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  • IslamicBanking

  • Founded in 1807, John Wiley & Sons is the oldest independent publish-ing company in the United States. With offices in North America, Europe,Australia, and Asia, Wiley is globally committed to developing and market-ing print and electronic products and services for our customers professionaland personal knowledge and understanding.

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  • IslamicBanking

    How to Manage Risk andImprove Profitability

    AMR MOHAMED EL TIBY

    John Wiley & Sons, Inc.

  • Copyright C 2011 by Amr Mohamed El Tiby. All rights reserved.

    Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.

    No part of this publication may be reproduced, stored in a retrieval system, or transmitted inany form or by any means, electronic, mechanical, photocopying, recording, scanning, orotherwise, except as permitted under Section 107 or 108 of the 1976 United States CopyrightAct, without either the prior written permission of the Publisher, or authorization throughpayment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Webat www.copyright.com. Requests to the Publisher for permission should be addressed to thePermissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030,(201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.

    Limit of Liability/Disclaimer of Warranty: While the publisher and author have used theirbest efforts in preparing this book, they make no representations or warranties with respect tothe accuracy or completeness of the contents of this book and specifically disclaim any impliedwarranties of merchantability or fitness for a particular purpose. No warranty may be createdor extended by sales representatives or written sales materials. The advice and strategiescontained herein may not be suitable for your situation. You should consult with aprofessional where appropriate. Neither the publisher nor author shall be liable for any loss ofprofit or any other commercial damages, including but not limited to special, incidental,consequential, or other damages.

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    Library of Congress Cataloging-in-Publication Data:

    El Tiby, Amr Mohamed, 1956Islamic finance : how to manage risk and improve profitability / Amr Mohamed El Tiby.

    p. cm. (Wiley finance ; 640)Includes bibliographical references and index.ISBN 978-0-470-88023-4 (hardback); ISBN 978-0-470-93010-6 (ebk);ISBN 978-0-470-93008-3 (ebk); ISBN 978-0-470-93011-3 (ebk)

    1. Banks and bankingIslamic countries. 2. RiskIslamic countries. I. Title.HG3368.A6E47 2011332.1dc22

    2010028557

    Printed in the United States of America

    10 9 8 7 6 5 4 3 2 1

  • To my mother,To the soul of my father,To my wife and children

    Mohamed, Nada, and Khaled

  • Contents

    List of Tables xi

    Foreword xiii

    Preface xv

    Acknowledgments xxi

    Introduction xxiii

    PART ONEUnderstanding the Origins 1

    CHAPTER 1Introduction to Islamic Banking 3

    CHAPTER 2History and Development of Islamic Banking 7

    The Early Days of Islam 7The Modern Islamic Banking System 9Regulatory Agencies for Islamic Financial Services 14The Spread of Islamic Banking 17Summary 23

    PART TWORisk in Islamic Banking 25

    CHAPTER 3The Nature of Risk in Islamic Banking 27

    Banking Risk and the Inherent Risk Associated with IIFS 29Summary 43

    vii

  • viii CONTENTS

    CHAPTER 4The Inherent Risk in Islamic Banking Instruments 47

    Murabahah 47Salam and Parallel Salam 49Istisna and Parallel Istisna 50Ijarah and Ijarah Muntahia Bittamleek 52Mudarabah 54Musharakah and Diminishing Musharakah 56Summary 57

    CHAPTER 5Operational Risk in Islamic Banking 59

    Noncompliance with Shariah Rules and Principles 60Fiduciary Risk 61Legal Risk 63Major Concerns with Legal Risk 68Summary 69

    CHAPTER 6The Islamic Capital Market 71

    Definition, Role, and Importance 71The Islamic Bond Market (Sukuk) 72Sukuk Structure and Types 73Challenges Facing the Development of the Market 76Summary 78

    PART THREECapital Adequacy 81

    CHAPTER 7The Importance and Role of Capital-Literature Review 83

    Definition, Functions, and Importance of Capital 84History of Capital Adequacy Regulations 88The Need for Banking Regulations and Supervision 89Summary 93

    CHAPTER 8The Regulatory Framework of the Conventional BankingSystem: Basel I and II 97

