Overview of Islamic Banking & Finance in Malaysia

By:
Prof. Dr. Mohd. Ma’sum Billah
masum@applied-islamicfinance.com
masum2001@yahoo.com
+6019-3699542

INTRODUCTION

Nowadays Islamic economy has succeeded to exclude conventional ideas such as capitalism and inequalities of distribution of human properties. Islamic Banking and Finance have become the main practice of Muslims society and well accepted by the non-Muslims in order to achieve equality in economic transactions. The main objective of Islamic Banking and Finance are related to realization and awareness to the need of balance and harmony between moral and material in human society. This is supported by Surah Al-Baqarah in verse 188 that:

“And do not eat up your property among yourselves for vanities”

The concept of Islamic Banking and Finance has long existed before the conventional banking system. Many claimed, trading activities are found by the Europeans. But how far this statement is true? There are many evidences that the Muslims in the Middle East firstly practiced Islamic finance . In Spain and Mediterranean, Muslim traders are the middlemen for their business events and transactions. Moreover, the European financiers and businessman later adopted concepts, techniques and instrument of Islamic Banks and Finance. So far Islamic Banking and Finance concepts continues to grow due to its value oriented principles, which enables it to draw finances from both Muslim and non-Muslim.

The main purpose of Islamic Banking is to prohibit ‘Riba’ . As a financial institution, Islamic Banking has identified itself with the principle or spirit of Shariah and introduced a scheme known as ‘Interest-free Banking Scheme’ . For instance, one of finance practiced by the Islamic Banking is ‘interest free loan’ (Qard Hasanah) whereby loan is given without the need of paying back the loan that being charge on the administration cost or other related cost. Additionally, Surah Al-Imran in verse 130 stated the prohibition and refused to admit ‘Riba’ as a kind of fair business transaction.

“O ye who believe! Devour not usury, doubled and multiplied; but fear God; that ye may (really) prosper”

Either than prohibition of ‘Riba’, the important criteria in Islamic Banking is, making money from money is not islamically acceptable. It means money is a medium of exchange. Thus, it is not allowed to give raise to more money via fixed interest payments. According to Imam Al-Ghazali, when money is exchanged for money or of the same denomination or measure of value, it should never be made an instrument generating profit by such exchange. Secondly, Islamic Finance is based on the belief that the provider of capital (Bank) and user of capital (borrower) should equally share the risk of business ventures. This is totally opposite to the interest based commercial banking system, where all pressure is on the borrower. The borrower must pay back his loan, with the agreed interest, regardless of the success or failure of his venture.

Construction of a casino, trades in alcohol are examples of business ventures that would not be financed by an Islamic Bank. Above are some of the overview on the principles in Islamic Banking and Finance.

In Malaysia, Bank Islam Malaysia Berhad (BIMB) was the first Islamic Banking established on 1983. The rules and regulations that Malaysia has adopted to operate Islamic Banking and Finance were based on Shariah principles and incorporated under Companies Act 1965. More than that, Bank Negara Malaysia (BNM) will administer the Islamic Banking Act 1983 (IBA) to supervise and regulate Islamic Banks and Compulsory Religious Supervisory Council to ensure its compliance . The long-term objective of Bank Negara Malaysia (BNM) is to create an Islamic banking system operating on similar basis with the conventional banking system.

This term paper will discuss on the evolvement of Islamic Banking and Finance Malaysian corporate sector. The past, present and future of Islamic Banking and Finance and its practical scenarios was discussed in this paper in order to give a clear view on the operation of Islamic Banking and Finance in Malaysia.

CENTRAL IDEA

Islamic Banks that are common in Muslim countries are now developing in western countries as well. The philosophies and principles practiced in Islamic Banks are not new. It has been outlined in the Holy Quran and Sunnah of Prophet Muhammad (PBUH), more than 1400 years ago.

In Malaysia, separate Islamic Legislation and banking regulation exits in order to distinguish between the regulations of the conventional banking system. On 7th April 1983, Islamic Banking Act (IBA), the legal basis for the establishment of investment bankers came into effect. It gives Bank Negara Malaysia power or authority to supervise and regulate Islamic Banks. On 1st July 1983, Bank Islam Malaysia Berhad (BIMB) commenced its operations as the first Islamic Bank in the country. The objective of the banking activities is based on Shariah rules and principles.

