Islamic Banking Systems

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INTRODUCTION

Capitalization could not solve the global economic problems. The world is looking for anew economic order. Islamic economic system will be that new economic order. Theglobally-booming Islamic finance is making strides and gaining popularity in Bangladesh,

with experts predicting that the shariàh-compliant industry will continue in steady steps tobecome the mainstream banking system in Muslim South Asian nation. Bangladeshentered the Islamic banking system only in 1983, with the establishment of Islami BankBangladesh.Patwary says that his bank is now one of the top performer banks in terms ofbusiness and profits among the 48 commercial banks operating in the country. IslamicBank Bangladesh Limited has gained first position in the all private banks in term ofdeposits, investment, export & import and remittance collection.People of this country arereligious, Patwary, of the Islami Bank, agrees. Islam forbids Muslims from usury, receivingor paying interest on loans. According to the Bangladesh Bank (BB), the central bank ofthe country, the deposits of the Islamic banking systems are now 25 percent of all privatebanks deposits and its investments are 30 percent. Bahauddin Mohammad Yousuf, vice

chairman of Al-Arafah Islamic Bank, has an explanation for Bangladeshs Islamic financeboom. A Muslim, whose religion prohibits earning or paying interests, Islamic bankingmakes it possible to operate interest-free business. Bankers believe that the Islamic bankingis set for even more progress, if a law governing Islamic Banking policies is introduced. Ifan Islamic banking Act is introduced, the Islamic banking systems will even furtherflourish. Experts predict that with the rapid rise of Shariàh-based systems, the industrywill ultimately turn to be the financial mainstream in Bangladesh. The interest-freeShariàh-based systems will be mainstream Banking and the conventional banks will be theminority systems in the OIC countries including Bangladesh within 2002, M Azizul Haque,a leading expert on Islamic banking in Bangladesh, told IOL. Azizul Haque, who is alsochairman of the Shariàh Council of Dhaka, believes that Bangladesh will follow the rest of

the world to the Islamic banking sector. He explains that the growth rate of Islamic bankingin the OIC countries for example is 15 to 20 percent while that of conventional banks is 10to 15 percent. Islamic finance is one of the fastest growing sectors in the global financialindustry. In defiance of the credit crunch, the global Islamic finance market has grownabout 15 percent in each of the past three years, and is now worth about $700 billionworldwide. Currently, there are nearly 300 Islamic banks and financial institutionsworldwide. Its assets are predicted to grow to $1 trillion by 2013. Azizul Haque expectsthat higher growth rates in the next decade will force the global financial systems toIslamic banking. There is not any sort of apprehension regarding the success of Islamicbanking, the renowned economic expert said. The future of the Islamic banking systemsis so bright. Mominul Islam Patwary, Chairman of the executive committee of Islami Bank

Bangladesh Limited, told IslamOnline.net. THE recent measures taken by BangladeshBank with regard to Islamic banks are indeed unprecedented and absolutely uncalled for.While it is true that ever since the inception of Islamic banking system in Bangladesh, therewas no expert group in Bangladesh Bank to monitor the activities of Islamic banks inBangladesh, Islamic banks operating in Bangladesh have formed their own Shariah councilto look into whether Islamic banking as a whole is in compliance with the Islamicprinciples. A central shariah council has also been formed. Although Bangladesh Bank hasmade a focus group, consisting of members of Shariah council and Islami bankers, to


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formulate detailed guidelines for the Islami banks on the basis of the Banking CompanyAct, Bangladesh Bank utterly ignored the report that has been finalised by the focus group.There are currently six commercial banks operating under Islamic principles. They are:Islami Bank Bangladesh Limited, Al-Arafah Bank, Social Investment Bank Ltd, EximBank Ltd, Oriental Bank Ltd, and Shahjalal Islami Bank Ltd. apart from some other banks

that also provide Islamic banking services in some of their branches. There are more than300 Islamic banks operating all over the world -- from Africa and Europe to Asia andAmerica. The Islamic banking industry is worth more than $200 billion and is growing at15 percent annually, a rate much higher than that of conventional banking.1

OBJECTIVE

Islamic banking systems are a quiet new phenomenon in the money market of Bangladesh.In order to go deep into this particular area of study and also to realize the objectives.

Interest Free Banking Islamic Banking and Finance-Sharjah Islamic Bank

Modern Vs Islamic Banking

Good prospects for Islamic banking

The basic principle of Islamic banking

Islamic Banks Success Story in Bangladesh

Understand problems of the Islamic banking activities

Islamic banks functions among other established conventional

REVIEW
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JEDDAH, 27 June 2006 Name the first country in South and Southeast Asia to havesuccessfully established an Islamic bank. Bangladesh. Yes, that is right. The local Islamicbanking and takaful industry has made steady progress since the establishment of the firstIslamic bank in 1983 and the formation of the first Islamic insurance company or takaful in

