accounts replaced PSIA

No link between return on assets and liabilities


Stability argument weakened

58

Islamic Modes of Financing

Modes

Sudan

Pakistan

Bahrain

UAE

Murabahah

42.45

50.96

51.73

49.29

Musharakah

17.77

2.52

0.89

2.59

Mudarabah

3.10

1.96

4.36

Ijarah

0.87

20.41

5.56

18.90

Istisna

0.95

0.63

3.22

Salam

0.55

0.23

Others (RE, bai-

34.31

25.88

39.23

21.65

muajjal, Invest.,
etc,)
Source: 2007 Islamic Finance Directory, Gen. Council for Islamic Banks & Fin. Institutions
59

Islamic Modes of Financing

Modes

Iran

Malaysia

Jordan

Saudi
Arabia

Murabahah

21.02

41.04

15.41

15.81

Musharakah

0.97

0.24

2.99

0.65

Mudarabah

1.51

0.27

11.36

0.05

Ijarah

2.18

9.40

13.80

0.04

Istisna

0.07

1.72

1.20

3.74

Salam

0.03

Others (RE, bai-

74.22

47.33

55.25

79.71

muajjal, Invest.,
etc,)
Source: 2007 Islamic Finance Directory, Gen. Council for Islamic Banks & Fin. Institutions
60

GLOBAL FINANCIAL CRISIS AND ISLAMIC FINANCE SOLUTION

61

Interesting Facts

The Median house price increased 4 times during 1980-2007


Stock Index increased from 803 in 1982 to 14,115 in 2007
US Savings declined from 11% in 1980 to less than 1% in 2007

Debt servicing increased to 35% in 2007


An average American gained about 20 Ibs in the last 20 years
The US obesity was 15% in the 70s and it is 33% now

62

Interesting Fact

In the 1980s, only two states (Nevada and New Jersey) had casinos,
now 12 states has casinos and 48 states legalized betting

In 1980, the US credit market debt was equal to US GDP

In 2007, it had risen to 350 times of US GDP

In 2007, CDS-45.5 trillion; US stock market 21.9 trillion;


mortgage security market-7.1 trillion; US treasury market-4.4
trillion

In contrast, the US GDP in 2007 was 13.4 trillion.

63

Causes of the US Subprime Mortgage Crisis

64

CAUSES FOR FINANCIAL CRISIS

The causes of the current crisis can be traced to


three levels:
Regulatory
Organizational
Products

65

Regulatory Environment
Financial Institutions operated in a deregulated environment
FedEmphasis on self-regulation
1999Gramm-Leach-Bliley Act (repeal of Glass-Steagall Act)
2004SEC loosened capital requirements for 5 large investment banks
(MerL, LehB, GolS, MorS, BeaS)
Increased leverage (BeaS had debt/equity ratio of 33:1)

Resistance to control OTC derivatives market


Basel IIMarket based risk assessment and capital requirements

66

Organizational Failures

Lax Risk Management Practices


High Leverage (low capitalization)
Transferring riskExcessive risk taking
Creating newer risks (not well understood)
Under-pricing of risks

67

Product Level
Innovations:
Securitization and sale of debt
Creation of complex and opaque financial instruments (derivatives)
Hedging (risk transfer)
Speculation
Changed financial structure
Sources of funds of banks moved from depositors to capital markets
(securitization)
A complex network of inter-relationships
Created systemic risks not well-understood

68

Making of the Crisis


1.

Driven by excessive profit-motives, banks/financial institutions


engaged in sub-prime lending (with adjustable interest rates)

2.

Loans packaged as Mortgage Backed Securities


(MBS)/Collateralized Debt Obligations (CDO)

3.

