ISLAMIC BANKING’S UNIQUE FEATURES - Bank Islam … · ISLAMIC BANKING’S UNIQUE FEATURES & THE NEXT FRONTIER ... for collective provision ... ie. using PSR for Mudarabah &

ISLAMIC BANKING’S UNIQUE FEATURES

&

THE NEXT FRONTIER

Presentation by

Mr. Malkit Singh

CFO, Bank Islam Malaysia Berhad

Lanai Kijang, Kuala Lumpur

24 June 2014

Page 2 Malkit Singh Maan 2014


PRESENTATION OUTLINE

Global Islamic Finance Industry

Malaysia Islamic Banking System

Challenges from the accounting perspective

• The next frontier

Islamic Financial Services Act 2013


GLOBAL ISLAMIC FINANCE INDUSTRY

Islamic finance assets estimated at USD1.8 trillion as at end 2013

During 2009 – 2013 CAGR of 17.07%

Y-o-Y growth of 18.6%

Banking sector accounted for 79.8% of the portfolio

Banking,

79.8%

Sukuk, 15.0%

Funds, 4.0% Takaful, 1.1%

Global Islamic Finance – Assets (2013*)

Source: Malaysia International Islamic Financial Centre : “Insights” 15 January 2014

* Estimated


MALAYSIAN ISLAMIC BANKING SYSTEM

Global level, Malaysian Islamic banking assets represent 13% share of

the total global Islamic banking assets

In South East Asia, Malaysian Islamic Banking assets represent 85% of

total assets of Islamic banking industry

Domicile of Islamic Banking (1H13)

Iran (37%)

Saudi Arabia (18%)

Malaysia (13%)

UAE (7%)

Kuwait (6%)

Qatar (4%)

Turkey (3%)

Bahrain (2%)

Indonesia (2%)

Sudan (1%)

Pakistan (1%)

Others (6%) Source: Malaysia International Islamic Financial Centre :

“Insights” 15 January 2014


MALAYSIAN ISLAMIC BANKING SYSTEM (Cont’d)

Continues to outperform the conventional banking sector with assets

CAGR of 18.7% during 2008 – 2013 whereas conventional banking

grew 8.2% during same period

Islamic banking market share increased from 7.8% in 2007 to 20.7% in

2013

7.8%

13.9% 15.8% 16.8%

18.4% 19.5%

20.7%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

-

50,000

100,000

150,000

200,000

250,000

2007 2008 2009 2010 2011 2012 2013

Islamic Banks Growth Commercial Banks Growth Banking System Growth IB Market Share

Source: BNM Monthly Statistical Bulletin April 2014


CHALLENGES FROM THE ACCOUNTING PERSPECTIVE

• Harmonisation of financial reporting

• Debatable Issues

Time value of money

Ijarah

• Areas not addressed by IFRS

Accounting for Zakat

Late payment charges (Ta’widh)

Qardh facility


HARMONISATION OF FINANCIAL REPORTING

Basis of preparation differs

No uniform financial reporting standards globally

IFRS the most common form of reporting though additional local

reporting requirements need to be adhered to


FINANCIAL STATEMENTS OF ISLAMIC FINANCE INSTITUTIONS (IFIs)

BASIS OF PREPARATION

Al Baraka Banking Group

Financial Accounting Standards (FAS)

issued by Accounting and Auditing

Organisation for Islamic Financial

Institutions (AAOIFI)

Where No AAOIFI standards exists -

relevant International Financial

Reporting Standards (IFRS) issued by

International Accounting Standards

Board (IASB)

Bahrain Commercial Companies Law

Central Bank of Bahrain and Financial

Institution Law

Al Rajhi Banking & Investment Corp. (M) Berhad

Malaysian Financial Reporting

Standards (MFRS)

Bank Negara Malaysia (BNM)

Guidelines

Companies Act, 1965




IFRS except for IAS 39 requirement

for collective provision…replaced by

Central Bank of Kuwait’s requirement

for a minimum general provision

Regulations of the Government of

Kuwait for financial services

institution regulated by the Central

Bank of Kuwait

Kuwait Finance House (M) Berhad

MFRS

IFRS

BNM Guidelines

Companies Act, 1965

Kuwait Finance House K.S.C & Subsidiaries

Maybank Islamic Berhad

MFRS

IFRS

BNM Guidelines

Company Act, 1965




Qatar Islamic Bank

FAS by AAOIFI

Where not covered by AAOIFI

standards - uses IFRS

Regulations of Qatar Central Bank

Provisions of the Qatar Commercial

Company Law

National Bank of Abu Dhabi

IFRS

Laws of the U.A.E

Emirates Islamic Bank

IFRS

Laws of the U.A.E

Bank Islam (M) Berhad

MFRS

IFRS

BNM Guidelines

Company Act, 1965



Common framework

Enhance transparency

Common framework Enhance transparency International

comparability of financial reporting

IFRS is not considered to be sufficient, especially by Islamic

Financial Institutions (IFIs) using accounting standards

issued by Bahrain based Accounting and Auditing Organisation for Islamic

Financial institutions (AAOIFI)

