## _wp14149

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### Background: principles and comparative features
- Islamic banking is based on profit and loss sharing (PLS) and avoidance of interest rate-based commitments and contracts that entail excessive risks and finance prohibited activities (e.g. gambling and alcoholic beverages).
- Under PLS, an ex-ante lending rate is replaced by a rate of return determined ex-post on a profit-sharing basis; only the profit sharing ratio is determined ex-ante.
- Risk-sharing features:
  - Investors and entrepreneurs bear business risk for a share in profits.
  - Equity-based financing and prohibition of speculation limit risks on the asset side of a bank’s balance sheet.
  - Islamic banks are required to know the project and use of funds, creating closer relationships with entrepreneurs and a higher likelihood that funds are allocated for the stated investment.
- Contrast with conventional banking: transactions involving interest payments are common in conventional banking.

### Market size and growth
- The market for Islamic financial assets has grown at an annual average rate of about 16 percent since 2006.
- From a handful of institutions in the late 1970’s, Islamic finance grew to about 350 institutions and total assets of about US$1.7 trillion in 2013.
- Despite growth, Islamic financial assets make up under 1 percent of the world’s financial assets.
- Global issuance of Sukuk accounted for nearly US$120 billion in 2013.
- Global sukuk issuance was US$115 billion in 2013 (separate mention in regional section).

### Institutional framework and standardization
- International standard-setting institutions:
  - Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), based in Bahrain, issues international standards on accounting, auditing, and corporate governance.
  - Islamic Financial Services Board (IFSB), based in Malaysia, issues standards for supervision and regulation.
- Standardization challenges:
  - Difficult to ensure standardization of Islamic products across countries due to different legal interpretations of principles, carrying reputational and operational risks.
  - AAOIFI has 41 accounting and governance guidelines; regulators in Bahrain, Qatar, Syria and Sudan made these standards mandatory, while most other countries consider them advisable.
  - IFSB has issued regulatory and prudential standards adopted by a number of countries.
- Compliance and governance:
  - Further work is needed to ensure compliance, including a transparent and credible assessment process for evaluating compliance with standards.
  - Internal Shari’ah boards and standard-setting bodies should focus on training, oversight and internal compliance audits.

### Modalities, instruments, and portfolio composition
- Dominant modalities:
  - Murabaha (bank buys goods and sells to a customer on a deferred basis) and other debt-based/mark-up instruments dominate asset portfolios.
  - Murabaha and other mark-up instruments represent about 86 percent of financing in Islamic banks in the Middle East and North Africa, 70 percent in East Asia, 92 percent in South Asia, and 56 percent in Sub-Saharan Africa.
- Common instruments and modes:
  - Resource mobilization:
    - Investment deposits: share net return on investment based on contracted ratio.
    - Demand or current account deposits: guaranteed liabilities but earn no return.
    - Sukuk: Islamic bonds representing undivided shares in ownership of tangible assets (examples: Sukuk Murabaha, Sukuk Al Ijara, Sukuk al Istisna, Sukuk al Isthithmar).
  - Resource allocation:
    - Sharing modes: Musharaka (full partnership), diminishing Musharaka, Mudaraba (non-voting/passive partnership).
    - Sale modes: Murabaha (deferred sale), Bay’salam/Istisna’ (deferred delivery purchase).
    - Leasing modes: Ijara/Ijara wal iqtina’ (lease or lease-purchase agreements; used in Islamic mortgages).
  - Other instruments: Bai’muajjal, Muswama, Jiala, Qard al Hasana (zero-interest loans).
- Asset allocation implications:
  - Islamic financing is restricted to productive activities, trade, and real assets; debt creation via direct lending and borrowing is not allowed.
  - Assets sold or leased should be real and owned by seller/lessor before the transaction.
  - Debt from sale or lease transactions cannot be sold to a third party to avoid associated risk.

### Risk, costs, and regulatory implications
- Risk characteristics:
  - Islamic contracts limit asymmetric risk and moral hazard by design, but risks remain.
  - Prohibition of excessive speculation and instruments like credit default swaps contributed to Islamic banks being less affected by the 2008 crisis in some studies.
- Costs and supervisory challenges:
  - Islamic finance instruments are more expensive than conventional instruments offering the same services due to information asymmetries and the need for careful scrutiny of investment viability.
  - Supervising and monitoring Islamic financial institutions involves higher transaction costs and complexity.
  - Need for standardization to: (i) enable new entrants to use existing products; (ii) make products easier to understand and evaluate; (iii) reduce Shari’ah compliance disputes; (iv) define tax treatment; and (v) facilitate secondary trading and liquidity management, especially with Sukuks.