But the first Islamic Financial Institution was established in the era of the 60’s. Muslim pilgrims Saving Corporation was set up in 1963 to help people safe for performing Haj. In 1969, this body evolved into Pilgrims Management Board, which is better known as Tabung Haji. Tabung Haji acted as a finance company that invests the money of the pilgrims of Haj concurrently in line with the Shariah. Its scope is rather limited. However, this non-bank financial institution provided the main impetus for the establishment of BIMB. Moreover, Tabung Haji provides 12.5% of BIMB initial capital of 80 million.

There was no other Islamic Banking established except BIMB. This is to ensure that the system works effectively and to gain the trust of users. BIMB are being governed by BNM with accordance to the IBA. The operation of BIMB was about 10 years and it shows that the system works. In Jan 17, 1992, BIMB was listed in the KLSE. It has now, restructuring the management in order to upgrade and opening branches throughout the country.

In the creation of Islamic Bank, it has still to satisfy users because of the limitation of branches on knowledge. It also needs to justify and strongly follow the rules and regulation sets down by Islamic Scholar concerning the operations.

The introduction of Islamic system in banking throughout the country has resulted in success. Therefore, Bank Negara Malaysia (BNM) has come out with ‘Interest-free Banking’ scheme that would allow other conventional banks to adopt the system and follow the operations set. This is a voluntary option for financial banks to either operate the Islamic system or not. The ‘Interest-free Banking’ scheme has resulted into a massive demand on Islamic Banking system on conventional banks.

The conventional banks that offer Islamic Banking system are governed by BNM and need to follow the rules stated by BNM. Furthermore, all the Islamic accounts or investment has to be kept separated with the conventional account.

The attractiveness of Islamic Banking has persuaded the non-Islamic bank intermediaries to improve their systems into Islamic banking sector. Both Conventional and Islamic Banks have practiced efficiently the concept of Murabahah and Mudharabah. The verses that give general permissibility on exercising concept of Murabahah and Mudharabah is An-Nisa : 29

“O you who believe! Eat not up your property among yourself unjustly except it be a trade amongst you, by mutual consent…”

Other than that Shariah ruling associated with Mudharabah mentioned in Surah Al-Baqarah: 198,

“There is no sin on you if you seek the Bounty of your Lord (during pilgrimage by trading)…”

Besides that in order to increase the demand of Islamic Banking, certain product incentives of development also has been included in the system. The examples are ijarah facilities, acceptance of Islamic repo and the offer of hibah or returns.

The requirement of Islamic Bank according to IBA 1983 requires the bank to appoint a Shariah advisor to advice on Shariah ruling concerning the transaction. In order to avoid differences of opinion and confusion, BNM has appointed the National Shariah Advisory council that will be the sole authoritative body to advice, co-ordinate Shariah issues, to analyze and evaluate the Shariah aspects concerning the system.

The attractiveness of Islamic Banking has persuaded the non-Islamic bank intermediaries to improve their systems into Islamic banking sector. The group institution is; takaful company, saving institution, the development financial institution and other financial intermediaries, which offer Islamic banking service, example: housing credit installment.

The growing needs of Islamic Bank has move towards the establishment of Islamic capital market that comprises of primary market, which involves on government Islamic securities and the Islamic corporation sector offer to public and institution and secondary market, whereby deals with existing government papers and Islamic corporation sector are traded.

The emergence of Takaful was in the early 80s.in 1982, the Task Force to study the establishment of an Islamic Insurance Company was formed. This group is formed in order to study the needs of Islamic Insurance to cater for the muslim.

Moreover, the parliament has enacted the Takaful Act 1984. And in Nov 1984, the first Takaful operator, Syarikat Takaful Malaysia Sdn Bhd (STMB) was incorporated.

The regulatory and supervisory of the Takaful industries are given to the BNM bby the government. This is to ensure the standards are met and also the public interests are being entertained.

The Malaysian models of Islamic insurance are divided into 3 categories, takaful, mudharabah and tabarru’. These are the main principle used in islamic insurance. There will be no element of riba occur in Islamic insurance.

