## _sdn1505

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### Executive summary — key contributions and challenges
- Potential contributions:
  - Foster greater financial inclusion among large underserved Muslim populations.
  - Asset-backed financing and risk-sharing could support SMEs and public infrastructure investment.
  - Risk-sharing features and prohibition of speculation suggest Islamic finance may, in principle, pose less systemic risk than conventional finance.
- Main challenges:
  - Industry development must address regulatory, supervisory, liquidity, standardization, governance, and market-deepening deficiencies to develop in a safe and sound manner.

### Islamic banking — regulatory and supervisory findings
- Standards and practice:
  - Specialized standard-setting bodies exist, but many national regulatory and supervisory frameworks do not cater to the industry’s unique risks.
  - Cross-border operations expanded without regulatory harmonization; complex products and corporate structures have emerged in practice.
- Supervisory needs and recommendations:
  - Increase regulatory clarity and harmonization and foster closer cooperation between Islamic and conventional financial standard-setters.
  - Enhance tools for effective supervision, adapt rating methodologies (such as CAMELS), and implement IFSB stress-testing guidance.
  - National authorities should implement the Core Principles for Islamic Finance Regulation (banking segment).

### Profit-sharing investment accounts (PSIA)
- Treatment and issues:
  - Many regulators treat PSIAs as deposits, undermining their loss and liquidity absorbency.
  - Where some loss-absorbency is allowed, implications for corporate governance and consumer protection are not always addressed.
- Policy recommendations:
  - Ensure PSIAs are not treated as pure deposits.
  - Ensure better disclosure and enforcement of investors’ rights, including those related to payouts and reserves.
  - Apply IFSB guidance in setting the supervisory “alpha” factor to preserve PSIAs’ loss-absorbency.
- Alpha-factor principles and practice:
  - Alpha = 0 if unrestricted PSIAs fully bear risks and receive returns equal to investment returns.
  - Alpha = 1 if the bank pays market return regardless of asset returns and there is no mitigation of displaced commercial risk by PER.
  - Alpha may be set between 0 and 1 depending on supervisor assessment.
  - Only six countries allow some pass-through of PSIA losses for CAR computation: Bahrain, Jordan, Oman, Qatar, Sudan, and Turkey (pass-through varies between 50 percent and 70 percent).

### Shari’ah governance and supervision
- Findings:
  - Regulators may lack capacity or willingness to ensure Shari’ah compliance; Shari’ah interpretation differences lead to inconsistency.
  - IFSB and AAOIFI recommend independent Shari’ah Supervisory Board (SSB) at bank level, internal Shari’ah review, and periodic external Shari’ah reviews.
- Recommendations:
  - Seek greater harmonization across and within countries, better implementation of existing Shari’ah governance standards, and consider centralized national Shari’ah boards.

### Capital and liquidity under Basel III and related market issues
- Capital:
  - Islamic banks appear well-capitalized with high levels of Tier 1 common equity.
  - Need clear national guidance on instruments eligible as additional Tier 1 and Tier 2 capital and adoption of IFSB-15.
  - Variation in national treatment of PSIAs and alpha factors complicates RWA calculation and Basel III application.
- Liquidity:
  - Scarcity of Shari’ah-compliant HQLA makes meeting Basel III LCR difficult; Islamic banks hold high liquidity and higher unremunerated reserves.
  - Policy options:
    - Grant highly rated and tradable Sukuk HQLA status.
    - Deepen local Sukuk and money markets.
    - Adopt LCR framework at a pace commensurate with local systemic risks.
    - Support growth of Sukuk issuer base and short-term Shari’ah-compliant securities (IILM efforts).

### Safety nets, deposit insurance, and resolution frameworks
- Current status:
  - Safety nets and resolution frameworks are underdeveloped; very few countries have full-fledged Islamic deposit insurance schemes with Shari’ah-compliant investment of premiums.
  - Only a small number of countries have Shari’ah-compliant lender-of-last-resort facilities.
- Key challenges and considerations:
  - Insurability of Mudharabah (profit-sharing deposits) remains problematic; Wadiah and Qard are more consensually insurable.
  - IDIS design must account for governance, legal enforceability, priority of claims (distinguishing Wadiah/Qard and PSIAs, restricted vs unrestricted PSIAs), and Shari’ah-compliant liquidity of funds.
  - Risk-based fees require capacity to quantify IB unique risks.
- Observed practice:
  - Four countries implemented Shari’ah-compliant deposit insurance schemes: Bahrain, Indonesia, Malaysia, and Sudan (Sudan uses a Takaful model; Malaysia uses a Wakalah model).
- Recommendations:
  - Develop Shari’ah-consistent resolution frameworks and liquidity facilities as Islamic banks grow in systemic importance.
  - Consider IDIS design options where conventional and Islamic banks coexist and ensure clarity on priority of claims and role in resolution.

### Sukuk markets — findings and recommendations
- Market facts and dynamics:
  - Sukuk market reached US$120 billion in 2013; outstanding Sukuk were US$270 billion by end-2013, representing ¼ percent of global bond markets.
  - Sukuk issuance concentrated in Malaysia and GCC countries; issuance is evenly split between sovereigns and corporate Sukuk and mainly denominated in Malaysian ringgits or U.S. dollars.
  - Supply of Sukuk falls short of demand; issuance often oversubscribed, yields lower when issuer fundamentals are strong; secondary-market liquidity is limited as investors tend to “buy and hold.”
- Policy recommendations for national authorities:
  - Develop market infrastructure, promote true securitization, and clarify investors’ rights.
  - Step up regular sovereign issuance to provide benchmarks for the private sector, underpinned by sound public financial management.
  - Deepen local Sukuk and money markets to alleviate scarcity of Shari’ah-compliant liquid assets.

