9181 C 77 e

1 Islamic Banking
BK 6503, BK5503
January Semester 2011
Prof. Saiful Azhar Rosly, Ph.D
Department of Banking, INCEIF
2
Islamic banking and finance
3
Islamic 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.
Contents
4
Islamic Finance
Islamic Banking Business
Shariah Framework
Regulatory Framework
Legal Framework
Deposits
Financing Operations
Risk faced by Islamic banks
Islamic Finance
Doing EQUITY,JUSTICE and FAIRNESS
the

Deterministic ie Rule set by God
Shariah Rules
Right
Philosophy Maqasid Al-Shariah
Thing
Doing EFFICIENCY efficient use of scarce
resources (ie funds)
Things Using Reason and Facts in decision

making
Strategies, Planning,
Right Process/procedures.
Back, Middle, Front Office.
Peter Drucker
Islamic Finance
6
Shari Components Tabi Components

Product development and Business models,
screenning activities strategies and policies
Value: Quran and Hadiths Value: Reason and
(Shariah) Experience
JUSTICE AND EQUITY
EFFICIENCY
The Emergence of Islamic
7
Finance
2000
onwards
1980s/199 Islamic
0s Finance
Islamic
Banking
1960s and
1970s
Islamic
Economics
Components of Islamic
8
Finance
Shariah
Islamic
Islamic
Wealth
Econo
Plannin
mics
g
Islami
c
Finan
ce
Takaful Islamic
Banking
Islamic
Capital
Market
Three Facets of Islamic
9
Finance
As a Financial
System : Set of
Rules and
Regulation that
As a Field of Study As a Business
govern the flow of
funds from the
Surplus Unit to the
Shariah Deficit Unit Equity Objective
Rule 1: Al-Ghorm
(Quran,Hadiths Achievable by
bil Ghonm
and Fiqh) adhering to the
no reward
as Primary or Shariah Rules and
without risk
Core Knowledge Values
Efficiency
Rule 2: Al-Kharaj
Secondary Objective
bil Daman
Knowledge from Achievable by
Reason and Facts with profit comes
observing the law
responsibility
in nature.
TOPIC 1
ISLAMIC BANKING BUSINESS
11
Nature of the Banking
Business
The Banking Business: Banks as
Financial Intermediaries
12
Holds Takes
Makes
Capita Depos
Loans
l its
Intermediation function of Conventional
banking: Bank as a borrower and lender and
13
carry financial risks
Bank as
Deficit Sector financial Surplus Sector
Intermedi
ary
A Bank as a Financial
14
Intermediary
Make loans to
customers
Borrows from depositors
Holds capital
Conventional Banks: Market for deposits and loans
based on interest rates.
15
Market
Market
for
for Loans
Deposits
Demand
Demand
for
for Loans
Deposits
Supply of Supply of
Deposits Loans
Asset Liability
Loans Deposits $200m@

The Banking Business
$200m@10% 5%
profit = (iL x L) (iD x D)
= (0.1 x 200m) (0.05 x $200m)
= $20m - $10m = $10 million Capital
Market for Financing Market for Deposit
SL r
r Sd
iL
10%
id
5%
DL Dd
L1 Loans D1 Deposit
16
$200m $200m
Profit versus Financial
17
Stability More bank profits:
Bank take risky
and aggressive
and irresponsible
positions to
maximize profits
Credit defaults and

bank closures:
Financial
Instability
Bank - Corporate Score
18
Card (Actual versus Budget)
Operating Profit before Allowances for Loss
Profit before Tax and Zakat
Profit after Tax and Zakat
Return on Equity
Return on Asset
Fee based income to Total income
Productivity ratio
1. Overhead to total income
2. Staff cost per employee
. Gross Financing to total deposit
. Financing growth
. Non-performing financing
. Financing loss coverage
. Risk-weighted Capital Ratio (RXCR)
Bank Regulation: The 3 Pillars of
Basel II
19
The new Basel Accord is comprised of three pillars
Pillar I Pillar II Pillar III

Minimum Capital Supervisory Review Market Discipline
Requirements Process
Bank will be required to

Establishes minimum Increases the responsibilities increase their information
standards for management of and levels of discretion for disclosure, especially on the
capital on a more risk sensitive supervisory reviews and measurement of credit and
basis: controls covering: operational risks.
Credit Risk Evaluate Banks Capital
Operational Risk Adequacy Strategies
Expands the content and
Market Risk Certify Internal Models improves the transparency of
Level of capital charge financial disclosures to the
Proactive monitoring of market.
capital levels and
ensuring remedial action
20
Risk-Weight
Assets - to
reflect risk-
profile of
business units
Capital To absorb
Adequacy potential
ratio = 8% losses
Bank
Capit
al
Business of Leveraging CAR = 8%.
CAR = Capital/ RWA; 0.08 = $100m/RWA
RWA = $1250m
21
Financing Deposits
$1250m
$1250m Capital = $100m
(for every $1 financing, it is supported (Bank can raise up to

with 8 cents of banks capital) $1.25billion of
deposits from its
$100m capital)
Risk-taking and Capital
22
Allocation
Financing Risk
Capital
weights
CAR = K/RWA
0.08 = K/ ($100 x .5)
K = $4m
$100m 50%
(to make $100m loan at
50% RW, the bank
needs to hold $4m)
Risk-taking and Capital
23
Allocation
Financing Risk
Capital
weights
CAR = K/RWA
0.08 = K/ ($100 x 1.5)
K = $12m
$100m 150% (to make $100m loan
without collateral at
150% RW, the bank
needs to hold $12m)
Risky Financing and Capital
24
Stress
Risky Higher
Higher
positio Risk-
capital
ns weights
Conventional risk-weights
25
Financing Risk-weights
Loans with collateral

50%
Personal loan
100%
Government bonds
50%
Corporate bonds
80%
Equities
150%
Risk-weights: Islamic
26
products
Financing Risk-weights
Murabaha with
collateral 50%
AITAB (financial lease 50%
with collateral) 50%
Government Sukuk 80%
Corporate sukuks 150%
Equities 150%
Istisna 150%
Bona fide Murabaha 150%

Conventional Banking Balance
27
Sheet
Asset Liability
Cash Current Account
Home Loans Savings Account
HP Car loans Fixed deposits
Personal Loans NICD
Government Securities
Corporate Bonds
Fixed Assets Shareholders Capital

Conventional banking P & L
28
Profit and Loss

Revenues $500m
Cost of Funds $200m
Gross Profit $300m
Overheads $80m
Provisions for NPL $10m
$5m
Profit Before Tax $200m
Tax $60m
Net Profit $140m
29
1. High
NPL
2. Low
Negative Capital Bank
revenues
Earnings Erosion Insolvent
3. High
cost of
deposits
30
1. Low NPL
2. High Capital Healthy &
revenues Positive
Accumulat Stable
3. Low Earnings
ion Banking
cost of
deposits
31
Aggressive
High yielding
Loans without
collateral Irressponsib
Safe le
Low yielding Loans to non-
loans with viable
control customer
repayment subprime
Bank loans
Busin
ess
Model
?
32
Islamic Banking within
conventional financial system
Take Extend
Holds
Deposi Financi
Capital
ts ng
Islamic banking: Bank as mudarib/agent and
depositors as investors: as a mudarib, the
33
bank manages deposit funds.
Bank as
Deficit Sector financial Surplus Sector
Intermedi
ary
Islamic banks as financial
intermediaries
34
Based on Trading
Deposit contracts
Not based on
Market lending and
borrowing
contracts
Financi Based on Trading

contracts
ng Not based on
lending and
Market borrowing
contracts
Allah has allowed Al-Bay (trading) but prohibits Riba
(Al-Baqarah 275)
35
AL-
BAY RIBA
Al-
Riba
Bay
Money
Money
exchanged for
exchanged for
goods and
more money
services
Financial risks
Business risk
Capital loss due
Capital loss due to credit default
to adverse price
and interest rate
movement
volatilities
36
Trading Models
37
Tradin Tradin
Buy Tradin
g Buy g g
Sell Financing
Model Sell Model Model
I II Financing II
Trading (Al-Bay) Models
38
Trading Model Trading Model Trading Model

1 II III
Buys at $10 Buys at $10 Buys at $15
Sells at $15 Sells at $15 Sells at $20
cash cash credit
Profit = $5 Sells at $20 Profit = $5
credit
Business Profit = $5 Credit risk
risk + $5 = $10 Interest rate
risk
Business
risk
Credit risk
Interest rate
risk
Business risk in Trading > Business risk in Islamic Banking
Capital = $50 million
Tradin Asset = $50 million
g
Islami Capital = $50 million
c Asset = $625 million (CAR

= 8%)
banki
ng
39
Trading Business risk
Islamic
banking Business risk
with credit Financial risk
system
Conventio
nal Business risk
banking
Financial risk
with credit
system
40
Islamic Banking Under
41
Basel II
Capital
charges on
asset
purchases
and equity
investment Bank faces
high business
Taxes on
risk with
asset
expectation
purchases
to earn higher
profits
Using
Trading
Model in
Banking
Types of Islamic banks
42
Islamic Islamic
Bank A Bank B
Sale and
Buy and Hold
buyback
and sell on
without title
credit
transfers
Business risk
Financial
+ financial
Risks
risks
Islamic Financial Market
43
Islamic
Financial
Financial
Market
Direct
Direct
Financial Indirect
Indirect
Market Financial
(Capital market
market
(Capital
Market)
Market)
Sukuk
Sukuk Equity
Equity
Takaful
Takaful Unit Trust Venture
Venture
65% 85%
18% Mutual Funds Capital
SC Screening SC Screening
Bank
20%
Dual-Banking System
44
IBA 1983: Trading Contracts
BAFIA 1989 : Lending and Borrowing
Contracts Asset Liabilities
Financin Wadiah
Asset Liability g Dhamana
Mortgage Saving Mortgag h Savings
Hire- Fixed e
Purchase Deposit HP
Personal
Personal
Bonds Capital Operatio Investmen
nal t Accounts
Leasing
JV
Stocks
Sukuks Capital
US Banking
45
Glass-Stegall Act
1932
Wall separating The GrammLeachBailey Act 1999
Commercial and Allowed commercial banks, investment

Investment banks, securities firms, and
insurance companies to consolidate
Banking and
Insurance
companies
Universal Banking
46
Retail Banking + Investment Banking +

Insurance
Retail Banking:
1. Take deposits
2. Make loans
. Investment Banking
1. Underwriting
2. Lead-Arrange
. Insurance
1. Underwrite pure risk
Islamic Banking Under IBA
47
1983
Financi Deposi
Asset Liabilitie
s ng t
Financing
Financin Wadiah Mortgage
Saving
g Dhamana
Hire-Purchase
Personal,
enterprise
h Savings ,
Operatio PSIA Leasing PSIA

nal
Leasing
JV Venture Private
capital Equity
Stocks
Sukuks Capital Property
BENEFITS
MORE OUTPUT AND REAPING ECONOMIES OF SCALE
Simple Bank Organization
48
Board of
Directors
Shariah
Audit Advisory
Committee
CEO
Risk
Investmen
Corporate Retail Managem ICBU
t
ent
Islamic Banks Average Balance
Sheet
49
Asset Liability
Cash Wadiah Dhamanah
Current Account
BBA Home Financing Wadiah Dhamanah
Savings Account
AITAB Car Financing Restricted Mudarabah
Account
Bay al-Inah Personal Unrestricted Mudarabah
Financing Account
Enterprise Financing
Government Islamic Commodity Murabahah
Securities Negotiable Islamic
Certificate of Deposits
Sukuk
Fixed Assets Shareholders Capital
Income Statement
Reward comes with Risk
50
Islamic Banking
Profit and Loss

Revenues $500m
Cost of Funds $200m
Gross Profit $300m
Overheads $80m
Provisions for NPF $10m
Profit Equalization $5m
Reserve
Profit Before Tax and $200m
Zakat
Tax and Zakat $60m
Net Profit $140m
Asset Liability
Financing $200m Deposits $200m

Profit = (rF1 x F1) (rd1 x D1)

= (0.1 x 200m) (0.05 x $200m)
= $20m - $10m = $10 million Capital
Market for Financing Market for Deposit
SL r
r Sd
rL1
10%
rd1
5%
DL Dd
F1 Financing D1 Deposit
51
$200m $200m
52
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 Bank
Profit = (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

Islamic Bank as a Financial Intermediary
1. CAR 8%
1a. Bank Capital $20b
1b. RW = 50%
53 0.08 = [$20b/F x 0.5]
F = $500b
2. Investment Deposit $500m@ 5% ex post
(Partnership)
Transaction Deposit
3. Financing (Trade) $500m@10%
4.Revenue $500m x 0.1 = $50b

5. Cost of deposits $500m x 0.05 = $25b
6. Overhead $3b
7. Provisions $1b
8. Profit $50b ($25b + 3B +
$1b) = $21
9. ROE ($21b/$20b) x 100%=

