Back Matter

Appendix I. Islamic Banking: Financing and Mobilizing Funds

Islamic Financial Instruments

1. Islamic financial instruments fall into three broad categories: profit-and-loss sharing, debt, and quasi-debt instruments. While each category covers a wide variety of instruments, this appendix gives a brief description of the main contracts that are most frequently used by IBs.

Profit-and-loss Sharing Instruments

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

3. A Mudarabah (participation or trust financing) is a contract that refers to an agreement whereby the bank contributes capital to an enterprise or activity which is to be managed by the customer. Profits generated by that activity are shared in accordance with the terms of the Mudarabah agreement, while losses are to be borne solely by the bank unless they are due to the customer misconduct, negligence, or breach of the contract terms. Mudarabah could be restricted to a specific transaction, or unrestricted.

Debt Instruments

4. Murabahah (cost-plus financing) contract refers to an agreement whereby the Islamic bank sells to a customer, at acquisition cost plus an agreed profit margin, a specified asset that is already in its possession (such as a manufactured good). Following delivery of the asset, a credit risk in respect of the amount receivable from the customer arises. The main features of this contract are: (a) the cost and the mark-up must be both known to the bank and the client; (b) the bank must assume the ownership of the goods prior to reselling them to the client (bearing all the ownership risks in the interim); (c) the client’s promise to buy the goods purchased on his order by the bank may or may not be binding (in most jurisdictions it is binding); (d) no interest is levied for late payments but the bank could require a collateral; and (e) the Murabahah contract cannot be sold except at par.

5. Salam (purchase with deferred delivery) is a purchase contract with deferred delivery of goods (opposite to Murabahah) and is mostly used in agriculture finance. The contract is used to purchase, at a predetermined price, a specified kind of commodity which is to be delivered on a specified future date in a specified quantity and quality (such as an agricultural or a manufactured product). As the buyer, the bank makes full payment of the purchase price upon execution of the Salam contract. To mitigate price risk (as a debt contract it cannot be sold to a third-party except at par), the bank enters, in certain cases, into a “Parallel Salam” to sell a commodity with the same specification as the purchased commodity under a Salam contract to a party other than the original seller.

6. Qard Hasan is an interest-free loan contract.

Quasi-debt Instruments

7. Ijarah (lease) contract refers to an agreement whereby the bank leases to a customer an asset (such as a ship, aircraft, or telecom equipment) for an agreed period against specified installments of lease rental. The contract commences with an agreement to lease that is binding on the part of the potential lessee and requires the bank to purchase or lease an asset prior to entering into the contract. An Ijarah contract could offer the lessee the option to purchase the asset either at the end of the lease period by means of a gift or a token consideration, or by installments of a specified amount. During the lease period, the bank, as the owner of the asset bears all the risks associated with ownership. The Ijarah contract can be sold at a negotiated market price, effectively resulting in the sale of the leased asset.

Mobilizing Funds by Islamic Banks

8. Current accounts are similar to non-interest paying call or demand deposits. They are set up on the basis of: (a) interest free loan (Qard Hasan) contract between the depositor (lender) and the bank (borrower); or (b) A Wadiah (safe keeping) contract between the depositor and the bank (custodian), with explicit permission given to the bank to utilize the funds. The bank guarantees these deposits and in return depositors are not entitled to any share in the bank’s profits. If the bank utilizes the deposits, it will be at its own risk; all profits and losses will be borne by the bank.

9. Savings and time accounts are similar to current accounts in the right of customers to withdraw their deposits on demand. However, to encourage depositors to commit their deposits for longer periods (e.g., three months), the bank may, at its sole discretion, reward depositors by sharing part of its profits with them from time to time, the depositors can share in the bank’s profits on the basis of a minimum balance that is maintained within a specified period of time. More recently, a number of IBs started offering these accounts based on commodity Murabahah contracts.

