IFI Instruments Pricing in Dual Banking System

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Mohammad Hafizi Hazran Md Zuki1000110

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Determining the Price of Islamic Financial

Instruments/Products in the Dual Banking System

Prepared By:

Mohammad Hafizi Hazran Md Zuki

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July 11, 2010

June August 2010


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D e t e r m i n i n g t h e P r i c e o f I s l a m i c F i n a n c i a l

I n s t r u m e nt s / P r o d u c t s i n t h e D u a l B a n k i n g S y s t e m

Mohammad Hafizi Hazran Bin Md Zuki1

June 2010

Abstract

The dual banking system whereby Islamic banking exits on a parallel with conventional

banking system can bring stiff competition in term of giving competitive market price of

financial instruments. Islamic Financial Institutions need to offer better pricing for their

instruments to attract more customers using the Islamic financial instruments rather than

using the conventional products. In the dual banking system country such as Malaysia,

consumers have two alternatives whether to select either conventional or Islamic banking

instruments. The issues of benchmarking of Islamic instruments based on the conventional

counterpart are also evaluated in this paper. Furthermore, this paper is written to evaluate

the EONCAP Islamic Berhad, Home/House Financing-i BBA financing product on how

the product pricing is determined in the dual banking system environment.

1 The author currently enrolled in Charted Islamic Finance Professional (CIFP) program at International

Centre for Eductaion in Islamic Finance


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Table of Contents

Abstract

List of Figures/Tables

1.0Introduction2.0Literature review

2.1Dual Banking System2.2Conventional Banking vs. Islamic Banking2.3Monetary policies by Bank Negara2.4Based Lending Rate2.5Benchmark in the pricing of Islamic Financial Instruments

3.0Pricing of Financial Islamic instrument in the dual bankingsystem

3.1Home/House Financing-i in EONCAPIslamic Berhad3.2Modus Operandi for BBA in EONCAPIslamic3.3Pricing Methodology of BBA3.4Benchmark to determine profit in BBA

4.0Conclusion and findingsReferences

Pages

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List of Figures

Figure 2.1: Monetary affect policies in term of economy and inflation

Figure 3.1: Home/House Financing-i product structure

Figure 3.2: Computation the Selling Price of Home/House Financing-i (BBA)

Figure 3.3: BBA Variable Rate Financing

List of Tables

Table 2.1: Differences between Islamic Banking and Conventional banking


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1.0IntroductionAs Islamic finance gradually gains distinction in the global financial view, never

ending debates have arose on whether Islamic or conventional banking products

would provide more value for money. Consumer always seeks for the instruments

that give them more value for money. In the dual banking system country such as

Malaysia, consumers have two alternatives whether to opt for conventional or

Islamic banking. In reality, what make consumers concern the most is whether the

banking products either from conventional or Islamic could provide them

competitive price and value added to their money.

In the past days, dealings such as the lending of cash were measured as a form of

charitable or social facility whereby the lender was expelled from making any

profit from his generosity. The borrower would have to pay the exact amount

borrowed which no more and no less. Conversely, in modern Islamic banking, such

exercise is no longer suitable because as commerce entities, Islamic banks need to

make a profit to stay in business and subsequently adding cost to the transaction.

As a substitute of charging interest from loans, these banks offer financing facilities

in other forms such as lease, sale and partnership. This allows Islamic financial

institutions to profit in ways that are permissible by Shariah law compared to

conventional banking system that totally based on riba transaction.

There are various banking products in the market in the dual banking system

country like Malaysia. Each of this financial institutions either Islamic or

conventional claimed that their products are cheaper that another product but in the


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nutshell the price of the banking product or the price competitiveness will depend

on various factors. This paperis written to examine that argument on what factors

that determining the price of Islamic financial instruments in the dual banking

system.

