Maan Barazy 's Islamic Finance and Challenges in the 2013

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This is a presentation given int he UAB conference in baghdad on Jan 11 2013 to highlight the challenges of islamic Finance Notably : World Economy Financial Slowdown Financial Regulation and the New Financial Architecture The New Risk Management precepts – Basel III what does it mean for Ibs Banks Exposure to Sovereign Islamic Capital Markets The Rise of Sukuk and Defaults The Infancy? of the Industry – the Need for Scholars and Economists What’s in it for Iraq? Conclusion and Recommendations

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Islamic Finance 2.0 and Capital Markets Integration Challenges presented to the Union of Arab Banks conference Baghdad January 11-12th:

Islamic Finance 2.0 and Capital Markets Integration Challenges presented to the Union of Arab Banks conference Baghdad January 11-12th Ma’an Barazy Specialist in Financial Economist and Islamic banking product auditing Certified Shari'a Adviser and Auditor (CSAA- AAOIFI Certified) - MA Islamic Comparative Jurisprudence  - BS International Economics Managing Partner And CEO of Data and Investment Consult-Lebanon – The Centre For Islamic Finance - Consultant Researcher and Lecturer Please maanbarazy@gmail.com

Outline:

Outline World Economy Financial Slowdown Financial Regulation and the New Financial Architecture The New Risk Management precepts – Basel III what does it mean for Ibs Banks Exposure to Sovereign Islamic Capital Markets The Rise of Sukuk and Defaults The Infancy? of the Industry – the Need for Scholars and Economists What’s in it for Iraq? Conclusion and Recommendations

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The Race for New Markets Architecture or Submission? The Race for New Instruments The Rise of Debt The Conflict of Governance and Standards

The Flight to safe capital ample liquidity risk management standards:

The Flight to safe capital ample liquidity risk management standards

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Global Economic Outlook 2012 The global economy is on a narrow path of slow and fragile recovery Oil and commodity prices remain high and will continue to put further pressure on the global economy South Africa’s robust financial institutions and moderate fiscal and external debt absorbed the impact of the global downturn to a large extent. However, the country needs to address its structural challenges including, unemployment, education and inequality in order to be a global economic player

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Global outlook Source: Economic Intelligence Unit, March 2012

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Global outlook Source: Economic Intelligence Unit, March 2012 The global economy is on a narrow path of slow and fragile recovery. Many countries are struggling with a massive debt burden and high unemployment persisting to bog down their economies and hampering growth. Oil and commodity prices remain high and will continue to put further pressure on the global economy

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Changes in global economic risks North American region Asia pacific region Middle East region African region Latin America & the Caribbean region Greater Russia region Europe region Source: Energy Policy Scenarios to 2050, World Energy Council (values in mn tonnes) Production (Mn tonnes) Consumption (Mn tonnes) Compounded annual growth rate consumption Legend 0.9% 1.8% 1.2% 0.8% - 2.4% - 1.2% - 0.9%

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Energy intensity Economic growth is closely related to growth in energy consumption because the more energy is used, the higher the economic growth. However, it is possible to decouple energy consumption and economic growth to some extent. More efficient use of energy may entail economic growth and a reduction in energy use. Economist Intelligence Unit, KPMG calculations

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Global outlook Emerging Markets The BRIC countries are recognised as having very large economies and populations, with unravelled growth potential in foreseeable years. The Brazilian economy experienced rapid expansion in the last decade with strong economic growth Russia experienced strong economic growth over the past few years, but manufacturing and foreign investment slowed down since the global downturn. BRICS The Next 11 consist of South Korea, Iran, Mexico, Turkey, Philippines, Indonesia, Egypt, Nigeria, Pakistan, Vietnam and Bangladesh. These economies are smaller in size than the BRIC countries, but with its large population size and growth rates of above the global average, promises favourable opportunities for future investment and market growth. The Next 11 Fears surrounding an economic downturn have lead EM central banks to either cut their interest rates or postpone monetary tightening during 2011. Market expectations are that EM countries will outperform developed countries between 2013 - 2016, as interest rate differentials will favour investment into these EM countries over that of the OECD economies.

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Where are we now? 2001 - 2010 2011 – 2015 : Forecast 2001 - 2010 2011- 2015 China 9.5 Nigeria 6.8 Zambia 6.9 Tanzania 7.2 India 8.2 Congo 7.0 Vietnam 7.2 Angola 11.1 Rwanda 7.6 Cambodia 7.7 Nigeria 8.9 Kazakhstan 8.2 Ethiopia 8.4 Myanmar 10.3 China 10.5 Chad 7.9 Mozambique 7.9 Ethiopia 8.1 Mozambique 7.7 Ghana 7.0 Source: IMF World Economic Outlook, February 2012 Most of the fastest developing economies are in the Sub- Saharan region

Risk factors the oil price, a hidden tax on consumption:

17 * Real oil price above the maximum of the previous 4 quarters Source: Datastream, Julius Baer Risk factors the oil price, a hidden tax on consumption

Islamic Finance A Niche in the World Economy :

Islamic Finance A Niche in the World Economy Liquidity Position of Islamic banks

Flow of Islamic Funds:

Flow of Islamic Funds

The State of the Economy Banks vs the Financial Slowdown:

The State of the Economy Banks vs the Financial Slowdown A Decline in cross border investments A rise of new bubbles

Did I say enough about the eurocrisis??? Its implication on Arab banking??:

Did I say enough about the eurocrisis ??? Its implication on Arab banking??

