## ENSURING FINANCIAL STABILITY IN COUNTRIES WITH ISLAMIC BANKING

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### Executive summary: growth, distinct features, and policy needs
- Islamic banking (IB) continues to grow rapidly in size and complexity, operating in more than 60 countries and becoming systemically important in 14 jurisdictions.
- IB accounts for less than 2 percent of global finance; assets concentrated in the Middle East and South East Asia, with expansion to sub-Saharan Africa and Central Asia.
- Distinct IF principles (e.g., prohibition of Riba, Gharar, Maysir) create unique operations, balance sheet structures, and risk profiles requiring adaptations to international prudential and accounting standards, governance, AML/CFT, and the financial safety net.
- Progress achieved on prudential standards (including capital adequacy and the “Core Principles of Islamic Finance Regulation for Banking”), but gaps remain in resolution, financial safety net frameworks, and liquidity management.
- International guidance and active participation by authorities are needed to accelerate issuance of Sukuk and other liquid instruments and to address hybrid products, supervision, and Shari’ah-related legal and governance issues.
- Fund role: the Fund has facilitated establishment of the Islamic Financial Services Board (IFSB), engaged with standard setters, and proposes a more comprehensive policy framework to guide surveillance, program, and TA work.

### Key guiding principles of Islamic Finance and implications for operations
- Shari’ah prohibitions and requirements:
  - Ban on interest (Riba), excessive uncertainty (Gharar), gambling (Maysir), short-sales, and financing of prohibited activities.
  - Transactions must be underpinned by real economic activities, involve risk-sharing, honor fair treatment and sanctity of contracts.
  - Financial transactions are implemented as (a) sales of goods/services/benefits or (b) profit-and-loss sharing (PLS) arrangements, giving an “assets-backed” characteristic.
- IB balance sheet and funding:
  - IBs act as financial intermediaries but also as partners in property ownership, trading tangible assets, and providing equity financing.
  - Funding primarily from noninterest-bearing current accounts and profit-sharing investment accounts (PSIA).
  - Assets: sales with deferred payments, leases, PLS financing, and fee-based services.
- Risk management:
  - Emphasis on risk-sharing limits use of conventional hedging and derivatives.
  - Rate of return risk and displaced commercial risk arise from mismatch between asset returns and expectations of fund providers.

### Industry structure, scale, and key statistics
- Product mix and asset composition:
  - Financing items (sales and lease-based contracts) account for about 70 percent of total assets; Murabahah and Ijarah are the largest items.
  - PLS contracts account for about 5 percent of IBs’ aggregate assets overall, with cross-country differences:
    - Iran: Musharakah 29 percent.
    - Indonesia: Musharakah 63 percent.
    - Pakistan: Musharakah 11 percent.
    - Sudan: Musharakah 13 percent.
  - Mudarabah contracts average around 5 percent in Indonesia, Iran, and Sudan.
- Funding structure (end-2015):
  - PSIA estimated to account for 40 percent of IBs’ aggregate liabilities (29 percent deposits; 11 percent interbank placements (PLS contracts)).
  - Commodity “Murabaḥah” 14 percent (grown rapidly); current deposit accounts 12 percent.
- Cross-country variations:
  - In Indonesia, Iran, and Jordan the share of PSIA ranges between 53 and 70 percent.
  - Saudi Arabia: greater reliance on current deposit accounts.
  - Malaysia, Pakistan, and the U.A.E.: greater reliance on fixed term-like deposit structures.
- Survey and market data:
  - According to the 2016 IB survey, a domestic currency interbank commodity Murabahah market exists between IBs in 35 percent of respondent countries; maturities range from overnight to one year.
  - IMF survey: 40.9 percent of central banks in IB jurisdictions engage in regular liquidity operations with IBs; of these central banks, 27 percent issue their own securities and 24 percent use government securities or Sukuk in liquidity operations.
  - Most central banks apply reserve requirements to IBs (86 percent); only 27 percent remunerate reserve requirements for IBs.

### Innovations, hybrid products, and systemic concerns
- Innovations:
  - PER (profit equalization reserves) and IRR (investment risk reserves) act as countercyclical buffers funded by IAH rather than shareholders; survey: 11 responded countries have allowed PER and six allowed IRR.
- Commodity Murabahah:
  - Mechanism used for short-term liquidity and interbank funding; controversial but widely used given dearth of Islamic HQLA.
  - Risks: market risk, counterparty risk, liquidity mismatch, rate of return risk, operational risk; can enable significant leverage expansion.
- Hybrid products:
  - Replicate aspects of conventional finance (e.g., liability-side fixed returns), changing IB risk profiles and raising concerns about adequacy of prudential regimes, governance, consumer protection, and reputational risk.
- Concentration and procyclicality:
  - Concentration in real estate, trade, and commodity finance may create concentration risk and potentially make IBs more procyclical than conventional banks.

### Prudential standards, supervision, and governance of IAH
- Standards and adoption:
  - BCBS prudential standards broadly relevant; IFSB standards (including the 2015 CPIFR) provide IB-specific guidance and can be used for self-assessment.
  - "About 60 percent of countries surveyed in 2016 have modified their domestic frameworks to accommodate IB."
  - Mandated AAOIFI accounting standards: eight countries (Bahrain, Djibouti, Jordan, Kyrgyzstan, Oman, Palestine, Qatar, and Sudan).
  - AAOIFI allowed as second option: four countries (Afghanistan, Guinea, Luxembourg and Saudi Arabia).
  - Mandated IFSB standards: ten countries (Bahrain, Bosnia and Herzegovina, Djibouti, Guinea, Jordan, Kyrgyzstan, Palestine, Qatar, Saudi Arabia, and Sudan).
  - Partial incorporation of IFSB aspects: six countries (Afghanistan, Kazakhstan, Kuwait, Lebanon, Oman, and Pakistan).
- Governance of investment accounts and IAH protection:
  - IAH have right to value maximization but lack shareholders’ legal voting rights, creating potential divergence of interests.
  - Jurisdiction practices include disclosure of investment policies, establishment of governance committees (minimum membership: audit committee member, Shari’ah expert, non-executive Director), and recognition of IAH monitoring rights.
  - Gaps: impracticality and cost of providing ex-ante prospectus-like information to unrestricted PSIA holders; governance committee reports to Board, not directly to IAH; termination by IAH may be a suboptimal disciplining mechanism.
- Licensing, concentration limits, and capital treatment:
  - Licensing should include IB-specific requirements: business plan addressing PSIA management, capital composition as per IFSB, fit and proper criteria that consider Shari’ah familiarity, transparent governance and internal controls.
  - Concentration limits need modification to reflect IB direct investments in commodities, real assets, and property development; supervisors should require additional capital where exposures are excessive.
  - Capital adequacy:
    - IFSB capital adequacy ratio (CAR) provides two formulas: standard and supervisory discretion formula with parameter α (alpha) governing pass-through of IA risks.
    - Survey example practices: Malaysia does not require general assets financed by investment accounts to be converted into risk-weighted assets; Sudan and Kuwait require 50 percent; Bahrain and Jordan require 30 percent; Afghanistan 12 percent.
    - Displaced commercial risk (DCR) arises when banks forgo profit shares to IAH, effectively transferring losses to IB capital.

