Islamic Financial Policy At Country Level

The development and implementation of Islamic financial policy varies across countries and takes many forms. Malaysia has a comprehensive Islamic financial architecture that is recognized as among the most advanced in the world. Financial policymakers and regulators in other countries have emulated Malaysia with varying degree of success. The main lessons that Malaysia’s experience can offer when it comes to developing an effective Islamic financial policy is consistency among all policy actions, integrate Islamic financial policy with national economic policies, ensure the readiness of market players to cope with any expected change and take a gradual approach in introducing new policies and guidelines.

Despite the many achievements, Islamic financial policy still has a long way to go before it can command the respect that it deserve. Unlike in the conventional financial system, many Islamic finance policymakers have yet to incorporate issues such as environmental and social factors into their core tasks of shaping efficient, resilient and effective financial markets. But as the internationalization of Islamic finance gathers pace, an important challenge for policymakers and regulators is ensure policies implemented reflect the growing cross-border dimensions of Islamic finance and its increased connectivity.

Islamic Financial Policy in Malaysia

Since its first introduction in 1983, the Islamic financial sector in Malaysia has developed immensely into a resilient regulatory and legal infrastructure which is far more advanced and relevant than most other Muslim countries. The government and regulators are the main catalysts in facilitating the further growth and expansion of the country’s Islamic financial sector. The initial series of 10-Year Financial Sector Master Plan launched in 2001 maps out the objective towards this effort. In order for the government to realize its objectives, certain liberalizations were put in place. Among others, the increase in the cap on foreign investment in local Islamic financial institutions, investment banks, conventional insurance and takaful operators. Market liberalizations and tax incentives were also deployed by the government to help further attract more investors and players towards favoring the Islamic financial sector.

To date, Islamic finance in Malaysia has strategically diversified the country’s existing financial system not just by rivalling its conventional counterpart but also by creating more opportunities for employment, credit, liquidity, risk management services, and investment intermediation to allocate savings to its most productive uses. This diversification is intended to support a much more sustainable economic growth performance in Malaysia. Along with this intended sustainable economic growth, Islamic financial policies are crucial to determine a positive growth and performance of the Islamic financial industry. The Islamic financial industry in Malaysia owes its very existence and growth to the country’s robust and facilitative legal system and policies.

Since the inception of Islamic banking thought in Malaysia, policy has been at the center of developing Islamic finance in the country. This is evident from the journey the country has taken to establish, revise and enhance policy to further establish the relevance of the Islamic finance in its society (see Figure 1). In 1983, before the establishment of the first Islamic bank in the country, the Islamic Banking Act was drafted to facilitate the governing framework for an Islamic bank to operate in. Subsequent progression witnessed the introduction of the Takaful Act in 1984. This course of action was pivotal as it was then understood that the essence of Islamic finance should be built on sound fundamentals.

As the country’s financial system matured, in particular the Islamic finance sector, greater governance was required to contain the robust growth and ensure that by all means the authenticity of the Shari’a is maintained. As such, the Central Bank Act was introduced in 2009 and catered, in certain areas for Islamic banking. Furthermore, a key development and fundamental policy was launched by the Bank Negara Malaysia (central bank in 2009; the Shari’a Governance Framework. A pioneering effort by Bank Negara Malaysia that has now become a sought after model by emerging Islamic finance markets. Finally, the latest major development is the Islamic Financial Services Act (IFSA) of 2013 that repealed the Islamic Banking Act of 1983. In addition, Bank Negara Malaysia, has also embarked to further develop and enhance Shari’a standards on particular contracts used in Islamic banks which will be coupled with operational requirements, all under the purview of the Shari’a.

Islamic Policymakers

Policymakers have the authority to set the policy framework of a country to meet the objectives of the governing body. To this end, they are responsible for the policies that govern the operations of a particular order and as such shall also be accountable for deficiencies in policies administered incorrectly. Thus, Islamic policymakers have a greater responsibility as they are not only subject to be accountable to the public but also the Lawgiver; Allah. Generally, there are 3 main authoritative bodies that oversee Islamic matters in Malaysia – Shari’a Advisory Council (SAC) of Bank Negara Malaysia, Shari’a Advisory Council (SAC) of the Securities Commission of Malaysia and the National Fatwa Council. These are the main resolution issuing bodies that have their members appointed by the King (Yang Di Pertuan Agong) himself. This level of authority, instituted by the King, ensures that these bodies have ample power to ensure that their rulings are binding on the people of Malaysia and those who operate within its borders.

While, the SAC of Bank Negara Malaysia is responsible for overseeing Shari’a matters related to Islamic banking and takaful; the SAC of Securities Commission of Malaysia is responsible for the same in the capital market. Therefore, any and every Shari’a matter, with regards to Islamic banking and takaful or capital market, which are referred to the courts and arbitrators must be referred to the respective SAC for their judgment. Hence, they are the authority of policy making of Islamic banking and finance in Malaysia. The third body is the National Fatwa Council, which is in charge of overseeing all other Shari’a matters not related to Islamic banking, takaful and the capital market. All State Muftis and a few members with different expertise are appointed by the Council of Rulers (Majlis Raja-Raja). However, the Council’s views are not binding unless gazetted by the states. Nevertheless, their views are widely respected by the public.

Islamic Banking Act 1983 (IBA 1983)

Over a span of 20 years, the IBA has been developed with amendments (additions and deletions) before being repealed by IFSA 2013. A major milestone for the IBA was the establishment of Bank Islam Malaysia Berhad, the first Islamic bank in the country and brainchild of Malaysian policymakers to govern their Islamic bank. The IBA provides for the licensing of Islamic banks and the regulation of Islamic banking. It does not provide any instructions for how Islamic banking principles should be carried out; such directives are to be found in the religious texts, for example, in the Quran and in the Sunnah. It is important to note that the Malaysian IBA is under the jurisdiction of civil law, not Islamic law (Shari’a). As such, in the case there is a conflict flanked by the two systems of laws, common law will override Islamic law. Other areas, such as personal family law relating to succession, marriage, divorce etc., do however fall within the jurisdiction of Islamic law, but only when it involves persons professing the religion of Islam (The Malaysian Federal Constitution, The Ninth Schedule, List II – State List).

The enactment of the Islamic Banking Act 1983 provided for the apt administration of Islamic banking business. Furthermore, it conferred power to Bank Negara Malaysia to regulate and supervise Islamic banks. It also granted a universal banking license to Islamic banks that allowed them to participate in broader market activity. Most importantly, the Act provided flexibility to Islamic banks to undertake a broad range of Shari’a-compliant banking business which ultimately acknowledged the acceptance of Islamic banking into the banking sector in Malaysia. Among many of its pioneering features, the following illustrates how the IBA of

1. Islamic Banking Act (Malaysia) 1983, preamble.
2. New Straits Times (Malaysia), 17 Nov 1997, “Clear frame of law needed for Islamic banking”.

1983 paved the way for the establishment of the country’s flagship Islamic bank; Bank Islam Malaysia.

Section 3 (5) of the IBA displays the rigor in the Act:

• The Central Bank shall not recommend the grant of a license, and the Minister shall not grant a licence, unless the Central Bank or the Minister, as the case may be, is satisfied—

1. that the aims and operations of the banking business which it is desired to carry on will not involve any element which is not approved by the Religion of Islam; and

• that there is, in the articles of association of the bank concerned, provision for the establishment of a Shari’a advisory body, as may be approved by the Central Bank, to advise the bank on the operations of its banking business in order to ensure that they do not involve any element which is not approved by the Religion of Islam.

Section 13A displays the authority given to the SAC:

1. An Islamic bank may seek the advice of the Syariah Advisory Council on Syariah matters relating to its banking business and the Islamic bank shall comply with the advice of the Syariah Advisory Council.

• In this section, “Syariah Advisory Council” means the Syariah Advisory Council established under subsection 16B (1) of the Central Bank of Malaysia Act 1958.

Section 30A displays the action against persons who contravenes the provisions made therein:

1. No person shall carry on international Islamic banking business unless it is

1. an Islamic bank; or

• a company or a foreign institution and holds a valid license under section 30B to carry on such business.

• Any person who contravenes the provisions of this section commits an offence and shall, on conviction, be liable to a fine not exceeding twenty thousand ringgit or to imprisonment for a term not exceeding three years or to both such fine and imprisonment.

Section 53A displays the authority given to the Central Bank to issue resolutions and guidelines related to Shari’a matters:

The Central Bank or the Minister may, from time to time, issue such guidelines, circulars or notes as the Central Bank or the Minister may deem expedient or necessary for carrying into effect the objects of this Act.

Throughout its tenure, the Act was constantly amended given the evolution of the Islamic banking environment in the country, until it was finally repealed by the IFSA in 2013.

Takaful Act 1984

Malaysia has also displayed pioneering efforts in the development of its takaful industry. With the enactment of the Takaful Act 1984, the first takaful company was established in 1985. Ever since, Malaysia’s takaful industry has positioned itself for greater development and has

been increasingly recognised as a significant contributor to Malaysia’s overall Islamic financial system. The Act was specially promulgated and passed by the Malaysian Parliament with a view of ensuring that takaful as a sector within the Islamic financial system would grow in an orderly manner. The insurance industry in Malaysia is licensed and regulated by a separate act. The Takaful Act 1984 provided a framework for the regulation and registration of takaful business, international takaful business, and for any other matters that are connected with takaful carried out by the takaful operator, international takaful operator, takaful agent, takaful adjuster and takaful broker. It was argued that Takaful Act 1984 was not fully comprehensive as it relied on other established Acts and silent on several matters including the Shari’a and operational aspects of takaful. Nevertheless, it was the only piece of legislation exclusively governing takaful operations. However, it is important to understand that the primary focus of Takaful Act 1984 during this period was to establish the basic infrastructure to support the takaful industry.

The Takaful Act of 1984 clearly identified the difference between takaful and insurance business. It stipulated that “takaful” means a scheme based on brotherhood, solidarity and mutual assistance which provides for mutual financial aid and assistance to the participants in case of need whereby the participants mutually agree to contribute for that purpose. Furthermore, it stipulated that “takaful business” means business of takaful whose aims and operations do not involve any element which is not approved by the Shari’a. The Act covers, amongst others, provisions on the registration of takaful operators, conduct of takaful business by registered takaful operators, examination on the operations of takaful business as well as disclosure of the financial results of takaful business. For the purpose of effective administration of the Act, the Minister of Finance is authorized under section 68 of the Act to make subsidiary legislations to prescribe detail particulars pursuant to various requirements under the Act.

A key clause in section 16 deals specifically with the establishment and maintenance of takaful funds, and allocation of surplus. The establishment of this fund is very important in the takaful set-up as it diffuses takaful operations from its conventional insurance counterpart. As such, this has become the underpinning reference for the establishment of takaful operations in Malaysia. IFSA amalgamates several separate laws to govern the financial sector under a single legislative framework for the conventional and Islamic financial sectors respectively, which includes the Takaful Act of 1984.

Central Bank Act 2009 The Central Bank of Malaysia Act 2009 (CBA), which came into force on 25 November 2009, replaces the Central Bank of Malaysia Act 1958. It provides for the continued existence of Bank Negara Malaysia, greater clarity to the Bank’s mandates on promoting monetary and financial stability, and to exercise oversight over payment systems. The Central Bank Act of 2009 has made particular provision for the establishment of a Shari’a Advisory Council. The provisions have been a determining factor in the behavior of Islamic financial institutions to conform and adhere to the resolution provided by the SAC. In doing so, it vests Bank Negara Malaysia with the necessary powers and instruments to achieve its mandates effectively. It also gives due recognition to the Islamic financial system in Malaysia by providing the legal foundation for its development in the overall Malaysian financial system.

“The Central Bank Act of 2009 has made particular provision for the establishment of a Shari’a Advisory Council. The provisions have been determining factor in the behavior of Islamic financial institutions to conform and adhere to the resolution provided by the SAC.”

The followings are pivotal to the authority and impact of the order of Shari’a guidance and interventions in court related matters. Section 56 and 57 illustrates provision that Shari’a matters are interpreted correctly:

• (1) Where in any proceedings relating to Islamic financial business before any court or arbitrator any question arises concerning a Shari’a matter, the court or the arbitrator, as the case may be, shall—

1. take into consideration any published rulings of the Shari’a Advisory Council; or

• refer such question to the Shari’a Advisory Council for its ruling.

• Any ruling made by the SAC pursuant to a reference made under this Part shall be binding on the Islamic financial institutions under section 55 and the court or arbitrator making a reference under section 56.

However, this does not mean that the SAC will intervene in the court case. The SAC will only give the view on Shari’a matters and the court remains the authority which will apply their judgment based on the facts of the case presented to them.

Shari’a Governance Framework (SGF) 2011

Shari’a principles are the foundation for the practice of Islamic finance through the observance of the tenets, conditions and principles espoused by Shari’a. Comprehensive compliance with Shari’a principles would bring confidence to the general public and the financial markets on the credibility of Islamic finance operations. In response to the above, Bank Negara Malaysia issued the Shari’a Governance Framework (SGF) for Islamic Financial Institutions in January 2011 to be used by all Islamic financial institutions in Malaysia in order to establish a proper internal Shari’a governance structure. The SGF of 2011 has become a referred model world-wide. This framework outlines a robust governing system to ensure optimal Shari’a supervision at every level of operations (Figure 2).

Bank Negara Malaysia places great importance in ensuring that the overall Islamic financial system operates in accordance with Shari’a principles that is achieved through a two-tier Shari’a governance infrastructure comprising two (2) vital components, which are centralized SAC of Bank Negara Malaysia and an internal Shari’a committee formed in each respective Islamic financial institutions. The SAC is a body established under section 51 of the Central Bank of Malaysia Act 2009 that has positioned the SAC as the apex authority for the determination of Islamic law for the purposes of Islamic financial business. The mandates of the SAC, among others, are to ascertain the relevant Islamic law on any financial matter and issue a ruling upon reference made to it, as well as to advise Bank Negara Malaysia and the Islamic financial institutions concerned on any Shari’a issues relating to Islamic financial business operations, activities or transactions.

The framework is also structured such that the institution’s Shari’a Committee (SC) is at the core of the governance process and reports directly to the Board of Directors just as any other “Board” Committee would do, i.e. Board Risk Management Committee and Board Audit Committee. Their central function is to ensure oversight on Shari’a related matters in the institution and report the relevant concerns to the Board. The Board holds the final decision to ensure that the concerns of the SC are adequately addressed. At the industry level, the duties and responsibilities of the internal SC advising the respective Islamic financial institutions on Shari’a matters were further deliberated in the Guidelines on the Governance of Shari’a Committee for the Islamic Financial Institutions which was issued in 2004. The guidelines are now superseded in light of new developments in Islamic finance as well as higher expectation of the key stakeholders of the Islamic financial institutions pertaining to the Shari’a compliance process.

Ultimately, the issuance of Shari’a governance framework for Islamic financial institutions is to enhance the role of the board, the Shari’a committee and the management in relation to Shari’a matters, including the relevant key organs having the responsibility to execute Shari’a compliance and research functions aimed at the attainment of a Shari’a based operating environment. It should also be noted that one of the major changes in the IFSA is the codification of Shari’a compliance that places Malaysia on a stronger foothold. Among the direct impact of this codification are:

1. Providing a more strengthened foundation to establish regulations and Shari’a governance that are transparent, effective and that simultaneously contribute to an efficient financial system that ought to be resilient to future stresses.

• Providing regulators with greater oversight vis-a-vis broader way of Shari’a law enforcement.

• Lifting what were previously only guidelines on Shari’a compliance to statutory requirements making licensed financial entities legally accountable for any breach of those requirements.

• Establishing more Shari’a certainty and achieving greater Shari’a standardization from Bank Negara Malaysia on the power to specify standards on Shari’a matters. The Shari’a standards that have been and will be issued progressively by Bank Negara Malaysia are complementary to those issued by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) in both theoretical (i.e. Shari’a stand- ards) and practical (i.e. operational standards) dimensions of Islamic finance practices.

• Reflecting the recommendations of international Shari’a governance and prudential standards for the industry. The standards will therefore minimize heterogeneous interpretations of fundamental Shari’a rulings and resolutions and hence help to streamline the product offerings by Islamic financial institutions.

The SC also has the responsibility to ensure that, through management, ongoing business and operations are in accordance with Shari’a principles. Furthermore, necessary support should be provided to management to address any Shari’a related issues. There are four operational units that assist the SC in ensuring Shari’a governance in the institutions:

1. Shari’a Risk Management Control Function

This unit systematically identifies, measures, monitors and controls Shari’a non-compliance risks to mitigate any possible of non-compliance events. The systematic approach of managing Shari’a non-compliance risks will enable Islamic financial institutions to continue its operations and activities effectively without exposing them to unacceptable levels of risk. They also report to the Board’s Risk and Management Committee.

• Shari’a Research Function

This unit conducts required research on particular Shari’a related matters arising in the institution prior to submission to the SC. This comprises of qualified Shari’a officers to con- duct pre-product approval process, research, vetting of issues for submission, and undertake administrative and secretarial matters to support the SC. This function refers to the conduct of performing in-depth research and studies on Shari’a issues, including providing day-to-day Shari’a advice and consultancy to relevant parties, including those involved in the product development process.

• Shari’a Review Function

The Shari’a review function refers to the regular assessment on Shari’a compliance in the activities and operations of the Islamic financial institutions by qualified Shari’a officer(s), with the objective of ensuring that the activities and operations carried out by the IFI do not contravene with the Shari’a.

• Shari’a Audit Function

This unit will from time to time conduct periodical assessments with the aim to provide an independent assessment and objective assurance designed to add value and improve the degree of compliance in relation to the Islamic financial institution’s business operation. This is to ensure a sound and effective internal control system for Shari’a compliance is in place. Besides the SC, they also report to the Board’s Audit Committee.

In addition to all of this, the requirement under SGF is that the SC shall consists of at least 5 members and any one member of the Islamic financial institution shall not be a SC member of another institution within the same industry. This means that if a person is a member of the SC in Bank A, he is not allowed to sit as a member of the SC in Bank B. Nevertheless, Islamic financial institutions should adequately manage SC members so as to ensure proper succession planning. This is because once the SC member is called up to the SAC, he has to forego his current position with the Islamic financial institution. To this end, it is clear that the SGF sets out to ensure a comprehensive governance framework to ensure Shari’a compliance.

Islamic Financial Services Act 2013

Development of a sound and strong prudential legal framework has always been Bank Negara Malaysia’s mission and objective to cater to the ongoing progression of the Islamic financial industry. The introduction of IFSA 2013 by replacing the repealed Islamic Banking Act 1983 and Takaful Act 1984 was to promote the said this objective by providing an end-to- end Shari’a compliance and governance for the Islamic financial sector. It is also suggested that with the IFSA, Islamic financial institutions will become more focused in their operations and by offering a greater range of products to best meet the changing demands of a modern economy.

The IFSA came into force on 30 June 2013 and sets out the regulatory framework for Malaysia’s Islamic financial sector with the principal regulatory objectives of promoting financial stability and compliance with Shari’a. Similar to its conventional counterpart (i.e. Financial Services Act 2013 or FSA), IFSA equips Bank Negara Malaysia with adequate regulatory and supervisory powers. In promoting compliance with Shari’a, IFSA imposes a duty on Islamic financial institutions to ensure compliance with Shari’a at all times and also empowers Bank Negara Malaysia to issue standards on Shari’a requirements to facilitate institutions in complying with Shari’a. A dedicated part on Shari’a requirements and other specific provisions on Shar’ia compliance throughout the IFSA provide a comprehensive regulatory framework to ensure an end-to-end Shari’a compliance by Islamic financial institutions. The Act provides a legal platform for development of Islamic finance in Malaysia which is reflected upon a comprehensive regulatory framework on specificities of the various Islamic financial contracts and supports on the effective application of Shari’a financial contracts in the offering of Islamic financial products and services. IFSA and the FSA repealed a total of six Acts as illustrated in Figure 3. This marked a significant milestone in aligning the Shari’a requirements of Islamic financial services in regulatory principles. The contract-based regulatory framework as shown in Figure 4 also gives regulators greater oversight and powers to further scrutinize financial holding companies and non-regulated entities if they pose a risk to financial stability. It is also believed that investors’ protection are improved as there are provisions that requires banks to distinguish deposits made for savings from those made for investments.

Salient Features of IFSA 2013

1. Importance of Shari’a and its Position

IFSA 2013 had codified and enacted the Shari’a governance as a law for the first time in history with regard to Islamic finance. IFSA 2013 recognized the importance of Shari’a governance as it embraces Shari’a requirements in Part IV with the incorporation of Shari’a compliance in division 1, Shari’a governance in division 2 and audit on Shari’a compliance in division 3. The provision in Section 28 (1) stipulates:

 

BOX 6.1:

IMPACT OF FSA/IFSA

1. Financial holding company restructuring

If impacted companies do not want to become financial holding companies under the Act(s), they may pare down their stakes in respective financial institutions to below 50%.

• Corporate restructuring: insurers

Separation into two legal entities or divestment of one of the businesses

• Audit compliance

Impacted companies to allocate more resources to improve any weaknesses in internal controls

• Individual shareholding limit

Impacted individuals may need to pare down their stakes to 10% or below.

• Talent recruitment

Bank Negara Malaysia (approval for appointment of chairman, director and chief executive officer; a senior officer can only be appointed if the person fulfils the requirements stated in the Act(s) and as specified by Bank Negara Malaysia.

Impact to composite insurers, takaful operators

1. Requirement

Insurance and takaful companies holding composite licences shall not carry on both life insurance/family takaful business and general insurance/general takaful business.

• Who will be impacted?

Licensed insurer/takaful operator lawfully carrying on both life insurance/family takaful business and general insurance/general takaful business

• Who will be exempted?

Licensed professional reinsurer and retakaful operator

• Timeline

Five years from the date of implementation of the Act(s) or longer as specified by the Minister of Finance, on the recommendation of Bank Negara Malaysia

• Non-compliance penalty

Imprisonment of 8 years or less

A fine of RM25 million or less        

 Or both

 

“A compliance with any ruling of the Shari’a Advisory Council in respect of any particular aim and operation, business, affair or activity shall be deemed to be a compliance with Shari’a in respect of that aims and operations, business, affair or activity.”

“An institution shall at all times ensure that its aims and operations, businesses, affairs and activities are in compliance with Shari’a”.

Section 28(2) further explained the meaning of Shari’a compliance as:

“a compliance with any ruling of the Shari’a Advisory Council in respect of any particular aim and operation, business, affair or activity shall be deemed to be a compliance with Shari’a in respect of that aims and operations, business, affair or activity”.

ŀ Elevation of stature and role of Shari’a Committee

IFSA 2013 stipulates that the SC performs a statutory role in advising Islamic financial institution to ensure its business, affairs and activities comply with Shari’ia. As such, the Committee’s duties are defined in Standards which include but are not limited to the liability for breach of confidentiality duty when reporting to Bank Negara Malaysia and defamation in respect of statements made without malice in discharging duties are also protected under the Act. Moreover, any breach of these duties may result in enforcement from Bank Negara Malaysia which includes the imposition of a monetary penalty.

ŀ Codification and Specification of Specific Roles and Responsibilities of Key

Functionaries

IFSA 2013 specifies in particular the role of key functionaries in the Islamic financial institution. For example, the role of the Board of Directors is to ensure oversight on Shari’a compliance of the Islamic financial institution. They are also entrusted with legislated duty of care to depositors, investors and takaful participants under the Act. Furthermore, it is stipulated that priority is given to takaful participants when in conflict with shareholders’ interest, and last but not least, due regards should be given to the decisions of the SC.

The Chief Executive Officer’s responsibility is to ensure that the business operations meet Shari’a requirements as set out in the Islamic financial institution’s Shari’a governance frame-work. It is also stipulated that they report all and any Shari’a non-compliance activity with rectification plan proposals to the Board and the SC. The audit function’s responsibility is to ensure enhanced statutory reporting obligations which may include the scope for a Shari’a Audit. In addition, the actuarial function is to assist the Board and Senior Management on oversight for sound and prudent management of takaful operators; safeguarding the interest of the takaful participants. Finally, the SC’s role is established to ensure oversight and advisory on Shari’a matters and Shari’a compliance in the Islamic financial institution. Moreover, they are tasked to oversee the implementation of the Shari’a Review and Shari’a Audit, and most importantly, they are empowered to confirm actual and potential Shari’a non-compliance and endorse proposed rectification plans.

ŀ Legislated Duty on IFIs to Ensure End-to-End Shari’a Compliance

IFSA 2013 further ensures that the codification of duty on Islamic financial institutions meet Shari’a requirements in terms of its aims, operations, business, affairs and activities. This codification and order of governance is further established in the SGF which has become a point of reference in governing end-to-end Shari’a compliance in Islamic financial institutions. Therefore, these legislative duties stipulate that the Islamic financial institutions should at all times be in compliance with the rulings of the SAC and as such has a duty to report Shari’a non-compliance imposed. Furthermore, Bank Negara Malaysia is empowered to assess rectification plans to address non-compliance and should be backed by comprehensive tools to address these non-compliance issues.

ŀ Legal Segregation Instead on Notional Segregation of Islamic Banking Business and On Par with Regulatory Requirements with Fully-Fledged Islamic Banks

The regulation of Islamic windows comes under both FSA and IFSA:

1. Legal segregation of Islamic banking business. The Acts provide that specific ring-fencing of capital is in place for Islamic banking windows that operate within the conventional parent operations. This entails that the Islamic window should have separate accounts and that the Islamic funds are not subject to other debts except that of the Islamic banking business.

• Parity of regulatory treatment with full-fledged Islamic banks. The Acts provide that prudential requirements of Islamic banking windows are on par with that of full-fledged Islamic banks. It also ensures that Shari’a governance and compliance requirements are applicable to Islamic banking windows and they have a duty to ensure Shari’a compliance at all times.

• Maintaining segregation from going concern to winding up. The Acts also provide that priority of payments are accorded to Islamic deposits and that assets of Islamic banking business meet all liabilities of the Islamic window first before considering returns to shareholders. Furthermore, it is stipulated that overall ranking be maintained on each side of the business operations and most importantly, to maintain the Shari’a principles of segregation between Islamic banking business and conventional banking business.

