ISLAMIC BANKING AND FINANCE

Mahyuddin Khalid

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OVERVIEW OF FINANCIAL SYSTEM

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CONTENT

OVERVIEW OF FINANCIAL SYSTEM FINANCIAL SYSTEM STRUCTURE IN

MALAYSIA BANKS AS FINANCIAL INTERMEDIARIES ISLAMIC BANKING GOALS AND OBJECTIVES OF ISLAMIC

BANKING DIFFERENCES BETWEEN ISLAMIC

BANKING AND CONVENTIONAL BANKING SYSTEM

ADVANTAGES OF ISLAMIC BANKING CHALLENGES OF ISLAMIC BANKS

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FINANCIAL SYSTEM

Concept of Financial System The collection of accounting processes and

procedures that allow a business to keep accurate financial records, monitor accounts, prevent fraud and mistakes, and catch any discrepancies.

A financial system allows a company to maintain accountability for expenditures and revenues, and to control their finances to minimize waste and loss.

A financial system is concerned about money, credit and finance.

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FINANCIAL SYSTEM

Concept of Money Money is anything generally accepted as a means of paying

for goods and services and a measure of value. Functions of Money :

Medium of exchange Measure of value Temporary store of value

Concept of 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(s) in time.

There is a predetermined time for repaying a loan, and generally the lender has to bear the risk that the borrower may not repay a loan (though modern capital markets have developed many ways of managing this risk).

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FINANCIAL SYSTEM

Concept of Finance Finance is the procurement (to get, obtain)

of funds and effective (properly planned) utilization of funds.

It also deals with profits that adequately compensate for the cost and risks borne by the business.

Finance deals with matters related to money and the markets.

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FINANCIAL SYSTEM STRUCTURE IN MALAYSIA

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)

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BANKS AS FINANCIAL INTERMEDIARIES

Financial intermediaries is an entity that acts as the middleman between two parties in a financial transaction.

Financial intermediaries encompass a wide range of entities in terms of size and scale of operation ranging from a banks, broker-dealers, investment advisers and financial planners.

Roles of banks as financial intermediaries:1. Promote savings and capital accumulation to finance

projects using various modes of financing.2. Finance international trade.3. Mobilize resources for investments for the benefit of

society.4. Contribute social welfare through Corporate Social

Responsibilities (CSR) and zakat.

PRINCIPLES GOVERNING OF ISLAMIC BANKING

Islam

Aqidah(Faith and

Belief)

Shariah (Practices and

Activities)

Ibadat Muamalat

Political Activities

Economic Activities

Banking & Financial Activities

Social Activities

Akhlak (Moralities and

Ethics)

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ISLAMIC BANKING

Islamic banking is defined as banking system which is in consonance with the spirit, ethos and value system of Islam and governed by the principles laid down by Islamic Shariah.

Islamic Banking according to Islamic Banking Act 1983: “..a company which carries on Islamic banking business

means banking business whose aims and operation do not involve any element which is not approved by the religion of Islam…”

Islamic banking, the more general term, is based not only to avoid interest-based transactions prohibited in Islamic Shariah but also to avoid unethical and un-social practices.

In practical sense, Islamic Banking is the transformation of conventional money lending into transactions based on tangible assets and real services.

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ISLAMIC BANKING IN MALAYSIA

The first Islamic bank was established in Malaysia in 1983 through Bank Islam Malaysia Berhad.

Later in March 1993, Bank Negara Malaysia (BNM) introduced Interest Free Banking Scheme (now replaced with Islamic banking scheme (IBS).

The scheme allowed conventional banking institutions to offer Islamic banking products and services using their existing infrastructure, including staff and branches

SALIENT FEATURES OF ISLAMIC BANKING

Main conce

rn

Ensuring justice

and equity in econom

y

PLS are major

features

Prohibition of riba

Financial transacti

on

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PHILOSOPHICAL FOUNDATIONS OF ISLAMIC BANKING

Huriyyah

Tazkiyah

Al-’adalah

Amanah

Khilafah

Tawhid

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GOALS AND OBJECTIVES OF ISLAMIC BANKING

• The thrust is towards financing on risk- sharing and strict focus on halal activities

• Focus on offering banking transactions adhering to Shariah principle and avoiding conventional interest- based banking transactions.