WHY HARMONIZATION

There are AAOIFI standards issued for

specific Islamic banking and finance practises not covered

by IFRS

Most countries in the world have adopted

or converged to International

Financing Reporting Standard (IFRS)



IFRS could be used as the default reporting framework although guidance based

on existing Islamic financial reporting models would need to be used to

supplement the standards for those IF transactions that do not fit simply into the

framework

Could explore the possibility of having a specific standard under IFRS for Islamic

finance transaction

Alternatively, a set of globally recognised Islamic accounting standards could be

used by IFIs; To assist IFIs and ultimately the users of financial statements, a

reconciliation to IFRS could also be provided, or common terms could be

provided.

Will show how IFRS can be used to apply to the latest Islamic Financial Services

Act 2013 requirement.

SUGGESTIONS ON HARMONISATION OF FINANCIAL REPORTING


DEBATABLE ISSUES – TIME VALUE OF MONEY

AAOIFI’s Financial Accounting Standard (FAS) 2, ‘Murabaha and Murabaha to Purchase Orderer’ recognises profit

proportionately over the repayment period or, in a departure from the accrual concept,

as and when installments are received

AAOIFI’s conceptual framework propounded that “money does not have a

time value” hence does not require the pattern of profit recognition to be related to

the amount of principal outstanding

AAOIFI’s FAS13 ‘Mudaraba’ states ‘”In measuring receivables neither time value

(interest rate) nor discount on current value for extension of period of payment shall be

taken into consideration

Under IFRS 39/ IFRS 9, ‘Financial instruments’ assets classified as financing are measured at amortised costs using an effective interest rate in order to take into

account the time value of money

TIME VALUE OF MONEY


Whereas, under AAOIFI’s FAS 10, ‘Istisna’a and Parallel Istisna’a’ an

Istisna’a financing receivable would be valued at historical cost

IFRS 39/ IFRS 9 ‘Financial Instruments’ allow users to evaluate the ‘ability of the

entity to generate cash and cash equivalents in the future’ often require

the use of discounted future cash flows to measure assets and liabilities

No active market – use valuation techniques based on discounted future cash flows. Sukuk – no active market

have to be measured this way

Under IFRS 36: ‘Impairment of Assets’ Impairment = Carrying value >

recoverable amount. Recoverable amount is again based on discounted

cashflows.

TIME VALUE OF MONEY




IFIs use discounted cash flows when calculating value in use

for impairment testing and valuation techniques for

Financial Investments like Sukuks, and Derivatives (IPRS)

which are measured at fair value

Use of discounted cash flows is to derive an approximation of a

market value

The prohibition of partaking in interest based transactions is

clearly fundamental to Islamic finance


ISLAMIC FINANCIAL SERVICES ACT (IFSA) 2013

Came into effect 30 June 2013

Amalgamated several separate laws to govern the financial sector

under a single legislative framework

Islamic Banking Act (IBA) 1983 Takaful Act 1984 Payment System Act 2003 Exchange Control Act 1953

Repealed 30 June 2013

Islamic Financial Services Act 2013


ISLAMIC FINANCIAL SERVICES ACT (IFSA) 2013

Provides BNM with the necessary regulatory and supervisory oversight powers

Maintain financial stability

Support inclusive growth in the financial system & economy

Provide adequate protection for consumers

OBJECTIVES


IFSA – REDEFINING DEPOSIT PRODUCT

Concept of Investment Account introduced

Treatment of Investment Account & Islamic deposits in line with Shariah requirements

DEFINITION OF INVESTMENT ACCOUNT

Acceptance of money for investments in accordance with Shariah Principles

No express or implied obligation to repay the money in full (not principal guaranteed)

PSR set upfront & can be loss bearing (Mudarabah & Musharakah) or distribution of profit after

deduction of agency fees & performance incentive fee (Wakalah). No profit smoothing allowed

Investment tenure must be specified (with or without maturity)

DEFINITION OF ISLAMIC DEPOSITS

Acceptance of money in accordance with Shariah Principles for deposits (Wadiah, Tawarruq &

Bai’ Inah)

On terms that the sum of money paid will be repaid in full (principal is guaranteed)

For term deposit, profit rate is known upfront (Tawarruq)

Repayment on demand or at a certain time


FEATURES OF INVESTMENT ACCOUNT

1. Must clearly state investment objectives, which covers type of assets that would

be invested in

2. An assessment of investment & risk management strategies to achieve

investment objectives, including expected return on investment on the assets

identified and stress testing or scenario analysis.

