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Bachelor Thesis - Islamic Banking

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Bachelor Thesis - Islamic Banking

  1. 1. University of Economics in Prague Faculty of Finance and Accounting Department of Banking and Insurance Study program: Banking and Insurance Islamic banking Author: Jakub Bláha Supervisor: Ing. Vladislav Vacek Year of defence: 2014
  2. 2. Declaration: I hereby declare that this bachelor thesis is my own work and that the information I used has been fully acknowledged in the text and listed in the bibliography. Prague, date: ...……………………….. Jakub Bláha
  3. 3. Acknowledgments: I would like to thank the supervisor of my bachelor thesis, Ing. Vladislav Vacek for his helpfulness, stimulating suggestions, reminders and patiance. Poděkování Na tomto místě bych rád poděkoval vedoucímu své bakalářské práce, Ing. Vladislavu Vackovi za vstřícnost, podnětné rady, připomínky a trpělivost.
  4. 4. Annotation: The aim of this bachelor thesis is to introduce the Islamic banking. Describing historical and religious background of Islam, the Islamic banking and Shari’ah law. Then presenting financing techniques used in the Islamic banking. Eventually describing and analysing the Islamic banking in Malaysia. Comparison between the Islamic banking and the conventional banking is given throughout the bachelor thesis. Key words: Islamic banking, Islam, Shari’ah, financing techniques, Malaysia, conventional banking Anotace: Cílem této bakalářské práce je představit islámské bankovnictví. Popsat historické a náboženské pozadí Islámu, islámského bankovnictví a práva Šaría. Poté prezentovat techniky financování používané v islámském bankovnictví. Nakonec popsat a analyzovat islámské bankovnictví v Malajsii. Srovnání mezi islámským a konvenčním bankovnictví je poskytnuto v průběhu celé bakalářské práce. Klíčová slova: islámské bankovnictví, Islám, Šaría, techniky financování, Malajsie, konvenční bankovnictví
  5. 5. Contents Introduction............................................................................................................................................. 7 1 The Islamic banking Framework...................................................................................................... 9 1.1 Historical background of Islam............................................................................................... 9 1.2 Religious background of Islam ............................................................................................. 11 1.2.1 Beliefs (Aqidah):............................................................................................................ 11 1.2.2 Morals (Akhlaq): ........................................................................................................... 11 1.2.3 Duties (Sharia’ah): ........................................................................................................ 12 1.3 Shariah .................................................................................................................................. 12 1.3.1 Man-to-man activities (Muamalat Ammah): .............................................................. 12 1.3.2 Sharia’ah in Islamic banking:........................................................................................ 13 1.4 Prohibitions in Islam............................................................................................................. 13 1.4.1 Halal and Haram........................................................................................................... 13 1.4.2 Riba (Prohibiton againts interest):............................................................................... 14 1.4.3 Gharar (prohibition against uncertainty): ................................................................... 14 1.4.4 Maysir (prohibition against gambling):........................................................................ 15 2 Techniques of financing in the Islamic banking............................................................................. 16 2.1 Profit loss sharing techniques .............................................................................................. 16 2.1.1 Mudaraba...................................................................................................................... 16 2.1.2 Musharaka .................................................................................................................... 17 2.2 Profit mark – up techniques................................................................................................. 19 2.2.1 Murabaha...................................................................................................................... 19 2.2.2 Ijarah ............................................................................................................................. 19 2.2.3 Istisna ............................................................................................................................ 20 2.2.4 Salam............................................................................................................................. 21 2.3 Sukuk..................................................................................................................................... 21 2.4 Takaful................................................................................................................................... 24 2.5 Zakat...................................................................................................................................... 26
  6. 6. 2.6 Current and Saving Accounts ............................................................................................... 26 3 Comparison of growth of islamic and conventional banking in the example of Malaysia............ 28 3.1 Introduction of practical example........................................................................................ 28 3.2 Malaysian Islamic financial sector ....................................................................................... 28 3.3 Comparison of asset growth and profitability..................................................................... 30 3.3.1 Asset growth comparison............................................................................................. 30 3.3.2 Profitability comparison............................................................................................... 35 3.3.3 Analysis summary......................................................................................................... 38 Conclusion ............................................................................................................................................. 40 4 Bibliography................................................................................................................................... 42 5 Annex............................................................................................................................................. 42
  7. 7. Introduction Islamic finance or more commonly used term Islamic banking has been shaping itself and the economies it serves for almost five decades. It has begun to spread after decolonisation in Egypt and in Malaysia, and then after being internationally acknowledged in 1973 by Muslim community in the form of the Islamic Development bank, it was clear that Islamic countries wanted for their citizens a financial system that would be simply in harmony with their daily life activities, their beliefs, their morals, just in harmony with their religion, Islam. The Islamic banking has started to gain greater popularity and recognition during and after the Financial crisis of 2008 which shown big imbalances in the global economy. For being more conservative than the conventional banking, the Islamic banking proved more resilient. In the established Shari’ah law legal framework equity risk sharing is encouraged instead of debt financing, riba (interest) is prohibited as well as speculation. With more than billion Muslims across the world, the market for Islamic finance is huge and because Islamic banks were built as retail banks, they were again more stable not being exposed to corporate sector. Being the fastest growing financial industry in the world, the Islamic banking is now attracting attention not only in Arabic or South-Asian countries, Europe itself has immense Muslim community which demands islamic financial products. But Islamic banks serve non-Muslims the same as Muslims offering an alternative to those seeking new ways for handling their finances1 . The first chapter of this thesis is introducing Islam not only as a religion but also as a way of living a life. Providing a description of historical background since the foundation of Islam to its presence, then a description of religious background with focus on Shari’ah which means duties to God and other men and prohibitions which are very important in the Islamic banking approach. The second chapter aims to describe islamic techniques of Shari’ah compliant financing that are either profit and loss sharing or with a profit mark-up. As well as presenting sukuk, takaful, zakat and forms of current and saving accounts. 1 IMF Survey: Islamic Banks: More resilient to crisis?. International Monetary Fund [online]. [cit. 2014-05-17]. Dostupné z: https://www.imf.org/external/pubs/ft/survey/so/2010/RES100410A.htm
  8. 8. The last chapter is introducing the Islamic banking in one of the most pioneer countries, Malaysia. The goal of the practical example is to characterize the development of the Malaysian Islamic financial sector with a hypothesis – Is the Islamic banking really growing more rapidly then the conventional banking in Malaysia? An analysis of asset growth and profitability between Islamic and conventional banks in Malaysia will be provided supplemented with own reasoning. The overall aim of this bachelor thesis is to introduce and compare the Islamic banking with the conventional western banking in its approaches to financing. Throughout this bachelor thesis only online sources and international eBooks were used mainly from ebrary Business & Economics provided by the Universty of Economics in Prague. Online sources consist of studies of International Monetary Fund and Ernst & Young company, then of websites of certain Islamic banks and institutions such as the Islamic Development Bank, Bank Negara Malaysia etc. Basic ratios of asset growth and profitability used in the analysis ware taken from a study made by Ernst & Young. The analysis itself was created on the basis of statements of financial position and statements of income according to IFRS2 . Ratios of total assets, equity and profit/loss for a certain year were used for the charts. This topis was chosen because of my interest in new alternative ways of financial systems. The Islamic banking is quintessentially based on solidarity which is, in my opinion, a path that should be followed hand-in-hand with competition to create more equitable and resilient economies. 2 International Financial Reporting Standards
  9. 9. 1 The Islamic banking Framework To fully understand and describe the world of islamic finance, we need to look to the history and at the basic religious principles which has been shaping this approach to finance in general for almost fifty years. 1.1 Historical background of Islam Islam is an Arabic word which means ‚peace and submission to Allah‘. A follower of Islam is called a Muslim. A Muslim strives to live in peace and harmony with the Creator, one self, other people and the environment. (Abdullah & Chee, 2010, p. 55) It all began when Allah revealed himself to prophet Mohammed through archangel Gabriel in 610 in Mecca. This revelation continued for 23 years until Mohammed’s death at the age of 63 and it is known as the Holy Koran. During that time Mohammed and his followers were forced to flee Mecca. They left for Medina, this event marks the beginning of the Muslim calendar. Before they were allowed to return to Mecca to finally establish the new religion, most of Arabia was Muslim. Muslims then divided into two groups that are called Sunni and Shiite. Sunni, when translated meaning tradition, recognise four schools of theological law – Hanbali, Shafi’i, Maliki and Hanafi and accepts that caliphs are the successors of Mohammed because he chose them himself. 85% of Muslims are Sunni, when each school accepts the validity of the other three and a Muslim can choose any one of them. Shiite is the second group counting for 15% of Muslims. Shiite believes that any leader of Muslims has to be a direct descendant of Mohammed’s daughter Fatima and her husband Ali3 . 3 CHEE, Daud Vicary Abdullah and Keon. Islamic finance why it makes sense [online]. Singapore: Marshall Cavendish Business [cit. 2014-03-29]. ISBN 978-981-4312-448.