10. Profit Sharing Investment Account (PSIA) is a contract by which an investor/depositor opens an investment fund with an Islamic bank on the basis of Murabahah. The bank could have restricted (restricted investment account (RIA)), or full discretionary power in making investment decisions (unrestricted investment account (URIA)). Both parties agree on a ratio of profit sharing, which must be disclosed and agreed upon at the time of opening the account. Profits generated by the IB are shared with the PSIA holder in accordance with the terms of the Murabahah agreement while losses are borne solely by the PSIA holder, unless they are due to IB’s misconduct, negligence, or breach of the contract terms. Often, the bank capital is invested in the same income-producing assets or economic activities and accordingly bear a share in the outcome.

Stylized Balance Sheet of Islamic and Conventional Banks

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Source: IMF Staff.

Appendix II. Key Unique Risks Exposed to Islamic Banks

Credit Risk

1. IBs are exposed to credit risk when using debt-type contracts for financing. In Murabahah transactions (the most common debt contract used in IB), IBs are exposed to credit risks when the bank arranges the delivery of the underlying goods to the client but does not receive payment from the client in time. In other more complex Murabahah transactions, the ownership of the real asset can change multiple times between the bank, other intermediary agents, or the final receiver of the assets. This means that any simple assessment as to the degree of credit risk exposure by the IB can vary at different times in executing the Murabahah contract. In a Mudarabah contract, where an IB enters into the contract as “principal” with an external “agent,” the IB is exposed to an enhanced credit risk on the amounts advanced to the agent. The bank is not in a position to know or decide how the activities of the agent can be monitored accurately, especially if losses are claimed.

2. Credit risk management for IBs is complicated further by additional factors. Especially in the case of default by the counterparty, IBs are generally prohibited from charging any accrued interest or imposing any penalty. During this delay, the bank’s capital is stuck in a nonproductive activity and the bank cannot earn income. Part of this risk could be mitigated through better collateralization and in the pricing of contracts.1 For example, the bank might ask the client to post additional collateral before entering into Murabahah transactions. In addition to collateral, personal and institutional guarantees are also accepted to minimize credit risks.

Market Risk

3. IBs are exposed to market risk due to the volatility in the value of tradable, owned, or leasable assets. Market risk is the risk that a bank may experience loss due to unfavorable movements in market prices. In the absence of hedging instruments, IB have traditionally tried to minimize open positions and speculative transactions, but have in general, smaller off-balance sheet structures. The prudential measures used for conventional banks such as position limits and stop loss provisions are also used by IB to manage market risks effectively. However, market risks have heightened in IB in recent years by the complexity of some products and increased reliance on commodities to structure some operations.

Operational Risk

4. IBs are more likely to be exposed to operational risk than comparable conventional banks. Operational risk is defined as “the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events.”2 Operational risks are likely to be significant for IBs reflecting the nature of their financing that is closely tied to real transactions, specific contractual features (e.g., buy and sell back), and the general legal environment that may not be adequately adapted to the IB model.3 Additionally, IBs face two unique operational risks: “Shari’ah non-compliance risk” arising from not having in place adequate systems and controls to ensure compliance, and “fiduciary risk” arising from not having in place mechanisms to safeguard the interests of IAH, especially when their funds are comingled with the bank’s own funds.4

5. The Shari’ah compliance is critical to IBs’ operations and such compliance requirements must permeate throughout the organization and their products and activities. Depositors’ perception regarding IBs’ compliance with IF principles is of great importance to their sustainability. Non-compliance could risk transactions being cancelled and income generated from them as illegitimate.

6. Fiduciary risk is the risk that arises from IBs’ failure to perform in accordance with explicit and implicit standards applicable to their fiduciary responsibilities. As a result of losses in investments, IBs may become insolvent and therefore, unable to meet the demands of current account holders for repayment of their funds and safeguard the interests of their IAH. IBs may fail to act with due care when managing investments resulting in the risk of possible forgone profits to IAH.

