Bahrain IBs financial fundamentals strong

The following is the last part of IMF’s detailed case studies on Kuwait, Bahrain,Turkey and Sudan Islamic Banking sector — Editor

B. Islamic Banks’ Operations and Soundness

Corporate and Balance Sheet Structure

5. Bahrain’s IF industry is complex and diverse. The IB industry consists of two broad segments — 6 retail IBs that focus on the domestic and regional markets for business and 19 wholesale IBs with a broader geographical footprint. There is crossshareholding between wholesale IBs and retail IBs, conventional wholesale banks and Islamic wholesale subsidiaries, and between Islamic retail banks and conventional retail banks. Most IBs are privately-owned with participation from foreign private shareholders from the Gulf Cooperation Council (GCC), primarily of Saudi, Omani, Kuwaiti and UAE origin, but one retail bank is indirectly majority owned by the Bahraini government via a state-owned conventional retail bank and social security institutions. The industry also includes large and systemically important IB groups as well as numerous small scale banks that focus on niche markets.

6. On the asset side, investments represent a large proportion and financing consists primarily of debt-based instruments, that transfer rather than share risks. At end June 2015, domestic assets accounted for 58 percent of the total assets of IBs, and the foreign assets included investments in the GCC, other Arab countries, Europe and the Americas. Financing items account for about 40 percent of total assets and most of the financing items are debt-based. Murabaah and Ijarah respectively account for over 70 percent and 19 percent of total facilities by retail IBs whereas financing facilities of wholesale banks are concentrated in Murabaah, which alone accounts for 90 percent of the total facilities. Risk sharing products such as Musharakah and Muarabah are, on the other hand, very small. A significant share of the financing is utilized in real estate (construction, commercial real estate and retail mortgages) which, respectively, accounts 28 percent and 22 percent of retail and wholesale IB financing. Other sectors accounting for a significant share of the financing are manufacturing, trade and consumer finance. The off-balance sheet component, which is equivalent to 7 percent of assets, mainly consists of assets funded with restricted investment accounts (RIA) while letters of credit (LCs) and bank acceptances account for about 2 percent of assets. Overall, while the aggregate balance sheet structure of the IBs is relatively diversified, many of the smaller IBs are reported to have concentrated portfolios.

7. Bahrain IBs finance their operations using both domestic and foreign sources of funding. Domestic sources of funding account for about 64 percent, of which private non-bank enterprises and households account for about 36 percent. Interbank deposits are a significant source of funding, accounting for 18 percent of total funding sources. Government deposits are small, accounting for about 4 percent. Other funding comes from head offices and bank affiliates as well as Sukuk issuance. Equity capital and other capital-like liabilities account for about 30 percent. Foreign funding comes mostly from the GCC and other Arab countries. Overall, while the bulk of the assets are funded by the banks’ “own funds” and current accounts, PSIAs represent a substantial share of funding, with URIAs estimated at 24 percent of total funding and RIA accounting for 7 percent.

Performance and Soundness of the Islamic Banking System

8. The financial fundamentals of IBs have been strengthening. The industry has for some years now been consolidating. At end September 2015, aggregate Capital Adequacy Ratios (CAR) were 20 percent for wholesale IBs and about 15 percent for retail IBs compared with a statutory minimum of 12.5 percent. Nonperforming financing (NPFs) is, on the other hand, elevated particularly for retail IBs. The IB sector remains profitable on aggregate, but wholesale IBs have registered a compression in profit margins to reach negative territory in September 2015. Liquidity positions are tighter compared to conventional banks, with retail IBs registering lower levels relative to the wholesale IB sector.

9. The operating environment is, however, becoming challenging due to headwinds from lower oil prices. With the slump in oil prices persisting, domestic and regional Gross Domestic Product (GDP) growth is projected to slow down and system wide liquidity has tightened, thus IBs, like their conventional counterparts, could face asset quality and liquidity pressures. The concentration of assets in cyclically sensitive sectors (construction, real estate, trade and manufacturing) increase risks for the IB sector.

C. The Regulatory and Supervisory Framework

10. Bahrain has enacted legislation that is explicit on permissible IB practices, products and institutions. The Central Bank and Financial Institutions Law, Legislative Decree 64, confers on the Central Bank of Bahrain (CBB) regulatory and supervisory powers for all financial institutions, including Islamic ones. The regulatory and supervisory responsibility was transferred to the CBB, from the Bahrain Monetary Authority (BMA), in September 2006. The CBB Law is supplemented by CBB rule books, which includes separate independent self-standing regulatory frameworks for conventional and IBs. The framework allows for the provision of IB products and services through various modes, including stand-alone banks, unit/business lines, branches, and subsidiaries.