### Status and potential in Sub-Saharan Africa (SSA)
- Institutional presence and counts:
  - As of end-2012, about 38 Islamic finance institutions—comprising commercial banks, investment banks, and takaful operators—were operating in Africa; 21 operated in North Africa, Mauritania and Sudan, and 17 in Sub-Saharan Africa.
  - Countries with Islamic banking activities in SSA include Botswana, Kenya, Gambia, Guinea, Liberia, Niger, Nigeria, South Africa, Mauritius, Senegal and Tanzania.
- Country snapshots:
  - South Africa:
    - Muslim population: 1.5 percent.
    - Early entrants: Al Baraka and Islamic Bank licensed in 1989; Islamic Bank liquidated in 1998.
    - Subsequent developments: WesBank launched an Islamic window in 2004; First National Bank and ABSA launched Islamic windows; presence of Islamic funds (Oasis Crescent Equity Fund, Symmetry Islamic Fund, Element Islamic Equity Fund, Stanlib Shari’ah Equity Fund).
    - South Africa is expected to launch its first sukuk Islamic bond in the year referenced in the source.
  - Nigeria:
    - Population context: about half of its 170 million people are Muslim.
    - Early activity: Habib Bank (now Bank PHB) operated an Islamic banking window in 1992.
    - Regulatory developments: Law Governing the Operation of Islamic Banks issued by the Central Bank of Nigeria in March 2009; Advisory Council of Experts for Islamic Finance set up by CBN.
    - Operational milestones: CBN issued guidelines for non-interest banking in June 2011 and approved a banking license for Jaiz International Bank, which became operational in 2012; Diamond Bank started establishing an Islamic banking window.
  - Kenya:
    - Islamic banking entry with Barclays launching Islamic banking products in December 2005.
    - Sector expanded with two Islamic banks: First Community Bank in 2007 and Gulf African Bank.
  - Mauritius:
    - Islamic banking presence since 1998 via Al Barakah Cooperative Society Limited.
    - Banking Act amended in 2007 to formally allow Islamic banking activities.
    - Finance Act 2008 amendments allowed multiple payments of duties under Islamic financing for land and property and allowed global investments and Shari’ah-compliant funds with net asset value of US$75 million.
    - HSBC Bank Mauritius launched Islamic banking products in first half of 2009; HSBC closed its Islamic window in October 2012.
    - In 2009, the Bank of Mauritius granted an Islamic banking license to Century Banking Corporation; as of end-2012, the bank had $9.3 million, representing less than one percent of total assets in the banking sector.
- Market scale, demand drivers, and opportunities:
  - Islamic finance in SSA remains nascent: the share of Islamic banks is still small and Islamic capital markets are virtually nonexistent (small Sukuk issuances noted in Gambia and Nigeria).
  - About half of the region’s total population remains to be banked.
  - The SSA Muslim population is currently at nearly 250 million people and is projected to reach 386 million in 2030.
  - The number of middle-class Africans has tripled over the past 30 years and amounts to about 34 percent of total population.
  - Opportunities: retail products to SMEs and micro-credit; Sukuk issuance to finance large infrastructure needs by channeling funds from the Middle-East, Malaysia, and Indonesia.
  - Recent issuance of a Shari’ah-compliant bond by Osun state in Nigeria could start a trend; Senegal and South Africa expected maiden sovereign sukuk issuances (US$200 million and US$500 million, respectively) in the first half of 2014 (IFIS report and Zawya, December 2013).
- Implementation modalities in SSA:
  - Islamic banking window: simplest form allowing customers to transact using only Shari’ah-compatible instruments.
  - Islamic (full-fledged) banking: establish subsidiaries or convert windows into full-fledged Islamic banks; subsidiary preferred to keep conventional business separate.
  - Islamic investment banking: sovereign and corporate sukuks and Shari’ah-compatible investment vehicles.
  - Islamic insurance (Takaful/retakaful): mutual assistance, burden-sharing models; gross takaful contributions across Africa had an 18 percent compound annual growth rate between 2005 and 2008 and increased by 26 percent in 2009 to reach an estimated US$377 million; global takaful contributions reached an estimated US$7 billion in 2009.
- Implementation issues and regulatory considerations:
  - Core Shari’ah product-design principles:
    - (i) prohibition of riba;
    - (ii) avoidance of preventable uncertainty and ambiguity in contracts (gharar) and gambling (maysir);
    - (iii) ethical principles of justice, fairness, transparency, and public interest, including risk and profit sharing between involved partners;
    - (iv) requirement that assets and investments can only come from, and be made in, Shari’ah-compliant activities backed by tangible, identifiable underlying assets.
  - Supervisory and operational challenges:
    - Segregation of funds is key to safeguard depositors and investors when conventional intermediaries offer Islamic services.
    - Islamic windows present disadvantages: difficulties in properly separating capital, combining Basel and IFSB standards for capital adequacy, supervising complex financial reporting given overlapping non-Islamic and Islamic activities, and complicating preparation and comparative analysis of financial reports.
    - Regulators will need to become familiar with the application of IFSB standards for Islamic banks.

