University of Economics in Prague

Faculty of Finance and Accounting

Department of Banking and Insurance

Study program: Banking and Insurance

Islamic banking

Author: Jakub Bláha

Supervisor: Ing. Vladislav Vacek

Year of defence: 2014

Declaration:

I hereby declare that this bachelor thesis is my own work and that the information I used has

been fully acknowledged in the text and listed in the bibliography.

Prague, date: ...………………………..

Jakub Bláha

Acknowledgments:

I would like to thank the supervisor of my bachelor thesis, Ing. Vladislav Vacek for his

helpfulness, stimulating suggestions, reminders and patiance.

Poděkování

Na tomto místě bych rád poděkoval vedoucímu své bakalářské práce, Ing. Vladislavu

Vackovi za vstřícnost, podnětné rady, připomínky a trpělivost.

Annotation:

The aim of this bachelor thesis is to introduce the Islamic banking. Describing historical and

religious background of Islam, the Islamic banking and Shari’ah law. Then presenting financing

techniques used in the Islamic banking. Eventually describing and analysing the Islamic

banking in Malaysia. Comparison between the Islamic banking and the conventional banking

is given throughout the bachelor thesis.

Key words: Islamic banking, Islam, Shari’ah, financing techniques, Malaysia, conventional

banking

Anotace:

Cílem této bakalářské práce je představit islámské bankovnictví. Popsat historické a

náboženské pozadí Islámu, islámského bankovnictví a práva Šaría. Poté prezentovat techniky

financování používané v islámském bankovnictví. Nakonec popsat a analyzovat islámské

bankovnictví v Malajsii. Srovnání mezi islámským a konvenčním bankovnictví je poskytnuto

v průběhu celé bakalářské práce.

Klíčová slova: islámské bankovnictví, Islám, Šaría, techniky financování, Malajsie, konvenční

bankovnictví

Contents Introduction ............................................................................................................................................. 7

1 The Islamic banking Framework ...................................................................................................... 9

1.1 Historical background of Islam ............................................................................................... 9

1.2 Religious background of Islam ............................................................................................. 11

1.2.1 Beliefs (Aqidah): ............................................................................................................ 11

1.2.2 Morals (Akhlaq): ........................................................................................................... 11

1.2.3 Duties (Sharia’ah): ........................................................................................................ 12

1.3 Shariah .................................................................................................................................. 12

1.3.1 Man-to-man activities (Muamalat Ammah): .............................................................. 12

1.3.2 Sharia’ah in Islamic banking: ........................................................................................ 13

1.4 Prohibitions in Islam ............................................................................................................. 13

1.4.1 Halal and Haram ........................................................................................................... 13

1.4.2 Riba (Prohibiton againts interest): ............................................................................... 14

1.4.3 Gharar (prohibition against uncertainty): ................................................................... 14

1.4.4 Maysir (prohibition against gambling):........................................................................ 15

2 Techniques of financing in the Islamic banking ............................................................................. 16

2.1 Profit loss sharing techniques .............................................................................................. 16

2.1.1 Mudaraba ...................................................................................................................... 16

2.1.2 Musharaka .................................................................................................................... 17

2.2 Profit mark – up techniques ................................................................................................. 19

2.2.1 Murabaha ...................................................................................................................... 19

2.2.2 Ijarah ............................................................................................................................. 19

2.2.3 Istisna ............................................................................................................................ 20

2.2.4 Salam ............................................................................................................................. 21

2.3 Sukuk ..................................................................................................................................... 21

2.4 Takaful ................................................................................................................................... 24

2.5 Zakat ...................................................................................................................................... 26

2.6 Current and Saving Accounts ............................................................................................... 26

3 Comparison of growth of islamic and conventional banking in the example of Malaysia............ 28

3.1 Introduction of practical example ........................................................................................ 28

3.2 Malaysian Islamic financial sector ....................................................................................... 28

3.3 Comparison of asset growth and profitability ..................................................................... 30

3.3.1 Asset growth comparison ............................................................................................. 30

3.3.2 Profitability comparison ............................................................................................... 35

3.3.3 Analysis summary ......................................................................................................... 38

Conclusion ............................................................................................................................................. 40

4 Bibliography ................................................................................................................................... 42

5 Annex ............................................................................................................................................. 42

Introduction

Islamic finance or more commonly used term Islamic banking has been shaping itself and the

economies it serves for almost five decades. It has begun to spread after decolonisation in Egypt

and in Malaysia, and then after being internationally acknowledged in 1973 by Muslim

community in the form of the Islamic Development bank, it was clear that Islamic countries

wanted for their citizens a financial system that would be simply in harmony with their daily

life activities, their beliefs, their morals, just in harmony with their religion, Islam.

The Islamic banking has started to gain greater popularity and recognition during and after the

Financial crisis of 2008 which shown big imbalances in the global economy. For being more

conservative than the conventional banking, the Islamic banking proved more resilient. In the

established Shari’ah law legal framework equity risk sharing is encouraged instead of debt

financing, riba (interest) is prohibited as well as speculation. With more than billion Muslims

across the world, the market for Islamic finance is huge and because Islamic banks were built

as retail banks, they were again more stable not being exposed to corporate sector. Being the

fastest growing financial industry in the world, the Islamic banking is now attracting attention

not only in Arabic or South-Asian countries, Europe itself has immense Muslim community

which demands islamic financial products. But Islamic banks serve non-Muslims the same as

Muslims offering an alternative to those seeking new ways for handling their finances1.

The first chapter of this thesis is introducing Islam not only as a religion but also as a way of

living a life. Providing a description of historical background since the foundation of Islam to

its presence, then a description of religious background with focus on Shari’ah which means

duties to God and other men and prohibitions which are very important in the Islamic banking

approach.

The second chapter aims to describe islamic techniques of Shari’ah compliant financing that

are either profit and loss sharing or with a profit mark-up. As well as presenting sukuk, takaful,

zakat and forms of current and saving accounts.

1 IMF Survey: Islamic Banks: More resilient to crisis?. International Monetary Fund [online]. [cit. 2014-05-17].

Dostupné z: https://www.imf.org/external/pubs/ft/survey/so/2010/RES100410A.htm

The last chapter is introducing the Islamic banking in one of the most pioneer countries,

Malaysia. The goal of the practical example is to characterize the development of the Malaysian

Islamic financial sector with a hypothesis – Is the Islamic banking really growing more rapidly

then the conventional banking in Malaysia? An analysis of asset growth and profitability

between Islamic and conventional banks in Malaysia will be provided supplemented with own

reasoning.

The overall aim of this bachelor thesis is to introduce and compare the Islamic banking with

the conventional western banking in its approaches to financing.

Throughout this bachelor thesis only online sources and international eBooks were used mainly

from ebrary Business & Economics provided by the Universty of Economics in Prague. Online

sources consist of studies of International Monetary Fund and Ernst & Young company, then

of websites of certain Islamic banks and institutions such as the Islamic Development Bank,

Bank Negara Malaysia etc.

Basic ratios of asset growth and profitability used in the analysis ware taken from a study made

by Ernst & Young. The analysis itself was created on the basis of statements of financial

position and statements of income according to IFRS2. Ratios of total assets, equity and

profit/loss for a certain year were used for the charts.

This topis was chosen because of my interest in new alternative ways of financial systems. The

Islamic banking is quintessentially based on solidarity which is, in my opinion, a path that

should be followed hand-in-hand with competition to create more equitable and resilient

economies.

2 International Financial Reporting Standards

1 The Islamic banking Framework

To fully understand and describe the world of islamic finance, we need to look to the history

and at the basic religious principles which has been shaping this approach to finance in general

for almost fifty years.

