CHAPTER 4

Islamic Banking Operations and Instruments

4.1 A Brief Introduction to Islamic Banking Operations and Instruments

Islamic banking has the same purpose and operations as conventional banking.
However, Islamic banking refers to a system of banking activities that operates within
the realms of Shariah teachings. An Islamic bank, while performing similar functions
as conventional banks (that is, matching surplus fund unit and deficit fund unit via
intermediation) is relatively different from its conventional counterpart due to its
unique nature of operations and activities which need to comply with Shariah
principles and rulings. Islamic banks have at their disposal a number of financial
contracts like wadiah yad dhamanah, murabahah, ijarah, istisna, etc., that create a
unique relationship between depositors and Islamic banks on one side, and Islamic
banks and financing customers, on the other.

In the case of Islamic banks, each and every contract has its own features and
characteristics that affect the nature of contractual relationship between the parties
involved. This relationship in the case of Islamic banks is inclined towards both
equity-based and debt-based financing as opposed to conventional banks which are
more inclined towards debt-based financing and lender-borrower relationship.
Islamic financial instruments may look like a mirror picture of conventional ones,
however, their underlying features, contractual relationships, mechanisms and
implications are not identical.

Since the charging and paying of interest is prohibited in Islam, Islamic banks use
various contracts that are Shariah compliant. Consequently, Islamic banks nowadays
use equity, as well as debt-based financial instruments for both mobilization and use
of funds. However, while similar in nature and functions, the Islamic financial
products differ significantly when it comes to the underlying contracts and
mechanisms used. In fact, it is due to these underlying contracts that the Islamic
mode of intermediation is distinguished from the conventional one.
On the liability side of an Islamic banks balance sheet, there are generally demand
deposits, investment accounts, special investment accounts, capital, equity and
reserves. An Islamic bank can mobilize funds through contracts such as mudarabah,
wakalah and wadiah. However, unlike deposits placed in conventional commercial
banks whose principals and returns are assumed to be guaranteed, Islamic banks
are not able to guarantee return of the capital and profit. This is especially true for
deposits and investments that are based on mudarabah (partnership) and wakalah
bi istithmar (agency for investment) principles. On the other hand, the principal
amount of deposits placed within an Islamic bank is based on the principle of wadiah
(custodianship) or qard (loan) and can be guaranteed by the bank but any returns
out of the invested amount will solely belong to the banks. It is up to the banks
discretion to share the surplus with the customers.

On the asset side of the Islamic banks balance sheet, there are varieties of
instruments available for use of the mobilized funds. These include sale-based
instruments (like murabahah, salam and istisna), lease-based instruments (ijarah),
equity-based instruments (mudarabah, musyarakah and wakalah bi istithmar) and
other fee / income generating instruments (like jualah, rahn, wakalah, kafalah, etc.).
The following sections will focus on delineating and illustrating the salient
instruments used on both sides of an Islamic banks balance sheet.

4.2 Sources of Funds

Islamic banks which consist of their own capital and equity will also rely on two other
main sources of funds. The first is the transactional deposits which are mainly risk
free and provides no return. The second is the investment deposits which carry the
risk of loss in capital for the investments made. There are a total of four main types
of deposits: savings deposit, current deposit, term deposit and investment deposit.

Savings Deposit
All Islamic banks operate savings deposit accounts; however, the operations of these
accounts vary at different banks. Generally, savings deposit permits the customers to
deposit and withdraw their money at any time and does not require a minimum
balance in the deposit account. It does not have any maturity date; therefore the
cash can be withdrawn at any time based on customer demand. Generally Islamic
financial institutions structure their savings deposit accounts based on the Shariah
principles, either in the form of qard, wadiah yad dhamanah and mudarabah savings
deposit.

Current Deposit
A current deposit account is a form of demand deposit that offers users safe keeping
of their cash deposits, and the choice to be paid in full upon demand. The current
account deposit facilities are usually offered to either individuals or companies. It
also shares similar features with savings deposit at it permits for the cash to be
withdrawn at any time. The main point of departure between a current deposit and a
savings deposit is the presence of a cheque book and a multi-functional card used in
the former. If the account holders were to withdraw more than what is sufficient in
their balance, there will also be no charges incurred. The three common structures of
current deposit in the Islamic financial institutions are qard, wadiah yad dhamanah
and mudarabah current deposit.

