WB 3053

ISLAMIC BANKING MANAGEMENT

CHAPTER 1

Objectives

• The objectives of this course are to:

1. Explain the function of Financial system in general

2. Familiarize students with the Malaysia Financial System, and

3. Explain the history and the development of Islamic Banking System in Malaysia.

Chapter 1

• Introduction

i. Four stages in Malaysian Economic System,

ii. The Flow of funds in financial system in Malaysia

• Content

Introduction

• The Development of financial system in Malaysia involved four basic stages:

i. Barter trade systemii. The practice of borrowing (primary debt)iii. The development of financial

intermediariesiv. The financial institutions embark on a

drive of maturity.

The flow of funds in financial system

Secondary debt/ indirect debt

Financial intermediaries

Surplus units

Deficit units

Primary debt/ direct debt

The flow of funds in financial system (cont…)

1. Primary debt is the direct loan from surplus units to deficit units.deficit units- individuals or enterprises which require to borrow.surplus units- persons or enterprises with funds to lend.

2. Secondary debt/ indirect debt- the development of financial intermediaries which were able to issue relatively risk-free liabilities to meet the varied needs of the surplus units. At the same time, these institution were also able to utilise the funds mobilised from the customers who saved with them.

TH E F IN A N C IA L S Y S TE MS tru c tu re as a t D ec 3 1 1 9 8 7

C om m erc ial banks

C redit G uaran tee C orporation

F inance C om pan ies M erchan t B anks M oney and F oreign E xchange M arket D iscoun t H ouses

The B ank ing S ys tem of M alays iaC en tral B ank of M alys ia

Non-Bank Financial IntermediariesDEVELPOMENT FINANCE INSTITUTIONS

MIDF

ABM

BDC

SCC

DBM

SDB

IBM

SAVING INSTITUTIONS AND CO-0PERATIVE SOCIETIES

NSB (BSN)

Bank Rakyat

CCB

UCCS

HC

RC

PROVIDENT & PENSION FUND

EPF

TPF

AFF

S0CSO

INSURANCE AND TAKAFUL COMPANIES

OTHER FINANCIAL INTERMEDIARIES

Housing Credit Inst.

MBSB

BHMF

CAGAMAS

HLDT

Capital Market

Unit Trust

Stock Exchange

Bursa Malaysia

Bursa Derivatif

IOFC

IOFC

The Financial System in Malaysia

• Two types of institutions in the Malaysian financial system:1. Banking System

(BNM, commercial bank, merchant banks, finance companies, discount houses)2. Non-Bank Financial Intermediaries

(Development finance institutions, saving institutions, co-operative societies, provident and pension funds, insurance and takaful companies, etc).

Commercial banks

• Commercial banks were brought under BNM supervision through Banking Act, 1973, but this was subsequently replaced by the BAFIA in 1989.

• Under this Act, a bank is defined as “ any person who carries on banking business” that is, “the business of receiving money on current or deposit account, paying and collecting cheques drawn or paid in by customers, and making advances to customers and includes such other business as the Central Bank, with the approval of the Finance Minister.

Finance companies• Finance companies, licensed under Finance Companies Act,

1969.• The Finance Companies Act 1969 was repealed by the

BAFIA 1989. Under the BAFIA, the legislative framework and the provisions of banking secrecy under the Banking Secrecy Act which applies to commercial banks are, thus, applicable to the finance companies as well.

• They were established as limited companies engaged in money-lending activities, by providing loans for purchase of consumer durables, such as the purchase of motor vehicles on hire-purchase terms, and short to medium-term business finance.

• Finance Companies can mobilised savings funds from the public through fixed and saving deposits with higher interest rates.

Merchant banks• There has been the growing need for full range of

specialised services relating to all aspects of corporate financing, financial investment and management advice, and investment portfolio management.

• They have been allowed to operate in “wholesale” banking and as corporate advisers and financiers.

• Unlike the commercial banks, which depend on their large deposit base to fund their loan and investment portfolios, the merchant banks have been envisaged to function primarily as specialist financial intermediaries in money and capital markets, with particular expertise in the provision of basically fee-based services.

Money and Foreign Exchange Market.

• The money and foreign exchange markets are intermediaries for short-term funds. The main difference between the two is that in the money market financial assets traded are dinominated in domestic currency, whereas in the foreign exchange market trading is conducted in foreign currencies.

• The Money Market-These are institutions and individuals who have funds which are temporarily surplus to their immediate requirements and others who need fund immediately for short periods.

