Islamic Financial Architecture and Infrastructures Development by Tariqullah Khan

  

Islamic Financial Architecture

and Infrastructures:

Development and Challenges

  

Tariqullah Khan

  

IRTI-GDLN World Bank

Lecture, April 7, 2009

  Outline

  

1. Overview of International Financial Architecture

  2. Defining Islamic Financial Architecture and Infrastructures

  

3. Building Blocks of Islamic Financial Architecture

  4. Lessons drawn from Global Financial Crisis

  5. Building Blocks of Islamic Financial Infrastructures

  6. Development: Challenges, Institutions and Initiatives Defnition of fnancial architecture Financial architecture is …. the 1) institutions, 2) markets, and 3) practices that governments, businesses, and individuals use when they carry out economic and fnancial activities.

  IMF (2000) - “Reforming the International Financial Architecture – Progress Through 2000”

  Purpose: Enhancing financial sector development & performance and strengthening macroeconomic growth and

stability

Pillars of Financial Architecture

  Pillar-1: Objectives of fnancial architecture Pillar-2: Specialization of standard setting and infrastructure development institutions Pillar-3: Functional relationships between specialized stakeholders

Pillar-4: Assessment and monitoring

  1. Detecting and Monitoring External

Pillar-1: Objectives

  Vulnerabilities

  2. Strengthening Financial System Performance and Stability

  3. Observance of International Standards and Codes

  4. Capital Account Issues

  5. Pursuing Sustainable Exchange Rate Regimes

  6. Involving the Private Sector in Forestalling and Resolving Crises

  7. Measures to Increase Transparency

  8. Reform of IMF Financial Facilities and Related Issues

  (IMF 2000) Pillar – 2: Specialized functional areas of standard setting and infrastructure development institutions Specialized Standard Setting Bodies

  Basel Committee for Banking Supervision (BCBS) International Organization of Securities

  Commissions (IOSCO) International Association of Insurance

  Supervisors (IAIS) Multilateral Institutions

  World Bank International Monetary Fund Regional Banks

  Financial Stability Forum (Board) Pillar-3: Functional Relationships between specialized entities _{International Financial Architecture Chart 1}

   Basel _IAIS ^IOSCO G7/G10 Other Industrial Developing _{Countries Countries Development Banks}

   IMF _{Financial Committee;}

International Monetary and Financial

_{G-7/G-10; Development Committee; Forum Stability Source: Evans (2000, p.27) Boards}

  IMF, World Bank Executive _{Financial Architecture”, Financial Supervisory Authority Occasional Paper Series No. 4; January Evans, Huw (2000): “Plumbers and Architects: A Supervisory Perspective on International}

Pillar – 4: Financial Sector Development & Performance Assessment

  1. Financial Sector Assessment Program (FSAP) of IMF and World Bank

  2. Reports on Observance of Standards and Codes (ROSCs) Coverage includes:

  Operational Banking

• nature:

  Supervision, Joint World Bank

• Data •

  & IMF character Dissemination,

  Voluntary

• Fiscal •

  participation Transparency,

  Case-by-case

  

Components of Islamic Financial

Architecture

Local Component ↓

  Global Component ↓

National Financial Infrastructures (NFI)

  International Financial Architecture (IFA)

Components of International Islamic Financial Architecture

  Universally Internationally acceptable credible & comparable guiding principles best practices derived of Islamic from the guiding economics and principles fnance

  Individuals & Institutions that set best practices, use them, enforce them and monitor enforcement

  

National Islamic fnancial

infrastructures l

  Legal, regulatory, supervisory, tax and other enabling, support and enforcement

  na

  facilities, instruments and resources

  io

  needed for implementation and compliance with the universally

  at

  acceptable Islamic guiding principles and

  N

  best practices

  At the across border level – r regional and multilateral ss de institutions, arrangements and facilities for compliance with the ro or universally acceptable Islamic

  C B guiding principles and best Objectives of International Islamic Financial

Architecture (IIFA)

  

1. Establishing universally acceptable guiding principles for

Islamic financial practices

  

2. Establishing best practices for Islamic financial services in

areas of:

• Shariah and corporate governance Corporate ethics and social responsibility
• Transparency and disclosures
• Risk management
• Capital adequacy
• Accounting and auditing
• 3. Narrowing Fiqh Interpretations

  4. Common regulatory and supervisory regime

  5. Compliance with relevant international best practices

  Building Blocks of IIFA

  Rules governing prohibitions – Riba, Gharar, Qimar, etc. Consumption, fnancing, production, and transaction of prohibited items Principles governing what is permitted

  First Building Block of IIFA:

Guiding Principles of Islamic Economics and Finance

  R u l e s P r i n c i p l e s N o r m

• sales, fnancing, investment, trade and commercial transactions Norms guiding good behavior and dealings with others

