1ST SESSION: Overview on Supervision of Islamic Banks

1ST SESSION:Overview on Supervision of Islamic Banks September 2011 ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS

Objectives of Presentation (for both sessions) To explain the main principles in banking supervision – modification required to cater for specificities in supervision of Islamic banking To highlight the Malaysian approach in supervising Islamic banks To share Malaysian experiences (where ever applicable)

Starting Point:How Different are Operation of Islamic banks? (in theory and practice) • Level of funding from IAH is the most significant differentiating factor • The investors-entrepreneur relationship changes the way Islamic banks operate: • Investors (IAH) bear fully the investment risk (while the bank is only exposed to negligence risk). IAH could therefore determine the investments/assets profile of the banks • Islamic banks have greater fiduciary duty to protect IAH’s investment

The uniqueness of the activities and risks of Islamic banks warrants special treatments in the following elements… • In addition to the traditional banking risk, supervisors must acknowledge the unique risks in Islamic banking e.g. asset price risk, rate of return risk, displaced commercial risk (DCR) and equity investment risk. • Supervisors must appreciate the risk transformation element and the additional aspects of operational risk in Islamic banking Risk management (DETAILED DISCUSSION IN THE 2ND SESSION) • Capital must be adequate to cushion for all risk including risks unique to Islamic banking as identified through proper risk management process. Capital Requirement • The role of Shariah Board in the governance. • Process and control to protect Investment Account Holder (IAH) • Transparency of financial reporting in respect to investment accounts Corporate Governance • The need to spur market discipline among Islamic banks with regard to the appropriate and timely disclosure of information on risks and returns Market Discipline • Supervision of Islamic banks is very similar to conventional banks i.e. any supervisory approach / framework may be relevant and applicable to Islamic banking supervision • However, specific considerations are required to address specificities of Islamic banks Supervisory Approach

The uniqueness of the activities and risks of Islamic banks warrants special treatments in the following elements… • In addition to the traditional banking risk, supervisors must acknowledge the unique risks in Islamic banking e.g.. asset price risk, rate of return risk, displaced commercial risk (DCR) and equity investment risk. • Supervisors must appreciate the risk transformation element and the additional aspects of operational risk in Islamic banking Risk management • Capital must be adequate to cushion for all risk including risks unique to Islamic banking as identified through proper risk management process. Capital Requirement • The role of Shariah Board in the governance. • Process and control to protect Investment Account Holder (IAH) • Transparency of financial reporting in respect to investment accounts Corporate Governance • The need to spur market discipline among Islamic banks with regard to the appropriate and timely disclosure of information on risks and returns Market Discipline • Supervision of Islamic banks is very similar to conventional banks i.e. any supervisory approach / framework may be relevant and applicable to Islamic banking supervision • However, specific considerations are required to address specificities of Islamic banks Supervisory Approach

Assessing Capital Adequacy for Islamic Banks Main Principle Capital must be commensurate with overall level of risk i.e. including the unique Islamic banking risks Challenges • How is capital framework modified to reflect the nature of Islamic bank where risks (except operational risk) are absorbed by IAH? • What is the appropriate level of capital charge for equity investment risk? should it attract 300-400% RWA based on IFSB CAS or 100-150% RWA based on the Basel 2 risk charge for non trading equity risk? • Some of the unique risks such as RoR risk and the additional aspects of operational risk are not addressed under pillar 1 • Risk transformation and capital adequacy • The capital charge for asset price risk of 15% is based on the commodity price risk, is it sufficient for other asset price risk particularly real estate? Malaysian Experience • Introduced the risk absorbent guidelines which laid out the qualitative criteria for risk absorbent. Currently the risk absorbent features is restricted to SIA only subject to meeting the qualitative criteria. • To ensure level playing field and competitiveness between Islamic banks and conventional, the 100-150% RWA is levied as the capital charge for equity investment risk. • The unique risk and additional aspects of operational risk which are not covered by the minimum capital requirement were addressed under pillar 2 – supervisory review process. • Structured training programme to supervisors • Undertake a study on the adequacy of capital for real estate price risk.

