This chapter explains the background of the study. It describes an overview of conventional banks that based on interest-based and interest-free of Islamic banks system in Malaysia. Furthermore, this chapter also will explain about the problem statement, research questions, research objectives and the expected contribution of this study. Finally, this chapter also provides research organization in which is describes the overview of the overall study.
Background of the study
Malaysia is one of the Muslim countries that are committed in not only developing Islamic banking system but also a complete Islamic Financial system. The Islamic banking system in Malaysia started in 1983 when the first Islamic bank, Bank Islam Malaysia Berhad (BIMB) commenced its operations. It was the objective of the Malaysian government to develop the Islamic banking system parallel to the conventional system. The concept of Islamic window started in March 1993 when the Central Bank of Malaysia or Bank Negara Malaysia (BNM) introduced the "Interest-Free Banking Scheme". Twenty-one Islamic financial products were developed to cater for this scheme with only three major banks participated initially.
Banking system in Malaysia is unique in the sense that both conventional and Islamic banks are currently operating side by side. The first full-fledged Islamic bank established in the country was Bank Islam Malaysia Berhad (BIMB), which commenced its operations on 1 July 1983.
Recognizing the increasing demand for Islamic products and services, Bank Negara Malaysia (BNM) has introduced a scheme known as 'Skim Perbankan Tanpa Faedah'. Or 'Interest-free Banking Scheme'(often knows as Islamic windows) in March 1993. Under this scheme, all conventional commercial banks, merchant banks and finance companies are given the opportunity to introduce Islamic banking products and services to their customers. In 1998, the second full-ledge Islamic bank that is Bank Muamalat was established. From a theoretical perspective, Islamic banking is different from conventional banking because interest (riba) is prohibited in Islam, i.e., banks are not allowed to offer a fixed rate of return on deposits and are not allowed to charge interest on loans. (Beng Soon Chong and Ming Hua Liu, 2009)
Shariah compliant finance does not allow for the charging of interest payments (riba) as only goods and services are allowed to carry a price. On the other hand, Shariah compliant finance relies on the idea of profit, loss, and risk sharing, on both the liability and asset side. In practice, however, Islamic scholars have developed products that resemble conventional banking products, replacing interest rate payments and discounting with fees and contingent payment structures. In addition, leasing like products are popular among Islamic banks, as they are directly linked to real sector transactions (Thorsten Beck, et al, 2010)
The key milestone of development of Islamic bank in Malaysia is when BNM allowed the conventional banks to established Islamic subsidiaries in year 2002. This transformation of Islamic banking windows into Islamic subsidiaries is mandatory of which the subsidiaries shall come under the governance of Islamic Banking Act 1983 instead of BAFIA 1992.
From a structural point of view, Islamic banks operate alongside of conventional banks in different countries and a parallel market for Islamic financial services has developed. Deficit and surplus units in the economy have the option to use the services provided by each mode of banking. If religious underpinnings for the provision of financial services do matter, then the bank clientele will choose to transact with full-fledged Islamic banks only (Rima Turk Ariss, 2010).
In his article published in The Star dated 31 October 2005, Professor Saiful Azhar Rosly, Director of Research at the Malayan Institute of Economic Research (MIER) explained that the rationalization for Islamic bank subsidiaries is mainly driven by Shariah requirement for greater compliance. For one thing, running interest-bearing and Islamic banking business under one roof may invite ambiguities (gharar) concerning the legitimacy of profits generated from the business. For example, in 2010, the Malaysian economy experienced a strong resumption in growth, recording an expansion of 7.2% following the downturn in 2009 Funded mainly by the interest-bearing mother bank, the capital injection remains an eyesore to many people in view of the Islamic label it carries.
Before that, in year 2004, BNM has issued Islamic banking license to foreign banking players to established Islamic financial institutions. Two pioneer foreign Islamic banks that had setup their operations in Malaysia were Kuwait Finance House and Asian Finance Bank. Since then, the participants in Islamic banking have mushroomed from a single monopoly 1980s i.e.
1.3 Problem statement
Many are skeptical about Islamic banks' performance as newcomers to the market which are like mushroom sprouting after the rain. Regarding Bley and Kuehn (1999), the knowledge of conventional banking terms and concepts was higher than was Islamic banking terminology. The poor knowledge of Islamic finance principle has been one area of concern in this literature for over ten years (Omer, 1992). Besides that, the analysis of interest rate reveal that, finance companies generally provide the highest interest rate compared of Islamic bank profit rate, local conventional banks and foreign conventional banks interest rate.
On the assets side, Islamic banks face a dilemma to extend financing on the Profit Loss Sharing (PLS) basis to firms in which broad policies, strategic plans, and day to day decisions are largely controlled by inside professional managers. While under PLS, Islamic banks share financial risk with the borrowing firms yet they do not have any controlling rights. The legal framework in which they operate does not recognize the special needs of Islamic banks. Thus a central problem is how to make borrowing firms accountable to the Islamic banks while maintaining the former's freedom, incentives and control over production and investment decisions (Humayon A. Dar and John R. Presley,2001).