  Second Building Block of IIFA: Shariah Standards (Accounting and Auditing Organization for Islamic Financial Institutions - AAOIFI)

  4. Settlement of Debt by Set- Off

  24. Syndicated Financing

  18. Possession (Qabd)

  12. Sharika (Musharaka) and Modern Corporations

  6. Conversion of a Conventional Bank to an Islamic Bank

  29. Stipulations and Ethics of Fatwa in the Institutional Framework

  23. Agency

  17. Investment Sukuk

  11. Istisna’a and Parallel Istisna’a

  28. Banking Services

  22. Concession Contracts

  16. Commercial Papers

  10. Salam and Parallel Salam

  27. Indices

  1.Trading in Currencies

  21. Financial Papers (Shares and Bonds)

  15. Jua’la

  9. Ijarah and Ijarah Muntahia Bittamleek

  3. Default in Payment by a Debtor

  26. Islamic Insurance

  20. Commodities in Organized Markets

  14. Documentary Credit

  8. Murabaha to the Purchase Orderer

  2. Debit Card, Charge Card and Credit Card

  25. Combination of Contracts

  19. Loan (Qard)

  13. Mudaraba

  7. Hawala

  30. Monetization (Tawarruq)

  Third Building Block of IIFA: Accounting Standards issued by AAOIFI _{1. Objectives of Financial}

  Accounting for Islamic _{Banks and Financial Institutions} ^{7. Disclosure of Bases for Profit Allocation} _{Between Owners’ Equity and Investment Account Holders} ^{13. Provisions and Reserves 19. Investment}

  2. Concepts of Financial _{Accounting for Islamic Banks and Financial Institutions} ^{8. Equity of Investment} _{Account Holders and Their Equivalent} ^{14. General Presentation and} _{Disclosure in the Financial Statements of Islamic Insurance Companies} ^{20. Islamic Financial} _{Services offered by Conventional Financial} Institutions _{3. General Presentation and Disclosure in the} Financial Statements of _{Islamic Banks and Financial Institutions} ^{9. Salam and Parallel Salam 15. Disclosure of Bases for Determining and Allocating Surplus or Deficit in Islamic} _{Insurance Companies} ^{21. Contributions in Islamic Insurance Companies}

  4. Murabaha and Murabaha _{to the Purchase Orderer} ^{10. Ijarah and Ijarah} _{Muntahia Bittamleek} ^{16. Investment Funds 22. Deferred} _{Payment Sale 5. Mudaraba Financing 11. Zakah 17. Provisions and Reserves} in Islamic Insurance _Companies ^{23. Disclosure on Transfer of Assets} _{6. Musharaka Financing 12. Istisna’a and Parallel} Istisna’a ^{18. Foreign Currency Transactions and Foreign} _Operations ^{24. Segment 25. Consolidation}

  Fourth Building Block of IIFA Shariah Governance Standards Standards Issued by AAOIFI

  1. Governance

  

2. Shariah Supervisory Board: Appointment, Composition and Report

  3. Shariah Review

  4. Internal Shariah Review

  5. Audit and Governance Committee for Islamic Financial Institutions

  6. Independence of Shariah Supervisor Board

  

7. Statement on Governance Principles for Islamic Financial Institutions

  8. Code of Ethics for Accountants and Auditors of Islamic Financial Institutions

  9. Code of Ethics for the Employee of Islamic Financial Institutions

Standard Issued by Islamic Financial Services

Board

“Guiding Principles on Corporate Governance for Institutions

  Fifth Building Block of IIFA Prudential guidelines and standards for Islamic fnancial services

  1. IFSB-7: Capital Adequacy Requirements for

  Sukuk, Securitisations and Real Estate investment

  2. IFSB-6: Guiding Principles on Governance for

  Islamic Collective Investment Schemes

  3. Guidance Note In Connection with the Capital Adequacy Standard: Recognition of Ratings

  4. IFSB-5: Guidance on Key Elements in the Supervisory Review Process

  5. IFSB-4: Disclosures to Promote Transparency and Market Discipline

  6. IFSB-3: Guiding Principles on Corporate Governance

  Lessons drawn from global fnancial crisis & strengths of the IIFA

  Lesson-1: Incentive structures; replacement of interest with proft sharing introduces fundamental changes in incentive systems Lesson-2: Excessive leverage; strong linkages between

fnancing and real economic transactions controls

leverage

  Lesson-3: Controlling speculation; “don't sell what you don’t own” rule limits speculation Lesson-4: Pyramid of debts; prohibition of sale of debt eliminates debt pyramids

