P2112 – Chapter 6The Concept of Islamic Banking

Objective

The overall objective of Islamic banking is tocreate an efficient, progressive andcomprehensive Islamic financial system thatcontributes significantly to the effectivenessand efficiency of the Malaysian financialsector while meeting the economic needs ofthe nation.

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P2112 – Chapter 6The Development of the Islamic Banking System

Exists side by side with the conventional banking system.

The legal basis for the introduction of banking productsalong Islamic principles is the Islamic Banking Act 1983,which came into effect on 7 April 1983.

The Islamic Banking Act provides the Central Bank withthe power to supervise and regulate Islamic banks similarto the case of other licensed banks.

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Treatment of Profits

Profits are paid to general investment accountholders out of the bank’s revenue from itsfinancing and investment activities, while…

special investment account holders are paidprofits or made to bear losses from themanner in which the deposits are utilized.

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P2112 – Chapter 6Financing Facilities Provide financing facilities such as:

project financing under the principles of Mudharabah and Musyarakah

lease financing under the principles of Al-Ijarah and Al-Takjiri

hire purchase financing under the principles of Al Bai Bithaman Ajil

trade financing (including bill financing and letter of credit) under principles of Murabahah and Wakalah

guarantee under the principles of Al-Kafalah

benevolent loans under the principles of Qard Hassan

insurance under the principles of Takaful

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P2112 – Chapter 6Regulations

The operation of all banks is governed by someregulations like all other conventional banking.

(i)Eligible Liabilities (EL)

The bank is required to observe a minimum riskweighted capital ratio of 8% with effect from 1 January1992.

It is also required to maintain a statutory reserveaccount with the Central Bank.

The EL comprises deposits, net borrowings from otherfinancial institutions, namely the commercial banks,finance companies and merchant banks and netrepurchase agreements.

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(ii)Liquid Assets

The liquid assets include cash balances, with the CentralBank (excluding statutory reserves) and GovernmentInvestment Certificates.

Requirements of a Banking System

The three requirements are:

(i) a large number of players;

means that there must be an adequate number of different types of institutions participating in the system.

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(ii) a broad variety of instruments

means that a large variety and range of different types ofinstruments must be available to meet the various needsof the financial institutions and the customers.

(iii) an Islamic interbank market

means that there must be an efficient and effectiveinterbank money market to link the players’ institutionsand the instruments

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P2112 – Chapter 6The Operations of the Islamic Banking System

(i) Setting up Options

Initially, the Central Bank considers three options in the setting up ofthe Islamic banking system. One is the large number of players.Therefore there are three options to achieve these objectives: To allow the setting up of new Islamic banks

To allow the existing financial institutions to set up subsidiaries to offer Islamic Banking services.

To allow the existing financial institutions to offer Islamic banking services using their existing infrastructure and branches.

After careful consideration, the third option was chosen as the most effective and efficient method to increase the number of institutions offering Islamic banking services at the lowest cost and within the shortest time frame.

The other option would be time consuming and may also be costly.

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(ii) Interest-Free Banking Scheme

A scheme was developed to allow the existing financialinstitutions to offer Islamic banking services.

This scheme was named Skim Pembankan TanpaFaedah (SPTF). The English version of it is the Interest-Free Banking Scheme.

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P2112 – Chapter 6The Need of Islamic Banking

Muslims throughout the world have not been able to avoid interest-based transactions which cover almost all aspects of their lives.

Some Muslim scholars were arguing for the exclusion of interest ratescharged by the banking system from the scope of usury, on theground that interest charges are necessary to ensure the existence ofan efficient-working financial system, and that these interest chargesare not excessively high qualify them as usury.

Over the last two decades prior to the establishment of BIMB,however, a consensus has developed among the Muslim scholars toregard interest charges as a form of usury which must be avoided byMuslim.

Consequently, an alternatively banking system which does not baseits operations on interest payment is deemed necessary in Islamiccountries.

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P2112 – Chapter 6 At the same time, the resurgence of religious awareness throughout the

world since 1970s had induced Muslims to organize their way of lifeincreasingly in accordance with Islamic principles.

The reordering of their economic activity, such as the introduction ofIslamic Banking, can be seen as an effort to generate an alternative model ofbanking which is compatible with Islamic teachings.

In Malaysia, the first major move towards establishing an Islamic financialsystem was the establishment of the Pilgrims Management and Fund Board(Tabung Haji) in 1969.

(i) The purpose of the Board is to promote and accumulate savings from theMuslims and at the same time, coordinate all aspects of pilgrimage activitiesundertaken by members.

(ii) The fund is managed according to the Islamic Trustees acting to ensurethat the accumulated funds are invested in securities and activitiespermissible in Islam.

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P2112 – Chapter 6 In July 1981, the Government mounted the National Steering

Committee to study in detail the possibility of establishing Islamicbanking in the country.

Upon the positive recommendation of the Committee, the IslamicBanking Act was tabled and passed by Parliament in 1983 to enablethe supervision and regulation of the Central Bank of Malaysia.

In the same year, Bank Islam Malaysia Berhad (BIMB) wasestablished with a total paid-up capital of RM80.0 million.

