Islamic Bank is Not Islamic? The Implementation of Islamic Banking and Finance in Malaysia

7/29/2019 Islamic Bank is Not Islamic? The Implementation of Islamic Banking and Finance in Malaysia

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Islamic Bank Is Not Islamic?

The Implementation of Islamic Banking and Finance in Malaysia

By

Mohd Fuad Mohd Salleh

1

UNISEL

Abstract

Since the introduction of the first full-fledged Islamic Bank in Malaysia in 1983, Islamic

Bank and Institutions have grown significantly. All of which are offering what is known

as a copy of conventional banking or some called it the Islamization of conventional

products. It is good to have many products and services offered to customers especially

those who are expecting the practice of Islamic Banking. The most misleading statement

in making a distinction between Islamic and conventional banking is the absence of

interest in Islamic Banking. Practitioners as well as customers are in the beliefs of

without interest, then, the banking system is now following the teaching of Islam. The

no interest statement is very misleading since no-interest is just one of the principles

in Islamic Financial System. There are other principles that must be observed in order for

any financial system to be accepted as a practice according to the Islamic teaching. The

other important principles is risk sharing where it is known as profit bear risks (al-

Ghunmu bi al-Ghorm).

Keyword: Islamic Finance, no-interest, profit, risks

Introduction

Islamic financial services industry has witnessed a pace of growth since its inception fourdecades ago. During the last decade Islamic finance is developing at a remarkable frenetic pace.The number of Islamic financial institutions worldwide has risen from one in 1969 with theformation ofTabung Haji (Pilgrimage Fund) in Malaysia followed by first commercial Islamic

bank, Dubai Islamic Bank in 1970 then Islamic Development Bank, the Jeddah-basedmultilateral development institution in 1975, to over 500 in 2009 in more than 75 countries withBahrain in the Middle East and Malaysia in Southeast Asia as the biggest hubs. Even thoughthey are concentrated in the Middle East and South East Asia, they are also appearing in othercountries in Asia-Oceania, Europe, and the United States.

1Mohd Fuad is the Dean of Faculty of Business, Universiti Selangor (Unisel).


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Islamic finance has grown tremendously since it first emerged in the 1970's. Current globalIslamic banking assets and assets under management have reached USD750 billion and isexpected to hit USD1 trillion by 2010. There are over 300 Islamic financial institutionsworldwide across 75 countries. According to the Asian Banker Research Group, the world's 100largest Islamic banks have set an annual asset growth rate of 26.7%2 and the global Islamic

finance industry is experiencing average growth of 15-20% annually (Mckinsey, 2008).While estimates about the size of the industry differ, conservative sources put the totalIslamic assets worldwide held by Islamic Banks, shari`ah-compliant banks and Islamic bankingand financial windows of conventional banks rose by 28.6% in 2009 to $822bn from $639bn in2008 and are constantly growing at an estimate of 15 percent a year. Islamic banking and financeassets continued double-digit growth in 2009, even as conventional bank growth stagnated,according to The Bankers world-renowned Top 500 Islamic Financial Institutions survey.Rising oil prices and Europe's growing Muslim population are driving an extraordinary surge infinancial products compliant with Islamic law and as such.

The data seems to be encouraging, but the fact remains that the industry is too smallcompared to the size of financial markets today. Furthermore it is very small compared to the

Muslim wealth which is estimated at about USD3 trillion that are concentrated in the MiddleEast. The strength that lies in the number of 1.6 billion Muslims and the Muslims wealth aroundthe world is yet to be exploited. One of the key factors that impede the growth of Islamic financeis lack of awareness among Muslims (regardless of who they are) about the Islamic models ofbanking, finance, insurance, and investments.

Islamic Finance

Islamic finance was practiced predominantly in the Muslim world throughout the MiddleAges, fostering trade and business activities with the development of credit. In Spain and theMediterranean and Baltic states, Islamic merchants became indispensable middlemen for tradingactivities. In fact, many concepts, techniques, and instruments of Islamic finance were lateradopted by European financiers and businessmen.

