Introduction To Islamic Financial System

ISB655 INTRODUCTION TO ISLAMIC FINANCIAL SYSTEM

1.1 History and Development 1.2 Islamic Banking in Some Muslim Countries 1.3 Overview of Islamic Banking in Malaysia

Learning Outcomes • Understand the Islamic financial/banking system; its history and development. • Understand the history and development of Islamic banking in Malaysia. • Understand the philosophies and principles of Islamic banking. [email protected]

History & Development • Generally aims to promote and develop the application of Islamic principles to the financial affairs. • An advantage of Islamic banking – do not deal with loans. • Instead introduces the principle of Musharakah & Mudharabah – investments will depend on the usefulness and feasibility of the invested projects. [email protected]

• Main principles – prohibition of interest, the basis of fair and legitimate profit and the prohibition of monopoly and hoarding. • BUT STILL…a profitable organizations that aim to gain profit. • Islamic banking only emerged as a new reality since 1970s, but its philosophies and principles are not new – birth of Islam. [email protected]

• The emergence of Islamic banking is evident of the revival of Islam and the desire of Muslims to live in accordance with the teachings of Islam.

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Islamic Banking In The Early Days of Islam • The four revelations of Al-Quran specifically dealing with riba shaped the operational aspects of the Islamic banking system. • The only known organised Islamic financial institution during the time of Prophet (saw) was called ‘Baitul Mal’. • Objective – manage the financial affairs of the Islamic state – not generally accept deposits nor grant loans. [email protected]

• Public money and valuables were kept by trustworthy individuals such as the Prophet (saw) and Zubair bin al-Awwam. • The Prophet (saw) was entrusted by the people of Mecca with safekeeping their money – this concept, the trustee did not have the right to use the funds. • Zubair bin al-Awwam chose to only receive money as a loan (qard) – had a right to make use of it & had the obligation to return it intact. [email protected]

• Ibnu Abbas was noted to have transferred some money to Kufah. So was Abdullah bin Zubair in Mecca, who sent money to his brother Hisab bin Zubair, who lived in Iraq – activities related to remittance and bills of exchange. • The use of cheques was widely known with the growing trade between the cities of Syam and Yaman – with this cheques the beneficiaries would be able to collect from Baitulmal a quantity of wheat imported from Egypt. [email protected]

• There were already a few individuals who practiced banking functions although not performing comprehensively.

To channel financing

Banking functions during the Prophet era

To accept deposits [email protected]

To transfer money

Banking Practices During Bani Umayyah and Bani Abbasiyah • In the Prophet (saw) time, banking functions were undertaken by individuals – one-man one-function basis. • In the era of Bani Abbasiyah, these three banking functions were undertaken individually – one-man multi-function banking practice. [email protected]

• When various types of currencies were in circulation, special expertise was required to distinguish one coin from the others. • Each coin had its own precious metal content, hence its own value. • Special expertise – naqid, sarraf,and jihbiz. – the impetus of the practice of money exchange. [email protected]

• The role of bankers began to pick popularity during the reign of Muqtadir – most wazirs had their own bankers. • A milestone in the development of banking practices at the time – wide circulation of saq (cheques) as an instrument of payment. • Money could be transferred across countries without a need to move the physical money. [email protected]

Islamic Banking in The Modern Era • The last decade has seen a marked decline in the establishment of new Islamic banks and the established banks seem to have failed to live up to the expectations. • The literature of the period begins with evaluations and ends with attempts at finding ways and means of correcting and overcoming the problems encountered by the existing banks. [email protected]

• The first such work is that of Muhammad Uzair (1955). Another set of works emerged in the late sixties and early seventies. Abdullah al-Araby (1967), Nejatullah Siddiqi (1961, 1969), al-Najjar (1971) and Baqir al-Sadr (1961, 1974) were the main contributors. • 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.

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• 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. • 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. But then closed down for various reasons.

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• 1963 • In Malaysia the Pilgrims Saving Corporation was incorporated, and it was launched on September 30, 1963. It changed its name to Pilgrims’ Administration and Fund (Tabung Hajji), and it took its final shape as a government sponsored and supervised financial insititution that collects savings and invests them in accordance with Shari’ah. • 1971 • The Nasir Social Bank, established in Egypt in 1971, was declared an interest-free commercial bank, although its charter made no reference to Islam or Shari’ah

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• 1973 • The Islamic Development Bank was established. The purpose of the Islamic Development Bank is to foster the economic development and social progress of member countries and Muslim communities in non-member countries individually as well as jointly in accordance with the principles of Shari’a. It certainly is one of the pioneering Islamic banks having been opened for operations on October 20, 1975. • 1975 • Established in 1975, Dubai Islamic Bank is the first Islamic bank to have successfully implemented the Islamic system of banking in all its shades. Bank’s headquarter is in Dubai. Help and encouragement came in from everywhere such as the government, people and the central bank of UAE.