Term Deposit
Term deposit is a type of arrangement where the customers deposits are held at a
bank for a fixed term. These deposits will then be deposited to a number of
investment pools where it will be invested in business activities which are in
accordance to Shariah. The money deposited in a term deposits, can only be
withdrawn at the end of the term as stated in the contract or by giving a pre-
determined number of days as notice. Usually, term deposits are short term deposits
where the maturities are within a period of one month to a few years. The Islamic
term deposits are commonly structured based on the commodity murabahah,
wakalah unrestricted investment and mudarabah general investment.

Investment Deposit
The investment deposit is usually known as a profit and loss sharing (PLS) account
or simply, the investment account. The main point of departure between the
investment deposit and both savings and current deposit is that the former is
normally structured based on either the mudarabah or wakalah bi istithmar principles
which do not entail a guarantee of neither principle nor return of profit. Nevertheless
the investment account holders have an opportunity to earn more attractive returns
although there is also a likelihood of having to bear the risk of capital losses.

Underlying Contracts for Savings and Current Deposit

The qard structure is predominantly used by the Islamic financial institutions in the
Middle East and Europe. Essentially the aim is to provide the depositors with a
guaranteed safe-keeping of the amount deposited, and at the same time allows
banks to utilize it for its banking and business activities. In a qard structure, the
depositor is deemed as a lender to the bank who acts as the borrower and the bank
guarantees such return even if there is negligence or loss of wealth.
It is not allowed for banks to provide qard-based deposit account holders material
gifts, financial inducements or benefits that are not related to the deposits and
withdrawals. However, the banks may opt at their own discretion to reward the
depositors through hibah (gift) as long as it is not pre-agreed and stipulated in the
contract.

Wadiah Yad Dhamanah Deposit

The term wadiah is defined as empowering someone to safeguard an owners
property explicitly or implicitly. It can be further divided into two types, namely wadiah
yad amanah and wadiah yad dhamanah. Wadiah yad amanah is a trust contract
where the trustee will be authorized to keep the funds of the depositors in his or her
safe custody by explicit or implicit terms.

However, there is a paradigm shift from a trust contract to a guaranteed wadiah

contract. The modification of the wadiah yad amanah contract is made by attaching
the contract of wadiah with a guaranteed element. The guaranteed element converts
the original concept of wadiah, which is based on trust, to a guaranteed safe
custody, also known as wadiah yad dhamanah. The element of guarantee is deemed
necessary since the bank is allowed to utilize the funds at its own risk. However, if
the depositors eventually decide to withdraw their money, the bank needs to assure
that the money is made available upon demand. The profit gained from the utilization
of the deposited funds belongs exclusively to the bank. However, the bank may
voluntarily choose to share the profits obtained with the depositors in the form of
discretionary hibah (gift).
Term Deposit
There are various structures of Islamic term deposit schemes which have been
experimented by Islamic banks to satisfy the needs and requirements of different
clienteles. Some of these schemes include structures based on commodity
murabahah term deposit, wakalah unrestricted investment deposit and mudarabah
general investment account. Most of these term deposit schemes are bank specific;
therefore all these various deposits may not be found in all the Islamic banks.

Mudarabah General Investment Account

This account provides an investment opportunity that operates under the Islamic
banking principle of mudarabah. Mudarabah is a form of partnership contract
whereby a customer known as rabbul mal (property owner) who is looking for
investment opportunities for his funds will invest through the bank who acts as the
manager of the fund (mudarib). Under this account, no minimum tenure of
investment is required and the investment product will not be unique. The mudarib
has a broad range of trade or business freedom on the basis of trust and the
business expertise he has. However, the actions of the mudarib must be in
accordance to the customs of the mudarabah operations and the subject matter of
the contract.

Investment Deposit
There are various investment deposits available in the Islamic banks. The two most
prominent investment deposits used in Islamic banks are the wakalah restricted
investment deposit and the mudarabah special investment account.

Mudarabah Special Investment Account

The main difference from the Mudarabah General Investment Account is that in this
account, the rabbul mal will be advised on where the funds will be invested, what the
minimum amount that they can invest in the projected return, and what is the loyalty
risk that come with it. Additionally, the returns on Special Investment Accounts are
generally much higher than the Mudarabah General Investment Account. In light of
this, the rabbul mal are usually government institutions, or large corporate customers
that are involved in specific investments, for example, project financing or
repurchase agreements in the Islamic Money Market.
4.3 Uses of Funds

Here, we will also focus on the various characteristics and principles underlying the
operations of Islamic financing facilities in Islamic banking. The most common
structure of any Islamic commercial bank involves two main sectors the personal or
retail sector and the corporate or trade sector.