### Access to finance and financial inclusion
- Evidence and potential:
  - Islamic banking has had limited impact so far on access to finance.
  - Only 24 percent of adults have a bank account and 7 percent have access to formal financing among large segments of the Muslim population, compared with 44 percent and 9 percent, respectively, for non-Muslim populations (Demirgüç-Kunt, Klapper, and Randall 2013).
  - Islamic finance principles may be well-suited to financing SMEs and startups; Sukuk can support infrastructure investment.
- Policy steps to unlock potential:
  - Reduce tax and regulatory impediments to Islamic bank financing.
  - Enhance financial infrastructure and financial literacy.

### Macroeconomic policy implications
- Monetary policy and liquidity management:
  - Scarcity of Shari’ah-compliant monetary policy instruments and limited understanding of the transmission mechanism weaken monetary policy effectiveness.
  - Scarcity forces Islamic banks to hold higher unremunerated reserves, affecting competitiveness.
  - Recommendation: deepen Sukuk markets and develop Shari’ah-compliant monetary policy instruments.
- Macroprudential policy:
  - Systemic risks arise from liability mixes (deposits and investments), concentration in cyclically sensitive sectors, and limited market infrastructure.
  - Recommendations: develop cross-sectoral supervision, explore macroprudential tools to contain concentration risks, close data gaps, and build capacity to assess systemic risks.
- Tax policy:
  - Issues: debt-versus-equity tax bias, tax treatment of sales and layered transactions, cross-border spillovers, and tax arbitrage.
  - Recommendations: base tax treatment on economic substance; move away from distortionary transaction taxes toward neutral profit-based taxes; develop international accounting/auditing standards for Islamic finance; strengthen regional and global tax cooperation.

### Sector snapshot and dynamics
- Growth and size:
  - Islamic finance assets grew from about US$200 billion in 2003 to an estimated US$1.8 trillion at the end of 2013.
  - Banking represented about four-fifths of total Islamic finance assets in 2013.
  - Sukuk market assets were equivalent to about 15 percent of the industry.
  - Islamic banking represents about 1¼ percent of global banking assets.
- Geographic concentration and market shares:
  - Assets remain concentrated in the GCC countries, Iran, and Malaysia.
  - Islamic banking exceeded 15 percent of banking system assets in 10 countries: Iran and Sudan (full-fledged Islamic financial sectors), Bangladesh, Brunei, Kuwait, Malaysia, Qatar, Saudi Arabia, the United Arab Emirates, and Yemen.
- Performance during crisis:
  - During the recent global financial crisis Islamic banks were less exposed to toxic assets but suffered second-round effects such as real estate slumps.
  - Asset quality and capitalization remain, on average, better than conventional banks; profitability remains lower (with wide cross-jurisdictional variation).

### Box: Complexity of Islamic finance — commodity-sale home example and risks
- Transaction layering and replication risk:
  - Islamic finance avoids Riba and uses asset-based transactions; transactions are often structured to mimic conventional debt, leading to complex layering and third-party involvement.
  - Murabahah and Tawarruq structures illustrate added steps and counterparties to replicate conventional mortgage-like financing.
- Key risks highlighted:
  - Displaced commercial risk, equity investment risk, rate-of-return risk, Shari’ah noncompliance risk, heightened market and operational risks, amplified credit risk in PLS contracts, liquidity risk from scarcity of Shari’ah-compliant instruments, and concentration risk in real estate and commodities.
- Market growth and liquidity:
  - Sukuk outstanding US$270 billion by end-2013; undersupply relative to demand leads to oversubscription and buy-and-hold investor behavior, reducing liquidity.
- Evidence limits:
  - Empirical evidence does not yet confirm IB has promoted financial access and depth once structural factors are accounted for.
  - True asset-backed Sukuk are the exception; many structures designed to avoid the appearance of paying interest (“Shari’ah arbitrage”).
  - Recent oil-price declines could affect growth given concentration in oil-exporting countries; oil price empirically affects IB diffusion.

### Regulatory, supervisory, and standardization issues — implementation gaps
- Standard-setters and adoption:
  - AAOIFI (est. 1990) and IFSB (est. 2002) have developed technical standards and guidance; uptake is uneven and limited in many jurisdictions.
  - IFSB risk management and capital adequacy standards applied in only 6 jurisdictions (21 percent) among a 29-country subset referenced in the IMF staff survey.
- Supervisory models:
  - Two models where Islamic and conventional banks coexist:
    - Single supervisory authority model (examples: Ethiopia, Kazakhstan, Kenya, Kuwait, Qatar, Saudi Arabia, Tunisia, Turkey, the United Arab Emirates, and the United Kingdom).
    - Separated supervision within a single authority with separate units (examples: Bahrain, Indonesia, Jordan, Lebanon, Pakistan, and Syria).
- Implementation constraints:
  - Scarcity of Shari’ah scholars with financial expertise, limited economies of scale, uneven playing field with conventional finance, and slow innovation encourage complex practices and heightened risks.