11. The CBB has been adapting its prudential framework to cater for risks that are specific to IB. Standalone IBs are issued with IB licenses and licensing requirements for conventional banks with Islamic windows have been customized. The regulatory capital adequacy requirements for IBs are based on the IFSB15 prudential standard, apply an alpha factor of 0.3 and do not consider PER and IRR as part of the eligible capital. Segregation regulations designed to limit the risk of commingling conventional and Islamic funds are in place. On the other hand, the regulations governing loan classification and provisioning, large and related exposure limits, anti-money laundering and combating the financing of terrorism (AML/CFT), and investments in real estate, and securities apply equally to conventional and IBs.

12. The CBB has also taken several steps to strengthen Shari’ah compliance by IBs and to reduce reputational risk. A Centralized Shari’ah Board was recently established and its mandate includes: overseeing product development IFIs and Islamic windows, strengthening Shari’ah compliance, providing guidance to the CBB in issuing rules and regulations for the sector, providing guidance to the courts in legal cases involving IFIs and acting as the Shari’ah Board for the CBB. Bahrain has adopted the AAOIFI standards for Shari’ah compliance and requires IFIs to establish a Shari’ah Supervisory Board (SSB), and conduct a Shari’ah review or Shari’ah audit. External auditors are also required to ensure Shari’ah compliance as part of ensuring internal controls.

13. The consumer protection framework incorporates the key elements, including a legal basis, disclosure requirements, consumer education and cost-effective dispute resolution processes. The Central Bank of Bahrain and Financial Institutions Law 2006 (‘CBB Law’) confers on the CBB duties to protect the legitimate interests of customers of financial institutions. The rulebook for IBs covers, among others, disclosure and reporting requirements. More specifically:

All IBs are required to publish audited annual and reviewed quarterly financial statements. The financial statements have to be prepared in accordance with the Financial Accounting Standards (FAS) issued by AAOIFI. When there are no specific accounting standards under AAOIFI, IBs must use International Financial Reporting Standards (IFRS). Banks must disclose the main features of all capital and equity related instruments and URIAs.

The SSB of IBs are required to publish a statement regarding the bank’s state of Shari’ah compliance.

IBs are permitted to use mechanisms (such as the PER) to smooth the low profits on URIAs accounts in low return periods, but bank customers have to be informed of their use. IBs are also required to appoint independent board of directors representing (explicitly or implicitly) the interests of IAHs, and to ensure that independent directors represent all stakeholders. In addition, banks are urged to have one of their SSB members to be in the Corporate Governance Committee of the Bank, representing RIAs and URIAs holders.

Bahrain has in place an Alternative Dispute Resolution (ADR) forum that customers may go to for the resolution of disputes involving IBs.

14. The reporting framework and supervisory process take account of the specifics of Islamic modes of banking. The regulatory framework mandates that AAOIFI standards must be used by IBs for financial reporting purposes. There is a dedicated unit for supervision of IBs and specific off-site and on-site examination manuals. Bahrain has also made advancements in building capacity for assessing financial stability risks in IBs. The CBB established the Bahrain Institute of Banking and Finance (BIBF) to facilitate training and education in IF. IBs are supervised on a consolidated basis but cross-border supervision is currently not fully in place. There is, however, no difference between conventional banks and IBs regarding the corrective and enforcement actions and the processes formulated in the regulatory framework.

D. Liquidity Management, Resolution and Deposit Insurance

15. The CBB has been at the forefront of developing financial markets and instruments to facilitate liquidity management by IBs. This includes developing Sukuk markets as well as the launch of Shari’ahcompliant CBB liquidity management instruments.

In 2001, the Bahrain government introduced the long-term Ijarah Sukuk and short-term Al-Salam Sukuk to provide IBs with investment opportunities and to facilitate systemic liquidity management by the central bank. There is no overnight standing credit facility for IBs in Bahrain, but the Ijarah Sukuk securities can be used as collateral for banks to obtain funding from the CBB for tenors of 1-week. The Monetary Policy Committee of the CBB sets the applicable rates.

In 2015, the CBB launched a new Shari’ah compliant Wakalah liquidity management instrument to absorb excess liquidity of the local retail IBs and place it with the central bank. The instrument has been developed based on a standard contract of the IIFM. The duration of the Wakalah is one week, which facilitates short term liquidity management

16. There is no special resolution framework for banks, nor does the framework distinguish between conventional banks and IBs. Banks are subject to the same insolvency framework as non-financial corporates. Nevertheless, in liquidation, the regulations give priority to demand deposits followed by RIAs, since the latter is an off-balance sheet item with restrictions in the manner as to where, how and for what purpose the funds are to be invested. Thereafter, the order of ranking is URIAs, and shareholders and creditors are last. Shari’ah boards do not play a role in resolution decisions and there are currently no cross border resolution arrangements.