In ensuring capital adequacy vis-à-vis the unique nature of Islamic banks, IFSB had issued Capital Adequacy Standard (which BNM adopted… with several local modification) Capital Adequacy Requirement Risk transformation & capital charges on different contracts Alpha ~ Risk absorbent feature of Profit Sharing Investment Accounts (PSIA) How does supervisor account for different risks embedded in one contract? How is capital framework modified to reflect the nature of Islamic bank where risks (except operational risk) are absorbed by PSIA? Main Principle Capital must be commensurate with overall level of risk i.e. including the unique Islamic financial risks

To understand the different embedded risks within a particular contract, supervisors need to understand the concept of risk transformation… e.g.. Non-binding Murabahah structure: The bank purchases an asset (e.g.. a house) for reselling at mark up Market Risk Transformation Customer approaches the bank and buy that house with a deferred settlement Credit Risk What is the capital charge on a Murabahah contract for financing a residential real estate?...

Risk Transformation and hence, capital charge for Murabahah contract depends on the nature of purchase order by the customers Non-binding Purchase Order Binding Purchase Order

Quite similar to Murabahah, capital charge for Ijarah contract depends on the nature of promise to lease…. And type of Ijarah Operating Ijarah Ijarah Muntahiah bi Tamleek (IMB)

Capital Adequacy Standard issued by IFSB recognised PSIA as risk absorbent… Banks assume all risks • in view of the obligation to protect the principal value of deposits arising from lender borrower relationship between bank and depositors • Required to allocate adequate capital against risk exposures Conventional formula Capital Base RWCR = Total Risk Weighted Assets (RWA) (credit + market + operational risk) IBs are not exposed to the credit and market risks of assets funded by PSIA funds Standardised formula under CAS issued by IFSB • In view that these risks are assumed by the IAH • CAS recommended that risk weighted assets (RWA) funded by PSIA be deducted from the computation of RWCR Capital Base RWCR = Total RWA Credit and Market RWA funded by PSIA Less

Capital Base RWCR = Credit and Market RWA funded by PSIA Total RWA Less In practice, the standard also recognised that IB may not pass all losses due to credit and market risks to IAH as a strategy to remain competitive Standard Formula Supervisory Discretion Formula Capital Base RWCR = Credit and Market RWA funded by Unrestricted PSIA (α) Credit and Market RWA funded by PSIA Total RWA Add Less Capital Base RWCR = Credit and Market RWA funded by UnrestrictedPSIA (1 - α) Total RWA Credit and Market RWA funded by Restricted PSIA Less Less • Alpha (α) represents the percentage of credit and market risks absorbed by IB instead of the IAH as a consequent of income smoothening practice or Displaced Commercial Risk (DCR). • Where αequal to: • ‘0’ means IB pass 100% of the credit and market risks to IAH ; and • ‘1’ means IB absorb 100% credit and market risks risk absorb by IB

We in Malaysia take a stance… the responsibility to prove the level of displaced commercial risk is at the hand of the banks Establish governance of PSIA • Outline the role of the Board of Directors and senior management in managing PSIA funds 1 Establish PSIA contract that incorporate adequate provisions to facilitate effective risks transfer • Explicitly stipulate that losses arising from the assets funded by PSIA shall be borne by the IAH • Ensure the PSIA contract is legally enforceable 2 Identify and match the PSIA funds with the assets funded by these funds • Enhanced the capability to identify and tag the assets with PSIA funds enable to facilitate the measurement of risks and return to IAH • Clarity in identifying and accounting of losses arising from assets funded by PSIA funds will contribute to the effective transfer of risk to IAH 3 Disclose relevant information pertaining to the PSIA funds to the IAH on a timely basis • Access to relevant information enables IAH to make an informed investment decision • Facilitate IAH to assess the risks and return profile of the investment portfolio as well as monitoring the performance of the investment 4

Internal audit & control External Auditors Bank Negara Malaysia has develop several regulatory and supervisory guidance to ensure Islamic banks practice proper corporate governance especially in Shariah management… • The Governance of Shariah Committee – 2004 • Financial Reporting for Islamic Banks - 2005 • Corporate Governance for Licensed Islamic Banks – 2007 The elements of the frameworks include: • Compliance with shariah • The role of shariah committee in the governance • Controls for protecting IAH’s rights • Transparency of financial reporting Supervisors role: to ensure elements of Shariah governance is effectively in place