105%
EXERCISE 1:
FINANCING DEPOSIT
54
BBA $300@8% CASA $300@1%

AITAB $600@7%
PSIA $950@3%
Personal F $250@10%
Sukuk$80m@5%
Mudarabah
$20m@15%
Total = $1250 Total = $1250
Calculate: Calculate:
Total revenues = Total cost of deposits =
Calculate PROFIT =
Income Statement
Reward comes with Risk
55
Islamic Banking
Profit and Loss

Revenues $20m ($9.80m)
Cost of Funds $10m ($6.85)
Gross Profit $10m ($2.95m)
Overheads $3m
Reserve
Zakat
Tax and Zakat $1m
Net Profit $3m
Islamic Banking
56
Performance
Market share in terms of asset: 17.3%
Average annual growth: 20%
65% of market is concentrated on 6
players
Majority are still small in size in capital
terms
Al-Bai-bithaman ajil
(BBA)
32.99%
Ijara
Murabaha Islamic Thumma
Financin
Financin
15.5% g
Al-Bay
31/12/08
31/12/08
(AITAB)
30.44
Ijarah
2.65%
57
Landed
Landed
property
property
22.2%
22.2%
Personal
Personal Use
Use Construction
Construction
9.4%
9.4% 2.4%
2.4%
Islamic
Financin
g by
Working Purchase
Purchase of
Working
Capital
Capital
purpose of
securities
securities
26%
26% 2.4%
2.4%
Purchase
Purchase of
of
transport
transport Credit
Credit Card
Card
vehicle
vehicle 0.7%
0.7%
30.5%
30.5%
58
Malaysian Islamic Financial
59
System
Islamic
Islamic
capital Islamic
Islamic
capital banking
market
market banking
Subsidiary
Subsidiary
2001
2001 2005
Tabung 2005
Haji
Financial
Financial Foreign
Foreign
II st
st Islamic
Islamic Sector
Sector Islamic
Islamic
Bank
Bank Master
Master Plan
Plan Bank
Bank
1983
1983 2001
2001 2005
2005
Islamic
Islamic Islamic
Bank
Islamic MIFC
window
window
1992
money
money
market
MIFC
2006
2006
Negara
1992 market
Bill 2010
TOPIC 2
SHARIAH FRAMEWORK
KNOW YOUR CUSTOMER!
THE WORLDVIEW Of A THE MUSLIM CUSTOMER
Alam Rahim
Alam Arwah Alam Dunya
(Life in
(Primordial (Life in this
Mothers
Life) World)
Womb)
Alam Barzakh
Life in the
Hereafter (Life in the
Grave)
AL-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
63
Man settle
Man is
his debt with
indebted
God by The Will of
(dyn) to God
submitting God is the
for giving
his desires to Shariah
him life and
the Will of
sustenance
God
The Shariah
Shariah
Akhlak
Aqidah Muamalat
(Moral
(Belief) (Transaction)
conduct)
Man with
5 Pillars of Allah swt Man among
Iman (Faith) 5 Pillars of Man
Islam
64
Objective of
Shariah
(Maqasid
Shariah)
Protecting
Public Interest
Removing the Securing the

Harm Benefit
Ibaa Tahsil
65
1.
Protectio
n of
Religion
(Din)
5.
2.
Protectio
Protectio
n of
Public n of Life
Property
Interest (Nafs)
(Mal)
(Maslah
a
Ammah)
4. 3.
Protectio Protectio
n of n of
Family Intellect
(Nasl) (Aql)
66
Protection Performance of
of Religion 5 daily prayers
(solat)
(Din)
Protection Capital
of Life punishment on
murder (Hadd)
(Nafs)
Protection
Prohibition of
of the consuming
Intellect Intoxicants
(qimar)
(Aql)
Protection
Prohibition of
of Family adultry (zina)
(Nasl)
Protection Prohibition of
riba, gambling
of Wealth Permissibility
(Mal) of trading (bay)
67
Some
Some Shariah
Shariah
rules: These rules are
The
The Shariah
Shariah
serves to 1. Prohibition meant to:
protect Public Shariah = of
of riba
riba 1. Prevent the
Interest
Interest Shariah rules
Shariah rules 2. Elimination Harm
Harm
(maslaha al of
of Gharar
Gharar 2. Preserve the
ammah) benefits
3. Prohibition of
Gambling
68
Shariah Framework for Islamic
69
Banking
5 Shariah Principles
3.Avoidanc
e of
1 4.Prohibiti
2.Applicati Gharar in
Prohibition on of
on of Al- Contracts
of Riba Gambling 5. Prohibition to
Bay ambiguiti
riba is (maisir) engage in the
work, es in trading of
profit outcome impure
effort and prices, commodities
derived due to
responsibil subject
from pure
ity matter,
loans chance
counterpar
ties.
Maqasid of Shariah (Objective of
Shariah)
70
Islamic 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).
Mudarat Manfaat
Sins Profits
Gambling
& Liqour
71
Mudar Manfa
at at
72 #1 NO Riba!
Aqidah Viewpoint: Trade
73
and Riba
Allah 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 appreciate. Principle + interest =
appreciation.
In trade (al-bay), money is converted into capital. Capital
is used to buy merchandize or underlying assets
Business capital can increase, decrease or remains the
same over time due to risk-taking. Risk is potential loss.
Capital is subject to market volatility.
Because there is no love for money but only God, money
must be allowed to appreciate and depreciate, leading to
gain or loss.
Fiqh Viewpoint
74
Contract of Qard with upfront/contractual

increase is invalid.
1. Agent of contract: Lender and borrower
2. Objective of contract: Exchange of
equivalents
3. Subject matter:
i. currency/money
ii. Price = 0
4. Ijab and Qabul
1.Al-Bay
2.Al-Ijarah RISK
3.Salam (Ghurmi) RIBA:
4.Istisna
5.Mudarabah ECONOMIC VIEWPOINT
6. Musyarakah
= IWAD WORK &

PROFIT (Equivalent countervalue) EFFORT
(Kasb)
#2 TRADING!
LIABILITY
(Daman)
75
Profit from Trading
76
Value-
addition
Capital at Responsibi
Risk lity
Profit
from
Trading
(al-Bay)
3 basic reasons
77
(Usulfiq
h)
Fiqh
Viewpoi
nt
Prohibiti
on of
Riba
(Usullud
Econom in)
ic
viewpoi Aqidah
nt Viewpoi
nt
Riba in Loan
78
1.An upfront and fixed

increase on a loan
$Riba 2. Fixed by the lender.

3. Contractual in nature
Islamic loan
79
$Increase 1.An increase on a loan

known only at maturity
on Islamic 2. Fixed by the debtor

3. Voluntary in nature
loan
Mudar Manfa
at at
Al-Bay
80
Mudarat >
Manfaat
HARAM
81
Mudarat <
Manfaat
HALAL
82
#3 NO GHARAR!
1.Gharar (ambiguities) must be avoided in contracts
2. Gharar will invite legal disputes leading to injury and loss of
83 well-being
1.
1. Buyer
Buyer
and
and Seller
Seller
(Rational
(Rational
and
and well-
well-
informed)
informed)
Pillars Subject
Subject
Price
Price of matter
matter
(must
(must be
be Contra (posesion
(posesion
set
set
upfront)
upfront)
ct and
and
ownership)
ownership)
(AQD)
Offer
Offer and
and
Acceptanc
Acceptanc
e
e
(negotiatio
(negotiatio
n)
n)
#4 No Gambling!
84
Profit from
Profit in Islam is gambling
derived from (maisir) is
risk, work and derived from
responsibility. game of
chance
TOPIC 3
REGULATORY FRAMEWORK
Basel 2, IFSB, AAOIFI, Central Banking

86
Bank regulations are a form of

government regulation which subject
banks to certain requirements, restrictions
and guidelines.
Financial instability hypothesis -
Regulation/Government intervention is
inevitable as the financial sector is
inherently unstable. Instability arising
from internal factors.
Efficient market hypothesis market is
inherently stable, thus the market does
Objectives of Regulation
Prudentia
l
protectio
n of
depositor
s
Banking Systemic
Credit
allocation Regulati risk
on reduction
Avoid
misuse of
banks
87
Islamic Banking Regulations
Regulato
88
Shariah
ry
Framewo
Framewo
rk
rk
Fiqh Academy
Basel II
Mekah
Islamic
AAOIFI, Financial
Bahrain Service Board
(IFSB)
Bank Negara
Shariah
Bank Negara
Supervisory
Malaysia
Board,
Malaysia
Regulato
89
Shariah
ry
Framewo
Framewo
rk
rk
Fiqh Academy
Basel II
Mekah
Islamic
AAOIFI, Financial
(IFSB)
Bank Negara
Shariah
Bank Negara
Supervisory
Malaysia
Board,
Malaysia
Regulato
90
Shariah
ry
Framewo
Framewo
rk
rk
Fiqh Academy
Basel II
Mekah
Islamic
AAOIFI, Financial
(IFSB)
Bank Negara
Shariah
Bank Negara
Supervisory
Malaysia
Board,
Malaysia
Islamic Banking Law
91
Islami
c
Banki
ng
Act
(IBA)1
983
Islamic bank means any
company which carries on Islamic
banking business and holds a valid
license;
license; and
and all
all the
the offices
offices and
and
branches of such a bank shall be
deemed to be a bank
Islamic banking business means banking

business who aims and operations do not
involve any element which is not allowed by
the Religion of Islam
Islamic Banking Act 1983
92
2. Financial
4. Restriction on requirement and
Business duties of Islamic
banks
1. Licensing
of Islamic
banks
5. Powers of
3. Ownership, control supervision and control
and management of over Islamic banks
Islamic banks
Islamic Banking Under IBA
93
1983
Financi Deposi
Asset Liabilitie
s ng t
Financing
Financin Wadiah Mortgage
Saving
g Dhamana
Hire-Purchase
Personal,
enterprise
h Savings ,
Operatio PSIA Leasing PSIA

nal
Leasing
JV Venture Private
capital Equity
Stocks
Sukuks Capital Property
MORE OUTPUT IN THE BANKING BOOK

Conventional to Islamic
94
IBA 1983: No Wall between Commercial and
Islamic Banking and BAFIA 1989 Investment banking
Asset Liability Asset Liabilitie

Mortgage Saving s
Hire- PSIA Financin Wadiah
Purchase g Dhamana
Mortgag h Savings
Personal e
Sukuks HP
Personal
Operatio PSIA
nal
Leasing
JV
Stocks
Sukuks
Universal Banking: Economies of Scale
and Scope
95
Less
More Cost Higher
Outputs per Profits
Unit
Shariah Advisory Board
96
Islamic Banking Act 1983 on Shariah

advisory body
that there is in the article of association of the bank concerned,

provision for the establishment of a Syariah advisory body to advise
the bank in the operation of its banking business in order to ensure
that they do not involve any element which is not approved by the
Religion of Islam
Islamic Banking Act 1983
Bank Negara Bill 2010
Fund
Commerci Investmen Joint Islamic
managem
al banking t banking -venture banking
ent
97
Role of Shariah Supervisory
98
Board
To study fatwas
Supervise
previously issued
activities of
by SSB of
member banks to
member banks
ensure they are in
and how these
conformity with
fatwas conform to
Shariah rulings
Shariah rulings
To issue fatwas
(religious legal
opinions) on Shariah Product
financial products Auditing
and banking
operations
Role of Shariah Supervisory
99
Board
Determination of profit-
Accounting policy sharing ratio between
adopted by banks banks and clients
Others
Duties
Determining the income
Determining the distributed and expenses
calculation and to be borne by depositors
payments of zakat
IFSB Guiding Principles on Shariah GovernanceIndependence of
Shariah Board
100
The Shariah Board

should play a strong
No individual or group
role and independent
of individuals shall be
oversight role, with
allowed to dominate
adequate capability to
the Shariah boards
exercise objective
decision-making
judgement on Shariah
related matters.
BNM Guidelines on Shariah Supervisory
2010
101
Shariah
Compliance
Shariah Framework
IMPACT OF BASEL II ON ISLAMIC
BANKING CAPITAL REQUIREMENT
103
Bank is required to back-up loans with

some capital.
If CAR = 8%, it means for every $100
loan given out, it must be supported by
$8 of banks capital.
CAR = Capital / Risk-Weight Assets
Conventional Bank Under Basel 2
104
Assets Amount Riskweights
RWassets
Loans $600m 50%
$300
Hire-Purchase $300m 50% $150
Personal Loans $200m 100%
$200
Bond $100m 50% $ 50
TOTAL $1200 $700
Capital ratio = (Regulated Capital / RWA)

8% = RC / $700
RWA = [($600m x 0.5) + ($300m x 0.5) + ($200m x 1.00) +
($100 x 0.5)]
= $300m + $150m +$200m + $50m = $700
RC = $700 x 0.08 = $56m

Note Risk weight also known as conversion factor.
Islamic Bank Under Basel 2: Higher Capital
Requirement
105
RWassets
Murabaha $600m 50% $300
AITAB $300m 50% $150
Personal F$200m 100% $200
Sukuk $100m 50% $ 50
TOTAL $1200 $700

