Islamic Finance Within Conventional Banking System Opportunities and

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

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

OVERVIEW OF ISLAMIC FINANCE 3

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

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

ECONOMIC GROWTH IN SOME GEOGRAPHIES Prioritization (Tier 1) Tier 2 Tier 3 Country Total Population (m) (% Muslim) Saudi Arabia UAE Malaysia Qatar Bahrain Pakistan Indonesia* Brunei UK Bangladesh Egypt Turkey China India Iraq 24 (99%) 5. 2 (76%) 26 (60%) 1. 2 (77%) 1. 0 (98%) 176 (97%) 240 (88%) 0. 4 (64%) 61 (3%) 29 (88%) 75 (85%) 77 (97%) 1300 (2%) 1100 (13%) 29 (97%) GDP (% real change per annum) 2008 4. 3 7. 0 4. 6 15. 2 8. 1 0. 6 6. 1 0. 61 0. 7 6. 22 7. 2 1. 1 9 7. 5 na 2009 f -0. 1 -1. 2 -3. 8 9. 8 5. 6 2. 4 3. 8 na -3. 8 6. 02 4. 3 -4. 4 8. 5 6 na 2010 f 3. 9 4. 3 6. 3 8. 82 6. 02 2. 9 5. 3 na 1. 6 6. 22 4. 1 2. 0 9 7. 5 na 2011 f 5. 9 6. 4 6 9. 4 5. 4 4 6. 2 Na 1. 8 6. 5 6. 4 3. 5 8. 5 7. 2 na 2012 f 5. 2 6. 1 6. 0 7. 5 5. 0 4. 0 6. 1 Na 2 6. 4 7 6 8. 5 7. 2 na § Of the total 1. 6 billion Muslims globally, there approximately 640 million in tier 1 & 2 markets. § Today, there are more than 390 Islamic banks and institutions spread across 75 countries. Source: HSBC Group economic forecast. INDUSTRY COMMENTATORS SEE ISLAMIC FINANCE INDUSTRY CONTINUING ITS RAPID GROWTH Total Global Islamic banking assets growth (USD bn) Banking Assets in key markets (USD bn) 13% CAGR 20%2 37% 5% CAGR 28% 13% 640 4% 7% 1 Sources: The Banker, Oliver Wyman 1 2007 – 2008 asset figures are based from The Banker 2 Oliver Wyman growth estimates 2 Note: Key markets include Tier 1 and 2 markets Source: The Banker, Central Bank Reports 6

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

ISLAMIC FINANCE – SUCCESS RECIPE 8

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

MODELS FOR ESTABLISHING ISLAMIC FINANCE 10

VARIOUS MODELS FOR CONSIDERATION Stand Alone Islamic Finance Islamic Subsidiary Islamic window License only to do Islamic finance business Subsidiary of the existing conventional in the country A division within the existing conventional bank Comprehensive infrastructure to support the business Sepa rate Board of Directors Structure Islamic products for distribution by conventional branches Leverage infrast ructure from the parent infrastructu re Using the main Bank infra structure to support the business Super vise the oper ations to ens ure Shariah compliance 11

ISLAMIC WINDOW OPERATIONS 12

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

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

CHALLENGES IN ISLAMIC FINANCE 15

CHALLENGES IN ISLAMIC FINANCE Meeting evolving consumers’ demand Strategy and Plan to develop the right business model Comprehensive Shariah Governance & Audit Challenges * Legal, Regulatory & Accounting Framework* Information system to cater to Islamic Finance transactions Risk Management* Replication v. Authenticity Willingness to invest in Human Capital Development Wealth Management 16

SHARIAH GOVERNANCE AND FRAMEWORK 17

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

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

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

LEGAL, REGULATORY & ACCOUNTING FRAMEWORK 21

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

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

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

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

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

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

RISK IN ISLAMIC FINANCE 28

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

MAJOR SHARIAH RISKS Concentrated reliance on a single broker for transacting commodity murabaha (substantial Global Business is based on this structure) Major Risks ACTIONS Identification of new brokers required and find alternative to existing commodity (eg. Bursa Al Sila’) Untested legal infrastructure (case laws or court proceedings) supporting products Using experienced legal counsel for preparing documentation and structures Credibility of “Commodity Murabaha” / “Tawarruq” structure questionable Looking to diversify to other structures. To address concerns raised. Manual Processes increase operational risks Rationalisation of product range. Long term, automation and standardisation required Lack of inter-bank market creates challenges in matching assets and liabilities This has to be addressed and financial linkages required 30

Thank You