ŀ  4.   Priority of Payments Reflective of Underlying Shari’a Contracts

This stipulation provides for the ring-fencing of investment account assets to meet its liabilities. This means that the investment account assets shall meets its liabilities accordingly. Assets of Investment Account shall be set-off against:

ŀ     Winding up costs and expenses and attributable tax in Companies Act

ŀ     Cost and expenses of investment-account

ŀ     Profits, gains or other remuneration due to the Islamic bank

ŀ     Liability to investment-account holder

Whereas, the abovementioned is ring-fenced from assets of the Islamic bank which are normally set-off against:

ŀ     Preferential debts in the Companies Act

ŀ     Government Debts

ŀ     Islamic deposit liabilities ŀ Other secured liabilities ŀ Unsecured liabilities

1. Treatment of “Deposit” and “Investment”

Under IFSA 2013, Islamic deposit and investment account is defined as follows: “Islamic deposit” means a sum of money accepted or paid in accordance with Shari’a—

1. on terms under which it will be repaid in full, with or without any gains, return or any other consideration in money or money’s worth, either on demand or at a time or in circumstances agreed by or on behalf of the person making the payment and person accepting it; or

• under an arrangement, on terms whereby the proceeds under the arrangement to be paid to the person paying the sum of money shall not be less than such sum of money,

“Investment account” means an account under which money is paid and accepted for the purposes of investment, including for the provision of finance, in accordance with Shari’a on terms that there is no express or implied obligation to repay the money in full and —

1. either only the profits, or both the profits or losses, thereon shall be shared between the person paying the money and the person accepting the money; or

• with or without any return.

Islamic banking considers safe-keeping (deposits) and investment quite differently and as such IFSA has accommodated for the proper implementation thereof. Nevertheless, some issues have arose since this “new” consideration of Islamic deposits and investment accounts. Depositors, both individual and institutional, do not have a full understanding about this “new” framework and as such this has not been well received by them. Institutional depositors are not ready to place their money for safe keeping purposes without any return. At the same time, they do not have the mandate to put their money in investment accounts that may give profit with the possible risk of capital depletion (for some types of contracts).

Current Account and Savings Account (CASA) could be based on an Islamic investment structure such as mudaraba, but such an account will not be treated as “investment” and not “deposit” and as such cannot have safekeeping features such as capital guarantee. On the other hand, where it is considered purely for safekeeping purposes, profits should not be expected as the underlying would then be qard (loan). These new changes may cause a transfer of funds from Islamic to conventional as the bank’s clients are not yet familiar with this adjustment.

Nevertheless, the approach may be new but is indeed a big step in the right direction for both Malaysia as a pioneer in Islamic financial policy and for the entire industry. The challenge lies in educating the masses about the true spirit of Islamic banking and how, as per Shari’a, these measures should be implemented. This will adjust the mismatch between assets and liabilities in Islamic banks.

Shari’a Standards and Operational Requirement

Compliance with Shari’a requirement is a prerequisite in ensuring legitimacy of Islamic financial products and services. Failure to observe the essential conditions of a specific Shari’a contract may render the financial transactions entered between an Islamic financial institution and a customer to be invalid and thus, may lead to an adverse impact on the institutional safety and soundness. In this regard, Bank Negara Malaysia has embarked on the development of a Shari’a contract-based regulatory policy to enhance end-to-end compliance with Shari’a and therefore, ensure the integrity and sustainability of the Islamic financial institution.

The Shari’a contract-based regulatory policy consists of two components; namely, Shari’a requirements and operational requirements. The first component highlights the salient features and essential conditions of a specific Shari’a contract. Clear stipulation of Shari’a rulings pertaining to a particular contract is intended to facilitate sound understanding and cohesive adoption among the Islamic financial institutions. The second component outlines operational requirements encompassing core principles underpinning sound banking practices, expectations for good governance, robust documentations, fair market practices and effective risk management. These regulatory expectations aim to complement and support effective application of the Shari’a contract.

The Standards are constructed to address mandatory enforcements as well as guidelines that allow flexibility and room for innovation. These stipulation are labelled as “S” and “G” in the Standards where;

ŀ “S” denotes a standard, requirement or specification that must be complied with. Failure to comply may result in one or more enforcement actions; and

ŀ “G” denotes guidance which may consist of such information, advice or recommendation intended to promote common understanding and sound industry practices which are encouraged to be adopted.10

In total, Bank Negara Malaysia envisages the release of eleven (11) Standards; namely, murabaha, tawarruq, musharaka, mudaraba, wadiah, wakalah, wa’d, ijara, isistna’, kafalah and hibah. To date, they have already released four (4) Standards; namely, murabaha, tawarruq, musharaka and mudaraba. These Standards shall become a fundamental point of reference to all Islamic financial institutions in Malaysia in the conduct of the activities when applying their said contracts in their operations.

1. Bank Negara Malaysia .ibid
2. BNM, Murabahah Standard
3. ibid

Law Harmonisation Committee

Although the success of Islamic financial industry is due to the robust and sound legal infrastructure, there is also a need to address and provide solutions for legal and structural anomalies and impediments. Naturally, there would be dichotomies between the Shari’a and the civil law of Malaysia. As part of Malaysia’s continuous efforts to further strengthen the legal system and infrastructure to cater for the growing development of the Islamic finance, the Law Harmonization Committee (LHC) has been established. The objectives for the establishment of LHC are:

1. To position Malaysia as the reference law for international Islamic finance transactions;

1. To achieve certainty and enforceability in the Malaysian law in regard to Islamic finance contracts; and

1. For Malaysian law to be the law of choice and Malaysian dispute resolution institutions as the forum for settlement of disputes for cross-border Islamic financial transactions as part of creating a conducive legal system for the Islamic finance industry.

The LHC aims to ensure due recognition on the Shari’a requirements in Islamic finance transactions is accorded in relevant laws affecting the same. It is envisaged that the relevant laws are accommodative and compatible with Shari’a requirements. In order to achieve this, the LHC will consult the SAC of Bank Negara Malaysia and SAC of Securities Commission Malaysia to seek their views on the Shari’a aspect of the recommendations. The LHC’s functions are:

1. To review existing laws with the objective of harmonizing the laws to be Shari’a compatible, insofar as it is applicable to Islamic finance; and

1. To review new laws that is being made in so far as they affect Islamic finance, to be Shari’a compatible.

To date, the LHC has identified the following issues in Malaysia that have been recommended for requiring amendments:

1. Legal recognition to Shari’a permissibility of imposing late payment charge on judgment debts in Islamic financial cases;

1. Improving access to financing (especially Islamic financing) involving reserved lands;

1. Recognition of Islamic finance transactions under the National Land Code 1965 – legal recognition of Shari’a principles to facilitate provision of Islamic finance under the National Land Code 1965.

Master Plan for the Financial Sector

Malaysia’s first Financial Sector Master Plan (2001-2010) published by Bank Negara Malaysia foundation for the development of the financial industry, with a focus on developing and strengthening the domestic financial infrastructure. Market liberalization and tax incentives were used as tool to attract foreign banks to the domestic Islamic banking sector; including increasing the cap on foreign investment in local Islamic banks, investment banks and takaful operates from 49% to 70% in 2009. The First Master Plan was followed by a second master plan, the Financial Sector Blueprint (2011-2020). The blueprint contains recommendations on the transformation of the Malaysian financial services industry with a focus on the internationalization of the financial services industry, including Islamic finance. These two financial sector master plans that cover a period from 2001-2020 are pivotal to the progressive development of the financial sector in Malaysia.

Conclusion

Islamic Finance in Malaysia will continue to expand reinforced by the global expansion where creation, preservation and distribution of wealth are effectively undertaken by market participants in a manner that promotes the universal values of Shari’a. With the support of a dynamic Islamic finance ecosystem that promotes greater mobilization of the increasing volume of global Islamic financial flows, it is desired that there is an increased diversity in terms of players as well as financial products and services; enhanced liquidity, market efficiency as well as depth of vibrancy of Islamic financial markets supported by robust platforms; and strengthened business framework and enhanced financial linkages between different jurisdictions. With all these in placed, Malaysia will be well positioned to achieve its aspiration of becoming a regional and international center for Islamic funds and wealth management.

The government as a catalyst has placed relevant and strong legal framework and policies far more advanced than any countries and this has contributed immensely to the growth of the Islamic financial industry in Malaysia. With the aim of achieving financial stability, the government has initiated various efforts to mark Malaysia as the international Islamic financial hub. The Islamic financial industry in Malaysia is still growing and the growth is not without any challenges. Moving from a Shari’a-compliant to a Shari’a-based industry; Malaysia will be exemplary for other countries with the backing of the government vis-a-vis strong legal framework and policies.

After several decades of evolution in policy and regulation, Malaysia is currently moving into a new paradigm of Islamic finance, in terms of policy. In the past, many constraints hindered progress, especially in respect of legal, taxation, risk, IT systems and others. In addition, competitive products were needed particularly in our dual banking system. Moving forward and through rigorous research and development, improvements and developments in human capital gave rise to the introduction of Shari’a advisers, Islamic finance practitioners, educators, authorities and clients that have ample knowledge and exposure in Islamic finance that contributed positively to further growth and development. Looking to the future, we expect that products are almost free from “makharij” and bring impact to real economic activity to all levels of society. The objective should be that Islamic finance serves as the preferred alternative to conventional finance. Ultimately, policy will serve as a compass that lead efforts in this direction.

Islamic Financial Policy in Pakistan

Pakistan is unique in its efforts to implement Islamic banking in the country. It has made two attempts with the first in the early 80’s when the then leadership gave a time bound executive order to ‘Islamise’ the banking system and eliminate interest entirely. This experiment met with little success but was instrumental in setting some groundwork on legal, regulatory and supervisory fronts. At the start of this millennium, Islamic banking was re-launched in parallel to the existing conventional banking. The second attempt has so far proven successful evidenced through the significant growth rate recorded. At present Islamic banking constitutes almost 11.5% share of total banking assets and 13.5% of total deposits. Although Islamic capital market has shown relatively slower growth, the pace has picked up in recent years and is expected to develop significantly in the near future.

The central bank of the country, State Bank of Pakistan (SBP) has been instrumental in developing Islamic banking in the country by playing the dual role of regulator and facilitator. As a regulator, SBP has laid sound foundations of regulatory and supervisory frameworks while as the facilitator it has worked aggressively in improving capacity building of the industry as well as enhancing awareness of all stakeholders including the general public. The role of SBP has been recognized internationally recently when it was voted as the “Best Central Bank for Promoting Islamic Finance” for year 2015, by Islamic Finance News of RED money Group Malaysia . Following the footsteps of SBP, the regulator of capital markets, Securities Exchange Commission of Pakistan (SECP) has over recent years become more proactive towards development of Islamic capital market. Not only a dedicated Islamic Finance Department was established at SECP, the regulator has also set up its own Shari’a board.

The present government seems more inclined and determined towards developing Islamic finance in the country. To this end, the most significant initiative is the formation of the high level Steering Committee for Promotion of Islamic Banking in Pakistan in December 2013, which is chaired by the Deputy Governor of SBP. The Steering Committee comprises of renowned Shari’a scholars, senior government officials, industry experts (local and international) and business leaders with the aim of developing proposals and recommendations for transforming the financial system in conformity with Shari’a principles. Major achievements of the Steering Committee up till now include the establishment of a dedicated department at SECP, establishment of Centers of Excellence in Islamic Finance Education, launch of All Share Islamic index and sukuk regulations. Moreover, the Steering Committee has been effective in creating the desired collaboration and cooperation among all stakeholders, thus boosting the growth of Islamic finance in the country. Supportive regulators, strong government commitment and enhance collaboration among all stakeholders has created a conducive ecosystem for Islamic finance to thrive and grow. Ernst & Young in its recent report highlighted that Pakistan is among the nine core regions that would lead the growth of Islamic finance globally.

History of Islamic banking and finance

Pakistan was one of the first countries to introduce Islamic banking at a national level with efforts to Islamize the economy started in the mid-60s as a response to both religious and

1. World Islamic banking Competitiveness Report 2016

economic needs. Interest free banking was implemented at the national level during the 1980’s which involved pioneering work on legal and regulatory fronts including amendments to the Banking Companies Ordinance (BCO-1962) to accommodate non-interest based transactions, enactment of Modaraba companies and Modarabas framework and issuance of BCD Circular No. 13 of 1984 by SBP that called for the elimination of riba from the banking system. However, these efforts did not produce the desired results mainly due to following reasons:

ŀ     Non flexibility of the system to cater to changing needs of a growing industry

ŀ     Absence of appropriate mechanism to ensure Shari’a-compliance

ŀ     Lack of ownership amongst the banks’ management and staff as well as the business community to abruptly shift to the new system

ŀ     Lack of awareness among masses about the utility of Islamic banking

ŀ     Lack of coordination among stakeholders

ŀ     Absence of adequate infrastructure and human resource

ŀ     Weak judicial system and dispute resolution mechanism

Consequently, practices of Islamic banking in the country was challenged in the Federal Shari’at Court (FSC) and the procedure adopted by banks was declared un-Islamic by the FSC in November 1991. This decision was challenged by the government and financial institutions who took their appeals to the Shari’at Appellate Bench (SAB) of Supreme Court of Pakistan. The SAB delivered its judgment on December 23, 1999 and reaffirmed the decision of FSC. In its judgment, SAB also recommended to abolish the prevailing system by June 30, 2001, which was later extended to June 30, 2002. The verdict was afterwards put in abeyance against an appeal.

In order to comply with the substance of the judgment, it was resolved to introduce Islamic banking in Pakistan in its true spirit. An independent commission of experts from banking, ulama, Shari’a scholars, academics and researchers from Islamic Development Bank was formed to advise the government and SBP on the most feasible option to bring about the transformation from conventional to Islamic banking. In light of the report prepared by the Commission, it was decided to launch Islamic banking in parallel to conventional banking while laying down a level playing field for both industries.

Hence, Islamic banking was re-launched in 2001 as a parallel system wherein both Islamic and conventional banks were allowed to operate alongside one another, rather than full Islamisation of the economy. This time there has been a shift in the approach from the legal and regulatory perspective to that of dealing with the whole affair of introducing Islamic banking in Pakistan as a change management issue. This approach has witnessed a very encouraging response as evidence in the growth of the Islamic banking industry in the country (Figure 1). A present, Islamic banking constitutes about 11.5% of total banking industry assets and market share of deposits stands at 13.5%. Total branch network of the industry comprises of 2,075 branches across the country. There are 22 Islamic banking institutions (IBIs) operating in Pakistan of which 5 are full-fledged Islamic banks, 16 are conventional banks having standalone Islamic banking branches and one Islamic banking subsidiary. On the basis of current growth rate it is expected that the industry will be able to achieve the target 15% share by 2018 as stipulated in the second strategic plan of Islamic banking Industry (2014-18).

Role of State Bank of Pakistan

The State Bank of Pakistan (SBP) has been playing a pivotal role not only in strengthening the regulatory and Shari’a-compliance framework for Islamic banking industry, but also in promoting Islamic banking among the masses including academia, business community, financial industry and the general public. Some of the more notable initiatives taken by SBP for the promotion of Islamic banking industry in the country are discussed in the following below.

1. Licensing

The SBP adopted a three pronged strategy to develop the Islamic banking market and to enhance the breadth of the industry. Based on this strategy, banks were allowed to offer Islamic financial services under the following three structures: (i) full-fledged Islamic banks,

(ii) Islamic banking subsidiaries of conventional banks and (iii) standalone Islamic banking branches (IBBs) of conventional banks. However, up until 2014, there has been no operational subsidiary in the country. In order to encourage the establishment of Islamic banking subsidiaries, the initial minimum capital requirement for subsidiary was rationalized by revising it downwards from Rs. 10 billion to Rs. 6 billion. Subsequently, one Islamic banking subsidiary has started its operations with a few more expected to follow suit. Conventional banks having IBBs are also allowed to have Islamic banking windows in their conventional branches under specific regulations for Islamic banking windows. In addition, SBP has been instrumental in the promotion of financial inclusion and development of the Islamic finance as alternative and compatible system in the country. SBP allows four types of institutional arrangements for offering Islamic microfinance:

ŀ     Full Fledged Islamic Microfinance Banks (IMFBs)

ŀ     Islamic Microfinance Services by Full-fledged Islamic Banks

ŀ     Islamic Microfinance Services by Conventional Banks

ŀ     Islamic Microfinance Services by Conventional Microfinance Banks (MFBs)

At present one microfinance bank, NRSP Microfinance has started its Shari’a-compliant operations through a pilot project after receiving the license from SBP. Many industry observers foresee that this move will encourage more microfinance banks and institutions to enter the Islamic financial market either by converting their business into an Islamic one or operate Islamic microfinance through separate window operations.

• Shari’a-Compliance Framework

Based on the lessons learnt from the history of Islamic banking efforts in Pakistan in the 80s, Shari’a-compliance has now been given much importance than previously. A comprehensive and mutltiered Shari’a-compliance framework has been put in place to ensure a deeper

1. BPRD Circular No. 10 of 2014 dated 17th October, 2014.

and extensive Shari’a-compliance supervision on an on-going basis. The Shari’a Compliance Mechanism consists of three main components:

Centralised Shari’a Board at SBP

This is the apex Shari’a body in the country for IBIs and has distinctive composition of members including Islamic scholars, bankers, accountants, lawyers and experts of other relevant fields. The composition of the Shari’a board has been formulated in a way that it can guide on almost all aspects of Islamic finance regulation and benefits the industry by providing comprehensive solutions that are not only Shari’a-complaint but also economically viable

Instructions and Guidelines for Shari’a-Compliance

These detailed instructions for IBIs was introduced in 2008 to provide guidance in areas like Shari’a-compliance, internal Shari’a audit, investment in shares, policy for profit distribution with Profit & Loss Sharing (PLS) account holders, financial reporting and general dis- closure etc. The essential of Islamic modes of financing issued in 2005 were augmented and made part of these instructions. Keeping in view the developments taken place in the Islamic banking industry over the years, some of the instructions and guidelines have been revisited and a comprehensive Shari’a Governance Framework has been issued in 20147. The primary objective of the framework is to further strengthen the overall Shari’a-compliance environment of IBIs and explicitly define the roles and responsibilities of various organs of IBIs including the Board of Directors, Executive Management, Shari’a Board, Shari’a-Compliance Department as well as internal and external auditors towards Shari’a-compliance.

The framework is applicable to all IBIs and makes it mandatory at the institutional level for each IBI to have a resident Shari’a board member who oversee the procedures to be adopted for implementation of the resolutions, pronouncements and fatwas of the Shari’a Board and provide guidance thereon. It is important to note that Shar’ia board decisions are binding on the management of Islamic banks but in the case of disputes they are to be referred to the Shari’a Board at SBP for resolution. At present all 22 IBIs in the country have established their Shari’a Boards having at least three Shari’a scholar members meeting the Fit and Proper criteria prescribed by SBP.

Periodic Shari’a Inspections by the Central Bank along with Routine Annual Inspection of IBIs.

The SBP is one of the very few central banks that have initiated Shari’a inspections with the view of ensuring Shari’a compliance to enhance credibility of the system. Before the formal launch of the Shari’a inspection, a comprehensive Shari’a inspection manual was developed and adequate training was imparted to SBP staff. The Shari’a Compliance Inspection covers a review of the Islamic financial arrangements, general banking services and operations, financial statements and accounting records of the Islamic banks so as to ensure that all their transactions and operations are being carried out in accordance with the injunctions of Shari’a in both their substance and their form.

• Instructions for Profit & Loss Distribution and Pool Management for Islamic

Banking Institutions

Considering the peculiar relationship between income of an IBI and depositor’s return, guidelines were issued in 2008 as a part of “Instructions & Guidelines for Shari’a Compliance in IBIs”. As the industry grew and evolved, the need was felt for improved transparency and bringing standardization in the practices and policies of IBIs with regards to profit and loss distribution and pool management. In this background, detailed instructions for Profit & Loss Distribution and Pool Management in IBIs were issued in 20129 and the earlier issued brief guidelines of 2008 were withdrawn. These instructions require IBIs to have in place a well-defined pool management framework for the creation and management of pools with each pool having distinct objectives and risk reward features, and to be managed as a virtual enterprise having clearly identifiable assets, liabilities, income and expenses. These instructions are expected to bring transparency and standardization across industry while safeguarding depositors’ interests.

1. Sukuk Issuance & Commencement of Open Market Operations for IBIs

SBP performs the role of an agent for the government in terms of issuance, management and repayment of Government of Pakistan (GoP) sovereign sukuk. It is important to note that the government is not only issuing domestic sovereign sukuk for raising funds since September 2008 but has also issued two international sukuk, in 2005 and 2014. In recent past, SBP decided to conduct outrigid purchase or sale of Government of Pakistan Ijara Sukuk (GIS)either on deferred payment basis (bai muajjal) or on ready payment basis through Open Market Operations (OMO) through a competitive auction process. This initiative is aimed at providing multiple liquidity management solutions for the industry by mopping up excess liquidity from the market and improving implementation of monetary policy stance of SBP. The Shari’a-complaint OMOs have not only facilitated Islamic banking industry in liquidity management but has also provided the central bank an effective transmission of monetary policy for IBIs.

1. Adoption of International Shari’a & Prudential Standards

SBP remains a key member of international standard setting bodies such as Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and Islamic Financial Services Board (IFSB). In order to increase standardization and to elevate the local industry to international standards, various standards issued by these international standard setting bodies have been adopted after customizing the same in accordance with the local market. To date SBP has adopted six AAOIFI’s Shari’a standards including “Default in Payment by a Debtor”, “Murabaha to the Purchase Orderer”, “Ijarah & Ijarah Muntahia Bittamleek”, “Mudaraba”, “Investment Sukuk”, and “Sharika (Musharaka) & Modern Corporation”. Further, three prudential standards issued by IFSB – pertaining to “Risk Management” “Corporate Governance” and “Shari’a Governance”.

• Issuance of Five Year Strategic Plan for Islamic Banking Industry of Pakistan

In an effort to step up existing growth momentum and lead the industry to the next level of development, SBP in consultation with all key stakeholders has developed the second five year Strategic Plan (2014-18) for Islamic banking industry in Pakistan. This Strategic Plan builds upon the major strengths of the industry, identifies key issues and weaknesses in the policy environment and gives strategies and action plans to address identified challenges. It also focuses on improving public perception of Islamic banking as a distinct and viable system capable of catering to the financial services needs of the public and business community in a Shari’a-compliant manner. It envisages intensifying the awareness creation efforts; strengthening consultation mechanism with stakeholders, removing confusion and making legal, regulatory and taxation environment more conducive, and deepening and broadening of product offerings by IBIs. The Plan envisions the industry to gain 15% share of the country’s overall banking system by 2018.

1. Reporting Framework

Due to the peculiar nature of Islamic finance, separate accounting and reporting standards are being prescribed for different modes of finance so that the true risk profile of the industry can be reflected through enhanced transparency and disclosure. It is an ongoing activity that is being carried out through combined efforts of all stakeholders including the Institute of Chartered Accountant of Pakistan (ICAP), Securities Exchange Commission of Pakistan (SECP), SBP and IBIs.So far SECP on the recommendation of ICAP has issued three Islamic Finance Accounting Standards (IFAS-I, II & III) on murabaha, ijara and PLS Deposits, respectively. In this regard, IBIs are already following IFAS I & II while IFAS-III is under review by SBP.

• Research Initiatives

Acknowledging the dire need for research for Islamic banking industry in the country, SBP launched a survey based on the study, Attitude and Practices of Islamic Banking in Pakistan or KAP to estimate demand for Islamic banking in the country. The main objectives of the study were (a) to quantify the demand for Islamic banking and identifying the type of demand (b) to determine the incidence of financial exclusion based on religious beliefs and (c) to identify critical areas requiring financing. The study is the first of its kind and was based on primary data collected through a survey of 10,000 respondents comprising households (demand) and practitioners (supply) across the country. The survey findings are highly encouraging and positive for Islamic banking in the country as according to the study there is an overwhelming demand for Islamic banking in Pakistan by both retail and corporate sectors. Given the supply-demand gaps, there is huge potential for further development of Islamic banking in Pakistan. As a large segment of demand for Islamic banking is yet to be met, and a significant proportion of demand lies amongst those who are still financially excluded, greenfield growth in Islamic banking has a huge scope.

• Capacity Building

One of the lessons learnt from the experience of the 80’s is the realization of having adequate infrastructure in place for a financial system to work efficiently. In a nutshell, availability of skilled human resource is central to the effective implementation of any financial policy. Realizing this challenge, SBP is actively engaged in enhancing the capacity of the industry through various promotion and training programs. The National Institute of Banking and Finance (NIBAF), a training subsidiary of SBP and a premier institution of the country, has been delivering quality training programs designed to cater to the needs of Islamic banking industry. NIBAF, over the years, has been offering various courses and programs including a three-week Islamic Banking Certification Course (IBCC) and a one-week Fundamental of Islamic Banking Operations (FIBO). IBCC is a comprehensive program offered at both campuses of NIBAF; Islamabad and Karachi. On the other hand, FIBO is offered at various cities across the country. FIBO is aimed for branch managers, operation managers and relationship managers of Islamic banking institutions (IBIs). Customized training programs on Islamic banking and finance to cater to specific/individual bank’s requirements are also being offered by NIBAF. Similarly SBP and NIBAF not only offer support and assistance to domestic initiatives but have also collaborated with reputed international organizations like Islamic Research and Training Institute (IRTI)-training arm of Islamic Development Bank (IBD) to conduct international Islamic banking training programs.

• SECP is regulator for capital market.
• KAP Study.

However, the pace of growth of the industry is greater than the supply of trained and well qualified Islamic finance professionals. A number of local institutions are also offering various education training programs; however, most of these facilities lack quality assurance and an accreditation framework. In this background, the idea of a dedicated institution was conceived that can not only lead, steer and synergize all efforts for bridging capacity gaps but can also work as research incubators. Subsequently, SBP in collaboration with DFID (UK) and support from the government has helped to establish three Centers of Excellence in Islamic Finance Education (CEIFE) in renowned institutions like Institute of Business Administration, Karachi (IBA), Lahore University of Management Sciences, Lahore (LUMS) and Institute of Management Sciences (IMS), Peshawar. These centers are established across three different regions to promote quality research and to address the capacity constraints in the Islamic banking industry. It is expected that these centers will enhance the number of certifications, degree programs and training programs related to Islamic banking and in the long run a stable stream of trained and qualified human capital will be available for the industry.

• Awareness Creation

Lack of awareness has been identified as one of the key impediments for growth of Islamic banking industry in the country. The public at large has little knowledge about the true state of affairs of the industry and there exist various misconceptions about the concept and practices of Islamic banking. According to SBP’s KAP study “Lack of general awareness about Islamic banking should be a major concern for stakeholders of the Islamic banking industry. The vast majority of respondents do not understand Islamic banking model, the nature of deposits, nature of contracts and Shari’a-compliance mechanism. Knowledge about Islamic contracts and terminology was almost non-existent”. The study therefore endorsed the dire need for initiating mass awareness campaign to increase public trust and confidence in Islamic banking. SBP is also playing its role in this regard by actively getting involved in conducting many targeted seminars, conferences, and workshops across the country along with extending support and collaboration to many local and international organizations for such programs. Despite that some IBIs are advertising their products and services through print and electronic media, the overall media coverage of the sector has been almost negligible. However, the need for appropriate media management (both electronic and print) was felt for improving the growth of the industry and ensuring its development on sound footings. The stakeholders over the years have raised this issue at many discussion forums and national and international seminars. Therefore, the industry joined hands under the patronage of SBP and a joint comprehensive media campaign has been initiated in 2013 to enhance awareness.