### Supervisory process, stress testing, and Shari’ah compliance
- Supervisory adaptations:
  - Supervisory review should be risk-based and incorporate CPIFR and IFSB “Risk Management” standards alongside BCPs.
  - Supervisors may adapt rating methodologies (e.g., CAMELS) and require IB-specific stress testing and ICAAP that capture reputational and Shari’ah compliance risks.
  - Cross-border and consolidated supervision complicated by diverse Shari’ah treatments and varying adoption of standards.
- Shari’ah compliance function:
  - Minimum supervisory requirement: ensure adequate Shari’ah compliance function exists without supervisors taking views on rulings’ merits.
  - Inadequate Shari’ah compliance can create consumer fraud, solvency and liquidity risk, and systemic risk if institutions are large and connected.
  - Supervisory policies on Shari’ah compliance are needed irrespective of legal recognition of Shari’ah.

### Resolution, deposit insurance, and financial safety net
- Resolution frameworks:
  - Legal and policy frameworks for resolving failed IBs are generally underdeveloped; very few jurisdictions have specialized IB resolution frameworks (exception: Malaysia’s Islamic Financial Services Act (Act 759) of 2013).
  - Key unresolved issues: applicability of conventional resolution powers and triggers; role of SSBs in resolution; legal/accounting inconsistencies complicating creditor hierarchies and cross-border resolution.
  - IFSB-15 allows certain Sukuk instruments as Tier 1/Tier 2, but SSB acceptance and legal certainty remain uncertain.
  - Recommended international actions: analytical work, harmonization of Shari’ah bankruptcy principles, and guidance on institutional arrangements and loss allocation mechanisms.
- Deposit insurance:
  - Design principles broadly apply but require adaptations for IB (definition/insurability of PSIA, priority of claims, role of fund in resolution, Shari’ah consistency).
  - Empirical status:
    - Full-fledged IDIS: one country (Sudan).
    - Dual DIS with IB premiums managed per IF principles: two countries (Bahrain and Malaysia).
    - Single scheme covering both systems with premiums in indivisible account: twelve countries.
  - Gaps: IFSB has not adopted a deposit insurance standard; uncertainty on PSIA treatment; liquidity needs for quick payouts conflict with dearth of IF liquid instruments.

### Liquidity management, money markets, and LOLR
- Liquidity instruments used by IBs (principal instruments noted):
  - Interbank Mudarabah Placements.
  - Commodity Murabahah (including Salam Sukuk variants).
  - Central Bank Wadiah Certificate/Deposit.
  - Central Bank Paper (Musharakah Certificates or Sukuk).
  - Government paper structured as Musharakah Certificates or Sukuk.
  - Islamic Repurchase Agreements or sale and buyback (limited).
- Obstacles and progress:
  - Slow development of Islamic liquidity instruments and money markets due to chronic sector-wide excess liquidity in some jurisdictions, slow sovereign Sukuk issuance, and lack of repo-like alternatives.
  - Countries with progress include Bahrain, Malaysia, and Sudan.
  - IMF IB survey: principal instruments used are central bank deposits, interbank Mudarabah market, and commodity Murabahah markets.
- Central bank reserve and LOLR practices:
  - Most central banks apply reserve requirements to IBs (86 percent); only 27 percent remunerate reserves.
  - Lender-of-last-resort (LOLR) function applies to IBs provided instruments and collateral comply with IF principles.
  - IFSB: 25 percent of regulatory and supervisory authorities have developed a LOLR framework for IBs using Muḍarabah, Musharakah, and Murabahah.
  - Adapting LOLR requires availability of non-interest alternatives, reconsideration of “penalty rate” definitions, and collateral policy decisions including acceptance of PLS assets.

### Key risks: credit, market, operational, liquidity, and rate of return
- Credit risk:
  - Arises in debt-type contracts (Murabahah) with deferred payment; complex ownership changes complicate exposure assessment.
  - In Mudarabah, bank-as-principal may face enhanced credit and monitoring challenges.
  - Prohibition on charging accrued interest or penalties can render nonperforming assets nonproductive; mitigation via collateral and guarantees is possible.
- Market risk:
  - Volatility in tradable, owned, or leasable assets; increased use of commodities and complex products heighten market risk.
- Operational risk:
  - Two unique operational risks: Shari’ah non-compliance risk and fiduciary risk related to IAH commingling and protection.
- Liquidity risk:
  - Historically reduced by IF features but changing due to increased wholesale funding (commodity Murabahah) and dearth of HQLA, especially sovereign Sukuk.

### Fund engagement, proposed work plan, and resource implications
- Fund involvement:
  - IMF engagement in IB dates to mid-1980s; TA from late 1990s; increased TA and surveillance involvement since mid-2000s as IFSB standards emerged.
  - The Fund played a central role in establishing the IFSB (process culminating in establishment in November 2002) and remains an associate member.
- Proposed work plan and resource needs:
  - Staff propose, in 2017, that the Board formally recognize the CPIFR as the international standard for supervision and regulation of IBs to be used in ROSC, surveillance, and TA.
  - MCM to develop CPIFR methodology further, stress testing tools, and financial stability analysis framework for IB.
  - A guidance note on IB to be prepared jointly by MCM, LEG, and MCD.
  - Estimated resource requirement: two staff full-time equivalents (FTE) from internal resources (one FTE from MCM; another jointly from MCM, LEG, and MCD).
  - Ongoing roles: MCD and area departments to provide policy advice; MCM and LEG to provide capacity development and engage with standard setters.
- Questions for Directors include agreement on staff approach to policy advice, inclusion in surveillance and program design, support to international standard setters, formal recognition of CPIFR in FY 2018, and estimated resource implications.

### Appendices (in brief)
- Appendix I: summary of Islamic financial instruments (profit-and-loss sharing, debt, quasi-debt) and mobilization of funds (current accounts, savings/time accounts, PSIA).
- Appendix II: key unique risks for IBs (credit, market, operational including Shari’ah non-compliance and fiduciary risks, liquidity).
- Appendix III: IMF involvement history and collaboration with WB, IFSB, AAOIFI, and other organizations.
- Appendix IV: World Bank Group involvement and initiatives in IF development and standards work.

*Source: ENSURING FINANCIAL STABILITY IN COUNTRIES WITH ISLAMIC BANKING — Executive Summary and selected excerpts.*

### EXECUTIVE SUMMARY

### EXECUTIVE SUMMARY

### Growth, scale, and systemic importance
- Islamic banking (IB) continues to grow rapidly, in size and complexity, posing a challenge to supervisory authorities and central banks.
- IB accounts for less than 2 percent of global finance, operates in more than 60 countries, and has become systemically important in 14 jurisdictions.
- Assets are concentrated in the Middle East and South East Asia but IB has expanded to sub-Saharan Africa and Central Asia.
- Most major financial centers (e.g., London, Luxemburg, Singapore, and Hong Kong) have opened markets to Islamic Finance (IF) products, including insurance and “Sukuk”.

### Distinct features and risk implications
- IF principles underpin IB and involve operations, balance sheet structures, and risks that differ from conventional banking counterparts.
- These distinct features generate specific risk profiles and corporate and balance sheet structures that require adaptations to international prudential and accounting standards, particularly in governance, AML/CFT, and the financial safety net.

### Legal environment and governance
- The legal environment for IB can be complex and challenging and varies across jurisdictions.
- Legal clarity and certainty for IB are important to promote confidence, mitigate regulatory arbitrage, and strengthen supervision.
- International governance standards apply but need customization for IB’s distinct governance features, including decision-making structures, Shari’ah compliance, and the rights of investment account holders (IAH).

### Prudential standards and supervisory progress
- Significant progress has been achieved in developing prudential standards for IB, including standards on capital adequacy, “Core Principles of Islamic Finance Regulation for Banking,” and the supervisory process.
- Prudential standards for conventional banks are generally applicable but gaps remain due to IB-specific features and risks.
- Adoption of IB-specific standards has progressed at different speeds across jurisdictions.

