## _wp13184

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### I. Introduction and research framing
- Context and motivation:
  - Recent global financial crisis prompted reevaluation of financial system features; concern about very highly-leveraged institutions maximizing return on equity via high-volume own-account trading in complex instruments perceived to have little net social value.
  - Perceived yearning for simpler, more client-oriented financial relationships tied to underlying “real” activities.
- Comparative resilience and rationale:
  - Cooperative banks (notably local credit unions) and Islamic banks survived the crisis relatively well and are worth studying for lessons.
  - When these institutions experienced difficulties, the primary driver was “old fashioned” credit risk rather than market risk or liquidity risk.
- Research questions:
  - How do Islamic and cooperative banks work, particularly relative to commercial banks and to each other?
  - Are there similarities between them and what can they learn from each other?
- Structure (as stated in source):
  - Next section: main characteristics, data on size/growth/performance, issues.
  - Section III: similarities and differences.
  - Section IV: lessons between institutions.
  - Section V: concludes.

### II. Characteristics — Cooperative banks and credit unions
- Ownership and governance:
  - Cooperative/mutual bank: owned by the majority of its customers through instruments that are not freely negotiable; normally each depositor has at least one share, redeemable only upon closure of the customer’s deposit account.
  - Wide variety of organizational forms: some cooperatives do retail business with non-members; some allow additional redeemable shares; some require borrowers to own shares.
- Activities and income:
  - Can engage in any conventional bank activity; typically strong retail orientation; most earn most profits from interest rate spreads and transaction fees.
- Credit unions (specifics):
  - Not-for-profit cooperative financial institutions owned and controlled by members; every member one vote regardless of savings/loan size; members run for volunteer boards.
  - Pool members' savings and shares to finance loan portfolios rather than relying heavily on outside capital.
- Membership advantages:
  - Common bond (community/organization/religion/employment) increases borrower information, creates repeated-game incentives, reduces adverse selection, and may facilitate tax efficiency.
- Capital and managerial constraints:
  - Cannot issue capital except to members; must rebuild reserves from retained earnings after large losses.
  - Diffuse ownership reduces individual incentives to monitor management; protected from hostile takeovers.
- Development and apex structure:
  - Over time sectors became more concentrated and integrated; local cooperatives often own shares in central “apex” institutions providing central services, liquidity reallocation, remunerated investments, oversight/resolution powers.
  - Apex strength varies across systems.
- Key statistics and trends:
  - EACB (2012): about 4,000 member cooperative banks and 72,000 branches in EACB member countries; in 28 European member countries: 56 million member-owners and served more than 217 million customers.
  - Average total asset size in Europe: about €1.4 billion (large dispersion).
  - Table 1 (selected figures, Million Euro): EU total assets 6,951,981 / total deposit 3,932,516 / total loans 4,033,568; Canada 144,124 / 93,539 / 94,867; Japan 653,180 / 396,750 / 133,476; Switzerland 128,940 / 101,053 / 112,659.
- Global credit union statistics (WOCCU, Table 2):
  - 2011: 100 countries / 51,013 credit unions / 196,498,738 members.
  - 2010: 100 / 52,945 / 187,986,967.
  - 2009: 97 / 49,330 / 183,916,050.
  - 2008: 97 / 53,689 / 185,800,237.
  - 2007: 96 / 49,134 / 177,383,728.
  - 2006: 96 / 46,367 / 172,007,510.
  - 2005: 92 / 42,705 / 157,103,072.
  - 2004: 82 / 41,042 / 128,338,297.
  - 2003: 84 / 40,457 / 123,497,445.
  - 2002: 78 / 40,258 / 118,268,624.
- Global credit union financials (WOCCU, Table 3; Million US$):
  - 2011: Savings 1,221,635 / Loans 1,016,243 / Reserves 141,314 / Assets 1,563,529.
  - 2010: 1,229,389 / 960,089 / 131,659 / 1,459,606.
  - 2009: 1,145,851 / 911,753 / 119,738 / 1,352,609.
  - 2008: 995,741 / 847,059 / 115,317 / 1,193,812.
  - 2007: 987,861 / 847,896 / 115,358 / 1,181,466.
  - 2006: 904,121 / 758,209 / 106,826 / 1,092,136.
  - 2005: 763,820 / 612,202 / 91,557 / 894,455.
  - 2004: 707,438 / 531,419 / 82,927 / 824,653.
  - 2003: 656,370 / 482,574 / 74,674 / 758,479.
  - 2002: 589,220 / 424,951 / 67,420 / 676,049.
- U.S. credit unions (as of September 2010, CUNA, 2012):
  - 7,535 credit unions serving nearly 91.8 million members → penetration rate 43.9 percent.
  - About 30 corporate credit unions.
  - Held about US$800 billion in savings → average deposit base about US$100 million each.
  - Two thirds of the 8,000 U.S. credit unions (13 million members) have assets under US$35 million.
  - Half of U.S. credit unions have less than $16 million in total assets.
- Performance and vulnerabilities:
  - Most credit unions did not suffer major losses in 2008 crisis; cooperative banks in Europe fared relatively well (Fonteyne and Hardy, 2011).
  - Vulnerable to common shocks affecting the community (industry-specific shocks); focus on household lending exposes institutions to unemployment and real estate collapses.
  - Small average size limits economies of scale and scope; increased mobility weakens common-bond.