The PLS paradigm, moreover, subjects Islamic banks to greater market discipline. Islamic banks, for example, are required to put in more effort to distinguish good customers from bad ones because they have more to lose than conventional banks. The banks also need to monitor their investments and borrowers more closely to ensure truthful reporting of profits and losses. Islamic bank depositors, furthermore, are required to choose their banks more carefully and to monitor the banks more actively to ensure that their funds are being invested prudently (Beng Soon Chong and Ming Hua Liu, 2009).
According Abdus Samad (2004), Islamic banks are non-conventional financial institution. Interest, the cornerstone of conventional banks, is completely prohibited under Islamic banking. Islamic banks also operate under dual constraints. While operating as a commercial bank, Islamic banks obey not only conventional business laws of the land, but also the Islamic laws. They have to sacrifice many profitable investment opportunities because those are not permitted under the divine laws of Islam.
It is important to analyze the bank performance, what determines it and how it differs from conventional and Islamic bank performance. The different structure and characteristics of conventional and Islamic banks on one hand, and the different influence of external factors on these banks on the other could lead to performance differences between the two categories. Empirical analysis of conventional and Islamic bank performance will illustrate if the two groups of banks perform differently and the reasons behind the difference. This may help clarify the necessary conditions for successful entry of commercial banks to commercial markets, and on the other hand, could assist in developing a regulatory framework for Islamic bank entry and the expansion in Malaysia. The problem here is to identifying what kinds of factors are affecting the performance of the conventional and Islamic banks and the comparison between the two banking types. This paper explores the comparative performance of Malaysia's interest-free Islamic banks and the interest-based conventional commercial banks with respect to their business volume and performance by applying t-test to financial ratios for Islamic and conventional commercial banks in Malaysia for the period 2009-2011.
1.4 Research question
The research questions of the study are as follows:-
What determines the performances in conventional and Islamic banking?
What are the different and similarities between this two banks system?
How it differs from conventional and Islamic bank performance?
1.5 Research objective
The objective of this study is to evaluate the performance of Islamic banks as compared to conventional banks in Malaysia. The specific objectives of this study are :
To evaluate the performance with the ratio and method by using the movement on financial statement of both banks.
To examine the different and similarities between this two banks system.
To examine the differ performance of Malaysia's interest-free Islamic banks and the interest-based conventional commercial banks with respect to profitability, liquidity risk, and credit risk.
1.6 Scope of research
This research will review the performance of the banks from 2002 until 2011 i.e. ten year analysis. This research will divide those banks in Malaysia include local and foreign banks as shown in table 1.1 and 1.2 below.
Table 1.1 Lists of licensed commercial banks in Malaysia
Commercial Banks
No.
Name
Ownership
1
Affin Bank Berhad
L
2
Alliance Bank Malaysia Berhad
L
3
AmBank (M) Berhad
L
4
BNP Paribas Malaysia Berhad
F
5
Bangkok Bank Berhad
F
6
Bank of America Malaysia Berhad
F
7
Bank of China (Malaysia) Berhad
F
8
Bank of Tokyo-Mitsubishi UFJ (Malaysia) Berhad
F
9
CIMB Bank Berhad
L
10
Citibank Berhad
F
11
Deutsche Bank (Malaysia) Berhad
F
12
HSBC Bank Malaysia Berhad
F
13
Hong Leong Bank Berhad
L
14
India International Bank (Malaysia) Berhad
F
15
Industrial and Commercial Bank of China (Malaysia) Berhad
F
16
J.P. Morgan Chase Bank Berhad
F
17
Malayan Banking Berhad
L
18
Mizuho Corporate Bank (Malaysia) Berhad
F
19
National Bank of Abu Dhabi Malaysia Berhad
F
20
OCBC Bank (Malaysia) Berhad
F
21
Public Bank Berhad
L
22
RHB Bank Berhad
L
23
Standard Chartered Bank Malaysia Berhad
F
24
Sumitomo Mitsui Banking Corporation Malaysia Berhad
F
25
The Bank of Nova Scotia Berhad
F
26
The Royal Bank of Scotland Berhad
F
27
United Overseas Bank (Malaysia) Bhd.
F
(sources: BNM website , updated September 2012)
Table 1.2 Lists of licensed Islamic banks in Malaysia
Islamic Banks
No.
Name
Ownership
1
Affin Islamic Bank Berhad
L
2
Al Rajhi Banking & Investment Corporation (Malaysia) Berhad
F
3
Alliance Islamic Bank Berhad
L
4
AmIslamic Bank Berhad
L
5
Asian Finance Bank Berhad
F
6
Bank Islam Malaysia Berhad
L
7
Bank Muamalat Malaysia Berhad
L
8
CIMB Islamic Bank Berhad
L
9
HSBC Amanah Malaysia Berhad
F
10
Hong Leong Islamic Bank Berhad
L
11
Kuwait Finance House (Malaysia) Berhad
F
12
Maybank Islamic Berhad
L
13
OCBC Al-Amin Bank Berhad
F
14
Public Islamic Bank Berhad
L
15
RHB Islamic Bank Berhad
L
16
Standard Chartered Saadiq Berhad
F
(sources: BNM website , updated September 2012)
Note : L = Local
F = Foreign
1.7 Contribution of the Study
This study will contribute to the performance of interest-based in conventional banks and interest-free in Islamic banks literature by offering greater imminent into the banks structures. In addition, this study also will add a comparison is useful in providing valuable information to relevant parties such as bank customers, bank management and bank regulators.