### Resolution and financial safety net
- International principles for deposit insurance, lender-of-last-resort (LOLR), and effective bank resolution regimes are broadly relevant for IB but require modification to address IB-specific issues.
- Country practices have diverged on key issues including the insurability of investment accounts, the priority of claims, the role of deposit insurance in resolution, and adequacy of IB instruments and collateral.
- International guidance is needed to address limited progress in developing resolution and financial safety net frameworks for IB.

### Liquidity management and money markets
- Progress has been slow in developing IB liquidity management and money markets.
- A dearth of high quality liquid assets (HQLA), including government Sukuk, has undermined IBs’ capacity to manage liquidity, interact with central banks, and develop money markets.
- The lack of HQLA has given rise to IB practices that may meet some liquidity objectives but are inefficient and present risks.
- International guidance and active participation by relevant authorities, particularly in countries where IB is systemically important, are needed to accelerate issuance of Sukuk and other liquid instruments.

### Emergence of hybrid financial products
- Hybrid financial products in IB have emerged that replicate aspects of conventional finance in an IB context.
- Drivers include profit opportunities in a rapidly growing IB sector and slow development of traditional IB infrastructure.
- The growth of hybrid products raises concerns about new complex risks, adequacy of existing prudential regimes, governance and consumer protection, and reputational risk.

### Role of the Fund and proposed engagement
- The Fund has played an important role in promoting financial stability in IB jurisdictions, facilitated the establishment of the Islamic Financial Services Board (IFSB), and worked closely with IB standard setters and international organizations to shape IB standards and promote best practices.
- Fund staff increasingly encounter IB-related issues in surveillance, program, and technical assistance (TA) work.
- A more comprehensive Fund policy framework will help support the Fund’s work going forward and guide development of assessment tools and staff advice for countries where IBs operate or are about to be introduced.

*Source: EXECUTIVE SUMMARY, ENSURING FINANCIAL STABILITY IN COUNTRIES WITH ISLAMIC BANKING, January 5, 2017.*

### 7.      IF refers to the provision of financial services in accordance with Islamic jurisprudence

### 7.      IF refers to the provision of financial services in accordance with Islamic jurisprudence

### Key guiding principles of Islamic Finance (Shari’ah)
- Shari’ah bans interest (Riba), products with excessive uncertainty (Gharar), gambling (Maysir), short-sales, and financing of prohibited activities.
- Transactions must:
  - Be underpinned by real economic activities.
  - Involve a sharing of risks in economic transactions.
  - Honor principles of fair treatment and the sanctity of contracts.
- Financial transactions must be representations of:
  - (a) sales of goods, services or benefits, or
  - (b) profit-and-loss sharing (PLS) arrangements,
  - giving rise to an “assets-backed” characteristic of IF.
- Sales-based transactions give rise to debt contracts (deferred payment terms); PLS arrangements give rise to equity-like instruments; lease transactions generate financial obligations but are not considered debt instruments.
- Financial returns are generated through the assumption of risk; capital-guaranteed instruments (e.g., conventional loans) cannot earn return.
- Risk management emphasizes risk sharing versus risk transfer, restricting the use of derivatives and conventional hedging mechanisms.
- Prohibition of short-sale curtails speculative trading in financial instruments and real assets.
- Other guiding principles: (i) minimize disputes, deception, and unfair trade practices (Gharar); and (ii) market determination of prices.

### Islamic Banking (IB) operations and balance sheet structure
- IBs play a financial intermediary role similar to conventional banks: mobilizing deposits, channeling them to investors, and undertaking maturity transformation.
- IB activities can extend beyond traditional intermediation: acting as partners in property ownership, trading tangible assets, and providing equity financing.
- Funding:
  - IBs are funded primarily by noninterest-bearing current accounts and profit-sharing investment accounts (PSIA).9
- Assets:
  - IBs do not engage in “lending” but in sales (with deferred payments), leases, PLS financing, and fee-based services.
  - All financial transactions are either PLS arrangements or must be underpinned by transactions in real assets.
- Risk management emphasizes risk-sharing, which significantly restricts the use of conventional hedging mechanisms (Box 2).

### Risk-sharing versus risk transfer (Box 2)
- Islamic Banks:
  - Sources of funds: (a) Current accounts, where deposits are guaranteed by the bank but earn no income; and (b) PSIA, where depositors share the risk and return with the bank, as the returns are not guaranteed and depend on the bank’s performance.
  - Uses of funds: The bank shares the earning risk in Mudarabah and Musharakah contracts and takes credit and transaction risks on other contracts, without the use of conventional hedging instruments.
- Conventional Banks:
  - Sources of funds: The bank takes all the risks and guarantees the deposits and a pre-specified return.
  - Uses of funds: Financing is debt-based; borrowers pay interest independent of project returns. The bank transfers or mitigates credit risk through securitization or hedging.

### Implications for resilience and prudential standards
- Two defining characteristics of traditional IB:
  - (a) IF principles limit capacity to engage in speculative financial transactions (short-selling, derivatives).
  - (b) Balance sheet risks are managed through risk-sharing.
- These features reduce active balance sheet management capacity but, through risk-sharing and loss-absorbing capacity, may enhance resilience relative to conventional banks if risks are well managed.
- Unique IB risks shape industry prudential and risk management standards.

### Shari’ah compliance risks
- Inadequate Shari’ah compliance functions can create public-interest risks including:
  - Fraudulent activities affecting consumers.
  - Bank solvency and liquidity risks if depositors and IAH lose confidence.
  - Systemic risk if an institution is sufficiently large and connected.
- Issues related to Shari’ah compliance are discussed in paragraphs 25–27.

### Industry practices, scale, and complexity
- IBs vary in scale from small niche banks to domestically systemically important banks (D-SIBs) with complex conglomerate structures, including nonfinancial corporations.11
- Some larger IBs have expanded abroad; cross-ownership linkages and affiliate networks (including non-banking financial institutions and conventional banks) have increased complexity and supervisory challenges.
- Product mix:
  - Financing items (sales and lease-based contracts) account for about 70 percent of total assets, with Murabahah and Ijarah as the largest items.
  - PLS contracts account for about 5 percent of IBs’ aggregate assets, mostly Musharakah contracts, with important cross-country differences:
    - Iran: Musharakah 29 percent.
    - Indonesia: Musharakah 63 percent.
    - Pakistan: Musharakah 11 percent.
    - Sudan: Musharakah 13 percent.
  - Mudarabah contracts average around 5 percent in Indonesia, Iran, and Sudan.

### Funding structure statistics and variations
- PSIA are the single largest source of funding for IBs on aggregate:
  - At end-2015, PSIA estimated to account for 40 percent of IBs’ aggregate liabilities, of which 29 percent were deposits and 11 percent were interbank placements (PLS contracts).
  - Other funding sources: commodity “Murabaḥah” 14 percent (grown rapidly), current deposit accounts 12 percent.
- Cross-country variations:
  - In Indonesia, Iran, and Jordan the share of PSIA ranges between 53 and 70 percent.
  - IBs in Saudi Arabia rely more on current deposit accounts.
  - Malaysia, Pakistan, and the U.A.E. show greater reliance on fixed term-like deposit structures.

### Divergent market and regulatory influences
- Larger, established IBs tend to offer broader financing options, including PLS contracts, aligning closer to traditional models.
- Smaller or newer IBs often focus on debt-type financing (e.g., Murabahah).
- Applying conventional regulatory norms to IBs without adaptation may have restricted IB growth and limited product scope (particularly PLS financing).
- Lack of supportive market infrastructure or HQLA availability has led to non-traditional practices and hybrid Islamic/conventional finance products.
- Concentration in real estate, trade, and commodity finance may create concentration risk and potentially make IBs more procyclical than conventional banks.
- These variations should be assessed and addressed through regulatory reforms or market development to ensure financial stability.