In contrast, the term "Islamic financial system" is relatively new, appearing only in themid-1980s. In fact, all the earlier references to commercial or mercantile activities conforming toIslamic principles were made under the umbrella of either "interest-free" or "Islamic" banking.However, describing the Islamic financial system simply as "interest-free" does not provide atrue picture of the system as a whole. Undoubtedly, prohibiting the receipt and payment ofinterest is the nucleus of the system, but it is supported by other principles of Islamic doctrineadvocating risk sharing, individuals' rights and duties, property rights, and the sanctity ofcontracts. Similarly, the Islamic financial system is not limited to banking but covers capitalformation, capital markets, and all types of financial intermediation.

Interpreting the system as "interest free" tends to create confusion. The philosophicalfoundation of an Islamic financial system goes beyond the interaction of factors of productionand economic behavior. Whereas the conventional financial system focuses primarily on theeconomic and financial aspects of transactions, the Islamic system places equal emphasis on theethical, moral, social, and religious dimensions, to enhance equality and fairness for the good ofsociety as a whole. The system can be fully appreciated only in the context of Islam's teachingson the work ethic, wealth distribution, social and economic justice, and the role of the state.


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The Islamic financial system is founded on the absolute prohibition of the payment orreceipt of any predetermined, guaranteed rate of return. This closes the door to the concept ofinterest and precludes the use of debt-based instruments. The system encourages risk-sharing,promotes entrepreneurship, discourages speculative behavior, and emphasizes the sanctity ofcontracts. Islamic finance and Islamic financial products are aimed at investors and depositors who want

to go with a system that comply with the Islamic laws (shariàh) that governed Muslim's daily life.These laws forbid giving or receiving interest or usury because Islam considered the earningprofit from an exchange of money for money is immoral; mandate that all financial transactions be basedon real economic activity. Excessive profit and other un-Islamic activities such as investment in tobacco,alcohol, gambling, and armaments industries are totally prohibited. Islamic financial institutions providean increasingly broad range of many financial services, such as fund mobilization, asset allocation,payment and exchange settlement services, and risk transformation and mitigation. But these specializedfinancial intermediaries perform transactions using financial instruments compliant with shariàhprinciples.

This practice is suitably in accordance with social responsibility from then Islamicperspective as it suited the principles ofmaslahah (the public good) which as the foundation of

Maqasid ai-Syariàh or Syariàh objective (Asyraf & Nurdianawati). Another key area of

concern relates to lack of human resources adequately trained in the models and tools of Islamicfinance and understand the real teaching of Islam as well as the objectives of Islamic Finance.Islamic financial institutions have generally been recruiting from the pool of conventionalbankers and financial professionals, who often find it too comfortable to camouflageconventional products and services as Islamic ones. The unsavory outcome of this is there for allto see. Because of the needs many financial institutions have introduced Islamic instruments tosatisfy customers need.

Today we can find a wide range of products and services, which look Islamic in form butconventional in every other sense. This could be because of lack in knowledge as most of thepeople involved in Islamic Banking and Finance are only focussing on three elements that mustnot exist, riba, maisir and gharar, in order for the product to be recognized as shariàh

compliance without understanding the whole Islamic Muàmalah systems and requirements. Asolution to the above perhaps lies not only creating greater awareness among market participantsthrough research, education and training but increase the understanding of what is really mean byIslamic Finance.

The depositors, investors, bankers, insurance professionals, financial analysts, regulatorsand policy makers need to be told the full story - why conventional financial products andservices are not acceptable in Islam; what are the specific elements and features that areunacceptable; what are the Islamic alternative products and services that fulfill similar needs andaddress similar concerns and finally whether the alternatives are efficient as well. But moreimportantly is whether the products and services really follow the Islamic teaching.

Financial System Efficiency

Promotion of efficiency is accepted as the primary goal of policy makers and regulatorsof financial systems. The criteria to measure efficiency of financial systems are well defined inliterature. Financial system efficiency is measured in terms of efficiency achieved in mobilizingsavings from the savings-surplus units in the economy and in allocating these funds amongsavings-deficit units in the economy. It is generally believed that an increase in the range offinancial assets and instruments would improve efficiency in mobilization of funds. Every saver


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or investor has unique risk-return expectations. The greater the variety of risk returncombinations offered by financial assets, the better would be the match between what investorsneed and what is available in the system.

