## _wp14220

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---

### I. INTRODUCTION — key messages and context
- The Islamic banking industry has grown rapidly and "is even systemically important in several countries" (Figure 1).
- Islamic banking is projected to continue to grow faster than conventional banking "for the foreseeable future" given:
  - low base,
  - low level of penetration,
  - substantial market potential,
  - strong demand in many Islamic countries for Shariah-compliant products.
- The 2008-09 financial crisis led to renewed interest in Islamic finance due to the "resilience of Islamic banking in many countries in Asia, Europe, and sub-Saharan Africa."
- The IMF is increasingly encountering Islamic banking issues in surveillance and technical assistance, and a 2011 survey of prudential frameworks was conducted to enhance Fund capacity.
- The paper uses the survey results to document current practices, identify supervisory and regulatory challenges, and inform Fund surveillance, policy, and technical assistance.

### Box 1 — Survey design and sample
- Survey headings: presence of Islamic banking; areas of Islamic banking (general and financial information, legal framework, regulatory and supervisory framework, liquidity management and central banking, resolution and deposit insurance).
- All Fund members with a significant Islamic banking presence were canvassed, and 39 countries responded.
- Ten countries self-excluded by answering "no" to three questions on explicit recognition and practice; thus the analysis refers to 29 non self-excluded respondent countries.
- The 10 self-excluding countries were: Azerbaijan, Burundi, China, Kosovo, Malawi, Namibia, Sierra Leone, Tajikistan, Uganda, and Zambia.

### II. LEGAL AND INSTITUTIONAL DEVELOPMENT — background and patterns
- Islamic banking is distinct from conventional banking and is based on Shariah Law (see Box 2).
- Islamic banks and Islamic banking are "largely merchant and investment banking oriented" and typically relate to the real economy, especially trade and investment.
- Shariah Law:
  - plays a varying role across jurisdictions — in some (e.g., Afghanistan, Bahrain, Iran, Pakistan, Saudi Arabia, Sudan) it is "the fundamental law of the land" or a key source, while in others it does not constitute part of the legal framework;
  - imposes ethics, prohibits activities considered morally distasteful (drugs, alcohol, prostitution, games of chance), and forbids instruments based on interest;
  - typically promotes financing of real assets and returns derived from exposure to proprietary risk taking rather than pure financial risk taking.
- Formalized Islamic banking institutions first appeared in the 1960s and the industry is still in development, resulting in a "wide dispersion of approaches" to legal and regulatory introduction and oversight.
- Legal bases for practice of Islamic banking vary:
  - Legislation passed by a representative assembly in 17 jurisdictions (examples: Indonesia, Iran, Jordan, Kuwait, Malaysia, Sudan).
  - A decree/directive by a ruling authority in 6 jurisdictions (examples: Kazakhstan, Qatar).
  - Regulations issued by a bank regulatory authority in 17 jurisdictions (examples: Afghanistan, Bahrain, Ethiopia).
  - Legal basis implicitly set by the bank regulatory and supervisory authority in 11 jurisdictions (examples: Botswana, Kenya, the U.K.).
- Islamic banking presence:
  - present in all countries where Muslim populations are a majority and in most countries with a significant Muslim minority;
  - in a few countries only Islamic banking is permitted; in most countries Islamic banking is conducted alongside conventional banking but typically grows faster than conventional banking.
- Jurisdictional approaches to permitted institutions:
  - Some jurisdictions (e.g., Malaysia, Saudi Arabia) permit stand-alone Islamic banks and Islamic windows; others (e.g., Iraq, Kuwait, Jordan) do not permit Islamic windows.
  - Some jurisdictions permit conventional banks to control Islamic banks (e.g., Bahrain, Indonesia, Malaysia); others do not (e.g., Pakistan, Saudi Arabia).
  - Conversion rules vary; in many majority-Muslim jurisdictions an Islamic bank cannot be converted into a conventional bank.

### II.B Survey results on legal and regulatory frameworks and scope (key statistics and findings)
- Explicit recognition of Islamic banking: 21 of the 29 respondents (72 percent) indicated the legal and regulatory framework explicitly recognizes Islamic banking practices, products or institutions.
- Stand-alone Islamic banks: 22 of the 29 respondents (76 percent) indicated Islamic banking was being conducted by a stand-alone Islamic bank.
- Islamic banking by conventional banks: 16 of the 29 respondents (55 percent) indicated Islamic banking was being conducted by a conventional bank.
- Number and assets of Islamic banks (at time of survey):
  - 176 stand-alone Islamic banks operating in 22 of the 29 respondent countries.
  - Stand-alone Islamic bank assets totaled US$871 billion.
  - Sudan had the highest number of stand-alone Islamic banks at 33.
  - Iran’s total Islamic banking assets amounted to US$481 billion (52 percent of the total US$871 billion).
  - Islamic banking windows: 130 conventional banks across 12 respondent countries operated Islamic windows, with assets totaling US$109 billion; US$80 billion of that amount is attributable to one country (Saudi Arabia).
  - Total assets with Islamic banks and Islamic banking windows were US$1.28 trillion at end-June 2013 (Islamic Financial Services Industry Stability Report (2014 IFSB) figure reported in the source).

### Box 3 — Islamic window advantages and disadvantages (survey-reported)
- Advantages of Islamic windows:
  - economies of scale and scope that help lower the cost of Islamic finance.
  - Islamic banking services/products benefit from the experience and systems that conventional banks (CBs) have; this might improve the quality of services/products and lower their cost, which could enhance intermediation.
  - Windows facilitate liquidity management, especially in countries where Islamic liquidity instruments are limited.
  - Windows usually have easy access to liquidity support from the conventional part of the bank.
  - Windows enhance competition in the market, which could lower the cost of finance for Shariah-compliant products.
  - For countries with small demand for Islamic banking services (countries with a small Muslim population), the IB window could be the only feasible way of providing IB services, thus enhancing financial inclusion.
- Disadvantages and risks of Islamic windows:
  - reputation risks,
  - supervisory complexities.
  - Commingling of Islamic windows’ assets and liabilities with conventional assets and liabilities could have significant reputational risk; depositors in windows might suddenly withdraw their money if rumors regarding commingling arise. It also raises issues related to consumer protection.
  - Windows could hinder the establishment of effective corporate governance and risk management systems:
    - The management and board of a conventional bank may not be sufficiently attuned to the unique risks inherent in IB activities, compromising oversight of the IB window.
    - If fit and proper criteria for conventional and Islamic intermediation should exist in CBs’ operating windows, it is likely that many CBs will be unable to meet these criteria (for the Islamic banking part).
    - Shariah boards might be unable to verify the complete segregation of assets and liabilities.
  - The operation of windows could open the door for regulatory arbitrage or unfair practices:
    - Given the profit-and-loss sharing nature of windows’ accounts, risky financing could be encouraged to get Islamic financing through windows because, in the case of default, the account holders of windows will bear the losses.
    - Securities holdings could be shifted between investment portfolios financed by conventional sources of funds and those financed by windows’ sources so as to smooth returns.
  - Windows could hinder effective financial oversight:
    - Some prudential ratios that might differ for Islamic banking could be difficult to monitor appropriately.
    - Windows could hinder the preparation of proper financial statements for windows activities, which could hinder effective oversight.
  - Resolution of the IB window is unresolved:
    - The issue of how distressed Islamic banks should be resolved in accordance with Shariah principles is still under deliberation. This issue is further complicated for an Islamic window operating within a conventional bank.
    - If the authorities are faced with a distressed conventional bank (with an Islamic window), they may not be able to carry out an orderly resolution satisfying financial stability objectives and Shariah principles that could potentially modify the treatment of the Islamic banking window.
  - Monitoring the impact of using an Islamic monetary instrument (e.g., Sukuk) could be difficult in the case of windows:
    - CBs’ pricing for IB activities will not be strongly linked to a Shariah-compliant liquidity level since CBs can use conventional deposits to finance Islamic banking assets. This could hinder the design of appropriate monetary policies.
- Some authorities advocate a "level playing field" policy (e.g., equal tax treatment) to address complaints about differential tax treatment between Islamic and conventional transactions.