### III. Characteristics — Islamic banks
- Shari’ah compliance and principles:
  - Financial investment must be connected to a specific “real” activity; prohibition on a predetermined interest rate (riba).
  - Trading financial instruments such as derivatives for the sake of making a financial profit is prohibited (use of forward contracts is allowed).
  - Emphasis on mutual solidarity; requirement to pay Zakat at rate of 2.5 percent for lunar calendar year (IFQ, 2007).
  - Provision of qard-hasn uncompensated loans.
- Product forms and business model:
  - Three principal asset-side modes: (i) sale-based instruments; (ii) lease-based instruments; (iii) partnership–based instruments.
  - Sale-based instruments include murabahah / cost plus, commodity murabahah (tawarruq), bai al inah; salam and istisna used for non-existent assets.
  - Lease-based instruments: ijarah and ijarah muntahiyah bi tamleek.
  - Partnership-based: musharakah, mudarabah, diminishing musharakah.
  - Liability-side deposit forms: al-wadiah safekeeping accounts; unrestricted mudarabah investment accounts; restricted investment accounts.
  - Banks generate management fees and engage in profit and loss sharing (PLS) arrangements; commissions and fee income are major business components.
- Operational implications:
  - Banks may take ownership of commodities, real estate, or other physical assets → need capacity for storage, maintenance, asset management and sector expertise.
  - Depositors in remunerated Islamic accounts face higher informational burdens and must evaluate bank investments.
  - Islamic banks typically require more monitoring and sector expertise relative to conventional banks.
- Development, size, and growth:
  - First modern Islamic bank founded in Egypt in 1962/63; movement expanded in the 1970s.
  - Sanusi (2011): at least 435 full-fledged institutions and 191 windows operating in over 48 countries.
  - Ernst and Young (2012): Islamic banking assets grew at an annual rate of 19 percent over the five years to end-2012, to reach US$1.55 trillion.
  - The Banker: Shari’ah-compliant assets of major Islamic financial institutions reached US$1.16 trillion in 2012, up from US$894 billion in 2010 and US$1,086 billion in 2011.
  - Estimated about 12 percent of Muslims use Islamic financial products (Zawya, 2012).
  - Globally, banks hold over 90 percent of Islamic assets.
  - According to Ernst and Young, just 13 Islamic banks had capital over US$1 billion at end-2012.
- Sukuk market (selected figures from source):
  - Sukuk issuance by issuer type (US$ millions): Sovereign 99,558; Quasi-sovereign 17,899; Corporate 22,88 (as presented in source).
  - Malaysia dominates global sukuk issuance; infrastructure and financial sectors are main non-government issuers.
- Liquidity, asset composition, and maturity mismatch:
  - Islamic banks often have surplus deposit funding and lack suitable investment opportunities; large maturity mismatches with short-term funding and demand for longer-term funding.
  - Bankscope (2010) sample: 118 Islamic banks with total assets of US$685 billion; deposits and other short-term funding constitute on average three quarters of liabilities (Figure 2).
  - MENA (2008): murabahah cost-plus products bulk of investments; leasing and hire purchase next; mudarabah important mainly in Saudi Arabia.
  - Bank Negara Malaysia (end-2012): musharakah and mudarabah 5.2 percent of Malaysian Islamic bank financing; bai al inah, istisna, and other murabahah 49.5 percent; ijarah 25.4 percent.
  - Liquidity management constrained by avoidance of interest-based intermediation; use commodity-based murabahah (relatively expensive) or central bank Shari’ah-compatible facilities where available.
- Performance and asset quality:
  - Relatively little affected by global financial turmoil starting in 2008 due to restrictions on investment activities and excess liquidity; limited exposure to U.S. sub-prime mortgage and related derivative markets.
  - Some suffered from heavy commitments to corrected markets (e.g., Gulf real estate) and from Sukuk defaults.
  - On average, nonperforming loan ratios of Islamic banks have been higher than comparable conventional banks, and profitability has tended to weaken (Islamic Financial Services Board, 2013).

### IV. Similarities and differences between cooperative and Islamic banks
- Shared features:
  - Both are depository financial intermediaries where savers deposit and withdraw funds under contractual conditions and act as intermediaries tied to “real” transactions.
  - Both require depositors to share risk in some form: Islamic banks explicitly in unrestricted investment accounts; cooperative banks pay interest plus a dividend dependent on revenues.
  - Both tend to be small, retail-focused, and emphasize serving members/customers rather than maximizing short-term profit.
- Payoff structures and risk sharing (notation from source):
  - Notations: total assets A, deposits D, capital K, gross revenue R, operating costs C, interest rate on deposits i, Islamic bank allocates proportion x of net revenues to depositors.
  - Payoffs when bank makes sufficient profits (ignoring retention):
    - Conventional Bank depositors: D*i
    - Cooperative Bank depositors: D*i + (R-C-D*i) = R-C
    - Islamic Bank depositors: x(R-C)
    - Conventional Bank shareholders: R-C-D*i
    - Cooperative Bank shareholders/depositor‑shareholders: (1-x)(R-C)
  - With retained earnings and Profit Equalization Reserve (PER) arrangements, payoffs become more complex (see source tables) and involve proportions y, y’, y’’, z. Examples in source:
    - Conventional Bank depositors: D*i
    - Cooperative Bank depositors: D*i + (1-y’)(R-C-D*i) = (1-y’)(R-C)+ y’D*i
    - Islamic Bank depositors: (1+x-zx)(R-C)
    - Conventional Bank shareholders: (1-y)(R-C-D*i)
    - Cooperative Bank shareholders: (1-y’’)(1-x)(R-C)
- Information asymmetry and monitoring:
  - Both face monitoring challenges because payouts depend on management accounting and disclosure; Islamic bank accounting may be harder to interpret due to financing heterogeneity and payout smoothing (PER).
  - Depositors in remunerated Islamic accounts bear higher informational burdens to evaluate investments.
- Asset-side differences:
  - Islamic banks often hold non-financial assets (commodities, inventory, real estate) and may need asset management capacity.
  - Cooperative banks/credit unions typically hold little non-financial assets beyond operations and seized collateral.
- Organizational objectives:
  - Both emphasize solidarity and rejection of usury; credit unions are community and not-for-profit–oriented; Islamic banks operate largely for shareholder benefit but have explicit injunctions to share risk and make charity contributions.
- Observed performance parallels:
  - Both sectors showed relative resilience in the 2008 turmoil; profitability and return on equity tend to be quite low but relatively stable.