17. IBs are covered by the same deposit insurance regulatory framework as conventional banks, but there are separate schemes within the framework. Bahrain’s pre-funded deposit insurance structure is based on the Shari’ah compliant contract of Takaful whereby the deposit insurer is only an agent operating and managing the pool of funds that are collected as contributions from participating IBs. When one of the members fails, the reimbursements for insured deposits are paid from respective Takaful funds. The coverage limit is 20,000 Bahraini dinars (about USD 53,000) and the deposits covered include Islamic deposits and URIAs but not RIAs. E. Conclusions and Policy Issues 18. Bahrain has, over the past decade, emerged as an important player in the global IF industry. Bahrain’s IF industry is well-established with a broad range of institutions, while the regulatory framework and financial infrastructures have been largely adapted to the specifics of IB. The recent establishment of a centralized Shari’ah board will help ensure consistency, strengthen supervision of Shari’ah-compliance, including fit-and-proper review of bank-level Shari’ah advisors, and facilitate the development of Shari’ah-compliant money and capital markets.

19. IBs in Bahrain have, nevertheless, experienced lower profitability and higher non-performing facilities than conventional banks, and low oil prices could present further challenges. This, in part, is due to higher real estate exposures, which affected IBs in a bigger way in 2009 and 2011. The concentration in loan portfolios, to some degree, reflects the lack of economic diversification and underscores the important role of diversifying the economy to ensure the sustained stability of the IB industry and the banking sector in general. Moreover, IB, which requires that all financing activities are underpinned by real economic activity, may be more exposed to macroeconomic shocks. Going forward, with oil prices projected to remain low, government spending is expected to decline and could negatively affect growth prospects, which coupled with concentrations in loan portfolios, could put further pressure on bank asset quality, profitability and internal capital generation. Strengthening the macroprudential framework and maintaining strong supervision will remain essential to mitigate risks and ensure the adequacy of the capital and liquidity buffers. In addition, the resolution framework should be further developed while taking into consideration the specificities of banking, and IB in particular.

A. Overview of the Islamic Finance Industry

182. Participation finance, a term for financial practices structured in accordance with Islamic law, is not a new phenomenon in Turkey. Participation banking in Turkey dates back to the early 1980s. As part of a plan to attract more foreign direct investment from the Arab Gulf states, the government issued a decree in 1983 to legalize the operation of “special finance houses (SFHs)” to provide interest-free banking without any direct reference to Islam or religion, in line with the secular constitution. Following on the decree, the first SFH was established in 1985.

183. The participation finance industry in Turkey is still of limited breadth and depth, although it is rapidly gaining acceptance. Participation finance institutions, which operate alongside conventional financial institutions, are currently comprised of a banking segment, Sukuk market, and the Takaful industry whereas the Islamic Funds industry has not yet developed. The participation banking segment dominates with a market share of 83 percent of the total participation finance industry assets. Participation banking industry assets have grown from a very low base of $3.7 billion in 2004 to $41.2 billion in 2015, representing a compound average growth rate (CAGR) of approximately 24.5 percent per annum as compared to 20.1 percent of conventional banking. However, despite this growth, participation banking accounts for only 5.2 percent of Turkey’s banking industry and 3 percent of the global IB assets.

184. The slow start of the participation finance industry in Turkey and its subsequent rapid growth reflects the interaction of domestic and external factors. Turkey wanted to maintain a secular image and therefore did not encourage the label of IF. When the SFHs were established, they were highly regulated, they were not covered by the deposit insurance program and did not invest in government securities since the securities are debt based. SFHs later experienced more rapid growth when established IF houses from the Gulf began setting up SFHs in Turkey and smaller domestic companies followed in their wake. The poor performance of conventional banks during the GFC further boosted depositor interest in ethical finance. Shifts in government’s priorities also allowed IF to gradually acquire legitimacy in Turkey.

185. Growth prospects are mixed. There are several factors that could boost industry growth, but there are also important countervailing factors.

On the upside there is a change in public policy and participation banking has gradually acquired legitimacy among the public. The growth of IF in other countries also had a positive demonstration effect. Latent demand is high as according to the Global Financial Inclusion (Global FINDEX) database, the percentage of adults claiming religion as the reason for excluding themselves from the financial system has increased from 6.9 percent in 2011 to 21.6 percent in 2014, leading to significantly lower access to formal accounts (World Bank 2016). There is also increased awareness, sensitivity and preference among households for Islamic financial products, aggressive marketing, and support from policy makers.

On the downside: Growth of participation banking has slowed down significantly since 2013 and continued following regulatory intervention in 2015 of one of the largest participation banks (Asya Participation Bank) which was handed over to Savings Deposit Insurance Fund (SDIF) due to non-compliance. Despite its growing popularity, IB faces strong competition from the conventional banking system and a somewhat unleveled playing field.

B. Participation Banks’ Operations and Soundness

Corporate and Balance Sheet Structure

186. Turkey’s IBs (termed participation banks) have diverse corporate and ownership structures with some cross border operations. At end June 2016, the participation banking sector comprised of six full-fledged participation banks, of which four are private banks and two are owned by the state. The private banks include subsidiaries of banking groups from the Gulf and some of Turkey’s participation banks have established cross-border operations through subsidiaries or branches in Europe and the Middle East. The industry is concentrated with the largest participation bank accounting for 35 percent of the participation banks’ total assets. Therefore, the IB sector is exposed to group and cross border risks.