### Approaches to accommodating Islamic banking in regulatory frameworks (from Box 3)
- Three broad approaches:
  - BCBS framework as default for all banks (no distinction between Islamic and conventional banks).
  - A generic BCBS component applied to all banks, with references identifying provisions applying only to Islamic banks; BCBS framework complemented by IFSB prudential standards where appropriate.
  - A separate regulatory framework that accommodates Islamic banking.
- Survey responses on regulatory frameworks (number of respondents):
  - 11 respondents indicated a single integrated regulatory framework applied to all banks (no reference to Islamic banking or Islamic banks).
  - 10 respondents noted a single integrated regulatory framework with references applying specifically to Islamic banking and banks.
  - 3 respondents pointed out two separate independent regulatory frameworks (one for Islamic banking and banks, and another for conventional banking and banks).
  - 7 respondents indicated a mixed approach (single regulatory framework for common areas, separate guidelines/regulations for Islamic banks).
- Supervisory responsibility:
  - The central bank is usually responsible for supervision of Islamic banks: 25 respondents out of 29 indicated that was the case.
  - Three respondents indicated an independent authority (outside the Ministry of Finance or the Central Bank) was in charge of regulation supervision.
- Shariah compliance in supervision:
  - Shariah compliance plays a role (explicitly or implicitly) in supervision. Example: In the U.K., the regulatory framework does not contain prescriptions on Islamic banking or Shariah compliance, but authorities take Shariah compliance into account indirectly when considering consumer protection, internal controls, governance, and reputational risk.

### Licensing, fit and proper, and governance (from Box 3)
- Licensing:
  - In 17 jurisdictions a stand-alone Islamic bank will be issued with an Islamic banking license.
  - In 12 jurisdictions a single (generic) banking license is issued to a bank, irrespective of whether the bank is Islamic or conventional (in some of these jurisdictions authorities are empowered to issue only an Islamic banking license).
- Fit and proper criteria:
  - Typically one set of fit and proper criteria applies to all banks; regulatory frameworks do not usually prescribe a distinct set for Islamic banks.
  - Important that Islamic banking management be trained and experienced in Islamic banking operations; expertise in Islamic accounting standards such as AAOIFI would be useful for roles like chief financial officer or internal auditor.
  - The fit and proper issue for individuals responsible for Shariah compliance (members of the Shariah board, Shariah accountant, Shariah internal auditor, Shariah compliance officer, Shariah external auditor) has not received sufficient attention.
  - Twelve respondents noted a bank’s proposal for Shariah scholars to be appointed to its Shariah board was not required to undergo a fit and proper test; 10 respondents noted the contrary.
- Corporate governance and Shariah law compliance:
  - A range of frameworks exists for setting up a Shariah board.
  - Four respondents (Palestine, Sudan, Turkey, and United Arab Emirates) indicated the legal framework requires a national/central Shariah board (note: law 1985 mentioned a national Shariah board for the U.A.E. but it has not been implemented; currently Shariah board operates at individual bank level only in U.A.E.).
  - Six respondents (Afghanistan, Malaysia, Pakistan, Palestine, Sudan, and Syria) noted the legal framework requires setting up a Shariah board for the central bank.
  - Central bank Shariah boards differ in mandate, scope, governance, and accountability.
  - Ultimate responsibility for a central bank’s Shariah compliance lies mostly with its Shariah board of directors; day-to-day compliance is delegated to senior management.
  - Models differ: in some cases (e.g., Malaysia, Sudan) the central bank’s Shariah board has overall authority and can be final arbiter in disputes (legislative and adjudicative powers); in other jurisdictions (e.g., Afghanistan, Pakistan, Syria) the central bank’s Shariah board does not have legislative or adjudicative powers but must be consulted on proposed amendments with Shariah implications.
  - Islamic bank Shariah boards:
    - A majority of jurisdictions require Islamic banks to have a Shariah board that has legal standing and whose actions have legal implications (e.g., Iraq, Kuwait, Malaysia, Sudan).
    - Ultimate responsibility for an Islamic bank’s Shariah compliance typically lies with the Islamic bank’s board of directors, delegating day-to-day compliance to senior management in line with Shariah board guidance (Shariah boards are typically advisory).
    - Legal frameworks require a Shariah board for an Islamic bank in 17 jurisdictions surveyed.
    - Status of Islamic bank Shariah boards (number of respondents):
      - Five respondents indicated it was a subsidiary organ of the general assembly of shareholders.
      - Eight respondents indicated it was a free-standing organ.
      - Two respondents mentioned it was a subsidiary organ of the board of directors.
      - Two other respondents noted none of the above categories applied.
    - Reporting lines of Shariah boards vary: board of directors (8 respondents), general assembly (8 respondents), top management (2 respondents), executive committee (2 respondents), the bank (1 respondent).
  - Shariah compliance function:
    - Ensuring Shariah compliance is usually conducted by internal auditors or Shariah auditors.
    - In jurisdictions where Shariah Law is the default source of all legislation (e.g., Iran, Pakistan, Saudi Arabia, Sudan), an Islamic bank’s internal auditor has statutory responsibility to ensure Shariah compliance.
    - In other jurisdictions, banks are required to have a dedicated Shariah auditor/Shariah compliance officer whose appointment may require supervisory authority approval.
  - External auditors:
    - Where Shariah Law is the default source of legislation, external auditors have statutory responsibility to assess and verify Shariah compliance.
    - In jurisdictions where Shariah Law is not the default source, external auditors generally have no direct responsibility to assess Shariah compliance.
    - Survey finding: in 20 jurisdictions external auditors of an Islamic bank do not have duties and responsibilities regarding Shariah compliance (only five respondents indicated external auditors do have such duties).