### Consumer protection, AML/CFT, and disclosure
- Consumer protection issues:
  - Complex contracts (for example, Ijārah Muntahia Bittamlīk) can disadvantage defaulting consumers who lose built equity.
  - Complexity impedes consumer understanding; conflicts of interest from bank subsidiaries can affect IAH returns.
  - Recommendations: tailor consumer protection frameworks to Islamic finance, improve financial literacy, and strengthen bankruptcy and insolvency regimes.
- AML/CFT:
  - No evidence that ML/FT risks are materially different from conventional finance, but product complexity and supervisory inexperience may be risk drivers.
  - Recommendation: FATF, Islamic finance standard-setters, and national regulators should collaborate to assess whether AML/CFT obligations need adaptation.
- Disclosure and corporate governance:
  - Disclosure practices vary; in some jurisdictions Islamic banks cannot publish financial statements until SSB sign-off.
  - Recommendations: enhance corporate governance, mandate Board accountability for IAH rights, and ensure full disclosure and transparency on performance, payouts, and reserves.

### Macroprudential supervision and IFSB-15 guidance
- Macroprudential scope and challenges:
  - Special emphasis on liquidity risks and tailored disclosure/reporting for health signals of Islamic institutions.
  - Fragmented Shari’ah governance complicates macroprudential implementation; cross-sectoral coordination is essential.
- IFSB guidance and quantitative measures:
  - ED of GN-6 provides risk weights, required stable funding factors, key parameter settings for LCR and NSFR, and guidance on HQLA for Islamic institutions.
- Institutional arrangements:
  - Possible arrangements include a single regulator or strong coordination among banking, nonbanking, and capital market authorities.
  - Multilateral collaboration (IFSB, IMF, others) recommended to adopt internationally accepted principles and harmonize regulations to limit cross-border arbitrage.

### Annex — key Islamic finance instruments (selected)
- Ijārah: Lease/lease-purchase with transfer of ownership at end of term.
- Istisna’: Deferred payment/deferred delivery manufacturing contract.
- Mudarabah: Trustee finance (capital provider and entrepreneur share profits; losses borne by capital owner).
- Murabahah: Mark-up financing with disclosed cost and profit margin.
- Musharakah: Equity partnership with profit distribution and loss sharing pro rata.
- Qard: Benevolent zero-return loan (administrative fee possible).
- Salam: Prepayment for deferred delivery.
- Sukuk Al Istithmar: Investment Sukuk where holders share returns and bear losses proportionally.
- Tawarruq: Multi-step commodity-based transaction for liquidity management.
- Wadi’ah: Trustee deposits guaranteed in capital value, earn no return.
- Wakalah: Agency contract where one acts as agent for another.

_Italic source: IMF staff discussion note, Executive Summary and referenced boxes and chapters in _sdn1505._

### EXECUTIVE SUMMARY ___________________________________________________________________________ 6

### EXECUTIVE SUMMARY

### Key potential contributions of Islamic finance
- Promises to foster greater financial inclusion, especially of large underserved Muslim populations.  
- Emphasis on asset-backed financing and risk-sharing could provide support for small and medium–sized enterprises (SME) and investment in public infrastructure.  
- Risk-sharing features and prohibition of speculation suggest Islamic finance may, in principle, pose less systemic risk than conventional finance.

### Main challenges to realizing potential
- Need to address a number of challenges for the industry to develop in a safe and sound manner.

### Islamic banking — regulatory and supervisory findings
- Specific standards have been developed by specialized standard-setting bodies, but regulatory and supervisory frameworks in many jurisdictions do not yet cater to the unique risks of the industry.  
- Practice in some jurisdictions has resulted in complex financial products and corporate structures; cross-border operations have expanded without regulatory harmonization.  
- Need for increased regulatory clarity and harmonization, closer cooperation between Islamic and conventional financial standard-setters, and enhancement of tools for effective supervision.

### Profit-sharing investment accounts (PSIA)
- Treatment of PSIAs:
  - Many regulators treat these as deposits, which undermines their loss and liquidity absorbency feature.  
  - When regulators allow some loss-absorbency, they do not always pay sufficient attention to implications for corporate governance and consumer protection.  
- Policy recommendations:
  - Regulation and supervision should ensure that PSIAs are not treated as pure deposits.  
  - Ensure better disclosure and enforcement of investors’ rights, including those related to payouts and reserves.

### Shari’ah governance and supervision
- Regulators do not always have the capacity (or willingness) to ensure Shari’ah compliance, undermining consistency within and across borders.  
- Recommendation: Seek greater harmonization across and within countries, including better implementation of existing standards for Shari’ah governance and possibly establishing central boards at the national level.

### Capital and liquidity under Basel III
- Although Islamic banks appear well-capitalized, implementation of the Basel III Accord raises challenges:
  - Need further clarification from national regulators regarding instruments eligible for treatment as additional Tier 1 and Tier 2 capital.  
  - Scarcity of Shari’ah-compliant high-quality liquid assets (HQLA) will make it difficult for Islamic banks to satisfy the Basel III liquidity coverage ratio (LCR) requirement.  
- Recommendation: National authorities should use the leeway in Basel standards to grant highly rated and tradable Sukuk HQLA status and take steps to deepen local Sukuk and money markets.

### Safety nets and resolution frameworks
- Safety nets and resolution frameworks remain underdeveloped:
  - Very few countries with IB have a full-fledged Islamic deposit insurance scheme with premiums invested in Shari’ah-compliant assets.  
  - Only a small number of countries have developed a Shari’ah-compliant lender-of-last-resort facility.  
- Recommendation: Develop Shari’ah-consistent resolution frameworks and liquidity facilities as Islamic banks grow in systemic importance.

### Access to finance
- Islamic banking has had a limited impact so far on access to finance.  
- To unlock potential: reduce tax and regulatory impediments to Islamic bank financing and enhance financial infrastructure.

