ISLAMIC BANKING’S UNIQUE FEATURES
&
THE NEXT FRONTIER
Presentation by
Mr. Malkit Singh
CFO, Bank Islam Malaysia Berhad
Lanai Kijang, Kuala Lumpur
24 June 2014
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PRESENTATION OUTLINE
Global Islamic Finance Industry
Malaysia Islamic Banking System
Challenges from the accounting perspective
• The next frontier
Islamic Financial Services Act 2013
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GLOBAL ISLAMIC FINANCE INDUSTRY
Islamic finance assets estimated at USD1.8 trillion as at end 2013
During 2009 – 2013 CAGR of 17.07%
Y-o-Y growth of 18.6%
Banking sector accounted for 79.8% of the portfolio
Banking,
79.8%
Sukuk, 15.0%
Funds, 4.0% Takaful, 1.1%
Global Islamic Finance – Assets (2013*)
Source: Malaysia International Islamic Financial Centre : “Insights” 15 January 2014
* Estimated
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MALAYSIAN ISLAMIC BANKING SYSTEM
Global level, Malaysian Islamic banking assets represent 13% share of
the total global Islamic banking assets
In South East Asia, Malaysian Islamic Banking assets represent 85% of
total assets of Islamic banking industry
Domicile of Islamic Banking (1H13)
Iran (37%)
Saudi Arabia (18%)
Malaysia (13%)
UAE (7%)
Kuwait (6%)
Qatar (4%)
Turkey (3%)
Bahrain (2%)
Indonesia (2%)
Sudan (1%)
Pakistan (1%)
Others (6%) Source: Malaysia International Islamic Financial Centre :
“Insights” 15 January 2014
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MALAYSIAN ISLAMIC BANKING SYSTEM (Cont’d)
Continues to outperform the conventional banking sector with assets
CAGR of 18.7% during 2008 – 2013 whereas conventional banking
grew 8.2% during same period
Islamic banking market share increased from 7.8% in 2007 to 20.7% in
2013
7.8%
13.9% 15.8% 16.8%
18.4% 19.5%
20.7%
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
-
50,000
100,000
150,000
200,000
250,000
2007 2008 2009 2010 2011 2012 2013
Islamic Banks Growth Commercial Banks Growth Banking System Growth IB Market Share
Source: BNM Monthly Statistical Bulletin April 2014
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CHALLENGES FROM THE ACCOUNTING PERSPECTIVE
• Harmonisation of financial reporting
• Debatable Issues
Time value of money
Ijarah
• Areas not addressed by IFRS
Accounting for Zakat
Late payment charges (Ta’widh)
Qardh facility
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HARMONISATION OF FINANCIAL REPORTING
Basis of preparation differs
No uniform financial reporting standards globally
IFRS the most common form of reporting though additional local
reporting requirements need to be adhered to
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FINANCIAL STATEMENTS OF ISLAMIC FINANCE INSTITUTIONS (IFIs)
BASIS OF PREPARATION
Al Baraka Banking Group
Financial Accounting Standards (FAS)
issued by Accounting and Auditing
Organisation for Islamic Financial
Institutions (AAOIFI)
Where No AAOIFI standards exists -
relevant International Financial
Reporting Standards (IFRS) issued by
International Accounting Standards
Board (IASB)
Bahrain Commercial Companies Law
Central Bank of Bahrain and Financial
Institution Law
Al Rajhi Banking & Investment Corp. (M) Berhad
Malaysian Financial Reporting
Standards (MFRS)
Bank Negara Malaysia (BNM)
Guidelines
Companies Act, 1965
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FINANCIAL STATEMENTS OF ISLAMIC FINANCE INSTITUTIONS (IFIs)
BASIS OF PREPARATION
IFRS except for IAS 39 requirement
for collective provision…replaced by
Central Bank of Kuwait’s requirement
for a minimum general provision
Regulations of the Government of
Kuwait for financial services
institution regulated by the Central
Bank of Kuwait
Kuwait Finance House (M) Berhad
MFRS
IFRS
BNM Guidelines
Companies Act, 1965
Kuwait Finance House K.S.C & Subsidiaries
Maybank Islamic Berhad
MFRS
IFRS
BNM Guidelines
Company Act, 1965
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FINANCIAL STATEMENTS OF ISLAMIC FINANCE INSTITUTIONS (IFIs)
BASIS OF PREPARATION
Qatar Islamic Bank
FAS by AAOIFI
Where not covered by AAOIFI
standards - uses IFRS
Regulations of Qatar Central Bank
Provisions of the Qatar Commercial
Company Law
National Bank of Abu Dhabi
IFRS
Laws of the U.A.E
Emirates Islamic Bank
IFRS
Laws of the U.A.E
Bank Islam (M) Berhad
MFRS
IFRS
BNM Guidelines
Company Act, 1965
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HARMONISATION OF FINANCIAL REPORTING
Common framework
Enhance transparency
Common framework Enhance transparency International
comparability of financial reporting
IFRS is not considered to be sufficient, especially by Islamic
Financial Institutions (IFIs) using accounting standards
issued by Bahrain based Accounting and Auditing Organisation for Islamic
Financial institutions (AAOIFI)
WHY HARMONIZATION
There are AAOIFI standards issued for
specific Islamic banking and finance practises not covered
by IFRS
Most countries in the world have adopted
or converged to International
Financing Reporting Standard (IFRS)
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HARMONISATION OF FINANCIAL REPORTING
IFRS could be used as the default reporting framework although guidance based
on existing Islamic financial reporting models would need to be used to
supplement the standards for those IF transactions that do not fit simply into the
framework
Could explore the possibility of having a specific standard under IFRS for Islamic
finance transaction
Alternatively, a set of globally recognised Islamic accounting standards could be
used by IFIs; To assist IFIs and ultimately the users of financial statements, a
reconciliation to IFRS could also be provided, or common terms could be
provided.