### Capital requirements — overview and survey findings (Box 4)
- Computation of the required capital adequacy ratio in Islamic banking is similar to the relevant BCBS formula, but variations exist in recognition of sources of funds and risk-weighted assets.
- PSIA loss absorbency:
  - PSIA holders are quasi-liability holders and are expected to absorb all losses on the investments made with their funds, unless there is evidence of negligence or misconduct on the part of the bank.
  - The capacity to pass-through low returns or losses to PSIA holders provides Islamic banks with an additional buffer to limit the impact of adverse shocks on their solvency.
  - The higher the share of PSIA as a source of funds and the lower their sensitivity to changes in returns, the better the solvency of IBs compared to conventional banks.
- IFSB standards and timeline:
  - In December 2006, a working group of the IFSB issued the first capital adequacy standard for institutions (other than insurance institutions) offering Islamic financial services.
  - The minimum regulatory capital adequacy requirement for Islamic banks in the IFSB standard is 8 percent.
  - In May 2008, IFSB issued a guidance note on recognition of ratings by external credit assessment institutions to facilitate application of Basel II.
  - In December 2013, IFSB revised its capital adequacy standards to incorporate many elements of Basel III.
- IFSB CAR calculation forms and supervisory discretion:
  - The IFSB standard provides two forms for calculating the capital adequacy ratio: standard and discretionary.
    - Standard formula: capital divided by risk-weighted assets excluding the assets financed by investment account holders.
    - Discretionary (supervisory discretionary) formula: modified to accommodate reserves maintained by Islamic banks to minimize displaced commercial, withdrawal, and systemic risks.
  - In markets where Islamic banks maintain profit equalization reserves (PER) and investment risk reserves (IRR), supervisory authorities have discretion to adjust the denominator of the CAR formula.
  - The IFSB Supervisory Discretionary Formula for CAR is expressed as:
    - [Eligible Capital]/{[total risk-weighted assets +operational risk]-[RWAs funded by restricted profit sharing investment accounts (credit + market risk) – [(1- α*) total risk-weighted assets funded by unrestricted profit-sharing investment accounts] – [ α* risk-weighted assets funded by PER and IRR of unrestricted profit sharing investment accounts]}, where α* is the proportion of assets funded by PSIAs and is determined by the supervisory authorities.
  - IFSB issued in March 2011 a guidance note with a methodology to estimate the value of alpha to be used in the supervisory discretion formula.
- Values of α* and country practices:
  - Although the value of α* normally does not exceed 30 percent, there are wide variations among countries:
    - Malaysia requires 100 percent of general assets financed by investment accounts to be converted into risk weighted assets.
    - Sudan requires 50 percent.
    - Bahrain and Jordan require 30 percent.
- Survey findings on CAR denominator adjustments and eligible reserves:
  - 14 respondents noted that an Islamic bank is required to hold capital against assets financed by an unrestricted investment account (URIA).
  - 10 respondents expressed that banks were required to hold capital against assets financed by a restricted investment account (RIA).
  - Seven respondents indicated that a PER was considered eligible capital for the regulatory CAR.
  - Seven respondents noted that an IRR was considered eligible capital for such purposes.
  - IFSB-15 (Revised capital adequacy standards for institutions offering Islamic financial services) made it clear that PER and IRR are not part of the capital of Islamic banks.
- Asset risk-weighting and income smoothing:
  - Assignment of risk weights to different classes of assets differs in Islamic banks because assets range from trade financing to equity partnership, affecting calculation of risk weights relative to conventional banks.
  - Income smoothing practices (e.g., reserves for income smoothing) have indirect implications for capital adequacy; regulators may take these into account when determining the capital adequacy ratio.
- Adjustments and comparability:
  - It may be difficult to compare capital ratios among Islamic banks in different countries due to differing adjustments.
  - Some jurisdictions apply an alpha factor, as proposed by the IFSB, to capture difference in risk exposure between Islamic banking risk-sharing products and conventional products (Box 4).
  - Example: In Turkey, authorities decided on a 70 percent risk weight to be applied to Islamic banking risk-sharing products.
  - These adjustments are based on assumptions about risk arising from particular transactions and whether there has been an effective transfer of risk to or from a third party.

### Leverage and liquidity
- Excessive leverage could be a valid concern for Islamic banks because, in most cases, there are no constraints on the amount of call funds or investment funds an Islamic bank may take on deposit.
- Exception: one jurisdiction (Bahrain) imposes a leverage ratio on Islamic banks, limiting the call funds and unrestricted investment funds placed with an Islamic bank to 20 times the capital of the bank.
- Islamic banks are not permitted to engage in “pure” financing (financing that does not involve a real asset), which constrains leverage and benefits financial stability.
- Windows facilitate liquidity management, especially in countries where Islamic liquidity instruments are limited, and usually have easy access to liquidity support from the conventional part of the bank.

### Profit sharing, participation ratios, and market practice (Box 5)
- Participation ratios on URIAs and RIAs are negotiated between the Islamic bank and its customers, with proliferation of ratios across jurisdictions.
- Key determinants of participation ratios: size of amount to be invested and duration of the investment.
- Strong correlation observed between deposit rates at conventional banks and participation ratios at Islamic banks.
- Turkey: supervisory authority prescribed the investment participation ratio as 75 percent (for the investor) and 25 percent (for the Islamic bank), implying the investor’s minimum profit share is 75 percent and the Islamic bank’s maximum profit share is 25 percent.
- Reported profit sharing examples from Turkey:
  - Fixed deposits: 75 percent to 25 percent.
  - Term deposits: 80 percent to 20 percent (according to one Turkish bank).
- Islamic banks must react speedily to market developments, such as changes in interest rates.
- Historical premium on Islamic bank deposits relative to conventional banks (due to perceived higher risk) has been diminishing.
- In Turkey, Islamic banks must keep the supervisory authority informed at all times of participation ratios and are not permitted to change these ratios more regularly than weekly.
- Symmetry generally exists between profit sharing ratios and loss sharing ratios.
- Loss-sharing constraint: the loss-sharing ratio of a bank may not be less than 50 percent (i.e., the loss-sharing ratio of a customer may not be more than 50 percent).
- No internationally accepted sequence of steps and definitions is applied by Islamic banks to compute rates of return on Islamic banking products.
- All income generated by an Islamic bank as a result of lending, investments and the bank's investment management and investment performance fees accrues to the (shareholders of the) Islamic bank.
- During the 2008-09 global crisis, some Islamic banks decided to forego investment management fees to the benefit of the investors in the Islamic banks’ URIA and RIA products.
- Distinction is important between:
  - “Smoothing” of the Islamic bank’s own revenues (not permissible under IFRS), and
  - “Smoothing” of amounts that belong to investors in URIA and RIA accounts (permissible if there is a legal contractual basis).
- No internationally accepted standards on URIA/RIA investment income smoothing; by default such smoothing is performed by Islamic banks in certain jurisdictions.
- Governance implication: transparency and legal contractual basis are central to permissible investment income smoothing.
- Shariah compliance and supervisory approaches:
  - Jurisdictions differ in approach to Shariah compliance risk:
    - In jurisdictions where Shariah Law is not the basis of the legal system, bank supervisory authorities typically address Shariah compliance from a secular perspective and do not generally build capacity to determine Shariah Law compliance.
    - In jurisdictions where Shariah Law is the fundamental source of law, supervisory authorities often have responsibility to ensure compliance with Shariah Law and provide supervisory staff with necessary training.
  - If a bank professes to be selling Shariah-compliant products it is required to be Shariah compliant.