1.1 Historical background of Islam

Islam is an Arabic word which means ‚peace and submission to Allah‘. A follower of Islam is

called a Muslim. A Muslim strives to live in peace and harmony with the Creator, one self, other

people and the environment. (Abdullah & Chee, 2010, p. 55)

It all began when Allah revealed himself to prophet Mohammed through archangel Gabriel in

610 in Mecca. This revelation continued for 23 years until Mohammed’s death at the age of 63

and it is known as the Holy Koran. During that time Mohammed and his followers were forced

to flee Mecca. They left for Medina, this event marks the beginning of the Muslim calendar.

Before they were allowed to return to Mecca to finally establish the new religion, most of Arabia

was Muslim.

Muslims then divided into two groups that are called Sunni and Shiite. Sunni, when translated

meaning tradition, recognise four schools of theological law – Hanbali, Shafi’i, Maliki and

Hanafi and accepts that caliphs are the successors of Mohammed because he chose them

himself. 85% of Muslims are Sunni, when each school accepts the validity of the other three

and a Muslim can choose any one of them. Shiite is the second group counting for 15% of

Muslims. Shiite believes that any leader of Muslims has to be a direct descendant of

Mohammed’s daughter Fatima and her husband Ali3.

3 CHEE, Daud Vicary Abdullah and Keon. Islamic finance why it makes sense [online]. Singapore: Marshall

Cavendish Business [cit. 2014-03-29]. ISBN 978-981-4312-448.

The reason why the islamic financial system has not been developing for a much more longer

period is that most of the islamic world was colonised by european nations. European masters

came with their own traditions, current western financial system being one of them. After

decolonisation in the second half of the 20th century, muslim countries started to create

institutions that would serve them as normal banks do but which would be in compliance with

their religion and beliefs. First two banks were set up in 1963 in Egypt and Malaysia mainly to

offer a possibility for Muslims to save up for a voayge to Mecca4.

In 1975 the Islamic Development Bank was established by the international community of

muslim countries as a reaction to the 1973 oil shock5. The purpose of the Bank is to foster the

economic development and social progress of member countries and Muslim communities

individually as well as jointly in accordance with the principles of Shari'ah i.e., Islamic Law

(About IDB: Islamic Development Bank, 2014). Since then the IDB has been helping to create

new islamic institutions around the world.

To develop an international stable financial system, islamic institutions, especially banks,

needed to standardize their practices because scholars can have different opinions on what is

Shari’ah compliant and what is not. So the Accounting and Auditing Organization for Islamic

Financial Institutions (AAOIFI), the Islamic Financial Services Board (IFSB) and the

organisation of International Islamic Financial Market (IIFM) were created to issue standards

on accounting, to regulate and supervise the markets and to standardise the products and their

marketability respectively.

The 2008 Subprime crisis had a major influence on the development of islamic finance. As

liquidity freezed, capital of many banks declined and credit was difficult to obtain. This was

the time when islamic financial institutions stroke. First advantage was cheap capital as Arabic

countries owe huge sources of oil. Then they has been creating and adjusting products which

are similar to conventional ones in order to be able to compete with them. Finally Islam is the

second largest religion in the world, projected to surpass Christianity during 21st century,

offering huge market to serve.

4 CHEE, Daud Vicary Abdullah and Keon. Islamic finance why it makes sense [online]. Singapore: Marshall

Cavendish Business [cit. 2014-03-29]. ISBN 978-981-4312-448. 5 CHEE, Daud Vicary Abdullah and Keon. Islamic finance why it makes sense [online]. Singapore: Marshall

Cavendish Business [cit. 2014-03-29]. ISBN 978-981-4312-44

1.2 Religious background of Islam

Islamic society and institutions must be in compliance with Islamic Law which originates from

two divine sources, the Holy Koran (Words of God) and Hadith (Words and deeds of

Mohammed). Every Muslim is defined by Koran because it covers law, worship, doctrine and

wisdom and also gives instructions for equitable, prosperous economic system, solidar society

and social and religious inclusion. Hadith can be explained as a guideline for Muslim in how to

live their daily lives. It is a recorded history of Mohammed’s life who was trusted by Allah to

explain, interpret and live the teachings of the Holy Koran.

To sum up the facts that are written above, Islam is a complex of laws. It says how to behave

in social, political and economic environment.

There are three areas that are regulated by the Holy Koran and Hadith. Beliefs (Aqidah), Duties

(Sharia’ah) and Morals (Akhlaq).

1.2.1 Beliefs (Aqidah):

Aqidah are those matters over which Muslims have conviction. There are six aspects of belief.

These beliefs are clearly articulated in the Holy Qu’ran as required of a Muslim:

1) Belief in Allah

2) Belief in the Prophets and Messengers sent by Allah, including Jesus, Moses and

Abraham.

3) Belief in the Angels. The Angles maintain a record of the actions and thoughts of each

human.

4) Belief in the Scriptures sent by Allah , including the Holy Qu’ran and the Hadith.

5) Belief in the Day of Judgement. On this day, all the people throughout the history of

mankind will be brought forth for accounting, reward and punishment.

6) Belief in Fate. A man’s fate is established by his own actions and thoughts.

(Abdullah & Chee, 2010, p. 66)

1.2.2 Morals (Akhlaq):

Akhlaq is the practice of virtue and morality. (Abdullah & Chee, 2010, p. 67) Islam teaches that

human perfection is determined by discipline and effort. If a Muslim wants to surpass the

Angles, he or she pursuits morals.

1.2.3 Duties (Sharia’ah):

Shari’ah defines duties that should be adopted by individuals on a path to Allah. It covers all

aspects of life such as commercial transactions, social behavior and faith. Two main categories

are covered by Shari’ah, man-to-God activities and man-to-man activites.

1.3 Shari’ah

For purpose of this thesis, man-to-God activites are not going to be covered as they are not

directly connected to the theme. The focus on man-to-man activites, called in Arabic Muamalat

Ammah, is stressed because these activites have a vital influence on Islamic finance.

1.3.1 Man-to-man activities (Muamalat Ammah):

There are five categories of human action that are relevant to commercial transactions, broadly

described as obligatory (Belief in God), recommended (kindness), permitted (doing business),

discouraged (divorce) and forbidden (gambling) (Abdullah & Chee, 2010, p. 70).

All actions taken by Islamic institutions, in this case banks, have to be in peace with Shari’ah

or said with more well-known term – Shari’ah compliant. Sharia is an Arabic word meaning

the path to be followed. (Kettel, 2011, p. 13) Path believed by all muslims to be the path shown

by Allah to Mohammed. Thus it is believed by Muslims that only Shari’ah liberates them from

servitude to other then Allah so that is the reason why Muslims are obliged to strive for it.

There are four sources of Shari’ah:

the Holy Koran,

the Sunnah (the Practice of Prophet Mohammed),

Ijma – consensus of opinion ot the Ulema,

Qiyas which are analogical deductions.

As explained above, the entire nation of Islam lives under the Shari’ah law. There is a council

of jurists which creates and interperts the Holy Koran and the Sunnah meaning that only these

men have the power and responsibility to make new laws according to Shari’ah. These religious

bases give a nonsided new laws, because these jurist creates laws which favor no politicians or

lobbyists but on the contrary should be in favor of people as a whole.

1.3.2 Shari’ah in Islamic banking:

Islam encourages all aspects of well-being meaning that economy is not an exception.

According to this religion economy should develop and serve the society so that there is no

poverty, the development should be done via trade so the financial system in general must

support the real economy through financing halal activities.