“According to SBP’s KAP study: “Lack of general awareness about Islamic banking should be a major concern for stakeholders of the Islamic banking industry. The vast majority of respondents do not understand Islamic banking model, the nature of deposits, nature of contracts and Shari’a- compliance mechanism. Knowledge about Islamic contracts and terminology was almost non-existent”.

The first phase of the campaign launched in 2013 focused on “creating awareness and improving visibility” of Islamic banking in the country. The second phase launched in 2014 had a focus on education, awareness and improving understanding of masses about Islamic banking and finance and its distinction from conventional banking. Major components of the campaign are advertisements in newspapers, television, radio, documentaries on Islamic finance, series of television and radio programs, publication of brochures, booklets, pamphlets and special supplements in newspapers, briefings and orientation sessions for media representatives covering Islamic finance and informative essays/articles in various newspapers. This campaign is an on-going activity and is expected to be instrumental in promoting Islamic banking as a viable and competitive banking system.

Role of Securities Exchange Commission of Pakistan

About 27 modaraba companies, 15 mutual funds and 5 takaful companies constitute Islamic capital market of the country, which is being regulated by the Securities Exchange Commission of Pakistan (SECP). The pace of growth of Islamic capital market has been relatively slow in the country compared to Islamic banking, consistent with a pattern of slow growth in other countries. However, in recent years SECP has become more proactive in developing Islamic capital market in the country. Under the guidance of GoP’s Steering Committee for Promotion of Islamic Banking in Pakistan, a dedicated Islamic Finance Department (IFD) was established at SECP. IFD is responsible for creating a Shari’a regulatory environment and ensuring companies undertake their business and activities in accordance to Shari’a principles. In this regard, IFD has been mandated to issue, amend and enforce a Shari’a-compliant regulatory regime for the capital market including the non-banking finance companies (“NBFCs”) sector, takaful, modarabas as well as other non-financial companies. Key developments of SECP over recent years include;

1. Review of Modaraba Guidelines to align with the overall regulatory framework of Islamic finance in the country

• Issuance of Sukuk Guidelines 2015

• Launch of All share Islamic index

Issuance of Takaful Rules 2012

Permission for insurance companies to establish takaful window operations Moreover, in order to ensure harmony in the overall financial system of the country both regulators i.e. SBP and SECP are coordinating with each other to create a conducive environment for robust and vibrant institutional arrangements to develop dynamic regulatory standards for overall Islamic finance industry in the country.

Roadblocks in Islamic Banking and Finance

Despite the fact that progress of Islamic banking industry has been impressive, there remains a number of challenges that need to be addressed in order to realize its true potential. Some major challenges are discussed here.

1. Insufficient Supply of Sukuk

Sukuk has remained a lucrative instrument for investors as well as an effective tool for fund raising. The issuance of sovereign ijara sukuk since 2008 has provided some relief to the Islamic banking industry by providing them an investment avenue and helped the government transform its existing debt into Shari’a-compliant financing. However, due to limited supply and increasing demand from Islamic treasuries, sukuk are rarely traded in the secondary market. Issues such as identification of assets, their valuation, documentation and legal issues are identified as barriers to the development of the sukuk market and had resulted in an illiquid secondary market. Consequently, Islamic banks prefer to hold sukuk till maturity due to high level of uncertainty surrounding their availability. As far as corporate Sukuk are concerned, these have started to pick up in recent years as evidence by successful issuance of sukuk by K-Electric and Engro Corp in 2015. However, without bringing in desired changes in legal, regulatory and taxation framework; sukuk market will remain very much undercapitalized.

1. Liquidity Management Issues

The lack of investment avenues, especially short-term, has been one of the major problems facing IBIs in Pakistan. The industry has still not been able to introduce any short-term liquidity management instrument; till now all domestic sovereign sukuk are of three years maturity. Consequently, Islamic interbank money market remains underdeveloped. Assets need to be identified for issuance of GoP sukuk of varying size and nature. This will not only help the industry in liquidity management and development of Islamic interbank money market but will also provide instruments for Shari’a-compliant monetary and fiscal policy. Furthermore, like many other jurisdictions, lender of last resort (LOLR) facility is not yet available in Pakistan, thus forcing IBIs to maintain larger cash balances. This adversely affects the return for depositors as well as the profitability of IBIs. Any other safety net like deposit insurance for Islamic banking is also absent. The need to develop these facilities is becoming critical with the expansion of Islamic banking industry in the country.

• Low Penetration in Strategic Sectors

Islamic banking industry is mainly inclined towards lending to government and corporate sector. Important sectors like agriculture and Small and Medium Enterprises (SMEs) are largely ignored by conventional industry. There are expectations from the Islamic banking industry given its risk sharing model to have had extended financing to SMEs on the basis of their feasibility rather than mere collateral. However, the numbers reflect reluctance on the part of IBIs mainly due to low economies of scale, dearth of skilled and trained human resource, high probability of moral hazard and adverse selection. The SBP’s KAP study also identified the relatively small size of Islamic banking industry and short history of the existing paradigm to be the keys reasons for limited financing to this sector. While these reasons are logical and acceptable, the industry needs to move away from the traditional ways of doing business and be innovative in their approach. This will have twofold benefits. Islamic banks on one hand will be able to expand their potential client base rather easily compared to traditional markets while these strategic sectors would have access to the much desired financing. In order to increase financing to these sectors, SBP recently had given targets to the banking industry including Islamic banks to cater to these strategic sectors. Moreover, not only legal amendments are required but other critical missing links include an adequate risk management framework, appropriate skills and dedicated teams to stimulate growth in these strategic sectors by capitalizing on its intrinsic strengths.

• Insignificant Contribution towards Poverty Alleviation

Islamic banking in Pakistan remains concentrated in urban and semi urban areas. Mandi towns and large rural areas are not served although these places have a large untapped client base waiting for Islamic financial products to become accessible and available to them. As highlighted in the KAP study, greenfield growth is needed for the long term development of the Islamic banking industry in the country due to widespread financial inclusion. Nonetheless, Islamic microfinance is still a very niche segment of the industry. Presently, there is only one microfinance bank offering Shari’a-compliant financial services. Islamic financial industry needs to leverage on Information and Communications Technology (ICTs) in designing innovative products towards achieving financial inclusion goals and broadening the industry’s client based. For example, the use of IT tools and alliances with Post Offices, and other distribution outlets to develop cost effective business model will result in significant contribution towards poverty alleviation.

• Lack of Harmonisation & Standardisation

Harmonization and standardization is critical to ensure sustainability of growth of the industry. The process of harmonization of Shari’a standards requires close collaboration between Shari’a scholars and market leaders and regulators. This collaboration must include a clear separation of responsibilities and attempts by each party to comprehensively convince the other of its needs in order to maintain proper emphasis for the achievement of the widely agreed goals. SBP arranges Shari’a advisors’ forums on regular basis to create synergy and harmony among Shari’a interpretations, however, there’s a need for more forums like this to remove confusions and misinterpretations.

• Taxation issues

Tax reforms play a pivotal role for any industry to grow with leaps and bounds. On the international front, governments like Malaysia and the UK are offering relaxed rules and taxation for tapping the great demand for Shari’a-compliant investments. Pakistan too can become a regional hub for Islamic finance if tax regulatory reforms are introduced. A revamp of the existing tax and duties structure is very much needed for a more conducive ecosystem for Islamic finance. Reforms should include the incorporation into the legislation amends to eliminate double tax on goods and recognize the bank as the facilitator of the transaction as opposed to a participant in the transaction.

• Lack of Research & Development

The sustenance of growth of Islamic banking industry critically hinges upon capitalizing on its competitive edge by moving away from traditional approaches and models. However, this demand a culture of research and development, which signifies the dire need for improving capacity of the industry and all related stakeholders. Hence, it is necessary to introduce educational reforms at different levels with emphasis on Islamic economics and Islamic finance. Both contemporary educational institutions and Madrasa should be encouraged to introduce Islamic banking and finance in their curricula. Higher Education Commission also needs to play an effective role in the promotion of Islamic finance education in higher learning institutions.

Conclusion

Despite issues facing Islamic banking industry it has gained attention by offering itself as a realistic alternative to the interest-based capitalist system. Going forward adopting a balanced and gradual approach with focus on setting sound foundations, Islamic banking and finance will be able to address the issues that may hinder its growth and development. Given the commitment and concerted efforts of all stakeholders in Pakistan, Islamic banking and finance is likely to grow on a sustainable basis to achieve the mainstream status.

Islamic Financial Policy in Indonesia

Despite home to the world’s largest Muslim population of more than 210 million and four decades of robust economic growth, Indonesia plays a minor role in the global Islamic banking industry. As of 2015, Islamic banking accounted for 5% of the country’s total banking assets. Through various initiatives implemented and some in the pipeline, the present government hopes to increase the market share to 15% by 2023. However, Indonesia’s road to obtaining a significant share of the global Islamic finance markets may be a long one, given that the country lags behind other Muslim countries especially its neighboring Malaysia.

Indonesia have made significant progress in the development of its Islamic finance industry in recent years due to increasing support from various quarters and the renewed interest from the government. Several new initiatives were introduced to make Indonesia a global hub for Islamic banking and finance. In Indonesia, the development of Islamic banking is based on two considerations. Firstly, there is a large niche market in Indonesia, which refuses to be serviced and catered by conventional banks, because of Islamic principles. Secondly, the Indonesian government wanted to develop Islamic banking is an alternative system as part of the country’s banking-restructuring programs.

Policy Development and Strategic Blueprints

Formal Islamic banking in Indonesia started with the enactment of the Banking Act No. 7/1992 and the establishment of the first Islamic bank in the country, Bank Muamalat Indonesia, in 1992. Based on this Act, the dual banking system was introduced where Islamic and conventional banks would operate in parallel to serve the economy. In the period between 1992 and 1998, there were one Islamic bank and 78 rural Islamic banks. However, Islamic banking faced some fundamental challenges that hindered its growth including the absence of Shari’a-compliant market instruments, liquidity management and open market operations. To overcome these problems and to encourage network expansion, the Banking Act was amended and revised with a new Banking Act No. 10/1998 that provided a stronger legal foundation for the development of Islamic banking as the term “Bank Syariah” was explicitly mentioned in the Act. A notable change in this Act was to allow conventional banks to operate Islamic banking unit, thus reinforcing the foundation for growth through network development.

In the following year, the Central Bank Act No. 23/1999 was amended making it possible for Bank Indonesia, as the central bank, to conduct monetary operations based on Shari’a including providing regulation, supervision and facilities for the operations of Islamic banks. Based on these acts, Bank Indonesia has made it a mandate to develop Islamic banking in the country. Following the revised Central Bank Act, the Islamic interbank money market or PUAS was introduced in 2000, which is a Shari’a-compliant short-term financial transaction among banks conducting business based on either the Rupiah or foreign currency. The instrument of the Islamic interbank money market is based on the Interbank Mudaraba Investment Agreement (IMA) Certificate. Bank Indonesia also launched the Wadiah Certificate (SWBI) in order to utilize liquidity management and as a means of investment. Between 1998 and 2001,

1. According to Indonesian banking law, Indonesian banking institutions are typically classified into commercial and rural banks. Commercial banks differ with rural banks in the sense that the latter do not involve directly in payment system and have restricted operational area.

Islamic banking grew about 74% per annum (in terms of asset size) from Rp479 billion in 1998 to Rp2.718 billion in 2001. As of 2001, there were two main Islamic banks, three conventional banks with Islamic banking units and 81 rural Islamic banks. In 2002, Bank Indonesia issued Act No. 4/1/PBI/2002, which marked the growing support by the central bank towards the growth of Islamic banking. The Act provided the legal basis for the:

ŀ     conversion of conventional bank into Islamic bank,

ŀ     conversion from a branch of conventional bank into a branch of Islamic bank,

ŀ     conversion from a cash office of a conventional bank into a branch of Islamic bank, ŀ         establishment of an Islamic sub-branch within a branch of a conventional bank, and ŀ      establishment of Islamic banking unit within a branch of a conventional bank.

However, the lack of progress made in Islamic banking was due to several factors. Most notably due to the lack a comprehensive and appropriate framework for regulation and supervision of Islamic banking, limited market coverage, lack of knowledge and understanding on the part of the public, lack of efficient institutional structures to support an efficient Shari’a-compliant operations and limited capability to comply with international Shari’a financial standards. Recognizing all these impediment to growth facing the Islamic banking industry, Bank Indonesia also published the Blueprint of Islamic Banking Development in Indonesia in 2002, which is a long-term plan based upon four phases of implementation (Figure 1). This plan was an important efforts to accelerate the growth of Islamic banking, enlarge its share in the national banking system, and drive the industry toward greater equity-based financing. The first phase involved laying the foundation for growth so that Islamic banks can provide an alternative for the Indonesian people through standardizing prudent policies, institutional reg- ulation and developing effective public education. The second phase is strengthening the industry so that it can play a bigger role in the economy by increasing Islamic banking operational efficiency and competitiveness. The third phase is the adoption of international standards by improving performance, increasing competitiveness, and shifting trade-related financing toward profit and loss sharing schemes. Finally, the fourth phase sets to have a well-integrated Islamic banking within the Islamic financial market in the country in order to facilitate a sustainable high growth regime.

The Blueprint identified major challenges of development in Islamic finance and provided vision, mission, and goal for development of Islamic banks, so that Islamic bank stakeholders had clear guidance to synchronize their long term strategies and programs to expand the industry. The blueprint sets out the development of Islamic banking industry from 2002-2015 and was later revised in 2005. The blueprint applies six initiative programs to be implemented within 10 years, which are:

ŀ     Increasing Shari’a-compliance;

ŀ     Increasing the quality of prudential banking operations ŀ           

  Increasing the operational efficiency and competitiveness

ŀ     Increasing the stability of banking system

ŀ     Increasing the expertise and quality of human resources; and

ŀ     Optimizing the social roles of Islamic banks in developing the small and medium enterprises

In between 2002 and 2004, emphasis was on creating a strong base for sustainable development of the Islamic banking industry. This included promoting a better understanding of Shari’a financial concepts, standardization of international Shari’a financial norms, improving the foundation for prudential regulation and good corporate governance, supporting economies of scope and scale, developing human resources and ensuring systemic stability. Since 2004, Bank Indonesia introduced several strategic programs to further consolidate the national banking system under the Indonesia Banking Architecture (API), which was to be fully implemented by 2010 where all banks must have capital at least Rp100 billion. The banking architecture aims to create a strong, healthy and efficient banking structure aimed at increasing the capacity of banks including in facing risks and expanding business scale through six pillars. Under the API, the “single presence policy” or SPP was introduced by Bank Indonesia in 2006, banning investors from being majority shareholders in more than one bank (including Islamic bank). The SPP prohibits investors from holding more than 25% of the shares in more than one bank at any one time, which meant that investors who did would be forced to either divest their holdings, merge their various banking assets and or set up a holding unit. Effectively, the new policy by the central bank is a reversal of the government’s policy allowing foreign investors to control up to 99% of a bank either through direct acquisition or through share market.

Between 2001 and 2009, there were seven mergers of medium-size banks whilst the number of small banks were also reduced. These consolidations increased the scale of economies of the merging banks. Empirical results have shown that bank consolidation policies driven by Bank Indonesia during the API period had reduced market concentration as the mergers were dominated by small and medium-sized banks. These policies had the desired impact of improved market share distribution, increased capacity of the merging banks and enhanced competition in the Indonesia banking industry. All these had subsequently helped increased the share of Islamic banking in the country from a mere 0.15% in 2000 to 1.38% by 2005 (see Table 1). By the end of 2005, there were 3 Islamic commercial banks and 19 Islamic banking units. Assets grew more than tenfold to Rp20.88 trillion, an average of 70% per year since 2000. Meanwhile, funds collected and financing channeled by Islamic banks registered at Rp15.58 trillion and Rp15.23 trillion, respectively. A significant development was the increase in the number of branch and sub-branch offices offering Islamic financial services, which expanded from 40 in 1999 to reach 504 by the end of 2005.

Bank Type	1992	1999	2000	2001	2002	2003	2004	2005
Islamic Bank	1	2	2	2	2	2	3	3
Islamic Banking Unit	–	1	3	3	6	8	15	19
Branch Offices	1	40	62	96	127	299	401	504
Islamic Rural Banking	9	78	78	81	83	84	86	92
Total Assets	NA	NA	1,790,168	2,718,770	4,045,235	7,858,918	15,325,997	20,879,874
Share of Total Banking	NA	NA	0.17%	0.25%	0.36%	0.74%	1.20%	1.42%
Financing	NA	NA	1,271,162	2,049,793	3,276,650	5,530,167	11,489,933	15,231,942
Share of Total Banking	NA	NA	0.40%	0.57%	0.80%	0.16%	1.93%	2.19%
Deposit	NA	NA	1,028,923	1,806,366	2,917,726	5,724,909	11,862,117	15,582,329
Share of Total Banking	NA	NA	0.15%	0.23%	0.35%	0.64%	1.23%	1.38%

In 2006, Bank Indonesia introduced the “office channeling” policy to improve public access to Islamic banking services. The policy aimed at improving the Islamic banking services network nationwide via conventional banks infrastructure in an attempt to reduce cost of setting up Islamic branches. The issuance of the “office channeling policy” spurred the development of the industry further as conventional banks were allowed to offer basic Islamic banking services using their existing infrastructure via Shari’a service counters in selected branches. This policy had successfully achieved its desired aim of reaching to wider customers who want Shari’a-compliant financing. At the end of 2011, Islamic banking customers had surpassed 10 million clients. As part of its concrete efforts and firm commitment to develop the industry, Bank Indonesia launched the ‘Grand Strategy of Islamic Banking Development’ in 2008. In line with its precursor (10-year Blueprint), this strategic document maps out the market development strategy of making Indonesia’s Islamic banks the most attractive in ASEAN. The Grand Strategy calls for the following visions: (i) Phase 1 in 2008 is on building understanding in Islamic banking as beyond banking by reaching an asset target of Rp50 trillion rupiah and industry growth of 40%, (ii) Phase 2 in 2009 is on positioning Islamic banking in Indonesia as the most attractive in ASEAN, and (iii) Phase 3 in 2010 is on attaining Indonesian Islamic banks as leading Islamic banks in ASEAN.

The participation of conventional banks in Islamic banking surged with the passing of the Islamic Banking Act No.21/2008 and Law No.11/2009 on the Regulation on the Conversion of a Conventional Bank to a Shari’a Bank. The Islamic Banking Act 2008 provided a more comprehensive regulatory framework for further development of the industry and covers both Islamic banks and Islamic business units. Several regulations which are related to institutional building such as Islamic Commercial Bank, Islamic Business Unit, Islamic Rural Bank, Conversion from Conventional Bank to Islamic Bank, Fit and Proper Test have been issued. Under the provisions of the Act also, a Shari’a Banking Committee was set up in Bank Indonesia in order to ensure the implementation Islamic banking regulations and better understand rulings or fatwa issued by the National Shari’a Board of the Indonesian Ulama Council (DSN).

The Law No.11/2009 was enacted with the aim of developing a sound Islamic banking network as part of the national banking system. As such, the main effect of the regulation was to allow the conversion of conventional banks to Islamic banks and community credit banks to Islamic community banks. The regulation also sets out 2023 as the deadline for the spin-off of all Islamic windows or business units. A further impetus to stimulate the development of the Islamic banking industry in Indonesia was provided with the amended Tax Law No. 42/2009, which rules on tax neutrality on Shari’a-based financial transactions in particular for murabaha transactions. Equally important, was the passing of the Sovereign Sukuk Act No. 19 of 2008, which provided the necessary legal foundation to sovereign sukuk in the country. In July 2012, Bank Indonesia issued a new regulation on the limit of shareholding in Indonesian banks. The Regulation No. 14/8/PBI/2012 on Share Ownership in Banks was issued to tighten the bank ownership rules. The aim of the regulation is to encourage consolidation so as to strengthen the Indonesia’s banking industry, reduce the dominance of single shareholders, and make Indonesian banks more competitive in anticipation of the 2020 ASEAN financial sector integration. This new bank ownership rules apply to both foreign and domestic banks (including Islamic banks), but not to state-owned banks and regional development banks. Under the new ruling, banks and non-bank financial institutions can hold up to 40% of a bank’s equity while non-financial institutions can hold up to 30%. Meanwhile, ownership limit for individual investors in conventional banks is 20% and 25% in Islamic banks, respectively. However, majority shareholders of Islamic banks that are created by the spin-off of Islamic business units will not be subject to the ownership limits until December 2028. Prior to the ruling, a foreign investor could own up to 99% of the issued and paid-up capital of an Indonesian commercial bank. Between 2008 and 2012, Islamic bank assets tripled, increasing by an average of 31.5% per annum. By the end of 2012, the number of Islamic banking outlets increased to 517, comprising 11 Islamic commercial banks, 24 Islamic banking units and 158 Shari’a-compliant rural banks. Islamic bank’s network has spread with the number offices rising at a rate of 27% year-on-year. The industry also registered a remarkable double digit growth of 49% in 2012 and an average growth rate of 40.2% in the last five years, outpacing conventional banking’s annual growth of 16.6% over the same period.

“For the banking sector, OJK’s vision on Islamic banking development is: “To establish Islamic banking that provides significant contribution to sustainable economic growth, equitable development and financial system stability and highly competitive”.

In 2013, a new financial services authority, the Otoritas Jasa Keuangan (OJK), took over responsibility for regulating capital markets and non-bank financial institutions in Indonesia. Starting January 2014, OJK took over the regulation and supervision of all financial institutions including Islamic banks from Bank Indonesia and cooperatives from Ministry of Cooperatives. A year later, all microfinance institutions through the implementation of the MFI Act No. 1 of 2013 came under the purview of this authority. As part of its five-year roadmap to develop Islamic finance in the country, OJK supports the consolidation of state-owned and Islamic commercial banks. Indonesia’s Islamic banking industry is highly fragmented, with 12 Islamic commercial banks, 163 Islamic rural banks and 22 Islamic windows. So consolidation would likely bring significant economies of scale, therefore making the industry more competitive. The roadmap aims to triple the market share of Islamic banks to 15% by 2023 through the implementation of various strategies, such as the reduction of fees on Shari’a-compliant banking products and the development of educational and training programs. It also involves intensifying coordination between the central government and private sector as well as strengthening monitoring in the Islamic banking industry and enhancing legal certainty.

For the banking sector, OJK’s vision on Islamic banking development is: “To establish Islamic banking that provides significant contribution to sustainable economic growth, equitable development and financial system stability and highly competitive”. This vision has translated into 7 policy directions and 41 priority programs. The policy directions are as follows:

1. Strengthen synergies between the authorities and government and other stakeholders in context of policy development;
2. Strengthen capital and business scale as well as enhance efficiency;
3. Improve funding structure to support expansion in financing segment;
4. Improve service quality and product diversity
5. Improvement of the quantity and quality of HR & IT as well as other infrastructure
6. Enhancement of public literacy and preference
7. Strengthen and harmonize regulations and supervision

To ensure a comprehensive development of Islamic finance in the country, OJK has developed specific roadmap and visions for Islamic banking, Islamic capital market and Islamic non-bank financial institutions with all the visions of each roadmap having the same common principle, i.e. significant contribution to national economy.  As for the Islamic capital market, OJK’s vision is: ”to give significant contribution to the national economy with equality, and to protect the public’s interests.” To achieve this, OJK has outlined 5 policy directions in the development of the Islamic capital market:

1. Strengthen regulations for the products, institutions, and supporting professions related to Islamic capital markets.
2. Improve supply and demand of the products.
3. Develop human resources and information technology.
4. Promotion and education of Islamic capital markets.
5. Coordination with the government and related regulators in order to create synergies of policies to develop Islamic capital market.

For Islamic non-bank financial institutions, the roadmap is “to become the robust provider of Islamic insurance, Islamic multi-finance, Islamic underwriting, Islamic pension funds, Islamic venture capital and other Islamic financial services, that serve the entire community and to contribute significantly to the national economy.” To realize this vision, OJK has developed 3 policy directions as follows: 

1. Increasing the role of Islamic non-bank financial institutions to support the economy and financial inclusion.
2. Establishing resilient, manageable and stable Islamic non-bank financial institutions.
3. Increasing the support for human resource, infrastructure and information technology.

These roadmaps and other relevant regulations related to Islamic finance are harmonized and synchronized within the Masterplan for Indonesian Islamic Finance Architecture 20142024, a comprehensive and realistic plan that outlined goals, strategies, measures and targets to boost the role of Islamic finance in the economic development and nation-building of Indonesia. The Masterplan is aimed to support the growth of Islamic finance in Indonesia by strengthening Islamic financial institutions and its products to be more inclusive, productive and profitable. Therefore, the significant contribution of the sector should be reflected in terms of increased market share of Islamic finance. The Masterplan also highlights some critical success factors including government policies and the consolidation and enforcement of regulation as well as identified some of major obstacles in growth. Main recommendations of the Master plan are:

1. Instatement of National Committee for Shari’a Finance (KNKS) through a Presidential decree
2. Formulating government policy that support Islamic finance by making it mandatory for all government entities and state-owned enterprises (Badan Usaha Milik Negara, BUMN) to place some of their funds in Islamic financial institutions and to offer their employees the choice of selecting Islamic bank accounts as well as having the choice to opt for Islamic pensions and takaful cover.
3. Enhancing the regulatory framework by consolidating the existing framework and making amendments or issuing new regulations to cover the gaps and provide more powers to the regulators. 
4. Offering tax incentives related to the Islamic instruments designed for funding national economic development projects

In November 2014, the OJK issued new rules regarding the development of Islamic finance in the country to encourage coordination in Islamic finance among government bodies and the private sector in order to help Islamic banks navigate a range of local and federal regulations. The new requirements include:

Indonesian Islamic banks (not Islamic business units of conventional banks) are to hold increasing levels of capital calculated according to a risk assessment process (those banks with the highest risk profile need to comply with a capital adequacy requirement of 14%; the previous highest requirement was 8%). The risk assessment process must be carried out every six months and more often if necessary.

The types of capital-boosting debt that Islamic banks can issue, which must include a loss absorption feature that allows regulators to convert such debt into equity if a lender faces insolvency.

Islamic banks are required to include ratios in contracts for common types of Islamic compliant profit-sharing financing (including mudaraba and musharaka), calculated on a feasibility analysis of a customer’s business and cash flows.

Issues such as the separation of Islamic units from conventional parents and guidance for conventional firms that want to become Shari’a-compliant ones.