Liquidity Risk

7. The idiosyncrasies of traditional IB seem to reduce its liquidity risks,5 albeit at the expense of profitability, but this profile is changing rapidly. IBs have not been able traditionally, to raise wholesale funding (given IF restrictions on direct interest-based borrowing and repo), relying instead, almost exclusively, on more stable deposits (current and investment) as a source of funding. However, IBs in recent years have been increasingly able to access wholesale funding through commodity Murabahah markets, rapidly increasing their leverage and exposing them to new risks. On the assets’ side, IBs have generally faced a dearth of acceptable and tradable assets, especially HQLA like sovereign Sukuk; instead they often resorted to holding excess cash reserves. This situation has been exacerbated for IBs by the slow progress in adopting standing facilities and other central banks liquidity management instruments suitable for IB.6

Rate of Return Risk

8. The IBs is generally exposed to rate of return risk, which is associated with overall balance sheet exposures where mismatches arise between assets and balances from fund providers. Rate of return risk differs from interest rate risk in that IBs are concerned with the result of their investment activities at the end of the investment-holding period. Such results cannot be pre-determined exactly. It also stems from uncertainty in the returns earned by IBs on their assets when an increase in benchmark rates results in expectations of higher rates of return on investment accounts.

Displaced Commercial Risk

9. A consequence of rate of return risk may be displaced commercial risk resulting in the IBs and their shareholders to forego part of their profits. IBs may be under market pressure to pay a return that exceeds the rate that has been earned on assets financed by IAH when the return on assets is under-performing as compared with competitors’ rates. IBs may decide to waive their rights to part or their entire Mudarib share of profits in order to satisfy and retain their fund providers and dissuade them from withdrawing their funds. Displaced commercial risk derives from competitive pressures on IBs to attract and retain investors (fund providers). The decision of IBs to waive their rights to part or all of their Mudarib share in profits in favor of IAH is a commercial decision, the basis for which needs to be subject to clear and well defined policies and procedures approved by the IBs’ board of directors.

Appendix III. International Monetary Fund’s Involvement in Islamic Banking and Finance

1. Fund engagement in IB issues dates back to the mid-1980s. In the decade since the mid-1980s, the Fund has not provided TA or policy advice but Fund staff published a number of important conceptual working papers that helped shape views on IB. The Fund started providing TA on IB in the second half of 1990s mostly in countries with relatively established IB practices (e.g., Sudan, Iran, Pakistan, etc.) and focused primarily on central banking operations and developing local government funding markets. The Fund did not provide any significant TA on legal and regulatory aspects of IBs until around 2005/06 after the IFSB began to issue its standards.

2. Fund staff involvement on IB issues is rising. Fund staff have been increasingly encountering IB related issues in surveillance work (FSAPs and Article IV missions) and in Use of Fund Resources (UFR) cases (e.g., Afghanistan, Pakistan, and Yemen). In addition, the number of IB-related TA requests has risen considerably in recent years, particularly, from new IB jurisdictions (e.g., Djibouti, Mauritania, Kenya, and Tanzania, etc.), on topics, such as regulation, supervision, and development of Sukuk markets. Fund staff have also participated in training and outreach as part of IMF Regional Technical Assistance Centers (RTACs) jurisdictions (e.g., Djibouti, Mauritania, Kenya, and Tanzania, etc.). The Fund did not provide any significant TA on legal and regulatory aspects IBs until around 2005/06 after the IFSB began to issue its standards.

3. The Fund has been collaborating closely with other international organizations and standard setters on IB issues. The Fund has carried out over the years, joint activities (TA, conferences, working groups, etc.) with organizations like the WB, the Arab Monetary Fund, the and the IsDB,1 as well as the standard setters for industry (IFSB and AAOIFI). Fund staff are undertaking training and outreach work as part of the IMF RTACs and contributing to G20 and other international conferences on IB matters. Finally, Fund staff continue to be called on to contribute to various international initiatives on IB-related issues (e.g., contributing to the working group developing Core Principles for Islamic finance regulation and commenting on drafts of various technical standards in Islamic finance).