Islam bannes a lot of activites which are normal for us, citizens of the West (USA, Japan, EU),

such as speculation but that is going to be explained later. To create a financial system, one

must have an institution, in this case an Islamic bank and products. The products that are used

by Islamic financial instituions have to be Shari’ah compliant meaning they have met all the

Islamic legal requirements. To ensure this, Islamic banks always appoint a Shari’ah supervisory

board which is comprised of scholars, independent professionals educated in Islamic legal

system, who guide and provide the supervision of the products and the bank itself. This

committee certifies products and says if the transactions and dealings set up by its bank are

permissible.

1.4 Prohibitions in Islam

Historically, Islam has origin in the Middle East in Medieval times where most of Arabians

were traders thus money is to be invested into real assets. Trade and partnerships are encouraged

as well as risk sharing. Islamic finance is focused on serving its clients through creating value

in the real economy.

1.4.1 Halal and Haram

The principles of halal (allowed or lawful) and haram (prohibited or unlawful) are applied in

a Muslim’s daily activites, including in food consumption, for the good of the individual,

society, nation and humanity. (Kadir, 2007)

Every action done by Muslims that is for example unselfish or kind is halal. On the contrary

when acting in a destructive behavior to themselves, the environment or other people, these

actions are haram. Basically every unjust, harming or destructive actions are haram.

Examples of haram (single examples, sectors connected to these examples are haram as well):

Alcohol,

Prostitution,

Producing and selling drugs,

Manufacturing of weapons,

Tobacoo,

Pork,

Riba,

Gharar,

Maysir.

1.4.2 Riba (prohibiton againts interest):

According to Sharia Law and the Holy Koran money are viewed only as a measuring tool for

value of assets but they are not an 'asset' themselves meaning that it is not possible to earn

income from money alone. Businesses are encouraged to increase wealth through trade, not

from borrowing and lending.

In Muslim countries, riba is considered exploitative because interest is earned from a borrower

without providing anything in return. In long-term interest-based financing can, if not handled

right, increase gap between poor and rich. For example in debt financing for business,

conventional banks require an asset as a collateral to hedge the risk but these practices tend to

favor bigger and established firms and the smaller ones are charged higher interest rates or

denied financing. This causes that bigger firms are getting bigger and the small ones have more

difficult conditions to finance themselves.

1.4.3 Gharar (prohibition against uncertainty):

In Arabic, uncertainty is called gharar. The term is not precisely defined, it also means hazard

or risk. Generally investment returns arisisng from an asset, such as a business or a stock, could

be either negative or positive meaning that certain level of gharar is allowed. Gambling and

speculation based on excessive gharar is prohibited. Speculation on stock prices, currency

movements or commodities is banned because it does not create any value in the real economy.

To remove Gharar form transactions, the conditions such as price or subject of the transactions,

should be clear between both parties.

Concepts in which gharar can occur:

• Uncertainty of ownership: A good example in conventional finance could be for

example short selling, a speculation on currency movements when the speculator does

not owe money needed for the speculation,

• Inadequacy of information: In islam, the weaker party should be protected from

irrelevant or insufficient information. All parts of a contract are clear meaning that all

information were revealed, price is fair, characteristics of an item are relevant,

• Conditional contract: The sale price of an item or service cannot be dependent on an

event that may not take place. Contracts cannot be interdependent, combined or linked.

Islamic finance differs from the conventional financial system concerning gharar in two ways.

Firstly in insurance sector where insured event can never occur or on the other side can occur

immediatelly. Secondly in financial derivatives where objects serving as a base for a contract

may not exist at the time the contract is executed.

1.4.4 Maysir (prohibition against gambling):

In Islam maysir is seen as a situation where one of two parties either win or lose. Casinos,

gambling machines, all of that is prohibited in Islam. It is an unjust enrichment of one side, it

also widens the gap between rich and poor. Concerning the finance, if simplified, gambling

could be identify in the stock market. If used for investment, Islamic finance does not have any

problem with stock market because the investor becomes one of shareholders, he buys an asset

on a risk sharing platform. But the stock market is also a place of excessive speculation where

an individual is able to earn huge amounts of money on betting if a price of a stock will go up

or down. Shari’ah compliant Islamic banks are investors not speculators.

2 Techniques of financing in the Islamic banking

Because of the prohibition of interest and speculation, islamic banks had to find new ways how

to transfer funds from depositors who are called investment account holders (owners of capital)

and business owners. Two methods were developed. First one is profit and loss sharing method

that includes Mudaraba and Musharaka and the other one is very similar to conventional

banking and includes Murabaha, Salam, Ijara, Sukuk etc.

2.1 Profit loss sharing techniques

2.1.1 Mudaraba

In general Mudaraba is a trade conract in which a Mudarib (business owner) is provided with

capital by a Rabb ul Mall (investor) for an agreed fee. It is characterized as a partnership

between two or more parties.

In this case an investment account holders provides via Islamic bank capital to Mudaribs. Then

the profit is shared in pre-agreed ratios, any loss on the other hand are borne by the Islamic

bank meaning that the bank bares the whole monetary loss. The loss is then transferred to

investment account holders. In mudaraba contract, Rab ul Mall sets the profit sharing ratio

which is in percentages not fixed. The ratio is adjusted to conditions concerning the type of

business invested in, place where Mudarib run the business and other things that could have an

influence on profit.

Shari’ah treats mudaraba in a way that the owner of capital (Islamic bank or actually

investment account holders) has no say in the usage of money provided to business. The whole

responsibility is put into Mudarib, Islamic bank can only specify conditions in order to ensure

better management of the capital.

There are two types of mudaraba:

Restricted mudaraba (Mudaraba Al Muqayyadah): In this case Rab ul Mall (owner of

capital) can specify a particular choice of investment for Mudarib,

Unrestricted mudaraba (Mudarab Al Mutlaqah): Full freedom is given to Mudarib by

Rab ul Mall in how to invest the capital, however it is forbidden to invest outside of the

normal routine of the business. If Mudarib wishes to do that, he or she must get a

permission by Rab ul Mall.

Two-tier Mudaraba:

As shown before, mudaraba is a two party contract. Islamic banks reshaped mudaraba so that

they could use in their ordinary activites. They have extended it to include three parties. Islamic

bank is a Mudarib opposite to its depositors (investment account holders) and it is a Rab ul Mall

opposite to the business sector.

The funds are received on the basis of unrestricted mudaraba so that there are no limits

imposed on the Islamic banks while doing their daily activities. They can use all the

funds together and work as an intermediary. But they must avoid haram investments

(alcohol, drugs, speculation). On the contrary banks use restricted mudaraba when

approaching the business sector in order to specify the kind of activites, duration of the

investment etc. But as mentioned before they cannot interfere after the funding is

provided,

Because mudaraba is a partnership, the Islamic bank trusts the investment decisions it

makes but with a possibility of future losses. It is forbidden to ask Mudaribs for

collateral or any other type of guarantee. The base of this system is solidarity.

Investment account holders take in account that they could lose their money,

Islamic bank then uses the pooling technique to aggregate all profits and share them

with depositors after deducting all costs. When losses occur depositors lose a part of

their funds.

2.1.2 Musharaka

Musharaka is a form of partnership between an Islamic bank and its clients whereby each party

contributes to the partnership capital, in equal or varying degrees, to establish a new project

or share in an existing one, and whereby each of the parties becomes an owner of the capital

on a permanent or declining basis and is owed its due share fo profits. Losses, however, are

shared in proportion to the contributed capital. It is not permissible to stipulate otherwise.