55% of the $10.2 trillion loans securitized (end 2006)


12-15% of securitized loans were sub-prime

Rating Agencies gave positive ratings to these securities (to get


more business and collect fees)

69

Making of the Crisis


4. Investors (banks, hedge and pension funds, municipalities,
schools, etc.) acquired these securities
5. Investors/speculators bought Credit Default Swaps (CDS) to
hedge credit risks on MBS/CDO

Notional amounts of OTC Derivatives in 2007 $596 trillion, CDS $58


trillion (US GDP $13.8 trillion)

6. Issuers of CDS (Investment banks & Insurance companies) took


on the risk of default

70

From Defaults to Economic Meltdown

Interest rates began to rise (1% to 5.25% between 2004-2006)


Adjustable rate subprime loans started to default
Holders of MBS/CDO incurred losses

Prices of CDOs fell

Issuers of CDS had to pay-off the losses caused by default


Losses caused depletion of capital of FIs
Scramble to get funds
Money market froze (as lenders did not know the risks involved)

Lack of financing caused housing market to crumplefurther decreasing


housing (CDO) prices and increasing market risks
Credit risks, market risks, and liquidity risks produced systemic risks
Vicious cycle of deleveraging and economic downturn

71

Locating Finance in Islam

Ethics related to financial activities

Prohibitions (fraud, hoarding, exploitation of need, gambling,


etc.)
Obligations & Recommended (charity, honesty, interest-free
loans, risk sharing, etc.)

Laws governing economic/financial activities

Principle of permissibility: All transactions are permitted


expect what is explicitly prohibited by Islamic law
Prohibitions are riba and gharar

72

Key Intrinsic Principles of the Islamic Financial System

73

Islamic Financial Principles and Crisis

Islamic principles:

Using risk-sharing instrumentsmore monitoring


Prohibition of selling of debt (CDOs)
Prohibition on derivatives (CDSs)
Prohibition on short-sellinglimiting betting on downside risks

If Islamic principles were followed, the crisis would not


have taken place the way it did

74

Crisis and Islamic Finance:


Ethical and Legal Dimensions
1.
2.
3.
4.
5.

Conventional
Banks/financial institutions
engaged in sub-prime lending
Loans packaged as MBS/CDO
Rating Agencies gave positive
ratings to these securities
Investors/speculators bought
securities
Credit Default Swaps (CDS) to
hedge/speculate on credit risks

Islamic
1. [Risksharing modes preferred]
[Excessive greed discouraged]

2. Selling of debt prohibited

3. [Dishonesty discouraged]

4. -

5. Derivatives prohibited
[Speculation discouraged]

75

Financial Crisis: Lessons for Islamic Finance

Key elements of the crisis from risk perspectives are


De-regulated environment
FIs seeking higher rates of profit (excessive risk taking
and leverage)
Using innovative complex instruments
If Islamic finance follows the same path, can it end up in
the same situation?

76

Status and Practice of Islamic Finance

Regulatory: IF regulatory environment in elementary stages and still


evolving
Organizational: Excessive profit/risk-takingdifficult to impose
moral order
Episodes of speculation observed in the Gulf states

Products: Innovations mimicking conventional products


Fixed income assetsNo risk-sharing
Sukuk
Risk transfer through securitization
Do investors have control over assets?

Return-swap
Returns on assets can be swapped with return on any class of assets (including sub-prime
CDOs)
Capital efficient solutions?

77

Crisis: Lessons for Islamic Finance


Markets/banks cannot be left to regulate themselves
Regulators have to address risks arising at systemic,
organizational and product levels

IF has principles at product level that could have prevented


the crisis
Shariah principles do not have anything specific to say
about systemic and organizational aspects of the crisis

78

Crisis: Lessons for Islamic Finance


Products developed are diluting the principles
Regulations must include three features
Minimizing Systemic Risks
Strengthening Organizational RM Regimes
Products Regulation

79

Regulations and Support Systems to Minimize


Systemic Risks
Until now, the focus has been on regulating individual
institutions
Need to minimize systemic risksoversee the system as a
whole
Regulate all FIsunderstand the inter-linkages
Separation of commercial and investment banking
Reformation and accountability of Rating Agencies
Sound Liquidity Framework to minimize liquidity risks
Takaful Fund to be used in case of crisis
80

Regulations: Strengthening Organizational


RM Regimes
Capital Requirementsunderstand the risks of Islamic
financial products
Introduce prudent risk management culture and practices
in IFIs

Prevent excessive risk-taking by setting investment criteria


Impose restrictions on excessive leveraging
Require more transparency and accountability
Enhance transparency and information disclosure
Ensure maintenance of credit standards at all times