The comparison of financial measures expressed in terms of various financial ratios indicates that there is no major difference in profitability and liquidity between Islamic banks and conventional banks. The findings also indicate that Islamic banks as newcomers to the financial market are doing as well as conventional banks. In addition, Islamic banks are exposed to less credit risk compared to conventional banks. Their credit performance is superior to that of conventional banks.( Abdus Samad, 2004)
(Samad and Hasan, 2001) finding that the profitability performance of Bank Islam, being the sole Islamic bank in Malaysia at that point of time, was lagging with the conventional banks due to limited business opportunities due to religious constraint. As a result, the bank was more liquid, less risky, and more solvent than its conventional counterparts.
On overall results of Beng Soon Chong and Ming Hua Liu (2009), suggest that Islamic banking, as it is practiced today in Malaysia, is not very different from conventional banking, and the alleged benefits of Islamic banking exist in theory only. There are two important implications associated with this finding: First, the key reason for the rapid growth in Islamic banking worldwide during the past decades is unlikely to be associated with the attributes of the Islamic PLS banking paradigm. Instead, its rapid growth is most likely spurred by the worldwide Islamic resurgence since the late 1960s, which leads to a heightened demand by Muslims for financial products and services that conform to their religion. Second, Islamic banks in practice are similar to conventional banks, and, as such, should be regulated and supervised in a similar fashion.
The results of this study are also very important for managers of the banks as the performance of the bank can be compared to the overall banks performance. This would be a good indicator for them to understand their banks' performance against the industry. Further analysis of financial ratios could also provide a signal and be able to predict future progress of their banks' situation that enhancing the financial institution efficiency and stability of the Malaysian financial structure.
1.8 Organization of research paper
This study consists of three chapters. Chapter one explains the introduction of the study. Generally, it describes about banking system and its performance of interest-based on conventional banks and interest-free on Islamic banks. It also discusses the problem statement, research questions, research objectives and expected contributions of the research. In chapter two, it covers the literature review on scope of banks performance with or without interest and most risky, liquid and solvency in banking system. Chapter three present the research methodology used in this study. It is also includes research hypotheses, data collection and data analysis methods.
CHAPTER 2
LITERATURE REVIEW
Chapter overview
This chapter will introduce the role of commercial banks including the conventional and Islamic banking in Malaysian. Moreover, this chapter describes about structural differences between conventional and Islamic banks. The detail explanation about the overview and development in Islamic banking in Malaysia also provided in this study. Finally, the chapter summary will summarize all of the literature and will be end of the chapter.
The role of commercial banks
A commercial bank is a financial institution that accepts demand deposits and makes loans and provides other services for the public, provides checking and savings accounts.
The roles of the commercial banks are considered as a back bone to the survival of the economy in the country. They are the main players in the financial system and the most active sector in the economy. Some objectives of commercial banks such as a commercial bank's are to make a profit by intermediating between depositors (savers) and borrowers (investors). In achieving this goal banks requires a good management team to enable them to segregate between different level of liquidity, maturity, and risk preferences. As such, the commercial banks must be able to evaluate a borrower's credit worthiness and monitor performance if they are to stay in profit.
However, bank could not escape form moral hazard and the risks of contagion effect that sometimes constrain their ability to make profit and banks also exist in a much regulated environment that are controlling the economic activity, interest rates, and risk in order to best manage their depositors' money from the public funds. Besides above, commercial banks have payment role by which they conduct payments on behalf of customers. On the other hand, the central bank manages monetary system in the country by controlling commercial banks and nonbanking financial institutions.
As a sample is Malaysian banks, it is useful if to get an overview of Malaysian banking system. The banking system in Malaysia, comprising commercial banks, investment banks, and Islamic banks, is the primary mobilizer of funds and the main source of financing to support economic activities in Malaysia. The non-bank financial intermediaries, comprising development financial institutions, provident and pension funds insurance companies, and takaful operators, complement the banking institutions in mobilizing savings and meeting the financial needs of the economy.
Banks, including Islamic banks, operate through a network of more than 2,200 branches across the country. Six Malaysian banking groups have presence in 18 other countries through branches, representative offices, subsidiaries and joint ventures. There are also 21 foreign banks which maintain representative offices in Malaysia.
The growth and development of the small, medium and micro-enterprise (SMME) sector is acknowledged by most interest groups and policy makers as being of critical importance to the country's economy. (Global China Times, July 14, 2009). Decision of the Finance Ministry of Malaysia proves that commercial banks' role in providing financing to SMME is great to improve the country's economy.