3. IAH's risk appetite to accept risk from proposed investment must be made

4. Minimum amount of investment must be specified

5. Investment tenure must be stated whether with or without maturity and

minimum investment tenure for those with maturity.

An Investment Account offering must cover the following:


FEATURES OF INVESTMENT ACCOUNT (con’t)

6. Stipulate redemption terms, taking into account liquidity risk management

strategies and rights to share profit & loss arising from early redemption.

7. Clearly set out, profit distribution methodology, ie. using PSR for Mudarabah &

Musharakah products; Agency fees & performance incentive for fees for

Wakalah product.

8. The manner in which profit shall be paid must be made known

9. State Valuation methodology consistent with MFRS, including impairment

assessment.

10. Terms of Termination of Investment Account:

manner of termination

valuation methodology

profit distribution

operational requirements that will affect conduct of business with IAH

to ensure all liabilities of IAH fund are discharged before completion or

winding up


TYPE OF INVESTMENT ACCOUNTS

Restricted Investment Account (RIA)

• Investment Account Holder provides a specific investment mandate (purpose, assets

class, economic sector & period of investment)

Source of funds

Management of funds

Application of funds

Profit/Loss

Distribution of Profit/Loss*

Investment Account Holders

Restricted Funds

Asset XYZ

Loss

Bank

Profit

Investment Account Holder

• Funds will be specifically utilized to fund a particular project of the investment account

holder. In return, the investment account holder will be entitled to a percentage share

of the investment income

*Profit or loss can be directly identified and distributed to the fund

providers



Unrestricted Investment Account (URIA)

• Investment Account Holder allows the bank to make the ultimate investment decision

without specifying any particular restriction or condition

Source of funds

Management of funds


Profit/Loss

Distribution of Profit/Loss

Assets Pool


Unrestricted Funds

Loss

Bank

Profit


• Funds will be placed in general bank’s pool of Shariah compliant banking activities. In

return, investment account holders will be entitled to a percentage share of the

investment income.

*All profit or loss arising from the assets shall be apportioned to

the respective fund providers based on proportionate tagging

• Must not be exposed to investment concentration risk

• Investment concentration limit to single counterparty shall be 25% of carrying value total net assets value of URIA fund.



Overview – Identification of Assets against funding sources

Source of funds

Management of funds


Profit/Loss

Distribution of

Profit/Loss

Shareholders’ funds and deposits

General pool

Profit/Loss

Bank


Unrestricted Funds

Loss

Bank

Profit



Restricted Funds

Asset XYZ

Loss

Bank

Profit


Depositors

Assets Pool Assets Pool


ACCOUNTING EVALUATION FOR INVESTMENT ACCOUNT

Are funds received from investors treated separately?

• Apply principles of MFRS 10 ‘Consolidated Financial Statements’

• Assess if Bank has control over the funds

Apply MFRS 132 ‘Financial Instruments: Presentation’ to assess if fund qualify as financial liability

Accounted for in accordance with MFRS 139 ‘Financial Instruments: Recognition & Measurement’

Further assessed under MFRS 132 in accordance with the substance of the contractual arrangement to determine appropriate treatment

Off balance Sheet On balance sheet

Apply MFRS 139. Evaluate if underlying assets met de-recognition criteria – ‘pass through arrangement’

Consolidate the funds

Risk & rewards test Transferred/ retained

substantially the risks & rewards

Off balance Sheet On balance sheet

Yes No

Yes No

Yes No

No Yes

Transferred Retained

IA – On or off balance sheet? Depends on IA product’s terms and conditions


TO DETERMINE WHETHER THE ENTITY SHOULD BE DEEMED A SEPARATE ENTITY

Specific assets of the investee are the only source of payment for specified

liabilities of the investee

All the assets & liabilities that are deemed separate entity are ring-fenced from

the overall investee

Deemed separate entity is called ‘silo’