### Innovations: PER and IRR (profit equalization reserves and investment risk reserves)
- PER and IRR are important innovations largely driven by competitive pressure:
  - PER: stabilizes returns on PSIA by smoothing profit payouts—profits above a threshold are transferred to PER to offset later lower returns.
  - IRR: cushions effects of future investment losses on IAH.
- Both act as countercyclical buffers funded by IAH rather than shareholders.

### Rise of hybrid products and systemic implications
- Hybrid financial products replicate aspects of conventional banking and transform IB risk profiles:
  - Example models: assets side solely Murabahah and reverse Murabahah on liabilities, creating balance sheets resembling conventional banks.
  - New instruments like commodity Murabahah effectively produce outcomes similar to conventional finance and expand exposure to liquidity, market, and interest rate risks.
- Regulatory and supervisory concerns:
  - Monitoring complex hybrid risks.
  - Determining appropriate prudential regimes to prevent systemic externalities.
  - Disparities in accounting and legal treatments.
  - Governance, consumer protection, and reputational risk issues.

### Commodity Murabahah (Box 3) — mechanism and risks
- Mechanism:
  - Facilitates cash advances for terms usually up to one year at a fixed markup using commodity contracts traded on an exchange.
  - Bank purchases a commodity contract and sells it to customer or another bank on deferred payment with agreed fixed profit; customer resells immediately via bank as agent to receive cash.
  - Reverse transaction creates deposits or funds the bank in the interbank market.
- Growth and controversy:
  - Use as a short-term money market and liquidity management instrument has spread rapidly, facilitated by existing commodity market infrastructure.
  - Practice is controversial among IF scholars; majority allow it out of necessity given dearth of Islamic HQLA.
- Risks that could transmit systemic risk:
  - (a) Market risk from commodity price fluctuations if bank holds the commodity.
  - (b) Counterparty risk, including commodity brokers.
  - (c) Liquidity mismatch risk.
  - (d) Rate of return risk when used on liability side creating contractually fixed return ex-ante.
  - (e) Operational risk from structuring complexity.
  - Commodity Murabahah can enable significant leverage expansion compared with traditional IB instruments.
- Empirical note:
  - According to the 2016 IB survey, there is a domestic currency interbank commodity Murabahah market between IBs in 35 percent of the countries that answered the survey; maturities range from overnight to one year.

### Performance and soundness of the Islamic Banking industry
- Overall performance:
  - IB industry has performed relatively well with very limited incidences of bank distress.
  - Available data show aggregate capital adequacy ratios above statutory limits.
  - Ratio of nonperforming loans (NPL) is relatively high in some countries.
  - IBs remain profitable on aggregate and are generally liquid.
  - Profit margins and liquidity indicators have been trending down.
- Sources of resilience and stress:
  - Limited stress incidents occurred mostly in smaller banks during the real estate downturn following the GFC.
  - Strong economic growth and real estate recoveries in IB-concentrated countries supported higher profits and internal capital generation.
  - Some larger IBs implementing Basel III have tapped international Sukuk markets to build tier II capital.
  - Deteriorating macroeconomic environment due to lower oil prices exacerbates risks for IBs concentrated in oil-exporting economies.
  - IBs in several countries show significant exposures to cyclically sensitive sectors: real estate, construction, and manufacturing.

*International Monetary Fund — ENSURING FINANCIAL STABILITY IN COUNTRIES WITH ISLAMIC BANKING*

### Box 4. Treatment of Islamic Financial Instruments in Macroeconomic Statistics

### Box 4. Treatment of Islamic Financial Instruments in Macroeconomic Statistics

### Overview
- The IMF’s Monetary and Financial Statistics Manual and Compilation Guide provides guidance on the classification of Islamic financial institutions (IFIs) and instruments in the context of compiling monetary statistics.
- The manual updates the current guidance followed by countries with IFIs that report monetary data to the IMF, and includes a discussion on additional Islamic financial instruments such as Sukuk and Takaful.
- Annex 4.3 of the manual focuses on various types of Islamic financial instruments in comparison with the conventional ones in the context of macroeconomic and financial statistics.

### Mapping to the 2008 SNA classification
- Islamic financial instruments are mapped to the 2008 System of National Accounts classification of financial instruments based on the nature of underlying transactions.
- For the majority of Islamic financial instruments, the mapping to the 2008 SNA classification is relatively straightforward.
- For those Islamic financial instruments that have somewhat ambiguous characteristics, specific guidance is provided for statistical compilers.

### Cross-country comparability and standards implementation
- Consistent treatment of Islamic financial transactions across countries is essential to ensure cross-country comparability of data.
- Islamic financial standard setting bodies such as the AAOIFI and the Islamic Financial Services Board (IFSB) have made efforts to develop accounting standards and a regulatory framework for IFIs, but these standards are not always fully implemented by IFIs when preparing their financial statements.
- The provision of international guidance on the treatment of IFIs in macroeconomic and financial statistics is important for achieving cross-country comparability.

### Data compilation recommendations for countries with dual systems
- The growing trend of Islamic finance (IF) worldwide calls for increased attention to the proper statistical treatment of Islamic financial instruments to underpin effective macroeconomic management.
- For analytical purposes, it is recommended that countries with dual banking systems compile separate aggregate data for Islamic banks (IBs), in addition to standard monetary statistics, to allow monitoring of specific indicators for the IB system such as:
  - growth in financing (credit)
  - sources of funding (deposits)

### Financial soundness indicators (FSIs)
- Guidance is being developed for the compilers of financial soundness indicators (FSIs) in countries with IFIs in the context of updating the IMF’s Financial Soundness Indicators Compilation Guide.

*Source: Box 4. Treatment of Islamic Financial Instruments in Macroeconomic Statistics, Monetary and Financial Statistics Manual and Compilation Guide (Annex 4.3) — prepublication draft as referenced in the source content.*

### 28.      Investment accounts offered by IBs present additional governance challenges, given

### pp-ensuring-financial-stability-in-countries-with-islamic-banking - 28.      Investment accounts offered by IBs present additional governance challenges, given

### Governance of Investment Accounts and IAH Protection
- Investment accounts offered by IBs present additional governance challenges, given the potential divergence of interests between shareholders and IAH.
- IAH have the right to value maximization similar to that of IB shareholders, in line with the PLS feature of PSIA.
- There may be situations where value maximization for IAH may not be fully aligned with shareholders’ long-term interests (i.e., different risk preferences).
- IAH cannot claim shareholders’ rights (e.g., voting on key corporate actions) under company law, creating a governance dilemma: how to protect IAH interests without impinging on shareholders’ rights.
- IAH have a direct stake in IBs performance, and their interest is increasingly acknowledged in IB governance structures.
- In line with the IFSB 2006 guiding principles on governance:
  - Some jurisdictions acknowledge the rights of IAH to monitor the performance of their investments and associated risks.
  - Some jurisdictions require IBs to disclose investment policies and the performance of the bank to facilitate monitoring by IAH.
  - Some jurisdictions require the establishment of a “governance committee” to protect the interests of stakeholders other than shareholders (primarily IAH), and to monitor the implementation of governance policies.
  - The governance committee, which reports to the Board of Directors, may comprise, at a minimum, a member of the audit committee, a Shari’ah expert, and a non-executive Director.
- Enhanced disclosure and governance committees will strengthen IAH protection, but important gaps may remain:
  - It may be impractical and costly for IBs to provide IAH (of unrestricted PSIA in particular) with ex-ante information similar to an “investment prospectus.”
  - Investment policies are usually too broad to inform IAH of the risks facing the bank.
  - Because the governance committee reports to the bank’s Board and not IAH, it is unclear to what degree IAH would be informed of any divergence of interest between shareholders and IAH.
  - IAH can terminate participation if dissatisfied, but this may be a suboptimal option for enforcing discipline within the bank.

