Chapter 5Operational Aspects

&Practices Of

Islamic Banking System

Made by:Nor Izzuddin Bin Norrahman, BBA.

Lecturer of Management, Banking & Islamic Finance

Astin College, Puchong

Contents…

• Services Provided By Islamic Banks– Deposit Facilities– Financing Facilities– Other Facilities

• Source Of Funds• Social and Welfare Activities• Accounting Policies• Risk Management

Services Provided By IB

• Islamic Banks is an institution which involved bank activities.

• Thus, Islamic Banks should provide services which can meet the needs of a range of users.

• ‘Users’ can be categorized as:– Individuals

• Individual with excess money who want to make a deposit for precautionary or investment purpose.

• Individuals who requires financing for investment or personal needs.

– Business Organizations• For businessmen hold money for transactions and

investment purposes.• Businessmen who require financing to either start or expend

their business.

– Government Bodies• For investment purposes.• To finance its budget deficit.

• Islamic Banks also offer other facilities in order to meet the needs of their customer.

• Such services include:– Letters of credit (LOC)– Letters of guarantee– Money Order– Foreign Exchange– Cheque– Bank Draft– Advisory services– Etc.

• Hence, services offered by Islamic banks may be classified into three groups:– Deposit Facilities– Financing Facilities– Other Facilities

Deposit Facilities

• The following are some of the similarities and differences among the deposit facilities provided by Islamic Banks:– The Similarities– The Differences

• The Similarities

– Islamic banks all over the world (except for Turkey) provide three types of deposit facilities which is:• Current Account• Savings Account• Investment Account

– In general, the investment account facility can be divided into three categories which is (1) based on time, (2) based on notice [Only in B’desh, Jordan & Bahrain], and (3) based on specified projects / purposes.

– Most banks provide a guarantee to return the full amount of deposits placed by customers except in profit sharing facility.

• The Differences

– There are some differences in the treatment of the savings account facility among Islamic Banks.• Iran, Pakistan and UAE regard the savings account as a

facility itself.• B’desh, Kuwait, Jordan consider it as one of the facilities in

the investment account.• M’sia & Indonesia offer two types of savings account, that

is, accounts using the wadiah and mudahrabah principles

– Sometimes there are differences in terms of the Syariah principles used in the deposit facilities in Islamic Banks.

– There are Islamic Banks which offered rewards/return to the depositors for their deposits (Malaysia & Iran).

Deposit Facilities Provided by Islamic BanksIran M’sia Pakistan B’desh Kuwait

Current Acc.

Savings Acc.

Investment Acc.

Mudharabah Funds:

-Current acc.-Savings Acc.Negotiable

Islamic Debt Certificate

Others

Non-mudharabah fund:

-Savings Acc.Investment Acc.

Current Acc.

Savings Acc.

Fixed Deposit

Term Acc.

Other Deposit

Current acc.:

-Taka acc.-Dollar acc.

-Foreign Currency acc.

-Property development acc.

Mudharabah Deposit:

-Savings-Special Notice

-Fund Bonds

Term Mud.

Non-Investment Deposit:

-Current Acc.

Investment Deposit:

-Restricted-Non-Restricted

Savings Acc.

Deposit Facilities Provided by Islamic Banks (2)

Jordan Bahrain Turkey UAE Indonesia

Trust Acc.:

-Current Acc.-Demand Acc.

Non-Restricted Investment

Acc.:

-Savings-Notice-Fixed

Restricted Investment

Acc.

Muqaradah bond

Current acc.

Non-Restricted Investment Acc.

Non-Restricted Investment Acc.

Special Current Acc.

Participatory Acc.

Current acc.:

Savings Acc.

Investment Acc.

Wadiah Acc.:

-Demand-Savings

Non-Restricted Mudharabah Acc.:

-Savings-Term

Savings Account - Wadiah

Source: https://www.sc.com/my/islamic-banking/sme-banking/biz-current-account-i/en/index.html

Savings Account - Mudharabah

Financing Facilities• Islamic banks also offer financing facilities to their

customers.