Offer Financial Services

• Established a direct and close relationship between the bank’s return on investment and the successful operation of the business by the entrepreneur.

Economic Development

• Considered to be most profitable, religiously permissible and are beneficial to the economy.

Optimum Resources Allocation

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GOALS AND OBJECTIVES OF ISLAMIC BANKING

• 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.

Optimum Approach

• Ensures equitable distribution of income and resources among the participation parties, with its profit- sharing approach which is one of a kind.

Equitable Distribution of Resources

• 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.

Facilitate Stability in Money Value

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PRINCIPLES OF ISLAMIC BANKING

Islamic banking is the conduct of banking based on SHARIAH principle, subject to among others:1. 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.

2. 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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PRINCIPLES OF ISLAMIC BANKING

3. 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.

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

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

5. 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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Islamic Banking System Characteristics

Conventional Banking System

•Functions and operating modes are based on Shariah law.•Banks have to ensure that all business activities are in compliance with Shariah requirements.

Business Framework

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

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

Shariah Supervisory

Board

•There is no such requirement necessary.

DIFFERENCES BETWEEN ISLAMIC BANKING AND CONVENTIONAL BANKING SYSTEM

COMPARISON BETWEEN ISLAMIC BANKING AND CONVENTIONAL BANKING SYSTEM

Islamic Banking System

Characteristics

Conventional Banking

Promotes risk sharing between investor and the bank & the bank and the entrepreneur : pre-agreed proportion

Risk sharing Predetermined rate of interest

Under PLS-return only if there is a profit-more concern with soundness of the project and managerial competence of the entrepreneur.

Emphasis to product

Credit worthiness

All economic agents have to work within the Islamic moral value.

Moral Dimension

Little attention to the moral implications of the activities

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Islamic Banking System Characteristics

Conventional Banking System

• 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.

Prohibition of Riba in Financing

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

•Islamic banks are restricted to participate in economic activities, which are not Shariah-compliant.

Restrictions •There are no such restrictions.

Pay zakat as a religious obligation and tax required by the government

Zakat (Religious

Tax)

Don’t pay zakat but only pay tax as required by the government

COMPARISON BETWEEN ISLAMIC BANKING AND CONVENTIONAL BANKING SYSTEM

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ADVANTAGES OF ISLAMIC BANKING

• 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.

Justice and Fairness

• 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.

Liquidity

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ADVANTAGES OF ISLAMIC BANKING

• 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.

Better Customer Relations

• 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.

No Fixed Obligations

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ADVANTAGES OF ISLAMIC BANKING

• Transparent to the account holders on the investments made in different areas and the profits realized from these investments. The profit is then shared in the pre-agreed ratio.

Transparency

• 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.

Ethical and Moral Dimensions

• Although based on Shariah principles to meet the financial needs of Muslims, it is not restricted to Muslim only and is available to non-Muslims as well.

Banking for All

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CHALLENGES OF ISLAMIC BANKING

Misconception about Islamic banking Many still has a wrong understanding or misconception

against Islamic Banking which among the thoughts are: Islamic Banking is only for Muslims Islamic Banking is not profitable because no interest is

charged Islamic Bank is a charitable organization

Thus better awareness shall be create among the customers that Islamic Banking is not only an alternative financial approach but also in some aspects provides better value propositions to the consumers.

Divergence of opinions Shariah interpretation versus business practicability/

financing commercial viability

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CHALLENGES OF ISLAMIC BANKING

Moving towards equity based financing (Musharakah/ Mudharabah) financing? Commercial banks requires a new set of technical and risk

management capabilities i.e. industry experts and know-how Market readiness – profit sharing, trade secrets, bank as strategic

business partners (potential conflicting interest). Balance sheet size, risk appetite and underwriting capabilities Supervisory and prudential regulatory framework. Accounting and auditing standards.

War of talents Global shortage of Islamic finance talents at almost all levels Inadequate pool of Shariah scholars with the right combination of

knowledge in Shariah and modern finance Rising Cost for Small Islamic Banks

Ballooning operating costs for Islamic banks as opposed to relative cost stability for the overall banking system - expenditure on IT infrastructure, expenses for R&D and product innovation and network expansion and new delivery channels

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