Shariah Compliance: Supervisory Perspective & Governance Structure AUDIT COMMITTEE True & fair opinion Express Shariah Opinion on IFI SHARIAH BOARD/ SHARIAH COMMITTEE EXTERNAL AUDITOR INTERNAL AUDIT Formulate Policy Shariah Endorsement Internal Shariah Review Shariah Review Testing for Shariah Compliance Shariah Review/ compliance Unit Internal control system Attest

…strong governance require full market awareness and greater disclosure Strong Governance Structure Enhanced Disclosure Full Market Awareness • The equity participation concept trigger fiduciary duty of the bank vis-à-vis costumers protection is crucial. Therefore, disclosure requirement must be more than those expected of conventional counterparts. • However, how much is enough? Supervisors must strike the balance between cost efficiency and meaningful disclosure and the need to protect proprietary information • Market as a whole must understand the uniqueness of Islamic banking. • However, we must ensure signals trigger such as rating agencies basing their assessment from the correct angle and consider the uniqueness of Islamic banking e.g.. rating methodology for sukuk musharakah / mudharabah should be based on the risk profile of the contract.

Effective Market DisciplineHow prepared is the Islamic banking market?... Pre-conditions for effective market discipline: • Market must understand and fully appreciate the nature and risk of Islamic banks • All parties (players, customers, investors, other supervisors, rating agency) are on the same wavelength to ensure consistent understanding of market signals and react accordingly. UNTIL AND UNLESS THE CRITERIA ARE MET, SUPERVISORS CANNOT PUT FULL RELIANCE ON MARKET DISCIPLINE TO REGULATE ISLAMIC BANKING INDUSTRY ISSUES EFFECTIVE MARKET DISCIPLINE Strong Governance Structure • Islamic bank’s fiduciary duty towards IAH is significant and therefore there should be high supervisory expectation with regards to this fiduciary responsibility. • There must also be supervisory expectation on the role of Shariah Supervisory Board for Islamic banks especially in ensuring the banks’ operations are Shariah compliant.

Malaysia’s Risk-based Supervisory Framework has been modified to fit the need for the risk assessment of Islamic banks taking into account the unique risks in Islamic banking Risk Based Supervisory Framework (RBSF) Modification done to fit the Islamic banking model Identification of Significant Activities • Supervisors must acknowledge the universal concept of Islamic banking – various activities could be carried out in addition to traditional banking business e.g.. real estate development and auto trading. Identification of Inherent Risk • Supervisors must acknowledge unique risks emanating from Islamic banking business e.g.. asset price risk, rate of return risk, displaced commercial risk and equity investment risk

Review of Significant Activities (Including Effectiveness of Risk Management Functions) Risk Matrix - Sample • Ratings: • High • Above Average • Moderate • Low “x”: potential area of which supervisors need to pay attention to the uniqueness of Islamic banking operation.

Supervisors need to focus on the Shariah governance & compliance, and the presence of appropriate resources and infrastructure catering the uniqueness of Islamic banking… • Operational Management • Appropriate policies & procedures to cater for the uniqueness • Understanding of the concept and unique products by the front liners • Board Oversight • The presence of effective and independent Shariah advisory committee • Board members must be well equipped with the knowledge of Islamic banking – ensure appropriate strategic direction of the Islamic banks. Unique elements in RMCF of Islamic banks • Risk Management • Need to have a pool of expertise to understand the uniqueness of Islamic banking in order to identify, measure, control and monitor the unique risks effectively. • Measurement methodology must be tailor-made to fit Islamic banking model • Compliance Function • Day-to-day compliance framework must be robust to ensure compliance to Shariah requirement • All elements of compliance from compliance officers to internal audit should be sufficiently trained to understand the uniqueness of Islamic banking

