IB1005
DEPOSITS AND FINANCING PRACTICES
OF ISLAMIC FINANCIAL INSTITUTIONS
CHAPTER 1 : ISLAMIC BANKING
COMPILED BY
HAMDAN HJ IDRIS, BSc Econs, MBA (Islamic Banking & Finance)
Certified Professional Trainer (MIM)
Industry Expert
INCEIF
PRESENTED BY
HJ MAHMUD HJ BUNTAT, MBA (AUOL, UK), DBM (Swansea Inst., UK), CIL (UIA)
Part-time Lecturer (INCEIF)
Former Head of Islamic Banking Division, OCBC Bank (Malaysia) Bhd
STRUCTURE OF ISLAMIC TEACHING
ISLAM
Aqidah
(Faith & Beliefs)
Shariah
Syariah
(Practices & Activities)
Ibadah
(Man-to-God worship)
Political Activities
Akhlak
(Moralities & Ethics)
Muamalat
(Man-to-man activities)
Economic Activities
Social Activities
Banking & Financial
Activities
2
SOURCES AND APPLICATION OF
SHARIAH LAWS
SHARIAH LAWS
(Practices & Activities)
PRIMARY SOURCES
Al-QURAN
(The Holy Book)
Al-SUNNAH
(The Practice of
Prophet Muhammad
[Peace be Upon Him])
SECONDARY SOURCES
IJMAK ULAMA
(The Consensus of
opinion of
Islamic scholars)
QIAS
(Analogical deduction
provided detailed
understanding derived from
Al-Quran and
Al-Sunnah)
3
LEVELS OF SHARIAH LAWS
1
Wajib
An obligatory duty where omission of this duty is
punishable.
Prayer 5 times a day,
Fasting, Zakat
2
Sunna
Duties and acts that are recommended but not
required. Performance of them is required, but the
omission is not punishable.
Giving donation, helping
people.
3
Harus
Indifferent actions, whose performance or omission
is neither rewarded nor punished.
Eating, sleeping.
4
Makruh
An action disliked yet not punishable but the
omission is rewarded.
Creating own/ unnecessary
rules to make things
difficult.
5
Haram
An action which is absolutely forbidden and is
punishable.
Gambling, Payment of
interest.
4
Chapter 1: Islamic Banking
Islamic Banking Law
Some basic principles have to be considered;
1. Riba must be eliminated as the basis of
banking transactions.
2. Activities financed by banks must be lawful.
3. Modes of financing should be based on their
economic merit.
4. The objectives of the banking system should be
related to the economic ideals of Islam.

“ Whereas legitimate trade or industry increases
the prosperity and stability of men and nations,
dependence over usury would merely encourage
a race of idlers, cruel bloodsuckers and worthless
fellows who do not know their own good and
therefore are akin to madmen” (Al-Baqarah
verse 2 :275)

The prohibition of interest essentially implies that
there can be no gain without risk- sharing, which
implies that if someone wishes to get returns he
must be liable for the loss.

No risk, no gain is actually the basic juristic
principle of Shariah.

Prohibition of gharar – excessive uncertainty
about subject matter.

Prohibition of Maisir/Qimar – game of chance, or
zero sum game… ”one gains at the cost of
others.”

Quran for prohibition on gambling (Al-Baqarah
verse 2 : 219 and Al-Maidah verse 5: 90,91).

Gambling is a form of gharar
Philosophy of Islamic Finance

Prohibition of riba and permission to trade
(Al-Baqarah verse 2: 275)

Towards asset-backed business & transaction

Real transaction or the sale of goods etc
Guiding Principles
1. Avoiding interest and Gharar,
2. Adhered to Shariah Principles,
e.g. mudharabah, musharakah, murabaha,
salam, Istina’
3. The business, investment and gain are
permissible (Halal)
4. Contribute to Zakat (Alms or Tithe)
Basic Operational Requirements
1.Profit – Risk with Resposibility
Shariah maxim “ Al Kharaj bi-al-Daman” or “ Al
Ghunum bil Gurm” , the criterion of legality of
any return on capital, meaning that one has to
bear loss if he wants to get any profit over his
investment.
2.Islamic Banks dealing in goods & document and
not money. Money only as medium of exchange
Basic Operational Requirements
(Continued)
2. Islamic Banks dealing in goods not
money – deal in goods & document,
money only as medium of exchange
3. Avoiding gambling & game of chance.
4. Transparency & Documentation.
5. Additional risks face by Islamic Banks
- asset, market risk, Shariah & non-compliance
risks, withdrawal risk, legal risk.