Structural differences between Islamic and conventional banks
In order to understand the strength and weakness of Islamic banks with regard to its performance, it is essential to know the basic environment in which Islamic banks operate. It is the difference in environment that makes the Islamic bank unique and distinguished. According to the Shariah, Islamic financial institutions must be based strictly on four basic principles:
All transactions must be interest free, i.e., free from riba.
The avoidance of economic activities involving oppression (zulm).
Activities or transactions involving speculation (gharar) must be avoided.
The implementation of zakat, the compulsory Islamic tax.
No involvement in the production or consumption of goods and services which are haram (i.e. illegal from the Islamic point of view).
The following is a discussion of these four principles that make the Islamic banking unique.
Riba
The Quran explicitly prohibits riba but does permit trade (al-Quran, 2: 185). It does not clearly mention whether riba is interest or usury. The lack of clarity led to a controversy among the Muslim scholars in the past. However, there now seems to be a general consensus that the term riba includes any amount charged over and above the principal. The payment of interest or receiving of interest, which is the fundamental principle of conventional banking and financing, is explicitly prohibited in Islamic banking and finance. Thus, the prohibition of interest, in payment or receipt, is the nucleus of Islamic banking and its financial instruments, while the charging of interest in all modes of transaction whether it is in loan, advances or leasing is the core in the conventional banking. The Islamic banking is not simply interest-free banking. It takes into account issues of gharar, haram, zakat and qarè al-úasan.
ii. Gharar
Gharar is speculation or gambling and is forbidden in Islam. Islam allows risk taking in business transactions, but it prohibits speculative activity and gambling. Any transaction involving the element of speculation like buying shares at a low price and selling them at a higher price in the future is considered illegal. Conventional banks, on the other hand, have no constraint in financing investment involving speculation.
Zakat
Zakat is a compulsory religious payment or tax on the wealth of the rich payable to the poor. It is a built in mechanism in Islam for ensuring the redistribution of wealth and the protection of a fair standard of living for the poor. Zakat is one of the five pillars of Islam. Each Islamic bank must establish a zakat fund and pay zakat on the profits earned. The payment of zakat is in addition to any conventional tax imposed (if the government is non-Islamic). Thus, the Islamic bank pays 'dual'taxes - zakat and corporate business tax. The interest-based conventional banks, on the other hand, are subjected to only corporate business tax, and thus have special advantage over the Islamic bank.
Islamic ethics of investment
In Islam, investment in production and consumption is guided by strict ethical codes. Muslims are not permitted to invest in production, distribution and consumption enterprises involved in alcohol, pork, gambling, illegal drugs, etc., even though these enterprises may be profitable. Providing financing for such activities is illegal in Islam. Hence, it is forbidden for an Islamic bank to finance activities or items that are not permitted by the Shariah. The limitation of investment and financing is extended to cover any activity or business which may be harmful to the individual or the society. Thus, financing investment for the production or consumption of tobacco, alcohol or pornography is also prohibited. This restriction provides limitation on the profitability of the Islamic banks. On the other hand, conventional banks do not face any such constraint in their financing investments.
Thus, Islamic banks face constraints and operate in a non friendly environment in most of the Muslim countries. One should keep the underlying differences in mind in order to make a fair comparison between the Islamic and the conventional banks.
For the interest of the readers, the unique features of the conventional banking and Islamic banking are shown in terms of a table 2.1 as shown below:-
Table 2.1 The features of the conventional banking and Islamic banking
Conventional Banks
Islamic Banks
1. The functions and operating modes of conventional banks are based on fully manmade principles.
1. The functions and operating modes of Islamic banks are based on the principles of Islamic Shariah.
2. The investor is assured of a predetermined rate of interest.
2. In contrast, it promotes risk sharing between provider of capital (investor) and the user of funds (entrepreneur).
3. It aims at maximizing profit without any restriction.
3. It also aims at maximizing profit but subject to Shariah restrictions.
4. It does not deal with Zakat.
4. In the modern Islamic banking system, it has become one of the service-oriented functions of the Islamic banks to be a Zakat Collection Centre and they also pay out their Zakat.
5. Lending money and getting it back with compounding interest is the fundamental function of the conventional banks.
5. Participation in partnership business is the fundamental function of the Islamic banks. So we have to understand our customer's business very well.
6. It can charge additional money (penalty and compounded interest) in case of defaulters.
6. The Islamic banks have no provision to charge any extra money from the defaulters. Only small amount of compensation and these proceeds is given to charity. Rebates are given for early settlement at the Bank's discretion.
7. Very often it results in the bank's own interest becoming prominent. It makes no effort to ensure growth with equity.
7. It gives due importance to the public interest. Its ultimate aim is to ensure growth with equity.
8. For interest-based commercial banks, borrowing from the money market is relatively easier.
8. For the Islamic banks, it must be based on a Shariah approved underlying transaction.
9. Since income from the advances is fixed, it gives little importance to developing expertise in project appraisal and evaluations.