### Sukuk markets — findings and recommendations
- Sukuk are well-suited for infrastructure financing because of their risk-sharing property and could help fill financing gaps.  
- Supply of Sukuk falls short of demand; issuance typically occurs without a comprehensive strategy to develop domestic markets in most jurisdictions.  
- Recommendations for national authorities:
  - Develop necessary infrastructure, including promoting true securitization and enhanced clarity over investors’ rights.  
  - Step up regular sovereign issuance to provide a benchmark for the private sector.  
  - Increased sovereign issuance should be underpinned by sound public financial management.

### Macroeconomic policy implications
- Monetary policy and liquidity management:
  - Formulation and implementation are challenging due to scarcity of Shari’ah-compliant monetary policy instruments and lack of understanding of the monetary transmission mechanism.  
  - Scarcity of instruments weakens transmission and forces Islamic banks to hold higher unremunerated reserves, affecting competitiveness with conventional banks.  
  - Recommendation: Further deepen Sukuk markets and develop Shari’ah-compliant monetary policy instruments.

- Macroprudential policy:
  - Systemic risks can result from the mix of deposits and investments on the liability side and greater concentration of assets in cyclically sensitive sectors.  
  - Recommendations: Develop cross-sectoral supervision, explore macroprudential tools to contain concentration risks, close data gaps, and build capacity to assess systemic risks.

- Tax policy:
  - Islamic finance raises taxation issues: tax incentives for debt over equity, tax treatment of sales and additional layers of transactions in some instruments.  
  - Differences in treatment of Islamic and conventional finance can create cross-border spillovers and encourage international tax arbitrage.  
  - Recommendations: Base treatment on economic substance; move away from distortionary transaction taxes toward more neutral profit-based taxes; further develop international standards for accounting and auditing of Islamic finance; strengthen regional and global tax cooperation.

### Sector snapshot and dynamics
- Growth and size:
  - Islamic finance assets grew from about US$200 billion in 2003 to an estimated US$1.8 trillion at the end of 2013.  
  - Banking represented about four-fifths of total Islamic finance assets in 2013.  
  - Sukuk market assets were equivalent to about 15 percent of the industry.  
  - Islamic banking represents about 1¼ percent of global banking assets.

- Geographic concentration:
  - Islamic finance assets remain concentrated in the Gulf Cooperation Council (GCC) countries, Iran, and Malaysia.  
  - Islamic banking crossed the threshold of 15 percent as a share of banking system assets in 10 countries: Iran and Sudan (with a full-fledged Islamic financial sector), Bangladesh, Brunei, Kuwait, Malaysia, Qatar, Saudi Arabia, the United Arab Emirates, and Yemen.

- Performance during crisis:
  - During the recent global financial crisis, Islamic banks were less exposed to toxic assets but suffered from second-round effects, notably through the real estate slump.  
  - Asset quality and capitalization are still better on average than for conventional banks, while profitability remains lower (industry averages mask wide variation across jurisdictions).

*Source: IMF staff discussion note, Executive Summary section.*

### Box 1. Complexity of Islamic Finance: The Commodity-Sale Home Example

### Box 1. Complexity of Islamic Finance: The Commodity-Sale Home Example

### Nature of Islamic finance and transaction layering
- Islamic finance requires provision of financial services in accordance with the Shari’ah ban on interest (Riba) and asset-based financing involving purchasing, ownership, transfer, and transactions of real goods between counterparties.
- There is a tendency to structure transactions to mimic conventional (debt) financial contracts, resulting in complex layering of transactions and involvement of third parties to ensure Shari’ah compliance.
- Complexity can create credit, market, operational, and legal risks at different stages of execution of Islamic finance contracts.
- Murabahah transactions allow the contract to mimic a conventional mortgage, but with layering of the initial set of transactions and an increase in the number of counterparties involved through the life of the mortgage.

### Commodity-sale home example: Pure Murabahah vs Tawarruq-Murabahah
- Pure Murabahah home purchase (key steps described in source):
  - Agreement between the bank and the purchaser (1).
  - Agreement between the property seller and purchaser (2).
  - Bank purchases the property (stages 3-5).
  - Bank sells it to the purchaser pursuant to the Murabahah agreement (6).
  - The deferred payment obligation of the purchaser is secured by a mortgage on the property (7).
  - Deferred payments are made as in (8).

- Tawarruq-Murabahah combined structure (key steps described in source):
  - Bank purchases a commodity (metal) (3) and (4).
  - Bank sells the commodity to the home purchaser at a price that includes a profit margin (5) and involves a mortgage agreement (6).
  - The purchaser then sells the commodity for cash (7) (8).
  - Cash (with any equity by the purchaser) is used to purchase property (9) (10) from the seller.
  - The amount financed from the commodity (metal) Murabahah agreement is repaid to the bank over time as deferred payments (11), mimicking the payment structure of a conventional interest-based home loan.

### Risks and operational challenges highlighted
- Displaced commercial risk where Islamic banks may forego profits to pay comparable returns or avoid subjecting investment account holders (IAH) to losses.
- Equity investment risk because assets are physical investments with uncertain returns.
- Rate of return risk leading to potential depositor flight if market interest rates rise beyond the return funded by Islamic banks’ assets.
- Shari’ah governance and compliance risks: a determination of noncompliance could trigger client flight.
- Heightened market and operational risks due to complexity of products, reliance on commodities, and lack of hedging instruments.
- Credit risk amplified by difficulty selling debt, charging accrued interest in default, and recognizing nonperforming loans (NPLs) in some profit-and-loss-sharing (PLS) contracts.
- Scarcity of Shari’ah-compliant liquidity instruments and infrastructure may increase liquidity risk.
- Concentration risk from asset-based financing leading to high exposure to real estate and commodities and creation of complex corporate structures.
- Islamic banks’ focus on consumer financing rather than industrial or business financing reflects greater certainty over guarantees, collateral value, and investor rights.