### V. Policy, organizational implications, and lessons each can learn from the other
- For Islamic banks:
  - Consider cooperative ownership/governance structures to enhance mutuality, equality among parties, and alignment with Islamic finance principles.
  - Converting unrestricted investment accounts into equity (mudarabah → musharakah) could give depositors broader equity-like positions.
  - Establish apex institutions (liquidity-pooling giro) to diversify idiosyncratic liquidity shocks, invest in longer-term projects, and provide central Shari’ah-compatible liquidity facilities.
  - Use PER and Investment Risk Reserves to smooth depositor returns; regulatory treatment of PER discussed in IFSB (2010).
  - Develop sector- and product-specific expertise for asset ownership and equity stakes.
- For cooperative banks and credit unions:
  - Pay out a higher share (or all) returns as dividends and a lower share as predetermined interest to increase depositor risk-bearing capacity and relax inflexible capital structure constraints.
  - Introduce automaticity to “bail in” some deposits up to a limit (example cited: say, 10 percent of the average balance).
  - Offer remuneration rules combining higher dividend rates with proportional write-downs in case of losses; offer multiple savings products to expand risk-return frontier.
  - Make higher-risk, higher-return deposits more attractive by granting enhanced voting rights to those accounts to incentivize monitoring.
  - Offer more risk-sharing contracts to borrowers (e.g., diminishing musharakah for home purchase, sales-based contracts where the institution retains ownership of financed inputs) to align incentives and provide recourse to collateral.
  - Consider establishing or using apex institutions for liquidity management, similar to WOCCU’s corporate credit unions or Islamic apex proposals.
- WOCCU’s experience and hybrid models (Box 2):
  - WOCCU’s IIFCs in Afghanistan deploy al-wadiah, murabahah, mudarabah, ijara, hybrid ijara-murabahah, and community development reinvestment/Zakat.
  - Combining cooperative ownership and Shari’ah compliance is feasible: requiring safekeeping account holders to hold minimum balances in investment/equity accounts; converting investment accounts into equity; restricting membership to a community and establishing one-vote-per-member governance to align with credit union principles.
  - Apex liquidity arrangements can help manage liquidity while enforcing rules to prevent abuse (e.g., limits, sanctions, confidentiality protections).
- Broader risk-sharing lessons:
  - Increasing variable dividend components and reducing fixed-interest components helps cooperatives absorb losses without rights issues and build reserves in good times.
  - Challenges include convincing members to bear extra risk, acquiring sector expertise, and managing nonbanking assets; supervisors must be shown expertise and legal backing.

### VI. Concluding synthesis
- Both Islamic banks and cooperative credit institutions share an ideology that finance should serve society and avoid exploitation; remunerated depositors in both institutions receive variable, performance-dependent returns, implying ex post risk sharing between depositors and the institution.
- A cooperative ownership and governance structure is consistent with Islamic precepts about inclusiveness and risk-sharing, can strengthen incentives to protect savers’ interests, increase resilience, and improve governance.
- Practical measures: adopt PER/Investment Risk Reserves, create apex liquidity facilities, offer diversified risk-sharing products, and consider mutualist ownership forms where legally and operationally feasible.

*Source: _wp13184 (References and excerpted sections and boxes from the provided IMF content).*

### References .............................................................................................................

### _wp13184 - References

### Tables listed in the content unit
- 1. Cooperative Banks: Financial Statistics for European Union, Canada, and Japan
- 2. Credit Unions: Worldwide Membership Statistics
- 3. Credit Unions: Worldwide Financial Statistics
- 4. Payoff for Depositors and Shareholders of Three Types of Financial Institution
- 5. Payoff for Depositors and Shareholders with Retained Earnings and Profit Equalization

### Figures listed in the content unit
- 1. Growth of Sukuk Issuance
- 2. Composition of MENA Region Islamic Banks’ Customer Accounts
- 3. Composition of Islamic Banks’ Investments
- 3 (duplicate numbering). [Appears twice in the list] — Composition of Islamic Banks’ Investments

### I. INTRODUCTION — key points and framing from the chapter excerpt
- Context and motivation:
  - The recent global financial crisis prompted reevaluation of desirable features of financial systems, with unease about the dominance of very highly-leveraged institutions maximizing return on equity via high-volume own-account trading in complex instruments perceived to have little net social value.
  - There is a perceived yearning for simpler, more client-oriented financial relationships tied to underlying “real” activities.
- Comparative resilience and rationale for study:
  - Parts of the financial system that survived the crisis relatively well are worth studying for lessons; cooperative banks (notably local credit unions) and Islamic banks are among such institutions.
  - These institutions are generally more distant from “speculative” financial markets and, on average, survived the crisis with comparatively little strain.
  - When cooperative or Islamic banks experienced difficulties, the primary driver was “old fashioned” credit risk rather than market risk or liquidity risk.
- Research questions and objectives:
  - How do Islamic and cooperative banks work, particularly relative to commercial banks and to each other?
  - Are there similarities between them?
  - What can they learn from each other?
- Structure of the paper (as stated in the excerpt):
  - The following section (after the Introduction) describes the main characteristics of cooperative and Islamic banks, presents data on the size, growth, and recent performance of these two kinds of institution, and summarizes some issues that they face.
  - Section III details their similarities and differences.
  - Section IV presents what the institutions can learn from each other.