The notion of allocation efficiency implies that funds flow into desirable projects. Morefunds should flow into projects with higher profitability and lower risk (hence, higher value) and

vice versa. This implies that financial instruments issued by such projects should involve a lowercost of funds for the issuer. Prices and rates of financial instruments should reflect the intrinsicworth or value of an instrument. If the instrument or project is more valuable, it should commanda higher price. A high price implies low rates or low cost of funds. Pricing efficiency is aprerequisite for allocation efficiency.

For example, suppose you receive a qard al-hasan student loan of $10,000 at thebeginning of the university semester. But you need only $2,000 of it towards tuition fee andpurchase of study materials for the current semester and another $3,000 towards living expensesfor the term. You deposit the balance $5,000, needed for the forthcoming term, into a threemonth mudharabah deposit. You can invest in this rather high-return savings scheme of the localIslamic bank because you are willing to invest your money for a fixed time period. The bank

then pools your $5,000 with funds from other students and makes a largeMurabahahh financingto the local book-seller to set up an internet browsing section. Given the cost of funds and itsprofit maximizing goal, the bookseller selects only the most profitable projects and drops otherprojects whose returns would be below the firm's cost of capital.

Other firms with projects that promise low returns will also find money too expensive tofinance those projects. If the financial system is working efficiently, the return you receive willbe the highest possible rate for your money for a three-month period, the book seller will haveborrowed money at the lowest possible cost, and only those projects with the highest rate ofreturn will have been financed. The more efficient our financial system, the more likely this is tohappen. Note that prices and rates would reflect the intrinsic value of a financial instrument whenall parties are adequately informed about the project its return potential and the risks itinvolves. Thus, the financial system must ensure costless flow of relevant information.Informational efficiency of the system is therefore, a prerequisite for pricing and hence,allocation efficiency. As we shall see later an Islamic financial system puts great emphasis on allthese dimensions of efficiency.

Another prerequisite to pricing efficiency is operational efficiency, which implies thattransactions should be executed at minimal costs. High transaction costs prevent prices and ratesfrom adjusting to changes. A related notion of efficiency is full-insurance efficiency that dealswith availability of methods and avenues of sharing and transferring risk within the system.

From the above, it is clear that any move that reduces transaction costs, simplifiestransaction system, increases the availability and accuracy of information, improves informationprocessing by participants is a step towards improving the allocation efficiency of the system.Instantaneous and accurate price adjustment also presupposes that intense competitive pressuresforce all participants to react without any lag and that the system is dominated by rationalinvestors who would not over-react or under-react. An efficient system is also a stable systemwhere violent swings in prices and rates due to irrational behaviour of the participants are ruledout.

Financial Products and Services


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Financial institutions that act as intermediaries, are mostly commercial banks. In a moremature financial system the process involves a direct offer of financial products by the savings-deficit units (SDUs) to savings-surplus units (SSUs). Financial institutions now act as facilitatorsin the process. They help business firms and governments in various ways in raising the fundsfrom households. They help SDUs design and create securities mostly sukuk, price them, and

market the same to SSUs. Financial institutions that act as facilitators, are called investmentbanks.The first task of mobilizing funds involves offering the SSUs a range of financial

products that match with their needs and expectations. These may be in the nature of variousdeposit products offered by an intermediary (where the process is indirect) and financial

securities offered by SDUs (where the process is direct). Every economic unit may have a uniqueneed or expectation (Ayub, 2009). What are the needs of an investor or buyer of a depositproduct or financial security? An investor likes returns. The higher the expected returns the moreattractive the product is and vice versa. An investor also dislikes risk and uncertainty.

