ISLAMIC BANKING PRODUCTS OPERATIONS Jeroen P M M

ISLAMIC BANKING PRODUCTS & OPERATIONS Jeroen P. M. M. Thijs Chief Risk Officer, Bank Islam Malaysia Berhad Islamic Finance: Structure and Instruments 26 – 30 September 2011 Ankara, Turkey STRICTLY PRIVATE & CONFIDENTIAL

KEY OBJECTIVES/ DELIVERABLES To provide an overview of Islamic banking products and operations To understand the sources and application of funds of an Islamic bank compared to conventional bank To familiarize with the types of products and services available which include the elements of risk, particularly unique risks pertaining to Islamic banking To differentiate the products and principles of Islamic banking and conventional banking To share Malaysian experience with regards to Islamic banking modalities ISLAMIC DEVELOPMENT BANK Page 1

FUNDAMENTAL ISLAMIC DEVELOPMENT BANK Page 3

PRODUCT OFFERINGS : CONVENTIONAL VS ISLAMIC Product Offerings Conventional Banking Islamic Finance Savings & Deposit Product Offerings Conventional Banking Islamic Finance Commercial Banking Current Account / / Term Financing / / Savings Account / / Overdraft/Cash line / / Investment Account / / Revolving Credit / / Time Deposit / / Working Capital / / Factoring/ Discounting / / Consumer Financing Personal Financing / / Leasing / / Home Financing / / Hire Purchase / / Vehicle Financing / / Trade Finance Share Financing / / Bank Guarantee / / Shipping Guarantee / / Wealth Management Structured Deposits / / Bankers Acceptance / / Unit Trust / / Latter of Credit / / Insurance/Takaful / / Multi Trade / / ISLAMIC DEVELOPMENT BANK Page 4

PRODUCT OFFERINGS : CONVENTIONAL VS ISLAMIC Product Offerings Conventional Banking Islamic Finance Investment Banking Product Offerings Conventional Banking Islamic Finance Banking Services Corporate Advisory / / Debit & Credit Card / / Debt Capital Market / / Internet Banking / / Equity Capital Market / / Mobile Banking / / Private Equity / / SMS Banking / / Infrastructure Financing / / Self Service Terminals / / Corporate Debt Restructuring / / Phone Banking / / Cash Management / / Bill Payments / / Treasury Services FX / / PDS / / Money Markets / / Hedging Solutions / / Structured Corp Deposits / / ISLAMIC DEVELOPMENT BANK Hajj Services / Wakaf Services / “… Islamic financial instruments may look like a mirror picture of conventional ones, however , its underlying features, contractual relationships, mechanisms and implications are not identical. ” Page 5

KEY DIFFERENCES – CONVENTIONAL VS ISLAMIC CONVENTIONAL ISLAMIC Sources & Application of Funds Primarily based on interest rate Interest is prohibited. Promote profit sharing transaction. Focus on financial activities, risk-return relationship Facilitate socio ethical, economic and financial activities. Prohibits excessive leveraging. Money is not a commodity. Debt based financing Both, debt and equity based financing Predominantly loans contract Single and multiple business or trade contract based un underlying Shariah principles. Lender & Borrower relationship Buyer and Seller, Capital Owner & Entrepreneur, Partnership. Pure profit orientation Against speculative activities. Linking financing to productivity. Guaranteed return on capital/deposit Islamic banks are not able to guarantee return on capital and profit. ISLAMIC DEVELOPMENT BANK Page 6

MAJOR SOURCES & APPLCATIONS OF FUNDS Total Liabilities Current & Savings A/C (Wadiah) General Investment A/C Wakalah Deposit (Mudarabah Deposit) Total Assets Restricted Investment A/C Negotiable Islamic Deposit Certificates, and etc Financing Assets (Debt based financing, Equity based financing, Leasing) Treasury Assets (Sukuk, Islamic PDS, Inter-bank Placement) Inventory (Real Estates, Automobiles, etc) Benevolent Loan (Qard) Other Assets Shareholders’ Fund “… An ideal Islamic financial institution is reflected through its balance sheet structure that is purely based on profit–and-loss sharing contracts (mudarabah and musharakah) on both assets and liabilities side. ” ISLAMIC DEVELOPMENT BANK Page 7