*Source: _wp13184 - References*

### Section V concludes.

### _wp13184 - Section V concludes.

### II. CHARACTERISTICS — Overview
- Contrasts cooperative banks and credit unions with the prototypical conventional bank:
  - Conventional bank: profit-maximizing, owned through negotiable shares, earns profits primarily from the spread between interest on loans and interest paid to depositors and other financing providers; may earn non-interest income from transaction fees.
  - Universal banks: may hold equity in non-financial companies, trade on own account, act as investment banks, finance customers with equity and lending, and sit on boards—potentially lowering monitoring costs but risking opaque or “cozy” bank–corporate relationships.
- Need to specify defining characteristics of Islamic banks and cooperative banks (including credit unions) and contrast them with conventional banks.

### A. Cooperative Banks and Credit Unions — Main Features
- Ownership and governance:
  - Cooperative/mutual bank: owned by the majority of its customers through instruments that are not freely negotiable.
  - Normally, each depositor has at least one share, redeemable only upon closure of the customer’s deposit account.
  - Wide variety of organizational forms: some cooperatives do retail business with non-members; some allow additional redeemable shares; some require borrowers to own shares even if not depositors.
- Activities and income:
  - Can engage in any conventional bank activity; typically strong retail orientation but some engage in investment-banking activities or provide equity-type financing to SMEs.
  - Most cooperative banks earn most of their profits from interest rate spreads and transaction fees.
- Credit unions (specific form of cooperative bank):
  - Not-for-profit cooperative financial institutions owned and controlled by members; operated to promote thrift, provide credit at reasonable rates, and provide other financial services to members.
  - Every member is an equal owner with one vote regardless of savings or loan size; members can run for volunteer boards.
  - Members benefit from acceptable returns on savings, reasonable loan rates, and fewer fees than typical conventional banks.
  - Credit unions pool members' savings and shares to finance their loan portfolios rather than relying heavily on outside capital; typically retail-focus including homeowner-related and SME lending; often do not provide more complex products.
- Membership and information advantages:
  - Membership usually based on a common bond (community, organization, religion, employment), which can:
    - Increase information about borrowers.
    - Create a “repeated game” promoting cooperative behavior.
    - Reduce adverse selection problems.
    - Facilitate tax efficiency.
- Capital and risk-bearing constraints:
  - Owner-members oversee management and receive dividends dependent on profits and reserves.
  - Risk-bearing and managerial control are connected: depositors share upside and, to some extent, downside risk before bankruptcy.
  - Limited capacity to manage capital structure: cannot issue capital except to members, limiting ability to raise outside capital to expand or shore up capitalization after losses.
  - If a credit union suffers large losses, it must slowly rebuild reserves from retained earnings.
- Governance challenges:
  - Diffuse ownership reduces individual incentives to monitor management.
  - Protected against hostile takeovers; few market performance indicators or outside analysis.
  - Apex institution can oversee a cooperative but shifts governance issues upward.

### A. Cooperative Banks and Credit Unions — Development and Organization
- Historical notes:
  - Origins: Franz Hermann Schulze-Delitzsch set up a cooperative bank in Germany in 1852; Friedrich Wilhelm Raiffeisen developed the movement further.
  - By 1888 credit unions spread to Italy, France, the Netherlands, Austria.
  - Movements infused with religious/secular morality emphasizing thrift, mutual solidarity, and opposition to usury.
  - Belief that financial services can help lift people out of poverty; related to micro-finance institutions (MFIs).
- Structure and apex institutions:
  - Over time cooperative sectors became more concentrated and integrated; some cooperative banks own listed subsidiaries; some cooperatives own limited liability banks.
  - Local cooperatives often own shares in a central “apex” institution that provides central services, reallocates liquidity, remunerated investments, and oversight/resolution powers.
  - Strength of apex over members differs across systems; arrangement presupposes coordination rather than fierce competition.
- Credit union organization (U.S. example):
  - Some U.S. credit unions state-regulated, others federally regulated reporting to the National Credit Union Administration (NCUA); NCUA insures accounts similar to FDIC.
  - Credit unions granted federal income tax exemption in the U.S. because they are not-for-profit cooperatives.
  - Local “natural-person credit unions” rely on “corporate credit unions” as apex institutions for liquidity management and other services; corporate credit unions are owned by natural-person credit unions and can be federal- or state-chartered.