  10. 10. The reason why the islamic financial system has not been developing for a much more longer period is that most of the islamic world was colonised by european nations. European masters came with their own traditions, current western financial system being one of them. After decolonisation in the second half of the 20th century, muslim countries started to create institutions that would serve them as normal banks do but which would be in compliance with their religion and beliefs. First two banks were set up in 1963 in Egypt and Malaysia mainly to offer a possibility for Muslims to save up for a voayge to Mecca4 . In 1975 the Islamic Development Bank was established by the international community of muslim countries as a reaction to the 1973 oil shock5 . The purpose of the Bank is to foster the economic development and social progress of member countries and Muslim communities individually as well as jointly in accordance with the principles of Shari'ah i.e., Islamic Law (About IDB: Islamic Development Bank, 2014). Since then the IDB has been helping to create new islamic institutions around the world. To develop an international stable financial system, islamic institutions, especially banks, needed to standardize their practices because scholars can have different opinions on what is Shari’ah compliant and what is not. So the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), the Islamic Financial Services Board (IFSB) and the organisation of International Islamic Financial Market (IIFM) were created to issue standards on accounting, to regulate and supervise the markets and to standardise the products and their marketability respectively. The 2008 Subprime crisis had a major influence on the development of islamic finance. As liquidity freezed, capital of many banks declined and credit was difficult to obtain. This was the time when islamic financial institutions stroke. First advantage was cheap capital as Arabic countries owe huge sources of oil. Then they has been creating and adjusting products which are similar to conventional ones in order to be able to compete with them. Finally Islam is the second largest religion in the world, projected to surpass Christianity during 21st century, offering huge market to serve. 4 CHEE, Daud Vicary Abdullah and Keon. Islamic finance why it makes sense [online]. Singapore: Marshall Cavendish Business [cit. 2014-03-29]. ISBN 978-981-4312-448. 5 CHEE, Daud Vicary Abdullah and Keon. Islamic finance why it makes sense [online]. Singapore: Marshall Cavendish Business [cit. 2014-03-29]. ISBN 978-981-4312-44
  11. 11. 1.2 Religious background of Islam Islamic society and institutions must be in compliance with Islamic Law which originates from two divine sources, the Holy Koran (Words of God) and Hadith (Words and deeds of Mohammed). Every Muslim is defined by Koran because it covers law, worship, doctrine and wisdom and also gives instructions for equitable, prosperous economic system, solidar society and social and religious inclusion. Hadith can be explained as a guideline for Muslim in how to live their daily lives. It is a recorded history of Mohammed’s life who was trusted by Allah to explain, interpret and live the teachings of the Holy Koran. To sum up the facts that are written above, Islam is a complex of laws. It says how to behave in social, political and economic environment. There are three areas that are regulated by the Holy Koran and Hadith. Beliefs (Aqidah), Duties (Sharia’ah) and Morals (Akhlaq). 1.2.1 Beliefs (Aqidah): Aqidah are those matters over which Muslims have conviction. There are six aspects of belief. These beliefs are clearly articulated in the Holy Qu’ran as required of a Muslim: 1) Belief in Allah 2) Belief in the Prophets and Messengers sent by Allah, including Jesus, Moses and Abraham. 3) Belief in the Angels. The Angles maintain a record of the actions and thoughts of each human. 4) Belief in the Scriptures sent by Allah , including the Holy Qu’ran and the Hadith. 5) Belief in the Day of Judgement. On this day, all the people throughout the history of mankind will be brought forth for accounting, reward and punishment. 6) Belief in Fate. A man’s fate is established by his own actions and thoughts. (Abdullah & Chee, 2010, p. 66) 1.2.2 Morals (Akhlaq): Akhlaq is the practice of virtue and morality. (Abdullah & Chee, 2010, p. 67) Islam teaches that human perfection is determined by discipline and effort. If a Muslim wants to surpass the Angles, he or she pursuits morals.
  12. 12. 1.2.3 Duties (Sharia’ah): Shari’ah defines duties that should be adopted by individuals on a path to Allah. It covers all aspects of life such as commercial transactions, social behavior and faith. Two main categories are covered by Shari’ah, man-to-God activities and man-to-man activites. 1.3 Shari’ah For purpose of this thesis, man-to-God activites are not going to be covered as they are not directly connected to the theme. The focus on man-to-man activites, called in Arabic Muamalat Ammah, is stressed because these activites have a vital influence on Islamic finance. 1.3.1 Man-to-man activities (Muamalat Ammah): There are five categories of human action that are relevant to commercial transactions, broadly described as obligatory (Belief in God), recommended (kindness), permitted (doing business), discouraged (divorce) and forbidden (gambling) (Abdullah & Chee, 2010, p. 70). All actions taken by Islamic institutions, in this case banks, have to be in peace with Shari’ah or said with more well-known term – Shari’ah compliant. Sharia is an Arabic word meaning the path to be followed. (Kettel, 2011, p. 13) Path believed by all muslims to be the path shown by Allah to Mohammed. Thus it is believed by Muslims that only Shari’ah liberates them from servitude to other then Allah so that is the reason why Muslims are obliged to strive for it. There are four sources of Shari’ah:  the Holy Koran,  the Sunnah (the Practice of Prophet Mohammed),  Ijma – consensus of opinion ot the Ulema,  Qiyas which are analogical deductions. As explained above, the entire nation of Islam lives under the Shari’ah law. There is a council of jurists which creates and interperts the Holy Koran and the Sunnah meaning that only these men have the power and responsibility to make new laws according to Shari’ah. These religious bases give a nonsided new laws, because these jurist creates laws which favor no politicians or lobbyists but on the contrary should be in favor of people as a whole.