81

Product Regulation
Products determine the nature and direction of industry
Shariah Boards play a key role in approving the appropriate
products
Products approved at organizational level taking the industry closer
to conventional
Shariah Board at the national level
Approve and monitor Islamic products
Provide Shariah governance guidelines
Reduce Shariah compliance and reputational risks

82

A CASE STUDY: HOW FINANCIAL MURABAHA EVOLVED

83

A Case Study: How Financial Murabaha evolved

Murabaha: Islamic Classical Standard


Murabaha: Modern Standard
Murabaha: Islamic Banking Practice
Risk Mitagation in Financial Murabaha

84

MURABAHA:
Islamic Classical Standard

2. purchase

BANK

3rd party
deliver

1. order
3. sell

4. pay

Client/customer

85

MURABAHA:
Modern standard

2. purchase

BANK

3rd party
deliver

1. order
3. sell

Client/customer

86

4. pay

MURABAHA:
Islamic Banking practice

BANK

3rd party

1. Order
1a. authorize
4. sell

5. Pay installment

2. purchase

3. delivery

Client/customer

87

Financial Murabahah

The financial institution buys and then sells the


good to the client at a mark-up
The bank must own and posses the good
The profit rate and other terms should be clearly
specified in the contract
The bank can ask for guarantees or collateral

88

Murabahah-basic features

1. Murabahah is a sale contract


2. The seller reveals the actual price of the asset/good
being sold and indicates the profit in lump-sum or as a
percentage
3. Delivery of the asset/good is spot, payment can be spot
or deferred
4. Bai-muajjal is a sale with spot delivery and deferred
payment

89

Murabahah as Financing Mode

As financial intermediaries, banks use


murabahah as financing mode (Purchase order
murabahah or financial murabahah)

Financial murabahah is a combination of


contracts

90

Financial Murabahah

Financial murabahah has the following elements:


1. Promise Agreement: The bank and the client signs and overall
agreement of the promise to buy/sell
2. Agency Agreement: The bank appoints the client as an agent to
purchase the good/asset
3. Purchase of the Good from the Supplier: The client buys the good
and takes possession as a agent
4. Offer of Purchase: The client offers to buy the good from the bank
5. Acceptance of the Offer: The ownership of the good transferred
from the bank to the client
6. Debt created: Payment due at future date(s)
91

Points to note

The commodity cannot be bought from the client


If the bank purchases, the agency contract not needed
In such cases, two separate contracts (for supplier and
buyer) and the purchase has to be before sale
Bills of trade resulting from transaction can be
transferred at face-value only

92

Risks in Financial Murabahah

Pre-Sale Risks
Loss/damage of the good before delivery
Refusal of the buyer to take delivery
Market (price) risk

Post Sale Risks


Latent defects in goods
Settlement (credit) risk
Market (benchmark) risk
93

Pre-Sale Risks Mitigation

1. Loss/Damage of good before delivery:


Before delivery, the good is banks responsibility

Risks mitigated by:

Minimize the period of holding (time between


purchase and sale)
If time is longinsurance can be bought

94

Pre-Sale Risks Mitigation

2. Refusal of the Buyer to take Delivery: The bank


is left with the good
Risks minimized by:
The bank purchases the good with a right to
return it within a specified time
The bank sells the good and client pays the
difference between cost and sale price

95

Pre-Sale Risks Mitigation

3. Market (price) risk: Risk of changes in price prior


to delivery of good to client
Risks mitigated by:
Minimizing the holding time by selling
immediately after buying

96

Post-Sale Risks Mitigation

1.

Latent Defects in Goods: It is possible that the


good supplied by the supplier is defective.

Risks minimized by transferring the liability to


the vendor/supplier (through warranty)

97

Post-Sale Risks Mitigation

2.

Settlement (credit) Risk: The risk that the client


will not pay his/her dues on time or default

Risk minimized by:


The bank can ask for a guarantee (sign a
guarantee agreement)
Ask for a security or collateralcan sell the
collateral if debtor defaults
Impose penalty for delinquency problem
98

Post-Sale Risks Mitigation

3.