Islamic Retail Financing

The characteristics of retail financing requirements are very narrow and specific to
basic individual necessities that can be divided into three broad categories which are
home financing, automobile financing and personal financing

Home Financing
The most common models and structures in Islamic home financing as offered by
many Islamic banks worldwide are either based on bay bithaman ajil (deferred
payment sale), musyarakah mutanaqisah (diminishing partnership), ijarah (leasing),
or parallel istisna (construction-required sale).

Musyarakah Mutanaqisah Home Financing

This is a hybrid contract which was recently developed by contemporary scholars.
Generally, it can be defined as a form of partnership in which one of the partners
promise to buy the equity share of the other partner gradually until the title of the
equity is completely transferred to him. According to this concept, the transaction
generally consists of three steps. First, a bank and a customer form a partnership
based on the contract of shirkah al-milk. Second, the customer agrees to rent the
banks undivided share in the property through the contract of ijarah. Finally,
throughout the financing tenure, the customer will gradually buy the banks shares
through the contract of bay. In addition, the customer will usually sign the purchase
undertaking agreement whereby he agrees to gradually buy shares from the bank.

Musyarakah mutanaqisah is also known to be an innovative and flexible instrument

for Islamic financing. The contract is mostly used in the area of property venture,
asset acquisition and business working capital. Many banks that provide home
financing adopted the musyarakah mutanaqisah financing instruments. Some
examples are HSBC Amanah (UK), Al Buraq (UK), Islamic Bank of Britain PLC and
KFH (Malaysia).

Parallel Istisna Home Financing

Istisna can be defined as a purchase contract of an asset whereby a buyer will place
an order to purchase the asset which will be delivered in the future. The buyer will
require a seller or a contractor to deliver or construct the asset that will be completed
in the future according to the specifications given in the sale and purchase contract.
Both parties of the contract will decide on the sale and purchase prices as they wish
and the settlement can be delayed or arranged based on the schedule of the work
completed.

Tawarruq Home Financing

This is another alternative home financing introduced by an Islamic bank in the
Middle East. The following demonstrates the common mechanism of tawarruq-
based home financing. The customer identifies a house from the developer or house
owner and pays a 10 per cent down payment. The customer approaches a bank to
apply for financing and the bank will assess his credit worthiness. The bank will buy
a commodity from broker A, costing say $100,000. The bank sells the commodity to
the customer for $140,000. The customer will pay the amount of $140,000 to the
bank by installment throughout the financing period. The customer sells the
commodity to broker B and gets cash. The customer pays the remaining 90 per cent
balance to the house developer.

Besides being used as a home financing instrument, tawarruq is commonly used by

Islamic banks as a mode of financing to facilitate cash transactions such as personal
financing, working capital financing and business cash line.

Automobile Financing
In retail banking business, automobile financing is another popular product offered
by IFIs. The most popular structure used by many IFIs is al-ijarah thumma al bay
(AITAB) or simply known as the Islamic hire purchase. The AITAB vehicle financing
is an Islamic vehicle financing facility, which is based on the Shariah concept of
ijarah (leasing) and bay (sale). Al-ijarah thumma al bay can be defined as a
contract of lease which is subsequently followed (thumma) by a sale contract.

Personal Financing
This is a type of financing that does not involve any asset acquisition. Rather,
customers require cash or liquidity for various reasons and purposes such as
education, medical, performing pilgrimage, payment of debt and others. In order to
accomodate the diverse customers needs and expectations, many IFIs are required
to offer personal financing products which are based on controversial principles such
as bay al inah and bay al tawarruq.

Islamic Credit Cards

Another important and popular segment of Islamic retail financing is the provision of
Islamic alternative structures to the credit card facility. The most common structures
of Islamic credit cards are inah-based, tawarruq-based and ujrah-based credit cards.
The difference between Islamic credit card and conventional credit card: (i) In Islamic
banking, the profit rate is non-compunding as compared to conventional credit card.
(ii) It cannot be used for transactions prohibited by Shariah such as gambling, liquor,
etc. (iii) The credit card is formulated based on Shariah concepts of inah, tawarruq
and ujrah.

The annual fee charged by an Islamic bank on its credit card may be higher than the
annual fee charged by other conventional banks, but it is totally free from any
element of interest and there is no hidden cost associated with the usage of the card.
All fees are explicitly made known to the customer. Therefore, based on usage, it
may not necessarily be expensive, vis--vis conventional credit cards in the
competitive market.