Will show how IFRS can be used to apply to the latest Islamic Financial Services
Act 2013 requirement.
SUGGESTIONS ON HARMONISATION OF FINANCIAL REPORTING
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DEBATABLE ISSUES – TIME VALUE OF MONEY
AAOIFI’s Financial Accounting Standard (FAS) 2, ‘Murabaha and Murabaha to Purchase Orderer’ recognises profit
proportionately over the repayment period or, in a departure from the accrual concept,
as and when installments are received
AAOIFI’s conceptual framework propounded that “money does not have a
time value” hence does not require the pattern of profit recognition to be related to
the amount of principal outstanding
AAOIFI’s FAS13 ‘Mudaraba’ states ‘”In measuring receivables neither time value
(interest rate) nor discount on current value for extension of period of payment shall be
taken into consideration
Under IFRS 39/ IFRS 9, ‘Financial instruments’ assets classified as financing are measured at amortised costs using an effective interest rate in order to take into
account the time value of money
TIME VALUE OF MONEY
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Whereas, under AAOIFI’s FAS 10, ‘Istisna’a and Parallel Istisna’a’ an
Istisna’a financing receivable would be valued at historical cost
IFRS 39/ IFRS 9 ‘Financial Instruments’ allow users to evaluate the ‘ability of the
entity to generate cash and cash equivalents in the future’ often require
the use of discounted future cash flows to measure assets and liabilities
No active market – use valuation techniques based on discounted future cash flows. Sukuk – no active market
have to be measured this way
Under IFRS 36: ‘Impairment of Assets’ Impairment = Carrying value >
recoverable amount. Recoverable amount is again based on discounted
cashflows.
TIME VALUE OF MONEY
DEBATABLE ISSUES – TIME VALUE OF MONEY
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DEBATABLE ISSUES – TIME VALUE OF MONEY
IFIs use discounted cash flows when calculating value in use
for impairment testing and valuation techniques for
Financial Investments like Sukuks, and Derivatives (IPRS)
which are measured at fair value
Use of discounted cash flows is to derive an approximation of a
market value
The prohibition of partaking in interest based transactions is
clearly fundamental to Islamic finance
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ISLAMIC FINANCIAL SERVICES ACT (IFSA) 2013
Came into effect 30 June 2013
Amalgamated several separate laws to govern the financial sector
under a single legislative framework
Islamic Banking Act (IBA) 1983 Takaful Act 1984 Payment System Act 2003 Exchange Control Act 1953
Repealed 30 June 2013
Islamic Financial Services Act 2013
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ISLAMIC FINANCIAL SERVICES ACT (IFSA) 2013
Provides BNM with the necessary regulatory and supervisory oversight powers
Maintain financial stability
Support inclusive growth in the financial system & economy
Provide adequate protection for consumers
OBJECTIVES
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IFSA – REDEFINING DEPOSIT PRODUCT
Concept of Investment Account introduced
Treatment of Investment Account & Islamic deposits in line with Shariah requirements
DEFINITION OF INVESTMENT ACCOUNT
Acceptance of money for investments in accordance with Shariah Principles
No express or implied obligation to repay the money in full (not principal guaranteed)
PSR set upfront & can be loss bearing (Mudarabah & Musharakah) or distribution of profit after
deduction of agency fees & performance incentive fee (Wakalah). No profit smoothing allowed
Investment tenure must be specified (with or without maturity)
DEFINITION OF ISLAMIC DEPOSITS
Acceptance of money in accordance with Shariah Principles for deposits (Wadiah, Tawarruq &
Bai’ Inah)
On terms that the sum of money paid will be repaid in full (principal is guaranteed)
For term deposit, profit rate is known upfront (Tawarruq)
Repayment on demand or at a certain time
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FEATURES OF INVESTMENT ACCOUNT
1. Must clearly state investment objectives, which covers type of assets that would
be invested in
2. An assessment of investment & risk management strategies to achieve
investment objectives, including expected return on investment on the assets
identified and stress testing or scenario analysis.
