Islamic Banking: Doing Things Right and Doing Right Things

Malaysian Journal of Economic Studies

 by Rosly, Saiful Azhar


To do the right thing, the contract (‘aqad) method is usually employed to define Syariah legitimacy of Islamic banks. Equally important, the Islamic banking business is expected to operate on the moral principles of risk-taking (ghorm), work (kasb) and responsibility (daman). By doing so, the ethico-legal dimension of Islamic banking can be made evident. While claiming Syariah legitimacy, doing things right is critical where Islamic banks must compete on the basis of efficiency. In this way, factors affecting bank performance such as size of capital, scale economies and adverse selection must not be discounted in determining the success of the Islamic banking business.

1. Introduction

The globalisation and liberalisation of the financial sector are expected to result in greater participation in Malaysia of Arab Islamic banks, notably Al-Barakah, Al-Rajhi and Kuwait Finance House (KFH), and western banks such as Citibank, ABN-Amro and Hong Kong and Shanghai Banking Corporation (HSBC). Islamic banking in Malaysia began operations in 1983 and is set to command a 20 per cent market share by the year 2010. Currently, Islamic banking consists of two full-fledged Islamic banks and the Islamic banking system (IBS) banks. Although it only accounts for 11 per cent of the Malaysian market share, up from 2.5 per cent in 1997, it has grown at an average rate of 18 per cent per year, against the global growth rate of 15 per cent. The IBS banks are governed by the Banking and Financial Institution Act (BAFIA) 1992 while the two full-fledged Islamic banks are run under the Islamic Banking Act 1983.

More broadly, the Securities Commission has prepared guidelines on Syariah stock screening. About 80 per cent of the stocks traded in the Bursa Malaysia are Syariah compliant. Although not accepted globally, Malaysian Islamic bonds have a sizeable 50 per cent share of the Malaysian bond market. Sale-buyback (bay ‘al- ‘inah) and debt-trading (bay ‘al-dayn) contracts are widely used in the Islamic money market. These include the Khazanah bonds, Islamic accepted bills and inter-bank money Islamic negotiable instruments (INI).

The Islamic insurance (takaful) business is relatively new and commands about 5 per cent of the Malaysian insurance market. There is no window-based takaful. Takaful operations are run by four full-fledged takaful companies namely, Syarikat Takaful Malaysia, Takaful Nasional Malaysia, Mayban Takaful and Takaful Ikhlas. Unit trust management companies (UTMCs) are also making inroads into Islamic financial markets. Issuance of units is made by the UTMCs via the contract of agency (wakalah). As a wakil (representative) of unit holders, UTMCs charge nominal fees for the service rendered. There are more than 13 Islamic funds in the market with about 5 per cent market share. These funds are invested in Syariah compliant financial assets as approved by regulatory bodies such as the securities Commission and Bank Negara Malaysia. Some examples are the Syariah Index, equity and Islamic bond funds.

Islamic finance is a huge business today and represents more than USD200 billion in funds worldwide. Western investment banks including HSBC and Citibank have made significant inroads into the fee-based business in structured Islamic finance involving more than USD50 billion global sukuks. It has also elevated some Muslim jurists into extremely well-paid global Islamic finance advisors to approve new Islamic financial products such as Islamic hedge funds. To some extent they are becoming more aggressive in ensuring that Islamic finance matters in the global financial market, even though they may cause controversies and misinterpretation of Islamic law. Are they doing the right thing?

2. Modern Islamic Finance: The Contract (‘Aqad) Approach

The nature of Islamic finance today is largely fashioned by Islamic finance jurists who hold the authority in determining the Syariah value of financial products. Syariah status is given by virtue of contract validation. That is, a financial instrument that uses a contract deemed valid by Islamic finance jurists is usually granted Syariah compliant status.

Since the Holy Quran has condemned interest and enjoins profit creation via trading (bay”), the Islamic finance jurists have resorted to applying the explicit meaning of al-bay i.e. trading in determining the Syariah legitimacy of financial instruments. By trading, they usually make reference to sale of goods and services. For example, a contract of sale consists of the following pillars:

(i) Buyer and seller

(ii) Object of sale

(iii) Price

(iv) Offer and acceptance

A valid contract must ensure that each of the above pillars does not contain the following prohibitions:

(i) Interest as riba

(ii) Ambiguities (gharar)

(iii) Gambling (maisir)

(iv) Prohibited commodities such as liquor, pork etc.

As an example, both buyer and seller must be rational. The object of sale is a permissible property (mal-mutaqawim). The seller must also hold ownership before making the sale. Price must be determined on the spot. The offer and acceptance is made explicit by way of a written document or verbal statement. These requirements must be strictly observed to avoid ambiguities (gharar) in the contract. Some sale contracts become invalid (batif) if they are inclined to gambling such as selling fish in the water or determining price using stones or arrows. As long as the contracting parties have fully observed the legal requirements concerning their transaction, the contract of sale is deemed valid (sahih).

Government to Sell $500m in Sukuk

Indonesia may sell as much as $500 million in its first sale of global Islamic bonds, the central bank’s deputy governor, Hartadi Sarwono, said on Thursday in Singapore.

The government plans to sell the bonds this year, Dahlan Siamat, director of Islamic financing policy at the Finance

Ministry, said in a separate interview from Jakarta. Indonesia has more than $600 million in assets available to back the sale of Islamic bonds, Siamat said. The debt, known as sukuk , is typically backed by assets or cashflow because Islamic law bars payment of interest.

Indonesia last month raised $3 billion from the largest sale of conventional dollar debt by an emerging market so far this year. Debt sales and overseas loans will help the government finance its budget deficit.

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