The basic modus operandi of Islamic credit cards based on ujrah is as follows. First,
the customer applies for a credit card from a bank. The bank provides a credit card
account based on the customers credit worthiness. The customer pays the
merchants for the goods from a credit card account. For this transaction, the bank
provides qard to the customer for the purchased goods. The customer pays the
purchase amount and fee to the bank. The customer will be charged a fixed fee
structure or other structures such as monthly service fee which is based on the
actual cost of managing the transaction and an annual service fee based on the
benefit rendered by the bank. The bank earns profit from the service fee and also
commission from the merchants, if any.

The basic modus operandi of Islamic credit cards based on inah is as follows. The
bank sells an asset to the customer on deferred payment to be paid within a certain
period of time (which is the credit cards expiry date). The customer subsequently
sells the asset back to the bank for a lower amount (equivalent to the credit limit) in
cash. This amount will be credited into a marginal wadiah account (also known as
the customers special account) at the bank for the customers use. Whenever the
customer uses the credit card, the amount will be paid by the bank by deducting it
from this account. Once the customer has made a repayment, the amount will then
be topped up.

The basic modus operandi of Islamic credit cards based on tawarruq is as follows.
First of all, tawarruq means to buy on credit and sell at spot value with the objective
of getting cash. In other words, the transaction is not the need of the buyer; he
simply wants liquidity, which he gets by purchasing a commodity (or item) on credit
and selling the same for cash. If he sells to any third party, it is acceptable from the
Shariah point of view, but if he sells to the person from whom he purchased on
credit, it is not Shariah compatible according to the majority view. Despite being a
grey area, tawarruq is being used by many Islamic banks for liquidity management
and as a mode of financing, especially for personal financing and credit cards.
Therefore, tawarruq is actually reverse murabahah for the purpose of acquiring cash
through trade activities.

The modus operandi of tawarruq formulated credit card is as follows. The bank
purchases a commodity from broker A. The bank sells the commodity to the
customer for deferred payment for a price equivalent to the credit limit plus profit.
The customer sells the commodity to broker B. Broker B deposits the cash into the
customers wadiah account. The customer buys the goods from the merchants using
the wadiah account. The purchase price is transferred to the merchants.

Islamic Corporate Financing

Corporate financing caters to the specific needs of the business community which
may differ from retail customers. Like its conventional counterpart, Islamic banking
also offers a wide range of corporate or business products ranging from term
financing, working capital financing, trade financing, and project financing.

Working Capital Financing

Working capital deals with the short term needs of businesses which are reflected in
their balance sheet of both the current assets and the current liabilities. Proper
management of working capital is vital as it ensures the companys continuous
operations and the availability of sufficient cash flow. This is necessary to pay any
upcoming short term debts and operational expenses. Accordingly, Islamic banking
plays a major role by providing various facilities to address the need of businesses to
remain competitive, viable and sustainable in the market. The two main products
offered by IFIs are Islamic overdraft and revolving credit. Most of the cash line
Islamic overdraft facilities are structured based on either inah or tawarruq. Under the
concept of bay al-inah, the financial institution will first sell to the customer an
identified asset belonging to the bank at a deferred price with a profit margin higher
than the financing value as per requested by the customer. Subsequently, the
customer will sell back the asset to the bank at a price equivalent to the value of the
financing amount. The amount which is supposed to be disbursed to the customer
as per the second sale execution will then be deposited into a suspense account.
From this suspense account, the customer is allowed to overdraw his current
account.

Project Financing

Project financing refers to the financing of long-term infrastructure, industrial projects

and public services based upon a non-recourse or limited recourse financial
structrure where project debt and equity are used to finance the project, and are paid
back from the cash flow generated by the project. The characteristics of project
financing are: (i) project cash flows; (ii) normally higher levels of debt; (iii) variety of
contractual obligations and undertakings to manage and reduce risk; (iv) a varity of
funding sources; (v) techniques and instruments must comply with Shariah principles
conceptually, structurally and documentaries; and (vi) modus operandi execution
and implementation.

Islamic Trade Financing Instruments and Practices

Trade finance is one of the most important services offered by Islamic banking,
especially to address the needs of the business involving cross border transactions.
Trade finance can be categorized into domestic and international. Domestic trade
involves the buying and selling of commodities in the country which includes retail
trade and wholesale trade. International trade is the external trade of the country,
and it encompasses the exchange of commodities between the country and other
countries including the import and export trade.

Islamic trade financing facilities include facilities such as Islamic letters of credit,
Islamic accepted bills, Islamic bank guarantee, Islamic shipping guarantee, Islamic
export credit refinancing and Islamic trust receipt.

