QUESTION 3
Discuss the importance of Islamic financial institutions and markets in any economy
[Hint: you may look at this problem from the FOUR (4) economic units’ point of views]. (5
marks)
The whole point of IFI’s to exist is to deal with the simple reality of mobilization of
resources to allow commerce and moving of funds to take place in the economy.
That is based on the understanding from the Black Box Theory.
The point is to mobilize funds from the (1) surplus units (House Holds, Business,
Governments, Foreigners) meaning the ones who have excess liquidity, and
transferring the surplus to the parties who are in (2) deficit units, meaning the ones
who are in need of liquidity to address their current circumstances which they are not
able to do so with their current strength.
This bridging of surplus and deficit is done through efficient methods where by
transactions can take place quickly. The financial intermediaries, such as banks, take
deposits from their clients (House Holds, Business, Governments, and Foreigners) and
those deposits are then funnelled to the parties who are the deficit units. This is the (3)
indirect method as IFI act as the financial intermediaries to deploy the resources.
Another method to deal with getting liquidity from the surplus to deficit parties is through
the Financial Markets, also known as the (4) direct method. An example would be the
dealing directly with IPO’s. So the stock offering is directly from the deficit party to the
surplus party.
QUESTION 4
Using examples, explain the concepts of direct and indirect finance in the context
of Islamic finance. (5 marks) NEXT PAGE
Question 7
A) Critically illustrate qualitative measures of stock screening process (HINT:
use of diagram might be useful. You may illustrate any of the widely used
standards such as the FTSE Global Islamic Index Series (GIIS), the Dow
Jones Islamic Market Indexes (DJIM) or the Malaysian Security
Commission Guidelines. January 2011, (10marks)
Answer
Qualitative measures of stock screening process aims to exclude from the
universe of investable stock, companies that operate businesses that violate
Shariah injunctions. In almost all cases, shares of firms whose primary business
activities are in the following sectors would be deemed as Shari’ah non-complaint
assets. In other words, qualitative screening process examines the core business
activities in order to ensure that companies produce goods and services which
are free from elements prohibited in the Quran, and the following diagram shows
the areas which qualitative screening process focuses by taking example of
FSTE.
Company
Conventional or interestbased finance
(Riba/interest)
Products & services
free from
Tobacco
manufacturing or sale
Gambling, gaming, casino
operations & number
forecasting (maysir)
Conventional insurance
(Gharar)
Prohibited goods and services
such as pork, non-halal meat,
alcohol and prostitution
B) Critically illustrate quantitative measures of stock screening process
(HINT: use of diagram might be useful. You may illustrate any of the widely
used standards such as the FTSE Global Islamic Index Series (GIIS), the
Dow Jones Islamic Market Indexes (DJIM) or the Malaysian Security
Commission Guidelines. January 2011, (10marks)
Answer
Quantitative measures of stock screening process examine the company’s financial
statements by filtering the financial ratios. However, companies are indifferent in
analysing financial statements; some just examine the profit and loss account only as in
the case of Malaysian Security Commission Guidelines, and FTSE and DJIM both look
balance sheet and income statement. For instance, FTSE does do examination in the
financial ratios by using its own benchmark and it evaluates the following areas, which
the following diagram depicts:
FTSE
Financial ratio filtering
in Balance Sheet & P&L
Accounting receivables & cash
<50%, or Receivable/Total
Assets <33%
Debt/Total Assets <
33%
Cash & interest bearng items
<33%, or interest
income/Total Asset<33%
Summary of the shari’ah screening process in a table format both qualitative and
quantitative
(In case, you need to take an example rather than FTSE, because in the exam each student may choose his own example)
Dow Jones Islamic Index
Core activities (qualitative)
 Alcohol
 Tobacco
 Pork related products
 Conventional financial services
(banking, insurance etc)
 Weapon and defence
 Entertainment (hotels,
casinos/gambling, cinemas,
pornography, music , etc)
Financial ratio filtering (quantitative)
All the following must be less than 33%
 Total debt divided by trailing 12
month average market
capitalization
 The sum of company’s and interest
bearing securities divided by trailing
12 month average market
capitalization
 Accounting receivables divided by
trailing 12 month average market
capitalization
Financial Times Stock Exchange (FTSE)
Core activities (qualitative)
 Conventional financial ( non islamic
banking, financial and insurance,
etc)
 Alcohol pork related products
 Entertainment (hotels,
casinos/gambling, cinemas,
pornography, music , etc)
 Weapon and defence
Financial ratio filtering (quantitative)
 Debt divided by total assets<33%
 Cash and interest bearing
items<33%
 Account receivable and cash<50%
 Non compliant income other than
interest<5%
 Total interest income<5%
 Purification ratio 5% of dividend
Security Commission Malaysia
Core activities (qualitative)
Financial ratio filtering (quantitative)
 Financial services based on
 5%creteria
Riba/interest
Clearly prohibited activities, Riba;
gambling, selling pork or liquor
 Gambling
 10%creteria
 Manufacture or sale of non halal
Prohibited element effecting most
products or related products
people and difficult to avoid (umum
 Conventional insurance
balwa), fixed deposit, tobacco
 Entertainment activities that are non

20%creteria
permissible according to shari’ah
Mixed rental from premises used in
 Manufacture or sale of tobacco
gambling, sale of liquor, etc
based products
 25%creteria
 Stock broking or share trading in
Generally permissible and would
non shari’ah approved securities
bring benefits, hotels and resort
 Other activities deemed non
operations, stock broking share
permissible by shari’ah
trading
1. Critically discuss FOUR (4) functions of an Islamic bank. (Repeated in June
2010)
1. Financial Contracts – The purpose is to provide financial contracts to help serve
economic necessitates, local and international according to the Shariah
principles. To provide and create flexibility in the financing costs through diverse
Islamic contracts in the area of trade finance, investment, term financing, house
financing etc…
2. Effective Resource Allocation – Islamic banks must help support the Islamic
societies by providing resources that can be mobilized to benefit them.
3. Investing in Development Project – Islamic banks help by investing in
development projects to help support societies and the economy. This in turn will
help create more jobs for the Muslims.
4. Profitable Placement of Surplus Liquid Funds – It’s a well known fact that when
there is excess liquidity that is not investment it in turn ends up leading to loss
a. Decrease purchasing power due to inflation
b. Decrease capital due to Zakat payment
c. Decrease circulation of money within a community so it will lead to
stagnation
Supplemental Information

By placing excess money into IFIs it will help in the following ways:
o Profits from investments
o Increase in savings, which would lead to less consumption, increase
capital (investments), and hope to increase the amount that can be given
for Zakat purposes.


o Protect capital
o Economic movement
All IFIs must be Shari’ah compliant!! This is the main differentiating factor
between the interest-based conventional banks and Islamic banks.
The main function of IFIs: Spread economic prosperity = goal of Islamic banking
2. Compare and contrast the differences in features of Islamic banks vs.
conventional banks: relationship, deposits, financing/loans and contracts
Relationship
Conventional banking: debtor-creditor relationship between depositor and bank and
then the borrower and bank on the other hand. Interest considered being price of credit
– opportunity cost of money.
Islamic banks: loan has to be given or taken free of charge. With that being said the
creditor cannot take advantage of the borrower; when money is lent out on the basis of
interest, more often that it leads to some kind of injustice. The first Islamic principle
underlying for such kind of transactions is “deal not unjustly, and ye shall not be dealt
with unjustly” [2:279] which explain why commercial banking in an Islamic framework is
not based on the debtor-creditor relationship.
Deposits:
Irrespective of whether the bank is functioning under the conventional system or Islamic
system deposits are collected from depositors for rewards purposes. The difference
comes in terms of the agreement of reward.
Conventional system:



Reward is fixed and pre-determined.
Higher return on long-term deposits, and lower on short-term deposits
Risk borne by bank and reward to depositor at fixed rate
Islamic Banks:


