Islamic Finance: What needs to be done for it to Succeed

1. Islamic Finance: What needs to be done for it to Succeed The World Bank Treasury 1818 H Street, NW Washington, DC 20433 USA Treasury.worldbank.org By ZamirIqbal Lead Investment Officer Quantitative Strategies, Risk, and Analytics (QRA)

2. Road Map • Where are we? Reality Check • What are the lessons? • What are the challenges and the opportunities? IV. What needs to be done?

3. Where are we? Consistent overall high growth: There is growing recognition and acceptance of Islamic finance. Growth in depositors and investors base. Rapid conversion of conventional banks into Islamic banks in several Muslim countries. Capital Markets: Large number of Islamic funds (equity, commodity, leasing, etc.) Gradual development of Sukuk market. Non-Bank financial intermediation: Development of Tatakful Micro-finance Regulatory framework: Establishment of standards setting and regulatory bodies Globalization of Islamic finance: Introduction of Islamic finance in non-Muslim countries. Participation, partnership, and competition with conventional financial intermediaries.

4. Contributing factors to Islamic Finance Going Global • Increased demand for Shariah-compliant products fuelled by increased liquidity in the market. • Successful track record of Shariah-compliant financial intermediation, i.e. Islamic banking. • Commitment by Islamic Development Bank to promote Islamic financial industry. • Development of standards setting institutions such as IFSB and AAOIFI. • Contribution of conventional financial intermediaries through research, development, and innovation. • Financial engineering and structured products in conventional finance which viewed Shariah-compliant products same as another structure.

5. Diversity of Shariah-Compliant Project Financing

6. Development of Sukuk (Islamic Bond) Market • Sukuk are asset-based securitieswith payoffs similar to a conventional fixed income security. • Market has experienced rapid growth • High demand by investors who tend to hold them till maturity. • Not limited to a local market but are issued by different issuer types, in different currencies, and in varying maturities.

7. Sukuk going global • Expanding investors’ base and global demand is sign of recognition and integration. • Active participation by leading conventional investment banks is sign of transfer of financial technology and appreciation of values.

8. Key Observations on the Current State of Affairs • Growth led by the private sector -> mainly driven by the demand. Public sector is lagging behind. • Short-term approach to innovation: • Preference is given to ‘replication’ or ‘wrapping’ or ‘reverse-engineering.’ • Lack of will to introduce new Shariah-based financial instruments. • Liquidity of Islamic products is low • No organized efforts being made to develop full fledged Islamic financial system • Current business model is not sustainable.

9. Functional Assessments of Islamic Financial Markets

10. !!!!! Reality Check !!!!!

11. Lessons from the financial crisis • Systemic / Infrastructure Issues • Exposures due to inherit features of the structure of the financial system. • Debt -> Excessive Leverage • Fractional Reserves System + Securitization => Rapid Money Growth • Classical Assets-Liabilities Mismatch • Remoteness (Real and financial sector) • Injudicious use of Derivatives • Commonalities with previous financial crisis

12. Systemic Exposures • Consistent patterns, practices, and group thinkingacross the financial system • Unregulated and uncontrolled innovation • Corporate governancelapses • Failure of market discipline • Failure of board oversight and risk controls • Short-sightedness • Breach of Trust and confidence • Liquidity • Complexity and Transparency Source: Edelman (2009)

13. What needs to be done?

14. How to Move Forward ? - I • Recognize and utilize inherit stability of Islamic system • 0 % Reserve system -> 0 Credit Multiplier • Assets backed by savings - Wealth creation • “Pass-through” intermediation • No Assets/Liabilities Mismatch • Promote risk-sharing and discourage leverage • Equity-participation instruments • Institutionalize “Musharakah” and “Mudarabah” • Establish linkage between “real” and “financial” sector • Develop truly “Asset-Linked” or “ownership-sharing” products • Prefer “Innovation” or “Replication”

15. How to Move Forward ? - II • Earn the “TRUST” of investors/depositors/Clients • Enhance Corporate Governance • Inclusion of Stakeholders • Enhance Transparency and disclosure • Financial sector development - Institutions • Develop Enterprise Risk Management Culture • Enhance Shariah governance • Liquidity, Liquidity, Liquidity • Develop products and mechanism to enhance LIQUIDITY • Reputational Risk !!!!!!!!

16. Thank You ! This presentation has been prepared by the Treasury of IBRD (TRE) for working purposes for the clients participating in SIP program to guide them in understanding certain concepts underlying investment management. It does not represent, and shall not be interpreted as specific advice or recommendation as to any particular matter covered herein, nor as an indication of market standard in a particular area. Nothing contained in the presentation constitutes or shall be construed as a representation or warranty by IBRD. The Client acknowledges that this presentation is a proprietary document of IBRD and by receipt hereof agrees to treat it as confidential and not disclose it, or permit disclosure of it, to third parties without prior written consent of IBRD.