  13. 13. 1.3.2 Shari’ah in Islamic banking: Islam encourages all aspects of well-being meaning that economy is not an exception. According to this religion economy should develop and serve the society so that there is no poverty, the development should be done via trade so the financial system in general must support the real economy through financing halal activities. Islam bannes a lot of activites which are normal for us, citizens of the West (USA, Japan, EU), such as speculation but that is going to be explained later. To create a financial system, one must have an institution, in this case an Islamic bank and products. The products that are used by Islamic financial instituions have to be Shari’ah compliant meaning they have met all the Islamic legal requirements. To ensure this, Islamic banks always appoint a Shari’ah supervisory board which is comprised of scholars, independent professionals educated in Islamic legal system, who guide and provide the supervision of the products and the bank itself. This committee certifies products and says if the transactions and dealings set up by its bank are permissible. 1.4 Prohibitions in Islam Historically, Islam has origin in the Middle East in Medieval times where most of Arabians were traders thus money is to be invested into real assets. Trade and partnerships are encouraged as well as risk sharing. Islamic finance is focused on serving its clients through creating value in the real economy. 1.4.1 Halal and Haram The principles of halal (allowed or lawful) and haram (prohibited or unlawful) are applied in a Muslim’s daily activites, including in food consumption, for the good of the individual, society, nation and humanity. (Kadir, 2007) Every action done by Muslims that is for example unselfish or kind is halal. On the contrary when acting in a destructive behavior to themselves, the environment or other people, these actions are haram. Basically every unjust, harming or destructive actions are haram.
  14. 14. Examples of haram (single examples, sectors connected to these examples are haram as well):  Alcohol,  Prostitution,  Producing and selling drugs,  Manufacturing of weapons,  Tobacoo,  Pork,  Riba,  Gharar,  Maysir. 1.4.2 Riba (prohibiton againts interest): According to Sharia Law and the Holy Koran money are viewed only as a measuring tool for value of assets but they are not an 'asset' themselves meaning that it is not possible to earn income from money alone. Businesses are encouraged to increase wealth through trade, not from borrowing and lending. In Muslim countries, riba is considered exploitative because interest is earned from a borrower without providing anything in return. In long-term interest-based financing can, if not handled right, increase gap between poor and rich. For example in debt financing for business, conventional banks require an asset as a collateral to hedge the risk but these practices tend to favor bigger and established firms and the smaller ones are charged higher interest rates or denied financing. This causes that bigger firms are getting bigger and the small ones have more difficult conditions to finance themselves. 1.4.3 Gharar (prohibition against uncertainty): In Arabic, uncertainty is called gharar. The term is not precisely defined, it also means hazard or risk. Generally investment returns arisisng from an asset, such as a business or a stock, could be either negative or positive meaning that certain level of gharar is allowed. Gambling and speculation based on excessive gharar is prohibited. Speculation on stock prices, currency movements or commodities is banned because it does not create any value in the real economy.
  15. 15. To remove Gharar form transactions, the conditions such as price or subject of the transactions, should be clear between both parties. Concepts in which gharar can occur: • Uncertainty of ownership: A good example in conventional finance could be for example short selling, a speculation on currency movements when the speculator does not owe money needed for the speculation, • Inadequacy of information: In islam, the weaker party should be protected from irrelevant or insufficient information. All parts of a contract are clear meaning that all information were revealed, price is fair, characteristics of an item are relevant, • Conditional contract: The sale price of an item or service cannot be dependent on an event that may not take place. Contracts cannot be interdependent, combined or linked. Islamic finance differs from the conventional financial system concerning gharar in two ways. Firstly in insurance sector where insured event can never occur or on the other side can occur immediatelly. Secondly in financial derivatives where objects serving as a base for a contract may not exist at the time the contract is executed. 1.4.4 Maysir (prohibition against gambling): In Islam maysir is seen as a situation where one of two parties either win or lose. Casinos, gambling machines, all of that is prohibited in Islam. It is an unjust enrichment of one side, it also widens the gap between rich and poor. Concerning the finance, if simplified, gambling could be identify in the stock market. If used for investment, Islamic finance does not have any problem with stock market because the investor becomes one of shareholders, he buys an asset on a risk sharing platform. But the stock market is also a place of excessive speculation where an individual is able to earn huge amounts of money on betting if a price of a stock will go up or down. Shari’ah compliant Islamic banks are investors not speculators.
  16. 16. 2 Techniques of financing in the Islamic banking Because of the prohibition of interest and speculation, islamic banks had to find new ways how to transfer funds from depositors who are called investment account holders (owners of capital) and business owners. Two methods were developed. First one is profit and loss sharing method that includes Mudaraba and Musharaka and the other one is very similar to conventional banking and includes Murabaha, Salam, Ijara, Sukuk etc. 2.1 Profit loss sharing techniques 2.1.1 Mudaraba In general Mudaraba is a trade conract in which a Mudarib (business owner) is provided with capital by a Rabb ul Mall (investor) for an agreed fee. It is characterized as a partnership between two or more parties. In this case an investment account holders provides via Islamic bank capital to Mudaribs. Then the profit is shared in pre-agreed ratios, any loss on the other hand are borne by the Islamic bank meaning that the bank bares the whole monetary loss. The loss is then transferred to investment account holders. In mudaraba contract, Rab ul Mall sets the profit sharing ratio which is in percentages not fixed. The ratio is adjusted to conditions concerning the type of business invested in, place where Mudarib run the business and other things that could have an influence on profit. Shari’ah treats mudaraba in a way that the owner of capital (Islamic bank or actually investment account holders) has no say in the usage of money provided to business. The whole responsibility is put into Mudarib, Islamic bank can only specify conditions in order to ensure better management of the capital. There are two types of mudaraba:  Restricted mudaraba (Mudaraba Al Muqayyadah): In this case Rab ul Mall (owner of capital) can specify a particular choice of investment for Mudarib,  Unrestricted mudaraba (Mudarab Al Mutlaqah): Full freedom is given to Mudarib by Rab ul Mall in how to invest the capital, however it is forbidden to invest outside of the normal routine of the business. If Mudarib wishes to do that, he or she must get a permission by Rab ul Mall.
  17. 17. Two-tier Mudaraba: As shown before, mudaraba is a two party contract. Islamic banks reshaped mudaraba so that they could use in their ordinary activites. They have extended it to include three parties. Islamic bank is a Mudarib opposite to its depositors (investment account holders) and it is a Rab ul Mall opposite to the business sector.  The funds are received on the basis of unrestricted mudaraba so that there are no limits imposed on the Islamic banks while doing their daily activities. They can use all the funds together and work as an intermediary. But they must avoid haram investments (alcohol, drugs, speculation). On the contrary banks use restricted mudaraba when approaching the business sector in order to specify the kind of activites, duration of the investment etc. But as mentioned before they cannot interfere after the funding is provided,  Because mudaraba is a partnership, the Islamic bank trusts the investment decisions it makes but with a possibility of future losses. It is forbidden to ask Mudaribs for collateral or any other type of guarantee. The base of this system is solidarity. Investment account holders take in account that they could lose their money,  Islamic bank then uses the pooling technique to aggregate all profits and share them with depositors after deducting all costs. When losses occur depositors lose a part of their funds. 2.1.2 Musharaka Musharaka is a form of partnership between an Islamic bank and its clients whereby each party contributes to the partnership capital, in equal or varying degrees, to establish a new project or share in an existing one, and whereby each of the parties becomes an owner of the capital on a permanent or declining basis and is owed its due share fo profits. Losses, however, are shared in proportion to the contributed capital. It is not permissible to stipulate otherwise. (Kettel, 2011, p. 77) One form of musharaka is called Mufawada which means unrestricted, unlimited and equal partnership. All partners are put at the same level in management, capital and ownership. Each partner guarantees the others and is also the agent of others.