1984. As at end-2000, the Islamic financial sector was represented by two Islamic banksand 47 conventional banking institutions (17 domestic commercial banks, four foreign-owned banks, 14 finance companies, five merchant banks and seven discount houses)participating in the Islamic Banking Scheme (IBS), which was made up of an Islamicmoney market, two takaful companies and a broad range of financial products. Uponcompletion of the merger exercise among the domestic banking institutions, the number ofconventional banking institutions participating in the IBS has now increased to 33,comprising nine domestic commercial banks, four foreign-owned banks, eight financecompanies, five merchant banks and seven discount houses. The significance of Islamicbanking has been on a progressive trend, recording an average annual growth of 49% interms of assets over the 1995-1999 period. In 2000, the sector continued to register strong

asset growth of 30% to RM47.1 billion while deposits and financing increased to RM35.9billion and RM20.9 billion respectively. In terms of performance relative to the wholebanking system, as at end- 2000, the share of Islamic banking assets has increased to 6.9%,with deposits and financing also rising in tandem, to 7.4% and 5.3% respectively. Thedelivery channels have also improved significantly as there are now more than 2,200branches of Islamic banks and IBS banks offering Islamic banking products and services.Islamic banking has also spurred efforts by other non-bank financial intermediaries such asdevelopment financial institutions, savings institutions and housing credit institutions tointroduce Islamic schemes and instruments to meet customer demand. In addition, thecapital market has seen the rapid growth of Islamic debt and equity markets. Tocomplement these developments, the Labuan IOFC (International Offshore FinancialCentre) has embarked on a serious effort to establish an International Islamic FinancialMarket to stimulate the creation of liquidity and financial instruments as well as enhanceinvestment opportunities aimed at greater mobilisation of Islamic funds. For example, in2006, the Malaysia International Islamic Financial Centre (MIFC) initiative was launchedto promote Islamic financial products and services in international currencies for the globalmarket. According to Bank Negara's 2006 annual report, the share of revenue from lendingand fee-based activity from Islamic banks has tripled to account for 6.4% of the revenue ofthe total banking system over the 2002-2006 period. Table 1 clearly shows that the four-year CAGRs (compounded annual growth rates) of the total deposits and loans of the IBSin the country have been rising steadily. However, more efforts are needed to fullfil theaspiration of having a 20% Islamic banking and insurance market share by 2010. As at end-2007, Islamic banking deposits and loans accounted for 11.9% and 13.7% respectively ofthe entire banking sector. Apart from its growing share, the prospects of Islamic bankingare also bright with the flush of petroleum money. According to Aseambanker Research,with oil prices averaging US$70 per barrel in 2007, the six countries making up the GulfStates, namely Saudi Arabia, Kuwait, United Arab Emirates (UAE), Qatar, Oman andBahrain, should reap a total of US$320 billion in oil exports in 2007. And with their totalproven reserves of 484 billion barrels, there is actually US$38.7 trillion worth of inventorysitting in the Arabian Peninsula, assuming a sustainable price level of US$80 per barrel. In


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1983 Islami Bank Bangladesh Limited (IBBL) became the first interest-free Shariah-basedbank to have been established in South and Southeast Asia. According to a report posted onthe banks website, IBBL started operations with an authorized and paid-up capital of 500million taka and 67.50 million taka respectively. The capital is divided into ordinary sharesof 1,000 taka each. The paid-up capital of the bank was enhanced to 640 million taka in

2001. Of the 79,500 ordinary shares of the bank in 1985, foreign sponsors, including theJeddah-based Islamic Development Bank, owned 56,000, while local sponsors and thegeneral public owned 23,500 shares. The Investment Corporation of Bangladesh wasallocated 20 percent of the banks issued capital, but the corporation subscribed shares of0.5 million taka only. The bank is listed on both Dhaka and Chittagong stock exchanges.The brain behind the bank was the late Fouad Abdul Hameed Al-Khateeb, Saudi Arabiasfirst ambassador to Bangladesh (1977-1982). He mobilized a group of entrepreneurialSaudis and other industrialists from the Gulf to launch the financial institution. Anotherfounder was Dr. Ali S. Al-Ghamdi, who was posted at the Saudi Embassy in Dhaka in the1980s. With more than 150 branches spread throughout the country, the bank has become aphenomenal success story and a role model for other Islamic banks. At a Bangladeshi

community gathering in Jeddah on Saturday night, Al-Ghamdi recalled how people wouldlaugh at the idea of an Islamic bank in the 1980s. Islamic banking was unheard of in thosedays. I would meet so many Bangladeshi professionals doctors, engineers, teachers, etc. and they would all laugh when the idea of Islamic banking was discussed. That wasthen. Al-Ghamdi said he recently met one of those Bangladeshi professionals. He talkedenthusiastically about his investments in Islami Bank Bangladesh Limited. He told me hewas making good money on his investments in the bank, Al-Ghamdi said with a chuckle.This is a source of pride for all of us, especially those of us who were associated with it inits embryonic stage. Mominul Islam Patwary, the executive committee chairman of thebank in whose honor the event was organized, said what was once an unheard of idea hasbecome a welcome option for Muslims. Islamic banking, Patwary said, is no longer analien concept. The idea has proved to be very successful and now that Islamic banks areavailable there is no reason for us to deal with regular banks. Earlier, there were no options.Now we have a choice. All the major banks are now coming up with Shariah-compliantinstruments. This indicates that Islamic banking is here to stay. Al-Ghamdi reminded thegathering that the idea behind the bank was not to make money. It was certainly not acommercial venture. All those businessmen who came forward at the urging of Fouad Al-Khateeb did so out of their love and responsibility toward their religion and their brethrenin Bangladesh. Material benefit was not on anybodys mind. That it would be such a hugecommercial success was something that nobody really imagined. We are glad we took thatcrucial and all-important first step and the rest, as they say, is for you to judge, Al-Ghamdisaid. Al-Ghamdi pointed out that Islami Bank Bangladesh Limited should not be merelyseen as a bank. It is an institution in itself. It is a charity institution, a medical institution,and a cultural institution. The bank is playing an important role in almost every aspect ofthe lives of Bangladeshis, he said while exhorting everyone to join the institution andsupport it by either opening accounts at the bank or purchasing its shares. Patwary listedthe banks many achievements and answered many questions from the Bangladeshiexpatriates at the gathering. He recalled one particular episode with pride. One of thegovernment ministers told us to take charge of the government-run Krishi Bank. Why?Because he said it had become a burden on the government? And why us? Because he said