### Development drivers and policy considerations
- Factors correlated with diffusion of Islamic banking:
  - Principles of risk-sharing underlying financing.
  - Growth of oil-rich economies.
  - Presence of Muslims in the population.
  - An enabling legal framework.
  - Economic integration with Middle Eastern countries or proximity to Islamic financial centers.
- Policy implications for countries introducing Islamic finance:
  - Strengthen legal and regulatory frameworks to accommodate Shari’ah-compliant instruments.
  - Promote standardization and transparent compliance assessment processes.
  - Invest in training, oversight, and internal compliance audits at institutions and by standard-setting bodies.
  - Consider the potential of tapping international sukuk markets even without a domestic Islamic financial system.

### Box 2 — Development of Islamic Banking in the United Kingdom: milestones, measures, and policy lessons
- UK development and milestones:
  - Islamic finance activity started in the UK in the 1980s; the first commodity Murabaha transactions and the first UK Islamic bank were launched in 1982.
  - Industry momentum after 2000 due to political and regulatory support via a Bank of England-led working group and the abolition of the double taxation regime in 2004.
- Implementation steps and tax/treatment measures:
  - (i) abolishment of capital gains tax and stamp duty (land tax) for sukuk issuances and Shari’ah-compliant home mortgages;
  - (ii) reform of arrangements for bond issues to enable returns and income payments to be treated similarly to interest;
  - (iii) legislation to ensure regulatory treatment of Islamic instruments is consistent with statutory objectives; and
  - (iv) tax relief on Islamic mortgages extended to companies as well as individuals.
- Capacity-building and regulatory posture:
  - Universities introduced executive courses on Islamic finance; specialized legal services developed for Islamic finance.
  - Supervisory authorities established a flexible regulatory framework without explicitly promoting Islamic finance.
- Comparative reference: Malaysia
  - Malaysia is a “hub” with the world’s largest Sukuk market and institutional counts including 20 Islamic banks, 16 Islamic windows, 9 Islamic Fund management companies, 8 Takaful companies, 4 re-takaful operators, and one international takaful operator; these institutions represent close to one third of the financial institutions in Malaysia.
  - Staged development from 1963 initial institutions to Islamic Banking Act of 1983, interbank markets, conversions to full-fledged Islamic banks, and development of Islamic Capital Markets by 2001.
- Policy recommendations (all-markets and large-market):
  - All-markets:
    - Strengthen accounting, auditing, and disclosure standards; apply IFSB and AAOIFI standards where appropriate.
    - Strengthen property rights and enforcement of private contracts.
    - Capacity building: develop technical knowledge and promote collaboration with leading countries such as Malaysia.
    - Implement prudential standards: adopt IFSB prudential standards and support an assessment process to evaluate compliance.
    - Taxation: avoid discrimination; ensure level taxation between proceeds from Islamic finance (profit) and interest; make business expenses related to Islamic finance deductible on the same basis as interest deductions.
  - Large-market:
    - Macro-prudential surveillance: promote a Shari’ah-compliant macro prudential surveillance framework established by the IFSB.
    - Liquidity management: develop Shari’ah-compliant interbank market, a liquidity management facility/center, and a repo market.
    - Financial safety nets: strengthen lender of last resort facilities, emergency financing mechanisms, and deposit insurance to comply with Shari’ah principles, recognizing implementation challenges.
    - Crisis management and resolution: develop Shari’ah-compliant insolvency laws and arrangements for non-performing assets, asset recovery, bank restructuring, bankruptcy, and bank recapitalization.
- Operational steps for introduction:
  - Launch a public awareness campaign.
  - Amend laws and accounting and prudential frameworks as needed.
  - Build central bank capacity, especially on supervision.
  - Consider setting up an appropriate liquidity management framework and introducing adequate monetary operations instruments.
  - Familiarize regulators and financial institutions with standards set by AAOIFI and IFSB; IFSB prudential and supervisory standards constitute the equivalent of Basel II in Islamic finance.
  - Adapt crisis management and resolution frameworks to Islamic finance specifics.
  - Consider developing new instruments inspired by Islamic finance principles but not necessarily Shari’ah certified to appeal to a broader population while avoiding instrument proliferation and market fragmentation in shallow markets.
- Potential role for the Fund:
  - Surveillance and technical assistance, especially in design and implementation of prudential standards and rules to facilitate stable, efficient, and integrated Islamic finance activities.