8% = RC / $700
RWA = [($600m x 0.5) + ($300m x 0.5) + ($200m x 1.00) + ($100
x 0.5)]
= $300m + $150m +$200m + $50m = $700
RC = $700 x 0.08 = $56m

106
Bank intends to give a $200,000 BBA

facility to Ali.
How much capital it require to hold given
that RW on the facility is 50%.
0.08 = x / RWA
0.08 = x / $200,000 x 0.5 = x /$100,000
X = $8,000.
Islamic Bank with Musharakah financing
under Basel 2: Higher Capital Requirement
107
RWassets
Murabaha $500m 50% $250
AITAB $300m 50% $150
Sukuk $100m 50% $ 50
Musharakah $100m 250% $250
TOTAL $1200 $900

8% = RC / $900
RWA = [($500m x 0.5) + ($300m x 0.5) + ($200m x 1.00) + ($100
x 0.5) + ($100 x 2.5)]
= $250m + $150m +$200m + $70m + $250 = $900
RC = $900 x 0.08 = $72.00m

Stress on Islamic bank
108
capital
Since the risk-weight for Musharakah is 250%, the bank
is charged higher capital from $56m to $78m. The bank
has to come up with $22m more capital to meet
regulators requirement in order to undertake the
Musharakah project.
In this sense, the Musharakah project places stress of
Islamic bank capital.
Basel II assumes that Islamic deposits are similar with
conventional deposits.
In conventional deposits, the deposits and interest
income are guaranteed.
This is not the case for Islamic deposits since they are
based on profit-sharing system. In this manner, the bank
need not provide capital guarantees.
Islamic Banking under Basel
109
II/IFSB
Islamic Products Risk-weights
Murabaha without 50%
title 150%
Murabaha with title 50%
Ijara Financing lease 100%
Ijara Operating lease 150%
Musharakah 100% - 150%
Salam 100%- 150%
Istisna 100%
Tawaruq
TOPIC 4
LEGAL FRAMEWORK
Legal Framework
111
Tax Law
Contract
Tax
Documenta
Neutrality
tion
Tax on
leasing,
Litigation
murabahah,
assets
Tax implication: Shariah and Civil Law
A true sale will trigger a tax claim by the government.

Murabaha stamp duties
Ijara stamp duties
Tax neutrality
1. PPA
2. PSA
. Since PPA and PSA is not a true sale it is easy to exempt it from
tax, thus a case of tax neutrality on Islamic financing.
. But the S & P agreement is still subject to tax since the sale is a
true one.
. When an Islamic bank purchases an asset (say, property) from
a developer, it will have to pay tax or stamp duties to the
government.
Stamp duty: Tax implication
Stamp duty tax is one of the important
property taxes applicable within the
country. For comparison, the stamp duties
in Malaysia within the year 2007 and 2008
are given below.
Price Stamp Stamp Duty in 2007 Stamp Duty
in 2008
RM250, 000 RM4, 500 RM2, 250 (-
50%)
RM150, 000 RM2, 000 RM1, 000 (-
50%)
RM350, 000 RM6, 000 RM6, 000
(unchanged)
Based on the current rate of 1% for first RM100,000 and 2% for RM100,001 to
RM1,000,000)
This situation is prompting property developers to provide more properties at below
Legal Framework: The Judiciary and Court of Law
Litigation Invalid contract

Credit
Financial Distress Foreclos
Civil Court
Shariah
Improper
risk
Default ure hearing riskdocumentation
11
4
True Bank carries higher capital
charge
Bank carries higher tax burden
Sale Bank to carry new risk ie.

business risk due to the
holding of inventories + credit
risk + market risk +
operational risk
Fictitio No extra capital

charge
us No new tax
implication
sale Bank only faces credit
risk + market risk +
operational risk
FICTITIOUS SALE : Sale without title transfer.
Bay al-enah
1)(1)Sells
Bankasset
Sells asset
X to$10,000 + profit
customer formargin = $12,000
RM15,000
2)Customer pays by
(2)
Equal instalment over 5
Installment
Bank Years = $12,000/60 = $200 Customer
Payments@
RM250
(3) Customer sells asset
To Bank for $10,000
COF = RM10,000Profit rate per al

(4) Bank pays cash $10,000
To Customer
((4) Cash payments RM10,000

Convergence
Fictitiou
Loan
s Sale
Divergence!
True Fictitiou
Sale s Sale
1st Arguement
Promotion and
Defence of Fictitious
Sale
Helps avoid capital

charges + new tax
burden + risk-taking
business
Islamic bank can run

a business based on
the lending
borrowing model
Less need to change

risk-appetite
behaviour of banks
stakeholders.
Protection of
Deposits and
Financial Stability
are Guaranteed
Promotion and
2 nd
Arguement Defence of Fictitious
Sale
Helps avoid capital

charges + new tax
burden + risk-taking
business
Islamic bank can run

a business based on
the lending
borrowing model
Less need to change

risk-appetite
behaviour of banks
stakeholders.
Intent of the Law

(Maqasid Shariah) in
riba prohibition is
not met
1. Higher
Capital Impact on:
Charges 1. Pricing of
2. New tax Islamic
True Sale
burden instruments
3. Carries new 2. Return on
risk business Equity
risk
Banking Non-bona
Infrastruc True Sale fide
ture sale
Bank purchases Asset from
Vendor as cash price (lower
price) Bank purchases asset from
Shariah Framewrok Customer at lower price and
Bank sells asset to sells it back at higher price.
Customer at credit price
(higher price)
Risk-weight equal to risk-

Regulatory Framework I Higher Risk-Weights
weight of loans
Islamic bank to hold Islamic bank holds same

Regulatory Framework II
additional capital amount of capital
Legal Framework I Pay Stamp-Duties No Stamp-duties
Legal Framework II No tax neutrality Tax neutrality
Civil Court determines sale Civil Court determines sale

character based on legal character based on legal
Legal Framework III
documentation drawn by documentation drawn by
solicitor Title transfer solicitor - no title transfer
Islamic Banking
PRODUCTS AND
SERVICES
124
125
Financing
CONTRACT
PRODUCT
Bai-bithaman Ajil
Home-financing
Home-financing
Al-Ijarah Thumma Al-bay
Auto-financing
Bay
Bay al-inah
al-inah
Wakalah LC
Personal financing
Murabahah LC
Trade financing
Trade financing
Kafalah LG
Islamic accepted bills.
Bay al-inah
Credit card
Islamic Banking = Equity + Efficiency
126
ISLAMIC BANKING
FINANCING OPERATIONS
ASSET-BASED PROFIT-SHARING FEE-BASED
Qirad/Musharaka
(partnership)
Istisna Kafalah
Murabaha Ijara Wakalah
(sale (guarantee)
(deferred (leasing) (Agency)
sale) by order)
TOPIC 5
DEPOSITS
Transaction and Investment Deposits
Basel III Back to Basics
Take Origina
Hold
Deposit te
Funding needs Back to
Basics
CORE
CORE FUNDING
FUNDING
Deposits
Deposits
(Financing/Deposit)
(Financing/Deposit) Ratio
Ratio
Fundi
ng
NON-CORE
NON-CORE
FUNDING
FUNDING
Interbank
Interbank
Market
Market
Subprime Crises, Northern
Rock etc
CORE
CORE
FUNDING
FUNDING
Deposits
Deposits
(Financing/
(Financing/
Deposit)
Deposit)
Ratio
Ratio
Fundi
ng
NON-CORE
NON-CORE FUNDING
FUNDING
Interbank Market
Interbank Market
131
Islamic Deposits
Profit- Transaction
Sharing/Mudarab Deposits Money Market
ah Investment (Safe-Custody Deposits
Account (PSIA) with Guarantee)
Wadiah Wadiah Negotiab

Dhaman Commod
Dhaman le Islamic
ah ity
General Specific ah Certificat
Murabah
Current Savings es of
a
Account Account Deposits
Transactional Deposits
132
Product Contract
Wadiah
Current Yad
Account Dhaman
ah
Wadiah
Savings Yad
Account Dhaman
ah
Investment Deposits
133
Product Contract
General
Investm Mudarab
ent ah
Account
Specific
Investm Mudarab
ent ah
Account
Money Market Deposits
134
Product Contract
Negotiab Bay al-
le Islamic Dayn
certificat
e of (Sale of
Deposit Debt)
Commod
ity
Tawaruq
Murabah
a
Wadiah Dhamanah Deposits
135
1. Islamic bank acts a custodian and guarantees
full withdrawal/capital protection with a
condition that depositors allow the bank to use the fund in its financing
operations. No fee charges on the safe-custodial service.
Deposit Deposit
s s
$5,000 0 $5,000
1/8/09 15/8/09
2. Bank does not give any fixed return on the deposits.

3. Bank may give an extra over the deposits based on
the principle of gift (hibah/hadiah).
Hibah is not contractual but voluntary
136
$5,000 $5 $5005
1/8/09 (Hibah) 15/8/09
Hibah is not fixed upfront
137
0%
10
5%
%
Hiba
h
Tagging deposits
138
financing
Transaction
Deposits
BBA (Current
and Savings
Account)
Joint
Venture Mudarabah
Deposits
Financing
139
RabulMal Contribu
tes
(Depositors) Capital
Mudarabah
Projec
Contribute t
Mudarib s
(Bank) Skill and
Expertise
140
Al-Mudarabah Investment
1. No guarantee on deposits
2. No guarantee on returns
3. Flexible rate liability
Placement of deposits using the principle of

Al-Mudarabah (trustee partnership)
Al-Mudarabah Depositors
Bank - Mudarib
Project Rabulmal
(value added) (Capital)
Loss (if any)- capital depreciation

Total liability on Profit
depositors Loss
Value added not compensated
Bank Negara Malaysia (BNM) Guidelines on Profit-Sharing
Investment Account (PSIA) with risk absorbent
141
In order to highlight the more accurate nature of mudarabah

deposits (PSIA) and its impact on bank capital, BNM has provided
a new formulation for determining regulated for Islamic banks.
PSIA will be used to finance a relatively more risky projects based
on mudarabah, istisna and musharakah contracts.
The formulation capital adequacy ratio (CAR) = Capital/ (RWA less
(1-)RWA funded by PSIA less ()RWA in the form of PER)
When = 1, the bank holds all risks in the balance sheet.
When is say 30%, the bank carry risks only from wadiah
dhamanah deposits and general mudarabah deposits.
Then 70% of the risks (1-) = (1-0.3), is carried by PSIA deposits.
Then CAR will be less than CAR without as a risk-absorbent
factor. This will reduce stress on Islamic banking capital.
Hence, the smaller the i.e. the more risks carried by PSIA, the
lower is the CAR.
Modified Formula Incorporating the Risk
nature of Mudarabah Deposits
142
RWCAR = [Capital Base] /[(TRWAIslamic)

Islamic
Less
(1-) (Credit and Market Risk
Weighted Asset funded by PSIA)
Less
()(proportional of Credit
and Market Risk Weighted Assets funded
by PSIA in the form of PER)]
Islamic Bank with Musharakah financing under Basel 2: Higher Capital
Requirement
RWassets
143
Murabaha $500m 50% $250
AITAB $300m 50% $150
Sukuk $100m 50% $ 50
Musharakah $100m 250% $250
TOTAL $1200 $900
Capital ratio = (Regulated Capital /( RWA [1-]RWA funded by PSIA [] RWA funded by PSIA
as PER)
1.= 30%
2.(1-) = 70%
3.RWA funded by PSIA = $250m (musharaka)
4.RWA as PER = $2m (by assumption)
RWA = [($500m x 0.5) + ($300m x 0.5) + ($200m x 1.00) + ($100 x 0.5) + ($100 x
2.5)]
= [$250m + $150m +$200m + $70m + $250] - (0.7)($250) (0.3)($2) = $900m -
$175m - $0.6m = $724.4m
RC = $724.4 x 0.08 = $57.95m

Note Risk weight also known as conversion factor.PER = Profit Equalization Reserve.
144
(1-) represents the quantum of PSIA

recognized as a risk absorbent for RWCR
computation purposes and approved by
Bank Negara Malaysia.
= 1 means all risks carried by bank
= 0 means all risks carried by PSIA.
The smaller the , the lower is RWCR.