### A. Cooperative Banks and Credit Unions — Key Statistics and Trends
- European cooperative banking (EACB, 2012):
  - About 4,000 member cooperative banks and 72,000 branches in EACB member countries.
  - In the 28 European member countries: 56 million member-owners and served more than 217 million customers.
  - Average total asset size in Europe: about €1.4 billion (large dispersion).
- Table 1: Cooperative Banks: Financial Statistics for European Union, Canada, and Japan (Total assets / Total deposit / Total loans, Million Euro)
  - EU: 6,951,981 / 3,932,516 / 4,033,568
  - Canada: 144,124 / 93,539 / 94,867
  - Japan: 653,180 / 396,750 / 133,476
  - Switzerland: 128,940 / 101,053 / 112,659
- Global credit unions (WOCCU, 2012) — Table 2: Credit Unions: Worldwide Membership Statistics (Year / Countries with credit unions / Credit Unions / Members)
  - 2011: 100 / 51,013 / 196,498,738
  - 2010: 100 / 52,945 / 187,986,967
  - 2009: 97 / 49,330 / 183,916,050
  - 2008: 97 / 53,689 / 185,800,237
  - 2007: 96 / 49,134 / 177,383,728
  - 2006: 96 / 46,367 / 172,007,510
  - 2005: 92 / 42,705 / 157,103,072
  - 2004: 82 / 41,042 / 128,338,297
  - 2003: 84 / 40,457 / 123,497,445
  - 2002: 78 / 40,258 / 118,268,624
- Global credit unions — Table 3: Credit Unions: Worldwide Financial Statistics (Year / Savings (Million US$) / Loans (Million US$) / Reserves (Million US$) / Assets (Million US$))
  - 2011: 1,221,635 / 1,016,243 / 141,314 / 1,563,529
  - 2010: 1,229,389 / 960,089 / 131,659 / 1,459,606
  - 2009: 1,145,851 / 911,753 / 119,738 / 1,352,609
  - 2008: 995,741 / 847,059 / 115,317 / 1,193,812
  - 2007: 987,861 / 847,896 / 115,358 / 1,181,466
  - 2006: 904,121 / 758,209 / 106,826 / 1,092,136
  - 2005: 763,820 / 612,202 / 91,557 / 894,455
  - 2004: 707,438 / 531,419 / 82,927 / 824,653
  - 2003: 656,370 / 482,574 / 74,674 / 758,479
  - 2002: 589,220 / 424,951 / 67,420 / 676,049
- U.S. credit unions (as of September 2010, CUNA, 2012):
  - 7,535 credit unions serving nearly 91.8 million members, implying a penetration rate of 43.9 percent.
  - About 30 corporate credit unions.
  - Held about US$800 billion in savings, implying an average deposit base of about US$100 million each.
  - Two thirds of the 8,000 U.S. credit unions (13 million members) are very small, with assets under US$35 million.
  - Half of U.S. credit unions have less than $16 million in total assets.
- Performance and resilience:
  - Most credit unions did not suffer major losses in the recent global financial crisis and did not contribute much to the preceding credit boom and structured-product markets.
  - Table 3 shows a slowdown in 2008 but steady growth thereafter.
  - Cooperative banks in Europe fared relatively well (Fonteyne and Hardy, 2011).
  - Conservative behavior may reflect dedication to serving known customer base, limiting dependence on outside funding, and not maximizing short-term profits.
- Vulnerabilities:
  - Cooperatives and credit unions can be vulnerable to common shocks affecting the community (e.g., industry-specific shocks).
  - Many focus on household lending including residential mortgages, making them vulnerable to unemployment and real estate bubble collapses.
- Economies of scale and scope:
  - Small average size limits ability to reap economies of scale and scope.
  - Engaging at large scale with non-members runs counter to guiding principles; local credit unions may lack expertise and systems.
  - Increased mobility (job/location changes) can weaken the “common bond” underlying credit unions.

### B. Islamic Banks — Main Features
- Shari’ah compliance:
  - Islamic banking must comply with Islamic religious law (Shari’ah) containing specific injunctions and general principles for financial operations.
  - Key requirement: financial investment should be connected to a specific, “real” activity (the provision of a good or service that is not itself a financial investment).
  - Prohibition on a predetermined interest rate (riba): predetermined returns that vary only in bankruptcy would lack connection to a real activity.
  - Trading financial instruments such as derivatives for the sake of making a financial profit is prohibited (use of forward contracts is allowed).
  - Islamic finance promotes mutual solidarity: neither provider nor user of financing should be exploited or gain a disproportionate share of benefits.
  - Requirement to pay Zakat: Zakat is levied at the rate of 2.5 percent for lunar calendar year (IFQ, 2007).
  - Islamic banks also provide qard-hasn uncompensated loans.
- Product forms and business model:
  - Wide variety of contract forms (including PLS arrangements) developed to provide financing and mobilize savings (Box 1 referenced in source).
  - Banks generate management fees and engage in profit and loss sharing (PLS) arrangements; free to provide fee-based transaction services.
  - Ancillary services provided in Shari’ah-compliant manner: bonds and guarantees, letters of credit, remittances, online banking, ATM/debit cards (including credit cards), safe deposit boxes, payment services, collection and assignment of bills (SBP, 2009).
  - Funding: PLS basis or non-remunerated safekeeping accounts.
  - Savers face a risk-return efficiency frontier and may allocate funds between safe assets and assets whose returns depend on bank operations.
- Operational form:
  - Islamic banks usually operate as universal banks with retail, wholesale, and own-account business.
  - Asset-side risk sharing includes equity- or partnership-like musharakah and mudarabah investments, and sale- or lease-based instruments (murabahah, tawarruq, ijara) where banks obtain outright ownership of commodities or goods.
  - Commissions and fee income form a major part of business from both retail and corporate clients.

*Source: _wp13184 - Section V concludes.*

### Box 1. Shari’ah-Compliant Financial Contracts

### Box 1. Shari’ah-Compliant Financial Contracts

### Asset side: principal Shari’ah-compliant financing modes
- Three main modes of permissible financing:
  - (i) sale-based instruments
  - (ii) lease-based instruments
  - (iii) partnership–based instruments
- Sale-based instruments (murabahah / cost plus):
  - True-trade murabahah: bank buys a tangible asset and sells it to the client who wants ownership.
  - Commodity murabahah (tawarruq): bank buys a commodity from a broker and sells it to the client, who then sells it to another broker to obtain cash (client does not want to own the commodity).
  - Bai al inah (Sale & buy back): bank sells its asset to the client on credit; client immediately sells back same asset to bank on cash basis to obtain funds.
  - Murabahah use cases:
    - Fund purchase of existing assets (e.g., a car, a completed building, machinery).
    - For assets not yet in existence (e.g., agricultural produce to be cultivated, properties under construction) use bai salam or istisna.
- Lease-based instruments:
  - Ijarah: leasing where ownership does not transfer; money exchanged for right to use an asset.
  - Ijarah muntahiyah bi tamleek: lease-to-buy contract.
- Partnership-based instruments (returns depend on actual business performance):
  - Musharakah (joint venture)
  - Mudarabah (passive partnership)
  - Diminishing musharakah: tenancy and sale mixed; one partner purchases units over time at a pre-agreed unit price.
- Operational implications for Islamic banks:
  - Must sometimes take ownership of commodities, real estate, or other physical assets → need capacity for storage, maintenance, asset management.
  - When providing equity, need in-depth understanding of commercial and noncommercial risks, investment and production processes.
  - Require financial experts plus sector experts for investments.

