Fundamental of Islamic Banking - Overview of Financial System


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Fundamental of Islamic Banking - Overview of Banking and Financial System

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Fundamental of Islamic Banking - Overview of Financial System

  3. 3. FINANCIAL SYSTEM  Concept of Financial System  The collection of accounting processes and procedures that allow a business to keep accurate financial records, monitor accounts, prevent fraud and mistakes, and catch any discrepancies.  A financial system allows a company to maintain accountability for expenditures and revenues, and to control their finances to minimize waste and loss.  A financial system is concerned about money, credit and finance. 3
  4. 4. FINANCIAL SYSTEM  Concept of Money  Money is anything generally accepted as a means of paying for goods and services and a measure of value.  Functions of Money :  Medium of exchange  Measure of value  Temporary store of value  Concept of Credit/Loan  An arrangement in which a lender gives money or property to a borrower, and the borrower agrees to return the property or repay the money, usually along with interest, at some future point(s) in time.  There is a predetermined time for repaying a loan, and generally the lender has to bear the risk that the borrower may not repay a loan (though modern capital markets have developed many ways of managing this risk). 4
  5. 5. FINANCIAL SYSTEM  Concept of Finance  Finance is the procurement (to get, obtain) of funds and effective (properly planned) utilization of funds.  It also deals with profits that adequately compensate for the cost and risks borne by the business.  Finance deals with matters related to money and the markets. 5
  6. 6. FINANCIAL SYSTEM STRUCTURE IN MALAYSIA Financial Institutions Financial Markets a) Banking System  BNM  Banking Institutions : - Commercial banks include Islamic banks - Finance Companies - Merchant Banks  Others: - Discount Houses - Representatives Offices of Foreign Banks - Offshore Banks in Labuan IOFC b) Non-Bank Financial Intermediaries : • Provident & Pension Funds • Insurance companies include Takaful • Saving institutions • Others: - Unit Trusts – Pilgrims Fund Board – Housing Credit Institutions – Cagamas Berhad –Credit Guarantee Corporation – Leasing Companies –Factoring Companies –Venture Capital Companies. a) Money & Foreign Exchange Markets : • Money Market • Foreign Exchange Market b) Capital Markets: • Equity markets • Bond Markets –Public Debt Securities – Private Debt Securities c) Derivatives Markets: • Commodity Futures • KLSE CI Futures • KLIBOR Futures d) Offshore Markets: • Labuan International Offshore Financial Centre (IOFC) 6
  7. 7. BANKS AS FINANCIAL INTERMEDIARIES  Financial intermediaries is an entity that acts as the middleman between two parties in a financial transaction.  Financial intermediaries encompass a wide range of entities in terms of size and scale of operation ranging from a banks, broker-dealers, investment advisers and financial planners.  Roles of banks as financial intermediaries: 1. Promote savings and capital accumulation to finance projects using various modes of financing. 2. Finance international trade. 3. Mobilize resources for investments for the benefit of society. 4. Contribute social welfare through Corporate Social Responsibilities (CSR) and zakat. 7
  8. 8. PRINCIPLES GOVERNING OF ISLAMIC BANKING Islam Aqidah (Faith and Belief) Shariah (Practices and Activities) Ibadat Muamalat Political Activities Economic Activities Banking & Financial Activities Social Activities Akhlak (Moralities and Ethics)
  9. 9. ISLAMIC BANKING  Islamic banking is defined as banking system which is in consonance with the spirit, ethos and value system of Islam and governed by the principles laid down by Islamic Shariah.  Islamic Banking according to Islamic Banking Act 1983:  “..a company which carries on Islamic banking business means banking business whose aims and operation do not involve any element which is not approved by the religion of Islam…”  Islamic banking, the more general term, is based not only to avoid interest-based transactions prohibited in Islamic Shariah but also to avoid unethical and un- social practices.  In practical sense, Islamic Banking is the transformation of conventional money lending into transactions based on tangible assets and real 9