Money market placement:
Commodity Murabaha
Sells X
Islamic Liquidity Broker B

Center (ILC)
Pays Cash $10m

Sells X
$10.5m Pays $10.5m at maturity
murabaha
Buys X
Broker A Surplus Bank (SB)
Pays cash $10m

Commodity Murabaha
SB to place excess funds with ILH in return for fixed income
and protected deposit. How?
SB purchases commodity (eg palm oil) from Supplier A via
broker A at $10m.
SB sells the commodity to ILH. ILH will pay on credit in 6
months at $11m. This is a 6-month facility placement.
ILH sells the commodity to Supplier B via Broker B and
obtain cash. Cash will be invested in ILH financing
operations.
ROI of the $10m varies. Assume that the ROI = 20%. Thus
ILH secures $10m x 0.2 = $2m profit.
At maturity ILH pays SB $11 million with net margin for SB
and ILH respectively = $1m.
Brokers charges: Commodity
Murabaha Deposit
147
Deposit = $20 million

Agents Fee (AF) = 25 basis points
$20,000,000 x 0.025 = $500,000
Brokers fees (BF) = $50 per $1 million
transaction
$50 x 20 = $1000
Depositor will received net of AF and BF.
TOPIC 6
FINANCING OPERATIONS
Products and Contracts
Retail Products
149
Product Contract
Al-Bai-
Home bithama
Financing n Ajil
(BBA)
Ijarah
Car Thuma
Financing Al-bay
(AITAB)
Retail Products
150
PRODUCT CONTRACT
Person
al Bay al-
Financi enah
ng
Credit Bay al-

card enah
151
PRODUCT CONTRACT
Letter of
Wakalah
Credit
Murabah
Trust
a
Receipt
Overdraf Bay al-

t enah
152
PRODUCT CONTRACT
Joint Musharak
venture ah
Sale by Istisna
Order Salam
HOME BBA
FINANCING :
Plain BBA
154
Customer
Customer pays
Bank on
deferred Bank Sells asset
2
payment basis. To Customer
Transfer
ownership
Developer Bank
$
1
Bank buys directly from Developer on cash basis
BBA as applied in Banks
155
Bank
Bank pays
Customer
cash
3
Bank Customer PPA
Sells PSA pays
Asset to by installment 2
Customer
S&P
Customer
Sells asset
Developer 1 Customer To bank
Customer Pays down payment

BBA Property Financing
156
Price of Property = $400,000

Down-Payment = $80,000 (20%)
Bank Financing = $320,000
Profit rate = r =6%
Tenure = n = 20 years
Profit margin = BF x r x n = $320,000 x 0.06 x
20
Selling price = BF + (BF x r x n) = $320,000 +
$384,000 = $704,000.
Monthly payment = {BF + (BF x r x n)} /120 =
$5,866.
Al-Bai-bithaman Ajil
157
Financing
Structure
1. Risk
2. Pricing Fixed and floating rate asset
3. Amortization allocation of profit and capital
. Documentation
1. Sale and Buyback
PPA : Property Purchase Agreement
PSA: Property sale Agreement
2. Charge agreement
. Governing Laws
1. Litigation
BBA Based on Novation
Agreement
Downside:
1. Developer will find it risky dealing Customer

with Bank as Buyer. Failure to deliver on
prescribed time has severe legal implications
since the developer is dealing now with a bank
and not an individual customer.
Customer promises
2. Bank feels uneasy since there is no binding to buy property from
comittement of Customer to purchase the property.
A promise (waad) may not be enough to guarantee Bank.
a sale.
Developer Bank
Developer to deliver asset to Bank as if the

Bank buys Asset on Behalf of Custom
Bank = Customer
CAR FINANCING
Leasing
Operational Financing
Leasing Leasing
Leasing Leasing
without with
Not a loan
intention to intention to
own own
Term Loan
HP Act 1967
161
Ijarah Thumma Al-Bay

(AITAB)
Leasing Sale
At maturity
Price
Bank
Bank holds
holds beneficial
beneficial Customer
Customer holds
holds legal
legal 1.
1. Last
Last installment
installment
ownership ownership payment
2. Nominal value $1
AITAB
162
Cost of Car = $40,000

Term charges = 7% per annum (flat)
Tenure = 5 years
Total charges = 0.07 x $40,000 x 5 = $14,000
Total rental to be collected over tenure = $40,000
+ $14,000 = $54,000
Monthly rental = $54,000/60 =$900
Documentation:
1. Master Ijarah agreement
2. Charge agreement
PERSONAL FINANCING
PRODUCTS
Islamic Personal Financing
164
Bay al-inah Personal Financing

(Malaysia)
Al-Rahn Personal Financing
At-Tawarruq Personal financing (Middle-
East)
165
Al-Rahn Personal Financing

In the Hedaya, rahn literally signifies the detention of a thing (the pledge or security) on account of a claim that may be answered by means of that thing
Contract of Qard (loan)

Contract of Al-Rahn (Mortgage)
Contract of Wadiah Amanah - Safe keeping
Borrower Qardhu Hasan
$4,000
Pledge
$4,000 Rahn
$5,000
Islamic
Pawn-
Broking Al-Wadiah Amanah
(Lender)
Custodial
Fee
16 ($4,000/$100) = 2% x 5 = $40
6
Al-Rahn Bank Rakyat
167
According to Bank Rakyat, a pledge valued at

less than $1,000 will cost the rahin (1,000/100) x
40 sen or $4 a month. Normally, only about half
of the pledge value is given to the rahin as an
interest-free loan. Thus, a $500 loan payable in 6
months will incur a storage cost of $4 x 6 = $24.
At the end of the term, the rahin will pay the
murtahin $524. The rahin can ask for periodic
loan extension provided he pays an additional
storage fee.
On failure to pay the loan after a prolonged
reminder, the operator holds the right to put the
collateral on auction.. The rahn company will
claim loan plus storage fees due to them. The
surplus therein will be returned back to the rahin.
Custodial Fee
168
Amount of Loan (Qard): $20,000

Rahn : $30,000
Service fee = 40 cents @$100 per
month
Tenure = 6 months
Ujrah (fee) = ($20,000 /$100) x 0.04 x 6
ISLAMIC PERSONAL FINANCING
Bay al-enah
169
(1) Bank Sells asset $10,000 + profit margin = $12,000
(2) Customer pays by

Equal instalment over 5
Years = $12,000/60 = $200
Bank Customer
(3) Customer sells asset

To Bank for $10,000
COF = RM10,000Profit rate per al (4) Bank pays cash $10,000

To Customer
Tawaruq
170
1) Sells X
Bank Client
2) deferred
payments Sells Pays cash
cash
Buyer
FEE-BASED
PRODUCTS
Kafalah
LG
Trade
Finan
ce
Muraba
Wakalah
ha
LC
LC
17
2
COMPONENTS OF
PROFIT IN ISLAM
2. Putting work and
1. Risking his Capital effort
Trader
deserves to
earn profit
3. Warranty 4. Delayed Payments
17
4
1.Al-Bay
2.Al-Ijarah RISK
3.Salam (Ghurmi) ISLAMIC NORMATIVE
4.Istisna
5.Mudarabah THEORY OF
6. Musyarakah
PROFIT
= IWAD WORK &

PROFIT (Equivalent countervalue) EFFORT
(Kasb)
LIABILITY
(Daman)
17
5
Cash Sale and Sale by deferred payments
176
CASH SALE DEFERRED SALE
1/6/09 5/6/09 5/6/10

Wholesale Retail Deferred price
Price = $20 Price = $25 $30
Profit = $5 = risk + effort + liability Profit = $5

Profits from delayed
177
payments
Opportuni
ty costs?
Profits
from
Default Inflation
risk?
Delayed risk?
Payment
s
Others?
178
Profit from
Profit from
delayed
cash price
payment
Cost price =
Retail price =
$10
$15
Retail price =
Credit price =
$15
Profit $20
from
Deferred
Sale
$10
Price of Sale with Deferred Payment
179
Price will possibly rise due to its deferred payment

(Badai as-Sonai, Al-Kasani, 5/187)
The deferment for some period of time has a value in the
price (Bidayatul Mujtahid, Ibn Rush Al-Hafid, 2/108)
Five which is paid in cash is equal to six which is paid on

deferred (Al-Wajiz, (Abu Hamid Al-Ghazali, 1/85).
The period is part of the price (Fatawa Ibn Taimiya, 29/499)
This is the evidence that the period of time in sale and

purchase has its portion in the price; and it is permissible
for sale and purchase contracts (Al-Mughni, Ibn-Qudamah,
6/385)
Profit from delayed
180
payments
Interest-
Murabaha bearing
Loan
Profit Profit
derived derived
from from
delayed delayed
payment payment
Money Money
exchange exchange
for Asset for money
Conditions on the permissibility of profits from
delayed payments
181 Price
determinati
on based
consent
(negotiation
Bank must ) Bank
hold exposure to
ownership inventory
of asset risk
Profit
from
delayed
paymen
ts
Cash Credit
Price Price
Default
risk?
Liquidity
risk?
Business
Business
risk
risk
18
2
Murabaha/BBA Financing
183
Murabaha/BBA
Selling Price
$150,000
Profit Margin
Cost Price Profit rate x $Facility
x tenor
$100,000
10% x $100,000 x 5
years = $50,000
Murabaha Financing
184
Profit Rate
Statutory Risk/Defa
Cost of ult
Overhead profit
Deposit
margin Premium
185
Interest Rate
Risk Free
Risk
rate
Premium
True Time
Credit +
Value of
Liquidity risk
Money
TOPIC 7
RISK EXPOSURE IN FINANCING
ACTIVITIES
Profitability vs Stability
Risks faced by Islamic
banks
Risk
managemen
t
Bank faces:
1.Credit risk
1. Credit risk managemen
2. Market risk t
3.Liquidity 2.Market risk
Bank takes risk managemen
position t
4.
Operational 3.Liquidity
and Shariah risk
risks managemen
t
4.Operationa
l risk
managemen
t
Trade and Risk
188
Allah has allowed al-bay but prohibits

riba (Al-Baqarah:275)
How is risk management related to the

above verse?
Risk Management
189
When a bank takes a position (ie.

decided to lend/to extend financing), it
has an exposure.
Exposure is a loose word to describe a

transaction which generates some risk.
Sometimes it also refers to the amount
of risk or amount subject to loss of value
or the size of the commitment.
Risk Management
190
Risk is the potential loss arising from

uncertainty of events, which can have a
potential adverse effect, which is a
possibility of loss. Uncertainty refer to
the randomness of outcomes.
Risk management is the process of

identifying, measuring, controlling and
pricing of the risks taken abroad.
Risk is potential loss
191
Risk itself is not an evil thing

Avoiding risk with zero profit is allowed
Wadiah Yad Dhamanah deposit
Avoiding risk with positive profit is not
allowed interest from loans.
Avoiding risk is an evil action if it injures
the counterparty interest from loans
Risk Management in Islamic
Banking
192
Fundamental principle in Islamic

business :
a. no reward without risk al-ghorm bil
ghonm
b. With profit comes liability al-kharaj bil
daman.
. Risk taking behaviour as the above
risk > 0, profit > 0 permissible

. Risk avoiding behaviour risk =0, profit
>0 - not permissible

Islamic Financing
193
Credit Credit
Financing Financing
based on based on
True Sale
(bona fide Non-bona
sale) fide Sale Credit risk,
Business Risk
Market risk
Credit and Rate of return

Market risk, risk, Displaced
commercial risk,
Rate of Return Rate of return
risk, Displaced risk, Shariah
commercial risk risk.
True Sale Financing System
194
Tax burden: tax on sale and purchase.

Who to absorb the new transaction cost?
Capital charge: higher capital allocation

to a more risky business unit.
Exposure to business risk (ie. asset

holding/ownership prior to sale).
Exposure to credit,market,RoR,DCR.
Business risk
195
Potential loss in the world of business

due to uncertainty about:
1. Demand for products
2. The price that can be charged for those
products
3. The cost of producing and delivery the
products
Islamic Financing without
196
True Sale
No new tax burden
No additional capital charge
No exposure to business risk
Exposure to credit and market risk.
Exposure to RoR,DCR.
Exposure to Shariah risk
Risks in BBA
Financing
Shariah Risk Operational

Credit Risk Market Risk Risk
Recent Court
Low credit Negative Gap Judgement Conventional
Conventional
scoring for can mean losses on solution/system not
solution/system not able
able
Islamic as murabaha/BBA as
to
to accomodate
accomodate Islamic
Islamic
accounting
accounting principles
principles
customers, Interest rate non bona fide leading
leading to
to
higher probability increases sale overcharging
overcharging and
and
undercharging
of default undercharging
customers.
customers.
(PD)
High NPF and Earning at risk Litigation Costs Increase

Write-Offs (EAR) Erosion of
Capital at risk
Overheads
Capital earnings
(EAR) Litigation costs
Depletion
19
7
Credit
Risk
Rate
of Return Marke
Risk t Risk
Islami
c
Banki
Shariah
Risk
ng Liquidi
Risk ty Risk
Displace Operation
Operation
Commercial al
al Risk
Risk
Risk
19
8
199
Islamic Banking
Profit and Loss

Revenues $500m
Cost of Funds $200m
Gross Profit $300m
Overheads $80m
Reserve
Zakat
Tax and Zakat $60m
Net Profit $140m
MARKET RISK
Income Gap Analysis
201
Impact on income from changes in profit-

rate
GAP = Rate sensitive assets (RSA) Rate
sensitive liabilities (RSL)
Change in income = GAP x (change in
profit rate)
Deposits
202
Wadiah Dhamanah Variable Rate

Mudarabah PSIA Deposits
Commodity Murabaha
Fixed rate Deposits
NICD
NICD
Capital
Financing
203
Musharakah Variabale Rate