ISLAMIC BANKING OPERATION IN A NUTSHELL Sources of funds Application of funds Non-mudharabah deposits Mudarabah deposits Shareholders’ Fund General Pool Specific account I Distribution of profit Depositors Bank or Specific account II Infrastructure (Branch, IT, Risk, Staff, etc) Marketing & Promotion ISLAMIC DEVELOPMENT BANK Profit Page 8 Depositors

TYPES OF ISLAMIC BANKING DEPOSITS Current & Savings Term Deposit Investment Deposit • Current & Savings deposit permits the customers to deposit and withdraw their money at anytime and does not require a minimum balance in the deposit account. • Generally, it is based on Shariah principles of qard, wadi’ah yad dhamanah or mudarabah. • Term deposit is a type of arrangement where the customer’s deposits are held at a bank for a fixed term. These deposits will then be invested in business activities which are in accordance with Shariah. • Term deposits are commonly structured based on the commodity murabahah, wakalah unrestricted investment and mudarabah general investment. • Usually known as a profit-and-loss sharing account. • The main point of departure between the investment deposit and both savings and current deposit is that the former is normally structured based on either the mudarabah or wakalah bi istithmar principles which do not entail a guarantee or neither principal or return of profit. Nevertheless, it allows holders to earn more attractive returns and although there is also a likelihood of having to bear the risk of capital losses. ISLAMIC DEVELOPMENT BANK Page 9

ISLAMIC DEPOSIT VS CONVENTIONAL DEPOSIT Current & Savings Term Deposit • Conventional deposits are interest driven but Islamic is based on safe custody with the bank’s discretion to reward the depositor through hibah (gift) as long as it is not pre-agreed and stipulated in contract. • Wadi’ah yad amanah is a trust contract where trustee will be authorized to keep the funds of the depositors in his or her safe custody by explicit or implicit term. There is a paradigm shift from trust contract to a guaranteed wadi’ah contract. • The principal amount is fully guaranteed (except for mudarabah deposit). For conventional, both principal and interest are predetermined and guaranteed. • For Islamic , the deposit is accepted on the condition that the money will be put to work together with the management expertise and skills of the bank whilst conventional deposit is a form of debt given to the bank by the customer. • Under the conventional term deposits practice, rates are fixed upfront and not tied directly to the financial performance of the bank. • Contrary, the rate of return has a direct bearing on the determination of profit sharing ratio between the bank (entrepreneur) and customer (capital provider). ISLAMIC DEVELOPMENT BANK Page 10

PROFIT SHARING INVESTMENT ACCOUNT Loss solely borne by depositor/ IAH Loss Depositor 3 a Profit distributed based on PSR 1 X: Y Profit Deposits RM XX 3 b 3 Specified Asset 2 Invests the funds in specific asset Doted line indicates flow of funds ISLAMIC DEVELOPMENT BANK Page 11 Generates profit/ incurs loss

NATURE OF PROFIT SHARING INVESTMENT ACCOUNT (PSIA) Ø Deposit accepted based on Mudarabah contract Ø Two types of PSIA: ü GIA – the funds utilized in unspecific investment (unrestricted investment) ü SIA – the funds utilized in specific investment (restricted investment) Ø Characteristic of PSIA: ü Capital amount of PSIA is not guaranteed ü Islamic bank as a fund manager while PSIA depositor as an investor & a risk bearer ü Losses to be borne by IAH/PSIA holder ü Islamic bank only exposed to negligence risk Ø PSIA as Risk Absorbent ü SIA depositor absorbs Credit and Market Risk ü GIA depositor does not absorb Credit and Market Risk ISLAMIC DEVELOPMENT BANK Page 12

USES OF FUNDS Asset Class Financing Assets Asset Mix Consumer Financing Business Financing Placements Treasury Assets Held –for-Trading Available-for-Sale Held-to-Maturity ISLAMIC DEVELOPMENT BANK Product Mix Key Application of Shariah Contracts Personal Financing Tawarruq, ‘Inah or Rahn Home Financing Bay Bithaman Ajil, Musharakah Mutanaqisah Vehicle Financing Al Ijarah Thumma Al Bay, Murabaha for Purchase Orderer Credit Cards ‘Inah, Tawarruq or Ujrah Term Financing Tawarruq, and ‘Inah Trade Financing Murabahah, Musharakah, Bay Al-Dayn, Wakalah, etc Revolving Credit Tawarruq Leasing Facility Ijarah Munthahiyah Bittamlik Cashline (Overdraft-i) Tawarruq Central Bank or Interbank Wadiah, Mudarabah & Commodity Murabahah Sukuk, Islamic PDS and etc Page 13 Mudarabah, Musharakah, Bay Bithaman Ajil Ijarah Thumma Al Bay, Ijarah Mawsufah fi Dhimmah, Wakalah bi Istithmar, Istisna’ and etc.

