Islamic Finance Within Conventional Banking System – Opportunities and Challenges

1. Islamic Finance Within Conventional Banking System – Opportunities and Challenges 02 July 2010 III Astana Economic Conference By Musa Abdul Malek Executive Director and CEO HSBC AMANAH Malaysia

2. CONTENTS Overview of Islamic Finance Islamic Finance – Success Recipe Models for Establishing Islamic Finance Islamic Finance Window Operations Challenges in Islamic Finance

3. OVERVIEW OF ISLAMIC FINANCE

4. Government Asia-Pacific Middle East Others driven Pakistan Sudan Malaysia Iran Bahrain HIGH Kuwait Brunei Qatar Indonesia UK Singapore Bangladesh Oman Sri Lanka United Arab Hong Kong Emirates Saudi Arabia Japan LOW South Korea USA Turkey Egypt China Market driven OVERVIEW OF THE ISLAMIC FINANCE INDUSTRY Each region is contributing in a unique way …with worldwide momentum from retail to regulator involvement Examples Malaysia’s Islamic Banking Act 1983 and the Banking & Financial Institutions Act 1989 are enacted as separate statutes Kuwait adopted a new regulatory framework for Islamic finance in 2003, by introducing a new section into the Central Bank Law of 1968 HIGH LOW Note: Circle sizes denote estimated size of the Islamic financial market in these respective countries Source: HSBC Amanah, Illustrative Comparison Model for the development of Islamic Markets and Regulations

5. 2005+ • commercial banking • project finance & syndications • equity • Ijarah • sukuk al ijarah • structured alternative assets • liquidity management tools 2000s 1990s • commercial banking • project finance & syndications • equity • Ijarah • sukuk al ijarah • structured alternative assets • commercial banking • project finance & syndications • equity • Ijarah 1980s • commercial banking • project finance & syndications 1970s • commercial banking OVERVIEW OF ISLAMIC FINANCE • Islamic finance has followed in the wake of innovations in the global financial services industry • A natural progression of the Islamic finance industry: • competitive retail offerings • sophisticated corporate banking products • innovative project finance solutions Islamic Finance In The Last 30 Years

6. ECONOMIC GROWTH IN SOME GEOGRAPHIES Of the total 1.6 billion Muslims globally, there are approximately 640 million in tier 1 & 2 markets. Today, there are more than 390 Islamic banks and institutions spread across 75 countries. Source: HSBC Group economic forecast. INDUSTRY COMMENTATORS SEE ISLAMIC FINANCE INDUSTRY CONTINUING ITS RAPID GROWTH Total Global Islamic banking assets growth (USD bn) Banking Assets in key markets (USD bn) 13% CAGR 20%2 37% 5% CAGR 28% 13% 640 4% 7% 1 2 Sources: The Banker, Oliver Wyman1 2007 – 2008 asset figures are based from The Banker 2 Oliver Wyman growth estimates Note: Key markets include Tier 1 and 2 markets Source: The Banker, Central Bank Reports

7. RISING ISLAMIC PENETRATION WITH GROWTH ACROSS DIFFERENT INDUSTRY SECTORS Islamic Retail Banking Assets (USD bn) CAGR 22% Being validated bottom up with Countries Source: Oliver Wyman Islamic Wholesale Banking Assets (USD bn) CAGR 19% Source: Oliver WymanNote: Wholesale includes corporates, wealth funds and private clients. Global Islamic Mutual Fund Assets (US bn) Islamic Gross Takaful Contributions (USD m) CAGR 12% CAGR 12% Source: Cerulli Associates Report Source: Ernst & Young

8. ISLAMIC FINANCE – SUCCESS RECIPE

9. ISLAMIC FINANCE PROPOSITION – Success Recipe • Majority or good percentage of population are Muslim • Market have strong demand for Shariah proposition but no issue to consider conventional • Government resolute in pursuing Islamic finance agenda and introduce conducive regulatory framework eg. Tax, legal etc. • Central Bank able to regulate Islamic financial institutions • Decide and provide guidelines on Shariah issues • Treatment of balance sheet - segregating or co-mingling • Provide framework to support and regulate the institutions • One stop centre to resolve issues by industry players • Sufficient talent to manage the business both the Shariah scholars and practitioners Success Recipe

10. MODELS FOR ESTABLISHING ISLAMIC FINANCE

11. VARIOUS MODELS FOR CONSIDERATION Stand Alone Islamic Finance Comprehensive infrastructure to support the business License only to do Islamic finance business Islamic Subsidiary Subsidiary of the existing conventional in the country Separate Board of Directors Leverage infrastructure from the parent infrastructure Using the main Bank infrastructure to support the business Supervise the operations to ensure Shariah compliance Islamic window Structure Islamic products for distribution by conventional branches A division within the existing conventional bank

12. ISLAMIC WINDOW OPERATIONS

13. ISLAMIC ‘WINDOWS’ OPERATIONS • A division within the conventional bank • Preferably to be headed by a Muslim • Need to set up Shariah Committee and Shariah department to ensure business undertaken is Shariah compliance • Minimum to have own product development team and dedicated IT team • Sharing the same system platform – tweak to meet with Shariah • Accounting treatment eg. penalty fee not compounded • Wordings on the statement and advises must be Shariah compliance • Leverage from existing infrastructure thus cost to do the business is lower • Preferable for the balance sheet to be separated Windows Operations