Mudarabah Assets
BBA
Fixed Rate Assets
AITAB
Capital
Islamic Banking Realities:
Negative Gap Asset-Liability
RSA < RSL
204
Fixed Rate
Deposits
Fixed Rate
Assets Variable Rate
Deposits
(RSL)
Variable Rate Assets
(RSA)
Income Gap Analysis
205
Fixed rate asset
(FRA)
1. BBA(F)
Fixed rate liabilities (FRL)
2. AITAB

1. CMD (Commodity Murabaha)

3. Tawaruq PF 2. NICD
. Variable rate liabilities (VRL or
. Flexible rate RSL)
asset (VRA or 1. WAD
RSA) 2.
3.
PSIA
INI
1. Mudarabah
2. Musharakah
3. BBA(V)
Salam Bank Balance Sheet
206
Asset Liability
BBA $700m Wadiah Dhamanah
$200m
AITAB $400m
PSIA $800m
Tawaruq PF $100m
CMD $250m
Mudarabah $ 50m
Fixed Asset $ 100m
Capital $100m
GAP = $50m - $1000m = -
207
$950m
FRA RSL
1. BBA $700m 1. WAD $200m
2.AITAB $400m 2. PSIA $800m

3. Tawaruq $100m
Total $1200m Total $1000m
RSA RSL
1. Mudarabah $50m 3. WAD & PSIA $1000
GAP = -$950 GAP = -$950

If profit rate decreases If profit rate increases
by 1%, then net by 1%, then net
income will increase income will fall by (-
by (-$950m x 0.01) $950m x 0.01) =
= $9.5m $9.5m.
Risks peculiar to Islamic
208
banks
Potential loss arising from loss of deposits
Rate of

Gap/Asset-Liability Mismatches
Rate of Islamic deposits < deposit interest rate
Return Risk

Rd < id
Actual rate of return < indicated/expected rate of return
Displacemen
t Potential loss that occurs when Shareholders Funds are
utilized to smoothen rate of return on Islamic deposits.
Commercial
Risk
Profit Amount appropriated out of total income to main an
acceptable level of return on Islamic deposits.
Equalization Serve to smoothen return on Islamic deposits (RoID).
Reserve
Increase PER provisions when RoID not competitive.
Implication of Negative Gap: Example:
209
Profit = ($100m x 0.07) ($100 x 0.03)

= $7m - $3m = $4m
When market interest rates go up, what can happen to the
bank?
The bank cannot raise then profit rate to accommodate
prevailing cost of fund. If it does, the murabaha contract turns
invalid.
The bank will lose deposits when Islamic deposit rate (IDR)<
conventional interest rates (CII).
When it losses deposits and forced to acquire money market
funds at a higher cost, the bank earning drops. This is known
as the Displaced Commercial Risk (DCR).
To mitigate DCR, the Profit Equalization Reserve (PER) was
instituted.
PER serves to fill the gap between IDR and CII. Or the expcted
rate of return and the realized rate of return.
1996-1997 Asian Financial Crises
2010 onwards.rising interest rates
Increase in
interest
rates
Loss of
income to
Islamic
banks
21
0
Low interest-rate environment 2004-2009
Fall in
interest
rates
Increase in
income for
Islamic
Banks
21
1
Lack of Liquidity
HIGH
INTENSITY OF Fall in bank
RSA<RSL -Income Gap
FIXED-RATE earnings
PRODUCT
Acquire funds Deposit Migration of

from money deposits from rd < id
market shortfall IB to CB
Bank
subsidizes
Further drop Displaced
Islamic
in banks commercial
depositors
earning risk
such that rd =
id
Mitigating Market risk:
Floating rate Murabaha/BBA
213
Set AQAD profit rate based on

future/projected/forecasted rate, say =12%
Current rate of profit = 8%
Monthly installment based on future rate =
$2,000
Monthly installment based on current/mark-to
market rate = $1,200.
Rebate = $800.
If rate rises to 9%, monthly installment = $1,300.
Rebate is less = $700 (ie. $2,000 - $1,300)
As profit rate increases due to higher cost of
funds, rebate decreases.
CREDIT RISK
Banks as Risk-Takers
Banks take money from depositors and extent financing to
clients.
In conventional system, a bank takes deposits and make
loans.
A bank can charge a very high rate to a very risky borrower
but it may suffer high losses when the borrower defaulted.
Credit risk is higher when the bank becomes an aggressive
risk-taker. It charges high credit risk premiums and hopes
that the customer will not default.
Deposit fund will be in danger when bank gives loan or
extends financing to clients with low creditworthiness.
But to play safe, by giving loans to clients with high
creditworthiness will mean small margins and if a default
occurs, it will wipe out banks entire profit.
Hence banks must seek strategies to minimize their risk
exposures through diversification.
Credit risk and Default
Products Failure
Murabaha To repay the installments

Ijara To pay rentals
Salam/Istisna To deliver goods at the
delivery date
Credit risk
Credit risk is the risk that a change in

the credit quality of a counterparty will
affect the value of a security or
portfolio.
When counterparty defaults, the bank
loses either all of the market value of
the position or, the part of the value
that it cannot recover.
a. Expected loss (EL) covered by
provisions
b. Unexpected loss(UL) covered by
Credit Risk Loss
Expected
Unexpecte
Loss
d Loss
(Covered Total Loss
(Covered
by banks
by capital)
provisions)
Rising
Non-
Loss due Capital Financial
Performi Reduce Bank
Credit Depletio Instabilit
ng Earnings Failure
Risk n y
Financin
g
Qualitative Method: Credit Risk Assessment
Qualitative
Characters
Low
Very good 1
Risk
Below average
Ratin
Good
Average Grad
2
Satisfactory Value 3
gs
Sufficient
Above average
es
4
Insufficient s High
5
Assessment
Default
Age
Education level
Years with current employer
Household income
Debt to income
Credit card debt
Other debt
Microeconomic Analysis of
default
Default = f (Age, education level, years with current employer, years
at current address, household income, debt to income, credit card
debt, other debt)
Y = b0 + b1X1 + b2X2 + b3X3 + b4X4 + b5X5 + b6X5 + b7X7 + b8x8

Relationship between dependent and independent variables
b1:
b2:
b3:
b4:
b5:
b6:
b7:
b8:
Macroeconomic Analysis of
Default
NPL = f(level of interest rates, GDP,
inflation rate, exchange rate, export,
import)
NPL = b0 + b1I + b2Y + b3IFL + b4FOREX

+ b5X + b6M
Total Loss
Expected Unexpected
Loss Loss
Largely due Largely due

to to
unsystemati systematic
c risk risk
Credit Risk in BBA
The risk of the facility is characterized
by:
1. The external and /or internal rating
attributed to each obligor, usually
mapped to probability of default (PD).
2. The loss rate given default (LGD) and
EAGD of the facilities. LGD is the loss

rate when the borrower defaults.
Credit Risk
1. Exposure at given default (EAGD) :
notional value of a loan, or exposure for
loan commitment. Amount of credit
outstanding at the time of default.
. The expected loss (EL) for each credit

facility:
EL = PD x EAGD x LGD
Credit risk inn BBA
Expected loss (EL) is the basis for the calculation of the
banks allowance for BBA losses, which should be sufficient
to absorb both specific and general credit related losses.
EL can be viewed as cost of doing business. That is, on
average, the bank will incur a credit loss amounting to EL.
However ACTUAL credit losses may be higher or lower than
EL.
The variation for credit losses beyond EL is called
unexpected loss (UL).
UL is the basis for the calculation of economic and
regulatory capital.
Example: Expected Loss
Zahidi Bank hold a $500 million BBA
portfolio with 15 years tenor.
PD of the portfolio = 10%
BBA defaulted after 5 years
Exposure at given default (EAGD) =
$400
Collateral $300m
Credit Risk
Loss rate given default = (EAGD
collateral)/EAGD
= ($400m - $300m)/$400m =
($100/$400) x 100% = 25%
EL= PD x EAGD x LGD
EL = 0.1 x $400m x 0.25 = $10 million
Bank will put aside $10 million for NPF
provisioning.
EXPECTED LOSS = PD x EAGD x LGD
EAGD = $400m
Origination Default Maturity

PD = 10%
BBA PORTFOLIO = $500m

Expected Loss is covered by Banks
Provisioning
General
and
Specific
Provisions
Expected
Loss (EL)
Loss Rate Exposure

Probability
Given at Given
of Default
Default Default
(PD)
(LRGD) (EAGD)
Assessing credit exposure
Compute EL
Compute UL
Determine the volatility of expected loss
of a BBA to the whole portfolio.
Calculate the probability distribution of
credit loss for the portfolio and asses the
capital required to absorb the
unexpected losses.
Credit Risk Valuation
When a customer defaulted on his debt obligation,
the bank will incur a loss.
The first type of loss is known as expected loss (EL)
which is a loss that bank expect to make as part of
doing the credit business and are covered by
reserves and income.
The second type of loss is called Unexpected loss
(UL) which is a loss to the bank as a result of
unexpected events except the catastrophic ones and
are covered by the economic capital.
Actual level of credit loss in any one period could be
significantly higher than the expected level.
Credit Risk Valuation
How to estimate Expected Loss (EL) and
Unexpected Loss (UL).
EL = PD x EAGD x LGD
PD = probability of default (in %)
EAGD = Exposure at given default (in
$values)
LGD = Loss rate given default (in %)
Probability of default (PD)
The PD is the likelihood that the
counterparty will be unable to comply
with his/her debt obligation.
Estimating PD
PD is the percentage of the contracts that were
defaulted in relation to the total portfolio of contracts
during the period of one year.
PD = (DCt/TC) x 100
DCt = the number of default contracts during the
period t under examination
TC = total number of contracts of the examined class.
Default is the inability of the debtors to pay a
substantial portion of the lend capital for a
predefined set of period such as three months or 90
days.
Exposure at Default (EAGD)
EAGD is the estimation of the
institutions exposure in the event of,
and at the time of, counterparty defaults
Loss Rate Given Default
(LGD)
LRGD is the weighting of the loss when a default
occurs.
LRGD is the ratio of losses to exposure at
default (EAGD).
An important parameter to estimate LGD is the
estimation of recovery rate (RR).
RR = [(recovery from cash payment + recovery
from collateral administrative cost)/(1-
variation in market value) divided by EAGD] x
100.
LGD = 1 - RR
LGD = Charge Offs (Net of Recovery)
/Outstanding Balance at Default (ie EAD)
Loss Rate Given Default
(LGD)
LGD parameter increases in value in
relation to the collateral asset.
If asset is not backed by a collateral
asset, the LGD will be high
If asset is backed by a collateral asset,
the LGD will be lower
Credit Risk: EL & UL
Suppose Salam Bank has portfolio of 5 murabaha customers with given EAD
(Exposure at default), LGD (Loss Given Default) and (PD) Probability of
Default.
Suppose the said figures for the first customer is are as given below -
EAD = 100,000, LGD = 0.45 and PD = 0.10.
Then the loss is 100,000 * 0.45 = 45,000. ie EAD x LGD
Expected loss for this customer is EL = 45,000*0.10 = 4,500 ie Loss x
0.1
Or EL = PD x EAD x LGD = 0.1 x 45,000 x 0.01 = 4,500
Calculate the unexpected loss (UL) for each murabaha facility?
Suppose bank data is as given below :
Customer EAD LGD PD
1 100,000 0.45 0.10
2 150,000 0.45 0.10
3 300,000 0.45 0.05
4 500,000 0.45 0.01
5 400,000 0.45 0.1
Unexpected Loss
Unexpected loss = Loss that is not budgeted for
(expected) and is absorbed by an attributed
amount of economic capital.
Unexpected loss=
P (1-P) x EAD x LGD
0.1 (1-0.1) x 45,000 x 0.1 = 0.3 x 45,000 x 0.1 = $1,350

Loss Distribution due to Credit Risk -
Expected and Unexpected Loss
242
Expected Loss: the mean loss due to a

specific event or combination of events
over a specified period
Unexpected Loss: loss that is not
budgeted for (expected) and is
absorbed by an attributed amount of
economic capital
Determined by Losses so remote that

confidence level capital is not provided
associated with to cover them.
targeted rating
Probability
EL UL
Cost
0 1,000 Economic Capital = 4,000

Expected Loss, Difference 3,000 Total Loss
Reserves incurred at x%
confidence
level
Credit Risk Management
This is done by
Screening
Monitoring & enforcing restrictive
covenants
Establishment of long term
customer relationships
Loan commitment
Specialized lending
Collateral and compensating
balance requirements
Credit rationing
Islamic
securitization
Asset-Backed Bay Al-Enah

Securitization Securitization
(True Sale via (No true sale,
SPV) no SPV)
Securitization of Securitization of Securitization of