In June 2015, the Indonesian President Joko Widodo threw his support behind efforts to boost Islamic banking in Indonesia by launching the “I Love Shari’a Finance” campaign. This campaign is initiated by the OJK as part of the authority’s efforts to improve the understanding and usage of Islamic financial products and services in the community. During the launch, the President called for Indonesia to be the global centre for Islamic finance. The government also offered a number of tax facilities and relaxations for Islamic banking industry as part of its 5th economic policy package to stimulus growth of Islamic banking. Likewise, the government would simplify the licensing and reporting mechanisms for Islamic banking products, in particular the activities related to pawnshops.

There will also be simplification of regulations in the opening of an office for Islamic banking network, including the use of the parent network. By end of 2015, OJK had released 6 new regulations related to the Islamic capital market including new regulation on Islamic capital market expert (Ahli Syariah Pasar Modal, ASPM) and special relaxation for Islamic mutual fund regarding the restriction of Islamic portfolio from 10% to 20% in one Islamic securities. Islamic mutual funds are also allowed to place the investment of at least 51% to maximum 100% in foreign Islamic securities. Previously (and still effective for conventional mutual funds), mutual funds can only park their funds under management up to 15% in foreign securities while special protected funds, the portion could reach 30%. This relaxation is expected to boost the growth of Islamic mutual fund in Indonesia.

In addition to those policies and programs by the government, the DSN approved 5 fatwas in 2015, as follows:

1. No 96/DSN-MUI/IV/2015: Islamic Hedging (al-Tahawwuth al-Islami)

Fatwa on Islamic hedging can be used as a guide for companies and Islamic financial institutions intending to protect their position from the deterioration of the exchange rate risk using a number of contracts that are in accordance with the provisions of Shari’a. This new fatwa is certainly part of the solution to mitigate the risk of increased uncertainty since 2015.

• No 97/DSN-MUI/XII/2015: Shari’a Negotiable Certificate of Deposits (Islamic

NCD)

Fatwa for Islamic NCD7 was in response to the needs of product development of Islamic banks in Indonesia. It is expected that Islamic banks can issue such instruments to support their growth.

• No. 98/DSN-MUI/XII/2015: Implementation Guidance for National Health Social-Insurance Based on Shari’a Principles

Fatwa No. 98 was issued in the wake of public concern on the practice of the national social-insurance program (Badan Penyelenggara Jaminan Sosial Kesehatan, BPJS Kesehatan) as they had expected the program to be implemented in accordance with Shari’a principles.

1. Negotiable certificates of deposit (NCD) are large-denomination negotiable liabilities issued at a discount by banks to businesses and government with fixed maturity.

• No. 99/DSN-MUI/XII/2015: Shari’a Annuity for Pension Program

Fatwa on Shari’a Annuity for Pension Program will facilitate Takaful or Islamic insurance operators to provide similar product akin to conventional with certain adjustment according to Shari’a principles.

• Voucher No: 100/DSN-MUI/XII/2015: Transaction Guidance for Shari’a Multi-

benefit.

Fatwa for Shari’a multi-benefit voucher was to provide guidance for new product proposal that is expected to roll out in 2016.

By 2015, the 12 Islamic commercial banks and 22 windows operating in the country had accumulated 5.3% of commercial bank deposits, 4.9% of their total assets, and 5.4% of their financing or loans. In short, Islamic banking still holds a small market share but still seen as a promising sector despite the economic slowdown. In early 2016, the government established a new national committee to develop Islamic banking and finance industry. The committee is called National Committee for Shari’a Finance (Komite Nasional Keuangan Syariah, KNKS) and to be chaired by President himself. The committee will comprise a number of relevant ministers while DSN will act as its advisory board. A Presidential regulation/decree is expected to be issued to legalize the committee.

The decision to establish KNKS is in line with the ongoing structural reforms in Indonesia whereby the Master plan for Indonesian Islamic Financial Architecture recommended the committee’s instatement. Among the committee’s task is to harmonize laws and to facilitate synergy among participants. Therefore, KNKS could help to improve coordination between related institutions overseeing the Islamic financial industry. The committee is also expected to increase the market share of Islamic finance which on average (for banking, capital market, insurance, and others) has remained below 5%. Other responsibilities of KNKS include to increase the role of Islamic finance in accelerating economic development and to continuously raise public awareness and literacy on Islamic finance.

Indonesia Economic Outlook 2016

The Indonesian economy is expected to improve in 2016 compared to 2015. The World Bank predicted that Indonesia’s economic growth in 2016 will hover around 5% to 5.3%. The global economy has yet to show signs of recovery and this has significant implications to the economic growth of Indonesia. The economic stagnant of Indonesia’s trading partners including China, is one of the leading factors contributing to the economic slowdown. For example, the downturn in China’s real sector had resulted in a drop in the commodity prices on the international market. In addition, fluctuations in the financial market as a consequence of uncertainty surrounding The Fed’s policy package had a downward pressure on Indonesia’s currency Rupiah. This situation is compounded by the indirect effect of the official acknowledgement of Greek as a bankrupt country.

Despite experiencing economic slowdown, Indonesia recorded better performance visà-vis the global and developing countries. Based on the World Economic Outlook published by IMF, the global economy in 2015 was predicted to grow only by 3.3%, whereas in 2016 the world economic growth is expected to strengthen by 3.8%. Meanwhile, the economy of developing countries is predicted to slow down from 4.6% in 2014 to 4.2% in 2015, and expected to increase to 4.7% in 2016. This prediction depends on the economic improvement in several crisis affected countries, including Russia and countries in Middle East and North Africa.

The magnitude of the positive development in Indonesia’s economy in 2016 will at least be determined by the following factors. The first is the level of household consumption. For several years, the aggregate consumption particularly contributed by household sector has always been the backbone of the national economy. The role of consumption is more crucial especially amid the low contribution of exports and investment. Last year the contribution of consumption to GDP reached 55%. The next factor is the effect of policy packages issued by Jokowi’s government. Up until the first quarter of 2016, the government had issued 10 policy packages that contain a number of economic deregulation to stimulate the national economy in response to the global economic pressures. A special incentive for the Islamic finance industry was included in the economic policy package. In addition to ensuring the stability of economy, the economic policy packages are expected to stimulate the growth of industries that give additional value to the economy and provide incentives for the businesses.

Apart from these economic policy packages, the government’s support can be seen through fiscal spending especially in infrastructure funding. Through The Masterplan for Acceleration and Expansion of Indonesia Economic Development (Masterplan Percepatan dan Perluasan Pembangunan Ekonomi Indonesia, MP3EI), the government has been supporting the acceleration of infrastructure development but progress has not been sufficient nor balanced geographically. In 2016, infrastructure budget was increased by 8% to about Rp313.5 trillion, which is the largest amount compared to previous years. This is expected to stimulate business climate in the country and result in a trickle down effect on Islamic finance industry.  If plans for KNKS materialize, market shares will undoubtedly resume their steady growth past the present high tide. As Bank Indonesia and OJK authorities have argued, the growth is essentially a matter of political will.

Islamic Financial Policy in Bahrain

Bahrain is a small 765 sq km island Kingdom in the Arabian Gulf, off the eastern coast of Saudi Arabia. Its total population numbers just over 1.3 million and its GDP in 2014 stood at US$33.9 billion. Given its central location and inclusive culture, Bahrain has for centuries served as a central hub for trade and investment in the Gulf region and beyond. Partly as a result, it has developed a highly open economy and inclusive culture, which in turn account for a number of pioneering achievements in the regional context. Bahrain’s dynamic economy has delivered real growth every year for several decades. The average annual rate of real GDP growth reached 4.7% between 2000 and 2014. This positive momentum is supported by significant and resilient structural growth drivers including:

Demographic dynamics: population growth remains rapid, partly because of natural fertility rates, partly because of an influx of expatriates who currently make up roughly one-half of the population Regional connectivity: Bahrain’s location at the heart of the Gulf region allows it to serve as a gateway to the broader region. It has strong connective infrastructure ranging from the causeway linking it to Saudi Arabia’s Eastern Province to a national carrier, Gulf Air, which offers an extensive route network across the Middle East. Economic diversification: Bahrain has actively promoted the growth of its non-oil economy. While oil and gas extraction still made up 44% of the Kingdom’s real GDP as recently as 2000, the non-oil economy had risen to make up 80% of the total by 2014. Having been the first Gulf country to begin to extract (1932) and refine (1937) oil, Bahrain has also led the region in economic diversification with sustained investments in sectors such as manufacturing and financial services starting close to half a century ago. The ALBA (Aluminum Bahrain) smelter began operations in the late 1960s and Bahrain successfully transformed itself into an offshore financial center in the early 1970s. Bahrain today has very diverse economic structure with hydrocarbons, financial services, and manufacturing each accounting for 15-20% of GDP in recent years. At the same time, several smaller sectors have been experiencing robust expansion, with average annual growth rates in recent year of nearly or even more than 10%. The most important ones include social and personal services (dominated by private education and health care), transportation and communications, and construction. Following its pioneering initiatives in telecommunications sector liberalization, for instance, Bahrain has made significant headway in developing its ICT sector and infrastructure. Bahrain is one of the top 30 economies as ranked by the World Economic Forum’s (WEF) Global Information Technology Report of Bahrain ranks fourth in the world in terms of government usage, providing insight into government ICT policies for competitiveness and wellbeing, the efforts they expend to implement their visions for ICT development in the country, and the number of government services they provide online. Some 90% of the population use the Internet and 93% of households being equipped with a computer (7th globally), indicating the high rates of ICT penetration in the Kingdom.      

The dynamism of the Bahraini labor market reflects the robust growth momentum of the broader economy. Bahrain has an active national labor force which is primarily engaged in the private sector. The number of Bahrainis employed in the private sector and the civil service reached 158,182 at the end of Q3 of 2015, representing an annual growth rate of 1.9%. Additionally, at the end of Q1 2015, total foreign employment in the Kingdom had increased to 559,036 from 521,656 a year earlier. Close to two-thirds of Bahraini nationals work in the private sector, the most important sectors being retail, manufacturing, financial services, real estate, and transportation & communications. Bahrain today is an economy with a unique value proposition in the broader region context. In a part of the world that is still above all recognized internationally for is hydrocarbons wealth, Bahrain competes on its human capital, connectivity, and regulation:

• Bahrain has an economically active and educated national, as well as expatriate, workforce. Some sectors, such as financial services, have very high rates of national employment (66%). This pool of bilingual talent enables companies to service the broader region through Bahrain.

Bahrain can capitalize on its central location at the heart of the Gulf region and the crossroads of Asia, Europe, and Africa thanks to high-quality, modern connective infrastructure. This connectivity also has a regulatory dimension. Bahrain has highly developed commercial links with a number of world economies through various bilateral and multilateral agreements.

Bahrain has been repeatedly recognized as the freest economy in the Middle East with a mature regulatory environment within a unified jurisdiction. For instance, 100% foreign ownership is allowed in most sectors, and is available across the economy, i.e. not limited to free zones. At the same time, Bahrain has mature regulations and regulatory institutions such as the Central Bank of Bahrain, which serves as a unified regulator for the financial services sector. As a testament to the high quality of regulations, Bahrain is (since 2006) one of only 20 countries globally to have a free trade agreement (FTA) with the United States, something that recognizes that local regulatory standards are consistent with US law.

The Financial System

The financial services sector remains the most important non-oil economic sector in Bahrain. Having served as a regional offshore hub since the early 1970s, Bahrain is the most established financial centers in the Gulf with over 400 licensed financial institutions. All these companies operate as part of the national jurisdiction and 100% foreign ownership is permitted as a rule. The financial services sector in Bahrain currently accounts for around 17% of real GDP and employs over 14,000 people, of whom two thirds are Bahrainis. National recruitment and human capital development is supported by the Bahrain Institute of Banking and Finance which is recognized region-wide and has partnerships with leading international higher education institutions, like the London School of Economics. The financial services sector remains a dynamic part of the economy and accounted for some 27% of all additional GDP created in Bahrain during the decade 2003-2013. The financial services sector in Bahrain is highly diversified:

Bahrain is home 22 conventional and six Islamic retail banks. The combined assets of these categories have in recent months exceeded BHD30 billion.

There are 56 conventional and 19 Islamic wholesale banks. The total assets of wholesale banks exceed US$100 billion.

Bahrain has 25 locally incorporated insurance firms and 11 overseas insurers. There are 31 insurance brokers, five insurance managers, four insurance consultants. 19 insurance companies, four insurance brokers, and two insurance consultants operate with licenses restricted to business outside of Bahrain. The Kingdom has 27 registered actuaries, 11 registered loss adjusters, and two insurance pools and syndicates. The insurance sector grew by an annual average of 12% in real terms from 2004 to 2014. The sector contributed BHD615 million to the economy in nominal terms in 2014 and accounted for around 31% of the financial services sector. Bahrain is a regional pioneer of Shari’a-compliant takaful as well as a leading center of reinsurance, both conventional and Islamic.

• The Central Bank of Bahrain (CBB) offers three types of licenses for investment business companies. These are currently divided into 20 Category 1 companies, 13 category 2 Companies, and 18 Category 3 license-holders.

• In addition, the CBB offers a range of specialised licenses as well as exchange licenses.

•  Bahrain currently has two microfinance institutions, Ebdaa Bank and Family Bank, the latter being a Shari’a-compliant institution.

Bahrain has well established capital market regulations and institutions. The Bahrain Bourse was originally established as the Bahrain Stock Exchange in 1987. It currently lists 43 equities, 9 fixed income instruments (both conventional and Islamic) and 21 mutual funds. As of June 2015, the market capitalization stood at US$21.3 billion. There are 17 brokers active in the market and day to day activity takes place through automated trading system. Bahrain operates an automated clearing, settlement, and Central Depository System. Under its strategy, the Bourse is engaged in ongoing innovation and in May 2015 announced its first real estate investment trust (REIT) listing. Bahrain Bourse is also in the process of launching Bahrain Investment Market, a new initiative targeted at companies looking for growth finance. Under this scheme small and medium sized enterprises can list on the stock exchange without having to go through the standard IPO process.

Prospects and Current Development of Islamic Finance in Bahrain

Bahrain is one of the pioneers of Islamic finance globally and has supported the development of the sector on multiple levels in a proactive manner. The oldest explicitly Shari’a-compliant bank in the Kingdom is Bahrain Islamic Bank, which was set up in 1978-9.  By 1994, Bahrain was home to five Islamic banks and one off-shore entity. Renewed growth followed during the past decade thanks to the liquidity boom created by rising oil prices. By 2007, Bahrain hosted 27 Islamic banks and 13 takaful companies. As of December 2012, Bahrain had 26 Islamic bank licenses, seven takaful companies, and two re-takaful firms. Recent years have seen some industry consolidation, partly due to efforts by the CBB to encourage the formation of larger entities. Islamic financial institutions have become a systemically significant element of the financial services sector in Bahrain:

	Bahrain was home to 24 Shari’a-compliant banks as of June 2015. The consolidated assets of Bahrain-domiciled Islamic banks have risen from US$1.9 billion in 2000 to US$25.5 billion in September 2015. Their share of total banking assets has increased from 1.8% to 13.4% over the same time period. Following a period of rapid growth, the proportion of Islamic assets has remained fairly steady for a couple of years.
	Apart from purely Islamic banks, a number of conventional banks offer Shari’a-compliant products through Islamic windows and some international banking groups have used Bahrain as the main hub for developing their Islamic product offering. The CBB was the first regulator globally to allow Islamic windows by conventional institutions.
	In Bahrain, there are currently seven locally incorporated takaful firms and two re-takaful firms. The sector has attracted several international players, including Legal & General, Medgulf Allianz, and Chartis Takaful Enaya. The gross contributions of takaful firms increased by around 7% to register BHD57.22 million in 2013 compared to BHD53.67 million in 2012. The takaful industry is one of the fastest growing segments of the overall insurance sector with takaful premiums constituting 22% per cent of total gross premiums of the insurance industry in Bahrain. Similar to Islamic banking, the growth of the takaful industry in Bahrain has consistently outpaced its conventional counterpart over the past decade. This is driven by increasing demand for Shari’a-compliant cover, growing public awareness about the benefits of insurance, the entry of international players to the domestic market and the existence of a well-regarded legislative framework.

	There are 88 Islamic funds that are incorporated and registered in Bahrain with total assets amounting to US$1.4 billion as of March 2015.
	Bahrain Bourse in September 2015 launched the Bahrain Islamic Index which currently includes 17 companies that operate in line with Shari’a principles.
	The CBB on behalf of the Government is a regular issuer of sukuk. As of June 2015, the total outstanding balance of sukuk was BHD1.26 billion. Bahrain Bourse has worked to enable the general public to buy government sukuk in order to create an active secondary market and retail participation in primary issues has been possible since 2015.
	As part of the ongoing efforts towards the development of Islamic banking and promoting efficient liquidity management for Islamic retail banks, the CBB in 2015 launched a new Shari ’a-compliant wakalah liquidity management instrument. The instrument is aimed at absorbing excess liquidity of the local Islamic retail banks by placing it with the central bank. The instrument is based on a standard contract of the International Islamic Financial Market (IIFM). Retail Islamic banks need to sign a wakalah agreement which appoints the CBB as an agent (wakil) to invest cash on behalf of the bank (muwakkil). Accordingly, the wakil will invest these funds in the investment portfolio allocated in advance, and contains sukuk. The duration of the wakalah is one week and is available for Islamic retail banks every Tuesday.

The growth of Islamic finance in Bahrain has benefited from the proactive role of the CBB(known in 1973-2006 as the Bahrain Monetary Agency) which has operated as a unified regulator for all types of financial services since 2006. In addition, Bahrain is home to a number of important infrastructure institutions for Islamic finance in the Kingdom, many of them set up with the active support and participation with the Jeddah-based, multilateral Islamic Development Bank (IDB). These include:

The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) which was established in 1990 and began operations in Bahrain the following year. The main objective of the organization was to establish accounting and Shari’a standards for Islamic institutions. The CBB was the first central bank to make the AAOIFI standards mandatory within its jurisdiction. At present, seven Middle Eastern jurisdictions have adopted the AAOIFI standards while six others, most of them outside of the region, have issued guidelines based on them. As a leading standard setter for the international Islamic finance industry, AAOIFI has issued a total of 94 standards – comprising 54 Shari’a standards, 26 accounting standards, 5 auditing standards, two codes of ethics and seven governance standards – for the international Islamic finance industry. The development and revision programs for those standards are overseen by the technical boards of the organization.

	The International Islamic Financial Market (IIFM) was established in November 2001 to create a structured global financial market and to foster cooperation among Islamic countries and financial institutions. Specifically, the IIFM has sought to foster the development and self-regulation of Islamic capital and money markets. It has been a key player in developing standardised structures and contracts for Islamic capital markets while improving products and market infrastructure. Current initiatives include further work to build on existing efforts to develop frameworks for Islamic hedging, master agreements for Islamic treasury murabaha contracts, and a framework for a secondary market for sukuk and other Islamic instruments. The IIFM works with market participants ranging from regulators to financial firms, lawyers, stock exchange, industry bodies, and other service provides through working groups and committees which are open to non-members as well.
	The Islamic International Rating Agency (IIRA) began operations in July 2005 following an Islamic Development Bank (IDB) initiative. It is a leading provider of credit analysis and ratings on Shari’a-compliant products and institutions. The Fiduciary Rating System of the IIRA is based on recognizing the mutual dependent nature of credit and fiduciary risks in Islamic financial institutions. It is composed of a Credit Rating and Fiduciary Score. The Fiduciary Score seeks to accommodate the specific qualities of Islamic institutions as well as jurisdiction-specific variation in Shari’a standards. The score is based on Corporate and Shari’a Governance, Shari’a Compliance, and Asset Manager Quality. IIRA ratings are recognized by the CBB and IDB. IIRA is supported by multilateral development institutions, financial service providers, and other rating agencies. Its shareholders are financial institutions representing 11 countries which are the primary focus jurisdictions of the agency.
	The General Council for Islamic Banks and Financial Institutions (CIBAFI) was established in May 2001 by the IDB and a number of Shari’a-compliant financial institutions with 39 members participating in its initial session. It serves as a coordinating body for Shari’a-compliant financial institutions. It disseminates information about the sector through events and publications. It supports its members through a range of training programs, typically provided jointly with external partners. An example is the globally recognised Certified Islamic Bankers qualification launched in 2010. The General Council currently has nearly 120 members representing more than 30 jurisdictions.

Reflecting the Kingdom’s pioneering role and a position as a hub for innovation and analysis, More than 30 countries have sought Bahrain’s help and guidance in setting up Islamic financial structures of their own. Bahrain has also invested from early on in human capital development in Islamic finance:

	In the area of financial education and training, the Bahrain Institute for Banking and Finance (BIBIF) has long been recognised as a regional leaders. The institute has played a key role in providing training and education programs in the area of Islamic finance. The BIBF works closely with a number of international partners and provides internationally recognised qualifications from Bangor University, the London School of Economics, and DePaul University. The BIBF has been repeatedly recognised as the leading global training provider for Islamic Finance and has received a number of other international awards. An ethics course offered by the BIBF has been made mandatory for the junior staff of all Islamic banks in the Kingdom.
	In 2006, CBB established a dedicated fund – the Waqf Fund – to support research as well as education and training in Islamic finance. The fund was created with the participation of the leading Islamic banks in the Kingdom. The fund currently has 21 member institutions. The fund spends its returns on a number of training, education, and research initiatives. These include a Graduate Sponsorship Program established in 2011 which funds a six-month diploma program for 25 graduates every year. Training programs include a Shari’a Reviewer Development Program and an Advanced Diploma in Islamic Commercial Jurisprudence. In addition, an Islamic Banking Ethics for Bankers course is under preparation. The Waqf Fund supports the Bahrain Institute of Banking and Finance in upgrading its programs for Shari’a financial professionals, arranges occasional roundtable discussions among industry participants and Shari’a scholars on topics of importance and has also organized a number of corporate governance workshops for industry professionals.
	The University of Bahrain graduated its first students with a Bachelor’s degree in Islamic finance in 2015. The four-year degree program was developed jointly with the Waqf Fund of the CBB.
	Other institutions based in the Kingdom, ranging from standard-setting bodies to local banks, offer Islamic finance training solutions, often in partnership with local or international academic institutions and training providers.

This exceptional infrastructure of Islamic financial institutions has prompted also private companies to base Islamic finance-related research and advisory functions in Bahrain. Companies in questions include Ernest & Young, Deloitte, and Thomson Reuters. One of the local banks, AlBaraka Banking Group, has invested in a World Bank research initiative on Islamic finance with a primary focus on risk management issues. Bahrain also hosts important forums and conferences, both recurrent and sporadic, in the area of Islamic finance. The most established of these is the World Islamic Banking Conference which has taken place with CBB support annually since 1994. AAOIFI, has organized important forums, in some cases jointly with the World Bank. Bespoke conferences take place in the areas of Funds and asset management, as well as insurance/takaful. The Waqf Fund of the CBB organizes regular roundtables as do several of the multilateral standard-setting bodies.

Legal and Regulatory Framework Governing Islamic Finance in the Country

Much of the momentum that has gathered around Bahrain as an Islamic financial Centre stems from the willingness of the CBB to establish a robust regulatory framework for the industry to thrive. Since its establishment in 1973, the CBB has actively promoted Bahrain as an international financial center and, indeed, the Central Bank of Bahrain and Financial Institutions Law 2006, Article 3 includes this among the formal responsibilities of the bank: “Develop the financial sector and enhance confidence therein (Article 3 (3)).” The CBB has from early on been a proactive enabler of Islamic finance through regulatory initiatives and the development of new products and market infrastructure. It provides guidance to the industry through ongoing consultations with various stakeholders and research. In many cases, its initiatives have marked world firsts.

In 2001, Bahrain became the first country in the world to develop and implement regulations specifically for Islamic banking through the CBB’s comprehensive Prudential Information and Regulatory Framework for Islamic Banks. The implementation of this regulatory framework began in 2002 and it has been repeatedly updated and refined. CBB regulation has sought to equalize the operating environment facing conventional and Islamic banks and is widely considered as the benchmark for Islamic banking regulation globally. The CBB’s rulebook for Islamic banks covers areas such as licensing requirements, controllers’ requirements, capital adequacy, risk management, business and market conduct, financial crime and disclosure/ reporting requirements, as well as reflecting the requirements and guidance related to Basel regulations.

In 2005, the first comprehensive regulatory framework specific to takaful and re-takaful companies was introduced. As with the banking sector, this Rulebook provided the first comprehensive regulatory frameworks in the international Islamic finance industry. It is continuously updated to reflect regulatory developments and industry best practice. In 2014, following a two year consultation process, the CBB released a new regulatory framework for the takaful sector. The new set of rules will regulate the operations and solvency of takaful firms. Bahrain’s Collective Investment Undertakings (CIUs) regulations provide for the establishment of Shari’a-compliant funds. The CIUs provide for a full range of investment funds catering to various types of investors, from retail to high net-worth individuals and institutional investors. In order to further enhance the existing CIUs framework, the CBB had issued the ‘Volume 7 Rulebook’ in 2015, which provides comprehensive regulations on the authorization and supervision of CIUs domiciled or offered for sale in Bahrain. The new CIUs recognize the importance of expanding key areas such as corporate governance, as well as the role and responsibilities of each relevant party of a scheme. The new regulation also expands the variety of funds that can be established in Bahrain by introducing rules governing Real Estate Investment Trusts and Private Investment Undertakings (PIUs). The PIUs are a new breed of investment funds with a high degree of flexibility in structuring, aimed basically to facilitate private investments, like family-held investment, single investor or single investment type.

The CBB has actively supported the standardization of products and practices in the industry by supporting and working with various standard-setting bodies in the sector, in many cases formally mandating their implementation. Efforts to further improve Shari’a governance include a Shari’a governance module which will expand on the roles of Internal Shari’a Review and Internal Shari’a Audit functions and also introduce a mandatory requirement for external independent Shari’a Audit. In a landmark step toward a comprehensive model of Shari’a governance for Islamic financial institutions (IFIs), the CBB has created a pioneering national Shari’a Board, which will help harmonise Shari’a practices of IFIs operating in Bahrain. Inconsistent Shari’a practices by banks are widely recognized as a threat to the industry, as they can undermine consumer confidence and market efficiency.

The Way Forward: Futuristic Approach for Further Development of Islamic Finance

A number of themes are likely to shape the future role of Bahrain in continuing to drive the development of Islamic finance in the region as well as globally.  The CBB has taken various initiatives to support Islamic finance and plays a big role in rolling out Islamic finance products with more and stricter regulations, stronger compliance requirements, larger capital commitment and better risk management increasingly becoming part of the new paradigm.