### Outstanding Issues and International Guidance Needs
- Additional efforts are needed by IB jurisdictions to ensure full and consistent implementation of IFSB and AAOIFI governance standards, which would enhance IBs stability.
- IB jurisdictions should continue to take necessary measures (including, where appropriate, legal reforms) to bring legal and regulatory frameworks in conformity with existing IB governance standards, and to ensure their consistent application.
- International guidance is still required for IB jurisdictions on:
  - (a) the precise design of SSBs (e.g., centralized and/or internal SSBs);
  - (b) the responsibilities of SSBs relative to those of the IB Board of Directors;
  - (c) mechanisms for the better alignment of the interests between IAH and shareholders.

### Regulatory Framework: Prudential Regulation Relevance and Adaptation
- Effective prudential regulation is as necessary for IB as it is in conventional banking to ensure financial stability and protect depositors and other stakeholders.
- Prudential standards developed by the BCBS are relevant for IB, but some modification is needed:
  - Prudential exposure requirements (large exposure and related lending limits), consolidated and cross-border supervision are, in principle, applied the same way to conventional banks and IBs.
  - When IBs use debt-type instruments, traditional loan classification and provisioning apply based on degree of credit risk and impairment.
  - Applying international standards to IBs without adjustments may not address the full spectrum of IB-specific risks and can give rise to regulatory gaps or inappropriate over-regulation.
- The application of IFSB and BCBS standards together creates a comprehensive prudential framework for IB:
  - The 2015 Core Principles for Islamic Finance Regulation for Banking (CPIFR) was built on the BCBS core principles and can be used for self-assessment of IB regulatory and supervisory frameworks.

### Progress and Gaps in Incorporating IB Standards
- While there is broad recognition of IFSB standards, formal incorporation into legal and regulatory frameworks has progressed at different speeds:
  - "About 60 percent of countries surveyed in 2016 have modified their domestic frameworks to accommodate IB."
  - Only eight countries (Bahrain, Djibouti, Jordan, Kyrgyzstan, Oman, Palestine, Qatar, and Sudan) have mandated AAOIFI accounting standards.
  - Four others (Afghanistan, Guinea, Luxembourg and Saudi Arabia) have allowed AAOIFI standards as a second option.
  - Ten countries (Bahrain, Bosnia and Herzegovina, Djibouti, Guinea, Jordan, Kyrgyzstan, Palestine, Qatar, Saudi Arabia, and Sudan) have mandated IFSB standards for IBs.
  - Six others (Afghanistan, Kazakhstan, Kuwait, Lebanon, Oman, and Pakistan) have only incorporated certain aspects of IFSB standards in their frameworks.
- The lack of consistent application of standards remains a concern, particularly in countries with systemically important IB.
- The emergence of hybrid IB institutions and products is a regulatory challenge, as existing prudential standards are premised on traditional IB models and hybrids create regulatory gaps, complex risks, and heightened financial stability concerns.

### Selected Regulatory Issues: Licensing, Concentration, Capital
- Licensing
  - Robust licensing procedures are necessary to ensure IBs are managed soundly and safely.
  - Many elements of conventional licensing apply but modifications are needed to reflect IB specifics (see Box 8 summary below).
- Box 8. Modifications to Licensing Requirements (selected bullets)
  - Business Plan: should include details on the IB’s strategy to attain and maintain profitability, including the funding plan and the management of the PSIA.
  - Capital Requirements: minimum levels (both in absolute and as a proportion of risk-weighted assets), composition and quality of initial capital should be ensured and prescribed (as per the IFSB standards).
  - Fit and Proper Requirements: suitability of significant shareholders and bank managers; a significant number of Board members should be familiar with IB; application to Shari’ah Board members and staff is limited in practice.
  - Corporate Governance: governance structure should be transparent and not hinder effective supervision.
  - Internal Control: supervisors should ensure administrative and internal control systems are adequate and understand the wide array of risks undertaken by the IB.
  - Transparency: criteria and requirements for an IB license should be published and applied in an even-handed way.
- Concentration Limit
  - Concentration limits as applied to conventional banks require modification to accommodate IB activities, especially where IBs invest directly in commodities and real assets and act as property developers or business owners.
  - Supervisors should assess the impact of such activities on the bank’s risk profile and require additional capital where exposures are excessive (applies particularly in the context of pillar 2 of Basel II for countries already applying it).
- Capital Requirements
  - Computation of capital adequacy ratios is similar to BCBS’ formula, but variations exist in recognition of sources of funds, risk-weighted assets, and eligible capital.
  - A major difference relates to PSIA loss absorbency: IAH are expected to bear the loss of earnings or investments made with their funds, providing an additional buffer to limit adverse shocks on IBs’ solvency.
  - The higher the share of IA as a source of funds and the lower their sensitivity to changes in return, the higher the solvency of IBs compared to conventional banks.
  - The calculation of risk-weighted assets needs to take into account transformation of risks across transaction stages (example: diminishing Musharakah).
  - IB practices differ globally in upholding the pass-through principle to IAH:
    - Many IBs face market pressure to pay competitive rates to IAH to avoid withdrawal risk.
    - Some IBs engage in income smoothing operations and sometimes investment guarantees by using PER and/or IRR.
    - Some IBs compensate IAH from shareholders’ profits instead of establishing a PER.
    - "Survey results shows that 11 responded countries have allowed PER and six allowed IRR."
  - Displaced commercial risk (DCR) arises when assets managed on behalf of IAH effectively transfer losses to IB capital because the bank forgoes part or all of its profit share to increase returns to IAH.
  - IFSB issued the first Capital Adequacy Standard in December 2005 and revised it in December 2013 to incorporate many elements of Basel III.
  - IFSB capital adequacy ratio (CAR) provides two formulas: standard and discretionary:
    - Standard Formula: IAH bear 100 percent of credit and market risks of assets funded by IAH and the IB bears 100 percent of operational risk.
      - Eligible capital / Total RWA (credit+market risks) + Op.risk – RWA funded by IA (credit + market risks)
    - Supervisory Discretion Formula: IB bears a proportion (α) of credit and market risks of assets funded by IAH and 100 percent of operational risk. If α=0, complete pass through to IAH; if α=1, IA are practically guaranteed as in conventional banks.
      - Eligible capital / Total RWA (credit+market risks) + Op.risk – RWA funded by RIA (credit + market risks) − (1−α)(RWA funded by URIA (credit + market risks)) − α (RWA funded by PER and IRR of URIA (credit + market risks))
  - Supervisory discretion over alpha can give rise to wide variations and challenges for cross-country comparisons; supervisors should assess risk profiles, develop robust models, decide on application, and disclose their approach to determining alpha.
  - Country practices cited: Malaysia does not require general assets financed by investment accounts to be converted into risk-weighted assets, while Sudan and Kuwait require 50 percent, Bahrain and Jordan require 30 percent only and Afghanistan 12 percent.