### Market growth, structure, and liquidity dynamics
- Sukuk market reached US$120 billion in 2013, bringing outstanding Sukuk to US$270 billion by end-2013, representing ¼ percent of global bond markets.
- Issuance concentrated in Malaysia and the GCC countries, with diversification ongoing to Africa, East Asia, and Europe.
- Sukuk issuance is evenly split between sovereigns and corporate Sukuk and mainly denominated in Malaysian ringgits or U.S. dollars.
- Demand generally outstrips supply, leading to oversubscription on most issuances, lower yields (when issuer fundamentals are strong), and less liquidity as investors prefer to “buy and hold.”
- Islamic banks suffer from a shortage of Shari’ah-compliant liquid assets.

### Financial inclusion and macro-financial implications
- Islamic finance potential to contribute to higher and more inclusive economic growth:
  - Only 24 percent of adults have a bank account and 7 percent have access to formal financing among large segments of the Muslim population, compared with 44 percent and 9 percent, respectively, for non-Muslim populations (Demirgüç-Kunt, Klapper, and Randall 2013).
- Principles of risk-sharing and link of credit to collateral may make Islamic banking (IB) well-suited to financing SMEs and startups.
- Sukuk have shown value in infrastructure finance and could support investment and economic growth.
- Islamic finance may promote macroeconomic and financial stability through risk-sharing and asset-based financing, potentially improving risk management and discouraging credit booms.
- A large portion of bank deposits are offered on a profit-sharing and loss-bearing basis (for example, 55 percent in the Middle East and North Africa region; Ali 2011), rendering them explicitly “bail-inable” in banking sector distress.

### Limits of current evidence and product features
- Empirical evidence does not yet confirm that IB has promoted financial access and depth once structural factors are accounted for (Barajas, Ben Naceur, and Massara 2015).
- Questions remain on whether financing by Islamic banks is truly risk-sharing or whether PSIAs are fully loss-absorbing (López-Mejía, Aljabrin, Awad, Norat, and Song 2014).
- True securitization of Sukuk underlying assets is the exception rather than the rule; asset-backed transactions are often highly complex and layered, designed to avoid the appearance of paying interest (“Shari’ah arbitrage”).
- Recent decline in oil prices could affect sustained growth given concentration in oil-exporting countries; there is empirical evidence that the oil price is a determinant of IB diffusion (Imam and Kpodar 2010).
- Low yields and lack of liquidity could weigh on long-term Sukuk market growth.

### Regulatory, supervisory, and standardization issues
- Specialized Islamic standard-setting bodies exist:
  - Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), established in 1990, for Shari’ah accounting and auditing standards.
  - Islamic Financial Services Board (IFSB), set up in 2002, for regulatory and supervisory standards.
- AAOIFI and IFSB have developed technical standards and guidance, working with the Basel Committee to ensure coherence with conventional standards.
- Application of these standards is not uniform across countries; limited uptake may undermine transparency and create scope for regulatory arbitrage.
- IMF staff survey (Box 2) findings (2011 survey, 39 respondents, 10 excluded as not recognizing IB):
  - 72 percent indicated the legal and regulatory framework explicitly recognizes IB practices, products or institutions.
  - 76 percent noted that IB was being conducted by a stand-alone Islamic bank.
  - 55 percent indicated that IB was being conducted through a conventional bank.
  - Diverse regulatory frameworks: 11 respondents indicated a single integrated regulatory framework with no reference to IB; 10 respondents indicated a single integrated framework with references identifying provisions applying only to IB; 3 respondents pointed out two separate independent regulatory frameworks; 7 respondents indicated a mixed approach with separate guidelines for areas specific to IB.
  - IFSB standards regarding risk management and capital adequacy are applied in only 6 jurisdictions (21 percent of respondents) among the 29-country subset referenced earlier.
- Jurisdictions take different approaches to the application of capital requirements:
  - Some apply the chosen Basel capital framework to all banks, including Islamic banks (examples cited in source: Ethiopia, Kazakhstan, the United Arab Emirates, and the United Kingdom).
  - Others contain prescriptions often based on IFSB prudential standards and guiding principles to adjust the Basel framework for IB features (examples cited: Bahrain, Jordan, Malaysia, and Sudan).
  - Some jurisdictions apply an alpha factor representing the ratio of actual risk transferred to shareholders of Islamic banks, capturing differences in risk exposure between IB risk-sharing products and conventional banking products.

### Implementation gaps and industry constraints
- Constraints impeding development:
  - Further scope for implementation of Islamic standards by national authorities that are often more focused on global conventional banking standards.
  - Lower economies of scale and sometimes an uneven playing field with conventional finance.
  - Large differences in practice across countries and limited standardization and securitization create additional uncertainty for customers.
  - Scarcity of Shari’ah scholars with financial sector expertise and a slow pace of innovation.
- These challenges may encourage complex practices and products that carry heightened risks.