Driving the Development of New Standards

Through its cluster of standard-setting institutions and in consultation with stakeholders globally, Bahrain is continuing to drive sustainable innovation in the sector. As a standard-setting body, the IIFM has taken important initiatives to unify and further develop liquidity management standards in the industry. Important recent initiatives include the Inter-Bank Unrestricted Master Investment Wakalah Agreement, and the Master Collateralized Murabahah Agreement. The IIFM is also working on hedging arrangements for the sector. The IIFM recently launched a standard contract template for Shari’a-compliant cross-currency swaps. The objective is to better manage risks associated with large currency exposures by Islamic financial institutions. The new standard is primarily intended for inter-bank treasury placements but are also applicable for sukuk as well as trade and corporate finance deals. The risk of cross-currency swaps being used for speculation, an activity banned under Shari’a law, had a key concern motivating the development of the new standard. The new arrangement involves two murabaha contracts linked with unilateral promises (wa’ad). The standard was developed jointly with the International Swaps and Derivatives Association.

Hosting Foreign Institutions

A number of Islamic financial institutions from outside of Bahrain are continuing to set up branches of subsidiaries in the Kingdom to benefit from the developed regulatory and institutional landscape, as well as access to the GCC market. Recent licenses include a leading Turkish participation bank, Türkiye Finance House Katılım Bankası and Sudan’s Bank of Khartoum. Both banks are looking to use their Bahrain presence for Shari’a-compliant wholesale operations.

Driving Thought Leadership

Apart from the ongoing efforts of the standard-setting institutions as well as the Waqf Fund and academic established, Islamic financial institutions in Bahrain are increasingly contributing to the development of the sector through innovative idea. Al Baraka Banking Group and the World Bank in August 2014 announced a research partnership which will assess risk management challenges facing Islamic banks. The primary focus will be on musharaka and mudaraba under the profit-and-loss-sharing system.

Developing New Educational and Training Solutions

Human capital is recognized as critical for the long-term success of the sector. In August 2014, the BIBF signed a MoU with the University of Bolton (UK) to develop an MBA in Islamic Banking. The Bahrain Economic Development Board and the Islamic Corporation for the Development of the Private Sector, the private sector arm of the Islamic Development Bank, have signed a MoU to promote the growth of SMEs in Bahrain by providing support in training and Shari’a-compliant financing.

Convening Representatives of the Industry.

Bahrain is recognized as a hub for Islamic scholars and institutions because of its history and institution. Beyond forums convened by standard-setting bodies, Bahrain hosts a number of regular and occasional conferences and events in the area of Islamic finance, including the World Islamic Banking Conference.

Islamic Financial Policy in Turkey

Islamic Financial Policy in Turkey

Islamic finance has half a century long history worldwide. Islamic financial policies carried out during this period have played an important role in such development including the establishment of global Islamic finance institutions such as the Islamic Financial Services Board, promotion of regulatory policies regarding money markets especially in Malaysia, and so on. When it comes to Turkey, Islamic finance has a shorter historical experience due to various reasons. One of the main reasons is the lack of supportive policies. Turkish Islamic finance indusTL depends predominantly on Islamic banking or known as participation banking. Therefore, policies related to the Islamic finance indusTL has paced through the way of participation banking policies.

Past Experiences of Islamic Financial Policies in Turkey

Since the establishment of the first modern Islamic bank, Mit Ghamr in 1963, Islamic finance and banking indusTL has been expanding both outwardly and in depth. Turkey’s inclusion in such development is a more recent phenomenon, which started with the establishment of Al Baraka Turk in the mid-1980s. The main reason why Turkey was a latecomer in the development of Islamic finance is rooted in the counTL’s long-run secular tradition and economic and financial policies based upon this tradition since the foundation of the Republic of Turkey in 1923. Contrary to what it generally suggests, this ideology did not cause separation between ‘mosque’ and ‘state’ but established a state hegemony over religion and religion-based structures. In this context, the ideological nature of the principle of secularism had shaped Turkish modern economy. In consequence, as a sub-branch of economic policy; financial policy of Turkey has also been shaped through the same ideology having the aforementioned idiosyncratic character. The 1980s was a turning point for many countries including Turkey as this era was marked with openness and liberalization. Thus, making it possible for Turkey to pursue Islamic financial policy.

From 1980s till 2001

Turgut Ozal, who was the Prime Minister of Turkey between 1983 and 1989, and the President from 1989 to 1993, opened up new possibilities for the roles of Islam and the Ottoman heritage. The rising Islamism (meaning political Islam) since 1970s created more demand for Islamic economic investment alternatives. Even in secular states such as Turkey, the promotion of Islamic banking was not simply a respond to such demands but also to send a political message to Islamic constituencies and receive their support. Such a policy produced its first fruits through the establishment of Islamic banks called ‘special finance houses’ or SFHs by the Decree of MinisTL of Councils numbered (83/7506) but without any direct reference to Islam or religion. These SFHs were established with large foreign capital (see Table 1).

The main motivation behind the allowance for the opening of Islamic banks under the name of special finance houses was to attract capital into the financial system, especially foreign direct investment from the Gulf Cooperation Council (GCC) namely Bahrain, Kuwait,

Oman, Qatar, Saudi Arabia and the UAE. Under the pressure of severe foreign currency needs, the government at that time treated Islamic banks as a safe pool of foreign currency resources^. However, it cannot be said that such a goal was substantially achieved. It can be seen from Table 2 that assets, deposits and financing of Islamic banks in Turkey were of small amounts. This was primarily due to the moderate policy pursued towards Islamic financial institutions during the early years. Although SFHs were given license to provide all banking services according to principles of Islamic law (Usul al-Fiqh), they were subjected to restraining financial policies.

Bank	Establishment Year	TR Group	FDI Group	Ownership Structure
Albaraka Turk	1985	Public	Albaraka- Bahrain	66% ownership belongs to foreign investors
Kuveyt Turk	1989	General Directorate for Foundations	KFH-Kuwait	KFH owns 62% of the Bank shares

Due to the secular political system in Turkey, strict rules were imposed against the political use of religion. This included the use of ‘Islamic’ as a descriptive label despite the fact that SFHs offered Shari’a-compliant financial products and services. Secondly, at the time of their establishments in 1985 and until 1999, SFHs were subjected to the Interest-free Banking Decree No. 83/7506 and were monitored and supervised by the Under secretariat of the Treasury and Central Bank of the Republic of Turkey (CBRT). Although they were highly regulated by skeptical bureaucracy, SFHs did not have the same status as conventional banks. The decree not only gave conventional banks unfair competitive advantages over SFHs, but informal restrictions limited the size of Islamic banks’ branch network; prevented their expansion; and reduced the ability to attract deposits.

Shortly after the decree, Al-Baraka Turk and Faisal Finance House became the first SFHs. This was followed by the establishment of Kuveyt Turk Finance in 1988. By 1991, three new SFHs were set up – Anadolu Finance House, Ihlas Finance House, and Asya Finance House. Unlike the earlier SFHs which were foreign owned, these SFHs were all 100% domestic capital. By 1999, five more had been established. The SFHs were required to keep only 10% of their current accounts and only 1% of their much larger provision accounts as reserves with the CBRT in contrast to the 10-15% reserve requirement that conventional banks were subjected to. Although Islamic finance grew progressively during the 1980s and 1990s, it constituted a small portion of the total banking sector, offering basic services such as retail banking and

Table 2:

SELECTED VARIABLES OF PARTICIPATION BANKS IN TURKEY DURING THEIR EARLY PERIOD

Variable	Year	Amount
Branches of Islamic Banks	1990	19
Total Assets of Islamic Banks	1990	2 million TL
Equity Funds of Islamic Banks	1990	0.14 million TL
Total Deposits of Islamic Banks	1995	66 million TL
Loan Funds of Islamic Banks	1995	63 million TL

Source: Participation Banks Association of Turkey

deposit accounts. During this era, Islamic finance was viewed with suspicious by state bureaucracy, military and leading business figures due to their strong secular values. Nonetheless, a growing class of religiously-observant businessmen and non-governmental organizations began to push for reforms of Islamic financial policies in Turkey.

Since SFHs were governed by a government decree instead of a law, they faced great uncertainty as to their regulatory status. Prior to 1999, SFHs were not governed by any proper legislative framework. However, effective December 1999, SFHs became subject to the new Banking Act No: 4389 and 4491, which effectively means that SFHs would be under the same regulatory umbrella as conventional banks. Within this framework, the legislation aimed at integrating SFHs into the domestic banking system. However, this could not be achieved completely because SFHs were not part of the system of deposit insurance. Their deposits were not protected by the Central Bank’s insurance system with the rationale that Shari’a-compliant profit and loss participation accounts do not guarantee return on the principal. Furthermore, by virtue of being an Islamic bank, SFH could not invest in government securities given the absence of Shari’a-compliant securities issued by the Turkish government. This deprived SFHs of a critical source of liquidity. In the end, the aforementioned structural weaknesses became apparent in 2001 with the collapse of Ihlas Finance, the then biggest SFH in Turkey.

From 2001 till 2008

Turkey had been experiencing high budget deficits and inflation throughout the 1990s, which ultimately led to a banking crisis and followed by a political crisis between 2000 and 2001. The fragility of the Turkish banking system was pinned on 4 main factors: deregulation and deposit insurance were without effective supervision; Turkish banks were vulnerable to sudden capital reversals as the banking system was highly reliant on foreign funding

the prevalence of politically motivated lending and lending to connected businesses; and Turkish banking sector was severely exposed to exchange rate risk. In the wake of the banking crisis, Ihlas Finance House faced a run on its deposits amounting to US$270 million out of the total deposit base of US$1.17 billion. When the Banking Regulation and Supervision Agency (BRSA) stepped in and cancelled the license of Ihlas Finance House, it was forced to liquidate. As a result, other SFHs faced sizeable loss of deposits as loss of confidence in them heightened. Assets of all SFHs recorded a sharp declined of 63% in 2001 as many depositors withdrew their funds before maturity (Table 3).

Special Finance House	Percentage Decline
Al Baraka Turkish Finance House	42.1
Family Finance House	29.4
Kuwait Turkish Evkaf Finance House	22.3
Anadolu Finance House	55.0
Ihlas Finance House	100.0
Asya Finance House	34.2

In response to the crisis, wide-ranging policy reforms to the counTL’s Islamic banking indusTL were initiated. Two major regulatory developments for Islamic banks were the establishment of Special Finance Houses Association (SFHA) and the introduction of Deposit Insurance Fund for SFHs. The Fund shall guarantee deposits at the SFHs in a manner similar to that of conventional banks and is administered by the SFHA. Meanwhile, the conventional deposit insurance fund is managed by the state. Another major difference is that while the Fund provided insurance up to TL50,000 for each deposit ownership in each SFH, the conventional insurance at that time had an unlimited coverage. Regulations on the principles and procedures relating to the establishment and activities of SFHs were published in September 2001 and the SFHA status was put into force with a Cabinet Decision published a month later. With this, membership to the SFHA was made compulsory for all licensed SFHs.

With the enactment of the Banking Act No. 5411 in December 2005, the “dual” deposit insurance system was revised and the management of the Islamic deposit insurance fund was transferred to the Savings Deposit Insurance Fund (SDIF). Of equal importance, following 15 amendments made to the banking law, SFHs were renamed as “Participation Banks”, which allowed them to integrate fully into the financial system. With this reform, SFHA was given a new name – The Participation Banks Association of Turkey (PBAT). The banking sector was composed of three types of banks: (i) commercial banks, (ii) development and investment banks, and (iii) participation (Islamic) banks. These amendments had also resulted in a fairer treatment to SFHs and were taken as an official acknowledgment of similar treatment to be given to Islamic banks vis-à-vis their conventional counterparts. This, however, had several vital implications. Any uncertainty and qualms about these institutions with regards to their names was ameliorated. With the status as “participation banks”, these institutions, from a regulatory perspective, started to operate just like other banks in the indusTL. Furthermore, any confusion in cross border operations due to its previous name was laid to rest. With the transfer of deposit insurance from SFHA to SDIF, the new law had explicitly guaranteed customers of participation banks the same rights of that of the conventional banks.

But, such a solution has trade-off between risk mitigation and Shari’a-compatibility since a possible problem of a counTL-wide deposit insurance scheme is that the paid capital of the Islamic Deposit Insurance (IDI) fund could be contaminated with conventional funds where conventional and Islamic banks co-exist together. This is exactly the situation in Turkey due to the current Turkish banking system where participation funds of Islamic banks and savings deposits of conventional banks are insured by the same institution and according to the same principles. Moreover, participation funds are insured generally without taking into account the differences among risk types. Such a risk differentiation approach is important because capital can only be assured if there is negligence or misconduct by the agent (mudarib) regarding the participation accounts.

After the Crisis in 2008

With the onset of the 2008 global financial crisis, Turkey experienced destabilizing impacts of the crisis although it was not severely affected as some other countries. On the other hand, the financial crisis became a milestone for the increasing popularity of Islamic financial institutions as Islamic banks appear to have weathered the financial crisis more resiliently than their conventional counterparts and had also contributed to financial and economic stability during the crisis. This had a positive impact on the development of Islamic financial policies in Turkey. One of the notable regulatory changes post global financial crisis was the enabling of various issuance of Shari’a-compliant financial products, including the issuance of sukuk to finance government spending as well as for corporate financing.

The participation banking has also been strengthened with other instruments such as takaful, participation funds, income indexed bonds (IIB) and a participation index on the Istanbul stock exchange market (ISEM). These are examples of diversifying Islamic financial products and are seen as important tools in resolving the capital adequacy ratio problem of participation banks. However, sukuk is seen by the Turkish government as an important financing tool for the realization of high growth targets.

The first formal provisions for sukuk in Turkey were laid out in the Sukuk Communique entitled ‘Principles Pertaining on Lease Certificates and Asset Leasing Companies’ (referred to as First Legislation) issued by the Capital Markets Board of Turkey (CMB) in April, 2010. In Turkey, sukuk issuance are based on ijara structure and hence, the terminology ‘asset leasing companies’ (ALCs) are used for Turkish sukuk structures as opposed to ‘sukuk trustees’ in other jurisdictions. The asset-based as opposed to asset-backed ijara structure was originally the only type of structure allowed under the First Legislation. The ALCs are typically special purpose vehicles, which are incorporated specifically to be able to issue certificates bought by investors (known as “certificate holders”) so as to purchase assets and lease them back to the originator. In essence, the special purpose vehicle finances the acquisition of assets using funds raised by the issue of certificates, and the lease rental payments from the originator mirror the profit distributions due under the certificates. The cash flows from the lease rentals are therefore used to service such profit distributions to certificate holders.

Pursuant to the newly enacted First Legislation, Kuveyt Türk issued the country’s pioneering sukuk in 2010 and a second sukuk was issued a year later after refinements in the tax regime related to sukuk was introduced. In June 2012, the government amended the Public Finance Law No 4749 to support sukuk issuance by the state, and Turkey made its maiden issuance with its first US$1.5 billion sovereign sukuk in September 2012. Another major milestone in the Turkish sukuk market was the issuance of Turkish Lira denominated sukuk of TL1.6 billion in the same year, which was followed by three more issuance two years later. As these Turkish denominated treasury sukuk issuances is accepted as a collateral asset in open market operations by the CBRT, this latest development in the sukuk market had the effect of minimizing the barriers and deepening the liquidity of Islamic banking in Turkey.

A new Capital Markets Law was introduced in December 2012, which clarified details of ALCs and their capital market instruments. This was followed by a new sukuk communique (Communiqué on Lease Certificates (III-61)) or the Second Legislation issued in June 2013, which defined and enabled ALCs to issue lease certificates based on mudaraba, murabaha, musharaka and istisna structures. Through these legislative changes, the opportunity to finance a much wider range of projects and businesses are now made possible. However, the ALCs, unlike other special purpose vehicles, remain heavily regulated by the CMB. For example, the Second Legislation states that ALCs can issue multiple sukuk as well as certificates for companies other than the company which was incorporated to issue them. However, ALCs can only be established by (1) real estate investment trusts listed on the stock exchange; (2) public companies in the first and second groups determined in accordance with corporate governance regulations of the CMB; (3) companies issued with a long term investment grade rating; and (4) companies of which 51% or more is owned by the Under secretariat of the Treasury; so long as these entities are actual fund users and the ALCs are not set up on behalf of third parties.

In March 2013, Bank Asya Katilim Bankasi A.S. (Bank Asya) became the first Turkish Islamic bank to issue a domestic sukuk of TL125 million and a 10-year US$250 million sukuk that was also the first Shari’a-compliant Tier 2 issuance from Europe. Other banks soon followed. In October 2013, the Republic of Turkey made another landmark international sukuk issuance of US$1.25 billion. The same month also saw the establishment of the Global Islamic Finance Center in Borsa Istanbul by the World Bank, which is envisaged to be the knowledge hub for developing Islamic finance in Turkey and globally. As shown in Figure 1, despite the latest developments concerning sukuk, compared to some other outstanding markets, sukuk issuances have stayed rather limited in Turkey. During 2010-2015 period, total sukuk issued in Turkey was TL32.9 billion of which TL18.1 million was corporate sukuk and the balance was sovereign sukuk (Figure 2).

Along with the First Legislation and Second Legislation, amendments in the tax legislation have also afforded certain tax advantages on sukuk, enabling a more efficient and competitive way of raising funds in the sukuk market. These significant tax exemptions are expected to facilitate growth of the sukuk market in Turkey. However, it should be noted that the current tax legislation is mainly applied to the ijara structured sukuk. Hence, further tax legislation will need to be enacted to encourage the use of the other structures that have been introduced in the Second Legislation. Some of the key tax advantages of the sukuk that have been recently passed pursuant to Turkish tax legislation are presented as follows:

Pursuant to the Corporate Tax Law (Law No 5520), any capital gains derived by an originator from the sale of an asset portfolio to and from an ALC are exempted from corporate tax on the condition that such sales are only made for the issuance of the certificates by the ALC. In order to benefit from such exemption, the capital gains derived from such sales must be reserved in equity as a fund that is not to be distributed for five years and the sale proceeds must be collected in cash within a two-year period.

 

The VAT Law (Law No 3065) exempts the delivery of certificates from VAT. Other VAT exemptions include the transfer of assets to an ALC and the lease of assets by an ALC as well as transfer of assets to the originator.

Pursuant to the Charges Law (Law No 492), the sale of the asset portfolio in a sukuk is exempt from the Title Deed RegisTL Fee and other fees.

The Income Tax Law (Law No 193) requires withholding tax from the interest income received under the certificates issued abroad. However, the rate of such withholding tax is reduced to 0% for such certificates with a maturity of five years.

Pursuant to the Stamp Tax Law (Law No 488), the transfer of assets to an ALC, the transfer of such assets by an ALC to the originator, and documents issued with respect to the lease and the certificates are all exempt from Turkish stamp tax. A non-resident holder will also not be liable for Turkish inheritance, registration or similar tax or duty with respect to its investment in lease certificates

Participation Banks’ Asset Share in the Banking Sector (2012-2015F;%)
	2012	2013	2014	2015F
Participation Banks	In PBs Sector	In Total Banking Sector	In PBs Sector	In Total Banking Sector	In PBs Sector	In Total Banking Sector	In PBs Sector	In Total Banking Sector
Al Baraka	18%	0.9%	18%	0.9%	22%	1.2%	25%	1.3%
Bank Asya	30%	1.6%	29%	1.6%	13%	0.7%	6%	0.3%
Kuveyt Türk	27%	1.4%	27%	1.5%	33%	1.7%	35%	1.8%
Türkiye Finance House	25%	1.3%	26%	1.5%	32%	1.7%	32%	1.6%
Ziraat Katilim*	–	–	–	–	–	–	2%	0.1%
*Opened on 29th May 2015

The growth of the sukuk market had contributed to the development of the Islamic capital markets. On the back of this, Borsa Istanbul Participation Index was launched in January 2011. In February of the same year, the Turkish parliament passed legislation for an international deal to “promote Islamic finance and improve access to funding based on religious rules.” The Turkish government aims to establish Istanbul as a regional financial center and then as a global financial hub by 2023.

Current State of Islamic Financial Policy in Turkey

Islamic finance in Turkey has been growing rapidly over the last decade. By the end of 2015, the growth of Islamic finance in Turkey has been driven by the four participation banks, namely Albaraka Turk Participation Bank, Kuveyt Turk Participation Bank, Turkiye Finance House Participation Bank and Bank Asya. While the market share of the participation banks represents a small portion of the Turkish banking indusTL, they have experienced double-digit rates of average annual growth over the 2009-2014 period.  By the end of 2014, the four participation banking total assets were approximately US$40 billion, which constituted around 5.2% of the Turkish banking indusTL. Although this share corresponds to a small share of the sector, the participation banking sector has shown an average annual growth of 25% in its assets in recent years, which is well above the indusTL average of 12% (Table 4).

If Turkey reach its full potential in Islamic finance, it is foreseen that the counTL will take first place in the world with US$775 billion in the medium term. Today, the market share of the participation banking sector is close to 6%, but it is anticipated to increase to 15% by 2023. In order to achieve this, it is essential to have more banks operating in the participation banking sector. In this respect, a state-run bank, Ziraat Bank, has entered the market under the name Ziraat Participation Bank at the end of 2015 after receiving approval from the CBRT to offer Islamic banking services. With this recent development, other state-run banks such as Halkbank and Vakifbank have also planned to launch Islamic windows later this year.

Once the political and economic stability in Turkey was achieved, participation banks exhibited significant growth with wider outreach throughout the counTL. It has been observed that penetration in branches, financial growth and increasing shares, improvements in financial regulations, product developments, the cooperative mutual efforts with sovereign and private partners, and the development of the Istanbul Finance Center Strategy have been the main corners and focused areas in 2015 (Figure 3).

Strategic Road Map to Develop Istanbul as a Global Finance Center

The Turkish government announced its aspiration to develop Turkey, specifically Istanbul as international financial hub known as the Istanbul International Financial Center (IIFC). This aspiration was motivated by Turkey’s strong presence in terms of economic and financial development in Eastern Europe, Middle East and Central Asia. Positive developments in the Turkish economy in the last decade have brought the counTL and namely Istanbul to the forefront. Its strategic geographical location coupled with its strategic advantages such as rich resources, proximity to important markets, labor force, competitive and diversified sectors; make Istanbul an attractive financial center. It is envisaged that Istanbul will become a regional financial center in the next 10 years and an international financial center in 30 years. In this respect, Islamic finance and participation banking was identified as a potential sector to support this main goal.

The IIFC Strategy and Action Plan (Strategy and Action Plan) was approved by the Supreme Planning Board’s decision no. 2009/31 dated September 29, 2009, and went into force after being published in the Official Gazette no. 27364, on October 2, 2009. The Strategy and Action Plan consisting of 71 articles was prepared within the framework of Istanbul Financial Center Project and is to carried out under the coordination of the Republic of Turkey MinisTL of Development. The Plan amongst others states priorities and actions aimed at developing a legal infrastructure up to international standards, increasing the diversity of financial products and services, simplifying and increasing the efficiency of the taxation system, improving the regulatory and supervisory framework, strengthening the physical and technological infrastructure, providing a training infrastructure to meet the requirement for qualified human resources, and creating an organizational structure that will realize promotional and monitoring activities worldwide. 

The “Strategy and Action Plan for İstanbul International Financial Center” was published by the MinisTL of Development in December 2014 as part of the 10th development plan. One of the relevant subcomponents was the paper on “Improving the Participation Banking and Islamic Financial System”. The actions plan for developing Islamic finance and banking were identified and classified as shown in Figure 4:

1. Improving the existing perception of Islamic finance system,
2. Development of the human resources and enrichment of the literature in the field of

Islamic finance,

• Development of institutional structure and legal system of Islamic finance infrastructure,

 

1. Increasing the diversity of Islamic finance products and services,
2. Foundation of institutional and legal infrastructure Islamic insurance (takaful) system.

A workshop was organized and hosted by BRSA and PBAT in 2013 to determine the basic dynamics of the Islamic banking indusTL and to put forward concrete proposals to contribute to the Strategy and Action Plan for the establishment of necessary infrastructure to support the indusTL’s growth and development in line with making aspirations put forth under the IIFC. Subsequent to this, the “Turkish Participation Banking Strategy Document” was published, which outlined a total of 17 strategies, 42 action steps and 84 actions that will allow the development and the growth of the indusTL.

Conclusion

The year 2016 is expected to be a year in which government support for the development of Islamic banking and finance intensifies and can be seen through IIFC action plans. More collaborative areas are expected in capital markets especially in Islamic securities. Growth of participation banks are expected to remain above the indusTL average supported by new entrants as well as increase penetration. The Turkish government’s efforts to support the Islamic finance indusTL including issuance of sukuk by the Treasury and the introduction of new regulations to allow for more Shari’a-compliant instruments are seen as favorable to growth. With all these positive developments taking place, the share of Islamic banking in the counTL’s banking sector is expected to increase from 5% to 15% by 2023 as envisaged in Turkey’s strategic plan.

Islamic Financial Policy in South Africa

South Africa is a country with deep Islamic heritage. The religion was first practiced in South Africa nearly 360 years ago, when the Dutch East India Company set-up its half-way port for its ships travelling between the Netherlands and India. The Cape of Good Hope was also used as settlement for its convicts and political prisoners from the Far East. Amongst those political prisoners, Muslims were the first to have been brought to South Africa. It is interesting to note that those very same political prisoners and political exiles would go on to lay profound and deep rooted foundations that would ultimately allow the Islamic faith to thrive, prosper and play pivotal roles in the ultimate development of the modern South Africa as we know today. Today South Africa’s Muslim population constitutes an estimated 2% of the total population.

While Muslim numbers are considered to be marginal, the Islamic infrastructure that the Muslims have built up around themselves is impressive by anyone’s standard. When compared to the country’s total population, the size of this constituency should not be confused with their influence on the economic, political and social environments that this small community has in the country. The community to date has nearly 600 mosques located around the country, no fewer than 400 Islamic educational institutions that cater to basic education through to advanced tertiary Islamic learning, a wide selection of halal food authentication agencies (disproportionately large when compared to the total population of Muslims in the country), various social counselling services (based upon an Islamic ethos), multiple Muslim Radio Stations that broadcast across the country aimed at selected communities, a Muslim TV Station that operates off the country’s premier satellite TV bouquet, a large number of charitable and relief organizations (amongst which the internationally famous ‘Gift Of The Givers’ is domiciled in South Africa) and Muslim professionals’ agencies that have been set up by various Muslim professionals to further benefit society at large.   

As is evident, the infrastructure that the Muslim community of South Africa has built for themselves is one that is intended to sustain an Islamic lifestyle.  A robust Islamic financial system has also been developed to ensure the complete entrenchment of an Islamic eco-system which is intended to become self-sustaining. It offers a variety financial services that range from Islamic banking, takaful, Islamic asset management, Islamic wealth advisory service and Islamic fiduciary and trust services catering to the needs of the Muslim individual and businessman alike.