Deposits accepted through Musharakah and Mudarabah where the reward is
variable.
Same as conventional - Higher weight for profit sharing on long-term deposits,
and lower on short-term deposits
o Share profits with depositors
o Both risk and rewards shared by depositor
Three (3) common Shariah principles used in structuring deposit products are:
Mudarabah, Wakalah, and Wadiah
Financing/loans:
Conventional Banking system:



Offer loan for a fixed reward
3 types of loans:
o Short term loans, overdrafts and long-term loans
Short & medium term loans are provided to customer to meet working capital
requirements
o Working capital required to invest in inventors and account receivables to
meet expenses
Islamic Banks:







Cannot charge interest but can charge profit on investments but not interest on
loans
Can only issue interest free loans (Qard al Hassan)
Inventory investment provided by Islamic banks through Murabaha
o Profit of a certain period is shared by IFIs
o Must prove viability of the project/business
No personal consumption loans issued
Murabaha financing is very useful for short to medium term financial
requirements of business/nonprofit organizations and individuals
Leasing provided under agreement of Ijarah
Recently IFIs have created an avenue to meet their liquidity requirement in the
form of Sukuk (Islamic Bonds) whereby servicing is fixed like conventional bonds
however such types of Sukuk can be issued against Ijarah receivables.
Contracts:
Conventional system: not based off of contract system.
Islamic banking system: Must be within the framework of Shariah. A contract only exists
once both trading parties have agreed on terms including: asset, price and delivery. A
contract is a legally binding agreement or a set of promises between two or more
parties – either written or oral.

Under the common law, the final elements must be met in order for a contract to
be valid:
o Intention/Consideration
o Certainty of terms – no ambiguity
o Capacity – mature and sane parties
o Informed consent – voluntary
o Legal/Permissible
o Parties must have ownership of asset that is being sold
o Parties must be able to deliver
SUMMARY OF MAIN POINTS:
Conventional Banks
Islamic Banks
1. Based off of manmade principles
1. Based
Principles
2.
Investor
–
assured
predetermined rate of interest
of
off
of
Islamic
Shariah
2. Risk sharing between provider of
a capital (investor) and the user of funds
(entrepreneur).
3. Aim: maximizing profit without any 3. It also aims at maximizing profit but
subject to Shariah restrictions.
restriction.
4. No Zakat
4. IFIs – Zakat Collection Centre and
they also pay out their Zakat
5. Lending money – get return with 5. Partnership – must understand
compounding interest
customer’s business very well.
6. No provision to charge any extra
money from the defaulters. Only small
amount of compensation and these
proceeds is given to charity. Rebates
6. Defaulters can be charged penalty given for early settlement at the Bank’s
and compounded interest
discretion.
7. Bank’s own interest prominent; no 7. Importance to the public interest. Its
effort made to ensure growth with ultimate aim is to ensure growth with
equity.
equity.
8. Since income from the advances is
fixed, it gives little importance to
developing
expertise
in
project
appraisal and evaluations.
8. Since it shares profit and loss, the
Islamic banks pay greater attention to
developing project appraisal and
evaluations.
9. Emphasis to credit-worthiness of the 9. Emphasis on the viability of the
clients
projects.
10. Relation: banks (creditors), clients 10. Clients – partners, investors,
(debtors)
traders, and buyer and sellers.
11. Guarantee deposits for deposit
account: al-Wadiah,
11. Guarantee all its deposits.
Mudarabah– clients share in a loss
Adverse selection and moral hazard in Islamic finance
The issue of adverse selection in Islamic finance arises due to asymmetry of
information, when Islamic financial Institutions are entering new market and launching
their initiatives in new place. They do not have complete information and credit history
of their new borrowers. Hence they may only consider those that they see as financially
solvent before providing finance, Another example is Mudarabah contract where the
bank does not share the loss with the investor but rather the profit, so the bank can
engage in risky investment to generate more profit because the higher the risk the
higher the return, Another example is Musharakah where the entrepreneurs know the
nature of their business and its profitability , they possess inside information about the
venture they are seeking financing for , adverse selection occurs because the bank has
less information, the moral hazard problem because of the ‘hidden’ action motivated by
self-interest of the entrepreneurs which is unknown to the bankers (information
concerning the true characteristics of an individual entrepreneur are concealed from the
bankers). Another example is health takaful when individual makes donation to the fund
because they know that their medical bills will exceeded their contribution and their true
intention for making the donation is concealed to the operator
Concept of time value of money in IF…. (You may read ISRA book which is very
good in this concept)
The concept of time value of money in islamic finance is based on shariah, The
Shari`ah does not rule out this consideration, for it does not prohibit any increment in a
loan given to cover the price of a commodity in any sale contract to be paid at a future
date. What is prohibited, however, is making money’s time value an element of any
lending relationship that considers it to have a predetermined value. Here, the Shari`ah
requires that a loan be due in the same currency in which it was given because it
considers money as only a medium of exchange not as a commodity hence it cannot
generate income. The Shari`ah has the genuine provision of converting money into
assets on the basis of which one can measure its utility. While it admits the concept of
money’s time value to the extent of pricing in a credit sale, it does not endorse placing
“rent” on money advances, as interest does in the case of credit and advances. As per
the Shari’ah rules, the aspect that matters is the
conversion of, for example, $1,000 into an asset, in which case that $1,000 asset may
be worth more or less in the future, a condition that will lead to a profit or a loss. This
conversion into assets is subject to well-articulated rules governing profit/loss sharing,
trading, and leasing.
Challenges of IFI in the wake of Global Financial Crisis
The challenges facing Islamic finance include:
Strengthening the infrastructural building blocks of the Islamic financial services industry
to further enhance the industry’s resilience
Accelerating the effective implementation of Shari'ah and prudential standards and rules
to facilitate the creation of a more stable, efficient and internationally integrated Islamic
financial services industry
Creating a common platform for the regulators of the Islamic financial services industry
to enhance constructive dialogue.
Improving accounting, auditing and disclosure standards for IIFS and their
counterparties, supported by adequate governance arrangement
Developing a robust national and international liquidity infrastructure,
encompasses the potential for monetary policy and money market operations?
which
strengthening of the financial safety net mechanism, namely, LOLR facilities and
emergency financing mechanisms as well as deposit insurance, all of which need to be
compatible with Shari’ah principles.
Developing a reliable crisis management and resolution framework, in addition to financial
safety nets; which includes bank insolvency laws and the arrangements for dealing with
non-performing assets, asset recovery and bank restructuring, as well as bank
recapitalization.
Capacity building as well as talent development to tackle the issue of man power in the
Indus

Deposit or financing product/ instrument, discuss pricing mechanism.
(indicate how benchmarking process takes place)
June 2010 
Price determinants:







Market forces: interaction between supply and demand – equilibrium price...
Profit margin – cost + profit margin = price
Innovative efforts – R&D e.g. Apple iphone
Cost of funds:
 Sources of funds: Deposits are the primary source of funds. Other sources of
funds include loans obtained through the credit program of the Bank (known as
"advances") and from other sources.]
 Cost of deposits/funds: based on interest rates.
Cost of funds determines the minimum return required by the firm on capital
deployed
IFI’s so far have been using the interest rate mechanism as a benchmark for
procurement and placement of funds
Example: based on LIBOR.
Pricing Deposits in Islamic Banking
The Shariah principles of each type of deposits play an important part in the calculation
of the rate of return (“ROR”) for the Islamic banking industry. For example, al-Wadiah
Yad dhamanah deposits do not earn any fixed returns because the amount of return is a
discretionary gift i.e. Hibah. The amount of Hibah dictates the ROR a depositor enjoys
and is calculated on a daily accrual basis at prevailing rates, depending on outstanding
balances. The pricing of al-Mudarabah deposits i.e. general investment accounts, alMudarabah special investment accounts and al-Mudarabah specific investment
accounts applies a pre-agreed profit sharing ratio on the investment returns. Unlike
conventional banking where returns are pre-determined, the indicative returns on such
deposits are based on historical performance and do not in any way guarantee the
future performance.
As such, the profit-sharing depositors of Islamic banking
institutions only know their actual returns at the maturity of the deposits. These returns
are subject to the profits accrued from investment and financing that are shared
between the banks and the depositors. The banks assume the role as entrepreneurs to
invest the depositors’ funds. In the event of loss, the depositor as the capital provider
will bear the losses except in cases where there is evidence of negligence by the bank
in managing the depositors’ funds.
In this regard, BNM issued the Framework of Rate of Return (“ROR Framework”) on
October 16, 2001 to standardize the method for calculating the rate of return. The
framework comprises 2 types of tables i.e. the calculation table (“CT”) and the
distribution table (“DT”). Taking into consideration the different funding strategy
adopted by the Islamic banking institutions, the banks are allowed to offer various profit
sharing ratio for the Mudarabah deposits. The banks are allowed to make changes to
the profit sharing ratio but the revised ratio shall only be applicable to new deposits. In
the CT, the banks derive the net distributable income to the depositors and the bank by
incorporating the income generated from assets, the relevant shared expenses and
allowances between the bank and the depositors, and income attributable to the various
types of depositors. Please see Formula 1 and 2 for more details.
In the DT, the banks are required to classify the current, savings and general
investment deposits into Mudarabah or non-Mudarabah deposits. All banks are
required to assign weight age to all types of deposits within the range of 0.76 and 1.24.
The weight age for the 12-month general investment accounts and specific investment
accounts must be fixed at 1.00. The weight age represents the risk attached to holding
each deposit. The assigned weight age is used to derive the weighted average daily
amount of deposits. Thereafter, the bank calculates the distributable profit, firstly for
Mudarabah deposit and subsequently for each type of Mudarabah deposit. Finally,
based on the profit sharing ratio of the respective deposit types and tenures, the bank
computes the net rate of return i.e. percentage of profit distributable to depositors and
banks per annum, after determining the gross rate of return for each type of deposits.
Please see Formula 3 until 7 for more details.
One important feature under the ROR Framework was the introduction of the Profit
Equalization Reserve (“PER”) to enable the banks to mitigate undesirable fluctuations of
income and remain competitive, particularly in term of the deposit rates. PER is the
amount appropriated out of the total gross income and is a provision shared by both the
depositors and the banks, and hence is deducted from the total gross income. Islamic
banking institutions are allowed to build up and maintain maximum accumulated PER of
30% of the bank’s capital funds or shareholders’ funds. The banks may write back the
amount of PER into the total gross income in the event that the prevailing rates become
less competitive. However, the banks must at all time exercise prudence in building up
and writing back the PER.
Pricing Financing in Islamic banking
In Islamic banking, financing are extended substantially based on fixed rate financing
through the wide application of certain Shariah principles, namely al-Bai Bithaman Ajil
(“BBA”), al-Murabaha and al-Ijarah Thumal al-Bai. To calculate COF, Islamic banking
institutions take into account the actual profit attributable to depositors. However, the
future trend of costs may differ from historical profit; hence careful consideration should
be exercised for the determination of COF. Projected increase in profit rate can be
factored in the pricing of financing. The Islamic Financing Rate (“IFR”) or Base
Financing Rate (“BFR”) is somewhat the equivalent of BLR. Nevertheless, the different
pricing models and qualitative factors applicable to conventional banking as discussed
by Rose et. Al (2010) is also relevant to the pricing of financing by Islamic banking
institutions. The introduction of Islamic Variable Rate Mechanism under the concept of
BBA by BNM in 2003 provided an alternative to the predominantly fixed-rate financing
portfolio. This Shariah-compliant product was structured to enable the Islamic financial
institutions which operate in a dual banking environment to match the current market
financing rate in order to provide matching returns to their depositors, thereby alleviating
any mismatch risk. By doing this, the Islamic financial institutions are able to receive
varying income streams from their financing activities, which will be distributed to the
depositors at a more competitive rate.
Benchmarking:


Shari’ah Scholars ruling is that if the transaction fulfils all the Shari’ah requirements,
then merely using an interest rate as a benchmark for determining the profit of the
underlying instrument does not render the transaction as haram or invalid, because
the transaction itself does not contain interest.
Some Scholars are of the view that this practice should be phased out, because
using the rate of interest as an ideal for halal business is not desirable

