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Risk Assessment & Regulatory Framework In Islamic Banks

The Lebanese Experience

Dr Amine Awad

Executive Director, Lebanon’s Banking Control Commission

Member of the Higher Banking Council

Coordinatior of Basel III Implementation Task Force

Washington D,C. October 18, 2012

Banking Control Commission

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Outline

Preface: What is Islamic Banking

Major Islamic Banking Rules & Standards

Brief History of I.B.’s in Lebanon

Major Regulations for I.B.’s in Lebanon

Liquidity in I.B.’s

Challenges Facing the Development of I.B.’s

List of Islamic Banking Regulations

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Islam encompass all aspects of Muslims life.

Islamic Law or “Shari’a”: derived from the holly Qoran and the Sunna (Practices of the Prophet).

Islamic Financial Model, as seen today, is based on the following 5 major principles:

Principle 1: Everyone involved in a transaction should be well informed

and not misled or cheated.

Principle 2: Islam encourages economic activities but makes a clear

distinction between activities Allowed and activities

Forbidden (Exp: Transactions involving Alcohol, pork,

gambling etc…)

(Cont.)

Preface


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Principle 3: The major Shari’a rule prohibits muslims of “Riba”

(i.e. usury or interest). Islamic Banking has developed

mechanisms that replaced interest income by cash flows

from productive sources (Exp: Profit from trading in assets,

rental income, leasing etc…)

Principle 4: The Islamic Banking Model is based on a Risk and Profit

– sharing (and Loss – bearing); so Shari’a Compliant

transactions are similar to Equity – based Transactions.

Principle 5: Contractual Certainty : Uncertainty or ambiguity that can

lead to disputes render a contract void under Shari’a.

Preface (Cont.)


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Major Islamic Banking

Rules & Standards

As Islam is based on Shari’a, there are 4 major Schools

(Mazahib) of Al – Fikh, i.e. the Interpretation of the Shari’a

Rules, from the extreme rigorous to the easiest:

• MALIKI

• HANBALI

• SHAFI’I

• HANAFI


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Rules & Standards

In the early 90’s the Islamic Banking Industry decided that the existing International Standards applying to Conventional Banking were inadequate to cater its needs.

In 1991, the AAOIFI (Accounting & Auditing Organization for Islamic Financial Institutions) was created in Bahrain.

Over the years AAOIFI has developed new Standards for Islamic Financial Institutions (I.F.I.) and has taken significant steps to encourage the application and enforcement of its standards.


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Rules & Standards

AAOIFI objectives are to:

* Develop Accounting and Auditing thoughts for IFI’s

* Disseminate these thoughts

* Preface and Review Accounting and Auditing Standards for

IFI’s, that respect Shari’a.

AAOIFI also created two diplomas for Islamic Banking:

* C.I.P.A. (Certified Islamic Public Accountant)

* C.S.A.A. (Certified Shari’a Advisor & Auditor)


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Rules & Standards

In 2012, there are:

* 26 Accounting Standards

* 5 Auditing Standards

* 7 Governance Standards

* 45 Shari’a Standards

* 2 Codes of Ethics


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Brief History of I.B.’s in Lebanon

Until February 2004, date of adoption of the Law No 575 on Islamic

Banking, there was no Islamic banks in Lebanon, except one (Al -

Baraka Bank), which was operating as a Conventional Bank,

respecting the shari’a.

Presently there is a small Islamic Banking Sector in Lebanon with 5

Banks, 2 of them are affiliated to large Lebanese Conventional banks

and 3 are affiliated to large Foreign Islamic banks (Bahrani, Qatar &

Iraq).

Lebanon decided to set the legal framework of an Islamic Banking

Sector because of the two following major factors:

Islamic Banking is growing rapidly worldwide (annual growth rate

is estimated at ≈ 15% for the last 7 years)

Excess of Liquidity in the Middle East Region


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Some Figures of the Islamic Banking Sector in

Lebanon

June

2012

2011 2010 2009 2008 2007 2006

5 5 4 4 4 4 4 Number of I.B.

18 18 17 16 13 12 10 Total Number

of Branches

June

2012

2011 2010 2009 2008 2007 2006

920 870 799 771 607 460 340 Total Footings

(Incl. Assets under

Management)

565 534 408 323 269 250 167 Total Deposits

(Restricted +

Unrestricted A/C’s)

129 131 136 134 130 112 112 Total Equity

In USD Million))


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Major Regulations for I.B.’s

→No Islamic Windows are allowed – only Independent Islamic Banks

can offer Islamic banking services and products:

. To put a Chinese wall between Conventional and Islamic Banking and avoid

misleading non – transparent practices.