Islamic Financial Industry Overview

In South Africa, Islamic banking was first introduced in 1989 by Albaraka Bank, which remains as the only full fledged Islamic bank in the country. It was only after more than a decade later that other banks such as First National Bank (FNB), Absa Bank and HBZ Bank provided Islamic financial products through their Islamic windows. Currently, Islamic banking assets account for about 2% of total banking assets, indicating much room for growth. South Africa is also home to other types of Islamic financial institutions. There are about 11 asset management companies offering various Shari’a-compliant investment products and only one takaful operator. In Sub-Saharan Africa, only South Africa and Nigeria offer Shari’a-compliant funds. Thus, making Islamic banking industry in South Africa one of the most sophisticated in the region besides Kenya, Nigeria, Sudan, Gambia and Senegal.

MAP OF ISLAMIC FINANCE ACTIVITY IN SUB-SAHARAN AFRICA

The significance of developing and preserving an efficient and effective system to regulate Islamic financial markets, Islamic financial institutions and Islamic service providers is core to the development of this niche financial services industry. The South African Islamic financial system has generally been operating without any legislation specifically directed towards the critical elements of Shari’a compliance within Islamic financial products. Islamic financial institutions are allowed to operate within the country on condition that they adhere and comply with prevailing standards that have been prescribed for conventional financial services companies. All Shari’a-related matters are generally managed internally through the institution’s self-appointed Shari’a Advisory Board or Committee.

There is no over-arching legislation or regulation that stipulates rules around Shari’a governance requirements. The authorities leave this critical element of compliance up to the individual institution to decide the most appropriate means to ensure suitable compliance. South African institutions that offer Islamic financial products uphold Shari’a compliance and governance by developing their own rules, which effectively, is a blend of standards that incorporate their own Shari’a Advisory bodies rulings combined with international best practice usually adopted from standard setting bodies like AAOIFI and the IFSB.

All South African banks, both conventional and Islamic, are regulated through the South African Reserve Bank’s (“SARB”), Bank Supervision Department (“BSD”) and all other financial service providers are regulated in some way or form through the Financial Services Board (“FSB”). The BSD has clarified its position regarding Islamic banks and Islamic banking windows in which all banks in South Africa have to comply with the Banks Act (Act No. 94 of 1990), the Regulations to the Banks Act and all other relevant legislation and regulations that apply to conventional banks. There are no specific provisions that relate to Islamic banks or Islamic financial products in the Banks Act. The BSD’s vision is to develop a sound, well-functioning and internationally competitive banking system promote the soundness of the banking system and contribute to financial stability. With this they encourage conventional banks that offer Islamic banking windows and stand-alone Islamic banks to appropriately understand the unique risks posed by offering Islamic banking and to ensure that there are appropriate risk management and risk mitigation processes in place to deal with any risk event that may occur.

The Islamic finance industry a few years back welcomed much needed revisions in the taxation regime that were effected through the amendments to the national taxation act for Islamic financial instruments. These amendments were some of the most progressive legislative advancements since the establishment of the Islamic financial industry nearly 30 years ago. Furthermore, revisions to Regulation 28 of the South African Pension Funds Act formally acknowledged Islamic financial structures for the very first time. In particular, ‘Islamic liquidity management financial instruments’ were specifically included in the definition of the Regulation’s new prudential limits.

The revision of this Act had far reaching consequences for not just the asset managers in the industry but also positively impacted the Islamic banks that provided liquidity management financial instruments, and of course the associated benefits that ultimately accrue to the purchaser of the end product. The infiltration of Islamic finance as an alternative in South Africa is an option that is being digested by the mainstream market and its application is finally gaining momentum. Boosted by the positive developments in Islamic finance and the strong financial services infrastructure that South Africa offers, it is a country that is well positioned to spring board this alternate form of finance into the greater African continent.

The Economic Sector

According to Price Waterhouse Coopers (PwC), “in 2014 the economic sector relating to finance, real estate and business services consolidated its position as the largest contributor to the country’s GDP, commanding an impressive 20.6% share of total value added in the economy. At the turn of the century, this share was 18.6%. In the process, South Africa is gradually approaching the status of a post-industrial emerging market economy. Since 2000, the share of the tertiary sectors of economic activity has increased from 64.9% to 68.1%.” Given the ever increasing role that the conventional financial services industry plays in shaping the country’s economy and contribution to the country’s GDP, the greater the significance that this industry is playing in shaping the development of the greater  economy of Africa.  Core to shaping financial policy in South Africa is the National Treasury. The National Treasury are the custodians of the country’s financial resources who are accountable to the nation in discharging its responsibilities efficiently and effectively, with the aim of promoting growth and prosperity for the entire nation. The National Treasury strives to raise fiscal resources equitably and manage government’s financial assets and liabilities soundly.

In addition, the ‘South African Fiscal Policy Framework’ is pro-actively managed through the ‘Fiscal Policy Unit’, This unit manages and develops the fiscal framework and is used to advise the Minister of Finance on policy options available in setting the budget framework. In effect, the key elements of sovereign strategy is executed through the National Budget, the National Budget Office provides the necessary fiscal advice, supervises expenditure planning and the administers the national budget process, leads the budget reform programme, manages official development assistance and compiles public finance statistics. It was through this intricate process that we witnessed the country’s first ever debut issuance of its sovereign sukuk, making it one of the pioneer non-Muslim countries to issue such an instrument.

The achievement was not only in the issuance of the sukuk, but a number of legislative amendments that were required to be passed in the run-up to the actual issuance of the sukuk. These legislative amendments managed to alleviate many legacy challenges that the Islamic finance industry had faced prior to the formal recognition of Islamic financial instruments through the taxation regime. Given the variety of Islamic financial services available to the South African customer, each sub-segment of the industry, whether in banking, insurance or asset management, all operate within a sophisticated environment and comply with the same rules and regulations as their conventional counterparts.

The Banking Sector   

The South African banking sector is advanced and boasts a robust regulatory system, and is supervised by its regulator the BSD, which forms part of the SARB. The Bank for International Settlements’ Basel Committee on Banking Supervision, recently conducted an assessment of the South African banking system as part of the Regulatory Consistency Assessment Programme (RCAP). On an overall basis, their assessment team found the South African prudential regulations to be compliant with the standards prescribed under the Basel framework. South African regulations were found to be compliant with all 14 components of the capital framework as per their Assessment of Basel III risk-based capital regulations.

The banking industry compares favorably with highly developed countries and the sector has significant participation of foreign banks in the industry and there are international institutions hold significant stakes in South African banks. The South African banking sector is very competitive, innovative and demonstrates continued diversification of its product sets. There is healthy competition in the industry and the net result is that the customers land up benefitting from the fruits of the competition. Furthermore, the industry promotes and supports Islamic banking interests. The banking sector comprises of 17 registered banks, two mutual banks, 14 local branches of foreign banks, two cooperative banks and 43 foreign banks with approved local representative offices. The industry is well represented through the South African Banking Association. The role of the Association is to facilitate the enablement of a conducive banking environment through robust engagement with government and relevant stakeholders.

A critical role of the Association is to work with its members to enable this role within the context of the transformation challenges prevailing in South Africa. The Association manages numerous committees that advise the Banking Association Executive on issues pertinent to the sector. The Executive of the Banking Association also leverages off the capacity of members of these committees, so as to bring the optimal resources to bear on pertinent issues. In addition to the committees, The Association oversees several business forums, task groups and sub-committees, which are interim structures, put in place to assist the committees in resolving a particular matter/issue at a given time. Amongst these sub-committees is the Islamic Banking Sub-Committee, the sub-committee plays a crucial role in representing the industry in critical discussions around legislation, regulation and promoting Islamic banking.

The sub-committee also promotes the virtues of Islamic banking to the general public as well. An excellent example of such intervention is through prominent programmes like the globally recognized “Teach a Child to Save Campaign” in South Africa where “Islamic Chapter” have been introduced. The Association specially re-developed training material to cater specifically for Muslim learners at school and encourages banking personnel to interact with children at school through the lecturing of the campaign’s training material. The South African Banking Association is the only African Banking Association that is a member of the International Banking Federation and is the only African Banking Association to contribute to the International Institute of Bankers Global Survey of Regulatory and Market Developments.

Islamic Investing

The Johannesburg Stock Exchange (“JSE”) offers secure, primary and secondary capital markets across a diverse range of securities, supported by post-trade and regulatory services. The JSE is a market of choice for local and international investors looking to gain exposure to the leading capital markets in South Africa and the broader African continent. The JSE is currently ranked the 19th largest stock exchange in the world by market capitalization and the largest exchange in the African continent. Given the increasing demand for additional Shari’a-compliant investing options, the market has witnessed the development of new and innovative products that range from bespoke equity investment portfolios, mutual funds and exchange traded funds. In addition, the JSE through the FTSE/JSE Africa Index Series, supplemented its Index Series offering with the launch of the FTSE/JSE Shari’a All Share Index, it is believed to be the first index of its kind in South Africa and possibly Africa.

The difference between this index when compared to other indices, is that this index is designed to track the performance of companies by full market capitalizations, whose activities are consistent with Islamic law. The index series, according to the JSE, is calculated by FTSE and the screening is then undertaken by Yasaar Research Inc. FTSE Group developed a joint venture with Yasaar Research Inc., to create a suite of Shari’a-compliant indices. Yasaar is responsible for reviewing the Shari’a-compliance of existing and prospective constituents of global, regional and partnership indices. Shari’a credibility is determined through company screening on both a financial and business level. The FTSE/Yasaar partnership began in January 2006, with the co-operation agreement to work together on the provision of index products suitable for the Islamic investment community. This partnership materialised following the growing interest in Islamic investment vehicles, covering a range of asset classes. Due to the conservative culture of the Muslim community in South Africa, for a long time Muslims generally did not invest in the JSE. They choose not to invest as they were not comfortable with the activities of certain listed entities or they were unable to sufficiently screen equity to warrant compliance with the necessary required principles of Shari’a.

With the advent of Shari’a-compliant mutual funds we witnessed a gradual acceptance of listed equities as a suitable investment option and expanded to other Islamic financial services providers that make available the universe of pre-screened equities that can be classified as Shari’a-compliant. With a resource rich country like South Africa, the availability of better quality information in the Islamic investment environment, this has prompted many more Muslim investors to further diversify their investment pools away from just the general community favorites like property and gold. The larger Islamic banking windows are also beginning to offer on-line trading platforms and offer greater support to those looking to build bespoke Shari’a-compliant equity portfolios. The JSE today boasts a number of Shari’a-compliant listed mutual funds and a selection of Shari’a-compliant exchange traded funds. As noted, the asset management industry, through the introduction of Shari’a-compliant mutual funds, have done a great job in sensitizing the Muslim community to investing on the JSE.  

On a legislative level, developments within the asset management industry prompted revisions to Regulation 28 of the South African Pension Funds Act and as noted earlier, Islamic financial structures were acknowledged. The extent of this acknowledgement provided clarity and benefited not just the asset manager but also benefited the Islamic banking industry that provides Islamic money market instruments to this industry. The Islamic money market instrument that is being referred to is essentially an Islamic fixed term deposit that in turn allows for a Shari’a-compliant fixed income on investments made by the Islamic asset manager with the Islamic bank. Regulation 28 effectively allows for a better spread of the cash component of such funds, through the taxation authority gazetting that no more than 20% of the cash component of the fund may be invested with any single bank.

Taxation of Islamic Financial Instruments and International Reporting Standards

Taxation – South African National Taxation Act (Act Number 58 of 1962)

Key to entrenching financial policy, is the embedment of supporting legislation that promotes the ideals and objectives of the underlying concept or in this case, of an entire industry. Given the continued yet quiet growth of the Islamic finance industry, a revision of the enablement structures to the Islamic finance industry were long overdue. The South African National Treasury was not unaware of such reconsideration. It was with a collaborative mind set (between the government and key industry players) and a strong desire to promote not just an alternate form of finance but rather to act as catalyst to ensure that South Africa as a country could be recognized as dominant player in the field of Islamic finance on the African continent. Coupled with the country’s strong and robust banking infrastructure this could well just be the boost that the continent needed to lead the path in developing the Islamic finance framework for Africa.

During 2010 the South African Minister of Finance noted that they will be reviewing the tax treatment of Islamic financial instruments to ensure their appropriate accommodation. This was an instrumental time for the Islamic finance industry as the country now witnessed formal acknowledgement of Islamic financial structures into South African financial legislation. The draft Taxation Laws Amendment Bill, was tabled on 10 May, 2010 wherein it specifically incorporated proposed amendments dealing with the taxation consequences of various forms of Islamic financing and also took into consideration Value Added Taxation (VAT) and Transfer Duty Taxation implications of such transactions.

In addition, the Finance Minister, during his introduction of the 2011 Taxation Laws Amendment Bill, to Parliament stated that this legislation was being incorporated into the Income Tax Act “to introduce a government savings instrument that is compliant with Shari’a principles, namely a Sukuk”. This was embraced positively by Islamic finance practitioners of South Africa due to the positive impact that the issuance of a sovereign sukuk would have on the overall recognition of the Islamic finance industry in South Africa. South Africa was also praised internationally as a pioneer non-Muslim country to seriously consider the issuance of sukuk. 

Tax legislation amendments

The element of parity of tax treatment between Islamic finance and conventional finance was of critical importance as they divide over even the most basic financial transactions began to discriminate against an individual that chose an Islamic financial alternative over a conventional financial product, so the taxation legislation amendments that came through were a welcome relief to both the customer and the financial services provider. In essence, the National Treasury implemented a substance over form approach, which, ensured through legislation that profit earned or paid received the same tax treatment as interest earned or paid. This provided an instant relief for all those customers who used Islamic financial products and were previously disadvantaged by the lack of parity in the tax system for Islamic financial products. 

The industry was further impressed with the subsequent development and roll out of the amended taxation legislation, where the South African National Treasury made significant strides in streamlining the processes around the taxation system, allowing for rationality and flexibility when dealing with alternate Islamic finance structures. The amended taxation legislation for Islamic financial instruments became effective on 1 January 2013. Following the precursor Taxation Laws Amendment Bills of 2010 and 2011, which, had set out the proposed legislation for Islamic financial products, which was subsequently gazetted to the National Income Tax Act. Section 24 JA of the Income Tax Act provides for the parity of tax treatment between Islamic finance products and conventional banking products. Section 24JA of the Income Tax Act sets out the tax consequences of mudaraba, murabaha, diminishing musharaka and sukuk. The Islamic finance tax provisions that were introduced provided guidance to the more commonly utilized underlying structures currently in use by South African Islamic finance practitioners.

Mudaraba

This is a commonly utilized structure which is generally utilized by most South African Islamic banks. It is more commonly used as the underlying structure of Islamic term deposits, savings and transactional banking accounts and usually pays a profit share to the customer. Profits earned by the Islamic banking institution are shared with the customer in a pre-agreed ratio. In terms of these contracts, the customer essentially bears all the risk of financial loss and the Islamic Banking Institution bears the operational loss.

In order for the Islamic bank to offer mudaraba based products that meet the requirements of the amendments to Tax Act, the provisions require that the arrangement must be advertised as Shari’a complaint and must be offered as such to the general public. The savings or investment arrangement must also satisfy the following requirements as required by Section 24JA of the Tax Act:

The money must be deposited with the bank by the customer.
	The anticipated return in respect of the Shari’a arrangement is dependent on the amount of money deposited by the customer in combination with the duration of the period for which the funds are deposited.
	The bank invests the funds deposited by the customer in other Shari’a arrangements.
	The client bears the risk of the loss in respect of the Shari’a arrangements.

• The return in respect of the Shari’a arrangements is divided between the customer and the Bank as agreed at the time that the customer deposits the funds with the Bank.

Section 24JA(2) provides that for the purposes of section 10(1)(i)(xv)(bb)(A) and section10(1) (i)(xv)(bb)(B) (the basic interest exemption), an amount received by or accrued to a customer in terms of a mudaraba is deemed to be interest. Therefore the profit earned by a natural person in terms of an acceptable mudaraba arrangement, as defined in the Act, is eligible for the same personal income tax – interest exemptions, as their conventional counterparts investing in interest-yielding products for taxation purposes.

Murabaha

The murabaha is a mark-up financing transaction generally offered by financial institutions to ensure that a client can obtain financing for the purchase of various assets (e.g. fixed property and equipment). The financial institution will purchase an asset (from a third party) at the instruction of the client and sell the asset to the client at a pre-agreed price. The preagreed price represents the cost of the asset acquisition plus a profit mark-up. Under the 2010 legislation, banks offering finance pursuant to a murabaha arrangement are deemed not to be involved in the acquisition or disposal of the asset that is the object of the arrangement.

The client is deemed to be acquiring the asset directly from the seller for the cost incurred by the bank (on the client’s behalf) and at the time the bank acquires the asset. This deeming of a direct acquisition by the client eliminates adverse indirect tax (e.g. Value Added Tax) consequences for the bank that do not exist in the case of traditional finance. The profit mark-up allocation by the bank is deemed to be interest for taxation purposes. It should be noted that the same principles explicitly apply to murabaha arrangements that entail financing by collective investment schemes to banks. In summary, this provision allows for a customer to acquire an asset from a third-party seller with the banking institution acting as facilitator to the transaction, all the while ensuring Shari’a compliance. The murabaha transaction between a bank and its customer is clearly defined for the purposes of:

• Direct Taxation – Income Tax
• Indirect Taxes – Value-Added Tax
•      Transfer Duty

In terms of Section 24JA(3), provision is made that where any murabaha is entered into between a Bank and a customer of that Bank, as contemplated in the definition of murabaha:

	the Bank is deemed not to have acquired or disposed of the asset under the Shari’a arrangement
	the customer is deemed to have acquired the asset from the seller:
	for consideration equal to the amount paid by the bank to the seller
	at such time as the bank acquired the asset from the seller by virtue of the transaction between the seller and the bank
	the murabaha is deemed to be an instrument for the purposes of section 24J
	the difference between the amount of consideration paid for the asset by the Bank to the seller and the consideration payable to the Bank by the customer to acquire the asset as contemplated in the definition of murabaha is deemed to be a premium paid for the purposes of section 24J
	the amount of consideration paid by the Bank to acquire the asset as contemplated in the definition of murabaha is deemed to be an issue price for the purposes of section 24J

In terms of Section 24JA(4), provision is made that when a murabaha is entered into between a portfolio of a Collective Investment Scheme in securities and a Bank as contemplated in the definition of murabaha which is in principle similar to the above definition for Banking institutions, however this provision relates to the sale of the asset by the portfolio of a Collective Investment Scheme in securities.

The Income Tax Act Impact of Bank Offering Murabaha

The mark-up differential by the bank is deemed to be interest for taxation purposes. Technically, to achieve this result, the Income Tax Act deems the murabaha arrangement as a whole to qualify as a Section 24J instrument, the mark-up to constitute a premium payable or receivable (thereby qualifying as Section 24J interest), and the bank consideration payable to the seller to constitute the issue price (thereby being taken into account as a section 24J initial amount). Similar principles apply to the portfolio of a Collective Investment Scheme in securities offered arrangements.

The Value Added Taxation (VAT) Treatment of Bank Offering Murabaha

Section 8A has been inserted into the Value-Added Taxation Act and Section 8A(1) provides specifically for the VAT treatment of Murabaha transactions as defined in Section 24J A of the Income Tax Act. Any premium paid or payable to the Bank by the customer is deemed to be consideration for an exempt financial service supplied by the bank as contemplated in Section 2(1)( f ). Provided that this paragraph must not apply to the extent to which the consideration constitutes a fee, commission or similar charge. The mark-up differential by the Bank is deemed to be interest. Its treatment as interest means that the mark-up is deemed to be an exempt financial service. But, financial-service treatment will not apply to the extent the bank is providing management services (instead of interest-bearing capital). Similar principles apply to the portfolio of a Collective Investment Scheme in securities offered arrangements.

Diminishing Musharaka

Diminishing musharaka is a partnership arrangement generally used for project financing. Under this arrangement, the client and the bank jointly acquire various assets. Alternatively, the bank acquires an ownership interest in an asset that is already owned by the client in return for financing of a development or refurbishment project. In both circumstances, the bank’s share in the asset is further divided into smaller units. The bank and the client enter into another agreement in terms of which the client undertakes to purchase the bank’s proportionate interest over time through the periodic purchase of individual units. With the implementation of this amendment to the Taxation Act, a ‘Diminishing Musharaka’ appropriately defines the joint purchase of an asset by the customer and the bank. Here, the bank’s ownership interest in the underlying asset is leased to the customer, with an overall undertaking that the customer will purchase all the units from bank.

In this context and as defined for the purposes of the Act, ‘Diminishing Musharaka’ means a Shari’a arrangement between a bank and a customer of that bank whereby:

the Bank and the customer jointly acquire an asset from a third party (the seller); or the bank acquires an interest in an asset from the customer

the customer will acquire the bank’s interest in the asset after its acquisition by the bank, and

the amount of consideration payable by the customer to the bank for the acquisition of the interest of the bank in the asset will be paid over a period of time as agreed between the customer and the bank.

For the purposes of determining the tax on income of the customer in respect of a ‘Diminishing Musharaka’, where the bank and the customer jointly acquire an asset, the customer is deemed to have acquired the bank’s interest in the asset:

	for an amount equal to the amount paid by the bank in respect of its interest in the asset
	at the time that the seller of the asset was divested of its interest in the asset by virtue of the transaction between the seller and the bank
	where the bank acquires an interest in an asset from the customer, the customer is deemed not to have disposed of the interest in the asset or to have acquired that interest from the bank

Direct Tax – Income Tax: The rental/instalment paid by the customer for the bank’s units will, for the purposes of income tax, be deemed interest.

Indirect Tax – Value Added Taxation: For VAT purposes the customer is considered to have acquired the asset outright at initiation of the deal and directly from the supplier, at the supplier’s price.

Indirect Tax – Transfer Duty: For the purposes of Transfer Duty, a similar treatment would be adopted as in the case of VAT.

Sukuk

Creation of an enabling framework for Islamic finance requires more than enacting accommodating tax legislation. Islamic financing, like conventional financing, requires government bonds as a “risk-free” standard so as to set the pricing for all other privately issued Islamic bonds. Moreover, Islamic finance providers typically utilize (and even require) Government bonds for regulating cash-flow and for balancing portfolios. In the case of banks, the need for Government-issued Islamic bonds is more acute. All banks must hold a certain percentage of investments in interest bearing instruments (including Government bonds) in terms of banking regulations. Yet, Islamic banks are religiously precluded from yielding economic benefits from interest bearing investments according to Shari’a law, even if required by local banking regulations.

In order to balance both religious and regulatory interests, truly proper Islamic banks surrender the interest received in respect of these investments. This lack of return places Islamic banking at a competitive disadvantage in comparison with conventional banks, thereby lowering the overall yield of Islamic savings products. The South African Government issued a sukuk to serve as a central focal point for Islamic finance. The sukuk that was issued was in the form of Ijara so that the bond fell within the dominant global standard for sovereign sukuk. In doing so, making South Africa, one of the first non-Muslim countries to do so.

Dividends Tax: Collective Investment Scheme Adjustments (and Islamic Finance Relief)

Applicable provisions: Section 25BA and 18A(1) of the Income Tax Act

With the development of Islamic finance within South Africa, Shari’a-compliant CISs have emerged. One pre-requisite of Islamic finance is the required forfeiture of interest and other impermissible income. In view of this pre-requisite, Shari’a-compliant CISs are subject to agreements that prevent impermissible amounts from being distributed to unit holders. These CISs instead donate impermissible amounts to various public benefit organizations. The impermissible amounts typically stem from interest received or accrued as well as dividends arising from profits derived from interest.

CIS Islamic donations of impermissible amounts

Although a CIS is entitled to deduct donations to public benefit organizations classified within Part II of the 9th Schedule like other taxpayers, the 10 per cent taxable income limit on deductible donations poses a practical problem. A CIS typically has little or no taxable income because taxable income is retained solely for management fees. This limit is especially problematic for Islamic finance CISs that regularly donate impermissible receipts or accruals.

South African Financial Reporting Standards

South Africa requires some companies to use International Financial Reporting Standards (“IFRS”), with the remaining companies being allowed to use IFRS or the IFRS for Small Medium Enterprises (“SMEs”). In 1995, the APB decided to harmonies SA Generally Accepted Accounting Practice (“GAAP”) with IFRS. Since 2003, after due process, the Accounting Practices Board (“APB”) has issued IFRS as SA GAAP without amendment. From 2003, SA GAAP was used by all companies in South Africa whether listed, unlisted and even extended to private companies. This changed in January 2005 for listed South African companies when the JSE listings requirements required that listed companies use IFRS (rather than the harmonized SA GAAP) for all their financial reporting. In 2011, the government adopted the new Companies Act regulations under which the Companies Act of 2008 prescribed that all reporting frameworks be based on each individual company’s public interest score.

The new Companies Act Regulations permits the use of either IFRS, the IFRS for SMEs, or SA GAAP in specific instances. However, because SA GAAP was identical to IFRS, SA GAAP was withdrawn for the years commencing on or after 1 December 2012. Accordingly, South African Islamic financial institutions report in terms of IFRS in alignment with mandated South African accounting standards. Islamic financial institutions operating in jurisdictions such as South Africa incorporate key AAOIFI accounting standards into their overall compliance, governance and reporting processes. These standards and internal guidelines are generally used on a voluntarily basis. While the AAOIFI auditing, governance and ethics standards are not part of the mandatory regulatory requirement for South African Islamic financial institutions, they provide much needed guidance in areas that conventional legislation and regulations overlook. In addition, South African Islamic financial institutions also acknowledge the compliance, governance and risk measurement principles as recommended by other recognized International Islamic finance standard setting bodies.

Conclusion

While South Africa does not have a specific Islamic financial policy, however the subsequent development of dedicated legislation, the growing number of Islamic financial services providers and the issuance of sovereign sukuk all point toward a greater acceptance of Islamic finance as a real alternative to a conventional means of growing the economy. It was evident that the debut USD 500 million, South African sovereign sukuk issuance proved to be an even greater success than anyone could have expected. It was four times over-subscribed at the international capital markets, priced at a coupon rate of 3.9%, and according to the South African National Treasury “representing a spread of 180 basis points above the corresponding benchmark rate”. In addition, the debut Sukuk ensured that South Africa earned its lowest dollar-borrowing costs, and according to available information, appears to be the lowest coupon out of 14 dollar bond issues since 1994.

Moreover, the sukuk issuance proved to be great in demonstrating to the general South African public that an Islamic financial structure could be used to great effect in benefitting all South Africans, irrespective of religious affiliation. Where the money raised through the sukuk issuance will eventually land up benefitting all South Africans through the new dam that will be built using the proceeds of the issuance. The success of this issuance has spurred further amendments to legislation and now South African state-owned entities and listed companies on the JSE are also now able to issue sukuk. These legislative developments are quickly beginning to shape an almost informal Islamic financial policy in the country and as the industry gains popularity, we are beginning to witness new entrants to the market.

