## pp040618the-core-principles-for-islamic-finance-regulations

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### Proposal and purpose
- Proposes incorporating the Core Principles for Islamic Finance Regulation (Banking Sector) (CPIFR) issued by the Islamic Financial Services Board (IFSB) as part of the standards used in assessing banking regulatory and supervisory regimes under the Financial Sector Assessment Program (FSAP) and the Reports on Observance of Standards and Codes (ROSCs).
- For jurisdictions with systemically significant Islamic banking sectors:
  - Use CPIFR for fully Islamic banking systems.
  - Use BCP and the five additional CPIFR principles for dual banking systems.
- Fund staff is seeking the endorsement of the Executive Board on this proposal.
- Paper submitted to the World Bank Board for information purposes; IMF staff seeks IMF Board endorsement to use the CPIFR to supplement BCP assessments where Islamic banking is systemically significant based on the 15 percent threshold proposed in the paper.

### Key statistics and scope
- Global Islamic financial assets have reached about US$2 trillion, with the banking sector accounting for about 85 percent of the total assets.
- Islamic banking exists in more than 60 countries.
- The industry has become systemically important in 13 jurisdictions.
- The domestic market share of Islamic banks increased in 18 countries in 2016.
- CPIFR includes five additional principles specific to Islamic banking operations.
- Executive Board decision referenced: February 3, 2017.

### Rationale: opportunities from Islamic finance
- Islamic finance can deepen financial markets and inclusion by offering new modes of finance and attracting “unbanked” populations.
- Products and services can facilitate the “bailing-in” of stakeholders (for example, investment account holders who bear losses on their invested capital) in bank resolution.
- Islamic finance emphasizes risk-sharing, strengthening the link between finance and the real economy.
- The industry’s potential contribution to the United Nation's sustainable development financing goals (SDGs) may support further progress.

### Distinct risks and regulatory challenges
- Islamic banks (IBs) generate distinct operations with risk profiles and balance sheet structures different from conventional banks, with implications for financial stability.
- Key unique risks include:
  - Equity investment risk
  - Displaced commercial risk
  - Rate-of-return (ROR) risk
  - Sharī`ah non-compliance risk
- Traditional risks that can be amplified in IBs:
  - Credit risk
  - Concentration risk
  - Liquidity risk
- Amplifying factors:
  - Limited availability of Sharī`ah-compliant liquidity instruments
  - Limited use of financial derivatives to hedge risks due to Sharī`ah constraints
  - Legal, tax, regulatory, and supervisory frameworks often developed for conventional banks
  - Financial safety nets and central bank liquidity frameworks may be absent or not tailored to Islamic banking characteristics

### Overview and intent of the CPIFR
- CPIFR aims to provide a set of core principles for regulation and supervision of the Islamic banking industry, taking into account Sharī`ah requirements and the underpinning by real economic activities.
- Sharī`ah prohibits riba, products with excessive uncertainty (gharar), gambling (maysir), short-sales, and financing of prohibited activities deemed harmful to society.
- CPIFR largely reflects the order of the Basel Core Principles on Effective Banking Supervision (BCP) and contains five additional principles specific to Islamic banking operations.
- CPIFR is intended to complement the international architecture for financial stability and provide incentives for improving prudential frameworks for Islamic banking across jurisdictions.
- The approach to regulating and supervising IBs needs to reflect:
  - The nature of risks to which IBs are exposed.
  - The financial infrastructure needed for effective regulation and supervision, which may require additional or different regulatory and supervisory practices.

### Application and implementation considerations
- CPIFR will be used in assessments for:
  - Fully Islamic banking systems (CPIFR).
  - Dual banking systems (BCP plus the five CPIFR-specific principles).
- The paper notes that many regulatory and supervisory authorities, including those new to IB regulation, face challenges identifying and applying appropriate principles and benchmarks to address gaps in existing structures and policies.

### Box 1 — Key principles governing Islamic banking
- Principle of equity:
  - Rationale for the prohibition of predetermined payments (riba) to protect weaker contracting parties.
  - Definition: riba means “hump” or “elevation”; an increase in wealth not related to engaging in a productive activity.
  - Basis for prohibiting excessive uncertainty (gharar); moral duty to disclose known information.
- Principle of participation:
  - Return on capital must be earned via participation in productive activity; return legitimized by risk taking and determined ex post based on asset performance.
  - Ensures link between financing activities and real activities.
- Principle of ownership:
  - Prohibitions such as “do not sell what you do not own” and restrictions on short-selling.
  - Islamic finance characterized as asset-based financing; preservation and respect for property rights and contractual obligations.

### Appendix I — The Islamic Financial Services Board (IFSB)
- Overview:
  - Based in Kuala Lumpur.
  - Officially inaugurated on November 3, 2002 and started operations on March 10, 2003.
  - The IMF is one of the founding members of the IFSB.
  - IFSB is an international standard-setting body promoting soundness and stability of the Islamic financial services industry (banking, capital market, insurance).
  - IFSB introduces new or adapts existing international standards to be consistent with Sharī`ah principles.
  - IFSB’s work complements BCBS, IOSCO, and IAIS.
- Membership and Governance:
  - As at December 2017, members comprise 75 regulatory and supervisory authorities and 8 international intergovernmental organizations including the IMF, the World Bank, and the BIS.
  - Collectively, these members operate in 57 jurisdictions.
  - The Governor of the Central Bank of Kuwait is currently the Chairman of the IFSB Council.
  - The Council consists of governors from 23 countries.
- Observer Members and Participation:
  - There are currently 102 market players who are observer members.
  - Observer members can participate in IFSB awareness programs on priority basis and at special members’ rates.
  - Observer members are not involved in the formulation of standards and receive complimentary copies of exposure drafts.
- Standards, Due Process, and Implementation Monitoring:
  - Since its inception, the IFSB has issued 27 Standards, Guiding Principles, and Technical Notes for the Islamic financial services industry.
  - Standards follow a lengthy due process involving exposure drafts and, where necessary, public hearings.
  - The IFSB Secretariat conducted a 2017 survey among RSA members on implementation status of selected standards (see Figure 1 in source document).