  18. 18. But the most common form of musharaka is shirkah al’inan. Parties involved create a capital fund in form of money or for example labour in order to execute a project. The parties only guarantees themselves, however they are not agents of one another. Profit is then shared in pre- agreed ratio in percentages, never fixed. However losses are always borne according to the capital contributions. There are two forms of musharaka:  Constant musharaka in which a contract has unlimited time expiratio,  Diminishing musharaka in which capital of the Islamic bank constantly decreases to zero. This type of musharaka is more commonly used. Mudaraba is used for financing short-term investment while musharaka is used for long-term investment. The differences are when a loss occurs, in musharaka the entrepreneur is prepared to share it with the Islamic bank.
  19. 19. 2.2 Profit mark – up techniques 2.2.1 Murabaha Murabaha is originally a sale contract that can be explained as sale on profit. In this type of contract a buyer appoints a seller who is supposed to buy an item for him with pre-agreed profit margin. The buyer must know the cost price as well as the profit margin. Applied in the Islamic banking, murabaha became the most used financing mode. The concept is that Islamic bank purchases an item for its clients with a profit margin or more commonly used ‘mark-up’ to its cost. Islamic bank is the owner of the item which is after that provided to its client. To secure itself, Islamic bank can require a collateral in a form of a different asset or the item itself but only in case when no other asset exists. The repayment is then done via agreed installments, paid immediately or delayed until the client resells the item. According to Shari’ah an item has to be resold so that murabaha fulfills a fact that it is a sale contract. Other condition is that Islamic bank really purchases the item and becomes an owner of it. However when a client is unable to repay an item of his or her desire, Islamic bank cannot request any further mark-ups. When a default occurs, in practice after two non-paid installments6 , Islamic bank can request all the others due to a certain date or charge a penalty which then has to be used for covering costs connected to the purchased item or for charity. 2.2.2 Ijarah Ijarah is originally a sale contract of an usufruct, an object or a hire of personal services. Ijarah when translated means lease or hire. It is then a leasing contract. Assests such as merchandise and property can be leased but for a shorter period of time then its useful life meaning they can be leased multiple times. Ijarah is widely used in islamic financing because no debt is created and furthermore it contains a collateral. The lessor has to be the owner of the leased object while the lease takes place meaning the lessor uses the leased object as security in the form of collateral. When a delay or default occurs, the lessor is entitled to take back his or her ownership. 6 IQBAL, Zamir a Abbas MIRAKHOR. An introduction to islamic finance: theory and practice [online]. 2nd ed. Singapore: John Wiley, c2011, xiv, 406 p. [cit. 2014-04-13]. ISBN 9780470828106.
  20. 20. Ijarah is very popular amongst conventional investors because it is almost the same as conventional leasing. Differences are that a leasing agency, in this case Islamic bank, must own the object as said earlier and the fact that no extra interest, while comparing the Islamic banking and the conventional banking, can be charged when an installment is delayed or the lessee is no more able to pay back his or her liability. In murabaha, the ownership of an object changes. When the agreed amount is repaid, the object becomes the property of the client. However in ijarah, the object remains the property of the lessor, in this case Islamic bank. It means that they are higher administrative costs in a form of taking care of the object and in a form of usage of the object once the contract is terminated. This led Islamic banks to seek an improved contract so Muslim jurists developed a contract called Ijara wa ‘qtina’ which is essentially a hire-purchase agreement. The object will be sold for pre-agreed price to the lessee by the lessor at the end of the agreement. 2.2.3 Istisna It is one of the basic conditions for the validity of a sale in Shari’ah that the commodity (intended to be sold) must be in the physical or constructive possession of the seller. There are only two exceptions to this general principle in Shari’ah. (BLOM, 2010) And one of them is Istisna. Istisna is a type of contract that is used in manufacturing and construction. There are two parties, the buyer and the manufacturer. The buyer places an order for an item or a building and then pays in advance, in installments or after the item is delivered. These three possibilites of repayment scheme give Istisna the advantage in the form of flexibility. When striking the contract the parties must agree on specifications of both the contract and the item. After the manufacturing process begins, it is impossible to retrieve the order. Finally the goods is delivered but when it does not conform the contract, the buyer has a possibility to cancel the order. Istisna is used especially for financing bigger projects in for example heavy industries such as ship-building, aircraft and locomotive manufacturing or in construction industry for building buildings or infrastructure.
  21. 21. 2.2.4 Salam Salam is a contract involving the purchase of a commodity for deferred delivery in exchange for immediate payment according to specified conditions, or the sale of a commodity for deferred delivery in exchange for immediate payment. (Kettel, 2011) Salam is essentially a purchase of an item at spot while the item is delivered later in the future according to the agreement. That means that Salam contains gharar so it should be banned to enter into such a contract. For those reasons prophet Mohammed permitted salam while fulfilling certain conditions. This contract was used specially in agriculture for financing farmer’s needs between harvets. Because they could not take a loan for their needs, it was allowed that farmers could sale their harvest or other agricultural products in advance. Salam is recorded in Hadidth, thus it is valid and Shari’ah compliant according to Muslim jurists. There are some conditions that have to be adrressed in salam. Firstly, the price for the goods should be paid fully at spot. Then the commodities, for which salam is used, are in general interchangeable meaning that a carrot can be replaced by a potato, a different item but still in the category of food. At last, the place and date of delivery must be set in the contract. As said before, salam is Shari’ah copmliant when used in the agriculture sector. It is basically the best way of financing small farmers and can be also used as a form of microfinance. For making a profit, the Islamic banks use the level of price. They fix the price at a lower rate than the price of the commodity would normally be when delivered at spot at the moment of entering salam. The difference between the two prices is then used as a profit. 2.3 Sukuk Sukuk is a financial instrument that is used primarely in capital markets and it is an alternative to conventional bonds. Sukuk is a plural form of a word ‘sak’ which also served as a base for word ‘cheque’ meaning that Muslim traders have been using sealed papers in a form of obligations since the Middle Ages. The Accounting and Auditing Organization for Islamic Finance (AAOIFI) defines Sukuk as investment certificates. All the certificates have equal value and represent shares in undivided ownership of an underlying assets. These underlying assets may be represented by tangible assets, usufructs or assets of a special investment project but they have to generate revenues.