2.0Literature Review

In the literature review part, the overview of dual banking system model is

discussed. The discussion on how Islamic banking and conventional banking

system operate within the dual banking system is also analysed. This is followed by

an overview of difference between conventional banking and Islamic banking. The

monetary policies conducted by Bank Negara Malaysia are also discussed in this

literature review. Then this is followed by the studied on Base Lending Rate (BLR)

usage in dual banking system and finally the discussion on the benchmark of

pricing for the Islamic financial instruments are also reviewed comprehensively.

2.1Dual Banking SystemIslamic banking in Malaysia has one distinctive attribute that sets it

separately from the model applied in Iran and Pakistan. According to Rosly,

the Malaysia model is based on parallel or dual banking system, which

allows interest-based and interest-free banking to coexist and contend for

deposits and financing. Since Malaysians are multi-religious and multi-

cultural, Islamic banking is therefore expected to deal with situations in

which the demand for and supply of excess funds are no longer made on the

basis of trust alone but also on factors such as return on deposits, cost of


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financing and convenience. He also added that religious and non-religious

elements in the market segment of the Malaysian Islamic banking industry

is likely to affect performance as changes in market interest rates will likely

to affect Islamic bankers asset and liability management strategy (Rosly,

S.A 1999).

The capability of interest-free bankers to use Mudharabah as the main

profits generating products is not merely controlled by the legal related

problems but equally important is the problem of information cost related to

the financial structure of the banking firm. A support system is said to be

necessary to ensure that the Mudharabah instrument is effectively and

profitably implemented. It is rather meaningless to arrive at complex

formulas or techniques to generate a scheme of realistic profit sharing ratios

if there is no transparent system to help overcome the problems caused by

moral hazards and unhelpful selection. According to Rosly, the future of

Mudharabah-Musyarakah banking in this country is said to be dependant on

the ability of the interest-free banking system to produce such support

system (Rosly, S.A 1995).

2.2Conventional Banking vs. Islamic BankingThe comparison between Islamic banking and conventional banking can be

identifying in various difference ways. The major variation is that Islamic

Banking is based on Shariah groundwork. Thus, all dealing, contract,

business approach, product characteristic, asset utilization are derived from

the Shariah point of view which guide to the important diversity in many


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part of the operations as compared to the conventional banking. The

institution of Islamic bank is based on the Islamic faith and must stay

within the limits of Islamic Law or the Shariah in all of its activities and

deeds.

The central principles of an Islamic bank are:

i. The absence of interest-based (riba) transactions;ii. The prevention of economic activities involving domination (zulm)

iii. The prevention of economic activities involving speculation(gharar);

iv. The opposition of the production of goods and services whichcontradict the Islamic value (haram)

v. The introduction of an Islamic tax, zakat;

The main variation among Islamic and conventional banking is that Islamic

philosophy says that money itself has no fundamental value and forbid

people from profiting by lending it, without tolerant a level of risk which in

other words, interest or riba cannot be charged. Making money from money

is prohibited and wealth can only be generated through rightful trade and

investment. Any gain relating to this trading is shared between the person

providing the capital and the person providing the capability.

There are two major differences between Islamic banking and conventional

banking. Conventional banking practices are concerned with the elimination

of risk where as Islamic banks bear the risk whenever it involves in any

transaction. When Conventional banks involve in transaction with consumer

they do not take the liability only get the benefit from consumer in form of


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interest whereas Islamic banks bear all the liability when involve in

transaction with consumer. Getting out any benefit without bearing its

liability is declared unlawful in Islam. The differences between Islamic

banking and conventional banking are summarized in Table 2.1.

Conventional Banking Islamic Banking

The operational and regulationsfor the conventional banks are

based on human thinkingrationale.

The operational and regulationsfor the Islamic banks are based

on the philosophy ofIslamic Shariah.

The investor is guaranteed of a

predetermined rate of interest.

In distinction, Islamic Banking

promotes risk sharing betweeninvestor and entrepreneur.

Lending money and realization it

back with compounding interestis the fundamental function of the

conventional banks.

Participation in partnership

business is the fundamentalfunction of the Islamic banks.