    The Regulatory Bodies 97Basel Capital Accord I: 1988 101Basel Capital Accord II: 2004 105

  • Contents ix

    The Revised Framework 107Three Methods for Calculating Operational Risk 113Summary 117

    CHAPTER 9The Regulatory Framework of Islamic Banks 119

    Background 119The Capital Adequacy Standard (CAS) 120The Definition and Role of Capital 123Determination of Risk Weights 124Credit Risk 126Minimum Capital Requirements for Islamic Financing Assets 130Recommendations 138

    PART FOURCorporate Governance 141

    CHAPTER 10The Supervisory Review Process and Issues 143

    The Supervisory Review Process 143Supervisory Issues of Islamic Banking 146Issues Specific to Islamic Windows 147The Relationship between Banking Supervision and

    Bank Risk Management 148Summary 149

    CHAPTER 11Corporate Governance in Islamic Banking 151

    Definition of Corporate Governance 153Corporate Governance Models 155The OECD Principles 156The Corporate Governance Framework 157Mobilization and Use of Funds 161Issues in Islamic Windows 164Shariah Governance System 165Summary 169

    CHAPTER 12Market Discipline and Transparency in Islamic Banking 171

    The Disclosure Framework for IIFS 172Market Discipline Issues 176Summary 179

  • x CONTENTS

    CHAPTER 13Challenges Facing Islamic Banking and Recommendations 183

    Conclusions 184Recommendations 185

    Abbreviations 187

    Glossary 189

    References 193

    About the Author 199

    Index 201

  • List of Tables

    Table 2.1 The Development of Islamic Banking from 1965to Present 10

    Table 3.1 IFSB Principle for General Requirement 28Table 3.2 Islamic Banking Risk 29Table 3.3 IFSB Principles for Credit Risk 32Table 3.4 IFSB Principles for Equity Investment Risk 34Table 3.5 IFSB Principles for Market Risk 36Table 3.6 IFSB Principles for Liquidity Risk 38Table 3.7 IFSB Principles for Rate of Return Risk 40Table 3.8 IFSB Principles for Operational Risk 42Table 7.1 Bank Capital Definition Matrix: Conventional

    and Islamic 94Table 8.1 Business Line and Beta Factor 115Table 9.1 Classification of Capital in Islamic Banking for

    Capital Adequacy Calculation 124Table 11.1 General Governance Approach of IIFS 159Table 11.2 Rights of Investment Account Holders (IAH) 160Table 11.3 Compliance with Shariah Rules and Principles 160Table 11.4 Transparency of Financial Reporting in Respect of

    Investment Accounts 161Table 11.5 General Approach to the Shariah Governance System 167Table 11.6 Competence in the Shariah Governance System 167Table 11.7 Independence in the Shariah Governance System 168Table 11.8 Confidentiality in the Shariah Governance System 168Table 11.9 Consistency in the Shariah Governance System 169

    xi

  • Foreword

    A s many would say that the worst of the financial crisis is now behindus, it is indeed an opportune time for the expert materials (such as thisbook) on the issues of risk and profitability, particularly with reference tothe Islamic financial services industry.

    As is well known in the Islamic banking and finance industry, Islamicbanking refers to a system of banking or banking activity that is consistentwith the principles of Islamic law (shariah) and its practical applicationthrough the development of Islamic economics.

    Islamic banking arguably emerged (and many view it) as a viable alterna-tive model to conventional banking. The Islamic financial services industry,while still at a growing stage compared with its conventional counterpart,is progressing with a consistent pace.

    Banks, conventional as well as Islamic, are subject to a wide rangeof risks in the course of their operations. Islamic banks, however, face anadditional set of unique risks that arise from the shariah-compliant financingstructures that they employ. I hope readers will have a better understandingof the risks associated with Islamic banking after reading this book.

    There has been a growing amount of capital availability with the Is-lamic banks and they have been aggressively looking for new investmentopportunities.

    The supply of funds coincided quite naturally with the demand forinfrastructure projects in the Middle Eastern Muslim countries. As a result,not only were Islamic banks able to participate in large-scale projects, butalso innovation and financial engineering in refining the Islamic financingtechniques experienced expon