9. Since it shares profit and loss, the Islamic banks pay greater attention to developing project appraisal and evaluations.
10. The conventional banks give greater emphasis on credit-worthiness of the clients.
10. The Islamic banks, on the other hand, give greater emphasis on the viability of the projects.
11. The status of a conventional bank, in relation to its clients, is that of creditor and debtors.
11. The status of Islamic bank in relation to its clients is that of partners, investors and trader, buyer and seller.
12. A conventional bank has to guarantee all its deposits.
12. Islamic bank can only guarantee deposits for deposit account, which is based on the principle of al-wadiah, thus the depositors are guaranteed repayment of their funds, however if the account is based on the mudarabah concept, client have to share in a loss position.
Based on the features of conventional and Islamic banks presented above, it is noted that Islamic banks face steep challenges in banking industry as the banks have to sacrifice many business opportunities that do not comply with the Shariah requirements. In addition to the above, Islamic banks must obey not only the Islamic laws, but also the conventional business laws of the land.
According Muhammad Hanif (2011), Islamic Financial Institutions (IFIs) are operating in the same society where conventional banks are operating and perform all those functions which are expected from a financial institution. IFIs are assisting business world by providing all the services required to run the economy smoothly, however, the philosophy and operations are different. Any financial system is expected to assist in running the economy by providing the following services grouped in two headings. First, savings mobilization from savers to entrepreneurs and second, provision of general utility services including transfer of funds, facilitation in international trades, consultancy services, safekeeping of valuables, and any other service for a fee. There is no restriction on provision of such services by IFIs as for the service is not against the Shariah. However there exists difference in mechanism of funds mobilization from savers to entrepreneurs as described following. Savings mobilization consists of two phases' i.e. accepting deposits and extending financing and investments.
Deposits
Deposits are collected from savers under both type of institutions for reward irrespective a bank is operating under conventional system or Islamic system. The difference lies in agreement of reward. Under conventional system reward is fixed and predetermined while under Islamic deposits are accepted through Musharakah and Mudarabah where reward is variable. Under conventional banking return is higher on long term deposits and lower for short term deposits. Same is the practice in Islamic banking to share profit with depositors. Higher weight for profit sharing is assigned to long term deposits being available to bank for investing in longer term projects yielding superior returns and lower weight for short term deposits which cannot be invested in long term projects. The only difference in conventional and Islamic system lies in sharing of risk and reward. Under conventional system total risk is born by the bank and total reward belongs to it after servicing the depositors at fixed rate while under Islamic system risk and reward both are shared with depositors. Reward of depositors is linked with outcomes of investments made by IFIs. Under Islamic financial system only those IFIs will be able to collect deposits who can establish trust in the eyes of masses hence leading to optimal performance by financial industry. So for IFIs working in have succeeded in establishing their credibility in the eyes of savers as depicted an increasing trend of deposits collection.
Financing and Investments
The second phase in savings mobilization process is extension of credit facility to business and industry for return. Both types of institutions (Islamic and conventional) are providing financing to productive channels for reward. The difference lies in financing agreement. Conventional banks are offering loan for a fixed reward while IFIs cannot do that because they cannot charge interest. IFIs can charge profit on investments but not interest on loans. In conventional banking three types of loans are issued to clients including short term loans, overdrafts and long term loans. Islamic banks cannot issue loans except interest free loans (Qarze Hasna) for any requirement however they can do business by providing the required asset to client.
Overdrafts/Credit Cards etc.
Conventional banks offer the facility of overdrawing from account of the customer on interest. One of its form is use of credit card whereby limit of overdrawing for customer is set by the bank. Credit card provides dual facility to customer including financing as well as facility of plastic money whereby customer can meet his requirement without carrying cash. As for facility of financing is concerned that is not offered by Islamic banks except in the form of Murabahah (which means IFI shall deliver the desired commodity and not the cash) however facility to shop/meet requirement is provided through debit card whereby a customer can use his card if his account carries credit balance. Under conventional banking a customer is charged with interest once the facility availed however under Murabahah only profit is due when the commodity is delivered to the customer. Furthermore in case of default customer is charged with further interest for the extra period under conventional system however extra charging is not allowed under Murabahah. Third under conventional system customer can avail the opportunity of rescheduling by entering into a new agreement to pay interest for extended period which is not the case under Murabahah. IFIs can claim only the original receivable amount agreed in initial contract. Another practical issue under Murabahah is how to deal with intentional defaulters. Different options are lying with IFIs including to blacklist the defaulter for any further financing facility, to stipulate in the contract that in case of default all installments will be due at once, to stipulate in the contract a penalty shall be imposed but the same shall not form income of IFIs rather it will go in charity (Usmani, 2002).
