Chapter 1

An Overview
of
Islamic Banking System
By
Dr Abdurraheem
FINANCIAL SYSTEM
2

 The financial system consists of a set of complex and closely

interconnected financial institutions, markets, instruments,
services, practices, and transactions.
Financial Structure in Malaysia

The Malaysian financial system is structured into

two major categories:
Financial Institutions and Financial Market.
 The Financial Institutions comprise Banking System and Non-bank
Financial Intermediaries.
 The Financial Market in Malaysia comprises four major markets
namely:
i. Money & Foreign Exchange Market,
ii. Capital Market,
iii. Derivatives Market, and
iv. Offshore Market.
 Financial System
Financi
Financi
al
al
Instituti
Non-Bank Financial Market
on
Intermediaries
Banking 1.. Provident and Pension
System Capital
Funds
Money Derivati Offshor
Market
1. Bank Negara 2. Insurance Companies
& ves e
Malaysia (including 1. Equity
Takaful) Foreign Market Market Market
2. Banking
Institutions 3.Development Finance Exchan 2. Bond 1.Commodit
Labuan
Market Internatio
• Commercial Institutns ge y Futures nal
Banks • Public
4. Savings Institutions Market Debt
2. KLSE CI Offshore
• Islamic Banks • National Savings Futures Financial
1. Money Securities
• Merchant Banks Bank 3. KLIBOR
Market • Center
3.Finance • Co-operative Futures (IOFC)
2. Foreign Private
Companies Societies
Exchange Debt
4. Others 5. Others Market Securities
• Discount Houses • Unit Trusts
• Representative • Pilgrims Fund
Board
Offices of Foreign
• Housing Credit
Banks
Institutions
• Cagamas
Berhad
• Credit
Guarantee
Corporation
• Leasing
Companies
• Factoring
Companies
Banking System

 The banking system consists of Bank Negara Malaysia

(Central Bank of Malaysia), banking institutions
(commercial banks, Islamic banks, merchant banks and)
finance companies, and a miscellaneous group (discount
houses and representative offices of foreign banks).

 The banking system is the largest component of the

financial system, accounting for about 67% of the total
assets of the financial system
Central Bank (Bank Negara)

 Bank Negara Malaysia (the Bank), the Central Bank, is the apex of the monetary
and banking structure of the country. Its main objectives as defined in the Central
Bank of Malaysia Act 1958 are to:
 Issue currency and keep the reserves safeguarding the value of the currency;
 Act as a banker and financial adviser to the Government;

 Promote monetary stability and a sound financial structure;

 Promote the reliable, efficient and smooth operation of national payment and
settlement systems and to ensure that the national payment and settlement
systems policy is directed to the advantage of Malaysia; and
 Influence the credit situation to the advantage of Malaysia.
 To meet its objectives, the Bank is vested with legal powers under various laws
to regulate and supervise the banking institutions and other non-bank financial
intermediaries. The Bank also administers the country's foreign exchange
control regulations and act as the lender of last resort to the banking system.
Commercial Banks

 The commercial banks are the largest and most significant providers of funds in
the banking system.
 There are currently 27 commercial banks (excluding Islamic banks) of which 19
are locally incorporated foreign banks.
 The main functions of commercial banks are to provide:
 Retail banking services such as the acceptance of deposit, granting of loans
and advances, and financial guarantees;
 Trade financing facilities such as letters of credit, discounting of trade bills,
shipping guarantees, trust receipts and Banker’s Acceptances; Treasury
services; Cross border payment services; and
 Custody services such as safe deposits and share custody.