  22. 22. It can be already seen that a main difference between sukuk and conventional bonds is the nature of the products while bonds are debt obligations, sukuk represents an ownership claim. (Fundamentals of islamic money) The most important advantage of sukuk compare to other islamic products that were already described here is its liquidity as the ability to be traded in the secondary market. Sukuk represent direct funding for companies in general via the capital market. According to Sharia’ah Law it is forbidden to use conventional bonds as a source of financing. In Islam bond is a financial instrument which fits riba definition perfectly. It essentially represents earning money on money. When trading in the capital market, the price of sukuk is based mainly on the price of the underlying assets and its volatility, however, the price of a bond is based mainly on the creditworthiness of the issuer. Before sukuk are issued they have to be Sharia’ah compliant meaning that the raised funds must be used for halal activities. The contract has to be transparent and all the specifications of it must be clear to all investors. There is no fix return guaranteed and the underlying asset has to generate revenue so that the investors could obtain income. Then a special purpose vehicle (SPV) is established. This SPV is usually a subsidiary company with legal status so that the obligations are not dependant on the parent company, therefore secured. The SPV has a limited operational framework and its task is mainly acquisition of assets and issuance of sukuk. There are two types of sukuk:  Asset-backed sukuk where the primary source of investment return is a revenue (or cash flow) generating Sharia’ah compliant asset. The funding costs are based on the strenght of the cash flow. In this case, the investors are owners of an asset which generates revenues, therefore cash flow, for a company and therefore for them,  Asset-based sukuk where investment returns are not based on revenues of a specified asset but sukuk is only backed by Sharia’ah compliant assets of a company, more specifically by their capital value. Compared with the conventional bonds, investors here are actually the owners of these underlying assets. Investment returns are not financed directly by a certain asset. The funding costs are more market driven depending on the creditworthiness (rating) of the issuer.
  23. 23. Table 2.3.1 Differences between Sukuk, Conventional Bonds, and Company Shares. Sukuk Bonds Shares Nature Not a debt of issuer but undivided ownership share in specific assets/projects/services. Debt of issuer. Ownership share in a corporation. Asset-backed A minimum of 51 percent tangible assets (or their contracts) are required to back issuance of sukuk al- ijarah. Generally not required. Not required. Claims Ownership claims on the specific underlying assets/projects/services and so on. Creditors claim on the borrowing entity, and in some cases liens on assets. Ownership claims on the company. Security Secured by ownership rights in the underlying assets or projects in addition to any additional collateral enhacements structured. Generaly unsecured debentures except in cases such as first mortgage bonds, equipment trust certificates, and so on. Unsecured. Principal and return Not guaranteed by issuer. Guaranteed by issuer. Not guaranteed by company. Purpose Must by issued only for Islamically permissible (halal) purposes. Can be issued for any purposes. Can be offered for any purposes. Trading of security Sale of and ownership interest in a specific asset/project/service and so on. Sale of a debt instrument. Sale of shares in a company. Responsibility of holders Responsibility for defined duties relating to the underlying assets/projects/transactions limited to the extent of participation in the issue Bondholders have no responsibility for the circumstances of the issuer. Responsibility for the affairs of the company limited to the extent of holdings in the company. Source: (Abduh & Raditya Omar, 2013, p. 80)
  24. 24. Sukuk al-Ijarah is the most commonly used form of sukuk so its functioning is going to be explained. When a company wants to issue sukuk, the Special Purpose Vehicle (SPV) is established. The SPV is responsible for issuing sukuk, paying distribution amounts and the dissolution amount. Investors then pay the principal amount for sukuk and the SPV creates a trust over the funding which it obtained. Then acting as a trustee on behalf of the investors, the SPV enters into a sale and purchase agreement with the originator of sukuk. Then the SPV purchases an asset from the originator for the principal amounts obtained from investors and leases it back to the originator in the form of ijarah for the period that matches the maturity of sukuk. Rental payments mady by the originator are equal to the distribution amounts meaning they are redistrubuted by the SPV between investors. At the end, the originator pays the exercise price to the SPV which equals the dissolution amounts needed to terminate this contract. In the case of default the SPV sells back the purchased asset and the originator must pay a higher exercise price that includes accrued distribution amounts owed to investors. 2.4 Takaful Takaful is an Arabic word meaning guaranteeing each other or joint guarantee. The main core of the Takaful system – the aspect that makes it free from uncertainty and gambling is Tabarru’, which means donation, gift, or contribution. The objective of Takaful is to pay a defined loss from a defined fund. (Kettel, 2011, p. 128) Takaful represents a form of islamic insurance which is Shari‘ah compliant. Muslim jurists have always had a problem with conventional insurance because it contains riba, maysir and gharar. There is uncertainty about the future amount that will be paid, then in addition if no insured event occurs in the future, the insurance company may keep the premiums paid by the policyholder. Riba is in life insurance products where policyholders recieve income from investment that includes for example obligations. Takaful is based on sincere solidarity. It expects its participants to donate their money to support other participants. In this insurance scheme every participant contributes to a fund that later covers their claims. If an individual wants to use takaful, the amounts that he or she will pay is defined by the expected claim in the future.
  25. 25. The Tabarru‘ core of takaful is actually an agreement by a participant to give up a part of his or her contributions to the mutual fund in order to fulfill his or her obligation of helping other takaful participants when an insured event takes place. Based on shared responsibility and cooperation between all participants, Shari‘ah approves takaful as an insurance. A takaful company is normally called a takaful operator. There are normally two funds managed by a Takaful operator. One is an investment fund managed as a mudaraba (profit sharing). The other one is managed according to the principles of tabarru‘, in other words treated as a charity. Table 2.4.1 Key differences between takaful and conventional insurance. Takaful Conventional insurance Takaful is based on cooperation and is void of interest (riba) and other prohibitions. Conventional insurance includes interest, uncertainty (gharar) and other prohibions. The presence of a legal control authority (Sharia’a board) to ensure that all the activities are done according to Sharia’a and void of any prohibitions. The presence of a technical commitee only. The original premium payment goes back to the insured after deducting its share of the indemnities and expenses. Neither the original premium nor any part of it goes back to the insured. The profits of investing premiums belong to the insured after deducting the operator’s share as a Mudarib. The profits of investing premiums and assets belong to the commercial insurance company only. The operator aims mainly at achieving cooperation among community members and developing the Ummah (the nation of Islam) The company aims at achieving the highest profit possible for its owners. The operator’s profits are the result of investing its money, its share as a Mudarib and the fees for running insurance operations. The company’s profits are the result of investing its money in addition to the commercial profits resulting from the entire insurance operations. The operator has a fixed capital that belongs to the participants and ‚variable‘ capital that belongs to the policyholders. The company has one source of capital that belongs to the commercial company only. Source: (Kettel, 2011, p. 131)