Discuss the Position of investing in equities or securities from Islamic
perspectives
June 2010
There is match particularly in investing in equities between the principle of Shariah
which are prohibitions of Riba, permissible of trade, prohibition of gambling, avoidance
of Gharar, and forbidden of non-shari’ah compliant business and financial products
parameters which are the natural of contract and Maqasid al-shari’ah.
From Islamic perspective the investing in the equities represents an ownership
certificate by join business under Musharakah contract, by the way the implementation
of sales contract impossible because there is no physical transfer of assets from the
buyer to the seller. This contract must fulfill all the requirements related in disclose
about the return ratio as well as the offer and acceptance of two parties those who are
the investors and the equities issuers with full legal capacity. Besides, the investor is
taking risks by no guarantee to the minimum return and the profit or loss due to price
fluctuation in the market otherwise the risk of bankrupt which will born the equities
holders loss in their capital, therefore in response to principle Al – ghonm bil ghonm (no
reward without risk) the equities return is permissible. As regards the preference stock
which is guarantee payment of the capital or of a certain amount of profit is
impermissible from Islamic perspective because give the extra benefits related in the
administrative matter to maintain equal treat for all investor.
Regarding to natural of contract, from Islamic perspective the contract must be free of
gambling and Gharar to maintain the contract valid unless these factors exist will make
the contract void and also if the contract explicitly has an exit policy, the contract can
become voidable. So the object from remove all of these elements in the contract is to
secure the investors and equities issuers from harm.
The relation between the equities holder and the business as usual based on Wakil
(agent) but the equities holder must be sure the management do not arrange prohibited
activities.
the investing in equities of business provide non shari’ah compliant products as well as
free of Riba because these elements clash with the shari’ah principle in forbidden nonshari’ah compliant business and prohibition of Riba.
Recognizing to the Maqasid al-shari’ah, investing in equities instead of hoard is protect
the property (Al mal) by protect the wealth from eroded and also investing in equities will
provide more Halal investment opportunities which are might lead to growth and
expansion in the economy which is one of Maqasid al shari’ah to achieve public utility.
a) Critically discuss THREE (3) objectives of a monetary policy under the dual
banking systems (Islamic and conventional banking system co-exists in the same
jurisdiction). (6 Marks)
The ultimate aims of any successful monetary policy for both Islamic and conventional
banking systems are concentrated towards the achievement of sustaining real
economic growth; reducing inflation and lowering unemployment.
1) Achieve Sustainable Economic Growth
This occurs when the production capacity of the economy increases over time,
which is achieved by increasing the quantity and/or quality of resources. When the
economy grows and production capacity expands, then more goods and services
are available to satisfy wants and needs. Without economic growth, the economy
stagnates, and often even experiences a falling living standard. The current
Malaysian Gross Domestic Product (GDP) for the 1st Quarter 2010 is stated at
10.1% (source: Department of Statistics Malaysia website).
For the banking system, the goal of steady economic growth is closely related to the
high employment goal because businesses are more likely to invest in capital
equipment to increase productivity and economic growth when unemployment is
low. Conversely if unemployment is high and factories are idle, it does not pay for a
firm to invest in additional plants and equipment. Although the two goals are closely
related, policies can be specifically aimed at promoting economic growth by directly
encouraging firms to invest or by encouraging people to save, which provides more
funds for firms to invest. In fact, this is the stated purpose of supply side economics
policies, which are intended to spur economic growth by providing tax incentives for
business to invest in facilities and equipment and for taxpayers to save more.
As for the Islamic banking system, to be the engine of growth, it must internationally
integrated and develop efficiently intermediate funds in the economy. The stable
growth is important in preserving and increasing wealth.
Interest rates tend to rise during business cycle expansions. Thus, a higher rate of
economic growth might not be possible without rising interest rates. In this case, the
goal of high employment and economic growth conflicts with the goal of stable
financial markets and interest rates.
2) Reducing Inflation
The inflation rate in Malaysia was 1.60 percent in May of 2010 (source:
http://www.tradingeconomics.com). Inflation rate refers to a general rise in prices
measured against a standard level of purchasing power. The most well known
measures of inflation are the CPI which measures consumer prices, and the GDP
deflator, which measures inflation in the whole of the domestic economy.
The aim for reducing the inflation rate interrelated with price stability. The objective
of price stability refers to the general level of prices in the economy and implies
avoiding both a substantial increase in the price level (inflation) and a permanent
decline in the price level (deflation).
For the banking system, the inflation erodes the purchasing power of financial
wealth. If the Islamic banks can be sure that prices will remain stable in the future,
they will not demand an inflation risk premium to compensate them for the risks
associated with holding nominal assets over the longer term. Lower risk premiums
on real profit rates makes the monetary policy more credible and thus increases the
efficiency with which capital markets allocate resources and this in turn makes
investing more attractive and fosters economic growth.
3) Full Employment
This results when all available resources (especially labour) willing and able to
engage in production are producing goods and services. Falling short of this goal
results in unemployment; because some degree of unemployment naturally exists in
a modern complex economy, full employment is achieved if the unemployment rate
is about 5 percent. Unemployment means the economy forgoes the production
goods and services. For 1st Quarter 2010, Malaysia achieve unemployment rate at
3.7% (source: Department of Statistics Malaysia website).
Two main transmission channels of unemployment over banking stability is due to
non performing loan (NPL) effect and demand for new loans effect. NPL effect is
an increase in the unemployment rate will cause a contraction of the reimbursing
capacity of households, triggering an increase in the default rate. On the other hand,
demand for new loans effect is an increase in the unemployment rate might produce
a material reduction of demand for new loans, which could lead to a significant
deterioration of the ratio between the bearing interest assets and bearing interest
liabilities. Under Islamic monetary system, such targets can only be achieved
through those monetary instruments, which are consistent with Islamic teachings.
b) For a Central Bank targeting interest rate as policy variable, discuss THREE (3)
monetary tools available at the Central Bank’s disposal in the conduct of
monetary policy [Hint: Illustrate how each of these tools work]. (6 Marks)
For a Central Bank targeting interest rate as policy variable such as Central Bank of
Malaysia, THREE (3) monetary tools available at the Central Bank’s disposal in the
conduct of monetary policy are open market operation; discount window and reserve
requirements.
1. Open Market Operation
Open market operations are the most useful and important of the policy tools in
managing the monetary environment of the country. Open market operations refer to
the purchase or sale of government securities by the commercial banks. For the
Islamic banking, an open market operation is where purchases and sales of financial
instruments such as Islamic Treasury Bills and government investment issues. Each
purchase or sale of securities directly affects the volume of reserves in the banking
system and therefore the whole economy. Purchases of government securities
increase reserves and eases credit while sales decrease reserves and tighten credit.
With each purchase of securities, the individual pays for the purchase by crediting
the reserve account of the seller’s depository institution. The bank can then loan out
the reserves and increase the supply of money. Conversely, sales of securities
reduce reserves and tighten credit because the seller chargers the reserve account
of the buyer’s bank, thus decreasing the reserves available for loan.
Open market operations are either dynamic or defensive. Dynamic operations are
those taken to increase or decrease the volume of reserves to ease or tighten credit.
Defensive operations are those taken to offset effects of other factors influencing
reserves. By influencing the amount of money/liquidity in the system, the Central
Bank can also indirectly affect the price of money/credit, which would in turn affect
the economic conditions of the country.
2. The Discount Window
Central Bank act as a safety valve in relieving market pressures through discount
window. By lending funds against acceptable collateral, the bank provides essential
liquidity to financial institutions, while helping to assure the basic stability of money
markets and the banking system.
Commercial banks borrowed from Central Bank by bringing bonds and other asset
documents to a teller’s cage or window. The amount loaned was the face value of
the asset, minus a discount. Today, financial institutions still borrow from Central
Bank. However, the term “discount window” is simply an expression for Central Bank
loans that are repaid with interest at maturity. These are nowadays arranged by
telephone and secured by pledged collateral.
The discount rate is the interest rate paid by depository institutions on loans from the
Central Bank’s credit facility, the discount window. Changes in the discount rate
affect credit conditions and therefore the economy. An increase in the discount rate,
for example, makes it more costly for depository institutions to borrow from the
Central Bank. The higher cost discourages depository institutions from using the
discount privilege. It may force depository institutions to screen their customers’ loan
applications more carefully and hence, slow the growth of their loan portfolios, which
may be a good thing during times of overheated economic conditions.
Apart from these direct impacts, changes in the discount rate can affect expectations
in financial markets. If, for example, the market interprets an increase in the rate as
the beginning of a sustained program to tighten credit, lenders will cut back
commitment, waiting for more attractive rates. Potential borrowers will try to borrow
before the expected higher rates materialize. These actions by lenders and
borrowers will produce a tightened credit situation.
3. Reserve Requirement
Reserve requirements are the percentages of deposits that depository institutions
must hold as cash in their institution or at Central Bank. The reserve requirement
affects monetary and financial conditions. For example, a reduction in the reserve
requirement decreases the amount of reserves that banks must hold and therefore
