Chapter 1: Overview of financial system

Mohammad Salleh Bin Abdul SahaRazizi bin Tarmuji

CTU351

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What is financial system ?

The processes and procedures used by an

organization management to exercise financial

control & accountant ability. These measures

include recording , verification, and timely

reporting of transactions that affect

revenues, expenditures, assets and liabilities.

The financial system is concerned about

money, credit and finance. (the three terms

are intimately related yet are somewhat different

from each other)

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What is money ?Money is anything of value that serves as a

generally medium of exchange.Unit of accounting measures.Means to save or store purchasing power.

What is credit/loan? An arrangement in which a lender gives money or

property to a borrower, and the borrower agrees to return the property or repay the money, usually along with interest, at some future point in time.

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What is finance ?A branch of economics concerned with resource

allocation as well as resource management, acquisition and investment. Simply,finance deals with matters related to money and the markets.

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Financial Institutions Financial Markets a) Banking System BNM Banking Institutions : - Commercial banks include

Islamic banks - Finance Companies - Merchant Banks Others: - Discount Houses - Representatives Offices of

Foreign Banks - Offshore Banks in Labuan IOFC

b) Non-Bank Financial Intermediaries :

• Provident & Pension Funds• Insurance companies include

Takaful• Saving institutions• Others: - Unit Trusts – Pilgrims Fund

Board – Housing Credit Institutions – Cagamas Berhad –Credit Guarantee Corporation –Leasing Companies –Factoring Companies –Venture Capital Companies.

a) Money & Foreign Exchange Markets :

• Money Market• Foreign Exchange Market

b) Capital Markets:• Equity markets• Bond Markets –Public Debt

Securities – Private Debt Securities

c) Derivatives Markets:• Commodity Futures• KLSE CI Futures• KLIBOR Futures

d) Offshore Markets:• Labuan International

Offshore Financial Centre (IOFC)

Financial System Structure in Malaysia

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Banks as Financial intermediariesWho is financial intermediaries ? Financial intermediaries may include banks, broker-

dealers, investment advisers and financial planners.

Roles? Promote savings and capital accumulation to finance

projects using various modes of financing.

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Finance international trade.

Mobilize resources for investments for the benefit of society.

Contribute social welfare through Corporate Social Responsibilities (CSR) and zakat.

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Islamic bankingWhat is islamic banking ?• Islamic banking is banking based on Islamic law

(Shariah). It follows the Shariah, called fiqh muamalat (Islamic rules on transactions). The rules and practices of fiqh muamalat came from the Quran and the Sunnah, and other secondary sources of Islamic law such as opinions collectively agreed among Shariah scholars (ijma’), analogy (qiyas) and personal reasoning (ijtihad).

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Islamic banking in Malaysia ? The first Islamic bank was established in Malaysia in

1983. In 1993, commercial banks, merchant banks and

finance companies begun to offer Islamic bankingproducts and services under the Islamic Banking Scheme

(IBS banks). The IBS banks have to separate the funds and activities

of the Islamic banking transactions from the non- You can identify an Islamic bank or an IBS bank from

the logo below:

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Section 2

CORPORATE INFORMATION

Banking Industry in Malaysia

ESTABLISHMENT OF ISLAMIC FINANCIAL SYSTEM IN MALAYSIA

MILESTONES OF ISLAMIC BANKING PRODUCTS1983-1990

1991-2000

2001-2005

2006-2008

2009 onwar

ds

Wadiah Current Account

Wadiah Savings Account

Mudharabah Financing

Ijarah Financing

BBA Financing

Mudharabah Investment Account

Murabahah LC

Musharakah LC

Wakalah LC

Bay Dayn Trade Financing

Murabahah Working Capital Financing

Sarf Forex

Mudharabah Interbank Investment

Musharakah Financing

Bay Inah Credit Card

Bay Dayn, Musharakah, Mudharabah

ICDO

Wadiah Debit Card

Bay Inah Overdraft

Bay Inah Commercial Credit Card

Bay Inah Personal Financing

Bay Inah Negotiable Instrument of

Deposit (NID)

Commodity Murabahah Profit Rate Swap

Commodity Murabahah Forward Rate

Agreement

Ijarah Rental Swaps-i

BBA Floating Rate

Murabahah Floating Rate

Istisna’ Floating Rate

Ijarah Floating Rate

Mudharabah Capital Protected Structured

Investment

Bay Inah Floating Rate NID

Mudharabah Savings Multiplier Deposit

Tawarruq Commodity Undertaking

Tawarruq Business Financing

Tawarruq Personal Financing

Tawarruq Credit Card

Murabahah with Novation Agreement

Istisna’ convertible to Ijarah

Bay and Ijarah (Sale and Lease Back)

Musharakah Mutanaqisah

Istisna’ with Parallel Istisna’

Note - This listing is far from being exhaustive.

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(April2009,)

Philosophical foundations of Islamic Banks

Tawhid

Khilafah

Al-’adalah

Tazkiyah

Huriyyah

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(April2008,April 2009,April 2011)

Goals and objectives of Islamic banking

• Offer Financial Services The thrust is towards financing on risk- sharing and strict focus on

halal activities Focus on offering banking transactions adhering to Syariah

principle and avoiding conventional interest- based banking transactions.

• Economic Development Established a direct and close relationship between the bank’s

return on investment and the successful operation of the business by the entrepreneur.

• Optimum Resources Allocation Considered to be most profitable, religiously permissible and are

beneficial to the economy.