187. The asset structure comprises mainly of financing, which in turn consist mostly of debt-based products structured on Murabaah contracts. Financing accounts for over 70 percent of total assets while investments have remained small. The financing is largely based on Murabaah contracts which at the end of September 2015 accounted for more than 95 percent [World Bank 2016]. The utilization of Ijarah has started to gain pace for the last five years and has reached 5.2 percent by the end of 2015, and this growth is attributed to the removal of a tax-disadvantage on Ijarah transactions. The sectoral distribution of the financing is very diverse, although the manufacturing sector, wholesale and retail trade businesses as well as individual credits, particularly for housing and automobile loans account for the bulk of the lending.

188. Customer deposits are the main source of funding for banks. The deposits are predominantly in the form of PSIAs, which at end of September 2015 accounted for 45 percent. The balance is almost equally divided between Commodity Murabaah, current, interbank, and capital. Participation banks have not attracted medium to long term funding. Deposits have predominantly been in domestic currency but the recent depreciation of the Lira has induced an increase in the share of foreign currency deposits.

Performance and Soundness of the Islamic Banking System

189. Participation banks remain sound but their financials deteriorated since 2013 and one of the banks had to be resolved. The CARs are above the statutory minimum level of 12 percent but below the banking system average. Asset quality has worsened somewhat since 2013 and remains weaker than the rest of the banking sector, with NPFs at 6.0 percent of total gross financing in 2015, up from 3.5 percent in 2013. Liquidity is generally tight and while all banks exhibit significant mismatches, the trend is more persistent for participation banks. Participation banks have also been less profitable and margins have declined further since 2013.

C. The Regulatory and Supervisory Framework

190. Participation banks are governed by the banking law which governs conventional banks, but there are some provisions that are specific to participation banks. In Oct 1983, the government issued a decree on Special Finance Houses that facilitated the establishment of the first SFH in 1985. In Dec 1999, SFHs were included in the banking law and in October 2005, the Banking law was amended to change the name of “Special Finance Houses” to “Participation Banks”. The Banking Law conferred on the Banking Regulation and Supervision Agency (BRSA) the regulatory and supervisory powers of the Turkish banking sector, including the participation banks. Participation banks also have to comply with the Capital Market Board’s regulations.

191. The prudential regulatory framework for participation banks is identical to that of conventional banks, with a few exceptions. Conventional and participation banks are subject to the same regulations for fit and proper, risk management, auditing requirements, AML/CFT, internal controls, liquidity requirements, CAR, provisioning, Large exposure limit, related party exposure and accounting standards. There are no differences in the corrective framework for conventional banks and IBs. Turkey is fully compliant with Basel III. The few exceptions are:

Computation of the CAR. While both conventional and participation banks are subject to CAR requirements of 8 percent for Tier 1 and 12 percent total CAR, and although PER and IRR are not considered part of capital, credit and market risk, the RWA are discounted with a factor of 70 percent for on-balance sheet assets funded by URIAs funds based on Mudarabah, whereas, there is no discount for conventional banks.

Segregation of funds: Participation banks have to maintain funds raised by way of Islamic deposits (demand deposits, URIAs, etc) separately from other funds.

Investment in fixed properties and movable properties. Conventional banks are limited to invest in fixed properties up to half of their regulatory capital whereas participation banks are exempt from this limit.

Loan classification: Financing sourced from URIA or RIA are classified separately in participation banks’ chart of accounts whereas there is no separation in conventional banks since they are not allowed to operate as windows.

Provisioning requirements: While the general and specific provisioning rates apply equally to conventional and participation banks, the way the provisions are accounted for differs.

Financial leasing: Participation banks are allowed to intermediate through financial leasing operations whereas conventional banks can only undertake financial leasing through subsidiaries.

192. Shari’ah governance remains unregulated. There is currently no legal requirement for participation banking to comply with Shari’ah requirements and the BSRA, by law, cannot have a Shari’ah board. Participation Banks Association of Turkey (PBAT) has proposed the establishment of a centralized Shari’ah board to serve the banking industry and the proposal is with BRSA for further action but the establishment of a Shari’ah board would require legislative approval unless it is a self — regulatory body. There is no disclosure requirement regarding participation bank’s state of Shari’ah compliance and external auditors of IBs do not have any duties and responsibilities regarding the Shari’ah compliance of participation banks. No limits have also been set on the number of Shari’ah board positions that scholars can hold. All participation banks have Shari’ah advisors and boards but their organizational set-up is not standard. In some cases, the Shari’ah board reports to the Board of Directors and in other cases it reports to the General Manager. Some participation banks have independent Shari’ah audit departments, in others it is part of the regular audit department and in many cases, the Shari’ah board is not part of the audit committee.