3. IAH's risk appetite to accept risk from proposed investment must be made
4. Minimum amount of investment must be specified
5. Investment tenure must be stated whether with or without maturity and
minimum investment tenure for those with maturity.
An Investment Account offering must cover the following:
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FEATURES OF INVESTMENT ACCOUNT (con’t)
6. Stipulate redemption terms, taking into account liquidity risk management
strategies and rights to share profit & loss arising from early redemption.
7. Clearly set out, profit distribution methodology, ie. using PSR for Mudarabah &
Musharakah products; Agency fees & performance incentive for fees for
Wakalah product.
8. The manner in which profit shall be paid must be made known
9. State Valuation methodology consistent with MFRS, including impairment
assessment.
10. Terms of Termination of Investment Account:
manner of termination
valuation methodology
profit distribution
operational requirements that will affect conduct of business with IAH
to ensure all liabilities of IAH fund are discharged before completion or
winding up
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TYPE OF INVESTMENT ACCOUNTS
Restricted Investment Account (RIA)
• Investment Account Holder provides a specific investment mandate (purpose, assets
class, economic sector & period of investment)
Source of funds
Management of funds
Application of funds
Profit/Loss
Distribution of Profit/Loss*
Investment Account Holders
Restricted Funds
Asset XYZ
Loss
Bank
Profit
Investment Account Holder
• Funds will be specifically utilized to fund a particular project of the investment account
holder. In return, the investment account holder will be entitled to a percentage share
of the investment income
*Profit or loss can be directly identified and distributed to the fund
providers
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TYPE OF INVESTMENT ACCOUNTS
Unrestricted Investment Account (URIA)
• Investment Account Holder allows the bank to make the ultimate investment decision
without specifying any particular restriction or condition
Source of funds
Management of funds
Application of funds
Profit/Loss
Distribution of Profit/Loss
Assets Pool
Investment Account Holders
Unrestricted Funds
Loss
Bank
Profit
Investment Account Holder
• Funds will be placed in general bank’s pool of Shariah compliant banking activities. In
return, investment account holders will be entitled to a percentage share of the
investment income.
*All profit or loss arising from the assets shall be apportioned to
the respective fund providers based on proportionate tagging
• Must not be exposed to investment concentration risk
• Investment concentration limit to single counterparty shall be 25% of carrying value total net assets value of URIA fund.
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TYPE OF INVESTMENT ACCOUNTS
Overview – Identification of Assets against funding sources
Source of funds
Management of funds
Application of funds
Profit/Loss
Distribution of
Profit/Loss
Shareholders’ funds and deposits
General pool
Profit/Loss
Bank
Investment Account Holders
Unrestricted Funds
Loss
Bank
Profit
Investment Account Holder
Investment Account Holders
Restricted Funds
Asset XYZ
Loss
Bank
Profit
Investment Account Holder
Depositors
Assets Pool Assets Pool
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ACCOUNTING EVALUATION FOR INVESTMENT ACCOUNT
Are funds received from investors treated separately?