### Appendix VI excerpts — Selected CPIFR principles and methodology

- CPIFR 14: Treatment of Investment Account Holders (IAHs)
  - Supervisory authority determines treatment of IAHs (regulatory treatment, governance and disclosures, capital adequacy and associated risk-absorbency features).
  - Reference documents: IFSB-1, December 2005; IFSB-4, December 2009; IFSB-10, December 2009; GN-3, December 2010; GN-4, March 2011; IFSB-15, December 2013; IFSB-13, March 2012; and IFSB-16, March 2014.
  - Essential Criteria highlights:
    - Supervisory authority determines UIAH treatment options: (a) investors bearing all earnings volatility and losses (assets excluded from capital adequacy denominator), (b) treated as liability of IIFS, or (c) partially risk absorbent with “alpha” (α) factor inclusion in capital denominator.
    - Supervisory authority requires initial risk disclosures consistent with prudential treatment.
    - Supervisory authority requires IIFS to apply appropriate treatment in capital adequacy matters and internal models where permitted.
    - Supervisory authority determines management within mandate, disclosures, competence of IIFS as Muḍārib or Wakīl, formal fiduciary guidance, and handling of smoothing mechanisms (PER, IRR).
    - Prudential limits and review for real estate investments of UIAHs where permissible.
    - Stress testing must account for IAH-associated risks and DCR; governance involvement in scenario development.
    - Where capital treatment determined case-by-case, supervisory authority requires robust measurement methodology for DCR.
    - Requirements for continuing disclosures to IAHs, separate accounting for RIAHs, and alignment of prudential approach with contractual rights in insolvency.

- CPIFR 16: Sharī`ah Governance Framework
  - Supervisory authority determines IIFS have robust Sharī`ah governance commensurate with size, complexity, nature of business; sets general approach and key elements.
  - Reference documents: IFSB-10, December 2009; and IFSB-16, March 2014.
  - Essential Criteria highlights:
    - Laws/regulations require IIFS products and services comply with Sharī`ah rules and that governance, policies, and procedures are in place.
    - Institutions cannot represent themselves as “Islamic” without such governance structures.
    - Sharī`ah board must play strong independent oversight role with appropriate capability; process for resolving differences with BOD including possible shareholder access.
    - IIFS required to have clear terms of reference, operating procedures, and professional ethics for Sharī`ah boards; fit and proper criteria for key members.
    - Mechanisms for obtaining Sharī`ah rulings, applying Fatāwa, ex-ante and ex-post Sharī`ah review and reporting; access of Sharī`ah board to internal ISCU and ISRU.
  - Appendix IV to IFSB-10 excerpts (paras 12–15) on supervisory authority responsibilities:
    - Elements to be reflected: issuance procedures and dissemination of Sharī`ah pronouncements; internal Sharī`ah compliance review/audit; annual Sharī`ah compliance review/audit.
    - Continuous professional development for Sharī`ah board, ISCU, ISRU; training policies.
    - Formal assessment of Sharī`ah board effectiveness and individual contribution; BOD to adopt assessment process.
    - Supervisory authority power to have full access to Sharī`ah board, staff, records, internal and external Sharī`ah audits.

- CPIFR 24: Equity Investment Risk
  - Supervisory authority ensures policies, procedures, strategies, risk management, reporting for equity investment risk (Muḍārabah and Mushārakah in banking book); consistent valuation methodologies; exit strategies; sufficient capital.
  - Reference documents: IFSB-1, December 2005; IFSB-4, December 2009; IFSB-15, December 2013; IFSB-13, March 2012; and IFSB-16, March 2014.
  - Essential Criteria highlights:
    - IIFS define objectives and criteria for profit-sharing investments, risk tolerance, expected returns, holding periods.
    - Policies, procedures, management structure for evaluating and managing acquisition, holding, exit risks; infrastructure to monitor investee performance.
    - Appropriate and consistent valuation methodologies; assessment of potential manipulation of reported results.
    - General criteria for exit strategies for Mushārakah and Muḍārabah; rules/guidelines for nonperforming equity investments and provisioning.
    - Regular review and updating of Mushārakah and Muḍārabah policies, and stress testing specifications.

- CPIFR 26: Rate-of-Return (ROR) Risk
  - Supervisory authority ensures IIFS have systems to identify, measure, evaluate, monitor, report, and control/mitigate ROR risk in the banking book; assesses capacity to manage ROR risk and resultant DCR; obtains information on IAH behavioral and maturity profiles.
  - Reference documents: IFSB-1, December 2005; GN-3, December 2010; GN-4, March 2011; and IFSB-16, March 2014.
  - Essential Criteria highlights:
    - Requirement for IIFS to have ROR strategy and management framework consistent with risk appetite, profile, systemic importance, and market/macro conditions.
    - Board approval and regular review of ROR strategy, policies, processes; senior management implementation.
    - Supervisory assessment of IIFS capacity to manage ROR; collection of information on IAH behavioral and maturity profiles; framework where supervisory authority states expected rate of return to UIAH.
    - Identification and measurement systems for ROR factors across currencies and jurisdictions.
    - Consideration of ROR risk in business/product strategy setting.
    - Policies/processes for controlled ROR environment: measurement systems, model validation, limits approval, exception tracking, information systems for monitoring and reporting.
    - Supervisory information requirements on benchmark rate risk, maturities, currencies, off-balance-sheet items, and behavioral maturity distinctions.
    - Requirement for frameworks to manage DCR, including PER balances judgment and stress testing scenarios for adverse benchmark rate movements.
  - Additional Criteria:
    - Supervisory authority obtains results of internal ROR measurement systems expressed in threat to economic value, including standardized benchmark rate shocks.
    - Assessment of adequacy of internal measurement systems to capture benchmark rate risks.