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we demonstrated how to run a bank successfully. This is a matter of great pride, Patwarysaid. He said the bank is committed to conducting all banking and investment activities onthe basis of an interest-free profit-loss sharing system. In doing so, it has unveiled a newhorizon and ushered in a new silver lining of hope toward materializing a long-cherisheddream of the people of Bangladesh for doing their banking transactions in line with what is

prescribed by Islam, Patwary said. He said when people talk of Bangladesh theyinevitably talk about the high level of corruption. Here we are, running the bank with nostain of corruption. Transparency has been and is the key to our success. We have becomethe role model for others. And for no small reason, we are the No. 2 bank in the privatesector. Ashraf Uddin, the Bangladeshi consul general in Jeddah, acknowledged the bankscontribution in the development of the country. It is beyond the pale of doubt,Responding to some mild criticism from the community members that he was not proactivein promoting the bank here in Jeddah, Ashraf Uddin said as a diplomat he has certainbindings. Since I am diplomat, I cannot support any specific bank. However, I havealways openly supported the concept of Islamic banking, he said. Ashraf Uddin alsopraised the banks representative in Jeddah. Mosharraf Hossain is the right man for the

right job. He created a lot of visibility for the bank in Saudi Arabia, the consul generalsaid. The two sons of Fouad Al-Khateeb Muhammad Al-Khateeb and Abu Bakr Al-Khateeb spoke about their late fathers vision and recalled how he would always talkabout it in the 1980s. He was very confident of the banks success but he had a tough taskin explaining his idea to others, recalled Muhammad Al-Khateeb who is the member ofthe banks board of directors. The bank helped us win the trust of the good people ofBangladesh. Abu Bakr Al-Khateeb, who is the senior general manager (engineering) atUnited Sugar Company, spoke in Bengali amid loud cheers from those present. He toorecalled his fathers passion for doing something good for Bangladesh. He would alwaysbe busy thinking about giving the project a practical shape. It is a moment of pride for us asthe bank marches ahead, he said. Abdullahil Mamoon Al-Azami, community developmentspecialist at the IDB, recalled the contribution of the Al-Khateebs in the development ofBangladesh. Ustaz Fuad Al-Khateeb was a great man, a visionary. He thought about anIslamic bank at a time when nobody would give it a second thought, he said. Al-Azami ishighly respected by the Bangladeshi community and is the son of professor Ghulam Azam,the former chief of Jamaat-e-Islami, Bangladesh. We all should support the bank not onlyby opening accounts in the bank but also by generating ideas. That can also be a wonderfulcontribution, Al-Azami said.

Goals, Objectives, Characteristics and Functions of Conventional

Bainking System

1. Background


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The financial system in Bangladesh includes Bangladesh Bank (the Central Bank),scheduled banks, non-bank financial institutions, microfinance institutions (MFIs),insurance companies, co-operative banks, credit rating agencies and stock exchange.Among scheduled banks there are 4 nationalised commercial banks (NCBs), 5 state-owned

specialised banks (SBs), 30 domestic private commercial banks (PCBs), 9 foreigncommercial banks (FCBs) and 29 nonbank financial institutions (NBFIs) as of December2006. However, Rupali Bank, an NCB is being sold to a foreign buyer, and once thistransaction is completed, the country will have only 3 NCBs. Which are beingcorporatized. Over and above the institutions cited above, three development financialinstitutions namely House Building Finance Corporation (HBFC), Ansar-VDP UnnayanBank and Karma Shangsthan Bank are operating in Bangladesh, all of which arestate owned.

2. Central Bank and its Policies

The objectives of the Bangladesh Bank (BB) is to formulate monetary policy which aims atsupporting the highest sustainable output growth while maintaining price stability,adjusting smoothly to the internal and external shocks faced by the economy from time totime. Within this mandate, BB also supervises and regulates scheduled banks and non-bankfinancial institutions operating in Bangladesh. It maintains the traditional central bankingroles of note issuance and the banker to the government and banks. Its prudentialregulations include, among others, ensuring minimum capital requirements, applying limitson loan concentration and insider borrowing, and, providing guidelines for assetclassification and income recognition. The Bangladesh Bank has the legal authority toimpose penalties for non-compliance and also to intervene in the management of a bank ifserious problems arise. It has the delegated authority of issuing policy directives regardingthe foreign exchange regime.

