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BK 6503, BK5503January Semester 2011Prof. Saiful Azhar Rosly, Ph.DDepartment of Banking, INCEIF

Islamic Banking 12

Islamic banking and financeIslamic 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.

3Contents4Islamic FinanceIslamic Banking BusinessShariah FrameworkRegulatory FrameworkLegal FrameworkDepositsFinancing OperationsRisk faced by Islamic banksIslamic FinancePeter DruckerIslamic Finance6The Emergence of Islamic Finance 7Components of Islamic Finance8Three Facets of Islamic Finance99TOPIC 1Islamic Banking Business

Nature of the Banking Business11The Banking Business: Banks as Financial Intermediaries12Intermediation function of Conventional banking: Bank as a borrower and lender and carry financial risks13Deficit SectorSurplus SectorBank as financial IntermediaryA Bank as a Financial IntermediaryMake loans to customers Borrows from depositors

Holds capital14Conventional Banks: Market for deposits and loans based on interest rates.15rDrLoansepositSdDdSLDLidiLD1L1Market for DepositMarket for FinancingLiabilityAssetDeposits $200m@ 5%Loans $200m@10%The Banking Business

profit = (iL x L) (iD x D) = (0.1 x 200m) (0.05 x $200m) = $20m - $10m = $10 million 10%5%$200m$200mCapital 16Profit versus Financial Stability17Bank - Corporate Score Card (Actual versus Budget)Operating Profit before Allowances for LossProfit before Tax and ZakatProfit after Tax and ZakatReturn on EquityReturn on AssetFee based income to Total incomeProductivity ratio Overhead to total incomeStaff cost per employeeGross Financing to total depositFinancing growthNon-performing financingFinancing loss coverageRisk-weighted Capital Ratio (RXCR)1819Bank Regulation: The 3 Pillars of Basel II The new Basel Accord is comprised of three pillarsPillar IMinimum Capital Requirements

Establishes minimum standards for management of capital on a more risk sensitive basis:Credit RiskOperational RiskMarket Risk Pillar IISupervisory Review Process

Increases the responsibilities and levels of discretion for supervisory reviews and controls covering:Evaluate Banks Capital Adequacy StrategiesCertify Internal ModelsLevel of capital chargeProactive monitoring of capital levels and ensuring remedial action

Pillar IIIMarket 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.The Banking Business20Business of Leveraging CAR = 8%. CAR = Capital/ RWA; 0.08 = $100m/RWARWA = $1250m$1250m

(for every $1 financing, it is supported with 8 cents of banks capital)

$1250m

Capital = $100m

(Bank can raise up to $1.25billion of deposits from its $100m capital)FinancingDeposits21Risk-taking and Capital Allocation$100m 50%

CAR = K/RWA0.08 = K/ ($100 x .5)K = $4m(to make $100m loan at 50% RW, the bank needs to hold $4m)

Financing Risk weightsCapital22Risk-taking and Capital Allocation$100m 150%

CAR = K/RWA0.08 = K/ ($100 x 1.5)K = $12m(to make $100m loan without collateral at 150% RW, the bank needs to hold $12m)

Financing Risk weightsCapital23Risky Financing and Capital Stress24Conventional risk-weightsLoans with collateralPersonal loanGovernment bondsCorporate bondsEquities

50%100%50%80%150%FinancingRisk-weights25Risk-weights: Islamic productsMurabaha with collateralAITAB (financial lease with collateral)Government SukukCorporate sukuksEquitiesIstisnaBona fide Murabaha

50%50%50%80%150%150%150%150%FinancingRisk-weights26Conventional Banking Balance Sheet27AssetLiabilityCashCurrent AccountHome LoansSavings AccountHP Car loansFixed depositsPersonal LoansNICDGovernment SecuritiesCorporate BondsFixed AssetsShareholders CapitalConventional banking P & L28Profit and LossRevenuesCost of Funds$500m$200mGross Profit$300mOverheadsProvisions for NPL$80m$10m$5mProfit Before Tax$200mTax$60mNet Profit$140m293031Islamic Banking within conventional financial system32Islamic banking: Bank as mudarib/agent and depositors as investors: as a mudarib, the bank manages deposit funds.33Deficit SectorSurplus SectorBank as financial IntermediaryIslamic banks as financial intermediaries 34Allah has allowed Al-Bay (trading) but prohibits Riba (Al-Baqarah 275)

353536Trading Models37Trading (Al-Bay) Models3839Business risk in Trading > Business risk in Islamic Banking40Islamic Banking Under Basel II41Types of Islamic banks42Islamic Financial Market43Dual-Banking System44AssetLiabilityMortgageSavingHire-PurchaseFixed DepositPersonalBondsCapitalAssetLiabilitiesFinancingMortgageHPPersonal

Wadiah Dhamanah SavingsOperational LeasingInvestment AccountsJVStocksSukuksCapitalIBA 1983: Trading ContractsBAFIA 1989 : Lending and Borrowing Contracts

US BankingGlass-Stegall Act 1932

Wall separating Commercial and Investment Banking and Insurance companiesThe GrammLeachBailey Act 1999