 Commercial banks are also authorised to deal in foreign exchange and are the
only financial institutions allowed to provide current account facilities.
Finance Companies

 Finance companies form the second largest group of deposit-taking

institutions in Malaysia.
 Finance companies were initially governed by BNM through the Finance
Companies Act 1969. This was replaced in 1989 with the Banking and
Financial Institutions Act 1989. There are currently 12 finance companies.
 Finance company business is defined as:
 The business of receiving deposits on deposit account, saving account or
other similar
account;
 The lending of money;
 Leasing business or the business of hire purchase; and
 Any other such business as BNM with the approval of the Minister may
prescribe.
 Merchant Banks

 Merchant Banks (also known as Investment Banks)

 Merchant banks emerged in the Malaysian banking scene in the
1970s, making an important milestone in the development of the
financial system alongside the corporate development of the
country.
 They play a role in the short-term money market and capital raising
activities including financing, specialising in syndication, corporate
finance and management advisory services, arranging for the issue
and listing of shares, as well as investment portfolio management.
Islamic Bank

 In Malaysia, separate Islamic legislation and banking regulations

exist side-by-side with those for the conventional banking system.
The legal basis for the establishment of Islamic banks was the
Islamic Banking Act (IBA), which came into effect on 7 April 1983
and IFSA 2013.
 The IBA 1983 and IFSA 2013 provide BNM with powers to
supervise and regulate Islamic banks, similar to the case of other
licensed banks.
 The banking activities of Islamic banks are based on Syariah
principles (the Islamic principles).
 The first Islamic bank established was Bank Islam Malaysia Berhad,
which commenced operations on 1 July 1983. On 1 October 1999, a
second Islamic bank, namely Bank Mualamat Malaysia Berhad was
Discount House

 Discount houses began operations in Malaysia since 1963. Generally, the

discount houses specialise in short term money market operations and mobilise
deposits from the financial institutions and corporations in the form of money at
call, overnight money and short term deposits.
 The funds mobilised are invested in Malaysian Treasury bills, Malaysian
Government Securities (MGS), banker acceptances (BAs), negotiable
certificates of deposit (NCDs), Cagamas bonds and Floating Rate Negotiable
Certificates of Deposit (FRNCDs), as well as to provide an active secondary
market for these activities. Cagamas bonds are fixed income debt instrument
issued by Cagamas Berhad. •

 Cagamas Berhad is an organization that purchases financial

institutions loans at a discount. • Cagamas Berhad funds its
purchases of loans and debts through the issuance of Cagamas
bonds.
Provident and Pension Funds

 Provident and Pension Funds (PPFs) are a group of financial

schemes designed to provide members and their dependents with
a measure of social security in the form of retirement, medical,
death or disability benefits.
 The major PPFs in Malaysia comprise the Employees Provident
Fund (EPF), the Social Security Organisation (SOCSO), the
Armed Forces Fund and the Teachers Provident Funds.
 The PPFs funds serve as important mobilisers of long term
savings in the economy for re-channelling into both the public and
private sectors to finance long-term investments.
 The PPFs are the second largest group of financial institutions in
the country in terms of aggregate assets, next to banking
 Development of Financial Institutions

 Development Financial Institutions (DFIs) are established by the

Government to promote the development of certain identified
priority sectors and sub-sectors of the economy, such as
agriculture, infrastructure development and international trade.
 DFIs generally specialise in the provision of medium and long
term financing of projects that may carry higher credit or market
risk.
 The following are the main DFIs in Malaysia:-
 Bank Pertanian Malaysia,
 Bank Industri & Technologi Malaysia,
 Bank Pembangunan & Infrastruktur Malaysia Berhad,
 EXIM Bank &
Financial Market

The Financial Market mainly comprises:-

 The Money and Foreign Exchange markets
 The Capital and Derivatives Markets
 The money and foreign exchange markets are integral to the
functioning of the banking system, firstly, in providing funding to
the banking system, and secondly, serving as a channel for the
transmission of monetary policy.
 These are governed by the Malaysian Code of Conduct for
Principals and Brokers in the Wholesale Money and Foreign
Exchange Markets 1994 which sets out the market practices,
principles and standards to be observed.
Banking Business
• “banking business” means—
(a)the business of:-
• (i)receiving deposits on current
account, deposit account,
savings account or other similar
account;
• (ii)paying or collecting cheques
drawn by or paid in by
customers; and
• (iii)provision of finance; or
• (b)such other businesses as the
Bank, with the approval of the
Minister, may prescribe;
15
Islamic Banking Definition
• Islamic Banking Act 1983 -
“Islamic bank” means any
company which carries on Islamic
banking business and holds a
valid license; and all the offices
and branches of such a bank shall
be deemed to be a bank”.