banks can make more loans. The larger volume of loans granted by financial
institutions stimulates the economy. Raising the reserve requirement has the
opposite effect. Reserve requirements are also used to regulate banks, so as to
provide security and stability in the banking system.
Reserve requirement is defined in terms of bank’s eligible liabilities (EL). The EL
base comprises deposits (including negotiable certificates of deposit and repurchase
agreements) and net interbank borrowings. By changing the rate of EL, the Central
Bank can withdraw or inject liquidity in the banking system to make up for excess
liquidity or lack of liquidity. The current statutory reserve requirement rate is 4% of
eligible liabilities. In principle, bank must maintain their reserve requirement
balances that are at least equal to the prescribed ratio. If fail to comply, banks are
liable to pay penalty.
c) Critically evaluate FOUR (4) types of financial instruments traded in the Central
Bank of Malaysia (Bank Negara Malaysia) Islamic Interbank Money market [Hint:
please include in your discussions, the tenor as well as the types of contracts
used for each instrument]. (8 Marks)
FOUR (4) types of financial instruments traded in the Central Bank of Malaysia (Bank
Negara Malaysia) Islamic Interbank Money market are as follows:
Government Investment Issues (GIIs)
When the first Islamic bank in Malaysia began operations in 1983, the bank cannot
among other things, purchase or trade in Malaysian Government Securities (MGS),
Malaysian Treasury Bills (MTB) or other interest-bearing instruments. However, there
was a serious need for the Islamic bank to hold such liquid papers to meet the statutory
liquidity requirements as well as to park its idle fund. To satisfy both requirements, the
Malaysian Parliament passed the Government Investment Act in 1983 to enable the
Government of Malaysia to issue non-interest bearing certificate known as Government
Investment Certificates (GIC) {now replaced with Government Investment Issues (GII)}.
The GII was introduced in July 1983 under the concept of Qard al- Hassan.
The concept of Qard al- Hassan does not satisfy the GII as tradable instruments in the
secondary market. To address this shortfall, BNM opens a window to facilitate the
players to sell and purchase the papers with the central bank. The price sold or
1)
purchase by the players is determined by BNM, which maintains a system to record any
movement in the GII.
On 15 June 2001, the Government of Malaysia with the advice by Bank Negara
Malaysia issued a 3 -year GII of RM2.0 billion under a new concept of Bai Al-Inah. The
move therefore had added depth to the IIMM as the GII is now tradable in the
secondary market via the concept of Bay ad- Dayn (debt trading).
On 16 March 2005, the Government of Malaysia with the advice by Bank Negara
Malaysia, issued first Profit-Based GII 5 -year tenure of RM2 billion. It is coupon bearing
paper which the Government pays half yearly profit to the investors.
On 17 June 2005 the Government has amended the Government Funding Act 1983
(previously known as the Government Investment Act 1983) to increase the issuance
size limit of GII from RM 15 billion to RM 30 billion. As at end of 2005, the outstanding
amount of the GII issued is RM10.1 billion
2)
Mudarabah Interbank Investment (MII)
MII refers to a mechanism whereby a deficit Islamic banking institution (investee bank)
can obtain investment from a surplus Islamic banking institution (investor bank) based
on Mudarabah (profit sharing). The period of investment is from overnight to 12
months, while the rate of return is based on the rate of gross profit before
distribution for investment of 1-year of the investee bank. The profit sharing ratio is
negotiable among both parties. The investor bank at the time of negotiation would not
know what the return would be, as the actual return will be crystallized towards the end
of the investment period. The principal invested shall be repaid at the end of the period,
together with a share of the profit arising from the used of the fund by the investee bank.
Wadiah Interbank Acceptance
Wadiah Acceptance is an interbank transaction between BNM and the Islamic banking
institutions. It refers to a mechanism whereby the Islamic banking institutions placed
their surplus fund with BNM based on the concept of Al- Wadiah. Under this concept,
the acceptor of funds is viewed as the custodian for the funds and there is no obligation
on the part of the custodian to pay any return on the account. However, if there is any
dividend paid by the custodian, is perceived as 'Hibah' (gift). The Wadiah Acceptance
facilitates BNM's liquidity management operation as it gives flexibility for BNM to declare
dividend without having to invest the funds received.
Under the liquidity management operation, BNM uses the Wadiah Acceptance to
absorb excess liquidity from the IIMM by accepting overnight money or fixed tenure
Wadiah.
3)
Malaysian Islamic Treasury Bills (MITB)
The MITB is an additional liquidity management instrument for Islamic bank to manage
liquidity. This instrument is structured based on Bai al-Inah concept with different
maturities such as 3, 6 and 12 months. In a bid to broaden the Islamic bond market,
the issuance of MITB has created an active short term benchmark yield curve.
4)
Bank Negara Monetary Notes-I (BNMN-I)
BNMN-I are Islamic securities issued by Bank Negara Malaysia replacing the existing
Bank Negara Negotiable Notes (BNNN) for purposes of managing liquidity in the Islamic
financial market which formerly using Ijarah based tool. The instruments will be issued
using Islamic principles which are deemed acceptable to Shariah requirement.
The maturity of these issuances has also been lengthened from one year to three
years. New issuances of BNMN-i may be issued either on a discounted or a couponbearing basis depending on investors' demand. Discount-based BNMN-i will be traded
using the same market convention as the existing BNNN and Malaysian Islamic
Treasury Bills (MITB) while the profit-based BNMN-i will adopt the market convention of
Government Investment Issues (GII).
5)
Islamic Debt Securities
Islamic Debt Securities were introduced in Malaysia in 1990. At the moment, the
IDS which are outstanding in the market were issued based on the Shariah compliant
concept of Bai Bithaman Ajil, Murabaha and al Mudarabah. It has maturity tenure
ranging from 3 to 15 years.
6)
Cagamas Mudarabah Bonds
Cagamas Mudarabah Bond was introduced on 1 March 1994 by Cagamas Berhad to
finance the purchase of Islamic housing debts from financial institutions that provides
Islamic house financing to the public. The SMC Mudarabah Bond is structured using the
concept of Mudarabah where the bondholders and Cagamas will share the profits
according to the agreed profit-sharing ratios. Subsequently, it then issued via Bai’
Bithaman Ajil concept to finance the purchase of Islamic housing finance/hire
purchase debts. The bond is structured whereby the bondholder and Cagamas will
share the profits according to an agreed profit sharing-ratio. This instrument is
redeemable at par with profit paid on maturity date. It has tenure of up to 10 years.
7)
Islamic Negotiable Instruments (INI)
The INI covers two instruments such as:i)
Islamic Negotiable Instruments of Deposit (INID). The applicable concept is
Al-Mudarabah. It refers to a sum of money deposited with the Islamic banking
8)
ii)
institutions and repayable to the bearer on a specified future date at the
nominal value of INID plus declared dividend.
Negotiable Islamic Debt Certificate (NIDC). The applicable concept is Bai
Bithaman Ajil (BBA). It represents Certificate of Deposits with negotiable
features. The transaction involves the sale of banking institution's assets to the
customer at an agreed price on cash basis. Subsequently the assets are
purchased back from the customer at principal value plus profit and to be
settled at an agreed future date. Basically, it is created to mobilize medium and
long term deposits.
Question: Advantage of Monetary policy
The advantages and disadvantages of monetary targeting and inflation targeting
Advantages:
 Inflation Targeting:
- Medium term strategy for monetary policy
- Allows a country to attain and maintain low and stable rate of inflation: easier
to focus on wage and price setting and domestic considerations.
- Increase Central Bank’s credibility to provide a clean reference point about
prices.
- Once specified, it does not need to be adjusted frequently since it directly
focuses on the final objective.
- High transparency and readily understood by public.
- Weakens the effect of inflationary shocks.
 Monetary Targeting:
- Information on whether CB is achieving its target is known almost
immediately. Easy to monitor.
- Monetary targets send almost immediate signals to the public markets. These
signals help fix inflation expectations and produce less inflation
Disadvantages:
 Inflation Targeting:
- no guarantee that the central bank will be successful in using its discretion to
appropriately set monetary policy
- requires consideration of long lags between changes in monetary policies
- no direct control
- rigid rules in policy making
- Sole focus on inflation may lead to larger output fluctuations.
 Monetary Targeting:
- Instability between the monetary aggregates and goal variables.
- There must be a strong and reliable relationship between the inflation and the
targeted monetary aggregate
Question: 4 functions of CB operated under the dual banking system.
1) Issuer
of
currency
&
keeps
reserves safeguarding
the
value
of
the
currency
Maintaining a strong reserve position->important to short term & long term
objectives of economic growth & sustainable development
Large reserve back up -> important in protecting a country against unforeseen
destabilizing development
2) Acts
as
a
banker
&
financial
adviser
to the
Government
Advise government on its loan programs. Responsible for trading, registering,
setting, & redeeming government securities through its trading & settlement
system
3) Promotes
monetary
stability
&
sound financial
structure
4) Influences
the
credit
situation
to
the advantage
of
the
country
5) Lender
of
last
resort
6) Shari’ah
supervisory
Questions: Give examples, explain what it meant by comingling funds. Why
comingling of funds considered non-shari’ah compliant. Discuss the roles of
Islamic Shariah advisers in resolving the issue. What could be the factors that
constraint the capacity of Shariah advisers in resolving this problem.
Commingling funds: mixing together between Islamic and conventional funds in term of
deposit insurance corporation practice
Deposit insurance in practice Basic Principle: No Co-mingling of Funds
 Rely on conventional deposit insurance
Islamic deposits are very small, thus no incentives for regulators to enforce the
establishment of deposit insurance scheme
 Mixed-pool of funds
Premiums received from conventional and Islamic banks are put in the same
pool and returns on investments are shared based on % of contributions from
each sector
 Separate pool of funds
Premiums received from Islamic & conventional banks are put into two separate
pools
Considered no shari’ah compliant because of the mixing Islamic & conventional funds
The shari’ah advisor / shari’ah board is a key element of the structure of an Islamic
financial institution, carrying the responsibility of ensuring that all products and services
offered by that institution are fully compliant with the principles of shari’ah law.
June 2011 Q. 6(a)
Compare and contrast any TWO (2) deposits and financing products, respectively,
across the Islamic financial services industry.
DEPOSIT PRODUCT
FINANCING PRODUCT
Contract of Wadiah
Contract of Murabaha