All of the operation of takaful are govern by the Takaful Act 1984. the concept of takaful is in line with the principle of compensation and shared responsibilities among community.

The result of the emergence of Islamic Banking and Finance in Malaysia signifies the development of Islamic economic and awareness of Islam in the new era of globalization. Islamic financial institutions have been growing not only in Islamic countries but also in non-Muslim countries. This can be seen by a greater interest of non-Muslim toward Shariah based transactions that to be competitive as conventional business transactions.

Nowadays existing Islamic banks have improved their performance and continued to focus on commercial banking, trade financing and leasing. More than that the Islamic banks need to the expansion of develop financial opportunities that may attract and satisfy the entire community internationally. In Malaysia, Islamic Bank and Finance have been operated based on these opportunities as an effective supervision compared to conventional practices. However lack of knowledge on the fundamentals of Shariah principles by non-Muslim and Muslim itself could be a hindrance to this expansion of Islamic Bank and Finance. In order to face this challenge, the community entirely especially the employees of Islamic Bank and Finance should be trained and exposed to the Islamic study such Usul-Fiqh, Fiqh Mualamat and others that upgrade their technically knowledge and skills.

In term of distribution channels, even though Islamic Banking and Finance have increasingly grown but still the number is insignificant. Lack of promotion on these institutions is due to inappropriate distribution channels that need to be overcome. Under commercial business, the ‘on-line services’ has been widely used as a part of financial transactions and in line with era of information technology. However Islamic Bank and Finance in Malaysia are still left behind and it is not sufficient with its website on promoting services provided. Islamic Bank and Finance especially the takaful are required to operate with well-established finance companies and merchant banks windows side by side with the conventional system. By this Islamic Bank and Finance may develop in good extent of Information Technology in each business process, complexity of the entity’s computer operations and organizational structure based on Shariah principles.

Another challenges facing Islamic Banking and Finance is the non-suitable environment of Muslims and non-Muslims. This mostly happens in non-Muslim countries. Malaysia is very fortunate as it involved in the early stage of the formation of Islamic Banking and Finance systems. The separate legislation and banking regulations such Islamic Banking Act and Government Investment Certificate (GIC) that based on Shariah principles were used to supervise and regulate Islamic banks. Moreover, in finance, Malaysia has a particular act passed by parliament governing Takaful known as the Takaful Act 1984. Moreover, BIMB holds 74.25% of Syarikat Takaful Malaysia Berhad’s takaful division. The government supports is always needed by Islamic Banking and Finance in order to create long-term demand of community and to convince that Islamic Banking and Finance offers a better alternatives to all people today and future without being biased.

Globalization and liberalization of financial services is another challenge facing Islamic Banking and Finance in the future. Now a day it already has been difficult for Islamic institutions to open up their banking and finance such insurance and securities market to foreign competition. In Malaysia itself, the Islamic Bank and Finance must be creative and search new and efficient solutions to match foreign competition. They need to develop its assets and get response that would have the knowledge and skills not only in management, financial and technical aspects but also with Shariah matters.

Not only that, according to a report by M.Banking in Europe 2000, more than 16 million of mobile phone users will be using mobile phone banking by the year 2004. Hence, this type of banking will be introduced into Islamic banking system very soon as the number of registered customers are rising with a daily average of 5000 people.

PRACTICAL SCENARIO

So far this paper have touched in detail on the general view of what Islamic Banking is really about and the evolution approach of Islamic Banking from years to future expectations.

Now this paper will go further detail to discuss the application of this Islamic Banking concept on daily scenarios. For this, both Bank Muamalat and Bank Islam are taken as sample studies for discussion. The services provided by these banks will be compared against the conventional concept of banking. At the end of the paper, it will notify which banking tends to provide benefit for the maslahah of the public rather than being a profit seeking institution. The distinction between conventional and Islamic concept of providing services will be clearly shown with the assistance of diagrams.

Since services provided by both banks are too wide, only few services will be considered in the study. Among the services picked are Current and Savings Account, Fixed Asset Financing and Letter of Credit.

There are three main accounts that is considered as deposits in the banking and financial system for the Malaysian corporate sector. They are saving account, current account and Mudharabah. Basically, users of banks will either choose these three accounts for different benefit each encounter.