193. The supervisory framework does not distinguish between conventional and participation banks. The Risk Management Department treats participation banks as conventional counterparts and implements legislation and guidelines related to risk management without differentiation. The manuals for onsite and offsite supervision are the same for participation and conventional banks. The BRSA conducts supervision of banks on a consolidated basis but there are as yet no cross-border arrangements. BRSA does not have expertise in Shari’ah-related matters, including Shari’ah audit as well as in complex Islamic contracts such as Tier-I and Tier-II Sukuk, which are being issued by participation banks. Human resources trained in IB remain limited.

194. The consumer protection framework has, for the most part, not been adapted to cater for participation banks’ business model. Participation banks are required by law or regulation to inform their RIA and URIA customers of their profit smoothing practices. Beyond this requirement, there is no difference between the disclosure requirements of conventional banks and participation banks. The institutions needed for resolution of disputes in Islamic financial transactions are not in place. There is no board representation to protect interests of IAHs. The consumer protection framework does not cover misrepresentation to the general public by someone or an entity holding itself out as conducting its banking business on a Shari’ah compliant basis. Participation banks have unfettered discretion in the setting of profit-sharing ratios on URIA accounts and are not required to have full disclosure of the profits and the payout computation. There is also no Shari’ah court, no Islamic court, no arbitral forums or ADR forums that customers may go to for the resolution of participation banking disputes.

D. Liquidity Management, Resolution, and Deposit Insurance

195. Progress in developing the supporting financial infrastructures has been uneven. Greater advances have been made in developing instruments for managing liquidity at the central bank and at the bank level. Beyond that, there is limited activity in the Sukuk market, though few sovereign Sukuk were issued recently, there are yet no interbank markets and no SCDIS.

196. The participation banks and the central bank have developed Shari’ah compliant liquidity management instruments. The central bank has a daily liquidity provision operation for IBs, using repo operations that have been modified to comply with Shari’ah — the repo ensures that Central Bank of the Republic of Turkey (CBRT) has an unbinding promise (Waad) to sell back the securities on maturity. The banks, on their part, have developed instruments for managing surplus and deficit liquidity positions, most notably reverse Murabaah, interbank Musharakah, Murabaah, Islamic placement accounts and commodity Murabaah. Acceptable collaterals include Domestic Government securities, FX Deposits and Banknotes, IILM Sukuk, domestic and Euro Ijara Sukuk issues by Turkish Treasury.

197. Interbank markets are not yet in place and participation banks are permitted to use facilities designed for conventional banks. There is no domestic currency interbank market between conventional and participation banks or between participation banks. The interbank commodity Murabaah transactions are mainly executed with domestic or foreign banks, mainly because all participation banks in Turkey have similar adverse liquidity positions. There are also no explicit or implicit provisions banning participation banks from utilizing the conventional facilities provided by the monetary authority for liquidity management purposes, such as the discount window or open market operations. Turkey does not yet have a Shari’ahcompliant mechanism of reserves remuneration so reserve requirements are remunerated in the same way as for conventional banks.

198. The existing bank resolution framework applies to both participation and conventional banks, though selected features apply specifically to participation banks. The order of payment takes account of the unique features of the liability structures of participation banks and accords the following priority for payment: Demand deposits, URIAs, and RIAs first followed by other creditors, and shareholders last. SSBs do not have a role in resolution and a cross border resolution framework is not yet in place and the absence of centralized Shari’ah board to support the resolution authority might hinder the Shari’ah compliance of resolution actions. Incidences of bankruptcy of participation banks have provided the Savings Deposit Insurance Fund (SDIF) operational experience in resolving participation banks under the Banking Law No. 5411.

199. Participation banks are covered by the same deposit insurance regulatory framework as conventional banks. Deposit insurance premiums collected are managed in a single indivisible pool. The insurance scheme covers all deposits, irrespective of whether they are investment or current accounts.

E. Conclusions and Policy Issues 200. Turkey’s experience underscores the importance of an enabling regulatory framework and consumer education in facilitating

growth and stability of IB. Participation banking is growing and gaining market share, albeit from a low base. The balance sheet structure of participation banks exposes the industry to standard banking risks such as credit, liquidity, exchange rate, group risk, cross border risks and to unique risks related to Shari’ah compliance and DCR. Meanwhile, progress has been slow in developing a regulatory and institutional framework as well as a consumer protection framework that caters to the specifics of IB.

201. The growing presence of IB will need to be accompanied by the development of effective regulation and supervision and sound infrastructure, if the industry is to grow in a sound and stable manner. In particular, reforms are needed to:

Enhance the regulatory framework for participation banks, including strengthening the consumer protection framework for less sophisticated IAHs, and the legal underpinnings for Shari’ah governance.

Enhance the supervisory framework, including developing supervisory manuals, guidelines, and expertise to better supervise participation banks.

Support consideration of international standards recommended by the IFSB and AAOIFI as additional sources of good practice.

Strengthen the Shari’ah governance framework of banks, including ensuring consistency in rulings and integration of audit functions.

Deepen the sovereign Sukuk market by regular issuance of tradable instruments at different maturities, including Shari’ah-compliant T-Bills, to provide liquid assets to participation banks and asset managers; and

Increase financial awareness and literacy of Islamic products and services as part of the consumer protection framework.