Market (benchmark rate) risk: The risk that the


returns of the bank will be affected if the
benchmark rate changes

Risks minimized by:


The contracts are usually of short-run duration

99

A CASE STUDY: LEGAL STRATAGEM OF TAWARRUQ

100

Case Study: Legal Stratagem of Tawarruq

Islamic Banking is mimicking conventional banking


From Inah to Tawarruq
Degrees of Separation to veil Riba
Bai al-inah
Tawarruq
Has ownership really changed?
The Unintended results
Imam Taymiyah on Sale/Riba

101

Would Islamic Banking take the Same Route?

What is the current model of


Islamic banking?
Is RIBA still not present?
Islamic banking products mimic
conventional via legal startegems
Selected judgments may provide the
indication

102

From Inah to Tawarruq to Sukuk

The idea of making an impermissible transaction


permissible through degrees of separation is not new
In fact, it underlies many of the juristic stratagems
(hiyal) for circumventing prohibitions
By adhering strictly to the letter but not the spirit of
the law

Inah

Tawarruq

Sukuk

103

Degrees of Separation to Veil Riba


RIBA
RM100 Cash

A
RM105 (deferred payment)

104

Baiul Innah
RM100 Cash

sell brick for cash

resell brick on credit

RM105 (deferred payment)

105

Degrees of Separation to Veil Riba


Riba (HARAM)

Baiul Innah (SYARIAH COMPLIANT?)


RM100
Cash

RM100
Cash

sell brick for cash


resell brick on credit

RM105
(deferred
payment)

106

RM105
(deferred
payment)

Tawarruq
Resells metal on credit

B
105 Cash (deferred payment)

C
Metal
Trader
107

Issues

What is the function of C?

Effect of 2 degrees of separation

No change of ownership of metal


Legal subterfuge?
Individually: syariah-compliant
Read together: syariah-compliant?
circumvent riba

Structure obeys the letter of the law but subverts the


spirit
Form over Substance, Compliance over Essence

108

Degrees of Separation

It is easy to see how we can keep adding degrees of


separation until eventually it would become impossible for
any jurists, however strict, to prohibit the practice as
merely a trick to subvert the substance of Islamic Law
(avoidance of interest-bearing loans) while adhering to its
medieval juristic forms.

109

The Danger

110

An impending subversion of Islamic Law


By approving and eventually codifying (through AAOIFI,
IFSB, OIC Fiqh Academy, etc.) legal stratagems to
replicate conventional financial practices, jurists, bankers
& regulators will eventually drown the substance of
Islamic Law, if not already!

The (Unintended?) Result

An illegal act will be made legal eventually, through the act


of codification!
With advances in structured finance, can easily disguise
riba in any contract, and it would be the ultimate of
disingenuousness to say "but this is bay` (sale), and Allah
has permitted bay` and forbidden riba"

111

IBN TAIMIYYAH
Like other major scholars, Ibn Taimiyyah considers bay
al-inah a legal device in order to overcome the
prohibition of riba, and is not deemed to be an act of
sale, as there is clear evidence that such act amounts,
in effect, to a contract of loan.

The use of legal device is evidence that the niyyah


factor is undermined or made secondary.

112

IBN TAIMIYYAH
Ibn Taimiyyah divides sales into three groups according to the buyers
intentions, namely:
that he purchases the goods in order to use or consume them such as food,
drink and the like, in which case this is sale, which God has permitted
that he purchases the goods in order to trade with them; then this is trade,
which God has permitted
that the reason for purchasing the goods is neither the first nor the second,
then the reason must be dirhams (money) which he needs, and it was
difficult for them to borrow, so he purchases the goods on credit (with an
increased dirhams) in order to sell it and takes its price. This, then, is inah
which is Haram according to the most eminent of the jurists.
113

A CASE STUDY: SUKUK

114

SukukEconomics of Growth

Several driving forces for Shariah compatible securities market

Demand side

Muslims/Islamic financial institutionsShariah compatible securities


Non-Muslims--Alternative investment opportunities

Supply Side

Provides a cheaper source of financing


Provides an alternative source of financing
Provides financing without diluting shareholder equity
Provides a source of off-balance sheet financing (can hold less capital)

Regulatory

Basel IImarketable securities need less capital than direct credit exposures

115

Sukuk al-Salam
Undertaking
Obligor

(undertakes
future sale
of commodity
for the investors)