Wadiah is purely a contract on
safe custody of goods without
any promise on rewards or
returns.
The bank accepts deposits from
its customers who looking for
safe custody and convenience.
The bank requests permission to
make use of the customers’
funds for investment purposes.
Under the contract of Wadiah,
the Bank is not allowed to
mention or to promise any
reward on the deposit received.
The depositors cannot demand
any rewards or return from their
Bank on their savings.

Contract of Mudarabah



Mudarabah
is
a
contract
between two parties (capital
provider and entrepreneur).
The capital provider does not
participate in the management
of the funds.
In the event of a loss, the capital
provider bears all the losses.



Murabaha means cost plus
mark-up sale.
The bank may finance customer
who wishes to acquire an asset
by purchasing the asset from the
developer and subsequently
sells to the customer.
The customer is allowed to settle
the payment of the asset by
installment within a pre-agreed
period.
Contract of Ijarah



Ijarah means lease or rent.
Generally, the contract of Ijarah
means giving the benefit or use
or service of an asset for a fixed
price.
Leasing is contract between a
lessor and a lessee for the lease
of equipment which is chosen by

Profits
generated
will
distributed according to
predetermined ratio.
be
the


the lessee.
Lessor
retains
beneficial
ownership to the equipment.
Lessee has possession and use
of the equipment through
payment of rentals over a
stipulated period of time.
June 2011 Q. 6 (c)
Question
3 major roles of non-bank fin. Institutions in promoting financial services industry
(e.g. wealth mgt, asset mgt etc)
1.
Takaful
Function:
•
A type of joint guarantee insurance mechanism where a large group of people
pool their financial resources together against certain loss of exposures.
•
Based on principles of co-operation, protection, mutual responsibility and avoid
acts of interest and uncertainty.
•
Takaful operator conducts all its affairs in a manner that adheres to Shariah
guidelines.
•
Takaful operators do not have policyholders. They are contributors or
participants, as they are participating jointly in a takaful fund for their mutual
benefits.
•
Contributors/participants: Owners of the fund.
Product:
Family Takaful
•
Has a defined period of maturity.
•
Insured persons commonly make periodic level premium contributions.
•
Contributions will be used primarily for meeting their targeted individual savings
and partly for assisting their families financially when the insured dies.
•
Contributions amount varies among the insured, depending primarily on the sum
(face amount) that each insured targets to accumulate at the end of the coverage
period and on the age, gender and health condition of the insured.
•
The takaful operator may set the minimum face amount for this purpose and may
also set minimum and maximum age limits for participating in this type of policy.
•
Takaful life insurance is also used for other purposes, including generating funds
for children’s education, securing a fund in case of mortgagor’s premature death
and protecting business interest against key employee’s death. Several takaful
polices now come with hospitalization and disability benefits.
•
There is virtually a counterpart takaful life insurance policy for each major type of
conventional life insurance policy, with a difference in how premiums are
allocated.
General Takaful
•
Takaful General Insurance Policy
•
Takaful operators offer coverage, commonly on an annually renewal basis, for
fire, automobile, liability, marine, worker’s compensation, fidelity and even crop
insurance.
•
Principles employed: principle of insurable interest to minimize the problems of
moral hazard, i.e., to separate insurance from gambling.
•
Using the principles of uberrima fides, both takaful and conventional insurers can
make a contract void if there is material misrepresentation concealment or
breaches of warranty made by insured.
•
“Valued policy”, actual cash value methods not permitted in takaful.
2.
•
•
•
•
Retakaful
Retakaful transfers are commonly classified into proportional and nonproportional arrangements.
Non-proportional arrangements such as excess of loss or stop-loss
arrangements may not be suitable because of the existence of uncertainty with
respect to the assessment of losses.
Islamic principles demand for clearly defined joint responsibility throughout the
coverage period.
Retakaful likely to be arranged on a pro-rata basis, e.g. quota share or surplus
Retakaful, where the reinsurer becomes a co-insurer of the original risks. If,
however, a non-proportional reinsurance arrangement is selected, it could be
based on a strict profit commission plan or on a reciprocal basis. In this regard, it
matters little whether the Retakaful transfer is on a facultative or treaty basis.
Addition:
•
Takaful operations now available in various countries throughout the world
(around 40 operators), primarily in Islamic countries and countries with large
Muslim population.
•
Industry growth: 10 -20% per year.
•
To enhance global takaful infrastructure, ASEAN
•
Retakaful International (L) Ltd. has been identified as one of the vehicles to
enhance Retakaful arrangements.
3.
Fund Management companies
Definition:
•
Fund management companies manage the funds of their clients.
•
Caters for people who either have no time to manage their own funds or are
fearful that they do not know how best to manage their funds, or believe that fund
managers have the expertise to seek out better yields at lower risk relative to
•
•
•
•
•
themselves.
Within the Islamic sphere, equity funds have been the most popular products
The Islamic equity funds market is one of the fastest growing sectors within the
Islamic financial system.
There are approximately 100 Islamic equity funds worldwide.
Growth of total assets managed: 12-15% per annum.
Since the launch of Islamic equity funds in the early 1990s, we have seen the
establishment of credible equity benchmarks by Dow Jones Islamic market index
and the FTSE Global Islamic Index Series.
4.
Pension Fund
•
1. HSBC Asset Management: Employers make direct deductions from salaries
and wages, which may include the employers’ own contribution and pass on the
funds to HSBC, which in turn invests the funds on home loans, as well as
Shariah-compliant equities.
Old Mutual Employee Benefits: Launched a product known as the Pristine
Retirement Scheme. Pristine Retirement Scheme is the first fully Shariahcompliant retirement scheme to be launched in South Africa. Pristine invests in
very selective Shariah-compliant investments.
Oasis Group Holdings: Manages the Crescent Global Fund, comprising funds
invested in Shariah-compliant products, and the Oasis Global Fund, which
invests in conventional equity products.
Islamic Development Bank (IDB) Infrastructure Fund's Emerging Markets
Partnership (Brunei) Ltd (EMP Brunei): Provides equity and complementary
financing for private sector infrastructure projects in a wide range of categories,
including power, telecommunications, transport, natural resources development,
and infrastructure related sectors.
In Malaysia’s case, there is no Islamic pension fund yet.
•
•
•
•
Function
•
Caters for the time when one is retired.
•
Pension funds basically accumulate the periodic contributions of employees and
employers and invest the pool of funds in projects that are deemed secure, but
which nevertheless yield an attractive return.
•
Investments undertaken by most pension funds / superannuation schemes are
often unacceptable to Muslims as the returns may come from interest bearing
accounts or from activities considered repugnant to Muslims.
Jan 2011 Q.5 (b)
Discuss problems of Islamic financial products harmonization (4 marks)
o Adhering to International Standard setting bodies are purely on voluntary basis The primary objective of International Islamic finance regulatory framework is to
promote cross boarder products harmonization. (E.g. AAOIFI, IFSB, IIFM).
However, These International standard – setting bodies do not posses any formal
supranational supervisory authority and its conclusion do not and were never
intended to have legal force.
o Different jurisdiction between countries & Different views by scholars. - Muslim
countries have their own religious bodies which are independent from one
another. They establish their own principles. A particular principle adopted by a
specific country is not necessarily regarded as distinct principle by other
countries.
E.g. – non-permissibility of BBA in most of the countries but
permissible in Malaysia.
Jan 2010, Question No.10 (b)
This question is basically based on the articles by Shariah scholars hold many positions
in many Shariah Board. I can’t find the actual article but it basically discussing on
Shariah scholar more than one position sin boards.
b) The number of Shariah scholars serving the IFIs within and between the GCC’s
jurisdiction is well documented in the article. This may led to greater
standardization and harmonization of the Islamic products/instruments within and
between GCC’s jurisdiction. Do you agree or disagree. Discuss.
Agree
Disagree
Minimize diversion of fatwa as the merely the
same person has derived the fatwa. For example,
any issue shared and discuss in Bank A will be
shared the same in Bank B. Thus, this will bring
correlation of same understanding.
Potential conflict of interest Shariah Advisory
firms not only consult but also engage in the
auditing same IFIs Multiple roles and boards
Shariah scholars serve. There will definitely be a
conflict of interest. When a Shariah scholar sits
on the board of a financial institution, he is
basically issuing Fatwa as to how to draft
something. Some are also Shariah auditors and
legislators of an organization which sets Shariah
standards. They could also play the role of judge
for a particular country. So, while you are on the
board of a financial institution and also the judge
of a high court in that country, there is a
possibility that the case of the financial institution
you are working for might come back to you as a
judge
Credible the scholars on the board are, and
therefore how much would the potential client
base trust those scholars to ensure everything is
being done in a Shariah-compliant manner. The
key criteria for any scholar are experience, an
understanding of local law and legislation, a
commitment to the institution and independence
Scarcity of scholars, many are shared by
institutions; this can impact on the quality and
potentially the impartiality of the advice. Most of
the time spends on travelling so do not have
ample time to do some research and deep
understanding of the subject matter to be
discussed. Existing scholars under formidable
pressure to deliver approvals promptly. The risk
is that insufficient time is being devoted to legal
documentation governing the structure of
products like Sukuk which can run to hundreds
of pages
This global interaction has an added benefit: it
can foster greater harmonization between the
different Shariah interpretations. While every
scholar needs to maintain the independent
authority to make their own decisions, a shared
understanding of how scholars approach their
work can be of great help to an industry that
remains geographically and culturally dispersed.
Most of the scholars holding many positions in
many board are senior in the industry which will
lead to hide new talents of young scholar
onboard who is well versed in economics can
add a lot of value to an existing board. New
talented young scholar might bring something
different views on the current issue. Of course,
mentorship is essential to these new talented
scholars.
Details of Shariah scholars in article will benefit
IFIs to find scholars most appropriate for
cooperation by analyzing their expertise (e.g.
sector/country exposure), experience, position
e.g. chairman), educational background (e.g.
degrees, majors or ongoing professorships),
company involvement, and identifying events
Top 2 scholar share 61% of their board
memberships together. Where is the room for
mentoring and apprenticeship systems when the
same people of similar seniority tend to occupy
the same boards
they should attend, at which scholars speak.
Thus, this will bring harmonization on developing
new products.
Opinions:
It’s ok to hold many positions in other boards.
However, to ensure there is sufficient rooms to
develop young talented scholars with all the
knowledge to avoid shortage of expertise in
Shariah jurisprudence.
Opinions:
Encourage the board to consider appointing at
least one member of the Shariah committee as a
member of the board that could serve as a
“bridge” between the board and the Shariah
committee
Cross border products harmonization
Advantages