3. Scheduled Banks

Out of 6562 scheduled bank branches operating in the country, upto end December 2006the NCBs operate 3384 branches, of which 2146 are in rural areas and 1238 are in urbanareas; SBs have 1354 branches of which 1200 are in rural areas and 154 are in urban areas;PCBs have 1776 branches of which 488 are in rural areas and 1288 are in urban areas; andFCBs have 48 branches exclusively in urban areas. Out of 30 PCBs, six have beenoperating as Islamic banks. Besides these full-fledged Islamic banks, 10 conventionalbanks in the private sector have opened selected branches and Islamic banking countersrespectively to deal with the Islamic banking business parallel to their conventionaloperations. NCBs owned 65.3 percent while PCBs, SBs and FCBs own 24.5, 6.6 and 3.6percent respectively of total assets of the scheduled banks. Of the total deposits, NCBs'share stood at 38.8 percent while SBs, PCBs and FCBs shared 5.8, 48.7 and 6.8 percentrespectively. Among PCBs, the Islamic Banks' share of deposits is 12.5 percent. On theother hand, NCBs disbursed 32.3 percent of total advances while SBs, PCBs and FCBs


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disbursed 9.3, 51.5 (of which 14.8 percent was disbursed by the Islamic Banks) and 6.9percent respectively at the end of September 2006.

4. Non-Bank Financial Institutions (NBFIs)

Non-Bank Financial Institutions are an important part of financial system in Bangladesh.NBFIs operations are regulated under the Financial Institutions Act, 1993. The NBFIsconsist of investment, finance, leasing companies etc. There were 29 financial institutionsoperating in Bangladesh as of 31 December 2006. Of these one is government owned, 15are local (private) and the other 13 are established under joint venture with foreignparticipation. Bangladesh Bank has introduced a policy for loan and lease classification andprovisioning for NBFIs from December 2000 on a half-yearly basis. Among the 29financial institutions, 12 have been listed in the stock exchanges up to 31 December 2006to strengthen financial capability and the rest are under process to be listed in due course.

5. Capital Market

The capital market in Bangladesh is regulated and supervised by the Securities andExchange Commission (SEC) under the SEC Act, 1993. The SEC so far has issued licensesto 27 nonbank institutions to participate in the capital market of which 19 institutions areMerchant Banker and Portfolio Manager while 7 are Issue Managers and l(one) acts asIssue Manager and Underwriter. The Dhaka Stock Exchange (DSE), which was establishedas a public limited company in April 1954, and the Chittagong Stock Exchange (CSE),established in April 1995, dealing in the secondary capital market. As of end December2006 the total number of enlisted securities with DSE stood at 310 of which 255 are listedcompanies, 13 mutual funds, 8 debentures and 34 treasury bonds. Recently, two powersector companies namely Dhaka Electric Supply Company (DESCO) and Power GridCompany of Bangladesh (PGCB) have been listed in the capital market under the newlyintroduced direct listing regulation. The Investment Corporation of Bangladesh (ICB) wasestablished in 1976 with the objective of encouraging and broadening the base of industrialinvestment. ICB underwrites issues ofsecurities, provides substantial bridge financing programs, and maintains investmentaccounts, floats and manages closed-end and open-end mutual funds and closed-end unitfunds to ensure supply of securities as well as generating demand for securities. ICB alsooperates in both DSE and CSE as dealer. Some SBs, such as Bangladesh Shilpa Bank(BSB), Bangladesh Shilpa Rin Sangstha (BSRS), Bangladesh Small Industries andCommerce (BASIC) Bank Ltd. As well as NCBs and some foreign banks are engaged inlong-term industrial financing.

6. Insurance


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The insurance sector is regulated by the Insurance Act, 1938 with regulatory oversightprovided by the Controller of Insurance on authority under the Ministry of Commerce. Aseparate Insurance Regulatory Authority is being established. A total of 62 insurancecompanies have been operating in Bangladesh, of which 18 provide life insurance and 44are in the general insurance field. Among the life insurance companies, except the state-

owned Jiban Bima Corporation (GBC) foreign owned American Life Insurance Company(ALl CO), and the rest of the private. Among the general insurance companies, state-ownedShadharan Bima Corporation (SBC) is the most active in the insurance sector. A total of 31insurance companies are listed in the capital market, of which 8 offer life insurances.

7. Microfinance Institutions (MFIs)

MFIs in Bangladesh were left unregulated for a long time since their inception. Thegovernment, with the close cooperation of Bangladesh Bank, undertook efforts to establisha regulatory framework which culminated in the enactment of the Microcredit RegulatoryAuthority Act, 2006. An Executive Board consisting of eight members is responsible for

executing the general and administrative tasks of the management. The Board consists ofthe Governor of Bangladesh Bank as ex-officio chairman, six government officialsnominated by the government and one executive vice-president who serves as the membersecretary of the board. The main responsibilities of the authority include issuance andcancellation of the license for microcredit, overseeing, supervising and facilitating theentire activities of MFls. In recognition of the robust poverty eradication via microfinanceactivities, the Grameen Bank and its founder, Dr. Muhammad Yunus have been awardedThe 2006 Nobel Peace Prize. Now it has been recognised worldwide that microfinance canbe easily adapted and thus replicated in diverse cultural and geographic locations all overthe world. The member-owned Microfinance Institutions (MFIs) have an explicit socialagenda to cater to the needs of the poorer sections of population, and have a particularfocus toward rural women clients. Grameen Bank was established in 1983 under a speciallaw with the initial support from the Bangladesh Bank. The typically landless borrowers ofGrameen Bank mostly women, are owners of the bank and it is the pioneer organization ofthis type. Besides Grameen Bank, there are more than 1000 semiformal institutionsoperating mostly in the rural sector of the country; of these, BRAC, ASA, and PROSHIKAare considered three largest NGO-MFIs.