Sukuk Certificates

2a

Sukuk Certificates
Salam Proceeds
3

SPV

2b

Commodity Sale Proceeds

Commodity
4

6
5

Commodity Sale

Commodity
Buyer

Sale of well-defined quality and quantity of commodity

Fixed rates of return

Sukuk al-salam are not negotiable

116

Proceeds

Investors

Sukuk al-Salam: Example


Sukuk name/date

Sukuk al-Salam/Aug. 1, 2007 (Issue no. 75)

Sukuk base

Aluminium

Obligor

Government of Bahrain

Issuer

Central Bank of Bahrain

Purpose of Offering

Short-term liquidity

Tenor

91 days

Issue size

BD 6 million

Expected rate of
return

5.06%

Credit enhancers

Guaranteed by Bahrain Government

Governing Law

Bahraini Law

Redemption/
Principal repayment

With price at maturity

Rating
117

None

Sukuk al-Ijarah
Sale/Transfer of Assets

Sukuk Certificates

2a

Purchase Price of Assets


Sponsor/
Originator/
Obligor

Sukuk Certificates
3

Lease of Assets
4a

Investors

Proceeds
2b

SPV

Periodic Rental
Payments

Rental Payment

4b

Transfer of assets back to Issuer can take place is 2 ways:

a. Periodic payments include rent and amortization (capital)

b. Bullet payment at maturity (the Issuer buys back the assets)

118

Sukuk al ijarah are negotiable


Can have fixed/flexible rates
Risks of assets transferred to certificate holders (though issuer can guarantee the capital)

Sukuk al-Ijarah: Example


Sukuk name/date

Qatar Global Sukuk/Oct. 8, 2003

Sukuk base

Certain Land Parcel in Qatar

Obligor

State of Qatar (lessee of leased assets)

Issuer

Qatar Global Sukuk QSC

Purpose of Offering

Construction of Hamad Medical City

Tenor

7 Years

Issue size

USD 700 million

Expected rate of
return

Semi-annual lease rentals (Libor+ credit spread+


amortization payment)

Credit enhancers

Guaranteed by Qatari Government

Governing Law

English and Qatari Law

Redemption/
Principal repayment

With rental payments (amortization with rental


payments)

119
Rating

A+ (S&P)

Balance Sheet Based SukukIDB

IDB is a multilateral development bank (MDB) operating on


Islamic principles
Before issuing sukuk, 100 percent equity based institution
(paid-up capital $4.3 billion)
Other MDBs raise funds from market

World Bank raised funds worth 918% its capital (total borrowing $ 96
billion)
ADB raised 777% of its capital (capital $3.6 billion)

Development impact of IDB small compared to other MDBs


Plans to raise up to USD 4 billion in the next 10 years

120

IDB-Hybrid Asset Sukuk


Provides guarantee about
assets

Sukuk Certificates

3a

Sukuk Certificates
Sells

Proceeds
3b

Delegates
1

assets

bundle
worth

agency
role

SPV

Appoints as agent to collect


income from assets

Periodic Income from

$400 m.

Investors

Assets
7

Sells assets $400m.


2

1. IDB bundled ijarah assets (65.8%), along with murabahah (30.7%) and istisna (3.5%) receivables

121

IDB-Hybrid Asset Sukuk


Sukuk name/date

IDB Global Trust Certificates/Aug.12, 2003

Sukuk base

Balance sheet assets of IDB (Ijarah, istisna,


murabahah)

Obligor

Islamic Development Bank

Issuer

Solidarity Trust Services Limited (through ICD)

Purpose of Offering

Financing other assets

Tenor

5 Years

Issue size

USD 400 million

Expected rate of
return

Semi-annual lease rentals (Fixed 3.625%)

Credit enhancers

Guaranteed by IDB

Governing Law

English Law

Redemption/ Principal Purchase of assets at maturity at sale price


repayment
122
Rating

AAA (S&P)

Sukuk al-Murabahah
Master Agreement
Sukuk Certificates

Commodity
Corporate/

Borrower

5b

2a
Issuer

Sukuk Proceeds

SPV

2b

Commodity

Sale Price + profits

Price
6

5a Commodity

3a

Commodities

3b

Price

Commodity
Price

Commodity

Commodity

Commodity

Buyer

Supplier

123

Sukuk al-Murabahah-Example
Sukuk name/date

Arcapita Multicurrency sukuk/June 2005

Sukuk base

Commodity (purchase/sale)