Risk refers to the possibility that the actual reward or return would turn out to be less thanwhat is expected. The higher the risk associated with a given product, the less attractive the

product is, and vice versa. Risk may itself be defined in various ways. Risk may relate to thevolatility of returns. The higher the volatility, the higher is the risk. Risk may also refer toliquidity of the product or the ease with which the same may be sold for a fair price. Everyinvestor may also have a unique time horizon or maturity preference. Given these multiple needs,if a product is less attractive along one dimension (say, more risky) then it must be moreattractive with respect to the second dimension (or should promise more returns).

Products designed to mobilize funds from SSUs must consider the characteristics andpreferences of the household sector in terms of return-risk-maturity and other dimensions. In theIslamic financial system, the SSUs have a unique requirement conformity to Shari`ah.Financial products must not violate norms of Islamic ethics to be acceptable to the Islamic SSU.For instance, as we shall see later, deposit products and fixed-income securities that violate theriba prohibition norm have no place in the Islamic financial system. The second important taskis to channel the savings or funds into SDUs. As mentioned above, the needs and requirements ofthe business firms and governments should now be taken into consideration in designingfinancial products and services. These needs may relate to cost of funds, maturity, level andpattern of expected cash inflows from the project and the like. The products are in the nature ofvarious financing products offered by intermediaries (where the process is indirect) andfinancial securities offered by SDUs (where the process is direct). As mentioned above, financialproducts must not violate norms of Islamic ethics to be acceptable to the Islamic SDU. Forexample, a business firm would not seek an interest-based loan, nor would offer interest yieldingdebt securities.

Besides the general categorization of financial institutions into intermediaries andfacilitators or into commercial and investment banks, a closer examination would reveal manydifferent types of players performing specific tasks that help achieve overall objectives of thefinancial system. For instance, insurance companies are a kind of contractual savings institutionsthat obtain funds under long-term contractual arrangements and invest the funds in the capitalmarkets. These institutions are characterized by a relatively steady inflow of funds fromcontractual commitments with their insurance policyholders. They provide various riskmanagement products to economic units and hence, help achieve full-insurance efficiency of thefinancial system.


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Islamic finance is not a product to be offered to a niche market. It is a system. It must bepromoted and implemented as a system. Where the monetary system is concerned, it cannot beachieved by the private sector alone, Islamic or otherwise. A lead is required from the State sincewe must redefine the meaning of the words 'legal tender'. We must somehow overturn themonetary system as it is. And that will require us to defeat the monster that faces us.

Meanwhile, in many countries, small and medium sized Muslim-owned businesses areoffered no Islamic finance facilities at all. When they do finally encounter a financing proposalfrom an Islamic bank, many of these businessmen quickly become cynical because the financingcost is fixed at the outset of the financing agreement (TarekEl Diwany, 2002).

At a very basic level, the disbursement of collateral free loans in some cases constitutes

an example of how Islamic banking and microfinance share common aims. Thus Islamic banking

and microcredit programs, may complement one another in both ideological and practical terms

(Dhumale, Sapcanin, 1999).The basic framework for an Islamic financial system is a set of rules and laws,

collectively referred to as shariah, governing economic, social, political, and cultural aspects ofIslamic societies. Shariah originates from the rules dictated by the Quran and its practices, and

explanations rendered (more commonly known as Sunnah) by the Prophet Muhammad. Furtherelaboration of the rules is provided by scholars in Islamic jurisprudence within the framework ofthe Quran and Sunnah. The two most important of the basic principles of an Islamic financialsystem are prohibition ofriba (interest) and risk sharing.

Prohibition of interest.

Prohibition of riba, a term literally meaning "an excess" and interpreted as "anyunjustifiable increase of capital whether in loans or sales" is the central tenet of the system. Moreprecisely, any positive, fixed, predetermined rate tied to the maturity and the amount of principal(i.e., guaranteed regardless of the performance of the investment) is considered riba and isprohibited. The general consensus among Islamic scholars is that riba covers not only usury butalso the charging of "interest" as widely practiced.