Short term loans
Short term and medium term loans are provided to customer to meet working capital requirements of firm by conventional banks. Working capital is required by firms to invest in inventories and accounts receivables and meet the expenses. As for inventory investment is concerned that is provided by Islamic banks through Murabahah. As for meeting of day to day expenses of business is concerned financing is provided through participation term certificates where by profit of a certain period (e.g. quarter, six month, one year) is shared by IFIs on prorate basis. However financing through participation term certificates is not as easy as a short term loan from conventional bank due to risk involved for IFIs in the transaction. Firm seeking short term facility from IFIs has to prove the viability of the project/business to the satisfaction of investor. For meeting the working capital requirements of nonprofit organizations to date there is no arrangement under Islamic financial system. Personal consumption loans are also not issued by IFIs how ever any individual of sound financial position can acquire anything for his personal use under Murabahah financing whereby a certain percentage of profit is added on cost by IFIs. Murabahah financing is very useful for short to medium term financial requirements of business/nonprofit organizations and individuals. Murabahah financing is asset based financing and anyone can request to an IFI for provision of an asset generally used for Halal (lawful) purposes. By default under Islamic financial system IFIs cannot lend cash for interest (only exception is Qarze Hasna - Charity loan). One of the features of Murabahah is in case of delay in payment by customer IFI cannot ask for extra amount as time value of money like conventional banks. However penalty is imposed on defaulter if stipulated in original contract of Murabahah duly signed by the customer but same cannot be included in the income of IFI. This penalty must be spent for charitable purposes. Under Murabahah scheme of financing facility is linked with assets which leads to economic stability and creates linkage between real and financial sector. It is not zero sum game because utility is created through services and products and not by mere building the blocks of wealth through dealing in paper money. Although Murabahah is being used by IFIs successfully and have succeeded in meeting short to medium term requirements of firms by providing a successful replacement of conventional loans yet certain differences exist in both type of financing. First is one cannot get cash under Murabahah. Second asset is purchased by IFI initially then transferred to customer hence IFI participate in risk. Third refinancing facility is not available under Murabahah. Fourth in case of default price of the commodity cannot be enhanced however penalty may be imposed if stipulated in original contract of Murabahah however same cannot be included in income of IFI. Fifth only those assets can be supplied by IFIs under Murabahah whose general and/or intended use is not against the injunctions of Shariah (e.g. supply of a machine to produce liquor)
Medium to long term loans
Medium to long-term loans are provided for purchase or building of fixed assets by firms to expand or replace the existing assets. Under Islamic financial system requirement of firms and individuals are fulfilled through Murabahah, Bai Muajjal, and Istasna. Another financing option for long-term financing is profit sharing under Musharakah and Mudarabah. Although financing under Murabahah, Bai Muajjal and Istasna is very much look like conventional loans with the only difference of provision of asset and not cash to client however differences exist in the contracts which alter the nature of risks and returns. Financing under Musharakah and Mudarabah is challenging for IFIs and firms as well. Under Shariah based financing schemes firms have to prove the viability/profitability of the project/business to the satisfaction of IFIs to get the finance because risk of losing the amount is involved.
Leasing
Leasing is relatively recent source of financing whereby usufruct of an asset is transferred to lessee for agreed amounts of rentals. Under leasing ownership may or may not be transferred. Same facility is provided by IFIs under agreement of Ijara. Under Ijara asset is provided to customer for use with out transfer of ownership for a specific period of time in exchange for agreed rentals. Ownership of asset can be transferred to customer through mutual agreement at the completion of lease term. All ownership risks are born by IFIs during Ijara tenure. Certain differences exist in the transaction under both systems. First is rental under Ijara are not due until asset is delivered to the lessee for use. Second additional rent cannot be demanded in case of default except a penalty (if stipulated in original contract of lease) which is not the income of IFI. Third during period of major repair rent cannot be demanded by IFI. Fourth if asset is lost or destroyed IFI cannot claim further installments hence all risks of ownership are born by IFI.
Agricultural Loans
Agricultural loans include both types of loans short-term as well as long term. Short-term loans are required by farmers for seeds and fertilizers and long-term loans are required to develop additional lands and purchase of equipments. Normally farmers return these loans after selling the finished crops. Conventional banks are providing credit facility by charging interest. Same facility is provided by IFIs to the farmers under Bai Salam, Murabahah, Musharakah, and Mudarabah. Under Bai Salam cash is provided to farmers for purchase of seeds and fertilizers however this is not loan rather purchase of finished crops to be delivered by farmers. For purchase of equipments Murabahah facility is used and for development of additional land Musharakah and Mudarabah is used by IFIs. To get finance for land development farmers have to convince the IFIs about profitability of the venture due to risk involved in the transaction.