*Sources: M.J.T. McMillen; and IMF staff.*

### References Applying to

### References Applying to

### Models of supervision and organizational arrangements
- Two models of supervision where Islamic banks and conventional banks coexist:
  - Single supervisory authority model: Islamic and conventional banks are subject to the supervision of a single supervisory authority (examples: Ethiopia, Kazakhstan, Kenya, Kuwait, Qatar, Saudi Arabia, Tunisia, Turkey, the United Arab Emirates, and the United Kingdom).
  - Separated supervision within a single authority: supervision of Islamic and conventional banks is separated and lies with separate supervisory units within a single supervisory authority (examples: Bahrain, Indonesia, Jordan, Lebanon, Pakistan, and Syria).
- In the single authority model a single supervisory framework applies to all banks; in the separated-units model separate supervisory frameworks may be applied to Islamic banks, with substantial information sharing between frameworks.
- Supervisory capacity constraints:
  - Many jurisdictions lack dedicated licensing and examination procedures for Islamic banking (IB).
  - Supervisors often lack capacity to oversee both banking and mutual fund–like activities of Islamic banks, requiring a cross-sectoral approach covering banking, insurance, and securities market–like activities.
- Recommended standards and tools:
  - National authorities should implement the Core Principles for Islamic Finance Regulation (banking segment) based on BCBS core principles; a draft for public consultation was issued at end-October 2014.
  - Development of financial soundness indicators (FSI) for Islamic banks is important; the IFSB is taking steps to develop prudential and structural indicators for Islamic finance based on the IMF’s FSIs.
  - Supervisors should adapt rating methodologies (such as CAMELS) to IB and implement the IFSB standard on stress testing.

### Disclosure, Shari’ah compliance, and corporate governance
- Public disclosure approaches vary:
  - Jurisdictions where Shari'ah Law is not a fundamental source of law: all banks subject to same disclosure requirements (examples: Turkey, and the United Kingdom).
  - Other jurisdictions: Islamic banks may be prohibited from publishing financial statements until the Shari'ah Board signs off (examples: Malaysia, Pakistan, and Sudan).
- Shari’ah governance and supervisory gaps:
  - Regulators may lack capability or willingness to ensure banks have a sound framework for Shari’ah compliance and do not always assess fitness and propriety of Shari’ah advisors.
  - Differences in Shari’ah interpretation can lead to lack of harmonization within and across borders.
  - IFSB and AAOIFI recommend: independent Shari’ah Supervisory Board (SSB) at bank level, well-resourced internal Shari’ah review, and periodic external Shari’ah reviews.
  - An increasing number of jurisdictions are moving toward a centralized Shari’ah Board (examples: Bahrain, Indonesia, Malaysia, Morocco, Nigeria, Oman, Pakistan, and Sudan).
- Corporate governance issues between investment account holders (IAHs) and shareholders:
  - IAHs share profits and bear losses but do not have shareholder rights.
  - IAHs may lack full disclosure on asset performance and return calculations; may be unable to reclaim contributions to buffers upon withdrawal.
  - Recommendations: enhance corporate governance, mandate some Board Directors be accountable for enforcing IAH rights, and ensure full disclosure and transparency on performance, payouts, and reserves.

### Profit-sharing investment accounts (PSIAs) and capital treatment (Alpha factor)
- Functional nature of PSIAs: closely mimic mutual fund shares; regulatory treatment varies.
- Only six countries allow some pass-through of losses on assets financed by PSIAs when computing the capital adequacy ratio (CAR): Bahrain, Jordan, Oman, Qatar, Sudan, and Turkey. Pass-through varies between 50 percent and 70 percent.
- PSIAs incentivize banks to hold higher reserve and liquidity buffers.
- IFSB Capital Adequacy Standard: supervisors should assess risks borne by PSIAs and reflect assessments in CAR via the supervisory discretion "alpha" factor.
- Key alpha-factor principles from Box 3:
  - If unrestricted PSIAs fully bear their own risks and receive returns equal to investment returns, alpha = 0 (no additional capital required).
  - If the Islamic bank pays IAHs market return regardless of asset returns and there is no mitigation of displaced commercial risk by PER, alpha = 1 (additional capital required).
  - Alpha may be set anywhere between 0 and 1 depending on supervisor assessment of displaced commercial risk and risk-mitigating factors.
- CAR formula as presented:
  - CAR=[Eligible Capital]/{[total risk-weighted assets (credit+market risk) + operational risk]-[risk-weighted assets [RWAs] funded by restricted profit-sharing investment accounts (credit+market risk)] – [(1-Г)*total risk-weighted assets (credit+ market risk) funded by unrestricted profit-sharing investment accounts] – [Г*risk-weighted assets funded by profit equalization reserve [PER] and investment risk reserve [IRR] of unrestricted profit-sharing investment accounts]}
- Policy guidance:
  - Ensure PSIAs are not treated like pure deposits.
  - Observe IFSB guidance in setting the alpha factor to preserve PSIAs’ loss-absorbency.
  - Synchronize legal, tax, Zakat and other regulatory statutes so stakeholders are informed by comparable financial statements.

### Capital, liquidity, markets, and Basel III application
- Islamic banks are generally well-capitalized with high levels of Tier 1 capital largely in the form of common equity.
- Complication in Basel III application: variation in national treatment of PSIAs and differing alpha factors affects calculation of risk-weighted assets (RWAs).
- Importance of greater consistency in alpha where displaced commercial risk and RWAs are similar.
- Need to clearly identify instruments eligible as additional Tier 1 and Tier 2 capital, including adoption of IFSB-15 (Revised Capital Adequacy Standard for Institutions Offering Islamic Financial Services).
- Liquidity challenges:
  - Islamic banks hold high levels of liquidity but lack well-developed markets for Shari'ah-compliant high-quality liquid assets (HQLA), forcing higher cash holdings and affecting profitability.
  - Absence of Shari'ah-compliant deposit insurance may lead to excess liquidity; Islamic banks apply higher run-off factors on deposits and PSIAs, exceeding recommended run-off factors in Basel III LCR.
- Policy options to alleviate liquidity shortage:
  - Grant highly rated and tradable Sukuk the status of HQLA.
  - Deepen local Sukuk and money markets.
  - Adopt the LCR framework at a pace commensurate with local systemic risks.
  - Growth and broadening of the Sukuk issuer base and IILM efforts in short-term Shari'ah-compliant securities can aid liquidity.