  26. 26. Takaful is presented here because it is a common islamic financial service also provided by the islamic banks. For example one of the leading islamic banks in the world Bank Islam Malaysia offers takaful in its personal banking services7 . 2.5 Zakat Zakat is the Islamic concept of tithing and alms. It is an obligation on Muslims to pay 2.5% of their wealth to specified categories in society, when their annual wealth exceeds a minimum level (nisab). Zakat is one of the Five Pillars of Islam. (Kettell, 2011, p. 82) The word zakat means ‘purification’ and ‘growth’. The possesions of an individual are purified by donating a part of his or her wealth to those in need. The existence of zakat is explained as a way of cutting down imbalances and encouraging growth. Zakat can be recieved by poor people, homeless people, zakat collectors, people who are close to becoming Muslims. Then by people who are freeing slaves or heavily indebted people and by travellers who find themselves in difficult situations. Zakat can be also donated to islamic schools, hospitals, mosques and to charity. When a certain Islamic state does not collect and distribute zakat, then Islamic bank is responsible for establishing a zakat fund or zakat accounts for its clients and distributing it according to Shari’ah. 2.6 Current and Saving Accounts To offer services to ordinary people who do not need financing but need to deposit their money, Islamic banks may use wadiah, which means safekeeping or custody. In this agreement an individual can deposit cash or other assets in Islamic bank with a guarantee of safety. The client can withdraw money anytime he or she wants. It is possible, and it is a common practice, that Islamic bank charges a fee for the safekeeping but on the other hand Islamic bank can also pay hibah (gift). 7 Personal Banking. Bank Islam Malaysia Berhad [online]. [cit. 2014-05-03]. Dostupné z :http://www.bankislam.com.my/en/Pages/PersonalBanking.aspx
  27. 27. Islamic bank can also use qard which is essentially an interest-free loan. The current account of a client, for example, works as a loan to the bank. Qard is due to pay immediately when requested8 . Islamic banks provide debit and credit cards for a fee. When credit card is issued there is always a fixed limit to which a client can borrow money. If credit is provided, a fixed fee is set for the client for borrowing money. Both fee and borrowed money have to be repaid back. However the most used scheme used in Islamic finance is two-tier mudaraba. As mentioned before, clients provide the Islamic banks with funds via unrestricted mudaraba. To sum up the information above, in mudaraba clients are rewarded because they provided Islamic bank with funds needed for the bank’s investment activities. However in the case of wadiah or quard, the depositors share profit with the bank and it is Islamic bank’s will if they will recieve hibah. 8 Current Account. Islamic Bank of Britain [online]. 2013 [cit. 2014-04-24]. Dostupné z: http://www.islamic- bank.com/current-account/
  28. 28. 3 Comparison of growth of islamic and conventional banking in the example of Malaysia 3.1 Introduction of practical example In this last section a closer look is going to be taken at a country which is trying to become a global leader in Islamic finance and that country is Malaysia. This part aims to describe the Islamic banking in practical way applied in the real economy. Malaysia is the example of a country that has been developing the Islamic financial industry for almost four decades. Nowadays its Islamic financial sector is fully integrated into Malaysian legal system, regulatory framework and into the overall Malaysian financial sector. History of Islamic finance in Malaysia will be presented, its foundation in 20th century and the development and growth to modern days. After that providing an analysis of the biggest banks in Malaysia in order to answer two questions. Is the Islamic banking in Malaysia really growing more rapidly then the conventional banking? If so, what could be probable causes of that success? 3.2 Malaysian Islamic financial sector Malaysia is a multinational and multireligious country with a Muslim Malay majority and two main minorities, Chinese and Indian. Altough the Malays make up the majority in Kuala Lumpur and nation wide as well, the Chinese were the ones who were driving the economic growth and industrialization of Malaysia. Ethnic protests took place in late sixties when Muslim majority wanted to gain more power over the Chinese who were controlling the commercial sector. In 1983 the Malaysian government decided to uprise its Muslim majority by setting up foundations fot the Islamic financial sector via the Islamic Banking Act (IBA) that enabled Bank Negara Malaysia (Central Bank of Malaysia) to regulate and supervise Islamic banks. Bank Islam Malaysia Berhad was established the same year as a pioneer Islamic bank in Malaysia, from that moment creating a dual banking sector. Government Investment Certificates (GIC) were issued the same year under the Shari’ah principles as liquid investment tools for Islamic banks. The purpose of GIC was to enable Islamic banks to meet regulatory requirments for liquidity.
  29. 29. In 1996 banks licensed under the Banking and Financial institutions Act (BAFIA), which was enacted in 1989, were allowed to establish new Islamic banking business. In 1997 Bank Negara Malaysia established the National Shari’ah Advisory Council (NSAC) to harmonise Sharia’ah principles used by banks. The NSAC operates as the highest Shari’ah authority in Malaysia overseeing Islamic finance (islamic banking and takaful). The NSAC also evaluates new products that Malaysian Islamic banks invent. In the year of 2004 Bank Negara Malaysia enacted a policy on takaful forcing Islamic banks to offer it as a first choice protection for its customers. Malaysia has one of the most developed Islamic financial systems in the world as the Islamic debt securities market, the Islamic equity market and the Islamic Interbank Money Market were established between 1990 and 1995. There are objections concerning the trading of debt securities between Muslim countries such as those in need of financing should know their creditors. However, according to Maliki scholars, which have been shaping the islamic finance in Malaysia, debt securities trading is possible as long as the debtors know their debts will be traded. On 30 June 2013 the Islamic Financial Service Act was enacted to further strenghten and establish a proper end-to-end Shari’ah regulatory framework which had not been provided before. The legislation specifically provides for the enforcement of Shariah non-compliance risk and imposes statutory duty upon the Islamic financial institutions to ensure that their aims, operations, affairs, businesses and activities are in compliance with Shariah rules. (Selangor, 2013)
  30. 30. 3.3 Comparison of asset growth and profitability The Islamic banking is known for its dynamic growth. The Islamic assets were set to cross 1.7 trillion US dollars in 2013 with 17.6% annual average growth between 2009 and 2012. Malaysian Islamic assets grew by average 20% in that period. However, the return on equity (ROE) in Islamic banks is overall lower than the ROE of their conventional competitors9 . 3.3.1 Asset growth comparison In this section, the asset growth between conventional and Islamic banks will be compared in 2012 and 2011 in order to discuss if the Malaysian Islamic banks have been really growing faster than the Malaysian conventional banks. The following charts are showing total assets of selected Islamic banks in Malaysia in thousands of Malaysian Ringgit. Selected Islamic banks are Bank Islam Malaysia Berhad, Maybank Islamic Berhad, HSBC Amanah Malaysia Berhad, Kuwait Finance House (Malaysia) Berhad, RHB Islamic Bank Berhad, Hong Leong Islamic Bank Berhad, Alliance Islamic Bank Berhad, CIMB Islamic Bank Berhad and Bank Muamalat Malaysia Berhad. Chart 3.3.1.1 Islamic banks – total assets in 2011 and 2012 9 World Islamic Banking Competitiveness Report 2013-2014: The transition begins. In: Ernst & Young [online]. 2013 [cit. 2014-05-17]. Available at: http://www.ey.com/Publication/vwLUAssets/EY_- _World_Islamic_Banking_Competitiveness_Report_2013%E2%80%9314/$File/EY-World-Islamic-Banking- Competitiveness-Report-2013-14.pdf RM32226504 RM43102785 RM6223100 RM22650317 RM12178617 RM10122166 RM10442833 RM75512938 RM18315209 RM37450798 RM51225040 RM6508221 RM25609662 RM21902469 RM9096691 RM12146179 RM91432370 RM20495378 Bank Islam Malaysia Berhad CIMB Islamic Bank Berhad Alliance Islamic Bank Berhad RHB Islamic Bank Berhad Hong Leong Islamic Bank Berhad Kuwait Finance House (Malaysia) Berhad HSBC Amanah Malaysia Berhad Maybank Islamic Berhad Bank Muamalat Malaysia Berhad TOTAL ASSETS IN 2011 AND 2012 Total Assets 2011 Total Assets 2012 Source: Statements of financial position. Own elaboration.