### Annex 1. Definition of Key Shariah-Compliant Contracts — sources of funds and uses of funds
- Profit Sharing Investment Account (PSIA)
  - "Profit Sharing Investment Account (PSIA) is a contract by which an investor/depositor opens an investment fund with an IB on the basis of Mudharabah."
  - "The IB could have restricted or full discretionary power in making investment decisions."
  - "The IB acts as an entrepreneur while the PSIA holder acts as a capital provider."
  - "Both parties agree on a ratio of profit sharing, which must be disclosed and agreed upon at the time of opening the account."
  - "Profits generated by the IB are shared with the PSIA holder in accordance with the terms of the Mudharabah agreement while losses are borne solely by the PSIA holder, unless they are due to IB’s misconduct, negligence or breach of the contract terms."
  - "Usually the IB’s money (bank capital) is invested in the same income-producing assets or economic activities. Hence, low income (losses) affect the IB through low (negative) return on shareholders’ invested capital and low (zero) income from managing PSIA accounts."
  - "This source of revenue is the main one for the IB, and it is used to cover operational expenses."
- Wadiah (deposit)
  - "A Wadiah (deposit) is a contract between the depositor and the IB (custodian) for safekeeping."
  - "The depositor grants the IB permission to utilize the funds for whatever purpose permitted by Shariah."
  - "The bank in return guarantees the value of the deposit and allows the depositor easy access for withdrawals whenever needed."
- Murabahah (Cost-plus financing)
  - "A Murabahah (Cost-plus financing) contract refers to an agreement whereby the IB sells to a customer, at acquisition cost plus an agreed profit margin, a specified kind of asset that is already in its possession (such as a manufactured good)."
  - "Following delivery of the asset, a credit risk in respect of the amount receivable from the customer arises."
  - "From the perspective of modern finance, a Murabahah facility is similar to an asset-backed risky loan."
- Salam (Purchase with deferred delivery)
  - "A Salam (Purchase with deferred delivery) contract refers to an agreement to purchase, at a predetermined price, a specified kind of commodity (physical product) which is to be delivered on a specified future date in a specified quantity and quality (such as an agricultural or a manufactured product)."
  - "As the buyer, the IB makes full payment of the purchase price upon execution of the Salam contract."
  - "To mitigate price risk, in certain cases, the IB enters into a back-to-back contract, namely Parallel Salam, to sell a commodity with the same specification as the purchased commodity under a Salam contract to a party other than the original seller."
- Ijarah (Lease)
  - "An Ijarah (Lease) contract refers to an agreement whereby the IB leases to a customer an asset (such as a ship, aircraft, or telecom equipment) for an agreed period against specified installments of lease rental."
  - "The contract commences with an agreement to lease that is binding on the part of the potential lessee and requires the IB to purchase or lease an asset prior to entering into the contract."
  - "An Ijarah contract could offer the lessee the option to purchase the asset either at the end of the lease period by means of a gift or a token consideration, or by installments of a specified amount during the lease period."
- Musharakah (Equity financing)
  - "A Musharakah (Equity financing) contract is an agreement whereby the IB and a customer contribute capital to an enterprise, whether existing or new, or to the ownership of real estate or a moveable asset, either on a permanent basis or on a diminishing basis where the customer progressively buys out the share of the IB (“diminishing Musharakah”).45"
  - "Profits generated by the enterprise or the asset/real estate are shared in accordance with the terms of the Musharakah agreement, while losses are shared in proportion to the respective contribution to capital."
- Mudharabah (Participation or trust financing)
  - "A Mudharabah (Participation or trust financing). It is a contract that refers to an agreement whereby the IB contributes capital to an enterprise or activity which is to be managed by the customer/investor."
  - "Profits generated by that enterprise or activity are shared in accordance with the terms of the Mudharabah agreement, while losses are to be borne solely by the IB unless they are due to the customer/investor’s misconduct, negligence, or breach of the contract terms."

*Source: _wp14220 - References .............................................................................................................*

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

### _wp14220 - References .............................................................................................................

### I. INTRODUCTION — key messages and context
- The Islamic banking industry has grown rapidly and "is even systemically important in several countries" (Figure 1).
- Islamic banking is projected to continue to grow faster than conventional banking "for the foreseeable future" given:
  - low base,
  - low level of penetration,
  - substantial market potential,
  - strong demand in many Islamic countries for Shariah-compliant products.
- The 2008-09 financial crisis led to renewed interest in Islamic finance due to the "resilience of Islamic banking in many countries in Asia, Europe, and sub-Saharan Africa."
- The IMF is increasingly encountering Islamic banking issues in surveillance and technical assistance, and a 2011 survey of prudential frameworks was conducted to enhance Fund capacity.
- The paper uses the survey results to document current practices, identify supervisory and regulatory challenges, and inform Fund surveillance, policy, and technical assistance.

### Box 1 — Survey design and sample
- Survey headings: presence of Islamic banking; areas of Islamic banking (general and financial information, legal framework, regulatory and supervisory framework, liquidity management and central banking, resolution and deposit insurance).
- All Fund members with a significant Islamic banking presence were canvassed, and 39 countries responded.
- Ten countries self-excluded by answering "no" to three questions on explicit recognition and practice; thus the analysis refers to 29 non self-excluded respondent countries.
- The 39 countries that were canvassed are listed in the source (not reproduced here per overlay rules).
- The 10 self-excluding countries were: Azerbaijan, Burundi, China, Kosovo, Malawi, Namibia, Sierra Leone, Tajikistan, Uganda, and Zambia.