- CPIFR 32: Islamic “Windows” Operations
  - Supervisory authorities define permitted forms of Islamic “windows” and review operations within supervisory review processes; ensure internal systems, risk management, segregation, and adequate disclosures.
  - Reference documents: IFSB-4, December 2009; IFSB-10, December 2009; IFSB-15, December 2013; and IFSB-16, March 2014.
  - Essential Criteria highlights:
    - Laws/regulations define permitted Islamic window forms; distinctions between self-contained/full windows and asset-side only windows.
    - Minimum funding from the conventional parent required for Islamic windows as per jurisdictional laws/regulations.
    - Transparent separation of Islamic assets/funds from non-Sharī`ah-compliant assets/funds to prevent channeling back to conventional parent.
    - Institutions offering windows must have systems to ensure Sharī`ah compliance and appropriate risk management.
    - Windows required to apply Sharī`ah governance arrangements comparable to full IIFS or have clear supervisory reasons for variations.
    - Supervisory capital assessment to account for Sharī`ah-compliant assets and risk-bearing nature of funds; IFSB’s Revised Capital Adequacy Standard provides a measurement approach.
    - Supervisory understanding of capital and liquidity provisioning to windows and loss absorption mechanisms.
    - Liquidity risk management evaluation at group/parent and Islamic entity level where conventional bank offers windows.
    - Disclosure requirements: sources of funds for liquidity deficits, capital-adequacy-related disclosures, risk management and governance, appointment of competent Sharī`ah scholar/board, Sharī`ah compliance report.
    - Prudential approach to windows should reflect understanding of treatment in liquidation/insolvency and contractual rights of clients including UIAHs.
    - Criteria for conversion of windows into Islamic banking subsidiaries, if policy exists, should be clearly specified and grounded in legal/regulatory framework.

*Source: EXECUTIVE SUMMARY and selected excerpts from pp040618the-core-principles-for-islamic-finance-regulations (April 6, 2018).*

### EXECUTIVE SUMMARY

### EXECUTIVE SUMMARY

### Proposal and purpose
- Proposes incorporating the Core Principles for Islamic Finance Regulation (Banking Sector) (CPIFR) issued by the Islamic Financial Services Board (IFSB) as part of the standards used in assessing banking regulatory and supervisory regimes under the Financial Sector Assessment Program (FSAP) and the Reports on Observance of Standards and Codes (ROSCs).
- For jurisdictions with systemically significant Islamic banking sectors:
  - Use CPIFR for fully Islamic banking systems.
  - Use BCP and the five additional CPIFR principles for dual banking systems.
- Fund staff is seeking the endorsement of the Executive Board on this proposal.
- Paper submitted to the World Bank Board for information purposes; IMF staff seeks IMF Board endorsement to use the CPIFR to supplement BCP assessments where Islamic banking is systemically significant based on the 15 percent threshold proposed in the paper.

### Key statistics and scope
- Global Islamic financial assets have reached about US$2 trillion, with the banking sector accounting for about 85 percent of the total assets.
- Islamic banking exists in more than 60 countries.
- The industry has become systemically important in 13 jurisdictions.
- The domestic market share of Islamic banks increased in 18 countries in 2016.
- CPIFR includes five additional principles specific to Islamic banking operations.
- Executive Board decision referenced: February 3, 2017.

### Rationale: opportunities from Islamic finance
- Islamic finance can deepen financial markets and inclusion by offering new modes of finance and attracting “unbanked” populations.
- Products and services can facilitate the “bailing-in” of stakeholders (for example, investment account holders who bear losses on their invested capital) in bank resolution.
- Islamic finance emphasizes risk-sharing, strengthening the link between finance and the real economy.
- The industry’s potential contribution to the United Nation's sustainable development financing goals (SDGs) may support further progress.

### Distinct risks and regulatory challenges
- Islamic banks (IBs) generate distinct operations with risk profiles and balance sheet structures different from conventional banks, with implications for financial stability.
- Key unique risks include:
  - Equity investment risk
  - Displaced commercial risk
  - Rate-of-return (ROR) risk
  - Sharī`ah non-compliance risk
- Traditional risks that can be amplified in IBs:
  - Credit risk
  - Concentration risk
  - Liquidity risk
- Amplifying factors:
  - Limited availability of Sharī`ah-compliant liquidity instruments
  - Limited use of financial derivatives to hedge risks due to Sharī`ah constraints
  - Legal, tax, regulatory, and supervisory frameworks often developed for conventional banks
  - Financial safety nets and central bank liquidity frameworks may be absent or not tailored to Islamic banking characteristics

### Overview and intent of the CPIFR
- CPIFR aims to provide a set of core principles for regulation and supervision of the Islamic banking industry, taking into account Sharī`ah requirements and the underpinning by real economic activities.
- Sharī`ah prohibits riba, products with excessive uncertainty (gharar), gambling (maysir), short-sales, and financing of prohibited activities deemed harmful to society.
- CPIFR largely reflects the order of the Basel Core Principles on Effective Banking Supervision (BCP) and contains five additional principles specific to Islamic banking operations.
- CPIFR is intended to complement the international architecture for financial stability and provide incentives for improving prudential frameworks for Islamic banking across jurisdictions.
- The approach to regulating and supervising IBs needs to reflect:
  - The nature of risks to which IBs are exposed.
  - The financial infrastructure needed for effective regulation and supervision, which may require additional or different regulatory and supervisory practices.

### Application and implementation considerations
- CPIFR will be used in assessments for:
  - Fully Islamic banking systems (CPIFR).
  - Dual banking systems (BCP plus the five CPIFR-specific principles).
- The paper notes that many regulatory and supervisory authorities, including those new to IB regulation, face challenges identifying and applying appropriate principles and benchmarks to address gaps in existing structures and policies.

*Source: EXECUTIVE SUMMARY of pp040618the-core-principles-for-islamic-finance-regulations (April 6, 2018).*

### Box 1. Islamic Finance—Key Principles Governing Islamic Banking

### Box 1. Islamic Finance—Key Principles Governing Islamic Banking

### Principle of equity
- Rationale for the prohibition of predetermined payments (riba), with a view to protecting the weaker contracting party in a financial transaction and promoting fair treatment.
- Definition: The term riba, which means “hump” or “elevation” in Arabic, is an increase in wealth that is not related to engaging in a productive activity.
- The principle of equity is also the basis for prohibiting excessive uncertainty (gharar) as manifested by contract ambiguity or elusiveness of payoff.
- Moral duty: Transacting parties have a moral duty to disclose known information before engaging in a contract, thereby reducing information asymmetry; otherwise, the presence of gharar would nullify the contract.