Outline:

Outline World Economy Financial Slowdown Financial Regulation and the New Financial Architecture The New Risk Management precepts – Basel III what does it mean for Ibs Banks Exposure to Sovereign The Rise of Sukuk and Sukuk Defaults The Infancy? of the Industry – the Need for Scholars and Economists What’s in it for Iraq? Conclusion and Recommendations

Basel 3 versus Dodd Frank:

Basel 3 versus Dodd Frank Dodd Frank an Act to promote the financial stability of the United States by improving accountability and transparency in the financial system, to end "too big to fail", to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes.

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Basel III's liquidity coverage ratio and the "bona fide liquidity management" exception in the Volcker Rule are poised to conflict. Currently, these assets, which would be mostly sovereign debt and cash, will have to meet four criteria: Low correlation with risky assets Low credit and market risk Ease and certainty of valuation Listed on a developed and recognized exchange market

Appendix A: Basel III – Phase-In:

38 Appendix A: Basel III – Phase-In 2011 2012 2013 2014 2015 2016 2017 2018 As of 1 January 2019 Leverage Ratio Supervisory monitoring Parallel run 1 Jan 2013 – 1 Jan 2017 Disclosure starts 1 Jan 2015 Migration to Pillar 1 Minimum Common Equity Capital Ratio 3.5% 4.0% 4.5% 4.5% 4.5% 4.5% 4.5% Capital Conservation Buffer 0.625% 1.25% 1.875% 2.50% Minimum Common Equity Plus Capital Conservation Buffer 3.5% 4.0% 4.5% 5.125% 5.75% 6.375% 7.0% Phase-in of Deductions from CET1 (Including Amounts Exceeding the Limit for DTAs, MSRs and Financials) 20% 40% 60% 80% 100% 100% Minimum Tier 1 Capital 4.5% 5.5% 6.0% 6.0% 6.0% 6.0% 6.0% Minimum Total Capital 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% Minimum Total Capital Plus Conservation Buffer 8.0% 8.0% 8.0% 8.625% 9.25% 9.875% 10.5% Capital Instruments That no Longer Qualify as Non-core Tier 1 capital or Tier 2 capital Phased out over 10 year horizon beginning 2013

Appendix B – Capital Surcharge:

39 Appendix B – Capital Surcharge Category (and weighting) Individual Indicator Indicator Weighting Cross-jurisdictional activity (20%) Cross-jurisdictional claims 10% Cross-jurisdictional liabilities 10% Size (20%) Total exposures as defined for use in the Basel III leverage ratio 20% Interconnectedness (20%) [1] Intra-financial system assets 6.67% Intra-financial system liabilities 6.67% Wholesale funding ratio 6.67% Substitutability (20%) Assets under custody 6.67% Payments cleared and settled through payment systems 6.67% Values of underwritten transactions in debt and equity markets 6.67% Complexity (20%) OTC derivatives notional value 6.67% Level 3 assets 6.67% Trading book value and Available for Sale value 6.67% [1] Securities finance transactions with other institutions are expressly included. For each bank, the score for a particular indicator is calculated by dividing the individual bank amount by the aggregate amount summed across all banks in the sample for a given indicator. The score is then weighted by the indicator weighting within each category. Then, all the weighted scores are added. For example, the size indicator for a bank that accounts for 10% of the sample aggregate size variable will contribute 0.10 to the total score for the bank (as each of the five categories is normalized to a score of one). Similarly, a bank that accounts for 10% of the aggregate cross-jurisdictional claims would receive a score of 0.05. Summing the scores for the 12 indicators gives the total score for the bank. The maximum possible total score (i.e., if there were only one bank in the world) is five.

A postponment of Basle3 rules:

A postponment of Basle3 rules On January 6 th the BIS decided on a postponment of the applicability of basel 3 rules Stiff liquidity norms or Liquidity Coverage Ratio (LCR) for banks, that were to kick in from 2015, has been extended till 2019. Banks to hold stocks of easy-to-sell assets to help them survive a market crisis The complete set of changes is on the BIS website, but here are some highlights. First, the full implementation has been delayed from 2015 to 2019; banks will only need to meet 60 per cent of the requirements by 2015. Second, the assets. Previously, qualifying assets were mostly limited to cash, government debt, reserves at central banks and some corporate bonds rated AA- or higher. But now banks now can hold the following securities for up to 15 per cent (after haircuts) of their high-quality liquid assets: - Corporate debt securities rated A+ to BBB– with a 50% haircut - Certain unencumbered equities subject to a 50% haircut - Certain residential mortgage-backed securities rated AA or higher with a 25% haircut

AUDITNG; CRISIS AND The Rise of the Islamic Standards !:

AUDITNG; CRISIS AND The Rise of the Islamic Standards !

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Overview of AAOIFI Standards AAOIFI AAOIFI is responsible for developing and issuing standards for international Islamic finance industry. Supported by over 200 institutional members from over 45 countries. Members are central banks, regulatory authorities, financial institutions, accounting & auditing firms, legal firms, etc.

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Overview of AAOIFI Standards (cont’d) Standards 44 Shari’a standards. 27 accounting standards. 5 auditing standards. 7 governance standards. 2 codes of ethics. In addition, new standards are being developed and existing standards reviewed.

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Overview of AAOIFI Standards (cont’d) Adoption of standards AAOIFI standards have been followed – as part of regulatory requirement, or internal guidelines – by leading Islamic financial institutions throughout the world . Also adopted by Islamic Development Bank Group.

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Overview of AAOIFI Standards (cont’d) Application of standards Expertise for technical application of standards is supported by AAOIFI’s professional development qualification programs: Certified Shari’a Adviser and Auditor (CSAA). Certified Islamic Professional Accountant (CIPA). AAOIFI has also launched Contract Certification Program.