SHARIAH CONTRACTS Sale-based • Bay Bithaman Ajil ( Deferred Payment Sale) • Tawarruq (Tripartite Sale) • Inah (Sale with Immediate Purchase) • Istijrar (Supply Contract) • Musawamah (Sale at bargained price) • Tawliyah (Sale at Cost Price) • Wafa (Sale & buy back) • Murabahah lil Amir bi Shira’ (Murabahah to Purchase Oderer) • Wadhi’ah (Discount Sale) Sale – Debt & Currency • Istisna’ (Manufacture Sale) • Salam (Forward Sale) • Bay Dayn (Sale of Debt) • Sarf (Sale of Currency) • Tawriq (Securitization) ISLAMIC DEVELOPMENT BANK Ijarah Partnership • Ijarah Munhtahia Bittamlik (Financial Lease) • Ijarah Thumma al Bai (Leasing and subsequently Purchase) • Ju’alah (Commission) • Ujr (Fee) • Ijarah Mawfusah fi zimmah (Forward Lease) Page 14 • Mudarabah (Profit Sharing) • Musharakah (Partnership) • Musharakah Mutanaqisah (Diminishing Partnership) • Muzara’ah (Sharecropping) • Musaqah (Agricultural Contract) Bilateral Unilateral • Wadiah (Safekeeping) • Rahn (Collateral/ Pledge) • Kafalah (Guarantee) • Wakalah (Agency) • Muqasah (Setting Off) • Hiwalah (Transfer of Debt) • Waqf (Endowment) • Ibra’ (Forgoing of Right) • Hibah (Gift) • Wasiah (Will) • Wa’d (Promise) • Tanazul

ELEMENTS OF SHARIAH CONTRACT – EXECUTION RISK Form of Contract Conditions of Offer & Acceptance Subject Matter of the Contract • Form of contract refers to an expression made by the contracting parties to declare their inner will to undertake a contract and thereafter be bound by certain obligation. • The offer and acceptance must clearly indicate the intended motive of the contracting parties. • A contract is not validly concluded if the subject of acceptance contradicts what has been offered. • Subject matter of the contract refers to the contracted object upon which legal rulings and effects of the contracts are manifested. • The contract should not be effected on a non-existent object or on something whose existence in the future is impossible. • The subject matter must be precisely determined and clearly known to the contracting parties. • Any form of serious or major ignorance and uncertainty in the subject matter will render the contract void. • The delivery of the subject matter must be certain at the time of the conclusion of the contract. • The subject matter must fulfill Shariah rulings which in turn entails that it should be object of intrinsic value and items of considerable value for Muslim, have some use, legitimately benefitting and can be possessed. ISLAMIC DEVELOPMENT BANK Page 15

ELEMENTS OF SHARIAH CONTRACT – EXECUTION RISK. . cont Contracting Parties • A contract can only be established in its actuality if the contracting party has a legal capacity that render him competent to offer or accept an offer made in a contract. ISLAMIC DEVELOPMENT BANK Page 16

INHERENT RISKS RELATED TO SHARIAH CONTRACT Murabahah (Cost Plus) Musharakah (Partnership) • A contract that refers to sale transaction whereby the cost and profit margin (mark-up) are made known and agreed by all parties involved. The settlement for the transaction can be either on spot basis or a deferred basis. • Credit Risk – Customer is unable to pay the monthly settlements of the selling price as and when it falls due. • Market Risk – Rate of Return Risk, a long term murabahah with deferred settlement (fixed) rate is susceptible to market rate hike as the Investment Account Holder may expect a higher return in line with the market. Negative impact to Economic Value of Equity in long run under the market rate hike scenario. • Operational Risk - Must ascertain that the ownership of the asset is properly transferred to Islamic bank. • Musharakah is a partnership (joint venture) between the Bank and its client(s) whereby each party contributes to the capital of the partnership either to establish a new project or deal, or share in an existing project. • Credit Risk – Counterparty risk occurs when the partner does not pay or share the profit. • Market Risk – For Diminishing Musharakah in real estate, Islamic bank is also exposed to the particular real estate price proportionate to its share in the Musharakah. • Operational Risk – Reputational risk when the partnership fails and accruing losses. ISLAMIC DEVELOPMENT BANK Page 17