*Source: _wp14149 - References (excerpts provided from the source PDF content).*

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

### _wp14149 - References .............................................................................................................

### Background: principles and comparative features
- Islamic banking is based on profit and loss sharing (PLS) and avoidance of interest rate-based commitments and contracts that entail excessive risks and finance prohibited activities (e.g. gambling and alcoholic beverages).
- Under PLS, an ex-ante lending rate is replaced by a rate of return determined ex-post on a profit-sharing basis; only the profit sharing ratio is determined ex-ante. More than two parties can pool resources for investment (Chong and Liu, 2009).
- Risk-sharing features:
  - Investors and entrepreneurs bear business risk for a share in profits.
  - Equity-based financing and prohibition of speculation limit risks on the asset side of a bank’s balance sheet.
  - Islamic banks are required to know the project and use of funds, creating closer relationships with entrepreneurs and a higher likelihood that funds are allocated for the stated investment.
- Contrast with conventional banking: transactions involving interest payments are common in conventional banking (Chong and Liu, 2009; Kahf, Ahmad, and Homud, 1998).

### Market size and growth
- The market for Islamic financial assets has grown at an annual average rate of about 16 percent since 2006.
- From a handful of institutions in the late 1970’s, Islamic finance grew to about 350 institutions and total assets of about US$1.7 trillion in 2013.
- Despite growth, Islamic financial assets make up under 1 percent of the world’s financial assets.
- Global issuance of Sukuk accounted for nearly US$120 billion in 2013.

### Institutional framework and standardization
- International standard-setting institutions:
  - Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), based in Bahrain, issues international standards on accounting, auditing, and corporate governance.
  - Islamic Financial Services Board (IFSB), based in Malaysia, issues standards for supervision and regulation.
- Standardization challenges:
  - Difficult to ensure standardization of Islamic products across countries.
  - Different legal interpretations of principles across countries prevent standardization and carry reputational and operational risks.
  - AAOIFI has 41 accounting and governance guidelines; regulators in Bahrain, Qatar, Syria and Sudan made these standards mandatory, while most other countries consider them advisable.
  - IFSB has issued regulatory and prudential standards adopted by a number of countries.
- Compliance and governance:
  - Further work is needed to ensure compliance, including a transparent and credible assessment process for evaluating compliance with standards.
  - Internal Shari’ah boards and standard-setting bodies should focus on training, oversight and internal compliance audits.

### Modalities, instruments, and portfolio composition
- Dominant modalities:
  - Murabaha (bank buys goods and sells to a customer on a deferred basis) and other debt-based/mark-up instruments dominate asset portfolios.
  - Murabaha and other mark-up instruments represent about 86 percent of financing in Islamic banks in the Middle East and North Africa, 70 percent in East Asia, 92 percent in South Asia, and 56 percent in Sub-Saharan Africa (Dusuki, 2007; Lewis, 2008).
- Common instruments and modes (Box 1 summary):
  - Resource mobilization:
    - Investment deposits: share net return on investment based on contracted ratio.
    - Demand or current account deposits: guaranteed liabilities but earn no return.
    - Sukuk: Islamic bonds representing undivided shares in ownership of tangible assets (examples: Sukuk Murabaha, Sukuk Al Ijara, Sukuk al Istisna, Sukuk al Isthithmar).
  - Resource allocation:
    - Sharing modes: Musharaka (full partnership), diminishing Musharaka, Mudaraba (non-voting/passive partnership).
    - Sale modes: Murabaha (deferred sale), Bay’salam/Istisna’ (deferred delivery purchase).
    - Leasing modes: Ijara/Ijara wal iqtina’ (lease or lease-purchase agreements; used in Islamic mortgages).
  - Other instruments: Bai’muajjal, Muswama, Jiala, Qard al Hasana (zero-interest loans).
- Asset allocation implications:
  - Islamic financing is restricted to productive activities, trade, and real assets; debt creation via direct lending and borrowing is not allowed.
  - Assets sold or leased should be real and owned by seller/lessor before the transaction.
  - Debt from sale or lease transactions cannot be sold to a third party to avoid associated risk.