### Supervisory Process and Implementation Challenges
- Effective prudential supervision is necessary in an IB framework as in conventional banking. Compliance with the Basel Core Principles (BCP) is important but needs supplementation with CPIFR and the IFSB “Risk Management” standard.
- Supervisory conduct must address IB special characteristics, unique risks, interactions with conventional banks, and potential regulatory arbitrage.
- The supervisory review process for IBs should be risk-based and culminate in a formalized supervisory strategy similar to conventional banks.
- Supervisors may need to adapt rating methodologies (e.g., CAMELS) for IBs and implement IFSB standards and technical guidance on stress testing.
- Frameworks for risk-based supervision and cross-border and consolidated supervision of IBs remain underdeveloped:
  - Approaches are being developed (including Shari’ah compliance, corporate governance, internal control, transaction testing), but progress is tempered by broader weaknesses in application of risk-based supervision in many IB jurisdictions.
  - Gaps in acceptability and application of IB prudential standards can affect capital and liquidity adequacy across countries and complicate cross-border and consolidated supervision.
  - Diverse approaches to treatment of Shari`ah matters across jurisdictions further complicate cross-border supervision.
- On- and off-site supervision has generally been integrated into broader supervisory processes, but a more nuanced approach is necessary:
  - In some jurisdictions, uniform off-site and on-site supervision applies to IBs and conventional banks, but jurisdictions with systemically important IB recognize the need to adapt supervisory processes to IB unique risks (e.g., on-site focus on operational risk and verification of underlying real transactions).
- Reputational risk from inadequate Shari’ah compliance requires careful review:
  - Many countries apply Pillar 2 of Basel II, which could be extended to capture reputational risk in ICAAP.
  - Example practices: Jordan’s supervisor can require higher capital to account for reputational risk; in Malaysia, uncaptured risks can be covered by special risk management control measures or additional capital.
  - Stress testing is regarded as crucial to capture these factors.

*ENSURING FINANCIAL STABILITY IN COUNTRIES WITH ISLAMIC BANKING*

### 48.      Given the unique challenges posed by Shari’ah compliance (as noted in paragraph 10),

### pp-ensuring-financial-stability-in-countries-with-islamic-banking - 48.      Given the unique challenges posed by Shari’ah compliance (as noted in paragraph 10),

### Supervisory policy and Shari’ah compliance
- Supervisors need a clear supervisory policy on Shari’ah compliance irrespective of whether laws recognize Shari’ah or are purely secular.
- Minimum supervisory requirement: ensure that IBs in the jurisdiction have an adequate Shari’ah compliance function in place without the supervisor needing to take views on the merits of resulting rulings.

### Outstanding issues for prudential standards and supervision
- Full implementation and consistent application of IFSB standards and strengthening of supervisory frameworks are required, particularly in jurisdictions with systemically important IB.
- International cooperation and additional efforts by relevant international bodies and standard setters are needed to broaden adoption and consistent application of IB prudential standards.
- Need to ensure adequate supervisory processes to identify, assess, measure, and monitor risks specific to IBs and evaluate potential impact on IBs’ capital adequacy and solvency.
- International guidance required to address concerns regarding hybrid IB institutions and products; work needed to understand structures and delineate effective regulation.

### Anti-Money Laundering and Countering the Financing of Terrorism (AML/CFT)
- Existing AML/CFT standards were developed mainly with the conventional financial sector in mind and did not consider potential ML/TF risks specific to IB.
- No evidence that ML/TF risks in IB differ from those in conventional banks, but very little international work has examined this issue.
- Features of IB that warrant further study for ML/TF implications:
  - the partnership relationship between an IB and its customers;
  - complexity of certain IB products and transactions.
- Recommended actions:
  - Develop a better understanding of ML/TF risks in IF through enhanced dialogue with supervisors, Islamic finance institutions, and practitioners.
  - Regulators, in consultation with the Fund, FATF, and other interested parties, should assess whether current FATF recommendations are sufficient or require further adaptation for IB-specific ML/TF risks.

### Resolution of Islamic banks
- Importance: Clear, well-designed frameworks for resolving failed IBs are important to maintain financial stability.
- Observations:
  - Certain IB characteristics (e.g., risk-sharing, conservative investment) may reduce failure risk, but IBs remain as vulnerable to crises as conventional banks.
  - Legal and policy frameworks for bank resolution in many countries with IB systems are generally not well developed.
  - Very few countries have specialized IB resolution frameworks; exception noted: Malaysia (Islamic Financial Services Act (Act 759) of 2013).
- International standards need adjustment to address IB-specific features; a customized approach to resolution regimes for IBs is called for.
- Key unresolved issues:
  - Applicability of conventional resolution powers and tools and triggers for placing an IB in resolution are unclear.
  - Role (if any) of the SSB in ensuring Shari’ah compliance in resolution is unclear.
  - Inconsistencies in legal and accounting status of IB transactions across jurisdictions complicate creditor hierarchies and cross-border application of resolution tools.
- Recommended actions:
  - Further analytical work by relevant international bodies on complexities and uncertainties.
  - Greater harmonization of Shari’ah bankruptcy principles and legal/accounting treatment of various assets and liabilities between jurisdictions.
  - International guidance on institutional arrangements for resolution and mechanisms for allocation of losses in resolution to stakeholders.

### Key resolution issues for Islamic banking (summary of Box 10)
- Legal and Accounting Status of Transactions:
  - Some IB contracts are not treated as debt contracts legally or for accounting, affecting tools like purchase and assumption (P&A) and bail-in.
- Creditor Hierarchy and Treatment of “Deposits”:
  - Differences exist in treatment and ranking of PSIAs, URIA, and RIAs; IFSB guideline envisions shareholders and IAH rank pari passu as residual claimants in commingled asset pools.
- Resolution Tools:
  - IF principles can complicate application of resolution powers (e.g., extent of permissible debt write-downs unclear; prohibition of interest affects P&A and bail-in).
  - IFSB-15 allows loss-absorbing Musharakah Sukuk and Muḍarabah or Wakalah Sukuk as Tier 1/Tier 2 instruments, but how SSBs would view these in absence of effective legal frameworks is unclear.
- Resolution Triggers:
  - Identifying indicators of non-viability for business models relying on partnerships, PLS, sales, and leasing is challenging; legal frameworks should clarify non-viability indicators.
- Institutional Arrangements:
  - Shari’ah compliance function in resolution could affect design of institutional arrangements, including potential role of SSBs.

### Deposit insurance for Islamic banking
- Design principles of deposit insurance broadly apply but require adaptation for Islamic context.
- Four key questions for Islamic Deposit Insurance Scheme (IDIS):
  - (a) Whether the PSIA should be treated as deposits despite equity-like features;
  - (b) What priority should be assigned to different types of IB deposits;
  - (c) What role the deposit insurance fund should play in resolution;
  - (d) Degree to which IDIS is consistent with IF principles.
- Empirical status:
  - Only one country (Sudan) has a full-fledged IDIS.
  - Two countries (Bahrain and Malaysia) have a dual deposit insurance scheme with IB premiums managed according to IF principles.
  - Twelve countries have a deposit guarantee scheme that covers both systems with premiums managed in a single, indivisible account.
- Gaps and challenges (Box 11):
  - IFSB has not adopted a standard or guideline on deposit insurance; Shari’ah compliance is a key challenge for IDIS.
  - Legal enforceability of alternative implementation approaches must be ensured.
  - Consensus on insurability of current accounts exists but uncertainty remains on definition and treatment of PSIA.
  - Risk-based fees require quantification of IB risks, demanding analytical capacity and data.
  - Liquidity needs for quick payout conflict with dearth of IF liquid instruments.
  - Co-existence options (conventional DIS vs IDIS; separate vs single agency) carry different governance, legal, and operational implications.
  - Under IDIS, distinctions in priority between current deposits, PSIAs, URIA, and RIAs raise priority-of-claims issues.
  - Role of DIS in funding bank resolution and Shari’ah compliance of such activity is unclear.