### Risk-based supervision, consumer protection, and AML/CFT
- Risk-based supervision for IB is underdeveloped in many countries:
  - Need for specific supervisory tools and methodologies to assess unique IB risks (e.g., transformation of risk, asset quality differences, sensitivity to certain market risks, heightened operational risks, Shari’ah governance).
  - Supervisors need to adapt rating systems and implement IFSB stress testing.
- Consumer protection issues specific to Islamic banking:
  - Contracts like Ijārah Muntahia Bittamlīk (“lease-to-purchase”) can disadvantage consumers who default, as they may lose built equity and cannot capitalize on capital gains to prepay.
  - Complexity of some contracts impedes consumer understanding of risks.
  - Conflicts of interest may arise from bank subsidiaries operating sales transactions, affecting IAH returns.
  - National authorities should develop consumer protection frameworks tailored to Islamic finance, improve financial literacy, oversee related-party financing to subsidiaries, and strengthen bankruptcy and insolvency regimes.
- AML/CFT considerations:
  - Limited work by international standard setters on AML/CFT risks specific to Islamic finance.
  - No evidence that ML/FT risks in Islamic finance are materially different from conventional finance.
  - Potential Islamic-finance-specific ML/FT risk drivers include product complexity, institution-client relationship nature, and limited supervisory experience in jurisdictions with multiple risk factors.
  - Recommendation: FATF, Islamic finance standard-setters, and national regulators should collaborate to better understand ML/TF risks specific to Islamic finance and assess whether AML/CFT obligations need adaptation.

### Safety nets, deposit insurance, and resolution frameworks
- Conventional resolution tools can, in principle, be applied to Islamic banks, but frameworks addressing Islamic finance's particular challenges are needed.
- Key policy areas to preserve financial stability:
  - Deposit insurance schemes that protect depositors of Islamic banks.
  - Development of Shari'ah-compliant emergency liquidity instruments.
  - Resolution frameworks enabling swift resolution measures.
- Challenges in extending deposit insurance to Islamic banks in dual systems:
  - Treatment and insurability of deposits accepted under profit-sharing contracts.
  - Priority of claims of different deposit types with Islamic banks.
  - Role of deposit insurance fund in resolution.
  - Funded Islamic deposit insurance schemes must be Shari’ah compliant in investment policies, but market limitations may hinder this objective.
- Observed practice: only two countries have a separate and full-fledged Islamic deposit (text truncated in source).

*Source: IMF — Islamic Finance (extracts from the chapter “References Applying to”)*

### Box 4. Islamic Deposit Insurance (IDI)— Challenges

### Box 4. Islamic Deposit Insurance (IDI)— Challenges

### Standards and implementation
- The IFSB has not adopted a standard or guideline on Shari’ah-compliant deposit insurance.
- The Islamic Deposit Insurance Group of the International Association of Deposit Insurers (IADI) has concluded that Shari'ah compliance is a key challenge for an Islamic Deposit Insurance Scheme (IDIS).1
- Four countries have implemented Shari’ah-compliant deposit insurance schemes, including Bahrain, Indonesia, Malaysia, and Sudan.
  - Sudan uses a Takaful-based model.
  - Malaysia uses a Wakalah-based model.

### Governing framework and legal enforceability
- Governments could take several alternative approaches to implementing an IDIS (for example, government regulation, Shari'ah contract, or a combination of both).
- The legal enforceability of each approach would need to be undertaken.

### Insurability of Islamic deposits and PSIAs
- There seems to be a consensus regarding the insurability of Wadiah (safe-keeping), or Qard.
- Mudharabah (deposits accepted under profit-sharing contracts) remains problematic.2
- Jurisdictions are divided on the definition and treatment of PSIAs:
  - Some countries provide protection to both unrestricted and restricted PSIA holders.
  - Some provide protection only to unrestricted PSIAs.
  - Some do not provide any protection to PSIAs.

### Risk-based fees and analytical capacity
- In jurisdictions that apply risk-based fees for the funding of deposit insurance, the unique risks of IB would need to be quantified.
- This implies the development of requisite analytical capacities and underlying data.

### Availability and liquidity of Shari'ah-compliant investments
- IDISs need to operate in compliance with Shari'ah rules.
- In an ex ante-funded IDIS, management and investment of funds could become problematic if Islamic instruments are limited.
- To ensure a quick payout to depositors, deposit insurance funds need to be liquefied on short notice, which would mean that IDIS funds would need to be invested in liquid instruments.

### Coexistence with conventional banking
- Options for governance where conventional and Islamic banks coexist include:
  - Islamic deposits covered by conventional deposit insurance.
  - Islamic deposits covered by an IDIS.
  - IDIS housed in a separate agency or in a single agency that manages both conventional and Islamic DIS.
- Each option has distinct governance, legal, and operational implications—particularly where Islamic windows are allowed.

### Priority of claims
- Under a conventional DIS all depositors are ranked equally; this is not necessarily the case under an IDIS.
- A distinction could be made:
  - Between actual deposits (Wadiah) and Qard on the one hand and PSIAs on the other hand.
  - Between restricted and unrestricted PSIAs.
- This ranking of priority in the case of banking stress could affect the attractiveness of Islamic deposits.