INHERENT RISKS RELATED TO SHARIAH CONTRACT Ijarah (Leasing) • A lease contract whereby lessor buys and then leases out an asset required by the lessee for an agreed rental amount and period in exchange for the benefits resulting from the use of the asset. • Operating Ijarah – The Bank (lessor) buys and leases out asset required by the customer (lessee) for an agreed rental fee. This does not conclude in a transfer of ownership of the leased assets to the lessee. • Ijarah Munthahia Bittamleek (IMB)- It differs from normal Ijarah in that such an arrangement provides a promise by the lessee to acquire the ownership of the asset at end of a specified period. • Credit Risk – Customer is unable to service the lease rental as and when it falls due. Difficult to transfer the lease to third party in the event of recovery action. • Market Risk – Similar to murabahah contract in respect of rate of return risk due to asset-liability gap. Islamic bank (lessor) is exposed to the fluctuation in the market value of the asset for leasing until the lessee take possession. Residual Value Risk – Islamic bank will bear the potential loss due to the fair value of the asset fall below its residual value estimated at maturity of lease contract except in the case if IMB where the leased asset is sold and the asset ownership is transferred to the lessee at maturity of lease contract. • Operational Risk – Supply risk, supplier unable to deliver the asset and unable to meet the specified requirement/quality. Reputational Risk – Occurs when the leased asset is used for non permissible activity. Asset Impairment Risk occurs when the leased asset is destroyed (not through misconduct) the Lessor has to provide an alternative asset and failing to do so the Lessee can terminate the lease without paying rentals for the remaining duration of the Contract. ISLAMIC DEVELOPMENT BANK Page 18

INHERENT RISK RELATED TO SHARIAH CONTRACT…cont • Istisna’ contract refers to agreement to sell to or buy from customer a non-existent asset which is to be manufactured or constructed or built according to the ultimate buyer’s specifications and is to be delivered on a specified future date at a predetermined selling price. The Islamic bank as the seller has the option to manufacture or build the asset on its own or to engage the services of a party than the Istisna’ ultimate buyer as supplier or subcontractor, by entering into a Parallel Istisna’ contract. Istisna’ • Credit Risk – Settlement Risk, when customer is unable to honor the payment for deferred installment or progress bill. Completion Risk for Istisna’ with Parallel Istisna’ i. e. when an advance payment been made by the Islamic bank, the subcontractor may abandon the project. (Manufacture Sale) • Market Risk – Direct Istisna’ – The Islamic bank will expose to price risk of its unbilled work-in-process inventory until the progress billing is sent to customer. Istisna’ with Parallel Istisna’ – No price risk provided that there is no provision in the Parallel Istisna’ contract does not allows variation in selling price. • Operational Risk – For Istisna’ with Parallel Istisna’ – Delivery Risk where an Islamic bank may unable to complete the manufacturing of asset as scheduled due to late delivery of completed asset by the sub-contractor of Parallel Istisna’ ISLAMIC DEVELOPMENT BANK Page 19

INHERENT RISK RELATED TO SHARIAH CONTRACT…cont • Salam is a purchase of a commodity for deferred delivery in exchange for immediate payment according to specified conditions. • Credit Risk – Delivery Risk when the purchased commodity is not delivered as scheduled by the seller or customer after payment is made. Salam (Forward Sale) • Market Risk – Every time the purchase price is fixed, Islamic bank is exposed to commodity price risks if the price fixed is higher than the market price upon disposal of the commodity. Asset Replacement Risk – Islamic bank has to purchase commodity from open market (which may be higher than selling price fixed with parallel salam) in order to meet its delivery obligation under Parallel Salam. • Operational Risk – Quality Risk – Goods of inferior quality delivered by direct salam counterparty. Catastrophic Risk – Natural disaster may give rise to the non-receipt of commodity. ISLAMIC DEVELOPMENT BANK Page 20

