The Aims and Objectives of an Islamic Bank
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Islamic banking is becoming increasingly popular and plays a prominent role in the financial services sector in Malaysia. According to latest statistics shown, the Muslim population of Malaysia is approximately 25 million. There is definitely a strong demand and strong growth potential in this sector. In Malaysia, the banking sector is mainly dominated by the conventional banking system whereby interest is not being prohibited. It is because the Islamic banking system is relatively new and there are insufficient regulations at present to govern them. If these obstacles are being resolved, the Islamic Banking sector will blossom given the influence of Malaysia in the international Muslim community.
The primary aim of this research is to examine and understand in depth the development of Islamic banking in the world of finance. This piece of research can be divided into three sections. The first section looks at significant differences between conventional banking and Islamic banking. Products and services offered by these financial institutions will be marked to comparison. The second section looks at how the practice of Islamic banking started and how it has emerged to become a vial force in the economy. The final part of the research will focus on how the Islamic banks penetrated the Malaysian market and the challenges faced.
1.1 Structure of Dissertation
This dissertation is divided into a few topics and each topic covers different areas of research. This is to give readers a clearer view of the research and make it more user-friendly. It is well thought and designed to ensure the smooth flow of the reading. The structure of the dissertation can be summarized as follows:
Chapter 1: This chapter describes the aims and objectives of this research.
Chapter 2: This chapter discusses the principles and fundamentals of Islamic banking
Chapter 3: This chapter explains in detailed the state and scope of Islamic banking industry in Malaysia. I have also mentioned to objectives and roles the Malaysia International Islamic Financial Centre Initiatives plays in the industry.
Chapter 4: Research methodologies and strategies that were being adopted for this paper was discussed.
Chapter 5: I have marked two Islamic banks in Malaysia for side by side comparison. I have drawn up a table to compare their financial performance and position over the past two years.
Chapter 6: I have interviewed two Islamic bankers from Malaysia. On top of that, I have also provided my personal analysis of their answers.
Chapter 7: Competition and globalization of the Islamic banking industry. Moreover, I have also discussed opportunities and challenges faced in the world and in Malaysia.
Chapter 8: A summary of the paper was included with recommendations and limitations to research.
So, what exactly is Islamic Banking? Islamic Banking is banking based on Islamic laws (Shariah). The Shariah principles are derived from the Quran and the Sunnah (sayings of Prophet Muhammad). Moreover, secondary sources of Islamic laws such as opinions collectively agreed among Shariah scholars, analogy and personal reasoning are also adopted in the rules and practices of Islamic banks (Al-Omar, 1996).
The research then looks at the differences between conventional banking and Islamic banking. There governing principles of Islamic banks are:
Absence of interest-based transactions. Charging of interest is prohibited under Shariah principles. Money itself does not have inherent value and should not be used to create more money. Wealth can only be generated through legitimate trade and investment.
Acts of speculation are not accepted under Islamic principles. For instance, buying goods now at lower price in the hope of selling them at higher price in future. The reason being speculators make private gains at the expense of society at large.
Introduction of Islamic tax for the purpose of wealth distribution so that every Muslim is guaranteed a fair standard of living.
It is forbidden for Islamic banks to finance activities forbidden in Islam such as prok meat and alcoholic beverage. In order to ensure that the trading activities do not contradict with Shariah principles, all Islamic banks are required to set up Shariah Committee, who acts as advisor to the banks.
On the other hand, conventional banks charge interest on transactions. These interests are widely seen as price of credit. Furthermore, conventional banks focuses on 'elimination' of risks and thus do not share any liabilities with the borrower.
Islamic Bank Vs Conventional Bank
Based on Shariahprinciples.
Based on best economic principles.
Bank should not take advantage of borrower. No interest charged.
Charges interest to reflect price of credit.
Does not allow involvement in haramactivities such as pork meat and alcoholic beverage.
Aims at maximizing profit without restrictions other than compliance with relevant regulatory frameworks.
Intoduction of zakat.
Non-existence of zakat.
Promotes risk sharing between providers of credit and borrower.
Interest is assured to providers of credit. No liabilities borne by the bank.
Emphasis placed on viability and feasibility of projects.
Emphasis placed on credit-worthiness of customers.
Only provide guarantee for deposit account (al-wadiah). If funds placed under mudarabah accounts, customers shares profit or loss incurred by bank.
Provides guarantee to all its depositors.
2.1 Fundamentals of Islamic Banking & Finance
Islamic commercial law is based on a few major principles. They will be discussed in detailed as follows:
Musharakah (Partnership Finance)
Musharakah is a contract in which the bank and the client contribute jointly to the capital of a specific project or deal to make a profit. Therefore, risks of profits and losses are being shared between these two parties according to terms and conditions stipulated in the contract. This principle exposes bank to the risks of the project, in other words protecting the interests of the community. This will prevent banks from yielding their unfair influence and sells disadvantage products to clients.