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Development of AAOIFI Standards Technical Infrastructure for Accounting Standards Accounting and Auditing Standards Board Ultimate authority on accounting, auditing, ethics, and governance standards. Comprises Shari’a scholars and senior representatives of regulatory authorities, Islamic financial institutions, accounting and auditing firms, legal firms, etc. Accounting Standards Committee Sub-committee of the Accounting and Auditing Standards Board. Working group on development of accounting, auditing, ethics and governance standards.

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Preliminary study Based on suggestions from industry and standards committee and board. Study is submitted for discussion at standards committee and board. Also applies to review of existing standards. Exposure draft Prepared by consultants. Discussions with industry. Draft preparation overseen by standards committee. Draft is subject to standards board’s approval. Draft is distributed to industry and submitted to public hearing. Approval of standard Final version of standard takes into account comments from industry and public hearings. Standard is subject to standards board’s approval. Publication of standard Standards are issued through AAOIFI’s standards publications. Announcements on approval and issuance of standards carried out in industry publications, etc. Development of AAOIFI Standards

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How AAOIFI Standards Support Islamic Finance Industry AAOIFI standards reflect concept and essence of Islamic finance transactions. And bring about harmonisation of Islamic finance practices. Enhance confidence of users of Islamic finance products. Promote growth of demand for Islamic finance.

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AAOIFI standards also ensure convergence of financial reporting by IFIs. And introduce greater clarity to the financial reports of IFIs. Promote better view of financial performance of IFIs. Enhance transparency of financial reports. How AAOIFI Standards Support Islamic Finance Industry (cont’d)

Outline:

Outline World Economy Financial Slowdown Financial Regulation and the New Financial Architecture The New Risk Management precepts – Basel III what does it mean for Ibs Banks Exposure to Sovereign Islamic Capital Markets The Rise of Sukuk and Defaults The Infancy? of the Industry – the Need for Scholars and Economists What’s in it for Iraq? Conclusion and Recommendations

Understanding the New Risks:

Understanding the New Risks

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State of Islamic Finance 2012 – Positioning of MENA and Gulf banks

Regarding Islamic asset management industry, there are common perceptions: :

Regarding Islamic asset management industry, there are common perceptions: Islamic Asset Management Today: Comparatively Small Size of Islamic Asset Management: →USD 52.3 billion, 5.5% of total Islamic Financial Assets (USD 1 trillion) Conventional vs Islamic mutual funds: →about 70,000 conventional funds worth >USD 20 trillion vs approximately 750 Islamic funds worth USD 30 to 50 billion Source: Zawya , Eurekahedge , Ernst & Young “Islamic Funds & Investments report 2010” , John A. Sandwick analysis

Islamic Asset Management Today : AUM Trend Comparison:

Islamic Asset Management Today : AUM Trend Comparison

Concentrated in Traditional Asset Classes & GCC Countries:

Concentrated in Traditional Asset Classes & GCC Countries

Potential Shariah sensitive assets estimated by Ernst & Young is approximately USD 360 – 480 billion based on 2009 survey figures, indicating about 7 - 9 times potential in size compared to current Shariah compliant AUM.:

Potential Shariah sensitive assets estimated by Ernst & Young is approximately USD 360 – 480 billion based on 2009 survey figures, indicating about 7 - 9 times potential in size compared to current Shariah compliant AUM.

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prohibited sectors NGOs not-for-profits SOCIAL IMPERATIVE ZONE OF SUSTAINABILITY Islamic businesses ECONOMIC IMPERATIVE Market - driven yet values - based G radualist and evolutionary nature S ymbiotic and synergistic relationship with mainstream finance Islamic Financial Institutions are positioned in a “zone of sustainability” Islamic finance characteristics:

Industry has advanced from niche to critical mass:

Market size estimated at USD 750 billion globally 1 Growing at 15 to 20% per annum 1 Within 8-10 years, industry estimated to capture half the savings of the 1.6 billion Muslim world 2 Young industry Mitghamr Savings Associations (1963) & Tabung Hajji Malaysia (1967) Islamic Development Bank (1974) & Dubai Islamic Bank (1975) Industry has advanced from niche to critical mass Market-driven proposition Retail customers historically the backbone of the industry Tipping point in retail sector: Saudi Arabia, UAE, Bahrain and Kuwait Self-regulating organisations, Standards bodies and Research and Training Institutes Global scale More than 250 Islamic banks worldwide operating in over 75 countries 3 GCC accounts for two-thirds of global Islamic assets * Malaysia leading industry maturity and sophistication Islamic Development Bank: largest pan-OIC financial institution Industry is fragmented, with slowly internationalising players Source:1: S&P Report ( 31 Aug 2006); 2: IIR Middle East (Apr 2006); 3 Bursa Malaysia “The Islamic Capital Market” 2005; * HSBC analysis 66% growth 33% growth Islamic banking assets as proportion of total (%) * 40% 20% 12% 30%

Industry has developed a comprehensive product offering over its young history:

Industry has developed a comprehensive product offering over its young history 1950s 60s 70s 80s 90s 00s Egypt and Malaysia pioneering institutions Establishment of OIC (1969) Development of theoretical framework Muslim-majority nation independence Islamic Development Bank (1974) and DIB One country-one bank setup Advancement of Islamic products Full “Islamization” of Pakistan, Sudan and Iran Entry of global institutions, e.g. HSBC Tipping point reached in some markets Development of industry-building institutions 1970s commercial banking insurance 1980s syndications structured and trade finance 1990s equity private equity project finance debt issues 2000s structured products 1970s 1980s 1990s 2000s Evolving richness in products Development of industry Industry has near like-for-like parity with conventional offering

Self-regulatory organizations bring credibility through standardization of practices:

GCIBFI (2001) Bahrain Promoting industry in theory and practice Disseminating Shariah concepts & multilateral understanding between IFIs and public Improving IFI practices, cooperation, professionalism and transparency IIFM (2001) Bahrain Development of global Islamic capital and money market Promoting active and regulated trading and capital flows Catalyzing trading infrastructure, product innovation and information flows Self-regulatory organizations bring credibility through standardization of practices AAO-IFI (1991) Bahrain Benchmark of Islamic accounting standards 56 accounting, auditing, governance and Shariah standards Enhancing clarity, transparency and harmonisation IIRA (2005) Bahrain Reference point for IFI ratings Issuing sovereign, credit, Shariah quality and corporate governance ratings Providing effective tool for informed investment decision-making IFSB (2002) Malaysia Standard-setting body of regulatory and supervisory agencies Complementing Basel II Capital Accord Key standards: risk management, capital adequacy & corporate governance LMC (2002) Bahrain Creation of active Islamic inter-bank market Creating secondary market for short-term Shariah-compliant treasury products Enabling IFI management of liquidity mismatch

Multinational banks have gradually increased their focus on Islamic finance:

Multinational banks have gradually increased their focus on Islamic finance Mainstream institutions are embracing Islamic banking Ad hoc participation Correspondent banking for IFIs Tailored Private Banking services for HNWIs Islamic client services Dedicated Relationship Managers for IFIs Dedicated Private bankers for HNWIs Islamic window model Committed unit for Islamic financial services Citi Islamic (1996), HSBC Amanah (1998) Dedicated Islamic subsidiary Islamic subsidiaries of conventional banks Joint ventures and partnerships Market entry strategy Defensive strategy Proactive strategy Service and retain existing Muslim clients Refine current proposition to reflect local needs Particularly important and economic clout of locals increased Protect and embed the brand Acquire new customers, especially wealthy locals Build a sustainable community banking proposition Benefit from higher growth rates of emerging markets Crucial as developed market growth slows Evolving commitment

The industry has not yet reached its potential:

Within 8 to 10 years, as much as half the savings of the world’s then 1.6 billion Muslims would be in Islamic banks 1 The global Islamic insurance ( Takaful ) market is estimated to reach USD 14.4 billion by 2010 1 Most Islamic financial institutions are highly liquid , and seek new asset classes and markets to diversify Project finance requirements of USD 500 billion in 5 years 2 Capital markets developments: Malaysia – Sukuks account for 71% of 1H06 debt issues 3 Islamic finance has also gained popularity in Muslim-minority countries Germany issued the first Islamic Eurobond (2004) UK’s first standalone Islamic bank (2004) Trends of convergence and conversion Ethical investing, community banking Conversion of banks: e.g. National Bank of Sharjah , Bank al Jazira , Dubai Bank The industry has not yet reached its potential Source: 1: IIR Middle East (Apr 2006); 2 Banker ME (June 2006); 3 RAM Islamic Ratings Services (2006)

The economic downturn has hardly left Islamic instruments unscathed. :

The economic downturn has hardly left Islamic instruments unscathed. Many investors in Islamic instruments are already overly exposed to real estate and related sectors that have yet to rebound from the downturn. The Sukuk market has also been affected, and while some recovery is in sight, sovereign issuers are outnumbering corporate ones. Meanwhile, some of the principles behind Shari’a compliance, including those that prohibit Islamic funds from investing in sectors ranging from pork and alcohol to significant parts of the financial service sector, raise diversification issues. With industries such as gaming and alcohol off limits, Islamic fund managers need to be careful to avoid real estate developments that include gambling or alcohol retail outlets or even conventional banks. More significantly, the overall lack of standardization in Islamic finance means that individual instruments often need to be structured in a piecemeal fashion, which makes them more costly at the outset.

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A successful roll-out of Islamic banking system could easily see the industry in Oman gaining up to US$6 billion in Islamic assets over next few years, according to estimates by Ernst & Young’s Islamic Financial Services Group (IFSG). Total banking assets in Oman in 2010 were estimated to be US$42 billion. Shari’a -compliant financial institutions, which are expected to commence operation in the country within a short period, are expected to capture a substantial share of this market and of total banking assets within a few years.

Regional & Global Sharia-Compliant Assets 2007 - 2010:

Regional & Global Sharia -Compliant Assets 2007 - 2010

Outline:

Outline World Economy Financial Slowdown Financial Regulation and the New Financial Architecture The New Risk Management precepts – Basel III what does it mean for Ibs Banks Exposure to Sovereign Islamic Capital Markets The Rise of Sukuk and Defaults The Infancy? of the Industry – the Need for Scholars and Economists What’s in it for Iraq? Conclusion and Recommendations

Banks Exposure to Sovereign :

Banks Exposure to Sovereign The financial crisis and the subsequent recession have caused a sharp deterioration in public finances across advanced countries, raising concerns about sovereign credit risk. Sovereign risk is already a major issue in the Eurozone, where three countries have received international assistance, and others have seen their credit ratings lowered during 2009-11 and/or their funding costs rise.