  31. 31. The analysis of asset size is based on data of financial positions according to IFRS. Islamic banks were selected according to availability of their financial results and according to their importance based on asset size and market capitalization10 (asset size and market capitalization of financial groups of which the Islamic banks are often subsidiaries). Most of them are a part of financial groups which also own conventional banks in Malaysia. The rate of growth of assets of selected Islamic banks is showed below. Chart 3.3.1.2 Islamic banks – asset growth 2011-2012 The analysis of the rate of growth of assets is based on data of financial positions according to IFRS. The Islamic banks were selected according to availability of their financial results and according to their importance based on asset size and market capitalization11 (asset size and market capitalization of financial groups of which the Islamic banks are often subsidiaries). Most of them are a part of financial groups which also own conventional banks in Malaysia. 10 Top Banks in Malaysia. Online Bank Watch [online]. 2012 [cit. 2014-05-05]. Available at: http://www.onlinebankwatch.com/malaysia/top-banks-in-malaysia.html 11 Top Banks in Malaysia. Online Bank Watch [online]. 2012 [cit. 2014-05-05]. Available at: http://www.onlinebankwatch.com/malaysia/top-banks-in-malaysia.html 16,21% 18,84% 4,58% 13,07% 79,84% -10,13% 16,31% 21,08% 11,90% Bank Islam Malaysia Berhad CIMB Islamic Bank Berhad Alliance Islamic Bank Berhad RHB Islamic Bank Berhad Hong Leong Islamic Bank Berhad Kuwait Finance House (Malaysia) Berhad HSBC Amanah Malaysia Berhad Maybank Islamic Berhad Bank Muamalat Malaysia Berhad ASSET GROWTH 2011-2012 Source: Statements of financial position. Own elaboration.
  32. 32. The annual average growth based on this selected data was 19,08% during the year 2012. Most of the Islamic banks expanded around this growing rate except of Alliance Islamic Bank which expanded by 4,58% and Hong Leong Islamic Bank which grew by almost 80%. Only Kuwait Finance House’s assets shrank by 10,13%. The following charts are showing total assets of selected conventional banks in Malaysia in thousands of Malaysian Ringgit. Conventional banks were selected according to the same criterias as Islamic banks were. Selected conventional banks are CIMB Bank Berhad, RHB Bank Berhad, Alliance Bank Malaysia Berhad, Hong Leong Bank Berhad, HSBC Bank Malaysia Berhad, Public Bank Berhad, Maybank Berhad, AFFIN Bank Berhad and AmBank Berhad. Chart 3.3.1.3 Conventional banks – total assets in 2011 and 2012 RM186722227 RM120731463 RM29380878 RM87650089 RM206768918 RM73756417 RM323999608 RM40070290 RM80495362 RM206795324 RM144661155 RM32772856 RM140284562 RM228575968 RM66956263 RM342556673 RM41676054 RM84064621 CIMB Bank Berhad RHB Bank Berhad Alliance Bank Malaysia Berhad Hong Leong Bank Berhad Public Bank Berhad HSBC Bank Malaysia Berhad Maybank Berhad AFFIN Bank Berhad AmBank Berhad TOTAL ASSETS IN 2011 AND 2012 Total Assets 2011 Total Assets 2012 Source: Statements of financial position. Own elaboration.
  33. 33. The analysis of asset size is based on data of financial positions according to IFRS. Conventional banks were selected according to availability of their financial results and according to their importance based on asset size and market capitalization12 (asset size and market capitalization of financial groups of which conventional banks are subsidiaries). The rate of growth of assets of selected Islamic banks is showed below. Chart 3.3.1.4 Conventional banks – asset growth 2011-2012 12 Top Banks in Malaysia. Online Bank Watch [online]. 2012 [cit. 2014-05-05]. Available at: http://www.onlinebankwatch.com/malaysia/top-banks-in-malaysia.html 10,75% 19,82% 11,54% 60,05% 10,55% -9,22% 5,73% 4,01% 4,43% CIMB Bank Berhad RHB Bank Berhad Alliance Bank Malaysia Berhad Hong Leong Bank Berhad Public Bank Berhad HSBC Bank Malaysia Berhad Maybank Berhad AFFIN Bank Berhad AmBank Berhad ASSET GROWTH 2011-2012 Source: Statements of financial position. Own elaboration.
  34. 34. The analysis of the rate of growth of assets is based on data of financial positions according to IFRS. Conventional banks were selected according to availability of their financial results and according to their importance based on asset size and market capitalization13 (asset size and market capitalization of financial groups of which the Islamic banks are often subsidiaries). The annual average growth based on this selected data was 13,07% during the year 2012. Four banks expanded around this growing rate. Maybank, which is the largest bank in Malaysia, saw the asset growth at 5,73% and two other banks grew similary around 4%. Hong Leong Bank Berhad is again by far the most growing according to assets, the bank expanded by 60,05%. On the other hand HSBC Bank Malaysia asset size shrank by 9,22%. The rates of asset expansion are shown below. Charts 3.3.1.5 Comparison of asset growth This analysis shows that the Islamic banking sector’s asset size grew 6,01% more than the asset size of conventional banking sector. 13 Top Banks in Malaysia. Online Bank Watch [online]. 2012 [cit. 2014-05-05]. Available at: http://www.onlinebankwatch.com/malaysia/top-banks-in-malaysia.html 19,08% 13,07% Annual Average Growth 2011-2012 Islamic banks Annual Average Growth 2011-2012 Conventional banks COMPARISON OF ASSET GROWTH Source: Statements of financial position. Own elaboration.
  35. 35. 3.3.2 Profitability comparison In this section, the profitability of conventional and Islamic banks will be compared in 2012 and 2011 in order to discuss if Malaysian Islamic banks had lower ratio of return on equity (ROE) than conventional banks in Malaysia did. Return on equity (ROE) is the amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested. (Investopedia, 2014) ROE = Net Income / Shareholder’s Equity. (Investopedia, 2014) Return on equity of selected Islamic banks is presented below. Chart 3.3.2.1 Islamic banks – ROE in 2011 and 2012 Ratios of ROE were analysed based on the data of same Islamic banks that were used in the asset comparison section. Maybank Islamic Berhad is excluded from this analysis because the net income for the year 2011 was only from 1.7.2011 to 31.12.2011. 13,44% 17,36% 11,99% 11,39% 7,79% -31,46% 11,19% 9,84% 13,90% 17,11% 13,28% 9,20% 12,63% 4,21% 12,81% 5,90% Bank Islam Malaysia Berhad CIMB Islamic Bank Berhad Alliance Islamic Bank Berhad RHB Islamic Bank Berhad Hong Leong Islamic Bank Berhad Kuwait Finance House (Malaysia) Berhad HSBC Amanah Malaysia Berhad Bank Muamalat Malaysia Berhad RETURN ON EQUITY IN 2011 AND 2012 ROE 2011 ROE 2012 Source: Statements of financial position and statements of income. Own elaboration.
  36. 36. Return on equity of selected conventional banks is presented below. Chart 3.3.2.2 Conventional banks – ROE in 2011 and 2012 Ratios of ROE were analysed based on the data of same conventional banks that were used in the asset comparison section. Maybank Berhad is excluded to give a fair comparison based on 8 subjects. 15,61% 15,87% 12,68% 12,30% 23,47% 19,48% 11,59% 20,21% 13,64% 14,90% 13,37% 12,35% 21,94% 19,38% 11,87% 20,13% CIMB Bank Berhad RHB Bank Berhad Alliance Bank Malaysia Berhad Hong Leong Bank Berhad Public Bank Berhad HSBC Bank Malaysia Berhad AFFIN Bank Berhad AmBank Berhad RETURN ON EQUITY IN 2011 AND 2012 ROE 2011 ROE 2012 Source: Statements of financial position and statements of income. Own elaboration.