### II. LEGAL AND INSTITUTIONAL DEVELOPMENT — background and patterns
- Islamic banking is distinct from conventional banking and is based on Shariah Law (see Box 2).
- Islamic banks and Islamic banking are "largely merchant and investment banking oriented" and typically relate to the real economy, especially trade and investment.
- Shariah Law:
  - plays a varying role across jurisdictions — in some (e.g., Afghanistan, Bahrain, Iran, Pakistan, Saudi Arabia, Sudan) it is "the fundamental law of the land" or a key source, while in others it does not constitute part of the legal framework;
  - imposes ethics, prohibits activities considered morally distasteful (drugs, alcohol, prostitution, games of chance), and forbids instruments based on interest;
  - typically promotes financing of real assets and returns derived from exposure to proprietary risk taking rather than pure financial risk taking.
- Formalized Islamic banking institutions first appeared in the 1960s and the industry is still in development, resulting in a "wide dispersion of approaches" to legal and regulatory introduction and oversight.
- Legal bases for practice of Islamic banking vary:
  - Legislation passed by a representative assembly in 17 jurisdictions (examples: Indonesia, Iran, Jordan, Kuwait, Malaysia, Sudan).
  - A decree/directive by a ruling authority in 6 jurisdictions (examples: Kazakhstan, Qatar).
  - Regulations issued by a bank regulatory authority in 17 jurisdictions (examples: Afghanistan, Bahrain, Ethiopia).
  - Legal basis implicitly set by the bank regulatory and supervisory authority in 11 jurisdictions (examples: Botswana, Kenya, the U.K.).
- Islamic banking presence:
  - present in all countries where Muslim populations are a majority and in most countries with a significant Muslim minority;
  - in a few countries only Islamic banking is permitted; in most countries Islamic banking is conducted alongside conventional banking but typically grows faster than conventional banking.
- Jurisdictional approaches to permitted institutions:
  - Some jurisdictions (e.g., Malaysia, Saudi Arabia) permit stand-alone Islamic banks and Islamic windows; others (e.g., Iraq, Kuwait, Jordan) do not permit Islamic windows.
  - Some jurisdictions permit conventional banks to control Islamic banks (e.g., Bahrain, Indonesia, Malaysia); others do not (e.g., Pakistan, Saudi Arabia).
  - Conversion rules vary; in many majority-Muslim jurisdictions an Islamic bank cannot be converted into a conventional bank.

### II.B Survey results on legal and regulatory frameworks and scope (key statistics and findings)
- Explicit recognition of Islamic banking: 21 of the 29 respondents (72 percent) indicated the legal and regulatory framework explicitly recognizes Islamic banking practices, products or institutions.
- Stand-alone Islamic banks: 22 of the 29 respondents (76 percent) indicated Islamic banking was being conducted by a stand-alone Islamic bank.
- Islamic banking by conventional banks: 16 of the 29 respondents (55 percent) indicated Islamic banking was being conducted by a conventional bank.
- Number and assets of Islamic banks (at time of survey):
  - 176 stand-alone Islamic banks operating in 22 of the 29 respondent countries.
  - Stand-alone Islamic bank assets totaled US$871 billion.
  - Sudan had the highest number of stand-alone Islamic banks at 33.
  - Iran’s total Islamic banking assets amounted to US$481 billion (52 percent of the total US$871 billion).
  - Islamic banking windows: 130 conventional banks across 12 respondent countries operated Islamic windows, with assets totaling US$109 billion; US$80 billion of that amount is attributable to one country (Saudi Arabia).
  - Total assets with Islamic banks and Islamic banking windows were US$1.28 trillion at end-June 2013 (Islamic Financial Services Industry Stability Report (2014 IFSB) figure reported in the source).

### Box 3 — Islamic window advantages and disadvantages (survey-reported)
- Advantages of Islamic windows:
  - economies of scale and scope that help lower the cost of Islamic finance.
- Disadvantages of Islamic windows:
  - reputation risks,
  - supervisory complexities.
- Some authorities advocate a "level playing field" policy (e.g., equal tax treatment) to address complaints about differential tax treatment between Islamic and conventional transactions.

### III. REGULATORY FRAMEWORK — objectives and implications
- Prudential regulation is "as necessary and desirable in Islamic banking as it is in conventional banking."
- Risks of Islamic banking are "those typical of financial intermediation."
- Regulatory objectives for Islamic financial activities mirror conventional aims: pursue and maintain financial stability by ensuring safety and soundness of banks to prevent systemic repercussions.
- Key elements of an effective regulatory framework for Islamic banking include:
  - understanding the nature of Islamic banking activities,
  - making appropriate changes to the existing regulatory framework for Islamic banking,
  - leveling the playing field between Islamic and conventional banking.
- Current trends: specific elements relating to Islamic banking are increasingly being incorporated into regulatory frameworks.

*Source: _wp14220 - References ............................................................................................................. (source PDF content supplied)*

### Box 3. Islamic Window vs. Fully-Fledged Islamic Bank

### Box 3. Islamic Window vs. Fully-Fledged Islamic Bank

### Advantages of Islamic windows (as noted by supervisory authorities who allow windows)
- Islamic banking services/products benefit from the experience and systems that conventional banks (CBs) have; this might improve the quality of services/products and lower their cost, which could enhance intermediation.
- Windows facilitate liquidity management, especially in countries where Islamic liquidity instruments are limited.
- Windows usually have easy access to liquidity support from the conventional part of the bank.
- Windows enhance competition in the market, which could lower the cost of finance for Shariah-compliant products.
- For countries with small demand for Islamic banking services (countries with a small Muslim population), the IB window could be the only feasible way of providing IB services, thus enhancing financial inclusion.