. To have a clear competitive market for Islamic Finance

→ Minimum Capital for an I.B. is USD 100 Million (with exceptions in

some cases)

→ The 15% cash “Hamesh Al Jaddia” )Margin) is mandatory, in Murabaha

Transactions.(= Margin against Trade Finance Transactions)

→ The legal liability of “Al A’mer Bil Shira’a” )Client) is mandatory in

Murabaha transaction.(including all types of Collaterals)

→ Financing of Real Estate Development Projects (L.T.V.) should not exeed 60% of the project’s value

→ All types of R.E. Intermediation and/or Financing Speculation on R.E. are prohibited


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Major Regulations for I.B.’s

There are many circulars issued by B.D.L. and B.C.C.L. to set the legal and regulatory framework of the various types of Islamic Transactions :

Murabaha (Retail & Trade Finance Transactions)

Musharaka or Mussahama → (Project Financing Transactions)

Ijarah & Ijarah Muntahia Bitamlik (Leasing Transactions)

Mudaraba (Profit sharing between the bank and the Client)

Salam (Advances against Future delivery of assets)

Istisna’a (Advances against manufacturing of an asset to be

delivered to the Islamic Bank)

Sukuk (Bonds) → (Islamic Asset Backed Instruments)

Islamic Mutual Funds

(Cont.)


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On the other hand B.D.L. issued four important Circulars:

- In August 2004, Circular # 94, setting Limit for I.B.’s Investments in R.E. (50% of the Total Investment Portfolio)

- In February 2007, Circular #107, drawing a specific form of Balance Sheet (including Off – Balance Sheet items) and P & L Account for I.B.(B.C.C.L. will issue in the next couple of weeks a Condensed B/S).

- In September 2007, Circular # 112, on Corporate Governance Practices in I.B. :

* Mandating Corp . Gov. Unit (with a Non – Executive Board

Member) (+) Shari’a Audit Unit (reporting to B.o.D. and Shari’a

Board), in addition to other B.o.D Committees (as for Conventional Banks)

* List of Disclosures for full transparency

* Role: - Protect the interests of the customers and other stakeholders

- Supervise and develop the systems relating to Corporate

Governance

Major Recent Regulations for I.B. (Cont.)


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Major Recent Regulations for I.B. (Cont.)

- In May 2008, Circular # 116, on new Capital Instruments (Tier2) in I.B.’s, including:

* Kard Al – Hassan (Subordinated Loan) (Perpetual = i.e. minimum 5 years no capital guarantee, not redeemed except from free distributable profits)

* Cash Contribution (with no return and for the whole life of the Bank)

- In May 2008, Circular # 163, on the pre - conditions to Sell Islamic Financial Products

* I.B. must obtain B.D.L. prior approval to sell any Islamic Financial Product to the public (to avoid misleading and protect consumers of Islamic financial services)

- In July 2008, Circular # 178, on Investments of I.B.:

* Total Lending of I.B.’s to their Affiliated Companies, should not exceed 30% of the bank’s Equity )and 10% per company)


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Methodology of Regulation /

Supervision of I.B.’s

- Joint Task Force (Between B.D.L. and B.C.C.L.) specialized in Islamic Banking that sets the Legal and regulatory framework of the I.B. Activities ( Mainly: Capitalization, Provisionning, Risk Management Approach, Int. / Ext. / Sharia’a Audit etc…)

- On – Site Examination Team, specialized in Sharia’a Compliant Banking Transactions.

- B.D.L. and B.C.C.L. are in the process of preparing a “Consolidated Balance Sheet” between a Conventional Bank and an Islamic Bank, that respects IAS/IFRS as well as IFSB/AAOIFI Standards:

* Because some Lebanese Conventional Banks have an

Islamic Subsidiary in Lebanon

* Some others have an Islamic Subsidiary abroad


Liquidity Management In I.B.’s

In addition to the methodology of Management of

Liquidity in Conventional Banks, many specific ratios

are used to measure the liquidity in I.B.’s; the most used

by the I.I.R.A. (Islamic International Rating Agency)

are:

LR (1) = Liquid Assets (a)

Liquid Liabilities (b)

LR (2) = Liquid Assets

Total Liabilities

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Liquidity In I.B.’s

LR (3) = Loans

Core Funding (c)

LR (4) = Interbank Borrowings

Total Assets

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Definitions of Liquidity Elements

(a) Liquid Assets of I.B.’s = Cash + Cash Equivalent

+Placements with Banks & F.I.’s +Liquid Investments

(b) Liquid Liabilities in I.B.’s = Deposits + Borrowings

from Bank & F.I.’s

(c) Core Funding in I.B.’s = Deposits + Capital –

Investments in Affiliates – Investments in Fixed Assets

– Large Deposits (> 5% of Equity) – Reserves with

Central Banks

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In a recent study (published in 2009), made by 4 experts

on the “Financial Performance of Malaysian I.B.’s v/s

Conventional Banks”, the authors reached the following

conclusion:

Average of Net Loans to Total Assets ratio for Islamic

banks stood at 45.2%, which is lower than Conventional

banks (57.1%). This means that Islamic banks are more

liquid than Conventional banks.

The Financing to Deposit Ratio for Islamic banks (49.2%)

is lower than Conventional banks (68.1%) by 18.9%, this

indicates that Islamic banks are more liquid than

Conventional banks. 19



Looking at these ratios, we could say that Islamic banks

seem to have better liquidity ratios in comparison to

Conventional banks.