### Role in resolution
- There is growing support for authorizing a DIS to fund bank resolution.
- Shari'ah compliance of such resolution activity by DIS is unclear.

*Source: Box 4. Islamic Deposit Insurance (IDI)— Challenges, _sdn1505.*

### Chapter 2 of IFSB-15, especially the sections on countercyclical buffer and leverage ratio, cover issues of

### Chapter 2 of IFSB-15 (sections on countercyclical buffer and leverage ratio — macroprudential supervision)

### Macroprudential supervision: scope and challenges
- Chapter 2 covers issues of macroprudential supervision (footnote 25).
- Reserves held by Islamic banks:
  - "Although these reserves may be helpful in mitigating some key risks and losses by the Islamic bank, it would not be able to address Shari’ah noncompliance risks." (footnote 26)
- Financing-to-deposit ratios:
  - "Financing-to-deposit ratios could be defined to include just Wadiah-like deposits or more broadly defined to include PSIAs as well." (footnote 27)
- Special emphasis on liquidity risks given difficulties in developing Shari’ah-compliant money markets and instruments.
- Need for disclosure and reporting tailored to provide adequate signals of the health of Islamic financial institutions.

### Liquidity standards and quantitative measures
- The IFSB Exposure Draft—Guidance Note on Quantitative Measures for Liquidity Risk Management in Institutions offering Islamic Financial Services (ED of GN-6) provides:
  - Risk weights.
  - Required stable funding factors.
  - Key parameter settings for LCR and NSFR determination.
  - Guidance on addressing HQLA for Islamic institutions.

### Institutional framework, cross-sectoral coordination, and Shari’ah governance
- Effective implementation of macroprudential policy is complicated by fragmentation in Shari’ah governance structures.
- Application of macroprudential policy under Islamic banking requires taking into account specificities of Islamic finance.
- Greater need for a cross-sectoral approach to regulation and supervision, taking account of group and cross-border risks.
- Possible institutional arrangements:
  - Single regulator, or
  - Strong coordination between banking, nonbanking, and capital market regulatory authorities.
- In countries with Islamic banking but no capital markets authorities or securities regulation, the mandate for bank regulators could be expanded to include conduct of business rules.
- Consideration of multilateral approaches to establish macroprudential guidelines, including collaboration between the IFSB, the IMF, and other relevant parties to:
  - Adopt internationally accepted principles for macroprudential oversight of Islamic banks.
  - Harmonize regulations to limit arbitrage across borders while ensuring a level playing field with conventional banks.

### Tax policy: leveling the playing field
- Tax areas requiring attention: income taxes, sales taxes (for example, value-added taxes), specific transaction taxes, and bilateral tax treaties.
- Debt-equity treatment issues:
  - Conventional tax systems recognize return to debt (but not equity) as a deductible cost — "debt bias" — which can disadvantage Islamic finance since Shari’ah does not recognize interest.
  - Most modern tax systems can treat the economic substance of Islamic instruments similarly to conventional instruments; this may or may not require changes to tax legislation.
  - Changes to regulations or application rules may be sufficient to provide transparency and certainty regarding tax treatment of main Islamic finance instruments.
- Cross-border spillovers and tax arbitrage risks:
  - Differences between Islamic and conventional treatment can create opportunities to treat a transaction as debt in one country and equity in another.
  - Importance of international collaboration to minimize these opportunities within bilateral tax treaty networks and more globally.
- Transaction taxes and complexity:
  - Islamic finance may generate higher transactions costs due to additional intermediaries and more complex transaction structures.
  - Transaction taxes (for example, stamp or similar fees) can disadvantage some Islamic instruments.
  - Preferable policy direction: shift away from distortionary transaction taxes toward more neutral profit-based taxes.
- Standards and transparency:
  - International accounting and auditing standards for Islamic finance are important for ensuring Shari’ah consistency within and across jurisdictions (Hurcan, Mansour, and Olden 2015).

### Annex: Key instruments of Islamic finance (selected descriptions)
- Ijārah (Lease, lease purchase): A party leases a particular product for a specific sum and a specific time period; lease purchase payments include a portion toward final purchase and transfer of ownership.
- Istisna’ (Deferred payment, deferred delivery): Manufacturer agrees to produce and deliver a good at a given price on a future date; price need not be paid in advance.
- Mudarabah (Trustee finance contract): Provider of capital supplies funds; entrepreneur offers labor and expertise; profits shared at fixed ratio; financial losses borne by capital owner.
- Murabahah (Mark–up financing): Bank purchases goods from a supplier and resells to borrower at agreed mark-up for immediate or deferred payment; cost and profit margin disclosed.
- Musharakah (Equity participation): Equity partnership with profit distribution per predetermined ratios and losses shared in proportion to capital contributions.
- Qard (Benevolent loan): Zero-return loans; banks may charge an administrative service fee not related to loan amount or maturity.
- Salam (Prepayment, deferred delivery): Buyer pays full price in advance for delivery at a future date.
- Sukuk Al Istithmar: Investment Sukuk allowing packaging of ijara, Murabahah, istisna receivables, equity shares; holders share returns per stated ratios and bear losses in proportion to investment.
- Tawarruq: Multi-step transaction used for interbank financing and liquidity management, often based on commodities; AAOIFI (2006, 525) defines Tawarruq and notes Shari’ah concerns in certain practices.
- Wadi’ah (Demand deposits): Trustee deposits guaranteed in capital value, earn no return.
- Wakalah (Agency): One party acts as agent to undertake transactions on behalf of another party.

*Source: Chapter 2 of IFSB-15 (as presented in the provided PDF content).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/sdn/2015/_sdn1505.pdf_