Shariah Contracts/Concepts for Trade Services

Wakalah (Agency)
It refers to an agency relationship where one party is appointed to act as an agent on
behalf of another party.

Murabahah (Cost Plus)

Under murabahah contract, the bank sells the goods to you at the banks selling
price which comprises the principal amount (i.e., the cost price of the goods) plus the
banks profit payable by you.

Kafalah (Gurantee)
It refers to a contract of performance or financial guarantee given by one party to
discharge the liability of a third party in the case of defaults.

Bai Dayn (Debt Trading)

This contract refers to the selling of your trade debts/receivable arising from trade-
related transactions. You will sell your trade debts/receivable to the bank for a
discounted amount.
Ujrah (Fee)
It refers to commission or fee charged for services rendered by the bank.

Islamic Letter of Credit (ILC) is a written undertaking given by the Islamic bank, to
the seller (the beneficiary) at the request and on the instructions of the buyer (the
applicant), to pay at sight or at a determinable future date, a stated sum of money
within a prescribed time limit and against stipulated documents which must comply
with terms and conditions. An Islamic bank may offer ILC under several Shariah
contracts, namely wakalah (agency), musyarakah (partnership) and murabahah
(cost-plus profit).

ILC Wakalah
The customer informs the Islamic bank of his ILC requirement and requests the
Islamic bank to provide him the facility. The Islamic bank may require the customer
to place a deposit for the full amount of the purchase price, which the Islamicv bank
accepts under the principle of wadiah yad dhamanah (guaranteed safe custody). The
Islamic bank establishes the ILC and pays the proceeds to the negotiating bank,
utiliuzing the customers deposit, and subsequently releases the documents to the
customer. The negotiating bank claims reimbursement from the Islamic bank. The
Islamic bank charges the customer fees and commission for its services under the
principle of al-ujr (fee) based on the wakalah principle.

ILC Musyarakah
The customer informs the Islamic bank of his ILS requirement and negotiates the
terms of musyarakah financing for his requirement. The customer places with the
Islamic bank a deposit for his share of the cost of goods to be purchased or imported
as per the musyarakah agreement, which the Islamic bank accepts under the
principle of wadiah yad dhamanah. The Islamic bank establishes the ILC and pays
the proceeds to the negotiating bank, utilizing the customers deposit and its own
share of financing, and subsequently releases the documents to the customer. The
customer takes possession of the goods and disposes these off in the manner
agreed. The Islamic bank and the cuastomer share the profit fronm the venture as
provided for in the agreement.

ILC Murabahah
The customer informs the Islamic bank of his ILC requirement. He requests the
Islamic bank to purchase or import the goods indicating that he would be willing to
purchase goods from the Islamic bank upon negotiation of the ILC using the principle
of murabahah. The Islamic bank appoints the customer as its agent to purchase the
required goods on its behalf. The Islamic bank establishes the ILC and pays the
proceeds to the negotiating bank, utilizing its own funds. The Islamic bank sells the
goods to the customer at a sale price comprising its cost and profit margin under the
principle of murabahah for settlement on deferred basis.

Islamic Accepted Bill (IAB) is an interest free accepted bill that was introduced in
1991. The objective of IAB is to encourage and promote both domestic and foreign
trade of Malaysian businesses. IAB is formulated is accordance with the Islamic
principles of murabahah and bay al-dayn (debt trading). The former refers to the
selling of merchandise at a price based on cost plus profit margin agreed to by both
parties. Bay al-dayn refers to the sale of a debt, the debt of which arises from a
permissible trade activity (as in the murabahah or deferred payment sale). Therefore,
IAB is an instrument evidencing a debt, which is tradable between an owner of debt
and the buyer of the debt. Since a debt is tradable, it can be securitized in the
secondary market. Bay al-dayn is a method of transacting a debt trading in Islam.

A debt is recognized by way of evidencing it with the creation of a bill of exchange to

evidence its existence arising from any permissible activity (e.g., murabahah
activity). In Malaysia, IAB is substantiated by the financing of imports and domestic
purchases, and the financing of exports and domestic sales.

Imports and local purchases

The financing is based on murabahah working capital financing. The Islamic bank
appoints the customer as its purchasing agent. The customer then purchases the
required goods from the supplier on behalf of the Islamic bank, which will pay the
supplier the purchase price and then resell the goods to the customer at selling price
inclusive of a profit margin. The customer is allowed a deferred payment term of up
to 200 days. Upon maturity of the murabahah financing, the customer pays the
Islamic bank the cost of goods plus profit margin.