To achieve a full-fledged Islamic Banking system none
of the above Four Guiding Principles
can be
ignored, but legislators may choose to either tackle
the four aspects all at once or in phases according to
circumstances.

Specific legislation has been developed for Islamic
banking and finance, for example in Bahrain and in
Malaysia,
as
well
as
more
comprehensive
amendments
in
Pakistan,
but
only
partial
amendments in the U.K. or none at all in the U.S.

The rulebook for Islamic banks covers areas such
as licensing requirements, capital adequacy, risk
management, business conduct, financial crime
and disclosure/reporting requirements.

Interestingly, under the Principles of Business
(PB) for Islamic banks, Article 1.1.1 (Integrity)
states, “All relevant persons should be
straightforward and honest in their services and
conduct. Integrity is not just limited to honesty
but also includes fair dealing and full disclosure
of all relevant information. Banks' management
must safeguard not only the interests of
shareholders of the bank, but also those of the
Profit Sharing Investment Account (PSIA)
holders.”
Regulatory Requirements
•
Bank Negara Malaysia (BNM) regulates banks
generally through the Banking and Financial
Institutions Act 1989 (BAFIA) and specifically,
Islamic Banks via the Islamic Banking Act of
1983 (IBA).
•
Islamic banking business ”means banking
business whose aims and operations do not
involve any element which is not approved by
the Religion of Islam” (refer to attached BAFIA
and IBA legislation).

The terms “banking business” itself is not defined in
the IBA although the terms is defined in BAFIA as
the business of:–
• Receiving deposits on current account, deposit
account, savings account or other similar account;
• Paying or collecting cheques drawn by or paid by
customers; and
• Provision of finance;

Such other business as the Bank [BNM], with the
approval of the Minister, may prescribe.

The terms ‘Religion of Islam’ is very broad and leaves
open the interpretation as to which school of law
should apply (historically, the majority of Muslims,
including those in South East Asia adopted the
Ottoman civil code, the Majallah

Additionally, in the act is that dispute resolution
in Islamic banking cases comes within the
jurisdiction of the civil courts (and not under the
Shari’ah courts as might be expected).

Neither the IBA or BAFIA exclude the application
of civil law to Islamic banking transactions, or
that Islamic law shall apply exclusively to such
transactions

Also the IBA does not limit the business of
Islamic banking to stand-alone operators, in fact,
in Section 124 of BAFIA, it empowers
conventional financial institutions to carry on
Islamic banking business to the same extent as
an Islamic bank, and thus conventional banks to
be permitted to operate Islamic window
platforms.

Islamic banks resolve this problem by offering
full repayment of the investment but informing
the customer how much should be repayable to
comply with the risk-sharing formulation.

This allows customers to choose not to accept
full repayment if their religious convictions
dictate otherwise.”
•
In other words, when face with a loss the
customer is presented with the option to accept
the loss, which if suddenly not accepted, would
require the bank to guarantee full capital
repayment as per U.K. law.
•
The UK legal definition of a deposit is: “a sum of
money paid on terms under which it will be
repaid either on demand or in circumstances
agreed by the parties". In other words, money
placed on deposit must be capital certain.

However with a savings account there is a
potential conflict between U.K. law, which
requires capital certainty, and Shari’ah law,
which requires the customer to accept the risk of
a loss in order to have the possibility of a return.

With the State Bank of Pakistan, legislation
has evolved that required a number of
amendments to existing laws. With the
introduction of interest-free banking in Pakistan
from 1st January 1981 amendments were made
in the Banking Companies Ordinance 1962,
which took effect from 24th December 1980, and

included new definitions of “creditor” and
“debtor” to make room for new modes of
receiving deposits or extending financial
accommodation. Also a new section 26A was
added, which authorized the banks in Pakistan to
accept deposits.

On participation in profit and loss of the bank.