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Optimum Approach Profit- sharing principle encourages banks to go for projects with

long- term gains instead of short- term gains. Banks conduct proper studies before getting into projects. High

returns distributed to shareholder maximize the social benefits and bring prosperity to the economy.

Equitable Distribution of Resources Ensures equitable distribution of income and resources among

the participation parties, with its profit- sharing approach which is one of a kind.

Facilitate Stability in Money Value Islam recognize money as a means of exchange and not as a

commodity. Riba- free system leads to stability in the value of money to

enable the medium of exchange.

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(Oct2006,Oct2007,April 2008,April2009, Oct2009,April 2010,April 2011,Sept2011)

Principles of Islamic Banking

• Islamic banking is the conduct of banking based on Syariah principle• Does not allow the paying and receiving of interest.• The principles for Islamic banking are listed:

Prohibition of Riba • Riba is strictly prohibited under Islam and is considered as

haram.• Islam allows only one kind of loan that is Qardhul Hassan.

Equity participation • Islam encourages muslims invest their money and become

partners in order to share profits and risk in the business instead of becoming creditors.

• In Islam, financing is based on the belief that the financier and borrower should equally share the risks of the business venture.

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Prohibition of gharar Gharar means to undertake a venture blindly without sufficient

knowledge or to undertake excessively transactions An Islamic financial system discourages hoarding and

prohibits transactions featuring extreme gharar. Contractual relationship

Depends upon the nature of transaction. It could be a seller and buyer relationship (Murabaha), a

lessor- lessee relationship (Ijara), and a partnership (Musyaraka)

Money as Potential Capital• It is way of defining the value of a thing.• Should not be allowed to give rise to more money, via fixed

interest payments, simply by being put in a bank or when lent to someone.

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(April2009)

Differences between Islamic Banking and Conventional Banking System

Business Framewor

kSyariah

Supervisory Board

Restrictions

Zakat (Religious

Tax)

Prohibition of Riba

in Financing

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Characteristics Islamic Banking System Conventional Banking System (Interest-Based)

Business Framework

Functions and operating modes are based on Syariah law.

Banks have to ensure that all business activities are in compliance with Syariah requirements.

Functions and operating modes are based on secular principles and not based on any religious law or guidelines.

Syariah Supervisory Board

Each bank should have a Syariah Supervisory Board to ensure that all business activities are in line with Syariah requirements.

There is no such requirement necessary.

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Prohibition of Riba in Financing

• Financing is not interest – oriented

• Based on the principle of buying and selling of assets, whereby the selling price include a profit margin

• Fixed from the beginning.

• Financing is interest – oriented

• A fixed/floating interest is charged for the use of money.

Restrictions Islamic banks are restricted to participate in economic activities, which are not Syariah-compliant.

There are no such restrictions.

Zakat (Religious Tax)

E.g. Banks cannot finance businesses involving pork, alcohol, etc.In the modern Islamic banking system, it has become one of the functions to collect and distribute zakat.

Do not deal in Zakat.

Islamic bank is a “bank” – intermediary in “indirect funding” between depositors and financing customers.

The difference is Shariah compliant الربا – حرم و البيع الله احل الربا مثل البيع انما

KEY DIFFERENTIATING FACTOR

CONVENTIONAL BANKING ISLAMIC BANKING

FUNCTIONS AND OPERATING MODES

Based on fully man-made principles

Based on the principles of Shariah

INTEREST- BASED TRANSACTIONS

Most of the activities are interest-based

Absence of interest-based (riba) transactions

RISK MANAGEMENT Concerned with "elimination of risk"

Islamic banks "bear the risk" when involve in any transaction

AIMS AT MAXIMIZING PROFIT

Without any restriction Subject to Shariah restrictions

PENALTY It can charge additional money (penalty and compounded interest) in case of defaulters

Charge in the form of ta’widh (compensation) as determined by the Shariah Advisory Council of BNM.

BANK-CUSTOMER RELATIONSHIP

Creditor and debtors Partners, investors and trader, buyer and seller

ISSUE 1: SIMILAR TO CONVENTIONAL BANKING?

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Advantages of Islamic Banking Justice and Fairness ~ The main feature of the Islamic model is that it is based on a profit-

sharing principle, whereby the risk is shared by the bank and the customer.

~ This system of financial intermediation will contribute to a more equitable distribution of income and wealth.

Liquidity ~ Follow the profit and loss-sharing principle to mobilize resources and

are less likely to face any sudden run on deposits.

~ As such, they have a minimum need for maintaining high liquidity.

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Better Customer Relations ~ Financing and deposits are extended under the profit and loss

sharing arrangement. The banks are likely to know their fund users better in order to ensure that the funds are used for productive purpose and vice-versa for investors.

~ It will develops better relations between the financial intermediary and the fund providers or consumers.

~ Also promote productive economic activities and socio-economic justice.

No Fixed Obligations ~ Islamic banks do not have fixed obligations such as interest

payments on deposits. Therefore, they are able to allocate resources to profitable and economically desirable activities.

~ Also holds good for Islamic financing, as the payment obligations of the entrepreneur is associated with the revenue.

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Ethical and Moral Dimensions ~ Strong ethical and moral dimensions of doing business and

selecting business activities to be financed, play an important role in promoting socially desirable investments and better individual or corporate behavior.

Banking for All ~ Although based on Syariah principles to meet the financial

needs of Muslims, it is not restricted to Muslim only and is available to non-Muslims as well.