The main objective of saving and current account is the same for both but the concept acquire by Conventional and Islamic Banking has a difference. The main difference is the term of dividend given by the conventional banks. From Islamic perspective, it is considered as Riba. Islamic banks give depositors hibah as a gift for depositing money to the bank. There is a difference between interest and hibah that need to be clarified.

It is important to know the source of the money that is being deposited by the depositor as it may contain from an unlawful source. The Conventional banks may also be involved in an unlawful transactions or investments. This will effect the distribution of the earnings between the Muslims and the non-Muslims. This is what we called dividend in a form of Riba.

For Islamic banks, the saving and current account holders will be given hibah at the end of each month with accordance to the balance in the account of the respective month. Hibah will be distributed based on the performance of the Bank. The difference here is concerning the current accounts. In Islamic banks the current accounts are given hibah plus a service charge of RM 10 per 6 month but for the conventional banks for the current accounts they were not given any dividend plus they have to pay the service tax provided by the bank. Therefore, this is one of the reason why non Muslims prefer Islamic current accounts rather than the conventional.

In conventional bank, the customer will inform the financial institution that is Bank about the Car Company the customer had made an agreement with. Later, the Bank will settle full costs of the car in lump sum to the Car Company. Thirdly, the Car Company will deliver the car to that particular customer and hence the customer will acquire the asset. And finally, the customer will pay back to the Bank the monthly installment of the car plus interest. Both parties will agree the amount of installment.

In Islamic bank that is Muamalat Bank, Islamic fixed asset financing is based on the BBA concept. This type of financing applies when the bank purchases the asset on behalf of the customer at cost price. Later, the bank will sell the asset to that particular customer at a cost plus profit selling price .The profit means as service charge for utilizing the fund and for management costs. The payments are made on deferred payment basis at the duration and price agreed by both parties, which later repayable by fixed installments.

In trade financing, both conventional and Islamic Banking provide service of ‘Letter of Credit’. Although Islamic Letter of Credit is much similar to conventional Letter of Credit there is a difference in term of service rendered to the client. Islamic banks offer various type of contract under Letter of Credit such as Letter of Credit under Wakalah, Musyarakah and Murabahah. However conventional banks offer merely one type of product that is Letter of Credit. In this term paper it will focus on Letter of Credit under contract of Wakalah as it has not been practiced and offered in any conventional banks.

In conventional bank, the Letter of Credit is a letter undertaken by the bank to pay the seller of goods interested by the client. The bank pay at sight or future date the stated amount of money in accordance to the time limit and against stipulated documents and compliance of terms and conditions in Letter of Credit. Actually, this Letter of Credit provides security by ensuring goods and documents are in order before payment. At the same time, the seller retains control of the goods until he is paid. In this scenario, bank will advance the money to the seller based on the Letter of Credit established by the bank. After received payment from the bank, the seller will send the specified goods to the client. Bank will issue documents provide service charge and tax and amount owed by the client. The client needs to settle amount due to him at maturity date plus interest imposed by conventional bank.

Meanwhile, Al Wakalah refers to any agency relationship where a bank acts as an agent on behalf of the client. Letter of Credit is written undertaking by the bank at the request to provide payment to a third party of the client’s choice.

In Islamic banking operation, the client has to place a full amount of deposit of the price of goods to be purchased to the bank under the contract of Wadiah. Later, bank establishes the Letter of Credit and pays the proceeds from the client’s deposit to the negotiating seller (beneficiary) at a certain sum of money provided. The seller will comply with the terms and conditions stated in the Letter of Credit. Subsequently bank releases the document to the customer on fees and commission for its service under the principal of Al Ujr (fee). In this event there is no financing from the bank but acts as agent to the client. Al Ujr is a contract which one party undertakes to pay a specified amount of money to another for rendering a specified service in accordance with the term agreed between them.

The diagram below shows the ‘Letter of Credit under Contract of Wakalah’ issued by Islamic banks: -

The advantages of exercising the letter of credit under contract of Wakalah are to ensure buyer receives merchandise on time and payment made upon receipt of complied document.