  10. 10. ISLAMIC BANKING IN MALAYSIA  The first Islamic bank was established in Malaysia in 1983 through Bank Islam Malaysia Berhad.  Later in March 1993, Bank Negara Malaysia (BNM) introduced Interest Free Banking Scheme (now replaced with Islamic banking scheme (IBS).  The scheme allowed conventional banking institutions to offer Islamic banking products and services using their existing infrastructure, including staff and branches 10
  11. 11. SALIENT FEATURES OF ISLAMIC BANKING Main concern Ensuring justice and equity in economy PLS are major features Prohibition of riba Financial transaction
  12. 12. PHILOSOPHICAL FOUNDATIONS OF ISLAMIC BANKING Huriyyah Tazkiyah Al-’adalah Amanah Khilafah Tawhid 12
  13. 13. 13 GOALS AND OBJECTIVES OF ISLAMIC BANKING • The thrust is towards financing on risk- sharing and strict focus on halal activities • Focus on offering banking transactions adhering to Shariah principle and avoiding conventional interest- based banking transactions. Offer Financial Services • Established a direct and close relationship between the bank’s return on investment and the successful operation of the business by the entrepreneur. Economic Development • Considered to be most profitable, religiously permissible and are beneficial to the economy. Optimum Resources Allocation
  14. 14. GOALS AND OBJECTIVES OF ISLAMIC BANKING • Profit- sharing principle encourages banks to go for projects with long- term gains instead of short- term gains. • Banks conduct proper studies before getting into projects. High returns distributed to shareholder maximize the social benefits and bring prosperity to the economy. Optimum Approach • Ensures equitable distribution of income and resources among the participation parties, with its profit- sharing approach which is one of a kind. Equitable Distribution of Resources • Islam recognize money as a means of exchange and not as a commodity. • Riba- free system leads to stability in the value of money to enable the medium of exchange. Facilitate Stability in Money Value 14
  15. 15. PRINCIPLES OF ISLAMIC BANKING  Islamic banking is the conduct of banking based on SHARIAH principle, subject to among others: 1. Prohibition of Riba  Riba is strictly prohibited under Islam and is considered as haram.  Islam allows only one kind of loan that is Qardhul Hassan. 2. Equity participation  Islam encourages Muslims invest their money and become partners in order to share profits and risk in the business instead of becoming creditors.  In Islam, financing is based on the belief that the financier and borrower should equally share the risks of the business venture. 15
  16. 16. PRINCIPLES OF ISLAMIC BANKING 3. Prohibition of gharar  Gharar means to undertake a venture blindly without sufficient knowledge or to undertake excessively transactions  An Islamic financial system discourages hoarding and prohibits transactions featuring extreme gharar. 4. Contractual relationship  Depends upon the nature of transaction.  It could be a seller and buyer relationship (Murabaha), a lessor- lessee relationship (Ijarah), and a partnership (Musyaraka) 5. Money as Potential Capital  It is way of defining the value of a thing.  Should not be allowed to give rise to more money, via fixed interest payments, simply by being put in a bank or when lent to someone. 16
  17. 17. Islamic Banking System Characteristic s Conventional Banking System •Functions and operating modes are based on Shariah law. •Banks have to ensure that all business activities are in compliance with Shariah requirements. Business Framework •Functions and operating modes are based on secular principles and not based on any religious law or guidelines. •Each bank should have a Shariah Supervisory Board to ensure that all business activities are in line with Shariah requirements. Shariah Supervisory Board •There is no such requirement necessary. DIFFERENCES BETWEEN ISLAMIC BANKING AND CONVENTIONAL BANKING SYSTEM 17
  18. 18. COMPARISON BETWEEN ISLAMIC BANKING AND CONVENTIONAL BANKING SYSTEM Islamic Banking System Characteristic s Conventional Banking Promotes risk sharing between investor and the bank & the bank and the entrepreneur : pre-agreed proportion Risk sharing Predetermined rate of interest Under PLS-return only if there is a profit -more concern with soundness of the project and managerial competence of the entrepreneur. Emphasis to product Credit worthiness All economic agents have to work within the Islamic moral value. Moral Dimension Little attention to the moral implications of the activities