Financial Assets Physical Asset Debt
Asset-Based
Securitization
LIQUIDITY RISK
Excess Liquidity - Liquid Assets financed
by High-Cost Deposits
Inter-
bank
Short-
term
placeme
nts
Liquid
Assets
Short-
term
governm
Cash ent
securitie
s
Underutilization of scarce
resources: Excess Liquidity in
Islamic Banks. Why? DISPLACEMENT
EFFECT
Shariah enah and tawaruq
Compliant products displacing
Issues risk-taking and
equity-based
products
EXCESS
IB risk- GREENFIELDS
LIQUIDITY adverse
appetite
True-sale
murabaha
Lack of towards
risk-taking Salam & Istisna
products
IB adverse
risk- GREENFIELDS
appetite
towards
Musharakah
risk- Mudarabah
sharing
Excess Liquidity
Less instrument
to do business
Islamic bank with
highly
less diversified Excess liquidity
dependence on
portfolio
credit based
financing
Sukuk/IPDS
market to
Reduces excess
mopped up
liquidity in
excess cash
Islamic banks
balances in
Islamic banks
Lack of Liquidity
HIGH
HIGH
INTENSITY OF
INTENSITY OF Fall
Fall in
in bank
bank
RSA<RSL
RSA<RSL -Income
-Income Gap
Gap
FIXED-RATE
FIXED-RATE earnings
earnings
PRODUCT
PRODUCT
Acquire
Acquire funds
funds
Deposit Migration
Migration of
of
from
from money
money
market
shortfal deposits
deposits from
IB
from rd
rd <
< id
id
market IB to
to CB
CB
l
Bank
Bank
subsidizes
subsidizes Displaced
Displaced
Further
Further drop
drop in
in Islamic
Islamic commercial
commercial
banks
banks earning
earning depositors
depositors risk
risk
such
such that
that rd
rd =
=
id
id
Lack of Liquidity
Islamic banks with high dependence on fixed rate assets
(FRA) will face income gap. When interest rate increases,
banks earning will fall and bank cant keep up with
conventional deposits rates. Rate of return on Islamic
deposits (rd) is now lower than interest rate on deposits
(id). When rd < id, outflow of Islamic deposits triggers
asset-liability mismatches with Financing/Deposits ratio >
1. To match the balance sheet, Islamic bank is forced to use
money market funds at a higher cost which further
depresses banks earning. To deter further outflow of
Islamic deposits, Islamic bank must ensure that rd = id,
which means giving Islamic depositors more that they
deserved. This is done by using banks own reserves. By
doing so, the bank faces displaced commercial risk (DCR).
The reserves or capital that the bank uses can support
financing operation bearing potential income.
US Subprime Crises Credit CrunchLack
of Liquidity
Money
Origina Distribu
Market
te te
Funds
LIQUIDITY RISK
Asset Deposit
Liquidity Liquidity
Risk Risk
Overdependence on
Unable to execute Corporate Deposits .
transactions at the
prevailing market price Overall cost of deposits
because there is no increases since corporate
market appetite for the deposits usually
product. command higher rate of
deposits on GIA.
When an Islamic bank is overly dependent

Inability to dispose of the
on corporate deposits, withdrawals at
asset due to Shariah
maturities will create adverse asset-
issues such as
liability mismatches. Cost overrun when
prohibitions of bay al-
the bank acquires funds from more costly
dayn (sale of debt) at
money market sources such as
discount.
Negotiable Islamic instruments (NII).
LIQUIDITY RISK
Asset Deposit
Liquidity Liquidity
Risk Risk
Overdependence on
Unable to execute Corporate Deposits .
transactions at the
prevailing market price Overall cost of deposits
because there is no increases since corporate
market appetite for the deposits usually
product. command higher rate of
deposits on GIA.
When an Islamic bank is overly dependent

Inability to dispose of the
on corporate deposits, withdrawals at
asset due to Shariah
maturities will create adverse asset-
issues such as
liability mismatches. Cost overrun when
prohibitions of bay al-
the bank acquires funds from more costly
dayn (sale of debt) at
money market sources such as
discount.
Negotiable Islamic instruments (NII).
Dependence on money
market funds to finance
operation.
Eg Northern Rock
Lack of Liquidity Funding Problem #1
Short- Long-
Term term
Deposits Deposits
Profit-
Current and Sharing
Savings Investment
Accounts Account
(GIA)
Low cost High Cost

deposits Deposit
Lack of Liquidity : Problem
#2
Depos
Assets
its
CA
BBA Mutual
SA Funds/Unit Trus
Stock Market
Sukuk PSIA
Concentration Risk
High-
Low-Cost
Cost
Deposit
Deposit
GIA
GIA
GIA
CA & SA
GIA
Asset Liability
Long- Short-
term term
Financing Funds
1-20 1-12
years months
Concentration Risk
Reliance on
money-market
funds to
replace
withdrawals
Withdrawals of
Corporate
Deposits
(PSIA)
Liquidity Risk
Fall in
Earning
s
Increas
e in
Cost of
Funds
Liquidity Risk
Funding liquidity risk a banks inability
to mobilize deposits to satisfy
withdrawals. Also referring to deposit
concentration risk.
Mitigating liquidity risk through Salam
contracts
Buy X at
$10m
Islamic Liquidity Broker B

Hub
Deliver X
Buy X
$9.5m Deliver X at specified date (maturity)
Cash $10m
Broker A Surplus Bank
Sells X $10m
Salam financing
SB places $10m with ILH with fixed
income. How?
SB buys commodity (ie palm oil) from ILH
for $9m (ie below market price) and waits
for delivery in 6 months time.
ILH uses the cash for investment. ROI
varies, not known upfront. (eg, 10%, 7%,
20%)
At maturity, ILH purchases commodity
from Supplier B via Broker B at $10m and
make delivery to SB.
SHARIAH RISK AND
OPERATIONAL RISK
Shariah risk is the potential loss to the Islamic bank arising from cost of civil actions carried or absorbed by the bank from lawsuits by
customers. The cost of the civil actions may include:
264
Returning
Compensati
profit
ons and
collected
damages
from the
paid to
Islamic
customers
facility
Cost of
court Reputation
proceeding risk.
s
Invalid contract
Credit
Financial Distress Foreclos
Litigation Shariah
Improper
risk
Default ure
Civil Court hearing riskdocumemntation
26
5
Court
judgement
issued by
Malaysian High
Legality Court Judge Shariah
Datuk Abdul
Issue Wahab Patail Risk
pertaining to the
invalidity of
murabaha/al-
bai-bithaman ajil
26
6
Do not Sell what you do not Own
Hadith (Sahih Bukhari)
High Court Judge Datuk Abdul Wahab Patail says that the
sale element in BBA sale is not a bona fide sale (Mayban Finance vs Taman Jaya)
BBA LEGAL DOCUMENTATION
2. Bank do not have

legal + beneficial ownership
1. No transfer of title from Customer
1.
to Bank
Sale and Purchase Agreement (SPA)
of property to make a valid sale
2. Property Purchase Agreement (PPA)
3. Property Sale Agreement (PSA)
4. Deeds of assignment/Charge
Latest Court Case on Islamic Banking
268
Abdul Khalid Ibrahim

(Defaulted on his debt
obligation, contract not BIMB
valid when BIMB violated (Dispose of collateral)
collateral agreement)
Shariah risk can be avoided by attending to:
269
Legal
Financial
documenta
reporting
tion
requiremen
requiremen
t
t
Maqasid- Shariah
Shariah Board
requiremen Governanc
t. e
270
Shariah Risk in BBA

Financing
Financial reporting:
prior to PSA, bank Maqasid approach:
must hold ownership benefits outweigh the
of asset. Recorded as disbenefits.
fixed asset.
Legal documentation:
transfer of ownership
from bank to
customer. Warranties.
There are two aspects of financial
transaction involving Islamic
banking business, namely:
The concept of the transaction: This concerns
whether the contract is based on sale, ijarah,
wakalah, musharakah and other common
contracts in Islamic banking, where the pillars of
aqd are central.
The legal documentation of the transaction that spelt out the
rights, responsibilities and obligations of the contracting parties.
In essence, it defines the relationship between the bank and the
customer. Usually the documentation is based on civil law.
27
1
Shariah Risk
Losses arising from money
paid by Islamic bank to
Form over
customers when contracts
substance.
were found invalid in favour of
customers.
Contracts and Purchase
legal Sale with no undertakings
documentatio transfer of in
ownership
n are not Musharakah
title.
consistent. sukuk.
27
2
Operational risk
An operational risk is, as the name
suggests, a risk arising from execution of
a company's business functions. It is a
very broad concept which focuses on the
risks arising from the people, systems
and processes through which a company
operates. It also includes other
categories such as fraud risks, legal
risks, physical or environmental risks.
Shariah risk
Basel II: Operational risk is the risk of loss resulting from
inadequate or failed internal processes, people and
systems, or from external events.
People outright fraud eg poor loan origination due to
kickbacks.
Shariah risk and People negligence and deliberate
action leading to improper conduct of contract
causing injuries to counterparties.
Murabaha/BBA: Sale contract but rights and obligation of
counterparties are equivalent to that of loan agreement.
Shariah Risk
There are two aspects of financial transaction
involving Islamic banking business, namely:
The concept of the transaction: This concerns
whether the contract is based on sale, ijarah,
wakalah, musharakah and other common
contracts in Islamic banking, where the pillars of
aqd are central.
The legal documentation of the transaction that
spelt out the rights, responsibilities and
obligations of the contracting parties. In essence,
it defines the relationship between the bank and
the customer. Usually the documentation is based
on civil law.
Approved Islamic Finance

Products
BBA Home Financing
Bay Inah Home Financing
Bay Inah Personal Financing/Overdraft/credit card
Tawaruk munazam personal financing
Commodity murabaha
Ijarah thumma al-bay
Bai-bithaman Ajil Islamic Debt Securities (BAIDS)
Discounted Bay al-dayn MuNif
Sukuk Ijarah
Sukuk Musharakah
Challenging issues in AQAD-based
Islamic Finance Products
Benchmaking profit rate against interest rate (LIBOR,KLIBOR).
Profit Equalization Reserve (PER) displaced commercial risk
Sale with condition to buyback at predetermined price between two and three
parties.
Profit generated over installment payments time value of money
Penalties on delayed payments
Benchmaking sukuk rates against LIBOR
Musharakah with Purchase undertakings fixed profit to one party only.
Ijarah Sukuk - Sale with repurchase agreement at par value and not mark-
to market
Ijarah Sukuk Ownership of asset by SPV
Profit-rate swaps speculation or gambling?
Shariah Risk
Foreclosure
Foreclosure is the legal process by which a mortgagee or other
lien holder, usually a lender, obtains a court ordered termination
of a mortgagor's equitable right of redemption. Usually a lender
obtains a security interest from a borrower who mortgages or
pledges an asset like a house to secure the loan. If the borrower
defaults and the lender tries to repossess the property, courts of
equity can grant the borrower the equitable right of redemption if
the borrower repays the debt. While this equitable right exists, the
lender cannot be sure that it can successfully repossess the
property, thus the lender seeks to foreclose the equitable right of
redemption.
Court Declaration
A declaration is a written statement submitted to a court
in which the writer swears 'under penalty of perjury' that
the contents are true. That is, the writer acknowledges
that if he is lying, he may be prosecuted for perjury.
Declarations are normally used in place of live testimony
when the court is asked to rule on a motion.
Effect on Profit and Loss
Client to return only the Principle Facility
Principle + Profit
Profit = earned and unearned profit.
Paid amount and earned profit
Bank to write-off earned profit
Clawback effect
Opportunity cost of Principle Facility.
Shariah risk in Islamic
Financial Instruments
Financial reporting: prior to PSA, bank must hold ownership
of asset. Recorded as fixed asset.
Legal documentation: transfer of ownership from bank to
customer. Warranties.
Shariah risk
Maqasid approach: benefits outweigh the disbenefits.
Losses arising from money paid by Islamic bank to
customers when contracts were found invalid in favour of
customers.
Form over substance.
Contracts and legal documentation are not consistent.
Eg. Sale with no transfer of ownership title.
Sale without warranties
Purchase undertakings in Musharakah sukuk.
Shariah risk
Shariah risk is the potential loss to the
Islamic bank arising from cost of civil
actions carried or absorbed by the bank
from lawsuits by customers. The cost of
the civil actions may include:
Compensations and damages paid to
customers
Returning profit collected from the
Islamic facility
Cost of court proceedings
Reputation risk.
INVESTMENT DAR
(KUWAIT) IN ISLAMIC
WRANGLE WITH BLOM
BANK (LEBANON)
Investment Dar defaulted on a $100 million sukuk last year
and is restructuring its debts.
Investment Dars Sukuk
Default
Kuwait's troubled shareholding company Investment
Dar is refusing to pay Lebanon's Blom Bank $10.7
million, saying that their original deal did not
comply with Islamic law, in a move that could
pressure the Islamic finance industry.
According to a legal brief circulated this week and obtained
by Reuters, Blom sued the company in a British court last
year, asking for the principal it invested plus a 5 percent
return, as structured in a deal it conducted with Daar in
2007.
Investment Dar vs Blom
Bank
The issue revolves around the
concept of interest and risk-sharing.
Under the deal, known as a wakala,
Dar served as an agent and
accepted funds from Blom that it
would invest in a sharia-compliant
manner.But the contract called for
the company to return the principal
investment plus a fixed profit -- a
deal Dar's attorneys now say
constitutes interest, which is
Investment Dar
286
This is a very dangerous defence," said