### Risks and concerns about Islamic windows (as noted by supervisory authorities who do not allow windows)
- Commingling of Islamic windows’ assets and liabilities with conventional assets and liabilities could have significant reputational risk; depositors in windows might suddenly withdraw their money if rumors regarding commingling arise. It also raises issues related to consumer protection.
- Windows could hinder the establishment of effective corporate governance and risk management systems:
  - The management and board of a conventional bank may not be sufficiently attuned to the unique risks inherent in IB activities, compromising oversight of the IB window.
  - If fit and proper criteria for conventional and Islamic intermediation should exist in CBs’ operating windows, it is likely that many CBs will be unable to meet these criteria (for the Islamic banking part).
  - Shariah boards might be unable to verify the complete segregation of assets and liabilities.
- The operation of windows could open the door for regulatory arbitrage or unfair practices:
  - Given the profit-and-loss sharing nature of windows’ accounts, risky financing could be encouraged to get Islamic financing through windows because, in the case of default, the account holders of windows will bear the losses.
  - Securities holdings could be shifted between investment portfolios financed by conventional sources of funds and those financed by windows’ sources so as to smooth returns.
- Windows could hinder effective financial oversight:
  - Some prudential ratios that might differ for Islamic banking could be difficult to monitor appropriately.
  - Windows could hinder the preparation of proper financial statements for windows activities, which could hinder effective oversight.
- Resolution of the IB window is unresolved:
  - The issue of how distressed Islamic banks should be resolved in accordance with Shariah principles is still under deliberation. This issue is further complicated for an Islamic window operating within a conventional bank.
  - If the authorities are faced with a distressed conventional bank (with an Islamic window), they may not be able to carry out an orderly resolution satisfying financial stability objectives and Shariah principles that could potentially modify the treatment of the Islamic banking window.
- Monitoring the impact of using an Islamic monetary instrument (e.g., Sukuk) could be difficult in the case of windows:
  - CBs’ pricing for IB activities will not be strongly linked to a Shariah-compliant liquidity level since CBs can use conventional deposits to finance Islamic banking assets. This could hinder the design of appropriate monetary policies.

### Approaches to accommodating Islamic banking in regulatory frameworks
- Three broad approaches:
  - BCBS framework as default for all banks (no distinction between Islamic and conventional banks).
  - A generic BCBS component applied to all banks, with references identifying provisions applying only to Islamic banks; BCBS framework complemented by IFSB prudential standards where appropriate.
  - A separate regulatory framework that accommodates Islamic banking.
- Survey responses on regulatory frameworks (number of respondents):
  - 11 respondents indicated a single integrated regulatory framework applied to all banks (no reference to Islamic banking or Islamic banks).
  - 10 respondents noted a single integrated regulatory framework with references applying specifically to Islamic banking and banks.
  - 3 respondents pointed out two separate independent regulatory frameworks (one for Islamic banking and banks, and another for conventional banking and banks).
  - 7 respondents indicated a mixed approach (single regulatory framework for common areas, separate guidelines/regulations for Islamic banks).
- Supervisory responsibility:
  - The central bank is usually responsible for supervision of Islamic banks: 25 respondents out of 29 indicated that was the case.
  - Three respondents indicated an independent authority (outside the Ministry of Finance or the Central Bank) was in charge of regulation supervision.
- Shariah compliance in supervision:
  - Shariah compliance plays a role (explicitly or implicitly) in supervision. Example: In the U.K., the regulatory framework does not contain prescriptions on Islamic banking or Shariah compliance, but authorities take Shariah compliance into account indirectly when considering consumer protection, internal controls, governance, and reputational risk.

### Licensing
- Licensing practices:
  - In 17 jurisdictions a stand-alone Islamic bank will be issued with an Islamic banking license.
  - In 12 jurisdictions a single (generic) banking license is issued to a bank, irrespective of whether the bank is Islamic or conventional (in some of these jurisdictions authorities are empowered to issue only an Islamic banking license).
- Fit and proper criteria:
  - Typically one set of fit and proper criteria applies to all banks; regulatory frameworks do not usually prescribe a distinct set for Islamic banks.
  - Important that Islamic banking management be trained and experienced in Islamic banking operations; expertise in Islamic accounting standards such as AAOIFI would be useful for roles like chief financial officer or internal auditor.
  - The fit and proper issue for individuals responsible for Shariah compliance (members of the Shariah board, Shariah accountant, Shariah internal auditor, Shariah compliance officer, Shariah external auditor) has not received sufficient attention.
  - Twelve respondents noted a bank’s proposal for Shariah scholars to be appointed to its Shariah board was not required to undergo a fit and proper test; 10 respondents noted the contrary.

### Corporate governance and Shariah law compliance
- Shariah boards and legal frameworks:
  - A range of frameworks exists for setting up a Shariah board.
  - Four respondents (Palestine, Sudan, Turkey, and United Arab Emirates) indicated the legal framework requires a national/central Shariah board (note: law 1985 mentioned a national Shariah board for the U.A.E. but it has not been implemented; currently Shariah board operates at individual bank level only in U.A.E.).
  - Six respondents (Afghanistan, Malaysia, Pakistan, Palestine, Sudan, and Syria) noted the legal framework requires setting up a Shariah board for the central bank.
- Central bank Shariah boards:
  - Central bank Shariah boards differ in mandate, scope, governance, and accountability.
  - Ultimate responsibility for a central bank’s Shariah compliance lies mostly with its Shariah board of directors; day-to-day compliance is delegated to senior management.
  - Models differ: in some cases (e.g., Malaysia, Sudan) the central bank’s Shariah board has overall authority and can be final arbiter in disputes (legislative and adjudicative powers); in other jurisdictions (e.g., Afghanistan, Pakistan, Syria) the central bank’s Shariah board does not have legislative or adjudicative powers but must be consulted on proposed amendments with Shariah implications.
- Islamic bank Shariah boards:
  - A majority of jurisdictions require Islamic banks to have a Shariah board that has legal standing and whose actions have legal implications (e.g., Iraq, Kuwait, Malaysia, Sudan).
  - Ultimate responsibility for an Islamic bank’s Shariah compliance typically lies with the Islamic bank’s board of directors, delegating day-to-day compliance to senior management in line with Shariah board guidance (Shariah boards are typically advisory).
  - Legal frameworks require a Shariah board for an Islamic bank in 17 jurisdictions surveyed.
  - Status of Islamic bank Shariah boards (number of respondents):
    - Five respondents indicated it was a subsidiary organ of the general assembly of shareholders.
    - Eight respondents indicated it was a free-standing organ.
    - Two respondents mentioned it was a subsidiary organ of the board of directors.
    - Two other respondents noted none of the above categories applied.
  - Reporting lines of Shariah boards vary: board of directors (8 respondents), general assembly (8 respondents), top management (2 respondents), executive committee (2 respondents), the bank (1 respondent).
- Shariah compliance function:
  - Ensuring Shariah compliance is usually conducted by internal auditors or Shariah auditors.
  - In jurisdictions where Shariah Law is the default source of all legislation (e.g., Iran, Pakistan, Saudi Arabia, Sudan), an Islamic bank’s internal auditor has statutory responsibility to ensure Shariah compliance.
  - In other jurisdictions, banks are required to have a dedicated Shariah auditor/Shariah compliance officer whose appointment may require supervisory authority approval.
- External auditors:
  - Where Shariah Law is the default source of legislation, external auditors have statutory responsibility to assess and verify Shariah compliance.
  - In jurisdictions where Shariah Law is not the default source, external auditors generally have no direct responsibility to assess Shariah compliance.
  - Survey finding: in 20 jurisdictions external auditors of an Islamic bank do not have duties and responsibilities regarding Shariah compliance (only five respondents indicated external auditors do have such duties).