### Risk, costs, and regulatory implications
- Risk characteristics:
  - Islamic contracts limit asymmetric risk and moral hazard by design, but risks remain.
  - Prohibition of excessive speculation and instruments like credit default swaps contributed to Islamic banks being less affected by the 2008 crisis in some studies.
- Costs and supervisory challenges:
  - Islamic finance instruments are more expensive than conventional instruments offering the same services due to information asymmetries and the need for careful scrutiny of investment viability.
  - Supervising and monitoring Islamic financial institutions involves higher transaction costs and complexity.
  - Need for standardization to: (i) enable new entrants to use existing products; (ii) make products easier to understand and evaluate; (iii) reduce Shari’ah compliance disputes; (iv) define tax treatment; and (v) facilitate secondary trading and liquidity management, especially with Sukuks.

### Status and potential in Sub-Saharan Africa (SSA)
- As of end-2012, about 38 Islamic finance institutions—comprising commercial banks, investment banks, and takaful (insurance) operators—were operating in Africa.
  - Of these, 21 operated in North Africa, Mauritania and Sudan, and 17 in Sub-Saharan Africa.
- Countries with Islamic banking activities in SSA include Botswana, Kenya, Gambia, Guinea, Liberia, Niger, Nigeria, South Africa, Mauritius, Senegal and Tanzania.
- Countries with scope for development: Zambia, Uganda, Malawi, Ghana and Ethiopia (all but Zambia have relatively large Muslim populations; Zambia is interested in using Islamic finance instruments to fund investment in the mining sector).
- Specific country notes:
  - South Africa:
    - Muslim population: 1.5 percent.
    - Early entrants: Al Baraka and Islamic Bank licensed in 1989; Islamic Bank liquidated in 1998.
    - Subsequent developments: WesBank launched an Islamic window in 2004; First National Bank and ABSA launched Islamic windows; presence of Islamic funds (Oasis Crescent Equity Fund, Symmetry Islamic Fund, Element Islamic Equity Fund, Stanlib Shari’ah Equity Fund).
    - South Africa is expected to launch its first sukuk Islamic bond in the year referenced in the source.
  - Nigeria:
    - Population context: about half of its 170 million people are Muslim.
    - Early activity: Habib Bank (now Bank PHB) operated an Islamic banking window in 1992.
    - Regulatory developments: Law Governing the Operation of Islamic Banks issued by the Central Bank of Nigeria in March 2009; Advisory Council of Experts for Islamic Finance set up by CBN.
    - Operational milestones: CBN issued guidelines for non-interest banking in June 2011 and approved a banking license for Jaiz International Bank, which became operational in 2012; Diamond Bank started establishing an Islamic banking window.
  - Kenya:
    - Islamic banking entry with Barclays launching Islamic banking products in December 2005.
    - Sector expanded with two Islamic banks: First Community Bank in 2007 and Gulf African Bank (GAB).
- Institutional counts and data sources:
  - Estimates based on Bankscope and Zawya, April 18, 2012.
  - Dow Jones Islamic Market Indexes, Quarterly Newsletter, July 2012.

### Development drivers and policy considerations
- Factors correlated with diffusion of Islamic banking:
  - Principles of risk-sharing underlying financing.
  - Growth of oil-rich economies.
  - Presence of Muslims in the population.
  - An enabling legal framework.
  - Economic integration with Middle Eastern countries or proximity to Islamic financial centers.
- Policy implications for countries introducing Islamic finance:
  - Strengthen legal and regulatory frameworks to accommodate Shari’ah-compliant instruments.
  - Promote standardization and transparent compliance assessment processes.
  - Invest in training, oversight, and internal compliance audits at institutions and by standard-setting bodies.
  - Consider the potential of tapping international sukuk markets even without a domestic Islamic financial system.

*Source: _wp14149 - References (excerpts provided from the source PDF content).*

### 2008. Other conventional banks such as Kenya Commercial Bank now offer Shari’ah

### _wp14149 - 2008. Other conventional banks such as Kenya Commercial Bank now offer Shari’ah

### Regional presence and recent developments
- Kenya
  - In 2010, through the Finance Act, Kenyan authorities amended Section 45 of the Central Bank of Kenya Act to allow the Central Bank as the government’s fiscal agent to recognize the payment of a return rather than interest on government securities, opening up Shari’ah-compliant investments in the country (Ndung’u, 2011).
  - In 2013, Standard Chartered Bank introduced an Islamic banking window in Kenya, adding to an existing window and two full-fledged Islamic banks operating in Kenya.
  - As of end-2013, Islamic banking accounts for two percent of the total banking business in Kenya.
- Mauritius
  - Islamic banking presence since 1998 via Al Barakah Cooperative Society Limited offering Murabaha schemes, Hajj saving accounts, and Istisna’ financing.
  - In 2007, the Banking Act was amended to formally allow Islamic banking activities.
  - Finance Act 2008 amendments allowed multiple payments of duties under Islamic financing for land and property, and allowed global investments and Shari’ah-compliant funds with net asset value of US$75 million.
  - HSBC Bank Mauritius launched Islamic banking products in the first half of 2009; HSBC closed its Islamic window in October 2012.
  - In 2009, the Bank of Mauritius granted an Islamic banking license to Century Banking Corporation, Mauritius’s first full-fledged Islamic bank; as of end-2012, the bank had $9.3 million, representing less than one percent of total assets in the banking sector.
  - Tata launched the Tata Indian Shari’ah Equity Fund through Tata Asset Management (Mauritius) Private Limited (TAMM) domiciled in Mauritius for investment in Shari’ah-compliant equity or equity-equivalent listed Indian companies.