Lesson-5: Regulation failure; Shariah supervision reduces the

risk of failure of regulation

Lesson-6: Social responsibility; Ethical screening of investment

opportunities strengthens social responsibility of wealth managers

  

Hence, IIFA has the inherent features and inbuilt

characteristics that ensure productive utilization of Pillars of & Building Blocks of Sound Financial Infrastructures

Pillars of a sound national fnancial infrastructure

• Pillar I—Macroprudential surveillance and fnancial stability analysis by the authorities to monitor the impact of potential macroeconomic and institutional factors (both domestic and external) on the soundness (risks and vulnerabilities) and stability of fnancial systems
• Pillar II—Financial system supervision and regulation to help manage the risks and vulnerabilities, protect market integrity, and provide incentives for strong risk management and good governance of fnancial institutions
• Pillar III—Financial system infrastructure:
• – Legal infrastructure for fnance
• – Systemic liquidity infrastructure FSAP: A Handbook, Chapter -1
• – Transparency, governance, and information infrastructure
• Pillar IV – Shariah Supervisory Framework and Governance System

  Building blocks of national Islamic fnancial infrastructures & challenges of enhancing them

  Building Block-1: Shariah Supervisory Systems Building Block-2: Legal, Regulatory and Tax

  Framework Building Block-3: Application of AAOIFI & IFSB standards of best practices for the

  Islamic fnancial services Building Block-4: Supervisory framework Building Block-5: Lender of last resort facility & systemic liquidity infrastructure Building Block-5: Deposit protection system Building Block-6: Human capital Building Block-7: Knowledge and professional services

  Areas of Standards Key Agency(s) in the International _{Financial Architecture} ^{Corresponding Agency(s)} _{in Islamic Finance 1. Accounting International Accounting Standards Board (IASB), International Federation of} Accountants (IFAC), Committee on Banking _{Supervision (BCBS)} ^AAOIFI _{2. Anti-Money Laundering / Combating the Financing of} Terrorism ^{Financial Action Task Force (FATF) Common} _{Auditing International Federation of Accountants (IFAC) AAOIFI 3. Banking Committee IFSB}

  4. Corporate Governance OECD, Basel Committee, World Bank AAOIFI and IFSB _{5. Data Dissemination IMF Common 6. Fiscal Transparency IMF Common 7. Insolvency and Creditor} Rights Systems ^{World Bank, United Nations Commission on International Trade Law (UNCITRAL),} _{International Bar Association (IBA)} ^{Not yet addressed but especially critical for Islamic} _{financing as it is based on risk sharing 8. Insurance Regulation International Association of Insurance} Supervisors (IAIS) ^{Not yet addressed but within the mandate of IFSB} _{9. Monetary & Financial Transparency Policies IMF Common 10. Payments Systems Committee on Payment and Settlements} Systems (CPSS) ^Common _{11. Securities Market Regulation International Organization of Securities Commissions (IOSCO) Not yet addressed but within the mandate of IFSB}

  Connections & Interactions Between International & Islamic Financial Architecture

  Islamic Financial Architecture - Challenges of Development

  1. Enabling Environment

  2. Effective Shariah Supervision and Governance

  3. Balancing speed and genuineness

  4. Application of AAOIFI and IFSB Standards

  5. Safeguarding against systemic risks of conventional system

  

6. Preventing risk transmission from conventional to Islamic

financial institutions

  7. Preventing risk transmission within Islamic funding source

  8. Systemic liquidity and safety-net infrastructures

  9. FSAP and Assessment Issues

  # Institution Mode of contribution to

  IIFA & Infrastructures

  

1 Islamic Development Bank (1976) TA, equity support and

collaboration with IFSB,

  IMF and World Bank & others

  2 The Islamic Research and Training Institute (IRTI) (1981) Research, training & Information services

  3 The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) (1991) Standard setting and training

  4 International Islamic Financial Market (IIFM) (2001) Product development and training

  5 The General Council of Islamic Banks and Financial Institutions (GCIBFI) (2001) Product development, training and research

  6 The International Islamic Rating Agency (IIRA) (2002) Rating services

  7 The Islamic Financial Services Board (IFSB) (2002) Standard setting and training

  8 International Islamic Centre for Dispute resolution

  Institutional Initiatives in developing IIFA

  References

  IMF & World Bank, Financial Sector Assessment – A Handbook (

)

  

IRTI/IFSB, IFSI Development: 10 Year Framework and Strategies

Chapra, M.U and Tariqullah Khan, Regulation and Supervision of Islamic Banks, IRTI

Khan, Tariqullah and Ahmed Habib, Risk Management – An Analysis of

Issues in Islamic Financial Industry, IRTI Khan, Tariqullah and Muljawan, Dadang, Islamic Financial Architecture: Risk Management, Regulation and Supervision, IRTI (

  Thanks