DO THE FUNDS QUALIFY AS FINANCIAL LIABILITY

Para 11 of MFRS 132 defines a financial liability as any liability that is:

a. a contractual obligation

i. To deliver cash or another financial asset to another entity; or

ii. To exchange financial assets or financial liabilities with another entity

under conditions that are potentially unfavourable to the entity; or

b. a contract that will or may be settled in the entity’s own equity instruments

At this stage, it can be argued Investment Account is a financial liability as the bank has a contractual obligation to return the proportionate share of capital invested at the maturity of the investment, plus a contractual obligation to

distribute profits in cash in the pre-determined ratio


DOES THE BANK CONTROL THE FUNDS

Accounting evaluation

• Under MFRS 10 the Bank controls the fund if and only if the Bank has all

of the following:

All 3 elements must be present in order for the Bank to have control

Control

Link between power & returns

Power

Exposure to

variability in returns



POWER

Scope of decision on making authority

Rights of other parties

Substantive or protective rights

Activities •Authority to set investment parameters •Type of investments

Purpose & Design •Key contributor to the purpose & design of the funds

Discretion •Discretion the Bank has to make investment decisions

Does fund providers individually or

collectively have rights to remove the Bank/

direct decision made by the Bank

Power on the relevant activities of

the fund



EXPOSURE TO VARIABILITY IN RETURNS

Magnitude & variability of remuneration

entitlement of the Bank

Magnitude

Market Terms

Variability

Pre-agreed profit sharing ratio

Variability of the Bank’s remuneration exposure to

the upside/ downside risk of investment versus fund

providers exposure

Is the remuneration deemed to commensurate with

market terms



Apply principles of para 21 of MFRS 118, an entity is acting as a principal when it has

exposure to the significant risks and rewards associated with the rendering of

services

One feature indicating an entity is acting as agent is that the amount the entity earns

is predetermined, being either a fixed fee per transaction or a stated percentage of

the amount billed to the customers.

LINK BETWEEN POWER & RETURNS

Principal- has control Agent- does not have control


EVALUATE DERECOGNITION OF FINANCIAL ASSETS

Para 17 of MFRS 139 states that a financial asset shall be derecognised when:

a. The contractual rights to the cash flows from the financial assets expire; or

b. When it has transferred the contractual right to receive the cash flows of

the financial asset


EVALUATE DERECOGNITION OF FINANCIAL ASSET – PASS THROUGH ARRANGEMENT

As per para 19 of MFRS 139, the following conditions should be met to achieve

a pass-through arrangement

a. The Bank has no obligation to pay amounts to the eventual recipients unless it

collects equivalent amounts from the original asset.

b. The Bank is prohibited by the terms of the transfer contract from selling or pledging

the original asset other than as security to the eventual recipients for the obligation to

pay them cash flows

c. The bank has an obligation to remit any cash flows it collects on behalf of the

eventual recipients without material delay. In addition, the Bank is not entitled to

reinvest such cash flows, except for investments in cash or cash equivalents

Yes to the above Banks does not have a liability. Acts more as an agent. Should be derecognised No to the above Funds received should be on balance sheet


EVALUATE DERECOGNITION OF FINANCIAL ASSET – RISKS AND REWARDS TEST

As per para 20 of MFRS 139, when an entity transfers a financial asset, it shall

evaluate the extent to which it retains the risks & rewards of ownership of the

financial asset. In this case, the Bank carries out the risks and rewards test as

follows

a. Has the Bank transferred substantially all the financial asset’s risks and

rewards of ownership

Yes to the above Derecognition and should be off balance sheet No to the above Consider item (b) below


EVALUATE DERECOGNITION OF FINANCIAL ASSET – RISKS AND REWARDS TEST

b. Has the Bank retained substantially all risks and rewards of ownership

Yes to the above Should be on balance sheet No to the above Consider item (c) below

c. Has the Bank retained control of the assets?

Yes to the above Continue to recognise on balance sheet No to the above Derecognise, off balance sheet


NEXT FRONTIER - CONCLUSION

INTRODUCTION OF IFSA PROMOTES…

True blue Islamic banking

Clear focus on Shariah compliance & governance

Product innovation

Product differentiation within IBs vs. Conventional Banks

Match risk & rewards – Not new under Islamic Finance. Has been laid down in

Islamic legal maxim known as Al-Ghunmu bi Al-Ghurmi (any profit is associated

with risks)

More transparency – it’s all about faith and trust


Documents

ISLAMIC BANKING’S UNIQUE FEATURES - Bank Islam … · ISLAMIC BANKING’S UNIQUE FEATURES & THE NEXT FRONTIER ... for collective provision ... ie. using PSR for Mudarabah &