• “Islamic banking business”

means banking business whose
aims and operations do not
involve any element which is not
allowed by Shariah.
16
Islamic Banking System
“The main objective of an Islamic 5 Basic Principles of
bank is to provide Muslims Islamic Banking System
alternative way out of dealing with
interest or usury which has been
strictly prohibited by Allah and to
protect them from one of the biggest
sins.”
Allah states prohibition of riba in
many places of the Quran. One of
which is:
Q 4:161. “ And their taking of Ribâ
(usury) though they were forbidden from
taking it and their devouring of men's
substance wrongfully (bribery, etc.). And
We have prepared for the disbelievers
among them a painful torment.” 17
Basis of Islamic Banking and Finance

Figure 1.1: Shari’ah as the Basis of Islamic Banking and Finance

 Basis of Islamic Banking and Finance ctd
The Qur’an
• The Qur’an is the first source of the Shari’ah
• General and specific rules on religious, commercial,
political, economic, legal and social norms are derived
from the Qur’an.
• Emphasises on mutual consent and consensus among
consenting parties.
• Prohibits exploitative measures:
• Excessive risk or uncertaintly (gharar)
• Usury or interest (riba)
• Prohibits cheating and corrupt practices in the
management of funds
• Prohibits dealings in certain specified prohibited products
Basis of Islamic Banking and Finance ctd
The Sunnah
• Sunnah is the second primary source of Shari’ah

• Comprises the sayings, practices and tacit approvals of

Prophet Muhammad (PBUH)

• Provides further explanations on the injunctions of the Qur’an

• For example, there are many prophetic traditions that deal

with riba that highlight the affirmative evidence of the
prohibition of riba already mentioned in the Qur’an
Principles of Islamic Banking System
Promote Public
Interest
Entitlement to
(Maslahah) Free from
Equal, Adequate,
Accurate Info. Riba (Usury)

Promote Free from

Equity Gharar (Ambiquity)

A system grounded Free from

on moral and Dharar (Detrimental)
ethics

Freedom to Free from

Characteristics of Shariah- Gambling
Contract
compliant Banking and Financial
System

Entitlement to Free from

Transaction at Price control &
Fair Price Manipulation
21
Philosophy of Islamic Banking

Avoid Unethical Practices

No Interest
No Gharar
Participating
No Maisir
Actively to
Achieve Goal
of Islamic
Economy

22
Key Operating Mechanisms of Islamic Banking and Finance
Key Operating Mechanisms of Islamic Banking and
Finance

The process of
Institution through
raising funds to
Fund mobilization the sale of shares
establish a viable
to investors and
financial system

receiving funds
from depositors. Net equities
Features include: An ethical manner owned by
shareholders

Investment
Demand deposits
deposits
 Fund utilization

Key Leasing modes - The rent of

Operating an asset or hire purchase

where a rental fee is paid for
a stipulated period of time
The process of using the
funds realized in Sharī'ah-
compliant
mutually agreed by the
Mechanis parties

ms of
Islamic
Banking Sale modes – The bank
purchases an item on behalf
the client and resells it to business:

and them on a deferred basis or

immediately

Finance Sharing modes - Partnership

where funds initially
mobilized are invested in
Sharī'ah-compliant business;
parties share profits or loss
3. Establishment of
Islamic Banking
 Pre Makkan
Society
 After Emergence
of Islamic State
 Birth of Islamic
Bank

26│26
│26
 Establishment of Islamic Banking:
Pre-Islamic Makkan society

• No banking system and

financial intermediation.
• 2 types of finance (use of
money):
1. Partnership (mudaraba):
Based on skills or reputation
and ability to make profits
(sharing basis).
2. Lending for usury (riba):
To maximize profit from
the money invested. 27
 Establishment of Islamic Banking:
After the Emergence of Islamic State