  37. 37. The last chart is directly comparing ROE in 2011 and 2012 between Islamic and conventional banks in Malaysia. Chart 3.3.2.3 ROE comparison Average annual ratios of ROE were counted with the arithmetic average technique. Data were used from the statements of financial position and statements of income according to IFRS of both Isalmic and conventional banks. Return on equity in the Malaysian Islamic banking sector is lower than than ROE of conventional banks. According to this analysis, ROE in 2011 was only 6,44%. This extremely low number is biased by the selected data when Kuwait Finance House (Malaysia) Berhad suffered losses and its ROE was negative. 2011; 6,44% 2012; 11,13% 2011; 16,40% 2012; 15,95% 1 2 ROE COMPARISON ROE of selected Islamic banks ROE of selected conventional banks Source: Statements of financial position and statements of income. Own elaboration.
  38. 38. 3.3.3 Analysis summary This analysis confirmed that the Islamic banks are really growing more rapidly than the conventional banks but the ROE is lower. The pace of growth of Islamic banking is globally slowing from rates around 20% but Malaysia was able to maintain high asset growth performance between 18% to 20% due to long-term developmnet of its Islamic financial sector14 . Weaker results in profitability could be explained by the architecture of the system. There is no compound interest that generates profits and higher costs can be caused by profit loss sharing. Building the sector for more than 30 years, Malaysia’s goal is to have a rich and stable financial system. The success of the Islamic banking in Malaysia consists of relentless product innovation, innovative Islamic investment products, wide range of domestic and foreign Islamic financial institutions and adoption of modern regulatory frameworks such as Basel III together with Shari’ah practices. Bank Negara Malaysia recognized the current importance of human capital so the International Center for Education in Islamic Finance (INCEIF) was set up by BNM in 2006 in order to strenghten the system and educate and train future leaders and decision makers of Islamic finance. There is also the Malaysia Islamic Financial Center (MIFC) Community founded in 2006. The MIFC Community is a network of regulators such as BNM, Securities Comission Malaysia, Bursa Malaysia, government agencies and takaful and re- takaful companies15 . Malaysia is one of the best examples that diverse and visionary driven financial sector is the key to a stable economy from that should benefit all. Long-term building, innovation, standardization and liberalisation of the Islamic banking is positioning Malaysia as the Islamic Finance hub and if Malaysia does not succeed as a global Islamic Finance leader, it will definitely play the key role at least in the South Asian region. 14 World Islamic Banking Competitiveness Report 2013-2014: The transition begins. In: Ernst & Young [online]. 2013 [cit. 2014-05-17]. Available at: http://www.ey.com/Publication/vwLUAssets/EY_- _World_Islamic_Banking_Competitiveness_Report_2013%E2%80%9314/$File/EY-World-Islamic-Banking- Competitiveness-Report-2013-14.pdf 15 BNM Malaysian Financial Sector. Bank Negara Malaysia Central Bank of Malaysia [online]. [cit. 2014-05- 14]. Dostupné z:http://www.bnm.gov.my/index.php?ch=fs_mfs&pg=fs_mfs_bank
  39. 39. The Islamic banking will play a global role in the financial industry because the conventional financial system favors speculation and it has been failing to deliver financing to entrepreneurs and companies (multinational companies excluded) which are the drivers of the real economy and innovation. Another key factor in favor of the Islamic banking is relatively low penetration of the markets that has already introduced it and then huge potentional markets such as India, former Soviet countries around the Caspian Sea and Europe. Europe is not potentionally only a big market from the perspective of a Muslim population mainly in the UK, France, Germany and Italy but also from the perspective and as a form of ethical banking (known as Socially Responsible Investing) which is becoming stronger, more visible a more needed than ever.
  40. 40. Conclusion The goal of this bachelor thesis was to introduce the Islamic banking as a new alternative model in comparison to conventional financial industry, decribe historical and religious background of Islam and financing techniques used in Islamic finance. Based on an interest-free scheme and limited speculation, the Islamic banking has Shari’ah law and Islamic ethical principles in its core. The main mission of the Islamic banking is to serve the real economy, not to master it, on the basis of cooperation (profit loss sharing) to eliminate poverty and inequality. Generating profit for shareholders is not the main idea of this system. The aim of the first chapter was to describe historical roots of Islam followed by the development of modern Islamic banking. From the formation of Islam in the 7th century to the modern era, especially 20th century, that saw decolonisation which made the foundation of the Islamic banking possible. The establisment of the Islamic Development bank was described as an important step in the internationalization of Islamic finance while other important institutions were created later, such as the Accounting and Auditing Organization for Islamic Institutions, in order to ensure standartization and integrated cooperation between Muslim countries. The second part of the chapter introduced Islamic religious principles, mainly Shari’ah law, that have a vital influence on the the Islamic banking scheme and daily practices. The focus was set on describing the difference between halal and haram activites, then the Islamic prohibitions were described such as gharar (uncertainty), maysir (gambling) and the most important one, riba (interest). Financing techniques used in Islamic finance were described in the second chapter. The financing techniques were divided into two groups and all of the the financing techniques are types of contracts. First group were profit loss sharing techniques represented by mudaraba and mushraka. Mudaraba is purely profit sharing technique where capital is provided for an agreed fee. Two-tier mudaraba was presented as a modern way of financing developed by the Islamic banks so that the funds can be transferred with the Islamic bank as an intermediary. While musharaka is the profit loss sharing technique. In both cases the fees, paid for the provided capital, are relative shares of profit. Second group are profit mark-up techniques represented by murabaha, istisna, ijarah and salam. All of these financing techniques are contracts of sale with the exception of ijarah. Ijarah is a lease contract very similar to conventional leasing that can be used as a base for sukuk. Sukuk was then described as an Islamic bond, generally and on the example of sukuk al-Ijarah.
  41. 41. Comparison of sukuk, conventional bonds and shares was provided. Takaful, Islamic insurance, was also presented as an important part of Islamic finance and a technique used by Islamic banks. There was also a description of zakat and techniques used for the management of deposits. The main goal of the last chapter was to provide comparison between the Islamic and conventional banking in Malaysia on the example of selected banks and its asset growth and profitability. Also to introduce the form and development of the Islamic banking in a pioneering country that is trying to become a global leader in the Islamic finance. The development is described chronologically from the year of 1983 to the 21st century. Malaysian current dual financial sector regulated by Bank Negara Malaysia (Central Bank of Malaysia) was presented as well as standardization and regulation of the Islamic financial products provided by the National Shari’ah Advisory Council which was established by Bank Negara Malaysia. The results of the analysis were discussed with the Islamic banking showing higher asset growth in the Malaysian financial sector while the profitability, presented by the return on equity, was lower than the profitability of conventional banks. Own explanations of the analysis were provided discussing mainly the gradual institutional development and government support as main drivers of the success of the Islamic banking in Malaysia.
  42. 42. 4 Bibliography 5 Annex Tables of auxiliary calculations for the Asset comparison.

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