One more practice that distinguishes Islamic Banking system from Conventional is the treatment of a bankrupt debtor. If he is found to be bankrupt, all his assets will be auctioned in order to satisfy his creditors. This is from the conventional part. Meanwhile, from Islamic point of view, zakat fund of the Islamic Banks will help the muflis. So, there will be no auction of assets of the muflis unless he surrenders himself. Therefore, this explicitly shows the beauty of Islamic Banking system in protecting its ummah.

FINANCIAL INSTITUTIONS IN MALAYSIA

The Islamic banks are not the only financial institutions involved in Islamic banking. Other financial institutions also offer Islamic banking services through the "Islamic Banking Scheme".

Islamic Banks

Commercial Banks

Finance Companies

Merchant Banks

Discount Houses

STATISTICAL DATA

RECOMMENDATION/IMPROVEMENT

The improvement can be seen in Islamic deposits is the contribution of non-Muslims in depositing their money in Islamic Banks. The main points, is to decide the source of money from the non-Muslim depositor. Whether it is derived from their income or other form source, and if it is from their income, they must also confirm that the money deposited is from lawful transactions. The reason for obtaining information of the source of money is because the money from non-Muslim will be added with the Muslim saver in the Islamic banks. Therefore, if the source is unlawful then it will affect the Muslim deposit too as the investment were added together and hence the circulation of money will not consists purely Islamic funds.

In order to enhanced the fixed asset transaction, the payment of principle plus profit should be flexible in the sense that if the customer would want to request for a shorter duration of installment. The concern here is should the profit margin change if the installment duration is rescheduled? If the payments are made earlier than the schedule, it is advisable for Islamic bank to reduce part of their profit as incentives based on the prophet SAW hadith, ‘reduce of debt and let them pay earlier’.

The issue arises in the letter of credit is concerning service charge imposed by the banks. Although both conventional and Islamic bank impose service charge in the letter of credit was based on ABM Rule (Association of Bankers in Malaysia) it is advisable for Islamic bank to state that the fees and commission (service charge) charged to the client are for the maintenance and management skill contribute by the bank. By this, service charge is known and considered allowable and this has been mentioned by Prophet SAW that “whoever hire a worker, inform him of his wage”.

In addition to the emergence of electronic commerce and online banking services, Islamic-banking system is lagging far behind. Islamic banking should create new online services for the convenience of their customers. Unlike Islamic banking, conventional banking provides services for depositors to check individual account balances and to get well informed on any latest news and events concerning their bank and accounts. So, Islamic banking too should create and develop latest services with latest technologies for their depositors.

CONCLUSION

Today, more than 100 Islamic banks operating in 40 countries worldwide. Islamic Banking also regarded as the fastest growing sector in the Middle East. But there are some problems faced by the banking system currently. It is highlighted by Professor Felix Pomeranz in his article titled ‘The Accounting and Auditing Organization for Islamic Financial Instrument’. He clarifies that, most Islamic deposits are said to be short term, resulting in mismatch with long-term investment. He further argues that, these conditions may due to an absence of a sufficient number of wealthy deposits, inability to borrow in interbank markets and depositors increasing earnings expectations.

Meanwhile, economists, Abdul Wassay Haqiqi elaborated that, lack of a deposit insurance system is another problem faced by Islamic Banking and Finance. He explained further that, the lack of such a system becomes more grave. It is because Islamic Banking generally does not have standard measures of reserve requirement or liquidity ratios.

Furthermore, there is an argument saying that, service charge imposed by the Islamic banks is equivalent or same as interest charge charged by the conventional banks. Is it true? This question arises due to lack of understanding by the public on the practical and practices conducted by Islamic banks. Service charge is not a fixed amount. It is imposed on two grounds. Firstly it is imposed for the money utilized by the user. This is because if the money is not borrowed, the Bank may use that money for investment purposes. Here, the service charge acts as compensation costs. Secondly, it is charged as an operating or management costs for managing the fund .So there is definitely a clear distinction between service charge and interest charge.

inally, this paper successfully concludes that, Islamic Banking and Finance is the only banking system, which runs or complies with the shariah principles. Hence, it is not a surprise to hear that more non-Muslims are interested to engage in this banking system. By practicing this Islamic system in our daily life, we may be protected or gain benefit in the eyes of Allah for complying rules and regulations as in the Holy books of Allah. Allah knows best.