8. Cooperative Banks

In Bangladesh 119 cooperative banks are operating, of which 64 are central cooperativebanks, 48 are land mortgage and rest 7 are other cooperative banks. The maximum share of


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total assets, 90 percent, is controlled by central cooperatives. Similarly the maximum sharedeposits (85 percent) and advances (90 percent) are likewise handled by the same centralcooperatives.

Goals,Objectives, Characteristics and Functions of Islamic

Banking System


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Introduction

The introduction of interest-free and equity-based financing by the Islamic banking systemis based on the principles of Islamic economics. The aim of Islamic economics, as observedby Molla et.al. (1988), is not only the elimination of interest based transactions and theintroduction of the zakah (contribution to poor) system but also the establishment of just

and balanced social order free from all kinds of exploitation. The Islamic banking system ishighlighted in the World Development report (1989, Box 6.3), as under; Islamic banksoffer savers risky open-ended mutual fund certificates instead of fixed-interest deposits.(This is not unlike cooperative banks and mutual in the west, where deposits earn variableinterest and double as equity.) Difficulties arise on the lending side. Arrangements to shareprofits and losses lead to considerable problems of monitoring and control, especially inlending to small business. Ahmed (1994), argues that elimination of interest does not meanzero-return on capital. Rather, Islam forbids a fixed predetermined return for a certainfactor of production i.e. one party having assured return and the whole risk of anentrepreneurship to be shared by others. The author also observed that it is the capitalentrepreneurship that shares both the real contribution and the real profitability. The

Islamic bank follows the principle ofequity basedinvestment. The Islamic banking systemalso proposes that resources can be contracted on the basis of venture capital and risksharing deals. The idea of equity-based investment banking is not new to the financialmarket. If we look into history it may be observed that capital, as loan capital as well asventure capital played a great role in promoting industrial and economic development ofvarious countries of the world. For example, during the 19th and 20th centuries investmentbanks played a great role in French tradition while in British model of banking equitybasedinvestment was limited. Similarly in Germany equity-based investment was being practicedby commercial banks during that period. Even the banking crisis in the western worldduring the great depression in the 30s or the 80s proposed two-tire banking i.e. hundredpercent deposit banking and the equity-based investment banking. In the modern financialmarket an alternate arrangement for participation of capital and entreprenurship startedwith the advent of Islamic Banking in the 70s. In a number of studies such as IMF, WorldBank and IFC, the Islamic bank activities were discussed in detail. Highlighting Islamicbanks principle Khan (1986, p. 19), in the IMF staff Paper, observed as;Indeed it is really apparent that the Islamic model of banking based on the principle ofequity participation bears a striking resemblance to proposals made in the literature on thereform of banking system in many countries. The Islamic System may well prove to bebetter suited to adjusting to shocks that result in banking crises and disruption on thepayment mechanism of the country. In an equity-based system that exclude predeterminedinterest rate and does not guarantee the nominal value of deposits, shock to asset positionare immediately absorbed by changes in the values of the share deposits held by the publicin the banks. Therefore, the real value of assets and liabilities of banks in such a systemwill be equal at all points in time. In the more traditional banking system since the nominalvalue of deposits is fixed, such shocks can cause a diversion between real assets andliabilities. It is not clear if this would be correct and how long the process would take. Astudy by OECD of the European countries, Paris, (1983) reveals the fact that interest-freebanking is a novel form of finance and they are not only trying to give interest anothername but that legal instruments within the framework of Shariah exist which permitprofitability on a different, albeit Qoranically acceptable basis. Islamic banks belong to the


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class of equity-participation bank. In this regard Ahmad (1994, P. 190) in his study quotedthe idea of Albach as; They supply equity in the form of venture capital to investorswhose share is their ingenuity and their labor. Secondly, they supply equity in the form ofequity capital participants in the type of project, which in general has majorityshareholders. They may be ideally suited to meet the need for equity capital in developing

countries where the business risk is particularly high as well as in the industrializedcountries where the development of new processes and new projects involves high risk andrequires large amount of venture capital Scharf (1983, P. 94-95), in his study entitledArab and Islamic Bank conducted by Development center, Organization of EconomicCooperation and Development (OECD), highlighted the Islamic banking principles andprospect as follows; Islamic banking is trying to develop the relationship between financeon one hand and industry and commerce on the other. This new relationship is the basis ofthe Islamic economic system being set up. Though Islamic principles have yet to be put tothe test in the competitive of international finance, the two systems are similar in that theyboth strive for closer ties between financial intermediation and economic asset creation.Islamic banks could make a useful contribution to economic growth and development

particularly in a situation of recession, stagflation and low-growth level because the core oftheir operation is oriented towards productive investment All countries both in the Northand in the South, need more venture capital. Loan capital is available, particularly fromindustrialized countries but at high interest rates. However, even from expansion andinnovation. This has acted as a brake on productivity and economic growth in the North.Thus practical and immediate cooperation possibility exists between Islamic banks andenterprises all over the world. The intermediation process remains to be fully developed.About the possibility of introducing an interest-free financing system through Islamicbanking principle Scharf (1983) also argues that the establishment Islamic FinancialSystem based on the principle of Shariah is not only feasible but also profitable. Westerncountries today realize the truth that interest is an unbearable burden for the developingcountries. Due to that, as observed by Ahmad (1994, p. 188), Canada has already waivedof all the interest. Australia has made a similar move. President Mitterrand of France hasofficially suggested in the Group-7 meeting that at least 30-35 percent of the presentinterest element of the debt should be waived off.