The sale of goods by the Islamic bank to the customer on deferred term constitutes
the creation of debt. This is securitized in the form of a bill of exchange drawn by the
Islamic bank and accepted by the customer for the full amount of the Islamic banks
selling price payable at maturity. If the Islamic bank decides to sell the IAB to a third
party in the secondary market (the Islamic interbank money market) at a discount,
then the concept of bay al-dayn will apply whereby the Islamic bank will sell the IAB
at the agreed price.

Exports and local sales

The business man or customer will sell his goods on credit to the importer (or buyer).
The customer prepares the sales documents as required under the sale contract or
letter of credit. The export documents will be sent to the importers Islamic bank. The
exporter or customer will draw on the commercial Islamic bank a new bill of
exchange as a substitution bill that represents the IAB. The Islamic bank will
purchase the IAB at a mutually agreed price using the concept of bay al-dayn and
credit the proceeds to the exporters account. On maturity, the customer settles the
face value of the IAB to the Islamic bank.

Securitization and debt securitization

Seecuritization is a process of transforming illiquid asset into a liquid one.
Technically, securitization can be defined as a process of packaging financial
promises and transforming them into a form whereby they can be freely transferred
among a multitude (i.e., large number) of investors. The financial promises are
essentially promises to pay that may originate from a variety of conmmercial
transactions, including direct loans, credit sales, lease arrangements, and even
equity participations. The goal of securitization is to transform the promises of
individuals and corporations to make future payments into freely transferable
securities that are appealing to investors.

In debt securitization, the raw assets are debts (as opposed to equities). The debts
can arise from straight borrowing (loans), or from other debt creating transactions. A
debt securitization normallty involves a two-step process. The first step is the
creation of the raw assets, i.e., the indebtedness (the financial promise to pay). The
second step is the securitization of the indebtedness into papers and tradable units.
The securitization of the indebtedness is normally done by the issuance of notes,
debt papers or bonds to evidence the indebtedness and obligation to pay. These
notes, debt papers and bonds are essentially debt securities representing IOUs. The
debt securities are negotiable (i.e., can be changed or agreed when people discuss
it) and can be traded to other parties at the secondary market. For the securitization
to be Islamic, both the raw assets (debt) and the transformation of the assets (debts)
into tradable units must comply with Islamic legal rules and principles.
Islamic Bank Guarantee is a guarantee which is a promise by a third party to carry
out the obligations owed by one person to another in the event of default. Under the
Shariah and in accordance with the principle of kafalah, an Islamic bank may issue
at the request of the customer an Islamic bank guarantee (IBG) to a beneficiary
named by the customer.

Therefore, an IBG is an indemnity letter in which an Islamic bank commits itself to

pay a certain sum if the customer fails to perform or if any other form of default
occurs. It is given by the Islamic bank (guarantor) in writing at the request of the
customer (principal) to pay a stated sum of money to the beneficiary in case a claim
is made by the beneficiary on first demand. Under the IBG, the financier provides an
undertaking in favor of the customer against the beneficiary. The customer pays the
fees and the financier pays the beneficiary if the customer failed to honor his
obligation and would claim from the customer to reimburse the payment made (at
par). One of its uses is when an Islamic bank wants a carrier to release a shipment
which it has financed but the original bill of lading is not yet available for surrender to
the carrier.

The kafalah principle used in IBG is a surety given by a third party who agrees to
discharge a liability of a second party in case the first party defaults in fulfilling his
obligation. The Islamic bank may require the customer to place a certain amount of
deposit for the facility which the Islamic bank accepts under the principle of wadiah
(safe custody). The Islamic bank charges the customer a fee for the service it
provides.

Islamic Shipping Guarantee or ISG is a letter of performance and indemnity issued

by the Islamic bank on behalf of the buyer or importer. This letter of performance and
indemnity, signed by the buyer or importer and counter signed by the bank, is
addressed to the owner or agent, charter party, or master of the vessel (ship) for the
release and delivery of the respective goods to the buyer or importer without
production of the bill of lading/document of title of goods. ISG is needed by the
importer or buyer due to the absence of the original Bills of Lading/document of title
of goods from the exporter, whereby the importer or buyer cannot claim the goods
when the goods reach the port. Therefore, the ISG is required to enable the importer
or buyer to claim the goods. By enabling the importer to take delivery of goods
immediately, the importer will not have to incur demurrage and extra port charges.
The importer can also sells his goods without delay. Islamic banks use the kafalah
principle to issue this instrument. The bank charges the customer a fee for the
service provided.