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• 1976 • The beginning of the new alliance between Shari’ah scholars and bankers had to wait until 1976 when the Faisal Islamic Bank of Egypt was established. The Bank was the first to have a formal Shari’ah board consisting of selected Ulama from Egypt. • 1977 • The Faisal Islamic Bank, whose principal patron was the Saudi prince, Muhammad ibn Faisal Al Saud, was officially established in Sudan in 1977. The Faisal Islamic Bank enjoyed privileges denied other commercial banks (full tax exemption on assets, profits, wages, and pensions), as well as guarantees against confiscation or nationalization.

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• 1977 • Kuwait Finance House (KFH) was established in Kuwait in 1977 as Kuwait's first Islamic Bank with an aim to develop and promote Islamic Banking worldwide. KFH was listed on the Kuwaiti Stock Exchange (KSE) in September 1984. Kuwait Finance House is the Gulf region's second-largest Shariah-compliant lender by market value. • 1978 • Jordan Islamic Bank was established in 1978 as the first Islamic bank in Jordan, and is one of the first banking units of the Group. The Bank is one of the most important Islamic banks in Jordan and ranks as the 3rd biggest bank in Jordan in terms of total assets and deposits, which is a big success considering the very tough competition from the traditional banks in the Jordanian market.

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• 1978 • Al Rajhi Banking and Investment Company (Al Rajhi) from Saudi Arabia was established in 1978 with the merger of a group of companies into Al Rajhi Trading and Exchange Corporation. Rajhi later converted into a joint stock company under the name of Al Rajhi Banking and Investment Corporation. Al Rajhi is the world’s biggest Islamic bank by assets, which stand at more than $28 billion. • 1979 • Bahrain Islamic Bank was established in 1979 as the first Islamic commercial bank in the Kingdom of Bahrain. The Bank has grown consistently and steadily since then to become a leading Islamic institution, to be publicly listed on the Bahrain Stock Exchange.

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• 1982 • The Qatar Islamic Bank is established as the first Islamic bank in Qatar in 1982, and it developed into one of the top ten listed companies in the country. • 1983 • Bank Islam was established in July 1983 as Malaysia’s first financial institution to be Shariah compliant. Today, the bank has a strong presence in the domestic arena catering for the personal and commercial needs of Muslims and nonMuslims alike. • 1985 • The very start of Islamic Banking in Turkey is in 1985 with Albaraka Türk, the Turkish participation banks (before called Special Finance Houses) were poised to aim at the Turkish market as a whole

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Name

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 Luxembourg International Holding

1978

Jordan Islam Bank

Jordan

1978

Bahrain Islamic Bank

Bahrain

1979

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Cont.. Islamic International Bank Egypt for Inv. & Development

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

1983

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Malaysia

Development of Islamic Banking in Some Muslim Countries

Egypt • • • • • •

Mit Ghamr Local Savings Bank privately-owned Received overwhelming support from customers Due to the turbulent political situation and changes in Egypt – been undertaken by the National Bank of Egypt and the Central Bank – reverted back. Reduced the number of depositors drastically. Nasser Social Bank Faisal Islamic Bank Islamic International Bank for Investment & Development Egyptian Saudi Finance Bank Bank of Egypt – Islamic Transaction branches.

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Iran • In Iran, certain administrative steps were taken in February 1981 to eliminate interest from banking operations. • In August 1983 the Usury-free Banking Law was introduced – required banks to become interestfree by 21 March 1984. • The whole system was converted to an interestfree one in March 1985 – allowed to accept 2 types of deposits : Qard hassan and investment term deposits. [email protected]

• Current & saving deposits – bank’s resources • Investment deposits – depositors’ resources. • Banks mainly channelling their funds towards markup instead of profit-sharing. • Lending on the basis of fixed rate of return continues – as fixed rate is not interest according to Shi’a teaching • International banking still based on interest.

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Pakistan • Islamisation of the banking system took place in end 1970s – “Superior Task Force” been set up to eliminate interest in the banking system. • 1979, 4 financial institutions started offering facilities based on Shariah. • June 1980, the State Bank of Pakistan started using ‘profitsharing’ and ‘mark-up’ methods. • January 1981, all banks had a counter for accounts based on profit-sharing and Shariah based services commenced. • January 1985, all financial transactions became interest-free. • 15 July 1985, all deposits placed became interest-free.

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Sudan • Islamisation was in 1977 when the Faisal Islamic Bank of Sudan (FIBS) was established. • 5 more Islamic banks were set up. • September 1983, all banks were asked to be Islamised but when that government was overthrown in 1985, there was disarray. • 1994, the existing government re-Islamised the entire banking system.