Free of interest or return in any form.
•
Thus in Pakistan, the bank evolved from full
financial intermediation, into an IFI that is
engaged in participatory intermediation

However, the business model of the bank, as
indeed reflected in Malaysian legislation, is still
required to reserve a percentage of liquid assets,
as referred to in Art.16 of the IBA (1983) and
Art.38 in BAFIA (1989), which refers to statutory
reserves required as per the Central Bank of
Malaysia Act (1958); this ratio is the deposit
multiplier inherent in fractional reserve banking
and thus, the basic function of a bank is dealing
with the commoditization, manufacture and
provision of money at a profit for the benefit of
it’s shareholders, and like any other company, it
is in the business of profit maximization.
Shariah Council
•
Under the IBA 1983, Islamic banks must set up
Shari’ah Advisory Boards (SAB), and ultimately
have to comply with the national Shari’ah
Advisory Council (SAC). Originally, the bank must
set up a Shari’ah advisory body (SAB).
•
In the articles of association of the bank
concerned, provision for the establishment of a
Syariah advisory body, as may be approved by
the Central Bank, to advise the bank on the
operations of its banking business in order to
ensure that they do not involve any element
which is not approved by the Religion of Islam.

Thus the SAB would ensure banking operations
conformed to Islam in Art. 3(5) b, but the IBA
was amended with effect from 1.1.2004, so that
the SAB would have to comply with the SAC upon
seeking its advice.

An Islamic bank may seek the advice of the
Syariah Advisory Council on Syariah matters
relating to its banking business and the Islamic
bank shall comply with the advice of the Syariah
Advisory Council.
Anti-Money Laundering and AntiTerrorism Financing Act

The Anti-Money Laundering and Anti-Terrorism
Financing Act (AMLA) was enacted in July 2001,
and came into force on 15th January 2002.

It involves financial intelligence, reporting and
investigation that may require suppression,
freezing and seizure of assets (including bank
accounts) of those engaged in money laundering
and terrorism.

The Financial Intelligence Unit (FIU) was
established on 8th August 2002 within Bank
Negara to perform the functions of AMLA.

The act provides for the FIU to collaborate with
any domestic regulatory, supervisory and
enforcement agencies in intelligence gathering,
analysis and dissemination.

The national money laundering programme
emphasizes on the funding of terrorists and thus
deemed to be abetting terrorism and liable for
prosecution under the Penal Code. Those
receiving funds also commit money-laundering
offences from dealing with proceeds from illegal
activities.

Banks typically should appoint a complianceofficer, to monitor and supervise all obligations
required under AMLA, including liaising with BNM
and the FIU.

Under AMLA activities are monitored in that any
transactions above RM 50,000 have to be
reported to BNM.

BNM has issued guidelines (BNM/GP9) on money
laundering and “Know Your Customer Policy” with
references to AMLA (2001).

Money laundering itself is changing the identity
of illegally obtained money into a legitimate
source. The key stage for the detection of money
laundering operations is where cash first enters
the banking system in the form of cash deposits.
There are three stages in the money laundering
Process:1. The placement stage
Whereby proceeds of illegal activities are
placed in a deposit account and purchase
travelers cheques, bankers cheques or demand
drafts.
2. The layering stage
Involves changing the structure of the funds,
and moving these funds from one bank to
another in order to conceal the source of
ownership through telegraphic transfer – this
separates the illicit proceeds from their source
by creating complex layers of financial
transactions designed to disguise the audit trail
and provide anonymity.
3. Integration stage
involves the funds re-entering the financial
system through the purchase of bonds, shares
and other investments, and thus turning the
criminally derived wealth into legitimate funds.

BNM as with other central banks have adopted
the Basel Committee on Banking Regulations and
Supervisory Practices’ “Know Your Customer
Policy.”

Customer identification – the bank must take the
effort to identify the customer when opening an
account or performing any other service.
•
Compliance with legislation and law enforcement
agencies – the bank must comply with all laws,
co-operate with enforcement authorities without
breaching
customer
confidentiality.
Record
keeping and system – the bank must maintain
proper record keeping and test for compliance.
•
Staff training – the bank must conduct on-going
education in procedures in order to recognize
and report money laundering.
•
Accordingly, banks should set up policies,
procedures and controls to combat money
laundering including; a statement of policies,
communicated to management and staff, relating
to money laundering which incorporates current
legislation

With regard to moving funds internationally by
telegraphic transfer as may be typically required
involving any illegal activities, this is typically
conducted via SWIFT, and post 9/11 some
intelligence services have now developed
programmes that can trace the transactional
history of movements of funds involving any
individual/institution using SWIFT services.
Islamic Banking Operations
•
An Islamic bank is a company whose main
objective is to earn profits. Profit is the difference
between revenues and costs.

To generate revenues, an Islamic bank sells
Shariah compliant financial products.

To do so, the bank must first acquire deposits.

All the above is only possible when the bank is
awarded a banking license by the monetary
authority.