• 610 a.c, normadic life declined

significantly and replaced with trade,
agriculture and crafts.
• A type of deposit for safekeeping was
introduced – the same amount of money
will be returned to the depositor when
required.
• The fall of Rome and the Dark Ages in
Europe had a marked impact on business
and particularly on development and trade
activities in the Muslim world.
• When the West awakened to its new dawn
in the 12th AD, they began to develop their
own banking system. 28
 Establishment of Modern Islamic Bank:
How Islamic Bank Started

01 02
First attempt
Modern Islamic
03
Based on concept
04
banking was Success of
to establish of German savings Islamic bank
established in Mit bank. The bank
Islamic Bank
was in
Ghamr in the Nile participate as a also contributed
Pakistan in
Delta of Egypt joint owner in by the high
late 1950s but between 1963 and equity interest rate
1967 by Ahmed participation and charged by
it did not have
al-Najjar-graduate sharing of profit money lenders.
lasting impact.
from German with entrepreneur
University. based on amount
of capital invested. 29
Origins and Historical Overview of Islamic Banking
and Finance

Figure 1.2:
Timeline of
Modern-day
Experiments of
Islamic banking
and finance from
1962 to 1975
4. Development of
Islamic Banking in
Malaysia

 When and How It

Starts

31│31
Development Of Islamic Banking in Malaysia
Initial Stage
The first formal request was
made during the Bumiputera (indigenous people)
Economic Congress in 1980

Pilgrims Savings Fund (Tabung haji) established in 1981

On July 30, 1981 government appointed

a National Steering Committee on Islamic Banking
32
 Development Of Islamic Banking in Malaysia
Second Stage
The Islamic Banking Act, 1983 and Government Investment Act
1983, paved the way for the establishment of Islamic banking in
Malaysia.

The first Islamic bank, Bank Islam Malaysia Berhad (BIMB) was
incorporated on March 1, 1983 and commenced operations on July
1, of the same year.

In 1993, BNM introduced a scheme known as ‘Skim Perbankan Tanpa

Faedah’ (SPTF)
The pilot phase launched on March 4, Second phase commenced in August 1993 10 more financial
33
1993, which involved the 3 largest institutions joining the scheme. December 1993, 21 financial
 Development Of Islamic Banking in Malaysia
Third Stage

National Shariah Advisory Councilndwas established in 1997

1 Objective : advising BNM on
st
2 Objective: analyzing the
matters relating specifically to Shariah compliance of new
Islamic banking, coordinating products or schemes submitted
Shariah issues. by banking institutions.

In October 1999, the government granted a license for a second

Islamic bank, Bank Muamalat Malaysia Berhad.
34
 Development Of Islamic Banking in Malaysia
Next Stage

In 2004, 3 Islamic financial institutions from the Middle East, namely

Kuwait Finance House, Al-Rajhi Banking & Investment Corporation
and a consortium of Islamic financial institutions represented by Qatar
Islamic Bank, RUSD Investment Bank Inc., and Global Investment
House.

BNM also issued 5 new licenses for domestic banks to create Islamic
subsidiaries. RHB Islamic Bank, which commenced operation on 16th
March 2005 and followed by Commerce Tijari Bank Berhad, which
started operation on 15th April 2005 and Hong Leong Islamic Bank
Berhad on 19th July 2005.
35
5. Growth of Islamic
Banking
 Global Islamic
Banking
 Malaysian Islamic
Banking Industry

36│36
│36
 Global developments – Islamic banking

Growth expected to continue

By 2020, estimated to reach
Almost 90% of global market USD4t
share are in top 6 Islamic financial
markets

Global growth rate of 15-20% per annum over the last

10 years
 Mid 1990s – approximately USD150b
 2009 – approximately USD780b
 2010 – estimated USD956b
 2012 – USD1.6t (IFSB estimate)
37
Courtesy of Bank Negara Malaysia
 Global developments
Breakdown of Islamic finance assets