Mudarabah (Trust Financing)
Mudarabah is a contract in which the banks provides all the capital required whilst the partner contributes in terms of skills, experiences and efforts. The bank receives a pre-determined share of profits as agreed by both parties upon commencement of the project. The major difference between mudarabah and musharakah is that in this case, the bank bears all financial loss whilst the client goes unrewarded. Therefore, it is also the bank's responsibilities to assess the feasibility and viability of the project. As such, it is vital for the bank to have a good and credible credit system to evaluate all its exposures on these projects. In short, this principle encourages individuals to participate in financial activities It also gives individuals without sufficient resources an opportunity and platform to prove themselves in the society.
Murabaha (Cost-plus Financing)
Murabaha is a contract in which the banks informs their client about the acquisition price of certain goods and products and sells them with a margin. It requires the bank to declare an honest price of acquisition. It is one of the most common principles adopted in Islamic banking system to promote interest-free transactions. It is widely practiced in asset financing and both commodity import and export.
Bai-Mua"jjal (Deferred Payment Sale)
It is a contract in which the seller sells a certain goods or products to the buyer at an agreed fixed price to be paid later at a specific date by the buyer. In short, it is a sale on credit. The bank merely acts as the financier by deferring the receipt of the sale price of goods it sells.
In this case, the bank buys capital equipment or property and leases it out under instalment to clients. Similar to conventional leasing, the client has the option to purchase the goods at the end of the lease period. The fact that there is real good to be financed means that it is Shariah compliant. A very common product adopting this principle is Islamic mortgage whereby the buyer buys the property on an instalment basis.
Islamic teachings promote brotherhood amongst Muslims. Qard Hassan is seen as a gratuitous loan that helps fellow Muslims who need financial assistance. It can be defined as a loan to be repaid at a later date without incurring any interests. According to Rob (1992), Islamic banks may raise funds through sale of shares to public and main deposit accounts. Therefore, the bank has a responsibility to lend a helping hand to those in desperate situation without taking of their advantaged position.
2.2 Compatibility of Islamic Banking with Conventional Banking
Islamic banking system has very similar features to conventional banking except that Islamic banks operate in compliant to Shariah laws and principles. Both banking systems have common features and common products. The main differences being prohibition of interests being incurred and sharing of profits and losses between banks and their clients (Abdur Rahim, 2009). They have the same objectives except interpretation of interest. Islamic banks fall into realms of the economic world as well. They try to ensure all their operations comply with Shariah laws yet at the same time conform to rules set by international bodies such as International Accounting Standards Board and Audit Practices Board. This is to ensure they remain relevant to the society and at the same time conform to their religious principles. Islamic banks sell products such as mortgages, savings accounts, insurance which is also sold by all conventional banks across the world. According to Nienhaus (1995), Islamic banks offer facilities more or less the same as conventional banks, in compliance with the welfare principles of Islam.
3 LITERATURE REVIEW
A literature review is a process in which published articles or information are studied as part of the research for the preparation of a dissertation. For the purpose of this project, I have gathered information from books and articles from various sources. I have studied the concept of Islamic banking, having limited understanding about this topic previously. Further, I have also included discussion about the development of Islamic banking in the world, and in particular, Malaysia. This paper allows readers to have a good grasp of Islamic banking in general. It gives readers the opportunity to study about Islamic banking in greater detail when the interest of this industry gathering strong momentum. This is of particular importance because Islamic banking has a huge impact of the world economy because of the strong influence of the oil-rich Gulf States.
Since a few decades ago, Islamic banking has emerged as a new reality in the world economy. Its philosophies and principles are however, not new, having been outlined in the Holy Qur'an and the Sunnah of Prophet Muhammad (p.b.u.h.) more than 1,400 years ago. The emergence of Islamic banking is often related to the revival of Islam and the desire of Muslims to live all aspects of their live in accordance with the teachings of Islam (Siddiqi, 1983).
This chapter provides a brief overview of how Islamic Banking was introduced in the World and how it penetrated the Malaysian market. Islamic banking today has proven to be a popular and reliable financial system in the world. It is widely seen as a viable alternative to the conventional banking system over last 3 decades. Islamic banking was described by scholars as 'wishful thinking' when the idea was first mooted almost thirty years ago (Iqbal and Philip, 2006). Many conferences and discussions were carried out at that time to work on the finer details of this system. Several blueprints were drafted by Islamic scholars from all over the world to ensure a detailed system is created.
The first international conference on Islamic Economics was organized by Kings Abdul Aziz University in Makkah marked an important milestone in the history of Islamic banking (Iqbal, 2005). Financial gurus, economic experts and Islamic leaders were invited to present their view and opinions.
Following this, the first Islamic bank, Dubai Islamic Bank (DIB) was established in the United Arab Emirates in 1975. Since its formation, it has established itself as the leader in the industry and has won several accolades internationally. In 2009, it recorded net profit of £200 million with assets worth over £14 billion. Islamic banking has gained tremendous momentum and has been growing rapidly over the years. Islamic banks now offer products in various areas such as banking, insurance, mortgage and asset management with annual growth of 10% for many years.