(Kettel, 2011, p. 77)

One form of musharaka is called Mufawada which means unrestricted, unlimited and equal

partnership. All partners are put at the same level in management, capital and ownership. Each

partner guarantees the others and is also the agent of others.

But the most common form of musharaka is shirkah al’inan. Parties involved create a capital

fund in form of money or for example labour in order to execute a project. The parties only

guarantees themselves, however they are not agents of one another. Profit is then shared in pre-

agreed ratio in percentages, never fixed. However losses are always borne according to the

capital contributions.

There are two forms of musharaka:

Constant musharaka in which a contract has unlimited time expiratio,

Diminishing musharaka in which capital of the Islamic bank constantly decreases to

zero. This type of musharaka is more commonly used.

Mudaraba is used for financing short-term investment while musharaka is used for long-term

investment. The differences are when a loss occurs, in musharaka the entrepreneur is prepared

to share it with the Islamic bank.

2.2 Profit mark – up techniques

2.2.1 Murabaha

Murabaha is originally a sale contract that can be explained as sale on profit. In this type of

contract a buyer appoints a seller who is supposed to buy an item for him with pre-agreed profit

margin. The buyer must know the cost price as well as the profit margin.

Applied in the Islamic banking, murabaha became the most used financing mode. The concept

is that Islamic bank purchases an item for its clients with a profit margin or more commonly

used ‘mark-up’ to its cost. Islamic bank is the owner of the item which is after that provided to

its client. To secure itself, Islamic bank can require a collateral in a form of a different asset or

the item itself but only in case when no other asset exists. The repayment is then done via agreed

installments, paid immediately or delayed until the client resells the item.

According to Shari’ah an item has to be resold so that murabaha fulfills a fact that it is a sale

contract. Other condition is that Islamic bank really purchases the item and becomes an owner

of it.

However when a client is unable to repay an item of his or her desire, Islamic bank cannot

request any further mark-ups. When a default occurs, in practice after two non-paid

installments6, Islamic bank can request all the others due to a certain date or charge a penalty

which then has to be used for covering costs connected to the purchased item or for charity.

2.2.2 Ijarah

Ijarah is originally a sale contract of an usufruct, an object or a hire of personal services. Ijarah

when translated means lease or hire. It is then a leasing contract. Assests such as merchandise

and property can be leased but for a shorter period of time then its useful life meaning they can

be leased multiple times.

Ijarah is widely used in islamic financing because no debt is created and furthermore it contains

a collateral. The lessor has to be the owner of the leased object while the lease takes place

meaning the lessor uses the leased object as security in the form of collateral. When a delay or

default occurs, the lessor is entitled to take back his or her ownership.

6 IQBAL, Zamir a Abbas MIRAKHOR. An introduction to islamic finance: theory and practice [online]. 2nd ed.

Singapore: John Wiley, c2011, xiv, 406 p. [cit. 2014-04-13]. ISBN 9780470828106.

Ijarah is very popular amongst conventional investors because it is almost the same as

conventional leasing. Differences are that a leasing agency, in this case Islamic bank, must own

the object as said earlier and the fact that no extra interest, while comparing the Islamic banking

and the conventional banking, can be charged when an installment is delayed or the lessee is

no more able to pay back his or her liability.

In murabaha, the ownership of an object changes. When the agreed amount is repaid, the object

becomes the property of the client. However in ijarah, the object remains the property of the

lessor, in this case Islamic bank. It means that they are higher administrative costs in a form of

taking care of the object and in a form of usage of the object once the contract is terminated.

This led Islamic banks to seek an improved contract so Muslim jurists developed a contract

called Ijara wa ‘qtina’ which is essentially a hire-purchase agreement. The object will be sold

for pre-agreed price to the lessee by the lessor at the end of the agreement.

2.2.3 Istisna

It is one of the basic conditions for the validity of a sale in Shari’ah that the commodity

(intended to be sold) must be in the physical or constructive possession of the seller. There are

only two exceptions to this general principle in Shari’ah. (BLOM, 2010) And one of them is

Istisna.

Istisna is a type of contract that is used in manufacturing and construction. There are two parties,

the buyer and the manufacturer. The buyer places an order for an item or a building and then

pays in advance, in installments or after the item is delivered. These three possibilites of

repayment scheme give Istisna the advantage in the form of flexibility.

When striking the contract the parties must agree on specifications of both the contract and the

item. After the manufacturing process begins, it is impossible to retrieve the order. Finally the

goods is delivered but when it does not conform the contract, the buyer has a possibility to

cancel the order.

Istisna is used especially for financing bigger projects in for example heavy industries such as

ship-building, aircraft and locomotive manufacturing or in construction industry for building

buildings or infrastructure.

2.2.4 Salam

Salam is a contract involving the purchase of a commodity for deferred delivery in exchange

for immediate payment according to specified conditions, or the sale of a commodity for

deferred delivery in exchange for immediate payment. (Kettel, 2011)

Salam is essentially a purchase of an item at spot while the item is delivered later in the future

according to the agreement. That means that Salam contains gharar so it should be banned to

enter into such a contract. For those reasons prophet Mohammed permitted salam while

fulfilling certain conditions. This contract was used specially in agriculture for financing

farmer’s needs between harvets. Because they could not take a loan for their needs, it was

allowed that farmers could sale their harvest or other agricultural products in advance. Salam

is recorded in Hadidth, thus it is valid and Shari’ah compliant according to Muslim jurists.

There are some conditions that have to be adrressed in salam. Firstly, the price for the goods

should be paid fully at spot. Then the commodities, for which salam is used, are in general

interchangeable meaning that a carrot can be replaced by a potato, a different item but still in

the category of food. At last, the place and date of delivery must be set in the contract.

As said before, salam is Shari’ah copmliant when used in the agriculture sector. It is basically

the best way of financing small farmers and can be also used as a form of microfinance. For

making a profit, the Islamic banks use the level of price. They fix the price at a lower rate than

the price of the commodity would normally be when delivered at spot at the moment of entering

salam. The difference between the two prices is then used as a profit.

2.3 Sukuk

Sukuk is a financial instrument that is used primarely in capital markets and it is an alternative

to conventional bonds. Sukuk is a plural form of a word ‘sak’ which also served as a base for

word ‘cheque’ meaning that Muslim traders have been using sealed papers in a form of

obligations since the Middle Ages.

The Accounting and Auditing Organization for Islamic Finance (AAOIFI) defines Sukuk as

investment certificates. All the certificates have equal value and represent shares in undivided

ownership of an underlying assets. These underlying assets may be represented by tangible

assets, usufructs or assets of a special investment project but they have to generate revenues.

It can be already seen that a main difference between sukuk and conventional bonds is the

nature of the products while bonds are debt obligations, sukuk represents an ownership claim.

(Fundamentals of islamic money) The most important advantage of sukuk compare to other

islamic products that were already described here is its liquidity as the ability to be traded in

the secondary market. Sukuk represent direct funding for companies in general via the capital

market.

According to Sharia’ah Law it is forbidden to use conventional bonds as a source of financing.

In Islam bond is a financial instrument which fits riba definition perfectly. It essentially

represents earning money on money. When trading in the capital market, the price of sukuk is

based mainly on the price of the underlying assets and its volatility, however, the price of a

bond is based mainly on the creditworthiness of the issuer.

Before sukuk are issued they have to be Sharia’ah compliant meaning that the raised funds must

be used for halal activities. The contract has to be transparent and all the specifications of it

must be clear to all investors. There is no fix return guaranteed and the underlying asset has to

generate revenue so that the investors could obtain income.

Then a special purpose vehicle (SPV) is established. This SPV is usually a subsidiary company

with legal status so that the obligations are not dependant on the parent company, therefore

secured. The SPV has a limited operational framework and its task is mainly acquisition of

assets and issuance of sukuk.