House financing
Housing finance/Mortgages is the more secured form of financing for both conventional banks and IFIs. Under conventional system loan is provided for interest while under Islamic financial system facility is provided through diminishing Musharakah. Under diminishing Musharakah house is purchased jointly by IFI and customer. IFI rents out its share in property to customer for an agreed amount of rent. Share of financier is divided in units of small denomination. Customer pays the installments to IFI consist of rentals plus purchase price of a unit. Stake of customer in property is increasing while of IFI is decreasing with payment of every installment. Finally with the payment of last installment stake of IFI reaches to zero and property is transferred in the name of customer. Diminishing Musharakah model can help out in avoiding the real estate crisis because when market value of property decreases both IFI and customer suffers according to their share in property and whole burden is not shifted on customer alone. Hijazi, & Hanif (2010) have raised certain questions about the existing practice of IFIs working and needs to be addressed by policymakers, Shariah boards and management of IFIs.
Investments
In order to maintain liquidity conventional banks have many avenues including government securities, shorter term loans and money at call and short notices, leasing companies' bonds, investment in shares etc. Interestingly mandatory reserve maintenance by conventional banks with central banks is also rewarded in the form of interest. Conventional banks can also create liquidity by issuing the bonds against their receivables. Commercial banks are also protected by central bank by providing liquidity in rainy days for interest. Interbank deposits are also rewarded in the form of interest by commercial banks. For IFIs avenues are very limited to create required liquidity at the same time to earn some revenue by investing in short term and liquid securities. IFIs cannot invest in government securities, short term loans, bonds and money at call and short notices because of interest based transactions. Mandatory reserve with central bank is maintained by IFIs but they are not rewarded like conventional banks. Looking towards central bank in rainy days to maintain liquidity is also not as straightforward due to interest demand of central bank. IFIs cannot demand interest on interbank deposits. As for investment in market able securities are concerned again IFIs are not free to invest in any equity security due to two reasons. First Halal business of the underlying firm is required. Second financial operations of underlying firm should be interest free. Keeping in view the dominance of conventional banking and existing business practices one can conclude safely that a very negligible number of firms meet both conditions. IFIs can invest only in those securities which are declared Shariah compliant securities through filtering of Shariah compliance criteria.
Table 2.2 below shows the number of local banks and finance companies in 1980s until late 1990s that was the prior to the merger between the commercial banks and respective finance arms.
Table 2.2 Financial institution in Malaysia in 1980s until late 1990s
Financial institutions 1980 1990 1999 2009
Commercial banks 21 22 21 22
Finance companies 47 45 23 28
Islamic banks - 1 2 15
TOTAL 68 68 46 65
(source : Annual Report BNM 1999 and monthly statistical bulletin 2009)
On 14 February 2000, BNM has confirmed its approval of 10 large banking groups with the acquirers and their respective targets (Rubi, 2007). Each groups consisted of at least a commercial bank, a finance company and a merchant bank.
On 31 May 2006, Bumiputra-Commerce Holdings Berhad, and Southern Bank Berhad have merged their businesses and marked as the Malaysia's final and largest domestic banking in history. The new merged entity is renamed as CIMB Bank Bhd.
Overview on Islamic banking in Malaysia
In Malaysia, Islamic banking is provided in dual banking environment. This means that the Islamic banking system operates in parallel with the conventional banking system. Since Islamic banking does not prohibit participation by non-Muslims its potential for further growth is tremendous.
The Islamic Banking Act 1983 defines Islamic banking business as banking business whose aims and operations do not involve any element which is prohibited by the religion of Islam. On the other hand, Ali and Sakar (1995) has defined Islamic banks as financial institution whose statues, rules and procedures expressly state that its commitment to the principle of Shariah and to the banning of the receipt and payment of interest on any of its operations. Therefore, Islamic banks are also commercial banks, which are alternatives to the conventional banking system and guided by mainly some key religious principles.
In full-fledge Islamic branch is only allowed to :
Accept and withdraw deposit from conventional account
Accept payment for the conventional loan
In the words, in addition to offerings Islamic products and services, full-fledge Islamic branches shall only be used as delivery channels for conventional banking transactions (if any).
2.4 Development of Islamic banking in Malaysia
The journey of Islamic banking in Malaysia began with the establishment of Bank Islam Malaysia Berhad (BIMB), which commenced its operations on 1 July 1983. During the first 10 years of its operations, the bank was given a privilege to be the sole Islamic bank operating in Malaysia as to allow the bank to operate in a smooth manner without undue the competition that might hinder the progress of Islamic banking.
In March 1993, Bank Negara Malaysia (BNM) has allowed all commercial banks, merchant banks, and finance companies to offer Islamic products and service via scheme known as 'Skim Perbankan Tanpa Faedah' or 'Interest-free Banking Scheme' (often known as Islamic windows). The second full-fledge Islamic bank i.e. Bank Muamalat commenced its operations on 1 October 1999. Today, in addition to Bank Islam and Bank Mualmalat, all the local conventional banks with Islamic banking windows have now migrated their Islamic operations to full licensed Islamic bank status as shown in table 2.3 below.