3.2 History of Islamic Banking in Malaysia
Islamic banking industry in Malaysia is growing at a moderate pace. It is a unique market because Islamic banks in Malaysia are allowed to operate in parallel to conventional banks (interest-based). The multi-ethnic population of Malaysia makes the entire change of financial system to follow the Shariah system not viable. Government of Malaysia opted for gradual way of introducing Islamic banking by allowing conventional banks to sell Islamic banking products and services such as sukuk (Arif, 1989). The dual banking system has been recognised by both West and East leaders and it is seen to be the model of the future. In fact, many central bankers have visited Malaysia to see the effectiveness of this dual system first hand. Furthermore, this dual system also eliminates the wrong concept of general public that Islamic banking products are sold exclusively to Muslims.
The history of Islamic banking industry goes back to as far as 1963, when the foresighted government set up the Lembaga Tabung Haji also known as the Pilgrims Management and Fund Board. It was set-up primarily to encourage Muslims in the country to save up on their income in order to perform pilgrimage in Mecca (Kamarulzaman & Bhupalan, 1983). Besides, the fund was also created to provide a platform for participation in the economic and investment activities. Based on the success of the Lembaga Tabung Haji, coupled with the consultation of Shariah experts and economic gurus, government then proceeded to set up the first ever Islamic Bank in 1983. Setting up of Bank Islam Berhad Malaysia (BIMB) marked a milestone in the banking industry. It proved to be hugely popular because over half the Malaysian population are Islam followers. What followed through was the listing of the bank in the stock exchange of Malaysia in the early 1990s. As of today, the bank has 100 braches located all over Malaysia.
With the fairytale of BIMB, central bank decided to allow commercial banks and merchant banks to offer Islamic banking products under the Islamic Banking Scheme. It was not long after that the central bank set up the National Shariah Advisory Council to oversee all issues pertaining to Islamic Banking.
Due to the economic liberalisation, central bank finally grants licenses to foreign Islamic banks to operate in Malaysia in 2004. Al-Rahji Bank and Kuwait Finance House took full advantage of this ruling and step foot into the Malaysian banking industry. The last count of Islamic banks operating in Malaysia stood at 21.
3.3 Scope of Islamic Banking in Malaysia
Islamic Banking started out as mere deposit taking and lending facility has since transformed into all aspects of banking, money and capital market operations. In Malaysia, the central bank is in favour of a dual banking system, whereby Islamic banks are allowed to co-exist with conventional banks. It is at the consumers' choice to select which services they prefer that cater to their needs. This is in stark contrast with the scenario in Iran and Pakistan, where conventional banking system is abolished completely to make way for Islamic banking. They claim to be devoid of conventional interest based financial transactions.
Today, the Malaysian Islamic banking sector is blossoming as reflected in the extensive distribution networks comprising 152 full-fledged Islamic banking branches. The ability of these Islamic banks to offer competitive products with attractive and innovative features has attracted both Muslim and non-Muslim population in the country. This has also spurred non banking institutions such as savings institutions to introduce Shariah compliance product to appeal to a wider consumer base.
According to Association of Islamic Banking Institutions Malaysia, there are 21 Islamic banks who have subscribed to their membership. The list of Islamic banks is provided as follows:
Affin Islamic Bank Berhad
Alliance Islamic Bank Berhad
Al-Rajhi Banking & Investment Corporation Berhad
AmIslamic Bank Berhad
Asian Finance Bank Berhad
Bank Islam Malaysia Bank Berhad
Bank Kerjasama Rakyat Malaysia Bank Berhad
Bank Muamalat Malaysia Bank Berhad
Bank Simpanan Malaysia Berhad
CIMB Islamic Bank Berhad
EONCAP Islamic Bank Berhad
Hong Leong Islamic Bank Berhad
HSBC Amanah Malaysia Berhad
Kuwait Finance House (Malaysia) Berhad
Maybank Islamic Bank Berhad
OCBC Al-Amin Bank Berhad
PT Bank Muamalat Indonesia
Public Islamic Bank Berhad
RHB Islamic Bank Berhad
Standard Chartered Saadiq Berhad
Unicorn International Islamic Bank Berhad
As evident from the list above, there are 21 banks offering Islamic products in the Malaysian market. Confidence is clearly shown on the Malaysian market with international banking powerhouse presence such as Standard Chartered group and Kuwait Finance House.
The Governor of Central Bank Malaysia recently declared the central bank's intention to lure larger overseas banks to provided services that comply with Muslim tenets. As a sweetener to any potential deal, the central bank has raised foreign ownership limits at local Islamic banks and insurance companies to 70%. Rising oil wealth has turned the Islamic banking into an industry with assets with $1 trillion in assets globally. The central bank is doing its utmost, implementing initiatives to explore this relatively untapped market. In addition to the changes in foreign ownership limits, the central bank is also offering tax breaks for Islamic products and has relaxed rules for Islamic banks to trade in foreign currencies (Aziz, 2006). This is seen as a major breakthrough because the foreign currencies dealing is tightly regulated due to the impact Malaysian market suffered in the 1997 Asian Financial Crisis.
In July 2010, Khazanah, Malaysia sovereign wealth fund made its debut in Singapore debt market issuing sukuk or Islamic bonds worth $1.5 billion, three times the size of Singapore sukuk market until now. This further strengthened the Malaysian government efforts to promote Islamic banking products both domestically and internationally.
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