There are two types of sukuk:

Asset-backed sukuk where the primary source of investment return is a revenue (or cash

flow) generating Sharia’ah compliant asset. The funding costs are based on the strenght

of the cash flow. In this case, the investors are owners of an asset which generates

revenues, therefore cash flow, for a company and therefore for them,

Asset-based sukuk where investment returns are not based on revenues of a specified

asset but sukuk is only backed by Sharia’ah compliant assets of a company, more

specifically by their capital value. Compared with the conventional bonds, investors

here are actually the owners of these underlying assets. Investment returns are not

financed directly by a certain asset. The funding costs are more market driven depending

on the creditworthiness (rating) of the issuer.

Table 2.3.1 Differences between Sukuk, Conventional Bonds, and Company Shares.

Sukuk Bonds Shares

Nature Not a debt of issuer but

undivided ownership share

in specific

assets/projects/services.

Debt of issuer. Ownership share in

a corporation.

Asset-backed A minimum of 51 percent

tangible assets (or their

contracts) are required to

back issuance of sukuk al-

ijarah.

Generally not

required.

Not required.

Claims Ownership claims on the

specific underlying

assets/projects/services

and so on.

Creditors claim on

the borrowing

entity, and in some

cases liens on

assets.

Ownership claims

on the company.

Security Secured by ownership

rights in the underlying

assets or projects in

addition to any additional

collateral enhacements

structured.

Generaly

unsecured

debentures except

in cases such as

first mortgage

bonds, equipment

trust certificates,

and so on.

Unsecured.

Principal and

return

Not guaranteed by issuer. Guaranteed by

issuer.

Not guaranteed by

company.

Purpose Must by issued only for

Islamically permissible

(halal) purposes.

Can be issued for

any purposes.

Can be offered for

any purposes.

Trading of security Sale of and ownership

interest in a specific

asset/project/service and

so on.

Sale of a debt

instrument.

Sale of shares in a

company.

Responsibility of

holders

Responsibility for defined

duties relating to the

underlying

assets/projects/transactions

limited to the extent of

participation in the issue

Bondholders have

no responsibility

for the

circumstances of

the issuer.

Responsibility for

the affairs of the

company limited to

the extent of

holdings in the

company.

Source: (Abduh & Raditya Omar, 2013, p. 80)

Sukuk al-Ijarah is the most commonly used form of sukuk so its functioning is going to be

explained. When a company wants to issue sukuk, the Special Purpose Vehicle (SPV) is

established. The SPV is responsible for issuing sukuk, paying distribution amounts and the

dissolution amount. Investors then pay the principal amount for sukuk and the SPV creates a

trust over the funding which it obtained. Then acting as a trustee on behalf of the investors, the

SPV enters into a sale and purchase agreement with the originator of sukuk. Then the SPV

purchases an asset from the originator for the principal amounts obtained from investors and

leases it back to the originator in the form of ijarah for the period that matches the maturity of

sukuk. Rental payments mady by the originator are equal to the distribution amounts meaning

they are redistrubuted by the SPV between investors. At the end, the originator pays the exercise

price to the SPV which equals the dissolution amounts needed to terminate this contract. In the

case of default the SPV sells back the purchased asset and the originator must pay a higher

exercise price that includes accrued distribution amounts owed to investors.

2.4 Takaful

Takaful is an Arabic word meaning guaranteeing each other or joint guarantee. The main core

of the Takaful system – the aspect that makes it free from uncertainty and gambling is Tabarru’,

which means donation, gift, or contribution. The objective of Takaful is to pay a defined loss

from a defined fund. (Kettel, 2011, p. 128)

Takaful represents a form of islamic insurance which is Shari‘ah compliant. Muslim jurists

have always had a problem with conventional insurance because it contains riba, maysir and

gharar. There is uncertainty about the future amount that will be paid, then in addition if no

insured event occurs in the future, the insurance company may keep the premiums paid by the

policyholder. Riba is in life insurance products where policyholders recieve income from

investment that includes for example obligations.

Takaful is based on sincere solidarity. It expects its participants to donate their money to support

other participants. In this insurance scheme every participant contributes to a fund that later

covers their claims. If an individual wants to use takaful, the amounts that he or she will pay is

defined by the expected claim in the future.

The Tabarru‘ core of takaful is actually an agreement by a participant to give up a part of his

or her contributions to the mutual fund in order to fulfill his or her obligation of helping other

takaful participants when an insured event takes place. Based on shared responsibility and

cooperation between all participants, Shari‘ah approves takaful as an insurance.

A takaful company is normally called a takaful operator. There are normally two funds managed

by a Takaful operator. One is an investment fund managed as a mudaraba (profit sharing). The

other one is managed according to the principles of tabarru‘, in other words treated as a charity.

Table 2.4.1 Key differences between takaful and conventional insurance.

Takaful Conventional insurance

Takaful is based on cooperation and is void

of interest (riba) and other prohibitions.

Conventional insurance includes interest,

uncertainty (gharar) and other prohibions.

The presence of a legal control authority

(Sharia’a board) to ensure that all the

activities are done according to Sharia’a and

void of any prohibitions.

The presence of a technical commitee only.

The original premium payment goes back to

the insured after deducting its share of the

indemnities and expenses.

Neither the original premium nor any part of

it goes back to the insured.

The profits of investing premiums belong to

the insured after deducting the operator’s

share as a Mudarib.

The profits of investing premiums and assets

belong to the commercial insurance

company only.

The operator aims mainly at achieving

cooperation among community members

and developing the Ummah (the nation of

Islam)

The company aims at achieving the highest

profit possible for its owners.

The operator’s profits are the result of

investing its money, its share as a Mudarib

and the fees for running insurance

operations.

The company’s profits are the result of

investing its money in addition to the

commercial profits resulting from the entire

insurance operations.

The operator has a fixed capital that belongs

to the participants and ‚variable‘ capital that

belongs to the policyholders.

The company has one source of capital that

belongs to the commercial company only.

Source: (Kettel, 2011, p. 131)

Takaful is presented here because it is a common islamic financial service also provided by the

islamic banks. For example one of the leading islamic banks in the world Bank Islam Malaysia

offers takaful in its personal banking services7.

2.5 Zakat

Zakat is the Islamic concept of tithing and alms. It is an obligation on Muslims to pay 2.5% of

their wealth to specified categories in society, when their annual wealth exceeds a minimum

level (nisab). Zakat is one of the Five Pillars of Islam. (Kettell, 2011, p. 82)

The word zakat means ‘purification’ and ‘growth’. The possesions of an individual are purified

by donating a part of his or her wealth to those in need. The existence of zakat is explained as

a way of cutting down imbalances and encouraging growth.

Zakat can be recieved by poor people, homeless people, zakat collectors, people who are close

to becoming Muslims. Then by people who are freeing slaves or heavily indebted people and

by travellers who find themselves in difficult situations. Zakat can be also donated to islamic

schools, hospitals, mosques and to charity.

When a certain Islamic state does not collect and distribute zakat, then Islamic bank is

responsible for establishing a zakat fund or zakat accounts for its clients and distributing it

according to Shari’ah.

2.6 Current and Saving Accounts

To offer services to ordinary people who do not need financing but need to deposit their money,

Islamic banks may use wadiah, which means safekeeping or custody. In this agreement an

individual can deposit cash or other assets in Islamic bank with a guarantee of safety. The client

can withdraw money anytime he or she wants. It is possible, and it is a common practice, that

Islamic bank charges a fee for the safekeeping but on the other hand Islamic bank can also pay

hibah (gift).