Assessing Quality of Risk Management for Islamic Banks Challenges Risk transformation: • Do supervisors have the ability to unbundle the risks involved? (especially if they doubt that the banks have done it effectively) • Do Islamic banks have the capability to capture this risk transformation? • The unique risks are still posing great challenges to supervisors : • What is the appropriate supervisory approach? • Do we have the competencies and expertise to supervise these risks effectively? • Illiquidity of Islamic hedging instruments Going Forward… • What is the institution aspiration on Business structure (activity-based vs. contracts-based) • Supervisor should change their perspective according to the need of the institution vis-à-vis the industry aspiration To ensure that capital charge reflects the risk transformation

Thank You

2nd SESSION:Essential Elements in the Risk-Based Supervision of Islamic Banking Institutions September 2011 ISLAMIC FINANCE: STRUCTURE & INSTRUMENTS

How Different is the Balance Sheet of Islamic banks? Assets Liabilities Inventories Real estates/Automobiles Demand Deposits Wadiah/custodian Currents and Savings accounts in Conventional banks Conventional banks do not have this Receivables from: Murabahah/Ijarah/ Istisna’/Salam Loans in Conventional banks General Investment Accounts Mudharabah Conventional banks do not have this Profit Sharing Transactions Mudharabah/Musharakah Investment Linked Deposit (ILD) accounts in Conventional banks Specific Investment Accounts Mudharabah Conventional banks do not have this Equity Fixed Assets Would supervisors be capable of assessing beyond the figures in financial statements?

As Islamic banking supervisors, we need to understand the different structures used by the Islamic banks and able to recognise the unique risk emitting from those structures… Islamic Financing & Investment Islamic Deposits & Funding Islamic FX & Money Market Core Banking Products & Risks Where are Risks Coming From? ALM Operations RoR Risk & Displaced Commercial Risk Income smoothing Mechanism

In supervising the ALM operations, bank supervisors need to be mindful of ALM risks & the use of income smoothing mechanism in mitigating the risks… ALM Operations ALM-related Risks Income Smoothing Mechanism Rate of Return (RoR) Risk Displaced Commercial Risk Profit Equalisation Reserves (PER) Investment Risk reserves (IRR) • Other operational risk issues to be considered… • The need to have additional contracts as shariah enabler e.g. commodity murabahah contract to facilitate Islamic Profit Rate Swap for hedging against RoR risk • Absence of Standard Agreement for Derivatives contract like ISDA

Assets Liabilities Profit Sharing Investment Accounts (PSIA) Mudharabah Asset-backed Transactions Receivables from Long Term Murabahah (deferred settlement) What is Rate of Return (RoR) risk? • Fundamentally if an Islamic bank assets are funded by Profit Sharing Investment Account (PSIA) both the credit and market risk (including RoR risk) will be solely borne by the (Investment Account Holder) IAH • Based on this fundamental, how would the Islamic banks expose to RoR risk? In order to answer that, we first need to understand what is RoR risk? Long Term Fixed Returns to investor Long Term fixed Return on Assets An increase in benchmark rates may result in IAH having expectation of a higher RoR, However if the assets funded by them are long term and fixed rate, IAHs’ return could not be repriced higher until those assets mature However, due to competitive pressure.....

Before a hike in benchmark rate Fixed return Fixed rate Mudharib (Islamic Bank) PSIA Holders Murabahah After a hike in benchmark rate Fixed rate PSIA Holders Islamic bank has to give up some portion of its return in order to pay a competitive rate to IAH and prevent them from leaving the bank (liquidity risk) Murabahah Mudharib (Islamic Bank) Portion of Islamic bank’s income gave up to IAH The bank has to displace the RoR risk from IAH to the bank in order to prevent massive withdrawal of investments (liquidity risk) and this is termed as displaced commercial risk: Displaced Commercial Risk (DCR) has brought back RoR risk to the bank