Sheikh Muddassir Siddiqui, sharia
scholar and partner at law firm Denton
Wilde Sapte. "For people dealing with
Islamic financial organizations, it adds
sharia risk to all the other common risks
out there.
TS ABDUL KHALID
IBRAHIM VS BIMB
Client defaulted on his RM66.60million BBA debt
obligation obtained in 2001
High Court ordered TS Khalid Ibrahim to
pay US$18.52m (RM66.67m) facilities
that he obtained from BIMB to purchase
Guthrie in 2001.
Court order without full court hearing
since this is a common case of default.
TS Khalid made an appeal.
Appeal court allows full court hearing if
the dispute involves violations of Islamic
law.
The Client claimed that the BBA contract
becomes invalid when BIMB disposes off
the collateral (Guthrie shares) upon
default.
BIMB sells the collateral to recover the
amount the Client owes the bank.
BBA agreement
Asset Purchase Agreement : Client sells
shares to Bank for $60m on cash basis.
Asset Sale Agreement : Bank sells shares
Client for $70m (ie. $60m principle +
$10m profit) on deferred payment basis
Charge Agreement: Client places the
shares as collateral.
Rahn and Charge
Agreement
Civil law : Charge agreement - does not
need court order to sell of the collateral.
Islamic law: shares charged to bank as
Rahn
Islamic law requirse full court hearing
before it can make a court judgement to
sell of the shares.
Shariah Risk
Potential loss to the bank arising from
cost of litigations against the bank as
result of contract invalidation through
the court of law.
Shariah risk can be avoided by attending
to:
1. Financial reporting requirement
2. Legal documentation requirement
3. Maqasid-Shariah requirement.
MEASUREMENT
OF SHARIAH RISK
AND BANK LOSS.
Shariah risk
Highly exposed Islamic banking portfolio to credit financing
instruments such as BBA is not spared from losses due to
default. Other unique risks faced by Islamic banks that can
severely reduce its earning are risk of return risk (RoR) and
displaced commercial risk (DCR). The former is potential
loss arising from loss of deposits to conventional banks
when rate of Islamic deposits are less competitive than
interest rates on conventional deposits. The latter is the
potential loss when the bank uses it own reserves to
smoothen rates on Islamic deposits. Recently, a new type
of risk called Shariah risk, surfaces into actual drama in
both the legal and banking fraternity as it challenged the
legality of BBA financing. It calls for immediate remedies to
save Islamic banking from serious reputational risk as well
as severe financial loss.
IFSB - Shariah risk
The Islamic Financial Service Board (IFSB) defines Shariah
risk as one arising when an Islamic financial institution (IFI)
offering Islamic financial services fails to comply with
Shariah rules and principles determined by Shariah Board
of the IFI or the relevant bodies in the jurisdiction in which
the IFI operates. It asserts that IFIs should ensure that their
contract documentation complies with Shariah rules and
principles with regards to the formation, termination and
elements possibly affecting contract performance such as
fraud, misrepresentation, duress or any other rights and
obligations (IFSB 2005).
Shariah risk
When an Islamic financing facility is ruled invalid in the
court of law due to say, fraud and misrepresentation,
Shariah risk can then be defined as the potential loss to the
Islamic bank arising from the nullification of contracts with
adverse impact on banks earnings. In general, Shariah risk
originates from credit risk. It is triggered by default on BBA
debt obligations leading to court hearing for foreclosure
wherein the plaintiff and defendant will put their cases
before the judge. The cost of the lawsuit may include the
compensations and damages paid to customers, returning
profit collected from the Islamic BBA facilities to the
customers, cost of court proceedings and reputation risk.
Shariah risk can emerge many ways
such as:
Foreclosure case against the

customer upon default
Customer seeking a court
declaration that BBA is invalid:
Foreclosure case against the
customer:
The bank filing lawsuit against a customer who has
defaulted on his murabaha/BBA obligation. But the
judgement may turned in favour of the defendant (ie.
customer) such as in the case of Arab-Malaysia Finance v
Taman Jaya when the Judge Dato Wahab Patail ruled the
contracted BBA as a non bona fide sale as it (ie BBA)
constitutes a financing facility with a charge agreement
rather than a sale. As the contract is void, the customer
should only gives back the principle amount advanced to
him by the bank. This also means that the bank must
return the profit it has acquired from the customer, if total
payments at default exceeded the original amount. This
shall be discussed in more detail in Section 10.
Validity of BBA
299
The court ruling by High Court Judge Dato Wahab Patail

concerning the validity of BBA (Abdul Wahad Patail 2008,
Arab-Malaysian Finance vs Taman Ihsan Jaya). It is a civil
court case that revolves around a default by Taman Ihsan
Jaya that had received a BBA facility from Arab Malaysian
Finance Berhad. Since the legal right of the property
remained with the client, the bank was seeking to foreclose
the property in court. Evidence concerning the contract
validity was first sought in the legal documentation of the
facility rather than what the counterparties perceived the
contract to be. The court ruling on July 18th 2008 was in
favour of the defendant as the judge held that the
application of the BBA contract ran contrary to the Islamic
Banking Act 1983, noting that the BBA sale is not a bona
fide sale. As the BBA contract was seen to be faulty, the
defendant was required to return only the original amount
of the BBA facility to the bank, thus affecting the profit
Customer seeking a court declaration
that BBA is invalid:
This action may take place when the customer is facing

difficulties to fulfill his BBA obligations as the housing
developer has abandoned the project. The customer is
paying both rental on the house his family is currently
staying and the BBA monthly payments which is too hard
to carry out. According to BBA contract, the bank who acts
as the selling party must made delivery of the subject
matter upon completion. But the seller/bank has failed to
deliver the property although the customer has made
payments based on the agreed contract. Another case
concerns incorrect use of contract.
High Court Ruling on BBA
301
[69] This court holds that where the bank purchased

directly from its customer (ie PPA) and sold back to the
customer with deferred payment (ie PSA) at a higher price
in total, the sale is not a bona fide sale, but a financing
transaction, and the profit portion of such Al-Bai Bithaman
Ajil facility rendered the facility contrary to the Islamic
Banking Act 1983 or the Banking and Financial Institutions
Act 1989 as the case may be.
[70] Acting upon the basis that the banks action resulted
more likely from a misapprehension rather than of intent
aforethought, the court holds the plaintiffs are entitled
under section 66 of the Contracts Act 1950 to return of the
original facility amount they had extended.
For example, a BBA contract is only suitable for completed
property but many Islamic banks have been using BBA
instead of istisna for housing under construction. There is
a Shariah compliance issue here at stake. In either case,
the customer will file a lawsuit against the Islamic bank for
not fulfilling its obligation. A lawsuit is a civil action brought
before a court in which a party (plaintiff) has claimed to
have received damages (ie. BBA payments without
delivery, rental paid on current premise), the plaintiff,
seeks a legal or equitable remedy.The defendants are
required to respond to the complaint of the plaintiff. If the
plaintiff is successful, judgment will be given in the
plaintiff's favor, and a range of court orders may be issued
to enforce a right, award damages, or impose an injunction
to prevent an act or compel an act. A declaratory judgment
may be issued to prevent future legal disputes.
Loan and BBA financing
Based on the rules of BBA, an illustration is given in the
following. Hamid is keen to purchase a $200,000 apartment
in Kuala Lumpur, which he has seen in person. He will
meet the developer/vendor and sign a Sale and Purchase
agreement (S&P) after placing a 10% down payment, i.e.
$20,000. In conventional practice, Hamid will look for a
bank that can lend him the remaining sum of $180,000.
Assume that Fastbank approves the loan and disburses a
sum of $180,000 to the developer on behalf of Hamid.
Thus, Hamid gets a loan from Fastbank and settled the
remaining balance with the developer on cash basis. Hamid
will pledge the property as collateral via the charge
agreement on the $180,000 loan. Assuming interest rate
at 4% flat over 20 years, Hamid will pay the bank $144,000
more in interest. His monthly installment = ($180,000 +
$144,000) / 240 = $1350.
BBA financing
Once the Fastbank holds ownership via PPA, it then sells the property to
Hamid via the Property Sale Agreement (PSA). The terms are as follows:
Seller (Fastbank) and Buyer (Hamid)
Object of sale : Apartment
Price of object: Cost price $180,000) + profit margin ($144,000) =
$86,000 = $324,000.
Installment payments = $324,000/240 = $1350 per month.
To sum up, conventional financing consists of the following contracts,
namely:
Contract of loan between the Fastbank and Hamid.
Deeds of Assignment/Charge.
BBA financing
The same procedure applies for Islamic banks. But the transaction
becomes complicated when Fastbank is not involved in the sale and
purchase agreement (S & P) with Hamid. Instead similar to conventional
arrangement, Hamid purchases the property from the developer. He puts
up RM20,000 as down payment to secure the Sales and Purchase (S&P)
agreement on his favour. In this manner, Hamid becomes the beneficiary
owner of the property.
But how could Fastbank observe the rules of BBA (to sell the property to
Hamid) when in the first place it does not own the asset? The Holy Prophet
pbuh says do not sell what you do not own. Here FastBank must be
careful not to violate this critical Shariah injunction. To observe this
Shariah rule, Fastbank is expected to purchase the property from Hamid
via the Property Purchase Agreement (PPA for $180,000). Current practice
indicates that the bank makes the $180,000 disbursement to Hamid,
which it (ie. Fastbank) passes on to the developer.
BBA sale
Once the Fastbank holds ownership via PPA, it then sells
the property to Hamid via the Property Sale Agreement
(PSA). The terms are as follows:
Seller (Fastbank) and Buyer (Hamid)
Object of sale : Apartment
Price of object: Cost price $180,000) + profit margin
($144,000) = $86,000 = $324,000.
Installment payments = $324,000/240 = $1350 per month.
BBA financing
Similar with conventional practice, the house will be placed
as a collateral via the Deeds of Assignment or Charge. It
says that the bank holds the right of beneficial ownership
of the property in the manner that it holds the right to sell
if when Hamid defaults on the BBA facility.
To summarize, BBA sale consists of three contracts,
namely:
Property Purchase Agreement (PPA): Bank buys property
from customer.
Property Sale Agreement (PSA): Bank sells property to
customer at BBA price.
Statement of Appeal Court on IBA
1983
308
The trial judge had misinterpreted the meaning of 'Islamic

banking business' under s 2 of the Islamic Banking Act 1983 ('the
Act'). 'Islamic banking business' as defined in s 2 of the Act
does not mean banking business whose aims and
operations are approved by all the four mazhabs. Further,
the judges in civil courts should not take it upon themselves to
declare whether a matter is in accordance to the religion of Islam
or otherwise as it needs consideration by eminent jurists who are
properly qualified in the field of Islamic jurisprudence. Moreover,
as we had the legal infrastructure to ensure that Islamic banking
business as undertaken by the banks in this country did not
involve any element not approved by Islam, the court had to
assume that the Syariah Advisory Council under the aegis of Bank
Negara Malaysia had discharged its statutory duty to ensure that
the operation of the Islamic banks was within the ambit of Islam
(see paras 29-32 & 35).
Measurement of Shariah
risk
Exposure to BBA financing means that Islamic banks are
equally concerned with credit risk. In managing credit risk,
they are required to measure the expected loss (EL) as well
as unexpected loss (UL) from their credit financing
portfolios.
Expected loss is covered by banks provisioning for bad
debts while unexpected loss (UL) is to be absorbed by
banks capital.
However, loss from Shariah risk is unique because it
originates from BBA defaults, thus tieing it to credit risk
rather than operational risk. At the moment Islamic banks
in Malaysia are more concerned with the court ruling by
High Court Judge Dato Wahab Patail in Malaysia concerning
the invalidity of BBA (Abdul Wahad Patail 2008, Arab-
Malaysian Finance vs Taman Ihsan Jaya).
Measurement of Shariah
risk
It is a civil court case that revolves around a default by Taman
Ihsan Jaya who had received a BBA facility from Arab Malaysian
Finance Berhad. Since the legal right of the property still remains
with the client, the bank seeks to foreclose the property in court.
Evidences concerning contract validity are first sought in the legal
documentation of the facility rather than what the counterparties
perceived the contract to be.
The court ruling dated July 18th 2008 ran in favour of the
defendant as the judge that the application of the BBA contract
before the court ran contrary to the Islamic Banking Act 1983 with
a note that the BBA sale is not a bona fide sale. As the BBA
contract was seen faulty, the defendant is required to return only
the original amount of the BBA facility to the bank, thus affecting
the profit already realized by the bank.
Some except of the judges opinion are given below
(MLJ 2008):
[69] This court holds that where the bank purchased