### Liability side: Shari’ah-compliant deposit schemes
- Deposit types offered:
  - current accounts
  - basic banking account
  - savings accounts
  - term deposits of various maturities
  - certificates of investment
- Principal forms of accounts:
  - Safekeeping account (al-wadiah): offers no regular return; guarantee on the principal.
  - Unrestricted mudarabah investment account: saver shares in the risky general return of the bank; bank management has discretion in allocation of resources.
  - Restricted investment account: saver decides on individual investments and shares in their returns.
- Guarantees and returns:
  - Restricted and unrestricted mudarabah accounts generally enjoy a guarantee against gross negligence or malfeasance by bank management, but otherwise receive a share of revenues net of operational costs.
  - Associated “real” activities: managerial and operational services provided by bank staff and management.

### Economic and incentive implications
- Conventional investment contracts with predetermined interest rates reduce monitoring and verification costs; Islamic banking lacks such fixed-rate instruments and thus must analyze and monitor financed projects more closely.
- Consequences of profit-and-loss sharing (PLS):
  - Islamic banks concentrate on sale- and leasing-based products, or low-risk sukuk, rather than partnership-based contracts due to asymmetric information and high monitoring costs.
  - Depositors in remunerated Islamic accounts face higher informational burdens: they need to evaluate where the bank invests and how it manages investments because returns are not predetermined.
  - Disciplining power for depositors: remove funds or shift to safekeeping (al-wadiah) accounts; depositors may withdraw funds when yield falls below reservation level even if bank remains solvent and liquid.
- Incentive trade-offs for management and owners:
  - Sharing upside with depositors may reduce managerial incentive to pursue very high-return, high-risk investments (mitigating some moral hazard).
  - Sharing downside with depositors can reduce management’s incentive to limit downside risk; owners/managers have less “skin in the game” and may exert less monitoring effort.
- Islamic banks typically need more monitoring and sector expertise relative to conventional banks.

### Development, size, and growth statistics
- Historical notes:
  - First modern Islamic bank founded in Egypt in 1962/63.
  - Movement expanded notably in the 1970s.
- Institution counts and presence (Sanusi, 2011):
  - at least 435 full-fledged institutions
  - 191 windows of conventional institutions
  - operating in over 48 countries
- Growth and asset figures:
  - According to a 2012 Ernst and Young survey, Islamic banking assets grew at an annual rate of 19 percent over the five years to end-2012, to reach US$1.55 trillion; growth is expected to remain strong.
  - Shari’ah-compliant assets of major Islamic financial institutions tracked by The Banker reached US$1.16 trillion in 2012, up from US$894 billion in 2010 and US$1,086 billion in 2011.
  - Estimated that about 12 percent of Muslims use Islamic financial products (Zawya, 2012).
  - Globally, banks hold over 90 percent of Islamic assets.
- Geographic hubs and prevalence:
  - Global hubs: Bahrain, Malaysia, United Kingdom.
  - Major Islamic banks also in Saudi Arabia, United Arab Emirates, Qatar.
  - Sudan and the Islamic Republic of Iran operate wholly Islamic banking systems.
- Sukuk market:
  - Much recent expansion of Islamic savings has gone into sukuk.
  - Malaysia dominates global sukuk issuance; infrastructure and financial sectors are main non-government issuers.
  - Figure cited data points (Sukuk issuance by issuer type): Sovereign 99,558; Quasi-sovereign 17,899; Corporate 22,88 (US$ millions) — as presented in source.
- Bank concentration:
  - According to Ernst and Young, just 13 Islamic banks had capital over US$1 billion at end-2012.

### Liquidity management, asset composition, and maturity mismatch
- Typical balance-sheet features and risks:
  - Islamic banks often have surplus deposit funding and a relative lack of suitable investment opportunities.
  - Large maturity mismatches: mostly very short maturity funding vs demand for longer-term project funding.
  - Sample (Bankscope, 2010): 118 Islamic banks with total assets of US$685 billion; deposits and other short-term funding make up on average three quarters of Islamic banks’ liabilities (Figure 2).
- Investment concentration (MENA and Malaysia examples):
  - For MENA region banks (2008), murabahah cost-plus products make up the bulk of investments, followed by leasing and hire purchase products; mudarabah partnerships important mainly in Saudi Arabia.
  - Bank Negara Malaysia (end-2012): musharakah and mudarabah products constituted 5.2 percent of Malaysian Islamic bank financing; bai al inah, istisna, and other murabahah products constituted 49.5 percent; ijarah products constituted 25.4 percent.
- Liquidity management constraints:
  - Difficult to manage short-term liquidity fluctuations; Islamic banks maintain substantial surplus liquidity earning low returns.
  - Avoid direct intermediation with conventional banks due to interest-based business; instead use commodity-based murabahah transactions (relatively expensive) or central bank Shari’ah-compatible facilities where available.
  - Debate continues on efficient Shari’ah-compatible liquidity arrangements.

### Performance during the global financial turmoil and asset quality
- Relative resilience in 2008 turmoil:
  - Islamic banks were relatively little affected by the global financial turmoil that started in 2008 due to restrictions on investment activities and excess liquidity; limited exposure to U.S. sub-prime mortgage and related derivative markets.
  - In some cases, heavy commitments to corrected markets (e.g., Gulf real estate) led to significant credit risk realization.
  - Recent Sukuk default(s) harmed some Islamic and non-Islamic banks during the crisis.
- Asset quality and profitability:
  - On average, nonperforming loan ratios of Islamic banks have been on average higher than comparable conventional banks, and profitability has tended to weaken (Islamic Financial Services Board, 2013).
  - Argument: linking financial activity to “real” transactions can reduce incentives for excessive leverage and arbitrage, but does not prevent exposure to real estate bubbles.