### Current scale, demand drivers, and opportunities in SSA
- Current scale and market gaps
  - Islamic finance in SSA remains at a nascent stage: the share of Islamic banks is still small and Islamic capital markets are virtually nonexistent (small Sukuk issuances noted in Gambia and Nigeria).
  - About half of the region’s total population remains to be banked.
- Demographics and demand projections
  - The SSA Muslim population is currently at nearly 250 million people and is projected to reach 386 million in 2030.
  - The sub-continent’s growing middle class and young population are seen as opportunities for Islamic finance expansion; the number of middle-class Africans has tripled over the past 30 years and amounts to about 34 percent of total population (African Development Bank, 2012).
- Product and market opportunities
  - Expected expansion of Islamic finance side-by-side with conventional banking, with opportunities in retail products to small and medium-sized enterprises (SMEs) and micro-credit.
  - SSA’s large infrastructure needs present opportunities for Sukuk issuance to channel funds from the Middle-East, Malaysia, and Indonesia.
  - Recent issuance of a Shari’ah-compliant bond by Osun state in Nigeria could start a trend in favor of sukuk, especially if planned sukuk by Senegal and South Africa materialize in 2014.
  - Senegal and South Africa are expected to launch maiden sovereign issuance of sukuk (US$200 million and US$500 million, respectively) in the first half of 2014 (IFIS report and Zawya, December 2013).
  - Global sukuk issuance was US$115 billion in 2013.

### Potential contributions to financial deepening and inclusion
- Financial deepening and intermediation
  - Islamic finance could facilitate financial deepening by increasing the depth and breadth of intermediation, extending the reach of the system (e.g., extension of maturities and facilitation of hedging and risk diversification).
  - A much larger non-Muslim population could find Islamic financial instruments attractive, broadening available options for SMEs and micro-credit.
  - New instruments inspired by Islamic finance—but not necessarily Shari’ah certified—could enhance deepening and inclusion (example: partial risk guarantees as in Mauritius).
- SME and microfinance implications
  - Islamic financing can help develop SMEs and microfinance activities where African households and firms have less access to credit from conventional banks compared to other developing regions.
  - Islamic banks can tap depositors who do not participate in or distrust interest-based banking and can promote SME access to credit by expanding acceptable collateral frameworks and providing participatory finance structures where collateral may be unnecessary or include intangible assets (El Galfy, 2012).

### Modalities for introducing Islamic finance in SSA
- Forms of operation (expanding on Sole (2008))
  - Islamic banking window
    - Simplest form: a conventional bank sets up an Islamic window allowing customers to transact using only Shari’ah-compatible instruments, including deposits and Islamic trade-finance products for small and medium companies.
  - Islamic (full-fledged) banking
    - Opportunities to establish Islamic subsidiaries or convert windows into full-fledged Islamic banks.
    - Subsidiary preferred by Sole (2008) to keep conventional business separate while expanding Islamic activities.
    - Challenges of full conversion include operational transition for interest-bearing balance-sheet items (ijara and Murabaha designed to address these), need to pace phasing in of Islamic instruments, and increased supervisory burden to apply IFSB standards.
    - Examples: ABSA launched Islamic banking in Tanzania through its subsidiary NBC in 2010; Tanzania launched its first Islamic bank, Amana Bank, in November 2011.
  - Islamic investment banking
    - Instruments and tools for SSA include sovereign and corporate sukuks and more sophisticated investment vehicles (example: Société Générale’s Shari’ah-compatible hedge fund).
  - Islamic insurance (Takaful and retakaful)
    - Forms of Islamic insurance/reinsurance based on mutual assistance, burden-sharing, and joint guarantees where individuals pool resources for use if there is a need.
    - World Bank data: gross takaful contributions across Africa had an 18 percent compound annual growth rate between 2005 and 2008 and increased by 26 percent in 2009 to reach an estimated US$377 million; global takaful contributions reached an estimated US$7 billion in 2009.