4. The Fund played a catalyst and central role in the establishment of the IFSB. By the end of the 1990s, the need to ensure that international prudential standards adequately capture the unique features of Islamic financial and banking products became increasingly evident. A meeting of central banks on the side of a conference on the regulation of IBs (Bahrain, February 2000) organized jointly by the IMF and AAOIFI called for international action to facilitate the development of relevant prudential standards. The Fund facilitated the subsequent consultation process culminating in the establishment of the IFSB in November 2002, as an international organization to develop the necessary prudential standards. The Fund provided significant TA support to the IFSB in its early years and remains an associate member.

Appendix IV. World Bank Group Involvement in Islamic Banking and Finance

1. The WB has accelerated in recent years its involvement in IF issues. In 2009, the WB established the Islamic Economics and Finance Working Group (part of the Financial Systems Practice), bringing together expertise in this area from across the WB.1 The Group has focused on: (a) strengthening the legal, regulatory, and institutional foundations for the sustainable development of the IF industry; and (b) knowledge sharing and capacity building. The WB also established in October 2013, the Global IF Development Center in Istanbul with the aim to contribute to the development of IF globally, through research, training and advisory services.

2. The WB has established working partnerships with the IFSB and AAOIFI. The WB has been working closely with the IFSB and AAOIFI in the design of a wide range of standards (e.g., Principles of Insolvency and Creditor Rights) and is currently engaged in efforts to expand the implementation of these standards in individual jurisdictions. Work is also underway with AAOIFI to develop accounting standards that are fully compliant with international accounting standards while taking into consideration the special features of IFI.

3. The WB is in the process of finalizing the Supplemental Corporate Governance Guidelines for IFI. These provide guidance on how to improve the governance of these institutions and are expected to provide the basis for the WB’s FSAP assessment of corporate governance in member countries.

4. The WB’s International Finance Corporation’s (IFC) involvement in IF issues have been rising in recent years. The IFC has formed an interdepartmental task force in 2008 to share knowledge and develop a more systematic approach to IF activities. Furthermore, the IFC has been engaged in a number of joint ventures and funding activities using IF instruments.


More detailed information can be found in the April 2015 Staff Discussion Note (SDN) “Islamic Finance: Opportunities, Challenges, and Policy Options,” (SDN/15/05).


Consistent with the definition in the “Financial Stability Report, 2016,” IFSB May 2016, IB is classified as systemically important if it accounts for 15 percent or more of the domestic banking system assets.


While the IB industry was negatively affected by the global recession that followed the GFC, the crisis itself left the industry largely unscathed. See “The Effects of the Global Crisis on Islamic and Conventional Banks: A Comparative Study,” Hasan, Maher and Dridi, Jemma, IMF Working Paper No. 10/201, 2010.


Sukuk are “certificates of equal value representing undivided shares in the ownership of tangible assets, usufructs, and services or (in the ownership of) the assets of particular projects or special investment activity” (AAOIFI, 2008).


The IFSB currently has 188 members, including regulatory and supervisory authorities, international organizations and market players, operating in 57 jurisdictions (source: IFSB:


AAOIFI was established in 1991 in Bahrain, to supplement international accounting and auditing standards by developing, interpreting and disseminating accounting, and auditing standards for IFIs. AAOIFI at present has 200 members from 45 countries, including central banks, financial institutions, and other participants from the international IB and finance industry, worldwide (source AAOIFI:


This paper will focus on IB only and will not cover other IF products and institutions (e.g., insurance).


The survey covered general IB information, legal, regulatory and supervisory framework, liquidity management and central banking, resolution regimes and deposit insurance. 31 countries responded to the survey: Afghanistan, Algeria, Bahrain, Bosnia and Herzegovina, Botswana, Djibouti, Guinea, Hong Kong, Indonesia, Iraq, Jordan, Kenya, Kazakhstan, Kosovo, Kuwait, Kyrgyzstan, Lebanon, Luxembourg, Malaysia, Morocco, Oman, Pakistan, Palestine, Qatar, Saudi Arabia, South Africa, Sudan, Tunisia, Turkey, United Arab Emirates (U.A.E.), and the United Kingdom (U.K.).