Debt to GDP Ratio (2010):

Debt to GDP Ratio (2010)

Size of the Problem Total of portugal,italy,spain,greece,= .160+1.84+.641+0.329=2.97 trillion (2010) :

Size of the Problem Total of portugal,italy,spain,greece ,= .160+1.84+.641+0.329=2.97 trillion (2010)

Future scenarios :

Future scenarios

Outline:

Outline World Economy Financial Slowdown Financial Regulation and the New Financial Architecture The New Risk Management precepts – Basel III what does it mean for Ibs Banks Exposure to Sovereign Islamic Capital Markets The Rise of Sukuk and Defaults The Infancy? of the Industry – the Need for Scholars and Economists What’s in it for Iraq? Conclusion and Recommendations

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Islamic Finance is rapidly emerging in new territories! Geographic expansion of Islamic Finance

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What makes Islamic finance different? The Five Pillars of Islamic Finance 1- Prohibition of interest 2- Prohibition of speculation 3- Prohibition of the financing of illicit sectors (pork, weapons, alcohol,…) 4- Profit & Loss sharing principle 5- Asset backing principle Islamic finance is not restricted to Muslims (the “natural” clients) as some of its principles may attract non-Muslim clients. Islamic Finance At A Glance

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We note that Islamic banks have no exposure to structured investment products (CDOs, SIVs and ABS…) and have not been directly affected by the decline of the value of these products. We note that Islamic banks are not risk free , however, as one of the principles of Islamic Finance requires that participants in each transaction share risks and rewards (profit & loss sharing principle). In our view, one of the main sources of risk for Islamic banks in the Gulf stems from their high exposure to the real estate sector (Dubai, in particular). Given the outlook for real estate sector in Dubai, for example, Standard & Poor’s took rating actions on Dubai-based banks, including the downgrade and the change of outlook to negative from stable on Dubai Islamic Bank (BBB+/Negative/A-2). Some Islamic banks are also under pressure due to: 1- Liquidity drying-up and their reliance on wholesale funding; and 2- Their exposure to the U.S and Europe through private equity, real estate, and asset-based investments.

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S&P’s expectations for rated Islamic banks (2009-2010) 1- Weaker financial performance as the economic environment has deteriorated (slowdown in business volumes, lower fees and commissions, higher price competition, higher provisioning needs…). 2- Weaker asset quality indicators. 3- More conservative approach toward growth, as liquidity is scarce and more expensive.

The European Experience:

The European Experience Target Market: Muslim population in Selected European Countries Total population Mil. (2008) % of Muslim population (Est.) Total Muslim population Mil. (Est.) GDP Per capita $ Est. (2009) Belgium 10.7 3.6 0.4 42,965 France 62.0 10.0 6.2 42,091 Germany 82.2 3.7 3.0 39,442 Netherland 16.4 5.4 0.9 47,042 Switzerland 7.6 3.1 0.2 66,127 Italy 59.9 2.4 1.4 34,955 Spain 46.5 1.2 0.6 31,142 United Kingdom 61.3 2.8 1.7 35,728 More than 14 million potential customers in the selected countries sample. Average GDP per capita of $42 K in 2009. Islamic Finance is not restricted to Muslims!

The European Experience:

The European Experience 2- Wholesale banking: corporate and project financing - SMEs financing, large corporate financing, foreign direct investment in Europe, private equity. Example: Viridian PLC acquired by Arcapita in the U.K. ($4.2 billion); CEPL acquisition in France by Arcapita ($450 million), etc. 3- Access to Islamic capital markets U.K. government plan to issue Sukuk, “rumors” on Sukuk issuance out of France, Switzerland… Investor base diversification and attraction of institutional investors (incl. Sovereign Wealth Funds).

The European Experience:

The European Experience Major hurdles/unanswered questions 1- Demand quantification: in the GCC, the offer created its own demand, is it replicable in Europe? 2- Regulatory environment: tax neutrality of Sharia compliant transactions, regulation of Islamic banks... 3- Political environment: launch of Sharia compliant operations in secular countries for example; necessity of political stakeholders’ support. 4- A common strategy for the E.U.? 5- Specific weaknesses of Islamic finance: standardization of products, Sharia interpretation, lack of qualified human resources, lack of liquidity instrument management, small size of the Sukuk market... Observations 1- IFOP : 47% of the sample are interested in Sharia compliant saving products; 55% in Sharia compliant financing. 2- Efforts deployed by U.K. and French regulators to render the environment more friendly. 3- France and U.K. communication from the top level of the state in favor of the development of Islamic Finance. 5- Efforts being deployed by stakeholders to overcome these hurdles.

The European Experience:

The European Experience Our opinions 1- Islamic finance development is expected to be gradual starting with wholesale activities and possibly retail offering in a second step (including the recycling of immigrants deposits and funds transfers as Islamic finance begins to emerge in home countries, mainly in Africa). 2- More private equity and FDI transactions from the Gulf states and other Muslim countries to Europe (mature economies, strong legal environment, still untapped opportunities...). 3- European banks to continue playing an important role in complex financial transactions and Sukuk structuring.

Sukuk Market At A Glance:

Sukuk Market At A Glance A sukuk is a Sharia compliant debt instrument that allows an entity to raise funds. Main reasons for Sukuk issuance: Size: limited access to bank financing (regulation limiting concentration, loan to deposit ratio limits). Cost of funding: desintermediated financing. Maturity: longer than bank loans. Sharia compliance: Sharia-compliant financing (if the structure is approved by Sharia board).

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Commercial Banking Commercial Banking Project Finance & Syndications Commercial Banking Project Finance & Syndications Equity Ijarah Commercial Banking Project Finance & Syndications Equity & Funds Ijarah Sukuk ( Ijarah , Musharaka , Istisna ) Structured Alternative Assets Commercial Banking Project Finance & Syndications-Investment Banking Equity/ Funds/ Securities/ Indexes Sukuk (Common & Hybrid) Structured Alternative Assets Liquidity Management Tools Takaful & Re-Takaful Hedging & Risk Management 1970’s 1980’s 2007+ 2000’s 1990’s Evolution of Islamic Finance Industry & Islamic Capital Markets 98

Islamic Capital Market Products vs Conventional Products :

Islamic Capital Market Products vs Conventional Products 99

Islamic Capital Market Products vs Conventional Products :

Islamic Capital Market Products vs Conventional Products 100

Overview & Trends in the Global Sukuk Market :