7 Personal Banking. Bank Islam Malaysia Berhad [online]. [cit. 2014-05-03]. Dostupné z

:http://www.bankislam.com.my/en/Pages/PersonalBanking.aspx

Islamic bank can also use qard which is essentially an interest-free loan. The current account

of a client, for example, works as a loan to the bank. Qard is due to pay immediately when

requested8.

Islamic banks provide debit and credit cards for a fee. When credit card is issued there is always

a fixed limit to which a client can borrow money. If credit is provided, a fixed fee is set for the

client for borrowing money. Both fee and borrowed money have to be repaid back.

However the most used scheme used in Islamic finance is two-tier mudaraba. As mentioned

before, clients provide the Islamic banks with funds via unrestricted mudaraba.

To sum up the information above, in mudaraba clients are rewarded because they provided

Islamic bank with funds needed for the bank’s investment activities. However in the case of

wadiah or quard, the depositors share profit with the bank and it is Islamic bank’s will if they

will recieve hibah.

8 Current Account. Islamic Bank of Britain [online]. 2013 [cit. 2014-04-24]. Dostupné z: http://www.islamic-

bank.com/current-account/

3 Comparison of growth of islamic and conventional banking in

the example of Malaysia

3.1 Introduction of practical example

In this last section a closer look is going to be taken at a country which is trying to become a

global leader in Islamic finance and that country is Malaysia. This part aims to describe the

Islamic banking in practical way applied in the real economy. Malaysia is the example of a

country that has been developing the Islamic financial industry for almost four decades.

Nowadays its Islamic financial sector is fully integrated into Malaysian legal system, regulatory

framework and into the overall Malaysian financial sector.

History of Islamic finance in Malaysia will be presented, its foundation in 20th century and the

development and growth to modern days. After that providing an analysis of the biggest banks

in Malaysia in order to answer two questions. Is the Islamic banking in Malaysia really growing

more rapidly then the conventional banking? If so, what could be probable causes of that

success?

3.2 Malaysian Islamic financial sector

Malaysia is a multinational and multireligious country with a Muslim Malay majority and two

main minorities, Chinese and Indian. Altough the Malays make up the majority in Kuala

Lumpur and nation wide as well, the Chinese were the ones who were driving the economic

growth and industrialization of Malaysia. Ethnic protests took place in late sixties when Muslim

majority wanted to gain more power over the Chinese who were controlling the commercial

sector.

In 1983 the Malaysian government decided to uprise its Muslim majority by setting up

foundations fot the Islamic financial sector via the Islamic Banking Act (IBA) that enabled

Bank Negara Malaysia (Central Bank of Malaysia) to regulate and supervise Islamic banks.

Bank Islam Malaysia Berhad was established the same year as a pioneer Islamic bank in

Malaysia, from that moment creating a dual banking sector. Government Investment

Certificates (GIC) were issued the same year under the Shari’ah principles as liquid investment

tools for Islamic banks. The purpose of GIC was to enable Islamic banks to meet regulatory

requirments for liquidity.

In 1996 banks licensed under the Banking and Financial institutions Act (BAFIA), which was

enacted in 1989, were allowed to establish new Islamic banking business.

In 1997 Bank Negara Malaysia established the National Shari’ah Advisory Council (NSAC) to

harmonise Sharia’ah principles used by banks. The NSAC operates as the highest Shari’ah

authority in Malaysia overseeing Islamic finance (islamic banking and takaful). The NSAC also

evaluates new products that Malaysian Islamic banks invent. In the year of 2004 Bank Negara

Malaysia enacted a policy on takaful forcing Islamic banks to offer it as a first choice protection

for its customers.

Malaysia has one of the most developed Islamic financial systems in the world as the Islamic

debt securities market, the Islamic equity market and the Islamic Interbank Money Market were

established between 1990 and 1995. There are objections concerning the trading of debt

securities between Muslim countries such as those in need of financing should know their

creditors. However, according to Maliki scholars, which have been shaping the islamic finance

in Malaysia, debt securities trading is possible as long as the debtors know their debts will be

traded.

On 30 June 2013 the Islamic Financial Service Act was enacted to further strenghten and

establish a proper end-to-end Shari’ah regulatory framework which had not been provided

before. The legislation specifically provides for the enforcement of Shariah non-compliance

risk and imposes statutory duty upon the Islamic financial institutions to ensure that their aims,

operations, affairs, businesses and activities are in compliance with Shariah rules. (Selangor,

2013)

3.3 Comparison of asset growth and profitability

The Islamic banking is known for its dynamic growth. The Islamic assets were set to cross 1.7

trillion US dollars in 2013 with 17.6% annual average growth between 2009 and 2012.

Malaysian Islamic assets grew by average 20% in that period. However, the return on equity

(ROE) in Islamic banks is overall lower than the ROE of their conventional competitors9.

3.3.1 Asset growth comparison

In this section, the asset growth between conventional and Islamic banks will be compared in

2012 and 2011 in order to discuss if the Malaysian Islamic banks have been really growing

faster than the Malaysian conventional banks.

The following charts are showing total assets of selected Islamic banks in Malaysia in thousands

of Malaysian Ringgit. Selected Islamic banks are Bank Islam Malaysia Berhad, Maybank

Islamic Berhad, HSBC Amanah Malaysia Berhad, Kuwait Finance House (Malaysia) Berhad,

RHB Islamic Bank Berhad, Hong Leong Islamic Bank Berhad, Alliance Islamic Bank Berhad,

CIMB Islamic Bank Berhad and Bank Muamalat Malaysia Berhad.

Chart 3.3.1.1 Islamic banks – total assets in 2011 and 2012

9 World Islamic Banking Competitiveness Report 2013-2014: The transition begins. In: Ernst & Young [online].

2013 [cit. 2014-05-17]. Available at: http://www.ey.com/Publication/vwLUAssets/EY_-

_World_Islamic_Banking_Competitiveness_Report_2013%E2%80%9314/$File/EY-World-Islamic-Banking-

Competitiveness-Report-2013-14.pdf

RM

32

22

6 5

04

RM

43

10

2 7

85

RM

6 2

23

10

0

RM

22

65

0 3

17

RM

12

17

8 6

17

RM

10

12

2 1

66

RM

10

44

2 8

33

RM

75

51

2 9

38

RM

18

31

5 2

09

RM

37

45

0 7

98

RM

51

22

5 0

40

RM

6 5

08

22

1

RM

25

60

9 6

62

RM

21

90

2 4

69

RM

9 0

96

69

1

RM

12

14

6 1

79

RM

91

43

2 3

70

RM

20

49

5 3

78

Bank IslamMalaysiaBerhad

CIMBIslamic Bank

Berhad

AllianceIslamic Bank

Berhad

RHB IslamicBank Berhad

Hong LeongIslamic Bank

Berhad

KuwaitFinanceHouse

(Malaysia)Berhad

HSBCAmanahMalaysiaBerhad

MaybankIslamicBerhad

BankMuamalatMalaysiaBerhad

TOTAL ASSETS IN 2011 AND 2012

Total Assets 2011 Total Assets 2012

Source: Statements of financial position. Own elaboration.

The analysis of asset size is based on data of financial positions according to IFRS. Islamic

banks were selected according to availability of their financial results and according to their

importance based on asset size and market capitalization10 (asset size and market capitalization

of financial groups of which the Islamic banks are often subsidiaries). Most of them are a part

of financial groups which also own conventional banks in Malaysia.

The rate of growth of assets of selected Islamic banks is showed below.