### Principle of participation
- Although commonly known as interest-free financing, the prohibition of riba does not imply that capital is not to be rewarded.
- Investment return must be earned in tandem with participation in the productive activity and not with the mere passage of time; this is also the basis of prohibiting riba.
- Return on capital is legitimized by risk taking and determined ex post based on asset performance or project productivity, thereby ensuring a link between financing activities and real activities.
- The principle of participation lies at the heart of Islamic finance, ensuring that increases in wealth accrue from productive activities.

### Principle of ownership
- Rulings such as “do not sell what you do not own” (for example, short-selling) and “you cannot be dispossessed of a property except on the basis of right” mandate asset ownership before transacting.
- Islamic finance is characterized as asset-based financing, forging a robust link between finance and the real economy.
- Requires preservation and respect for property rights, as well as upholding contractual obligations by underscoring the sanctity of contracts.

*Source: Box 1. Islamic Finance—Key Principles Governing Islamic Banking*

### Appendix I. The Islamic Financial Services Board

### Appendix I. The Islamic Financial Services Board

### Overview
- The Islamic Financial Services Board (IFSB) is based in Kuala Lumpur.
- Officially inaugurated on November 3, 2002 and started operations on March 10, 2003.
- The IMF is one of the founding members of the IFSB.
- The IFSB serves as an international standard-setting body of regulatory and supervisory agencies that promotes the soundness and stability of the Islamic financial services industry, which includes banking, capital market, and insurance.
- The IFSB promotes the development of a prudent and transparent Islamic financial services industry by introducing new or adapting existing international standards to be consistent with Sharī`ah principles and recommends them for adoption.
- The IFSB’s work complements that of the BCBS, the IOSCO, and the IAIS.

### Membership and Governance
- As at December 2017, the members of the IFSB comprise 75 regulatory and supervisory authorities and 8 international intergovernmental organizations including the IMF, the World Bank, and the BIS.
- Collectively, these members operate in 57 jurisdictions.
- The Governor of the Central Bank of Kuwait is currently the Chairman of the IFSB Council.
- The Council consists of governors from 23 countries.

### Observer Members and Participation
- There are currently 102 market players (e.g., financial institutions, professional firms, industry associations, and stock exchanges) who are observer members.
- Observer members can participate in IFSB awareness programs on priority basis and at special members’ rates.
- Observer members are not involved in the formulation of standards and receive complimentary copies of exposure drafts.

### Standards, Due Process, and Implementation Monitoring
- Since its inception, the IFSB has issued 27 Standards, Guiding Principles, and Technical Notes for the Islamic financial services industry.
- The standards prepared by the IFSB follow a lengthy due process which involves, among others, the issuance of exposure drafts that are posted on the website of the IFSB and, where necessary, the holding of a public hearing.
- The IFSB Secretariat conducted a survey among its members that are regulatory and supervisory authorities (RSA) about the implementation status of selected IFSB standards in 2017; the result is indicated in Figure 1 of the source document.

*Source: Appendix I. The Islamic Financial Services Board (content reproduced from the supplied IMF document).*

### Appendix VI. Summary of the Unique CPIFR and the

### Appendix VI. Summary of the Unique CPIFR and the Corresponding Methodology

### CPIFR 14: Treatment of Investment Account Holders (IAHs)
- The supervisory authority determines how IAHs are treated in its jurisdiction. The supervisory authority also determines the various implications (including the regulatory treatment, governance and disclosures, and capital adequacy and associated risk-absorbency features, etc.) relating to IAHs within its jurisdiction.
- Reference documents: IFSB-1, December 2005; IFSB-4, December 2009; IFSB-10, December 2009; GN-3, December 2010; GN-4, March 2011; IFSB-15, December 2013; IFSB-13, March 2012; and IFSB-16, March 2014.