Frequently it results in the bank's

own interest fitting prominent. Itmakes no effort to ensure growth

with equity.

It gives outstanding importance

to the public interest. Itsultimate aim is to ensure growth

with equity.

Interest-based commercial banks,

borrowing from the money

market is relatively easier.

For the Islamic banks, it must

be based on a Shariah approved

underlying transaction.

The conventional banks givegreater emphasis on credit-

worthiness of the clients.

The Islamic banks, on the otherhand, give greater emphasis on

the viability of the projects.

The status of a conventional

bank, in relation to its clients, is

that of creditor and debtors.

The status of Islamic bank in

relation to its clients is that of

partners, investors and trader,

buyer and seller.

Table 2.1: Differences between Islamic Banking and Conventional banking

2.3Monetary policies by Bank NegaraBank Negara Malaysia has a number of monetary instruments at its

discarding to infuse and extract funds to influence the level of interest rates

in the financial environment that operate dual banking system. Examples of


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these instruments would include the purchase and sale of Bank Negara

Malaysia and Malaysian Government papers, changes in the statutory

reserve requirements and direct lending and borrowing in the interbank

market. Furthermore, The Overnight Policy Rate (OPR) will also be the

gauge of the monetary policy position. The OPR will have dual roles which

are act as a signalling device to designate the monetary policy position and

as a mark rate for the day-to-day liquidity operations of the Central Bank.

Any change in the monetary policy position would be signalled by the

adjusted value in the OPR. It will serve as the primary reference rate in

determining other market rates. To replicate the unchanged position of

monetary policy, the OPR will be set at the current interbank overnight rate.

Overnight rate as the solitary operating target monetary operations of BNM

will target the overnight interbank rate. Liquidity management will aim at

ensuring the appropriate level of liquidity that would influence the

overnight interbank rate to move close to the OPR.

Liquidity operations will also be conducted at other maturities but without

targeting a specific interest rate level. Therefore, interbank interest rates at

other maturities would be market determined, reflecting overall demand and

supply conditions in the money market as well as interest rate expectations.

Introduction of Overnight Operating Corridor and Standing Facilities is to

minimize the excessive volatility in the overnight rate; Bank Negara

Malaysia will specify a corridor around the OPR. The corridor is set at

more or less than 25 basis points around the OPR. Day-to-day liquidity

operations will aim to hold the overnight rate close to the announced OPR.


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A standing facility is introduced to ensure that the overnight interbank rate

fluctuates within this corridor by providing a lending facility at the upper

limit of the operating band and a deposit facility at the lower limit of the

operating band. Market participants will transact among interbank

institutions at a rate within the operating band to meet their short-term

liquidity needs before utilising the standing facility. This policies introduce

is said by BNM as an advantage to both conventional and Islamic banking

system.

2.4Based Lending RateBase Lending Rate (BLR) is a lowest amount interest rate deliberate by

financial institutions based on a principle which takes into consideration the

institutions cost of funds and other administrative costs. This BLR is

defined by central bank, Bank Negara Malaysia (BNM). The Overnight

Economic

Growth/Inflation

Consumer &BusinessSpending

BankReserves(Liquidity)

Monetary Operation

Money supply

Interest rates

ExchangeRates

Bank NegaraMalaysia

Figure 2.1: Monetary affect policies in term of economy and inflation


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Policy Rate (OPR) from Bank Negara Malaysia is indication or benchmark

for the banks in BLR adjustments, but there might be at variance from bank

to others bank. At the global money market down turn, BLR will get lower

and if the money market on uptrend, it will correspondence upward. It is

prudently and timely to consider take up finance loan and start to own your

property at the lowest BLR rates. From the evidence, it shows that the

utmost BLR Malaysia ever achieved is 12.27% in year 1998 and the lowest

BLR is 5.55% in year 2009. The average is 8.1%.