The Malaysian Government provided RM30.0 million of the capitalwhile the rest was provided by other Muslim organizations.

The corporate objectives of BIMB is to provide banking facilities andservices to Malaysians in general, and Malaysian Muslims inparticular, in accordance with Islamic Commercial Law.

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P2112 – Chapter 61. Principles of Al-Wadiah (trusteeship)

Is used in the mobilization of demand and savingsdeposits.

Under this principle, the bank is entrusted with the safekeeping of the customers’ deposit, which can bewithdrawn at any time upon demand by the customers.

Payments of dividends are not obligatory but at thediscretion of the bank since the customer already benefitfrom the safe custody of their money.

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2. Principles of Al-Mudharabah (trustee profit-sharing)

Islamic Banking offer investment accounts to their customer.

Under the arrangement, the deposits will be used by the bank for investment purposes, whereby the profit will be shared between the bank and the customers.

At the same time, the investment account holders bear part of the loss if the investments were not profitable.

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3. Principles of Al-Musyarakah

The bank shares the cost of the project with theentrepreneur based on an agreed proportion, and bothparties have the right to participate in the managementof the project as well as to waive such rights.

The profit from the project will be shared according toan agreed ratio which is not necessarily the same as theshare of the cost.

However, in the event of losses, these will be shared byboth parties according to an earlier agreed cost-sharingformula.

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P2112 – Chapter 64. Principles of Al-Bai Bithaman Ajil (deferred sale or

sale by instalment)

The bank determines the requirements of the customer inrelation to the period and manner of his repayment(normally by instalments).

Having done that, the bank purchases the asset andsubsequently sells it to the customer at an agreed pricewhich includes the actual cost of the asset to the bank anda profit margin which varies according to the value andtype of the asset.

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5. Principles of Assalam

Is a sale whereby the seller undertakes to supply some specific goods to the buyer at a future date in exchange of an advanced price fully paid at the spot.

Assalam was beneficial to the seller, because he received the price in advance.

It was beneficial to the buyer also because normally the price in assalam used to be lower than the price in spot sales.

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5. Principles of Murabahah

A customer agrees to buy the goods from the bank onarrival.

The bank in turn issues a letter of credit and settles thepayments to the negotiating bank using its own funds.

Later it sells the good at a marked-up price to thecustomer, and the settlement by customer to the bank isdone either on cash or instalment term.

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6. Principles of Al-Ijarah

Financing under the Al-Ijarah (leasing) requires thebank to acquire the asset chosen by the customer and,subsequently, lease it to the customer for a fixedperiod of time at the cost and terms and conditionsagreed to both parties.

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7. Principles of Al-Wakalah

The bank provides short-term facility through the issue of the letters of credit.

The customer may be required to deposit with the bank the full price of the goods to be purchased or imported, before a letter of credit can be issued.

The customer also needs to pay fees and commissions to the bank for the provision of this facility.

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8. Principles of Al-Kafalah

Another trade financing facility provided by the bank isthrough the issue of letters of guarantee under theprinciple of Al-Kafalah.

A customer is required to place a certain amount ofdeposit with the bank as a collateral to the guarantees.

The bank also charges service fees for the facility.

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9. Principles of Ar-Rahn (collateralized borrowings)

A thing deposited as a pledge in exchange for debt that canbe repaid in order to get the thing back. The bank use Ar-Rahn policy to ensure the safety of its rights while runningbusiness with it’s clients or it may provide the servicedirectly in order to widen the bank function.

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10. Principles of Al-Qardhul Hasan (benevolent loan)

Refers to an interest-free loan given mainly for welfarepurposes.

The borrower is only required to repay the principleamount borrowed, but he may pay an extra amount as agift (Al-Hibah) for such services.

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P2112 – Chapter 611. Principles of Al-Hiwalah (remittances)

Transfer debt from the debtor to other’s responsibility. Banks offer its clients Al-Hiwalah service in the form of money transformation.

The bank will charge them with varieties of service charge:

Commission

Cost of operation

Transaction fee

Differed price in money changes

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12. Principles of Al-Dayn (Bai’ Al-Dayn)

Refers to debt financing, for example the provision offinancial resources required for production, commerceand services by way of sale/purchase of trade documentsand papers.

It is a short-term facility with a maturity of not morethan a year.

Only documents evidencing debts arising from bonafide commercial transactions can be traded.

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P2112 – Chapter 6

Comparison Between Islamic Banking System and the Conventional Banking System

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i. Doesn’t involve the interest taking

or giving activities which is

prohibited in Islam.

ii. Functions as to enliven the

compulsory zakat and allows social

strength by establishing security fund

which is known as Qardhul Hassan.

iii. Operates base on Al Mudharabah

principle as a substitute to the

interest practice which has ‘riba’

element leading to a fairer profit to

all depositors.

i. Involve the interest taking or

giving activities.

ii. Doesn’t function as the

means of zakat collection.

iii. Doesn’t operate base on Al

Mudharabah principle but base

on interest practice.

P2112 – Chapter 6

The end…

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