Overview & Trends in the Global Sukuk Market Sukuk Emergence Sukuk Ruling (The Fiqh Academy of the OIC ) Shell MDS RM125 Million Sukuk Issue (based on BBA structure) Kumpulan Guthrie $100 Million Malaysian International Sukuk Issue ( Ijarah structure) Short-term Ijarah Sukuk by Central Bank of Bahrain International Sukuk Issuances in Bahrain, Pakistan, Indonesia, UAE, Germany, Qatar, Saudi Arabia Sukuk Issuance by IDB First International Sukuk issued in Indonesia IFC Sukuk $ 100 Million GE Sukuk $ 500 Million KT Turkey Sukuk Limited $100 Million 1988 1990 2001 2002 > 2009 2010 101

Overview & Trends in the Global Sukuk Market:

Overview & Trends in the Global Sukuk Market Total Global Sukuk Issuance Sovereign, Quasi Sovereign & Corporate Issue (All currencies), Period 1 st Jan 2001 – 31 st Dec 2010 102

Overview & Trends in the Global Sukuk Market:

Overview & Trends in the Global Sukuk Market Country-wise Breakdown of Total Global Sukuk Issuance by Volume Sovereign, Quasi Sovereign & Corporate Issue (All currencies), Period 1 st Jan 2001 – 31 st Dec 2010 Country Number of Issues Volume (US $ Million) % of Total Value Malaysia 1592 115393.76 58.51% UAE 41 32201 16.33% Saudi Arabia 22 15351.88 7.78% Sudan 22 13057.713 6.62% Bahrain 125 6291.69 3.19% Indonesia 70 4658.5 2.36% Pakistan 35 3447.207 1.75% Qatar 6 2500.79 1.27% Kuwait 9 1575 0.80% Brunei Darussalam 21 1175.91 0.60% USA 3 767 0.39% UK 2 271 0.14% Singapore 5 191.96 0.10% Germany 1 123 0.06% Turkey 1 100 0.05% Japan 1 100 0.05% Gambia 7 2.086 0.00% Grand Total 1963 197208.496 100.00% 103

Overview & Trends in the Global Sukuk Market:

Overview & Trends in the Global Sukuk Market Breakdown of Total Global Sukuk Issuance by Issuer Status Sovereign, Quasi Sovereign & Corporate Issues (All currencies) by Volume (Period 1 st Jan 2001 – 31 st Dec 2010) International Sukuk Domestic Sukuk 104

Overview & Trends in the Global Sukuk Market:

Overview & Trends in the Global Sukuk Market Structural Breakdown of Total Global Sukuk Issuance by Volume Sovereign, Quasi Sovereign & Corporate Issue (All currencies), Period 1 st Jan 2001 – 31 st Dec 2010 International Sukuk Domestic Sukuk 105

Overview & Trends in the Global Sukuk Market:

Overview & Trends in the Global Sukuk Market Structure Developments International Corporate Sukuk Issues 2001 – 2005 Ijarah (Dominant structure) 2005 – Q2 2008 Musharaka , Mudaraba , Exchangeable, Convertible Q2 2008 – Dec 2010 Ijarah , Murabaha and Wakala 106

Overview & Trends in the Global Sukuk Market:

Overview & Trends in the Global Sukuk Market Structure Developments – Lessons from Corporate Issuance Sukuk Defaults and Restructuring Investment Dar (Kuwait) East Cameron (US) Golden Belt (Saudi Arabia) Tabreed (UAE) $463 Million IIG (Kuwait) 107

Overview & Trends in the Global Sukuk Market:

Overview & Trends in the Global Sukuk Market Structure Developments – Lessons from Corporate Issuance Asset Based vs Asset Backed Are Sukuk holders investment pari pasu with other secured or unsecured creditors? Do Sukuk holders have title transfer? In case of Real Estate, is property freehold? 108

Overview & Trends in the Global Sukuk Market:

Overview & Trends in the Global Sukuk Market Sukuk Trends – Impact Due To Downturn International Sukuk Issuance 2007 - $ 13.8 billion 2008 - $ 2.15 billion 2009 - $ 7.5 billion 2010 - $ 5.35 billion 109

Overview & Trends in the Global Sukuk Market:

Overview & Trends in the Global Sukuk Market Sukuk Trends – Shariah Impact Example GCC Gulf Holding Company Sukuk , $190 million ( Musharaka Structure) Adjustment due to AAOIFI Shariah Ruling - Purchase undertaking does not specify purchase price and linking of redemption and periodic profit payments to the projects profitability - Use of Standby Letter of Credit as a ‘Security Package’ 110

Overview & Trends in the Global Sukuk Market:

Overview & Trends in the Global Sukuk Market Developments in Sukuk Market Call back of a portion of Sukuk Dubai Islamic Bank $200million - Cash tender offer @ 88% of face value Sukuk Issuance based on Reverse Enquiry Monetary Authority of Singapore Domestic Retail Sukuk Issuance Indonesia Islamic Government Investment Securities Issuances State Bank of Pakistan Investment Sukuk Issuance Islamic Development Bank Fixed Rate of Profit Issuances Bahrain, Indonesia and IFC Sukuk 111

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Main developments/Hurdles 1- Sukuk default (The Investment Dar, East Cameron Gas, Golden Belt…). 2- Comments made by AAOIFI regarding the Sharia compliance of sukuk issued so far and lack of standardization. 3- Low liquidity of the sukuk market (mostly OTC instruments) Efforts deployed/Conclusions 1- Default is providing the market with interesting information on Sukuk resolution (access to the underlying assets; guarantee enforcement, etc.) 2- AAOIFI will screen products for Sharia compliance and the National Sharia Advisory Council of Bank Negara Malaysia have the status of final arbiter for Sharia compliance. 3- Creation of Saudi Sukuk and bond market (might help improving the liquidity of sukuk listed there).