Assessment of RoR risk – Measuring the RoR risk • Methods for measuring the interest rate risk in the banking book of conventional banking i.e. Earnings at Risk (EAR) and Economic Value of Equity (EVE)can be adopted for measuring the RoR risk of Islamic banks by focusing on the substance (from the risk perspective) of the Islamic banking products as e.g..: • Fixed Ijarah, Murabahah and BBA financing can be modelled as fixed rate loans • Floating Ijarah can be modelled as floating rate loans • BBA (with Ibra’ Feature) financing can be modelled as floating rate loans with cap • Tweaking needed: • PSIA should be slotted only in the 1 week to 1 month bucket or earlier • What is the rationale? • Segregations by the source of fund e.g.. funded by GIA, SIA or Shareholders’ fund (including other non-PSIA fund) • What is the rationale? Unlike conventional bank’s fixed deposit where the rate is fixed rate, PSIAs’ are subjected to monthly performance of the assets being funded and hence reprice monthly Islamic bank has the option whether to pass the RoR risk to investors (GIA and SIA) or absorb them

Balance sheet structure and the level of inherent RoR risk Assets: Liabilities HIGH Long Term Fixed rates Mudharabah (Profit Sharing) deposits Floating rates Fixed rate deposits Assets: Liabilities Medium Term Fixed rates Mudharabah (Profit Sharing) deposits Floating rates Fixed rate deposits Level of Inherent RoR Risk Assets: Liabilities Medium Term Fixed rates Mudharabah (Profit Sharing) deposits Floating rates LOW Fixed rate deposits

Income smoothing mechanism – risk mitigant to minimise displaced commercial risk • Profit Equalisation Reserves (PER) and Investment Risk Reserve (IRR) are utilised to ensure rate stability – avoid volatility on return to IAH which can lead to lack of competitiveness during the economic downturn • However, Malaysia choose PER over IRR approach to minimise moral hazard as PER require the bank to contribute to the reserves as oppose to IRR which contain only investors’ contribution. A portion of distributable profit is kept-aside during good times and will be released during bad times • PER • Provision made at gross level i.e. both bank’s and investors’ portion is deducted • Used to cover shortfall in profit • IRR • Provision made at net level i.e. only investors’ portion is deducted • Used to cover shortfall in profit and principal

For several Islamic contracts, similar concepts are used to structure different products on the balance sheet… Core Banking Products & Risks Islamic Financing & Investment Islamic Deposits & Funding Islamic FX & Money Market COMMODITY MURABAHAH MUDHARABAH (profit sharing) SARF (exchange) WAKALAH (agency) IJARAH (leasing) MURABAHAH (profit plus) ISTISNA (project financing) MUDHARABAH & MUSHARAKAH (profit sharing)

Customer submits Ijarah contractual application MR MR IFI acquires assets from supplier OR OR Sign direct Ijarah contract Contract Mature Ijarah Muntahia Bittamleek? Asset return to lessor Normally, Islamic banks would opt for IJARAH and/or Ijarah Muntahia Bittamleek (IMB) for the Auto Financing – What are the unique risks which supervisors need to pay attention in these contracts? A customer enters into a Promise to Lease (PL) with an Islamic Financial Institution (IFI) requesting the IFI to purchase a specified kind of asset with a promise to lease. The PL may be binding or non binding depending on the applicable shariah interpretations If customer opts not to fulfil the non-binding PL, the IFI will be exposed to fluctuation in the value of the asset Compliance with Shariah principles in terms of operations. Yes Sign direct sale contract No The lessor is responsible for defects throughout the Ijarah period in the event that takaful/ insurance is not sufficient Contract Mature Fluctuation in the carrying value of the asset will expose the IFI to asset price risk

MR OR The widely used contract for Islamic House Financing is MURABAHAH – What are the unique risks which supervisors need to pay attention in this contract? Murabahah for the Purchase Orderer (MPO) Agent identify specific asset from a supplier. 2 CUSTOMER 1 IFI executes a Promise to Purchase (PP) with customer and appoints customer as an agent to acquire the asset. ASSET 4 5 SUPPLIER IFI sell the asset to Customer through Murabahah contract. (Transfer of title to Customer) Customer will settle the sale price on deferred payment over a specific tenor. Cash Payment IFI 3 IFI will purchase the asset from supplier. (Transfer of ownership to IFI) IFI may need to sell the goods in the open market if customer cancel the non-binding PP Shariah Compliance Risk: Sequent of transaction is important i.e.. the IFI should not sell the asset to the customer until it takes possession of the asset