Essential Criteria
- 1. The supervisory authority determines, from a prudential perspective, how UIAHs are treated by the IIFS in the jurisdiction. In this respect, UIAHs are treated in any one of the following ways:
  - (a) As investors who bear all the earnings volatility and risks of losses on their investment accounts (absent misconduct or negligence on the part of the IIFS). In such cases, the (credit and market risk-weighted) assets financed by the funds of the UIAH are excluded from the denominator of the standard capital adequacy formula;
  - (b) As a liability of the IIFS, which therefore bears the risk of the assets funded by UIAHs; or
  - (c) As partially risk absorbent so that the IIFS bears part of the earnings volatility of the assets funded by the UIAH. In such a case, IIFS include a corresponding proportion (known as “alpha” (α) factor) of the credit and market risk-weighted assets financed by UIAH in the denominator of the standard capital adequacy formula.
  - Notes: In the opinion of the Sharī`ah board of the IsDB, approach (b) is not Sharī`ah-compliant. Whether the IIFS engages in practices designed to smooth returns or principal risk to IAH will be evidence as to whether the IAH are being treated as risk absorbent. Such smoothing practices are not normally employed in the case of restricted IAH (RIAH), but where they are, RIAH should be treated for capital adequacy purposes similarly to UIAH. In addition to determining whether smoothing arrangements exist, the supervisory authority may take into account whether the IIFS may come under market pressure to increase returns to avoid investors withdrawing their funds (DCR).
- 2. The supervisory authority requires that initial risk disclosures to IAHs are consistent with the prudential treatment of their accounts.
- 3. The supervisory authority requires IIFS to apply the appropriate treatment of IIFS in all capital adequacy matters, including their own determinations of their capital needs, and internal models where these are permitted for capital adequacy purposes.
- 4. The supervisory authority determines that investment accounts are managed by the IIFS within the parameters of the given mandate, including all requirements as written in the contractual agreement between the IIFS as Muḍārib or Wakīl and the IAHs, and any declared policies for the use of smoothing mechanisms such as a profit equalization reserve (PER) or investment risk reserve (IRR). The supervisory authority also determines that IAHs are adequately advised by the IIFS of their contractual rights and risks in regard to investment account products, including primary investment and asset allocation strategies and the method of calculating the profit/loss made from their investments.
- 5. The supervisory authority determines that an IIFS, when managing the investments of the IAHs, clearly displays the level of competence necessary to fulfil its fiduciary duties as Muḍārib or Wakīl and that adequate policies and procedures are in place.
- 6. The supervisory authority prescribes formal guidance for IIFS to ensure they fulfil their fiduciary duties towards their IAHs (whether UIAHs or RIAHs).
- 7. The supervisory authority determines that IIFS clearly indicate the existence of various practices of smoothing the profit payout to IAHs that are employed, due to various internal and regulatory considerations, to mitigate the risk of withdrawal of funds by IAH (withdrawal risk). Where supervisory authorities have approved various techniques of smoothing in their respective jurisdictions, they provide a policy (or written guideline) to IIFS with respect to these practices, with particular reference to the criteria or procedures used by them to assess an IIFS’ exposure to DCR in assessing the IIFS’s capital adequacy.
  - Note: GN-3 gives examples of smoothing practices used by IIFS.
- 8. In jurisdictions where real estate investment is permissible, supervisory authorities provide prudential limits on the percentage of UIAHs’ funds that may be invested in real estate and a limit to single exposures within the jurisdiction. In this respect, the supervisory authority reviews IIFS’ operations to ensure that they have adequate resources and capabilities for undertaking real estate investment activities through UIAHs’ funds.
  - Note: Some supervisory authorities adopt a combined approach in limiting the risks to which the IIFS or its IAHs are exposed through restricting the total amount of exposures in the sector, restricting the usage of unrestricted investment accounts, or applying specific risk weights for this investment.
- 9. The supervisory authority determines that stress testing conducted by the IIFS takes account of the risks associated with investment accounts and the position of IAHs as providers of risk-absorbent funds. The supervisory authority also determines that the Governance Committee (or equivalent) is actively involved in the development of the scenarios with respect to IAHs, particularly in the context of unrestricted PSIA.
  - Note: See IFSB-13, and in particular the narrative to Principle 3.10.
- 10. Where the supervisory authority determines the capital adequacy treatment of IAH on a case-by-case basis, rather than for all IIFS in its jurisdiction, it requires IIFS to implement a sound and robust measurement methodology for DCR based on adequate and reliable data. The supervisory authority also assesses and evaluates the reliability and accuracy of the methodology as a basis for measuring the proportion of the risk that is effectively borne by IIFS in the form of DCR.
- 11. The supervisory authority determines that IIFS provide timely and relevant continuing disclosures to IAHs (including profit calculation and distribution, and investment strategies and risk exposures).
- 12. The supervisory authority determines that an IIFS maintains separate accounts in respect of the IIFS’s operations undertaken for RIAHs and ensures proper maintenance of records for all transactions in investments.
- 13. The supervisory authority’s approach to IAHs, including its prudential approach, is in accordance with the authority’s best understanding of the contractual rights of the parties, including UIAHs, according to applicable law during the insolvency or liquidation of the IIFS.

### CPIFR 16: Sharī`ah Governance Framework
- The supervisory authority determines that IIFS have a robust Sharī`ah governance system in order to ensure an effective independent oversight of Sharī`ah compliance over various structures and processes within the organizational framework. The Sharī`ah governance structure adopted by an IIFS is commensurate and proportionate with the size, complexity and nature of its business. The supervisory authority also determines the general approach to Sharī`ah governance in its jurisdiction and lays down key elements of the process.
- Reference documents: IFSB-10, December 2009; and IFSB-16, March 2014.
  - Note: The IFSB’s guiding principles on Sharī`ah governance (IFSB-10) acknowledge that there are various Sharī`ah governance structures and models adopted in different jurisdictions where IIFS are present, suggesting no “single model” or “one-size-fits-all” approach.

Essential Criteria
- 1. Laws, regulations, or the supervisory authority determine that the IIFS are under an obligation to ensure that their products and services comply with Sharī`ah rules and principles. The supervisory authority further determines that in all aspects of IIFS operations—including products and services—a governance structure, policies, and procedures exist to ensure that the Sharī`ah rules and principles are adhered to at all times.
- 2. Laws, regulations, or the supervisory authority ensure that a financial institution is not allowed to represent itself as “Islamic,” either expressly or by implication, without having such a governance structure, policies, and procedures.
- 3. The supervisory authority determines that the Sharī`ah board of an IIFS plays a strong and independent oversight role, with adequate capability to exercise objective judgment on Sharī`ah-related matters. The supervisory authority also determines that IIFS has in place an appropriate and transparent process for resolving any differences of opinion between the BOD and the Sharī`ah board. This process may include having direct access (after duly informing the supervisory authority) to the shareholders as a “whistle-blower.”
  - Note: In some jurisdictions the supervisory authority may be involved in this process of resolving differences without compromising the binding nature of the pronouncements/resolutions of the Sharī`ah board.
- 4. The supervisory authority requires that each IIFS has a properly functioning Sharī`ah governance system in place, which clearly demonstrates, among other things:
  - (a) clear terms of reference regarding the Sharī`ah board’s mandate, reporting line and responsibility;
  - (b) well-defined operating procedures and lines of reporting; and
  - (c) good understanding of, and familiarity with, professional ethics and conduct.
  - Note: A reference to Sharī`ah board in this essential criterion includes clear terms of reference for a Sharī`ah adviser reporting to a national Sharī`ah Council (where one exists), and to firms that are allowed to use the services of an external Sharī`ah consultancy, in their jurisdictions.
- 5. The supervisory authority determines that an IIFS ensures that the key members of its Sharī`ah governance system fulfil acceptable “fit and proper” criteria.
- 6. The supervisory authority determines that IIFS comply at all times with the Sharī`ah rules and principles as determined by the relevant body in the jurisdiction in which they operate with respect to their products and activities.
- 7. The supervisory authority requires IIFS to have in place an appropriate mechanism for obtaining rulings from Sharī`ah scholars, applying Fatāwa (i.e., Sharī`ah pronouncements/resolutions), and monitoring Sharī`ah compliance in all aspects of their business operations.
- 8. The supervisory authority determines the requirement and criteria for the establishment of a Sharī`ah board or equivalent body in an IIFS’ governance structure. The supervisory authority also determines that the qualifications of the members of the Sharī`ah board are subject to review, and makes available evaluation criteria for the assessment of the qualifications and reporting responsibilities of the Sharī`ah board.
- 9. The supervisory authority determines that the Sharī`ah board or comparable body is provided with complete, adequate, and timely information prior to all meetings and on an ongoing basis on any product or transaction on which a pronouncement is sought, including having its attention drawn to any areas of possible difficulty identified by the IIFS’ management. The management of an IIFS has an obligation to supply the Sharī`ah board with complete, accurate, and adequate information in a timely manner. The supervisory authority also determines that the Sharī`ah board has free access to the company’s senior management for all the information it needs.
- 10. The supervisory authority requires an IIFS’ Sharī`ah governance system to cover the relevant ex-ante and ex-post processes. Ex-ante processes cover those for: (a) the issuance of Sharī`ah pronouncements/resolutions; and (b) compliance checks before the product is offered to the customers. Ex-post processes cover internal and external Sharī`ah review and Sharī`ah governance reporting. The supervisory authority also determines that IIFS engage appropriate experts, including a Sharī`ah adviser or Sharī`ah board, to review and ensure that new financing proposals that have not been proposed before or amendments to existing contracts are Sharī`ah-compliant at all times.
  - Note: The supervisory authority determines that the IIFS’ Sharī`ah board has free access to the internal Sharī`ah compliance unit/department (ISCU) and internal Sharī`ah review/audit unit/department (ISRU), respectively, to check whether internal control and compliance procedures have been...

