ISLAMIC BANKING

OPERATIONS

TOPIC 1: A BRIEF INTRO TO MONEY &

ISLAMIC BANKING
FINANCING DURING
THE PROPHET’S ERA
• Trade was the main economic activity of the tribe of Quraish
during the time of the Prophet’s SAW
• During this time, people were trading through riba based
transactions (before it was prohibited), mudarabah, bay’ al-
salam, etc.
ISLAMIZATION OF THE CONVENTIONAL
BANKING SYSTEM IN THE 1960S
• In 1963, the Islamization of the modern banking system
started as an idea in Egypt, Mit Ghamr town when Professor
Ahmad Al Najjar set up the Mit Ghamr Savings Bank based on
the concept of profit sharing rather than interest through
lending and borrowing
• Though it was not called an Islamic bank, the essence of
Islamic banking, which is the prohibition of interest, was first
practiced to remain the cornerstone of Islamic banking until
this day
• Mit Ghamr bank was closed in 1967 due to various political
reasons. In 1972, the bank was reopened under the name of
Nasser Social Bank
ISLAMIZATION OF THE CONVENTIONAL
BANKING SYSTEM IN THE 1970S
• In 1975, after 12 years from the establishment of Mit Ghamr,
the Islamic Development Bank (IDB) was established after a
resolution was passed by the First Conference of Finance
Ministers of the Organization of Islamic Conference (OIC),
which was held in Jeddah, Saudi Arabia on December 18, 1973
• IDB is a multinational financing institution that acts as a
development assistant agency and aims at promoting Islamic
banking by encouraging member countries to establish Islamic
banking
• Hence, IDB will provide its support to members engaged in
Islamic banking activities whenever needed
ISLAMIZATION OF THE CONVENTIONAL
BANKING SYSTEM IN THE 1970S (CONT)
• Moreover, the rise of world gas prices in 1973 has resulted in
a massive accumulation of petro dollar surpluses in the
Middle East (oil producing countries)
• These surpluses of governments and individuals were looking
for available shariah compliant investment opportunities
• Thus, Dubai Islamic Bank was established in 1975 specifically
to cater for these needs to become the world’s first full
fledged Islamic bank
ISLAMIZATION OF THE CONVENTIONAL
BANKING SYSTEM IN THE 1980S
• In 1983, The enactment of Malaysia’s Islamic Banking Act
paved the way for the establishment of Bank Islam Malaysia
Berhad, the first full-fledged Islamic commercial bank in
Malaysia
• Today, Islamic finance in Malaysia is still growing rapidly,
owing to its continuous product innovation, comprehensive
financial infrastructure and adoption of regulatory and legal
best practices
• Malaysia has emphasized on human capital development
alongside the development of the Islamic financial industry to
ensure the availability of Islamic finance talent (BNM
established ISRA & INCEIF)
BASIC SHARIAH
PRINCIPLES
• Sources of the Islamic law (shariah)

1. Quran (The Holy Book)

2. Sunnah (The Traditions / Practices of The Prophet SAW)
3. Ijma’ (Consensus)
4. Qiyas (Analogy)
BASIC ISLAMIC BANKING
PRINCIPLES

• Prohibition of interest (riba)

• Risk sharing
• Asset-based
• Prohibition of speculative behavior (gharar & maysir)
• Sanctity of contracts and preservation of property rights
HISTORY & DEVELOPMENT
OF FINANCIAL SYSTEMS
• The Basic Stage
• Barter trade (commodity as money)
• Coincidence of wants
• The Second Stage
• The development of borrowing-lending
• Mostly direct financing
• The Third Stage
• The development of financial intermediaries (indirect financing)
• E.g. Retail banking, corporate banking, etc.
• The Current Stage
• Mature financial institutions
• Current scenario
 DIRECT FINANCE VS.
INDIRECT FINANCE
Surplus Units Deficit Units
$$$
++++++++++++ ------------
Direct Finance
$$$ + interest (7%)
• Individuals • Individuals
• Governments • Governments
• Corporations • Corporations