Basis and Business Practice of Islamic Banking

From the viewpoint of Islamic Shariah, in order to be justified islamically the bankingsystem has to avoid interest. Consequently, financial intermediation in Islamic bankingbetween the bank and the client takes place as a partner rather than a debtor-creditor. Thefinancial activities of modern conventional banks are based on a creditor-debtorrelationship between depositors and bank on the one hand and between the borrower and


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the bank on the other. Interest is regarded by conventional banks as the price of creditreflecting the opportunity cost of money. As interest is prohibited in Islam, commercialbanking in an Islamic framework could not be based on the creditordebtor relationship. Theother aspect of the theoretical basis of Islamic banking is that the interest free bank is notrisk free. This principle is applicable to two main factors of production, i.e. labor and

capital. According to this principle, as no payment is allowed to labor, unless it is appliedto work, no reward for capital should be allowed, unless it is exposed to business risk.From these two principles of the theoretical basis of Islamic banking, it may be said thatIslamic financial relationships are of a participatory nature (Ahmad, 1993). Based on thetheoretical background, business practices of Islamic bank, especially sources and uses ofbanks funds, are characterized by the following modes or techniques.

Sources of Funds of Islamic Banks

Current Accounts

Islamic banks accept deposits from customers on current accounts as conventional banksdo. This account is also known as Demand Deposit as the deposited amount is payable tocustomers on demand without any notice. As banks use current account deposits on theirown risk the depositors of this type of account are not entitled to any share in the profitearned by the bank.

Savings Accounts

Islamic banks accept saving deposits from customers under Al-Wadia and Al-MudarabaSharia Principles. The word Al-Wadia means Trusteeship. In this case banks act astrustee for its customers. In Saving Accounts under the Al-Wadia principle the bank isgiven an authorization by depositors to use the fund at the banks own risk. This type ofdeposit is almost similar to a Current Account or Demand Deposit except that the bankguarantees its customer the full return of the deposited fund with any profit voluntarily.Under the Al-Mudaraba Shariah principle there are two different types of savings accounts,such as

-savings under profit and loss sharing agreement and-savings under Investment Account.

The word Al-Mudaraba originates from the word Mudarib and means The Managerofthe fund. The bank in this case acts as a manager of customers funds. The depositors onthe other hand are known as Sahib-Al-Mal meaning the owner of the fund. Depositsaccepted on savings under the Profit and Loss sharing agreement is invested by the bank onits own risk. Customers give authorization to the bank to invest funds and share profit orloss on agreed proportions. Account holders of this type of account are required to maintaina minimum balance in the account. Further to the above, Islamic banks accept depositsfrom customers under the Investment Account on a Profit and Loss Sharing basis. The


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saving account of such a nature in an interest-free banking system is also known as aparticipatory account or a Profit or Loss Sharing (PLS) account. Depositors of this type ofaccount receive share of profit to the agreed ratio from their funds invested by the bank.The profit and loss sharing also depends on the total amount deposited and the length ofperiod the money is held by the bank. Depositors of an Investment Account are required to

give prior notice to the bank if they withdraw their invested funds under any specialcircumstance. In such a case no share of profit is given for the amount withdrawn.Investment accounts are again subdivided into the following various categories.

Joint or General Investment Account Limited-Period Investment Deposit Unlimited-Period Investment Deposit Specified Investment Deposit

Under the Joint or General Investment Account the bank pools together investmentdeposits of different maturities which are not invested in any specified project but utilized

for different financing operations of the bank. Depositors of this type of account receiveprofits at the end of the period, which is accounted and distributed on a pro rata basis. TheInvestment Deposits on Limited Period basis indicates a type of investment, where thebank accepts deposits from customers for a specified period of time. The bank refunds themoney to depositors after the time is expired. The profit generated from such funds isdistributed at the end of the financial year. The bank also accepts deposits from itscustomers under an Unlimited-Period Investment Deposit, where investment deposits areautomatically renewable without specifying the period. Depositors of this type of accountmay withdraw their funds within three months notice to the bank. Profits are distributed todepositors at the end of the financial year. Some Islamic banks accept a SpecifiedInvestment Deposit, where the bank and the customer agree to invest this fund to aspecific project or trade. Profits accrued from this type of investment are shared by thebank and the customer. The bank in this regard, works as an agent for the customer, andmay charge an agreed fee for the investment function or may share the profit at an agreedproportion.

Saving Deposit as Quard E Hasan

Apart from the above Islamic banks accept savings from customers as Quard E hasan(benevolent loan) from the customers. Depositors of this sort of savings deposits receivefinancial or non-financial benefits from the bank.