Strengthen the resolution framework for participation banks.

SUDAN

A. Overview of the Islamic Finance Industry

153. Sudan — along with Iran — operate banking systems that are exclusively Shari’ah-compliant. IB in Sudan started in 1978 when the first and full-fledged Islamic bank (Faisal Islamic Bank) was established. The private sector (local and foreign) opened five more IBs between 1980 and 1983. The government in 1983 decided that all banks had to operate in accordance with Shari’ah rules. Accordingly, in 1984, the Central Bank of Sudan (CBOS) issued a circular that eliminated interest rate carrying financial instruments. The deepening of Islamization would eventually take effect with the 1991 Banking Business (Organization) Act, and the establishment of the High Shari’ah Supervisory Board (HSSB) in 1992. In 2005, following the signing of the Comprehensive Peace Agreement to address the long-standing civil conflict in southern Sudan, a dual banking system was adopted, with conventional banks in the South. After the secession of South Sudan in 2011, the full Islamic financial system was reinstated.

154. The IF industry has registered considerable growth and breadth. The number of IBs increased from four banks in 1983 to 37 at end 2015. There are also 15 Takaful companies providing Islamic insurance services. Other financial segments include the pension fund industry, more than 30 microfinance institutions, and a capital market comprised of the Sukuk market and stock market. Banking is the dominant segment, accounting for more than 90 percent of total financial system assets (IRTI 2016). The Sukuk market is dominated by short-term domestic sovereign issuance and corporate issuance has been limited since the one issuance in 2007. However, despite the whole industry being Islamic, Sudan accounts for less than one percent of global IB assets and 2.1 percent of global Sukuk issuance [IIFM 2016].

155. The IB industry registered rapid growth in assets, but overall intermediation levels remain low. The bank assets of the industry grew at a CAGR of 20.4 percent over the 5-year period from 2010 to 2015, but in 2015, broad money represented only 19 percent of GDP, far below the average of 48 percent in LICs. Credit to the private sector of 9 percent of GDP compares unfavorably with the average of 18 percent for low income countries (LICs). In addition, while bank deposits steadily increased in nominal terms, they have lagged behind nominal GDP growth, as a result of which the ratio of deposits to GDP dropped from 17 percent in 2010 to 13 percent in 2015.

156. Prospects for further

growth are mixed. Latent demand for Islamic financial products is high. Sudan is a Muslim country with a total population of 36 million, which is largely under banked. Access to finance is low, with only about seven percent of the adult population reported to have a bank account, and access is concentrated in urban centers. However, Sudan faces major challenges in developing its financial industry. The business environment is weak and access to global markets is restricted, partly attributed to the sanctions imposed by the United States. Sudan also faces political challenges, economic uncertainty and infrastructure inadequacy.

B. Islamic Banks’ Operations and Soundness

Ownership and Balance Sheet Structure

157. Sudan’s banking system is highly concentrated despite a diverse ownership structure. Of the 37 licensed commercial banks at end 2015, five are government-owned, 25 are joint ventures with the government or the CBOS, and seven are foreign-owned. The top three banks account for 38 percent of total assets.

158. Bank assets comprise largely of financing based on Murabaah contracts, but investment in Central bank and government paper is also significant. At end December 2015, financing accounted for 49 percent of total bank assets, most of which is directed to construction, agriculture, industry and trade. Debt-based instruments account for the bulk of the financing with Murabaah contracts representing about 50 percent of total financing, followed by Mugawala contracts at around 18 percent. Risk sharing products based on Musharakah contracts have declined significantly from 30 percent in 2005 to 9 percent in 2015, while Mudarabah contracts have remained small at around 4 percent. The main risks facing the banks are credit, market, equity investment and operational risks.

159. Banks maintain considerable excess liquidity. Reserves accounted for 30 percent of assets in 2015, of which only one-quarter

were required reserves. The excess reserves have also remained high despite the fact that the CBOS, in 2014, established the Liquidity Management Fund that serves as a vehicle to provide liquidity to banks, to enable banks with excess liquidity to utilize their surpluses profitably and promote the interbank market. The persistent excess liquidity could therefore be attributed to the limited availability of alternative liquid instruments and an inactive secondary market for Sukuk.