According to Haron (2004) Islamic banks experienced

excess liquidity given the lack of Islamic Financial

Instruments in the market for the Islamic bank to invest

in. Besides, the lower assets tied to net loans of Islamic

banks compared to Conventional banks which resulted

in higher liquidity may be due to the stringent financing

policy (i.e. must comply with Shari’a unlike the

Conventional banks).

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Comparative Liquidity in I.B.’s v/s C.B.’s

(Malaysia)

Liquidity I.B.’s C.B.’s

Net Loans / Tot Assets 45.2 57.1

Net Loans / Dep & ST Funding 49.2 68.1

Net Loans / Tot Dep & Borrowings 48.8 66.0

Liquid Assets / Dep & ST Funding 45.1 30.4

Liquid Assets / Tot Dep &

Borrowings

44.7 28.5

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3 Liquidity Ratios (in I.B.’s)

Level 1 (on-B/S)

=(Cash + Central Bank + Nostro Banks + Murabaha with Central Bank + Murabah with Banks

(B/S) - Vostro Banks -Banks Unrestricted investment accounts) / (current accounts including

margins on LC's & Hamish Jaddiyya + Sundry Creditors)

Level 2 (on-B/S & off- B/S unrestricted murabaha with banks)

= (Cash + Central Bank + Nostro Banks + Murabaha with Central Bank+ Murabah with Banks

(B/S) + Murabaha with Banks unrestricted-Vostro Banks -Banks Unrestricted investment accounts)

/ (current accounts including margins on LC's & Hamish Jaddiyya + Sundry Creditors +

Unrestricted Investments Accounts + Profits to be distributed on unrestricted investments accounts)

Level 3 (on-B/S & off-B/S unrestricted & restricted murabaha included)

= (Cash + Central Bank + Nostro Banks + Murabaha with Central Bank + Murabah with Banks

(B/S) + Murabaha with Banks unrestricted+ Murabah with Banks Restricted-Vostro Banks -Banks

Unrestricted investment accounts -Restricted Wakala (banks)) / ( current accounts including margins

on LC's & Hamish Jaddiyya + Sundry Creditors + Unrestricted Investments Accounts + Profits to

be distributed on unrestricted investments accounts + restricted Investments Accounts + profits to

be distributed on restricted investments accounts))

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Challenges Facing the Development of I.B.

1) Shari’a Arbitrage: as the Regulator / Supervisor is not in a position to assess the suitability of the different scholars consulted by the Islamic Banks. However the references are the I.F.S.B. (Islamic Financial Services

Board) Principles and the AAOIFI Standards

2) Absence of Capital Adequacy Standard: for I.B’s )Basel II & Basel III)

3) Human Resources: There is a shortage of experienced professionals in the Islamic Financial Sector. This needs more education and trainings.

4) Contracts & Documentation Risk: Equivalent to the Legal Risk in Conventional Banks.

If a transaction reveal to be Shari’a non – compliant, the Asset can be converted into liability in the Islamic Banks B/S (in addition to the Zakat Penalty)

5) Reputational Risk.

Mainly due to lack of transparency or to wrong presentation of the Islamic products and services and their underlying risks.

P.S. The B.C.C.L. Try to apply the Risk Identification, Assessment and Quantification in I.B.’s under the Pillar II.


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List of Most Important Islamic Banking

Rules in Lebanon

BDL Circular # 94, dated August 2004: Practice of

Islamic Banking in Lebanon

BDL Circular # 95, dated August 2004: Conditions of

Establishment of an I.B. in Lebanon

BDL Circular # 96, dated October 2004: MURABAHA

BDL Circular # 97, dated January 2005 & BCCL Circular

# 246 :MUSHARAKA (or MUSSAHAMA)

BDL Circular # 98, dated June 2005: Islamic Collective

Investment Schemes


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Rules in Lebanon

BDL Circular # 99, dated June 2005 & BCCL

Circular # 247: IJARAH & IJARAH

MUNTAHIA BITTAMLEEK

BDL Circular # 100, dated July 2005 & BCCL

Circular # 249: MUDARABA

BDL Circular # 101, dated December 2005 &

BCCL Circular # 253 : BAI’ SALAM

BDL Circular # 102, dated December 2005 &

BCCL Circular # 254: ISTISNAH


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Rules in Lebanon

BDL Circular # 107, dated February 2007: I.B. Financial Statements

BDL Circular # 112, dated September 2007: Corporate Governance in I.B.

BDL Circular # 116, dated May 2008: Capital Instruments in I.B.

BDL (Intermed.) Circular # 163, dated May 2008: Islamic Financial Products

BDL (Intermed.) Circular # 178, dated July 2008: Limit for I.B.’s lending to their Affiliates

P.S: Central Bank Website: www.bdl.gov.lb

Banking Control Commission Website: www.bccl.gov.lb

http://www.bdl.gov.lb/

http://www.bccl.gov.lb/


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Discussion

[email protected] Mail: –E

Documents

Risk Assessment & Regulatory Frameworksiteresources.worldbank.org/FINANCIALSECTOR/Resources/Amine_Awad...Risk Assessment & Regulatory Framework In Islamic Banks ... is mandatory, in