14. ISLAMIC ‘WINDOWS’ OPERATIONS ADVANTAGES • Sharing the same infrastructure • Sharing the same system platform – tweak to meet with Shariah • Cost to do the business is lower • Inclusive proposition DISADVANTAGES • Always guided by the conventional banking way • Business requirements may conflict with Shariah • CHALLENGES • Awareness on Islamic finance amongst the internal customers is low • Shariah compliance to be the main driver for the business • Potential canabalising the conventional business Windows Operations

15. CHALLENGES IN ISLAMIC FINANCE

16. CHALLENGES IN ISLAMIC FINANCE Meeting evolving consumers’ demand Challenges Strategy and Plan to develop the right business model Comprehensive Shariah Governance & Audit * 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

17. SHARIAH GOVERNANCE AND FRAMEWORK

18. SHARIAH COMPLIANCE IS FUNDAMENTAL IN ISLAMIC BANKING AND FINANCIAL INSTITUTIONS IFSB Islamic Financial Services Board (IFSB) Guiding Principles of Risk Management indicates: Shariah Compliance is categorised as higher priority in relation to identified risks and; There must be a comprehensive and sound Shariah Compliance framework and mechanism in place.

19. MEMORANDUM & ARTICLES OF ASSOCIATION OF MOST ISLAMIC FINANCE INSTITUTIONS PROVIDE: Compliance The business of the Company will be transacted in ACCORDANCE with the : Rules Islamic Principles Practices In this respect, the Company isPROHIBITEDfrom carrying out any transactions which involve any elements that are not in compliance with the Islamic principles, rules and practices.

20. SHARIAH STRUCTURE Shariah Committee Term Of Reference of Shariah Committee Rulings of Shariah Committee Shariah Structure Shariah Advisory & Development Shariah Compliance & Review Shariah Research Shariah Dept Internal Policies, Procedures, Guidelines, Manuals, Matrix & Certificates • Shariah Compliance Manual • Guidelines on the Shariah Committee • Shariah Compliance Certificate • Guidelines on Services & Transactions

21. LEGAL, REGULATORY & ACCOUNTING FRAMEWORK

22. Legal Need a Robust Structure Regulatory Flexible yet decisive Accounting AAOFI vs IFRS LEGAL, REGULATORY & ACCOUNTING FRAMEWORK

23. LEGAL FRAMEWORK – Need a robust structure Ensure compliant with Shariah but yet enforceable under applicable secular law Current transactional practise with respect to existing legal opinion - Different islamic jurisprudence interpret Shariah differently - Lack of binding precedents and published decision - Is Shariah compliance considered in judgement eg Zulkifli vs Affin Bank (Malaysia), Investment Dar vs Lebanon Blom Bank Untested certainty/predictability for Shariah compliant transactions in different jurisdiction Willing to change to accommodate Shariah requirements eg. legal ownership over home financing if structure based on Ijarah or Musyarakah Legal

24. REGULATORY FRAMEWORK – Flexible yet decisive Willing to change the act to accommodate Islamic Finance - Land Code - Tax issue eg. VAT, property gain tax Propose to adopt tax neutrality Regulatory

25. ACCOUNTING FRAMEWORK (AAOIFI vs IFRS) AAOIFI Develop the accounting, auditing and banking practices through relating to the activities of the Islamic Financial Institutions (IFIs) Prepare, promulgate and interpret accounting and auditing standards for IFIs in order to harmonize the accounting practices and auditing procedures Review and amend the accounting and auditing standard for IFIs to cope with developments in the accounting and auditing through practices Accounting 1

26. ACCOUNTING FRAMEWORK (AAOIFI vs IFRS) IASC Foundation and IASB • To develop a single set of high quality, understandable, enforceable and globally accepted international financial reporting standards (IFRS) through its standard-setting body of IASB • To promote the use and rigorous application of those standards • To bring about the convergence of national accounting standards and IFRS to high quality solutions Main Differences AAOIFI and IFRS • AAOIFI • Specific for Islamic industry • Accounting, Auditing, Ethics, Governance & Sharia • IFRS • Entire economic & social activities • Specific to accounting Accounting 2

27. ACCOUNTING FRAMEWORK (AAOIFI vs IFRS) Consideration Standalone and fully Islamic Group – AAOIFI Subsidiary with conventional parent – IFRS Window – IFRS Rationale for window to adopt IFRS Consolidation Accounting treatment eg. Unrestricted investment as a separate item instead of presented as liabilities (along with other liabilities) in IFRS Accounting 3

28. RISK IN ISLAMIC FINANCE

29. RISK MANAGEMENT IS Embedded within the conventional business risk management framework Shariah Risk Management Non-compliance with Shariah rules and regulations New product due diligence including simplification of product complexities Application of Late Payment / Penalty for default in a Shariah compliance manner Advise on debt restructuring Changes in fatwa resulting in existing product being non-compliance Advising / guiding with ongoing Shariah requirements • Credit Risk • Market Risk • Insurance Risk • Sustainability Risk • Liquidity Risk • Pension Fund Risk • Residual Value Risk • Reputation Risk • Operational Risk Accounting Business Continuity Fiduciary Fraud Information Legal Compliance Operations People Tax Technology

30. MAJOR SHARIAH RISKS ACTIONS RISKS Concentrated reliance on a single broker for transacting commodity murabaha (substantial Global Business is based on this structure) Identification of new brokers required and find alternative to existing commodity (eg. Bursa Al Sila’) Major Risks 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

31. Thank You