Investment accounts can be compared to collective investment schemes (CIS), in which participants have mandated their fund managers to manage their investments. Both IAH and CIS participants:

(i) entrust their money to be invested and managed by a fund manager (that is, the Islamic bank in the case of IAH and the CIS operator in the case of CIS participants);

(ii) bear the risk of losing the capital of their investment; and

(iii) have minimal rights in controlling the conduct of the fund manager; more often they would have to vote with their feet—that is move their investment away if they find the fund manager’s performance is unsatisfactory.

However, in most cases, CIS participants stand in a better position than the IAH, since securities regulation usually ensures that CIS operators meet stringent requirements before they can operate a CIS. CIS participants enjoy more rights—in particular, concerning their access to information. Furthermore, CIS participants often know the net asset value of their investments, which would allow them to dispose of the investments swiftly in a secondary market.


Issues related to the Shari’ah compliance function are discussed in paragraphs 25–27 below.


Some IBs have an extensive networks of subsidiaries, associate companies and joint ventures in a broad range of sectors, insurance, leasing, schools, aircraft leasing, textiles, labor services, hospitals, hotels, computers, infrastructure.


It is important to note that factors such as low income levels or underdeveloped financial market in some of the countries where IB operates will create broader difficulties, such as lack of HQLA or underdevelopment of money or bond markets, for all banks, Islamic and conventional.


These standards and the body of related rulings (including those of the Fiqh (jurisprudence) Academy of Organization of the Islamic Conference (OIC) countries) are collectively referred to as “Islamic finance principles.”


Background Paper on Ensuring Financial Stability in Countries with Islamic Banking Sectors: Country Case Studies.


This broader applicability of international governance norms to IBs has been acknowledged by the IFSB 2006 “Guiding Principles on Corporate Governance for Institutions offering only Islamic Financial Services.”


From the 2016 survey results, there are 141 stand-alone Islamic banks operating in 18 of the 27 respondent countries with stand-alone banking assets totaling US$602 billion.


The total size of IB assets that belong to windows in 17 respondent countries (140 conventional banks had Islamic windows), amounted to US$188 billion, with Saudi Arabia accounting for US$175.4 billion (2011: US$80 billion).


Background Paper on Ensuring Financial Stability in Countries with Islamic Banking Sectors: Country Case Studies.


Nearly all international banks, such as HSBC, Standard Chartered, Deutsche Bank, Citibank, and others, have engaged in Islamic banking and finance activities, through investment, private, and retail banking. They adapted their services to meet their business objectives and accommodate local requirements, including through locally incorporated subsidiaries (e.g., Citi Islamic Investment Bank in Bahrain, and HSBC) or through windows (Standard Chartered in Tanzania and Citibank in Malaysia).


IFSB Guiding Principles on Shari’ah Governance Systems for Institutions Offering Islamic Financial Services— December 2009.


See AAOIFI Governance Standards on Shari’ah Supervision and Compliance and IFSB Guiding Principles on Governance Systems, which makes a distinction between compliance and control functions. SSBs may alternatively be called Shari’ah Committees or SSBs.


CPIFR was developed with the Fund’s TA support.


Background Paper on Ensuring Financial Stability in Countries with Islamic Banking Sectors: Country Case Studies.


Unless there is evidence of negligence or misconduct on the part of the bank.


Heavy early withdrawals penalties that are usually imposed on IA would lessen the impact on the IB solvency in the case of significant and unexpected IA deposits’ withdrawals in response to low profits or losses.


Survey results shows that 11 responded countries have allowed PER and six allowed IRR.


Malaysia does not require general assets financed by investment accounts to be converted into risk-weighted assets, while Sudan and Kuwait require 50 percent, Bahrain and Jordan requires 30 percent only and Afghanistan 12 percent. These variations reflect the supervisors’ views of local IB practices.


The alpha factor identifies the proportion of losses which are due for pass-through to IAH. Specifically, alpha determines the proportion of credit and market risk-weighted assets funded by PSIA.