### Implementation issues and regulatory considerations
- Core Shari’ah principles to be respected in product design
  - (i) prohibition of (riba), (ii) avoidance of preventable uncertainty and ambiguity in contracts (gharar) and gambling (maysir), (iii) ethical principles of justice, fairness, transparency, and public interest, including risk and profit sharing between involved partners, and (iv) requirement that assets and investments can only come from, and be made in, Shari’ah-compliant activities backed by tangible, identifiable underlying assets.
- Supervisory and operational challenges
  - Segregation of funds is key to safeguard depositors and investors when conventional intermediaries offer Islamic services.
  - Islamic windows present disadvantages due to difficulties in properly separating capital, combining Basel and IFSB standards for capital adequacy, supervising complex financial reporting given overlapping non-Islamic and Islamic activities, and complicating preparation and comparative analysis of financial reports.
  - Regulators will need to become familiar with the application of IFSB standards for Islamic banks.

*Source: _wp14149 - 2008. Other conventional banks such as Kenya Commercial Bank now offer Shari’ah (PDF chapter/section).*

### Box 2. Development of Islamic Banking in the United Kingdom

### Box 2. Development of Islamic Banking in the United Kingdom

### Development and milestones in the United Kingdom
- Islamic finance activity started in the UK in the 1980s; the first commodity Murabaha transactions and the first UK Islamic bank were launched in 1982.
- The industry gained momentum after 2000 following political and regulatory support via a working group led by the Bank of England with representatives from the Treasury, FSA, the Council of Mortgage Lenders, financial institutions and members of the Muslim community.
- Two major determinants facilitated development: the abolition of the double taxation regime in 2004 and a broad consultative process initiated by UK authorities to clarify the regulatory treatment of corporate sukuk.
- The UK supervisory authorities did not aim at promoting Islamic finance but set up a regulatory framework flexible enough to adapt to market changes.

### Implementation steps and tax/treatment measures in the UK
- The implementation comprised:
  - (i) the abolishment of capital gains tax and stamp duty (land tax) for sukuk issuances and Shari’ah-compliant home mortgages;
  - (ii) the reform of arrangements for bond issues to enable returns and income payments to be treated similarly to interest in conventional banking systems;
  - (iii) legislation to ensure that the regulatory treatment of Islamic instruments is consistent with its statutory objectives and principles; and
  - (iv) tax relief on Islamic mortgages extended to companies as well as to individuals.
- Particular attention was placed on the tax treatment of sukuk; sukuk were structured along similar lines as conventional debt instruments: they do not pay interest but entitle investors to a share in the returns generated by the underlying asset.

### Shari’ah scholarly capacity, services, and regulatory posture in the UK
- Preparatory and instructional work was launched regarding Islamic finance and its instruments; several universities introduced executive courses on Islamic finance.
- The UK provided specialized legal services for Islamic finance, including tax, compliance, regulations, management, operations, and information technology systems.
- Supervisory authorities established a flexible regulatory framework but were not explicitly promoting Islamic finance.

### Comparative reference: Malaysia (relevant practices and scale)
- Malaysia is considered a “hub” of Islamic finance and holds the world’s largest Islamic bond market (Sukuk).
- Institutional counts and market features:
  - 20 Islamic banks;
  - 16 Islamic windows;
  - 9 Islamic Fund management companies;
  - 8 Takaful companies;
  - 4 re-takaful operators; and
  - one international takaful operator.
- These institutions represent close to one third of the financial institutions in Malaysia.
- Malaysia also has Islamic Capital Markets with nearly the majority of securities listed on the Malaysia Stock Exchange and 143 Islamic Unit Trust Funds.
- Timeline of Malaysian development stages (as classified by Sole (2008)):
  - First stage (1963): small Islamic financial institution started operations with an Islamic savings fund for pilgrims.
  - 1983: the first Islamic bank (Bank Islam Malaysia Berhard) was granted a full-fledged banking license following enactment of the 1983 Islamic Banking Act, establishment of a dispute settlements mechanism, and issuance of Shari’ah compatible investment certificates.
  - 1984: three conventional banks opened Islamic windows (with restrictions, such as no commingling of funds); Bank Negara Malaysia established the Islamic Interbank Money Market.
  - Third stage: conversions into full-fledged Islamic banks when Islamic windows reached critical mass; Bank Muamalat created in 1999 from a merger; first inter-bank money market introduced in 1994 to facilitate liquidity management.
  - Final stage: Islamic Capital Markets developed (2001) with several Islamic securities issued and traded; in June 2005 the Dow Jones launched the Islamic Malaysia Index which tracks over 45 Shari’ah-compliant companies; in 2005 Malaysian Parliament approved creation of the Perbadanan Insurans Deposit Malaysia (PIDM) covering conventional and Islamic deposits; the International Finance Centre Initiative launched in 2006 positioning Malaysia at the core of Islamic finance.

