Chapter I: Principles and Development of Islamic Finance

Islamic finance is a rapidly growing part of the financial sector in the world. Indeed,
it is not restricted to Islamic countries and is spreading wherever there is a sizable
Muslim community. More recently, it has caught the attention of conventional
financial markets as well. According to some estimates, more than 250 financial
institutions in over 45 countries practice some form of Islamic finance, and the
industry has been growing at a rate of more than 15 percent annually for the past
five years. The market’s current annual turnover is estimated to be $350 billion,
compared with a mere $5 billion in 1985.1 Since the emergence of Islamic banks
in the early 1970s, considerable research has been conducted, focusing mainly on
the viability, design, and operation of “deposit-accepting” financial institutions,
which function primarily on the basis of profit- and loss sharing partnerships rather
than the payment or receipt of interest, a prohibited element in Islam.

• Institutions offering financial instruments and services compatible with the

principles of Islam are emerging rapidly in domestic and international
financial markets.
• The basic framework for an Islamic financial system is a set of rules and
laws, collectively referred to as Shariah, governing economic, social,
political, and cultural aspects of Islamic societies.
• Prohibition of riba —a term literally meaning “an excess” and interpreted
as “any unjustifiable increase of capital whether in loans or sales”—is the
central tenet of the system. Such prohibition is applicable to all forms of
“interest” and therefore eliminates “debt” from the economy.
• Efforts to develop financial intermediation without interest started in the
1960s. Several Islamic banks were established in the 1970s, and their
number has been growing since then.
• The last decade has witnessed rapid developments in the areas of financial
innovation, risk management, regulation, and supervision.
 Chapter II: Theory and Practice of Islamic Financial Intermediation

Financial systems are crucial for the efficient allocation of resources in a modern
economy. Their landscape is determined by the nature of financial intermediation—
that is, how the function of intermediation is performed and who intermediates
between suppliers and users of the funds. The acquiring and processing of
information about economic entities, the packaging and repackaging of financial
claims, and financial contracting are common elements that differentiate financial
intermediation from other economic activities.

• The Islamic financial system is based on a set of contracts. These contracts

include contracts for real economic activities, financing, intermediation, and
social welfare.
• The mudarabah (trust financing) contract is the cornerstone of financial
intermediation by Islamic banks. The owner of capital (depositors) forms a
partnership with a manager (financial intermediary) on a profit- and loss-
sharing basis.
• Both the assets and liabilities side of an Islamic bank balance sheet are based
on Shariah compatible financial instruments. Depositors are considered
investors and are known as investment account holders.
• The assets of Islamic banks consist of trade financing, commodity trading,
leasing, partnerships, and equity-based partnerships.
• Islamic products are offered by dedicated Islamic banks and several non-
Islamic banks through special “Islamic windows.”
• The number of Islamic investment banks, mortgage companies, Islamic
insurance (takaful), and Islamic funds is growing.
 Chapter III: Corporate Governance: A Partnership

The issue of corporate governance has recently received considerable attention in

conventional economic literature and public policy debates.

This attention can be attributed to several factors: (a) the growth of institutional
investors—that is, pension funds, insurance companies, mutual funds, and highly
leveraged institutions—and their role in the financial sector, especially in major
industrial economies; (b) widely articulated concerns and criticism to the effect that
the contemporary monitoring and control of publicly held corporations in English-
speaking countries, notably the United Kingdom and United States, are seriously
defective, leading to suboptimal economic and social development; (c) the shift
away from a traditional view of corporate governance as centered on “shareholder
value” in favor of a corporate governance structure extended to a wide circle of
stakeholders; and (d) the impact of increased globalization of financial markets, a
global trend toward deregulation of financial sectors, and liberalization of
institutional investors’ activities.