Uses of Funds of Islamic Banks


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Based on the theoretical viewpoint as discussed earlier two fundamental techniques ormodes of investment advocated by the Islamic Shariah Principle is;- Mudaraba (Capital Financing)- Musharaka (Partnership )

Mudaraba (Capital Financing)

Capital Trust financing is a contract between at least two parties in which the bank as the investorsupplies the entire capital of the business forming a relationship between the supplier of capitaland the user of capital. These two parties work together and share profits and losses. UnderMurabaha financing the investor is known as Rab-Al-Mal which means the owner of theproperty and the entrepreneur is called Mudarab, meaning the manager of capital. When theventure ends, the manager of capital i.e. the entrepreneur returns the entire capital to the bank,along with an agreed proportion of profit. If there is any loss, it is born by the bank. The mainadvantage with this type of partnership is that it combines the efforts of human beings and theirskills with the capital, which contribute greatly towards the development activities in a societyand also assists to solve unemployment problems by utilizing manpower resources in aproductive way.

Musharaka (Partnership)

The word Musharaka means a profit sharing joint venture, designed to limited production orcommercial activities of long duration. In this case the bank and the customer contribute capitaljointly. They also contribute managerial expertise and other essential services at agreedproportions. Profit or losses are shared according to the contract agreed upon. An individualpartner does not become liable for the losses caused by others. In addition to the above twofinancial arrangements, Islamic Banks currently in existence are also engaging in or activelyconsidering several other financial practices usually acceptable in Islamic Law. These are: Murabaha (Mark-up or Cost-Plus-based Financing)

Ijara (Leasing) and

Quard- E- Hasan (Interest-Free Loan)

Murabaha (Cost plus profit)

The word Murabaha means a cost-plus Profit contract. In this system of financing the bankagrees to purchase for a client who will then reimburse the bank in a stated time period at anagreed upon profit margin. The mark-up price that the bank and the buyer agree to is mainlybased on the market price of the commodity. Thus the bankearns a profit without bearing any risk.

Ijara (Leasing)The word Ijara indicates leasing. The leasing purchase is another technique followed byIslamic banks in financing customers. This system is almost similar to the leasing activityprovided in traditional banking. Leasing is a contract between the bank and the customer touse particular assets. In this case the bank is called lessor and the customer is called lesseewho wants to use the assets and pays rent. Zineldin(1990, p.83), in this regard argues as, The leasing agreement is based on profit sharing in which the bank buys the movable orimmovable property and lease it to one of its client for an agreed sum by installments and


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for a limited period of time into a saving account held with the same bank. Theseinstallments are invested in Mudaraba investment (Venture) for the customers account.The accumulated profit generated from the payments, and the payments themselves areinvested in the banks investment ventures over the time period of lease, contributing toeventual purchase of the leased assets. According to the Western leasing system the lessee

pays specific rentals and a fixed rate of interest over a given period for the use of specificassets. But in the Islamic banking system of leasing the risk related to leasing has to beshared between the bank and the lessee, in case of any damage to the leased assets. Thecontract is called ijara-wa-iqtina i.e. leasing purchase, when the ownership of the assetsis transferred to the clients after the completion of the leasing contract.

Quard E Hasan (Interest free loan)

Quard E Hasan means an interest-free loan given by the Islamic bank to the needy peoplein a society. The practice of dealing with this sort of investment differs from bank to bank.Quard E Hasan is normally given to needy students, small producers, farmers,

entrepreneurs and economically weaker sections of the society, who are not in a position toobtain loan or any financial assistance from any other institutional sources. The main aimof this loan is to help needy people in a society in order to, make them self-sufficient and toraise their income and standards of living. (Zineldin, 1990; Khan, 1897; Kazarian, 1991,Ahmad, 1993)

REASONS

Capitalization could not solve the global economic problems. The world is lookingfor a new economic order. Islamic economic system will be that new economicorder.

Islamic finance is one of the fastest growing sectors in the global financial industry.

The interest-free Shari`ah-based systems will be mainstream Banking and theconventional banks will be the minority systems in the OIC countries including


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Bangladesh within 2002, M Azizul Haque, a leading expert on Islamic banking inBangladesh, told IOL.

Azizul Haque, who is also chairman of the Shari`ah Council of Dhaka, believes thatBangladesh will follow the rest of the world to the Islamic banking sector. Heexplains that the growth rate of Islamic banking in the OIC countries for example is

15 to 20 percent while that of conventional banks is 10 to 15 percent. In defiance of the credit crunch, the global Islamic finance market has grown about

15 percent in each of the past three years, and is now worth about $700 billionworldwide. Currently, there are nearly 300 Islamic banks and financial institutionsworldwide. Its assets are predicted to grow to $1 trillion by 2013.

Azizul Haque expects that higher growth rates in the next decade will force theglobal financial systems to Islamic banking.

There is not any sort of apprehension regarding the success of Islamic banking, Therenowned economic.

Bangladesh entered the Islamic banking system only in 1983, with theestablishment of Islami Bank Bangladesh. Since then, five more full-fledged private

Islamic banks and 20 Islamic banking branches of conventional banks have beenestablished. Patwary says that his bank is now one of the top performer banks interms of business and profits among the 48 commercial banks operating in thecountry.

Islamic Bank Bangladesh Limited has gained first position in the all private banksin term of deposits, investment, export & import and remittance collection.According to the Bangladesh Bank (BB), the central bank of the country, thedeposits of the Islamic banking systems are now 25 percent of all private banksdeposits and its investments are 30 percent.

A Muslim, whose religion prohibits earning or paying interests, Islamic bankingmakes it possible to operate interest-free business.