Chart 3.3.1.2 Islamic banks – asset growth 2011-2012

The analysis of the rate of growth of assets is based on data of financial positions according to

IFRS. The Islamic banks were selected according to availability of their financial results and

according to their importance based on asset size and market capitalization11 (asset size and

market capitalization of financial groups of which the Islamic banks are often subsidiaries).

Most of them are a part of financial groups which also own conventional banks in Malaysia.

10 Top Banks in Malaysia. Online Bank Watch [online]. 2012 [cit. 2014-05-05]. Available

at: http://www.onlinebankwatch.com/malaysia/top-banks-in-malaysia.html

11 Top Banks in Malaysia. Online Bank Watch [online]. 2012 [cit. 2014-05-05]. Available

at: http://www.onlinebankwatch.com/malaysia/top-banks-in-malaysia.html

16,21% 18,84%

4,58% 13,07%

79,84%

-10,13%

16,31% 21,08%

11,90%

Bank Islam Malaysia Berhad

CIMB Islamic Bank

Berhad

Alliance Islamic Bank

Berhad

RHB Islamic Bank

Berhad

Hong Leong Islamic Bank

Berhad

Kuwait Finance House

(Malaysia) Berhad

HSBC Amanah Malaysia Berhad

Maybank Islamic Berhad

Bank Muamalat Malaysia Berhad

ASSET GROWTH 2011-2012

Source: Statements of financial position. Own elaboration.

The annual average growth based on this selected data was 19,08% during the year 2012. Most

of the Islamic banks expanded around this growing rate except of Alliance Islamic Bank which

expanded by 4,58% and Hong Leong Islamic Bank which grew by almost 80%. Only Kuwait

Finance House’s assets shrank by 10,13%.

The following charts are showing total assets of selected conventional banks in Malaysia in

thousands of Malaysian Ringgit. Conventional banks were selected according to the same

criterias as Islamic banks were. Selected conventional banks are CIMB Bank Berhad, RHB

Bank Berhad, Alliance Bank Malaysia Berhad, Hong Leong Bank Berhad, HSBC Bank

Malaysia Berhad, Public Bank Berhad, Maybank Berhad, AFFIN Bank Berhad and AmBank

Berhad.

Chart 3.3.1.3 Conventional banks – total assets in 2011 and 2012

RM

18

6 7

22

22

7

RM

12

0 7

31

46

3

RM

29

38

0 8

78

RM

87

65

0 0

89 RM

20

6 7

68

91

8

RM

73

75

6 4

17

RM

32

3 9

99

60

8

RM

40

07

0 2

90

RM

80

49

5 3

62R

M2

06

79

5 3

24

RM

14

4 6

61

15

5

RM

32

77

2 8

56

RM

14

0 2

84

56

2

RM

22

8 5

75

96

8

RM

66

95

6 2

63

RM

34

2 5

56

67

3

RM

41

67

6 0

54

RM

84

06

4 6

21

CIMB BankBerhad

RHB BankBerhad

AllianceBank

MalaysiaBerhad

Hong LeongBank Berhad

Public BankBerhad

HSBC BankMalaysiaBerhad

MaybankBerhad

AFFIN BankBerhad

AmBankBerhad

TOTAL ASSETS IN 2011 AND 2012

Total Assets 2011 Total Assets 2012

Source: Statements of financial position. Own elaboration.

The analysis of asset size is based on data of financial positions according to IFRS.

Conventional banks were selected according to availability of their financial results and

according to their importance based on asset size and market capitalization12 (asset size and

market capitalization of financial groups of which conventional banks are subsidiaries).

The rate of growth of assets of selected Islamic banks is showed below.

Chart 3.3.1.4 Conventional banks – asset growth 2011-2012

12 Top Banks in Malaysia. Online Bank Watch [online]. 2012 [cit. 2014-05-05]. Available

at: http://www.onlinebankwatch.com/malaysia/top-banks-in-malaysia.html

10,75%

19,82%

11,54%

60,05%

10,55%

-9,22%

5,73% 4,01% 4,43%

CIMB Bank Berhad

RHB Bank Berhad

Alliance Bank

Malaysia Berhad

Hong Leong Bank

Berhad

Public Bank Berhad

HSBC Bank Malaysia Berhad

Maybank Berhad

AFFIN Bank Berhad

AmBank Berhad

ASSET GROWTH 2011-2012

Source: Statements of financial position. Own elaboration.

The analysis of the rate of growth of assets is based on data of financial positions according to

IFRS. Conventional banks were selected according to availability of their financial results and

according to their importance based on asset size and market capitalization13 (asset size and

market capitalization of financial groups of which the Islamic banks are often subsidiaries).

The annual average growth based on this selected data was 13,07% during the year 2012. Four

banks expanded around this growing rate. Maybank, which is the largest bank in Malaysia, saw

the asset growth at 5,73% and two other banks grew similary around 4%. Hong Leong Bank

Berhad is again by far the most growing according to assets, the bank expanded by 60,05%. On

the other hand HSBC Bank Malaysia asset size shrank by 9,22%.

The rates of asset expansion are shown below.

Charts 3.3.1.5 Comparison of asset growth

This analysis shows that the Islamic banking sector’s asset size grew 6,01% more than the asset

size of conventional banking sector.

13 Top Banks in Malaysia. Online Bank Watch [online]. 2012 [cit. 2014-05-05]. Available

at: http://www.onlinebankwatch.com/malaysia/top-banks-in-malaysia.html

19,08%

13,07%

Annual Average Growth 2011-2012 Islamicbanks

Annual Average Growth 2011-2012Conventional banks

COMPARISON OF ASSET GROWTH

Source: Statements of financial position. Own elaboration.

3.3.2 Profitability comparison

In this section, the profitability of conventional and Islamic banks will be compared in 2012

and 2011 in order to discuss if Malaysian Islamic banks had lower ratio of return on equity

(ROE) than conventional banks in Malaysia did.

Return on equity (ROE) is the amount of net income returned as a percentage of shareholders

equity. Return on equity measures a corporation's profitability by revealing how much profit a

company generates with the money shareholders have invested. (Investopedia, 2014)

ROE = Net Income / Shareholder’s Equity. (Investopedia, 2014)

Return on equity of selected Islamic banks is presented below.

Chart 3.3.2.1 Islamic banks – ROE in 2011 and 2012

Ratios of ROE were analysed based on the data of same Islamic banks that were used in the

asset comparison section. Maybank Islamic Berhad is excluded from this analysis because the

net income for the year 2011 was only from 1.7.2011 to 31.12.2011.

13,44%

17,36%

11,99% 11,39%

7,79%

-31,46%

11,19% 9,84%

13,90%

17,11%

13,28%

9,20%

12,63%

4,21%

12,81%

5,90%

Bank IslamMalaysiaBerhad

CIMB IslamicBank Berhad

AllianceIslamic Bank

Berhad

RHB IslamicBank Berhad

Hong LeongIslamic Bank

Berhad

KuwaitFinanceHouse

(Malaysia)Berhad

HSBCAmanahMalaysiaBerhad

BankMuamalatMalaysiaBerhad

RETURN ON EQUITY IN 2011 AND 2012

ROE 2011 ROE 2012

Source: Statements of financial position and statements of income. Own elaboration.

Return on equity of selected conventional banks is presented below.

Chart 3.3.2.2 Conventional banks – ROE in 2011 and 2012

Ratios of ROE were analysed based on the data of same conventional banks that were used in

the asset comparison section. Maybank Berhad is excluded to give a fair comparison based on

8 subjects.