$$$ $$$

$$$+ $$$+
5% 10%

Indirect Finance
ISLAMIC BANKING
• Bank Negara Malaysia (BNM) regulates banks generally through the
Banking and Financial Institutions Act 1989 (BAFIA) and specifically,
Islamic Banks via the Islamic Banking Act of 1983 (IBA)
• “Islamic banking business” means banking business whose aims and
operations do not involve any element which is not approved by the
Religion of Islam” (BAFIA and IBA legislation)
• BAFIA defines the banking business as the business of:
1. Receiving deposits on current account, deposit account,
savings account or other similar account
2. Paying or collecting cheques drawn by or paid by customers
3. Provision of finance
ISLAMIC BANKING (CONT.)
• The terms ‘Religion of Islam’ is very broad and leaves open the
interpretation as to which school of law should apply
(historically, the majority of Muslims, including those in South
East Asia adopted the Ottoman civil code, the Majallah)
• Under the IBA 1983, Islamic banks must set up Shari’ah
Advisory Boards (SAB), and ultimately have to comply with the
national Shari’ah Advisory Council (SAC). Originally, a the bank
must set up a Shari’ah advisory body (SAB)
• SAB will advise the bank on the operations of its banking
business in order to ensure that they do not involve any
element which is not approved by the Religion of Islam
ISLAMIC BANKING (CONT.)
• Thus the SAB would ensure banking operations conformed to
Islam in Art. 3(5) b, but the IBA was amended with effect from
1.1.2004, so that the SAB would have to comply with the SAC
upon seeking its advice
• An Islamic bank may seek the advice of the Syariah Advisory
Council on Syariah matters relating to its banking business and
the Islamic bank shall comply with the advice of the Syariah
Advisory Council.”
SETTING UP AN
ISLAMIC BANK
• The bank first applies for a banking license by the monetary
authority
• To qualify for a license, the bank must put up a minimum
required capital to support the deposit it acquires from the
public
• Hence, an Islamic bank is a company whose main objective is
to make profit, which is the difference between revenues and
costs
• To generate revenues, an Islamic bank sells Shariah compliant
financial products
• To do so, the bank must first acquire deposits
SETTING UP AN
ISLAMIC BANK (CONT.)
• It must have a sound business plan and credible group of
individuals to run the business
• An Islamic bank is usually set up as a joint-stock company
• To raise capital, the bank the company issues shares for sale
to the public
• The bank’s management team who devise business strategies
usually consists of the principle officers such as the chief
executive officer (CEO), the chief financial officer (CFO) and
the heads of the retail, corporate and risk management
departments
SETTING UP AN
ISLAMIC BANK (CONT.)
• Banks must be supervised and regulated since they are using
public’s money to generate earnings for the shareholders
• Negligence as well as taking excessive risk will lead to high bad
debts and erodes deposits
• The shareholders are entitled to the bank’s net profit. They
are liable to losses up to face value of their shareholdings. The
limited liability principle still holds for Islamic banking
• The banking business is highly regulated since the depositors’
money must be protected from depletion. When banks suffer
from high bad debts, failure to honor deposit withdrawals will
result in bank runs and consequently credit squeeze and
financial chaos
SETTING UP AN
ISLAMIC BANK (CONT.)
• In conventional banks, accepting deposits and providing loans
are based on lending and borrowing via interest
• In Islamic banking, deposits cannot be mobilized via the
contract of debt with interest as it is tantamount to riba
• Instead, deposits are mobilized through safe-keeping (wadiah
yad dhamanah) and partnership (mudarabah) contracts
ACCEPTING DEPOSITS
• A wadiah yad dhamanah deposit is in essence a deposit that
gives no contractual returns
• However, there is capital protection on the deposited amount
• A mudarabah deposit is an investment deposit, thus it runs on
the principle of “al-ghurm bil ghonm” meaning that “ with
profit comes risk”… no pain no gain
• Accordingly, no capital protection is awarded to the
mudarabah investment while returns are based on
performance
ACCEPTING DEPOSITS
These contracts are in turn driven by the 3 principles of trading,
namely
1. The principle of risk-taking (ghorm)
2. The principle of work and effort (kasb)
3. The principle of liability (dhaman)

• Based on the Islamic bank’s simple balance sheet and profit-

loss statement, it is now well understood that the gross profit
generated by an Islamic bank is based on the principle of
trading (al-bay’)
DIFFERENCE BETWEEN
SALE & INTEREST
• In interest-based transactions, risk is transferred to the
borrower so that all interest-bearing assets become risk free
(this is socially inequitable & economically inefficient)