### Developmental strategies and policy issues (general guidance)
- Strategies must be tailored to country characteristics, including economy size and conventional financial system, while strengthening capacity for domestic supervision, liquidity monitoring, and crisis management.
- Legal and prudential framework adjustments should include adequate but not preferential treatment for Islamic banks, avoiding regulatory arbitrage and ensuring a level-playing field.
- Suggested strategic directions for SSA countries and others:
  - South Africa, Nigeria, and aspiring service hubs like Mauritius or Seychelles should ensure introduction of international standards set by IFSB and AAOIFI and follow Shari’ah compliance.
  - Many countries can absorb the spirit of risk-sharing and profit-sharing to develop instruments improving access to finance for SMEs; economies with strong religious requirements may be stricter about Shari’ah compliance.

### All-markets policy recommendations
- Strengthening accounting, auditing, and disclosure standards for Islamic financial institutions and counterparties, supported by adequate governance arrangements; apply IFSB and AAOIFI standards where appropriate.
- Strengthening property rights and enforcing private contracts to support financial deepening for Islamic and conventional banking.
- Capacity building: develop technical knowledge and skills; promote collaboration and exchanges with leading countries such as Malaysia.
- Implementation of prudential standards: adopt IFSB prudential standards and support an assessment process to evaluate compliance and recommend improvements.
- Taxation: tax systems must not discriminate against Islamic finance structuring; ensure level taxation between proceeds from Islamic finance (profit) and interest; make business expenses related to Islamic finance deductible on the same basis as interest deductions.

### Large-market policy recommendations
- Macro-prudential surveillance: promote Shari’ah-compliant macro prudential surveillance framework established by the IFSB to standardize reporting of financial indicators and promote stability.
- Liquidity management: develop Shari’ah-compliant (i) interbank market, (ii) a liquidity management facility/center, and (iii) a repo market to allow excess funds to be channeled and to support monetary policy operations.
- Financial safety nets: strengthen lender of last resort (LOLR) facilities, emergency financing mechanisms, and deposit insurance to comply with Shari’ah principles; recognize implementation challenges due to funding structures (current accounts and unrestricted profit sharing and loss-bearing investment accounts).
- Crisis management and resolution framework: develop Shari’ah-compliant insolvency laws and arrangements for non-performing assets, asset recovery, bank restructuring, bankruptcy, and bank recapitalization; address challenges within conventional legal systems concerning liquidation and priority of claims.

### Concluding observations and operational steps for introduction
- Islamic finance in Sub-Saharan Africa (SSA) is nascent, with potential supported by Muslim population growth and global expansion of Islamic finance activities.
- Islamic finance can complement conventional systems by broadening options, extending maturities, facilitating hedging and risk diversification, and supporting SME and microfinance development.
- Constraints and risks include supervisory and monitoring costs and reputational risk from products not properly certified as Shari’ah-compliant.
- No strict template is required; there is no need to introduce Islamic Law to supersede conventional regulatory frameworks.
- Critical preparatory issues include clarifying ex ante capital gains taxation for sukuk issuances and Shari’ah-compliant mortgages and building Shari’ah scholarly expertise.
- Suggested phased steps for introducing Islamic banking activities:
  - Launch a public awareness campaign;
  - Provide needed infrastructure by amending laws and accounting and prudential frameworks as needed;
  - Build central bank capacity, especially on supervision;
  - Consider setting up an appropriate liquidity management framework and introducing adequate monetary operations instruments.
- Regulators and financial institutions should familiarize themselves with standards set by AAOIFI and IFSB and apply them as needed; the IFSB has issued prudential and supervisory standards constituting the equivalent of Basel II in Islamic finance.
- As Islamic finance grows, adapt crisis management and resolution frameworks to Islamic finance specifics to ensure prompt crisis management.
- Consider developing new instruments inspired by Islamic finance principles but not necessarily Shari’ah certified to appeal to a broader population while avoiding instrument proliferation and market fragmentation in shallow markets.
- Potential role for the Fund: surveillance and technical assistance, especially in design and implementation of prudential standards and rules to facilitate stable, efficient, and integrated Islamic finance activities.

*Source: Box 2. Development of Islamic Banking in the United Kingdom (extracted content).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2014/_wp14149.pdf_