160. Domestic deposits are the main source of funding for banks.

At end 2015, domestic deposits accounted for about 60 percent of total liabilities. An estimated 46 percent of the deposits are in the form of current accounts — these are safekeeping contracts with zero return, subject to bank service fees. PSIA accounted for 36 percent of total deposits. Savings accounts are small but they have increased from about 5 percent to 13 percent. Since banks are not permitted to use any mechanisms to smooth the low profits on RIAs in low return periods, the large share of PSIAs reduces cost for banks but renders funding and liquidity risks material for banks. Performance and Soundness 161. The banking system is stable and FSIs have improved. The aggregate CAR has increased significantly since 2010, more than doubling to 20 percent in 2015 and far above the required 12 percent minimum requirement. The capital is also of high quality as Tier 1 capital is equally high. The asset quality of financing has improved as measured by the NPF ratio, declining from 14 percent of total financing in 2010 to 5 percent in 2015, owing to the establishment of the credit registry in 2010 which enhanced banks’ assessment of clients’ creditworthiness. The NPF ratio net of provision to capital also declined from 14.4 percent in 2010 to 3 percent in 2015, largely reflecting the tightening of provisioning regulations. On the other hand, due to the high levels of unremunerated liquidity, bank profitability has weakened significantly in 2015, thereby eroding internal capital generation capacity.

C. The Regulatory and Supervisory Framework

162. IB is governed by the 2002 Bank of Sudan Act and the 2003 Banking Business (Organization) Act. The law confers on the CBOS powers to regulate and supervise the banking system.

163. Pursuant to the provisions of the law, the CBOS has issued prudential guidelines tailored to

the Islamic mode of banking. The prescribed minimum CAR was increased to 12 percent by the end of 2006 from 8 percent, in light of the inherent risks in the operating environment for banks. The regulatory framework requires the use of the IFSB discretionary formula in the calculation of the CAR and the Alpha for capital adequacy calculation is specified at 0.5. The risk weighting assigned to assets varies depending on the mode of financing. Funds allocated for PER are eligible for regulatory capital adequacy requirements whereas allocation for the IRR cannot be counted toward the capital adequacy requirements. Loan classification and provisioning also differ according to the modes of financing (Murabaah and other financing such as Musharakah). IBs are not required to hold capital against assets financed by RIAs, but have to provide capital against assets financed by demand deposits and a share of URIAs.

164. Sudan has also adopted Islamic international regulatory standards. Banks are required to adhere to AAOIFI standards and to adopt a number of IFSB guidelines, including the definition for HQLA. The AML/CFT laws have been strengthened, as a result of which Sudan was removed from the Financial Action Task Force (FATF) “grey list” in October 2015.

165. However, some gaps remain in the prudential framework.

These include: The banking law contains restrictions on lending to individual directors and shareholders of the bank, but there is no restriction on aggregate financing of such connected parties. No macro prudential policies have been put in place.

166. Sudan’s Shari’ah governance framework has evolved from a bank specific framework to the current centralized Shari’ah board overseen by the central bank. Upon the introduction of IB in Sudan, Shari’ah governance was solely regulated by the internal Shari’ah committees of the IBs. However, in 1992 the Sudanese government created a HSSB —an independent body — as a regulatory body to supervise the development of the banking system. The HSSB interprets the Shari’ah, ensures that institutions are Shari’ah-compliant, and adjudicates disputes related to financial transactions. Each bank must also appoint a SSB and must have a Shari’ah auditor. Among the requirements, banks have to publish a statement on Shari’ah compliance and external auditors also have to report on compliance.

167. The Consumer protection framework has not been explicitly adapted for financial services, but there are several provisions that provide a degree of protection for consumers. Banks have unfettered discretion to set profit-sharing ratios subject to a maximum limit of 0.5. Banks are also required to give an indication of future rates of return on investment and have to inform the clients of the bank. Sudan also has a Shari’ah court and an Islamic Affairs Ministry. Bank customers can also avail themselves of the services of the Bank Special prosecution. The decisions issued by the Bank special prosecution are binding in the courts.

D. Liquidity Management, Resolution, and Deposit Insurance

168. The CBOS has been making efforts to develop liquidity management instruments, and has in this regard availed itself of IMF

technical assistance. The CBOS mainly operates through changes in the unremunerated reserve requirement and to a lesser extent through open market operations — providing liquidity to ailing banks by purchasing government securities. It developed the first generation of Sukuk, Central Bank Musharakah Certificates (CMCs) and Government Musharakah Certificates (GMCs) to inject and withdraw liquidity from the system. The CBOS also developed Central Bank Ijara Certificates (CBICs) to manage liquidity in the banking system. The CBIS are lease contracts backed by the assets owned by the CBOS and are traded only by the banks operating in Sudan.

169. Commercial banks have also developed instruments for managing liquidity but domestic financial markets remain largely

underdeveloped. The banks mainly use interbank Musharakah and Mudarabah and Islamic placement accounts to manage both liquidity surplus and shortages. However, among commercial banks, liquidity allocation has been less than efficient in the context of excess reserves, shallow interbank and secondary markets, and a cap on banks’ holdings of government securities.

170. To encourage interbank

activity, a Liquidity Management Fund (LMF) was introduced in 2014. The LMF aims at encouraging the interbank market and limiting CBOS support as “lender of first resort”. All banks were required to subscribe. The establishment of the Liquidity Management Fund (LMF) in 2014 widened the scope for banks to properly manage liquidity and helped reduce short term liquidity risk. However, despite the recent establishment of the LMF, the CBOS still occasionally acts as “lender of first resort” for banks facing persistent liquidity shortages.