*Appendix VI. Summary of the Unique CPIFR and the Corresponding Methodology (excerpts).*

### Appendix IV to IFSB-10 gives examples of competence criteria for members of a Sharī`ah board.

### Appendix IV to IFSB-10 — Examples of competence criteria for members of a Sharī`ah board (excerpts)

### Sharī`ah governance: supervisory authority responsibilities (paras 12–15)
- 12. The supervisory authority determines that the following elements in the Sharī`ah governance mechanism have been reflected by IIFS:
  - (a) issuance procedures of relevant Sharī`ah pronouncements/resolutions and dissemination of information on such Sharī`ah pronouncements/resolutions to the operative personnel of the IIFS who monitor day-to-day compliance with the Sharī`ah pronouncements/resolutions;
  - (b) an internal Sharī`ah compliance review/audit for verifying that Sharī`ah compliance has been achieved; and
  - (c) an annual Sharī`ah compliance review/audit for verifying that the internal Sharī`ah compliance review/audit has been appropriately carried out and its findings have been duly noted by the Sharī`ah board.
- 13. The supervisory authority determines that an IIFS facilitates continuous professional development of persons serving on its Sharī`ah board, as well as its ISCU and ISRU, if any. The supervisory authority also determines that training policies are established with adequate consideration given to training needs to ensure compliance with the IIFS’s operational and internal control policies and procedures, and all applicable legal and regulatory requirements to which the IIFS generally, and members of the Sharī`ah board and internal Sharī`ah officers particularly, are subject.
- 14. The supervisory authority determines that there is a formal assessment of the effectiveness of an IIFS’s Sharī`ah board as a whole and of the contribution by each member to the effectiveness of the Sharī`ah board. The supervisory authority also determines that an IIFS’ BOD specifies and adopts a process for assessing the effectiveness of the Sharī`ah board as a whole, as well as the contribution by each individual member to its effectiveness. The criteria for this assessment should be established by the BOD in consultation with the SSB. The performance assessment report is submitted to the BOD for its review.
- 15. The supervisory authority has the power to have full access to the Sharī`ah board and relevant staff and records in order to monitor compliance with relevant laws and regulations, and internal compliance with the pronouncements/resolutions of the Sharī`ah board. This includes access to both internal and external Sharī`ah audits, and to the assessment of the effectiveness of the Sharī`ah board.
- Note: Footnotes reference juristic opinion, fit and proper criteria, and IFSB-10 paragraphs 3–6.

*Source: Appendix IV to IFSB-10 excerpts in the supplied content.*

### CPIFR 24: Equity Investment Risk — supervisory expectations and Essential Criteria
- Overview:
  - Supervisory authority ensures adequate policies and procedures including appropriate strategies, risk management, and reporting processes for equity investment risk management, including Muḍārabah and Mushārakah investments in the banking book (i.e., financing on a profit-and-loss sharing basis).
  - Supervisory authority ensures IIFS have consistent valuation methodologies; define and establish exit strategies; and have sufficient capital when engaging in equity investment activities.
  - Reference documents: IFSB-1, December 2005; IFSB-4, December 2009; IFSB-15, December 2013; IFSB-13, March 2012; and IFSB-16, March 2014.
- Essential Criteria (numbered as in source):
  - 1. Laws, regulations, or the supervisory authority determine that the IIFS define and set the objectives of—and criteria for—investments using profit-sharing instruments (e.g., Muḍārabah and Mushārakah investments in the banking book), including the types of investment, tolerance for risk, expected returns and desired holding periods.
  - 2. The supervisory authority determines that the IIFS have—and keep under review—policies, procedures, and an appropriate management structure for evaluating and managing the risks involved in the acquisition of, holding, and exiting from profit-sharing investments. The supervisory authority ensures that proper infrastructure and capacity are in place to monitor continuously the performance and operations of the entity in which IIFS invest as partners.
  - 3. The supervisory authority determines that an IIFS ensures that its valuation methodologies are appropriate and consistent, and that it assesses the potential impacts of its methods (mutually agreed between the IIFS and the Muḍārib and/or Mushārakah partners) on profit calculations and allocations, taking into account market practices and liquidity features. The supervisory authority also determines that the IIFS assesses and takes measures to deal with the risks associated with potential manipulation of reported results leading to overstatements or understatements of partnership earnings.
  - 4. The supervisory authority determines that an IIFS defines and establishes general criteria for exit strategies in respect of its equity investment activities, including extension and redemption conditions with the mutual consent of the parties for Muḍārabah and Mushārakah investments, alternative exit routes, and the timing of exit.
  - 5. The supervisory authority sets rules or guidelines for measuring, managing, and reporting the risk exposures when dealing with nonperforming equity investments and providing provisions.
  - 6. The supervisory authority determines that there is a systematic process for regularly reviewing and updating the Mushārakah and Muḍārabah policies, processes, and limits to take into account the risk appetite of the IIFS and changes that take place in the IFSI.
  - 7. The supervisory authority determines that appropriate policies and procedures on stress testing for Mushārakah- and Muḍārabah-related exposures are clearly specified by the IIFS.
- Notes and examples:
  - Footnote 17: Risks for trading or liquidity equity instruments are dealt with under market risk in CPIFR 25.
  - Footnote 18: Example of Mushārakah with a redemption option (diminishing Mushārakah).
  - Footnote 19: Due diligence importance when investing as a partner via Muḍārabah or Mushārakah, including IAH fiduciary responsibilities.
  - Footnote 20: Valuation and accounting methods for privately held entities; mutually agreed methods such as a percentage of gross or net profit; fair value for changing partnership shares.