The largest share of Islamic financial assets

remains in Islamic banking, although growth is
slowing
 Sukuk and takaful continues to grow
 Islamic funds registers a slight decrease

38
Courtesy of Bank Negara Malaysia
 Post crisis global Islamic banking industry
Largely shielded
Study on Top 10 Conventional banks vs Top 10 Islamic banks

Between Conventional Islamic

Dec 2006- May 2009

Combined market
capitalisation 42.8%  8.5% 

Declined from Increased by 9%

Net profits USD116b to from USD4.2b to
USD42b loss USD4.6b

36%
Total assets growth (USD17.4t) 55% (USD147b)

Total equity growth 24% 36%

Leverage ratio From 16.6x From 5.8x to
(Assets/equity) to18.2x 6.6x

2008  Only 1 Islamic financial institution required government assistance

 5 top conventional banks received government assistance of USD163.0b or
26% of their combined equity

 Not even a single Islamic bank required to be rescued

2009

Source: IFSB-IRTI-IDB Islamic Finance and Global Financial Stability Report,

39
6 April 2010 based on E&Y study
Courtesy of Bank Negara Malaysia
Emerging interest on Islamic finance as viable alternative to the global financial
system …
Starting in 1971 with the first Islamic bank in Egypt,
Germany
there are now more than 600 Islamic financial institutions in
 Saxony-Anhalt state issued South Korea
75 countries
government sukuk Parliament expected to
UK
 First Islamic bank to operate pass the law related to
 Gov’t sets an objective to ‘entrench offering of tax waiver on
in 2010
London as a global gateway for Islamic foreign investors’ interest
finance income from sukuk issued
 5 FSA-approved Islamic banks and Turkey
Takaful operators  Announced IFC Istanbul in Sep ’09

 Plans to issue sovereign sukuk, amend

with focus includes interest-free Japan
tax law on IF financial business
Law passed allowing
Iran Bahrain banks to do Islamic
Qatar Pakistan finance
France Malta Saudi Arabia UAE
 Passed rules/regulations to  Plans to position Kuwait Thailand Hong Kong
support Islamic finance as Islamic finance Malaysia
Sudan  Aims to become Islamic
activities hub for the
Mediterranean finance gateway to China
 In process of licensing
Islamic banks Indonesia  Plans to issue sovereign sukuk
 Made fiscal & legal  Hang Seng Islamic China Index
Jordan
adjustment for IF Fund in 2007
 Plans to tap sukuk market to
transaction i.e. taxation
finance its deficit Singapore
guidelines on sukuk &
murabaha  Established first Islamic bank Brunei
 Introduced tax neutrality for Islamic finance Aim to become
 Aspiring to be centre for Islamic finance Islamic financial
services hub for
 Launched Islamic ETF
Asia

Muslim-majority countries offering Islamic finance (IF)

Non-muslim countries starting to offer IF 40
Courtesy of Bank Negara Malaysia
 Global Islamic finance industry
Largely shielded: reasons why
• Avoidance of unethical
• Direct link to real economy
activities
• Certainty – supported by
• Avoidance of maisir (gambling)
underlying activities
& riba (interest) & non-
(prohibition of gharar -
permissible goods & services
uncertainty)
• Screening investment
• Prohibits excessive leveraging
• Forbearance for customers in Real Activities
Ethical • Money is not commodity
difficulties
Shariah values
 Real Activities  Ethical
consistent with
universal value
• Greater transparency &
disclosure: Governance Partnership • Different contractual
 relationship
additional Shariah  Governance
governance
• Equity-based & risk-sharing
 transactions
unique risks
• Clearly defined risk & profit-
• Greater fiduciary duties &
sharing characteristics
accountability
serve as additional built-in
• Emphasis on clear documentation
mechanisms
& contract add to soundness &
stability

41
Courtesy of Bank Negara Malaysia