### Similarities and differences with cooperative banks (credit unions)
- Shared features:
  - Both are financial depository institutions where savers deposit and withdraw funds under contractual conditions and act as financial intermediaries.
  - Both require depositors to share risk in some form; Islamic banks make this explicit for unrestricted investment accounts, cooperative banks pay interest plus a dividend dependent on revenues.
- Payoff structures (simple representation in source):
  - Notations: total assets A, deposits D, capital K, gross revenue R, operating costs C, interest rate on deposits i, Islamic bank allocates proportion x of net revenues to depositors.
  - Payoffs when bank makes sufficient profits (ignoring retention):
    - Conventional Bank depositors: D*i
    - Cooperative Bank depositors: D*i + (R-C-D*i) = R-C
    - Islamic Bank depositors: x(R-C)
    - Conventional Bank shareholders: R-C-D*i
    - Cooperative Bank shareholders (depositor-shareholders): (1-x)(R-C)
- Complications with retained earnings and smoothing:
  - Banks may retain proportion y of profits; Islamic banks may operate a Profit Equalization Reserve (PER) to smooth returns—proportion z of revenues allocated to depositors may be retained into PER or used to top up earnings when poor.
  - With retained earnings and PER, payoffs become (as per source tables):
    - Conventional Bank depositors: D*i
    - Cooperative Bank depositors: D*i + (1-y’)(R-C-D*i) = (1-y’)(R-C)+ y’D*i
    - Islamic Bank depositors: x(R-C)+(1-z)x(R-C) = (1+x-zx)(R-C)
    - Conventional Bank shareholders: (1-y)(R-C-D*i)
    - Cooperative Bank shareholders: (1-y’’)(1-x)(R-C)
    - Future depositors and total depositors entries shown in source tables.
- Risk-bearing thresholds and capital calls:
  - Islamic bank depositors bear much risk before the bank becomes substantially undercapitalized; threshold for action is higher than for conventional banks.
  - Cooperative banks may face difficulties obtaining explicit additional capital contributions if ownership is highly diffuse.
- Information asymmetry and monitoring:
  - Islamic and cooperative banks: payouts largely determined by management based on accounting data; complex accounting and information asymmetries make monitoring management difficult.
  - Islamic bank financial results may be especially hard to interpret due to financing heterogeneity, comingling of funds, and payout smoothing.
- Asset-side differences:
  - Islamic banks often take outright ownership or shares in commodities, products, and firms and therefore hold non-financial assets (inventory of cars, apartments, houses).
  - Cooperative banks/credit unions typically own little non-financial assets beyond operations and collateral seized from defaulted loans.
- Organizational objectives:
  - Both sectors emphasize solidarity and rejection of usurious conditions; credit unions are community- and not-for-profit-oriented; Islamic banks have explicit injunctions to share risk and make charity contributions but are mostly established and operated for shareholder benefit.
- Observed performance parallels:
  - Institutions tend to be small; e.g., 13 Islamic banks had capital over US$1 billion at end-2012.
  - Profitability and return on equity tend to be quite low but relatively stable.

### What each can learn from the other (policy and organizational implications)
- Potential for cooperative structures in Islamic banks:
  - Islamic banks could be organized along cooperative or credit-union lines to enhance mutuality, equality among parties, and respect diverse interests—consistent with principles of Islamic finance.
  - Depositors could in principle have a broader equity-like position rather than a limited role; such structures have been attempted (e.g., credit unions on Islamic principles in Afghanistan noted in source).
- Operational and regulatory considerations:
  - Use of PER and Investment Risk Reserves can smooth depositor returns; regulatory treatment of PER discussed in IFSB (2010).
  - Need for sector- and product-specific expertise within Islamic banks due to ownership of physical assets and equity stakes in enterprises.
  - Continued development of Shari’ah-compatible liquidity facilities (central bank or market-based) where feasible to mitigate maturity mismatch and low-return surplus liquidity holdings.

*Source: Box 1. Shari’ah-Compliant Financial Contracts (excerpt).*

### Box 2. WOCCU’s Project for Islamic Credit Unions

### Box 2. WOCCU’s Project for Islamic Credit Unions

### Overview
- WOCCU has undertaken a project to set up Islamic Investment and Finance Cooperatives (IIFCs) in Afghanistan. These IIFCs are the only credit unions within WOCCU system with Islamic financing features.
- WOCCU believes that the design and delivery of financial products and services is shaped by local customs, religious beliefs, and the economic environment. Successful financial sector development in a predominately Muslim country often requires the application of Islamic law and its guiding principles, as it has with WOCCU's financial cooperative development experience in Afghanistan.

### Shari’ah‑compliant products developed by WOCCU for IIFCs
- al-wadiah safekeeping accounts.
- Working capital loans (Murabahah) for the purchase of inputs on a mark-up basis.
- Financial investment (mudarabah) on a passive partnership basis.
- Financial lease (ijara) for equipment.
- Hybrid loans (ijarah paired with murabahah).
- Islamic cooperatives are encouraged to reinvest some portion of their profits into community development initiatives; Zakat is giving back to the community. In Afghanistan, the Islamic cooperatives have helped rebuild schools and clinics, as well as provide scholarships for students.

### How IIFCs combine Islamic and credit union principles (summary of table)
- Prohibition of interest-based transactions:
  - Emphasize a member's investment by offering an opportunity to purchase shares. Loans are made as financial contracts between borrowers and the cooperative.
- Profit and loss sharing:
  - Establish member-ownership through the purchase of share savings. Share profits among members as dividends.
- Transactions must be backed by assets rather than financial speculation:
  - Financial contracts must detail the specific product/service being bought or sold.
  - Provide loans by purchasing a physical asset and either (i) leasing it to the member (ijarah), or (ii) transferring ownership to the member who pays a mark-up (murabahah).
- Prohibition of financing activities considered harmful to society:
  - Lend only to Shari’ah-compliant businesses.