2.5Benchmark in the Pricing of Islamic Financial InstrumentsIn the recent years, the Islamic finance institutions (IFI) have accomplished

huge expansion and developed from position commerce to a practical

substitute for global financial architecture. However, IFI still relies on

conventional finance benchmarks, such as LIBOR, to determine its own

cost of funds, and hence its return to financial investments.

At the present time, IFI uses the interest rate as the benchmark for Islamic

finance products. Profit rates charged by IFIs are basically replicate of the

market interest rates. This practice, although dispirited, is basically

accepted in Islamic finance as the interest rate is used purely as a

benchmark only. Nonetheless, any reference to the interest rate should be

minimised and therefore the need for providing an Islamic pricing

benchmark for IFI should be emphasised. Rosylin (2009) attempted not

only to implement a analytical approach to model retail assets rental values

to be benchmarked in opposition to the conventional interest rates


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(KLIBOR, LIBOR, and EURIBOR), but also proposed the use of the

balance property rental values as alternatives to the current conventional

interest rates

3.0Pricing of Islamic Financial Instrument in Dual Banking System

The dual banking structure of Malaysia is exclusively categorized among other

countries as a securely governed lawful system, where split regulatory systems for

Islamic banks and other conventional banks are operating side by side. In Malaysia,

Islamic banking was formally set up in 1983 by virtue of the Islamic Banking Act

1983. Consequently, the Interest-Free Banking Scheme was introduced in 1993 to

lodge a full-fledged Islamic banking system on parallel basis with a conventional

banking system. Dual banking systems are juristically criticized for not totally

eliminating interest-rate financing, which is prohibited in Islamic jurisprudence,

but duality has its own sensible qualities over the full- fledged single Islamic

banking systems.

Rigid competition between Islamic products and conventional instruments in the

dual financial market has effectively resulted in Islamic banking products that are

more sophisticated and have a more diversified range than those offered in single

Islamic systems. The challenge of surviving in such competitive markets requires

innovative efforts in designing Islamic financial products to satisfy conventional

needs of sophisticated customers, which, however, have to be clearly guided by

Shariah principles to ensure Islamic legitimacy. In surviving in the competitive

market a good pricing mechanism in the Islamic instruments is needed.


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This paper will evaluate the pricing of BBA contract in Home/House Financing-i

from EONCAP Islamic Bank Berhad. Making a loan under under conventional

banking is one of the most common ways to own a house but in Islamic banking

there are BBA financing for customer to own a house.

3.1Home/House Financing-i from EONCAP Islamic Bank Berhad2

Ownership a house is now made simple for all with the Home/House

Financing-i (BBA) from EONCAP Islamic Bank Berhad. This product is

based on Bai Bithaman Ajil (BBA) contract, Home/House Financing-i

(BBA) lets the customer purchase their dream home after determining the

customer needs. The property will then be sold to the customer at a pre-

agreed price, which includes EONCAP Islamic Banks purchase price and

profit margin. There are three packages available for these products which

are:

i. Fixed monthly obligation during progressive releases to facilitatethe customer to for future financial planning.

ii. Variable/floating rate home financing based on the association of theBase Financing Rate (BFR) with capped at an agreed ceiling rate.

iii. Customer with eligible condition is entitle for Year End AnnualHoliday payment

3.2Modus operandi of BBA at EONCAP IslamicThe Home/House Financing-i is an Islamic financing facility, which is

based on the Shariah concept of Al Bai Bithaman Ajil (BBA). It is a

2Available at internet

http://www.eonbank.com.my/islamic/financing/home_house_financing_i.shtml


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contract of deferred payment sale like the sale of goods on deferred

payment basis at an agreed selling price, which includes a profit margin

decided by both parties. Profit in this context is justified since it is derived

from the buying and selling transaction as divergent to interests accruing

from the principal lent out. The structured of this product is illustrated in

Figure 3.1.