15

,61

%

15

,87

%

12

,68

%

12

,30

%

23

,47

%

19

,48

%

11

,59

%

20

,21

%

13

,64

%

14

,90

%

13

,37

%

12

,35

%

21

,94

%

19

,38

%

11

,87

%

20

,13

%

CIMB BankBerhad

RHB BankBerhad

Alliance BankMalaysiaBerhad

Hong LeongBank Berhad

Public BankBerhad

HSBC BankMalaysiaBerhad

AFFIN BankBerhad

AmBankBerhad

RETURN ON EQUITY IN 2011 AND 2012ROE 2011 ROE 2012

Source: Statements of financial position and statements of income. Own elaboration.

The last chart is directly comparing ROE in 2011 and 2012 between Islamic and conventional

banks in Malaysia.

Chart 3.3.2.3 ROE comparison

Average annual ratios of ROE were counted with the arithmetic average technique. Data were

used from the statements of financial position and statements of income according to IFRS of

both Isalmic and conventional banks.

Return on equity in the Malaysian Islamic banking sector is lower than than ROE of

conventional banks. According to this analysis, ROE in 2011 was only 6,44%. This extremely

low number is biased by the selected data when Kuwait Finance House (Malaysia) Berhad

suffered losses and its ROE was negative.

2011; 6,44%

2012; 11,13%

2011; 16,40% 2012; 15,95%

1 2

ROE COMPARISON

ROE of selected Islamic banks ROE of selected conventional banks

Source: Statements of financial position and statements of income. Own

elaboration.

3.3.3 Analysis summary

This analysis confirmed that the Islamic banks are really growing more rapidly than the

conventional banks but the ROE is lower. The pace of growth of Islamic banking is globally

slowing from rates around 20% but Malaysia was able to maintain high asset growth

performance between 18% to 20% due to long-term developmnet of its Islamic financial

sector14. Weaker results in profitability could be explained by the architecture of the system.

There is no compound interest that generates profits and higher costs can be caused by profit

loss sharing.

Building the sector for more than 30 years, Malaysia’s goal is to have a rich and stable financial

system. The success of the Islamic banking in Malaysia consists of relentless product

innovation, innovative Islamic investment products, wide range of domestic and foreign Islamic

financial institutions and adoption of modern regulatory frameworks such as Basel III together

with Shari’ah practices. Bank Negara Malaysia recognized the current importance of human

capital so the International Center for Education in Islamic Finance (INCEIF) was set up by

BNM in 2006 in order to strenghten the system and educate and train future leaders and decision

makers of Islamic finance. There is also the Malaysia Islamic Financial Center (MIFC)

Community founded in 2006. The MIFC Community is a network of regulators such as BNM,

Securities Comission Malaysia, Bursa Malaysia, government agencies and takaful and re-

takaful companies15.

Malaysia is one of the best examples that diverse and visionary driven financial sector is the

key to a stable economy from that should benefit all. Long-term building, innovation,

standardization and liberalisation of the Islamic banking is positioning Malaysia as the Islamic

Finance hub and if Malaysia does not succeed as a global Islamic Finance leader, it will

definitely play the key role at least in the South Asian region.

14 World Islamic Banking Competitiveness Report 2013-2014: The transition begins. In: Ernst & Young [online].

2013 [cit. 2014-05-17]. Available at: http://www.ey.com/Publication/vwLUAssets/EY_-

_World_Islamic_Banking_Competitiveness_Report_2013%E2%80%9314/$File/EY-World-Islamic-Banking-

Competitiveness-Report-2013-14.pdf

15 BNM Malaysian Financial Sector. Bank Negara Malaysia Central Bank of Malaysia [online]. [cit. 2014-05-

14]. Dostupné z:http://www.bnm.gov.my/index.php?ch=fs_mfs&pg=fs_mfs_bank

The Islamic banking will play a global role in the financial industry because the conventional

financial system favors speculation and it has been failing to deliver financing to entrepreneurs

and companies (multinational companies excluded) which are the drivers of the real economy

and innovation. Another key factor in favor of the Islamic banking is relatively low penetration

of the markets that has already introduced it and then huge potentional markets such as India,

former Soviet countries around the Caspian Sea and Europe. Europe is not potentionally only a

big market from the perspective of a Muslim population mainly in the UK, France, Germany

and Italy but also from the perspective and as a form of ethical banking (known as Socially

Responsible Investing) which is becoming stronger, more visible a more needed than ever.

Conclusion

The goal of this bachelor thesis was to introduce the Islamic banking as a new alternative model

in comparison to conventional financial industry, decribe historical and religious background

of Islam and financing techniques used in Islamic finance. Based on an interest-free scheme

and limited speculation, the Islamic banking has Shari’ah law and Islamic ethical principles in

its core. The main mission of the Islamic banking is to serve the real economy, not to master it,

on the basis of cooperation (profit loss sharing) to eliminate poverty and inequality. Generating

profit for shareholders is not the main idea of this system.

The aim of the first chapter was to describe historical roots of Islam followed by the

development of modern Islamic banking. From the formation of Islam in the 7th century to the

modern era, especially 20th century, that saw decolonisation which made the foundation of the

Islamic banking possible. The establisment of the Islamic Development bank was described as

an important step in the internationalization of Islamic finance while other important institutions

were created later, such as the Accounting and Auditing Organization for Islamic Institutions,

in order to ensure standartization and integrated cooperation between Muslim countries. The

second part of the chapter introduced Islamic religious principles, mainly Shari’ah law, that

have a vital influence on the the Islamic banking scheme and daily practices. The focus was set

on describing the difference between halal and haram activites, then the Islamic prohibitions

were described such as gharar (uncertainty), maysir (gambling) and the most important one,

riba (interest).

Financing techniques used in Islamic finance were described in the second chapter. The

financing techniques were divided into two groups and all of the the financing techniques are

types of contracts. First group were profit loss sharing techniques represented by mudaraba and

mushraka. Mudaraba is purely profit sharing technique where capital is provided for an agreed

fee. Two-tier mudaraba was presented as a modern way of financing developed by the Islamic

banks so that the funds can be transferred with the Islamic bank as an intermediary. While

musharaka is the profit loss sharing technique. In both cases the fees, paid for the provided

capital, are relative shares of profit. Second group are profit mark-up techniques represented by

murabaha, istisna, ijarah and salam. All of these financing techniques are contracts of sale with

the exception of ijarah. Ijarah is a lease contract very similar to conventional leasing that can

be used as a base for sukuk. Sukuk was then described as an Islamic bond, generally and on the

example of sukuk al-Ijarah.

Comparison of sukuk, conventional bonds and shares was provided. Takaful, Islamic insurance,

was also presented as an important part of Islamic finance and a technique used by Islamic

banks. There was also a description of zakat and techniques used for the management of

deposits.

The main goal of the last chapter was to provide comparison between the Islamic and

conventional banking in Malaysia on the example of selected banks and its asset growth and

profitability. Also to introduce the form and development of the Islamic banking in a pioneering

country that is trying to become a global leader in the Islamic finance. The development is

described chronologically from the year of 1983 to the 21st century. Malaysian current dual

financial sector regulated by Bank Negara Malaysia (Central Bank of Malaysia) was presented

as well as standardization and regulation of the Islamic financial products provided by the

National Shari’ah Advisory Council which was established by Bank Negara Malaysia. The

results of the analysis were discussed with the Islamic banking showing higher asset growth in

the Malaysian financial sector while the profitability, presented by the return on equity, was

lower than the profitability of conventional banks. Own explanations of the analysis were

provided discussing mainly the gradual institutional development and government support as

main drivers of the success of the Islamic banking in Malaysia.

4 Bibliography

5 Annex

Tables of auxiliary calculations for the Asset comparison.