Interest Free Export Credit Refinancing (IECR) provides an alternative short term
pre- and post-shipment financing to direct/indirect exporters to promote export of
manufactured products, agricultural products and primary commodities. It is available
to a manufacturer or trading company with ECR credit line duly established with any
participating Islamic bank. Pre-shipment IECR is a financing facility based on
mudarabah contract granted to customer as direct or indirect exporter for preparing
goods prior to shipment. IECR post-shipment is a financing facility based on bay al-
dayn contract granted to customer as a direct exporter who exports eligible products
on sight or usance terms. For sight term, financing period will not exceed 60 days.
The objective of pre-shipment IECR facility is to realize the national insustrialization
policy by way of implementation of the following strategies: (1) Assisting the
production of eligible goods for export and promotong the backward linkages in
industrial development. (ii) Extending the facility scheme to a wide range of direct
and indirect exporters especially the small and new exporters. This facility is made
available to direct and indirect exporters (manufacturers) by way of financing the
working capital requirement and input purchases under the principle of murabahah.

Islamic Trust Receipt (ITR) is a financing facility to finance domestic or international

trade documents drawn against ILC or wakalah inward bills for collection. This facility
is approved only to customers who have been approved the wakalah letter of credit
facility. Islamic banks issue the ITR facility to the customer based on the murabahah
principle for financing the purchase of goods. It is a document of trust signed by the
customer (importer), the strength of which the Islamic bank releases the shipping
documents to the purchaser/importer who undertakes to land, store, insure, hold and
deliver to his buyers the said goods or merchandise. The Islamic bank holds the
customers ITR, executed by him, to signify his holding of goods in trust pending the
sale of the goods. In other words, the bank retains the legal title of the shipping or
transport documents/goods, but relinquishes physical possession of the goods to the
purchaser/importer who acts as agent of the bank. The customer disposes the goods
profitably and pays the bank the agreed selling price on or before the maturity or due
date.

For example, a customer, who is involved in trading or manufacturing may require to

purchase goods or raw materials during the course of his business. In this case, the
customer may require the wakalah letter of credit together with financing facility over
a certain period of time. The bank would offer the customer WLC/Murabahah Trust
Receipt facilities.

The bank, having made the payment to the negotiating bank, will then sell the goods
to the purchaser/importer at a sale price comprising its cost and profit margin under
the principle of murabahah where settlement is on deferred term. The deferred
payment term of sale of goods granted to the customer constitutes the creation of a
debt. This is securitized in the form of a Bill of Exchange drawn by the Islamic bank
and accepted by the customer and payable on maturity. Before the Islamic bank
issue the ITR facility, the customer must first have an approved ITR line. Request for
financing must include submission of the relevant documents evidencing the
underlying transaction and also compliance to the terms of the facility. The Islamic
bank holds the ITR executed by the customer to signify that the customer holds the
goods in trust pending the sale of the goods.

The discussions of this Chapter make it clear that Islamic banking is not a negligible
or merely temporary phenomenon. Islamic banks are here to stay and there are
signs that they will continue to grow and expand. Even if one does not subscribe to
the Islamic injunction against the institution of interest, one may find in Islamic
banking some innovative ideas which could add more variety to the existing financial
network.

One of the main selling points of Islamic banking, at least in theory, is that, unlike
conventional banking, it is concerned about the viability of the project and the
profitability of the operation but not the size of the collateral. Good projects which
might be turned down by conventional banks for lack of collateral would be financed
by Islamic banks on a profit-sharing basis. It is especially in this sense that Islamic
banks can play a catalytic role in stimulating economic development. In many
developing countries, of course, development banks are supposed to perform this
function. Islamic banks are expected to be more enterprising than their conventional
counterparts. In practice, however, Islamic banks have been concentrating on short-
term trade finance which is the least risky.

Part of the explanation is that long-term financing requires expertise which is not
always available. Another reason is that there are no backup institutional structures
such as secondary capital markets for Islamic financial instruments. It is possible
also that the tendency to concentrate on short-term financing reflects the early years
of operation: it is easier to administer, less risky, and the returns are quicker. The
banks may learn to pay more attention to equity financing as they grow older.

It is sometimes suggested that Islamic banks are rather complacent. They tend to
behave as though they have a captive market in the Muslim masses that will come to
them on religious grounds. This complacency seems more pronounced in countries
with only one Islamic bank. Many Muslims find it more convenient to deal with
conventional banks and have no qualms about shifting their deposits between
Islamic banks and conventional ones depending on which bank offers a better return.
This might suggest a case for more Islamic banks in those countries as it would force
the banks to be more innovative and competitive. Another solution would be to allow
the conventional banks to undertake equity financing and/or to operate Islamic
'counters' or 'windows', subject to strict compliance with the Shariah rules. It is
perhaps not too wild a proposition to suggest that there is a need for specialized
Islamic financial institutions such as mudharabah banks, murabahah banks
and musyarakah banks which would compete with one another to provide the best
possible services.