• Financing for businesses:– Short Term

• For meeting working capital

– Long Term• Covers capital expenditure

• Financing for individuals:– Financial aid

• Housing• Personal• Goods

• Since the only recognize loan in Islam is qard hassan, all financing operations are either based on the profit-loss sharing principle or the principle of fees, commission and fixed charges.

• The is no clear rules in terms of priority in the use of principles when meeting the financing needs of customers.

• However, the principles of mudharabah and musyarakah are widely used in financing working capital (short term).

• While the principles of murabahah, bai muazzal and ijarahare used to finance fixed assets for the customers.

• The financing principles used by the Islamic Banks depend a lot on the law governing their operations.

Table 6-4: Percentage of financing based on syariah principles

Source: Sudin Haron, W. Nursofiza, (2009). Islamic Finance and Banking System : Philosophies, Principles & Practices. PG. 305,

Selangor, Malaysia. McGraw-Hill (Malaysia) Sdn. Bhd.

Principles BIMB, Malaysia

SBOB, Bahrain

IBB, Bangladesh

BMI,Indonesia

KFH,Kuwait

Albaraka Turk,

TurkeyDIB, UAE IIAB,

Jordan

Musyarakah - 8.8 0.7 43.2 - - 7.8 0.1

Mudharabah 0.09 9.7 <0.05 56.8 - - 11.3 3.8

Murabahah 17.7 75.0 50.9 - 91.0 - 45.1 68.1

BBA 52.8 - - - - - - -

Ijarah 2.6 4.9 - - - - 18.5 19.3

Qard Hassan - - 1.3 - - - - 0.2

Istisna 4.9 - - - 8.9 - 13.5 -

Other Principles

21.9 1.6 47.7 - - - 3.8 8.5

Total 100 100 100 100 100 - 100 100

Other Facilities

• Apart from deposit and financing, Islamic banks also provide other facilities to their customer.

• Such facilities depend on the capability and capacity of the particular bank.

• The facilities are:– Letters of credit (LOC)– Letters of guarantee– Money Order– Foreign Exchange– Cheque– Bank Draft– Advisory services– Etc.

Steps in Letter of Credit

• Source: http://www.aibtradefinance.com/tf/productdiag.asp?5

Types of LOC in IB

• Wakalah• Musyarakah• Murabahah

Source Of Funds

• Generally, there are three main sources of funds for Islamic banks which is:– Deposit– Other Liabilities• Funds acquired from other liabilities, usually from short

term liabilities.

– Shareholders’ Funds• Paid-up capital, various reserves and retained earnings.

Source Of Funds BIMB, Malaysia

SBOB, Bahrain

IBB, Bangladesh

BMI,Indonesia

KFH,Kuwait

Albaraka Turk,

TurkeyDIB, UAE IIAB,

Jordan

Deposit 88.4 72.3 86.9 87.0 74.4 81.2 77.6 84.8

Shareholders’ Funds

5.6 20.5 6.2 8.0 16.0 14.5 12.7 12.5

Others 6.0 7.2 6.9 5.0 9.6 4.3 9.7 3.1

Total 100 100 100 100 100 100 100 100

Table 6-7: Sources of Funds of Islamic Banks (%)

Source: Sudin Haron, W. Nursofiza, (2009). Islamic Finance and Banking System : Philosophies, Principles & Practices. PG. 316,

Selangor, Malaysia. McGraw-Hill (Malaysia) Sdn. Bhd.

Uses Of Funds

• Islamic banks use their funds according to the types of assets held.

• Mainly, there are five main categories:

– Cash• Includes cash in hand, balance with the central bank or

reserves and balances with other financial institutions.• Usually, banks do not hold high percentages of cash.• The amount of reserves kept with the central bank

depends on the ratio set by the central bank.• It is also depends to a large extent on how the central

bank implements its financial policies.

– Financing• Comprises all loans extended under the principles of

mudharabah, musyarakah, murabahah, bai muazzal, ijarah and qard hassan.

– Investment• Includes the investment in government securities,

treasury bills and investment in subsidiaries and associated companies.

– Fixed Assets• Include all land, buildings, vehicles, factories, furniture,

and fixtures.

– Other Assets• All assets that are not categorized under the four

mentioned categories.