The 2014 IFSB guideline on the Supervisory Review Process also recommends that supervisory authorities ensure, inter alia, that supervisors fully address Shari’ah governance and coverage of Islamic windows, banks practices on meeting capital requirements, ICAAP, and risk management.


In some cases, there may be a national Shari`ah board, whereas, other jurisdictions may mainly require applicable Shari`ah systems to be in place. In some arrangements, prior consent of the home supervisory authority may be an integral part of the product and service authorization process. In other cases, there may be simply a notification requirement or no formal authorization or approval required.


Discussions continue on whether to establish separate supervisory functions for conventional and IBs or integrate them into one function. The trend seems to be moving toward the latter to eliminate duplication, as significant part of the supervisory process is also applicable to IB.


IFSB 16—Supervisory Review Process.


This has been the approach, for example, of many purely secular jurisdictions including, for example, the U.K. and Hong Kong.


ML/TF and the related predicate crimes can undermine the stability of a country’s financial system or its broader economy. The Financial Action Task Force (FATF), the standard setter on AML/CFT, calls for countermeasures against countries where there is a high risk of money launder or terrorist financing.


See “Islamic Finance and anti-money laundering and combating the financing of terrorism” Nadim Kyriakos-Saad, Manuel Vasquez, Chady El-Khoury, Arz El Murr, IMF Working Paper, 2016 Working Paper No. 16/42, 2016.


This could be done in the context of the ongoing round of assessment of the effectiveness of AML/CFT regimes.


With the exception of Malaysia (Islamic Financial Services Act (Act 759) of 2013), IB jurisdictions do not provide for IB-specific resolution regimes addressing their unique features.


See “Resolution Frameworks for Islamic Banks” Addo Awadzi, E., Carine Chartouni, and Mario Tamez, IMF Working Paper, 2015 Working Paper No. 15/247, 2015.


The Core Principles for Effective Deposit Insurance adopted (November 2014) by the International Association of Deposit Insurers (IADI),, and the “Handbook for the Assessment of Compliance with the Core Principles for Effective Deposit Insurance Systems” (March 2016): Blanket guarantees and implicit deposit protection schemes are not covered in this paper.


Similar issues were identified by the 2010 “Survey on Islamic Deposits Insurance” prepared by IADI.


Given that the primary focus of this paper was financial stability (including the discussion on liquidity management), issues related to monetary policy (effectiveness, monetary transmission, etc.) are not covered in the paper.


In cases where IBs’ required reserves are remunerated, the proceeds are usually used by to pay licensing fees and taxes or distributed for charitable purposes.


In practice, the application of these principles varies across jurisdictions and a number of important questions continue to be debated (e.g., coverage: bank vs. nonbank, liquidity vs. solvency issues, and triggers for the provision of government guarantees, etc.).


Chattha and Abdul Halim (2014).


Grenning and Iqbal (2008), pp. 120–127.


Basel Committee: “Principles for the Sound Management of Operational Risk,” BIS, June 2011.


See also Grenning and Iqbal (2008), pp. 174–176.


IFSB: “Guiding Principles of Risk Management for Institutions (Other Than Insurance Institutions) Offering Only Islamic Financial Services,” December 2005.


See “The Effects of the Global Crisis on Islamic and Conventional Banks: A Comparative Study,” Hasan, Maher and Dridi, Jemma, IMF Working Paper No. 10/201, 2010.


The central banks of Indonesia, Iran, Kuwait, Luxemburg, Malaysia, Mauritius, Nigeria, Qatar, Saudi Arabia, Sudan, Turkey, the U.A.E., and the IsDB established in October 2010 the Kuala Lumpur-based International Islamic Liquidity Management Corporation (IILM), to create and issue short-term Shari’ah-compliant financial instruments to facilitate effective cross-border Islamic liquidity management.


The IsDB has been supporting part of the IMF’s TA program to IsDB member countries in developing their financial markets, with focus on IB and finance issues.


Initial work has also commenced within the Global Capital Markets Practice, which covers securities markets and nonbank financial institutions, on Sukuk and Takaful (insurance) issues, but presently have limited capacity.