Cont…

• Those with surplus funds would want to lend and earn some return rather than holding them either in non-interest earning demand deposits or currency notes and coins.

• At the same time, those who are in need of fund could raise them in the market either by borrowing or selling their holdings of short-term negotiable financial instrument, such as Treasury bills, bills of exchange, promissory notes and Government securities.

Discount Houses• The Seven discount houses in operation in

Malaysia are the only financial institutions that specialise in short-term money market operation.

• At least 75% of the funds from their deposits are required by Central Bank regulations to be invested in Treasury bills and other government securities with remaining maturities of not more than five years.

• The balance (i.e 25%) can be invested in bankers acceptances, negotiable certificates of deposit and Cagamas bonds.

The Capital Market

• The capital market in Malaysia refers to the market in longer-term financial assets, comprising all public and private debt instruments with maturities exceeding one year; corporate stocks and shares, for which there is no fixed maturity period; and commodity futures.

• In the primary market, new issues of Government and corporate securities are offered directly to the investors.

• Secondary transactions in Malaysia Government securities (MGS) are conducted mainly through the money market while secondary market trading of corporate securities is carried out in the Kuala Lumpur Stock Exchange (recently called Bursa Malaysia)

IOFC- International Offshore Financial Centre

• An IOFC is basically a small territory or jurisdiction that imposes low or no taxes on income, profit, dividend and interest earned or derived from the offshore business activities or transactions carried out by offshore multinational corporations (MNCs) in or from those jurisdiction.

• Activities promoted:1. Offshore banking operation2. Trust and fund management3. Offshore insurance and offshore insurance-related business and,4. Offshore investment holding companies

History and Development of Islamic Banking

• Banking Under The Influence of Islamic Culture1. Prophet Muhammad (peace be upon him) noted as

‘trustworthy’; deposits remained in his custody until a short while before he emigrated from Mekka to Medina, when he assigned Ali to return the deposits to their owners.

2. Az-Zubair bin Awwam was one of those who entrusted with the safekeeping of money; he was a man of sagacity and intelligence who refused to take money on deposit preferring to take it as a loan, thus realizing two objectives:i. He reserved his right to dispose of the money considering it a loan not a deposit; andii. It represent a secure guarantee to the owner because where money remains a deposit without use, it would constitute a loss to the owner; but when deposit becomes a loan it would be secure as the borrower liable for it.

Cont…• Exchange of money:

Ibn Omar said: I used to sell camels in Baqi’ (a place in Al Medina), I sell by dinars and take darahim (kind of money) and sell by darahim and take the dinars, which thing had an effect on me, so I came to the Prophet (peace be upun him) while he was in Hafsa’s house- or, he said when he left Hafsa’s house- and said: ‘ Oh God’s Prophet, take it easy, I wish to ask you: ‘I sell the camels in Baqi’, I sell by dinars and take darahim and sell by darahim and take dinars. The Prophet said: ‘It would be unobjectionable if you take them at the price of their day unless you depart and leave something berween you”.

Cont…• Transfer Operationi. It is narrated that Ibn Al Abbas used to take the ‘warik’ (i.e. silver

minted into dirhams) in Mekka and write acknowledgement thereof to El-Kufa, where they used to cash it.

ii. It is related that Saif ed-Daulah al Hamadani who was Amir of Aleppo about the middle of 4th. Century A.H, visited Baghdad and wanted to see it without being recognised; he went disguised to the houses of Bani Khaqan to listen and drink; they served, but did not know him. When he was about to leave he asked for an inkpot and wrote on a slip of paper and left in the pot; when they unfolded the paper they found it was addressed to some money changers in the sum of one thousand dinars. When they presented the slip of paper to the money changer, who honoured the paper and paid the sum of dinars therein stated ‘immediately and in time’.When they asked the money changer who was the man who wrote the paper, he replied that he was Saif au-Dawla Al-hamadani.

Cont…• The use of cheques for commercial purposes.The Persian explorer Naser Khasro in his book entitled:

‘Safarnama’ in which he recorded what he had seen during his travel between the years 437-444 A.H. reported in one place how the work was being carried out in the city of Basra as he witnessed it himself:

‘A market is set up in three locations in Basra every day: in the morning, exchange is carried out in Khaza’ market, at noon, in Othman Market and at sunset in Qaddahin market; the work in a market is as follows: every person who has money gives it to the money changer and take in return a cheque and then buy all needs and pays for them by money changer’s cheque; a purchaser uses no other than the cheque of the money changers so long as he is resident in the city’

Islamic Banking in The Modern Era• The Attempts to establish an interest-free bank1. The first attempt came in Malaysia mid-1940s. A

plan to invest prospective pilgrim savings in real estate and plantations in accordance with Syariah was, however, unsuccessful.