  19. 19. Islamic Banking System Characteristic s Conventional Banking System • Financing is not interest – oriented • Based on the principle of buying and selling of assets, whereby the selling price include a profit margin • Fixed from the beginning. Prohibition of Riba in Financing • Financing is interest – oriented • A fixed/floating interest is charged for the use of money. •Islamic banks are restricted to participate in economic activities, which are not Shariah-compliant. Restrictions •There are no such restrictions. Pay zakat as a religious obligation and tax required by the government Zakat (Religious Tax) Don’t pay zakat but only pay tax as required by the government COMPARISON BETWEEN ISLAMIC BANKING AND CONVENTIONAL BANKING SYSTEM 19
  20. 20. 20 ADVANTAGES OF ISLAMIC BANKING • The main feature of the Islamic model is that it is based on a profit-sharing principle, whereby the risk is shared by the bank and the customer. • This system of financial intermediation will contribute to a more equitable distribution of income and wealth. Justice and Fairness • Follow the profit and loss-sharing principle to mobilize resources and are less likely to face any sudden run on deposits. • As such, they have a minimum need for maintaining high liquidity. Liquidity
  21. 21. ADVANTAGES OF ISLAMIC BANKING • Financing and deposits are extended under the profit and loss sharing arrangement. The banks are likely to know their fund users better in order to ensure that the funds are used for productive purpose and vice-versa for investors. • It will develops better relations between the financial intermediary and the fund providers or consumers. Better Customer Relations • Islamic banks do not have fixed obligations such as interest payments on deposits. Therefore, they are able to allocate resources to profitable and economically desirable activities. • Also holds good for Islamic financing, as the payment obligations of the entrepreneur is associated with the revenue. No Fixed Obligations 21
  22. 22. ADVANTAGES OF ISLAMIC BANKING • Transparent to the account holders on the investments made in different areas and the profits realized from these investments. The profit is then shared in the pre-agreed ratio. Transparency • Strong ethical and moral dimensions of doing business and selecting business activities to be financed, play an important role in promoting socially desirable investments and better individual or corporate behavior. Ethical and Moral Dimensions • Although based on Shariah principles to meet the financial needs of Muslims, it is not restricted to Muslim only and is available to non-Muslims as well. Banking for All 22
  23. 23. CHALLENGES OF ISLAMIC BANKING  Misconception about Islamic banking  Many still has a wrong understanding or misconception against Islamic Banking which among the thoughts are:  Islamic Banking is only for Muslims  Islamic Banking is not profitable because no interest is charged  Islamic Bank is a charitable organization  Thus better awareness shall be create among the customers that Islamic Banking is not only an alternative financial approach but also in some aspects provides better value propositions to the consumers.  Divergence of opinions  Shariah interpretation versus business practicability/ 23
  24. 24. CHALLENGES OF ISLAMIC BANKING  Moving towards equity based financing (Musharakah/ Mudharabah) financing?  Commercial banks requires a new set of technical and risk management capabilities i.e. industry experts and know-how  Market readiness – profit sharing, trade secrets, bank as strategic business partners (potential conflicting interest).  Balance sheet size, risk appetite and underwriting capabilities  Supervisory and prudential regulatory framework.  Accounting and auditing standards.  War of talents  Global shortage of Islamic finance talents at almost all levels  Inadequate pool of Shariah scholars with the right combination of knowledge in Shariah and modern finance  Rising Cost for Small Islamic Banks  Ballooning operating costs for Islamic banks as opposed to relative cost stability for the overall banking system - expenditure on IT infrastructure, expenses for R&D and product innovation and network expansion and new delivery channels 24
  25. 25. END OF CHAPTER25