Obligor

Arcapita Bank BSC

Purpose of Offering

Investment in assets

Tenor

5 Years

Issue size

USD 210 million

Expected rate of
return

0.175% above LIBOR rates

Credit enhancers

Full recourse to Arcapita

Redemption/ Principal Bullet payment at maturity


repayment
Rating
124

Arcapita rating (BBB)

Investors

Sukuk al-Musharakah
Physical Asset Contribution
1

Periodic profit and


Incentive fee

Musharakah

Periodic profit 5

Corporate

3 Sukuk proceeds

Sukuk Certificates

Corporate undertakes to

2a

buy musharakah shares


of7the SPV

Investors

Sukuk Proceeds
2b

SPV

Periodic profit
6

Transfer of Assets Back to Issuer can take place is 2 ways:


1. Payments Include profit and purchase of shares (diminishing musharakah)
2. At maturity, the corporate buys back the shares.
125

Sukuk al-Musharakah: Example


Sukuk name/date

Wings-FZCO Sukuk/June, 2005

Sukuk base

Issuer provides assets in kind ($100 million)

Obligor

Emirates Airlines

Issuer

Wings FZCO

Purpose of Offering

Construction of Group Headquarters and


Engineering Centre

Tenor

7 Years

Issue size

USD 550 million

Expected rate of
return

1st coupon after year, thereafter semi-annually


(0.75% above USD LIBOR rates)

Credit enhancers

Strength of Emirates and UAE

Governing Law

English Law and Dubai Law

Redemption/ Principal Bullet payment at redemption


repayment
Rating/Listing
126

Listed with Luxemburg SE

Shariah-related issues

Asset typemost of the sukuk issued are backed by real estate


or other tangible assets
Tangible assets may be limited (as services constitute larger
percentage of output)
May limit the growth of sukuk industry
Way forward

Use other structures (e.g., musharakah)


Add newer asset classes (services, usufructs, intellectual properties)

127

Shariah-related issues

Guarantee in Sukuk issues--3rd party guarantees allowed


without any charges
Originator provides guarantees against a shortfall in capital

128

Critics: Originator/guarantor and SPV same entity guarantee of


capital/return can open doors for riba
Supporters: SPV independent from originator, guarantee by
originator is by 3rd party

Shariah-related issues

Ijarah and lease back structure a form of bai-al-wafa or bai alinah


Objections to redemption/purchase of asset/shares at predetermined price

Ijarah sukuk, Obligor buys back assets at maturity at sale price (face value)
In musharakah sukuk, one musharakah partner buying shares of another at
face value

Redemption/purchase of asset/shares at market price allowed

129

Economic IssuesLiquidity

Liquidity/marketability of Debt Sukuk

While equity-based and asset-backed sukuk are tradable, debt-based


sukuk are not.
This may pose problems in the growth and development of the
Islamic money/capital markets

Possible solutions

Hybrid sukuk (with minority debt component)


Embedded options in sukuk

130

Conversion of debt into goods/assets/shares

Economic IssuesRisks

Risks of Islamic financial instruments in general and sukuk in particular are


complex and not well understood
As Islamic financing is asset-backed or equity-based, market risks play an
important role along with credit risk

Credit/Counter-party risks
Risks related to obligor (default, coupon payment, and asset redemption risks)
Market risks

Interest rate risk (in fixed income sukuk)


Risks related to commodity/asset (loss, damage, etc.) and its price

Liquidity risks

Lack of secondary markets for sukuk


Debt based sukuk cannot be traded

131

Legal and Regulatory Issues

Securities and sukuk laws to protect investors


Most SPVs are trusts

Created for bankruptcy remoteness


Lack of trust laws in many countries

Legal risks

Legal transfer and ownership to SPV


Conflict in lawscommon law, civil law, and Shariah

A Shariah contract originating in civil law countries using English law as the
governing law
Different components of the transaction has different applicable laws (ijarah and
musharakah vs. trust)

Rating agenciesuse the criteria of conventional securities to rate


sukuk
132

Future Market Prospects

Demand for sukuk much greater than supply

Over-subscription of all sukuk issues


Huge liquidity in the regionlack of investment opportunities
Islamic financial industry growing at a fast pacemore demand for
Islamic products for treasury operations
Strong demand for Islamic products from non-Muslim countries