BBA refers to the sale of goods on a deferred payment basis at a marked-up

credit price, which includes a profit margin agreed by both parties. The

packing involves a combination of sales, profit margin and deferment,

conducted between two parties. The sales between the customer and the

bank (bai); a cost plus a sale including a stated profit margin (murabahah);

a deferred payment (al-ajal); and involves one party selling an asset at a

CustomerHome-buyer

SellerDeveloper

EONCAP Islamic

Customer sells house toIFI for the cost offinancing (SellingPrice), to settle the

balance with thedeveloper

Customer immediatelybuys the house back fromthe IFI including the IFIsfinancing and its profit

margin (Purchase Price), asa deferred credit price

Developer sells

house and home-buyer pays a deposit

to seller

Pays balance to sellerwho then transferstitle to buyer

1

2

4

Figure3.1: Home/House Financing-i product structure


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higher deferred price but buys it immediately for a lower cash price( bai al-

inah) as reflected in the financing of the new home as per Figure 3.1.

The process of BBA involves a Sale & Purchase Agreement between the

buyer and the original seller (developer) of the house, which includes a

payment of a deposit to the seller. Subsequently, a Property Purchase

Agreement (PPA) involves the bank agreeing to buy the house from the

customer for the cost of the financing followed by a Property Sale

Agreement (PSA) is signed immediately afterwards with bank selling the

property back to the customer including its profit margin. Subsequently, the

transfer of Title occurs between the original seller (developer) and the buyer

(customer). The buyer then takes out a famliy takaful mortgage plan for the

value of the banks Purchase price(financing). Whetter the calculation

includes a fixed or variable rate, the mechanics reveal that the financing is

the same as monthly reducing balance or constant rate return

The main characteristics of this product is all the mechanism to determine

the selling price have to be fixed because the selling price has to be fixed at

the time the contract is made. Hence, the profit rate for the BBA financing

is fixed and constant throughout the period of financing. The BBA

financing design is not tagged to the BLR. Thus, the instalments will be

fixed according to the rates declared upon agreement. The selling price

formula for Home/House Finanicng-i is illustrated in Figure 3.2:


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3.3Price Methodology of BBA by EONCAP IslamicA common conventional housing loan is set on the basis of debtor and

creditor relationship. Whereby, the sum of loan is being charged interest is

normally quoted at a certain percentage above the Base Lending Rate

(BLR) over the loan period which repayable in periodic instalment. The

BLR will fluctuate up or down and it will affect the total loan cost.

Concurrently, amount outstanding in conventional loans are normally

capitalized. However, under the Islamic banking scheme, since the BBA

concept is being applied, a seller-buyer relationship will be established and

the selling price is fixed upfront. The sales price is then repaid in periodic

instalments and the agreed instalments will remain fixed throughout the

Selling price = (monthly instalment x number of financing months) + grace

period profit (if any).

Example:

Financing amount: RM48,000.00

Profit rate: 4%

Financing period: 20 years

Installment per month: RM360.00

Selling price = (RM360.00 X (20 X 12)) + 0 = RM86,400.00

Figure 3.2: Computation the Selling Price of Home/House Financing-i (BBA)


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financing period. As such, a customers interest rate risk is eliminated.

Furthermore, amount outstanding will not be capitalized.

3.4Benchmark to determine profit in BBAInstead of using fixed rate financing mechanism in determines the profit for

BBA contract the variable rate financing is also offered by the Home/House

Financing-i. The variable rate financing is also offered by the bank that

enable the Islamic financial institutions which operate in a dual banking

environment to constantly match the current market financing rate in order

to provide matching returns to their depositors and thereby alleviating any

mismatch risk. By doing this, the EONCAP Islamic is able to receive

varying income streams from it financing activities, which will be

distributed to the depositors at a more competitive rate.

The floating rate financing is an improvement to the existing BBA

financing concept which is fixed-rate in nature. Under the BBA, the selling

price of the asset sold to the purchaser on deferred terms would be fixed at a

profit rate known as the ceiling profit rate. The ceiling rate is higher than

the profit rate under the fixed rate BBA financing where in theory the

contractual selling price and instalments would be higher. However, rebate

known as ibra which mean a waiver of right to claim unearned profit is

required to be granted at every instalment for example on a monthly basis

in order order to reduce the monthly instalments to match the current

market level as illustrated in Figure 3.3.