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Turkey • The only Muslim country which was completely secular in its banking system. • December 1983 onwards, laws relating to Islamic banking were decreed. • Instead of ‘Islamic Bank’,‘Special Finance House’ were used, such as Albaraka Turkish Finance House and Faisal Finance Institution Incorporation which provide deposits and financing facilities. [email protected]

Overview of Islamic Banking in Malaysia

• Influenced by both external and internal factors. • Establishment of the Pilgrims Fund Board in 1963 and the calls from Malaysian Muslims for the need to establish an Islamic bank have prompted the government to respond accordingly. • In Malaysia, separate Islamic legislation and banking regulations exist side-by-side with those for the conventional banking system. • The legal basis for the establishment of Islamic banks was the Islamic Banking Act (IBA) which came into effect on 7 April 1983. • The Government Investment Act 1983 was also enacted at the same time to empower the Government of Malaysia to issue Government Investment Issue (GII).

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• The first Islamic bank established in the country was Bank Islam Malaysia Berhad (BIMB) which commenced operations on 1 July 1983 • Listed on the Main Board of the Kuala Lumpur Stock Exchange on 17 January 1992. • The long-term objective of BNM is to create an efficient, progressive and comprehensive Islamic financial system that contributes significantly to the effectiveness and efficiency of the Malaysian financial sector. • Requires three vital elements : 1. a large number of global players; 2. a broad variety of instruments; and 3. a comprehensive financial infrastructure.

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• The foundations of an Islamic banking system must also reflect the socio-economic justice and values in Islam, as well as must be Islamic in both substance and form. • The effort to streamline and harmonise the Shariah interpretations among the Islamic banks and takaful companies, BNM established the Shariah Advisory Council for Islamic Banking and Takaful (SAC) on 1 May 1997.

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Development of Islamic Banking in Malaysia Year

Remark

1980

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

July 30, The Government appointed National Steering Committee on Islamic 1981 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.

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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.

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Cont..

August 21, 1993

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

January, 1994 The establishment of the Islamic Money market which consists of three elements namely, i. Trading in financial instruments, ii. Mudharabah inter-bank investments (MII) iii. Islamic cheque clearing system

1998

BNM replaced term SPTF (Interest-free scheme) with the SPI (Islamic Banking Scheme)

October 1999 Bank Muamalat Malaysia Berhad commenced operations on 1 October 1999 as the second Islamic Bank in Malaysia. 2004

BNM approved three new licenses to foreign financial institutions to set up new Islamic banks.

2005

Three new local Islamic banks commence operations i.e. BBCB Tijari, RHB Islamic Bank & Hong Leong Islamic Bank

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List of Financial Institutions Offering Islamic Banking Services • • • • • • • • • • • • •

Full-fledge Islamic Banks Affin Islamic Bank Berhad Al Rajhi Banking & Investment Corporation Berhad AmIslamic Bank Berhad Asian Finance Bank Berhad Bank Islam Malaysia Berhad Bank Muamalat Malaysia Berhad CIMB Islamic Bank Berhad EONCAP Islamic Bank Berhad Hong Leong Islamic Bank Berhad Kuwait Finance House Berhad Maybank Islamic Berhad RHB ISLAMIC Bank Berhad

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• • • • • • • • •

Participating banks in the Islamic Banking Scheme Commercial Banks ABN Amro Bank Berhad Alliance Bank Malaysia Berhad Citibank Berhad HSBC Bank Malaysia Berhad Malayan Banking Berhad OCBC Bank (Malaysia) Berhad Public Bank Berhad Standard Chartered Bank Malaysia Berhad

• • • • •

Investment Banks Affin Investment Bank Berhad Alliance Investment Bank Berhad AmInvestment Bank Berhad CIMB Investment Bank Berhad CIMB Investment Bank Berhad

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• • • • • • •

Development Financial Institutions Offering Islamic Banking Services Bank Kerjasama Rakyat Malaysia Berhad Bank Pertanian Malaysia Bank Perusahaan Kecil dan Sederhana Malaysia Berhad Bank Simpanan Nasional Berhad Export-Import Bank of Malaysia Berhad Range of Islamic Banking Products and Services in Malaysia www.bnm.gov.my Deposits Investments Financings Trade Finances Card Services

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Conclusion • The development of philosophies and objectives in Islamic banking are in line with the principles of Islamic business as highlighted in the al-Quran and Sunnah. • As institutions whose foundations are based on Islamic doctrines, Islamic banks must conforms to Islamic rules and regulations. • Islamic business entities are required to engage themselves in legitimate and lawful business, and to fulfill all obligations and responsibilities. • Islamic bank have to uphold both profit and moral principles.

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