directly from its customer (ie PPA) and sold back to the
customer with deferred payment (ie PSA) at a higher price
in total, the sale is not a bona fide sale, but a financing
transaction, and the profit portion of such Al-Bai Bithaman
Ajil facility rendered the facility contrary to the Islamic
Banking Act 1983 or the Banking and Financial Institutions
Act 1989 as the case may be.
[70] Acting upon the basis that the banks action resulted
more likely from a misapprehension rather than of intent
aforethought, the court holds the plaintiffs are entitled
under section 66 of the Contracts Act 1950 to return of the
original facility amount they had extended.
Continue..
Although Abdul Wahab Patails ruling was later overturned by the
Court of Appeal, it is imperative that the loss incurred by the bank
is estimated if the customer had instead seek a court declaration
for BBA invalidation or if the Court of Appeal agrees with the
judges ruling. We will consider three situations involving a BBA
default and the ruling based on section 66 of the Contract Act
1950 that is, to return the original facility amount to the bank.
The three situations are given below:
Case A: Paid amount is less than original facility, which is
equivalent to 75 monthly payments before defaulting.
Case B: Paid amount is equal to original facility which is
Case C: Paid amount is more than original facility which is
Based on the contract between Fastbank
and Mr. Hamid, the total murabaha
obligation is $324,000 with the original
facility at $180,000.
The financing is for 20 years (240 moths)
at 4% flat profit rate per annum.
Price of object: Cost price $180,000 +
profit margin $144,000 = $324,000.
Installment payment: $324,000/240 =
$1,350 per month ($750 principal
portion + $600 profit portion).
Example: Case A
Case A1: Mr. Hamid has paid $101,250 (75 months monthly
installment) before defaulting. The outstanding balance is
$222,750. However, the court has ruled the nullification of
BBA and the profits elements of the 75 installments paid
are to be clawed back and returned back to the customer.
The court requires him to pay extra $123,750 representing
the unpaid capital portion.
Basically, the total of amount of the unpaid financing will
be $222,750. The amount represents the 165 months of
unpaid monthly installments ($1,350 x 165 months =
$222,750). However, the court settlement requires Mr.
Hamid to pay another $123,750 ($180,000 - $56,250 =
$123,750) being the capital portion of original financing. In
other words, any profit portions from the 75 monthly
installments paid are to be returned back to the customer.
Continue..Case A
Impliedly, the court judgment states that the financing that was
based on trading of asset was not a bona fide sale and therefore,
there shall be no profits recognized from the transaction.
Therefore, the bank has to claw back any profits that have been
recognized so far. This means, there will be adjustments to be
taken up to the current years profits and the retained earnings
brought forward.
From the 75 monthly installments paid by the customers, the
bank has recognized $45,000 profit paid. Therefore, $45,000 must
be reversed out or clawed back from the bank current years
profits plus retained earnings brought forward and to be returned
back to the customer. The result of the clawed back resulting
the bank to loss $45,000. Here, the customer is appearing to
gain $45,000 as a result from the court injunction notwithstanding
that his liability is now $123,750.
Net payment to Bank = $123,750 - $45,000 =$78,750.
SHARIAH RISK
MITIGATION
Shariah Compliance: Consistency is
Critical to avoid Shariah risk
AQAD
Principles
LEGAL/CONTRACT
MAQASID DOCUMENTATION
Benefits vs disbenefits Protection of Rights
FINANCIAL
REPORTING
AAOIFI/IFSB/IFRS
Shariah Compliant
Parameters
Aqad-based Contract-based
Maqasid al-Shariah (purpose of the
Law) impact on society

Financial Reporting actual strength
and performance of companies

Legal documentation identification
and recognition of rights and obligations

of contracting parties.
#1 AQAD Method
Aqad
Agents Objectiv Offer &

Subject
of e of Accepta
Matter
Contract Contract nce
Sale (Al-
Bay)
Transfer of
Buyer & Ownership Price set on
Property
Seller from Buyer the spot
to Seller
Contract of Sale
Example: Murabaha/BBA Sale
1. Buyer and Sellereg. Seller owns asset/subject matter
before making sale
2. Subject mattereg. Mal mutaqawim property with
usurfruct
3. Priceeg. Set on the spot
4. Offer & Acceptance eg. Verbal or in writing
Method #2: Maqasid al-Shariah/Objective of Shariah
To protect the interest of the public

(society)- maslahah al-ammah by:
1. removing the harm ( ibqa)

2. securing of benefits (tahsil)
#2 Maqasid Method
Maqasi
d
Shariah
Removi Securin
ng the g of
Harm Benefit
in Gambling (maisir) and Liqour
(qimar), there are some sins and
some profits. But the sins are greater
than the profits (Al-Baqarah: 168).
Mudarat Manfaat
Sins Profits
Gamblin
g
& Liqour
Mudarat >
Manfaat
HARAM
Mudarat <
Manfaat
HALAL
Downside (Madarrah) of Credit-
Financing
MACRO MICRO
Economic Bubbles Bankruptcy
Subprime Loans Foreclosure
Financial Turmoil Unemployment

The upside (Manfaat) of Credit-
Financing
MACRO MICRO
Allocation of Capital Wealth creation
Economic Growth Rich becoming richer
Leisure, luxury and

lifestyle
Maqasid
To analyse(theoretical) and
measure( empirical) impacts of
financial intermediation based on aqad-
based Shariah compliant products.
1. Efficiency studies
2. Profitability studies
3. Studies on Consumer welfare and
protection
4. Studies on Financial stability
Maqasid protecting public
interest.
Aqad-based products (ABP) SHOULD contain more
benefits and less harm.
What if, it was proven than they (ABP) contain more
harm than good?
eg. Abandon projects customer cannot make recourse
against bank as selling party?
Defaulted BBA customer are required to make
settlement based on the selling price.
Sale with no transfer of ownership.
Giving away clean inah personal financing at high profit
rates a way towards subprime inah?
Conflict between Aqad and Maqasid?
Method #3: Financial
Reporting
Proper recording of transactions to evident TRUE SALE.
BBA bank must put BBA asset on balance sheet prior to
sale. I week, 1 month it depends.
Once sold, it is recorded as BBA receivables.
AITAB assets should be on banking book as leasing assets
but now treated as financing and advances.
External auditors (PWC, KPMG etc.) are not required by the
authority to conduct Shariah audit. And they may not be
not capable to do so.
Conflict between AQAD and financial reporting?

Islamic Bank Average Balance
Sheet
Assets Liabilities
Murabaha/BBA Wadiah Dhamanah

deposits
AITAB Profit Sharing

Investment Acct
Islamic Securities/Sukuk Capital

1st October 2008
Assets Liabilities
FIXED ASSET
1. BBA asset
15 October
2008
Assets Liabilities
CURRENT ASSET
2. BBA Receivables
1. 1/9/2008 Bank purchases Property from

Vendor for $200,000
2. 15/9/2008 Bank Sells Property to Customer

for $280,000
Do not Sell what you don not Own
Hadith (Sahih Bukhari)
High Court Judge Datuk Abdul Wahab Patail says that the
sale element in BBA sale is not a bona fide sale (Mayban Finance vs Taman Jaya
BBA LEGAL DOCUMENTATION

1. Sale and Purchase Agreement
(SPA)
2. Property Purchase Agreement
(PPA)
3. Property Sale Agreement (PSA)
4. Deeds of assignment/Charge
2. Bank do not have
legal + beneficial ownership
1. No transfer of title from Customer to Bank of property to make a valid sale
Method #4: Legal
Documentation
BBA should be documented as a true sale and
not as a loan. (Dato Nik vs. BIMB)
Ijarah should be documented as operating lease

and not a loan (Tinta Press vs. BIMB)
Islamic bank has not practice fairness compared
with conventional bank (Affin bank vs Zulkifli).
Conflict between AQAD and documentation of

AQAD?
336
Islamic Banking
Performance
Islamic Banking
Doing the right
thing
1. Role of Shariah
2. Achieving Doing things right

Equity, Justice & 1. Role of reason (aql) and experience.
Fairness 2. Efficiency
Measuring Economic
Efficiency
Economic efficiency occurs when the
cost of producing a given output is as
low as possible.
Production of a unit of good or services
is termed economically efficient when
that unit of good or service is produced
at the lowest possible cost.
Economic efficiency occurs when the
cost of producing a given output is as
low as possible.
Malaysian bank : efficiency studies
1. Katib, 1999: bank did not effectively

combine their inputs
2. Amrizal & Nursofiza 2002 : BIMB

performed below its optimum level
where input element were not fully
utilized
3. Majid et, 2003 : the efficiency of Islamic

bank is not statistically different from
conventional bank
Global- Islamic banks
1. Yudistira 2003 DEA Islamic banks suffered
inefficiencies during the financial crisis
2. Hassan 2005 SFA Islamic banking industry
is relatively less efficient compared to their
conventional counterparts
3. Al-Jarrah & Molyneux 2003 Larger Islamic
banks are more profit efficient than smaller
Islamic banks
4. Brown & Skully 2005 DEA Islamic banks in
the Middle-east are the most efficient,
followed by Asia and Africa.
5. Saaid et al 2003 Islamic banks in Sudan
have low efficiency
Islamic Banking Strategies
To increase revenues:
Retain and expand client base
Improve cross-selling opportunities
Increase customer profitability through a better understanding
of behavior, needs, and preferences
Detect and deter fraudulent activity such as money laundering
and identity theft
Address globalization issues, cross-border Islamic banking
performances, capitalization
Better manage the risk associated with investments, credit
and financing and consumer bankruptcies
Increase efficiency of core business (eg. retail) processes such
as call center management, processing of financing
applications, etc.
Comply with industry regulations .
Religiosity = Ethics and Law MAQASID
Religiosity = Niche products
Niche products larger revenues blue ocean
BUT
Religiosity AQAD alone credit culture
cannot compete with large conventional
banks that run on credit too!
Islamic banks running on credit are expected
to plan and strategize smartly to remain
competitive in the global environment. To do
so, they must have access to information that
help them make faster decisions.
Credit based Banking: Bank Failure - Bank of
Hiawassee
High CRE and ADC loan concentrations

Weak loan underwriting and credit administration
process contributed to the asset quality problem.
Capital levels did not support the risks associated with
its high CRE and ADC concentrations.
Bank loan losses and increases in NPL eroded capital.
The increasingly relied upon non-core funding sources
to support its loan growth.
Bank of Hiawassee closed down on March 19, 2010
because the institution was unable to raise sufficient
capital to support its operations.
Bank Failure
Concentration risk property sector
Weak credit administration
Weak loan origination/underwriting
practices
Reliance on potentially volatile funding
sources.
Weak Board oversight
Whats Next?
345
Shariah-based products
1. Musharakah
2. Salam & Istisna
. Issues:
1. Bank risk-appetite
2. Capital requirement
3. Funding
4. Taxation
346
Thank
You
Imam Shafi`i: Knowledge is what
benefits, knowledge is not what one
has memorized.

9181 C 77 e

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9181 C 77 e

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1 Islamic Banking

Islamic finance has grown tremendously since it

There are over 300 Islamic financial institutions

Doing EQUITY,JUSTICE and FAIRNESS

Things Using Reason and Facts in decision

Shari Components Tabi Components

Loans Deposits $200m@

Market for Financing Market for Deposit

Credit defaults and

Pillar I Pillar II Pillar III

Bank will be required to

$1250m Capital = $100m

(for every $1 financing, it is supported (Bank can raise up to

Loans with collateral

with collateral) 50%

Government Sukuk 80%

Corporate sukuks 150%

Bona fide Murabaha 150%

Cash Current Account

Home Loans Savings Account

HP Car loans Fixed deposits

Personal Loans NICD

Fixed Assets Shareholders Capital

Profit and Loss

Financi Based on Trading

Trading Model Trading Model Trading Model

Capital = $50 million

Tradin Asset = $50 million

c Asset = $625 million (CAR

Wall separating The GrammLeachBailey Act 1999

Commercial and Allowed commercial banks, investment

Retail Banking + Investment Banking +

Operatio PSIA Leasing PSIA

Profit and Loss

Financing $200m Deposits $200m

Profit = (rF1 x F1) (rd1 x D1)

Market for Financing Market for Deposit

Profit = (iL x L) (iD x D)

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

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

4.Revenue $500m x 0.1 = $50b

9. ROE ($21b/$20b) x 100%=

BBA $300@8% CASA $300@1%

Profit and Loss

When thy Lord drew

Removing the Securing the

Islamic financial products as defined by

in gambling (maisir) and liqour (qimar),

Contract of Qard with upfront/contractual

2. Objective of contract: Exchange of

= IWAD WORK &

1.An upfront and fixed

$Riba 2. Fixed by the lender.

$Increase 1.An increase on a loan

on Islamic 2. Fixed by the debtor

Basel 2, IFSB, AAOIFI, Central Banking

Bank regulations are a form of

Islamic banking business means banking

Operatio PSIA Leasing PSIA

MORE OUTPUT IN THE BANKING BOOK

Asset Liability Asset Liabilitie

Islamic Banking Act 1983 on Shariah

that there is in the article of association of the bank concerned,