Islam forbids Muslims from usury, receiving or paying interest on loans.

Islamic banks and finance institutions cannot receive or provide funds for anythinginvolving alcohol, gambling, pornography, tobacco, weapons or pork.

Shari`ah-compliant financing deals resemble lease-to-own arrangements, layawayplans, joint purchase and sale agreements, or partnerships.

Bangladesh is the worlds third largest Muslim majority country, with Muslimsmaking up more than 80 percent of the nations 148 million population.

SUGGESTION

Banking Environment in Bangladesh

Bangladesh appeared as a new nation on the world map in the year 1971. Afterindependence financial institutions, especially banks played a vital role in re-constructingthe war-torn economy of Bangladesh. As reported by BSB (P. 29, 1993), the bankingsystem of Bangladesh is a mixed one comprising nationalized, private and foreigncommercial banks. Bangladesh Bank is the central bank of the country and is in charge ofmonetary policies of the Government and controls all commercial banks. Immediately


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after independence the government of Bangladesh nationalized most of the bankinginstitutions, though, within a short period, due to the failure in administering themproperly, many of them were returned to their owners. The banking sector is one of the fastgrowing sectors of economy in Bangladesh. At present there are 34 banks working in thefinancial market of the country, including four Islamic banks and a number of foreign

banks. The total figure of banking institutions in Bangladesh may be stated by thefollowing Table.

Source: GOB 1993/1994

During the Fiscal Year 1993-94 the banking institutions of Bangladesh transacted theirbusiness through 5,780 branches (BSB, 1994). The deposit of scheduled banks (excludinginter-bank items) amounted to TK. 309,884 million*. The bank deposits during the year1993-94 were increased by TK. 27,629 million, of which 12.29% was in time deposits andTK. 22,043 million or 25.50% in demand deposits. The total bank credit in the same yearwas TK. 240,870 million. Of this, credit to the government sector recorded a decrease of55.05% and credit to the private sector expanded by 8.55%. (GB, 1993/94).

Establish a partnership relationship with customers and to eliminate the idea ofthe debtor-creditor

Relationship of traditional banks. Establish welfare oriented banking system;

Mobilize savings towards productive sectors; Invest on profit and risk sharing basis;

Invest to those businesses sectors that are found legal from


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The religious point of view. Create employment opportunities by investing savings towards prospective

economic sectors.

Extend banking services towards the poor, helpless and low-income group ofpeople in the society in order to uplift of their standard of living.

Contribute to establishment of a society by equitable distribution of wealth

Establish justice in trade and commerce in the country;

Develop morals among the people and to establish the shariah in the field oftrade and commerce;

Render services for the economic development of the nation. Contribute towards establishment of an Islamic Economic System in the

Country.

Need to Combine Islamic Economic History with Islamic Institutional

Economics.

Mudaraba Frame Work.

Islamic Discipline of Economics Emerged in late-colonial India

Islamic Economics Needs a Great Deal of Creative Thinking.

Bankers believe that the Islamic banking is set for even more progress, if a law

governing Islamic Banking policies is introduced.

If an Islamic banking Act is introduced, the Islamic banking systems will even

further flourish.

Experts predict that with the rapid rise of Shari`ah-based systems, the industry

will ultimately turn to be the financial mainstream in Bangladesh.

CONCLUSION

It may be concluded from the above discussion that the Islamic Banking System shows anoverall success in both deposits and investment positions since it started its bankingactivities. ISLAMIC BANKING is increasingly becoming an area to watch in the localbanking industry. This is especially so given that Bangladesh is already quite well knownfor its Islamic banking infrastructure and may thus be a draw for petrodollars. Islamic
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banking, which started as experiments of individuals. But its tremendous progress alsocarries a lot of challenges for those who work in the field. Need for investing more inhuman capital development. We know that humans, the makers of progress and success,are also behind failures and collapses. Emphasizing the need to focus more on educationand training to strengthen the sector. Employees lack of knowledge of Islamic banking

principles would have a negative effect on the system, as they would not be able to marketproducts effectively. Well also advise member countries on how to manage Zakah andWaqf successfully, following modern asset management principles. It is also observed that,the bank did not succeed much in accumulating deposits under various term deposits. Thisultimately results in a reduction of the long-term investment of the bank, especiallyinvestment towards industrial sectors. It is always assigned that the growth rate of bankbranches should increase the savings position of the bank, which was not the case with theIslami Bank. Apart from its growing share, the prospects of Islamic banking are also brightwith the flush of petroleum money. Islamic banking is seeing rapid expansion worldwide,with strong growth in the Middle East. As regards the overall investment position of theIslami Bank Bangladesh it may be concluded that, since the beginning of banking activities

the bank has not invested any amount in any project on the Mudarab mode of investment.Although, the Islamic banking theory as regards investment of funds and acceptance ofdeposits is based on two fundamental techniques such as Mudaraba (capital financing) andMusharaka (Partnership), It was observed from the response of a few small-scaleindustrialists that the remarkable advantages they get from the bank are easy formalities ofobtaining loan and quick action in processing loan activities. Moreover, clients of all levelscan have free access to the bank and can discuss business matters with senior officials.There is an immense need for Bangladesh Bank to have a group of Islamic bankers andShariah experts of its own who can properly monitor and formulate guidelines for allIslamic banks and Islamic banking windows in the conventional banks.

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