### Capital requirements
- BCBS regulatory minimum capital adequacy requirement applies in most countries where Islamic banks are present; many jurisdictions strive for compliance with the BCBS capital framework (Basel I, Basel II, Basel III).
- Prescribed minimum overall capital adequacy ratio (CAR) for Islamic banks ranges from 8 percent to 12 percent.
- Approaches:
  - Some jurisdictions apply the chosen BCBS capital framework to all banks (no distinction between Islamic and conventional banks) (examples: Ethiopia, Kazakhstan, Turkey, United Arab Emirates, United Kingdom).
  - Other jurisdictions contain prescriptions based on IFSB prudential standards to adjust the BCBS framework for Islamic banking features (examples: Bahrain, Jordan, Malaysia, Sudan).
- Comparability issues:
  - It may be difficult to compare capital ratios among Islamic banks in different countries due to differing adjustments.
  - Some jurisdictions apply an alpha factor, as proposed by the IFSB, to capture difference in risk exposure between Islamic banking risk-sharing products and conventional products (Box 4).
  - Example: In Turkey, authorities decided on a 70 percent risk weight to be applied to Islamic banking risk-sharing products.
  - These adjustments are based on assumptions about risk arising from particular transactions and whether there has been an effective transfer of risk to or from a third party.

### Leverage
- Excessive leverage could be a valid concern for Islamic banks because, in most cases, there are no constraints on the amount of call funds or investment funds an Islamic bank may take on deposit.
- Exception: one jurisdiction (Bahrain) imposes a leverage ratio on Islamic banks, limiting the call funds and unrestricted investment funds placed with an Islamic bank to 20 times the capital of the bank.
- Islamic banks are not permitted to engage in “pure” financing (financing that does not involve a real asset), which constrains leverage and benefits financial stability.

*Source: Box 3, _wp14220 - Box 3. Islamic Window vs. Fully-Fledged Islamic Bank*

### Box 4. Capital Requirements

### Box 4. Capital Requirements

### Overview
- Computation of the required capital adequacy ratio in Islamic banking is similar to the relevant BCBS formula, but variations exist in recognition of sources of funds and risk-weighted assets.
- A major difference relates to profit sharing investment account (PSIA) loss absorbency: PSIA holders are quasi-liability holders and are expected to absorb all losses on the investments made with their funds, unless there is evidence of negligence or misconduct on the part of the bank.
- The capacity to pass-through low returns or losses to PSIA holders provides Islamic banks with an additional buffer to limit the impact of adverse shocks on their solvency.
- The higher the share of PSIA as a source of funds and the lower their sensitivity to changes in returns, the better the solvency of IBs compared to conventional banks.

### Asset risk-weighting and income smoothing
- Assignment of risk weights to different classes of assets differs in Islamic banks because assets range from trade financing to equity partnership, affecting calculation of risk weights relative to conventional banks.
- Income smoothing practices (e.g., reserves for income smoothing) have indirect implications for capital adequacy; regulators may take these into account when determining the capital adequacy ratio.

### IFSB standards and timeline
- In December 2006, a working group of the IFSB issued the first capital adequacy standard for institutions (other than insurance institutions) offering Islamic financial services.
- The minimum regulatory capital adequacy requirement for Islamic banks in the IFSB standard is 8 percent.
- In May 2008, IFSB issued a guidance note on recognition of ratings by external credit assessment institutions to facilitate application of Basel II.
- In December 2013, IFSB revised its capital adequacy standards to incorporate many elements of Basel III.

### IFSB CAR calculation forms and supervisory discretion
- The IFSB standard provides two forms for calculating the capital adequacy ratio: standard and discretionary.
  - Standard formula: capital divided by risk-weighted assets excluding the assets financed by investment account holders.
  - Discretionary (supervisory discretionary) formula: modified to accommodate reserves maintained by Islamic banks to minimize displaced commercial, withdrawal, and systemic risks.
- In markets where Islamic banks maintain profit equalization reserves (PER) and investment risk reserves (IRR), supervisory authorities have discretion to adjust the denominator of the CAR formula.
- The IFSB Supervisory Discretionary Formula for CAR is expressed as:
  - [Eligible Capital]/{[total risk-weighted assets +operational risk]-[RWAs funded by restricted profit sharing investment accounts (credit + market risk) – [(1- α*) total risk-weighted assets funded by unrestricted profit-sharing investment accounts] – [ α* risk-weighted assets funded by PER and IRR of unrestricted profit sharing investment accounts]}, where α* is the proportion of assets funded by PSIAs and is determined by the supervisory authorities.
- IFSB issued in March 2011 a guidance note with a methodology to estimate the value of alpha to be used in the supervisory discretion formula.

### Values of α* and country practices
- Although the value of α* normally does not exceed 30 percent, there are wide variations among countries:
  - Malaysia requires 100 percent of general assets financed by investment accounts to be converted into risk weighted assets.
  - Sudan requires 50 percent.
  - Bahrain and Jordan require 30 percent.

### Survey findings on CAR denominator adjustments and eligible reserves
- The Islamic banking survey revealed varying practices:
  - 14 respondents noted that an Islamic bank is required to hold capital against assets financed by an unrestricted investment account (URIA).
  - 10 respondents expressed that banks were required to hold capital against assets financed by a restricted investment account (RIA).
  - Seven respondents indicated that a PER was considered eligible capital for the regulatory CAR.
  - Seven respondents noted that an IRR was considered eligible capital for such purposes.
- IFSB-15 (Revised capital adequacy standards for institutions offering Islamic financial services) made it clear that PER and IRR are not part of the capital of Islamic banks.

*Source: _wp14220 - Box 4. Capital Requirements*

### Box 5. Profit Sharing Ratios

### Box 5. Profit Sharing Ratios

### Profit sharing ratios and market practice
- Participation ratios on URIAs and RIAs are negotiated between the Islamic bank and its customers, with proliferation of ratios across jurisdictions.
- Key determinants of participation ratios: size of amount to be invested and duration of the investment.
- Strong correlation observed between deposit rates at conventional banks and participation ratios at Islamic banks.
- Turkey: supervisory authority prescribed the investment participation ratio as 75 percent (for the investor) and 25 percent (for the Islamic bank), implying the investor’s minimum profit share is 75 percent and the Islamic bank’s maximum profit share is 25 percent.
- Reported profit sharing examples from Turkey:
  - Fixed deposits: 75 percent to 25 percent.
  - Term deposits: 80 percent to 20 percent (according to one Turkish bank).