• Apply principles of MFRS 10 ‘Consolidated Financial Statements’
• Assess if Bank has control over the funds
Apply MFRS 132 ‘Financial Instruments: Presentation’ to assess if fund qualify as financial liability
Accounted for in accordance with MFRS 139 ‘Financial Instruments: Recognition & Measurement’
Further assessed under MFRS 132 in accordance with the substance of the contractual arrangement to determine appropriate treatment
Off balance Sheet On balance sheet
Apply MFRS 139. Evaluate if underlying assets met de-recognition criteria – ‘pass through arrangement’
Consolidate the funds
Risk & rewards test Transferred/ retained
substantially the risks & rewards
Off balance Sheet On balance sheet
Yes No
Yes No
Yes No
No Yes
Transferred Retained
IA – On or off balance sheet? Depends on IA product’s terms and conditions
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TO DETERMINE WHETHER THE ENTITY SHOULD BE DEEMED A SEPARATE ENTITY
Specific assets of the investee are the only source of payment for specified
liabilities of the investee
All the assets & liabilities that are deemed separate entity are ring-fenced from
the overall investee
Deemed separate entity is called ‘silo’
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DO THE FUNDS QUALIFY AS FINANCIAL LIABILITY
Para 11 of MFRS 132 defines a financial liability as any liability that is:
a. a contractual obligation
i. To deliver cash or another financial asset to another entity; or
ii. To exchange financial assets or financial liabilities with another entity
under conditions that are potentially unfavourable to the entity; or
b. a contract that will or may be settled in the entity’s own equity instruments
At this stage, it can be argued Investment Account is a financial liability as the bank has a contractual obligation to return the proportionate share of capital invested at the maturity of the investment, plus a contractual obligation to
distribute profits in cash in the pre-determined ratio
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DOES THE BANK CONTROL THE FUNDS
Accounting evaluation
• Under MFRS 10 the Bank controls the fund if and only if the Bank has all
of the following:
All 3 elements must be present in order for the Bank to have control
Control
Link between power & returns
Power
Exposure to
variability in returns
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DOES THE BANK CONTROL THE FUNDS
POWER
Scope of decision on making authority
Rights of other parties
Substantive or protective rights
Activities •Authority to set investment parameters •Type of investments
Purpose & Design •Key contributor to the purpose & design of the funds
Discretion •Discretion the Bank has to make investment decisions
Does fund providers individually or
collectively have rights to remove the Bank/
direct decision made by the Bank
Power on the relevant activities of
the fund
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DOES THE BANK CONTROL THE FUNDS
EXPOSURE TO VARIABILITY IN RETURNS
Magnitude & variability of remuneration
entitlement of the Bank
Magnitude
Market Terms
Variability
Pre-agreed profit sharing ratio
Variability of the Bank’s remuneration exposure to
the upside/ downside risk of investment versus fund
providers exposure
Is the remuneration deemed to commensurate with
market terms
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DOES THE BANK CONTROL THE FUNDS
Apply principles of para 21 of MFRS 118, an entity is acting as a principal when it has
exposure to the significant risks and rewards associated with the rendering of
services
One feature indicating an entity is acting as agent is that the amount the entity earns
is predetermined, being either a fixed fee per transaction or a stated percentage of
the amount billed to the customers.
LINK BETWEEN POWER & RETURNS
Principal- has control Agent- does not have control
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EVALUATE DERECOGNITION OF FINANCIAL ASSETS
Para 17 of MFRS 139 states that a financial asset shall be derecognised when:
a. The contractual rights to the cash flows from the financial assets expire; or
b. When it has transferred the contractual right to receive the cash flows of
the financial asset
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EVALUATE DERECOGNITION OF FINANCIAL ASSET – PASS THROUGH ARRANGEMENT
As per para 19 of MFRS 139, the following conditions should be met to achieve
a pass-through arrangement
a. The Bank has no obligation to pay amounts to the eventual recipients unless it
collects equivalent amounts from the original asset.
b. The Bank is prohibited by the terms of the transfer contract from selling or pledging
the original asset other than as security to the eventual recipients for the obligation to
pay them cash flows
c. The bank has an obligation to remit any cash flows it collects on behalf of the
eventual recipients without material delay. In addition, the Bank is not entitled to
reinvest such cash flows, except for investments in cash or cash equivalents
Yes to the above Banks does not have a liability. Acts more as an agent. Should be derecognised No to the above Funds received should be on balance sheet
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EVALUATE DERECOGNITION OF FINANCIAL ASSET – RISKS AND REWARDS TEST
As per para 20 of MFRS 139, when an entity transfers a financial asset, it shall
evaluate the extent to which it retains the risks & rewards of ownership of the
financial asset. In this case, the Bank carries out the risks and rewards test as
follows
a. Has the Bank transferred substantially all the financial asset’s risks and
rewards of ownership
Yes to the above Derecognition and should be off balance sheet No to the above Consider item (b) below
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EVALUATE DERECOGNITION OF FINANCIAL ASSET – RISKS AND REWARDS TEST
b. Has the Bank retained substantially all risks and rewards of ownership
Yes to the above Should be on balance sheet No to the above Consider item (c) below
c. Has the Bank retained control of the assets?
Yes to the above Continue to recognise on balance sheet No to the above Derecognise, off balance sheet
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NEXT FRONTIER - CONCLUSION
INTRODUCTION OF IFSA PROMOTES…
True blue Islamic banking
Clear focus on Shariah compliance & governance
Product innovation
Product differentiation within IBs vs. Conventional Banks
Match risk & rewards – Not new under Islamic Finance. Has been laid down in
Islamic legal maxim known as Al-Ghunmu bi Al-Ghurmi (any profit is associated
with risks)
More transparency – it’s all about faith and trust
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