Come June 30, 2015, all Islamic banks and commercial banks with Islamic banking
subsidiaries offering Islamic deposits must classify them either as principal
guaranteed or investment accounts which are not principal guaranteed under
Shariah contracts in line with the Islamic Financial Services Act (IFSA).
This means that products with mudarabah (profit sharing) or wakalah (agency)
features are considered investment accounts which are non-principal guaranteed.
Islamic deposits, on the other hand, like wadiah (custodian), qard (loan) and
tawarruq (sale) are principal guaranteed. Currently, all Islamic deposits are protected
by the Malaysia Deposit Insurance Corporation (PIDM). It is estimated that about 50
per cent of Islamic deposits in the banking system falls under the investment account
category.

Based on PIDMs statistics for the assessment year in 2012, total insured deposits
for the Islamic banking business totalled RM50.2 billion compared with RM40 billion
in the previous year. A BNM official said that such classification was necessary as it
would provide greater legal clarity on the various types of Shariah financial contracts
and to ensure end-to-end compliance in full cycle of Islamic banking operations.
From a market standpoint, he said it would not cause inconvenience to customers as
they would now have a choice and be able to differentiate between products that are
principal guaranteed and those which are not that provide potentially higher risk
returns like mudarabah. Customers whose Islamic deposit accounts are structured
based on syariah contract with non-principal guaranteed feature will be informed of
the alternative products and provided with sufficient information/transparency to
make an informed decision. They will have a choice to either maintain their funds
with Islamic deposit or change to investment account product depending on the
customers risk appetite. Customers would be given sufficient time to inform the
banks of their decision, adding that during this process they would be ensured that
their rights and deposits are protected. The Financial Services Act (FSA) and the
IFSA, which came into effect July last year, has repealed the Banking and Financial
Institutions Act 1989, the IBA, the Insurance Act 1996, the Takaful Act 1984, the
Payment Systems Act 2003 and the Exchange Control Act 1953.
On the possible impact of the move to banks, he said banks were required to make
available alternative Islamic deposit products based on syariah contracts with
principal guaranteed feature as a substitute to the Islamic deposit products with non-
principal guaranteed feature.The official said some Islamic banks have already
started to provide alternative Islamic deposit products. It is learnt that some banks
are looking into the possibility of transferring these deposits to takaful or Islamic
insurers for insurance protection. Banks on the whole were studying the matter
carefully before giving their views to the central bank, an industry observer said.
To facilitate a smooth implementation of the reclassification process and ensure
relevant stakeholders interest are protected, the BNM has formulated a transition
plan to allow banks to complete the process by June 30 next year (i.e., 2015).

Questions to Check Your Understanding of this Chapter

1. Compare and contrast both the Islamic and conventional banks.

2. Compare and contrast both the Islamic and conventional leasing with special
reference to the AITAB facility.

3. Explain one unique relationship between depositors and Islamic banks.

4. Explain one unique relationship between financing customers and Islamic banks.

5.Assuming that in the Mudarabah General Investment Account (a deposit facility of

Islamic bank), the Islamic bank acting as mudarib start to request for
administrative fees, etc. for the management of funds of the rabbul mal
(depositor). Is this act permissible under the context of Shariah based principle of
mudarabah.

References

Islamic Financial System: Principles and Operations (2011), International Shariah Research Academy
for Islamic Finance (ISRA).

Nyazee, I.A.K. (2006). Islamic Jurisprudence. New Delhi: Adam Publishers & Distributors.

Rosly, S.A. (2005), Critical Issues on Islamic Banking and Financial Markets: Islamic Economics,
Banking & Finance, Investments, Takaful and Financial Planning. Kuala Lumpur: Dinamas
Publishing.

Abd Rahman, Z. (2008). Money, You & Islam: Views on Contemporary Financial & Islamic Banking
Issues. Selangor: Dolphin Press Sdn Bhd.

Ismail, A,G. (2010). Money, Islamic Banks and the Real Economy. Singapore: Cengage Learning
Iqbal, Z & Mirakhor, A. (2007), An Introduction to Islamic Finance: Theory and Practice. Singapore:
Saik Wah Press Pte Ltd (Wiley Finance)