### Competitive dynamics, frequency of change, and loss sharing
- Islamic banks must react speedily to market developments, such as changes in interest rates.
- Historical premium on Islamic bank deposits relative to conventional banks (due to perceived higher risk) has been diminishing.
- In Turkey, Islamic banks must keep the supervisory authority informed at all times of participation ratios and are not permitted to change these ratios more regularly than weekly.
- Symmetry generally exists between profit sharing ratios and loss sharing ratios.
- Loss-sharing constraint: the loss-sharing ratio of a bank may not be less than 50 percent (i.e., the loss-sharing ratio of a customer may not be more than 50 percent).

### Income attribution, fee practices, and crisis responses
- No internationally accepted sequence of steps and definitions is applied by Islamic banks to compute rates of return on Islamic banking products.
- All income generated by an Islamic bank as a result of lending, investments and the bank's investment management and investment performance fees accrues to the (shareholders of the) Islamic bank.
- During the 2008-09 global crisis, some Islamic banks decided to forego investment management fees to the benefit of the investors in the Islamic banks’ URIA and RIA products.

### Smoothing, accounting treatment, and governance
- Distinction is important between:
  - “Smoothing” of the Islamic bank’s own revenues (not permissible under IFRS), and
  - “Smoothing” of amounts that belong to investors in URIA and RIA accounts (permissible if there is a legal contractual basis).
- No internationally accepted standards on URIA/RIA investment income smoothing; by default such smoothing is performed by Islamic banks in certain jurisdictions.
- Governance implication: transparency and legal contractual basis are central to permissible investment income smoothing.

### Shariah compliance and supervisory approaches
- Jurisdictions differ in approach to Shariah compliance risk:
  - In jurisdictions where Shariah Law is not the basis of the legal system, bank supervisory authorities typically address Shariah compliance from a secular perspective and do not generally build capacity to determine Shariah Law compliance.
  - In jurisdictions where Shariah Law is the fundamental source of law, supervisory authorities often have responsibility to ensure compliance with Shariah Law and provide supervisory staff with necessary training.
- If a bank professes to be selling Shariah-compliant products it is required to be Shariah compliant.

*Source: Box 5. Profit Sharing Ratios (_wp14220)*

### Annex 1. Definition of Key Shariah-Compliant Contracts

### Annex 1. Definition of Key Shariah-Compliant Contracts

### Overview
- 43,44

### Sources of Funds (Deposits and Investment Accounts)
- Profit Sharing Investment Account (PSIA)
  - "Profit Sharing Investment Account (PSIA) is a contract by which an investor/depositor opens an investment fund with an IB on the basis of Mudharabah."
  - "The IB could have restricted or full discretionary power in making investment decisions."
  - "The IB acts as an entrepreneur while the PSIA holder acts as a capital provider."
  - "Both parties agree on a ratio of profit sharing, which must be disclosed and agreed upon at the time of opening the account."
  - "Profits generated by the IB are shared with the PSIA holder in accordance with the terms of the Mudharabah agreement while losses are borne solely by the PSIA holder, unless they are due to IB’s misconduct, negligence or breach of the contract terms."
  - "Usually the IB’s money (bank capital) is invested in the same income-producing assets or economic activities. Hence, low income (losses) affect the IB through low (negative) return on shareholders’ invested capital and low (zero) income from managing PSIA accounts."
  - "This source of revenue is the main one for the IB, and it is used to cover operational expenses."

- Wadiah (deposit)
  - "A Wadiah (deposit) is a contract between the depositor and the IB (custodian) for safekeeping."
  - "The depositor grants the IB permission to utilize the funds for whatever purpose permitted by Shariah."
  - "The bank in return guarantees the value of the deposit and allows the depositor easy access for withdrawals whenever needed."

### Uses of Funds (Financing and Investment)
- Murabahah (Cost-plus financing)
  - "A Murabahah (Cost-plus financing) contract refers to an agreement whereby the IB sells to a customer, at acquisition cost plus an agreed profit margin, a specified kind of asset that is already in its possession (such as a manufactured good)."
  - "Following delivery of the asset, a credit risk in respect of the amount receivable from the customer arises."
  - "From the perspective of modern finance, a Murabahah facility is similar to an asset-backed risky loan."

- Salam (Purchase with deferred delivery)
  - "A Salam (Purchase with deferred delivery) contract refers to an agreement to purchase, at a predetermined price, a specified kind of commodity (physical product) which is to be delivered on a specified future date in a specified quantity and quality (such as an agricultural or a manufactured product)."
  - "As the buyer, the IB makes full payment of the purchase price upon execution of the Salam contract."
  - "To mitigate price risk, in certain cases, the IB enters into a back-to-back contract, namely Parallel Salam, to sell a commodity with the same specification as the purchased commodity under a Salam contract to a party other than the original seller."

- Ijarah (Lease)
  - "An Ijarah (Lease) contract refers to an agreement whereby the IB leases to a customer an asset (such as a ship, aircraft, or telecom equipment) for an agreed period against specified installments of lease rental."
  - "The contract commences with an agreement to lease that is binding on the part of the potential lessee and requires the IB to purchase or lease an asset prior to entering into the contract."
  - "An Ijarah contract could offer the lessee the option to purchase the asset either at the end of the lease period by means of a gift or a token consideration, or by installments of a specified amount during the lease period."

- Musharakah (Equity financing)
  - "A Musharakah (Equity financing) contract is an agreement whereby the IB and a customer contribute capital to an enterprise, whether existing or new, or to the ownership of real estate or a moveable asset, either on a permanent basis or on a diminishing basis where the customer progressively buys out the share of the IB (“diminishing Musharakah”).45"
  - "Profits generated by the enterprise or the asset/real estate are shared in accordance with the terms of the Musharakah agreement, while losses are shared in proportion to the respective contribution to capital."

- Mudharabah (Participation or trust financing)
  - "A Mudharabah (Participation or trust financing). It is a contract that refers to an agreement whereby the IB contributes capital to an enterprise or activity which is to be managed by the customer/investor."
  - "Profits generated by that enterprise or activity are shared in accordance with the terms of the Mudharabah agreement, while losses are to be borne solely by the IB unless they are due to the customer/investor’s misconduct, negligence, or breach of the contract terms."

### Footnotes and Notes
- "43 This follows closely the IFSB definition of contracts and it is largely based on Hasan, M. and J. Dridi (2010)."
- "44 In the case of lease-to-buy contracts, the asset backing the lease is strictly non collateral as it remains the property of the lessor. It may be described as quasi-collateral (see the IFSB capital adequacy standard)."
- "45 Diminishing Musharakah is a means of providing financing on a profit and loss sharing basis."

*Annex 1. Definition of Key Shariah-Compliant Contracts*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2014/_wp14220.pdf_