• Corporate governance provides a disciplined structure through which a bank

sets its objectives, determines the means of attaining them, and monitors the
performance of those objectives.
• Financial risk management is the responsibility of several key players in the
corporate governance structure. Each key player is accountable for a
dimension of risk management.
• The key players are regulators or lawmakers, supervisors, shareholders,
directors, executive managers, internal auditors, external auditors, and the
general public.
• To the extent that any key player does not, or is not expected to, fulfil its
function in the risk management chain, other key players have to
compensate for the gap created by enhancing their own role. More often
than not, it is the bank supervisor who has to step into the vacuum created
by the failure of certain players.
 Chapter IV: Key Stakeholders

As emphasized in the previous chapter, corporate governance is a collective effort

and the process itself functions optimally only when different stakeholders work
collectively. As the Islamic banking industry has developed, several institutions
have played important roles. New institutions to support further growth are
emerging and becoming stakeholders in the fast-growing industry. This chapter
focuses on the role of relevant stakeholders in the public and private sectors and
discusses the significance of each. The players in the Islamic finance industry
include the internal stakeholders, the different interest groups, and the institutions
created to regulate, promote, and monitor their activity.

• Effective stakeholder participation is integral to good corporate governance. The

stakeholders in the Islamic finance industry include the internal stakeholders, the
different interest groups, and the institutions created to regulate, promote, and
monitor their activities.
• Shariah boards are a distinct feature of Islamic banks. Operating at the
institutional and systemic level, Shariah boards have a great responsibility to
protect the rights of all stakeholders according to the principles of Shariah.
• Shariah boards play a critical role in the introduction of new products and the
provision of an oversight function.
• Multilateral institutions have played an important role in the development and
growth of Islamic markets and banks. The Islamic Development Bank is
dedicated to that purpose. The International Monetary Fund and the World Bank
have contributed through research.
• Several key institutions such as Islamic Financial Services Board and the
Accounting and Auditing Organization of Islamic Financial Institutions were
established to strengthen regulatory framework.
• New stakeholders are emerging to develop financial infrastructure, including
institutions dedicated to developing capital markets, rating agencies, and
institutions that help to manage liquidity.
 Chapter V: Framework for Risk Analysis

The goal of financial management is to maximize the value of a bank, as defined

by its profitability and risk level. Financial management comprises risk
management, a treasury function, financial planning and budgeting, accounting and
information systems, and internal controls. In practical terms, the key aspect of
financial management is risk management, which covers strategic and capital
planning, asset-liability management, and the management of a bank’s business and
financial risks. The central components of risk management are the identification,
quantification, and monitoring of the risk profile, including both banking and
financial risks.

• Analytical techniques facilitate an understanding of interrelationships

between risk areas internally and among different banks.
• Trend analysis provides information regarding the volatility and movement
of an individual bank’s financial indicators over different time periods.
• The percentage composition of the balance sheet, income statement, and
various account groupings enables comparison between time periods but
also between different banking institutions at a given point in time.
• Ratios are often interrelated and, when analyzed in combination, provide
useful information regarding risk.
• Computation of ratios and trends provides an answer only as to what
happened.
• Analysis of the results should be performed by asking why events occurred,
the impact of those events, and what action management should take to
rectify a situation or continue a desired trend.
 Chapter VI: Balance-Sheet Structure

The goal of financial risk management is to maximize the value of a bank, as

determined by its level of profitability and risk. Since risk is inherent in banking
and unavoidable, the task of the risk manager is to manage the different types of
risk at acceptable levels and sustainable profitability. Doing so requires the
continual identification, quantification, and monitoring of risk exposures, which in
turn demands sound policies, adequate organization, efficient processes, skilled
analysts, and elaborate computerized information systems. In addition, risk
management requires the capacity to anticipate changes and to act in such a way
that a bank’s business can be structured and restructured to profit from the changes
or at least to minimize losses. Regulatory authorities should not prescribe how
business is conducted; instead they should maintain prudent oversight of a bank by
evaluating the risk composition of its assets and by insisting that an adequate
amount of capital and reserves is available to safeguard solvency.

• The composition of a bank’s balance-sheet assets and liabilities is one of the

key factors that determine the level of risk faced by the institution.
• Growth in the balance sheet and resulting changes in the relative proportion
of assets or liabilities affect the risk management process.
• Changes in the relative structure of assets and liabilities should be a
conscious decision of a bank’s policy makers: the board of directors.
• Monitoring key components of the balance sheet may alert the analyst to
negative trends in the relationships between asset growth and capital
retention capability.
• It is important to monitor the growth of low, nonearning, and off-balance-
sheet items.
• Balance-sheet structure lies at the heart of the asset-liability management
process.