To qualify for a license, the bank amongst others
must put up a minimum required capital to
support the deposit it acquires from the public.
•
It must have a sound business plan and credible
group of individuals to run the business.

An Islamic bank is usually set up as a joint-stock
company.

To raise capital, the bank the company issues
shares for sale to the public.
•
The bank’s management team who devise
business strategies usually consists of the
principle officers such as the chief executive
officer (CEO), the chief financial officer (CFO)
and the heads of the retail, corporate and risk
management departments to name a few.
•
Banks must be supervised and regulated since
they are using public’s money to generate
earnings for the shareholders.

Negligence as well as taking excessive risk will
lead to high bad debts and erodes deposits.

The shareholders are entitled to the bank’s net
profit. They are liable to losses up to face value
of their shareholdings. The limited liability
principle still holds for Islamic banking.

In conventional banking, deposits are mobilized
via the contract of debt.

It is a business that purely relies on leverage.
•
For this reason, the banking business is highly
regulated as depositors’ money must be
protected from depletion. When banks suffer
from high bad debts, failure to honor deposit
withdrawals will result in bank runs and
consequently credit squeeze and financial chaos.
•
Thus the deposit market is based on lending and
borrowing on interest.

In an Islamic bank, deposits are not mobilized
via the contract of debt with interest as this is
tantamount to riba

Instead, deposits are mobilized through safekeeping (wadiah yad dhamanah) and partnership
(mudarabah) contracts.
•
A wadiah dhamanah deposit is in essence a
transaction deposit that gives no contractual
returns.

However, there is capital protection on the
principle deposit.
•
A mudarabah deposit is an investment deposit,
thus it runs on the principle of “al-ghurm bil
ghonm” meaning that
“ with profit comes risk”…no risks no gain.

Accordingly, no capital protection is awarded to
the mudarabah investment while returns are
based on performance.
These contracts are in turn driven by the 3
principles of trading, namely

1) the principle of risk-taking (ghorm)

2) the principle of work and effort (kasb)
and

3) the principle of liability (daman).

Based on the Islamic bank’s simple balance sheet
and profit-loss statement it is now well
understood that the gross profit generated by an
Islamic bank is based on the principle of trading
(al-bay’).
•
Revenues are earned from the application of
murabaha, ijarah, salam and partnership
(shirkat) contracts while costs are payments or
profits paid to Islamic depositors.
How much profits an Islamic bank can make thus
depends on the four variables evident in the
profit equation, namely 1) rate of return on
financing (rF) 2) size of financing (F) 3) rate of
return on deposits (rD) and 4) size of deposits
(D).

(Revenues – Cost) = Profit

(rF x F) – (rD x D) = Profit
•
Rate of return on financing (rF): This is the
profit rate the bank uses to compute the selling
price of murabahah, bai-bithaman ajil and ijarah
thumma al-bay (AITAB). The rate is set based on
the riskiness of the facility given. The higher the
risk, the higher is the profit rate.
•
On the financing side, an Islamic bank does not make
loans to make profits.

Instead, financing is based on the principles of
trading (al-bay’).

Some trading contracts include murabahah and albai-bithaman ajil, ijarah, salam, istisna, mudarabah
and musharaka.

Current practices have shown the benchmarking of
profit rate based on interest rate.
•
Size of financing (F): This variable is usually
influenced by economic conditions. In a booming
economy, the level of income increases and so do
consumption and business spending.

Lower cost of funds may also raise the demand
for funds.
•
Deposit rate of return (rD): This is the profit rate
on investment deposits/ profit-sharing
investment account (PSIA).

If rF is low, so is rD and vice versa.

PSIA is a risky deposit, thus PSIA holders expect
to see higher rD than interest rate on fixed
deposits
•
rD is not contractual, and thus cannot be set upfront like interest rates. It is only known when
PSIA matures.

Size of deposit (D): Deposits are acquired from
households, business enterprises, corporations
as well as government agencies.
An Islamic bank can further improve
performance by reducing two expenditures,
namely:Overhead expenditures
 Provision for non-performing financing
 Provisions for Profit-Equalization Reserves
(PER)- the provision is taken from the gross
profit of financing operation before distribution.
•
New Product Approval Process
•
The precise approval process may vary from
bank to bank, but all products must be approved
by an IFI’s SSB and BOD, as well as BNM’s SAC,
with pre-approved products requiring 21 days for
approval by BNM.
 Have
a good day 
 May God Bless you
 Thank you & Wassalam