Outline:

Outline World Economy Financial Slowdown Financial Regulation and the New Financial Architecture The New Risk Management precepts – Basel III what does it mean for Ibs Banks Exposure to Sovereign Islamic Capital Markets The Rise of Sukuk and Defaults The Infancy? of the Industry – the Need for Scholars and Economists What’s in it for Iraq? Conclusion and Recommendations

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Outline:

Outline World Economy Financial Slowdown Financial Regulation and the New Financial Architecture The New Risk Management precepts – Basel III what does it mean for Ibs Banks Exposure to Sovereign Islamic Capital Markets The Rise of Sukuk and Defaults The Infancy? of the Industry – the Need for Scholars and Economists What’s in it for Iraq? Conclusion and Recommendations

The Challenge of Product Design and Differentiation in the Market:

Islamic Finance Master Class 116 The Challenge of Product Design and Differentiation in the Market Principles: Goals and rules for economic transactions Strategies: methods and techniques Innovative: New and novel Solutions: Satisfy real needs and create added value

Creativity:

Islamic Finance Master Class 118 Creativity Value of innovation Lateral thinking Value of constraints Shariah and creativity How To Present A True Economic Tangible ADDED VALUE That Can Be Demonstrated How To Do Away with: Complicated Structures That Lead to Disputes and Lengthy Trials. Sophisticated Ruses, Circumventions and Financial Engineering That Create Disputes and Government Suspicions

Principles:

Islamic Finance Master Class 119 Principles The doctrine of maslahah , (seeking of benefit and repelling of harm) is well-recognized in Fiqh . It is something similar to the principle of utility (securing maximum human happiness). However, Muslim jurists have pointed out that from a technical point of view, maslahah means the securing of the objectives of Shariah rather than maximisation of happiness as seen by human beings . However, the objectives of Shariah , themselves, aim at maximising human welfare in this life as well as the life Hereafter. (The Creator knows what is best for His creations) With this distinction in view, let us call it, “ The Doctrine of Maximising Human Welfare ”. Objectives Balance Integration Methodology: Acceptability Consistency

Principle of Balance:

Islamic Finance Master Class 120 Principle of Balance Balance for-profit and non-profit activities Capitalism: market-based solutions Communism: voluntary-based solutions Islamic Economics: balanced solutions Forbearance for unable debtors Mutual insurance

Principle of Integration:

Islamic Finance Master Class 121 Principle of Integration Integration of financial for-profit activities with real business Riba: Separates finance from business Gharar: Separates risk from business Murabaha: Could be applied to both

Principle of Acceptability:

Islamic Finance Master Class 122 Principle of Acceptability All economic transactions are acceptable unless otherwise stated Roots of prohibited dealings: Riba and gharar. Acceptability and creativity

Principle of Consistency:

Islamic Finance Master Class 123 Principle of Consistency Form and substance of Islamic products must be consistent Evaluation of products: Evaluate substance Evaluate form

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Islamic Finance Master Class 124 Evaluation Substance acceptable? no yes Form acceptable? yes Product acceptable no Product design revise

Strategies:

Islamic Finance Master Class 125 Strategies Where to start? From conventional products: Imitation From Islamic products: Mutation From real needs: Satisfaction

Imitation:

Islamic Finance Master Class 126 Imitation Replicate conventional products Give form priority over substance Islamic industry becomes a follower Invite alien problems Produce inefficient results

Mutation:

Islamic Finance Master Class 127 Mutation Start from Islamic products Genetic Algorithms Istisna Lease-to-own Value-based Salam

Satisfaction:

Islamic Finance Master Class 128 Satisfaction Start from real needs What does the borrower need? Cash is 10% of money Most transactions are electronic Money is a means Efficiency of Islamic finance

Ten Guiding Principles for FE :

Ten Guiding Principles for FE 1. The Doctrine of Maximising Human Welfare 2. The Doctrine of General Permissibility 3. Prohibition of Riba 4. Prohibition of Gharar 5. Prohibition of Gambling 6. Prohibition of Selling Without Having Possession and Two Deals in One 7. No pain no gain (Al- Kharaju Bil -Daman) 8. Permissibility of Hybrid Contracts and Rules Governing them 9. Principle of Relief ( Istahsan ) 10. The Doctrine of Necessity 129

Five Cs of Islamic Financial Engineering :

Five Cs of Islamic Financial Engineering Compatibility That the deal is fully compatible with the requirements of the Shariah , i.e., does not involve anything declared impermissible by Qur'an, Sunnah or ijma . Consciousness That the parties should consciously and willingly agree on the conditions of the contract without any compulsion or duress. An implication of this is that any agreement made in the state of unconsciousness (like under the influence of intoxicants or imposed by force) is not valid. Clarity That the parties are fully aware of all the implications of the conditions laid down in a contract. Any ambiguity (with the exception of gharar yasir ) will make the agreement invalid. An implication is to minimize asymmetric information. Capability That the parties are reasonably certain that they are capable of complying with all conditions of the contract. An implication of this is that in general the sale of any goods (or services) which are not owned and possessed by the seller at the time of the contract is not valid. Commitment That the parties intend and are committed to respect the terms of a contract both in letter and spirit. An implication of this is that any subterfuge to go around any Shariah condition through linguistic or legal tricks is not allowed. 130

Suggestion for Iraq contribution in World Credit Markets:

Suggestion for Iraq contribution in World Credit Markets Demand Side Sovereign Debt International Agencies Corporate Debt Project Finance Consumer Debt

Sovereign Islamic Debt:

Sovereign Islamic Debt In recent years, several Islamic Countries and their instrumentalities, as well as non-Islamic countries, have issued sovereign debt in the form of sukûk : Department of Civil Aviation, Dubai: $1 billion Qatar: $700 million Pakistan: $600 million Malaysia: $600 million German State of Saxony-Anhalt: €100 million Bahrain: $79.5 million

International Agencies:

International Agencies International Agencies Have Issued Sukûk in recent years: Islamic Development Bank: $400 million World Bank: $200 million

Islamic Corporate Debt:

Islamic Corporate Debt Private Issuances of Sukûk : DP World: $3.5 billion 7.5% sukûk , convertible into equity at the time of a qualifying initial public offering National Central Cooling Company: $200 million, rated BBB- by S&P Listed on London Stock Exchange Previous issuance by same issuer listed on Luxembourg Stock Exchange

Islamic Corporate Debt (II):

Islamic Corporate Debt (II) Global issuance of sukûk has exceeded $20 billion Dow Jones Citigroup ® Sukûk Index Comprised of seven sukûk $2.8 billion aggregate principal amount Each issue rated at least A by S&P Average tenor 3 years

Islamic Corporate Debt (III):

Islamic Corporate Debt (III) Biggest challenge thus far is limited secondary trading market for sukûk Demand for sukûk has far exceeded supply; offerings typically oversubscribed, even after substantial upsizing of the offering at times DP World offering originally contemplated for $2.8 billion but was upsized to $3.5 billion to meet excess demand; no road show needed to market the offering

Islamic Finance and Project Finance:

Islamic Finance and Project Finance Infrastructure projects in the Gulf region largely financed on a corporate basis until the mid-1990s Sadaf, a joint venture between Shell Oil and Saudi Arabian Basic Industries Corporation (SABIC), first important project finance transaction in Gulf region, closed in 1995 Project Finance now preferred structure for infrastructure investment

Islamic Finance and Project Finance (II):

Islamic Finance and Project Finance (II) Islamic sources of capital traditionally played minor role in project finance in Gulf In recent years, however, no deal gets done without a substantial Islamic tranche Financing needs exceed capacity of commercial banks and export credit agencies Desire of project hosts to diversify sources of capital and take advantage of local capital to the extent feasible

Islamic Finance and Project Finance (III):

Islamic Finance and Project Finance (III) Rabigh Refinery and Petrochemicals Project, Kingdom of Saudi Arabia $9.9 billion total cost, of which $5.8 billion was debt $4.1 billion equity split 50-50 between Saudi Aramco and Sumitomo Chemical $2.5 billion loan provided by Japan Bank for International Cooperation $1 billion loan from Saudi Public Investment Fund $1.7 billion commercial loan $600 million Islamic tranche

Islamic Finance and Project Finance (IV):

Islamic Finance and Project Finance (IV) YANSAB Project $5 billion greenfield petrochemical project $3.5 billion debt: $1.067 billion, 13-year tranche from Saudi Public Investment Fund $850 million, 12-year Islamic tranche $700 million export credit agencies tranche $533 million 12-year commercial bank tranche $350 million working capital facility ABN AMRO was sole arranger, underwriter and bookrunner on deal

Islamic Finance and Project Finance (V):

Islamic Finance and Project Finance (V) Future Demand for Project Finance Last two years saw $40 billion of project finance in gulf region Saudi Arabia estimates it will invest $90 billion in domestic power generation over the next fifteen years Other states in the gulf also investing heavily in infrastructure projects, particular petrochemical There will be a continuing demand in the region for capital to invest further expansion of the region’s infrastructure

Opportunities for Iraqi Banks:

Opportunities for Iraqi Banks Deal flow shows no sign of abating International banks have shown an ability to compete successfully Because of the size of new deals, Islamic banks need to partner with international banks to take advantage of their larger distribution networks Success of sukûk issues means that conventional market investors have grown comfortable with their structure and will invest in them so long as credit profile meets investors’ needs

Opportunities for Iraqi Banks (II):

Opportunities for Iraqi Banks (II) Success in penetrating markets for arranging credit could lead to mandates in upcoming equity offerings Future opportunities to advise in connection with an inevitable consolidation of banks in the Gulf region Opportunities for wealth management of wealthy Islamic investors Merrill Lynch identified 300,000 U.S. dollar millionaires in the Middle East

Opportunities for Iraqi Issuers:

Opportunities for Iraqi Issuers Iraqi Issuers, public and private, may consider tapping the Islamic capital markets Because of Islamic finance is asset-based, Iraq is a natural fit with the structures so far developed in Islamic finance Because of high-liquidity of Islamic banks and Islamic investment funds, issuers who tap this market may be able to obtain relatively favorable pricing relative to the conventional market

Opportunities for Iraqi Infrastructure Firms:

Opportunities for Iraqi Infrastructure Firms Because of infrastructure boom in Gulf region, large premiums have been paid on Engineering, Procurement and Construction contracts Successful competition for infrastructure projects inevitably requires support of export credit agency Export Development would have an important role to play in promoting Iraqi firms’ expertise in the region

Conclusion:

Conclusion Islamic finance and conventional finance are quickly converging in the Gulf region As conventional investors gain more comfort with Islamic structures, cost differential between Islamic products and conventional products have almost disappeared As a result, Islamic products may be more practical because they appeal to both Islamic and conventional investors It is not too late for Iraqi banks to compete for business in the Islamic finance arena To do so successfully, they will need to establish a presence in the region, as have their competitors

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Some instruments to provide Working Capital and Financing Overdraft facilities Have not been exploited. Fear of risk taking should not inhibit Islamic financial institutions from exploring what could possibly be more profitable and constructive.

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