KEY CHALLENGES IN EQUITY-BASED FINANCING IN MALAYSIA Commercial banks to act as venture capital, hence requires a new set of technical and risk management capabilities i. e. industry experts and know-how Market readiness – profit sharing, trade secrets, bank as strategic business partners (potential conflicting interest). Balance sheet size, risk appetite and underwriting capabilities Supervisory and prudential regulatory framework. Accounting and auditing standards. ISLAMIC DEVELOPMENT BANK Page 21

ISLAMIC BANKING OPERATION & MODALITIES ISLAMIC DEVELOPMENT BANK Page 22

PRE-REQUISITE EXTERNAL INFRASTRUCTURE Tax Neutrality Policy Removal of Stamp Duty to facilitate buy & sell transaction Comprehensive Legislation ISLAMIC DEVELOPMENT BANK Page 23 Islamic Interbank Money Market Islamic Counterparty

PRE-REQUISITE INTERNAL INFRASTRUCTURE Knowledgeable & Experience Personnel Risk Management Policy Shariah Governance Framework • • Credit Market Operational Shariah Compliance ISLAMIC DEVELOPMENT BANK IT Infrastructure (customized solutions to accommodate Shariah requirement) • Core Banking System • Risk Mgmt System • ALM System, etc Page 24 Integrated Accounting Policy, System & Procedures • Accommodate profit/loss sharing • Rate of Return Framework • Equity-based financing • Benevolent Loan Shariah Contracts, Products, Documentation, Standard Operating Procedures Treasury Capability & Middle Office

GOVERNANCE STRUCTURE @ BANK ISLAMIC DEVELOPMENT BANK Page 25

SHARIAH GOVERNANCE FRAMEWORK @ BANK ISLAM SHARIAH AS OVERARCHING PRINCIPLE IN BANK ISLAM SHARIAH SUPERVISORY COUNCIL (SSC) • Oversight accountability on Shariah matters. BOARD RISK COMMITTEE BOARD OF DIRECTORS (Overall oversight on Shariah governance structure & Shariah compliance) AUDIT & EXAMINATION COMMITTEE (AEC) MANAGEMENT • Ensure execution of business & operations are in accordance with Shariah principles. • Provide necessary resources, infrastructure, enablers to the SSC. Shariah Review Function: Review business operation on regular basis to ensure Shariah compliance. Shariah Risk Management Control Function: Identify, measure, monitor, report & control Shariah non-compliance risk ISLAMIC DEVELOPMENT BANK Shariah Research Function: (under Product Development) Conduct in-depth Shariah research prior to submission to Shariah Committee. Page 26 Shariah Audit Function: Provide independent assessment & objective assurance designed to value add & improve Bank Islam adherence to Shariah

INTEGRATED OVERSIGHT FRAMEWORK Feedback from Audit & Examination Committee Board of Directors Set Risk Appetite & Tolerance Level Risk Policies & Capital Allocations Board Risk Committee [Present single view of risks and to ensure adequate policies and control] Management Risk Control Committees Monitoring & Reporting MRCC ALCO SCRC ORCC RMC Risk Management Division Credit Risk Management Business Division ü Consumer Banking ü Corporate Inv. Banking ü Commercial Banking ü Treasury Market Risk Management Operation Division ü Branches ü Cash Management ü Organization & Methods ISLAMIC DEVELOPMENT BANK Operational Risk Mgmt Business Support Div. ü Credit Administration ü Transaction Services ü Trade Operations Page 27 Other Div. ü Information Tech. ü Product Dev. ü Human Resource ü Corporate Com, etc

ISLAMIC BANKING JOURNEY – MALAYSIAN EXPERIENCE Instituting Foundation • 1970 – 1992 (Establishment of Enabling Infrastructure) • “Alternative to Conventional Bank” Institutional Building, Activity Generation & Market Vibrancy • 1993 -2005 (Deepen Islamic Banking, Create Critical Mass & Liberalization ) • “Greater Access to Islamic Finance” Strategic Positioning & International Integration • (2006 onwards) • “Hub of International Islamic Finance” ISLAMIC DEVELOPMENT BANK Page 28