Source Of Funds BIMB, Malaysia

SBOB, Bahrain

IBB, Bangladesh

BMI,Indonesia

KFH,Kuwait

Albaraka Turk,

TurkeyDIB, UAE IIAB,

Jordan

Cash 42.2 28.2 8.9 1.6 6.3 4.0 5.9 5.9

Financing 38.5 39.4 75.7 38.7 57.5 73.0 58.4 51.1

Investment 15.6 26.9 10.6 0.4 6.7 0.1 11.3 4.3

Fixed Asset 0.5 0.6 4.5 0.7 4.6 1.1 0.8 1.5

Other Asset 3.2 4.9 0.3 58.6 24.6 21.8 23.6 37.2

Total 100 100 100 100 100 100 100 100

Table 6-9: Sources of Funds of Islamic Banks (%)

Source: Sudin Haron, W. Nursofiza, (2009). Islamic Finance and Banking System : Philosophies, Principles & Practices. PG. 319, Selangor, Malaysia.

McGraw-Hill (Malaysia) Sdn. Bhd.

Social and Welfare Activities

• Most Islamic banks have a high sense of corporate social responsibility (CSR).

• The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) – responsible for preparing and issuing accounting standards of Islamic Banks.

• AAOIFI does not provide any standards on matters relating to social responsibility.

• However, AAOIFI provide standards that deal with the determination of zakat.

• In includes:– Measurement of items to be included in the zakat

base– Disclosure of zakat in the financial statement of

Islamic Banks.• In this case, zakat is regarded as a social rather

than religious responsibility.

Accounting Policies

• Islamic banks must comply with Islamic business principles in all their transactions.

• As such, many Muslim scholars are of the view that Islamic banks should have methods of measuring , recording and reporting of transactions that are differ from the conventional banks.

• It was as a result of the recommendations made regarding the need to have a common standard of accounting for Islamic banks that the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) was formed in 1991.

• AAOIFI has produced several standards related to accounting and other financial transactions of Islamic banks.

The Basis of financial statement preparation

• Islamic banks are not legally bound to comply with these standards set by AAOIFI.

• This is because Islamic banks somehow have to comply with standards and legislation imposed by the regulatory authority of those country.

• Example: Malaysia – Companies Act 1965• Islamic banks which comply with AAOIFI standards

are mostly originating from Middle East.• This is also indicate that the acceptance of

accounting standards by AAOIFI is relatively low.

Revenue Recognition

• Revenue recognition is the record of revenue when an exchange transaction has taken place or when the earning process has been completed.

• Not all Islamic banks describe their revenue recognition policy in their annual reports.

• Nonetheless, the methods of recognizing revenue may be vary among them.

• AAOIFI has issued a guide on revenue recognition.

Investment

• Investment is one of the methods on how Islamic banks generate revenue.

• There are four types of investment:– Purchase of negotiable securities (Shares, bonds,

etc.)– Investment in subsidiary & associated companies– Investment in properties and real estates– Other investment

Provision for doubtful debts

• Doubtful debts or bad debts are unavoidable in the banking industry.

• For this, AAOIFI has suggested that Islamic banks present four matters related to the doubtful debts:– Provision charged to income statement during the

period– Receivables written off– Receivables collected which previously written off– The balance of the allowance for doubtful debts as of

the beginning and end of the period.

Fixed asset and depreciation

• Fixed assets are assets bought to generate revenue.

• Fixed assets are usually in the form of:– Buildings– Motor Vehicles– Office Equipment– Management information system

• AAOIFI does not provide the detailed guidelines related to fixed assets.

Allocation of profit

• One of special features of Islamic banks is the application of profit-loss sharing principle in their transactions.

• Depositors of Islamic banks does not know in advance returns from their deposit unlike the conventional banks. This is because IB use mudharabah principles.

• AAOIFI merely states that Islamic Banks will receive return in the form of percentage of the profit.

Payment of zakat

• The obligation to pay zakat is another unique features of Islamic Banks.

Risk Management

• Market Risk• Credit Risk• Liquidity Risk• Operation Risk• Syariah-compliance Risk

• Source:Sudin Haron, W. Nursofiza, (2009). Islamic Finance and Banking System : Philosophies, Principles & Practices, Selangor, Malaysia. McGraw-Hill (Malaysia) Sdn. Bhd.