ISTISNA'A CUSTOMER (Buyer) 2 4 1 ORDERED RAW MATERIAL FOR MANUFACTURING GOODS 5 MR 3 IFI 9 7 6 ORDERED OR OR GOODS 10 PARALLEL ISTISNA'A (Seller) 8 PROCESS FLOW 1 Customer approaches IFI to manufacture or build something 2 IFI can ask customer to furnish an urbun (security deposit) 3 IFI has the option to manufacture or build the asset on its own (no. 6) 4 Delivery of an ordered goods Flexibility in term of time of payment and mode e.g... lump sum/installment. 5 6 Enter into Parallel Istisna'a to procure an asset from a party other than the original Istisna’a customer 7 It is possible that the IFI to give guarantee to the Parallel Istisna'a seller. 8 Parallel Istisna'a seller shall obtain own materials 9 Delivery of an ordered goods 10 Flexibility in term of time of payment and mode e.g... lump sum/installment. ISTISNA’A is the preferred choice of contract in project-based financing – What are the unique risks which supervisor need to pay attention in this contract? Price Risk relating to input materials Late Delivery of completed goods byParallel Istisna’a seller RAW MATERIAL FOR MANUFACTURING Legal Risk: Claims on the Parallel Istisna’a seller for non-completion of works (litigation cost, legal claims etc.)

Contract of Sale (Bai’) Partnership (Shirkah) Equity-based ISLAMIC CONTRACTS Leasing (Ijarah) Others Equity Investment Risk:the main peculiar risk on the balance sheet of an Islamic bank What is Equity Investment Risk? • broadly defined as the risk arising from entering into a partnership • for the purpose of undertaking or participating in a particular financing or general business activity as described in the contract; • in which the provider of finance, shares the business risk • e.g.. private equity, venture capital Why Equity Investment Risk exist? • Due to equity based financing under Islamic contract : • Musharakah • Mudharabah

CUSTOMER EIR BANK OR MUSHARAKAH: contract (normally used in Commercial/Corporate Banking) that attracts equity investment risk – What are the unique risks which supervisor need to pay attention to? Business failure due to lack of proper feasibility studies, poor selection of partner and key management • Bank and customer provide capital for the project e.g... RM6 million from bank and RM4 million from customer. • Both parties agree on profit sharing ratio (e.g.. 70:30) i.e. 70% of gross profit to be distributed to customer and remaining 30% to bank. The issue of human talent and system to manage the specific project Equity investment risk is evidenced by the risk to assume the loss based on the equity ratio PROJECT 30% 70% PROFIT OR 60% 40% Early termination of partnership by one of the partner. LOSS

CUSTOMER EIR BANK OR MUDHARABAH Financing: slight variation to Musharakah – also attract equity investment risk 1 • Bank provides capital to customer e.g.. RM3 mil • Both parties agree on profit sharing ratio. (e.g.. 60:40) i.e. 60% of gross profit to be distributed to bank 40% to customer/partner. 2 Equity investment risk is even greater as the loss is 100% borne by the bank 2. PROJECT 60% 40% Business failure due to lack of proper feasibility studies, poor selection of partner and lack of talent & system at the bank 3. PROFIT IF 4. LOSS 100%

In view of high-risk nature of Musharakah & Mudharabah investment & financing, BNM has issued specific guidelines… No restriction on funding so long assessment on the appropriateness of fund and effective management of liquidity are in placed. • Availability of a comprehensive risk management infrastructure, system and internal control • Strategies, Policies & procedures • Valuation methodology • Exit strategy and mechanism • To ensure credible corporate governance practices: • BOD must ensure necessary expertise & qualified personnel are in place • Shariah governance framework must be in place • establishment of oversight committee based on materiality BNM M&M Guidelines Subject to other prudential limits e.g... SCL Subject to capital adequacy requirement • Appointment of board representative from IFI in the invested entity to safeguard IFI interest. • Subject to materiality • the board rep must be ‘fit and proper’ • Roles & responsibilities governed by T&C agreed • Mechanism to monitor the effectiveness of board representative Disclosure of risk management policies and practices in financial statements