MALAYSIAN ISLAMIC BANKING LANDSCAPE Mega Islamic Banks (Paid Up Capital of US$1 bil) STAND-ALONE SUBSIDIARIES OF CONVENTIONAL BANKS ISLAMIC WINDOWS & DFIs INTERNATIONAL ISLAMIC BANKS ISLAMIC DEVELOPMENT BANK Page 29

ISLAMIC BANKING MODALITY Standalone Islamic Bank • Independent financial institutions • Independent infrastructure (IT, Risk Management, Human Talent, etc) • High cost-to-income ratio • Offer full range of Islamic compliant products & services • Retail banking, Wealth/Asset Mgmt/ Corporate Banking, Advisory & Capital Markets • Bank Islam Malaysia Bhd, Bank Muamalat Bhd, Al Rahji, Al-Baraka Banking Group, Kuwait Finance House, PT Bank Syariah Muamalat, etc Subsidiary of Conventional Bank Islamic Window • Specialized set-ups within conventional banks • Different balance sheet but common operations /infrastructure • Dominated by global players with limited presents in the country that they are operating • Similar offerings to standalone Islamic banks • Generally targeted at affluent market segments and institutional investors • Private banking, structured deposits, and corporate banking • Citi. Islamic, Bank Simpanan Nasional, HSBC Amanah, etc ISLAMIC DEVELOPMENT BANK • Subsidiary of domestic conventional banks • Dedicated governance structure • Shared infrastructure (branch networks, IT, Risk Management, etc) • Transfer Pricing - cost • Minimal staffing • Low cost-to-income ratio and high productivity index. • Similar offerings to standalone Islamic banks • Retail banking, Corporate Banking, and Capital Market. • Offered Wealth/Asset Mgmt/ Advisory via sister company, another subsidiary of conventional bank. • Maybank Islamic, CIMB Islamic, Affin Islamic, etc Page 30 Specialized Institutions • Takaful & Re-Takaful Players • Islamic Mortgage Companies • Islamic Investment Fund Management Companies • Islamic Trustee Companies • Ar Rahnu or Islamic Pawnbroking • Islamic REIT Companies

CONVENTIONAL BANKS WITH WINDOW Ø … a total segregation of funds management to meet Shariah requirement: A dedicated Islamic Banking Division Separate Balance Sheet & Financial Statements Dedicated minimum capital as Islamic Banking Fund Separate clearing account with the Central Bank Separate cheque clearing system Separate submission of statistical reports in Financial Inst. Statistical System on monthly basis ü Additional disclosure of Islamic banking portfolio in financial statements ü ü ü Ø … leverage on conventional branch network, IT Infrastructure, risk management, human talents, brand positioning, sales force, and etc. Ø … business model based on cost transfer or transfer pricing ISLAMIC DEVELOPMENT BANK Page 31

STAND-ALONE VS WINDOW Source: Boston Consulting ISLAMIC DEVELOPMENT BANK Page 32

ﺍﻻﻡ ﺍﻻ Disclaimer: This presentation material has been prepared by Bank Islam Malaysia Berhad (the Bank”) for information purposes only and does not purport to contain all the information that may be required to evaluate the Bank or its financial position. No representation or warranty, express r implied, is given by or on behalf of the Bank as to the accuracy of the information or opinions contained in this presentation. The presentation does not constitute or form part of an offer, solicitation or invitation of any offer, to buy or subscribe for any securities , nor should it or any part of it form the basis of, or be relied in any connection with, any contract, investment decision or commitment whatsoever. The Bank does not accept any liability whatsoever for any loss howsoever arising from any use of this presentation or their contents or otherwise arising in connection therewith. BANK ISLAM MALAYSIA BERHAD 11 th Floor, Wisma Bank Islam Jalan Dungun, Bukit Damansara 50490 Kuala Lumpur Tel: 603 2088 8222 Jeroen P. M. M. Thijs Chief Risk Officer Contact: 603 2088 8027 Email: jeroen@bankislam. com. my www. bankislam. com. my ISLAMIC DEVELOPMENT BANK Page 33 Hizamuddin Jamalluddin AGM, Strategic Planning Contact: 603 2088 8077 Email: hizamuddin@bankislam. com. my