Allowed commercial banks, investment banks, securities firms, and insurance companies to consolidate45Universal BankingRetail Banking + Investment Banking + InsuranceRetail Banking:Take depositsMake loansInvestment BankingUnderwritingLead-ArrangeInsurance1. Underwrite pure risk

46Islamic Banking Under IBA 198347AssetLiabilitiesFinancingWadiah Dhamanah SavingsOperational LeasingPSIAJVStocksSukuksCapitalMORE OUTPUT AND REAPING ECONOMIES OF SCALEBENEFITSSimple Bank Organization48Shariah Advisory Committee AuditIslamic Banks Average Balance Sheet49AssetLiabilityCashWadiah Dhamanah Current AccountBBA Home FinancingWadiah Dhamanah Savings AccountAITAB Car FinancingRestricted Mudarabah AccountBay al-Inah Personal FinancingEnterprise FinancingUnrestricted Mudarabah AccountGovernment Islamic SecuritiesCommodity MurabahahNegotiable Islamic Certificate of DepositsSukukFixed AssetsShareholders CapitalIncome StatementReward comes with Risk50Islamic Banking

Profit and LossRevenuesCost of Funds$500m$200mGross Profit$300mOverheadsProvisions for NPFProfit Equalization Reserve$80m$10m$5mProfit Before Tax and Zakat$200mTax and Zakat$60mNet Profit$140mrDrFinancingepositSdDdSLDLrd1rL1D1F1Market for DepositMarket for FinancingLiabilityAssetDeposits $200mFinancing $200mThe Banking Business

Profit = (rF1 x F1) (rd1 x D1) = (0.1 x 200m) (0.05 x $200m) = $20m - $10m = $10 million 10%5%$200m$200mCapital 51

Conventional bank

Profit = (iL x L) (iD x D)iL = 10%, iD = 5%L = D = $100 million

Profit = (0.1 x 100) (0.05 x 100) = 10m 5 m = $5m

Islamic BankProfit = (rF x F) (rD x D)rF = 10%, rD = 5%F = D = $100m

Profit = (0.1 x 100) (0.05 x 100) = 10m .5 m = $5

52Islamic Bank as a Financial Intermediary1. CAR 8%1a. Bank Capital1b. RW = 50%0.08 = [$20b/F x 0.5] F = $500b$20b2. Investment Deposit (Partnership) Transaction Deposit$500m@ 5% ex post3. Financing (Trade)$500m@10%4.Revenue$500m x 0.1 = $50b5. Cost of deposits$500m x 0.05 = $25b6. Overhead $3b7. Provisions $1b8. Profit$50b ($25b + 3B + $1b) = $219. ROE($21b/$20b) x 100%= 105%10. ROD 5%53EXERCISE 1: FINANCING DEPOSITBBA $300@8%AITAB $600@7%Personal F $250@10%Sukuk$80m@5%Mudarabah $20m@15% Total = $1250

Calculate:Total revenues =CASA $300@1%PSIA $950@3%

Total = $1250

Calculate:Total cost of deposits =54Calculate PROFIT = Income StatementReward comes with Risk55Islamic Banking

Profit and LossRevenuesCost of Funds$20m ($9.80m)$10m ($6.85)Gross Profit$10m ($2.95m)OverheadsProvisions for NPFProfit Equalization Reserve$3m$2m$1mProfit Before Tax and Zakat$4mTax and Zakat$1mNet Profit$3mIslamic Banking Performance56Market share in terms of asset: 17.3%Average annual growth: 20%65% of market is concentrated on 6 playersMajority are still small in size in capital terms5758Malaysian Islamic Financial System59TOPIC 2Shariah FrameworkKNOW YOUR CUSTOMER!THE WORLDVIEW Of A THE MUSLIM CUSTOMERAL-MITHAQ (THE PRIMODIAL COVENANT)When thy Lord drew forth from the Children of Adam, from their loins their descendants, and made them testify concerning themselves, (saying), Am I not your Lord (Who cherishes and sustains you)? They said: Yea! We do testify! (This), lest ye should say on the Day of Judgement: Of this we were never mindful. (Al-Araf: 172)63The Shariah6465666768Shariah Framework for Islamic Banking69Maqasid of Shariah (Objective of Shariah)70Islamic financial products as defined by AQAD methodology, should contain more benefits (masalih) and less or no harm (madarah).

in gambling (maisir) and liqour (qimar), there are some sins and some profits. But the sins are greater than the profits (Al-Baqarah: 216).

in Gambling (maisir) and Liqour (qimar), there are some sins and some profits. But the sins are greater than the profits (Al-Baqarah: 216).Gambling & Liqour71#1 NO Riba!72Aqidah Viewpoint: Trade and Riba73Allah has allowed trade but prohibits riba. Explain the verse in the light of risk magement. Main lesson: Rejecting love for money, which is one form of Hubbul Dunya. The believer must only love Allah swt since He is the Creator and Sustainer of life.In riba, money will always apprecia