133

Future Market Prospects

Most sukuk are short-termgreat potential for sukuk of longterm maturities


Infrastructure financing

134

Estimated +$300 billion for MENA for next 10 years


New emphasis on private-public participation

Sukuk and Saudi Market

Sukuk market in Saudi Arabiasleeping giant


Being the largest economy in the regiona great potential
exists
After the Capital Market Law, two large sukuk issued
SABIC20 year SR 3 bill. sukuk (2006)
Saudi Electric Company 20 year SR 5 bill sukuk (15/7/07)

The initiatives of developing the infrastructure and economic


cities opens up opportunities for the sukuk market
Capital investment planned for next few years-$283 billion
Saudi Aramco capital expenditure plan-$190 billion

135

RISK AND REGULATION OF ISLAMIC


FINANCE

136

Critics of Islamic Finance


Practice of Islamic finance far from ideal
Bankers
A $300 billion deception
Islamic economists
Fulfilling the form, not the substance or spirit of Islamic finance
Similar to conventional, but more inefficient

Shariah scholars
Shariah scholars questioning the acceptability of some products

137

CHALLENGES IN ISLAMIC FINANCE

Meeting evolving consumers


demand

Strategy and Plan to develop the


right business model

Comprehensive Shariah
Governance & Audit *

Challenges

Legal, Regulatory & Accounting


Framework*

Information system to cater to


Islamic Finance transactions

Risk Management*

Replication v. Authenticity
Willingness to invest in Human
Capital Development
Wealth Management

138

RISK MANAGEMENT IS
Embedded within the conventional
business risk management framework

Credit Risk
Market Risk
Insurance Risk
Sustainability Risk
Liquidity Risk
Pension Fund Risk
Residual Value Risk
Reputation Risk
Operational Risk

Shariah Risk Management


Non-compliance with Shariah rules and
regulations

Accounting
Business Continuity
Fiduciary
Fraud

New product due diligence including


simplification of product complexities
Application of Late Payment / Penalty for
default in a Shariah compliance manner

Information
Legal
Compliance
Operations
People
Tax
Technology

Advise on debt restructuring


Changes in fatwa resulting in existing
product being non-compliance
Advising / guiding with ongoing Shariah
requirements

139

MAJOR SHARIAH RISKS


RISKS
Concentrated reliance on a single
broker for transacting commodity
murabaha (substantial Global
Business is based on this structure)

Major Risks

ACTIONS
Identification of new brokers required
and find alternative to existing
commodity (eg. Bursa Al Sila)

Untested legal infrastructure (case


laws or court proceedings)
supporting products

Using experienced legal counsel for


preparing documentation and
structures

Credibility of Commodity Murabaha


/ Tawarruq structure questionable

Looking to diversify to other


structures.
To address concerns raised.

Manual Processes increase


operational risks

Rationalisation of product range.


Long term, automation and
standardisation required

Lack of inter-bank market creates


challenges in matching assets and
liabilities

This has to be addressed and


financial linkages required

140

Functional Segmentation During Transition


1)

Given the lagging institutional infrastructure, segmentation of


payments / transaction functions and investments may present
advantages.

2)

Investment activities can be modulated to the degree of


investors risk appetite.

3)

Segmentation would facilitate regulation of IFI

141

Outline of Segmented Activity: Depositors Risk


Appetite
ASSETS

LIABILITIES

AssetBacked / Trade
Financing

Segment A
Minimal Risk

Depositors

Ijara, Istisna, Mudaraba

Segment B

LowMed Risk

Depositors

MusharakaMudaraba

Segment C

Vc-Private Equity

Depositors

142

A Market Vision for the Industry Growth


In designing the regulatory framework for IFIs, regulators should
recognize the current difference between the theory and practice
of Islamic Finance.

- First, they should accommodate current practices to promote


stability and soundness of the Islamic financial operations.
- Second, they should provide right incentives so that different
players are encouraged to follow the paradigm of Islamic banking
in the future.
- How ? By improving information facilities to reduce asymmetric
information problems between IFI and investors and by
improving the legal system supporting bank activities.
143