The year 2015 proved that South Africa was still in need of much needed core infrastructure development, scheduled power cuts dampened corporate and civilian life, which in turn directly negatively impacted on the country’s GDP growth statistics. These inconsistent electricity supply problems increased pressure on the government to stabilize the South African electricity grid and to ease electricity cuts. As noted, these power interruptions demonstrated to be detrimental to output production in the country and adversely affected the business sector confidence. The country and the continent’s largest power supplier Eskom is still urgently searching for alternate sources of funding. Eskom have been discussions with many a financial services provider and have thoroughly scrutinized sukuk as a new funding option.  

The positive Islamic finance legislative and operational developments that have taken place in South Africa allow it to become the gateway of Islamic finance to Sub-Sharan Africa. South African Islamic banking units have used this platform to launch Islamic banking businesses in other African countries. Moreover, the demand for Islamic banking on the African continent is continually growing, with nearly 500 million Muslims that call Africa home this should come as no surprise. The challenge, however, still lies in creating an even deeper awareness among the African Muslim community of the benefits of taking up Islamic financial services. Even with impressive growth that is being recorded in all the various financial sectors that offer Islamic finance alternatives.

There is still a combination of uncertainty and reservation regarding Islamic financial services by the average Muslim in Africa. This is as a result of poor understanding and skepticism created by volatile economic conditions. In challenging times, customers generally leave their money in familiar structures (or keep it) and with organizations that they believe are protected and safe. Awareness creation and education on the subject is a collective responsibility of not just the financial services industry but that of the community and Muslim theological bodies as well. A clear and concise formal Islamic financial policy that is shared and understood by all the key stakeholders and would go a long way to further establishing Islamic finance as a legitimate alternative to conventional finance. Its merits and benefits should be expounded upon and the Islamic finance policy should always be clear on the benefits that would accrue to the state and civilian, irrespective of faith.

Islamic Financial Policy in Kazakhstan

Kazakhstan arguably has the most sophisticated and enabling environment for Islamic banking and finance in Central Asia. With the passing of its Islamic finance law in 2009, Kazakhstan became the first country in the CIS region and Central Asia to introduce legislation in Islamic finance. Although the development has been somewhat slower than expected, Islamic finance industry is set the gain traction given the continuous commitment shown by the government to develop a supportive ecosystem for Islamic finance in the country and subsequently make Kazakhstan the regional hub of Islamic banking for the CIS and Central Asia by 2020.

For the oil-rich Kazakhstan, adopting Islamic finance is the country’s efforts to diversify its dependence on oil income amidst the sharp fall in crude prices. With plans to position Astana, Kazakhstan’s second largest city, to become an international financial centre of the new Silk Road and a regional hub for Islamic finance; Kazakhstan has made significant progress in liberalising its economy and facilitating foreign investments. The existence of a legal framework for Islamic finance and strong political support from the President of Kazakhstan had greatly contributed to the development of Islamic finance. However, the achievements of Islamic finance remain modest. To date, Islamic finance in Kazakhstan is implemented through Islamic banking, takaful, Islamic securities and sukuk.

Macroeconomic Outlook and Financial Landscape

Kazakhstan has a sound external position. According to the latest estimates by the International Monetary Fund (IMF) 2015, the country’s current account deficit will be 3.3% of GDP in 2015, 2.9% in 2016, and will be gradually reduced to 1.1% of GDP in 2019. These projections, however, do not account for the steep devaluation (83% since beginning of the year) in 2015. Undoubtedly this will improve the country’s current account position over the medium term. At the end of 2014, Kazakhstan’s total external debt constituted about 71.2% of GDP, out of which public external debt was 4.7% of GDP, and private external debt to GDP was 67.5%. If intra-company loans by which the international corporations had financed their subsidiaries in Kazakhstan are excluded from private external debt, the share of total private debt would fall to 35.3% of GDP. At the same time, National Bank of Kazakhstan’s (NBK) gross international reserves amounted to US$28.9 billion (6.7 months of next year imports), and the National Fund Reserves were US$73.6 billion. The results of 2015 are not available yet. The difficult year has taken a toll on country’s reserves. However, the external position and reserves are expected to remain solid.

With respect to raising financing through Islamic instruments, the Development Bank of Kazakhstan (DBK) issued the first regional sukuk in 2011, Sukuk al-Murabaha, in the amount of US$76.5 million. About 62% of the issues were distributed among foreign investors (mostly Malaysians). In terms of institutional structure, 45% of the sukuk issues were bought by asset management funds, 34% by insurance companies, and 21% by banks. Encouraged by this success, the government intends to issue the first sovereign sukuk in 2016 based on ijara structure for which the authorities have completed the necessary legal and technical preparations. It is expected that a successful Kazakhstan sovereign sukuk issuance will pave the way for other Kazakh quasi-sovereigns and first-rate borrowers with their sukuk financing to capitalize on Islamic instruments.

Presently, Islamic financial assets comprise less than 0.01% of total banking assets but they have the potential to grow over the medium term to between US$3 billion and US$5 billion, comprising 3-5% of total banking assets. The return on banking assets for the top Kazakh banks has averaged around 2.7 – 3.5% per annum in the last decade and these figures do not incorporate the crisis years of 2008 to 2010 as well as the 2015 devaluation. The potential of Islamic finance lies in serving the corporate sector by funding their businesses in a Shari’a-compliant way. The performance of the first Islamic bank Al Hilal Bank Kazakhstan, which is the only full-fledged Islamic bank in the country, (see figures in Table 1) is a prime example of a successful business venture coupled with prudent banking management. The bank has been profitable since establishment. It is worth noting that most of the profit came from serving the Kazakh corporates as the bank faced obstacles in developing and scaling up full-fledged Islamic corporate and retail products stemming from the undeveloped legal framework and rudimentary markets.

	2012	2013	2014	2015
Assets, US$ mln	121,6	159,6	183,2	211,0
Financing, US$ mln	112,2	112,0	171,3	181,1
Deposits, US$ mln	51,3	88,6	118,6	145,9
Net income, US$ mln, YTD	1,297	2,707	3,219	2,735

Legal and Regulatory Framework

The legal system in the Republic of Kazakhstan belongs to the Roman-German (continental) legal system, and it consists of hierarchically structured and enacted laws. The principal source of law is the Constitution of the Republic of Kazakhstan, which has been adopted by the national referendum on 30 August 1995 and has the highest legal force. Following the Constitution, regulatory legal acts are prioritized in a hierarchical order: starting with the constitutional laws, decrees of the President of the Republic of Kazakhstan having force of the law, codes and laws approved by the Parliament, and legal decisions of the local executive and representative bodies. No regulatory legal acts of the lower level in the hierarchy may contradict the legal acts of higher levels. In the event of contradicting provisions in regulatory acts of different levels, the higher level provisions prevail. In the event of contradicting provisions in regulatory acts of the same level, the most recent provisions apply. Moreover, the international treaties ratified by Kazakhstan have priority over the laws of Kazakhstan and are applied directly while the recognized principles and provisions of international law constitute an integral part of the legal system of Kazakhstan.

Article 6 of the Constitution states that public and private property in Kazakhstan are equally recognized and protected. The Civil Code of Kazakhstan sets forth civil law relations. It consists of two parts, the General Part, and the Special Part. The General Part of the Civil Code governs matters such as legal status of individuals and legal entities, transactions, property rights, general provisions on obligations and contracts. The Special Part of the Civil Code deals with the types of obligations as sale and purchase, gifts/donations, lease, contracting, and so one, as well as matters of intellectual property rights, inheritance and international private law. Along with the Civil Code and certain provisions of the Constitution of the Republic of Kazakhstan, there are other regulatory legal acts that govern business activities in Kazakhstan. The Civil Code is regularly updated to account for changing regulatory environment (e.g. introduction of Islamic finance transactions).

Business and Investment Laws

The business and investment laws in Kazakhstan comply with general international practices. Kazakhstan has joined, ratified or adopted main multilateral international treaties aimed at promoting and securing investment and trade flows. These are the 1985 Seoul Convention on Establishing the Multilateral Investment Guarantee Agency (MIGA), the 1997 Moscow Convention on Protection of Investor Rights, and the 1965 International Convention on Settlement of Investment Disputes between States and Nationals of Other States (the ICSID Convention). Kazakhstan has also signed and ratified bilateral agreements on investment promotion and protection with over 45 countries, including Turkey, China, Saudi Arabia, Spain, Italy, Egypt, Iran, the UK, France, Malaysia, Switzerland, Russia, Kuwait, Pakistan, Jordan, Qatar, UAE, Uzbekistan, Kyrgyzstan, Tajikistan, Azerbaijan, the Eurasian Economic Union, and other countries.

The Kazakh government has also signed and enacted trade and investment promotion agreement with the US government. On July 19, 2015, Kazakhstan became a WTO member, successfully completing 19 years of negotiation. The investment relations are governed by the Law of the Republic of Kazakhstan On Investment dated 8 January 2003. The law determines the legal and economic grounds for investment, provides guarantees of investors’ rights investing in Kazakhstan, and defines measures for government support of investment, as well dispute resolution procedures with investors.

Banking Sector Regulation

Kazakhstan has a two-tier banking system. The National Bank of the Republic of Kazakhstan (NBK) is the country’s central bank and represents the upper (first) tier of the banking system, while other banks represent the lower (second) tier. The primary goal of NBK is to ensure price stability in the country. Based in Almaty, the central bank consists of 29 departments; 16 territorial branches and other affiliated organizations. The department for development of the Regional Financial Center of Almaty and Islamic finance carries out and coordinates Islamic finance activities; while the supervisory departments undertake daily regulation and supervision of conventional and Islamic finance institutions. The principal regulatory acts governing financial system in Kazakhstan are:

	Law of the Republic of Kazakhstan On Banks and Banking Activities in the Republic of Kazakhstan, dated 21 August 1995;
	Law of the Republic of Kazakhstan On the National Bank of the Republic of Kazakhstan, dated 30 March 1995;
	Law of the Republic of Kazakhstan On Government Regulation and Supervision of the Financial Market and Financial Organizations, dated 4 July 2003; and
	Law of the Republic of Kazakhstan On the Securities Market, dated 2July 2003.

Kazakhstan has an open, well developed and private banking system. As of September 1, 2015, there are 35 second tier banks, out of which 16 are foreign banks, among them are 14 foreign subsidiaries. All local commercial banks are privately owned, except for state development banks. Total assets of Kazakh banks amount to US$82 billion as compared to US$100 billion as of January 1, 2015, having increased by 6.8 % from the beginning of the year. The decrease in dollar terms is due to the devaluation of the local currency, tenge. As of September 2015, credit portfolio takes the lion’s share in banking assets at 63.6% of total assets. Credit portfolio comprises loans to legal entities (44.5%), loans to individuals (28.1%), out of which consumer loans represent 19.5%, mortgages at 7.8%, and 26.4% are loans to SME. The growth of credit portfolio has slowed down in recent years due to unfavorable macroeconomic environment caused by regional instability, slowing economy, and the consorted efforts of the authorities and banks to improve the quality of portfolio after the last global financial crisis.

The liabilities side of the Kazakh banking system comprised of client deposits (74.3%), securities (10.4%) and liabilities to non-residents (9.2%). In recent years, the banking system has largely been internally funded with share of external debt finance reduced significantly. This improves banking system stability and resilience to external shocks. It is worth noting that after the financial crisis of 2008, the Kazakh authorities have taken measures to increase the clarity of ownership and prevent excessive risk taking by commercial banks. In particular, a number of amendments were made to the existing law aimed at increasing transparency of banking structures and management, including the new definitions of “bank holding company” and “bank conglomerate”. The financial authorities also made new rules to issue permits and approvals to owners acquiring the status of bank holding company or major bank participant or participation of banks in the activities of their subsidiaries and affiliates. These measures are applicable to both conventional and Islamic banks.

In addition to commercial banks, there are two state development banks. The first one is the Development Bank of Kazakhstan (DBK), which was established to fund and finance state development projects that could not be financed by commercial banks. The DBK provides lending for mid-term (5 years and longer) and longer-term (up to 10 years and in certain cases up to 20 years) investment projects in state priority sectors. It also provides export-import financing, and takes part in government industrial programs. The bank’s management is keen in developing Islamic finance instruments. The DBK was the first regional sub-sovereign to issue sukuk in 2014. The bank’s leasing subsidiary, DBK Leasing, actively promotes Islamic leasing to corporate clients. In December 2015, DBK signed a MoU with Islamic bank Al Hilal Kazakhstan to provide access to Islamic finance corporate instruments to both public and private Kazakh corporations.

The second state development bank is the Housing Construction Savings Bank (HCSB). It is established to provide affordable financing to low-income borrowers who are unable to obtain commercial mortgages. The bank’s model is based on the system of construction savings successfully introduced in Germany in the 20th century where it provides private depositors with an option to save a certain amount of deposit to buy property. The HCSB will then lend the remaining amount to such depositors at lower rates as compared to commercial banks. In addition, under the system the government will make premium payments to depositors. The HCSB management is working with the NBK, IDB and the private sector to introduce Islamic finance instruments that would complement existing mortgages and provide better opportunities to clients.

Islamic Financial Sector Regulation Active development of Islamic finance industry in Kazakhstan started since 2007 albeit small and the legal basis of these Islamic financial transactions conducted were unclear. In 2009, the authorities approved the first package of legislation aimed at introducing Islamic banking and finance in Kazakhstan and facilitate Islamic banking opportunities. The Islamic Finance Law 2009 was intended to broaden the range of finance options available to Kazakhstani companies and to provide a legal framework for Islamic finance to flourish in Kazakhstan. The Islamic Finance Law is basically a set of amendments to various other laws, including the Civil Code, the Tax Code and the banking, securities market, investment funds, corporate and other laws. Soon afterwards the first Islamic bank – Al Hilal Islamic Bank Kazakhstan opened its door in March 2010.

A subsidiary of Al Hilal Bank in Abu Dhabi, Al Hilal Bank Kazakhstan was established based on an intergovernmental agreement signed between the Republic of Kazakhstan and the government of the UAE. The first Islamic insurance company in the form of Mutual Insurance Society ‘Takaful’ (MIS Takaful) was registered in 2010 with the objectives of providing (rendering) services of Islamic insurance in the Kazakhstani market and becoming an engine of Islamic insurance development in Kazakhstan. The MIS Takaful adopts the waqf model based on mudaraba and wakala principles (Figure 1). But due to lack of appropriate instruments for investing takaful funds, MIS Takaful was forced to accumulate saving contributions from participants. Presently, the Islamic finance industry consists of one Islamic bank, one takaful company, one ijara company, a representative office of the Malaysian Islamic advisory firm, one trade finance company, and one zakat fund. In accordance with the legislation, the first three entities are classified as Islamic. The zakat fund was launched in 2011 with the aim of collecting and distributing zakat tax amongst the poor. Based on waqf principles, the fund would accumulate voluntary donations. An Islamic Investment Hajj Fund of Kazakhstan was also established by Fattah Finance (a local Islamic brokerage company) with the Malaysian state-owned company AmanahRaya.

The growth of Islamic banking and finance in Kazakhstan has been slow. The Kazakh authorities had been cautious in introducing new instruments and amending the legislation until they saw the pressing need for it. The Islamic Finance Law 2009 made it possible to introduce Islamic banking in the country, to set up and open Islamic banks, and to make state regulation and supervisory framework for this new sector. The followings are some of the key legislations that were amended to accommodate Islamic finance:

The Civil Code of the Republic of Kazakhstan – to clarify the specifics of Islamic banking;

The Tax Code – with respect to taxation of Islamic financial institutions;

The Law On Banks and Banking Activities– with respect to matters relating to setting up a legal framework for operation of Islamic banks, removal of restrictions impeding introduction of Islamic banking, and determination of the forms and methods of government regulation and supervision of the activities of Islamic banks;

The Law On Securities Market – aimed at specifying the definitions of Islamic securities and the order of their issue and circulation;

The Law On Investment Funds – with respect to the requirements applicable to Islamic investment funds;

The Law on State Registration of Immovable Property Rights and Transactions with Such Property – with respect to the registration of rights to immovable property acquired by Islamic banks acting as trustees using funds from investment deposits; and

The Law On Compulsory Insurance of Deposits Held in Second Tier Banks of the Republic of Kazakhstan – with respect to exemption of interest-free deposits and investment deposits held in Islamic banks from the provisions of this Law.

The Law established basic requirements of Islamic bank activities based on Islamic financing principals such as accepting interest-free demand and investment deposits from individuals and entities, opening and maintaining bank accounts, provide interest-free loans, financing of commercial operations through purchase/sale of goods or by way of participation in projects, leasing, and agency activity when undertaking Islamic banking operations. However, deposits in Islamic banks are not guaranteed by the deposits obligatory insurance system. The Law also states that an Islamic bank is subject to the same requirements as conventional banks in the areas of shareholders, operations, control, establishment procedures, capital adequacy requirements and liquidation/rehabilitation procedures. A distinctive requirement is the prohibition of setting up an Islamic branch or window in commercial banks. The Law makes it mandatory for Islamic bank to operate as a full-fledged standalone Islamic financial institution.

Another prerequisite for Islamic bank is to have a Council on Islamic Finance Principles (CIFP), which is an analogue to Shari’a Supervisory Boards. CIFP shall be an independent body appointed by the general meeting of shareholders upon recommendation of the bank’s Board of Directors. All banking transactions of an Islamic bank must get the approval of CIFP except for transactions executed in accordance with approved model terms. CIFP also has the right to review any transactions to ensure its compliance with Islamic finance principles. In the event of any inconsistency with Shari’a, the transaction is either abandoned or if already executed, shall be terminated at the request of the bank in the court. In terms of products, the Islamic Finance Law introduces new banking products such as investment deposits, finance of business activities (by way of participation in projects) and trade finance through sale/ purchase of goods.

The authorities have also amended a number of internal tax, banking and securities supervisory regulations to allow for Islamic finance transactions. The Securities Market Law was amended to provide for the new concepts of Islamic securities and several new market players. This Law provides for the following types of Islamic securities: stocks and shares in Islamic investment funds; Islamic rent certificates; Islamic participation certificates; and other securities recognized as Islamic securities according to Kazakhstan legislation. Of these Islamic securities, Islamic rent certificates and Islamic participation certificates are particularly novel to Kazakhstan’s securities market. Islamic rent certificates are issued by an Islamic special finance company (ISFC) and have a fixed maturity whilst holders are entitled to income from underlying rent agreement(s).

Similarly, Islamic participation certificates are issued by an ISFC with fixed maturity period. Funds raised are generally for the purpose of establishing a new investment project, developing an existing investment project or financing a business activity either on the basis of a partnership contract or through a project company in the form of a joint stock company or a limited liability partnership. As holders of Islamic participation certificates, they have the right of common ownership over the project’s asset. Alike the Banking Law, the amended Securities Market Law contains the followings prohibitions intended to comply with principles of Islamic finance:

ŀŀ

both consideration in the form of interest “from the value” of Islamic securities and a guaranteed income from Islamic securities are prohibited; and

ŀŀ

funds received from the issuance and placement of Islamic securities should not be directed to finance activities related to production and/or trade in tobacco, alcohol, weapons, ammunition, gambling, and other businesses prohibited for financing by the Islamic Securities Council. The Council is responsible for ensuring that projects being financed comply with Islamic finance principles. In the event that the originator is an Islamic bank, the respective CIFP shall serve as the Islamic Securities Council. Otherwise an independent member may be appointed on a contract basis.

In order to introduce several of the above-described Islamic finance instruments, the Tax Code was also amended. Most notably, the amendments present a number of tax incentives for Islamic finance in Kazakhstan. In terms of corporate income tax, income under an investment deposit placed with an Islamic bank is exempt from income tax for individuals (both resident and foreign), and income of a Kazakhstani-incorporated ISFC received from assigning debt receivables is exempt from corporate income tax. Several banking transactions by Islamic banks are also VAT exempt including:

ŀŀ Interest-free demand and investment deposits of individuals and legal persons, opening and maintenance of their bank accounts.

 ŀŀ Mark-up receivables by an Islamic bank in the course of trade financing activities.

In 2011, the Kazakh authorities made additional amendments to allow government and government-owned entities to issue Islamic securities (sukuk), Islamic lease certificates and Islamic participation certificates, issuance of sovereign Islamic securities, and to allow listing and secondary trading on the Kazakhstan Stock Exchange (KASE). The list of corporate issuers of Islamic securities was also expanded. This allowed DBK to issue the first regional quasi-sovereign sukuk. In general, the amendments to the law during the period 2009 to 2011 served as a legislative bases for the establishment and operations of Islamic financial institutions, issuance of sukuk and offering Shari’a-compliant financial products and services. Although the legal developments were important for the operational of Islamic finance in the country, practical implementation of Islamic financial services revealed several drawbacks of the present legislation.

As part of the ongoing development and in providing the necessary legal framework for the development of Islamic finance in the country, the central bank authorities successfully passed through Parliament the long awaited package of amendments aimed at developing Islamic insurance and leasing in April 2015. The law introduced the concept of Islamic insurance and reinsurance and made it mandatory the use of the term “Islamic insurance” for takaful operators to differentiate them from conventional insurers. It also made Islamic insurance a licensed activity and put takaful operators under the supervision of NBK. The law stipulated that takaful companies should have Islamic finance councils as independent bodies set up by the Board of Directors to ensure Shari’a-compliance in daily operations, management and investment. However, the operations of conventional insurers through Islamic windows are not allowed.

The amendments also introduced Islamic leasing operations (ijara). Unlike Islamic bank and takaful operator, both conventional and Islamic leasing companies may operate without a license. In addition, Islamic leasing can be performed by either Islamic banks under the Islamic banking license or corporates under the Law on Financial Leasing. Islamic leasing also requires the companies to have an Islamic Leasing Council to oversee and ensure compliance with Shari’a rules and procedures. If the total leasing portfolio does not exceed US$45.5 million, the leasing companies may hire external Islamic Finance Councils. The amendments introduced new Islamic financial instrument, namely commodity murabaha, and made necessary amendments to the Tax Code. This is in addition to the existing instruments such as musharaka, murabaha, ijara, wakala, mudaraba and qard al-hasan.

Legislative efforts continued with the passing of new amendments to the Islamic Finance Law in November 2015. This time the authorities introduced provisions to facilitate the conversion of conventional banks into Shari’a-compliant ones. The law stipulated measures and steps to be taken by the shareholders and management of banks wishing to convert their operations to Islamic ones. Prior to this, the rigidity of the existing law means that conventional banks would have to shut down and then reapply for licenses to convert their operations to offer Islamic finance services, which could take up to 3 years. With this, Islamic banking is expected to grow progressively in the next few years as competition is likely to increase when more products are introduced. It is worth noting that in 2015, the NBK, through a grant received from Islamic Development Bank, signed an agreement with an international legal firm Norton Rose Fulbright to develop a new standalone comprehensive law on Islamic finance in the country by taking into account international best practices.

Shari’a Regulation

The current legislation of the Republic of Kazakhstan strictly demands that all Islamic financial institutions form the Council for Islamic Financing Principles (CIFP). This law applies to banks, takaful operators and ijara companies. However, some market participants that fall outside the scope of NBK regulation, due to the small volume of transactions, prefer to hire external Shari’a experts or fully outsource this professional service to Shari’a advisory companies. The present legislation, however, does not make possible to establish a central CIFP within a governmental body because the supervision of Shari’a-compliance pertaining to financial transactions cannot be included into the functions of either the government or the central bank.

Due to this reason and coupled with the insufficient number of market participants in the Islamic finance industry in Kazakhstan to date, the NBK has recommended that the Association of Development of Islamic Finance (ADIF) – an organization established for the development of Islamic financial market in Kazakhstan, to undertake research and consider various options for establishing CIFP. The ADIF has recently established an Expert Council who shall be responsible for Shari’a legal issues faced by members of the association. An agreement was signed between ADIF and the Shari’a Review Bureau, which specializes in Shari’a advisory and Islamic law. In addition, there is already an operational CIFP created within Al Hilal Bank Islamic Bank in Kazakhstan. The members of this CIFP are well-known Shari’a advisors such as Shaikh Dr. Abdussattar Abu Ghuddah, Shaikh Dr. Nizam Yaquby, and Shaikh Esam Mohammed Ishaq. The Shari’a Board’s secretary coordinates the activities and functions of the Shari’a’ Board and supervision of the local bank.

Road Map for Islamic Finance Development in Kazakhstan

A Road Map for Islamic Finance Development in Kazakhstan by 2020 was approved by the President’s decree No. 371 in March 2012. The roadmap aims at mobilizing support from the public and private institutions for the development of Islamic finance in terms of legislative improvements, public awareness, Islamic financial infrastructure, public sector development, development of Islamic financial services, education, and investor relations. In addition to these, the road map also outlines specific activities on the creation of conducive conditions for the development and attraction of Islamic financial institutions as well as the introduction of Islamic financial instruments and activities for the issuance of Islamic sovereign and corporate securities. The country expects Islamic banking assets to reach 3-5% of total Islamic banking assets in the medium term.

The Astana International Financial Centre

In April 2015, during his inauguration speech, the President of Kazakhstan Nursultan Nazarbayev announced the establishment of the new regional financial centre – the Astana International Financial Centre (AIFC). With this, the NBK and the government of Kazakhstan drafted the Constitutional Law “On Astana International Financial Centre”, which was later approved by Parliament. To be based in Astana, AIFC is expected to begin its operations in early 2016 and become fully operational by the beginning of 2018. The center is based on four key pillars:

1.	Development of a local capital market. The principal activities are:

Issuance and placement of the government treasury bonds through Kazakhstan Stock Exchange (KASE), integration of  issues with different maturities and subsequent issuance of  infrastructure bonds;

IPO of the companies from a quasi-public sector that are most attractive in terms of investment, with the placement of at least 25 % of the total outstanding shares for a wide range of investors (both domestic and international) via KASE;

Active role of the United Accumulative Pension Fund (UAPF) as a player in the secondary market. To grant mandates to the local and foreign management companies localized in Kazakhstan to manage pension funds.

Development of asset management market and expertise. This will require:

localising international management companies (MC) specialising in asset management and determine the amount of the funds of the National Fund to be transferred under the management of the external MCs.

developing local expertise in asset management by involving local qualified MCs in the management of the UAPF funds that have passed the preliminary certification and selection (similar to the management companies of the National Fund);

the gradual completion  of the process of redistribution of the public funds from the external MCs to localised MC with the development of the localisation process of the external MCs;

Developing a class of alternative investments (private equity funds, hedge funds and venture capital). This will make it possible to “inject” liquidity and utilize expertise in the investment projects.

3.	Development of private banking. This will develop the pillar of asset management in terms of both the servicing of local affluent people and management of repatriated funds and funds attracted from the Central Asian countries.
4.	Establishment of the Islamic finance market and the conducive conditions for

issuance of sovereign Islamic securities. This pillar will ensure incentives for inflow of Islamic capital into the country and development of alternative banking sector in addition to the traditional one. Measures to develop Astana as a regional hub in Islamic finance and gain 3-5% share in the total banking assets are focused on issuance of Islamic securities e.g. sukuk, localization of the international Islamic financial organizations in AIFC, introduction of “Islamic windows” in the traditional second-tier banks, develop conducive conditions for the conversion of the banks and guaranteeing of deposits.