• According to the term value of money, which is accepted by

shariah, the capital involved in trade may both grow or
decline though time

• Whilst in riba based transactions capital automatically

increases over time
PROFITABILITY
• Revenues are earned from the application of murabahah,
ijarah, salam, musharakah, mudarabah, etc., while costs are
payments and/or profits paid to Islamic depositors (partners)
and managerial expenses
• How much profits an Islamic bank can make thus depends on
the four variables evident in the profit equation, namely:
1. Rate of return on financing (rF)
2. Size of financing (F)
3. Rate of return on deposits (rD) and
4. Size of deposits (D).
Profit = (Revenues – Cost) = (rF x F) – (rD x D)
PROFITABILITY (CONT.)
• Rate of return on financing (rF) is the profit rate the bank
uses to compute the selling price of murabahah, bai-bithaman
ajil (BBA) and ijarah thumma al-bay’ (AITAB).
• The rate is set based on the riskiness of the facility given. The
higher the risk, the higher is the bank’s profit rate
• Hence, an Islamic bank does not make loans to profit. Instead,
financing is based on the principle of trading (al-bay’)
• Some trading contracts are murabahah, BBA, ijarah, salam,
istisna, mudarabah and musharaka
• Current practices have shown that the benchmarking of profit
rate is based on prevailing interest rate
PROFITABILITY (CONT.)
• Deposit rate of return (rD) is the profit rate on investment
deposits/profit-sharing investment account (PSIA)
• If rF is low, so is rD and vice versa
• PSIA is a risky deposit, thus PSIA holders expect to see higher
rD than interest rate on conventional fixed deposits
• rD is not contractual, and thus it cannot be fixed up-front as
the case for interest rates
• It is only known when PSIA matures
PROFITABILITY (CONT.)
• Size of financing (F) is usually influenced by economic
conditions
• In a booming economy, the level of income increases and so
do consumption and business spending
• Lower cost of funds may also raise the demand for funds

• Size of deposit (D) is related to the level of savings of

households, business enterprises, corporations as well as
government agencies
PROFITABILITY (CONT.)
• An Islamic bank can further improve its performance by
reducing expenditures, such as:
1. Overhead expenditures
2. Provision for non-performing financing (NPF)
3. Provisions for Profit Equalization Reserves (PER) which is
taken from the gross profit of financing operations before
distributing net profits among those eligible to share
EVOLUTION OF ISLAMIC
FINANCIAL PRINCIPLES
• Many Muslim scholars held the view that the Islamic financing
approach should primarily be based upon a principle whereby
the rate of return on financial capital should vary in
accordance with the variations in the return of the whole
enterprise such as in:
1. Profit Sharing Principle (PSP)
2. Profit & Loss Sharing Principle (PLSP)
SALE PROFIT SHARING
PRINCIPLE (PSP)
• PSP is based on the mudarabah principle i.e. profits will
be shared between the capital provider (rabbul mal) and
the entrepreneur (mudarib) based on a pre-agreed ratio
whereas losses under normal circumstances would be
solely borne by rabbul mal whilst the mudarib loses his
time and efforts
• However, in case of mismanagement, misconduct or
negligence, the mudarib is held accountable for any loss
caused due to any of the above reasons
PROFIT & LOSS SHARING
PRINCIPLES (PLSP)
• The PLSP is based on the musharakah principle i.e.
profits are distributed according to contractually agreed
shares while losses are borne by all capital providers
solely based on their capital contribution share
FORMS OF PERMISSIBLE
DEFERRED SALES
• Salam Sale (the price is paid at the time of contract while the object
of sale becomes due as debt in kind)

• Maua’jjal Sale (the object of sale is delivered at the contract time

while the price becomes due as debt)

• Istisna’ Sale (the price is either paid fully at the time of contract or
progressively in installments while the object of sale is
manufactured and delivered later)
FORMS OF PERMISSIBLE
DEFERRED SALES (CONT.)
• Ijarah (the sale of the beneficial ownership of of assets where assets
are delivered to the tenant, who in turn pays periodic rentals)

• Murabahah li al’amer bi al shira’ (a fiduciary kind of sale to the

purchase orderer where the asset is purchased by the bank based
on the client’s promise to buy while the price is paid in a future
date)

• Musharakah Mutanaqisah is a form of partnership in which one of

the partners promises to buy the equity share of the other partner
gradually until the title of the equity is completely transferred to
him/her