% of bank’s ownership in the property Periodic rental payment (Rental is calculated based on banking institution’s prevailing share) Lease rental & gradual transfer of banking institution’s ownership 0% OR To Tn Tm Acquisition Date Maturity Date DIMINISHING MUSHARAKAH (an alternative for house financing): an attempt to benefit from three different contracts – what are the unique risks which supervisor need to pay attention in this contract? Diminishing Musharakah is a form of partnership in which one partner (i.e.. customer) promises to gradually acquire the equity share of the other partner (i.e.. the bank) until the share of ownership is completely transferred to the customer. • Compliance with Shariah principles in terms of usage and operations. • How to enforce the promise?

EIR The element of “wa’ad” (promise) in diminishing Musharakah would create different spectrum of complication particularly in the case of default– who will bear the risk/loss? To Tn Tm Acquisition of property by both parties • Default Event/Early Termination • Without wa’ad, the asset will be sold and the proceeds will be divided according to the latest ownership shares of the banking institution and customer. • With Wa’ad, the customer is obliged to acquire the banking institution’s remaining share. This create debts to be paid by the customer to the banking institutions. Equity investment risk is evidenced by the risk to assume the shortfall based on the equity ratio Proceeds from disposal of property Surplus Shortfall Without Wa’ad Shortfall shared by the bank and customer based on the last ownership ratio. - Bank will have to assume the shortfall based on equity ratio on top of credit risk of the borrower. Without Wa’ad Any surplus will be shared by the bank and customer based on the last ownership ratio (if the bank help to find buyer for the property). With Wa’ad Any surplus will be returned to the customer. Does it really work? With Wa’ad Shortfall fully borne by the customer - Effectively no risk to be borne by the bank, other than credit risk of the borrower.

Tweaking/adding of contracts for replicating conventional treasury products creates additional operational risk in treasury operation of Islamic banks TREASURY Money Market FX Operation The use of ‘wa’ad’ in FX forward which resulted in a unilateral type of contract The need to have additional contracts as Shariah enabler e.g.. commodity murabahah contract Commodity Murabahah for MM operation: How it works in Malaysia • Shariah requirements of exchange contracts for currency: • Payment and delivery must be immediate • Same value if same currency t0 Lending bank Borrowing bank tm BROKER B • So, how to operationalise forward FX? • Use of Wa’ad concept • The issue of legal binding arise (again) BROKER A CM House tm Movement of commodity (all at t0) Movement of short term MM fund

DEPOSITOR BANK Main contract used for funding/deposits is MUDHARABAH… very much investor-entrepreneur relationship Mudharabah Deposits 1 • Depositor provides capital to bank e.g.. RM300,000 • Both parties agree on profit sharing ratio. (e.g.. 60:40) i.e. 60% of gross profit to be distributed to bank 40% to customer/partner. 2 General / Specific pool General operation of the bank 60% 40% Specific project PROFIT IF LOSS 100%

DEPOSITOR BANK Some banks offer alternative contracts for deposit-taking activity i.e.. WAKALAH deposits… very much investor-agent relationship Wakalah Deposits 1 • Depositor provides funds to bank e.g... RM300,000 • The bank act as an agent and invest the fund accordingly. The would normally charge a fixed fee to ac as an investment agent • In some circumstances, depositors would only agree to take up profit up to certain amount, any excess would be a performance-based incentive fee to the bank 2 General / Specific pool General operation of the bank All profit to depositors – up to agreed amount to be received Fixed fee + incentive fee Specific project PROFIT IF LOSS 100%

CONCLUSION (for both sessions) • In essence, supervision of Islamic banks is very similar to conventional banks i.e. any supervisory approach / framework may be relevant and applicable to Islamic banking supervision • However, Islamic banking supervisors must acknowledge the unique nature of Islamic banking • Efforts must be put in place to improve the skill set of banking supervisors in understanding the uniqueness – we do not need different set of supervisors; same resources with enhanced competencies in appreciating Islamic banking operation

Thank You (Q & A)

1ST SESSION: Overview on Supervision of Islamic Banks