An important feature of AIFC will be the existence of a separate legal system, according to which the AIFC Financial Court and International Arbitration Centre will operate. The legal system will be based on the principles of the common law that will enhance significantly the confidence of foreign investors. The AIFC official language is English. The AIFC management structure will consist of four AIFC bodies, infrastructure organizations and organizations engaged in financial activities in AIFC.

ŀ  AIFC Management Council – the standing collegial body headed by the President of the Republic of Kazakhstan. The Council will determine the AIFC development strategy and adopt the AIFC legal acts in the form of resolutions.

ŀ AIFC Administration – the joint-stock company to be established by NBK will support the AIFC operations and represent its interests. It will draft resolutions of the Council, agree on the drafts with the AIFC Committee and submit them for public discussion and forward to the Council for adoption.

ŀ  AIFC Committee for Regulation of Financial Services – the legal entity in charge of the regulation of financial services and related activities in AIFC. It will draft resolu- tions of the Council concerning the regulation of financial services and related activities in AIFC, and submit them for the public discussion and forward to the Council for adoption.

ŀ  AIFC Court – the independent body separate from the judicial system of the Republic of Kazakhstan. AIFC Court will consist of two instances: the court of first instance and the court of appeal. Here, AIFC will rely on the successful experience of the English law courts, namely, the courts Dubai International Financial Centre (DIFC Courts). This body, as is known, is operating within the frameworks of the independent jurisdiction based on the principles of English case law, and has its own rules of civil and commercial law, which are different from the laws adopted in the UAE.

Subsequently all AIFC management bodies will be independent of all state agencies, including NBK, and will be subordinate only to the AIFC Management Council under the President of Kazakhstan. Key activities of the AIFC participants, including a specific list of operations carried out in AIFC, will be determined by the AIFC internal regulations. At the same time, these will be determined by the scope of the main strategic pillars of the AIFC development, such as development of the capital market, asset management, private banking and Islamic finance. The authorities expect that the development of AIFC will promote significant development of the securities market, ensure its integration with the international capital markets, and attract foreign investments into the country. All these are anticipated to give a significant boost to diversification of the economy of Kazakhstan, and positively influence both the economic and social factors of the country development.

Regulatory and Legal Issues, and Challenges for Islamic Finance in Kazakhstan

Despite good progress and results achieved over last few years, Islamic finance is still new and relatively unknown in Kazakhstan. Several regulatory and legal issues are hindering the growth of Islamic finance in the country.

Lack of public awareness and understanding

The first and foremost challenge is the lack of public awareness and knowledge of Islamic finance in Kazakhstan. At the request of the Islamic Research and Training Institute (IRTI), a consumer financial survey was conducted in July 2015 whereby 1,557 residents of major cities and towns in the country took part in the survey. Findings from the survey found that 71% of the respondents had never heard of Islamic banking and finance, of which 46% of them were Muslims and Russian Orthodox Christians. About 21% of the respondents answered they “had heard something about Islamic finance”, whereby 72% of respondents were Muslims and 21% were Orthodox Christians. About 7% had “a very vague idea about it.” And only 1% of respondents were “well aware of the concept and principles of Islamic financing.”

Among the survey respondents, 41% did not understand the differences between Islamic and conventional banking. Another 39% said they are not interested to find out more about Islamic banking and finance, and another 15% answered “Islamic finance was not needed, the conventional banks were enough.” In the meantime, 40% of the respondents requested more information/education. 25% believed that “Islamic finance was not religiously authentic today” and the same percentage described Islamic finance as “banking services for Muslims only”.

1. Cited from Thompson Reuters –IRTI-CIBAFI Report “Kazakhstan – New Frontier for Islamic finance,” December 2015.

Inadequate Education Resources

While good progress has been achieved in recent years, there is still huge untapped potential. Islamic banking and finance education is developed primarily by enthusiasts and volunteers from public and private sector, as well as from academia. Given the resources and support the Kazakh government annually directs towards the educational sector, the present state of support in Islamic banking and finance education remains inadequate. The major challenges in Islamic finance education are as follows:

ŀ Lack of state funding, programs and support for Islamic finance education at national and regional levels;

ŀ     Lack of literature on Islamic finance in Russian and Kazakhstan;

ŀ     Lack of qualified teachers in Islamic economics, finance, and jurisprudence;

ŀ Absence of Bachelor, Master and PhD programs in Islamic finance offered by univer- sities in Kazakhstan;

ŀ Insufficient quality of scholarly discussions among local researchers, scholars in terms of publications; low participation in international conferences on Islamic economics and finance;

ŀ Lack of access to international scholarly journals, data base and knowledge hubs on Islamic economics, finance, and jurisprudence.

High Entry Barriers to Establish Islamic Banks

When drafting the Islamic finance legislation, the authorities took an equal regulatory approach towards Islamic banking and conventional banking. In particular, the requirements to establish an Islamic bank is similar to those of the conventional bank. Given the undeveloped nature of the local financial markets, lack of Islamic financial instruments as well as funding base, coupled with unstable regional environment and market turbulence, this has resulted in high entry barriers for any potential entrants to commercial banking (and Islamic banking as well!) in Kazakhstan. In particular, the followings are the legislative requirements to establish an Islamic subsidiary bank:

ŀ Receive preliminary approval from the authorised body (i.e. NBK) for establishing a subsidiary.

ŀ Receive the preliminary written approval by NBK to acquire the status of banking holding for an Islamic subsidiary.

ŀ Receive preliminary approval by NBK to open the Islamic subsidiary (this is done when NBK inspects the soon to be established Islamic subsidiary with respect to the banking regulations and procedures).

ŀ Breakeven performance on consolidated and non-consolidated basis of the last two financial years and conformance with NBK prudential ratios.

• The same requirements apply to establish a subsidiary conventional bank in Kazakhstan.

ŀ The share of bank participation in the Islamic subsidiary charter should not exceed 10% of the bank’s total shareholders’ equity. The aggregated value of the bank’s participation in the charter capital of the Islamic subsidiary should not exceed 50% of the bank’s shareholders’ equity.

ŀ The bank is allowed to establish and open the Islamic subsidiary if it observes minimal capital adequacy ratios set by NBK.

ŀ Minimal charter capital of the Islamic subsidiary bank should be US$30.3 million plus US$9.1 thousand per each branch. In March 2016, NBK eased the capital requirement for foreign entities with long-term credit ratings of “A” and higher to reduce charter capital by twice, i.e., US$15.2 million.

It becomes immediately clear that any potential new entrant should commit at least US$30- 35 million for establishing the new Islamic bank in Kazakhstan with reasonable branch network coverage. This does not entail other medium-term direct and indirect expenses associated with setting up and developing the new bank entity. Incorporating expenses and costs will drive this cost higher for the new Islamic bank in Kazakhstan well above US$50 million within the three-year budget framework (a minimal planning period in the business plan). As the new entity will have no clients and no funding at the initial period, one has to add up the associated funding and financing costs. In practical terms the bank ownership requirements set by NBK limit potential domestic new entrants to this market. With a rare exception none of them has any firm past experience or even a desire to start a new business in Islamic finance. There are no proven business models, no risk appetite, and no qualified staff and Islamic banking and finance professionals who are able to form the team, argue and convince the management, directors and shareholders to set up the new banking entity and commit the funds.

While there have been numerous discussions among regulators and shareholders of major Kazakh banks in recent years, some of the shareholders have privately expressed their desire to move towards Islamic banking model. So far none has come up with the funds and public statement to start the work on establishing an Islamic subsidiary bank in Kazakhstan. The local banking industry at large has taken a “wait-and-see” approach towards Islamic banking and finance. The new banking amendments adopted in November 2015 will reduce the regulatory hurdles and barriers associated with conversion of conventional to Islamic banks for the medium and small local banks wishing to change their operational and business models in conformity with Shari’a requirements and tenets of Islamic banking. However, the banks having limited branches and operations outside their core regions most likely will be unable to provide Islamic banking services nationwide, especially for retail and SME customers.

Indecisive Foreign Islamic Banks

As far as foreign Islamic banks are concerned, there have been discussions with all major players in Islamic finance and banking over the years. The NBK team has taken the lead in negotiations. Many banks showed an avid interest in expanding in Kazakhstan. However, there is still no foreign bank operating in the country except for Al Hilal Bank of Kazakhstan. The business relations between local banks and their Islamic counterparts are scarce, whilst opened trade finance lines are few.

Business Hurdles

Presently, Islamic financial institutions in Kazakhstan encounter challenges in everyday operations. To their credit, the authorities in particular the NBK are committed to resolving them but the work and efforts should intensify to provide a real impetus to Islamic banking and finance in Kazakhstan. The most important and salient business hurdles currently facing Islamic financial institutions are as follows:

ŀ Tax and regulatory treatment of Islamic financial instruments and products as financial services and products.

Due to the present regulatory regime, only the legislatively approved Islamic financial instruments are treated as financial products. It takes time and efforts to amend the legislation for each and every product. This severely limits competition and innovation in the industry. In the meantime Islamic financial intermediaries are taxed as individual transactions since every transaction in Islamic banking involves purchase and sale of goods. The national legislation should permit purchase and sale of property, goods and commodities by the Islamic banks as financial transaction and should not be treated as separate entrepreneurial activity. Accordingly, all Islamic financial instruments should have equal treatment with conventional financial instruments. This means:

ŀ Individual Islamic banking operations or financial instruments should not be taxed. Instead taxation should be done at the Islamic financial institution level as profit center similar to that of conventional financial institutions.

ŀ Overall tax and regulatory regime for Islamic financial institutions should be harmonized and brought on equal terms with the tax regime for conventional banks. Purchase and sale of property and assets under Islamic financial schemes should be treated similar to that of conventional financial instruments.

ŀ  NBK and Ministry of Finance of Kazakhstan should have the authority to approve or change Islamic finance instruments by internal regulation and not by amending national legislation every time such changes are required. This would make the pro- cess of approving and introducing the new Islamic financial instruments faster and more efficient, and help in developing the local Islamic finance industry on par with best international standards.

ŀ The usual property rights registration mechanism for Islamic finance instruments should be substantially streamlined allowing fast track procedures for registration of underlying property and assets of Islamic finance instruments. This is closely linked with the proposed change in the taxation regime mentioned earlier and would help bring Islamic finance on par with conventional finance instruments.

ŀ Islamic mortgage should have the same tax and regulatory regime as traditional mortgage. This would drive the costs down and make the Islamic mortgage more widely accepted among the retail customers.

ŀ Amending legislation for government and quasi-government corporates to allow for Islamic banking

At present, government-owned or controlled corporates are experiencing a difficult in financing their operations through Islamic banking products. Since Islamic banking involves purchase and sale of goods, Islamic banks have to pass through government tender and procurement procedures. In addition, the natural monopolies do not allow the purchase certain goods. This puts Islamic banks at a disadvantage vis-à-vis conventional banks that do not have to go through such procedures. There will be no real take-off for large scale corporate raising

their funds through Islamic banking until the legislation is amended to provide a level playing field to Islamic banks.

ŀ     Developing liquid and deep internal market in local currency (tenge) for Islamic

financial institutions

There is no domestic market in tenge for Islamic financial institutions. Islamic financial institutions are not allowed to use traditional financial instruments, and there is lack of Shari’a-compliant market based and market-traded liquidity instruments. One of the best ways to develop Islamic financial products in domestic currency (tenge) would be to issue tenge denominated sukuk for local corporates. The present legislation allows for that.

ŀ     Introducing and streamlining the legislation for sukuk issuance

The present legislation allows for issuance of an asset-backed sukuk only. This implies a mandatory transfer of ownership of the underlying assets to the Islamic special purpose vehicle that would become the issuer. For many government and quasi-government corporates, this is not feasible due to restrictions on the transfer of property and assets. They would be ready to participate in asset-based sukuk programs as they do not require actual transfer of the ownership from originator. Accordingly, the securities legislation should be amended to allow for the issuance of asset-based sukuk as well as their listing and registration on the Kazakhstan Stock Exchange (KASE). The KASE listing and registration procedures should treat Islamic and conventional financial instruments equally. It should also be possible to register and list sukuk issued in other domiciles for the purchase by domestic investors, and to develop the local OTC market for Islamic securities.

ŀ  Issuing the first sovereign sukuk

In 2015, the authorities completed the necessary work to issue sovereign sukuk. The Ministry of Finance has a debut sukuk issue in its plan once the market conditions become favorable.

ŀ Amending the legislation to allow for issuance of fixed fee and covered Islamic

banking cards.

Presently Islamic banks are unable to issue Shari’a-compliant Islamic banking cards, as there are numerous tax and regulatory implications. Developing retail Islamic banking products that form the ground for Islamic banking cards will involve streamlining and amending the corresponding national legislation.

The Way Forward: Ensuring the Level Playing Field for Islamic finance in

Kazakhstan

Establish and Develop Public Awareness Programs and Education Resources

ŀ Potential clients both individuals and legal entities should have basic knowledge about Islamic banking system and financial products. This could take a variety of channels such as the mass media and public education, and specialized providers, both educational and professional providers.

ŀ The NBK and the Government of Kazakhstan are strongly encouraged to move faster with practical design and implementation of programs.

Work with Local Banks

ŀ Local banks must take the lead role in developing new Islamic retail and corporate products in order to reap larger market share. Due to geographical factors, domestic banking system is better developed in the largest cities that are characterized by good infrastructure, higher economic activities and population incomes.

ŀ Most of the native Muslim population resides in rural areas and small towns where access to modern banking services remains difficult. Large local banks with developed branches and regional infrastructure may be able to serve them better.

ŀ Local conventional banks may introduce Islamic windows, thus giving them economies of scale in providing Islamic financial instruments in the best commercial way. As experience of other countries shows, Islamic window is an effective instrument to develop Islamic banking quickly and broadly at the early stages. Once Islamic banking establishes its niche, Islamic windows can be split into separate legal entities or converted into standalone Islamic banks.

Develop Mutual Business with Foreign Partners

Develop joint ventures or strategic alliances between local financial institutions and foreign counterparts to set up Islamic financial institutions. This may take the form of legal incorporation like local Islamic bank (newly established or converted one), or in a less formal way of revenue sharing via agreements to transfer technological know-how and human capital from foreign to local banks.

Develop and promote other Islamic financial intermediaries

Level of penetration in insurance remains low but has huge growth potential. Presently the sector (both conventional and Islamic) constitute less than 1.5% of GDP. Recent IRTI-CIBAFI consumer study showed that 61% of respondents expressed an interest in either becoming customers or getting more information about Islamic finance. Leasing and microfinance companies represent another layer of Islamic financial intermediation. They are not very active now but set to continue growing ahead of market provided they secure adequate and competitive funding. Lack of longer-term Shari’a-compliant tenge and dollar funding remains a key challenge. Kazakhstan is a relatively rich country. It has one of the highest GDP per capita in the region. According to estimates, potential annual zakat collection in Kazakhstan exceeds US$10 million. Presently this amount is not formally collected and distributed efficiently. An efficient and transparent zakat system would help the needy and the poor, support important Islamic charitable and developmental projects and provide the funds for education.

Improve Legislation and Move Towards Kazakhstan’s Model of Islamic finance

The country needs its own authentic model of Islamic finance that is customized to fit with the country’s history, economy, regulatory regime, legal system and financial system. A comprehensive and robust legislation is required. The speedy adoption of legislation on the Astana International Financial Center in 2015 was a good development in this regard.

Stay on the Path. Be Consistent.

Kazakhstan has put a lot of efforts in establishing Islamic finance industry. It has to maintain the momentum to move it forward. It is important to fulfil commitments and achieve targeted milestones. This will attract consumers and businesses to the market which will further accelerate the development of the industry.

Islamic Financial Policy in France

Islamic Financial Policy in France

France has the advantage of having the largest Muslim population in Europe and represents a high level potential in Islamic finance area. According to the Pew Research Center, Muslims will represent 10% of the French population in 2030. With such demographic data, it is obvious that Islamic finance has a bright future ahead in this country. Despite this advantage, Islamic finance has been much slower to develop in France due to largely rigid regulatory standards and lack of legislative accommodations. Since the then France’s economy minister, Christine Lagarde, announced in 2008 her intention of making France more open to Islamic finance her top priority, economic and financial policy has been changing to help Islamic finance find a foothold in the country. Notable developments in France legal framework have been made to better accommodate Islamic financial products and services whereby a series of tax and legislative changes have been implemented to boost the Islamic finance industry. Although French banks control only a negligible share of the Islamic banking sector, the French government believes the sector in France is worth up to 120 billion (US$170 billion) and hopes Paris will take 10% of the global market by 2020.

Policy Changes to Accommodate Islamic Finance

France implemented the first changes in legislation and policy in order to enable Islamic finance transactions in 2008. The changes were related to the listing of sukuk in the French regulated market and, to a lesser extent, reforms regarding fiducie (French trust). At the same time, the Autorité des Marchés Financiers or AMF, the French financial markets’ regulatory authority, announced tax and regulatory changes to facilitate Islamic finance in France. This marks the clear intention of the French government to create in France a hub for Islamic finance. However, AMF involvement in developing Islamic finance was evident as early as 2007 when the French regulator published its recommendation on the regulatory conditions to be met by domestic mutual funds that are Shari’a-compliant. It is no surprise that the first legislative changes to accommodate Islamic finance in France focused on the asset management industry given that the country’s market share of global assets under management (AuM) is 18%, making France a strong market for asset management in Europe. Institutional investors account for about 81% of these managed funds and mandates. At present, there are six Shari’a-compliant funds in France with total AUM of US$147.2 million, which are relatively evenly distributed between money market (47%) and equity (53%).

It should be noted that investment funds structures under the French law are compatible with mudaraba. However, AMF noted that it had to address specific features of Islamic investment funds especially with regards to the fund’s management techniques. Among the requirements, the management company must preserve autonomy with its Shari’a Board. The latter can provide advice and opinion, but are not allowed to interfere in the management affairs of the fund with the ultimate decision rests on the fund manager. The AMF also authorized the purification of asset management funds (i.e. distribution of certain income to charities) provided that this was mentioned in the fund’s prospectus. This is to ensure transparency as well as to protect investors’ interests. The recommendation set forth also relates Islamic mutual funds to ethical funds where AMF noted that it shall treat Shari’a funds in the same manner as

1. Kern, 2011

any other investment funds using extra-financial criteria to build their portfolio, such as social responsibility funds.

In July 2008, the AMF published its position regarding the admission to listing of sukuk on a French regulated market. With this, AMF acknowledged sukuk issuance as either an asset-based or asset-backed structure. It also sets out the level of disclosure required in the sukuk prospectus for each type of sukuk. This was to ensure that sukuk prospectuses are prepared in accordance with European laws and regulations, in particular the Commission Regulation (EU) no. 809/2004 of 29 April 2004 and Directive 2003/71/EC (the Prospectus Regulation). The published statement also requires sukuk issuers to inform the AMF the type of sukuk being listed and the relevant annexes of the Prospectus Regulation with which they are complying when filing the draft prospectus. However, the AMF emphasised that the compliance of the sukuk with Shari’a law does not fall within its ambit. It is the responsibility of the issuers to document relevant information in the prospectus, including appropriate details of the Shari’a board involved in the transaction to enable investors to make informed decisions. With this development the the Bourse de Paris (Paris Stock Exchange) created a Sukuk segment and four tax regulations (relating to murabaha, sukuk, ijarah and istisna products) have been published that confirm a parity of tax treatment with conventional financial products.

In 2009, the French Tax Administration issued guidelines relating to the tax treatment of murabaha and sukuk. Under the French law, a murabaha contract is defined as a sale agreement from a legal standpoint and hence, profit derived from such sale is immediately taxable. This was the major impediment to the use of murabaha contract in the country. Under the new tax treatment on murabaha, taxation of the profit margin generated by the financier shall be taxable on a straight line basis over the life of the murabaha contract regardless of when the amounts are reimbursed on the condition that the contract was properly drafted and specific accounting requirements are met. It should be noted that this is limited to the portion of the profit pertaining to the consideration for the differed payment and not to the portion of the profit relating to the reward of the financier.

In the case of profit margin paid by the French investor company to the financier located outside France, such payment is exempted from French withholding tax according to domestic tax rules (Article 131 quater of the French Tax Code). For French transfer tax purposes, since a murabaha arrangement qualifies as the acquisition and disposal of an asset, this would normally trigger the tax consequences of two consecutive disposals, i.e. 5.19% for each transfer of French real estate and 5% for each transfer of French real estate shares. The tax guidelines provide a favorable tax regime applicable to real estate dealers which avoids any double taxation as regards to transfer fees relating to the two transfers of property (on acquisition and then on resale). Hence, a murabaha arrangement on French real estate shares would only trigger a 5% tax charge once. For the acquisition of a French real estate property, acquisitions made by the financing entity will bear the cadastral tax (0.715%), the registrar’s fee (0.10%) and the notary fees. The guidelines also treat the margin relating to the deferred payment as interest and as such are VAT exempt.

Under the existing tax regime, remuneration paid to the sukuk holders could be considered as a distribution of profit and as such could not be deductible from the issuer’s tax basis.

• Pasquier and Cekici, 2009
• Mohammed, 2014.
• The AMF is also planning to issue other guidelines dealing with other Islamic finance products such as musharaka and mudaraba.
• Landwell & Associés, 2009.

This barrier to sukuk financing was dissuasive for Islamic investors. In the 2009 guidelines, the French Tax Administration confirms that remuneration paid under sukuk or similar debt instruments qualify as interest and hence, are deductible from the taxable basis of the SPV. However, the company interest has to be preserved and sukuk have to comply with ordinary French tax rules regarding limitation of interest deduction provided by Articles 39, 1 3° and 212 of the French Tax Code. VAT exemption could be achieved on the transfer of goods, rights and warranties from the SPV to the fiduciary provided that the transaction is structured appropriately. Remuneration paid to non-French sukuk holders can benefit from the French domestic withholding tax exemption on interest.

In July 2010, the French government enacted an amendment removing Double Stamp Duty to facilitate sukuk issuances. This amendment effectively made sukuk a viable alternative to the conventional bond. With this amendment also, all expenses related to Islamic financial contracts could be exempted in France from the double tax. However, France does not have a trust law that approves dual ownership given that it is a civil law country. An amendment of Article 2011 of the French Civil Code passed by the French National Assembly rectified this issue and was seen as a positive step toward facilitating the origination of sukuk out of France.

In November 2011, Paris Europlace launched the French Sukuk guide to support the issuance of sukuk in France. The guide explains how the French legal, regulatory, and tax frame-works operate for sukuk issuance as well as documentation requirements put forth by AMF. In 2011, the first French sukuk with a value of US$6 million was issued by French halal food specialist, Bibars, to finance the opening of its new restaurant in Paris. The first green sukuk was also issued out of France. The Orasis Sukuk, launched by Legendre Patrimoine, was for the financing of solar panels and takes the form of ownership rights that can be acquired by individual and institutional investors alike. In June 2011, the first Islamic deposit scheme was introduce and operated by Chaabi Bank (French subsidiary of the Moroccan bank) via its Islamic window. Following this successful launch, the bank launched an Islamic home finance product, a 10-year murabaha contract a year later. Currently, there are plans to launch a similar Shari’a-compliant deposit scheme aimed at small and medium-sized enterprises.

French Players in the Global Islamic Finance

With favorable environment for Islamic finance to thrive and strong political will from the government to introduce Islamic finance in the country, several French players have emerged in recent years to capitalize on the industry’s robust growth prospects. Societe Generale, French’s third largest bank by assets, announced it has received approval from Bank Negara Malaysia and the Securities Commission to launch a sukuk program in June 2014. The proposed program would have a nominal value of US$314.82 and a tenure of up to 15 years, with the first tranche to be launched in July. Although the planned issuance did not materialized, the bank affirmed that it will continue to strengthen its Islamic finance capabilities and presence. Other French banks that are actively involved in the Islamic finance industry are BNP Paribas Najmah and Credi Agricole, but have remained active overseas rather than in the domestic market. These banks provide a range of Islamic financing solutions including Shari’a-compliant investments, wealth management and asset management. Active in the Islamic finance industry since the early 1980s especially in the sukuk market, BNP Paribas was among the leading banks to recognize the importance of Islamic banking.

In 2003, it established BNP Paribas Najmah, the group’s global Islamic banking division, in Bahrain and later in Malaysia in 2011. In 2009, BNP Paribas Investment Partners, was granted license to set up an Islamic Asset Management company by Securities Commission Malaysia. With this, BNP Paribas Investment Najmah was established. Similar to BNP Paribas, Credit Agricole’s offers a wide range of Shari’a-compliant financial products and services out of France. Headquartered in Dubai, Credit Agricole CIB provides expertise in syndicated financing, project and structured finance and sukuk issuance. Credit Agricole also has a stake in Banque Saudi Fransi, a Saudi Joint Stock Company. The Saudi-based bank offers a wide range of commercial banking services including Islamic banking. 13 of its 83 branches are dedicated Islamic branches. In 2009, the group set up its first Islamic fund, Crédit Agricole Asset Management (CAAM), which is domiciled in Luxembourg and Amundi Islamic was established in August 2010 following the merger of Société Générale Asset Management and CAAM.

The takaful sector in France is still in its nascent stage. There is no global takaful solution in France and currently takaful solutions exist only within three life insurance contracts: “Salam Epargne et Placement” by Swiss Life; “Amane Executive Life” by Vitis Life; and “Ethra’a Takaful Famille” by FWU AG. These family takaful contracts do not contain either death claim payment or life annuity and were validated by the Independent Committee of the Islamic Finance in Europe. Similar to the takaful sector, Islamic banking in France is served by foreign banks (e.g. from North-Africa or Middle East) that provide retail Islamic finance products via their European affiliates in France.

Opportunities and Challenges for Islamic Finance in France

According to report published by the European Central Bank in 2013, there is huge potential for Islamic finance to flourish in France. Overtime, France could overtake the UK in developing Islamic finance as a viable alternative financial system. The French government’s interest in Islamic finance is due to its keen interest to attract investors from Gulf countries to the Paris market. It is forecasted that France may attract US$120 billion in Islamic assets through lending and investments in French businesses, property, and financial markets by 2020. However, it is highly likely that a French Islamic financial sector would be markedly different that Islamic

1. Grassa and Hassan, 2015

financial hubs the likes of Dubai and Malaysia. A French Islamic financial hub would be based more on the notion of ethical finance.

Despite its favorable demographic advantage and somewhat conducive regulatory environment, the development of Islamic finance in France still lags behind in comparison to its other European peers. While Islamic finance could be an avenue for the country to tap petrodollars, the nation may have reservations toward taking that path considering its political, religious and social dynamics.