Promote market liquidity - Liquidity flows for efficient resource utilization and
supplementation that apply equally across both conventional and islamic sectors
Harmonize disclosure standards, align distributions and develop mutual
recognition for primary offerings
Mutual recognition of market professionals involves
Promote investment through local intermediaries
Allow local intermediaries to distribute and market products
Build and link infrastructure
Disadvantages



Duplicating or altering existing standards
Compliance burden
Constrain cross border product flows
The salient features of dual banking system, advantages and disadvantages and discuss
efforts and initiatives taken in promoting IF in those countries where parallel jurisdiction
between Islamic and conventional.
A dual banking system involves the existence of dual laws in parallel for the Islamic as well as
conventional financial institutions. Both banking systems are equally comprehensive and viable.
Malaysia is the best example of dual banking system, full fledged Islamic banking system
operating on a parallel basis with a full fledged conventional system. Not only do the two
systems work on a parallel basis, they also utilize essentially the same set of banking
infrastructure.
The Malaysian model has many advantages compared to the conventional system.

The Muslims in the countries which have only a conventional system do not have the
opportunity to benefit from the facilities of a modern banking system without being
involved in Riba.

In the case of the conventional plus system (conventional system with a few Islamic
banking institutions operating on the fringe of the banking system ex. Saudi Arabia,
Bangladesh, and Bahrain): the services they offer are not as comprehensive and as
sophisticated as the conventional system. The small scale nature of the operations of
the Islamic banking institutions in these countries also make their services less efficient
and more costly compared to the conventional institutions.
In the dual banking system in Malaysia, the Islamic banking system is a full-fledged system
with a large number of products, a large number of institutions and an interbank money
market. The Islamic banking products offered in Malaysia's dual system are therefore much
more sophisticated and cover a wider range of services than the Islamic banking products
offered in the conventional plus system.
In a dual system, therefore, the Islamic banks cannot afford to be complacent, since they
operate in a competitive and dynamic environment. In the single Islamic system model, on the
other hand, the financial institutions would not have a similar incentive to expand the range of
the Islamic banking products as the possibility of domestic customers shifting away to the
conventional
system
does
not
rise.
In addition to wider range of services, the Islamic banking products in the dual system can also
be expected to have a higher level of sophistication compared to the Islamic banking
products in the single Islamic system. In a dual system of banking, such innovations will
quickly find their way to the domestic conventional banking system. The Islamic bankers
operating in the dual system would have no choice but to create similar sophisticated products
on an Islamic basis. This will be an on-going process, whereby the level of sophistication in the
Islamic
banking
system
will
continuously
be
upgraded.
Disadvantages come from the fact that Islamic Banking in dual-banking system is subjected to
the same supervision and regulatory regimes of a Central bank than for the conventional one.
As IFI have to face competition coming from conventional banks, Islamic bank will have no
choice to copy conventional financial products.
Efforts and initiatives that can also be applied for pure Islamic banking system:

Deployment of human and financial resources to develop Islamic financial instruments.

Development of secondary market

Strategic alliances have been made between International Financial Exchange and the
Bahrain SE: cross-border and trading of Islamic financial products

Development of the Islamic Capital Market: ex in Malaysia, Introduction in 2005 of the
Citigroup Malaysian Government Securities Index and the DJ RHB Islamic Malaysia
Index
1. Principles of Islamic Finance - Discuss 5 principles (repeated in Jan 2011 and
Sept 2010)

Prohibition of Riba/ Usury/ Interest.
Riba means extra amount or deferment in the exchange of certain
commodity. Riba is absolutely prohibited in Islamic law. There are two
types of Riba which must be prevented by the player in financial
transactions: Riba Nasa' and Riba Fadl.

Money as potential capital.
What is considered by the objective of Shariah is money as potential
capital, meaning that money becomes capital only when it is invested in a
business. Accordingly, money which is advanced to a business as a loan
is regarded as a debt of the business and not as a capital which is not
entitled to any returns i.e. interest.

Risk-Sharing.
The risks in every business transactions are shared between the parties
who involve in the transaction. It is because one of the objectives of
Shariah is to ensure justice among the people.

Prohibition of speculative behavior.
Islam prohibits all types of Gambling, speculative and extremely uncertain
behavior. Islam seeks protection from deceit, uncertainty, economic
injustice, and ignorance for so it has clearly forbidden all business
transactions, which leads to exploitation and injustice in any form to any of
the parties of a contract.

Sanctity of contracts.
Islamic financial products and services are essentially based on contracts.
The importance of contracts in Islamic financial products and services is
more significant in Islamic finance because these products, unlike
conventional financial system, relate to various forms of contracts. The
elements of contract in Islamic commercial law consist of six elements
comprising of offer, acceptance, offeror, offeree, price, and subject matter.
2. 4 challenges faced by IF services industry that might impede the growth of the
country.

Cross border product recognition.
Lack of shari'ah standards cross border products acceptance.

Shari'ah scholars – governance.
Lack of regulatory or government supports.

Regulating shari'ah scholars.
Lack of qualified Islamic finance professionals, including shari'ah scholars.