### CPIFR 26: Rate-of-Return (ROR) Risk — supervisory expectations, Essential and Additional Criteria
- Overview:
  - Supervisory authority determines IIFS have adequate systems to identify, measure, evaluate, monitor, report, and control or mitigate rate-of-return risk in the banking book on a timely basis, taking into account IIFS’ risk appetite, risk profile, and market and macroeconomic conditions. Supervisory authority assesses capacity to manage ROR risk and any resultant DCR, and obtains sufficient information to assess IAHs’ behavioral and maturity profiles.
  - Reference documents: IFSB-1, December 2005; GN-3, December 2010; GN-4, March 2011; and IFSB-16, March 2014.
- Essential Criteria (numbered as in source):
  - 1. Laws, regulations, or the supervisory authority require IIFS to have an appropriate ROR risk strategy and ROR management framework that provides a comprehensive IIFS-wide view of ROR risk. This includes policies and processes to identify, measure, evaluate, monitor, report and control or mitigate material sources of ROR. The supervisory authority determines that the IIFS’ strategy, policies, and processes are consistent with the risk appetite, risk profile, and systemic importance of the IIFS; take into account market and macroeconomic conditions; and are regularly reviewed and appropriately adjusted, where necessary, with the IIFS’ changing risk profile and market developments.
  - 2. The supervisory authority determines that an IIFS’s strategy, policies, and processes for the management of ROR have been approved—and are regularly reviewed—by the IIFS’ board. The supervisory authority also determines that senior management ensures that the strategy, policies and processes are developed and implemented effectively.
  - 3. The supervisory authority assesses the capacity of IIFS to manage ROR risk. The supervisory authority obtains sufficient information to assess the IAHs’ behavioral and maturity profiles, and to satisfy itself as to the adequacy and quality of IIFSs’ policies and procedures regarding the management of ROR risk. Where the supervisory authority has a policy of stating an expected rate of return to UIAH, the supervisory authority establishes a framework within which this is to be undertaken by the IIFS operating in its jurisdiction. The framework may include, among other methods, applicable periods and recognizable income and expenses, and other calculation bases relating to the use of funds. This framework should assist the supervisory authority to assess the efficiency of IIFS in terms of their profitability and prudent management.
  - 4. The supervisory authority determines that IIFS are aware of the factors that give rise to ROR risk, and that they have in place appropriate systems for identifying and measuring the factors which give rise to ROR risk. In assessing whether a potential threat is likely to have a material, likely, and imminent impact on a balance sheet position, IIFS will ensure that they understand the different characteristics of their balance sheet positions in the different currencies and jurisdictions within which they operate.
    - Footnote 22: ROR risk in the banking book is an analogue of interest rate risk; arises from impact of changes in market rates and relevant benchmark rates on returns on assets and returns payable on funding; differs because of profit-sharing with IAH and can lead to DCR if IIFS absorbs shortfalls by reducing Muḍārib share or donation from shareholders’ share of income.
    - Footnote 23: Primary ROR risk form is increasing long-term fixed rates in the market; profit rates on assets reflect previous-period benchmark and do not immediately correspond to increased benchmark rates.
    - Footnote 24: Example re early repayment and rebates in Murābahah or Ijārah transactions across jurisdictions.
  - 5. The supervisory authority ensures that IIFS consider ROR risk when setting and reviewing business and product strategies, and assess its impact on their balance sheet structure.
  - 6. The supervisory authority determines that IIFS’ policies and processes establish an appropriate and properly controlled ROR environment, including:
    - a. comprehensive and appropriate ROR measurement systems;
    - b. regular review and independent (internal or external) validation of any models used by the functions tasked with managing ROR (including review of key model assumptions);
    - c. appropriate limits, approved by the IIFS’ boards and senior management, that reflect the IIFS’ risk appetite, risk profile, and capital strength, and which are understood by, and regularly communicated to, relevant staff;
    - d. effective exception tracking and reporting processes that ensure prompt action at the appropriate level of the IIFS’ senior management or boards where necessary; and
    - e. effective information systems for accurate and timely identification, aggregation, monitoring, and reporting of ROR exposure to the IIFS’ boards and senior management.
  - 7. The supervisory authority obtains from IIFS sufficient and timely information with which to evaluate their level of benchmark rate risk. This information should take appropriate account of the range of maturities and currencies in each IIFS’ portfolio, including off-balance sheet items, as well as other relevant factors, such as the distinction between fixed-rate and variable-rate Sharī`ah-compliant contracts. Supervisory authorities collect additional information from IIFS on those positions where the behavioral maturity is different from the contractual maturity.
  - 8. The supervisory authority requires IIFS to have in place an appropriate framework for managing DCR, where applicable. This requires the IIFS to have in place a policy and framework for managing the expectations of their shareholders and IAHs. Where market rates of return of competitors’ IAH are higher than those of the IIFS’ IAH, the IIFS will evaluate the nature and extent of the expectations of their IAHs and assess the amount of the gap between competitors’ rates and its own IAHs’ expected rates. In this context, IIFS need to develop and maintain an informed judgment about an appropriate level of the balances of PER (or an equivalent reserve maintained by the IIFS), bearing in mind that its essential function is to provide mitigation of DCR.
  - 9. The supervisory authority requires IIFS to include appropriate scenarios in their stress testing programs to measure their vulnerability to loss under adverse benchmark rate movements.
- Additional Criteria:
  - 1. The supervisory authority obtains from IIFS the results of their internal ROR measurement systems, expressed in terms of the threat to economic value, including using a standardized benchmark rate shock on the banking book.
  - 2. The supervisory authority should particularly assess whether the internal measurement systems of IIFS adequately capture the benchmark rate risks in their banking book.