### Liquidity management and lender-of-last-resort
- IBs face liquidity risks similar to conventional banks and need robust liquidity management and access to HQLA and money markets.
- Key IB liquidity instruments (Box 12):
  - Interbank Mudarabah Placements.
  - Commodity Murabahah (including Salam Sukuk variants).
  - Central Bank Wadiah (Trust) Certificate/Deposit.
  - Central Bank Paper (Musharakah Certificates or Sukuk).
  - Government paper structured as Musharakah Certificates or Sukuk.
  - Islamic Repurchase Agreements or sale and buyback (limited by Shari’ah and operational issues).
- Progress and obstacles:
  - Development of Islamic liquidity instruments and money markets has faced obstacles: chronic sector-wide excess liquidity in some jurisdictions, slow sovereign Sukuk issuance, and lack of alternatives to repo-like transactions.
  - Some progress in countries with substantial IB presence or developed money and sovereign Sukuk markets (examples noted: Bahrain, Malaysia, and Sudan).
  - IMF IB survey results of 2016: principal instruments used by IBs to manage liquidity are central bank deposits, the interbank Mudarabah market, and increasingly commodity Murabahah markets.
- Central bank operations and reserve practice:
  - 40.9 percent of central banks in IB jurisdictions, according to 2016 IB survey, engage in regular liquidity operations with IBs.
  - Of these central banks, 27 percent issue their own securities (maturities usually ranging from one week to one year).
  - 24 percent use government securities or Sukuk in their liquidity operations with IBs.
  - Most central banks apply reserve requirements to IBs (86 percent of the respondents according to the survey).
  - Reserve requirements are applied to domestic currency denominated demand deposits and to domestic currency PSIAs, as well as to foreign currency deposits.
  - Only 27 percent of central banks surveyed remunerate the reserve requirements for IBs, reflecting lack of a mechanism for reserves remuneration that complies with IF principles.
  - Where reserve requirements are not remunerated, high reserve required ratios create distortions, increase the cost of IB credit, and constrain growth.

*ENSURING FINANCIAL STABILITY IN COUNTRIES WITH ISLAMIC BANKING — INTERNATIONAL MONETARY FUND*

### 61.      The LOLR function is an important tool for central banks to safeguard financial

### ENSURING FINANCIAL STABILITY IN COUNTRIES WITH ISLAMIC BANKING

### Lender of Last Resort (LOLR) and Islamic Banking
- The LOLR function is an important tool for central banks to safeguard financial stability, including in the context of IB.
- Broad principles that govern the LOLR framework for conventional banks apply also to IBs, provided that the LOLR structure and the collateral used complies with the relevant IF principles.
- According to the IFSB, 25 percent of the regulatory and supervisory authorities have developed a LOLR framework for IBs using different types of instruments (Muḍarabah, Musharakah, and Murabahah).
- Adapting conventional LOLR to cover IBs would require central banks to consider:
  - (a) The availability for central banks of alternatives to interest-bearing loans, which in turn depends on whether existing mechanisms available for regular liquidity management have been adapted for IBs or whether new instruments need to be created.
  - (b) The definition of “penalty rate” will need to take into account the type of central bank regular liquidity management used with IBs. For example, in some countries (e.g., Sudan), central banks sometimes use a PLS Mudarabah facility to extend funding to IBs, often with a preannounced profit-sharing rate (i.e., lower profit-sharing rate compared to the rate used in standing facility).
  - (c) Bilateral LOLR is usually provided against broader and less liquid collateral than central banks’ regular liquidity management operations. Traditional collateral policy issues (asset quality and marketability, haircut, etc.) apply; additional issues include whether or not to accept PLS assets as collateral.

### Outstanding Issues
- Robust financial safety nets that comply with IF principles and reflect international best practices are essential for IB jurisdictions.
- International guidance needed for:
  - The design of IB resolution frameworks drawing on the key attributes, including ex-ante clarification of institutional arrangements for resolution, the legal and accounting status of IB transactions for resolution purposes, creditor hierarchies for IB claims, and cross-border issues.
  - The design of IB deposit insurance schemes to address insurability of Islamic “deposits,” fund management arrangements, and the potential for resolution funding.
- Orderly development of Islamic money and sovereign Sukuk markets is important for financial stability in countries with systemically important IB and for the sustainable development of the IB industry.
- Factors hindering deep Sukuk markets include subjugating issuance of government Sukuk to the fiscal position irrespective of market development needs, weak public debt management, and reliance on complex designs.

### Conclusions and Issues for Board Consideration
- Significant progress has been achieved in developing prudential standards for IB, but progress has been limited in developing resolution, financial safety net, and liquidity management frameworks.
- The IFSB standards, in conjunction with the BCBS, provide a comprehensive framework for regulating and supervising IBs.
- Further strengthening of implementation and consistent application of these standards are needed, particularly in jurisdictions where IB has become systemically important.
- Emergence of hybrid institutions and products is a regulatory challenge with potential implications for financial stability.
- Active international collaboration is needed to address gaps arising from lack of HQLA and limited progress on standing facilities and other central bank liquidity instruments suitable for IB.
- International guidance is required on a number of key issues highlighted in paragraphs 31, 49, 50, 52, 55, 62, and 63.

### Fund Staff Work Plan and Resource Implications
- Staff propose to implement a work plan involving several initiatives:
  - Staff will propose, in 2017, that the Board formally recognize the CPIFR as the international standard for the supervision and regulation of IBs so that these standards can be formally used and assessed under the ROSC program (together with the World Bank) and in financial surveillance and TA.
  - MCM will focus on developing further the methodology for the CPIFR, as well as stress testing tools and financial stability analysis framework for IB.
  - A guidance note on IB will be prepared jointly by MCM, LEG, and MCD.
- Resource estimate:
  - Taken together, this work is expected to require two staff full-time equivalents (FTE), which will be made available from internal resources that have already been allocated to IB work; specifically, one FTE from MCM, and another jointly from MCM, LEG, and MCD.
- Ongoing roles:
  - MCD and other area departments will continue to provide policy advice to relevant countries on IB issues in the context of Article IV surveillance and program design.
  - MCM and LEG will provide capacity development services and engage with relevant standard setters in their respective mandates.
- Questions for Directors include agreement on:
  - (a) staff’s proposed approach in providing policy advice on IB-related issues and areas where further work is needed;
  - (b) the Fund providing such advice in the context of surveillance, program design, and capacity development activities;
  - (c) Fund staff continuing to support work streams of the relevant international standard setters and other international bodies to help address current gaps in the international regulatory agenda for IBs;
  - (d) staff proposing formal recognition of the CPIFR, to be included in a forthcoming paper to the Board in FY 2018;
  - (e) the estimated resource implications for IB-related Fund work.

### Appendix I — Islamic Financial Instruments (summary)
- Islamic financial instruments fall into three broad categories: profit-and-loss sharing, debt, and quasi-debt instruments.
- Profit-and-loss Sharing:
  - Musharakah: equity financing where IB and customer contribute capital; profits shared per agreement; losses shared in proportion to capital contribution; can be diminishing Musharakah.
  - Mudarabah: bank provides capital, customer manages; profits shared per agreement; losses borne solely by the bank unless due to customer misconduct, negligence, or breach.
- Debt Instruments:
  - Murabahah: cost-plus financing; bank sells asset at acquisition cost plus agreed profit margin; features: cost and mark-up known; bank must assume ownership prior to resale; client’s promise may be binding; no interest for late payments but collateral can be required; contract cannot be sold except at par.
  - Salam: purchase with deferred delivery; bank pays full price up front for specified commodity to be delivered in future; used in agriculture finance; bank may enter Parallel Salam to mitigate price risk.
  - Qard Hasan: interest-free loan contract.
- Quasi-debt:
  - Ijarah: lease contract where bank leases asset against lease rental; bank bears ownership risks during lease; lessee may have option to purchase at end of lease; Ijarah can be sold at negotiated market price.
- Mobilizing Funds by Islamic Banks:
  - Current accounts: structured as Qard Hasan or Wadiah; bank guarantees deposits and depositors not entitled to share in profits.
  - Savings and time accounts: similar to current accounts; bank may share part of profits at its discretion to encourage longer deposits; some accounts offered based on commodity Murabahah.
  - Profit Sharing Investment Account (PSIA): investment fund with IB on basis of Murabahah; can be restricted (RIA) or unrestricted (URIA); profit-sharing ratio agreed at account opening; losses borne solely by PSIA holder unless due to IB misconduct, negligence, or breach.
- Stylized Balance Sheet headings for Islamic and Conventional banks are provided (Assets, Liabilities, Owner’s Equity, Off-balance sheet items).