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In practice, the rebate would be varied so that the effective profit rate

(ceiling profit rate less rebate) reflects the fluctuating market financing rate.

Accordingly, the bank would be able to raise their financing rate when there

is a rise in market rate, hence, it can give better returns to its depositors.

The ceiling rate would provide some comfort to the customer that the

effective profit rate would be capped at that rate. There are many literatures

suggested Islamic banks to evade conventional rate used in pricing Shariah

products in the deficiency of a benchmark Islamic rate. This is due to the

benchmarking that will expose it products to the instability in conventional

financial markets. Iraj Toutounchian (2009) once recommended that the

weighted average of the internal rate of return is uses as benchmark in

formative the Islamic banks margin over profit. Furthermore, Taqi Usmani

(2005) also commented on this issue with his idea of substitute which is the

Islamic banks and the financial institutions should struggle for developing

their own benchmark. This can be done by creating their own inter-bank

Figure 3.3: BBA Variable Rate Financing


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market base on Islamic principles. The purpose can be achieved by creating

a common pool which invests in asset-backed instruments like musharakah

or ijarah.

4.0Conclusion and Findings

As conclusion, in order for the Islamic Financial Institutions develop to be

privileged in the financial industry, there is a need to re-evaluate their marketing

strategies, especially their pricing strategy. In Home/House Financing-i BBA

product from EONCAP Islamic Berhad, the practise of offering either fixed or

floating rate BBA financing is merely to attract different segments of customer.

Benchmarking is essential for IFIs to be at par with others conventional

counterpart. Hence, a proper and fresh benchmarking parameters need to be

introduced to facilitate IFIs in evaluating their relative competence, identifying the

performance gaps and formulating strategies to improve and deliver the best

results. Therefore, it is essential for IFIs to strengthen research and development

efforts in Islamic financial products innovation. This will involve Islamic banking

institutions to consider the opportunity of forming strategic alliances to tap the

research and development expertise for development outside the banking industry

in order to create the range of Islamic financial products capable of meeting the

consumer requirements and preferences.


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References

Ayub, Muhammad. (2008). Understanding Islamic finance. Hoboken, NJ: John

Wiley & Sons.

Bank Negara Malaysia. The Financial Sector Masterplan: Islamic Financial

System on floating/variable rate for BBA Financing

Reterived 5 July 2010, at http://www.bnm.gov.my/files/publication/ar/en/2003/

cp05_003_whitebox_intro.pdf

Chong Kok Loong. (2009)Differences between Musharakah Mutanaqisah and al-

Bay Bithaman Ajil. Paper presented at The 3rd Islamic Economics

Conference 2009. (Unpublished).

EONCAP Islamic web site. (2009). Home /House Financing-i (BBA).

Retrieved 30 June 2010, at

http://www.eonbank.com.my/islamic/financing/home_house_financing_i.shtm

Hamdan Haji Idris(2010), Deposit & Financing Operations of Islamic Banks

Iraj. Toutochian. (2009). Islamic Money & Banking;Integrating Money in

Capital Theory.Singapore: John Wiley & Sons (Asia) Pte. Ltd. Islamic


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Banking Act 1983 (IBA)

Radiah Abdul Kader and Yap Kok Leong. (2009). The Impact of Interest Rate

Changes on Islamic Bank Financing. International Review of Business

Research Papers. 5(3). p.

Rosly, S.A. (1999) Al-Bai-Bithman Ajil financing: Impacts on Islamic Banking

performance. Journals for Kulliyah of Economics and Management Science.

Edition of Semester 2 March 1999, pp36.

Usmani, Muhammad Taqi. (2005). An introduction to Islamic finance.

(Special edition.). Karachi, Pakistan: Maktaba Ma'ariful Qur'an.

IFI Instruments Pricing in Dual Banking System

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