Table 2.3 List of Islamic subsidiary banks and their parent bank
No
Parent bank
Islamic subsidiary bank
Commence-ment date
1
2
3
4
5
6
7
8
Affin Bank Bhd
Alliance Bank Malaysia Bhd
AmBank (M) Bhd
CIMB Bank Bhd
Hong Leong Bank Bhd
Malayan Banking Bhd
Public Bank Bhd
RHB Bank Bhd
Affin Islamic Bank Bhd
Alliance Islamic Bank Bhd
AmIslamic Bank Bhd
CIMB Islamic Bank Bhd
Hong Leong Islamic Bank Bhd
Maybank Islamic Bhd
Public Islamic Bank Bhd
RHB Islamic Bank Bhd
1 April 2006
1 April 2008
1 May 2006
8 March 2005
28 March 2005
1 January 2008
1 Nov 2008
1 March 2005
However, to a certain extent, the Islamic subsidiary bank is also sharing the same resources, system, personnel, platform including branches and marketing strategies with the parent bank. In lately May 2011, EON Bank Group, consisting of EON Bank Berhad, EONCAP Islamic Bank Berhad and MIMB Investment Bank Berhad are now part of Hong Leong Bank Group and not listed as bank in Malaysia anymore, but it will appear in Hong Leong Bank Berhad report as a part of Hong Leong Bank Berhad..
With the liberalization of the financial system, BNM has also issued Islamic banking licenses to foreign banking players to establish Islamic financial institutions since 2004 as shown in table 2.4 below.
Table 2.4 List of foreign Islamic banks in Malaysia
No
Banks
Commencement date
1
2
3
4
5
6
Al Rajhi Banking & Investment Corporation (Malaysia) Berhad
Asian Finance Bank Berhad
HSBC Amanah Malaysia Berhad
Kuwait Finance House (Malaysia) Berhad
OCBC Al-Amin Bank Berhad
Standard Chartered Saadiq Berhad
16 October 2006
28 November 2005
26 February 2008
25 August 2005
21 May 2008
30 June 2008
With that Malaysia has a total of 16 Islamic banks as at 31 December 2011 which made her one of the countries with highest number of Islamic banks in the world.
Table 2.5 Summary of presence Islamic banks in Malaysia
No
Banks
No of banks
Local full-fledge Islamic banks
Local Islamic subsidiary banks
Foreign Islamic banks
TOTAL
2
8
6
16
In summary, Malaysia currently has 43 commercial and Islamic banks i.e. 27 commercial banks and 16 Islamic banks as shown in table 1.1 before.
The key element of Islamic banking is not just the interest free receipt and use of funds. One of the most important elements of Islamic banking or finance is the concept of profit and loss sharing. Based on the profit and loss sharing principles, there are various types of Islamic financial instruments available in the market. Some of the instruments are equity like contracts and some of them are debt like contracts. Musharakah (partnership) and mudharabah (trust financing) are the equity like products. On the other hand, the debt type contracts products are murabahah (cost-plus financing), ijarah (leasing), bay bithaman ajil (deferred payment financing), istisna'a (progressive payment) and qarè al-úasan (benevolent loan). There is a large literature available as to how these financial products work and can replace the provision of interest (Siddiqi, 1983a; Ahmad, 1984; Iqbal and Mirakhor, 1987; Ahmad, 1987)
Today, Malaysia is widely believed to have the most developed Islamic financial system in the world that operates side by side with a conventional banking system. Besides the Interest-free Banking Scheme, Malaysia has a well-developed Islamic interbank money market, Islamic government debt securities market, and Islamic insurance market. The Islamic interbank money market, introduced in January 1994, allows Islamic banking institutions to trade in designated Islamic financial instruments among themselves.
The Mudarabah Interbank Investments (MII) mechanism, moreover, allows a deficit Islamic banking institution to obtain investment from a surplus Islamic banking institution on a mudarabah (profit sharing) basis. The Government Investment Issues (GII) market, which was introduced in 1983, is the Islamic equivalent of a conventional Treasury bill and bond market. Islamic insurance, or takaful, was first introduced in 1985 when the first takaful operator was established to fulfil the public's need for insurance products that are Shariah compliant.
Although Islamic banking is said to have made significant inroads in Malaysia, some find that, in practice, the adoption of the PLS paradigm of Islamic banking in Malaysia has been much slower on the asset side than on the liability side. Table 1 provides a breakdown of the types of Islamic financing and Islamic deposits in Malaysia. Total financing in the Islamic banking sector amounts to RM57.9 billion as of the end of 2004. The Islamic banking sector, in general, has been expanding much more rapidly than the conventional banking sector. This has resulted in an expansion of the market share for Islamic financing to 11.3% of total banking sector financing as of the end of 2004 (Beng Soon Chong and Ming Hua Liu, 2005).
2.5 Chapter summary
This chapter has summarized the journey of the evolution of Malaysian banking industry as well as highlighting the development of Islamic banking in this nation. This chapter also reiterates the relationship between conventional bank and Islamic subsidiaries as well as pointing out the distinguish features. In summary, Islamic banking has surpassed the infant stage as their foundation has been built for more than two decades in Malaysia. In fact, Islamic banking has emerged as rapidly growing alternative system of financial management in Muslim countries as well as in the western world.