171. The CBOS, in its capacity as LoLR, can provide liquidity support to banks. In the recent past, the CBOS has provided support to banks with long-term liquidity shortages in the form of deposits that were converted into equity. However, since the establishment of the LMF, banks can only recourse to the CBOS for any overdue repayments to the Fund. The remaining challenges are that the CBOS does not distinguish between a temporary liquidity shortage of a solvent bank and liquidity strain stemming from a solvency issue; and the CBOS resources are not protected by ensuring that the liquidity support is properly collateralized.

172. Sudan is ranked the second largest issuer of short term Sukuk, but some challenges remain that constrain further and efficient development of the market. Sudan has developed three types of government and central bank securities (Sukuk) and banks are the largest holders of government securities. Development of the Sukuk market has been constrained both on the supply and the demand sides largely for policy reasons. On the supply side, issuance of government and central bank securities has been limited by the limited supply of eligible public assets to back the securities. On the demand side, the ceiling on bank holdings of Sukuk has clearly limited banks’ capacity to absorb these securities and resulted in considerable excess liquidity. As a result, much of the government’s financing needs have been covered by direct money creation by the central bank, while the CBOS has not been able to develop liquidity management instruments.

173. Since Sudan has an exclusive Shari’ah compliant banking system, the resolution framework for banks is aligned with Shari’ah principles, but some gaps remain. The legal framework provides explicit powers for taking over failing IBs and Sudan has already experienced bankruptcy of IBs. In liquidation, demand deposits are given priority followed by RIAs, URIAs other creditors and shareholders respectively. However, the law offers very limited alternative possible actions to resolve an ailing bank should the shareholders prove unwilling or unable to restore the soundness of the financial situation and management of the bank. There are also no crossborder resolution arrangements and Shari’ah boards do not play a role in determining or approving resolution actions in respect of failed IBs.

174. An SCDIS has been in place

since 1996. The scheme, termed the Bank Deposits Security Fund (BDSF), is based on the Shari’ahcompliant contract of Takaful. The Fund covers current accounts (Qar), and Investment accounts (Mudarabah) of full-fledged IBs and Islamic investment banks. The maximum coverage is SD 15,000 and all investment accounts are eligible for SCDIS protection. Banks pay an annual premium equal to 0.003 of current and savings deposits and owners of investment accounts pay the same (0.003). The Ministry of Finance and

Economic Planning and the Central Bank of Sudan each pay 15 percent of the amount paid by banks. E. Conclusions and Policy Issues 175. Sudan is one of the only two countries to have established a financial system that fully follows Islamic principles. While IF presents opportunities for Sudan’s predominantly Muslim population, the financial system faces similar challenges as conventional systems in many low-income countries: underdeveloped markets, limited monetization and access to credit, and uneven banking supervision. Moreover, IF faces additional challenges, including a dearth of Sukuk and liquidity management instruments that constrain government financing and monetary policy. This requires reforms to address general structural constraints as well as those specific to IF.

Addressing general structural constraints

176. Monetization and access to financing. Greater macroeconomic stability, particularly an environment of low inflation and stable exchange rate would help increase demand for money. Increasing access to finance would require restructuring weak banks, bolstering bank competition, improving the collection and sharing of credit information, strengthening the judiciary, and improving financial education. Microfinance that caters to small enterprises and rural dwellers would improve financial inclusion.

177. Deposit insurance. Funding for the BDSF should be reviewed to ensure sufficient funds to cover deposits in case of bank failure, which should enhance depositors’ confidence.

Addressing issues related to Islamic finance

178. Sukuk market and budget financing. Stepping up the volume of issuance of tradable Sukuk and lengthening their maturities would help deepen the market for government securities, create a benchmark for private issuance, and reduce the need for monetization of budget deficits (IMF 2015). Increasing the issuance of Sukuk may require a more active debt management strategy or innovative Shari’ah-compliant financial engineering to overcome limits on assets available to underpin the Sukuk issuance.

179. Monetary policy framework. Stepping up regular issuance of Shari’ah-compliant liquidity management instruments by the CBOS (including new CICs) is urgently needed to regain monetary control.

180. Liquidity management and

LoLR. Limited Shari’ah-compliant interbank money market instruments restrict the options in managing liquidity effectively. Shallow secondary markets also contribute to the problem of access to liquidity. In 2015, LMF has contributed to improving the banks’ liquidity management through collaborative redistribution of liquidity surpluses to finance banks with liquidity shortages as a result of which the CBOS interventions in the money markets has been reduced. Nevertheless, current bank regulations do not prevent banks from continued reliance on CBOS financing. This exposes the CBOS to credit risk in case of default. Bank regulations should clearly distinguish vbetween banks’ temporary liquidity shortfalls and solvency problems, to prevent banks from continued reliance on CBOS financing.

181. Resolution framework.

Strengthening the legal framework, including broadening the instruments for resolving banks could minimize resolution costs and contribute to financial stability.