2. The first experimental local Islamic bank was established in the late 1950s in a rural area of Pakistan that charged no interest on its lending.

3. The establishment of Mit Ghamr Local Savings Bank marked a new milestone in the revolution of the modern Islamic banking system. The bank was considered to be the most innovative and successful experiment with interest-free banking.

List of Islamic BanksName Country Date of

Establishment

Nasser Social Bank Egypt 1972

Islamic Development Bank Saudi Arabia 1975

Dubai Islamic Bank UAE 1975

Faisal Islamic Bank of Egypt Egypt 1977

Faisal Islamic Bank of Sudan Sudan 1977

Islamic Banking System International Holding

Luxembourg 1978

Jordan Islam Bank Jordan 1978

Bahrain Islamic Bank Bahrain 1979

Dar al-Mal al-Islami Switzerland 1981

Bahrain Islamic Inv. Company Bahrain 1981

Cont…Islamic International Bank for Inv. & Development

Egypt 1981

Islamic Investment House Jordan 1981

Al-Baraka Investment & Development Company

Saudi Arabia 1982

Saudi-Philippine Islamic Development Bank.

Saudi Arabia 1982

Faisal Islamic Bank Kibris Turkey 1982

BIMB Malaysia 1983

Islami Bank Bangladesh Ltd Bangladesh 1983

Islamic Bank International Denmark 1983

Tadoman Islamic Bank Sudan 1983

Qatar Islamic Bank Qatar 1983

Development of Islamic Banking system in Malaysia

Year Remark

1980 Formal request to set-up Islamic Bank was made during the Bumiputera Economic Congress

July 30, 1981

The Government appointed National Steering Committee on Islamic Banking. The secretarial functions were given to the Pilgrimage Board of Malaysia. This committee studied both operations of the Faisal Islamic Bank of Egypt and The Faisal Islamic Bank of Sudan.

July 5, 1982

Among the recommendations made by the committee in its report:

i. The Government should establish an Islamic bank whose operations are in accordance to the principles of Syariah.

ii. The proposed bank is to be incorporated as a company under the auspices of the Companies Act, 1965.

iii. A new Islamic banking act must be introduced to license and supervise the Islamic bank.

iv. The Islamic bank is to establish its own Shariah Supervisory Board whose function is to ensure that the operations of Islamic bank are in accordance to the Shariah.

Cont…Mac 1, 1983 BIMB was incorporated and commenced operations on July 1, 1983.

March 10, 1983

The Islamic Banking Act was gazetted.

April 7, 1983 The Islamic Banking Act came into effect.

July 1, 1983 BIMB commenced operations.

1983 The Government introduced The Government Investment Act in 1983 to enable the government to issue Government Investment Certificates, which are government bonds issued in accordance to Islamic principles.

March 4, 1993

Central Bank has introduced a scheme known as ‘Skim Perbankan Tanpa Faedah’ or ‘Interest-free Banking Scheme’ (Often known as ‘Islamic windows). Under this scheme, all commercial banks, merchant banks and finance companies are given an opportunity to introduce Islamic banking products and services. The pilot phase of the scheme involved the three largest commercial banks in Malaysia.

Cont..

August 21, 1993

The second phase started with 10 more finance institutions joining the scheme.

January, 1994

The Islamic inter-bank market was introduced in Malaysian financial system, which consists of three elements namely,

i. Interbank trading in financial instruments,

ii. Islamic inter-bank investments

iii. Islamic inter-bank cheque clearing system

Conclusions• The history of Islamic banking began from the early days of

Islam.• There is also evidence that today’s banking activities such as

money-exchange businesses, remittance services and the usage of cheque have been in existence during the early Islamic civilisation.

• The functions of financial institutions in early days of Islam were undertaken by individuals.

• The prohibition of ‘riba’ through revelations, shaped the practices of Islamic banking.

• The establishment of Mit Ghamr Local Savings Bank in 1963 marked a new milestone in the revolution of the modern Islamic banking system.

Main References

• The Economics Department (1989). Money and Banking in Malaysia. Bank Negara Malaysia. Kuala Lumpur.

• Sami Hassan Homoud (1985). Islamic Banking. Arabian Information. London.

• Sudin Haron and Bala Shanmugam (2001). Islamic Banking System- Concepts & Aplication. Pelanduk Publications. Kuala Lumpur.