### CPIFR 32: Islamic “Windows” Operations — supervisory definitions, prudential treatment, disclosures
- Overview:
  - Supervisory authorities define permitted forms of Islamic “windows” in their jurisdictions and review Islamic windows’ operations within their supervisory review process using existing supervisory tools. Where windows are present, supervisory authorities satisfy themselves that institutions offering such windows have internal systems, procedures, and controls to provide reasonable assurance that: (a) transactions and dealings of the windows are in compliance with Sharī`ah rules and principles; (b) appropriate risk management policies and practices are followed; (c) Islamic and non-Islamic business are properly segregated; and (d) the institution provides adequate disclosures for its window operations.
  - Reference documents: IFSB-4, December 2009; IFSB-10, December 2009; IFSB-15, December 2013; and IFSB-16, March 2014.
- Essential Criteria (numbered as in source):
  - 1. Laws, regulations, or the supervisory authority determine, with appropriate definitions, what forms of Islamic window operation are permitted to operate in the jurisdiction.
    - Footnote 25: Definition distinctions between (A) Islamic “window operation” as part of a conventional financial institution (self-contained/full windows) and (B) “asset-side only windows”; supervisory issues differ between types.
  - 2. The supervisory authority determines that an Islamic window has, both initially and on an ongoing basis, a minimum amount of funding from the conventional parent as required by the laws and regulations of the jurisdiction, including its capital adequacy and liquidity requirements.
  - 3. The supervisory authority determines that an institution with Islamic windows has a system such that the separation of Islamic assets and funds from non-Sharī`ah-compliant assets and funds is made transparent. The system should act both to prevent the window from investing in non-Sharī`ah-compliant assets, and from channeling investors’ funds back to the conventional parent entity.
    - Footnote 26: The window’s share of profits may be channeled back to the parent; losses of the parent should not lead to withdrawal of funds from the Islamic window.
  - 4. Supervisory authorities in jurisdictions where windows are present satisfy themselves that the institutions offering such windows have the internal systems, procedures, and controls to provide reasonable assurance that: (a) the transactions and dealings of the windows are in compliance with Sharī`ah rules and principles; and (b) appropriate risk management policies and practices are followed.
  - 5. The supervisory authority requires a window to apply Sharī`ah governance arrangements comparable to those of a full-fledged IIFS. If the supervisory authority permits any variation to those arrangements (in respect of the institution’s Islamic business), it should have clear reasons for doing so. In such cases, the supervisory authority should satisfy itself that pertinent Sharī`ah Fatāwa and resolutions are complied with by the financial institution’s management in their offering of Islamic financial services.
  - 6. The supervisory authority takes account of the Sharī`ah-compliant assets of the window, as well as the risk-bearing nature of the Sharī`ah-compliant funds that are invested in these assets, in assessing the capital adequacy of the conventional financial institution concerned. The IFSB’s Revised Capital Adequacy Standard provides a measurement approach that may be used for this purpose, although in general the overall capital regulatory requirement is embodied in the regulatory requirement at the main institutional (consolidated or parent) level, irrespective of whether the parent is in the same jurisdiction or in another jurisdiction.
    - Footnote 27: Clarification of “consolidation” for the principle on Islamic windows.
  - 7. The supervisory authority determines and understands the manner in which capital and liquidity are to be made available to Islamic windows, and how losses generated by the windows will eventually be absorbed.
  - 8. In cases where a conventional bank offers Islamic operations through Islamic windows, supervisory authorities fully evaluate the liquidity risk management framework at both the group/parent level and the Islamic entity level. The supervisory authority also determines that senior management of a conventional bank operating Islamic operations in the form of an Islamic window is aware of the differences, complexities, and constraints in managing liquidity in the Islamic operations vis-à-vis at the bank level.
    - Footnote 28: Normally, a dedicated funding line is made available from the head office treasury to meet any liquidity shortfalls in normal and stressed times, on a Sharī`ah-compliant basis.
  - 9. The supervisory authority requires the Islamic window to disclose information that is material in the sense that its omission or misstatement could influence a user relying on that information for the purpose of making economic and legitimate assessments or decisions in accordance with Sharī`ah requirements. The supervisory authority requires the institution to publish a full separate set of financial statements for its window operation either: in the notes to the financial statements of the conventional financial institution of which the window is a part; or separately, in readily accessible form. In particular, the supervisory authority requires the institution to disclose publicly, among other things:
    - sources of funds to cover a liquidity deficit of the window, if any;
    - capital-adequacy-related disclosures;
    - risk management and governance;
    - appointment of a competent Sharī`ah scholar or Sharī`ah board; and
    - a Sharī`ah compliance report covering, among other things, the mechanism established to provide Sharī`ah oversight of the activities of an Islamic window.
  - 10. The supervisory authority’s approach to a window, including its prudential approach, reflects its best understanding of how an Islamic window will be treated in liquidation or other insolvency, including the contractual rights of the window’s clients, including UIAHs, according to applicable law.
  - 11. If the supervisory authority has a policy requiring Islamic windows to be converted into Islamic banking subsidiaries, the criteria for requiring conversion are clearly specified (e.g., in terms of asset size of the window in absolute terms or as a percentage of the parent’s balance sheet, years of operation, etc.). Such criteria are clearly grounded in the overall legal and regulatory framework in the jurisdiction as well as its overall strategic plan for the Islamic banking industry, if any.

*Source: Excerpts from the supplied PDF chapter/section content.*

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_Source: https://www.imf.org/-/media/files/publications/pp/2018/pp040618the-core-principles-for-islamic-finance-regulations.pdf_