This prohibition is based on arguments of social justice, equality, and property rights.Islam encourages the earning of profits but forbids the charging of interest because profits,determined ex post, symbolize successful entrepreneurship and creation of additional wealthwhereas interest, determined ex ante, is a cost that is accrued irrespective of the outcome ofbusiness operations and may not create wealth if there are business losses. Social justicedemands that borrowers and lenders share rewards as well as losses in an equitable fashion andthat the process of wealth accumulation and distribution in the economy be fair andrepresentative of true productivity.

Lush (2009) argued that interest became the 'financial screen' from Islamic bankingpractitioner, is banned because of concern about usury--lending at interest in the Western way isseen as taking advantage of the borrower.

Risk Sharing

The basic framework for an Islamic financial system is a set of rules and laws, governingeconomic, social, political, and cultural aspects of Islamic societies. Shariah originates from therules dictated by the Quran and its practices, and explanations rendered (more commonly known


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major question in the implementation of waad is why in most cases it is the customer who ismade to be legally bound by any promise that the customer may be asked to make in favour ofIslamic financial institutions.

The concept invoked in this connection is what is known as the notion of binding promisepremised on views as adopted by some school of thought or Islamic schools of Jurisprudence.

Although a great majority of Muslim jurists right from the earliest period of Islamic law haveheld the view that a promise is undeniably morally binding upon the promisor, but they acceptedthe view that in a law or judicial term it is not binding in the sense that if the promisor shouldbreak his promise he could not be sued in any Shariah court for such a breach.

Conclusion

Based on the above discussion, in order for a banking and financial system being accepted as

Islamic, it cannot break away from what I called Islamic Based and not only Islamic

Compliance. There are some critical principles where the implementation of Islamic financial

product must follow the basis of Islamic teaching and upheld the Shariàh objectives (Maqasid

As-Shariàh). Because of the importance in introduction of Islamic Banking and Financialsystem stems in the need to bring the Muslim closer to Allah every product introduced must

follow strictly the teaching of Islam.

If the preceding practice has not yet being changed, then the banking system in Malaysia has to

be revamped in order to save the people from continuously involved in a questionable activities.

Again, the Islamic Banking practice should bring Muslim closer to Allah and not the opposite.

References:

1. Asyraf, W. D. and Nurdianawati, I,A. Maqasid al-Syariàh, Masalah and Corporate SocialRespomnsibility. The merican journalof Islamic Social Sciences 24:1.

2. Bank Negara Malaysia: Annual Banking Statistics 20073. Dhumale R., Sapcanin A. An Application of Islamic Banking Principles to Microfinace

Technical Note, A study by the Regional Bureau for Arab States, UNDP, incooperation with the Middle East and North Africa Region, World Bank.

4. Fuad, S. and Maisalmah, A. (2009).Marketability of Islamic Banking and Finance TowardsMuslims in Kuala Lumpur. Unpublished Master Thesis.

5. Fuad, S. and Normilia, A. (2010). Customer Preferences Towards Islamic Home Financingin Klang Valley. Unpublished Master Thesis.

6. Lush, E. (2009). Islamic finance stakes its claim: banking governed by Koranic principles isa rare growth market in a shaken financial world, says Edie Lush--but is it really morestable than its Anglo-Saxon equivalent? The Spectator, October 17, 2009.

7. Malaysian Accounting Standards Boards (2004). Financial Reporting Standard i-1 2004.8. Mckinsey, (2008). The World Islamic Banking Competitiveness Report 2007-08, "Capturing

The Trillion Dollar Opportunity"

9. Muhammad Ayub, (2009). Understanding Islamic Finance. West Sussex: John Wiley &Sons.


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10. Segrado, C. (2005). Islamic microfinance and socially responsible investments.Microfinance at the University of Torino. http://www.gdrc.org/icm/islamic-microfinance.pdf . Surf on 10th. Nov 2012.

11. Siti Salwani, R. (2008). The Concept OfWaad In Islamic Financial Contract. IslamicBanking, Accounting and Finance Conference (iBAF 2008), The Legend Hotel, Kuala

Lumpur.12. Tarek El Diwany (2002). Islamic Bank Isnt Islamic. Banker Middle East, November 2002.

Islamic Bank is Not Islamic? The Implementation of Islamic Banking and Finance in Malaysia

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