*Source: IMF Staff.*

### Appendix II — Key Unique Risks Exposed to Islamic Banks
- Credit Risk:
  - IBs exposed to credit risk when using debt-type contracts (e.g., Murabahah) where delivery is arranged but payment is delayed.
  - Complex Murabahah transactions can involve multiple ownership changes, complicating credit exposure assessment.
  - In Mudarabah, IB as principal may face enhanced credit risk vis-à-vis the agent; monitoring difficulties increase risk.
  - IBs generally prohibited from charging accrued interest or penalties on default, causing capital to be stuck and nonproductive; mitigation via better collateralization, pricing, additional collateral, and guarantees is possible.
- Market Risk:
  - Exposure due to volatility in tradable, owned, or leasable assets.
  - Absence of hedging instruments historically led IBs to minimize open positions; more complex products and increased use of commodities have heightened market risk.
  - Prudential measures like position limits and stop loss provisions are used.
- Operational Risk:
  - IBs face significant operational risk due to financing tied to real transactions, specific contractual features, and legal environments not adapted to IB models.
  - Two unique operational risks:
    - “Shari’ah non-compliance risk” from inadequate systems and controls to ensure compliance.
    - “Fiduciary risk” from inadequate mechanisms to safeguard interests of IAH when funds are comingled with the bank’s own funds.
  - Shari’ah compliance permeates organization and is critical; non-compliance could lead to transaction cancellation and income deemed illegitimate.
  - Fiduciary risk arises when IBs fail to perform fiduciary responsibilities, potentially causing forgone profits to IAH and inability to meet current account withdrawals.
- Liquidity Risk:
  - Traditional IB features reduced liquidity risk but at the expense of profitability; profile changing rapidly.
  - IBs historically relied on stable deposits due to IF restrictions on direct interest-based borrowing and repo.
  - Recent increased access to wholesale funding through commodity Murabahah markets has rapidly increased leverage and new risks.
  - IBs face a dearth of acceptable and tradable assets, especially HQLA like sovereign Sukuk, often resulting in excess cash reserves.
  - Slow progress in central bank standing facilities and liquidity instruments suitable for IB has exacerbated liquidity management challenges.

### 8.      The IBs is generally exposed to rate of return risk, which is associated with overall

### 8.      The IBs is generally exposed to rate of return risk, which is associated with overall balance sheet exposures where mismatches arise between assets and balances from fund providers

### Rate of return risk — characteristics and sources
- Rate of return risk differs from interest rate risk: IBs are concerned with the result of their investment activities at the end of the investment-holding period; such results cannot be pre-determined exactly.
- Rate of return risk also stems from uncertainty in returns earned on IBs’ assets when an increase in benchmark rates results in expectations of higher rates of return on investment accounts.
- Rate of return risk arises where mismatches occur between assets and balances from fund providers across the IBs’ balance sheet.

### Displaced commercial risk — mechanism and corporate governance implications
- Displaced commercial risk can be a consequence of rate of return risk, causing IBs and their shareholders to forego part of their profits.
- Competitive pressure can force IBs to pay a return that exceeds the rate earned on assets financed by IAH when asset returns underperform competitors’ rates.
- IBs may waive part or all of their Muḍārib share of profits to satisfy and retain fund providers and dissuade withdrawals.
- Such waivers are commercial decisions that should be governed by clear and well defined policies and procedures approved by the IBs’ board of directors.

### Appendix III — International Monetary Fund’s involvement in Islamic Banking and Finance (summary of engagement)
- Fund engagement in IB issues dates back to the mid-1980s.
- In the decade since the mid-1980s, the Fund published conceptual working papers but did not provide TA or policy advice.
- The Fund started providing TA on IB in the second half of 1990s, mostly in countries with relatively established IB practices (examples given: Sudan, Iran, Pakistan), focusing primarily on central banking operations and developing local government funding markets.
- The Fund did not provide significant TA on legal and regulatory aspects of IBs until around 2005/06 after the IFSB began to issue its standards.
- Fund staff involvement on IB issues is rising: IB-related issues increasingly encountered in surveillance work (FSAPs and Article IV missions) and in Use of Fund Resources (UFR) cases (examples given: Afghanistan, Pakistan, and Yemen).
- The number of IB-related TA requests has risen considerably in recent years, particularly from new IB jurisdictions (examples given: Djibouti, Mauritania, Kenya, and Tanzania), on topics such as regulation, supervision, and development of Sukuk markets.
- Fund staff participate in training and outreach as part of IMF RTACs jurisdictions (examples given: Djibouti, Mauritania, Kenya, and Tanzania).
- The Fund has collaborated closely with other international organizations and standard setters on IB issues, carrying out joint activities (TA, conferences, working groups) with organizations like the WB, the Arab Monetary Fund, and the IsDB, as well as industry standard setters (IFSB and AAOIFI).
- The Fund played a catalyst and central role in establishing the IFSB: a meeting of central banks on the side of a conference on the regulation of IBs (Bahrain, February 2000) organized jointly by the IMF and AAOIFI called for international action; this process culminated in the establishment of the IFSB in November 2002.
- The Fund provided significant TA support to the IFSB in its early years and remains an associate member.
- Fund staff contribute to international initiatives on IB-related issues, including work on Core Principles for Islamic finance regulation and commenting on drafts of technical standards in Islamic finance.

### Appendix IV — World Bank Group involvement in Islamic Banking and Finance (summary)
- The WB accelerated its involvement in IF issues in recent years; in 2009, the WB established the Islamic Economics and Finance Working Group (part of the Financial Systems Practice).
- The Group has focused on: (a) strengthening the legal, regulatory, and institutional foundations for the sustainable development of the IF industry; and (b) knowledge sharing and capacity building.
- The WB established in October 2013 the Global IF Development Center in Istanbul to contribute to the development of IF globally through research, training and advisory services.
- The WB has established working partnerships with the IFSB and AAOIFI and has worked on the design of standards (example: Principles of Insolvency and Creditor Rights) and on expanding implementation in individual jurisdictions.
- Work is underway with AAOIFI to develop accounting standards that are fully compliant with international accounting standards while taking into consideration the special features of IFI.
- The WB is finalizing Supplemental Corporate Governance Guidelines for IFI to guide improvements in governance and to provide the basis for the WB’s FSAP assessment of corporate governance in member countries.
- The IFC’s involvement in IF issues has been rising: the IFC formed an interdepartmental task force in 2008 to share knowledge and develop a systematic approach; the IFC has engaged in joint ventures and funding activities using IF instruments.

*Source: ENSURING FINANCIAL STABILITY IN COUNTRIES WITH ISLAMIC BANKING (excerpt).*

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_Source: https://www.imf.org/-/media/files/publications/pp/pp-ensuring-financial-stability-in-countries-with-islamic-banking.pdf_