Fiscal regime.
3. Compared to other countries, Bahrain and Malaysia are quite successful in promoting Islamic
financial services industry can be attributed to strong government & regulatory supports.
Discuss. June 2011
(5marks)
Success Factors in Malaysia due to:
-
Government Support
-
Legal/Regulatory Framework
-
Education-Public & Industry
Success Factors in Bahrain due to:
-
Triggered by hike in Oil Price-Gulf War
o
-
High concentration of Islamic Financial Institution
o
-
Search for Shariah investment
Creation of Bahrain Financial Harbour (BFH) US 1.3 Billion
Regulatory Framework:
o
Only nation to codified rules for Islamic Fin. Institution
o
Most number of Islamic Banks on country basis
o
Bahrain Monetary Agency (BMA)- Prudential Information and Regulatory
Framework (PIRI)
-
Supporting institution
o
AAOIFI
o
Liquidity Management Center (Money market)
o
International Islamic Rating Agency
-
Strong Government Support & Commitment to Islamic Finance
o
BMA-Sharia Advisory Council
o
IIBF – Training institute talent development
o
Regular issuance of Sukuk & leasing securities
4. Critically discuss the challenges of introducing Islamic financial services in the nonMuslim countries (Hint: You may select any countries such as the CIS, Australia, China, and
African countries to substantiate your arguments). (Repeated in Jan 2010)
June 2010
(10 marks)
(you can summarize and take important points on below short article)
In Australia
Australia is one of the many non-Muslim nations that have shown a keen interest in establishing
Islamic banking and finance in the country. It is a country closely watched by Islamic finance
scholars and practitioners as the favorable developments have encouraged tapping the Australian
financial market. It can be understood that country’s interest has been further fueled by the
United Kingdom’s successful implementation of Islamic finance and growth potential of the
sector. Australia with its vibrant and efficient financial markets undoubtedly is an ideal platform
for Islamic finance to grow.
Muslims are one of the many minorities in Australia, the history of the Muslim Community in Australia
dates from the sixteenth century. Some of "Australia's" earliest visitors were in fact Muslim fishermen
from the island of Makassar from the east Indonesian archipelago (Brief history, 2002). Their population
has seen ups and downs due to reasons of history, economic development and politics. It is only in the
recent decades that the Muslim minority in Australia has become more noticeable (Mirza, 2003). Author
Mirza (2003) also states that in 2001 (the last official census date), there were 281,578 Muslims
representing 1.5% of the total population up from 1.1% in 1996. This number is continuously growing as
the 80% of current Muslim population arrived after 1980’s.
As other Muslims around the world, Australian Muslims share the same discomfort of dealing with
conventional banks. As a result, demand for Islamic finance has been growing in the country. Today, the
Muslim Community Credit Union Ltd (MCCU) and the Muslim Community Co-Operative (Australia) Ltd.
(MCCA) cater to the financial and banking needs of Australia's Muslim minority community (Mirza,
2003). The MCCA operates as a co-operative and specifically deals with investment accounts, where
withdrawals are restricted. The services offered by MCCA are personal and business finance, halal
investments, qard hassan and zakat collections and distributions. This institution has had a tremendous
response from the Muslim community. The MCCA and MCCU are now well established and on the way
to becoming a fully-fledged Islamic Bank (Mirza, 2003). These developments translate in to one that
Australia’s Muslim community drives the demand for Islamic finance.
In general, Australia is a multi cultural and multi faith society that enjoys high living standards.
Australia, like most developed countries, has an ageing population. As productivity commission
report (2005) indicates the proportion of people aged 65 and over is expected to more than
double over the next few decades. This trend also indicates population’s possible inclination
towards ethical investment approach would further increase.
Moreover, this generation is more conscious of the environment and socially responsible
activities is more likely to be interested in ‘ethical investing’ The concept has already been well
received by many Australians who have a positive view of ethical financial deals. For example,
Australian Ethical Investment (AEI) Limited is on investing in highly ethical companies through
using positive screens for finding companies involved in the renewable energy sector, the
production of ‘natural food’, recycling and public/efficient transport providers (Wikipedia).
Company states that baby boomers are converting their socially responsible consciousness of the
1960’s into a useful tool to help them determine how they will invest as they near-retirement.
For non-Muslims Islamic finance has the same appeal as ethical investing where Islamic finance
deviates from conventional finance. In this aspect, it would be wise for Islamic financial
institutions to promote the concept of ethical investment which is the very idea of Islamic
finance eagerly endorses. Australia provides the right market for IFIs to introduce these products
that would be widely received by interested parties. In addition, baby boomers would create
perfect conditions for takaful operators to establish their presence in Australian market.
In one of the latest developments in Islamic finance, Australia has expressed its interest in
accommodating Islamic finance in country’s financial framework. Australia has arguably the
most efficient and competitive financial sector in the Asia-Pacific region, but there are further
opportunities to expand country’s exports and imports of financial services. . This is
complimented by the high recognition of Australia’s financial sector with Australia’s financial
system and capital market ranking second among 55 leading nations in 2009 (Freudenberg).
Australia, its location within Asia-Pacific with its large Muslim population combined with its
political stability and prudential banking record provides a competitive advantage in facilitating
greater penetration of Islamic finance (Freudenberg). Australia sits on the doorstep of the some
of the largest Islamic regions in the world and as analysts predict it could become a major
Islamic financial hub in 10 to 20 years time (Lannin, 2007). Standard and Poor's in Australia,
says it expects an Islamic stock market index to be based in Australia within the next few years.
It is noteworthy to mention the views expressed by Australian Assistant Treasurer Senator Nick
Sherry in Doha, Qatar that how keen Australia is to embrace Shariah finance. In a renewed
attempt to make Australia’s financial infrastructure more attractive government made a range of
recommendations including steps to ensure Islamic finance is enabled in Australia
(Muehlenberg, 2010). According to Muhelenberg (2010) Australian government believes that
this will present opportunities for Australian-based banks and financial institutions to develop
Shariahh-compliant finance products for domestic and international markets. Australian
government report on this regard has made several recommendations including removal of
regulatory barriers to the development of Islamic finance products. The report further
recommended an inquiry by the Board of Taxation into whether Australian tax law needs to be
amended to ensure that Islamic financial products have parity of treatment with conventional
products ((Muehlenberg, 2010). The future potential for Islamic finance is bright and
government concern in promoting Islamic finance would further encourage IFIs to move in to
country.
Among the major issues IFIs would face in a non-muslim country like Australia the current
financial regulations remain a hurdle. While these countries have an interest in
accommodating Islamic finance, a separate regulation dedicated for Islamic finance would be
hard to enforce. The IFIs would be required to operate in existing conventional framework that
will have certain provisions to support Islamic finance. There needs to be tax reforms (amongst
others) to ensure taxation is responsive and enabling for Islamic finance although not
preferential. However, this raises the fundamental question as to whether it is constitutionally
possible for Australia to implement such tax reforms to encourage and facilitate faith-based
transactions (Freudenberg). The possibility of providing a responsive tax structure must be
studied in the light of Australian constitution.
Common Challenges:
1. Product Development and innovation
Successful financial markets offer the market players, among other factors, a wide array
of products t invest in. this provides adequate flexibility for investors to make investment
decisions. Similarly, for an Islamic financial market to be successful, it must provide the
market players with the range of products that would enable the investors to match their
investment appetite and profile.
2. Building credibility and confidence
The challenge of credibility and confidence in Islamic finance stems from a set of factual issue
combined with a slew of misrepresented beliefs about Islam. Perceptions of Islamic finance
being tainted with terrorist funding and home of anti-money laundering are far from the truth.
3. Skills and expertise
One of the most vexing managerial issues in Islamic finance issues is the lack of skilled
personnel with knowledge and subject matter expertise in banking and Shariah
compliance. The issue has hampered the pursuit of product development efforts and has
also at times resulted in operational losses (Sultan, 2008).
4. Designing an effective money market system
Islamic banks are operationally similar to conventional banks hence they rely on liquid,
short term maturity liabilities to fund asset growth (Sultan, 2008). This compels Islamic
banks to hold substantial liquid assets and excess reserves. This in turn inhibits financial
intermediation. Difficulties in defining rates in these instruments have also constrained
the development of money and interbank markets.