### Cooperative ownership and governance applied to Islamic banks
- It would seem possible to give an Islamic bank a cooperative ownership and governance structure: converting (unrestricted) investment accounts into equity would effectively turn the bank into a cooperative. The depositor-owners would not be entirely passive suppliers of financing; the contact form would change from mudarabah to musharakah.
- One could require those with safekeeping accounts to hold minimum balances in investment/equity accounts, so they too would have an equity stake.43
- To be more like a credit union, the Islamic bank could be established as a not-for-profit institution; its membership could be restricted to a certain community; and all members would be given one voting share (their other savings would remain in Islamic deposits of the familiar sort).
- Such an approach would reduce the risk that the owners and managers of an Islamic bank shift too much risk to savers—risk and control would become more closely linked—or otherwise exploit their position unduly.44
- In a cooperative Islamic bank, the depositor-owners would delegate much operational control to the bank’s management, and thus they would not themselves need to devote effort to selecting projects in which to invest.45 Nonetheless, they would have more control over management strategy and performance than if they are passive providers of financing.

### El‑Gamal’s mutualist argument and authors’ view
- El-Gamal (2005, 2006) argues that much of what is currently represented as Islamic finance is based on dubious foundations because the purpose is to increase capital through financial intermediation, and for the benefit of a relatively small number of major shareholders. He argues that only a fully mutualist institution can clear the obstacles to financial intermediation posed by Islamic jurisprudence, such as prohibitions against riba and gharar.
- His recommended solution is to make Islamic financial intermediaries truly mutual entities, in which returns are distributed as dividends on shares, and the charity implicit in Islamic lending drives the institution’s quest for growth.
- The authors are not fully convinced by the most rigorous form of this argument, but El-Gamal points to the possibility of an Islamic bank being controlled by very narrow and possibly short-term interests.

### Apex liquidity management and cooperative arrangements
- In some countries it may be worthwhile to establish an apex organization to help individual Islamic banks better manage their liquidity, and possibly to provide other services, similar to the institutions used by cooperative banks and credit unions.46
- Liquidity management is relatively difficult for Islamic banks, especially where the central bank has not established a dedicated facility and where there is no large stock of suitable sukuk outstanding.
- Islamic banks could establish their own liquidity-pooling giro institution, where they could place funds partly on an unremunerated al-wadiah basis, but partly also on a remunerated basis.47
- The apex institution could diversify idiosyncratic liquidity shocks and safely invest in profitable longer-term projects more than a single bank could.
- A bank needing liquidity could do so up to a limit on a qard-hasn basis, but mechanisms would be needed to prevent abuse; the apex institution would have to establish and enforce rules requiring that unremunerated borrowings even out over some time period. Possible sanctions include issuing equity to the apex institution or rights to a maximum daily overdraft and a maximum period-average gross overdraft.
- The apex institution must protect confidential information of individual member banks so that information about liquidity and funding situations does not become available to competitors.48

### Broader risk‑sharing lessons for cooperative banks and credit unions
- Pay out a higher share (or even all) returns as dividends and a lower share as predetermined interest on accounts so depositors bear more risk year-to-year and the cooperative’s inflexible capital structure is less constraining.
- If depositors are compensated more in the form of variable dividends, they can absorb some loss in bad periods without a rights issue, and the cooperative can retain earnings in good times to build reserves or finance growth.
- Introduce automaticity to “bail in” some deposits, possibly up to some limit (say, 10 percent of the average balance in the account).
- Offer a remuneration rule (for example, double the dividend rate paid on interest-bearing accounts, but a proportional write-down in case of losses) or rely on a reputation for prudence and satisfactory returns.
- Constraint: cooperatives must persuade members to bear extra risk and earn a predetermined return that is lower than that available from commercial banks.49 Cooperatives can offer multiple savings products to expand the risk-return frontier.
- Make higher risk, higher return deposits more attractive by granting enhanced voting rights to those accounts; this incentivizes monitoring of management.
- Require preventing strategic withdrawals before losses are imposed (e.g., escrow until next payout).
- Offer more risk-sharing contracts to borrowers, involving the credit union more directly in projects (examples include diminishing musharakah for home purchase; sales-based contracts where the bank retains ownership of financed inputs until use).
- For asset-backed or leasing-based contracts, advantages include immediate recourse to collateral; may require establishing a non-financial company (leasing company) to hold assets due to prudential regulations.50
- Challenges include acquiring sector expertise and managing nonbanking assets if credit quality deteriorates; the institution must convince members and supervisors it has expertise and legal backing.

### Products and positioning
- Cooperative banks and credit unions could consider offering Islamic-type products (not necessarily marketed as Islamic or with Arabic names) as differentiation from conventional banks, appealing to customers who value responsibility toward stakeholders and preserving niches with limited competition.

### Conclusion (paper’s summary)
- The paper reviews Islamic banks and credit unions, their similarities and differences, and how each can learn from the other.
- Both share an ideology that finance is meant to serve society and should not involve exploitation. Remuneration of depositors in Islamic banks and cooperative banks is variable and dependent on overall performance: ex post depositors in either institution receive an overall reward that depends on the realized difference between revenue and non-interest costs, so risk is shared.
- An institution with cooperative ownership and governance could operate according to Islamic principles and there may be advantages in doing so: a mutualist structure aligns with Islamic precepts about inclusiveness and risk-sharing, strengthens incentives to protect savers’ interests, makes the institution more resilient, and may strengthen incentives for good governance.

*Box 2. WOCCU’s Project for Islamic Credit Unions (from provided IMF content).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2013/_wp13184.pdf_